Week 5-10 Flashcards
Acquisition
When one company takes over another company
Merger
Combination of two companies of similar size to form a new company
Operation synergies
When the value of the two combining firms is greater than the separate sum of their individual parts (Vab - (Va +Vb))
Financial bidder
Acquirer attracted to the takeover because of the potential return of selling the target in a few years
Strategic bidder
Acquirer attracted to the takeover due to the potential strategic fit of the two companies - improve operations
Motivations for M&A’s
Economies of scale
Economies of vertical integration
Market power
Diversification
Earning per share growth
Difference between strategic and financial bidders
Payment method
Motivations
Deal premium
The difference between the stand alone market value and the higher deal price
Tender offer
A public offer by one firm to directly buy the shares of another firm
Hostile bid
An offer directly to shareholders, which threatens to initiate a proxy fight to remove company directors unless they negotiate
Proxy fight
Attempt to gain control of the firm by supporting a sufficient number of shareholder votes to replace management
Efficient market hypothesis
An efficient capital market is one in which share prices immediately and fully reflect available information. No one can beat the market.
Implications of efficient capital management
Normal rate of return
Firm receives fair value
Assumptions of EMH (3)
Investors are rational
Independent deviations from rationality
Arbitrage
Weak form
Todays share price reflects all the data of past prices so investors cannot predict price fluctuations
Semi strong vs strong market efficiency
Semi strong incorporates public information and strong markets use all information and insiders cannot make abnormal return
Behavioural finance view on rationality (2)
Investors are not rational
Do not diversify
Behavioural finance view on independent deviations(2)
People draw conclusions from insufficient data
People are conservative and too slow to react
Behavioural finance view on arbitrage
Few professionals cannot offset many small investors
Evidence supporting behavioural finance view on market efficiency (4)
Earnings surprise
Size effect
Value versus growth effect
Bubbles
Net present value
The difference between the present value of cash inflows and the present value of cash outflows over a period of time
Cost of capital/required return
How much the firm must earn from an investment to compensate the investors for the use of capital to finance the project
Cost of equity
The return that equity investors require on their investment in the firm
Cost of debt
The return that lenders require on the firms debt
Dividend growth model
Cost of equity = (dividend in next period/current share price) + dividend growth rate
SML approach
Return on equity = risk free rate + systematic risk coefficient * (market risk premium)
Advantages/disadvantages of dividend growth model
Simplicity
But doesn’t account for risk
Growth rate unlikely to be constant
Advantages of SML (2)
Adjusts for risk
Applicable even when you don’t have steady dividend growth
Disadvantages of SML
Difficult to work out market risk premium and systematic risk
Difficult to predict the future
Systematic risk
Cannot be eliminated by diversifying
Weighted average cost of capital
The minimum return a firm needs to satisfy investors
WACC proper definition
The weighted average of the cost of equity and the after-tax cost of debt
Two approaches for expanding into new industry
SML - use beta coefficient for the new industry
Divisional cost of capital - calculate WACC for each division of a large corporation
Unlevered firm
Financed by only equity
MM proposition I (perfect market)
Value of levered firm = value of unlevered firm
Change in capital structure doesn’t change value of the firm
MM proposition II
Cost of equity for leveraged firm has a positive linear correlation with debt-equity ratio (more debt = higher Re)
Increasing debt in MM proposition II
Shareholders ask for more compensation for bearing higher risk - cost of equity increases
Why will WACC be unchanged if debt-equity ratio changes
Cost of debt will be offset by effect of the change in the cost of equity
Key assumptions to MM propositions (3)
Individuals can borrow as cheap as corporations
No taxes
No transaction costs
Tax and debt
The tax paid on interest rates on debt is tax deductible, so debt financing will result in higher market value
Debt-equity ratio and taxes
Firms can raise their total cash flow for substituting equity for debt
Debt = tax shield
Value of unlevered firm (taxes)
Cash flow/cost of capital
MM Proposition I (taxes)
Value of levered firm = value of unlevered firm + present value of tax shield
Dangers of debt
Bankruptcy costs - direct(legal/administrative)
Indirect - borrow money at high int rate
Cost of capital - debt - taxes
Issuing more debt will increase total cash flows and so lowers risk and cost of capital
How firms decide debt-equity ratio(3)
Taxes
Type of assets
Uncertainty of income
