Week 5-10 Flashcards by A P

Acquisition

When one company takes over another company

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Merger

Combination of two companies of similar size to form a new company

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Operation synergies

When the value of the two combining firms is greater than the separate sum of their individual parts (Vab - (Va +Vb))

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Financial bidder

Acquirer attracted to the takeover because of the potential return of selling the target in a few years

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Strategic bidder

Acquirer attracted to the takeover due to the potential strategic fit of the two companies - improve operations

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Motivations for M&A’s

Economies of scale
Economies of vertical integration
Market power
Diversification
Earning per share growth

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Difference between strategic and financial bidders

Payment method
Motivations

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Deal premium

The difference between the stand alone market value and the higher deal price

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Tender offer

A public offer by one firm to directly buy the shares of another firm

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Hostile bid

An offer directly to shareholders, which threatens to initiate a proxy fight to remove company directors unless they negotiate

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Proxy fight

Attempt to gain control of the firm by supporting a sufficient number of shareholder votes to replace management

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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.

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Implications of efficient capital management

Normal rate of return
Firm receives fair value

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Assumptions of EMH (3)

Investors are rational
Independent deviations from rationality
Arbitrage

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Weak form

Todays share price reflects all the data of past prices so investors cannot predict price fluctuations

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Semi strong vs strong market efficiency

Semi strong incorporates public information and strong markets use all information and insiders cannot make abnormal return

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Behavioural finance view on rationality (2)

Investors are not rational
Do not diversify

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Behavioural finance view on independent deviations(2)

People draw conclusions from insufficient data
People are conservative and too slow to react

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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