CORPORATE FINANCE. Fall 2018 Period I. Lecturer: Bunyamin (Ben) Onal

Transcription

1 CORPORATE FINANCE Fall 2018 Period I Lecturer: Bunyamin (Ben) Onal 1

2 Course objective Purpose of the course Provide a basic understanding of the financial decisions any business enterprise faces Key financial decisions: Investment decisions Capital budgeting M&As Financing decisions Capital structure Securities offerings Financial planning Working capital management Payout decisions Dividends, Stock repurchases 2

3 Why corporate finance? Most corporate finance textbooks are intended for publicly traded (large) corporations In financial theory, (public) financial markets have an important role in corporate decision making Most small firms do not operate on financial markets (i.e., not listed on stock exchanges and have no bond issues) However, the underlying principles generally apply to smaller firms too Financial markets have a less important role in e.g. financial planning, credit and cash management Theories related to these issues are directly applicable to smaller companies 3

4 What this course requires Good command of the material covered in the Introduction to Finance (Rahoituksen perusteet, 28A00110) course / Chapters 1-13 of Brealey-Myers-Allen textbook 12 th edition No additional math skills required Good work ethics Large sample evidence (own questionnaire, response rate 90%) Statistics on hours worked on this course: Mean: hours Median: hours Other same level courses with same number of credit units: Mean: hours Median: hours Small sample evidence (official questionnaire, response rate 10%) Amount of effort spent relative to 160 hours Much more effort: 28%; somewhat more effort: 48%; effort equals 160 hours: 16%; somewhat less effort: 8%; much less effort: 0% 4

5 Readings / class material Brealey-Myers-Allen, Principles of Corporate Finance, any of the 6 th to 12 th edition McGraw-Hill 12 th edition, chapters 14-19, 25, (students are required to be familiar with chapters 1-13) Lecture slides Guest lecture slides Exercises and case study Any other material posted on course webpage 5

6 Lectures: topic and material Topic Introduction: Overview of corporate finance How corporations issue securities Payout policy Capital structure Capital structure and valuation Leasing Financial planning Working capital management Mergers and acquisitions Textbook chapters Ch. 14 Ch. 15 Ch. 16 Ch. 17 Ch Ch. 25 Ch. 28 and 29 Ch. 30 Ch. 31 6

7 Lectures: topic and material Topic Guest lecture on IPOs (September 18 at 15:15) Guest lecture on M&As (October 16 at 13:15) Guest lecture on TBD (October 18 at 13:15) Textbook chapters / Other Material provided by Antti Niini, Goldman Sachs Material provided by Bain & Company Material provided by Danske Bank 7

8 Exercises/Case: Practicalities Exercises and case report can be done individually or in groups consisting of no more than three students Co-operation among groups or individuals belonging to different groups is prohibited Exercise/case reports are due at 13:15 (sharp!) on the due date provided in the syllabus: You can access your individual grades via mycourses 8

9 Accessing course material Textbook: Bookstores or library The graphs in the lecture notes where source is not mentioned are obtained from the course book check the sources there if you are interested Lecture notes, exercises and results: course web site Course home page can be accessed via the MyCourses portal: You need to log in to access exercises, lectures, grading and possible other materials Let me know if you do not have personal login for the network 9

10 Grade Part I. Exercises and case study: 50 points 4 Exercise sets; points are not evenly distributed Part II. Exam: 50 points Closed-book exam; one make-up exam True-False questions Numerical problems These problems may have verbal parts too Requirement for a passing grade: minimum 50% of the points on each part That is, you must score at least 25 points on the exam and, also, at least 25 points on exercises 10

11 Grade scale Total Points Final Grade (Fail)

12 Scholastic honesty and academic integrity We expect adherence to highest standards of scholastic honesty Examples of scholastic dishonesty are: sharing exercise answers between groups presenting answers as own work without proper citation to the sources (plagiarism) sharing answers during the final exam All classwork must be done by the students that return the work, co-operation in preparing answers to the exercises across groups (i.e., any individuals not belonging to the same group) is strictly prohibited 12

13 Scholastic honesty and academic integrity However, you are allowed to discuss the exercise problems with fellow students in general terms: the definition of terms and concepts in the questions, and what issues are central to a particular question. Every group should proceed on their own from there Failure to adhere to these guidelines is subject to disciplinary action, varying from receiving no points on the particular exercise or exam to complete removal from the course. Turning in class assignments is considered acknowledgement of these guidelines For more information, consult the section Academic Integrity and Handling Violations Thereof at Into for Aalto students 13

14 FAQs related to exam Do we need to memorize the formulas for the exam? A formula sheet will be attached to the exam so you will not need to memorize the provided formulas. If needed, additional inputs will be provided. Also, you do not need to memorize derivation of the formulas But you are expected to know how to use the formulas by heart, e.g., value of a right, WACC, etc. Do we need to memorize verbal concepts for the exam? You are expected to know the basic concepts by heart, e.g., winner s curse, pecking order theory, etc. But you do NOT need to know exact definitions or memorize long lists 14

15 FAQs related to exam Do I need to register separately for the exam? Not for the first exam. By registering for the course, you automatically registered for it For the makeup exam, yes! Via WebOodi as usual Exam registration on WebOodi closes always 7 days before the exam 15

16 FAQs related to course administration Why don't you post model answers to exercises on the web? Supply of high quality questions is limited Giving out model answers in electronic format would, in the long run, probably lead to a situation where there would be a full menu of model answers that could be applied without much thought to whatever question type we have in mind Learning experience, aggregated over all students, and taking into account future students, would probably not improve from what it is presently Answers to practice problems (which are old exam or exercise problems) are provided Questions related to group formation and management Disclaimer: Students have full responsibility in forming and managing groups based on course policy (i.e., maximum three members) 16

17 Logistical and contact information Lecture and exercise times and locations * Tuesdays 13:15-14:45 & 15:15-16:45 at Y203A Thursdays 13:15-14:45 & 15:15-16:45 at U157 * Exceptions: Only one session on the first day No sessions on Thursday, September 13 th Different classroom on October 9 th : Y205 Regular Office hours: Tue and Thu, 30 minutes between and following the sessions of the day. In addition, ask quick questions/make appointments by bunyamin.onal@aalto.fi 17

18 Course Feedback Course feedback will be collected online (via mycourses) Constructive comments are particularly helpful e.g. The course could use a case study, we need more demos or problem sets to practice Comments against the house rules will not make impact e.g., Exercise answers should be posted, exercises are too difficult compared to demo problems etc. Thank you for your cooperation! 18

19 Course messengers In addition, KY Finance has launched messenger students for selected Bachelor s level courses Two students will gather feedback from students during the course and provide it to the professors Corporate Finance is one of the selected courses Your comments and suggestions on the go are welcome 19

20 Quick detour: B.Sc. Thesis The seminar is going to be the most important and educational finance class you've taken so far Student comment This course can help you find a good research idea for your thesis. Some examples from previous years: Top-tier Investment Banks and Bidders Announcement Returns: Evidence from European Mergers and Acquisitions Environmental Value in Corporate Bond Prices: Evidence From Green Bonds How Corruption Affects Cash Holdings Role of Female Directors in Finnish Boardrooms Examination of Committee Memberships Start thinking about a thesis topic and research questions, feel free to discuss them with potential supervisors 20

21 Introduction Overview of corporate financing Chapter

22 Overview Sources of funds Internal External External financing Stages of external financing Principal forms of capital Debt financing Equity financing Venture capital Next lecture: public equity issues 22

23 Sources of funds for non-financial firms in the U.S. 23

24 Finnish corporate sector s internal-financing ratio 24

25 Life cycle of financing Firm size Public debt issues Public equity issues Bank loans, venture capital Own/family funds Amount of funds 25

26 Two principal forms of financing Equity securities Gives ultimate control rights, subject to debt covenants Provides residual cash flows Debt securities Provides fixed but privileged cash flow rights No control rights as long as the firm keeps its promises And there are hybrid securities E.g., Preferred equity Contain features of both equity and debt 26

27 Debt financing Different features: Private or public Short-term or long-term Fixed or floating rate Convertible or not Callable or not Senior, secured Country and currency Default risk On- or off-balance sheet 27

28 T/F Problem Keeping everything else constant, a company with more pricing power is more likely to issue floating-rate debt than a company with less pricing power True or False? True. A key factor affecting interest rates is inflation. A firm that sells floating-rate bonds is subject to greater inflation risk if it doesn t have the power to change its prices when inflation rate changes Companies with little or no pricing power should avoid floating-rate debt especially when there is greater uncertainty about future interest rates 28

29 Example: Apple s debt moves Apple borrowed $17 billion in the US bond markets in 2013 (first time ever since 1994) Despite sitting on $145 billion of cash ($100 billion abroad) at the time Issued to partly finance the promised $100 billion cash return to shareholders It included 3-year, 5-year, 10-year and 30-year fixed-rate bonds and 3- year and 5-year floating-rate notes 3-year floating rate bonds were sold at 5bp and 5-year ones for 25bp over the LIBOR Continued with selling first non-dollar bonds in 2014, including 8 and 12-year euro-denominated bonds worth 2.8bn at lowest ever yields for corporate bonds with those maturities 29

30 Apple was not alone Source: 30

31 Finnish non-financial corporations interest-bearing debt Note: MFI stands for Monetary Financial Institutions (mainly, commercial banks) 31

32 Role of venture capitalists What is venture capital and who are venture capitalists? Financial institutions, wealthy individual investors (business angels) and some large corporations (i.e., corporate VCs) What do venture capital firms do? Pool investors cash and invest it in new businesses Bring in managerial/sectoral expertise and contacts Provide these benefits at a high price (a large equity stake and say in decision-making) Venture capitalists expect to be able to make an exit to sell their stake in an IPO or buyout transaction within several years from their investment Most VC funds are limited partnerships and have a fixed life of 10 years 32

33 Venture capital payoff patterns Venture capitalists tend to invest in companies which have a chance of becoming highly successful Expect to be able to earn a very high return on their capital Venture capitalists tend to be selective in their investments E.g., Finnish venture capitalists tend to accept less than onetenth of the applications for capital Distribution of the outcome from a venture capital (VC) investment tends to be very skewed For every ten first-stage venture capital investments, only two or three may survive as successful businesses only one may pay off big 33

34 Venture capital payoff patterns Only 2 (30) out of 1000 randomly selected VC-backed companies become unicorns i.e., exit at $1bn+ ($100mn) valuation More than 70% fail Source: 34

35 Elements of venture capital VC investments tend to be made in several stages New ventures often have very large financing needs and major uncertainties There is significant information asymmetry (and related agency problems) between the founding owners and the venture capitalists It makes little sense to provide venture financing for a long period at any one time Venture capitalists tend to seek for board representation in the company they invest in Allows them to monitor their investment and to help in the strategic management of the company 35

36 Venture capital investments in the US 36

37 Some examples 37

38 Venture capital investments as % of country GDP in Europe 38

39 How corporations issue securities: Public offerings Chapter 15 39

40 Overview Public equity offerings: key concepts IPOs Motives for going public Short-term performance Underpricing and winner s curse hypothesis Timing Long-term performance SEOs Announcement effect Rights offer 40

41 Equity offerings: key concepts Three questions (1) Have the shares been listed before? In an initial public offering (IPO) the issuer sells its shares (on average about a third of the stocks outstanding) to the market for the first time In an seasoned equity offering (SEO) the share is already listed at the time of the issue (2) Who are the shares sold to? Rights offerings are targeted to current stockholders General cash offerings are targeted to the investing public in general (3) Who gets the money? In a primary offering the issuer issues new shares In a secondary offering the original owners sell their shares to investors 41

42 Why go public? 42

43 Example: Facebook s acquisition spree 43

44 Key (hidden) cost: IPO underpricing IPO firms and their original shareholders leave substantial amounts of money on the table Most IPO shares trade initially at substantial premiums relative to offer price Initial IPO return in Finland and the U.S. has been on average 15-20% These returns are typically realized during a short period of time (a few days or so) This initial return is frequently called the "underpricing" of IPOs IPOs by small and risky firms tend to be most underpriced 44

45 Examples: Money left on the table Source: Jay Ritter, 45

46 Average initial IPO returns ( ) Average first-day returns 60% 50% 40% 30% 20% 10% 0% Source: Jay Ritter, 46

47 Initial returns of recent Finnish IPOs Source: Nasdaq OMX 47

48 Winner s curse problem Starting point: informed and uninformed investors Information and underpricing in IPOs More demand for underpriced than overpriced IPOs (informed investors take part only in underpriced IPOs) Underpriced offers need to be rationed more than overpriced offers Uninformed investors participating in the market will get relatively more overpriced shares than underpriced Consequently, uninformed investors would always suffer losses and withdraw from the market, if IPOs were not underpriced on average 48

49 Winner s curse: simple example Two equally-likely offerings: Underpriced ( Hot ) - initial return: + 40% Overpriced ( Cold ) - initial return: - 30% You ask for 1000 shares of each with the offer price of 1 You are allocated 500 shares of hot IPO, 1000 shares of cold one With full-allocation, your initial euro return would be: 1000x40% x30% = 100 (or 5% of investment) Due to rationing in the hot IPO, your actual return is: 500x40% x30% = (or -6.67% of investment) 49

50 Demo 1 - Problem 2: Hot, normal and cold IPOs Suppose there are three equally frequent types of IPOs: hot, normal, and cold. Hot IPOs are oversubscribed 10 to 1 (there are ten subscriptions for each offered share) and have an initial return of 60%. Normal IPOs are oversubscribed 4 to 1 and return 10% initially. Cold IPOs are not oversubscribed and decline 10% in value initially. Assume that oversubscribed issues are allocated on pro rata basis. a) What is the average initial return in the IPO market? b) What average return can you expect if you start investing in IPOs, and cannot distinguish between the exact types? 50

51 Demo 1 - Problem 2: Hot, normal and cold IPOs a) What is the average initial return in the IPO market? Using simple (i.e., unadjusted) average: % % 1 3 (-10%) 20% 51

52 Demo 1 - Problem 2: Hot, normal and cold IPOs b) What average return can you expect if you start investing in IPOs, and cannot distinguish between the exact types? For every euro of subscription: % % 1 3 (-10%) 0.5% 52

53 Empirical Evidence on Winner s Curse (e.g., Keloharju, 1993) 53

54 How to reduce IPO underpricing? Under the winner s curse and alternative hypotheses, underpricing is driven by information asymmetry or castes between the participants in the IPO market Potential solution: reducing information asymmetries or preferential treatment among investors Book-building Investment bank obtains non-binding demand info (indications of interest) from investors before setting the final price Informed or favored investors obtain desired allocations of hot issues in return Auctions Offer price based directly on investor bids 54

55 Hot new-issue periods Equity offerings, particularly IPOs, tend to be clustered in hotissue periods, i.e., when stock prices are historically high: IPOs are timed to coincide with these periods leading to IPO waves Hot issue markets are often driven by issuers in a given industry The Economist (2011) 55

56 IPO volume in the U.S. In , an average of 310 firms went public every year In , an average of 111 firms went public every year Aggregate IPO proceeds in 2014: $ billion Source: Jay Ritter, 56

57 IPO volume in Europe Source: IPO Watch Europe Annual Review 2017, PWC 57

58 IPOs in Finland In Sweden, over 160 small growth companies have already got listed on the First North market since 2005; in Finland, only 6 have done so during the same period The only major difference between the two countries is taxation. Source: Economic Growth Through IPOs, NASDAQ OMX Helsinki, May

59 Long-term performance IPOs (and SEOs) tend to underperform similar firms in the long run, both in terms of operating performance and stock market performance The underperformance appears to last at least 3 years An investor would have to invest 44% more money in the IPO firms than non-issuers to have the same wealth five years after the offering. Source: Loughran and Ritter (Journal of Finance, 1995) 59

60 Long-run performance of IPOs in Finland 30% 20% 10% 0% -10% -20% -30% -40% -50% -60% Months in relation to date of IPO CAR Market Raw Source: Kulp (1995) 60

61 Facebook is an exception Source: Nasdaq.com 61

62 Facebook is an exception Source: Nasdaq.com 62

63 Seasoned Equity Offerings General cash offers As in IPOs, securities are sold to an underwriter who then offers them to the public Rights offers Targets existing shareholders Each stock has one subscription right A given number of subscription rights (N in the formula given later) gives the right to purchase one additional stock at a pre-specified price during a pre-specified time period Subscription rights can be traded separately for a prespecified time period 63

64 SEO announcement effect Announcement of seasoned equity offerings tend to lead to adverse price effects In the U.S., announcement of an SEO typically results in a 3-4% decline in the stock price This decline is economically important On average, the fall in the stock value is equivalent to about a third of the new money raised by the offering Why? Greater supply of stocks lower stock price? Not so much! Information revealed by the stock issue 64

65 SEOs in Europe Total money raised by FOs (i.e., SEOs) in 2014 increased by 19% from 120.1bn in 2013 to 143.2bn in % of FO proceeds was raised via primary offerings, where the companies themselves receive the money instead of shareholders selling down their positions. As in the previous year, 2014 primary proceeds have mainly been driven by funds being raised by European banks to recapitalize and strengthen their balance sheets due to more stringent capital requirements. Seven of the top ten FOs were by banks, raising over 27bn. This includes Deutsche Bank in Germany, Lloyds Banking Group in the UK, Monte dei Paschi in Italy and Eurobank Ergasias in Greece. Source: IPO Watch Europe 2015, PWC 65

66 Demo 1 T/F Problem Most financial economists attribute the drop in the price of equity subsequent to the announcement of a new issue to an increase in the supply of shares. True or False? False. Financial economists attribute the drop in the stock prices following SEO announcements largely to information effects. 66

67 Rights offers: numerical examples 1 for 11 at 22 1 for 5 1/2 at 11 Before issue # of shares held Share price (rights on) Value of holding After issue: # of new shares 1 2 Amount of new investment Total value of holding Total # of shares New share price (ex-rights) 286/12= /13=22 Value of a right = =2 67

68 Value of a right: Formal derivation Notation: Terms of offer: 68

69 Value of a right: Formal derivation Formula derivation: 69

70 Value of a right: Formal derivation Alternative formula: 70

71 Valuing subscription rights The value of each subscription right is as follows: Valueof a right Right-on pricesubscription price N 1 OR Value of a right Ex - right price Subscription price N Plugging the parameters of the previous example into the first formula, the value of the right is: (24-22)/(11+1) = 0.17 (1 for 11 at 22) (24-11)/(5.5+1) = 2.00 (1 for 5 1/2 at 11) 71

72 Demo 1 - Problem 3: Simpsonite rights issue Simpsonite has decided to raise 120 million in a rights issue. The market price of the company s 10 million shares is 80. Simpsonite is considering setting the subscription price at 60. a) Assuming the shares will be fully subscribed, how many rights will be required to purchase one share? b) What is the value of each right? c) What is the ex-rights share price? d) What is the value of each right if good news increases the stock price to 85 after the ex-rights day? 72

73 Demo 1 - Problem 3: Simpsonite rights issue a) Assuming the shares will be fully subscribed, how many rights will be required to purchase one share? If each existing share gets one right, then number of rights needed to buy one new share is: Total Proceeds 120m NNew_Shares 2 million P 60 Subscription 10 million 2 million 5 rights 73

74 Demo 1 - Problem 3: Simpsonite rights issue b) What is the value of each right? Value of a right P Cumright P N 1 Subscription

75 Demo 1 - Problem 3: Simpsonite rights issue c) What is the ex-rights price? The price falls by the value of the right. P Ex P right Cumright Value of a right

76 Demo 1 - Problem 3: Simpsonite rights issue d) What is the value of each right if good news increases the stock price to 85 after the ex-rights day? Valueof a right P Exright P N Subscription

77 Rights issue price is irrelevant IF... Subscription price for rights issues is irrelevant for the owners if all existing owners participate in the issue Easy to see that this holds in the previous example In both cases the amount of new investment and the value of the portfolio after the offering is the same, although terms of the two rights offers are very different In practice some subscription rights are sold to outsiders This matters if existing shareholders (i.e. the investors who sell their rights) have inside information If all rights are sold to outsiders, rights offers should have similar adverse selection effects as general cash offerings 77

78 Signaling with rights offers Rights offers may act as a signal of the management s intentions or expectations A lower offer price: May be a good signal implies a larger increase in the future dividends Companies tend to be reluctant to decrease the dividend per share But may also signal management s concern of offer failure at a higher price Evidence so far: It doesn t matter in the US and Norway, but produces a positive reaction in Italy 78

79 Direct costs of raising capital 79

80 Underwriting spreads 7% puzzle 80

81 Demo 1 - Problem 4: Avista s public offering Avista is about to go public by issuing 10 million shares at an offer price of 25 per share. The underwriter will charge a 7% underwriting fee. On the first day of trading Avista opens with a stock price of 28. a) What is the initial return of the offering? b) How much money does Avista raise? c) What is the total cost (direct and indirect) of the offering for Avista? 81

82 Demo 1 - Problem 4: Avista s public offering a) What is the initial return of the offering? Inital Return P P First _ Trading _ Day P Issue Issue % 82

83 Demo 1 - Problem 4: Avista s public offering b) How much money does Avista raise? Money Raised Proceeds P Issue N Underwriting New_Shares_Issued Cost Cost Underwriting Underwriting 2510m- 7% ( 2510m) 232.5m 83

84 Demo 1 - Problem 4: Avista s public offering c) What is the total cost (direct and indirect) of the offering for Avista? Underwriting fee is the direct cost Underpricing is the indirect cost Cost Underwriti ng 250m 7% 17.5m Cost Underpricing (P First_Trading_Day P Issue ) N New_Shares_Issued m 30m Cost Total 17.5m 30m 47.5m 84

85 Payout policy Chapter 16 85

86 Overview Dividends: key concepts Share repurchases Payout decisions in practice Time trends Survey evidence Do dividends (or payout decisions) matter? Three opposing views: Center Dividends are irrelevant Rightists Dividends are valuable Leftists Tax considerations Dividends and taxes in Finland 86

87 Dividends: important concepts Dividend per share = Total dividends/number of shares Dividend yield = Dividend per share / Stock price Dividend payout ratio = Dividend per share / Earnings per share Timeline of a dividend event Announcement date = Board s decision for dividend per share is announced Ex-dividend date = First day on which the stock trades without the dividend; 1-2 business days before record date Record date = Date by which a shareholder must officially own shares in order to be entitled to a dividend Date of payment 87

88 Exxon Mobil s dividend Close on Feb 7: $86.34 Open on Feb 8: $

89 How firms repurchase stock i. Open market repurchases (most common), with restriction such as it cannot exceed a fraction of daily trading volume Typically 25%. But 50% in Finland since its stock exchange has limited liquidity ii. Tender offer: Offer to buy back at a premium (about 20%). Shareholders decide whether to accept the offer or not iii. Dutch auction: 1. Series of prices at which the firm is prepared to buy back 2. Shareholders declare how many they are willing to sell at each price 3. Firm chooses lowest price at which it can buy the desired number of shares iv. Negotiation with a major shareholder 89

90 Dividends and repurchases in U.S. 90

91 Dividends and repurchases in Europe Figure: Dividend payouts and share repurchases by Stoxx 600 companies Source: Bloomberg, S&P, Gutmann KAG 91

92 Dividends vs. Repurchases in Europe 92

93 Dividend decision in practice 93

94 Example: UPS Source: 94

95 Example: UPS Source: 95

96 Share repurchase decision A 2004 survey of financial executives asked them to state the importance of different factors to the repurchase decision. Our stock is undervalued Lack of good investment opportunities Mergers and acquisitions strategy Stability of future earnings A sustainable change in earnings Having surplus liquid assets The influence of institutional shareholders Executives who stated factor was important or very important Source: a. Brav, J.R. Graham, C.R. Harvey, and R. Michaely, "Payout Policy in the 21st Century," Journal of Financial Economics 77 (September 3005), pp

97 Recent debate: Repurchase revolution or bubble? Today no chief executive can ignore buybacks. They are an idea that has conquered the world However, among fund managers and some executives, there is little doubt that the pressure to boost cash returns can contribute to low investment. Simon Henry, the finance chief of Shell,, The longevity of the firm is what matters...executives need to hold their nerve against short-term pressure so that they can invest for the long run there are signs that buy-back boom is peaking There are even signs that investing may be back in fashion. Exxon, the biggest spender on buybacks thus far, has recently tempered them in favor of longterm projects Source: 97

98 Demo 1 T/F Problem When companies with outstanding businesses and comfortable financial positions find their shares selling far below their intrinsic value in the market place, no alternative action can benefit (all) shareholders as surely as repurchases. (Repurchase Revolution, Economist, September, 2014) True or False? 98

99 Demo 1 T/F Problem False. Next paragraph: Sadly, this is a delusion. If a firm buys its stock at a price that, with the benefit of hindsight, is low, it transfers wealth from the shareholders, who sold too cheaply, to its continuing owners. It does not enhance shareholder value overall. Managers duty is, of course, to all shareholders. (Repurchase Revolution, Economist, September, 2014) 99

100 Does payout policy matter? Three schools of thought: Middle-of-the-roaders Miller and Modigliani (1961) Payout decision is value-irrelevant and should just be a by-product of profitability and (positive-npv) investments, keeping financing policy fixed Leftists Dividends are wrong because capital gains are historically taxed at lower rates than dividends Rightists Dividends are preferred by certain investors and discipline management 100

101 Does payout policy matter? Payout decision may be flip side of an investment decision or a financing decision Pay out cash or set it aside for investment Pay out cash and borrow or use the cash to finance investments To understand payout decisions, we must think of them independently from investment and borrowing decisions Miller-Modigliani irrelevancy theorem 101

102 Dividend irrelevancy theorem Miller-Modigliani (1961) Useful starting point for analysis of dividend policy Assume: No taxes, transaction costs or other imperfections A fixed capital investment program A financing policy in which borrowing is set Remaining needed funds come from retained earnings, and extra cash is paid as dividends Capital markets are efficient and transactions take place at fair prices No information asymmetry and signaling 102

103 Dividend irrelevancy theorem Given the assumptions, if a firm wants to increase its dividends it needs to finance it with an equity issue Consequently, each share is worth less because more shares have to be issued against the firm s assets In an efficient market, the decrease in share price is exactly worth the dividend per share Dividend policy is irrelevant! Firms should let dividends be a by-product of their investment and financing decisions 103

104 Dividend irrelevancy: example Suppose your company has a market capitalization of 10 million (1 million shares at 10 each); no debt; 1 million surplus cash. Current dividend policy: Pay the 1 surplus cash per share on 1 million shares outstanding Ex-dividend price: 9; and market cap = 9 million Change of plans: Increase dividend payout to 2 a share Ex-dividend price: 8 104

105 Dividend irrelevancy: example Borrowing and investments are fixed! The extra 1 million must come from selling new shares: Sell 1 million/ 8= 125,000 new shares After the issue: million shares outstanding Market cap still 9 million but share price = 8 Old stockholders wealth per share with old and new policy: 9 share price + 1 dividend = 8 share price + 2 dividend Dividends are value irrelevant! Firm value with old and new dividend policy = 9 million 105

106 Dividend irrelevancy theorem 106

107 Home-made dividends Underlying idea behind dividend irrelevancy theorem can also be understood by the concept home made dividends Investors can do or undo at no cost anything the firm can do Example Investors who want more cash income than the company distributes as dividends can sell some of their shares at market prices Investors will not be willing to pay anything for something they can do themselves at a zero cost 107

108 Irrelevance of repurchases Dividend irrelevancy argument also applies to share repurchases In a perfect market, shares will be repurchased at the market price stock price will not be affected In the Miller-Modigliani world, dividends and repurchases can be viewed as substitutes to each other Only difference between dividends and repurchases When paying dividends, the stock price after the dividend payment will be less than in the case of repurchase This difference will be compensated by the dividend 108

109 Dividends vs. repurchases: example Suppose again: 10 million market cap (1 million shares at 10 each); no debt; 1 million surplus cash Payout decision 1: Pay dividend of 1 million Dividend per share: 1 Stock price on ex-dividend date: ( 10mn- 1mn)/1mn = 9 Payout decision 2: Repurchase 100,000 shares at 10 Equivalent to the dividend payout Share price: ( 10mn- 1mn)/(1mn-0.1mn) = 10 Summa summarum for shareholders: Decision 1: 9 + 1; Decision 2:

110 Middle of the roaders : Dividends are irrelevant A company s value is not affected by its dividend policy Doesn t mean payout decisions are random, they should be based on the life cycle of the firm Young, growth companies retain and reinvest all earnings to maximize the cash for investments in positive-npv projects Maturing, profitable companies see positive-npv investments disappear over time and are left with excess cash that enable large payouts Fixing debt policy, payout decisions are by-product of investments and profitability 110

111 Life cycle of the firm: Apple s cash holdings They have a ridiculous amount of cash There is no feasible acquisition that Apple could do that would need that much cash Douglas Skinner, Chicago Booth School of Business On March 19, 2012, Apple announced it would pay a quarterly dividend of $2.65 per share and spend 10 billion for share buybacks. 111

112 Demo 1 - Problem 5: Dynasty s payout policy Dynasty is an all-equity financed firm with 100 million shares outstanding. It announced an annual 3 dividend per share and its stock will go ex-dividend tomorrow. Further, this dividend is expected to grow by 5% annually. Dynasty s shares have a beta of 2. The risk free interest rate is 4%. The market index is expected to return 8% annually. a) What is Dynasty s current share price? b) What will Dynasty s ex-dividend share price be? Suppose Dynasty, instead of paying a dividend, uses the 300 million to repurchase shares. c) What is the share price after the repurchase? d) What action can an investor who would have preferred the dividend payment to a share repurchase take? 112

113 Demo 1 - Problem 5: Dynasty s payout policy a) What is Dynasty s current share price? Share Price (Gordon growth model): P 0 D r g 1 Cost of Capital (CAPM): E( r i) rf E( rm) rf i r e 4% 2(8% - 4%) 12% P 3(1 5%) 12% - 5% 0_ ExDividend 45 P0 _ cum P0 _ ExDividend D

114 Demo 1 - Problem 5: Dynasty s payout policy b) What will Dynasty s ex-dividend share price be? 48-3 =

115 Demo 1 - Problem 5: Dynasty s payout policy Suppose Dynasty, instead of paying a dividend, uses the 300 million to repurchase shares. c) What is the share price after the repurchase? The share price will not change: P after V N after after 100m m 300m 100m

116 Demo 1 - Problem 5: Dynasty s payout policy d) What action can an investor who would have preferred the dividend payment to a share repurchase take? If Dynasty paid dividend, an investor who owns 100 shares would have received 300 of dividends. Her shareholding before the payout is 100x 48= So, she can receive the same amount by just selling a number of shares to the firm: a * 48= 300 a= 300/ 48=6.25 (i.e., 6.25% of her shares) This is true for all shareholders. All they have to do is sell 6.25% of their shareholding to obtain an equivalent home-made dividend. 116

117 Right-Wing : Dividends are valuable In practice, firms do not behave as if dividends are irrelevant E.g., Dividend smoothing Natural clientele of investors that prefer regular, stable cash dividends Legally restricted financial institutions, older individual investors Does supply of dividend paying firms meet demand? If so, no need to change dividend policy (middle-of-the-roaders win) Management can use dividend policy to signal their private information about the future prospects of the company Dividend increases send good news about cash flows and earnings Dividend cuts or omissions send bad news 117

118 Right-Wing : Dividends are useful Most convincing: Commitment to dividends can act as a disciplinary mechanism Investors demand high dividends because they do not fully trust the managers with free cash flow If not paid out, surplus cash can be used for empire-building or excessive executive pay and perk consumption (or both) Dividends can also force managers to raise additional financing from capital markets which comes with external forces of discipline 118

119 Left-wing : Dividends and taxes If dividends are taxed relatively more than capital gains, companies should distribute a relatively smaller fraction of their profits as dividends and a relatively larger fraction as repurchases Example: What is the current price of two identical firms, except that one pays dividend (firm B) while the other pays no dividend (firm A)? Suppose that the tax rate on capital gains is zero and the tax rate on dividends is 30% for all investors Assume a discount rate of 10% a year 119

120 Left-wing : Dividends and taxes Firm A Firm B (No dividend) (High dividend) Next year's price Dividend 0 10 Total pretax payoff Today's stock price P A = 100 P B =? Capital gain P B Taxes 0 3 After-tax gain (100 - P B ) 120

121 Left-wing : Dividends and taxes We find the equilibrium level of P B by equating the after-tax rates of returns on the two firms 10/100 = [7 + (100 P B )] / P B P B = 107 / 1.1 = P B is less than P A (= 100) More generally, whenever the tax rate on dividends is higher than the tax rate on capital gains, P B would be less than P A 121

122 Postponing capital gains tax In the US, the difference in tax rates for dividends and capital gains has disappeared since 2003 But, unlike dividend tax, capital gains tax can be postponed Assume: An investor s stock portfolio includes several stocks with capital gains and losses on paper Investor wants to sell stocks with paper gains Solution: Sell also stocks with losses on paper Use realized losses to offset capital gains in personal taxation Repurchase these stocks (or similar stocks) at a price lower than original purchase price, possibly after a delay 122

123 Dividends and taxes in Finland In Finland, corporate taxation is linked to financial reporting Corporate tax is paid from reported earnings before tax In practice, companies can delay paying corporate taxes by managing earnings downward, BUT Companies cannot pay dividends without reporting profits Current corporate tax rate in Finland is 20% Capital income interest income, capital gains, and dividends is taxed using a 30% rate (32% for income above 40,000) However, only 85% of dividend income from publicly listed companies is considered taxable in personal taxation Some investor categories, such as foundations and pension funds, are not subject to taxation 123

124 Dividends and taxes in Finland Both capital gains and dividends are double taxed First at the company level at the corporate tax rate Second at the investor level at the capital income tax rate Foreign investors are subject to the tax laws of their home country 124

125 Demo 1 - Problem 6: East Oil s payout policy East Oil will pay constant dividend of 2 per share annually in perpetuity. Assume all investors pay a 20% tax on dividends and that there is no capital gains tax. Investors in East Oil s shares require an after tax return of 12 %. a) What is the share price of East Oil? b) Assume that management makes a surprise announcement that East Oil will no longer pay dividends, but will use cash to repurchase stock instead. What is the price of a share now? 125

126 Demo 1 - Problem 6: East Oil s payout policy a) What is the share price of East Oil? Share price (perpetuity valuation): D1 P0 r 2 (1-20%)

127 Demo 1 - Problem 6: East Oil s payout policy b) Assume that management makes a surprise announcement that East Oil will no longer pay dividends but will use the cash to repurchase stock instead. What is the price of a share of now? Because there is no capital gains tax, each year the after-tax cash flow to shareholders is 2 per share =

128 Empirical evidence The empirical evidence of which of these views (leftist, rightist, or middle-of-the-roader) is most correct seems ambiguous There is some truth to all 128

129 Week 1 - Recap: Corporate financing Sources of financing Internal funds Pros and cons of internal financing External funds Debt vs. equity issues: Cash flow & control rights Raising external funds Venture capitalists Who are they? How are they different from other investors? Public equity offerings: IPOs (motivation, underpricing, long-term underperformance etc.) SEOs: General cash offerings & rights offerings 129

130 Week 1 - Recap: Payout Policy Two decisions: Amount and form of payout Dividends vs share repurchases Time trends in payout policy: Increasing popularity of repurchases (revolution or bubble?) Payout in practice (survey results): Dividend smoothing and stickiness; repurchase undervalued stock Does payout policy matter? Basic theories: Dividend/repurchase irrelevance, life cycle Three schools of thought: Rightists: Dividends/repurchases are valuable as a signal Leftists: Dividends hurt value (due to higher taxation) Middle-of-the-roaders: Payout policy is a no-brainer 130

131 Capital structure and valuation Part 1 Chapter

132 Overview Part 1 Debt ratios across time, countries and industries Irrelevance of capital structure Modigliani-Miller (MM) Proposition 1: Value of a business is independent of its financing decisions How financial leverage affects returns MM Proposition 2: Expected return on common stock increases in proportion to financial leverage How financial leverage affects risk Higher financial leverage means higher risk faced by shareholders 132

133 Debt ratios in the US 133

134 Average Debt Ratios in Europe 134

135 Debt ratios across industries 135

136 MM on Capital structure Modigliani-Miller (1958) Assume: (1) Markets are perfect (2) No taxes (3) Symmetric information (4) Firms future cash flows are independent of capital structure Given these assumptions, the market value of a firm is independent of its capital structure (= mix of debt and equity) Intuition: If (1)-(4) hold, an investor can do or undo whatever the firm does Home-made leverage 136

137 Irrelevance of capital structure: example Consider two firms which generate identical streams of operating income: Firm U: Unlevered. Value of equity (E U ) = Value of firm (V U ) Firm L: Levered. Value of equity (E L ) = V L -D L (value of debt) (a) Consider a 10% investment in Firm U: Investment 0.1 V U Return 0.1 Profit (b) Consider a 10% investment in debt and equity of Firm L: Investment 0.1 (D L + E L ) = 0.1 V L Return 0.1 Interest (Profit - Interest) = 0.1 Profit Since portfolios (a) and (b) have the same payoff, they must have the same equilibrium price: V U =V L 137

138 Unlevered Levered E U E L D L 10% 10% 10% 138

139 Irrelevance of capital structure: example Example continues: (a) Consider a 10% investment in Firm L s equity: Investment 0.1 E L = 0.1 (V L -D L ) Return 0.1 (Profit - Interest) (b) Purchase 10% of Firm U and borrow 10% of D L : Investment 0.1 V U D L = 0.1 (V U -D L ) Return 0.1 Profit Interest = 0.1 (Profit - Interest) Again (a) and (b) have the same payoff and must have the same price: V U =V L Here (b) is an example of home-made leverage 139

140 Unlevered Levered E U E L D L 10% 10% Borrow debt in the amount of 10% of D L 140

141 How leverage affects returns: example Assume an unlevered firm with: 1000 shares outstanding Price $10 per share Expected earnings $1500 per year, to be paid out as dividends Expected return: $1.50 per share / $10 per share = 15% Now, suppose that: The firm issues $5000 worth of debt at 10% interest Uses the proceeds to buy back 500 shares 141

142 How leverage affects returns: example MM proposition says the value of the firm is unchanged, i.e. $10,000 Since value of debt = $5000, value of equity must be $5000 and price per share = $10 as before BUT! With leverage: Expected earnings $ Interest $500 = Dividends $1000 Dividend per share = $2 per share. Expected return = $2/$10 = 20% > 15%! 142

143 Earnings and return: all equity financing 143

144 Earnings and return: 50% debt financing 144

145 Borrowing and EPS 145

146 Individual investors can replicate leverage Investor borrows $10 at 10% and buys another share of the unlevered firm Expected return is the same V U =V L! 146

147 M-M Proposition I MM Proposition I: The market value of any firm is independent of its capital structure Leverage increases expected EPS but not the share price Increase in expected EPS is exactly offset by increase in the rate at which earnings are discounted MM Proposition II explains how 147

148 How leverage affects returns No-tax weighted average cost of capital (r A, WACC) is as follows: WACC r A D D E r D E D E r E where r D and r E refer to cost of debt and equity, respectively 148

149 How leverage affects returns Re-arranging the equation yields: r E r A D E ( r r ) D A As D/E increases, r E increases Why? What happens to risk of shareholders? A D D E D E D E E where A, D, and E refer to the betas of the firm s assets, debt, and equity, respectively 149

150 How leverage affects returns: riskless debt 0.16 Required rate of return D/E ra rd re 150

151 How leverage affects returns: risky debt 0.12 Required rate of return D/E ra rd re 151

152 How leverage affects returns Re-arranging the equation yields: r E r A D E ( r r ). D A As D/E increases, r E increases Why? What happens to risk of shareholders? A D D E D E D E E where A, D, and E refer to the betas of the firm s assets, debt, and equity, respectively 152

153 How leverage affects returns Rearranging yields: E A D E ( ). D A As D/E increases, E increases Raising D/E is analogous to borrowing to buy the stock Q: Why does the expected return on equity go up from 15% to 20%? A: Because the stock is more risky 153

154 How leverage affects returns: example Example revisited: Suppose actual earnings = $500 Unlevered firm: Return = $0.5/$10 = 5% Return is 15% - 5% = 10 percentage points below expected Levered firm: Return = 0/$10 = 0% Return is 20% - 0% = 20 percentage points below expected The equity beta of the levered firm is twice the equity beta of the unlevered firm (assuming riskless debt) 154

155 How leverage affects risk Beta BetaA BetaD BetaE D/E 155

156 M-M Proposition II M-M Proposition II: The expected rate of return on the share of a levered firm increases in proportion to the debt-equity ratio Any increase in expected return is exactly offset by an increase in risk, and therefore shareholders required rate of return 156

157 Demo 2 - Problem 2: Globocorp debt issue Globocorp is an all-equity financed firm and its stock has a beta of 1. The stock is priced to offer a 10% expected return. The company decides to repurchase half of the common stock and substitute an equal value of debt. Assume that the debt yields a risk-free return of 5%. a) Calculate The beta of the debt. The beta of the common stock after the refinancing. The beta of the company after the refinancing. b) Calculate Investors required return on the common stock before refinancing. The required return on the common stock after the refinancing. The required return on the debt. The required return on the company after the refinancing. 157

158 a) Calculate the Betas. The beta of the debt. Demo 2 - Problem 2: Globocorp debt issue Debt is risk-free: D 0 (by definition) Using CAPM: r r r r r D D r f f D m f D 0 158

159 Demo 2 - Problem 2: Globocorp debt issue a) Calculate the Betas. The beta of the common stock after the refinancing. Weighted average: Before: A _ Before 1 After: A _ After A _ Before D D E V 1 0 * E _ 2 E _ After After E V 1 * 2 _ After

160 Demo 2 - Problem 2: Globocorp debt issue a) Calculate the Betas. The beta of the company after the refinancing. Risk of the assets is unaffected. Therefore, beta of the company remains the same: A _ After 1 160

161 Demo 2 - Problem 2: Globocorp debt issue b) Calculate Investors required return on the common stock before refinancing. It is given: r E r _ Before A _ Before 10% All equity financed before refinancing. 161

162 Demo 2 - Problem 2: Globocorp debt issue b) Calculate The required return on the common stock after the refinancing. Using WACC: r E _ After r A D E r r 10% 10% 5% 1 15% A D Alternatively, using CAPM: r r E _ After E _ After r f E _ After 5% 2 (10% 5%) r m r f 15% Question: Why is r m =10% here? 162

163 Demo 2 - Problem 2: Globocorp debt issue b) Calculate The required return on the debt. Again, debt is risk-free: r D r f 5% The required return on the company after the refinancing. Same as before: r A _ After 10% 163

164 Demo 2 - Problem 3: Microtech bond yield Microtech operates in the M&M world without taxes. Its shares have a beta of 1.7, the company s WACC is 11% and the expected return on its bonds is 7% (debt is risky). The risk-free rate of return is 6.5%, and the market portfolio has an expected return of 11.5%. a) What is the company s D/E ratio? b) Suppose Microtech issues debt to buy back half of its shares. The beta of Microtech s stock increases to 2.4 following the restructuring, what is the new expected return on the company s bonds? 164

165 a) What is the company s D/E ratio? In the WACC formula, don t know E/V & r E! Use CAPM for r E : r E Demo 2 - Problem 3: Microtech bond yield r f E r r 6.5% % 6.5% 15% m f Now, solve for E/V: E E ra re rd 1 11% V V E V r r A E E D r r 1 D D 11% 15% 7% 7%

166 Demo 2 - Problem 3: Microtech bond yield b) Suppose Microtech issues debt to buy back half of its shares. If the beta of Microtech s stock increases to 2.4 following the restructuring, what is the new expected return on the company s bonds? After refinancing: E V 1 4 ; D V 3 4 Find r E_After using CAPM: r E _ After r f E r r 6.5% % 6.5% 18.5% m f Now, using WACC: r A r E _ After E V r D D V 11% r D r A E V r D V E _ After 1 11% 18.5% % 166

167 b) (Continued) Alternative solution: Find A using CAPM, then from weighted-average-of-betas formula obtain D, finally using CAPM again find r D : CAPM: Weighted: CAPM: r r A D r A r f f Demo 2 - Problem 3: Microtech bond yield E A D E V r m r D1 11% 1 11% 6.5% % 6.5% r r 6.5% 0.4 (11.5% 6.5%) 8.5% m f f E V A D r r A m A r r f f E V E V E

168 Demo 2 - Problem 4: High End Costume EPS and P/E ratio High End Costume is all-equity financed and its stock has a price to earnings ratio of 15. The company is considering a capital restructuring by substituting a third of the common stock with an equal value of debt. The debt is issued at a riskfree return of 6%. Assuming that the operating profit remains constant, calculate the following: a) The percentage increase in earnings per share following the restructuring b) The new P/E ratio 168

169 Demo 2 - Problem 4: High End Costume EPS and P/E ratio a) The percentage increase in earnings per share? Earnings After = Earnings Before Interest Interest = Debt x Interest rate (6%) Debt = 1/3 of Firm Value (= Equity value before restructuring) V Before P N 15EPS N 15 Earnings Before Before Before Before Before D 15 EarningsBefore EarningsBefore 1 1 VBefore Interest D r 5 Earnings 6% 30% Earnings D Before Before 169

170 Demo 2 - Problem 4: High End Costume EPS and P/E ratio a) (Continued) Earnings After Earnings Before Interest Earnings Before 30% Earnings Before 70% Earnings Before Earnings 70% EPS After Before Before EPS After N 1 After (1 N Before ) 3 N EPS Before EPS After EPS EPS Before Before 1.05EPS Before EPS Before EPS Before 5% 170

171 Demo 2 - Problem 4: High End Costume EPS and P/E ratio a) Before and after comparison: Before After P/E 15 P 15*EPS 15*EPS V P*N=15*EPS*N 15*EPS*N D 0 (1/3)V= 5*EPS*N Interest on D 0 6%D=0.3*EPS*N Earnings EPS*N 0.7*EPS*N EPS EPS (0.7*EPS*N) / (1-1/3)N --> 1.05*EPS! 171

172 Demo 2 - Problem 4: High End Costume EPS and P/E ratio a) (Continued) Shorter alternative using MM proposition II: r a = Operating Income/MV of Assets = EPS Before /Stock Price = 1/15 (or 6.667%) r e_after = r a + (r a -r d )D/E = 6.667% + (6.667% - 6%)1/2 = 7% r e_after = EPS After /Stock Price EPS After = 7% x Stock Price EPS Before was 6.667% x Stock Price EPS After is 1.05 times EPS Before 172

173 b) The new P/E ratio? Demo 2 - Problem 4: High End Costume EPS and P/E ratio The share price after the restructuring stays the same. P E After P EPS After After P EPS Before After 15 EPS 1.05 EPS Before Before

174 Demo 2 - Problem 4: High End Costume EPS and P/E ratio b) The new P/E ratio on the table Before After P/E 15 15*EPS /1.05*EPS --> P 15*EPS 15*EPS V P*N=15*EPS*N 15*EPS*N D 0 (1/3)V= 5*EPS*N Interest on D 0 6%D=0.3*EPS*N Earnings EPS*N 0.7*EPS*N EPS EPS (0.7*EPS*N) / (1-1/3)N --> 1.05*EPS! 174

175 Capital structure and valuation Part 2 Chapters 18 &

176 Overview Capital structure theories Trade-off theory Tax benefit of debt Disciplinary benefit of debt Financial distress costs Agency costs of debt Pecking order theory Debt policy in practice Valuation Adjusted discount rate method Adjusted present value method 176

177 Corporate income tax rates around the world United States down from 35% before 12/31/ % France 34% Germany 30% Sweden Switzerland Estonia United Kingdom Finland 22% 21% 20% 20% 20% Ireland 13% Source: OECD & KPMG 0% 5% 10% 15% 20% 25% 30% 35% 40% Tax rate, % 177

178 Corporate taxes and capital structure: example Unlevered Levered EBIT Interest (5% on 1000) 0 50 EBT Corporate tax (20%) CF to shareholders CF to debt holders 0 50 CF to share- and debt-holders Interest tax shield (= 20% x Interest)

179 Unlevered + Gov t Levered + Gov t CF to E U =800 CF to E L =760 CF to G U =200 CF to G L =190 Interest L =50 179

180 Corporate taxes and capital structure Interest tax shield = tax savings resulting from deductibility of interest payments Assume that 1000 debt is permanent PV of stream of interest tax shields = 10/0.05 = 200 (i.e., 20% of 1000) PV of interest tax shield assuming fixed, perpetual debt = [(Debt Interest(%)] Tax(%) / Interest(%) = Debt Tax(%) V L = V U + t c Debt If we incorporate only corporate taxes into the MM model, optimal capital structure should be 100% debt?! 180

181 Corporate and personal taxes and capital structure: example Unlevered Levered EBIT Interest (5% on 1000) 0 50 EBT Corporate tax (20%) CF to shareholders before personal taxes CF to shareholders after personal taxes (30%) CF to debt holders before personal taxes 0 50 CF to debt holders after personal taxes (30%) 0 35 CF to share- and debt-holders after personal taxes Value of tax shield

182 Corporate and personal taxes and capital structure 182

183 Relative advantage formula 1T p 1T pe 1T c The relative advantage formula shows the effect of considering personal taxes If (1 T P )/[(1 T PE ) (1 T C )] >1 debt is preferred If (1 T P )/[(1 T PE ) (1 T C )] <1 equity is preferred The relative advantage of debt depends on the differential personal tax rate 183

184 Corporate and personal taxes and capital structure Unlevered firm: Cash flow = CF U = EBIT (1-T c )(1-T pe ) Levered firm: CF L = (EBIT-r D D)(1-T c )(1-T pe )+r D D(1- T pi ) = EBIT (1-T c )(1-T pe ) + [(1-T pi )-(1-T c )(1- T pe )]r D D = Cash flow of unlevered firm + Net Tax Effect of Debt If (1-T pi ) = (1-T c )(1-T pe ) CF U = CF L and capital structure does not matter If (1-T pi ) > (1-T c )(1- T pe ) Leverage increases the value of the firm 184

185 Leverage clienteles and optimal capital structure If (1-T pi ) = (1-T c )(1- T pe ), capital structure does not matter Suppose now: T pe = 0 (defer capital gains until death) Then, capital structure does not matter if T pi = T c Variation in leverage ratios across firms and in marginal tax rates among investors gives also rise to leverage clienteles Some investors prefer levered firms for tax reasons, others prefer unlevered firms 185

186 Debt as a disciplining mechanism Recall: High payout ratio is demanded by investors if the firm has the free cash flow problem (i.e., cash in excess of valuable investments) Dividends are sticky but not guaranteed. Repurchases can be avoided at no cost Managers sitting on ample cash have the temptation to be sloppy, be too generous to themselves in compensation and perks, and make ill-advised investments Higher debt ratio can fix the problem Unlike dividends, debt repayments are obligatory Greater monitoring and scrutiny by creditors 186

187 Costs of Debt: Financial distress Firms with high debt ratios face the likelihood of financial distress and even bankruptcy Experienced when payments to creditors are covered with difficulty or cannot be covered Expected Cost of F.D.= Probability of F.D. x Costs of F.D. At small debt levels financial distress is unlikely taking on extra debt is not too costly At high debt levels taking on extra debt can be very costly due to increased likelihood of financial distress 187

188 Earnings and return: 50% debt financing 188

189 Comparison of limited and unlimited liability 189

190 Costs of financial distress: examples Costs of financial distress without bankruptcy Damage to customer & supplier relations and talent retention Conflict of interests between borrowers and creditors leads to agency costs of debt e.g., Risk shifting (e.g. overinvestment into lottery-type projects), debt overhang (underinvestment if main benefactors are debtholders) Credit rationing and debt covenants Added costs of financial distress with bankruptcy Direct costs Legal and administrative costs Indirect costs Management of bankrupt firm 190

191 Payoff to security holders of a limited liability company 191

192 Traditional trade-off theory Market value = Value if all equity financed + PV (Tax shield) - PV (Costs of financial distress) Target debt ratio where last euro of debt satisfies: PV(Tax shield)=pv(costs of financial distress) 192

193 Trade-off theory 193

194 Do firms have a target debt ratio? 19% 37% 34% 10% Source: John R. Graham and Campbell Harvey, "The Theory and Practice of Corporate Finance: Evidence from the Field," Journal of Financial Economics 60, 2001, pp

195 Demo 2 T/F Problem Because both bondholders and stockholders demand higher rates of return from firms with higher leverage, a firm that uses less debt can reduce both its cost of debt and cost of equity. Therefore, reducing a company s debt ratio is an easy way to boost its value. True or False? 195

196 Demo 2 T/F Problem False. Not necessarily. Under Modigliani-Miller assumptions, e.g., cost of capital of a firm (r A ) is not affected by the choice of capital structure. As the debt-equity ratio decreases, the overall effect is to leave the firm s cost of capital and value unchanged. Alternatively, according to the trade-off model of capital structure, effect of lower debt ratio depends on where the current debt ratio is relative to the optimal debt ratio. 196

197 Demo 2 - Problem 5: Westside Hotel s tradeoff Westside Hotel expects its EBIT to be 12 million every year into perpetuity. It has 60 million of debt outstanding, with an expected rate of return (and interest rate) of 6%. Were it all-equity financed, it would have a 10% cost of capital. The corporate tax rate is 25%. The following table shows an estimate of the present value of financial distress costs at specified levels of debt: Debt PV(Costs of financial distress) 60 million 10 million 65 million 11 million 70 million 13 million 75 million 16 million 80 million 20 million 197

198 Demo 2 - Problem 5: Westside Hotel s tradeoff a) What is the value of Westside Hotels? What is its D/E ratio? V V allequity PV Tax _ Shield PV Financial _ Distress _ Costs 12m( ) V m 10m 95m 01. D E 60m 95m- 60m

199 Demo 2 - Problem 5: Westside Hotel s tradeoff b) What is the value of Westside Hotels at its optimal capital structure? At what D/E ratio is this? Assume the company can raise debt only in portions of 5 million, and that it uses the money to buy back shares. D/E 65m m- 65m

200 Trade-off theory: Empirical evidence Can explain: Why high-tech, growth companies use little debt Why larger firms and firms with tangible assets use more debt Firms with long-lasting relationships with customers/suppliers use less debt Cannot explain: Why highly profitable companies use little or no debt (e.g., Apple, Microsoft, Johnson and Johnson etc.) Graham (2000): Average tax-paying firm can add 7.5% to firm value by increasing leverage moderately Large and permanent variations within industries Variations across time and countries 200

201 Pecking order theory: Motivation Developed by Stewart Myers and Nicholas Majluf in 1984 by introducing information asymmetry to the MM-world Consider press releases of two seemingly identical companies: DuperCell will issue 120 million EUR five-year senior debt Lovio plans to issue 1.2 million new shares of common stock; expects to raise 120 million EUR Stock prices based on current information: 100 true value could be higher or lower What do rational investors learn from these announcements? 201

202 Pecking order theory Assume managers are better informed than investors and maximize the wealth of existing shareholders Firm will sell equity only if management knows their stock is overvalued (i.e., true value < 100) If firm announces an equity issue, market participants can infer that management thinks the shares are overvalued Negative stock price reaction! If there is no other way to raise capital, the fear of adverse stock price reaction can even lead to rejection of a positive NPV investment 202

203 Pecking order theory The firm with underpriced stock can issue debt, which is less affected by information asymmetries Debt is preferred to external equity Internal equity is least affected by information asymmetry Internal equity (i.e., profits) is most preferred This gives the pecking order of corporate financing: (1) Internal equity (2) Debt (3) External equity List of most used sources of finance has the same ranking as that given by the pecking order theory (see Chapter 14) 203

204 Demo 2: T/F Problem Pecking order theory predicts that, of private and publicly listed firms that are otherwise similar, private ones are more likely to prefer borrowing when in need of external capital. True or false? 204

205 Demo 2: T/F Problem True. The pecking order theory (Myers and Majluf, 1984) predicts that the more asymmetric the information between insiders and outsiders is, the less firms will rely on the information-sensitive instrument, equity, and the more firms will rely on the information-insensitive instrument, debt. If private equity is more costly because private firms are more opaque, then the second empirically testable implication is: Conditional on visiting the external capital market and facing the debt equity choice, private firms are less likely to use equity than public firms. - Omer Brav (Journal of Finance, 2009) 205

206 Choice of debt level in practice Source: Bancel and Mittoo (2004) 206

207 Valuation How to value a project including the value contributed by financing decisions? Two ways: 1. Adjust the discount rate Modify the discount rate to reflect capital structure, bankruptcy risk, and other factors 2. Adjust the present value Assume an all equity financed firm and then make adjustments to value based on financing Either, not both! 207

208 After-tax weighted average cost of capital The after-tax weighted average cost of capital: WACC D rd (1 Tc ) D E E D Important: WACC is applicable to projects that are carbon copies of the company. Otherwise: If investment project or division is riskier (less risky) than company on average, it needs to use a larger (smaller) discount rate If the project will lead the company to change its debt ratio permanently, WACC should change accordingly E r E 208

209 WACC in the MM-World Required rate of return ra rd re D/E 209

210 After-tax WACC at varying debt ratios Differently from the MMbased graph, WACC decreases as debt ratio increases thanks to tax-deductibility of interest! Correction: The x-line plots D/E, not D/V. How to calculate WACC at a different debt ratio? Follow the three-step process: Step 1: Calculate r (= WACC as if there are no taxes). This also gives r E at D/E=0 Step 2: Estimate r D at the new D/E and calculate r E at the new D/E Step 3: Recalculate WACC using the new weights, r D and r E 210

211 Demo 2 - Problem 6: Luxor s WACC Luxor Gold has 2.5 million shares which are currently trading at 84 per share and have an expected return of 16%. The company also has debt with a market value of 135 million, and an expected return of 9%. Assume a MM world with a corporate tax rate of 20%. a) Calculate Luxor s after-tax WACC. b) Suppose Luxor adopts a more conservative debt policy. It reduces its debt ratio to 20% (D/V = 0.2), and as a result experiences a drop in the expected return of its bonds to 8.6%. Recalculate Luxor s WACC under these new assumptions. 211

212 Demo 2 - Problem 6: Luxor s WACC a) Calculate Luxor s after-tax WACC. WACC r (1 T ) D c D V r E E V E 2.5m m V 210m 135m 345m WACC 9% (1 20%) 135m 345m 16% 210m 345m 12.56% 212

213 b) Suppose Luxor adopts a more conservative debt policy. It reduces its debt ratio to 20%, and as a result, experiences a drop in the expected return of its bonds to 8.6%. Recalculate Luxor s after-tax WACC under these new assumptions. Three-step WACC Adjustment: (1) Unlever r E (i.e., r E with no debt=r A ); r A r D Demo 2 - Problem 6: D V r E Luxor s WACC E V 135m 210m 9% 16% 13.26% 345m 345m (2) Calculate r E for 20% debt using the corresponding r D ; r E r A D E 20% V (1 20%) V r r 13.26% (13.26% 8.6%) 14.43% A D 213

214 Demo 2 - Problem 6: Luxor s WACC b) Three-step WACC Adjustment (Continued): (3) Finally, recalculate WACC with the new r E,r D and weights: D E WACC rd (1 Tc ) re V V 8.6% (1 20%) 20% 14.43% (1 20%) 12.92% 214

215 Most common ways of determining the discount rate in Finland Source: Keloharju and Puttonen (1995) 215

216 The adjusted present value (APV) The value to shareholders from an investment project is expressed as the sum of the following components: The NPV of the project s after-tax cash flows (as if the firm is all-equity financed; discount rate = r) The NPV of costs due to the financing of the project The NPV of subsidies (tax breaks plus other subsidies) due to the financing of the project Any transfers to shareholders from existing debt holders due to the financing of the project 216

217 APV method Example: Consider a project with a cost of capital of 8% if financed entirely with equity Project is expected to generate the following after-tax cash flows at the end of each year: Year 1 Year 2 Year 3 Year The project will be initially financed with equity capital At the start of year 3 the firm will repurchase some of its equity and borrow 2000 to finance for the two remaining years Risk-free rate is 5% and corporate tax rate is 20% What is the present value for the project given the plan for debt financing? 217

218 APV method Step 1: Compute present value of cash flows if financed entirely with equity: PV Step 2: Compute present value of the tax shield generated by the debt financing: 218

219 APV method Step 3: The present value of the project given its operating and financing aspects is: = Benefits of the APV method: Exposes each financing side effect distinctly and how much it adds or takes away from project (and firm) value In the WACC method, they will all be hidden in the WACC estimate Doesn t require a fixed debt ratio (i.e., rebalancing) assumption as WACC method 219

220 Demo 2 - Problem 7: Plant Expansion A chemical company is evaluating a $6 million plant expansion, which it estimates will generate $750,000 in after-tax cash, year in and year out, perpetually. The cash flow is assumed to occur at the end of each year. The return obtained on investments of comparable risk is 13%. a) Calculate the project s NPV, assuming no tax shields. b) Calculate the project s NPV, assuming there are tax shields from the issuance of debt. The debt is fixed in amounts equal to 40% of the project s cost and expected to yield a 9% interest rate. The company s marginal tax rate is 20%. c) What level of annual income must the company reach so that it would invest in the plant expansion? d) Determine the minimum acceptable internal rate of return. 220

221 Demo 2 - Problem 7: Plant Expansion a) Calculate the project s NPV, assuming no tax shields. NPV BaseCase 750,000 6,000, ,769 13% 0 221

222 Demo 2 - Problem 7: Plant Expansion b) Calculate the project s NPV, assuming there are tax shields from the issuance of debt. The debt is fixed in amounts equal to 40% of the project s cost and expected to yield a 9% interest rate. The company s marginal tax rate is 20%. Fixed debt = 40% $6m = $2.4m PV Tax _ Shield APV TC r r D D D T C D 20% 2,400,000 NPV Base Case PVTax _ Shield 230, , , ,

223 Demo 2 - Problem 7: Plant Expansion c) What level of annual income must the company reach so that it would invest in the plant expansion? Break-even annual income must satisfy: APV NPV Base Case PVTax _ Shield 0 Annual _ Net _ Income 6,000, , % Annual _ Net Annual _ Net Income (6,000, ,000) 13% Income 717,

224 Demo 2 - Problem 7: Plant Expansion d) Determine the minimum acceptable internal rate of return. It is based on the minimum acceptable annual income: r Annual _ Net _ Income Investment _ in _ Expansion 717,600 6,000, % 224

225 Week 2 - Recap: Capital Structure ~ Debt Policy ~ Leverage 1. In theory (perfect markets) : Debt policy doesn t matter! a) Perfect market b) Modigliani Miller (MM) Propositions: No optimal D/E ratio. MM I: Capital structure irrelevance MM II: Leverage s impact on returns c) Valuation (when capital budgeting & financing decisions are independent): The size of a pie is independent of how it is sliced. 2. In practice (imperfect markets): Debt policy does matter! a) Market imperfections: Interest Tax Shields Financial Distress Costs b) MM Opponents: Capital structure trade-off theory (Optimal D/E ratio) Pecking order theory (Optimal order of financing choices) c) Valuation (when capital budgeting & financing decisions interact): Adjust the discount rate: WACC Adjust the base-case NPV: APV 225

226 Week 2 - Recap: Capital Structure ~ Debt Policy ~ Leverage 1. In theory (perfect market assumptions) : Debt policy doesn t matter! a) Modigliani Miller (MM) Propositions: no optimal D/E ratio! MM I: Capital structure irrelevance (D/E ratio firm value, price, r A unaffected) V AllEquity V Levered, V A_ after V A_ before, r A_ after r A_ before, A_ after A_ before r A ROA Expected Operating Income Market Value Firm value is determined by the LHS (assets), not RHS (debt and equity) MM II: Leverage s impact on returns (D/E ratio E, r E, WACC= r A unaffected) WACC portfolio D E ra rd re r D E D E D E A D E E D E D E E r A A D ra rd E D E A D b) Valuation (capital budgeting & financing decisions are independent): The size of a pie is independent of how it is sliced. 226

227 Week 2 - Recap : Capital Structure ~ Debt Policy ~ Leverage 1. In theory (perfect market) : Debt policy doesn t matter! (No optimal D/E ratio) 2. In practice (imperfect market): Debt policy does matter! (Optimal D/E ratio) Operating income is also unaffected and market value is flat as debt ratio varies. 227

228 Week 2 - Recap : Capital Structure ~ Debt Policy ~ Leverage 1. In theory (perfect market) : Debt policy doesn t matter! a) Perfect market: b) Modigliani Miller (MM) Propositions: No optimal D/E ratio. MM I: Capital structure irrelevance MM II: Leverage s impact on returns c) Valuation (when capital budgeting & financing decisions are independent): The size of a pie is independent of how it is sliced. 2. In practice (imperfect market): Debt policy does matter! a) Market imperfections: Interest Tax Shields Financial Distress Costs b) MM Opponents: Capital structure trade-off theory (Optimal D/E ratio) Pecking order theory (Optimal order of financing choices) c) Valuation (when investment & financing decisions interact): Adjust the discount rate (WACC) Adjust the base-case NPV (APV) 228

229 Week 2 - Recap : Capital Structure ~ Debt Policy ~ Leverage 2. In practice (imperfect market): Debt policy does matter! a) Market imperfections: Taxes PV Tax _ Shield Corporate taxes: debt interest is tax deductable PV T tax _ shield cd (Assume Permanent Debt) Personal taxes: Relative tax advantage of debt Financial Distress bankruptcy cost (direct, indirect) financial distress cost (varying with assets) PV Financial conflicts of interests of shareholders & debtholders (game costs) _ Distress _ Costs After tax WACC r 1T 1TpD (1 T )(1 T pe C ) D c D D E r E E D E b) Financing choices - optimal D/E ratio: Capital structure trade-off theory: V V all equity PV Tax _ Shield PV Pecking order theory: Internal funds (re invested e arnings) debt equity Financial _ Distress _ Costs 229

230 Week 2 - Recap : Capital Structure ~ Debt Policy ~ Leverage c) Valuation (when capital budgeting & financing decisions interact): i. When capital budgeting is independent of financing decisions: ii. Four steps to evaluate a project: Forecast future after-tax cash flows (assuming all-equity financing) Assess risk Estimate opportunity cost of capital r Find NPV using r When capital budgeting & financing decisions interact: Adjust the discount rate: After-tax WACC Assumptions (same business risk level, constant debt ratio after the restructuring) Three-step adjustment for after-tax WACC: Value businesses: PV FCF Adjust the present value: APV 1 FCF... 2 H 1 WACC 1 WACC 1 WACC 1 WACC H APV (assumptions, value businesses, eg. Trade-off): APV NPV base case PV 2 r ( MM _ world ) new r newwacc r 1T A FCF H E PV H I i1 D c Financing_ Side_ Effects D r V E 230 E V

231 Week 2 - Recap : Capital Structure ~ Debt Policy ~ Leverage 1. In theory (perfect market) : Debt policy doesn t matter! No optimal D/E ratio 2. In practice (imperfect market): Debt policy does matter! Optimal debt policy! 231

232 Leasing Chapter

233 Overview Leasing: market size (in Europe) and key concepts Operating vs. financial leases Lease accounting in Finland Importance of accounting corrections Why lease? Sensible reasons Dubious reasons Agency problems in leasing and some solutions Valuation of financial leases International leasing 233

234 Leasing volumes by asset type in Europe Source: 234

235 New leasing volumes in Europe 235

236 Leasing agreement Lease = Rental agreement that extends for a year or more and involves a series of fixed payments A lease agreement is made between the lessor (= the owner of the leased asset) and the lessee (= the user) Ownership of the asset makes a difference on who gets the salvage value at the end of the lease period who gets the tax privileges Lease agreement gives lessee control over the asset for a prespecified period of time At end of the leasing period lessee often has the option to renew the lease or purchase the asset from lessor Typical leased assets include automobiles, airplanes, machinery and industrial equipment, computers, real estate 236

237 Operating and financial leases: general Operating lease Short-term lease characteristics Cancelable at the option of the lessee Financial lease Long-term lease for most of the asset s economic life Non-cancelable Operating leases are much riskier for the lessor than financial leases In operating leases, lessor must consider the risk that the asset will stay idle at least for some of the time 237

238 Leasing: further definitions Who maintains, insures and pay taxes on the asset? Full-service (or rental) lease: Lessor Net lease: Lessee Arrangement Direct lease: The firm leases an asset from its supplier or arranges for a leasing company to buy and lease the asset Sale and lease-back: The firm sells an asset to a lessor and leases it back Leveraged lease Financial lease where the lessor borrows part of the purchase price, using the leased equipment as collateral 238

239 Operating and financial leases according to IFRS rules Categorization according to IFRS rules (IAS 17 Leases ) Financial leases transfer substantially all the risks and rewards of ownership, and give rise to asset and liability recognition by the lessee Operating leases result in expense recognition by the lessee, with the asset remaining recognized by the lessor Criteria for financial leases are broadly defined 239

240 Lease accounting in Finland Listed Finnish companies have to conform to IFRS rules Financial leases have to be reported on the balance sheet as equivalent ownership of the asset with the lease obligations capitalized and shown on the liability side Non-listed Finnish companies do not need to report financial leases on their balance sheets 240

241 Accounting analysis Objective: To what extent the firm s accounting numbers capture its business reality? Identify any significant distortions where there is accounting flexibility and using cash flow information and notes to adjust accounting numbers to undo the distortions Sound accounting analysis sound financial analysis 241

242 Why account for operating leases? On December 27, 2011, the Group sold a portfolio of 97 supermarket properties owned by Carrefour Property for 365 million euros. The supermarkets will continue to be operated under the Carrefour Market banner under long-term fixed rent leases with an indexation clause. The transaction qualifies as a sale-and-leaseback transaction under IAS 17 Leases. The leases with the new owner of the properties, for an initial term of 12 years with multiple renewal options, fulfill the criteria for classification as operating leases, as substantially all the risks and rewards incidental to ownership of the asset are retained by the lessor. The properties were sold at market price and the capital gain, net of transaction costs, was recognized in full in the 2011 income statement in the amount of 229 million euros. Source: Carrefour, 2011 Financial Report 242

243 Why account for operating leases? Criteria for classifying leases as operational are not strictly defined and leave room for opportunistic accounting Important particularly for heavy-asset industries to detect and correct for such distortions One of Carrefour s key assets are the company s stores, many of which are leased under operating leases Estimated PV of these leases in 2011= 3.15 billion EUR 33% of long-term borrowings 23% of tangible fixed assets To synchronize the financials across comparable firms 243

244 Demo 3: T/F Problem Signing a financial lease on an asset will lead to a higher cost of equity capital than not investing in the asset at all. True or false? 244

245 Demo 3: T/F Problem True. Leasing an asset is comparable to purchasing the asset with a loan. Similar to debt finance, a lease agreement will increase expected EPS and make it more sensitive to changes in operating income. The cost of capital for equity will thus increase. 245

246 Sensible reasons for leasing Under the Modigliani-Miller assumptions, there is no difference between owning an asset and leasing an asset Leasing policy is just a special case of financial policy, and can matter if at least one of the following is true: Financial policy affects a firm s tax obligations Financial policy affects contracting costs Financial policy affects real investment policy 246

247 Sensible reasons for leasing Convenience Flexibility Shifting the risk of obsolescence Standardization leads to low costs Lessor may be able to use tax breaks from depreciation more effectively Additional source of financing, less susceptible to financial distress 247

248 Dubious reasons for leasing Leasing avoids internal capital expenditure controls Leasing preserves capital Leases may be off balance sheet financing Leasing increases book rate of return In early years, lease payments < interest + depreciation Off-balance sheet assets may never appear in the denominator 248

249 Agency problems and lease provisions Leasing separates rights to the cash flows of the asset from its salvage value This generates incentives for agency problems such as asset abuse, under-maintenance Provisions in lease contracts are designed to solve these problems. For example: Deposits and penalty clauses Options to extend/purchase or cancel Restrictions to sublease Metering: a contractual provision that ties lease payments to some measure of the intensity of the asset s use Tie-in sale: a contractual requirement to use a specified nondurable input in the operation of the leased asset 249

250 Evaluating financial leases Example: A company is evaluating the lease of a new computer (cost: 150) The computer s economic life is 5 years after which it is obsolete The annual lease payments are 31, payable in five installments, the first being payable when the contract is signed The firm can borrow at the long term rate of 9%, the tax rate is 20%, and depreciation is straight line in 5 years (the first installment after one year) Should the company lease or borrow to buy the asset? 250

251 Evaluating financial leases Initial cost 150 The NPV of the lease contract is Yr 0 Yr 1 Yr2 Yr 3 Yr 4 Yr 5 Depreciation Lost depreciation tax shield Lease payment Tax shield on lease payment Lease cash flow NPV at after-tax rate 9%* (1-0.20) 17.1 The company should lease rather than borrow to buy the computer 251

252 Evaluating financial leases Now suppose that the purchase of the computer had a NPV of 2 if the company financed it with debt Computer should not be purchased if there are no other financing options When the possibility of advantageous lease financing is considered, the adjusted present value (APV) of the project is: = 15.1 The company should go ahead with the project and lease the computer 252

253 Formal analysis of lease vs. borrow to buy Denote corporate tax rate with T c, lease payment with L, and depreciation with Dep Leasing instead of buying generates the following net cash flow stream every year: -[(1-T c )L t + T c Dep t ] This reflects the fact that the lessee will lose the depreciation tax shield in addition to having to pay the lease payments Therefore, the NPV of the lease decision (vs. borrow to buy) is: NPV ( Lease) I 0 n t1 Tc Dept (1 Tc ) L t [1 (1 T ) r ] where I 0 is the cost of the asset and (1-T c )r D is the after-tax borrowing rate for the company c D t 253

254 Demo 3 - Problem 2: Buy or lease? TX Textile Company is considering whether to lease or buy a weaving machine. The lease would last for ten years and TX would pay an annual lease payment of 28,000 at the beginning of each year. If TX were to buy the machine, it would cost the company 190,000. Assume a corporate tax rate of 30%, an interest rate of 6%, straight-line depreciation, and zero salvage value. Also assume that there are no other costs (e.g. maintenance, insurance, etc.) that affect TX s decision. Calculate the NPV of the lease to TX. 254

255 Buy or lease calculation: Demo 3 - Problem 2: Buy or lease? Time Cash flow effects Initial cost Lease payments Tax-shields Depreciations Lost Tax-shields Total PV@6%*(1-0.3) NPV ,63 TX should buy the machine, because the NPV of the lease is negative. 255

256 Demo 3 - Problem 3: Royale Casino s lease Royale Casino has been offered a four year financial lease on a limousine which would be used to transport VIP guests between the casino and the airfield. The firm constructs a table, bottom line presented below, reflecting the cost of the limousine, depreciation tax shields, and the after-tax lease payments. Assume that the firm could borrow at 8 %, and faces a 26 % marginal tax rate. Ignore salvage value. Year 0 Year 1 Year 2 Year 3 Year 4 Lease cash flow + 56,500-20,100-16,650-13,200-9,750 Suppose Royale Casino was considering buying the limousine last week, but found the project to have a NPV - 6,000, and didn t go ahead with the investment. 256

257 Demo 3 - Problem 3: Royale Casino s lease a) How much could Casino Royale borrow now with a repayment plan (net outflow of cash) that matches the lease cash flows from year 1 to year 4? Royale Casino can effectively borrow or lend at 8%(1-0.26) = 5.92%. 20, (1 16, ) 13,200 ( ) 9, ( ) 52, b) What is the NPV of the lease? Lease NPV = 56,500-52, = 3,

258 Demo 3 - Problem 3: Royale Casino s lease c) Should Royale Casino accept the lease offer (given the lease NPV from b)? Accept the offer if APV > 0 (i.e., APV=Project NPV + Lease NPV > 0) APV=- 6, , = - 2, Do not accept! 258

259 When is leasing most tax advantageous? Other things being equal, the potential gains to lessor and lessee are highest when: The lessor s tax rate is substantially higher than the lessee s The depreciation tax shield is received early in the lease period The lease period is long and the lease payments are concentrated toward the end of the period The interest rate is high 259

260 Cross-border leasing Cross-border leasing contracts can take advantage of asymmetric tax treatment of leasing between the countries the lessee and the lessor are domiciled Multinational companies may use cross-border leasing To limit the ownership of assets by subsidiaries in politically unstable countries The risk of losses from asset appropriation (nationalization) is lower if the asset is not owned by local subsidiary To extract cash more easily from affiliates located in countries that have exchange controls Lease payments may be a more acceptable method to repatriate funds than dividends, interest, or royalty payments 260

261 Financial planning Chapter 29 (Prerequisite: Chapter 28) 261

262 Overview What is financial planning? Strategic planning and finance Long-term planning Financial planning models: key concepts Example of financial planning model External financing and growth Short-term planning Cash budgeting Sources of short-term financing 262

263 What is financial planning? Financial planning is a process consisting of (1) Identification: Analyzing the investment opportunities and financing choices open to the firm (2) Modeling: Projecting the future consequences of current decisions (3) Decision: Deciding which alternatives to undertake (4) Monitoring: Measuring subsequent performance against the goals set forth in the financial plan It is customary to analyze different scenarios (e.g. best case, normal case, and worst case) to find out how vulnerable the financial plan is to its assumptions 263

264 Contribution of finance to strategic planning Financial tools are used to determine the feasibility of a strategic plan, given firm s existing and prospective sources of funding Finance guides and helps manage the implementation of strategic plans Financial analysts prepare cash budgets that help avoid liquidity problems Finance also contributes to strategic planning through risk management 264

265 Long-term planning: financial planning models Financial planning models Help to explore the consequences of alternative strategies Are particularly crucial for firms with changing capital needs Growth firms Financially distressed firms Financial planning models often start from estimating sales Costs and summary items such as net working capital are often defined as proportional to sales Percentage of sales method 265

266 Long-term planning: financial planning models Sales forecasts can be made in two ways: Top-down approach uses macroeconomic and industry forecasts to establish sales goals E.g., estimate total market size and expected market share Bottom-up approach forecasts sales on a customer-bycustomer or product-by-product basis Customer-based at B2B level; Product/division-based otherwise The outputs of financial planning models are projected or forecast financial statements ( pro forma ) The balancing item, or the plug, is the variable that adjusts to maintain the consistency of a financial plan 266

267 Financial planning model: example Income statement 2017: Revenue COGS % of sales = EBIT Interest 40 10% of debt = EBT Tax 64 40% of EBT = Net income 96 Dividends 64 Payout ratio 2/3 Retained earnings 32 Net income - div 267

268 Financial planning model: example Balance sheet 2017: Assets: Net working capital % of sales Fixed assets % of sales Net assets 1000 Liabilities & equity: Long-term debt 400 Equity 600 Totals

269 Financial planning model: example Pro forma financial statement for 2018 Assume: Sales and operating costs increase by 10% Interest rates remain at the current level Dividend policy is unchanged Fixed assets and net working capital will need to increase 10% to support the larger sales volume 269

270 Financial planning model: example Pro forma income statement for 2018: Revenue % higher - COGS % higher = EBIT Interest 40 Unchanged = EBT Tax 72 40% of EBT = Net income 108 Dividends 72 Payout ratio 2/3 Retained earnings 36 Net income - div. 270

271 Financial planning model: example Pro forma balance sheet 2018: Assets: Net working capital % higher Fixed assets % higher Net assets 1100 Liabilities & equity: Long-term debt 400 Temp. held fixed Equity Totals 1036 Required external financing

272 Financial planning model: example Pro forma statement of sources and uses of funds for 2018: Sources: Retained earnings 36 New borrowing 64 Total sources 100 Uses: Investment in working capital 20 Investment in fixed assets 80 Total uses 100 The company uses additional borrowing of

273 Demo 3 - Problem 4: Galvin s financial planning Galvin Manufacturing s financial statements are presented below. All figures are in thousands of euros. Balance Sheet, Year-end Assets Liabilities and Stockholders' Equity Current assets: Current liabilities: Cash Accounts payable Accounts receivable Short term debt Inventories Long-term debt Fixed assets Stockholders' equity: Total Common stock Total retained earnings Total

274 Demo 3 - Problem 4: Galvin s financial planning Income statement Payout policy Sales Dividends paid out Cost of goods sold Retained earnings Depreciation S&A expenses* EBIT Interest expense Tax Earnings *S&A = Selling and administrative 274

275 Demo 3 - Problem 4: Galvin s financial planning a) Using this information, construct a sources and uses of funds statement for Balance Sheet, Year-end Assets Liabilities and Stockholders' Equity Source/Use Source/Use Current assets: Current liabilities: Cash Accounts payable Accounts receivable Short term debt Inventories Long-term debt Fixed assets (net) Stockholders' equity: Total Common stock Total retained earnings Total NWC = Current Assets Current Liabilities = 150 From the income statement (internal source of funds): Operating cash flow = Earnings + Depreciation = =

276 Demo 3 - Problem 4: Galvin s financial planning a) Using this information, construct a sources and uses of funds statement for Sources Explanation Operating cash flow 1040 earnings + depreciation Issue of long term debt 0 increase in long term debt Issue of equity 0 increase in common stock Total 1040 Uses Investment in NWC 150 (current assets - current liabilites) Investment in Fixed Assets 800 depreciation + increase in (net) fixed assets Dividends 90 earnings - increase in retained earnings Total

277 Demo 3 - Problem 4: Galvin s financial planning b) Construct a pro forma income statement and balance sheet for Assume the following: Sales growth equals the sales growth in Accounts receivable, inventories, fixed assets, and accounts payable will all grow at the same rate as sales. Cost structure will remain constant, i.e. cost of goods sold, depreciation, and S&A expenses will be in the same proportion to sales as in The interest rate, dividend payout ratio, and effective tax rate are the same as in Interest expense for a given year is paid on the sum of long and short term debt at the beginning of that year. Galvin Manufacturing plans to cover any cash outflows from its operating cash flows and cash reserves, and expects to make no net issues or repayments of equity and debt. 277

278 Demo 3 - Problem 4: Galvin s financial planning b) Income statement Payout policy Sales g=0.074 Dividends paid out d=0.122 Cost of goods sold p=0.710 Retained earnings Depreciation p=0.026 S&A expenses* p=0.121 EBIT Interest expense r=0.066 Tax t=0.452 Earnings Balance Sheet, Year-end Assets Liabilities and Stockholders' Equity Current assets: Current liabilities: Cash plug Accounts payable g Accounts receivable g Short term debt Inventories g Long-term debt Fixed assets g Stockholders' equity: Total Common stock Total retained earnings Total

279 b) Pro forma income statement: Demo 3 - Problem 4: Galvin s financial planning Income statement Assumptions 2015 Sales % sales growth continues Cost of goods sold 8810 Cost margin as in 2014 (about 71%) Depreciation 322 Prop to sales as in 2014 S&A expenses 1504 Prop to sales as in 2014 EBIT 1773 Interest expense 369 r = interest exp / debt 2013 = 6.6% Tax 634 T = Taxes 2014 / EBT 2014 = 45% Earnings 769 Payout policy 2015 Dividends paid out 94 Payout ratio = Div 2014 / Earnings 2014 = 12% Retained earnings

280 b) Pro forma balance sheet: Demo 3 - Problem 4: Galvin s financial planning Balance Sheet, Year-end Assets Liabilites & Equity Current assets: Current liabilities: Cash 1042 Accounts payable 1074 Accounts receivable 2149 Short term debt 2000 Inventories 3223 Long-term Debt 3600 Fixed assets 4835 Stockholders' equity: Total Common stock 2000 Retained earnings 2575 Total Underlying assumptions: All items grow with the same rate as sales (g=7.44%) except: Debt and common stock remain constant Total retained earnings increases by the retained earnings of 2015 Cash acts as a plug 280

281 External financing and growth Assuming (as in the example before) that a given increase in sales requires a similar increase in assets, the requirement for new investment is simply: New investment = Growth rate x Initial assets Since part of the investment requirement can be financed with retained earnings, the amount of required external financing is: Required external financing = New investment Retained earnings = Growth rate x Initial assets Retained earnings 281

282 External financing and growth Example (from slides ) continues: Using the above formula, the required external financing is: 10% 1, = 64 This is exactly the same result as that obtained from the earlier financial planning model A company can finance its growth itself only to the extent it can generate retained earnings The internal growth rate is the maximum rate of growth that a company can achieve without external financing: Internal growth rate Retained earnings Assets 282

283 Internal growth rate The relationship between projected growth rate and internal growth rate can be illustrated as follows: Required external funds 0 Internal growth rate Required external funds Projected growth rate 283

284 Internal growth rate The internal growth rate can be further divided into several components: Internal growth rate Retained earnings Net income A firm can achieve a high growth rate without external capital if it Plows back a high proportion of its earnings Has a high return on equity (ROE) Has a low total debt ratio Net income Equity Equity Assets Equity Plowback ratio Return on equity Assets 284

285 Internal growth rate Example continues: Recall that the plowback ratio is 1/3, the amount of equity and assets at the start of the year 600 and 1000, respectively, and projected net income 108 This gives the following internal growth rate: Internal growth rate % Since this is less than the growth rate of 10%, the firm needs additional financing 285

286 Sustainable growth rate Sustainable growth rate Growth rate that can be maintained without further equity issues Allows further debt issues which maintain the capital structure, i.e. the level of Equity/Assets, at the present level The sustainable growth rate can be determined as follows: Sustainable growth rate = Plowback ratio x Return on equity 286

287 Sustainable growth rate The sustainable growth rate is: Sustainable growth rate1108 6% This number is also smaller than the projected growth rate The firm not only requires additional borrowing but also has to increase its total debt ratio In the long run, the company either has to raise additional equity or cut back its growth rate 287

288 Demo 3 - Problem 5: SFF s prospective figures The business of SFF Technology is booming and its sales went up by 30% this year. The same sales growth rate could continue next year if the company is able to expand its capacity in equal proportion to the sales. The firm currently has assets worth 4 million, 1 million in debt, a return on equity of 25% and a dividend payout ratio of 50%. a) What is SFF s internal growth rate if it holds its dividend payout ratio constant? b) What is the company s sustainable growth rate? c) Calculate SFF s required external funds next year if the company wishes to grow by 30% and hold its dividend payout ratio constant. 288

289 a) What is the internal growth rate? ROE = 25%; Equity = Assets Debt = 4m - 1m = 3m Net income = 750,000 Demo 3 - Problem 5: SFF s prospective figures RE = 50% of Net Income = 375,000 With 375,000 of internal funds invested in new assets, asset base grows by 9.38% Alternatively, using directly the extended formula: Internal growth rate Retained Earnings Assets Plowback ratio ROE Equity/Assets 50% 25% 75% 9.38% 289

290 Demo 3 - Problem 5: SFF s prospective figures b) What is the sustainable growth rate? Given a target leverage ratio and without issuing new equity, the maximum achievable growth is given by: Sustainable growth rateplowback Ratio ROE 50% 25% 12.5% c) External funds needed = Funds needed for growth Retained earnings 30% 4m 375, ,

291 A firm s cumulative capital requirement Line A: Permanent cash surplus Line B: Short-term lender for part of year, borrower for remainder Line C: Permanent short-term borrower 291

292 Value of cash holdings US and European non-financial firms hold more cash today than they used to Advantages of holding more cash Readiness for unexpected contingencies Smaller growth firms facing high costs of raising external capital Market value of a $1 of cash at such firms is worth more than $1 (Pinkowitz and Williamson, 2007) Disadvantages of excess cash Tax disadvantage of lending (i.e., investing in marketable securities) Agency problems For firms with poor corporate governance or facing financial distress, a $1 of cash is worth less than a dollar to investors 292

293 Demo 3: T/F Problem Suppose that Firm A has large blocks of ownership whereas Firm B is owned widely by atomic investors. The firms are otherwise similar. An extra dollar at Firm A s use is likely to be worth more in the stock market than a dollar at Firm B s use. True or false? 293

294 Problem 1: True/False True. Firm A is less vulnerable to agency problems because management can be more effectively monitored and disciplined by investors with large blocks of ownership. The threat of replacement in the case of misuse of available funds is palpable. Firm B s managers, on the other hand, are less likely to be challenged by organized efforts (too costly for an atomic investor) if they spend the extra dollars on private benefits. Stock market participants are aware of these differences and value assets of the firms (part of which is cash) accordingly. 4

295 Short-term planning: cash budget Cash budget (for time periods of less than 1 year) Schedule of cash inflows and outflows in the near future Necessary for maintaining liquidity at all times A firm should have at the same time several cash budgets for different time periods E.g. a daily, a weekly, and a monthly cash budget The more the cash flows fluctuate, the more important the cash budgets are (seasonalities...) The more customers, the easier it is to predict cash flows (diversification argument) 295

296 Working capital: Cash cycle 296

297 Cash budgeting: example 2017 Q4 Q Q2 Q3 Q4 1. Receivables, start of period 30 32,5 30,7 38,2 2. Sales 75 87,5 78, Collections Sales in current period (80%) 70 62,8 92,8 104,8 Sales in last period (20%) 15 17,5 15,7 23,2 Total collections 85 80,3 108, Receivables, end of period 4= ,5 30,7 38,2 41,2 297

298 Cash budgeting: example 2018 Q1 Q2 Q3 Q4 Sources of cash 85 80,3 108,5 128 Uses of cash 131,5 95, Cash at start of period 5-41,5-56, Change in cash balance (sources - uses) -46, , Cash at end of period (3 = 1 + 2) -41,5-56, Minimum operating cash balance Cumulative financing required (5 = 4-3) 46,5 61,

299 Demo 3 - Problem 6: Freestyle s cash budget The last day of November is at hand, and Freestyle Sports is assessing its cash needs for the upcoming ski season. The tables below show, in thousands of euros, a forecast of the company s sales and expenses during the next 5 months, as well as its current solvency. In addition to these cash needs, Freestyle needs to pay a tax bill of 300,000 in February, and will invest 800,000 in April to modernize its production equipment. 299

300 Demo 3 - Problem 6: Freestyle s cash budget Ski season forecast Expected Dec Jan Feb March April Sales Purchases Other costs Current solvency Nov 30 Cash 700 Accounts payable Due in Dec 280 Accounts receivable Due in Dec 460 Due in Jan

301 Demo 3 - Problem 6: Freestyle s cash budget In each month 50% of the sales will be paid in cash, 30% will be paid one month later, and 20% in two months. The suppliers of Freestyle s materials grant a credit of one month for 40% of the company s purchases, while the rest of them have to be paid in cash. All other costs, including the tax bill and investment, must be paid when they incur. a) Draw up a five month forecast of Freestyle s cash balance. b) Assume Freestyle needs a cash balance of at least 200,000 at all times as a buffer against short term uncertainty. How much cash can the company distribute to shareholders in January if it doesn t want to use any external financing during the season? 301

302 a) Cash budget for five months? Each month: 50% of sales in cash, 30% due in one month and 20% due in two months; 60% of purchases in cash, 40% due in one month Cash inflows in Dec: Cash sales = 50% of all sales = 650 Collections (given) = 460 Cash outflows in Dec: Demo 3 - Problem 6: Freestyle s cash budget Cash purchases= 60% of all purchases = 630 Payment of credit (given) = 280 Other costs (given) = 240 Net cash flow in Dec = = -40 Ending cash balance = Beg. cash balance Net cash flow = =

303 Demo 3 - Problem 6: Freestyle s cash budget a) Cont ed : Cash inflows in Jan: Cash sales = 50% of all sales = 750 Collections = % of Dec = = 590 Cash outflows in Jan: Cash purchases= 60% of all purchases = 756 Payment of credit = 40% of Dec = 420 Other costs (given) = 265 Net cash flow in Jan= = -101 Ending cash balance = =

304 a) Continued: Full five month forecast Demo 3 - Problem 6: Freestyle s cash budget Expected Dec Jan Feb Mar Apr Terms Inflows: Cash sales *S t Collections *S t *S t-2 Outflows: Cash purchases *P t Payments of credit *P t-1 Other costs Payment of tax bill 300 Production upgrade 800 Net Cash flow Cash balance

305 Demo 3 - Problem 6: Freestyle s cash budget b) Assume Freestyle needs a cash balance of at least 200,000 at all times as a buffer against short term uncertainty. How much cash can the company distribute to shareholders in January if it doesn t want to use any external financing during the season? The cash balance reaches its lowest point in February. At that point the balance is still 423, ,000 = 223,000 above the minimum, so that amount can be distributed in January. 305

306 Sources of short-term financing Line of credit Agreement with a bank that a company may borrow any time up to an established limit Typically unsecured, i.e. with no collateral, and reviewed annually Revolving credit arrangement is a similar agreement but usually lasts for several years Factoring Company sells its receivables to a factor who then takes care of collecting the receivables Secured loans which use e.g. accounts receivable or inventories as collateral Delay payment of accounts payable Expedite payment of receivables 306

307 Week 3 - Recap: Leasing a) Preliminaries (rental contract, lessor, lessee, good and bad reasons for leasing) b) Categories operating vs. financial (a.k.a. capital or full-payout) leases; full-service/rental vs. net leases; direct lease vs. sale and lease back; leveraged leases 1) Operating Leases (short-term, cancelable): Lessor absorbs risks! Valuation of a project: Equivalent annual cost 2) Financial Leases (long-term, non-cancelable): Lessee absorbs risks! a) Financial leases are a source of financing! debt (similarities & differences) b) Valuation of a project: NPV of financial leases (equivalent loans, lease cash flows, after-tax interest rate): NPV Lease Valuation of a project: c) Total gains to lessor and lessee n CF t I t T r t0 1 T t0 C D 1 n T APV NPV c Depreciation By Leasin g t C NPV (1 T r D t Pr oject C ) L t NPV Lease 307

308 Week 3 - Recap: Financial Planning 1) Preliminaries: a) Financial statements (balance sheet, income statement, cash flow statement) b) Key financial ratios (performance, efficiency, leverage, liquidity) 2) Financial Planning: a) Model: Pro Formas (balance sheet, income statement, cash flow statement) b) Financial planning Long-term financial planning: Constructing Pro Forma statements Short-term financial planning: - Changes in cash & working capital (sources & uses of cash statement) - Cash budgeting: expected receivables (forecast sales & collections), expected inflows & outflows (sources minus uses), short-term financing requirement - Sources of short-term financing c) Financing sources: Internal financing (Additional RE): - Internal growth rate (no external funding) = RE/A = Plowback ratio x ROE x (E/A) External financing (New investment RE) - New investment = Growth Rate x Initial assets - Sustainable growth rate (no external equity financing, fixed debt ratio) = Plowback ratio x ROE 308

309 Working capital management Chapter

310 Overview How to evaluate working capital management Inventory management Optimal order size (i.e., economic order quantity) Credit management Credit terms Analysis of credit risk Credit decision Repeat orders Credit check General principles Cash management Cash vs. marketable securities 310

311 How to evaluate working capital Operating cycle management Number of days from purchases of inventory materials to the collection of cash from customers Cash (conversion) cycle Number of days from cash payment to suppliers to the collection of cash from customers 311

312 Cash cycle: Examples In Finland, for a typical non-financial company: Cash cycle = Inventory period + Collection period Payables period = = days (Median) Source: Enqvist, Graham, and Nikkinen (2014) 312

313 Working capital composition in different industries Mean percentages for firms in the S&P Composite Index in

314 Working capital management in Finland Source: Enqvist, Graham, and Nikkinen (2014) 314

315 Inventory management Trade-off: Carrying costs vs. Ordering costs Benefits of large inventory: Low order frequency, low risk of delays Costs of large inventory: Storage, insurance, forgone interest etc. Example: Assume a bookstore sells 100 copies of a given book a year and orders Q books at a time The number of orders will therefore be 100 / Q Assume further: An order is made at the time when the inventory is empty The demand for the books is evenly distributed over time The average inventory size will be Q/2 (see next slide) 315

316 Inventory management 316

317 Assuming further: Inventory management Annual carrying cost per book is 1 Each order costs 2 Total carrying cost = Carrying cost per book Average inventory of books = 1 Q/2 = Q/2 Total order cost = N. of orders per year Cost per order = (100/Q) 2 Efficient inventory management requires minimizing the sum of these two costs 317

318 Optimal order quantity 318

319 Inventory management The optimum is where the total carrying cost equals total order cost (solve min Q/2+200/Q): Q/2 = 100/Q 2 => Q 2 = 400 => Q = 20 The optimal order level is 20 books This can be generalized with notation. The economic order quantity (EOQ), i.e. order size that minimizes total inventory costs, is: EOQ 2SalesCost per order Carrying cost 319

320 Inventory management Plugging the numbers of the example into this formula gives: Economic order quantity , which is exactly the result we obtained earlier 320

321 Credit management Takes several steps: (1) Fix terms of sale (e.g., COD or trade credit with 2/10 net 30 ) (2) Decide on form of contract (e.g., open account or commercial draft) (3) Analyze credit risk (e.g., internal or external) (4) Grant or refuse credit (5) Collect cash (or sell to a factor) 321

322 Parenthesis: Cost of stretching payables Example: 2/10 net 30; good costs 100 Pay by day 10: Discounted price of the good will be % = 98 Pay on day 30: Same as a 20-day loan from the seller You will pay 2/98 = 2.04% more for the good Number of 20-day periods in a year = 365/20 = At the interest rate of 2.04%, the principal will grow in a year to = Your annual cost is = 44.6% 322

323 Payment patterns in Europe (2018) Survey of 9670 European companies Some observations: Payment period shorter: Down from 37 days in 2017 to 34 days in 2018 New European Late Payment Directive stipulates 30 days (mandatory for public sector) Non-payment also smaller: Percent of revenues that had to be written off down from 2.44% in 2016 to 1.69% in 2018 In Greece, down from more than 10% in 2015 to 2.14% in 2018 Finland second lowest after Denmark: 0.61 in 2018 (down from 0.9% in 2016 & 17) Payment behavior in Finland: B2B: 20 days offered; 25 days actual B2C: 14 days offered; 14 days actual Late payment more likely due to administrative inefficiency of customers or intentional delay than financial difficulty Source: Intrum Justitia, European Payment Report 2018

324 Analysis of credit risk The following C s are often taken into account when analyzing credit applicants: The customer s character The customer s capacity to pay The customer s capital The collateral provided by the customer The condition of the customer s business Credit agencies such as Dun & Bradstreet and, in Finland, Asiakastieto provide credit information In the analysis of large orders, other useful sources include financial ratio analysis and the analysis of credit ratings 324

325 Credit decision: No repeat order 325

326 Credit decision Decision Expected profit Refuse credit 0 Grant credit p PV(REV-COST) - (1-p) PV(COST) Example: What is the break-even probability p that customer pays, when PV(REV) = 1200 and PV(COST) = 1000? Expected profit = p( ) - (1-p)1000 = 0 p = 5/6 (83.34%) 326

327 Credit check Example continues: When should a credit check be made? Assume the firm has the following type of customers: Category Probability Proportion of of default customers Prompt payer Slow payer Expected profit (loss) from a slow payer: (1-0.2)( ) = -40 Do not sell to slow payers 327

328 Credit check Assume the price of a credit check is 10 Expected return from a credit check = Proportion of slow customers x Saving from not selling to a slow customer - Cost of credit check = = -8 Do not make a credit check for a sale of one item only What about a larger order (10 items)? Expected profit from a credit check: = = 10 > 0 Make a credit check 328

329 Repeat order and credit decision Example continues: What if there is a chance of repeat orders? Assume A new customer will pay with probability 0.8 Using the earlier result, the expected profit from the initial order is -40 Customer will purchase again next year if she pays for her first order Conditional probability of the second payment is 0.95 Suppose discount rate is 20% 329

330 Repeat order and credit decision 330

331 Repeat order and credit decision Next year s expected profit on repeat order: p 2 PV(REV 2 - COST 2 ) - (1-p 2 )PV(COST 2 ) = (1-0.95)1000 = 140 Taking into account both the initial order and the repeat order, we obtain: Total expected profit = Expected profit on initial order + Probability of payment and repeat order x PV (Next year s expected profit on repeat order) = /1.2 = The customer should be extended credit 331

332 General principles of credit decisions The goal is to maximize expected profit (NPV), not minimize bad accounts Concentrate on large and doubtful applications Look beyond the immediate order 332

333 Demo 4 - Problem 2: Credit Management Aeron Inc. is a wholesale distributor of aircraft engines. A new customer has placed an order for 8 turbine engines. The cost of the engines for Aeron is 1.7 million per engine (in cash), and it offers to sell the engines at a credit price of 1.8 million per engine. Aeron has to pay for the engines immediately after it has agreed to sell them. If Aeron grants the credit, the customer must pay for the engines in one year. Based on historical experience, payment for 1 out of 60 of similar orders is never collected. Aeron s required return for the credit period of one year is 5%. 333

334 Demo 4 - Problem 2: Credit Management a) Assume that this is a one-time order and that the customer will not accept the offer if she cannot pay with credit. Should Aeron grant the credit? Calculate the NPV of the credit extension: NPV credit PV(E Revenue ) Cost of Engines 1 ( ) ( 18. m8) m8-114,000 0 Credit should not be granted! 334

335 Demo 4 - Problem 2: Credit Management a) What is the break-even probability of default? Break-even probability of default: NPV credit p 18. m8 ( 1-p) m8 0 p p Given probability of default 1/60 =

336 Demo 4 - Problem 2: Credit Management b) Suppose that customers who do not default on their first payment become repeat customers and place the same order every year into perpetuity. Further assume that repeat customers never default. Should Aeron grant the credit? Timeline and cash flows for Aeron are as follows: At t=0: Purchase for the first order and pay 8 1.7m immediately At t=1, 2, 3, : With 59/60 probability, receive 8 1.8m for the previous order and pay 8 1.7m for the next order Cash flows per engine from 59 out of 60 similar customers: Collection of receivable 1,8 1,8 1,8 -Expense in cash 1,7 1,7 1,7 1,7 Net -1,7 0,1 0,1 0,1 336

337 b) Suppose that customers who do not default on their first payment become repeat customers and place the same order every year into perpetuity. Further assume that repeat customers never default. Should Aeron grant the credit? NPV Credit (per engine) = (59/60) [ 100k/0.05] - 1.7m = 266,667 NPV Credit (full order) = 8 266,667 = $2.13 million Credit should be granted! Demo 4 - Problem 2: Credit Management Alternatively, we can extend the formula in part (a): NPV credit PV ( E(Collections - Costs) t m 1.7m8 [ ( ) t 1 60 ) Cost of 0] 17. m8 Initial Order 2,130,

338 Demo 4 - Problem 2: Credit Management b) What is the break-even probability of default? (Here break-even probability of default refers to default on the first payment, since once customers become repeat customers, they never default.) Break-even probability of default: NPV credit p 1. 8m 1.7m m p

339 Cash management Personal cash management: How much cash do you need per month? Typical amount withdrawn from ATM? Personal cost for withdrawing from ATM? Opportunity cost of holding cash? Trade-off: Carrying costs vs. order costs Cash holding vs. investing in short-term securities Benefits of large cash balance: Liquidity, low transaction costs Cost of large cash balance: Lost interest income 339

340 Cash management The EOQ concept can be directly applied to cash management Example: You can invest in Government notes at 8% Every sale of these notes costs 20 You need to raise cash at a rate of 105,000 per month, i.e. 1,260,000 per year Here, interest rate = carrying cost (cost of carrying non-interest bearing funds) and cost per sale = order cost Optimal amount of notes to be sold at one time is: 2 1,260, ,

341 Cash management The notes will have to be sold 105,000 / 25,100 = 4.2 times a month The average cash balance will be 25,100 / 2 = 12,550 The above relationships hold only if the firm uses its cash balance evenly over time Large firms have subsidiaries each holding cash balances To avoid transaction costs paid to outsiders, these cash balances tend to be centralized all subsidiaries are either lending or borrowing at the same time 341

342 Demo 4 T/F Problem A decrease in interest rates will increase the optimal cash holding of a company. True or false? True. A decrease in interest rates will decrease the opportunity cost of holding cash and, thus, lead to an increase in optimal cash balance. 342

343 Demo 4 - Problem 3: Cash Management Decode Corporation is a biotech start-up. The company has just raised new funds from a venture capitalist in order to finance the development of a new biotech product. Decode has no sales or other sources of revenue and currently holds its funds in marketable securities that have an annual return of 5%. Decode knows for certain that it will need 300,000 in cash every month to finance its R&D work. The R&D costs will occur evenly throughout the month, so there are no fluctuations in cash needs. The cost of selling the company s marketable securities is estimated to be per each transaction. Assume that the company earns no interest on the cash it holds. 343

344 Demo 2 - Problem 3: Cash Management a) How often should the company sell its securities to finance the R&D work? The problem can be solved with the EOQ formula. M = total money needed annually c = fixed (transaction) cost r = opportunity cost of capital Q* = optimal amount of securities 2 M c , Q* r , Number of order times per month 300,000 68, The securities have to be sold 4.35 times a month or about once a week. 344

345 Demo 2 - Problem 3: Cash Management b) How does your answer to part (a) change if the company must have at least 10,000 in cash at all times? There is no change as the EOQ remains the same. The only difference is that the company should only sell securities after the cash balance reaches 10,000 and maintain the cash balance above 10,

346 Extra Problem: True/False No real problems can arise from management retaining a high level of positive net working capital in a firm. It will simply provide the firm with the flexibility to invest in value maximizing opportunities that arise. 346

347 Extra Problem: True/False False. Unusually high level of net working capital is a sign for inefficient working capital management. Detailed financial ratio analysis and comparisons over time and with similar companies can help the manager identify the sources of the problem and propose solutions. Some examples of real problems: Excessive inventory: high storage/insurance costs, forgone interest income, risk of obsolescence Lax credit policy: too many defaults/realized losses Too much cash (i.e., dark side of financial flexibility): risk of wasteful investments/operating inefficiencies, foregone interest income on idle cash 347

348 Week 4 - Recap: Working Capital Management 1. Working Capital: Net Working Capital, Operating and Cash Cycles 2. Working Capital Management - Current Assets a) Inventory management: b) Credit management (Accounts receivable): 5 steps Terms of Sale (e.g., cash discount 2/10, net 30 ) Contract form (e.g., open account) Credit risk analysis (e.g, credit agencies or bureaus) Credit decision (expected profits-binomial trees, 3 general principles) - non-repeat orders: - repeat orders: EOQ Collection policy (e.g., factoring) E E Pr ofit 2 Sales Cost Per Order Carrying Cost Per Unit * Pr ofit EP rofit p PV( EP rofit E P rofit InitialOrder (RevenueCost) InitialOrder (RevenueCost) payment& repeatorder NextYear peatorder p PV venue Cost (1 p ) PVCost E P rofit p PV Re p PV 1 (1 p) PV 2 (Re Cost (1 p ) PV ) 1 Cost 2 NextYearRe peatorder ) d) Cash management (liquidity vs. forgone interest) e) Marketable Securities: Money market 3. Working Capital Management - Current Liabilities a) Short-term borrowing: sources (bank loans, commercial paper etc.) b) Accounts payable Q 2 Amount Needed Cost Per Transaction Opportunity Cost of Captial * 348

349 Mergers and acquisitions (M&As) Chapter

350 Overview M&As: key concepts and time trends Theories of M&As Dubious motives for M&As Estimating NPV of M&As Winner s curse in acquisitions Stock price reaction Risks of M&As M&A waves 350

351 Definitions Market for corporate control The market where corporate assets match with owners and management teams (if efficient, those who can make the most of the assets) Proxy contests to elect a new board of directors and takeovers are key instruments enabling changes in control Corporate restructuring Set of actions taken to expand or contract a firm s operations or to change its asset or financial structure Merger Transaction forming one economic unit from two or more previous ones Acquisition Purchase of a controlling interest in the firm, generally via a tender offer for the targeted shares Tender offer: One party asks the shareholders of a firm to tender the shares of the firm 351

352 Mergers and acquisitions (M&As) - Worldwide Source: Thomson Financial, Institute of Mergers, Acquisitions and Alliances 352

353 Mergers and acquisitions in Europe Source: Thomson Financial, Institute of Mergers, Acquisitions and Alliances 353

354 Largest M&A deals - Worldwide Rank Date Announced Acquiror Name Target Name Value of Deal (Euro mil) 1 11/14/1999 Vodafone AirTouch PLC Mannesmann AG , /10/2000 America Online Inc Time Warner , /26/2015 Altice Sa Altice Sa , /02/2013 Verizon Communications Inc Verizon Wireless Inc , /29/2007 Shareholders Philip Morris Intl Inc , /16/2015 Anheuser-Busch Inbev SA/NV SABMiller PLC , /25/2007 RFS Holdings BV ABN-AMRO Holding NV , /04/1999 Pfizer Inc Warner-Lambert Co , /01/1998 Exxon Corp Mobil Corp , /17/2000 Glaxo Wellcome PLC SmithKline Beecham PLC , /28/2004 Royal Dutch Petroleum Co Shell Transport & Trading Co , /05/2006 AT&T Inc BellSouth Corp , /06/1998 Travelers Group Inc Citicorp , /08/2001 Comcast Corp AT&T Broadband & Internet Svcs , /08/2015 Royal Dutch Shell PLC BG Group PLC , /17/2014 Actavis PLC Allergan Inc , /26/2009 Pfizer Inc Wyeth , /12/2015 Dell Inc EMC Corp , /29/2014 UBS AG UBS AG , /11/1998 SBC Communications Inc Ameritech Corp ,26 Source: Thomson Financial, Institute of Mergers, Acquisitions and Alliances 354

355 Types of Acquisitions Financial acquirers Make a return on their investment by re-selling parts of the acquired business Strategic (synergistic) acquirers Keep what they buy and add it to the business they already own They can pay more than financial acquirers, because the latter have no strategic synergies Hostile acquisition Present management of target is against the bidder Friendly acquisition Present management of target is in favor of the bidder 355

356 Types of M&As Horizontal Combining companies in the same line of business Vertical Combining companies from different stages in the supply chain, that is, a supplier and its customer, vice versa E.g. pulp-paper, oil drilling - oil refining - gasoline stations Conglomerate Combining companies in unrelated types of business activities 356

357 Theories of mergers (1) Efficiency (1.1) Operating synergy Economies of scale; e.g. Exxon-Mobil Complementary resources; e.g., large mature firm teaming up with small innovative target (1.2) Financial synergy Economies of scale in security offerings Lower distress costs: higher debt capacity and larger interest tax shields (1.3) Adjusting quickly to new environment 357

358 Theories of mergers (1.4) Differential managerial efficiency Management of the acquiring firm may have excess capacity and more talent than management of the acquired company (1.5) Diversification and internal labor market Provides managers and other employees with more job security and opportunities for promotion, resulting in lower labor costs 358

359 Theories of mergers (2) Agency problems Managerialism: Managers are motivated to increase the size of the firm, resulting in merger activity Free cash flow hypothesis: Firms tend to use their free cash flows to purchase other companies Takeovers also act as a solution to agency problems which cannot be resolved otherwise (3) Hubris hypothesis Bidders make errors in evaluating the acquired companies They may think that they make a good deal when they actually do not (4) Market power and higher profit margins 359

360 (6) Redistribution Theories of mergers Increases in leverage redistributes wealth from bondholders to stockholders Renegotiating salaries and other benefits is a wealth transfer from employees to stockholders (7) Misvaluation In the absence of complete information, investors may overor under-value a firm. Acquirers can profit by buying undervalued targets for cash at a price below their intrinsic value or with stock as long as their stock is more overvalued than target s 360

361 Demo 4 T/F problem All other things being equal, a company where managers have significant ownership is more likely to be targeted than a company with little managerial ownership. True or false? 361

362 Demo 4 T/F problem False. Acquiring a company where the management controls a large part of the ownership is difficult if the management resists the takeover. Also, such a company is less likely to suffer from value loss due to agency problems which would, otherwise, increase the appetite of potential acquirers. 362

363 Dubious motives for mergers Mergers allow to diversify risks in several industries Investors can do this more easily and cheaply than the company BUT: owners of closely-held companies may find it worthwhile to diversify if they do not want to lose their control in the company 363

364 Dubious motives for mergers Mergers decrease the cost of debt When two companies merge, the probability of default on debt decreases Debt has better protection and, thus, the cost of debt capital decreases BUT: because of the decrease in the probability of default, stockholders option to default is also less valuable This will eliminate the benefit arising from the decreased interest costs Stockholders can even lose if the merger comes as a surprise Nevertheless, the expected bankruptcy costs will decrease 364

365 Dubious motives for mergers Mergers increase EPS (Bootstrap effect) Example: Assume that a merger does not increase the combined value of the firms (i.e., no synergies) Firm A Firm B Combined AB V 4,000,000 2,000,000 6,000,000 Earnings 200, , ,000 N 100, , ,000 P EPS P/E E/P

366 Dubious motives for mergers euro + EPS increases - Average growth rate of the merged company AB decreases from that of A B A AB 366

367 NPV of M&A s An M&A provides a gain if the companies are worth more together than apart: Gain = PV AB (PV A + PV B ) 0 The cost of acquiring B is the purchase price of B minus the value of B separately: Cost = B s purchase value PV B The acquirer A should acquire B only if: NPV = Gain Cost = PV AB (PV A + PV B ) (B s purchase value PV B ) 0 367

368 NPV of M&A s: Cash offer Example: Firm A plans to acquire Firm B for 65m in cash PV A = 200m and PV B = 50m PV of cost savings from the merger = 25m PV AB = 275m The gain from the merger is: Gain = PV AB (PV A + PV B ) = 25m Cost (to A) = 65m 50m = 15m [ merger premium ] NPV (to A) = Gain Cost = 25m 15m = 10m 368

369 NPV of M&A s: Stock offer Example continued: Suppose A instead offers 325,000 shares for all of B's shares A's stock price before deal announcement is 200 (1 million shares outstanding) and B's market value 50 million The cost appears to be: 325, m = 15m Recall that A s and B's joint market value is: 200m+ 50m + 25m = 275m 369

370 NPV of M&A s: Stock offer The number of shares outstanding due to the acquisition increases by 325,000 shares The share price after the acquisition is: 275m / 1,325,000 = per share Thus, the actual cost of the acquisition is: 325, m = 17.45m and not 15m The actual cost can also be calculated using B's share of combined company: 325,000 / 1,325,000 = 24.5% B's shareholders gain: m - 50m = 17.45m 370

371 NPV of M&A s In general: If the acquisition is financed with stock, the cost of acquiring the company B is: Cost = B s share of AB PV AB PV B If the acquisition is financed with cash, the cost of the merger is unaffected by the merger gains: Cost = Cash paid PV B 371

372 Demo 4 - Problem 4: M&A Valuation Centro Corporation is considering whether to acquire Dynamic Enterprises. The CFO has collected the following information: Centro Dynamic Price to earnings ratio Shares outstanding 2,500, ,000 Earnings 2,000, ,000 Centro also knows that securities analysts expect the earnings and dividends of Dynamic (which has just paid out an annual dividend of 2.25 per share) to grow at a constant rate of 5% per year. Centro s management believes that the acquisition of Dynamic will provide synergies that will increase Dynamic s growth rate to 7% per year. Assume that capital markets are perfect and that the acquisition does not alter the stand alone riskiness of either firm. Also assume that the value of Centro as a stand alone entity is unaffected by the acquisition. 372

373 Demo 4 - Problem 4: M&A Valuation a) What is the value of Dynamic to Centro? Dynamic s stand-alone growth= 5% & growth as part of Centro= 7% First, calculate the stand-alone value of Dynamic s stock and the corresponding required return: P V D _ alone P N 9 EPS EPS N ,000 m V D _ alone P N Div1_ ( r g alone alone ) N 2.25(1 5%) 180,000 r -5% r 9.725% 373

374 Demo 4 - Problem 4: M&A Valuation a) What is the value of Dynamic to Centro? Now, calculate Dynamic s value with Centro (i.e., when g after =7%): V D _ after P N Div1_ ( r g after after ) N 2.25 (1 7%) ( ) 180, % - 7% 15.9m 374

375 Demo 4 - Problem 4: M&A Valuation b) How valuable are the synergy benefits? Since the value of Centro stays the same after the acquisition as its stand-alone value, the synergies are just made of the increase of the value of Dynamic: Gain VD _ after VD _ alone 15.9m 9m 6. 9m 375

376 Demo 4 - Problem 4: M&A Valuation c) What is the highest bid per share for Dynamic that would be acceptable to Centro s management? Value of Dynamic to Centro is 15.9m, which is per share: V D _ after N 15.9m 180, is the highest offerable bid, because costs exceed the gains at higher bids. 376

377 Demo 4 - Problem 5: M&A Valuation Now, suppose Centro Corporation offers 70 in cash for each share of Dynamic. a) What is the NPV of the acquisition to Centro? Cash offered = ,000= 12.6m NPVC Gain CostC 6.9m ( 12.6m 9m) 3. 3m 377

378 Demo 4 - Problem 5: M&A Valuation b) What is the NPV to Dynamic s shareholders? Centro s cost is Dynamic s NPV: NPV D Cash _ Offered PV m 3.6m D _ alone Dynamic s shareholders get a higher portion of the total gain of the merger 378

379 Demo 4 - Problem 5: M&A Valuation c) If Centro were to offer 3 new Centro shares in exchange for each Dynamic share (instead of the 70 cash offer), what would the NPV of the acquisition be to Centro? How much would Dynamic s shareholders gain per share? Centro s shareholders receive a company worth 15.9m, and in exchange give 3x180,000 = 540,000 shares to Dynamic s shareholders. The value of the merged company: V CD V C V D _ after ( P EPS ) C EPS N C 15.9m 22 2m 59.9m 15.9m 379

380 Demo 4 - Problem 5: c) NPV of the acquisition to Centro? How much would Dynamic s shareholders gain per share? NPV of the acquisition to Centro: 540,000 NPV C 6.9m ( 59.9m 9m) 5. 26m 2,500, ,000 Dynamic s shareholders NPV: M&A Valuation NPV D 17.76% 59.9m 9m 1. 64m Dynamic s shareholders gain per share 1.64m 180,

381 Demo 4 - Problem 6: Dubious reasons for M&As Chateau Local and Ruth s Vineyard, two wineries located in different continents, have decided to merge and form CLRV Wines. The two firms are identical except for their location. Their company value is determined entirely by the weather conditions of the upcoming year, as shown below: State (for the whole year) Probability Company value Dry million Temperate million Wet million 381

382 Demo 4 - Problem 6: Dubious reasons for M&As The weather conditions in each location are independent of each other. Both companies have one outstanding bond claim of 30 million to be paid at the end of the year. A drop in company value below this figure would lead to bankruptcy. Once the bond claim has been paid, the remaining company value belongs to equity holders. Assume that all investors, including bondholders, are risk neutral (they only want to maximize their expected payoff) and have a zero discount rate. It is currently the beginning of the year, and the merger is to be announced and completed the next day. 382

383 Demo 4 - Problem 6: Dubious reasons for M&As a) What is the combined market value of the two companies debt before the merger announcement? For both companies, stand-alone payoffs are as follows: State Probability Company value Debtholder Equity Holder Dry m 20m 0 Temperate m 30m 20m Wet m 30m 10m Bondholders don t get fully paid in the dry state (with p=0.2). The company goes bankrupt and bondholders get 20m with 20% probability. So, pre-merger value of each company s debt is: V D _ alone m (1-0.2) 30m 28m Total value of two companies debt is 2x 28m = 56m 383

384 Demo 4 - Problem 6: Dubious reasons for M&As b) What is the same value after the merger announcement? The payoffs for the merged firm (CLRV) are as follows: State Probability Company value Debtholder Equity Holder DD 0.2x m 40m 0m DT 0.2x m 60m 10m DW 0.2x m 60m 0m TD 0.4x m 60m 10m TT 0.4x m 60m 40m TW 0.4x m 60m 30m WD 0.4x m 60m 0m WT 0.4x m 60m 30m WW 0.4x m 60m 20m Total debt of the merged firm is 60m, which will be fully repaid unless both wineries simultaneously experience a dry season (V CLRV = 40m < 60m) but the probability of that state is only 4%! Thus, market value of the CLRV s debt is now: m (1-0.04) 60m 59. 2m 384

385 Demo 4 - Problem 6: Dubious reasons for M&As c) Suppose that the merger plan is announced and that the shares of the new company will be divided on equal basis among the shareholders of the old companies. Calculate the expected announcement effect (percentage change) on both companies share price. Assume that capital markets are perfect and that the merger creates no synergy benefits that affect the company value. Total firm value before: VCL VRV 2 ( ) 80m Total equity value (E = V D) before: ECL ERV 80m 56m 24m Firm value after merger (no synergies): V CLRV 80m Equity value (E = V D) after: E CLRV V CLRV D CLRV 80m 59.2m 20.8m As soon as the announcement is made, E CL and E RV will each drop from 12m to 10.4m. 385

386 Demo 4 - Problem 6: Dubious reasons for M&As c) Suppose that the merger plan is announced and that the shares of the new company will be divided on equal basis among the shareholders of the old companies. Calculate the expected announcement effect (percentage change) on both companies share price. Assume that capital markets are perfect and that the merger creates no synergy benefits that affect the company value. Percentage change in E CL (or RV) = ( 10. 4m 12m)/ 12m % [What about the percentage change in the value of debt? What s the wealth transfer in from D to E? What could CL&RV do to offset this effect if there were gains>0 from the merger?] 386

387 Stock price reaction Acquired firms shareholders tend to win from the acquisitions Market value of acquired company increases substantially (in the U.S. about 15% in mergers and 30% in tender offers) On average, the market value of the shares of the acquiring company remains the same or even decreases Stock price reaction for the bidder tends to be worse than otherwise when: Bidder management owns little stock The acquisition is financed by issuing stock [signal] Bidders diversify Bidders have low growth opportunities and high cash flows 387

388 Stock price reaction: Case of Microsoft-Nokia Source: Yahoo Finance 388

389 Winner s curse in mergers In an efficient market: evaluate an acquisition by asking why the company would be worth more combined than separately If target firm has several potential acquirers, you should not bid for a company if it is not worth more to you than to others Winner's curse: If you pay the most of many competing potential acquirers, you are likely to have overestimated the value of the target company most If you "win" the buying competition, you may be "cursed" because you have probably paid too much 389

390 Risks of mergers Many acquisitions are not value-enhancing deals for the buyer, and some of them are disastrous There are many risks that are often difficult to assess before the deal The following types of acquisitions are particularly risky: Acquisitions without sufficient strategic fit Large acquisitions Cross-border acquisitions Acquisitions of companies whose most important assets are human capital 390

391 Merger waves M&A activity tends to be clustered over time Merger waves tend to occur when stock prices are at historically high levels Sector-related changes/shocks vs. valuation errors The Economist (2008) 391

392 Week 4 - Recap: Mergers & Acquisitions 1. Preliminaries Definitions (Mergers, acquisitions, tender offers) Categories: - horizontal, vertical, conglomerate ones; - hostile, friendly ones; - strategic, financial ones Theories - Merger theories - Dubious reasons 2. Evaluation of M&As a) Gain from merger: b) Cost to acquirer: Payment with cash: - costs unaffected by gains - positive price reaction for the acquired company Payment with stock: Gain PV ( PV PV ) PV Cost CashPaid PV A ( Cash ) B B Cost - costs depend on gains - negative price reaction for the acquiring company AB N A P B PV AB ( NPV x ) PV PV ( NPV A ( Stock) B AB B B AB B B ) c) NPV of a merger or acquisition: NPVA Gain Cost A 392

393 Final remarks 17 lectures (inc. 3 guest lectures), 11 chapters, 4 exercise sets and one case study in 5½ weeks! We have tracked much of the financial life of a business enterprise and covered the mainstream theories and key principles: Inception and growth with personal funds/bank loans/venture capital Continued growth through larger investments and acquisitions makes internal/private funds/bank loans insufficient and public equity/debt offerings necessary [IPOs, SEOs] Separation of ownership and control (i.e., management) makes corporate governance important [e.g., independent board, pay-for-performance, not resisting valuable takeovers] Acquiring existing firms are, at times, preferable to organic growth [M&As] Mature, value firms: Slow growth and assets in place generating large cash flows make payout policy crucial [how much? dividends vs. repurchases?] Decline and/or deviations from optimal investment or financing decisions lead to corporaterestructuring [downsizing, leveraged restructuring, takeovers/lbos, bankruptcies etc.] 393

394 Thanks for participating and best wishes 394