Company: Basic concepts and financing choices. Equity financing

Transcription

1 Company: Basic concepts and financing choices Equity financing International Financial Markets 2011

2 Company: basic concepts Funding (basic decision is between equity and debt) Choose depending on stage of the cycle of the company, investment project Investment (acquire assets exepected to generate satisfactory cash flows) Hurdle rate > funding cost : minium rate of return that project must satisfy aim: Maximise value of the company (discounted profits) If markets are efficient, maximising value is tantomount to maximising stock price Due to separation of ownership and management control accompanied by imperfect and asymetric information on management decisions, other, management-oriented goals may be pursued International Financial Markets 2011

3 Company: basic concepts Fisher Separation Theorem Firm's investment decision is independent of the preferences (riskaversion) of the owner, The investment decision is independent of the financing decision Assumption: Investor can lend and borrow at risk-free rate Modigliani-Miller Theorem The value of the firm is unnafected by how it is financed Assumptions: no bunkrupcy costs, no asymetric information, information efficient market While these concepts provide influential background for thinking about corporate finance, the reality is often at odds with their implciations: People spend a lot of time thinking about the right financing mix Ongoing research in this area: Agency models, Asymetric information, Strategic default International Financial Markets 2011

4 Financing choice Equity Residual claim on cash flows Lowest priority in bankrupcy Not tax deductible Perpetual Some management control Increased debt capacity Shared/diluted ownership Examples: Common shares, venture capital Debt Fixed claim on cash flows High priority in bankrupcy Tax deductible Fixed maturity No management control Smaller flexibility Increased management discipline Examples: Bank debt, corporate bonds, commercial papers International Financial Markets 2011

5 EARNINGS Financing choice and constrains Equit y Debt Bank loans Bonds Source: Wiki International Financial Markets 2011

6 Equity financing Private Equity Cost Angel Investors (minority share, start-up/very early stage) Low Venture Capital (control, early stage) Growth capital (minority share, mature companies, transition phase) Leveraged buyouts (majority share, mature companies) (+hybrids i.e. mezzanine) Price Low Agreement flexibility High Public Offering Initial Secondary Rights offering High Low High Low stock market rules Public Issue: Easier access to capital in the future Market Valuation Publicity/ Prestige

7 Private equity: shareholders agreement Core business / Strategy of the Company and majority needed to change it Management and its appointment Supervisory Board composition Scope of decisions made at Shareholders and Supervisory Board Meetings (and majority needed) Anti dilution decisions on capital increases EXIT (usually after 5-7 years; selling the bussiness to other investors or IPO) Put option Call option Right of First Refusal Drag-along rights Tag-along rights International Financial Markets 2011

8 Situation One You are a successful businessman. You started in the tourist business 10 years ago, first 5 years renting a house you inherited, than building your first hotel (by taking mortgage over land, your apartment and selling the inherited house). The hotel was so popular that you shortly decided to built another one. Thanks to good publicity your two hotels are now well known. You would like to expand (built a network of 3-5 hotels) and you cheaply bought a nice land in three tourist districts. How can you finance your expansion. What are pros and cons of different options? Do you built hotels one by one or all at once? International Financial Markets 2011

9 Situation Two You are leading a large oil group, that has a refinery and a network of petrol stations. The Company is listed at the Hungarian stock exchange. You see the opportunity in entering the oil exploration. Thanks to your business contacts you have identified an interesting piece of land in Kazakhstan. The largest shareholder approves this strategy, however some minorities consider it too risky. How do you finance your plans? Within the existing Company or by establishing new one? Do you use debt or equity? International Financial Markets 2011

10 Situation Three You are a bright postgraduate. Together with your friend you developed a social internet network for graduates of your uni but business-oriented (split by the type of job performed). It became popular and you started make money on adds. You financed it by friends and family money. Than another uni asked you to replicate this, which you did partly via prepayment from uni, but rest from own profits form first project. Now you have the idea to expand the business onto 100 universities in US. This requires 200 million into IT, with expected profits of 30 million a year, but possible only after ca. 2 years when systems gain popularity. A well known business man offered you help in raising 95% finance for 66% of your profits. Do you accept his help? What options to finance you have and which would you choose. International Financial Markets 2011

11 Publicly traded equity International Financial Markets 2011

12 World equity market International Financial Markets 2011

13 Preparatory stages for IPO Appoint an IPO advisor/ brockerage house Appoint an auditor Appoint legal advisor and PR agency Register with securities commission Publish preliminary prospectus ( red herring ) Road Show Final Prospectus (with price range) Book-building Share issue International Financial Markets 2011

14 Actors IPO adviser (brkoegare house, investment bank etc) prepares prospectus, assists with investors and SEC meetings, helps in setting the price range, underwrites the issue Auditor - verifies the financial statements of the capital group for at least 3 years. Has to be independent. Legal Advisor prepares legal section of the Prospectus, introduces necessary changes in the corporate documents and bylaws, prepares decissions of the Shareholder s meeting PR/IR agency ensures appropriate information flow to the potential investors, arranges investors meeting and appropriate publicity /marketing for the issue International Financial Markets 2011

15 Prospectus Document that presents the Company seeking capital market investors The core binding legal document describing the share issue Contains information on: The Company: its operations, permissions, management, past and forecasted results, company by-laws The Offer: incl. issue size, instrument issued, use of proceeds, targeted secondary market, costs, planned timetable Risk Summary International Financial Markets 2011

16 Equity Markets Investors Perspective Market Efficiency Risk-Return Capital Market Line CAPM Diversification Index International Financial Markets 2010

17 Equity Investors private equity Individuals Corporates Seed funding (friends, family; < USD k) Business Angels (between Seed and VC) Venture Capital Funds (min. USD1-2 mln) Private Equity Fund International Financial Markets 2010

18 Equity Investors public equity 1. Individuals 2. Pension Funds 3. Mutual Funds (open-end fund) 4. Hedge Funds 5. Insurance Companies 6. Trusts (close-end fund) 7. Sovereign Wealth Funds 8. Corporates International Financial Markets 2010

19 Share Price International Financial Markets 2010

20 Valuation Methods Discounted Dividends/Cash Flow Shareholder has the right to a proportion of Company s profits. Those are either reinvested or distributed to Shareholders in form of dividend. Discounting Dividend stream/ Discounting Free Cash Flow and terminal value allows to value the shares. Comparables The shareprice is valued based on its key financials and using multiples characteristic for its market segment International Financial Markets 2010

21 Multiples Most common multiples: Price / Earnings Price / Net Asset Value Enterprise Value / Operating Profit Enterprise Value / EBITDA Industry Specific Price / Sales Price / Capacity or Production International Financial Markets 2010

22 Factors affecting share price All factors afecting the expectationas about the Company s future performance and factors affecting the overall demand for equities. Market/Industry Factors Firm Specific International Financial Markets 2010

23 International Financial Markets 2010

24 What is your bet when investing in a given security? You are not betting that the Company s results will be good. But that they will be better than the market currently expects Or That other investors will shortly revise their expectations about the Company s performance upwards International Financial Markets 2010

25 International Financial Markets 2010

26 Stock Returns world of randomness International Financial Markets 2010

27 Reasons for Market Efficiency Many investors Investors have access to the same information Investors use similar valuation techniques Market price reflects the demand and supply at a given point What are investors doing if a they find shareprice too low? What happens with the price? International Financial Markets 2010

28 Market Efficiency Weak future equity prices cannot be established by analysing historic trends and returns Medium one cannot calculate future equity price moves with help of technical analysis and fundamental analysis (based on publicly available information) Strong even an investor who has inside knowledge about the Company cannot foresee future returns. International Financial Markets 2010

29 Market Efficiency Returns are of random character Fundamental factors are reflected in the market price Price anomalies disappear Investors cannot systematically find extraordinary returns (alpha) International Financial Markets 2010

30 Market Efficiency - Reality In a developed market like the United States market-wide movements explain only 3 percent of the daily variation of individual stock, while in emerging countries such as Taiwan and Poland they explain far more (approximately 40% and 60% ) International Financial Markets 2010

31 What is not implied? Common Misinterpretations stock prices cannot deviate from true value there can be large deviations from true value, but they need to be random. no investor will 'beat' the market in any time period Approximately half of all investors should beat the market in any period. no group of investors will beat the market in the long term A group of investors can beat the market not because of strategy but because they are lucky. International Financial Markets 2010

32 Mechanics of randomness STABILISING SPECULATION EQUITY PRICES DESTABILISING SPECULATION Based on fundamental factors Based on non-fundamental factors International Financial Markets 2010

33 What about exit risk in case of public equity? What equity market can be described as safe? International Financial Markets 2010

34 Why is liquidity important Allows to close the position quickly and without a significant influence on the price Volume Liquid markets: Deep Safe International Financial Markets 2010

35 International Financial Markets 2010

36 Risk - Return RETURN BETTER? Stock A? WORSE RISK International Financial Markets 2010

37 Intuition With the same expected return do you prefer risky or riskless asset? What does the risky asset give you that the riskless cannot? You are a stock market investor: would you add to your portfolio - a stock that earns in market boom or - a stock that earns in market downturn? International Financial Markets 2010

38 Two Assets RETURN Stock B Stock A??? RISK International Financial Markets 2010

39 Two Assets w A of stock A (r A, σ A ) w B of stock B (r B, σ B ) r( x) w A r A w B r B

40 Two Assets RETURN Stock B Stock A RISK International Financial Markets 2010

41 B B A A x r w r w r Two Assets w A of stock A (r A, σ A ) w B of stock B (r B, σ B ) B A B A B B A A Cov w w w w x, B A B A B A Cov Corr,,

42 Role of correlation RETURN Stock B Stock A RISK 2 x w 2 A 2 A w 2 B 2 B 2w A w B Cov A, B International Financial Markets 2010

43 r w r w r F A A x Two Assets incl. Risk-free w A of stock A (r A, σ A ) w F of risk free asset (r, 0) 2 2 2, A A x A F A F A A x w Cov w w w w International Financial Markets 2010

44 If one of asset is risk free RETURN Stock A Risk Free RISK r x 2 x w A 2 A w 2 A r A w F r International Financial Markets 2010

45 If one can borrow RETURN Stock A Risk Free RISK r x 2 x w A 2 A w 2 A r A w F r International Financial Markets 2010

46 Expected return Capital Market Line M B M International Financial Markets 2010 Risk

47 CAPM Pricing Model Required Return Behavior vs market r i r i Equity market premium rm - r Risk Free Return International Financial Markets 2010

48 Diversification PORTFOLIO RETURN (weighted average) RISK (less than average) International Financial Markets 2010

49 Diversification Portfolio approach it s not about the riskiness of asset that is added to the portfolio But about the impact of this asset on the portfolio risk - return profile International Financial Markets 2010

50 Equity Risk Management When buing a share one takes: Equity market risk Company s specific risk First way of risk management is always to: International Financial Markets 2010

51 Diverify!!! International Financial Markets 2010

52 Two approached to stock investing Stock picking - selecting the companies one by one Index investing - investing in wide range of shares, adjusted by overweigting/underweighting specific sectors or shares International Financial Markets 2010

53 Bet that one would be better than another!!! International Financial Markets 2010

54 How to do it? Buy the shares of Company that you think would outperform its Compatitor(s) and Sell short the shares of Compatitor(s) International Financial Markets 2010

55 HSBC will outperform Citi Buy HSCB shares Sell Citi shares for the same amount Fingers crossed. Long HSBC Short Citi International Financial Markets 2010

56 HSBC outperforms Citi Long HSBC Short Citi International Financial Markets 2010

57 Advantages of spread betting Specify the risk you are taking Win also in falling markets Limit market risk Require less capital International Financial Markets 2010

58 Common relative value strategies Stock A vs Stock A in a different market Stock A vs stock B Stock A vs mix of industry stocks Stock A vs index Index X vs Index Y Stocks of industy A vs stocks of industryb International Financial Markets 2010

59 Equity Risk Management Diversification Relative value International Financial Markets 2010

60 Two approached to stock investing Stock picking - selecting the companies one by one Index investing - investing in wide range of shares, adjusted by overweigting/underweighting specific sectors or shares International Financial Markets 2010

61 What is your bet when investing in an index? That share price constituting the index are in general cheap or That investors will be more willing to invest in equities in the near future International Financial Markets 2010

62 Index Why is index popular? Who would invest in index? How to invest in index? International Financial Markets 2010

63 Index investing 1. Replication Not perfect High transaction costs 2. Index trackers Tracking error 3. Index derivatives Index futures Index options International Financial Markets 2010

64 Tbc: other topics in equity Equity Options and Futures Equity Investment Strategies Hedging Equity Risk International Financial Markets 2010

65 Equity Derivatives International Financial Markets 2011

66 Derivatives: basic concepts Derivative: a contract which derives its value from the value (price) of the underlying asset In principle derivatives increase the effeciveness of the market Can allow for better risk sharing in the economy by Limiting risk (hedging) or Acquiring risk (speculation) Not properly understood (what am I buying here exactly?) and abused (high leverage) can lead to instability of the system International Financial Markets 2011

67 Equity Markets - Portfolio Equity Futures and Forwards Equity Options Equity Swaps Value at Risk International Financial Markets

68 Equity Risk Management When buing a share one takes: Equity market risk Company s specific risk By increasing number of stocks one dilutes company specific risk and can improve risk-return profile (see Excel example) International Financial Markets 2010

69 Index investing easy way to diversify portfolio Replication Not perfect High transaction costs Index trackers Tracking error Index derivatives Index futures Index options International Financial Markets

70 Future/Forward Financial contract between parties to exchange the underlying in the future at a preagreed price. or to settle a financial difference between a preagreed value and the value at settlement date Forward: Inter-bank market (OTC), settlement at expiry Futures: Regulated market (Exchanges), daily settlement (margins and margin calls) International Financial Markets 2010

71 Leverage Notional Amount -Basis to calculate profits & losses CAPITAL International Financial Markets

72 At what price would you sell stocks in one year? Buy derivative/off-balance Buy Stocks now/balance SHEET Forwards F Stocks S Borrow money Future proceeds have to be sufficient to repay the loan and interest F S 1 i International Financial Markets

73 What would you do if F>S(1+i) Buy derivative/off-balance Buy Stocks now/balance SHEET Forwards F Stocks S Borrow money In one year you will get F for the stocks and will have to pay bank S(1+i), so you have guaranteed a profit of: F S 1 i International Financial Markets

74 Using Stock Futures Share price is now 100, and the interest rate at 4%. You are buying one-year future for 104. In half year time share price is still 100. What would be your result if you close your position now? Interest rates remain unchanged (and are flat) In 1 year time the share price is 106. What is happening? What would happen if shareprice was 100 at that day? International Financial Markets

75 Example Investing in futures in practice International Financial Markets

76 WIG20 Futures Point value = 10zł Contract value=10zł index level Expiry: III(H), VI(M), IX(U), XII(Z) Initial deposit 10% (i.e. leverage of 10) Maintenance deposit 10% 76 International Financial Markets

77 WIG20=1617,31 Buy FW20H09 po 1650 What is the value of the position? zł What deposit needs to be paid in? 10% zł = 1650zł Do we benefit from increase or drop? Long => so benefit if WIG20 goes up What whould be the deposit if we sold one contract? Same 77 International Financial Markets

78 Next day: WIG20=1555,68 FW20H09 are at1591 What is the value of our position? zł Howm much have we gained/lost? zł zł = -590zł In the deposit sufficient? At our =1060 Minimum: 10% 15910zł=1591(too little) What is the margin call? = International Financial Markets

79 WIG20=1676,12 We bought 1650, now 1710 What is the value of our contract? 1710zł What is our aggregated gain/loss? zł zł = 600zł The level of deposit (assuming no flows) 1650zł+600zł=2250zł FW20U How can we roll our contract? We sell the June contract and purchase September one. We can cash out the difference between the value of our deposit account (2250) and the minimum required for the new contract (1720zł). 79 International Financial Markets

80 Benefits from the Futures + FW20H09@1650 (WIG20@1617,31), - FW20H09@1710 (WIG20@1676,12) Gain: 600zł What is the % change of index? Ca. 3.6% What is our return on capital invested? Investment 1650zł Gain 600zł Return 36% Leverage 80 International Financial Markets 2010

81 Alternatives: Mutual Funds (with equity strategy) High costs Subscription Commission Management Fee!!! Sometimes: success fee Fixed exit date Index Trackers (ETFs, ishares) Low transaction costs Only long position possible 81 International Financial Markets

82 Alternative 2: Options Financial contract that gives its buyer a right to purchase or sell an underlying asset in the future at a preagreed price (seller must oblige) Asymetric, allows to speculate with downside protection thus more expensive than forward/future Call option: option (right) to buy underlying asset Put option: option (right) to sell underlying asset One can both buy or sell these rights: buy/sell call/put option European: can be excercised only at maturity American: can be excercised whenever the buyer wants (more profit oportunities, is therefore more expensive) 82 International Financial Markets

83 Options basic arithmetics How much is an (Europen) option worth at expiry and when you excercise it? At expiry there is no uncertainty about the payoff, so Call: Price(C) = max(current price-strike,0) If the current price at expiry is below the Strike, you would not excercise your option, as it is cheaper to buy the asset in the market. Option is worth zero. Otherwise you excercise and buy cheaply using your option. Put: Price(P) = max(strike-current price,0) 83 International Financial Markets

84 Options basic arithmetics cd. How much is an (Europen) option worth before expiry? Before expiry the price of the option must also be adjusted for the probability that during the remaining time it will end up in the money and how much it can therefore potentially pay-out We augment the previous formula with probabilities: Price(C,t) = E(Asset price(at expiry)-strike) where E stands for Expected value from the whole distribution of possible values (i.e. mean value) In other words option price reflects its expected (average) payoff at expiry More accurately, it reflects the expected value of these payoffs (due to risk aversion, people may value some payoffs more than other - example: insurence may cost more than its expected value is and we still want to buy it) 84 International Financial Markets

85 Call Option - example You purchased DB call option with a strike of EUR 80 that expires in 3 months. For this option you paid EUR 5. It means, in 3 months you CAN (but do not have to) purchase one DB share at EUR 80. International Financial Markets 2010

86 Purchased Call: Strike = EUR 80 At settlement the price is 75. What do you do? In the market One share is EUR 75 Option Contract: One share is EUR 80 International Financial Markets

87 Purchased Call: Strike = EUR 80 At settlement the price is 90. What do you do? In the market One share is EUR 90 Option Contract: One share is EUR 80 International Financial Markets

88 Purchase of Call: Strike = EUR 80 NET RESULT Actual price -5 Maximum loss when buying an option is the premium that was paid. International Financial Markets

89 How about the put option? You purchase a put option for DB at a strike of 70, one month expiry at price of EUR 3 It means that in a month time you can (but do not have to) sell one DB share at EUR 70 International Financial Markets

90 Purchase PUT: Strike = EUR 70 Result Actual price -3 When purchasing put option the maximum loss is the price paid! International Financial Markets

91 C A RESULT BUY RESULT SELL L K PRICE K PRICE L RESULT RESULT P U K PRICE K PRICE T International Financial Markets 91

92 Amount to be received for the shares You will get 100 shares in one year do nothing Gain Wait a year and sell 100 share you just got Loss Current price (t0) Share price in one year International Financial Markets

93 Amount to be received for the shares You will get 100 shares in one year sell them forward Gain Wait a year and sell 100 share you just got 2. Hedge with Forward (sell 100 shares in a foward): No gains nor losses 0 Loss Payout from forward F Share price in one year International Financial Markets

94 Amount to be received for the shares Payoff from the put option You will get 100 shares in one year buy a put option 1. Wait a year and sell 100 share you just got 0 Hedge with option (buy a put option with excercie price = forward price) F Share price in one year International Financial Markets

95 Amount to be received for the shares Payoff from the put option You will get 100 shares in one year alternative actions to take 1. Wait a year and sell 100 share you just got 3. Hedge with option (buy a put option with excercie price = forward price) 0 F Share price in one year International Financial Markets

96 Amount to be received for the shares Payoff from the put option You will get 100 shares in one year alternative actions to take Premium 1. Wait a year and sell 100 share you just got 3. Hedge with option (buy a put option with excercie price = forward price) 2. Hedge with Forward (sell 100 shares in a foward) 0 F Share price in one year International Financial Markets

97 What other instruments are there in the international equity markets? CIRS BONDS Shares Currencies REPO 97 International Financial Markets

98 Equity Total Return Swaps A fund manager of a passively managed Profit I equity fund is managing EUR 100 million portfolio of stocks. However currently he is worried that the market can be very volatile during the earning season. What can he do? TR Swap Market Maker Portfolio returns 9% PROFIT Quote 9%-10% 8% Portfolio of stocks (EUR 100 million) dividends International Financial Markets

99 Dividend Swap An Investment Fund (Profit II) is an equity fund of a passive character and 5 year investment horizon. It has a portfolio of EUR 100 million in Eurostoxx shares. They expect that the return over next year (including dividend stream) will be 8%. The Fund manager is afraid that given the recent crises companies might be more reluctant to share profits. The analysts are expecting (2%). He uses a dividend swap: Dividend Swap Market Maker dividends 1.8% PROFIT Quote 1.8%-2.2% 8% Portfolio of stocks EUR 100 million dividends International Financial Markets

100 Main reasons to enter equity swaps Hedging Investing with limited cash (leverage) Enter new markets (to diversify) International Financial Markets

101 Value at Risk (VaR) A standard workhorse in risk management

102 Value at Risk Tells us what happens in the normal circumstances an A VaR is like an airbag that always works, except when you have accident Problems: Short time series Volatility and dependence structures changes across time and may have complex co-dependences asset classes (ie. tail dependence) Does not tell how large the losses can be Conditional VaR can, but the above problems remain Is not a guarantee, it s a probability statement International Financial Markets 2010

103 -5,0% -4,5% -4,0% -3,5% -3,0% -2,5% -2,0% -1,5% -1,0% -0,5% 0,0% 0,5% 1,0% 1,5% 2,0% 2,5% 3,0% 3,5% 4,0% 4,5% 5,0% More Frequency Calculating Value at risk WIG VaR Based on 2005 and 2006 data Percentile minimum -5.33% 1% -3.34% 2% -2.81% 5% -1.86% 10% -1.14% 90% 1.43% 95% 1.79% 98% 2.26% 99% 2.73% maximum 4.14% International Financial Markets