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Summary
Finance 2
Summary
E
D
+
Rd=Ru
E+ D
E+ D
=Ru+
D
( RuRd )
E
=ru+
D
( rurd )
E
D
( ud )
E
Measure leverage in terms of the firms net debt: debt = holding of excess cash or short-term
investments.
The assets on a firms balance sheet include any holdings of cash or risk-free securities.
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Because these holdings are risk-free, they reduce the riskand therefore the required risk
premiumof the firms assets. For this reason, holding excess cash has the opposite effect
of leverage on risk and return. From this standpoint, we can view cash as negative debt.
Leverage can increase a firms expected earnings per share, but doesnt increase the firms
stock price because the risk of earnings has changed.
EPS increases on average, but this increase is necessary to compensate shareholders for the
additional risk theyre taking. So the share price doesnt increase as a result of the transaction.
Fallacy: issuing equity will dilute existing shareholders ownership, so debt financing should
be used instead. This is not true.
Dilution of ownership: if the firm issues new shares, the cash flows generated by the firm
must be divided among a larger number of shares, thereby reducing the value of each
individual share.
But: the cash raised by issuing new shares increases firms assets.
As long as the firm sells the new shares of equity at a fair price, there will be no gain or loss
to shareholders associated with the equity issue itself. The money taken in by the firm as a
result of the share issue exactly offsets the dilution of the shares. Any gain or loss associated
with the transaction will result from the NPV of the investments the firm makes with the
funds raised.
Conservation of value principle for financial markets: With perfect capital markets,
financial transactions neither add nor destroy value, but instead represent a repackaging of
risk (and therefore return).
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c D
E
D
D
r E+
r D
r
E+D
E+D
E+ D D c
Pretax WACC | Reduction due to interest tax shield
The higher the firms leverage, the more the firm exploits the tax advantage of debt, and the
lower its WACC.
When securities are fairly priced, the original shareholders of a firm capture the full benefit of
the interest tax shield from an increase in leverage.
Market value balance sheet: total market value of a firms securities must equal total market
value of firms assets. We must include the interest tax shield as one of the firms assets.
Even though leverage reduces the total value of equity, shareholders capture the benefits of
the interest tax shield upfront (share price rises at announcement of recap).
By reducing a firms corporate tax liability, debt allows the firm to pay more of its cash flows
to investors. But after receiving the cash flows, investors are taxed again. Individuals: income
tax, equity investors: also taxes on dividends and capital gains.
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Just like corporate taxes, personal taxes reduce the cash flows to investors and diminish firm
value the actual interest tax shield depends on the reduction in the total taxes that are paid.
Every $1 received after taxes by debt holders from interest payments costs equity holders $(1
*) on an after-tax basis, where
1
1
1
( i)
( c )(1 e )
( i)=1
( 1 i ) ( 1 c ) (1 e )
>
, then > c
VL = VU + x D
Personal taxes:
o Reduce benefit of leverage;
o Cause WACC to decline more slowly with leverage than otherwise.
Preference for debt as a source of external financing for most firms.
Most investment and growth is supported by internally generated funds, like retained
earnings.
The use of leverage varies greatly by industry. Many firms retain large cash balances to
reduce their effective leverage (net debt is negative when cash holdings > outstanding debt).
But: debt provides a tax advantage that lowers a firms WACC and increases firm value, so
why dont more firms have half debt in their capital structure?
No tax benefit when: interest payments > EBIT tax disadvantage at investor level:
investors pay higher personal taxes.
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expected taxable earnings, the marginal tax advantage declines, limiting the amount of debt
the firm should use.
The optimal proportion of debt in the firms capital structure [D/(E+D)] will be lower, the
higher the firms growth rate.
Taxable earnings will be reduced, to the extent that a firm has other tax shields.
Increasing the level of debt increases the probability of bankruptcy. Debt payments must be
maid to avoid bankruptcy.
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3. Appropriate discount rate for distress costs, depends on firms market risk. Distress
costs are high when firm does poorly beta of distress costs will have opposite sign
to that of the firm. The higher the firms beta, the more likely it will be in distress, the
more negative the beta of its distress costs will be. Negative beta leads to lower cost of
capital (below risk-free rate), other things equal the PV of distress costs will be higher
for high beta firms.
Trade-off theory: firms should increase their leverage until it reaches the level D* for which
VL is maximized. The tax savings that result from increasing leverage are just offset by the
increased probability of incurring the costs of financial distress.
Higher costs of financial distress firm chooses lower leverage.
Capital structure can alter managers incentives and change their investment decisions.
Agency costs: the costs that arise when there are conflicts of interest between stakeholders.
When a firm faces financial distress, shareholders can gain from decisions that increase the
risk of the firm sufficiently, even if they have a negative NPV.
Asset substitution problem: leverage gives shareholders an incentive to replace low-risk
assets with riskier ones.
Can lead to over-investment: shareholders may gain if the firm undertakes negative-NPV, but
sufficiently risky projects.
Both ways: total value of the firm will be reduced. Anticipating this, security holders will pay
less for the firm initially.
When a firm faces financial distress, it may choose not to finance new, positive-NPV projects.
Debt overhang / under-investment problem: shareholders prefer not to invest in a positiveNPV project. Is costly for debt holders and overall value of the firm.
Management entrenchment: facing little threat of being fired and replaced, managers are
free to run the firm in their own best interests may take decisions that benefit themselves at
investors expense.
Leverage can provide incentives for managers to run the firm more efficiently and effectively:
o Leverage allows original owners of the firm to maintain their equity stake;
o Holding cash tight (FCF hypothesis), leverage commits firm to making future interest
payments;
o Managers are more likely to be fired when a firm faces financial distress;
o Creditors will closely monitor the action of managers;
o Manager can become a fiercer competitor in protecting markets, cant risk possibility
of bankruptcy.
Why managers over-invest:
o Managers prefer to run large firms rather than small ones empire building, engage
in negative-NPV investments that increase the size rather than profitability. Large
firms higher salaries, more prestige, greater publicity;
o Theyre overconfident, can become committed to investments the firm already made
and continue to invest in them, while they should have been canceled.
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Free cash flow hypothesis: wasteful spending is more likely to occur when firms have high
levels of cash flow in excess of what is needed to make all positive-NPV investments and
payments to debt holders.
VL = VU + PV(interest tax shield) PV(financial distress costs) PV(agency costs of debt) +
PV(agency benefits of debt).
Management entrenchment theory: managers choose a capital structure primarily to avoid
the discipline of debt and maintain their own entrenchment seek to minimize leverage to
prevent job loss that would accompany financial distress. Firms will have leverage that is less
than optimal level D*, and increase it towards D* only in response to a takeover threat or the
threat of shareholder activism.
Credibility principle: claims in ones self-interest are credible only if they are supported by
actions that would be too costly to take if the claims were untrue.
Signaling theory of debt: use of leverage as a way to signal good information to investors.
Adverse selection lemon principle: when a seller has private information about the value of
a good, buyers will discount the price theyre willing to pay due to adverse selection.
Implications of adverse selection for equity issuance:
Lemons principle implies that:
o Stock price declines on announcement of an equity issue;
o Stock price tends to rise prior to the announcement of an equity issue;
o Firms tend to issue equity when information asymmetries are minimized, such as
immediately after earnings announcements.
Implications for capital structure:
o Managers who perceive the firms equity is underpriced will have a preference to fund
investment using retained earnings, or debt, rather than equity.
Pecking order hypothesis: idea that managers will prefer to use retained earnings first, and
will issue new equity only as a last resort.
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In perfect capital markets setting of Modigliani and Miller: method of payment (dividend /
share repurchase) doesnt matter.
Example: Genron Corporation:
o $20 million in excess cash, no debt;
o 10 million shares outstanding;
o Expects to generate additional free cash flows of $48 million per year;
o Unlevered cost of capital is 12%;
o Enterprise value = PV(future FCF) = 48/12% = $400 million;
o Including cash: total market value is $420 million;
How to pay out $20 million in excess cash to shareholders?
1. Pay dividend with excess cash;
2. Share repurchase (no dividend);
3. High dividend (equity issue).
1. Pay dividend with excess cash
Use all excess cash to pay a dividend. 10 million shares outstanding $2 dividend
immediately. Firm expects to generate future FCF of $48 million future dividend of $4.80
per share.
Fair price for share is PV of expected dividends given firms equity cost of capital.
Price(cum) = current dividend + PV(future dividends) = 2 + (4.80/0.12) = $42
Stock trades cum-dividend (with dividend) because anyone who buys stock will get
dividend.
Price(ex) = PV(future dividends) = (4.80/0.12) = $40
Stock trades at ex-dividend.
Holders of the stock have no loss, because they already have the $2 in cash.
in a perfect capital market, when a dividend is paid, the share price drops by the amount of
the dividend when the stock begins to trade ex-dividend.
2. Share repurchase (no dividend)
Genron doesnt pay dividend, but uses $20 million to repurchase its shares on the open
market. How will this affect the share price?
Share price = $42 repurchase $20million/$42 = 0.476 million shares, leaving 10 0.476 =
9.524 million shares outstanding.
The market value of Genrons assets falls when company pays out cash, but number of shares
outstanding also falls, they offset each other so share price remains the same.
By not paying a dividend today and repurchasing shares instead, Genron is able to raise its
dividends per share in the future. This compensates shareholders for the dividend given up
today.
in perfect capital markets, an open market share repurchase has no effect on the stock
price, and the stock price is the same as the cum-dividend price if a dividend were paid
instead.
What would an investor prefer? Issue a dividend or repurchase stock? Only difference is
distribution between cash and stock holdings. Prefer one approach or other based on whether
needing the cash or not.
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In the case of a share repurchase, by selling shares an investor can create a homemade
dividend, and gets the money anyway.
in perfect capital markets, by selling shares or reinvesting dividends, the investor can
create any combination of cash and stock desired investor is indifferent between various
payout methods.
3. High dividend (equity issue)
Board wants to pay > $2 per share.
Next year: $48 million in dividends. If they want to start with that today, it needs an additional
$28 million now.
Raise cash by:
o Scaling back investments (reducing investments with positive NPV lower firm
value);
o Borrow money;
o Sell new shares (equity issue).
Consider the equity issue. Share price is $42. Raise $28 million by selling 28/42= 0.67 million
shares. Increases number of outstanding shares to 10.67 million dividend per share:
48/10.67 = 4.50 per share.
Price(cum) = 4.50 + 4.50/0.12 = 4.50 + 37.50 = 42.
initial share value is unchanged by this policy, and increasing the dividend has no benefit
to shareholders.
If a company pas a higher current dividend per share, it will pay lower future dividends per
share.
MM dividend irrelevance: in perfect capital markets, holding fixed the investment policy of
a firm, the firms choice of dividend policy is irrelevant and doesnt affect the initial share
price.
It is the imperfections in capital markets that should determine the firms dividend and payout
policy.
Now we look at the market imperfection: taxes.
Shareholders pay taxes on the dividends they receive and on capital gains when they sell their
shares.
Do taxes affect investors preferences for dividends versus share repurchases? Mostly:
dividends are charged at higher rate than capital gains shareholders prefer share
repurchases to dividends.
The optimal dividend policy when dividend tax rate > capital gain tax rate = pay no dividends
at all.
Dividend puzzle: fact that firms continue to issue dividends despite their tax disadvantage.
Many investors have a tax preference for share repurchases instead of dividends, the strength
of that preference depends on
difference between dividend tax rate
and capital gains tax rate they face.
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The effective dividend tax rate for an investor depends on the tax rates he faces on dividend
and capital gains, they differ across investors for a variety of reasons:
o Level of income;
o Investment horizon;
o Tax jurisdiction;
o Type of investor or investment account.
Clientele effects: differences in tax preferences, in which dividend policy of a firm is
optimized for the tax preference of its investor clientele. Individuals in highest tax brackets
want stocks with low or no dividends, tax-free investors and corporation want stocks with
high dividends. A firms dividend policy is optimized for the tax preference of its investor
clientele.
Dividend-capture theory: absent transaction costs, investors can trade shares at the time of
the dividend so that non-taxed investors receive the dividend. Non-taxed investors need not
hold the high-dividend-paying stocks all the time, it is necessary only that they hold them
when the dividend is actually paid.
For some the transaction costs and risks of trading the stock offsets the benefits associated
with dividend capture.
clientele effects and dividend-capture strategies reduce the relative tax disadvantage of
dividends, but dont eliminate it.
Payout versus retention of cash
Once a firm has taken all positive-NPV investments, it is indifferent between saving excess
cash and paying it out.
MM payout irrelevance: in perfect capital markets, if a firm invests excess cash flows in
financial securities, the firms choice of payout versus retention is irrelevant and doesnt affect
the initial value of the firm.
The decision on whether to retain cash depends on market imperfections: taxes.
Corporate taxes make it costly for a firm to retain excess cash.
The decision to payout versus retain cash may also affect the taxes paid by shareholders.
Effective tax disadvantage of retaining cash:
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= investors personal
tax rate.
After adjusting for investor taxes, there remains a substantial tax disadvantage for the firm to
retaining excess cash.
Other market imperfection: asymmetric information.
Firms adjust dividends relatively infrequently = dividend smoothing. And also, dividends are
more increased than cut. Theyre only raised when theres a long-term sustainable increase in
expected level of future earnings.
Dividend increases positive signal to investors.
Dividend decreases earnings are reducing, negative signal to investors.
= dividend signaling hypothesis: dividend changes reflect managers views about a firms
future earnings prospects.
Share repurchases may also signal managers information to the market, but:
o Managers are less committed to share repurchases than to dividend payments;
o Firms dont smooth their repurchases from year to year;
o Cost of a share repurchase depends on market price of the stock:
Stock = overvalued share repurchase is costly to shareholders who choose
to hold onto their shares;
Stock = undervalued positive NPV investment for shareholders.
Managers more likely buyback shares if they believe the stock to be undervalued.
Stock dividend: each shareholder who owns the stock before it goes ex-dividend receives
additional shares of stock of the firm itself (stock split) or of a subsidiary (spin-off).
Stock split
With a stock dividend, a firm doesnt pay out any cash to shareholders total market value
of firms assets and liabilities (its equity) doesnt change. Only thing that changes is number
of shares outstanding stock price will fall.
50% stock dividend = 3 for 2 stock split. 100% stock dividend = 2 for 1 stock split.
Motivation for stock split: keep share price in a range thought to be attractive to small
investors. This can increase the demand for and liquidity of the stock, which can boost the
stock price.
Firms also dont want their stock prices to fall too low:
o Raises transaction costs for investors;
o Exchanges require stocks to maintain a minimum price to remain listed on an
exchange.
If the price of the stock falls too low: company can do reverse split: reduce number of shares
outstanding. In a 1:10 reverse split, every 10 shares of stock are replaced with 1 share
share price tenfold.
Through a combination of splits and reverse splits, firms can keep their share prices in any
range they desire.
Market capitalization: total market value of equity; equals market price per share x number
of shares.
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To obtain WACC:
d is the projects debt-to-value ratio (D/(E+D)).
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For capital budgeting: the projects financing is the incremental financing that results if the
firm takes on the project = change in firms total debt (net of cash) with project versus without
the project.
Some important concepts to remember when determining the projects incremental financing:
o Cash is negative debt;
o Fixed equity payout policy implies 100% debt financing;
o Optimal leverage depends on project and firm characteristics;
o Safe cash flows can be 100% debt financed.
Until now: debt-equity ratio should stay constant. Now we will relax this equity cost of
capital and WACC for a project will change over time as debt-equity ratio changes WACC
and FTE method are difficult to implement, APV method is preferred.
Two alternative leverage policies:
o Constant interest coverage;
o Predetermined debt levels.
Constant interest coverage
Constant interest coverage ratio: when firm keeps its interest payments to a target fraction
(k) of its FCF. Interest paid in year t = k x FCFt
tax shield is proportional to projects FCF, has the same risk as it and should be discounted
at the same rate (unlevered cost of capital rU)
How to choose between the tree methods: WACC, APV and FTE?
Each method produces same valuation for investment matter of convenience. Mostly
WACC method is easiest when having a constant debt-equity ratio.
For alternative leverage policies, APV method is easiest.
FTE method only used in complicated settings.
Other imperfections associated with leverage:
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o Issuance and other financing costs: if the bank providing the loan charges fees after
tax deductions: NPV = VL (Investment) (After-Tax Issuance Costs)
o Security mispricing: if securities are mispriced, the NPV of the transaction (difference
actual money raised and true value of securities) should be included when evaluating
decision;
o Financial distress and agency costs: affect future FCF, so can be incorporated directly
into estimates of projects expected FCFs. When debt level (and thus probability of
financial distress) is high expected FCF will be reduced by expected costs of
financial distress and agency problems. Financial distress and agency costs also have
consequences for cost of capital: increase sensitivity of firms value to market risk,
further raising cost of capital for highly levered firms. How incorporate these costs in
valuation methods?
Adjust FCF estimates to account for costs and increased risk;
First value project ignoring these costs, and then add PV of incremental cash
flows associated with financial distress and agency problems.
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money. An American option cannot be worth less than its intrinsic value
(arbitrage);
Time value of an option: difference between current option price and its
intrinsic value. American option cannot have a negative time value.
o Option prices and the exercise date:
American options: longer time to exercise date, more valuable option. An
American option with a later exercise date cannot be worth less than an
otherwise identical American option with an earlier exercise date;
European options: longer time to exercise date, sometimes less valuable
option.
o Option price and volatility of underlying stock: the value of an option generally
increases with the volatility of the stock. Increase in volatility increases likelihood of
very high and very low returns for the stock. (Lowest return still is 0, so gain from
increase in volatility). Put options are more valuable too, because buying insurance
against more volatile stock is more valuable.
Exercising options early
Non-dividend-paying stocks
Price of zero-coupon bond: PV(K) = K dis(K). dis(K) = amount of discount from face value
to account for interest.
Call
The price of any call option on a non-dividend-paying stock always exceeds its intrinsic value
never optimal to exercise a that option early.
An American call on a non-dividend-paying stock has the same price as its European
counterpart, because the right to exercise the call early is worthless.
Put
Does it make sense to exercise it early?
S is high, and put option is deep in-the-money, discount will be large relative to value of the
call, and time value of a European put option will be negative. It will sell for less than its
intrinsic value. Its American counterpart cannot sell for less than its intrinsic value (arbitrage)
American option worth more than European option.
Dividend-paying stocks
Call
Put-call parity relationship:
If PV(Div) is large enough, the time value of a European call option can be negative,
implying price < intrinsic value. American option can never be worth less than intrinsic value
American price > European price.
Put
Put-call parity relationship:
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Less likely that a put option on a dividend-paying stock will be exercised early, because
holder of put option will benefit by waiting for the stock price to drop after it goes exdividend before exercising.
For the deep in-the-money puts, the interest on the high strike prices > dividends earned,
making it costly to wait.
Equity as a call option. Think of a share of stock as a call option on the assets of the firm with
a strike price equal to the value of debt outstanding. If the firms value < the value of debt
outstanding at the end of the period, the firm must declare bankruptcy and the equity holders
receive nothing. If the firms value > value of debt outstanding at the end of the period, the
equity holders get whatever is left once the debt has been repaid.
Debt as an option portfolio. Debt holders: owning firm and sold call option with strike price =
required debt payment. Value of firm > required debt payment: call is exercised: debt holders
receive strike price and give up firm. Value of firm < required debt: call is worthless, firm will
be bankrupt and debt holders are entitled to firms assets.
Another way to view corporate debt: as a portfolio of risk-free debt and a short position in a
put option on the firms assets with a strike price equal to required debt payment:
Risky debt = risk-free debt put option on firm assets.
Firms assets < required debt payment: put = in-the-money: exercise option and receive
difference between required debt and firms asset value.
Firms assets > required debt payment: put is worthless; debt holder is left with required debt
payment.
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with
N(d) = cumulative normal distribution.
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This model assumes that call is a European option. In this case (no dividends): both American
and European call options on non-dividend-paying stocks.
Put
Price of European put from put-call parity is: P = C S + PV(K)
Black-Sholes Price of a European Put Option on a Non-Dividend-Paying Stock:
Dividend-paying stocks
European call option: holder doesnt receive dividends prior to expiration date of option.
Market price security identical to the stock:
Because a European call option is the right to buy the stock without these dividends, we can
evaluate it using the Black-Scholes formula with S* in place of S.
Q = stocks (compounded) dividend yield until expiration date.
S* = S/(1+q)
The parameter , volatility, is not directly observable. Two strategies to estimate it:
o Use historical data on daily stock returns;
o Use current market prices of traded options to back out the volatility that is consistent
with these prices based on the Black-Scholes formula.
Implied volatility: estimate of a stocks volatility which is implied by an options price. Can
be used to estimate the value of other options on the stock with the same expiration date.
Black-Scholes Replicating Portfolio of a Call Option:
= N(d1) and B = PV(K) N(d2)
N(d): cumulative normal distribution function. Minimum of 0, maximum of 1.
B is between K and 0
The replicating portfolio is a leveraged position in the stock: long position in the bond, short
position in the stock.
Black-Scholes Replicating Portfolio of a Put Option:
= [1 N(d1)] and B = PV(K) [1 N(d2)]
= between -1 and 0, B is between 0 and K.
Replicating portfolio consists of a long position in the bond and a short position in the stock.
Put options on a positive beta stock, will have a negative beta.
Risk-Neutral Two-State Model
If all market participants were risk neutral, then all financial assets would have the same cost
of capital: the risk-free rate of interest.
The risk-neutral probability that the price will be S satisfies the following condition
u
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Derivative security: any security whose payoff depends solely on the prices of other
marketed assets.
Monte Carlo simulation: risk-neutral pricing method is basis for this common technique for
pricing derivative securities. The expected payoff of the derivative security is estimated by
calculating its average payoff after simulating many random paths for the underlying stock
price. In the randomization, the risk-neutral probabilities are used, and so the average payoff
can be discounted at the risk-free rate to estimate the derivative securitys value.
Measure risk of an option: compute option beta. Simplest way: compute beta of replicating
portfolio. Beta of portfolio = weighted average beta of the constituent securities that make up
the portfolio.
Call: > 0 en B < 0. Call on stock with positive beta, beta of call > beta of stock.
Put: < 0 en B > 0. Put on stock with positive beta, beta of put < beta of stock.
Options leverage ratio: S / (S + B) ratio of amount of money in stock position in the
replicating portfolio to the value of the replication portfolio.
Out-of-the-money calls have the highest expected return & highest beta.
Out-of-the-money puts: lowest expected return & lowest beta.
Calculate the beta of equity from the unlevered beta of equity (beta of debt is 0):
Calculate the beta of equity from the unlevered beta of equity when beta of debt is not 0:
= 0.
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Find optimal order to stage mutually dependent projects by ranking each, from highest to
lowest according to: (1 PV(success))/PV(investment)
PV(success): present value of risk-neutral probability of success.
PV(investment): projects required investment, expressed as a present value at the projects
start.
Two commonly used rules of thumb:
o Profitability index;
o Hurdle rates.
Profitability index rule: invest whenever the profitability index exceeds some predetermined
number. When investment cannot be delayed: invest whenever profitability index > 0.
Profitability index = NPV / initial investment.
Hurdle rate rule: raises discount rate. Uses higher discount rate than cost of capital to
compute NPV, and then applies regular NPV rule. Higher discount rate = hurdle rate.
When source of uncertainty that creates a motive to wait is interest rate uncertainty: natural
way to approximate the optimal hurdle rate.
Hurdle rate = cost of capital x (callable annuity rate / risk-free rate)
Callable annuity rate: rate on a risk-free annuity that can be repaid (or called) at any time.
Invest whenever NPV of project is positive using this hurdle rate as discount rate.
Key insights from real options:
o Out-of-the-money real options have value: maybe it is worth something in the future;
o In-the-money real options need not be exercised immediately: option to delay might
be worth more than exercising it now;
o Waiting is valuable: you can make better decision with better information. No costs of
waiting wait. Costs of waiting trade-off uncertainty and costs;
o Delay investment expenses as much as possible: incur investment expenses at last
possible moment. Committing capital before it is absolutely necessary reduces value
because it gives up the option to make a better decision once uncertainty has been
resolved;
o Create value by exploiting real options: firm must continually re-evaluate investment
opportunities and optimize decision-making dynamically.
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Secondary offering: shares sold in IPO are existing shares that are sold by current
shareholders (as part of their exit strategy).
Best-efforts IPO: underwriter doesnt guarantee the stock will be sold, but tries to sell the
stock for best possible price. Either all of shares are sold in IPO, or deal is called off.
Firm commitment IPO: underwriter guarantees it will sell all of the stock at the offer price.
Underwriter purchases entire issue at lower price and resells at offer price. If entire issue
doesnt sell out, underwriter takes the loss. More common.
Auction IPO: selling new issues directly to the public using online auction IPO mechanism
called OpenIPO. Market determines price of stock by auctioning off the company.
Lead underwriter: primary banking firm responsible for managing the deal. Provides most
of advice and arranges for a group of other underwriters = syndicate, to help market and sell
the issue.
The SEC requires that companies prepare a registration statement: legal doc that provides
financial and other info about the company to investors prior to an IPO.
Before the offer price is set, underwriter work closely with company to come up with a price
range they believe provides a reasonable valuation for the firm. Two ways to value a
company: estimate future cash flows and compute present value, or estimate value by
examining comparable companies.
Road show: senior management and lead underwriters travel around country promoting the
company and explaining their rationale for the offer price to the underwriters largest
customers.
Book building: process for coming up with the offer price based on customers expressions of
interest.
Underwriting spread: fee for underwriters that company has to pay.
Over-allotment allocation / greenshoe provision: allows underwriter to issue more stock or
the original offer size at the IPO offer size. Way for underwriter to protect themselves against
a loss.
Lockup: shareholders cannot sell their shares for 180 days after the IPO.
Four characteristics of IPOs puzzle financial economists:
o On average, IPOs appear to be underpriced: price at end of trading on the first day is
often substantially higher than IPO price. Who benefits? Underwriters by controlling
their risk, investors who are able to buy stock from underwriters at IPO price. Who
bears costs? Pre-IPO shareholders of issuing firm. They are selling stock in their firm
for less than they could get in the aftermarket. So why do they do that? Winners
curse: you get all the shares you requested (win) when demand for shares by others is
low, and IPO is more likely to perform poorly;
o Number of issues is highly cyclical: when times are good, market is flooded with new
issues, when times are bad, number of issues dries up. Surprising: magnitude of
swings. Number of IPOs is not solely driven by demand for capital, sometimes firms
and investors seem to favor IPOs, sometimes alternative sources of capital;
o Costs of an IPO are very high, unclear why firms willingly incur them. No good
answer;
o Long-run performance of a newly public company is poor a three- to five-year buy
and hold strategy appears to be a bad investment. Also associated with subsequent
issuances.
Finance 2
Summary
Seasoned equity offering (SEO): firms return to equity markets and offer new shares for
sale.
Using SEO follows many of same steps as for an IPO. Main difference: a market price for
stock already exists with SEO.
Two kinds of SEOs:
o Cash offer: firm offers new shares to investors at large;
o Rights offer: firm offers new shares only to existing shareholders.
Advantage of cash offer: underwriter takes on larger role and can credibly certify the issues
quality. But rights offer is cheaper.
Announcement of SEO price drop: investors infer from decision to sell that company is
likely to be overvalued.
Finance 2
Summary
Finance 2
Summary
credit: credit commitment for a specific time period up to some limit (i.e. five years
and 1.6 billion) which a company can use as needed;
o Private placements: bond issue that doesnt trade on a public market but rather is
sold to a small group of investors. Doesnt need to be registered less costly.
Above is all about corporation, but other entities issuing debt are:
o Sovereign debt: by national governments. See table 24.4;
o Municipal bonds: by state and local governments. Income isnt taxable at federal
level. Coupons can be fixed (same coupon over life of bond) or floating (coupon is
adjusted periodically). Municipal bonds arent as secure as bonds backed by federal
government;
o Asset-backed securities (ABS): security made up of other financial securities. Asset
securitization: process of creating an asset-backed security. Largest sector: mortgagebacked security (MBS). Holders of MBSs face prepayment risk: risk that bond will
be partially/wholly repaid earlier than expected. Collateralized debt obligation
(CDO): new ABS after banks resecuritize asset-backed and other fixed income
securities.
Covenants: restrictive clauses in a bond contract that limit issuer from taking actions that
may undercut its ability to repay the bond.
Repayment provisions:
o Callable bonds;
o Sinking funds;
o Convertible bonds: converting them into equity.
Callable bonds: bonds that contain a call provision that allows the issuer to repurchase the
bonds at a predetermined price.
A call feature allows the issuer of the bond the right to retire all outstanding bond on a
specific date (call date) for the call price.
When yields have risen, the issuer will not choose to exercise the call on the callable bond.
Issuer will exercise call option only when coupon rate of bond > prevailing market rate.
A callable bond will trade at a lower price (and therefore a higher yield) than an otherwise
equivalent non-callable bond.
Yield to call (YTC): annual yield of a callable bond assuming that the bond is called at the
earliest opportunity.
Sinking fund: way of repaying bonds. Instead of repaying entire principal balance on
maturity date, company makes regular payments into a sinking fund administered by a trustee
over the life of the bond. These payments are used to repurchase bonds. Which bonds to
repurchase? Bonds that are trading below their face value. If all are trading above face value,
decision is made by lottery.
Sinking fund allows issuer to repurchase bonds at par.
Balloon payment: sometimes sinking fund payments < entire issue, company must make
large payment on maturity date.
Conversion ratio: ratio at which the bondholder can convert each bond owned into a fixed
number of shares of common stock. Such bonds: convertible bonds. Its like a regular bond +
special type of call option: warrant: call option written by company itself on new stock
(regular call option is written on existing stock).
Finance 2
Summary
Finance 2
Summary
In many cases the lease allows the lessee to obtain ownership of the asset for some price:
o Fair market value (FMV) lease: lessee has option to purchase asset at its FMV at
termination of lease;
o $1.00 out lease (finance lease): ownership of asset transfer to lessee at end of the
lease for nominal cost of $1.00;
o Fixed price lease: lessee has option to purchase asset at end of the lease for fixed
price set upfront in lease contract. Market value > fixed price: lessee buys asset at
below market value. If not, lessee doesnt buy and purchase asset for less money
elsewhere higher lease rate to compensate for this option for lessor;
o Fair market value cap lease: lessee has option to purchase asset at minimum of FMV
and a fixed price (cap).
Perfect capital market, without imperfections: MM proposition: leases neither increase nor
decrease firm value, but only divide firms cash flows and risks in different ways.
Effects of leasing on accounting:
Lessees accounting balance:
o Operating lease: viewed as rental. Lessee reports entire lease payments as operating
expense. Doesnt deduct depreciation expense for asset and doesnt report asset, or
lease payment liability on balance sheet. Are disclosed in footnotes of financial
statements;
o Capital lease (finance lease): viewed as acquisition. Asset is listed on balance sheet,
lessee incurs depreciation expenses for asset. Future lease payments are listed as
liability. Increase leverage on balance sheet.
Finance 2
Summary
FASB: lease is capital lease and must be listed on balance sheet if it satisfies any of following
conditions:
o Title to property transfers to lessee at end of lease term;
o Lease contains option to purchase asset at bargain price that is less than FMV;
o Lease term is 75% or more of estimated economic life of asset;
o PV of minimum lease payments at start of lease is 90% or more of assets FMV.
Effects of leasing on taxes
Two broad categories of leases:
o True-tax leases: lessor receives depreciation deductions associated with ownership of
asset. Lessee can deduct full amount of lease payments as an operating expense, for
lessor: these lease payments are revenue;
o Non-tax lease: legal ownership of assets resides with lessor, but lessee receives
depreciation deductions. Lessee can also deduct interest portion of lease payments as
interest expense. These are interest income for lessor.
If the lease satisfies any of these conditions it is treated as non-tax lease:
o Lessee obtains equity in leased asset;
o Lessee erceives ownership of asset on completion of all lease payments;
o Total amount that lessee is required to pay for a relatively short period of use
constitutes an inordinately large proportion of total value of total value of asset;
o Lease payments exceed current fair rental value of asset;
o Property may be acquired at a bargain price in relation to FMV of asset at time when
option may be exercised;
o Some portion of lease payments is specifically designated as interest or its equivalent.
Leasing and bankruptcy
Treatment of leased property in bankruptcy depends on how the lease is classified by the
bankruptcy judge. Two categories:
o Security interest: firm is assumed to have effective ownership of asset and asset is
protected against seizure. Lessor is treated as any other secured creditor and must
await firms reorganization or ultimate liquidation;
o True lease: lessor retains ownership rights over asset. Bankrupt firm must choose
whether to assume or reject the lease. Assume: settle all pending claims and continue
to make all promised lease payments. Reject: asset must be returned to lessor.
Operating and true tax leases are mostly viewed as true leases.
Capital and non-tax leases are mostly viewed as security interest.
Should I buy or should I lease?
Perfect capital market: doesnt matter.
Real world decision depends on market frictions.
For a true tax lease:
Lease-equivalent loan: loan that is required on the purchase of the asset that leaves the
purchases with the same obligations as the lessee would have.
Loan balance = PV(Future FCF of lease versus buy at r (1- )).
D
Finance 2
Summary
We can compare leasing to buying the asset using equivalent leverage by discounting the
incremental cash flows of leasing versus buying using the after-tax borrowing rate.
Negative NPV: leasing unattractive compared to traditional debt financing.
For a non-tax lease:
Directly comparable to traditional loan in terms of cash flows.
Attractive if it offers better interest rate than would be available with a loan: discount lease
payments at firms pretax borrowing rate and compare to purchase price of asset.
Lease has to be attractive to both lessee and lessor gains must come from some underlying
economic benefits that the leasing arrangement provides:
o Tax differences;
o Reduced resale costs;
o Efficiency gains from specialization;
o Reduced distress costs and increased debt capacity;
o Transferring risk;
o Improved incentives.
Other arguments for leasing:
o Avoiding capital expenditure controls;
o Preserving capital
o Reducing leverage through off-balance-sheet financing.
Finance 2
Summary
Finance 2
Summary
o Staggered boards: every director serves a three-year term and terms are staggered so
that only one-third of directors are up for election each year;
o White knights: target company looks for another company to acquire it;
o Golden parachute: guaranteed to firms senior managers in event that firm is taken
over and managers are let go;
o Recapitalization: company changes its capital structure to make itself less attractive
as a target;
o Regulatory approval: mergers must be approved by regulators.
Free rider problem of takeovers: existing shareholders dont have to invest time and effort, but
still participate in all the gains from the takeover. Solve this problem:
o Toehold: acquire initial stake in target, to gain control of company;
o Leveraged buyout;
o Feezeout merger: laws on tender offers allow acquiring company to freeze existing
shareholders out of gains from merging by forcing non-tendering shareholders to sell
their shares for the tender offer price.
Acquiring company must give up most of the value added to the target shareholders.