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CORPORATE FINANCE REVIEW

INTRODUCTION
1) What is finance made for: Finance is here to create a balance between agents who have money
but no ideas and agents who have ideas but no money.
Surplus of resources Financial System Deficit of resources

2) Money has a cost:
Cost of money is the interest rate. It derives from the renunciation of immediate consumption in order
to enjoy greater revenue in the future.

3) The 3 roles of CFO:
To provide the firm with sufficient funds to finance its development,
To make sure that the investment undertaken by the firm generates in the long term, at least the
return required by investors,
To take care of financial risks.
A good CFO will understand his/her clients (fund providers) and propose appropriate financial
instruments to them.
Market Money Financial instrument
Demand Firms Investors
Supply Investors Firms
Target Minimize interest rate Maximize value
4) Financial instrument:
Are series of CF to be received (or paid) according to a set timetable. The value of the financial
instrument is equal to the sum of discounted CF.
The CFO segments the investors market. He/she creates financial instrument for each market segment
depending on the risk that the investor is ready to bear. 3 features to differentiate debt from equity:
Debt always needs to be repaid, not equity.
Debt generates fixed return interest, whereas payment of dividends is not compulsory. The lack
of payment of interest can lead to bankruptcy.
In case of bankruptcy, creditors will be repaid prior to shareholders.

5) The financial investor: 3 types of behavior
Speculation: bet with potential loss or profits. To speculate is to take a risk.
Hedging: the opposite of speculation. To hedge is to transfer a pre-existing risk to an investor
who accepts to bear the risk.
Arbitrage: risk-free transaction that generates a profit for sure. Arbitrage opportunities are rare
in general.
Common point for all investors is the expected return = r
f
+ (k
M
-r
f
) / r
f
= risk free rate, k
M
= market
return. Risk of an investment = market risk (non-diversifiable risk) + specific risk. Only market risk
generates a return as specific risk can be avoided thanks to portfolio diversification.

6) Financial markets: key concepts
Primary market: market for new instruments issued by firms (direct source of financing for firms).
Secondary market: market for investors to exchange financial instruments. This does not provide the
firms with new funds. This market allows investors to realize their instruments before the contractual
maturity (if any) of the instrument.
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Primary and secondary markets are closely linked; the prices observed on the secondary market define
the price for new issues (primary market).
Development of derivative market: derivatives (options, futures, forwards, swaps) derive from an
underlying asset. They do not provide financing to the firm but allow the firm to more easily hedge or
speculate. The derivatives market is a zero profit market (what is earned by one is lost by another) that
does not generate wealth.

7) Financial risk
Risk is equivalent to the change in value of the financial instrument. The greater the price change, the
greater the risk.

I-FINANCIAL ANALYSIS
1- Get to know the business well (preliminary tasks): Understanding the production cycle - Who are
the clients: what are the sales made of? Who are the suppliers? Who are the employers?
2- Understanding the accounting principles and policies:
- Reading the auditors report: most likely non informative, but any comment or reserve should
raise suspicion.
- Accounting principles: Provisions (amt, probability of occurrence) Accruals: R&D, starting
costs (difference between Capex and expense) Stocks Depreciation Accounting for
revenue Scope of consolidation (SPV, non-controlled entities,etc.)
3- Analysis of the wealth creation (IS):
Sales: - Change in sales year on year: growth, stagnation, decrease
- Sources of changes: price, volume, external growth, disposals.
Understand the business and the change in business volumes.
Operating profit (EBIT): changes in operating profit compared to changes in sales shows
whether costs are under control or not.
- Scissors effect: diverging growth of sales and costs due to the negotiating power of the
different players in the value chain.
- Breakeven point: level of activity for which total revenue cover total costs. Below this level,
the fir; will be loss making, above it will profitable.

4- Analysis of Investment: investments allow the firm to generate wealth. They are of 2 types.
Investments in Fixed Assets (Capex): property, plants and equipment, subsidiaries, patents, etc.
- Depreciation (that reflects from an accounting point of view the use of assets) needs to be
compared to annual Capex. If Capex is superior: investment company, if equal:
maintenance/renewal, if inferior: disinvestment.
The investment policy needs to be compared to the changes in sales volumes (eg increase
capacity during growth phase).
- FA before depreciation (initial acquisition price) can also be compared to FA after
depreciation. This gives an idea of the age and competitiveness of FA and their adequacy.
Working Capital (WK): it derives from the difference in timing between the moment when
suppliers are paid and the moment when clients pay. It is an investment as it is an immediate
cash outflow with hope of higher cash inflow in the future.
- WK is liquid: it represents a use of cash over a short period of time.
- WK is permanent: there will always be inventories debtors and creditors.
- WK evolves with activity (with no growth, regular growth, with growth and seasonal
activity).
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- WK will change across the year with the seasonality of activity.
When they can, firms set their financial year and when WK (and therefore debt) is at its lowest.
WK = Stocks (inventories) + Debtors (Receivables) Creditors (Payables)
Ratios:
o WK expressed in number of days of sales: WK/Sales*365
o DSO (Days sales outstanding): Receivables/Annual Sales (inc. VAT)*365
o DPO (Days payables outstanding): Payables/Annual Purchases (inc. VAT)*365
o DIO (Days inventory outstanding): Inventories & WIP/Annual Sales (exc.
VAT)*365. Approximate in number of days of inventory.
5- Analysis of financing: 2 approaches.
Dynamic (trend, management of financing needs over time): 3 ways self-financing, new
money from shareholders, debt.
The understanding of debt capacity requires the transformation of accounting data (IS) into CF
(actual cash inflows and outflows).
The change in real cash is called CF. It differs from NI as you have to add back depreciation as it
is not an expensed but only an accounting entry. CF as defined above is, nevertheless, not yet a real
flow of cash.
NI + Depreciation = CF - WK = CF from operations
- Invt
outflows
- Div.
+
Share
issues
=
Reduction
(increase)
in net debt
Account.
(not CF)
Not CF Closer to a
flow of cash
Corrects the
timing diff.
CF available for invt.,
dividend payment or
reduction in debt

Static analysis: at one point of time, how the firm is financed, what are its financing options in
the future. To assess, on the basis of the current financing data of the firm, whether it will be in
position to repay its debt in the future.
Ratio Debt/EBITDA. EBITDA = proxy for available cash to repay debt.
< 2.5 (all right), between 2.5 and 3.5 (keep eyes wide open), 4-5 (difficulties), > 5 (critical).
Remark: Debt/Equity ratio implicitly assesses that you expect to repay debt with equity which
happens only in a bankruptcy process.
Warning: check that EBITDA becomes cash at some point in time for the ratio to be relevant.
6- Analysis of return/profitability
Return = Profit/Funds invested to generate this profit (2 types):
- Return from invested capital,
- Return for sharholders.
o Return On Capital Employed (ROCE)
Capital Employed = FA + WK. ROCE = EBIT * (1-Tax rate) / Capital Employed
ROCE is independent from financial structure. It can be split into:
Operating Profit before Tax / Cap. Empl. = OPBT / Sales * Sales / Cap. Empl.
Warning: do not use the amount of corporate tax paid (computed after interest) as ROCE measures
return BEFORE allocation of wealth creation (to lenders or shareholders).
o Return On Equity (ROE) = NI / Equity
ROE = ROCE (after tax) + {ROCE (after tax) after tax (cost of debt)}*Net debt/Shareholder Equity
Leverage effect
If ROCE = ROE: shareholders earn exactly what the assets generate.

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Conclusion
1- For the lender:
Assess liquidity of the firm in the mid term, i.e. capacity to repay its debt in due time.
Assess solvency in case liquidity has disappeared.
2- For the shareholder: potential value creation, comparison of ROCE and cost of capital.

II-INVESTMENT CRITERIA
1) NPV

C
0
is the investment at t =0 / r = required rate or return.
NPV represents the actual value generated by an investment.
If NPV>0; the investment is valuable from a financial perspective.
If NPV<0; not interesting from a financial perspective but may be done for other reasons
(strategic, affective, moral)

2) IRR
The higher the discount rate, the lower the NPV. IRR (in %) is the rate for which NPV=0.
If NPV>0, IRR>r and vice versa.

3) Payback ratio
Its the period for which a sum of positive CF is equal to the sum of negative CF. A discounted
payback can be computed (correct but more complex). It is a subjective criterion (risk of mistake).

4) Principles
1/ CF are to be considered and not accounting data.
2/ Assessment of the investment has to be made regardless of the financing: only operating CF of the
project are considered. No CF linked to financing should be included.
3/ Reasoning should be in marginal terms, we only care about all CF generated by the investment. CF
incurred prior to the investment decision (sunk costs) should be disregarded. Nevertheless, these costs
will be taken into account in setting the selling price of future products.
4/ Reasoning should be in opportunity cost: land bought for 100, 10 years ago and worth 300 today
corresponds to a CF of 300.
5/ Be consistent:
- CF computed without inflation should be discounted using a discount rate without inflation.
- If CF are pre-tax, discount rate should be pre-tax too.
- If CF are in local currency, discount rate should reflect investments in that currency.

5) Computation of the CF
There are 3 different types of CF to be considered:
- Investment CF
- Operating CF: computed on the basis of forecasted IS and BS
- Terminal CF
EBITDA - WK - Taxes - Capex = Free CF
Closer to CF before any allocation (interest,
dividends) to investors = EBIT + depreciation
Theoretical tax on EBIT
(EBIT*Tax rate)


Two methods for VALUATION
Comparative method: through comparison with other similar firms
Intrinsic method: considering only CF generated by the firm.
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In addition, 2 approaches are possible for each method.
Indirect approach: computation of the value of capital employed (entreprise value) of which
debt is subtracted to derive equity value V
Eq
= EV - V
D

Direct approach: direct computation if the equity value V
Eq
= V
Eq

Intrinsic Comparative
Direct
(1)
V
Eq
=
F|
(1+K)
|
|=
=
DIF|
(1+K)
|
|=

k = r
f
+ (k
M
-r
f
)
(3)



V
Eq
= NI * P/E
Indirect
(2)
V
Eq
=
FCF
(1+Ki)
|
|=
- V
D

(4)



V
Eq
= EBIT multiple*EBIT - V
D

kk (2)

1/ Intrinsic direct method
Assumptions:
- Div
i
= constant / V = Div/k = p/o * EPS/k (p/o = Payout ratio |0-1|)
- Div
(i+1)
= Div
i
* (1+g) / V = Div/k-g = p/o * EPS/k-g (g = dividend annual growth)
- If g>k as growth decreases over time, payout ratio increases.

2/ Intrinsic indirect method
Valuation of Capital Employed i.e. funds provided by lenders and shareholders and not only
shareholders, also called Entreprise Value (EV) or Invested Capital. V
Eq
= EV - V
D

EBIT + Depreciation (=EBITDA) change in WK corporate tax (EBIT*T rate) Capex = FCF
EV =
FCF
(1 +K)
|
|=

Assumptions:
- FCF
i
= constant / EV = FCF/k
- FCF
(i+1)
= FCF
i
* (1+g) / EV = FCF
1
/k-g (g = annual growth of FCF, g<k)
- If g>ksee 1/c.
- k = WACC (cost of capital)

3/ Comparative direct approach
The basic principle for this method is that the value of the share does not depend directly on its own
merits but on its performance compared with others. You should then compare the market value of
equity for1 euro of NI in comparable companies (geography, business). This ratio is called Price
Earning Ratio (P/E). P/E = Value of the share / Earnings per share (EPS).
Assumptions:
- Growth rate: The lower the anticipated growth, the lower the P/E and vice versa.
- Risk: if risk is limited and visibility on future earnings is high then P/E is high.
- Interest rates: if interest rates are high, you will require a high return and therefore P/E will
be low.
P/E is popular because it is simple and quick to use but all elements are synthetized in only one figure,
analysis is then hard to refine.

4/ Indirect comparative approach
This approach focusses on the valuation of capital employed (indirect, of interest for all funds
providers) but using a multiple that compares different companies.
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They key is EBIT as it reflects the operating wealth creation of the firm that has then to be allocated to
lenders and shareholders (interest for lenders and NI for shareholders). Sometimes EBITDA is used
especially for capital intensive businesses.
V
Eq
= EV - V
D

EV = EBIT * EBIT multiple (EV is derived)
EBIT multiple = EV/EBIT
It uses the same reasoning as P/E (but applied to EBIT instead of NI), consequences are the same:
- Anticipated growth: if high, EBIT multiple will be high.
- Risk: if low, EBIT multiple will be high.
- Interest rates: if low, EBIT multiple will be high.

Conclusion The 1
st
method (DDM) is now rarely used as the 2
nd
method (DCF) has became the most
popular valuation method. DCF requires that all assumptions are clearly stated.

III-COST OF CAPITAL
WACC: is the return required by investors (shareholders and lenders) to finance the assets (capital
employed) of the firm. It depends only on the risk of the assets.
Cost of capital exists before the capital structure. Risk of the assets defines the cost of capital, cost of
equity and cost of debt are then derived from that.
WACC = k
Eq
*
FFq
FFq+FD
+ k
D
* (1-TR) *
FD
FFq+FD
/ k
Eq
= r
f
+ (k
M
-r
f
)
1- This formula suggests that WACC is derived from cost of equity and cost of debt: it is the
reverse.
2- All reasoning should be made in market values and not accounting values. Returns used
should be todays and not historical rates.
3- The weighting should be made on the basis of market values. In particular for equity for which
you need to use the market value (eg number of shares * share price for listed firms).
4- In the same way, cost of debt to be used is todays cost of debt. In some cases, value of debt
can differ materially from the accounting data (solvency deterioration for instance).
5- k
Eq
= r
f
+ (k
M
-r
f
): return required by shareholders.
6- Watch out for excel: you cannot change the weighting of debt and equity without changing
their costs.
7- You cannot decide on an investment according to its financing. You first need to compare the
IRR to WACC, then decide on how you want to finance it.
8- There might not be only one WACC, one firm can have several cost of capital as:
a. The firm can have diversified businesses, each will have its own risk and therefore its
own WACC.
b. The firm can run businesses in different geographical areas with for each very different
costs of financing (risk free rate)

IV-CONCEPTUAL FOUNDINGS OF CORPORATE FINANCE
1- Efficient market theory:
Information is easily available at no cost. At any instant, market prices reflect all available
information. This theory is correct in most cases. Some temporary forms of inefficiencies regularly
happen, especially in crisis times.
2- Signalling theory:
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Assumes that everybody has the same level of information. This asymmetry can be a problem as the
value of a financial instrument does not reflect all available information.
Illustration: an issue of share made when the price of the share is low and does not reflect its real
value requires the issue of more shares. Dilution will be higher for existing shareholders who then
have to bear this cost.
A signal is a free decision taken in order to implicitly communicate new information to the market, a
sanction is embedded if the information is not correct.
In order to be a signal, the information should:
- Be given voluntarily,
- Originate from someone who has information that the market does not already have,
- Lead to a sanction for the issuer of the signal if the information is not true. Accordingly, the
issuer can cheat.
The signal will reduce information asymmetry between management and investors.
3- Agency theory:
Revisits the principle according to which management of a firm aims at maximizing the value of the
funds invested by the shareholders in the firm. Maximization of value can sometimes be forgotten and
management instead has its own agenda: try to increase sales, internal expansion, diversify business
There are diverging interests between shareholders and management. This explains that some
decisions are taken not for their own merits but to solve or reduce agency conflicts.
Illustration: debt is one way to force management to generate regular CF in order to meet debt
commitments.
4- Behavioral finance:
Revisits the principle according to which all agents act purely rationally ignoring fear, greed, altruism..
Behavioral finance mixes neurosciences and psychology to better understand the behavior of investors.
Its applications are still reduced and largely focused on financial market matters, rather than on
corporate finance ones.
V-CAPITAL STRUCTURE THEORY
Financing structure (capital structure) is the split of the financing of capital employed between debt
and equity.
WACC = k
Eq
*
FFq
FFq+FD
+ k
D
* (1-TR) *
FD
FFq+FD

k
Eq
= r
f
+ (k
M
-r
f
)
1/ Traditional approach pre-1958
The more debt the firm is carrying, the riskier it will be. Return requested on equity will therefore
increase in proportion to the ratio D/Eq. In addition, the risk taken by the lender will always be below
the risk taken by shareholders k
D
< k
Eq
Finally, when debt level increases, risk for the lender increases and k
D
will be high.

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According to this theory, WACC presents a minimum and therefore there is an optimal ratio D/Eq that
make it possible to minimize cost of capital and the maximize EV.
2/ 1958: Modigliani-Miller
Have proved that whatever the capital structure, the WACC will stay unchanged, otherwise, there
would be arbitrage opportunities. The value of capital employed will remain the same.
Criticism: this theory does not take into account corporate tax (debt provides a tax shield).
3/ 1963: Modigliani-Miller
Taking into account the bias created by the debt tax shield, they demonstrate the existence of an
optimal capital structure.

4/ 1977: Miller
He then takes into account, in addition to corporate tax, tax at the investor level. Most tax systems
favour investment in shares compared to investment in debt.
So, if a company takes debt instead of equity financing, the investor will receive income in the form of
interest. This interest will be taxed more than if the income had came via dividends. Thus, the investor
will require a higher return to compensate for higher taxation. This requirement will be proportionate
to the savings on corporate tax that the firm will make by financing itself through debt.

Conclusion
The tax shield generated by debt is counterbalanced by the higher tax rate at the investor level.
Overall, taxation on debt does not provide an advantage, there is, therefore no optimal capital
structure.

VI-HOW TO CHOOSE A CAPITAL STRUCTURE
1/ Most important is not the choice of a capital structure but the investment choice
The quality of investment creates value: if the assets are good, the capital structure can be changed
without a problem, the reverse is not true.
2/ There is no such thing as an expensive source of financing
The cost of a financing source cannot be isolated from its risk. Debt costs less than equity but it
increases the risk for the company (eg short term debt with Dexia): tradeoff between cost and risk.

3/ There is no such thing as an optimal capital structure
Research in this field has not concluded anything. In practice, there is a large set of situations. We note
that leading firms in their domains are generally financed with a very low level of debt.

4/ Choice factors
Shareholders risk aversion and dilution appetite: Some like risk, and then do not fear debt. Debt
can also be chosen by shareholders who do not want to be diluted through issue of new shares, they
will then keep their control over the firm.

Flexibility: the market for equity is volatile with phases during which the issue of shares can be
difficult, impossible or unfavorable. The market for debt is more stable. The firm should, therefore, not
take on too much debt so as not to put itself in a position of hampering new investments, financed by
debt, if equity cannot be raised at that time.

Sectors specifics: some industries are volatile with low visibility (airlines, technology, biotech), on
the contrary others are very stable (food, retail).
In a volatile sector, the firm should rather choose equity financing. It will, therefore, not increase its
fixed costs base that could weaken the company. Debt is preferable for sectors with high visibility.

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Fixed costs and variables costs: in sectors where FC are structurally high, equity should be favored as
it makes it possible not to increase breakeven point, as debt does through financial costs.

Competition: in a sector where all firms have high gearings, it is easier to convince investors that debt
is the right choice.

VII-HOW TO CHOOSE A CAPITAL STRUCTURE
In a pure financial logic: a firm that does not have investment opportunities that generate at least a
return equal to its WACC should not keep the money once it reached its targeted financial structure. It
should give it back to shareholders.
1/ Dividend policy and financial theories:
- Efficient market theory: does not explain anything as giving back the money or reinvesting it at
the right return is equivalent.
- Signalling theory: if the firm increases its dividend, it means that management thinks it will be
able to sustain this level in the future. Dividend is a proper signal of the companys good
financial health and of managements confidence in the future.
- Agency theory: dividends keep management under control as they limits the cash available in
the firm. This limits the risk of overinvestment (investment in value destroying projects) or
badly thought out diversifications.
- Psychological dimension: shareholders cannot stop themselves from liking receiving dividends,
it is perceived as a bonus. It is a mistake though as wealth remains unchanged; the share price
decreases by the exact amount of the dividend. The only change is that part of the wealth has
became liquid.

2/ How in practice:
Ordinary dividend: amount paid each period to its shareholders (quarter in the US, half in UK
or year France, Italy, Germany). 2 parameters:
- Dividend per share: strong signal, a decrease is badly perceived.
- Payout ratio: between 0 and 100%, generally close to 0 in growing companies and close to
100% in mature ones.
Dividends help gain loyalty of shareholders: they give the false impression that it is better to get
dividends than to sell shares. The reverse is also true: low dividends may lead shareholders to sell
their shares.
Extraordinary dividend: single payment, non recurring and clearly presented as such to
shareholders. Can follow a large disposal for example.
On the market share buybacks: the firm buys back its own shares in the market. It then
cancels the shares. It targets a limited and small (in %) number of shares as it is forbidden for
firms to artificially drive the price of their shares up.
Share repurchase offer: offer made to shareholders to repurchase their shares for a significant
volume. The firm offers a significant premium to share price (usually 15%). Shares acquired
are then cancelled. Final outcome is a transfer of cash from the firm to its shareholders.
Differences with on the market: One off transaction much higher volume premium over
share price material change in capital structure, leverage increases and so does ROE.

2/ Which type of transaction to choose:
Signal: increase in dividend (positive), extraordinary dividend (neutral), share buyback
(positive: shows that management believes share is undervalued).
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Flexibility: the least flexible is the ordinary dividend, then on the market, other methods are
one-offs.
Impact on shareholding structure: dividend (ordinary or extra) has no impact on
shareholding structure. Share buyback changes shareholder base as all shareholders do not
participate. Those who do not sell see their share increase but the value can decrease as the
premium paid to others is a destruction of value.
Taxes: can differ from tax on capital gains.
Impact on stock options: dividends decrease the value of the underlying share by the amount
of the dividend. Therefore, if management holds stock options it will favor share buybacks in
the hope that it will push up the share price and not reduce it.

VIII-SHARE ISSUE
A share issue is a sale of shares, the proceeds of which go to the firm and which implies a sharing (as
the shareholder base will change)
Shares should ideally be issued when the share price is high.
A share issue can be a unique opportunity to accelerate the development of a company.
Application: assume that a company wants to finance development through equity, it needs 200.
Company A
Eq =200
VEq = 100
Company B
Eq =200
VEq = 200
Company C
Eq =200
VEq = 400
Eq brought Voting right Eq brought Voting right Eq brought Voting right
Existing
shareholders
1/2 1/3 1/2 1/2 1/2 2/3
New
Shareholders
1/2 2/3 1/2 1/2 1/2 1/3
:
A has destroyed value in the past. The share issue will give a lot of power to new shareholders.
It is a sanction for existing shareholders who are diluted and give away power to the new ones.
Conversely, C generates a higher return than what shareholders require. The new shareholders
will therefore have to pay a premium: they bring more equity (1/2) than the voting rights that
they get (1/3).

A share issue can be a unique opportunity to accelerate the development of a company.

Application: assume that a firm has 1 million shares outstanding and issues 1 million more.
Company A
Eq =200
VEq = 100
Company B
Eq =200
VEq = 200
Company C
Eq =200
VEq = 400
Eq brought Voting right Eq brought Voting right Eq brought Voting right
Existing
shareholders
200 1/2 200 1/2 200 1/2
New
Shareholders
100 1/2 200 1/2 400 1/2
Total 300 /+50% 400 /+100% 600 /+200%
For the same dilution, equity increases by 50% (company A) to 200% (company C).
In addition, the issue of shares makes it possible to raise more debt. In the case of C, it creates a huge
leverage.
Stock markets recognize the skills of Cs management. For the same dilution in all 3 cases, the
financing capacity is very different and so is the financial strength.
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Share issues and financial theory
1- Efficient market theory: not much to say
2- Signaling theory:
A share issue is interpreted negatively by the market as it suggests that the share price is overvalued.
This leads to a drop in share price at announcement of the transaction. This signal can be mitigated by:
- A convincing speech on the industrial project.
- An underwriting commitment subscribed by banks that will have done some due diligence.
3- Agency theory:
Share issues are a way for shareholders to take more power from management as the transaction
requires the approval of shareholders. It requires management to detail its business project,
shareholders can then say yes or no.
4- The specifics of the distressed company
The value of debt is below book value as there is a risk of bankruptcy.
If a share issue is envisaged, lenders will be happy as the funds raised will allow the company either to
repay debt or to finance a project that will increase its EV and therefore the value of their debt.
Conversely, shareholders will be unhappy as the share price will drop (equity injected making it
possible to increase the value of debt).
There is a value transfer from shareholders to lenders.

Placing techniques
1. Without subscription rights:
Method used when we want to go fast and target all investors (not only existing shareholders).
Banks will buy and place new shares in a very short time frame. Banks buy the share slightly below
market price, the difference being their remuneration.
2. Without subscription rights (rights issue):
This technique allows existing shareholders to subscribe to the issue of new shares in proportion of
their current holding.
Implementing this technique implies time. As there is a lapse of time (usually c. 3 weeks); there will be
risk attached. Therefore, the issue price is set at a discount (as a buffer) compared to current price.
If an existing shareholder does not want to buy as many shares as he has the right to, he can sell all or
part of his rights. On the other hand, an investor may wish to buy more shares than his original holding
allows. The rights, therefore, have a certain financial value. There is an official market for rights
during a few weeks.

Computation of the value of the subscription right
Valuation based on arbitrage:
Share price = 78. Issue of 1 new share for 10 existing at 67.
Value of the subscription right = d
On the day of issue of the rights, the new share price becomes 78-d (share price drops but the
investors portfolio remains unchanged, the drop is only technical)
Two options:
a) Buy the share on the market for 78-R
b) Buy 10R + 67
For no arbitrage to be possible 78 R = 10R +67 R= 1
In any case, the new shareholder pays 77 for the share. The existing shareholder, if he does not
follow, is diluted but receives compensation of 1. His shares are now worth 77, but his wealth
remains unchanged.
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Formula:
Value of the right =
Share pr|ce-xuhxcr|pt|un pr|ce
1+Par|ty


Parity =
Numher uJ ex|xt|ng xharex
Numher uJ new xharex


Dilutions
Following a share issue, there are two types of dilution:
- Dilution of EPS,
- Dilution of control.
1) Dilution of EPS:
Inevitable once the after tax rate of return of the income form the share issue proceeds is less than the
inverse of the P/E ratio.
This is the most frequent case in the short term as investments made with the proceeds from the share
issue earn very little initially.
Its counterpart is a reduction in the risk of the share and accordingly, normally, a higher P/E ratio.
Generally, there is no impact on the shares value.
2) Dilution of control:
It corresponds to the reduction of rights to profits, equity and voting rights for the shareholder, for
whom the share issue does not result in either a net inflow or a net outflow.
When there is not preferential subscription right, it is calculated as follows: ???

When there is a preferential subscription right, the formula is the same, but N corresponds to the
number of shares that would have been issued if the issue price of the new shares had been equal to the
market value of the share.
Except for firms where a shareholders control is precarious, dilution of control is not a very important
issue.
What counts is the return on investments financed by the share issue compared with the required rate
of return.
Better to have a share issue with preferential subscription rights and a high level of dilution control
than alternatively to have to sell an asset at a knock-down price.

IX-DEBT STRUCTURING
To structure a debt, 5 key choices must be made:

1/ Maturity
a) Liquidity
It is clearly limited at the moment but this is not always the case (high liquidity period 2005-2007)
b) Interest rates
Borrowing short term generates risk as the renewal of the loan might be at a higher rate
Borrowing long term makes it possible to fix the rate over a long period but long term interest rates are
generally higher than short-term rates
c) Existing lenders
Existing lenders may be reluctant for the firm to borrow at shorter term than the existing debt as it will
increase their risk of not being reimbursed.

2/ Choosing between fixed and floating rate
Fixed rates give a certain comfort whereas floating rates are more risky (bet on decrease in interest
rates)
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3/ Choosing the currency
Currency for which interest rates are low may appear attractive but unfavorable movements in
exchange rate are likely to counterbalance this advantage.

4/ Asset based financing or plain vanilla financing
Plain vanilla financing: financed by the firms cash flows
Asset based financing: loan secured by one of the firms assets. In this case, the lender knows exactly
what it is financing.
Warning: using a low risk asset as collateral to finance the firm, makes it possible to obtain good
conditions on the specific loan but makes the rest of the firm more risky to finance. Lenders will be
more reluctant to lend and will ask for higher rates.

5/ Bank loan or bonds
For a small amount only bank financing is available (there is almost no bond issue for less than
100m).
Interest rate on bank loans is generally lower than on bonds as banks use this product to gain a
commercial relationship with the firm, they then try to sell other higher margin products.
Speed of implementation: issuing bonds requires some time whereas a bank loan can be obtained very
rapidly.
Covenants: banks usually require that covenants be attached to the loan so as to restrict how the funds
will be used. Covenants make it possible to monitor the risk on lent funds.
It is useful to have two types of lenders (banks and the bond market) in order to be able, at any
moment, to tap into different financing sources.

X-LBOs
An LBO is a transaction whereby a target company is acquired by a holding company that will raise
debt to buy the shares from existing shareholders. The holding company will then repay its debt thanks
to the cash flows of the target.
This structure leads to a large increase in the consolidated net debt of the group.

1/ LBO: new governance structure
Governance: interaction mode between shareholders and management.
In an LBO, management is offered two things:
- Managers have to become shareholders of the company. As equity is rather low due to the high
level of debt, the financial leverage is high and therefore there is potentially a high return for
shareholder over a limited time frame (3 to 5 years). This carrot leads to a strong
management commitment.
- But there is also a stick: if the company does not perform, the structure will go bankrupt and
managers will lose their jobs, their investments, and their reputations.
The double incentive leads to proven higher ROCE for companies under LBO compared to their
competitors. High level of debt pushes them to create value through better operating performance.

Limits of the structure:
Obsession to generate cash with high focus on short term
If things go wrong, the discouragement will be all the more serious

Managers are highly tempted by this type of structure due to the very high return potential.
2 / Players
a) LBO funds: private equity
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Small teams of high profile professionals that raise equity from investors. They will:
- Identify the targets
- Negotiate the acquisition with the seller
- Put in place the new governance
- Monitor the implementation of the business plan
- Sell at the appropriate time to realize capital gain
Anticipated return over 3 to 5 years is c. 25% p.a. (it would be c. 9% without leverage)
Actual returns are on average 15%, but can reach 30 to 40%
A private equity firm that has demonstrated its ability to invest will then easily raise funds as investors
will be satisfied.
Examples of private equity funds: KKR, Wendel, PAI; etc.

Shareholders
(institutional or wealthy individuals)

LBO fund
Management
Company

Holding 1 Holding 2 Holding 3

Target 1 Target 2 Target 3

b) Lenders
Lenders are banks that have to assess precisely the risk taken (often debt/EBITDA > 4, it can reach 7
or 8 etc.)
Banks very carefully analyze the capacity of the target to generate cash and the structure of debt.
Senior debt (tranche A, B and C): priority repayment
Mezzanine debt: more risky and therefore more expensive. Part of the interest is paid in cash, part is
capitalized (PIK) and part is in the form of warrants (call options)

This makes it possible to create different risk segments depending on the investors taste for risk.

c) Managers
They can be existing managers (MBO), newly brought-in mangers (MBI) or a mix of the two.
Managers generally go for 1, 2 or 3 LBOs but then retire (exhausted and rich or bankrupt)

d) Targets
Initially, typical target companies were highly stable mature companies in sectors with high barriers to
entry. But as LBOs developed the sectors broadened with even some restructuring companies
becoming targets. Some sectors are not suitable (biotech, high tech) as volatility of the capital
employed is too high or capex are too large.
Before 2007, 15 to 20% of acquisitions were made in the form of an LBO.

3/ Exit of an LBO
a- Bankruptcy
In general, it is a real slaughter (fight between shareholders, unstable management, etc.)
b- Disposal to an industrial buyer
End of the dream: aggressive and free actions stopped, administrative routine comes back

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c- IPO
Illustration; Legrand in 2006 after and LBO (2003) leading to an increase in EV from 3bn to 7bn.
.
d- Disposal to another LBO fund
Secondary LBO. This is the case of Picard (which belonged to Carrefour) bought by Candover, then
resold with high returns to another fund (BC Partners) which sold it to Lion Capital which sold it to

e- Leverage recapitalization
A large portion of Equity is distributed in the form of dividends financed by new debt. This is
equivalent to a secondary LBO but with the same equity investors.

Remarks:
- LBO funds may appear cynical as only the IRR is important
- Only little data available on failures
- Shareholders of the fund have very little decision making power over the management
company.

XI-M&As
1 / Reasons
a) Microeconomic factors
Share fixed costs: e.g. Pernod and Absolut Vodka; as sales force of Pernod are fixed costs.
Acquire market share: organic growth is sometimes not enough to gain market share.
Gain time: organic growth can be a lengthy process.
Get larger to take more risks: capex in some sectors can be extremely high (R&D in the
pharmaceutical industry, IT costs for banks)
Acquisition opportunities: family selling their business
Media impact of an acquisition

b) Macroeconomic factors
Deregulation: in the US Glass-Stagall Act used to prevent investment banks from commercial
bank operations.
Geographical change of scope: sector growing from being national to European, and then
worldwide.
Technical innovation
Development of financial markets that offers more financing to industrial buyers
Waves of M&A:
o In the 60s, large conglomerates appear as management skills are offered to subsidiaires.
o In the 80s, the conglomerates died, some financial investors (Hanson) specialize in
splitting those groups (e.g. ITT)
o Since 97-98, M&A transactions justified by industrial synergies have come in waves
(economic environment, mimetic behavior).
2 / Implementation
a- Cash acquisition
Easiest way. Strong psychological value for the seller

b- Payment in shares
The payment in shares is much more complex. If the buyer is not listed, the counter value of the shares
can be hard to assess and liquidity will be an issue. The shareholders of both companies need to agree
on the transaction.
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Pros:
- Common interest of the buyer and the seller
- Sometimes not avoidable as banks will not lend large amounts to some sectors (eg volatile
industries: Lucent / Alcatel)
Two methods:
Merger: transaction through which 2 legal entities are regrouped into one. There is only one
surviving entity.
The buyer issues new shares that are given to the seller in exchange for the shares of the target.
The target becomes a subsidiary of the buyer.
c) Mix of cash and shares
Illustration: acquisition of Arcelor by Mittal.
Cash offer and Exchange offer are ways of implementing an acquisition.

3 / Key parameters
a- Premium
To acquire, a premium has to be paid. The buyer can afford to pay this premium as it anticipates
delivering synergies that will make it possible to increase profits of the targets.
The average premium paid is 20-30%. Theoretically the maximum premium paid should be the NPV
of 100% of anticipated synergies.

b- The proportion of cash
Obviously from 0% to 100%, depends on:
- The debt capacity of the acquirer (depends on its financial situation pre-acquisition and on the
industry in which it operates).
- Shareholders: acquisition using shares will alter the shareholding structure and the power of
controlling shareholders if any.
- Tax issues: a swap of shares is usually treated differently from a cash payment (immediate tax
on capital gain). Exchange of shares can be more complex but more interesting from a tax point
of view.
- Signal: to issue shares may lead the market to believe that shares are overvalued even if this
signal is not the key decision making criteria.
- Impact on EPS

4 / Conclusion
The buyer should not overpay but in rare circumstances, it is better for strategic reasons to overpay
than miss the deal.

The success of an M&A transaction depends on the implementation of the consolidation of the teams
(complex and delicate human phase). The integration of the teams should be done quickly. If buyers
behave in an aggressive manner, integration can be a disaster.

c- Ggg
d- gg