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CORPORATE FINANCE

First principles: Objective: Max firm value. Investors


base decisions about firms future based on the quality of
the firms projects (investment decision) and the amount of
earnings it reinvests (dividend decision). The financing
decision affects the firm value through creation of a hurdle
rate - Violating first principles will lead to huge costs.
(1) Investment decision: Invest in assets that earn a return
greater than the minimum acceptable hurdle rate (that
reflects riskiness of investment whether money is raised
from debt/equity, and what returns one could have made
by investing elsewhere)
- The return should reflect the
magnitude and the timing of the cash flows, and all side
effects
(2) Financing decision: Find right kind of debt for firm and
right mix of debt/equity to max the value of the
investments made
(3) The Dividend decision: If cannot find investments that
make your min. acceptable rate, return the cash to owners
- How much cash you can return depends on current and
potential investment opportunities - How you return
depends on whether they prefer dividends or buybacks
Objective in decision making: Maximise firm value and
if markets are efficient: Maximise stock price (a)
Stockholders have power to hire/fire managers, so they set
aside their interests and max stock prices - Alignment of
interests due to fear of stockholders or cos management
holds enough stock (b) Managers will reveal information
honestly and on time, so markets are efficient and
stockholders wealth is maximised (c) Bondholders are
protected from stockholder actions, hence they lend
money to firms to maximise firm value (based on opt
financing decision)- Stockholders concerned about
reputation if they hurt lenders and damage future
borrowing, or bondholders have covenants to protect
themselves (d) Social costs can easily be traced to firm,
so firm does not create burdens for society
- However, agency costs may form due to conflict of
interests among stockholders, managers, bondholders and
society which may result in the objective function of stock
price maximisation going awry
Stockholders vs Managers: Limitations of current
measures
(1) The annual meeting- not a good disciplinary
mechanism: Power of stockholders is diluted due to: (a)
Most small stockholders do not go for meetings because
the cost of going > value of their holdings, (b) Proxy forms
are usually not returned as small stockholders may not
know enough about how good/bad the management is,
hence incumbent management get advantage as unvoted
proxies become votes for them, (c) Large stockholders
choose to vote with their feet when they are dissatisfied
with management (simply sell stock and move on) - Also,
institutional investors may go along with incumbent
managers as they want to keep good relations with
managers to avoid decisions made by management that
could affect them negatively
(2) Board of Directors- not a good disciplinary measure:
(BODs fiduciary duty is to ensure that managers serve and
look out for the interests of the stockholders) - However,
(a) The CEO often hand-picks directors: Hence although
most directors are outsiders, they are not independent, (b)
Many directors only hold token stakes of their corporations,
Hence interests are not aligned with stockholders, (c) Many
directors are CEOs/directors of other firms so they cannot
spend much time on their fiduciary duties and there is
potential conflict of interest, (d) Lack of expertise on the
companys internal workings, accounting rules etc
- Example: Disney 1997 had a bad board of directors
(1) Too many insiders (current and ex-employees) who
would not want to challenge the CEO, (2) The CEO and
chairman were the same person hence there was no
challenging during the meeting, (3) Large boards not
efficient since hard to get a consensus, (4) Some directors
had bad reputations, (5) Not independent: Connected
based on school of the CEOs kids, personal lawyer etc
- Calpers Tests for Independent Boards
(1) Are a majority of the directors outside directors? (2) Is
the chairman of the board independent of the company?
(E.g. Not the CEO) (3) Are the compensation and audit
committees composed entirely of outsiders?
Consequences of stockholder powerlessness:
Managers put their interests over stockholder instead of
maximising stockholder value
- Managers choose to avoid hostile takeovers even if
stockholders are getting a good deal, as this would cost
them their jobs
(1) Greenmail: Managers of target firm of a hostile
takeover choose to buy out the potential acquirers
existing stake at price much higher than the price paid by
the raider, in return for the signing of a standstill
agreement, (2) Golden parachutes: Provisions in
employment contracts for the payment of a lump sum or
cash flows over a period (using shareholders money) if
managers lose their jobs in a takeover, (3) Poison pills:
Security where rights or cash flows are triggered by hostile
takeover to make it difficult/costly to acquire control (e.g.
issue new shares to existing shareholders except for the
new bidder to halve his value), (4) Shark repellents: Antitakeover amendments that require stockholder assent (E.g.
Super-majority amendment where acquirer needs to

RISK-RETURN MODEL
Risk-free rate: LT govt bond rate, same currency as cash
flows - If no default-free entity, deduct default spread by:
(1) Obtain default spread based on rating/risk score, (2)
Use alternate currency to do analysis, (3) Compare
government bond issued in USD with USD govt bond rate
to get default spread, (4) Use CDS as default spread
Risk premium:
(1) Survey approach
(2) Historical premium approach: Define time period for
estimation, calculate average returns on stock index during
period (geometric average), calculate average returns on
riskless security during period and find difference
- Standard error in estimate =
- For emerging markets with less historical data, add
country risk premium. Use countrys bond rating/default
spread and multiply by (SD of countrys equity/SD of
countrys bond). Add to US risk premium.
(3) Implied premium approach: Add dividends and
buybacks yield against index and find average yield over a
few years. Use average yield to estimate CF this year by
multiplying by index NPV. Estimate earnings growth and
calculate CF for next few years (grow at same rate). After a
few years, assume earnings grow at risk-free rate.

Solve for IRR (r) and obtain implied risk premium (E(r) = rf
+ RP)
- Choosing between historical/implied: Historical RP
assumes market is mispriced while implied RP assumes
market is fairly priced (on average) and is more forward
looking.
Beta (top-down): Regress stock returns against market
returns
- Decide on an estimation period (trade-off: accuracy vs
relevance) and decide on return interval (usually
weekly/monthly/quarterly since daily and yearly avoided
due to thin-trading and few data points)
- Estimate returns (including dividends for ex dividend
months)
- Choose market index (based on marginal investorsdiversify locally/globally) and estimate returns inclusive of
dividends
- Regression results:
- Beta (b) is gradient
- Standard error of beta estimate: Find confidence intervals
- y intercept (a): a > rf(1-b) means stock did better than
expected during regression period
- Jensens alpha: a = rf(1-b) Annualized excess return =
*RMB to correct rf to monthly if returns are monthly
- R-squared: Estimate of proportion of total risk attributed
to market risk
(Diversified investor look at beta, non-diversified look at R 2
and beta)
Beta (Bottom-up): Better estimate as standard error is
lower and can reflect current and expected future mix
rather than historical.
Determinants of beta: (1) Industry effects (sensitivity of dd
to macro factors), (2) Operating leverage (Higher OL,
higher proportion of fixed cost, greater earnings
variability), (3) Financial leverage (Hamada equation
)
*Regression beta is levered
*Betas of portfolios are MV weighted average of betas of
individual investments in portfolio
*Mergers beta calculation:
General method: (1) Find biz segments of firm, (2) Obtain
median beta for each segment in industry, (3) Find median
D/E in each segment, (4) Use hamada to find unlevered
beta for each segment, (5) Correct unlevered beta for cash
using median (cash/firm value)
(6) Find median enterprise value/sales for each segment
(EV is market cap+debt-cash), (7) Multiply firms biz
segment revenue to each EV/sales to get estimated value,
(8) Use proportions of estimated values and unlevered
betas for each segment to find firms unlevered beta, (9) If
finding overall levered beta, use hamada on firms
unlevered beta and actual D/E ratio, (10) If finding levered
beta for each segment, allocate firms debt across biz
segments by estimating each segments debt using
median D/E and estimated value of segments, (11) Use
proportion of estimated debt and multiply by actual total
debt to get allocated debt, (12) Take estimated value
allocated debt to find estimated equity, (13) Use (allocated
debt)/(estimated equity) to find levered beta for each
segment, (14) To get beta for assets (not just operating
assets, use

Other issues: (1) Single division firms- just use re of whole


firm, or instead of breaking up into biz segments, use e.g.
emerging markets for related firms beta and median
values to find unlevered beta corrected for cash, and use
actual D/E to get levered beta, (2) Firms with similar biz
segments- no need to allocate debt (use actual D/E for
both segments, (3) Financial institutions- Take median of
beta of similar firms and revenues as weights (difficult to
find D/E so no need to find unlevered beta), (4) Non-traded

INVESTMENT RETURNS
(A) To all investors
(1a) Accounting view of return: Find return on
capital
- Estimate accounting earnings on project (operating
income after tax)
- Revenue direct expenses depreciation (inclusive of
pre-project) allocated G/A costs Taxes
*AKA
EBIT(1-T) before interest
- Find average book value of capital/beginning book value
of capital
- BV = BV of pre project investment + BV of fixed assets +
BV of working capital (non-cash and non-debt only)
*WC
= CA - CL
- Find ROC
*Always calculate implied tax rate!!!!
*If given EBIT after operating lease expenses/debt, add
back interest expense (PV/debt value of lease payment x
cost of debt)
(1b) EVA and comparison
- To value the entire firm (existing investments), compare
ROC of firm with WACC of firm
- To value new investments, compare ROC of individual
project with WACC of biz segment/firm
*Adjust WACC
for EM risk etc
- EVA (Economic value added) = (ROC WACC) x BV of
capital invested
(Value spread x investment = excess returns)
(2a) Cash flow view of return: Find incremental cash
flows and NPV/IRR
- EBIT(1-T) (accounting earnings) + D/A (inclusive of preproject) Capex change in non-cash working capital
- In year 0, add back pre-project investment (previously
expensed off- since it would have existed anyway. Left with
normal investment and increase in working capital)
- In years 0-10, deduct pre-project depreciation x tax to
remove tax benefit from sunk depreciation (only have tax
benefit from normal dep)
- In years 0-10, add back after-tax fixed/non-variable G/A
costs since only variable costs will contribute to cash-flows
on project
*To know if variable/fixed, compare allocated expense and
increase in expense due to project. If increase in
expense>allocated so instead of adding back (allocatedincrease)(1-T), minus (increase-allocated)(1-T)
- Get incremental cash flows: Time-weighted
(compounding/discounting)
- Closure: For projects with short/finite life, find salvage
value (expected proceeds from selling investment in proj
which is fixed assets+WC). For projects with infinite life,
compute terminal value =
(2b) Measures of return
- NPV > 0 means add value to firm - Minus year 0
investment (BV of fixed assets and WC) from NPV of cash
flows. May have salvage/terminal value
- Annuity to compare NPV of proj with different span:
- IRR > Hurdle rate (IRR: Discount rate that sets NPV = 0)
- NPV vs IRR: (1) Project only has 1 NPV but may have >1
IRR, (2) NPV ($ value) will be larger for large-scale projects
while IRR (% value) will be larger for small-scale projects,
(3) NPV assumes CF reinvested at hurdle rate while IRR
assumes reinvested at IRR
*Overall NPV more reliable
(2c) Consistency rule: Project conclusions identical in
different currencies
(B) To shareholders only
(1a) Accounting view of return: Find return on
equity
- Estimate net income/year (EBIT Interest Taxes) *Get
tax rate
- Find debt payments per year:
Beg
debt
100,00
0

Intere
st
6,373

Principal
repaid
7,455

Total
paid
13,828

End
debt
92,545

i/r x
BD

- Find BV of capital = BV of fixed asset + BV of working


capital
- Find BV of equity = BV of capital Beginning debt for
project only
- Find average BV of equity (beg+end/2)
- Find ROE (can also use EVA method)
- Compare ROE with WACC of firm
(2a) Cash flow view of return
- FCFE = Net income + D/A capex change in non-cash
WC + change in debt (new debt - principal amount repaid)
(2b) Measures of return: NPV and IRR
(2c) Consistency rule
(C) Uncertainty in project analysis: (1) Payback period,
(2) Sensitivity analysis and what-if questions (hold one
variable constant), (3) Simulations (vary many variables
and obtain distributions)
(D) Macro uncertainty: (1) Commodity prices risk
(Should commodities firms hedge against commodity
prices? No cos investors are betting that prices will rise.
Should users of commodities (firms) hedge? Yes),
(2) Exchange rate risk (hedge, investors not interested to
take this risk)
CAPITAL STRUCTURE
(1) Optimal mix of D/E
- Debt: All interest-bearing liabilities (ST/LT)
- Equity: BV/MV of market cap (MV: Current stock price x
issued shares #)

acquire more than usual 51% shares to take over) Give


managers larger bargaining power and may work in the
interest of shareholders if managers bargain for higher
prices to be paid for shares, (5) Overpaying on takeovers:
Acquisitions often are driven by management interests
rather than stockholders interests - Quickest and most
decisive way to impoverish stockholders - Usually
takeovers are not successful for the bidding firm and stock
prices usually decline on the takeover announcements Mergers usually do not work
*(1)-(3): Only directors approval is required *Other ways
managers can make stockholders worse off are by
investing in bad projects, taking up too much or too little
debt and overpaying on a takeover
Stockholders vs Managers: Other issues
- If government is a major stockholder, the government
may force the company to pay more taxes, force them to
lower or force the company not to outsource - If a certain
family of companies hold most of the shares, managers
may choose to put the familys interests above other
stockholders - If influential figures hold large amounts of
shares, smaller institutional investors may feel safer as he
will whistle-blow
Bondholders vs Stockholders: Different objectives due
to the different payoff structures - Bondholders:
Concerned about safety and ensuring they get paid their
claims, do not like risk in project choice as they do not get
to participate in the upside gains - Stockholders:
Concerned about upside potentials since they have limited
liability - What is good for the stockholders (increasing
share price/dividends) may not be whats good for
bondholders (reducing default risk/increasing bond price)
(1) Increase dividends significantly: Stockholders benefit
while lenders are hurt since the firm is riskier without the
cash and there will be less cash to meet debt obligations.
Possibility of bankruptcy increases (2) Firm takes riskier
projects than agreed: The higher the risk, the higher the i/r
and bond price falls, (3) Firm borrows more on the same
assets (uses same assets as collateral): If lenders do not
protect themselves, can be hurt by firms actions (E.g.
Leveraged buyout: Bidder uses the target companys cash
flows/assets as collateral to borrow to purchase shares)
Firms vs Financial markets: Problems with using stock
prices as estimate for shareholder wealth: (1) The
information problem
- Managers control the release of info to the general public
- Info that is negative is suppressed or delayed by
managers seeking a better time to release it (manipulate
information flow) - Rationale: Panic trading cause prices to
change more. Firms hope bad news will go away or be
paired with future good news to release to investors - In
some cases, firms intentionally release misleading info
about their current conditions and future prospects to keep
investors happy and raise market prices - Easier for small
firms cos of large number of analysts following larger firms
(2) Market inefficiency: Problem with using financial
markets to evaluate performance - Investors are irrational
and prices are more volatile than justified by the
underlying fundamentals. - ST price movements have little
to do with info hence it is inaccurate as a measure of
managerial performance - Investors (especially ST
investors) are short-sighted and do not consider the longterm implications of actions taken by the firm (e.g. LT
investment in R&D) - Financial markets are manipulated
by insiders and hence prices may not be reflective of true
value
Firms vs Society: Social costs may be considerable but
cannot be traced back to firm. May not be known at time of
decision - Difficult to quantify and person-specific (different
decision-makers weigh them differently)
Solution 1: Choose different objective function (1)
Max market share (More observable and measurable with
assumption: Higher market share, more pricing power and
higher profits), (2) Max profit (Higher profits, higher value
in LR), (3) Max revenue/size, (4) Max social welfare, (5)
Max consumer satisfaction( Quality products at lower
price)
Solution 2: Maximise stock price, subject to
constraints (reduce agency costs) - Internal selfcorrection mechanism (1) Stockholders vs Managers:
Stockholders/institutional investors taking part more
actively to voice displeasure, monitor companies and
demand changes - The Icahn effect: Some individuals take
large positions in companies where they feel need to
change management ways and push for changes (punish
managers and help small shareholders) - The hostile
acquisition threat: The best defence against a hostile
takeover is to run firm well and earn good returns for your
stockholders - More effective board of directors: Smaller
boards with fewer insiders, directors are compensated with
stocks instead of cash and directors are identified and
selected by a nominating committee rather the CEO (2)
Bondholders vs Stockholders: More restrictive bond
covenants: restrict the firms investment policy, dividend
policy and additional leverage - Puttable bonds where the
bondholder can put the bond back to the firm and get face
value if the firm takes actions that hurt them - Ratings
Sensitive Notes where the i/r on notes adjusts according to
rating of firm - Hybrid bonds: With equity component so
bondholders can become equity investors (3) Firms vs
Financial Markets: Analysts to provide an active market for

assets only have BV (no MV) D/E available so estimate that


firms DE is similar to median D/E of comparable firms, (5)
For private firms (not diversified), adjust beta to reflect
total risk (if not, will underestimate hurdle rate)
Cost of equity = rf + b(RP)
To convert to local currency,
Cost of equity = (1+$COE)(
)1
(Or just replace rf with nominal local rf rate but not as
accurate)
MM theorem: COE =
Cost of debt: Debt includes interest bearing liability
(ST/LT) and any lease obligation (operating/capital)
(1) Firm has outstanding bonds, and are traded Use YTM
on LT straight (no special features) bond (Or coupon rate of
bond trading at par)
(2) Firm is rated Use typical default spread based on
rating + rf rate
(3) Firm is not rated (a) i/r on recent LT borrowing (b)
Estimate synthetic rating and obtain default spread to add
to rf rate
*Add country spread for countries that face default risk
Synthetic rating: Interest coverage ratio [EBIT/Interest
expenses]
- Compared to actual ratings: Synthetic only reflects
interest coverage ratio (no other ratios/qualitative factors),
do not allow for sector-wide biases in ratings, based on
EBIT for the year while actual reflects normalized earnings,
presence of country risk
Cost of preferred stock (not tax deductible):
Cost of convertible debt: break into parts
MV of CD = MV of straight debt + convertible option
(derived value)
*Only include if significant (>5% in value)
Weighted average cost of capital (WACC) Use
market values
MV of equity: Market capitalization
MV of debt: PV of interest paid on debt (e.g. bonds) + PV of
debt + PV of lease payments (discount at cost of debt)
Formula:
*Bank loan (CF are interest payments) vs bonds (CF are
coupons)
Other issues: (1) Currency effects- Use same method as
under COE to convert to local currency, (2) Divisional
WACC- continuing from beta discussion- can use different
weights (D/FV and E/FV) for each segment
Inflation: Discount real cash flows with real discount rate
(dont use nominal for only one) Real cash flow = Nominal
cash flow/(1+i/f)t
Real discount rate = ((nominal+1)/(1+i/f)) 1
MM-theorem: re = ra + (D/E)(1-T)(ra-rD)
*ra is expected
return on assets, which is independent of financial
leverage
VALUATION
(A) Relative valuation: Value of asset estimated based
on what investors pay for similar assets. Use price
multiples and compare same biz firms.
- Decide on market multiple (e.g. P/E, P/divid, P/sales, P/BV
of equity)
- Find benchmark firm(s) market multiple (e.g. P/E) and
multiply by e.g companys earnings to get estimated P
- Find benchmark firm: Look at interpretation of market
multiples
E.g. For P/divid (=1/r e-g), since re is dependent on industry
and debt policy, choose benchmark firm in same industry
and w same debt policy
- Usually choose firm with same growth rate, same
industry, same capital structure May not choose P/divid
since some firms dont pay divid
- May not choose P/E if firm is losing money
- Advantages: Quick and straightforward
- Disadvantages: May not be precise, may not be easy to
find benchmark firm, provides little info on how firm value
is related to corp decisions
(B) Discounted CF valuation: Value of asset is a
function of its fundamentals (CF, growth and risk)
(1) Choose CF to discount
- Equity valuation: Value of equity =
(specialised case: dividend discount model)
- Firm valuation: Value of firm =
- If cannot estimate FCFE/FCFF, use dividends
- If firms debt ratio not expected to change, use FCFE
- If debt ratio changes, difficult to estimate FCFE so use
FCFF
(2) Estimate FCFF (EBIT(1-T) + D/A capex change in NC
WC)
*May use normalized value (when investments are
irregular)
(3) Estimate discount rate (WACC/re) See hurdle rate
section
(4) Estimate expected growth
(a) Based on net income: g = retention ratio x ROE =
RE/Equity
*Since RE = earnings dividends, retention ratio = (1
divid/net income)
(b) Based on operating income: g = reinvestment rate x
ROC
*ROC = EBIT(1-T)/BV of capital, reinvestment rate = (-D/A
+ capex + change in NC WC)/EBIT(1-T)
(5) Getting closure in valuation

- Optimal mix: WACC weights constant for a long time


- Trade-off: Benefits/costs of debt
(2) Benefits of debt: (a) Tax benefit since interest
expense is deductible while dividends are paid after tax
(tax benefit each year = T x interest) Hence other things
equal, the higher the marginal tax rate, the more debt firm
should have
*17% SG rate is considered low
(b) Adds discipline to management: Managers with no debt
may become complacent, hence inefficient or invest in
poor projects. Assuming they dont hold a lot of shares,
there is little cost borne when stock price falls hence
forcing firm to take debt, need to earn enough return to
cover interest (if not bankruptcy, loss of job, difficult to find
job again)
(3) Costs of debt: (a) Bankruptcy cost: Probability of
bankruptcy (depends on uncertainty of future CF) and cost
of bankruptcy (direct costs like legal costs or indirect costs
from negative perception) Hence other things equal, the
greater the indirect cost, the less debt firm should have
(e.g. airplane manufacturer has higher indirect costs than
grocery store)
(b) Agency cost: Arises when you hire someone to do
something for you (conflict of interest) Lenders (get money
back) vs shareholders (max wealth) Other things equal, the
greater the agency problems, the less debt a firm can
afford to use (lenders increase i/r to protect themselves)
(c) Loss of future financing flexibility: When firm borrows up
to capacity, loses flexibility of financing future projects with
debt (better projects come along) Other things equal, the
more uncertain a firm is about its future financing
requirements and projects, the less debt it should use
(4) Alternative to optimal mix: Pecking order theory
- RE, debt (straight, convertible), new equity (common,
straight preferred, convertible preferred)
- Managers value flexibility to use capital w/o restrictions or
having to explain its use, managers value control to
maintain control of the business (lose a bit of control to
shareholders/debtors)
- Hence when firm issues convertible preferred stock,
signals that firm is in financial trouble
(5) Optimal mix: Cost of capital approach (minimise
cost of capital)
(a) Estimate cost of equity at different debt levels using
hamada eqn
- Start with current levered beta, find unlevered beta *Can
use segments
(b) Estimate cost of debt at different debt levels
- Find EBIT and debt amount
- Predict bond rating and check corresponding pre-tax cost
of debt
- Find interest expense (pre-tax COD x debt)
- Calculate interest coverage ratio (EBIT/interest) and
check if it corresponds to rating previously predicted. If
wrong, predict again.
- Multiply by (1-T) to obtain after-tax COD
*Tax rate may end up lower at higher debt level since EBIT
< Interest so new marginal tax rate = (TxEBIT)/Interest
(c) Estimate WACC at different levels of debt
- Should increase since debt will cost rd and re to rise. But
may fall slightly first since put more weight on smaller rd
value
(d) Calculate effect on firm value and stock price
- Find FCFF = EBIT(1-T) + D/A capex + change in noncash WC
- Find implied growth rate g (if no growth, no g)
*Value of firm = D+E
*r = current cost of capital
- Revalue firm with new WACC
- Calculate increase in firm value
- Another way: Annual savings next year = Change in
WACC x FV
Increase in FV = annual savings next year/(WACC new-g)
Repurchase price
- Assume rationality: New stock price = current + increase
in FV/# shares
- Buy back at current price: # shares bought = New
debt/current stock px
New stock price = current + increase in FV/new #
outstanding shares
- Buy back at certain price px: # shares bought = New
debt/certain px
New stock price = current + (increase in FV (Px P) x #
shares bought)/new # outstanding shares
Issuing shares (instead of repurchase)
New price=Current+(Increase in FV+(Px-P)x # shares
bought)/outstanding
Paying dividend (instead of repurchase)
(1) Calculate increase in FV and increase in debt, (2)
Calculate change in equity (change in FV-change in debt),
(3) Deduct/add to current equity and divide by # shares
Limitations: (1) Constraint on debt due to ratings
constraint as managers have desired bond rating (protect
against downside risk in operating income, indirect
bankruptcy cost with drop in rating, ego factor) Cost of
rating constraint = Value at desired debt level Value at
optimal debt
(2) Static: EBIT should change every year, (3) Indirect
bankruptcy cost ignored: Higher debt should reduce EBIT,
(4) Betas and ratings: Hamada assumes the only factor
affecting beta is D/E, CAPM has many unrealistic
assumptions, debt rating only looks at interest coverage

info: Payoff to uncovering negative news about firm for


their clients is large since such news is eagerly sought Option trading on bad news more common
- Investor access to info is improved so more difficult for
firms to control when/how info is released - When firms
mislead markets, punishment is swift and savage (market
value falls by a huge extent due to investors lack of trust
and negative view on future cash flows) (4) Firms vs
Society:
- Government laws and regulations - For firms catering to
socially conscious clientele, failure to meet societal norms
leads to loss of business - Investors may choose not to
invest in firms they view as socially irresponsible
DIVIDEND POLICY
(1) Measures of dividend policy
- Dividend payout = Dividends/Net income
- Dividend yield = Dividends per share/Share price
(2) Dividends dont matter: M-M hypothesis: Divid dont
affect value
- Underlying assumptions: (1) No tax diff between
dividends and capital gains, (2) If companies pay too much
in cash, they can issue new stock to replace cash w/o
flotation costs/signalling consequences - When issue new
equity, reduce expected price appreciation of stock but this
will be offset by higher dividend yield (expected return =
capital gains yield + dividend yield), (3) Investment
projects dont change even if there is excess cash when
company pays less dividends
(3) Dividends are bad - Tax rate for dividends usually
higher than for capital gains - Investors have to pay tax
when receive dividends but only pay tax on CG when they
sell the stocks and realize the CG - Tax reforms may reduce
dividend tax rate to a flagged rate (usually at marginal
income tax rate, but may reduce)
- (PbPa)/D = (1to)/(1tcg)
- If divid taxed at a higher rate, price change will be less
than dividend
- If both CG and dividends are taxed equally, the price
change on ex-dividend day will be equal to dividend (see
dividends dont matter)
*But px change/dividend may not = 1 even if tax rates are
the same due to timing issue, so CG tax rate is slightly
lower than expected
(4) Dividends are good: (a) Clientele effect: Investors
like dividends (cash dividends > stock dividends) - But
investors in high tax brackets may invest in stocks that
dont pay dividends (avoid paying high taxes) - Older
investors and poorer investors would hold high dividend
stock
(b) Signalling effect: Dividends are signals to market that
you have good cash prospects in the future - Usually
dividends wont change much because paying less
dividends will cause a large drop in share price (sell stocks
away) due to signalling effect and paying more dividends
will create high expectations (not sustainable, may choose
to pay special dividends instead) (c) Agency/discipline:
Force managers to be disciplined in project choice and
reduce cash available for managers discretionary use - In
firms with clear separation btw ownership and
management, managers should pay larger dividends than
in firms with substantial insider ownership and involvement
in managerial decisions
(5) Finding optimal dividend: The Cash/Trust Nexus
1. How much company paid out: Add dividends and
buybacks each year
2. How much could company have afforded to pay out
- Find FCFE each year (Amt of cash left after non-equity
claimholders (debt/preferred stock) have been paid and
after any reinvestments)
- FCFE = Net income + D/A Preferred dividends Capex
change in non-cash WC + (new debt - principal amount
repaid)
- If leverage is stable, an easier way: FCFE = Net income
(1 D/C)(Capex- Dep) - (1-D/C

)(change in non-cash

WC)
*Concept: Change in debt/capital (asset growth or
reinvestment). Assumes that net debt is always a stable
proportion of reinvestment
- Compare cash returned/FCFE ratio
3. How much do you trust the management with excess
cash?
- If cash returned/FCFE ratio < one, there is cash balance in
the company
- Performance measures: (a) Investment perf: Compare
ROE and re
(b) Stock performance: Jensens alpha (if negative,
underperformance)
- E.g. Disney could have afforded to pay more divid but
chose to invest in

- If assume to grow at constant rate g forever, terminal


value = expected CF next period/(r-g)
- g is called stable
growth rate and cannot be higher than growth rate of
economy
To calculate expected CF next period: (1) Calculate EBIT(1T)(1+g)t-1(1+gc)
(2) Calculate reinvestment = constant g/ROC x EBIT(1-T)t ,
(3) Deduct reinvestment to get FCFFt. Terminal value =
FCFFT/(waccnew constant g)
- Getting to stable growth
- Key assumption in DCF model is period of high growth:
Firm in alr stable growth, 2-stage: high growth for a period
then drop to stable growth, OR 3-stage: high growth for a
period then gradually fall to stable growth
- Assumption of duration of high growth depends on size of
firm (large firm-shorter), current growth rate (high-longer),
barriers to entry and differential advantages (high-longer)
Phases

High growth

Transition

ROC

9.91%

Reinvest
rate

53.72%
based on
acquisition
costs
ROC x
reinvest rate
26.7%
Beta =
0.9033
COD = 6%

Declines linearly
to 9%
Declines to
33.33%
(= g/ROC)

Expected
g
D/C ratio
Risk
paramet
ers

Stable
growth
Stable at 9%
33.33%
(= g/ROC)

Linear decline to
3%
stable g of 3%
Stays unchanged
Beta changes
Beta = 1
linearly to 1
No change in COD

(6) Firm value to equity value/share


- If you had discounted divid/share at re, PV is value of
equity/share
- If you had discounted FCFE at re, PV is value of aggregate
equity so subtract value of equity options given to
managers and divide by # shares
- If you had discounted FCFF at WACC, PV is value of
operating assets, so add the value of non-operating assets
(cash/near cash) and value of minority cross holdings to
get PV of assets. Subtract debt outstanding and value of
equity options given to managers, and divide by # shares
Ways to change value- Through: (financing/investing
decisions)
(1) CF from existing assets: How well you manage existing
investments
(2) WACC: Determined by operating risk/default risk of
company and mix of D/E used in financing
(3) Expected growth in high growth period
- Growth from new investments: Created by making new
investments, a function of amount and quality
- Growth from existing assets: Created by using existing
assets better
- Length of high growth period: A function of magnitude of
competitive advantages and sustainability of competitive
advantages (since value-creating growth requires excess
returns)
(4) Stable growth- cannot be changed
poor projects and was underperforming hence was under
pressure to pay more divid. After management was
changed, stock performance improved (+ve Jensens
alpha) and project choice improved (ROC> re). Cash
returned > FCFE and they avoided making large
acquisitions.
Cash
Surpl
us

Poor projects
Force managers to justify holding
cash or return cash to
shareholders

Defici
t

Firm should deal w investment


problem first then cut dividends
(problem is not divid policy but
manager ability/incentive

Good projects
Give managers
flexibility to keep
cash and set
dividends
Firm should cut
dividends and
reinvest more

Other issues: Whether there is takeover threat (low if


closely held and outperformance) which dictates
immediacy, history of paying dividends
(6) Finding optimal dividend: The Peer Group
Approach (A) Industry average: Idea: Optimal is close to
industry average - But does not take into account that may
not be any average company (e.g. Disneys large market
cap), (B) Market regression: Regress divid yield and payout against variables - Dependent variables: PYT (divid/net
income) and YLD (divid/current px) - E.g. of independent
variables: ROE, expected g, SD in equity values and %
insider holdings (related to agency problem)
- Estimate values of independent variables for company
and sub into the two regression equations to get predicted
divid yield and divid pay-out

ratio
(6) Optimal mix: Enhanced cost of capital approach
- Takes into account indirect cost of bankruptcy
- Use same steps as prev method but reduce EBIT
according to predicted rating accordingly
- When computing FCFF and FV, reduce EBIT too
(7) Optimal mix: Adjusted present value approach
(max firm value)
- FV = Value of firm w/o debt + effect of debt on FV
- FV = VU + Tax benefit Bankruptcy cost
(a) Estimate Vu
- Estimate unlevered beta, find re and FCFE/FCFF FV=
OR
- Estimate current MV firm Current tax benefit + current
expt bank cost
- Current tax benefit = Current debt x T
- Current bankruptcy cost = predicted probability of
bankruptcy x predicted cost of bankruptcy (%) x firm value
(b) Estimate tax benefit at different levels of debt
(c) Estimate bankruptcy cost at different levels of debt
- Probability of debt corresponding to synthetic rating of
debt (in first approach)
(d) Find debt level where VL is the highest
*VL=VU + dollar debt(% debt x VL)*T P(D)*cost of debt*VL
but difficult to solve so assume VL is same as current FV to
calculate dollar debt and COB
(8) Optimal mix: Relative analysis (industry avg w
subjective adjust)
- Choose variables (subjective adjustments- e.g. tax rate,
insider ownership, income stability, amount of intangible
assets)
- Run regression of debt ratios on these variables
E.g. Debt ratio = a + b*(tax rate) + C*(earnings volatility)
- Estimate proxies of firm and enter into cross sectional
ratio to get estimate of predicted debt ratio
- Compare actual to predicted debt ratio
- R-squared tells us how close data is to regression line
- Can do based on industry or whole market (extend
sample scope)
(9) Changing debt from actual to optimal
1. Timing: If there is bankruptcy/takeover threats
(a) Quickly increase debt ratio (takeover threat) Sell
operating assets and use cash to buy back stock, or pay
special dividend Borrow money to buy back stock
(b) Gradually increase debt ratio Take good projects with
debt
(c) Quickly reduce debt ratio (bankruptcy threat) Sell
operating assets and use cash to pay off debt Issue new
stock to retire debt or get debt holders to accept equity
(d) Gradually reduce debt ratio Take new good projects
with equity/RE (not debt) If no good projects, pay off debt
by issuing new equity Reduce dividends
2. Choosing right kind of debt: Ensure CF on debt matches
as closely to CF on firms assets Reduce default risk,
increase debt capacity and FV
(a) Intuitive approach
- Duration (ST/LT)
- Currency
- Effect of inflation uncertainty about future (market leader
use floating rate since less affected by i/f, just raise prices)
- Industry competition (competitive, use fixed)
- Growth patterns (growth firms, low current CF, high future
CF)
- Cyclicality (E.g. commodity bonds- i/r and principal
payments linked to commodity prices, catastrophe
bonds/notes issued by insurance companies- i/r and
principal payment linked to disasters)
(b) Quantitative approach- to confirm intuitive approach

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