1-5
1-5
1-5
Lecture 1
Introduction
1
Learning Outcomes
Know the basic types of financial management
decisions and
Know the goal of financial management
Be able to compute net present value, payback,
internal rate of return and profitability index,
and understand the advantages and
disadvantages of these approaches.
Understand the definition of incremental cash
flows
2
What Is Corporate Finance?
Corporate Finance addresses the
following three questions:
1. What long-term investments should the
firm choose?
2. How should the firm raise funds for the
selected investments?
3. How should short-term assets be managed
and financed?
Common feature
Invest cash today in exchange for expected, but
generally risky, cash flows in the future. Time
0 1 2 3 4 5 ….
Cost CF
Payoff CF1 CF2 CF3 CF4 CF5
The key of FM or CF is about
what??
--- Adverse selection leads to only bad used cars will be available in
the market.
Equity market
Insurance market
Job market
Signaling in lemon market
市场价格已充分反应出所有过去历史的证券价格信息,包括股票的成交价、成交量、卖空金额,融资金融等,价值投资
价格已充分反应出所有已公开的有关公司营运前景的信息。这些信息有成交价、成交量、盈利资料、盈利预测值,公司管理
状况及其它公开披露的财务信息等, 内幕交易。
价格已充分地反应了所有关于公司营运的信息,这些信息包括已公开的或内部未公开的信息, 资产配置。
前提:参与市场的投资者有足够的理性,并且能够迅速对所有市场信息作出合理反应。
对冲基金(Hedge funds)基金经理人一直在市场上寻找任何的价格错
配(mispricing)并且根据错配进行long/short操作迫使价格回归正确
。
•Warren Buffet (Long-term investors of Coca Cola), 但斌
Fixed Assets
1 Tangible
Shareholders’
2 Intangible Equity
The Capital Budgeting Decision
Current
Liabilities
Current Assets
Long-Term
Debt
Fixed Assets
Q1. What long-
1 Tangible term Shareholders’
investments
2 Intangible Equity
should the firm
choose?
The Capital Structure Decision
Current
Liabilities
Current Assets
Long-Term
Q2. How should Debt
the firm raise
funds for the
Fixed Assets
selected
1 Tangible investments?
Shareholders’
2 Intangible Equity
Short-Term Asset Management
Current
Liabilities
Current Assets
Net
Working Long-Term
Capital Debt
21
The Financial Manager
22
The Importance of Cash Flow
Firm invests Firm issues securities (A) Financial
in assets markets
(B)
Invests
Retained
in assets cash flows (F)
(B)
Short-term debt
Current assets Cash flow Dividends and Long-term debt
Fixed assets from firm (C) debt payments (E)
Equity shares
Taxes (D)
24
The Net Present Value (NPV) Rule
Net Present Value (NPV) =
Total PV of future CF’s + Initial Investment
Estimating NPV:
1. Estimate future cash flows: how much? and
when?
2. Estimate discount rate
3. Estimate initial costs
Minimum Acceptance Criteria: Accept if
NPV > 0
Ranking Criteria: Choose the highest NPV
25
Why Use Net Present Value?
26
The Payback Period Method
27
The Payback Period Method
Disadvantages:
Ignores the time value of money
Ignores cash flows after the payback
period
Biased against long-term projects
Requires an arbitrary acceptance criteria
A project accepted based on the payback
criteria may not have a positive NPV
Advantages:
Easy to compute and understand
Biased toward liquidity
28
The Discounted Payback Period
30
IRR: Example
0 1 2 3
-$200
The internal rate of return for this project is 19.44%
31
Calculating IRR with Spreadsheets
32
Mutually Exclusive vs. Independent
Mutually Exclusive Projects: only ONE of
several potential projects can be chosen,
e.g., acquiring an accounting system.
RANK all alternatives, and select the best one.
33
Problems with IRR
Problems for both mutually exclusive
projects and independent projects
Multiple IRRs
Problems for mutually exclusive projects
The Scale Problem
34
Multiple IRRs
There are two IRRs for this project:
$200 $800
0 1 2 3
-$200 - $800
IRR = 0% or 100%
Which one should we use?
35
Internal Rate of Return (IRR)
Disadvantages:
There may be multiple IRRs
Problems with mutually exclusive
investments
Advantages:
Easy to understand and communicate
36
NPV versus IRR
37
The Profitability Index (PI)
Ranking Criteria:
Select alternative with highest PI
38
The Profitability Index
Disadvantages:
Problems with mutually exclusive
investments
Advantages:
Easy to understand and communicate
Correct decision when evaluating
independent projects
May be useful when available
investment funds are limited
39
The Practice of Capital Budgeting
40
Incremental Cash Flows
41
Cash Flows—Not Accounting Income
42
Incremental Cash Flows
Only cash flows that are incremental to
the project should be used.
We are interested in the difference between
the cash flows of the firm with the project and
the cash flows of the firm without the project.
Sunk costs are not relevant
Just because “we have come this far” does not
mean that we should continue to throw good
money after bad.
43
Incremental Cash Flows
44
Incremental Cash Flows
48
Investments of Unequal Lives
There are times when application of
the NPV rule can lead to the wrong
decision. Consider a factory that
must have an air cleaner that is
mandated by law. There are two
choices:
The “Cadillac cleaner” costs $4,000
today, has annual operating costs of
$100, and lasts 10 years.
The “Cheapskate cleaner” costs $1,000
today, has annual operating costs of
$500, and lasts 5 years.
49
Investments of Unequal Lives
50
Investments of Unequal Lives
51
Equivalent Annual Cost (EAC)
The EAC is the value of the level payment
annuity that has the same PV as our
original set of cash flows.
52
Equivalent Annual Cost (EAC)
EAC for the Cadillac and Cheapskate
should be:
–4,614.46 = PVIFA(10%,10) EAC(Cadillac)
–2,895.39 = PVIFA(10%,5) EAC(Cheapskate)
53
FIN3004 Corporate Finance
Lecture 2
Cost of Capital
54
Learning Outcome
Know how to determine a firm’s
cost of equity capital
Understand the impact of beta in
determining the firm’s cost of
equity capital
Know how to determine the firm’s
overall cost of capital
Understand the impact of flotation
costs on capital budgeting
55
Where Do We Stand?
56
The Cost of Equity Capital
Shareholder
Firm with invests in
excess cash Pay cash dividend financial
asset
A firm with excess cash can either pay a
dividend or make a capital investment
Shareholder’s
Invest in project Terminal
Value
Because stockholders can reinvest the dividend in risky financial assets,
the required return on a capital-budgeting project should be at least as
great as the expected return on a financial asset of comparable risk. 57
The Cost of Equity Capital
From the firm’s perspective, the
expected return is the Cost of Equity
Capital:
R i RF βi ( R M RF )
• To estimate a firm’s cost of equity capital, we need
to know three things:
1. The risk-free rate, RF
2. The market risk premium, R M RF
58
Example
Suppose Quantram has a beta of 1.3,
and the firm is 100% equity financed.
Assume a risk-free rate of 5% and a
market risk premium of 8.4%.
What is the appropriate discount rate for
an expansion of this firm?
R RF βi ( R M RF )
R 5% 1.3 8.4%,
R 15.92%
59
Example
Suppose the stock of Stansfield
Enterprises, a publisher of PowerPoint
presentations, has a beta of 2.5. The
firm is 100% equity financed.
Assume a risk-free rate of 5% and a
market risk premium of 10%.
What is the appropriate discount rate for
an expansion of this firm?
R RF βi ( R M RF )
R 5% 2.5 10%
R 30% 60
Example
Suppose Stansfield Enterprises is evaluating
the following independent projects. Each costs
$100 and lasts one year.
Project Project Project’s IRR NPV at
Estimated Cash 30%
Flows Next
Year
A 2.5 $150 50% $15.38
61
Using the SML
Return
Good SML
A
project
30% B
Reject!
C Bad project
5%
Firm’s risk (beta)
2.5
An all-equity firm should accept projects whose IRRs
exceed the cost of equity capital and reject projects
whose IRRs fall short of the cost of equity capital. 62
The Risk-free Rate
Treasury securities are close proxies for
the risk-free rate.
63
The Market Risk Premium
64
Beta
66
Stability of Beta
Most analysts argue that betas are
generally stable for firms remaining
in the same industry.
That is not to say that a firm’s beta
cannot change.
Changes in product line
Changes in technology
Deregulation
Changes in financial leverage
67
Using an Industry Beta
It is frequently argued that one can better
estimate a firm’s beta by involving the
whole industry.
If you believe that the operations of the
firm are similar to the operations of the
rest of the industry, you should use the
industry beta.
68
Using an Industry Beta
If you believe that the operations of the
firm are fundamentally different from the
operations of the rest of the industry, you
should use the firm’s beta.
Do not forget about adjustments for
financial leverage.
69
Example
Microsoft 0.86
Apple 2.43
ADP 0.76
EDS 1.13
Oracle 1.54
Computer Sciences 1.19
CA 2.03
Fiserv 1.24
Accenture 1.18
Symantec 0.64
Paychex 0.96
Average Beta (i.e. Industry Beta) 1.27
70
Example
Given Rf = 1.2%, Rm – Rf = 7%
Cost of capital of Symantec =
1.2% + 0.64 * 7% = 5.68%
Or, Symantec wants to use
industry beta, so
Cost of capital will be
1.2 % + 1.27 * 7% = 10.09%
71
Determinants of Beta
Business Risk
Cyclicality of Revenues
Operating Leverage
Financial Risk
Financial Leverage
72
Cyclicality of Revenues
Highly cyclical stocks have higher betas.
Empirical evidence suggests that retailers and
automotive firms fluctuate with the business cycle.
Transportation firms and utilities are less dependent
on the business cycle.
Note that cyclicality is not the same as
variability—stocks with high standard
deviations need not have high betas.
Movie studios have revenues that are variable,
depending upon whether they produce “hits” or
“flops,” but their revenues may not be especially
dependent upon the business cycle.
73
Operating Leverage
74
Financial Leverage and Beta
Operating leverage refers to the sensitivity to
the firm’s fixed costs of production.
Financial leverage is the sensitivity to a
firm’s fixed costs of financing.
The relationship between the betas of the
firm’s debt, equity, and assets is given by:
75
Financial Leverage and Beta
The beta of debt is low in practice, so
sometimes it is convenient to assume
beta of debt = 0 and a simplified version
of the above formula will be:
S
Asset Equity
BS
B
and , Equity Asset (1 )
S
• Financial leverage always increases the equity beta
76
Example
Consider Grand Sport, Inc., which is
currently all-equity financed and has a
beta of 0.90.
The firm has decided to lever up to a
capital structure of 1 part debt to 1 part
equity.
Assuming that its asset beta remains 0.90.
77
Example
Assuming a zero beta for its debt, its
equity beta would become twice as large:
1
Asset = 0.90 = × Equity
1+1
78
Example
79
Example
B
Equity Asset (1 ),
S
1
Equity 0.8 1 , Equity 1.2
2
If 1 part of debt to 1 part of equity, equity
beta will be:
1
Equity 0.8 1 1.6
1
Financial leverage always increases the equity beta! 80
Cost of Debt
81
Example
82
Cost of Preferred Stock
Preferredstock is a perpetuity,
so its price is equal to the
coupon paid divided by the
current required return.
Rearranging, the cost of
preferred stock is:
RP = C / PV
83
The Weighted Average Cost of Capital
84
The Weighted Average Cost of Capital
(without Preferred Stocks)
Equity Debt
RWACC = × REquity + × RDebt ×(1 – TC)
Equity + Debt Equity + Debt
S B
RWACC = × RS + × RB ×(1 – TC)
S+B S+B
• Because interest expense is tax-deductible, we
multiply the last term by (1 – TC).
85
Steps to Compute WACC
First, we estimate the cost of equity
and the cost of debt.
We estimate an equity beta to
estimate the cost of equity.
We can often estimate the cost of
debt by observing the YTM of the
firm’s debt.
Second, we determine the WACC by
weighting these two costs
appropriately.
86
Example: International Paper
The industry average beta is 0.82,
the risk free rate is 3%, and the
market risk premium is 8.4%. Thus,
the cost of equity capital is:
RS = RF + i × ( RM – RF)
= 3% + 0.82×8.4%
= 9.89%
87
Example: International Paper
The yield on the company’s debt is
8%, and the firm has a 37%
marginal tax rate.
Thus, the cost of debt is:
R B (1 TC )
8% (1 0.37)
The company has no preferred stock.
88
Example: International Paper
S B
RWACC = × RS + × RB ×(1 – TC)
S+B S+B
= 0.68 × 9.89% + 0.32 × 8% × (1 – 0.37)
= 8.34%
89
Example: International Paper
90
Capital Budgeting & Project Risk
A firm that uses one discount rate
(e.g. WACC) for all projects may over
time increase the risk of the firm
while decreasing its value.
Why?
The risk associated with different
projects may be different!
We should always evaluate projects
based on discount rates that
correspond to the project risk level.
91
Capital Budgeting & Project Risk
Return The SML can tell us why:
SML
Incorrectly accepted
negative NPV projects
Discount/ RF β FIRM ( R M RF )
Hurdle
rate Incorrectly rejected
rf positive NPV projects
Firm’s risk (beta)
FIRM
92
Capital Budgeting & Project Risk
To estimate the cost of capital for a
division, a “pure play” approach
could be used, although finding
exactly similar firms may be difficult,
particularly considering underlying
financial and operational structure.
93
Capital Budgeting & Project Risk
The risk-free rate is 4% and the market risk premium is 10%.
Suppose the Conglomerate Company has a beta of 1.3. This is a
breakdown of the company’s investment projects:
1/3 Automotive Retailer = 2.0
1/3 Computer Hard Drive Manufacturer = 1.3
1/3 Electric Utility = 0.6
96
Appendix
97
Estimation of Beta
Cov( Ri , RM )
β
Var ( RM )
• Problems
1. Betas may vary over time.
2. The sample size may be inadequate.
3. Betas are influenced by changing financial leverage and business risk.
• Solutions
– Problems 1 and 2 can be moderated by more sophisticated statistical
techniques.
– Problem 3 can be lessened by adjusting for changes in business and
financial risk.
– Look at average beta estimates of comparable firms in the industry. 98
Beta, Covariance and Correlation
( Ri )
Cov( Ri , RM )
i
( RM )
2
( RM )
99
Operating Leverage
100
Dividend Discount Model
R D 1
g
P
The DDM is an alternative to the CAPM for
calculating a firm’s cost of equity.
The DDM and CAPM are internally consistent,
but academics generally favor the CAPM and
companies seem to use the CAPM more
consistently.
This may be due to the measurement error associated
with estimating company growth.
101
Flotation Costs
102
Flotation Costs
103
Example
If Spatt is an all equity firm and
wants to raise $100M through
equity. If flotation cost of equity is
10%, how much equity should Spatt
sell?
104
Example
Now if Spatt is financed by 60%
equity and 40% debt, and fS =10%
as before, and fB = 0.05
Lecture 3
Dividend Policy
106
Learning Outcomes
■ Understand dividend types and
how they are paid
■ Understand the issues
surrounding dividend policy
decisions
■ Understand why share
repurchases are an alternative to
dividends
■ Understand the difference
between cash and stock
dividends 107
Source: The Standard, 4 Aug, 2016 108
Think about it (for slide-3)
■ Why does HK Bank “waste” the cash to buy
back shares given the business prospects
and performance has worsened?
■ Why share price jumped when HK Bank
announced the stock buyback?
■ If HK Bank has excess cash, why not paying
out more dividend instead of stock buyback?
109
Different Types of Payouts
$P
$P - div
The price drops Ex-
by the amount of dividend
the cash Date
dividend.
Standard Method of Cash Dividend Payment 117
Price Behavior
⚪Taxes complicate things a bit.
Empirically, the price drop is less
than the dividend and occurs within
the first few minutes of the ex-date.
-t … -2 -1 0 +1 +2
…
$P
$P – div(1-Tp)
Ex-
dividend
Date
136
Example 19.1 (Continued)
137
Real-World Factors Favoring High Dividends
⚪ Agency Costs
● High dividends reduce free cash flow.
144
Back to our case…
Source: The Standard, 4 Aug, 2016
Think about it
⚪Why does HK Bank “waste” the cash
to buy back shares given the
business performance has
worsened?
⚪Why share price jumped when HK
Bank announced the stock buyback?
⚪If HK Bank has excess cash, why
not paying out more dividend
instead of stock buyback?
MC exercise
Concept check (CFA practice exercise)
⚪ A company has 35 million shares outstanding with
a current market price of $49.75 per share. The
company has maintained a $1.00 per share
quarterly dividend for several years, but for the
next quarter, management is considering whether
to implement a $35 million share repurchase in
place of the regular quarterly dividend. Assuming
the tax treatments and information effects of
either alternative are the same, the net impact of
the share repurchase, compared to the payment
of a cash dividend, is to:
A. decrease shareholder wealth.
B. have no effect on shareholder wealth.
C. increase shareholder wealth.
Concept check (CFA practice exercise)
⚪A financial advisor makes the following
statements about dividends: (1) With
respect to dividends, an investor should
be indifferent between purchasing a stock
before or after the payment date because
on the payment date the value of the
shares will fall by approximately the
amount of the dividend; (2) The holder-
of-record date occurs two business days
before the ex-dividend date. Are the
advisor’s statements accurate?
A. Both of these statements are accurate.
B. Neither of these statements is accurate.
C. Only one of these statements is accurate.
Concept check
153
Learning Outcomes
154
Source:http://citeseerx.ist.psu.edu/vie
wdoc/download?doi=10.1.1.576.14&re
p=rep1&type=pdf
Think about it
If companies borrow more or less, will the decision affect the
NPV of the expansion, change the value of the firm and its
share price?
What are the tradeoff of using more debt?
155
Capital Structure and the Goal of
Financial Management
156
Stockholder Interests
157
Maximizing Firm Value versus
Maximizing Stockholder Interests
158
Leverage and Return to Shareholders:
An Example (Table 16.1)
Current Proposed
Assets $8,000 $8,000
Debt 0 $4,000
Equity (market and book) $8,000 $4,000
Interest rate 10% 10%
Market value / share $20 $20*
Shares outstanding 400 200
159
Leverage and Return to Shareholders :
An Example: No Debt (Table 16.2)
160
Leverage and Return to Shareholders :
An Example: Debt = $4,000 (Table 16.3)
161
Assumptions of the M&M Model
Homogeneous Expectations
Perpetual Cash Flows
Perfect Capital Markets:
Perfect competition
Equal access to all relevant information
No transaction costs
Firms and investors can borrow/lend at
the same rate
No taxes
162
Modigliani and Miller Proposition I
163
MM Proposition I
164
Modigliani and Miller Proposition I
165
Homemade Leverage (Table 16.4 of
Textbook)
170
MM Proposition II (No Taxes)
Proposition II
Leverage increases the risk and return to
stockholders
rs = R0 + (B / SL) (R0 - RB)
RB is the interest rate (cost of debt)
Rs is the return on (levered) equity (cost of
equity)
R0 is the return on unlevered capital (cost of
capital)
B is the value of debt
SL is the value of levered equity
171
MM Proposition II (No Taxes)
The derivation is straightforward:
B S
RW ACC RB RS Then set RW ACC R0
BS BS
B S BS
RB RS R0 multiply both sides by
BS BS S
BS B BS S BS
RB RS R0
S BS S BS S
B BS
RB RS R0
S S
B B B
RB RS R0 R0 RS R0 ( R0 RB )
S S S
172
MM Proposition II (No Taxes)
Cost of capital: R (%)
B
RS R0 ( R0 RB )
SL
B S
R0 RW ACC RB RS
BS BS
RB RB
Debt-to-equity Ratio B
S
173
An Example (Table 16.5)
174
An Example (Table 16.5)
Hence, the cost of unlevered equity is
$1,200 / $8,000 = 15%
Similar, the cost of levered equity is
$800/$4,000 = 20%
B
Or, using the formula, RS R0 ( R0 RB )
s L
175
Summary of MM without taxes
Results
Proposition I: VL = Vu (Value of levered firm
equals value of unlevered firm)
B
Proposition II: Rs = R0 +S (R 0 – R B )
L
Intuition
Proposition I: through homemade leverage
individuals can either duplicate or undo the
effects of corporate leverage
Proposition II: the cost of equity rises with
leverage because the risk to equity rises with
leverage
176
The Basic Insight: MM Without Taxes
All-equity firm Levered firm
S S
B
S G S G
• The levered firm pays less in taxes than does the all-equity
firm.
• Thus, the sum of the debt plus the equity of the levered firm
is greater than the equity of the unlevered firm.
• This is how cutting the pie differently can make the pie
“larger.” --the government takes a smaller slice of the pie! 178
Taxes and Cash Flow (Example 16.3)
B = 4M, RB = 0.1, tc = 0.35
Plan I Plan II
Interest = RB x B
181
MM Proposition I (With Taxes)
VL VU TC B 182
MM Propositions I & II (With Taxes)
EBIT (1 tc ) tc RB B
VL ,
Ro RB
EBIT (1 tc )
Let VU ,
Ro
As VL = VU + tc B, so leverage
increases firm value, under a world
of taxes
183
Example 16.4 (Divided Airlines)
186
The Effect of Financial Leverage
Cost of capital: R B
(%) RS R0 ( R0 RB )
SL
B
RS R0 (1 TC ) ( R0 RB )
SL
B SL
RW ACC RB RS
R0 BSL B SL
B SL
RW ACC RB (1 TC ) RS
BSL B SL
RB
Debt-to-equity
ratio (B/S) 187
WACC and Corporate Taxes
SL B
VL =s L+B, and RWACC RS RB (1 tc )
VL VL
For Divided Airline:
Divided Airlines
Balance Sheet (All-Equity Firm)
Physical Assets Equity $500
$153.85/0.2 * (1-0.35) (100 shares)
= $500
189
Divided Airlines Example
Divided Airlines
Balance Sheet (upon Announcement of Debt Issue)
Physical Assets $500 Equity $570
Present value of tax (100 shares)
shield: tc B = 35% x
$200 = $70
190
Divided Airlines Example
Divided Airlines
Balance Sheet (after Exchange has taken place)
Physical Assets $500 Equity $370
Present value of tax (100 – 35.09 = 64.91
shield $70 shares)
Debt 200
Total Assets $570 Debt + Equity $570
191
Revision Topics and Checkpoints
In a world of no taxes, the value of the firm is
unaffected by capital structure.
This is M&M Proposition I:
VL = V U
Proposition I holds because shareholders can
achieve any pattern of payouts they desire with
homemade leverage.
In a world of no taxes, M&M Proposition II states
that leverage increases the risk and return to
stockholders.
B
RS R0 ( R0 RB )
SL
192
Revision Topics and Checkpoints
In a world of taxes, but no bankruptcy costs, the
value of the firm increases with leverage.
This is M&M Proposition I:
VL = VU + TC B
Proposition I holds because shareholders can
achieve any pattern of payouts they desire with
homemade leverage.
In a world of taxes, M&M Proposition II states
that leverage increases the risk and return to
stockholders.
B
RS R0 (1 TC ) ( R0 RB )
SL
193
Back to our case…
Source:http://citeseerx.ist.psu.edu/vie
wdoc/download?doi=10.1.1.576.14&re
p=rep1&type=pdf
Think about it
If companies borrow more or less, will the decision affect the
NPV of the expansion, change the value of the firm and its
share price?
What are the tradeoff of using more debt?
195
Leverage & Capital
Structure: Limits to the
Use of Debt
196
Learning Outcomes
Define the costs associated with
bankruptcy
Define financial distress and understand
what happens to a firm in distress
Apply the Z-Score Model for predicting
bankruptcy
Understand the theories that address the
level of debt a firm carries
Tradeoff
Signaling
Agency Cost
Pecking Order
Think about it
Due to lack of capital, ATV failed to pay debts, license fee, wages and was
penalized by the Communication Authority. Finally, provision liquidator was
appointed by court.
What are the costs induced if a company fall into financial trouble?
Why the ATV’s investors did not inject funds to rescue the TV station? 198
What Is Financial Distress?
Cash flow
shortfall
Contractual
obligations
Insolvency time
10%
Source: Karen H. Wruck, “Financial Distress: Reorganization and Organizational Efficiency,” Journal of Financial Economics
27 (1990), Figure 2. See also Stuart C. Gilson; Kose John, and Larry N.P. Lang, “Troubled Debt Restructurings: An Empirical
Liquidation
Study of Private Reorganization in Firms in Defaults,” Journal of Financial Economics 27 (1990); and Lawrence A. Weiss, Chapter 7
“Bankruptcy Resolution: Direct Costs and Violation of Priority Claims,” Journal of Financial Economics 27 (1990).
Direct Costs
Legal and administrative costs of
Liquidation or Reorganization
Indirect Costs
Impaired ability to conduct
business (e.g., lost sales)
Agency Costs
Selfish Strategy 1: Incentive to
take large risks
Selfish Strategy 2: Incentive
toward underinvestment
Selfish Strategy 3: Milking the
property
Consider a government-sponsored
project that guarantees $350 in one
period.
Cost of investment is $300 (the firm
only has $200 now), so the
stockholders will have to supply an
additional $100 to finance the
project.
$350
NPV $300 $18.18
1.10
Liquidating dividends
Suppose our firm paid out a $200
dividend to the shareholders. This
leaves the firm insolvent, with nothing
for the bondholders, but plenty for the
former shareholders.
Such tactics often violate bond
indentures.
Increase perquisites to
shareholders and/or management
222
Table 30.2: Financial Statement Ratios One
Year before Bankruptcy: Manufacturing Firms
223
The Z-Score Model: Public, Manufacturers
Altman’s Z-Score = 3.3*(EBIT/Total Assets)
+ 1.2*(NWC/Total Assets) +
1.0*(Sales/Total Assets) + .6*(MV Equity /
BV Debt) + 1.4* (Accumulated RE / Total
Assets)
Z-Score < 1.81 indicates high probability
of bankruptcy
Z-Score between 1.81 and 2.99 is a grey
area
Z-Score > 2.99 indicates a low probability
of bankruptcy
224
The Z-Score Model: Private, Non-
Manufacturers
Altman’s Z-Score = 6.56*(NWC/Total
Assets) + 3.26*(Accumulated RE / Total
Assets) + 1.05*(BV Equity / Total
Liabilities) + 6.72*(EBIT/Total Assets)
Z-Score < 1.23 indicates high probability of
bankruptcy
Z-Score between 1.23 and 2.90 is a grey
area
Z-Score > 2.90 indicates a low probability of
bankruptcy
WARNING: this formula is CORRECT, but
in the textbook there is incorrect formula!!
225
Tax Effects and Financial Distress
VT = S + B + G + L
S
B
L G
0 Debt (B)
B*
Optimal amount of debt
Ro
RWACC
0 Debt (B)
B*
Optimal amount of debt
Signaling 231
Signaling
Signaling 232
2. Agency Cost of Equity
247
Source:https://news.m
ingpao.com/pns/dailyn
ews/web_tc/article/20
160307/s00017/14572
87540064
Think about it
Due to lack of capital, ATV failed to pay debts, license fee, wages and was
penalized by the Communication Authority. Finally, provision liquidator was
appointed by court.
What are the costs induced if a company fall into financial trouble?
Why the ATV’s investors did not inject funds to rescue the TV station? 248
One more case
249
Source: https://kotaku.com/toysrus-files-
for-chapter-11-bankruptcy-but-its-not-de-
1818546132
Think about it
Why did ToysRus file
for bankruptcy?
Is liquidation the
one and only one
outcome after filing
for bankruptcy?
What are the other
possible outcomes?
250