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FIN3004 Corporate Finance

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?

Foundation: Valuation (cash flow, discount,


balance sheet, etc)
3
Valuation is the key
Applications
 Real assets (capital structure and budgeting)
 Bonds (debt financing)
 Stocks (equity financing, M&A, …)

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??

 Maximize firm value/stock


price/asset/return/operating
performance/cash flow/market
share
"Success is usually judged by value:
Shareholders are made better off by any
decision which increases the value of their
stake in the firm... The secret of success in
financial management is to increase value.”
Stakeholder view of firm and
problem
Separation of Ownership and
Control/Management

 Agency conflict arises due to Separation of


ownership and control
 Berle and Means (1932): shareholder’s dispersion
 managerial control and decision making (Jensen and
Mechling(1976)’s Agency Problem) 
 Abuse of power/maximize private benefit

 Principle conflict between controlling shareholders


(appointing managers) and small shareholders
 State owned enterprises (国有企业)
 Family firms (俏江南)
 Founders (雷氏照明)
Example of Conflict

 Dual Class Shares (Google,


Facebook, JD, Alibaba)
 Class A, one vote/share; Class B, 10
votes/share
李嘉诚家族企业
Agency Theory

 Developed by Jensen & Meckling


1976
 Agency relationship: a contract
under which one or more persons to
perform some service on their
behalf which involves delegating
some decision making authority to
the agent
Agency model on manager
behavior
Lemon problem
 In automobile markets:
 In the model, there are two kind of cars: old one with good and
bad quality.
 Individuals buy a used car in the market: they know with
probability q it is a good car, and 1-q a bad car.
 Presence of information asymmetry: sellers of used cars will
know better about the quality of his cars than buyers.

--- Adverse selection leads to only bad used cars will be available in
the market.

How about other markets?


 Insurance?
 Credit markets?
Lemon market examples

 Equity market

 Insurance market

 P2P lending market

 Job market
Signaling in lemon market

 Type G (worthy 100) and Type B (worthy


60) firms want to raise fund at cost 20.
Outsiders do not know their true value.

 Type G and Type B can invest a project that


cost them c to verify their value. If c is above
40 and below 80, Type G can take the project
and signal it has a high value.
Market Efficiency theory

Fama (1970): Stock market are efficient in reflecting information about

individual shock and stock market shock as a whole.


1. 弱式有效市场假说(Weak Form Efficiency)

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

2. 半强式有效市场假说(Semi-strong Form Efficiency)

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。

3. 强式有效市场假说(Strong Form Efficiency)

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

•George Soros (Attack British Pound, Asian Financial Crisis by attacking


stock market and currency market)

•Muddy Waters (famous short seller)

•LTCM: When Genius Failed

•Flash Boys, Big Shorts

Watch Movie: “Big Short” and think: 套利的成本与机会


Balance Sheet Model of the Firm
Total Value of Assets: Total Firm Value to Investors:
Current
Liabilities
Current Assets
Long-Term
Debt

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

Q3. How should


Fixed Assets
short-term assets
1 Tangible be managed and
financed? Shareholders’
2 Intangible Equity
The Goal of Financial Management

 What is the correct goal?


 Maximize profit?
 Minimize costs?
 Maximize market share?
 Maximize shareholder wealth?
 Maximize the market value of the
existing owner’s equity?

21
The Financial Manager

The Financial Manager’s primary goal


is to increase the value of the firm by:
1. Selecting value creating projects
2. Making smart financing decisions

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)

Ultimately, the firm The cash flows from


must be a cash the firm must exceed
Government
generating activity. the cash flows from
the financial markets.
23
Net Present Value & Other
Investment Criteria

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?

 Accepting positive NPV projects


benefits shareholders.
 NPV uses cash flows
 NPV uses all the cash flows of the
project
 NPV discounts the cash flows properly

26
The Payback Period Method

 How long does it take the project to


“pay back” its initial investment?
 Payback Period = number of years
to recover initial costs
 Minimum Acceptance Criteria:
 Set by management
 Ranking Criteria:
 Set by management

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

 How long does it take the project to


“pay back” its initial investment,
taking the time value of money into
account?
 Decision rule: Accept the project if
it pays back on a discounted basis
within the specified time.
 By the time you have discounted
the cash flows, you might as well
calculate the NPV.
29
The Internal Rate of Return
 IRR: the discount rate that sets NPV to
zero
 Minimum Acceptance Criteria:
 Accept if the IRR exceeds the required
return
 Ranking Criteria:
 Select alternative with the highest IRR
 Reinvestment assumption:
 All future cash flows are assumed to be
reinvested at the IRR

30
IRR: Example

Consider the following project:


$50 $100 $150

0 1 2 3
-$200
The internal rate of return for this project is 19.44%

31
Calculating IRR with Spreadsheets

 You start with the same cash flows


as you did for the NPV.
 You use the IRR function:
 You first enter your range of cash flows,
beginning with the initial cash flow.
 The default format is a whole percent –
you will normally want to increase the
decimal places to at least two.

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.

 Independent Projects: accepting or


rejecting one project does not affect the
decision of the other projects.
 Must exceed a MINIMUM acceptance criteria

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

 NPV and IRR will generally give the


same decision.
 Exceptions:
 Non-conventional cash flows – cash
flow signs change more than once
 Multiple IRRs
 Mutually exclusive projects
 Initial investments are substantially
different

37
The Profitability Index (PI)

 Minimum Acceptance Criteria:


 Accept if PI > 1

 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

 The most frequently used technique


for large corporations is either IRR
or NPV.
 Varies by industry:
 Some firms use payback, others use
accounting rate of return.

40
Incremental Cash Flows

41
Cash Flows—Not Accounting Income

 Consider depreciation expense.


 You never write a check made out
to “depreciation.”
 Much of the work in evaluating
a project lies in taking
accounting numbers and
generating cash flows.

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

 Opportunity costs do matter. Just


because a project has a positive
NPV, that does not mean that it
should also have automatic
acceptance. Specifically, if another
project with a higher NPV would
have to be passed up, then we
should not proceed.

44
Incremental Cash Flows

 Side effects matter.


 Erosion is a “bad” thing. If our new
product causes existing customers
to demand less of our current
products, we need to recognize
that.
 If, however, synergies result that
create increased demand of
existing products, we also need to
recognize that.
45
Incremental Cash Flows

 Cash flows matter—not accounting


earnings.
 Incremental cash flows matter.
 Sunk costs do not matter.
 Opportunity costs matter.
 Side effects like cannibalism and
erosion matter.
 Taxes matter.
 Inflation matters.
46
Estimating Cash Flows

 Cash Flow from Operations


 Recall that:
OCF = EBIT – Taxes + Depreciation
 Net Capital Spending
 Do not forget salvage value (after tax,
of course).
 Changes in Net Working Capital
 Recall that when the project winds
down, we enjoy a return of net working
capital.
47
Appendix

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

 Assuming a 10% discount rate,


which one should we choose?

 NPV of “Cadillac cleaner” and


“Cheapskate cleaner” are –4,614.46
and –2,895.39 respectively.

50
Investments of Unequal Lives

 This overlooks the fact that the


Cadillac cleaner lasts twice as
long.
 When we incorporate the
difference in lives, the Cadillac
cleaner is actually cheaper (i.e.,
has a higher NPV).

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)

 Thus, EAC(Cadillac) = -$750.98 and


EAC(Cheapstake) = -$763.80

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?

 Earlier discussions on capital


budgeting focused on the
appropriate size and timing of
cash flows.
 This lecture discusses the
appropriate discount rate when
cash flows are risky.

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

B 2.5 $130 30% $0

C 2.5 $110 10% -$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

 Method 1: Use historical data


 Method 2: Use the Dividend
Discount Model (DDM):
D1
R g
P0
 Market data and analyst forecasts
can be used to implement the DDM
approach on a market-wide basis

64
Beta

 Beta - Sensitivity of a stock’s


return to the return on the market
portfolio.
 Market Portfolio - Portfolio of all
assets in the economy. In practice,
a broad stock market index, such as
the S&P 500 or the Hang Seng
Index, is used to represent the
market.
65
Bloomberg

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

 The degree of operating leverage


measures how sensitive a firm (or
project) is to its fixed costs.
 Operating leverage increases as fixed
costs rise and variable costs fall.
 Operating leverage magnifies the
effect of cyclicality on beta.

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:

Asset = Debt × Debt + Equity × Equity


Debt + Equity Debt + Equity

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
BS
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

Equity = 2 × 0.90 = 1.80

78
Example

 Rapid is currently all equity and has


a beta of 0.8. The firm desires to
have 1 part of debt and 2 parts of
equity.
 Assuming that the asset beta
remains the same and debt beta of
0, we have:

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

 Interest rate required on new debt


issuance (i.e., yield to maturity on
outstanding debt)
 Adjust for the tax deductibility of
interest expense
 Cost of debt (after corporate tax) =
RB x (1 – tC)

81
Example

 Borrowing Rate (RB)= 10%


 Tax Rate (tC) = 40%
 After tax cost of debt = RB x (1 –
tC) = 10% x (1 – 0.4) = 6%

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

 The Weighted Average Cost of Capital is given


by:

• Because interest expense is tax-deductible, we


multiply the last term by (1 – TC).

84
The Weighted Average Cost of Capital
(without Preferred Stocks)

 The Weighted Average Cost of Capital is given


by:

Equity Debt
RWACC = × REquity + × RDebt ×(1 – TC)
Equity + Debt Equity + Debt

RWACC = WS × RS + WB× RB ×(1 – TC)

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

 The debt to value ratio is 32%


 Thus, the WACC is:

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

o 8.34% is International’s cost of capital. It


should be used to discount any project
where one believes that:

• the project’s risk is equal to the risk of the firm


as a whole and

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

oBased on the CAPM, the firm has a cost of capital of:


4% + 1.3 × 10% = 17%.

oWhen evaluating a new electrical generation investment,


which cost of capital should be used?
94
Capital Budgeting & Project Risk
SML

24% Investments in hard


Project IRR

drives or auto retailing


17%
should have higher
10% discount rates.

Project’s risk ()


0.6 1.3 2.0
R = 4% + 0.6×(14% – 4% ) = 10%
10% reflects the opportunity cost of capital on an investment
in electrical generation, given the unique risk of the project. 95
Revision Topics and Checkpoints
 How do we determine the cost of
equity capital?
 How can we estimate a firm or
project beta?
 How does leverage affect beta?
 How do we determine the weighted
average cost of capital?

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 )

 Beta is qualitatively similar to the covariance


since the denominator (market variance) is a
constant.
 Beta and correlation are related, but different. It
is possible that a stock could be highly correlated
to the market, but it could have a low beta if its
deviation were relatively small.

99
Operating Leverage

 The degree of operating leverage is


given by:

DOL =  EBIT Sales


×
EBIT  Sales

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

 Flotation costs represent the


expenses incurred upon the issue, or
float, of new bonds or stocks.
 These are incremental cash flows of
the project, which typically reduce
the NPV since they increase the initial
project cost (i.e., CF0).

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?

 $100 M = (1 – 0.1) X Amount


Raised, so Amount Raised = $100 M
/ 0.9 = $111.11 M

104
Example
 Now if Spatt is financed by 60%
equity and 40% debt, and fS =10%
as before, and fB = 0.05

 The weighted average flotation cost


will be:
 fA = (E/V)* fE + (D/V)* fD
 = 0.6 * 0.1 + 0.4*0.05
 = 0.08

 Amount raised will be $100 M / (1-


0.08) =$108.70 M
105
FIN 3004 Corporate Finance

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

⚪Many companies pay a regular cash


dividend.
● Public companies often pay
quarterly.
● Sometimes firms will pay an extra
cash dividend.
● The extreme case would be a
liquidating dividend.

Different Types of Payouts 110


Different Types of Payouts

⚪An alternative way to pay cash to


investors is through a share
repurchase or buyback.
● The firm uses cash to buy shares
of its own outstanding stock.
● These shares are generally held in
the corporate treasury.

Different Types of Payouts 111


Different Types of Payouts

⚪Some companies use stock


dividends or stock split.
● No cash leaves the firm.
● The firm increases the number of
shares outstanding.
⚪Other companies declare a dividend
in kind.
● Wrigley’s Gum sends a box of
chewing gum.

Different Types of Payouts 112


Procedure for Cash Dividend
04 Mar. 3 Apr. 4 Apr. 3 May

Record
Declaration Date Payment
Date =Ex-dividend Date Date
(in USA)
⚪Declaration Date: The Board of
Directors authorizes and declares the
dividend.
⚪After the board declares the
dividends, the firm is legally obligated
to make the payment.
Standard Method of Cash Dividend Payment 113
Procedure for Cash Dividend
04 Mar. 3 Apr. 4 Apr. 3 May

Record
Declaration Date Payment
Date =Ex-dividend Date Date
(in USA)
⚪Record Date: the firm will pay the
dividend to all shareholders of record
on a specific date, set by the board,
called the record date.

Standard Method of Cash Dividend Payment 114


Procedure for Cash Dividend
04 Mar. 3 Apr. 4 Apr. 3 May

Record
Declaration Date Payment
Date =Ex-dividend Date Date
(in USA)
o Ex-Dividend Date:
o Anyone who purchases the stock on or after the
ex-dividend date will not receive the dividend.
o A share of stock becomes ex dividend.
o USA: since May 2024, it takes one business
days for shares to be registered (“T+1”)
o With T+1 settlement, ex-dividend date will be
the same as record date.
Standard Method of Cash Dividend Payment 115
Procedure for Cash Dividend
04 Mar. 3 Apr. 4 Apr. 3 May

Record
Declaration Date Payment
Date =Ex-dividend Date Date
(in USA)
⚪Payment date: the firm mails dividend
checks to shareholders of record.

Standard Method of Cash Dividend Payment 116


Price Behavior
⚪ In a perfect world, the stock price
will fall by the amount of the
dividend on the ex-dividend date.
-t … -2 -1 0 +1 +2 …

$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

Standard Method of Cash Dividend Payment 118


The Irrelevance of Dividend Policy

⚪A compelling case can be made that


dividend policy is irrelevant.
⚪Since investors do not need
dividends to convert shares to cash;
they will not pay higher prices for
firms with higher dividends.

An Illustration of the Irrelevance of Dividend Policy 119


The Irrelevance of Dividend Policy

⚪In other words, dividend policy will


have no impact on the value of the
firm because investors can create
whatever income stream they prefer
by using homemade dividends.

An Illustration of the Irrelevance of Dividend Policy 120


Homemade Dividends

⚪Bianchi Inc. is a $42 stock about to


pay a $2 cash dividend.

⚪Bob Investor owns 80 shares and


prefers a $3 dividend.

An Illustration of the Irrelevance of Dividend Policy 121


Homemade Dividends

⚪Bob’s homemade dividend strategy:


● Sell 2 shares ex-dividend
homemade dividends $3 Dividend
Cash from dividend $160 $240
Cash from selling stock $80 $0
Total Cash $240 $240
Value of Stock Holdings $40 × 78 = $39 × 80 =
$3,120 $3,120

An Illustration of the Irrelevance of Dividend Policy


122
Dividend Policy Is Irrelevant
⚪ In the above example, Bob
Investor began with a total wealth
of $3,360:

⚪ After a $3 dividend, his total wealth


is still $3,360:

An Illustration of the Irrelevance of Dividend Policy 123


Dividend Policy Is Irrelevant

⚪After a $2 dividend and sale of 2


ex-dividend shares, his total wealth
is still $3,360:

An Illustration of the Irrelevance of Dividend Policy 124


Repurchase of Stock
⚪ Instead of declaring cash
dividends, firms can rid themselves
of excess cash through buying
shares of their own stock.

⚪ Recently, share repurchase has


become an important way of
distributing earnings to
shareholders.

Repurchase of Stock 125


Repurchase of Stock
⚪Similar to a cash dividend in that it
returns cash from the firm to the
stockholders
⚪This is another argument for
dividend policy irrelevance in the
absence of taxes or other
imperfections

Repurchase of Stock 126


Repurchase of Stock
Imagine an all-equity firm with 100,000 shares outstanding. Its
net income for the year is $49,000.
Let’s consider the wealth of an investor holding 100.

Market Value Balance Sheet


(before paying out excess cash)
Excess cash $300,000 Debt $0
Other assets $700,000 Equity $1,000,000
Total $1,000,000 Total $1,000,000
Stock price = $1,000,000/100,000 = $10
EPS = $49,000/100,000 = $0.49
PE ratio = $10/$0.49 = 20.4
Investor wealth = 100 × $10 = $1,000

Repurchase of Stock 127


Repurchase of Stock
Cash Dividends: The firm pays out $300,000/100,000 = $3 per
share as extra cash dividend.

Market Value Balance Sheet


(after cash dividends)
Excess cash $0 Debt $0
Other assets $700,000 Equity $700,000
Total $700,000 Total $700,000
Stock price = $700,000/100,000 = $7
EPS = $49,000/100,000 = $0.49
PE ratio = $7/$0.49 = 14.3
Investor wealth = 100 × $7 + 100 × $3 = $1,000

Repurchase of Stock 128


Repurchase of Stock
Repurchase: The company uses the money to repurchase
$300,000/$10 = 30,000 shares, there are 70,000 shares left
outstanding.
Market Value Balance Sheet
(after share repurchase)
Excess cash $0 Debt $0
Other assets $700,000 Equity $700,000
Total $700,000 Total $700,000
Stock price = $700,000/70,000 = $10
EPS = $49,000/70,000 = $0.70
PE ratio = $10/$0.70 = 14.3
Investor wealth = 100 × $10 = $1,000

Repurchase of Stock 129


Repurchase of Stock
⚪Stock repurchase allows investors
to decide if they want the current
cash flow and associated tax
consequences
⚪In US tax structure, repurchases
may be more desirable due to the
options provided stockholders
⚪It has been estimated that only
about one-third of all share
repurchases are ever completed
Repurchase of Stock 130
Repurchase of Stock

⚪Stock repurchases send a positive


signal that management believes
that the current price is low
⚪Tender offers send a more positive
signal than open market
repurchases because the company
is stating a specific price
⚪The stock price often increases
when repurchases are announced

Repurchase of Stock 131


Stock Dividends
⚪ Pay additional shares of stock instead of
cash
⚪ Increases the number of outstanding
shares
● If you own 100 shares and the
company declared a 10% stock
dividend, you would receive an
additional 10 shares
⚪ No effect on investor wealth, why?

⚪ There are more shares outstanding,


each is simply worth less.
Stock Dividend and Stock Splits 132
Stock Dividends
⚪ The Peterson Co. has 10,000 shares of stock
outstanding, each selling at $66. It announces
a 10% stock dividend. An investor has 100
shares. Does the value of the investor’s shares
change?
Before the 10% stock dividend:
⚪ # shares = 10,000
⚪ Total value of equity = 10,000 × $66 =
$660,000
⚪ Investor wealth = $66 x 100 shares = $6,600
After the 10% stock dividend:
⚪ # shares = 10,000 x 1.1 = 11,000
⚪ New share price = 660,000 / 11,000 = $60
⚪ Investor now has 100 x 1.1 = 110 shares
⚪ Investor wealth = $60 x 110 shares = $6,600

Stock Dividend and Stock Splits 133


Stock Dividends
⚪Stock splits – essentially the same
as a stock dividend except
expressed as a ratio
● For example, a 2 for 1 stock split is the
same as a 100% stock dividend
⚪Stock price is reduced when the
stock splits
⚪Common explanation for split is to
return price to a “more desirable
trading range”
Stock Dividend and Stock Splits 134
Example 19.1: Dividend or
Purchase Financial Assets?
⚪Regional Electric has $1000 cash.
⚪T-bill yield is 10%
⚪Tc = 0.34, Ts = 0.28, t = 5 years
⚪Max tax on dividend is 0.15
⚪Plan A: dividends are paid now
● shareholders receive =
$1000 x (1-0.15) = $850 after tax
● After Ts return of T-bill investing =
10% x(1-0.28)= 7.2%
● The $850 dividend will yield $850 x
1.0725 = $1,203.35
135
Example 19.1 (Continued)

⚪Plan B: The firm retains the cash


and invest in T-bill
● Its after tax return is 10% x (1-0.34) =
6.6%
● The firm will have $1000 x 1.0665 =
$1,376.53
● If these are all paid to shareholders,
their after tax return will be $1,376.53
x (1-0.15) = $1,170.05

136
Example 19.1 (Continued)

⚪Hence, it is better to pay now


⚪This example shows the dividend
decision depends on personal and
corporate tax rates.

137
Real-World Factors Favoring High Dividends

⚪ Desire for Current Income


⚪ Behavioral Finance
● It forces investors to be disciplined.
⚪ Tax Arbitrage
● Investors can create positions in high
dividend yield securities that avoid tax
liabilities.

Real World Factors Favoring High Dividends 138


Real-World Factors Favoring High Dividends

⚪ Agency Costs
● High dividends reduce free cash flow.

⚪ Information Content of Dividends


and Dividend Signaling

Real World Factors Favoring High Dividends 139


The Clientele Effect

⚪ Clienteles for various dividend payout policies


are likely to form in the following way:
Group Stock Type
High Tax Bracket Individuals Zero-to-Low payout
Low Tax Bracket Individuals Low-to-Medium payout
Tax-Free Institutions Medium payout
Corporations High payout

Once the clienteles have been satisfied, a corporation is


unlikely to create value by changing its dividend policy.

The Clientele Effect 140


What We Know and Do Not Know

⚪ Dividends are substantial


⚪ Corporations “smooth” dividends.
⚪ Fewer companies are paying
dividends.
⚪ Dividends provide information to
the market.

What We Know and Do Not Know about Dividend Policy 141


What We Know and Do Not Know

⚪ Firms should follow a sensible


policy:
● Do not forgo positive NPV projects just
to pay a dividend.
● Avoid issuing stock to pay dividends.
● Consider share repurchase when there
are few better uses for the cash.

What We Know and Do Not Know about Dividend Policy 142


Revision Topics and Checkpoints
⚪ What are the different types of dividends,
and how is a dividend paid?
⚪ What is the clientele effect, and how does it
affect dividend policy irrelevance?
⚪ What is the information content of dividend
changes?
⚪ What are stock dividends, and how do they
differ from cash dividends?
⚪ How are share repurchases an alternative
to dividends, and why might investors
prefer them?

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

⚪ From a tax-paying investor's point of view, a


stock repurchase:
A. is equivalent to a cash dividend.
B. is more desirable than a cash dividend.
C. has the same tax effects as a cash
dividend.
D. is more highly taxed than a cash dividend.
E. creates a tax liability even if the investor
does not sell any of the shares he owns.
Concept check
⚪ Robinson's has 15,000 shares of stock
outstanding with a par value of $1.00 per share
and a market price of $36 a share. The balance
sheet shows $15,000 in the common stock
account, $315,000 in the capital in excess of par
account, and $189,000 in the retained earnings
account. The firm just announced a 3-for-2 stock
split. What will the market price per share be
after the split?
A. $18
B. $24
C. $42
D. $48
E. $54
Leverage & Capital
Structure: Basic Concepts

153
Learning Outcomes

 Understand the effect of financial


leverage on shareholders’ earnings
 Understand homemade leverage
 Understand capital structure
theories with and without taxes
 Be able to compute the value of the
unlevered and levered firm

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

 The value of a firm is defined to be


the sum of the value of the firm’s
debt and the firm’s equity.
V=B+S
 The goal of the firm’s management is
to pick the debt-equity ratio (i.e.,
capital structure) that makes the firm
as valuable as possible

156
Stockholder Interests

There are two important questions:


1. Why should the stockholders care about
maximizing the value of the entire firm?
(Why should the shareholders not prefer
the strategy that maximizes their interest
only?)

2. What is the ratio of debt-to-equity that


maximizes the shareholder’s value?

157
Maximizing Firm Value versus
Maximizing Stockholder Interests

 Changes in capital structure benefit the


stockholders if and only if the value of the
firm increases.
 Then, managers should choose the capital
structure that they believe will have the
highest firm value because this capital
structure will be most beneficial to the
firm’s stockholders
But would changes in capital structure
increase the value of the firm?

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)

Recession Expected Expansion

Return on Asset (ROA) 5% 15% 25%

Earnings $400 $1,200 $2,000

Return on Equity (ROE) = 5% 15% 25%


Earnings / Equity

Earnings per share (EPS) $1.00 $3.00 $5.00

160
Leverage and Return to Shareholders :
An Example: Debt = $4,000 (Table 16.3)

Recession Expected Expansion

Return on Asset (ROA) 5% 15% 25%

Earnings before Interest


$400 $1,200 $2,000
and Taxes

Interest -400 -400 -400

Earnings after interest $0 $800 $1,600

Return on Equity (ROE) =


0% 20% 40%
Earnings / Equity

Earnings per share (EPS) $0.00 $4.00 $8.00

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

 A firm cannot change the total value


of its outstanding securities by
changing the proportions of its
capital structure.
 In other words, capital structure is
irrelevant to firm value

163
MM Proposition I

 Recall that, in Table 16.1 (Slide 7),


when we assume that the stock
price is unchanged (= $20) under
the proposed leverage, the value of
the levered firm is the same as the
value of the unlevered firm.
 So the key is to prove that the stock
price is irrelevant to capital structure.

164
Modigliani and Miller Proposition I

 Modigliani and Miller showed that, if


levered firms are priced too high,
rational investors will simply borrow
on personal level to buy shares in
unlevered firms.
 This substitution is called
homemade leverage.

165
Homemade Leverage (Table 16.4 of
Textbook)

Strategy A: Buy 100 shares of levered equity (debt-


equity ratio = 1)
Initial cost = 100 shares @ $20 / share = $2,000

Recession Expecte Expansion


d
EPS of levered equity $0 $4 $8

Earnings for 100 0 400 800


shares/Net earnings
ROE (Net Profits / 0% 20% 40%
$2000)
166
Homemade Leverage continued (Table
16.4 of Textbook)

Strategy B: Homemade Leverage (Borrow on personal account


according to the preferred leverage ratio. Then, buy shares of the
unlevered firm. Personal debt-equity ratio = 2,000/2000 = 1. $4,000 are
invested in 200 shares)
Initial cost = 200 shares @ $20 / share - $2,000 = $2,000

Recession Expected Expansion

EPS of unlevered equity $1 $3 $5


( see Table 16.2)
Earnings per 200 shares of $200 $600 $1,000
unlevered equity
Interest at 10% on $2,000 -200 -200 -200

Net earnings $0 $400 $800

ROE (Net Profits / $2000) 0% 20% 40%


167
Homemade Unleverage
Strategy A: Buy 100 shares of unlevered equity (debt-
equity ratio = 0)
Initial cost = 100 shares @ $20 / share = $2,000

Recession Expecte Expansion


d
EPS of unlevered $1 $3 $5
equity
Earnings for 100 $100 $300 $500
shares/Net earnings
ROE (Net Profits / 5% 15% 25%
$2000)
168
Homemade Unleverage continued
Strategy B: Homemade Unleverage (Divide the personal wealth
according to the debt-equity ratio of the levered firm. Then, buy
shares of levered firm and buy interest-earning securities.
Personal wealth =$2,000; debt-equity ratio for investment = 1:1.
So, invest $1,000 to buy 50 shares of levered equity and the
remaining $1,000 to buy interest-earning securities.)
Initial cost = 50 shares @ $20 / share + $1,000 = $2,000

Recession Expected Expansion

EPS of levered equity ( see $0 $4 $8


Table 16.2)
Earnings per 50 shares of 0 200 400
levered equity
Interest at 10% on $1,000 100 100 100

Net earnings $100 $300 $500

ROE (Net Profits / $2000) 5% 15% 25%


169
MM Proposition I (No Taxes)

 We can create a levered or


unlevered position by adjusting the
trading in our own account.
 This homemade leverage suggests
that capital structure is irrelevant
in determining the value of the firm:
VL = VU

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
BS BS
B S BS
 RB   RS  R0 multiply both sides by
BS BS S
BS B BS S BS
  RB    RS  R0
S BS S BS S
B BS
 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
BS BS

RB RB

Debt-to-equity Ratio B
S
173
An Example (Table 16.5)

 Using the same example in Slide 8


 From Slide 9, the expected earnings
after interest for unlevered firm is
$1,200
 From Slide 10, the expected
earnings after interest for an
levered firm is $800

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

 B = S = 4000, R0 = 15%, RB = 10%,


 RS = 0.15 + 4000/4000 (0.15 – 0.1) =
0.2

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

• The total value of a firm (the pie) is equal to the market


value of the total cash flows generated by its assets and is not
affected by its choice of capital structure.
•Different capital structures are just different ways to cut the
pie among investors.
• Cutting the pie differently cannot make the pie “larger.” 177
The Basic Insight: MM With Taxes

All-equity firm Levered firm

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

EBIT $1,000,000 $1,000,000

Interest (RB* B) 0 400,000

EBT 1,000,000 600,000

Taxes 350,000 210,000

EAT 650,000 390,000

Total Cash Flow to both 650,000 790,000


stockholders and bondholders
EBIT x (1-tc) +tc RBB
179
Present Value of Tax Shield

 Interest = RB x B

 Reduction in corporate taxes = tc x


RB x B

 If cash flows are perpetual and in the


same risk class as interest on debt,
PV of tax shield t: R B
C B
 tc B
RB
180
Value of Levered Firm

 Annual after tax cash flow of


unlevered firm is: EBIT x (1 – tc)

 Value of unlevered firm is:


EBIT  (1  tc )
Vu 
Ro

181
MM Proposition I (With Taxes)

The total cash flow to all stakeholde rs of the levered firm is


( EBIT  RB B )  (1  TC )  RB B
The present value of this stream of cash flows is VL
Clearly ( EBIT  RB B )  (1  TC )  RB B 
 EBIT  (1  TC )  RB B  (1  TC )  RB B
 EBIT  (1  TC )  RB B  RB BTC  RB B
The present value of the first term is VU
The present value of the second term is TCB

VL  VU  TC B 182
MM Propositions I & II (With Taxes)

 Proposition I (with Corporate Taxes)


 Firm value increases with leverage

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)

 EBIT = 153.85 (perpetuity), tc =


0.35, so EAT = 100
Plans to issue debts B = 200 to
conduct share repurchase;
RB = 0.1, R0 = 0.2
 VU = EBIT x (1- tc) / R0 = $153.85 x
(1-0.35)/0.2 = 500
 tc B = 0.35 * $200 = $70
 So VL = VU + tc B = $500 + $70 =
184
MM Propositions I & II (With Taxes)

 Proposition II (with Corporate Taxes)


B
RS = R0 + S ×(1-TC)×(R0 - RB)
L
• RB is the interest rate (cost of debt)
• RS is the return on equity (cost of equity)
• R0 is the return on unlevered equity (cost
of capital)
• B is the value of debt
• s L is the value of levered equity
 Some of the increase in equity risk and
return is offset by the interest tax shield
185
Continue with the Divided Airlines
Example

 Back to Example 16.4 on Slide 43:


 R0 = 0.2, tc = 0.35,
 B = 200, S 
( EBIT  R B )(1  t ) (153.85  0.1x 200)(1  0.35)
L  B c
 370
R 0.2351
S L = 570 – 200 = 370, R = 0.1 S

 Thus, Rs = 0.2 + (200/370) x (1-0.35) x


(0.2-0.1) = 0.2351

 Note that RS is higher than R0

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 BSL B  SL

B SL
RW ACC   RB  (1  TC )   RS
BSL 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:

( EBIT  RB B)(1  tC ) (153.85  0.1 200)(1  0.35)


SL    370
RS 0.2351
370 200
RWACC   0.2351   0.1 (1  0.35)  0.1754
570 570

EBIT  (1  tc ) 153.85  (1  0.35)


VL    570
RWACC 0.1754
188
Market Value Balance Sheet under
Corporate Taxes: Divided Airlines Example

 Use the Divided Airlines Example:

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

 Issue $200 debt

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

Total Assets $570

190
Divided Airlines Example

 Equity worth $570/100 = $5.7, reduction


of no. of shares = 200/5.7 = 35.09

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

 Know real world factors that affect the


197
197
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? 198
What Is Financial Distress?

 Financial distress is a situation where


a firm’s operating cash flows are not
sufficient to satisfy current
obligations, and the firm is forced to
take corrective action.
 Financial distress may lead a firm to
default on a contract, and it may
involve financial restructuring
between the firm, its creditors, and
its equity investors.
What is Financial Distress? 199
Insolvency
 Flow-base insolvency occurs when the
firms cash flows are insufficient to cover
contractually required payments.
$

Cash flow
shortfall
Contractual
obligations

Firm cash flow

Insolvency time

What is Financial Distress? 200


Responses to Financial Distress
 Think of the two sides of the balance
sheet.
 Asset Restructuring:
 Selling major assets
 Merging with another firm
 Reducing capital spending and R&D spending
 Financial Restructuring:
 Issuing new securities
 Negotiating with banks and other creditors
 Exchanging debt for equity
 Filing for bankruptcy
What Happens in Financial Distress? 201
What Happens in Financial Distress?
No financial
restructuring
49%
Financial Private
distress workout
47%
51%
Financial Reorganize
restructuring and emerge
83%
53%
Legal bankruptcy 7% Merge with
Chapter 11 another firm

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).

What Happens in Financial Distress? 202


Bankruptcy Liquidation: Priority of Claims

 Liquidation proceeds are distributed in


order of priority:
 Administration expenses associated with
liquidation
 Unsecured claims arising after the filing of
an involuntary bankruptcy petition
 Wages
 Contributions to employee benefit plans
 Consumer claims
 Tax claims
 Secured and unsecured creditors’ claims
 Preferred stockholders’ claims
 Common stockholders’ claims 203
Costs of Financial Distress

 Bankruptcy risk versus bankruptcy


cost
 The possibility of bankruptcy has a
negative effect on the value of the
firm.
 However, it is not the risk of
bankruptcy itself that lowers firm
value.

Costs of Financial Distress 204


Costs of Financial Distress

 Rather, it is the costs associated


with bankruptcy that lowers firm
value.
 It is the stockholders who bear
these costs.

Costs of Financial Distress 205


Example 17.1 Bankruptcy Cost
Knight Day
Boom Recession Boom Recession
Cash Flow $100 $50 $100 $50
Payment of Interest 49 49 60 50
and Principal on
Debt
Distribution to $51 $1 $40 $0
stockholders

 Assume the probabilities of boom and


recession are 0.5, and the cost of equity
and the interest rate are 10%

Costs of Financial Distress 206


Example of Bankruptcy Cost
$51 0.5  $1 0.5
S Knight   $23.64,
1 .1
$49  0.5  $49  0.5
BKnight   $44.54
1 .1
VKnight  $68.18
$40  0.5  $0  0.5
S Day   $18.18,
1.1
$60  0.5  $50  0.5
BDay   $50
1.1
VDay  $68.18
Costs of Financial Distress 207
Example of Bankruptcy Cost
 The values of Knight and Day are
the same, though Day is running a
risk of bankruptcy.

 Return to bondholders of Day is $60


/ $50 -1 = 0.2

 Further assume an additional cost


of $15 is involved in bankruptcy.

Costs of Financial Distress 208


Example of Bankruptcy Cost
Day
Boom Recession
Cash Flow $100 $50
Payment of Interest and Principal on Debt 60 35

Distribution to stockholders $40 $0

 SDay will be ($40x0.5+0x0.5) / 1.1 = $18.18,


which is the same as before;
 BDay will be ($60x0.5+35x0.5) / 1.1 = $43.18;
 VDay will be $61.36.

Costs of Financial Distress 209


Example of Bankruptcy Cost

 The possibility of bankruptcy has a


negative effect on the value of the firm.
 It is the costs associated with
bankruptcy that lowers firm value.
 Return to bondholders of Day is $60 /
$43.18 -1 = 0.39, a high return is to be
associated with high risk.
 It is the stockholders who bear these
costs.

Costs of Financial Distress 210


Description of Financial Distress Costs

 Direct Costs
 Legal and administrative costs of
Liquidation or Reorganization
 Indirect Costs
 Impaired ability to conduct
business (e.g., lost sales)

Costs of Financial Distress 211


Description of Financial Distress Costs

 Agency Costs
 Selfish Strategy 1: Incentive to
take large risks
 Selfish Strategy 2: Incentive
toward underinvestment
 Selfish Strategy 3: Milking the
property

Costs of Financial Distress 212


Example: Company in Distress
Assets BV MV Liabilities BV MV
Cash $200 $200 LT Bonds $300 $200
Fixed Assets $400 0 Equity $300 $0
Total $600 $200 $600 $200

The bondholders get $200; the shareholders


get nothing.

Costs of Financial Distress 213


Selfish Strategy 1: Take Risks

The Gamble Probability Payoff


Win Big 10% $1,000
Lose Big 90% $0
 Cost of investment is $200 (all the firm’s
cash)
 Required return is 50%
 Expected CF from the Gamble = $1000 ×
0.10 + $0 = $100
$100
NPV  $200   $133
1.50
Costs of Financial Distress 214
Selfish Strategy 1: Take Risks
 Expected CF from the Gamble
 To Bondholders = $300 × 0.10 + $0 = $30
 To Stockholders = ($1000 – $300) × 0.10 +
$0 = $70
 PV of Bonds Without the Gamble = $200
 PV of Stocks Without the Gamble = $0
 PV of Bonds With the Gamble: $30 / 1.5 =
$20
 PV of Stocks with the Gamble: $70 / 1.5 =
$47

Costs of Financial Distress 215


Selfish Strategy 2: Underinvestment

 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.

Costs of Financial Distress 216


Selfish Strategy 2: Underinvestment

 Required return is 10%.

$350
NPV  $300   $18.18
1.10

 Should we accept or reject?

Costs of Financial Distress 217


Selfish Strategy 2: Underinvestment

 Expected CF from the government


sponsored project:
To Bondholder = $300
To Stockholder = ($350 – $300) = $50

Costs of Financial Distress 218


Selfish Strategy 2: Underinvestment

 PV of Bonds Without the Project


= $200
 PV of Stocks Without the Project
= $0
$300
 PV of Bonds With the Project =  $272.73
1.10

 PV of Stocks With the Project


$50
 $100   $54.55
1.10
Costs of Financial Distress 219
Selfish Strategy 3: Milking the Property

 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

Costs of Financial Distress 220


Can Costs of Debt Be Reduced?
 Protective Covenants
 Positive covenants: specify actions
that the company agrees to take or a
condition the company must abide by.
 Negative covenants: limit or prohibit
actions that the company may take.
 Debt Consolidation:
 If we minimize the number of parties,
contracting costs fall.

Can Costs of Debt be Reduced 221


Tool for predicting bankruptcy: The Z-Score
Model

 Credit scoring models provide a quick,


objective way to evaluate
creditworthiness.
 The key intuition behind the Z-score
model is that bankrupt firms and
nonbankrupt firms have very different
financial profiles one year before
bankruptcy.

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

 There is a trade-off between the


tax advantage of debt and the
costs of financial distress.
 The firm’s capital structure is
optimized where the marginal
subsidy to debt equals the marginal
cost.
 It is difficult to express this with a
precise and rigorous formula.
Tax Effects and Financial Distress 226
The Pie Model Revisited
 Taxes and bankruptcy costs can be
viewed as just another claim on the cash
flows of the firm.

 Let G and L stand for payments to the


government and bankruptcy lawyers,
respectively.

Tax Effects and Financial Distress 227


The Pie Model Revisited

 VT = S + B + G + L
S
B

L G

 The essence of the M&M intuition is


that VT depends on the cash flow of
the firm; capital structure just slices
the pie.
Tax Effects and Financial Distress 228
Tax Effects and Financial Distress
Value of firm under
Value of firm (V) MM with corporate
Present value of tax taxes and debt
shield on debt
VL = VU + TCB

Maximum Present value of


firm value financial distress costs
V = Actual value of firm

VU = Value of firm with no debt

0 Debt (B)
B*
Optimal amount of debt

Tax Effects and Financial Distress 229


Tax Effects and Financial Distress
Cost of Capital (%)

Ro

RWACC

0 Debt (B)
B*
Optimal amount of debt

Tax Effects and Financial Distress 230


Other theories that address the level of debt
1. Signaling

 Investors view debt as a signal of


firm value.
 Firms with low anticipated profits
will take on a low level of debt.
 Firms with high anticipated profits
will take on a high level of debt.

Signaling 231
Signaling

 A manager that takes on more debt


than is optimal in order to fool
investors will pay the cost in the
long run.

Signaling 232
2. Agency Cost of Equity

 An individual will work harder for a


firm if he is one of the owners than
if he is one of the “hired help.”

 While managers may have motive to


partake in perquisites, they also
need opportunity. Free cash flow
provides this opportunity.

Agency Cost of Equity 233


Agency Cost of Equity

 The free cash flow hypothesis says


that an increase in dividends should
benefit the stockholders by reducing
the ability of managers to pursue
wasteful activities.
 The free cash flow hypothesis also
argues that an increase in debt will
reduce the ability of managers to
pursue wasteful activities more
effectively than dividend increases.
Agency Cost of Equity 234
3. The Pecking-Order Theory

 Theory stating that firms prefer


to issue debt rather than equity
if internal financing is
insufficient.
 Rule 1: Use internal financing
first
 Rule 2: Issue debt next, new
equity last

The Pecking Order Theory 235


The Pecking-Order Theory

 The pecking-order theory is at


odds with the tradeoff theory:
 There is no target D/E ratio

 Profitable firms use less debt

 Companies like financial slack

The Pecking Order Theory 236


4. Growth and the Debt-Equity Ratio

 Growth implies significant equity


financing, even in a world with low
bankruptcy costs.
 Thus, high-growth firms will have
lower debt ratios than low-growth
firms.
 Growth is an essential feature of
the real world. As a result, 100%
debt financing is sub-optimal.
Growth and the Debt-Equity Ratio 237
5. Personal Taxes

 Individuals, in addition to the


corporation, must pay taxes. Thus,
personal taxes must be considered
in determining the optimal capital
structure.

Personal Taxes 238


Personal Taxes

 Dividends face double taxation (firm


and shareholder), which suggests a
stockholder receives the net amount:
 (1-TC) x (1-TS)

Personal Taxes 239


Personal Taxes

 Interest payments are only taxed


at the individual level since they
are tax deductible by the
corporation, so the bondholder
receives:
 (1-TB)

Personal Taxes 240


Personal Taxes

 If TS= TB then the firm should be


financed primarily by debt (avoiding
double tax).
 The firm is indifferent between debt
and equity when:
(1-TC) x (1-TS) = (1-TB)

Personal Taxes 241


How Firms Establish Capital Structure

 Most corporations have low Debt-


Asset ratios.

How Firms Establish Capital Structure 242


How Firms Establish Capital Structure

 There are differences in capital


structure across industries.

How Firms Establish Capital Structure 243


How Firms Establish Capital Structure

 There is evidence that firms behave


as if they had a target Debt-Equity
ratio.

How Firms Establish Capital Structure 244


Factors in Target D/E Ratio
 Taxes
 highly profitable firms should use more debt (i.e.,
greater tax benefit `.`interest is tax deductible,).
 Types of Assets
 The costs of financial distress depend on the types
of assets.
 Uncertainty of Operating Income
 uncertain operating income  high probability of
experiencing financial distress.
 Pecking Order and Financial Slack
 Theory stating that firms prefer to issue debt rather
than equity if internal financing is insufficient.

Factors in Target D/E Ratio 245


Key Concepts and Skills

 What are the direct and indirect costs


of bankruptcy?
 Define the “selfish” strategies
stockholders may employ in
bankruptcy.
 Explain the tradeoff, signaling,
agency cost, and pecking order
theories.
 What factors affect real-world debt
levels?
246
Back to our case…

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

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