04 - Corporate Issuers

04 Corporate Issuers Corporate Issuers 2024 Level II High Yield Notes LM01 Analysis of Dividends and Share Repurchases Dividend types Cash dividends are payments made to shareholders in cash. The three types of cash dividends are: • Regular cash dividends are paid out on a consistent basis. Stable or increasing dividend is viewed as a sign of financial stability. • Special dividends are one-time cash payments when the situations are favorable (Also called as extra dividends or irregular dividends; used by cyclical firms). • Liquidating dividend is distributed to shareholders when a company goes out of business. Due to cash dividends, the total shareholder wealth does not change. Only the distribution between cash and share value changes. As cash is paid out of the company, the company’s liquidity and leverage ratios become worse. Stock dividends are payments made to shareholders in additional shares instead of cash. Stock splits divide each existing share into multiple shares. Reverse stock splits are the opposite of stock splits and decrease the total number of outstanding shares. Since stock dividends and splits do not result in an outflow of cash, they do not affect the liquidity and leverage ratios. A share repurchase is when a company buys back its own outstanding shares using cash. Due to stock dividends, there is no impact on shareholder’s wealth as there is no outflow of cash. Also, the company’s leverage and liquidity ratios stay the same. Divided policy theories MM’s dividend irrelevance theory: According to this theory, if we assume perfect capital markets (i.e., there are no taxes, no transaction costs and symmetric information), then dividend policy does not matter. It will have no impact on the cost of capital or on the company’s value. There is no meaningful distinction between dividends and share repurchases. Investors can generate homemade dividends. If investors want income, they can sell shares to create dividends. Dividends can be used to purchase shares, if investors do not need income. The bird in the hand argument: This theory states that investors view cash dividends as less risky than the same amount of capital gains. Hence, companies that pay dividends have a lower cost of equity as compared to companies that do not pay dividends. The lower cost of equity results in a higher present value for the companies that pay dividends. © IFT. All rights reserved 1 Corporate Issuers 2024 Level II High Yield Notes MM counter argument: Whether or not dividends are paid, does not impact the riskiness of future cash flows. The tax argument: This theory states that investors do not like dividends because dividends are taxed at a higher rate than capital gains. Hence, they prefer companies that pay low dividends. This increases the value of companies with low dividend payout ratios. Signaling content of dividends Usually, there is some level of information asymmetry, i.e., managers/ insiders know more than outside investors. Hence, the board/management may use dividends to signal how the company is really performing. Dividend initiation or increase is generally seen as a positive signal and stock prices will probably rise in the short-run. However, if revised dividends are not sustainable, stock price will fall. Decrease in dividends or omission of dividends is generally seen as a negative signal and stock price will probably fall in the short-run. Agency costs A major concern to shareholders is that management might invest in negative NPV projects. Such projects may increase the size of the company and thus be better for managers, but they will generate negative economic returns. This potential overinvestment problem can be partially controlled through high dividend payouts. If most of the free cash flow is paid out, managers would be constrained in their ability to overinvest by undertaking negative NPV projects. However, dividend payments can worsen conflicts of interest between shareholders and debt holders. Factors affecting dividend policy Factors that affect dividend policy are: • Investment opportunities: All else equal, a company with many profitable investment opportunities will pay out less dividends than a company with fewer opportunities. • The expected volatility of future earnings: When earnings are volatile, companies are more cautious in the size and frequency of dividend increases. • Financial flexibility: To obtain financial flexibility associated with holding more cash, companies may not initiate, may reduce or omit dividends. © IFT. All rights reserved 2 Corporate Issuers • • • 2024 Level II High Yield Notes Tax considerations: Under double taxation systems, dividends are taxed at both the corporate and shareholder level. Under tax imputation systems, a shareholder receives a credit on dividends for the tax paid on corporate profits. Under split-rate taxation systems, corporate profits are taxed at different rates depending on whether the profits are retained or paid out in dividends. Flotation costs: It is more expensive for companies to raise new equity capital than to use their own retained earnings. As a result, many companies avoid establishing a level of dividends that would create a need to raise new equity capital in future. Contractual and legal restrictions: Often the payment of dividends is affected by legal or contractual restrictions or rules. Effective tax rate Double taxation: Under double taxation systems, dividends are taxed at both the corporate and shareholder level. The effective tax rate is given by, Effective tax rate = Corporate tax rate + (1 – corporate tax rate) * (individual marginal tax rate on dividends) Tax imputation systems: Under tax imputation systems, a shareholder receives a credit on dividends for the tax paid on corporate profits. Corporate profits that are distributed as dividends are only taxed once; the effective tax rate is equal to individual marginal tax rate of the investor. Split-rate taxation systems: Under split-rate taxation systems, corporate profits are taxed at different rates depending on whether the profits are retained or paid out in dividends. Earnings distributed as dividends are still taxed twice, but the comparatively low corporate tax rate on earnings lessens that penalty. Payout policies Stable dividend policy: In this policy, a company tries to align its dividend growth rate to the company’s long-term earnings growth rate. The stable dividend policy can be represented by a gradual adjustment process in which the expected increase in dividends is calculated as: Expected increase in dividends = (Expected earnings × Target payout ratio – Previous dividend) × Adjustment factor Adjustment factor = 1/ number of years over which the adjustment in dividends will take place New dividend = Original dividend + Increase in dividend © IFT. All rights reserved 3 Corporate Issuers 2024 Level II High Yield Notes Example: Current dividend = 0.4. Expected earnings for the year ahead = 1.50. Target payout ratio = 0.5. Adjustment period = 5 years. Calculate the expected dividend. Solution: Adjustment factor = 1/5 = 0.2 Expected increase in dividends = (1.5 x 0.5 – 0.4) x 0.2 = 0.07 Expected dividend = 0.4 + 0.07 = 0.47 Constant dividend payout ratio policy: In this policy, a company applies a target dividend payout ratio to current earnings; therefore, dividends are more volatile than with a stable dividend policy. Share repurchase methods The four main types of repurchase methods are: • Buy in the open market – has maximum flexibility because the company can time the buyback. The method can be cost effective if share repurchase is timed to minimize price impact and to exploit perceived undervaluation. • Buy back a fixed number of shares at a fixed price – can be accomplished quickly but the company usually has to offer a premium; pro-rata if necessary. Example: stock selling at $37 and the company offers to buy 5 million shares for $40. • Dutch auction – slower than the previous method, but can give a better price. Example: stock selling at $37 and the company offers to buy 5 million shares in the $38 to $40 range. • Repurchase by direct negotiation – company buys back shares from a large shareholder. This method helps avoid market impact of a large transaction. Financial statement effects of repurchases If net income remains unchanged, then a lower number of outstanding shares due to a share repurchase can result in higher earnings per share. However, the change in net income depends on how the repurchase is financed. • If the share repurchase is financed internally, a repurchase increases EPS only if the funds used for the repurchase would not earn their cost of capital if retained by the company. • If the repurchase is financed by taking external debt, the effect on EPS is positive if the earnings yield exceeds the after-tax cost of financing the repurchase. If the earnings yield is lower than the after-tax cost of financing, EPS would decrease. If share repurchase is financed with surplus cash: • EPS increases • Assets and equity decrease • Liquidity ratios decrease © IFT. All rights reserved 4 Corporate Issuers • • 2024 Level II High Yield Notes Debt to asset ratios increase Debt to equity ratios increase If the market price per share is higher than book value per share, BVPS will decrease after the share repurchase. On the other hand, if the market price per share is lower than book value per share, BVPS will increase after the share repurchase. Cash dividend vs. share repurchase decision Theoretically, share repurchases are equivalent to cash dividends of equal amount in their effect on shareholders’ wealth, all other things being equal. However, all other things are not necessarily equal. Listed below are factors to consider when evaluating share repurchases. • Potential tax advantages • Share price support/signaling that the company considers its shares a good investment • Added managerial flexibility • Offsetting dilution from employee stock options • Increasing financial leverage Global trends in payout policy The following broad trends have been observed: • A lower percentage of companies in a given U.S. stock market index have paid dividends than have companies in a comparable European stock market index. • The fraction of companies paying cash dividends has been in long-term decline in most developed markets (e.g., the United States, Canada, the European Union overall, the United Kingdom, and Japan). • Since the early 1980s in the United States and the early 1990s in the United Kingdom and continental Europe, the fraction of companies engaging in share repurchases has trended upward. Analysis of dividend safety Net Income: The traditional measure of dividend safety is the dividend payout ratio and its inverse the dividend coverage ratio. Dividends Dividend payout ratio = Net Income Net Income Dividend coverage ratio = Dividends A higher dividend payout ratio or a lower dividend coverage ratio tends to indicate, all else equal, higher risk of a dividend cut. © IFT. All rights reserved 5 Corporate Issuers 2024 Level II High Yield Notes Free Cash Flow: A more comprehensive measure of dividend safety is to use FCFE coverage ratio. FCFE FCFE coverage ratio = (Dividends + Share repurchases) If this ratio is 1, the company is returning all available cash to its shareholders. If the ratio is significantly greater than 1, the company is building up its cash reserves. If the ratio is significantly less than 1, the company is paying out more than it is earning. This is not sustainable; it will deplete the cash reserves and the company will have to raise new equity. An analyst should assess coverage ratios relative to historical levels and peer companies. He should also look at the stage in the industry lifecycle the company is in while making his decision. © IFT. All rights reserved 6 Corporate Issuers 2024 Level II High Yield Notes LM02 ESG Considerations in Investment Analysis Global variations in ownership structures and their effects on corporate governance Corporate ownership structures can be classified as: • Dispersed: Many shareholders exist and none of them have the ability to individually exercise control over the company. • Concentrated: An individual shareholder or a group has the ability to exercise control over the company. • Hybrid: Combination of the above two types. Controlling shareholders may be either majority shareholders or minority shareholders. Despite their low ownership stake, minority shareholders can still exercise control through the following arrangements: • Horizontal ownership: Companies have cross-holding share arrangements with each other. They may also share key customers or suppliers. Such a structure can help facilitate strategic alliances and foster long-term relationships among such companies. • Vertical (or pyramid) ownership: A company or group has a controlling interest in two or more holding companies, which in turn have controlling interests in various operating companies. • Dual-class (or multiple-class) shares: One share class has superior or even sole voting rights, whereas the other share class has inferior or no voting rights. Different kinds of conflicts exist depending on the ownership structure and voting power. 1. Dispersed ownership and dispersed voting power: The managers may use the company’s resources to pursue their own interests at the expense of shareholders. This conflict is known as a principal-agent problem. 2. Concentrated ownership and concentrated voting power: The controlling owners may be able to use the company’s resources to pursue their own benefit at the expense of minority owners. This conflict is known as a principal-principal problem. 3. Dispersed ownership and concentrated voting power: This case is similar to case#2 and can lead to a principal-principal problem. The only difference is that the controlling shareholders are minority shareholders and they do not own more than 50% of the company’s shares. 4. Concentrated ownership and dispersed voting power: This situation can arise when there are legal restrictions on voting rights of majority shareholders, known as voting caps. Voting caps are usually imposed by sovereign governments to prevent foreign investors from exercising control over strategically important local companies. © IFT. All rights reserved 1 Corporate Issuers 2024 Level II High Yield Notes Types of influential owners include banks, families, sovereign governments, institutional investors, group companies, private equity firms, foreign investors, managers, and board directors. Two typical structures for a company’s board of directors are: • One-tier board - A one-tier board structure consists of a single board of directors, composed of executive (internal) and non-executive (external) directors. Most countries have a one-tier board structure. • Two-tier board – A two-tier board structure consists of a supervisory board that oversees a management board. Some countries mandate a two-tier board structure. CEO duality exists when the chief executive officer (CEO) also serves as the chairperson of the board. Evaluating corporate governance policies and procedures Board policies and practices: To evaluate a company’s board policies and practices, we look at the following: • Board of directors’ structure: Analysts consider whether the structure is a one-tier or two-tier structure and if this structure provides sufficient oversight, representation, and accountability to shareholders. • Board independence: A board with a majority of independent board members is considered positive. • Board skills and experience: A board with diverse skills and expertise directly related to the company’s core operations is considered positive. • Board composition: A board with more diversity with respect to profession, culture, geographical background, gender, age and tenure is considered positive. An issue related to skills and experience is board tenure. A board member’s tenure is considered long if it exceeds 10 years. This can be viewed positively (the board member has more knowledge and experience) or negatively (the board member could be too closely aligned with management). Executive remuneration: Factors to consider while evaluating executive remuneration include: • Transparency of compensation • Performance criteria for incentive plans – both short term and long term • Linkage of remuneration with company strategy • Pay differential between the CEO and the average worker • “Say-on-pay” provision allows shareholders to vote and/or provide feedback on remuneration issues. • A “claw-back” policy allows a company to recover previously paid remuneration if certain negative events are uncovered. © IFT. All rights reserved 2 Corporate Issuers 2024 Level II High Yield Notes Shareholder voting rights: • Under straight voting share structures, shareholders get one vote for each share owned. • Under dual-class share structures, company founders and management have shares with more voting power. Identifying and evaluating ESG-related risks and opportunities Materiality and investment horizon: There are several challenges while evaluating ESG information. Companies usually report information and metrics that are inconsistent, making comparisons across companies difficult. Also, ESG disclosures are voluntary. Therefore, different companies may report different levels of information. This again makes comparisons across companies difficult. While evaluating ESG factors, analysts first need to evaluate if an information is material. Materiality typically refers to ESG related issues that can affect a company’s operation, its financial performance, and the valuation of its securities. Analysts also consider their investment horizon when deciding which ESG factors to consider in their analysis. Some factors may affect a company’s performance in the short term, whereas other issues may be more long term in nature. Relevant ESG-related factors: Analysts typically use three approaches to identify a company’s (or industry’s) ESG factors: 1. Proprietary research: involves the use of own judgment or their firm’s proprietary tools to identify ESG information. 2. ESG data providers: involves the use of information supplied by ESG data providers, such as MSCI or Sustainalytics. 3. Not-for-profit industry organizations and initiatives: involves the consideration of not-for-profit initiatives that provide data and insights on ESG issues. Equity vs. fixed-income security analysis • Equity analysis: ESG integration is used to both identify potential opportunities and mitigate downside risk. Analysts adjust financial model variables such as cost of capital to reflect ESG factors. • Fixed-income analysis: ESG integration is generally focused on mitigating downside risk. Analysts usually do not focus on potential opportunities. The credit assessment may vary depending on maturity. ESG integration The typical starting point for ESG integration is the identification of material qualitative and quantitative ESG factors that pertain to a company or its industry. For equities, adjustments related to ESG factors may be made to cost of capital, price multiple, and terminal value. © IFT. All rights reserved 3 Corporate Issuers 2024 Level II High Yield Notes For bonds, an analyst may adjust an issuer’s credit spread or CDS to reflect anticipated effects from ESG considerations. © IFT. All rights reserved 4 Corporate Issuers 2024 Level II High Yield Notes LM03 Cost of Capital - Advanced Topics Cost of capital factors Several factors can influence a company’s cost of capital. These factors can be either topdown (i.e., external or systematic) or bottom-up (i.e., company specific or idiosyncratic). These factors are listed in the table below. Top-Down, External Capital availability Market conditions (risk free rates, credit spreads, and ERP) Legal and regulatory considerations/country risk Tax jurisdiction Bottom-Up, Company Specific Revenue, earnings, and cash flow volatility Asset nature and liquidity Financial strength, profitability, and leverage Security features (Features of debt securities, such as callability, putability, and convertibility, affect the cost of debt. Features of equity securities, such as cumulative dividends, affect the costs of equity) Estimating the cost of debt The cost of debt varies depending on the type of debt, the liquidity of the debt issue, the credit rating of the debt, and the currency in which the debt is issued. If a company has publicly traded debt with no embedded options, then the YTM on the company’s existing debt with the longest maturity can be interpreted as the current cost of issuing new debt. For non-traded debt, the analyst needs to use approaches like synthetic credit rating and matrix pricing. Determining the cost of bank debt and leasing requires information for the calculation of the effective cost of this financing. The cost of debt in international markets can be estimated using country risk rating (CRRs) that reflect economic, political, and exchange rate risk, as well as information about the financial markets and regulation. The ERP (Equity Risk Premium) The equity risk premium is the incremental return that investors require for holding equities rather than a risk-free asset. © IFT. All rights reserved 1 Corporate Issuers 2024 Level II High Yield Notes There are two broad approaches to estimate the equity risk premium (ERP): historical estimates and forward-looking estimates. A historical equity risk premium estimate is calculated as the mean value of the differences between broad-based equity-market-index returns and government debt returns over a given time period. Forward-looking estimates (or ex-ante estimates) are based on current information and expectations concerning economic and financial variables. The three main categories of forward-looking estimates are: • • • Survey estimates: Ask experts for their opinion. Dividend discount models: ERP = market dividend-yield + consensus long-term earnings growth rate – current long-term government bond yield Macroeconomic modeling: ERP = [DY + Δ(P/E) + i + g + ΔS] – E(rf) Estimating the required return on equity DDMs: The stock’s required rate of return is composed of two components: dividend yield D ( P1 ) and price appreciation (g). 0 re = D1 +g P0 Bond Yield Plus Risk Premium Approach: Cost of equity = YTM on the company’s long-term debt + risk premium The YTM on the company’s long-term debt already includes: the real interest rate, a premium for expected inflation, and a default risk premium. The additional risk premium in the formula compensates for the added risk arising from holding the firm’s equity. Risk-Based Models CAPM: According to CAPM, the required return on an asset can be calculated as: re = rf + β̂ (ERP) Fama–French Models: Using the three-factor model, a company’s excess return on equity is calculated as: re = rf + β1 ERP + β2 SMB + β3 HML where: SMB is the size premium, equal to the average difference in equity returns between companies with small and large capitalizations © IFT. All rights reserved 2 Corporate Issuers 2024 Level II High Yield Notes HML is the value premium, equal to the average difference in equity returns between companies with high and low book-to-market ratios The five-factor Fama–French model adds two other factors—a profitability factor (RMW) and an investment factor (CMA): re = rf + β1 ERP + β2 SMB + β3 HML + β4 RMW + β5 CMA where: RMW is the profitability premium, equal to the average difference in equity returns between companies with robust and weak profitability CMA is the investment premium, equal to the average difference in equity returns between companies with conservative and aggressive investment portfolios Estimating the Cost of Equity for Private Companies: The required return on equity for private companies often includes: • • • a size premium (SP), an industry risk premium (IP), and a specific-company risk premium (SCRP) Two commonly used methods to estimate the required return on equity for private companies are: • • the expanded CAPM and the build-up approach Expanded CAPM: re = rf + βpeer (ERP) + SP + IP + SCRP Build-Up Approach: re = rf + ERP + SP + SCRP International Considerations: Investing in emerging markets exposes investors to additional risks as compared to investing in developed markets. Two methods for building risk premiums into the required return for emerging markets are: • • the country spread model the country risk rating model Country spread model: According to the country spread model, the ERP for an emerging equity market can be calculated as: ERP = ERP for a developed market + (λ × Country risk premium) © IFT. All rights reserved 3 Corporate Issuers 2024 Level II High Yield Notes where: λ is the level of exposure of the company to the local country Country risk premium = Sovereign yield spread x σEquity/ σBond International CAPM: Under the international CAPM (ICAPM) approach, the returns on a stock in an emerging market are regressed against the risk premium of a global index (rgm) in addition to that of wealth-weighted foreign currency index ( rc ): E (re) = rf + βG (E(rgm) − rf) + βC (E(rc) − rf) © IFT. All rights reserved 4 Corporate Issuers 2024 Level II High Yield Notes LM04 Corporate Restructuring Types of corporate restructuring and motivations for pursuing them Corporate restructuring can be classified as one of nine types as shown in Exhibit 5 from the curriculum. Exhibit 3 from the curriculum lists the typical motivations for corporate structural change. Issuer-specific motivations Top-down drivers © IFT. All rights reserved Investment Actions Divestment Actions Restructuring Actions • Realize synergies • Focus operations • Improve returns on • Increase growth and business lines capital • Improve • Valuation • Financial challenges, capabilities or • Liquidity needs including bankruptcy secure resources • Regulatory and liquidation • Opportunity to requirements acquire an undervalued target • High security prices • Industry shocks 1 Corporate Issuers 2024 Level II High Yield Notes Evaluating corporate restuructring The evaluation of corporate restructurings is composed of four phases as shown in Exhibit 12 from the curriculum. The initial evaluation of a corporate restructuring involves answering four questions: • • • • What is happening? Why is it happening? Is it material? When is it happening? Preliminary valuation If a restructuring is material, an analyst should conduct a preliminary valuation of the target to check if the management is using stakeholder resources optimally. Three valuation methods commonly used in this step are: comparable company analysis, comparable transaction analysis, and premium paid analysis. Comparable Company Analysis The steps for the comparable company approach are: 1. Define a set of comparable firms. Include companies in similar industries that have similar size and capital structure. 2. Calculate various relative value measures based on the current market price of the comparable companies. For example, EV/EBITDA, P/S, P/E, P/CF, etc. 3. Review descriptive statistics like mean, median, and range for the metrics chosen and apply judgment and experience to estimate company value. © IFT. All rights reserved 2 Corporate Issuers 2024 Level II High Yield Notes The comparable company analysis is often used to assess the value of targets in spin offs rather than acquisitions. This is because in acquisitions, acquirers pay a premium for control and the acquisition price typically exceeds the price estimated by this method. Comparable Transaction Analysis The steps for the comparable transaction approach are: 1. Collect a sample of recent and relevant takeover transactions. 2. Calculate various relative measures like P/E, P/CF, P/B based on prices actually paid in the deals (not current market prices). 3. Review descriptive statistics like mean, median, and range for the metrics chosen and apply judgment and experience to estimate company value. Unlike comparable company analysis, the valuation multiples in comparable transaction analysis include takeover premiums, because they reflect historical acquisitions. Premium Paid Analysis To estimate or judge a sale value or acquisition price for a listed issuer, an analyst could also calculate an estimated takeover premium. The takeover premium is the amount by which the takeover price for each share of stock must exceed the current stock price in order to entice shareholders to relinquish control of the company to an acquirer. This premium is usually expressed as a percentage of the stock price and is calculated as: PRM = (DP − SP) SP where: PRM = takeover premium (as a percentage of stock price) DP = deal price per share of the target company SP = stock price of the target company To calculate a relevant takeover premium, analysts compile a list of takeover premiums paid for companies similar to the target in the recent past. Modeling and valuation The next step of the evaluation process is creating pro forma financial statements that include the effect of the restructuring. Exhibit 15 from the curriculum demonstrates how to create a pro forma income statement. Revenue Pro Forma Income Statement (Acquisition) Modeling 1. Combine acquirer and target revenues. 2. Add revenue synergies or subtract the cost of incompatible activities (dis-synergies). © IFT. All rights reserved 3 Corporate Issuers Operating expenses Depreciation and amortization Other expense or income Interest expense Income taxes Shares outstanding 2024 Level II High Yield Notes 1. Combine acquirer and target operating expenses. 2. Subtract cost synergies or add the cost of incompatible activities (dis-synergies). 1. Combine acquirer and target depreciation and amortization. 2. Add amortization of acquired intangible assets. 1. Combine acquirer and target other expense or income. 1. Start with current acquirer interest expense. 2. Add increased interest from new debt issuance and revised interest rate. 1. EBT-weighted average of tax rates of acquirer and target; estimate usually provided by issuer 1. Start with current acquirer shares outstanding 2. Add shares from any share issuance Pro forma WACC The WACC for an issuer is determined by the weights of different capital types and the constituent costs of capital. A restructuring can change both the weights and the costs of each type of capital. The costs of capital are influenced by several factors both inside and outside the issuer. Restructurings change the costs of capital by changing these factors. © IFT. All rights reserved 4