Corporate Finance Ultimate Cheat Sheet

Lecture 1: Corporate Governance & Objective of Corp Fin 4 Issues with Stock Price Maximization as the sole objective 1) Shareholder-Manager’s Conflict (Agency problem) Stockholders control management through AGM, and interests are represented by BOD AGM - Small stockholders don’t go AGM because value of holdings is too small - Unused votes are utilized by incumbent management in their favour - Large institutional investors go with incumbent (rather sell stock rather than create change) BOD - Often handpicked by management (and won’t go against mgmt decisions) - Directors hold token (very small) stakes in company – no vested interest - May be CEOs and sit on each other’s boards to rubber-stamp decisions How do Managers put their own interests over shareholders? Greenmail: Managers, under threat of takeover, buy out acquirer’s existing stake at a much higher price to keep their jobs  firm’s cash is misused Golden parachutes: Large unemployment benefits paid out to managers Poison pills: Defensive tactic which floods market with new shares, and makes acquiring the firm much more expensive  individual stock’s value eroded Overpaying on takeovers: ∆Firm value is distributed to stakeholders of acquired company 2) Shareholder-Bondholders Conflict Bondholders  Safe projects to ensure they get paid; minimize downside risk Stockholders  Risky projects to gain capital appreciation; focus on upside Actions which worsen bond-holders positions Increasing dividends: Less cash on hand, lower liquidity  Higher default risk Taking riskier projects than agreed: Higher risk profile, at unchanged coupon rate Borrowing more on same assets: Divided salvage value  Make existing lenders worse of 3) Firms and Financial Markets Inefficiency  Stock price does not reflects value Information can be suppressed or delayed; or released intentionally to mislead current/ future prospects to market. Manipulation of financial markets by insiders Short-sightedness of investors  reward short term gimmicks, fail to see good long term projects; overreact to news. Irrational and prices can move for no reason Conflict of interest btwn analyst’s coverage and brokerage services (more likely to say BUY) 4) Firms and Society Social cost/benefit cannot be fully traced back to the firm. Costs unknown at time of activity; costs weighed diferently by diferent people Shareholders’ REPONSE: Vote against BOD selection/ Mgmt compensation contracts Activist investors like Carl Icahn, take large positions to drive change Nomination Committee to nominate suitable directors without COI Institutional investors are more active in monitoring companies (Calpers and Lens Fund) 1. Identify Country Default Risk, using 1) Credit Default Swaps; 2) Moody’s Rating of Country; or 3) Diference in YTM of 10yr USD bond issued by SGD - 10yr USD bond issued by USD. 2. YTM of SG Govt-issued 10yr SGD bond - SG Default Spread = Risk-free rate in SG C) If country no rating, never issue bonds, then do the analysis in USD currency. Then, convert USD Cost of equity to Local currency, accounting for inflation: 1+ In 1+COE∈SGD= ( 1+COE∈USD ) [ 1+ In Determine Risk Premium = (Market Risk – Risk Free) A) Historical Premium Approach (Regression) - Mature, Developed Countries 1. Define time period for estimation (5yr, mthly) 2. Calculate returns on a stock index 3. Calculate returns on a riskless security 4. Calculate the diference. Std Devof Stock Prices √ Numberof years C) Implied Risk Premium approach 1. Equate current index to PV of CFs (dividend yield). Estimate g using S&P500. 2. Calculate IRR which is = expected return on stocks. 3. Implied Equity Risk Premium = Rm –Rf R 1+IR¿ ¿ ¿ D1 D2 Index valueP0= + 1+ IRR ¿ R 1+IR¿ ¿ ¿3 ¿ D3 ¿ Financial Markets REPONSE: Payof to uncovering negative news is high, with Option trading & Short-selling Greater access with technology – more difficult to control information Punishment for misleading information through dumping of stock (Volkswagen emissions) Societal REPONSE: Laws and regulations against flouting societal norms and social costs Consumers choose not to purchase from socially-irresponsible firms (Palm oil companies) Modified Objective Functions: Public traded + Efficient Mkts + Protected B/H – Maximize Share Price Public traded + Inefficient Mkts + Protected B/H – Maximize S/H wealth Public traded + Inefficient Mkts + Unprotected B/H – Maximize Firm value Private – Maximize S/H wealth if B/H are protected, maximize Firm value if not Lecture 2: Risk and Return Models + Hurdle Rates CAPM requires least inputs. Alternative Models measure past returns better, but not future. Marginal investor: owns a lot of stock and trades a lot; likely to make next trade. Capital Asset Pricing Model: ExpectedReturn= R f +β (R M − R f ) Assumptions: Perfect information; No transaction costs. Everyone holds a diversified portfolio. Only one source of risk: market risk, is rewarded. Uses the variance of actual returns around expected return as a measure of risk Expected R = what investors expect to make, if stock is correctly priced & CAPM is correct  Hurdle Rate for managers = Riskfree + Risk Premium on Investment Determine Riskfree Rate A) Developed, Mature Country 1. No default risk or uncertainty about reinvestment – US govt Zero-coupon bond, 10 years 2. Use same maturity as the CF being analyzed, generally longer maturity better 3. Issuer from same country as where CFs are derived, to prevent inflation risk B) Emerging Country  No default-free entity, Govt has default risk. + Returns=a+ βR M Returns=R f (1−β )+ βR M R ¿ ]  +ve means stock ¿ Jensen's Alpha=a−¿ outperformed its CAPM projections *Regression should be done against an index based on investor’s portfolio *Gradient R 2 β represents beta of stock represents the proportion of market risk. 1- R 2 of comparable firms and their mean D/E ratios βU . Adjust away cash, if it skews Enterprise Value. β EV(Correct forcash)= 3A) Find beta of individual division. a. Obtain industry averages of βU Cash 1− FirmValue is firm-specific risk. B) MV of Operating leases: PV of lease obligations and discounted at Pre-tax cost of debt. Adjusted EBIT = Reported EBIT + Int PMT. [Assume: prin. repayment = depre of leased asset] *Int PMT= Pre-tax cost of debt × Debt value (which is PV of lease payments) e. Use weighted average of Division EV + Cash to get Company βL Proportional Debt Policy: of each βU . . - Assumption: D/E is evenly distributed across all divisions Beta of a firm post-merger is Market-value Weighted Average of both companies, using unlevered betas. Then, lever up using post-transaction D/E. Bottom-up beta for financial institutions: Difficult to diferentiate operating and financing assets: cannot get unlevered beta Deutsche Bank – Split into commercial banking and investment banking, then use the average levered beta of comparable banks in both division Bottom-up beta for non-traded assets: Use public comparable firms to estimate of similar public firms + D/E ratios. Un-lever to get βU , then lever using actual D/E Private Firms: Adjust beta to reflect total risk rather than just market risk: BetaLevered Totalbeta= √ R2 *Take R2 (correlation of sector with market) of comparable publicly traded firms. Going public & business diversification  lowers the cost of equity DEBT: Commitment for future fixed payments; include lease obligations. Tax deductible. Cost of Debt: 1) YTM on outstanding LT, straight bonds 2) If firm is rated AA, use typical default spread on that rating 3) Use I/R on recent LT borrowing from bank. 4) If not rated, use Synthetic Rating. Use Int Cov Ratio to find Default Spread on table Interestcoverageratio= U L D Purpose: value of debt is proportional to unlevered firm value βL 3B) Use Net Assets of division as proxy for Weighted Average to get Company βL ( ) E D β =( β +( β E+D ) E+D ) D β L =β U + ( 1−T ) (β U −β D ) E division. βL *r = pre-tax Cost of Debt; n = Weighted Average Maturity of debt Add MV of Conversion Option to Equity, MV of straight debt to Debt, under Capital Structure. Non-investment grade Debt; below BBB considered Junk, considered risky debt. Has beta. Adjusted Hamada Equation: EV Sales d. Allocated debt / Estimated equity – D/E ratio for divisions. Lever to get 1) Find 1+r ¿n ¿ 1+r ¿n ¿ BVofdebt ¿+ ¿ 1 1− ¿ ¿ Est.MV of debt=PMT¿ MV of Conver.Option ( Eq ) =MVof Con of b. Division EV * Industry Average D/D+E = Proportion of debt for divisions. Express each division’s debt as % of total debt. Multiply with Total Actual debt = Allocated debt. c. Division EV – Allocated debt = Estimated Equity for each Division Lever up using firm’s D/E ratio to get Weights for WACC calculation Weights used in WACC computation should be Market values. A) MV of interest-bearing debt: C) MV of Convertible bonds EV Mktequity+Debt−Cash = Sales Revenues Division EV = Revenue of division * Real Discount Rate = (1+ Nominal Discount Rate / 1+ Inflation) -1 Regression Beta: CAPM: βL comparable firms. D) Survey approach  reflects hopes; not accurate Evaluation: A) Statistically-accurate, requires long time period. C) IERP is based on projections of g and dividends. More forward-looking. Assumes market pricing efficient. Regression equation: ( ) D β L =β U [1+ (1 −T ) ] E 2) De-lever to get industry B) Historical Premium Approach - Developing Countries 1. Obtain Indo Default Spread (shown earlier with 3 methods) 2. Adjust against Std Dev of Stock index and Std Dev of bond index Indo Country Risk Premium= Indo Default spread × (SD of stock index/SD of bond index) 3. COE in US terms = US Rf + [ BetaL ( US Equity RP + Indo RP ) ] Bondholders’ DEFENSE: Restrictive covenants on corporate decisions incorporated into lending agreement; Feature Bonds: Puttable bonds - protect from downside and sell at PAR value, Ratings sensitive bonds - compensate higher coupon for higher company risk profile Convertible bonds - Bondholders can convert to equity-holders to gain upside  high earnings variability  higher beta 3. Financial leverage: Higher interest payments  earnings volatility  higher beta 1) Find mean | + Longer time horizon, minimizes Std Error in estimate + Use Geometric Average to derive LT cost of equity (like CAGR) - Assumes no change in Risk aversion of investors, nor Riskiness of index - Emerging markets may not have enough data; or too short time horizon  high std error Test for Board Independence (Calpers Test) 1) Are majority of directors “outside directors”, not holding a position in company? 2) Is Board’s Chairman independent of company? (Benefits of CEO being chair  efficiency) 3) Are compensation and audit committees composed entirely of outsiders? (COI) Others: Qualifications/experience, Independence (no COI), Tenure Outcome: Boards are now smaller, ½ outsiders, with lead independent chairman; board compensated with stocks and options, not just cash. % Change∈ EBIT/% Change ∈revenues *Use Marginal TR, unless Tax Exp > EBIT. Effective TR = (EBIT/ Tax Exp * Marginal TR) Bottom-up beta: | Price today = Price begin (1+GA)n | MRP = GAIndex – GAT-bill | Std Error ¿ Lecture 3: Hurdle Rates Part II Determinants of Beta: 1. Nature of Business (Consumer Discret. – above 1; Utility – Below 1, less volatile than market) 2. Operating leverage: Fixed costs/Variable costs  nature of industry EBIT Interestexpens Diference between Synthetic and Actual ratings Actual: 1) considers more ratios and factors, like country risk; 2) Allow for sector-wide biases in ratings; 3) Reflect normalized earnings, not one-time high EBIT Debt Cost of Capital: YTM is return an investor will earn from holding bond to maturity If Default Risk low, YTM = Investor Expected Return; If Default Risk high, YTM overstates Investor Expected Return. Expected return of bond: rd = (1-p) YTM + p (YTM-L) P: probability of default; YTM = yield to maturity; L = expected loss rate (60%) Lecture 4: Measuring Investment Returns - Use “incremental” cash flows, not total. – Use incremental, not allocated. - Use Relevant Depreciation (Not Sunk Costs + Fixed Costs) to adjust EBIT(1-T) - WC = Current Assets – Current Liabilities FCFEquity =EBIT(1−T )+ Dep−Cape ¿ FCFFirm= EBIT ( 1−T ) +Dep−Capex ¿ FCFFirm= FCFE + Interestexpense ( 1 Net Debt Issued = (D/ D+E) * (Capex – Dep + ∆Noncash WC) Ending BV of Assets = Beginning BV – Depre + Capex Maintenance BV of Equity = BV of Assets + BV of Working Capital – BV of Debt In determining WACC for FOREIGN PROJECTS, consider: 1) Exchange rate risk - Adjust cost of capital for company’s investments in other markets. However if company has projects in a large number of countries, OR its investors are globally diversified, it may be diversifiable – ignore. 2) Political risk, esp in emerging markets. When calculating COE, using additional CRP. Measuring ROC of existing investments AftertaxROC= EBIT (1− ( BV of debt+BVofequ ReturnSpread = AftertaxROC−WACC EconomicValue Added=ReturnSpread TotalCapital=PreprojectInvestments+ If depreciation method is straight line, can just take the average of initial investment and the salvage value to compute average book value. AverageBV = Initialinvestment+Endin 2 Assuming purchasing power parity: $ Rinflation t ¿ dollarinf $R Expectedexchangerate t ( )=Exch dollar Net Present Value (NPV): Sum of present values of all cash flows from the project (including initial investment). Accept if NPV>0. Company will increase in value = NPV. Internal Rate of Return (IRR): The discount rate that sets the NPV=0. Percentage rate of return based upon incremental time-weighted cash flows. Accept if IRR>hurdle rate. Salvage value: Expected proceeds from selling all the investment in the project at the end of project life. Usually = BV of fixed assets + Working Capital Initial Investments: at time=0, Investment costs + Working Capital Terminal value: PV of all cash flows that occur after estimation period ends NPV=−8 m+ Average DebtMaturity= [( MaturityA∗M Finding the right financing mix Optimal debt ration minimizes the WACC of firm, maximizing firm value (NPV). 1) Cost of Capital Approach: Estimating Optimal WACC A. Calculate Cost of Equity for each D/E  afects levered beta B. Calculate Pretax Cost of Debt. Step 1) Use D/(D+E) × Market value of firm = $ Debt value Step 2) $ Debt x Estimated Rating’s Cost of debt = Interest Exp Step 3) EBIT / Int Exp = Interest Coverage Ratio Step 4) If Int Cov Ratio out of Synthetic Cost of Debt, use high COD. Do Step 2 again C. Calculate Cost of Capital = WACC. Firmvalue= FCF (1+g ) ∨FirmValue= WACC−g 2. Unlevered FV = Current MV of firm – Tax benefits of Debt + Expected Bankruptcy cost B). Estimate tax benefits (PV of all future tax savings) at diferent levels of debt.  PV of Taxbenefits=Dollar debt×taxra C) Estimate a probability of bankruptcy at each debt level. Multiply by cost of bankruptcy (including both direct and indirect) to estimate expected bankruptcy cost. FCFEbank = NI – Increase in Regulatory Capital or Book Equity Dividend matrix Cash surplus + poor projects – pressure to pay more dividends/do buybacks Cash surplus + good projects – flexibility in dividend policy Cash deficit + poor projects – cut dividends but real problem is investment policy Cash deficit + good projects – reduce cash payout Lecture 6 Supplementary 4) Relative analysis: Compare with industry average, based on determinants, like tax rates, stability of income and amt of intangible assets. Regress debt ratios on variables to determine debt ratios. Estimate variables under consideration. Plug into cross-sectional regression and estimate predicted debt ratio. Debtratio=a+ b ( Taxrate ) +c ( Earnings 1. Higher tax rates  Tax benefits; 2. Stable income  Lower bankruptcy costs 3. Insider ownership  Greater discipline 4. Intangible assets  Agency problems Evaluation: Best measure depends on objective of analysis –if want to issue lot of debt, choose highest optimal ratio. Method 1, 2 and 3 are absolute – solely determined by firm’s characteristics. Method 4 is RELATIVE – benchmarked to industry. 5 Types of Share Repurchases in US 1. Open-Market buyback: Buy at prevailing price 2. Fixed Tender price: Buy at fixed price, prorate if oversubscribe 3. Dutch auction: Firm declares # to buyback. S/H submit bids. Clearing price at last tendered 4. Targeted share repurchase: Buyback from certain shareholders 5. Transferable put right: For 5 shares owned, get 1 free put, sell stock to firm at exercise price 2 Share Repurchases in SG 1. Of-market: Equal access buyback scheme. Up to 10% total; can hold as treasury stock. 2. On-market purchase: Cap on price ≤5% average for last 5 days – reduce index volatility Reasons for Share Repurchase (Reduce E) 1. Tax – good for shareholders if dividends tax higher than capital gain 2. Signaling - signal undervaluation. 5% rule limits efectiveness in SG 3. Takeover defense: Mops up shares from holders wanting to sell 4. Earning mgmt: manage EPS (Earnings Yield> After Tax Cost Of Debt). 5. Executive Stock Options. 6. Distribute one-time gains Share Price Other measures to combat uncertainty in project analysis: - Payback period in years - Sensitivity analysis and what-if questions - Simulations – Incorporate probabilistic estimates Equity analysis Netincomeafterdebt payments BVequity , has to be larger than COE 4. Find new Firm Value with new WACC, to find the increase in firm value. Incremental approach NPV∗WACC =EAA 1− (1+WACC)−n FVnew−F Vold= F Vold(WACC old−WAC (WACC new−g) Limitations: 1) Static. EBIT is critical in analysis – if EBIT changes, optimal debt ratio changes. 2) As debt ratio and rating changes, indirect bankruptcy costs cause EBIT to be afected, not accounted for. 3) Beta and ratings – assumes how market risk and default risk get borne as firm borrows more money. 4) Only Int Cov used to estimate Cost of Debt, no qualitative factors 2) Enhanced Cost of Capital Approach: Indirect costs of bankruptcy built into Operating Income  Estimate drop in EBITDA for rating  Adjust interest coverage ratio  Recalculate cost of debt  Recalculate cost of capital. Seeks balance between low COC and high OI Lecture 5: Capital Structure Disadvantages: 1) Increase expected bankruptcy cost = Probability of going bankrupt × Cost of bankruptcy (Direct + Indirect); May trigger debt covenants, higher IR on notes. Value of firm afected. 2) Agency costs of asset substitution harming BH 3) Loss of future flexibility – When borrowing reaches capacity, unable to finance in the future.  Higher marginal tax rate, lower after-tax COD, should take on more debt EPS # shares repurchased After-tax Cost of Debt Earnings Yield (EPS/P0) $1.00 200,000 4% 5% Earnings before Buyback After-tax cost of funds $2,000,000 $160,000 [200k *$20*4%] Earnings After Buyback $1,840,000 # shares outstanding 1,800,000 EPS after buyback 1,840,000/ 1,800,000 = $1.02 High P/E firm buy Low P/E firm EPS increases also. No synergies. Other Distribution Methods: 1. Capital Reduction: Buyback and cancel the shares 2. Distribution in Specie: Distribute assets of company, like shares in subsidiaries 3. Stock Dividend Splits: Keep share price attractive Designing debt Maturity – Long if high Capex; long term projects; long equipment life; many intangible assets Currency – Mixed if CFs are mixed. Dollar if CFs in USD. Fixed/floating – Floating if company is mature/ has high pricing power. Can raise prices with inflation; manage greater uncertainty Straight/convertible – Convertible if cash flows are low now but high expected growth (Convertible bonds have lower coupon, more afordable in short-term) Lecture 6: Dividend Policy Dividends Dividendpayout= ∨Divide Net Income For banks: hard to estimate Interest Expenses. Focus on long-term debt to calculate interest coverage ratio, and use book value of equity capital. Debt capacity pegged to equity raised. Increase ∈ firmvalue Number of sharesoutstanding New stock price = Current price + Increase in value MM Hypothesis: Dividends don’t afect value. If a firm’s investment policies don’t change, the value of the firm should not change. If a firm pays more dividends, it may issue new equity to fund the same projects, or limit price appreciation. Investors are indiferent to dividends or capital gains, if tax on both is same. Dividends are “bad”: Tax on capital gains is paid when stock is sold - timed to match the fall in gains in other investments. Tax on dividends payable upon receipt (PV OF MONEY) If mgmt holds options  prefer buyback cos dividend cos price to fall B) Investors are irrational 1. Calculate increase in Firm Value 2. # of shares repurchased = Excess debt capacity/Repurchase price 3. # of outstanding shares = Total - # of shares repurchased 4) Increase in value per Remaining share = ∆Firm value – [(Repurchase– Original Price) x # shares repurchased]/ # remaining shares Assuming investor is indiferent btw selling before and after ex-dividend day: Determinants of the Optimal Debt Ratio: 1) Marginal tax rate –Higher the marginal TR, greater benefit of borrowing 2) Pre-tax CF return – Firms that have more Operating Income and CFs, relative to firm value, should have higher optimal debt ratios (due to greater ability to take on debt)  If tax is the same, Price should fall by Dividend price. K = efficiency of price change. Cashflow potential= Advantages of debt 1) Tax Shield – Interest expenses are tax-deductible, dividends are not 2) Added discipline –Mitigate agency costs for managers to undertake negative NPV projects, exercise prudence in investment decisions 2,000,000 - Repurchase price A) Investors are rational and want same share of firm value as those who sell, Increase in value per share = Comparing NPVs with unequal lives Use Equivalent Annuity Approach. 1. Calculate each project’s NPV over its lifetime 2. Compute each project’s EAA (N=years, I/Y=WACC%, PV=NPV, FV=0, Find PMT) 3. Select project with the higher EAA. $20 #shares outstanding Full valuation approach FCFF. CFA CFA CFB +…1.2. Estimate Calculate implied g in current market value (equity value + debt value). + + …+ 4 g=[ ( Firmvalue×WACCold )−FCFF]/( 1.10 1.13 1.2 Possible reasons for different NPV and IRR results: - Project can only have one NPV, but more than one IRR. - NPV likely to be larger for “large-scale” projects, which IRR% is higher for “small scale” - NPV assumes intermediate cash flows get reinvested at the “hurdle rate” - IRR assumes intermediate cash flows get reinvested at IRR% ROE=  Stable earnings, lower bankruptcy cost, can take on more debt  More accountability and transparency, can take on more debt  More uncertainty about future funding needs, should take on less debt  Firms with high info asymmetry issue more debt, avoid selling underpriced securities Calculate Debt Maturity [ Pbefore− Pafter ∗] k =D( 1−t ord income ) 1−t cg Why dividends good? 1. Clientele efect – Investors in low tax brackets and are older might prefer dividends  Lower tax on dividends + income stability 2. Dividends send a signal – If investing in new markets, continue paying dividends, invest in new markets, issue new stock to cover shortfall (don’t cut!) BUT for growth companies, it may signal co. is running out of good investment opportunities. 3. Wealth Appropriation: transfer wealth to stockholders EBITDA MV of equity+ MV Growth firms have lower CFs as % of firm value and lower optimal debt ratios. More intangible assets  more agency costs  lower optimal debt ratio. 3) Operating risk –Volatile OI, earnings variability, higher unlevered betas  higher COE. Lower bond ratings, higher default spread & COD  Lower optimal debt ratios 3) Adjusted Present Value Approach: Value of the firm = Value of the firm without debt + Efect of debt on firm value Taxbenefitsof debt−PV of Expectedba Firmvalue=Unleveredfirmvalue + P A) Estimate unlevered firm value. 1. Estimate unlevered beta, cost of equity and value the firm. Trends of Dividends: Cuts signify loss in business confidence; inability to maintain earnings. Dividends trail income potential As tax rate increase, cost of debt falls. Prefer to issue debt, buyback stock. Assessing Dividend Policy (Investors’ perspective): A) Cash/Trust Assessment; B) Peer Group Analysis How much avail: FCFE=¿+ Dep−Capex −∆ NoncashW How much paid out: Cash Payout = Dividends + Buyback How is their managers’ performance: ROC; Economic Value Added Did stock outperform: Jensen’s Alpha Capital Raising Alternatives for Private Companies: Angel Investors; Venture Capitalists; Private Equity; Institutional & Corporate Investors Benefits of IPO : Stockholders diversify; IPO is exit opp for VCs; Increase liquidity; Easier to raise capital in future; Establish firm value and brand recognition; ESOP is more efective Disadvantages: Legal, report & admin filings; Disclosure of operating data; Officers must disclose holdings; Small issues illiquid & not reflect true value; hard to manage investor rls Seasoned Equity Offerings (Raise E) 1) Seasoned Public Ofering – sale of securities by firm already listed 2) Private placement – sale of securities to limited no. of investors Adv: faster; new investors taking a monitor/ certification role; increase free-float & improve liquidity; mitigate info asymmetry problem Disadv: discounted price; ownership dilution for existing investors; cap on funds raised 3) Rights Issue – give shareholders right to buy new shares. Can exercise or sell right. Adv: large ofer size; no ownership dilution (major shareholders retain control) Disadv: slower; more regulatory requirements Rights Issue Example: 8 for 10 Rights ofer @ $1 per share Cum-rights share price: $1.43/ share Assume 100% subscription Current MV= 10 x $1.43 = $14.30 Total number of shares = 10 + 8 = 18 Amt of Funds = $14.30 + $8 = $22.30 New Share Price = $22.30 / 18 = $1.239 Value of Right = $1.239 - $1 = $0.239 - Scenario 1: Buy shares Before: 10 shares *$1.43 = $22.30 After: 18 shares x $1.239 = $22.30 Scenario 2: Sell right Before: 10 shares *$1.43 = $22.30 After: Total = $22.30 10 shares x $1.239 = $12.38 8 rights * $0.239 = $ 1.912 - Preference Shares (Preferred Stock) (Raise D) Adv: Dividends not contractual obligation and can be cumulative; avoids dilution of ordinary shares (control); avoid large repayment of principal. Disadv: not tax deductible; cost more than debt; increase fin lev Bond with Warrants: Bong + Long term right to purchase newly-issued stock (Raise D + E) - High info asymmetry  coupon rates high, covenants restrictive. Warrants can reduce coupon rate/ interest payments; Inject fresh funds for growth without negative signal of stock issuance; Reduce agency problem of asset substitution (transfer of wealth from BH to SH) Value of Total Package= Value of Bond + Value of Warrant Assume Warrant Value = $150 PV = $850; Y = 12%, N = 20, FV = $1000, PMT = 100, Coupon Rate = 10%, instead of 12% Convertible Securities: Bonds or Preference Sh that convert into Ordinary shares (Raise D / E) - Fixed rate bond + long term conversion option; share price depressed though. - Does not bring in additional funds, unlike warrants; replaces debt with equity on B/S Rationale: mitigate info asymmetry; agency prob of asset substitution (transfer value BH to SH) Exchangeable Bonds: Borrower issues debt, convertible to 3 rd party equity (Raise D, Reduce E ) Used as divestment mechanism, to offload stake in 3rd party without market impact; reduce coupon rate; seems attractive to 3rd party investors M&A Strategies Non-M&A. Organic growth, Partnering (alliances – buy each other’s shares to create vested interest, JV, franchising), Asset swaps, Financial & Operational restructuring. M&A. Mergers: StatutoryM  2 into 1; SubsidiaryM  1 becomes subsidiary of 1; Merger of Equal  50/50; HorizontalM 2 firms in same industry; VerticalM  forward/backward integration on value chain. Consolidation  2 dissolve into 1. Hostile takeover  not common in Asia as majority shares retained by controlling family. Scheme of Arrangement  Special resolution 75% to approve sale of shares. If resolution passed, 100% shares must be sold. Purchase premium: ofer price – pre-merger share price. Control premium: premium paid to gain controlling interest. Conglomerate discount: “Sum of Indiv segments – total FV”, due to info asymmetry in congl. Motivations for M&A (BUY) 1) Strategic realignment  concentration, diversification, defensive tactics, avoid startup risk 2) Synergies: Cost Savings –EOS, shared resources, eliminate roles; Revenue enhancement – Cross-sell, distribution channels; Process improvement – transfer of best practices/ core competencies; Financial – acquire cash-cow to stabilize volatility, can take on more debt together; Tax – Transfer profits to lower tax arm; move domicile 3) Expansion into new product/ geography; acquisition of expertise, R&D, licenses & patents 4) Financial gains: Target undervalued coys, with easy, cheap credit with falling I/R M&A Failure Reasons:1) Overpay due to overestimation of synergy, synergies are often hard to materialise, difficult to estimate and take a while to yield results  impoverish existing S/H; 2) org cultural diferences  Slow, poor integration and failure to reap synergies; 3) Poor strategies. Fail to manage acquisition process; 4) Poor due diligence; 5) Government regulations – Anti-trust prevents MnA from going through Solution: Organisational discipline to evaluate MnA and walk away when necessary Valuation Methods 1. Discounted FCF: WACC 1+¿ ¿ ¿3 ¿ FCFF3 ¿ 1+WACC¿2 ¿ FCFF2 FCFF1 + FV= ¿ 1+WACC +  termi val. Dividend discount model: firm value = PV of expected future dividends 2. Trading/ Transaction Multiples. Fin metrics: EV/sales; EV/EBITDA; EV/EBIT; P/E; P/B. Move from sales to earnings, incorporate efects of capital and operating efficiency; but also subject to accounting distortions. Non-fin metrics: EV/Subscribers. Comparable Firm Selection: Industry (proxy for asset risk); Firm size (proxy for risk factors, EOS, earnings potential); Fin leverage (proxy for financial risk) *Trade of betwn comparability & stat accuracy. Other factors: Friendly vs hostile acquisition; Completed vs withdrawn deals; Timing Issues with Valuation by Multiples 1) Cannot find comparable firm; 2) No rules on how to adjust for diferences in expected future growth or diference in accounting policies. 3) Entire industry may be overvalued – Multiples rate value relative to other firms Method of payment Stock: Acquirer 1) high investment opportunities, rather use cash for projects; 2) S/H share risk of overpayment with Target S/H  stock price falls after acquisition, compared to write-of on books; 3) Shares overvalued now Target 4) want retain control. 5) High confidence in Acquirer. Cash: Acquirer 1) Avoid control dilution; 2) Cash-rich; don’t want return to S/H; 3) Faster & less resistance; 4) Tax & transaction costs Target: 5) cash is reason for sale Equity Restructuring : Spin-off (distribution in specie) and Carve-outs (SELL) Spin-of: pro-rata distribution of subsidiary’s shares to parent’s existing S/H. *no cash is raised Carve-out: IPO of subsidiary = Equity ofering of subsi+ Divestment by parent *cash is raised. Parent maintains majority interest in subsidiary. Must be big enough. Sources of Value in Equity Restructuring (SELL) 1) Reduction of info asymmetry: greater transparency + increase analysts following 2) Better alignment of compensation of management with performance (less agency costs); 3) Eliminate inefficiency & cross-subsidies between divisions (-ve synergies & conglo discount); 4) Disciplining efects: increased probability of takeover due to smaller market cap. 5) Able to do business with competitors (Paypal with Amazon) & be acquired by rivals 6) Focus on core business; or sell to people who can realise value 7) Flexibility to assign debt/ cash away (Bufet Duracell) reinvestmentrate= capex−dep.+WCch EBIT(1−T ) Premises of Corporate strategy - Competition occurs at the business unit level - Diversification inevitably adds costs constraints to business units - Shareholders can diversify themselves more cheaply, as they avoid acquisition premium. 3 Conditions for Diversification to create shareholder value: 1) Attractiveness test: Chosen industry is structurally attractive (Use Porter’s Five Force – Barriers to Entry; Supplier & Buyer Power; Substitutes; Competition) 2) Cost-of-entry: Must not capitalize all future profits (Returns>COC) 3) Better-off: Significant synergies or comparative advantage to be gleaned (diversify risk CMI) 1. Portfolio management – Diversification through acquisition. Corporations acquire sound, attractive companies with competent managers who agree to stay on; Spot attractive acquisition candidates which the individual shareholder cannot; Provide capital on favourable terms indicating fund-raising capability; Introduce professional management skills and discipline; High quality review and coaching - Superior insight in identifying and acquiring undervalued companies, willingness to sell losers quickly or to divest good performers if buyers are willing to pay large premiums. Guidelines and constraints for senior management to perform review. Access private companies or underdeveloped capital markets. Ability to shift away from portfolio management once capital markets develop or company gets unwieldy. - Autonomous business units, a very small, low cost corporate staf, incentives based largely on business unit results - Benefits less relevant, given today’s developed capital markets. Common failure to consider 3 tests in acquisitions, only cost of entry. May have high capex and WC costs. 2. Restructuring – Seek out un-developed, sick or threatened organizations or industries on the threshold of significant change. - Superior insight into identifying restructuring opportunities , willingness and capability to intervene to transform acquired units, broad similarities among the units in the portfolio, willingness to cut losses and sell units - Autonomous business units, talent and resources to oversee the turnarounds and strategic repositioning of acquired units, incentives based on acquired units results - Mistaking rapid growth as sufficient evidence for restructuring, lacking the resolve or resources to take on restructuring, ignoring fact that industry structure is not attractive 3. Transfer of skills and knowledge and sharing activities (synergies & best practices) - Identified through the value chain, that each business unit is a collection of discrete activities (Primary and support), transfer of skills among similar value chains creates synergies. Activities have to be similar enough and must create sufficient competitive advantage - Proprietary skills in activities important to competitive advantage in target industries, ability to accomplish the transfer of skills among units on an ongoing basis, acquisitions of beachhead positions in new industries as a base - Largely autonomous but collaborative business units, high-level corporate staf members who see their role primarily as integrators, strategic groups that serve as a focal points for capturing and transferring skills, incentives based in part on corporate results - Mistaking similarity or comfort with new businesses as sufficient basis for diversification, providing no practical ways for skills transfer to occur, ignoring the fact that the industry structure is not attractive Calculating synergy value (BUY) 1. Cost savings – Eliminating jobs, facilities and related expenses when functions are consolidated, attaining economies of scale Problems: Definitions of cost categories vary from company to company, costs are incurred in diferent places depending on the structure of the company, human talent not easily eliminated. 2. Revenue enhancements – Higher level of sales growth from: - Superior/complementary products being brought to more extensive distribution channels (Cross-selling) and larger customer audiences - Distribution channels used to escalate sales - Build sufficient critical mass to attract revenue 3. Process enhancements – Managers transfer best practices and core competencies from one company to another resulting in both cost and revenue enhancements 4. Financial engineering – Economic benefits leaned from pooling working capital finance requirements, surplus cash as well as netting currency positions, refinancing of debt position with better credit profile after acquisition 5. Tax synergies Portfolio restructuring –Change in mix of assets/ lines of business owned by the firm: liquidations, divestitures, asset sales and spin-ofs Rationale – 1) Increase focus; 2) Buyers can manage division better and generate greater value for buyer, and sale price for seller Financial restructuring – Change capital structure of Company: LBOs (borrow on target’s assets), leveraged recapitalisations (borrow to buy-back shares) and Debt for Equity swaps Rationale – 1) Debt Shield: Corporate debt adds value to the firm in the form of a capitalized value of the tax shield on interest. Maximise firm value with lower WACC; 2) Improve operation efficiency with lower Int Exp; 3) Wealth transfer from BH to SH; 4) Free cashflow hypothesis - Reduce agency cost of investing in negative NPV projects Olam – Immediate repayment of debt by asset sale. Lower gearing. Sale and lease back  Lease rent lower than IR on debt. Nestle – Asset swap instead of market divestiture. HP – carve-out due to lack of synergies. No revenue-enhancement at all. Non-voting shares (Google) Pros: Purely for capital appreciation + dividends. Puts choices in hands of the intelligent  wont waste proxy votes. Owners retain control. Cons: concentration of power, pricing valuation difficulties  what is the value of a vote. Relationship between Price/Earnings Ratio and Capital Structure P MarketCap StockPri ratio= = E Earningsafter Tax Earni As Capital Structure has High %Debt  Lower %Equity. Assume same FV; Market Cap lower, P/E ratio lower. First principles 1) investment: return > hurdle rate 2) Financing: optimal mix of DE, debt design match tenure and currency 3) Dividend: how much & how to return cash Three key assumptions when calculating new COC: 1. Operating income remains unchanged as the debt ratio changes 2. All existing debt is refinanced at the new cost of debt 3. Debt is used to buy back stock rather than invest in projects