Financial Accounting 1. Generally Accepted Accounting Principles (created by acc. industry NOT gov; discretionary) a. Historical Cost Principle 1. Report assets at their historical cost (price originally paid) (NOT FMV) 1. e.g., buy land for $1M & land worth $2M now—must continue to record historical value ($1M) on the accounting statements 2. Exceptions a. Inventories (products not sold but already made) 1. Accounting statement value @ FMV minus cost of production 2. Use the lower of market value or historical cost b. Marketable Securities (stocks)—valued @ market value b. Reliability Principle 1. Must be able to verify numbers on accounting statement through research/doc prep 2. BUT not to the extent that you waste money trying to value things of very small value c. Economic Entity 1. Must consolidate the results of the entire business operations into accounting statements 2. e.g., Parent with Subsidiaries—subsidiaries revenue & business operations will be included on Parent’s accounting statements (if subsidiaries are effectively part of parent) d. Matching Income & Expenses in Accounting Period (accrual) 1. Income is recorded when the business has a legal right to it 2. Business must record expense when it is legally obligated to pay the money 3. Cash Accounting is an alternative, but we focus on accrual in this class e. Transparency of Methods 1. Must be clear what choices the accountant made and what methods were used to construct the accounting statements – clarify this in the footnotes 2. e.g., you sell 100% of your products but then 80% are returned 1. Must clarify in a footnote that some products were returned f. Consistency of Methods 1. Use same accounting methods as your industry and year to year so you can compare your current business to your previous business and competitors g. Going Concern Assumption 1. Accountant will insert assumption that the business is going to keep operating 2. This is standard practice h. Conservatism Principle 1. Understate asset values – only record when they gains are certain 2. Overstate liabilities – record if probable II. Financial Reports Balance Sheet Equity = Assets – Liabilities 1. Double Recording: Any txn results in an entry on both sides of the balance sheet (increase or decrease) 2. Assets a. Traditional Def: a probable future economic benefit owned or controlled by the business that is obtained in a transaction to which accountants can attach a price 1. i.e., firm must have legal title / clear right to use asset AND asset must be expected to possess future benefits that can be measured 1. e.g., lulu uses $1M to buy yoga pants = asset (future benefit if sold) 2. e.g., spends $1M on a massive end of year party ≠ asset (no future benefit) b. Current Assets • Assets expected to sell within a year (listed in order of liquidity so cash is always on top) 1. Cash 2. Receivables 1. Record at Sale Cost 2. Net of Doubtful Accounts a. Subtract accounts when it is doubtful company will actually get paid 3. Ex: Lulu sells clothing to a retailer on credit 3. Inventory 1. Record at FMV minus cost of production a. Unless FMV drops below cost of production → then you record at FMV 2. Ex: all clothing Lulu has sitting in warehouse that they expect to sell within year 4. Prepaid and Receivables Income Taxes 1. Reconciles the differences between business and tax accounting c. Other Assets (aka Capital Assets) • Assets not expected to turn into cash within the year 1. Property, Plant, Equipment 1. Record at Book Value – historical cost principle 2. “PPE Net” means depreciation has been taken out 2. Intangible Assets 1. Ex: patent, trademark, goodwill 2. Record on accounting statement only if you bought it a. Ex: If you created the IP then it is worth $0 on the balance sheet 3. Goodwill a. Record @ price you purchased business for minus FMV of business’ assets 1. Only goodwill on balance sheet is good will from acquisition b. Ex: If Coke buys Pepsi, they can include Pepsi’s goodwill 1. BUT Coke can’t include Coke’s goodwill c. Don’t depreciate unless there’s a decline in goodwill of assets – disclose in footnote 3. Liabilities a. An obligation to provide economic benefits to a third party in the future b. When is a Liability Recorded? – 3 Requirements 1. Future obligation is probable 2. Amount of obligation is known or can be reasonably estimated 3. The transaction or event causing the obligation has already occurred c. Current Liabilities 1. Expenses that become due within the year 1. Current maturities of long term debt 2. Accounts Payable 1. Ex: Company purchases supplies or equipment on credit 2. Ex: unredeemed gift cards d. Loans 1. Part of it will be a current liability - interest payment 2. Other part will be a long-term liability - principal payment e. Contingent Liabilities 1. Left off balance sheet because not sure if the liability will actually exist 1. Description included in the footnotes 4. Stockholder Equity a. Formula: Stated Capital + Capital Surplus + Retained Earnings 1. Records what book value is left after creditors are paid 2. If company has preferred stock, it will be listed first b. Stated Capital 1. Money earned from selling shares @ par value c. Capital Surplus 1. Money earned from selling shares that is in excess of par value d. Ex: Par is $1; 10 Shares sold for $3 1. Stated Capital = $10 2. Capital Surplus = $20 e. Retained Earnings 1. Formula: Profits Earned minus Dividends Paid Out minus accumulated losses 5. How is the Balance Sheet Used in Litigation? a. Bolt v. Merrimack Pharm. Inc: Issue: was the co’s net worth over $__? 1. Should the mezzanine investment be included as a liability or equity? 2. Angel Investors: people who invest after friends & family; usually invest only up to $2 mil; a larger investment would be a VC company 3. Mezzanine Investment: Somewhere between a liability and stock 4. Preferred stock (Mez Inv) is NOT a liability under GAAP – counted as common stock II. Financial Reports Income Statement (matching principle is key) 1. Net Revenue a. “Net” accounts for the fact that there might be returns i. Footnotes will clarify how the company is estimating or measuring returns b. Potential Scam: book company makes it seem like they are selling a huge number of books by shipping them all to stores even though the company doesn’t know if they will sell i. Company will have to disclose in footnotes that the books are sold yet 2. Cost of Goods Sold a. Include the direct costs that go into making the product – material and labor costs i. Overhead NOT included b. General Rule: make this year’s taxes lower > defer costs > invest the money > collect interest c. Potential Manipulation i. inflate to make company seem less profitable (less taxes) ii. understate so company looks more profitable (execs want to have a big company b/c they are selfish; CEO might have stock options) 3. How to Manipulate Cost of Goods Sold a. Inventory Accounting i. First In, First Out (FIFO) 1. Assumes the oldest products were sold 2. Makes company look good – higher profit ii. Last In, First Out (LIFO) 1. Assumes most recent products were sold 2. Makes company look bad = lower taxes b. Depreciation i. Listed as an expense ii. Manipulated by useful life & depreciation method 1. Footnotes disclose useful life and method chosen iii. Different Useful Life 1. Shorter useful life has a larger impact on profits b/c you take a larger expense for the depreciation each year 2. Ex: $100 asset a. 5/yr life = $20 depreciation/yr – 10/yr life = $10 depreciation/yr iv. Straight Line Depreciation 1. amount depreciated = useful life/total cost v. Accelerate Depreciation – 2 Methods: a. Use these if you want more depreciation in the early years 2. Sum of Digits Methods – more depreciation in early years = larger impact on profits a. Add up digits of useful life (10 yrs – 1+2+3...+10 = 55) then divide by year, decreasing by 1 each year (Y1: 55/10 = 18.1% is depreciated) 3. Double Declining Balance Depreciation – less depreciation in early years than SoD but more than straight line 4. Gross Profits a. Net Revenue minus Cost of Goods Sold 5. Overhead Costs a. Expenses that do not relate to the production of the firm’s goods or services but must still be incurred for the company to do business b. Selling, General and Administrative i. Includes: rent, salaries, advertising c. Research and Development d. Other Expense i. Depreciation expense is listed here 6. Operating Income a. Gross profits minus overhead costs^ b. “Other Income/Expenses” are those that are unusual and aren’t expected to be repeated i. Ex: Company sells off a business segment 7. EBIT a. Tells you profits before interest payments & taxes i. Allows you to see how a company is doing regardless of their capital structure 8. EBITDA a. Earnings Before Interest, Taxes, Depreciation and Amortization b. Removes any manipulation by depreciation 9. Net Income a. Shows you how well the stockholders are doing b. Earnings Per Share (EPS) i. EPS (Basic) 1. Formula: Net Income/Shares Outstanding ii. EPS (Diluted) 1. Assumes all the people with options will exercise them 2. Increase shares outstanding by the # of option contracts there are iii. If basic and diluted are similar, then there are not many options outstanding 10. Hypo – Movie Star a. Compensation was tied to net revenue but then movie company inflated expenses, so they had to pay him less b. He should have tied his compensation to gross revenue b/c it is harder to manipulate this number 11. Alayian v. Insightful Corp a. Facts: employee went to his boss b/c corp was improperly accelerating revenue that wasn’t actually gained yet; boss fired him b. Was the discharge wrongful b/c it violated a clearly articulated public policy? i. No – companies have leeway to decide how they keep their accounting records c. Law: Rule10(b)(5) – company is liable if P can show i. Scienter, Reliance, Loss Causation, Damages d. SHEP thought this should have come out differently 12. IMAX Securities Litigation a. Issue: did IMAX improperly accelerate the recognition of revenue? b. Law: SEC Staff Accounting Bulletin No. 101: revenue should not be recognized until it is “realized or realizable and earned,” or, in other words, when: i. Persuasive evidence of an arrangement exists ii. Delivery has occurred or services have been rendered 1. Delivery occurs when the seller has “substantially completed or fulfilled the terms specified in the arrangement.” iii. The seller’s price to the buyer is fixed or determinable; and iv. Collectability is reasonably assured c. Takeaway: Executives can escape liability by claiming they relied on the financial statements i. Exception: If the accounting entries are so obviously wrong that the execs should have known, then courts may find them liable II. Financial Reports Statement of Cash Flows - Shows how a company’s cash position changed during the accounting period - Other statements won’t reflect when you switch one asset out for another so that’s why you need this statement - Broken down into Three Sections: Operating, Investing, and Financing Activities 1. Cash Flows from Operating Activities a. Net Income i. Compare with Change in Cash Flow 1. If they are similar = good sign 2. Not similar = red flag, company might have had to make a large expense b. Depreciation/Amortization i. Added back into the cash flow statement since these expenses were not actually paid in the accounting period c. Other Adjustments i. Stock based compensation to executives – no cash flowed so must be added back in on this statement d. Changes in Operating Assets and Liabilities i. Inventory 1. Subtract the amount you paid for the inventories – ( ) mean it is subtracted ii. Assets 1. If you sell assets, included in “other assets” 2. Ex: sold stock for cash - so cash increases iii. Liabilities 1. An increase in liabilities means you have more cash 2. Ex: you take out a loan 2. Cash Flows from Investing Activities a. Purchase of Property and Equipment i. Generally used as a proxy for Capital Expenditure ii. Ex: purchase a new plant or truck b. Other Investing Activities i. Cash used for investments 3. Cash Flows from Financing Activities a. Repurchase Common Stock i. If positive, then company sold stock ii. If negative, then the company repurchased stock b. Net Borrowing c. Other Financing Activities i. If they borrowed money for the financing activities Statement of Changes in Stockholder Equity 1. Formula a. Change in Stockholder Equity = Net Income minus Dividends paid plus Funds raised by selling stock minus Funds expended to repurchase shares 2. Total Stockholder Equity: a. Contributed Capital b. + Retained Earnings c. + Other Stockholders Equity d. This is your starting figure – total --> Financial Ratios 1. Gross Margin πΊπππ π ππππππ‘ (ππππππ) a. πΊπππ π ππππππ‘ πππππππ‘πππ = π ππ£πππ’π i. Shows how expensive it is for the firm to make or source its products or services ii. Used for… 1. Same Firm Performance – compare GP% from previous years 2. Competing Firm Performance – compare GP% of competitors a. Often shows if the business environment was worse/better than others iii. Can compare across industries with different capital structures (interest not included in the caluclation) b. ππππππ‘ ππππππ = πππ‘ πΌπππππ πππππ (πππ‘ π ππ£πππ’π) i. What percentage of every sale ends up as profit? ii. Differs from GP% b/c PM includes other sales and overhead costs iii. Cannot compare profit margins across industries as accurate indicator b/c they could be selling a lot or few products (ex: grocery stores vs. pianos) 1. Sometimes it’s better to invest in co with low gross margin than high gross margin 2. Selling low volume at high markup (high gross margin); or high volume with low markup (low gross margin) iv. Can’t compare profit margins across companies with different capital structures (e.g., raised money via debt vs. stock) (cost to issuing more stock; ownership is diluted but NOT reflected in profits) (whereas DEBT makes profits / profit margin look lower because of interest). 2. Return on Investment a. πΈπππππππ πππ πβπππ (πΈππ) = πππ‘ πΌπππππ π΄ππ‘ππ πππππππππ π·ππ£ππππππ ππππβπ‘ππ π΄π£πππππ ππ’π‘π π‘ππππππ πβππππ π·π’ππππ π‘βπ ππππππ i. Shows earnings available to stockholders after paying interest on debt, taxes & dividends on preferred stock ii. Weighted Avg = the avg. # of shares @ beginning and end of accounting period iii. Can compare across industries (SHs care about how much they get) iv. If earnings per share increase this year → tends to indicate they will increase next year 1. Example: Company A EPS = 5 Company B EPS = 10 2. People would be willing to pay double the amount for Company B than A v. Issues with EPS: Can be frauded; must be cautious b. π ππ‘π’ππ ππ πΈππ’ππ‘π¦ (π ππΈ) = πππ‘ πΌπππππ π΄π£πππππ ππ‘πππβππππππ ′ πΈππ’ππ‘π¦ i. Avg. St Eq = add beginning & ending equity balances and divided by 2 ii. Equity changes from year to year—usually take average from last year to this year c. Return on Sales d. Return on Assets 3. Protection for Creditors a. π·πππ‘ π‘π πππ‘ππ π΄π π ππ‘π π ππ‘ππ (π·πππ‘ π ππ‘ππ) = πππ‘ππ πΏπππππππ‘πππ πππ‘ππ π΄π π ππ‘π i. Higher ratio, greater burden of interest & debt repayments ii. Assets = book value of assets, not FMV iii. Leveraged = debt financed (HIGHER RISKS) 1. Higher gains from borrowing money (vs. raising money by selling stocks—dilutes value); leverage magnifies the gains & losses (that = risk) 2. Gains are better with debt financing 3. Losses are better with equity financing 4. Lenders concerned about how leveraged the company is b. π·πππ‘ π‘π πΈππ’ππ‘π¦ π ππ‘ππ (π·πΈπ ) = πππ‘ππ πΏπππππππ‘πππ πππ‘ππ πΈππ’ππ‘π¦ i. Shows leverage of firm but most people prefer Debt Ratio instead ii. If more than 50% of capital is raised via debt, DER will be greater than 1 c. πΆπ’πππππ‘ π ππ‘ππ (πππππππ πΆππππ‘ππ) = πππ‘ππ πΆπ’πππππ‘ π΄π π ππ‘π πππ‘ππ πΆπ’πππππ‘ πΏπππππππ‘πππ i. Higher ratio, greater cushion b/t current obligations & firm’s ability to pay them ii. Current assets are assets reasonably expected to be converted into cash within the current accounting cycle d. πππππ πΌππ‘ππππ π‘ πΈπππππ (πΌππ‘ππππ π‘ πΆππ£πππππ) π ππ‘ππ = πΈπ΅πΌπ π΄πππ’ππ πΌππ‘ππππ π‘ πΈπ₯ππππ π i. Higher ratio = good; Lower ratio = could trigger default ii. Measures extent to which interest obligations can be covered from EBIT iii. Common ratio for creditor protection in a loan agreement 4. GAAP v. Non-GAAP Financial Measures a. EBIT i. Shows what amount is available to pay the primary claimants on a company’s profits, who generally consist of investors & the gov’t ii. BUT doesn’t show actual income b/c EBIT reflects non-cash expenses (depreciation & amortization) b. EBITDA i. Assumes your PPE doesn’t wear out b/c doesn’t included deprecation but Free Cash Flow fixes that by subtracting out capital expenditures c. Free Cash Flow i. FCF = EBITDA – capital expenditures ii. EBITDA and EBIT assumes that assets do not deteriorate 1. Investors understand that while depreciation reflects past expenditures, there needs to be money set aside for improvements/replacements 2. So FCF subtracts out this amount as “capital expenditures” a. Best way to determine how much assets have deteriorated is by looking at how much you expensed to repair/maintain – which is probably close to your capital expenditure figure Valuing Firm Output value of an asset = how much money it can produce 1. How to Determine Value a. What is the stream of income? When is it paid? b. How much are people willing to pay for the stream of income? c. This will tell you… i. What sum do I need today to reach the future stream? 2. Future Values & Interest a. Simple Interest i. Original investment is used as a benchmark for determining how much to pay in interest b. Compounding Interest i. Benchmark changes over time so the bank has to pay interest on the interest ii. Could be annual or quarterly 3. Calculating Future Value i. How much money will we have at a future date if you invest a certain sum today? b. Annual Compounding Return i. πΉπ = ππ(1 + π)(π‘) 1. Shep writes this as: A=S/(1+r)^n c. Non-Annual Compounding Return π i. πΉπ = ππ(1 + π)(π‘×π) ii. n = number of times that an investment is compounded in a year d. Continuously Compounding Return (e = Euler’s constant ~ 2.718) i. πΉπ = πππ ππ‘ 4. Calculating Present Value i. How much money do we need today to reach a certain sum in the future? b. Formula π i. ππ = (1+π)π c. General Rules i. The longer in the future until you receive the payment, the lower the PV ii. The higher the interest rate, the lower the PV iii. If interest rates (r) decrease, PV increases 5. Valuing Bonds, Annuities (interest payment), and Perpetuities a. Valuing Bond π i. ππ = (1+π)π b. PV of Annuity i. A fixed payment to be received for a set number of years ii. PV = Annual Payment r − Annual Payment r(1+r)n c. Valuing a Bond with Interest i. Must separately calculate the PV of Interest Payments (annuity) and of Principal Payment (bond) 1. See slides for how to calculate – use the charts d. Perpetuity i. An annuity that goes on forever – you get a set payment indefinitely 1. Ex: stock, savings account (pays interest), house (provides value as long as you own it) ii. Formula πππ¦ππππ‘ (π) 1. ππ ππ π ππππππ‘π’ππ‘π¦ = π·ππ πππ’ππ‘ π ππ‘π (π) 6. Valuing Common Stock a. Dividend Discount Model (DDM) i. Assumes the value of a share of stock is simply the sum of all expected future dividends discounted to the present value 1. π·ππ£πππππ π·ππ πππ’ππ‘ πππππ = πΈπππππππ πππ πβπππ π·ππ πππ’ππ‘ π ππ‘π (π) b. Gordon Growth Model (GGM) i. Same as DDM but assumes the dividend will grow annually at a particular rate πΌπππ‘πππ πππ¦ππππ‘ (π) ii. ππ ππ π πΊπππ€πππ ππππππ‘π’ππ‘π¦ = π·ππ πππ’ππ‘ π ππ‘π (π)−πΊπππ€π‘β π ππ‘π (π) iii. Exception: formula doesn’t work if the growth rate is greater than the discount rate c. Example: earnings = $2, r =.2 i. DDM = $2/.20 = $10 ii. GGM = $2.06/ .20 – .03 $2.06/.17 = $12.12 7. Valuing a Perpetuity with Initial Growth a. Calculate the PV of the initial payments that assume growth b. Then use the final payment in the perpetuity formula with the discount since it is in a future year c. Add these together 8. Valuing Projects a. Net Present Value 1. πππ = ππ ππ πΉπ’πππ π‘π ππ π πππππ£ππ − ππ ππ πΉπ’πππ πΌππ£ππ π‘ππ ii. Basic Rule 1. Do all projects with net positive present value even if you have to borrow money to do it iii. Cost of Capital (capital budgeting for firm) is the same as the Discount Rate (stock investors) 1. Rate of return the investors expect 2. Risk of the investment opportunity b. Inferior Valuation Methods i. Internal Rate of Return 1. Return / Investment 2. Faulty Idea: invest where IRR is greater than cost of capital ii. Payback Period 1. Look @ how long it would take to pay back the project 2. Bad b/c it doesn’t use (1) discount rate and (2) rejects projects that have large, late payoffs Discount Rates aka Cost of Capital 9. Basic Principles a. Discount rates compensate investors for the amount of worry and wait associated with an investment b. Investor’s demand a default premium to compensate for risk and a time premium in risk-free markets b/c of inflation c. Inflation & Interest i. If a company has debt with interest rate of 4% and inflation is 3% what is the cost of capital? 1. 1% because inventory will be 3% more valuable when it has to pay the 4% d. Theory of Insurance i. House costs $10,000,000 and there is a .01% chance it burns down 1. Expected value of loss each year is 1k 2. You will pay more than 1k/yr for insurance to eliminate this risk e. Risk Aversion i. creates incentives to diversify investments ii. causes discount rates to include compensation for non-diversifiable risk 10. Calculating Variance i. Variance is the avg. deviation from the mean squared 1. Shows the amount of risk in an investment b. Step 1: Find all possible outcomes i. $0, 50, 100, 150, 200 c. Step 2: Multiply each outcome by its probability of occurring i. This gives the product aka weighted outcome ii. Firm A: $0, 5, 80, 15 iii. Firm B: $0, 10, 40, 30, 20 d. Step 3: Add product/weighted outcomes together to get expected outcome (total product) i. $100 for both firms ii. If the expected outcome is greater than not taking the wager = take the wager e. Step 4: Find (the average deviation from the mean)2 for each outcome (slides below) i. Mean: $100 1. Outcome: 50 2. Deviation -50 a. Squared: 2,500 f. Step 5: Multiply deviation sq by probability i. 2500 x .1 = 250 g. Step 6: Add up all outcomes from probability times deviation squared to get the Variance i. Firm A: 500, Firm B: 3,000 h. Step 7: see slide on right Take square root of variance to get the Standard Deviation 1. Larger = outcomes are less certain, more risk 11. Diversification a. If the returns are uncorrelated, unique risk can be eliminated i. Regardless of the weather, you get $.25 if you own two shares or $.125 if you own one share b. Market risk cannot be eliminated through diversification c. Beta i. Determines the cost of capital b/c it reflects the undiversifiable risk in the company ii. Show how sensitive a stock’s returns are to general market movements 1. Beta of 1 means the company moves the same as the market a. Don’t need to know how to calculate, just look it up 2. Higher Beta – stock is very sensitive to market movements a. Ex: airlines – strength of economy can impact how often people fly 3. Low Beta Examples a. Fast food – people will always eat it b. Funeral home – ppl always die c. Biotech – ppl pay for treatment regardless (.5) 12. Determining Discount Rates a. Discount Rate for Debt i. πΆππ π‘ ππ π·πππ‘ = ππππ ππππππ’π + π·ππππ’ππ‘ ππππππ’π + πππ − π·ππ£πππ πππππππ π ππ π ππππππ’π b. Discount Rate for Equity i. Could appear in one of two ways: 1. πΆππ π‘ ππ πΈππ’ππ‘π¦ = ππππ ππππππ’π + πππ − π·ππ£πππ πππππππ π ππ π ππππππ’π 2. πΆππ π‘ ππ πΈππ’ππ‘π¦ = ππππ ππππππ’π + ππππππ‘ ππππππ’π ii. What is the Non-Diversifiable Risk aka Market Premium? 1. ππππππ‘ ππππππ’π = π΅ππ‘π π₯ πΈππ’ππ‘π¦ ππππππ’π a. Equity premium is determined by looking at “Returns to Asset Classes” chart i. What kind of equity is it? Short term? Long term? 13. Capital Asset Pricing Model (CAPM) a. Helps us figure out the relationship between a company’s beta and its cost of capital b. If you know the beta, you can figure out the company’s equity CoC by looking at the Capital Market Line c. Formula – πΆππ π‘ ππ πΈππ’ππ‘π¦ = ππππ ππππππ’π + π ππ π ππππππ’π i. Time Premium is aka Risk Free Rate (4%) ii. Risk Premium = equity premium (6%) x beta d. Levered Betas i. The more leveraged the company is, the higher the beta b/c there is more risk 1. Company with higher systematic risk and beta will have lower stock price compared to a company with similar earnings but with lower risk ii. Unlevered Beta shows how risky the company is without the leverage 1. πππππ£ππππ π½ = πΏππ£ππππ π½ ÷ [1 + (1 – π‘ππ₯ πππ‘π)(ππππ‘/πππ’ππ‘π¦)] a. π½ is Beta e. Limitations of CAPM i. CAPM underestimates the returns on small company and value stocks 1. Value stock = stocks with high book to market ratios ii. The Explanations for Limitations 1. The market is inefficient in pricing securities according to beta, or 2. CAPM does not accurately predict a security’s future returns 14. Factor Models a. Arbitrage Pricing Theory (APT) i. A security’s expected returns depend on the security’s exposure to specific macroeconomic factors that represent non-diversifiable risk ii. Differs from CAPM b/c it does not assume a theoretical set of non-diversifiable factors 1. Instead, the data tells us what factors to look at b. Fama & French Three Factor Model i. Looks at size of firm and firms with higher book to market ratios rather than beta because the former were better indicators of avg returns on the stock c. Momentum Anomaly i. Stocks with positive returns in the past 12 months tend to have positive current returns ii. Momentum factor was added to F&F Factor Model d. Limitation of Factor Models i. Models are only as reliable as the empirical findings that support them 1. Sometimes the empirical findings disappear ii. New factor model is the result of data mining b/c factors are added in without a reason why iii. Assumption on Market Efficiency 1. Assumes model accurately prices stocks, can evaluate risk profile of each security, and can estimate future cash flows 15. Industry Models i. Not really accepted approaches b/c they contradict a lot of financial literature b. Build Up Method i. π ππ‘π’πππππ’ππ‘π¦ = π π + π ππ + π ππ + π ππ’ 1. Rf = risk free rate 2. RPm = general equity risk premium a. This is one limitation – CAPM looks at stock specific risk (beta) but this is looking at entire economy 3. RPs = size premium 4. RPu = risk premium attributable to the specific company or to the industry a. CAPM doesn’t add this b/c it argues you can eliminate this risk with diversification ii. In Re Appraisal of the Orchard Enterprises 1. β side wanted judge to use CAPM, π wanted Build-Up Method 2. Holding a. CAPM is best approach b. No discount for unsystematic risk b/c this can be removed with diversification 3. Takeaways a. When judges appraise companies, they look @ the value of the company before the merger was announced b. Companies want high cost of capital b/c that means higher discount rate and less value per share c. Present Discounted Value works well only when users have an incentive to be accurate c. DE Block Method i. Look at three different factors and add them together 1. Weight is determined by the Court 2. DE judges are supposed to use PDV but sometimes they use the DE block method instead ii. Market Value = Value x Weight = Result 1. Look at price per share iii. Earnings Value = Value x Weight = Result 1. ππππ’π = π΄π£π πΈπππππππ ππ πππ π‘ 5 πππ π₯ 1 πΆππ π‘ ππ πΆππππ‘ππ a. 1/Cost of Capital is the multiplier iv. Net Asset Value = Value x Weight = Result 1. Look at book value v. Add all three together to get Total Value per Share d. Problems w/Block Method i. Avg. past earnings are not a reliable indicator ii. Difficult to establish the proper multiple for earnings value iii. Assets may not have any book value 1. Why? Assets deteriorate over time or may have no book value if intangible asset was created by the Corp 16. Weighted Average Cost of Capital (WACC) π· πΈ a. ππ΄πΆπΆ = [π × (1 − ππ )πππππ‘ ] + [π × ππππ’ππ‘π¦ ] i. D = amount of debt ii. E = amount of equity iii. Rdebt = cost of debt capital iv. Re = cost of equity capital v. Tc = corporate tax rate vi. V = D+E b. WACC is the rate of return the business must produce each year to keep all of its investors (stockholders & creditors) content c. Two Ways to Figure out Equity Cost of Capital i. CAPM ii. Earnings/Market Value 1. Must know the firm’s market value to do this Valuing Entire Firms 1. Valuing with Comparables a. Investors will pay ~25% more for a stock with a liquid market i. If comparing for purpose of determining private stock value, you have to discount by 25% b. Process i. First, look at specific performance metrics (revenue, EBITDA, net income) ii. Second, divide the firm's market values by the metrics and take the average iii. Third, multiply the firm in question's specific metrics by the average to get an estimated firm value iv. Each metric will give you a different estimate, so you have a range of what the firm is worth c. Limitations of Valuing with Comparables i. Hard to find truly comparable companies ii. Assumes market is efficient iii. Relies on sound judgment of analyst since analyst has lots of discretion iv. Assumes the illiquid discount is applied 2. Discounted Cash Flow Analysis a. Looks at PV of cash flows arising from entire business, rather than simply looking at the stream of interest payments/dividends b. π·πΆπΉ = πΆππ β πΉπππ€π π·ππ πππ’ππ‘ π ππ‘π i. aka Perpetuity Formula aka Present Discounted Value ii. Can also use to value company as a perpetuity with initial growth (slide 359) c. Free Cash Flows Formula i. Only looks at cash flows that business is free to distribute to investors ii. πΆπΉπ‘ = πΈπ΅πΌππ‘ × (1 − π) + π·πΈππ π‘ − πΆπ΄πππ‘ − βπππΆπ‘ 1. CF = Free Cash Flow 2. EBIT = earnings before interest and taxes 3. T = corporate tax rate 4. DEPR = depreciation and amortization 5. CAPX = capital expenditures 6. βNWC = increase in net working capital 3. Market Values a. Most straight forward approach but also very much contested b. Best estimate of value of a share = market price c. Best estimate of value of whole company = price per share x total # of shares Efficient Capital Markets Hypothesis 1. Two Kinds of Efficiency a. Distributional i. No bargains in the securities market ii. No one can gain at the ignorance of another by studying the market iii. This is true in practice b. Allocative i. Capital always flows to the stock with the highest expected returns 1. But this isn’t really true in practice 2. Assumptions of Efficient Capital Markets Hypothesis a. Zero transaction costs in securities b. All available information is costless available to market participants c. Agreement on the implication of current information for stock prices i. Everyone will agree that interest rates change when the Fed Res announces ii. Not everyone will agree about the significance of results of a clinical trial of new drugs 1. This will depend on expert knowledge of the molecular structure of the drug and experts may disagree d. Sufficient capital to engage in risky arbitrage i. Some traders act in irrational ways which makes the markets inefficient ii. Ex: everyone buying LIIT stock after they put “blockchain” in name iii. But LIIT stock could be efficient if there are enough short sellers to counter-act the irrational traders 3. Three Answers to Efficient Market a. Weak Form i. All past information about a stock is reflected in the stock’s price 1. Can’t use past price movements to determine future price movement ii. Stocks have a random walk iii. Rejects charting and technical analysis b/c past won’t predict future iv. Is it Valid? 1. Yes – evidence shows stocks move according to a random walk b. Semi-Strong Form i. Market reflects all public information 1. Difference from weak: assumes there can be info about a stock that is not publicly available – aka private information about a stock (insider trading) 2. Cannot make a profit trading on public information b/c stock price will react quick to public dissemination of information ii. Market isn’t fooled by cosmetic adjustments to reported earnings by companies 1. Ex: company uses a different depreciation method to inflate earnings iii. Regular investor can choose stocks just as well as financial advisor 1. Proof: mutual investment funds a. Survivorship Bias – mutual fund ads i. Open up 100 mutual funds ii. After a few years, close all of those that don’t beat the market iii. Now they can claim “all of our funds beat the market” iv. Is it Valid? 1. Yes – evidence shows that US markets adhere to this b/c stock prices fluctuate based on earnings before they are released c. Strong Form i. Prices reflect all information – public & private ii. Shep rejects this form b/c you can still make money by trading on inside information iii. Is it Valid? 1. Probably not – little support, insider trading rebuts this form d. Warren Buffet i. Beat the market for years but hasn’t since 1988 – now he accepts the ECMH ii. Buffet Rule: don’t invest in actively managed funds b/c your just as well off on your own and not paying the 1-2% 4. Lessons of Market Efficiency a. Bubbles don’t refute the ECMH i. There can be bubbles in a stock price ii. Ex: Amazon had no earnings but high stock price 1. People thought this was a bubble but clearly wasn’t b. Markets have no memory c. Trust market prices d. Market prices give lots of info about performance i. If bond prices are low for one company compared to other companies’ bonds, this may suggest that creditors think the company is going bankrupt e. No financial illusions i. Stock splits don’t affect value 5. Judicial Suspicion of Market Efficiency a. Historically, DE courts have rejected the ECMH, but some DE judges began to accept it in 2002 b. DE courts don’t like market values b/c the great depression questioned the validity of market prices i. People thought they had a certain amount but then market crashed, and they had nothing 6. More Valuation in Courts a. Bankruptcy i. Must determine if going concern value is more than its liabilities 1. If yes, then court will allow company to be reorganized b. Merger i. Is the value of the company correct? c. Appraisal i. Dissatisfied shareholders ask court to review a price for sale/purchase ii. Could be used even in a divorce proceeding 1. Ex: calculate one spouse’s expected future earnings 2. Ex: Bowie Bonds – sold interest in his future earnings d. Dell v. Magnetar Global - Delaware i. Rejected DCF analysis and said deal price should have been used instead b/c it didn’t reflect the change in stock price post-merger announcement ii. No discount for minority interests despite lack of marketability iii. Takeaway - Old school DE judges do not like using market values in appraisal actions 1. 2. 3. 4. 5. Capital Structure Common stockholders are residual claimants – Creditors will get paid before stockholders Three Main Sources of Capital a. Retained Earnings b. Equity c. Debt Factors to Consider in Choosing Capital Structure a. Risk b. Return c. Tax Savings Ways to Generate Capital a. Operating - Invent a new product or merger for economies of scale b. Fundraising - Fool investors by issuing a security or reduce some other expense of the business c. Financial Choices i. Bootstrapping - putting revenue from prior activities into new projects 1. Pro: no cost of raising capital 2. Con: opportunity cost ii. Issue New Stock 1. Pro: avoid incurring a fixed repayment obligation 2. Con: voting control diluted iii. Issue Preferred Stock 1. Pro: avoid common stock dilution 2. Con: stock comes with liquidation and other priorities iv. Short Term Debt 1. Pro: cheaper interest rates 2. Con: expose firm to additional risk if financing needs to be rolled over v. Long Term Debt 1. Pro: short-term flexibility 2. Con: more expensive interest rates Equity a. Options & Warrants i. Risker than common stock because they may expire and be worth nothing ii. Warrant = call option issued by the corporation b. Common Stock i. Board of directors owes fiduciary duty to common stockholders ii. Stock can be separated into classes with different voting rights 1. Ex: non-voting, voting, super-voting c. Preferred Stock i. Stock with different rights than common stock 1. Flexible investment that falls somewhere between debt and common stock Debt a. Short Term i. Payment is due within one year from the time it is incurred b. c. d. e. ii. “Current debt” on balance sheet iii. Used for operations financing iv. Less time = less interest rate or bankruptcy risk = lower interest rate Long Term i. Payment due more than a year after it is incurred ii. “Funded debt” on balance sheet iii. More time = more risk = higher interest rate 1. More chance the company goes bankrupt, or interest rates change Long Term Bonds are more sensitive to interest rate changes i. As interest rates fluctuate in the economy, it will cause the value of the bonds to change 1. Example: 1 yr Bond - costs $1000; pays $100; interest rate (r) 5% i. Present Discounted Value = 1000 ii. Payment/1+r iii. 1050/1.05=1000 b. Infinite bond - pays 50, r 5% i. PDV = Payment/r 1. 50/.05=1,000.0 c. What if r changes to 10%? i. 1 year bond 1. 1050/1.1=954.5455 a. 5% loss ii. Infinite bond 1. 50/.1=500 a. 50% loss 2. Takeaway a. Long-term bond is more sensitive to interest rate changes than the short-term bond Unsecured vs. Secured Debt i. Unsecured is less risky than stock ii. Unsecured is riskier than secured debt = interest rate for unsecured debt is higher Bank Loans i. Most common way to raise capital in Europe 1. Less common in US b/c US companies can sell bonds to the public a. Selling bonds to public is not as common in other countries ii. Syndication 1. When a borrower’s needs are larger than a bank’s capacity, the bank will bring in other banks to participate on the loan iii. Term Loans (asset-based financing) 1. Used for long term financing of business operations, includes structured financing 2. Backed by business’ assets – receivables & inventory a. Accounts Receivable Financing i. Used for short-term cash flow ii. AR is collateral iii. “Factoring” is when bank buys the accounts receivable iv. Lenders typically loan 75% of AR but this will decrease over time b. Inventory Financing f. i. Similar to AR, but collateral is the business’ current inventory ii. Amount of loan a bank will give depends on… 1. how quickly business can sell the inventory 2. how much the business can sell the inventory for 3. usually can borrow 60-80% in retail and 30% in manufacturing 3. Interest Rates a. Either Fixed or Floating i. Floating – fixed rate for first year but then floats based off LIBOR 1. Less risk for both parties if interest rates increase or decrease iv. Lines of Credit (revolver) 1. Typically used for temporary working capital - Secured by AR or inventory a. Ex: employee salaries & operating expenses i. Company takes out revolver, pays salaries, pays back revolver with EOY profits 2. Establishes a maximum amount of funds that are available from a bank that a company can draw from as needed a. Interest accrues only on what is borrowed 3. Revolvers are renewable and terms can range up to several years v. Commercial Loan 1. Similar to line of credit but usually only taken out for a specific expenditure 2. A fixed amount of money is borrowed for a set time with interest paid on the lump sum 3. Secured, short-term or a period of 3-5 years a. If short term = secured by short term assets b. If long term = secured by long term assets vi. Letter of Credit 1. Guarantees payment upon proof that contract terms between a buyer and seller have been completed a. Issuing bank will deliver funds to the seller’s bank upon receipt of satisfactory documentation proving the goods were delivered b. Asset transferred = funds released 2. Common when the parties do not have a continuing relationship a. Ex: international credit purchase Capital Markets 1. Debt that is not from a financial intermediary (bank) ii. Commercial Paper 1. Short-term unsecured debt (9 mos. or less), issued in $100,000 units a. Usually b/t corporations, but could also sell via dealer that resells on commercial paper market 2. Very cheap debt to raise b/c there are fewer reporting requirements since this is not considered a security 3. Common for borrower to rollover commercial paper loans since repayment is so soon iii. Debentures (aka Notes) 1. Unsecured debt, issued in increments of $1,000 a. If they are secured = bond b. Could be long-term or short-term 2. Sold on the public market 3. Could be subordinated to other debt so the risk is similar to a risk of stockholders 4. If more than $10 mil then trustee must be appointed iv. Structured Financing - Special Purpose Vehicle (SPV) 1. Company has high-quality assets and separates them from risk of the overall business by selling them to a special purpose vehicle 2. Common when company is in financial hardship and needs to raise debt a. SPV makes company look better than it actually is 3. Company places all of its good assets in the SPV 4. SPV borrows money from bank, backed by good assets, and then gives it to the company who probably couldn’t get the capital directly g. Capital Lease i. Less hassle for the Lessor 1. Eliminates credit investigation of lessee b/c lessor owns the asset 2. If lessee defaults, lessor can lease asset again or sell it to cover the costs of default ii. At end of lease, lessee may have right to purchase the asset iii. Greater Deduction – Tax fraud 1. If you take out a loan to pay for a truck, you only can deduct the interest you pay on the loan a. But at the end of the lease, you own the truck 2. If you lease the truck, you can deduct the entire lease amount as a business expense a. May allow you to buy truck for $1 at end of the lease 3. Ex: Truck costs $100 a. Loan = 10% interest i. Deduction = $10 b. Lease = $100 i. Deduction = $100 6. Leverage and Capital Structure a. Average leverage depends on the industry (see slide) b. Net Income Perspective i. Hypothesis: Leverage increases shareholder value 1. This is actually false ii. A firm’s earnings are more volatile after the borrowing because creditors must be paid first 1. If there is good revenue, then yes it increases shareholder value 2. But if they have bad revenue then the shareholders are screwed iii. Higher the leverage = higher the discount rate c. Modigliani and Miller’s Irrelevance Hypothesis i. Hypothesis: increasing the amount of debt will not result in greater net income ii. Two Propositions 1. A firm is only worth the discounted present value of its future cash flows from operations, regardless of capital structure a. AKA: you cannot increase the total size of the pie by cutting it into differentsized pieces 2. The expected discount rate on the common stock of a levered firm will increase in proportion to the debt-equity ratio of the firm a. Higher the leverage, the greater the risk, so required return on equity rises with an increase in debt b. To figure out how it changes: plug new figure in for the amount of equity and solve for discount rate πͺπππ ππππ i. π¨πππππ ππ π¬πππππ = π«πππππππ πΉπππ iii. Problems w/M&M Hypothesis 1. Prop 1 assumes wrongly that… a. No tax or bankruptcy costs b. No difference in borrowing costs b/t corps and shareholders c. Symmetry of market info b/t companies and investors d. Low transaction costs 2. Home-made leverage has the same returns as the leveraged investment a. But it is personal debt so more liability d. Real World (relaxing the M&M assumptions) i. Increasing debt increases the value of the company to a certain extent b/c of the tax shield which the M&M hypothesis assumes doesn’t exist a. Only to “a certain extent” b/c more debt increases risk of bankruptcy so at some point additional debt would decrease the value of the company ii. Why does increasing debt increase value of company? 1. Corporation can deduct interest payments a. Tax shield – can’t deduct for dividends or capital gains iii. Changing Tax Rates 1. Increase – corps take on more debt 2. Decrease – less debt b/c less tax shield 3. 2018 tax bill put a cap on deductions for interest payments @ 30% of adjusted taxable income iv. Tax Shield Present Value 1. π·π½ π»ππ πΊπππππ = π»ππ πΉπππ π π¨πππππ ππ π«πππ π°πππππππ πΉπππ v. Value of Levered Firm 1. πΏππ£ππππ πΉπππ = ππππ’π ππ πΈππ’ππ‘π¦ πΉππππππππ + πππ₯ π ππ‘π π₯ π΄πππ’ππ‘ ππ π·πππ‘\ vi. M&M Response 1. Value of Levered Firm (Vl) that pays corporate taxes is equal to the value of an unlevered firm (Vu) plus the present value of the tax shields from debt (TcD) 2. π½π = π½π + π»ππ« e. Cost of Financial Distress - Trade Off Theory i. Firms with safe, tangible assets and plenty of taxable income should have relatively high debt to equity ratios 1. High taxable income = Corp can gain from tax shield 2. Safe, tangible assets = not a high cost of financial distress ii. Fluctuates between industries 1. Utility company (safer) relies on debt financing more than high-tech growth companies (risker) iii. Counterexample: Exxon Mobil 1. They have safe, tangible assets and high taxable income but little long-term debt so there must be other explanations f. Pecking Order Theory i. Investors don’t have the same info about the company as the managers 1. This rebuts a presumption of M&M ii. Managers of a company will act in best interests of shareholders by seeking to minimize negative wealth effects associated with raising external capital 1. Negative Wealth Effects a. Raising capital via new issuance may cause outside investors to think that mgmt. thinks that the shares are overvalued b. Managers try to minimize these effects by finding capital w/o them iii. So, managers will turn to internal cash flows before external financing 7. Capital Structure & Agency Costs a. Agency Costs i. Managers may bad business decisions that cost the company and shareholders revenue 1. Ex: having a corporate jet, high salary, fancy office ii. Agency Cost of Debt 1. Manager behavior that benefits shareholders at expense of debt investors a. Ex: taking on super risky projects b. Aka – stockholder-bondholder conflict iii. Agency Cost of Equity 1. When there is little debt, managers have “financial slack” and an incentive to not try hard and take on bad expenses b. Takeaways i. Agency Costs of Equity rise with the use of outside equity ii. Agency Costs of Equity are reduced by additional outside debt b/c 1. the discipline imposed by indenture terms, and 2. the owner/manager still bears the agency costs imposed on residual claimants iii. Agency Costs of Debt rise with increasing uses of debt 1. Managers are tempted to take more risk b/c shareholders would benefit but any costs would be borne by the creditors iv. Both Agency Costs can be reduced through various monitoring and bonding mechanisms to protect outside investors, whether shareholder or creditors c. Ways to Control Agency Costs i. Use of outside auditors to ensure accurate reports of expenses ii. Use of outside directors to assure monitoring of managerial behavior iii. Performance based compensation for managers iv. BUT all of these control methods also come with costs: 1. Ex: you have to pay the auditors & outside directors d. Reasons to have Debt i. Tax Shield ii. Creditors will monitor managers iii. More leverage, greater danger of bankruptcy 1. CEO has incentive to not make stupid expenses that could force company into bankruptcy e. Quadrant Structured Products v. Vertin i. When a corporation is insolvent, some courts (minority) say that the corporation has to be run for the benefit of the creditors 1. DE disagrees 8. Adjusting Capital Structure a. Recapitalization (increase/decrease debt to equity ratio) i. Issuing Debt to Buy Back stock 1. Debt ο Equity ο — Increases Debt:Equity Ratio a. Allows recap without changing total size of the firm 2. Revlon v. McAndrews - Raising Debt to Fight a Hostile Takeover a. Shark wants to acquire & sell off assets b. Company repurchased 10 million shares w/debt i. Debt had conditions that prevented the company from taking on additional debt, selling assets, or paying dividends ii. So now the shark’s plans were not possible c. Court held that the defense measures were legal ii. Issuing Debt to Pay Large Dividends 1. Debt ο Equity ο — Increases Debt:Equity Ratio i. Large dividend would decrease firm’s equity balance iii. Issuing Equity to Buy Back Debt 1. Debt ο Equity ο — Decreases Debt:Equity Ratio a. Deleveraging - typically done to reduce financial distress 2. S. Muoio v. Hallmark a. P challenged the recapitalization as unfair price & process b. Takeaway: corp had legal defense b/c it was a fair price & process i. Did not arise to some strategic plan to dispose assets to screw over creditors b. Leveraged Buy Out i. Bidder uses the debt-financing to essentially subsidize the ultimate valuation of the target 1. LBOs make sense when: corp isn’t taking full advantage of tax shield and agency costs should be reduced 2. Firms with low debt are often in riskier industries b/c they need to maintain a cash buffer ii. Strip Financing 1. Lender receives equity that is “stapled” to the debt piece 2. Reconciles the stockholder/bondholder conflict a. Lender has few possible gains in pushing for bankruptcy b/c it would hurt their interest as an equity owner b. Lender also doesn’t want to take on risky projects b/c it could hurt their interest as a creditor 1. In re Tribune Media Co – LBO that went bad a. Tribune enters LBO i. The LBO debt had senior rights to pre-LBO debt ii. Tribune files for bankruptcy iii. Pre-LBO creditors sue for breach of fiduciary duty iv. Tribune offers a settlement to pre-LBO creditors v. Takeaway: settlement plan was reasonable b/c it was the most the creditors were going to get out of any situation Common Stock 1. Basics of Stock & Common Stockholders a. Equity financing is typically the first step in a company’s lifestyle b. Common Stockholders are residual claimants and elect the board of directors c. Common Stock rights are determined by State Corporate Laws and then the Article of Formation or Certificate of Incorporation 2. Pricing a Common Stock Financing – Questions to Ask: a. What is the capitalization of the company? b. How much money is being invested in the financing? c. What is the value of the company? 3. Corporate Documents controlling Common Stock a. Certificate of Incorporation, ByLaws, or any Special Agreement b/t shareholder & corp: i. Shareholder Voting Agreements 1. More common in small closely held firms where stockholders agree to vote for certain individuals ii. Shareholder Voting Trusts 1. Shares are put into a trust and shareholders tell trustee how to vote 4. Dilution a. Voting Dilution i. When shares are issued and previous stockholders have less voting power b. Economic Dilution i. General rule: never sell the shares for less that what you paid for b/c then there is no loss ii. Voting dilution can exist w/o economic dilution if the shares are sold for a price higher than what you paid per share/market value of the share c. Formula for Dilution – WILL BE TESTED i. πΏ = ππ − ππ₯ + π π₯+π (π) 1. L – existing shareholder loss through dilution 2. M – market price of a share before issuance 3. A – shareholder’s share ownership @ time new shares are issued 4. X – total shares outstanding before issuance 5. D – number of shares issued 6. P – proceeds from sale of new shares ii. Similar to a cost of rights plan for buyer 5. Addressing the Risk of Dilution a. Preemptive Rights i. Stockholders have the right (not the obligation) to buy shares upon a new issuance 1. Stockholders would receive the shares on the same terms being offered to the other people ii. Stokes v. Continential Trust Co b. c. d. e. 1. Old Rule: preemptive rights automatically exist 2. New Rule: preemptive rights only exist if included in articles of incorporation iii. Corporations don’t usually have preemptive rights b/c it would be a huge hassle since there are so many individual shareholders & different classes of shares iv. No preemptive rights for shares issued for… 1. Compensation 2. Satisfying a conversion or option right 3. Or sold otherwise than for money 4. Examples a. Stock issued for fleet of truck – no preemptive rights b. Stock issued for cash – preemptive rights v. Preferred shareholders have no preemptive rights for the common stock 1. Same goes for common stockholders if preferred shares are issued vi. Fiduciary Duty to Minority Shareholders? 1. Only in some states (MA) – not DE a. Usually, majority shareholders are protected by the BJR/free contract theory Anti-Dilution Protection i. Comes into play when shares are offered for less than original offering b/c this creates economic dilution ii. Common Provisions 1. Floor on how low the new stock may be issued for a. If company goes below floor, they have to give stock to existing stockholders for free 2. Company just pays cash to the stockholder to cover the economic dilution Fiduciary Duties i. If stockholders challenge the approval of sale of stock, it will be reviewed under the BJR 1. Unless the directors personally benefit from the transaction, then court will apply enhanced scrutiny ii. Katzowitz v. Sidler – penalty dilution 1. Corp issues new shares for very low price and stockholders have are redemption rights 2. If the stockholders did not exercise their rights, then they would suffer severe economic dilution a. Aka – Penalty dilution 3. Majority: penalty dilution is fine b/c shareholders have the right to choose to buy 4. Minority: failure to invest amounts to penalty dilution so court will decide in favor of minority shareholder suing Dilution Hypos – likely on exam i. Corp offers shares @ fair value so loss is the same whether or not the shareholders participate 1. Investors will sit back and hope the other investors buy the shares 2. Bad situation for the corp if no one buys them ii. Corp offers shares @ less than fair value – economic dilution 1. Corp does this to induce their shareholders to participate in the offering Poison Pill i. A promise to issue new shares of common stock to all shareholders if an uninvited bidder for control acquires a specified percentage of the company’s shares – aka Rights Plan 1. Helps mgmt. at the expense of the shareholders 2. Purposeful dilution in order to prevent a takeover ii. Increases the cost of an acquisition by 6% 1. Uninvited bidder cannot participate in new offering of shares & shares are sold at a price well below FMV iii. Usually only triggered if there is a mistake 1. Shark will negotiate w/mgmt. to avoid triggering the pill 2. Company also doesn’t want it to trigger and only uses it as leverage to force shark to negotiate iv. “Flip In” vs. “Flip Over” 1. When shark acquires a certain portion of the company, rights exercisable for the target’s common stock “flip in” 2. When a shark acquires the target via merger, the rights “flip over” to become exercisable in the shark’s common stock v. Are Poison Pills legal? 1. Moran v. Household International Inc. – Majority View a. Court held it was legal b/c it was included in corp docs ahead of time rather than being in response to the potential takeover b. BJR wasn’t used b/c there was a conflict of interest for the directors 2. Minority View a. Courts say they are illegal b/c they help managers at the expense of shareholders b. But if a state court says they are illegal, the state legislatures will typically overrule the court and say they exist i. States want to be a good place for incorporation c. So, basically they are legal regardless of the minority court position b/c the legislature will just later overrule 3. Cost of Rights Plan for Bidder/Shark a. πΏ = ππ − ππ₯+(π)π π₯+π L – bidder’s loss through dilution C – bidder’s avg. pre-trigger cost per share M – pre trigger market price A – bidder’s share ownership @ time when rights are triggered X – shares outstanding before dilutive issuance D – number of shares issued in dilution distribution P – proceeds from the exercise of rights 1. (x – a)e viii. E – exercise price of rights i. ii. iii. iv. v. vi. vii. 6. Shareholder Agreements a. Distributions (Salary & Retirement) i. Employment agreement may give the minority shareholder a set salary so minority shareholder can ensure they receive financial compensation since they can’t force corp to issue a dividend 1. Problem arises when duties change over time, but salary doesn’t to reflect more/less duties ii. Retirement 1. Retired shareholders will contract for right to future distributions since it is the only way they can be paid for their ownership b. Protection for Creditors i. Control risky lines of business & decisions to enter into new ones by requiring majority or super-majority vote for certain decisions ii. Con: Higher vote requirement can make it difficult for business to gather sufficient consensus to pursue an opportunity c. Allowing Liquidity – Buy-Sell Agreements with Corporation i. In close corps, minority shareholders don’t have a market to sell their shares so they may contract for the buy-sell agreement ii. Common for agreement to set the specific price since it is hard to determine fair value in a closely held corp iii. Corps fund these with “Key Person” insurance that develops $ value over time to fund the buyout iv. If Corp’s funding is tight, buy-out could occur over a number of years d. Transfer Restrictions, Tag-Along, and Drag-Along Rights i. Problem 1. Shares can be traded w/o shareholder approval so it presents the concern that shares will be transferred to someone with different goals than the corp ii. Solution: Share Transfer Restriction 1. Restrictions must be placed conspicuously on stock certificate to be enforced against third parties 2. Consent of Shareholders a. Restrictions cannot be unreasonable restraints on alienation or court may overrule it b. More likely to be upheld when requiring majority consent rather than unanimous 3. Right of First Refusal a. Less controversial b. Seller can get screwed if shareholders buy 19% of the 20% offered i. No one will want to buy the 1% left off b/c so small c. So, sellers protect themselves by including provisions that allow other shareholders to buy the remainder or if not all the shares are purchased, the seller can proceed with the original transaction 4. Tag-Along a. Shareholder wants to sell b. Other shareholders don't want to buy but instead also want to sell to the thirdparty on the same terms c. Tag along rights allow the shareholders to sell their shares on the same terms as the departing shareholder 5. Drag-Along a. Opposite of tag-along; Pretty rare b/c so harsh b. Here, an investor finds a potential buyer who wants all of the company's shares or none at all c. Drag-along forces the other shareholders to sell their shares to the bidder if requested by the investor 7. Creditor Protection: Legal Capital a. General Idea i. Assure a creditor of a business that the aggregate par value of a corporation’s shares had actually been invested by its shareholders and that this capital would remain locked in the corporation to minimize the risk of insolvency b. If money comes in from a sale of no-par stock, it is assumed to be stated capital unless the Board declares otherwise c. MBCA abolished par value but DE still has it although it is usually $0.0001 d. Par Value – Stated Capital i. The amount raised through selling the shares for par value ii. Can’t pay dividends from this account e. Capital Surplus i. Amount raised through selling the shares that exceeds the par value ii. Dividends can be paid out of this account 8. Public Securities Market & Regulation a. Securities Act of 1933 and Exchange Act of 1934 i. In response to Great Depressions ii. Gives SEC authority to promulgate rules & regulations iii. Both contain (1) anti-fraud provisions and (2) disclosure requirements iv. Does not contain merit regulation 1. Feds can choose if a corp can go public based on how many of those corps the country already has and the experience of the officers a. Ex: Germany requires you to have a certain amount of money to become a corp 2. This exists in other countries but was not included in the ’33 and ‘34 acts b. Securities Act of 1933 i. Purpose – fill in the gaps left by state regulation that could not effectively reach transactions that occurred across state lines ii. Heart of the Act – Section 5 1. Requires securities to be registered before sold and the prospectus to be delivered to all prospective buyers iii. Registration Statement 1. Part I of RS is the prospectus which contains many of the required disclosures about the business 2. If you don’t make the required disclosures than everyone who purchased the stock can sue for their money back iv. SEC must approve the Registration Statement 1. “Waiting” or “Quiet” Period a. Time when SEC is reviewing registration statement & company’s officers cannot make any statements to the public or market the securities 2. If SEC is not satisfied, they can recommend revisions via “letter of comments” v. Investment Bank vi. vii. viii. ix. x. 1. Firm Underwriting a. Bank buys all the shares at a set price and then finds investors to resell them to b. Bank will only do this if they are confident, they can sell the shares 2. Best Efforts Sale a. Bank says they will make their best effort to help company sell their stock b. Bad Signal for the market i. Bank knows the most about the business so if they choose a bestefforts sale over a firm underwriting then it might suggest something is wrong IPO Cost 1. Usually 7-14% of the money coming in Exemptions - allows you to get around the securities laws, but other laws may apply 1. Exemptions for Classes of Securities a. Depends on what securities are sold i. Ex: bank deposit, treasury bills, savings account b. Exempt b/c there are a ton of other regulations that cover these classes of securities 2. Exemptions for Types of Securities a. Depends on how the securities are sold i. Ex: selling to only accredited investors, selling to investors only in one state, or a private offering b. Exempt b/c they are sophisticated investors, or the state supplies the law instead International Offerings 1. If a substantial amount of the securities sold in another country are expected to end up back in the US, then the US will require the US securities laws to apply to the offering in the other country Safe Harbors: Reg D – 2 Exemptions 1. Offerings under $5 million as long as the issuer avoids general solicitation a. General solicitation – offering securities to people who you do not have a preexisting relationship with 2. Offerings over $5 million are exempt if a. Issuer avoids general solicitation4 b. Sales are restricted to 35 people or less who are i. Sufficiently experience in business and financial matters that they can judge the risk of investment AND ii. They receive largely the same sort of info that would have been provided by a registration statement c. BUT: if offered to an accredited investor, no restriction on the number of people Crowd Funding 1. Equity Crowd Funding a. Non-sophisticated people can purchase stock in a start up i. Aka securities crowd funding 2. Reward Crowd Funding – not considered a security a. You invest money in a company and get their product/service once they begin producing it i. This has nothing to do with the securities laws b. Ex: Shep buys a light up bike helmet on Kickstarter xi. Shelf Offering 1. Corp compiles all the documents and disclosures & gets approval from SEC but then “shelves” them for later 2. Allows the company to issues bonds at a moment’s notice when interest rates are prime a. Company doesn’t have to spend the time creating the docs & disclosures xii. At the Market Offering 1. Number of securities sold is usually smaller than conventional offering 2. Company sells the stock while it is favorably priced but then stops once stock price drops and is unacceptable xiii. Definition of a Securities 1. Defined through common law 2. SCOTUS said if you sell land with a contract for the maintenance of the orange trees, this is the same as buying stock in the orange company c. Securities Act of 1934 i. Focuses on the provision of information about companies whose shares are either: 1. Traded on a registered stock exchange, or 2. Are otherwise held by either more than 500-non accredited investors or 2,000 securities holders ii. Required Reports 1. Annual Report: 10-K 2. Quarterly Report: 10-Q 3. Specific Corporate Events: 8-K a. Must be filed w/in 4 days b. Examples i. Creation or termination of a material definitive agreement ii. Declaration of bankruptcy iii. Substantial acquisition or disposition of assets iv. Replacement of certain executive officers or directors v. Change in auditors iii. Anti-Fraud Provision 1. Rule10(b)(5) Corporate Debt 1. Three Main Forms of Corporate Borrowing a. Private Loan Agreements i. Insurance fund invests in mutual fund, teacher’s pension, etc… b. Public Borrowing i. Cheaper way to raise debt than going to the bank ii. Large companies were typically the only ones to go to the public market until junk bonds appeared 1. Smaller companies use junk bonds to raise debt 2. Similar risk to stock b/c you only get paid if the company does well enough to pay off the junk bonds c. Commercial Paper i. Large, established corps will issue it b/t themselves b/c it is exempt from securities laws 2. Conventions of Public Debt (Bonds) a. Bond Indenture i. When debt > $10 mil there must be a bond indenture to set up how the bond will work ii. Require by Trust Indenture Act b. Bond Quotation i. AES – name of company ii. First number is the interest rate (4 ½) iii. Second number is year it matures (05 – so 2005) iv. Close is the price the bond is trading at on the market 1. Multiply this number by 10 to get the real price c. Bond Valuation & Interest Rates i. If value of bond is lower, interest rates must have risen ii. If interest rates drop, the value of the bond will increase b/c investors can’t get the bond’s interest rate elsewhere in the market iii. The later the bond matures, the more impact fluctuating interest rates will have on the value of the bond 3. Calculating Bond Yields a. πΆπ’πππππ‘ πππππ = πΌππ‘ππππ π‘ πππ¦ππππ‘ ππππππ‘ πππππ b. Maturity Yield i. When the price of bond is lower than $1000 = higher maturity yield ii. If the price of the bond is above $1000 = lower maturity yield c. Yield to Maturity i. Calculate by using PDV formula and solve for r d. Inversion of Yield Curve i. Occurs when the interest rates are lower for long-term bonds than short-term ii. Why? 1. Investors expect bad things to happen to the economy which means future interest rates will be lower 4. Adjustable-Rate Securities a. Floating Notes & Floaters i. Notes begin with a certain interest rate for a number of years and then floats based off of LIBOR 5. Contract Interpretation a. Court interprets bond indenture provisions as a matter of law rather than looking at the intent of the parties i. Provision will have identical meaning across all indentures no matter what the parties intended ii. Mellon Trust Co. v. Liberty Media 1. “Courts will not look to the intent of the parties, but rather the accepted common purpose of such provisions” 2. Held: Corp was not found in breach of indenture for selling off its assets – they were distinct independent business decisions, not an overarching scheme to strip assets away from the creditors 6. Description & Analysis of Bond Covenants a. List of Corporate Actions that Increase Risk for Creditor i. Incurring More Debt 1. Reduces equity cushion, new creditor has better rights, priority over existing creditors ii. Choosing Riskier Projects (asset substitution) 1. Interest rates are usually tied to the risk of the corporation’s line of business 2. If Corp goes into new, risker ventures then interest rate demanded will be higher 3. Corp only has to disclose the immediate use of the funds so down the road they could enter into risker business lines with the capital iii. Withdrawal of Shareholder Capital (dividend payment) iv. Underinvestment 1. Asset backing the debt declines in value over time b/c managers do not maintain it overtime with repairs & improvements) b. List of Covenants for Creditors to Reduce Risk of Corporate Actions i. Place limits on risk, debt, dividends, and other distributions 1. Capital leases will be included in definition of debt 2. May also apply to subsidiaries ii. Requirements for investments iii. Acceleration upon default c. Avoiding Claim Dilution: (1) Restricting New Debt i. Corp harms creditors by issuing new debt 1. Claims are diluted b/c you have to share w/more ppl 2. Two Covenants for Protection: a. Blank prohibition on new debt b. Corp can only issue new debt if it maintains certain financial ratios ii. Corp harms creditors by issuing new debt with superior rights 1. New debt may have senior claim on assets of a firm through a mortgage or security interest 2. Two Covenants for Protection: a. Prohibit such mortgages and liens; or b. Require that the existing bondholder share in the priority iii. BUT Debtors do not like absolute prohibitions 1. Why not? a. Requires all future financing to be done through equity 2. So instead, debtors & creditors compromise: a. Specific dollar limits on the amount of new debt b. Limiting total debt to a specified percentage of net tangible assets i. Typically, good will is excluded c. Limiting new debt so that debt service (both interest and debt amortization) do not exceed a stated percentage of earnings; or d. Providing that the ratio of current debt does not exceed some percentage of current assets (working capital tests) iv. Metro v. RJR Nabisco 1. Issue: did the corp breach the covenant of good faith by proposing an LBO that dropped the price of the bonds by 20%? 2. Held: No, the indenture did not include an implied restrictive covenant against new debt being incurred to facilitate the LBO 3. Takeaway: The only rights bondholders have are those that they contracted for in the indenture d. Risky Investments i. Debtor doesn’t want to issue cash for purpose A and then corp uses it for a different purpose 1. Debtors must place restrictions for protection but also must be careful to not handcuff the Corp ii. Common Covenant for Protection 1. Net tangible assets must meet some proportion of the debtor's balance sheet or 2. Limit intangible assets to some percentage of the firm's capitalization iii. Merger is an easy way for corp to change business operations 1. Protection against Mergers/Acquisitions/Asset Sales a. Covenant makes the surviving company liable for the bonds of the target company b. Surviving company will autonomically assume liabilities so this covenant really just protects from asset sales iv. Covenant for Protection against Financial Investments 1. Debtor cannot make investments in other companies a. Typically excludes liquid assets and subsidiaries e. Withdrawal of Shareholder Capital i. Debtor issues all of its assets to the shareholders before things get bad so not assets left when bankrupt ii. Covenant for Protection 1. To make a distribution, minimum capital requirements must be established so the creditor maintains the equity cushion f. Underinvestment i. Fear that mgmt will get lazy, forget to maintain PPE or passes up on good business opportunities ii. Covenants for Protection 1. “Project” be defined with particularity so the mgmt doesn’t pass up on a good business opportunity 2. Maintenance schedule or a third party that submits reports to the creditors to ensure that the proper funds are used to maintain the existing plant and equipment 3. Insurance Requirements – 2 types a. Bond holders will require company to have insurance i. Ex: fire burns down all company’s assets, if no insurance then bondholders are screwed b. Life Insurance policy on key people that may run directly in favor of bond holders i. Ex: CEO dies, company’s value plummets ii. Ex: Elon Musk & Steve Jobs iii. Covenant for Existence 1. Creditors are ensured that the corporation will continue and maintains corporate existence by filing necessary paperwork each year with their state of incorporation iv. More Rigid Covenant: require firm to maintain a specific level of working capital 7. Substitutes for Covenants a. Sinking Funds – borrower has to redeem some of the bonds early i. Borrower sets aside funds into a separate account that can be reinvested by… 1. Repurchasing the bonds @ par value subject to prepayment penalty, or 2. Repurchasing bonds on market @ current market value a. If they are retired early when bond price goes down = benefits creditors b. If they are retired when bond price is above what they were sold for = benefits company b/c company only has to pay what is on the prepayment schedule, not the new cost of the bond b. Convertible Debt i. Bondholder can convert their bond into common stock @ a certain price 1. See preferred stock for more on this ii. When included… 1. there will be few negative covenants along with it 2. signals risker debt so lower current interest rate in exchange for conversion right c. Control of Debtor i. Creditors assume control by having one of their own serve as manager or on the board ii. KEY: if creditor runs corporation for the benefit of creditors, a court may rule that the creditor is liable for all of the company’s other obligations d. Call Protection i. Protects against the corporation repaying debt too early and creditors not getting the high interest rate they contracted for ii. Call Premium – cannot recall bonds for the first few years iii. Make Whole Premium – most restrictive 1. Corp must pay out all interest that would have collected if the bond wasn’t retired early iv. Morgan Stanley v. Archer 1. Can a company retire bonds with proceeds from equity when the indenture has a covenant against retiring the bonds with proceeds from issuing new debt? a. Yes - It must be in the bond indenture for the bond holders to get the protection v. Why don’t companies always recall new debt when interest rates fall below the rate issued? 1. B/c there are transaction costs so the interest rate must fall low enough that issuing new debt and retiring old debt would cover the transaction costs 2. Bondholders have 30 days to retire the bond so the price could drop during this time a. Company will wait until they have a good cushion 8. Monitoring Compliance a. Statement of Compliance i. Officer must issue this statement to inform creditors/trustee that they are in compliance with the indenture covenants b. Notice of Certain Events – 8-K i. requires companies to disclose changes to the company’s senior management or to its outside accountants, dispositions of assets, and the entry of material contracts 9. Amendment to the Indenture a. Amendments are the most common in an LBO and are constrained by the Trust Indenture Act i. Corp will usually just pay off the bondholders to waive the covenants so the LBO can proceed forward ii. Covenants = Property rights for creditors to use as a bargaining chip b. General Rules i. Amendments - Need 50%+ 1. Sometimes increased to 2/3 ii. Defer interest payments – need 75% 1. Can only defer for 3 years iii. To change maturity or the principal amount of bonds – Need 100% 1. If company wants to do this but can’t get the votes, they could also file for bankruptcy c. Katz v. Oak Industries i. Facts: D offered bondholders the ability to transfer bond for common stock but conditioned this on amending the indenture 1. essentially handcuffed the bondholders into accepting the common stock 2. P sued for breach of good faith ii. Held: amendment want necessary 1. This action was not taken to benefit the common stockholders at the expense of the debtors 2. Nothing in the indenture gave the bond holders the power to a. veto proposed modifications or b. restrict Oak from offering an inducement to get bondholders’ consent to an amendment 10. Enforcement of Covenant Breaches a. Problem: Underenforcement i. Hedge funds have helped address this issue b/c they have the resources and knowledge to pursue enforcement b. Recent Examples i. Spectrum 1. Three hedge funds sent notice to spectrum that their revolver violated the indenture of their 8.5% senior notes c. Delinquent SEC filings may also be a violation of the indenture i. Depends on the specific terms; some courts say that late filing w/SEC isn't a violation, but company must send notice to creditors in time 11. Indenture Trustee a. Why have it? i. Centralizes monitoring and enforcement into 1 role b. Trustee Indenture Act i. Applies to debt securities > $10 mil ii. The debtor appoints and pays the trustee c. Trustee Requirements i. Must have at least 150k in capital & surplus ii. Cannot have a conflict with another trust after default 1. Specific Conflicts NOT allowed: a. Being trustee for another indenture for the same debtor b. Being an underwriter for a debt issue of the same issuer c. Owning 10% or more of the debtor’s voting securities d. Debtor owns 10% stock of the trustee i. Common if bank is the trustee e. Holding other debt of the debtor that is in default iii. Must give bondholders an annual report of: 1. Any change in trustee’s eligibility to serve as trustee 2. The amount owed by the debtor d. Trustee Duties i. Before Default 1. Trustee only has to perform duties set out in the indenture ii. After Default 1. Trustee is held to prudent person standard iii. Elliot Associates v. Henry Schroder Bank & Trust 1. Trustee failed to give the 50-day notice and cost bond holders $1.2 mil in payments, so they sued 2. Law: trustee’s rights and duties are only those found in the indenture 3. Held: trustee did not breach their duty a. Notice period was only for the trustee’s benefit so the trustee would have enough time to handle administrative duties before the redemption i. If the full 50 days was not needed, then the trustee could ignore it e. Trustee Filing Suit i. 25% of holders of bonds must want to sue for Trustee to file suit ii. EXCEPTION: if 50% say no, even if there is 25% saying yes, it will override and there will be no suit f. When is there Default? i. Failure to pay interest or principal ii. Failure to comply with covenants iii. Company files for bankruptcy g. What happens in Default? i. Bondholders can accelerate the bonds, could force company into insolvency h. Suing the Trustee i. Trust Indenture Act get claim into federal court via federal question jurisdiction 1. Could also sue in state court for breach of contract ii. Gives private right of action to bondholders to sue trustee iii. Greezer v. Wells Fargo Bank 1. Trustee failed to: file renewed lien after it expired, give notice of default, and accelerate the bonds a. Did trustee violate a duty before default? 2. Held: no, nothing in indenture says trustee has to act in favor of bondholders before default i. Creditors & Fiduciary Duties i. Why don’t they have them? 1. Mgmt. could act in their own interest but say it is for the interest of some other group a. Ex: “Acting in the best interest if the creditors by moving the HQ” i. But really his wife just wants to move to a new city 2. Indenture protects the creditors 3. Creditors are compensated for absence of fiduciary duty with a higher return ii. When do Creditors have Fiduciary Duties Owed? 1. If Corp is in vicinity of bankruptcy, fiduciary duties should go to creditors, not the shareholders - DE courts disagree with this: a. North American Catholic v. Rob Gheewalla i. Facts: P is a creditor of C 1. C has financial troubles but negotiates hard with P 2. C goes out of business 3. P sues C – argues C should have treated P better when C was close to bankruptcy ii. Held: No duty to creditors except what was in the indenture 1. Creditors can bring a derivative claim (mgmrs hurt the corp) but cannot bring a direct claim b/c they weren’t owed any fiduciary duty iii. Dividend Policy 1. Corp can’t give a dividend when a. Equity insolvent – can’t pay bills as they come due b. Bankruptcy insolvent – liabilities > assets i. Assets might be larger but could still be insolvent if the asset is in a property or plant that you cannot sell easily to cover the liabilities 2. Directors are personally liable for improper dividend 3. Can the Company issue a Dividend? - Hypos: a. Calculate the discounted present value of the expected liabilities and compare to amount in capital surplus b. Coal Plant suffers loss on long-term contracts i. No dividend 1. not equity insolvent but they are likely bankruptcy insolvent c. Asbestos Company sees similar companies getting sued and going bankrupt i. No dividend 1. Company isn’t insolvent yet but there are expected future liabilities from the asbestos suit that could put company into bankruptcy 12. Creditor Liability a. Krivo Industrial Supply Co. v. National Distiller & Chemical Corp i. Facts 1. P owns investment company; D beings to help out, D loans some equipment to P on credit; P can’t pay back and ends up owing $10 mil 2. D sends an employee of theirs over to help P get it under control ii. Issue 1. Did D dominate P so much that D should be liable for P’s insolvency? iii. Law 1. Instrumentality Theory a. Debtor must have had control of the subservient corp: i. Actual exercise of control is required ii. Not just “power to control” iii. Debtor must actively manage b. Debtor’s misuse proximately caused harm to plaintiff i. Examples of misuse 1. Corp favoring dominant creditor 2. Dominate creditor tricks other lenders into making loans 3. Dominant creditor tricks other creditors into thinking that they are dealing with the dominant creditor and not the debtor 2. Court decided not to apply the identity theory iv. Held: No 1. Not enough control here – only had negative veto power a. D’s employee oversaw operations but only had power to tell P what they couldn’t do b. Liability of Affiliated Parties – Deepening Insolvency Doctrine i. Parties may be held liable when they deepen insolvency 1. AKA – company already has a ton of debt but the bank helps them raise more debt ii. Official Committee of Unsecured Creditors v. Lafferty & Co. – (PA) 1. Facts: law firm and bank committed fraud in a debt offering for a subsidiary whose parent had significant financial troubles 2. Held: firm & bank were liable for deepening insolvency iii. Trenwick America Litigation Trust v. Ernst & Young LLP (DE) 1. Facts: D kept acquiring insurance companies but eventually their claims became to burdensome and D had to sell them off and file for bankruptcy – Shareholder of D (plaintiff) sue 2. Held: Deepening Insolvency Doctrine is not recognized in DE a. Mgmt is protected by the BJR b. If a plaintiff cannot state a claim that the directors of an insolvent corporation acted disloyally or without due care in implementing a business strategy, it may not cure that deficiency simply by alleging that the corporation became more insolvent as a result of the failed strategy 13. Capital Leases a. Short-leases can be more efficient i. Doesn’t tie up lessee’s capital ii. Lessor is more of an expert on buying the assets 1. Ex: U-Haul knows what truck are good to buy to rent out iii. Lessor is better at servicing the asset 1. U-Haul has people to fix the trucks b. Financial Lease is not efficient i. No service provided by lessor – just cash ii. Lessee chooses the trucks and tells the lessor which one to buy iii. So why do it? Better tax treatment 1. You can deduct interest from the loan & depreciation 2. Makes company look less leveraged unless the indenture also covers capital leases to protect creditors from this scam Options 1. Basic Terms to Know a. Call Option – Right to purchase stock @ specified price on or before a certain date i. Warrant – Call option issued by the company b. Put Option – Right to sell stock @ specific price on or before a certain date c. Option Term – period until it expires d. Strike Price – price at which the option is exercised i. “in the money” – profitable to exercise ii. “out of the money” – unprofitable to exercise iii. “at the money” – exercise price = stock price e. American vs. European i. American Option – exercisable at any time ii. European Option – exercisable only at expiration f. Naked vs. Covered i. Naked – writer of call option doesn’t own the shares ii. Covered – writer owns the shares g. Method of Exercise i. Must define how option is exercised – what form? h. Method of Payment i. Must define – cash? Baseball cards? Reliving debt? i. Options Clearing Corporation i. Makes sure people honor their options commitments j. Future/Forward Contract i. Contract to buy/sell at a fixed price – firm commitment to sell, not an option 2. Betting on Price Changes a. Betting on Price Decrease i. Sell or write a call option ii. Buy a put option iii. Forward/futures contract to sell at a fixed price iv. Short selling b. Betting on Price Increase i. Sell/write a put ii. Buy a call option iii. Future contract to buy at a fixed price iv. Buy stock long 3. Convertibles a. Convertible Securities i. Basically, embedded call options that can be exercised by tendering the original securities ii. ππ’ππππ ππ πβππππ π πππππ£ππ = ππππππππ πΌπ π π’π πππππ πΆπππ£πππ πππ πππππ b. Convertible Debt i. Creditor may be able to surrender notes to company in exchange for company equity 1. This right will be laid out in the indenture with the specific formula for conversion c. Hypo – Protecting With a Put Option i. CEO exercises his option to buy 5 mil shares for $1 each while they trade at $3 each ii. Now CEO has $15 mil tied up in PV stock & can’t just sell it all so he needs protection that it won’t drop iii. CEO should ask for a put option @ $1 so if the shares fall below $1, you at least get the $5 mil b/c you’d be able to force the company to purchase the shares at $1/per share 4. Warrants a. Issued to non-employees such as a consultant i. Ex: CRE companies who lease buildings to start-ups will hold warrants in the tenants as a way to acquire a right to invest in the start-ups that are successful b. Common in Venture Lending i. Lender will give $5 million loan to a start up ii. Start up has preferred stock @ $2/share iii. Lender receives 10% warrant coverage 1. Meaning lender can buy 10% worth of the loan in warrants a. $500,000k in preferred stock @ $2/share 5. Listed Options a. Options trading on the market b. Every listed equity option will have at least four expiration months that are currently trading, with the expiration date for each month typically occurring on the third Friday of that month c. Option Cycles – what are the remaining two months? i. Cycle 1 – the ensuing January, April, July, or October ii. Cycle 2 – the ensuing February, May, August, or November iii. Cycle 3 – the ensuing March, June, September, or December d. LEAPS - Long-Term Equity Anticipation Securities i. Option contracts with expiration dates of 1-2 years in the future ii. Issue dates depend on cycle but typically expire in January 6. Use of Options a. Gambling b. Compensation i. Gives the executives an incentive to run the corp well ii. Problems 1. You have to expense salary for exec which makes balance sheet look bad a. There used to be a loophole to characterize exec salary as an option so balance sheet looked better but this loop hole has been fixed 2. If market price declines substantially then execs know it is virtually impossible to get to the strike price so the incentive to run business well is gone a. Corp will have to renegotiate strike price or the CEO will go golfing c. Hedging i. Stocks 1. Own a stock trading @ $55, buy a put @ $50 in case it goes down 2. If it doesn’t fall below $50, you get the premium 3. If it does, you get the premium and might be able to sell it for more than what the stock is trading at ii. Inventory 1. You produce grain and want to sell it for $100/bushel (today’s price) 2. Buy a put @ $100 and sell a call at $100 a. If price goes above $100, your CALL will be exercised by the purchaser, so you sell it for $100/bushel b. If price goes below $100, you exercise your PUT and sell for $100/bushel 7. Real World Options a. Real option theory can turn a project with a negative expected net income into a positive expected income b/c investor has the option to abandon b. Stockholders hold a call option on the assets of the firm, which is why the stock price of distressed firms—even those that have filed for bankruptcy—can continue to trade with positive value c. Value of Call Option increases with volatility of the underlying asset d. Examples i. Manufacturing company buys a vacant parcel of land next to a plant 1. Creates the option to expand in the future ii. Inventor files a patent application 1. Creates an exclusive option to exploit the invention in the future iii. Oil & Gas 1. Oil company purchases contractual right to mine for oil 2. They will only exercise the right to mine if oil hits a certain price in the future 3. Often there is a fee as long as lessee doesn’t produce oil & gas so price would have to also cover this cost over time iv. Law School 1. Perhaps you want to be a novelist but want a backup plan so you go to law school so that you can be a lawyer if the novel fails 2. Cost of Option = opportunity cost (lost salary while in school) + law school tuition 8. Pricing Options a. Exercise Prices i. Call Option: lower exercise price = higher price for option ii. Put Option: higher exercise price = higher price for the option b. Term Period i. Longer the term on the option, higher the price for the option 1. More chance that the option will eventually end up in the money c. Stock Price Volatility - inverse relationship to risk i. More volatile the stock = higher option price 9. Put-Call Parity Theorem a. Purpose i. Use options to create the same return as if you had held the stock for the option term b. Strategy 1 - Sell a Put & Buy a Call @ same price i. If stock increases, you exercise the call 1. Stock: $60, Call: $55, $5 profit ii. If stock decreases, put will be exercised against you 1. Stock: $50, Put: $55; $5 loss iii. Conclusion: profit/loss is the same as if you had held 1 share of the stock c. Strategy 2 – Mimic Forward Contract to Sell @ $100 i. Buy a Put & Sell a Call 1. Put - Right to Purchase @ $100 2. Call - Have to Sell @ $100 ii. Very different economic outcomes than example 1 Preferred Stock 1. Article/Certificate of Incorporation a. Defining the Preferences i. Preferred stock preferences must be specified and authorized in the articles 1. Default rule for voting = 1 share, 1 vote 2. Failure to specify any special preference on preferred stock means that capital and surplus will be distributed ratably among common and preferred stockholders in proportion to the number of shares held by each b. Work Around: Blank Preferred i. Board authorizes preferred stock but does not issue it & preferences are decided at a later date 1. Saves time from amending the articles & getting shareholder approval 2. Preferred Stock & Debt a. Differences i. No required regular payments 1. Instead, PS may have dividend rights, but these aren’t automatic like interest payments ii. No repayment of principal 1. Instead, PS may be convertible or can force company to redeem iii. When there is a conflict, fiduciary duty is owed to common stockholders over preferred stockholders b. Why have Preferred Stock over Debt i. No risk of default ii. Good for start-ups with no money to pay interest iii. Preferred shareholders can have control mechanisms without potential liability 1. Ex: creditor takes too much control of the debtor 3. Common Preferences for Preferred Stock a. Economic Preferences i. Dividends 1. Straight Dividend a. If common stock gets a dividend, so does the preferred i. Amounts may vary if preferred has different preferences b. Potential Scam when not cumulative i. Company doesn’t make any dividends for a few years, saves up capital, then issues a huge dividend all at one time, PS gets their dividend, but Board gives majority to common stock 2. Cumulative Dividend a. Regardless of whether the company declares a dividend, preferred dividends will accumulate at a specified rate, to be paid out at a future date before the common stockholders receive anything b. Company must pay dividend before… i. Any common stock dividend can be declared ii. Contractual language indicates 1. Ex: “when the company has net profits” iii. Any preferred stock is redeemed iv. Company is liquidated or sold 3. What happens when the articles do not specify cumulative or straight dividend? a. Default: Straight b. Minority (NJ) - Cumulative ii. Liquidation Preference 1. Preferred will get paid before anything is given to common shareholders 2. Common for the term to be “1x” where x represents the originally money invested a. Allows preferred to get their initial investment back iii. Redemption Rights 1. Investor may have right to force company to buy shares OR company has right to buy shares 2. Usually, won’t kick it for a certain number of years 3. May require a certain number of shareholders to request redemption before company is obligated to buy shares back 4. Company can make a redemption when… - 2 Requirements a. There is surplus available, and b. It would not make the company bankrupt i. Unable to pay bills or liabilities > assets iv. Conversion Rights 1. Preferred stockholder forfeits preferred stock rights to convert to common stock a. Dividend preference may carry over b. Control Preferences i. Voting Rights 1. Default – 1 vote per share 2. Voting rights could be tied to the conversion ratio 3. Preferred may NOT have voting rights ii. Preferential Voting Rights 1. Right to Elect some Directors a. Might be tied to company not issuing dividends for a certain number of years b. More common in VC context 2. Protective Provisions a. Company cannot engage in certain activities without approval from preferred shareholders 4. Uses of Preferred Stock a. Regulatory Capital i. Banking regulations require financial institutions to have a minimum about of regulatory capital to absorb unexpected declines in the value of the firm's assets ii. Financial institutions will issue preferred stock to prevent common stock dilution 1. The preferred shares tend to not have voting rights 2. Usually have dividend payments and other rights tied to missing dividend payment such as ability to elect director b. Balance Sheet Management i. More leverage without taking on more debt ii. Company may issue PS to achieve a desired level of leverage on the common stock without issuing debt 1. Why? a. Bond indenture may prevent the company from issuing more debt 2. Usually non-voting until company misses a dividend iii. Typically only firms that are already highly leveraged will do this c. VC and PE i. In VC/PE, return is expected from the ability to convert PS into CS as the firm prospers 1. In non-VC/PE contexts, the investor expects their return in form of a dividend ii. Typically includes voting rights 1. Allows VC to have some control without facing liability that they may have if they were a creditor with the same control 5. Legal Treatment of Preferred Stock Bargain a. Board’ Discretion to Pay Dividends i. Decision to issue/not to issue will be reviewed under the BJR, unless Board is dominated by representative of the preferred stock 1. If this conflict exists, decision may be reviewed under the intrinsic fairness test ii. Arizona Western Insurance Co v. LL Constantin & Co 1. Facts a. Bad drafting that led to preferred shares getting a right to a dividend each year 2. Issue a. Can a Corp contract the right to an automatic dividend and take the discretion away from the Board? 3. Held a. Yes—if contracted for in the Cert. of Incorp. b. Here, the cert. of incorp. was very clear that it gave the stockholders the right to force a dividend iii. LL Constantin & Co v. R.P. Holdings Corp 1. After that case^ the Board amended the By-Laws to clarify that dividend policy was the Board’s discretion and the preferred shares did not have the right to an automatic dividend a. PS shareholders sued and said no, you agreed in the articles that it did 2. Held a. No— Cert of Incorp. is ambiguous so decision still rests with Directors regardless of availability of net profits b. Shep thought this came out wrong b/c the Cert. usually overrides anything in the By-Laws, but maybe the Court was just trying to ensure the Board had discretion iv. Can the Board use the net profits for capital improvements instead of paying the dividend? 1. Guttman v. Illinois Central R. Co. a. Preferred stock was non-cumulative but anytime there was net profits, the directors had discretion to make dividend i. Directors chose to use net profits for capital improvements b. Held: YES – Board can use for capital improvements b/c there was no abuse in discretion in withholding dividends for any past years and no right survived to have those dividends declared subsequently 6. Legal Restrictions on Preferred Stock Distributions a. What is Surplus? i. DGCL – excess company net assets over the par value of the corporation’s issued stock 1. AKA – additional paid in capital (shares sold in excess of par) + retained earnings b. Issue with Cumulative Dividend Rights i. Hay v. Hay 1. Issue a. Are holders of cumulative preferred stock, upon liquidation of the corporation, entitled to be paid accrued dividends from the corporate assets before the common stockholders, when the corporation has no profits? 2. Held a. The parties clearly contracted that the preferred stockholders would receive a cumulative dividend and upon liquidation, they would be paid for missed dividends, regardless of whether there was any net profits ii. What happens when dividends have accumulated over the years, but company doesn’t have the funds to pay the dividend? 1. Court is split on this – some say only when there are net profits, others say anytime because that is what was contracted for c. Does the dividend accrue annually or daily? i. Smith v. Nu-West Industries 1. Depends on what the Corp’s Articles of Incorporation say a. Standard: What would a reasonable person in the position of the parties conclude as to the language in the articles? 2. Here, In the event of redemption, the certificate expressly provides that “dividends shall cease to accrue from and after the Class A Redemption Date designated in the notice of redemption.” a. Fact that it “accrued” suggested that there would be partial calculation if there was notice of redemption d. Mandatory Restraints on Redemption Rights i. SV Investment Partners v. Thoughtworks, Inc. 1. There is a difference between having “funds” and having “surplus” a. Surplus is legally available money i. Meaning, it would not make the Corp balance sheet insolvent or violate some other provision of the articles b/c it was an improper distribution 2. Here, P failed to show that D had funds legally available a. If D redeemed the preferred stock, there was a significant risk that the company would be rendered insolvent ii. Redemption is OK if – (2) 1. There is surplus available 2. Paying would not make the company bankrupt
