KMF – INSTITUT FÜR KAPITALMÄRKTE
UND FINANZWIRTSCHAFT
Corporate Finance
Institute for Capital Markets and Corporate Finance
Prof. Dr. Markus Glaser
Summer Term 2024
KMF – INSTITUT FÜR KAPITALMÄRKTE
UND FINANZWIRTSCHAFT
Some Remarks on this Course
• Topics chosen: minimum overlap with related courses (e.g. valuation)
• Repeating (corporate) finance basics (if necessary)
• Slides are completely based on Berk / DeMarzo (2020), Corporate Finance, 5th Edition (BD5e; older editions
can also be used)
• One main goal: Preparation for exam
• „Managerial Practice“?
Dietrich, Hans & Alexander Patzina (2023): Erwerbsverläufe von Personen mit allgemeiner Hochschulreife: Auf den Abschluss kommt es an
- Universität im Vergleich zu anderen Hochschulen. (IAB-Kurzbericht 2/2023), Nürnberg, 8 S. DOI:10.48720/IAB.KB.2302
"Junge Menschen mit allgemeiner Hochschulreife haben beim Erwerbseinstieg einen kurzzeitigen Startvorteil, wenn sie ihr Studium nicht an
einer Universität, sondern an einer anderen Hochschule abschließen. Im weiteren Erwerbsverlauf müssen aber Personen mit einem
anderen Hochschulabschluss im Vergleich zu denen mit Universitätsabschluss mit Einkommens- und Statusnachteilen rechnen. Nach
Geschlecht betrachtet erfahren insbesondere Absolventinnen von den anderen Hochschulen längerfristig Nachteile bei Einkommen und
Erwerbsstatus."
All Slides: Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
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UND FINANZWIRTSCHAFT
Also in this Course
• Understand various reasons for relevance of financial markets for corporate finance
• Economic mechanisms (“theory”) and their intuition (without too much math)
• Empirical evidence (testing theories, identifying mechanisms)
• Getting an idea of corporate finance research and how to evaluate it (relevance of data, identification of
economic mechanisms)
• No law or tax details
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UND FINANZWIRTSCHAFT
A Helpful Classification of (Corporate) Finance Insights
• Starting point: perfect markets. Then, adding…
• Real world frictions (taxes; transaction costs)
• Agency conflicts
• Asymmetric information
• Behavioral aspects
(“irrational markets”; “irrational managers”)
Agency problem When decision makers, despite being
hired as the agents of other stakeholders, put their own
self-interest ahead of the interests of the stakeholders.
(BD Glossary)
Asymmetric information A situation in which
parties have different information. It can arise
when, for example, managers have superior
information to investors regarding the firm’s
future cash flows. (BD Glossary)
Will be found in this course
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UND FINANZWIRTSCHAFT
CF@LMU: Lecture “Investition und Finanzierung”
Chapters of Berk/DeMarzo, Corporate Finance
 Chapter 1: The Corporation
 Chapter 2: Introduction to Financial Statement Analysis
 Chapter 3: Financial Decision Making and the Law of One Price
 Chapter 4: The Time Value of Money
 Chapter 5: Interest Rates
 Chapter 6: Valuing Bonds
 Chapter 7: Investment Decision Rules
 Chapter 8: Fundamentals of Capital Budgeting
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CF@LMU: Lecture “Investition und Finanzierung” cont.
 Chapter 9: Valuing Stocks
 Chapter 10: Capital Markets and the Pricing of Risk
 Chapter 11: Optimal Portfolio Choice and the Capital Asset Pricing Model
 [Chapter 12: Estimating the Cost of Capital]
 [Chapter 13: Investor Behavior and Capital Market Efficiency]
 [Chapter 14: Capital Structure in a Perfect Market]
 [Chapter 15: Debt and Taxes]
 [Chapter 16: Financial Distress, Managerial Incentives, and Information]
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UND FINANZWIRTSCHAFT
CF@LMU: Lecture “Risk Management”
Chapters of Berk/DeMarzo, Corporate Finance
 Chapter 20: Financial Options
 Chapter 21: Option Valuation
 Chapter 30: Risk Management
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UND FINANZWIRTSCHAFT
CF@LMU: Lecture “Corporate Finance”
Chapters of Berk/DeMarzo, Corporate Finance
 Chapter 12: Estimating the Cost of Capital
 Chapter 13: Investor Behavior and Capital Market Efficiency
 Chapter 14: Capital Structure in a Perfect Market
 Chapter 15: Debt and Taxes
 Chapter 16: Financial Distress, Managerial Incentives and Information
 Chapter 23: Raising Equity Capital
 Chapter 28: Mergers and Acquisitions
 [Chapter 20: Financial Options]
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Lecture content
KMF – INSTITUT FÜR KAPITALMÄRKTE
UND FINANZWIRTSCHAFT
Agenda
1
Risk and Return
Berk/DeMarzo Ch. 13
2
Capital Structure
Berk/DeMarzo Ch. 14-16
3
Cost of Capital
Berk/DeMarzo Ch. 12
4
Raising Equity Capital
Berk/DeMarzo Ch. 23
5
Mergers and Acquisitions
Berk/DeMarzo Ch. 28
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UND FINANZWIRTSCHAFT
Market Efficiency and the CAPM are Core Concepts in Corporate Finance
• Efficient Markets Hypothesis
•
Implies that securities will be fairly priced, based on their future cash flows, given all information that is available to
investors.
• Public, Easily Interpretable Information
•
If the impact of information that is available to all investors (news reports, financials statements, etc.) on the firm’s
future cash flows can be readily ascertained, then all investors can determine the effect of this information on the firm’s
value
•
In this situation, we expect the stock price to react nearly instantaneously to such news
• Private or Difficult-to-Interpret Information
•
Private information will be held by a relatively small number of investors
•
These investors may be able to profit by trading on their information
•
In this case, the efficient markets hypothesis will not hold in the strict sense. However, as these informed traders begin
to trade, they will tend to move prices, so over time prices will begin to reflect their information as well
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Market Efficiency and the CAPM are Core Concepts in Corporate Finance
• Private or Difficult-to-Interpret Information
•
If the profit opportunities from having private information are large, others will devote the resources needed to acquire it
•
In the long run, we should expect that the degree of “inefficiency” in the market will be limited by the costs of obtaining
the private information
• Consequences for Investors
•
If stocks are fairly priced, then investors who buy stocks can expect to receive future cash flows that fairly compensate
them for the risk of their investment
•
In such cases, the average investor can invest with confidence (in the diversified market portfolio), even if she/he is not
fully informed
• Implications for Corporate Managers
•
Focus on NPV and free cash flow
•
Use financial transactions to support investment
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Types of Market Efficiency
The type of market efficiency we describe here, where all publicly available information
is incorporated very quickly into stock prices, is often called semistrong form market
efficiency. The term “semistrong” indicates that it is not as complete as strong form
market efficiency, where prices immediately incorporate all information, including private
information known, for example, only to managers. Finally, the term weak form market
efficiency means that only the history of past prices is already reflected in the stock
price. It helps to think of the different forms of market efficiency as meaning that
prices incorporate a steadily increasing set of information, each of which
encompasses all the lower forms. For example, since the history of past prices is
public information, semistrong form efficiency encompasses weak form. The diagram
illustrates the idea. In the diagram, the information sets of weak form, semi- strong form,
and strong form efficiency are represented by the blue, green, and yellow circles,
respectively.
Not all market participants believe that the stock market is semistrong form efficient.
Technical analysts, who look for patterns in stock prices, do not believe the market is
even weak form efficient. Mutual fund managers and fundamental analysts, such as
those who work for brokerages and make stock recommendations, believe that
mispricing can be uncovered by careful analysis of company fundamentals. There is
evidence that traders with inside information about upcoming merger or earnings
announcements can make abnormal returns by trading (illegally) on that information, so
the market is clearly not strong form efficient.
Fundamentals of Corporate Finance, Global Edition, Jonathan Berk, Peter DeMarzo, Jarrad Harford
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UND FINANZWIRTSCHAFT
Market Efficiency and the CAPM are Core Concepts in Corporate Finance
• The efficient markets hypothesis states that securities with equivalent risk should have the same expected
return
• An arbitrage opportunity is a situation in which two securities with identical cash flows have different prices
• To measure the systematic risk of a stock, determine how much of the variability of its return is due to
systematic risk versus unsystematic risk
•
To determine how sensitive a stock is to systematic risk, look at the average change in the return for each 1% change in
the return of a portfolio that fluctuates solely due to systematic risk (i.e., the market portfolio)
• Sensitivity to Systematic Risk: Beta (β)
•
The expected percent change in the excess return of a security for a 1% change in the excess return of the market
portfolio
•
Beta differs from volatility. Volatility measures total risk (systematic plus unsystematic risk), while beta is a measure of
only systematic risk
• Capital Asset Pricing Model (CAPM):
E  R  = Risk -Free Interest Rate + Risk Premium
= rf + β × ( E  RMkt   rf )
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Style-Based Techniques and the Market Efficiency Debate (1)
• Excess Return and Market Capitalizations
•
Small market capitalization stocks have historically earned higher average returns than the market portfolio, even after
accounting for their higher betas.
• Excess Return and Book-to-Market Ratio
•
High book-to-market stocks have historically earned higher average returns than low book-to-market stocks.
• Book-to-market ratio The ratio of the book value of equity to the market value of equity. (BD Glossary)
• Efficient market When the cost of capital of an investment depends only on its systematic risk, and not its
diversifiable risk. (BD Glossary)
• Efficient markets hypothesis The idea that competition among investors works to eliminate all positiveNPV trading opportunities. It implies that securities will be fairly priced, based on their future cash flows,
given all information that is available to investors. (BD Glossary)
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Excess Return of Size Portfolios
• If the market portfolio is efficient and
there is no measurement error, all
portfolios would plot along this line.
• The error bars mark the 95%
confidence bands of the beta and
expected excess return estimates.
• Note the tendency of small stocks
to be above the security market
line.
Figure 13.9 Excess Return of Size Portfolios, 1926-2018
Source: Data courtesy of Kenneth French. The plot shows the average monthly excess return (the return minus the one- month risk-free rate) for ten portfolios formed in each year based on firms’ market capitalizations,
plotted as a function of the portfolio’s estimated beta. The black line is the security market line.
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Excess Return of Book-to-Market Portfolios
• Note the tendency of value
stocks (high book-to-market)
to be above the security
market line, and growth stocks
(low book-to-market) to be near
or below the line.
Figure 13.10 Excess Return of Book-to-Market Portfolios, 1926–2018
Source: Data courtesy of Kenneth French. The plot shows the same data as Figure 13.9, with portfolios formed based on stocks’ book-to-market ratios rather than size.
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Style-Based Techniques and the Market Efficiency Debate (2)
• Momentum
•
Momentum Strategy
•
Buying stocks that have had past high returns and (short) selling stocks that have had past low returns
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Multifactor Models of Risk
• Using Factor Portfolios
•
A self-financing portfolio can be constructed by going long in some stocks and going short in other stocks with equal
market value.
•
In general, a self-financing portfolio is any portfolio with portfolio weights that sum to zero rather than one.
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Multifactor Models of Risk (cont´d)
• Selecting the Portfolios
•
Market Capitalization Strategy
•
Each year, we place firms into one of two portfolios based on their market value of equity: Firms with market values
below the median of NYSE firms form an equally weighted portfolio, S, and firms above the median market value
form an equally weighted portfolio, B.
•
A trading strategy that each year buys portfolio S (small stocks) and finances this position by short selling portfolio B
(big stocks) has produced positive risk-adjusted returns historically.
•
This self-financing portfolio is widely known as the small-minus-big (SMB) portfolio.
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Multifactor Models of Risk (cont´d)
• Selecting the Portfolios
•
Book-to-Market Ratio Strategy
•
Each year firms with book-to-market ratios less than the 30th percentile of NYSE firms form an equally weighted
portfolio called the low portfolio, L. Firms with book-to-market ratios greater than the 70th percentile of NYSE firms
form an equally weighted portfolio called the high portfolio, H. A trading strategy that each year takes a long position
in portfolio H, which it finances with a short position in portfolio L, has produced positive risk-adjusted returns.
•
This self-financing portfolio is widely known as the high-minus-low (HML) portfolio.
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Multifactor Models of Risk (cont´d)
• Selecting the Portfolios
•
Past Returns Strategy
•
Each year, after ranking stocks by their return over the last one year, a trading strategy that buys the top 30% of
stocks and finances this position by short selling bottom 30% of stocks has historically produced positive riskadjusted returns.
•
This self-financing portfolio is widely known as the prior one-year momentum (PR1YR) portfolio.
•
This trading strategy requires holding the portfolio for a year, and the process is repeated annually.
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FFC Portfolio Average Monthly Returns, 1927–2018
Average Monthly
Return (%)
95% Confidence
Band (%)
Mkt − rf
0.66
±0.32
SMB
0.26
±0.19
HML
0.38
±0.21
PR1YR
0.66
±0.28
Factor Portfolio
• Fama-French-Carhart (FFC) Factor Specifications:
E[ Rs ]  rf   sMkt ( E[ RMkt ]  rf )   sSMB E[ RSMB ]
  sHML E[ RHML ]   sPR1YR E[ RPR1YR ]
Table 13.1 FFC Portfolio Average Monthly Returns, 1927–2018
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Agenda
1
Risk and Return
Berk/DeMarzo Ch. 13
2
Capital Structure
Berk/DeMarzo Ch. 14-16
3
Cost of Capital
Berk/DeMarzo Ch. 12
4
Raising Equity Capital
Berk/DeMarzo Ch. 23
5
Mergers and Acquisitions
Berk/DeMarzo Ch. 28
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Agenda
2
Capital Structure
Berk/DeMarzo Ch. 14-16
Chapter 14
Capital Structure
Chapter 15
Debt and Taxes
Chapter 16
Financial Distress, Managerial Incentives, and Information
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Financing a Firm with Equity
• You are considering an investment opportunity.
•
For an initial investment of $800 this year, the project will generate cash flows of either $1400 or $900 next year,
depending on whether the economy is strong or weak, respectively.
•
Both scenarios are equally likely.
Capital structure The relative proportions of debt, equity, and other securities that a firm has outstanding. (BD
Glossary)
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Financing a Firm with Equity (cont´d)
• The project cash flows depend on the overall economy and thus contain market risk.
•
As a result, you demand a 10% risk premium over the current risk−free interest rate of 5% to invest in this project.
• What is the NPV of this investment opportunity?
• Risk premium Represents the additional return that investors expect to earn to compensate them for a
security’s risk. (BD Glossary)
• Net Present Value (NPV) Decision Rule When making an investment decision, take the alternative with the
highest NPV. Choosing this alternative is equivalent to receiving its NPV in cash today. Also known as NPV
Investment Rule. (BD Glossary)
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Financing a Firm with Equity (cont´d)
• The cost of capital for this project is 15%. The expected cash flow in one year is
1
1
$1400
+

  $900  = $1150.
2
2
• The NPV of the project is
$1150
NPV = $800 +
= $800 + $1000 = $200.
1.15
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Financing a Firm with Equity (cont´d)
• If you finance this project using only equity, how much would you be willing to pay for the project? Recall
that, in the absence of arbitrage, the price of a security equals the present value of its cash flows.
$1150
PV (equity cash flows) =
= $1000
1.15
• If you can raise $1000 by selling equity in the firm, after paying the investment cost of $800, you can keep
the remaining $200, the NPV of the project NPV, as a profit.
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Financing a Firm with Equity (cont´d)
• Unlevered Equity
•
Equity in a firm with no debt
• Because there is no debt, the cash flows of the unlevered equity are equal to those of the project.
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Financing a Firm with Equity (cont´d)
• Shareholder’s returns are either 40% or −10%
1
1
 40%  +  10%  = 15%.
2
2
• Because the cost of capital of the project is 15%, shareholders are earning an appropriate return for the risk
they are taking.
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Financing a Firm with Debt and Equity
• Suppose you decide to borrow $500 initially, in addition to selling equity
•
Because the project’s cash flow will always be enough to repay the debt, the debt is risk free, and you can borrow at
the risk−free interest rate of 5%. You will owe the debt holders
•
$500 × 1.05 = $525 in one year.
• Levered Equity
•
Equity in a firm that also has debt outstanding
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Financing a Firm with Debt and Equity (cont´d)
• Given the firm’s $525 debt obligation, your shareholders will receive only $875 ($1400 − $525 = $875) if the
economy is strong and $375 ($900 − $525 = $375) if the economy is weak.
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Financing a Firm with Debt and Equity (cont´d)
• What price E should the levered equity sell for?
• Which is the best capital structure choice for the entrepreneur?
• Modigliani and Miller argued that with perfect capital markets, the total value of a firm should not depend on
its capital structure.
•
They reasoned that the firm’s total cash flows still equal the cash flows of the project and, therefore, have the same
present value.
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Financing a Firm with Debt and Equity (cont´d)
• Because the cash flows of the debt and equity sum to the cash flows of the project, by the Law of One Price
the combined values of debt and equity must be $1000.
•
Therefore, if the value of the debt is $500, the value of the levered equity must be $500.
•
E = $1000 − $500 = $500
Law of One Price In competitive markets, securities or portfolios with the same cash flows must have the same
price. (BD Glossary)
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Financing a Firm with Debt and Equity (cont´d)
• Because the cash flows of levered equity are smaller than those of unlevered equity, levered equity will sell
for a lower price ($500 versus $1000).
•
However, you are not worse off.
•
You will still raise a total of $1000 by issuing both debt and levered equity.
•
Consequently, you would be indifferent between these two choices for the firm’s capital structure.
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The Effect of Leverage on Risk and Return
• Leverage increases the risk of the equity of a firm.
•
Therefore, it is inappropriate to discount the cash flows of levered equity at the same discount rate of 15% that you
used for unlevered equity. Investors in levered equity will require a higher expected return to compensate for the
increased risk.
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The Effect of Leverage on Risk and Return (cont´d)
• The returns to equity holders are very different with and without leverage.
•
Unlevered equity has a return of either 40% or −10%, for an expected return of 15%.
•
Levered equity has higher risk, with a return of either 75% or −25%.
•
To compensate for this risk, levered equity holders receive a higher expected return of 25%.
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The Effect of Leverage on Risk and Return (cont´d)
• The relationship between risk and return can be evaluated more formally by computing the sensitivity of each
security’s return to the systematic risk of the economy.
Return Sensitivity
(Systematic Risk)
Risk premium
ΔR = R(strong) − R(weak)
5% − 5% = 0%
5% − 5% = 0%
Unlevered equity
40% − (−10%) = 50%
15% − 5% = 10%
Levered equity
75% − (−25%) = 100%
25% − 5% = 20%
Debt
Systematic, undiversifiable, or market risk Fluctuations of a stock’s return that are due to market-wide news
representing common risk. (BD Glossary)
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The Effect of Leverage on Risk and Return (cont´d)
• Because the debt’s return bears no systematic risk, its risk premium is zero.
• In this particular case, the levered equity has twice the systematic risk of the unlevered equity and, as a
result, has twice the risk premium.
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The Effect of Leverage on Risk and Return (cont´d)
• In summary,
•
In the case of perfect capital markets, if the firm is 100% equity financed, the equity holders will require a 15%
expected return.
•
If the firm is financed 50% with debt and 50% with equity, the debt holders will receive a return of 5%, while the levered
equity holders will require an expected return of 25% (because of their increased risk).
•
Leverage increases the risk of equity even when there is no risk that the firm will default.
•
Thus, while debt may be cheaper, its use raises the cost of capital for equity. Considering both sources of capital
together, the firm’s average cost of capital with leverage is the same as for the unlevered firm.
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Modigliani−Miller I: Leverage, Arbitrage, and Firm Value
• The Law of One Price implies that leverage will not affect the total value of the firm.
•
Instead, it merely changes the allocation of cash flows between debt and equity, without altering the total cash flows of
the firm.
• Modigliani and Miller (MM) showed that this result holds more generally under a set of conditions referred to
as perfect capital markets:
•
Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their
future cash flows.
•
There are no taxes, transaction costs, or issuance costs associated with security trading
•
A firm’s financing decisions do not change the cash flows generated by its investments, nor do they reveal new
information about them.
• MM Proposition I
•
In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows generated by its
assets and is not affected by its choice of capital structure.
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Modigliani−Miller II: Leverage, Risk, and the Cost of Capital
• Leverage and the Equity Cost of Capital
•
MM’s first proposition can be used to derive an explicit relationship between leverage and the equity cost of capital.
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Modigliani−Miller II: Leverage, Risk, and the Cost of Capital (cont´d)
• Leverage and the Equity Cost of Capital
•
E
•
•
Market value of equity in a levered firm
D
•
•
Market value of debt in a levered firm
U
•
•
Market value of equity in an unlevered firm
A
•
Market value of the firm’s assets
Market value balance sheet Similar to an accounting balance sheet, with two key distinctions: First, all assets
and liabilities of the firm are included, even intangible assets such as reputation, brand name, or human capital
that are missing from a standard accounting balance sheet; second, all values are current market values rather
than historical costs. (BD Glossary)​
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Modigliani−Miller II: Leverage, Risk, and the Cost of Capital (cont´d)
• Leverage and the Equity Cost of Capital
•
MM Proposition I states that
E  D  U  A.
• The total market value of the firm’s securities is equal to the market value of its assets, whether the firm is
unlevered or levered.
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Modigliani−Miller II: Leverage, Risk, and the Cost of Capital (cont´d)
• Leverage and the Equity Cost of Capital
•
The return on unlevered equity (RU) is related to the returns of levered equity (RE) and debt (RD):
E
D
RE 
RD  RU
ED
ED
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Modigliani−Miller II: Leverage, Risk, and the Cost of Capital (cont´d)
• Leverage and the Equity Cost of Capital
•
Solving for RE:
RE 
RU
Risk without
leverage
•

D
( RU  RD )
E
Additional risk
due to leverage
The levered equity return equals the unlevered return, plus a premium due to leverage.
•
The amount of the premium depends on the amount of leverage, measured by the firm’s market value debt−equity
ratio
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Modigliani−Miller II: Leverage, Risk, and the Cost of Capital (cont´d)
• Leverage and the Equity Cost of Capital
•
MM Proposition II:
•
The cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a premium that is
proportional to the market value debt−equity ratio
•
Cost of Capital of Levered Equity
D
rE  rU  (rU  rD )
E
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Modigliani−Miller II: Leverage, Risk, and the Cost of Capital (cont´d)
• Leverage and the Equity Cost of Capital
•
Recall from above:
•
If the firm is all−equity financed, the expected return on unlevered equity is 15%.
•
If the firm is financed with $500 of debt, the expected return of the debt is 5%.
D
rE  rU  (rU  rD )
E
rE  15% 
500
(15%  5%)  25%
500
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Capital Budgeting and the Weighted Average Cost of Capital
• If a firm is unlevered, all of the free cash flows generated by its assets are paid out to its equity holders
•
The market value, risk, and cost of capital for the firm’s assets and its equity coincide and therefore
rU  rA
• If a firm is levered, project rA is equal to the firm’s weighted average cost of capital.
•
Unlevered Cost of Capital (Pretax WACC)
Equity
Debt
 Fraction of Firm Value  
  Fraction of Firm Value  

rwacc  


 


 Financed by Equity   Cost of Capital   Financed by Debt   Cost of Capital 
E
D

rE 
rD
ED
ED
rwacc  rU  rA
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Capital Budgeting and the Weighted Average Cost of Capital (cont´d)
• With perfect capital markets, a firm’s WACC is independent of its capital structure and is equal to its equity
cost of capital if it is unlevered, which matches the cost of capital (return) of its assets.
• With no debt, the WACC is equal to the unlevered equity cost of capital.
• As the firm borrows at the low cost of capital for debt, its equity cost of capital rises. The net effect is that the
firm’s WACC is unchanged.
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WACC and Leverage with Perfect Capital Markets
• (a) Equity, debt, and weighted average costs of
capital for different amounts of leverage. The rate
of increase of rD and rE, and thus the shape of the
curves, depends on the characteristics of the firm’s
cash flows.
• (b) Calculating the WACC for alternative capital
structures. Data in this table correspond to the
example in Section 14.1.
Figure 14.1 WACC and Leverage with Perfect Capital Markets
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WACC and Leverage with Perfect Capital Markets
• Remark (beyond this course):
• *This level of leverage corresponds to a promised yield of 16.67%. Because the firm defaults and debt earns
a zero return with 50% probability, the expected return of the debt, rD, is only 8.33%, representing a risk
premium of 3.33%. This risk premium is 1/3 that of unlevered equity, which is justified since it has 1/3 the
return sensitivity (16.67% versus 50%).
• Note: 1050/900 – 1 = 16.67% and 900/900 – 1 = 0%
• Equity (good state): (1400 – 1050)/100 – 1 = (350 – 100)/100 = 250%
• Equity (bad state): (100 – 100)/100 – 1 = (0 – 100)/100 = –100%
• Return (equity) = 0.5 × (–100%) + 0.5 × 250% = 75%
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Textbook Example 14.5
Enterprise value: The total market value of a firm’s equity and debt, less the value of its cash and marketable
securities. It measures the value of the firm’s underlying business. (BD Glossary)
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Textbook Example 14.5 (cont´d)
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Levered and Unlevered Betas
• The effect of leverage on the risk of a firm’s securities can also be expressed in terms of beta:
E
D
βU 
βE 
βD
ED
ED
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Levered and Unlevered Betas (cont´d)
• Unlevered Beta
•
A measure of the risk of a firm as if it did not have leverage, which is equivalent to the beta of the firm’s assets.
• If you are trying to estimate the unlevered beta for an investment project, you should base your estimate on
the unlevered betas of firms with comparable investments.
• Leverage amplifies the market risk of a firm’s assets, βU, raising the market risk of its equity
D
βE  βU  ( βU  βD )
E
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Textbook Example 14.7
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Textbook Example 14.7 (cont´d)
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Textbook Example 12.6
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Textbook Example 12.6 (cont´d)
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MM: Beyond the Propositions
• Conservation of Value Principle for Financial Markets
•
With perfect capital markets, financial transactions neither add nor destroy value, but instead represent a repackaging
of risk (and therefore return).
•
This implies that any financial transaction that appears to be a good deal may be exploiting some type of
market imperfection.
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Chapter Quiz
1.
How does the risk and cost of capital of levered equity compare to that of unlevered equity?
2.
Which is the superior capital structure choice in a perfect capital market?
3.
What is a market value balance sheet?
4.
With perfect capital markets, as a firm increases its leverage, how does its debt cost of capital change? Its
equity cost of capital? Its weighted average cost of capital?
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Agenda
2
Capital Structure
Berk/DeMarzo Ch. 14-16
Chapter 14
Capital Structure
Chapter 15
Debt and Taxes
Chapter 16
Financial Distress, Managerial Incentives, and Information
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The Interest Tax Deduction
• Corporations pay taxes on their profits after interest payments are deducted.
•
Thus, interest expense reduces the amount of corporate taxes.
•
This creates an incentive to use debt.
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The Interest Tax Deduction (cont´d)
• Consider Macy’s, which had earnings before interest and taxes of approximately $2.8 billion in 2014 and
interest expenses of about $400 million.
•
Macy’s marginal corporate tax rate was 35%
• Macy’s net income in 2014 was lower with leverage than it would have been without leverage.
With Leverage
Without Leverage
EBIT
Interest expense
$2800
−400
$2800
0
Income before tax
Taxes (35%)
2400
−840
2800
−980
Net income
$1560
$1820
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The Interest Tax Deduction (cont´d)
• Macy’s debt obligations reduced the value of its equity.
• But the total amount available to all investors was higher with leverage.
With Leverage
Without Leverage
Interest paid to debt
holders
Income available to
equity holders
400
1560
0
1820
Total available to all
investors
$1960
$1820
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The Interest Tax Deduction (cont´d)
• Without leverage, Macy’s was able to pay out $1820 million in total to its investors.
• With leverage, Macy’s was able to pay out $1960 million in total to its investors.
• Where does the additional $140 million come from?
• Interest Tax Shield
•
The reduction in taxes paid due to the tax deductibility of interest
•
In Macy’s case, the gain is equal to the reduction in taxes with leverage: $980 million − $840 million = $140 million
•
The interest payments provided a tax savings of 35% × $400 million = $140 million
Interest Tax Shield  Corporate Tax Rate  Interest Payments
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Textbook Example 15.1
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Textbook Example 15.1 (cont´d)
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Valuing the Interest Tax Shield
• When a firm uses debt, the interest tax shield provides a corporate tax benefit each year.
• This benefit is computed as the present value of the stream of future interest tax shields the firm will receive.
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The Interest Tax Shield and Firm Value
• The cash flows a levered firm pays to investors will be higher than they would be without leverage by the
amount of the interest tax shield
 Cash Flows to Investors   Cash Flows to Investors 


  (Interest Tax Shield)
with Leverage

  without Leverage 
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The Interest Tax Shield and Firm Value (cont´d)
• MM Proposition I with Taxes
•
The total value of the levered firm exceeds the value of the firm without leverage due to the present value of the tax
savings from debt:
V L = V U + PV (Interest Tax Shield)
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The Interest Tax Shield with Permanent Debt
• Typically, the level of future interest payments is uncertain due to changes in the marginal tax rate, the
amount of debt outstanding, the interest rate on that debt, and the risk of the firm.
• For simplicity, we will consider the special case in which the above variables are kept constant.
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The Interest Tax Shield with Permanent Debt (cont´d)
• Suppose a firm borrows debt D and keeps the debt permanently. If the firm’s marginal tax rate is 𝜏c , and if
the debt is riskless with a risk-free interest rate rf , then the interest tax shield each year is 𝜏c × rf × D, and the
tax shield can be valued as a perpetuity:
PV (Interest Tax Shield) 
 c  Interest
rf

 c  ( rf  D )
rf
c  D
C
PV (C in perpetuity) =
r
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The Interest Tax Shield with Permanent Debt (cont´d)
• We will now look at an alternative way to derive this result​
• If the debt is fairly priced, no arbitrage implies that its market value must equal the present value of the future
interest payments:
Market Value of Debt = D = PV (Future Interest Payments)
Arbitrage The practice of buying and selling equivalent goods or portfolios to take advantage of a price
difference. (BD Glossary)
Arbitrage opportunity Any situation in which it is possible to make a profit without taking any risk or making
any investment. (BD Glossary)
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The Interest Tax Shield with Permanent Debt (cont´d)
• If the firm’s marginal tax rate is constant, then
PV (Interest Tax Shield)  PV (τ c  Future Interest Payments)
 τ c  PV (Future Interest Payments)
 τc  D
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The Weighted Average Cost of Capital with Taxes
• With tax-deductible interest, the effective after-tax borrowing rate is r(1 − 𝜏c) and the weighted average cost
of capital becomes
rWacc 
E
D
rE 
rD (1  c )
ED
ED
E
D
D
rWacc 
rE 
rD 
rD c
ED
ED
ED
Pretax WACC
Reduction Due
to Interest Tax Shield
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Textbook Example 12.9
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Textbook Example 12.9 (cont´d)
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The WACC with and without Corporate Taxes
• The firm’s unlevered cost of capital or pretax
WACC is constant, reflecting the required
return of the firm’s investors based on the risk
of the firm’s assets.
• However, the (effective after-tax) WACC, which
represents the after-tax cost to the firm,
declines with leverage as the interest tax shield
grows.
• The figure assumes a marginal corporate
income tax rate of tc = 35%.
Figure 15.2 The WACC with and without Corporate Taxes
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Optimal Capital Structure with Taxes
• Do Firms Prefer Debt?
•
When firms raise new capital from investors, they do so primarily by issuing debt.
•
In most years, aggregate equity issues are negative, meaning that on average, firms are reducing the amount of equity
outstanding by buying shares.
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Net External Financing and Capital Expenditures by U.S. Corporations, 1975–2017
• In aggregate, firms have raised external
capital primarily by issuing debt.
• These funds have been used to retire equity
and fund investment, but the vast majority of
capital expenditures are internally funded.
Figure 15.5 Net External Financing and Capital Expenditures by U.S. Corporations, 1975–2017
Source: Federal Reserve, Flow of Funds Accounts of the United States, 2017.
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Optimal Capital Structure with Taxes (cont´d)
• Do Firms Prefer Debt?
•
While firms seem to prefer debt when raising external funds, not all investment is externally funded.
•
Most investment and growth is supported by internally generated funds.
•
Even though firms have not issued new equity, the market value of equity has risen over time as firms have grown.
•
For the average firm, the result is that debt as a fraction of firm value has varied in a range from 30% to 45%.
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Debt-to-Value Ratio [D/(E + D)] of U.S. Firms, 1975–2017
• Although firms have primarily
issued debt rather than equity, the
average proportion of debt in their
capital structures has not
increased due to the growth in
value of existing equity.
Figure 15.6 Debt-to-Value Ratio [D/(E + D)] of U.S. Firms, 1975–2017
Source: Compustat and Federal Reserve, Flow of Funds Accounts of the United States, 2017.
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Optimal Capital Structure with Taxes (cont´d)
• Do Firms Prefer Debt?
•
The use of debt varies greatly by industry.
•
Firms in growth industries like biotechnology or high technology carry very little debt, while airlines, automakers,
utilities, and financial firms have high leverage ratios.
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Debt-to-Enterprise Value Ratio for Selected Industries
• Enterprise value The total market value of a
firm’s equity and debt, less the value of its cash
and marketable securities. It measures the value
of the firm’s underlying business. (BD Glossary)
• Net debt Total debt outstanding minus any cash
balances. (BD Glossary)
Figure 15.7 Debt-to-Enterprise Value Ratio for Selected Industries
Source: Capital IQ, 2018.
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Debt-to-Enterprise Value Ratio for Selected Industries
• Figure shows industry median levels of net debt
and total debt as a percentage of firm enterprise
value.
• The spread between them, shown by the blue
bars, corresponds to cash holdings. For example,
Biotech firms tend to have no debt but hold a great
deal of cash, and so have negative net debt.
• Consumer Finance firms have much less cash and
over 50% total debt. While the median level of debt
for all U.S. stocks was about 17% of firm value,
note the large differences by industry.
Figure 15.7 Debt-to-Enterprise Value Ratio for Selected Industries
Source: Capital IQ, 2018
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Limits to the Tax Benefit of Debt
• To receive the full tax benefits of leverage, a firm need not use 100% debt financing, but the firm does need
to have taxable earnings.
•
This constraint may limit the amount of debt needed as a tax shield.
• The optimal level of leverage from a tax saving perspective is the level such that interest equals EBIT.
•
At the optimal level of leverage, the firm shields all of its taxable income, and it does not have any tax-disadvantaged
excess interest (because interest payments constitute a tax disadvantage at the investor level).
•
In the U.S. and many other countries, interest income has historically been taxed more heavily than capital gains from
equity.
• However, it is unlikely that a firm can predict its future EBIT (and the optimal level of debt) precisely.
•
If there is uncertainty regarding EBIT, then there is a risk that interest will exceed EBIT. As a result, the tax savings for
high levels of interest falls, possibly reducing the optimal level of the interest payment.
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Interest Payments as a Percentage of EBIT and Percentage of Firms with Negative Pre-tax
Income, S&P 500 1975–2017
• On average, firms shield less than one
third of their income via interest
expenses
Figure 15.9 Interest Payments as a Percentage of EBIT and Percentage of Firms with Negative Pre-tax Income, S&P 500 1975–2017
Source: Compustat
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The Low Leverage Puzzle
• It would appear that firms, on average, are under-leveraged. However, it is hard to accept that most firms
are acting sub-optimally.
•
In reality, there is more to the capital structure story than discussed so far.
• A key item missing from the analysis thus far is that increasing the level of debt increases the probability of
bankruptcy.
• If bankruptcy is costly, these costs might offset the tax advantages of debt financing.
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Chapter Quiz
1. How do corporate taxes impact a firm’s value as leverage changes?
2. How does leverage affect a firm’s weighted average cost of capital?
3. Under current tax law, why is there a personal tax disadvantage of debt?
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Agenda
2
Capital Structure
Berk/DeMarzo Ch. 14-16
Chapter 14
Capital Structure
Chapter 15
Debt and Taxes
Chapter 16
Financial Distress, Managerial Incentives, and Information
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Default and Bankruptcy in a Perfect Market
• Financial Distress
•
When a firm has difficulty meeting its debt obligations
• Default
•
When a firm fails to make the required interest or principal payments on its debt or violates a debt covenant
•
After the firm defaults, debt holders are given certain rights to the assets of the firm and may even take legal
ownership of the firm’s assets through bankruptcy.
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Bankruptcy and Capital Structure
• With perfect capital markets, Modigliani-Miller (MM) Proposition I applies: The total value to all investors does
not depend on the firm’s capital structure.
• There is no disadvantage to debt financing, and a firm will have the same total value and will be able to raise
the same amount initially from investors with either choice of capital structure.
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Direct Costs of Bankruptcy
• The bankruptcy process is complex, time-consuming, and costly.
•
Costly outside experts are often hired by the firm to assist with the bankruptcy process.
•
Creditors also incur costs during the bankruptcy process.
•
They may wait several years to receive payment.
•
They may hire their own experts for legal and professional advice.
• The direct costs of bankruptcy reduce the value of the assets that the firm’s investors will ultimately receive.
•
The average direct costs of bankruptcy are approximately 3% to 4% of the pre-bankruptcy market value of total assets.
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Indirect Costs of Financial Distress
• Although the indirect costs are difficult to measure accurately, they are often much larger than the direct
costs of bankruptcy.
•
Loss of Customers
•
Loss of Suppliers
•
Loss of Employees
•
Loss of Receivables
•
Fire Sale of Assets
•
…
• The indirect costs of financial distress may be substantial
•
It is estimated that the potential loss due to financial distress is 10% to 20% of firm value.
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Optimal Capital Structure: The Tradeoff Theory
• Tradeoff Theory
•
The firm picks its capital structure by trading off the benefits of the tax shield from debt against the costs of financial
distress (and agency costs).
•
According to the Tradeoff theory, the total value of a levered firm equals the value of the firm without leverage
plus the present value of the tax savings from debt, less the present value of financial distress costs:
V L = V U + PV (Interest Tax Shield)  PV (Financial Distress Costs)
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The Present Value of Financial Distress Costs
Two key factors determine the present value of financial distress costs:
1. The probability of financial distress
•
The probability of financial distress increases with the amount of a firm’s liabilities (relative to its assets).
•
The probability of financial distress increases with the volatility of a firm’s cash flows and asset values.
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The Present Value of Financial Distress Costs (cont´d)
Two key factors determine the present value of financial distress costs:
2. The magnitude of the costs after a firm is in distress
•
Financial distress costs will vary by industry.
•
Technology firms will likely incur high financial distress costs due to the potential for loss of customers and key
personnel, as well as a lack of tangible assets that can be easily liquidated.
•
Real estate firms are likely to have low costs of financial distress because the majority of their assets can be sold
relatively easily.
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Optimal Leverage
• For low levels of debt, the risk of default remains low, and the main effect of an increase in leverage is an
increase in the interest tax shield.
• As the level of debt increases, the probability of default increases.
•
As the level of debt increases, the costs of financial distress increase, reducing the value of the levered firm.
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Optimal Leverage (cont´d)
• The Tradeoff theory states that firms should increase their leverage until it reaches the level for which the
firm value is maximized.
•
At this point, the tax savings that result from increasing leverage are perfectly offset by the increased probability of
incurring the costs of financial distress.
• The Tradeoff theory can help explain
•
Why firms choose debt levels that are too low to fully exploit the interest tax shield (due to the presence of financial
distress costs).
•
Differences in the use of leverage across industries (due to differences in the magnitude of financial distress costs and
the volatility of cash flows).
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Optimal Leverage with Taxes and Financial Distress Costs
• As the level of debt, D, increases, the tax
benefits of debt increase by t*D until the
interest expense exceeds the firm’s EBIT.
• The probability of default, and hence the
present value of financial distress costs, also
increase with D.
• The optimal level of debt, D*, occurs when
these effects balance out and VL is
maximized.
• D* will be lower for firms with higher costs of
financial distress.
Figure 16.1 Optimal Leverage with Taxes and Financial Distress Costs
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Exploiting Debt Holders: The Agency Costs of Leverage
• Agency Costs
•
Costs that arise when there are conflicts of interest between the firm’s stakeholders
• Management will generally make decisions that increase the value of the firm’s equity.
•
However, when a firm has leverage, managers may make decisions that benefit shareholders but harm the firm’s
creditors and lower the total value of the firm.
Agency problem When decision makers, despite being hired as the agents of other stakeholders, put their own
self-interest ahead of the interests of the stakeholders. (BD Glossary)​
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(Extreme) Example: Cashing Out
• When a firm faces financial distress, shareholders have an incentive to withdraw money from the firm, if
possible.
•
For example, if it is likely the company will default, the firm may sell assets below market value and use the funds to
pay an immediate cash dividend to the shareholders.
•
This is a form of under-investment that occurs when a firm faces financial distress.
•
Example:
•
Wirecard employees removed millions in cash using shopping bags | Financial Times (ft.com); APRIL 22 2021;
https://www.ft.com/content/31a8ed93-f602-47f0-9120-4b4f152ec7bc)
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Motivating Managers: The Agency Benefits of Leverage
• Problem: Management Entrenchment
•
A situation arising as the result of the separation of ownership and control in which managers may make decisions that
benefit themselves at investors’ expenses.
•
Entrenchment may allow managers to run the firm in their own best interests, rather than in the best interests of the
(remaining) shareholders.
• Solution: Leverage can provide incentives for managers to run the firm more efficiently and effectively
•
Concentration of Ownership
•
Reduction of Wasteful Investment
Management entrenchment A situation arising as the result of the separation of ownership and control in
which managers may make decisions that benefit themselves at investors’ expense.
Management entrenchment theory A theory that suggests managers choose a capital structure to avoid the
discipline of debt and maintain their own job security. (BD Glossary)​
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Concentration of Ownership
• One advantage of using leverage is that it allows the original owners of the firm to maintain their equity stake.
• As major shareholders, they will have a strong interest in doing what is best for the firm.
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(Reduction of) Wasteful Investment
• A concern for large corporations is that managers may make large, unprofitable investments.
•
What would motivate managers to make negative-NPV investments?
• Managers may engage in empire building
•
Managers often prefer to run larger firms rather than smaller ones, so they will take on investments that increase the
size, but not necessarily the profitability, of the firm.
•
Managers of large firms tend to earn higher salaries, and they may also have more prestige and garner greater
publicity than managers of small firms.
•
Thus, managers may expand unprofitable divisions, pay too much for acquisitions, make unnecessary capital
expenditures, or hire unnecessary employees.
Financial slack is valuable. Having financial slack means having cash, marketable securities, readily salable real assets, and
ready access to debt markets or to bank financing. In the long run, a company’s value rests more on its capital investment and
operating decisions than on financing. Therefore, you want to make sure your firm has sufficient financial slack so that financing
is quickly available for good investments. Financial slack is most valuable to firms with plenty of positive-NPV growth
opportunities. That is another reason why growth companies usually aspire to conservative capital structures (i.e., a low leverage
ratio). Of course financial slack is only valuable if you’re willing to use it. (Brealey / Myers / Allen)
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(Reduction of) Wasteful Investment (cont´d)
• Managers may over-invest because they are overconfident.
•
Even when managers attempt to act in shareholders’ interests, they may make mistakes.
•
Managers tend to be bullish on the firm’s prospects and may believe that new opportunities are better than they
actually are.
• Free Cash Flow Hypothesis
•
The view that wasteful spending is more likely to occur when firms have high levels of cash flow in excess of what is
needed after making all positive-NPV investments and payments to debt holders.
• When cash is tight, managers will be motivated to run the firm as efficiently as possible.
•
According to the free cash flow hypothesis, leverage increases firm value because it commits the firm to making future
interest payments, thereby reducing excess cash flows and wasteful investment by managers.
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Reduction of Wasteful Investment (cont´d)
• Leverage can reduce the degree of managerial entrenchment because managers are more likely to be fired
when a firm faces financial distress.
•
Managers who are less entrenched may be more concerned about their performance and less likely to engage in
wasteful investment.
• In addition, when the firm is highly levered, creditors themselves will closely monitor the actions of managers,
providing an additional layer of management oversight.
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Agency Costs and the Tradeoff Theory
• The value of the levered firm can now be shown to be
V L = V U + PV (Interest Tax Shield)  PV (Financial Distress Costs)
 PV (Agency Costs of Debt) + PV (Agency Benefits of Debt)
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Corporate perks
Corporate perks – examples:
• a large office with fancy artwork
• a corporate limo and driver
• a corporate jet
• a large expense account
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Optimal Leverage with Taxes, Financial Distress, and Agency Costs
• As the level of debt, D, increases, the value of
the firm increases from the interest tax shield
as well as improvements in managerial
incentives.
• If leverage is too high, however, the present
value of financial distress costs, as well as the
agency costs from debt holder–equity holder
conflicts, dominates and reduces firm value.
• The optimal level of debt, D*, balances these
benefits and costs of leverage.
Figure 16.2 Optimal Leverage with Taxes, Financial Distress, and Agency Costs
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The Optimal Debt Level
• R&D-Intensive Firms
•
Firms with high R&D costs and future growth opportunities typically maintain low debt levels.
•
These firms tend to have low current free cash flows and risky business strategies.
• Low-Growth, Mature Firms
•
Mature, low-growth firms with stable cash flows and tangible assets often carry a high-debt load.
•
These firms tend to have high free cash flows with few good investment opportunities.
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Asymmetric Information and Capital Structure
• Asymmetric Information
•
A situation in which parties have different information.
•
For example, when managers have superior information to investors regarding the firm’s future cash flows.
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Issuing Equity and Adverse Selection
• Adverse Selection
•
The idea that when the buyers and sellers have different information, the average quality of assets in the market will
differ from the average quality overall.
• Lemons Principle
•
When a seller has private information about the value of a good, buyers will discount the price they are willing to pay
due to adverse selection.
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Issuing Equity and Adverse Selection (cont´d)
• A classic example of adverse selection and the lemons principle is the used car market.
•
If the seller has private information about the quality of the car, then his desire to sell reveals the car is probably of low
quality.
•
Buyers are therefore reluctant to buy except at heavily discounted prices.
•
Owners of high-quality cars are reluctant to sell because they know buyers will think they are selling a lemon and offer
only a low price.
•
Consequently, the quality and prices of cars sold in the used-car market are both low.
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Issuing Equity and Adverse Selection (cont´d)
• This same principle can be applied to the market for equity.
•
Suppose the owner of a start-up company offers to sell you 70% of his stake in the firm.
•
He states that he is selling only because he wants to diversify.
•
You suspect the owner may be eager to sell such a large stake because he may be trying to cash out before negative
information about the firm becomes public.
• Firms that sell new equity have private information about the quality of the future projects.
•
However, due to the lemons principle, buyers are reluctant to believe management’s assessment of the new projects
and are only willing to buy the new equity at heavily discounted prices.
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Issuing Equity and Adverse Selection (cont´d)
• Therefore, managers who know their prospects are good (and whose securities will have a high value) will
not sell new equity.
• Only those managers who know their firms have poor prospects (and whose securities will have low value)
are willing to sell new equity.
• The lemons problem creates a cost for firms that need to raise capital from investors to fund new
investments.
•
If they try to issue equity, investors will discount the price they are willing to pay to reflect the possibility that managers
have bad news.
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Implications for Equity Issuance
• The lemons principle directly implies the following:
•
The stock price declines on the announcement of an equity issue.
•
The stock price tends to rise prior to the announcement of an equity issue.
•
Firms tend to issue equity when information asymmetries are minimized, such as immediately after earnings
announcements.
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Stock Returns Before and After an Equity Issue
Stocks tend to rise (relative to the market)
before an equity issue is announced. Upon
announcement, stock prices fall on average.
Figure 16.3 Stock Returns Before and After an Equity Issue
This figure shows the average return relative to the market before and after announcements using data from D. Lucas and R. McDonald, “Equity Issues and Stock Price Dynamics,” Journal of Finance 45 (1990): 1019–1043.
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Implications for Capital Structure
• Managers who perceive the firm’s equity is underpriced will have a preference to fund investment
using retained earnings, or debt, rather than equity.
•
The converse is also true: Managers who perceive the firm’s equity to be overpriced will prefer to issue equity, as
opposed to issuing debt or using retained earnings, to fund investment.
• Pecking Order Hypothesis
•
The idea that managers will prefer to fund investments by first using retained earnings, then debt, and equity only as a
last resort.
•
However, this hypothesis does not provide a clear prediction regarding capital structure.
•
While firms should prefer to use retained earnings, then debt, and then equity as funding sources, retained earnings
are merely another form of equity financing.
•
Firms might have low leverage either because they are unable to issue additional debt and are forced to rely on
equity financing or because they are sufficiently profitable to finance all investment using retained earnings.
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Aggregate Sources of Funding for Capital Expenditures, U.S. Corporations
• The chart shows net equity and
debt issues as a percentage of
total capital expenditures. In
aggregate, firms tend to
repurchase equity and issue
debt.
• But more than 75% of capital
expenditures are funded from
retained earnings.
Figure 16.4 Aggregate Sources of Funding for Capital Expenditures, U.S. Corporations
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Market Timing
• Market Timing View of Capital Structure
•
The firm’s overall capital structure depends in part on the market conditions that existed when it sought funding in the
past.
Market timing The strategy of buy or selling securities (or an asset class) based on a forecast of future price
movements. (BD Glossary)​
Market timing view of capital structure The idea that capital structure decisions are made in part to exploit
under or overpricing of the stock in the market. (BD Glossary)​
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Options and Corporate Finance
• Equity as a Call Option
•
A stock can be thought of as a call option on the assets of the firm with a strike price equal to the value of debt
outstanding.
•
If the firm’s value does not exceed the value of debt outstanding at the end of the period, the firm must declare
bankruptcy and the equity holders receive nothing.
•
If the value exceeds the value of debt outstanding, the equity holders get whatever is left once the debt has been
repaid.
Call option A financial option that gives its owner the right to buy an asset.
Strike (exercise) price The price at which an option holder buys or sells a share of stock when the option is
exercised. (BD Glossary)​
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Equity as a Call Option
• If the value of the firm’s assets
exceeds the required debt payment,
the equity holders receive the value
that remains after the debt is repaid;
otherwise, the firm is bankrupt and
its equity is worthless.
• Thus, the payoff to equity is
equivalent to a call option on the
firm’s assets with a strike price
equal to the required debt payment.
Figure 20.8 Equity as a Call Option
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Agency Conflicts
• In addition to pricing, the option characterization of (debt and) equity securities provides a new interpretation
of agency conflicts.
• Because equity is like a call option, equity holders will benefit from risky investments.
• This can potentially lead to an overinvestment problem.
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Capital Structure: The Bottom Line
• The optimal capital structure depends on market imperfections, such as taxes, financial distress costs,
agency costs, and asymmetric information.
• Capital structure concepts / hypotheses / theories / views:
•
Modigliani-Miller Theorem of Capital Structure Irrelevance
•
Tradeoff Theory
•
Pecking Order Hypothesis
•
Market Timing View
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Capital Structure: The Bottom Line (“McKinsey on Finance”)
…Managing capital structure thus becomes a balancing act. In our view, the trade-off a company makes
between financial flexibility and fiscal discipline is the most important consideration in determining its capital
structure and far outweighs any tax benefits, which are negligible for most large companies unless they
have extremely low debt. (At extremely low levels of debt, companies can create greater value by increasing
debt to more typical levels.)
Mature companies with stable and predictable cash flows as well as limited investment opportunities should
include more debt in their capital structure, since the discipline that debt often brings outweighs the need for
flexibility. Companies that face high uncertainty because of vigorous growth or the cyclical nature of their
industries should carry less debt, so that they have enough flexibility to take advantage of investment
opportunities or to deal with negative events.
Not that a company’s underlying capital structure never creates intrinsic value; sometimes it does. When
executives have good reason to believe that a company’s shares are under- or overvalued, for example, they
might change the company’s underlying capital structure to create value either by buying back undervalued
shares or by using overvalued shares instead of cash to pay for acquisitions. …
https://www.mckinsey.com/capabilities/strategy-and-corporate-finance/our-insights/making-capital-structure-support-strategy
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Chapter Quiz
1. What is the “Tradeoff” in the Tradeoff theory?
2. Why do firms have an incentive to both take excessive risk and underinvest when they are in financial
distress?
3. In what ways might managers benefit by overspending on acquisitions?
4. The Coca-Cola Company is almost 50% debt financed, while Intel, a technology firm, has no net debt. Why
might these firms choose such different capital structures?
5. Why might firms prefer to fund investments using retained earnings or debt rather than issuing equity?
6. What are some reasons firms might depart from their optimal capital structure, at least in the short run?
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Agenda
1
Risk and Return
Berk/DeMarzo Ch. 13
2
Capital Structure
Berk/DeMarzo Ch. 14-16
3
Cost of Capital
Berk/DeMarzo Ch. 12
4
Raising Equity Capital
Berk/DeMarzo Ch. 23
5
Mergers and Acquisitions
Berk/DeMarzo Ch. 28
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The Equity Cost of Capital
• The Capital Asset Pricing Model (CAPM) is a practical way to estimate the cost of capital or the expected
return.
• The cost of capital of any investment opportunity equals the expected return of available investments with
the same beta.
• The estimate is provided by the Security Market Line equation:
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Textbook Example 12.1
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Textbook Example 12.1 (cont´d)
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The Market Risk Premium
• Most practitioners use the S&P 500 index as the market proxy, even though it is not actually the market
portfolio
• Determining the Risk-Free Rate
•
The yield on U.S. Treasury securities
• The Historical Risk Premium
•
Estimate the risk premium (E[RMkt] − rf) using the historical average excess return of the market over the risk-free
interest rate
*Based on a comparison of compounded returns over a ten-year holding period.
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Beta Estimation
• Using Historical Returns
•
Recall, beta is the expected percent change in the excess return of the security for a 1% change in the excess return
of the market portfolio.
•
Consider Cisco Systems stock and how it changes with the market portfolio.
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Monthly Returns for Cisco Stock and for the S&P 500, 2000-2017
• Cisco’s returns tend to move in the same direction, but with greater amplitude, than those of the S&P 500.
Figure 12.1 Monthly Returns for Cisco Stock and for the S&P 500, 2000-2017
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Scatterplot of Monthly Excess Returns for Cisco Versus the S&P 500, 2000-2017
• Beta corresponds to the slope of the best-fitting line.
• Beta measures the expected change in Cisco’s
excess return per 1% change in the market’s excess
return.
• Deviations from the best-fitting line correspond to
diversifiable, non-market-related risk. In this case,
Cisco’s estimated beta is approximately 1.56.
Figure 12.2 Scatterplot of Monthly Excess Returns for Cisco Versus the S&P 500, 2000-2017
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Beta Estimation (cont´d)
• Using Historical Returns
•
As the scatter plot on the previous slide shows, Cisco tends to be up when the market is up, and vice versa.
•
We can see that a 10% change in the market’s return corresponds to about a 16% change in Cisco’s return.
•
Thus, Cisco’s return moves about two for one with the overall market, so Cisco’s beta is about 1.6.
Beta corresponds to the slope of the best-fitting line in the plot of the security’s excess returns versus the
market excess return
Required return The expected return of an investment that is necessary to compensate for the risk of
undertaking the investment. (BD Glossary)
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The Debt Cost of Capital
• Debt Yields Versus Returns
•
Yield to maturity is the IRR an investor will earn from holding the bond to maturity and receiving its promised
payments.
•
If there is little risk the firm will default, yield to maturity is a reasonable estimate of investors’ expected rate of return.
•
If there is significant risk of default, yield to maturity will overstate investors’ expected return.
Internal rate of return (IRR) The interest rate that sets the net present value of the cash flows equal to zero.
(BD Glossary)
Yield to maturity (YTM) The discount rate that sets the present value of the promised bond payments equal to
the current market price of the bond. Equivalently, it is the IRR of an investment in a bond that is held to
maturity and does not default. (BD Glossary)
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The Debt Cost of Capital
• Consider a one-year bond with YTM of y. For each $1 invested in the bond today, the issuer promises to pay
$(1 + y) in one year.
• Suppose the bond will default with probability p, in which case bond holders receive only $(1 + y − L), where
L is the expected loss per $1 of debt in the event of default.
• So the expected return of the bond is
rd  (1  p ) y + p ( y  L)  y  pL
 Yield to Maturity  Prob  default   Expected Loss Rate
• The importance of the adjustment depends on the riskiness of the bond.
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Annual Default Rates by Debt Rating (1983–2011)
Rating:
AAA
AA
A
BBB
BB
B
CCC
CC−C
Default Rate: Average
0.0%
0.1%
0.2%
0.5%
2.2%
5.5%
12.2%
14.1%
In Recessions
0.0%
1.0%
3.0%
3.0%
8.0%
16.0%
48.0%
79.0%
• Credit rating A rating assigned by a rating agency that assesses the likelihood that a borrower will default.
(BD Glossary)​
• Credit risk The risk of default by the issuer of any bond that is not default free; it is an indication that the
bond’s cash flows are not known with certainty. (BD Glossary)​
• Credit spread The difference between the risk-free interest rate on U.S. Treasury notes and the interest
rates on all other loans. The magnitude of the credit spread will depend on investors’ assessment of the
likelihood that a particular firm will default. (BD Glossary)​
Table 12.2 Annual Default Rates by Debt Rating (1983–2011)
Source: “Corporate Defaults and Recovery Rates, 1920-2011,” Moody’s Global Credit Policy, February 2012.
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The Debt Cost of Capital
• The average loss rate for unsecured debt is 60%.
• According to Table 12.2, during average times the annual default rate for B-rated bonds is 5.5%.
• So the expected return to B-rated bondholders during average times is 0.055 × 0.60 = 3.3% below the
bond’s quoted yield.
• Debt Betas
•
Alternatively, we can estimate the debt cost of capital using the CAPM .
•
Debt betas are difficult to estimate because corporate bonds are traded infrequently.
•
One approximation is to use estimates of betas of bond indices by rating category.
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Average Debt Betas by Rating and Maturity
Table 12.3 Average Debt Betas by Rating and Maturity
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Textbook Example 12.3
Rating:
AAA
AA
A
BBB
BB
B
CCC
CC−C
Default Rate: Average
0.0%
0.1%
0.2%
0.5%
2.2%
5.5%
12.2%
14.1%
In Recessions
0.0%
1.0%
3.0%
3.0%
8.0%
16.0%
48.0%
79.0%
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Textbook Example 12.3 (cont´d)
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A Project’s Cost of Capital
• All-Equity Comparables
•
Find an all-equity financed firm in a single line of business that is comparable to the project.
•
Use the comparable firm’s equity beta and cost of capital as estimates.
• Levered Firms as Comparables
•
For levered firms, the cash flows generated by the firm’s assets are used to pay both debt and equity holders.
•
As a result, the returns of the firm’s equity alone are not representative of the underlying assets; in fact, because of the
firm’s leverage, the equity will often be much riskier.
•
Thus, the beta of a levered firm’s equity will not be a good estimate of the beta of its assets and of our project.
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Textbook Example 12.4
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Textbook Example 12.4 (cont´d)
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Industry Asset Betas
• We can combine estimates of asset betas for multiple firms in the same industry.
• Doing this will reduce the estimation error of the estimated beta for the project.
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Textbook Example 12.7
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Textbook Example 12.7 (cont´d)
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Industry Asset Betas (2018)
Figure 12.4 Industry Asset Betas (2018)
Source: Author calculations based on data from Capital IQ.
• The plot shows the median, as well as upper and lower quartiles, for estimated asset betas of S&P 1500 firms in
selected industries.
• Note the low asset betas for less cyclical industries such as utilities and household products, versus the much
higher asset betas of technology firms, asset management, and capital-intensive cyclical industries (like autos
and construction).
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Project Risk Characteristics and Financing
• Differences in Project Risk
•
Firm asset betas reflect market risk of the average project in a firm.
•
Individual projects may be more or less sensitive to market risk.
• Financial managers in multidivisional firms should evaluate projects based on asset betas of firms in a similar
line of business.
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Final Thoughts on Using the CAPM
• There are a large number of assumptions made in the estimation of cost of capital using the CAPM.
• The types of approximation are no different from those made throughout the capital budgeting process.
•
Errors in cost of capital estimation are not likely to make a large difference in NPV estimates.
• CAPM is practical, easy to implement, and robust.
• CAPM imposes a disciplined approach to cost of capital estimation that is difficult to manipulate.
• CAPM requires managers to think about risk in the correct way.
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Textbook Example 13.3
• Assume: risk-free monthly rate of 1.2%/12 = 0.10%
• Recall: The Fama-French-Carhart (FFC) Factor Model
E[ Rs ]  rf   sMkt ( E[ RMkt ]  rf )   sSMB E[ RSMB ]
  sHML E[ RHML ]   sPR1YR E[ RPR1YR ]
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Textbook Example 13.3 (cont´d)
FFC Portfolio Average Monthly Returns,
1927–2015
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Multifactor Models of Risk
• The Cost of Capital with Fama-French-Carhart Factor Specification
•
Although it is widely used in research to measure risk, there is much debate about whether the FFC factor specification
is really a significant improvement over the CAPM .
•
One area where researchers have found that the FFC factor specification does appear to do better than the CAPM is
measuring the risk of actively managed mutual funds.
•
Researchers have found that funds with high returns in the past have positive alphas under the CAPM.
•
When the same tests were repeated using the FFC factor specification to compute alphas, no evidence was found
that mutual funds with high past returns had future positive alphas.
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Methods Used in Practice
• Financial Managers
•
A survey of CFOs found that 73.5% of the firms used the CAPM to calculate the cost of capital
•
40% used historical average returns
•
16% used the dividend discount model
•
Larger firms were more likely to use the CAPM than were smaller firms
Dividend-discount model A model that values shares of a firm according to the present value of the future
dividends the firm will pay. (BD Glossary)
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How Firms Calculate the Cost of Capital
Figure 13.11 How Firms Calculate the Cost of Capital
Source: J. R. Graham and C. R. Harvey, “The Theory and Practice of Corporate Finance: Evidence from the Field,” Journal of Financial Economics 60 (2001): 187–243.
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Chapter Quiz
1. What inputs do we need to estimate a firm’s equity cost of capital using the CAPM?
2. How can you estimate the market risk premium?
3. How can you estimate a stock’s beta from historical returns?
4. Why does the yield to maturity of a firm’s debt generally overestimate its debt cost of capital?
5. Describe two methods that can be used to estimate a firm’s debt cost of capital.
6. What data can we use to estimate the beta of a project?
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Chapter Quiz (cont´d)
7. Why does the equity beta of a levered firm differ from the beta of its assets?
8. Why might projects within the same firm have different costs of capital?
9. Even if the CAPM is not perfect, why might we continue to use it in corporate finance?
10. What is the most popular method used by corporations to calculate the cost of capital?
11. What other techniques do corporations use to calculate the cost of capital?
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Agenda
1
Risk and Return
Berk/DeMarzo Ch. 13
2
Capital Structure
Berk/DeMarzo Ch. 14-16
3
Cost of Capital
Berk/DeMarzo Ch. 12
4
Raising Equity Capital
Berk/DeMarzo Ch. 23
5
Mergers and Acquisitions
Berk/DeMarzo Ch. 28
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The Initial Public Offering
• Initial Public Offering (IPO)
•
The process of selling stock to the public for the first time.
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Advantages and Disadvantages of Going Public
• Advantages
•
Greater liquidity
•
Private equity investors get the ability to diversify.
•
Better access to capital
•
Public companies typically have access to much larger amounts of capital through the public markets.
• Disadvantages
•
The equity holders become more widely dispersed.
•
This makes it difficult to monitor management.
•
The firm must satisfy all of the requirements of public companies.
•
SEC filings, Sarbanes-Oxley, etc.
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Types of Offerings
• Primary and Secondary Offerings
•
Primary Offering
•
•
New shares available in a public offering that raise new capital
Secondary Offering
•
Shares sold by existing shareholders in an equity offering
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The Mechanics of an IPO
• Underwriter
•
An investment banking firm that manages a security issuance and designs its structure.
• Underwriters and the Syndicate
•
Lead Underwriter
•
•
The primary investment banking firm responsible for managing a security issuance
Syndicate
•
A group of underwriters who jointly underwrite and distribute a security issuance
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The Mechanics of an IPO (cont´d)
• Valuation
•
There are two ways to value a company:
•
Compute the present value of the estimated future cash flows.
•
Estimate the value by examining comparables (recent IPOs).
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Valuation Based on Comparable Firms
• Method of Comparables (Comps)
•
Estimate the value of the firm based on the value of other, comparable firms or investments that we expect will
generate very similar cash flows in the future
• Valuation Multiple
•
A ratio of firm’s value to some measure of the firm’s scale or cash flow
• The Price-Earnings Ratio; P/E Ratio
•
Share price divided by earnings per share
• Other Multiples
•
Multiple of sales
•
Price to book value of equity per share
•
Enterprise value per subscriber; Used in cable TV industry
•
…
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Valuation Based on Comparable Firms
• When valuing a firm using multiples, there is no clear guidance about how to adjust for differences in
expected future growth rates, risk, or differences in accounting policies
•
Comparables only provide information regarding the value of a firm relative to other firms in the comparison set
•
Using multiples will not help us determine if an entire industry is overvalued
• Discounted cash flows methods have the advantage that they can incorporate specific information about the
firm’s cost of capital or future growth
•
The discounted cash flow methods have the potential to be more accurate than the use of a valuation multiple
• No single technique provides a final answer regarding a stock’s true value
•
All approaches require assumptions or forecasts that are too uncertain to provide a definitive assessment of the firm’s
value
•
Most real-world practitioners use a combination of these approaches and gain confidence if the results are consistent
across a variety of methods
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The Mechanics of an IPO (cont´d)
• Valuation
•
Road Show
•
•
During an IPO, when a company’s senior management and its underwriters travel around promoting the company
and explaining their rationale for an offer price to the underwriters’ largest customers, mainly institutional investors
such as mutual funds and pension funds.
Book Building
•
A process used by underwriters for coming up with an offer price based on customers’ expressions of interest.
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Textbook Example 23.4
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Textbook Example 23.4 (cont´d)
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IPO Puzzles
• Underpricing
•
Generally, underwriters set the issue price so that the average first-day return is positive.
•
Research has found that about 75% of first-day returns are positive.
•
The average first-day return in the United States is 17%.
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International Comparison of
First-Day IPO Returns
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IPO Puzzles (cont´d)
• Underpricing
•
Although IPO returns are attractive, all investors cannot earn these returns.
•
When an IPO goes well, the demand for the stock exceeds the supply.
•
Thus the allocation of shares for each investor is rationed
•
When an IPO does not go well, demand at the issue price is weak, so all initial orders are filled completely.
•
Thus, the typical investor will have their investment in “good” IPOs rationed while fully investing in “bad” IPOs.
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IPO Puzzles (cont´d)
• Underpricing
•
Winner’s Curse
•
Refers to a situation in competitive bidding when the high bidder, by virtue of being the high bidder, has very likely
overestimated the value of the item being bid on.
•
You “win” (get all the shares you requested) when demand for the shares by others is low and the IPO is more
likely to perform poorly.
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Textbook Example 23.5
Over-allotment
allocation (greenshoe
provision) On an IPO,
an option that allows
the underwriter to issue
more stock, usually
amounting to 15% of
the original offer size, at
the IPO offer price. (BD
Glossary)
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Textbook Example 23.5
(cont´d)
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Cyclicality and Recent Trends
• The number of issues is highly cyclical.
•
When times are good, the market is flooded with new issues; when times are bad, the number of issues dries up.
•
What is surprising is the magnitude of the swings.
•
Another striking feature of the data in the following figure is that while the average dollar volume of IPO s since 2000
has been similar to that in the 1990s, the average number of IPO s per year has fallen significantly.
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Cyclicality of Initial Public Offerings in the United States
Figure 23.5 Cyclicality of Initial Public Offerings in the United
States
Source: Adapted courtesy of Jay R. Ritter from “Initial Public
Offerings: Tables Updated through 2017”
(bear.warrington.ufl.edu/ritter/).
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Costs of an IPO
• A typical spread is 7% of the issue price.
•
By most standards, this fee is large, especially considering the additional cost to the firm associated with underpricing.
•
It is puzzling that there seems to be a lack of sensitivity of fees to issue size.
•
One possible explanation is that by charging lower fees, an underwriter may risk signaling that it is not the same
quality as its higher priced competitors.
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Relative Costs of Issuing Securities
• This figure shows the total direct costs (all
underwriting, legal, and auditing costs) of
issuing securities as a percentage of the
amount of money raised.
Figure 23.6 Relative Costs of Issuing Securities
Source: Adapted from I. Lee, S. Loch head, J. Ritter, and Q. Zhao, “The Costs of Raising Capital,” Journal of Financial Research 19(1) (1996): 59–74.
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Long-Run Underperformance
• Although shares of IPOs generally perform very well immediately following the public offering, it has been
shown that newly listed firms subsequently appear to perform relatively poorly over the following three to five
years after their IPOs.
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The Seasoned Equity Offering
• Seasoned Equity Offering (SEO)
•
When a public company offers new shares for sale
•
Public firms use SEOs to raise additional equity.
•
When a firm issues stock using an SEO, it follows many of the same steps as for an IPO.
•
The main difference is that a market price for the stock already exists, so the price-setting process is not
necessary.
• Researchers have found that, on average, the market greets the news of an SEO with a price decline.
•
This is consistent with the adverse selection discussed in Chapter 16 of Berk/DeMarzo
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Chapter Quiz
1. What are some of the advantages and disadvantages of going public?
2. List and discuss four IPO “puzzles.”
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Agenda
1
Risk and Return
Berk/DeMarzo Ch. 13
2
Capital Structure
Berk/DeMarzo Ch. 14-16
3
Cost of Capital
Berk/DeMarzo Ch. 12
4
Raising Equity Capital
Berk/DeMarzo Ch. 23
5
Mergers and Acquisitions
Berk/DeMarzo Ch. 28
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Background and Historical Trends
• Market for Corporate Control
•
Acquirer (or bidder) – the buyer of the firm
•
Target – the seller of the firm
• The global takeover market is highly active, averaging more than $1 trillion per year in transaction value.
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Background and Historical Trends (cont'd)
• Merger Waves
•
Peaks of heavy activity followed by quiet troughs of few transactions in the takeover market
• The greatest takeover activity occurred in the 1960s, 1980s, 1990s, and 2000s.
•
1960s
•
•
Known as the conglomerate wave
1980s
•
•
Known for the hostile takeovers
1990s
•
•
Known for the “strategic” or “global” deals
2000s
•
Marked by consolidation in many industries and the larger role played by private equity
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Fraction of U.S. Public Companies Acquired Each Year, 1926–2018
Figure 28.1: Fraction of U.S. Public Companies Acquired Each Year, 1926-2018
Source: Authors’ calculations based on Center for Research in Securities Prices data
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Types of Mergers
• Horizontal merger
•
Target and acquirer are in the same industry
• Vertical merger
•
Target’s industry buys from or sells to acquirer’s industry
• Conglomerate merger
•
Target and acquirer operate in unrelated industries
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Market Reaction to a Takeover
• In most U.S. states, the law requires that when existing shareholders of a target firm are forced to sell their
shares, they receive a fair value for their shares.
•
As a consequence, a bidder is unlikely to acquire a target company for less than its current market value.
•
In practice, most acquirers pay a premium on the current market value.
• Acquisition Premium
•
Paid by an acquirer in a takeover, it is the percentage difference between the acquisition price and the pre-merger
price of a target firm
•
Research has found, as shown on the next slide, that acquirers pay an average premium of 43% over the pre-merger
price of the target.
•
When a bid is announced, target shareholders enjoy a gain of 15% on average in their stock price.
•
Acquirer shareholders see an average gain of 1%, but half receive a price decrease.
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Average Acquisition Premium and Stock Price Reactions to Mergers
Source: Data based on all U.S. deals from 1980 to 2005 as reported in Handbook of Corporate
Finance: Empirical Corporate Finance, Vol. 2, Chapter 15, pp.291430, B. E. Eckbo, ed.,
Elsevier/North-Holland Handbook of Finance Series, 2008.
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Returns to Holding Target Stocks Subsequent to Takeover Announcements
• After the initial jump in the stock price at the
time of the announcement, target stocks do
not appear to earn abnormal subsequent
returns on average.
• However, stocks that are ultimately acquired
tend to appreciate and have positive alphas,
while those that are not acquired have
negative alphas. Thus, an investor could
profit from correctly predicting the outcome.
Figure 13.5 Returns to Holding Target Stocks Subsequent to Takeover Announcements
Source: Adapted from M. Bradley, A. Desai, and E. H. Kim, “The Rationale Behind Interfirm Tender Offers: Information or Synergy?” Journal of Financial Economics 11 (1983) 183–206.
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Market Reaction to a Takeover (cont'd)
• Why do acquirers pay a premium over the market value for a target company?
• Although the price of the target company rises on average upon the announcement of the takeover, why
does it rise less than the premium offered by the acquirer?
• Why does the acquirer not consistently experience a price increase?
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Reasons to Acquire
• Large synergies are by far the most common justification that bidders give for the premium they pay for a
target.
•
Such synergies usually fall into two categories: cost reductions and revenue enhancements
•
Cost-reduction synergies are more common and easier to achieve because they generally translate into layoffs of
overlapping employees and elimination of redundant resources.
•
Revenue-enhancement synergies, however, are much harder to predict and achieve.
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Economies of Scale and Scope
• Economies of Scale
•
The savings a large company can enjoy from producing goods in high volume that are not available to a small
company
• Economies of Scope
•
Savings large companies can realize that come from combining the marketing and distribution of different types of
related products
• A cost associated with an increase in size is that larger firms are more difficult to manage.
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Vertical Integration
• Vertical Integration
•
Refers to the merger of two companies in the same industry that make products required at different stages of the
production cycle
• A major benefit of vertical integration is coordination.
•
For example, Apple Computers makes both the operating system and the hardware.
• However, not all not all successful corporations are vertically integrated.
•
For example, Microsoft makes (made) the operating system but not the computers.
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Expertise
• Firms often need expertise in particular areas to compete more efficiently.
•
Particularly with new technologies, hiring experienced workers directly may be difficult.
•
It may be more efficient to purchase the talent as an already functioning unit by acquiring an existing firm.
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Monopoly Gains
• It is often argued that merging with or acquiring a major rival enables a firm to substantially reduce
competition within the industry and thereby increase profits.
• Most countries have antitrust laws that limit such activity.
• While all companies in an industry benefit when competition is reduced, only the merging company pays the
associated costs (from, for instance, managing a larger corporation).
•
This may be why, along with existing antitrust regulation, that there is a lack of convincing evidence that monopoly
gains result from the reduction of competition following takeovers.
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Efficiency Gains
• Another justification acquirers cite for paying a premium for a target is efficiency gains, which are often
achieved through an elimination of duplication.
•
Acquirers often argue that they can run the target organization more efficiently than existing management could.
•
Although identifying poorly performing corporations is relatively easy, fixing them is another matter entirely.
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Diversification
• Risk Reduction
•
Like a large portfolio, large firms bear less unsystematic risk, so often mergers are justified on the basis that the
combined firm is less risky.
•
A problem with this argument is that it ignores the fact that investors can achieve the benefits of diversification
themselves by purchasing shares in the two separate firms.
• Debt Capacity and Borrowing Costs
•
All else being equal, larger firms are more diversified and, therefore, have a lower probability of bankruptcy.
•
The argument is that with a merger, the firm can increase leverage and thereby lower its costs of capital.
•
Due to market imperfections like bankruptcy, a firm may be able to increase its debt and enjoy greater tax savings
without incurring significant costs of financial distress by merging and diversifying.
•
Gains must be large enough to offset any disadvantages of running a larger, less focused firm.
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Diversification (cont'd)
• Asset Allocation
•
A diversified conglomerate may benefit by being able to quickly reallocate assets across industries.
•
For example, the firm may redeploy managerial talent to where it is most needed to exploit emerging opportunities.
•
On the other hand, agency costs may lead to the opposite result: profitable divisions may subsidize money-losing ones
for longer than is optimal.
• Liquidity
•
Shareholders of private companies often have a disproportionate share of their wealth invested in the private company.
•
The liquidity that the bidder provides to the owners of a private firm can be valuable and often is an important incentive
for the target shareholders to agree to the takeover.
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Managerial Motives to Merge
• Conflicts of Interest
•
Managers may prefer to run a larger company due to additional pay and prestige.
• Overconfidence
•
Roll’s “hubris hypothesis” maintains that overconfident CEOs pursue mergers that have low chance of creating value
because they believe their ability to manage is great enough to succeed.
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Valuation and the Takeover Process
• Valuation
•
A key issue for takeovers is quantifying and discounting the value added as a result of the merger.
•
For simplicity, any additional value created will be referred to as the takeover synergies.
•
The price paid for a target is equal to the target’s pre-bid market capitalization plus the premium paid in the acquisition.
•
If the pre-bid market capitalization is viewed as the stand-alone value of the target, then from the bidder’s perspective,
the takeover is a positive - NPV project only if the premium it pays does not exceed the synergies created.
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The Offer
• Once the acquirer has completed the valuation process, it is in the position to make a tender offer.
•
Not all tender offers are successful.
•
Often acquirers have to raise the price to consummate the deal.
• A bidder can use one of two methods to pay for a target: cash or stock.
•
In a cash transaction, the bidder simply pays for the target, including any premium, in cash.
Tender offer: A public announcement of an offer to all existing security holders to buy back a specified amount
of outstanding securities at a prespecified price over a prespecified period of time. (BD Glossary)
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The Offer (cont´d)
• A bidder can use one of two methods to pay for a target: cash or stock.
•
In a stock-swap transaction, the bidder pays for the target by issuing new stock and giving it to the target shareholders.
•
The bidder offers to swap target stock for acquirer stock.
• Exchange Ratio.
•
The number of bidder shares received in exchange for each target share
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The Offer (cont´d)
• A stock-swap merger is a positive-NPV investment for the acquiring shareholders if the share price of the
merged firm exceeds the pre-merger price of the acquiring firm
• Let A be the pre-merger value of the acquirer, T be the pre-merger value of the target, and S be the value of
the synergies created by the merger
•
If the acquirer has NA shares outstanding before the merger and issues x new shares to pay for the target, then the
acquirer’s share price should increase post-acquisition if
A+T +S
A
>
= PA
NA + x
NA
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Who Gets the Value Added from a Takeover?
• Evidence suggests that the premium the acquirer pays is approximately equal to the value it adds, which
means the target shareholders ultimately capture the value added by the acquirer.
• It does not appear that the acquiring corporation generally captures this value.
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The Free Rider Problem
• Often times the target firm is poorly managed, resulting in a low share price. If the corporate raider can take
control of the firm and replace management, the value of the firm (and the raider’s wealth) will increase.
• Assume the current price of the target firm is $45 per share and the potential price if the firm is taken over is
$75 per share.
•
If the corporate raider makes a tender offer of $60 per share, tendering shareholders gain $15 per share.
•
$60 − $45 = $15
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The Free Rider Problem (cont´d)
• But non-tendering shareholders can “free ride”.
•
By not tendering, these shareholders will receive the $75 per share or a gain of $30 per share.
•
However, if all the shareholders feel that the potential price is $75, they will not tender their shares and the deal will not
go through.
• The only way to persuade shareholders to tender their shares is to offer them at least $75 per share, which
removes any profit opportunity for the corporate raider.
• The problem is that existing shareholders do not have to invest time and effort but still participate in all the
gains from the takeover that the corporate raider generates, hence the term “free rider problem”.
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Competition
• Why do acquirers choose to pay so large a premium?
•
The most likely explanation is the competition that exists in the takeover market.
•
Once an acquirer starts bidding on a target company and it becomes clear that a significant gain exists, other
potential acquirers may submit their own bids.
•
The result is effectively an auction in which the target is sold to the highest bidder.
•
Example:
•
Monday October 25, 2021: “Rival buyout groups Hellman & Friedman and EQT have teamed up to launch a €3.7bn
takeover for Zooplus, ending a fiercely competitive bidding war to gain control of one of Europe’s biggest online
pet supplies retailers. US-based Hellman & Friedman and Sweden’s EQT made a final offer of €480 a share for
Zooplus, which is €10 more than previous separate offers from the two private equity groups. The sweetened offer
represents an 85% premium to Zooplus’s share price before the bidding war started on 12 August. …”
Private equity rivals join forces to make €3.7bn bid for Zooplus - Private Equity News (penews.com)
https://www.penews.com/articles/private-equity-rivals-join-forces-to-make-e3-7bn-bid-for-zooplus-20211025
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Chapter Quiz
1. What is the difference between a horizontal and vertical merger?
2. On average, what happens to the target share price on the announcement of a takeover?
3. On average, what happens to the acquirer share price on the announcement of a takeover?
4. Based on the empirical evidence, who gets the value added from a takeover? What is the most likely
explanation of this fact?
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General Questions
1. Why should corporate financial managers know something about the efficiency of financial markets? Why
should we study empirical evidence from capital markets in a corporate finance lecture?
2. An event study is a statistical study that examines how the release of information affects prices or
corresponding returns. List event study examples from the lecture slides!
3. Throughout the lecture slides, we discuss behavioral finance issues. List examples for the two main
approaches, the irrational managers approach and the irrational markets approach!
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Mock Exam Question 1
Below you find five statements. Please indicate for each statement whether it is true or false and explain your
answer briefly (one or two sentences).
1. The beta of cash is one.
2. The beta of the market portfolio is one.
3. The beta of the risk-free asset is zero.
4. The risk premium of the risk-free asset is zero.
5. The beta of an individual stock is calculated by regressing individual stock prices on S&P index levels.
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Mock Exam Question 2
It is possible to calculate the present value of the interest tax shield as follows:
PV(Interest tax shield) = τc  D
with τc indicating a firm’s tax rate and D indicating a firm’s debt level.
Mention and shortly explain three simplifying assumptions we need to make to use this simple formula!
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Mock Exam Question 3
One bank manager (Manager X) argues:
“A return on equity of up to 25% is possible in banks.”
Another bank manager (Manager Y) states:
“It is impossible to earn a 25% return on our operating activities.”
Do these two statements contradict each other? Why? Why not?
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Mock Exam Question 4
Is it conceivable that a firm’s equity beta is lower than its (operating) asset beta?
Name a situation in which this would be the case and briefly discuss the underlying intuition.
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Mock Exam Question 5
Explain what is wrong with the following argument:
“If a firm issues debt that is risk free, because there is no possibility of default, the risk of the firm’s equity does
not change. Therefore, risk-free debt allows the firm to get the benefit of a low cost of capital of debt without
raising its cost of capital of equity.”
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KMF – INSTITUT FÜR KAPITALMÄRKTE
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Mock Exam Question 6
Which type of firm is more likely to experience a loss of customers in the event of financial distress? Shortly
explain your answer.
1. Campbell Soup Company (a processed food and snack company) or Intuit, Inc. (a maker of accounting
software)?
2. Allstate Corporation (an insurance company) or Adidas AG (maker of athletic footwear, apparel, and sports
equipment)?
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Mock Exam Question 7
Assume that a senior manager of the company argues that it is in the best interest of the shareholders to
choose the capital structure that leads to the highest expected return for the stock.
Do you think he is right? Briefly explain.
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Mock Exam Question 8
Which of the following industries or firms should have low optimal debt levels according to the trade-off theory?
Which should have high optimal levels of debt? Explain your conclusions!
1. Real Estate Investment Companies
2. Young Start-Ups
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Mock Exam Question 9
Consider the manager of a car manufacturer who wants to take on more debt to reduce the expected expense
of car warranties.
To quote the manager, “If we go bankrupt, we don’t have to service the warranties. We therefore have lower
bankruptcy costs than most corporations, so we should use more debt.”
Is he right?
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Mock Exam Question 10
Explain why an employee who cares only about expected return and volatility will likely underweight the amount
of money she/he invests in his own company’s stock relative to an investor who does not work for his company.
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Mock Exam Question 11
Which of the following industries have low optimal debt levels according to the trade-off theory? Which have
high optimal levels of debt? Explain your answer briefly!
a. Tobacco firms
b. Accounting firms
c. Mature restaurant chains
d. Lumber companies
e. Cell phone manufacturers
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Mock Exam Question 12.1-12.5
Below you find 10 statements which are false. Please indicate for each statement what is wrong and how the
correct statement would look like (one or two sentences).
1. “Beta measures the diversifiable risk of a security, as opposed to its market risk.”
2. “Securities that tend to move more than the market have betas lower than 0.”
3. “Asset betas are expected to vary greatly within firms in the same industry.”
4. “When estimating beta by using past returns it is best to use the longest time horizon of returns available.”
5. “If we can identify a comparison firm whose assets have the same risk as the project being evaluated, and if
the comparison firm is levered, then we can use its equity cost of capital as the cost of capital for the
project.”
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Mock Exam Question 12.6-12.10
Below you find 10 statements which are false. Please indicate for each statement what is wrong and how the
correct statement would look like (one or two sentences).
6. “When a firm changes its capital structure without changing its investments, its levered beta will remain
unaltered, however, its asset beta will change to reflect the effect of the capital structure change on its risk.”
7. “To receive the full tax benefits of leverage a firm needs to use 100% debt financing.”
8. “In financial distress, the loss of customers is likely to be large for producers of raw materials (such as sugar
or aluminum), as the value of these goods, once delivered, depends on the seller's continued success.”
9. “Firms whose value and cash flows are very volatile (for example, semiconductor firms) must have much
higher levels of debt to avoid a significant risk of default.”
10. “Firms with high R&D costs and future growth opportunities typically maintain high debt levels.”
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Mock Exam Question 13
Use the following information to answer the questions below.
"Eenie"
"Meenie"
"Miney"
"Moe"
Beta
0.45
0.75
1.05
1.20
Volatility
20%
18%
35%
25%
Assume that the risk-free rate of interest is 3% and you estimate the market's expected return to be 9%.
1. Which firm has the most total risk?
2. Which firm has the least market risk?
3. Which firm has the highest cost of equity capital?
4. Calculate the equity cost of capital for "Miney"!
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Mock Exam Question 14
Over the last years, Facebook, Inc. had (almost) no debt.
By issuing debt Facebook can generate a very large tax shield potentially worth nearly $2 billion.
Given Facebook’s success, one would be hard pressed to argue that Facebook’s management are naïve and
unaware of this huge potential to create value.
A more likely explanation is that issuing debt would entail other costs. What might these costs be?
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Mock Exam Question 15
From the start of 1999 to the start of 2009, the S&P 500 had a negative return. Does this mean the market risk
premium we should have used in the CAPM was negative? Explain your answer!
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Mock Exam Question 16
Galt Industries is trading for $20 per share and has 25 million shares outstanding. Galt Industries has a debtequity ratio of 0.4 and its debt is zero coupon debt with a ten-year maturity and a yield to maturity of 8%.
In describing Galt's equity as a call option, calculate the strike price of the call option!
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UND FINANZWIRTSCHAFT
Mock Exam Question 17
A manager at a German top 100 firm, wit headquarters in Munich, says:
“Sales have nothing to do with firm value”.
Correct? False? Comment!
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Mock Exam Question 18
Douglas Elliott is a Partner at Oliver Wyman in New York:
“The problem with [equity] capital is that it is expensive. If capital were cheap, banks would be extremely safe
because they would hold high levels of capital, providing full protection against even extreme events.
Unfortunately, the suppliers of capital ask for high returns because their role, by definition, is to bear the bulk of
the risk from a bank’s loan book, investments and operations” Elliott (2009, p. 12).
Statement: “Increased equity requirements increase the funding costs for banks because they must use more
equity, which has a higher required return.”
Assessment: This argument is false. Although equity has a higher required return, this does not imply that
increased equity capital requirements would raise the banks’ overall funding costs.
Taken from: Admati/DeMarzo/Hellwig/Pfleiderer, Fallacies, Irrelevant Facts, and Myths in the Discussion of
Capital Regulation: Why Bank Equity is Not Socially Expensive (October 22, 2013). Available at SSRN:
https://ssrn.com/abstract=2349739
Explain why the argument is false!
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