corporate finance - beny w2011

8/3/2019 Corporate Finance - Beny W2011

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rt

Law 635 Outline

I. Basic Finance Equations

a. PV

=

Ct

1r

t , where ris discount factor and C = dollars in year t

b. NPV = C0

T

Ct

1rt

C c. DCF =

t(For different cash flows Ct at each t)

t1 (1r)

Cd. PV of perpetuity =

r

e. PV of annuity =

1 1r r1r

t (t-year annuity factor) for fixed sum forspecified period

f. Annuity due: first payment made immediately; multiply PV of ordinaryannuity by (1 + r)

1rt1

g. FV of annuity =r

C1h. PV of growing

perpetuity = rg, where g is the growth rate

i. PV of T-period growingannuity =

1rg

1g

t

rg1r

t

j. Continuous compounding annuity: the new ris such that er= 1+[old rate]

1 1 1 i. PV C *

r r ert

mn

k. Compound Interest: FV

nP*

1m

, where m is number of compounds peryear

i. Limit as m gives you FVn = Pert

II. Bonds

a. Definitions

i. Bond:

1. Entitled to fixed set of cash payoffs; regular interestpayments (coupon)

2. At maturity, you get final interest payment + face value


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(par value) of the bond

ii. Ask Price: Amount needed to buy note

from dealer iii. Bid price: Amount needed

to sell note to dealer

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T

iv. Spread: Difference between bid and ask

v. Duration / Macaulay duration = weighted average of times whenbonds cash payments

are received

vi. Term structure of interest rates = relationship b/w short-

and long-term rates vii. Spot rate rn = n-year rate of interest

viii. Stripped bond / strips = bonds that make onecash payment

ix. Arbitrage = money

machine x. Ratings

(Moodys / S&P

1. High = AAA; AA

2. Medium = A; BBB

3. Low = BB; CCC; CC

4. Very Low (Junk) = C, D

b. PV of bond = (coupon * annuity factor) + (final payment *discount factor)

1i. = C*

1 ParValue

rr1rt

1rt

ii. Example: 4-year bond with $8.5 coupon; 3% discount rate; $100 facevalue

PV8.5* 1

1 100iii.

0.03

0.03

*1.034

(1.03)4

c. YTM = rate of return on the bond (IRR), backed out from PV calculation as a

function of price, coupon, and par value

d. Duration = t*PV(C

t)

, where final maturity date is at Tt1 PV

i. A weighted average time to each payment; shorter than thematurity date

duration

e. Modified duration =volatility = 1

yield

, a measure of interest-rate risk

i. A measure of how much the bond price changes given a 1% change inYTM

ii. Bond prices and interest rates move in

opposite directions f. Inflation, Nominal Cash Flows, Real

Cash Flows

Ct


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i. Real cash flow atdate t=

, where C = nominal cash flow(1CPI)

t

ii. Real rate ofreturn =

1i

1CPI

1, where i is nominal interest rate

iii. Real interest rate i CPI

iv. Average US inflation is about 3%

v. Fishers theory: Change in expected inflation rate causes same

proportionate change in n o m i n al interest rate; no effect on required

real interest rate

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1. 1 + i = (1 + r)(1 +CPIexpected)

g. Types of corporate bonds

i. Floating rate bonds (e.g. coupon payments tied to treasury rate + 2%)

ii. Convertible bonds (may exchange bond for shares of common stock)

h. How bond yields vary with maturity depends on

i. Real rate of interest (theoretically, this is flat)

ii. Expected future inflation (can be upward or downward sloping)

iii. Interest rate risk premium (increases with time)

i. Expectations theory of term structure: bonds priced so that investor who

holds succession of short bonds can expect same return as investor who

holds long-term bond

i. But it leaves out risk

j. Some comparative statics

Factor (as this goes Effect on Bond Price

Default probability Lower

Inflation risk Lower

Taxability of coupon Lower

Liquidity Higher

Yield to maturity / IRR Lower

Coupon rate Higher

III. Stocksa. Definitions

i. Primary market = Sales of shares to raise new capital

ii. Secondary market = stock exchanges like NYSE / NASDAQ

iii. Market order = to buy / sell stock at best available price

iv. Limit order = Price at which person is willing to

buy/sell stock v. Auction markets: NYSE; TSE; LSE;

Deutsche Borse

vi. Non-auction market: NASDAQ

vii. Exchange-traded funds (ETFs): portfolios of stocks to buy/sell in asingle trade

viii. Growth stocks bought primarily for capital gains; income stocks

primarily for dividends b. Valuation Techniques / Stock price determinants

i. Comparables: Look at market-to-book value ratio;

price-earnings ratio ii. PV(stock) = PV(dividends),

theoretically

1. Gains come from dividends and capital gains; that is, rDIV

1


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(P1P0 )

P0

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?1

2. Rearranging gives you

Equation (1): P0

DIV1

P1

1r

3. r= market capitalization rate or cost of equity capital,which is the rate of

return of stocks in the same risk class (assumed to all havesame return)

DIVP4. We know from (1) that P 2 2 ; we could plug thisinto (1) 1

5. Or, we can generalize

to P0

1r

DIV

1

1r

DIV2

1r2 ...

DIVH PH

1rH

H

DIV P6.

Rearranged, P

t H , where H is the horizon.

0

t1 1rt

1rH

Theoretically, though, the terminal price should approach zeroas H approaches

DIVinfinity,giving us

P0

t1

t

rt

iii. Dividend theory: growth companies (e.g. CSCO) that never pay

dividends now are just investing for later when there are fewer

profitable opportunities; those later dates will have higher dividends

(which accounts for the high valuation today)

c. Cost of Equity Capital

i. If we forecast a growth rate g for the companys expected dividends,we get:

P DIV

1 , so long as r> g0rg

ii. Rearranging, we get rDIV1 g

, whereP0

DIV1 is the dividend yieldP

0

iii. Example: Company has stock price of $42.45; dividend payments of$1.68 / share;

annual growth of 6.1%

1. r= (1.68 / 42.45) + (0.061) = 0.101 = 10.1%

iv. Since long-run growth rate is hard to come by, can also use payoutratio (Div / EPS)

DIV1. Plowback ratio = 1 payout ratio = 1


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EPS

2. EPS / book equity per share = return on equity = ROE

3. Dividend growth rate = g = plowback * ROE

d. DCF Valuation with Varying Growing Rates

i. Plowback ratio is based on old numbers; may represent

unsustainable growth ii. Instead, get the realistic growth

number gt at time t, and back out rfrom it

DIV DIV

1

DIV

P 1 2 ...

* t 0

1r (1r)2

(1r)

t rg t

4


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iii. You can use multiple-stage DCF models to do ramp-up years and

steady growth years using the model above

e. Price and EPS

i. Expected return of company that plows back nothing and only

produces dividends = like a perpetual bond; expected return istherefore dividend yield = EPS1 / P0

1. Therefore, P0 = EPS1 / r

ii. If earnings are reinvested (a stock thats purely a growth stock

rather than an income stock), and reinvestment has same risk as

present business, then share price should be unaffected

1. Reduction in value by 0 dividend should be offset by

increase in value in dividends in later years, so same

formula for P0

2. This is only true if the NPV of the new project is 0.

3. More

generally, P0

EPS

1 PVGO , where PVGO is the net

present valuer

of growth opportunities

a. Example: Stock with market capitalization rate of 15%;$5 dividend in

Y1 and 10% growth thereafter; ROE = 0.25.

i. Then, P0

DIV1

rg

$5

0.150.1

$100

b. Assume earnings per share is $8.33

i. Payout ratio is thenDIV1

EPS

1

$5

$8.33

0.6 , whichmeans

that the plowback ratiois 40%.

ii. The equation balances g = (plowback * ROE) =(0.4 * 0.25)

=0.1

c. If there were no growth opportunities, weshould find

P EPS1

$8.33

$55.56, but

instead, P

= $100.

0r 0.15

0

d. Since ROE = 0.25, the plowback NPV can be represented

as


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NPV1 (0.4)* ($8.33)

[(0.4)*($8.33)]* 0.25

$2.220.15

e. In Year 2, the plowback has a 10% growth rate, giving usabout $2.44:

NPV2 (0.4)*(8.33)* (1.1)

[(0.4)*(8.33)*

(1.1)]*0.25

0.15

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f. That is, NPVt= (1.1)(NPVt - 1), which gives us

PVGO NPV

1

rg

$2.2

2

0.150.1

$44.44 , which completesthe

f. Valuation throughDCF

equation:

P0

EPS

1 PVGO $55.56 $44.44 $100r

i. Free cash flow = amount of cash a firm can pay to investors

after paying for all investments necessary for growth

ii. Valuation: discount the free cash flows to horizon, and add the

discounted present value at time H

1. Estimating horizon value

a. Constant-growth DCF formula

i. Example: discount rate of 10%; long-run growthrate of 6%;

free cash flow of 1.59 at year 7

1 FCF ii. PV

H1 [CHECK THIS et seq.for

H(1r)

H

rg

off-by-one

error]b. P/E ratios

i. Example: Take an assumed P/E ratio, and plug itin

ii. PVH

1

(1r)

H

(ratio*earnings

H1 )

c. Market-Book ratios

i. Example: Take an assumed Market-Book ratio,and plug it

ii. PVH

1

(1r)

H

(MarketToBookRatio*AssetValue

H)

d. Growth Opportunities

i. Assume that, at some point H, PVGO is zero

earnings

g. Price/Earnings

R ii. PVH


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H1 r

i. Growth stocks: low current earnings,

high PVGO ii. Income stocks: high current

earnings, low PVGO iii. Rough guide to

PVGE

1. 0-10 = stock undervalued, or earnings expected to decline

2. 10-17 = P/E is at fair value

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3. 17-25 = overvalued or earnings fell relative to last report

4. 25 = very promising future or speculative bubble

IV. Alternatives to the NPV

a. Three things to remember about NPV

i. Dollar today worth more than a dollar tomorrow

ii. NPV depends on cash flow and opportunity cost of capital

1. Investors who look at book rate of return only dont get the

whole picture (depends whats treated as a capital

investment); companies may worry how book return is

affected by an investment

iii. NPV(A + B) = NPV(A) + NPV(B)

b. Competitors to the NPV

Rule i. ThePayback Rule

1. Definition

a. Payback period found by counting tit takes before

cumulative cash flow equals the initial investment

b. Payback rule = if payback period is less than some t,

then the project should be accepted.

2. Three Examples

Proje C0 C1 C2 C3 Payback NPV at

A (2,00 50 50 5,00 3 2,62

B (2,00 50 1,80 0 2 (58

C (2,00 1,80 50 0 2 50

a. If the cutoff above is 2 years, then only B and C get

investments even though B has a negative NPV

3. Problems with payback rule

a. Ignores cash flows after cutoff date

b. Equal weight to all cash flows before the cutoff date

4. Advantages with payback rule

a. Easy to communicate / justify

b. Short paybacks = quick profits = quick promotions

c. Limited access to capital favors rapid payback evenw/some NPV hit

5. Discounted Payback

a. Definition: How long does it last in order for NPV to bepositive?

b. In example above, DPP(A) = 3; DPP(B) = DNE; DPP(C) = 2


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c. Allows manager to reject non-NPV-positive projects

that make sense from a payback-only perspective

ii. Book Rate of Return / Accounting Rate of Return

1. Definition

a. Average income divided by average book value overproject life

BookIncomeb. Book Rate ofReturn =

2.

Problems

BookAssets

a. Not a good measure of true profitability; depends on

whats capex and whats opex

b. Average across all of the firms activities; thats not

usually the right hurdle for new investments

i. E.g. if opportunity cost of capital is 12% but

historic book return is 24%, implication is

reject a 20% rate of return investment

iii. IRR (Internal Rate of Return) / DCF (Discounted Cash Flow)

1. Definition in single period is easy

a. IRR Payoff

1Investment

b. NPVC

0

C11r

0 , which can berewritten as r

C1 1C

0

2. Calculating the IRR

a. NPVC

0

C

1

1IRR

C

2

(1IRR)2

...C

T

(1IRR)

T

0,

which is solved through trial and error.

3. The Rule

a. IRR rule = accept a project if the opportunity cost of

capital is less than the internal rate of return

4. Problems

a. Lending or Borrowing?

i. Project A has C0 of (1,000), C1 of 1,500, IRR =

50%

ii. Project B has C0 of 1,000, C1 of (1,500), IRR =

50%

iii. These arent equally attractive; one is borrowing(which we


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want to do at a low IRR) and one is lending(want high)

b. Multiple Rates of Return

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c. CapitalRationing

i. Sometimes, you can solve for two different r

that satisfy the IRR equation. (There can be

infinitely many; depends on how many sign

changes there are in the cash flows). There are

also cases where no IRR exists.c. Mutually Exclusive Projects

i. A project may have higher IRR but lower NPV; if

theyre mutually exclusive (e.g. capital

constraints), you actually want the one with

better NPV.

ii. IRR also doesnt have the value additivityproperty (cf. NPV)

d. Multiple Opportunity Costs of Capital

i. Cost of capital varies over time

ii. Inappropriate when short- and long-term ratesdiverge

i. Basic Equation

1. ProfitabilityIndex =

NPV

Investm

ent

2. Pursue the projects that have the highest profitability index, butthere are capital

constraints; with a limited number of projects, its easy, but with

more, uselinear programming models

ii. Soft Rationing capital constraints are soft and are provisionallimits adopted by

management

iii. Hard Rationing implies market imperfections; examples are

shareholder vetoes, etc. d. How to apply NPV

i. Three rules

1. Only cash flow is relevant

2. Always estimate cash flows on an incremental basis3. Be consistent in your treatment of

inflation ii. Rule 1 (cash flow is king)

1. Always estimate cash flow on an after-tax basis

2. Make sure cash flows recorded only when

they occur iii. Rule 2 (cash flows on an incremental

basis)

1. Dont confuse average and incremental payoffs

a. Incremental NPV from investing in a loser may be

positive (chasing losses is OK); similarly, dont chase


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good money after good (a 20-year old race horse is not

a good investment)

2. Include all incidental effects

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?

V.

Risk

a. E.g. investing in a new regional air route may be NPV inisolation, but

+NPV when adding new business

b. E.g. New product may cannibalize own business, but

competitor products will eat away market share

anyway; invest and hope for good.

3. Forecast sales today and recognize after-sales cash flows tocome later

4. Dont forget working capital requirements

a. Definitions

i. Diversifiable risk risk that can be reduced

or eliminated ii. Nondiversifiable cannot be

eliminated

b. Order of risk (in descending order)

i. Small cap

stocks ii. Large

cap stocks iii.

Junk bonds

iv. Investment-grade

corporate bonds v. Municipal

bonds

vi. US T-bills /

bonds c. Measuring

risk

i. Variance / Standard Deviation

2 2 22ii. Portfolio variance for twoassets:

x1

1

x22 2(x1x21212 )

iii. Portfolio risk = systematic risk + unsystematic risk

1. Beta = sensitivity of stocks return to return on market portfolio(cannot be

eliminated throughdiversification)

ima. i 2

m

, with numerator = covariance with market

2. Portfolio Beta = weighted average of each stocks portfolio

3. Systematic risk is the market standard deviation

multiplied by beta d. Efficient Frontier / Market Porfolio borrowing

and lending at risk-free rate

rm

rf


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i. Slope of capital market line is the Sharpe Ratio, which ism

ii. Bottom line points:

1. Only invest in efficient portfolios that maximize return per unit ofrisk

2. Capital market line depicts tradeoff b/w risk and return fordiversified portfolios

3. Separation theorem: Its efficient just to invest in the marketportfolio, and

borrow / lend at the risk-free rate

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VI. CAPM

a. Expected return on an

asset = rf

b. Challenges to the model:

a (rmrf )

i. Can only test model against actual results, so not

testable ex ante ii. Estimating beta is difficult

iii. Can only use a proxy for the complete market portfolio, since not all

assets are publicly traded

iv. Testing CAPM is a joint test of both the validity of CAPM and efficiency

of asset pricing c. Assumptions underlying CAPM:

i. No transactions

costs ii. No taxes

iii. Homogenous expectations /valuations iv. Passive

investment

v. Ability to freely borrow / lend at

risk-free rate vi. Risk-free security

exists

vii. Investors only concerned about

systematic risk viii. Market efficiency

d. Arbitrage Pricing Theory

i. Identify a reasonably short list of macroeconomic factors expected to

affect stock returns ii. Estimate risk premium on each of these factors;

multiply by sensitivity of stock to each of

these factors

VII. Cost of Capital and WACC

a. Cost of capital = expected return on assets = rdebt * (debt / total firm

value) + requity * (eq/total firm value)

b. WACC = (1 Tc) * rD * (D / V) + rE * (E / V), where Tc is the marginal rate of

corporate taxVIII. Efficient Markets

Hypothesis a. Three

Forms:

i. Weak (price reflects historical price / trading information) (random walkhypothesis)

ii. Semi-strong: Market prices reflect all publicly

available information iii. Strong: Market prices reflect all

information, both public and private

1. Implication: even corporate insiders cannot earn


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abnormal returns b. Testing these hypotheses

i. Weak form: technical analysis doesnt provide greater returns than buy& hold, given

trading costs

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ii. Semi-strong: Observe stock price response to events like stock splits /

dividends announcements, etc. prices react within 5-10 minutes for

earnings and dividend changes (Patell & Wolfson)

iii. Strong: Whether mutual funds / pension funds consistently outperformthe market;

1. Jeng et al. corporate insiders buys have abnormal returns >6%/year

2. Ziobrowski Senators portfolios outperform market by 12%

c. Mechanisms (Gilson andKraakman):

i. Universally informed trading

ii. Professionally informed

trading iii. Derivatively

informed trading

1. Made permissible by direct / indirect info leakages2. Trade decoding

3. Price

decoding iv.

Uninformed trading

1. Soft information like forecasts /

predictions d. Information Costs

i. Acquisition

costs ii.

Processing Costs

iii. Verification

Costs

e. Anomalies

i. January effect: Returns tend to be higher in January than other

months (particularly small-cap stocks); seems to have

disappeared lately

ii. Returns tend to be lower on Monday

iii. Investors tend to underreact to surprise earnings

announcements iv. Stock market overreaction (e.g.

JPN stock market in the 1980s) v. New-issue puzzle:

IPOs tended to underperform

vi. S&P Effect: When added to S&P 500, price rises between 2-3%

vii. Stock market crash (1987): 23% devaluation of American corporatesector

1. But can be explained using Div / (r g) with big dropoff in g orbig increase in r

viii. Internet Bubble: Companies excess valued, but even savvy

analysts pushing f. Behavioral Finance Theory (Shleifer & Summers)


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i. Two types of traders: arbitrageurs;

noise traders ii. Noise traders =

responsive to pseudo-signals iii.

Investor biases:

1. Overconfidence

2. Over / underreaction to recent events

3. Trend chasing

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4. Excessive trading

5. Underdiversification

iv. Arbitrageurs are risk-averse and cant totally eliminate noise tradersnoise

1. Arbitrage has high transaction costs

2. Short-selling prevents convergence trading

3. Budget constraints

4. Risky to adopt contrarian position

v. Heterogeneous Expectations Asset Pricing Model (HEAPM)

1. CAPM assumes investors have homogenous expectationsvalue converges to

bestestimate

2. HEAPM assumes investors disagree on future risks / returns,

PLUS limits to arbitrage, making stock prices notfundamentally efficient

vi. Critiques

1. Anomalies shouldnt account for much money relative to size ofmarket

2. Many anomalies tend to be short-lived and disappear whendiscovered

3. Anomalies not easily translatable into profitable trading

strategies b/c of transactions costs

4. Unpredictable

IX. Corporate Finance

a. Terms

Tunneling = transfer of assets / profits out of firms for benefit of

ii. Preferred stock takes priority over common stock in regards to

iii. Floating-Rate Preferred Stock Pays dividends that vary with short

iv. Subordinate debt = repaid in bankruptcy only after senior debt

v.

vi.

Secured debt = first claim on specific collateral in event of default

Protective covenants = Restrictions on firm to protect bondholders

vii. Eurodollars = dollars held on deposit in bank outside the US

viii. Eurobond = Bond marketed internationally; may be denominated in

ix. Private placement = sale of securities to limited number of qualifiedinvestors without a

x. Convertible bond = bond that holder can exchange for some other

bond + call option)

xi. Warrant: Right to buy shares from company at stipulated pricebefore set date

xii. Book Value: backward looking; cf. Market value


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b. Relationship v. Arms Length Finance

i. Relationship finance: Financier has power over the firm being financed

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1. Physical asset-intensive businesses; older industries; lower

market-to-book ratios

ii. Arms length finance: Financier protected by explicit Ks /transparency

1. High-tech; intangible assets like IP; R&D; high

market-to-book iii. Various pros and cons (search Arms

Length Finance)

iv. Venture capital = hybrid (financing for start-ups; usually high tech)

1. Exit mechanisms:

a. Sale to another

company b. Start-up

buys itselfback

c. Block sale of VCs stake to another block investor

d. IPO

c. IPO terminology

i. Underwriter: Firm that buys an issue of securities; resells to public

1. Asymmetric info b/c of new issuer; underwriter reduces

verification costs ii. Prospectus: Formal summary, provides info like

risk factors / line of business

iii. Underpricing: Issue securities at offering price set below true

value of security iv. Rights Issue: Issue of securities offered only

to current stockholders

d. Dividendsi. Term

sCash Dividend = payment of cash by firm to sh/hs

2. Ex-dividend date: Determines date when stockholder is

3.

payment

Record date: Person who owns stock on this date receives

acquired after ex-dividend date

ii. Type

1. Regular Cash Dividend

2. Special Cash Dividend

3. Stock Dividend

4. Stock Repurchase

a. Buy shares on open

market b. Tender

offer to shareholders c.

Private negotiation

d. Dutch

auction iii. Dividend Policy


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1. Lintners Sylized Facts (from interviews with corporatemanagers)

a. Long-term target payoutratios

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b. Managers reluctant to make changes (esp. increases)

that might have to reverse

c. Transitory earnings changes unlikely to affect dividendpayouts

d. Repurchase, rather than issue dividends with large

amount of unwanted cash

2. Information effect: Investors react positively to dividend

increases; negatively to decreases

a. Signaling effect

b. Firm value change? Three theories

i. Dividend policy ir r ele v a n t (Miller-Modigliani)

1.

Assumptions:

a. No taxes, transaction costs,

market imps b. Fixed capital

budgeting plan

c. Fixed borrowing

d. Efficient capital markets

e. Financial deficit funded by retained

earnings; all extra cash paid out asdividends

2. Investors dont need dividends to

convert shares to cash

X. Capital Structure

a. Miller-

Modigliani


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a. Wont

pay

higher

prices

forfirms

with

more

divide

nd

payou

ts

b.

Divid

end policy = irrelevant; no impact

on firm value!

ii. Dividends increase firm value

1. Some investors prefer high dividends

to support current income

2. Managers that dont have high present

value growth opportunities have

incentives to spend cash wastefully

(Goodyear)

3. Easterbrook: Mitigate monitoring costs with

Easterbrook

iii. Dividends reduce firm value

1. Dividends w e r e taxed more heavily thancapital gains

2. No longer true after Bushs 2003 dividendtax cut

i. Proposition I capital structure doesnt matter

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1. Doesnt matter whether f ir m borrows or in d i v id u a l borrows

2. Claim: levered firm and unlevered firm have same value

3. Assumptions:

a. Perfect capital markets

i. Perfect competition in

capital market ii. Firms /

investors borrow at same rate

1. Brealey-Myers: This isnt

realistic iii. Equal access to all

relevant information

iv. No transaction costs;

no taxes b. No bankruptcy

costs

c. Capital structure doesnt affect investment / operatingpolicies /

managementincentives

d. WACC is fixed (rA = Operating Income / Value of

securities)

ii. Proposition II : Leverage raises requiredreturn on equity

1. Return on equity increases in proportion to the debt-equity

ratio; rate of increase depends on spread between expected

return on assets and on debt:

D2. r

E rA (rArD )E

3. Similarly, leverage increases beta of firms shares

D4. E A (AD )E

5. Critique (Brealey Myers)

a. At moderate levels of debt, shareholders dont

increase their required rate of return in exact

proportion to increase in leverage

b. Imperfections in the capital market give corporate debtan advantage

over personal debt; shareholders thus pay premium forlevered shares

Db. Tax-Adjusted WACC: WACC rD *(1T

C )*V

c. Why Debt Policy DOE S Matter

ErE *

V

i. Tax Advantage interest expenses deductible from corporate income


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1. All else equal, levered firm pays less in taxes than all-equityfirm

2. PV(tax shield) = TC * D, assuming permanent borrowing

a. This is equal to corporate tax rate * interest payment /

expected return on debt

b. For more, search PV of Tax Shield or Space Babies

3. Firm value = Value of All-Equity Firm + PV (Tax Shield)

4. M-M I with corporate taxes suggests: Optimal = 100% debt

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a. BUT company needs to have income

to shield b. Alternative means to shield

income from taxes

c. Need to consider offsetting costs of debt

5. New M-M I: VL = VU + TCD+ Costs ofFinancialDistress ii. Costs of Financial Distress

1. Direct costs

2. Indirect Costs

3. Agency Costs

a. When firm is levered, conflict b/w interests of

s t o c kh o ld er and bo n d h o ld er arise

b. Temptation to cash in and run, play for time,

bait and switch c. Undertake negative NPV

investments corporate waste)

4. Adjusted Present Value = Base Case NPV +

PV Impact iii. Trade-Off Theory

1. Capital structure is a tradeoff between tax savings anddistress costs of debt

2. Companies with intangible assets have higher costs of

distress; should have lower D/E ratios. Safe tangible asset

companies should have high D/E ratios

3. Consistent with industry differences in structure

4. BUT some highly profitable companies like MSFT/PFE haveminimal debt iv. Pecking-Order Theory

1. Premise = asymmetric information

2. Issuing equity signals managers belief that firm is

o v e r v alu ed the firms stock price will fall, so issue debt if

possible

3. Issue debt next; choose safest debt first

4. Conflicts with Trade-off Theory (Look up Tensions b/wTheories)

XI. Optionsa. Payoff Diagrams (x-axis is stock price; y-axis is payoff)

b. Buying a call:

c. Selling a call:


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d. Buying a put:

e. Selling a put

f. Protective Put (buy stock;

buy put) Downside protection,

w upside potential

g. Straddle (buy call,

buy put) Profit from

volatility

h. Downside Protection (buy call and have bank deposit paying the strike

price same payoff diagram as the protective put

i. Put-Call Parity: Value of call + PV of exercise price = Value of put + Share price

j. Option value determinants:

Factor (as this goes Effect on Call Price Effect on Put Price

Stock price (intrinsic + -

Exercise price (intrinsic) - +

Interest rate (speculative) + -

Volatility (speculative) + +

Expiration date + +

k. Intrinsic value = difference between exercise price and spot price ofunderlying asset

l. Speculative value = difference between option price and intrinsic value ofoption

XII. Executive Compensation

a. Goal = reduce Principal-Agent

problem b. Options


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compensation incentivizes, but:

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i. Too many options might make managers reckless

ii. Need to get the right mix of stocks / options / other forms of

compensation to get incentives correct

iii. Option compensation might run risk of

self-dealing c.Options Repricingi. Lower the strike price so options dont fall out

of the money ii. FASB said no, but firms found

backdoor means

d. Options Backdating

i. Manager designates grant date earlier than date board made

decision to grant options ii. Estimated cost = $500mm per sample

firm

e. Options Forward Dating

i. If stock price has been falling, manager designates

later grant date f. Option Reloading

i. Receive a new option for each received when you

exercise options ii. Exercise price of new options set to

new stock price

g. Bullet Dodging delay options grant until just

after bad news h. Spring loading time an

options grant to precede good news

i. Checks: SEC disclosure rules; substantive restrictions

XIII. Yields

a. An example: Bond has par of $1K, 5% coupon, 20% chance of bankruptcy(will only pay $500)

i. Expected CF = (1050 * 0.8) + (500 * 0.2) = $940

1. Value = $940 / 1.05 = $895

2. YTM = (1050 / 895) 1 =17.3%

b. Default Option:

i. Bond value = bond value assuming no default, less value of putoption on assets


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corporate finance - beny w2011

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