Corporate Finance

Topics Covered
 Time value of Money  Equity Valuation
 Annuity/Perpetuity  Enterprise Value
 Risk  Free Cash Flow
 Portfolio Theory  IPO Mechanism
 CAPM  Right Issues
 Capital Structure  Stock Bonus and
 WACC Stock Split
 Capital Budgeting –  M&A – Synergy
NPV, IRR, Payback
What is time value of money?
 The time value of money is a recognition that money
received today is worth more than an equal amount
of money received months or years in the future:
 In solving any time-value problems, it is important to
know if the cash flows take place at the beginning or
at the end of the period.
 Translating a current value into its equivalent future
value is referred to as compounding.
 Translating a future cash flow or value into its
equivalent value in a prior period is referred to as
discounting.
Present Value

 Discounting translates a value back in time.

 Discount factor=1/Compounding Factor
 Compounding Factor=FV/PV
 Discounting Factor=PV/FV
Annuity Factor

 A series of cash flows of equal amount,

occurring at even intervals is referred to as
an annuity.
 Determining the value of an annuity, whether
compounding or discounting, is simpler than
valuing uneven cash flows.
Present Value of a Perpetuity

 There are some circumstances where cash

flows are expected to continue forever.
 For example, a corporation may promise to
issue a perpetual bond carrying fixed rate of
interest

PV=CF/i

To see why, consider the present value annuity factor

for an interest rate of 10%, as the number of payments goes from 1 to
200
Example Application of PV - Bond
Pricing
 A bond is typically issued at par value of the
principal amount.
 However, in the secondary market, the price of a
bond can fluctuate greatly from its par value.
 The price of a bond is determined by:
 Expected periodic cash flows
 The discount rate used for each cash flow.
 Value of debt security = Present value of future
interest payments + Present value of maturity value.
 A fundamental property of a bond is that its price
changes in the opposite direction of the change in
the interest rates.
Bond Pricing Formula

 
C = coupon payment (Interest Payments)
n = number of payments 
i = interest rate, or required yield (Yield to Maturity)
M = value at maturity, or par value  (Principal)
The Concept of Risk
 Whenever you make a financing or investment
decision, there is some uncertainty about the
outcome.
 Though the terms “risk” and “uncertainty” are often
used to mean the same thing, there is a distinction
between them.
 Uncertainty is not knowing what is going to happen.
 Risk is the degree of uncertainty.
 Thus, greater the uncertainty, the greater the risk.
Expected Return

 Expected returns are a measure of the

tendency of returns on an investment.

Stand alone risk of expected value= standard Deviation

Risk Tolerance

 Most people do not like risk—they are risk averse.

 Does this mean a risk averse person will not take on
risk?
 No—they will take on risk if they feel they are
compensated for it.
 A risk neutral person is indifferent toward risk. Risk
neutral persons do not need compensation for bearing
risk.
 A risk preference person likes risk—someone even
willing to pay to take on risk.
Risk Tolerance
 When we consider financing and investment
decisions, we assume that most people are
risk averse.
 Risk aversion is the link between return and
risk.
 To evaluate a return you must consider its
risk: Is there sufficient compensation (in the
form of an expected return) for the
investment’s risk?
Expected Return, Risk and
Diversification
 As managers, we are concerned about the
overall risk of the business’s portfolio of
assets.
 The return on a portfolio (rp) is the weighted
average of the returns on the assets in the
portfolio, where the weights are the
proportion invested in each asset.
Portfolio Risk
 Portfolio risk depends not only on stand alone risk of
each individual asset in the portfolio but also on their
co-movement.
 A statistical measure of how two variables—in this
case, the returns on two different investments—
move together is the covariance.
 The portfolio’s variance depends on:
 ■ The weight of each asset in the portfolio.
 ■ The standard deviation of each asset in the portfolio.
 ■ The covariance of the assets’ returns.
Portfolio Variance

 Let cov1,2 represent the covariance of two

assets’ returns. We can write the portfolio
variance as:

It can be shown that for a large portfolio of

multiple of assets, the portfolio variance
depends more on the covariances than on the
respective variances of individual assets.
Diversifiable and Non-diversifiable
Risks
 We refer to the risk that goes away as we add
assets to a portfolio as diversifiable risk (also
known as unsystematic risk).
 We refer to the risk that cannot be reduced by
adding more assets as nondiversifiable risk (also
known as systematic risk).
 The idea that we can reduce the risk of a portfolio by
introducing assets whose returns are not highly
correlated with one another is the basis of modern
portfolio theory (MPT).
Diversifiable and Nondiversifiable Risks
 Some portfolios have a higher expected return than other
portfolios with the same level of risk.

Some portfolios have a lower standard deviation than other portfolios

with the same expected return.
Because investors like high returns and low risk, some
portfolios are preferable to others.

Portfolio that deliver the highest return for the level of risk make up
what is called the efficient frontier.
Modern Portfolio Theory
 Harry Markowitz tuned us into the idea that investors hold
portfolios of assets and therefore their concern is focused
upon the portfolio return and the portfolio risk, not on the
return and risk of individual assets (Journal of Finance,
1952).
 The risk of a well diversified portfolio depends on the market
risk of the securities included in the portfolio.
 The contribution of an individual security to the risk of a well
diversified portfolio depends on two factors: the importance
(weight) of the security in the portfolio and the sensitivity of
the security to market movements (beta).
 All the assets in each portfolio, even on the frontier, have
some risk. However, regardless of the level of risk one
chooses, one can get the highest expected return by a
mixture of a portfolio in the efficient frontier and a risk free
asset. (See figure in the following slide)
We see that the best portfolios are no longer those along the entire length
of the efficient frontier; The straight line shown below provides better return
than the efficient frontier for any given level of risk. This straight line is a
combination of the risk free asset and one – and only one – market
portfolio.
Capital Market Line
 If investors are all risk averse—they only take on risk
if there is adequate compensation—and if they are
free to invest in the risky assets as well as the risk-
free asset, the best deals lie along the line that is
tangent to the efficient frontier.
 This line is referred to as the capital market line
(CML). The CML specifies the returns an investor
can expect for a given level of risk.
 If the portfolios along the capital market line are the
best deals and are available to all investors, it
follows that the returns of these risky assets (Which
are there in the portfolio) will be priced to
compensate investors for the risk they bear relative
to that of the market portfolio.
CAPM
 So, there is a specific level of return which a investor
should get from an asset for bearing a specific level
of risk. The CAPM uses this relationship between
expected return and risk to describe how assets are
priced.
 The CAPM specifies that the return on any asset is
a function of the return on a risk-free asset plus a
risk premium.
 The return on the risk free asset is compensation for
the time value of money.
 The risk premium is the compensation for bearing
risk.
CAPM

 The expected return on an individual asset is

the sum of the expected return on the risk-
free asset and the premium for bearing
market risk.

If we represent the expected return on each asset and its beta

as a point on a graph and connect all the points, the result is
the security market line (SML).
CML and SML - Recap
 CML: Graph Showing portfolio return and
risk; shows highest return an investor can
expect from a portfolio, for a given level of
risk.
 SML – Graph showing expected return from
an individual asset and its Beta (risk of
individual asset). It shows return an investor
should expect from a risky asset which can
compensate him for bearing the associated
risk.
CAPM: Assumptions
 All investors have rational expectations.
 There are no arbitrage opportunities.
 Returns are distributed normally.
 Perfectly efficient capital markets.
 Investors are solely concerned with level and uncertainty of
future wealth
 Risk-free rates exist with limitless borrowing capacity and
universal access.
 The Risk-free borrowing and lending rates are equal.
 No inflation and no change in the level of interest rate exists.
 Perfect information, hence all investors have the same
expectations about security returns for any given time period.
CAPM: Limitations
 A beta is an estimate.
 The CAPM includes some unrealistic assumptions. For example,
it assumes that all investors can borrow and lend at the same
rate.
 The CAPM is really not testable. The market portfolio is
theoretical and not really observable.
 CAPM captures all market risk in one variable.
 CAPM does not explain the differences in returns for securities
that differ over time, differ on the basis of dividend yield, and
differ on the basis of the market value of equity (the so called
“size effect”).
What is Capital Structure?
 The combination of debt and equity used to finance
a firm’s projects is referred to as its capital
structure.
 The capital structure of a firm is some mix of debt,
internally generated equity, and new equity.
 Equity owners can reap most of the rewards through
financial leverage (raising level of Debt) when their
firm does well.
 But they may suffer a downside when the firm does
poorly
Cost of capital
 The cost of capital is the return that must be
provided for the use of an investor’s funds.
 Cost of Debt:
 Direct Approach – Rate of Borrowing
 Weighted Average Method – Interest Expense / Total
Borrowing
 Cost of Equity: CAPM
 What is the risk-free rate?
 Logic of using a long-term rate.
 What is your equity beta?
 How much is the equity risk premium (ERP)?
WACC

Where: 
Re = cost of equity 
Rd = cost of debt 
E = market value of the firm's equity 
D = market value of the firm's debt 
V = E + D 
E/V = percentage of financing that is equity 
D/V = percentage of financing that is debt 
Tc = corporate tax rate
WACC

 But WACC keeps on changing every year, so

how can we discount future cash flow by
current WACC?
 Use target capital structure to find WACC
 Use Industry’s average capital structure to
find WACC
 Discount each year’s cash flow by
corresponding year’s WACC – Variable
WACC
What is capital budgeting?

 Analysis of potential additions to fixed

assets.
 Long-term decisions; involve large
expenditures.
 Very important to firm’s future.
Stages in Capital Budgeting

 Because a firm must continually evaluate

possible investments, capital budgeting is an
ongoing process.
 Five stages:
 Stage 1: Investment screening and selection
 Stage 2: Capital budget proposal
 Stage 3: Budgeting approval and authorization
 Stage 4: Project tracking
 Stage 5: Post-completion audit
Project Classifications: Based on
dependence
 Independent Projects
 Mutually Exclusive Projects
 Contingent Projects
 Complementary Projects
What is the difference between
independent and mutually
exclusive projects?
Projects are:
independent, if the cash flows of one are
unaffected by the acceptance of the other.

mutually exclusive, if the cash flows of

one can be adversely impacted by the
acceptance of the other.
An Example of Mutually Exclusive
Projects

BRIDGE vs. BOAT to get

products across a river.
Project Classification: According to
Risks
 Valuing a project requires considering risks
associated with its cash flows:
 ■ Replacement projects: investments in the replacement of
existing equipment or facilities.
 ■ Expansion projects: investments in projects that broaden
existing product lines and existing markets.
 ■ New products and markets: projects that involve
introducing a new product or entering into a new market.
 ■ Mandated projects: projects required by government laws
or agency rules.
Financial Appraisal Tools
 Accounting rate of Return.
 Payback Method.
 Discounted Payback Method.
 NPV.
 IRR
 Project IRR
 Equity IRR
 Profitability Index.
What is the payback period?

The number of years required to

recover a project’s cost,

or how long does it take to get the

business’s money back?
Payback for Project L
(Long: Most CFs in out years)
0 1 2 2.4 3

CFt -100 10 60 100 80

Cumulative -100 -90 -30 0 50

PaybackL = 2 + 30/80 = 2.375 years

Project S (Short: CFs come quickly)

0 1 1.6 2 3

CFt -100 70 100 50 20

Cumulative -100 -30 0 20 40

PaybackS = 1 + 30/50 = 1.6 years

Strengths of Payback:
1. Provides an indication of a
project’s risk and liquidity.
2. Easy to calculate and understand.

Weaknesses of Payback:
1. Ignores the TVM.
2. Ignores CFs occurring after the
payback period.
Discounted Payback: Uses
discounted
rather than raw CFs.
0 1 2 3
10%

CFt -100 10 60 80
PVCFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79
Discounted
payback = 2 + 41.32/60.11 = 2.7 yrs

Recover invest. + cap. costs in 2.7 yrs.

NPV and IRR

 Accounting rate of return method has

limitations.
 The payback and discounted payback
approaches also have limitations.
 The NPV (and IRR) method is free of such
limitations.
Steps

1. Estimate CFs (inflows & outflows).

2. Assess riskiness of CFs.
3. Determine k = WACC for project.
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR >
WACC.
Normal Cash Flow
Project:
Cost (negative CF) followed by a
series of positive cash inflows.
One change of signs.

Nonnormal Cash Flow Project:

Two or more changes of signs.
Most common: Cost (negative
CF), then string of positive CFs,
then cost to close project.
Nuclear power plant, strip mine.
NPV: Sum of the PVs of inflows and
outflows. n
CFt
NPV   .
t  0 1  k 
t

Cost often is CF0 and is negative.

n
CFt
NPV    CF0 .
t 1 1 k t
What’s Project L’s NPV?

Project L:
0 1 2 3
10%

-100.00 10 60 80

9.09
49.59
60.11
18.79 = NPVL NPVS = $19.98.
Rationale for the NPV Method

NPV = PV inflows - Cost

= Net gain in wealth.

Accept project if NPV > 0.

Choose between mutually

exclusive projects on basis of
higher NPV. Adds most value.
Using NPV method, which
project(s) should be accepted?

 If Projects S and L are mutually

exclusive, accept S because NPVs >
NPVL .
 If S & L are independent, accept both;
NPV > 0.
Internal Rate of Return: IRR

0 1 2 3

CF0 CF1 CF2 CF3

Cost Inflows

IRR is the discount rate that forces

PV inflows = cost. This is the same
as forcing NPV = 0.
NPV: Enter k, solve for NPV.
n CFt
  NPV.
t  0 1  k 
t

IRR: Enter NPV = 0, solve for IRR.

n CFt
  0.
t  0 1  IRR
t
What’s Project L’s IRR?

0 1 2 3
IRR = ?

-100.00 10 60 80
PV1
PV2
PV3
0 = NPV

IRRL = 18.13%. IRRS = 23.56%.

Rationale for the IRR Method

If IRR > WACC, then the project’s

rate of return is greater than its
cost-- some return is left over to
boost stockholders’ returns.

Example: WACC = 10%, IRR = 15%.

Profitable.
IRR Acceptance Criteria

 If IRR > k, accept project.

 If IRR < k, reject project.

Decisions on Projects S and L per
IRR

 If S and L are independent, accept

both. IRRs > k = 10%.
 If S and L are mutually exclusive,
accept S because IRRS > IRRL .
Construct NPV Profiles

Enter CFs in CFLO and find NPVL and

NPVS at different discount rates:
k NPVL NPVS
0 50 40
5 33 29
10 19 20
15 7 12
20 (4) 5
NPV ($) NPVL NPVS
k
60
0 50 40
50 5 33 29
40
Crossover 10 19 20
Point = 8.7% 7 12
15
30
20 (4) 5
20
S
IRRS = 23.6%
10 L
0 Discount Rate (%)
0 5 10 15 20 23.6
-10
IRRL = 18.1%
NPV and IRR always lead to the same
accept/reject decision for independent
projects:
NPV ($)
IRR > k k > IRR
and NPV > 0 and NPV < 0.
Accept. Reject.

k (%)
IRR
 Mutually Exclusive Projects

NPV k < 8.7: NPVL> NPVS , IRRS > IRRL

CONFLICT
L k > 8.7: NPVS> NPVL , IRRS > IRRL
NO CONFLICT

S IRRS

k 8.7 k %
IRRL
To Find the Crossover Rate

1. Find cash flow differences between the

projects.
2. Calculate IRR on cash flow differential.
Crossover rate = 8.68%, rounded to 8.7%.
3. Can subtract S from L or vice versa, but
better to have first CF negative.
4. If profiles don’t cross, one project
dominates the other.
Two Reasons NPV Profiles Cross

1. Size (scale) differences. Smaller

project frees up funds at t = 0 for
investment. The higher the opportunity
cost, the more valuable these funds, so
high k favours small projects.
2. Timing differences. Project with faster
payback provides more CF in early
years for reinvestment. If k is high,
early CF especially is good, NPVS >
NPVL.
Reinvestment Rate Assumptions
(Imp.)

 NPV assumes reinvest at k (opportunity

cost of capital).
 IRR assumes reinvest at IRR.
 Reinvest at opportunity cost, k, is more
realistic, so NPV method is best. NPV
should be used to choose between
mutually exclusive projects.
Multiple IRR

 There is another situation in which the IRR

approach may not be usable-when projects
with nonnormal cash flows are involved.
 Projects with nonnormal cash flows would
provide multiple IRRs.
Inflow (+) or Outflow (-) in Year

0 1 2 3 4 5 N NN
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN
Equity Valuation

 Because common stock never matures,

today’s value is the present value of an
infinite stream of cash flows (i.e., dividend).
 But dividends are not fixed.
 Not knowing the amount of the dividends—or
even if there will be future dividends— makes
it difficult to determine the value of common
stock.
Valuation Models

 Dividend Valuation Model (DVM):

 Constant dividend: Let D be the constant DPS:

The required rate of return (re) is the return shareholders

demand to compensate them for the time value of money tied
up in their investment and the uncertainty of the future cash
flows from these investments.
Valuation Models

 Dividend growth at a constant rate (g): (also

known as Gordon Model)

OR

OR
Sustainable Growth Model (What should
be g?)
 Return on Equity = Net Income/Total Equity
 Dividend Payout Ratio = Dividend per share/EPS
 Sustainable Growth (g) = (1-Dividend Payout)* ROE
 The sustainable growth model shows us that when firms pay
dividends, earnings growth lowers. If the dividend payout is
20%, the growth expected will be only 80% of the ROE rate.
 A company cannot grow earnings faster than its current
ROE without raising additional cash. That is, a firm that now
has a 15% ROE cannot increase its earnings faster than
15% annually without borrowing funds.
 ROE is, in effect, a speed limit on a firm's growth rate, which
is why money managers rely on it to gauge growth potential.
DCF Model
 The price of a stock can also be found using
discounted cash flows.
 Steps:
 Find out free cash flows of the firm.
 Estimate the present value of the free cash flow using
required rate of return (WACC)
 Find out the enterprise value.
 Deduct net debt
 Divide the resultant figure by the number of outstanding
shares.
Enterprise Value
 EV = Market value of equity + Preferred stock +
Minority Interests + Market Value of debt – cash and
cash equivalents
 Takeover value of the company
 All the components are market, not book values
 Sum of claims of all the security-holders: debt
holders, preferred shareholders, minority
shareholders, common equity holders
 Better than market cap, since it also consider value
of debt, which needs to be paid by the buyer of firm.
 EV can be negative in certain cases—for example,
when there is too much cash in the company
Free Cash Flow

 FCF is a cash flow available for distribution

among all the security holders of a company.
They include equity holders, debt holders,
preferred stock holders and so on.
 FCF = EBIT + Depreciation – Increase in
working capital – Capital Expenditure – Tax
Rate * EBIT
 Discount at WACC to get Enterprise Value
Capital Cash Flow
 Capital Cash Flow = EBIT + Depreciation – Increase
in working capital – Capital Expenditure – Tax Rate *
(EBIT – Interest )
 Tax Shield = tax rate * Interest Expense

 Capital Cash Flow = Free Cash Flow + Tax Shield

 Discount Capital Cash flow at following discount

factor to get enterprise value

RA = Rd * D/V   + Re * E/V
(Note how it differs from WACC, this discount factor is
called expected return from Asset)
FCF vs CCF
 Lets Define
 Hypothetical taxes = tax rate * EBIT
 Actual Taxes = tax rate * (EBIT – Interest) , This is what
you have on your P&L statement
 FCF doesn’t include benefit of tax shield in the cash
flow. But it’s discounted at WACC, so benefit of tax
shield is included in the discount rate. Note: WACC
includes (1-tax rate) in its calculation.
 Capital Cash Flow includes benefit of tax shield in
the cash flow itself.
 So, you include the benefit of tax shield either in
cash flow or discount rate.
Equity Cash Flow
 One method to find Total Equity Value is to get
Enterprise Value (Which is total firm value) using any of
the two previously described methods and then use
following equation to get Market Value of Equity
Enterprise Value = Market value of equity + Preferred
stock + Minority Interests + Market Value of debt – cash
and cash equivalents
 Another method is to find equity cash flow and discount it
at cost of equity (Re).
 Equity Cash Flow = EBIT + Depreciation – Increase in
working capital – Capital Expenditure – Actual Taxes –
Interest Expense – Debt Repayment + New Debts
(This is the cash flow available only for equity holders, after
paying debt holders)
Market Multiple
 Another method of stock valuation is market multiple
analysis.
 This method applies a market determined multiple to
net income, EPS, net sales, book value etc.
Examples:
 Value of Equity = Market Average P/E * Firm’s EPS
 Value of Equity = Market Average P/S * Firm's Annual Sale
 Value of Equity = Market Average P/B * Firm’s Book Value
 One measure of market average can be the average of the
industry group to which the firm belongs
 This method is used to price an IPO and also to
value unlisted firms.
Raising Money through Equity

 Private Placement
 Public Offering
 Right Issues
 In a private placement, such as to angels or
VCs, securities are sold to a few investors
rather than to the public at large.
 In a public offering, securities are offered to
the public and must be registered with SEBI.
Why should a company consider going
public?

 Advantages of going public

 Current stockholders can diversify.
 Liquidity is increased.
 Easier to raise capital in the future.
 Going public establishes firm value.
 Makes it more feasible to use stock as
employee incentives.
 Increases customer recognition.
 Disadvantages of Going Public
 Must file numerous reports.
 Operating data must be disclosed.
 Officers must disclose holdings.
 Special “deals” to insiders will be more
difficult to undertake.
 A small new issue may not be actively
traded, so market-determined price may not
reflect true value.
 Managing investor relations is time-
consuming.
 What are the steps of an IPO?
 Select investment banker (Underwriter)
 Firm Commitment – underwriters buy the unsold

shares
 Best Effort - underwriters only agree to do their best

to sell shares to the public

 File “Draft Offer Document” with SEBI
 Offer document in draft stage

 Contains all financial data, information on the

management team, description of company's target

market, competitors, and growth strategy – Everything
an investor needs to know
 SEBI may specify changes to be made
Steps of IPO
 File “Offer Document” with the Registrar of
Companies /Stock Exchanges
 After, Lead Banker carry out required changes in
Draft Offer Document.
 Find price range for preliminary (or “red
herring”) Prospectus
 Number of Shares and upper and lower prices are
specified.
 File with Registrar of Companies/Stock
Exchanges
Steps of IPO

 Go on road show
 Senior management team, investment banker,
and lawyer visit potential institutional investors
 Usually travel to ten to twenty cities in a two-week
period, making three to five presentations each
day.
 Set final offer price in final prospectus –
Through book building process
Describe how an IPO would be priced.
 Since the firm is going public, there is no
established price.
 Banker and company project the company’s future
earnings and free cash flows
 The banker would examine market data on similar
companies.
 Price set to place the firm’s P/E and M/B ratios in
line with publicly traded firms in the same industry
having similar risk and growth prospects
 On the basis of all relevant factors, the investment
banker would determine a ballpark price, and
specify a range (such as Rs.55 to Rs62) in the
preliminary prospectus.
 Class of Investors
 Three classes of investors can bid for the
shares:
 Qualified Institutional Buyers: QIBs include mutual
funds and Foreign Institutional Investors. At least
50% of the shares are reserved for this category.
 Retail investors: Anyone who bids for shares under
Rs 50,000 is a retail investor. At least 25% is
reserved for this category.
 The balance bids are offered to high net worth
individuals and employees of the company.
What is “book building?”
 Investment banker asks investors to indicate how
many shares they plan to buy, and records this in a
“book” – Price Discovery Process
 The number of shares are fixed. After evaluating the
bid prices, the company will accept the lowest price
that will allow it to dispose the entire block of shares.
That is called the cut-off price. All bidders get
allotment at cutoff price.
 The bids are first allotted to the different categories
and the over-subscription in each category is
determined. Retail investors and high net worth
individuals get allotments on a proportional basis
What are the direct and indirect costs of
an IPO?
 Underwriter usually charges a 5-7%
spread between offer price and proceeds
to issuer.
 Direct costs to lawyers, printers,
accountants, etc. can be over a crore of
rupees.
 Preparing for IPO consumes most of
management’s attention during the pre-
IPO months.
 What is a rights offering?

 A rights offering occurs when current

shareholders get the first right to buy new
shares.
 Shareholders can either exercise the right
and buy new shares, or sell the right to
someone else.
 Wealth of shareholders doesn’t change
whether they exercise right or sell it.
Right Issues: Example
 Current Share Price = Rs 50
 You have 50 shares, Current Value = Rs 2500
 Company announces right offer, 1 share for every 5 shares
at Rs 40 (20% discount)
 You choose to exercise (get 10 new shares @ 40)
 10*40 = Rs 400 passes from shareholder to firm.

 Total Value of Investment = 2500 + 400 = Rs 2900

 Share Price After Right Issues: 2900/60 = 48.333

 This is theoretical price, price generally rises because of

positive signal.
 You choose to sell the right
 Right price = 48.333 – 40 = 8.333

 Your wealth = 48.333 * 50 + 10*8.333 = Rs 2500

Different Types of Dividends
 Many companies pay a regular cash dividend.
 Public companies often pay quarterly.
 Sometimes firms will throw in an extra cash dividend.
 The extreme case would be a liquidating dividend.
 Often companies will declare stock dividends.
 No cash leaves the firm.
 The firm increases the number of shares outstanding.
 Some companies declare a dividend in kind.
 Wrigley’s Gum sends around a box of chewing gum.
 Dundee Crematoria offers shareholders discounted
cremations.
 Share Repurchase: Instead of declaring cash
dividends, firms can rid itself of excess cash through
buying shares of their own stock.
Stock Bonus and Stock Split
 Bonus Shares
 Additional Shares issued and given free.
 A company builds up its reserves by retaining part of its
profit over the years, these reserves increase gradually,
and the company wanting to issue bonus shares
converts part of the reserves into capital.
 Accounting Treatment: Transfer the total value of new
shares issued from reserves to share capital
 Positive Signal
 Stock Split
 Face value decreases. If a share of face value 10 split into
two, the face value of each share become 5.
 Just a technical change – increases liquidity of trading
 A bonus is a free additional share. A stock split is
the same share split into two.
M&A

 Decisions
 What price to pay? – Value Target, Value
Synergies
 How to pay? – All Equity, All Cash, Combination
of equity and cash
 How to finance the deal? – Raise new equity, new
debt, internal funds
 Target’s Performance Improvement requirement
to achieve the desired synergies and how to
achieve it?
M&A: Synergy
 Additional value that is generated by combining two
firms, which would not be generated if companies
operated independently.
 Synergies create value by harvesting benefits that
each company would not be able to gain on its own.
 To be successful in M&A it is important to
 Understand the credible sources of synergy and dubious
ones
 Value Synergies
 Value from Synergies = Value of combined firm with
synergies – Value of Acquirer – Value of Target if
optimally managed (According to market
expectations)
The Synergy Trap
 When an acquirer pays acquisition premium,
he/she has two business problems to solve:
 to meet the performance targets the market
already expects;
 to meet the even higher targets implied by the
acquisition premium.
 Hence, Synergy can be defined as “increases in
competitiveness and resulting cash flows beyond
what the two companies are expected to
accomplish independently”.
The Acquisition Game
 Acquisition is a business gamble where
the acquirer pays up front for the right to
control the assets of the target firm and
earn, hopefully, a future stream of cash
flows.
 But while the acquisition premium is
known with certainty, the payoffs are not.
 NPV (of playing the acquisition game)=
Synergy- Premium.