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CAPITAL STRUCTURE Capital structure is o D/E ratio ; Debt Ratio = D/(D+E)= D/A Intuitive. If 10%, low risk.

k. o Know how to change from D/A to D/E o If no debt, inefficient. Paying high cost of capital. If a lot of debt, very risky and high bankruptcy possibility. o Calculate unlevered beta:

Calculate levered beta (Hamada):

Compare Debt and Equity o Payment of CF: Debt is mandatory, Equity is discretionary o Tax deductibility: Debt yes, Equity no o Priority of claim: Debt is higher, Equity is lower o Maturity: Debt is fixed, Equity is perpetual Tax benefit of debt is (Tax*rd*Debt amount). Cost of Equity is most expensive but safest from investor perspective because low possibility of going bankrupt. If wish to maintain debt level, can do roll-over (loan from one bank to pay other bank). PV of roll-over is for perpetual: o PV = tax * cost of debt * Debt * (1/r) * [1- 1/(1+r)T] = tD o R for bank loan is not Rf as there is risk, possibility will go bankrupt. Types of Financing o Internal Retained Earnings o External ST Trade Credit, Overdrafts LT debt Bank loans, Bonds LT equity Common stocks, Pref Shares Hybrid Debt with warrants, CB o For LT external financing, important to have alternative sources. Example: when banks pull back credit due to market downturn, still have others. Optimal D/E o Industry/Peer group average D/E o Qualitative method is subjective. If want can put weights on several factors (total add to 100%), then put 1 for Debt and 0 for equity. If weighted sum nearer to 0, then choose equity. Tax: Preferred financing is debt (tax benefit) Cost of funding: debt is cheaper Bankruptcy Costs: equity Control: debt Flexibility: equity. Debt has collaterals, covenants.

Timing: debt Impact on Financial Statements Debt Ratio (equity), Interest Coverage [EBIT/Interest Expense] (equity), ROE (debt), EPS (debt), CF (equity) Quantitative APV adjust for bankruptcy cost by looking at drop in value and bond rating. Direct and indirect cost of bankruptcy (Banker charger higher interest rate, market value drop, lose existing and potential customers, loss in suppliers); For WACC, bankruptcy cost look at cost of debt only. However, it is convenient. WACC WACC is a U-shaped curve, so optimal is where WACC is minimum. This decrease is due to (1) swapping from expensive to cheaper cost and (2) tax benefit. Market Value of Firm = Market Value of Equity + Debt. Share price: (1) last closing price of the year [may be subject to manipulation] (2) last 30 days closing price average Rf: Can justify to use 3 months as the shortest term is most purest (least risk of bankruptcy even for government). Can also justify longest as company is perpetuity (exist forever). Risk premium: Suggest use 1-3 full cycle of good and bad economy to eliminate errors. Calculate firms unlevered beta for D/V = 0. Then obtain levered beta for various D/E ratios and use CAPM to calculate corresponding cost of equity. For all D/V ratios, find cost of debt but could be circular. Solution: If use ICT with Bond Rating, start with unlevered firm. Assume best rating and use i/r to calculate ICR. If fall within ICR range of AAA, then ok, else move to next lower rating. Computer WACC for all ratios and choose the one which min WACC. Adjusted PV APV or VL = VU + PV(tax shield) PV(expected bankruptcy cost) Obtain VU VL = Market Value of Firm; PV(tax shield) = tax * debt (when perpetual); PV(expected bankruptcy cost) = Prob of Default * Bankruptcy Prob * Firm Market Value Computer tax shield for various D/V ratios Compute Exp Bankruptcy Cost for each D/V ratio using Default Rate based on Bond Rating and (VU + Tax Shield) for Firm market value Compute APV for each D/V and choose max Gap between upward line and curve is expected bankruptcy cost

Adjusting to meet optimal D/E o If actual>optimal debt, (1) rights issue (2) Sell non-core asset (properties and financial assets) and lease back (3) reduce dividends o If actual<optimal debt, (1) issue bond and declare dividend (2) buy-back share and cancel (3) reduce capital by halving par value Designing Debt Security o Maturity ST loan is cheaper than LT loan (higher i/r and longer length of interest payments); Risk that not able to roll over ST loan and unclear on rollover i/r Consider not only life of company/project as well as ability to pay Company would try to pay a low rate, minimal default probability and roll-over if needed Use stress test (worst case) on how soonest can pay until at a comfortable level. Correct to match loan with project/asset life but end up paying high. So should think next step. o Currency Currency is very unpredictable. Very volatile and beyond operating margins. Solution is to hedge: borrow in local currency and do one-time spot exchange Exposure on profits (just impact on money made) vs Exposure on loan (high bankruptcy chance) If local currency i/r is much higher than other currency or cant borrow in local currency, use correlation to find other similar currency movement or try to find base in local o Fixed or Variable Interest Based on probability (more likely to go up) and down-side risk (amount of going down smaller than amount of going up) In analysing: Useful to look at past cycles (I/R is more predictable and slower) to tell upper and lower bound; prediction of business cycle going up or down will also be a forecast; reading statements by Feds/Central Bank o Repayment Schedule Bullet Payment Service interest then lump sum at maturity. Favoured by TMV. Paying cheapest to banker. High risk for bank especially if LT loan.

Alternative is issue low coupon bond which will be taken by retail investors (especially in low i/r environment where their savings<coupon). Zero coupon bond is favoured by insurance companies. Inflation-index bonds (TIPS) Holiday scheme No payment for initial years then instalment. Match loan payment with cash flow of project.

VALUE CREATION Stakeholder in Firm o Customer, Supplier, employee, bankers, shareholder, govt o Revenue from customer COGS to supplier SG&A to employee & mgt = operating profit o Operating profit interest to bankers = NPBT o NPBT Tax to govt = NPAT o NPAT Dividends to shareholders o In general, as there is no leeway for suppliers, banker, government, likely argument is between employee & mgt and shareholder when it comes to lowest priority. Shareholder Value o Shareholders activism Tremendous pressure on management as presence of institutional investors (who act on behalf of indv investors) grow strong o Globalisation of Markets Create value: Attract global investors; Lose value: Investors have many other options o Ranking of Firms o Asian Financial Crisis Corporate inefficiencies leading to losses and sharp fall in profits. ST solution is cut cost. LT solution is restructure coy and mgt system Value Creators enable o Easy access to capital, Employment creation, High market value Value Destroyers cause o Unhappy shareholders, Hostile takeovers Measure of Value Value created only if measurable o Profits, ROA, ROE, etc. o Share Price Most immediate measure of shareholder value However if tie employee compensation to share price, difficult. Firstly, share price is short-term. Secondly, share price may be out of control of employee. Market practice has CEO, CFO and COOs pay related to share price to ensure they keep an eye on share price. Companies like IBM encourage manager-level to purchase stocks too. P = D/(re-g) o Discounted Cash Flows DCF never used in compensation as mistakes cannot be undone. Tough to assume positive performance, agree to pay high bonus and then realised it is a mistake. Nash Equilibrium will have CFO being very conservative, giving low package which in turn is difficult to retain staff o EVA

Residual Income/Economic Profit/EVA = NOPAT Capital Charge or (ROICWACC)*IC ROIC = NOPAT / IC Capital charge = cost of capital (ie. WACC) x investment capital (ie. D+E) Investment Capital includes Liabilities, Equity, Accumulated Loss, Accumulated Goodwill Amortisation NOPAT: Net operating profit after tax = OP x (1- tax rate) or (NI minus nonrecurring items) or (OP + goodwill amortisation Cash Taxes) Cost of debt = Yr 0 Interest Expense / (Average of Yr 0 and Yr 1 liabilities). Liabilities = Loans, Finance Lease Commitments, LT liabilities Incremental value created by firm Positive EVA indicates firm is creating value. Benefits Focus on value creation Superior to accounting performance measures Link management incentives to creation of shareholders wealth Simple to understand and use For compensation, EVA considers WACC. This means NOPAT has to be at least suff to pay both equity and debt. Through IC, it also includes B/S which tells how much asset used to generate NOPAT (accounts for asset usage). Question though, who should EVA be used for? EVA best suited for CEO, then divisional head. Relevance gets lower as we go down to support staff. For support staff, balance scorecard is more relevant. EVA does not allow amortising or writing-off of goodwill. Keep the amount paid for goodwill in Investment Capital. Therefore, for staff doing M&A, will be pressured into considering how that will lead to high Capital Charge.

Creating Value o Refocus on creating value : Value mindset Corporate Goal is create shareholders value Link compensation to shareholders value Value drivers create EVA which builds shareholder value Value driver is variable or activity that has impact on shareholder value NOPAT similar to NPAT. Hence, strategies are tried-and-tested. To increase NOPAT, increase sales, reduce cost margin, look at product margin/mix. Lower invested capital while maintaining operations reduce working capital and fixed assets while increasing growth of assets. Reduce WACC reduce cost of funds and optimise capital structure Outsource reduces fixed assets. (1) Change in EVA = Fixed assets*WACC. (2) Savings = Current operating and depreciation costs - outsource cost (3) Total Saving = Change in EVA + (1-tax)*Savings

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Restructure company : Corporate restructure Re-Engineer management processes : Value-oriented management system Strategic planning IC >< Assets as some assets cannot be priced. Eg. accruals, payables. ROIC = NOPAT div IC EVA = NOPAT (WACC * IC) = (ROIC*IC) (WACC*IC) = IC(ROIC WACC) For capital growth, moving up is growing biz, moving down is shrinking biz.

Investments Evaluating new projects NPV analysis Sensitivity and scenario analysis Compensation system Performance measurement Balanced Scorecard

Target setting Set absolute/relative EVA targets Company and Biz Units Target must stretch company Set time frame

CORPORATE RESTRUCTURING 1. Current Status perceived by Market (Market Value) a. Stock Analyst, Newspaper Report b. Feedback from customers/bankers c. Review return to shareholders compared with stock market / peer group 2. Current Status perceived by Management (Intrinsic Value) a. Value gap = Market Intrinsic Value i. Positive 1. Takeover target 2. New strategic opp 3. Market inefficient 4. Good time to have rights issue if money needed ii. Negative 1. Market inefficient 2. Repurchase share 3. Employ spin doctors 4. Poor fundamental/management 5. Need to restructure b. Understand basis of markets view i. Analysis of biz environment Porters Five forces ii. Financial ratio analysis iii. Driver analysis compare ratios with peers; focus of EVA on IC and WACC as Margin is traditional method of profit focus iv. Value Map 3. Internal Restructuring a. Re-org to improve profitability/returns i. Increase capital allocation invest in projects/biz to generate ROIC > WACC ii. Decrease capital allocation scale down biz whose ROIC < WACC b. Reduce cost c. Improve efficiency of assets d. Consolidate operations to obtain EOS 4. Financial Engineering a. Determine optimal capital structure b. Re-align current capital structure to optimal (min WACC) c. Reduce cost of financing through innovative financing

5. External Restructuring a. M&A i. Value creation through synergies ii. NPV = Synergies Premium > 0 b. Divestiture i. Sell off biz unit (release ownership & control in return for cash) ii. Assets, Pdt line, Sub, Division iii. Fit with overall firm strategy, core competencies, competitive advantage over peers, profitable in LR? iv. NPV = Sale Price PV of CF Spillover effects on other assets; If >0, divest v. Provide cash to pay off debt or finance strategic investments, increase focus on core biz, create value for shareholder c. Ownership restructuring i. Spin-off 1. 2 entities with separate share holdings 2. Pro rata distribution of shares to parent shareholders 3. No money change hands 4. Regarded as stock div so tax-free 5. Use when sub not realising full value ii. Equity carve-out 1. 2 entities with separate share holdings 2. Some equity of sub sold to outside investors through IPO 3. Parent still hold majority stake in subsidiary 4. Used when need for cash iii. privatisation INITIAL PUBLIC OFFERING 1. Identify IPO Candidate a. Satisfy listing requirements b. Strong financial position and operating performance c. Good growth potential d. Productive use of funds raised e. Implicit requirements i. Good industry prospects

ii. Strong, capable & credible management iii. Health CF and adequate Working Cap iv. No conflict of interests of key shareholders and managers v. Good spread of customers and suppliers (< 20%) 2. Appoint Issue Manager a. Administration of IPO, Advise, Underwrite, Distribute, Certify quality of IPO candidate b. Pre-underwriting conference: Amt of $ to raise, underwriting syndicate, selling group, sign underwriting contract i. Amount of $ depends on market appetite (how much market can absorb), use of funds ii. Underwriting has better fees than selling. However, some will take on selling in hopes of future chances of underwriting. c. Issue Methods: Firm Commitment, Best effort, All or none i. Firm commitment has heavy risk for underwriter. ii. Best efforts has little guarantee for listing firm. Taken when listing firm has little choice (not confident) d. Coy also have to appoint underwriters, auditors, lawyers, PR firm

3. Audit Accounts and Price Shares a. By recognised accounting firm b. Follow standard accounting conventions c. Method of valuing coys share d. Factors that determine final issue price i. Listing firm would like to earn a premium on its intrinsic value. While the investment banker would like to price it below intrinsic value to ensure shares taken up.

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ii. Generally, the price would be at a discount. The amount of discount depends on: (1) market sentiment which is viewed by volume traded and price movements (2) bargaining power between coy and IB (if coy smaller than IB, usually have to follow IBs stance which is usually steeper discount) (3) perceived risk of company by both retail and institutional investors (4) growth potential of company (5) how much value want to give shareholders iii. Draft IPO application & prospectus a. Follow exchange guidelines and address exchanges concerns Submit application to exchange and wait for in-principle approval Corporate restructuring a. Assets Price at market value (either write-off if low or revalue if high) b. Cap structure c. Ownership of sub and associate coys Ensure clear corporate linkages d. Relationships with suppliers & customers Ensure arms-length Exchange approve issue & prospectus a. Lodge final prospectus with MAS b. Market shares (road shows) c. Tombstone advertisement Launch IPO a. Timing of launch b. Press conference and news release c. Analysts and investors meeting d. Issue of prospectus to investors Benefits of IPO o Branding: Credibility, Exposure to new markets, Analyst coverage o Unlock Investment and Diversify risk of asset (ie. Money which is locked into business). o Need financing for expansion o Future financing: Create liquidity of private shares o Executive stock options for employee Disadvantage of IPO o Listing costs o Potential loss of control o Compliance cost Stock Exchange requirement, etc. o Accountable to public shareholders o Close scrutiny of results o Regulatory requirements Structure of IPO o Public offer vs Private Placement Shift in trend from public offer to private placement. If large portion to retail investors (who generally have short term views), then trading is quite heavy. Hence, if prefer long-term, should try private placement. o Fixed vs Tender system

Problem with fixed price is demand and supply may not match. If oversupply, then will use balloting where categories of quantities are set by IB and balloting ratios are set. For tender system, it is like auction where investors can post price and qty to purchase. IB will take a cumulative and pro-rate if there is leftover. Problem of winners curse (pay much more than others) However, can also have single price system where will take lowest price within range and apply for all. o Type of auction Direct Cost (4-8% of gross proceeds) o Underwriting commission o Mgt and Distribution fees o PR and Advertisement Fees o CDP and SCCS, Share Registrar Fees o Auditor and Legal Fees o Printing prospectus and share certificates o Press and Investment Conference Expenses o Initial fee & perusal fee of security commission o GST Indirect Cost o Under-pricing o Green-shoe option If oversubscribed, allow IB to issue more shares than original. Which results in more costs to company. Market Reaction to Equity Issues o Sharp Increase in Price during first day of trading for IPO o Average initial returns is closing price on first day vs listing price.

MERGER & ACQUISITION Merger : Combination of two coys to form new coy; Acquisition purchase of one coy by another in which no new coy formed. o External Factors Competitive pressure Regulatory changes - Anti-monopoly, banking act, new compliance requirements Financial stress need to raise cash o Underlying Internal Rationale Strategic Speculative dotcom, buy & split & sell Financial realignment Management motive Drivers of Acquisition o Inorganic growth Pros: Faster, Less risky (established) Cons: Pay premium, Existing legacy, may not be available o Diversification

Cash rich but lack opportunity in existing business Goal of building conglomerate Spread risk (conglomerate discount) Exposed to buy-and-split

Consolidation Mature biz, Survival of Fittest No new entrants Most rewarding Anti-competition issue o Synergy/access to: Markets/customers/contracts Technology New product/services Distribution/outlets Sales force Production facility/capacity Hostile take-over o No consultation/negotiation, Quick o Listco, no controlling shareholder o Objective: Control/Defensive or Buy & Strip o Not necessarily under-performing Acquisition vs Divestment o Similar process, different emotions o LT commitment, big ticket item, Seller must be involved (Buy House/Car)

Steps of M&A 1. Deal identification a. Objectives i. Core & Adjacent Biz ii. Integration Horizontal, Vertical iii. Diversification, Consolidation, Access to Resources? b. Resources, mandate, constraints i. Funds available (Cash, Share) ii. Existing Mgt Resource

iii. Risk Appetite iv. Owner or Boards taboo/allergy v. Can accept initial loss? c. Screening criteria i. Right size funnel revenue, assets, growth ii. Geography iii. Business (Pdt/Svc) iv. Synergy 1. Operating Synergy Size (EOS, Power), Complementality (Vertical, Horizontal) 2. Financial/Tax Size (Capacity & Cost of borrowing), Complementaility (CF, Depreciation, Tax losses, Allowance) 3. EOS: Rev (sales/customer, marketing, distribution), Cost (purchases, production, admin, accounts) 4. Estimation: (1) Mkt Analysis (2) Peer Comparison (3) DCF v. Profitability, Cash Flow vi. Full or partial ownership 1. Wholly Owned (100%) 2. Super Majority (75%) 3. Majority (> half) Control 4. 29.9% (below GO trigger point) 5. Minority stake (20-50%, associate) 6. Passive stake (<20%) 7. Key man risk and control issues 8. Protection of minority shareholders 9. Tax issue (change of control) vii. Management Team d. Source for targets i. In-house resource BD Dept, Sales/Marketing staff ii. Investment Bankers Retainer/Ad Hob, Referral/Proj Mgt iii. Biz Network 2. NDA/LOI/MOU a. NDA i. Purpose Confidentiality (seller), Exclusivity (buyer) ii. Key terms Define confidential, purpose of disclosure, period/gestation, who are bound, governing law b. MOU i. Agreement in principle (subject to definitive agreement) ii. Key terms agreed (price, range, formula) iii. Announceable for listco iv. Binding (locked in) v. Governing law c. LOI i. Break-up (walk-away) fees ii. No-shopping provision (exclusive period)

iii. Deposit (refundable?) iv. Terms transferred to definitive agreement v. Conditions to closing (CP) vi. Biz conduct prior to closing 3. Due Diligence a. Reasonably assured that sellers claims about biz are fair and legitimate. Confirm assumptions or preliminary assessment b. Financial, legal, strategic/business c. Expensive & time consuming but necessary especially for areas w/o Reps & Warranties d. Search for skeletons e. Limited scope for listco f. Sensitive and painful for seller g. Choose DD advisors i. Agree on scope ii. Fees relative to deal size (get quote) iii. Regional network vs OMO iv. Financially astute lawyer v. Language ability h. Financial DD i. P&L Rev (sustainability, trend, customer & market concentration risk), Cost (depreciation policy), Adjust for related transactions (rent, salary/fees, interestfree loans) ii. B/S Receivables (ageing, bad debt, provision), inventory (valuation, provision), payables, loans (terms, rates, shareholder change), PPE (over-statement, impairment) iii. Tax (Corp, VAT/Sales, Biz) Outstanding issues, potential liability, underprovision, tax losses/allowance iv. 3-5 years history v. Audited i. Legal DD i. Titles to assets ii. Licenses iii. Litigations iv. Get good legal firm. Easier if asset deal. j. Strategic DD i. Industry trend/outlook ii. Key drivers - Profitability, attractiveness iii. Competition - Marketing strength/weakness, Competitive advantage iv. Synergistic potential k. DD for listed coy i. Limited ii. Public info only AR, announcements, press releases iii. Lower risk audited, corporate governance iv. Sensitive 4. Valuation

a. Combination of various methods: b. DCF i. Discount rate, WACC, terminal value ii. Problems: 3 year is min, 5 year most common, 7 year ideal, 10 year is stretched. Growth, margin? iii. Mature vs High-tech industries c. Earnings Multiple i. PAT/EBIT/EBITDA ii. Historical average and/or forward projection iii. Market comparables : problem is hard to find similar coy and big range iv. Use sales multiple for start-ups, hi-tech, internet bubble period d. Payback (simple or discounted) e. Book value (premium/discount) i. For asset heavy biz but need to revalue and mark to market. ii. Assess realisability of value iii. Use RNAV for property companies iv. Use P/B for banks v. Ignore intangibles like technology, rights, licenses, copyrights f. Earnings accretive i. Incremental PBT > interest cost of debt g. Strategic returns (non-quantitative) i. Control premium, listing premium, etc 5. Structure Deal a. Share vs Asset b. Liability issue c. Stamp duty savings d. Impact on existing licenses e. Employees f. Offshore share transfer (BVI, Bermuda) g. Caveat: some agreements have shareholder change clause Earn out Claw back (against Installments (bridge valuation over-payment, gap) under perf) Upside for seller * Seller has continued control * * Formula or fixed quantum * * Usually Fixed Milestones * * * (measurable, no dispute) Frequency, time frame * * Time Frame Audited accounts * * * h. Call & Put Option i. Engagement period ii. Can be in multiple stages iii. Option period (expiry date) iv. Pricing formula i. Profit sharing

i. Shareholders remain in team ii. Attractive perf bonus (with cap) iii. Up to X years iv. Clear Perf Targets 6. Negotiate Definitive Agreements a. Consideration b. Conditions precedent c. Call & put option d. Non-complete condition Biz scope, duration, territory e. Reps & Warranties i. Receivables, inventory value, tax (no limit, indefinite), key staff (service contract) ii. Templates vs Customised (DD findings) iii. Time vs $ limits depend on types of biz iv. Indemnity claim basket (trigger point) f. Payment terms Installments, Escrow g. Minority Protection (if <51%) i. Pre-emptive right ii. Board structure and issues requiring unanimous decisions iii. Tag along & drag along 7. Completion a. Legal to lead b. Adjustments c. Conditions precedent satisfied d. Completion account (min. NAV) e. Extension if necessary f. Long stop date g. Titles to assets h. Share cert. i. Disclosure list j. Employment agreements (if asset deal) k. Board resolutions l. Resignation and appointment of directors m. Purchase payment i. Cash, escrow ii. Share new, existing, DD on buyer? 8. Integration a. Plan ahead b. Timing c. Identify & involve project driver in acquisition d. Execution and monitoring e. Drivers from various divisions f. Potential issues: lose key staff/customers/suppliers, synergy not realised g. Cultural issues corporate cultural, cross cultural