Perpetuity Dividend Growth Model Ratios / Perpetuities Plowback Ratio Calculating Share Value Taxes and NOPAT Accounting

Dividend Growth Model Ratios / Perpetuities Plowback Ratio Calculating Share Value Taxes and NOPAT Accounting Statement
t
C V2.2 - Licence / Copyright
Cashflow PV = ∑ AKA the Gordon Growth Model or Ratios can be equivalent to a b = plowback ratio To value shares, divide dividends and If actual taxes are known then we Revenues
C 1 (1 + r )t Potential problem: RoI = Book Income constant growth model. Assumes perpetuity resulting in Dividends = E(1-b) repurchases by number of shares can use - Costs
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PV = multiple IRRs
Book Assets constant growth, ok for mature or Ratio = r – g RoE > r : positive growth opportunities outstanding EBIT – Tax Expense = EBITDA (operating income)
Attribution-ShareAlike 3.0
r−g Growth NPV stable industries => beware same assumptions as RoE < r : value being destroyed Instead of NOPAT - Depreciation
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Discount rate rate r such that Accounting DGM = EBIT (operating profit)
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1 NPV = 0 Rate of Return - Interest Expense
DFt =
Annuity (1 + rt )t IRR
D0 ⋅ (1 + g ) Note: VA = Free Cash Flows of the company
= Pretax Income

V=
- Taxes
P (1 − b ) (1 − b )
discount Created © Matt McNeill 2007

(RE − g ) V / EBITDA Funds that would be available to equity holders if D = 0: = Net Income
C C (1 + g )t factor
= = mmcneill.semba2008@london.edu
PV = − E RE − g RE − RoE ⋅ b
Funds from company free cash flows - Dividends (& share buy-backs)
Contributions: Mike Rizzo, Mark Carroll
(r − g) (r − g) (1 + r)t Payback = NOPAT = Addition to Retained Earnings

Equivalent to
equivalent Dividend + Depreciation
Project Valuation annual cost RoE = Net Income - Change in NWC ( = current assets – current liabilities)
perpetuity at time 1 – perpetuity at time t Growth Model Stockholders Equity
PV (COSTS ) Market Value of Equity + New investments NPV (All Equity) Notes on FCF
EAC = Ratios
Interest Rates AnnuityFactor Book Value of Equity
EBIT (1 − T )
also known as Use a ratio for a given VE = Essentially cash generated before

(1 + r )(1 + π ) = (1 + i )
break-even rental industry or similar firms
Operating FCF [NOPAT = EBIT (1 − T )] ( RE − g ) payment is made to debt holders
and apply. •Sunk costs – ignore, but market value if
(FCF)
real inflation nominal RoI Firm Value FCF = NOPAT + DEPREC − CAPX − ΔNWC for all equity firm : sold is relevant.
VA − VD = VE
r +π ≈ i (rate of return) Comprises of value of all
FCF [WACC = RA = RE ] •Opportunity costs – (incremental) should
be included (not allocated). Excess
V=
its projects - The present

(WACC − g )
CashOut capacity is not free.
T RoI = −1 discounted value of all its
Equity FCF EFCF = NetIncome + Depreciation − CAPX − ΔNWC + NetDebt
⎛ APR ⎞ InitialInvestment cashflows. •Inflation – cashflows need to be matched
r = EAR = ⎜1 + EFCF = FCF − Interest (1 − T ) + NetDebtIssues
(EFCF)
⎟ C1 + L + Ct
to rates of return (nominal usually)
effective ⎝ T ⎠ Adjusted Present Value (APV) •Financing costs – taken into account in
RoI = −1 VE + VD = VA WACC (e.g. dividends and interest)
annual rate C0 Corporate Value project as if all equity financed – use
Valuation Note: VE = Free Cash Flows available to equity holders Operating FCF, discount at RA = RE all equity
•Depreciation is not inflated in
firm. Add PV(TS) generated by new project
Free Cash Funds available in company after: nominal/real calculations.
Market Value Flows -Building up NWC
Mergers & Acquisitions -New investments
APV = NPV ( AllEquity) + PV (TS )
Market Value (MV) could be a
combination of PV and expectation -Paying off old debt / Issuing new debt Note: APV assumes D constant over time,
Overall / Economic Gain
(P) of takeover premium (C): Funds available in form of dividends or share iterative WACC assumes D/V ratio constant, so Modigliani-Miller
MV = PV + P*C
Gain = PV ( AB ) − [PV ( A) + PV (B )] repurchases
values may be slightly different.
• MMI – Capital Structure Irrelevant
• Perfect Capital Markets:

Cost of CASH Acquisition / Premium (A buying B) Terminal Value Bankruptcy Costs (BC) P(ExpectedCost ) • Individuals can borrow at the same
Stock Acquisitions PV( BC ) = rate as corporations.
• FCF insufficient to meet RD.D (interest)
Cost = Cash − PV (B )
RBC • No bankruptcy costs / distress costs
Note: that the cost to firm A cannot Based on the PV of a constant FCF (as in • Direct Costs – Legal, Accounting, • No agency problems
be calculated from the stock price Company Value
Gain − Cost = PV ( AB ) − PV ( A) − Cash
last period) with constant growth Trustee, Management fees etc • Symmetric information
ratio.

FCFT ⋅ (1 + g )
•Indirect Costs – Production inefficiencies V PV(TS) •NO TAXES
FCF1 FCF2 FCFT 1 (e.g. supplier terms), lost investment

V = FCF0 + + + L+ ×
The economic Gain is required to opportunities, talent loss etc PV(TS)-PV(BCFD)-PV(AC)
Cost of STOCK Acquisition / Premium (A buying B) This allows us to make RA = WACC

(1+ WACC) (1+ WACC)2 (1 + WACC)T (1 + WACC )T (WACC − g )

calculate true cost, since share price •Typically 1-20%, μ=3-4%, Ç young firms
may change with merger.
Cost = x ⋅ PV ( AB ) − PV (B ) Financial Distress Costs (FD) VU Thus RA does not change due to capital

Gain − Cost = PV ( AB ) − PV ( A) − x ⋅ PV ( AB )
structure – but this does not hold in the
True cost can also be calculated •Reduced financing capacity (D & E)
Note: Perpetuities bring back 1 period (T = last real world of taxes etc.
from computing gain to shareholders •Higher cost of capital
x = fraction of combined firm stock going to period of FCF model)
of company B.
shareholders of B Tax Shields R A ≤ RTS ≤ RD •Loss of customers / suppliers / talent Optimum Leverage D/E
Optimum Leverage
Valid Motives
Tax = T ⋅ (EBIT − Interest ) ⎛ R D⎞ PV( BCFD ) << PV(TS )
Shareholders are better off Does the Market Value of the firm reflect
WACC = R A ⎜⎜1 − T D ⎟ VL = VU + PV(TS ) − PV(BCFD) − PV(AC)

Cost of capital
VU = VL − PV (TS )
Unlevered RA

RTS V ⎟⎠
takeover premium?
•Value Creation = T ⋅ EBIT − T ⋅ Interest PV( AC ) << PV(TS )
•Operating synergies – horiz:
market power and vert: market Cost = [Cash − MV (B )] + [MV (B ) − PV (B )] [Interest = RD ⋅ D] ⎝ Agency Costs (AC) wacc
foreclosure.
•Complimentary resource
synergies
Premium paid
over market value
Difference between
MV and value as
= T ⋅ EBIT − T ⋅ RD ⋅ D RAVU + T ⋅ RD D = RD D + RE E When RTS = RD • Debt Overhang
•New E raised goes to D shortfall if project
• Risk Shifting
•2 +ve NPV projects with different risk Risk of bankruptcy due to debt
D/V
separate entity (PV) Thus annual tax savings are:
•Cheaper external financing Real additional successful. E insures D. •D fear funds will be allocated to hi-risk payments makes debt more risk
•Correct management failure
•Wealth Transfers Dubious Motives TS = T ⋅ RD ⋅ D When T=0
cashflows from TS RE = R A +
D
(RA − RD )(1 − T ) •Soln: Issue more D, use E to buy back D,
convertibles
(ltd liability of E means D loses)
•D thus require higher RD and no
E • Overinvestment projects now have +ve NPV
•Bondholders to shareholders •Agency – empire building, larger T ⋅ RD ⋅ D D E Leverage
•Employees to shareholders companies, prestige, perks, compen. PV (TS ) = R A = RD + RE When RTS = RA •FCF which should go to D is risked by E on •Soln: Debt covenants etc
Gearing = Leverage = D/V
(wage concessions)
•Customers to shareholders
•Diversification – declining cash rich
industry. Funds should be returned to
RTS V V RE = RA +
D
( R A − RD ) risky project.
•Downside goes to D, upside to E (ltd liability)
(market power) shareholders.
RTS approximates to RD when risk of E Asset Beta = unlevered
•Taxes to shareholders (unused NOT using tax shields is minimal
•Increase EPS – number of shares Equity Beta = levered
RA = RF + β A (RM − RF ) (β A − β D )
taxshield) traded may not be equal. R A ≤ RTS ≤ RD D
βE = βA +
E
Leverage
Interest Rates Covered Interest Parity Expected Divisional Leverage
Estimating
D E
WACC = RD (1 − T )
•S$£ : $/£ spot exchange rate ($x:£1) future
D E β A = βD + βE
+ RE
To UK +1 year Back to US spot rate future
•F$£ :$/£ forward exchange rate No riskless arbitrage
forward
(1 + r$ ) = F$£ (1 + r$ ) S
•r£ : nominal interest rate £
•r$ : nominal interest rate $ $1 →
1
→
1
(1 + r£ ) → 1 (1 + r£ )F$£ F$£ = E(S$£
′ ) ⇒ E(S$£
′ )≈
rates
V V CAPM V V Company

(1 + r£ ) S$£ (1 + r£ ) $£ RE = RF + β E (RM − RF )
•i£ : UK inflation rate S$£ S$£ S$£ D1 , E1 D2 , E2
•i$ : the US inflation rate.
(1 + r$ )
RD = YTM on the Can be assumed to
[S$£ x S£$ = 1] $1 → debt of the company be 0 if debt is risk-free β E1, β D1, β A1 β E 2 , β D2 , β A2
P$
Purchasing
P S $£ ≈ P ⇒ S $£ ≈ £
£ $
D1 D
Bonds Power Parity
P Risk Free Rate Equity Beta L= L= 2
E (1 + i$ ) E (S$£
′ )
Market Risk Premium V1 w % V2 w2 %
Price = P(C,T) Given by short term
coupon face ≈ Given by the covariance of 1

E (1 + i£ )
treasury bills (up to 1 year
P = ∑ PV (C ) + PV ( F )
The difference between the the stock with a give index
coupon terminal S$£ maturity) in the US, or gilts DC
% period r2 in the UK.
return expected from
investing in shares and the
(usually via regression DC , EC , β EC , β DC , L =
analysis) VC
T
C F risk free rate.
P=∑ r3 Tax Rate Debt Equity
Zero-Coupon Bonds + Forward
ZCB
β AC = w1β A1 + w2 β A2
Use ZCBs to get r-values for each t =1 (1 + rt )t (1 + rT )T Rates (1 + r3 )3 Only consider
The market value of the
equity of the company
Typically ~ 5%

year (spot values) when Expected interest Interest bearing

2T C F
PSEMI = ∑
rates in the future $1 debt
× (1+ 2 r3 )
calculating bond prices if there is 2
+ (1+ r2 )2 E = share price * number of
RP = w1 R1 + w2 R2
Beta
(1 + ) (1 + )
non-flat term structure. t 2T shares outstanding Actual Returns:
(could use annuity only when t =1
rt r2 T Taxes Paid Portfolio Theory A measure of how much a stock
E (RP ) = w1 E (R1 ) + w2 E (R2 )
2 2
term-structure is flat) EBT Expected Returns: contributes to portfolio risk, i.e. how much
D = LT Debt βI x Rm Major Part the stock moves when the market moves.
B(0,t) is equivalent to Pricing t Variance: V (RP ) = w12V (R1 ) + w2 2V (R2 ) + 2w1w2 ⋅ COV (R1 , R2 ) Market Specific

(1+2 r3 ) = (1 + r3 )2 = DF2
3 Earnings Risk of 1 = same as market
$1 ZCB for t years + ST Debt = risk of + risk of
before tax Efficient Market share 0 = unrelated to the market
share share
(1 + r2 ) DF3 σ P = w1 σ 1 + w2 σ 2 + 2w1w2σ 1, 2
(if ST debt is not Standard Deviation: 2 2 2 2 2
-1 = inverse to the market
1 related to workng
Hypothesis
B(0, t ) =
[σ = ρ1, 2σ 1σ 2 ] corr(mkt, stk ) ⋅σ stk
Risk of Market Specific
(1 + rt )t T captial)
Abnormal Returns [w1 + w2 = 1] [ρ ≡ rho] portfoli = risk of + risk of
βi =
D = ∑ t ⋅ wt
1, 2
o share share
σ mkt
[V (R ) = σ 2 ]
Yield to Bonds &
Discount Factor Maturity Fixed Income t =1
cashflow
- Cash αi = Ri − [RF + βi (RM − RF )] Correlation
between two
βp x Rm Negligible
(if cash is not
1 Ct at time t used
stocks Portfolio Terms
Interest Rate Term Structure What value of r gives wt = ⋅
Graph of YTM for
ZCBs over time
the market price P
Duration P (1 + rt )t for working capital
it could be used to
Risk = covariance / correlation
equal to the discounted Abnormal Returns Portfolio Risk and Diversity Portfolio Performance
r pay off debt 1 T
ΔV Δr
∑ rt
cash flows for the bond? The weighted average of the Correlation
yield
Market
price T time taken to get payments = −D ⋅ holders) Abnormal returns: αi Risk Idiosyncratic Risk RP RP rho = -1 (max benefits from
μ = mean return =
C F 1+ r T t =1
P=∑
curve V Specific Risk diversification)
+ But if capital markets are (Diversifiable Risk)

t =1 (1 + YTM ) (1 + YTM )T
t
ratio of change ratio of change Tax Debt efficient then -1 < rho < 1 (some benefits
1 T
t
∑ (rt − μ )
2
in value in interest rate Market
from diversification) VAR =
Ri = RF + β i (RM − RF )
The tax rate to be used In principle the market
may not be the value of the debt, but in Risk Market Risk
(Systematic Risk) rho = 1 (no benefits from
T t =1
ZCB Duration Interest Rate Sensitivity Treasury Securities Forward Rates corporate tax rate. practice this hard to ⇒ E ( ARi ) = 0 # Stocks
diversification)
The duration of a ZCB is the same Interest rates are more sensitive: 1yr <= T-Bills Nomenclature: Strictly speaking it find. Book value is a 20
0% 100% w1:w2 Risk StdDev = SQRT(VAR)
r ≡ f (0,2,3)
as its time to maturity - when maturity is longer 10yr <= T-Notes should be the effective valid proxy unless A portfolio of about 20 stocks can diversify (Mix)
tax rate company is in distress. (StdDev)
- when the coupon is lower 10yr > T-Bonds 2 3 almost all specific risk
 Terminology
Long = Buy the right to… S>K = In the money
S=K = at the money
Short = Sell the right to…
Call = … buy at given price
Put = … sell at given price
S<K = out of the money
Strike = Exercise = K
Premium = Cost = P, C
Stock Price = S
C St
Option types
P
European
Can exercise only on
given maturity date
American
Can exercise any time up
to (and on) the given
maturity date.
maturity = expiration
Arbitrage Principle
If two combinations of
assets have same
cashflows in every period
and every outcome, then
they must have the same C(X)
price. + σ T
This can be used to
P(X)
calculate replicating
portfolio for use in pricing
options
Put-Call Parity
P(K ) + S = C(K ) + PV(K )
$ + $ = $
K K
K F – S0 < 0 Market is in Backwardation
S K S S S
Equity Issues
•IPO = Initial Public Offering, a
company’s first offering of shares to the
general public.
•Primary Shares – new shares
issued by company where money
raised is invested in the firm
•Secondary Shares – insiders selling
stake in company where money
raised goes to the previous owners
•SEO = Secondary/Seasoned Equity
Offering, an equity issue by a firm that is
already public.
•Pecking Order: (1) Internal Funds,
(2) Debt, (3) Equity
Underwriters
•Investment banks which advise the firm
and provide independent monitoring of
quality of firm to the market.
•Also handles:
•Roadshows – for signalling
considerations and demand
evaluation
•Bookbuilding – bids during BB
period (~2 weeks) can be revised
and cancelled.
•Price and Allocation – following BB
period.
•Alternatives to BB might be allocations by
auctions, but no discretion to underwriter
on final price and allocations (Google)
•UW formally buy shares from firm and sell
to public at higher price.
•Various sales models:
•Firm commitment – all shares (see
Underwriter’s put)
•Best Efforts – sale and return
•All-or-none
•Price premium covers UW responsibility:
•Market maker – liquidity in first
trading days
•Research coverage after IPO
•Price premium covers UW risks:
•Stabilising prices – if they fall below
offer price
•Buying unallocated stock
•Mitigated by green shoe option
(option to purchase additional ~15%
shares from company at offer price if
demand high within ~30 days of
IPO)
•IPO Fees usually a fixed % of the issue
(~7% in US, ~5% in UK, ~3.5% in Europe)
•SEO fees about half IPO – very varied
•Rights fees usually ~2%
•Underpricing IPOs (-12% UK, -15.8% US)
•UW favour current / potential clients
•Signalling/Reputation (future SEO)
•Dispersion/Liquidity on lower prices
•Attract less informed investors
(mitigating winners curse problem)
Call Option Put Option Replicating Portfolio 2 Period Binomial Model C2U = max{0, S2U − K} Warrants Convertible Bonds n = number of existing shares
V2.2 - Licence / Copyright
m = number of bonds
S<K = In the money Use arbitrage principle. For European Call Option = S2U ⋅ Δ′ + (1 + RF ) B′ Equiv. To Call option except: Equivalent to a package of a:
t
S=K = at the money r = conversion ratio: number of shares per bond Creative Commons
Δ = proportion of stock = S1U ⋅ Δ′ + B′ • Issued by company so company gets straight bond + warrant = face value of each bond
FB Attribution-ShareAlike 3.0
S>K = out of the money
Options (aka hedge ratio / option delta)
B = value of risk free Bonds C1U = S1U ⋅ Δ + (1 + RF ) B
t
= S2M ⋅ Δ′ + (1 + RF ) B′
t
purchasing price
• On exercise company issues new shares
•Mitigate agency problems of debt
•Mitigate signalling problems
FB/r
KB
= conversion price
= conversion value: market price of bond
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Call: Δ > 0, B < 0 (long S, short B) C0 = S0 ⋅ Δ + B C1M = max{0, S2M − K} and gets exercise price •Can obtain debt at lower current cost (coupon divided by r (strike price of each share).
Long Call Short Call Put: Δ < 0, B > 0 (short S, long B)
C1D = S1D ⋅ Δ + (1 + RF ) B = S2M ⋅ Δ′′ + (1 + RF ) B′′ • Delayed equity issue (mitigates signalling discount related to value of warrant) Usually calculations worked out with complete
t
$ t
$ problem) company values:
C = S1D ⋅ Δ′′ + B′′ • Exec stock options are warrants Created © Matt McNeill 2007
K
C = Max{0, S - K} value of
V = S ⋅Δ + B = S2 D ⋅ Δ′′ + (1 + RF ) B′′ convertible = warrant + straight FD = Face value of debt (#bonds * FB)
t
K St Note: that Δ,B in each period will • Equity rights issues are “special mmcneill.semba2008@london.edu
option bond bond KD = Exercise (strike) price of debt
C2D = max{0, S2D − K} warrants”.
CB = W + B(C , T )
Change depending on outcome of E0 = Value of initial equity Contributions: Mike Rizzo
previous period (Dynamic Replication) E0* = Adjusted value of initial equity
Need to solve ET * = Adjusted value of equity at maturity
Option Binomial Model Treat same as Options for pricing but need to
C1U = max{0, S1U − K } = S1U ⋅ Δ + (1 + RF )B
Long Put Short Put recursively
$ $ Pricing adjust for share increases and purchase price
X [where F’ = CB See bond pricing [
CB = max λ ⋅ ET − FD ,0
*
]
Convertible (CB)
P = Max{0, K - S}
P% n = number of existing shares ???] on other side
K St m = number of warrants ⎡ * F ⎤
K
Value of
P not known, thus cannot Using replicating portfolio, = λ ⋅ max ⎢ ET − D ,0⎥
0
St
P C0 = S 0 ⋅ Δ + B use weighted average for C0 solve simultaneously for Δ, B
r = number of shares per warrant FD ⎣ λ ⎦
(conversion ratio)
-X
European Call 1-P% K = exercise price
C1D = max{0, S1D − K } = S1D ⋅ Δ + (1 + RF )B
( )
option λ = dilution factor (% fraction of E that goes to
Payoff
W = λ ⋅ C BS E0 , K D , T , R f , σ
Profit new stockholders) *
FD FD/λ Value of firm (ET*)
Black-Scholes Value of all V0 = E0 + m ⋅ (price of warrants) default holds converts
Combining options requires Normal bonds to shares
European Call option equity firm
going long / short on options Derived from cumulative VT = ET + mrK
C = S ⋅ N(d1 ) − PV(K ) ⋅ N(d 2 ) λ ⋅ ET ∗ > F
WT = λ ⋅ max[ET − nK ,0]
binomial with density Conversion exercised if:
with different strike prices.
infinitely small distribution Value of all E0 = PV ET
*
( ) *
W0 = λ ⋅ C BS (E0 , nK , T , R f , σ )
F
Long Call = +45˚ (L Æ R)
periods (and Incorporating warrants ⇒ KD =
assumptions) ⎛ coupons before ⎞ λ
⎟⎟ − PV (dividends)
Short Call = -45˚ (L Æ R) dividends into BS
E0 = E0 − PV⎜⎜
*
mr
C = (S − PV(D )) ⋅ N(d1 ) − PV(K ) ⋅ N(d 2 ) λ=
Long Put = +45˚ (L Å R) μ d2 d1
⎝ maturity ⎠
Short Put = -45˚ (L Å R) n + mr
E0 = (n ⋅ S0 ) + (m ⋅ FB )
ln⎛⎜ S ⎟⎞
⎝ PV(K )⎠ + σ T
e.g. Straddle e.g. Butterfly
$ $
European Put option d1 = existing monies raised
2 equity by convertible
X
= Long C(X)
P = − S ⋅ N(− d1 ) + PV(K ) ⋅ N(− d 2 ) d 2 = d1 − σ T
issue
St
X Y Z St + 2 x Short C(Y)
Incorporating
PV(K ) =
+ Long C(Z) K
dividends into BS
P = −(S − PV(D )) ⋅ N(− d1 ) + PV(K ) ⋅ N(− d 2 )
(1 + R ) f
T
Forward & Future Contracts Assuming both strategies of
buying now and storing (at
Futures Swaps
Forward Contract is commitment to deliver • Extremely liquid due to use of exchange A swap is an agreement by which 2 parties exchange
zero cost) and buying a F
predetermined asset at a future time for a
forward contract on the S0 = • Firms can quickly rebalance risk cash-flows of 2 securities (without changing their
American Options Black-Scholes Shorthand Black-Scholes Assumptions predetermined price.
asset are both 100% (1 + r )T management portfolios at low cost ownership)
PV(K ) =
B(0, K ) • BUT: we do not know counterparty and
C = C BS (S , K , T , R f , σ )
•Can be exercised before maturity date •Stock variance σ2 is constant Futures Contract is a standardised forward riskless then: Interest Rate Swap is an exchange of interest
(1 + RF )T
F = S0 ⋅ (1 + r )
default risk.
•Call options – Effect on CBS if the given •Rf is constant contract traded on an organised exchange. (risk of underlying asset T payments on debt (most commonly the coupon swap:
• THUS: exchanges require collateral and
P(K ) = − C(K ) - No dividends = European Call variable increases in value: •No dividends S0 = current spot price (t=0) already incorporated in S0) fixed rate with floating rate)
typically daily settlements (potentially
- Price: calc euro call options maturing + S = Stock price at time 0 •Frictionless trading (no transaction F = cost of T-period forward contract requiring some cash now) Currency Swap is an exchange of payments in
And now accounting for the costs of
at all dividend paying & expiry dates - K = Strike price / exercise price costs) Cost of carry: different currencies.
storage and income from the asset:
and choose largest + T = Time to maturity (years) Note: σ is not an observed quantity F – S0 > 0 Market is in Contango
= $ +$ •Put options – + Rf = Risk free rate Interest Rate Swap Example
F = [S0 − PV(income) + PV(storage costs)]⋅ (1 + r )T
K in market, and BS is often used to
S - no dividends: may still exercise early + σ = volatility find implied volatility. •Assume that the floating coupon is 8% in first
- value larger than euro put semester and increases 1% every period
•The net payments from X to firm Y are
Advantages of IPO Rights Issue Hedging Real Options Payout Policy S1 S2 S3 S4
Floating rate 8% 9% 10% 11%
• Obtain cash – bank finance, venture capital not • Rights = short warrants (~3 weeks) issued at zero price • Hedging is obtaining insurance against some exogenous risk by These are options as applied to business Real Options This is how a firm distributes cash to the X’s payment $5 $5 $5 $5
enough • UK ~60% equity issues, US <5% taking an offsetting risk. decisions: shareholders in one of two ways: Y’s payment $4 $4.5 $5 $5.5
• Cheaper financing – higher liquidity and lower • Rights issued are proportional to shares owned • Risk Management is defining an optimal set of hedges Y pays to X $1.0 $0.5 $0.0 -$0.5
Dividends – firm distributes cash (or stocks) to
info asymmetry (disclosure reqs.) • Shares trade “cum rights”, but later can be split and We usually want to hedge: Follow-on investment (Call option / BS) shareholders in proportion to number of
• Other financing cheaper – (as above) traded separately. Timing options (American calls / Binomial) By entering the rate swap, Y borrows at floating rate
•Interest rate risk (inflation / real rate changes) shares held. (to which it has access) but eliminates interest rate
• Insiders can cash out • Exercise price drivers: •Currency risk Abandonment Options (Put option / binomial) •DPS – dividends per share
• Easy future access to equity markets risk.
• low as possible to ensure that always in money •Fluctuation of commodity prices (inputs / complementary •Dividend Yield: DPS / share price
Disadvantages of IPO
C = C BS (S , K , T , R f , σ )
and all rights are exercised (income) products) Follow-On Investment •Payout Ratio: DPS / EPS
• Costly – admin fees (4%) & underwriters fees • not so low as to signal the market that the Value of hedging usually depends on the need for a stable Share repurchases – firm buys shares from
•Although a project may not
• Loss of control managers think the share price will drop a lot in the cashflow to take on other projects. shareholders (US = treasury shares / UK Signalling Methods
next 3 weeks look as if it will payoff at t=0, the eliminated, unless reserved to balance stock
• Legal reqs. – disclosure rules etc •If the hedge will provide the capital for the stable project it is a volatility and upside risk profile S = NPV of FCFs (at t=0) • Dividends: most effective since they set future
• Value of firm subject to external perception • shareholders not bothered, since right value will good thing to do. Risk is bad. K = PV(expected investment) t=0 options etc.)
may still make the option very commitment.
• Easier target for hostile takeovers always balance dilution of current share price. •If the hedge eliminates the chance of raising the capital for a T = Time of inventment (years) •Open market repurchases
valuable. • Shares repurchases with auction: very effective, if the
project it is a bad thing to do. Risk is good. Rf = Risk free rate •Fixed Price Tender Offer
•The risk downside is not shares are bought at a premium and management
E0 = value of pre-rights company (all equity) σ = volatility (comparable stocks) •Dutch Auction Tender Offer
n = number of existing shares relevant since option would not precommits not to tender (i.e. not selling own stock at
ET = value of pos-rights company (all equity) Share repurchases should only be used to a premium).
i = issue ratio (rights issued per share) be exercised in that case.
S0 = value of each pre-rights stock Discount at RF distribute extraordinary surplus cash-flow, but • Open-market share repurchases: weakest signal.
m = number of rights (m = i.n) Assume firm value V, depends on asset price S: Discount at RP
ST = value of each post-rights stock since mid 1980s US firms now redistribute – Shares are bought at their current market price.
r = number of shares per right (r = 1) PV0(FCF) FCFT+1 FCFT+2 …
= underwriter’s fees S1U Return on asset S for 1 period upside of 50%. Europe is 20%. – 50% of announcements do not follow through, and
(conversion ratio) FUW P%
investment
K = exercise price V0 = value of exercising a right immediately P%⋅ (S1U − S0 ) + (1− P%) ⋅ (S1D − S0 ) PV0(inv) InvT 10% repurchase less than 5% of the value announced.
λ = dilution factor (% fraction of E that goes to W0 = value of the option of exercising a right at maturity
S0 RS = 0 T
new stockholders) S0 t Payout Policy Irrelevance Signalling and Dividends
1-P% PV(FCF) PV(Inv)
S1D
In perfect capital markets and dividends and • Investors react sharply to changes in dividends
E0 = S 0 ⋅ n Find expected return cap gains tax are zero or the same, payout – Omission: -9.5%
Value of exercising
Value of option of No Hedge Timing Options
ET = E0 + nK a right now Valuing Rights Current value of the firm
policy is irrelevant. – Reduction of more than 25%: -6.4%
exercising a right at
maturity P%
V (S1U ) •Cashflows equivalent to
dividends from a stock. When a P%
S1U S = Value of project Dividends: shareholders could use dividends – Reduction: -1.2%
ET – Increase: 0.7%
P%⋅V (S1U ) + (1− P%) ⋅V (S1D )
D = cashflows from project
ST = to buy more shares, or could sell shares for
(n + mr ) V0 V0 =
project’s forecasted cashflows
are sufficiently large the
S0 during period 1 cash to simulate dividend. – Increase of more than 25%: 1.0%
– Initiation: 3.9%
1+ RS investment is made right away 1-P%
Rf = Risk free rate Share repurchase: shareholders total wealth
S1D P% = chance of going high • A superior firm has higher payouts to signal wealthy
V (S1D )
1-P% unchanged whether they sell shares or not.
(option is called) and confident. Less profitable firm cannot sustain large
Also equal to dividend distributions. If shares
W0 = ⋅ λ ⋅ C BS (E0 − FUW , nK , T , R f , σ )
1 ⎡ (S + D1U ) ⎤ ⎡ (S + D ) ⎤ dividends over long run.
V0 = ST − K If C0 > S0-K then the option to RP = P%⎢ 1U −1⎥ + (1 − P%)⎢ 1D 1D −1⎥
repurchased at premium there is no wealth
• A less profitable firm will eventually have to cut
F = S0 ⋅ (1 + r )
T transfer between shareholders unless some
Full Hedge r = risk free rate defer the project and miss ⎣ S0 ⎦ ⎣ S0 ⎦ dividends, miss investments, issue equity or debt to
V0 < W0
m possible cash-flows is more
fail to participate in bid.
finance dividends (inefficient!)
V (S1U ) −V (S1U − F ) = V (F )
valuable. i.e. Wait and see. To find P%, set RP = RF (for example) Payout Policy Relevance
S 0 = ST + V0 ⋅ i Options increase Implications – select conservative ratios, and avoid
V (F )
P%
value of the rights C = P% ⋅ max{0, S1U - K} When dividends and capital gains are taxed raising dividends if risk of having to reverse it.
Payoff
Shareholders are Rights issues where K is closer to
V0 V0 = differently, payout policy is not irrelevant. Dividend change should be smaller than change
+ (1 − P%) ⋅ max{0, S1D - K}
not bothered ST have higher (W0) option values 1+ r Dividends: pay taxes on full cash distribution. implied by earnings (smoothing). Avoid dividend cuts if
since the downside is more limited
V (S1D ) −V (S1D − F ) = V (F )
1-P% Share repurchases: cost is small.
(value of a call option decreases
as K is further from S) Abandonment Options •Pay cap gains tax rate only (typically lower)
•Only pay tax on part of distribution (the gain)
Hedging Instruments •Exercised when value
•Only pay tax if chose to sell
Stock Splits
K K* ST recovered from project’s assets
C – right owner
Payoff structure should cancel underlying risk as much as possible • Stock Splits: Increasing the number of the
P – firm si greater than the PV of Depends on investors tax bracket, e.g.
outstanding shares by reducing its nominal value.
UP Forwards Futures Swaps Options continuing the project for at pension funds are indifferent (but may like
• Example: In a 2:1 split, investors receive two new
Cunstomised Yes No Yes No* least 1 more period. predictability of dividends)
UP = λ ⋅ PBS (E0 − FUW , nK , T , R f , σ )
Upfront Payment No No** No Yes shares in exchange for each old one. The stock price
Liquidity Low High High*** High drops by 50% (no money ever changes hands!).
K S Default Risk High Low High Low Tax Clienteles • A rationale for a stock split is that it makes stocks
(*) Unless traded OTC, but then they are (much) less liquid. cheaper for small investors.
Investors with different dividend tax treatment • However, this “liquidity effect” is not well supported
(**) However they do require a margin account.
P – underwriter will hold shares of firms with different by the existing empirical evidence: there is no
(***) Huge demand for swaps makes them extremely liquid. dividend-payout ratios. significant price response to a stock split.
Different investors might pay different tax
Underwriter’s Put Preferred Stocks Optimal hedging rates on dividend income and capital gains:
When firm’s get a firm commitment from the • Shares with fixed dividend (like debt) Optimal hedging depends of structure of costs associated with low • In most countries individual investors pay Tax Cost of Excess Cash
underwriters, then it is equivalent to the firm • Junior claim to debt, but senior to ordinary stocks cash flow. higher tax rates on dividends than on capital
gains. • Excess cash is effectively generating a negative tax
putting a put option on the rights it is selling • Dividend may not be paid, but only if ordinary stock dividend not paid • Inability to service interest payments, increasing costs of financial
• Pension funds are tax exempt. saving for the investors.
• Limited voting rights (usually become normal voting rights if dividend not distress and decreasing debt capacity (tax savings) of the firm.
• Corporations typically pay lower tax rates on • If firms have more cash than what they actually need
UP is typically a very small part of the fee. paid) •Inability to take advantage of profitable investment opportunities
dividends than individuals. to finance their business and have financial flexibility,
Advice and monitoring is usually much more • Often viewed as flexible leverage (classified as equity, limited control, •Inability to perform dividend smoothing. then they should distribute it to shareholders.
significant. cashflow flexibility if dividends not paid) This creates different tax clienteles for • Important caveat: “cash required to finance the
• Often bought by institutions, corporations or low income tax bracket •Note: These are only valid of there is a cost of obtaining outside dividends: e.g. attracting institutional business” and “cash required for financial flexibility” are
(income tax < cap gains tax) financing. investors. not exactly well-defined quantities!