Corporate Finance Valuation

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Corporate Finance Outline
I. Valuation
A. Elements of Valuation
1. Future Value- the value of a current sum of money on some future date,
assuming it was invested and earned a specified rate of interest between
now and that future date:
a. FVn= x(1+k)n
i. FVn => Future value at the end of “n” periods of time

ii. n => the period of time
iii. x => sum of money to be invested
iv. k => rate of interest compounded annually to be earned
1) if interest is not compounded annually, divide
interest rate “k” by frequency of compounding “m”
and multiply “n” by “m”:
FVn= x(1+k/m)n*m
2) the more frequent the compounding the greater the

resulting future value.
2. Present Value- Money to be received or paid in the future valued in
today’s dollars. We move backward in time through the process of
discounting.
a. PV of a Lump Sum:
PV= ___xn___
(1+k)n
i. PV => what is being determined. It represents the value

measured in today’s dollars of the future sum to be received at
a future date.
ii. n => the period of time into the future that the future sum is to
be paid or received.
iii. xn => the future sum of money.
iv. k => discount rate- the rate of interest to be compounded
annually to be earned on investments between the present and
future date.
1) If compounding is more frequent than annually,
divide the interest rate “k” by frequency of
compounding “m” and multiply “n” by “m”:
PV= ___xn___
(1+k/m)n*m
2) The more frequent the compounding the lower the

resulting present value will be.
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b. PV of an Annuity
PVa = ∑ xn____
(1+k)n
i. Annuity is the payment of a constant sum of money at fixed

intervals over a period of years.
ii. Illustration: If you win the lottery should you take the lump
sum of $1 million or ten yearly payments of $150,000
(annuity)? Find the PV of the annuity (doing calculation or
using chart) and if it’s greater than the lump sum, you would
take the annuity payments.
3. Net Present Value: Analyzing projects or ventures
a. Positive NPV: PV of Receipts-Present Value of Future Outlays >
Initial Investment => Good Investment
4. Internal Rate of Return- discount rate at which the net present value turns
out to be zero. It allows a firm to rank investments or projects of different
size so that a choice can be made among profitable projects where there are
not enough funds to invest in all of them.
B. Bond Valuation
1. General Principles
a. Corporate bond normally has face value of $1000 and pays interest
semi-annually at its stated rate of interest.
b. Coupon rate: stated rate of interest on a bond that is paid semi-
annually generally.
c. During the bond’s life it is interest-only and the face value is paid in a
lump sum on the bond’s maturity.
d. Bonds can be sold on the secondary market before maturity.
e. YTM- yield to maturity- secondary market investors demand interest
rates competitive with those of newly issued bonds, which could be
higher or lower than the coupon rate.
i. Bonds’ coupon rate cannot be changed so the only way to
raise or lower the YTM is for a bond to sell at a premium
(above the face value) or at a discount (below face value).
ii. If market interest rates increase above coupon rate, must sell
bonds at discount.
iii. If market interest rated are below coupon rate, must sell bonds
at a premium.
2. Value of Bond in Secondary Market
a. PV of principal payment + PV of remaining interest payments
(annuity)
b. Duration- longer time to maturity the more volatile a bond’s value is-
the greater it will be affected by changing interest rates.
c. Bonds with lower coupon rates are also more sensitive to changing
interest rates because this type of bond derives a greater proportion of
its value from its face value to be received at maturity.
d. Creditworthiness also affects bonds value because if issuer
creditworthiness goes down, investors will discount the bonds at a
higher rate which makes the value go down, and vice versa if the
issuer’s creditworthiness improves.
i. Metropolitan Life Ins. Co. v. RJR Nabisco- Bondholder’s sued
over the decline in their bonds’ value that resulted from
issuer’s increase default risk. (Case discussed below in more
detail)
e. Calculating YTM (yield to maturity)- need a financial calculator
3. Zero Coupon Bonds
a. Bond that pays no annual interest and sold at a significant discount to
its face value. Upon maturity, issuer has to pay the full face value so
bondholder’s compensation is the difference between the full face
value and the discounted face value bond was purchased for.
b. Implicit rate of interest= discounted purchase price is the present
value of the full face value, so using the table can figure out the
interest rate.
i. Even though no interest is received by bondholder during the
life of the zero, this imputed income is taxable.
ii. For the issuer of zero bonds the “implicit interest” payments
are tax deductible, even though they make no interest
payments during the life of the bond.
1) In a project where the profit wont be made until later
it makes sense to issue zero bonds so you wont have
to make interest payments yet the interest expense is
tax deductible, and when its time to pay the face
value you will have the money because it after the
project is profitable.
4. Bond Market Pricing Terminology
a. Bid Price: what a purchaser is willing to pay for a bond.
b. Asked Price: the price at which the seller is willing to sell the bond.
c. Bid-Ask Spread: The difference between the bid price and the asked
price.
d. Tick: smallest price change in a bond- 1/32.
C. Valuing Companies: Attempts to identify the “true” or “intrinsic” value of a
company.
1. Balance Sheet-Based Valuation Methods
a. Book Value (BV) (synonymous with liquidation value)
i. BV = Total Assets – Total Liabilities on Balance Sheet
ii. BV per share= BV/ # of outstanding shares
iii. Net Tangible Book Value= (Total Assets-Intangible Assets) –
Total Liabilities
iv. Problems with Book Value Method:
1) Uses balance sheet’s historical numbers which
generally understates the current value of company’s
assets
2) Does not recognize that company is a “going
concern”
In re Watt & Shand- “total assets are worth
more than the sum of their parts, because the
include qualities useful in the context of a
particular business that they would lose if put
to different uses.”
v. Conclusion: Book Value tends to provide a minimum value
for the company, so it is favored by purchasers and disfavored
by sellers.
b. Adjusted Book Value
i. Assets on the balance sheet are restated to reflect their current
market value (CMV): Adjusted BV= CMV of Total Assets –
Total Liabilities
ii. Still has problem of not valuing business as a “going concern”
c. Net Asset Value
i. Determines what it would cost to duplicate the company. It
considers what it would cost to purchase the same group of
assets, the costs associated with establishing name recognition,
training company’s employers, developing its products,
creating brand awareness, and retaining its customer base, i.e.
it considers the concept of “goodwill”
ii. Market to Book Ratio: market price per share of a publicly
traded company to its book value per share:
M/B Ratio= Market Price per share/ BV per share
1) Use this ratio of a comparable publicly traded

company and multiply it by the privately held
company’s book value per share to find market price
per share of the privately held company. Multiply by
the total number of outstanding shares and you have
an approximate value of the company:
Market Price per share of privately held

company= M/B Ratio of comparable publicly
traded company * BV per share of private
company
2) Problems:
How to find a comparable publicly traded
company?
2. Capitalization of Earnings Method
a. PV= E/R
i. E- Earnings
ii. R- Capitalization Rate- rate of return that is representative of
the risks inherent in that company.
1) Can be determined as the reciprocal of the price to
earnings (P/E) ratio of a comparable publicly traded
company (multiplier).
b. Earnings
i. Normalized earnings per share- the average of the earnings per
share of that company generated over a period of time
1) Problems:
Does not consider whether earnings are to be
paid out to stockholders in the form of
dividends or will be reinvested in the company.
Heavily dependent on past earnings
Earnings manipulation
 Excessive salaries of managers will
reduce earnings and result in lower
valuation of the company as a whole;
 Donahue v. Draper- Excessive salaries
considered as earnings which resulted in
higher valuation.
ii. Expected Return: weighted average of all possible outcomes

by multiplying each possible outcome by its probability and
adding all the outcomes.
c. Risk and Return- Determining the capitalization rate based on risk-
discussed below.
D. Measuring Risk and Return

1. Risk is essentially a psychological concept. Increases in money do not
necessarily bring increases in pleasure and but people generally do not like
wide variations in expected returns because of the greater uncertainty so
generally the higher risk the higher the rate of return- people are
compensated for this extra risk.
2. Statistical Measures of Risk
a. Variance, Standard Deviation- measures the variation in the possible
returns and the smaller the variation/volatility the less risk.
b. Risk Premium= amount added to risk free asset because the higher the
risk the higher the return.
3. Francis Dupont v. Universal City Studios- Used Delaware block method
for appraisal values (See below)
4. Jade Oil and Gas Co.
a. General Facts: Bankruptcy action where the court needs to figure out
the value of the company in order to determine whether company
should stay in business or liquidate.
b. Returns (E)- based on cash flows for the past five years.
c. Discount Rate (R):
i. P/E Ratio- reciprocal of this ratio of comparable companies-
multiple of comparable company.
1) Problem: using historical accounting data
ii. Market Price: saying that is a reflection of future dividends
and determine cap rate from that.
1) Many companies don’t pay out dividends
iii. Capital Asset Pricing Model (CAPM)- discussed below
1) Rejected because SEC says that industry does not
allow for an average capitalization rate because
disparities between companies is too great for
comparison.
5. Le Beau v. MG Bancorporation- See below. Different valuation theories
reviewed by the Court.
6. Portfolio Theory
a. General theory: Don’t put all your eggs in one basket. Certain risks
from owning a particular stock may be reduced by holding a portfolio
of multiple stocks- diversification.
b. Types of Risk
i. Unsystematic- risk inherent in investing in a particular
company. Business-specific risk.
ii. Systematic- market risk; all non-business specific risk.
c. Theory says that investors can reduce the unsystematic risk of a
particular stock down to zero by diversification- holding portfolio of
multiple stocks. Systematic risk cannot be reduced by this type of
diversification. Therefore, the investor should not be compensated for
unsystematic risks, so market returns on a particular stock are only
based on the systematic risk of that stock= investors should only be
rewarded for risk they couldn’t diversify away.
i. Some hold that this should reduce the duty of care liability of
directors because risk of incompetent directors can be
diversified away- encourage investors to diversify their
portfolios by limiting their abilities to sue directors. (Joy v.
North)
d. Capital Asset Pricing Model- Since investors should only be
compensated for systematic risk, this model determines rate of return
based on the relationship between the risk of an individual stock to
the market as a whole= Beta (β)
i. β of the market is 1.0. If the β of a particular stock is greater
than 1, it is riskier than the market as a whole and has a higher
rate of return; if it is lower than 1.0 it is less risky than the
market and the rate of return is lower.
ii. Determining the rate of return using β:
Ei= Ef + [βi * (Em - Ef)]
1) Ei- Expected Return on security (i)
2) Ef- expected return on a riskless security (US
treasury bond)
3) βi- beta of the security (relationship to market as a
whole)
4) Em – expected return on market portfolio.
iii. Problems with β:
1) Susceptible to fluctuate due to extraordinary events
Cede & Co v. Technicolor- During an
appraisal proceeding the beta figure used was
noted to be high for a company with relatively
stable cash flows- the beta was affected by an
event- the announcement of proposal to acquire
shares of another company.
2) Based on suspect assumptions:
There is a security that provided a risk free rate
of return- which virtually exists but even US
treasury securities are affected to some degree
by inflationary pressures.
Faith in how the market works- does the market
work efficiently to eliminate unsystematic risk?
3) Empirical evidence does not support it in recent
years.
e. Arbitrage Pricing Theory- If there is a riskless security with a high
rate of return, buy a lot of the security to even it out and bring down
the rate of return.
7. Multiples- the inverse of rate of return (P/E ratio above); higher the
multiple the higher the value and lower the risk.
PV= e * multiple
a. Takes into account growth potential, which explains why risky

companies have high multiples.
b. Can use these multiples of comparable companies to determine your
cap rate for an IPO.
E. Efficient Market Hypothesis

1. General theory: a price of a share of stock accurately reflects information
relating to that stock. Thus, changes in stock price reflect changes in
information regarding that stock.
2. Random Walk= future stock price changes are independent of past price
changes- cannot predict future stock prices from past stock prices. EMH
comports with this theory.
3. Forms of EMH:
a. Weak- current security prices fully reflect all information concerning
past securities prices.
i. Empirical evidence shows that it is valid.
b. Semi-Strong- current security prices fully reflect all information that
is currently publicly available.
i. Empirical evidence shows that this is valid in most cases.
c. Strong- current security prices reflect all currently existing
information, including both public and non-public information- inside
info.
i. Empirical evidence does not support this form. Trading on
non-public info rewards you above market returns (but it
legally prohibited)
4. Efficiency paradox- If information is incorporated into its stock price why
would anyone spend time and money analyzing information? If nobody
does that how will the stock price reflect information?
5. Noise theory- Public capital markets will not reflect fundamental asset
values because those markets are infected by substantial trading based on
information unrelated to fundamental asset values- noise trading- trading
based on rumor, innuendo, or misinformation.
6. Basic v. Levinson- A publicly traded company made three public
announcements over a period of 2 years denying that it was engaged in
merger negotiations when it in fact was. Several former stockholders of the
company sued after they sold their shares when the merger was first denied.
Plaintiffs did not need to show reliance on the misleading statements as is
usual in fraud actions, because the Court said that their was fraud on the
market place.
a. Fraud on the market place- creates a rebuttable presumption that the
plaintiffs relied on D’s press releases, because in an open and
developed securities market, the price of company’s stock is
determined by the available material information.
b. Court embraced the semi-strong form of EMH.
F. Hedging- ways of trying to limit risk
1. Derivative Instruments- its value is derived from the value of another asset
or financial variable. It is linked to or dependent on the value of that other
asset.
a. Investors use derivative instruments for speculation or risk reduction.
The speculative use of derivatives is to enter into derivative
transactions for betting purposes.
b. Investors use derivatives to reduce or hedge the risk of their
investment portfolios- engaging in a transaction that offsets the risks
associated with another transaction. By using derivatives investors
can reduce their exposure to drops in the price of particular stocks,
changes in interest rates, etc.
2. Types of Derivatives
a. Options- gives the holder the right but not the obligation to buy from
or sell to the option writer a specified asset on or before a specified
expiration or maturity date at a specified price (strike price). Option
holder must pay a fee- an option premium.
i. Call Option- right to buy the underlying asset on which option
is written at a strike price.
ii. Put Option- right to sell the underlying asset on which option
is written
iii. Option value- intrinsic value and time value.
1) Intrinsic value- depends on relationship to spot price
(underlying asset’s market price)
2) Time value- longer the time has before expiration the
more time value
iv. Setting Option premiums: Black and Scholes independent of
underlying asset pricing model. Variables to consider-
1) Trading volatility of underlying asset
2) Manner of exercise
3) Proximity of strike price to current market price
4) Duration of the option
5) Interest rate environment and other macroeconomic
variables
v. Reducing your risk through options- could cap your potential
loss if you have a put option on stocks you think will go down
in value.
b. Forward contracts- private agreement that obligates the purchaser to
purchase and the seller to sell a specified asset at a specified price
(forward price) on a specified date in the future. Typically asset is a
commodity. A tool designed primarily to decrease the contracting
party’s exposure to price fluctuations of the asset covered by the
contract.
i. Determining forward price
1) FP= Spot Price + Cost to carry underlying asset-
distribution if any to be received on the underlying
asset
ii. Distinction from options
1) Obligatory not discretionary
2) No premium paid on execution of forward contract
3) Physical transfer of underlying asset- not cash
transfer
c. Future contracts- essentially publicly traded forward contracts but
settled daily and by cash not physical transfer
d. Swaps- a forward contract that requires each party to satisfy the
financial obligation of another party rather than physically
transferring and paying for underlying asset. Types of swaps:
i. Currency swaps
ii. Commodity swaps
iii. Credit-Default Risk swaps
G. Valuation Review (See pages 11-17 of outline)
1. In Re Atlas Pipeline- Bankruptcy case where court must decide whether
company has more value as a going concern or in liquidation.
a. Liquidation Value is generally the book value- total assets less total
liabilities.
b. Value as a going concern
i. Earnings? Past five years or past five months
ii. Discount Rate?
2. Cede v. Technicolor- Valuation in appraisal action.
II. Senior Securities
A. Bondholder’s Rights
1. General principles of Debt Financing
a. Leverage- financial impact on a company when it takes on debt.
b. Leverage effect- debt financing effect on potential for greater gains or
losses on the company’s common stock.
i. Because interest rate payments on money borrowed is capped,
but earnings on money borrowed isn’t:
Rate of return on equity = investment return-interest payment

Equity investment
c. Debt to Equity Ratios affect default risk- highly leveraged companies

have a higher default risk.
2. Types of Debt Instruments
a. Bonds
i. Long term promissory notes with maturities of 30 years or
longer that are secured by collateral of the corporate issuer.
ii. Face Value-Corporate bonds are normally issued at face
values of $1000.
iii. Coupon Rate- Issuer pays bondholder interest at its coupon
rate until maturity and then the face value at maturity.
iv. Bond Indenture- contract with terms of a particular issuance of
bonds. Corporate issuer and indenture trustee sign the
contract, and bondholders are 3rd party beneficiaries of the
contract.
b. Debentures
i. Long term unsecured promissory notes with usually shorter
maturities than bonds. Main difference between debentures
and bonds is that debentures are unsecured debt.
ii. Debenture Indenture- contract with terms of a particular
issuance of debentures. Corporate issuer and indenture trustee
sign the contract, debenture holders are 3rd party beneficiaries
of contract.
c. Notes
i. Shorter term promissory notes with maturities ranging from
five to ten years. Notes may be either secured or unsecured.
ii. Note agreement- contract that sets forth terms of the note.
Note holder and corporate issuer usually sign the agreement
and are in direct privity with note holders rather than trustee.
3. Debt Security Rating Services
a. 2 investment rating services:
i. Moody’s Investor’s Service
ii. Standard & Poor’s Corp.
b. Attempt to assess the likelihood that an issuer will meet its debt
service responsibilities.
c. Ratings are reviewed periodically throughout the course of the debt
security’s life.
d. Grades: High, Medium, Low, Very Low.
i. High and Medium are investment grade debt securities
ii. Low and Very Low are “Junk” securities- highly speculative
and very risky.
4. Trust Indenture Act of 1939 (TIA) as modified by Trust Indenture Reform
Act of 1990 (TIRA)
a. Primary Purposes
i. Provide full and fair disclosure to debt holders throughout the
life of the security.
ii. Provide a tool whereby debt holders may organize for the
protection of their own interests
iii. Ensure that debt holders will have the services of a
disinterested indenture trustee which conforms to the high
standards of conduct observed by trust institutions.
b. Provisions:
i. Exemptions
1) (Generally doesn’t apply to transactions that are
exempt from Securities Act registration
requirements.)
2) Securities covered by an indenture where the total
amount of debt issued does not exceed $10 million
within a 36 month period
3) Debt securities pursuant to a transactional exemption
under the Securities Act are generally exempt
ii. Qualifications of the Indenture
1) Issuer must file indenture for its debt offering as an
exhibit to its Securities Act registration statement so
that SEC can determine whether indenture qualifies
under TIA
iii. Trustee Eligibility Requirements
1) Throughout the life of the indenture one or more
trustees must serve as indenture trustee.
2) Under TIA had to be a corporation organized or
doing business in the US, under TIRA foreign
entities can be trustees.
3) Additional trustees can be appointed by issuer if
indenture requires it
4) Each trustee is required to be authorized under law to
exercise trust powers and be subject to supervision or
examination by government authorities.
5) Trustee must have capital and surplus of $150,000
minimum throughout life of the indenture
iv. Conflicts of Interest
1) Trustee and issuer cannot have a relationship
v. Mandatory and Permissive Indenture Provisions
1) Sets forth certain mandatory provisions to safeguard
investors of debt securities. All other provisions are
permissive.
vi. Legal Actions by Debt Holders
1) Debt holders are protected by payment defaults by
TIA. Debt holders may bring suit for the
enforcement of payment on or after the due date.
2) Non-payment defaults- DH may not bring suit unless
gives notice to the trustee, holders of 25% of the
principal amount of the debt agree to bring suit, and
the trustee refused to cure the default.
vii. Duties and Obligations of Trustee
1) Prior to default, (default is defined by indenture) the
duties of an indenture trustee are limited to those
expressly set forth in the indenture- essentially
ministerial and controlled by contract.
Elliot Assoc. v. J Henry Schroder Bank &
Trust- holding that trustee does not have broad
fiduciary duties toward debt holders prior to an
event of default.
2) Post Default
Give notice to all debt holders of all defaults
known to trustee within 90 days after the
occurrence of default. Thereafter must exercise
rights and powers vested in it by the indenture.
Standard of Care- degree of care and skill as a
prudent man would exercise in the conduct of
his own affairs. Failure to comply with this
standard of care could cause the trustee to incur
liability to DH.
3) Limitations on Trustee’s Liability
Indenture may contain provisions limiting
liability of trustee so long as they don’t
contradict TIA- i.e. trustee cannot be relieved
of liability for negligent or willful misconduct.
TIA protects trustees who err in good faith
unless indenture specifically provides
otherwise.
4) Criminal liability- if trustee makes willful false or
misleading statements with respect to any material
fact.
5. Key Contractual Terms and Protective Provisions
a. Promise to Pay- Every debenture sets forth the issuer’s promise to
repay DH the borrowed funds along with interest.
i. Many investors insist on additional indenture provisions
designed to risk or impact of a payment default:
1) Collateralize the debt security
2) Demanding guarantees from a third party.
3) Creation of a sinking fund- requires issuer to
periodically deposit a percentage of its cash flow into
a custodial account typically maintained by the
indenture trustee.
b. Subordination
i. Ranking of debt security to other debts held by issuer- purely
determined by contract. Subordinated debt demands a higher
yield for their additional risk. Referred to as high-yield or
junk
c. Covenants- designed to ensure that issuer operates in a way most
conductive to fulfilling its promise to pay the debt holders. Can be
either affirmative or restrictive (negative)
i. Standard Affirmative Covenants
1) Pay taxes
2) Maintain its properties and corporate existence
3) Deliver its financial info to indenture trustee
4) Obtain and maintain insurance on its properties
ii. Negative Covenants- thou shalt nots
1) Limitation on the Incurrence of Indebtedness
Prevents issuer from increasing its debt load
unless it is generating enough cash flow to
easily satisfy its principal and interest payments
on the debt securities in question.
2) Restricted Payments
Typically prohibits the issuer from distributing
cash to its equity holders either through
dividends or through stock repurchases or fm
purchasing or redeeming any indebtedness of
the issuer subordinated to the debt securities in
question.
Purpose is to keep money within the issuer for
use in servicing the debt securities in question.
Typically allows issuer to make some restricted
payments if certain conditions are met.
3) Asset Sales
Prohibits issuer from selling substantial assets
unless:
 No default or event of default exists;
 The issuer receives consideration for the
assets at least equal to the fair market
value of the assets sold; and
 A high percentage of the consideration
received is cash or cash equivalents
 Usually carves out an exception for sale
of assets less than a certain amount.
Usually when asset sale is permitted under this
covenant it often requires that the issuer
reinvest the proceeds in its core operations
4) Merger, Consolidation, or Sale of Substantially All
Assets
Prevents the issuer from consolidating,
merging, or selling all or substantially all of it
assets to any other person unless certain
conditions are met:
 Issuer must be the surviving entity or
the surviving entity must be a company
existing under US law.
 Surviving entity must assume all of the
issuer’s obligations
 Valuation of the issuer or surviving
entity must not be less after the
transaction that it was prior to
transaction
 Immediately after transaction no default
or event of default must exist.
Purpose is to restrict the issuer from engaging
in a reorganization in which either the issuer
does not survive or the surviving entity is
financially weaker than the issuer. Also
prevents surviving entity from assuming assets
without the indebtedness. The debt must follow
the assets.
Sharon Steel v. Chase Manhattan Bank-
Involved the interpretation of a successors
provision found in various indentures of UV
industries. The provision provided that UV
could merge or consolidate with or sell
substantially all of its assets to another
company so long as that company promised to
pay principal, interest, and any premium on the
debt, agreed to adhere to all covenants, and
entered into a supplemental indenture with the
indenture trustee. Ct ruled this was a boilerplate
provision and interpretation was an issue of law
not fact so that all interpretations would be
uniform. Ruled that the debt could not be
transferred but redeemed.
5) Dividend and Other Payment Restrictions on
Subsidiaries
Typically when issuer is a holding company,
thus covenant prohibits issuer and its
subsidiaries from entering into any contract or
arrangement that could impede the subsidiaries
from up-streaming cash to the holding
company.
6) Transactions with Affiliates
Ensures that an issuer will bargain on an arm’s
length basis with affiliates. Prevents sweetheart
deals which siphon off funds of the issuer that
could otherwise be used to service the debt
securities in question.
7) Restrictions on Liens
Typically appears when secured debt is issued.
Prohibits the issuer from permitting liens on its
assets unless certain conditions are met.
8) Line of Business
Can restrict issuer from engaging in any
business activity other than those specified in
the indenture.
d. Redemption
i. Indenture may provide for optional or mandatory redemption
of debt securities issued by issuer prior to their maturity date.
ii. Optional (like prepayment)
1) If issuers want to refinance because interest rates
have fallen and DH don’t want them to because they
want to get their above market interest rate.
2) Call protection- compromise. Issuer can redeem its
debt securities early but only after a period of years
where redemption is prohibited. Thereafter the
issuer has the option of redeeming some or all of its
securities at a premium that declines to zero plus
accrued and unpaid interest to the date of
redemption.
Cannot voluntarily trigger default to avoid
paying redemption premium (as in Sharon Steel
where Ct ordered redemption premium to be
paid.)
3) Morgan Stanley v. Archer Daniels Midland (ADM)
Debenture indenture allowed for early
redemption at certain prices, but debt could not
be redeemed using proceeds from incurrence of
cheaper debt- i.e. debenture could not be
refinanced, could only be redeemed with
proceeds from sale of equity securities.
ADM raised substantial amounts of capital
through 2 additional debt offerings and 2
offerings of common stock. The cost of debt
was cheaper than debentures.
ADM announced it was redeeming debentures.
Morgan Stanley purchased the debt at a
premium just before the announcement.
Morgan Stanley brought suit against ADM
claiming it was redeeming the debentures from
proceeds of cheaper debt which violated the
indenture.
ADM argued that as long as it could point to
non-debt source for repayment of the
debentures it was not in violation.
Ct ruled in favor of ADM
iii. Mandatory Redemption
1) Require issuer to redeem bonds prior to maturity date
at some triggering event.
e. Events of Default
i. Default in the Payment of Interest or Principal
1) Failure of issuer to make a scheduled interest or
principal payment is the most fundamental event of
default.
2) Acceleration of Debt- trustee may declare the full
principal amount of the debt securities plus any
accrued and unpaid interest immediately due and
payable.
ii. Breach of a Covenant, Warranty, or Representation
1) Non-payment default
2) Issuer usually given a grace period to cure default
3) If default not cured trustee can accelerate the debt
iii. Bankruptcy/Insolvency
1) Constitutes an event of default and debt can be
accelerated immediately if voluntary bankruptcy or
after a grace period if involuntary.
iv. Cross-Default
1) Defaulting on another indebtedness can constitute
default on debt security in question.
6. Legal Treatment of Debt Holders
a. Fiduciary Duties
i. Bond Doctrine- rights of debt holders are determined by their
contract, and accordingly corporate directors do not owe
fiduciary duties to debt holders, even if holding debt securities
convertible to common stock.
b. Implied Covenant of Good Faith
i. In disputes not covered by the indenture, DH often invokes
implied covenant of good faith and fair dealing.
ii. Goal is to preserve the benefit of the parties’ bargain- how
would they have resolved it had they thought of it.
iii. Metropolitan Life v. RJR Nabisco- Involved the leveraged
buyout (LBO) of Nabisco by LBO firm KKR. KKR’s winning
bid for the company was $109/share- a 100% premium over
share price before announcement that it was for sale. When
news of the proposed LBO became public, the value of RJR
Nabisco’s public bonds plummeted in value because the
additional debt the company would incur as a result of the
LBO made the bonds much more risky. The bonds were
downgraded from investment grade to junk, and therefore fell
dramatically in value because a much higher discount rate was
being applied. P bondholders- 2 insurance companies- sued
Nabisco saying that in effect Nabisco had misappropriated the
value of their bonds to help finance the LBO and provide an
enormous windfall for stockholders, while their bonds
decreased in value. They alleged that his constituted a breach
of the covenant of good faith.
1) Court looked at the explicit terms of the indenture
agreement because the implied covenant will only
further the explicit terms of the agreement- it will
never impose obligations inconsistent with the
agreement.
2) Implied covenant is only breached when the party
seeks to prevent the contract’s performance or
withhold its benefit.
3) The Court found that the main purpose of the
indenture- the payment of principal and interest on
the bonds- was not affected by the LBO.
Accordingly the P’s were trying to get the Court to
create benefits for them that they never bargained
for.
Supporting the court’s conclusion was the fact
that the indenture did not prohibit Nabisco from
completing an LBO or otherwise incurring
additional debt. Nor was there any restriction
on its ability to engage in a merger,
consolidation, or sale so long as the acquirer
was a US company and agreed to assume
Nabisco’s debt.
The Court noted that predecessor indentures
had these restrictions but the Ps gave away
these protections when they negotiated the
successor indentures.
7. Altering the Bond Contract
a. Aladdin Hotel v. Bloom- Bloom is a bondholder complaining that
Aladdin modified the indenture by extending her maturity date by 10
years. Companies want to do this if rates in the market are higher
than their coupon rate. Bloom claims that she is entitled to 8%
interest because the contract says that if they are not paid at maturity
they get 8% instead of 5%. SH were also controlling BH and forced
the minority BH to stay for 10 more years at 5%. Ct found for
Aladdin because all bonds were treated equally as per the indenture.
b. Katz v. Oak Industries- Oak industries was experiencing financial
troubles and located another company to acquire them, whereby Oak
would sell its materials for much needed cash. They also entered into
a stock purchase agreement, whereby the acquirer would infuse
capital into Oak in exchange for common stock. This stock purchase
agreement was conditioned on at least 85% of DH converting their
debt to equity. In other words, they wanted Oak to restructure. Oak’s
exchange offers to the creditors was sometimes substantially less than
the principal amount of the debt securities. The exchange offer was
conditioned on DH’s consent to amend the indenture by removing
protections and the prohibition against exchange offers. P contended
that this was coercive because if he did not agree he would be left
with unsecured debt that he couldn’t sell with an indenture that had no
protections in it, and this violated the implied covenant of good faith.
i. Delaware Ct spelled out the appropriate legal test:It is clear
from what was expressly agreed upon that the parties who
negotiated express terms of the contract would have agreed to
proscribe the act later complained of as a breach of the implied
covenant of good faith-had they thought to negotiate with
respect to that matter. If the answer is yet then a court is
justified in concluding that such act constitutes a breach of the
indenture.
ii. Applying this test to the facts, the court found that the link of
the exchange offer to the consent solicitation did not breach
the implied covenant of good faith for 3 reasons:
1) Nothing in Oak’s conduct violated the reasonable
expectation of those who negotiated the indenture on
behalf of the DH.
2) Nothing in the indentures implied that Oak could not
offer an inducement to DH to give their consent to
the amendments in question. It may be coercive but
not per se illegal.
3) The court did not see any conflict of interest in
having DH who accepted the exchange offer to vote
on amendments to the indenture when they would no
longer have an interest in the debt security-it only
mattered that currently they had a financial interest.
B. Preferred Stockholder’s Rights
1. Overview
a. Preferred Stock is a hybrid security featuring characteristics of both
debt and equity
b. It is called preferred because they have a dividend and liquidation
preference over common stockholders.
c. Have very limited voting rights.
d. Stock may be recallable at company’s discretion
2. Similarity to Debt and Equity
a. Debt-like Characteristics:
i. High par value similar to the face value of a bond
ii. Regular defined dividends similar to interest payments
iii. Conversion rights
iv. Redemption rights
v. Restricted voting rights
vi. Ranking senior to common stock at liquidation
vii. Rights spelled out primarily in a contract
b. Equity-like Characteristics
i. Dividends payable at the board’s discretion
ii. Limited fiduciary duties
iii. Non-deductibility of preferred stock dividends for tax
purposes
iv. Indefinite duration unless subject to redemption
v. Ranking junior to company’s creditors in liquidation
vi. Rights, although contractual, are set for in the company’s
certificate of incorporation
3. Preferred Stock Contract
a. Amendment to charter that common stockholders approve; or
b. Blank check preferred stock provision of charter that grants the board
power to issue new series of preferred stock and rights are put in
board resolutions
c. General Terms
i. Whether cumulative or non-cumulative
ii. Number of shares issued and price per share
iii. Yield- annual dividend- reflective of current market interest
rates, but usually higher that interest rate than debt security.
iv. Subordination- ranking of classes of preferred stock.
v. Voting rights
1) Typically receive very limited voting rights
Statutory
 Generally must approve amendments to
charter under state law. (NY and DL)
Contractual
 Typically right to elect specified
number of members of the board if the
company misses a specified number of
quarterly dividends. Once dividend
arrearages are paid, voting rights are
extinguished and elected directors must
resign.
 Sometimes can vote on mergers- Pages
292-295 of Nutshell- cases on
contractual right to vote on mergers.
Baron v. Allied Artist Picture Corp- PSH
elected majority of Board upon 6 missed
dividend payments. After Board was there for
over a year with enough money to pay
dividends, common SH sued to extinguish the
voting rights and elect a new board. Ct ruled
that it was within the board’s discretion to pay
out dividends and new board could stay until
then but they owe all SH fiduciary duties.
vi. Redemption Provisions
vii. Conversion Rights
viii. Exchange Rights
ix. Participation Rights
1) These rights entitle them to receive in addition to
their preferred stock dividends, dividends payable to
common stock as if each share of PSH were a share
of CSH
2) Generally not allowed for liquidation preference
x. Affirmative and Negative Covenants
4. Issuer Motivation and Holder Expectations
a. Why would someone buy preferred stock?
i. Looking for higher yield but the steady return of debt
ii. Venture capitalist buy this in young companies because of its
liquidation preference- usually buy convertible so that they
can convert to common stock if company succeeds.
b. Why do companies issue preferred stock?
i. To take advantage of dips in market interest rates (?)
5. Characteristics of Preferred Stock
a. Preference Rights
i. Dividend Preference
1) Dividends are payable at the Board’s discretion.
However, in the event that dividends are paid PSH
must receive their fixed dividend before any
dividends are paid to their common SH. If PSH is
cumulative (discussed below) than the dividend
preference extends to any dividend arrearage
(previous dividends) that the board did not declare.
ii. Liquidation Preference
1) Upon liquidation get paid before common SH their
liquidation amount- usually par value (like bond’s
face value)- but paid after creditors.
2) If not enough to pay their liquidation preference
available funds divided on pro rata basis.
b. Non-cumulative Dividend Rights
i. The contract states that preferred stock dividends that the
board does not declare and pay in any quarterly period will not
accrue- it is extinguished. However, if quarterly dividends are
not paid on PS the company cannot pay dividends on its stock
junior to the PS.
ii. Pages 284-287 of Nutshell have cases on extinguishment.
c. Cumulative Dividend Rights
i. PS dividends that the board does not declare and pay out in
any quarterly period are not extinguished but accrue. Accrual
occurs regardless of the financial condition of the company.
ii. Before company can pay out on the junior stock, must pay all
accrued dividends to PSH.
iii. Vast majority of PS issued is cumulative.
6. Alteration to PSH rights:
a. Goldman v. Postal Telegraph- Postal wanted to sell to Western
Union. Wanted to amend cert of incorporation to alter liquidation
preference of PSH from $60/share to a owning a share of Western
Union. Proposal was passed and P wants to enforce his liquidation
preference. Court finds in favor of Postal because not a fiduciary duty
claim, must look to the contract to determine the rights, and all SH
voted on the proposal.
b. NY Statutes- see page 40 and 45 of outline
c. Rothschild v. Liggett Group- PSH were entitled to$30 premium in the
case of liquidation. GM is acquiring Liggett here and they want to get
rid of PSH, so they make a tender offer to PSH and some held out.
GM then created a subsidiary that merged with Liggett, now a
subsidiary of GM (Reverse triangular merger). Ps want their
liquidation preference because although it was a tender offer it was
really liquidation. Delaware Ct value form over substance- each
transaction has independent legal significance and as long as you
conform to the statute it’s OK. Court rules in favor of D.
d. Elliott Assoc. v. Avatex- In a merger the PSH would be converted to
CSH of the new company. PSH contended that due to the weak
financial condition of the company the PS was more valuable than the
CS and they were being adversely affected by the merger. PSH did
not vote on the merger but the certificate of incorporation stated that a
2/3 vote of PSH was necessary to amend whether by merger or
otherwise, and provision of certificate of incorporation that would
materially and adversely affect any right of PSH. Ct found that the
merger in question triggered this voting clause and PSH were entitled
to vote on the merger.
e. Warner Communications v. Chris Craft Indus.-
7. Fiduciary and Good Faith Duties
a. Duties governed by contract but also SH- any fiduciary duties owed to
PSH?
b. Dalton v. American Investment Co- PSH alleged that AIC board
breached its fiduciary duty to them in structuring a merger where
common SH would cash out and PSH would be frozen in the new
company. PSH were being offered a higher yield and 5% to be
redeemed each year at their liquidation preference of $25/share. A
previous offer to AIC by another company would have cashed out all
the PSH at $25/share. PSH claimed that the president acted unfairly
and solicited an offer that would be pro-common SH.
i. Ct found that the president did not solicit the transaction and
therefore could not have breached any duty because their
actions did not cause the loss of which P’s complained.
ii. Ct didn’t answer the question of whether fiduciary duty is
owed.
c. Dart v. KKR- PSH got stuck with a highly leveraged company
because they never got to vote on cash out as per their agreement. Ct
found that this was unfair and PSH should have been able to vote.
d. Jedwab v. MGM Grand Hotels- Involved a merger and the allocation
of funds to CSH ($18/share) and PSH ($14/share)Ct stated that with
respect to matters relating to preferences or limitations that
distinguish the PS from CS, the duty of the corporation to the PSH is
purely contractual and the scope of duty is defined by the terms of the
contract. But, if it is a right shared equally with the common stock
then a fiduciary duty exists. Ct applied the fairness standard to this
situation because it was alleged to be a self-dealing transaction, and
found that the allocation was fair.
e. Eisenberg v. Chicago Milwaukee Corp- Company made tender offer
to repurchase PSH at above market prices. However, PSH claimed
this was misleading (lacked disclosure) and coercive- because if not
repurchased would be de-listed with no chance for PSH to sell. Court
found this violated fiduciary duty because it was actionably coercive.
f. Good faith statutes also protect PSH- see pages 407-408 of text book.
8. Summary of Claims Available to PSH:
a. Contractual Remedies
b. Fiduciary Duty (in limited circumstances)
c. Federal Securities Law- may have claim based on disclosure.
C. Convertible Securities
1. Overview-
a. holders of convertible bonds or convertible PS can convert those
securities to common stock
b. they typically receive a lower yield on those securities in exchange for
conversion rights
c. conversion price is specified by contract
d. special contract provisions are inserted to convertible security
contracts to protect conversion rights
2. Valuation of Convertible Bonds
a. Conversion right allows its holder to convert the convertible bond into
common stock at a preset conversion price by turning in his
convertible bond.
b. The cost of the conversion right is the difference between the bond’s
face value and present value at issuance (present value is less than
face value because its coupon rate is lower than market interest rates
and when market rates are above coupon rate the face value of the
bond is discounted- See above).
c. Conversion price usually set at 20-30% above market share price.
Similar to option pricing.
d. Conversion value- how much common stock you can buy at the
conversion price with your bond multiplied by the current market
price of the shares.
e. Conversion Ratio: Face Value/Conversion Price
f. Doesn’t make any sense to convert your bonds if the shares are selling
below or at the same price as your conversion price then your
conversion value is below or the same as market value and you don’t
get your interest payments once you convert.
g. Conversion Premium- difference between present value of debt or
conversion value (whichever is greater) and market value= the value
of the option to convert. When the premium disappears that’s when
holders convert.
3. Notice of Redemption
a. The convertible security contract often grants the company an
optional right of redemption. If company exercises that right,
convertible security holder cannot convert their securities once
conversion deadline passes. If the conversion value exceeds the
redemption price and he fails to convert he forfeits that excess money,
therefore notice of redemption is crucial.
b. Van Gemert v. Boeing Co.- Appellant owned convertible redeemable
debentures in Boeing Co that were listed for trading on the NYSE.
After Boeing redeemed the debentures appellants sued alleging they
were given inadequate and unreasonable notice and they were unable
to convert their debentures to common stock before the conversion
deadline, and resulted in a tremendous forfeiture by appellants.
Boeing provided notice in newspapers and published a press release 3
days before the deadline (in violation of NYSE rules). Court found
their notice insufficient.
i. Today security lawyers are very careful about drafting notice
provisions in their indentures.
4. Antidilution
a. A convertible security contract will typically include antidilution
provisions which protect security holders against company actions
that dilute the common stock they receive upon conversion. They
cover stock splits, reverse stock splits, and dividends.
b. Antidilution provisions typically seek to adjust the conversion price
based on a proportional formula so that a convertible security holder
receives the number of shares of common stock for each convertible
security after the action in question had he converted immediately
prior to the action.
c. Reiss v. Financial Performance- D issued warrants to the plaintiff in
partial repayment of a loan. The warrants allowed the plaintiffs to
purchase shares of D’s common stock for 10 cents per share until
specified dates. Before warrants expired Ds effected a 1 for 5 stock
split. As a result, FPC stockholders were deemed to hold 1/5 the
number of shares they had before the split, but their shares increased
in value 5 times. When Ps wanted to exercise their warrant they
wanted to purchase their shares for 10 cents without taking into
account the stock split. Contract was silent on this situation, so Ps
argued that Ds assumed the risk of a stock split and the warrants
should be enforced on their own terms. Ds said this would give Ps a
windfall and asked courts to imply an adjustment provision. Ct held
that the warrants were enforceable on their own terms because Ds
could have foreseen this situation when drafting the contract.
d. Cheap Stock- Anti-dilution provisions also cover a company’s
issuance of common stock at prices below the current market price of
its common stock because the issuance of cheap stock dilutes the
value of the company’s existing common stock. There is an
adjustment formula for the conversion price is such a situation. (page
315 of Nutshell)
e. Distribution of Evidences of Indebtedness and Assets
i. Adjustments to the conversion price are typically made when
the company distributes evidences of indebtedness or assets
(i.e. shares of a sub distributed as a spin off) to its common
stock holders. (Exceptions are made for dividends, etc.)
ii. Adjusted Conversion Price= Existing Conversion Price x
[(Current Market Price Per Share– Per Share Value of
Distribution to Common SH)/ Current Market Price Per Share
iii. HB Korenvaes v. Marriott Corp.- Discusses adjustments to
conversion price of convertible PS in the face of a spin off
(distribution of assets). Marriott decided to place all of its
growth businesses into a new subsidiary, Marriott
International and distribute all of the shares of that new sub to
Marriott’ common stock holders in a spin off. Ps sought to
enjoin the spin off. They alleged that Marriott undervalued the
sub which was to determine the adjusted conversion price for
the PSH. PSH said the value of the sub should be the “when
issued” price on the NYSE and Marriott did their own
valuation calculation. Because both valuation methods made
sense to the Court they deferred to the business judgment of
the Marriott directors.
5. Duties Implied In Law
a. Cowles v. Empire- Convertible debenture holders had conversion
price of about $50. The price of stock went down so the conversion
right has much less value. Merger- CSH and convertible holders are
offered the same deal- $22/share plus $5 straight debt. The debenture
holders want a downward adjustment of their conversion price under
a provision of their indenture (stock splits/asset distribution). Court
goes according to merger provision- because this is a merger- and
makes not adjustment to conversion price in merger situation. Ct
doesn’t like uncertain terms so they stick to the literal words of the
contract.
b. Harff v. Kerkorian- Convertible BH want to bring a derivative suit
like SH because they have the option to become SH. Their complaint
is regarding a dividend distribution that hurts their potential to
convert, which was self-dealing to help the controlling SH. Lower Ct
and Supreme Ct found that they could not bring a derivative suit
because they were not SH at the time of the harm. But the SC said
they can bring a class action fraud claim because it doesn’t involve
fiduciary duty.
i. No STATE LAW fiduciary duty to convertible security
holders, but under federal law considered to be equity holders.
1) Pittsburgh v. B & O Railroad- Convertible debenture
holders sue because they distributed stock of sub as a
dividend to SH without notice to the DH, depriving
them of their conversion value. No contract violation
but Court found that this violated federal securities
law duty to disclose under 10b-5.
c. Broad v. Rockwell International Corp.
D. Venture Capital Finance
1. Equity Linked Investors v. Adams- Equity Linked (P), a venture capital
firm holds convertible preferred stock in Genta. Genta is not doing so well,
the market for the product is not coming up fast enough although it has a lot
of potential. P wants to bail out and get their liquidation preference. The
common stock holders want to hold out and not liquidate. The company
borrowed money from another company, Aries, for a secured note and
warrants- which puts them ahead of PSH on liquidation- and also takes
control of the company. Ps make a better offer than Aries to try to get what
they can, and the Board refused their offer.
a. P claims that this is a Revlon situation- once breakup is inevitable,
must be a fair auctioneer- to the highest bidder.
b. Ct holds that this is not a Revlon situation because PSH bid is not the
best outcome for the common stock holder but the best for them so
that they could liquidate the company. Revlon doesn’t apply and even
if it did, don’t have to accept their offer because its not the best result
for common SH.
i. No fiduciary duty under state law to convertible security
holders.
III. Capital Structure and Leverages

A. Leverage Effect & the Cost of Capital- See above
B. Optimal Capital Structure
1. Miller & Modigliani Thesis
a. Based these assumptions:
i. Markets are perfect
ii. No transaction costs
iii. Taxes and bankruptcy don’t matter
b. Capital Structure doesn’t matter if the above assumptions are true- it
doesn’t matter if you use debt or equity to finance your company.
c. Why does M & M’s thesis have any importance if in the real world
NONE of these assumptions are true?
i. Because it shows that these are the factors that do make a
difference in determining a capital structure and those are the
factors companies should focus on when determining a capital
structure.
2. Factors- Read
a. Taxes and Capital Structure
b. Bankruptcy Costs
c. Agency Costs
d. Market Imperfections
3. Legal Capital Rules
a. Each state’s corporate code has a legal capital rule which states the
amount of capital that stockholders contribute to company that must
remain permanently in the company to satisfy the claims of creditors.
Designed to protect creditors by ensuring there is a minimal capital
cushion that always exists.
IV. Dividends
A. Dividend Policy
1. Generally
a. Financial perspective- what would be the best for the capital structure
of the company in terms of a dividend policy
b. Legal- if dividend payouts affect share price are directors complying
with their fiduciary duties?
2. Conventional View
a. Dividends should be as stable as possible and constitute a generous
fraction of earnings. Failure to do so will mean a failure to maximize
share values
b. Dividend v. Investment Decision= flaw in the conventional view is
that it is an either or, just because money is not used as dividends does
not mean it can be reinvested or that the company can expand
c. Revisionist statement of the conventional view: A firm with
substantial earnings is likely to generate spare cash- cash that is not
needed to maintain the existing level of investment- SH will gain
from a policy of generous dividends.
3. Tax Issues
a. IRC taxes any cash dividends SH receive and corporate earnings as a
whole are taxed, thus corporate earnings are subject to double
taxation.
b. S corporations- flow through tax entities and avoid double taxation
c. 2003 changes to IRC- maximum tax rate on corporate dividends is
15% rather than investor’s personal income tax rate
d. Capital gains upon shares- lower taxed rate in 2003
4. Wealth Transfers Between Equity and Debt holders
a. Retention of assets as opposed to payment of dividends will increase
the equity cushion for debt holders and thereby decrease the default
risk, making the debt more valuable. Therefore the retention of assets
will benefit the DH at the expense of SH.
5. Holders of options have an incentive to discourage payment of dividends
because it is distribution of assets that they aren’t a part of.
6. Valuation of Shares: Dividend Capitalization Model
a. The value of a share of stock is equal to the value of all future
dividend payments capitalized at a rate reflecting the market’s view of
the risks associated with the firm’s expected income stream
b. PV= d/(k-g)
i. PV= value of the share
ii. d= dividend
iii. k=market rate of return
iv. g=growth rate
7. Irrelevance of Dividends
a. Total value of the firm is determined by its investment policy not its
dividend policy
b. If you decide to retain the earnings and invest the money the share
price could go up, but if you decide to give it out as a dividend the
share price will stay the same and you’ll get the difference as a
dividend= so you’ll end up with the same amount of money.
B. Types of Dividends
1. Cash Dividend
2. Stock Dividends/Spin offs
a. Dividends paid to the SH in the form of stock instead of cash.
b. The stock a company distributes may be shares of its own stock
c. May distribute shares in a wholly owned subsidiary owned by that
company. If the company distributes all the shares of the sub it is
called a spin off. Now the SH directly own the sub instead of
indirectly. If only a portion of the sub is distributed it is called a
carve out.
d. Why stock dividends?
i. Conserve cash needed to run the business
ii. Give the investor the ability to sell the shares he receives and
generate cash from that sale= gives investor option of timing
his cash income
iii. Shares received as a dividend are taxed only when sold
iv. Can lower the stock price into a more desirable trading range
in the secondary market
3. Stock Splits
a. Similar to stock dividend but on a larger scale. Company increases
total number of common stock.
b. Price of shares is divided by stock split ratio, i.e. 2:1 stock split,
divide share price by 2. Makes price per share more affordable to a
wider range of investors
c. Viewed as a positive sign by the market
4. Reverse Stock Splits
a. The number of outstanding shares is reduced, and share price is
multiplied by the inverse of the stock split ratio, i.e. 1:3, multiply
price by 3.
b. Reasons:
i. Increase the per share trading price
ii. Eliminate minority SH
1) May have fiduciary duty challenges if this is done.
(See pages 349-352 of Nutshell)
c. Viewed as a negative sign by the market
C. Legal Standards
1. Dividends are payable at the discretion of the board of directors subject
only to the restrictions in the company’s charter if any, legal capital rules of
the state, and fiduciary duties.
2. Directors generally have broad discretion in declaring dividends and are
protected by the business judgment rule- courts will rarely declare that a
board’s dividend decision is a violation of fiduciary duty.
3. Dodge v. Ford Motor- rare instance where a court did step in to help SH in
their pursuit of a dividend. Company had paid out regular dividends and
special dividends. Ford stopped paying special dividends and Dodge sued.
Ford claimed that SH had made enough money and that he wanted to give
some back to the American people through lower car prices.
a. Social benefit is not an appropriate corporate objective
b. Court set forth bad faith test- court will only interfere with dividend
policy decisions if not paying dividends is such an abuse of discretion
that it would constitute fraud or a breach of a good faith duty the
directors owe to SH.
4. Berwald v. Mission Development Company-
D. Repurchase of Outstanding Shares
1. Overview
a. Very similar to dividends because it puts cash in the hands of
company’s SH.
b. Refers to a company’s repurchase of its stock, and reduces the
number of outstanding stock.
c. Can repurchase on the open market or repurchase tender offer
2. Economics
a. Valuation ?
b. Tax- capital gains- only taxed on amount received above your
purchase price of the stock
3. Repurchases by Privately held companies
a. Primarily to facilitate SH exit from the company
b. Repurchases that are not contractually required have a considerable
potential for abuse of discretion since they are not readily saleable on
the open market.
4. Repurchases by Publicly Traded Companies
a. Typically when Board views its shares as undervalued on the market,
and this typically causes stock price to rise because it is viewed as a
positive sign.
b. RTO- Repurchase tender offer- governed by securities law and
Williams Act
5. Regulation
a. Federal Securities Law
i. Williams Act- prohibits material misrepresentations and
omissions, manipulation, and fraudulent practices in
connection with any tender offer.
1) Self tender offers (RTO)- empowers SEC to avoid
fraudulent, deceptive, and manipulative acts
whenever an issuer purchases its own equity. Rule
focuses on extensive disclosure in going private
transactions and freezeouts.
ii. Rule M- deals with market manipulation when repurchases are
made on the open market- usually drives up stock price.
1) Stabilization is allowed- companies are allowed to
stabilize the price of stock
2) Safe harbor rule- in order to protect companies from
being accused of manipulation the rule guides them
on how to buy their own shares on the open market.
iii. Coyne v. MSL Industries- company tendered for $25/share and
then was later bought by an outside tender offer for $50/share,
and those who self-tendered got screwed because they sold for
a lower price. Is this an insider trading(10b-5) violation? Does
company have to disclose future facts- soft info?
1) Only if its more than a prediction can they incur
liability.
b. Fiduciary Duty
i. Kahn v. Sugar Corp- Leveraged tender offer for 75% of the
shares- the company was borrowing money to buy back the
shares from all the SH.
1) P’s complaint: the tender offer statement issued was
coercive because it made the minority SH choose
between selling at $68/share or staying in a highly
leveraged company, where the stock would probably
be de-listed because the value would go down so
low.
Unfair price
Lack of disclosure of value of the company
from experts- price was just a mgmt decision
Coercive
2) Company’s motive in repurchase: Mgmt wanted to
maintain control but still cash out on their investment
3) Ct ruled this was a breach of fiduciary duty because
of lack of disclosure of material facts- the value of
the company. (Not fed law case, but state law
disclosure)
V. Mergers and Acquisitions
A. Introduction
1. Reasons for Mergers
a. Should be thought of as another form of investment. From the
acquirer’s point of view they must ask is this the best use of the
company’s funds.
b. Acquirers usually pay a premium over the share price for assets of the
target firm- Why?
i. Traditional Gains Hypotheses
1) Acquirers will better manage the assets and create
new value for the premium they paid
2) Private information theory- is that market is
uninformed and undervaluing the shares but the
acquirer has info market does not
3) Tax hypotheses- significant tax gains by stepping up
the basis on target assets
ii. Discount Hypotheses- the premium paid reflects the existing
value of the target’s asset which is greater than the pre-bid
value. Why?
1) Misinvestment hypothesis- the current managers are
not investing the cash flow of the target properly so it
is appraised at a lower value, but now that there is
new managers the value goes up
2) Market Hypothesis- market discounts share values
for a variety of reasons, not a good estimate of the
value of the corp.
iii. Management Motivation
1) Hubris
2) Self interest
3) Quasi-rationality
2. Concerns
a. Acquirer- whether too much is being paid
b. Target (Acquired Company)- whether enough is being paid for the
value given up and whether the transaction is self dealing on the part
of the directors.
c. Corporate law concerns:
i. Procedural aspects of transaction
ii. Disclosure to SH
B. Accounting
1. Required Method- Purchase method (FASB)
a. Assets and liabilities of the acquired company are recorded on the
books of the acquiring company at their fair market values as of the
date of combination.
b. Any difference between the amount paid and the fair market value
will be recorded as goodwill.
2. Pooling Method- May not be Used Today
a. Leave the acquired company’s books alone and copy the numbers into
acquiring company’s books- not buying company just combining with
it.
C. Taxes
1. Asset Purchases- target taxed at 2 levels- the corporation and individual SH
are taxed for any gains received on the sale.
2. Share purchases- target is taxed at only one level- the individual SH are
taxed on the gain received.
3. Mergers for cash/debt- target taxation on one level- capital gains treatment,
with a max tax of 20% on long-term capital gains.
4. Reorganizations- Statutory merger/consolidation- not taxable (not
triangular mergers).
5. Acquisitions are not taxable for the acquirer.
D. Merger Agreement
1. Seller’s Point of View- sellers are concerned that the deal will not close
because of circumstances that are not in their control, so they will draft an
agreement that protects against that.
2. Material Adverse Change Clauses- protects purchaser against the seller
losing value between the time of agreement and actual merger. Seller may
want to make some exceptions for changes that result in the announcement
of the transaction
3. Due Diligence- Seller should resist provisions that permit the buyer to
forgo closing based on the results of due diligence after the signing of the
agreement.
4. Antitrust Issues- Antitrust law requires parties to supply info to determine if
certain assets need to be divested in order to not violate antitrust laws.
Sellers will want to bind purchaser even if some assets have to be divested.
5. Non-reliance Clauses under the Federal Anti-Fraud Rules
a. AES v. Dow Chemical- Misrepresentation claim under 10b-5
regarding financial info. D defended that the agreement contained
disclaimer. 10b-5 calls for reasonable reliance on misrepresentation,
the non-reliance (disclaimer) clause is not determinative in a 10b-5
case because the act is designed to protect rights created by the act not
the contract.
6. Enforcement of Merger Agreements
a. IBP v. Tyson Foods- Tyson tried to get out of merger agreement by
saying according the merger agreement Tyson did not have to close of
IBP had to restate its warranted financials or IBP suffered from
material adverse effect. Court rejected both claims by Tyson and
enforced the merger agreement.
b. Merrill Lynch v. Allegheny Energy- Merrill Lynch, the financial
advisor of Allegheny proposed to acquire for them GEM, an energy
trading company. When negotiations began Merrill Lynch withdrew
as their financial advisor. Disclaimer was made that any
representation or evaluations not in the agreement were warranted to
be accurate or complete. After purchase agreement, Allegheny
discovered that Merrill Lynch had misrepresented GEM and that
GEM was saddled with criminal business practices and shams, so it
refused to honor the purchase agreement. Merrill Lynch sued for
enforcement, and Allegheny counterclaimed for fraudulent
inducement, breach of contract and breach of fiduciary duty. Court
denied Merrill Lynch’s motions to dismiss these claims and A could
proceed with all claims.
7. Reformation for Mistake
E. Formal Aspects
1. Overview: Five Basic Types of Transactions:
a. Acquisition or Purchase
b. Merger, Consolidation, or Conversion
c. Leveraged Buy Out (LBO)
d. Recapitalization
e. Restructuring
2. Acquisition or Purchase Transactions
a. Asset Acquisition
i. Cash for Assets Acquisition
1) Acquirer pays target company cash for all or
substantially all its assets. Target company dissolves
and distribute cash to creditors than stock holders.
2) Majority of SH of target must approve sale; SH of
acquirer do not have voting rights. (Del Law)
3) No appraisal rights
4) Tax consequences:
Target company is taxed at two levels-
corporation and individual SH are taxed for any
gains they receive.
Generally no tax consequences for either
acquirer or its SH.
5) Key Question: What constitutes sale of all or
substantially all assets which would then trigger
voting rights of the target’s SH?
ii. Stock for Assets Acquisition
b. Mergers
i. Stock for Stock
1) Voting rights on both sides
2) No appraisal rights
ii. Small Scale Merger- acquirer a closely held corp
1) Acquirer- not voting or appraisal rights
2) Target- voting and appraisal rights
iii. Cash out Merger
1) Acquirer- no voting or appraisal rights
2) Target- voting and appraisal rights
iv. Short form merger (Parent 90%-Sub merger)
1) Through board resolution, and sub only gets
appraisal rights
v. Triangular merger
1) Forward triangle- Acquirer creates a subsidiary and
the target merges into the subsidiary and target SHs
receive parent shares.
2) Reverse- subsidiary created merges into the target
and shares of the target are converted into parent
shares
No voting or appraisal for acquirer
Voting for target but no appraisal (unless
receive cash instead of shares)
F. Appraisals
1. Delaware Block Method- court would value the company by examining and
weighting each of the following factors:
a. Market value based on trading price of stock of company in question
b. Earnings value-estimate of what company would earn in the future
c. Net asset or book value
2. Francis DuPont v. Universal City Studios- Short form merger and minority
SH are exercising appraisal rights. Ct used the block method and weighted
the values and used a multiplier to come up with an appraisal value.
3. Weinberger v. UOP- Delaware courts in reviewing appraisal valuations
must use a “more liberal approach that must include proof of value by any
techniques or methods which are generally considered acceptable by the
financial community and otherwise admissible in court.”- not solely the
block approach
4. MG Bancorporation v. Le Beau- Involved a short form merger in which
minority SH get appraisal rights, so at issue was the fair value of the shares
left with the minority SH. After hearing testimony from financial experts
the Courts determined that the shares were worth over double the amount
offered to them by the majority.
a. 4 categories of valuation reviewed by the Court:
i. Determining value based on comparable companies
ii. Book value valuations
iii. Price to earnings ratios
iv. Valuations based on discounted cash flow
b. Ultimate selection of valuation method is within court’s discretion
c. Standard of review of lower courts valuation choice is abuse of
discretion
5. Control premiums
a. Rapid-American v. Harris- Rapid was a heavily leveraged company
with 3 subs. CEO started market and self repurchasing causing the
CEO’s control to increase. Rapid agreed to a merger with another
company which would be privately owned by the CEO and another
guy. Rapid’s other SH would receive a package, which was
challenged here by exercise of appraisal rights. P wanted to value
each sub separately and add a control premium. Ct found for P.
G. Freezeouts/Going Private
1. Taking the corporate private means freezing out public SH by using control
to cash out minority SH. Must have equal treatment for all members of the
SH class.
a. Coggins v. New England Patriots Football- Sullivan, a part owner of
the corporation does an LBO and needs to freeze out minority SH in
order to do LBO. Court held that when a controlling SH is doing a
merger must have some legitimate business purpose. It is a violation
of fiduciary duty if the sole purpose is to eliminate others.
i. Delaware courts requires fair dealing and fair price only, no
business purpose requirement
ii. NY has business purpose requirement
H. Management Buyouts- usually involves the purchase by a newly formed corporation
of all the corporation’s stock or assets for cash and the receipt by old management
the bulk of the equity in the new company. New company is a combination of high
leverage and outside private equity with management’s commitment to remain with
new corporation in exchange for substantial equity participation. Not as coercive as
controlling SH going private because anyone else can come in a buy the company at
a higher price.
1. Field v. Allyn- management buyout approved because they gave adequate
disclosure and did what any other party could have done.
2. Process Rules
a. Fiduciary Duty standard apply for management conduct with bidding
competitors when involved in buyout
b. Must be a window of time open for competing bids
c. Committee of independent directors to represent the corporation
d. Fairness opinion
I. Fiduciary Standards
1. Appraisal Rights
a. Rabkin v. Hunt- Entire fairness Weinberger standard applied. Full
disclosure and independent committee does not establish entire
fairness.
b. Cede v. Technicolor- If a SH has initiated an appraisal action he may
later in a separate action initiate an equitable action based on newly
discovered facts of breach of fiduciary duties.
2. Interested Directors/Controlling SH
a. Kahn v. Lynch- Burden of proof to show fairness is on the defendant
unless use an independent, fully informed committee, that can
negotiate at arm’s length, and then burden is shifted to Ps. In this
case the independent committee was coerced into accepting merger
deal by controlling SH, which violated controlling SH fiduciary duties
to minority SHs
b. Kahn v. Lynch II- On remand Ds were able to show that transaction
was entirely fair.
c. Krasner v. Moffett- Should BJR or entire fairness standard apply to a
board’s decision to approve a friendly merger when a majority of the
board is interested? B/P on directors to show truly independent
committee and then b/p shifts to Ps.
d. In Re Siliconix Inc. Shareholder’s Litigation- Controlling SH are not
obligated to offer fair price in tender offer as long as it is not coercive
and there is full disclosure. If not coercive and there is full disclosure,
do not have to meet entire fairness standard.
i. Why lesser standard in tender offer context than merger
context? Because it is the decision of individual shareholder
not the entire corporation.
e. Glassman v. Unocal- No entire fairness review for short form
mergers, just disclosure.
f. In re Pure Resources SH Litigation- Tender offers are not subject to
entire fairness review BUT cannot be coercive and have to be able to
get recommendation from independent directors on the target’s board.
3. Duty of Care
a. Smith v. Van Gorkom- Business Judgment Rule will apply to Board’s
decisions unless gross negligence in the decision making process has
occurred (like deciding to sell your company after a 2 hour meeting)
b. Cede & Co v. Technicolor- P refused to tender in tender offer made
by another company and dissented from the cash out merger. Sought
judicial appraisal and through discovery found directory misconduct
and sued in equity for rescission. Court found that entire fairness
applied- fair dealing and fair price with B/P on directors because they
made an uninformed decision. P does not need to show proof of
injury.
c. Duty of Care and merger negotiations
i. 102(b)(7) Defense: in DE corps can amend their charters to
opt out of liability for breaches of duty of care.
J. Disclosure
1. State
a. Fiduciary Law- Duties to disclose arises under the duty of care and
loyalty
i. Lynch v. Vickers Energy Corp- must disclose all information
in their possession germane to the transaction at issue.
ii. Emerald Partners v. Berlin
iii. Zirn v. VLI- used TSC materiality approach to determine
director’s duty to disclose.
iv. Del 102b-7- shields directors from personal liability for
fiduciary duty breaches. However, does not apply to duty of
loyalty which also embraces the duty to disclose or from
equitable relief.
1) Arnold- good faith omission of material fact is
protected under 102b-7 shield. But not an exemption
from equitable relief only personal liability.
v. Disclosure of merger negotiations- no duty prior to execution
of a definitive merger agreement
2. Federal
a. All material information must be disclosed and any information that is
necessary to make the filed information not misleading.
i. TSC Industries v. Northway- Prevailing definition of
materiality- substantial likelihood that a reasonable SH would
consider it important in deciding how to vote.
b. Basic v. Levinson- Fraud on the Market Theory. See Above.
VI. Tender Offers
A. Overview
1. Tender Offer is an invitation to all SH of a target corporation to tender their
shares at a specified price. Will usually pay premium above market price
2. Why make a tender offer? Acquirer either thinks stock is undervalued or
expects to use control to enhance going concern value.
3. Do Hostile Takeovers benefit society?
a. Traditional Commentators: NO
b. Managerialists: Takeovers waste capital and management energy
better spent on internal improvements
c. Proponents: best method to displace inefficient management
4. Do Hostile Takeovers benefit SH?
a. SH of target usually do gain because of premiums they receive or
increased stock price.
b. Dispute about SH of acquirer’s gain or loss.
B. Tactics
1. Bidders
a. Short Duration- will want to give as little notice as possible and
consummate quickly to preclude incumbent management resistance,
change in interest/market prices that will negate the premium offered.
i. Effect on target SH- coercive because no competing offer
b. Limited information to SH
2. Managerial Defenses
a. Defenses requiring amendment of charter:
i. Staggered election of board members
ii. Requiring cause for removal of directors
iii. Requiring special qualifications for election of board members
iv. Curtailing availability of written consent action by SH
v. Limited voting power of SH
vi. Supermajority requirements for removal of directors
b. Defenses not requiring amendment
i. Poison Pill- SH rights plans: When it is triggered by a bidder
rights holders generally have the option to buy stock at half
price in either the target or the bidder which dilutes the value
of the stock and makes the company less attractive or more
expensive to purchase.
1) Flip In- buy stock of target company
2) Flip Over- buy stock of acquirer’s company after the
merger which also makes the company less attractive
and more expensive to purchase.
3) Redeemable
ii. Stonewalling with staggered board- takes longer time to
change board to do away with poison pill.
C. Williams Act- special obligations imposed on bidders, competing bidders, and target
companies to protect investors NOT to regulate takeovers. Imposes regulatory
restrictions and disclosure obligations.
1. Disclosures By Bidder
a. Identity and funding of the bidder
b. Purpose in making acquisition
c. Plan of acquisition and disposal of additional securities causing any
additional transactions later
d. Financial statements
e. Electronic Specialty Company v. International Controls- ICC sought
to acquire ESC. Management opposed tender offer. Sued ICC for
making false and misleading statements (share price dropped after
tender offer). Question to ask in determining violation of securities
law is whether any of SH would probably not have tendered had the
alleged violations not occurred. No violation of disclosure
requirements because they are not required to offer alternatives to
their tender offer.
f. Flynn v. Bass Bros. Enters.- Ds sued for failing to disclose material
information with their tender offer. They did not state that more
money could be made through long-term liquidation or continuation
as a going-concern and the tender offer stated that they had no
material non-public info. Once Bass had 92% did short form merger.
Ps contending that violated disclosure laws by not disclosing asset
appraisal values. Ct held the appraisal projections (soft info) must be
disclosed in appropriate cases- by weighing the potential aid against
the potential harm in undue reliance on the projections.
2. Disclosure by Target
a. Requires target to send a statement disclosing its position with respect
to the tender offer within 10 days of the commencement of the offer.
Must also include a reason for position taken.
b. Radol v. Thomas- Board recommended tender offer to SH after
considering some other offers. Acquirer got 92% of company from
the tender offer and a board meeting with 2/3 vote would consummate
a merger between the 2 companies. Any asset appraisal in connection
with the merger must be included in merger papers, and Ps contend
that they should have been included with tender offer. Ct held that
tender offers must include soft info if the predictions have a
substantial likelihood to hold. Do not have to include merger
materials with tender offer materials even if merger will certainly
occur upon successful tender offer.
3. Disclosure of Defensive Negotiations
a. Panter v. Marshall Field- Target SH unsuccessfully brought an action
under 14e with respect to managerial defensive actions that caused
prospective hostile bid to materialize. Ct held that must show reliance
and since tender offer was withdrawn- no decision, no reliance.
4. Undistorted Choice for Target SH
a. Withdrawal and Proration-Third party bidders are permitted to offer
extensions but without withdrawal of rights for those tendering during
the extension period. Long list of restrictions.
b. Equal Treatment
i. Tender offer must be open to all SH and must receive the
same consideration- All Holders Rule
1) Polaroid Corp v. Disney- SEC was acting within its
authority and the purpose of full disclosure when
prescribing the All Holder’s Rule
2) Gerber v. Computer Assoc.- P contended that CEO
was paid more $ for shares in violation of equal
treatment rule.
c. Side Deals- if integral to tender offer will violate rule 14d-10
d. Rule 14e-5- prohibits purchases of subject security outside the tender
offer because it could deceive investing public and defeat tender offer
by driving the market price up.

Corporate Finance Valuation

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Corporate Finance Valuation

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i. FVn => Future value at the end of “n” periods of time

2) the more frequent the compounding the greater the

i. PV => what is being determined. It represents the value

2) The more frequent the compounding the lower the

i. Annuity is the payment of a constant sum of money at fixed

M/B Ratio= Market Price per share/ BV per share

1) Use this ratio of a comparable publicly traded

Market Price per share of privately held

ii. Expected Return: weighted average of all possible outcomes

D. Measuring Risk and Return

a. Takes into account growth potential, which explains why risky

E. Efficient Market Hypothesis

II. Senior Securities

Rate of return on equity = investment return-interest payment

c. Debt to Equity Ratios affect default risk- highly leveraged companies

III. Capital Structure and Leverages

V. Mergers and Acquisitions

VI. Tender Offers

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