2021CFA二级公司金融基础班 PDF

CFA ®
Level II
Corporate Finance
Kyle Wang CFA

CONTENTS SS7: Corporate Finance (1)
R20: Capital Budgeting
R21: Capital Structure
R22: Dividends and Share Repurchases: Analysis
SS8: Corporate Finance (2)
R23: Corporate Performance, Governance, and Business
Ethics
R24: Corporate Governance
R25: Mergers and Acquisitions
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Capital Budgeting
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What we are going to learn?
1. Capital budgeting project evaluation
2. Inflation effects on capital budgeting
3. Mutually exclusive projects with different lives
4. Project risk analysis
5. Using the CAPM in capital budgeting
6. Evaluating projects with real options
7. Common capital budgeting pitfalls
8. Alternative measures of income and valuation models
9. Other valuation models
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Types of capital projects
 Classification of capital projects
 Replacement projects
 To replace the wore out equipment to maintain current business;
 To reduce the cost of the business, or improve the efficiency.
 Expansion projects
 For current projects;
 For new product or new services.
 Mandatory investment
 Regulatory projects;
 Safety projects;
 Environmental projects;
 Frequently required by a government agency.
 Other projects: projects that cannot be easily analyzed by using capital budgeting process.
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Basic principles of capital budgeting
 Basic principles of capital budgeting

 Incremental cash flow: the cash flow that is realized because of adopting the projects;
 Decisions are based on cash flows, not based on accounting concepts, such as net income;
 Timing of cash flows is crucial;
 Cash flows are analyzed on an after-tax basis;
 Cash flows are estimated considering the opportunity costs.
 Cash flows that should be ignored in capital budgeting
 Sunk costs;
 Financing costs.
 Cash flows that should be included in capital budgeting
 Externality;
 Opportunity cost.
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The capital budgeting process
 Capital budgeting is the process of selecting and determining the most profitable
long-term projects
Idea generation Project
evaluatio
n
Analyzing project proposals
Create the firm-wide capital budget
Monitoring decisions and conducting a post-

audit
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MACRS
 Under MACRS, real property is usually depreciated straight-line over a 27.5- or 39-
year life;
 Assets are grouped and a special depreciation schedule in each class;
 The depreciation is double-declining-balance with a switch to straight-line when
optimal and with a half-year convention.
Depreciation methods affect capital budgeting decisions

because they affect after-tax cash flow.
In general,
accelerated depreciation methods (MACRS) lead to
higher after-tax cash flows and a higher project NPV.
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MACRS
Ownership Year Class of Investment

3-Year 5-Year 7-Year 10-Year
1 33% 20% 14% 10%
2 45 32 25 18
3 15 19 17 14
4 7 12 13 12
5 11 9 9
6 6 9 7
7 9 7
8 4 7
9 7
10 6
11 3
100% 100% 100% 100%
Buildings are 39-year assets: 1.3% in years 1 and 40 and 100/39 =2.6% in the other years.
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Cash flow projection – expansion project
Terminating
stage
Operating
stage
Initial  OCFT
stage  WC
 Operating CF  FA
 CAPEX
 W.C. investment TNOCF = NWCInv + SalT
– T(SalT – BT)
OCF = (S–C–D)(1–T) + D
=(S–C)(1–T)+D*T t=0:
Initial outlay =  Initial outlay
FCInv + NWCInv t=t:
 OCFt
t=T:
 OCFT
 Return of WC
 Sale of old assets
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Capital budgeting cash flows example
$’000
Year 0 1 2 3 4 5
Investment outlays:
Fixed capital –200
Net working capital –30
Total –230
Annual after-tax operating cash flows:
Sales 220 220 220 220 220
Cash operating expenses 90 90 90 90 90
Depreciation 35 35 35 35 35
Operating income before taxes 95 95 95 95 95
Taxes on operating income (tax rate = 40%) 38 38 38 38 38
Operating income after taxes 57 57 57 57 57
Add back: Depreciation 35 35 35 35 35
After-tax operating cash flow 92 92 92 92 92
Terminal year after-tax non-operating cash flows:
After-tax salvage value (Proceeds of sale= 50,000) 40
Return of net working capital 30
Total 70
Total after-tax cash flow –230 92 92 92 92 162
Net present value at 10 percent required rate of return 162.217
Internal rate of return 32.70%
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 Correct Answer:
Outlay=FCInv+NWCInv
Outlay = 200,000 + 30,000 – 0 + 0 = $230,000
CF = (S – C – D)(1 – T) + D
= (220,000 – 90,000 – 35,000) × (1 – 0.40) + 35,000 = $92,000
CF = (S – C)(1 – T) + T × D
= (220,000 – 90,000) × (1 – 0.40) + 0.40 × (35,000)
= 130,000 × (0.60) + 0.40(35,000) = 78,000 + 14,000 = $92,000
BT = H.C. – A.D. = 200,000 – 35,000 × 5 = 25,000
TNOCF = SalT + NWCInv – T(SalT – BT)
= 50,000 + 30,000 – 0.40(50,000 – 25,000)
= 50,000 + 30,000 – 10,000 = $70,000
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 The old fixed capital (including land) is sold for $50,000, but $10,000 of taxes must
be paid on the gain. Including the $30,000 return of net working capital gives a
terminal year non-operating cash flow of $70,000.
The NPV of the project is the present value of the cash flows—an outlay of $230,000
at time zero, an annuity of $92,000 for five years, plus a single payment of $70,000 in
five years.
5
92, 000 70, 000
NPV  230, 000     230, 000  348, 752  43, 465  $162, 217
1.1 1.1
t 5
t 1
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Replacement capital project
 For a Replacement project, the cash flow are the same as expansion project except
 Current after-tax salvage value of the old assets reduces the initial outlay.
Initial outlay= FCInv + NWCInv - [Sal0 – (Sal0 – B0) × T]
 The cash flows relevant to an investing decision are the incremental cash flows
(ΔCF)
 The cash flows the company realizes with the investment compared to the cash
flows the company would realize without the investment.
CF  (S  C )(1  t )  D  t

 Assumption
 Same useful life of old and new assets.
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Cash flow projection – replacement project
Terminating
Replacement project
stage
Operating
stage
Initial OCFT
stage WC
 Operating CF Sale of old FA
 CAPEX
 W.C. investment TNOCF = NWCInv + Δ SalT
 Cash collected – T(Δ SalT – ΔBT)
ΔCF = (ΔS–ΔC–ΔD)(1–T) +Δ D
=(ΔS–ΔC)(1–t) + Δ D*T
Initial outlay =
FCInv + NWCInv
- [Sal0 - T(Sal0 – B0)]  Incremental sales;
 Incremental cost;
 Incremental depreciation.
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Capital budgeting CFs-replacement project
Old Equipment New Equipment

Current book value $400,000
Current market value $600,000 Acquisition cost $1,000,000
Remaining life 10 years Life 10 years
Annual sales $300,000 Annual sales $450,000
Cash operating Cash operating
$120,000 $150,000
expenses expenses
Annual depreciation $40,000 Annual depreciation $100,000
Accounting salvage Accounting salvage
$0 $0
value value
Expected salvage Expected salvage
$100,000 $200,000
value value
 If the new equipment replaces the old equipment, an additional investment of $80,000 in net
working capital will required. The tax rate is 30%, and the required rated of return is 8%.
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 Correct Answer:
Outlay = FCInv + NWCInv – Sal0 + T(Sal0 – B0)
Outlay = 1,000,000 + 80,000 – 600,000 + 0.3(600,000 – 400,000)
= $540,000
The incremental operating cash flows are:
CF = (ΔS–ΔC–ΔD)(1–T) +Δ D
= [(450,000 – 300,000) – (150,000 – 120,000) – (100,000 – 40,000)](1 – 0.30) +
(100,000 – 40,000)
= (150,000 – 30,000 – 60,000)(1 – 0.30) + 60,000 = $102,000
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 At the project termination, the new equipment is expected to be sold for $200,000,
which constitutes an incremental cash flow of $100,000 over the $100,000 expected
salvage price of the old equipment. Since the accounting salvage values for both the
new and old equipment were zero, the gain is taxable at 30%. The company also
recaptures its investment in net working capital. The terminal year incremental
after-tax non-operating cash flow is:
TNOCF = Δ SalT + NWCInv – T(Δ SalT – ΔBT) =(200,000 –100,000) +80,000 –
0.30[(200,000 – 100,000) – (0 – 0)] = $150,000
Once the cash flows are identified, the NPV and IRR are readily found. The NPV,
found by discounting the cash flows at the 8 percent required rate of return, is
10
102, 000 150, 000
NPV  540, 000   t
 10
 $213,907
t 1 1.08 1.08
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Cash flow projection
 Special topics
 Replacement project
 Current after-tax salvage value of the old assets reduces the initial outlay;
 Depreciation is the change in depreciation if the project is accepted compared to
the depreciation on the old machine.
 Depreciation schedules
 It affects capital budgeting decisions because they affect after-tax cash flow;
 In general, accelerated depreciation methods lead to higher after-tax cash flows
and a higher project NPV;
 Interest is not included in operating cash flows for capital budgeting purposes
because it is incorporated into the project's cost of capital;
 US IRC adopts MACRS system for tax deduction with depreciation.
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Inflation effects on capital budgeting
 Inflation affects capital budgeting analysis in several ways
 The first decision the analyst must make is whether to do the analysis in “nominal” terms or in “real”
terms.
 Nominal cash flows include the effects of inflation, it must be discounted at the nominal interest
rate;
 Real cash flows are adjusted downward to remove the effects of inflation, and it must be discounted
at the real interest rate.
 Relation between nominal rate and real rate
 (1 + nominal rate) = (1 + real rate)(1 + inflation rate)
 If inflation is higher than expected
 The profitability of the investment is lower than expected;
 Reduces the value of depreciation tax savings;
 Increases the corporation's real taxes because it reduces the value of the depreciation tax shelter;
 Reduces the value of fixed payments to bondholders.
 Inflation does not affect all revenues and costs uniformly.
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Mutually exclusive projects with different lives
 The issue
 Can NOT assess directly by comparing with the NPV of 2 projects with different lives;
 Assume that the 2 projects are repeated over the time horizon.
 Two methods to compare projects with unequal lives that are excepted to be repeated
indefinitely
 Least common multiple of lives approach
 Extends the lives of the projects so that the lives divide equally into the chosen
time horizon.
 Equivalent annual annuity (EAA) approach
 EAA is the annuity payment (series of equal annual payments over the project’s life)
that is equivalent in value to the NPV.
 The decision rule: to choose the investment chain that has the highest EAA.
 The two approaches are logically equivalent and will result in the same decision.
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Example
 Assume we have two projects with unequal lives of two and three years, with the
following after-tax cash flows
CFt -100 60 90
Project S
T 0 1 2
CFt -140 80 70 60
Project L
T 0 1 2 3
Both projects have a 10 percent required rate of return.

Decide which project to choose by using EAA approach and least common multiple of
lives approach.
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Example: least common multiple of lives
 Correct Answer:
The least common multiple of 2 and 3 is 6, project S would be replicated three and
project L would be replicated two times. The cash flows for replicating Projects S and
L over a six-year horizon are shown below:
CFt -100 60 (-100+90) 60 (-100+90) 60 90
Project S
T 0 1 2 3 4 5 6
CFt -140 80 70 (-140+60) 80 70 60
Project L
T 0 1 2 3 4 5 6
Discounting the cash flows for the six-year horizon
NPV for Project S is $72.59;
NPV for Project L is $62.45.
Project S should be chosen based on least common multiple of lives.
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Example: EAA
 Correct Answer:
For project S above, we already calculate the NPV of the project over its two-year
life to be $28.93. For a two-year life and a 10% discount rate, a payment of $16.66 is
the equivalent annuity.
The EAA for project L is found by annuitizing its $35.66 NPV over three years, so
the EAA for project L is $14.34.
The decision rule for the EAA approach is to choose the investment chain that has
the highest EAA, which in this case is Project S.
 The two approaches result in the same decision.
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Capital rationing
 Capital rationing is the case in which the company’s capital budget has a size
constraint.
 Hard capital rationing
 The budget is fixed and the managers cannot go beyond it.
 Soft capital rationing
 Managers may be allowed to over-spend their budgets if they argue effectively
that the additional funds will be deployed profitably.
 A firm with less capital than profitable (positive NPV) projects should choose the
combination of projects they can afford to fund that has the greatest total NPV.
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Example
 Schoeman Products has evaluated several investment projects and now must choose
the subset of them that fits within its C$40 million capital budget. The outlays and
NPVs for the six projects are given below. Schoeman cannot buy fractional projects,
and must buy all or none of a project. What is the optimal subset of the six projects
that Schoeman Products would like to choose?
A. 1 and 5. B. 2, 3, and 4 C. 2, 4, 5, and 6.

Project Outlay PV of Future Cash Flows NPV
1 31 44 13
2 15 21 6
3 12 16.5 4.5
4 10 13 3
5 8 11 3
6 6 8 2
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Example: capital rationing
 Correct Answer: A.
Combination Combined NPV

Project 1+5 $13+$3= $16
Project 2+3+4 $6+$4.5+ $3= $13.5
Project 2+4+5+6 $6+$3+ $3+ $2= $14
 Among the sets of projects suggested, the optimal set is the one with the highest
NPV, provided its total outlay does not exceed $40 million. The set consisting of
Project 1 and 5 produces the highest NPV.
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Risk analysis—stand-alone methods
 Risk analysis techniques
 Sensitivity analysis
 Sensitivity analysis calculates the effect on the NPV of changes in one variable at a time;
 In a sensitivity analysis, the manager can choose which variables to change and by how much.
 Scenario analysis
 Scenario analysis creates scenarios that consist of changes in several of the input variables
and calculates the NPV for each scenario.
 Simulation analysis (or Monte Carlo simulation)
 Simulation analysis is a procedure for estimating a probability distribution of outcomes;
 Assume several variables to be stochastic, following their own probability distributions.
 These risk measures depend on the variation of the project’s cash flows.
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Example: base case
Base case
Unit price $5.00
Annual unit sales 40,000
Variable cost per unit $1.5
Investment in fixed capital $300,000
Independent
Investment in working capital $50,000
variables or
inputs Project life 6 years
Depreciation (straight line) $50,000
Expected salvage value $60,000
Tax rate 40%
Dependent Required rate of return 12%

variable or NPV $121,157
outputs
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Example: sensitivity analysis
Sensitivity analysis
Base value Low value High value
Unit price $5.00 $4.50 $5.50
Annual unit sales 40,000 35,000 45,000
Variable cost per unit $1.50 $1.40 $1.60
Expected salvage value $60,000 $30,000 $80,000
Tax rate 40% 38% 42%
Required rate of return 12% 10% 14%
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Example: sensitivity analysis
Projected NPV
Variable Base case With Low With High Range of

estimate estimate estimate Most
sensitive
Unit price 121,157 71,820 170,494 98,674
Annual 121,157 77,987 164,326 86,339
unit sales
Cost per 121,157 131,024 111,289 19,735
unit
Salvage 121,157 112,037 127,236 15,199

value
Tax rate 121,157 129,165 113,148 16,017
Required 121,157 151,492 93,602 57,890
return
Treat independent for

low and high estimate
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Example: Scenario analysis
Scenario analysis
Variable Pessimistic Most likely Optimistic
Unit price $4.50 $5.00 $5.50
Annual unit sales 35,000 40,000 45,000
Variable cost per unit $1.60 $1.50 $1.40
Treat
together Investment in fixed capital $320,000 $300,000 $280,000
Investment in working capital $50,000 $50,000 $50,000
Project life 6years 6years 6years
Depreciation $53,333 $50,000 $46,667
Salvage value $40,000 $60,000 $80,000
Tax rate 40% 40% 40%
Required rate of return 13% 12% 11%
NPV -$5,725 $121,157 $269,685
IRR 12.49% 22.60% 34.24%
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Monte Carlo simulation
 Steps in Monte Carlo simulation
 Step 1: make basic assumptions for the probability distribution for inputs if
needed;
 Step 2: based on the assumed distribution, make the simulation and get the
results of each input variable;
 Step 3: based on the inputs simulated from step 2, estimate a NPV for the project;
 Step 4: repeat the previous two steps for hundreds of thousands of times;
 Step 5: based on the output of step 4, get the mean, standard deviation and the
correlation of the NPV;
 Step 6: build a good estimate of the distributions for the NPV of the project.
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Monte Carlo simulation
 Monte Carlo simulation can provide a distribution for the NPV of the project, instead
of several amount of the NPV under specific circumstances.
 The distribution of the NPV is not always normally distributed, but when the amount
is large enough, its distribution would be normally distributed.
Mean NPV=$10
Std. deviation=$10
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Risk analysis—market risk methods
 The discount rate in capital budgeting is the risk-adjusted rate rather than WACC.
 The discount rate should reflect the risk of project to be evaluated;
 WACC reflects the risk of whole company.
 The CAPM can be used to determine the appropriate discount rate for a project
based on risk.
 The project beta is used as a measure of the systematic risk of the project and
the security market line (SML) estimates the required return.
 When the risk of a project is different from the overall company, using WACC will
R project  R f   project [ E ( RM )  R f ]
 Overestimate the NPV, if project’s risk > company’s risk;

 Underestimate the NPV, if project’s risk < company’s risk.
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Evaluating projects with real options
 A critical assumption of traditional capital budgeting tools is that the investment
decision is made now, with no flexibility considered in future decisions.
 Real options are capital budgeting options that allow managers to make decisions in
the future that alter the value of capital budgeting investment decisions made today.
 Just deal with real assets instead of financial assets;
 Entail the right to make a decision, but not the obligation;
 The flexibility is given to managers to enhance the NPV of the company’s capital
investments.
 Types of real options include
 Timing options;
 Sizing options;
 Flexibility options;
 Fundamental options.
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 Timing options: the company can delay investing.

 Sizing options
 Abandonment option
 The company can abandon the project when the financial results are
disappointing after investing.
 Expansion option
 The company can make additional investments when future financial results are
strong after investing.
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 Flexibility options: once an investment is made, other operational flexibilities may be

available besides abandonment or expansion.
 Price-setting options
 By increasing prices, the company could benefit from the excess demand, which
it cannot do by increasing production.
 Production flexibility options
 The company can profit from working overtime or from adding additional shifts.
 Fundamental options
 The payoffs from the investment are contingent on an underlying asset, just like
most financial options.
 High oil prices, drill a well.
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 Critical assumptions of traditional capital budgeting tools
 The investment decision is made now;
 No flexibility considered in future decisions.
 More reasonable approach: assume that the corporation is making sequential

decisions, some now and some in the future.
 Real options analysis tries to incorporate rational future decisions into the
assessment of current investment decision making.
 This future flexibility, exercised intelligently, enhances the value of capital

investments.
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 Four common sense approaches to real options analysis
 Use DCF analysis without considering options
 If the NPV is positive without considering real options, and the project has real options that would
simply add more value, it is unnecessary to evaluate the options.
 Consider the Project NPV = NPV(based on DCF alone) - Cost of options + Value of options
 Use decision trees
 Decision trees can capture the essence of many sequential decision making problems.
 Use option pricing models
 Some large companies have their own specialists.
Project NPV
Overall Based on
Equal DCF
NPV
Option
Option
Value
Cost
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Example: evaluating projects with real options
 Sackley Aqua Farms estimated the NPV of the expected cash flows from a new processing
plant to be -$0.40 million. Sackley is evaluating an incremental investment of $0.30 million
that would give management the flexibility to switch between coal, natural gas, and oil as
an energy source. The original plant relied only on coal. The option to switch to cheaper
sources of energy when they are available has an estimated value of $1.20 million. What is
the value of the new processing plant including this real option to use alternative energy
sources?
 Correct Answer:
The NPV, including the real option, should be
Project NPV =NPV (based on DCF alone) – cost of options + value of options = -0.40 million
-0.30 million + 1.20 million =$0.50 million
Without the flexibility offered by the real option, the plant is unprofitable. The real
option to adapt to cheaper energy sources adds enough to the value of this investment to
give it a positive NPV.
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Common capital budgeting pitfalls
 Common mistakes that managers may make
 Incorrect anticipation for economic response;
 The template model does not match the project;
 Influential managers for pet projects;
 Investment decision made based on EPS, NI or ROE;
 Basing decisions on the IRR;
 Bad accounting for incorrect estimation for cash flows;
 Misstate the overhead costs;
 Use improper discount rate;
 Overspending and under-spending the capital budget;
 Failure to consider alternative investment ideas;
 Ignoring sunk cost or opportunity costs.
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Economic and accounting income
 Economic income is the profit realized from an investment.

 Calculation
 Economic income = cash flow - economic depreciation
 Economic income = cash flow + (ending market value - beginning market value)
 Economic income = cash flow + change in market value
 Economic depreciation = beginning market value - ending market value
 Accounting income is the profit reported in the I/S
 The accounting depreciation schedule does not follow the declines in the market
value of an asset;
 Accounting net income is the after-tax income remaining after paying interest
expenses on the company’s debt obligations.
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 How to understand economic income
0 1 2
PV0 CF1 CF2

PV1
PV0 = (PV1+CF1)/(1+r)
PV0 × (1+r) = PV1+CF1
EI = PV1 + CF1 - PV0 = PV0*r
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 Economic income Vs. Accounting income
Economic income Accounting income

Economic income = ATCF + ΔMV Accounting income= revenue – expense
Economic depreciation: the Accounting depreciation: the decrease in
decrease in MV of investment BV based on the original cost
Financing cost: ignored Financing cost: subtracted to arrived at NI
 Accounting income for this company will differ from the economic income for two reasons.
 The accounting depreciation is based on the original cost of the investment; Economic
depreciation is based on the market value of the asset;
 Interest expense is considered while calculating accounting depreciation, but interest
expense is ignored for economic income.
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Economic profit approach
 Alternative forms of determining income should theoretically lead to the same

calculated NPV if applied correctly.
 Economic profit (EP)
= NOPAT - $WACC = EBIT x (1-T) – WACC x capital
 EP reflects the income earned by all capital holders;
 The NPV based on economic profit is called the market value added (MVA).
¥
EPt Distinguish between
NPV=MVA=
t=1 (1+WACC) t economic income and
economic profit
Vfirm =MVA + investment
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Residual income approach
 Alternative forms of determining income should theoretically lead to the same

calculated NPV if applied correctly.
 Residual income is the earnings for a given period minus a deduction for common
shareholders’ opportunity cost in generating the earnings.
 RI t NI t re Bt 1
 RI reflects the income to equity holders only


RIt
NPV  
t 1 (1  re )
t
VE NPV BVE
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Claims valuation approach
 Alternative forms of determining income should theoretically lead to the same calculated
NPV if applied correctly.
 Claims valuation approach divide the operating cash flows between security holder
classes, and then value the debt and equity cash flows separately.
 The free cash flow to the firm approach is fundamentally the same as the basic
capital budgeting approach;
 The free cash flow to equity approach is related to the claims valuation approach;
 The net present value (NPV) is the present value of all after-tax cash flows.
 The claims valuation method calculates the value of the company, not the project. This
is different from the economic profit and residual income approaches, which calculate
both project and company value.
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Economic income and Economic profit
 Pure is a simple corporation that is going out of business in five years, and Pure has a
12% weighted average cost of capital, and 40% tax rate, and Pure is considering to
invest in a project with initial investment of 200,000, and the table shows the
financial information for the project.
Year 1 2 3 4 5
Depreciation 40,000 40,000 40,000 40,000 40,000
EBIT 30,000 40,000 50,000 60,000 40,000
After tax salvage 12,000
1. Economic income during year one is closest to:

A. 23,186. B. 29,287. C. 46,101.
2. What is EP during Year 1?
A. -12,101. B. -6,000. C. 6,000.
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 Correct Answer to 1: B.
Year 1 2 3 4 5
EBIT 30,000 40,000 50,000 60,000 40,000
EBIT(1-0.4) 18,000 24,000 30,000 36,000 24,000
Depreciation 40,000 40,000 40,000 40,000 40,000
After tax salvage 12,000
CF 58,000 64,000 70,000 76,000 76,000
CF1  58, 000

58, 000 64, 000 70, 000 76, 000 76, 000
V0   2
 3
 4
 5
 244, 054.55
1.12 (1.12) (1.12) (1.12) (1.12)
64, 000 70, 000 76, 000 76, 000
V1   2
 3
 4
 215,341.10
1.12 (1.12) (1.12) (1.12)
Economic income in Y1=58,000-(244,054.55-215,341.10)=29,286.55
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 Correct Answer to 2: B.
EP  NOPAT  $WACC
NOPAT  EBIT (1  T )  30, 000(1  0.4)  18, 000
$WACC  WACC  Capital  0.12  200, 000  24, 000
EP  18, 000  24, 000  6, 000
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Capital Structure
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1. Capital Structure Objective

2. Capital Structure Theory
3. Costs and their Potential Effect on the Capital Structure
4. Static Trade-Off Theory
5. Implications for Managerial Decision Making
6. Target Capital Structure
7. Role of Debt Rating
8. Capital Structure Policy and Valuation
9. International Differences in Leverage
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Capital Structure Objective
 The objective of a company’s capital structure (D/E) decision is to determine the

optimal proportion of debt and equity financing that will minimize the firm’s WACC
and maximize the firm’s value.
D E
WACC  ( )rd  (1  t )  ( )re
V V
D: market value of debt;
E: market value of shareholders’ equity
V: market value of the firm
 Please be noted that the optimal capital structure is not the one that makes the
maximum EPS or ROE.
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Capital structure objective
Optimal capital structure
Minimize cost of capital
Maximize the value of company
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Capital structure theory
 Capital structure theory
 MM theory 1958  No taxes, no costs of financial distress;
 MM theory 1963  With taxes, no costs of financial distress;
 The static trade – off theory  With taxes, with costs of financial distress.
MM: Modigliani - Miller
Under different assumptions of taxes, transaction costs,

and bankruptcy costs, there are different conclusions.
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 MM proposition 1 without taxes: capital structure irrelevance
 Conclusion
 The market value of a company is not affected by the capital structure.
 Assumptions
 Investors agree on the expected cash flow from a given investment;
 Bonds and shares of stock are traded in a perfect capital market;
 Investors can borrow/lend at the risk-free rate;
 No agency costs;
 Financing decision and investment decision are independent.
150 D E
100
60 40
50 V1=V2
40 60
0
Firm 1 Firm 2
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 MM proposition 1 without taxes: capital structure irrelevance

 Value is not created simply by changing company’s capital structure;
 With the increase in leverage, the increase in equity returns is offset by
increases in the risk and the associated increase in the required rate of return on
equity.
 For simplification, assume 2 firms have the same cash flow (FCFF) and
uncertainty.
 The firm value is the same as the discount rate is the same.
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 MM proposition 2 without taxes: higher leverage raises the cost of equity

 The cost of equity is a linear function of D/E;
 Assumption
 Financial distress has no cost;
 Debt holders have prior claim to assets and income  rd < re
 re rises with higher D/E to offset the increased use of cheaper debt to maintain constant
WACC.
D
re r0 (r0 rd )( )
Cost of E The r0 is not
capital determined by capital
D E D
 a  ( )d  ( )e  e   a  ( a  d ) structure, but by
V V E
business risk of the
r0 WACC company.
EBIT
rd Cost of debt V
r0
D/E
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 MM proposition 1 (with taxes)

 The tax deductibility of interest payment creates a tax shield that adds value to the firm,
and the optimal capital structure is 100% debt.
VL  VU  t  d
 MM proposition 2 (with taxes)
 WACC is minimized at 100% debt.
Cost of
capital D
re r0 (r0 rd )( )(1 t ) We do not consider the
E costs here
 Cost of financial distress;
 Cost of bankruptcy.
WACC
After-tax cost of
debt EBIT (1 t )
VL
D/E WACC
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Short summary for MM theory
 Difference between Proposition 2 without taxes and with taxes

 When t ≠ 0, (1 - t) lowers cost of leveraged equity compared to no-tax case.
 re becomes greater as the company increases the debt financing, but re does not rise as
fast as it does in the no-tax case. Because the slope coefficient (r0-rd)(1-t) < (r0-rd) in
the case of no taxes;
 WACC for the leveraged company falls as debt increases, and overall company value
increases;
 If taxes are considered but financial distress and bankruptcy costs are not, debt
financing is highly advantageous;
 In extreme, optimal capital structure is all debt.
Without taxes With taxes
Proposition 1 VL=VU VL=VU+t*D
Proposition 2 re= r0+(r0-rd)*D/E re= r0+(r0-rd)(1-t)*D/E
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Costs of financial distress
 During the downward economy, earnings are magnified downward during economic
slowdowns.
 Lower or negative earnings put companies under stress, and this financial distress
adds to companies.
 Companies whose assets have a ready second market have lower cost associated with
financial distress
 Companies with relatively marketable tangible assets incur lower costs from
financial distress;
 Companies with few tangible assets have less to liquidate and therefore have a
higher cost associated with financial distress.
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Costs of financial distress
 Components of expected cost of financial distress
 Costs of financial distress and bankruptcy
 Direct costs: actual cash expenses associated with the bankruptcy process
 Legal fees;
 Administrative fees.
 Indirect costs
 Foregone investment opportunities;
 Impaired ability to conduct business;
 Agency costs associated with the debt during periods in which the company is near or
in bankruptcy.
 Probability that financial distress and bankruptcy happen
 Operating leverage and financial leverage;
 Quality of management and corporate governance structure.
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Agency costs
 Agency costs are the incremental costs arising from conflicts of interest when an
agent makes decisions for a principal.
 Agency costs to equity
 Smaller stake the mangers have, HIGHER cost;
 Net agency cost of equity consist of three components
 Monitoring costs are the costs borne by owners to monitor the management of the
company;
 Bonding costs are the costs borne by management to assure owners that they are
working in the owners’ best interest;
 Residual losses are the costs incurred even when there is sufficient monitoring and
bonding, because monitoring and bonding mechanisms are not perfect.
 The better the company is governed, the lower agency cost;
 The increase in use of debt vs. equity, decrease the agency cost.
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Cost of asymmetric information
 Cost of asymmetric information result from managers having more information about a firm than
investors.
 The provider of both debt and equity capital demand higher returns from companies with higher
asymmetry in information because there is a great likelihood of agency costs.
 Pecking order theory suggests that the management of the company prefers the way of financing
that disclose less information.
 Pecking order
 Managers prefer internal financing;
 If internal financing is insufficient, managers next prefer debt;
 The final choice is equity.
 Based on the manager’s choice of financing method, the signal can be read;
 It indicates that the management prefers to issue equity when it is overvalued; but is reluctant
to issue equity when it is undervalued;
 Issuance of equity is a negative signal of the company.
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Static trade-off theory
 The static trade-off theory is a theory pertaining to a company’s optimal capital

structure;
 The optimal level of debt is found at the point where additional debt would cause the
costs of financial distress to increase by a greater amount than the benefit of the
additional tax shield. VL  VU  (t  d )  PV(Costs of Financial Distress)
Firm value Cost of capital
Costs Of Financial
Max distress
firm Cost of equity
value Value of
levered firm
PV of
tax shield Value of WACC
unlevered firm
After-tax
cost of debt
with financial
distress
D/E
Optimal capital Optimal capital D/E
structure structure
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Static trade-off theory
 Key points of static trade-off theory

 With increase in financial leverage
 The tax shield add value to the firm;
 The impact of cost of financial distress, agency cost and cost of asymmetric
reduce the firm value
 Unlike the MM proposition of no optimal capital structure, or a structure with
almost all debt, static trade-off theory puts forth an optimal capital structure
with an optimal proportion of debt.
 Once the value adding from tax shield and value reduction from these costs are
balanced, the company reaches a max value with lowest cost of capital  optimal
capital structure.
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Implications for managerial decision making
 MM’s proposition
 No tax: irrelevant
 With tax: tax shield makes borrowing valuable, WACC is minimized at 100% debt
Without taxes With taxes
Proposition 1 VL=VU VL=VU+t*D
Proposition 2 re= r0+(r0-rd)*D/E re= r0+(r0-rd)(1-t)*D/E
 Static trade-off theory

 The optimal capital structure depends on
 Company’s business risk, combined with its tax situation;
 Corporate governance;
 Financial accounting information transparency, etc.
 Optimal proportion of debt
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Target capital structure
 The target capital structure
 Optimal capital structure is the capital structure at which the value of the company is
maximized.
 When the company recognizes its most appropriate or best capital structure, it
may adopt this as its target capital structure.
 Reasons why the capital structure for the company differs from its target capital
structure
 Management may exploit short-term opportunities in one or another financing source;
 Market value fluctuations continuously affect the company’s capital structure;
 It may be impractical and expensive for a company to continuously maintain its
target structure.
 However, so long as the assumptions of the analysis and the target are unchanged,
analysts and management should focus on the target capital structure.
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Role of debt rating
 Debt ratings are an important consideration in the practical management of leverage.

 As leverage rises, rating agencies tend to lower the ratings of the company’s debt
to reflect the higher credit risk resulting from the increasing leverage.
 In practice, most managers consider the company’s debt rating in their policies
regarding capital structure.
 Managers must be mindful of their company’s bond ratings because the cost of
capital is tied closely to bond ratings.
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Evaluating capital structure policy
 Factors an analyst should consider when evaluating a firm’s capital structure include
 The capital structure of the company over time;
 The capital structure of competitors that have similar business risk;
 Company-specific factors, such as the quality of corporate governance.
 A common goal of capital structure decisions is to finance at the lowest cost of
capital.
 Analysts can use a scenario approach to assess this point for a particular com-
pany, starting with the current cost of capital for a company and considering
various changes.
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International differences in leverage
 For international firms, country-specific factors have explanatory power similar to or
even greater than that of the company’s industry affiliation in determining a com-
pany’s capital structure.
 For total debt
 Companies in France, Italy, and Japan tend to be more highly levered than
companies in the United States and the United Kingdom.
 For long-term debt
 North America companies tend to use longer maturity debt than companies in
Japan.
 Emerging market differences
 Companies in developed markets typically use more long-term debt and tend to
have higher long-term debt to total debt ratios compared to their emerging
market peers.
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 Major factors that explain the majority of the differences in capital structure across countries
 Institutional and legal factors
 Power of legislation;
 Taxes;
 Information of asymmetry.
 Financial market and banking system factors
 Liquidity of capital markets;
 Reliance on banking system;
 Institutional investor presence.
 Macroeconomic factors
 Inflation;
 GDP growth.
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 Institutional and legal factors

 Power of legislation
 The quality of investors’ legal protections depends on both the content and the
enforcement of the contracts and laws.
 Weak legal system: higher leverage, a greater use of short-term debt financing.
 Efficient legal system: lower leverage, a greater use of long-term debt financing.
 Taxes
 The benefit from the tax deductibility of interest encourages companies to use debt
financing. However, if dividend income is taxed at lower rates than interest income,
some of the advantage of debt versus equity financing may be reduced.
 Companies in countries that have lower tax rates on dividend income also have less
debt in their capital structures.
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 Institutional and legal factors
 Information asymmetry
 High information asymmetry between insiders and outsiders encourages the use
of more debt than equity and more short-term debt to long-term debt.;
 Auditors and financial analysts can help reduce information asymmetries, thus
increasing the level of transparency and lowering the financial leverage;
 The importance of auditors is usually strongest in emerging markets, whereas

the presence of analysts is more important in developed markets.
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 Financial market and banking system factors
 Liquidity of capital markets
 Companies in countries that have liquid and active capital markets tend to use more long-term
(as opposed to short-term) debt with longer maturity (30-year maturity is preferred to 15-
year maturity).
 Reliance on banking system
 Companies in bank-based countries exhibit higher financial leverage compared to those that
operate in market-based countries.
 Institutional investor presence
 Some institutional investors may have preferred debt maturities (preferred habitats);
 Insurance companies and pension plans may prefer investing in long-term debt securities in
order to match the interest rate risk of their long-term liabilities;
 Companies in countries that have more institutional investors in their markets tend to have
more long-term debt and somewhat lower debt-to-equity ratios.
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 Macroeconomic factors
 Inflation
 High inflation has a negative impact on both the level of debt financing and the
use of long-maturity debt, since higher inflation reduces the real value of
coupon payments.
 GDP growth
 Developing countries find that companies in countries with high growth rely
more on equity financing;
 The growth in GDP is associated with longer debt maturity in developed markets.
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 Impact of country-specific factors on capital structure
Country-specific factors D/E ratio Debt Maturity
Institutional Framework
Legal system more efficient lower longer
Legal system origin: common law lower longer
Information intermediaries: lower N/A
auditors/analysts
Taxation: favor equity lower longer
Banking System, Financial Market
Active equity and bond markets N/A longer
Bank-based not market-based country higher N/A
Investors lower longer
Macroeconomic environment
High inflation lower shorter
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Dividends and Share
Repurchases: Analysis
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1. Dividends policy and company value theory

2. Factors affecting dividend policy
3. Payout policies
4. Analysis of dividend safety
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Cash dividends
 Regular cash dividends
 Many companies choose to distribute cash to their shareholders on a regular schedule. Most
companies that pay cash dividends strive to maintain or increase their dividends.
 Extra or special dividends
 An extra dividend or special dividend is a dividend paid by a company that does not pay dividends
on a regular schedule or a dividend that supplements regular cash dividends with an extra
payment.
 Liquidating Dividends
 A dividend may be referred to as a liquidating dividend when a company:
 Goes out of business and the net assets of the company (after all liabilities have been paid)
are distributed to shareholders;
 Sells a portion of its business for cash and the proceeds are distributed to shareholders; or
 Pays a dividend that exceeds its accumulated retained earnings (impairs stated capital).
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Dividend reinvestment plans
 In some world markets, companies are permitted to have in place a system that allows
shareholders to automatically reinvest all or a portion of cash dividends from a
company in additional shares of the company. Such a dividend reinvestment plan is
referred to as a DRP.
 The three types of DRPs are distinguished by the company’s source of shares for
dividends reinvestment.
 An open-market DRP: the company purchases shares in open market to acquire
the additional shares
 A new-issue DRP: the company meets the need for additional shares by issuing
them
 Plans that are permitted to obtain shares through either open-market purchases
or new share issuance.
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Dividend reinvestment plans
 Dividend reinvestment plans
 Advantages
 Encourage a diverse shareholder base by providing small shareholders an easy means to
accumulate additional shares;
 Stimulate long-term investment in the company;
 New-issue DRPs allow the company to raise new equity capital without the flotation costs
associated with the secondary equity issuance using investment bankers;
 DRPs allow the accumulation of shares using cost averaging.
 Disadvantages
 A disadvantage to the shareholder is the extra record keeping involved in jurisdictions
where capital gains are taxed;
 A further disadvantage to the shareholder is that cash dividends are fully taxed in the
year received even when reinvested.
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Cash dividends
 The effect on shareholders’ wealth and financial ratios

 Reduces both the value of the company’s assets and the market value of equity (by
reducing retained earnings);
 No effect on shareholder wealth;
 Liquidity ratio such as the cash ratio and current ratio decreases;
 Financial leverage ratios such as debt-to-equity ratio and debt-to-asset ratios
increases.
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Stock dividends
 With a stock dividend (also known as a bonus issue of shares), the company distributes
additional shares (typically 2-10% of the shares then outstanding) of its common stock
to shareholders instead of cash.
 No effect on shareholders’ wealth, asset and equity;
 Retained earnings are reduced by the value of stock dividends paid, contributed
capital increases by the same amount;
 The number of shares outstanding increases;
 Price decreases, EPS decreases, P/E constant;
 Stock dividends have no effect on liquidity ratios (cash ratios, current ratios) and
financial leverage ratios (D/E, D/A).
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Stock dividends
 The impact of a 3% stock dividend to a shareholder who owns 10% of a company with
a market value of $20 million.
Before dividend After dividend

Shares outstanding 1,000,000 1,030,000
Earnings per share $1 $0.97
Stock price $20 $19.4175
P/E 20 20
Total market value $20million $20million
Shares owned 100,000 103,000
Ownership value $2,000,000 $2,000,000
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Stock splits
 If a company announces a two-for-one stock split, each shareholder will be issued an
additional share for each share currently owned. Thus, a shareholder will have twice
as many shares after the split as before the split.
 No effect on the market value of the shareholders’ wealth and total shareholders’
equity;
 The numbers of shares outstanding increases, price decreases, EPS decreases;
 Have no effect on liquidity ratios and financial ratios.
 Many investors view the announcement of a stock split as a positive sign pointing to
future stock price increases
 More often, announced stock splits merely recognize that the stock has risen enough
to justify a stock split to return the stock price to a lower, more marketable price
range.
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Stock splits
 The effect on a two-for-one stock split
Before split After split

Number of shares
4 million 8 million
outstanding
Stock price $40 $20
Earnings per share $1.5 $0.75
Dividends per share $0.5 $0.25
Dividend payout ratio 1/3 1/3
Dividend yield 1.25% 1.25%
P/E 26.7 26.7
Market value of equity $160 million $160 million
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Reverse stock split
 A reverse stock split increases the share prices and reduces the number of shares
outstanding, with no effect on the market value of a company’s equity or on
shareholders’ total cost basis.
 Increase the share price;
 Reduce the number of shares outstanding;
 No effect on the market value of the firm’s equity.
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Stock dividends and stock splits
 Although both stock dividends and stock splits have no effect on total shareholders’
equity
 A stock dividend is accounted for as a transfer of retained earnings to

contributed capital.
 A stock split does not affect any of the balances in shareholder equity accounts.
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Dividend policy and company value theory
 Theories in dividend policy and company value

 Does not matter;
 Bird in hand;
 Tax aversion;
 Clientele effect;
 Signaling;
 Agency costs and dividend as a mechanism to control them.
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 Dividend policy does not matter

 Inference from MM theory
 Under MM assumption, no meaningful distinction between dividends and share
repurchases.
 Perfect capital market assumptions
 Dividend is irrelevant to company value
 Homemade dividend by investors: if investors need dividend, they can construct
their own dividend by selling sufficient shares to create cash flow;
 It does not mean dividend per share is irrelevant but the dividend policy is
irrelevant.
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 Dividend policy matters: bird in hand argument

 Prefer cash dividend to capital dividends as it is more certain
 The argument is that a company that pays dividends will have a lower cost of
equity than a similar company that does not pay dividends, thus result in a
higher share price.
 MM theory contend that it is incorrect
 under their assumption, current dividend does not affect the risk of future
cash flow, only lower the ex-dividend price.
 Dividend policy matters: tax aversion
 The investors prefers the way that incur lower tax;
 Dividends are taxed at higher rates than capital gains;
 Taken to its extreme, this argument would advocate a zero payout ratio.
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 Clientele effect
 Different investors desire different dividend policy
 Tax consideration: If TCG < TD, investor prefers capital gains.
 Many investors indicate a preference for dividends
 Some institutional investors, including certain mutual funds, banks, and insurance companies, will only
invest in companies that pay a dividend;
 Some individual investors use a discipline of “only spend the dividends, not the principal” to preserve
their capital.
 Dividend clienteles may tend to promote stability of dividend policy and do not contradict
dividend policy irrelevance.
 If the demands of all clienteles for various dividend policies are satisfied by sufficient
numbers of companies, a company cannot affect its own share value by changing its dividend
policy;
 The change would only result in a switch in clientele.
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 Clientele effect
 Tax effects the trading strategies in regard with dividend
 Sell just before ex-dividend: Pw–(Pw–Pb)TCG
 Sell just after ex-dividend: Pw–(PX–Pb)TCG+D(1–TD)
 Indifferent: Pw–(Pw–Pb)TCG = PX–(PX–Pb)TCG+D(1–TD)
 P  Pw  Px  D (1  TD ) / (1  TCG )
 Where, Pw= price before ex-dividend
Pb= purchase price
PX= ex-dividend date price
TD= dividend tax, TCG= capital gain tax
 Conclusions
 TCG = TD, share drops = dividend
 TCG < TD, share drops < dividend
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Example: dividend vs. capital gain
 An individual investor pays taxes of 28 percent on the next dollar of dividend income
and taxes of 15 percent on the next dollar of capital gains. Which would she prefer:
$1 in dividends or $0.87 in capital gains?
 Correct Answer:
 For this investor, after taxes

1  0.28 = $0.85
$1 in dividends is worth $1
 l  0.15
Because $0.87 exceeds $0.85, this investor would prefer $0.87 in capital gains to
$1 in dividends.
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Example: dividend vs. capital gain
 Suppose the tax rate on capital gains is 20 percent for all investors, but the tax rate
on dividend income differs among investors. A share drops by 70 percent of the
amount of the dividend, on average, when the share goes ex-dividend. Assume that
any appropriate corrections for equity market price movements on ex-dividend days
have been made. Calculate the marginal tax rate on dividend income applying to those
who trade the issue around the ex-dividend day.
 Correct Answer:
(Pw  Px )
 The statement of the problem implies that  0.70
D
0.70 
1-Td  
1-Td 
( 1-Tcg ) 1- 0.20 
TD  1- 0.8  0.7  0.44
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 Signaling
 MM assume all investors, including outside investors, have the same information.
In reality, mangers have more information (asymmetric info);
 For outside investors, dividend is meaningful because of asymmetric information;
 A company’s BOD and management may use dividends to signal to investors how the
company is really doing.
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 Signaling
 Dividend increases or decreases may affect share price because they may convey
new information about the company.
 A company’s dividend initiation or increase tends to be associated with share
price increases because it attracts more attention to the company;
 Dividend cuts or omissions, in contrast, present powerful and often negative sig-
nals.
 Managers have an incentive to increase the company’s dividend if they believe the
company to be undervalued because the increased scrutiny will lead to a positive
price adjustment.
 Merely maintaining the dividend or not cutting it as much as expected is usually
viewed as good news, unless investors view managers as trying to convey erroneous
information to the market.
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 Agency issues
 Between shareholders and managers
 Managers may have an incentive to maximize their own welfare at the company’s
expense because they own none or small percentages of the company;
 One managerial incentive of particular concern is investment in negative NPV
projects. This potential overinvestment agency problem might be alleviated by the
payment of dividends.
 Between shareholders and bondholders
 When a company has risky debt, the payment of dividends reduces the cash cushion
available to the company for the disbursement of fixed payments to bondholders;
 The payment of large dividends, with the intention of transferring wealth from
bondholders to shareholders, could lead to underinvestment in profitable projects.
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Example - agency issues and dividends
 Two dividend-paying companies A and B directly compete with each other. Both are
all-equity financed and have recent dividend payout ratios averaging 35 percent. The
corporate governance practices at Company B are weaker than at Company A.
Recently, profitable investment opportunities for B have become fewer, although
operating cash flow for A and B is strong.
Based only on the information given, investors who own shares in both A and B are
most likely to press for a dividend increase at:
A. Company A, because it has better growth prospects than Company B.
B. Company B, because a dividend increase may mitigate potential overinvestment
agency problems.
C. Company B, because a dividend increase may mitigate potential underinvestment
agency problems.
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Example - agency issues and dividends
 Correct Answer: B.
Company B's strong operating cash flow in an environment of fewer profitable growth
opportunities may tempt Company B's management to overinvest. The concern is
increased because of Company B's relatively weak corporate governance.
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Factors affecting dividend policy
 Investment opportunities
 More profitable investment opportunity, less cash dividend.
 Expected volatility of future earnings
 The more volatile earnings are, the greater the risk that a given dividend increase may not be covered by earnings in a
future time period.
 Financial flexibility
 When increasing financial flexibility is an important concern, a company may decide to distribute money to
shareholders primarily by means of share repurchases rather than regular dividends.
 Tax considerations; (see next page)
 Flotation costs
 Flotation costs make it more expensive for companies to raise new equity capital than to use their own internally
generated funds.
 Contractual and legal restrictions
 Impairment of capital rule: dividend paid < retained earnings
 Debt covenants: a response to the agency problems that exist between shareholders and bondholders and are put in
place to limit the ability of the shareholders to expropriate wealth from bondholders.
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Tax consideration – taxation methods
 Tax consideration: effective tax rate depends on the tax system

 Double-taxation
 Corporate earnings are taxed at the corporate level and then taxed again at the
shareholder level if they are distributed to taxable shareholders as dividends.
 Calculation of effective tax (example below).
 Split-tax rate system
 Corporate earnings that are distributed as dividends are taxed at a lower rate
at the corporate level than earnings that are retained.
 At the individual level, dividends are taxed as ordinary income. Earnings as
dividends are still taxed twice, but with relatively low corporate tax rate. The
effect is to offset the higher (double) tax rate applied to dividends at the
individual level.
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Tax consideration – taxation methods
 Tax consideration: effective tax rate depends on the tax system

 Tax-imputation system
 Corporate profits distributed as dividends are taxed just once, at the
shareholder’s tax rate.
Effective tax rate = shareholder’s marginal tax rate.
 When those earnings are distributed to shareholders in the form of dividends,
however, shareholders receive a tax credit, known as a franking credit;
 If the shareholder’s marginal tax rate is higher than the company’s, the shareholder
pays the difference between the two rates.
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Tax consideration – dividends or capital gains
 Tax consideration: shareholder preference for current income vs. capital gains
 All else equal, the lower an investor's TD relative to TCG, the stronger preference for
dividends.
 Other issues also impinge on this preference
 The investor may buy high-payout shares for a tax-exempt retirement account. Even
if TD < TCG, it is not clear that shareholders will necessarily prefer higher dividends.
 Tax-exempt institutions (e.g. pension funds and endowment funds) are major
shareholders in most industrial countries and are exempt from both TD and TCG
(indifferent).
 TCG not have to be paid until being sold, whereas TD must be paid in the year
received, even if reinvested.
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Example: Double taxation system
39.6% 15%
Net income before taxes $100 $100
Corporate tax rate 35% 35%
Net income after tax $65 $65
Dividend assuming 100% payout $65 $65
Shareholder tax on dividend $25.74 $9.75
Net dividend to shareholder $39.26 $55.25
Double tax rate on dividend distributions 60.74% 44.75%
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Example: Split-rate system
Pretax income $200
Pretax income retained 100
35% tax on retained earnings 35
Pretax earnings allocated to dividends 100
20% tax on earnings allocated to dividends 20
Dividends distributed 80
Shareholder tax rate 35%
After tax dividend to shareholder [(1 - 0.35) x 80] = 52
Effective tax rate on dividend [20% + (80 x 0.35)%] = 48%*
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Example: Tax imputation system
15% 47%
Pretax income $100 $100
Taxes at 30% corporate tax rate 30 30
Net income after tax 70 70
Dividend assuming 100% payout 70 70
Shareholder tax on pretax income 15 47
Less tax credit for corporate payment 30 30
Tax due from shareholder (15) 17
Effective tax rate on dividend 15/100 47/100
=15% =47%
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Payout policies (new change ***)
 Types of dividend policies
 Stable dividend policy;
 Constant dividend payout ratio policy (seldom used);
 Residual dividend policy.
 Stable dividend policy
 Regular dividends are paid that generally do not reflect short-term volatility in earnings;
 Target payout adjustment model
 A target payout ratio is a goal that represents the proportion of earnings that the company
intends to distribute (pay out) to shareholders as dividends over the long term;
 The expected increase in dividends=(Expected earnings x target payout ratio – previous
dividend) x adjustment factor; ***
 Adjustment factor is one divided by the number of years over which the adjustment in
dividends should take place.
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Example: Target payout approach ***
 Last year Luna Inc. had earnings of $2.00 a share and paid a regular dividend of
$0.40. For the current year, the company anticipates earnings of $2.80. It has a 30
percent target payout ratio and uses a 4-year period to adjust the dividend. Compute
the expected dividend for the current year.
 Correct Answer:
Expected dividend = Last dividend + (Expected earnings x Target payout ratio –
Previous dividend) x Adjustment factor
= $0.40 + [($2.80x 0.3-0.4) x (1/4)]
= $0.40 + ($0.44 x 0.25)
= $0.51
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Payout policies
 Residual dividend model

 An intuitively appealing dividend policy that is rarely used in practice because it
typically results in highly volatile dividend payments.
 The residual dividend policy is based on
 Paying out dividends after the full amount of any internally generated funds
remaining after financing with the target capital structure;
 Equity financing comes from reinvested earnings rather than new share
issuance;
 Puts investment in positive NPV projects ahead of considerations of not
reducing the dividend.
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Payout policies
 Steps to determine the target payout ratio
 Identify the optimal capital budget;
 Calculate the equity amount needed to finance for the given capital structure;
 Meet the requirement of the equity by using retained earnings as much as possible;
 Dividends are paid with the residual earnings available after the needs for optimal
capital budgets are met.
Dividend = Earnings
– (Capital budget * Equity% in capital structure)
or zero, whichever is greater
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Example: residual dividend model
 Suppose a company has €900 million in planned capital spending (representing positive NPV
projects). The company’s target capital structure is 60 percent debt and 40 percent
equity. Given that the company follows a residual dividend policy, the company’s indicated
dividend with earnings of €500 million, is closest to:
A. €140 million.
B. €360 million.
C. €500 million.
 Correct Answer: A.
The company will obtain €900 million x 0.60 = €540 million in new debt financing. The rest
€900 million - €540 million = €360 million is financed internally.
After excluding €360 million investing in the new project, the rest €140 million is used to
pay out in dividends.
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Example: residual dividend approach
 Target Debt/Equity Ratio of 30/70 (dollars in millions)
$100 capital budget $150 capital budget
Earnings $100 $100
Capital spending $100 $150
Financed from new debt 0.3*$100=$30 0.3*$150=$45
Financed from retained earnings 0.7*$100=$70 (0.7*$150>$100)=$100
Financed from new equity or debt $0 $5
Residual cash flow = residual dividend $100-$70=$30 $100-$100=0
Implied payout ratio 30/100=30% 0
 The $150 million in capital spending requires $105 million in equity ($150*0.7), which
is greater than the company’s total earnings of $100 million. The company would
probably finance the shortfall with debt, temporarily deviating from target capital
structure, rather than use more costly external equity financing.
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Payout policies
 Advantages
 Simple to use;
 Maximizes the earnings to investment.
 Disadvantage
 Dividend fluctuates with investment opportunities and earnings;
 Uncertainty cause higher excepted return and lower valuation.
D1
rs  P0  
rs  g
 To overcome the problem of volatile dividends, companies may use a long-term residual
dividend approach to smooth their dividend payments.
 The approach would involve forecasting earnings and capital expenditures in the
future.
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Share repurchase methods
 Share repurchase: a share repurchase is a transaction in which a company buys back

its own shares.
 Treasury shares: shares that have been issued and subsequently repurchased are
classified as treasury shares if they may be reissued or canceled shares if they will
be retired; in either case, they are not then considered for dividends, voting, or
computing earnings per share.
 Share repurchase methods
 Buy in the open market: this method of share repurchase is the most common,
with the company buying its own shares as conditions warrant in the open market.
(most flexible option)
 The open market share repurchase method gives the company maximum
flexibility.
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Share repurchase methods
 Share repurchase methods
 Buy back a fixed number of shares at fixed price
 Make a fixed price tender offer to repurchase a specific number of shares at a fixed price
that is typically at a premium to the current market price;
 A fixed price tender offer can be accomplished quickly.
 Dutch auction
 A Dutch auction is also a tender offer to existing shareholders, but instead of specifying a
fixed price for a specific number of shares, the company stipulates a range of acceptable
prices;
 Dutch auctions can be accomplished in a short time period.
 Repurchase by direct negotiation
 In some markets, a company may negotiate with a major shareholder to buy back its shares,
often at a premium to the market price.
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Financial statement effects of repurchases
 Share repurchase using the company’s surplus cash (internal financing)

 B/S
 Asset and equity decreases
 Leverage ratio (D/E) increases
 I/S
 Earnings yield<interest income and earnings, EPS decreases
 Earnings yield>interest income and earnings, EPS increases
 Earnings yield=interest income and earnings, EPS constant
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 Share repurchase using debt to finance the repurchase (external financing)
 B/S
 Asset constant, equity decreases
 Leverage (D/E) increases
 I/S
 Earnings yield<after-tax cost of financing the repurchase, EPS decreases
 Earnings yield>after-tax cost of financing the repurchase, EPS increases
 Earnings yield=after-tax cost of financing the repurchase, EPS constant
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 Jensen Farms Inc. plans to borrow $12 million, which it will use to repurchase shares.
The following information is given:
 Share price at time of share repurchase = $60
 Earnings after tax = $6.6 million
 EPS before share repurchase = $3
 Price/Earnings ratio (P/E) = $60/$3 = 20
 Earnings yield (E/P) = $3/$60 = 5%
 Shares outstanding = 2.2 million
 Planned share repurchase = 200,000 shares
1) Calculate the EPS after the share repurchase, assuming the after-tax cost of
borrowing is 5%.
2) Calculate the EPS after the share repurchase, assuming the company’s borrowing
rate is 6%, 4%
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 Solution to 1:
total earnings -after-tax cost of fund
EPS after buyback=
shares outstanding after buyback
$6.6 million-(12 million  0.05)

(2.2 million-0.2 million) shares
$6.6 million-$0.6 million

2 million shares
= $3.00

EPS after buyback=
 Solution to 2:


2 million shares
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= $2.94
Effects of share repurchase on EPS
 Correct Answer:
EPS after buyback with borrowing rate of 4%

EPS after buyback=


2 million shares
= $3.06
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Effects of share repurchase on BVPS
 BVPS > market price (repurchase price), BVPS increases

 BVPS < market price (repurchase price), BVPS decreases
 BVPS = market price (repurchase price), BVPS constant
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 The market price of both Company A’s and Company B's common stock is $20 a share,
and each company has 10 million shares outstanding. Both companies have announced a
$5 million buyback.
 Company A has a book value of equity of $100 million and BVPS of $100 million/10
million shares = $10. The market price per share of $20 is greater than BVPS of
$10,
 Company B has a book value of equity of $300 million and BVPS of $300 million/10
million shares = $30. The market price per share of $20 is less than BVPS of $30,
Calculate the BVPS of each company after the share repurchase.
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 Correct Answer:
Both companies
 buy back 250,000 shares at the market price per share ($5 million buyback/$20 per
share = 250,000 shares);
 are left with 9.75 million shares outstanding (10 million pre-buyback shares - 0.25
million repurchased shares = 9.75 million shares).
After the share repurchase
 Company A’s shareholders’ equity at book value falls to $95 million ($100 million - $5
million), and its book value per share decreases from $10 to $9.74 (shareholders’
equity/shares outstanding = $95 million/9.75 million shares = $9.74).
 Company B’s shareholders’ equity at book value falls to $295 million ($300 million - $5
million), and its book value per share increases from $30 to $30.26 (shareholders’
equity/shares outstanding = $295 million/9.75 million = $30.26).
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Payout policies - repurchase vs. cash dividend
 Repurchase vs. cash dividend
 Share repurchases are equivalent to cash dividends of equal amount in their effect on shareholders’ wealth, all other
things being equal.
 Rationales for share repurchase
 Tax advantages
 In jurisdictions that tax shareholder dividends at higher rates than capital gains, share repurchases have a
tax advantage over cash dividends.
 Share price support/signaling
 Added flexibility
 Share repurchase programs appear not to create the expectation among investors of continuance in the
future;
 Share repurchase by open market purchase does not typically create an obligation to follow through with
repurchases.
 Offsetting dilution from employee stock options
 Increase financial leverage
 Share repurchases increase leverage;
 Modify the company’s capital structure.
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Example: share repurchase and cash dividend
 Example: impact of share repurchase and cash dividend
ABC Company has 30 million shares outstanding with a current market value of $60 per
share. In the most recent quarter, ABC has made $150 million in profits, and only 80%
of these profits will be reinvested into the company, ABC's Board of Directors is
considering two alternatives for distributing the remaining 20% to shareholders
 Pay cash dividend: $30 million / 30 million shares = $1 per share
 Repurchase $30 million worth of common stock.
 Assuming that
 Dividends are received when the shares go ex-dividend;
 The stock can be repurchased at the market price of $60;
 There are no differences in tax treatment between two choices.
 How would the wealth of an ABC shareholder be affected by the board's decision
on the method of distribution?
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 Correct Answer:
 Share repurchase
 With $30 million, ABC could repurchase $30,000,000 / $60 = 500,000 shares
of common stock.
 The share price after the repurchase is as
 30,000,000 $60 - $30,000,000  $1770,000,000  $60
30,000,000 - 500,000 29,500,000
 Total wealth from the ownership of one share = $60.
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 Cash dividend
 After the shares go ex-dividend, for each share, shareholders would have $1 in
cash and a share worth $60 - $1 = $59
 The ex-dividend value of $59 can also be calculated as:
 30,000,000  $60  - $30,000,000  $59
30,000,000
 Total wealth from the ownership of one share = $59+ $1 = $60.
Cash dividend = share repurchase, in terms

of the effect on shareholders’ wealth
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Summary
Indicator Cash div. Stock div. Stock split Repurchase

No. of shares No changes Increase Increase Decrease
Ex-div Increased if
Pro-rata
Stock price Ex-div signal is
(pro-rata) decrease
positive
EPS No change Decrease Decrease Uncertain
P/E Decrease No change No change Uncertain
Decrease by Decreased by
Market value No change No change
cash paid cash paid
Share owned
No changes Increase Increase Depends
by individual
Decrease in
Ownership value but
No changes No change Increase
value same in % of
ownership
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Payout policies
 Global trends in payout policy

 Typically, a lower percentage of companies in a given US stock market index have
paid dividends than have companies in a comparable European stock market index;
 The fraction of companies paying cash dividends has been in long-term decline in
most developed markets
 Since the early 1980s in the United States and the early 1990s in the United
Kingdom and continental Europe, the fraction of companies engaging in share
repurchases has trended upward.
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Analysis of dividend safety
 Calculation of dividend coverage ratio

 Net income method
 Dividend coverage ratio = net income/dividend paid
 Free cash flow method
 FCFE coverage ratio = FCFE/(dividends + share repurchases)
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Example: dividend sustainability analysis
 Harley Davidson, Inc. (NYSE symbol HOG) produces and sells luxury motorcycles in
the United States and Europe. The company has paid dividends since 1993.
2006 2007 2008

NI 1,043 934 655
CFO 762 798 (685)
FCInv 220 242 332
Net borrowing 493 352 1,845
Dividend paid 213 261 302
Stock repurchase 936 1,132 249
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 1. Using the above information, calculate the following for 2006, 2007, and 2008:
A. Dividend/earnings payout ratio
B. Earnings/dividend coverage ratio
C. Free cash flow to equity (FCFE)
D. FCFE/ [dividend + stock repurchase] coverage ratio
2. Discuss the trend in earnings/dividend coverage as compared with the trend in
FCFE/[dividend + stock repurchase] coverage.
3. Comment on the sustainability of HOG’s dividend and stocks repurchase policy after
2008.
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 Correct Answer to 1:
A. Dividend/earnings payout = $213/$1,043 = 0.20 or 20 percent in 2006, 0.28 or 28
percent in 2007, and 0.46 or 46 percent in 2008.
B. Earnings/dividend coverage = $1,043/$213 = 4.9x in 2006, 3.6x in 2007, and 2.2x
in 2008.
C. FCFE = Cash flow from operations (CFO) - FCInv + Net borrowing = $762 - $220 +
$493 = $1,035 in 2006, $798 - $242 + $352 = $908 in 2007, and $828 in 2008.
D. FCFE coverage of dividends + share repurchases = FCFE/dividends + stock
repurchases = $1,035/($213 + $936) = 0.90x in 2006. Similar calculations result in
0.65x in 2007 and 1.50x in 2008.
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 Correct Answer to 2:
Earnings/dividend coverage declined over the three years. Still, even in 2008,
accounting earnings were more than twice the amount necessary to pay the dividend.
An analyst who looked at only this metric might not have suspected problems.
The FCFE coverage of both the dividend and stock repurchases was less than 1 in
2006 and 2007, indicating the company was reducing liquidity (and/or consciously
electing to move to a more leveraged capital structure) by returning money to
shareholders. The increase in this ratio to 1.5x in 2008 was the result of net
borrowings. Harley was funding almost everything (negative CFO, capital expenditures,
dividends, and share buyouts) with new borrowings. Analysis of FCFE generation in
2008, showing its reliance on net borrowing, was a better indicator of problems latent
in Harley’s payout policies than earnings/dividend coverage.
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 Correct answer to 3:
Funding dividends and stock repurchases with net borrowings is a short-term
proposition and not a sustainable policy. Something has to give: cut the dividend and/or
curtail share repurchases.
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Corporate Performance,
Governance, and Business
Ethics
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1. Stakeholders of a company
2. Stakeholders Impact Analysis
3. An agency relationship
4. Roots of unethical behavior
5. Ethical considerations
6. Philosophical Approaches to Ethics
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Stakeholders of a company
 A company's stakeholders can be divided into internal stakeholders and external

stakeholders.
Internal Stakeholders
Classification Interests and Concerns
Stockholders Maximize the return on their investment
Employees Salary, job satisfaction, etc.
Managers
Board members
External Stakeholders
Classification Interests and Concerns
Customers Reliable products
Suppliers Revenues and dependable buyers
Creditors Receive principle and interest on time
Governments Companies to obey the rules
Unions Union members’ benefit
Local communities Responsible citizens
www.zecaiedu.cn General public The quality of life will be improved
Stakeholders impact analysis
 The reason of a stakeholders impact analysis
 The goals of different groups of stakeholders may conflict. A company must identify the
most important stakeholders and give highest priority to pursuing strategies that satisfy
their needs.
 Three stakeholder groups must be satisfied above all others if a company is to survive and
prosper: customers, employees, and stockholders.
Maximize Shareholders’ Maximize the company’

return long-run profitability
 Conflict of interest
 Not all stakeholder groups want the company to maximize its long-run profitability and
profit growth;
 Suppliers want to receive higher prices for their goods and services;
 Customers want to receive lower prices for the products they purchase from the company.
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An agency relationship
 A principal-agent relationship
Principal
Shareholders
A principal-agent problem
The agent may act for his
authority
Delegate
Board of
directors own well being rather than
(BOD) that of the principal.
Agent
Management
Ensure management is
acting in the best
interest of shareholders
Company
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 Agency relationship
 An agency relationship arises whenever one party delegates decision-making authority
or control over resources to another;
 The relationship between stockholders and senior managers is the classic example of
an agency relationship.
 Potential conflicts between
 Managers and shareholders
 Although the manager is responsible for advancing the shareholder’s best interests,
this may not happen
 Use funds to try to expand the size of the business;
 Grant themselves numerous and expensive perquisites;
 Make business decisions like investing in highly risky ventures;
 Investors and other stakeholders are unable to evaluate the company’s financial position
and riskiness.
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 Potential conflicts between

 Directors and shareholders
 The conflict between directors and shareholders arises when directors come to
identify with the managers’ interests rather than those of the shareholders.
 The board is not independent;
 The members of the board have business or personal relationships with the
managers;
 Many corporations have been found to have interlinked boards;
 The frequently overly generous compensation paid to directors for their services.
 Agency problem is not confined to the relationship between senior managers and
stockholders.
 It can also bedevil the relationship between the CEO and subordinates, and between
them and their subordinates.
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 The challenge for principals is

 Shape the behavior of agents;
 Reduce the information asymmetry between agents and principals;
 Develop mechanisms for removing agents who do not act in accordance with the
goals of principals and mislead them.
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Roots of unethical behavior
 Unethical behavior often arises in a corporate setting when managers decide to put the attainment
of their own personal goals, or the goals of the enterprise, above the fundamental rights of one or
more stakeholder groups.
 Self-dealing occurs when managers find a way to feather their own nests with corporate monies.
 Information manipulation occurs when managers want to enhance their own financial situation or
the competitive position of the firm.
 Anticompetitive behavior covers a range of actions aimed at harming actual or potential
competitors.
 Opportunistic exploitation violates the rights of suppliers.
 Substandard working conditions arise when managers want to reduce company’s costs of
production.
 Environmental degradation occurs when the firm takes actions that directly or indirectly result
in pollution or other forms of environmental harm.
 Corruption occurs when managers pay bribes to gain access to lucrative business contracts.
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Roots of unethical behavior
 Root cause of unethical behavior

 Personal ethical code ;
 Unconscious conduct of behaving unethically;
 Organizational culture that de-emphasizes business ethics and considers all
decisions to be purely economic ones;
 Pressure from top management to meet performance goals;
 Unethical leadership.
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Ethical considerations
 Managers can and should do at least seven things to ensure that basic ethical
principles are adhered to and that ethical issues are routinely considered when
making business decisions.
 Favor hiring and promoting people with a well-grounded sense of personal ethics;
 Build an organizational culture that places a high value on ethical behavior;
 Make sure that leaders within the business not only articulate the rhetoric of
ethical behavior but also act in a manner that is consistent with that rhetoric;
 Put decision-making processes in place that require people to consider the ethical
dimension of business decisions;
 Hire ethics officers;
 Put strong governance processes in place;
 Act with moral courage.
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Philosophical Approaches to Ethics
 The Friedman Doctrine (stockholder theory)
 The only social responsibility of business is to increase profits, as long as the com-
pany stays within the rules of law;
 A company should have no "social responsibility" to the public or society because
its only concern is to increase profits for itself and for its shareholders.
 Weakness: have no regard for potential harm, justice.
 Utilitarian and Kantian ethics
 From a utilitarian perspective, the best decisions are those that produce the
greatest good for the greatest number of people.
 Weakness: have no regard for potential harm, justice.
 Kantian ethics indicate that people are not instruments, like a machine. People
have dignity and need to be respected as such.
 Weakness: have no place for moral emotions or sentiments.
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Philosophical Approaches to Ethics
 Rights theories
 Rights theories recognize that human beings have fundamental rights and
privileges. Rights establish a minimum level of morally acceptable behavior (e.g.
the right to free speech).
 Justice theories
 The first principle is that each person should be permitted the maximum amount
of basic liberty compatible with a similar liberty for others. Rawls takes these
liberties to be political liberty (the right to vote), freedom of speech and
assembly, liberty of conscience and freedom of thought, the freedom and right to
hold personal property, and freedom from arbitrary arrest and seizure.
 The second principle is that once equal basic liberty is ensured, inequality in basic
social goods— such as income, wealth, and opportunities—is to be allowed only if it
benefits everyone.
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Corporate Governance
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1. What Is The Corporate Governance
2. Three Major Business Forms
3. Responsibilities of The Board of Directors
4. Corporate Governance Best Practices
5. Corporate Governance Policies: Investors And Analysts Should Assess
6. The Strength And Effectiveness of A Corporate Governance System
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What is the corporate governance?
 Corporate governance is the system of principles, policies, procedures, and clearly defined
responsibilities and accountabilities used by stakeholders to overcome the conflicts of
interest inherent in the corporate form.
 Two major objectives of corporate governance
 To eliminate or mitigate conflicts of interest;
 To ensure that the assets of the company are used efficiently and productively and in
the best interests of its stakeholders.
 The core attributes of an effective corporate governance system are
 Delineation of the rights of shareholders and other core stakeholders;
 Clearly defined manager and director governance responsibilities;
 Identifiable and measurable accountabilities for the performance of the
responsibilities;
 Fairness and equitable treatment in all dealings;
 Complete transparency and accuracy in disclosures regarding operations, performance,
risk, and financial position.
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Three major business forms
 Sole proprietorship is a business owned and operated by a single person. Liability unlimited,
easy to set up.
 Fewer risks than the corporation because the manager and the owner are one and the
same;
 the major corporate governance risks are those faced by creditors and suppliers of
goods and services to the business.
 Partnerships are composed of more than one owner/manager. Liability unlimited, similar
to sole proprietorship, more recourses.
 Two advantages
 Pooling together of financial capital of the partners;
 Sharing of business risk among them.
 Overcome conflicts of interest internally by engaging in partnership contracts
specifying the rights and responsibilities of each partner;
 Conflicts of interest with entities outside the partnership are similar to sole
proprietorship.
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Three major business forms
 Corporations are a legal entity, and has rights similar to those of a person. The chief
officers of the corporation act as agents for the firm.
 Advantages
 Corporations can raise very large amounts of capital by issuing either stocks or
bonds to the investing public;
 Corporate owners need not be experts in the industry or management of the
business;
 Stock ownership is easily transferable;
 Corporations to have unlimited life, shareholders have limited liability.
 Disadvantage
 Subject to more regulation than are partnerships or sole proprietorships;
 Managers are the agents who act on behalf of the shareholders, and conflicts of
interest exists.
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Responsibilities of the board of directors
 Responsibilities of the board of directors

 Establish corporate values and governance structures for the company;
 Ensure that all legal and regulatory requirements are met;
 Establish long-term strategic objectives for the company;
 Establish clear lines of responsibility and a strong system of accountability and
performance;
 Hire the chief executive officer, determine the compensation package, and peri-
odically evaluate the officer’s performance;
 Ensure that management has supplied the board with sufficient information;
 Meet regularly to perform its duties, and meet in extraordinary session if
required;
 Acquire adequate training.
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Evaluate effectiveness of BOD
 Analyst might evaluate the board of directors in following aspects
 Board composition and independence;
 Independent chairman of the board;
 Qualifications of directors;
 Annual election of directors;
 Annual board self-assessment;
 Separate sessions of independent directors;
 Audit committee and audit oversight;
 Nomination committee;
 Compensation committee;
 Board's independent legal and expert counsel;
 Statement of governance policies;
 Disclosure and transparency;
 Insider or related-party transactions;
 Responsiveness of board of directors to shareholder proxy votes.
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 Board composition and independence
 Best practice: at least three-quarters of board members should be independent.
 Factors that often indicate a lack of independence include
 Former employment with the company;
 Business relationships;
 Personal relationships;
 Interlocking directorships;
 Ongoing banking or other creditor relationships.
 Independent chairman of the board
 Many companies have a single individual serve the dual role of CEO and Chairman of the
Board;
 Independence of the chairman of the board does not guarantee that the board will function
properly, but should be regarded as a necessary condition, even if it is not a sufficient one.
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 Qualification of directors
 Best practice
 Board members have the requisite industry, strategic planning, and risk
management knowledge (expertise in the industry);
 Not serve on more than two or three boards (dedication to the board);
 Show a commitment to investor interests and ethical management and investing
principles (dedication to investors).
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 Annual election of directors

 Proponents of staggered elections say that they ensure board continuity;
 But strong corporate governance practice says that staggered elections limits the
power of shareholders and doesn't allow changes to the board composition to
occur quickly;
 Annual elections force directors to make more careful decisions and be more
attentive to shareholders because they can cast a vote to keep or eliminate a
director each year.
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 Annual board self-assessment

 Boards should evaluate and assess their effectiveness at least annually.
 The review should include
 Board’s effectiveness as a whole;
 Performance of board members;
 Board committee activities;
 Effectiveness in monitoring and overseeing their specific functions;
 Future needs of the board;
 Report of the board self-assessment.
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 Separate sessions of independent directors

 Best practice
 Independent directors of the board meet at least annually, and preferably
quarterly, in separate sessions;
 The purpose of these sessions is to provide an opportunity for those entrusted
with the best interests of the shareholders;
 Separate sessions could also enhance the board’s effectiveness by improving the
cooperation among board members, and their cohesiveness as a board.
 Regulatory filings should indicate how often boards have met, and which meetings
were separate sessions of the independent directors;
 The investment professional should be concerned if such meetings appeared to be
nonexistent, infrequent, or irregular in occurrence.
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 Audit committee & audit oversight
 The audit committee of the board is established to provide independent oversight of the
company’s financial reporting, non-financial corporate disclosure, and internal control systems.
 Best practice: the audit committee must
 Include only independent directors;
 Have adequate accounting and auditing expertise;
 Oversee the internal audit function;
 Have sufficient resources to be able to properly fulfill their responsibilities;
 Have full access to and the cooperation of management;
 Have authority to investigate fully any matters within its purview;
 Have the authority for the hiring of auditors;
 Meet with auditors independently at least once annually;
 Have the full authority to review the audit and financial statements.
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 Nominating committee
 Best practice
 Nominees to the board be selected by a nominating committee comprising only
independent directors.
 Responsibilities of the nominating committee
 Establish criteria for evaluating candidates of directors;
 Identify candidates for the board and committees;
 Review the qualifications of the nominees to the board;
 Establish criteria for evaluating nominees for senior management positions in the
company;
 Identify candidates for management positions;
 A review the qualifications of the nominees;
 Document the reasons for the selection of candidates.
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 Compensation committee
 The compensation should include incentives to meet and exceed corporate long-
term goals, rather than short-term performance targets.
 Different types of compensation awards
 Salary, generally set by contractual commitments between the company and the
executive or director;
 Perquisites, additional compensation in the form of benefits;
 Bonus awards, normally based on performance as compared to company goals and
objectives;
 Stock options, options on future awards of company stock;
 Stock awards or restricted stock.
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 Board’s independent or expert legal counsel

 The BOD should hire expert legal counsel to fulfill its fiduciary duties and assess
the company's compliance with regulatory requirements.
 Poor corporate governance
 Internal corporate counsel to advise the BOD.
 Best practice
 The board use independent, outside counsel whenever legal counsel is required.
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 Statement of governance policies

 Should assess the following
 Codes of ethics;
 Directors' oversight, monitoring, and review responsibilities;
 Management’s responsibility to the board;
 Reports of directors’ oversight and review function;
 Board self assessments;
 Management performance assessments;
 Director training.
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 Disclosure and transparency

 Investors depend on timely, complete, and accurate financial statements to value
securities, inaccurate financial data can result in mispriced securities, thus reduce
the efficiency of financial markets.
 Best practice
 More disclosure is better;
 A company should provide information about organization structure, corporate
strategy, insider transactions, compensation policies, and changes to governance
structures.
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 Insider or related party transactions

 The analyst should assess the company's policies concerning related-party
transactions, whether the company has entered into any such transactions, and, if
so, what the effects are on the company's financial statements.
 Best practice
 Any related-party transaction should require the prior approval of the BOD and
a statement that such transactions are consistent with company policy.
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 Responsiveness of board of directors to shareholder proxy votes

 A clear indicator of the extent to which directors and executives take seriously
their fiduciary responsibility to shareholders is the response of the company to
shareholder votes on proxy matters;
 If an important matter such as executive compensation, a merger, or a governance
issue is put to a shareholder vote and management ignores the result of the vote,
it is obvious that management is not motivated by shareholder opinion as to what
is in the best interest of the shareholders.
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Environmental, Social, and Governance Factors
 ESG factors
 Environmental risk: generally considered material in the investment analysis process
include natural resource management, pollution prevention, etc.
 Social risk: pertain to human rights and welfare concerns in the workplace.
 Governance risk: the company’s government structure works effectively.
 The risks from these ESG factors can be categorized as follows
 Legislative and regulatory risk
 Governmental laws and regulations directly or indirectly affecting a company's
operations will change with potentially severe adverse effects on the company's
continued profitability and even its long-term sustainability.
 Investors who consider ESG factors and monitor regulatory and legislative
developments for the companies they follow will be better equipped to make sound
investment decisions.
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 Legal risk
 Failures by company managers to effectively manage ESG factors will lead to lawsuits and
other judicial remedies, resulting in potentially catastrophic losses for the company.
 An investor can begin to analyze the potential for such risks in a particular company by
reviewing regulatory filings for the particular jurisdictions in which the company operates.
 Reputational Risk
 Reputational risk has risen in importance as ESG factors are increasingly recognized as a
potentially major source of risk.
 Companies whose managers have demonstrated a lack of concern for managing ESG factors in
the past will suffer a diminution in market value relative to other companies in the same
industry that may persist for a long period of time.
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 Operating Risk
 The risk that a company’s operations may be severely affected by ESG factors,
even to the requirement that one or more product lines or possibly all operations
might be shut down.
 Financial Risk
 The risk that ESG factors will result in significant costs or other losses to the
company and its shareholders;
 Any of the above sources of risk can affect a company and its financial health,
sometimes severely.
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The strength & effectiveness
 The strength and effectiveness of a corporate governance system
 Strong/effective corporate governance system:
 High measures of profitability;
 Generates higher returns for shareholders.
 Weak/ineffective corporate governance system:
 Risk to investors increase;
 Reducing the value of the company;
 May cause a company to go bankrupt.
 Risks of an ineffective corporate system include
 Accounting risk: the risk that a company’s financial statement recognition and related
disclosures;
 Asset risk: the risk that the firm’s assets will be misappropriated by managers or directors;
 Liability risk: the risk that management will enter into excessive obligations;
 Strategic policy risk: the risk that managers may enter into transactions.
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Mergers and Acquisitions
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1. Categorize Merger And Acquisition Activities
2. Bootstrapping *
3. The Industry Life Cycle And Merger Motivations
4. Key Differences Between Forms of Acquisition
5. Method of Payment And US Antitrust Legislation
6. Takeover Defense Mechanisms: Pre-offer And Post-offer
7. The Herfindahl-Hirschman Index (HHI)
8. Valuing A Target Company: Three Basic Methods
9. Evaluating A Merger Bid
10.Downsizing Operations Through Corporate Restructuring

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Categorize merger and acquisition activities
 Types of mergers
 In a horizontal merger, the acquirer company and the merging companies are in the
same kind of business, usually as competitors.
 Motivations
 The pursuit of economies of scale;
 To increase market power.
 In a vertical merger, the acquirer buys another company in the same production chain.
 A vertical merger may provide greater control over the production process.
 In a conglomerate merger, an acquirer purchases another company that is unrelated
to its core business.
 Synergies from combining the two companies
 Reduce the volatility of the conglomerate’s total cash flows;
 Company level diversification is not necessarily in the shareholders’ best interests.
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 Forms of integration
 In a statutory merger, one of the companies ceases to exist as an identifiable
entity and all its assets and liabilities become part of the purchasing company.
A + B = A
 In a subsidiary merger, the company being purchased becomes a subsidiary of the
purchaser.
A + B = A + B
 With a consolidation, both companies terminate their previous legal existence and
become part of a newly formed company.
A + B = C
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 Merger motivations
 Synergies
 1 + 1 > 2;
 Cost saving due to economies of scale;
 Revenue synergies are created through the cross-selling of products, expanded market share,
or higher prices arising from reduced competition.
 Growth
 Making investments internally (organic growth) or buying the necessary resources externally
(external growth);
 It is typically faster for companies to grow externally. Growth through M&A activity is
common when a company is in a mature industry;
 External growth can also mitigate risk. It is considered less risky to merge with an existing
company than to enter an unfamiliar market and establish the resources internally.
 Increasing market power
 Both vertical and horizon integration increase market power.
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 Acquiring unique capabilities and resources
 Many companies undertake a merger or an acquisition either to pursue competitive
advantages or to shore up lacking resources.
 Diversification
 Not in the best interest of the conglomerate’s shareholders.
 Bootstrapping earnings
 Possible to create the illusion of synergies or growth.
 Personal benefits for managers
 Manger’s compensation highly related to company size;
 Corporate executives may be motivated by self-aggrandizement.
 Tax benefits
 A target with tax losses has the tax shield, but not legally approved if the primary
reason for merger is tax avoidance.
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 Unlocking hidden value
 Sometimes mergers are conducted because the acquirer believes that it is
purchasing assets for below their replacement cost.
 Achieving international business goals
 Exploiting market imperfections;
 Overcoming adverse government policy;
 Technology transfer;
 Product differentiation;
 Following client.
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Bootstrapping earnings
 Bootstrapping occurs when a company’s earnings increase as a consequence of the merger
transaction itself (rather than because of resulting economic benefits of the
combination).
 The “bootstrap effect” occurs when the shares of the acquirer trade at a higher price-
earnings ratio (P/E) than those of the target and the acquirer’s P/E does not decline
following the merger.
 If the market is efficient, the post-merger P/E should adjust to the weighted average of
the two companies’ contributions to the merged company’s earnings.
 The market usually recognizes the bootstrapping effect, and post-merger P/Es adjust
accordingly.
 But there have been periods when bootstrapping seemed to pay off for managers, at least
in the short run.
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The industry life cycle and merger motivations
Industry Types of
Life cycle Motivations
characteristics mergers
• Younger, smaller
companies may sell
themselves to larger
companies in mature
or declining
• Industry exhibits
industries and look
substantial
for ways to enter
Pioneering development costs • Conglomerate;
into a new growth
development and has low, but • Horizontal.
industry;
slowly increasing,
• Young companies
sales growth.
may look to merge
with companies that
allow them to pool
management and
capital resources.
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Industry Types of
• Explosive growth in
• Industry exhibits
sales may require
Rapid high profit margins
large capital • Conglomerate;
accelerating caused by few
requirements to • Horizontal.
growth participants in the
expand existing
market.
capacity.
• Mergers may be
• Industry experiences
undertaken to
a drop in the entry of
Mature achieve economies • Horizontal;
new competitors, but
growth of scale, savings, and • Vertical.
growth potential
operational
remains.
efficiencies.
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Industry Types of
• Mergers may be undertaken
to achieve economies of scale
in research, production, and
marketing to match the low
cost and price performance
Stabilization • Industry faces
of other companies (domestic
and market competition • Horizontal.
and foreign).
mature and constraints.
• Large companies may acquire
smaller companies to
improve management and
provide a broader financial
base.
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Industry
Life cycle Motivations Types of mergers
characteristics
• Horizontal mergers may be
undertaken to ensure
survival;
• Vertical mergers may be
carried out to increase
• Industry faces
Deceleration efficiency and profit • Horizontal;
overcapacity
of growth margins; • Vertical;
and eroding
and decline • Companies in related • Conglomerate.
profit margins.
industries may merge to
exploit synergy;
• Companies in this industry
may acquire companies in
young industries.
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Form of acquisition
 Form of acquisition
 Stock purchase
 A stock purchase occurs when the acquirer gives the target company’s
shareholders some combination of cash and securities in exchange for shares of
the target company’s stock;
 Stock purchases are the most common form of acquisition;
 The target company’s shareholders exchange their shares for compensation and
must pay tax on their gains, but there are no tax consequences at the corporate
level;
 Use of a target’s accumulated tax losses is allowable in the United States for
stock purchases;
 The acquiring company assumes the target company’s liabilities.
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Form of acquisition
 Asset purchase
 When the assets > 50% of the company, shareholder approval is required.
 Advantage
 It can be conducted more quickly and easily than a stock purchase because
shareholder approval is not normally required unless a substantial proportion of the
assets are being sold;
 An acquirer can focus on buying the parts of a company of particular interest.
 No direct tax consequences for the target company’s shareholders, but the
target company itself may be subject to corporate taxes.
 Specifically avoid assuming liabilities is fraught with legal risk because courts
have tended to hold acquirers responsible for the liabilities in these cases.
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Key differences between forms of acquisition
Major Differences of Stock versus Asset Purchases

Stock purchase Asset purchase
Payment • Target shareholders • Payment is made to the selling
receive compensation company rather than directly to
in exchange for their the shareholders.
shares.
Approval • Shareholder approval • Shareholder approval might not
required. be required.
Tax: corporate • No corporate level tax. • Target company pays taxes on

any capital gains.
Tax: shareholder • Target company’s • No direct tax consequence for
shareholders are taxed target company's shareholders.
on their capital gains.
Liabilities of target • Acquirer assumes the • Acquirer generally avoids the
target’s liabilities. assumption of liabilities.
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Method of payment
 Method of payment
 A securities offering, a cash offering, and combination of the two.
 In a securities offering, the target shareholders receive shares of the acquirer’s common
stock as compensation.
 In a cash offering, the cash might come from the acquiring company’s existing assets or from
a debt issue.
 Exchange ratio
 Definition
 The exchange ratio determines the number of shares that stockholders in the target company receive
in exchange for each of their shares in the target company.
 Because share prices are constantly fluctuating, exchange ratios are typically negotiated in
advance for a range of stock prices.
 The acquirer's cost is the product of the exchange ratio, the number of outstanding shares of
the target company, and the value of the stock given to target shareholders.
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Method of payment
 Factors to be considered when deciding payment method
 The distribution of risk and reward between acquirer and target shareholders
 When an acquiring company's management is highly confident both in their ability to
complete the merger and in the value created by the merger, they are more inclined
to negotiate for a cash offering.
 Relative valuations of the companies involved in the transaction
 When an acquirer's shares are considered overvalued relative to the target's shares,
stock financing is more appropriate;
 stock offerings interpreted as overvaluation of acquirer’s shares.
 The accompanying change in capital structure
 Borrowing to raise funds for a cash offering increases the acquirer’s financial
leverage and risk;
 Issuing a significant number of new common shares for a stock offering can dilute
the ownership interests of existing shareholders.
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Mind-set of target management
 Attitude of target management
 In a friendly merger, the acquirer will generally start the process by approaching target
management directly.
 The negotiations revolve around the consideration to be received by the target company’s
shareholders and the terms of the transaction as well as other aspects, such as the post-
merger management structure;
 The defensive merger agreement contains the details of the transaction, including the terms,
warranties, conditions, termination details, and the rights of all parties;
 The target shareholders approving the stock purchase or the acquirer shareholders approving
the issuance of a significant number of new shares, the material facts are provided to the
appropriate shareholders in a public document called proxy statement;
 Target shareholders receive the consideration agreed upon under the terms of the
transaction, and the companies are officially and legally combined.
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Mind-Set of Target Management
 Attitude of target management:

 Hostile merger offers
 Bear hug: in a hostile merger, which is a merger that is opposed by the target
company's management, the acquirer may decide to circumvent the target
management's objections by submitting a merger proposal directly to the target
company's board of directors and bypassing the CEO.
 If the bear hug is not successful, then the hopeful acquirer will attempt to
appeal more directly to the target company’s shareholders.
 Tender offer: the acquirer invites target shareholders to submit their shares in
return for the proposed payment.
 Proxy battle: a company or individual seeks to take control of a company through a
shareholder vote.
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Takeover defense mechanisms
 When a target is faced with a hostile tender offer (takeover) attempt, the target managers and board of
directors face a choice
 Sell the company to hostile bidder or third party;
 Attempt to remain independent.
 If the mangers and BOD decided to keep independent, a series of defense actions will be taken to protect
from taking over.
 A target might use defensive measures to delay, negotiate a better deal for shareholders, or attempt to
keep the company independent.
 Pre-offer takeover defense
 Two broad varieties are rights-based defenses, such as poison pills and poison puts, and a variety of
changes to the corporate charter that are sometimes collectively referred to as shark repellents.
 Post-offer takeover defense
 Typically used in conjunction with pre-offer defenses.
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 Pre-offer defense mechanisms
 Poison pill
 Flip-in pill: the common shareholder of the target company has the right to buy its shares at
a discount;
 Flip-over pill: the target company’s common shareholders receive the right to purchase
shares of the acquiring company at a significant discount from the market price;
 Dead hand provision: the provision allows the board of the target to redeem or cancel the
poison pill only by a vote of the continuing directors.
 Poison put
 It gives rights to the bondholders of the target;
 In the event of takeover, it allows bondholders to put the bonds to the target;
 Increase the need for cash and raises the cost of acquisition.
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 States with restrictive takeover laws
 Companies that anticipate the possibility of a hostile takeover attempt may find it attractive
to reincorporate in a jurisdiction that has enacted strict anti-takeover laws.
 Staggered board
 Only a part of board of directors are due to election each year;
 It delays the control of boards by acquiring company due to freeze of election of most of
board members in the coming future.
 Restricted voting rights
 Restricts stockholders who have recently acquired large blocks of stock from voting their
shares;
 The possibility of owning a controlling position in the target without being able to vote the
shares serves as deterrent.
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 Supermajority voting provision
 Many target companies change their charter and bylaws to provide for a higher
percentage approval by shareholders for mergers than normally is required.
 Fair price amendment
 A term in corporate charter and bylaws that disallow mergers for which the
offer is below a certain threshold.
 Golden parachutes
 Allows the senior management of the target to receive lucrative payouts if they
leave the target following a change in corporate control;
 Encourage key executives to stay with the target as the takeover progresses
and the target explores to generate shareholder value.
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 Post-offer defense mechanisms
 “Just say no” defense
 If the acquirer attempts a bear hug or tender offer, then target management
typically lobbies the board of directors and shareholders to decline and build a
case for why the offering price is inadequate or why the offer is otherwise not
in the shareholders’ best interests.
 Litigation
 File a lawsuit against the acquiring company based on alleged violations of
securities or antitrust laws.
 Greenmail
 This technique involves an agreement allowing the target to repurchase its own
shares back from the acquiring company, usually at a premium to the market
price.
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 Share repurchase
 Rather than repurchasing only the shares held by the acquiring company, as in
greenmail, a target might use a share repurchase to acquire shares from any
shareholder.
 Leveraged recapitalization
 Repurchase of shares with assumption of a large amount of debt.
 Crown jewel defense
 Target sells off assets to party upon announcement of taking-over;
 This part of assets to be sold might be significant;
 It makes target unattractive to acquiring company.
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 Pac-man defense
 The target can defend itself by making a counteroffer to acquire the hostile
bidder.
 White knight defense (overpay of winner, winner’s curse)
 The target company to seek a third party to acquire the target;
 It may increase the biding price if the white knight appears.
 White squire defense
 The target seeks a friendly-party to buy a substantial minority stake the target;
 It will block the hostile takeover without selling the entire company. (high
litigation risk due to direct buying from target but no compensation for target’s
shareholders).
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Antitrust law and HHI
 US antitrust legislation
 1890
 The Sherman Antitrust Act (monopolize is illegal).
 1914
 The Clayton Antitrust Act (detail the business practice).
 1950
 The Celler-Kefauver Act (acquisition of asset, conglomerate not just previous
shares acquisition, horizontal).
 1976
 The Hart-Scott-Rodino Antitrust Improvements Act (required to be review an
approve in advance).
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Antitrust law and HHI
 The HHI is calculated by summing the squares of the market shares for each company in an
industry.
n
HHI   ( MSi 100) 2
i 1
MSi = market share of firm i
n = number of firms in the industry
 HHI concentration level and likelihood of antitrust action

Government
Post-merger HHI Concentration Change in HHI
action
Less than 1,000 Not concentrated Any amount No action
Between 1,000 and Moderately
100 or more Possible challenge
1,800 concentrated
Highly
More than 1,800 50 or more Challenge
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Valuing a target company
 The three basic methods that analysts use to value target companies in an M&A
transaction are
 Discounted cash flow analysis;
 Comparable company analysis;
 Comparable transaction analysis.
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Discounted cash flow analysis
 Discounted cash flow analysis: similar to the free cash flow to the firm (FCFF)
approach.
 Select the model used for the analysis;
 Estimate pro forma ratio for financial information needed;
 Calculate FCF;
 Calculate the present value of the FCF at the appropriate discount rate;
 Calculate the terminal value of the company, and calculate its present value;
 Calculate the value of the target firm based on the previous calculation.
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 Discounted cash flow analysis: similar to the free cash flow to the firm (FCFF)
approach.
Net income
+Net interest after tax
=unlevered net income
+change in deferred taxes
=Net operating profit less adjusted taxes(NOPLAT)
+Net noncash charges
-Change in net working capital
-Capital expenditures(capex)
=Free cash flow(FCF)
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 Discounted cash flow analysis – several concerns

 Terminal value can be reached by
 Perpetuity growth from a certain years’ estimate, like Gordon growth model.
FCFT (1+g)
Terminal valueT 
(WACCadjusted  g )
 Use multiplier that the analyst believes that the firm will trade at the end of
the first stage.
P
Terminal valueT  FCFT 
FCF
 Discount rate
 The discount rate is adjusted WACC to reflect the risk of the target.
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Summary: discounted cash flow analysis
 Summary: discounted cash flow analysis
 Advantages
 Expected changes in the target company’s cash flows;
 An estimate of intrinsic value based on forecast fundamentals is provided by the model;
 Changes in assumptions and estimates can be incorporated by customizing and modifying
the mode.
 Disadvantages
 It is difficult to apply when free cash flows do not align with profitability within the
first stage;
 Estimating cash flows and earnings far into the future is exact;
 Estimates of discount rates can change over time;
 Terminal value estimates often subject the acquisition value calculations to a
disproportionate degree of estimate error.
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Comparable company analysis
 Comparable company analysis
 The analyst first defines a set of other companies that are similar to the target
company under review;
 Calculate various relative value measures based on the current market prices of
the comparable companies in the sample;
 Calculate various relative value metrics to produce a different estimate for the
target’s value.
 The estimated stock value of the target is a mean of value estimated with
various multiples;
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 Comparable company analysis

 To calculate an acquisition value, the analyst must also estimate a takeover
premium.
DP-SP
PRM=
SP
 PRM= takeover premium as a percentage of stock price;

 DP= deal price per share of the target company;
 SP= stock price of target company.
 To calculate the relevant takeover premium for a transaction, analysts usually
compile a list of the takeover premiums paid for companies similar to the target.
 Target’s takeover price = estimated stock value  1  PRM 
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 Step 1: define a set of other companies that are similar to the target
Valuation variables Company1 Company2 Company3

•Current stock price 20 32 16
•Earnings per share 1.00 1.82 0.93
•Cash flows per share 2.55 3.90 2.25
•Book value per share 6.87 12.80 5.35
•Sales per share 12.62 18.82 7.62
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 Step 2: calculate various relative value measures based on the current market prices
of the comparable companies in the sample.
Valuation ratio Company1 Company2 Company3 Mean

P/E 20.00 17.58 17.20 18.26
P/CF 7.84 8.21 7.11 7.72
P/BV 2.91 2.50 2.99 2.80
P/S 1.58 1.70 2.10 1.79
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 Step 3: calculate various relative value metrics to produce a different estimate for
the target’s value.
Target Comparable Mean Estimated stock

Target company company companies’ value based on
Valuation variables valuation comparables
a variable b a*b
Earnings per share 1.95 P/E 18.26 35.61
Cash flows per share 4.12 P/CF 7.72 31.81
Book value per share 12.15 P/BV 2.80 34.02
Sales per share 18.11 P/S 1.79 32.42
Estimated stock value Mean 33.47
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 Step 4: estimate a takeover premium.

 PRM = takeover premium as a percentage of stock price DP  SP
PRM 
 DP = deal price per share of the target company SP
 SP = stock price of target company
Target Stock price prior to Take over

Take over price
company takeover premium
V 23.00 28.50 23.9%
W 17.25 22.65 31.3%
X 86.75 102.00 17.6%
Y 45.00 43.75 19.4%
Z 36.75 45.00 22.4%
Mean premium 22.9%
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 Step 5: calculate the takeover price
 Target's take over price  estimated stock value  1  PRM 
 Target’s estimated stock value (Step 4) $33.47
 Estimated take over premium (Step 5) 22.9%
 Estimated takeover price of target $33.47x1.229 = $41.14
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Summary: comparable company analysis
 Summary: comparable company analysis
 Advantages
 A reasonable approximation of a target company’s value relative to similar companies in
the market;
 Most of the required data are readily available;
 The estimates of value are derived directly from the market.
 Disadvantages
 The method is sensitive to market mispricing;
 Using this approach yields a market-estimated fair stock price for the target company;
 The analysis may be inaccurate because it is difficult for the analyst to incorporate any
specific plans for the target;
 The data available for past premiums may not be accurate for the particular target
company under consideration.
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Comparable transaction approach
 Comparable transaction analysis uses details from recent takeover transactions for
comparable companies to make direct estimates of the target company’s takeover value.
 Collect a relevant sample of recent takeover transactions.
 Look at the same types of relative value multiples that were used in comparable
company analysis.
 The price used in calculating in the comparable multiples is the takeover price not
the stock price prior transaction.
 Look at descriptive statistics and apply judgment and experience when applying that
information to estimate the target’s value.
 The estimated takeover price is the mean of value estimated with various multiples.
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 Step 1: collect a relevant sample of recent takeover transactions
Acquired Acquired Acquired

Valuation variables
Company1 Company2 company3
Current stock price 35.00 16.50 87.00
Earnings per share 2.12 0.89 4.37
Cash flows per share 3.06 1.98 7.95
Book value per share 9.62 4.90 21.62
Sales per share 15.26 7.61 32.66
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 Step 2: look at the same types of relative value multiples that were used in
comparable company analysis.
Valuation Acquired Acquired Acquired Mean

ratio Company1 Company2 company3
P/E 16.5 18.5 19.9 18.3
P/CF 11.4 8.3 10.9 10.2
P/BV 3.6 3.4 4.0 3.7
P/S 2.3 2.2 2.7 2.4
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 Step 3: look at descriptive statistics and apply judgment and experience when
applying that information to estimate the target’s value
Estimated
Target Target Comparable Weighted
Mean stock value Weight
company company companies’ estimated
based on
Valuation valuation
b comparables d
variables a variable cxd
a x b=c
Earnings per
2.62 P/E 18.3 47.95 20% 9.59
share
Cash flows
4.33 P/CF 10.2 44.17 40% 17.67
per share
Book value
12.65 P/BV 3.7 46.81 20% 9.36
per share
Sales per
22.98 P/S 2.4 55.15 20% 11.03
share
Estimated stock value Mean 47.65
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 Summary: comparable transaction approach
 Advantages
 It is not necessary to separately estimate a takeover premium;
 The takeover value estimates come directly from values that were recently established in the
market;
 The use of prices established through other recent transactions reduces litigation risk for
both companies’ board of directors and managers regarding the merger transaction’s pricing.
 Disadvantages
 There is a risk that the real takeover values in past transactions were not accurate;
 There may not be any, or an adequate number of, comparable transactions to use for
calculating the takeover value;
 The analysis may be inaccurate because it is difficult for the analyst to incorporate any
specific plans for the target.
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Evaluating a merger bid
 Post-merger value of an acquirer

VAT  VA  VT  S  C
VAT  post - merger value of the combined company (acquirer and target)
VA  pre - merger value of acquirer
VT = pre - merger value of target
S  synergies created by the merger
C  cash paid to target shareholders
 Gains accrued to the target
GainT  TP  PT  VT
GainT  gains accrued to target shareholders
TP  takeover premium
PT  price paid for target
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VT  pre - merger value of target
Evaluating a merger bid
 Gains accrued to the acquirer
GainA  S  TP  S  ( PT  VT )
GainA  gains accrued to the acquirer shareholders
 Cash payment versus stock payment
 The choice of payment method is influenced by both parties’ confidence in the
estimated synergies and the relative value of the acquirer’s shares.
PT  N  PAT
N  number of new shares the target receives.
PAT  price per share of combined firm after the merger announcement
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Effects of price and payment method
 Effect of price
 The acquirer wants to pay the lowest price;
 The target wants to receive the highest price.
 Effect of payment method
 Cash offer: cash offer is the most straightforward and easiest to evaluate, and
the risk and rewards bear by acquirer firm;
 Stock offer: target company shareholders assume a portion of the reward as well
as a portion of the risk related to the estimated synergies and the target
company’s value;
 The more the merger is paid for with the acquirer’s stock, the more that the risks
and benefits of realizing synergies will be passed on to the target shareholders.
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Who benefits from merger?
 Distribution of merger benefits: empirical evidence related to the distribution of benefits in a merger.
 Short-term performance studies show
 Target shareholders reap 30% premiums over the stock's pre-announcement market price, and the
acquirer's stock price falls between 1 and 3%;
 On average, both the acquirer and target tend to see higher stock returns surrounding cash offers
than around share offers.
 The high average premiums paid to target shareholders may be attributed to the winner's curse.
 Hubris of acquirers’ mgt by overestimating synergies. Even if no synergies from a merger, managerial
hubris would still lead to higher-than-market bids and a transfer of wealth from the acquirer's
shareholders to the target's shareholders
 Longer term performance studies show
 Merger transactions create value for target company shareholders in the short run;
 Both the acquirer and target tend to see higher stock returns surrounding cash acquisition offers
than around share offers.
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Who benefits from merger?
 Characteristics of M&A deals that create value
 The buyer is strong
 Acquirers whose earnings and share prices grow at a rate above the industry
average for three years before the acquisition earn statistically significant
positive returns on announcement.
 The transaction premiums are relatively low
 Acquirers earn negative returns on announcement when paying a high premium.
 The number of bidders is low
 Acquirer stock returns are negatively related to the number of bidders.
 The initial market reaction is favorable
 Initial market reaction is an important barometer for the value investors place
on the gains from merging as well as an indication of future returns.
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Corporate restructuring
 Divestitures
 Definition
 A company decides to sell, liquidate, or spin off a division or a subsidiary.
 Ways for company to divest assets
 Equity carve-outs, involves the creation of a new legal entity and sales of equity in it to
outsiders;
 Spin-offs, parent company shareholders receive a proportional number of shares in a new,
separate entity; Whereas the sale of a division results in an inflow of cash to the parent
company, a spin-off does not;
 Split-offs, some of shareholders of parent company are given shares in new entity in
exchange for shares of the parent company;
 Liquidations involves breaking up a company, division, or subsidiary and selling off its assets
piecemeal.
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Corporate restructuring
 Previous mergers that did not work out as planned are not the only reason companies may choose to
divest assets.
 Some of the common reasons for restructuring
 Change in strategic focus: either through acquisitions or other investments over time,
companies often become engaged in multiple markets.
 Poor fit (low profit)
 Reverse synergy: individual parts are worth more than the whole.
 Managers may feel that a segment of the company is undervalued by the market because of
poor performance;
 It is possible that the division and the company will be worth more separately than combined.
 Financial or CF needs: if times are tough, managers may decide to sell off portions of the
company as a means by which to raise cash or cut expenses.
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CFA ®

Kyle Wang CFA

 Basic principles of capital budgeting

Create the firm-wide capital budget

Monitoring decisions and conducting a post-

Depreciation methods affect capital budgeting decisions

Ownership Year Class of Investment

CF  (S  C )(1  t )  D  t

Old Equipment New Equipment

Both projects have a 10 percent required rate of return.

A. 1 and 5. B. 2, 3, and 4 C. 2, 4, 5, and 6.

Combination Combined NPV

Dependent Required rate of return 12%

Variable Base case With Low With High Range of

Salvage 121,157 112,037 127,236 15,199

Treat independent for

 Steps in Monte Carlo simulation

 Overestimate the NPV, if project’s risk > company’s risk;

 Timing options: the company can delay investing.

 Flexibility options: once an investment is made, other operational flexibilities may be

 Critical assumptions of traditional capital budgeting tools

 The investment decision is made now;

 No flexibility considered in future decisions.

 More reasonable approach: assume that the corporation is making sequential

 This future flexibility, exercised intelligently, enhances the value of capital

 Economic income is the profit realized from an investment.

 How to understand economic income

PV0 CF1 CF2

 Economic income Vs. Accounting income

Economic income Accounting income

 Alternative forms of determining income should theoretically lead to the same

 Economic profit (EP)

= NOPAT - $WACC = EBIT x (1-T) – WACC x capital

 EP reflects the income earned by all capital holders;

 Alternative forms of determining income should theoretically lead to the same

 RI reflects the income to equity holders only

1. Economic income during year one is closest to:

CF1  58, 000

1. Capital Structure Objective

 The objective of a company’s capital structure (D/E) decision is to determine the

Optimal capital structure

Minimize cost of capital

Maximize the value of company

 Capital structure theory

 MM theory 1958  No taxes, no costs of financial distress;

 MM theory 1963  With taxes, no costs of financial distress;

MM: Modigliani - Miller

Under different assumptions of taxes, transaction costs,

 MM proposition 1 without taxes: capital structure irrelevance

 MM proposition 2 without taxes: higher leverage raises the cost of equity

 MM proposition 1 (with taxes)

 Difference between Proposition 2 without taxes and with taxes

 The static trade-off theory is a theory pertaining to a company’s optimal capital

 Key points of static trade-off theory

 Static trade-off theory

 Debt ratings are an important consideration in the practical management of leverage.

 Institutional and legal factors

 The importance of auditors is usually strongest in emerging markets, whereas

1. Dividends policy and company value theory

 The effect on shareholders’ wealth and financial ratios

Before dividend After dividend

 The effect on a two-for-one stock split

Before split After split

2021CFA二级公司金融基础班 PDF

2021CFA二级公司金融基础班 PDF