Spring  
14  

Corporate  finance  
Anders  Bäckström  
Summary  of  the  course  Corporate  finance  7,5  HP  

S t o c k h o l m   B u s i n e s s   S c h o o l  
Corporate  Finance   Anders  Bäckström   2014-­‐03-­‐10  
 
Introduction  
 
The  goal  of  the  firm  is  to  maximize  shareholder  wealth.  Which  is  done  via  maximizing  
the  share  price.  
 
There  are  different  relationships  between  different  stakeholders.  For  example  between  
stockholders  and  managers,  stockholders  and  bondholders,  the  firm  and  the  financial  
markets  and  lastly  between  the  firm  and  society.  In  all  these  relations.  There  might  be  
contradicting  interests  that  refer  to  as  agency  problems  and/or  agency  costs.  The  goal  of  
maximizing  shareholder  wealth  might  be  fulfilled  because  of  conflicts  between  different  
parties.  These  problems  are  some  times  referred  to  as  the  agency  theory.  
 
The  agency  problems  occurs  when  the  goals  of  the  principal  and  agent  conflict.  The  
principal  must  provide  incentives  so  that  management  acts  in  the  principals’  best  
interest  and  then  monitor  results.  Incentives  include  stock  options,  perquisites  and  
bonuses.  These  costs,  that  arises  when  working  through  an  agent  are  called  agency  costs  
and  consists  of  three  types.  Direct  contracting  costs,  monitoring  costs  and  loss  of  
principal’s  wealth  due  to  residual,  unresolved  agency  problems.  
 
In  order  to  maximize  the  shareholders’  wealth,  the  firm  must  take  four  types  of  financial  
decisions:  financing,  investment,  liquidity  and  dividend  decisions.  
 
1. Investment  decisions  
 
In  order  to  create  cash  flows  that  maximize  shareholders’  wealth,  the  firm  must  invest  in  
fixed  assets.  These  are  often  long  term  decisions  that  involve  large  expenditures  and  are  
thus  very  important  for  the  firm’s  future.  To  be  able  to  do  the  investments  that  best  fulfil  
the  firm’s  purpose,  the  management  should  evaluate  the  projects,  which  can  be  done  
with  different  methods.  
 
• Payback  Period  (PBP)  
o This  is  the  simplest  method  of  evaluating  an  investment.  The  analyst  
simply  calculates  the  amount  of  years  it  will  take  for  the  company  to  get  
the  invested  money  back.  The  four  steps  in  calculating  the  pay  back  period  
are:  
§ Create  a  cash  flow  time  line  
§ Add  a  line  for  cumulative  cash  flow  
§ Identify  the  last  year  that  cumulative  cash  flow  is  negative,  we  call  
it  A.  
§ Payback  period  is  than  calculated  as  follows:  
 
𝐶𝐶𝐹!
𝑃𝑎𝑦𝑏𝑎𝑐𝑘  𝑝𝑒𝑟𝑖𝑜𝑑 = 𝐴 +    
𝐶𝐹!!!
 
o The  rule  is  to  invest  if  the  payback  period  is  shorter  than  some  specified  
period.  
o This  method  is  easy  but  not  very  good.  The  method  does  not  take  the  time  
value  of  money  or  the  riskiness  of  the  project  into  account.  Nor  does  it  
take  cash  flows  that  come  after  the  payback  period  into  account.  
Corporate  Finance   Anders  Bäckström   2014-­‐03-­‐10  
 
• Discounted  Payback  Period  (DPBP)  
o This  is  a  way  to  solve  some  of  the  problems  with  the  simple  payback  
period.  The  method  has  the  following  steps  
§ Create  a  cash  flow  line  
§ Convert  cash  flows  to  present  value  
§ Add  a  line  for  cumulative  present  value  cash  flows  PV(CCF)  
§ Identify  the  last  year  that  cumulative  present  value  cash  flow  is  
negative,  we  call  it  A  
§ Discounted  Payback  Period  is  calculated  as  follows  
 
𝑃𝑉𝐶𝐶𝐹!
𝑃𝑎𝑦𝑏𝑎𝑐𝑘  𝑝𝑒𝑟𝑖𝑜𝑑 = 𝐴 +    
𝑃𝑉𝐶𝐹!!!
 
o The  rule  is  to  invest  if  the  discounted  payback  period  is  shorter  than  some  
specified  period.  
o This  method  takes  the  riskiness  of  the  problem  as  well  as  the  time  value  of  
money  into  account,  but  it  does  not  take  cash  flows  after  the  payback  
period  into  account.  
 
• Net  Precent  Value  (NPV)  
o This  is  the  most  widely  accepted  method  that  is  some  times  called  the  
mother  of  all  models.  The  investor  calculates  the  net  present  value  of  all  
future  cash  flows  that  the  specific  investment  should  yield.  The  process  is  
as  follows:  
§ Estimate  the  positive  and  negative  future  cash  flows  that  the  
investment  will  give.    
§ Discount  these  with  till  today  with  the  discount  rate.  
• The  discount  rate  is  often  the  WACC,  but  can  deviate  from  
this  depending  on  the  risk  profile  of  the  investment.  
§ Subtract  the  capital  investment  from  the  present  value  of  future  
cash  flows.  If  the  NPV  is  zero  or  above,  you  should  accept  the  
investment,  but  if  it  is  below  zero,  you  should  reject.  
 
𝒏
𝑪𝑭𝒕
𝑵𝑷𝑽 =   −   𝑪𝑭𝟎  
𝟏+𝒓 𝒕
𝒕!𝟏
 
• The  Internal  Rate  of  Return  (IRR)  
o The  IRR  is  the  discount  rate  that  makes  the  NPV  equal  to  zero.  The  higher  
the  IRR,  the  better  the  project  is.  In  some  cense,  the  IRR  can  be  viewed  as  
the  rate  of  return  that  the  investment  will  yield.  If  the  IRR  is  at  least  as  
high  as  the  discount  rate,  you  should  accept  the  project.  However  if  the  
cash  flow  will  change  sign  more  than  once,  you  might  get  multiple  IRRs,  
which  creates  a  problem.  In  these  cases,  NPV  is  the  only  method  that  
works.  
 
𝑪𝟏 𝑪𝟐 𝑪𝒕
−𝑪𝟎 + 𝟏
+ 𝟐
+ ⋯+ 𝒕
= 𝟎  
𝟏+𝒓 𝟏+𝒓 𝟏+𝒓
 
Corporate  Finance   Anders  Bäckström   2014-­‐03-­‐10  
 
There  are  different  types  of  projects  and  some  of  the  might  complicate  the  investing  
decisions.  Projects  are  independent  if  the  cash  flows  of  one  project  are  unaffected  of  the  
acceptance  of  the  other  project.  Put  differently:  all  projects  can  be  undertaken  given  that  
the  company  has  sufficient  funds.  The  company  should  always  accept  independent  
projects  that  have  a  positive  NPV.  If  some  has  to  be  chosen,  the  ones  with  the  highest  
NPV  ought  to  be  undertaken,  everything  else  held  constant.  NPV  and  IRR  will  provide  
the  same  ranking  in  this  case.  If  instead  one  projects  cash  flow  can  be  adversely  
impacted  by  the  acceptance  of  the  other  project,  or  if  only  one  of  the  projects  can  be  
undertaken,  the  projects  are  mutually  exclusive.  If  the  projects  have  similar  life  times,  
accept  the  project  with  the  highest  NPV.  There  might  be  conflicts  in  the  rankings  
between  NPV  and  IRR  due  to  the  scale  of  the  investment,  the  cash  flow  patterns  or  the  
project  life.    
§ Implicit  assumptions  the  reinvestment  of  intermediate  cash  flows  –  cash  inflows  
received  prior  to  the  termination  of  a  project:  
§ NPV  assumes  intermediate  CF  are  invested  at  the  discount  rate  
§ IRR  assumes  intermediate  CF  are  invested  at  the  IRR  
§ Solution  
§ Assume  intermediate  CF  reinvested  at  the  hurdle  rate  
§ Calculate  the  IRR  from  initial  investment  and  terminal  value:  This  is  the  
modified  IRR  (MIRR)  

 
 
Projects  compared  must  have  the  same  risk  and  discount  rate.  
 
When  mutually  exclusive  project  have  unequal  life  times,  we  cannot  just  use  the  NPV  
rule,  why  we  calculate  the  Equivalent  Annual  Annuity.  
• Equivalent  Annual  Annuity  
o The  value  of  the  level  payment  annuity  that  has  the  same  PV  as  our  
original  set  of  cash  flows.  
§ Convert  the  net  present  values  of  the  options  into  equivalent  
annuities.  
§ After  annualizing  the  NPVs  a  direct  comparison  between  (among)  
different  projects  can  be  made.  
 
𝑁𝑃𝑉
𝐸𝐴𝐴 =    
1 − 1 + 𝑟 !!
𝑟
 
§ Capital  rationing  occurs  when  a  company  chooses  not  to  fund  all  positive  NPV  
projects.  
§ The  company  typically  sets  an  upper  limit  on  the  total  amount  of  capital  
expenditures  that  it  will  make  in  the  upcoming  year.  
§ The  Profitability  Index  approach  is  most  useful  in  capital  rationing  situations,  
where  not  all  positive  NPV  projects  can  be  accepted  due  to  a  limited  capital  
budget.  
§ This  is  calculated  by  dividing  the  present  value  of  a  project’s  cash  inflows  
by  the  present  value  of  its  outflows.  
 
Corporate  Finance   Anders  Bäckström   2014-­‐03-­‐10  
 
• The  investment  decision  issue  
• Requires  estimates  of:  
o Relevant  Cash  flows  
o Cost  of  capital  
§ Cost  of  equity;  
§ Cost  of  preference  stock;  
§ Cost  of  debt;  
§ WACC  
 
Estimating  cash  flows  
The  key  to  analysing  a  new  project  is  always  to  think  incrementally.  It  is  the  incremental  
cash  flows  that  is  of  interest,  why  it  is  important  to  consider  the  effect  on  the  firms  other  
investments  when  evaluating  the  investment.  The  following  are  the  mayor  components:  
1. Initial  cash  flow  
a. This  is  the  initial  investment,  but  if  the  company  gets  any  after-­‐tax  cash  
inflows  from  liquidation  of  old  assets,  these  need  to  be  considered.  
i. +  Cost  of  new  assets  
ii. +  Capitalized  expenditures  
iii. +  (-­‐)  Increased  (decreased)  net  working  capital  
iv. –  Net  proceeds  from  sale  of  an  old  asset,  if  replacement  
v. +  (-­‐)  Taxes  (savings)  due  to  the  sale  of  old  asset(s)  if  replaced  
vi. =  Initial  cash  outflow  
2. Operating  (incremental)  cash  flows  
a. The  new  asset  will  produce  operating  cash  flows,  but  you  need  to  deduct  
operating  cash  flows  that  the  company  would  have  gotten  from  the  old  
asset  that  are  now  liquidated.  
i. +  (-­‐)  Net  increase  (decrease)  in  operating  revenue  less  (plus)  any  
net  increase  (decrease)  in  operating  expenses,  excluding  
depreciation  
ii. –  (+)  Net  increase  (decrease)  in  tax  depreciation  
iii. =  Net  change  in  income  before  taxes  
iv. –  (+)  Net  increase  (decrease)  in  taxes  
v. =  Net  change  in  income  after  taxes  
vi. +  (-­‐)  Net  increase  (decrease)  in  tax  depreciation  changes  and  
changes  in  working  capital  
vii. =  Incremental  net  cash  flow  for  a  period  
3. Terminal  cash  flow  
a. This  is  after-­‐tax  cash  flows  from  termination  of  a  new  asset  but  you  need  
to  deduct  the  after-­‐tax  cash  flows  from  termination  of  the  old  asset  
i. Calculate  the  incremental  terminal  net  cash  fow  for  the  terminal  
period  
ii. +(-­‐)  Salvage  value  (disposal/reclamation  costs)  of  any  sold  or  
disposed  assets  
iii. –  (+)  Taxes  (tax  savings)  due  to  asset  sale  or  disposal  of  “new”  
assets  
iv. +  (-­‐)  Decreased  (increased)  level  of  net  working  capital  
v. =  Terminal  year  incremental  net  cash  flow  
 
 
Corporate  Finance   Anders  Bäckström   2014-­‐03-­‐10  
 
• Free  cash  flows  to  the  firm  (FCFF)  
o These  represents  the  cash  flows  to  which  all  stakeholders  make  claim  
 
𝐹𝐶𝐹𝐹 = 𝐸𝐵𝐼𝑇 1 − 𝑡 + 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛  𝑎𝑛𝑑  𝑎𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛 − 𝐶𝐴𝑃𝐸𝑋 − ∆𝑊𝐶  
 
• Free  cash  flows  to  equity  (FCFE)  
o These  cash  flows  represents  those  to  equity  holders  
 
𝐹𝐶𝐹𝐸 = 𝑁𝑒𝑡  𝑖𝑛𝑐𝑜𝑚𝑒 + 𝑁𝑜𝑛𝑐𝑎𝑠ℎ  𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠 − 𝐶𝐴𝑃𝐸𝑋 −   ∆𝑊𝐶 − 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙  𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠
− 𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒  𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠  
 
o Principal  payment  
§ -­‐  if  principal  payment  are  made  
§ +  if  new  loans  are  taken  
 
To  be  able  to  forecast  future  cash  flows,  we  need  to  estimate  the  growth,  which  we  do  
the  following  way.  
• Expected  growth  in  net  income  
o 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛  𝑟𝑎𝑡𝑖𝑜 ∗ 𝑅𝑂𝐸  
!"#"$%&$' !"#  !"#$%&
!!
!"#  !"#$%& !""#  !"#$%  !"  !"#$%&
 
• Expected  growth  in  operating  income  
o 𝑅𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡  𝑟𝑎𝑡𝑒 ∗ 𝑅𝑂𝐶  
!"#  !"#$%!∆!" !"#$(!!!)
!"#$(!!!) !""#  !"#$%  !"  !"#$%"&
 
Estimating  the  discount  rate  
The  discount  rate  needs  to  take  the  risk  into  account.  The  discount  rate  chosen  depends  
on  the  source(s)  of  finance  for  the  project.  The  cost  of  common  equity  are  adjusted  for  
the  equity  risk,  the  cost  of  preferred  equity  for  the  preferred  equity  risk,  the  cost  of  debt  
for  the  debt  risk  and  finally,  the  cost  of  capital  takes  the  risk  of  all  stake  holders  into  
account.    
 
𝐷 𝐸 𝐸(𝐷𝐼𝑉!" ) 𝑃𝑆
𝑊𝐴𝐶𝐶 =   𝑟! 1 − 𝑡 + 𝑟! +  
𝐷 + 𝐸 + 𝑃𝑆 𝐷 + 𝐸 + 𝑃𝑆 𝑃!" 𝐷 + 𝐸 + 𝑃𝑆
 
Estimating  the  cost  of  equity  
The  cost  of  equity  can  be  approximated  by  the  expected  equity  return  for  the  equity  
holders  
𝑟! = 𝑟! + 𝛽 𝑟! − 𝑟!  
 
𝜎! 𝜎!,!
𝛽! = 𝜌!,! = !  
𝜎! 𝜎!
 
𝛽!
𝛽! =  
𝐷
1+ 1−𝑡 𝐸
 
Corporate  Finance   Anders  Bäckström   2014-­‐03-­‐10  
 
In  the  bottom-­‐up  approach,  the  risk  of  the  firm  and  the  risk  of  the  financial  leverage  are  
separated.  The  firm  risk,  or  unlevered  beta  are  affected  by  the  nature  of  the  product  or  
service  offered  by  the  company,  where  more  discretionary  products/services  generates  
higher  betas.  For  example  luxury  goods  are  highly  cyclical  and  thus  generates  short-­‐run  
volatility.  Other  things  equal,  cyclical  and  growth  firms  as  well  as  firms  selling  exclusive  
products  ought  to  have  higher  betas.  The  firm  risk  however  is  also  affected  by  the  
operating  leverage,  that  is  the  fixed  costs  as  a  percentage  of  revenue.  If  the  proportion  of  
fixed  costs  is  high,  the  company  becomes  inflexible  and  thus  more  risky.  Young  and  
small  firms  as  well  as  firms  with  high  infrastructure  should  have  higher  betas.  Lastly,  the  
total  risk  of  the  firm  and  therefore  the  levered  beta  are  also  affected  by  the  financial  
leverage.  Firms  that  have  a  greater  proportion  of  debt  are  more  risky  and  therefore  have  
higher  betas.  
 
Steps  in  the  bottom-­‐up  beta  approach  
Step 1: Find the bu siness or businesse s that your firm operates in.

Possible Refinements
Step 2: Find publicly traded firms in each of these businesses and
ob tain their regression betas. Compute the simple averag e across
these regression betas to arrive at an average beta for these publicly If you can, a djust this beta for differences
traded firms. Unlever this average beta u sing the a verage debt to be tween your firm and the comparable
eq uity ratio across the publicly traded firms in the sample. firms on operating leverage a nd product
Unlevered beta for busine ss = Average beta across publicly traded characteristics.
firms/ (1 + (1- t) (Average D/E ratio across firms))

While revenues or operating income

Step 3: Estimate how much value your firm derives from each of are often u sed as weights, it is better
the different businesses it is in. to try to estimate the value of each
bu siness.

Step 4: Compute a weighted average of th e unlevered betas of the If you e xpect the business mix o f your
different busin esses (from step 2) using the weights from step 3. firm to change over time, you can
Bottom-up Unle vered beta for your firm = Weighted average of the change the weights on a year-to-year
un levered betas of the individual bu siness ba sis.

If you e xpect your debt to equity ratio to

Step 5: Compute a levered beta (equity beta) fo r your firm, using change over time, the levered beta will
the market debt to equity ratio for you r firm. change over time.
Le vered bottom-up beta = Unlevered beta (1+ (1-t) (Debt/Equity))

   
Estimating  the  cost  of  debt  
The  cost  of  debt  can  be  estimated  with  the  yield  to  maturity  on  a  long-­‐term,  straight  
bond  if  the  company  have  outstanding  bonds  that  are  traded.  If  the  firm  does  not  have  
outstanding  bonds  that  are  traded,  but  if  they  are  rated,  one  can  use  the  rating  and  and  
adding  a  default  spread  to  the  risk  free  rate.  If  the  firm  has  not  been  rated,  one  can  use  
the  interest  rate  on  a  recently  taken  long-­‐term  loan  from  the  bank.  Lastly,  one  can  
estimate  a  synthetic  rating  for  the  company,  and  use  the  synthetic  rating  to  arrive  at  a  
default  spread  and  a  cost  of  debt.  
 
Estimating  capital  weights.  
Equity  
Market  value  of  equity  should  include  the  following:  
1. Market  value  of  shares  outstanding:  𝑆ℎ𝑎𝑟𝑒𝑠  𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 ∗ 𝐶𝑢𝑟𝑟𝑒𝑛𝑡  𝑠𝑡𝑜𝑐𝑘  𝑝𝑟𝑖𝑐𝑒  
2. Market  value  of  warrants  outstanding  
3. Conversion  option  value  of  outstanding  convertible  bonds  
 
 
Corporate  Finance   Anders  Bäckström   2014-­‐03-­‐10  
 
Preference  shares  
1. 𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒  𝑠ℎ𝑎𝑟𝑒𝑠  𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 ∗ 𝑐𝑢𝑟𝑟𝑒𝑛𝑡  𝑝𝑟𝑖𝑐𝑒  
 
Debt  
The  market  value  of  debt  should  include  
1. The  market  value  of  straight  debt  
a. Estimate  the  market  value  of  debt  from  the  book  value  by  treating  the  
entire  debt  as  one  coupon  bond,  with  a  coupon  (C)  set  equal  to  interest  
expenses,  and  maturity  (n)  equal  to  the  average  maturity  of  all  debt  
outstanding,  and  using  the  current  before-­‐tax  cost  of  debt  (BT  rd).    
 
1
1− 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙
1 + 𝐵𝑇𝑟! !
𝑀𝑉 𝐷 = +  
𝐵𝑇𝑟! 1 + 𝐵𝑇𝑟! !

 
2. The  debt  aspect  of  convertible  bonds  
3. Leases  
 
Often  companies  ad  an  addition  risk  factor  to  the  WACC,  for  example  1,5%  since  there  
are  many  estimations,  in  which  the  analyst  can  do  something  wrong.  
 
Business  valuation  techniques  
§ Discounted  cash  flow  (DCF)  approaches  
§ Dividend  discount  model  (DDM)  
§ Free  cash  flows  to  equity  model  (FCFE  -­‐  direct  approach)  
§ Free  cash  flows  to  the  firm  model  (FCFF-­‐  indirect  approach)  
§ Relative  valuation  approaches  
§ In  relative  valuation,  the  value  of  an  asset  derived  from  the  pricing  of  
‘comparable’  assets  standardized  using  a  common  variable,  e.g.,  earnings,  
cash  flows,  book  values,  and  revenues.  
§ P/E  (capitalization  of  earnings)  
§ Determines  by  the  growth,  payout  and  risk  
§ PEG  Ration  
!
!"#$%
§ !
!"#$%$&'  !"#$%!
 
§ Enterprise  Value/EBITDA  
§ Determines  by  the  growth,  net  capital  expenditure  needs,  leverage  
and  risk.  
§ Price/Book  value  
§ Determines  by  the  growth,  payout,  risk  and  ROE  
§ Price/Sales  ratio  
§ Determines  by  the  growth,  payout,  risk  and  net  margin  
§ P/CF  
§ To  use  a  multiple  you  must  know  what  are  the  fundamentals  that  
determine  the  multiple.  Know  how  changes  in  these  fundamentals  change  
the  multiple  and  know  what  the  distribution  of  the  multiple  looks  like.  
 
 
Corporate  Finance   Anders  Bäckström   2014-­‐03-­‐10  
 
§ Mergers  and  acquisitions    
§ Control  transaction  based  models  (e.g.  value  based  on  acquisition  premia  
of  “similar”  transactions)    
 
Different  valuation  techniques  yields  different  values  and  are  based  on  different  prior  
beliefs.  The  DCF  rests  on  the  assumption  that  the  market  makes  mistakes  and  that  you  
can  find  under-­‐priced  stocks.  The  market  will  however  correct  itself  over  time.  The  
relative  valuation  claims  instead  that  the  market  is  fairly  efficient  and  although  it  makes  
mistakes  on  individual  assets  it  is  correct  on  average.  
 
 
 
2. Financing  decisions  
 
The  firm  takes  decisions  on  how  to  finance  its  assets.  There  are  different  models  that  
describe  the  effect  on  the  firm  value  for  different  mixes  of  financing  sources.    
1. M&M  Capital  structure  theory  –  three  special  cases  
I. Case  1  assumes  no  corporate  or  personal  taxes  and  no  bankruptcy  costs  
i. 𝑉! = 𝐸 + 𝐷 = 𝑉!  
ii. If  an  investor  buys  a  fraction  of  an  unlevered  firm,  he/she  will  
receive  that  fraction  times  the  EBIT  as  net  payoff.    Since  the  
investor  can  buy  debt  as  well  as  equity  in  a  levered  firm,  the  payoff  
will  be  the  same  and  hence,  the  price  of  the  levered  as  well  as  the  
unlevered  firm  needs  to  equate.  
iii. In  this  case  the  WACC  will  remain  constant  when  changing  the  
capital  structure  from  100%  equity  to  100%  debt.    

Cost
    Re

WACC
RD
 

iv.   Debt-to-  
v. In  a  perfect  capital  market,  the  total  value  of  a  firm  is  equal  to  the  
market  value  of  the  total  cash  flows  generated  by  its  assets  and  is  
not  affected  by  its  choice  of  capital  structure.  
vi. The  cost  of  equity  capital  is  simply  the  earnings  yield  and  is  
estimated  as  follows:  

(EBIT-RD D)
Re =
EL

i.  
Corporate  Finance   Anders  Bäckström   2014-­‐03-­‐10  
 
vii. Since  the  value  of  the  firm  is  unchanged  by  leverage,  we  can  
define  the  unlevered  value  (VU)  by  discounting  the  firm’s  expected  
EBIT  by  it  unlevered  equity  cost  (RA):  

EBIT
VU = = E + D = VL
RA

i.  
viii. Cost  of  equity:  

Re = RA + ( RA − RD ) D / E

i.  
b. If  the  firm  has  no  debt,  the  equity  investor  requires  
RA  (cost  of  unlevered  equity).  
c. RA  depends  on  business  risk  of  the  firm.  
d. As  the  firm  uses  debt,  the  equity  cost  increases  due  
to  the  financial  leverage  risk  premium.  
II. Case  2  assumes  corporate,  but  no  personal  taxes  and  no  bankruptcy  costs  
i. Since  the  company  has  a  tax  shield  on  debt  payment,  the  value  of  
the  company  increases  as  the  degree  of  financial  leverage  is  used.  
i. Tax  corrected  cost  of  equity:  

Re = RA + ( RA − RD )(1 − T ) D / E

ii.  
b. Both  the  interest  cost  and  the  financial  leverage  risk-­‐
premium  on  the  equity  cost  are  reduced  by  (1-­‐  T)  
c. As  the  use  of  debt  increases,  WACC  decreases,  and  
therefore  the  value  of  the  firm  in  a  world  with  
corporate  taxes  should  increase    
ii. When  we  include  taxes,  the  WACC  constantly  decreases  as  the  
degree  of  financial  leverage  increases.    
III. Case  3  assumes  corporate,  but  no  personal  taxes,  but  also  that  there  are  
bankruptcy  costs  
i. Direct  costs:  
1. Liquidation  of  assets  
2. Loss  of  tax  losses  (potential  tax  shield  benefits)  
3. Legal  and  accounting  costs  
ii. Indirect  Cost  
1. Increasing  costs  of  doing  business:  
2. Creditors  tightening  trade  credit  terms  
3. Lending  increasing  risk  premiums  and  increasing  
monitoring  surveillance  
4. Loss  of  key  staff  and  increases  in  recruitment  and  retention  
costs  
5. Distracted  management  focused  on  financing  and  not  on  
management  of  business  operations.  
iii. Reduced  sales  revenue:  
1. Management  is  distracted  by  financial  issues  
2. Customers  may  become  wary  and  look  for  other  suppliers  
Corporate  Finance   Anders  Bäckström   2014-­‐03-­‐10  
 
iv. At  some  point,  the  additional  value  of  the  interest  tax  shield  will  be  
offset  by  the  expected  bankruptcy  costs  
v. At  this  point,  the  value  of  the  firm  will  start  to  decrease  and  the  
WACC  will  start  to  increase  as  more  debt  is  added  

 
Cost
    Re

  WAC
RD
 

   
  Debt-to-
  D/ equity
Fir E*
m  
Val

 
vi.  

vii.  
 
Corporate  Finance   Anders  Bäckström   2014-­‐03-­‐10  
 

 
 
 
2. Perking  order  theory  
I. Static  Trade  off  model  ignores  two  issues:  
i. Information  asymmetry  problems  
ii. Agency  problems  
II. These  factors  are  likely  responsible  for  what  Myers  and  Donaldson    call  
the  pecking  order.  
III. The  pecking  order  is  the  order  in  which  firms  prefer  to  raise  financing    
i. Starting  with  internal  cash  flow,    
ii. Debt  and    
iii. Finally  issuing  common  equity  
 
3. Dividend  policy  
Dividend  Policy  refers  to  the  explicit  or  implicit  decision  of  the  Board  of  Directors  
regarding  the  amount  of  residual  earnings  (past  or  present)  that  should  be  distributed  
to  the  shareholders  of  the  corporation.  
Corporate  Finance   Anders  Bäckström   2014-­‐03-­‐10  
 
 
2 business days prior to the Date of Record

Date of Date of
Declaration Record Payment
         
   

Ex Dividend Date is determined

The Board by the Date of Record.
Meets The market value of the shares
and passes the drops by the value of the dividend
motion to per share on market  
  opening…compared
§ There  is  no  legal  obligation  for  firms  to  pay  dividends  to  common  shareholders  
§ Shareholders  cannot  force  a  Board  of  Directors  to  declare  a  dividend,  and  courts  
will  not  interfere  with  the  BOD’s  right  to  make  the  dividend  decision  because:  
§ Board  members  are  jointly  and  severally  liable  for  any  damages  they  may  
cause  
§ Board  members  are  constrained  by  legal  rules  affecting  dividends  
including:  
§ Not  paying  dividends  out  of  capital  
§ Not  paying  dividends  when  that  decision  could  cause  the  firm  to  
become  insolvent  
§ Not  paying  dividends  in  contravention  of  contractual  commitments  
(such  as  debt  covenant  agreements)  

 
 
§ Dividends  can  be  in  the  form  of:  
§ Cash  
§ Special  
§ Additional  Shares  of  Stock  (stock  dividend)  
§ Return  of  Capital  
§ Share  Repurchase  
Corporate  Finance   Anders  Bäckström   2014-­‐03-­‐10  
 
§ If  a  firm  is  dissolved,  at  the  end  of  the  process,  a  final  dividend  of  any  residual  
amount  is  made  to  the  shareholders  –  this  is  known  as  a  liquidating  dividend.  
§ This  decision  is  considered  a  financing  decision  because  the  profits  of  the  
corporation  are  an  important  source  of  financing  available  to  the  firm.    
§ In  the  absence  of  dividends,  corporate  earnings  accrue  to  the  benefit  of  
shareholders  as  retained  earnings  and  are  automatically  reinvested  in  the  
firm.  
§ When  a  cash  dividend  is  declared,  those  funds  leave  the  firm  permanently  
and  irreversibly.  
Distribution  of  earnings  as  dividends  may  starve  the  company  of  funds  required  for  
growth  and  expansion,  and  this  may  cause  the  firm  to  seek  additional  external  capital  
 
Difference  between  interest  and  dividends  
Interest  
§ Interest  is  a  payment  to  lenders  for  the  use  of  their  funds  for  a  given  period  of  
time    
§ Timely  payment  of  the  required  amount  of  interest  is  a  legal  obligation  
§ Failure  to  pay  interest  (and  fulfill  other  contractual  commitments  under  the  bond  
indenture  or  loan  contract)  is  an  act  of  bankruptcy  and  the  lender  has  recourse  
through  the  courts  to  seek  remedies  
§ Secured  lenders  (bondholders)  have  the  first  claim  on  the  firm’s  assets  in  the  
case  of  dissolution  or  in  the  case  of  bankruptcy  
Dividends  
§ A  dividend  is  a  discretionary  payment  made  to  shareholders  
§ The  decision  to  distribute  dividends  is  solely  the  responsibility  of  the  board  of  
directors  
§ Shareholders  are  residual  claimants  of  the  firm  (they  have  the  last,  and  residual  
claim  on  assets  on  dissolution  and  on  profits  after  all  other  claims  have  been  fully  
satisfied)    
 
Signaling  with  payout  policy  
§ Dividend  Smoothing  
§ The  practice  of  maintaining  relatively  constant  dividends  
§ Firm  change  dividends  infrequently  and  dividends  are  much  less  
volatile  than  earnings.    
§ Research  suggests  that  
§ Management  believes  that  investors  prefer  stable  dividends  with  
sustained  growth.  
§ Management  desires  to  maintain  a  long-­‐term  target  level  of  dividends  as  a  
fraction  of  earnings.  
§ Thus,  firms  raise  their  dividends  only  when  they  perceive  a  long-­‐
term  sustainable  increase  in  the  expected  level  of  future  earnings,  
and  cut  them  only  as  a  last  resort.  
 
§ Dividend  Signaling  Hypothesis  
§ The  idea  that  dividend  changes  reflect  managers’  views  about  a  firm’s  
future  earning  prospects  
Corporate  Finance   Anders  Bäckström   2014-­‐03-­‐10  
 
§ If  firms  smooth  dividends,  the  firm’s  dividend  choice  will  contain  
information  regarding  management’s  expectations  of  future  
earnings.  
§ When  a  firm  increases  its  dividend,  it  sends  a  positive  signal  to  investors  that  
management  expects  to  be  able  to  afford  the  higher  dividend  for  the  foreseeable  
future.  
§ When  a  firm  decreases  its  dividend,  it  may  signal  that  management  has  given  up  
hope  that  earnings  will  rebound  in  the  near  term  and  so  need  to  reduce  the  
dividend  to  save  cash.  
§ While  an  increase  of  a  firm’s  dividend  may    
signal  management’s  optimism  regarding  its  future  cash  flows,  it  might  also  
signal  a  lack  of  investment  opportunities.    
§ Conversely,  a  firm  might  cut  its  dividend  to  exploit  new  positive-­‐NPV  investment  
opportunities.  
§ In  this  case,  the  dividend  decrease  might  lead  to  a  positive,  rather  than  
negative,  stock  price  reaction.  
 
There  are  three  schools  of  thought  on  dividends  and  its  effect  on  the  company  
 
1.  If  there  are  no  tax  disadvantages  associated  with  dividends  and  no  costs  
§ Dividends  do  not  matter,  and  dividend  policy  does  not  affect  value.  
§ M&M  
§ Basis:  
§ Investment  policy  and  thus  cash  flows  doesn’t  
change  why  the  value  of  the  firm  cannot  change.  
§ Underlying  Assumptions:  
§ There  are  no  tax  differences  between  dividends  and  
capital  gains.  
§ If  companies  pay  too  much  in  cash,  they  can  issue  
new  stock,  with  no  flotation  costs  or  signaling  
consequences,  to  replace  this  cash.  
§ If  companies  pay  too  little  in  dividends,  they  do  not  
use  the  excess  cash  for  bad  projects  or  acquisitions.  
§  
2.  If  dividends  have  a  tax  disadvantage,  
§ Dividends  are  bad,  and  increasing  dividends  will  reduce  value  
§ Basis:    
§ Dividends  are  taxed  more  heavily  than  capital  gains.  
A  stockholder  will  therefore  prefer  to  receive  capital  
gains  over  dividends.    
§ Additionally,    
§ Flotation  costs  –  low  payouts  can  decrease  the  
amount  of  capital  that  needs  to  be  raised,  thereby  
lowering  flotation  costs  
§ Dividend  restrictions  –  debt  contracts  might  limit  the  
percentage  of  income  that  can  be  paid  out  as  
dividends  
3.  If  stockholders  like  dividends,  or  dividends  operate  as  a  signal  of  future  prospects,  
§ Dividends  are  good,  and  increasing  dividends  will  increase  value  
Corporate  Finance   Anders  Bäckström   2014-­‐03-­‐10  
 
§ The  bird  in  the  hand  fallacy:  Dividends  are  better  than  capital  
gains  because  dividends  are  certain  and  capital  gains  are  not.  
§ Argument:  Dividends  now  are  more  certain  than  capital  
gains  later.  Hence  dividends  are  more  valuable  than  capital  
gains.  
§ Counter:  The  appropriate  comparison  should  be  between  
dividends  today  and  price  appreciation  today.  (The  stock  
price  drops  on  the  ex-­‐dividend  day.)  
§ The  Excess  Cash  Argument:  The  excess  cash  that  a  firm  has  in  any  
period  should  be  paid  out  as  dividends  in  that  period.  
§ Argument:  The  firm  has  excess  cash  on  its  hands  this  year,  
no  investment  projects  this  year  and  wants  to  give  the  
money  back  to  stockholders.  
§ Counter:  So  why  not  just  repurchase  stock?  If  this  is  a  one-­‐
time  phenomenon,  the  firm  has  to  consider  future  financing  
needs.  
§ Consider  the  cost  of  issuing  new  stock  
 
Potentially  good  reasons  for  paying  dividens  
§ Argument:  The  firm  has  excess  cash  on  its  hands  this  year,  no  investment  
projects  this  year  and  wants  to  give  the  money  back  to  stockholders.  
§ Counter:  So  why  not  just  repurchase  stock?  If  this  is  a  one-­‐time  phenomenon,  the  
firm  has  to  consider  future  financing  needs.  
§ Consider  the  cost  of  issuing  new  stock  
 
Mergers  and  Acquisitions  
§ Classification  
§ Consolidation  
§ Tender  offer  
§ Purchase  of  assets  
§ Management  buyout  
§ Leverage  buyout  
Motives  
§ Undervalued  firms    
§ Diversify  to  reduce  risks  –  Conglomerate  vs  Focus?    
§ Operating  synergy    
§ Economies  of  scale    
§ Pricing  power    
§ Combination  of  different  functional  strengths    
§ Access  to  growth  markets    
§ Financial  synergy