Jan Schnitzler Corporate Finance 2.5

1.
Introduction
Jan Schnitzler
Corporate Finance 2.5

Teaching staff
Jan Schnitzler
 Email: j.schnitzler@vu.nl
 Office 7A-62
 Assistant Professor of Finance
 From Mainz, Germany
 Open office hours: Tue, 2pm
Education:
 PhD, Stockholm School of
Economics
 Undergraduate studies in
Mannheim and Toulouse
Jan Schnitzler 2
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Jan Schnitzler
Outline of this lecture
Administrative Things
Introduction Corporate Finance
Repetition 1: Time value of money
Repetition 2: Discount Rates and risk
Repetition 3: Free Cash Flows
Working Capital Management
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Relevant Materials
 Berk/DeMarzo: Corporate Finance – 4th Edition
 Lecture Slides
 Lecture Recordings
 Problem Sets
 Case Study Material (tba)
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Schedule Online Meetings
Week Date Class Topics Reading Graded
1 Mon, Mar 30 Q&A call Introduction BM 4,8,11,12, 26, 27.1
2 Tue, Apr 7 Case call Case 1 X

Wed, Apr 10 Q&A call Modigliani-Miller BM 14, 15,16.1-16.4
Trade-Off Model PS 0/1
Wed, Apr 15 Q&A call Agency conflicts BM 16.5-16.8

Asym. Information PS2
Wed, Apr 22 Q&A call Valuation BM 18;

PS 3-4
Wed, Apr 29 Q&A call Payout policy BM 17, 23

Equity markets
6 Wed, May 6 Q&A call Debt markets BM 24-25, 27, 28, 29
Governance PS 5
7 Tue, May 12 Case call X
Case 5
Exam Thu, May 28
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Grading
Exam 5 Group Assignments

The exam counts 50%  3/5 cases will be grade
To pass the course, you have counting 50%
to get at least 5.0 in exam.  Three cases are available
More details will follow later from Harvard Publishing:
https://hbsp.harvard.edu/import/717271
during the course.
 If you did case work last year:
https://hbsp.harvard.edu/import/717505
 Two other cases are empirical

assignments (Stata)
 Stata download:
https://vu-software.azureedge.net/statacorp-stata-
se-16-x64-en.iso
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Case Submission Details
 One case group consists of 4 students (Canvas Sign-in).
 Contents issues:
 Each group works independently (no cooperation).
 If you raise great issues but every other group includes them as well, you
deflate your value.
 Electronic case submission via Canvas:

 Please submit only one version per group!
 Writing issues:
 Canvas conducts an automatic plagiarism test. Don’t score too high there!!!
 The program compares your copy to the internet and an internal VU library.
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Structure of Case Report
Two main parts:

1. Strict limit of 2 pages text (reasonable font size and margins).
2. Additional appendix with tables/figures allowed.
Text structure:
 No need for additional executive summary. It is already short.
 Give crisp motivation for your analysis in first sentences.
Analysis is key, but text style matters too!

Think of a short memo for a board meeting.
We can discuss more details in our first case meeting.
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Questions regarding the organization?
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What is Corporate Finance?
Corporate finance studies all decisions taken by firms

 Because all business decisions have financial implications
Objective function: to maximize the value of the corporation
Corporate finance concepts are widely used:

 In business: Banking, M&A, PE & VC, etc.
 In research: covers the firm as decision maker, but also its stakeholders
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What is a Corporation?
Legal definition:
 Artificial entity owned by its shareholders (but distinct)
 As a legal person, a corporation can make contracts, carry out
business activities, pay taxes, sue or be sued, etc.
US entities NL equivalent Entity Liability

Sole Proprietorship Eenmanszaak no unlimited
General Partnership VoF yes unlimited
Limited Partnership CV yes both
Limited liability company B.V. yes limited
Corporation N.V. yes limited
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The main stakeholders of a firm
 Shareholders
 Creditors/Bondholders
Focus of this course
 Managers
 Government/Society (Taxes)
 Employees
 Suppliers/Customers
 Competitors
 Etc.
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Corporate Finance Decisions
Shareholders
Conflict of
Interest?
Managers
Investment Financing Repayment

Decision Decision Decision
Good Project? Debt vs. Equity? Dividend?

NPV positive? Repurchase?
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The focus of this course
 We will study the implications of the financing decision:

 Is there an optimal capital structure?
 If yes, taking a project’s characteristics into account, how
should it be financed?
 Introduce valuation models that take the capital structure of

companies into account.
 Discuss institutional market features that affect corporate financing

decisions.
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Repetition 1: Time Value of Money
$1 is more worth today than $1 next year
 Opportunity cost
$1 could have been used for consumption or investment
 Inflation
Purchasing power of $1 generally lower due to increasing price levels
 (Risk-based explanations)
- see Repetition 2
In order to build valuation models, we need a tool that makes cash

flows at different points in time comparable.
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A simple DCF model
 Let be a factor that makes an expected period i cash flow

comparable to a cash flow today. Then we can define the present
value of stream of cash flows as:
 Assuming a constant discount factor per period of time , we

can rewrite instead:
Remember:
The simplification is for illustration purposes. As it gives us shorter formulas, we rely on it
for most parts of the course. With a computer you can easily implement time-varying
discount factors.
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Net present value (NPV)
 Our main decision criteria to evaluate investment projects (or

value projects and entire firms)
NPV – Rule
 Take all projects with NPV>0
 Reject all projects with NPV<0
 If projects are mutually exclusive, choose the one
with the highest NPV.
 Alternatively, we will use relative pricing:
Valuation multiples are frequently used, e.g. in M&A.
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Discounting: Useful Present-Value formulas
 Perpetuity of cash flows CF:
 Perpetuity of cash flows CF growing at the rate g:
 Annuity that pays cash flow CF for T consecutive years:
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Valuation – or the Art of Corporate Finance
 So far, we developed our main framework.
 Next, we have to learn what to plug into our model.

 What are these variables?
Repetition 3
Repetition 2
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Repetition 2: Discount Rates and Risk
What is a sensible discount rate?
 What is a risk-free rate?
 For what types of risk do investors require compensation?

 Project specific risk?
 Systematic risk? Which systematic risk factors are relevant?
 How much compensation do investors request?
 Lots of research in asset pricing provides guidance of which risk

factors are priced.
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Discount Rate and Cost of Capital
 The discount rate of a project should be equal to the cost of capital

of an asset (or portfolio) with equivalent timing and risk
Otherwise, arbitrage opportunities exist.
 Managers have to take this opportunity cost of capital into

account, otherwise they will not be able to raise financing (or
investors will lose money)
 Note: different cash flow streams generally have different risk

characteristics, i.e. costs of capital should differ, too.
- Safer cash flows have lower cost of capital than riskier ones
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Capital Asset Pricing Model (CAPM)
Investors hold well-diversified portfolios

Idiosyncratic (firm-specific) risk are wiped out
Only systematic (economy-wide) risk is priced
,
Systematic risk:
Market risk premium:
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Risk-free Rate
Conceptually, a risk-free interest rate is important.

 To discount a cash flow, we want to use the risk-free rate that
matures on the date when cash flow accrues.
 Lacking a better alternative, we generally use interest rates of

long-term government debt
 On the short-term end of the yield curve there is often variation, less so on
the long-term end
 Does a risk-free asset exist in practice?
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10-year sovereign bond yields
35
30
25
Belgium
Germany
20 Ireland
Greece
Spain
15 France
Italy
Netherlands
10 United Kingdom
0
Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14
Source: ECB
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Market Risk Premium
 In principle, we should use the expected risk premium for the

entire universe of assets
 Common shortcut: Difference between the return of a common

market index and a risk-free rate
 In practice, the choice of risk premium may be very controversial

 We decide for each valuation case what a reasonable benchmark is
 We might want to extend our model by many other risk factors
 Lots of scope for model crunching, but we leave this for investment, or generally
asset pricing courses
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Estimates for the Market Risk Premium
International Annualized Equity Premiums (1900-2005)
10-year US premiums relative to T-bills, 1900-2005

Source: Dimson et al. (2006)
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Repetition 3: Free Cash Flows (FCF)
What are Cash Flows?

 Not a measure of accounting earnings
- In accounting, main function of earnings is to be informative
- How profitable is a firm? Thereby, investment expenses are to some extent
attributed to revenues that result from it
 Here, we are interested in the timing of when actual cash flows
accrue to investors!
 Free cash flows consist of four main components: Revenues,

Costs, Net Investments, Taxes
 Complication: Depreciation is not a cash flow, but it affects taxes
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Relation: Income Statement and Free Cash Flows
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Depreciation
We can rewrite the previous equation also to
⇒ Fastest depreciation method maximizes NPV!
However, there are regulations how to depreciate assets.

 In this course, we use linear depreciation.
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Components of Investments
1. Initial Capital Expenditures
2. Required ongoing Capital Expenditures
3. Change in Net Working Capital
4. Terminal Value
 At the end of the planning horizon, assets may still have some value
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Net Working Capital
 Net working capital (NWC) includes a company’s liquid reserves

that are required to operate assets (also called net current assets)
 These funds are not available for distribution to investors (in

contrast to excess cash)
 If we increase investments (or sales), we may have to increase

net working capital to operate assets or maintain liquidity.
 To derive FCFs, subtract changes in NWC (not levels)!
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Liquidation Value / Terminal Values
Liquidation of remaining assets or terminal values should be

considered in our NPV analysis:
 Liquidation values are usually non-zero

 They may even have large negative values, e.g. nuclear waste
 Remember: Profits on sold assets have to be taxed
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Incremental Cash Flows
Use incremental cash flows if you don’t want to value an entire firm,
but solely a particular project:
 Only use incremental cash flows that are a consequence of this

particular project
 Alternatively, discount total firm cash flow with project vs. without
project
Remark:
 Ignore costs that the firm would incur regardless of whether it does
the project or not.
 Include opportunity costs of assets that are within the firm.
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Technical Remark: Pro-Forma cash flows are uncertain
 So far we discussed computation of historical (not future) free cash flows

 We frequently only quote expected values of future cash flows, but there is an
entire distribution of possible realizations
 Alternatively, we simplify by explicitly modeling some states
Most corporate finance models require risk
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FCF – Example (see BM Chapter 8)
Free Cash Flows t=0 t=1 t=2 t=3 t=4 t=5

Sales - 26,000 26,000 26,000 26,000 -
COGS - -11,000 -11,000 -11,000 -11,000 -
Gross Profit - 15,000 15,000 15,000 15,000 -
SG&A Expenses - -2,800 -2,800 -2,800 -2,800 -
R&D Expenses -15,000 - - - - -
Depreciation - -1,500 -1,500 -1,500 -1,500 -1,500
EBIT -15,000 10,700 10,700 10,700 10,700 -1,500
Tax (40%) 6,000 -4,280 -4,280 -4,280 -4,280 600
Unlevered Net Income -9,000 6,420 6,420 6,420 6,420 -900
Plus: Depreciation - +1,500 +1,500 +1,500 +1,500 +1,500
Less: CapEx -7,500 - - - - -
Less: Change in NWC - -2,250 - - - +2,250
Free Cash Flows -16,500 5,670 7,920 7,920 7,920 2,850
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Working Capital Management
Value maximization requires to optimize the liquidity of a company:
+ A company running out of liquidity runs a high risk of bankruptcy

+ Keep capacity that always allows you to service your customers
- Maintaining liquidity of assets binds costly capital
Trade-off that requires active management
 Best practice solutions depends on product and industry features

 Competitive pressure forces company’s to run with relatively low
liquidity buffers
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The Cash and Operating Cycle
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The Cash Conversion Cycle (CCC)
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Separate Analysis of NWC Components
 For financing purposes, we often focus on the net working capital

position because this is the amount that needs to be funded.
 Separately analyze main items of net working capital to learn
more about potential risks and undesirable developments.
We will look at the following individual positions of NWC:

 Managing Accounts Receivable
 Managing Accounts Payable
 Inventory management
 Cash management
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Summary
We looked at building blocks for valuation models:
1. Defined scope of Corporate Finance

2. Introduced NPV concept as main decision tool
3. Learned useful formulas for discounting repeated cash flows
4. Discussed Free Cash Flows as relevant cash flows to investors
(Chapter 8)
5. Discussed risk premium of discount rates and CAPM as our
benchmark model (Chapter 11 and 12)
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2. Modigliani-Miller
Jan Schnitzler

Outlook for this lecture
This lecture is about capital structure in perfect capital markets:
 Define the capital structure of a firm
 Discuss the famous Modigliani-Miller Theorem and discuss its

required assumptions
 Combine capital structure with the CAPM we saw last week
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Major types of financial securities
 Debt
• Short-term vs. long-term debt
• Public vs. private/generally bank debt
 Convertible Debt
Our focus Hybrid securities
 Preferred Shares
 Warrants (Options)
 Common Shares/Equity
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Capital structure
 Capital structure describes how a firm finances its assets.
 Major focus in our lecture is the debt-equity-ratio, which is

generally referred to as Leverage.
Most relevant Differences between Debt and Equity

 Debt claims have a higher seniority, i.e. interest payments
are paid out prior to dividends
 Equity holders are owners of the firm, they have voting
rights and are ultimate residual claimants
 Equity holders are secured by limited liability
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A simple financing model for a firm/project
 An entrepreneur has a project that requires an initial investment of

$1M today. The entrepreneur is penniless and needs external
financing.
 With equal probability, the project will either fail or succeed in one
year. The payoffs of the project are the following:
0.5 $3.15M
-$1M
0.5 $1.05M
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Financial markets
Investors can trade 2 securities:

A risk-free asset:
0.5 $1.05M (+5%)
-$1M
0.5 $1.05M (+5%)
A speculative asset:
0.5 $2.80M (+180%)
-$1M
0.5 $0M (-100%)
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Issuing Equity or Debt?
The investment bank offers two options to the entrepreneur:

 Issue equity that offers new shareholders an expected return of
20%.
 Issue a risk-free debt claim at 5%.
We will do the following:

1. Compute entrepreneur’s stake under equity financing
2. Compute entrepreneur’s stake under debt financing
3. Compare outcomes
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Equity financing
The entrepreneur sells a fraction α of the project to new shareholders

with an NPV of $1M and keeps the remaining shares (1-α).
The share α owned by new shareholders to break-even
The entrepreneur’s share is worth:
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Debt financing
To raise $1M in debt, the entrepreneur needs to promise creditors

$1.05M at a risk-free rate of 5% next year.
 Remember: debt claim senior to equity claim
Caution: always verify whether issued debt is indeed risk-free, i.e. for each
realization: cash flow/value of project interest/face value of debt.
Expected residual cash flow going to entrepreneur next year:
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Comparing entrepreneur’s stakes
 Equity financing:
We valued already entrepreneur’s stake at 0.75M.
 Debt financing:
We computed an expected payoff for entrepreneur’s equity of 1.05M next year.
What is this stake worth today? (What is the right discount factor?)
Using 20% as in the case of equity financing, we get:
Does this mean the entrepreneur should prefer debt financing?
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Searching for arbitrage opportunities…
 What is an arbitrage opportunity? – A riskless profit

Active market participants constantly search for arbitrage strategies,
e.g. Hedge funds, High-frequency traders, etc.
No-arbitrage required for a normal market equilibrium
 Arbitrageur builds replicating portfolio:

Security t=0 t=1 & success t=1 & fail
Levered Equity (short) +0.875M -2.1M 0M
Speculative asset (long) -0.875M 2.45M 0M
Portfolio 0M 0.35M 0M
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What went wrong?
 Under no arbitrage conditions, the levered equity should have the

same expected return as the speculative asset, which is 40%.
 Using this as discount rate instead, we get:
What is our take away?

1. The entrepreneur is indifferent between issuing equity or debt.
The remaining equity stake is worth 0.75M in either case.
2. Increasing the leverage of a firm increases the risk of the equity
stake. Therefore, the appropriate discount factor is 1.4 (not 1.2).
3. In either case, new equityholders or new debtholders get a zero
NPV transaction.
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Modigliani – Miller’s Proposition 1
Capital Structure Irrelevance Proposition

In perfect capital markets, the total value
of a firm is independent of the firm’s capital
structure. The total value of a firm is equal
to the market value of the cash flows
generated by its assets.
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Foundations of a Modigliani-Miller World
The theorem requires as qualifier perfect capital markets:
1. The NPV of issuing new securities is zero.

2. The free cash flows to a levered firm is the same as to an all
equity firm.
Assets Liabilities
Assets generating cash flows Debt
Equity 1. Set of
Assumptions
2. Set of Assumptions
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MM-Assumptions I
1. Issuing new securities has zero NPV:
 Financial markets are competitive

 Firms and investors are price-takers
 New investors only break-even
 Financial markets are complete

 The cash flows of a security can be replicated by other existing securities
 Investors can do what firms can do, they can choose any consumption pattern and
risk profile, by borrowing, lending, and hedging.
 Financial markets are strong-form information efficient

 Market prices reflect all available information
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MM-Assumptions II
2. The capital structure does not affect the firm’s cash flows:
 No distortionary taxes
 No cost of financial distress
 No transaction costs from issuing securities
 No agency conflicts between stakeholders:

 Manager vs. Shareholder
 Shareholder vs. Creditors
 Large shareholder vs. small shareholder
 Etc.
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Market Value balance sheet
Assets Liabilities
Tangible Assets Debt
- Cash - short-term debt
- PPE - long-term debt
- etc. - etc.
Intangible Assets Equity (residual claim to balance asset and
- Intellectual property liability side)
- Talent - Common stock
- etc. - Preferred stock
- etc.
In contrast to accounting balance sheets:

 entirely forward-looking
 covers everything of value
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What about other corporate finance decisions?
Modigliani-Miller applies to all corporate financing decisions:
 Dividend policy is irrelevant

 Share repurchases are irrelevant
 Long-term vs short-term financing is irrelevant
 Risk management is irrelevant
 M&A activity is irrelevant
Modigliani-Miller’s Irrelevance Theorem applies to all financial

transactions because they are fairly priced and therefore zero
NPV transactions.
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Modigliani-Miller and the Cost of Capital
 Modigliani-Miller 1 claims that the market value of a firm is

independent of its capital structure.
 Writing this proposition in terms of returns, the return on assets

are independent of the firm’s capital structure.
 Interpreting it from the liability side of the balance sheet, return on

assets is equivalent to the average cost of capital.
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Separation into cost of debt and equity
 The firm can be viewed as a portfolio of stocks and bonds.
 The required return on assets can be expressed as a weighted

average of the firm’s cost of debt and equity.
Rearranging terms leads to Modigliani-Miller’s second proposition:
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Modigliani-Miller Proposition 2
The effect of leverage on equity cost of capital
The equity cost of capital is

 linearly increasing in leverage
 by a factor that is equal to the difference between the average
cost of capital and the debt cost of capital.
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Intuition for the result
 Leverage increases the equity cost of capital because risky cash

flows to equity become more volatile.
 Since risk requires a market premium, equity holders need to get

compensated.
 Any attempt to substitute ‘cheap’ debt for ‘expensive’ equity

makes the remaining equity in a way more expensive such that
the overall cost of capital remain constant.
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Graphical Illustration: Cost of Capital vs. Leverage
Source: Berk and DeMarzo
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Back to our example
 Let’s consider the cost of equity in our example of the

entrepreneur who needs to raise $1 Million.
Equity financing:
The required return on equity was 20%
Debt financing:
The risk-free rate was 5% and the levered equity stake had
the same risk as the speculative asset (40%)
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Capital Structure and Asset Pricing Models
 To build a tractible model that can be used in practice, we have to

decide how we want to model risk.
 We can make use of the CAPM (as of every other asset pricing
model) in our capital structure model of the firm.
The first application of the CAPM was in equity markets.

Equity betas are readily available
For investment decisions, we need another beta (asset beta)
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Un-levering Equity Beta
Let’s start with an equation we know already:
Linearity of covariance allows us to conclude

cov cov cov
The risk of a project is a weighted average of debt and equity risk.
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Estimating β for a company/project
1. If we intent to value entire publicly traded firm:

Use beta available for the firm
2. If we want to value a project that has the same risk as the rest of
the company (e.g. expansion):
Use beta available for the firm
3. If the risk of the project is better characterized by another

company:
Use Identical Twin Method:
i.e. beta of competitors in same industry
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Re-levering Equity Beta
We can rewrite the previous equation:
 Equity risk increases with leverage

 In an all equity firm
Therefore, we cannot use the equity beta of a twin company directly. Compute the
asset beta of a twin firm and use it in the CAPM.
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Debt beta
 If debt levels are low and repayment is certain, assume .
 Low liquidity of corporate bonds make a similar estimation like in

the stock case more difficult.
 We can rely on Fama and French (1993) estimates:
Corporate bond rating Estimated 𝛃𝐃

Investment grade Aaa 0.19
Investment grade Aa 0.2
Investment grade A 0.21
Investment grade Baa 0.22
Non-investment grade 0.30
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Capital Structure Fallacies
Frequently we hear incorrect arguments regarding a firm’s capital

structure. They seem convincing at first sight, but they take not the
full picture into account.
 WACC Fallacy: “Interest rates on debt are lower than investors’ required return
on equity. Thus, debt financing is preferred because it is cheaper than equity.”
 EPS Fallacy: “Equity is more expensive than debt because equity issues reduce
expected earnings per share and drive down the stock price.”
 Dilution Fallacy: “Debt financing should be used because equity financing
dilutes existing shareholders. If new shares are issued, cash flows must be
divided among a larger number of shares leading to a lower share price.”
 Clientele Fallacy: “Investors have different preferences and desire different
cash flow streams. By issuing tailor-made securities, firms can attract
clienteles/investors who are willing to pay a premium”
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Take-away from Modigliani-Miller
 Modigliani-Miller builds an abstract world using restrictive

assumptions
 Obviously, some of these assumptions are not realistic.
 It provides, however, a very useful benchmark case:

 By showing when capital structure is irrelevant, it provides
guidance for when it is relevant.
 Natural starting point: Check consequences of deviating from
every assumption we discussed.
 It gives structure to the way we think about capital structure. If
we are not sure, we can always compare to an MM world.
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Summary
 In perfect capital markets, a firm’s capital structure does not affect

its market value.
 We discussed assumptions that define perfect capital markets.
 We used no arbitrage arguments to proof this claim.
 While capital structure does not affect average costs of capital, it

does affect the contribution on capital costs for debt and equity.
 We combined our capital structure model with the CAPM and

discussed how to use it for valuations.
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3. Taxes & Financial Distress
Jan Schnitzler

Financial Policy: Next Steps
Last week: Modigliani-Miller Irrelevance Proposition (1958))

 In perfect capital markets there is no role for capital structure
 This holds under a set of restrictive assumptions
Today: How does the real world differ from MM

 Is there empirical evidence that capital structure matters?
 We will extend our capital structure model by:
1. Corporate taxes, (plus taxes at investors’ level)
2. Costs of financial distress
This leads to a new capital structure model: Trade-off model
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Funding Sources: US corporations
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Leverage ratio in US (2010 - 2018)
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Stylized empirical facts about capital structure
1. Firms prefer internal financing trough retained earnings instead of

selling securities in financial markets.
2. Debt seems to be a preferred source of financing than seasoned

equity offerings.
3. Security issuance differs over time and over the business cycle.
 In particular equity issues and non-investment grade bonds
4. Capital structures vary systematically across countries and

industries.
Firms seem to care about capital structures.
Jan Schnitzler 5
Relaxing the MM assumptions
 Financial transactions generate zero NPV:

1. Financial markets are competitive.
2. Financial markets are complete.
3. Financial markets are strong-form efficient.
 The financial policy does not change the after-tax free cash flow
from real investment policy:
1. No distortionary taxes
2. No cost of financial distress.
3. No issuance cost
4. No agency conflicts between managers and investors.
Jan Schnitzler 6
The effect of corporate taxes
 Taxes do not reduce the “size of the pie” (i.e. value of pre-tax cash
flows) but means that government gets part of it.
 Smaller share available to investors.
 In the U.S. (and most other countries), interest payments of
corporations are tax-deductible, while dividends are not.
 Problem is not taxes per se, but that interest and dividends have a
different tax treatment.
 Hence, there is a strict tax advantage to financing with debt rather
than equity.
Jan Schnitzler 7
Example: The interest tax shield
Let’s consider a very simple example of a firm:
 A firm generates a certain EBIT of $100M every period in

perpetuity. This is the only cash flow the firm has.
 The risk-free rate is 10%.
 The corporate tax rate ( ) is 40%.
Jan Schnitzler 8
Example: All-equity firm
If the firm is 100% equity financed, what is the value of the firm?
 Every period shareholder receive the net income as cash flow:
(1−
 The value of the unlevered firm, , equals the market value of

equity:
Jan Schnitzler 9
Example: Levered Firm
Suppose the firm takes on $500M of debt.
What is the coupon of the debt?

 The debt is risk-free Debtholders require a return of 10%.
 The coupon of the debt is
What is the new value of equity?

 Each period, equity holders get the same net income.
. $ $ $
 Value of Equity:
. .
What is the total value of the levered firm?

 Firm value:
Jan Schnitzler 10
Example: Interest tax shield
Where does the increase in firm value of $200M come from?
 Gain to investors from the tax deductibility of interest payments

 Each period, the firm saves in taxes where is the
corporate tax rate and is interest expenses.
 Hence, yearly tax savings are equal to
 The present value of the interest tax shield is:
Jan Schnitzler 11
Market value of firms with corporate taxes
 In a perfect capital market (without taxes) capital structure is

irrelevant:
 With corporate taxes, capital structure matters:
Intuition:
 Investors cannot get equivalent tax break on homemade leverage.
 Hence, they are willing to pay a premium for levered firms.
Jan Schnitzler 12
Interest tax shield with permanent debt
Assume a firm with permanent/constant debt level:

 The market value of debt, D, equals the present value of the
interest payments.
 In this case we obtain a simple formula for the tax shield:
Jan Schnitzler 13
Other common tax shields
Firms pay effectively less than the statutory rate in corporate taxes
 Firms will not have taxable income every year.
 Net operating losses (NOLs) can be carried forward (or even

backwards) to offset profits in other years.
 Some firms have large non-debt tax shields, such as depreciation,

investment tax credits, etc.
Jan Schnitzler 14
Investment Decision and Taxes
Source: Xu and Zwick (2018)
Firms have higher Q4 investments

Jan Schnitzler 15
Determinants of the interest tax shield
 Tax benefit of taking on additional debt is lower if

1. Profits are more volatile
2. Firm already has a lot of debt
3. Firm has NOLs and substantial non-debt tax shields
Less likely to have profits left to shield with additional debt
 John Graham (2000) estimates the U.S. effective corporate tax

rate at about 30%.
 Conclusion: Use some caution when evaluating the tax shield for
a company.
Jan Schnitzler 16
Who gains from taking on debt?
Let’s continue with our previous example:
 Suppose that the firm has 10M shares outstanding

 Before taking on any debt, each share is worth
 Now the firm takes on $500M of debt, and buys back shares worth
$500M.
 Think about this as happening in two steps:
Jan Schnitzler 17
Example, cont’d
(1) The firm raises $500 in debt:
 Firm consists of the present value of future cash flows plus

$500M in cash.
 The interim-value of the firm is:
 The value of equity is:
 Share price increased from $60 to $80.
Original shareholders get the whole $200M gain of the new

interest tax shield!
Jan Schnitzler 18
Example, cont’d
(2) Firm does a share repurchase of $500M
 With $500M the firm buys back $500M/$80=6.25M shares

 The value of the firm is:
 The value of equity is:
 The new share price is $300M/3.75M=$80.
The equity market cap is lower, but shareholders’ wealth consists

of $300M in stock + $500M in cash = $800M
Jan Schnitzler 19
Weighted average cost of capital (WACC)
 With tax-deductible interest, the effective borrowing rate after tax

is )
 Tax-deductibility of interest lowers the effective after-tax cost of

debt of the firm
WACC with corporate taxes :
Unlevered Cost of Capital Tax shield
Jan Schnitzler 20
Cost of capital pre-tax and after-tax
Jan Schnitzler 21
Including investors’ personal taxes
 Only considering corporate taxes implies 100% debt financing is

optimal.
 Introducing personal taxes can change this conclusion if investors’

returns from debt and equity are taxed differently
 Interest payments are taxed as ordinary income
 Capital gains and dividends are taxed at a lower rate
 Capital gains can be deferred (contrary to dividends and interest income)
⇒ Generally this leads to a tax advantage of equity for individual

investors, partly offsetting the tax shield of debt.
Jan Schnitzler 22
5 Relevant types of tax rates
Depending on jurisdictions, there may be up to 5 different tax rates to

consider:
 Corporate ordinary income tax rate ( ), paid on taxable income
from operations
 Corporate capital gains tax rate ( , ), paid on a firm’s capital
gains/losses.
 Personal ordinary income tax rate ( ), paid by individuals on
income from wages, salaries, and received interest
 Personal capital gains tax rate ( , ), paid by individuals on
profits/losses derived from equity sales
 Personal dividend tax rate ( , ), paid by individuals on
received dividends
Jan Schnitzler 23
Overall effect of investors’ personal taxes
 Assume , and define , ,
Flow to debtholders Flow to equityholders

Assumed Earnings $1 $1
Corporate taxes 0 (debt is deducted)
Income after
corporate tax
Personal taxes
Income after taxes
⇒ Cash flows accruing to investors are greater under debt financing

than under equity financing if:
Jan Schnitzler 24
Interest tax shield with personal taxes
 If the RHS of the equation reduces to our previous formula
 If the value of the tax shield becomes less valuable
Jan Schnitzler 25
Equity Ownership in the US
 On the other hand, a large fraction of U.S. securities are held by

institutional investors:
 Institutions like mutual funds, pension funds, and endowments hold more
than 50% of U.S. public equity, and most of corporate bonds.
 Many of these institutions (more than half) are tax exempt, e.g. pension
funds and endowments.
 If most of a firm’s corporate bonds are held by tax-exempt
institutions, then personal taxes do not reduce the value of the tax
shield.
 The firm does not have to pay any “tax-penalty” (i.e. in terms of a higher
interest) when issuing debt.
Jan Schnitzler 26
Bottom Line: Personal Taxes
 The effect of personal taxation is very complex. It depends on:

 Ownership structure: percentage of firm’s securities held by institutions and
individuals
 Investor clienteles
 Whether investors adjust portfolios in a tax-efficient way
 Still, even after accounting for personal taxes a substantial interest

tax shield remains
⇒ We often ignore personal tax considerations in our valuation

models and compute interest tax shields with corporate tax only
Jan Schnitzler 27
Summary of tax effects
If we only relax the MM tax assumption, we get the following results:
 Corporate tax deductibility of interest payments creates a valuable

interest tax shield of debt
 Personal taxes may reduce the value of the interest tax shield
Firms should use 100% debt financing
 Does not seem to match very well with what we observe in reality
 Yet this result gets you to ask the right question: “What are the
costs associated with debt?”
Jan Schnitzler 28

1. No taxes
3. No issuance cost
Jan Schnitzler 29
The other side of debt: Financial Distress
Defining financial distress:

 A firm is in financial distress if it is not able to service interest or
principal repayments to debtholders.
 Associated with financial distress is a cost that would not have
been imposed in the absence of debt.
Economic distress Financial distress:

 Economic distress: business operations perform poorly (e.g. sales
or profits are low, product fails, cost structure inefficient etc.).
Not related to the leverage of a firm.
 Financial distress: Consequences arising due to a potential shift of
ownership to debtholders.
Jan Schnitzler 30
A simple example of financial distress
 Firm’s assets in place generate the following payoffs with equal

probability:
0.5 100
0.5 20
 To keep things simple, assume that investors are risk-neutral,
discount rates are zero, and there are no taxes
 The total value of the firm is the expected cash flow:
 The equity claim of an all-equity firm is:
Jan Schnitzler 31
A simple example of financial distress, cont’d
 Assume instead that the firm has an outstanding debt claim with
face value 50.
 Equity and debt holders receive the following cash flows:
𝑳
𝑯
 The overall market value of the firm is:
⇒ The market value of the firm under debt financing remains

unaffected of financial distress.
⇒ MM holds even with financial distress (as long as bankruptcy does
not impose additional costs to the firm.)
Jan Schnitzler 32
Modigliani-Miller and Bankruptcy
 If the value of equity falls to zero, debtholders take over the firm.
 In a perfect capital market, there are no cost of financial distress

 Efficient transfer of ownership from equityholders to debtholders
 No reduction in cash flows generated by the firm
 Therefore, the possibility that a firm defaults on its debt obligations

does not itself violate MM!
This results holds as long as financial distress does not impose an

additional cost.
Jan Schnitzler 33
Cost of Financial Distress (COFD)
Why does MM break down with COFD?
 Interest and principal payments to debtholders are legal

obligations.
 Dividends are common but voluntary decisions.
⇒ Only failed payments to debtholders have negative legal
consequences related with costs.
Direct COFD:
 Legal expenses, court costs
 Advisory fees, etc.
Jan Schnitzler 34
Trade-off Theory of Capital Structure
Optimal capital structure balances tax and bankruptcy effects:

1. Leverage increases the value of the interest tax shield of debt
2. Leverage increases the expected costs of financial distress
depends on:
 Ex-ante probability that financial distress occurs
 Magnitude of costs of financial distress
 Risk-adjusted discount rate
Jan Schnitzler 35
Graphical representation of the Trade-off Theory
Jan Schnitzler 36
Management Options under financial distress
 Restructure liabilities:
 Negotiate and restructure debt claims (bank debt vs. bonds)
 Raise new capital (probably equity)
 Restructure assets:
 Asset sales (fire sales), layoffs
 Declare bankruptcy:
 Liquidation (Chapter 7 in U.S.)
 Reorganization (Chapter 11 in U.S.)
Jan Schnitzler 37
Two Types of Corporate Bankruptcy
Liquidation (Chapter 7 in U.S.)

 In US rather unusual, more common in Europe
 Court appoints trustee to liquidate assets
 Cash will be distributed following a strict schedule:
1. Secured claims
2. Wages
3. Taxes
4. Unsecured claims (in order of seniority)
5. Equity
Reorganization (Chapter 11 in U.S.)

 Debtor, as debtor-in-possession, proposes reorganization plan in court
 If plan gets accepted by court (and creditors), debtor keeps on running the firm
 Creditors may become new owners
 Otherwise, bankruptcy may be converted into Chapter 7
Jan Schnitzler 38
Assessing direct COFD
 Lehman Brothers paid lawyer fees exceeding $1bn in 2008.

 Estimates of direct COFD are 2-5% of firm value for large firms.
 Up to 20-25% for small companies.
For capital structure decisions, expected COFD relevant:

 Ex ante, this needs to be weighted by the probability of bankruptcy
(On average, 0.07% NYSE-AMEX firms go bankrupt a year).
⇒ Expected direct COFD tend to be small!
⇒ If interest tax shields are in range of 10-35% of debt value, debt
benefits should outweigh direct COFD.
Jan Schnitzler 39
Indirect COFD
We could think of various indirect COFD:
1. Loss of customers
2. Loss of suppliers
3. Loss of employees
4. Loss of receivables
5. Fire sales of assets
6. Delayed liquidation
Jan Schnitzler 40
How large are indirect Cost of Financial Distress
 It is very difficult to quantify indirect costs of financial distress:

1. We need to estimate losses to total value (not only to
equityholders)
2. We need to estimate incremental losses of financial distress that
are independent of economic distress
 In practice very difficult to distinguish
 Many indirect costs are incurred prior and irrespective of whether

actual bankruptcy occurs.
 Economic magnitude could be more important: Andrade and
Kaplan (1998) estimate in a sample of leverage buyouts (LBOs)
10-20% of firm value.
Jan Schnitzler 41
Summary
 We first discussed capital structure implications of corporate and

personal taxes.
 As a benefit of debt we introduced the concept of a debt tax shield
 As a cost of debt we introduced costs of financial distress
 We separated direct from indirect costs of financial distress and
discussed their economic magnitudes.
 In competitive capital markets, expected costs of financial distress
are anticipated by debtholders and therefore borne by
shareholders.
 Building the two pieces together, we defined the trade-off model of
capital structure.
Jan Schnitzler 42
4. Agency conflicts
Jan Schnitzler

Agency conflicts
Definition: costly disagreements among various stakeholders.

 Within firms, there are various layers of agency conflicts.
 Our focus: Managers
Shareholders Debtholders
General economic framework used in many areas.

Here: how agency conflicts affect firms’ capital structures.
Jan Schnitzler 2
Managers’ objective function
Managers are in the focus:

 delegated to make (daily) decisions that maximize value.
 appointed by shareholders (indirectly via board).
We cover two scenarios:

1. Managers maximize shareholder value:
 Manager and shareholder interests are aligned.
 Conflict: shareholder vs. debtholder.
2. Managers have own objectives:
 Conflict: manager vs. shareholder.
 Potential conflict: manager vs. debtholder.
Jan Schnitzler 3

1. No taxes
3. No issuance cost
4. No agency conflicts between managers/investors.
Jan Schnitzler 4
1. Dark-side Incentive Effects of Debt
Assumption: managers act strictly in the interest of shareholders!

⇒ Conflict between shareholders and debtholders.
⇒ What is debtholders’ fear?
⇒ Link to financial distress (see Lecture 3).
We cover 3 conflicts of interest:

1. Wealth Transfers
2. Debt-Overhang Problem (or Underinvestment Problem)
3. Risk-Shifting Problem (or Asset Substitution Problem)
⇒ All problems start with firms with existing debtholders.
⇒ These debt claims are/become risky.
Jan Schnitzler 5
Wealth Transfers (or Cashing Out)
Managers take actions that dilute existing debtholders’ claims:

 Issue new debt of equal/higher seniority
 New debtholders just break even.
 Existing debtholders’ claims become more risky. Who gains?
 More blatant wealth transfers are possible:
 Issue debt and pay proceeds as dividends to shareholders.
 Sell operating assets and pay a dividend to shareholders.
Direct Wealth transfers are relatively easy to detect.

Triggers retaliation from debtholders. How?
Jan Schnitzler 6
Debt covenants
Covenants are affirmative/restrictive clauses in a debt contract that

define action space of managers:
 Limitations on debt of equal or higher seniority
 Limitations on leasing
 Limitations on dividends or share repurchases
 Related to mergers or change in control
 Working capital maintenance provisions
Costly to negotiate and monitor.

Cannot account for every eventuality (incomplete contracting).
May restrict managers even if they act value-enhancing.
Jan Schnitzler 7
Example: General Motors Bankruptcy
Timeline of bankruptcy:
 In 2nd quarter of 2008, GM lost $15.5 billion or $27.33/share.
 A few months later the company asked for government aid.
 On June 1, 2009, GM officially declared bankruptcy.
How to interpret the following decision?

 GM pays dividend of $0.25/share on May 14, 2008?
 Agency conflict with creditors?
 Maybe, agency conflict with taxpayer (through bailout)?
Jan Schnitzler 8
The Risk-Shifting Problem
Going back to Jensen and Meckling (1976).
More subtle version of the blatant Wealth Transfer:

 Manager increases the risk of operations (instead of directly
cashing out).
 Hard to control such activity with covenants (overly restrictive).
 Also difficult to verify motives in court.
Why do shareholders like an increase in risk/volatility?
Jan Schnitzler 9
Excursion: A Call Option Analogy
The equity payoff is the residual claim:
 This formula reminds us of a call option:

 We learned in the derivatives course that the value of a call option
increases with volatility.
 Option holder collects full upsides of volatility but the downsides are limited.
 Due to limited liability, downsides of equityholders in a company
are also limited
Value of equity increases with volatility, whereas value of debt decreases
 Note one important difference: While the stock price is given for
a holder of the call option, may be manipulated by managers.
Jan Schnitzler 10
Graphical Call Option Representation of a firm
Jan Schnitzler 11
Example Risk-Shifting: Firm with risky Debt
Let’s return to our example of a firm with risky debt:

discount rates are zero, and there are no taxes.
 The firm has an outstanding debt claim with face value 50.
probability: 0.5 100
0.5 20
 The total value of the firm is:
 The value of equity:
 The value of debt
The debt claim is risky!
Jan Schnitzler 12
Example Risk-Shifting: New Investment Opportunity
The firm has a new investment opportunity.
 The project requires an initial investment of 10

 First, assume that the firm can finance the project internally
with excess cash.
 The project increases the payoff in the good state, whereas in the
bad state it becomes worthless
 This project has a negative NPV:
 The firm value becomes:
⇒ Managers should not invest if maximizing firm value
Jan Schnitzler 13
Example Risk-Shifting: Take Away
Are managers willing to invest in the new NPV-negative project?
 How do cash flows to debt and equity change:
 The net effect for equityholders is positive.

 Managers will invest in a negative NPV project.
Jan Schnitzler 14
Example Risk-Shifting: External Debt Financing
Suppose instead the firm did not have excess cash for the project
 Assume that existing debtholders did not secure their claim with a
seniority covenant
 Managers raise senior debt with face value 10 to finance the
project
Exactly the same thing as before. Equityholders gain to the

detriment of existing debtholders.
Jan Schnitzler 15
The Risk-Shifting Problem in Practice
 The existence of risk-shifting seems reasonable: managers are

able to control the riskiness of operations.
 However, it is very difficult to provide clean examples
Some decisions could indicate risk-shifting:

 Spinning-off safer business units.
 M&A with risky companies (potentially using more leverage).
 Postponing liquidation of currently inefficient businesses.
 Excessive dividends and share repurchases.
Jan Schnitzler 16
The Debt-Overhang Problem
Going back to Myers (1977).
Debt-overhang has opposite implication compared to Risk-shifting.

 Firms cannot fund positive NPV projects.
 Why do firms become liquidity constrained when they have too
much debt?
 E.g. why can’t the firm just issue more equity, to both service the debt and
cover new investments?
 Would you invest in firms in financial distress? Why not?
Jan Schnitzler 17
Example Debt-Overhang: Firm with risky Debt
Let’s return to our example of a firm with risky debt:

discount rates are zero, and there are no taxes.
 The firm has an outstanding debt claim with face value 50.
probability: 0.5 100
0.5 20
 The total value of the firm is:
 The value of equity:
 The value of debt
The debt claim is risky!
Jan Schnitzler 18
Example Debt-Overhang: New Investment Opportunity
The firm considers investing in a new project:

 It requires investments of 10 today and yields additional cash
flows of 15 with certainty
and the firm should invest
 After investing in the project, the market value of the firm is:
Problem: The firm does not have any cash left.
Is the firm able to raise the required funds by issuing new equity?
Jan Schnitzler 19
Example Debt-Overhang: Take Away
Is the firm able to raise equity for a new NPV-positive project?
 However, the net effect for equityholders is:
Equityholders are not willing to finance this NPV-positive project
Jan Schnitzler 20
Intuition for Debt Overhang
Wealth transfer to debtholders:

 Debt overhang arises in situations where debt is risky.
 A project’s positive cash flows make existing debt claims less
risky.
 If the transfer is larger than the NPV of the project, shareholders
will not be willing to provide financing.
Debt overhang and the seniority of new securities:

Equity issuance is no option to raise funds.
Debt junior to existing debt is no option either.
Solution: fund investment with debt senior to existing debt.
Jan Schnitzler 21
The dilemma of Debt-overhang and Risk-shifting
 Risk-shifting stresses why debtholders restrict new debt with equal

(or higher) seniority in the real world.
 At the same time, these covenants aggravate debt-overhang.
When choosing your capital structure, you do not know which
problem will occur in the future.
Important exception for US:

 “Debtor-in-possession” rule under Chapter 11 bankruptcy allows to
issue new senior debt.
 Designed to alleviate debt-overhang under bankruptcy.
 However, this has the flip side that management may undertake
risk-shifting projects (gamble for resurrection).
Jan Schnitzler 22
Empirical evidence for Agency Costs
What are the agency costs of debt?

 A levered firm may forgo positive NPV projects or undertake
negative NPV projects.
 This would have not been the case for an all-equity firm.
Capital Structure affects a firm’s investment decision
Capital Structure affects a firm’s cash flows
Challening to quantify agency costs for a valuation model:

Estimates are either derived in context-specific settings or under
very restrictive assumptions.
Economists tend to agree that the costs are sizeable.
Jan Schnitzler 23
Who bears Agency Costs?
Investors rationally anticipate agency conflicts:

 Potential creditors are aware if a firm is prone to suffer from
agency problems.
 Expected conflicts are incorporate into the pricing of debt, which
leads to:
1. Higher interest rates
2. Additional covenants restricting the behavior of the firm
Initial equityholders have to bear these agency costs.

Shareholders would be better off if they could credibly commit
before the capital structure choice not to “expropriate” creditors.
Jan Schnitzler 24
2. Incentive Benefits of Debt
Assumption: managers follow an own agenda which differs from

shareholders’ (investors’) interests.
Possible examples of disagreement:
 Excessive consumption of perquisites
 Empire-building
 Excessive diversification
 Entrenchment
 Short-termism
Debt may create agency benefits by incentivizing management to

act more in the interest of shareholders/investors.
Jan Schnitzler 25
Corporate Governance Outlook
For now, we still focus on capital structure issues:

 Debt may help to align manager’s objectives with shareholder
interests.
 Yet, it is not the only (and maybe not most obvious) tool.
Other corporate governance mechanisms are:

- Structure of management compensation
- Board of directors
- Active monitoring through large blockholder
- Takeover market
Our Corporate Governance Lecture covers this in more detail.
Jan Schnitzler 26
Aligning managers’ interests
 High leverage reduces the market capitalization of equity.

⇒ Allows managers to own larger stakes in the firm
⇒ Direct alignment of interest since managers=shareholders
 Several types of financial transactions try to realize similar

incentive benefits of debt:
1. Leveraged Buyouts (LBOs)
2. Management Buyouts (MBOs)
3. Private Equity
 Jensen (1989) predicting the eclipse of public corporations.
Jan Schnitzler 27
Example: Aligning Managers’ Effort
 Consider an entrepreneur who needs to raise 45 for a new

company.
 Assume that investors are risk-neutral, discount rates are zero,
and there are no taxes.
 He can choose between two strategies, A and B. Personally, he
prefers strategy B as it gives him private benefits .
0.8 90 0.2 90
0.2 40 0.8 40
Jan Schnitzler 28
Example: Equity Financing
Suppose the entrepreneur finds an equity investor who is willing to

provide 45 for investment in return for an ownership stake
 What fraction of the company requires the entrepreneur to
retain, such that he is still willing to run the efficient project A?
Incentive Compatibility (IC) Constraint:
 If new shareholders demand a stake larger than 1/3, the

entrepreneur prefers to choose strategy B and collect c.
 Note: If , the IC is always satisfied.
Jan Schnitzler 29
Example: Equity Financing cont’d
 Will the equity investor break even if he is going to get a maximum

stake of 1/3 in the firm in return for the investment of 45?
Investors Participation Constraint (PC):
There exist no equity contract such that the manager chooses the
efficient strategy A and the investor breaks even.
 What stake does the investor require to be willing to provide equity
financing, given the entrepreneur chooses strategy B?
 Under equity financing, the entrepreneur chooses strategy B and

retains an equity stake of 10%.
Jan Schnitzler 30
Example: Debt Financing
Suppose the entrepreneur finds a creditor who is willing to provide 45

for investment in return for a debt claim with face value K
 What is the maximum face value of debt claim, such that the
entrepreneur is willing to run the efficient project A?
Incentive Compatibility Constraint (IC):
 If creditors require a debt claim with face value larger than 56.67,
the entrepreneur prefers to choose strategy B and collect c.
Jan Schnitzler 31
Example: Debt Financing cont’d
 Assuming that the entrepreneur will choose strategy A, what is the

minimum face value of the debt claim, such that the creditor is
willing to finance the entrepreneur?
Investors’ Participation Constraint (PC):
 Under debt financing, the entrepreneur chooses the efficient

strategy A and issues a debt claim with face value
Jan Schnitzler 32
Example: Debt vs. Equity financing
Intuition:
 Debt financing allows the entrepreneur to maintain a larger
ownership stake.
 This provides stronger incentives by allowing the entrepreneur to
capture a larger fraction of the upside potential of the project.
Comparison with Modigliani-Miller:

 Assuming there are no conflicts of interest is equivalent to
 In this case, the entrepreneur will always choose strategy A and
there is no difference between debt and equity financing.
Jan Schnitzler 33
Free-Cash-Flow Problem (Jensen 1986)
Underlying idea: Managers have inherent need to grow

 Managers rather take on less profitable investments than returning
cash to shareholders (Example: diversifying oil companies in 80s)
 FCF-problem is more severe for companies that are:
 More mature
 Slow growth
 Stable cash flows
 Debt as disciplining device:
1. Scheduled interest payments force managers to pay out parts
of free cash flows on an ongoing basis.
2. Creates the need for continuous cash flows helping to
maintain efficient cost structures.
Jan Schnitzler 34
Augmented Trade-off Model
If we are able to quantify incentive benefits and costs that are due to
capital structure, we can extend our tradeoff model:
Augmented Tradeoff Model
Jan Schnitzler 35
Graphical Representation
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Capital structure: symptom or remedy?
 Who develops capital structure policies?
 Possible alternative explanation: Managers dislike leverage!

 Larger fraction of free cash flows reserved for interest payments and
thereby not under manager’s control.
 Managers are most likely fired in states of financial distress.
Could explain low leverage according to trade-off theory.
 Empirical evidence that weak corporate governance is correlated

with capital structure
 E.g. leverage is lower in firms with lower CEO incentive pay, weaker
boards, less concentrated ownership etc.
Jan Schnitzler 37
Summary
 Differences of stakeholders’ objective functions create agency

conflicts.
 Conflicts between shareholders and debtholders lead to agency

costs of debt.
 Conflicts between managers and investors lead to agency benefits
of debt.
Decide case-specific which effect dominates
 While economists believe that the economic magnitude of agency

effects is important, it is nevertheless hard to estimate.
Jan Schnitzler 38
5. Asymmetric Information
Jan Schnitzler


1. No taxes
3. No issuance cost
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Market Efficiency
A market is efficient if prices reflect all available information
where denotes the information set at point t.

3 Definitions following Fama (1970):
1. Strong form Efficiency: Prices incorporate all information
2. Semi-strong form Efficiency: Prices incorporate all publicly
available information
3. Weak-form Efficiency: Prices incorporate the history of past
prices
Jan Schnitzler 3
Empirical Evidence on Efficiency in Financial Markets
Pro Market Efficiency Contra Market Efficiency

 Statistical Random Walk tests:  Excess Volatility Puzzle
No serial correlation between (Shiller 1991)
a return and lagged returns  Momentum Effect (Jegadeesh
(Fama 1965) and Titman 1993)
 On average, mutual funds do  Long-term Reversal (DeBondt
not outperform benchmark and Thaler 1985)
indices (Fama and French  Equity Premium Puzzle
2010) (Mehra and Prescott 1985)
Financial markets are fairly efficient (efficiently inefficient).

There are some puzzles and markets don’t get it always right.
Jan Schnitzler 4
Market Efficiency and Asymmetric Information
 Most tests of market efficiency deal with weak form efficiencies, or

at best semi-strong form efficiencies.
 Even there efficiency is controversially discussed
Market efficiency is less likely to hold in its strong form!
 The Modigliani-Miller Theorem is based on strong-form efficient

markets. We will see why!
Let’s see what happens under information asymmetry, i.e. when one
side of a transaction knows more than the other side.
Jan Schnitzler 5
Adverse Selection in Economics
Akerlof (1970): Analysis of market for used car
 There are cars of good/bad quality

 Under asymmetric information, buyers don’t observe quality and
offer a price that reflects the average value of used cars.
 Owners of good cars are not willing to sell at this price.
Lemons Problem: Only low quality cars are offered for sale
 Buyers are not willing to pay average price because they face
adverse selection of sold goods.
 Another important application: Insurance industry.
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Asymmetric Information and Corporate Finance
 Most economists agree that markets for financial securities are at

best semi-strong form efficient.
 Managers know more about the firm than outside investors.
 Evidence for the relevance of this problem is the strict regulation

of insider trading in a company’s securities:
 Who are insiders? Managers, directors, and large shareholders.
 Insider trading generally allowed, but not on material non-public
information.
 All insider trades follow strict disclosure requirements.
 If managers are convicted in court, it is very often for trading on or leaking
of insider information.
Jan Schnitzler 7
Adverse Selection and Capital Structure
 “Good” and “bad” firms seek financing for a project

 Managers know whether a firm/project is good or bad
 Investors don’t observe it but are aware of asymmetric information
Thus, investors’ initial belief is to price securities at average value
Implication of asymmetric information for good firms:

+ Gain through positive NPV of project
- Loss through underpricing of securities
Implication of asymmetric information for bad firms:
+ Gain through positive NPV of project
+ Gain through overpricing of securities
Jan Schnitzler 8
Asymmetric Information Equilibria
Depending on the setting, two equilibria are possible:
1. Pooling: both types of firms raise funds and invest

 Positive NPV of project outweighs underpricing for good firms
⇒ Good firms subsidize bad firms
⇒ Investors are diversified and break-even on average
2. Adverse Selection: Good firms forgo the investment opportunity

 Underpricing outweighs positive NPV of project for good firms
 Only bad firms are left in the market
Equity issues overpriced/Debt more risky than market average
Investors anticipate it and adjust prices
Jan Schnitzler 9
Signaling
Good firms could try to reveal their type through signals:

 Investors try to infer types by observing and interpreting all
managers’ signals and decisions.
What is a credible signal?

 Not every signal of a good firm is credible because bad firms
could simply try to mimic a signal.
⇒ A credible signal needs to impose a cost that is too high for bad
firms to follow.
⇒ Debt could be such a positive signal because it leaves the more
senior claim to investors.
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Other signaling devices to mitigate Adverse Selection
These examples could be used as signals for risky debt issues:
Certification (through informed third party):

 Credit rating agencies
Guarantees:
 Offering collateral
Reputation:
 Short-term borrowing (to be rolled over).
Jan Schnitzler 11
Example: Capital Structure and Information Asymmetry
 Let’s consider a firm with assets in place.

 With equal probability these assets have the value:
0.5 150
0.5
50
 The firm has a new investment opportunity that requires an
investment of 18 and yields a certain payoff of 22.
 Assume the appropriate discount rate for the new project is 10%.
Should the firm undertake the project?

Should the firm use internal or external financing?
Jan Schnitzler 12
Example: Symmetric Information
 Valuation of new project:
Firm should undertake new project
Assumption 1: Manager and investors do not know the true value of

assets in place.
Internal Financing:
 If the firm has 18 in cash, it launches the new project
Existing shareholders collect the NPV of 2
Jan Schnitzler 13
Example: Symmetric Information cont’d
Equity Financing:
 After the new project is funded, the value of the firm is:
 What fraction of the firm is sold to finance the new project?
 Existing shareholders get:

Again, existing shareholders collect the entire NPV of 2
Modigliani-Miller holds, the managers are indifferent between internal

financing and external (equity) financing.
Jan Schnitzler 14
Example: Asymmetric Information
 Assumption 2: While investors do not know the true value of

assets in place, managers know it and investors are aware of it.
There are two different cases to consider:

1. Managers know that the true value of assets in place is 150
2. Managers know that the true value of assets in place is 50
Internal Financing:
 In either case, the NPV of the new project will accrue to existing
shareholders, thereby increasing their NPV by 2
Jan Schnitzler 15
Example: Asymmetric Information cont’d
Equity Financing:
Case 1: Managers know that the true value of assets in place is 150
 Investors don’t know the true value of assets

Existing shareholders will not issue equity. Why?
 15% share sold for 18 but it is worth

 NPV of project + Loss from Underpricing
Jan Schnitzler 16
Case 2: Managers know that the true value of assets in place is 50

 Investors don’t know the true value of assets

Existing shareholders are willing to issue equity. Why?
 15% share sold for 18 but it is worth

 NPV of project + Gain from Overpricing
Note: this calculation is off-equilibrium because we saw on the
previous slide that “good” managers would not want to participate.
Jan Schnitzler 17
Debt Financing: The firm could also issue a risk-free debt claim
 To raise 18 the claim needs a face value of
Existing shareholders with assets worth 150 get:
Existing shareholders with assets worth 50 get:
Conclusion:
High value firms would rather finance with debt than equity
If we observe an equity issue, the market learns that it must be a
low value firm as they are indifferent between debt and equity.
Jan Schnitzler 18
Take Away
 Cash in the firm is valuable because it is not subject to asymmetric

information.
 Similarly, if risk-free debt is feasible, it solves the asymmetric
information problem.
 Otherwise, adverse selection creates costs of external finance:

“$1 in the firm is worth more than $1 outside the firm”
The costs of external finance are lower for debt than equity issues
because debt is less sensitive to the firm’s value.
Jan Schnitzler 19
Empirical Results for Equity Issuance
The asymmetric information model predicts that equity issues are

more likely when stocks are overpriced.
The following established facts are in line with this:
1. Stock Prices decline on the announcement of equity issue
2. Stock Prices tend to rise prior to equity issues
3. Firms time equity issues when information asymmetries are

minimized, e.g. after earnings announcements
Jan Schnitzler 20
Stock Price Reaction of SEO Announcements
Source: Asquith and Mullins (1986)
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Stock Price Dynamics prior to Equity Issue
Source: Lucas and McDonald (1990)
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Equity Issues after Earnings Announcements
Source: Korajczyck, Lucas,

and McDonald (1990)
Jan Schnitzler 23
Pecking Order Hypothesis (Myers and Majluf 1984)
 Under asymmetric information, financing decisions carry an

additional signaling component about the prospects of the firm.
 Firms prefer to issue low information-sensitive securities first:
1. Internal financing
2. Risk-free Debt
3. Risky Debt
4. Equity
Jan Schnitzler 24
Pecking Order and Capital Structure
 Pecking-Order is a dynamic description of capital structure

 Which source should fund our next investment project
 It does not provide a theory for an optimal debt-equity ratio.
 The decision rule for equity and debt gets blurred:

 Internal financing is an equity funding source as well because
it is taken from retained earnings.
 However, retained earnings do not suffer from the asymmetric
information problem like external equity.
Jan Schnitzler 25
Funding Sources: US corporations 1979-1997
Jan Schnitzler 26
Equity Market Timing
The following evidence supports equity market timing:
 In surveys managers rank market timing as one of the most

important factors when issuing equity.
 Timing is successful on average:

 Equity issuance is relatively high when valuations are high.
 Share repurchases are high when valuation is low.
 Firms issue equity when investors are overly enthusiastic about

earnings growth.
Jan Schnitzler 27

1. No taxes
3. No issuance cost
Jan Schnitzler 28
Assumption: Financial Transactions have zero NPV
1. Financial markets are competitive

 All market participants are not providing a scarce security.
 They are price-takers and cannot charge a price premium due
to potential market power.
2. Financial markets are complete

 This assumption is important because it allows investors to build
replicating portfolios, as seen in the MM proof.
 Otherwise, arbitrageurs may not be able to exploit potential
mispricing of equity-financed and debt-financed firms.
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Assumption: No Issuance/Transaction Costs
 There are no distortionary transaction costs between debt and

equity financing.
Otherwise, one financing method may have a valuable advantage
and MM breaks down.
Symmetric fixed transaction cost:

 Firms will only adjust the capital structure if it is too far away from
the optimal level and the benefits outweigh the costs.
 Many changes to the Debt-Equity ratio may occur passively due to
changes in the stock price.
Jan Schnitzler 30
Summary
 In reality, mangers are better informed about the value of a firm

than outside investors
 This asymmetric information creates adverse selection costs

 Undervalued firms may forgo positive NPV projects
 Corporate investments should follow a strict Pecking –Order:

 Issue low information-sensitive securities first
 This theory describes persistent funding patterns of capital
expenditures
Jan Schnitzler 31
6. Valuation – APV & WACC
Jan Schnitzler

Valuation with capital structure effects
What do we know about valuation?

 Valuation of assets/cash flows (time value of money, risk, etc.)
 In special cases, we computed already tax shield values.
Define flexible models that take financing effects into account:

 Incorporate value of interest tax shields
 Neglect other capital structure effects (could be included)
This lecture is about the most common DCF models:

 Adjusted Present Value (APV) method
 WACC Method
Jan Schnitzler 2
I. Adjusted Present Value (APV)
The APV method involves 3 steps:
1. Estimate unlevered value of the project/firm.
2. Model present value of interest tax shields separately:

 Amount of debt used
 Relevant corporate tax rate
 Leverage policy (determining the riskiness of tax shield)
3. Add the two components
Jan Schnitzler 3
Unlevered Value of a Firm/Project
 Project FCF of an all-equity firm

 (no interest expenses!)
 Include a terminal value for long-lived projects:
 Use unlevered cost of capital to discount cash flows

 Think about risk of cash flows and how to estimate !
Jan Schnitzler 4
The Value of the Debt Tax Shield
 We learned that interest expenses are tax-deductible

 Treat reduced tax payments as if they were additional positive
cash flows
Remember:
 For project financing, only include incremental debt
 Debt tax shield only valuable if we pay taxes
 Otherwise, keep track of net operating losses and carrybacks
Jan Schnitzler 5
Discounting interest tax shields
What is the risk of interest tax shields?

 If the debt level fluctuates with future cash flows:
Use the unlevered cost of capital as discount rate:
 If the debt level is pre-determined:
Use the debt cost of capital as discount rate:
Leverage policies and discount rates for interest tax shields:

1. Constant target leverage ratio ( )
2. Pre-determined, dynamic debt policy ( )
3. Permanent, fixed amount of debt ( )
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1. Target Leverage Ratio
 The firm adjusts debt continuously such that the debt-equity ratio
remains constant.
 If operating cash flows increase, more debt is issued and the
value of the tax shield increases.
 If operating cash flows decrease, debt is retired and the value
of the tax shield decreases.
⇒ Under a target leverage ratio:
Jan Schnitzler 7
Example 1: Target Leverage Ratio
A firm considers the acquisition of a competitor:

 The assets of the target company are assumed to have the same
business risk as the firm’s assets.
 The firm has equity cost of capital of 10% and debt cost of capital
of 6%, and it maintains a debt-equity ratio of 1.
 The FCF of the target in the first year is estimated at 4.5M,
subsequently growing at a rate of 2% p.a.
 The acquisition is financed with $50M of debt and the firm intends
to maintain this underlying debt-equity ratio in the future.
 Assume a 40% tax rate.
Jan Schnitzler 8
Example 1: Target Leverage Ratio cont’d
 Unlevered cost of capital:
 Step 1: Value of unlevered firm
 Step 2: Value of tax shield
Note: To keep debt-equity ratio constant, the debt level

needs to grow at the same rate of 2% as free cash flows.
 Step 3:
Jan Schnitzler 9
2. Pre-determined dynamic debt policy
 One advantage of the APV method is that it allows us to value

different debt policies in a very flexible way.
 If the entire debt schedule is pre-determined, the interest tax

shield does not fluctuate with the value of the project and is
therefore fixed.
 Under a pre-determined debt schedule, the risk of the tax shield is
lower than the risk of cash flows
Use cost of capital as discount rate
 Let’s look at an example (see Berk and DeMarzo)
Jan Schnitzler 10
Example 2: Pre-determined Debt Schedule
Year 0 Year 1 Year 2 Year 3 Year 4

Sales - 60 60 60 60
COGS - -25 -25 -25 -25
Gross Profit - 35 35 35 35
Operating Expenses -6.67 -9 -9 -9 -9
Depreciation - -6 -6 -6 -6
EBIT -6.67 20 20 20 20
Income Tax (40%) 2.67 -8 -8 -8 -8
Unlevered Net Income -4 12 12 12 12
Plus: Depreciation - 6 6 6 6
Less: Capital Expenditures -24 - - - -
Less: Increases in NWC - - - - -
Free Cash Flow -28 18 18 18 18
Jan Schnitzler 11
Example 2: Pre-determined Debt Schedule, cont’d
 Unlevered cost of capital for the project are 8%.

 Assume that the firm finances initial expenditures of 30.67M
entirely with debt. This debt gets repaid consecutively according to
the following schedule
Debt level 30.67 30 20 10 0
 Assume that the project is relatively small with respect to the

overall size of the firm such that the cost of debt for the firm does
not change and remains at 6%.
Jan Schnitzler 12
Example 2: Pre-determined Debt Schedule, cont’d
 Project value without leverage:
 Present value of interest tax shield (discounted at ):

Debt level 30.67 30 20 10 0
Interest paid (𝑟 = 6%) - 1.84 1.8 1.2 0.6
Debt tax shield (𝜏 = 40%) - 0.73 0.72 0.48 0.24
 Project value with leverage:
Jan Schnitzler 13
3. Constant, permanent debt level
This special case we know already:
 Schedule of all future debt payments is pre-determined

 Since debt schedule is known, we discount at :
 Consistent with Example 2
Jan Schnitzler 14
Example 3: Constant, permanent debt level
Back to first example on slide 8:
 Assume that instead of keeping a constant debt-equity ratio

the firm issues 50M of debt and maintains that level
 It’s a coincidence that valuation is exactly the same. Why?
Jan Schnitzler 15
Unlevering Beta with pre-determined debt
Starting point is accounting identity:
 If we keep a constant debt level D, we argued that the risk of the

debt shield is lower than the risk of the assets. ( )
⇒ Without adjustment, estimate for asset beta too low
Jan Schnitzler 16
Unlevering Returns with pre-determined debt
The same risk adjustment has to be reflected in cost of capital:
The unlevered cost of capital is:
Re-levering the equity cost of capital:
Note:
 These formulas hold if we assume (or )
 Otherwise, prior formulas from Modigliani-Miller Lecture hold.
Jan Schnitzler 17
Example: Unlevering with pre-determined debt
You consider the acquisition of a privately owned start-up:

 You intend to add no leverage to the target after the acquisition
 Expected cash flows of $2M pre-tax in perpetuity
 Corporate tax rate is 40%
 The current market risk premium is 8.6%
 Risk-free rate is 5%
 The business risk of the target is most similar to two other publicly
traded companies that maintain fixed, permanent debt:
𝑬 𝑫
Twin firm 1 1.32 0.23 0.5
Twin firm 2 1.66 0.57 1.2
Jan Schnitzler 18
Example: Unlevering with pre-determined debt, cont’d
 The unlevered betas of the twin firms are:
 The corresponding unlevered cost of capital are:
 The value of the target company is
Jan Schnitzler 19
Extending the APV Method
 We can extend the APV method by including other costs and

benefits of leverage
Other financing effects include:

 Transaction costs/Underwriting costs
 Underpricing/Overpricing
 etc.
Jan Schnitzler 20
Cost of Financial Distress
 Estimate present value of costs of financial distress directly:
Hard to obtain good estimates for distress costs (see Lecture 3)
 Instead, we can also create a distress scenario:

1. Define a financial distress scenario:
a. What is the probability of this scenario?
b. Adjust cash flows for COFD
2. Compute weighted average:
Jan Schnitzler 21
Example: Issuance Cost
A company recently launched a new business unit:

 The firm expects the new unit to generate after-tax cash flows of
1.8M over the next 10 years
 The opportunity cost of capital is set at 12%.
 The corporate tax rate is 20% and there are no personal taxes
 Right now, this unit is all-equity financed
 The firm considers issuing $3M in debt to generate a tax shield
 Cost of debt are 8%, the issuance of debt requires however
issuance costs of 1.5% of debt value.
Is it valuable to issue the described debt claim?
Jan Schnitzler 22
Example: Issuance Cost cont’d
What is the value of the investment project?
First step: NPV if project was all-equity financed
Second step: tax shield of debt plus issuance cost

 Annual tax shield:
 Issuance cost:
 Debt is a fixed amount ⇒ Use cost of debt as discount rate
Jan Schnitzler 23
II. Weighted Average Cost of Capital (WACC)
 Due to tax deductibility of interest payments, assets only need to

earn to pay debt holders a return of .
 The WACC is:
 Note: Formula relies on assumption that firm maintains a constant

debt-equity ratio.
Jan Schnitzler 24
WACC Method
 Like in the APV method, predict unlevered free cash flows of the
investment project/firm
 Estimate the weighted average cost of capital using the after-tax

cost of capital for debt.
 Compute the present value with leverage by discounting free cash

flows with weighted average cost of capital.
Jan Schnitzler 25
Deriving the WACC Method
 Value of firm’s liabilities next year:

 Value of firm’s asset next year:
 Where is the value of remaining cash flows with leverage
 Accounting Identity:
You see connection between APV and WACC?

 Multiply the LHS of previous equation by and rearrange
Jan Schnitzler 26
Deriving the WACC Method, cont’d
 Dividing both sides by , we obtain:
 Assuming that remains constant over time, which requires

that the debt-equity ratio remains constant, we can iterate our
previous strategy:
Jan Schnitzler 27
Example: WACC Method
 A Dutch networking company considers expanding to Belgium.

 The product cycle of the latest routers lasts 4 years.
 The Dutch company is publicly traded: it has 800,000 shares
outstanding trading at $65/share, and $15M worth of debt
 It has the following betas: and .
 The market premium is 8% and the risk-free rate 5%.
 The company has a marginal tax rate of 34%.
Assumptions:
 Maintain the same constant debt-equity ratio after the expansion.
 The Belgium market is equally risky as the Dutch market.
Jan Schnitzler 28
Example: WACC Method, cont’d
 Analysts predict the following cash-flows for the Belgian market:

Year 1 Year 2 Year 3 Year 4
EBIT 2,620 3,436 3,671 3,976
Tax 891 1,168 1,248 1,352
Unlevered Net Income 1,729 2,268 2,423 2,624
+ Depreciation 449 475 475 475
- Capital Expenditures 522 512 525 538
- Δ Net Working Capital -203 -275 200 225
Free Cash Flow 1,859 2,506 2,173 2,336
 What is the value of the expansion?
Jan Schnitzler 29
The risk of the Belgium router market is comparable and the firm
intends to maintain the same debt-equity ratio
We can use WACC of Dutch market to discount free cash flows
from Belgium
What is the WACC of the Dutch market?
 First, we compute cost of debt and equity using the CAPM
Jan Schnitzler 30
 The market value of equity is
 Using these numbers, the WACC in the Dutch market is
 The present value of the expansion to Belgium with this leverage

policy is
 Note: We did not have to compute the value of debt at each point
in time to value the project.
Jan Schnitzler 31
Additional issues with the WACC method
i. Determining a firm’s debt capacity implied by WACC
ii. Project-based WACC formula
iii. Using WACC with changing capital structures
Jan Schnitzler 32
i. Implementing a Target Debt-Equity Ratio
In our previous example, we assumed a constant debt-equity ratio

and computed the project’s value.
How much additional debt does the firm require in each year such
that the debt-equity ratio remains constant?
Let’s define this level as the debt capacity
 Back out the debt capacity at each point in time t by:
Jan Schnitzler 33
Example: Computing Debt Capacity
 Back to the example, we can compute the value of the project in

Belgium at each point in time using .
 The debt capacity follows by multiplying the levered value with the
target debt-equity ration.
Free Cash Flow - 1,859 2,506 2,173 2,336
Levered Value 6,148 5,272 3,609 2,014 -
( )
Debt Capacity 1,376 1,180 808 451 -
( )
 Note: Try to solve this example with the APV Method. It requires simultaneous
solving for and . (See BM – Ch.18 Appendix)
Jan Schnitzler 34
ii. Project-based WACC Formula
 After having estimated , we have to relever the cost of capital

with the desired debt-equity ratio
 Which then can be used to compute
Alternatively, we can express in terms of instead of :
Where is the debt-to-value ratio, , aimed for the project
Jan Schnitzler 35
Example: WACC with different Risk
 Kodak is a traditional firm in the photographic film business.

 In a new diversification strategy, they intend to acquire a little
start-up that specializes in digital photography.
 Other firms in the digital photography business have unlevered
cost of capital of 15%.
 Kodak plans to finance the new division with 10% debt financing
at a borrowing rate of 6%.
 The corporate tax rate is 35%.
Jan Schnitzler 36
Example: WACC with different Risk, cont’d
 Strategy 1: Re-lever the cost of capital and use regular WACC

formula
 Strategy 2: Use project-based WACC formula
Jan Schnitzler 37
iii. Time-varying Debt-Equity Ratio
What if the debt-equity ratio is not constant?
 Use separate WACC for every period:
, , ,
 Remember: When adjusting WACC
, , ,
Don’t plug new capital structure simply into equation.

Unlever cost of capital and re-lever cost of equity to new debt ratio.
Jan Schnitzler 38
Example: Changing Target Leverage
Consider a firm with the following financing characteristics:

 Debt/Value ratio of 25%
 Debt cost of capital of 6.67%
 Equity cost of capital of 12%
 Tax rate of 40%
The current WACC is:
Jan Schnitzler 39
Example: Changing Target Leverage, cont’d
 Suppose the firm increases its target debt-to-value ratio to 50%.

 Also, suppose the firm’s cost of debt rises to 7.34% due to the
higher leverage.
 What is the new WACC?
 It is not:
 And it is not:
Jan Schnitzler 40
Example: Changing Target Leverage, cont’d
 We first determine the unlevered cost of capital:
 Then we re-lever the equity cost of capital:
 Finally, we can use these numbers to compute the WACC:
Jan Schnitzler 41
Comparison APV vs. WACC Method
WACC Method APV Method

+ Very easy to implement if a company + Transparent: it separates the value
maintains a target debt-equity ratio of assets from the value of financing
+ Can be used as a hurdle rate for decisions
investment decisions + Very flexible, we can use different
- Cumbersome to accurately adjust for discount rates that reflect the risk of
changes in leverage different cash flow components
- In that case, it effectively requires to - Requires explicit schedule of future
solve the APV method because debt levels and interest payments
and are needed to compute - If the firm keeps constant leverage,
WACC we have to solve simultaneously for
and
Jan Schnitzler 42
Summary: APV and WACC method
Most commonly used DCF models:
 Both, APV and WACC method, rely on (unlevered) FCFs

 Difference in treatment of interest tax shields:
 APV explicitly models interest tax shields and computes
present values.
 WACC implicitly takes account of it via a lower discount rate.
 If applied consistently, both methods should yield same results.

 Depending on capital structure assumptions, either method might
be easier to implement.
Jan Schnitzler 43
7. Valuation II
Jan Schnitzler

Outline of this lecture
Additional valuation topics:
I. Equity DCF valuation (FTE method)
II. Relative valuation (valuation multiples)
III. Valuation of real options
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I. Flow-to-Equity Method (FTE)
1. In contrast to APV or WACC Method, project free cash flows to

equity ( ).
2. Estimate equity cost of capital .
3. Determine the present equity value by discounting free cash

flows to equity with the equity cost of capital.
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Free Cash Flow to Equity (FCFE)
 Cash flows that accrue to shareholders after taking into account

all payments to and from shareholders
 We can begin the computation of FCFE at a lower item in the

income statement (after-tax and after interest payments)
 What is the adjustment for net borrowing?
 Net Borrowing is positive if the firm issues more debt

 Net Borrowing is negative if the firm retires more existing debt
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Income Statement of Royal Dutch Shell (2006)
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Relation between FCFE and FCF
Alternatively, we could start computing FCFE with FCF:
 Adjust for after-tax interest payments, since interest payments are

ignored in FCF.
 Adjust for changes in debt.
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Conceptual Difference to APV and WACC Method
Using APV or WACC Method:

 We estimate the levered value of a firm/project.
 If we want to obtain the equity value , we have to subtract the
debt value .
Using the FTE Method:
 We directly end up with an estimate for the equity value .
APV or WACC Method: FTE Method:
Debt Debt
Assets Assets
Equity Equity
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Example: FTE Method
 Let’s return to our example of a Dutch networking company

expanding to Belgium (Lecture 6).
 The company had a marginal tax rate of 34%.
 We assumed a constant debt-equity ratio
 Equity cost of capital was estimated at 19.4% and debt cost of
capital at 6.6%
 We did compute already free cash flows and the debt capacity of
the project in Belgium:
Free Cash Flow - 1,859 2,506 2,173 2,336
Debt Capacity 1,376 1,180 808 451 -
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Example: FTE Method, cont’d
 We first have to compute FCFE. Let’s start from the FCF we have
observed already:
Debt Capacity (𝑫𝒕 ) 1,376 1,180 808 451 -
Free Cash Flow - 1,859 2,506 2,173 2,336
− 𝟏 − 𝝉𝑪 𝒓𝑫 𝑫𝒕 (𝝉𝑪 = 𝟑𝟒%) - -59 -52 -35 -20
+𝑵𝒆𝒕 𝑩𝒐𝒓𝒓𝒐𝒘𝒊𝒏𝒈 +1,376 -196 -372 -357 -451
Free Cash Flow to Equity 1,376 1,604 2,082 1,781 1,866
Note: the slightly different valuation is due to rounding errors.
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Example: FTE Method, cont’d
 Why is equity value from FTE method not different compared to

the levered firm value from WACC method
Because we issue and fully repay debt during our projection
horizon and end up with all-equity.
Net Borrowing +1,376 -196 -372 -357 -451
Interest expenses - -91 -78 -53 -30
Cash Flow from Debt +1,376 -287 -450 -410 -481
 Borrowing is zero-NPV since fairly priced.
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Assessment of FTE Method
 Note that in our example the debt capacity was given and that
the firm maintained a target debt-equity ratio.
 In contrast to the WACC method, the FTE method requires the

computation of a project’s/firm’s debt capacity (like APV method).
Interest payments are subtracted to obtain FCFE.
Debt capacity also important for net borrowing activity.
 If debt-equity ratio changes over time, we have to recalculate

equity cost of capital for each period.
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Example: FTE Method and Constant Growth
 A firm considers to acquire a competitor in the same industry

(assume that the target’s assets have the same risk).
 The expected FCF of the target company for the next year is
$3.8M and the firm plans with a 3% growth rate thereafter.
 The firm intends to use $50M of debt for the acquisition that has
been offered by a banking consortium for 6% p.a.
 With this financing mix, the firm calculates with equity cost of
capital of 10%.
 Assuming the firm faces a corporate tax rate of 40% and aims at
maintaining a fixed debt-equity ratio, what is the maximum price it
should offer to acquire the target company?
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Example: FTE Method and Constant Growth, cont’d
 The firm collects $50M debt financing today:
 The firm will pay 6% interest on the debt next year:
 To keep the debt-equity ratio constant, outstanding debt will also

grow at a rate of 3%. Therefore, the firm will issue additional debt:
 All components of the sum will grow with a rate of 3% in the future.
 With this financing, the maximum price should be 100M

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Valuing Financial Institutions
FTE method is particularly useful to value financial institutions:

 Rather than a source of funding, debt is at the core of their
business model (Transforming characteristics of debt).
 It is difficult to define debt, interest payments are often the largest
expense item.
 Very high leverage, plus tier capital ratio regulated.
⇒ Consider cost of equity as capital cost since a financial institution
needs to finance a certain amount by equity
⇒ Rather than valuing assets and subtracting the value of debt, value
equity stake directly. (FTE method)
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General Comparison of DCF Valuation Models
All methods are based on discounting cash flow models:

 APV method: adjusts cash flows
 Explicitly models free cash flows and tax shields
 Uses 𝑟 to discount assets
 Discount tax shields at 𝑟 or 𝑟 - depending on the leverage policy.
 WACC method: adjusts discount factors

 Only based on free cash flows
 Does not use 𝑟 as discount rate
 Instead, uses after-tax WACC to adjust for the tax shield
 FTE method: compute cash flows to equity

 Models free cash flows to equity (FCFE)
 FCFE take all payments to and from debtholders into account
 Discount with equity cost of capital 𝑟
If based on equal assumptions, all methods lead to same valuation.
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II. Valuation Multiples
Financial metric that standardizes market value:
( )
Conceptually, very different than DCF valuation:

 Intrinsic vs. relative valuation
 Scaling statistic has to be a persistent key value driver.
There are two main types of valuation multiples:

1. Enterprise multiples (Firm value)
2. Equity multiples
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Valuation steps
 Select group of comparable assets with observed market prices:

 Usually public firms from same industry/country.
 Important that value fundamentals are similar.
 Create price multiples by standardizing market values:
 Used metrics are persistent value drivers.
 Most common statistics: sales, earnings, cash flows, book values.
 Forward multiples: use forecasted statistic for next period.
 Trailing (current) multiples: use realized current or past statistics to
standardize market value.
 Scale multiples with metrics for asset of interest:
 Compare valuations for traded assets (mispricing).
 Get market price for untraded assets.
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Evaluating Valuation Multiples
Advantages Disadvantages
+ Readily available - In its basic form a static model
+ Based on actual prices traded - Its simple computations may
in markets (rather than our lead to premature decisions
forecasts of FCF) without understanding
+ Easy to communicate - So many different definitions
such that selective reporting
could justify any valuation
- Universe of comparable
assets (and comparability)
limited
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Relative pricing: A caveat of multiples
 Multiple valuations often focus narrowly on same industry:

⇒ doesn’t help if entire industry is over/undervalued
Example: Dot-Com bubble

 In late 90s many IT start-ups did not even have sales, but aimed to
issue equity in financial markets.
 No sales makes multiple valuations difficult.
 The industry developed new creative multiples, like price per
number of page views.
 These multiples were later hard to reconcile with traditional
multiples.
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Importance of Valuation Multiples
Valuation multiples are pervasively used in practice:

 Many multiples are reported in financial media, and assets are
compared using these multiples.
 Used in core finance areas, like M&A advising.
 Easy to communicate/defend valuation estimates.
 Natural starting point for DCF analysis:
 It gives you a range where your valuations could end up.
 Often reverse engineering of DCF analysis to see where the
company generates value.
 Particularly useful to help determine terminal value in DCF
analysis.
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List of Valuation Multiples
Equity multiples - based on market value of equity

 Price/Earnings ratio
 Price-to-book value
 Dividend yield
Enterprise multiples - based on enterprise value defined as:
 EV/Sales ratio
 EV/EBITDA
 EV/EBIT
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Price/Earnings Ratio
 One of the most important valuation multiples is the

Price/Earnings ratio:
 Affected by capital structure of firms

 Adjust earnings for extraordinary items and write-offs to make it
comparable
 Cannot be used with negative earnings
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P/E Ratio and Economic Fundamentals
 Use formulas from DCF models, to build economic fundamentals

into the P/E ratio.
 Forward P/E ratio:
 All else equal, P/E ratio increases with dividend payout ratio and
EPS growth, and it decreases with risk ( ).
 Trailing P/E ratio:
where refers to the EPS growth rate.

Similar equations can be derived for all other valuation multiples.
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Example: P/E Ratio
Your team of specialists is asked to value a private company.

Target firm:
 You estimate net income to be $100M.
Comparable firm:
 There is only one comparable firm publicly traded.
 Analysts estimate that the net income is increasing by 4% p.a.
 The payout ratio is 50% and the equity beta equals 1.
 Assume that the CAPM holds. The current risk-free rate is 4% and
the market risk-premium 6%.
 What is the P/E ratio of the comparable firm, and what is the value
of the target?
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Example: P/E Ratio, cont’d
 Compute cost of equity of comparable firm:
 Compute forward P/E ratio of comparable firm:
 Compute equity valuation of target company:
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Distribution of P/E Ratios in US
Source: Damodaran 2012
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Price/Book
Fraction of shareholder equity that is captured in the balance sheet
 Useful if tangible assets are core of company’s value creation.

 Book value may differ across firms with different accounting
practices.
 Mainly applied to financials where mark-to-market accounting
gives book values a more reliable economic value.
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Distribution of Price-to-Book Ratios in US

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Dividend Yield
Often considered for investors’ portfolio decisions:
 Reversed ratio (low ratio=high valuation)

 Neglects share repurchases as alternative way to return cash to
shareholders
 Dividends are sticky: Stocks with very high dividend yields may be
the ones running into financial distress
Of interest to investors requiring steady repayments
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EV/EBITDA
 Probably the most common multiple based on enterprise value:
 Unaffected by different depreciation policies of firms

 Downside: firms with different capital intensity are difficult to
compare.
 Not affected by different capital structure of the firms
 It is a pre-tax earnings measure (doesn’t capture different tax
management of firms)
 Cannot be used when (very rare)
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EV/EBITDA Ratio and Economic Fundamentals
 Similar to what we did for the P/E ratio, we can link the
EV/EBITDA ratio to economic fundamentals:
 Determinants of EV/EBITDA ratio are cost of capital (risk),

expected growth, tax rate, and reinvestment (Depr,Capex,NWC)
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EV/EBIT
A closely related multiple is EV/EBIT ratio:
 More comparable when capital intensity across firms differ

Downside: Affected by different depreciation policies of firms
 Not affected by different capital structure of the firms
 It is a pre-tax earnings measure (doesn’t capture tax
management)
 Cannot be used when
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Distribution of EV/EBITDA Ratios in US

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EV/Sales ratio
Another multiple with useful applications:
 Least susceptible of accounting differences.

 Less useful if operating margins differ widely across firms.
 In that case, however, it helps to identify restructuring potential
 Frequently used in retail industries.
 The only financial multiple to value young growth firms generating
losses.
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Distribution of EV/Sales Ratio in US

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Equity vs. Enterprise Multiples
EV Multiples Equity Multiples

 Independent of firms’ capital  Of higher interest to most
structures equity investors
 Statistics to standardize EV  Equity value clearly defined
multiples are less affected by whereas enterprise value is
accounting not
 Gives opportunity to adjust for  Market values for corporate
non-core assets debt are sometimes stale
whereas stock prices are not
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III. Real Options
 The right (not the obligation) to make/change a particular business

decision, such as a capital investment
 Instead of treating today’s decision as irreversible, it allows for
future flexibility under changing conditions.
 Financial options (puts and calls) give the option to sell (or buy)
the underlying security for a pre-specified price at a given date.
 A key distinction between real options and financial options is that

real options, and the underlying assets on which they are based,
are often not traded in competitive markets.
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Valuation Effect of Real Options
 So far, we have considered NPV-rule for project evaluation:
 Often cash flows depend on future decisions, which in turn

depend on future cash flow outcomes.
 The opportunity to adjust a project’s characteristics in the future
will increase today’s value of the project.
 Relevant issues of this topic:
 How to spot real options
 How to account for them in your NPV calculation
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Conditions for Real Options
Three conditions are required for real option value:
1. New information must arrive (i.e. prices change, or we get

information about technology, product, customer demand, etc.).
2. The project can be modified after learning more about its
characteristics.
3. Either new information or the option to modify the project require
an initial investment. (Exclusive right to exercise option)
 Similar conditions are required for financial options to be valuable.
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Characterization of Real Options
 Option to wait: the exercise price is the amount required for

launching the project.
 Option to expand/shrink: the exercise price is the investment
required to scale up/down a project.
 Option to abandon: very common feature of many investments.
The exercise price is the amount paid for abandoning the project.
 Option to continue: the exercise price is the amount invested to
extend the life of a project.
Many investment opportunities may be better described by a

combination of previous real options.
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Main analytical tools for Real Options
Managers often incorporate real option values into decision making

based on rough estimates from their experience.
Better verify your intuition in an analytical way:
 Option Pricing Theory (Black-Scholes model)
 Decision Tree analysis
 Monte Carlo simulations
These methods are covered in advanced valuation courses.
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Useful Implications from Option-Pricing Theory
Robust insights from option-pricing theory:

 The option value increases in volatility of the underlying security.
 The larger the difference between “success” and “failure”, the
larger the value of the option.
 The option value increases in time to maturity.
 The option value can be positive, even though a project currently
has negative NPV.
 The option value decreases in current profitability of the project
 Foregone profits to keep option alive.
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Value Drivers of Flexibility
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Relevance of Real Options for Valuation Models
 Real options are pervasive.

 Most investment decisions include embedded real options.
It is important to
 spot existence of real options.
 identify and quantify most valuable real options.
The contracting in some industries display real option features:

 Venture capital (Investment staging)
 Bio-tech, pharma (R&D intensive)
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Incorporating real option value into DCF Models
Consider Real Option a complement to standard DCF valuation:
1. Build a regular DCF model

2. Add option value of features that appear particularly valuable:
 Unique features of real options require separate analysis
 Categories of interest are R&D, product developments, etc.
 Don’t double count valuable features by including them in DCF
and Option value
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8. Payout Policy
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Use of Free Cash Flows
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Chronology of Dividend Payments
 Declaration Date
 Dividend decision taken by board of directors
 Once decided, the dividend payment becomes a legal obligation
 Ex-Dividend Date
 First Date on which the stock trades without the dividend
 Two business days prior to the record date
 Record Date
 Shareholders registered on this date are entitled to the dividend
 Distribution Date
 Dividend is paid out to shareholders
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Important Dividend Metrics
 Dividend per share (DPS): dollar amount paid per share.
 Dividend yield: Percentage of share price paid as dividend
 Payout ratio: Percentage of income paid to equity investors as a

dividend.
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Share Repurchase Transactions
 Open Market Repurchase

 Most common route to repurchase shares (95%)
 Firm trades in regular exchanges over a longer interval
 Fixed Price Tender Offer
 Firm offers to buy shares at a pre-specified price until number of desired
shares has been reached
 Dutch Auction
 Firms announces to repurchase a pre-specified number of shares
 Shareholders submit for each price tick how many shares they are offering
 Transaction takes place at the lowest price that fills target number of shares
 Targeted Repurchase (Greenmail)
 Firm negotiates directly with a large blockholder to repurchase shares
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Example: Cash Dividend
 A firm expects to generate free cash flows of $1M in perpetuity

 The firm has 100,000 shares outstanding and shareholders
require a return on equity of 10%
Assume the firm intends to pay the entire cash flows as dividends
and today is the ex-dividend date of this year’s dividend.
$
per share
,
What is the stock price?
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Microsoft stock price before/after $3 dividend
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Example: Stock Repurchase
Assume instead that the firm uses this year’s free cash flows to
repurchase shares.
 How many shares will be repurchased for $1M?
$
shares
$
 What is the stock price?
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Example: Special Dividend plus Equity Issue
Assume that the firm wants to pay a special dividend worth $2M.
 The firm needs additional $1M How many shares to issue?
$
shares
$
 Future free cash flows are distributed among more shares
$
,
per share
$
,
per share
What is the stock price?
Jan Schnitzler 9
Dividend Decision in Perfect Capital Markets
Modigliani-Miller Dividend Irrelevance

In perfect capital markets, a firm’s payout policy
does not affect the (initial) value of the firm.
 Similar to our capital structure analysis, MM provides a starting

point when dividend/repurchase decision is irrelevant
 Payout policy interacts with financial & investment decisions
 Start with usual suspects to learn more about dividend/payout
decisions.
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I. Dividends vs Share repurchases
Clientele effect: firm’s payout policy attracts a specific investor base.

Some shareholders have preferences for stable cash flows.
Different shareholders face different tax implications.
 Many countries tax dividends and repurchases differently:

1. Dividend tax rate
2. Capital gain tax rate
 If dividend tax rates are higher than capital gains tax rate:
Optimal payout policy is to pay no dividends!
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Dividend Puzzle: Payout ratios in US
 Despite dividends had a higher tax rate over a long period in the
US, dividends were still very commonly used.
Dividend Puzzle
Year Capital Gains Dividends
Tax rate Tax rate
1971-1978 35% 70%
1979-1981 28% 70%
1982-1986 20% 50%
1987 28% 39%
1988-1990 28% 28%
1991-1992 28% 31%
1993-1996 28% 40%
1997-2000 20% 40%
2001-2002 20% 39%
2003- 15% 15%
Source: Grullon and Michaely (2002)
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Tax clientele effect
Investor buys stock at and sells at

Collect after-tax dividend:
but realizes trading loss:
Under no arbitrage:
Investors Preference Clientele effect: payout policy affects

Individual investors Buybacks shareholder composition.
Retirement accounts No preference Dividend stripping: low -investor
Institutional investors No preference holds stock around dividends.
Corporations Dividends
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II. How much cash should be distributed?
“The company should pay out its cash rather than just invest in T-bills
at a low interest rate. This would increase investors returns.”
Modigliani-Miller Payout Irrelevance

In perfect capital markets, if a firm invests excess
cash flows in financial securities, the firm’s choice
of payout versus retention is irrelevant and does
not affect the initial value of the firm.
 To finance positive-NPV projects, firms can always raise funds in

perfect capital markets after having paid dividends.
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Example: Payout vs. Retention of Cash
Assume perfect capital markets:

 A firm has cash flow-generating assets worth $1000 and excess
cash of $100 on its balance sheet
The firm considers a special dividend of $100 or, alternatively, an

investment in risk-free T-Bills (Fair price: NPV-zero investment)
 If the firm invests in T-Bills, investors don’t get a current dividend
but a claim to the increased future cash flow of the T-bill.
 However, if investors get the immediate dividend, they can
replicate the payoff by buying T-bills themselves.
The firm value does not change!
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Excess Cash and Leverage
 Managing excess cash and deciding on a firm’s capital structure is

essentially the same decision
All theories we discussed for the capital structure could have

similar (reversed) implications for cash management
 When analyzing capital structures, we often take net debt values

into account:
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Example: Payout vs. Retention with Taxes
Consider the same firm again investing in T-bills returning 10%.

 Let’s assume that the firm pays corporate taxes of 40% and that
the investors are tax-exempt.
Retention and internal T-bill investment:


Dividend and investor undertakes T-bill investment:

Keeping excess cash creates a “negative” tax shield of

Possible to include taxation at investors’ level (see Lecture 3)
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Payout over the Life Cycle of a Firm
What indicates a firm’s payout potential?

Free cash flow to equity, or Net income
Young firms: Positive-NPV projects, but negative cash flows.

Growth firms: Growth potential, but insufficient cash flows.
Value firms: Risk of negative-NPV projects, positive cash flows.
Remember: Getting funds into the firm is costly!

 Transaction costs
 Asymmetric information cost
Not all firms should pay dividends (less than 50% pay dividends)
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Dividends as Signaling Device
Dividends are very sticky (Dividend Smoothing)

 If a firm increases dividends, it is confident that it can maintain it.
 The market interprets dividend changes as a signal for E(FCFE).
If dividend decreases are costly, it can be a commitment device
mitigating FCF problems (just like interest payments)
Signaling value of dividend introduction is double-edged sword:

+ Positive about future cash flow expectations
- Indicates end of growth period
Repurchases are less sticky (more volatile)

 Rather a signal about managers’ price expectation (underpricing).
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Dividend Smoothing: EPS vs DPS for General Motors
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Empirical Results
Event study analysis gives us the following empirical findings:
1. Dividend introductions are accompanied with large positive,

abnormal returns.
2. Dividend increases lead to positive, but smaller positive returns
3. Dividend omissions are followed by negative abnormal returns
4. Regular stock repurchases increase the stock price
5. Greenmail, however, may lead to negative stock price effects
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Stock Price Reaction and Initial Dividends
Source: Asquith and Mullins (1986)
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Stock Price Reaction and Repurchases
Source: Vermaelen (1981)
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Summary: Excess Cash in Imperfect Capital Markets
Disadvantages:
- Effective tax disadvantage
 Even after adjusting for taxes at the investors’ level
- Agency Cost of Free Cash Flows
 Excess cash tempts mangers to overinvest (aggravating FCF Problems)
Advantages:
+ Transaction Costs
 1%-3% for debt issues; 3.5%-7% for equity issues
+ Costs of Financial Distress
 Cash helps to bridge a period of illiquidity avoiding financial distress costs
+ Asymmetric Information
 Cash reserves (internal financing) is not subject to asymmetric information
Jan Schnitzler 24
Special Dividends: Non-Cash Dividends
Stock issuance/split: distribution of additional shares to shareholders

 No cash flow consequences: # shares and stock price
 In contrast to cash dividends, no tax consequences
 In contrast to share issuance, no additional cash raised
 Reverse split: combining several shares into one new share
Motivation: Keep stock prices in certain price range

If stock prices are too high:
 Stocks only trade in full units
Small investors cannot afford a single share (e.g. Berkshire Hathaway)
If stock prices are too low:
 Transaction costs become high (bid/ask spreads)
 Most exchanges have listing requirements (stock prices above 1$)
Jan Schnitzler 25
Special Dividends: Spin-offs
A spin-off is a transaction where a company establishes a division as

a separate business entity.
Shareholders receive pro-rata equity shares in the newly created
company, which they can trade separately from each other.
Comparison to a standard divestment (sale plus cash dividend):

 The distribution of a special stock dividend does not have
immediate tax consequences.
 Avoids transaction costs associated with sale, but requires
establishing a separate entity.
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Other Corporate Decision: Risk Management
Firms can actively manage the risk of assets and liabilities

 Instead of managing the size of the balance sheet, risk
management is about the volatility and related risk factors
Risk Management:
1. Operating decisions
2. Capital Structure
3. Financial contracts/derivatives
 In perfect capital markets, investors can perfectly replicate the risk

management of the firm (homemade risk management)
No arbitrage implies that risk management does not increase firm
value
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9. Equity Financing
Jan Schnitzler

Outlook for this lecture
Berk and DeMarzo: Chapter 23
 We covered trade-offs between equity and debt financing.
 But how does a firm actually raise equity capital?

- Who are potential investors?
- How does the ownership structure change over the life-cycle of
a company?
- How does a firm get publicly listed?
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Life-cycle of a company
Not all business ideas need outside equity:

 Some businesses (especially services) are hard to scale
- e.g. law firms, medical services, restaurants, etc.
Firm characteristics that require outside funding:

 Increasing returns of scale or scope
 Large initial capital expenditures for research or investment
 Few tangible assets
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Entrepreneurial Finance
 Small companies owned by individuals/family

 Organized as sole proprietorship or partnerships
If outside equity is raised, entrepreneurs face the following trade-offs:

+ Helps to diversify private wealth of entrepreneur
+ Potentially only available financing source
+ Certification signal to the market
- Giving up control
Problems in decision-making process
Dilution of entrepreneur’s stake may cause problems in 2nd financing round
- Selling for a discount
Jan Schnitzler 4
Equity funding sources over the life-cycle
Early options:
1. Angel investors
2. Venture capital funds
3. Strategic corporate investors
Later options:
4. Private placements to institutional or financial investors
5. Initial public offering (IPO)
6. Seasoned equity offering (SEO)
Jan Schnitzler 5
Characteristics of Start-up Firms
Start-ups seeking external capital face the following challenges:

 High uncertainty about technology
 Large failure rate
 Significant asymmetric information
 Large fraction of intangible assets
 Expected years of negative earnings
Jan Schnitzler 6
Angel investors
Individuals who provide initial seed funding for a start-up firm:

 Founders, wealthy people, financial experts, etc.
 Alternatively, family and friends, more recently crowdfunding
What do they do?
 Buy equity or convertible debt in start-up firms
 Often limited amounts but only available financing source
 Request large influence on business decisions
 Bring in important business connections
Diverse motivation of angel investors (pure altruism, mentoring,
hijacking good projects)
First financing with wrong incentives may be already decisive
Jan Schnitzler 7
Venture Capital firms
 Organized as limited partnerships with finite lives (10 years)

 General partner – venture capital firm
 Limited partners – institutional investors (pension funds,
endowments, etc.)
VC structure offers:
1. Access to start-up investments
2. Diversification in start-up investments (even syndication)
3. Expertise and network of venture capital managers
Jan Schnitzler 8
Why is venture capital special?
Venture capitalists are active investors:

 1.5%-2.5% management fee
 Additional 20% carried interest
Payoff highly performance dependent
 Specialized industry knowledge (with financial background)

 Venture firms with reputation provide valuable certification
 Take seats in the board of portfolio companies
 Bring in their own executive managers
 Encourage cooperation of separate portfolio companies
Jan Schnitzler 9
Venture capital amounts under management
Jan Schnitzler 10
Characteristics of VC portfolio firms
Jan Schnitzler 11
Venture Firm Contracting with Entrepreneurs
Investments of VC firms take features of targets into account:
 Staged financing
 Future financing depends on reaching specified milestones
 Right contingencies (Kaplan and Stromberg (2003))

 Venture contracts are effective at separating cash flow rights,
board rights, voting rights, liquidation rights
 If firm performs poorly, VC firms take more control
 Otherwise, entrepreneur retains control rights
Jan Schnitzler 12
Example: Staged financing
Opportunity to invest into a new venture project:
 Overall investment need of $100M to bring project from the brain-

storming stage to the IPO phase
 You expect a 10% probability that the entire development process
up to the IPO turns out successful, in which case you will make
$800M in present-value terms.
Would you invest?
Jan Schnitzler 13
Example: Staged financing cont’d
IPO
PV = 800
Let’s split the development process into stages: 20%
Invest:I
2=-90 No IPO
Works
50% 80%
Don’t
I1=-10 PV =0
invest I2
PV =0
Not
Remarks: 50% PV =0
 Ex-ante probability of IPO is still:
 Overall investment is still:
 However, the information set for parts of the investment decisions are
different:
Jan Schnitzler 14
Contingent Contracting
In addition to common equity,

 VC holds convertible preferred stock
- Senior to common equity and pays an interest rate
- Convertible to equity according to a preset conversion ratio
 Anti-dilution clauses
 Vesting provisions for managers’ shares/options (based on
time/performance)
 Non-compete clauses for entrepreneurs
Entire structure strongly incentivizes entrepreneurs!
Jan Schnitzler 15
Exit Strategies for Early Equity Investors
 Founders may want to move on or retire.

 Venture capital funds have a finite life of 10 years
Requires exit plan
There are two main exit strategies:

 Sale of entire company
 to a large strategic investor
 to a financial investors (possibly another private equity firm)
 Going public
Jan Schnitzler 16
Acquisition by Strategic Investors
 Innovation often takes place in start-up companies

- Large companies have difficulties to maintain innovative
research environment
- Not enough upsides for inventors offered in a large firm
 Large companies purchase technology

- Substitutes in-house research
- Weakens potential future competition
- Most VC-backed companies exit through an acquisition
Jan Schnitzler 17
VC-backed IPOs
Jan Schnitzler 18
The Going Public Decision
Advantages Disadvantages
 Better access to large  Insiders may lose their
amounts of capital controlling stake
 Initial investors get opportunity  Dispersed ownership makes
to diversify (creates liquidity) monitoring difficult
 Improves bargaining power  Firms must comply with
with respect to other investors disclosure requirements of
 Transparency imposes stock regulators/stock exchanges.
market discipline on  Underpricing due to
managers asymmetric information
 Marketing effects
Jan Schnitzler 19
Initial Public Offerings (IPOs)
The process of selling stock to the public for the first time.
 The firm hires an investment bank for the underwriting process.
 Large IPOs are often managed by syndicates with one assigned

lead underwriter.
Jan Schnitzler 20
Types of IPO Offerings
 Best-efforts IPO:
 Underwriter markets stock and tries to sell it at the best price
 Common structure for smaller IPOs
 Deals often have a contingent all-or-none clause
 Firm commitment IPO:
 Underwriter guarantees sale of entire issue at the offer price.
 If not all shares were sold, the underwriter takes the loss.
 Most common IPO structure.
 Auction IPO:
 Public auction defines price that clears market.
 Example: Google’s IPO
Jan Schnitzler 21
The traditional Timeline of an IPO
The underwriter advises and helps to manage the deal:

1. Arrange a syndicate of banks if necessary.
2. Register preliminary and final prospectuses with the SEC
3. Set a size and price range to market the issue.
4. Organize a road show with main customers/investors.
5. Customers give non-binding bids for shares, which get registered
in the book building process.
6. Shares start trading in a public venue.
7. Initial market making of stock after IPO to maintain stocks liquid.
8. Existing shareholders are subject to a 180-day lockup period.
Jan Schnitzler 22
Compensation of Underwriters
Underwriting spread:
 7% fee of issue volume.
 In firm commitment IPOs, underwriter buys shares from issuing
entity for a discount.
Over-allotment allocation (Greenshoe provision):

 Allows underwriter to sell additional 15% of original offer size.
 This over-allotment gets also offered to investors.
 In a successful IPO, the underwriter will exercise the option.
 Otherwise, underwriter repurchases over-allotment in public
market and does not exercise option.
Jan Schnitzler 23
Stylized Empirical Facts
What do we know about IPO outcomes?
I. IPO Underpricing
II. Cyclicality of IPOs
III. The Cost of an IPO
IV. Long-Run IPO Underperformance
Jan Schnitzler 24
I. IPO Underpricing
First-day return after listing:

 Average return of 17%
 Globally observed
against efficient markets
extra issuance cost
Consequences:
Underwriter’s risk limited (commitment deals). Source: Ljungqvist (2004)
Original shareholders bear underpricing cost.
Jan Schnitzler 25
“The Winner’s Curse” (Rock 1986)
Asymmetric information among potential investors:

 Informed investors only bid for attractive IPOs while uninformed
investors bid indiscriminately
 Attractive IPOs are oversubscribed
 Uninformed investors get rationed with a pro-rata share
 In unattractive IPOs, uninformed investors get all shares
If IPOs were fairly priced, uninformed investors would make losses

in expectation and thus not participate.
If uninformed capital is required for success of IPO, initial owners
have to offer underpricing.
Jan Schnitzler 26
A Book-building Theory
Asymmetric information between underwriter and investors

 Strict pro-rata allocation often not binding leaving discretion about
allocation to underwriter
 Eliciting price information of informed investors main challenge
 Underwriter designs mechanism that induces truth-telling:
- Discriminate allocation between bidder’s who reveal a lot of
information and passive bidders.
- Truth-telling only compatible if some gain to informed investors
is left on the table
Underpricing of IPOs helps to collect demand-side information
Repeated interactions between underwriters and investors
strengthens mechanism.
Jan Schnitzler 27
II. Cyclicality of IPOs
IPO cycle overlaps with business cycle:
Window of opportunity
- Launch IPO if high market valuations.
- Other financing in crisis (if available).
Extreme fluctuations:
Driven by investment opportunities?
Evidence for market frictions?
Jan Schnitzler 28
III. Direct Cost of IPOs
Direct cost
 Depends on issue size
 Largest for equity
Violation of MM!
Relative cost
 Surprisingly flat
 7% Plus Contracts
Collusion among investment banks?
Lower cost signal for low reputation of
underwriter?
Jan Schnitzler 29
IV. Long-run IPO Underperformance
Source: Ritter (1991)
Jan Schnitzler 30
Seasoned Equity Offerings (SEOs)
Capital increase of a stock that is already publicly listed.

 Requires a similar underwriting process as IPO.
 Main difference: there exists a market price.
 Primary or secondary shares can be offered.
There are two kinds of SEOs:

 Cash offer: new shares are offered to the public.
 Rights offer: only existing shareholders get the option to purchase
additional shares.
Underpricing of a cash offer dilutes claims of existing shareholders
Jan Schnitzler 31
Post-SEO performance
Jan Schnitzler 32
10. Debt Financing
Jan Schnitzler

I. Corporate Borrowing
 Usually one class of common equity

 Very complex structure on debt side:
 Publicly traded or privately held debt
 Different maturities
 Different seniority (senior vs. subordinate)
 Fixed-rate or floating-rate
 Callable or retractable (puttable)
 Convertible
 Sinking fund provisions
We have to rely on fixed-income models to price debt claims.
The pricing of residual claims depends on entire capital structure.
Jan Schnitzler 2
Risk-free Debt
 If all debt securities were risk-free:

- No need for differential treatment of claims
- Every claim perfectly priced by risk-free rate
- The only thing that matters is time to maturity
Yet, there is corporate credit risk:

 Existing bondholders try to defend their claims from dilution
through new bondholders (dynamic build-up of complex structure).
 Bondholders try to defend their claims from the risk of
expropriation and risk-shifting through equityholders.
Jan Schnitzler 3
Credit Risk
Credit risk can be separated into three components:

1. Default risk:
 Risk that issuer fails to service interest or principal payments.
 Corporate bonds have credit spreads over treasury securities.
2. Credit spread risk:
 Market changes perception of credit risk of company, industry,
or the entire corporate sector.
 Relevant for investors who do not hold until maturity.
3. Credit downgrade risk:
 Rating downgrade has significant price impact (discontinuity).
Jan Schnitzler 4
Credit Scoring
Statistical method to predict default probability of borrower

 Estimate effect of observable characteristics on delinquencies
 Mainly used by banks to assess the risk of loans:
- Consumer lending
- Mortgage lending
- But also small business lending
+ Cheaper and more objective than decision of loan officer
- Hard to incorporate officer’s soft information
Option for financial institutions

Difficult for small or diversified investors
Jan Schnitzler 5
Credit Rating Agencies
 Debt issuer purchases credit rating:

 Major agencies: Moody’s, Standard & Poor’s, Fitch
 Rating at security not company level
 Investment grade: AAA, AA, A, BBB
 Non-investment grade (high-yield, junk): BB, B, CCC, CC, C
 Exact formula business secret
 Financial markets have a good sense how to grade a bond
 Important variables: leverage ratio, interest coverage ratio, RoA
Ratings are closely followed by investment community.

In particular difference between BBB and BB important since
some investors are only allowed to buy investment grade.
Jan Schnitzler 6
Interest Coverage Ratio
 It measures how many times a company could pay its interest

payments with its current earnings:
If no rating is assigned or observed:

Use interest coverage to determine a hypothetical credit rating.
This rating can be used to estimate cost of debt.
Jan Schnitzler 7
What is Public Debt?
Bond Indenture:
 Formal contract between a bond issuer and a trust company
 The trust company enforces statutes of indenture
 In case of default, trust company represents bondholders
What makes it public?

 Exchange listed or Over-the-counter (OTC) from brokers
 Contract features highly standardized
 Face value denominated in $1000 (but usually priced in yields)
 Significantly lower liquidity than stocks (prices can be stale)
Jan Schnitzler 8
Total Debt Securities Outstanding by Issuer Sector
Financial Non-Financial
Country Government Corporations Corporations
US 16,736 15,074 5,836
JP 10,504 2,701 747
CN 3,283 3,520 2,598
GB 2,690 2,693 571
FR 2,051 1,489 641
DE 1,833 1,457 170
IT 2,090 844 140
NL 377 1,663 90
All amounts in billions of US dollars as of September 2016
Source: BIS
Jan Schnitzler 9
Secured Types of Corporate Bonds
Corporate bonds in which specified assets are pledged as collateral.
Mortgage bonds:
 Real properties are used as collateral.
 Bondholders have direct claim on these assets in case of
bankruptcy.
Asset-backed securities:
 Backed by any kind of asset owned by the company.
 Bondholders have direct claim on these assets in case of
bankruptcy.
Jan Schnitzler 10
Unsecured Types of Corporate Bonds
Corporate debt that, in the event of bankruptcy, gives bondholders a

claim to assets that are not pledged as collateral for other debt.
 Debentures: long-term (more than 10 years)

 Medium-term Notes: maturities from 1 year to 15 years
 Commercial paper: short-term debt
Seniority:
 Senior debt
 Subordinate debt
Jan Schnitzler 11
Default of investment and non-investment Grade Bonds
Jan Schnitzler 12
Global Average Transition Rates (S&P)
1-year AAA AA A BBB BB B CCC/C D NR

AAA 87.03 9.03 0.54 0.05 0.08 0.03 0.05 0.00 3.19
AA 0.54 86.53 8.14 0.54 0.06 0.07 0.02 0.02 4.07
A 0.03 1.83 87.55 5.38 0.35 0.14 0.02 0.07 4.64
BBB 0.01 0.11 3.58 85.44 3.75 0.56 0.13 0.20 6.23
BB 0.01 0.03 0.14 5.16 76.62 6.96 0.66 0.76 9.64
B 0.00 0.03 0.10 0.21 5.40 74.12 4.37 3.88 11.89
CCC/C 0.00 0.00 0.14 0.22 0.65 13.26 43.85 26.38 15.49
5-year AAA AA A BBB BB B CCC/C D NR
AAA 49.79 27.77 4.90 0.83 0.25 0.17 0.08 0.36 15.85
AA 1.58 49.58 25.05 3.87 0.62 0.42 0.05 0.36 18.48
A 0.09 5.34 54.14 15.18 2.25 0.79 0.17 0.62 21.42
BBB 0.03 0.52 10.40 49.87 7.69 2.47 0.43 2.15 26.44
BB 0.01 0.08 1.15 12.80 29.42 11.24 1.33 8.35 35.62
B 0.02 0.03 0.32 1.68 10.57 23.89 2.85 20.61 40.03
CCC/C 0.00 0.00 0.14 0.74 2.96 12.11 2.68 47.53 33.84
Jan Schnitzler 13
Corporate Credit Spreads
Jan Schnitzler 14
Other Bond Contracting Features
 Zero-coupon
 Floating-rate (often linked to LIBOR)
 Callable bond
- Issuer has the right to retire a bond on (or after) a specified
date for a set call price (often face value).
- Alternatively, issuer repurchases bonds in secondary markets.
 Retractable (puttable) bond
- Call option is given to bondholders, instead.
 Convertible bond
- Bondholder has the right to convert a bond into common
shares at a fixed conversion ratio.
Jan Schnitzler 15
Execution of Callable Bond on Call Date
Callable bonds trade at a discount before call date

Jan Schnitzler 16
Convertible Bond
Jan Schnitzler 17
Private Debt: Bank Loans
Bank loans to SMEs:

 Often only source of debt funding
Bank loans to large companies:

 Use bank financing as a flexible complement to bonds
 Revolving credit lines (commitment fee on undrawn amounts)
 Bridge loans
 Also as a substitute for longer-maturity term loans
 Large volumes arranged by bank syndicates
 Secured by collateral (receivables or inventories)
 Covenants on bank loans stricter, but also easier renegotiated
Jan Schnitzler 18
Matching Principle
How should the maturity composition of debt look like?

 Long-term financing needs should be financed with long-term
sources of funds
e.g. fixed assets, permanent changes in working capital
 Short-term funding needs should be financed with short-term debt
temporary working capital
 Funding needs triggered by seasonality of industry
 Shocks to cash flows
 Financial institutions require similar management, Asset-Liability

Management (ALM), largely to control interest rate risk
Jan Schnitzler 19
Forecasting Short-term Financing Needs
Seasonality
 Often sales are seasonal leading to seasonal cash flows.
 Inflows and outflows may have different timing.
 To some extent, this carries over to business cycle.
Negative/positive cash flow shocks
 Overall, one cash flow shock is positive the other one negative
 However, both shocks create a temporary financing need
 E.g. broken equipment, new sales contract of large volume
Seasonality requires pro-active management

Shocks are by definition hard to predict (more risk management)
Jan Schnitzler 20
Dependence on Short-term Funding
 Aggressive financing:
- Firm finances part of permanent working capital or invested
capital via short-term financing
 Balanced financing:
- Firm follows the matching principle
 Conservative financing:
- Firm finances even short-term needs with long-term financing.
- This implies temporary periods of excess cash.
Under MM choice does not matter.
What could be arguments for or against aggressive financing?
Jan Schnitzler 21
Two Strategies for Short-term Financing Needs
Jan Schnitzler 22
II. Leasing: What is a Lease?
 Contractual agreement over the use of an asset.

 The lessee pays periodic installments (lease payments) to the
lessor in return for the right to use the asset.
 Additional rights and obligations may be embedded in the lease
contract. In particular:
 Who retains ownership of the asset at the end of the lease.
 Potential options for extending or canceling a lease.
 Additional maintenance and servicing costs related to the asset.
Instead of borrowing funds for investment, the lessee borrows the

asset directly
Jan Schnitzler 23
End-of-Lease terms
 At the end of the lease contract, lessee returns asset to lessor.

 In many contracts, lessee has an option to acquire ownership of a
leased asset.
Common end-of-lease options:

 Fair market value lease
 $1 out lease
 Fixed price lease
 Fair market value-cap lease
Agreed end-of-lease terms have implications for pricing of lease.
Jan Schnitzler 24
Lease Payment
Assume perfect capital markets where lessors compete with each

other.
 Lease payments should be set such that lessors undertake zero-
NPV transactions.
Lease Irrelevance Theorem

In a perfect capital market, the cost of leasing is
equivalent to the cost of purchasing and reselling
the asset.
Jan Schnitzler 25
Example: Lease Term in Perfect Capital Markets
 The purchase price of an asset is $50,000.

 Its residual value in 5 years is $10,000 and there is no default risk.
If the risk-free rate is 4.8% p.a., what is a monthly lease payment for
a 5-year lease?
Jan Schnitzler 26
Types of Leases
Sales-type lease:
 A lease contract offered by manufacturer of the asset.
 Often bundled with maintenance support, upgrades, etc.
Direct lease:
 A lease in which the lessor is not the manufacturer.
 Specialized financial investor provides lease of an asset.
Sale and lease-back:

 Transaction in which a firm sells an asset just to lease it back.
 Often response to regulatory changes or to create liquidity.
Jan Schnitzler 27
Types of Leases, cont’d
Leveraged lease:
 Lessor purchases leased asset with borrowed funds.
 Lease payments are used to service debt.
Synthetic lease:
 A lease designed to obtain specific accounting/tax treatment.
 Uses Special-purpose Entities (SPEs) to achieve structure.
Jan Schnitzler 28
Accounting Classification of Leases
Operating lease:
 Lease payment is an operating expense for lessee
 Disclosed in footnotes of lessee’s financial statement
Capital lease (Financial lease):
 Capitalized on balance sheet of lessee
 Depreciation item to lessee
 PV(future lease payments) is a liability
 Its implicit interest portion is an interest expense
For valuation purposes, capitalize operating leases to make

financial statements comparable.
Jan Schnitzler 29
IFRS 16
Since 2019, new accounting convention in use:

 All leases exceeding one year displayed on balance sheets.
 Brings accounting closer to how finance views leases.
 Changes affect important metrics like EBITDA, EBIT, etc.
Tax implications complex:

 State secretary of Finance states that IFRS 16 not in accordance
with Dutch sound business practices (“Goedkoopmansgebruik”)
 This leads to differences between financial and tax accounting
Jan Schnitzler 30
Classification of Leases for Tax Purposes
Not accounting but tax treatment is cash flow relevant.

True-tax lease:
 The lessor receives the depreciation deductions of the asset.
 The lessor recognizes lease payments as revenue.
 The lessee deducts lease payments as an operating expense.
Non-tax lease:
 The lessee receives the depreciation deductions of the asset.
 The lessee can also deduct the interest portion of lease payments
as an interest expense.
 The lessor recognizes the interest portion of lease payments as
interest income.
Jan Schnitzler 31
Identifying Non-tax Leases
IRS Ruling 55-540 defines non-tax leases:

1. The lessee obtains equity in the asset.
2. The lessee receives ownership of the asset on completion of all
lease payments.
3. The total amount that the lessee is required to pay for a relatively
short period of use constitutes an inordinately large proportion of
the total value of the asset.
4. The lease payments greatly exceed the asset’s fair rental value.
5. The asset may be acquired at a bargain price in relation to the fair
market value at the time when the option may be exercised.
6. Some portion of the lease payments is specifically designated as
interest or its equivalent.
Jan Schnitzler 32
Leases and Bankruptcy
 If a lease is considered a true lease, the lessor keeps ownership

rights over an asset even under Chapter 11 bankruptcy.
 Within 120 days of filing for Chapter 11, a firm must
1. Either settle all pending lease payments
2. Or return the asset to the lessor.
Gives an extra level of protection to lessors making them most
senior creditors.
Enables small or risky firms to finance assets with leverage.
 If a lease is not considered a true lease, the lessor gets treated

like any other secured creditor.
Jan Schnitzler 33
The Leasing Decision
Leasing represents an alternative to purchasing an asset:

 Tempting to compare lease with all-cash transaction.
 However, a fair comparison includes leverage since lease
payments increase future obligations (creating tax shields).
 Additional leverage also creates interest tax shields
Compare lease to a purchase that includes comparable leverage

to the transaction.
The lease-equivalent loan is the amount of debt that leaves a
purchases with the same future obligations.
Jan Schnitzler 34
Evaluating a True Tax Lease
Implementing the lease-equivalent loan benchmark:
1. Compute incremental cash flows for leasing versus buying

including all tax considerations.
2. Compute NPV of incremental cash flows based on the firm’s
after-tax borrowing rate.
If NPV is positive, the offered lease payments provide an

advantage over purchasing the asset.
Jan Schnitzler 35
Example: True Tax Lease
Emory Printing needs a new printing press.

Assume a tax rate of 35% and borrowing cost of 8%.
Lease:
 5-year lease contract costs $12,500/year.
 True tax lease is an operating expense.
 Additional operating tax shield is $4,375.
Purchase:
 Purchase in cash for $50,000.
 Straight-line depreciation over 5 years ($10,000/year).
 The machine has no residual value after 5 years.
 Depreciation tax shield is $3,500.
Jan Schnitzler 36
Example: Incremental Cash Flows of Lease vs. Buy
Jan Schnitzler 37
Example: The Lease-equivalent Loan
 Reverse-engineering: How much can a firm borrow such that

after-tax interest payments balance incremental cash flows?
 The after-tax cost of debt is:
 Instead of leasing, Emory could buy the printing press and borrow
$43,747.
This saves in the initial period while
incremental cash flows for all later periods are balanced.
Jan Schnitzler 38
Evaluating a Non-tax Lease
Evaluating a non-tax lease is more straightforward:

 Irrespective of buying or leasing, lessee receives depreciation.
 The lessee deducts the interest portion of lease payments.
 A non-tax lease is thus directly comparable to a traditional loan
Determine whether it offers a better interest rate:
- discount the lease payments at the pre-tax borrowing rate
- compare PV to the purchase price of the asset.
Back to Example:
Lease implies higher interest payments
Jan Schnitzler 39
Motives for Leasing
1. Tax differences:
 A lease allows the party with the higher tax rate to take on
more valuable deduction item, thus saving more taxes.
 Firms with low tax rates tend to lease more.
2. Reduced resale costs:
 Lower transaction costs for short-term use.
 Specialized lessors improve secondary market quality.
3. Efficiency gains from specialization:
 Lower maintenance cost for assets
 Better quality of assets or operations
Jan Schnitzler 40
Motives for Leasing, cont’d
4. Reduced distress costs:

 True leases have lower risk than secured debt.
 Increased debt capacity for capital constrained firms.
 Leasing may help to mitigate the debt overhang problem.
5. Transferring asset risk to lessor:
 The lessor may be better suited to bear the risk.
 A sales-type lease improves incentives of manufacturer to
internalize product quality.
Jan Schnitzler 41
11. Corporate Governance
Jan Schnitzler

Corporate Governance
What is corporate governance?

 “Corporate Governance refers to the design of institutions that
induce or force management to internalize the welfare of the
stakeholders” (Tirole, 2001)
 Focusing on shareholder value, two agency conflicts of interest:

1. Conflicts between managers and investors/shareholders
2. Conflicts between controlling shareholders (often related to
management) and dispersed shareholders
Arises due to separation of ownership and control.
Jan Schnitzler 2
Conflicts between Managers and Investors
Inefficient investments:
 Value decreasing investments / pet projects
 Empire building
 Excessive risk-taking
Entrenchment:
 Managers undertake actions to secure their position to the
detriment of shareholders
 Investments in business lines that make mangers indispensable
 Resistance to hostile takeovers
Jan Schnitzler 3
Conflicts between Managers and Investors, cont’d
Insufficient effort:
 Managers may abstain from cutting costs (decreasing wages,
switching to cheaper supplier, etc.)
 Managers devote too much attention to outside activities (board
membership, political involvement)
Self-dealing:
 Consumption of perks (corporate jets, entertainment and
representation expenses)
 Connect family and friends with firm (suppliers, boards, etc.)
 Misconduct of corporate funds
Jan Schnitzler 4
Limitation of Agency Conflicts: Competition
 Competition is one of the strongest mechanisms in a market.

Inefficient management strengthens competitor’s position.
Firm looses market share, might end up in economic distress.
Managers get fired and stigmatized.
 Product market competition sets a range in which a firm can allow

for inefficiencies. Beyond that it will severely hurt everyone
invested in the firm.
 Yet, negative effects materialize slowly (not immediately).
Jan Schnitzler 5
Why does Corporate Governance matter?
Corporate governance is a positive NPV project:

 Agency conflicts waste valuable resources that could be saved.
 If agency conflicts are solved/mitigated, the firm will have cheaper
access to funding in financial markets.
Problem: What are the right corporate governance institutions?

There is no one-size-fits-all recipe:
 Agency problems differ across companies, industries, countries.
 Most governance mechanisms also have an inherent dark side.
Trade-off between benefits and costs of individual governance
institutions itself, and the entire corporate governance system.
Jan Schnitzler 6
Most Common Corporate Governance Institutions
Internal governance:
1. Board of Directors
2. Management compensation
3. Monitoring by shareholders (maybe external governance)
External governance:
1. Product market competition
2. Takeover (Threat)
3. Regulation
Jan Schnitzler 7
I. Board of Directors
The existence of the board of directors is justified from its fiduciary

duty to their shareholders. Principal functions are:
 Hiring, compensating, and firing of top management.
 Ratifying major business decisions (dividends, equity issues,
merger proposals).
 Monitoring business decisions of management.
 Providing advice to top management.
Standard process of composing the board:

 Directors are elected by shareholders at general meeting (AGM).
 Nomination committee of board selects suitable candidates.
Jan Schnitzler 8
Board Composition
Directors can be categorized into 3 groups:

 Inside directors: current or former employees, typically CEO and
CFO, family members of employees
 Gray directors: persons having business relations with the firm,
e.g. suppliers, bankers, lawyers
 Independent directors: persons without links to the firm, usually
CEOs of other firms, or other prominent people
 Proportion of independent directors has steadily increased.

 Average board size has been shrinking over last decades.
 Trend towards separating the CEO and Chairman positions.
Jan Schnitzler 9
Board Structures around the World
Single-tier boards
 Consist of executive and outside directors.
 Common in US, UK, Japan, and others.
 Trend towards delegating tasks subject to conflicts of interest to
sub-committees, e.g. audit, remuneration, or nomination.
Two-tier boards
 Supervisory board appoints and supervises management board.
 Formalizes different roles of inside and outside directors.
 Common in Netherlands, Germany, China, etc.
Jan Schnitzler 10
Directors: Watchdogs or Lapdogs?
 Lack of independence
 Executive directors often play influential role
 Executives have considerable influence over the choice of other directors
 Insufficient incentives
 Outside directors have limited stakes invested in the firm
 Many directors sit on a large number of boards
 Difficult to build case on violations of fiduciary duties (accountability)
 Avoidance of conflicts
 Even truly independent directors may prefer not to be fully confrontational
⇒ Boards may be captured and under the control of management

⇒ Leads to insufficient effective monitoring
Jan Schnitzler 11
Monitoring vs. Advising
“Too much emphasis on monitoring tends to create a rift between non-executive

and executive directors, whereas the more traditional job of forming strategy
requires close collaboration. In both activities, though, independent directors
face the same problem: they depend largely on the chief executive and the
company’s management for information.” Economist
 The roles of monitoring and advising are difficult to combine:

 Monitoring is about confronting management decisions.
 Advising about cooperating in the decision process.
 Independent directors are more reliable monitors.
 Management is less inclined to cooperate with monitors.
⇒ Trade-off between better advice vs. more interference.
Jan Schnitzler 12
Board Characteristics of Economic Interest
Various board characteristics have been studied in theoretical and/or

empirical research:
 Board composition: proportion of independent directors increasing
 Board size: number of directors shrinking over last decades
 Classified board: different class directors serve different length
 Staggered board: a fraction (1/3) of directors are elected per year
 Busy directors: directors with several board seats
 CEO-Chairman duality: Trend towards separation in US and UK
 Interlocked directors: CEO serves on other board, and vice versa
 Board diversity (e.g. gender, background)
Jan Schnitzler 13
II. Management Compensation
Fundamental problem: managerial action cannot be directly observed

 Delegation of management because owners do not want to deal
with daily operations.
 Top management is better qualified (owners cannot evaluate)
 Do not want to write overly restrictive contracts that limit managers
scope of action
Goal of compensation packages:

1. Attract skilled top management
2. Align management interests with those of shareholders
⇒ Alignment by linking compensation to firm performance
Jan Schnitzler 14
Optimal Design of Compensation Package
 Trade-off between managers’ risk aversion and incentive provision

 Ideally, unaffected by factors outside managers’ control -
“compensation for effort not luck”
 Difficult to separate in contracts (e.g. dependence on oil price)
 One option, measure relative performance against competitors
 If managers were risk-neutral and without financial constraints,
agency problems could be solved by making them the only
shareholders
 Not feasible for large public corporations (Reason for separation of
ownership and control)
 Efficient structure for small firms
 VC funds look carefully in management compensation of their portfolio
start-up firms
Jan Schnitzler 15
Structure of Top Management Compensation
Main components:
1. Base salary
2. Annual cash bonus, generally linked to accounting performance
3. Grants of stocks and/or stock options
4. Long-term incentive plans, like restricted stock option plans and
multi-year accounting performance plans
5. Special insurance and pensions plans
Jan Schnitzler 16
Trends in S&P 500 CEO compensation
Source: Murphy (2012)

Jan Schnitzler 17
How are Compensation Packages negotiated?
 Compensation committee: comprised of a subset of directors

 Management may have influence over weak boards
 Management effectively designs its own compensation
⇒ Compensation structure could be a symptom rather than a

solution to the agency conflict
 Cover-up for excessive management compensation
 Weak relationship between pay and performance
Jan Schnitzler 18
Corporate Ownership Structures
It is useful to distinguish between two types of large shareholders
Inside ownership:
 Aligns interest of management with shareholders
 Makes managers more entrenched
Empirical question which effect dominates
Outside ownership:
 Monitoring of large outside shareholders mitigates agency
conflicts between management and shareholders
 Yet, few external shareholders are truly active
 Gives room for collusion between managers and blockholders
Jan Schnitzler 19
Performance of Firms with Inside Ownership
 This Figure plots the performance of a portfolio that is long US

firms with inside ownership larger 10% and shorts all other firms.
Source: Lilienfeld and

Ruenzi (2014)
Jan Schnitzler 20
III. Shareholder Activist Campaigns
Small, dispersed shareholders have weak incentives of exerting

(costly) effort to monitor management of the firm.
If board not fulfilling fiduciary duty, at least in eyes of some

shareholders, what options do shareholders have:
1. Shareholder loyalty: diversified shareholders consider
management misconduct an unavoidable risk factor
2. Shareholder exit: disagreeing shareholders can simply sell
their shares at relatively low transaction costs
3. Shareholder voice: dissatisfied shareholders can influence
management or other shareholders
 Significant ownership stake
 Convincing activist agenda
Jan Schnitzler 21
Shareholders’ Involvement with Management
Natural rights given to shareholders:

 Shareholders don’t interfere with daily decisions and operations.
 Shareholders elect directors at AGM.
 Fundamental decisions (like M&A, liquidation, etc.) require
shareholder approval.
 Shareholders decide on issues regarding the company’s equity
capital (e.g. share issuance).
Most activist campaigns take a more active stand and target at

influencing/opposing management opinion on the following issues:
 Corporate governance
 Social responsibility
Jan Schnitzler 22
Activist Options for Shareholder Intervention
1. Shareholder Proposals: According to rule 14a-8, Shareholders

can put resolutions to a vote at general meetings.
 Voting outcome generally non-binding
2. Dialog with management

 Large shareholders request board representation.
3. Bring discussion to public and other shareholders’ attention

through media
4. Proxy contest: bringing in a rival slate of directors who compete to

be elected to the board.
Jan Schnitzler 23
Governance Issues of Shareholder Proposals
Source: Gillan and Starks (2007)
Jan Schnitzler 24
Shareholder Activism and Corporate Governance
Voting Outcomes:
 Low percentage of proposals wins majority support (about 10%)
 Corporate Governance proposals get more support than social
responsibility
 Removal of antitakeover mechanisms fairly successful
Election of directors:
 Vote-no campaigns: Solely aimed at weakening reputation /
entrenchment of board (e.g. Walt Disney Co. in 2004)
 Proxy fights: management often keeps majority in proxy fight, but
looses reputation, like in vote-no campaigns
Jan Schnitzler 25
IV. Market for Corporate Control
 Change of ownership and control of an entire firm

 Acquirer may also purchase a sub-division of a firm
 At least one management group needs to be replaced
Mergers: Two firms combine their assets to create a new firm

 Friendly negotiations among equals
Acquisitions: Target firm is taken over by acquiring firm
 Board and management of target firm may agree (friendly
takeover)
Tender offer: Circumvent target management and give bid to
purchase shares directly to shareholders
Jan Schnitzler 26
Merger Waves
Jan Schnitzler 27
Formalizing the Market of Corporate Control
At , firm is run by the incumbent manager (I):

 Ownership is fully dispersed
 Under I’s control, shares are worth
 For simplicity, I has no shares
At , a bidder (B) approaches the firm’s shareholders and

makes a take-it-or-leave-it tender offer.
 Under B’s management shares would be worth , where .
 By being in control B generates private benefits , however, the bidding
process requires to incur bidding costs .
 The bidder makes a conditional and unrestricted offer at bid price .
• Conditioned upon 50% acceptance rate
• Bidder has to accept all tendered shares
Jan Schnitzler 28
Formalizing the Market of Corporate Control, cont’d
At , shareholders non-cooperatively decide to tender (or not)

If B receives more than 50% of shares, takeover will take place\
Otherwise, I continues to run the firm
If B takes control over the firm by offering a price that

gets accepted:
- the bidder makes a profit of
- Shareholders also benefit:
Jan Schnitzler 29
Free-rider Problem (Grossman and Hart (1980))
 Assume at first no private benefits for bidders:

 Each shareholder is dispersed, i.e., he neglects his decision’s
impact on the outcome of the takeover
Takeover Outcome
Success Failure
Tender 𝑏 𝑋
Retain 𝑋 𝑋
Tendering only weakly dominates retaining if
The bidder’s profit is negative:
The bidder will not make an offer
 In this model the takeover takes only place if the bidder’s have
private benefits
Jan Schnitzler 30
Bidder and Target Returns of Mergers
Source: Betton, Eckbo,

and Thorburn (2008)
Jan Schnitzler 31
Mechanisms to mitigate Free-rider Problems
Toeholds:
 Bidders can acquire initial toehold in secret (without a premium)
 Profit on these shares helps to overcome takeover costs
Freezeout mergers:
 Successful bidders can buy untendered shares at tender price
 Deprives target shareholders from post-takeover gains creating
“pressure to tender”
Leverage Buyouts (LBOs):
 Successful tender offer is largely financed by debt
 After takeover, debt gets attached to target’s assets
Jan Schnitzler 32
Leveraged Buyout
Similar setup as before, except now debt financing D is used:

Takeover Outcome
Success Failure
Tender 𝑏 𝑋
Retain 𝑋 −𝐷 𝑋
Tendering only weakly dominates retaining if

The bidder’s profit is:
The more debt is used, the stronger the incentive to tender
Sufficient leverage solves free-rider problem
 Note: minority shareholders need legal protection:
Jan Schnitzler 33
Takeover Defenses
Target managers often oppose takeovers because they lose their job
 Staggered boards: each year only 1/3 of directors are up for
election such that it takes time to replace an entire board.
 Poison Pills: An offering that gives existing target shareholders
the right to purchase shares at a deeply discounted price.
 Golden parachutes: lucrative compensation package for target
managers in case of a takeover.
 Supermajority: corporate charters sometimes require the
takeover acceptance of a shareholder supermajority (up to 80%)
 Regulatory hurdles: government intervenes if competition is
threatened by takeover
Jan Schnitzler 34
V. Regulation
Prior institutions are market responses to agency conflicts:
These institutions are accompanied by set of rules:

 enforced through government legislation
 self-imposed by companies in its charter or industry standards
 US takes relatively bold legal measures (if it decides to act):

 Sarbanes-Oxley Act (2002)
 Dodd-Frank Act (2010)
 International coordination for Multinational Companies
 In many EU countries comply-or-explain basis is common
Jan Schnitzler 35

Jan Schnitzler Corporate Finance 2.5

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Corporate Finance 2.5

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Introduction Corporate Finance

Repetition 1: Time value of money

Repetition 2: Discount Rates and risk

Repetition 3: Free Cash Flows

Working Capital Management

 Berk/DeMarzo: Corporate Finance – 4th Edition

 Case Study Material (tba)

1 Mon, Mar 30 Q&A call Introduction BM 4,8,11,12, 26, 27.1

2 Tue, Apr 7 Case call Case 1 X

Wed, Apr 15 Q&A call Agency conflicts BM 16.5-16.8

Wed, Apr 22 Q&A call Valuation BM 18;

Wed, Apr 29 Q&A call Payout policy BM 17, 23

Exam Thu, May 28

Exam 5 Group Assignments

 Two other cases are empirical

 One case group consists of 4 students (Canvas Sign-in).

 Electronic case submission via Canvas:

Two main parts:

Analysis is key, but text style matters too!

Corporate finance studies all decisions taken by firms

Objective function: to maximize the value of the corporation

Corporate finance concepts are widely used:

US entities NL equivalent Entity Liability

Investment Financing Repayment

Good Project? Debt vs. Equity? Dividend?

 We will study the implications of the financing decision:

 Introduce valuation models that take the capital structure of

 Discuss institutional market features that affect corporate financing

$1 is more worth today than $1 next year

In order to build valuation models, we need a tool that makes cash

 Let be a factor that makes an expected period i cash flow

 Assuming a constant discount factor per period of time , we

 Our main decision criteria to evaluate investment projects (or

 Perpetuity of cash flows CF:

 Perpetuity of cash flows CF growing at the rate g:

 Annuity that pays cash flow CF for T consecutive years:

 So far, we developed our main framework.

 Next, we have to learn what to plug into our model.

What is a sensible discount rate?

 What is a risk-free rate?

 For what types of risk do investors require compensation?

 Lots of research in asset pricing provides guidance of which risk

 The discount rate of a project should be equal to the cost of capital

 Managers have to take this opportunity cost of capital into

 Note: different cash flow streams generally have different risk

Investors hold well-diversified portfolios

Conceptually, a risk-free interest rate is important.

 Lacking a better alternative, we generally use interest rates of

 Does a risk-free asset exist in practice?

 In principle, we should use the expected risk premium for the

 Common shortcut: Difference between the return of a common

 In practice, the choice of risk premium may be very controversial

International Annualized Equity Premiums (1900-2005)

10-year US premiums relative to T-bills, 1900-2005

What are Cash Flows?

 Free cash flows consist of four main components: Revenues,

We can rewrite the previous equation also to

⇒ Fastest depreciation method maximizes NPV!