Corporate Finance

Introduction to Corporate Finance
‡ What is finance? ‡ What is the distinction between financial and real assets? ‡ What is corporate finance? ‡ What is the role of financial assets in corporate finance?

‡ How do firms finance their investments?
± Earnings (free cash flow, internal capital) ± Equity capital (external ± public or private) ± Debt capital (external)

Financial Markets and Financial Instruments

‡ Public and private capital ‡ Trading of public capital
± New issues ± Secondary trading

Equity Issues
‡ First time a firm seeks public equity is called an initial public offering (IPO)
± Primary issue: new equity is issued ± Secondary issue: existing private equity is sold to outside investors (most privatisations take this form) ± Legal and underwriting services provided by investment banks

Debt Issues
‡ Bank loans ± not publicly traded ‡ Corporate Bonds ± traded actively in the secondary market ‡ Debt capital and equity capital account for most of the firm¶s financial capital

Definition of Debt
‡ Fixed claim
± Specifies what needs to be repaid to the investor and when ± Default risk ± risk that the repayment plan is not fulfilled ± Conversion options ± covenants that allow debt to be reclassified as equity

Definition of Equity
‡ Residual claim
± Does not specify a repayment plan ± Repayment is defined as the residual: whatever is not claimed by other claim holders should go to the equity holders ± Voting rights: Equity holders normally have a right to vote on important corporate decisions
‡ Mergers, takeovers ‡ Large investments ‡ Board representation

Trends in Corporate Finance
‡ ‡ ‡ ‡ Globalisation Deregulation Financial innovation Technological advances in the financial system ‡ Securitization

What you should take home
‡ You should be able to
± Understand the distinction between a fixed claim and a residual claim ± List the main attributes of a debt claim ± List the main attributes of an equity claim ± Describe the ways in which firms raise funds for new investment ± Describe the difference between private and public equity ± Describe the difference between bank loans and corporate bonds

‡ Grinblatt/Titman: Financial Markets and Corporate Strategy
± Ch 1: overview of the process of raising capital for investment ± Ch 2: overview of the process of raising debt capital ± Ch 3: overview of the process of raising equity capital

1. Why do firms use underwriters when they issue new equity? 2. In what ways do you think it matters that debt holders have a fixed claim when equity holders have not? 3. In what ways do you think it matters that equity holders have voting rights when debt holders have not?

Review problems
1. 2. 3. 4. 5. Invest 95 and sell for 102 ± what is the return? Invest 95 and sell for 102. Each transaction is charged a 1% trading commission ± what is the return? Invest 95 and sell for 102. You receive additional interest payments/dividends of 2 during the holding period. What is the return? Invest 95 and sell for 110 three years later ± what is the annual return on your investment? Invest 95 now and another 98 next year. In the following year you sell your investment for a total of 202. What is the annual return on your investment?

‡ Tool box

Valuing Financial Assets: Portfolio Tools
± Expected portfolio return ± Portfolio variance ± Covariance between the return on two assets

‡ Optimal investment
± ³Fair´ price of an asset means that the value equals the purchasing price ± Even if prices are ³fair´ there are still ways of investing your money that is better than others

‡ Risk Aversion
± Investors demand compensation for including risk in their portfolio

Portfolio weights
‡ A portfolio of financial assets can be represented in a number of ways
± The number of shares held in the various stocks (e.g. 1000 shares in BT, 250 shares in Marks&Spencer etc.) ± The dollar-value held in the various stocks (e.g. £2,500 in Lloyds Bank, £10,000 in Jarvis etc.) ± As portfolio weights: the dollar-weight of the various stocks (e.g. if total portfolio is £100,000, then the portfolio weight of Lloyds is 0.025 and the portfolio weight of Jarvis is 0.1 etc.)

From portfolio weights to portfolio expected return and variance
‡ To determine the expected return and variance of a portfolio we need to know
± The portfolio weights ± The expected return on the individual assets ± The variance of the return on the individual assets ± The covariance between the return on any pair of assets

Expectation, Variance and Covariance
‡ Expected return (³average´ return) is a location measure ‡ Variance of return is a spread measure ‡ Covariance is a measure of how the return of two assets are ³related´ (they can move in the same or opposite directions, or they can be uncorrelated) ‡ If the returns move in the same directions, covariance is positive, if the returns move in the opposite directions, covariance is negative, and if uncorrelated, covariance is zero

The input data for a portfolio of N assets
‡ N expected returns ‡ N variances ‡ N(N-1)/2 covariances ‡ Plus N portfolio weights ‡ For FTSE100 there are therefore 100+100+100(99)/2 = 5150 data points that need to be estimated even before working out the portfolio weights

E ( rP ) ! § wi E (ri )
i !1 N

Var (rP ) ! §§ j !1 wi w j Cov (ri , rj )
N i !1 N


Var (rP ) ! § wi2Var (ri )  2§ wi w j Cov (ri , rj )
i !1 i j

Covariance and Correlation
‡ Covariance is a measure of relatedness that depends on the unit of measurement, so if the return is measured as a percent (e.g. 10 percent) or as a desimal (e.g. 0.10) the covariance will be different ‡ Correlation is a measure of relatedness that is normalized to be independent of the unit of measurement

Covariance and Correlation

Cov( ri , rj ) ! V ij Var (ri ) Var (rj ) ! VijW iW j Correlation ! Vij ! Cov(ri , r j ) W iW j

The Mean-Standard Deviation Approach to Investment
‡ Risk averse investors don¶t like risk ‡ Variance averse investors don¶t like risk that comes as variance ‡ This is not the same in general ± variance aversion is a special case of risk aversion ‡ Portfolio theory takes the variance aversion approach ± which in practice means that we assume investors wish to maximize their expected return given a certain variance, or minimize their variance given a certain expected return

Mean-Standard Deviation for Two-Asset Investments

E (rP ) ! wE (r1 )  (1  w) E (r2 ) Var (rP ) ! w2Var (r1 )  (1  w) 2 Var (r2 )  2 w(1  w)Cov(r1 , r2 )

Portfolio Frontier

Mean-Std Dev for Portfolios of the Risk Free Asset and a Risky Asset

E ( rP ) ! wE ( r )  (1  w)rF ! rF  w( E (r )  rF ) Var (rP ) ! w2Var (r ) ! Var ( r ) w

Covariance as Marginal Variance
‡ We can interpret the covariance between the return on a stock and the return on a portfolio as the stock¶s marginal variance ‡ That is, if we increase the stock¶s portfolio weight marginally, the portfolio variance will increase by approximately twice the stock¶s covariance with the portfolio

Algebraic ³proof´
r ! rP  mri  mrF ! rP  m(ri  rF ) E ( r ) ! E (rP )  m( E (ri )  rF ) Var ( r ) ! Var ( rP )  m Var (ri )  2mCov(rP , ri )

dVar (r ) ! 2mVar ( ri )  2Cov(rP , ri ) dm dVar (r ) ! 2Cov (rP , ri ) dm m!0

What to take home
‡ Understanding of expected values, variances, and covariances ‡ Understanding of expected return and variance for a portfolio ‡ Understanding of risk aversion and variance aversion ‡ Understanding of the portfolio frontier ‡ Appreciation of the linearity of expected return and standard deviation for portfolios consisting of the risk free asset and a risky portfolio

‡ Chapter 4 in Grinblatt/Titman

1. Variance: Prove that E(x-E(x))2=Ex2(E(x))2 2. Covariance: Prove that E(x-E(x))(yE(y))=Exy-E(x)E(y) 3. Take a time series of returns 0.05, -0.03, 0.10, 0.04, -0.10, 0.20. Estimate the expected return and the variance of return.

From Mean-Variance to the CAPM
‡ Capital Market Line
± Finding the market portfolio

‡ Two-fund Separation
± Optimal diversification ± Market vs idiosyncratic risk

‡ CAPM expected returns relationship
± Expected return on assets depend on their covariance (i.e. their relatedness) with the market portfolio ± Estimating beta risk

Capital Market Line
‡ The line that goes through the risk free asset and the tangency portfolio ‡ Identification?
± Maximization procedure ± Simplifying ³trick´, the excess return on any asset divided by its covariance with the tangency portfolio, is constant

Maximization programme to find the Capital Market Line
‡ We can identify the frontier portfolios of risky assets ‡ Consider investments consisting of the risk free asset and a frontier portfolio ± these are represented by straight lines ‡ For the frontier portfolio that is the tangency portfolio, the angle of the straight line is the steepest

Capital Market Line cont..


E ( rT )  rF Var (rT )

E (rT ) ! wE (rA )  (1  w) E (rB ) Var (rT ) ! w 2Var (rA )  2w(1  w)Cov( rA , rB )  (1  w) 2Var (rB ) w( E (rA )  E (rB ))  ( E ( rB )  rF ) max w Var (rT )

Capital Market Line cont..
‡ The maximization programme normally leads to a fairly complicated equation ± with two risky assets we get a quadratic equation to solve ‡ In the class exercises you will be asked to have a go at such a problem

Simplifying ³trick´: finding the Capital Market Line
‡ We know the expected return on all risky assets and the risk free return ‡ The difference between the two is called the ³excess return´ for the asset ‡ The excess return, divided by its covariance with the tangency portfolio, is always constant

Capital Market Line
Cov (ri , rT ) ! w1Cov(r1 , ri )  w2Cov(r2 , ri )  .  wiVar (ri )  .  wN Cov (rN , ri ) Cov (ri , rT ) ! E (ri )  rF w1Var (r1 )  .  wN Cov(rN , r1 ) ! E (r1 )  rF w1Cov(r1 , r2 )  .  wN Cov (rN , r2 ) ! E (r2 )  rF / w1Cov(r1 , rN )  .  wNVar (rN ) ! E (rN )  rF

.002 .001 0 Var/Cov ! .001 .002 .001 0 .001 .002

.15 - .06 Excess Return ! .17 - .06 .17  .06

Example cont..
.002w1  .001w2  0 w3 ! .15  .06 .001w1  .002w2  .001w3 ! .17  .06 0w1  .001w2  .002 w3 ! .17  .06 w1 ! 40 w2 ! 10 w3 ! 50 w1 ! .4, w2 ! .1, w3 ! .5

CAPM: Risk and Return
‡ Since the excess return divided by the covariance with the tangency portfolio is constant across assets, we can derive important relationships between risk and return ‡ The covariance with the tangency portfolio is, if solved for the tangency portfolio itself, equal to the variance of the tangency portfolio

Risk and Return
E ( ri )  rF ! constant Cov (ri , rT ) E (rT )  rF ! constant Var (rT ) E ( ri )  rF E (rT  rF ) ! Cov (ri , rT ) Var (rT ) Cov (ri , rT ) E (rT )  rF E (ri ) ! rF  Var (rT ) E (ri ) ! rF  F i E (rT )  rF

Security Market Line
‡ The expected return of securities is linear in their beta-factors ‡ In the (beta,expected return) plane, the line crossing through (0,rF) and (1,E(rT)) is called the security market line

Properties of betas
‡ Beta is linear: the beta of a portfolio of securities equals the portfolio-weighted average of the betas of the individual securities ‡ An implication is that the beta of the assets of the company equals the valueweighted beta of the liabilities of the company

Tracking portfolios
‡ A portfolio tracks another perfectly if the difference in the returns of the portfolios is a constant (possibly zero) ‡ Imperfect tracking: A portfolio consisting of a weight (1-b) in the risk free asset and a weight b in the tangency portfolio tracks a stock with beta =b, because the two should have the same expected return

Tracking Errors
‡ The two investments should have the same expected return, which implies that the tracking error has zero expectation and zero value ‡ Of course, investors do not like risk so they choose to hold the tracking portfolio instead of the stock ‡ Because such diversification is free of cost, the tracking error is also free of cost (i.e. it has zero value)

Estimating the risk free return
‡ For risk free return use government bond or government bill data (long or short term instruments backed by the government) ‡ The return offered on such instruments is a good proxy for the actual risk free return ‡ Alternative, use the average return of a zero-beta risky stock, or the intercept with the y-axis if no zero-beta stock exists

Estimating market risk premia
‡ Estimate the long-run average return on a broad stock market index and subtract the risk free rate ‡ Both the average stock market index return and the risk free return change over time ‡ The change in the difference is more volatile than the changes in the individual time series. ‡ Therefore, estimate the long-run average index return first. Do not estimate the difference between the market return and the risk free rate directly

Beta estimation
‡ A raw beta estimate can be obtained from historical covariance and variance estimates (or by a regression) ‡ Average beta is one (this is the beta of the market index) ‡ If the raw estimate exceeds (is below) one, we know there is a possibility that the raw beta is an overestimate (underestimate) ‡ Raw beta estimates should be adjusted ± i.e. they should be pulled down if they are above one or be bumped up if they are below one. ‡ There are ways of optimally adjust beta estimates

Beta Adjustment
‡ Bloomberg adjustment
± Adjusted beta = .66 times Unadjusted beta + .34 times One

‡ Rosenberg adjustment
± Adjustment also incorporates fundamental variables (industry variables, company characteristics such as size, etc..)

‡ Also betas are adjusted sometimes to take into account infrequent trading problems

What to take home
‡ Two-fund separation ‡ Capital Market Line vs Security Market Line ‡ Risk-Return relationships ‡ Tracking portfolio ‡ Parameter estimation: problems and current practice

‡ Grinblatt/Titman ch 5

‡ What is the tracking portfolio for a real asset? ‡ How would you estimate the beta of the assets of a firm that has traded debt and equity? ‡ How would you estimate the beta of a company that has never traded?

From CAPM to Arbitrage Pricing Theory
‡ Main purpose is to extend the valuation approach into more advanced and flexible valuation models ‡ CAPM can be thought of as a ³one-factor´ model (returns are determined by movements in the market portfolio only) but has important empirical problems (systematic deviations from predictions) ‡ APT extends to ³multi-factor´ pricing that can mitigate some of the CAPM¶s empirical problems

Risk Decomposition
‡ The Market Model
± One-factor (the return on the market portfolio) ± Related to the CAPM model ± The regression estimates of the market model generates raw beta-estimates for the CAPM

‡ Risk Decomposition
± Systematic (market) risk: asset risk that is explained by market movements ± Unsystematic (diversifiable, idiosyncratic) risk: asset risk that cannot be explained by market movements

Market model regression
rit ! E i  F i rMt  I it E i ! (1  F i ) rF cov(rit , rMt ) Fi ! var(rMt ) cov(I it , rMt ) ! 0

Risk Decomposition
var(rit ) ! total risk var(F i rMt ) ! F var(rMt ) ! market risk
2 i

var(I it ) ! idiosyncratic risk var(rit ) ! F var(rMt )  var(I it )
2 i

APT: The arbitrage principle behind factor models
r i ! ai  bi f
~ ~ ~

w ri  (1  w) rj ! w(ai  bi f )  (1  w)(a j  b j f ) Set wbi  (1  w)b j ! 0 which has solution w ! bj




bj b j  bi

¨ bj ¸ ~ ¹ rj ! risk free ! rF ri  ©1  © b b ¹ b j  bi j i º ª

APT: Factor pricing
¨ bj ¸ ¹a j ! rF ai  ©1  © b b ¹ b j  bi j i º ª b j ai  bi a j ! b j rF  bi rF bj ai  rF a j  rF ! ! constant ! P bi bj E ( ri ) ! ai ! rF  bi P For CAPM, P ! E (rM )  rF

Multi-factor models
K - factor model E (ri ) ! rF  bi1P1  bi 2 P2  .  biK PK rit ! ai  bi1 f1t  bi 2 f 2t  .  biK f Kt  I it
~ ~ ~ ~ ~

We do not know what the factors are!
‡ Can be evaluated statistically ± using a method called factor analysis ‡ The output generates portfolios associated with each factor ‡ Can use firm characteristics or macroeconomic variables as proxies for the factors

Factor betas
‡ The betas determine the asset¶s sensitivity to the factors ‡ A high loading on factor number 2 means that the asset is particularly sensitive to risks associated with factor 2 ‡ Factor models extends into portfolio analysis since the factor betas of portfolio is just the value-weighted average factor beta for the individual assets in the portfolio

Factor models: computing the variance-covariance structure
‡ Recall that computing the variance-covariance structure requires a large number of estimates ‡ For N assets, N variance estimates and N(N-1)/2 covariance estimates ‡ N=100, 100 variance estimates and 100(99)/2 = 4950 covariance estimates ‡ Using the market model, we can work out the covariance structure from the beta estimates, i.e. from the N beta estimates

Covariance structure estimation
ri ! ai  bi f  I i cov(ri , rj ) ! cov(bi f  I i , b j f  I j ) ! bi b j var( f )  bi cov( f , I j )  b j cov( f , I i )  cov(I i , I j ) ! bi b j var( f )
~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~

Variance estimation
var(r i ) ! bi2 var( f )  var(I i )
~ ~ ~

Tracking Portfolio
‡ Objective: to design a portfolio that has certain factor betas (or factor loadings) ‡ Why? The use of tracking portfolios are many
± Risk management: if the company is subject to risks beyond its control, e.g. currency risk, it may create a tracking portfolio that offsets the risk ± Capital allocation: the company may wish to allocate capital to investments that yield a greater return than their tracking portfolio and to reduce its exposure to investments that yield a smaller return than their tracking portfolio

Designing a Tracking Portfolio
‡ First, determine the number of relevant factors (guesswork, statistical analysis) ‡ Second, determine the factor betas of the investment you wish to track (statistical analysis, comparison with existing traded companies) ‡ Third, gather a collection of different assets with known factor loadings ‡ Forth, calibrate your portfolio such that the portfolio factor beta equals the target factor beta for each factor

Two - factor tracking portfolio, target betas 1 and 2 for factor 1 and 2 respectively Three assets with factor beta 1, 3, 1.5 for factor 1 and - 4, 2, 0 for factor 2 Calibration : x1  x2  x3 ! 1 x1  3x2  1.5 x3 ! 1  4 x1  2 x2 ! 2 Output : x1 ! 0.1, x2 ! 0.3, x3 ! 0.8

Applying Pricing Theory
‡ Use pricing models to investment analysis (optimal investment strategies in financial markets ± diversification) ‡ Use pricing models to calibrate investments (design of tracking portfolios) ‡ Use pricing models as a benchmark for real investment (comparing real investment returns to the return on tracking portfolios)

‡ Chapter 6 in Grinblatt/Titman

‡ There are three relevant factors driving asset returns
± The factor structure of the debt of the company is (0.01, 0,0) ± The factor structure of the equity of the company is (2,5,1) ± The company consists of 1/3 debt and 2/3 equity

‡ What is the factor structure of the company¶s real assets (investments)?

Investment Analysis ± the case of Risk Free Projects
‡ Apply pricing technology to real investment analysis ‡ Net Present Value Rule ‡ Complications
± Sunk cost ± Opportunity cost ± EVA and IRR

Fisher Separation
‡ With different tastes, why should investors agree on investment policy?
± Long-term vs short term ± Risky vs Risk free

‡ Fisher separation
± Agreement is optimal regardless of taste ± Net present value rule: Invest in all projects that cost less than the value of the project¶s tracking portfolio ± NPV = PV(future investment) ± Investment cost

‡ Cash flows of our investment ‡ Investment cost ‡ Discount rates (if risk free projects ± use a risk free discount rate)

Present Value = sum of discounted cash flows
Cash flows : C1 , C2 , - , CT Tracking portfolios : ¨ C1 ¸ C1 grows to © © (1  r ) ¹(1  r ) ! C1 in year 1 ¹ (1  r) ª º ¨ C2 ¸ C2 ¹(1  r ) 2 ! C2 in year 2 grows to © © (1  r ) 2 ¹ (1  r) 2 ª º etc... Present value ! sum of the value of tracking portfolios ! C1 C2 C3  .  (1  r ) (1  r ) 2 (1  r )T

Net Present Value
C1 C2 CT NPV !  I 0   .  2 T 1  r (1  r ) (1  r )

NPV and Arbitrage
Adopt the project when it has positive NPV is equivalent to making money through arbitrage Cash flows : 20,40,10,30 40 10 30 NPV ! 20    ! 34.94 2 3 1.05 1.05 1.05 Equivalent to undertaking the project, buying a bond paying 40 in period 1, selling a bond paying 10 in period 2, buying a bond paying 30 in period 3.

Value Additivity of NPVs
Project A has NPVA Project B has NPVB Project A  B (i.e. the combined cash flows of the two projects) has net present value : NPV A B ! NPV A  NPVB

Mutually Exclusive Projects
‡ This is an ³either-or´ situation ± you can invest in project A or you can invest in project B, but you cannot invest in both at the same time ‡ Both projects may have positive NPV so are worthwhile on their own ‡ ³Either-or´ situations often arise naturally. For instance, all timing decisions are mutually exclusive. You can invest now or you can invest in the future, but you cannot invest both now and in the future.

Which project to choose when they are mutually exclusive
‡ The choice criterion is to maximize the net present value of investment. ‡ Therefore, if you have two or more mutually exclusive projects to choose from you should choose the one with the most positive NPV.

Capital Constraints
‡ There are situations in which you may have more projects with positive NPV available than you have funds for investment ± i.e. you have a budget constraint ‡ Then the choice criterion is to invest in the projects that offer the greatest profitability index

Profitability Index
Present Value cash flow PV Investment cost  I 0 Net present value NPV ! PV  I 0 PV Profitability Index PI ! I0

Project A : PV A ! 10m, I A ! 8m Project B : PVB ! 100m, I B ! 90m Project C : PVC ! 1000m, I C ! 950m What is the optimal investment policy if the projects are independent? What is the optimal investment policy if the projects are mutually exclusive? Total investment budget B ! 100m. What is the optimal investment policy subject to staying within budget?

Example cont.
Profitability indexes : 10 ! 1.25 8 100 ! 1.1111 PI B ! 90 1000 ! 1.0526 PI C ! 950 Invest in A first, then B and C. PI A ! Optimal mix : All of A (using 8 of 100 budget) plus all of B (using additional 90 of budget, leaving 2 to invest in C) plus 2 ! 0.2105% of C 950 2 Total NPV : (10  8)  (100  90)  (1000  950) ! 12.11 950

Economic Value Added
‡ EVA is a profitability measure that has become widely used in corporations ± initially to replace accounting earnings or profit measures ‡ Accounting measures do not always measure economic performance (depreciation cost, for instance, is not a cash flow and should not be included in project evaluation) ‡ Accounting measures are therefore not directly consistent with NPV ‡ Economic Value Added is consistent with NPV

EVA: Definition
‡ Three components
± Cash flow ± Change in asset base ± Economic return on assets

‡ EVA(t) = Ct + (It ± It-1) ± rIt-1 ‡ EVA(t) = Ct + It ± (1+r)It-1 ‡ Discounted sum of EVA(t) = Net Present Value

EVA, cont.
‡ ‡ ‡ ‡ ‡ Investment of 100 The first year cash flow is 50 The second year cash flow is 150 Discount rate is 10% Assets are depreciated by 50% in the first year and by 100% in the second year.

‡ NPV = -100 + 50/1.1+150/1.12=69.42

EVA, cont.
‡ EVA(0) = -100(cash flow)+(100-0)(change in assets)0(0.1)(economic cost of initial assets) = 0 ‡ EVA(1)=50(cash flow)+(50-100)(change in assets)100(0.1)(economic cost of initial assets) = -10 ‡ EVA(2)=150(cash flow)+(0-50)(change in assets50(0.1)(economic cost of initial assets)= 95 ‡ Discounted EVA = EVA(0)+EVA(1)/1.1+EVA(2)/1.12 = 69.42 = NPV

IRR: Internal Rate of Return
‡ Often managers base investment decision on the IRR instead of the NPV ‡ The rule is: if IRR is greater than the discount rate (i.e. the cost of capital) then adopt the project ‡ In many cases this leads to the same investment decision, as IRR is greater than the discount rate only if the NPV is positive ‡ In other cases this is not true however, so to be safe always use NPV or EVA calculations

C1 C2 CT  .  NPV !  I 0  2 T 1  r (1  r ) (1  r ) C1 C2 CT  .  0 ! I0  2 1  IRR (1  IRR) (1  IRR)T

‡ Investment cost = 100 ‡ First year¶s cash flow = 150 ‡ Discount rate 10% ‡ NPV = -100+150/1.1=36.36 ‡ IRR: 0=-100+150/(1+IRR) yields 50% ‡ Since 50% > 10% (IRR > discount rate) it is optimal to adopt the project

Projects that have the cash flow profile of a loan
‡ ³Investment cost´ = 150 ‡ Next year¶s cash flow = -100 ‡ Discount rate = 10% ‡ NPV = 150 ± 100/1.1 = 59.09 ‡ IRR: 0 = 150 ± 100/(1+IRR) yields a negative IRR of -33.33% but this project is clearly profitable even though IRR < discount rate

Problems with IRR
‡ IRR criterion is sensitive to the type of cash flow (asset or liability?) ‡ IRR is not unique in general (for T period projects there can be up to T different IRRs) ‡ IRR is not appropriate for mutually exclusive projects as small projects with high IRR and small NPV might then be preferred to large projects with low IRR and large NPV

IRR and mutually exclusive projects
‡ Discount rate 2% ‡ Project A: -10, -16, +30 ‡ Project B: -10, 2, 11 ‡ NPV(A) = 3.149 ‡ NPV(B) = 2.534 ‡ IRR(A) = 10.79% ‡ IRR(B) = 15.36%

Important points
‡ Fisher separation ‡ NPV definition ‡ NPV with mutually exclusive projects (either-or) ‡ NPV with budget constraints ‡ EVA and NPV ‡ IRR ‡ IRR pitfalls

‡ Grinblatt/Titman chapter 10

Test for next week:
‡ Readings chapter 4, 5, 6 and 10 ‡ Important formulas
± CAPM: exp return = risk free plus risk adjustment ± Beta-factor: covariance/variance ± Factor models: exp return = risk free plus risk adjustment

‡ Risk free real investments
± ± ± ± NPV rule Profitability Index EVA IRR

Very important formulas
CAPM : E (r ) ! rF  F ( E (rM )  rF ) Cov(r,rM ) Beta : F ! Var (rM ) Factor models : E (r ) ! rF  F1P1  .  F K PK (where P denotes risk premium) C1 CT Net present value : NPV !  I 0  .  T 1 r (1  r )

Sample test questions
1. 2. The risk free return is 5% and the market index has an average return of 12%. What is the expected return for an asset with beta 1.5? An investment costs 100,000 and offers a cash flow of 50,000 in year 1 and 150,000 in year 2. The discount rate is 5%. What is the net present value of the investment? Should you adopt the investment? Explain. In a two-factor market, the factor betas of asset A are 1 and 0, and the factor betas of asset B are 0 and 1, respectively. The risk free return is 5%, and the average return on asset A and B are 10% and 15%, respectively. What are the risk premia associated with factor 1 and 2?


Investing in Risky Projects
‡ Applying the CAPM and APT in the capital budgeting process ‡ Key problem: estimating the cost of capital for risky projects
± Applying CAPM and APT ± Using comparison firms ± The dividend discount model

Risk Adjusted Discounting
Compute the expected future cash flow (we do not know exactly what we' ll get) E (Ct ) in period t Compute the beta risk associated with this cash flow (the beta is the covariance of the return with the market return, over the variance of the market return F Compute the expected market return of the cash flow r ! rF  F ( E (rM  rF ) E (Ct ) Discount : PV ( E (Ct )) ! (1  r )t

Fundamental problem: Estimating the beta factor
‡ Betas for traded equity are easy to estimate ± we simply regress equity returns on the index return, and possibly adjust to take into account estimation error (e.g. Bloomberg adjustment) ‡ Betas for projects are much more difficult to estimate as there simply does not exist a trading history ‡ Possible solution: use comparison firms (firms we imagine has similar risk profile to the project in question)

Using comparison firms
‡ Asset base needs to be sufficiently similar to the planned investment ‡ We need to adjust for leverage effects (the comparison firm may have debt)
± In general, it is only the equity beta of the comparison firm we can estimate but we are really interested in the asset beta ± The more the firm borrows, the higher the equity beta (even though the asset beta remains the same)

Adjusting for leverage
Asset beta ! value - weighted sum of debt and equity beta D E F A ! FD  FE V V V ! DE D F E ! F A  (F A  F D ) E Estimated equity beta equals the asset beta plus a leverage term

Value assets 100, value debt 40, and value equity 60. Estimated equity beta 1.5 Estimated debt beta 0 40 1.5 ! F A  ( F A  0) 60 1.5 implies F A ! ! 0. 9 40 1 60

Implementing risk adjusted discounting with comparison firms
A project has the average beta of Church' s Chicken, McDonald's and Wendy's. The equity betas of these three companies are 0.75, 1.00, and 1.08 respectively. The debt and equity values of these companies are 0.004 and 0.096 (Church' s Chicken), 2.300 and 7.700 (McDonalds) and 0.210 and 0.790 (Wendy's), respectively, and the beta of the debt of these companes is assumed equal to zero. The asset betas are Church' s Chicken 0.72 ! McDonalds 0.77 ! 0.096 0.75 0.100

7.7 1.00 10 0.79 Wendy's 0.85 ! 1.08 1.0

0.72  0.77  0.85 Average beta ! project beta ! 0.78 ! 3 Risk free rate 4% and market risk premium 8.4%. Cost of capital (discount rate) for the project is 0.1055 ! 0.04  0.78(0.084)

Applying APT
The APT model estimates the cost of capital by a factor model, so present values are given by E (Ct ) PV ( E (Ct )) ! t (1  rF  F1P1  .  F K PK )

APT and CAPM vs Alternative methods
‡ A drawback with the APT and CAPM models is that they require a number of estimates: the risk free rate of return, the beta factor(s), the market risk premium and the factor risk premia. ‡ It can in some circumstances be better to work with simpler model. The dividend growth model is an alternative to the APT and CAPM.

Dividend Discount Model
div1  S1 (1  r ) div2  S 2 , etc... S1 ! (1  r ) S0 ! div1 div2 div1 div1 (1  g ) S0 !  . !  . 2 2 (1  r ) (1  r ) (1  r ) (1  r ) div1 S0 ! rg r!g div1 ! growth in dividends dividend yield S0

What if comparison firms don¶t exist?
‡ In general there is little we can do ‡ However, if there exist firms where one division is similar to our project we may be able to identify the relevant betas. ‡ For instance, if you want to estimate the beta of the network division of television companies you can use the fact that these divisions play a varying role in generating the asset beta for these companies

Network division example
General Electric : asset beta 0.99, 25% of value from network division, 75% from non - network divisions. Viacom : asset beta 0.78, 50% of value from network division, 50% from non - network divisions. If non network divisions are sufficiently similar, we know that F GE ! 0.25F Network  0.75F Non  network ! 0.99 FViacom ! 0.5F Network  0.5F Non  network ! 0.78   F Network ! 0.36

Pitfalls in using the comparison method
‡ Project betas not the same as firm betas: mature projects generally lower beta than R&D projects etc ‡ Growth opportunities are usually the source of high betas: company value often significantly linked to future growth opportunities as opposed to current investments

‡ Investment cost 100,000 ‡ Annual running cost 5,000 for 5 years ‡ Expected revenue stream 50,000 for 5 years ‡ Beta-risk of revenue stream 1.2 ‡ Risk free return 5% ‡ Expected market return 12%

Example cont«
The discount rate for running costs : 5% (as the costs can be assumed risk free?) The discount rate for the revenue stream : 5%  1.2(12%  5%) ! 13.4% PV ! 5(1.05) 1  5(1.05)  2  5(1.05) 3  5(1.05)  4  5(1.05) 5  50(1.134) 1  50(1.134)  2  50(1.134) 3  50(1.134)  4  50(1.134) 5 ! 21.65  174.16 ! 152.51 NPV ! 100  152.51 ! 52.51 " 0 Therefore, adopt project.

Comparison method, example
‡ A firm with equity currently valued at 100,000 and outstanding debt worth 50,000 holds 25% cash and 75% of a risky asset on its balance sheet ‡ The equity beta is 1.5 ‡ You consider investing in a project very similar to the risky asset owned by this firm ‡ The risk free rate is 5% and the expected return on the market is 12% ‡ Work out the project beta and the cost of capital for your project

Comparison method cont«
Assume debt beta is very close to 0, and also assume that the cash balance has a beta close to 0 1.5 The total asset beta F A ! !1 50 1 100 Total asset beta F A ! 0.25(0)  0.75F RiskyAsset F RiskyAsset 1 ! ! 1.33 0.75

Cost of capital ! 5%  1.33(12% - 5%) ! 14.33%

‡ Grinblatt & Titman chapter 11 ‡ I have not emphasized the certainty equivalent method

Week 7: Taxes and Financing
‡ Irrelevance in the absence of transaction costs and taxes (Modigliani-Miller) ‡ Financing choices not neutral to taxation:
± Level: corporate vs private tax rates ± Timing: dividends can be deferred whereas interest payments on debt cannot

‡ The operating cash flow is divided into two components
± Cash flow to debt holders ± Cash flow to equity holders

‡ Fundamental question: Does it matter how the split is made? ‡ If it does we can create value also through financing choices (not only through investment choices)

MM cont«
‡ Modigliani-Miller proved that capital structure choices are irrelevant ± the split does not matter ‡ This proof rests on the absence of transaction costs of any kind: taxes, trading costs, and bankruptcy costs ‡ The proof of the MM theorem uses a ³no arbitrage´ argument ± financial markets do not admit ³free lunches´, or trading strategies giving you a positive cash flow with no prior investment

MM cont«
‡ Consider two ³versions´ of the same firm ± one version is U for unlevered (with no debt) and the other version L for levered (with debt) ‡ The firms have otherwise the same operating cash flow X ‡ The unlevered firm has value VU and the levered firm value VL

MM cont«
‡ The fundamental question is whether VU and VL differ ‡ The cash flows of firm U¶s equity holders is simply X ‡ The cash flow of firm L¶s debt holders is (1+r)D to the firm¶s debt holders and X-(1+r)D to the firm¶s equity holders, in total a cash flow of X also ‡ The value of L is the combined value of the debt and the equity

MM cont«
‡ Suppose VL is smaller than VU ‡ Then an investor can buy a 10% holding of L¶s debt and a 10% holding of L¶s equity, which entitles the investor to a 10% share in the total cash flow X. He would then go to the market and sell 10% of the cash flow X, which is valued at 10% of the value of U. This leaves him with zero future liability. ‡ His trading gains are 10% of the difference between VU and VL, which we have assumed is positive ‡ This cannot be possible in an arbitrage free market, so we can conclude that VL must be equal to or greater than VU

MM cont«
‡ Now suppose VU is smaller than VL ‡ An investor buys 10% of the cash flow X and sells 10% of a claim that promises the cash flow (1+r)D. The net cash flow is 10% of a claim that pays X-(1+r)D at maturity, which is priced at 10% of the equity in L ‡ The net future liability is zero, and the trading gains equal 10% of the difference between VL and VU, which we have assumed positive ‡ Again, this is not consistent with arbitrage free markets ‡ In conclusion, it must be the case that VU = VL and that capital structure is irrelevant

What about risky debt?
‡ When the corporate debt contract is risky it may be difficult to find a ³synthetic´ corporate debt contract if a real one does not exist ‡ We must assume, therefore, that the markets are sufficiently complete in order to conclude that financing does not matter ‡ Complete market = a market where the dimensionality of the asset structure equals the dimensionality of the uncertainty structure ‡ If there are two states of nature (e.g. ³good´ and ³bad´) then it suffices with two distinct assets to make the market complete

Bankruptcy costs
‡ The Modigliani-Miller theorem also assumes that there are no deadweight costs of bankruptcy ‡ The debt holders may not get all their money back if the firm defaults, but this is not in itself enough to jeopardise the MM-theorem ‡ There must also be deadweight costs or liquidation costs (i.e. the value of the assets in default is less than the value of the assets as a going concern)

Taxes: Another important factor
‡ The tax system is generally fairly complex with different tax rates for different individuals and institutions, and for different types of income ‡ Therefore, it may be scope for ³tax arbitrage´ profits in financing

After tax cash flow analysis
A constant after tax discount rate r Tax rate for personal income from debt tD Tax rate for personal income from equity tE Corporate tax rate tC Earnings before taxes and interest payments X Earnings before taxes (X ± kD) (k coupon rate, D nominal amount borrowed) ‡ After tax personal income from debt kD(1-tD) ‡ After tax earnings (X-kD)(1-tC) ‡ After tax personal income from equity (X-kD)(1-tC)(1-tE) ‡ ‡ ‡ ‡ ‡ ‡

After tax cash flow from investor perspective C ! ( X  kD)(1  tC )(1  t E )  kD(1  t D ) ¨ (1  tC )(1  t E ) ¸ ¹ ! X (1  tC )(1  t E )  kD(1  t D )©1  ¹ © 1  tD º ª Discounted after tax cash flow X (1  tC )(1  t E ) kD(1  t D ) ¨ (1  tC )(1  t E ) ¸ ©1  ¹  DC ! ¹ 1 r 1 r © 1  tD ª º ! Value unlevered firm discounted tax benefits

‡ If there is a positive discounted tax benefit firms choose to borrow more, and investors with higher personal tax rate on debt income is encouraged to enter the market. This implies a reduction of tax benefits of borrowing. ‡ Reverse effect is there is a negative discounted tax benefit of borrowing ‡ In equilibrium, we expect the tax benefit from borrowing to be equal to zero ‡ This is the so-called ³Miller¶s equilibrium´ described in Appendix 14A in the textbook

Preferred stock
‡ Preferred stock: dividends on preferred stock are not tax deductible at the corporate level as are interest payments on debt ‡ This implies that corporate junior debt may be tax efficient relative to preferred stock ‡ However, the US tax code allows a 70% tax exclusion for preferred dividends paid to corporate holders, so the yield on preferred stock is often lower (before tax) than on junior debt even though the debt has seniority over the preferred stock

Investor conflicts?
‡ Tax exempt equity holders prefer in general to reduce the borrowing of the firm so as to transfer income from debt repayments to dividend payments ‡ High-tax bracket investor prefer the opposite ‡ Often tax-exempt municipal bonds (or similar investments) offer yields that are greater than the after tax yield on corporate bonds for high-tax bracket investors ‡ Thus, the firm can give these investors an advantage by increasing the firm¶s borrowing, as this frees capital that the investors can use to invest in tax-exempt municipal bonds

‡ We expect to see a one-to-one relationship between inflation and nominal interest rates - if inflation increases by one percentage point then so do nominal interest rates ‡ Higher inflation, therefore, leads to higher nominal borrowing costs that yield in turn greater tax deductions ‡ Therefore, the tax effect has greater bite in periods of high inflation

Empirical evidence
‡ Do firms with greater taxable earnings borrow more?
± No, but this may be because firms in general rarely issue equity ± Firms that perform poorly, therefore, tend to accumulate debt to meet their investments

‡ Tax code changes that affect the relative tax benefit of borrowing should have an impact on corporate financing
± Yes, US tax reform of 1986 which reduced the tax benefits of other things than debt (such as depreciation rules and investment tax credits) gave rise to an increase in borrowing among firms most affected ± The firms less affected did not increase their borrowing to the same extent

‡ Taxes matter but don¶t explain everything

‡ Grinblatt/Titman chapter 14, including the appendix ‡ 14.10 Are There Tax Advantages to Leasing not so relevant

1. A firm has assets valued at 100, and debt valued at 50. It plans to restructure its liability side by increasing its borrowing to 70 and paying a dividend of 20 to its shareholders. The debt has zero beta before and 0.001 beta after the recapitalization. The beta of the equity is 2 before the recapitalization.
a) b) c) d) What are the values of the equity before and after the recapitalization? What is the beta of the assets of the firm? What is the beta of the equity after recapitalization? The recapitalization has increased the beta of the debt (and therefore the cost of debt capital). Has it also increased the beta of the equity? Does this mean that the total cost of financing has increased? Explain.

Taxes and Dividends
‡ In frictionless markets dividends don¶t matter ‡ Why do firms nonetheless pay dividends? ‡ Taxes and dividends ‡ Stock returns and dividend yields ± what is the connection? ‡ Investment distortions caused by taxes in dividends

Cash flow to shareholders
‡ Shareholders earn money through holding equity that earns a cash flow (such as dividends) and capital gains (which can be realized through selling stock) ‡ The cash distribution to shareholders is normally discretional ± the company can decide how much cash flow to give their shareholders ‡ Cash distribution comes in two forms ± dividend payments and share repurchase schemes ‡ Dividend payments do not affect the number of shares but will reduce the value of each share ‡ Share repurchases do normally not affect the value of each share but will reduce the number of shares outstanding

How much of earnings is cash flow to shareholders?
‡ Dividend payout ratio: the ratio of dividends to earnings ‡ In the US, this ratio has declined from about 22% in 1980 to about 14% in 1998 ‡ Over the same period, the ratio of share repurchases to earnings increased from 3% to about 14% ‡ The total ratio of cash flow to earnings has been relatively stable at about 25% of earnings

Dividend yields
‡ Dividend yield is the ratio of dividends per share over price per share ‡ Typical pattern is that high-tech growth firms have low dividend yield and dividend payout ratios (Microsoft paid its very first dividend this year) ‡ Stable, old economy companies such as mining, oil and manufacturing pay about half their earnings as dividends

What is the optimal dividend payout ratio?
‡ Assumption: frictionless economy (no transaction costs, taxes, or other frictions) ‡ Investment policy unaffected by dividend payments ‡ Modigliani-Miller Dividend Irrelevance Theorem:
± The choice between paying dividends and repurchasing shares is a matter of indifference to shareholders

Modigliani-Miller Irrelevance
‡ Consider two identical equity financed firms, the only difference is dividend policy ‡ Firm 1 pays 10m as dividends ‡ Firm 2 repurchases stock worth 10m ‡ After the end of the year, the firms are worth X ‡ In the beginning each firm has 1m shares outstanding

MM cont«
‡ Each share eventually sells for X divided by the number of shares ‡ Firm 2 buys back 10m worth of stock ‡ If share price is p, and firm 2 buys back n shares, we know that pn=10m ‡ We also know that p=X/(1m-n) ‡ Suppose X = 150m ‡ Solving both equations gives us n = (10m1m)/(X+10m), so we get n = 62,500, and p = 150m/(1m-62,500) = 160 ‡ Firm 1: stock price is p = 150m/1m = 150, but each stock gives a dividend worth 10m/1m = 10, so the total value of each stock is 150+10 = 160 ‡ Since shareholders get the same cash flow eventually, the shares must sell at the same price initially, i.e. dividend policy does not matter

Taxes and cash distribution to shareholders
‡ Classical tax system
± Dividends taxed as ordinary income and capital gains at a lower rate than ordinary income ± Dividends are not tax deductible at corporate level, so dividends are also subject to corporate taxation

‡ Imputation system
± Dividends are taxed as ordinary income but investors get a partial tax credit for corporate taxes (to offset personal taxes) ± Dividends are not tax deductible at corporate level

‡ Systems that eliminate double taxation
± Dividends are tax deductible at corporate level and taxed as ordinary income at investor level

Classical tax system
‡ The classical tax system implies a tax disadvantage of dividend payments ‡ Dividend $100, 35% tax implies an immediate tax liability of $35 ‡ Share repurchase scheme: an investor sells $100 worth of shares. Suppose original cost was $76. This implies a taxable capital gain of $24. Taxed at 20%, this implies an immediate tax liability of $4.8 ‡ Share repurchase scheme much cheaper than paying dividends

Tax avoidance schemes
‡ In theory, investors can often invest in a scheme that gives an immediate tax relief against a deferred future tax liability ‡ In practice, investors do not take advantage of these schemes but instead choose to pay taxes (or are unable to invest in tax avoidance schemes) on the received dividends ‡ The question is, therefore, why corporations continue to pay dividends when they are so tax inefficient

Dividend clienteles
‡ Some investors do not pay taxes ‡ These investors will, everything else being equal, prefer high dividend yield firms to low dividend yield firms as they do not pay tax on the dividend ‡ Firms might adopt different dividend policies to attract different investor clienteles ‡ Empirical evidence suggests that investors¶ portfolios have dividend yields that are related to their tax status (high tax bracket investors choose low dividend yield stocks and vice versa)

Dividend payments and stock returns
‡ Do stocks with high dividend yield compensate investors for the tax disadvantage? ‡ Higher returns should then lead to lower values, reflecting the higher discount rates applied to future cash flows ‡ Research has focused on two returns effects
± Ex-dividend day behaviour of stock prices ± Whether cross-sectional dividend yield differences affect expected returns

Ex-dividend day price drop
‡ If you buy the stock on the day before the ex-dividend day, you are entitled to the future value of the stock and the current dividend payment ‡ If you buy the stock on the ex-dividend day, you are entitled only to the future value of the stock ‡ The stock price should, therefore, drop on the ex-dividend day to reflect the dividend payment ‡ Empirical results from the 1960s indicate that the ex-dividend day price drop is about 77.7% of the dividend payment on average, but was higher (90%) for dividend payments greater than 5% of the stock price, and lower (50%) for the smallest dividends. ‡ These results indicate a tax effect (investors discount a tax rate of around 22.3% on dividends), and a clientele effect (investors with different tax rates hold portfolios with different dividend yields)

Ex-dividend day cont«
‡ Transaction cost argument
± Consider buying a stock at $20 before the ex-div day, receive a $1 dividend, then sell the stock for $19.20. This yields $1 taxable profits and $(20-19.20) = $0.80 tax deductible losses. The net profit is $0.20 less taxes, but it is still arbitrage profits. The stock needs to drop by the full amount to preclude arbitrage profits. ± If there is a $0.10 per share transaction cost, the investor receives taxable profits of $1 in dividends, and incur $0.80 in tax deductible losses. The net profit is $0.20, but the investor must also pay $0.10 in transaction costs, so the net profit is only $0.10 less taxes. If the stock drops to $19.10, therefore, there are no arbitrage profits to be made. ± If the dividend payment is only $0.40, the necessary price drop is $0.30 to prevent arbitrage profits. That is, the price drop is greater for high dividend yielding stocks in percentage terms (as the clientele effect predicts).

‡ Price drop less than the dividend payment is also observed in countries that do not have a classical tax system, suggesting this is not a tax driven phenomenon at all

Cross-sectional relation between dividend yield and stock returns
‡ If dividends are more heavily taxed than capital gains, the expected return must be greater for high dividend yield stocks. ‡ Empirically, stocks with high dividend yields have higher returns, but the relationship is not straightforward ‡ The relationship is U-shaped, with zero dividend yield stocks have higher expected return than stocks with low dividend yield, but for stocks paying dividends, the expected return increases with the dividend yield

How dividend taxes affect financing and investment decisions
‡ Marginal tax rate of 50% ‡ Company has a choice between paying $1m in dividends or retain the earnings ‡ Retained earnings yield 6% after corporate taxes (alternative II) ‡ Dividends yield 7% before personal taxes in corporate bonds (alternative I) ‡ Alternative I yields $500,000 to invest at 7%, which after tax yields $17,500 per year ‡ Alternative II yields $60,000 in extra dividend payments per year, which yields $30,000 after tax to the investor ‡ If you are a zero tax payer, however, alternative I yields $1,000,000 to invest at 7%, which equals $70,000, and alternative II only $60,000 in additional dividends per year. ‡ Investors with different tax rates are likely to disagree with regard to the dividend policy the firm should pursue

The general principle
‡ Investors prefer retained earnings if (1-corporate tax rate) x (pretax return internally at corporate level) > (after tax return at investor level) ‡ This has implications for investment policy as well
± Tax-exempt and tax-paying investors agree on externally funded projects but may disagree on internally funded ones (tax exempt investors require higher return on internal investment than tax-paying investors)

‡ Grinblatt/Titman chapter 15

1. A stock trades at 100p per share (prior to ex-dividend day) and the firm will pay a dividend of 10p per share.
a) b) c) d) e) Work out the ex-dividend day price if investors pay 40% tax on dividends and the ex-dividend day price equals the initial price less after-tax dividend payment Work out the minimum transaction cost per share that prevents tax-arbitrage by a tax-paying investor Suppose the dividend payment was 50p per share. What is your answer to a) and b) now? Suppose the actual transaction cost is 2p per share. What are the arbitrage free price drops in a) and c) above now? What are the ³implied´ tax rates on dividends in d)?

Managerial Incentives and Corporate Finance
‡ Manager ± shareholder conflicts
± Occidental Petroleum and founder/CEO Armand Hammer case in the textbook ± Maxwell Communications and Robert Maxwell

‡ How such conflicts affect investment, financing, and ownership structure ‡ How such conflicts can be mitigated by executive compensation schemes

Separation of ownership and control
‡ The separation of ownership and control is beneficial in terms of diversification and optimal investment while keeping a stable management team in control of the firm ‡ But it can be harmful if the management team is more interested in pursuing their own interest as opposed to their shareholders¶ interests ‡ In what way do their interests differ?
± Managers represent investors, customers, suppliers, and employees ± not just investors ± Managers get utility from non-financial benefits such as status, perks, job-security etc and are willing to spend corporate resources on these even though they are likely to be negative NPV projects

Factors that determine the manager-shareholder conflict
‡ Proportions of stock owned by the manager ‡ Managerial entrenchment and lack of means to control managers
± Diffuse ownership structure (no individual manager benefits enough to take action) ± Proxy fights (shareholder revolt at general meeting) are very expensive and difficult to organize

‡ Bonus schemes not performance sensitive enough ‡ Changes in corporate governance have made managers more accountable in recent years

Ownership structure
‡ ‡ ‡ ‡ ‡ ‡ ‡ Ownership structure is on the whole more concentrated than we would expect (CAPM advocates diversification), particularly outside the US/UK Ownership concentration a response to weak legal protection of shareholders¶ interests UK/US have the strongest protection and the most diffuse ownership structure Managers tend to keep a significant ownership stake in firms where the incentive conflict with the shareholders is the greatest In many internet IPOs, the managers kept a large share of their holding in order to get a higher price in the IPO (lock in clauses) Eg. ± Martha Lane-Fox and Brent Hoberman (founders ± Hoberman still manager) were still large owners after IPO and were prevented from selling their share for a given time period after the IPO Firms with higher concentration of management ownership have higher market values relative to their book values, provided management share is not too big. If it gets above 5%, managers become ³entrenched´ which allows them to pursue own interests more

How managers distort investment decisions
‡ Managers prefer investments that fit the manager¶s expertise
± Makes him (her) more indispensable

‡ Investments in visible/fun industries
± Raising the manager¶s external profile (and his potential future job opportunities and wages)

‡ Investments that pay off early
± Financial success in the short run can increase bonus, reduce the risk of losing job, increase the possibility of raising more capital

‡ Investments that reduce risk and increase the scope of the firm
± To avoid bankruptcy the manager seeks relatively safe investments and may take a portfolio approach to investments

Capital structure and managerial control
‡ Managers are likely to prefer equity to debt because they are interested in minimizing the probability of default ‡ Shareholders may, therefore, prefer debt financing as debt is a good way to discipline managers (the fear of losing job is a good motivator) ‡ Empirical investigations show there is a positive relationship between leverage and
± ± ± ± Percentage of executive pay tied to performance Percentage of equity owned by managers Percentage of investment bankers on the board of directors Percentage of equity owned by large individual investors

‡ Debt is a good way to curb overinvestment ‡ Debt engages often a bank who is a good monitor of management

Executive compensation
‡ The problem of incentivizing managers is often called a principal-agent problem
± Tenant farmer works the land of a land-owner. If compensated too much in terms of output, the tenant farmer must bear all the risk influencing output (weather etc). If compensated too little in terms of output, the tenant farmer doesn¶t put in the required effort. ± Compensation is a matter of balancing the two concerns: Called the problem of designing the optimal incentive contract ± Effort (input) cannot be observed, otherwise compensation could be tied to effort instead of output ± Design objective is to minimize the agency costs of delegated control

Performance based executive compensation
‡ ‡ ‡ ‡ ‡ ‡ Jensen and Murphy (1990) found that a $1000 increase in firm value is associated with a $3 increase in CEO bonus (a $10m jet costs the CEO $30,000 just in lost bonus payments) Some disagreement about this result, as it may have underestimated the real sensitivity by ignoring longer term impact on bonus payments Substantial differences in pay-for-performance sensitivity across firms
± Some explained by the agency costs of delegated control ± Some explained by the risk of the firm


Over time, the pay-for-performance sensitivity has been increasing Adoption of performance-based pay is generally a positive signal to the investors What about relative performance sensitivity (pay linked to the position of the company relative to the average for the industry)? Relative performancepay is rarely observed, but can be costly to investors in terms of price wars and overly aggressive competition. Stock-based performance versus earnings-based performance. Stock based performance is much noisier than earnings-based performance, but in return earnings can be manipulated by the manager

Mergers, Spin-offs, Carve Outs
‡ It may be easier to design an optimal compensation contract for a small, single-unit, firm than for a multi-divisional conglomerate ‡ Solution may be a spin-off (a division set up as an independent firm by distributing shares in the new firm to the existing investors) or a carve-out (do an IPO of the division and sell to new investors) ‡ Spin-offs and carve-outs are positive signals ‡ Mergers create the opposite effect, and in particular conglomerate mergers can be seen as a negative signal to investors as they affect managerial incentives negatively (conglomerate mergers are relatively rare now but were popular in the 1960s and 70s) ‡ Many spin-offs and carve-outs are reversing prior conglomerate mergers

‡ Grinblatt/Titman chapter 18

1. The manager of a firm considers investing £1m of free cash flow (earnings currently held in a bank account) in a project that has private value £10,000 to the manager but NPV of £200,000 to the investors. What is the optimal decision for the manager if
a) He has fixed pay? b) He has in addition a bonus scheme where an increase of £1000 in the stock value leads to an increase of £10 to the manager? c) What is the optimal bonus scheme for the manager in this case?

Information and Financial Decisions
‡ Key premise: managers have better information than investors ‡ What managers do, therefore, conveys information to the market ‡ Managers can
± Distort accounts to manipulate the information flow ± Reveal information through dividend policy, capital structure choice, and investment decisions

‡ Empirical evidence: how stock prices react to various financial decisions

What can better informed individuals do?
‡ Signals: they act in a way that conveys their information
± Difference between ³cheap talk´ and ³credible action´ ± Signals need to be costly

‡ Pooling: they act in a way that everybody else act in order not to reveal information
± It is too expensive to send a signal

‡ Manipulation
± Actions: Investors overestimate the true cost of signalling ± Reporting: ³Bad´ reports attract attention ± it may be easier to disguise bad outcomes by submitting an ³average´ report

Distortions to managerial incentives
‡ Managers seek to maximize the share price ‡ The share price may, however, deviate from the ³intrinsic value´ (the full information price) ‡ Long term investors prefer that managers maximize the intrinsic value (which eventually transpires) ‡ Short term investors prefer that managers maximize the current share price (which may be distorted due to lack of information) ‡ The conflict is, therefore, essentially one of shorttermism versus long-termism

Why do managers care about the current share price?
‡ New issues or the managers may plan to sell private stock ‡ Low prices attract bidders in takeovers ‡ Managerial compensation directly linked to stock price ‡ Customers or employees may flee the company if the stock price goes too low

Earnings manipulation
‡ The same underlying profits can be reported in different ways as earnings
± Depends on the choice of depreciation method ± Choice of inventory valuation method (FIFO LIFO) ± The estimates of the economic value of assets, the estimates of the cost of guarantees or warranties issued, the estimates of the pension liability of the firm, the discount rates used for valuation of leases and pensions etc.

‡ There is a tendency to inflate reported earnings to increase the current stock price ‡ But managers may also find it useful sometimes to deflate reported earnings
± For instance when the manager has just been hired ± When applying for government subsidies or tariff protection against foreign competitors

Short-termism in investment
‡ Bias towards short term projects because these makes it clear very quickly whether the investment is a good one ‡ Example:
± Project A: yr 1 cash flow 40; yr 2-11 cash flow 80 per year; PV 840 ± Project B: yr 1 cash flow 60; yr 2-11 cash flow 50 per year; PV 560 ± Project C: yr 1 cash flow 40; yr 2-11 cash flow 40; PV 440

‡ Investors think C is much more realistic than A or B ‡ If company chooses A, the stock price is close to 440 after yr 1 earnings are revealed, why? ‡ If company chooses B, the stock price is close to 560 after yr 1 earnings are revealed, why? ‡ Company has a disincentive to choose the best project which is A because it is too similar to C in the first year ‡ If managers seek to maximize the intrinsic value they should choose A regardless

Dividends and Stock Repurchases: Announcement Effects
‡ An announcement of a dividend increase normally increases the stock price by about 2% ‡ If a company announces it is to cut its dividend completely, the stock price decreases by about 9.5% ‡ Is paying dividends therefore a good decision?
± Dividends may be a costly signal conveying information that is hidden from investors ± Paying dividends is, in effect, a cost to the shareholders to ensure that current information is reflected in current prices ± The alternative: long term savings in signalling costs against the cost of deviations between the current stock price and the intrinsic value of equity

Dividends and Investment Opportunities
‡ News may be
± Increased cash flow ± Increase in investment opportunities

‡ An increase in dividends signals increased cash flow (as dividends then are more affordable) but is not consistent with an increase in investment opportunities (as they are then needed for investments) ‡ An increase/cut in dividends is, therefore, a more complex signal than is suggested in previous slides ‡ Empirical evidence suggests that cuts are viewed more favourably when the firms experience an increase in investment opportunities

Capital Structure and Information
‡ Borrowing can also be thought of as a costly signal:
± If mangers are convinced that future cash flow is high then the most credible way of communicating this information is to borrow ± If the manager is ³lying´, the firm is going to default on its debt liability and the manager will be out of a job

‡ Firms with poor prospects find it hard to ³mimic´ the same borrowing decisions

Empirical Evidence
‡ Event study methodology ‡ Leverage increasing transactions (debt-for-equity swaps) have positive stock price response ‡ Leverage neutral transactions (debt-for-debt) have zero response ‡ Leverage decreasings (equity-for-debt) have negative stock price response ‡ Security sales (equity, debt) have negative stock price response, and more so for equity than for debt ‡ Empirical evidence is consistent with information theories (this week) but is also consistent with incentive theories (last week)

Adverse Selection
‡ Sick people tend to see health/life insurance as cheap ± consequently they will be over-represented in the group of buyers of this type of insurance ‡ Example: very expensive insurance that covers 100% of all costs ± or ± cheap insurance that covers only 80% of all costs
± In this case the sick people might migrate to the expensive type of insurance and the healthy ones to the cheap type

‡ This is called adverse selection ± buyers or sellers do not always select themselves randomly but rather according to their ³type´ ‡ This also plays a role in the sale of corporate securities

‡ Corporation can be expected to sell equity when the stock is overvalued and buy back equity when the stock is undervalued ‡ This makes sell transactions a bad signal and buy transactions a good signal ‡ This makes equity a bad source of capital for new investment, since it must be sold at a discount to the current stock price (why?) ‡ Pecking-order theory: firms prefer retained earnings to external capital, and external debt to external equity, when financing investments

Managers have inside knowledge and at the same time sell or buy corporate securities

‡ Grinblatt/Titman chapter 19

‡ A firm has already made an investment and is considering an additional investment opportunity
± State of nature is good or bad, equal probabilities. Assume risk neutral valuation with zero discount rates. Manager knows the true state of nature ± Current investment has value 150 (good) or 50 (bad) ± NPV investment opportunity is 20 (good) or 10 (bad) ± Currently the firm is financed by equity only ± It plans to issue equity to finance the new investment, which costs 100 ± To do:
‡ Set up the balance sheet before and after investment @ expected values ‡ Work out how much of the existing equity the firm needs to sell in order to finance the investment ‡ Compare the value of the existing (old) equity with investment and without investment in the good and the bad state ‡ If the manager acts in the interests of the existing shareholders, should he always go ahead with investment. Explain.

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