FIN 321
Assume that Omicron uses the entire $50 million to repurchase shares. The amount of the regular yearly dividends in the future is closest to:
$4.50
A firm has $400 million of assets that includes $50 million of cash and 10 million shares outstanding. If the firm uses $40 million of its cash to repurchase shares, what is the new price per share?
$40
Assume that Omicron uses the entire $50 million to repurchase shares. The number of shares that Omicron will repurchase is closest to:
1.1 million
Suppose a project financed via an issue of debt requires five annual interest payments of $10 million each year. If the tax rate is 30% and the cost of debt is 6%, what is the value of the interest rate tax shield?
12.64 million
A firm has a market value of assets of $50,000. It borrows $10,000 at 3%. If the unlevered cost of equity is 15%, what is the firm's cost of equity capital?
16%
Different types of dividend payments as well as share repurchases
Cash dividends Stock dividends Regular dividends Special dividends Liquidating dividends Types of share repurchases Open Market Repurchase (the most common) Tender Offer Targeted share repurchase (greenmail)
Difference between share repurchases and dividends
Differences Between Share Repurchases and Dividends Managers are much less committed to share repurchases than to dividend payments Unlike with dividends, firms do not smooth their repurchase activity from year to year The cost of a share repurchase depends on the market price of the stock
Way in which corporations can make distributions to shareholders
Dividends Share Repurchases
Domestic vs International bonds
Domestic bonds: When a firm issues a bond dominated in local currency in its own country International bonds: Foreign bond: a bond sold to local investors in another country's bond market Examples: Yankee bond: a bond sold by a foreign company in the US Samurai: a bond sold by a foreign firm in Japan Eurobonds: the bond is not issued in a particular country market (so not subject to the country's regulations) but it is sold internationally
How to calculate PV of tax shields from from interest expenses
To find the present value of tax shield, we need to divide each period's tax shield by a discount rate. The most common assumption is that the risk of the tax shields is the same as that of the interest payments generating them. If debt is permanent: PV(Tax Shield)=Tax Shield/ Discount Rate
Are the rights of shareholders better protected in the United States or in France?
US LEGAL SYSTEM IS BASED ON british common law, which offers more protection to minority shareholders than french civl law does.
Understand how trade-off theory works
We can combine the benefit of debt with costs of debt There is a trade-off between too little debt (giving up the tax advantage of debt) and too much debt (incurring significant bankruptcy costs)
The Principal-Agent Problem arises
because managers have little incentive to work in the interest of shareholders when this means working against their own self-interest. B. because of the separation of ownership and control in a corporation.
When a firm pays out a dividend, the share price ________, and when it conducts a share repurchase at the market price, the share price ________.
decreases, is unchanged
During the 1990s, most companies adopted compensation policies
hat more directly gave managers an ownership stake by including grants of stock or stock options to executives.
Prada has nine million shares outstanding, generates free cash flows of $ 40 million each year and has a cost of capital of 10%. It also has $30 million of cash on hand. Prada wants to decide whether to repurchase stock or invest the cash in a project that generates free cash flows of $5 million each year. Should Prada invest or repurchase the shares?
invest
The optimal dividend policy when the dividend tax rate exceeds the capital gain tax rate
is to pay no dividends at all.
Which of the following is NOT a method for a firm to payout excess cash to its shareholders?
issue new shares
A(n) ________ is the most common way that firms repurchase shares.
open market share repurchase
When a firm pays a dividend,
shareholders are taxed according to the dividend tax rate. If he firm repurchases shares instead, and shareholders sell shares to create a homemade dividend, the homemade dividend will be taxed according to the capital gains tax rate.
When the tax rate on dividends exceeds the tax rate on capital gains
shareholders will pay lower taxes if a firm uses share repurchases rather than dividends for all payouts.
As the level of debt increases the tax benefits of debt increase until
tax shield benefit exceeds distress
Omicron Technologies has $50 million in excess cash and no debt. The firm expects to generate additional free cash flows of $40 million per year in subsequent years and will pay out these future free cash flows as regular dividends. Omicron's unlevered cost of capital is 10% and there are 10 million shares outstanding. Omicron's board is meeting to decide whether to pay out its $50 million in excess cash as a special dividend or to use it to repurchase shares of the firm's stock. 6. Assume that Omicron uses the entire $50 million in excess cash to pay a special dividend. Omicron's ex-dividend price is closest to:
$40
Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity firm, with 1 million shares outstanding that trade for a price of $24 per share. With has 2 million shares outstanding and $12 million in debt at an interest rate of 5%. According to MM Proposition I, the stock price for With is closest to:
$6.00
Difference between YTC & YTM
A bond's yield to maturity calculation provides you with the total return you would receive if the bond was held through its maturity date. For most bond investors, it is important to also estimate the yield to call, or the total return that would be received if the bond purchased was held until its call date instead of full maturity. Because it is impossible to know when an issuer may call a bond, you can only estimate this calculation based on the bond's coupon rate, the time until the first (or second) call date, and the market price.
Three options to firms for the early repayment of debt: call options, sinking fund provisions, convertible provisions
Callable bonds: a bond that may be repurchased by a firm before maturity at a specified call price is Most long-term debt issued by U.S. companies is callable The call provision provides the company with a valuable option, but that is recognized in a lower issue price Specified features Call Date Call Price Call Premium Call Provisions and Bond Prices Investors will pay less for a callable bond than for an otherwise identical noncallable bond A firm raising capital by issuing callable bonds instead of non-callable bonds will either have to pay a higher coupon rate or accept lower proceeds Sinking Fund Provision-It is common that long-term debt is repaid before maturity In particular, each year the corporation places money into a sinking fund, and the money is used to redeem part of the bond issue Most sinking fund start between 5 and 10 years after initial issuance Balloon Payment A large payment that must be made on the maturity date of a bond when the sinking fund payments are not sufficient to retire the entire bond issue. Sinking funds provide extra protection to bondholders Convertible provisions allow bonds to be converted to stocks A convertible bond starts life as a bond, but subsequently may turn into stock if the bondholder decides to convert Features Conversion ratio: Number of shares into which each bond can be converted Conversion price: Bond face value / Conversion ratio In-the-money vs. out-of-the-money: In-the-money when conversion price < share price in the market Why does a company want to issue a convertible bond? Convertible bonds make sense when it is costly to assess the risk of debt or whenever investors are worried that management may not act in the bondholders' interest Why does an investor want to buy a convertible bond? We can think of a convertible bond as equivalent to a straight bond plus the option to acquire common stock Therefore, the bondholder can participate in the increase in the stock price This option is valuable, so the bondholder may be willing to accept a lower interest rate
Short term vs Long term debt
Corporate debt can be short-term (maturity less than one year) or long-term Examples of short-term debt are: Bank term loan Line of credit Commercial paper In the following slides, we are going to focus on long-term debt and we will provide several examples of it
Aside from tax savings and bankruptcy costs, know the other benefits and costs of debt
Costs: Bankruptcy costs (we have discussed this) Loss of flexibility-If a firm borrows up to its capacity, it loses the flexibility of financing future projects with debt. Other things remaining equal, the more uncertain a firm is about its future financing requirements and projects, the less debt the firm will use for financing current projects. Agency costs-A firm's stockholders and lenders have different interests. When the firm is in financial distress, the interests of shareholders and bondholders may be in conflict. Shareholders may pursue self-interest rather than the usual objective of maximizing overall market value Shareholders may pursue selfish strategies at creditors' expense These strategies can reduce overall value Benefits: Tax shield (we have discussed this)-A tax shield is the reduction in income taxes that results from taking an allowable deduction from taxable income. For example, because interest on debt is a tax-deductible expense, taking on debt creates a tax shield. Disciplines managers-Suppose the following scenario: You are the manager of a firm that generates high cash flows, and you are entrenched. What consequences would this have on the firm's investment policy? What are your costs? Suppose you are forced to borrow money the manager will have to ensure that the investment will have to earn enough to cover the interest payments. If not, the firm will eventually go bankrupt. Benefits of the disciplinary effect go up as the agency problem become worse.
Know the three dividend payments are bad arguments
Dividends are bad Taxes: whenever dividends are taxed more heavily than capital gains, firms should pay the lowest cash dividend they can get away with and earnings should be retained or used to repurchase shares If dividends are taxed differently than capital gains (dividends taxed as ordinary income) and the marginal tax rate of dividends is higher than that of capital gains, there exists a tax disadvantage for those stockholders who receive dividends Even if ordinary income and capital gains are taxed the same, dividends have a tax disadvantage because investors do not have the choice of when to report the dividend as it is the case with capital gains Dividends are good The clientele argument Dividends as signals Dividends may discipline managers
Dividends are good arguments
Dividends are good The clientele argument-There are stockholders who like dividends, either because they value the regular cash payments or because they do not face the tax disadvantage The dividend policy of a firm reflects the tax preferences of its investor clientele Individuals in the highest tax brackets have a preference for stocks that pay no or low dividends Tax-free investors and corporations have a preference for stocks with high dividends The dividend policy of a firm is optimized for the tax preference of its investor clientele Dividends as signals-Asymmetric Information When managers have better information than investors regarding the future prospects of the firm, their payout decisions may signal this information. By changing their dividend policy, firms send signals about their future cash flows to market participants When firms increase dividends, they somehow commit to those higher dividends, and, thus, send a signal that they expect to have higher future cash flows (share price increases) Dividends may discipline managers-Dividends discipline managers In firms with principal-agent problems between stockholders and managers and the potential of free cash flows being wasted, making a commitment to pay dividends imposes discipline on managers
Which of the following statements is FALSE?
Firms that use dividends will have to pay a lower after-tax return to offer their investors the same pretax return as firms that use share repurchases.
Describe the FIVE different governance mechanisms
Governance mechanisms: 1. Monitoring Board of directors Other monitors- Three types of directors: inside, gray, and outside Inside directors: employees, former employees, family members Apple example: Tim Cook (CEO of Apple) Outside/independent directors: Apple example: Arthur D. Levinson (Chairman of the board, Former Chairman and CEO of Genentech) Gray directors: not directly connected to the firm as insiders are but have previous business relationship with the firm Apple example: Robert A. Iger (Disney) The importance of an independent board A board with more outside directors is more likely to fire an underperforming CEO. A board can be "captured" The longer the CEO has served, the more likely the board is to become "captured". Other Problems: CEOs often hand pick directors. A 1992 survey by Korn/Ferry revealed that 74% of companies relied on recommendations from the CEO to come up with new directors; Only 16% used an outside search firm. While more companies have outsiders involved in picking directors now, CEOs still exercise significant influence over the process. Directors often hold only token stakes in their companies. Many directors are themselves CEOs of other firms. Worse still, there are cases where CEOs sit on each other's boards. Includes security analysts, lenders, the SEC, employees, and large outside shareholders Securities analysts produce independent valuations of the firms they cover so that they can make buy and sell recommendations to clients. Lenders carefully monitor firms to which they are exposed as creditors. Employees of the firm are most likely to detect outright fraud because of their inside knowledge. The SEC protects the investing public against fraud and stock price manipulation. 2. Compensation-How can compensation be used to reduce agency problems? Link managers pay to the performance of the firm: Pay executives stocks, not cash Stock and options grants give managers a direct incentive to increase the stock price. Some believe that CEO incentives are not strong enough. CEO pay rises only $3.25 for every $1000 of shareholder value created. Others believe that incentives are poorly designed. Why aren't incentive contracts indexed to stock market performance? 3. Market for corporate control-The lower the stock price, the more attractive the take-over becomes. The idea here is to exercise takeover pressure. One motivation for a takeover can be to replace poorly performing management An active takeover market is part of the system through which the threat of dismissal is maintained. There are many shark-repellent charter amendments: Staggered board - The board is classified into three equal groups. Only one group is elected each year. Therefore the bidder cannot gain control of the target immediately. Supermajority - A high percentage of shares is needed to approve a merger, typically 80%. Usually, simple majority is enough Poison Pill - Measure taken by a target firm to avoid acquisition; for example, the right for existing shareholders to buy additional shares at a very low price as soon as a bidder acquires 20%. Greenmail - Bribe paid to unwanted bidder to get him to go away (a "targeted share repurchase" since target buys back only shares of raider, and usually at a big premium). Very upsetting to target shareholders! Rarely used. 4. Using proxy fights-A group of shareholders join forces and gather enough shareholder proxies to win a corporate vote Problems Most shareholders don't attend meetings, "free-rider problem' Incumbents have big edge Campaign with firm's money Shareholder lists, etc 5. Regulation-Corporate scandals create a force for legislative responses. Scandals at Enron and WorldCom laid the groundwork for Sarbanes-Oxley. The Sarbanes-Oxley Act (SOX) The overall intent of SOX was to improve the accuracy of information given to both boards and to shareholders SOX attempted to achieve this goal in three ways: By overhauling incentives and independence in the auditing process By stiffening penalties for providing false information By forcing companies to validate their internal financial control processes
A callable bond will typically have a ________ yield than an otherwise identical bond without a call feature because ________
Higher, the option to call a bone is vaulable
Understand how/whether payout policy matters in M&M's perfect world and a world with taxes
In conclusion: In perfect capital markets, investors are indifferent between the firm distributing funds via dividends or share repurchases By reinvesting dividends or selling shares, they can replicate either payout method on their own
Which of the following statements is false?
Increasing the pay-for-performance sensitivity comes with the added benefit of reducing manager's risk.
Compare corporate governance practices across countries. Understand how the legal systems and corporate ownership is part of governance system
Manufacturing firms in Russia (at time of privatization) were estimated to have market values of 1% of comparable Western firms Poor management is part of the story But equally important seems to be the ability of managers of Russian firms to divert profits and assets to themselves Stealing from shareholders is the ultimate agency problem! There are systematic differences in governance across countries. The U.S. is one of the countries with the best governance. Common law countries (i.e. U.S. and Canada) have better governance compared to civil law countries (i.e. France and Italy ) US Either "other people's money" problems if management owns too little stock Or "entrenchment" if management owns too much stock Most of the Rest of the World Both problems in the same firms Control pyramids Dual class shares Plus a new third agency problem: "self dealing"
Understand limits within bond contracts that protect the interests of bondholders: bond covenants
Peking Order of Claims (First in line at the top): Bank Debt Senior Secured Bonds Senior Unsecured Bonds Senior Subordinated Bonds Subordinated Bonds Junior Subordinated bonds Preferred Equity Common Equity Bond Covenants-Bonds can be secured or unsecured. However, even the secured bonds face the risk of default. To reduce that risk, bondholders may put some clauses in the debt contract, so that the management won't take unreasonable risks These clauses are called covenants. Restrictive clauses in a bond contract that limit the issuer from taking actions that may undercut its ability to repay the bonds With more covenants, a firm firms can reduce its costs of borrowing. The reduction in the firm's borrowing cost can more than outweigh the cost of the loss of flexibility associated with covenants
Types of debt financing available to a firm
Private debt: Bank Loans Term Loan Syndicated Bank Loan Revolving Line of Credit Asset-Backed Line of Credit Private Placements Public Debt Different types of debt: Short term vs. long term Fixed rate vs. floating rate Registered vs. bearer bond Secured vs. unsecured Senior vs. subordinated Domestic vs. international Callable bonds Convertible bonds
Registered vs Bearer Bond
Registered Bond Company keeps track of bond owners, repays them directly Most common in the US Bearer bond Bondholder sends in "coupons" to claim interest payments Must send the certificate in to claim principal repayment More common overseas
Seniority of debt
Seniority A bondholder's priority, in the event of a default, in claiming assets not already securing other debt Tranches Different classes of securities that comprise a single bond issuance Senior vs. subordinated bonds In the event of default holders of subordinated debt must give preference to senior creditors who are paid first Remember: debt is always paid before equity - even the subordinated debt
Know what voting premium is and why it can be different across countries
The difference in price between a share that has one vote and a share that has no vote but pays the same dividend is called a voting premium. Consider two shares with equal cash flow rights but different voting rights: The one with superior voting rights often trades at a premium! Indicates that "control" is valuable, i.e. if you have enough shares, you get other benefits of control (jet...) beyond just dividends. Outside the US, most firms are controlled by wealthy families through control pyramids Magnifies "other people's money" agency problems Family controls > 50% of votes in firms A to F But family really only owns 3.1875% of Firm F If firm F spends $1M on a Lear jet, the cost to the family is only 3.1875% of this, or $31,875 Cross-holdings Family owns 5% of the stock in Firm A Firm A owns 51% of the stock in Firm B Firm B owns 46% of the stock in Firm A Result The family actually owns 5% of Firm A 2.55% of Firm B Family controls 51% of the votes in both A and B Multiple classes of common stock with different voting rights Family has super voting shares Non-voting or restricted voting shares for outsiders Family has > 50% of votes yet owns only a tiny fraction of stock at each level in the pyramid
Secured Vs Unsecured Bonds
The firm may set aside some of its assets specifically for the protection of particular creditors. Such debt is said to be secured and the assets that are set aside are known as collateral In particular, in event of default, these assets can be sold to satisfy the debt for which the security is given Examples of unsecured debt are: Notes: maturity less than 10 years Debentures: maturity 10 years and more Examples of secured debt are: Mortgage bonds: sometimes the asset is a specific building, more often on all the firm's buildings Collateral trust bonds: assets consist in common stock in a number of subsidiaries Asset-backed securities: instead of borrowing money directly, the firm bundles up a group of assets and sell the cash flows from these assets They are common for real-estate companies: in this case the assets are the mortgage loans But any type of assets can be used (e.g., David Bowie's royalties)
Define Corporate governance, and describe its role in the successful reduction of agency problems
The system of controls, regulations, and incentives designed to minimize agency costs between managers and investors and prevent corporate fraud The role of the corporate governance system is to mitigate the conflict of interest that results from the separation of ownership and control without unduly burdening managers with the risk of the firm.
Fixed rate vs Floating rate Debt
What is Fixed-rate debt? keeps paying a constant interest rate over the life of the bond What is Floating-rate debt? pays an interest rate that fluctuates with the general level of interest rates Common benchmark rate is LIBOR ("London InterBank Offered Rate") Most bank loans and some bonds are floating rate debt
Stock and option grants give managers
a direct incentive to increase the stock price to make their stock or options as valuable as possible.
Tradeoff Theory suggests
the firm should choose a debt level where the tax savings from increasing leverage are just offset by the increased probability of incurring the costs of financial distress.
By tying compensation to performance,
the shareholders effectively give the manager an ownership