Corporate Finance

Reconciling Interests

- Goals of stakeholders often in conflict, such as between shareholders and employees. Shareholders want more profit, employees want higher wages - Firms need to balance current profitability vs. long term profit growth - If can balance profit growth and long-run profitability, can satisfy diverse stakeholders -Can try and align stakeholders interest, like share-based compensation.

Clientele Effects Due to Taxes

- Investors are concerned about after tax income. Depending on capital gains tax vs dividend tax, an investor will prefer one over the other -For a given amount of dividend (D), investor would be indifference if the price of the stock would drop by a change in Price when it goes ex dividend This formula is also the expected drop in share price when stock goes ex-dividend. Change in price vs. D is the two indifference levels.

Attitude of Target Management: Hostile Takeover

-Acquirer submits proposal to BoD, process is known as a bear hug -If unsuccessful, next step is to appeal directly to target's shareholders using one of the two methods: 1. Tender offer - acquirer offers to buy shares directly from target shareholders, and each individual shareholder either accepts or rejects the deal 2. Proxy battle - acquirer seeks to control the target by having shareholders approve new "acquirer approved" BoD.

Mature Growth Phase: Common Mergers

-Reduced profit margins due to new competition, but potential still exists for above average growth Merger motivations: Efficiency, economies of scale/synergies Types of mergers: Horizontal and vertical

Pioneer/Development Phase:Common Mergers

-Uncertain of product acceptance, low profit margin, and large capital requirements -Need access to capital, management talent - Types of mergers: Conglomerates (can provide the capital) and horizontal (looking for growth)

Constant Dividend Payout Policy vs Dividend Stability Policy

A constant portion of earnings paid out as dividends and hence dividends fluctuate directly with earnings. Example: a constant 10% of net income paid out as dividends Vs. Dividend Stability Policy -Stable $ dividend payout regardless of earnings volatility. -Based on forecast of long run earnings Dividend growth = long run earnings growth rate. Example: Pay $2M in dividends a year

Other Dividend Policy THeories

A. Clientele effect due to: - Tax considerations -Requirements of institutional investors - some have a preference for more/less dividends -Individual investor preference - some may want long term growth, thus less dividends

After-Tax Operating CF

Add back depreciation tax shield because it is a non cash expense

Agency Relationships

Agents can act for own benefit instead of principals interest. Areas of concern: -Managers vs shareholders -Directors vs shareholders

Costs of Asymmetric Information

Asymmetric info: managers know more about firm prospects than shareholders Costs higher if complex product or poor financial statements. A stock offering by managers can be read as a negative signal (offering to sell overvalued stock) A debt offering by managers can be read as positive signal (avoid selling undervalued stock; management confident can make payments)

Other Dividend Policy Theories

B. Agency Issues - Conflict of interest between shareholders and managers: Dividends reduce FCF for managers to invest in empire building. -Conflict of interest Between shareholders and bondholders: Dividends transfer wealth from bondholders to shareholders.

Downsizing Operations Through Corporate Restructuring

Divestitures: Selling ,liquidating, or spinning off a division of subsidiary Equity Carve out: Creates a new independent company. Sell shares to outside stockholders through public share offering Spin offs: Create a new, independent company. Distribute shares to parent company shareholders Split off: Existing shareholders must exchange shares for shares of new division Liquidation: Break up firm and sell piece by piece. Parts worth more than sum of the whole.

Alternative Valuation Models (Residual Income)

Focus on returns to equity holders.

Gains to Acquirer

GainsA = S - TP Gains for Acquirer = Synergies - Transaction Premium TP = Pt - Vt Transaction premium = Price paid for Target (Pt) - Premerger value of Target (Vt) If deal isn't cash, then adjust for stock payment (in OUR firm, the combined firm) Pt = (N * Pat) N= Number of new shares target receives ***Pat= Price per share AFTER MERGER ANNOUNCED***

For the Exam:

Horizontal mergers common in all life cycles Conglomerates mergers at pioneer, development, declining phase Tend to see vertical mergers primarily in mature and declining phases

Effects of Inflation on Analysis

Inflation > Expect Inflation results in: 1. Reduced REAL value of depreciation tax shield (depreciation stays the same no matter what) 2. Decreases value of fixed payment to bondholders 3. Different impact on revenues vs costs

Corporate Governance Policies

Investors & analysts should assess the following policies of corporate governance, which can be found in public regulatory filings. - Code of ethics -Director's oversight, monitoring -Management's responsibility to board -Reports of director's oversight -Board self assessment -Management performance assessment -Director training

Tax Preference Theory (Tax Aversion)

Investors prefer small dividends over large dividends. Subject to taxation. Capital gains are: 1. Sometimes taxed at a lower rate 2. Not taxed until realized Result: Smaller dividends result in higher stock price and lower cost of equity

Herfindahl-Hirschman Index

Key Measure of market power for determining anti-trust violations. -Can determine if merger will be blocked or not.

Other Dividend Policy Approaches

Longer term residual dividend model - forecast capital budget 5-10 years -Allocate left over RE as dividends -Pay out in relatively equal amounts - Distribute excess with share repurchases

Role of Debt Rating

Lower debt rating = higher credit risk Increase in debt rating leads to lower cost of debt AND cost of capital (WACC)

Dividend Irrelevance Theory

MM: Dividend policy is irrelevant, if you want a dividend you can sell stock. Assumes no corporate taxes, bankruptcy costs, transaction costs. Homemade dividends: - Invests who want more dividends can sell their stock - Investors wanting less dividends can use dividends to buy new stock

Agency Relationship Conflicts

Manager (Agent) vs Shareholder (Principal) -Agent unwisely expands size of firm (mergers) -Excessive compensation, perquisites (three secretaries, non who can type) -Taking too much risk -Not taking enough risk - protecting cushy job Directors (Agent) vs Shareholder (Principal) -Lack of independence (managers on BoD and more interested in board's interest, not shareholders) -Board members have personal relationship with management - old friends -Board members with consulting agreements -Interlinked boards -Directors are overcompensated Point: BOD align with management, not shareholders

John Rawls

Maximum basic liberty compatible with the same liberty for others. Beyond basic liberty, inequality of results only if consistent with the difference principal ( unequal distributions only justified if bigger shares to least advantaged in society)

Utilitarianism

Morality of actions is determined by their consequences, good or bad. - Cost-benefit analysis is example of weighing good/bad consequences Leads to seeking the greatest good for greatest number of people. Flaws: 1. How to measure all costs and benefits unclear 2. Can lead to exploiting a small group of people for benefit of many

Alternative Valuation Models (Market Value added)

NPV Based on Economic profit, mathematically equal to NPV. Must recalc $WACC after each term, capital for following year is reduced by depreciation.

Miller & Modigliana

Proposition 1: The value of the firm Proposition 2: The WACC (Tells same story, different way.) Know both with: No taxes, taxes. Assumes: Capital markets perfectly competitive, investors have homogeneous expectations, Riskless borrowing and lending, no agency costs, investment decisions unaffected by financing decisions

Stakeholder Impact Analysis (SIA)

Purpose is to force company to decide which stakeholders are most crucial. The SIA should: - Identify relevant stakeholders - Their critical interest and desires - Their demands - max returns, low wages, etc. - Prioritize the stakeholders - Design a business plan to meet critical demands

Business Ethics

Treat stakeholders fairly and ethically, will benefit firm and its managers. Noblesse Oblige - argues those who benefit most from society (including successful business owners) have moral obligation to do best thing and act in best interest of society.

Unethical Behavior

Unethical behavior includes: -Self-dealing agents who use corporate funds for personal interest -Information manipulation to hide misbehavior -Anti competitive behavior to gain monopoly power -Opportunistic exploitation of suppliers and distributors in violation of contract terms (taking advantage of them when in weak conditions) -Substandard working conditions for employees -Environmental degradation -Corruption and bribery

Post-Offer Defense Mechanisms

"Just Say No Defense" - refuse to takeover offer, then convince shareholders to do the same Litigation: File a lawsuit against acquirer to consume acquirer's time and money Greenmail: Targeted repurchases shares from the acquirer at a premium -Like a payoff to acquirer, think "blackmail" -50% tax on greenmail profits Share repurchase: Target submits a tender offer for its own shares Leverage recapitalization: Target assumes a large amount of debt to repurchase shares or make current capital structure less than ideal. Crown jewel defense: Target sells a major asset to a neutral third party, which is the asset the acquirer may want. -Risk is that court could declare sale illegal Pac-man Defense: Target makes a counter offer to acquirer the acquirer White-knight defense: Friendly third party makes offer to acquirer target. May start bidding war. White squire Defense: Friendly third party buys minority stake in target. Block potential acquirer from gaining enough shares

Capital Budgeting Pitfalls

- Failing to incorporate competitor/market response - Misuse standardized templates: Managers look at lots of projects, often create templates to streamline analysis. Not appropriate, not all projects are the same. - Pet projects not analyzed properly: biased valuation of capital projects, show project in good light - Base investment decisions on EPS or ROE (accounting metrics). Should use NPV IDEALLY - Use IRR for mutually exclusive projects: ALWAYS GO WITH NPV - Poor cash flow estimation - Over/underestimate overhead costs: Should only include incremental overhead costs related to management time and information technology support - Use incorrect discount rate - Internal politics involved with spending entire capital budget vs. returning excess funds - Failing to generate alternative investment ideas: dont want to just look for +NPV projects. Want to seek out highest NPV projects - Handle sunk costs and opportunity cost improperly

Attitude of Target Management: Friendly Acquistion

- If both parties like idea of potential deal, they will negotiate the method of payment and terms. -Each party to the merger will conduct due diligence. - Once negotiation and due diligence is done, attorney drafts definitive merger agreement outlining the deal. -Once agreement signed, transaction is announced to the public

Share Repurchase Vs Cash Dividend

- If tax treatment is the same, no difference in effect on shareholder wealth regardless if dividend issuance or share repurchase. -Rationales for share repurchase: 1. Tax advantage to shareholders: If tax rate on capital gains < tax on dividends. 2. Signal to shareholders management believes shares are undervalued. 3. Added flexibility: Repurchase is not sticky and so can be used whenever there is excess cash. 4. Offsetting dilution: Prevents EPS dilution from exercise of employee stock options. 5. Increase leverage: Repurchase shares to increase financial leverage. 35% debt and 65% equity is target structure, can borrow money and buy back stock, changes leverage. Change in capital structure. If after tax cost of borrowing < earnings yield, share repurchase will increase EPS

Leverage Analysis Implications: Financial Markets and Banking Systems & Macroeconomic FActors END***********

- Longer maturity debt isn't a worrisome investment when more liquidity. Overall liquidity doesn't sway investors to equity or debt - Greater reliance on banking system means debt is used more often, more likely to see total use of debt higher - Greater institutional investor presence are likely less risk adverse than individual investors. Will take on less debt, thus overall use of total debt lower. - When inflation is high, debt investors are getting money back at a depreciated value. Less likely to use debt, will invest in shorter maturity debt - Higher GDP growth rate high means risk of economy is low, so investors are willing to take more risk. Will invest in equity and longer term debt.

Bootstrapping

-Boostrapping EPS: Increased EPS that occurs when a high P/E firm acquires a lower P/E firm, create value by bringing in earnings from low P/E firm to high P/E firm. -No real economic gains here. -Point: EPS increases, but share price doesn't -Here we see a firm exchanging higher priced shares for lower priced shares, a ratio less than 1 for 1. Thus when we calc EPS the numerator is equal to the sums of the combined firms, but denominator is less than combined.

BoD Assessing Attributes and Best Practices

-Composition of board; at least 75% of director independent - no relationship with firm other than on the board - Independent board chairman (NOT CEO) - Qualified directors (no brother-in-laws, friends, etc.) -Election procedures (annual elections best) -Board self-assessment practices - evaluate their own accomplishments -Frequency of separate sessions for independent directors without insiders of the board (at least annually) - Audit Committee (ONLY independent directors) - Nominating Committee (only independent Directors) -Compensation committee (linked compensation to mostly performance, focus LT) -Use of independent and expert legal counsel -Statement of governance policies -Disclosure and transparency (more "light" is better, make sure information is accurate.) -Insider or related party transaction (board approval for such transactions) -Responsiveness to shareholder proxy vote - Meet regularly to perform duties (once every 6 months)

External Stakeholders

-Customers - want stability, product choice, low prices (lower revenue) - Suppliers/creditors - seek stability and higher prices (higher expenses) -Unions seek stability plus higher wages and benefits for their members (higher expenses) - Government make rules; local communities and the general public provide infrastructure (can disrupt company operations)

Internal Stakeholders

-Employees seek stability and compensation growth (higher costs) - Managers are also employees but with asymmetric information advantages (can pursue personal interest at the expense of the company) -Board members should monitor senior managers, also enjoy asymmetric info advantage and risk becoming too close to managers.

Roots of Unethical Behavior

-Employing agents with flawed personal ethics -Failing to realize a business situation has an ethical dimension -Organization culture focusing only on economic outcomes and pressure from top management to meet unrealistic performance goals.

Philosophies Underlying Business Ethics

-Friedman Doctrine -Utilitarianism -Kantian Ethics -Right Theories -Justice Theories

Rapid Growth Phase: Common Mergers

-High profit margins, accelerating sales, and earnings, but still low industry competition Merger motivations: Access to capital, expand growth capcity Types of mergers: Conglomerates (can provide the capital) and horizontal (looking for growth)

Global Trends in Dividend Policy

-Lower proportion of U.S. companies pay cash dividends (compared to European companies) -Fewer firms in developed markets paying dividends -More companies in developed markets doing share buybacks

The Friedman Doctrine

-Milton Friedman proposed that only social responsibility of business is to maximize profits (1) within the rules of the game, and (2) through open and fair competition without deception or fraud.

Princiapl Agent Relationship (Agency Costs)

-Shareholders are the principal, senior executives are their agents and are suppose to maximize shareholder value. -Senior executives have asymmetric info advantage and can thus use that advantage for own self interest -Shareholders often lack the info needed to confirm that management is utilizing resources appropriately -Senior execs can enjoy excessive perks in the guise of necessary business expenses -Top executives often receive a compensation increase/bonus irrespective of the company's performance -Simply expanding the size of the business (empire building) may benefit the CEO, as CEO pay is linked to company size even if growth of size doesn't help shareholders

Nike and Justice Theories ****END of CORP GOV pt. 1*****

-Supplier's treatment of workers might be argued to pass the difference principal - Difficult to imagine under the veil of ignorance that anyone would want to be placed in those working conditions -The veil of ignorance helps define a moral compass for making tough decisions but looking behind the veil to determine what is best for society.

Comparable Company Analysis

-Use relative value metrics from similar companies (P/E ratio) -Add a takeover premium to determine fair price to pay for takeover stake Premium = (Pdeal - Ppre-deal) / Ppre-deal -Big point: Valuation relative to minority - does not use transacted firms Identify comp firms, calc relative value measures, calc descriptive stats, estimate takeover premium, calculate estimated takeover price. If estimated stock value is based on comparable transactions, don't need to calculate premium as it is already in the transaction itself Advantages: - Data for comps is easy to access - Assumption that similar assets should have similar values is fundamentally sound - Estimates of value are derived directly from the market instead of assumptions/estimates about future Disadvantages: - Approach implicitly assumes that the market valuation of the comparable companies is accurate -USing comp companies provides estimate of fair stock price, but not a fair takeover price. Takeover premium must be calculated separately. -Hard to incorporate merger synergies or changing capital strucutre -Historical data used to calc take over premium may not be up to date and reflect current M&A space

Valuing a Target Company

1. DCF 2. Comparable company analytic -Use relative value metrics + premium -Start with minority interest 3. Comparable transaction analysis

Capital Budgeting Principal

1. Decisions are based on incremental AFTER TAX cash flow. - Sunk costs are not incremental (irrelevant). Regardless of accept/reject, still take on cost -Externalities are incremental, positively/negatively influences on cash flows. - Cannabilization is an example 2. Cash flows are based on opportunity cost (cash flows firm will lose by undertaking the project) 3. Timing of Cash Flows is important (TVM) 4. Financing cost already reflected in required return DO NOT Include interest expense!

Major Reasons for Divestitures

1. Division no longer fits long-term strategy 2. Lack of profitability 3. Individual parts worth more than the whole 4. Infusion of cash: company needs cash

Actions in Pursuit of Ethical Behavior

1. Hire and promote those with strong personal and business ethics. Use psychological testing and review of past employment. 2. Build an organization and culture that value highly ethical behavior 3. Select leaders who will implement #2 4. Establish a decision process incorporating moral compass, rights theory, and Rawl's theory of justice. Then implement a series of yes or no decision tools, such as: - Does this meeting out code of ethics & standards? -How will it look if this decision is widely reported to stakeholders and the press? -Would others whose opinion I value and respect approve of this decision? 5. Appoint Ethics officers to articulate, propose, train, monitor, and revise a code of ethics, and make sure that it is adhered to. 6. Show moral courage by supporting managers who make tough decisions consistent with good business ethics, even at expense of short term profits. 7. Establish strong corporate governance procedures: -A majority of the BoD that are independent, outside, knowledgeable, and high integrity with no tie to the company -Chairman and CEO are separate individuals with the chairmen being an independent, outside director -Compensation committee made up of exclusively independent, outside directors - Retain outside auditors with no conflicts of interest (such as providing consulting services to the firm)

Factors Affecting Dividend Payout Policy

1. Investment Opportunities - firms with lots of investment opportunity, retain cash and dividend payment low 2. Expected vol of future earnings - if vol is high, dividend payout is low. Firms more cautious in changing dividend policy. 3. Financial flexibility - if firm is worried about being flexible, may keep dividend low. 4. Tax considerations - Tax on CG vs Tax on Dividends. If benefit to one, that cash flow will be favored. 5. Flotation costs - affects cost of new equity, when high then makes sense for firm to use retained earnings to generate new earnings. When high, dividends are lower. 6. Contractual and legal restrictions - factors influence what dividend policy should be. Common legal and contractual restrictions on dividend payments include: -Impairment of capital rule: A legal requirement mandating that dividends paid cannot be in excess of retained earnings -Debt Covenants: protects bondholders, dictate things a company must or must not do

Merger Motivations (motivations in press release & behind the scenes)

1. Synergies - Mergered companies worth more than the sum of each. Think economies of scale/scope 2. Achieving more rapid growth - Increased revenues growth, less risky to acquire growth 3. Increased market power: Market share and prince influence (can gouge consumers), reduced dependence on outside suppliers. Horizontal mergers. 4. Gaining access to unique capabilities: Cost effective way to acquire resources or capabilities a firm doesn't have but needs 5. Diversification: -Finance theory: unlikely to increase value but will stabilize cash flows, becomes smoother 6. Bootstrapping -Positive impact on EPS from all stock deals 7. Personal benefits for managers -High correlation between size of the company and manager compensation -Power and presitge of being large company 8. Tax benefits -Acquirer can use target's tax losses to lower tax liability -regulators tend not to approve if that is sole reason 9. Unlocking hidden value -Accomplished by improving management, adding resources, or improving organizational structure -When something is cheaper a buyer may come along and try and pay a lower price to ultimately unlock value 10. Achieving international business goals -Take advantage of market inefficiencies (cheap labor) -Avoid disadvantageous government policies (tariffs) -Use technology in new markets -Product differentiation -Provide supporting to existing clients

Effect of Price and Payment Method

Acquirer will want to pay the lowest possible price, Target wants to recieve the highest possible price. Floor = Vt Ceiling= Vt + S Effect of Payment: Cash Offer -Acquirer assumes the risk and receives the potential reward -Gain for target shareholders is limited *Synergies > Expected: Takeover premium for target is fixed, acquirer unlocks value *Synergies<Expected: Acquirer loses, paid too much Effect of Payment: Stock Offer -Some of the risks and potential rewards shift to the target firm -Remember: Target shareholders will own part of acquiring firm

Forms of Integration

Acquistion: One company buys only part of another company Merger: One company absorbs another company entirely Statutory merger: Acquiring company obtains all of the target's assets and liabilities; the target company ceases to exist. Equity of target company ceases to exist Subsidiary merger: the target company becomes a subsidiary of the acquirer; often used when target has strong brand identity Consolidation: Acquirer and target cease to exist in their prior form but come together to form a completely new company. A+B = C Horizontal Merger: Two businesses operate in the same or similar industry Vertical merger: Target company is along the supply chain of the acquiring company Conglomerate Merger: Two companies form completely separate industries. Limits option in the market, have to take both businesses if someone goes to buy it. Trades at a cheaper valuation.

Capital Budgeting Alternatives: Economic and Accounting Income

Alternative to DCF approach to capital budgeting; should give us consistent results Economic Income (Not accounting income, so if given B/S we need to calc our own NI) = After tax operating cash flow - economic depreciation Economic depreciation = Change in market value of company Accounting income is reported net income on financial statements. Differs because: - Is based on original cost (Not MV) of the investment - Financing costs not included

Optimal Capital Structure

Capital structure that minimizes WACC or maximizes firm stock price WACC is weighted average of the marginal cost for each type of capital.

Incremental Cash Flows

Cash flows are evaluated in 3 stages - Initial investment outlay (Outlay) (-) -After tax operating cash flow over projects life (OCF) (+) - Terminal-year end cash flow - which are asset salvage values (TNOCF) WACC - We use MV of Equity and MV of Debt, also use interest rate, not coupon rate, for debt portion.

Stabilization PHase: Common Mergers

Competition has reduced most of indsutry's growth potential Merger motivation: economies of scale, reduce costs, improve management Types of mergers: Horizontal

Agency Cost of Equity

Cost associated with conflict of interest between shareholders and managers. Shareholders will take steps to minimize these costs, the net result is called net agency cost of equity. Types of agency costs of equity: - Monitoring costs (better corp. governance, lower agency costs) - Bonding cost (costs management takes on to assure shareholders that managers are working for best interest of them, i.e. non-compete agreement) - Residual loss (losses that will occur and can't eliminate) Point: Greater financial leverage reduces agency costs equity because managers have less FCF to blow

MM Prop II (WITH Tax)

Cost of debt is significantly lower due to tax subsidy, which is WACC is pulled down. Raaches optimal level when we have 100% Debt Big point prop 3 & 4: In a world with debt, firms should use 100% debt because of tax shield. Doesn't work in practice because of risk of bankruptcy.

MM Proposition II (No Taxes)

Cost of equity is higher than cost of debt because equity is more risky than debt. Equity increases linearly as company increases proportion of debt financing. Debt has lower risk, first to be paid WACC DOESNT CHANGE! Big point prop 1 & 2: In world with no tax, capital structure DOESNT MATTER

Cost of Financial Distress

Costs incurred when company has trouble paying fixed financing costs (interest) - Direct cost, such as legal expenses - Indirect costs, such as loss of customer trust Lower leverage = lower probability of financial distress Higher quality of management = lower probability of financial distress Better corporate governance (monitoring) = lower probability of financial distress Bonding costs - premiums for insurance to guarantee performance and implicit costs associated with non-compete clauses

MM Prop I (WITH Tax)

Debt creates a tax shield. Debt interest payments are tax deductible, tax shield increases the size of the pie. Result: VL= Vu + (Tax rate * Value of Debt) Optimal capital structure: 100% Debt!

Decline Phase: Common Mergers

Declining profit margins, overcapacity, and lower demand due to shifts in consumer taset -Merger motivations: survival, operating efficiencies, new growth opportunities -Types of merger: Horizontal, vertical, and conglomerate

Mitigating PAR Problems

Develop corporate government procedures that: - Motivate agents to behave in accordance with goals set by principals - Reduce info asymmetry between agents and principals - Remove agents who misbehave or engage in unethical behavior

CFs for Replacement Project

Differences: - when we have a replacement, sell the old equipment & buy the new. Thus initial outlay is offset by inflows from sales of old equipment - Use the difference between old and new depreciation - We only care about INCREMENTAL operating cash flows

Dividend Preference Theory (Bird in Hand Argument)

Dividend preference: Suggests that investors prefer the certainty of a cash dividend over the uncertainty of a stock price increase (Bird-in-hand argument) Results: Higher dividends will lead to higher stock prices

Alternative Valuation Models (Claims Valuation Approach) END OF CAPITAL BUDGETING!!!!

Divides CFs into claims of debt and equity holders. They are valued separately, then added together to estimate value. CF to debt holders = interest and principal, discount at cost of debt CF to equity holders = dividends and share repurchases, discounted at cost of equity

Effective Tax rate on Dividends

Double Taxation: Tax at corporate level, and then tax at a personal level. -Effective tax rate = Corporate Tax Rate + (1-Tax Corporate)(Tax Individual) Split Rate System: -Taxes earnings distributed as dividends at a lower rate than earnings that are retained to offset higher (double) tax rate applied to dividends at individual level. -Calculated just like double taxation, except corporate tax rate is tax rate for distributed income Effective Tax rate = Tax Corp Dist. Income + (1 - Tax Corp Distribution for Distributed Income)*(Individual Tax) Imputation System: Taxes are paid at the corporate level but are attributed to the shareholder, so that all taxes are effectively paid at shareholder rate. Shareholder tax bracket < company rate, shareholder receives a tax credit equal to the difference. If higher, shareholder pays difference. The effective tax rate on the dividend is simply the shareholder's marginal tax rate. MOST PREFERRED, ELIMINATES DOUBLE TAXATION

Alternative Valuation Models (Economic Profit)

Economic Profit - profit in excess of dollar cost of all capital (debit and equity) invested in project Include salvage in the last year calculation for EP

Initial Investment Outlay

FCInv = cost of investment, getting it there NWCInv = Change in non-cash current assets - change in non-cash current liabilities We add NWCInv amount if amount went up, subtract if went down.

Evaluating Capital Structure Policy

Factors to consider: 1. Changes in capital structure overtime (Time Series) 2. Capital structure of competitors with similar business risk (cross-sectional) 3. Company Specific Factors (Agency costs: Higher quality of corporate governance will lead to lower agency costs and less debt need to prevent managers from inefficiently using debt.) Can also use scenario analysis to determine if management's current structure policy is maximizing the value of the firm.

Corporate Governance and Company Value

Firms with strong/effective governance systems exhibit: -Higher profitability - ROA, ROE, margins -Higher returns - EPS Firms with weak/ineffective governance systems exhibit: -increased risk to investors (firm may face accounting risks, asset risk, liability risk, and strategic risk). -Reduced value -Extreme cases: bankruptcy

Stable Dividend Policy Target Payout Ratio Adjustment Model

Focuses on a steady dividend payout, even though earnings may be volatile from year to year. Dividends are based on long-term earnings forecast. Dividends are smoothed so as to not fluctuate with earnings. If a company's earnings are expected to increase and the current payout ratio is below target ratio, investor can estimate future dividend formulas through target payout ratio adjustment.

Leverage Analysis Implications: Institutional, Legal, and Taxation Factors

For international firms, country specific factors may have a significant impact on a firm's capital structure policy. Observations regarding international differences in financial leverage include: -Debt: Japan, Italy, France tend to have more debt than firms in US/UK -Debt Maturity: Companies in North America tend to use longer maturity than in Japan -Emerging MArket Differences: Developed countries use more debt w/ longer maturity than Emerging markets - Less debt needed with strong legal system because legal system ensures better protection. Willing to take more risk. Debt issued can have longer maturity. -Less information asymmetry means lower debt needed, less risk so willing to take on equity. Debt issued can have longer maturity. -Favorable personal taxes on dividends vs interest (less tax on dividends), make more sense to invest in equity. - Common law (US and UK) vs. Civil Law (welfare focused on all owners, not just shareholders). Common law shareholders don't mind taking more risk because more protection built into protecting them.

Rights Theory

Fundamental rights trump collective good; shareholders,employees,etc...have fundamental rights. -Business managers have a moral compass and respect these rights -Businesses also have rights, but these right impose the obligation to respect others (don't pollute or harm workers/customers)

Dividend Coverage Ratios (sustainability of payout) ****END OF DIVIDEND and SHARES REPURCHASES***

Higher dividend payout ratio/Lower dividend coverage ratio = Greater chance of cut. FCFE Coverage ratio significantly < 1 is considered highly unsustainable. Remember: FCFE = CFO - FCinv + Net Borrowing

Real Options

Managers have the option to make future decisions that can change the value of projects initiated today. Real options are based on real assets and not financial assets and are contingent on future vents. Offers flexibility that can improve NPV estimates for individual projects, but NOT obligated. Types of real options: Timing options - allows company to wait for better information before making an investment Abandonment options - Exit project early if failure is on horizon Expansion: Option to make additional investments in a project if doing so creates value Flexibility Options: Gives a manager choices regarding the operational aspect of the project. ---Price Setting: Change product price ----Production Flexibility: Overtime, different materials, different variety of product Fundamental Options: Entire project is option itself because the payoff DEPENDS ON UNDERLYING ASSET. Example: Copper mine project is dependent on market price for copper. If copper prices are low, makes sense to open project.

Pecking Order Theory

Managers prefer to make financing choices that are least likely to send signals to investors. Financing choices are from most favored to least favored (pecking order) based on their information content. - Internally generated funds (most favored) ***Retained earnings*** - Debt - Newly issued equity (least favored)

Kantian

People deserve to treat with dignity and respect (Sweat shop are unethical). Incomplete as a moral philosophy as it does not address moral emotions like sympathy or caring.

Capital Ration (alternative to capital budgeting)

Point: Allocate fixed capital to maximize shareholder wealth. How? Choose the combination of projects with total high total NPV by ranking projects using profitability index. SOFT Capital rationing - managers are allowed to increase allocated capital budget if they can justify to senior management that the additional funds will create shareholder wealth. HARD capital rationing - fund allocated to managers under capital budget cannot be increased.

Residual Dividend Model

Point: Dividends = earnings minus funds retained to finance equity portion of capital budget. Dividends are an after thought. Model is based on: - Investment opportunity schedule - look at all projects and analyze which projects want to take. Tells you how much capital you need. - Target capital structure - depending on weight of debt and equity -Access to and cost of external capital - some will come from RE, some new issue of equity (which depends on cost of external capital).

Discount Rate Using CAPM

Point: Must use project beta (not firm beta) Project cost of capital: Use project beta with CAPM to find appropriate discount rate. This will yield the project return specific discount (hurdle rate), which we can use to get NPV. Hurdle Rate - risk adjusted require rate of return for project If we use company beta and company beta > project beta, we will get discount rate too large discount rate, too low of NPV, and will reject more projects.

Pre-Offer Defense Mechanisms

Poison pill - allows shareholders the right to buy more shares at a discount. -Flip-in Pill: Buy target's shares -Flop-over Pill: Buy acquirer's shares if deal goes through Poison Put: Bondholders can demand immediate repayment in case of takeover States with restrictive takeover laws: Company can reincorporate in a state with anti-takeover laws (Ohio is best law). Being in these states one can avoid Staggered board: Bidder can only win a minority of the board seats in one year, slows number of years it takes to get takeover through Restrictive voting rights: Equity ownership above threshold level causes loss of voting rights unless approved by board. Fair price amendment: Restricts merger unless a fair price is offered. Golden parachutes: Managers receive lucrative cash payouts if they leave the target company after a merger

Board of Directors

Responsibilities: -Institute corporate values -Create LT strategic objectives -Determine management's responsibilities -Ensure complete and accurate info -meet regularly -Ensure board members are adequately trained

ESG Risks (Environmental, social, and governance risk)

Risks from ESG factors that impact profitability and long term success of the firm: -Legislative and regulatory risk - tobacco industry -Legal risk -Reputation risk - BP oil spill -Operating risk - possibility that a firm will be forced to modify an operation, or shut it down, due to the impact of ESG factors. -Financial risk - ESG risks will result in monetary cost to the firm or shareholders.

Static Trade Off Theory

Seeks to balance the cost of financial distress with the tax shield benefits from using debt. Theory says there is optimal capital structure with optimal level of debt, and thus optimal cost of financial distress one should take on: VL = Vu + (T * D) - PV(Financial Distress cost) After-tax cost of debt is upward sloping due to increase cost of financial distress that comes with additional leverage. As cost increases, cost of equity also increases because some of the costs of financial distress are effectively born by equity holders. Optimal proportion of debt is where marginal benefits provided by the tax shield of taking on additional debt = marginal cost of financial distress

Project Risk Analysis

Sensitivity analysis: Begin with base case, change a single input variable, look at change in NPV, and continue over and over again. The project with NPVs more sensitive to changes in input variables are riskier Scenario Analysis: We look at multiple scenarios. Examine best-case, worse-cast, and most-likely case. Calculate NPV for each, will get mean and STD of NPV. Monte Carlo Simulation: 1. Determine which inputs are uncertain. Assign probability distribution to each distribution 2. Simulate a random drawing from assumed distribution for each input variable. 3. Given each of the inputs from step 2, calculate the project NPV 4. Repeat step 2 & 3 10,000 times 5. Calc mean NPV, STD NPV, and the correlation of NPV with each variable 6. Graph resulting 10,000 NPV outcomes as probability distribution

Distribution of Merger Benefits

Short term of effect on stock price -Target average gain approx 30% -Acquirer loses between 1% and 3%. This is a winners curse (pay too much in bidding war). Managerial hubris is when we think we can make anything work -Long term affect on stock price: Acquirers tend to unperformed, fail to capture promised synergies.

Signaling Content of Dividends

Signaling due to information asymmetry between managers and investors - When increase in dividend, positive signal because dividends are sticky. -When decrease/omission of dividends, negative signal. Lack of confidence. -When dividend is declared, positive signal. But if firm is growing fast and declares dividend, can be a bad signal that growth is slowing down.

Business Forms and Conflicts of Interest

Sole proprietorship: owned by an individual - Conflicts of interest: Creditors and suppliers Partnerships: Two or more owners/managers -Conflicts of interest: Creditors and suppliers Both do not have a separation of ownership and management Corporations: Distinct legal entity -Conflict of interest: between shareholders and management and BoD -Conflict created by separation of ownership and control

Evaluating Projects with Real Options

Step 1: Determine NPV without option Step 2: Add estimated value of option to project NPV (done either via a decision tree, or option pricing model) If project is negative, look at if project will be positive when we add the value of the option.

Discounted Cash FLow

Step 1: Determine which FCF model to use: 2 stage, 3 stage? Step 2: Develop pro forma financials Step 3: Calculate free cash flows Step 4: Discount FCFs back to the present Step 5: Determine terminal value and discount it back to present Step 6: Add discounted values for each stage Advantages: - Relatively easy to model changes in CFs -Estimated value is based on fundamental conditions in the future rather than current data - Model is easy to customize Disadvantage -Difficult to apply when FCF are neg - estimates of cash flows and earnings are highly subject to error - Discount rate changes over time, which can have a big impact - Estimation error is a major concern since the majority of the estimated value for the target is based on terminal value

Residual Dividend Model

Steps to determine target payout ratio: 1. Identify optimal capital budget 2. Determine amount of equity needed given target capital structure. (Dividend= NI - RE) (RE comes from equity needed for optimal target structure) Planned Capital Spend/Budget < Total Capital Available - there is money left over for dividends 3. Meeting equity requirements to extent possible with Advantages: -Easy to use -Management can identify investment opportunities without considering dividends Disadvantages: - Dividend payments may be unstable - Investment opportunities and earnings often vary YoY, so dividends will fluctuate if a firm strictly adheres to a residual dividend policy.

Forms of Acquistion

Stock purchase: Target company's shareholders sell their shares directly to the acquiring firm Asset purchase: Acquirer makes payment to target company to acquire assets Payment method: -Securities offering: Target shareholders receive shares of acquirer's common stock. Based on exchange ratio (e.g., 14 to 1) Cash offering: Target shareholders receive cash for shares -In an all cash offering, acquiring firm assumes all risk - If acquirer feels that their shares are overvalued, may use their shares in a transaction. Sends signal that acquirer's share may be overpriced.

Corporate Governance System

System that defines who is responsbile for what, there will be accountability, responsibility, and how to deal with conflicts Objectives: -Eliminate/reduce conflicts of interest -Ensure company assets used in best interest of investors Core Attributes of an Effective System: 1. Define shareholder rights 2. Define oversight responsibilities - who looks over who 3. Provide fair and equitable treatment of all stakeholders of the firm 4. Provide transparency/accuracy in disclosures

Other Dividend Policy Approaches (Target Payout Adjustment Model)

Target Payout Adjustment Model: Dividends paid out as percentage of total earnings with stable dollar amount General approach: - Set target dividend payout based on long term sustainable earnings - Move slowly toward that target - Avoid cutting or eliminating dividend except in extreme circumstances.

Actual vs Optimal Capital STructure

Target capital structure = optimal capital structure that maximizes value, minimizes cost. However, capital structure may deviate from optimal: -When raising equity is cheap, or when interest rates or low, may want to capitalize on these opportunities. - Day to day fluctuations in market value can impact

Projects with Unequal Lives - Least Common Multiple of Lives

Three conditions that must be satisfied when using unequal lives analysis: 1. Projects must be mutually exclusive 2. Have unequal lives 3. Replaced continuously When we have two mutually exclusive (both cannot occur) projects with different lives and projects replaced repeatedly. Example: Cost of capital = 12% NPV of book press w/ 6 years = $3245 NPV of offset printer with 3 years = 2577 POINT: Bookpress may not be best because takes longer to generate higher NPV. Will use Least Common Multiple of lives to compare If INDEPENDENT PROJECT then we would pick book press.

Comparable transaction analysis

Uses details from completed M&A deals for companies similar to target. Advantages: - Since the approach uses data from actual transaction, no need to estimate a separate takeover premium -Estimates of value are derived from recent deals completed in market rather than from assumptions about future - Use of price established by recent transactions reduces risk that target's shareholders could file a lawsuit against managers/BoD for mispricing Disadvantages - Approach assumes M&A market valued past transactions correctly - May not be enough comparable transactions to develop reliable data for estimated target value. - Difficult to incorporate merger synergies or changing capital structure into analysis.

MM Proposition I (No Taxes)

Value of firm is unaffected by its capital structure. Levered firm and unlevered firm at equal in value. Holds in perfect markets where: - No taxes -No transaction costs -No costs of finncial distress

Evaluating a Merger Bid

Vat = post merger value of comparable firm Vat = Va + Vt + S - C

Justice Theories

A fair and equitable distribution of goods and services is just: - John Rawls argues that rules are fair if all would agree they are fair when deciding under a veil of ignorance - Under a veil of ignorance - one cannot know anything in advance about the outcome. WAy to come up with good ethics