ADVANCED CORPORATE FINANCE

Final exam 80% (2 hrs)

Class participation and wooclap 20%
Additional assignments if you do all 3 30% and the final exam 50%

28/09 Financial statements

Income Statement/statement if earnings or p&l account
Balance Sheet => 2 opposite views:
- Backwards looking: where did the company’s money come from (liabilities) and where did it go (assets)?
- Forward looking: what does the company need to pay back (liabilities) and what are the resources to do this (assets)?
Cash flow statement

Sales revenue and turnover, what is the difference?

Sales USA term
Revenues sometimes larger than sales
Turnover UK term

5/10

Total risk: enters in the numerator in the form of expected value.

Systematic risk: enters in the denominator as risk premium. (non-diversifiable risk)

A company with a high book to market ratio => bad (book > market)

SET 1: FINANCIAL STATEMENTS AND FORECASTING

1. Financial Statements
l Income Statement (US) (= statement of earnings, profit and loss account)
 Estimate of profit “earned” in a period of time
 Always judgement based
 Always possibility of « Earnings Management »
l Balance Sheet: Two opposing views:
 Backwards looking: Where did the company’s money come from (Liabilities) and where did it go (Assets)?
 Forward looking: What does the company need to pay back (Liabilities) and what are the resources to do this (Assets)?
 IFRS: mixture of both views
l Cash Flow Statement
 How much did the company’s bank account increase?
 The only « hard » non judgement-based information
 But often not very useful….

Income Statement

- Revenues (us) = Turnover (UK) = SALES

- P&L lists revenues and expense during a particular period.
- The difference between revenues and expenses is the “net income” or “net profit”
- Revenues: recorded when “earned”
  (premature) revenue recognition?
- Expenses: recorded when corresponding revenues are earned (matching principle)
 (delayed/ omitted) expense recognition

- COGS VS SG&A:
 Cost of Goods Sold (COGS): Direct production costs, can include D&A of production equipment… mostly variable costs.
 Selling, general, and administrative expenses (SG&A): combined payroll costs (salaries, commissions, and travel expenses) of
executives, sales people and administrative employees, and advertising expenses….rather fixed costs.

- Operating Expenses vs. Financing Costs

 Operating Expenses (Opex): Everything that is not financial expenses and capital expenditure i.e. COGS + SG&A, Sometimes used
equivalently to SG&A.
 Financing Costs: Interest paid to creditors and dividends paid to preferred stockholders.

D&A => Capital Expenditures (Capex) produce Fixed Assets with a lifetime of more than one year.
Example: We spend 100 in Capex to buy a machine that lasts 10 years. How to transform Capex into costs?

Two different views:

 Matching principle: These costs should be distributed over the lifetime of the asset.
 Market value of asset: The loss in value due to the aging of the machine should be considered as the cost

Depreciation: Tangible assets

Amortization: Intangible assets (Brand, Goodwill)
Capitalize or Expense? Often both choices possible

Balance Sheet

In market value:

n Book Values vs Market Values

Traditional Accounting: Book value of asset = Historical cost – depreciation
Problems:
- Historical cost ≠ current cost or value
- Depreciation ≠ value loss
- Consequence: book values are often meaningless
 New approach (IFRS): Book value = fair value
Problems:
- Market, NPV or Cost-based
- Often impossible to define or arbitrary
- Frequent Fluctuations
Fair value of liabilities?
n Current vs Fixed Assets
 Current assets or gross working capital comprise assets that are relatively liquid, or expected to be converted into cash within 12
months. Current assets typically include:
- Cash
- Accounts Receivable
- Inventory (raw materials, work in process, and finished goods held for eventual sale)
- Other expenses (e.g. prepaid expenses)

n Tangible vs Intangible Assets

 Tangible fixed assets (Property, plant, and equipment/ PP&E)
- Machinery and equipment
- Buildings
- Land
 Tangible current assets: Inventory
 Intangibles: Software, trademarks, patents, copyrights, import quotas, Goodwill

n Current vs Long-Term Liabilities

 Current Liabilities, such as short term debt (payable within 12 months), accounts payables (credit extended by suppliers to a firm),
accrued expenses (short term liabilities incurred in the firm’s operations but not yet paid for, such as rent, interest, wages ect..)
 Long-Term Debt: loans from banks and other institutions for longer than 12 months
 Other Long-Term Liabilities: ex pension liabilities
 Capital Employed = non-current liabilities = equity and long term (operating and financial) debt

n Financial vs Operating Liabilities

 Financial Debt = debt provided by a financial investor (Bank debt, Bonds outstanding)
 Operating Liabilities = financing generated by the firm’s operations (Accounts payable, Accrued expenses, Long term operating
liabilities (pensions, lease obligations))
 Invested Capital* = Financial Liabilities
 Almost all assets are « operating assets » except « cash and equivalent »

n Net Working Capital

 Net Working Capital = Current assets – current liabilities = Cash + Receivables + Inventory – Payables – short term debt
- Problem: Mixture of Financial and Operating Items
 Net Operating Working capital = Operating assets – operating liabilities = Receivables + Inventory – Payables

If you start a business you have to raise money to finance Fixed Assets + Net (Operating) Working Capital

n Equity = money invested (or left in the company) by shareholders in the past
n Common stock and additional paid in capital
n Retained earnings = money that could have been taken out but hasn’t = cumulative total of all the net income over the life of the firm,
less common stock dividends that have been paid out over the years
n Treasury Stock = Stock that was once outstanding and has been re-purchased by the company; Needs to be subtracted from equity

Cash Flow Statement

n FREE CASH FLOW TO THE FIRM => cash flow of the project/ firm, calculated as if it was financed entirely by equity. It is independent of
financing decisions.
n Operating Cash = Net Income + Depreciation – Change in operating working capital + interest expense (sometimes omitted) = After-tax
cash flows from operations

Reminder: change in operating working capital = change in current operating assets – change in current operating liabilities =
= Change in receivables + Change in inventory – Change in payables

n Investing Cash Flows and Financing Cash Flows

Investing:
- (Net) Capital expenditures = Change in Gross Fixed Assets (not net Fixed Assets) =
- Includes sale of fixed assets (positive cash flow)
- Sometimes includes financial investments
Financing
A firm can either receive money from or distribute money to its investors. The firm can:
- Pay interest to lenders (included if added back in operating cash)
- Pay dividends to stockholders.
- Increase or decrease in financial-term debt.
- Issue stock to new shareholders or repurchase stock from current shareholders.

Notes to the Financial Statements: The notes are a key part of analyzing a company’s financials. Important reconciliations in the notes
- can’t fully understand the numbers without them.
- explain accounting method decisions.
Parts to look at are MD&A (Management Discussion and Analysis), Debt reconciliations, Acquisitions, Segment data.

Sources of Financial Statements information:

- Stock market listed US companies have to disclose detailed financial statements
- The quarterly statements are calles 10-Q and the annual statements 10 –K
- They can be downloaded at the US governments EDGAR website
- Other more convenient web sources of financial information are Reuters (for financial ratios) Bloomberg (for government bond rates) ,
as well as Yahoo Finance (for stock prices and financial statements).
- At ESCP we have access to Bloomberg terminals (data room) and Refinitiv (Online through Library website)

2. Financial Ratios
In order to obtain a first understanding of a company’s risk and return, financial analysts use different types of ratios. Ratios are not very
helpful by themselves; they need to be compared to something.
- Time-Trend Analysis: Used to see how the firm’s performance is changing through time
- Peer Group Analysis: Compare to similar companies or within industries

 Categories of Financial Ratios

l Financial Ratios can be classified into 5 main categories:
1. Profitability Ratios
2. Liquidity or Short-Term Solvency ratios
3. Financial Structure/Capitalisation/ Long Term Solvency Ratios
4. Asset Management or Activity Ratios
5. Market Value Ratios
In general, there are no rules, financial analysts make up their own ratios

 Limitations of Ratio Analysis

- Accounting numbers always subject to window dressing.
- Accounting practices differ among firms
- Sometimes ratios cannot be caluclated (e.g. negative equity)
- Ratio magnitudes are largely irrelevant; a good ratio in one environment can be bad in another.
- Difficulty in finding peers
- Peer group averages affected by the presence of heterogeneity between firms in a given industry
- Peer group may not provide a desirable target ratio or norm
PROFITABILITY RATIOS:
Profitability Measures assess the firm's ability to generate income.
Two general forms:
 Margins = Measure of Profit/Sales
- Gross Profit Margin (GPM)
- Operating Profit Margin (OPM)
- Net Profit Margin (NPM)
 Returns = Measure of Profit/ Investment
- Return on Assets (ROA)
- Return on Equity (ROE)

Different types of returns:

 ROA = Net Income / Total Assets => make no sense => several variants:
 EBIT Return On Assets = Return on Total Assets (ROTA) = EBIT/ Total Assets
 ROCE = EBIT (1-tax) / Capital Employed
 ROIC = EBIT (1-tax) / Invested Capital

 ROE = Net Profit / Total Equity (depends heavily on leverage)

LIQUIDITY RATIOS
Liquidity ratios measure the company's ability to pay their bills in the short run:
 Current Ratio = Current Assets / Current Liabilities
 Quick Ratio = (Current Assets – Inventory) /Current Liabilities

ACTIVITY / ASSET UTILIZATION RATIOS

Asset utilization ratios measure the efficiency of asset management: How are assets used to generate revenues?
 Asset Turnover = Sales/Total Assets
 Fixed Asset Turnover = Sales/Net Fixed Assets
 Inventory Turnover = Sales /Inventory
Sometimes: Cost of Goods Sold /Inventory
 Receivables Turnover = Sales/ Receivables
 Payables Turnover = Annual Purchases/ Payables

Asset utilization ratios are sometimes expressed in “days of sales”, or “days of cost” to calculate the average collection/payment period.
 Average Collection Period = Accounts Receivable /(Annual Sales/365)
 Average Payment Period = Accounts Payable/(Purchases from suppliers /365)

FINANCIAL STRUCTURE OR CAPITALISATION RATIOS

Information about capital structure can be expressed in different ways:
 Debt Ratio = Debt/ Total Assets
 Equity ratio = Equity/Total Assets
 Debt-Equity Ratio = Leverage = Debt/ Equity
All of these ratios can be calculated in Market Values or Book Values
 Debt/EBITDA Ratio : Commonly used in Buyouts
 Times Interest Earned Ratio = EBIT/ Interest
(Sometimes more complicated versions such as Fixed Payment Coverage Ratio = EBIT + Lease Payments/ (Interest + Lease Payments +
{(Principal Payments + Preferred Stock Dividends) X [1 / (1 -T)]})

MARKET VALUE RATIOS

 Enterprise Value = Market Value of Assets = Market Value of Debt + Market Value of Equity – Cash
 D/EV = is the debt ratio at market values
 P/E = Price/Earnings ratio = Stock Price/ Earnings per Share = Market Capitalization/ Earnings
 EBIT Multiplier = Enterprise Value/ EBIT
 EBITDA Multiplier = Enterprise Value/ EBITDA
 Market to Book ratio = Market Value of Equity/ Book Value of Equity
 Tobin’s q = Enterprise Value/ Book Value of Assets

3. FORECASTING FINANCIAL STATEMENTS

Operating / 3 statements model helps to evaluate companies, anticipate investment and financing policy and analyze risk by developing
scenarios.
 The %SALES method: The most basic method of forecasting financial statements. This method assumes that most items maintain a
constant relationship to the level of sales. However, some items always need to be separately estimated based on the previous year’s
values:
- PP&E(t) = PP&E(t-1) - D&A(t)+ Capex(t)
- Debt(t)=Debt(t-1) + New issues (t) - Reimbursements (t)
- Equity(t)= Equity(t-1) + Net income(t)- Dividends(t)

Steps in building an operating model:

1. Obtain historical financials
2. Calculate historical ratios and build assumptions for forecast on separate sheet
3. Project the Income Statement
4. Determine PPE/D&A/Capex, Equity and Debt on separate sheet
5. Project the Balance Sheet
6. Determine operating WC
7. Project the Cash Flow Statement
8. Balance the Balance Sheet
9. Add interest to the Income Statement
10. Check consistency
11. Check basic financial ratios

Project Income Statement:

- Sales using the growth formula
- COGS projected as a % of sales
- SG&A can be considered fixed, but here % of sales
- Link to D&A (and Capex) calculated later in the PP&E sheet
- Non-recurring items cannot be projected: 0
- Link to interest income and expense calculated later in the debt schedule.
- Dividend per share projected using a growth rate or a payout ratio

Project Balance Sheet:

 As a %sales: cash and cash equivalent, accounts receivables
 As a %COGS: inventories, accounts payables
 Net PP&E: here % of sales -> we determine necessary capex; Other possibilities:
- Gross Values constant (no capex)
- Net values constant (only replacement Capex = D&A)
- Predetermined Capex/investment program
 Equity: Determined in the calculation sheet using past equity and retained earnings.
 Debt repayment or issuance: From the separate debt schedule; Likely needs to be adjusted to balance the balance sheet.

Project Cash Flow Statement:

o Operating cash flow = Net income + D&A – increase operating WC +interest
o Investing cash flow = Capex (including change in other LT assets and proceeds from sale of fixed assets)
o Financing cash flow = Dividends +interest+ Change in Debt + Change in Equity

Balance the BS: Traditional Approach

This approach does not need the cash flow statement
- Add a balance check line under the balance sheet before attempting to balance the model
- If Assets> Liabilities, the company will require additional funding
- If Assets<Liabilities, the company generates excess cash
- Include “Excess cash” and “Revolver (short term debt)” accounts in the BS
- Excess cash = MAX (Liabilities- Assets, 0)
- Revolver = MIN(Liabilities- Assets, 0)
Add new long term financing or increase payout if these accounts become too large.

Interest Income vs Interest Expense

Two methods of interest calculation
o Last year’s debt or cash balance * interest rate
o The average of last year’s and this year’s debt or cash balances * interest rate
Calculated on the debt schedule including Revolver
- Interest income on cash can be included
Using the average balance makes the model circular

Consistency check: Calculate difference in cash (iucluding excess cash and revolver as negative cash) ; Verify that it is identical to cash flow
from the cash flow statement.
Balance the BS: Modern Approach
This approach relies on the cash flow statement to balance the balance sheet:
- Add (subtract) the change in cash obtained from the cash flow statement to the firm’s cash position
- If firm’s cash position becomes negative, add short term debt (revolver) to liabilities
- If the model contains no errors it should now verify Asssets= Liabilities

SET 2: PRESENT VALUE

VALUE IN FINANCE is always PRESENT VALUE.

Note:
- Total risk enters in the numerator in the form of the expected value;
- Systematic risk enters in the denominator as risk premium.

Calculating Expectations Cash Flows

Outcomes:
o Cash Flows CF i , t realize in period t with probability pi ,t
 Option 1: Discount expected flows.
First calculate expected cash flows E(CF ¿¿ t)= ∑ p i ,t CFi , t ¿
i
(CF ¿¿ t)
Then discount expected cash flows PV =∑ E ¿
t ( 1+r )t
 Option 2: Calculate expectation of discounted flows
Scenarios a), b) …with cash Flows CF a¿ ,t ¿ realize with probability pa ¿ ¿ ( e.g.: a) worst case b) base case c) best case.
∑ CF a ¿ , t
Calculate present value for each scenario PV ¿= t
¿
a¿ t
( 1+r )
Then calculate overall value as probability weighted average PV = pa ¿ PV ¿a ¿ ¿+ p b ¿ PV ¿b ¿ ¿+ … .

Example:
Solar energy producer will generate free cash to the firm of 10M per year forever if its new plant is approved.
If the plan is not approved the old plant produces 5M per year.
Statistics show that the probability of the new plant being approved is 70%.
What is the value of the company?
Cost of capital 5%
o Option 1:
Expected cash flow 0,7*10+ 0,3*5=8,5
Value = 8,5/0,05=170
o Option 2:
Success cash flow 10
Value in success scenario = 10/0,05 = 200
Failure cash flow 5
Value in failure scenario = 5/0,05 = 100
Total value= 0,7*200+0,3*100 = 17

The standard model to determine RISK PREMIA: CAPM

The Capital Asset Pricing Model (CAPM) is the most frequently used model to determine the risk premium on a given investment. Risk
premia only depend on systematic risk measured with beta according to the following formula:

E(Ri) = required and anticipated return on asset

BETA of the financial asset:

Determining BETA with a linear regression

A stock’s beta can be determined with a linear regression of its excess return Rit – RFt against the market’s excess return Rmt – RFt :
(Rit – RFt) = αi + βi1(Rmt – RFt) + eit
αi = Jensen’s alpha = Actual rate of return– Expected Rate of Return. Often used as measure of portfolio manager’s ability
Attention: Regressing returns Rit instead of excess returns Rit – RFt will yield the same beta but not alpha.

The R squared (R2) of the regression provides an estimate of the proportion of the risk (variance) of a firm that can be attributed to market
risk.

CAPM with EXCEL

Using Regession in Data Analysis Tool and data from Yahoo Finance and Fama’s homepage*
- Dependent Variable Y= AMD return – risk free rate
- Independent Variable X= Market – risk free rate
Output:

MARKET RISK PREMIUM AND HISTORICAL RISK PREMIUMS

The historical premium is the premium that stocks have earned over riskless securities.It depends on
- How far back you go in history…
- Whether you use T.bill rates or T.Bond rates
- Whether you use geometric or arithmetic averages.
- The country you look at

Theoretically, we have

Using analyst forecast of expected dividends we can (numerically) solve for the Market Risk Premium.
Do stocks with higher beta perform better? => EMPIRICAL SECURITY MARKET LINE
How well CAPM predict actual stock returns?
- Size effect
- Book to market effect

MULTIFACTORS MODELS: FAMA & FRENCH

Use multiple instead of simple regression: (Rit – RFt) = αi + βi1(Rmt – RFt) + βi2SMBt + βi3HMLt + eit
Where:
- Rmt is the return on a stock market portfolio.
- SMB (i.e., “Small Minus Big”) is the return to a portfolio of small capitalization stocks less the return to a portfolio of large capitalization
stocks.
- HML (i.e., “High Minus Low”) is the return to a portfolio of stocks with high ratios of book-to-market values (i.e., “value” stocks) less the
return to a portfolio of low book-to-market value (i.e., “growth”) stocks.
Long Term risk premia associated with factors:

Similar to the market risk premium in the CAPM these premia can be multiplied with the respective factor betas to generate an Size and
Market/Book adjusted expected return

More recent research: Skewness & Low risk anomaly

- Harvey and Siddique (2000) Smith (2007: Investors like Skewness and Co-skewness => Small stocks and stocks with high market to
book ratio have lower (co) skewness of returns, i.e. more downside risk
- Ang et al (2006, 2009 ) : Low risk anomal, ideosyncratic volatility is negatively related to expected returns. Probably related to
« gambling » investors.
- Bali et al. (2011) : Effect disappears if we control for stocks that have made very high returns in previous month.

Low Risk Anomaly:

Summary: How well does the CAPM predict actual stock returns
CAPM determines the risk premium rational investors should require. In the long run this risk premiums should show up as an increase in
expected returns. Empirical evidence on this is mixed
- Stocks with high beta do generally have a higher return but the exact relationship depends a lot on the time and methodology of the
study
- There are other factors that do predict stock returns : Size, Book to Market ratio
Factor models such as the Fama French Models can be used to take these effects into account. Low risk anomaly: There seems to be a
negative risk premium for « gambling stocks ».
The CAPM is widely used in a corporate finance/M&A despite it’s poor empirical performance.
- Simple, intuitive, consistent
- Normative rather than positive
- Gambling preferences not relevant
Multifactor models are recommended (McKinsey valuation) but rarely used.
Low risk anomaly seems to have implications for capital strucutre theory (Leverge and the beta anomaly, Baker et al. 2019, See later in
class).

SET 3: VALUATION OF FINANCIAL ASSET

Three approaches to value a bond:
You want to buy bonds with a rating of BBB. The bonds have the following characteristics:
- face value 1000 euros
- Annual coupons of 15%
- maturity 3 years
What price are you willing to pay?
Possible valuation approaches :
1. Theoretically correct: Discount expected cash flows with CAPM generated discount factor
2. Different discount factor: Discount expected cash flows at average historic return on similar bonds
3. Used in practice for low risk bonds: Discount promised cash flows at yield of comparable bonds

First approach: Valuing a risky bond using expected cash flows and CAPM
You think a rating of BBB implies:
- a default probability of 1%.
- only the final pay-out is risky
- the loss given default is 100%
- the bond’s beta is β=0.1,
- the market risk premium is 5%
- the risk-free rate is 5%
- The CAPM formula yields a required return of 5%+0,1*5% = 5,5%
o We get for the value of the bond:

Problem with this approach:

- Bond risk is very asymmetric, but this asymmetry is not captured in the CAPM.
- Future default probabilities are difficult to estimate.
- In practice rarely used because risk premia for bonds are not well predicted by CAPM

There are 3 different “rate differences”:

o SPREAD = Promised – risk free
 o RISK PREMIUM = Expected – risk free
o EXPECTED LOSS RATE = Promised – expected

Second approach: Discounting expected flows at expected return of similar bonds

Same assumptions as before, :
Historically the risk premium, (i.e. the average outperformance compared to the risk free rate) on a portfolio of bonds with BBB rating has
been 1,5 %. Current risk-free rates are 5%, hence we should earn 6.5% on average

150 150 1150∗0 , 99

We get for the value of the bond: + + = 1215
1,065 ( 1,065 )2 ( 1,065 )3

This approach still requires an estimate of expected cash flows. In practice only applied in high-risk companies.

Third approach: Standard bond valuation

Normally bonds are approximately valued by discounting promised flows (not adjusted for default probabilities) at “promised rates”.
These promised rates are calculated as risk-free (or benchmark) rate + spread.
Example:
Risk free rates are 5%
Comparable BBB bonds have an average spread of 170 basis point i.e. a yield of 6,70%
Discounting the promised flows at this rate we get

150 150 1150

+ 2+ =1219
1,067 ( 1,067 ) ( 1,065 )3
Price quotes for Bonds
The full price (dirty price, invoice price): The euro amount the buyer pays (seller receives) when he purchases (sells) a bond.
The quoted price (clean price): Normally bond prices are given as a percentage of face value and as “clean prices” excluding accrued
interest.

Applying the present value principle to stock valuation:

Problem:
- Payoff from stock is highly uncertain.
- Stocks do not have a predetermined lifetime.
Nevertheless a stock price should correspond to the present value of dividends received by investors.

How should we calculate this present value in concrete cases?

 GORDON GROWTH MODEL
Assumption => dividends evolve with a constant growth rate f g% per year:

In this case we can apply the formula for growing perpetuities and obtain the GGModel:

Examples: valuing simple cash flows streams using the Gordon Model:
- Income stock: Div1 = 10, r=10%, g=0%
- Growth stock : Div1 = 10, r=10%, g=5%
- Declining stock : Div1 = 10, r=10%, g=-5%
- Extreme growth : No dividend for the next 20 years, then constant dividend of 10

Calculate for every stock 1) the price 2) the dividend yield 3) the expected capital gains
FREE CASH TO EQUITY (FTE) vs DIVIDENDS
Free Cash to Equity represents “potential payout to shareholders” i.e. cash that can be paid out as dividends/buybacks or kept on the
balance sheet as excess cash. The present value of FTE must be the same as the present value of dividends.
Simplified Calculation:
+ EBIT
- Interest
= taxable income
- taxes paid
= Net Income
+ Depreciation and Amortization
- Increase in Working Capital
- Capital expenditures
+ Change in Debt
= FTE

The sustainable growth formula

No company has permanent perpetual growth. Estimating the permanent growth rate g is therefore always an approximation. Practitioners
sometimes use the « sustainable growth » formula => g = b x ROE

Here b is the « reinvestment rate » or plowback, i.e. the fraction of profits reinvested in the company. The formula relies on very restrictive
assumptions but can be used as a cross-check for growth rates.

P/E Ratios: a common but very imprecise valuatiol tool

The Price / Earnings ratio tells us the value of one dollar in the company’s earnings.

The inverse of the P/E ratio is called the earnings yield.

P/E ratios can be calculated with trailing (last) twelve month (TTM or LTM) or forward earnings. Unfortunately, the P/E ratio varies widely
over time and across companies and countries:
- Increases with growth.
- Decreases with risk.

PE RATIOS & Gordon Growth Model

Using the Gordon Growth model and an earnings plowback of b:

Hence the Price Earnings Ratio (PE) should depend on:

- Dividend growth
- Discount rates (and therefore risk)
- The payout ratio (attention: payout ratio will influence growth)

Valuing investments projects: the last of our 3 applications of NPV

Procedure:
- Establish accounting forecasts
- Transform these forecasts into Free Cash Flows to the Firm: Eliminate accrual accounting and identify project specific flows
- Calculate Net Present Value (NPV) of the Project
- Decide to invest or not!

FREE CASH TO THE FIRM

Definition: Free Cash Flow to the Firm is the cash flow of the project/ firm, calculated as if it was financed entirely by equity.
Simplified calculation:
+ EBIT - taxes on EBIT
= NOPLAT
+ Depreciation and Amortization - Increase in Working Capital - Capital expenditures
= FCTF

WACC => appropriate discount rate for FCFT

Comments:
- The formula only makes sense if the project has the same risk as the firm’s existing assets.
- We will sometimes also calculate nontax adjusted WACC.

Example: evaluate an investment project

A tannery wants to invest in a new machine which will tan leather hides for 3 years.

Fundamentals of company valuation

In finance we value companies as investments.
Principle: Determine price which gives the investor an appropriate return by discounting future cash flows at this return
Note:
- There are more traditional valuation approaches that do not use this principle (book value based, multiple approach).
- Some buyers may derive non-monetary benefits – impossible to value.

Value and price of a company’s assets

Companies can be valued by evaluating the assets. Buying a company’s assets is an investment project with NPV of:

The highest price the acquirer should pay (i.e. the value of the target’s assets) is therefore:
Valuing a company by valuing its liabilities
Companies can also be evaluated by valuing their liabilities:
- Value of Equity: Discount future Free Cash to Equity (dividends and changes of equity level) at cost of equity.
- Value of Debt: Discount Cash to Debt (interest rates and changes of debt level) at cost of debt.
Enterprise value should be the sum of the two.

Combining the 2 valuations approach we obtain:

Free Cash to the Firm / Cash to Debt / Cash to Equity

o Cash to Equity: Cash that can be paid out to shareholders.
o Cash to Debt: Cash that is paid out to creditors (Interest + Change in debt level)

Without corporate taxes => Free Cash to the Firm = Cash to Debt + Cash to Equity

With corporate taxes => Free Cash to the Firm + tax shields of debt = Cash to Debt + Cash to Equity

The traditional accounting BALANCE SHEET

Backwards looking: Where did the cash come from (liabilities) and where did it go (assets)?
Forward looking: where will the cash come from (assets) and where will it go (liabilities)?

Note: both views are present in modern accounting (IFRS).

Summary:
- Value in Finance is Present Value
- Risky Cash Flows should be evaluated by calculating expectations and discounting with a discount rate including a risk premium
- The risk premium is normally determined with the CAPM
- The P/E ratio of a stock depends on growth(+) and risk (-)
- Bonds are usually discounted at promised rates determined as risk free rate + spread
- Companies can be valued by valuing their liabilities as well as by directly valuing their assets

SET 4: MODIGLIANI MILLER THEOREMS

Capital structure, cost of capital and firm value:
The value of the Firm can be calculated by discounting FCTF at WACC. FCTF does not change with leverage. Therefore, maximizing firm
value is equivalent to minimizing WACC.
What is the effect of leverage on the cost of capital? 50 years after the seminal Modigliani Miller paper on capital structure and firm value
there is still considerable confusion among practitioners about the effect of leverage on firm value!

WACC & LEVERAGE

The cost of debt is lower than the cost of equity (why?).
However: Increasing the proportion of debt finance will not necessarily decrease the weighted average cost of capital.

Leverage will increase the risk for shareholders and therefore also their required return!

Illustration: RISK & LEVERAGE

Leverage increases stock volatility:
Example: Identical companies with and without leverage

Now an economic shock decreases asset value by 10%. What percentage of their investment do shareholders lose if the company has no
debt? If the company is levered?
Note: This increase in risk has nothing to do with bankruptcy risk!

Leverage, firm value, and cost of capital

The discount rate for very risky earnings must be higher than the discount rate for less risky earnings! What does this imply for the cost of
capital?
- It could decrease with leverage because this increase in risk is not very high.
- It could increase because the increase in risk for shareholders outweighs the increased usage of debt.
Answer: Modigliani Miller Theorems

Assumptions
 Free Cash to the Firm is not affected by financial structure: financial structure does not affect investment policy of the firm, managerial
effort, corporate governance, compensation of management, bargaining power of firm, competitive dynamics between firms.
 No transactions costs: no bankruptcy costs (The possibility of bankruptcy is not excluded) and no costs of financial distress.
 No taxes.
 Symmetric information: every agent has the same information. Nobody knows more than anybody else.
 No arbitrage.

Taxonomy

Questions asked by MM:

- Is the value of the levered firm EVL different from the value of the unlevered firm EVU?
- How does the required rate of equity return rEL change as leverage D / EL changes?
- What happens to the firm’s WACC under a leverage change?
- How do the answers change under corporate taxation? (next session)

Modigliani Miller Theorems: without corporate taxes

Modigliani-Miller Prop. I: The value of a firm does not change with its capital structure.

Modigliani-Miller Prop. II: Cost of Equity increases with leverage as

Modigliani-Miller on Cost of Capital: “Cost of capital does not change with leverage”.

o Proof N1: Proposition 1

Underlying idea: Buying debt and equity of the leveraged company results in receiving the same cash flows as the unleveraged
company. Hence, the value of both must be the same.
In detail: Two investments with the same payoffs:
1. Buy a proportion k of equity in firm U
2. Buy a proportion k of equity and debt (perpetual) of firm L

Annual payoffs: Costs:

1. k EBIT k EU
2. k (EBIT-rDVD) + k rDD = k EBIT k (EL+D) = k EVL

As the payoffs are identical, the costs (i.e., the value) must be identical too:

o Proof N2: Cost of Capital

If the company’s value can be calculated as present value of the Free Cash flows to the firm discounted at WACC:
- FCTF do not change with capital structure.
- Firm value does not change with capital structure.
 Therefore, WACC must also remain constant.

o Proof N3: Proposition 2

If the weighted average cost of capital is to be constant it hast to be equal in particular to the cost of capital (=cost of equity) of the
unlevered company.

U D ❑ D L
This implies: r E= L
rD + L rE
E +D E +D

D U ❑
L( E
r −r D )
L U
Or r E=r E +
E
The role of Leverage in pictures :

MM Theorems: the “Pizza” intuition

Company value is determined by what the company owns not how it is financed. Fundamentally the cash flows produced by a company’s
assets determine its value. Capital structure determines how these cash flows are shared among different types of investors but does not
influence the total value of these cash flows. Standard capital structure creates two types of flows:
- a risky, less valuable one: Dividends (or potential dividends i.e. Cash to Equity).
- a less risky, more valuable one: interest and principal reimbursement (Cash to Debt).
However risk and cash are divided up, the value remains the same.

MM Theorems: “Homemade leverage” intuition

Idea: In our idealized world leverage on the company’s balance sheet produces exactly the same effects than leverage on the level of an
investor’s portfolio:
- An investor can therefore lever the cash flows of an unlevered company himself, buy levering up his portfolio, or
- unlever the cash flows of a levered company but investing part of his wealth in debt.
Conclusion: If the investor can do it himself, why should levering or unlevering add value for him?

Consequences of the MM Theorems on financing decisions

- Only operational decisions create value.
- Financing decisions are irrelevant.
- A company can chose any capital structure, it doesn ’t matter. That would be a pity for corporate finance researchers.
Problem: We know that companies in the same industries tend to have similar capital structures. Therefore, there seems to be something
like a preferred capital structure. We know also that sometimes capital structure change can create wealth (LBO).

Consequences of the MM Theorems on investment decisions

- An investment project is profitable or not, independently of the way it has been financed.
- Investment decisions can therefore be separated from financing decisions.
- We have already used this result when discounting an investment project’s cash flows at the cost of capital.

So, finally what determines capital structure?

We will reason backwards: If capital structure is important in real life situation this is because some of the assumption necessary for the
Modigliani Miller Theorems do not hold true.
For example: We know that companies pay taxes. That capital markets are imperfect. That capital structure can influence operational
decisions and therefore a company’s assets.

MM and the CAPM

Modigliani Miller is more general than the CAPM, it holds even if the CAPM doesn ’t hold. In the case the CAPM holds we can calculate the
beta of a portfolio containing all the firm’s equity and debt as:

This must be equal to the beta of the unlevered company’s equity. This equation allows us to adjust betas for leverage (see next handout for
exercises)
- « Unlevered beta » reflects the economic risk of the company’s free cash flows to the firm.
- « Levered beta » or stock beta reflects the economic as well as the financial risk affecting the cash flows to equity.

Dilutive and accretive effects of capital structure changes

Earnings by share (EPS) changes are a widely used performance metric. Capital Structure changes will affect EPS.
- Increasing Leverage normally increases EPS.
- Increasing Equity finance will normally decrease EPS.
Exception: High growth companies

In a Modigliani Miller world these EPS changes will not affect the stockholders’ wealth. A PE change will compensate EPS changes.
This principle can be used to easily anticipate the consequences of leverage changes on EPS and PE ratios.

Example: capital structure and EPS changes

Parapluie SA is fully equity financed with 100 shares outstanding. There are no taxes. EBIT=FCTF= € 10. Market value of equity = € 100.
- Share price = € 1
- EPS = € 10/100= € 0,1
- PER= €100/ €10=10x
Now the company issues € 40 in debt at an interest rate of 5%. This money is used to buy back and cancel 40 shares.
What is the company’s EPS after the operation?
What is the company’s stock price after the operation?
- Net income after operation: € 10-0,05* € 40= € 8
- Number of shares still outstanding: 60
- Hence new EPS: € 8/60= € 0,13
The operation is accretive, EPS has increased by 33%!
Did the operation increase the stock price? Wrong reasoning:

Problem with this reasoning: Leverage increased risk and growth of earnings and therefore PER will change!

Applying MM reasoning:
- EV is 100 before and after the operation
- Hence the value of the levered firm’s equity is €100- €40= €60
- This implies a PER of €60/ 8€= 7,5 instead of 10 as before!
- With this PER we obviosuly get

-
The increase in leverage has not affected stock prices. Higher EPS (=dividends) have been exactly compensated by higher risk.

If we replace the share buyback with a dividend payout, we will get EPS dilution. However normally EPS should be adjusted for dividend
payouts to reflect the earnings received by a shareholder who remains “fully invested”. After ajustement, we will get the same EPS increase
In previous example:
- Dividend of € 40 or € 0,4/share
- New stock price = € 0,6
- Invest dividends back into shares: 0,4 € buys 2/3=0,666 of one share.
- Total shares owned by fully invested shareholder: 1,666
- Earnings on these shares: 1,666*0,08=0,13 as before!

Leverage can also be dilutive:

Normally higher leverage implies lower PERs. However, in companies with high growth potential, higher leverage increases PERs.
Precise condition:
PER > 1/after tax interest rate
⇔ after tax interest rate> earnings yield.

Example: Umbrella Inc, is fully equity financed with 100 shares outstanding. There are no taxes. EBIT=FCTF= € 4
Market value of equity = € 100.
- Share price = € 1
- EPS = € 4/100= € 0,04
- PER= €100/ €4=25x
Now the company issues € 40 in debt at an interest rate of 5%.

- Net income after operation: € 4-0,05* € 40= € 2

- Number of shares still outstanding: 60
- Hence new EPS: € 2/60= € 0,03
- The operation is dilutive, EPS has decreased by 66%!
Again this does not imply a decrease in the stock price.

Applying MM reasoning:
EV is 100 before and after the operation. Hence the value of the levered firm’s equity is €100- €40= €60. This implies a PER of €60/ 2€= 30
instead of 10 as before!
With this PER we obviosuly get

The increase in leverage has not affected stock prices. Lower EPS (=dividends) have been exactly compensated by higher growth (and
higher risk).

Dilutive leverage: intuition

If “after tax interest rate> earnings yield”, company must be growing. For growing companies, leverage can increase the growth rate of net
(after interest) income.
Example: Unlevered firm growth at 20%, i.e., EBIT = Net Income = 10, 12 ,14,4….
If we subtract 2 in interest every year, we get Net Income = 8,10, 12,4. This is a growth rate of 10/8-1= 25% in the first year and 12,4/10-
1=24% > 20% in the second.
Intuition: Subtracting a fixed number from a growing series increases the growth rates.

Summary: Leverage & EPS

Leverage changes always impact EPS:
- Low growth firm with PER < 1/after tax interest rate => Leverage is accretive
- High growth firm with PER > 1/after tax interest rate => Leverage is dilutive
In the MM world these changes have no impact on the stock price as they are compensated by a change in risk and growth of the levered
cash flow.
Conclusion: EPS may be useful to assess the effect of operating reforms but not to assess financial transactions.

Supplement: Leverage & ROE

ROE is a frequently used performance indicator but not the real return to shareholders. In basic Financial Analysis classes, you learn about
the « leverage effect », i.e. that an increase in leverage increases ROE if:

We now know that this increase is basically « window dressing » i.e., not related to shareholder value because it is accompanied by an
equivalent increase in risk/gowth of earnings.

Merger/Demergers & EPS

Merger: general term, two separate corporations combine to form a single corporation.
Consolidation: Both firms cease to exist and a new corporation is established.
Example: Two utilities, Peco Energy Co. and Unicom combine to form Exelon (nation’s fourth largest power generator). Each Peco share
could be exchanged for one share of Exelon common stock or $45. Unicom share could be exchanged for 0.95 share of Exelon or $42.75.
Acquisition: Shareholders of the acquired firm receive cash or an equity stake in the new entity.
Example: HP-Compaq merger - - Compaq shareholders received 0.6325 shares of HP common stock for each Compaq share OR equal cash
value.

Demergers Terminology
- Sell-Offs: direct sale of a subsidiary or part of the company to another company.
- Spin-Offs: A subsidiary is floated on the stock market and the subsidiary’s shares are distributed to the original shareholders.
- Equity Carve-Outs: Similar to Spin-Offs, but a majority of the shares will be kept by the parent company.
- Bust-up: Complete piecemeal sale of a conglomerate company.
Basic economic effects of mergers:
- Risk of the merged entity?
- Growth of the merged entity?
- Cost of capital of the merged firm ?
- Value of the merged firm?
- Wealth generated during the merger?
- Distribution of the wealth generated?
- Evolution of accounting ratios such as: EPS, ROE, P/E
- Impact of payment methods: Shares ; Cash

Example: Merger without synergies

Part 1
We live in a Modigliani Miller World without taxes.
- Company A has no debt, a perpetual stable cash flow of 10m and a cost of capital of 5%.
- Company B has no debt, perpetual cash flows of 7,5m and a cost of capital of 15%.
Values of Company A and B?
Cash flows, cost of capital and company value if A and B merge (no synergies)?
Specific risk of A, B and merged company AB?
P/E ratio of A, B and AB?

Part 2
Assume that every company has 10m shares => Share price and EPS of A and B

A buys B for $50m with a share issue at market price

- How many shares issued at which price?
- EPS dilution or accretive?
- Stock Price reaction of A?

Same question if A buys B at $60m

Solutions :
PVA=$200m, PVB=$50m, PVAB=$250m,
P/EA=20, P/EB=6.6, P/EAB=14.2,
CashAB=17.5m, WACCAB=7%,
Shareprice A=20, B=5. EPSA=1, EPSB=7.5,
Acquisition at 50: A issues 50/200*10=2.5 shares, EPS AB=17.5/12.5=1.4, -> accretive but neutral
Acquisition at 60: A issues 60/200*10=30 shares, EPS AB=17.5/13=1.35 accretive but stock price reaction: 5% decrease!

First conclusions: Mergers in the MM world

We have demonstrated that in a perfect MM world:
- There are no « financial synergies. »
- Cost of capital will be weighted average cost of previous costs of capital.
- EPS change has no close relationship with value change.
An equity financed acquisition of a company with expensive earnings (higher PE than the acquirer) will always mechanically decrease EPS
and vice versa. This EPS change is not related to shareholder value changes!

Risk Fallacy n1: Mergers diversify risk

Management will often argue that a merger with a non-related business is necessary to diversify a company’s risk. This should decrease the
company’s cost if finance and create shareholder value.
Wrong: The merger only reduces divesifiable risk and diversifyable risk is not related to the cost of finance.

Risk Fallacy n2 : Mergers reduce interest rates on loans

Merged companies will often have a lower risk and therefore be able to obtain lower interest rates on debt. Strictly speaking this should not
influence the cost of debt of the company, i.e. the risk adjusted return the company pays on its borrowings.
Possible argument: Larger companies have a better bargaining power and can therefore get a better deal from the bank.

Example: Mergers and interest rates on loans

Suppose companies A and B have asset value of 300 each and a 5% default risk with 100% loss given default. This risk will never realize at
the same time for both companies.
Both companies have 100 in debt with 10% interest rate that needs to be paid back at the end of the year.
Before merger:
- Value of debt =100
- Expected return (=cost of) on debt = 110*0.95/100-1=4.5%
After merger debt is risk free, if interest rate remains
- Value of debt at least =110/1.045≈105
- Value of Equity for A+B after merger: 600-2x105=390 => Merger destroys 10 in shareholder value

Motivation for Mergers

A Merger/ Company sale should create value for shareholders (of the acquirer at least). Value creation with a Merger:
and inversely for value generation with a De-Merger.
Good Reasons for value creation: Increase in Cash Flows
Bad arguments for value creation: Decrease in Discount Factors

Allocating the value created

If there is value creation the value has to be divided between shareholders of target and the acquirer. Range of feasible prices for target B:

 Price at low range: Acquirer will receive the value-

 Price at high range: Target shareholders will receive the value.
Distribution of this surplus will be determined by the respective bargaining power of acquirer and target.

Example: Merger with synergies

PVA=$200m, PVB=$50m
Merging A and B allows cost savings with a PV of $25m.
So, Gain = PVAB– (PVA+PVB) = ∆ PVAB = $25m

Suppose B is bought for cash for $65m.

o a $15m (30%) premium, not unusual
NPV to A: Gain – Cost = $50m+$25m-$65m=$10m
Prediction: Upon announcement of merger, B’s market capitalization will rise to $65m, A’s will rise by $10m

Estimating mergers costs for stock deal

When merger is financed by giving shares in the acquirer (normally issued after the merger announcement) to the target shareholders, the
cost calculation is different. Cost depends on value of shares in new company received by shareholders of selling company.
If sellers receive N shares, each worth PAB , then: Cost = N * PAB

Merger decision
Example (continued)
- Suppose A has 1m shares outstanding.
- Suppose B is bought for .325m shares (not cash)
- Cost to A is not .325*200 = 65 since A’s share price will go up at the merger announcement
- Need to calculate post-deal share price of A => New firm will have 1.325m shares outstdg., will be worth $275m
- So new share price is 275/1.325=207.55
- Cost = .325*207.55 = $67.45m
- NPV to A = $75 - $67.45 = $7.55m
When will acquirers pay with shares and when in cash?

Further conclusions In a perfect world:

- Wealth creation has to be allocated to acquirer and target shareholders.
- Shares are in general considered less valuable but in fact more expensive if the deal is really value increasing!

Sensible reasons for mergers:

o Economies of Scale: A larger firm may be able to reduce its per-unit cost by using excess capacity or spreading fixed costs across more
units.
o Economies of Scope: Producing related products in one company may be cheaper than producing them separately.
o Economies of Vertical Integration: Merge with supplier (integrate “backward”) or customer (integrate “forward”), control over
suppliers may reduce costs, or control over marketing channel may reduce costs.
o Eliminate Inefficiencies in the Target: Target may have unexploited investment opportunities, or ways to cut costs or increase earnings,
replace firm with “better management”. (Many “hostile” deals fall in this category)
o Unused tax shields: Firm may have potential tax shields but not have profits to take advantage of them. After Penn Central
bankruptcy/reorganization, it had $billions of unused tax-loss carryforwards. It then bought several mature, taxpaying companies so
these shields could be used.
o Exit of initial owner: Owner manager of family want to diversify their wealth because of personal risk aversion.

Dubious arguments for mergers:

o To Use Surplus Cash: If your firm is in a mature industry with no positive NPV projects left, cash should be handed back to
shareholders.
o Diversification of acquirer: Investors should not pay a premium for diversification if they can do it themselves! In fact, normally
diversified firms sell at a discount. Makes sense only to the extent that reduces costs of financial distress or if the target’ owner is
undiversified.
o Increasing EPS: Some mergers undertaken simply to raise EPS. This can be easily obtained by structuring the deal appropriately but
does not mean that shareholder value is increased.
o Lower (promised) rates on debt: Merged firm can borrow at lower interest rates. This happens because when A and B are separate, they
don’t guarantee each other’s debt. After the merger, each one does guarantee the other’s debt; if one part of business fails, creditors
can still get money from the other part. However, this is not a net gain. Now, A and B’s shareholders have to guarantee each other’s
debt. This loss to shareholders cancels the gain from the safer debt.
o Possible argument: Bargaining power of merged company is larger and therefore bank margins lower!

Likely but bad motivations:

o Managerial Self Interest: Hubris /empire building of acquirer; Risk diversification of management; Wealth extraction through insider
trading, success fees, golden parachutes, higher salaries.
o Reduction of competition: Good for shareholders but bad for the economy.

Empirical evidence in value creation in mergers:

o Accounting based performance evaluation:
- Only about 40% of the mergers seem to improve combined profits or cash flows.
- Some evidence that persistent acquirers perform better.
- Some evidence that acquirers are more dynamic.
o Management’s evaluation
o Executives regard more than 50% of mergers as failure, mostly because of cultural differences and insufficient post
acquisition planning.

Empirical evidence on mergers and stock prices:

Wealth Creation for the shareholders: Target shareholders do very well => Average return for target’s shareholders: between 20 and 30%
around announcement date.
Acquiring shareholders slightly negative or zero over announcement period => Average return for bidder’s shareholders: between -6 and
0%.
Combined effect is slightly positive.
Taking longer term view, acquiring shareholders do badly and overall mergers result in negative gains.

Performance impact of announcements depends crucially on certain factors:

 Method of payment: cash has positive impact; equity has negative impact.
 Horizontal or conglomerate: horizontal deals do better.
 Time period: deals during boom periods underperform.
 Organisational form of target: acquisitions of private targets do not underperform.
 Hostile or friendly: hostile deals do better.

Interpretation of impact evidence:

- Consistent with managerial motives.
- Only weakly consistent with efficiency motives.
- Controversy: Initial share price reaction is accurate and low long run returns reflect other factors; Initial share price reaction is wrong
because stock market overvalues takeovers during the announcement period and then reverts its value over the long run.

PAYOUT POLICY ACCORDING TO MODIGLIANI AND MILLER

Types of Payouts:
 Dividends:
- Regular cash dividend (Public companies in the US often pay quarterly dividends)
- Extra cash dividend/ Special Dividend (the extreme case would be a liquidating dividend)
 Stock repurchase
- Open market repurchase
- Tender Offer to all Shareholders
- Private negotiation (green mail)

Attention: Stock dividends are not payouts => No cash leaves the firm. The firm only increases the number of shares outstanding, equivalent
to stock splits.

Dividends are reported in different ways (financial ratios):

 Dividend rate = annual dividend
 Dividend per share (DPS): dollar amount per share
 Dividend yield: DPS divided by share price.
 Pay-out ratio: DPS divided by EPS.
 Dividend cover = EPS /DPS = 1/Payout Ratio.
(Each measure can be calculated to include repurchases)

Procedure for cash dividend payment:

Declaration Date: The Board of Directors declares a payment of dividends.

Cum-Dividend Date: The last day that the buyer of a stock is entitled to the dividend.
Ex-Dividend Date: The first day that the seller of a stock is entitled to the dividend.
Record Date: The corporation prepares a list of all individuals believed to be stockholders as of 6 November.

Price behavior around the Ex-Dividend Date

In a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date.

Stock Repurchase vs Dividends

Consider a firm that wishes to distribute $100,000 to its shareholders.

 If they distribute the $100,000 as cash dividend, the balance sheet will look like this:

 If they distribute the $100,000 through a stock repurchase, the balance sheet will look like this:

Modigliani Miller Theorem for Payout Policy

If there are:
- No taxes.
- No transaction costs.
- Investment and operating policies are held fixed.
- Symmetric information.
Then shareholders are indifferent between paying the money out as a dividend, via repurchases or keeping it on the balance sheet.

Irrelevance of Payout Policy:

Pay-out policy normally involves 2 decisions:
- How much of the firm’s earnings should be distributed to shareholders as dividends?
- How much should be retained for capital investment?
Only the investment decision is important for share value. Pay-out policy is irrelevant if we keep the capital investment fixed.
The investment policy determines the cash flow available for paying dividends. Pay-out policy will only influence:
- the timing of the pay-out.
- the form of the pay-out.
This will not affect the NPV of the cash received by the shareholders.

Taxes, issuance costs and dividends

MM assumed no taxation. In reality long-term capital gains had a big tax advantage over dividends for high-income individuals in the US,
but this almost disappeared in 2003 following the Bush tax reform:
- The same low tax rate (15% used to be 39.6% under Clinton) now applies to dividends and long-term capital gains.
- The effective tax rate on long-term capital gains is even lower than 15% if your holding period is longer than a year.
- Short-term capital gains are taxed as ordinary income (35%).

Summary: Pay-Out Policy

In a perfect Modigliani Miller world shareholders’ wealth is not affected by the company’s pay-out policy if it does not affect the company’s
FCTF. Dividends decrease the stock price by the amount paid out. Share buybacks decrease the number of shares outstanding without
affecting the share value. In reality share buybacks have a tax advantage.

SET 5: RISK AND CAPITAL STRUCTURE

Taxes, Capital Structure and Firm Value
If the company pays taxes, pre-tax cash flows are distributed to:
 Shareholders
 Creditors
 The state
Company value = value of flows distributed to shareholders and creditors = after tax value
Taxes depend on debt levels. Therefore, after tax value of the company depends on debt levels.

Umbrella SA pays 50% corporate taxes. The owner wants to exchange 80% of equity by a 5% loan from his own pocket.

Debt increases the total amount of cash received by the investor.

Cash flows and tax shields

We can write:

We must adapt WACC if we still want the present value of Free Cash to the Firm and Cash Flows to the different types of investors to be
equal.

The Cash Flows of the Unlevered and Levered Firm

Modigliani Miller with taxes

Proposition I (with taxes): Company Value increases with leverage.

Proposition II (with taxes) : The cost of equity increases with leverage but at a slower rate than without taxes.
Weighted average cost of capital: Wacc decreases with leverage.

Note: The detailed relationship between leverage and WACC depends on assumptions made about the future debt levels. Several
adjustment formulas are available.

Corporate Tax Effects: Formulas for constant debt levels (APV case)
The exact values depend on capital structure policy, i.e., future debt levels:
- Constant in absolute numbers
- Constant leverage at market values
Denote by VL and VU the after-tax values:

Corporate Tax Effects

Intuition: Government takes away a part of the pizza. The tax slice is smaller with more debt finance (higher leverage).
The role of leverage under taxation

Conclusion:
- “All else equal, considerations of the corporate income tax should make debt finance more attractive.”
- Unprofitable investment projects can become profitable for the levered firm.
- If the world worked as in the MM Theorem with taxes the optimal financial structure would entail 100% debt finance. Why do firms not
take? Reason: Personal taxes, Bankruptcy costs, Agency costs

Exercise: Taxes and Debt

Umbrella SA is equity financed and has a pre-tax income/Ebit of 10. The corporate tax rate is 50%, the company’s cost of capital is 10%. The
owner wants to exchange 67% of equity with a 3% loan.
- Determine the annual tax shields of the levered company.
- What is the present value of the tax shields discounted at cost of debt?
- Determine the value of the levered company as sum of the unlevered company’s value and the present value of tax shields.
- Determine the levered company’s cost of equity and WACC using the formulas given in class.
- Verify that you do indeed find the same equity and firm value as before.

Value unlevered firm =50. Debt level= 0,67*50=33

Annual tax shields = Interest* tax rate=1*0,5 Present value of tax shield 3%*0,5=1/0,03*0,5=16,6
- Value of the unlevered company=50
- Value of the levered company= 50+16=66
- Value of the levered equity=66-33=33
- Cost of equity levered company= 10%+33/33(10%-3%) (1-0,5) =13,5%
- Wacc using formula=7,5%
- Wacc using weights =7,5%
- FCTF discounted at tax adjusted Wacc=5/0,075=66

Personal Income Taxes are included in total taxation

Individual income tax

While the corporate income tax encourages debt finance, the individual income tax serves to mitigate this preference.
  Interest income: taxed at the individual level in the year it is earned. This is known as taxing on an accrual basis. Further, interest
income is taxed at the individual’s full marginal tax rate.
 Equity income: dividends and capital gains.
- Dividends are taxed when paid. In some countries the tax on dividends is lower than the tax on interest.
- Capital gains are taxed when realized. This creates a deferral advantage (since delaying reduces the PV of tax bill).

The intuition: Think about having $1 that you are free to label as “interest” or “equity return” for tax purposes. What label should you
apply?
 You should label it debt when: (1-TD) > (1-TC) (1-TE)
 You are indifferent between the label if:(1-TD) = (1-TC) (1-TE)

Example
In 1981, the maximum individual income tax rate in the US was 70% and the average effective tax rate on capital gains was estimated to be
16%. The corporate income tax rate was 46%. Using these figures, total taxation of equity 1-(1-0.46) (1-0.16) =0.55 and total taxation on
debt 0.70. Under this set of assumed rates, there would be a tax disadvantage to debt finance. In reality, many investors in debt are also tax
exempt.

Conclusion
Various institutional features cause equity income to face a lower effective tax rate than debt income at the individual level. These
differences mitigate the tax advantage to debt finance at the corporate level. In fact, it is possible for there to be a net disadvantage to debt
finance. Historically, and under current tax law, there is a net advantage to debt finance for a corporation in the top bracket.

Bankruptcy and Bankruptcy Costs

Bankruptcy in perfect markets
- In the Modigliani/Miller world: bankruptcy simply means that there is not enough cash for shareholders. In this case creditors receive
all the FCTF.
- In the real world: bankruptcy is a complicated court administered procedure to resolve conflicts in case creditors cannot be paid in full.
In an efficient bankruptcy process the creditors become the company’s new owners. They will typically not liquidate the company but
continue to run the company. The company’s value should therefore be the same independently if it is run by the old shareholders or
the creditors -> similar to MM world.

Example: Bankruptcy and Enterprise Value

Startup SA will produce perpetual cash flows of 15 or 5, with probabiltiy 50%, depending on the signature of an important contract.
Cost of Capital 10%.
Without debt => Enterprise value is 100

With debt of face value 75 :

The expected value of the company didn ’t change.

In the case of bankruptcy 20 go to judges lawyers etc.

Without debt => Enterprise Value 100

With debt with a face value of 75 :

Company value exactly decreases by the expected bankruptcy costs.

In the case of bankruptcy half of the existing clients will leave
Without debt => Enterprise Value 100
With debt with a face value of 75

Company value exactly decreases by the expected bankruptcy costs.

Conclusion:
Contrary to the assumptions of Modigliani and Miller, in reality bankruptcy reduces the value of the firm.
- direct transaction costs
- indirect costs: lower expected future cash flows due to the bankruptcy
These expected additional future costs will reduce the value of the levered company today.
- Higher leverage makes bankruptcy more likely and increases therefore expected bankruptcy costs.
- Risky companies have higher bankruptcy probabilities and therefore higher bankruptcy costs.
- Companies with a lot of intangibles will tend to lose more value during bankruptcy.

Leverage and company value

Trade-off theory
Can the optimal capital structure really be determined as a trade-off between bankruptcy costs and tax shields?
According to this theory which type of companies should have low or high leverage?
What about the identity of the shareholders?
What about the number and identity of creditors?

Applications
Tax motivated financial innovation
Idea: Accept high bankruptcy risk to be able to benefit from tax shields.
- « Junk bonds »: Have high interest rates and therefore high tax shields. Enable even risky companies to extract tax shields.
- LBO’s

Idea: Allow tax deductibility of payments but reduce probability or cost of bankruptcy.
- Pay-in-Kind Securities (PIK's): Give issuer option to pay interest in cash or in additional securities valued at par. Zero coupon bonds
give the corporation interest deductions without forcing it to part with internal cash-flow. There is no danger of bankruptcy (but the
danger of dilution of existing shareholders).
- ARCN: adjustable-rate convertible notes
- Strip Financing: Debt securities are held in equal proportions by all outside equity holders. That is, debt strips are stapled to equity.
This aligns the interests of debt and equity. Allows firms to exploit tax advantage of debt at a lower cost in terms of agency conflicts.

PRIDES: First introduced by Merrill Lynch, PRIDES are synthetic securities issued by special purpose vehicles (SPVs). The SPV is situated in
an offshore jurisdiction and financed with equity. The SPV then lends money at a fixed, tax-deductible interest rate to the company. In
addition, the SPV enters in a forward contract to purchase at the maturity of the loan equity in the company for a price equal to the loan’s
face value. Similar to ARCNs, PRIDES allow for a series of tax-deductible payments but generate little bankruptcy risk as there is no
reimbursement of the debt’s face value.
Exercise: Firm value and risky debt
A joint venture is supposed to deliver a cash flow of either 60 or 160 with probability 50% at the end of the year. The company will then be
dissolved without bankruptcy costs. Cost of capital is 10%
What is the value of the joint venture today?
Suppose that the firm is financed with 60 in debt. What interest rate should the bank ask for to get on average the risk-free return of 5% on
the risky loan?
What should be the cost of equity of the levered company according to the MM theorems?
Calculate the weighted average cost of capital for the levered company.
Evaluate the company’s assets by discounting free cash flow at the weighted average cost of capital.

Value: 110/1,1=100,
In the case of bankruptcy, the bank gets 60 otherwise it gets (1+interest) *60. The interest of 10% yields an average return of 5%

Suppose now that in the case of bankruptcy the bank has to pay 10 in order to liquidate the joint venture and get some money back. What
interest rate does the bank have to ask for to get on average the risk-free return of 5%?
What is the risk adjusted cost of debt for the company?
Calculate the weighted average cost of capital for the levered company including bankruptcy costs.
Suppose the company is paying taxes of 30%. Which capital structure is cheaper: 100% equity or 60% debt?

Surprisingly, the local savings bank has agreed to provide credit at a 7% interest rate.
What is the risk adjusted cost of debt for the company?
Calculate the weighted average cost of capital for the levered company and use it to evaluate the company.
What is the market value of debt assuming a 5% expected yield?
What is the market value of equity?

Appendix: Levering / Unlevering Betas with tax shields

Value of Levered Firm = Value of Unlevered Firm + Tax Shields = Equity + Debt
EVL = VU + D × TC = E + D
Remember: portfolio beta is weighted average of the betas of the assets in the portfolio
Beta of levered firm’s assets:

Alternatively: beta of levered firm’s assets using beta of Unlevered Firm and beta of Tax Shields

Combining the two expressions for βA:

Multiply both sides by VL and replace VU with E + D – tCD:

Deduct DβD from both sides and then divide by E:

Rearrange for βEU to obtain formula to un-lever beta:

Limited Liability and Option Theory of Capital Structure
Limited Liability implies that an investor in equity cannot lose more than he has invested, even if he has wealth outside the business.
This is different from “de facto” limited liability which arises because the shareholder has no additional wealth. Not a straightforward
concept (middle age in Europe: debtor’s prison).
Early limited liability concepts: Roman and early Islamic law: Have a slave running a business. 17th century, joint stock charters with limited
liability were awarded as privilege to special companies such as the East India Company.
General limited liability statues:
- French société commandite 1671
- Limited partnership statutes in different US states, first enacted by New York in 1822
- UK: Limited liability act in 1855
Limitations to limited liability: Veil piercing; Action en comblement du passif.

Debt, Equity and Enterprise Value with Limited Liability

Value as a function of asset value at the maturity of the debt with face value FVD.

- The value of equity is max (Assets-FVD, 0)

- The value of debt is min (Assets, FVD)
Equity can be understood as a Call option on the company’s assets with a strike price equal to the face value of debt FVD. Risky debt can be
understood as a risk-free asset with a current value of PV(FVD) together with a short position in a put option on the company’s assets with a
strike price equal to the face value of debt FVD.
This is useful to understand qualitatively how risk affects debt and equity values and quantify the value of equity and debt in highly levered
companies.

Limited Liability, Risk and Value of Debt and Equity

Limited liability and the option feature of capital structure has direct implications:
- Debt value = Value of risk-free debt – put => These decreases with an increase in risk
- Equity value = value of call => These increases with risk

Hence shareholders will generally have incentives to increase the risk of assets.

Example: risk and shareholder value

Farine SA today has a value of 100.
With a more aggressive corporate strategy the company could achieve 50 or 150 (with prob. 50%) depending on whether an important
contract will be signed. The company is financed with long term loans having a face value of 70.
Determine for both strategies:
- Today ’s company value
- The value of equity
- The value of debt

Increasing the risk by keeping the expected company value constant will increase shareholder value => They gain from the upside + No
increased losses on the downside.
On average their payoff will increase. This increase in shareholder value comes from a decrease in the value of debt due to the increase of
default risk.

Using the Black and Scholes formula to price Debt, Equity with Limited Liability
Value as a function of asset value
The Put-Call equality for the firm’s capital structure
The following two strategies yield the same result:
o Owning the firm’s asset and a put with strike of FVD.
o Owing a risk-free bond and a call on the firm’s assets with strike D.

Therefore, these strategies must have the same price:

Reminder: the Call is equivalent to the firm’s equity and debt is equivalent to the risk-free bond and a short position in the Put = PV(FVD) –
Put = Assets – Call.

The Black and Scholes formula: The Black and Scholes model values European options on non-dividend paying stock.
The value of a call option in the Black-Scholes model can be written as a function of the following variables:
S = Current value of the underlying assets = EV
K = Strike price of the option = FVD
t = Life to expiration of the option
r = Riskless interest rate corresponding to the life of the option
s2 = Volatility of the underlying asset

Value of Call => C= S N(d1) – K e- r t N(d²)

where, N is the cumulative Normal Distribution and

Application to valuation: A simple example

Assume that you have a firm whose assets are currently valued at $100 million and that the standard deviation in this asset value is 40%.
The face value of debt is $80 million (It is zero coupon debt with 10 years left to maturity).
The ten-year treasury bond rate is 10%,
Questions: What is the value of the equity? What should the interest rate on debt be?

Model parameters
 Value of the underlying asset = S = Value of the firm = $ 100 million
 Exercise price = K = Face Value of outstanding debt = $ 80 million
 Life of the option = t = Life of zero-coupon debt = 10 years
 Volatility = Standard deviation in firm value = 0.4
 Riskless rate = r = Treasury bond rate corresponding to option life = 10%

Valuing Equity as a Call Option

Based upon these inputs, the Black-Scholes model provides the following value for the call:
d1 = 1.5994 N(d1) = 0.9451
d2 = 0.3345 N(d2) = 0.6310
Value of the equity= call = 100 (0.9451) - 80 exp (-0.10) (10) (0.6310) = $75.94 million
Market value of the outstanding debt = $100 - $75.94 = $24.06 million
Appropriate interest rate on debt = ($ 80 / $24.06) ^1/10 -1 = 12.77%

The Effect of Catastrophic Drops in Value

Assume now that a catastrophe wipes out half the value of this firm (the value drops to $ 50 million), while the face value of the debt
remains at $ 80 million. What will happen to the equity value of this firm?
Possible answers:
- It will be worth nothing since the face value of debt outstanding > Firm Value
- It will drop in value to $ 25.94 million [ $ 50 million - market value of debt from previous page]
- It will be worth more than $ 25.94 million.

Valuing Equity in the Troubled Firm

- Value of the underlying asset = S = Value of the firm = $ 50 million
- Exercise price = K = Face Value of outstanding debt = $ 80 million
- Life of the option = t = Life of zero-coupon debt = 10 years
- Volatility = 0.4
- Riskless rate = r = Treasury bond rate corresponding to option life = 10%

Based upon these inputs, the Black-Scholes model provides the following value for the call:
d1 = 1.0515 N(d1) = 0.8534
d2 = -0.2135 N(d2) = 0.4155

Value of the call = 50 (0.8534) - 80 exp (-0.10) (10) (0.4155) = $30.44 million
Value of the bond= $50 - $30.44 = $19.56 million

When the value of the Assets drops by 50m, the equity value only drops by $75.94 - $30.44 = $35,5m because of the option characteristics of
equity. The difference is absorbed by a decrease in the value of debt. This explains why often stock in firms, which are essentially bankrupt,
still have value.

Options and Capital Structure: Implications

- Equity can have positive value (option value) even if the current value of assets is lower than the value of debt.
- The value of debt can be lower than face value even if today assets have a higher value than debt: The sum of both must still be the
value of the assets: value preservation!
- An increase in volatility of asset values will increase the value of equity: This can be seen from the Black Scholes formula but is also
directly intuitive:
 Higher risk will increase upside for shareholders but not decrease downside which is capped by limited liability.
 Higher risk will decrease debt values; therefore, it must increase equity values (value preservation!).

Some words on real option valuation

Option theory is also used in a different context, to evaluate strategic options and estimate the value of flexibility.
Example 1 (starting option): A company buys a copper mine with production costs of $3/lb. Current prices are at $2.6/lb.
Example 2 (waiting option): An investment is profitable at current product prices but may become unprofitable if future prices go down.
Should the company invest or wait?
Again, the Black Scholes formula can be adapted to these situations. In practice these tools are mostly used for commodity investments.

SET 6: COMPANY VALUATION

Companies have to be evaluated in many different contexts:
- Stock market analysis
- Takeovers and Mergers
- Credit decisions
- Restructuring decisions
Reminder I: Fundamental concept of value in Finance = Present Value/ Discounted Cash Flow (DCF)
However: Sometimes other valuation methods are more practical.
Reminder II: There is a difference between price and value!

Basic valuation methods

 Book Value Based
- Reevaluated assets
- Liquidation value
 Multiples
- Equity Multiples
- Enterprise Multiples
 DCF
- WACC
- Adjusted Present Value (APV)
 - Flow to Equity (FTE)
- Capital structure as option
- Real Options…

Methods based on book value

 Balance sheet based methods
 Book Value of Assets = Market Value of Assets?
- Historical Cost, Depreciation
 Market Value of Assets = Market Value of Company?
 Tangible assets
- Reevaluation possible, but conceptual problems: sales price; replacement value.
- The sum can be more valuable than the parts.
 Intangible assets: patents, trademarks
 Assets which cannot be listed on the balance sheet: market position, reputation.

Market value of an investment: This is the present value of the cash flows generated after making the initial investment.

Book value of the investment: Essentially initial investment outlay (minus depreciation). We have:

NPV can be understood as the difference between market and book value, the « value created ».

Re-evaluated assets
Book values can be made more realistic by replacing them with the current market values of assets. Several conceptual problems:
- Groups of assets may be more valuable than separate assets
- Sales value or Replacement value?
- Normally Re-evaluated sales value of assets is lower than company value
- Otherwise: Liquidate Company!

Re-evaluated assets = Liquidation Value = Lower boundary for firm value

Summary: Balance sheet-based methods

 No theoretical foundation: Balance sheet data are backwards looking; Market values depend on the future.
 Useful to determine the liquidation value: Therefore, used by banks; Used in the case of bankrupt companies.
 Can be used as complement to an evaluation: If asset value is higher than cash flow value –> liquidate.
 Less useful for modern companies: service sector; human capital.

Comparables | Multiples
Fundamental idea: Compare the companies you want to evaluate with similar companies for which you know the value and adjust for
different size:

Two types of values:

 Equity value
 Enterprise value (Equity + Debt – Cash)

Both types of values can come from stock markets (“compco”) or other transactions (“comptrans”).
Proxies for size:
- EBIT, EBITDA, Cash, Sales, number of clients
- total assets, retail surface, total reserves

Equity vs. Enterprise Value Multiples

Enterprise value multiples:
- use the total value (debt + equity – cash) of the comparable companies.
- theoretically sounder way.
- to get the equity value, subtract value of debt.
- Size proxy must be independent of leverage: EBIT, EBITDA, Cash to the Firm, Sales, Assets, Nr. Clients.
Equity value multiples:
 - directly evaluate the company’s equity.
- often more practical.
- will lead to valuation errors if companies with different leverage are compared.
- Size proxy must be consistent with “money to equity”, i.e. net profits, EBITDA-interest, cash to equity, book value of equity etc.

The most common multiples

Price/ Earnings ratio
 Equity and Enterprise version:
Equity Value/Net profits
Enterprise Value / EBITDA, Enterprise Value / EBIT, Enterprise Value/ Cash
 Inconsistent calculation: Enterprise Value / Net profits
Price/ capital ratio
 Equity and Enterprise version:
Market value of equity/Book value of equity
(Market value of equity+ value of debt)/Book value of total assets (Tobin’s q)
 Inconsistent calculation: Market value of equity/Book value of total assets

Reminder: Equity Multiples and Leverage

A change in debt level can have an impact on the price/earnings multiple if it is calculated as Equity Multiple
Reasons:
- Net earnings in a highly levered company are more risky and therefore less valuable than earnings in a similar company with low
debt.
- Net earnings in a high growth companies grow even faster if the company is levered. Earnings in a levered company can therefore
be more valuable than earnings in a similar company with low debt.
This error is extremely common for stock market investors. It can be avoided by using Enterprise Multiples.

Other problems with multiples

Multiples do not only depend on leverage but also on:
Growth, size, industry, country, time…..

Using the average multiple will we underestimate or overestimate the value of Hyperstore?

Adjusting multiples using regression analysis

The influence of different factor on Multiples can be taken into account with regression analysis:

Example: Valuing Hyperstore using regression

More precise solution:

- capture the effect of size with a linear regression of Multiples on growth factors

- The estimated coefficients of the regressions are:

 - New estimate of the appropriate EBIT Multiplier

- The new estimation for the value of the company is:

Conclusion: Multiples and regression

Linear regression allows to take into account the growth of the company we want to evaluate. If the company grows faster than the sample
of comparable companies, we will obtain a higher value.
The regression method can be generalized to take into account other variables influencing the price: leverage, size, other financial ratios.
Problems:
- you need a large number of comparable companies.
- Multiples are still a « Black Box approach » the statistical adjustment does not explain why the value is more important.
Comments: the PER/ Growth ratio makes no sense whatsoever and should not be used.

Problems with multiples

Fundamental Problems: A number of different factors influence multiples: earnings growth (Gordon/Shapiro), leverage (risk premia,
Modiglani/Miller).
Practical Problems: Often comparable companies (peer group) are difficult to find, especially for conglomerates, international companies
or new industries. Time frame for calculation of multiples: Multiples change in time.
Accounting Problems: Very similar companies can have very different multiples depending on their accounting policy: “Adjustments” in
order to obtain consistent information.
Evaluation with multiples means relying on the evaluation done by others on other companies if everybody else gets it wrong so will I
stock market bubbles (internent; japanese stockprices)

Summary: Valuing with Multiples

 Multiples valuation is valuation by comparison.
 (Almost) anything goes, except inconsistently calculated multiples.
 Enterprise value multiples are less dependent on leverage than equity multiples.
 Regression analysis can be used to refine multiple valuation.
 But fundamentally multiples are a simple but very imprecise method to value companies.
 Often multiples are used to summarize a valuation.

DCF Methods
Basic idea
Valuation Principle: A company is an investment and should therefore be valued with the same methods as other investments. The price
should be chosen such that the investor obtains at least the same return as on other investments with similar risk.
We know from financial mathematics: The PV of a series of cash flows corresponds to the price at which the investor gets a return equal to
the discount rate. The return on an investment with high systematic risk should be higher than the return on an investment with low risk
(CAPM).

Several variants of DCF Models

 Enterprise value (Entity) methods: give the enterprise value.
 Use Free Cash Flow to the Firm (FCTF)and cost of capital.
 Different ways to adjust for tax shields of debt (WACC, APV)
 Equity methods: directly give the value of equity.
 Dividend Discount Models: Directly evaluate the cash flow to investors by discounting dividend forecast at cost of equity.
 Free Cash to Equity: Use free cash to equity (i.e. potential dividends) instead of dividends

Modelling Risk in Discounted Cash Flows (DCF) Methods

 Usually a single stream of (expected) cash flow forecasts is discounted.
 It is often a good idea to forecast and evaluate different scenarios. The firm value is the probability weighted average of these scenario
values.
 Sensitivity analysis consists in identifying “value drivers” which have a high impact on the firm value (e.g. sales growth) and therefore
need to be forecasted with high precision.

Using Option Pricing Methods in Discounted Cash Flows (DCF) Methods

Capital structure options: This approach makes sense if:
 - Firms are very highly levered/close to insolvent.
- Asset volatility can be easily quantified (e.g., commodity producers, real estate)
Real option analysis can be understood as a more detailed scenario analysis, where some choices precondition other choices.

Reminder: Free Cash to the Firm (FCTF), Cash Flow to Equity (FTE) and Dividends
Free Cash to the Firm is the cash produced or absorbed by the company’s assets.
- Can be accumulated or paid out to creditors or shareholders.
- Is affected by economic risk.
Free Cash to Equity is the cash produced or absorbed by the company’s assets and the company’s debt.
- Can be accumulated or paid out to shareholders.
- Is affected by economic and financial risk.
Dividends are the part of Cash to Equity that is paid out to shareholders; the remaining part is accumulated on the balance sheet.
- Eventually all Cash to Equity must be paid out as dividends.

l Free Cash to the Firm:

EBIT
- taxes on EBIT
= NOPLAT
+ Depreciation and Amortization
- Increase in Working Capital
- Capital expenditures
= FCTF

l Free Cash to Equity

EBIT
- Interest
= taxable income
- taxes paid
= Net Income
+ Depreciation and Amortization
- Increase in Working Capital
- Capital expenditures
+ Change in Debt
= FTE

Present Value of Dividends, Cash to Equity and Free Cash to the Firm (without taxes)
 According to Modigliani Miller (1958): The value of a company does not depend on its capital structure (except for tax effects)!
Therefore, we can evaluate a company as if it was entirely equity financed:
- FCTF would be the firm’s Cash to Equity in case the firm had no debt!
- WACC would be the firm’s cost of equity in case it has no debt!
 According to Modigliani Miller (1961)
- The value of a company does not depend on its payout policy!
- CTE and Dividends differ in timing but should always have the same present value!
- Usually, CTE is easier to forecast because it does not depend on payout decisions.

Tax Treatment in Entity methods

Free Cash to the Firm assumes more taxes than the company has really paid. How can we adjust for this difference?
WACC approach: Adjust for tax shield of debt by adjusting discount factor by the (1-tc) tax factor (WACC)
APV approach: Calculate discount factor without tax correction, add NPV of debt tax shields to obtain enterprise value. More on this later.

Overview: APV, FTE, and WACC

Reminder: Cost of Equity and Cost of Debt
Cost of Equity= required average return for shareholders:
- CAPM
- Fama-French
- Subjective
Cost of Debt= required average return for creditors
- Yield minus expected loss rate
- Risk free rate plus risk premium
- For investment grade companies no risk adjustment necessary: Interest rate on bank loans, Current yield on bonds, Weighted
average between long- and short-term rates.

Reminder: Weighted Average Cost of Capital (WACC)

Discount rate for a given company’s FCTF:

Tax Shields
How to take into account tax shields?
- Total Cash Flow goes to three parties: Debtholders, Equity holders and State.
- Free Cash Flow assumes that taxes are paid on EBIT.
- Real taxes are lower because they are calculated after interest payments.
- Firm value using discounted FCF would therefore be too low.
- Two methods for adjusting for tax shields of debt: Adding back net present value of tax shields: Adjusted present value (APV);
Adjusting discount rate downwards in order to increase NPV of the firm: Weighted Average Cost of Capital (WACC)

The Adjusted-Present-Value (APV) Approach

APV explicitly calculates the value of the tax shields.
Procedure:
- Calculate Cash Flows as if Firm was all equity financed.
- Calculate required return for unlevered firm without tax correction

- Discount the company’s Cash Flows

- Add NPV of debt tax shields to obtain enterprise value

Implicit Assumption: The amount of future debt is known and independent of the firm’s evolution. Advantage: Possible to handle complex
tax situations and capital structures.

Example: Pivatejet Inc.

Privatejet Inc. produces Free Cash Flows of €20million/ year without growth. The unlevered cost of capital is 10%. The company pays 40 %
taxes but as a startup in France the first 3 years are exempt from taxation. The company has a debt level of €150million on which it pays 3%
interest and which it will maintain for 5 years. Then debt will be reduced to a permanent level of €50million from year 6 on.
Calculate the value of the firm without debt and tax exemption.
What is the value of the tax exemption?
What is the present value of the tax shield generated by debt?

Unlevered and fully taxed value €200million

PV of legal tax shields: EBIT = € 20m/ (1-0,4) =33m, Tax shield = € 13m/year, PV of tax shield = 13/1,1+13/1,1^2+13/1,1^3=32m

PV of interest tax shield:

150*3%*0,4= € 1,8m annual tax savings with PV of 1,8/1,03^4+1,8/1,03^5= € 3,2m in years 4 and 5
50*0,4/1,1^5= € 12,4m
Overall value of levered company: 200+32+3,2+12,4= € 247,6million

The Weighted-Average-Cost-of-Capital (WACC) Approach

WACC includes the tax shields in the discount factor. Procedure:
- Calculate Cash Flows as if Firm was all equity financed.
- Calculate average Weighted Average Cost of Capital with adjustment factor for tax deductibility of interest:

- Discount the company’s Cash Flows with the Industry WACC

Implicit Assumption: The capital structure at market values stays the same if the firm value changes, i.e., the amount of debt is
readjusted aftershocks to the company value.

Simple Example: Evaluating Companies using WACC

Privatejet Inc. wants to maintain the value of debt issued at about the same size than the value of equity. How would you estimate the value
of the company using the WACC Approach?
Solution
Cost of Equity for similar firms (CAPM): rE=17%
Unlevered cost of capital: r0 = 17%*1/2 + 3%*1/2=10%
Discount rate adjusted for tax shields
rWACC = 17%*1/2 + 3% (1-0,4) *1/2=9,4%

Discounting the Free Cash flow at WACC we obtain an enterprise value of € 20m/0,094= € 212

Lower than the APV value because tax shields are (implicitly) assumed to be risky.

Problem 1: Levered and unlevered WACC

I want to evaluate firm B, but I only know the cost of capital for a firm A in a similar industry but with a different capital structure. How do I
adjust WACC for the different capital structures?

Step 1: Calculate unlevered cost of capital for A

Step 2: Calculate levered cost of equity for B

Step 3: Calculate new weighted cost of capital for B

Problem 2: The circularity problem

Problem: If you want to calculate WACC you need to know the capital structure in market values. This implies that you know the value of
equity which is precisely what we were looking for!
Frequently used but wrong solution:
 - Use book value of equity.
- the evaluation errors produced by this method can be important.
Correct solution:
- Find a solution to the following fixed-point problem.
- Start by assuming some value of Equity.
- Calculate WACC using this value.
- Calculate value of equity using this WACC
- Compare the obtained and the starting value of Equity.
- Adjust starting value until you find the same value as the input value.

The circularity problem: Example

The cost of capital for unlevered firms is 10%. Privatejet has €100m of riskless debt at 3% outstanding.
Problem: How to calculate cost of Equity? How to calculate WACC?
Solution: Assume E= €100m. Then calculate r E=r0+D/E(r0-rD) and rWACC=E/(D*E)rE+(1-r) D/(D*E)rD, evaluate the company using this r WACC and
recalculate E. Readjust your first estimate of E and repeat until you get the same values:

Comparing entity methods: APV versus WACC

APV:
 Theoretically the most appealing method.
 Clear distinction between value if equity financed a tax shield.
 Complicated tax situations are much easier to consider.
 Changing capital structure can be adjusted for.
 Appropriate method if future amount of debt is known.
 Financing subsidies, cost of issuing.
WACC
 Appropriate if capital structure is re-balanced to remain constant in market values.
 Only one discount factor, easier to calculate.
 Industry standard.
 Circularity problem.

The Flow-to-Equity (FTE) Approach

FTE directly discounts the cash flows received by shareholders. Procedure:
- Calculate Cash Flows to Equity after interest and taxes.
- Calculate required Return for Equity.

- Discount Cash Flow to Equity at rE.

- If you want to find the value of the entire company, add the market value of debt.

Difficult to calculate but appropriate for banks and insurance companies -value creation with liabilities. Very complex if future capital
structure changes.

Comments : FTE and the « PE method »

 Cash-Flow to Equity is normallly not used because it requires a detailed forecast of debt levels
 Exception : Banks and Insurance Companies
o These companies are not financed in perfect capital markets, therefore MM theorems do not apply
o They make money with their liabilties
o Focussing on FCTF would neglect value creation with liabilites (deposits, technical reserves)
o FTE includes cash generated by liabilities
 Private Equity funds often use a FTE approach but do not adjust the cost of equity for the change in leverage during the holding period.
 This is conceptually wrong!

Continuing Values
Usually, it does not make much sense to try to project a company’s cash over more than 10 years. The firm’s value coming from cash
generated after 10 years can be taken into account in a continuing value that will be discounted as the last cash flow. Depending on
economic assumption about the company different continuing values can be chosen:
- Perpetual growth of cash flows
- Convergence and asset replacement scenarios
- Values form comparables (multiples)
Asset Replacement = Convergence Scenario
Asset replacement scenario: At time T we have no new net investment; therefore, the FCF is equal to NOPLAT:

Convergence scenario: From time T on, competitive forces (entry, imitation) will ensure that ROIC is equal to WACC.

Substitute INV in FCF definition:

FCT is proportional to NOPLAT and grows at rate g.

PV of a cash flow which grows at rate g:

If ROIC = WACC after period T, we get

Estimating Continuing Values

 Asset replacement scenario (constant NOPLAT = FCF forever after T) and convergence scenario (ROIC = WACC after T) imply the same
continuing value.
 The convergence scenario has growing NOPLAT and growing FCF, but also growing net investment; it is not more advantageous.
 Growing NOPLAT and growing FCF is in itself not a sign of success; important is how much capital is used up to reach this growth.
Model building: How to forecast Cash Flows?
This is the most important part of valuation. Think about Competitive position, new products, evolution of costs, evolution of prices, market
share, R&D.
Develop scenarios and calculate average values. Think about financial rations that should remain constant. Check consistency. Think about
strategic options and apply real option methods. Estimate continuing value / sustainable growth.

One way of proceeding:

- Forecast the size and growth of the target market.
• Are these forecasts reasonable?
- Forecast the market share.
• Competitive analysis (product positions, etc.)
• Market structure (entry and exit)
• Check against similar markets.
- Forecast profit margin.
• Explore the profit drivers of a firm.
• Evolution of comparative advantage .
What are typical profit margins in the industry?

Knowing the Company …

What are the profit determinants of a firm?
l Sales volume? In which division? Which product line?
l Number of clients? Service?
l Product positioning? Marketing?
l Production costs? Energy costs? Capital costs? Labour costs?
FCF analysis should be grounded in a knowledge of the profit drivers.

Getting the details right

 In real world evaluation problems, you will encounter a high number of practical problems.
 You will have to solve the most of these problems on a pragmatic case by case base, keeping in mind the fundamental principles and
methods of valuation.
 For a number of these problems there are standard solutions:
o Getting around accounting problems
o Finding the Value of Debt, Equity and other financial instruments
 Finding the Cost of different financial instruments

The risk of a project changes over time

If the projects non diversifiable risk changes over time the cost of capital can be adapted to take into account, the new risk.
l Attention: Initial risk of most projects is diversifiable
l Don’t use high interest rate instead of taking expectations!
Example: You want to buy an oil drilling right. In the first year you have a 50% risk that there will be no oil, afterwards cash flows will be very
stable.
Solution: Calculate beta of oil prices and corresponding discount factor. Discount Expected CF=1/2*Success CF at this rate.

Fundamental Problems with DCF Valuation

- Optional nature of equity neglected: Real Options, strategic default models.
- Debt is always good.
 more debt means more tax shields, means more value.
 A firm which is entirely financed by debt would be paying no corporate taxes.
 this only bothers academics (until recently?)
- What are the limits for the use of debt?
 Bankruptcy costs: Direct Costs (lawyers, fees) and Indirect Costs (interruption of supply and sales networks, loss of personnel)
 Agency costs: Shirking, Risk Shifting.

Understanding value drivers

- To better understand the risks, it can be useful to
- Decompose the value of a company in : the liquidation value of existing assets, the value generated by the existing assets, the
value of investment opportunities
- Decompose the value of a company into the value of different business units.
- Analyse the value of the company under different scenarios and calcualte expected values.

Exercise
Machinetec is a medium sized machine tool company, specializing in the fabrication of clutches for industrial applications. The company’s
owner and CEO has now reached the age of 75 and decided that he will not be able to efficiently manage the business any more. His unique
son is not interested in replacing him as CEO, he follows its own carrier as a researcher in the US. You have recently been hired as analyst by
the boutique investment bank which has advised Machinetec for many years now on financial transactions. Your boss, an old friend of
Machinetec’s CEO, has asked you to closely analyze the following exit options for the company.
- Management buyout with the help of buyout firm
 - Sale to a large and diversified German machine tool company
- Introduction to the stock market.

You start by trying to find out the approximate market value of Machinetec’s equity. Last year’s financial statements in simplified form are
given below:
Balance sheet in millions
Assets Liabilities
Current Assets 80 Current Liabilities 30
Property Plant and Equipment 100 Long Term Debt 120
Intagibles 20 Equity 50
Total Assets 200 Total Liabilities and Equity

P&L in Millions
Sales 500
EBITDA 50
EBIT 30
Net Interest 10
Pre-tax Profit 10
Tax@50% 10
Net Profit 10

l Calculate Machinetec’s Free Cash Flow to the Firm for the given year, assuming that working capital remained constant compared to
the year before and that last year the company has made gross investments of 10 million Euro.
l Calculate Machinetec’s Free Cash Flow to the Equity using the same assumptions as in a), assuming that last year the company has paid
back 10 million Euro of long-term debt.
l The company’s stock has a beta of 1.5. The current risk-free rate of return is 3%. Calculate the company’s cost of equity using a market
risk premium of 8%.
l Use the Flow to Equity method to give an approximation of the company’s value, assuming that in the following years the company will
not change its debt level but otherwise deliver perpetually the same Cash to Equity as last year.
l Machinetec’s pays an average interest rate of 8.3% on its long-term debt and pays corporate taxes of 50%. Assuming that the market
value of its equity is 130 million Euros, what would be its WACC?
l Can you evaluate again now the company’s equity using a Free Cash to the Firm/WACC approach?
l What would be the cost of capital value of the firm’s equity in case it had no debt and no tax shields?
l What would be the value of the firm’s equity in case it had no debt and no tax shields?
l What is the present value of the tax shields if the company permanently keeps the current debt level? Use the APV approach to
determine the value of tax shields.
l What is therefore the value of the firm’s equity determined with APV?
l What is the company’s Price/Earnings ratio? The average P/E ratio of the machinetool industry is 8. How could you explain the
difference?

SET 7: ASYMMETRIC INFORMATION

 Moral Hazard

Capital Structure and Enterprise Value

What we have done so far:
- MM without taxes:
 Capital Structure does not matter.
 Not consistent with evidence.
- MM with taxes and Bankruptcy costs (Tradeoff Theory):
 Seems to explain some observations.
 But there are many exceptions.
 Quantitative predictions are very far from reality.
- Next attempt:
 Remove the assumption that future Free Cash Flows are not affected by capital structure, i.e. capital structure affects
investment and management decisions.

Capital structure affects investment and management decisions

Assumptions so far :
- Management and Shareholders maximize enterprise value
- Make all investments with positive NPV, avoid investments with negative NPV.
- This will determine future Free Cash Flows
Why would they do something different, if capital structure changes?
Why does capital structure impact Free Cash Flows?
Answer Nr. 1 Conflicting Objectives
 Optimal decision for firm ≠ Optimal decision for management or shareholders.
 This creates Moral Hazard.
 Conflicts of interest are affected by capital structure.
 These conflicts are analysed by Agency Theory.
Answer Nr. 2 Information Content of Financing Actions
 Financing decisions can be understood as a signal.
 This will impact the firm value because of Adverse Selection.
 These situations are analysed by Signalling Theory.

Both of these theories build on the economics of asymmetric information.

The economics of asymmetric information vs. traditional economics

 The Modigliani/Miller framework is the corporate finance equivalent of the traditional Arrow/Debreu world in economics.
 In this world there are essentially no good reasons for why bad decisions are taken.
 A firm will always realize all positive NPV projects and maximize its value.
 Financing decisions will not affect this value.
 This “value preservation principle” allows us to obtain quick but often approximate solutions for many problems in finance.
 In the 1970s Joseph Stiglitz, Michael Spence and George Akerlof developed formal arguments for why rational decision makers take
suboptimal decisions.
 Their key insight was that in many situations we have “information asymmetry”, i.e., a situation where one decision maker has better
information than another. This information asymmetry cannot be easily overcome because credible communication is not possible.
 Together with the evolution of game theory this led to the evolution of modern Microeconomics with many applications to questions
of optimal firm behaviour, market design, regulation etc.
 In finance these theories can help to explain why and how financing decisions affect firm value.

Moral Hazard and Adverse Selection

Asymmetric information appears in two forms:
 Asymmetric information about actions => Moral hazard => agency/incentive problems
 Asymmetric information about characteristics (quality) => Adverse selection => market failure

In both types of situations free markets will lead to a suboptimal outcome (so called « second best »). Different financial structures,
regulations and appropriate market design can then improve the functioning of the market (approach « first best »)

Agency Problem N1: Shareholder Creditor conflicts

We know that because of limited liability /option characteristics of debt and equity:
- Shareholders benefit from high profits.
- Creditors suffer from high risk.
Therefore, Shareholders and Creditors do not have the same objectives:
- Creditors want the company to be managed for low risk.
- Shareholders want the company to be managed for high profitability and high risk.

This conflict can lead to suboptimal decisions on the part of shareholders.

Example:
Farine SA has a low-risk strategy producing a stable enterprise value (EV) of 100. With a more aggressive corporate strategy the company
could achieve a future EV of 40 or 140 (with prob. 50%)
Case Nr. 1: What is the current EV if the firm is unlevered?
Case Nr. 2: What is the EV if the company is financed with long term loans having a face value of 70

To determine EV, determine for both strategies:

- Today ’s company value
- The value of equity
- The value of debt
- Repeat with a loan value of 40.

- Safe strategy: EV=100

- Risky strategy: EV= 90
 With 0 debt, EV=EU: Safe strategy will be implemented
 With 70 debt: Safe strategy: EL=100-70=30; Risky strategy: EL = (140-70) *0,5+ 0*0,5=35
⇒ Risky strategy will be implemented!
⇒ EVL= 90 ≠ EVU= 90, DL +EL =EVL ⇒ DL =EVL –EL =55
Leverage transfers 15 in value from creditors to shareholders but creates agency costs of 10. Overall shareholders are still benefitting,
despite a reduction in enterprise value of 10.

Conclusion 1: Leverage and Risk-Shifting

l The upside potential of high risk is captured by shareholders whereas the downside potential is absorbed by creditors.
l Therefore, shareholders can increase the current (= expected future) value of shares by choosing a risky strategy.
l This is more profitable if the company has higher leverage.
l This behaviour is referred to as “risk shifting” or “asset substitution”.
l It can lead to the choice of inferior but risky projects by the company’s management if the company is too highly levered.

Who bears the agency costs?

In the previous example the lender loses money: He provides a loan of 70 that after the increase in risk is valued at 55. A smart bank will
protect itself with a high interest rate. At what rate would the bank accept to finance the loan of 70?
(40+x)/2=70 ⇒ x= 100 (interest rate 100/70-1=42%)
The bank will only lend if in case of success if it receives 100.
In this case the value of equity will become EL = (140-100) *0,5+ 0*0,5=20. ⇒ The shareholders suffer from their own behaviour!

Conclusion 2: Risk shifting that is anticipated by creditors hurts shareholders

l If risk shifting is anticipated by the creditors, they will protect themselves with high interest rates.
l In this case the reduction in EV will translate into a reduction in the equity value.
l Can the shareholder avoid this? This depends on asymmetric information.
l Suppose the creditor does not observe the shareholders risk shifting? Does the shareholder have incentives to shift risk?
l Answer: Ex ante the shareholder has incentives to commit to not shift risk, ex post after the loan is awarded, he will always shift risk.
l Commitment devices: Governance structure, loan covenants etc.

Leverage and Firm Value with risk shifting

Discussion: Which firms are likely to suffer most from risk shifting?
Firms with a potential for risk-shifting by management will lose value if financed with too much debt. These firms should be financed by
equity or more sophisticated financial contracts (convertibles, preferred stock etc.). Two conditions for risk shifting:
- There exist many strategic options with different risk.
- Creditors cannot distinguish between these different choices.
Applies to: Startups, high tech firms, firms that are in a reorientation phase etc. Does not apply to: Utilities, mines etc.

Credit Rationing
Companies often claim that banks don’t provide loans despite the fact that they have safe and profitable investment projects. This is
surprising: Why do banks not exploit this opportunity? Answer: asymmetric information:
Assume that the company in the previous example needs a loan of 92 to finance the project yielding a safe 100. Will the bank provide the
loan? No, because… the firm implements the risky project which yields 90<92. Hence: Some companies with valuable investment projects
cannot be financed by debt. If the bank awards a loan the firm, it will shift to a highly risky, but unprofitable strategy.
Summary: Risk and Shareholder Value
Increasing risk will often increase shareholder value. They gain from the upside. No increased losses on the downside. On average their
payoff will increase. Risk shifting can increase shareholder value even though Enterprise value will go down. With rational lenders
shareholders suffer from their own risk-shifting. Firms with high potential for risk shifting should not use too much debt.
In many cases the potential for risk-shifting will lead to credit rationing, where banks do not want to finance profitable projects even at high
interest rates.
Underinvestment/ Debt Overhang
The Underinvestment/ Debt Overhang problem is a specific variant of the general « risk shifting » problem. Making new equity
investments in a risky firm will decrease the risk for creditors. This benefits creditors and harms shareholders. Shareholders of highly
levered companies will therefore often not be able to capture the return on their new investment. In this case they will renounce to make
profitable investments.
Example:

A company has existing assets and a new investment project with the following anticipated cash flows:

Year 1 2
Existing Assets 100 50
Investment Project -75 100

If we set the discount rate to zero we find:

PV (Existing Assets) = 150
NPV (New Investment) = 25

The project is profitable and will be carried out if the company is equity financed. Lets assume that the company has debt promising a flow
of 100 in period 2:

Period 1 2
Existing Assets 100 50
Investment Project -75 100
Debt -100

What is the value of the debt?

Conclusion: Shareholders are reluctant to invest money in a highly levered company because the wealth generated by this investment
mainly benefits the creditors. Essentially the equity injection would reduce risk and therefore have a negative effect on shareholders. As
before, if creditors anticipate this underinvestment behaviour, it is the shareholders who will suffer from their own behaviour.

How can the problem be solved or at least reduced?

Possible Solutions:
l Avoid high leverage.
l Limit dividend payments.
l Renegotiate debt.
l Choose debt with short horizon.

Applications
 Gambling for Resurrection: The “risk shifting” problem is particularly important if the company is close to bankruptcy.
Profit for shareholders with a reasonable strategy: probably nothing because the company is already bankrupt.
Loss in case of failure of a risky project: nothing because everything is already lost.
Therefore, banks often prefer to liquidate companies which are close to bankruptcy.

 Take the Money and Run: Similar to explicit risk shifting, risk shifting through underinvestment becomes especially important in
companies that are close to bankruptcy. A company can then even make negative investments: Shareholder will liquidate profitable
projects to have the cash paid out as dividends. This is called the “Take the Money and Run” strategy.

 Structuring Venture Finance: Venture Capitalists almost never use debt to finance start-ups. Reason: Start-up companies have many
strategic options; it is therefore almost impossible to control the risk of a start-up company; pure debt finance would provide high
incentives for risk shifting.
Convertible debt in Venture => Finance Venture finance mostly uses “convertible preferred stock”. This is a security with debt like
features that can be exchanged into a certain number of shares. Conversion will take place is the company is very successful and dilute
the wealth of the Manager/Owner. This has two effects:
- By reducing the upside for the Manager/Owner it reduces incentives to increase risk
- If the Manager/Owner nevertheless shifts risk the investor will participate

 Flight Security and Leverage: It has been shown that more highly levered airlines have more small technical problems. Reason is
Under Investment in maintenance. Example: Xavier Niel has recently taken the group private. The operator's shares were finally
delisted from Euronext Paris from October 14 following a squeeze-out offer. Since then, Iliad has entered the high-yield debt market,
placing a €3.7 billion ($4.2 billion) four-tranche bond issue with European and American investors.

Example: Financing Start-up Firms with many Strategic Options / Risk Shifting
Outside Investment of 5m needed to start a company. The owner-manager has two possible strategies.
- low risk/high expected return: Value of the company always 6m, expected return 20%
- high risk/low expected return
• Proba 50%, Strategy unsuccessful: Value 0
• Proba 50%, Strategy successful: Value 10
• Expected value 5m, expected return 0%

Excessive Risk Taking with Debt Finance

- Financing with debt:
o suppose owner chooses risk-free strategy. He will make a benefit of 6m-5m=1m
o suppose he chooses the risky strategy. He will make an expected benefit of 0.5*(10m-5m) = 2.5m. Hence, he will always
choose the risky strategy.
- Additional Problem: the bank will not provide debt of 5m because the interest rate would be prohibitive.
- Debt financing is not feasible!
- Financing with Equity: Sell 5/6 of the shares to outside investor:
o Payoff for entrepreneur: with safe strategy 1m and with risky strategy 1/6*10*0,5=0.83.
- He will choose safe and profitable strategy.

Example: Convertible debt can solve the problem!

- Financing with convertible debt: Bank has the right to convert debt into 82% of the firm’s capital.
o suppose owner chooses riskless strategy. Will the bank convert? No because 0,82*6m<5m.
o suppose he chooses the risky strategy.
 In case of the successful outcome the bank will convert because 10*0.82=8.2>5. Only 1.8 will remain for the
initial owner.
 In case of the unsuccessful outcome the bank will not convert and try to squeeze the max out of the bankrupt
firm.
 Expected profit for owner 0.9.
- The owner has no incentive to increase risk and debt financing becomes feasible.
- Value of convertible debt will be less information sensitive than equity value.

Example: Shareholder - Creditor Conflicts and Capital Structure Choices

- A company has 100 which it can invest in projects A or B with the following characteristics:
o Project A: 105 or 115 with 50% probability
o Project B: 160 or 50 with 50% probability
- We assume for simplification risk neutral investors and a zero-discount rate.
o What is the NPV of both projects?
o What is the company value with100% equity and with debt of face value of 70?
o If creditors anticipate the shareholder ’s behaviour how much will they ask to be reimbursed for investing 70?
o What will be the value of shares in this case?
o What will the shareholders do?
- Project C :180 or 0 with probability of 50%

Agency Problem N2: Management - Shareholder conflicts

External and Internal Equity
- The separation of ownership and control/management creates the second classic agency problem.
o The manager (agent) will not entirely work in the interest of the shareholders (principals) agent (Manager).
 Not work hard, exploit private benefits, avoid risk
o This conflict between shareholders and managers implies that firms with outsider shareholders are less efficient than
owner - managed companies.
o Shareholders can try to improve the manager’s performance with an incentive contract, but as long as they have
imperfect information about the manager’s actions the problem will not disappear.

Example: Insufficient Incentives with outside Equity

Two options:
- Fly economy class:
ticket costs: 200, Value of frequent flyer miles 50
- Fly first class:
ticket costs 1000, Value of frequent flyer miles 250
100% Management Ownership: Cost/Benefit to Manager
Economy class: -200+50=-150
Business class: -1000+250=-750
He chooses economy.

15% Management Ownership: Cost/Benefit to Manager

Economy class: 0.15* (-200) + 50= 20
First Class: 0.15 *(-1000) + 250= 100
He chooses first class.

Examples of Manager-Shareholder Conflicts

 Private benefits / perquisites (perks): see above.
 Quiet life: low effort can be understood as another form of private benefits.
 Entrenchment: Contractual or organizational arrangements that make it difficult to replace existing management.
 Empire building: Management wants size, shareholders profitability.
 Overinvestment: Invest in negative NPV projects to increase company size
 Prestige Projects: Add to the management’s reputation but not necessarily to firm value.
 Excess Risk aversion: Management wants low risk because their human capital is tied to the company.

Reducing Manager Shareholder Conflicts with incentive contracts

In principle agency conflicts can be reduced by providing incentives. These incentives will work better if there is less asymmetric
information. Incentive contracts:
- Provide management with a share in the value they contribute to the firm.
- Bonus payments, stock options, partial ownership.

Empirical evidence on management incentives

Jensen, M. C., & Murphy, K. J. (1990). Performance pays and top-management incentives. Journal of political economy, 98(2), 225-264.
“CEO wealth changes $3.25 for every $1,000 change in shareholder wealth”
Jensen’s conclusion: Top Management Incentives are insufficient.
Problems: Management should not be remunerated for an increase in value that is not related to their actions, incentive contracts cannot
achieve “first best”, provide “informational rents” to agents (Management).

Terminology
 The mathematical analysis of incentives i.e., the “moral hazard problem” is called “agency theory”, which is part of a field of
Microeconomics/ Game theory called “contract theory”.
 Agency Theory: How to provide someone (an “agent”) with the incentives to do what somebody else (the “principal”) wants him to do
 Contract Theory: Because incentives are normally specified in a contract (implicit or explicit).
 Moral Hazard: Because the agent does not exactly do what the principal wants him to do.
 Imperfect Information: Because if you have perfect information about what the agent does it is possible to provide perfect incentives.

The 2016 Nobel Price in Economics for Contract Theory

- (actually, Sveriges Riksbanks Prize in Economic Sciences in Memory of Alfred Nobel 2016)
- Oliver Hart and Bengt Holmström have worked in particular on the tension between insurance and incentives and ssymmetric
Information vs. incomplete contracts.

Example: Reducing Agency conflicts with incentive contracts

Field can produce wheat with value of 50 or 100.
Agent (farmer) has two effort levels:
 High: cost of effort 5, Probability of 100= 80%, probability of 50=20%
 Low: cost of effort 0, Probability of 100= 50%, probability of 50=50%

“First best” solution with symmetric information: Pay 5 to farmer if he works hard: Overall Surplus: 0,8*100+0,2*50-5=90-5=85
“Inefficient” solution with asymmetric information: Pay 5 to farmer: Inefficient surplus: 0,5*100+0,5*50=75

Example: Agency conflict

“Second best” solution with incentive contract: Pay contingent wage w50 > 0, w10 0> 0.
Agent only invests effort if (Incentive constraint): 0.8*w100+0.2*w50-5 > 0.5*w50+0.5*w100.

Agent only accepts job if (Participation constraint): 0.8*w100+0.2*w50-5 > 0.

The solution is w100=8.3, w50=-8.3 but negative wages are normally not feasible. This solution means that all the risk is absorbed by the
agent/worker.

Solution with non-negative wages:

The cheapest solution with non-negative wages is w 50=0, w100=16,6. (give 50 +1/3 or remaining harvest) The agent makes an average gain
(information rent) of 8,3.
The owner receives 90-8,3=81,7 which is still better than 75 without effort

Solution for reducing the risk

Reduce the risk for the worker, by increasing w50 and decreasing w100=16,6. but then, he will again not work hard.

In more realistic models with more than 2 effort levels and risk averse agents
- the agent will never invest the optimal effort level.
- the principal will never pay a wage of zero.

Takeaway: Normally incentive contracts cannot achieve optimal –” first best” outcome and provide informational rents (Holmström, 1979).
Only solution: Reduce asymmetric information.
If the information asymmetry is reduced, 1) more surplus is generated and 2) informational rents are reduced.
Example: Amazon.

Summary: Agency Theory/Understanding Incentives

In a world with perfect information, delegation of tasks has no negative effects.

 The “principal” specifies a task, the “agent” perfectly executes this task according to these specifications and gets compensated
for his costs.
 Example: Unload a truck
With imperfect information about the agent’s actions this is not possible anymore:
 The principal cannot observe how well the task is carried out; he only sees the result which is imperfectly correlated with the
quality of the work.
 An “incentive contract” may improve the agent’s effort but leads to “informational rents.”
 Example: grow wheat

Where would we expect to see important management/shareholder conflicts?

l Firms that are likely to suffer from managerial agency costs.
- (Partial) Separation between Ownership and Management
- Asymmetric Information concerning the Management’s actions.
- High Free Cash-Flow that can be turned into private benefits (“Free Cash Flow Problem”, Jensen,1986)
l Examples
- listed companies with fragmenting uniformed shareholders.
- Mature industries with profitable businesses and few investments.

Reducing Managerial Agency Costs

l “Free Cash Flow” problem.
 Can be solved with high leverage:
 Debt reduces the cash flow that can potentially be wasted by the management.
l Focus on Core business.
 The performance of a company with only one business line is easier to evaluate.
 Manager’s payoff is more tightly tied to the business performance.
l Invest in easily understandable/short term strategies.
 Principals may prefer businesses with low information asymmetries.

Leverage and Firm Value with risk shifting

Applications: Stock Options

 Stock Call Options are call options on the firm’s shares, given to the management.
 This is a simple form of incentive payment.
 Normally the strike price is equal to the current stock price.
 Until recently this form of remuneration had no impact on accounting costs.
Corporate Governance: is the set of mechanisms that are destined to ensure that the firm is managed in the interests of the shareholders.
o Executive Contracts (to provide incentives)
o Board structure and (to reduce asymmetric information)

SET 8: ASYMMETRIC INFORMATION II

 Adverse Selection

Asymmetric Information about quality leads to market failure

Market Failure: seller has lower valuation than buyer but there is no transaction.
Akerlof’s “Lemon” Example: Owner of a used car: Value for the owner between $0 and $9000; Value for the buyer $1000 more than for the
owner. How much should the buyer offer?
- Expected value for buyer $5500.
- Expected value for owner $4500.
Note: The owner knows the exact value, the buyer doesn’t!
Assume buyer offers $5000 ($500 more than expected value for seller). In which case will the owner sell?
Only if value of car to him is below $5000. But this means that the expected value for the owner is $2500 and the expected value for the
buyer $3500. If the buyer proposes $3500 the same thing happens…
Outcome: Buyers will offer $1000, and the seller will sell in case his value is between 0 and $1000

In all other cases markets fail, there will be no transaction!

In a situation with asymmetric information trades will only happen:
- For low quality goods at low prices
- If the difference between the buyer’s and seller’s valuation is extremely high
Example: MBS/ABS after the financial crisis! Problem for accounting and definition of fair value as market value.
Possible solutions require reduction of asymmetric information: Rating agencies, external evaluators, repeated transactions, guarantees
etc.

Application to Finance: Issuing Financial Assets under Asymmetric Information

Fundamental Problem: A company is likely to have more information about the value of its own financial assets than an investor. The fact
that the company is willing to sell assets at a given price implies that the value (for the company) is probably lower than this price. This will
make it difficult to sell securities at their correct value. It can also explain the pattern we observe for the announcement effects of security
issues.

Witout asymmetric informaton: Basic wealth dilution/ accretion from equity issuance
Example: A company has 10 million shares outstanding. The value of one share is €10.
Assume that the company is selling 5 million new shares at a price of €5/share. What is the value of one (new or old) share after the issue is
completed?
Assume that the company is selling 5 million new shares at a price of €10/share. What is the value of one (new or old) share after the issue is
completed?
Assume that the company is selling 5 million new shares at a price of €15/share. What is the value of one (new or old) share after the issue is
completed?

l Operation 1:
§ Value of company’s assets after share issue: €100 million + €25million in cash =€125million
§ Nr of shares 15million
§ New share price €125/15=€8,3 Dilution!
l Operation 2:
§ Value of assets : €100 million + €50million=€150million
§ Nr of shares 15million
§ New share price €15/15=€10 as before!
l Operation 3:
§ Value of assets : €100 million + €75million=€175million
§ Nr of shares 15million
§ New share price €175/15=€11,6 Accretion!

Basic EPS dilution/ accretion

Example: A company has 10 million shares outstanding. The value of one share is €10. Earnings Per Share (EPS) are €1. The company
generates 0% interest on cash.
Assume that the company is selling 5 million new shares at a price of €5/share. What are EPS after the issue is completed?
Assume that the company is selling 5 million new shares at a price of €10/share. What are EPS after the issue is completed?
Assume that the company is selling 5 million new shares at a price of €15/share. What are EPS after the issue is completed?
l Operations 1, 2, and 3
§ Earnings after the issue = €1 x 10 million = €10 million
§ Nr of shares: 15 million
§ New EPS = € 10million/15million= € 0,66/share EPS Dilution!
If we take into account positive interest, the effect will normally be weaker but remain qualitatively similar.
Conclusion: EPS is (almost completely) useless!!!!!
Investment banking workaround: Look at future EPS: « Operation will be EPS accretive in year 5 »….Not very meaningful

Share Buybacks: Basic wealth dilution/ accretion

Example: A company has 10 million shares outstanding. The value of one share is €10. Interest rates are 0%.
Assume that the company is buying back 5 million shares at a price of €5/share. What is the value of one share after the buyback? The
operation is financed with debt.
Assume that the company is buying back 5 million new shares at a price of €10/share. What is the value of one share after the buyback?
Assume that the company is buying 5 million new shares at a price of €15/share. What is the value of one share after the buyback?
l Operation 1:
§ Value of company’s equity after share buyback: €100 million - €25million in debt =€75million
§ Nr of shares 5million
§ New share price €75/5=€15 => Wealth Accretion!
l Operation 2:
§ Value of equity €100 million - €50million=€50million
§ Nr of shares 5million
§ New share price €5/5=€10 as before!
l Operation 3:
§ Value of assets : €100 million - €75million=€25million
§ Nr of shares 5million
§ New share price €25/5=€5 => Dilution!

Basic EPS dilution/ accretion

Example: A company has 10 million shares outstanding. TEPS €1/share. Interest rates are 0%.
Assume that the company is buying back 5 million shares at a price of €5/share. The buyback is financed with debt. What are EPS after the
buyback?
Assume that the company is buying back 5 million shares at a price of €10/share. What are EPS after the buyback?
Assume that the company is buying 5 million shares at a price of €15/share. What are EPS after the buyback?

l Operations 1, 2, and 3
§ Earnings after the issue = €1 x 10 million = €10 million
§ Nr of shares: 5 million
§ New EPS = € 10million/5million= € 2/share EPS Accretion!
If we take into account positive interest, the effect will normally be weaker but remain qualitatively similar. Conclusion: EPS is (almost
completely) useless!!!!! Investment banking sales pitch « The levered Dividend Recap will be immediately EPS accretive»….Not very
meaningful
Wrong explications for stock market reaction after equity issuance/ buyback
1. EPS dilution/accretion
- Equity issues typically reduce EPS and could therefore reduce share prices.
- Buybacks have he opposite effect
Counter-argument :
- Wealth dilution depends on issue price
- we know that equity issues for a correct price should not influence stock prices (Modigliani Miller)
- The decrease of EPS should be compensated by an increase in the appropriate PE (lower risk/ higher growth)
- Indeed if EPS dilution was a relevant argument the company should take on the maximum possible amount of debt to
increase ist share price.

2. Company moves away from optimal financial structure.

- Equity issues could make the company deviate from its optimal financial structure and therefore decrease company value.
- Buybacks would bring it back to optimal leverage and reduce WACC.
Counter-argument:
- Why should equity issues always make the company deviate from the optimal capital structure and never bring the company
closer to its optimum?
- This would imply that most companies are underlevered.

3. Quantity increase (decrease) decreases (increases) prices. => unlikely explication for stock market reaction
- If there is a demand function for shares an increased supply should decrese prices
Counter-argument: Perfect Markets
- In perfect markets there is no real demand function for shares. If underpriced, everybody would want to buy them, if
overpriced nobody.
- In imperfect markets the might be a short term reaction, but it should reverse -> not the case in reality!
- Larger companies with more shares don’t have lower stock prices.
- The price reaction after block sales is not related to the size of the block but to the identity of the seller.

4. The equity issue/buybacks signals the manager’s and shareholder ’s information about the company to the market => correct
explication for stock market reaction
- Managers and existing shareholders know more about the company than the market -> information asymmetry!
- Managers would not issue (buy back) shares if the company was undervalued (overvalued) by the market.
- An equity issue (buyback) therefore signals that the stock is rather overvalued (undervalued).
- The effect is particularly strong if the equity issue is unexpected
- The « equity story » is necessary to motivate the equity issue and reduce the information effect.
- A company may forgoe investment opportunities because it cannot finance them with equity. (Myers and Majluf, 1984 )

Implications for security issues: Pecking Order Theory

If there is an asymmetric information problem the company will try to issue first the securities which are not « information sensitive »
o Secured bank debt: does not change a lot in value if the firm value changes
o Unsecured bonds: change in value if firm value changes
o Convertible bonds: change even more
o Equity: most sensitive to information about the firm value

Information sensitivity explains why there exists a preference ranking( “Pecking Order”) of financing tools:
(In decreasing order of preference)
o Internal Finance
o Bank Debt
 o Bonds
o Convertibles
o External Equity
o This seems to correspond to how managers think about fiinancing decisions
Note that there is a differnece between internal and external equity

Until now: Determinants of optimal capital structure

Now: No optimal capital structure but. Company will raise finance using the least costly way. Observed capital structures are the outcome
of past financing decisions.
Conclusion: If there really is an optimal capital structure companies could sometimes be very far from the optimum.

Summary: Capital Structure Theories

Trade off Theory
- Tax shields of debt vs. Expected bankruptcy costs
Agency Theory
- Shareholder Creditor conflicts favor equity finance
• Asset substitution/risk shifting
• Underinvestment
- Shareholder Management conflicts favor debt finance
• Free Cash-Flow
• Management Incentives
Pecking Order Theory
- Asymmetric information implies a ranking of financing tools depending on their « information sensitivity »

Other Applications of Adverse Selection

l Insurance Markets:
n For good risks an average insurance contract will be loss making and therefore be refused
l Risk Management:
n Some risks come without asymmetric information and are therefore cheap to hedge Commodity Price risk, inflation risk
etc.
n Other risks come with asymmetric information and are therefore difficult to hedge: Future sales, success of research
projects etc.

SET 9: RECENT RESEARCH ON CAPITAL STRUCTURE

Basic tools from Asymmetric Information/ Agency Theory can generate insights into the relationship between capital structure and
corporate strategy.
Product quality
Competitiveness
Labor relationships
Beyond agency theory, game theory (Nash) and the theory of industrial organization (Tirole)

Capital Structure and Quality literature showing high leverage correlated with lower quality.
Potential endogeneity / causality problem, but some of these papers use “natural experiments”.
Underinvestment? Lack of Free Cash Flow leads to excessive cost cutting?

Leverage and Competitiveness moderate debt taking is associated with relative-to-rival sales gains; high indebtedness leads to product
market underperformance.
Leverage makes firms more aggressive Risk shifting/ shareholders care less about large losses.
Strong leverage makes it less likely to survive a price war.

Finance Labor relationships rigid labor regulations and higher firing costs produce lower leverage.
firms use financial leverage to gain bargaining power over their unions.
advantage of leverage increases efficiency produces the same output with lower inputs.

BEHAVIOURAL CORPORATE FINANCE

Many irrational market outcomes are result of asymmetric information not irrationality.
There are many irrational decisions, but difficult to predict patterns.
Patterns change market participants understand the irrationality of behavior tend to change.
Critique of behavioral finance many micro-effects (anomalies) but likely no macro consequences

Behavioral biases and limited information processing predictable deviations from what a utility maximizing computer would do.
Potentially important for stock market prices
Inability to fully master complex situations
Fallback on simple heuristic rules

Reciprocity, Cooperation, Fairness, Inequity aversion, Altruism seemingly irrational decision making influenced by ethical rules or feelings
can conflict with predictions of agency theory.

Reasons for irrational behavior biological limits of the brain limited information processing capacity.
Pre-programmed decision pattern that produced evolutionary advantage in the past

Behavioral biases and stock prices overconfidence and self-esteem maintenance

Dunning-Kruger-Effect Stupidest guy most likely to think he is capable to solve a given problem.
Endowment effect, Loss aversion, Disposition bias reluctance of investors to sell losing stocks, Ambiguity Aversion

Determinants of Behavioral biases Neuroeconomics/ Feelings, Testosterone/ Cortisol level in traders drive risk taking, Oxytocin increases
social altruism.
Markets earn positive returns on sunny days and returns are mediocre on cloudy days.
Behavioral biases and stock prices
Excess Volatility that stock price volatility is far too high to be attributed to new information about future real dividends.

Bubbles Mass irrationality or changing risk aversion/opportunity costs/ information not clear whether bubbles are a rational or irrational
phenomenon:
"Prices are high, risk aversion must have fallen”.
"prices are high, there must be a wave of irrational optimism “.

Can companies exploit mispricing of their own stock?

Market timing theory firms issue equity when prices are too high and buy back securities when they are too low, current capital structure
can to a large extent be explained by past decisions.

low risk anomaly and capital structure

Low risk anomaly high risk equity does not require higher returns, weighted cost of capital can be reduced by increasing equity risk only
when debt becomes risky as well, WACC decreases again.
Reciprocity, Cooperation, Fairness, Altruism vs. Agency Theory, many of prescriptions of Agency
theory do not work well in practice.