Teoria Financial Management II
Teoria Financial Management II
Forecasting earnings
A capital budget lists the projects and investments that a company plans to undertake during
the o i g ea . Fi s fo e ast the p oje t’s futu e o se ue es fo the fi determining the
i e e tal ea i gs of a p oje t. That is, the a ou t hi h the fi ’s ea i gs a e
expected to change.
Earnings and cash flows are not the same. To pass from earnings to cash flows we should add
depreciation and amortization, subtract capital expenditures, and subtract the increase in
NWC. (CashFlow= Earnings + Depreciation + Amortization – Capital Expeditures – Increase in
NWC)
Feasibility Study
Are taxes relevant even if we make losses? Yes, for example, in year 0 the company will owe
$ illio less. The fi should edit this ta sa i gs to the p oje t’s i e e tal ea i gs
forecast.
Investments in plant, property and equipment are a cash expense not directly listed as
expense but a fraction of cost deducted each year as depreciation. Some methods are:
St aight Li e Dep e iatio : Asset’s ost is divided equally over its life ($7.5 million ÷ 5
years = $1.5 million/year).
Modified Accelerated Cost Recovery System (MACRS).
The cash included in NWC is cash that is not invested to earn a market rate of return (non-
invested ash held i the fi ’s he ki g a ou t, i a o pa safe o ash o . Fi s a
need to maintain a minimum cash balance to meet unexpected expenditures, and inventories
of raw materials and finished products to accommodate production uncertainties and demand
fluctuations. Also customers may not pay for the goods they purchase immediately
(receivables). While sales are immediately counted as part of earnings, the firm does not
receive any cash until the customers actually pay. In the same way, payables measure the
credit the firm has received from its suppliers.
Recall sales were 23.500, so if receivables are the 15% of sales, receivables are: 3.525.
Recall COGS were 9500, so if payables are the 15% of COGS, payables are: 1.425.
Indirect effects
1. Project Externalities: There are indirect effects of the project that may increase or
decrease the profits of other business activities of the firm. Cannibalization is an
example, is when sales of a new product displaces sales of existing product. Would
customers of HomeNet have purchased existing Linksys wireless routers?
2. Opportunity costs: The value a resource could have provided in its best alternative
use. Ho e et’s e uipment will be housed in an existing lab, but what is the
opportunity cost of using the space for its best alternative? Renting it out?. Because
this value is lost when the resource is used by the project, we should include the
opportunity cost as an incremental cost of the project.
3. Further... sales, the average selling price, the average cost per unit will vary over time.
Where should we allocate the $300,000 of the feasibility study? This cost is not part of the cost
of the project, we should not include this 300.000$ as part of the cost because is money we
spend to know if the project is good or not, so it’s a sunk cost. If we do the feasibility study we
spe d this ua tit a d it does ’t atte if e do the p oje t o o.
Assume that we have projects with known and certain future cash flows.
How to compare present and future? A euro today is worth more than one tomorrow. There is
the possibility to earn interest. For example, if interest is 10% a year, investing 10 million today
gives 11 million in a year:
The future value in a year of 10 million is 11 million and the present value of 11 million in a
year is 10 million.
The future value is the amount to which an investment will grow after earning interest:
The present value is the value today of a future expected cash flow:
Cash flows: i ediate $ . illio outflo a da i flo of $ illion per year for 4
years. Therefore, if discount rate is r = 0.10, the NPV is 7.2. Discount rate depends on the
riskiness of the cash flows:
NPV investment rule: when making an investment decision, take the alternative with the
highest NPV. Choosing this alternative is equivalent to receiving its NPV in cash today. In the
case of a stand-alone project, we must accept the project if it’s NPV is positi e.
But there are other criteria to decide whether is a good idea to take a project or not. Although
the NPV rule is the most used method there are: the IRR rule, the payback rule, the book rate
of return rule and the profitability index rule.
The internal rate of return of a cash flow stream is the interest rate ry that makes the NPV of a
project equal to 0.
The IRR rule take (r>i) any investment opportunity where the IRR exceeds the opportunity cost
of capital. And turn down (r<i) any opportunity whose IRR is less than the opportunity cost of
capital.
The IRR rule is only guaranteed to work for independent projects if all of the p oje t’s egati e
cash flows precede its positive cash flows. If it is not the case, the IRR rule can lead to incorrect
decisions.
The payback period is the number of periods (years) it takes before cumulative
forecasted cash flow equals initial outlay.
The payback rule says only to accept p oje ts that pa a k i the desi ed ti e
frame.
This method is deficient, primarily because it ignores cash flows after payback period
and the present value of future cash flows. Relies on an ad hoc decision: Which is the
appropriate payback time?.
This rule is typically used for small investment decisions. In such cases, the cost of
making an incorrect decision might not be large enough to justify the time required to
calculate de NPV.
Project Selection
If only one from a set of positive NPV projects can be selected, we should select that with the
largest NPV. When resources are limited, the profitability index (PI) helps selecting among
various project combinations and alternatives:
When projects are mutually exclusive, the firm can only take on one of the projects even if
many of them are attractive. Often this limitation is due to resource constraints. Then the firm
must choose the best set of investments it can make given the resources it has available.
Managers often work within a budget constraint that limits the amount of capital they may
i est i a gi e pe iod. The a age ’s goal is to hoose the p oje ts that a i ize the total
NPV while staying within the budget.
Profitability Index
The profitability index measures the value created in terms of NPV per unit of resource
consumed. After computing the profitability index, we can rank projects based on it. For it to
be completely reliable, two conditions must be satisfied:
1. The set of projects taken following the profitability index ranking completely exhausts
the available resource.
2. There is only a single relevant resource constraint.
Future cash flows should be f o o o e pe ted ash flo s . Example: Expected cash flow
of a project: CF=$100 per year for three years.
Discount rate needs to reflect risk of cash flows and therefore may need to be higher than the
isk-f ee rate:
Discount Rate (r) = Risk Free Rate (rf) + Risk Premium (rp)
Expected cash flows may come from scenario analysis. For example, CF = $100 if:
The return one can receive on similar investments, i.e. bearing same risks!
Ofte alled cost of capital as it easu es oppo tu it ost of fu ds.
Second, incorporate the possibility that it has debt, so there is the need to take into account
cost of debt as well as the cost of equity: We use weighted average cost of capital (WACC) (see
next chapter) .
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Security: the way the firm is financed, it can be debt and/or equity.
This picture shows an overview of how firms are financed. Firms in the top use very little debt
(leverage). The proportional debt in average is low (see the red line).
The objective of this chapter is trying to understand why this differences (why one firm
chooses more debt than another one).
We can see in the graph that, in general, technological firms tend to have less debt. Why? They
have fewer tangible assets and so they need fewer loans. The value of these firms is given by
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intangible assets. Another reason could be that firms in this sector can have very uncertain
cash flows. Firms below the graph (with higher debt) have more certain or stable cash flows.
Firms with more certain cash flows are more likely to be financed.
How I finance my project to maximize the value of the firm? And how I finance my project to
minimize the cost of capital?
Firms are getting money from investors and they have to pay an interest (cost of capital for the
firm and a return for the bank).
If a project is financed with (internal or external) equity and has similar risk as the firm overall
and the firm is unlevered (no debt) use the expected return that equityholders can take
(equity cost of capital) as the cost of capital for the project. That is, use the estimates derived
from the CAPM model.
In many cases firm has both debt and equity. How do we adjust discount rate if the firm is
levered (it has both debt and equity)?
/ + /
NPV = - 800 +
,
= 200M > 0
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The maximum you will be willing to pay is 1000. You can get 1400 or 900 if you buy all the
shares, so in expected terms buying shares can give you 𝑥 + 𝑥9 =$ , but
/ + /
you have to discount it: = $1000. This is the value of the equity.
,
You give Albert $1000M, he uses $800M to invest and 200 is the amount of money he pocket.
That’s h people ha e to i est in positive NPV.
Returns in the good scenario: He pays 1000 and in the good scenario gets 1400, so
−
= 40%
Returns in the bad scenario: He pays 1000 and gets 900, so the return is -10%.
−
General return: = %. It’s ou etu , ut Al e t’s ost of e uit .
If we increase the value invested to 1500, then the expected return decreases and so the cost
of capital decreases too.
I te est ate ill depe d o the alue of the fi . Be ause it’s a isk f ee p oje t, the i te est
rate will be the riskfree interest rate of 5%.
The value of the debt is 500 the face value of the debt is 525 (500x1,05)
At the end of the year, Albert will have to pay $525M for the loan of $500M. We can see that
this is a riskfree investment, because I can pay it for sure getting 1400 or 900.
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EQUITY: What should now be the market value of equity today if you buy 100% of
shares?
Now we have to discount the expected cash flow. How can we find the discount rate?
We ould o side that it’s %, ut it ill e wrong. The real cost of equity is higher, because
whenever you invest in a leverage firm you get more risk. On average you get more dispersion,
so you need to discount more.
The isk of the p oje t is ot the sa e as the isk of e uit e ause it’s a De t + Equity). Here
the discount we should use is 25%.
If you pay 500 for the equity, you get 25% return:
− Value of equity: 25%
Good scenario: 1400 – 525 = 875 Return: = 75%
−
− = 25%
Bad scenario: 900 – 525 = 375 Return: = -25%
Now we can calculate what you are willing to pay for the 100% shares.
1. The value of the firm in Case 1 (only equity) or in Case 2 (both equity and debt) is the
same (1000). And the amount pocket will be the same (200).
In Case 2 it does ’t atte ho the fi is fi a ed that the total alue of the fi has
to be the same. This is true under certain conditions. For example, if debt is 300 and
we know the value is 1000, then using the formula (Value of the firm = Equity + Debt)
we get that the equity value is 700.
What is goi g to e a p o le is a k upt . The , this o lusio o ’t e t ue.
The assumptions here were:
- The value is the maximum investors are willing to pay.
- The e’ e s e a ios e uall likel .
- The e’ e ot ta es. Whe the e’ e ta es it does ’t hold.
2. The cost of capital in both Cases is the same. And the NPV will also be the same.
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What’s the a e age etu i esto s a e getti g i Al e t’s fi ost of apital i Case
? The e’ e t pes of i esto s: a k and shareholders.
- Arbitrage opportunities
- Taxes
- Costs of bankruptcy
- Information problems
- Transaction costs
Then, with absence of this factors, the sum of cash flows to debt and equity holders is constant
(as we have seen in the example above). This is the same as saying that the formula V = E + D
holds (the value is constant).
Proof: Take two identical firms, Unilevcom and Levcom, except for their capital
structure. They exist for a year and produce identical pre-tax profits X at the end of the
year (unknown at the beginning). Unilevcom is unleveraged (no debt) and Levcom has
any given level of leverage (has some debt). Assume that its debt is riskless, at interest
rate rD.Both will generate some cashflows with same probability.
Total and split cash flows are:
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The same cash flows are X. In the case of Unilevcom all cash flows go to equityholders. The
present value will be U (or 1000 in the example seen before).
Lunievcom first pay debtholders, so if debt is D the face value is (1 + rD)D. In this case the
future value of the cashflows paid to equityholders is (X – (1 + rD)D ), and its present value is E.
The result is that it has to be true that U = D + E. That’s hat proposition 1 says.
To see that D+E has to e e ual to U, e a e goi g to see hat ill happe if this does ’t hold.
What if Unilevcom has $100M worth of equity (U) and Lunilevcom has $60M of equity (E) and
$30M of debt (D)?E + D = 90 < 100 = U.
- Buy 10% of equity ($6M) and 10% of debt ($3M) of Lunilevcom
- Sell short10% of equity of Unilevcom ($10M)
- Cash inflow of $1M at the beginning of the year
Receive (buy):0.1[X-(1+rD)D]+0.1(1+rD)D
1rst part of the equation: amount paid to equity holders
2nd part of the equation: amount paid to debt holders. I get 10% of each one.
Pay (sell short):0.1X
In total: 0.1[X-(1+rD)D]+0.1(1+rD)D - 0.1X= 0!!
At time 1 I have 0 risk. Arbitrage opportunity!
Similarly, arbitrage opportunity if D+E > U.
IMP: I do ’t a e a out X, if it’s high I e ei e a lot of o e a d I also pa a lot. If it’s lo I
receive less money but also pay less; the terms cancel each other and whatever the X is, the
result is finally 0.
The WACC (weighted average cost of capital) is always equal to rU (the return equity holders
would make if there was no debt).
r(Pre-tax) WACC = rE + rD = rU
+ +
If the firm has no debt Equity (E) = Assets (A) rE = rA WACC = rA(because if D=0 we
can see in the formula above that rE = rU rE= WACC rA=WACC). So, WACC is equal to the
return of the project.
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We can see that the debt cost of capital is cheaper than the equity cost of capital.
As the fraction of the firm financed with debt increases, both the equity and the debt become
riskier and their cost of capital rises.Because more weighted is put on the lower-cost debt, the
weighted average cost of capital (WACC) remains constant.
Proof:
By holding all debt and equity, we can replicate cash flows from unlevered equity, and as
in portfolio theory:
RE + RD = RU
+ +
r(Pre-tax) WACC = rE + rD = r U
+ +
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Example:
WACC:
r(Pre-tax) WACC = rE + rD = rU
+ +
Capital budgeting
ov r,rM
β=
𝑉𝑎 𝑀
βA= βE + βD= βU
+ +
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where eta of the fi ’s assets easu es the isk of the fi ’s usi ess a ti ities.
βE = βU + (βU –βD)
βE = (1+ )βU
This equation shows how the risk of equity changes with the amount of debt. As debt
increases, it also increases βE.
An example: Ideko is private firm (no publicly trading). Equity betas of comparables of Ideko (3
firms similar to Ideko but publicly trading):
U le e i g the etas
In the picture above, β is aptu i g the isk of the e uit . The capital structure may be
completely different.
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(Table 2)
2) Estimate the average unlevered beta. (We can take an average of the 3 unlevered
betas obtained).
Therefore, unlevered beta should be: βU,I= 1,2 (a number between 1,5 and 0,62).
3) Relever the beta with the capital structure of the firm of interest, to find its equity
beta.
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In this part (b), we add reality to our assumptions. In the real world, people have to pay taxes.
The two results no longer hold. But we can see how the results change in terms of taxes.
We should consider:
- Corporate taxes: entities have to pay taxes, then a part of the after tax income is paid
to investors.
- Personal taxes: For example: investors also have to pay taxes on the dividends
received.
- Cost of bankruptcy
Corporate Taxes:
Without taxes (and without bankruptcy costs, etc.) companies should be indifferent between
debt and equity.
Suppose for the moment that companies are taxed but investors are not (e.g. pension funds).
- Interest payments are tax-deductible while dividends are not. (Interest is considered
as an expense you pay before taxes). Therefore, firms prefer debt to equity.
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As investor is considered anyone who has bought a security in the firm. So, are both
equityholders and debtholders.
One advantage of having debt is that ou’ e a le to give money to your investors
(debtholders) before paying taxes. The o e de t ou ha e, the lo e ou’ll pa ta es.
Another example:
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By increasing the cash flows paid to debt holders through interest payments, a firm reduces
the amount paid in taxes. The increase in total cash flows paid to investors is the interest tax
shield. (The figure assumes a 40% marginal corporate tax rate).
Personal Taxes:
Most investors are taxed when they receive cash.
- Dividends: they pay an income tax (like IRPF) on the dividends. Depending on the
amount they receive they will pay more or less taxes.
- Capital gain: they pay a tax on the benefit they get from selling at a higher price.Ex.
You buy your shares at 5 and sell them at 10 capital gain of 5.You need to pay taxes
o apital gai s. It has a ad a tage: ou do ’t ha e to pay them immediately (they
might be deferred).
- Interest income from debt: they pay an income tax (like IRPF) on the interest payments
they receive.
Typically, capital gains are taxed at lower rates than dividends or interests. For example, the
taxes that equity holders and debt holders have to pay are:
We can see that equity holders compensate their tax payments, so finally:
As a result: TE < TD
Therefore, in the case of personal taxes equity has an advantage over debt.
One can show that cost of capital of the project is then equal to:
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It can then be shown that the levered value of an investment then is:
In this case the discount rate will e lo e . You’ e value of the project (present value) will be
higher, because it will be discounted at a lower rate (now, WACC < rU).
This is the same picture as before, but now with the presence of taxes. We can see that now
WACC is not constant, it’s lo e tha ithout ta es.
- No taxes the value and the returns are the same no matter the debt it has.
- Taxes you can distribute each year more money to your investors and increase
value.
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A o’s Ma ket Value Bala e Sheet $M a d ost of apital ithout the RFX p oje t:
Assume that the project has the same risk as the company overall and that the project is
financed with the same proportion of debt as the company overall (eg. If the company is
financed 30% debt and 70% equity the project will have the same percentages).
COSTS OF BANKRUPTCY
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Direct costs: Legal process of restructuring (court costs, advisory fees, consulta ts… .
On average 2-3% of the assets (firm). Examples: United Airlines had $8,6M per month
for legal and professional services related to chapter 11 reorganisation.
Indirect costs: they may come from different sources:
- Loss of customers: Bankruptcy may enable firms to walk away from future
commitments (support, future upgrades, etc.). When people think a company
is in trouble they stop buying.
- Loss of suppliers: Bankruptcy may enable firms not to pay for inventory. Eg.
Swissaair forced to shut because supplie s efuse to fuel pla es. That’s
because in the moment it has to declare bankruptcy no one wanted to sell to
them.
- Loss of employees: fear of job security. Eg. Pacific Gas and Electric Co paid to
retain 17 key employees.
- Loss of receivables: Debtors might have an opportunity to avoid obligations.
- Fire sales of assets: Companies need to sell assets quickly to raise cash. Firms
end up selling at a lower price, because they are forced to sell.
All this costs mean that the company will have less value, because of the bankruptcy it will
try to have less debt (in order to avoid this costs).
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Westlake wants to borrow $1M for one year from a bank. It has 10% probability of going
bankrupt, in which case assets can be sold for $600.000. Legal costs would be $100.000.
Then, how much interest will the bank charge if it wants an average return of 10%?
If it charge 10%, then it get 10% in 90% of the time but lose in 10% of the time (because of 10%
probability of bankruptcy). What can the bank do?
0,9(1+r)1.000.000 + 0,1(600.000-100.000)=1.100.000
r= 0,166 = 16,6%
Because of bankruptcy, the cost of capital increases. If the firm takes too much debt, the cost
of de t i eases e ause the e’s o e p o a ilit to a k upt.
If bankruptcy is possible ut it does ’t ha e a k upt osts, then the cost of capital would
be lower:
0,9(1xr)1.000.000 + 0,1(600.000)=1.100.000
r= 0,158 = 15,8%
- If no bankruptcy 10%
- If possible bankruptcy (but no costs of bankruptcy) 15,8%
- If bankruptcy costs 16%
The higher the bankruptcy costs, the higher the interest rate the bank will charge to the firm.
SUMMING UP:
- Tax benefits vs. costs of financial distress (bankruptcy) costs: if you have debt you benefit on
taxes but if you have debt, it increases the possibility of going to bankruptcy. Trade-off
theory.
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Optimal leverage:
This g aph sho s the alue of the fi depe di g o the de t it has. The e’ e effe ts:
- If the firm has more debt, it benefit from taxes increase value.
- If it has more debt, increase the probability to bankrupt decrease value.
(increase bankruptcy costs)
The optimal level of debt (that will maximize the value of the firm) depends on the firm itself
(as we have seen before).
The firm with the green line, with high distress costs, has it optimal level in D*high this is the
point that maximizes its value.
AGENCY COSTS
What are agency costs?
Example: The CEO can be seen as an agent of the board of directors, and the board of directors
is the agent of shareholders, etc.
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Here we will talk about shareholder being principal of CEO, they are in an agency relation. And
also, debtholders (banks, people who buy bonds) are principal of CEO and shareholders
(debtholders trust that they will run the company well, hoping that at the end they pay them).
Managers often own shares and are elected by shareholders (insiders). And managers
a i ize sha eholde ’s ealth, so eti es at the e pe se of de tholde s a d e en at expense
of fi ’s alue.
Some examples:
The firm asks for a loan of $1M due at the end of the year. Without any change, market value
of its assets will be $900,000 at that time. Therefore, the firm will default on its loan and go
bankrupt.
The e’ e optio s:
In terms of the NPV is better to do nothing the firm should not change the strategy.
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- If do nothing: 900,000
, , + ,
- If change the strategy: = 650,000
Shareholders care about themselves and have incentives to change strategy and gamble. In
this case, we can see that if shareholders decide to change the strategy they gain, but the firm
and debtholders lose. In this case, sha eholde s take a p oje t that is good fo the ut it’s
bad for the firm and debtholders.
The firm ask for a loan of $1M due at the end of the year. Without any change, market value of
its assets will be $900,000 at that time. Therefore, the firm will default on its loan and go
bankrupt.
We a see that it’s a good p oje t to ha ge the st ateg . The fi i ests , toda a d
gets 150,000 next year.
If so, how to pay fo it e ause assu e that the e’s o ash a aila le ? Ho to fi a e it?
Cash flow (new investor) if it has 10% shares Cash flow (new investor) if it has 100%
shares
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Any rational shareholder will not invest in that firm, so no one will accept to become a
shareholder.
What a out old sha eholde s? Would the e illi g to i est , e t a? No, it’s the sa e
case.
In this problem, if investors put money they lose money. The ones beneficing for this
investment are debtholders. All the money investors put will go to pay the debtholders. This is
a problem called debt overhand problem.
*Debt overhang is the condition of an organization that has existing debt so great that it
cannot easily borrow more money, even when that new borrowing is actually a good
investment.
Therefore, although it’s a good p oje t to ha ge the st ateg , sha eholde s a e ot goi g to
do it, because the value of taking it goes to debtholders.
Renegotiate part of the debt. The firm has to reduce debt claims of debtholders from
1,000,000 to a number that permits that shareholders obtain a return of 105,000. So, the firm
has to reduce the debt in order to induce new investors.
Cash flow (new investor) if it has 100% shares Cash flow (debtholders)
t=0 t=1 t=0 t=1
-100,000 (the money 105,000 - 945,000
he invest) (1Mx1,05)=1,05M –
0,945M = 105,000
The table shows that the firm has to renegotiate the debt in order to reduce the amount to
pay to 945,000. Then, new investors will be willing to invest in the project. Doing this we
solve the problem.
We can see that the sum of what the firm pays to shareholders and what it pays to
debtholders is equal to the value of the firm making the project:
Conclusion: if the firm is in trouble may find it difficult to finance itself, although the NPV is
positive. Solutio : Do ’t ha e so u h de t.
- Cashing out: Incentives to withdraw money just before default (Eg. Sell assets
below market value and use funds to pay immediate dividend).
- Short-sighted investment problem: Tendency to take up projects that pay up
early. You take projects that pay early (and you can pay them as a dividend),
instead of paying them in the future (that maybe will give the firm more
profitability).
Ex-post, le e age a e ou age i side s to take a tio s that i ease sha eholde ’s alue ut
edu e de t a d fi ’s alue Over-investment). As debt holders are the once bearing the
costs, ex-ante, the o ’t be willing to pay in debt issuance (cost of debt higher). Therefore, it
would be less money to distribute to shareholders.
Separation of ownership and control: Managers own small fractions (median: 0,25%), they are
rarely dismissed, but control the corporation. Why do we use them, then?
Managers care about investors (equity and debt holders), customers and suppliers, employees
and themselves!
Can debt help with this potential interest conflict? Yes. Increasing the level of debt will solve
these problems. Debt is going to put some pressure to the manager to behave well (he will
ake the possi le to i ease assets a d so, i ease ash flo s to pa de t a d do ’t
undertake negative NPV projects). If not, the CEO will try to decrease debt to have less
pressure.
Another advantage: if you increase debt, then it also increases the monitoring (undertaken by
a ks, i esto s… .
Leverage:
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The free cash flow hypothesis: wasteful spending especially if large FCF available.
Reasons that push firms to increase debt (situations in which is considered that the firm has
too little leverage):
Reasons that push firms to decrease debt (situations in which is considered that the firm has
too much leverage):
- Firms with intense R&D have high R&D costs and future growth opportunities.
Current free cash flows may be low, because they have to do a lot of capital
investments. They have risky business strategies. Low debt levels.
- Low-growth/mature firms have stable cash flows and tangible assets. Here
managers may misbehave the cash flows and engage to negative NPV. High
debt levels.
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ASYMMETRIC INFORMATION
Asymmetric information: parties have different information. For example, managers have
superior information than investors rega di g fi ’s futu e ash flo s.
Credibility Principal: O e’s self-interested seems credible only if they are supported by actions
that would be too costly if the claims were untrue.
In order to signal quality, managers have an additional incentive to increase their debt ratio. If
firm has good quality, it will have no trouble to paythe debt interests. If not, the financial
distress and costs will be higher for the firm.
For the signal to be credible is important that firms in bad shape cannot mimic behaviour of
good firms, but indeed high debt ratio is costly for bad firms.
- Adverse selection: buyers and sellers have different information. The average
quality of the assets in the market differ from the average quality overall.
- Lemons principle: seller has private information about the good’s alue.
Buyers are willing to pay less due to adverse selection.
Selling Equity
Firms that sell new equity have private information about the quality of the future projects
the e’ e i e ti es to issue e uit he sto k is o e alued. The efo e, buyers might only be
willing to buy the new equity at heavily discounted prices.
I side s’ jo is to o i e i esto s that the e’ e othe easo s to sell e uit , as illi g ess to
diversify or need of cash to fund new positive NPV investments.
35
Firms with more retained earnings use less debt not because of lower optimal debt ratios but
because of asymmetric information external financing is more costly.
1. With perfect capital markets fi ’s apital st u tu e alte s the isk of the e uit , ut
not its value or the amount raised from outsiders.
2. Optimal capital structure depends on imperfections:
- Taxes: Interest tax shield allows repayment without paying corporate tax. Each
dolla of pe a e t de t gi es pa e t o th .
- Bankruptcy: Too much leverage might lead to bankruptcy and its associated
costs.
- Agency costs: Too much debt can induce excessive risk-taking or
underinvestment, but with high free-cash flows too little might lead to
wasteful spending.
- Asymmetric information: Increasing leverage can be used to signal confidence
in the firm. Leverage is better than equity to deal with adverse selection.
36
We can see that Hertz made a lot of money trough debt securities ($11.123,9). They used both
public and private debt.
A term loan is a loan that the bank gives to the company and lasts for a specific term.
A revolving line of credit is a particular type of loan; a company asks for a line of $200, but if
they only spend $130, they only have to pay interest on that $130. By contrast, if you ask for a
term loan of $200 you will have to pay interest on the whole amount of money even if you
had ’t used all.
An asset- a ked fleet de t is a loa i hi h if the o pa does ’t epa a k the o e ,
they have the right to charge the money by acquiring assets of the company (in the case of
Hertz, with cars). Those assets are called collaterals (avals).
37
Example: A $1000 bond with a 10% coupon rate with semi-annual payments, pay coupons:
$1000 x 0.10 / 2 = $50 every 6 months.
Types of bonds
Registered bond: a bond in which the Company's records denote ownership, and in
which interest and principal are paid directly to each owner.
Bearer bonds: the bond holder must send in coupons to claim interest and must send a
certificate to claim the final payment of principal. Example: years ago the bond holder
had a paper with the coupons printed and he had to cut and send it in order to receive
the payment.
Tranches: Different classes of securities that comprise a single bond issue. All classes of
securities are paid from the same cash flow source. (See Hertz example below)
Seniority: Indicated the order of priority when debt has to be paid: A senior bondholder is paid
first, in contrast, a junior debt holder has a lot more risk.
Most debenture issues contain clauses restricting the company from issuing new debt with
equal or higher priority than existing debt.
Hertz Junk Bond Issues: Here we can see 3 tranches with different conditions. For instance, the
subordinated Dollar-Denominate Note is a Junior Note, and by this they demand higher
interest due to the risk they carry (10,5%).
38
Repayment provisions: The issuer can repurchase a fraction of the outstanding bonds in the
market or make a tender offer for the entire issue. For callable bonds, exercise the call
provision.
Callable bonds: Issuers have the right (but not the obligation) to retire all outstanding bonds
on (or after) a specific date (the call date), for the call price (a certain price specified on the
bond contract). This property affects the price of the bond.
International bonds
Domestic Bonds: Issued by local entity and traded in local market, but purchased by foreigners
(in the currency of the country).
Foreign Bonds: Issued by a foreign company in a local market and intended for local investors.
Example: an American company issuing a bond in Europe.
They are denominated in the local currency.
- Yankee bond: a bond sold publicly by a foreign company in the US. Example:
Telefonica selling a bond in the US market.
- Samurai: a bond sold by a foreign firm in Japan.
- Bulldogs: foreign bonds in the United Kingdom.
Eurobonds: Not denominated in the local currency of the country in which they are issued.
Global Bonds: Bonds that are offered for sale in several different markets simultaneously.
Revolving Line of Credit: credit commitment for specific period (2, 3 years) that can be
used as needed. Gives a lot of flexibility.
Private Placements: Bond issue sold to small group of investors rather than the general
public.
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- Treasury bills: zero-coupon bonds with maturities up to 26 weeks (less than one
year).
- Treasury Notes: semi-annual coupon bonds with maturities 2 to 10 years
- Treasure bonds: semi-annual coupon bonds with maturities > 10 years
- Long Bonds: those with longest outstanding maturities (now 30 years)
- TIPS (Treasury-Inflation-Protected Securities): inflation-indexed bond (the
outstanding principal is adjusted for inflation)
Part (c): Risk-free Bond Valuation
Yield to maturity = cost of debt = expected return debt holders will make on the debt
If the bond becomes less attractive, the price will be lower and so the YTM higher: negative
relation between the price of the bond and the YTM. It applies both on the private and
secondary market.
YTM: unique implicit discount rate r that makes the bond cash flows has the value at its
current price.
For a risk-free (safe) bond: YTM = r = IRR (The Internal Rate of Return) of investing in the bond,
given its current price.
Zero-coupon bonds
The do ’t pa oupo s oupo ate = , ou o l get the fa e value at the maturity date) and
therefore are always sold at a discount (lower price than the principal), and are also called
pure discount bond. Example: Treasury Bills of the U.S. government.
Example: A safe bond without coupon with $ 100,000 of principal has a price of $ 96,618.36.
The cash flows and the YTM is:
FV
P=
+ YTM ^n
Since it is a safe zero-coupon bond that gives an interest without risk in that period, YTM must
be equal to the risk-free interest rate IRR = YTM if safe, and YTM = irisk-free if safe and zero –
coupon.
What if not? Arbitrage opportunity.
Coupon bonds
These bonds pay, in addition to the principal, coupons. Examples of these are the treasury
notes and bonds.
Price of a bond with CPN annual coupons maturing in n years is:
The advantage of using YTM is that it does not depend on the principal (to solve this prices are
often given in percentage of the principal (face value)).
40
What is the difference between yield to maturity and the coupon rate?
- A bond's coupon rate is the actual amount of interest earned on the bond each year
based on its face value. The coupons are fixed; no matter what price the bond trades
for, the interest payments always equal $X per year.
- A bond's yield to maturity is the average rate of return based on the assumption it is
held until maturity date and not called. YTM is a complex but accurate calculation of a
o d’s etu i ludes the oupo ate that helps i esto s o pa e o ds ith
different maturities and coupons. There is a different YTM for every year to maturity.
Why bonds traded at a discount have CPN < YTM? Because at a discount means that the face
value is greater that the price of the bond (as 90 --- 100) and so, the YTM is higher than the
coupon rate.
Can zero-coupon bonds trade at a premium? No, without coupons this cannot happen (100 ---
90).
Coupon rates are often chosen so that bond trades initially at par.
Example
Zero coupon bond with YTM of 5% and FV of $100:
Value (price):
Notice that buying for $ 23.14 and selling to 29.53 after five years, IRR is:
The return still 5%, so the YTM is also the return you get from buying and selling the bond.
41
Why the changes of non-zero coupon bonds are not smooth? Be ause the do ’t ha e
coupons.
What happens if the YTM changes? If interest rates change in the economy:
- Rates that investors demand for investing in bonds also change.
- The price of the asset in the market also changes.
Example
Zero coupon bond with YTM of 5% and FV 100.
Value:
42
Similarly, bonds with higher coupon rates are less sensitive to changes in interest
rates because they pay more upfront, and so, lower coupon bonds are more
sensitive.
Duration of a bond: It is a measure of the price sensitivity to changes in interest rates (YTM).
And measures how long, in years, it takes for the price of a bond to be repaid by its internal
cash flows = average number of years of the discounted cash flows.
- Zero-Coupon Bond - Duration is equal to its time to maturity.
- Coupon Bond - Duration will always be less than its time to maturity.
43
With a zero-coupon bond and no probability to default, the YTM = risk free rate
(expected return).
2) Certain Default (default for sure): the issuer will pay 90% of obligation. Here we know
for sure that the face value is going to be 900, so we calculate the price using 900
YTM higher than the expected return: . We see that here the YTM is different
from the expected return (15% vs. 4%).
With the possibility of default (for sure or not), the YTM is difference expected return.
However, notice that lower YTM do not imply lower expected return! Compare this example to
the previous example where the return was 4%.
Bond ratings
44
CALLABLE BONDS: the company may call the bond back giving you a certain payment.
Issuers (for instance, firms) have the right (but not the obligation) to retire all outstanding
bonds on (or after) a specific date (the call date), for the call price.
If interest rates in the market have gone down by the time of the call date, the issuer will be
able to refinance its debt at a cheaper level and so will be incentivized to call the bonds it
originally issued in order to resell it at a higher price. Another way to see this is that, as
interest rates go down, the price of the bonds goes up; therefore, it is advantageous to buy the
bonds back at par value.
This is comparable to selling an option: the option writer gets a premium up front, but has a
downside if the option is exercised.
Prices of callable (at par) and non-callable bonds prior to call date
45
Suppose that this is a 20-year 5 coupon bond and the call time (when the bond can be called)
at par is in year 5:
We are interested in the yellow line (because it is the one that shows the payoffs of our 20-
year callable bond) and we will compare it with a 20 year non-callable bond and 5 year non-
alla le o d oth ha e the sa e % oupo . If it has a highe du atio it’ll e o e
sensitive (the line is stepper).
- If the yields are very high (9% a 10%) this bond is not going to be called (right side
of the g aph , that’s h the p i e ill e si ila to the -years non-callable
bond.
- The firm will call the bond if the yields are lower than 5%.
Convertible bonds are corporate bonds with a provision that gives the bondholder an option to
convert the bond into a fixed number of shares of common stock. The number of shares you
would get in exchange is previously stipulated.
Conversion Ratio: The number of shares received upon conversion of a convertible
bond, usually stated per $1000 of face value.
Conversion Price: The face value of a convertible bond divided by the number of
shares received if the bond is converted.
Example
You have a convertible bond with a $1000 face value and a conversion ratio of 15: If you
convert bond into stock, you will receive 15 shares.
If you do not convert, you will receive $1000
- B o e ti g ou esse tiall pa $ fo sha es, i pl i g a o e sio
price per share of $66.67 1000/15 = 66,67
46
- If the price of the stock exceeds $66.67, you will choose to convert; otherwise, you
will take the cash.
Convertible Bond Value
The higher the stock price, the higher the value for the share and also the higher the value of
the bond, because this bond in convertible in shares.
By holding this type of bond you will always get the best of the two, and whether you convert
or not will depend on the shares price.
These bonds are more attractive and so more expensive to buy. It is also similar to a call option
for the buyer of the bond.
We assume that we are 1 minute before maturity and we can exert this convertible option
the payment of our bond in the maximum of the blue and the red lines.
- If e do ’t e e t the optio e ill e ei e the red payment which is the FV =
1000. Otherwise, the payoff of the blue line depends on the share price.
- Whether we convert or not will depend on the share price of that moment.
47
Personal funds: when somebody starts a company it usually begins with personal
fu ds. It’s diffi ult to o tai a loa f o the a k he the e t ep e eu has o l a
project.
Equity capital
Debt financing
Other creative sources
FRIENDS AND FAMILY: friends and family are the second source of funds. They often give
loans or do investments with mild conditions but they also make gifts. Sometimes there is no
compensation for this loans or the compensation is delayed. And in case of a rent, it is usually
free or reduced.
BOOTSTRAPPING METHODS: these methods consist of finding ways to avoid the need for
external financing or funding through creativity, ingenuity, thriftiness (ahorro), cost-cutting or
any means necessary. For example, some of these methods could be: buy used instead of new
equipment, coordinate purchases with other businesses, lease equipment instead of buying,
obtain payments in advance from customers, avoid unnecessary expenses, minimize personal
expenses, share office space with other businesses and apply for obtaining grants
(subvenciones).
BUSINESS ANGELS
Business angels are individuals who invest their personal capital directly in small start-ups with
positive perspectives. They are typically about 50 years old, with high income and wealth, well
educated and they usually have succeeded as entrepreneur. The number of business angels
has increased over the past decade.
48
VENTURE CAPITAL
Venture capital firms invest in start-ups and small businesses with exceptional growth
potential. There are much fewer entrepreneurial firms in comparison to business angels. These
types of firms look for big successes so they reject the majority of the proposals they consider.
If a venture capital invests in a company which later goes public, it will earn lots of money.
Venture capital firms are limited partnerships that raise money in funds to invest in start-ups
and growing firms. The funds are raised from wealthy individuals, for instance. In the US there
are lots of venture capital firms, but there is much less activity in Europe. The few activity of
venture capital firms in Europe is mostly in the UK and Holland, whereas in Spain the activity is
very little.
The IPO is the o pa ’s fi st sale of sto k to the pu li . Whe a o pa goes pu li its sto k
is traded on one of the stock exchanges (bolsa de valores). This usually happens when a firm
has demonstrated it is viable and has a bright future, then the market values the firm for the
first time.
This is a complicated and expensive process usually done by successful firms and it is usually
necessary to hire and investment bank that acts as an advocate and adviser and walks a firm
through the process. This investment bank is the one who establishes an initial valuation of the
sto k ased o the fi ’s p i ate i fo atio a d it also fi ds out the investors willingness to
pa . T pi all the e is a oad sho that is a tou of eeti gs of the fi ’s top a age e t
with investors where the firm presents its business plan and tries to know the willingness to
pay of these potential investors.
The higher the stock price the better to the firm because they raise more money. But the price
should ’t e too high e ause if it is the ase i esto s ould ’t u these sto ks.
REASONS TO GO PUBLIC
Reason 1: is a way to raise equity capital to fund current and future operations (cash
needs).
Reason 2: a IPO aises a fi ’s pu li p ofile aki g it easie to att a t high-quality
customers, alliance partners and employees (marketing).
49
Reason 3: an IPO is a liquidity event that provides a means for a company shareholders
to cash out their investments (hacer líquidas sus inversiones).
Reason 4: by going public a firm creates another form of currency that can be used to
grow the company.
Shareholders prefer a public firm because of flexibility, if a company is public it’s easie
to buy and sell stocks.
SHARES
New shares: the money goes to the Old shares: the money goes to old
company. shareholders and they cash their
investments.
This consists of and already traded firm that issues new shares. Market values are already
established so placing these securities is generally less difficult than an IPO since there is less
asymmetric information (investors already know the company).
Types of SEOs
Payout policy
Free cash flows can be retained or handed back to shareholders by paying dividends in cash or
buying back shares. Dividends can be regular cash dividends or special cash dividends. And the
buying back of shares can be a purchase directly from the market, a purchase at a fixed price
offered to shareholders (tender offer) or through private negotiations (greenmail).
Tender offer (oferta pública de adquisición: OPA): is a market operation by which a person or
entity offers to the shareholders of a company to buy their shares at a price higher than the
market price to achieve a majority stake in the company. This transaction can be done with the
50
The first time Microsoft returned money to its shareholders the company did a repurchasing of
shares, later on, it started to pay dividends. Share repurchases: 5.4bilions per year on average
from 1999 until 2004.
Dividends:
- Sta te di ide d of $ . pe sha e i .
- One-time dividend of $3 per share (total $32b) in 2004 (extraordinary dividend).
Four year plans from 2004:
- Repurchase $30b of its stock
- Pay regular annual dividends of $0.32 per share (not compulsory but shareholders
expect them).
When a firm issues shares it is important to decide how much money is it going to return to
shareholders. For debt the returning was compulsory but regarding shares the firm can decide
how much it wants to retain and how much it wants to pay out.
51
Example: Genron
No debt.
Expected cash flows: 48 million per year indefinitely.
The cost of capital (unlevered) is 12%.
10 million shares outstanding.
20 million i e ess ash i the ea futu e.
Market value of equity: E = (48m/0,12) + 20m = 400 + 20 = 420 million (This is the
value of the equity and in this example it is also the value of the firm because there is
no debt).
How to pay back the 20 million? And the rest of cash flows?
OPTION 1
Value of a share: P =
420m/10million of shares = €
(price per share).
¿What is the price of the share once the dividend of 2 Euros has been paid?
52
P = 4,8/0,12 = € (price per share). The share price will go down by the exact value of
the dividend.
The price before the dividend should be higher and at the moment this dividend is paid the
share price will go down by the exact value of the dividend.
¿What is the price of the share a minute efore re ei i g the regular di ide d of 4,8€?
In the previous
graph we can
observe the oscillation
of the share price due
to dividends,
as we can see the
variations are very
similar to the ones
of the bonds
with the coupons.
Cum-dividend Ex-dividend
Cash 20 0
Other assets 400 400
Total market value of assets 420 400
Millions of shares 10 10
Share price € €
, , ,
𝐏 𝐢 𝐢 𝐬= + + ,
+ +⋯ = + = 𝟒𝟐€
+ , ^ ,
,
𝐏 𝐱 𝒊𝒗𝒊 = ,
= 𝟒𝟎€
53
OPTION 2
The firm has 20 million that are going to be used to repurchase shares in the open market and
then burn them. In the future, there will be pay out cash generated through regular dividends.
The only difference is that at time 0 the firm is going to repurchase shares instead of paying a
dividend. How many shares the firm will be able to buy?
Now there are less shareholders, reducing the number of shares they push up the dividend per
share:
P = 5,04/0,12 = € (price per share). The share price will go up and down by the exact
value of the dividend: 42 + 5.04 = 47.04€
Suppose your name is Stanley and you own 2.000 shares of the company. What would you
prefer? Option 1 or Option 2? (The first option is more liquid).
54
From option 2 Stanley can create homemade dividends and get exactly the same profile as in
optio → C eatio of the ho e ade di ide ds: sell sha es a d get € * €/sha e) in
cash. The the ould ha e €i ash a d . i sha es * €/sha e).
OPTION 3
Suppose the firm wants to pay more than 2$ per share, for instance, suppose it wants to pay
48$ million in dividends in year 0. So the firm needs 28$ million extra to achieve its purpose.
How can the firm raise this extra money? They can issue new stock or borrow money.
. . $= €*X
X = 666.666,66 shares.
Now the firm will have 10.000.000 + 666.666,66 = 10.666.666,67 shares outstanding.
. . €/ . . , = . €
Cum-dividend Ex-dividend
Share price P= , €+ , / . = € P= , / . = , €
55
Modigliani-Miller theorem
The choice of paying dividends or repurchasing of stock is irrelevant for shareholders in the
absence of (perfect capital market):
Arbitrage opportunities.
Taxes.
Transaction costs.
Agency costs.
Information problems.
And if the investment, financing and operating policies are held fixed: the firm knows
how much to redistribute.
Effects of Taxes
Remember that companies pay corporate taxes on earnings, that dividends are taxed
as ordinary income and that capital gains are usually taxed at a lower rate. We
understand capital gains as the taxes paid when repurchases are made.
Still, tax rates differ according to income level, income horizon, tax jurisdiction and
type of investor account.
Investors have different preferences.
56
There is no difference between pre-tax distribution through stock repurchase or dividends. But
dividends pay more immediate taxes (higher rate and all gains are immediately taxed). Future
tax liabilities are lower for dividends because capital gains will be lower. However, the total
amount paid in taxes (and its present value) will be higher for dividends.
Usually repurchases have more advantages than dividends. But paying dividends has also some
advantages, for example, dividends have lower transaction costs. Tax-exempt shareholders
may prefer dividends because of the transaction costs of repurchases (brokerage fees →
charged for services such as negotiations, sales, purchases, delivery or advice on the
transaction , registration costs...).
There might be clientele effects: investors have some preference over company's policies, such
as payout policies. For instance, some investors may prefer the firm to pay dividends, so they
will invest in the firms that take this policy. While some other investors may prefer the firm to
epu hase. A o pa ust hoose poli ies to satisf i esto ’s eeds, othe ise i esto s
may sell their shares. In other words, investor's preference is an important factor in
determining firm's payout policy, which in some sense is a deviation for the MM theorem.
A company's stock price will move according to the demands and goals of investors in reaction
to a tax, dividend or other policy change affecting the company. The clientele effect assumes
that investors are attracted to different company policies, and that when a company's policy
57
changes, investors will adjust their stock holdings accordingly. As a result of this adjustment,
the stock price will move. It can be that investors choose which company to invest depending
on their dividend policies.
Shareholders can be individuals or corporations (for instance, La Caixa and BBVA are investors
of Telefónica). Individual shareholders pay less taxes if there are stock repurchases than if
there are dividends. But for firms this is the opposite: corporations that hold shares of other
corporations may prefer dividends because they are taxed at a lower rate. This is why
companies like Telefónica do stock repurchases and also dividend policies. So as we can see,
the type of shareholders a company has, affects their decisions. In theory, the company looks
for what is better for its shareholders, but actually, managers change very little the dividend
policy to please the shareholders of the company.
In principle, firms that pay a lot of dividends is because they have investors unaffected by taxes
or that the majority of their shareholders are firms. But in reality, the company does not adapt
much, is the shareholder (individual or firm) who chooses the company to invest in.
What do a firm does with the cash available? 1. If the firm has cash available an there are
projects with positive NPV the firm must invest in them (and we should ask for money to invest
i those p oje ts if e ha e ’t got e ough!! . 2. If there are not projects available or after
investing in some projects there is still excess cash, the firm must pay out, hold the cash or buy
fi a ial assets → What should the firm do? → i pe fe t apital a kets this should ot
matter (MM). In theory, it is the same, the value for the shareholders should be the same.
But maybe the conditions of this theorem (MM) do not apply. For instance, there could be
bankruptcy costs. If this is the case, the firm should accumulate some cash to avoid problems.
Specially if the cash flows of this company are very volatile. One reason in favour of paying out
the excess cash is that, maybe, if the company keeps this cash there is a temptation to waste
this money.
58
Retain
Advantages Disadvantages
Cash available to Agency costs:
cover future management may
investments (R&D use fund inefficiently.
projects,
acquisitions..).
Avoids direct and
indirect costs of
raising external
capital.
If earnings are
volatile this can help
to avoid bankruptcy
and its costs.
Which companies will keep more cash? You will have to decide depending on the type of
firm:
- Startups will tend to retain the earnings as they are growing.
- Stable and mature firms will tend to payout.
59
It may be that earnings are very volatile, but dividends are quite stable. When a company has
to lower dividends, the decrease is stronger that the increase (which is more gradual).
Companies know that any change of the dividends will affect the price of the share a lot.
How does the market react to payout policy announcements? When a firm announces some
change in the payout policy the price of the share changes when the announcement is made
(not when the real change is made).
SOME EXAMPLES:
Initiation of quarterly dividends: Starting paying dividends push the share price up.
An increase in dividends: Increase of the share price (on average 2%).
Omission of a dividend: Share price goes down on average by -9.5%.
A repurchase of share with tender offer (a lot of shares): Share price goes up a lot
(+16%).
A repurchase of share at the open market (less amount of shares repurchased):
Share price goes up but only 3% on average.
What do managers maximize? There are two type of values: intrinsic value and perceived
value. If you are a short-term shareholder, for you, the market value (perceived) is important.
If you are a long-term investor, you care about the intrinsic value (the real value). There are
decisions that increase or decrease both values, and these decisions will be easier to take. But
there are some decisions that increase a value and decrease the other one...
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Implicit assumption:
A CEO owns 20.000 shares and he plans to sell 10.000 in the near future and hold 10.000
indefinitely. He has a fixed salary and he does not have any previous concerns. He will weight
u e t a d i t i si alue e uall , a d a edu tio of € i i t i si alue eeds to e
compensated with an increase 1$ in current value.
This model tries to capture the idea of asymmetric information and the idea that managers
manipulate dividends to pretend to be of high quality.
61
Usually operating cash flows cannot be fully observed, if investment expenditures and
di ide ds a e o se a le, these ope ati g ash flo s a e dedu ted.
If dividends are higher than expected it could be because operating cash flows are higher (this
would be a good new about the company). But it could be that dividends are higher because
i est e t e pe ditu es a e lo e ed → this ould e a ad e . Doi g this, the o pa
pretends to have higher operating cash flows to simulate being better.
If a manager has incentives to maximise the intrinsic value then he will pick up the optimal
investment level. If this manager wants to maximise the perceived value he will invest less and
increase the dividends.
Suppose that management gives same weight to intrinsic and perceived value
If the company chooses option 3 instead of option 2 investors would not know if operating
cash has increased (good) or investment has decreased (bad because long term value will be
lower).
62
SUMMARY
A manager with equal weight for short and long term value will choose option 2.
Market correctly inferred that the firm would choose this option.
If they had unexpectedly paid more dividends investors would have incorrectly
believed that the firm had better than expected cash flows.
We are going to study 4 methods used by a firm when it has to decide to take a project or not:
Essentially, all methods compute cash flows and discount these cash flows, but in different
ways.
Method 1 and 2 discount free cash flows (FCF), and give you the value; method 3 discounts the
free cash flow equity (FCFE), and give you the NPV; and method 4 discount the capital cash
flows, and give you the value.
Other methods:
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The Unlevered Net Income, also alled Nopat, it’s diffe e t f o the et i o e u le e ed
et i o e does ’t ha e i te est . U le e ed et i o e is the i o e that the fi ould
ha e if it did ’t ha e de t.
The free cash flow (FCF) is after-tax flows generated from operations, without taking into
a ou t the de t st u tu e. I othe o ds, it’s the h potheti al ash flo s that ill go to
shareholders if there was no debt.
Unlevered net income can also be computed by adding back the afte -ta i te est to the Net
income.
ASSUMPTIONS:
1) Project has average risk. This means that the project itself has the same risk as the
company as a whole P oje t’s ost of apital is ased o the isk of the fi .
2) D/E and D/V (where D is net debt) is constant: that means that the ratio debt to
equity or debt to value of the firm is constant.
o The isk of e uit a d de t a d WACC does ’t ha ge.
o The firm will need to adjust continuously its leverage.
o The percentage is a choice of the firm.
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3) The corporate tax is the only imperfection. E.g. We assu e that the e’ e eithe
financial distress (bankruptcy) nor agency costs.
As we saw earlier,
Net debt:
Enterprise value:
Enterprise Value = Equity + Net Debt = Equity + Gross Debt – Cash, or market value of non-cash
assets.
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Now, we can calculate the NPV, which is what you get from the project minus what you have
to pay.
Steps:
The value of the firm (assets) will increase by 61,25 (the present value).
The new project will generate more assets in the future increase the value of equity.
Therefore, once the firm implements the project, the value of the assets will increase.
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Total assets: 620 + 61,25 = 681,25 Total liabilities 620 + 61,25 = 681,25
+ equity
The loan gives as money (it goes in debt because we have to pay it). The loan is of 30,625 but
the firm has to pay the initial investment of the project, then:
30,625 – 28 = 2,625 The firm can keep this money as cash. However, with this option the
proportion would ’t e the a o ded o e / . So, the fi ould pa it as a dividend.
It’s i po ta t to k o that hat sha eholde s get f o a p oje t is the NPV. That’s h fi s
may choose positive NPV, and the higher the value more benefits to shareholders.
OPTION 2: An alternative to increase debt by 30,625 could have been reducing cash to 0 and,
instead of asking for a loan of 30,625 now we ask for a loan of 10,625 (because we have
reduced 20 cash and so, we need to cover the 10,625 left with debt).
We have to continue financing new investment with net debt = 50% of their market value (D/V
= ½)
The market value have increased by 61,25, hence we need to increase net debt by 30,625.
That’s e ause e ha e to keep the p opo tio : D/V = ½
D/ 61,25 = ½ D= 30,625
Uses of funds: we pay the initial investment of 28 and pay the rest to shareholders (30,625-
28=2,625) together with the increased equity value of 30,625. In total:
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DEBT CAPACITY
Defi itio : It’s the a ou t of et de t Dt to have constant so that target ratio is constant. In
othe o ds, it’s the e t a a ou t of de t that ou eed to take fo the p oje t.
t
Dt = d x VLt or d =
𝑉𝐿
Where d is ta get atio a d VLt is leveraged value at time t (remember that VL0 is
o ti uatio alue, ot NPV . I optio e a ple d as ½, a d Dt was 30,625.
Notice that leverage value will change over time, therefore the amount of debt would also
change.
To obtain the levered value in each year: In year 0 we have to discount the free cash flows of
the 4 following years. In year 1, we have to discount the free cash flows of the 3 following
years (2, 3, 4). In year 2, we have to discount the FCF of the following 2 years (3, 4). At year 3
we have to discount the FCF of year 4. Finally, in year 4 V4L is e ause the e’s o futu e fo
the project.
We calculate debt capacity with the formula: D/V = ½ D = V/2. As we can see in the table,
debt capacity is half of the levered value.
As the alue ill go do , de t should go also do to ai tai the ta get atio . That
ea s that e ha e to pa pa t of the p i ipal. The efo e, the fi do ’t pa the principal
o e o ti e, as it’s likel ith o ds. He e it keeps pa i g it as ti e goes . A d, the fi
needs cash to cancelling debt (this additional debt because of the project). This has an impact
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on the amount of interest that you need to pay. It will change over time, because it depends
o the a ou t of de t. That’s ho o tgages o ks you keep paying part of the principal
over time and then your interest also goes down.
It can be shown that it is valid to use this equation even if there are taxes as long as company
adjusts to a target debt level.
In this case, we take into account the advantage of taxes separately e do ’t i lude it i the
formula of ru).
If we keep a constant leverage ratio, the tax shield has a similar risk as the project as a whole
discount with the unleveraged WACC.
EXAMPLE RFX:
rU = 𝑥 %+ 𝑥 % = 8%
+ +
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Value added
of tax shield
Steps:
Compute the cash flow available for equity holders (FCFE), taking into account:
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Here we find the actual net income, not the unlevered. So, we need to add Interest Expense
and Net Borrowing.
We calculate the net borrowing with the calculation we have obtained before of Dt:
Once we have the FCFE, we can discount using the cost of equity capital to find the added
value to shareholders (=NPV):
This method gets us directl the NPV ho u h sha eholde s e efit of the p oje t . It did ’t
give us the value.
The NPV it’s , M. If the fi a ts to see the alue of the p oje t e ha e to add the i itial
investment of 28.
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From discounting FCFD with cost of debt capital, we can compute the debt value:
From discounting FCFE with cost of equity capital, we can compute the equity value:
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73
𝐸 𝑖 𝑦
𝑆ℎ𝑎 𝑒 𝑃 𝑖𝑐𝑒 𝑃 º ℎ𝑎 𝑎 𝑖 𝑔 𝑒 𝑖
𝑃𝐸𝑅 = = = 𝑖 =
𝑎 𝑖 𝑔 𝑒 ℎ𝑎 𝑒 𝑃𝑆 𝑒 𝑖 𝑐 𝑒
º ℎ𝑎 𝑎 𝑖 𝑔
Assuming constant
growth of dividends:
Then, to calculate the firm value: (EBIT of the firm) x (V/EBIT of similar companies).
Assuming constant growth of free cash flows:
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*Firms want to have the lowest possible working capital to be able to use the cash for other
things that give them some benefit.
Steps:
Enterprise Value = Equity + Net Debt = Equity + Debt (gross debt) – Cash (excess cash) = 150m
+ 4.5m – 6.5m = 148m value of the firm (148) < value of equity (150), due to the negative
net debt.
Conclusion: still paying 148 (a lot more than the book value of Ideko), the multiples look similar
to the
closest competitors, and this is an indication that buying Ideko would probably be a good
investment for PKK.
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The previous table shows that Ideko owner wanted to reduce the amount of receivables and
raw material (inventory), and keep more or less the same amount of cash and finished goods.
In the following table we can see that net working capital decreases in 2006 in respect to 2005,
and this is due to these changes, but notice also that, on the following years, net working
capital will constantly increase.
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We plan to increase leverage by borrowing a 100M loan in 2005, and this debt will have an
interest rate of 6.8%.
In addition the company will need more funds in 2008 and 2009 because of the expansion (the
big investments previously seen): in those years we ask for 20 million more.
At time 0 PKK needs to pay 53M. We need to go from earnings to cash flows and then discount
it.
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We need to add back the interest tax but discount the tax shield: to do it simple we add the
after tax interest expense.
We can observe a negative FCF in 2009 (the year of the biggest investment). Also in 2008 we
have an increase in the net borrowing of 15.000 (we have increased the debt by 15 M and 5
o ei . I o pa iso to hapte , he e e do ’t a el the de t, a tuall e i ease
it.
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Estimating the cost of capital: Based on the CAPM of comparable firms, because Ideko is
unlisted.
Remember: B expresses the correlation between earnings and changes in the economy.
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BU is the risk of the risk itself without the risk coming from the debt.
BD = 0 means 0 probability of bankruptcy: how risky the debt payments are.
If we wanted, from BU we could relever and get BE for Ideko.
Now I can discount the cash flows. It’s i po ta t to k o that this fo ula o ks also fo BE,
and then gives us the rE.
Multiple method to estimate continuation value What happens to the value of the firm in
2010?
Recall that we could use different multiples and get different values in consequence.
Here we assume some growth (g): If sales grow at a nominal rate g and if the proportion of
operating expenditures is constant, income will also grow at a rate g.
Now we have the final value in 2010 and free cash flows 2005-2010, and the discount rate. All
we needed. Now compute recursively:
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* We only discount this once because this formula is an abbreviation of the longer one (as
done in previous chapters). It is the same as discounting every year each cash flow.
Given that the initial equity cost of the purchase is $53m, the purchase is attractive:
$ −$ =$ PKK should buy Ideko!
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