Transcript Document

CORPORATE FINANCE
MANAGEMENT 2
Master Course VŠFS
Fall 2012
Irena Jindřichovská
[email protected]
Dr Irena Jindrichovska
Corporate Finance Management 2
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Literature
• Brigham, E and Ehrhardt, M (2004) Financial management:
theory and practice, 13th ed., Thomson Learning ISBN-10:
0324259689; ISBN-13: 9780324259681
• Other recommended sources:
• Brealey, R., Myers, S. and Allen, F. (2006) Corporate Finance,
8th international ed., McGraw-Hill ISBN: 0-07-111795-4
• Ross, Westerfield & Jaffe; Fundamentals of Corporate Finance,
4th edition
• Bender and Ward: Corporate Financial Strategy, 3rd ed.
Butteworth-Heinemann, 2009
• More sources may be recommended in lectures
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Teaching plan
• Regular studies:
12 hours lectures
6 hours excercises+ presentation of own work
• Assignment conditions - essay on topic given + active
participation in seminars
• Exam: Written exam consisting of short essays and
calculations
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Outline of the course
1. Introduction to Corporate finance management
2. Mergers and acquisitions
3. Cost of capital and capital structure
4. Strategy and tactics of financing decisions investment decision making
5. Capital Restructuring and Multinational Fin.
Management
6. Lease Financing and Working Capital
Management
7.
Risk
Management
and
Real
Options
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Jindrichovska
Corporate
Finance
Management
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INTRODUCTION TO
CORPORATE FINANCE
MANAGEMENT
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Outline Lecture 1
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Introduction
Capital structure
Company lifecycle
Role of financial manager
Financial markets
Agency theory
Stakeholders’ theory
Summary, exercises, references
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Introduction to
Corporate Finance
•
Basic questions not only from corporate
finance:
1. What long-term investment strategy
should a company take on?
2. How can cash be raised for the required
investments?
3. How much short-term cash flow does a
company need to pay its bills?
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The Balance-Sheet Model of the
Firm
• Current assets
• Current liabilities
– Net working capital
• Long term debt
• Fixed assets
– Tangible fixed assets
– Intangible fixed assets
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• Shareholders’ equity
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Capital Structure
• Financing arrangements determine how
the value of the firm is sliced up.
• The firm can then determine its capital
structure.
• Capital structure changes in the lifetime of
the firm
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Capital Structure
• The firm might initially have raised the
cash to invest in its assets by issuing more
debt than equity;
• Later again it can consider changing that
mix by issuing more equity and using the
proceeds to buy back some of its debt
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Life Cycle of the company and
its funding
• Boston Consulting Group Matrix
• Axes
– horizontal: speed of growth of the market share
– vertical: market share
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•
•
•
Start-up
Growth
Maturity
Decline
• Each phase requires different approach to financial
management – according to generated Cash Flow
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Life Cycle of the company II
Maturity
•Low investment need
•High CF generated
•Growth
•High investment need
•High CF generated
Decline
•Low investment need
•Low CF generated
•Start up
•High investment need
•Low CF generated
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Role of the Financial Manager
1. The firm should try to buy assets that
generate more cash than they cost.
2. The firm should sell bonds and stocks and
other financial instruments that raise more
cash than they cost.
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Role of the Financial Manager
• The firm must create more cash flow than
it uses.
• The cash flows paid to bondholders and
stockholders of the firm should be higher
than the cash flows put into the firm by the
bondholders and stockholders.
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Financial Markets
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Primary and secondary markets
Spot and forward markets
Money markets
Equity markets
Organized and over-the-counter markets
– LSE, AMEX, NYSE; NASDAQ
• Derivative markets
– LIFFE, CBOT
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Primary and secondary markets1
• Help to get financing for companies
• Investment companies
• Pool together and manage the money of
many investors
• Arrange corporate borrowings and security
issues
– Issuing process
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Primary and secondary markets2
• Establish the price of securities through
supply and demand
• Execute and settle the transaction
• Guarantee the settlement through the
‘Clearing house’- a special institution
connected with each Stock Exchange
– There is also a securities exchange
commission (SEC ) setting the standards and
rules of listing
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Agency Theory
• There are two groups with different interest in
each corporation – Shareholders and Managers
• Goals of shareholders and managers are not the
same
• Jensen and Meckling (1976): Theory of the Firm:
Managerial Behavior,Agency Costs and
Ownership Structure, JFE 1976
• Defined Principal – Agent relation
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Principal - Agent
• Owners i.e. Shareholders are Principals
• Managers are Agents
• Shareholders want value of their firm to be
maximized
• Managers should act on principals’ behalf
but have different goals
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Management Goals
• Survival - avoid risky business decisions
• Selfsufficiency – prefer internal financing to
issuance of new stock
• Shareholders need to control management –
Agency Costs –
– Monitoring costs
– Incentive fees to convince management to act in
shareholders’ interest
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Control methods
• Directors are voted by Shareholders and
management is selected by directors
• Management compensation methods
– Stock option plan
– Bonuses
– Performance shares
• Threat of takeovers
• Competition on management labor market
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Stakeholders’ theory
• All interested parties that have some relation to
the company
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–
–
Shareholders
Employees
Creditors
Banks
Suppliers
Clients
Environment
Municipalities
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Summary
1.
2.
The goal of financial management in a for-profit
business is to make decisions that increase the value
of the stock, or, more generally, increase the market
value of the equity.
Business finance has three main areas of concern:
a. Capital budgeting. What long-term investments should the firm
take?
b. Capital structure. Where will the firm get the long-term financing
to pay for its investments? In other words, what mixture of debt
and equity should we use to fund our operations?
c. Working capital management. How should the firm manage its
everyday financial activities?
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Summary 2
3. The corporate form of organization is superior
to other forms when it comes to raising money
and transferring ownership interests, but it has
the significant disadvantage of double taxation.
4. There is the possibility of conflicts between
stockholders and management in a large
corporation. We call these conflicts “agency
problems” and discussed how they might be
controlled and reduced.
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Exercise problems
•
Define and compare the three forms of
organisation a proprietorship, a partnership
and a corporation.
• Explain the agency problem and discuss the
relationship between managers and
shareholders
– What are the two types of agency costs?
– How are managers bonded to shareholders?
– Can you recall some managerial goals?
– What is the set-of-contracts perspective?
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Useful web source
• On Agency theory – A review paper
• http://classwebs.spea.indiana.edu/kenrich
a/Oxford/Archives/Oxford%202006/Course
s/Governance/Articles/Eisenhardt%20%20Agency%20Theory.pdf
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RECOMENDED READINGS
• Brigham and Houston: Fundamentals of
Financial Management, 12th ed, Ch 1
• Ross, Westerfield & Jaffe; Fundamentals
of Corporate Finance, 4th edition Ch 1
and 2
• Bender and Ward: Corporate Financial
Strategy, 3rd ed. Butteworth-Heinemann,
2009, Ch 2
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COST OF CAPITAL AND
CAPITAL STRUCTURE
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Outline
•
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Introduction
Sources of long term financing
Debt versus equity
Long term debt
Preferred shares
Retained earnings
Newly issued shares,
– Gordon model, debt plus risk premium, CAPM approach
• WACC
• Value of a company
• Summary, exercises, references
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Equity versus debt
Feature:
Equity
Debt
Income:
Dividends
Interest
Tax
status:
Taxed as personal income.
Are not business expense
Taxed as personal income.
Are business expense
Control:
Common stocks
(sometimes preferred)
usually have voting right
Control is exercised with
loan agreement
Default:
Firms cannot become
Unpaid debt is a liability.
bankrupt for nonpayment of Nonpayment results in
dividends
bankruptcy
Bottom
line:
Tax status favours debt, but default favours equity.
Control features of debt and equity are different but one is
not better than other
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Long term debt
• Loans and bonds
– Loans (interest is paid before taxes –
creation of tax shield, that lowers the cost
of L/T debt); T = tax rate
kd  knom (1  T )
– Bonds (yield to maturity)
1  (1  r ) t
M
BC

t
r
(1  r )
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Preferred shares
• Perpetuity P = C/r; i.e.
k p= C / P
• May need to take in consideration
issuance cost (flotation cost F)
kp= C / (P-F)
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Cost of retained equity
• Using Gordon model of growing
perpetuity:
• P=D1/ (r-g); i.e.
ks = (D1 / P) + g
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Cost of new equity
• Using Gordon model of growing perpetuity
taking in consideration flotation cost:
ke = (D1 / (P-F)) + g
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The CAPM approach
• Estimate using the CAPM
– Estimate of risk free rate rRF
– Estimate the market premium RPM
– Estimate the stock’s beta coefficient bs
– Substitute in the CAPM equation:
rs  rRF  ( RPM )bs
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Bond yield plus risk premium
approach
• Some analysts us an ad hoc procedure to
estimate the firms cost of common equity
• Adding a judgmental risk premium (3-5%)
rs = bond yield + bond risk premium
• It is logical to think that firms with risky, low
rated high-interest-rate debt will also have
risky high-cost equity
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WACC
• Weighted average cost of capital – one
way of measuring cost of capital of a
company
WACC=wd*kd + wp*kp + ws(e)* ks(e)
• Another way may be estimating through
market model (SML) – ex-post valuation
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Factors that affect the weighted
average cost of capital
• Factors that firm cannot control
– The level of interest rates
– Market risk premium
– Tax rates
• Factors the firm can control
– Capital structure policy
– Dividend policy
– Investment policy
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Summary
1.
2.
Earlier chapters on capital budgeting assumed that
projects generate riskless cash flows. The appropriate
discount rate in that case is the riskless interest rate.
Of course, most cash flows from real-world capitalbudgeting projects are risky. This chapter discusses
the discount rate when cash flows are risky.
A firm with excess cash can either pay a dividend or
make a capital expenditure. Because stockholders can
reinvest the dividend in risky financial assets, the
expected return on a capital-budgeting project should
be at least as great as the expected return on a
financial asset of comparable risk.
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Summary 2
3.
4.
5.
The expected return on any asset is dependent upon
its beta. Thus, we showed how to estimate the beta of
a stock. The appropriate procedure employs
regression analysis on historical returns.
We considered the case of a project whose beta risk
was equal to that of the firm.
If the firm is unlevered, the discount rate on the project
is equal to RF+( M - RF)*ß
where M is the expected return on the market portfolio
and RF is the risk-free rate. In words, the discount rate
on the project is equal to the CAPM’s estimate of the
expected return on the
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Exercise questions
1. Describe the various sources of
capital.
2. Describe the ”optimal” capital structure.
3. Explain the concept: weighted average
cost of capital (WACC).
4. Explain how to calculate a value of a firm
using WACC.
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Exercise problem 1
• 12.13 RWJ
• Calculate the weighted average cost of capital
for the Luxury Porcelain Company.
• The book value of Luxury’s outstanding debt is
$60 million. Currently, the debt is trading at 120
percent of book value and is priced to yield 12
percent. The 5 million outstanding shares of
Luxury stock are selling for $20 per share. The
required return on Luxury stock is 18 percent.
The tax rate is 25 percent.
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Exercise problem 2
• 12.14 RWJ
• First Data Co. has 20 million shares of
common stock outstanding that are currently
being sold for $25 per share. The firm’s debt
is publicly traded at 95 percent of its face
value of $180 million. The cost of debt is 10
percent and the cost of equity is 20 percent.
What is the weighted average cost of capital
for the firm? Assume the corporate tax rate is
40 percent.
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Useful web sources
• Online Tutorial #8: How Do You
Calculate A Company's Cost of
Capital?
• http://www.expectationsinvesting.com/tu
torial8.shtml
• And a video lecture (rather easy)
• http://www.youtube.com/watch?v=JKJgl
PkAJ5o
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RECOMENDED READINGS
• Fundamentals of Corporate Finance,
Ross, Westerfield and Jaffe, 6 th edition.
Ch 12
• Brigham and Houston: Fundamentals of
Financial Management, 12th ed, Ch 10
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MERGERS AND
TAKEOVERS
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Outline
•
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Introduction
Mergers ad acquisition rationale
Underling principles
Business motives for acquisitions
Financial strategy
Price reaction n acquisition announcement
Takeover defense
Summary, exercises, references
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Mergers and Acquisitions
• Mature companies try to reverse or accelerate
the life cycle through dynamic changes in the
structure of the business by mergers or
acquisitions
• Two businesses combine into one
• Mergers are rare  Acquisitions
• Larger and smaller company  acquirer and
target company
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Underlying principles
• Combined future CF’s are bigger than sum
of CF’s of two individual companies
• Not in case of large premium paid to
shareholders of the target
– (90%-125% of exp. value of the synergy has
been paid to the sellers) - better to be seller
then buyer
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M&A’s = “market
imperfections”
• Asymmetric price reaction on acquisition
announcement:
• Target company is undervalued in the
market (inefficient market)
• Participants do not agree on the price of
the target company stock
• ? Synergy effect (2+2=5)
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Source of synergy from
acquisitions
• Revenue Enhancement
– Marketing Gains
– Strategic Benefits
– Market or Monopoly Power
• Cost Reduction
–
–
–
–
Economies of Scale
Economies of Vertical Integration
Complementary Resources
Elimination of Inefficient Management
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Source of synergy from
acquisitions 2
• Tax Gains
– Net Operating Losses
– Unused Debt Capacity
– Surplus Funds
• The Cost of Capital
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Two “bad” reasons for mergers
• Earnings Growth
– EPS Game
• Diversification
– Systematic variability cannot be eliminated by
diversification, so mergers will not eliminate
this risk at all. By contrast, unsystematic risk
can be diversified away through mergers.
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Influence of innovative products
• Management may forget the underlying
principles justifying M&A
• Target company must be worth more than
it will cost the acquirer
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Cash versus Common Stock
• Whether to finance an acquisition by cash or by
shares of stock is an important decision.
• The choice depends on several factors, as
follows:
• 1. Overvaluation. If in the opinion of
management the acquiring firm’s stock is
overvalued, using shares of stock can be less
costly than using cash.
• 2. Taxes. Acquisition by cash usually results in a
taxable transaction. Acquisition by exchanging
stock is tax free.
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Cash versus Common Stock 2
• 3. Sharing Gains. If cash is used to
finance an acquisition, the selling firm’s
shareholders receive a fixed price. In the
event of a hugely successful merger, they
will not participate in any additional gains.
Of course, if the acquisition is not a
success, the losses will not be shared and
shareholders of the acquiring firm will be
worse off than if stock were used.
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Financial strategy in
acquisitions
• Financial role - to evaluate the synergy
effect
• Strategy - change the financial structure of
target company  leverage the company
• Target company with cash surpluses
(mature group)  Corporate raider
acquires the company, strips it off the cash
and leverages the company
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Diversified companies
• Diversified group should be valued at
minimum weighted average P/E applicable
to its component businesses
• If the company does not perform well after
acquisition  sell parts of the group for
higher P/E – divestiture, spin-offs,…
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“Greenmailing”
• Significant minority impacts on the
corporate strategy
• Raider buys a significant part of the co.
which he considers undervalued and
“greenmails” the management, asserting
that the company is badly managed
• Management buys him out  cash drain
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EPS game
• Growth in P/E is automatically created by an
equity funded acquisition if P/E of bidder > P/E
of target
• If companies have the same P/E multiple
• And financial structure of target company is
changed  debt instead of equity
• EPS of the group 
• However, increased growth prospects are offset
by  financial risk due to  debt
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EPS game
Company A is considering acquiring companies
B, C, and D but it wishes to ensure that each
deal increases EPS. Finance can be raised
through equity or debt or through any other
financial mechanism. After-tax cost of debt =
5%.
PEGroup 
PATAcq * PE Acq  PATTg * PETg
PATAcq  PATTg
Share price  PE * EPS
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Acquirer
A no of shares
10 000 000
share price (£)
Target
1
A no of shares
10 000 000
share price (£)
1
A no of shares
10 000 000
share price (£)
1
A no of shares
10 000 000
share price (£)
1
PAT (£)
1 000 000
PAT (£)
1 000 000
PAT (£)
1 000 000
PAT (£)
1 000 000
EPS (£)
0,1
EPS (£)
0,1
EPS (£)
0,1
EPS (£)
0,1
P/E
10
P/E
10
P/E
10
P/E
10
B no of shares
5 000 000
share price (£)
1
C no of shares
10 000 000
share price (£)
0,5
D no of shares
share price (£)
1 000 000
5,0
D no of shares
1 000 000
share price (£)
5,0
PAT (£)
1 000 000
PAT (£)
500 000
PAT (£)
250 000
PAT (£)
250 000
EPS (£)
0,2
EPS (£)
0,05
EPS (£)
0,25
EPS (£)
0,25
P/E
5
P/E
10
P/E
20
P/E
20
P/EA > P/EB
P/EA = P/EC
P/EA < P/ED
Invert the transaction !
Deal
A issues 5 mil shares at 1£
A issues 5 mil debt for (5%)
A issues 5 mil shares at 1£
D issues 2 mil shares at 5 £
structure
and buys B
and buys B
and buys D
and buys A
New shares
5 000 000
New shares
New debt
cost of debt
Result
0
New shares
5 000 000
New shares
2 000 000
15 000 000 DA no of shares
3 000 000
5 000 000
250 000
AB no of shares
15 000 000
AC no of shares
PAT (£)
2 000 000
PAT (£)
1 250 000
PAT (£)
1 250 000
PAT (£)
1 250 000
EPS (£)
0,133
EPS (£)
0,125
EPS (£)
0,083
EPS (£)
0,417
P/E
share price (£)
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7,5
1,00
P/E
share price (£)
10 000 000 AD no of shares
10
1,25
P/E
share price (£)
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1,00
P/E
share price (£)
12
5,00
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Higher growth companies
• EPS bidding < EPS target
• P/E bidding < P/E target
• Post-acquisition P/E  to appropriate
weighted average of the original
businesses
• EPS  because bidding company is larger
than target company
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Takeover defense
• Pre-offer defense
–
–
–
–
–
Shark repellent
Staggered board
Quorum
Poison pills
Re-capitalization with special right shares
• Post offer defense
–
–
–
–
Pacman defense
Violation of antitrust law
Change of asset structure
Change of liabilities structure
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Summary
1. The synergy from an acquisition is defined as
the value of the combined firm (VAB) less the
value of the two firms as separate entities (VA
and VB), or Synergy VAB - (VA + VB)
The shareholders of the acquiring firm will gain
if the synergy from the merger is greater than
the premium.
2. The three legal forms of acquisition are merger
and consolidation, acquisition of stock, and
acquisition of assets.
3. Mergers and acquisitions require an
understanding of complicated tax and
accounting rules
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Summary 2
4. The possible benefits of an acquisition come
from:
a. Revenue enhancement, b. Cost reduction,
c. Lower taxes, d. Lower cost of capital
The reduction in risk from a merger may help
bondholders and hurt stockholders.
5. The empirical research on mergers and
acquisitions is extensive. Its basic conclusions
are that, on average, the shareholders of
acquired firms fare very well, while the
shareholders of acquiring firms do not gain
much.
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Exercise problems
1. Do M&As create value at all?
2. Who are the main beneficiaries of M&A in the
short term / long term?
3. In an efficient market with no tax effects,
should an acquiring firm use cash or stock?
4. Explain the Japanese Keiretsu, how does it
function?
5. M&A valuation problem – on separate sheet
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Useful web sources
• A book on Mergers and acquisitions by
Weston and Weaver (2001) - book
preview
• http://www.google.com/books?hl=cs&lr=
&id=Y2Mz7tOuJBgC&oi=fnd&pg=PP9&
dq=mergers+and+acquisitions&ots=85k
GKKGutc&sig=iY_Ztx8tQY42Kzmw2UrVp25rTM#v=onepage&q=mergers%2
0and%20acquisitions&f=true
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Useful web source 2
• Characteristics of takeover defense
strategies
• http://www.investopedia.com/articles/stock
s/08/corporate-takeoverdefense.asp#axzz29MjA54dw
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RECOMENDED READINGS
• Fundamentals of Corporate Finance,
Ross, Westerfield and Jaffe, 4th edition.
Ch 29
• Brigham and Houston: Fundamentals of
Financial Management, 12th ed, Ch 15
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CAPITAL STRUCTURE
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Outline
•
•
•
•
•
•
•
•
Capital structure concept – maximizing value
Optimal capital structure
M&M Theory of Independence
M&M Theory of Dependence
Taxes and financial leverage
Cost of financial distress and agency costs
EBIT-EPS analysis
Summary, exercises, references
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Goal of capital structure
management
• Maximize the share price
• Minimize the weighted average cost of
capital
• Too big financial leverage can bring firm to
bankruptcy
• Too small financial leverage leads to
undervaluing of share price
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Miller & Modigliani (1958)
• The Cost of Capital, Corporation Finance
and the Theory of Investment, American
Economic Review 48: 261-297
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Importance of capital structure
• Cost of capital is one of the cost and
therefore influence dividends
• If the cost of capital are minimized, the
payments to shareholders is maximized
• If the cost of capital can be determined by
corporate capital structure then the capital
structure management is an important part
of firm management
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Corporate Finance Management 2
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Assumptions
• The share price is a perpetuity: P0 = Dt/Kc
• The firm pays constant dividends
• Dividend-Pay-Out = 100%, i.e. no retained
earnings
• There are no taxes
• Capital structure consists of Debt & Equity
only
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Further assumptions
• Financial structure is modified by issuing
new shares to buy out debt or the other
way around
• EBIT is assumed to remain constant
• Shares and other securities are traded on
efficient market
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Proposition I.
Independence Hypothesis
• The cost of capital of the firm (K0) and share
price P0 are both independent on capital
structure (financial leverage)
• Total market value of the firm securities stays
unchanged disregarding the degree of leverage
(picture)
• The basic relation of Independence Hypothesis:
Percentage change of cost of equity Kc =
Percentage change in dividends Dt
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Corporate Finance Management 2
78
Proposition II.
Dependence Hypothesis
• Both the cost of capital (K0) and share
price (P0) are influenced by firm’s capital
structure
• Weighted average cost of capital (K0) will
decrease as the D/E increases, and the
share price (P0) increases with growing
leverage, therefore companies should use
as high leverage as possible (picture)
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Corporate Finance Management 2
79
Dependence Hypothesis
• According to Dependence Hypothesis:
Percentage change of cost of equity Kc= 0,
however, percentage change in dividends
Dt > 0
• Percentage change of price = percentage
change of dividends
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Corporate Finance Management 2
80
Taxes and financial leverage
• The interest is deductible from the tax
base
• Use of debt in capital structure should lead
to increased market value of firm
securities
• The middle view assumes that interest tax
shied has its market value which increases
total market value of the firm
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Corporate Finance Management 2
81
Cost of financial distress
• The probability of bankruptcy increases with
increasing leverage.
• The firm has the highest costs if it gets bankrupt
–
–
–
–
–
Assets are liquidated for lower than market price
Banks refuse to lend
Suppliers refuse to grant commercial credit
Dividend payments are stopped
• At certain point the expected bankruptcy costs
outweigh the tax shield and the firm has to
change the capital structure (Pictures)
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Corporate Finance Management 2
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Further topics
•
•
•
•
•
Optimal financial structure
EBIT-EPS analysis
Point of financial indifference
Implicit cost cost of debt – increased risk
Practical measures of capital structure
management
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Corporate Finance Management 2
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Capital structure theories
• The trade-off theory
– The trade-off between benefits and costs of
debt
– Small debt – small tax shield but more
financial flexibility
• Pecking order theory
– Different types of capital have different costs the least expensive source is used first
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Summary 1
•
•
•
•
In general, a firm can choose among many
alternative capital structures.
It can issue a large amount of debt or it can
issue very little debt.
It can issue floating-rate preferred stock,
warrants, convertible bonds, caps, and callers.
It can arrange lease financing, bond swaps,
and forward contracts.
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Summary 2
•
•
•
Because the number of instruments is so
large, the variations in capital structures are
endless.
We simplify the analysis by considering only
common stock and straight debt in this
chapter.
We examine the factors that are important in
the choice of a firm’s debt-to-equity ratio.
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Exercise questions
1. Explain the concept of capital structure
2. Define the optimal capital structure
3. Explain the logic of M&M Theory of
independence
4. Explain M&M Theory of dependence
5. Explain the role of taxes in financial structure
6. Explain the cost of financial distress and
agency costs
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Exercise problem 1
•
•
Gearing Manufacturing, Inc is planning a $ 1
000 000 expansion of its production facilities.
The expansion could be financed by the sale of
$1 250 000 in 8% notes or by the sale of $ 1
250 000 in capital stock. Which would raise the
number of shares outstanding from 50 000 to
75 000. Gearing pays income taxes at a rate of
30%.
Suppose that income from operations is
expected to be $ 550 000 per year for the
duration of the proposed debt issue, Should
Gearing be financed with debt or stock?
Explain your answer.
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Corporate Finance Management 2
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Useful web sources
• Financing decisions: Capital Structure and
cost of capital
• http://www.slideshare.net/meowbilla/4a304capital-structure
• CFA 1 Materials
• http://www.investopedia.com/exam-guide/cfalevel-1/corporate-finance/mm-capitalstructure-versus-tradeoffleverage.asp#axzz1sgRpYOfd
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RECOMENDED READINGS
• Fundamentals of Corporate Finance,
Ross, Westerfield and Jaffe, 6 th edition.
Ch 12
• Brigham and Houston: Fundamentals of
Financial Management, 12th ed, Ch 10
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Corporate Finance Management 2
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STRATEGY AND TACTICS
OF FINANCING DECISIONS
- INVESTMENT DECISION
MAKING
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Outline
•
•
•
•
•
•
•
Introduction
Investment decision making
Nature of projects and incremental cash flows
Project phases and relevant cash flows
Decision making methods incl. pros and cons
Comparing different projects
Summary, exercises, references
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Corporate Finance Management 2
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Investment Projects
• Nature of project
• Profit generating projects
– Increasing capacity, new equipment
– Replacement projects
• Ecological projects – minimizing loss
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Corporate Finance Management 2
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Long-term nature of projects
• Analyzing - incremental cash flows
– Changes of the firms cash flow that occur as a
direct consequence of accepting the project
• Costs vs. Cash flows
• Sunk costs
• Opportunity costs (potential revenues form
alternative uses are lost)
• Side effects - transfers
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Corporate Finance Management 2
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Project Phases
1. Investment phase
2. Operating phase (income and taxes)
3. Liquidating phase (sometimes included
in operating phase)
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Corporate Finance Management 2
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Investment decision making
methods
Net Present Value - NPV
Internal Rate of Return - IRR
Payback Period - PP
Profitability Index - PI
Modified Internal Rate of Return - IRR*
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Corporate Finance Management 2
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Net Present Value
• The most frequently used decision making
method
• Discounts individual positive and negative
cash flows to the present – finding their
present value
• Projects with positive net present value
are accepted
• This method is sensitive to the discount
rate used in the process of calculation
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Corporate Finance Management 2
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Internal Rate of Return
The discount rate of the project that forces its net
present value to equal zero
NPV = 0
• Positive and negative cash flows are discounted at
rate IRR. APPROXINMATION of this rate can be
found using iterations or linear interpolation
• Advantage - comparison with cost of capital
• STRONG ASSUMPTION - cash inflows are
reinvested at a rate IRR
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Corporate Finance Management 2
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Payback Period
•
•
•
•
Non-discounted method
Discounted method
Cumulated cash flows
ASSUMPTION- evenly distributed cash
flows during the course of each period
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Corporate Finance Management 2
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Profitability index
• Present value of cash inflows to present
value of cash outflows
• Decision rule: PI > 1
• The same decisions as NPV
• Profitability indexes of two projects can
not be added, whereas the NPVs can
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Corporate Finance Management 2
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Modified Internal Rate of Return
• Removes the strong assumption about
reinvesting cash inflows for the high IRR
• Maintains the advantage - easy
comparison with cost of capital – the
appropriate discount rate
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Corporate Finance Management 2
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Modified IRR* - formula
T
T
COFt

t 
t  0 1  r 
(T t )


 CIFt 1  r
t0
(1  IRR*) T
T
IRR* 
Dr Irena Jindrichovska
T t
CIF
(1

r)
 t
t 0
T
T
COFt

t
(1

r)
t 0
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1
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Comparing projects
Conflict between NPV and IRR
Projects with irregular cash flows
Projects with several negative cash flows
Comparing projects with different time horizon
Crossover rate
Capital Asset Pricing Model - CAPM
application in capital budgeting
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Corporate Finance Management 2
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Summary
1. Investment decision making must be placed on
an incremental basis - sunk costs must be
ignored, while both opportunity costs and side
effects must be considered.
2. Inflation must be handled consistently. One
approach is to express both cash flows and the
discount rate in nominal terms.
3. When a firm must choose between two
machines of unequal lives, the firm can apply
either the matching cycle approach or the
equivalent annual cost approach. Both
approaches are different ways of presenting
the same information.
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Summary 2
4.
5.
In this chapter we cover different investment decision
rules. We evaluate the most popular alternatives to the
NPV: the payback period, the accounting rate of return,
the internal rate of return, and the profitability index. In
doing so, we learn more about the NPV.
The specific problems with the NPV for mutually
exclusive projects was discussed. We showed that,
either due to differences in size or in timing, the project
with the highest IRR need not have the highest NPV.
Hence, the IRR rule should not be applied. (Of course,
NPV can still be applied.)
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Exercise questions
1.
2.
3.
4.
5.
6.
7.
What are the difficulties in determining incremental
cash flows?
Define sunk costs, opportunity costs, and side effects.
What are the items leading to cash flow in any year?
Why is working capital viewed as a cash outflow?
Discuss the pros and cons of investment decision
making methods
What is the difference between the nominal and the
real interest rate and nominal and real cash flow?
Discuss the problems of IRR method
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Useful web sources
• http://www.studyfinance.com/lessons/capbud
get/
• http://www.capitalbudgetingtechniques.com/
• What is capital budgeting - text
• http://www.exinfm.com/training/capitalbudgeti
ng.doc
• Impact of inflation on investment decision
making
• http://www.studyfinance.com/jfsd/pdffiles/v9n
1/mills.pdf
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RECOMENDED READINGS
• Fundamentals of Corporate Finance,
Ross, Westerfield and Jaffe, 4th edition.
Ch 7
• Brigham and Houston: Fundamentals of
Financial Management, 12th ed, Ch 9, 10
Dr Irena Jindrichovska
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