Transcript Corporate Financial Theory

CORPORATE
FINANCIAL
THEORY
Lecture 5
Topic Flow Chart
Goal of Finance = Maximize Value of Firm
HOW? Get the most cash
Steps
1. Methods to evaluate projects cash flow (NPV, IRR, etc)
2. Develop risk adjusted discount rates for use in NPV
3. Apply NPV, IRR, Decision Trees, PVI, etc to capital budgeting decisions
4. Changes in capital structure influence discount rates
5. Financial Distress can result form changes in capital structure
Efficient Capital Markets
•
Switches gears
•
Past lectures decided how to spend money (invest)
•
•
Today’s lecture deal with raising money (financing
decisions)
Fisher Separation Theorem
Efficient Capital Markets
Cost of Capital = Price of Money
Interest Rates
Demand
Supply
Equilibrium exists in capital markets
Quantity
Market Efficiency Theory sez
Expected Return (%)
SML
Risk
Return to NPV
Example
The government is lending you $100,000 for 10
years at 3% and only requiring interest payments
prior to maturity. Since 3% is obviously below
market, what is the value of the below market rate
loan?
NPV  amount borrowed - PV of interest pmts
- PV of loan repayment
Return to NPV
Example
The government is lending you $100,000 for 10 years at 3% and only
requiring interest payments prior to maturity. Since 3% is obviously below
market, what is the value of the below market rate loan?
Assume the market return on equivalent risk projects is 10%.
 10 3,000  100,000
NPV  100,000  

t
10
 t 1 (1.10)  (1.10)
 100,000  56,988
 $43,012
Market Efficiency Lost
Interest Rates
Demand
Funding
Shortage
Supply
Equilibrium Rate = 10 %
Subsidized Rate = 3 %
Quantity
Efficient Market Theory

Weak Form Efficiency

Market prices reflect all historical information
Efficient Market Theory
Technical Analysts
– Forecast stock prices based on the watching the
fluctuations in historical prices (thus “wiggle
watchers”)
Random Walk Theory


The movement of stock prices from day to day DO
NOT reflect any pattern.
Statistically speaking, the movement of stock prices
is random (skewed positive over the long term).
Random Walk Theory
Coin Toss Game
Heads
Heads
$106.09
$103.00
Tails
$100.43
$100.00
Heads
Tails
$100.43
$97.50
Tails
$95.06
Random Walk Theory
Level
S&P 500 Five Year Trend?
or
5 yrs of the Coin Toss Game?
120
70
Month
Random Walk Theory
S&P 500 Five Year Trend?
or
5 yrs of the Coin Toss Game?
Level
230
180
130
80
Month
Random Walk Theory
S&P 500 Five Year Trend?
or
5 yrs of the Coin Toss Game?
Random Walk Theory
Efficient Market Theory

Weak Form Efficiency
 Market

prices reflect all historical information
Semi-Strong Form Efficiency
 Market
prices reflect all publicly available information
Efficient Market Theory
Microsoft
Stock Price
$40
Actual price as soon as upswing is
recognized
30
20
Cycles
disappear
once
identified
Last
Month
This
Month
Next
Month
Efficient Market Theory
Cumulative Abnormal Return
(%)
Announcement Date
39
34
29
24
19
14
9
4
-1
-6
-11
-16
Days Relative to annoncement date
Example: How stock splits affect value
Cumulative
abnormal
return %
40
35
30
25
20
15
10
5
0
-29
0
Month relative to split
Source: Fama, Fisher, Jensen & Roll
30
Efficient Market Theory

Weak Form Efficiency
 Market

Semi-Strong Form Efficiency
 Market

prices reflect all historical information
prices reflect all publicly available information
Strong Form Efficiency
 Market
private
prices reflect all information, both public and
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1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Efficient Market Theory
Average Annual Return on Mutual Funds and the Market Index
50
40
30
20
10
0
-10
-20
-30
Funds
Market
-40
-50
Efficient Market Theory
IPO Non-Excess Returns
Average Return (%)
20
IPO
Matched Stocks
15
10
5
0
First
Second
Third
Fourth
Fifth
Year After
Offering
Efficient Market Theory
The average return 1972–2001 on stocks of firms over the six months following an
announcement of quarterly earnings. The 10% of stocks with the best earnings news
(portfolio 10) outperformed those with the worst news (portfolio1) by about 1% per
month.
Price Anomalies
Log Deviations From Royal Dutch Shell / Shell T&T Parity
1980 - 2004
20
10
-20
-30
-40
Apr-03
Aug-00
Jan-98
Jul-95
Dec-92
May-90
Oct-87
Mar-85
-10
Aug-82
0
Jan-80
Deviation, %
30
Efficient Market Theory
Historical performance
Insurance Investment Mutual
Banks Companies Advisors
Funds
Abnormal
- 1.6 %
Returns
- 1.1%
- 1.6%
- 1.4
Efficient Market Theory
Fundamental Analysts
– Research the value of stocks using NPV and other
measurements of cash flow
Lessons of Market Efficiency






Markets have no memory
Trust market prices
Read the entrails
There are no financial illusions
The do it yourself alternative
Seen one stock, seen them all
Behavioral Finance
 Factors related efficiency and psychology
1. Attitudes towards risk
2. Beliefs about probabilities
 Limits to arbitrage
 Incentive problems and the subprime crisis
 LTCM
Efficient Market Theory
2009 Recession
PV ( stocks) May 2009
Div
217


 $7,000
r  g .072  .041
PV ( stocks) growth drops
Div
217


 $6,028
r  g .072  .036
Efficient Market Theory
2000 Dot.Com Boom
PV (index ) March 2000
Div
154.6


 12,883
r  g .092  .08
PV (index)October 2002
Div
154.6


 8,589
r  g .092  .074
Efficient Market Theory
1987 Stock Market Crash
PV (index ) pre crash
Div
16.7


 1193
r  g .114  .10
PV (index) postcrash
Div
16.7


 928
r  g .114  .096
Market Efficiency Theory

•
•

•
•
•
Conflicts in Theory
Stock market crash of 1987
Daily fluctuations
Culprits?
Arbitrage
Computers
Institutions
Corporate Financing
•
READ TEXT CH 14 & 15 FOR TERMINOLOGY
Financial Markets
Company
Banks
Obligations
Insurance Cos.
Funds
Intermediary
Brokerage Firms
Obligations
Funds
Depositors
Policyholders
Investors
Investor
Financial Markets
Types of Financing
1 - Equity
2 - Debt
3 - Hybrids
Equity Holdings 2011
Bond Holdings 2011
Initial Offering Process






Initial Public Offering (IPO)
Investment Banker
Underwriter
Broker
Prospectus & Shelf Registration
Underpricing
IPO “Friends and Family”
Senator Barbara Boxer’s IPO participation (2000)
The Top Managing Underwriters
2011
Underwriting Spreads (2010)
Motives For An IPO
Percent of CFOs who strongly agree with the reason for an IPO
To create public shares for use in future acquisitions
59.4
To establish a market price/value for our firm
51.2
To enhance the reputation of our company
49.1
To broaden the base of ownership
45.9
To allow one or more principals to diversify personal holdings
44.1
To minimize our cost of capital
42.5
To allow venture capitalists to cash out
32.2
To attract analysts' attention
29.8
Our company has run out of private equity
27.6
Debt is becoming too expensive
14.3
0
10
20
30
40
50
60
70
Average Initial IPO Returns
Russia
Argentina
Austria
Canada
Denmark
Chile
Norway
Netherlands
France
Turkey
Spain
Portugal
Nigeria
Belgium
Israel
Hong Kong
Mexico
UK
Italy
USA
Finland
S. Africa
New Zealand
Philippines
Iran
Australia
Poland
Cyprus
Ireland
Germany
Indonesia
Sweden
Singapore
Switzerland
Sri Lanka
Brazil
Bulgaria
Thailand
Taiwan
Japan
Greece
Korea
Malaysia
India
China
137 %
0
20
40
60
return (percent)
80
100
Initial Offering
Average Expenses on 1767 IPOs from 1990-1994
Value of Issues
Direct Avg First Day
Total
($mil)
Costs (%)
Return (%) Costs (%)
2 - 9.99
16.96
16.36
25.16
10 - 19.99
11.63
9.65
18.15
20 - 39.99
9.7
12.48
18.18
40 - 59.99
8.72
13.65
17.95
60 - 79.99
8.2
11.31
16.35
80 - 99.99
7.91
8.91
14.14
100 - 199.99
7.06
7.16
12.78
200 - 499.99
6.53
5.70
11.10
500 and up
5.72
7.53
10.36
All Issues
11.00
12.05
18.69
IPO Proceeds
IPO Proceeds and First Day Returns
80
70
60
50
40
30
20
10
0
Issue proceeds ($bn)
First-day return
Investment Vehicles (2011)
SPEs and Enron

Special-Purpose Entities (SPEs)
 Raise
cash through equity and debt
 Do not show up on balance sheet
Mahonia
JP Morgan
Enron
Types of Equity






Partnerships
LLP & LLPs
Public Benefit Corporations
Trusts
Real Estate Investment Trust (REIT)
Private equity
Private Equity Returns
U.S. Venture Capital Investments
120
104.4
100
53.5
60
40.5
30.9 28.3
2009
2008
2007
2006
20.1
29.1
23.3
2011
2005
26.7
2010
22.4
2004
21.7 19.6 21.8
2003
2001
2000
1999
1998
14.6
1997
0
7.9
1996
20
10.8
20.7
2002
40
1995
$ Millions
80
Total Direct Costs of Raising Capital
Total Direct Costs, %
9.0
IPOs
SEOs
Convertibles
Bonds
8.0
7.0
6.0
5.0
4.0
3.0
2.0
1.0
0.0
Proceeds, $M
Source: Data from SDC Platinum. 5706 domestic issues between 2004 and 2008. Closed-end funds (SIC 6726), REITS (SIC 6798), ADRs, mortgage-backed and
Federal agency (SIC 6011, 6019, 6111 and 999B) issues are excluded.
Rights Issue
Rights Issue - Issue of securities offered only to current
stockholders.
Example – BNP Paribas Bank needs to raise €5.50 billion of new
equity. The market price is €77.40/sh. BNP decides to raise
additional funds via a 1 for 10 rights offer at €65.40 per share.
If we assume 100% subscription, what is the value of each right?
Rights Issue
Value of a Right
𝑃𝑟𝑒𝑃𝑟𝑖𝑐𝑒 − 𝐼𝑠𝑠𝑢𝑒 𝑝𝑟𝑖𝑐𝑒
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎 𝑟𝑖𝑔ℎ𝑡 =
𝐻𝑒𝑙𝑑 𝑆ℎ𝑎𝑟𝑒𝑠
+1
𝑁𝑒𝑤 𝑠ℎ𝑎𝑟𝑒𝑠
Rights Issue
Example - BNP Paribas Bank needs to raise €5.50 billion of new equity.
The market price is €77.40/sh. BNP decides to raise additional funds via a 1
for 10 rights offer at €65.40 per share. If we assume 100% subscription,
what is the value of each right?





Current Market Value = 10 x €77.40 = €774.00
Total Shares = 10 + 1 = 11
Amount of funds = 774 + 65.40 = €839.40
New Share Price = (839.40) / 11 = €76.31
Value of a Right = 1.0909
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎 𝑟𝑖𝑔ℎ𝑡 =
77.40 − 65.40
= 1.0909
10
1 +1
Rights Issue
Slightly More Difficult Example
Lafarge Corp needs to raise €1.28billion of new equity.
The market price is €60/sh. Lafarge decides to raise
additional funds via a 4 for 17 rights offer at €41 per
share. If we assume 100% subscription, what is the
value of each right?
Rights Issue
Example - Lafarge Corp needs to raise €1.28billion of new equity. The
market price is €60/sh. Lafarge decides to raise additional funds via a 4 for
17 rights offer at €41 per share. If we assume 100% subscription, what is
the value of each right?





Current Market Value = 17 x €60 = €1,020
Total Shares = 17 + 4 = 21
Amount of funds = 1,020 + (4x41) = €1,184
New Share Price = (1,184) / 21 = €56.38
Value of a Right = 3.619
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎 𝑟𝑖𝑔ℎ𝑡 =
60.00 − 41.00
= 3.619
17
4 +1
Rights Issue - example
YRU Corp currently has 9 million shares outstanding. The
market price is $15/sh. YRU decides to raise additional
funds via a 1 for 3 rights offer at $12 per share. If we
assume 100% subscription, what is the value of each right?





Current Market Value = 9 mil x $15 = $135 mil
Total Shares = 9 mil + 3 mil = 12 mil
Amount of new funds = 3 mil x $12 = $36 mil
New Share Price = (136 + 36) / 12 = $14.25/sh
Value of a Right = 0.75
15 − 12
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎 𝑟𝑖𝑔ℎ𝑡 =
3
+1
1
= .75