Financial Management/ Corporate Finance
Ken Choie
http://dasan.sejong.ac.kr/~kchoie
textbook: Investments by Bodie, Kane and Marcus
1. Time Value of Money
 Interest rate and FV
 Discount rate and PV
 Measurement of Investment Return
2. Capital Budgeting (Capital Rationing)
 Cash Flow Projection
 NPV Analysis
 NPV Profile
 NPV Profile and IRR
3. Cost of Capital
 The Cost of Capital
 The Cost of Equity
 Operational and Financial Leverages
4. Capital Structure and Solvency
 The Optimal Capital Structure
 Issues in Capital Structure Policy
5. Working Capital (Liquidity) Management
 Managing the Cash Position
 Cash Generating Ability
 Managing Short-term Financing
6. Dividend Policy and Share Repurchase
 Dividend Policy and Company Value
 Share Repurchase
 Payout Policy and the Signaling Effect
7. Mergers and Acquisitions
 Motives for Merger
 Merger Transaction and Merger Analysis
 Divestiture
8. Corporate Governance
 Objectives and Guiding principles
 Conflicts of Interest
 Corporate Governance and Investment Analysis
1. Time Value of Money
A:
Interest rate and FV:
Simple vs. compounding interest rates (frequency):
S(t) = S(0) * ( 1 + r) t
r
S(t) = S(0) * ( 1 + n) nt
=> S(0) * ert
 Stated annual rate vs. effective annual rate (EAR) with compounding;
 the rule of 72:
# of years to double up = 72 / the compound rate
FV of Constant CF:
Annuity of A: the 1st payment of A is one year from now.
FV(A) = A *
B:
(1 + r)n − 1
r
Discount rate and PV:
Net present value of a cash flow:
NPV = ∑
CFt
(1+r)t
 Discount rate = default risk-free rate + risk premiums
PV of Constant CF (annuity A):
1−
PV(A) =
A*
1
(1 + r) n
r
 Calculation of bond price:
Bond as a sum/ portfolio of zero coupon bonds
Consol bond: constant interest payment for perpetuity
A
r
 Calculation of stock price: Dividend Discount model:
Constant dividend payment for perpetuity
P=
D
r
Dividend growing at a constant rate, g, for perpetuity:
P=D*
C.
(1+g)
(r−g)
Measurement of Investment return:
Time weighted (Geometric Mean):
1
(1 + r ∗ ) = [ ∏ (1 + ri ) ] n
Compound growth rate (Global Investment Performance Standard);
Average growth rate = compound growth rate;
Equally weighted periodic rates of return.
Dollar weighted (Internal Rate of Return):
CF
P = ∑ (1+rt∗)t
IRR on a bond = yield to maturity (YTM);
Since Inception-IRR for private equity funds
Varying weights on each period
 arithmetic mean > geometric mean
1. Capital Budgeting (Capital Rationing)
 maximize long-term profitability (thru investing in long-term assets);
 ensure short-term liquidity (i.e., managing working capital);
 The investments in long-term assets ultimately decide the future (i.e.,
profitability) of the firm;
 Investment is an economic decision, not an accounting decision.
A. Cash flow Projection:
How do you forecast the cash flow?
The most pivotal question in Finance!
Simple projection (the short term);
Current assets are sales driven
Projection models (the mid-term);
Statistical modes (the long term);
The cash flows occurring at each point in time,
at t=0, capital goods are bought:
no cash flow from depreciation itself but the cash flows from depreciation
tax credits in the subsequent periods.
An accelerated depreciation would increase NPV and lower the cash flow in
later periods.
at t =0, net working capital is a cash outflow:
the net working capital would be recovered in the terminal year (nonoperating cash inflow).
At each subsequent period,
after-tax cash flows in each period =
(sales- operating expense – depreciation allowance) * (1 – tax rate)
+ depreciation allowance
In the terminal period, T,
the cash flow =
after-tax cash flow in each period + net working capital recovered
+ after-tax value of salvageable assets
 Add any opportunity costs involved onto the initial cash outlay.
 Add on any positive cash flow in the future from a ripple effect (externality).
 After-tax interest expenses should not be subtracted from the cash flows (the effect
of financing costs are captured in the discount rate
 The discount rate may vary period to period.
B. NPV Analysis
The firm’s Objective: Profit maximization:
Profit = Revenue - Expenses
Profit = PV of inflow – PV of outflow
In capital budgeting analysis, we use cash flow projection, not economic income projection
or accounting income projection, to evaluate the desirability (to calculate NPV) of project.
NPV method:
The sum of the PVs of all after-tax cash flows excluding the funding costs such as
interest costs (cash outlays & cash inflows).
CF
NPV = ∑ (1+r)t t
The discount rate
= default-risk free rate + risk premiums
= the opportunity cost of funds
= market value weighted average cost of capital
The decision rule: Is NPV > 0 ?
 The market value of the firm would increase by the NPV of the project..
 Sunk Cost:
If the capital goods were acquired in the past (i.e., sunk cost) then use the opportunity
cost of using the asset rather than the historical acquisition cost in calculating NPV
 Abandonment Option:
Compare the abandonment value with the PV of the remaining cash flows
 Comparing projects:
Rank them by their profitability (= NPV/ outlay) ratios.
 Comparing mutually exclusive projects:
The least common multiple of lives:
The projects are replicated over the same time horizon,
Compare the NPVs over the time horizons
The equivalent annual annuity (i.e., the time horizon is infinite):
Compute the NPV,
Calculate annuity payments that have a value equivalent to the NPV.
Compare the Equivalent Annual Annuity (EAA) s.
 Cash flows:
Unit sales, sales growth, the sale price, operating expenses as a percentage of total
revenue, the salvage value of investments are all random variables with certain
probability distributions.
 Uncertainty of Cash Flow (risk) and NPV valuation:
NPV of a project
= NPV(success) * P (success)
+ NPV (fail) * P (failure)
Quiz:
initial outlay is $1m; success would yield $8m in the 5th year with a probability of
25%; the discount rate is 10%. What is the NPV?
Q:
Consider the following investment proposal:
At t=0, initial outlay of $190m
Probability =.7 that cash flow of $50m per annum for t=1 through 10;
Probability =.3 that cash flow of $20m per annum for t=1 through 10.
The applicable discount rate = 10% per annum.
Would you undertake the project?
The double-up option:
at t=1, you may double up the operation by incurring another outlay of $190 which
will generate a cash flow for t=2 through 10.
What is the NPV of the project with the option?
Q:
Suppose you own a fleet of vans which cost you per van:
Initial cost of $30k; Annual cost of $12k in the 1st year, $15k in the 2nd, $20
in the 3rd, $25 in the 4th; the salvage value is $20k at the end of 2nd year,
$17k at the 3rd, $12K at the 4th.
How often should you replace vans if the discount rate was 5%?
Q:
Consider the following 12-year investment project:
Initial fixed capital outlay of $1.5 billion; straight-line depreciation is over a six-year
period with zero salvation value; the capital equipment will be sold for $0.5 billion at
the end of 12th year.
Net working capital required is $0.4 billion.
The project will generate additional annual revenue of $0.1 billion, and reduce cash
operating expenses by $0.25 billion per year.
The tax rate is 40%; the required rate of return is 12%.
Calculate the after-tax cash flow for t=0, … , 12
What is the NPV of the project?
What is the impact (i.e., positive or negative) of a reduction in the initial capital
outlay of $0.3 billion on the NPV and the first year after-tax operating income?
Q:
Suppose the rates of return were 100% in the 1st year, -50% in the 2nd year.
What are the arithmetic average and geometric average rates of return?
If you had invested at the beginning of 1st year $100M and another $100M at the
beginning of the second year, what would have been the internal rate of return over
the two-year span?
 Sensitivity:
Sensitivity analysis when one factor changes
Scenario analysis when multiple factors change
Monte Carlo simulation to estimate the probability distributions for NPV
C. NPV Profile
NPV (Y-axis) vs. the discount rate (X-axis)
Y intercept: when the discount rate = 0;
X intercept: when NPV =0.
NPV
0
B
A
Discount Rate
 A delay in the receipt of cash flows will make a project’s NPV more sensitive to
changes in the discount rate.
IRR: The discount rate that makes NPV = 0 on the NPV profile:
NPV >0
=> the discount rate (the weighted average cost of capital) < IRR,
NPV <0
=> the discount rate (the weighted average cost of capital) > IRR
D. NPV Profile and IRR
IRR method:
The decision rule:
IRR > r* (cost of capital)?
What is the economic meaning of the IRR?
the reinvestment rate.
Multiple IRRs: the cash flow changes signs more than once
No IRR
NPV vs. IRR decision rules:
the (opportunity) cost of funds vs. a reinvestment rate (IRR).
the scale of the project doubles up, the NPV doubles up, the IRR stays the same.
two projects of differing scale, compare the two projects by the NPV profiles.
When the two decision rules are in conflict, use the NPV profiles (economic meaning).
Use NPV profile for a cash flow with multiple IRRs.
NPV profile for a project w/ no IRR
Uncertainty (random variable) and the probability distribution of NPV:
Probability distribution
Statistics (sample data)
Investment decisions (portfolio management)
The post-audit as part of the capital budgeting process:
The purpose is not to revise the original forecast (a sunk cost);
To monitor forecasts, improve operations and generate ideas for future investments.
2. Cost of Capital
What should the discount rate for the CF be?
discount rate = default risk-free rate + risk premiums
A. The Cost of Capital (observed):
The costs of debt, preferred stock
The cost of Debt:
Yield to Maturity of bond * (1 –t);
Where, YTM (annual) = six-month yield of bond * 2
6-mo yield = IRR based on semi-annual coupon payments
The cost of Preferred stock =
preferred dividend $
market price of preferred $
B. The Cost of Equity (theories):
(1) The risk premium over bond approach:
The cost of equity = the before tax bond yield + equity risk premium
(2) The dividend discount model approach:
(𝟏+𝐠)
P = D * (𝐫 − 𝐠)
The cost of equity =
r = [D * (1+g)]
P
+
g
The cost of equity = the expected return on the equity
= expected dividend yield + expected growth rate
(3) The CAPM approach:
The cost of equity = long-term default risk-free rate + the equity risk premium
E(R i )
= Rf +
βim x
[ E(R m ) – R f ]
where
𝛃𝐢𝐦 =
𝐂𝐨𝐯 (𝐑 𝐢 ,𝐑 𝐦 )
𝐕𝐚𝐫 (𝐑 𝐦 )
Or,
the equity risk premium =
𝛃𝐢𝐦
*
market equity risk premium
(4) The APT approach:
The cost of equity = default risk-free rate +
∑ 𝛃𝐣
*risk factor i premium
where,
the betas are the risk factor betas.
How to estimate the cost of equity:
(1) The historical equity risk premium over bond yield approach:
Calculate the premium from historical data
(2) The dividend discount model based approach:
Estimate
(3) The CAPM approach
g = (1 -
𝐃
) * ROE
𝐄𝐏𝐒
(a) If the firm’s stock is publicly traded, regress the company’s stock returns
(𝐑 𝐢𝐭 ) against market returns (𝐑 𝐦𝐭 ) over T periods to get the firm’s equity
beta:
𝐑 𝐢𝐭
=
b
a + b *𝐑 𝐦𝐭
t = 1, 2, … T
𝐂𝐨𝐯 (𝐑 𝐢 ,𝐑 𝐦 )
=
𝐕𝐚𝐫 (𝐑 𝐦 )
(b) If the firm’s stock is NOT traded publicly, then estimate the firm’s equity
beta from the equity betas of publicly traded peer firms.
The unlevered systemic risk of the firm’s assets is (i.e., the risk of
the cash-flow):
βasset =
D
D+E
βd +
E
D+E
βe
With tax, VL = VU + tD ; VU = VL − tD = E +D -tD
Hence,
Since 𝛃𝐝 = 𝟎,
βasset =
E
D(1−t)+E
βe =
𝛃𝐞
𝐃
[𝟏 + (𝟏−𝐭)]
𝐄
Calculate the asset betas of the peer firms using the above equality,
𝐃
given the equity betas and their 𝐄 of peer firms;
Substituting the average asset beta of the peer firms, βasset ∗ , and the non𝐃
traded firm’s 𝐄 into the equation below:
βe = βasset ∗
[𝟏 +
𝐃
𝐄
(𝟏 − 𝐭)]
The result is the estimate for the non-traded firm’s equity beta.
Once the firm’s equity beta is determined, either (a) or (b) above, use the CAPM
equation to get the firm’s cost of equity.
 Computation of the beta for a given capital project:
estimate the asset beta of the project first and adjust it to reflect the risk of the
contemplated project (e.g., debt-equity ratio).
C. Operational and Financial Leverages
Leverage: the use of fixed costs (operating + financing) in a firm’s cost structure
Operating Income (OI)
Net Income (NI)
= PQ – QV – fixed operating costs
= PQ – QV – fixed operating costs – fixed financing costs
Operating leverage
Business risk = the risk related to the firm’s operations
= operating income (revenue) risk + operational expenses risk
Operating Income (OI)
=
PQ – QV – Fixed operating costs
=
PQ – QV - F
The degree of operating leverage (DOL):
= the elasticity of OI to change in Q
𝛛𝐎𝐈 𝐱 𝐐
=
𝛛𝐐 𝐱 𝐎𝐈
𝐐 ( 𝐏 – 𝐕)
=
Business Risk
𝐐 (𝐏 – 𝐕) – 𝐅
=
Sales risk (Price * Quantity)
+ Operating Risk (variable & fixed operating costs)
At the operating breakeven point
(i.e., operating income = 0; revenue – operating expenses)),
Q(P–V)–F
Q =
𝐅
(𝐏−𝐕)
= 0;
Financial Leverage
Financial risk = the risk related to the firm’s capital structure
PQ – QV – Fixed operating costs – Fixed financing costs
Net Income (NI) =
PQ – QV – F - C
=
The degree of financial leverage (DFL)
= the elasticity of NI to change in OI
=
𝛛𝐍𝐈 𝐱 𝐎𝐈
𝛛𝐎𝐈 𝐱 𝐍𝐈
𝐐(𝐏–𝐕)–𝐅
=
𝐐(𝐏–𝐕)–𝐅–𝐂
The Total Leverage
The degree of total leverage
=
the elasticity of NI to change in Q
=
=
=
𝛛𝐍𝐈 𝐱 𝐐
𝛛𝐐 𝐱 𝐍𝐈
DOL * DFL
𝐐 ( 𝐏 – 𝐕)
𝐐(𝐏–𝐕)–𝐅–𝐂
At the breakeven point (i.e., net income = 0),
Q(P–V)–F–C
Q =
𝐅+𝐂
𝐏–𝐕
= 0;
A summary of the Cost of Capital:
rWACC =
D
V
E
rd (1 - t) +
re
V
How to determine the cost of equity (i.e., the required rate of return on equity) re :
1. The DDM approach
𝐫𝐞
The cost of equity =
= [D * (1+g)]
P
+
g
This follow from
CF
D
NPV = ∑ (1+r)t t
t
; NPV ~ ∑ (1+r)
t ;
(𝟏+𝐠)
NPV = P ~ D *(𝐫 − 𝐠)
Solve for r from the last equation.
2. The CAPM approach
The cost of equity = long-term default risk-free rate + the equity risk premium
𝐫𝐞
= Rf +
βe [ E(R m ) – R f ]
How to estimate β
If publicly traded, run a regression using price data;
𝐑 𝐢𝐭 =
a + b *𝐑 𝐦𝐭
b=
t = 1, 2, … T
𝐂𝐨𝐯 (𝐑 𝐢 ,𝐑 𝐦 )
𝐕𝐚𝐫 (𝐑 𝐦 )
If not publicly traded, estimate using peer firms
𝐃
βe = βasset ∗ [𝟏 + 𝐄 (𝟏 − 𝐭)]
3. Capital Structure and Solvency
Are the value of the firm and its discount rate (i.e., the cost of capital/ the rate of return
required by the fund suppliers) related to the capital structure (i.e., the form of financing)?
A. The Optimal Capital Structure
The objective is to determine the capital structure/ financial leverage that maximizes the
value of the firm by minimizing the weighted average cost of capital.
MM (Modigliani-Miller) without taxes:
Assumptions:
Borrowing and lending at the same rf ,
Homogeneous expectations,
Perfect capital market,
MM Proposition I:
The value of leveraged firm = the value of unleveraged firm
VL
= VU
Earningst
 The value of a firm = ∑ (1+ r
t
WACC )
Where,
rWACC =
D
V
 if VL = VU =>
rd +
E
V
re
r0 = rWACC
=
D
V
rd +
E
V
re
i.e., if VL = VU for a given cash-flow, then the cost of capital must be the
same regardless of the firm’s capital structure.
MM Proposition II:
D
re = r0 + (r0 - rd )
E
Where, r0 is the cost of capital for the firm financed only by equity.
 The cost of equity is a linear function of the firm’s debt/equity ratio.
 re must increase as
D
E
increases at (r0 - rd ).
MM Propositions with taxes,
MM Proposition I with taxes:
VL = VU + tD
 The PV of the tax benefits of Interest
=
∑
D∗rd ∗tax rate
(1+ rd )t
=
D∗rd ∗tax rate
rd
= D ∗ tax rate
 VL is a function of D/E.
 After-tax cost of debt = before- tax cost of debt * (1 – marginal tax rate)
rWACC =
D
V
rd (1 - t) +
E
V
re
MM Proposition II with taxes:
re = r0 + (r0 -rd ) (1 – t)

D
E
re is a an increase function of D/E.
The optimal capital structure:
The capital structure that minimizes the weighted average cost of capital (WACC)
also maximizes the value of the company (the PV of after-tax cash flows).
The Y-axis, Costs of Equity and Debt; the X-axis, Debt/Equity Ratio
M-M without Taxes:
Cost of capital
re
rWACC
ro
rd
Debt/Equity
M-M With Taxes
Cost of capital
re
ro
rWACC
rd
Debt/Equity
The Static Trade-off theory:
There is a trade-off between tax benefits (deductibility of interest expenses) of debt
and the costs of financial distress due to debt.
The increase in equity returns through leverage is offset by the increased required
rate of return.
Cost of Capital
Cost of Capital
Cost of Equity
Weighted Ave
After-ta
Market Value
Cost of Capital
Debt
VL = VU + tD
Equity
VL = VU + tD + Financial Distress
VU
Debt
B. Issues in Capital Structure Policy
WACC is also affected by the quality of corporate governance (i.e., the agency costs),
More debt in the capital structure reduces the net agency costs of equity,
The asymmetric information would cause fund providers to demand higher returns:
Managers would conduct their funding activities considering the signaling effect of
their choice of funding vehicle;
Internally generated funds are preferable to both new equity and new debt, managers
next prefer new debt, and finally new equity (issued if it is overpriced) - the pecking
order theory.
Firms may not operate at the optimal capital structure but try to operate near their target
structure.
Many firms try to maintain a certain credit rating on their debt,
Security floating cost and cost of capital:
Adjusting the initial cash outlay, ex ante, to account for the floatation costs is more
logical than trying to account for the floatation costs by adding a spread to the cost of
capital, ex post.
 Estimating the country risk:
Country equity risk premium from $ based investors
= sovereign yield spread * (standard deviation of the country’s equity in $)
(standard deviation of the country’s bond in $)
Quiz: given the following information on your firm,
Book value
Market Value
Current Year
Debt
50
Equity
60
Debt
55
Equity
100
Next Year
50
65
57
110
What are the weights you would apply in computing the cost of capital for debt and
equity?
If the expected YTM on debt is 8% and the equity risk premium is 4% per annum,
what is the expected cost of capital under the current D/E ratio?
Quiz 2: given the following information,
EBIT
Debt (MV)
D/E
Tax rate
$100M
$200M
.4
35%
What is the market value of the firm?
What is the weighted average cost of capital?
If the current cost of equity 12%, what is the current cost of debt?
What is the cost of equity if D/E =0, under the Modigliani-Miller proposition?
4. Working Capital (Liquidity) Management
Corporate finance is about
 maximizing long-term profitability (e.g., investing in long-term assets),
 ensuring short-term liquidity (e.g., managing working capital).
A. Managing the Cash Position
Liquidity:
the ability to meet the short-term obligations by generating cash from assets and
liabilities. (Managing liquidity does not involve much theory but practical savvy.)
Sources of liquidity:
Assets:
Cash,
Convertibles (s-t marketable securities, accounts receivable, inventory)
Liabilities:
Payables
Credit reserves/ Borrowings
Measuring Liquidity (credit worthiness/ perceived liquidity):
Working capital = current assets – current liabilities
Current ratio = current assets / current liabilities
Quick ratio = (current assets - inventory) / current liabilities
Current ratio > quick ratio
Managing the Cash position:
Ensuring that the net cash position is not negative
Short-term cash forecast: inflows and outflows
Investment risks:
credit (default) risk, market (interest rate) risk, liquidity risk , FX risk, etc.
B. Cash Generating Ability:
Managing Accounts Receivable:
Control the credit risk:
Trade Credit Granting Process; credit scoring models,
Centralize the accounts receivable function;
Securitization of accounts receivable:
use a captive finance subsidiary and lower the funding costs
Receivable Turnover (= credit sales / average receivable)
DSO (# days of sales outstanding) = 365/ receivable turnover
Managing Accounts Payable:
Payables Turnover (= [cost of goods sold + change in inventory] / average payable);
DIP (# days in payables) = 365 / payable turnover
Trade discount:
2/10, net 30:
2% discount if paid within 10 day, full amount by the 30th day.
the effective borrowing cost for 20-day = [100 / 98] ^(365/20) – 1
 Operating Cycle:
Day of Inventory on Hold + Days Credit Sales outstanding
DOH + DSO
 Cash Conversion Cycle: DOH +DSO – DIP
 Net operating cycle
= operating cycle
- # of days of payables
Managing Inventory:
Transaction motive, precautionary stocks (to avoid stock-out losses)
Economic order quantity-reorder point (EOQ-ROP); the level above safety stock
Just-in-time method
Carrying costs vs. stock-out costs
Inventory Turnover (= cost of goods sold / average inventory);
DOH (# days of inventory on hold) = 365/ inventory turnover
C. Managing Short-term Financing:
Credit Reserves:
Bank sources- lines of credit, revolving credit agreements, asset-based loans
Capital market- commercial papers (CP)
Compute and compare the effective cost of short-term borrowing alternatives
Banker’s acceptance =
interest
(loan – interest)
Line of credit
=
(interest + commitment fee)
loan amount
CP
=
(interest + commission + back-up cost)
(loan – interest)
Short-term Investments:
Repos ( 1 day +), CPs (1 -270 days), CDs (14-365 days),Euro TD( 1-180 days)
Be able to compare different rates; know the formulas:
Bank Discount Yield
= [(F-P) ] * (360 )
F
t
Money Market Yield
= [ (F-P) ] * (360 )
P
t
or = bank discount * (F )
P
Note that BDY <MMY
Holding Period Yield =
[ P(t) – P(o) + C(t)]
P(o)
Quiz:
Effective Yield
= { 1+ (Pt –Po +Ct) } ^ (365 ) -1
Po
t
Bond yield equivalent
= (F – P)
P
*
365
D
= 2
x
(semi-annual yield to maturity)
= 2
x
(6-mo holding period yied)
Given the following data,
Credit sales
Cost of goods sold
Accounts receivable
Accounts payable
Inventory, beginning
Inventory, ending
$100M
$80M
$25M
$15M
$10M
$12M
Compute Day of Inventory on Hold (DOH) and Days Credit Sales outstanding (DSO).
What is the operating cycle?
Compute the DIP (# days in payables).
What is the net operating cycle?
5. Dividend Policy and Share Repurchase
A. Dividends and Company Value:
Shareholders receive the return on their investment.
Investor Preference for dividends:
Dividend Irrelevance:
dividend income can be had by selling shares
Miller-Modigliani (MM): in a perfect capital market where there are no taxes
or transaction cost and equal symmetric information among investors,
dividend policy has no impact on the cost of capital or on shareholders’
wealth.
the Clientele Effect:
different classes of investors have differing preferences for dividends
investors preferring dividend income will buy high yielding shares.
the Tax Effect:
when dividends are taxed at a higher rate than capital gains, share
repurchases are preferable to dividends.
double taxation system, tax imputation system (shareholders), splitrate taxation system (corporation)
the bird-in-hand theory:
dividends today are preferred to uncertain capital gains in the future.
Payout Policy and the Signaling Effect
Initiating or increasing a dividend sends a positive signal; cutting or omitting a
dividend sends a negative signal
Dividend and P/E ratio:
The dividend discount model approach:
P=D*
P
E
=
(𝟏+𝐠)
(𝐫 − 𝐠)
𝐃(𝟏+𝐠)
𝐄
;
∗
𝟏
(𝐫 − 𝐠)
B. Payout Policies:
Dividend Payout Policies are influenced by:
Investment opportunity,
The volatility of expected future earnings,
Tax consideration,
Financial flexibility due to debt covenants,
Floating costs on issuing new debt or equity.
A stable dividend policy:
The firm tries to align the dividend growth rate to the long-term earnings
growth rate,
Or
adopts a gradual adjustment process in which the expected dividend = last
year’s dividend + this year’s expected increase in earnings * the target
payout ratio * an annual adjustment factor.
A constant dividend payout ratio policy:
The firm applies a target dividend payout ratio to current earnings.
 dividends are as volatile as earnings
A residual dividend policy:
Annual dividend =
annual earnings – (the capital budget * % of retained Earnings)
Dividend Safety; how safe is the future dividend income?
Is the earning, or cash flow, sufficient to sustain the dividend payments?
Is the dividend yield too high?
Is the firm borrowing funds (incurring floating costs) to pay dividends?
Dividend payments and Conflict of interest:
Reduce the conflict between management (agent) and shareholders;
Worsen the conflict between debt-holders and share-holders:
By restrictive (negative) debt covenants
Share Repurchase:
Used in lieu of increasing cash dividends (irregular cash dividends);
More flexible than cash dividends (by not establishing a certain expectation on future
cash dividends);
The firm attempts to send a signal that the share is undervalued by the market:
It may backfire: investors think that the firm has no good investment
opportunities.
6. Mergers and Acquisitions
A. Motives for Merger
Horizontal: among peer firms to gain economies of scale
synergy, growth, increasing market power, managers’ personal incentives
Vertical: to acquire unique capabilities and resources along a given value chain
backward integration (acquisition of supplier)
forward integration (acquisition of distributor)
Conglomerate:
to acquire firms in unrelated businesses for diversification,
to bootstrap (make illusionary) earnings
if the acquirer’s P/E is higher than the target’s P/E,
EPS of the acquirer would rise following the merger,
the stock price would also increase to maintain the P/E level.
B. Merger Analysis (Equity Valuation on the target firm):
 Will the transaction create value?
 Does the price outweigh the expected benefits?
Discounted (free) cash flow:
Discount free cash flow (net operating profit less adjusted taxes) at the
weighted average cost of capital assuming a constant growth rate, g, and the
perpetuity of the cash flow.
Comparable company analysis (the relative valuation):
Compute the averages of P/E, P/sales, P/book of comparable companies;
Multiply the average ratios to the target firm’s earnings, sales, book value;
Compute the average of the three (estimated) prices.
Comparable transaction analysis:
1) do the comparable company analysis using the acquisition prices;
2) alternatively, add the average takeover premium (acquisition price less
market price before takeover announcement) onto the price computed
from the comparable company analysis.
C. Merger Transaction:
Stock purchase:
buy the target firm’s shares (payments made to the shareholders)
Asset purchase:
buy the target firm’s assets (payments to the target firm)
Method of Payment:
Cash offering
Securities offering (at a certain exchange ratio)
Mixed offering
Form: Statutory: one company merges into another
Subsidiary: the target becomes a subsidiary of the acquirer
Consolidation: the two firms merge into a new entity
Regulations:
Antitrust legislation prohibits transactions that impede competition:
Herfindah-Hirschman Index (HHI): ∑(market share in %)2
Is the change in the HHI large (> 100)?
Is the post -merger concentration level high (HHI > 1000)?
Securities Laws ensures a fair tender offer process
D. The Merger Bids:
The deal price =
the value (stock price) of the target company
+ the control (synergy) premium
The target company shareholders receive the takeover premium.
The acquirer gets the value of synergy – the premium paid to the target shareholders.
The empirical evidence suggests the acquirer gets very little (i.e., over-paid)
Friendly Mergers: (endorsed by the target firm’s management)
Due diligence and negotiations
Definite merger agreement
Proxy statement (to shareholders of the target/ acquirer)
Hostile takeover transactions: (opposed by the target firm’s management)
Bear hug:
proposal to the board bypassing the CEO
Proxy fight:
seeking the control of the target through a shareholder vote on directors
Tender offer:
Buying the shares from the target firm’s shareholders
Hostile takeover Defense Mechanisms:
Pre-offer defense mechanism: shark repellents
poison pills (shareholders), poison puts (bondholders) , incorporating in
states with restrictive takeover state laws, staggered board of directors,
restricted voting rights, super-majority voting provision, fair price
amendment, golden parachutes
Post-offer defense mechanism:
Greenmail (buying back shares from the acquirer at a premium), litigation,
leveraged recapitalization (share repurchase), selling off “crown jewel”
assets defense, counter offer “pac-man” defense, finding a white knight/
white squire
E. Divestiture:
Sale of assets to another company (unlocking hidden value?):
acquisition by the buyer
Sale of equity in a new entity (a new subsidiary) to outsiders:
an equity carve-out
Spin-off (or split off) to the existing shareholders:
Generates no cash inflow
Liquidation:
7. Corporate Governance
A. Objectives and Guiding principles
1) To eliminate or minimize conflicts of interest among stakeholders:
Delineate the rights of shareholders and the responsibilities of managers and
directors,
Establish identifiable and measurable accountabilities for the performance of
responsibilities,
2) To ensure that the assets of the company are used for the best interests of the
investors:
Transparent and complete disclosures regarding operations, performance,
financial positions, risks, (through effective corporate governance, the
operational risk of the firm is controlled)
B. Conflicts of Interest (in corporate agency relationships)
Fairness in all dealing between managers, directors and shareholders,
Manager-shareholder conflicts
Are the managers working for the shareholders or themselves
Director- shareholder conflicts
independence of the board from the management’s control is esential
The responsibilities of board members:
Establish governance structures;
failure to do so represents an operational risk to the firm
Ensure that all legal and regulatory requirements are met;
Establish long-term strategic objectives;
Establish lines of responsibility, a system of accountability, and performance
measurement in the firm’s operation;
Hire the CEO
B. Corporate Governance & Investment Analysis:
Assess:
Board composition (qualification) and independence;
Board self-assessment practice;
Nominating committee, Audit committee, compensation committee;
The use of independent legal and expert counsels;
Statement of corporate governance policies
Weak corporate governance systems give rise to:
Accounting risk;
Asset risk;
Liability risk;
Strategic policy risk