Advanced Corporate Finance

Lec 10 Final Review

Professor Sudip Gupta
BITSoM
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 What have we learned so far?

• Free Cash Flow

• Separation between investment and financing activities
• A finance’s view, instead of an accounting’s view, of cash
flow
• It is operating cash flow in excess of investments needed for
business activity
• We extract information from accounting statements to
compute FCF
• Net income must be adjusted to use in financial analysis

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The Weighted Average Cost of Capital Method
E D
rwacc = rE + rD (1 - tc )
E +D E +D

Because the WACC incorporates the tax savings from debt,

we can compute the levered value of an investment, by
discounting its future free cash flow using the WACC

FCF1 FCF2 FCF3

V =
0
L
+ + + ....
1 + rwacc (1 + rwacc )2
(1 + rwacc )3

Capital Structure Choice: Choose capital structure that

maximizes firm value or minimize the cost of capital
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 Recap MM: Required assumptions
• No taxes
• No financial distress costs
• No direct transaction costs
• Firm managers don’t have private information about the
firm’s prospects that investors do not have
• No agency problems between managers and investors
• Investors can borrow or lend on their own account on the
same terms as the firm
• Markets are perfectly competitive and thus efficient with
respect to public information

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 Recap: MM without Taxes
• In a world of no taxes, the value of the firm is unaffected by
capital structure.
• This is M&M Proposition I:
VL = VU
• Proposition I holds because shareholders can achieve any
pattern of payouts they desire with homemade leverage.
• In a world of no taxes, M&M Proposition II states that leverage
increases the risk and return to stockholders.

B
RS = R0 + × (R0 − RB )
SL
 MM Proposition II (No Taxes)
Cost of capital: R (%)

B
RS = R0 + ´ ( R0 - RB )
SL

B S
R0 RW ACC = ´ RB + ´ RS
B+S B+S

RB RB

Debt-to-equity Ratio B
S
 Recap: MM with Taxes
• In a world of taxes, but no bankruptcy costs, the value of the
firm increases with leverage.
• This is M&M Proposition I:
VL = VU + TC B
• Proposition I holds because shareholders can achieve any
pattern of payouts they desire with homemade leverage.
• In a world of taxes, M&M Proposition II states that leverage
increases the risk and return to stockholders.

B
RS = R0 + × (1− TC ) × (R0 − RB )
SL
 The Effect of Financial
Leverage
Cost of capital: R B
(%)
RS = R0 + ´ ( R0 - RB )
SL

B
RS = R0 + ´ (1 - TC ) ´ ( R0 - RB )
SL

R0

B SL
RW ACC = ´ RB ´ (1 - TC ) + ´ RS
B+SL B + SL
RB

Debt-to-equity
ratio (B/S)
 MM: Required assumptions
• No taxes
• No financial distress (bankruptcy) costs
• No direct transaction costs
• Firm managers don’t have private information about the
firm’s prospects that investors do not have
• No agency problems between managers and investors
• Investors can borrow or lend on their own account on the
same terms as the firm
• Markets are perfectly competitive and thus efficient with
respect to public information

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 Tax Effects and Financial Distress

• There is a trade-off between the tax advantage of debt and the

costs of financial distress.
• It is difficult to express this with a precise and rigorous
formula.

• VL = VU + PV(tax savings) – PV(costs of financial distress)

 Tax Effects and Financial Distress
Value of firm (V) Value of firm under
MM with corporate
Present value of tax taxes and debt
shield on debt
VL = VU + TC B

Maximum Present value of

firm value financial distress costs
V = Actual value of firm
VU = Value of firm with no debt

0 Debt (B)
B*
Optimal amount of debt
 Combined impact of all
imperfections
V ( L) = V (U ) + value added by debt
• When you incorporate corporate taxes, bankruptcy costs and agency
problems into the MM world

• where, Value added by debt

= Tc D - PV (expected bankruptcy costs)
- value loss due to excess risk taking
+ value gain from improved monitoring

• It is more difficult to calculate these new costs and benefits

 The Pecking-Order Theory

• Theory stating that firms prefer to issue debt rather

than equity if internal financing is insufficient.
• Rule 1
• Use internal financing first
• Rule 2
• Issue debt next, new equity last
• The pecking-order theory is at odds with the tradeoff
theory:
• There is no target D/E ratio
• Profitable firms use less debt
• Companies like financial slack
 Recap: Once a capital structure is
chosen, we can compute WACC
• WACC (without tax) – debt and equity financing
B S
WACC = RB + RS
V V
• V = B + S, B and S: market values of Debt and Equity
• WACC (with tax) – debt and equity financing
S B B S B
WACC = RS + RB − RBTC = RS + RB (1− TC )
V V V V V
• Interest paid on debt is tax deductible ® cost of debt is reduced
• TC is the corporate tax rate
• WACC with debt, preferred equity and common equity financing
S B P
WACC = RS + RB (1− TC ) + RP
V V V
• V=S+B+P
• The formula above can be modified to include additional terms, provided the total
weights sum to 1
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 Two ways to examine how
leverage affects a firm
• DCF approach (narrow definition)
• Forecast free cash flows
• Discount by WACC
• Adjusted Present Value (APV) approach
• Forecast free cash flows
• Discount by unlevered cost of capital
• Compute PV of any cash flows from financing effects
• Summing up these two components
• APV = VUA + Value due to having debt

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The basic idea behind APV
Value due to
having debt

VUA

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Conflict between Shareholders and Debtholders

• We saw that risk-shifting destroys firm value

• i.e., when agency problems between shareholders and debtholders are
concerned, debt actually destroys firm value

• But how serious is this problem? That depends on firm

characteristics, mainly growth prospects

• Risk shifting is a serious concern with high growth firms and

risky firms…
• Example: most high tech businesses
• Less serious problem with large established firms
Conflict between Shareholders and Managers

• Managers can misuse “excess” FCF by

• Investing in negative NPV pet projects (“empire building”),
consuming excessive perks, etc.
• Excess FCF is the portion of FCF left over after dividend and
debt payments have been made

• Debt mitigates (i.e., reduces) agency problems between

shareholders and managers
• Lenders (banks, etc.) act as monitors by serving on firm’s board
of directors, etc.
• Also, by requiring frequent payments, debt minimizes the
amount of excess FCF that can be wasted
 Capital Structure in the Real
World
• Why do Debt Ratios Differ across Firms?
• Interest tax shield is the same for all firms with the same effective
tax rate

• Financial distress costs increase with

• probability of bankruptcy (risk and volatility)
• cost of bankruptcy (intangibles)

• Agency problems between debtholders and shareholders are more

severe for firms with higher growth opportunities

• Agency problems between managers and shareholders are more

severe for firms with high excess FCF
 Understanding Firms Debt
Ratios
• Why doesn’t Microsoft have any debt? Because benefits of debt
are outweighed by costs of debt
• High growth/ risky firm, so greater agency problems between debtholders
and shareholders (High cost of debt)
• High intangibles, so high bankruptcy costs (High cost of debt)
• Although probability of bankruptcy is low
• High insider ownership, so agency problems between managers and
shareholders is not much of an issue (low benefit of debt)
• Firms that have higher than average debt to assets ratios
• Examples: General Motors, Sears, etc.
• Why? Benefits of debt exceed costs
• These are low intangible, (relatively) low risk, high FCF firms that stand to
benefit from debt
 Business Risk and Financial Risk
• In a world with corporate taxes, and riskless debt, it can be
shown that the relationship between the beta of the unlevered
firm and the beta of levered equity is:
# Debt &
β Equity = %1+ × (1− TC )( β Unlevered firm
$ Equity '

• Since #%1+ Debt × (1− T )&( must be more than 1 for a

C
$ Equity '
levered firm, it follows that bEquity > bUnlevered firm
 Key Points

• A firm would choose a leverage level that maximizes

firm value (i.e, minimizes cost of capital)
• All else equal, a firm will choose high leverage if:
• Effective corporate tax rate is high
• Bankruptcy costs and/ or probability of bankruptcy are low
• Agency problems between shareholders and debtholders (risk-
shifting) are less severe
• Agency problem between managers and shareholders (arising
from excess FCF) is more severe
 Dividend policy
Dividend policy is part of the firm’s financing
policy
• The level of the distribution
• How much of its free cash flow should be paid as dividend?
• The stability of the distribution
• Should a firm maintain a stable, constant payment policy, or
should it let the payments vary as conditions change?
• The form of the distribution
• How to distribute to shareholders, dividend or stock
repurchase?
 Distribution to Shareholders

• Payout Policy
• The way a firm chooses between the alternative ways to
distribute free cash flow to equity holders
 Does payout policy matter when the
market is not perfect?

• Uncertainty of cash flows

• Bird-in-the-hand theory
• Taxes
• Tax preference theory: taxes on dividends versus capital gains
• Clientele effect: taxes on individuals with different tax brackets
• What should a firm do?
• Agency problems
• Asymmetric information
• Stability of distribution
 Problems in NPV approach

• Investment decision is sensitive to the accuracy of NPV

• NPV approach requires many forecasts and assumptions
• The uncertainty of the forecasts leads to uncertainty about
the NPV
• What if our assumptions and forecasts are wrong?
• What if things do not turn out to be what we have thought?

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 Introducing Managerial Options
• How to infuse flexibility and resilience in corporate projects
• How to value flexibility ?
• Capital investment projects can have embedded options
• Real options or managerial options
• Manager’s right, not obligation, to modify the project as events occur
• These options have value
• Static DCF analysis ignores managerial options
• Potentially under-estimate the NPV and reject profitable projects
• How to value the option embedded in a project?
• Value of the project=NPV without option + real options value
• “Real Option” Value = NPV w/ option - NPV w/o option

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 Types of managerial options
• Timing Options
• The option to wait (and learn) before investing
• A call option on the investment project
• Growth Options (Options to expand)
• A call option on follow-on projects
• Strategic investments fall under this category
• Abandonment Options
• A put option with exercise price equal to the value of the project’s assets
if sold or shifted to a more valuable use
• Provides partial insurance against failure (Resilience to the firm)
• Designed-in Options
• Options which allow a firm input flexibility, output flexibility, or
expansion capabilities

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 Types of managerial options

• Case Discussion
• MW Petroleum corporation
• Black Scholes based valuation of real options
• When is it optimal to exercise the “real” options

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 Raising Equity Financing: IPO

1. What are the main sources of funding for private companies

to raise outside equity?
2. What is a venture capital firm?
3. What are some of the advantages and disadvantages of going
public?
4. IPO Process
1. Book-building, auctions
5. List and discuss IPO “puzzles.”
1. Underpricing
2. Cyclicity
3. Long Run underperformance
International Comparison of First-Day IPO Returns
 Cyclicality of Initial Public Offerings in the
United States

Source: Adapted courtesy of Jay R. Ritter from “Initial Public Offerings: Tables
Updated through 2017” ([Link]/ritter/).
Similar trends in India and worldwide
 M&A Valuation

1. Case discussion
a. Valuation in a M&A
b. How to interpret market reaction
c. Agency issues
d. Corporate governance issues