CORPORATE FINANCE SUMMARY

Tuesday, 5 November 2024 10:31

The 4 types of firm

Sole proprietorship (sole trader/ entreprise individuelle)
• Owned and run by 1 person; has few, if any, employees
• Easy to create BUT there is no separation between the firm and the owner -> unlimited personal liability and have
limited life
• Example: Local café
Partnership: similar to sole proprietorship
• More than one owner, 2 types of owners:
○ General Partners: unlimited liability, run the firm on a daily basis
○ Limited partners: limited liability (cannot lose more than their initial investment), have no management
authority and cannot legally be involved in the managerial decision making for the business
• All partners are personally liable for all of the firm's debts: lenders can require any partner to repay all outstanding
debts
• The partnership ends with the death or withdrawal of any single partner
• Create managerial and creative synergies relative to sole traders BUT more room for conflict
• Example: law firms, consultancies, PE funds, hedge funds
Limited liability company
• All owners have limited liability and can run the business
• Like a corporation but without separation of ownership and control and disclosure requirements.
• Example: Most startups, large corps gone private
Corporations:
• A legal entity separate from its owners, has many legal powers as individuals have (enter into contracts, own assets,
and borrow money)
• Is solely liable for its own obligation. No owners are liable for those
• Ownership: no limit to the number of shareholders and, thus, the amount of funds a company can raise by selling stock
• Taxation: Double taxation
• Ownership vs. control: ownership and direct control are typically separate
○ Ethics and incentives: agency problems -Managers may act in their own self interest rather than in the best
interest of the shareholders
○ Firm and Society:
 Main goal of the firm's management team: maximize shareholder or stakeholder (social) value?

Valuation and Decision Making

• Cost-Benefit analysis
○ Convert to common unit
○ Calculate the net value in common unit
• Time value of money
○ Money in the future is not worth the same as money today
○ Current interest rate = the rate at which we can exchange money today for money In the future
○ NPV rule:
 Accept any projects with positive NPV
 If projects are mutually exclusive: take one with highest NPV
○ Compounding and discounting
CAPITAL BUDGETING
Forecasting earnings
• Capital budget = a list of the investments that a company plans to undertake
• Capital budgeting: the process used to analyze alternate investments and decide which ones to accept
• Incremental earnings = the amount by which the firm's earnings are expected to change as a result of the investment
decision
○ Unlevered net income = EBIT - Income tax
○ Opportunity costs and earnings externalities
• Free Cash Flow: = EBIT - Income tax + Depreciation - CapEx - change in NWC
○ Depreciation: non-cash expense
○ Capital Expenditure: actual cash outflows when an asset is purchased
○ Net working capital: NWC(t) = Cash(t) + Inventory(t) + Trade credit(t) (= Receivables - Payables)
 to maintain a min cash balance to meet unexpected expenditures,
 to keep inventories to meet uncertain production requirements
• Project's discount rate: must reflect the project's opportunity cost of capital
○ = the expected return of an equally risky investment in the financial market
○ Risker projects pay higher return (higher r)
• Criteria to choose project:
○ NPV rule
○ Payback rule:
 accept projects that have payback period less than a pre-specified length of time
 Simplicity but ignores project's cost of capital, cash flows after payback period, relies on an ad hoc decision
criterion
○ IRR rule:
 accept projects with the IRR higher than the opportunity cost of capital
 Only works when the benefits of an investment occur before the costs
Does not work when the future cashflows are both positive and negative
• Project analysis:
○ Break-even analysis
○ Sensitivity analysis

Valuation of stock
• DCF: The expected return on equity can be decomposed into the dividend yield and the expected capital gains

• Comparable firms or investments that we expect will generate very similar cash flows in the future
○ PE ratio
○ Enterprise value ratio
• Relation between Multiples and DCF:
○ Multiples method do not adjust for known differences in expected future growth rates, risk or differences in
accounting policies --> only provide info regarding the value of a firm relative to other comparable, does not help
if the entire industry is overvalued
○ DCF: can incorporate specific information abt the firm's cost of capital or future growth
• Risk aversion: Risk averse investors will require a premium for taking risk
○ Risk types:
 Common/ systematic risk: affects all stocks -> perfectly correlated across all stocks
 Independent/ Idiosyncratic risk: affects one particular stock only -> uncorrelated across all stocks
 ○ Diversification: reduction in overall risk via the averaging out of independent/ idiosyncratic risks in a large
portfolio

 The total idiosyncratic risk in a portfolio decreases with the number of stocks in it
 The systematic risk component is independent of the number of stocks, i.e., it cannot be diversified away
 Actual firms are affected by both market-wide risks and firm-specific risks. Only the unsystematic risk will
be diversified when many firm’s stocks are combined into a portfolio. The volatility will therefore decline
until only the systematic risk remains.
○ Expected returns of an individual stock:
 Investors do not a return premium for holding stocks with firm-specific risk: that risk will be diversified
within their portfolios.
 The return premium of a stock must be determined by how much systematic risk it has.
 The stock's own return volatility (STD) is not useful in determining the risk premium investors expect to
learn --> Need a measure of a stock's systematic risk
○ CAPM Beta: the expected percent change in the excess return of a security for a 1% change in the excess return
of the market portfolio
 Efficient Portfolio: contains only systematic risk - Market Portfolio
 Beta (=/= volatility): related to how sensitive its underlying revenues and cash flows are to general
economic conditions: Stocks in cyclical industries are likely to be more sensitive to systematic risk and have
higher betas than stocks in less sensitive industries
 Risk premium

FIRMS' COST OF CAPITAL

• Equity cost of capital:
○ Return of the market portfolio
○ Risk-free rate: yield on U.S Treasury securities or government-issued bonds but what maturity (same maturity as
that of investment)
○ Beta: a stock’s Beta corresponds to the slope of the best-fitting line in the plot of the security’s excess returns
versus the market excess return
• Debt cost of capital:
○ Yield to maturity: the IRR an investor will earn from holding the bond to maturity and receiving its promised
payments
○ Depending on probability of default, yield maturity may or may not be a reasonable estimate of investors.
Suppose the bond will default with probability p and L is the expected loss per $1 of debt in the event of default
(loss given default), the expected return of the bond is:

○ In principle, we can use CAPM to estimate debt cost of capital but debt betas are difficult to estimate because
corporate bonds are traded infrequently
• Project's cost of capital:
○ For all-equity comparables: find an all equity financed firm in a single line of business that is comparable to the
project, use the comparable firm's equity beta and cost of capital as estimates
○ For levered firms as comparables: unlever beta or cost of capital

CAPITAL STRUCTURE AND Modigliani and Miller Theorem

WITHOUT TAX
Example: A firm is considering an initial investment of 800 this year, for a project

(1) The firm can raise up to 1000 in equity and keep 200 as a profit. Equity return rate = 0.5 ( 40% -10%) = 15%
(2) The firm can borrow 500, and have to pay back 525 regardless of future cash flow. Equity return = 0.5(75% - 25%) = 25%

--> MM1: in a perfect capital market, total value of a firm = the market value of the total cash flows generated by its assets
and not affected by its choice of capital structure
• In the absence of taxes or other transaction costs, the total CF paid out to all of a firm's security holders = total CF
generated by the firm's assets
• A firm's financing decisions do not change the CF generated by its investments nor do they reveal new information
about them
--> MM2: Cost of capital of levered equity = cost of capital of unlevered equity + a premium that is proportional to the
market value of D/E ratio

WITH TAX
Example:

Debt reduced the value of equity because of interest expense

But the total amount available to all investors was higher with leverage because the tax amount was lower for the case with
leverage

--> MM1 (with taxes): Total value of the levered firm = Total value of the unlevered firm + Present value of the tax savings
from the debt
--> MM 2 (with taxes): With tax-deductible interest, the effective after-tax borrowing rate is Rd x (1-T) and the weighted
average cost of capital becomes: ….

RECAPITALIZING Example: Firm A has 20 mil shares outstanding with a market P of 15 per share and no Debt, tax = 35%
Plan: borrow 100 million on a permanent basis -> repurchase outstanding shares
• Total value of firm A will increase from 300 mil to 335 mil thanks to 35 mil of tax savings.
• Value of equity will reduce from 300 to 235 but share price will increase from 15 to 17.625
• If the shares were worth $17.625/share after the repurchase, why tender shares to Firm A at $15/share?
○ Law of one price: no arbitrage opportunity
○ Value of equity will rise immediately from 300 to 335 after the announcement
 Share price after announcement but before buyback: 335/ 20 = 16.75
 Shareholders who sell or hold gain: 16.75 - 15 = 1.75
 1.75 x 20 = 35.0 which is the capital gain
Personal Tax
• CF to investors are taxed twice: once at corporate level, and one for interest income, dividends and capital gains
--> offset some of corporate tax benefits of leverage
--> Actual interest tax shield depends on both corporate and personal taxes that are paid
• Effective tax rate of debt =
 ○ If no personal taxes (no T on debt/equity income), effective tax advantage = corporate tax
○ When equity income is taxed less heavily than debt income: effective tax advantage < corporate tax
--> the benefit of leverage is reduced in the presence of personal taxes
• Reality:
○ many investors face no or low personal taxes
○ Calculating effective tax advantage of debt accurately is difficult bc personal taxes are different
○ Tax advantage of debt varies across firms and from investors to investors
Optimal Capital Structure
• Use of debt varies greatly by industry:
○ Firms in growth industries carry very little debt
○ Airlines, automakers, utilities and financial firms have high leverage ratio
• Low Leverage Puzzle: Firms have far less leverage than the analysis of the interest tax shield would predict

Trade-off theory of Capital Structure

Bankruptcy and Financial Distress Costs
• With perfect capital markets: risk of bankruptcy is not a disadvantage of debt
--> bankruptcy: ownership shifted from equity holders to debt holders without changing the total value available to all
investors
• Reality:
○ long and complicated process
 Chapter 7 procedure: a liquidation
 Chapter 11 procedure: a reorganization
○ Distress costs:
 Direct Costs: experts voting on reorganization, lawyers representing management or creditors, waiting for
resolution --> estimates vary from 3-4% of pre-distress asset value
 Indirect costs: loss or hold-up by customers/ suppliers, loss of employees/ receivables, fire (discounted)
sale of assets, delayed liquidation --> estimates vary from 10-20% of pre-distress asset value
• The value of the firm is maximizd by picking the capital structure that trades off the benefits of the tax shield from
debt against the costs of financial distress and agency costs.

• Determinants of distress costs:

○ Probability of financial distress: increase <-> amount of the firm's debt, volatility of the firm's CF and asset values
○ Magnitude of the costs:
 Higher for technology firms: intangibility
 Lower for Real estate firms or airlines: easily redeploy-able assets
○ Discount rate for the distress costs:
 Beta of distress costs has the opposite sign to that of the firm
 Higher beta -> higher present value of distress cost
• Therefore: lever up until marginal benefits of leverage = marginal costs of leverage
Bankruptcy and Agency costs of leverage
• Agency costs arise <-> conflicts between the firm's shareholders and debtholders
• Managers may make decisions that maximize shareholder value at the expense of the firm's creditors
○ Strategy 1: debt overhang - not taking positive-NPV projects (incentive to underinvest)

 Shareholders contribute 100k but get back only 50k while 100k goes to the debtholders
 The project is a negative-NPV opportunity for shareholders but a positive NPV for the firm
 ○ Strategy 2: asset substitution - taking negative-NPV project (incentive to take larger risks)

 The debtholders' expected payoff drops by 250k = 100k drop in firm value due to risky strategy plus the
shareholders' 150k gain
 Shareholders are gambling with creditors' money

Payout policy
• FCF: to retain (investment in new projects or cash reserves) or pay out (share buyback or dividend payment)
• Types of dividends:
○ Regular Dividends: paid according to a pre-announced schedule, e.g., semi-annually;
○ Special Dividends: a one-time dividend payment a firm makes, usually larger than regular dividends;
○ Stock Split (Stock Dividend): a dividend paid in new shares of stock rather than cash;
○ Return of Capital: a dividend paid from other sources, such as paid-in-capital or the liquidation of assets;
○ Liquidating Dividend: a return of capital to shareholders from a business operation that is being terminated.
• Important dates

• Share repurchases
○ Open market repurchase: abt 95% of all buyback transactions
○ Tender offer: a public announcement to buy back a specified amount of outstanding securities at a prespecified
price over a prespecified period of time; Offer is cancelled if shareholders do not tender enough shares.

Share repurchase vs dividend in perfect capital market

• Example: Pay out 20 million in excess cash to shareholders. Company has no debt -> Re = WACC = 12%. FCF: 48 million
per year. 10 million shares outstanding
 • Modigliani-Miller for Payout Policy: An open market share repurchase has no effect on the stock price, and the stock
price is the same as the cum-dividend price if a dividend were paid instead.
○ Investors are indifferent between firms' decision to pay dividends or share repurchase
○ Homemade dividend: investors can reinvest cash dividends or sell paid shares for cash
○ Choice of dividend policy is irrelevant and does not affect the initial share price

Payout Policy with Market imperfections:

• Taxes: investors have to pay taxes on dividends and capital gains
○ long-term investors can defer the capital gains tax forever by not selling
○ If T(d) > T(e): shareholders will pay lower tax in case of share buyback rather than dividends
○ Investors have varying preferences regarding dividends due to different effective dividend tax rate across
investors
○ Dividend-Capture theory:
• Cash retention: help reduce costs of raising capital in the future BUT
○ Taxes: Cash <-> negative leverage: tax advantage of debt <-> tax disadvantage to holding cash
○ Agency costs: Paying out excess cash can boost the stock price by reducing managers' ability and temptation to
waste resources
--> only accumulating a large cash balance if future earnings are expected to be insufficient to fund future positive-NPV
investment opportunities
• Dividend Signaling Hypothesis:
○ Dividend Smoothing: constant dividends
○ Deviations from stable dividends are informative abt management's expectations

APV method
• Using WACC method: when the firm will maintain a fixed D/V ratio
• Using APV method: alternative leverage policies follow from investments, can easily be extended to include other
market imperfections

REAL OPTIONS
• Investment projects in practice have more flexibility than assumed in traditional DCF analysis:
○ Option to delay: can be done now or later
○ Option to adapt: can be abandoned, downsized or expanded
○ Option to pursue follow-up projects: can create new investment opportunities
--> Real options provide flexibility that adds value which traditional NPV analysis may often ignore this value

Example 1: Shut-down Option

Example 2: Universal Studio's option to produce sequentially

Example 3: Car Dealership - Delay Option

Example 4: Option to Expand - Growth Option

Example 5: Option to Abandon - Abandonment Option