Advanced Financial Management

Advantages of APV
-Flexibility: project doesn’t have to have same characteristics as firm like risk and debt ratio
-Assumed level of debt is known over life of project
-Good for LBOs, Real Options, Leases
Disadvantages of APV
Incorporating financing side effects like bankruptcy costs are difficult to estimate
Price/Book value of equity
Industry matters:
-Asset intensive industries have high book value from so many assets
-Service/technology firms have low book value because they don’t sell tangible goods
High goodwill increases book value, making ratio lower
-doesn’t mean firm is undervalued
Price/Sales
-Use when earnings are temporarily depressed
-Low margin businesses (retail) will have lower ratio
-High margin (software or pharmaceutical) will have higher ratio
Value/EBIT
-Businesses that sell things on credit may have lower cash flow and therefore higher ratio
-If cash is received upfront (insurance), may have inflated ratio
-Depreciation increases cash flows, high depreciation can indicate large future capital expenditures
Limitations of Multiples method
Assumes the firm is very similar to comparable firms
-Industry
-Risk
-Phase of growth cycle
-Idealogy
-Cash flow patterns
Principal-agent problem
How do shareholders get managers to act in their interest aka maximize NPV?
-Exists because there is separation of ownership and control
* Benefits: limited liability, professional management, shareholder diversification
* Costs: agency problems – managers do not bear the full costs of their decisions since they don’t own the whole firm
Corporate governance mechanisms
Ensure that business is well-run and investors are treated fairly
-Giving incentives to managers
Manager incentives
-High salaries for CEOS
-Equity or stock options
-EVA
-Financing with debt
-Proxy fights
EVA Incentive-Advantages
-Managers motivated to only invest in projects that earn more than they cost
-Makes cost of capital visible to managers
-Based on absolute manager performance rather than performance relative to investor expectations
EVA Incentive-Disadvantages
-Low EVA can be from factors outside manager’s control
-Rewards quick paybacks and ignores time value of money
-Managers can manipulate earnings so that EVA rewards negative NPV projects
Financing with Debt
If there is constant pressure to meet interest payments, managers can’t waste money
-Prevents agency problems caused when mature firms have a lot of excess cash because they don’t have good investment opportunities
Proxy Fights
Shareholders organize themselves to fight management
-Free-rider problem: only a few shareholders need to combat management, why should any one individually put in the effort?
Merger
Total absorption of selling firm – no longer exists as a separate entity
Merger Advantages
-Simple: buyer assumes all assets and liabilities
-No minority interest
Merger Disadvantages
-Requires approval of shareholders of both firms
-Dissenting shareholders can sue to receive fair value
Stock Acquisition
Acquirer buys target’s share in the open market
-May involve a tender offer
Stock Acquisition Advantages
-Doesn’t need to be approved by target company
-Can be used for hostile takeover
Stock Acquisition Disadvantages
-Minority holdout
-Integration is not possible without 100% of target’s shares
Asset Acquisition
Buy specific assets of target
-can buy some or all
Asset Acquisition Advantages
-Direct acquisition of assets
-Requires approval of only 50% of sellers’ shareholders
-Allows cherry-picking of assets
Asset Acquisition Disadvantages
Legal and administrative costs
Horizontal Merger
Target and acquirer are competitors in the same market
-Regulatory requirements
-Ex: BofA and Merrill Lynch
Vertical Merger
Target and acquirer are at different stages of production
-Ex: Google and DoubleClick
Conglomerate Merger
Target and Acquirer are in unrelated lines of business
-Unpopular due to lack of synergies
Proxy
Right to vote someone else’s shares
Proxy Contest
Goal is to obtain enough proxies to vote a desired person onto the board of directors
-Used by major shareholders who are dissatisfied with how firm is managed
Proxy Contest Advantages
-Can be used to oust manager or change firm policy
-Allows control of corporation without acquiring all the shares
Proxy Contest Disadvantages
-Expensive
-Difficult to win
Sensible Motives for Mergers
-Economies of scale: reduction of unit costs by spreading fixed costs across more units (motive for horizontal mergers)
-Economies of vertical integration:
* Integrate “backward”: merge with supplier, may reduce costs
* Integrate “forward”: merge with customer, control over marketing channel may reduce costs
-Combining complementary resources: two merging firms each have what the other firm needs
* Ex: biotech firms have innovative products and patents, pharmaceutical firms have the resources to use the patents
-Unused tax shields: firm may have potential tax shields but not have the profits to take advantage of them (especially after bankruptcy)
-Use surplus cash if there are few positive NPV investments
-Eliminate Inefficiencies in the target firm
* Target may have unexploited investment opportunities, ways to cut costs or increase earnings
* Improve firm’s management
-Industry consolidation: industry with too many firms and too much capacity
* Mergers allow cutting capacity and employment to release capital for investment elsewhere
Dubious Reasons for Mergers
-Diversification: investors should not pay a premium for diversification if they can do it themselves
* Makes sense only to the extent that it reduces cost of financial distress: allows merged firm to take on more debt or taxe advantage of tax shields
-Lower cost of debt: merged firm can borrow at lower interest rates
* Both firms guarantee each other’s debt –> not a net gain because giving guarantees means taking risk
Leveraged Buyouts (LBOs)
Company goes private, purchase price is mostly financed with debt, buyer is usually private equity firm
-Financing of LBO:
* 70-85% debt secured by the target company’s assets (mostly junk debt)
* 15-30% equity from private equity firm
-Shareholders of target receive takeover premium: usually a large gain
* The difference between the final offer price and the share price 20-60 days before the LBO announcement
Main sources of value in LBOs
-Leverage: high leverage mitigates agency problems associated with high free cash flow
* Interest tax shields
* Cost: financial distress from increased debt
-Cheap financing: junk bonds
* LBOs boom whenever there is a credit market boom
-Corporate governance engineering:
* Incentives for management are altered
* Active monitoring of management
-Private equity investors do not hesitate to replace poor management
-Smaller boards, more frequent meetings
-Operational engineering: private equity sponsor adds value through industry and operating experience
* Cuts inefficiencies
* Cap ex. plans are more closely scrutinized
Management Buyouts (MBOs)
Management participates as buyers in LBO
-Management has HUGE incentive to perform
Spin-off
Creates a new, independent company by detaching some of parent company’s assets and operations
-Shares distributed to parent company’s stockholders
-Can improve incentives for managers
* Performance of subsidiary is now measurable
* Limits possibility to siphon resources out of profitable business to support unprofitable business
-Usually has positive stock market reaction
* Better investment decisions and operating performance
Equity carve-outs
Partial spin-off where shares are sold in a public offering
-Carved out business becomes a separate legal entity
-Parent keeps 80% ownership
-Usually positive stock market reaction
Asset Sales
Simple sale of part of a firm
-Get rid of assets that do not fit the firm
-Often after takeovers
-Positive effect for shareholders
Two ways to pay cash out to shareholders
-Dividends
-Share repurchase/stock buyback
Cash dividend
-Declaration date: board of directors declares dividend payment
-Cum-dividend date: last day on which an investor can buy stock and be entitled to receive the dividend (3 days before record date)
-Ex-dividend date: first day that an investor who buys the stock is NOT entitled to receive the dividend (day after cum-dividend date)
* In a perfect world, the stock price would fall on the ex-dividend date by the amount of the cash dividend
-Record date: firm prepares a list of registered shareholders as of this date
-Payment date: firm mails dividend checks
Stock dividend
No cash leaves the firm: convert retained earnings into common stock
Dividend in kind
send out product to shareholders
How do firms decide to issue dividends?
-Longer term target dividend payout ratios
-Managers reluctant to make dividend changes that may have to be reversed
-Dividend changes follow shifts in long-run sustainable levels of earnings, rather than short run changes
Dividends as signals to investors
Provide info about management’s confidence in the future
-Dividend increase: positive signal that management expects permanent increase in earnings
-Dividend cut: signals that management does not think earnings will rebound in near term
Share repurchase
Get rid of excess can by buying shares of firm’s own stock
-Can buy shares on open market
-Tender offer to shareholders: commit to buying all shares in program very quickly at fixed price (usually at a premium)
-Auction
-Targeted repurchase directly from major shareholder
MM’s Irrelevance Theorem
Why dividends could matter (as opposed to being irrelevant in perfect capital markets)
-Assumptions:
* Firm’s investment policy is set ahead of time and is not changed by changes in dividend policy
* No transaction costs
* No taxes (or dividends and capital gains are taxed at the same rate)
-Interpretations:
* Since investors do not need dividends to convert shares to cash, they will not pay higher prices for firms with higher dividend payouts
* If company investment policy is fixed, its NPV is fixed so if there are no changes on the asset side then firm value remains the same
-Implication of Theorem: firms should never forgo positive NPV projects to increase a dividend
Option
Gives the right (NOT obligation) to buy or sell asset at a future date at a pre-specified price (Strike or exercise price)
Call Option
Option holder has right to buy
Put Option
Option holder has right to sell
European Option
Can only be exercised on the expiration date
American Option
Can be exercised anytime ON or BEFORE the expiration date
Long Option
Buys the right to exercise option
-Must pay a premium
Short Option
Sells the right to exercise option
-Receives a premium
-Obligated to comply if the buyer chooses to exercise
Option chain
list of prices for calls and puts with certain maturities and strike prices
Covered call
Buy share and sell call option
-No upside
-Very low risk
Protective put
Buy share and buy put option, have protection against loss but you pay a premium for it
Put-call parity
Two ways to construct a protective put:
-Buy put, buy share
-Buy call option, invest PV of strike price in risk-free asset
-Since they have the same payoff, they have the same price
* Call price + PV(strike) = put price + share price
* Can create a put option using a call option
– Put price = call price + PV(strike) – share price
Bounds on option price
Lower bound: option cannot be worth less than (stock price – strike price)
Upper bound: option cannot be worth more than stock
In The Money (ATM) option payoff
Stock – strike < stock
At The Money/Out of The Money (ATM/OTM) option payoff
0 < stock
Factors influencing option value
-Stock price: value of call option increases as stock price increases
-Interest rates and time to maturity: value of option increases as interest rates and time to maturity increase
* When price increases a lot, option price approaches [stock price – PV(strike price)]
-Volatility: option price always exceeds its minimum value
* Probability of a large payoff increases if the stock is more volatile or there is a longer time to expiration
Forward Contract
Obligation to buy/sell asset at a future date at price specified today
-No premium paid
Futures contract
Obligation to buy/sell asset at future date at price specified today
-Standardized contract traded on an exchange (guarantees no counterparty risk)
-Buyer and seller must deposit margin in form of cash or treasury bills
-Marked-to-market on daily basis
Advantage of buying future
Don’t pay up front so you earn interest on the purchase price
Disadvantage of buying future
Do not receive interest or dividends paid on the security itself
Commodity futures
Advantages:
-Don’t need to pay up front so earn interest on purchase price
-Save cost of storing the commodity for that time period
Disadvantages:
-Lose convenience yield: the value of immediate access to the commodity