Corporate Finance CFA Level II PDF

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Corporate Finance CFA Level II...

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Study Session 7: Corporate Finance Capital Structure Theory: Published by Modigliani & Miller in 1958. Proposition I (No Taxes): The Capital Structure is irrelevant -> Valeur Entreprise similaire MM proved that the value of a firm is unaffected by its capital structure. Assumptions: - Capital Markets are Perfectly Competitive  No transactions costs, taxes or bankruptcy costs - Investors have Homogeneous Expectations  same expectations regarding CF - Riskless borrowing & lending  Investors can borrow/lend at the risk free rate - No Agency Costs  No conflict of interest between managers & shareholders - Investment decisions are unaffected by Financing Decisions  Operating income is independent of how assets are financed Vleverage = Vunleverage

MM Proposition II (No Taxes): Cost of Equity & Leverage Proposition -> WACC The cost of equity increases linearly as a company increases its proportion of debt financing. MM assume a perfect market where there are no taxes, cost of bankruptcy & homogeneous expectations. Debtholders have a priority claim on assets & income. As the leverage increase, the cost of equity increases but the WACC & the cost of debt is unchanged.

Requity = Cost of Equity WACCunleveraged = WACCleverage

MM Proposition I (With Taxes): Value is Maximized at 100% Debt -> Valeur Entreprise Tax Shield provided by debt. The differential tax treatment encourages firms to use debt financing because debt provides a tax shied that adds to the value of the company. Debt Interest payment are Tax deductible! Tax Shield = Marginal Tax Rate x Amount of Debt in the Capital Structure VL = VU + (t x d)  Value of a Levered firm = Value of an Unlevered firm + Tax Shield The value of the company increases with increasing levels of debt & the optimal capital structure is 100% debt.

MM Proposition II (With Taxes): WACC is Minimized at 100% Debt -> WACC RE = R0 + (D/E) (R0 – RD) (1 – Tc). (Where: Tc is the tax rate)

Ke= WACC + (WACC – Kd (1-t)) (D/E)

Analysis: The Tax shield provided by debt causes the WACC to decline as leverage increases. The value of the firm is maximized at the point where the WACC is minimized, which is 100% debt. Costs & Potential effect on the Capital Structure: Cost of Financial distress  Increased costs a company faces when earning declines & the firm has trouble paying its fixed financing costs. 2 components: - Costs of financial distress & Bankruptcy can be direct (cash expenses, legal & administrative fees) or indirect (foregone investment opportunities, losing trust of customers, creditors, suppliers etc.) - Probability of Financial distress is related to the firm’s use of operating & financial leverage. Also, lower quality management & corporate governance lead to a higher probability of financial distress. Agency Costs of Equity  Costs associated with the Conflicts of interest between managers & owners. Shareholders will try to minimize these costs with the Net Agency costs of equity. Greater Financial Leverage reduces Agency Costs. It has 3 components: -

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Monitoring Costs: costs associated with supervising management & include the expenses associated with making reports to shareholders and paying the board of directors. (MC can be reduced by a Strong corporate governance system) Bonding Costs: Assumed by management to assure shareholders that the managers are working in the shareholder’s best interest. Residual Losses: may occur even with adequate monitoring & bonding provisions

Cost of Asymmetric Information  Costs resulting from the fact that managers typically have more information about a company’s prospects & future performance than owners or creditors. Complex products & little transparency will lead to higher asymmetric costs & higher required returns on debt & equity capital. Valuation Implications: - If the firm make fixed interest payments through debt  Management has confidence in the firm’s ability to make these payments in the future. Positive Signal - Issuing equity is viewed as negative signals  Firm’s stock is overvalued. The cost of asymmetric information increases as the proportion of equity in the capital structure increases

Pecking Order Theory (Based on asymmetric information) Related to the signals managements sends to investors through its financing choices. Managers prefers to make financing choices that are least likely to send signals to investors. Financing choices follow a hierarchy based on visibility to investors (from most favoured to least favoured): 1) Internally generated Equity (Retained Earnings) 2) Debt 3) External Equity (Newly issued Shares)  The pecking order theory predicts that the capital structure is a by-product of the individual financing decisions. Static Trade-Off (= Arbitrage) Theory  Balance the cost if financial distress with the tax shield benefits from using debt. There is an optimal capital structure that has an optimal proportion of debt: Upside down U-shaped - There comes a point where the additional valued added from the debt tax shield is exceeded by the value-reducing costs of financial distress from the additional borrowing. - These point represents the optimal capital structure for a firm where WACC is Minimized & value of the firm is Maximized VL = VU + (t x d) – PV (Costs of Financial Distress) Static Trade-Off Theory: Cost of Capital vs. Capital structure

Analysis: The after-tax cost of debt has an Upward slope due to the increasing costs of financial distress that come with additional leverage. As the cost of debt increases, the cost of equity also increases because some of the cost of financial distress are borne by equityholders. The optimal proportion of debt is reached at the point when: Marginal benefit provided by the tax shield of taking on additional debt = Marginal costs of financial distress incurred from the additional debt. Static Trade-off Theory: Firm value vs. Capital Structure

When evaluating a firm’s capital structure, an analyst should consider: - Capital structure of competitors with similar Business risk -

Changes in the firm’s capital structure over time

Optimal Capital Structure depends on the following factors: -

Firm’s Operating Risk Sales Risk Tax Situation

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Corporate Governance Industry influences

Optimal Debt Ratio = Firm’s target capital structure

Implications for Managerial Decision Making: MM’s propositions with No taxes  No taxes & no costs associated with financial distress 1st Proposition: The Capital Structure of a firm is irrelevant because the value of a company is determined by the discounted present value of its operating earnings. 2nd Proposition: Increasing the use of cheaper debt financing will increase the firm’s cost of equity (0 net change in the firm’s WACC) MM’s proposition with taxes  The Tax shield provided by interest expense makes borrowing valuable. WACC is minimized at 100% debt and firm’s value is maximized. Static Trade-off Theory  There are tax benefits associated with issuing debt because interest expense is tax deductible, but increasing the use of debt also increases the costs of financial distress. Managers have to identify an Optimal capital structure. Target Capital Structure  Structure that the firm uses over time when making decisions about how to raise additional capital. In practice, the firm’s actual capital structure tends to fluctuate around the target capital structure for 2 reasons: -

Management may choose to exploit opportunities in a specific financing source Market value fluctuations will occur. Market fluctuations may cause the firm’s actual capital structure to vary from the target.

Debt Ratings  Reflect the creditworthiness of a company’s debt, ratings are based on the bond’s default risk. Higher ratings mean cheaper financing costs. Investment Grade = AAA  BBB pour S&P et de Aaa  Baa pour Moody’s Speculative Grade = BB  D pour S&P et de Ba  C pour Moody’s When evaluating a Company’s Capital Structure, you should consider: - The changes in the company’s capital structure over time - The capital structures of competitors with similar business risk - Company-Specific factors

Historically, the average spread between AAA & BBB rated bonds has been 100 basis point

For international firms, Country-Specific Factors have to be consider: - Total Debt - Debt Maturity - Emerging Market Differences

Factors which have the potential to influence Capital Structure:

US & UK firms issue less debt than Japanese or French firms US firms use longer maturity debt than Japanese firms.

- Financial Distress costs - Agency Costs - Asymmetric Information

Institutional & Legal Factors -

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Strength of Legal System  Firms operating in countries with weak legal systems tend to have greater Agency Costs due to the lack of legal protection for investors. Use more Leverage in Capital Structure & greater reliance on short-term debt. Information Asymmetry  A High level of information asymmetry encourages greater use of debt in the capital structure. Increased transparency tends to result in lower financial leverage. Taxes  The tax shield provided by debt encourages the use of debt financing

Country Specific Factor Strong Legal System Less Information Asymmetry Favourable tax rates Common Law as opposed to Civil Law

Use of Total Debt Lower Lower Lower Longer

Maturity of debt Longer Longer N/A Longer

Financial Markets & Banking System Factors: -

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Liquidity of Capital Markets  Liquid capital markets tend to use longer maturity debt Reliance on Banking System  Companies operating in countries that are more reliant on the banking system than corporate bond markets as a source of corporate borrowing tend to be more highly leveraged. Institutional Investor Presence  Institutional investors may have preferred maturity ranges for their debt investments.

Country Specific Factor More liquid Stock & Bond Markets Greater reliance on banking system Greater Institutional Investor Presence

Use of Total Debt N/A Higher Lower

Maturity of debt Longer N/A Longer

Macroeconomic Factors: -

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Inflation  Higher inflation reduces the value to investors of fixed interest payments. Firms operating in countries with high inflation tend to use less debt financing & the debt used has a shorter maturity GDP Growth  Firms operating in countries with higher GDP growth tend to use longer maturity debt.

Country Specific Factor Higher Inflation Higher GDP Growth

Use of Total Debt Lower Lower

Maturity of debt Shorter Longer

Keys Questions to the Exam: What is the Optimal Capital Structure? - MM I & MM II - Agency Costs / Relationships - Optimal / Static Trade-Off - Asymmetry Information / Pecking Order

Dividends & Share Repurchases: Analysis Types of dividends include the following: 1) Regular Cash Dividends  Periodic dividend payments made in cash. Stable or increasing dividends paid regularly are perceived as a sign of Consistent profitability. DRPs are reinvestment plans where all or part of the regular cash dividend is automatically reinvested by purchasing additional shares in the Open Market or in a New Issue DRP (or “Scrip Dividend Scheme” in the UK.) by the company. A DRP promotes a diverse shareholder base because DRPs provide a cost effective opportunity for small shareholders to accumulate shares. It also promotes Long Term investment because new issue DRP allows companies to raise additional capital without the floatation cost of a secondary offering. DRP’s Advantages for Shareholders: - Purchase of additional shares with No transaction costs - Allow shareholders to benefit from Cost averaging - Shares are sometimes at a Discount to market price

Jensen’s FCF Theory  Management will squander (gaspiller) FCF by undertaking unprofitable project

DRP’s Disadvantages: - Shareholders may have to cope with Additional record keeping for tax purposes - Dividends reinvested at a market price higher than the original purchase price increase the average cost basis - Dividends are fully taxed in the year they are paid; therefore, it makes sense to hold DRP’s in tax-sheltered accounts (E.g Retirement Accounts). 2) Extra or Special (irregular) Dividends  Cash dividend supplementing regular dividends paid under unusual circumstances under the expectation that the dividend is not recurring. 3) Liquidating Dividend  Paid by a company when the whole firm or part of the firm is sold or when dividends in excess of cumulative retained earnings are paid. It is considered to be a return OF capital & NOT a return on capital . 4) Stock Dividend  A non-cash dividend paid in the form of additional shares. Shareholders have more shares & the cost per share will be lower after it. Ownership percentage of the company does not change for the shareholders & no taxation on it. + Financial Leverage Advantages: - Encourage Long-term investing. Both is when an Optimal trading range exists. - Reduce the cost of capital - Increase a stock’s float & its liquidity - Can be used to decrease the market price of a stock to a desirable trading range that attract more investors Stock Splits  Similar to stock dividends (non-cash) but larger in size. A 2 for 1 stock split is the same as a 100% stock dividend. The shareholder wealth is unchanged. The stock price tends to rise after splits if good earnings follow.

Cash Dividends Accounting Issues:

Stockholder’s Equity Quick Ratio & Current Ratio Leverage (D/E or D/A) Company’s Capital Structure

Effect Lower Lower Higher Unchanged

Stock Dividend Accounting Issue: Effect Retained Earnings Contributed Capital Total Equity

Lower Higher Unchanged

Dividend Theories: Dividend Irrelevance  M.Miller & F.Modigliani maintain that dividend policy is irrelevant because it has no effect on the price of the firm’s stocks or its cost of capital. The dividend irrelevance theory only works in a perfect world with No taxes, No brokerage costs & infinitely divisible shares. Rien ne bouge pour l’actionnaire peut importe si on +- Payout Bird-in-Hand Theory (or Dividend Preference Theory)  M.Gordon & J.Lintner argue that the return on equity decreases as the dividend payout increases because investors are less certain of receiving future capital gains from the reinvested retained earnings than they are of receiving current dividend payments. Higher dividends lead to higher stock prices Investors place a higher value on a dollar of dividends that they are certain to receive than on a dollar of “Expected” capital gains. Tax Aversion  Dividends have historically been taxed at higher rates than Capital gains. Therefore, investors will prefer to NOT receive dividends due to their higher tax rates in order to not being burdened with tax rates. Research suggests that higher tax rates do results in lower dividend payouts. There is empirical support for the “Bird-in-hand” theory as some companies that pay dividends are perceived as less risky & specific investors do prefer dividend paying stocks. MM counter this argument by saying that different dividend policies appeal to different clients so that dividend policy has no effect on company value if all clients are satisfied. Information Asymmetry  Differences in information available to a company’s board & managements as compared to the investors. Dividends convey more credible information to the investors compared to plain statements. Dividend Initiation can be ambiguous. On one hand it could mean that a company is optimistic about the future & is sharing its wealth with stockholders (Positive Signal). On the other hand, initiating a dividend could mean that a company has a lack of profitable reinvestment opportunities (Negative signal). Unexpected Dividend Increase can signal to investors that future prospects are strong & managers will share the success with shareholders. Companies with a long history of dividend increases are dominant in their industries & have High returns on Assets & low debt ratios. US -> Très sensible aux variations de dividendes Asie -> Pas sensible aux variations dividendes

Unexpected dividend Decreases or Omissions Are Negative signals that the business is in trouble & that management does not believe that the current dividend payment dividend can be maintained. Clientele Effect  Refers to the varying dividend preferences of differents groups of investors. Different groups desire different levels of dividends depending on: - Tax Consideration: High-taxed investors (individuals) prefers low dividend payouts while low-taxed investors (corporations or pension funds) prefers high dividend payouts. When the Stock goes ex-dividend: P = D(1 – TD) / (1 – TCG) where: TCG = Capital Gains, TD = Tax rates on dividends, D = Dividend &P = % Variation prix -

Requirement of Institutional Investors: For legal or strategic reasons, some investors will invest only in companies that pay a dividend or have a dividend yield above some targets. - Individual Investor Preferences: Some investors prefer to buy stocks so they can spend the dividends while preserving the principal. The existence of Dividend Clienteles DOES NOT contradict Dividend Irrelevance Theory. Agency Costs:  Conflict of Interest Between Shareholders & Managers  Agency costs reflect the inefficiencies due to divergence of interests between managers & stockholders. Managers may have an incentive to overinvest which can reduce stockholder wealth. To reduce Agency cost is to increase the payout of free cash flow as dividends. Between Shareholders & Bondholders  When there is risk debt outstanding, shareholders can pay themselves a large dividend, leaving the bondholders with a lower asset base as collateral. Transfer of wealth from bondholders to stockholders. It can be resolved via provisions in the bond indenture as restrictions on dividend payment or maintenance of certain balance sheet ratios. 6 Primary Factors can affect a Company’s dividend payout policy: 1) Investment Opportunities  If the firm faces many profitable investment opportunities & has to react quickly to capitalize on the opportunities, dividend payment would be low. 2) Expected Volatility of Future Earnings  When earnings are volatile, firms are more cautious in changing dividend payout 3) Financial Flexibility  Firm with excess cash & a desire to maintain financial flexibility may resort to stock repurchases instead of dividends as a way to payout excess cash. Financial flexibility is important during times of crisis. 4) Tax Considerations  The method & amount of tax applied to a dividend payment can have a significant impact on a firm’s dividend policy.

However, a lower tax rate for dividends compared to capital gains does not necessarily mean companies will raise their dividend payouts for multiple reasons: - Taxes on Dividends are paid when the dividend is received, while Capital Gains taxes are paid only when shares are sold - The cost of shares may receive a step-up in valuation at the shareholder’s death. This means that taxes on capital gains may not have to be paid at all - Tax-exempt institutions, will be indifferent between dividends or capital gains. 5) Floatation Costs  The higher the floatation costs, the lower the dividend payout is, given the need for equity capital in positive NPV projects. 6) Contractual & Legal Restrictions  Companies may be restricted from paying dividends either by legal requirements or by implicit restrictions caused by cash needs of the business such as: - Impairment of Capital rule: Dividends paid cannot be in excess of retained earnings - Debt Covenants: Covenants require a firm to meet or exceed a certain target for liquidity ratios & coverage ratios before they can pay a dividend. Double-Taxation System  In the USA, earnings are taxed at the corporate level regardless of whether ...