Corporate finance notes PDF

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Corporate finance notes: Lecture 1: Intro: assumed objective of firm - maximisation of shareholder wealth - corporate finance = normative (how things should be done) separation of ownership from management/control efficient market hypothesis - it is impossible to ‘beat the market’ because the stock ...

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Corporate finance notes: Lecture 1: Intro: assumed objective of firm - maximisation of shareholder wealth

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corporate finance = normative (how things should be done) separation of ownership from management/control efficient market hypothesis - it is impossible to ‘beat the market’ because the stock market is perfectly efficient causing share prices to always fully reflect all relevant information. o

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principal-agent relationship - assumption that managers (agents) act in interests of shareholders (principals) o

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this goes against other economic assumption that people act selfishly and rationally (i.e. managers would follow their own personal interests which may not be wealth maximisation and so be sub-optimal for the firm). potential ‘conflict of interest’ between shareholders and managers. There are potential agency issues associated with this. are there alternative/multiple corporate objectives (Jensen, 2001)? and consequences of this (hierarchy of objectives)

principal-agent relationship led to firms trying to pay managers related to share price to align their incentives with those of shareholders and therefore get them to act in mutual interests. pay-for-performance compensation - when compensation linked to performance (examples below) o

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[assumptions necessary for this: large number of investors, stock prices adjust instantly, stock prices reflect all available information]

aim to provide incentive for SVM, however must be weighed against increased risk that executives then face. The appropriate amount compensation linked to performance is ultimately determined by the level of risk-aversion of the manager. we talk about the ‘sensitivity of manager’s pay to performance'

compensation policies: [objective - to align interests of ownership and management] o

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salary + bonus (most simple and perhaps most common) - bonuses based on earnings growth, performance relative to market etc.  however, if over-relied on, means that people concentrate too much on yearly performance with less of a long-term viewpoint. Also may contribute to competition in the workplace (can be good, but could also be a negative thing). stock option grants - became popular in the 90s. Give executives option (or no option, but the option is more common) to become shareholders (thereby

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reducing the principal agent problem as they then have direct incentive to achieve share value maximisation).  however, incentive for managers to release bad evidence before the stock options are granted and good news after. Means share price lower when stocks are awarded (so manager gets more), then price rises and he could sell. Existence of this has led to backdating where the grant date of stocks is backdated to an earlier time when the stock price was low (e.g. 3 month low). Means now there is no incentive for managers to try to reduce share price. psychological compensation from enjoying work. Linking compensation too highly to performance-related targets can damage this. long-term incentive plans - pay tied to long-term performance. Reduces the negative problems of fluctuations in performance and rewards employees for a) long-term high performance b) staying with the firm so no hiring/firing costs

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primary/stated aim at the top but this leads to the ultimate aim at the bottom, because that is what will lead to that outcome.

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JAMES MONTIER (2014), The World Dumbest Idea (article) - shareholder value maximisation (SVM) does not lead to success for firms. Solely following the aim of maximising share price will likely lead to less of a return than other objectives (e.g. responsibility to employees, responsibility to community etc). o Obviously an aim should be SVM but not necessarily the primary aim and probably not the sole aim. o the era of SVM (1970s+ ?) has been accompanied by CEOs having significantly shorter tenures and firms being in the S&P500 for significantly shorter (i.e.

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when SVM is the primary aim, shareholders become fixed on short-term share value and not the longer term direction and performance of the firm). o another piece of damage done by single-minded approach to SVM is declining rates of business investment. Short-term performance goals mean less incentive to invest, particularly when managers are unlikely to be in the job for too long. Also, the vast majority of investment for firms is internal (i.e. financed by retained earnings not borrowing), therefore solely focussing on SVM (including giving higher dividends and share buybacks) means less investment. DAN ARIELY, 2005 - tested 3 groups of people (one low incentive, one medium incentive and one high incentive) and got them to do a task to get a payout. Found that the high incentive group got the worst results, implying that this group had started to obsess about the payout rather than concentrating on the task in hand which would give them the payout. The medium group got slightly better results than the low incentive group which shows that a reasonable level of payoff should be used. o in the world of corporate finance, managers focussing too heavily on SVM probably won’t achieve it as successfully as those where there are SVM incentives but these are one of a selection of goals. share buybacks often more tax efficient than dividend payments (capital gains). long term funding via equity capital (retained earnings, primary source) or debt capital (borrowings). equity to debt levels = capital structure of the firm 3 key issues: o o o

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what to invest in how to finance investments dividend decisions

expected return to investor = cost of capital for firm [two sides of the same coin] share price - determined by internal AND external issues [e.g. Glencore in Sept-Oct 2015. Falling as confidence in commodities fell (external) but then started to rise when they announced the sale of 2 low performing mines amongst other things (internal).] debt v equity finance: o o o

debt finance - go to bank, obtain loan equity finance - sell a stake in your business (e.g. shares, % of profit) debt finance tends to be cheaper than equity finance:  debt finance - you pay back interest repayments  equity finance - no debt, but you lose a portion of profit.  n.b. debt finance can be utilised by stable companies with more certain future cash flows, whereas less stable firms (e.g. startups) may have to rely more heavily on equity finance which is often more expensive

n.b. ‘tax shield’ may make debt finance even more preferable to equity finance o tax shield - interest repayments are tax deductible (can be deducted from taxable income) whereas equity finance such as dividends and capital gains are not 

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toehold shareholders - those with a small share of the business (typically less than 5%). However, when it comes to shareholder votes can wield a lot of power o

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toehold acquisitions as an M&A tactic? - purchasing a limited number of shares of firm you are potentially acquiring so as to get people on the other side. Can reduce the cost of an acquisition.

cost of equity capital ( = CAPM) = required rate of return o

it is the rate investors will lend to firm, therefore the cost

Stuff from seminar 1: a. Discuss reasons why there might be a divergence of interests between owners and managers. Firstly shareholders may invest for reasons other than pure financial gain. In addition, the firm may be thought of as having a number objectives (some of which will be conflicting), resulting from the fact that it has responsibility to others, e.g.: (a) employees and management to ensure continued, useful and profitable employment; (b) the environment and society at large (c) government and country not to break the law However, of most importance is the fact that there is often a separation of ownership from control. The managers of the firm are delegated responsibility for acting on behalf of the shareholders of the firm. Managers may wish to pursue their own goals which may conflict with those of the shareholders. b.

What do you understand by the concept of agency costs as defined by Jensen and Meckling in their 1976 paper. Provide examples of agency costs. Jensen and Meckling argue that agency costs comprise monitoring costs, bonding costs and residual loss. Consider managers pursuing their own interests (0verconsuming perks etc.), thus have to be monitored, but costly. Therefore use of incentive mechanisms to align objectives. Bonding costs may include managers taking on more debt which thus constrains their actions (interest payments have to be met and thus act as a source of discipline). Consider explicitly information asymmetries.

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Explain why corporate management need to be concerned with firm valuation. Nevertheless, management cannot ignore the firm's valuation and the wishes of shareholders for the following main reasons: (i) if firm value falls below what it could be, the risk of take-over is increased (ii) firms may face problems raising additional finance if managers pursue their own goals (iii) the managerial labour market is likely to value managers who pursue the interests of owners, more highly. (iv) threat of bankruptcy - managers have more to lose if the firm is bankrupt, since they have much of their wealth (their human capital) tied up in the company….counter point to this is my essay.

Also look at my formative essay for this topic.

Lecture 2: Valuation of securities:

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3 types of dividend policy: o constant dividend o constant growth dividend o non-constant growth dividend

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valuation as much an art as it is a science as we must make assumptions about cash flows, growth rates and discount rates. time value of money - the difference in value between a sum of money today and that same sum at a time in the future. Due to income that can be earned on investments in the intervening period. law of one price - derived from the ideas of purchasing power parity and the ‘no arbitrage’ assumption, this says that a good should sell for the same price in all locations. future value - what the present value is actually worth in the future (e.g. with interest rate of 10% you would say that present value of $1,000 has a future value in 2 years of $1,210)

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present value - could be asked to work out what a given amount of money in the future is worth in current pounds.

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bond - a security sold by govts/firms which raises money from investors today in exchange for promised future repayments. bonds typically make two payments to bondholders: o coupons - regular interest payments

face value - the amount used to compute the coupon payments. Tend to be repaid at maturity. o e.g. a $1,000 bond with a 10% coupon rate and semiannual payments would pay $100 in coupons per year divided as 2x$50 (each 6 months) zero-coupon bonds - these are bonds where there are no coupon repayments and so the investor just receives back the face value on the maturity date. o e.g. Treasury Bills (US govt bonds up to 1 year) o zero coupon bonds trade as a discount (i.e. the price of them is lower than the face value) because otherwise there would be no incentive for investors as there are no coupons. So they are often called pure discount bonds. coupon bonds may trade: o at a discount (PFC, coupon rate > YTM) o at par (P=FC, coupon rate = YTM) o

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discount rate - the risk-free interest rate and the one that is used in discount cash flow (DCF) analysis. o also called the cost of capital as there is a cost to holding money rather than investing it risk-free equal to this rate.

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yield to maturity - the total return on initial investment. o the discount rate which sets the present value of the promised bond payments equal to the current market price of the bond

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YTM is the per-period rate of return for holding the bond from today until maturity. FV=face value, P=price, n=time periods takes account not only of annual interest payments but also capital repayments at maturity. It is a measure of the total return of holding the bond until maturity.

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Dividend yield - dividend in next period divided by current price

Capital gains yield - change in price over current price

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Total Return = dividend yield plus capital gains yield

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Equity cost of capital (cost of equity, cost of equity capital) - the expected return on other investments in the market with equivalent risk to holding the firm’s shares (i.e. what the firm must pay shareholders in order that investors would be willing to buy the stock).

Dividend-discount share valuation model – -

current share price is the discounted future dividend flow the price of a share should reflect its total value to the shareholder - i.e. the sum of dividends that will be received and the capital gains that will hopefully be earned upon selling the share.

constant dividend:

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above example is for a share held for one year, if held for more:

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Thus:

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Constant dividend growth rate:

Derivation of constant dividend growth:

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in order to estimate the growth rate of dividends we can either estimate, look at historical data or use a payout ratio. o payout ratio = dividends per share / earnings per share limitations of constant growth rate model:

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o dividend growth rates may not be constant - if this is so, the formula must be revised o requires knowledge, or a reliable estimate, of expected future dividend Firms may wish to retain earnings to reinvest with the expectation that, although current dividends are now lower, future dividends will be higher. However, some shareholders rely on a constant dividend for income and therefore may object to dividends being withheld. o in this case, those shareholders can create “home-made dividends” by selling some of their shares in the years where dividends are cut.

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non-constant growth rate: o here we will add up the years when the growth rate is not assumed to be constant and then treat the following years as a constant rate equation similar to above.

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for example, in the above equation years 1-3 are calculated individually based on expected dividend and from this point onwards a constant growth rate of dividend is predicted.

Valuing debt: o o

o o o

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debt holders have a prior claim on the assets of a company and therefore debt capital typically lower risk and cheaper than equity capital. the nominal yield (or coupon rate) is the rate of interest on the face value of the unit of the bond - this is not necessarily the same as the market rate of interest (because bonds rarely trade at their face value). inverse relationship between price of bonds and interest rate - IR rises, prices of bonds fall. current yield - nominal interest payment (£s) divided by the current market price yield to maturity (most important rate of interest to investor) - takes account of annual interest payments as well as capital repayments at maturity. The TOTAL return from holding the stock until maturity.

current yield - annual interest payment divided by the current market price

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less time to maturity = higher price

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for corporate bonds (i.e. firms not govts) there is a credit risk to the bond because there is a risk that the issuer may default. Therefore the bond’s cash flows are not known with certainty. o in reality there is a risk to Treasury bills as well, but we tend to assume they are risk free because the chance of this is so low.

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bond ratings are used to rate the creditworthiness of firms. two main ratings agencies - Standard & Poor’s, Moody's Moodys grades: o Investment grade debt:  Aaa - ‘the smallest degree of investment risk and are generally referred to as "giltedged”'  Aa - together with Aaa they make up the 'high-grade' bonds.  A  Baa - medium-grade obligations o Speculative bonds:  Ba  B  Caa  Ca  C - lowest rated class of bonds and can be regarded as having extremely poor prospects of ever attaining any real investment standing.

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yield curves - these show the YTM for different levels of maturity as a curve.

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sovereign bonds are bonds issued by national govts.

not all as risk-free as US Treasury securities the bonds issued by countries which have economic or political instability and high levels of debt tend to have higher yields and lower prices. primary difference between sovereign bonds and corporate bonds is that when a country has difficulty paying its financial obligations it can print money (though of course this will lead to inflation and a devaluation of the currency). o o

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alternative ways to value a firm’s shares (other than dividend discount model): o total payout model - has become more useful in recent years as firms have increasingly replaced dividends with share buybacks/repurchases. This means that investors are seeing non-dividend returns on investment and this should be factored into share valuation.  the price is therefore the present value of all future total dividends AND repurchases divided by the number of shares outstanding: o discounted free cash flow model - the advantage of this is that it allows investors to value a firm without explicitly forecasting its dividends, share repurchases or its use of debt.

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when bonds trade below face value, this implies there are other assets of the same risk which can be invested in to give a higher expected return at that time (or for same return, less risk necessary). o if interest rates were to fall, then the price of bonds would rise as other assets no longer offer such relatively higher returns than bonds. bonds trade at par value only if the coupon payment equals the yield at maturity.

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Bond Valuation:

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The current yield is the nominal interest payment, expressed in pounds, divided by the current market price The most important rate of interest from the point of view of the investor and the firm is the yield to maturity. The yield to maturity takes account not only of the annual interest payments, but also capital repayments at maturity.

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It is a measure of TOTAL return from holding the stock until maturity.

Chapter 9: Berk and DeMazo reading notes: - Limitation of Dividend-Discount model…the model values stock based on a forecast of future dividends paid to shareholders. But UNLIKE A Treasury Bond whose cash flows are known will virtual certainity, a tremendous amount of uncertainty is associated with any forecast of a firm’s future dividends. Stuff from seminar 2: -

look over question one on share buybacks. Some limitations given: Assumed perfect market for shares - other things might influence share price -. Share prices may not be determined solely by fundamentals. In addition, we have treated expectations as though they are certain - In practice all variables may vary The investor who wishes to make 'homemade dividends' by selling shares will have to incur transactions costs.

Also last q uses trial and error to find the YTM...and some tables? Look up these tables.

Topic 3: Investment Decision making under conditions of certainity: