FIE 402 Corporate Finance, Grade A PDF

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FIE 402E Corporate FinanceMich a e l Ki ss er , Ph D A s s o cia te P ro f es so r - No rg e s Han d el sh ø ys ko le ( N HH)The course assessment is based on a 3 hours written school exam , which must be answered in English.There are no requirements for course approval other than the final exam.The...

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S184341: John-Andreas Nyheim

FIE 402E Corporate Finance Michae l Kisser, PhD Asso ciate Profes sor - Norge s Ha ndel shøysko le (N HH)

The course assessment is based on a 3 hours written school exam, which must be answered in English. There are no requirements for course approval other than the final exam. The goal of this course is to teach students the principles and tools of corporate financial management. Students should be able to: -

Critically evaluate different capital structure theories

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Compare and apply various discounted cash flow techniques

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Critically reflect the implications of Option Valuation for firms financing and investment decisions

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Critically evaluate merger & acquisition opportunities

Students should acquire the skills to: -

Apply capital structure theories to come up with optimal financing strategies for firms

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Value assets using complex discounted cash flow methods

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Analyse investment decisions using a ‘Real Options’ approach

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Analyse different payment methods for Mergers & Acquisitions

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Assess the costs and benefits of different risk management strategies

Students should develop the competence to: -

Use the ideas and techniques of financial economics to deal with applied real-world problems.

Course Book: Corporate Finance by Berk/DeMarzo Online Task: http://www.pearsonmylabandmastering.com/global/students/get-registered/index.html Course code: kisser58152

S184341: John-Andreas Nyheim

Short Refresher: 𝐹𝐶𝐹 = (𝑅𝑒𝑣 − 𝐶𝑜𝑠𝑡 − 𝐷𝑒𝑝𝑟) ∗ (1 − 𝑡𝑐 ) + 𝐷𝑒𝑝𝑟 − 𝐶𝑎𝑝𝐸𝑥 − Δ𝑁𝑊𝐶

𝑁𝑂𝑃𝐿𝐴𝑇 = 𝐸𝐵𝐼𝑇 ∗ (1 − 𝑡𝑎𝑥) 𝑃0 = (

𝐷1

𝑟𝑗 − 𝑔

)

→

𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝐷𝑡 = 𝑆ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 ∗ 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡𝑒

Δ𝐸 = 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 ∗ 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠 → 𝐸

𝑌𝑇𝑀 = 𝑟𝑑 = 𝑦𝑖𝑒𝑙𝑑(𝐼𝑅𝑅)

𝑔𝑟𝑜𝑤𝑡ℎ = 𝑅𝑅 ∗ 𝑅𝑂𝐼

𝐴𝑑𝑗. 𝑌𝑇𝑀 = 𝑌𝑇𝑀 − 𝑝𝐿 → 𝑝 = 𝑝𝑟𝑜𝑏 𝑜𝑓 𝑑𝑒𝑓𝑎𝑢𝑙𝑡, 𝐿 = 𝑙𝑜𝑠𝑠 𝑖𝑛 𝑐𝑎𝑠𝑒 𝑜𝑓 𝑑𝑒𝑓𝑎𝑢𝑙𝑡

Capital Structure Theory: Miller & Modigliani:

Understanding the capital structure choice: -

Perfect markets; no frictions, financing does not affect cash flows. Imperfect markets; taxes, bankruptcy costs, agency costs, asymmetric information, friction. Correct capital structure can minimize the effects of imperfection, i.e., provide value.

MM-Proposition 1: (perfect market) There are no leverage gains from using debt, the value of the firm will be the same. 𝑟𝑊𝐴𝐶𝐶 = 𝑟𝑢 = (

𝐷 𝐸 ) ∗ 𝑟𝐸 + ( ) ∗ 𝑟𝑑 𝑇𝐾 𝑇𝐾

MM-Proposition 2: Introduces the cost of default risk and the effect of debt financing on equity cost. Still, there is nothing to gain by leveraging debt as this increases the cost of equity. 𝑟𝐸 = 𝑟𝑢 +

𝐷 (𝑟𝑢 − 𝑟𝑑 ) 𝐸

𝑟𝑢 is the WACC of an unlevered firm, which is a measurement of the business risk. In this world, with only default risk included, the 𝑟𝑢 = 𝑟𝑊𝐴𝐶𝐶 . To get an estimate for the business risk we must delever its beta. 𝛽𝑢 =

𝐷 𝐸 ∗ 𝛽𝐸 + ∗ 𝛽𝐷 𝐸+𝐷 𝐸+𝐷

Then we can use it

𝛽𝐸 = 𝛽𝑈 +

𝐷 (𝛽 − 𝛽𝐷 ) 𝐸 𝑈

Finding risky cost of debt We can find the risky cost of debt in multiple ways; - Finding the beta of debt (using credit rating data or by Black Scholes) and place it in CAPM - Finding the YTM of the debt, reduce it by the probability of loss with loss rate. - Replicating payoff between two states, quite popular exam-question.

S184341: John-Andreas Nyheim

To derive the risky cost of debt, we can replicate the payoff in the weak and strong state. The debt holders ‘reward’ in the strong economy is offset by the downfall in the weak state. Weak state: (1) 𝐴0 ∗ 𝑥𝑢 + 1 ∗ 𝑥𝑑 = 𝐷0 (2) 𝐴1 ∗ 𝑥𝑢 + (1 + 𝑟𝑓 ) ∗ 𝑥𝑑 = 𝐷1

A; assets, D; debt

(1) – (2) Find 𝑋𝑢 𝑎𝑛𝑑 𝑋𝐷 and put the formula with the numbers from the strong state: 𝐸1 ∗ 𝑥𝑢 + (1 + 𝑟𝑓 ) ∗ 𝑥𝑑 = 𝐴1 (𝑤𝑒𝑎𝑘) ∗ (1 + 𝒓𝒓) 𝒓𝒓 contains 𝑟𝑑 and the total loss of debt; 𝐷 𝑟𝑑 = 𝑝 ∗ 𝑟𝑟 − 𝑝 ∗ ( 1 − 1) 𝐷 Fallacies

0

A common fallacy in capital structure is that leveraging debt into the firm increases EPS and therefore shareholder value. Increased debt means that a larger amount of fixed payments is taken from cashflow. This creates volatility in expected free cash flow to equity, which increases the cost of equity. In good times, the EPS will indeed be larger in a leveraged firm than an unleveraged, but the opposite will happen in bad times. This will leave the value of the firm unaffected by leverage; the explanation for MM-1 proposition. Another fallacy is that new equity issues dilute existing equity since the total number of shares increases. Will shareholder value be destroyed? No. The numbers of shares increases, but so does the market value of the company’s assets due to cash gained from the issue. Fairly priced issues do not destroy value. Notes for real life Application This graph summarizes a lot of relevant capital structure theory necessary for understanding the effect of debt leveraging in the ‘real world’. Debt is commonly considered a cheaper way of funding, and with the increased tax benefit by interest expenses the WACC is reduced, leading to an increased firm value. However, it’s very difficult to assess true tax advantage of debt, mainly due to the fluctuations of interest, payment periods and the expected future of the company. Debt is payed off and new debt is gained, with different criteria’s. Recent studies confirms that the effect of debt leverage exists. It’s important to note that this graph does not include the costs and risks of default, which will make the WACC curve upwards when debt-ratio becomes to high, leading to reduced firm value from further debt leverage. Another difficult aspect is to correctly assess when and how much the cost of bankruptcy kicks. Bankruptcy processes is associated with real costs, it has an impact on the capital structure decision. A rule of thumb, the direct costs is around 3-4% of pre-bankruptcy firm value. The indirect costs might be higher. We only know for sure that the risk of default increases with the increased amount of debt, finding the optimal amount of debt might only be an imitation of peers in the industry and/or using the equity requirements from debt issuers as a rule of thumb. Its only important to note that we can with simplicity use the equation for Adjusted Present Value: 𝑉𝐿 = 𝑉𝑢 + 𝑃𝑉(𝑇𝑆) − 𝑃𝑉(𝐹𝐷𝐶).

A final thing to notice is the agency costs that may arise from leverage, that is the costs that arise when there are conflicts of interest between the firm’s stakeholders. I will shortly address these issues:

S184341: John-Andreas Nyheim

Agency costs -

-

Debt overhang: The debt burden is so large that an entity cannot take on additional debt to finance future projects (even if proved profitable), dissuading current investment possibilities. Excessive risk-taking: A company’s debt surpasses the firm’s market value, the firm have a high-risk project that might save them but also lead to further default. As the firm is already in line, they have nothing to lose, only the shareholders have. Managerial: Overconfidence, empire building, excess cash is used non-satisfactory projects. Equity claims: Owners with contradicting interests and requirements regarding present and future funding, and the use of funds.

Its also important to address the agency benefits of leverage. When the firm is correctly leveraged, interest payments eats up excess cash, leading to managerial motivation to run the firm efficiently. Creditors themselves will closely monitor the actions of managers, mitigating managerial entrenchment. Capital stack (tiers of financing): -

-

-

Senior debt – the first priority to be paid out in and illiquidity event. This is also the cheapest and most secure form of capital, primarily loans from big commercial banks with a claim on equity. With its low cost of cap, this form of financing is usually maxed out before other options are used. Subordinated debt – Also known as junior debt. Higher risk and cost of cap, unsecured creditor whom is second in line for claims on the company. Mostly high yield corporate bonds (investment grade or junk bonds) and credit loans like Mezz warrantless, PIK notes and Vendor notes. Equity – the check that the investors must write.

Pecking Order Theory: In corporate finance, the theory postulates that the cost of financing increases with asymmetric information. Companies prefer to fund investments by first using retained earnings, then debt and equity only as a last resort. The reason why stems mainly from liquidity, more directly the transaction cost. Issuing equity dilutes how much profit the owners have at the end of the day, as well as risk. Issuing debt in its basic form is only as risky as losing the asset that was used as a collateral, with equity you stand to lose the whole company.

Payout Policy

With perfect capital markets, it does not matter how a firm returns cash to its shareholders. In real life however, the decision matters because of various frictions such as tax, flexibility and signalling. There is no such thing as a ‘correct’ payout policy in the real world due to factors and opinions contributing to the specific firm. In imperfect capital markets cash is taxed first at firm level and then at investor level. There is agency costs correlated with excess cash, as cash can be wasted by management. But then again cash have option value and gives financial flexibility in time of need. So how much cash is really needed? The question is subject to strong informational asymmetries.

S184341: John-Andreas Nyheim

Ways to pay out cash to shareholders: -

Dividends: Special dividend, Stock dividend (stock split) Share repurchases: Repurchases or buyback shares, resulting in a increased stock price for every shareholder. 95% are over the open market, other options is by a tender offer, targeted repurchase from a specific shareholder, or by greenmail (repurchasing shares from a hostile takeover).

Shareholder must pay taxes on the dividends they receive and also pay capital gains taxes when they profit from selling shares. The tax rate on dividends are typically taxed at a higher rate than capital gains. Long-term investor can defer from paying capital gain taxes by simply not selling. The result of this is that commonly, the ‘correct’ payout policy favours share repurchases over dividends. Share repurchases typically signal underpricing as managers have better information, market reacts positive to initiation of share repurchases.

Security issues Companies can raise equity capital from following parties: -

Private companies: PE, Venture, Institutional Investors, Corporations, Angels Public: Initial Public Offering (IPO), Seasoned Equity Offering (SEO)

Some necessary terminology: Underwriting: The process by which Investment bankers raise investment capital from investors on behalf of corporations and governments that are issuing either equity or debt securities. A collection of underwriters participating in the issue is called a syndicate. Registration Statement: A legal document that provides financial and other information about a company to investors prior to a security issuance. Preliminary Prospectus (Red Herring): Part of the registration statement prepared by a company prior to an IPO that is circulated to investors before the stock is offered. Final Prospectus: Part of the final registration statement that contains all the details of the offering, including the number of shares offered and the offer price. Three common methods for underwriting -

Firm Commitment – Underwriter accepts the responsibility for all unsold shares

-

Best Efforts (mostly used) – Underwriter attempts to sell the whole issue but can return any unsold shares to issuer.

-

All-or-none – Entire issue must be sold, or the deal is pulled

-

Auction IPO: Underwriter allocates shares to buyers and takes bids from investors, underwriter sets a price that clears the market.

The book building process begins with a price range considered interesting for institutional investors. From the final price is set to ensure clearing. Key issues in pricing is price stability, buoyant after market, depth of investor base and access to market. It’s a battle between under-pricing (leaving money on the table) and after market price performance. Main idea: reduce the risk of equity overhang but ensure aftermarket buoyancy. The roadshow process is common part of capital raising, it is the process where the management goes “on the road” to investment banks to meet institutional investors. The purpose is to convince investors of the strength of the business case. Critical areas include -

Management structure, governance and quality

S184341: John-Andreas Nyheim

-

Key risks and their factors.

-

Strategy, both tactical and long-term

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Funding requirements and purpose demonstrate use of proceeds.

-

Main competitors

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Analysis of the industry/sector

Underwriters manages their risk by first receiving a fee of 7% of the issue. Second, they receive an over-allotment allocation (called greenshoe provision), an option that allows the underwriter to issue more stock, usually amounting to 15% of the original share size at the IPO offer price. The greenshoe provision works as the underwriters can short sell the allotment, if the issue is a success the option is exercised, if its not a success the short position is covered by repurchasing the allotment in the market. Exercise example on IPO: Your firm has 8 million shares and are about to issue 6 million more in an IPO. The IPO price is set to 15$ and the underwriting spread is 8%. The IPO is successful, the share price is 51$ the following day. - How much did your firm raise from the IPO? 6 mill shares * 15$*(1-8%) = 82.8 million in cash. - The firms market value after the IPO? 14 mill shares * 51$ = 714 mill - Assume post IPO value is the correct market value, what would the price per share be if you did not have to issue an IPO?

issued to investors :

82.2$𝑐𝑎𝑠ℎ 78.9

714$𝑚 − 82.8$𝑐𝑎𝑠ℎ = 𝟕𝟖. 𝟗𝟎$ → 𝑐𝑜𝑟𝑟𝑒𝑐𝑡 𝑠ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒 8𝑚 𝑠ℎ𝑎𝑟𝑒𝑠

= 1.04943 𝑚𝑖𝑙𝑙 𝑛𝑒𝑤 𝑠ℎ𝑎𝑟𝑒𝑠

End result 8𝑚+1.04943𝑚 𝑠ℎ𝑎𝑟𝑒𝑠 = 78.90$ 714$𝑚 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒

(78.9 − 51) ∗ 8𝑚 𝑠ℎ𝑎𝑟𝑒𝑠 = 223.20 𝑚𝑖𝑙𝑙𝑖𝑜𝑛

- What is the cost of market imperfections (underwriting cost) for the original investors?

S184341: John-Andreas Nyheim

Capital Budgeting & Valuation with Leverage Our expositions will rely on the assumptions that the project has average risk, the firm’s debt-equity ratio remains constant and corporate taxes are the only imperfections in the market. In this course we focus on three different valuation methods: -

WACC

𝑟𝑊𝐴𝐶𝐶 = 𝑛

𝑉0𝐿 = ∑ 𝑛=1

𝐸

𝐸+𝐷

𝐷 𝑟𝑒 + 𝐸 + 𝐷 𝑟𝑑 (1 − 𝑡)

𝐹𝐶𝐹𝑛 1 + 𝑟𝑊𝐴𝐶𝐶

𝐷𝑡 = 𝑑 ∗ 𝑉𝑡𝐿 .

The constant D/E ratio means that the debt levels needs to match todays D/E ratio (d).

Practically this means that the firm needs to reduce cash or increase debt relatively to the changing value of the firm. If the firm buys a project with an expected present value of 61.25M$, the firm needs to borrow half of it to maintain a 50% debt ratio (30.625M$), or spend cash accordingly (spend 20M$ borrow 10.625M$). In result, the NPV of the project equals to the value added for shareholders. The Debt capacity for a project decreases per year, this means that the firm either retires debt or increases the cash balance to maintain debt ratio. -

Adjusted Present Value (APV)

𝑉 𝐿 = 𝐴𝑃𝑉 = 𝑉 𝑈 + 𝑃𝑉(𝑇𝑆)

The unlevered value is calculated by discounting FCF at the unlevered cost of capital. Which is calculated as pretax

WACC, however this argument relies on the assumption that the overall risk of the firm is independent of the choice the business. If this is not the case, we need to compute the 𝑟𝑢 of comparables;

of leverage, which is true only if the firm maintains a target leverage ratio and if the risk of the project is the same as 𝑟𝑒 = 𝑟𝑢 +

𝐷

𝐸

(𝑟𝑢 − 𝑟𝑑 ) → and then back into wacc with project leverage.

A constant market debt-equity ratio is a special case, if CF realization is high, the firm will add debt and vice versa. The actual tax shield depends on the realization of the CFs and thus similar risk is achieved. 𝑛

𝑉0𝑈 = ∑

𝑛=1

𝐹𝐶𝐹𝑛 1 + 𝑟𝑢

𝑛

𝑃𝑉(𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑡𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑) = ∑ ( 𝑛=1

𝑟𝑑 ∗ 𝐷𝑡−1 ∗ 𝑡𝑎𝑥 ) 1 + 𝑟𝑢

A circularity problem occurs unless you know the levered firm value, as the future debt is unknown; To calculate debt level’s we need FCFs, to compute FCFs we need future debt levels. We can solve this using Excel’s iteration procedure. Start with a guess of debt and wait for convergence. (This is not relevant for the exam) There are two scenarios where APV performs the best, two alternative leverage policies: - Interest payment is a targeted fraction of its free cash flows 𝑡 = 𝑘 ∗ 𝐹𝐶𝐹𝑡

Such that 𝑉𝐿 = 𝑉𝑢 + 𝑃𝑉(𝑇𝑆) = 𝑉𝑢 + 𝑡𝑐 𝑘 ∗ 𝑉𝑢 →

𝑉𝐿 = (1 + 𝑡𝑐 𝑘)𝑉𝑢

- Predetermined debt levels: Adjusting its debt according to a fixed schedule that is known in advance, they do not depend on the risk of the project. The result is that the present value of the tax shield is discounted with the debt cost of capital, and not the wacc.

S184341: John-Andreas Nyheim

-

Flow-to-Equity Method (FTE)

A valuation method that calculates free cash flow available to equity holders. 𝐹𝐶𝐹𝐸 = 𝐹𝐶𝐹 − (1 − 𝑡𝑐 ) ∗ 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 + 𝑁𝑒𝑡 𝐵𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔

The cash flow to equity is then discounted using the equity cost of capital. Note that iteration is also necessary here as the debt capacity is unknown and therefore the interest payment will differ. Real life method choice Typically, the WACC method is the easiest when the firm will maintain a fixed debt-to-value ratio. For alternative leverage policies, the APV method is usually the simplest approach. When the tax shield and debt values are difficult to determine, the FTE is typically used. Different valuation methods lead to similar results if applied correctly, its important to know which one to use for different scenarios. Commonly, analysts use an array of valuation methods to derive an interval containing the ‘correct’ firm value.

Financial Options & Option Valuation A financial option gives its owner the right to purchase or sell an asset at a fixed price on some future date. European Option: Can only be exercised at maturity date. American Option: Can be exercised at any time within or at the maturity date. Holding a long term put(sell)-option on stocks you already own can insure your portfolio against losses. The same result can be done by buying riskless bonds and a call(buy)-option.

This implies the put-call parity; the law of one price: 𝑆𝑡 + 𝑃𝑡 = 𝑃𝑉(𝐾) + 𝐶𝑡

Binomial Option Pricing Model The underlying asset have two potential future values, the option value depends on the payoff in these two states. The model(s) we use are to correctly discount these values, given the probability of them happening.

𝑍0 = Δ𝑆0 − 𝐵

Δ;

𝑍𝑢 −𝑍𝑑

𝑆𝑢 −𝑆𝑑

𝐵; ( 1+𝑟 ) ( 1

𝑓

𝑍𝑢 ∗𝑆𝑑 −𝑍𝑑 ∗𝑆𝑢 𝑆𝑢 −𝑆𝑑

The Δ and B can be used as a measure of hedging.
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