FINA3070 Lecture Notes v4 PDF

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FINA3070 CORPORATE FINANCE: THEORY AND PRACTICE Dr. Anson C. K. AU YEUNG Table of Contents 1 Topic 1 – Capital Structure: Modigliani and Miller Theorem ......................................... 7 1 The Modigliani-Miller Irrelevance of Capital Structure ..................................................

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FINA3070 CORPORATE FINANCE: THEORY AND PRACTICE Dr. Anson C. K. AU YEUNG

Table of Contents 1

Topic 1 – Capital Structure: Modigliani and Miller Theorem ......................................... 7 1.1

The Modigliani-Miller Irrelevance of Capital Structure .................................................. 7

1.1.1 1.1.2 1.1.3 1.2 1.3 1.4 1.5 1.6 2

Leverage and the Cost of Capital ................................................................................... 14 Leverage and Beta .......................................................................................................... 17 A Synopsis...................................................................................................................... 19 Summary of the MM Propositions ................................................................................. 20 The Road Map Ahead .................................................................................................... 20

Topic 2 – Capital Structure: Static Tradeoff Theory ...................................................... 21 2.1

Interest Tax Deduction ................................................................................................... 21

2.1.1 2.1.2 2.1.3 2.2 2.3 2.4 2.5 3

The Value of Tax Shield ......................................................................................... 22 Weighted Average Cost of Capital with Taxes....................................................... 23 Return on Equity with Taxes .................................................................................. 24

Personal Taxes................................................................................................................ 27 Costs of Bankruptcy and Financial Distress .................................................................. 28 Optimal Capital Structure............................................................................................... 29 Implications from the Static Tradeoff Theory................................................................ 30

Topic 3 – Agency Theory and Debtholder – Equityholder Conflicts ............................. 32 3.1 3.2 3.3 3.4 3.5 3.6 3.7

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Financial Leverage and Firm Value .......................................................................... 9 Homemade Leverage .............................................................................................. 10 Proof of MM Proposition I ..................................................................................... 12

The Debt Overhang Problem.......................................................................................... 33 The Asset Substitution Problem ..................................................................................... 36 Shortsighted Investment Problem .................................................................................. 38 The Reluctance to Liquidate Problem ............................................................................ 40 Mitigating the Agency Costs of Debt............................................................................. 41 Agency Benefits of Debt ................................................................................................ 42 Agency Theory and the Tradeoff Theory....................................................................... 43

Topic 4 – Capital Structure: Pecking Order Theory ....................................................... 44 4.1 4.2

Implications of the Pecking Order Theory ..................................................................... 44 A Numerical Example .................................................................................................... 45

4.2.1 Case I – The Project is Financed with Internal Equity ........................................... 46 4.2.2 Case II – The Project is Financed with External Equity and the Informational Environment is Symmetric ................................................................................................... 47 4.2.3 Case III – The Project is Financed with External Equity and the Informational Environment is Asymmetric. ................................................................................................ 48 1

4.2.4 4.2.5 5

Summary ................................................................................................................. 49 Case IV – The Project is Financed with Debt ......................................................... 50

Topic 5 – Initial Public Offering ........................................................................................ 53 5.1 5.2

Equity Financing ............................................................................................................ 53 Going Public................................................................................................................... 53

5.2.1 5.2.2 5.3

The Investment Banking ................................................................................................ 56

5.3.1 5.3.2 5.3.3 5.3.4 5.3.5 5.3.6 5.3.7 5.3.8 5.3.9 5.3.10 5.3.11 5.3.12 5.3.13 5.3.14 5.3.15 5.4

The Main Departments Involved in an IPO ............................................................ 56 An IPO Syndicate ................................................................................................... 56 Underwriter Compensation ..................................................................................... 57 The IPO Timetable .................................................................................................. 58 The IPO Process...................................................................................................... 58 Due Diligence ......................................................................................................... 59 Sell-side Research ................................................................................................... 59 Valuation ................................................................................................................. 60 The Management Roadshow................................................................................... 60 Bookbuilding ....................................................................................................... 61 Underwriting ....................................................................................................... 61 Pricing and Allocating an IPO ............................................................................ 62 The Dark Side of Bookbuilding .......................................................................... 64 Hong Kong Practice ............................................................................................ 64 After the IPO ....................................................................................................... 65

IPO Performance Measures............................................................................................ 66

5.4.1 5.4.2 5.4.3 5.5

Reasons for Going Public ....................................................................................... 54 Costs of Going Public ............................................................................................. 55

Short-run Performance Measure ............................................................................. 67 Long-run Performance Measure ............................................................................. 67 The Issue of Benchmarking .................................................................................... 69

Short-run Underpricing of IPOs ..................................................................................... 70

5.5.1 5.5.2 5.5.3 5.5.4 5.5.5 5.5.6 5.5.7 5.5.8 5.5.9 5.5.10

Explanations of Underpricing ................................................................................. 72 The Winner’s Curse ................................................................................................ 73 Information Revelation Theories ............................................................................ 74 Principal Agent Models .......................................................................................... 74 Underpricing as a Signal of Firm Quality ............................................................... 75 Legal Liability......................................................................................................... 75 Underpricing as a Means to Retain Control ............................................................ 75 Underpricing as a Means to Reduce Agency Costs ................................................ 76 Cascades.................................................................................................................. 76 Prospect Theory and Mental Accounting ............................................................ 77 2

5.6

Long-run Underperformance.......................................................................................... 78

5.6.1 5.6.2 5.7 6

Summary ........................................................................................................................ 80

Topic 6 – Seasoned Equity Offering .................................................................................. 81 6.1

Flotation Methods of SEOs ............................................................................................ 81

6.1.1 6.1.2 6.1.3 6.1.4 6.1.5 6.2 6.3

6.4

Valuation Effects of SEO Announcement .............................................................. 87 Cross-sectional Analysis of Valuation Effects ....................................................... 88 Explanations of Announcement Effects.................................................................. 90

Long Term Underperformance after SEO ...................................................................... 92 Hong Kong Evidence ..................................................................................................... 93

6.6.1 6.6.2 6.6.3 6.6.4 6.6.5 6.6.6 6.6.7 6.6.8 6.7

Direct Flotation Costs ............................................................................................. 85 Indirect Flotation Costs ........................................................................................... 85 Rights Offer Puzzle ................................................................................................. 86

Announcement Effects of SEO ...................................................................................... 87

6.4.1 6.4.2 6.4.3 6.5 6.6

Rights Offer ............................................................................................................ 81 Firm Commitment Offer ......................................................................................... 83 Best Efforts Offer .................................................................................................... 83 Shelf Registration.................................................................................................... 83 Private Placements .................................................................................................. 84

Floatation Method Trends .............................................................................................. 84 Flotation Costs and Rights Offer Puzzle ........................................................................ 85

6.3.1 6.3.2 6.3.3

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Evidence .................................................................................................................. 78 Reasons of Long-run Underperformance................................................................ 79

Number of SEOs and Dollar Amount Placed in Hong Kong ................................. 93 Issue and Firm Characteristics of SEOs.................................................................. 94 Announcement Effects of SEOs in Hong Kong ..................................................... 95 Number and Dollar Amount of Rights Issues Floated in Hong Kong .................... 96 Issue and Firm Characteristics of Rights Issues ..................................................... 96 Announcement Effects of Rights Issues in Hong Kong ......................................... 97 Why Do Firms Choose Value-destroying Rights Offerings in Hong Kong? ......... 98 Logit Regression to Explain the Floatation Choice: Placing versus Rights Issues. 99

Summary ...................................................................................................................... 100

Topic 7 – Dividend Policy ................................................................................................. 101 7.1 7.2 7.3

Dividend Policy is Important ....................................................................................... 101 What Do We Know about Dividend Policy ................................................................. 101 The Miller and Modigliani Dividend Irrelevancy Theorem......................................... 106

7.3.1

Case I – Residual Dividend Policy ....................................................................... 107 3

7.3.2 7.3.3 7.4

The Tax Effects ............................................................................................................ 109

7.4.1 7.4.2 7.4.3 7.4.4 7.4.5 7.5 7.6

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Stockholders versus Bondholders ......................................................................... 127 Management versus Stockholders......................................................................... 127

Conclusion.................................................................................................................... 127

Topic 8 – Investment Decisions........................................................................................ 128 8.1

Investment in Risk Free Projects.................................................................................. 128

8.1.1 8.1.2 8.1.3 8.1.4 8.1.5 8.2

8.3

Net Present Value (NPV) Rule ............................................................................. 128 Issues in NPV Rule ............................................................................................... 130 Internal Rate of Return (IRR) ............................................................................... 132 Pitfalls in Evaluating with IRR ............................................................................. 133 Summary of Comparison of NPV and IRR .......................................................... 136

Investment in Risky Projects........................................................................................ 136

8.2.1 8.2.2

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The Individual Firm .............................................................................................. 116 The Value of Old Equity ....................................................................................... 118 The Value of New Equity ..................................................................................... 120 The Market ............................................................................................................ 121 Good Firms Versus Bad Firms ............................................................................. 121 Pooling Equilibrium .............................................................................................. 122 Signaling ............................................................................................................... 123 Separating Equilibrium ......................................................................................... 125

Incomplete Contract and Agency Models .................................................................... 126

7.7.1 7.7.2 7.8

Personal Taxes ...................................................................................................... 109 Corporate Taxes .................................................................................................... 110 Dividend Clientele ................................................................................................ 112 The Ex-Dividend Day Studies .............................................................................. 113 A Summary on Dividends and Taxes ................................................................... 115

Asymmetric Information and Dividend Signaling ....................................................... 115 Dividend Signaling Example ....................................................................................... 116

7.6.1 7.6.2 7.6.3 7.6.4 7.6.5 7.6.6 7.6.7 7.6.8 7.7

Case II – Managed Dividend Policy ..................................................................... 107 Proof of MM Dividend Irrelevancy Theorem....................................................... 108

Risk-adjusted Discount Rate Approach ................................................................ 137 Certainty Equivalent Approach............................................................................. 138

Concluding Remarks .................................................................................................... 139

Topic 9 – Real Options ..................................................................................................... 140 9.1

Comparing NPV with Real Options............................................................................. 140

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9.1.1 9.1.2 9.1.3 9.2

Valuing Real Options ................................................................................................... 142

9.2.1 9.2.2 9.3 9.4 9.5 9.6 9.7 9.8 10

Static NPV Approach ............................................................................................ 140 Expanded NPV Approach ..................................................................................... 141 NPV and Managerial Flexibility ........................................................................... 141

One-step Binomial Model ..................................................................................... 142 A Generalization ................................................................................................... 144

Static NPV Analysis..................................................................................................... 145 The Option to Defer ..................................................................................................... 146 The Option to Expand .................................................................................................. 148 The Option to Contract................................................................................................. 149 Implications for Capital Budgeting .............................................................................. 150 Appendix ...................................................................................................................... 151

Topic 10 – Mergers and Acquisitions .............................................................................. 152

10.1 10.1.1 10.2 10.3 10.4 10.5 10.5.1 10.5.2 10.5.3 10.5.4 10.5.5 10.6 10.6.1 10.6.2 10.6.3 10.7 10.7.1 10.7.2 10.8 10.8.1 10.8.2 10.8.3 10.8.4

M&A Terminology ................................................................................................... 152 Merger .......................