Lectures 8 and 9 - Lecture notes 8-9 PDF

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Lecture Notes for weeks 8 and 9. ...

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Lecture 7:

Lecture 8: Trade off theory: Value of an unlevered firm:

The concept is above, it’s not a formula. You are not examined on the above formula. It’s just something to wrap your head around everything you need to know.

The higher the leverage, the higher the tax shield. Tax benefit will increase firm value. When you hit the peak of the orange line, you should stop increasing leverage due to the costs outweighing the benefits. (Optimal leverage cause (D(star)) level. The Present Value of Agency benefits of debt is not examinable. Agency cost is the conflict of interest between the debt holders and equity holders. They may make decisions that benefit equity holders, but not debt holders visaversa Vu = Value unlevered VL = Value levered

Not all firms have the same level of debt. So R&D normally has very low debt levels, due to debt lenders being less willing to give lots of money to a risky firm with limited tangible assets. Also, they don’t want high debt levels in the early stages, cause it looks bad for investors. They also have low cashflow levels. The benefit for the interest tax shield will be lower, cause does not need to debt to provide a tax shield Low growth, Mature firms. Stable cashflows, tangible assets and a high leverage level.

They can get more benefits from the interest tax shield.

Asymmetric information: (slide 8) Definition: One group of people know something, while others don’t. Asymmetric info: The quality of the car. Adverse Selection: (slide 14/16) Assumes all the cars are lemons. Seller wants to sell for $5k So, what do you do due to the asymmetric info? You discount the price to 4K Seller of the non – lemon cars pull out of the market, because they know it’s not a lemon and they can’t sell a car WORTH 5k for 4k. So that leaves you with the problem that all cars still being sold at 4k are lemons.

This same principle can be applied to the market for equity. Suppose the owner of a start-up company offers to sell you 70% of his stake in the firm. He states that he is selling only because he wants to diversify. You suspect the owner may be eager to sell such a large stake because he may be trying to cash out before negative information about the firm becomes public. Therefore, managers who know their prospects are good (and whose securities will have a high value) will not sell new equity. Only those managers who know their firms have poor prospects (and whose securities will have low value) are willing to sell new equity.

Credibility Principle:   

Actions speak louder than words. If a firm has a large new profitable project but can’t discuss the project due to competitive reasons. One way to credibility communicate this positive info is to commit the firm to large future debt payments:

o If the information is true, the firm will have no trouble making the debt payments. o If the information is false, the firm will have trouble paying its creditors and will experience financial distress. This distress will be costly for the firm.

Leverage of 55 will make it credible. Why? Because you wouldn’t put yourself in 55 mil worth of debt, when the company has a 50/50 chance of being 50 mil or 100mil valuation. But if you are certain you'll be 100million, then taking on the debt is reasonable. 55 mil debt > 50 mil valuation (default)

The lemon problem creates a cost for firms that need to raise capital from investors to fund new investments If they try to issue equity, investors will discount the price they are willing to pay to reflect the possibility that managers have bad news.

Price = expected value. The 80 and 60 are both 50% chances. So the new expected stock price is 70.

Implications for Equity Issuance The lemons principle directly implies that: –

The stock price declines on the announcement of an equity issue.

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The stock price tends to rise prior to the announcement of an equity issue.

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Firms tend to issue equity when information asymmetries are minimized, such as immediately after earnings announcements

Implications for Capital Structure

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Managers who perceive the firm’s equity is underpriced will have a preference to fund investment using retained earnings, or debt, rather than equity. –

The converse is also true: Managers who perceive the firm’s equity to be overpriced will prefer to issue equity, as opposed to issuing debt or using retained earnings, to fund investment.

Pecking Order Hypothesis The idea that managers will prefer to fund investments by first using retained earnings, then debt and equity only as a last resort 1. Retained Earnings (Money that the firm keeps or has) (cheapest) 2. Debt 3. Equity (most expensive) Firms might have low leverage either because they are unable to issue additional debt and are forced to rely on equity financing or because they are sufficiently profitable to finance all investment using retained earnings.

Why equity is negative. Some firms are buying shares back. I.e. they issue 5million shares but buy back 10million.

Equity= $10mil/(1-5%)=$10.5mil Discount rate = 6%..

0.094 extra is the present value ontop of the 10 mill.

Retained earnings = 10 million Debt = $10.094 Equity = 10.5 Don’t need to go into too much detail with this question..

Market Timing View of Capital Structure -

The firm’s overall capital structure depends in part on the market conditions that existed when it sought funding in the past.

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Managers’ choice of financing will depend on whether they believe the firm is currently under-priced or overpriced.

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Overpriced used equity

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Under price – use other.

Lecture 9: Payout Policy: –

The way a firm chooses between the alternative ways to distribute free cash flow to equity holders

Type of Dividend: • •

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Cash dividend Stock dividend – When a company issues a dividend in shares of stock rather than cash to its shareholders Special dividend – A one-time dividend payment a firm makes, which is usually much larger than a regular dividend

Share Repurchases •

An alternative way to pay cash to investors is through a share repurchase or buyback. – The firm uses cash to buy shares of its own outstanding stock.

Example Question: • •

The firm’s board is meeting to decide how to pay out $20 million in excess cash to shareholders. Genron has no debt, its equity cost of capital equals its unlevered cost of capital of 12%.

Option 1: Pay Dividend with Excess Cash

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With 10 million shares outstanding, Genron will be able to pay a $2 dividend immediately. The firm expects to generate future free cash flows of $48 million per year, thus it anticipates paying a dividend of $4.80 per share each year thereafter.

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The cum-dividend* price of Genron will be:

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* Cum dividend, which means "with dividend," is when a buyer of a security is entitled to receive a dividend that has been declared, but not paid. A stock trades cum-dividend up until the ex-dividend date, after which the stock trades without its dividend rights.

Share repurchase: No dividend: Suppose that instead of paying a dividend this year, Genron uses the $20 million to repurchase its shares on the open market. With an initial share price of $42, Genron will repurchase 476,000 shares. $20 million ÷ $42 per share = 0.476 million shares This will leave only 9.524 million shares outstanding.

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10 million (on the market originally) − 0.476 million (share buyback) = 9.524 million

The share repurchase doesn’t affect the share price at the current share price So, if they do a repurchase at $42, then there will be no change. BUTTT, their dividend will increase. Why, because less people receiving the pie. So, After the repurchase, the future dividend would rise to $5.04 per share. • $48 million ÷ 9.524 million shares = $5.04 per share • Genron’s share price is:

In a perfect capital market, an open market share repurchase has no effect on the stock price, and the stock price is the same as the cum-dividend price if a dividend were paid instead.

Investors at the end of the day can actually receive whatever they want (between a div or buyback) •

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In the case of Genron, if the firm repurchases shares and the investor wants cash, the investor can raise cash by selling shares. – This is called a homemade dividend. If the firm pays a dividend and the investor would prefer stock, they can use the dividend to purchase additional shares.

Option 3: High Dividend (Equity Issue) •

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Suppose Genron wants to pay dividend larger than $2 per share right now, but it only has $20 million in cash today. – Thus, Genron needs an additional $28 million to pay the larger dividend now. To do this, the firm decides to raise the cash by selling new shares. Given a current share price of $42, Genron could raise $28 million by selling 0.67 million shares. – This will increase the total number of shares to10.67 million.

48m is your future free cash flow

Option 1: Dividend Option 2: Share Buyback Option 3: High Dividend Option 4: Stock Split •

With a stock dividend, a firm does not pay out any cash to shareholders. As a result, the total market value of the firm’s equity is unchanged. The only thing that is different is the number of shares outstanding and per share price.

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Suppose Genron paid a 50% stock dividend (a 3:2 stock split) rather than a cash dividend. – A shareholder who owns 100 shares before the dividend has a portfolio worth $4,200 ($42 × 100 = $4,200) – After the dividend, the shareholder owns 150 shares. Since the portfolio is still worth $4,200, the stock price will fall to $28 ($4,200 ÷ 150 = $28)

Modigliani and Miller Theory M&M “Capital Structure Irrelevance Principle” Definition: It is a financial theory stating that the market value of firm is determined by its

earning power and the risk of its underlying assets and is independent of the way it chooses to finance its investment or distribute dividends. It makes no difference whether the firm finances its activit...