Corporate Finance Cheatsheet 6t1y2s

CORPORATE FINANCE First principles: Objective: Max firm value. Investors base decisions about firm’s future based on the quality of the firm’s projects (investment decision) and the amount of earnings it reinvests (dividend decision). The financing decision affects the firm value through creation of a hurdle rate - Violating first principles will lead to huge costs. (1) Investment decision: Invest in assets that earn a return greater than the minimum acceptable hurdle rate (that reflects riskiness of investment whether money is raised from debt/equity, and what returns one could have made by investing elsewhere) - The return should reflect the magnitude and the timing of the cash flows, and all side effects (2) Financing decision: Find right kind of debt for firm and right mix of debt/equity to max the value of the investments made (3) The Dividend decision: If cannot find investments that make your min. acceptable rate, return the cash to owners - How much cash you can return depends on current and potential investment opportunities - How you return depends on whether they prefer dividends or buybacks Objective in decision making: Maximise firm value and if markets are efficient: Maximise stock price (a) Stockholders have power to hire/fire managers, so they set aside their interests and max stock prices - Alignment of interests due to fear of stockholders or cos management holds enough stock (b) Managers will reveal information honestly and on time, so markets are efficient and stockholder’s wealth is maximised (c) Bondholders are protected from stockholder actions, hence they lend money to firms to maximise firm value (based on opt financing decision)- Stockholders concerned about reputation if they hurt lenders and damage future borrowing, or bondholders have covenants to protect themselves (d) Social costs can easily be traced to firm, so firm does not create burdens for society - However, agency costs may form due to conflict of interests among stockholders, managers, bondholders and society which may result in the objective function of stock price maximisation going awry Stockholders vs Managers: Limitations of current measures (1) The annual meeting- not a good disciplinary mechanism: Power of stockholders is diluted due to: (a) Most small stockholders do not go for meetings because the cost of going > value of their holdings, (b) Proxy forms are usually not returned as small stockholders may not know enough about how good/bad the management is, hence incumbent management get advantage as unvoted proxies become votes for them, (c) Large stockholders choose to vote with their feet when they are dissatisfied with management (simply sell stock and move on) - Also, institutional investors may go along with incumbent managers as they want to keep good relations with managers to avoid decisions made by management that could affect them negatively (2) Board of Directors- not a good disciplinary measure: (BOD’s fiduciary duty is to ensure that managers serve and look out for the interests of the stockholders) - However, (a) The CEO often hand-picks directors: Hence although most directors are outsiders, they are not independent, (b) Many directors only hold token stakes of their corporations, Hence interests are not aligned with stockholders, (c) Many directors are CEOs/directors of other firms so they cannot spend much time on their fiduciary duties and there is potential conflict of interest, (d) Lack of expertise on the company’s internal workings, ing rules etc - Example: Disney 1997 had a bad board of directors (1) Too many insiders (current and ex-employees) who would not want to challenge the CEO, (2) The CEO and chairman were the same person hence there was no challenging during the meeting, (3) Large boards not efficient since hard to get a consensus, (4) Some directors had bad reputations, (5) Not independent: Connected based on school of the CEO’s kids, personal lawyer etc - Calpers Tests for Independent Boards (1) Are a majority of the directors outside directors? (2) Is the chairman of the board independent of the company? (E.g. Not the CEO) (3) Are the compensation and audit committees composed entirely of outsiders? Consequences of stockholder powerlessness: Managers put their interests over stockholder instead of maximising stockholder value - Managers choose to avoid hostile takeovers even if stockholders are getting a good deal, as this would cost them their jobs (1) Greenmail: Managers of target firm of a hostile takeover choose to buy out the potential acquirer’s existing stake at price much higher than the price paid by the raider, in return for the g of a standstill agreement, (2) Golden parachutes: Provisions in employment contracts for the payment of a lump sum or cash flows over a period (using shareholders’ money) if managers lose their jobs in a takeover, (3) Poison pills: Security where rights or cash flows are triggered by hostile takeover to make it difficult/costly to acquire control (e.g. issue new shares to existing shareholders except for the new bidder to halve his value), (4) Shark repellents: Antitakeover amendments that require stockholder assent (E.g. Super-majority amendment where acquirer needs to

RISK-RETURN MODEL Risk-free rate: LT govt bond rate, same currency as cash flows - If no default-free entity, deduct default spread by: (1) Obtain default spread based on rating/risk score, (2) Use alternate currency to do analysis, (3) Compare government bond issued in USD with USD govt bond rate to get default spread, (4) Use CDS as default spread Risk : (1) Survey approach (2) Historical approach: Define time period for estimation, calculate average returns on stock index during period (geometric average), calculate average returns on riskless security during period and find difference - Standard error in estimate = - For emerging markets with less historical data, add country risk . Use country’s bond rating/default spread and multiply by (SD of country’s equity/SD of country’s bond). Add to US risk . (3) Implied approach: Add dividends and buybacks yield against index and find average yield over a few years. Use average yield to estimate CF this year by multiplying by index NPV. Estimate earnings growth and calculate CF for next few years (grow at same rate). After a few years, assume earnings grow at risk-free rate.

Solve for IRR (r) and obtain implied risk (E(r) = rf + RP) - Choosing between historical/implied: Historical RP assumes market is mispriced while implied RP assumes market is fairly priced (on average) and is more forward looking. Beta (top-down): Regress stock returns against market returns - Decide on an estimation period (trade-off: accuracy vs relevance) and decide on return interval (usually weekly/monthly/quarterly since daily and yearly avoided due to thin-trading and few data points) - Estimate returns (including dividends for ex dividend months) - Choose market index (based on marginal investorsdiversify locally/globally) and estimate returns inclusive of dividends - Regression results: - Beta (b) is gradient - Standard error of beta estimate: Find confidence intervals - y intercept (a): a > rf(1-b) means stock did better than expected during regression period - Jensen’s alpha: a = rf(1-b) Annualized excess return = *RMB to correct rf to monthly if returns are monthly - R-squared: Estimate of proportion of total risk attributed to market risk (Diversified investor look at beta, non-diversified look at R 2 and beta) Beta (Bottom-up): Better estimate as standard error is lower and can reflect current and expected future mix rather than historical. Determinants of beta: (1) Industry effects (sensitivity of dd to macro factors), (2) Operating leverage (Higher OL, higher proportion of fixed cost, greater earnings variability), (3) Financial leverage (Hamada equation ) *Regression beta is levered *Betas of portfolios are MV weighted average of betas of individual investments in portfolio *Mergers beta calculation: General method: (1) Find biz segments of firm, (2) Obtain median beta for each segment in industry, (3) Find median D/E in each segment, (4) Use hamada to find unlevered beta for each segment, (5) Correct unlevered beta for cash using median (cash/firm value) (6) Find median enterprise value/sales for each segment (EV is market cap+debt-cash), (7) Multiply firm’s biz segment revenue to each EV/sales to get estimated value, (8) Use proportions of estimated values and unlevered betas for each segment to find firm’s unlevered beta, (9) If finding overall levered beta, use hamada on firm’s unlevered beta and actual D/E ratio, (10) If finding levered beta for each segment, allocate firm’s debt across biz segments by estimating each segment’s debt using median D/E and estimated value of segments, (11) Use proportion of estimated debt and multiply by actual total debt to get allocated debt, (12) Take estimated value – allocated debt to find estimated equity, (13) Use (allocated debt)/(estimated equity) to find levered beta for each segment, (14) To get beta for assets (not just operating assets, use

Other issues: (1) Single division firms- just use re of whole firm, or instead of breaking up into biz segments, use e.g. emerging markets for related firms’ beta and median values to find unlevered beta corrected for cash, and use actual D/E to get levered beta, (2) Firms with similar biz segments- no need to allocate debt (use actual D/E for both segments, (3) Financial institutions- Take median of beta of similar firms and revenues as weights (difficult to find D/E so no need to find unlevered beta), (4) Non-traded

INVESTMENT RETURNS (A) To all investors (1a) ing view of return: Find return on capital - Estimate ing earnings on project (operating income after tax) - Revenue – direct expenses – depreciation (inclusive of pre-project) – allocated G/A costs – Taxes *AKA EBIT(1-T) – before interest - Find average book value of capital/beginning book value of capital - BV = BV of pre project investment + BV of fixed assets + BV of working capital (non-cash and non-debt only) *WC = CA - CL - Find ROC *Always calculate implied tax rate!!!! *If given EBIT after operating lease expenses/debt, add back interest expense (PV/debt value of lease payment x cost of debt) (1b) EVA and comparison - To value the entire firm (existing investments), compare ROC of firm with WACC of firm - To value new investments, compare ROC of individual project with WACC of biz segment/firm *Adjust WACC for EM risk etc - EVA (Economic value added) = (ROC – WACC) x BV of capital invested (Value spread x investment = excess returns) (2a) Cash flow view of return: Find incremental cash flows and NPV/IRR - EBIT(1-T) (ing earnings) + D/A (inclusive of preproject) – Capex – change in non-cash working capital - In year 0, add back pre-project investment (previously expensed off- since it would have existed anyway. Left with normal investment and increase in working capital) - In years 0-10, deduct pre-project depreciation x tax to remove tax benefit from sunk depreciation (only have tax benefit from normal dep) - In years 0-10, add back after-tax fixed/non-variable G/A costs since only variable costs will contribute to cash-flows on project *To know if variable/fixed, compare allocated expense and increase in expense due to project. If increase in expense>allocated so instead of adding back (allocatedincrease)(1-T), minus (increase-allocated)(1-T) - Get incremental cash flows: Time-weighted (compounding/discounting) - Closure: For projects with short/finite life, find salvage value (expected proceeds from selling investment in proj which is fixed assets+WC). For projects with infinite life, compute terminal value = (2b) Measures of return - NPV > 0 means add value to firm - Minus year 0 investment (BV of fixed assets and WC) from NPV of cash flows. May have salvage/terminal value - Annuity to compare NPV of proj with different span: - IRR > Hurdle rate (IRR: Discount rate that sets NPV = 0) - NPV vs IRR: (1) Project only has 1 NPV but may have >1 IRR, (2) NPV ($ value) will be larger for large-scale projects while IRR (% value) will be larger for small-scale projects, (3) NPV assumes CF reinvested at hurdle rate while IRR assumes reinvested at IRR *Overall NPV more reliable (2c) Consistency rule: Project conclusions identical in different currencies (B) To shareholders only (1a) ing view of return: Find return on equity - Estimate net income/year (EBIT – Interest – Taxes) *Get tax rate - Find debt payments per year: Beg debt 100,00 0

Intere st 6,373

Principal repaid 7,455

Total paid 13,828

End debt 92,545

i/r x BD

- Find BV of capital = BV of fixed asset + BV of working capital - Find BV of equity = BV of capital – Beginning debt for project only - Find average BV of equity (beg+end/2) - Find ROE (can also use EVA method) - Compare ROE with WACC of firm (2a) Cash flow view of return - FCFE = Net income + D/A – capex – change in non-cash WC + change in debt (new debt - principal amount repaid) (2b) Measures of return: NPV and IRR (2c) Consistency rule (C) Uncertainty in project analysis: (1) Payback period, (2) Sensitivity analysis and what-if questions (hold one variable constant), (3) Simulations (vary many variables and obtain distributions) (D) Macro uncertainty: (1) Commodity prices risk (Should commodities firms hedge against commodity prices? No cos investors are betting that prices will rise. Should s of commodities (firms) hedge? Yes), (2) Exchange rate risk (hedge, investors not interested to take this risk) CAPITAL STRUCTURE (1) Optimal mix of D/E - Debt: All interest-bearing liabilities (ST/LT) - Equity: BV/MV of market cap (MV: Current stock price x issued shares #)

acquire more than usual 51% shares to take over) Give managers larger bargaining power and may work in the interest of shareholders if managers bargain for higher prices to be paid for shares, (5) Overpaying on takeovers: Acquisitions often are driven by management interests rather than stockholders interests - Quickest and most decisive way to impoverish stockholders - Usually takeovers are not successful for the bidding firm and stock prices usually decline on the takeover announcements Mergers usually do not work *(1)-(3): Only directors’ approval is required *Other ways managers can make stockholders worse off are by investing in bad projects, taking up too much or too little debt and overpaying on a takeover Stockholders vs Managers: Other issues - If government is a major stockholder, the government may force the company to pay more taxes, force them to lower or force the company not to outsource - If a certain family of companies hold most of the shares, managers may choose to put the family’s interests above other stockholders - If influential figures hold large amounts of shares, smaller institutional investors may feel safer as he will whistle-blow Bondholders vs Stockholders: Different objectives due to the different payoff structures - Bondholders: Concerned about safety and ensuring they get paid their claims, do not like risk in project choice as they do not get to participate in the upside gains - Stockholders: Concerned about upside potentials since they have limited liability - What is good for the stockholders (increasing share price/dividends) may not be what’s good for bondholders (reducing default risk/increasing bond price) (1) Increase dividends significantly: Stockholders benefit while lenders are hurt since the firm is riskier without the cash and there will be less cash to meet debt obligations. Possibility of bankruptcy increases (2) Firm takes riskier projects than agreed: The higher the risk, the higher the i/r and bond price falls, (3) Firm borrows more on the same assets (uses same assets as collateral): If lenders do not protect themselves, can be hurt by firm’s actions (E.g. Leveraged buyout: Bidder uses the target company’s cash flows/assets as collateral to borrow to purchase shares) Firms vs Financial markets: Problems with using stock prices as estimate for shareholder wealth: (1) The information problem - Managers control the release of info to the general public - Info that is negative is suppressed or delayed by managers seeking a better time to release it (manipulate information flow) - Rationale: Panic trading cause prices to change more. Firms hope bad news will go away or be paired with future good news to release to investors - In some cases, firms intentionally release misleading info about their current conditions and future prospects to keep investors happy and raise market prices - Easier for small firms cos of large number of analysts following larger firms (2) Market inefficiency: Problem with using financial markets to evaluate performance - Investors are irrational and prices are more volatile than justified by the underlying fundamentals. - ST price movements have little to do with info hence it is inaccurate as a measure of managerial performance - Investors (especially ST investors) are short-sighted and do not consider the longterm implications of actions taken by the firm (e.g. LT investment in R&D) - Financial markets are manipulated by insiders and hence prices may not be reflective of true value Firms vs Society: Social costs may be considerable but cannot be traced back to firm. May not be known at time of decision - Difficult to quantify and person-specific (different decision-makers weigh them differently) Solution 1: Choose different objective function (1) Max market share (More observable and measurable with assumption: Higher market share, more pricing power and higher profits), (2) Max profit (Higher profits, higher value in LR), (3) Max revenue/size, (4) Max social welfare, (5) Max consumer satisfaction( Quality products at lower price) Solution 2: Maximise stock price, subject to constraints (reduce agency costs) - Internal selfcorrection mechanism (1) Stockholders vs Managers: Stockholders/institutional investors taking part more actively to voice displeasure, monitor companies and demand changes - The Icahn effect: Some individuals take large positions in companies where they feel need to change management ways and push for changes (punish managers and help small shareholders) - The hostile acquisition threat: The best defence against a hostile takeover is to run firm well and earn good returns for your stockholders - More effective board of directors: Smaller boards with fewer insiders, directors are compensated with stocks instead of cash and directors are identified and selected by a nominating committee rather the CEO (2) Bondholders vs Stockholders: More restrictive bond covenants: restrict the firm’s investment policy, dividend policy and additional leverage - Puttable bonds where the bondholder can put the bond back to the firm and get face value if the firm takes actions that hurt them - Ratings Sensitive Notes where the i/r on notes adjusts according to rating of firm - Hybrid bonds: With equity component so bondholders can become equity investors (3) Firms vs Financial Markets: Analysts to provide an active market for

assets only have BV (no MV) D/E available so estimate that firm’s DE is similar to median D/E of comparable firms, (5) For private firms (not diversified), adjust beta to reflect total risk (if not, will underestimate hurdle rate) Cost of equity = rf + b(RP) To convert to local currency, Cost of equity = (1+$COE)( )–1 (Or just replace rf with nominal local rf rate but not as accurate) MM theorem: COE = Cost of debt: Debt includes interest bearing liability (ST/LT) and any lease obligation (operating/capital) (1) Firm has outstanding bonds, and are traded – Use YTM on LT straight (no special features) bond (Or coupon rate of bond trading at par) (2) Firm is rated – Use typical default spread based on rating + rf rate (3) Firm is not rated – (a) i/r on recent LT borrowing (b) Estimate synthetic rating and obtain default spread to add to rf rate *Add country spread for countries that face default risk Synthetic rating: Interest coverage ratio [EBIT/Interest expenses] - Compared to actual ratings: Synthetic only reflects interest coverage ratio (no other ratios/qualitative factors), do not allow for sector-wide biases in ratings, based on EBIT for the year while actual reflects normalized earnings, presence of country risk Cost of preferred stock (not tax deductible): Cost of convertible debt: break into parts MV of CD = MV of straight debt + convertible option (derived value) *Only include if significant (>5% in value) Weighted average cost of capital (WACC) – Use market values MV of equity: Market capitalization MV of debt: PV of interest paid on debt (e.g. bonds) + PV of debt + PV of lease payments (discount at cost of debt) Formula: *Bank loan (CF are interest payments) vs bonds (CF are coupons) Other issues: (1) Currency effects- Use same method as under COE to convert to local currency, (2) Divisional WACC- continuing from beta discussion- can use different weights (D/FV and E/FV) for each segment Inflation: Discount real cash flows with real discount rate (don’t use nominal for only one) Real cash flow = Nominal cash flow/(1+i/f)t Real discount rate = ((nominal+1)/(1+i/f)) – 1 MM-theorem: re = ra + (D/E)(1-T)(ra-rD) *ra is expected return on assets, which is independent of financial leverage VALUATION (A) Relative valuation: Value of asset estimated based on what investors pay for similar assets. Use price multiples and compare same biz firms. - Decide on market multiple (e.g. P/E, P/divid, P/sales, P/BV of equity) - Find benchmark firm(s) market multiple (e.g. P/E) and multiply by e.g company’s earnings to get estimated P - Find benchmark firm: Look at interpretation of market multiples E.g. For P/divid (=1/r e-g), since re is dependent on industry and debt policy, choose benchmark firm in same industry and w same debt policy - Usually choose firm with same growth rate, same industry, same capital structure – May not choose P/divid since some firms don’t pay divid - May not choose P/E if firm is losing money - Advantages: Quick and straightforward - Disadvantages: May not be precise, may not be easy to find benchmark firm, provides little info on how firm value is related to corp decisions (B) Discounted CF valuation: Value of asset is a function of its fundamentals (CF, growth and risk) (1) Choose CF to discount - Equity valuation: Value of equity = (specialised case: dividend discount model) - Firm valuation: Value of firm = - If cannot estimate FCFE/FCFF, use dividends - If firm’s debt ratio not expected to change, use FCFE - If debt ratio changes, difficult to estimate FCFE so use FCFF (2) Estimate FCFF (EBIT(1-T) + D/A – capex – change in NC WC) *May use normalized value (when investments are irregular) (3) Estimate discount rate (WACC/re) – See hurdle rate section (4) Estimate expected growth (a) Based on net income: g = retention ratio x ROE = RE/Equity *Since RE = earnings – dividends, retention ratio = (1 – divid/net income) (b) Based on operating income: g = reinvestment rate x ROC *ROC = EBIT(1-T)/BV of capital, reinvestment rate = (-D/A + capex + change in NC WC)/EBIT(1-T) (5) Getting closure in valuation

- Optimal mix: WACC weights constant for a long time - Trade-off: Benefits/costs of debt (2) Benefits of debt: (a) Tax benefit since interest expense is deductible while dividends are paid after tax (tax benefit each year = T x interest) Hence other things equal, the higher the marginal tax rate, the more debt firm should have *17% SG rate is considered low (b) Adds discipline to management: Managers with no debt may become complacent, hence inefficient or invest in poor projects. Assuming they don’t hold a lot of shares, there is little cost borne when stock price falls hence forcing firm to take debt, need to earn enough return to cover interest (if not bankruptcy, loss of job, difficult to find job again) (3) Costs of debt: (a) Bankruptcy cost: Probability of bankruptcy (depends on uncertainty of future CF) and cost of bankruptcy (direct costs like legal costs or indirect costs from negative perception) Hence other things equal, the greater the indirect cost, the less debt firm should have (e.g. airplane manufacturer has higher indirect costs than grocery store) (b) Agency cost: Arises when you hire someone to do something for you (conflict of interest) Lenders (get money back) vs shareholders (max wealth) Other things equal, the greater the agency problems, the less debt a firm can afford to use (lenders increase i/r to protect themselves) (c) Loss of future financing flexibility: When firm borrows up to capacity, loses flexibility of financing future projects with debt (better projects come along) Other things equal, the more uncertain a firm is about its future financing requirements and projects, the less debt it should use (4) Alternative to optimal mix: Pecking order theory - RE, debt (straight, convertible), new equity (common, straight preferred, convertible preferred) - Managers value flexibility to use capital w/o restrictions or having to explain its use, managers value control to maintain control of the business (lose a bit of control to shareholders/debtors) - Hence when firm issues convertible preferred stock, signals that firm is in financial trouble (5) Optimal mix: Cost of capital approach (minimise cost of capital) (a) Estimate cost of equity at different debt levels using hamada eqn - Start with current levered beta, find unlevered beta *Can use segments (b) Estimate cost of debt at different debt levels - Find EBIT and debt amount - Predict bond rating and check corresponding pre-tax cost of debt - Find interest expense (pre-tax COD x debt) - Calculate interest coverage ratio (EBIT/interest) and check if it corresponds to rating previously predicted. If wrong, predict again. - Multiply by (1-T) to obtain after-tax COD *Tax rate may end up lower at higher debt level since EBIT < Interest so new marginal tax rate = (TxEBIT)/Interest (c) Estimate WACC at different levels of debt - Should increase since debt will cost rd and re to rise. But may fall slightly first since put more weight on smaller rd value (d) Calculate effect on firm value and stock price - Find FCFF = EBIT(1-T) + D/A – capex + change in noncash WC - Find implied growth rate g (if no growth, no g) *Value of firm = D+E *r = current cost of capital - Revalue firm with new WACC - Calculate increase in firm value - Another way: Annual savings next year = Change in WACC x FV Increase in FV = annual savings next year/(WACC new-g) Repurchase price - Assume rationality: New stock price = current + increase in FV/# shares - Buy back at current price: # shares bought = New debt/current stock px New stock price = current + increase in FV/new # outstanding shares - Buy back at certain price px: # shares bought = New debt/certain px New stock price = current + (increase in FV – (Px – P) x # shares bought)/new # outstanding shares Issuing shares (instead of repurchase) New price=Current+(Increase in FV+(Px-P)x # shares bought)/outstanding Paying dividend (instead of repurchase) (1) Calculate increase in FV and increase in debt, (2) Calculate change in equity (change in FV-change in debt), (3) Deduct/add to current equity and divide by # shares Limitations: (1) Constraint on debt due to ratings constraint as managers have desired bond rating (protect against downside risk in operating income, indirect bankruptcy cost with drop in rating, ego factor) Cost of rating constraint = Value at desired debt level – Value at optimal debt (2) Static: EBIT should change every year, (3) Indirect bankruptcy cost ignored: Higher debt should reduce EBIT, (4) Betas and ratings: Hamada assumes the only factor affecting beta is D/E, CAPM has many unrealistic assumptions, debt rating only looks at interest coverage

info: Payoff to uncovering negative news about firm for their clients is large since such news is eagerly sought Option trading on bad news more common - Investor access to info is improved so more difficult for firms to control when/how info is released - When firms mislead markets, punishment is swift and savage (market value falls by a huge extent due to investor’s lack of trust and negative view on future cash flows) (4) Firms vs Society: - Government laws and regulations - For firms catering to socially conscious clientele, failure to meet societal norms leads to loss of business - Investors may choose not to invest in firms they view as socially irresponsible DIVIDEND POLICY (1) Measures of dividend policy - Dividend payout = Dividends/Net income - Dividend yield = Dividends per share/Share price (2) Dividends don’t matter: M-M hypothesis: Divid don’t affect value - Underlying assumptions: (1) No tax diff between dividends and capital gains, (2) If companies pay too much in cash, they can issue new stock to replace cash w/o flotation costs/signalling consequences - When issue new equity, reduce expected price appreciation of stock but this will be offset by higher dividend yield (expected return = capital gains yield + dividend yield), (3) Investment projects don’t change even if there is excess cash when company pays less dividends (3) Dividends are bad - Tax rate for dividends usually higher than for capital gains - Investors have to pay tax when receive dividends but only pay tax on CG when they sell the stocks and realize the CG - Tax reforms may reduce dividend tax rate to a flagged rate (usually at marginal income tax rate, but may reduce) - (Pb–Pa)/D = (1–to)/(1–tcg) - If divid taxed at a higher rate, price change will be less than dividend - If both CG and dividends are taxed equally, the price change on ex-dividend day will be equal to dividend (see dividends don’t matter) *But px change/dividend may not = 1 even if tax rates are the same due to timing issue, so CG tax rate is slightly lower than expected (4) Dividends are good: (a) Clientele effect: Investors like dividends (cash dividends > stock dividends) - But investors in high tax brackets may invest in stocks that don’t pay dividends (avoid paying high taxes) - Older investors and poorer investors would hold high dividend stock (b) Signalling effect: Dividends are signals to market that you have good cash prospects in the future - Usually dividends won’t change much because paying less dividends will cause a large drop in share price (sell stocks away) due to signalling effect and paying more dividends will create high expectations (not sustainable, may choose to pay special dividends instead) (c) Agency/discipline: Force managers to be disciplined in project choice and reduce cash available for manager’s discretionary use - In firms with clear separation btw ownership and management, managers should pay larger dividends than in firms with substantial insider ownership and involvement in managerial decisions (5) Finding optimal dividend: The Cash/Trust Nexus 1. How much company paid out: Add dividends and buybacks each year 2. How much could company have afforded to pay out - Find FCFE each year (Amt of cash left after non-equity claimholders (debt/preferred stock) have been paid and after any reinvestments) - FCFE = Net income + D/A – Preferred dividends – Capex – change in non-cash WC + (new debt - principal amount repaid) - If leverage is stable, an easier way: FCFE = Net income – (1 –D/C)(Capex- Dep) - (1-D/C

)(change in non-cash

WC) *Concept: Change in debt/capital (asset growth or reinvestment). Assumes that net debt is always a stable proportion of reinvestment - Compare cash returned/FCFE ratio 3. How much do you trust the management with excess cash? - If cash returned/FCFE ratio < one, there is cash balance in the company - Performance measures: (a) Investment perf: Compare ROE and re (b) Stock performance: Jensen’s alpha (if negative, underperformance) - E.g. Disney could have afforded to pay more divid but chose to invest in

- If assume to grow at constant rate g forever, terminal value = expected CF next period/(r-g) - g is called stable growth rate and cannot be higher than growth rate of economy To calculate expected CF next period: (1) Calculate EBIT(1T)(1+g)t-1(1+gc) (2) Calculate reinvestment = constant g/ROC x EBIT(1-T)t , (3) Deduct reinvestment to get FCFFt. Terminal value = FCFFT/(waccnew – constant g) - Getting to stable growth - Key assumption in DCF model is period of high growth: Firm in alr stable growth, 2-stage: high growth for a period then drop to stable growth, OR 3-stage: high growth for a period then gradually fall to stable growth - Assumption of duration of high growth depends on size of firm (large firm-shorter), current growth rate (high-longer), barriers to entry and differential advantages (high-longer) Phases

High growth

Transition

ROC

9.91%

Reinvest rate

53.72% based on acquisition costs ROC x reinvest rate 26.7% Beta = 0.9033 COD = 6%

Declines linearly to 9% Declines to 33.33% (= g/ROC)

Expected g D/C ratio Risk paramet ers

Stable growth Stable at 9% 33.33% (= g/ROC)

Linear decline to 3% stable g of 3% Stays unchanged Beta changes Beta = 1 linearly to 1 No change in COD

(6) Firm value to equity value/share - If you had discounted divid/share at re, PV is value of equity/share - If you had discounted FCFE at re, PV is value of aggregate equity so subtract value of equity options given to managers and divide by # shares - If you had discounted FCFF at WACC, PV is value of operating assets, so add the value of non-operating assets (cash/near cash) and value of minority cross holdings to get PV of assets. Subtract debt outstanding and value of equity options given to managers, and divide by # shares Ways to change value- Through: (financing/investing decisions) (1) CF from existing assets: How well you manage existing investments (2) WACC: Determined by operating risk/default risk of company and mix of D/E used in financing (3) Expected growth in high growth period - Growth from new investments: Created by making new investments, a function of amount and quality - Growth from existing assets: Created by using existing assets better - Length of high growth period: A function of magnitude of competitive advantages and sustainability of competitive advantages (since value-creating growth requires excess returns) (4) Stable growth- cannot be changed poor projects and was underperforming hence was under pressure to pay more divid. After management was changed, stock performance improved (+ve Jensen’s alpha) and project choice improved (ROC> re). Cash returned > FCFE and they avoided making large acquisitions. Cash Surpl us

Poor projects Force managers to justify holding cash or return cash to shareholders

Defici t

Firm should deal w investment problem first then cut dividends (problem is not divid policy but manager ability/incentive

Good projects Give managers flexibility to keep cash and set dividends Firm should cut dividends and reinvest more

Other issues: Whether there is takeover threat (low if closely held and outperformance) which dictates immediacy, history of paying dividends (6) Finding optimal dividend: The Peer Group Approach (A) Industry average: Idea: Optimal is close to industry average - But does not take into that may not be any average company (e.g. Disney’s large market cap), (B) Market regression: Regress divid yield and payout against variables - Dependent variables: PYT (divid/net income) and YLD (divid/current px) - E.g. of independent variables: ROE, expected g, SD in equity values and % insider holdings (related to agency problem) - Estimate values of independent variables for company and sub into the two regression equations to get predicted divid yield and divid pay-out

ratio (6) Optimal mix: Enhanced cost of capital approach - Takes into indirect cost of bankruptcy - Use same steps as prev method but reduce EBIT according to predicted rating accordingly - When computing FCFF and FV, reduce EBIT too (7) Optimal mix: Adjusted present value approach (max firm value) - FV = Value of firm w/o debt + effect of debt on FV - FV = VU + Tax benefit – Bankruptcy cost (a) Estimate Vu - Estimate unlevered beta, find re and FCFE/FCFF FV= OR - Estimate current MV firm – Current tax benefit + current expt bank cost - Current tax benefit = Current debt x T - Current bankruptcy cost = predicted probability of bankruptcy x predicted cost of bankruptcy (%) x firm value (b) Estimate tax benefit at different levels of debt (c) Estimate bankruptcy cost at different levels of debt - Probability of debt corresponding to synthetic rating of debt (in first approach) (d) Find debt level where VL is the highest *VL=VU + dollar debt(% debt x VL)*T – P(D)*cost of debt*VL but difficult to solve so assume VL is same as current FV to calculate dollar debt and COB (8) Optimal mix: Relative analysis (industry avg w subjective adjust) - Choose variables (subjective adjustments- e.g. tax rate, insider ownership, income stability, amount of intangible assets) - Run regression of debt ratios on these variables E.g. Debt ratio = a + b*(tax rate) + C*(earnings volatility) - Estimate proxies of firm and enter into cross sectional ratio to get estimate of predicted debt ratio - Compare actual to predicted debt ratio - R-squared tells us how close data is to regression line - Can do based on industry or whole market (extend sample scope) (9) Changing debt from actual to optimal 1. Timing: If there is bankruptcy/takeover threats (a) Quickly increase debt ratio (takeover threat) – Sell operating assets and use cash to buy back stock, or pay special dividend – Borrow money to buy back stock (b) Gradually increase debt ratio – Take good projects with debt (c) Quickly reduce debt ratio (bankruptcy threat) – Sell operating assets and use cash to pay off debt – Issue new stock to retire debt or get debt holders to accept equity (d) Gradually reduce debt ratio – Take new good projects with equity/RE (not debt) – If no good projects, pay off debt by issuing new equity – Reduce dividends 2. Choosing right kind of debt: Ensure CF on debt matches as closely to CF on firm’s assets – Reduce default risk, increase debt capacity and FV (a) Intuitive approach - Duration (ST/LT) - Currency - Effect of inflation uncertainty about future (market leader use floating rate since less affected by i/f, just raise prices) - Industry competition (competitive, use fixed) - Growth patterns (growth firms, low current CF, high future CF) - Cyclicality (E.g. commodity bonds- i/r and principal payments linked to commodity prices, catastrophe bonds/notes issued by insurance companies- i/r and principal payment linked to disasters) (b) Quantitative approach- to confirm intuitive approach