Advanced Financial Management – Flashcards
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-Flexibility: project doesn't have to have same characteristics as firm like risk and debt ratio -Assumed level of debt is known over life of project -Good for LBOs, Real Options, Leases
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Advantages of APV
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Incorporating financing side effects like bankruptcy costs are difficult to estimate
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Disadvantages of APV
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Industry matters: -Asset intensive industries have high book value from so many assets -Service/technology firms have low book value because they don't sell tangible goods High goodwill increases book value, making ratio lower -doesn't mean firm is undervalued
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Price/Book value of equity
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-Use when earnings are temporarily depressed -Low margin businesses (retail) will have lower ratio -High margin (software or pharmaceutical) will have higher ratio
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Price/Sales
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-Businesses that sell things on credit may have lower cash flow and therefore higher ratio -If cash is received upfront (insurance), may have inflated ratio -Depreciation increases cash flows, high depreciation can indicate large future capital expenditures
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Value/EBIT
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Assumes the firm is very similar to comparable firms -Industry -Risk -Phase of growth cycle -Idealogy -Cash flow patterns
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Limitations of Multiples method
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How do shareholders get managers to act in their interest aka maximize NPV? -Exists because there is separation of ownership and control * Benefits: limited liability, professional management, shareholder diversification * Costs: agency problems - managers do not bear the full costs of their decisions since they don't own the whole firm
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Principal-agent problem
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Ensure that business is well-run and investors are treated fairly -Giving incentives to managers
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Corporate governance mechanisms
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-High salaries for CEOS -Equity or stock options -EVA -Financing with debt -Proxy fights
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Manager incentives
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-Managers motivated to only invest in projects that earn more than they cost -Makes cost of capital visible to managers -Based on absolute manager performance rather than performance relative to investor expectations
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EVA Incentive-Advantages
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-Low EVA can be from factors outside manager's control -Rewards quick paybacks and ignores time value of money -Managers can manipulate earnings so that EVA rewards negative NPV projects
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EVA Incentive-Disadvantages
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If there is constant pressure to meet interest payments, managers can't waste money -Prevents agency problems caused when mature firms have a lot of excess cash because they don't have good investment opportunities
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Financing with Debt
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Shareholders organize themselves to fight management -Free-rider problem: only a few shareholders need to combat management, why should any one individually put in the effort?
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Proxy Fights
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Total absorption of selling firm - no longer exists as a separate entity
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Merger
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-Simple: buyer assumes all assets and liabilities -No minority interest
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Merger Advantages
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-Requires approval of shareholders of both firms -Dissenting shareholders can sue to receive fair value
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Merger Disadvantages
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Acquirer buys target's share in the open market -May involve a tender offer
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Stock Acquisition
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-Doesn't need to be approved by target company -Can be used for hostile takeover
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Stock Acquisition Advantages
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-Minority holdout -Integration is not possible without 100% of target's shares
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Stock Acquisition Disadvantages
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Buy specific assets of target -can buy some or all
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Asset Acquisition
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-Direct acquisition of assets -Requires approval of only 50% of sellers' shareholders -Allows cherry-picking of assets
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Asset Acquisition Advantages
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Legal and administrative costs
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Asset Acquisition Disadvantages
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Target and acquirer are competitors in the same market -Regulatory requirements -Ex: BofA and Merrill Lynch
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Horizontal Merger
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Target and acquirer are at different stages of production -Ex: Google and DoubleClick
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Vertical Merger
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Target and Acquirer are in unrelated lines of business -Unpopular due to lack of synergies
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Conglomerate Merger
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Right to vote someone else's shares
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Proxy
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Goal is to obtain enough proxies to vote a desired person onto the board of directors -Used by major shareholders who are dissatisfied with how firm is managed
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Proxy Contest
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-Can be used to oust manager or change firm policy -Allows control of corporation without acquiring all the shares
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Proxy Contest Advantages
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-Expensive -Difficult to win
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Proxy Contest Disadvantages
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-Economies of scale: reduction of unit costs by spreading fixed costs across more units (motive for horizontal mergers) -Economies of vertical integration: * Integrate "backward": merge with supplier, may reduce costs * Integrate "forward": merge with customer, control over marketing channel may reduce costs -Combining complementary resources: two merging firms each have what the other firm needs * Ex: biotech firms have innovative products and patents, pharmaceutical firms have the resources to use the patents -Unused tax shields: firm may have potential tax shields but not have the profits to take advantage of them (especially after bankruptcy) -Use surplus cash if there are few positive NPV investments -Eliminate Inefficiencies in the target firm * Target may have unexploited investment opportunities, ways to cut costs or increase earnings * Improve firm's management -Industry consolidation: industry with too many firms and too much capacity * Mergers allow cutting capacity and employment to release capital for investment elsewhere
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Sensible Motives for Mergers
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-Diversification: investors should not pay a premium for diversification if they can do it themselves * Makes sense only to the extent that it reduces cost of financial distress: allows merged firm to take on more debt or taxe advantage of tax shields -Lower cost of debt: merged firm can borrow at lower interest rates * Both firms guarantee each other's debt --> not a net gain because giving guarantees means taking risk
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Dubious Reasons for Mergers
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Company goes private, purchase price is mostly financed with debt, buyer is usually private equity firm -Financing of LBO: * 70-85% debt secured by the target company's assets (mostly junk debt) * 15-30% equity from private equity firm -Shareholders of target receive takeover premium: usually a large gain * The difference between the final offer price and the share price 20-60 days before the LBO announcement
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Leveraged Buyouts (LBOs)
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-Leverage: high leverage mitigates agency problems associated with high free cash flow * Interest tax shields * Cost: financial distress from increased debt -Cheap financing: junk bonds * LBOs boom whenever there is a credit market boom -Corporate governance engineering: * Incentives for management are altered * Active monitoring of management -Private equity investors do not hesitate to replace poor management -Smaller boards, more frequent meetings -Operational engineering: private equity sponsor adds value through industry and operating experience * Cuts inefficiencies * Cap ex. plans are more closely scrutinized
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Main sources of value in LBOs
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Management participates as buyers in LBO -Management has HUGE incentive to perform
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Management Buyouts (MBOs)
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Creates a new, independent company by detaching some of parent company's assets and operations -Shares distributed to parent company's stockholders -Can improve incentives for managers * Performance of subsidiary is now measurable * Limits possibility to siphon resources out of profitable business to support unprofitable business -Usually has positive stock market reaction * Better investment decisions and operating performance
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Spin-off
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Partial spin-off where shares are sold in a public offering -Carved out business becomes a separate legal entity -Parent keeps 80% ownership -Usually positive stock market reaction
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Equity carve-outs
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Simple sale of part of a firm -Get rid of assets that do not fit the firm -Often after takeovers -Positive effect for shareholders
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Asset Sales
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-Dividends -Share repurchase/stock buyback
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Two ways to pay cash out to shareholders
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-Declaration date: board of directors declares dividend payment -Cum-dividend date: last day on which an investor can buy stock and be entitled to receive the dividend (3 days before record date) -Ex-dividend date: first day that an investor who buys the stock is NOT entitled to receive the dividend (day after cum-dividend date) * In a perfect world, the stock price would fall on the ex-dividend date by the amount of the cash dividend -Record date: firm prepares a list of registered shareholders as of this date -Payment date: firm mails dividend checks
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Cash dividend
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No cash leaves the firm: convert retained earnings into common stock
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Stock dividend
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send out product to shareholders
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Dividend in kind
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-Longer term target dividend payout ratios -Managers reluctant to make dividend changes that may have to be reversed -Dividend changes follow shifts in long-run sustainable levels of earnings, rather than short run changes
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How do firms decide to issue dividends?
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Provide info about management's confidence in the future -Dividend increase: positive signal that management expects permanent increase in earnings -Dividend cut: signals that management does not think earnings will rebound in near term
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Dividends as signals to investors
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Get rid of excess can by buying shares of firm's own stock -Can buy shares on open market -Tender offer to shareholders: commit to buying all shares in program very quickly at fixed price (usually at a premium) -Auction -Targeted repurchase directly from major shareholder
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Share repurchase
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Why dividends could matter (as opposed to being irrelevant in perfect capital markets) -Assumptions: * Firm's investment policy is set ahead of time and is not changed by changes in dividend policy * No transaction costs * No taxes (or dividends and capital gains are taxed at the same rate) -Interpretations: * Since investors do not need dividends to convert shares to cash, they will not pay higher prices for firms with higher dividend payouts * If company investment policy is fixed, its NPV is fixed so if there are no changes on the asset side then firm value remains the same -Implication of Theorem: firms should never forgo positive NPV projects to increase a dividend
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MM's Irrelevance Theorem
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Gives the right (NOT obligation) to buy or sell asset at a future date at a pre-specified price (Strike or exercise price)
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Option
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Option holder has right to buy
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Call Option
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Option holder has right to sell
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Put Option
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Can only be exercised on the expiration date
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European Option
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Can be exercised anytime ON or BEFORE the expiration date
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American Option
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Buys the right to exercise option -Must pay a premium
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Long Option
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Sells the right to exercise option -Receives a premium -Obligated to comply if the buyer chooses to exercise
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Short Option
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list of prices for calls and puts with certain maturities and strike prices
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Option chain
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Buy share and sell call option -No upside -Very low risk
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Covered call
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Buy share and buy put option, have protection against loss but you pay a premium for it
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Protective put
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Two ways to construct a protective put: -Buy put, buy share -Buy call option, invest PV of strike price in risk-free asset -Since they have the same payoff, they have the same price * Call price + PV(strike) = put price + share price * Can create a put option using a call option - Put price = call price + PV(strike) - share price
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Put-call parity
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Lower bound: option cannot be worth less than (stock price - strike price) Upper bound: option cannot be worth more than stock
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Bounds on option price
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Stock - strike < stock
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In The Money (ATM) option payoff
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0 < stock
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At The Money/Out of The Money (ATM/OTM) option payoff
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-Stock price: value of call option increases as stock price increases -Interest rates and time to maturity: value of option increases as interest rates and time to maturity increase * When price increases a lot, option price approaches [stock price - PV(strike price)] -Volatility: option price always exceeds its minimum value * Probability of a large payoff increases if the stock is more volatile or there is a longer time to expiration
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Factors influencing option value
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Obligation to buy/sell asset at a future date at price specified today -No premium paid
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Forward Contract
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Obligation to buy/sell asset at future date at price specified today -Standardized contract traded on an exchange (guarantees no counterparty risk) -Buyer and seller must deposit margin in form of cash or treasury bills -Marked-to-market on daily basis
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Futures contract
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Don't pay up front so you earn interest on the purchase price
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Advantage of buying future
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Do not receive interest or dividends paid on the security itself
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Disadvantage of buying future
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Advantages: -Don't need to pay up front so earn interest on purchase price -Save cost of storing the commodity for that time period Disadvantages: -Lose convenience yield: the value of immediate access to the commodity
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Commodity futures
