Summary Fundamentals of Corporate Finance

This Summary of Fundamentals of Corporate Finance is written in 2013-2014

Chapter A – Raising Equity Capital

Private companies

When a private company decides to raise outside equity capital, it can seek funding from several potential sources namely:

1. Angel investors: Individual investors who buy equity in small private firms. Usually this is the first source where a firm seeks funding.
2. Venture capital firms: a limited partnership that specializes in raising money to invest in the private equity of young firms. The institutional investors are known as the limited partners in a venture capital firm. The venture capitalists are the general partners who work for and run a venture capital firm.
3. Institutional investors, such as pension funds and insurance companies. They are also active investors in private companies. Institutional investors may be limited partners in a venture capital firm, or may invest directly in private firms.
4. Corporate investors are corporations that invest in private companies. Also known as corporate partners, strategic partners or strategic investors.

If a company sells equity to outside investors for the first time, they prefer to issue preferred stock rather than common stock. Preferred stock issued by mature companies such as banks, usually have a preferential dividend and seniority in any liquidation and sometimes special voting rights. Preferred stock issued by young companies has seniority in any liquidation but typically does not pay cash dividend. It usually gives the owner the right to convert it into common stock on some future date. Then the stock is called a convertible preferred stock.

The pre-money valuation is the value of a firm’s prior shares outstanding at the price in the funding round. The post-money valuation is the value of the whole firm (old + new shares) at the price at which the new equity is sold.

The relation between firm and its investors is subjected to changes as needs and resources develop. The exit strategy is an important consideration for investors in private companies. It details how they eventually will realize the return from their investment. There are two ways in which investors exit: through an acquisition or through a public offering.

The initial public offering

The initial public offering (IPO) is the process of selling stock to the public for the first time.

Going public has some advantages: it provides companies with greater liquidity and better access to capital. When companies go public their private equity investors have the ability to diversify.

The major disadvantage of going public is a consequence of the major advantage: when investors sell their stake and thereby diversify their holdings, the equity holders of the corporation become more widely dispersed. This means a loss of control. Another disadvantage: when a company goes public, it must satisfy all of the requirements of public companies. Last century new standards were adopted (set by the Securities and Exchange Commission for example), compliance with these standards is costly and time-consuming for public companies.

An underwriter is an investment banking firm that manages a security issuance and designs its structure. An underwriter helps a company after it decides to go public.

There are two IPO possibilities:

• Primary offering: new shares available in a public offering that raise new capital.
• Secondary offering: an equity offering of shares sold by existing shareholders (as part of their exit strategy).

A standardized form of a traditional IPO process, the steps underwriters go through during an IPO:

1. Underwriters and the syndicate

The large and complex IPOs are managed by a group of underwriters. The lead underwriter is the primary banking firm responsible for managing a security issuance. It provides the most of the advice on the sale and arranges for a group o other underwriters called the syndicate. The syndicate is a group of underwriters who jointly underwrite and distribute a security issuance.

2. SEC fillings

A requirement of the SEC is for companies to prepare a registration statement: a legal document that provides financial and other information about a company to investors prior to a security issuance. Managers work closely with their underwriters to prepare this statement. The preliminary prospectus or red herring is a part of the registration statement prepared by a company prior to an IPO that is circulated to investors before the stock is offered. The SEC requires companies to make a registration statement to make sure the company has disclosed all of the information for investors to decide whether to purchase the stock. Before the IPO, the company prepares the final registration statement. The final prospectus is part of this final registration statement prepared that contains all the details of the offering, including the numbers of shares offered and the offer price.

3. Valuation

The underwriters and the company come up with a price range that they think is a reasonable valuation for the firm. There are two ways to value a company. The first one is to estimate the future cash flows and to compute the present value. The second option is to estimate the value by examining comparable companies.

After the price range is set, the underwriters explore what the market thinks of the valuation. They arrange a road show: during an IPO, when a company’s senior management and its lead underwriters travel to promote the company and explain their rationale for an offer price to institutional investors such as mutual funds and pension funds. After the road show, the underwriters get the information of the customers about their interest. The customers tell how many shares they may want to purchase. After that, the book building follows: this is a process used by underwriters for coming up with an offer price based on customers’ expressions of interest.

4. Pricing the deal and managing the risk

The most common agreement is a firm commitment: an agreement between an underwriter and an issuing firm in which the underwriter guarantees that is will sell all of the stock at the offer price.

Sometimes the company pays a spread: a fee a company pays to its underwriters that is a percentage of the issue price of a share of stock.

Underwriters appear to use information they acquire during the book-building stage to intentionally underprice the IPO. Underwriters can use a mechanism that allows them to sell extra shares of more successful offerings called over-allotment allocation or greenshoe provision. This allows the underwriter to issue more stock, usually amounting to 15% of the original offer size, at the IPO offer price.

When the IPO process is complete, the company’s shares trade publicly on an exchange. Issuers have continuous access to the equity markets. Often existing shareholders are subject to a lockup, a restriction that prevents them from selling their shares for some period (usually 180 days) after the IPO.

Besides the traditional method discussed before, there also other ways shares may be sold during an IPO:

• Best-efforts: for smaller IPOs, a situation in which the underwriter does not guarantee that the stock will be sold, but instead tries to sell the stock for the best possible price.
• Auction IPO: an online method for selling new issues directly to the public that lets the market determine the price through bids from potential investors.

IPO puzzles

Several puzzles are associated with IPOs:

1. IPOs appear to be underpriced, on average: the price at the end of trading on the first day is often substantially higher than the IPO price.
2. New issues are highly cyclical: the market is flooded with IPOs when times are good, but when times are bad, the number of IPOs declines. (“Hot” and “Cold” IPO markets). 
3. The transaction costs of an IPO are very high.
4. On average, the long-run performance after an IPO is poor.

The seasoned equity offering

When a public company returns to the equity markets and offers new shares for sale, this is called a seasoning equity offering (SEO). The processes of an IPO and a SEO are almost the same. In a SEO the market prices for the stock already exists, so there is no price-setting process.

Primary shares are new shares issued by a company in an equity offering. Secondary shares are shares sold by existing shareholders in an equity offering.
Tombstones are newspaper advertisements in which underwriters advertise a security issuance. By reading the tombstones investors know who to call to buy the stock.

There are two types of seasoning equity offering:

1. A cash offer: a type of seasoned equity offering in which a firm offers the new shares to investors at large.
2. A rights offer: a type of seasoned equity offering in which a firm offers the new shares only to existing shareholders. These offers protect existing shareholders from under pricing.

The stock price reaction to a SEO is negative: on average, the market greets the news of an SEO with a price decline.

Adverse selection reflects the lemons principle or the idea that when quality is hard to judge, the average quality of goods being offered for sale will be low. 

Seasoned offerings are, as well as IPOs, expensive. A firm has to pay direct costs, in addition to the price drop.

Chapter B – Debt Financing

Abbreviations:

PV = present value
YTM = yield to maturity on a bond
YTC = yield to call on a callable bond

Corporate debt

Companies can raise debt using different recourses. Corporate debt can be private debt or public debt. Corporate bonds are the securities that companies issue when raising debt.

1. Private debt is debt that is not publicly traded. Private debt is negotiated directly with a bank or a small group of investors. An example of private debt is a bank loan. The advantage of private debt: avoiding the costs and delay of registration with the SEC. The disadvantage of private debt: illiquidity, for a holder of the firm’s private debt, is hard to sell it in a timely manner because private debt is not publicly traded.

Segments of the private debt market:

• Bank loans (term loans and lines of credit)

A term loan is a bank loan that lasts for a specific term. A syndicated bank loan is a single loan that is funded by a group of banks rather than just a single bank. A revolving line of credit is a credit commitment for a specific time period, typically two to three years, which a company can use as needed. An asset-backed line of credit is a type of credit commitment, where the borrower secures a line of credit by pledging an asset as collateral.

• Private placements

A private placement is a bond issue that does not trade on a public market but rather is sold to a small group of investors.

2. Public debt is traded in a public market. In a public bond issue, a prospectus (or offering memorandum) describes the details of the offering. The prospectus for a public offering must include an indenture: a formal contract between a bond issuer and a trust company, which represents the bondholders’ interests. Almost all corporate bonds pay coupons semiannually. There are also corporations who have issued zero-coupon bonds. An original issue discount (OID) bond is a coupon bond issued at a discount. Historically, bonds have been issued with a wide range of maturities.

There are four types of corporate debt, which fall into two categories:

1. Unsecured debt is a type of corporate debt that, in the event of bankruptcy, gives bondholders a claim to only the assets of the firm that are not already pledged as collateral on other debt.

1. Notes are a type of unsecured corporate debt with maturities shorter than ten years.
2. Debentures are a type of unsecured corporate debt with maturities of ten years or longer.

2. Secured debt is a type of corporate loan or debt security in which specific assets are pledged as a firm’s collateral that bondholders have a direct claim to in the event of a bankruptcy.

3. Mortgage bonds are a type of secures corporate debt in which real property is pledged as collateral.
4. Asset-backed bonds are a type of secured corporate debt in which specific assets are pledged as collateral.

Tranches are different classes of securities that comprise a single bond issuance.

Seniority: a bondholder’s priority, in the event of a default, in claiming assets not already securing other debt. Seniority is important because more than one debenture might be outstanding. When a firm conducts a subsequent debenture issue that has lower priority than its outstanding debt, the new debt is known as a subordinated debenture. In the event of default, the assets not pledged as collateral for outstanding bonds cannot be used to pay off the holders of subordinated debentures until all more senior debt has been paid off.

International bonds are classified into four categories:

1. Domestic bonds: bonds issued by a local entity, denominated in the local currency, and traded in a local market, but purchased by foreigners.
2. Foreign bonds: bonds issued by a foreign company, denominated in the local currency, in a local market and are intended for local investors.
3. Eurobonds: international bonds that are not denominated in the local currency of the country in which they are issued. There is no connection between the location of the issuing entity and the psychical location of the market.
4. Global bonds: bonds that are offered for sale in several different markets simultaneously. A combination of the domestic, foreign en Eurobonds.

The risk of holding the currency occurs when a bond makes its payment in a foreign currency. For that reason, the bond is priced off the yields in similar bonds in that currency.

Bond covenants

Covenants are restrictive clauses in a bond contract that limit the issuer from taking actions that may undercut its ability to repay the bonds. Covenants are there to protect debt holders when equity holders can take actions that benefit the equity holders at the expense of debt holders.

Typical bond covenants: there are restrictions on issuing new debt, on dividends and share repurchase, on mergers and acquisitions and on asset disposition. There is also a possibility that covenants require the maintenance of accounting measure, for example a minimum retained earnings, working capital and/or net assets or maximum leverage ratios. Limitation of the company’s (or the borrower’s) ability to increase the risk of the bond is the main goal.

Although you do not expect, the equity holders do benefit from the restrictions in the covenants. The stronger the covenants in the bond contract, the less likely the firm will default on the bond, and thus the lower the interest rate investors will require to buy the bond. The costs of borrowing will reduce if a firm includes more covenants. This cost reduction may outweigh the cost of the loss of flexibility associated with covenants.

Repayment provisions

The repayment of a bond consists of the coupon payment and the principal payment. But a firm can also repay bonds in other ways: repurchasing or making tender offers.

Three main features affecting the repayment of the bond:

1. Call provision

By exercising a call provision, a firm can repay bonds. Callable bonds are bonds containing a call provision that allows the issuer to repurchase the bonds at a predetermined price. The call date is the date in the call provision on or after which the bond issuer had the right (not the obligation) to retire the bond. The call price is the price specified at the issuance of a bond for which the issuer can redeem the bond.

When the call price of the bond is less than the market price, the firm will call the bond. A financial manager will choose to call the bonds only when the coupon rate the investor is receiving exceeds the market interest rate.

Investors pay less for callable bonds than for identical non-callable bonds, because the firm is forcing the investor to relinquish the bond at a price below the value it would have were it to remain outstanding. If a firm decides to issue callable bonds, they have to pay a higher coupon rate or accept lower proceeds. If a firm finds the option to refinance the debt in the future particularly valuable, it will choose to issue callable bonds despite their higher yield.

Financial managers need information about how investors are evaluating the firm’s callable bonds.

The yield to call (YTC) is the yield of a callable bond calculated under the assumption that the bond will be called on the earliest call date. The yield to maturity of a callable bond is the interest rate the bondholder receives if the bond is not called and repaid in full.

The yield to worst is quoted by bond traders as the lower of the yield to call or yield to maturity. See attachment 2.1 for a table of bond calls and yields.

2. Sinking funds

Sinking fund: a method for repaying a bond in which a company makes regular payments into a fund administered by a trustee over the life of the bond. These payments are then used to repurchase bonds, usually at par. Using this method, a company can reduce the amount of outstanding debt without affecting the cash flows of the remaining bonds.

It depends on the issue how an outstanding balance is paid off using a sinking fund. A balloon payment is a large payment that must be made on the maturity date of a bond when the sinking fund payments are not sufficient to retire the entire bond issue. Bonds can be issued with both a sinking fund and a call provision.

3. Convertible provisions

Converting bonds into equity is another way to retire bonds. Convertible bonds are corporate bonds with a provision that gives the bondholder an option to convert each bond owned into a fixed number of shares of common stock. The conversion ratio is the number of shares received upon conversion of a convertible bond, usually stated per $1000 face value. The conversion price is the face value of a convertible bond divided by the number of shares received if the bond is converted.
An example: imagine a convertible bond, face value $1000 and conversion ratio 20. If you decide to convert the bond on its maturity date, you would receive 20 shares. If you decide not to convert, you will receive $1000. By converting, you ‘pay’ $1000 for 20 shares. This implies a share price of $50 per share.
A company can also decide to issue convertible bonds that are callable.

A straight bond is a non-callable, non-convertible bond. A straight bond is also called a plain-vanilla bond. Because the option to convert a bond into equity is valuable for a bondholder, a convertible bond is worth more than a straight bond prior to the bond maturity date.

The current stock price determines the likelihood of eventually converting a convertible bond into equity. Conversion is likely if the stock price is high and the convertible bond’s price is close to the price of converted share. Conversion is unlikely if the stock price is low and the value of the convertible bond is close to that of a straight bond.

Leveraged buyout (LBO): when a group of private investors purchases all the equity of a public corporation and finances the purchase primarily with debt.

Chapter C – Capital structure

Abbreviations:

D = market value of debt
E = market value of levered equity
U = market value of unlevered equity
VL = value of the firm with leverage
VU = value of the firm without leverage
NPV = net present value
EPS = earnings per share
Tc = marginal corporate tax rate
rD = expected return (cost of capital) of debt
rE = expected return (cost of capital) of levered equity
rU = expected return (cost of capital) of unlevered equity
rf = risk-free interest rate
rWACC = weighted average cost of capital

Capital structure choices

The capital structure of a firm is determined by the relative proportions of debt, equity and other securities that a firm has outstanding. Most firms choose to finance with equity alone or a combination of debt and equity. Various financing choices will promise different future amounts to each security holder in exchange for the cash that is raised today. A firm must also take into account whether the securities it issues will receive a fair price in the market, have tax consequence, entail transactions costs or change its future investment opportunities. Decisions on whether to accumulate cash, pay off debt or pay dividend, or conduct share repurchases also affect the capital structure. 

The debt-to-value ratio is the fraction of a firm’s total value that corresponds to debt. See attachment C.1 for the formula. The debt-to-value ratios differ across industries. But the debt-to-value ratio may also differ within industries.

Capital structure in perfect capital markets

The decision of a financial manager to issue debt, equity or other securities to fund a new investment has got many potential consequences. It is very important whether different choices will affect the value of the firm and thus the amount of capital it can raise.

First step is to consider this in a simple environment: a perfect capital market. Perfect capital markets is a market in which the following conditions are set:

• Securities are fairly priced. Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows.
• There are nog tax consequences or transaction costs, there are no frictions.
• Investment cash flows are independent of financing choices.

A tool to measure a possible financing decision in a perfect capital market is the Net present value (NPV). See attachment C.2 for the formula to calculate the NPV.
If the NPV is positive, you need to raise the money for the upfront investment. But how?

First possibility: equity financing (raising money solely by selling equity).
The value of a security equals the present value of its future cash flows. See attachment C.3 for the formula. The firm’s equity cost of capital is the same as the discount rate for the NPV, because the risk is the same.

Unlevered equity is equity in a firm with no debt.

Imagine the present value of the equity cash flows is $50.000 then you can raise $50.000 by selling all the unlevered equity in your firm.
The project’s NPV represents the value to the initial owner of the firm created by the project.

Second possibility: levered financing (borrowing some of the money you will need to invest).
If a part of the cash flow is certain, you can borrow that amount at the current risk-free interest rate, because you will be able to pay the debt at the end of the year without any risk of defaulting.

Levered equity is equity in a firm with outstanding debt.

The amount equity holders can expect to receive is the total (future) cash flow minus the repayment of the debt. Although financing with debt seems very promising, there is a downside: leverage will increase the risk of the firm’s equity and raise its equity cost of capital.

The researchers Modigliani and Miller considered whether leverage would increase the total value of the firm. They come up with what we called the ‘first Modigliani and Miller proposition’:

MM proposition I:  in a perfect capital market, the total value of a firm is equal to the market value of the free cash flows generated by its assets and is not affected by its choice of capital structure. See attachment C.4 for the formula that goes with this proposition.

Because leverage increases the risk of the equity of a firm, it is inappropriate to discount the cash flows of levered equity at the same discount rate that we used for unlevered equity.

The expected return of levered equity is the expected payoff divided by the amount equity holders are willing to pay for the levered equity, minus 1.

Unlevered versus levered returns with perfect capital markets shows that leverage increases the risk of equity even when there is no risk that the firm will default. Leverage splits the firm’s return between low-risk debt and high-risk levered equity compared to the equity of an unlevered firm. You see, the returns of levered equity are twice as sensitive to the firm’s cash flows as the return of unlevered equity. This doubling of risk justifies a doubling of the risk premium.

Homemade leverage is when investors use leverage in their own portfolios to adjust the leverage choice made by a firm. Homemade leverage is a perfect substitute for the use of leverage by the firm, as longs as investors can borrow or lend at the same interest rate as the firm (this is the case in a perfect capital market).

Because the portfolio of equity and debt of a levered firm together has the same value and cash flows as the unlevered firm, the expected return of the portfolio should equal the expected return of the unlevered firm. The expected return of the portfolio equity and debt is the weighted average of the expected returns of each security. See attachment C.5 for the formula.

Where the right-hand side is the pretax WACC: the weighted average cost of capital computed using the pretax cost of debt. The right-hand side represents the fraction of the firm’s value financed by equity and the fraction financed by debt. According to the equation, the pretax WACC is unchanged for any choice of capital structure and remains equal to the firm’s unlevered cost of capital. The reason for this: the two effects of leverage (we finance a larger fraction of the firm with debt, which has lower cost of capital, but simultaneously we add leverage, which raises the firm’s equity cost of capital) should exactly cancel out because the firm’s total risk has not changed.

Rearranging the last equation gives us the cost of capital of levered equity, which formula you can find in attachment C.6.

MM proposition II: the cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a premium that is proportional to the debt-equity ratio (measured using market values). 

The MM propositions we made were based on the assumption of perfect capital markets. However, in practice capital markets are not perfect. In the real world, we will find that the capital structure can have an effect on a firm’s value. MM’s propositions reveal that any effect of capital structure must similarly be due to frictions that exist in capital markets. Possible sources of these frictions are: debt and taxes, bankruptcy costs, agency costs and (asymmetric) information.

Debt and taxes

One important market friction is corporate taxes. How can the firm’s choice of capital structure affect the taxes it must pay and therefore its value to investors?

Corporations have got the possibility to deduct interest expenses from their taxable income. Because the deduction reduces the taxes and increases the amount available to pay to investors, the value of the corporation will increase.

It seems that net income of a firm is lower with leverage than without leverage. But, a firm can be better off with leverage even though its earnings are lower. The total amount available to all investors can be higher with leverage. The difference can be explained by the interest tax shield.

The interest tax shield is the reduction in taxes paid due to the tax deductibility of interest payments. It is the additional amount a firm can pay to investors by saving the taxes it would have paid if it did not have leverage. See attachment C.7 for the formula to calculate the interest tax shield.

This interest tax shield is a tax benefit, when the firm uses debt. We can determine the benefit of leverage for the value of the firm, by computing the present value of the stream of future interest tax shield a firm will receive.

Each year a firm makes interest payments, the cash flows it pays to investors will be higher than they would be without leverage by the amount of the interest tax shield, see attachment C.8.

The figure in attachment C.9 shows this relationship. Notice: some fraction of the pretax cash flow is used to pay taxes and the rest is paid to investors. If the amount paid to debt holders increases through interest payments, the fraction of the pretax cash slows that must be paid as taxes will decrease. This gain is the interest tax shield.

What is true for the cash flows is also true for the value of the firm according to the Valuation Principle. So the MM proposition I changes as follows in the presence of taxes:

The total value of the levered firm exceeds the value of the firm without leverage due to the present value of the tax savings from debt, see attachment C.10.

The first method to calculate the value of the tax benefit:
The interest tax shield can be determined by forecasting future interest payments. If the interest tax shield is determined, we can compute its present value by discounting it at a rate that corresponds to its risk.

Imagine the case a firm has got permanent debt (as old bonds/loans mature then the firm starts new loans and issues new bonds). See attachment C.11 for the formula to calculate the market value of debt.

If the marginal tax rate Tc is constant:

Value of the interest tax shield of permanent debt

See attachment C.12. The formula shows the magnitude of the interest tax shield. Imagine a 25% corporate tax rate, this means that for every $1 in new permanent debt that the firm issues, the value of the firm increases by $0,25.

This first approach is simplest to apply when the amount of debt is fixed permanently. Another way to calculate the benefit of the interest tax shield is to incorporate it in the cost of capital of the firm by using the WACC:

Weighted average cost of capital with taxes:

See attachment C.13 for the formula of rWACC.
We see that the reduction in the WACC increases with the amount of debt financing. The WACC declines with leverage; the higher the leverage, the more the firm exploits the tax advantage of debt and the lower the WACC. One can see this in the graph in attachment C.14.

This second approach is simplest to apply when the debt-to-value ratio of a firm is constant over time. This section presents an interesting question: given the tax benefit, why don’t firms shift to nearly 100% debt?

Costs of bankruptcy and financial distress

One part of the answer to the question mentioned above is: because of the existence of bankruptcy costs. If a firm has more debt, the chance that the firm will be unable to make its required interest payments and will default on its debt obligations is greater. A firm is in financial distress when a firm had difficulty meeting its obligations. Bankruptcy costs can be either direct or indirect:

• Direct costs can be fees paid to lawyers and bankruptcy experts.
• Indirect costs can be a loss of customers, a loss of suppliers, a loss of employees or the fact that the firm is being forced to sell assets at a deep discount to raise money.

These indirect bankruptcy costs often occur because when the firm is in financial distress, it may renege on commitments and contracts. A firm may also have to pay these indirect costs if it faces a significant possibility that financial distress may occur in the future.

The tradeoff theory

Combining our knowledge of the benefits of leverage from the interest tax shield and the information about the costs of financial distress associated with leverage gives information about the amount of debt a firm should issue to maximize its value. This is called the tradeoff theory: the total value of a levered firm equals the value of the firm without leverage plus the present value of the tax savings from debt, less the present value of financial distress costs. See attachment C.15 for the formula.

The present value of financial distress costs is almost impossible to calculate. There are two qualitative factors that determine the present value of financial distress costs:

1. The probability of financial distress and
2. The magnitude of the direct and indirect costs related to financial distress that the firm will incur.

The probability of financial distress depends on the likelihood that a firm will be unable to meet its debt commitments and therefore default. The magnitude of the direct and indirect costs depends on the relative importance of the resources of these costs and is likely to vary by industry.

The figure in attachment C.16 illustrates the optimal leverage with taxes and financial distress.

The tax benefits of debt will increase as the level of debt increases. The increase will go on until the interest expense exceeds the firm’s EBIT. As the level of debt increases, the probability of default will also increase and therefore, the present value of financial distress costs will also increase. When these effects balance out the optimal level of debt (D*) will occur, and the value of the levered firm is maximized. When a firm has got higher costs of financial distress, the optimal level of debt will be lower.

The tradeoff theory helps to resolve to important facts about leverage:

1. The presence of financial distress costs can explain why firms choose debt levels that are too low to fully exploit the interest tax shield.
2. Differences in the use of leverage across industries can be explained by differences in the magnitude of financial distress costs and the volatility of cash flows.

Agency costs and information

Two other market imperfections are agency costs and asymmetric information.

1. Agency costs are the costs that arise when there are conflicts of interest between stakeholders. This is the consequence of the separation of ownership and control in corporations. This separation creates the possibility of management entrenchment: a situation arising as a result of the separation of ownership and control, in which managers may make decisions that benefit themselves at the investors’ expense.
When equity ownership is highly diluted, so that no individual shareholder has an incentive to monitor management closely, and when a great deal of cash is available for managers to spend on wasteful projects, agency costs will increase. In this case, debt can help: 1. Ownership of the firm may remains more concentrated when a firm decides to borrowing instead of raising funds by issuing shares.

This concentration of ownership will improve the monitoring of management. 2. Debt reduces the funds available at management discretion, when a firm is forced to pay out cash to meet interest and principal payments.

Conflicts of interest between equity holders and debt holders will occur if investment decisions have different consequences for the value of equity and the value of debt. This conflict is likely to occur when the financial distress costs of a firm are high.

Excessive risk-taking is a situation that occurs when a company is near distress and shareholders’ have an incentive to invest in risky negative-NPV projects that will destroy value for debt holders and the firm overall.

An under-investment problem is a situation in which shareholders choose not to invest in a positive NPV project because the firm is in financial distress and the value of undertaking the investment opportunity will accrue to bondholders rather than to shareholders.

The figure in attachment C.17 shows the optimal leverage with taxes, financial distress and agency costs.

The value of a firm increases as the level of debt increases (from the interest tax shield and improvements in managerial incentives). However, the present value of financial distress costs and agency costs from debt holder-equity holder conflicts dominated, if leverage is too high. This will reduce the value of the firm. The optimal level of debt (D*) balances these benefits and costs of leverage.

2. The last market imperfection is asymmetric information: a situation in which parties have different information. It can arise when, for example, managers have superior information to that of outside investors regarding the firm’s future cash flows.

Managers of a firm can use leverage as a way to convince investors that they do have information that the firm will grow. This is called the signaling theory of debt: the use of leverage as a way to signal good information to investors.

Managers may attempt to engage in market timing when they have better information than outside investors. Market timing: when managers sell new shares because they believe the stock is overvalued, and rely on debt and retained earnings (and possibly repurchasing shares) if they believe the stock is undervalued.

The pecking order hypothesis: the idea that managers will have a preference to fund investment using retained earnings, followed by debt, and will only choose to issue equity as a last resort. When firms are profitable and generate sufficient cash to fund their investments, they will not issue debt or equity, but just rely on retained earnings. So, highly profitable firms will have little debt in their capital structure.

Putting it all together

Short summary of this chapter:

The optimal capital structure depends on market imperfections (taxes, financial distress costs, agency costs and asymmetric information) as follows:

1. If your firm has consistent taxable income, make use of the interest tax shield.
2. Search for a balance in the tax benefits of debt and the costs of financial distress.
3. Consider short-term debt for external financing when agency costs are significant.
4. Increase leverage to signal managers’ confidence in the firm’s ability to meet its debt obligations.
5. Keep in mind that investors are aware that you have an incentive to issue securities that you know are overpriced.
6. Rely first on retained earnings, then debt and finally equity.
7. Do not change the firm’s capital structure unless it departs significantly from the optimal level.

Chapter D – Payout Policy

Abbreviations:

Pcum = cum-dividend stock price
Pex = ex-dividend stock price
Prep = stock price with share repurchases

Distributions to shareholders

Payout policy is the way a firm chooses between the alternative ways to pay cash out to shareholders. A firm can retain its free cash flows or pay out its free cash flow. If a firm decides to retain it, the firm has the opportunity to invest or to accumulate (an increase of the cash reserves). If a firm decides to pay out its free cash flow, the firm can repurchase its shares or pay its dividends. We will focus on the opportunity to pay dividends and to repurchase shares. In attachment D.1 one can see a figure about the options of the free cash flow.

Dividends
The amount of dividend is set by the public company’s board of directors. This board also decides when the payment will occur. There are four important dates:

1. The declaration date: the date on which a public company’s board of directors authorizes the payment of a dividend.
2. The record date: the specific date set by a public company’s board of directors such that the firm will pay a dividend to all shareholders of record on this date.
3. The ex-dividend rate: a date, two days prior to a dividend’s record date, on or after which anyone buying the stock will not be eligible for the dividend.
4. The payable date or distribution date: a date, generally within a month after the record date, on which a firm mails dividend checks to its registered stockholders.

An example to explain the different dates can be found in attachment D.2.
One-time a firm may pay a special dividend: a one-time dividend payment a firm makes that is usually much larger than a regular dividend.

Usually, dividends are a cash outflow for the firm, paid out of current earnings. A return of capital is when a firm, instead of paying dividends out of current earnings (or accumulated retained earnings), pays dividends from other sources, such as paid-in capital or the liquidation of assets. A liquidating dividend is a return of capital to shareholders from a business operation that is being terminated.

Share repurchases
An alternative way to pay cash to investors through a share purchase or buyback. With a share repurchase, a firm uses cash to buy shares of its own outstanding stock. Three possible transaction types for a share repurchase:

• Open market repurchase: when a firm repurchases its own shares by buying them on the open market over time. This is the most common way firms use to repurchase shares.
• A tender offer: a public announcement of an offer to all existing security holders to buy back a specified amount of outstanding securities at a prespecified price over a short time period, generally 20 days. A related method is the Dutch auction: a share repurchase method in which shareholders indicate how many shares they are willing to sell at each price. The firm then pays the lowest price at which it can buy back its desired number of shares.
• A targeted repurchase: when a firm purchases shares directly from a specific shareholder; the purchase price is negotiated directly with the seller. A greenmail is when a firm avoids a threat of takeover and removal of its management by a major shareholder by buying out the shareholder, often at a large premium over the current market price.

Dividends versus share repurchases

We will see that in a perfect capital market, the method of payment (dividend payments or share repurchases) does not matter.

A firm has got three options to pay out an excess cash to shareholders:

• Pay a dividend with excess cash
• Repurchase share instead of paying a dividend
• Raise additional cash to pay an even larger dividend today and in the future

Alternative policy 1: pay a dividend with excess cash
Just before the ex-dividend date, the stock is said to trade cum-dividend: when a stock trades before the ex-dividend date, entitling anyone who buys the stock to the dividend. See attachment D.3 for the formulas to calculate Pcum and Pex.

In a perfect capital market, when a dividend is paid, the share price drops by the amount of the dividend when the stock begins to trade ex-dividend.

Alternative policy 2: share repurchases

• In perfect capital markets, 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.
• In perfect capital markets, investors are indifferent between the firm distributing funds via dividends or share repurchases. By reinvesting dividends or selling shares, they can replicate either payout method on their own.

Alternative policy 3: high dividend (equity issue)
To raise more cash, a firm can decide to issue equity. In this case, the initial value is unchanged by this policy and increasing the dividend has no benefit to shareholders.

The result of these three policies is the Modigliani and Miller dividend relevance:

MM dividend relevance: in perfect capital markets, holding fixed the investment policy of a firm, the firm’s choice of dividend policy is irrelevant and does not affect the initial share price. However, in reality market are not perfect and market imperfections affect the dividend policy of a firm.

Tax disadvantages

The influence of taxes (as an important market imperfection) on the decision of a firm to pay dividends or repurchase shares is great.

Shareholders have to pay taxes on dividends they receive and taxes on capital gains when they sell their shares. Because dividends are taxed at a higher rate than capital gains, shareholders will prefer share repurchases to dividends. But the tax rates on dividends and capital gains have equalized by recent changes to the tax code. Nonetheless, there is still a tax advantage for share repurchases over dividends because long-term investors can defer the capital gains tax until they sell their shares.

It seems that the optimal dividend policy, when the dividend tax rate exceeds the capital gain tax rate, is to pay no dividends at all. But dividends remain a key form of payouts to shareholders.
Dividend puzzle: when firms continue to issue dividends despite their tax disadvantage.

Because taxes rates differ by income, by jurisdiction and by whether the stock is held in a retirement account, the tax disadvantage differs between investors. The result is that different groups of investors prefer different payout policies. 

Tax rates differ across investors for a variety of reasons:

1. Different income levels à different tax rates.
2. Different investment horizons
3. Tax jurisdiction
4. Type of investor of investment account

Investors have varying preferences regarding dividends, because their tax rate differs:

1. Long-term investors would prefer share repurchases to dividend payments, because they are more heavily taxed on dividends (about 53% of the investors).
2. One-year investors, pension funds and other non-taxed investors prefer a payout policy that closely matches their cash needs because they have no tax preference for share repurchases over dividends (about 46% of the investors).
3. Corporations enjoy a tax advantage associated with dividends due to the 70% exclusion rule (about 1% of the investors)

The different tax preferences across investor create clientele effects. This is when the dividend policy of a firm reflects the tax preferences of its investor clientele.

Payout versus retention of cash

Insight from Modigliani and Miller regarding policy irrelevance in perfect capital markets:

MM payout irrelevance: in perfect capital markets, if a firm invests excess cash flows in financial securities, the firm’s choice of payout versus retention is irrelevant and does not affect the initial value of the firm.

From this irrelevance, it is clear that the decision of whether to retain cash depends on market imperfections:

• Taxes and cash retention: corporate taxes make it costly for a firm to retain excess cash.
• Investor tax adjustments: even after adjusting for investor taxes, there remains a substantial tax disadvantage for the firm to retaining excess cash under most tax regimes.
• Issuance and distress costs: even though there is a tax disadvantage to retaining cash, some firm accumulate cash balances. These balances help firms to minimize the transaction costs of raising new capital when they have future potential cash needs. However, there is no benefit to shareholders from firms holding cash in excess of future investment needs.
• Agency costs of retaining cash: agency costs may arise as managers may be tempted to spend excess cash on inefficient investments and perks, in addition to the tax disadvantage of holding cash. Without pressure from shareholders, managers may choose to horde cash to spend in this way or as a means of reducing a firm’s leverage and increasing their job security. Dividends and share repurchases help minimize the agency problem of wasteful spending when a firm has excess cash.

Signaling with payout policy

The market imperfection asymmetric information may also affect the payout policy. When managers have got better information than investors, their payout decisions may signal this information.

Dividend smoothing is the practice of maintaining relatively constant dividends. In general, firms try to maintain dividends constant and dividends are much less volatile than earnings. Firms raise their dividends only when they perceive a long-term sustainable increase in the expected level of future earnings, and cut them only as a last resort.

The firm’s dividend choice will contain information regarding management’s expectations of future earnings, if firms smooth dividends.

1. A firm increases its dividend: this is a positive signal to investors that management expects to be able to afford the higher dividend for the foreseeable future.
2. A firm cuts the dividend: this is a signal that managers have given up hope that earnings will rebound in the near term and so need to reduce the dividend to save cash.

This is the: dividend signaling hypothesis, the idea that dividend changes reflect managers’ view about a firm’s future earnings prospects.

Furthermore, an increase in the dividend might also signal a lack of investment opportunities. Conversely, a firm might cut its dividend to exploit new positive-NPV-investment opportunities.

Share repurchases may also signal managers’ information to the market. Share repurchases may be used to signal positive information, as repurchases are more attractive if management believes the stock is under-valued at its current price.

Several important differences distinguish share repurchases and dividends:

1. Managers are much less committed to share repurchases than to dividend payments.
2. Firms do not smooth their repurchase activity from year to year, as they do with dividends.
3. The cost of a share repurchase depends on the market price of the stock.

Stock dividends, splits and spin-offs

Stock dividend or stock split: when a company issues a dividend in shares of stock rather than in cash to its shareholders. Because a firm does not pay out any cash to its shareholders, the total market value of the firm’s assets and liabilities (and of its equity) is unchanged. The only thing that will change is the number of share outstanding. For this reason, the stock price will fall because the same total equity value is now divided over a larger number of shares. In contrast to cash dividends, stock dividends are not taxed.

The typical motivation for a stock split is to keep the share price in a range thought to be attractive to small investors.

A spin-off is when a firm sells a subsidiary by selling shares as a non-cash special dividend in the subsidiary alone.

Advice for the financial manager

When making payout policy decisions, a financial manager should consider the following:

1. Try to minimize the after-tax payout to shareholders (use the difference in dividend taxes and repurchase taxes).
2. Repurchases and special dividends are useful for making large, infrequent distributions to shareholders. Neither implies any expectation of repeated payouts.
3. Only set regular dividend levels of which you are confident the firm can maintain them because the increase of a regular dividend is seen by shareholders as an implicit commitment to maintain this level of regular payout indefinitely.
4. Regular dividends send a stronger signal of financial strength to shareholder than infrequent distributions such as repurchases.
5. Be mindful of future investment plans. It is expensive to make a large distribution and then raise capital to fund a project, because transaction costs are associated with these actions. Making a smaller distribution and funding the project internally would be better.

Chapter E – Financial Modeling and Pro Forma Analysis

Long-term financial planning

Long-term financial planning and modeling can help the financial manager to reach its goal; to maximize the value of the stockholders’ stake in the firm.

Making a financial model to forecast the financial statements and free cash flows of a firm allows the financial manager to identify important linkages and to plan for future funding needs. It also allows us to analyze the impact of potential business plans. 

The percent of sales method

The percent of sales method is a forecasting method that assumes that as sales grow; many income statement items and balance sheet items (costs, working capital and total assets) will also grow, remaining the same percent of sales. Using this method, some items on the income statement and balance sheet are marked “NM”, this means “not meaningful” in the percent of sales column. For example, the long-term debt and equity of a firm will not naturally grow in line with sales (in contrast to for example assets and accounts payable). Instead, the change in equity and debt will reflect choices we make about dividends and net new financing. Net new financing is the amount of additional external financing a firm needs to secure to pay for the planned increase in assets. See attachment E.1 for the formula.

A pro forma income statement projects the firm’s earnings under a given set of hypothetical assumptions. The net income, forecasted on the income statement, will be one of the inputs to the pro forma balance sheet. The part of that net income not distributed as dividends will add to stockholders’ equity on the balance sheet. A pro forma balance sheet projects the firm’s assets, liabilities and equity under the same assumptions used to construct the pro forma income statement. The assets and liabilities/equity sides must be equal in a balance sheet.

Forecasting the balance sheet with the percent of sales method requires two passes:

1. The first pass reveals by how much equity and liabilities would fall short of the amount needed to finance the expected growth in assets. This amount by which the financing falls short is called the plug: the amount of net new financing that needs to be added to the liabilities and equity side of the pro forma balance sheet to make it balance.
2. In the second pass, the pro forma balance sheet shows the necessary financing from the planned sources and is in balance.

Forecasting a planned expansion

Because the percent of sales method is a useful starting point, it may even be sufficient for mature companies with relatively stable but slow growth. However its shortcoming is handling fast growth requiring lumpy investments in new capacity.

An improvement over the percent of sales method is to forecast the firm’s working capital and capital investment, along with planned financing of those investments directly. With such a model, we can estimate the firm’s future free cash flows, because the model will have the correct timing of external financing and capital investment.
A firm will have to seek for external financing for the debt it has. This can for example be done by issuing coupon bonds. The firm will only pay interest on the bonds until the repayment of principal. See attachment E.2 for the calculation of the interest in year t.

To build the pro forma income statement we need to calculate the sales, see attachment E.3.

If liabilities and equity are less than assets: new financing is needed, the firm must borrow or issue new equity to fund the shortfall.
If liabilities and equity are greater than assets: excess cash is available, the firm can retain it as excess cash reserves (thus increasing assets), pay dividends or reduce external financing by retiring debt or repurchasing shares.

Valuing the planned expansion

The Valuation Principle helps us to determine whether the expansion is a good idea, after we have the implications of the planned expansion for the debt, net income and working capital.

To estimate the free cash flows, we combine the earnings, depreciation and interest expenses (income statement), the capital expenditures and the changes in net working capital. The forecasted free cash flow is the net income, plus the after-tax interest expense. This is called the unlevered net income. See attachment E.4 for the formula of the after-tax interest expense.

To the unlevered net income, we add the depreciation and we subtract the increases in NWC and the capital expenditures to get the free cash flow of the firm. This free cash flow is the cash the firm will generate for its investors, both debt and equity holders.

To calculate the free cash flow to equity holders, we can adjust the free cash flows to account for all (after-tax) payments to or from debt holders. So, from the free cash flow we subtract the after-tax interest expense and we add the increase in debt to calculate the free cash flows to equity. This cash flow is the total amount of excess cash flows that belongs to the equity holder for them to use to pay dividends, repurchase shares and retain in the firm as cash, or retire debt.

In addition to forecasting cash flows for a few years, we need to estimate the firm’s continuation value at the end of the forecast horizon. Because distant cash flows are difficult to forecast accurately, estimating the continuation value of a firm based on a long-term estimate of the valuation multiple for the industry is a common approach.

The EBITDA (earnings before interest, taxes, depreciation and amortization) is the most often used valuation multiple. Because the EBITDA accounts for the firm’s operating efficiency and because it is not affected by leverage differences between firms, the multiple is more reliable than sales or earnings multiples. See attachment E.5 for the formula for the continuation enterprise value at forecast horizon.

When calculating the firm’s value with an expansion you have to do the following steps:

• First need to calculate the present value of the free cash flows. You have to discount the free cash flows at the firm’s pretax WACC because they represent cash flows to both debt and equity holders and because you have to account for the benefits of the interest tax shield separately.
• Second step is to calculate the present value of the continuation value. The discount rate is the same as before.
• Finally, because the expansion is financed with debt, you will have additional interest tax shields. The interest tax shield is calculated by multiplying the net interest expense by the tax rate. To calculate the present value of the interest tax shield you have to use the interest rate on debt as the discount rate. You do not use the WACC, because the tax shield is only as risky as the debt that creates it.

The total firm value is the sum of the present values of the forecasted unlevered free cash flows (step 1), the continuation value of the firm (step 2) and the interest tax shields (step 3).

If you want to know if the expansion is a good idea, you can compare the firm’s value with the expansion to the firm’s value without the expansion.

But what if the firm has the option to simply delay its expansion for one or more years? To analyze this, you need to repeat the valuation analysis above for expansion in each following year. The value of a firm may be maximized by delaying the expansion. The reason is that while delaying expansion means the firm cannot produce enough units to meet the demand, the shortfall is not too great until a certain year.

Growth and firm value

Growth (expansion) may add to or detracts from the value of the firm. We now will discuss two growth rates that factor in financing needs and revisit our top decision rule: NPV analysis.

The internal growth rate is the maximum growth rate a firm can achieve without resorting to external financing. In other words, this is the growth a firm can support by reinvesting its earnings. See attachment E.6 for the formulas.

In this context, the retention rate is often called the plowback ratio: one minus the payout ratio of the firm.

The sustainable growth rate is the maximum growth rate a firm can achieve without issuing new equity or increasing its debt-to-equity ratio. In other words, this growth rate tells how fast the firm can grow by reinvesting its retained earnings and issuing only as much new debt as can be supported by those retained earnings. See attachment E.7 for the formulas.

The sustainable growth rate will be greater than the internal growth rate, because the ROE will be larger than the ROA anytime you have debt.

Imagine your forecasted growth is greater than the internal growth rate, in this case you will have to either reduce your payout ratio (increase your plowback ratio), plan to raise additional external financing, or both.

Imagine you forecasted growth is greater than the sustainable growth rate, in this case you will have to increase your plowback ratio, raise additional equity financing, or increase your leverage (increase your debt faster than keeping you debt-to-equity ratio constant would allow).

A comparison of the internal growth rate and the sustainable growth rate (summarized), see attachment E.8.

The internal growth rate and the sustainable growth rate cannot tell you whether your planned growth increases or decreases the value of the firm. This growth rates are only useful in alerting you to the need to plan for external financing. The growth rate does not evaluate the future costs and benefits of the growth. According to the Valuation Principle, growth rates must do so to make value implications. Only an NPV analysis can tell us whether the contemplated growth will increase or decrease the value of the firm. 

Chapter F – Working Capital Management

Abbreviations:

CCC = cash conversion cycle
EAR = effective annual rate
g = perpetuity growth rate
r = discount rate

Overview of working capital

The main components of net working capital are cash (not excess cash), inventory, receivables and payables.

The level of working capital reflects the length of time between when cash goes out of a firm at the beginning of the production process and when it comes back in.
The operating cycle is the average length of time between when a firm originally receives its inventory and when it receives the cash back from selling its product. The cash cycle is the length of time between when a firm pays cash to purchase its initial inventory and when it receives cash from the sale of the output produced from that inventory.

The cash conversion cycle (CCC) is a measure of the cash cycle calculated as the sum of a firm’s inventory days and accounts receivable days, less its accounts payable days. See attachment F.1 for the formula of the CCC and its components.

If the cash cycle of a firm is long, the firm has more working capital and needs more cash to carry to conduct its daily operations.

Working capital levels differ between industries, because each industry has different characteristics. The cash conversion cycle also differs between industries.

Any reduction in working capital requirements generates a positive free cash flow that the firm can distribute immediately to shareholders. If managers manage the working capital efficiently, the free cash flows of the firm will increase and the managers can maximize the value of the firm.

Trade credit

Trade credit is the difference between receivables and payables that is the net amount of a firm’s capital consumed as a result of those credit transactions; the credit that a firm extends to its customers. Of course, a firm would prefer to be paid in cash at the time of purchase. However, a ‘cash-only’ policy may cause it to lose its customers to competition. This section focuses on comparing the costs and the benefits of trade credit to determine optimal credit policies.

The cost of trade credit depends on the credit terms;

• The cash discount is the percentage discount offered if the buyer pays early.
• The discount period is the number of days a buyer has to take advantage of the cash discount.
• The credit period is the total length of time credit is extended to the buyer.

In reality (when markets aren’t perfect competitive) firms can maximize their value by using their trade credit options effectively.

Cost of trade credit
In essence, a trade credit is a loan from the selling from to its customer. The price discount represents an interest rate. But how do we compute the interest rate on trade credit?
See the following example:
Imagine a firm, selling a product for €100 and offering its customer terms of 2/10, net 30. In this case, the customer doesn’t have to pay anything for the first ten days. For this period, the customer had a zero-interest loan. The customer only pays €98 for the product if he decides to take advantage of the discount and pays within the 10-day discount period. The cost of the discount to the selling firm can be calculated by multiplying the discount percentage by the selling price: 0,02 x €100 = €2,00.
Rather than pay within 10 days, the customer had the option to use the €98 for an additional 20 days (30 – 10 = 20). The interest rate for the 20day term of the loan is: €2/€98 = 2,04%. If we convert this interest rate to an effective annual rate (EAR), we can camper this 20-day interest rate with interest rates available from other financing sources. See attachment F.2 for the formula of the EAR. In this example it will be:

If the firm can obtain a bank loan at a lower interest rate than 44,6%, the firm would be better off borrowing at the lower rate and using the cash proceeds of the loan to take advantage of the discount offered by the supplier.

Benefits of trade credit
- Trade credit is simple and convenient to use.
- Trade credit has lower transaction costs than alternative sources of funds.
- Trade credit is a flexible source of funds and can be used as needed.
- Sometimes trade credit is the only source of funding available to a firm.

Trade credit vs. standard loans
Why do companies provide trade credit?

• Providing financing at below-market rates is an indirect way to lower prices for only certain customers.
• A supplier may have more information about the credit quality of the customer than a traditional outside lender would have, because a supplier may have an ongoing business relationship with its customer.
• By threatening to cut off future supplies if payment is not made, the supplier may be able to increase the likelihood of payment.
• The supplier may be able to seize the inventory as collateral, if the buyer defaults.
   

The time between a bill is paid and the cash is actually received, contributes to the length of a firm’s receivables and payables.

The collection float is the amount of time it takes for a firm to be able to use funds after a customer has paid for its goods. Three factors are important here:

• The mail float: how long it takes to receive a customer’s payment check after the customer mailed it.
• The processing float: how long it takes a firm to process a customer’s payment check and deposit it in the bank.
• The availability float: how long it takes a bank to give a firm credit for customer payments the firm has deposited in the bank.

.

The disbursement float is the amount of time it takes before a firm’s payments to it suppliers actually result in a cash outflow for the firm. This is also a function of mail time, processing time and check-clearing time.

The Check Clearing for the 21^st Century Act (Check 21) eliminates the disbursement float due to the check-clearing process. Under the act, banks can process check information electronically and, in most cases, the funds are deducted from a firm’s checking account on the same day that the firm’s supplier deposits the check in its bank.

Receivables management

Establishing a credit policy involves three steps:

1. Establishing credit standards
2. Establishing credit terms
3. Establishing a collection policy

To analyze whether its credit policy is working effectively, a firm must monitor its accounts receivable. There are two methods to monitor the effectiveness of a firm’s credit policy:

• Accounts receivable days: the average number of days that it takes a firm to collect on its sales. By comparing this number to the payment policy specified in its credit terms the firm can analyze the effectiveness of its credit policy.
• Aging schedule: categorized a firm’s accounts by the number of days they have been on the firm’s books. It can be prepared using either the number of accounts of the dollar amount of the accounts receivable outstanding. The aging schedule is also sometimes augmented by analysis of the payments pattern. It provides information on the percentage of monthly sales that the firm collects in each month after the sales.

Payables Management

Accounts payable should be used to borrow only if trade credit is the cheapest source of funding.

Firms should monitor accounts payable to ensure that they are making payments at an optimal time. There are two techniques to monitor accounts payable:

• First method: calculating the accounts payable days outstanding and comparing it to the credit terms. If the accounts payable days outstanding is higher than the credit terms (e.g. 40 days versus terms 2/10, net 30), the firm is paying late and may be risking supplier difficulties. If the accounts payable days outstanding is lower than the credit terms (e.g. 25 days versus terms 2/10, net 30, this means the firm has not been taking the discount), the firm is paying too early.
• Second method: stretching the accounts payable: when a firm ignores a payment due period and pays later. This reduces the direct cost of trade credit because it lengthens the time a firm has use of the funds.

Inventory management

The inventory manager has to search for a balance between the costs and benefits associated with inventory. Because excessive inventory uses cash, efficient inventory management increases the firm’s free cash flows and thus increases the value of the firm.

1. Benefits of holding inventory

Reasons a firm needs inventory to operate:

• Minimizing the risk that the firm will not be able to obtain an input it needs for production. Stock-outs is the situation that occurs when a firm runs out of inventory. This leads to lost sales. Disappointed customers may switch to one of the firm’s competitors.
• Customer purchases may not perfectly match the most efficient production cycle because of seasonality in demand.

2. Costs of holding inventory:

Direct costs associated with inventory:

• Acquisition costs: costs of the inventory itself over the period being analyzed.
• Order costs: total costs of placing an order over the period being analyzed.
• Carrying costs: storage costs, insurance, taxes, spoilage, obsolescence and opportunity costs.

Tradeoffs must be made to minimize these costs.

An alternative: “Just-in-time” (JIT) inventory management: when a firm acquires inventory precisely when needed so that its inventory balance is always zero, or very close to it.

Cash management

Three motivations for holding cash:

• To meet its day-to-day needs.
  The transactions balance is the amount of cash a firm needs to be able to pay its bills. It depends on both the average size of transactions made by the firm and the firm’s cash cycle.
• To compensate for the uncertainty associated with its cash flows.
  The precautionary balance is the amount of cash a firm holds to counter the uncertainty surrounding its future cash needs. The size depends on the degree of uncertainty surrounding a firm’s cash flows.
• To satisfy bank requirements.
  The compensating balance is an amount a firm’s bank may require the firm to maintain in an account at the bank as compensation for services the bank may perform.

If a firm’s need to hold cash is reduced, the funds can be invested in a number of different short-term securities, including Treasury bills, certificates of deposit, commercial paper, repurchase agreements, bankers acceptances and short-term tax exempts.

Chapter G – Short-Term Financial Planning

Abbreviations:

EAR = effective annual rate
APR = annual percentage rate

Forecasting short-term financing needs

Forecasting the future cash flows of a firm is the first step in short-term financial planning. The two goals of this: determining whether the firm has a surplus or a cash deficit for each period and deciding whether that surplus or deficit is temporary or permanent.

Firms need short-term financing for three reasons; seasonal working capital requirements, negative cash flow shocks or positive cash flow shocks.

1. Seasonality: firms dealing with a fluctuation in sales and cash because of seasonality, often have short-term financing needs.  
2. Negative cash flow shocks: when cash flows are temporarily negative for an unexpected reason, the situation is called a negative cash flow shock. These negative cash flow shocks can create short-term financing needs.
3. Positive cash flow shocks: although this surprise is good news, it still creates demand for short-term financing.

Cash budget: A forecast of cash inflows and outflows on a quarterly (or sometimes monthly) basis used to identify potential cash shortfalls.

The matching principle

A possible policy that minimizes the transaction costs, to maximize the value of the firm, is the matching principle. The matching principle states that firm’s short-term cash needs should be financed with short-term debt and that long-term cash needs should be financed with long-term sources of funds.

Permanent working capital is the amount that a firm must keep invested in its short-term assets to support its continuing operations. This is a long-term investment, because this investment is required so long as the firm remains in business. According to the matching principle, this permanent investment should be financed with long-term sources of funds.

Temporary working capital is the difference between the firm’s actual level of investment in short-term working capital needs and its permanent working capital requirements. This is a short-term need and according to the matching principle this portion should be financed with short-term financing.

Because of seasonality the net working capital of a firm may differ during the year. The result is a minimum in a period and a maximum in another period. This minimum level of working capital represents the permanent working capital of a firm. The difference between this minimum level and the higher levels in other period represents the temporary working capital requirements. Not all firms follow the matching principle, there are also alternatives.

Aggressive financing policy is the financing part or all of a firm’s permanent working capital with short-term debt. A firm might choose this alternative when agency costs and asymmetric information is important.

Because the value of short-term debt is less sensitive to the firm’s credit quality than long-term debt, the value of the firm will be less affected by management’s actions or information. Consequently, short-term debt can have lower agency and lemons costs than long-term debt and this policy can benefit shareholders. Meanwhile, the firm exposes itself to funding risk: the risk of incurring financial distress costs should a firm not be able to refinance its debt in a timely manner or at a reasonable rate.

Conservative financing policy is when a firm finances its short-term needs with long-term debt. To implement this policy effectively, there will necessarily be periods when excess cash is available.

The following section focuses on the specific financing options that are available: bank loans, commercial paper and secured financing.

Short-term financing with bank loans

The commercial bank is one of the primary sources of short-term financing. Typically, bank loans are initiated with a promissory note: a written statement that indicates the amount of a loan, the date payment is due and the interest rate.

Three types of bank loans: a single, end-of-period payment loan, a line of credit and a bridge loan.

1. Single, end-of-period payment loan

In this case, the firm pays interest on the loan and pays back the principal in one lump sum at the end of the loan. Interest rate may be variable or fixed.

With a variable rate, the rate will vary with some spread relative to a benchmark rate. Two examples of benchmark rates:

• A prime rate is the rate banks charge their most creditworthy customers. However, large corporations can often negotiate bank loans at an interest rate that is below this prime rate.
• A London Inter-Bank Offered Rate (LIBOR) is a rate of interest at which banks borrow funds from each other in the London interbank market.

2. Line of credit

A line of credit is a bank loan arrangement in which a bank agrees to lend a firm any amount up to a stated maximum. This flexible agreement allows the firm to draw upon the line of credit whenever it chooses.

An uncommitted line of credit is a line of credit that is an informal agreement and does not legally bind a bank to pride the funds a borrower requests.

A committed line of credit is a legally binding written agreement that obligates a bank to provide funds to a firm (up to a stated credit limit) regardless of the financial condition of the firm (unless the firm is bankrupt) as long as the firm satisfies any restrictions in the agreement.

A revolving line of credit is a line of credit, which as company can use as needed that involves a solid commitment from a bank for a longer time period, typically two to three years.

An evergreen credit is a revolving line of credit with no fixed maturity.

3. Bridge loan

A bridge loan is a type of short-term bank loan that is often used to “bridge the gap” until a firm can arrange for long-term financing.

A discount loan is a type of bridge loan in which the borrower is required to pay the interest at the beginning of the loan period. The lender deducts interest from the loan proceeds when the loan is made.

Loan stipulations and fees that affect the effective interest rate on a loan: commitment fees, loan origination fees and compensating balance requirements.

4. Commitment fees

The commitment fee is associated with a committed line of credit, this fee increases the effective cost of the loan to the firm. The “fee” can be considered as an interest charge under another name.

5. Loan origination fee

A loan origination fee is a common type of fee, which a bank charges to cover credit checks and legal fees that a borrower must pay to initiate a loan.

6. Compensating balance requirements

This means that the firm must hold a certain percentage of the principal of the loan in an account at the bank. This will reduce the usable loan proceeds.

Short-term financing with commercial paper

A commercial paper is a short-term, unsecured debt issued by large corporations that is usually a cheaper source of funds than a short-term bank loan. The interest on commercial paper is typically paid by selling it at an initial discount. Commercial paper is referred to as either direct paper or dealer paper. A direct paper is a commercial paper that a firm sells directly to investors. A dealer paper is a commercial paper that dealers sell to investors in exchange for a spread (or fee) for their services.

Short-term financing with secured financing

Businesses can obtain short-term financing by using a secured loan. A secured loan is a type of corporate loan in which specific assets, most typically a firm’s accounts receivable or inventory, are pledged as the firm’s collateral. Common sources for secured short-term loans are commercial bank, finance companies and factors. Factors are firms that purchase receivables of other companies.

A firm can use accounts receivable or inventory as security for a loan:

• Accounts receivable as collateral: can be used as security for a loan by pledging or factoring
  • Pledging of accounts receivable: an agreement in which a lender reviews the credit sales of the borrowing firm and decides which credit accounts it will accept as collateral for the loan, based on its own credit standards.
  • Factoring of accounts receivable: an arrangement in which a firm sells receivables to the lender (i.e. the factor) and the lender agrees to pay the firm the amount due from its customers at the end of the firm’s payment period.

A financing agreement may be with recourse or without recourse.
With recourse: a financing agreement in which the lender can claim all the borrower’s assets in the event of a default not just explicitly pledged collateral.
Without recourse: a financing agreement in which the lender’s claim on the borrower’s assets in the event of a default is limited to only explicitly pledged collateral.

• Inventory as collateral

There are three ways to use inventory as collateral for a loan: as a floating lien, as a trust receipt or in a warehouse arrangement.

• A floating lien (general lien or blanket lien) is a financing arrangement in which all of a firm’s inventory is used to secure a loan.
• A trust receipts loan (or floor planning) is a type of loan in which distinguishable inventory items are held in a trust as security for the loan. As these items are sold, the firm remits the proceeds from their sale to the lender in repayment of the loan.
• A warehouse arrangement is when the inventory that serves as collateral for a loan is stored in a warehouse. There are two methods: a public warehouse or a field warehouse.
  • A public warehouse is a business that exists for the sole purpose of storing and tracking the inflow and outflow of inventory, providing the lender tighter control over the inventory.
  • A field warehouse is a warehouse arrangement that is operated by a third party, but is set up on the borrower’s premises in a separate area so that the inventory collateralizing the loan is kept apart from the borrower’s main plant.

Short-term financial plan

A short-term financial plan tracks a firm’s cash balance and new and existing short-term financing. The plan allows managers to forecast shortfalls and plan to fund them in the least costly manner.

Chapter H – Option Applications and Corporate Finance

Option basics

The language of options:

Financial option:       a contract that gives its owner the right (but not the obligation) to purchase or sell an asset at a fixed price at some future date.

Call option:                a financial option that gives its owner the right to buy an asset.

Put option:                a financial option that gives its owner the right to sell an asset.

Option writer:           the seller of an option contract.

Derivatives:              securities whose cash flows depend solely on the prices of other marketed assets.

Warrant:                     a call option written by a company itself on new stock.

Write an option:        sell an option

Option contracts:

Exercising an option: when a holder of an option enforces the agreement and buys or sells a share of stock at the agreed-upon price.

Strike (exercise) price: the price at which an option holder buys or sells a share of stock when the option is exercised.

American options:    the most common kind of option, they allow their holders to exercise the option on any date up to and including the expiration date.

European option:     options that allow their holders to exercise the option only on the expiration date.

Expiration date:        the last date on which an option holder has the right to exercise the option.

Stock option quotations:

Open interest:          the total number of contracts of a particular option that have been written and not yet closed.

At-the-money:           describes options whose exercise prices are equal to the current stock price.

In-the-money:            describes an option whose value if immediately exercised would be positive

Out-of-the-money:    descries an option that if exercised immediately, results in a loss of money.

Deep-in-the-money: describes options that are in-the-money and for which the strike price and the stock price are very far apart.

Deep out-of-the-money: describes options that are out-of-the-money and for which the strike price and the stock price very far apart.

Options on other financial securities
To reduce risk by holding contracts or securities whose payoffs are negatively correlated with some risk exposure is called hedging.
Speculating is when investors use securities to place a bet on the direction in which they believe the market is likely to move.

Options payoffs at expiration

Long position in an option contract

Call value at expiration.

See attachment H.1 for the formulas of the call value. When the stock price is less than the strike price, the holder will not exercise the call, so the option is worth nothing.

Put price at expiration:

See attachment H.2 for the formulas of the put value. The holder of a put option will exercise the option if the stock price is below the strike price. Because the holder receives the strike price when the stock is worth less, the holder’s gain is equal to the strike price minus the stock price.

The short position’s cash flows are the negative of the long position’s cash flows, because the investor takes the opposite side of the contract to the investor who is long. An investors in long position can only receive money at expiration, an investor in short position can only pay money at expiration.

Because the stock price cannot fall below zero, the downside for a short position in a put option is limited to the strike price of the option.

In contrast to the payouts on a long position in an option contract, the profits from purchasing an option and holding it to expiration could be negative. When the profit is negative, the payout at expiration is less than the initial cost of the option. The further in-the-money the option is, the higher its initial price and thus the larger your potential loss.
The profits from a short position in an option are the negative of the profits of a long position, because a short position in an option is the other side of a long position.

Factors affecting option prices

See attachment H.3 for a table that shows the relationship between factor and the option values.

Option values and expiration dates
According to the Valuation Principle: an American option with a later exercise date cannot be worth less than an otherwise identical American option with an earlier exercise date. Because a European option cannot be exercised early at six months, this is not the case for European options. Consequently, a European option with a later exercise date may potentially trade for less than an otherwise identical option with an earlier exercise date.

Option values and risk-free rates:
If the risk-free rate increases, the value of an option increases too. This is because a higher discount rate reduces the present value of the strike price. This reduction in the present value of your payment (you have to pay the strike price to exercise a call option) increases the value of the option. The reduction in the present value of the strike price decreases the value of the put option, because you receive the strike price when you exercise a put.

Option values and volatility:
The value of an option generally increases with the volatility of the stock, because an increase in volatility increases the likelihood of very high and very low returns for the stock.

The Black-Scholes option pricing formula

Black-Scholes price of a call option on a non-dividend-paying stock, see attachment H.4.

You can calculate the present value by using the risk-free rate.
N(d1) and N(d2) are probabilities.

The pricing formula shows that the price of an option on a non-dividend-paying stock is a function of only the current stock price, the strike price, the time to expiration, the volatility of the stock and the risk-free rate. Notable: we do not need to know the expected return of the stock.

Put-call parity

The prices of put and call on a given stock are related to each other, because these prices are influenced by the price of the same underlying stock. We will develop this relation by showing that both put and calls can be packaged in different ways to provide insurance against a drop in the price of a stock.

A possible way to insure against a loss:
A protective put is purchasing a put option on a stock you already own.

A possible way to insure against a loss on an entire portfolio of stocks (combinations of holding stocks and put options):
A portfolio insurance is a protective put written on a portfolio rather than a single stock.
 

Non-dividend paying stock
One can also achieve portfolio insurance by purchasing a bond and a call option.

There are the two different ways of constructing portfolio insurance:

1. Purchase the stock and the put
2. Purchase a bond and a call

The both positions provide exactly the same payoff. For this reason, the Valuation Principle and the Law of one price require that they must have the same price, see attachment H.5.

Left side represents the cost of buying the stock and a put. Right side is the cost of buying a zero-coupon bond with face value equal to the strike price of the put and a call option. Rearranging the formula gives the formula in attachment H.6.

This relationship is known as Put-call parity (for non-dividend paying stocks). It gives the price of a call option in terms of the price of a put option plus the price of the underlying stock minus the present value of the strike price.

Dividend-paying stock
When the stock pays a dividend, the payoff isn’t the same anymore because the stock will pay a dividend while the zero-coupon bond will not. To adjust for the dividends, we need to add the present value of the future dividends to the equation. See attachment H.7.

Options and corporate finance

A very important corporate finance application of options is interpreting the capital structure of the firm as option on the firm’s assets.

A share of stock can be thought of as a call option on the assets on the firm with a strike price equal to the value of the debt outstanding.

Equity can be viewed as a call option on the firm.
The debt holders can be viewed as owning the firm and having sold a call option with a strike price equal to the required debt payment.

Chapter I – Mergers and acquisitions

 Mergers and acquisitions are part of what is often referred to as “the market for corporate control”.

When one firm acquires another, there is typically a buyer (acquirer or bidder) and a seller, called a target firm.

The acquirer is the firm that, in a takeover buys another firm. Target firm is the firm that is acquirer by another in a merger or acquisition.

Takeover refers to two mechanisms, either a merger or an acquisition, by which ownership and control of a firm can change.

Merger waves: Peaks of heavy activity followed by quiet troughs of few transactions in the takeover market.

There are different types of mergers:

• Horizontal merger:  the type of merger when the target and acquirer are in the same industry.
• Vertical merger: The type  of merger when the target’s industry buys or sells to the acquirer’s industry
• Conglomerate merger: The type of merger of when the target and acquirer operate in unrelated industries

Deals also vary based on whether the target shareholders receive stock or cash as payment for target shares. When they receive stock it is called a stock swap.

Term sheet is also something important for a merger. It is a summary of the structure of a merger transaction that includes details as who will run the new company, the size and composition of the new board, the location of the headquarters, and the name of the new company.

Most acquirers pay a substantial acquisition premium: This is a paid by an acquirer in a takeover, it is the percentage difference between the acquisition price and the premerger price of a target firm.

The basis of the assumption that value of the combined companies will be worth more than the sum of the two companies individual values is the assumption that they will create synergies.

Synergies: Value obtained form an acquisition that could not be obtained if the target remained an independent firm!

Some examples of synergies:

• Economies of scale and scope

Economies of scale: The savings a large company can enjoy from producing goods in high volume, that are not available in a small company!

Economies of scope:  Savings large companies can realize that come from combining the marketing and distribution of different types of related products.

• Vertical integration

Vertical integration refers to the merger of two companies that make products required at different stages of the production cycle for the final good. Also refers to the merger of a firm and its supplier or a firm and its customer. The principal benefit of vertical integration is coordination

• Expertise

Firms often need expertise in particular areas to compete more efficiently. By mergers or acquisitions firms achieve more expertise. In this situation a firm can enter a labor market and attempt to hire personnel with the required skills.

• Monopoly gains

When there are not many firms in the market there is more power for the firm as a monopoly because there is less competition.

• Efficiency gains

Takeovers relying on the improvement of target management are difficult to complete and post-takeover resistance to change can be great. Thus not all inefficiently run organizations necessarily become more efficient following a takeover.

• Tax savings from operating losses

 Conglomerate: Losses in one division can be offset by profits in another division.

• Diversification

Diversification has 3 benefits:

• Direct risk reduction
• Lower cost of debt or increased debt capacity.
• Liquidity enhancement

• Earnings growth

It is possible to combine two companies with the result that the earnings per share of the merged company exceed the premerger earnings per share, even when the merger itself creates no economic value!

The takeover process

Once the acquirer has completed the valuation process, it is in the position to make a tender offer! That is a public announcement of its intention to purchase a large block of shares for a specified price.

Important in a stock-swap transaction: The bidder pays for the target by issuing new stock and giving it to the target shareholders. The price offered is determined by the exchange ratio.

Exchange ratio is in a takeover, the number of bidder shares received in exchange for each target share. See attachment I.1.

Important: Merger “arbitrage”.

Risk arbitrageurs: Traders who, once a takeover offer is announced, speculate on the outcome of the deal.

Merger- arbitrage spread: In a takeover, the difference between a target’s stock price and the implied offer price. However it is not a true arbitrage opportunity because there is a risk that the deal will not go through.

Step up refers to an increase in the book value of a target’s assets to the purchase price when an acquirer purchases those assets directly instead of purchasing the target stock.

For a merger to precede both the target and the acquiring board of directors must approve the deal and put the question to a vote of the shareholders.

• Friendly takeover: When a target’s board of directors supports a merger, negotiates with potential acquirers and agrees on a price that ultimately put to a shareholder vote
• Hostile takeover: A situation in which an individual organization, sometimes referred to as a corporate raider, purchases a large fraction of a target corporation’s stock and in doing so gets enough votes to replace the target’s board of directors and its CEO.

The corporate raider is the acquirer in a hostile takeover. For this takeover to succeed, the acquirer must go around the target board of directors and appeal directly to the target shareholders. The acquirer will usually do this with a proxy fight.

Proxy fight: The acquirer attempts to convince target shareholders to unseat the target board by using their proxy votes to support the acquirers candidates for election to the target board.

The most effective defending strategy is the poison pill: A defense against a hostile takeover, it is a rights offering that gives the target shareholders the right to buy shares in either the target or a n acquirer at a deeply discounted price.

Other defending strategies:

• Staggered boards: Board of directors whose three years terms are staggered, so that only one-third of the directors are up for election each year
• Golden parachute: An extremely lucrative severance package that is guaranteed to a firm’s senior managers in the event that the firm is taken over and the managers are let go.
• White knight”: Target Company’s defense takeover attempt, it looks for a friendlier company to acquire it.
• White squire: A variant of white knight. It agrees to purchase a substantial block of shares in a target with special voting rights.
• Recapitalization: A company changes its capital structure to make itself less attractive as a target.

When a bidder makes an offer for a firm, the target shareholders can benefit by keeping their shares and letting other shareholders sell at a low price. However, because shareholders have the incentive to keep their shares, no one will sell. This scenario is known as the free rider problem. To overcome this problem, bidders can acquire a toehold in a target, attempt a leverage buyout or in the case when the acquirer is a corporation, offer a freezeout merger.

A toehold is an initial ownership stake in a firm that a corporate rider can use to initiate a takeover attempt.

A freezeout merger is a situation in which the laws on tender offers allow an acquiring company to freeze the existing shareholders out of the gains from merging by forcing nontendering shareholders to sell their shares for the tender offer price.

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