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1 MN50324: Corporate Finance 2011/12: 1.Investment flexibility, Decision trees, Real Options 2.Asymmetric Information and Agency Theory 3. Capital Structure.

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Presentation on theme: "1 MN50324: Corporate Finance 2011/12: 1.Investment flexibility, Decision trees, Real Options 2.Asymmetric Information and Agency Theory 3. Capital Structure."— Presentation transcript:

1 1 MN50324: Corporate Finance 2011/12: 1.Investment flexibility, Decision trees, Real Options 2.Asymmetric Information and Agency Theory 3. Capital Structure and Value of the Firm. 4. Optimal Capital Structure - Agency Costs, Signalling 5. Dividend policy/repurchases 6. Mergers and Acquisitions/corporate control 7. Venture Capital/Private Equity/hedge funds 8. Behavioural Corporate Finance. 9. Emotional Corporate Finance 10. Revision.

2 2 1: Investment Flexibility/ Real options. Reminder of Corporations Objective : Take projects that increase shareholder wealth (Value-adding projects). Investment Appraisal Techniques: NPV, IRR, Payback, ARR Decision trees Real Options Game-theory approach!

3 3 Investment Flexibility, Decision Trees, and Real Options Decision Trees and Sensitivity Analysis. Example: From Ross, Westerfield and Jaffe: Corporate Finance. New Project: Test and Development Phase: Investment $100m chance of success. If successful, Company can invest in full scale production, Investment $1500m. Production will occur over next 5 years with the following cashflows.

4 4 Date 1 NPV = = 1517 Production Stage: Base Case

5 5 Decision Tree. Test Do Not Test Success Failure Invest Do not Invest Invest NPV = 1517 NPV = 0 NPV = Date 0: -$100 Date 1: Solve backwards: If the tests are successful, SEC should invest, since 1517 > 0. If tests are unsuccessful, SEC should not invest, since 0 > P=0.75 P=0.25

6 6 Now move back to Stage 1. Invest $100m now to get 75% chance of $1517m one year later? Expected Payoff = 0.75 * *0 = NPV of testing at date 0 = = $890 Therefore, the firm should test the project. Sensitivity Analysis (What-if analysis or Bop analysis) Examines sensitivity of NPV to changes in underlying assumptions (on revenue, costs and cashflows).

7 7 Sensitivity Analysis. - NPV Calculation for all 3 possibilities of a single variable + expected forecast for all other variables. Limitation in just changing one variable at a time. Scenario Analysis- Change several variables together. Break - even analysis examines variability in forecasts. It determines the number of sales required to break even.

8 8 Real Options. A digression: Financial Options (revision) A call option gives the holder the right (but not the obligation) to buy shares at some time in the future at an exercise price agreed now. A put option gives the holder the right (but not the obligation) to sell shares at some time in the future at an exercise price agreed now. European Option – Exercised only at maturity date. American Option – Can be exercised at any time up to maturity. For simplicity, we focus on European Options.

9 9 Example: Today, you buy a call option on Marks and Spencers shares. The call option gives you the right (but not the obligation) to buy MS shares at exercise date (say 31/12/10) at an exercise price given now (say £10). At 31/12/10: MS share price becomes £12. Buy at £10: immediately sell at £12: profit £2. Or: MS shares become £8 at 31/12/10: rip option up!

10 10 Factors Affecting Price of European Option (=c). -Underlying Stock Price S. -Exercise Price X. -Variance of of the returns of the underlying asset, -Time to maturity, T. The riskier the underlying returns, the greater the probability that the stock price will exceed the exercise price. The longer to maturity, the greater the probability that the stock price will exceed the exercise price.

11 11 Options: Payoff Profiles. Buying a Call Option. Selling a put option. Selling a Call Option.Buying a Put Option.

12 12 Pricing Call Options – Binomial Approach. S=20 q 1- q dS=13.40 uS=24.00 S = £20. q=0.5. u=1.2. d=.67. X = £ rf = 1.1. Risk free hedge Portfolio: Buy One Share of Stock and write m call options. uS - mCu = dS – mCd => 24 – 3m = M = By holding one share of stock, and selling 3.53 call options, your payoffs are the same in both states of nature (13.40): Risk free. c q 1- q Cu = 3 Cd=0

13 13 Since hedge portfolio is riskless: 1.1 ( 20 – 3.53C) = Therefore, C = This is the current price per call option. The total present value of investment = £12.19, and the rate of return on investment is / = 1.1.

14 14 Alternative option-pricing method Black-Scholes Continuous Distribution of share returns (not binomial) Continuous time (rather than discrete time).

15 15 Real Options Just as financial options give the investor the right (but not obligation) to future share investment (flexibility) Researchers recognised that investing in projects can be considered as options (flexibility). Real Options: Option to delay, option to expand, option to abandon. Real options: dynamic approach (in contrast to static NPV).

16 16 Real Options Based on the insights, methods and valuation of financial options which give you the right to invest in shares at a later date RO: development of NPV to recognise corporations flexibility in investing in PROJECTS.

17 17 Real Options. Real Options recognise flexibility in investment appraisal decision. Standard NPV: static; now or never. Real Option Approach: Now or Later. -Option to delay, option to expand, option to abandon. Analogy with financial options.

18 18 Types of Real Option Option to Delay (Timing Option). Option to Expand (eg R and D). Option to Abandon.

19 19 Option to Delay (= call option) Project value Value- creation Investment in waiting: (sunk)

20 20 Option to expand (= call option) Project value Value creation Investment in initial project: eg R and D (sunk)

21 21 Option to Abandon ( = put option) Project value Project goes badly: abandon for liquidation value.

22 22 Valuation of Real Options Binomial Pricing Model Black-Scholes formula

23 23 Value of a Real Option A Projects Value-added = Standard NPV plus the Real Option Value. For given cashflows, standard NPV decreases with risk (why?). But Real Option Value increases with risk. R and D very risky: => Real Option element may be high.

24 24 Comparing NPV with Decision Trees and Real Options (revision) Dixit and Pyndyck (1994): Simple Example: Decide today to: Invest in a machine at end of year: I = £1,600. End of year: project will be worth 300 (good state forever) or 100 (bad state forever) with equal probability. WACC = 10%. Should we invest?

25 25 Dixit and Pyndyck example Either pre-commit today to invest in a machine that will cost £1,600 at year end. Or defer investment to wait and see. Good state of nature (P = 0.5): product will be worth £300. Bad state of nature (P = 0.5): product will be worth £100.

26 26 NPV of project under pre- commitment =>

27 27 Value with the option to defer Suppose cost of investment goes up to £1,800 if we decide to wait (so, cost of waiting). Year end good state: Year-end bad state:

28 28 Value with option to defer (continued) Therefore, deferring adds value of £ Increasing uncertainty; eg price in good or bad state = 400 or zero (rather than 300 or 100) => Right to defer becomes more valuable.

29 29 Comparing NPV, decision trees and Real Options (continued) Invest Pre-commitment to invest

30 30 Comparing NPV, decision trees and Real Options (continued) Defer 0.5 V= Max{1500,0} Max {-700,0} Dont Invest Invest Value with the option to defer

31 31 Simplified Examples Option to Expand (page 241 of RWJ) Build First Ice Hotel If Successful Expand If unsuccessful Do not Expand

32 32 NPV of single ice hotel NPV = - 12,000, ,000,000/0.20 =-2m Reject? Optimistic forecast: NPV = - 12M + 3M/0.2 = 3M. Pessimistic: NPV = -12M + 1M/0.2 = - 7m Still reject? Option to Expand (Continued)

33 33 Option to expand (continued) Given success, the E will expand to 10 hotels => NPV = 50% x 10 x 3m + 50% x (-7m) = 11.5 m. Therefore, invest.

34 34 Option to abandon. NPV(opt) = - 12m + 6m/0.2 = 18m. NPV (pess) = -12m – 2m/0.2 = -22m. => NPV = - 2m. Reject? But abandon if failure => NPV = 50% x 18m + 50% x -12m/1.20 = 2.17m Accept.

35 35 Real Option analysis and Game theory So far, analysis has assumed that firm operates in isolation. No product market competition Safe to delay investment to see what happens to economy. In real-world, competitors (vultures) Delay can be costly!

36 36 Option to delay and Competition Smit and Ankum model (1993) Option to defer an investment in face of competition Combines real options and Game-theory. Binomial real options model: lends itself naturally to sequential game approach (see exercise 1).

37 37 Option to delay and competition (continued) Smit and Ankum incorporate game theory (strategic behaviour) into the binomial pricing model of Cox, Ross and Rubinstein (1979). Option to delay increases value (wait to observe market demand) But delay invites product market competition: reduces value (lost monopoly advantage). cost: Lost cash flows Trade-off: when to exercise real option (ie when to delay and when to invest in project).

38 38 Policy implications of Smit and Ankum analysis. How can firm gain value by delaying (option to delay) in face of competition? Protecting Economic Rent: Innovation, barriers to entry, product differentiation, patents. Firm needs too identify extent of competitive advantage.

39 39 Real Options and Games (Smit and Trigeorgis 2006) Game theory applied to real R and D/innovation cases: Expanded (strategic) NPV = direct (passive) NPV + Strategic (commitment) value + flexibility Value. Innovation race between Philips and Sony => Developing CD technology.

40 40 P\SWaitInvest Wait300, 3000, 400 Invest400, 0200, 200 Each firms dominant strategy: invest early: => Prisoners dilemma. How to collaborate/coordinate on wait, wait?

41 41 Asymmetric Innovation Race/ Pre-emption Asymmetry: P has edge in developing technology, but limited resources. S tries to take advantage of this resource weakness Each firm chooses effort intensity in innovation Low effort: technology follower, but more flexibility in bad states High effort: technology leader, higher development costs, more risk in bad state.

42 42 P\SLow effortHigh Low200, 10010, 200 High100, , -100 Grab the dollar game

43 43 Sequential Investment Game P S S High effort Low effort High effort Low effort -100m,-100m 100m, 10m 10m, 200m 200m, 100m

44 44 European Airport Expansion Case: Real Options Game (Smit 2003)

45 45 Two-stage Investment Game (Imai and Watanabe 2004)

46 46 Option to delay versus competition: Incorporating contracts/ Legal system (RF) Firm 1\Firm 2Invest earlyDelay Invest early NPV = 500,NPV = 500NPV = 700, NPV = 300 Delay NPV = 300, NPV = 700 NPV = 600,NPV = 600

47 47 Option to delay versus competition: Incorporating contracts/ Legal system (continued) Firm 1\ Firm 2Invest earlyDelay Invest early NPV = 500,NPV = 500NPV = , NPV = Delay NPV = , NPV = NPV = 600,NPV = 600

48 48 Use of Real Options in Practice

49 49 In practice, NPV not always used:Why Not?. -Agency (incentive) problems: eg Short-term compensation schemes => Payback. Behavioural:- Managers prefer % figures => IRR, ARR Managers dont understand NPV/ Complicated Calculations. Payback simple to calculate. Other Behavioural Factors (see later section on Behavioural Finance!!) Increase in Usage of correct DCF techniques (Pike): Computers. Management Education.

50 50 Game-theoretic model of NPV. Israel and Berkovitch RFS NPV is seen as standard value-maximising technique. But IBs game-theoretic approach considers the impact of agency and assymetric information problems

51 51 Israel and Berkovitch (continued) A firm consisting of two components: 1: Top management (Headquarters) 2. divisional managers (the manager). Objective of headquarters: Maximisation of shareholder value. Objective of manager: maximise her own utility.

52 52 Israel and Berkovitch (continued) HQ needs to design a monitoring and incentive mechanism to deal with these conflicting objectives. => capital allocation system specifying: A capital budgeting rule (eg NPV/IRR) and a wage compensation for divisional managers.

53 53 Israel and Berkovitch Paper demonstrates the ingredients of a game-theoretic approach. Players. Objectives (utility functions to maximise) Strategies. Payoffs.

54 54 2. Information Asymmetry/Agency Theory Chapter 12 CWS. We will see that info assymetry and agency theory play a large role in CF analysis. Investment appraisal, capital structure, dividend policy => Game theory

55 55 Game theory Players (eg managers/investors: or competing companies) Actions (eg invest in a project, issue debt, pay dividends etc) Strategies Payoffs/ optimisation. Equilibrium: eg good firm issues high debt, bad firm issues low debt. Or Good firm pays high dividends, bad firm pays low dividends.

56 56 Information Asymmetry Insiders/managers better informed than investors about projects, prospects etc. Managerial actions (eg capital structure choices: debt/equity issues, dividends, repurchases) may reveal information to the market Signalling models of debt, dividends, repurchases

57 57 Asymmetric info/signalling models Typically, two types of firm: High quality/low quality. Type unobservable to outside investors Manager of High quality firm would like to signal his type to market. Costly signals Cheap-talk signals. Eg level of investment, amount of debt, size of dividend.

58 58 Pooling versus separating equilibria Separating equilibrium: good firm can separate for bad firm eg by higher debt Cost of signal: eg expected financial distress Separation requires cost of signal => bad firm cannot (or is unwilling) to mimic good firms debt level. Separation: outsiders can determine firm types Pooling: outsiders cannot differentiate between the two types

59 59 Corporate Finance: Signalling Models Based on models from Informational Economics. Eg Akerlof (1970): price signals of quality in used car market (mkt for Lemons!) Spence (1973): education as signals of skill in job market. Myers-Majluf (1984): equity-signalling model based on Akerlofs Lemons market!

60 60 Major CF signalling models Signalling project quality with investment (Leland and Pyle 1977) Signalling firm quality with debt (Ross 1977) Signalling expected cashflows with dividends (Bhattacharya 1979) Signalling and the equity issue-invest decision (Myers-Majluf 1984)

61 61 Stock Split signalling Copeland and Brennan 1988 Brennan and Hughes Debt/equity Heinkel 1982

62 62 CF and Agency Theory Standard CF statement: the firm aims to maximise shareholder wealth => NPV rule. But agency theory => Separation of Ownership and control Principal/agent relationship Outside investors = Principal Manager = agent

63 63 Agency theory (contiuned) Manager self-interested. he may takes private benefits (perks) out of the firm Invest in favourite (pet) projects: empire-builder (eg rapid value-destroying growth => mergers?) Effort-shirking Capital structure/dividends may serve to align managers and investors interests.

64 64 2. Cost of Capital/discount rate/investors required return. What discount rate to use in NPV/ valuation? Portfolio analysis => Investors required return as a compensation for risk => CAPM (capital asset pricing model) => cost of equity (risk-averse equity-holders required return): increases with risk.

65 65 Cost of Capital/discount rate/investors required return (continued). Cost of debt (debt-holders required return). Capital structure (mix of debt and equity). => discount rate/cost of capital/investors required return=>

66 66 Example New project: initial investment Project expected to generate £150 per year forever (perpetuity) Kd=5%, Ke = 15% (Capital structure =50% debt/50% equity) Consider Market Value of firms debt = market value of firms equity=> WACC = 10%.

67 67 Firm Valuation (CWS Chapter 14) Formula Approach for Valuing Companies t0t1t2 tN

68 68 Valuation of all-equity firm with growth =>

69 69 Valuation of all-equity firm with growth (continued) Present value of the firm is the sum of discounted cashflows from operations less new investments required for growth Fundamental Value (= market value? Efficient mkts/ BCF) Dividend policy (dividends versus investment for growth)

70 70 Valuation of all-equity firm with growth (continued) V0 = value of assets in place + value of future growth

71 71 Infinite constant growth model =>

72 72 By substitution: But: => Gordon Growth Model: Consider later in div policy lecture

73 73 3. Capital Structure. Positive NPV project immediately increases current equity value (share price immediately goes up!) Pre-project announcement New project: New capital (all equity) Value of Debt New Firm Value Original equity holders New equity

74 74 Example: = = = 40. = 500. = = 540 = 20 = = Value of Debt Original Equity New Equity Total Firm Value

75 75 Positive NPV: Effect on share price. Assume all equity.

76 76 Value of the Firm and Capital Structure Value of the Firm = Value of Debt + Value of Equity = discounted value of future cashflows available to the providers of capital. (where values refer to market values). Capital Structure is the amount of debt and equity: It is the way a firm finances its investments. Unlevered firm = all-equity. Levered firm = Debt plus equity. Miller-Modigliani said that it does not matter how you split the cake between debt and equity, the value of the firm is unchanged (Irrelevance Theorem).

77 77 Value of the Firm = discounted value of future cashflows available to the providers of capital. -Assume Incomes are perpetuities. Miller- Modigliani Theorem: Irrelevance Theorem: Without Tax, Firm Value is independent of the Capital Structure. Note that

78 78 K D/E K V V Without Taxes With Taxes

79 79 Examples Firm X Henderson Case study

80 80 MM main assumptions: - Symmetric information. -Managers unselfish- maximise shareholders wealth. -Risk Free Debt. MM assumed that investment and financing decisions were separate. Firm first chooses its investment projects (NPV rule), then decides on its capital structure. Pie Model of the Firm: D E E

81 81 MM irrelevance theorem- firm can use any mix of debt and equity – this is unsatisfactory as a policy tool. Searching for the Optimal Capital Structure. -Tax benefits of debt. -Asymmetric information- Signalling. -Agency Costs (selfish managers). -Debt Capacity and Risky Debt. Optimal Capital Structure maximises firm value.

82 82 Combining Tax Relief and Debt Capacity (Traditional View). D/E V K

83 83 3: Optimal Capital Structure, Agency Costs, and Signalling. Agency costs - managers self interested actions. Signalling - related to managerial type. Debt and Equity can affect Firm Value because: - Debt increases managers share of equity. -Debt has threat of bankruptcy if manager shirks. - Debt can reduce free cashflow. But- Debt - excessive risk taking.

84 84 AGENCY COST MODELS. Jensen and Meckling (1976). - self-interested manager - monetary rewards V private benefits. - issues debt and equity. Issuing equity => lower share of firms profits for manager => he takes more perks => firm value Issuing debt => he owns more equity => he takes less perks => firm value

85 85 Jensen and Meckling (1976) B V V* V1 B1 A If manager owns all of the equity, equilibrium point A. Slope = -1

86 86 B V Jensen and Meckling (1976) V* V1 B1 A B If manager owns all of the equity, equilibrium point A. If manager owns half of the equity, he will got to point B if he can. Slope = -1 Slope = -1/2

87 87 B V Jensen and Meckling (1976) V* V1 B1 A B C If manager owns all of the equity, equilibrium point A. If manager owns half of the equity, he will got to point B if he can. Final equilibrium, point C: value V2, and private benefits B1. V2 B2 Slope = -1 Slope = -1/2

88 88 Jensen and Meckling - Numerical Example. Manager issues 100% Debt. Chooses Project B. Manager issues some Debt and Equity. Chooses Project A. Optimal Solution: Issue Debt?

89 89 Issuing debt increases the managers fractional ownership => Firm value rises. -But: Debt and risk-shifting.

90 90 OPTIMAL CAPITAL STRUCTURE. Trade-off: Increasing equity => excess perks. Increasing debt => potential risk shifting. Optimal Capital Structure => max firm value. D/E V D/E* V*

91 91 Other Agency Cost Reasons for Optimal Capital structure. Debt - bankruptcy threat - manager increases effort level. (eg Hart, Dewatripont and Tirole). Debt reduces free cashflow problem (eg Jensen 1986).

92 92 Agency Cost Models – continued. Effort Level, Debt and bankruptcy (simple example). Debtholders are hard- if not paid, firm becomes bankrupt, manager loses job- manager does not like this. Equity holders are soft. Effort Level HighLowRequired Funds Income What is Optimal Capital Structure (Value Maximising)?

93 93 Firm needs to raise 200, using debt and equity. Manager only cares about keeping his job. He has a fixed income, not affected by firm value. a) If debt < 100, low effort. V = 100. Manager keeps job. b) If debt > 100: low effort, V bankruptcy. Manager loses job. So, high effort level => V = 500 > D. No bankruptcy => Manager keeps job. High level of debt => high firm value. However: trade-off: may be costs of having high debt levels.

94 94 Free Cashflow Problem (Jensen 1986). -Managers have (negative NPV) pet projects. -Empire Building. => Firm Value reducing. Free Cashflow- Cashflow in excess of that required to fund all NPV projects. Jensen- benefit of debt in reducing free cashflow.

95 95 Jensens evidence from the oil industry. After 1973, oil industry generated large free cashflows. Management wasted money on unnecessary R and D. also started diversification programs outside the industry. Evidence- McConnell and Muscerella (1986) – increases in R and D caused decreases in stock price. Retrenchment- cancellation or delay of ongoing projects. Empire building Management resists retrenchment. Takeovers or threat => increase in debt => reduction in free cashflow => increased share price.

96 96 Jensen predicts: young firms with lots of good (positive NPV) investment opportunities should have low debt, high free cashflow. Old stagnant firms with only negative NPV projects should have high debt levels, low free cashflow. Stultz (1990)- optimal level of debt => enough free cashflow for good projects, but not too much free cashflow for bad projects.

97 97 Income Rights and Control Rights. Some researchers (Hart (1982) and (2001), Dewatripont and Tirole (1985)) recognised that securities allocate income rights and control rights. Debtholders have a fixed first claim on the firms income, and have liquidation rights. Equityholders are residual claimants, and have voting rights. Class discussion paper: Hart (2001)- What is the optimal allocation of control and income rights between a single investor and a manager? How effective are control rights when there are different types of investors? Why do we observe different types of outside investors- what is the optimal contract?

98 98 Conflict Benefits of DebtCosts of Debt Breaking MM Tax ReliefFinl Distress/ Debt Capacity Agency Models JM (1976)Managerial Perks Increase Mgrs Ownership Risk Shifting Jensen (1986)Empire BuildingReduce Freecash Unspecified. StultzEmpire BuildingReduce FreecashUnderinvestment. Dewatripont and Tirole, Hart. Low Effort level Bankruptcy threat =>increased effort DT- Inefficient liquidations.

99 99 Signalling Models of Capital Structure Assymetric info: Akerlofs (1970) Lemons Market. Akerlof showed that, under assymetric info, only bad things may be traded. His model- two car dealers: one good, one bad. Market does not know which is which: 50/50 probability. Good car (peach) is worth £2000. Bad car (lemon) is worth £1000. Buyers only prepared to pay average price £1500. But: Good seller not prepared to sell. Only bad car remains. Price falls to £1000. Myers-Majuf (1984) – securities may be lemons too.

100 100 Asymmetric information and Signalling Models. - managers have inside info, capital structure has signalling properties. Ross (1977) -managers compensation at the end of the period is D* = debt level where bad firm goes bankrupt. Result: Good firm D > D*, Bad Firm D < D*. Debt level D signals to investors whether the firm is good or bad.

101 101 Myers-Majluf (1984). -managers know the true future cashflow. They act in the interest of initial shareholders. Expected Value New investors Old Investors

102 102 Consider old shareholders wealth: Good News + Do nothing = 250. Good News + Issue Equity = Bad News and do nothing = 130. Bad News and Issue equity =

103 103 Old Shareholders payoffs Equilibrium Issuing equity signals that the bad state will occur. The market knows this - firm value falls. Pecking Order Theory for Capital Structure => firms prefer to raise funds in this order: Retained Earnings/ Debt/ Equity.

104 104 Evidence on Capital structure and firm value. Debt Issued - Value Increases. Equity Issued- Value falls. However, difficult to analyse, as these capital structure changes may be accompanied by new investment. More promising - Exchange offers or swaps. Class discussion paper: Masulis (1980)- Highly significant Announcement effects: +7.6% for leverage increasing exchange offers. -5.4% for leverage decreasing exchange offers.

105 105 Practical Methods employed by Companies (See Damodaran; Campbell and Harvey). -Trade off models: PV of debt and equity. -Pecking order. -Benchmarking. -Life Cycle. time Increasing Debt?

106 106 Trade-off Versus Pecking Order. Empirical Tests. Multiple Regression analysis (firm size/growth opportunities/tangibility of assets/profitability….. => Relationship between profitability and leverage (debt): positive => trade-off. Or negative => Pecking order: Why? China: Reverse Pecking order

107 107 Capital Structure and Product Market Competition. Research has recognised that firms financial decisions and product market decisions not made in isolation. How does competition in the product market affect firms debt/equity decisions? Limited liability models: Debt softens competition: higher comp => higher debt. Predation models: higher competition leads to lower debt. (Why?)

108 108 Capital Structure and Takeovers Garvey and Hanka: Waves of takeovers in US in 1980s/1990s. Increase in hostile takeovers => increase in debt as a defensive mechanism. Decrease in hostile takeovers => decrease in debt as a defensive mechanism.

109 109 Garvey and Hanka (contiuned) D/E D/E* V Trade-off: Tax shields/effort levels/FCF/ efficiency/signalling Vs financial distress

110 110 Practical Capital Structure: case study

111 111 Game Theoretic Approach to Capital Structure. Moral Hazard Model. Asymmetric Information Model. See BCF section 8 for incorporation of managerial overconfidence.

112 112 Cash-flow Rights and Control Rights Debt-holders: first fixed claim on cash- flows (cash-flow rights); liquidation rights in bas times (control rights)- hard investors. Equity-holders: residual claimants on cash- flows (cash-flow rights): voting rights in good times (control rights) – soft investors. => minority shareholder rights versus blockholders.

113 113 Equity-holders control rights Voting rights. Soft: free-rider problems. Minority holders versus block-holders. Minority –holders versus insiders. Separation of ownership and control. Corporate Charter. Dual class of shares. Pyramids/tunelling etc.

114 114 Capital/corporate structure in emerging economies. Separation of ownership and control. Corporate Charter. Dual class of shares. Pyramids/tunelling etc. Weak Legal Systems. Cultural differences.

115 115 Game-theoretic approaches. JFE special issue 1988 (Grossman and Hart, Stultz, Harris and Raviv). Bebchuk (lecture slides to follow). Garro Paulin and Fairchild (2006) Lecture slides to follow.

116 116 Mergers and Acquisitions

117 117 Mergers and Acquisitions Acquisitions Divestitures Restructuring Corporate Governance

118 118 Growth Strategies Mergers: one economic unit formed from 2 or more previous units A) Tender offer

119 119 Takeovers Acquisition Proxy Contest Merger Stock Acquisition 1. Merger- must be approved by stockholders votes. 2. Stock acquisition- No shareholder meeting, no vote required. -bidder can deal directly with targets shareholders- bypassing targets management. - often hostile => targets defensive mechanisms. -shareholders may holdout- freerider problems. 3. Proxy Contests- group of shareholders try to vote in new directors to the board.

120 120 Growth Strategies Mergers: one economic unit formed from 2 or more previous units A) Tender offer B) Pooling of Interest Joint Ventures Other collaborations (supplier networks, alliances, investments, franchises)

121 121 Shrinkage strategies Divestitures Equity carveouts Spin-offs Tracking stock

122 122 Theories of M and A. Efficiency increases (restructuring) Operating Synergies Financial Synergy Information Hubris and the Winners curse Agency Problems (changes in ownership/managerialism/FCF) Redistribution (tax, mkt power, …)

123 123 Synergy Value of a Merger Synergy comes from increases in cashflow form the merger:

124 124 Example: Market Value after Merger. Firm A (bidder): cashflows = £10m, r = 20%. V = £50m. Firm B (target): cashflows = £6m, r = 15%. = £40m. If A acquires B: Combined Cashflows are expected to increase to £25m P.A. New Discount rate 25%. Synergy cashflows = £9m. Total value = £100m. Synergy Value = £10m.

125 125 Who gets the gains from mergers? Who gets the gains from mergers? Depends on what the bidder has to pay! (bid premium) If Bidder gets all of the positive NPV. If Target gets all of the positive NPV.

126 126 Why a Bid premium? Hostile Bid: defensive (anti-takeover) mechanisms (leverage increases, poison pills, etc): Bidding wars. Market expectations.

127 127 Effects of takeovers on stock prices of bidder and target. Successful BidsUnsuccessful Bids Jensen and Ruback JFE 1983

128 128 Game Theoretic Approach to M and A. Grossman and Hart (Special Issue on Corporate Control 1982). Harris and Raviv (Special Issue on Corporate Control 1982). Bebchuk (Special Issue on Corporate Control 1982).. Burkart (JOF 1995). Garvey and Hanka. Krause.

129 129 Garvey and Hanka paper Lecture slides to follow.

130 130 Grossman and Hart free-rider paper Lecture slides to follow.

131 131 Convertible Debt -Valuation of Convertibles. -Impact on Firm Value. -Why firms issue convertibles. -When are they converted (call policy)? Convertible bond -holder has the right to exchange the bond for common stock (equivalent to a call option). Conversion Ratio = number of shares received for each bond. Value of Convertible Bond = Max{ Straight bond value, Conversion Value} +option value.

132 132 Value of Convertible Bond. Straight Bond Value Conversion Value Total Value of Convertible Bond V Firm Value Face Value

133 133 Conflict between Convertible Bond holders and managers. Convertible Bond = straight debt + call option. Value of a call option increases with: Time. Risk of firms cashflows. Implications: Holders of convertible debt maximise value by not converting until forced to do so => Managers will want to force conversion as soon as possible. Incentive for holders to choose risky projects => managers want to choose safe projects.

134 134 Reasons for Issuing Convertible Debt. Much real world confusion. Convertible debt - lower interest rates than straight debt. => Cheap form of financing? No! Holders are prepared to accept a lower interest rate because of their conversion privilege. CD = D =

135 135 Example of Valuation of Convertible Bond. October 1996: Company X issued Convertible Bonds at October 1996: Coupon Rate 3.25%, Each bond had face Value £1000. Bonds to mature October Convertible into Shares per per bond until October Company rated A-. Straight bonds would yield 5.80%. Now October 1998: Face Value £1.1 billion. Convertible Bonds trading at £1255 per bond. The value of the convertible has two components; The straight bond value + Value of Option.

136 136 Valuation of Convertible Bond- Continued. If the bonds had been straight bonds: Straight bond value = PV of bond = Price of convertible = Conversion Option = 1255 – 933 = 322. Oct 1998 Value of Convertible = = = Straight Bond Value + Conversion Option.

137 137 Alternative Analysis of Irrelevance of Convertible Debt. Firm Indifferent between issuing CD, debt or equity. -MM.

138 138 Why do firms issue convertible debt? If convertible debt is not a cheap form of financing, why is it issued? A. Equity through the Back Door (Stein, Mayers). -solves asymmetric information problems (see Myers- Majluf). -solves free cashflow problems. B. Convertible debt can solve risk-shifting problems. - If firm issues straight debt and equity, equity holders have an incentive to go for risky (value reducing) NPV projects. Since CD contains an option feature, CD value increases with risk. -prevents equity holders risk shifting.

139 139 Convertible Debt and Call Policy. Callable Convertible debt =>firms can force conversion. When the bond is called, the holder has 30 days to either: a) Convert the bond into common stock at the conversion ratio, or b) Surrender the bond for the call price. When should the bond be called? Option Theory: Shareholder wealth is maximised/ CD holders wealth is minimised if Firm calls the bond as soon as value = call price.

140 140 Call Puzzle. Manager should call the bond as soon as he can force conversion. Ingersoll (1977) examined the call policies of 124 firms He found that companies delayed calling far too long. - median company waited until conversion value was 44% above call price - suboptimal. Call Puzzle addressed by Harris and Raviv. - signalling reasons for delaying calling. - early calling might signal bad news to the market.

141 141 4: Dividend Policy Miller-Modigliani Irrelevance. Gordon Growth (trade-off). Signalling Models. Agency Models. Lintner Smoothing. Dividends versus share repurchases. Empirical examples

142 142 Early Approach. Three Schools of Thought- Dividends are irrelevant (MM). Dividends => increase in stock prices (signalling/agency problems). Dividends => decrease in Stock Prices (negative signal: non +ve NPV projects left?). 2 major hypotheses: Free-cash flow versus signalling

143 143 Important terminology Cum Div: Share price just before dividend is paid. Ex div: share price after dividend is paid < Cum div. P Time CD ED CD ED CD ED

144 144 Example A firm is expecting to provide dividends every year-end forever of £10. The cost of equity is 10%. We are at year-end, and div is about to be paid. Current market value of equity = 10/ = £110 Div is paid. Now, current market value is V = 10/0.1 = £100. So on…

145 145 P Time CD = 110 ED = 100 CD ED CD ED

146 146 Common Stock Valuation Model You are considering buying a share at price Po, and expect to hold it one year before selling it ex-dividend at price P1: cost of equity = r. What would the buyer be prepared to pay to you?

147 147 Therefore: Continuing this process, and re-substituting in (try it!), we obtain: Price today is discounted value of all future dividends to infinity (fundamental value = market value).

148 148 Dividend Irrelevance (Miller- Modigliani) MM consider conditions under which dividends are irrelevant. Investors care about both dividends and capital gains. Perfect capital markets:- No distorting taxes No transactions costs. No agency costs or assymetric info.

149 149 Dividend Irrelevance (MM): continued Intuition: Investors care about total return (dividends plus capital gains). Homemade leverage argument Source and application of funds argument => MM assumed an optimal investment schedule over time (ie firm invests in all +ve NPV projects each year).

150 150 Deriving MMs dividend irrelevance Total market value of our all-equity firm is Sources = Uses

151 151 Re-arranging: Substitute into first equation: At t =0,

152 152 Successive substitutions Current value of all-equity firm is present value of operating cashflows less re-investment for all the years (residual cashflow available to shareholders) Dividends do not appear! Assn: firms make optimal investments each period (firm invests in all +ve NPV projects). Firms balance divs and equity each period: divs higher than residual cashflow => issue shares. Divs lower than free cashflow: repurchase shares.

153 153 Irrelevance of MM irrelevance (Deangelo and Deangelo) MM irrelevance based on the idea that all cash will be paid as dividend in the end (at time T). Deangelo argues that even under PCM, MM irrelevance can break down if firm never pays dividend!

154 154 Irrelevance of MM irrelevance (continued) Consider an all-equity firm that is expected to produce residual cashflows of £10 per year for 5 years. Cost of equity 10%. First scenario: firm pays no dividends for the first 4 years. Pays all of the cashflows as dividends in year 5. Now it is expected to pay none of the cashflows in any year: Vo = 0 !

155 155 Breaking MMs Irrelevance MM dividend irrelevance theorem based on: PCM No taxes No transaction costs No agency or asymmetric information problems.

156 156 Gordon Growth Model. MM assumed firms made optimal investments out of current cashflows each year Pay any divs it likes/ balanced with new equity/repurchases. What if information problems etc prevent firms easliy going back to capital markets: Now, real trade-off between investment and dividends?

157 157 Gordon Growth Model. Where does growth come from?- retaining cashflow to re-invest. Constant fraction, K, of earnings retained for reinvestment. Rest paid out as dividend. Average rate of return on equity = r. Growth rate in cashflows (and dividends) is g = Kr.

158 158 Example of Gordon Growth Model. How do we use this past data for valuation?

159 159 Gordon Growth Model (Infinite Constant Growth Model). Let = 18000

160 160 Finite Supernormal Growth. -Rate of return on Investment > market required return for T years. -After that, Rate of Return on Investment = Market required return. If T = 0, V = Value of assets in place (re-investment at zero NPV). Same if r =

161 161 Examples of Finite Supernormal Growth. T = 10 years. K = 0.1. A.Rate of return, r = 12% for 10 years,then 10% thereafter. B. Rate of return, r = 5% for 10 years,then 10% thereafter.

162 162 Dividend Smoothing V optimal re-investment (Fairchild 2003) Method:- GG Model: derive optimal retention/payout ratio => deterministic time path for dividends, Net income, firm values. => Stochastic time path for net income: how can we smooth dividends (see Lintner smoothing later….)

163 163 Deterministic Dividend Policy. Recall Solving We obtain optimal retention ratio

164 164 Analysis of If Ifwith Constant r over time => Constant K* over time.

165 165 Deterministic Case (Continued). Recursive solution: => signalling equilibria. Shorter horizon => higher dividends. When r is constant over time, K* is constant. Net Income, Dividends, and firm value evolve deterministically.

166 166 Stochastic dividend policy. Future returns on equity normally and independently distributed, mean r. Each period, K* is as given previously. Dividends volatile. But signalling concerns: smooth dividends. => buffer from retained earnings.

167 167 Agency problems Conflicts between shareholders and debtholders: risk-shifting: high versus low dividends => high divs => credit rating of debt Conflicts between managers and shareholders: Jensens FCF, Easterbrook.

168 168 Are Dividends Irrelevant? - Evidence: higher dividends => higher value. - Dividend irrelevance : freely available capital for reinvestment. - If too much dividend, firm issued new shares. - If capital not freely available, dividend policy may matter. C. Dividend Signalling - Miller and Rock (1985). NCF + NS = I + DIV: Source = Uses. DIV - NS = NCF - I. Right hand side = retained earnings. Left hand side - higher dividends can be covered by new shares.

169 169 Div - NS - E (Div - NS) = NCF - I - E (NCF - I) = NCF - E ( NCF). Unexpected dividend increase - favourable signal of NCF. E(Div - NS) = E(NCF - I) = 300. Date 1 Realisation: Firm B: Div - NS - E (Div - NS) = 500 = NCF - E ( NCF). Firm A : Div - NS - E (Div - NS) = -500 = NCF - E ( NCF).

170 170 Dividend Signalling Models. Bhattacharya (1979) John and Williams (1985) Miller and Rock (1985) Ofer and Thakor (1987) Fuller and Thakor (2002). Fairchild (2009/10). Divs credible costly signals: Taxes or borrowing costs.

171 171 Competing Hypotheses. Dividend Signalling hypothesis Versus Free Cashflow hypothesis. Fuller and Thakor (2002; 2008): Consider asymmetric info model of 3 firms (good, medium, bad) that have negative NPV project available Divs used as a) a positive signal of income, and b) a commitment not to take –ve NPV project (Jensens FCF argument). Both signals in the same direction (both +ve)

172 172 Signalling, FCF, and Dividends. Fuller and Thakor (2002) Signalling Versus FCF hypotheses. Both say high dividends => high firm value FT derive a non-monotonic relationship between firm quality and dividends. Firm Quality Divs

173 173 Fairchild (2009, 2010) Signalling Versus FCF hypotheses. But, in contrast to Fuller and Thakor, I consider +ve NPV project. Real conflict between high divs to signal current income, and low divs to take new project. Communication to market/reputation.

174 174 Cohen and Yagil New agency cost: firms refusing to cut dividends to invest in +ve NPV projects. Wooldridge and Ghosh 6 roundtable discussions of CF.

175 175 Agency Models. Jensens Free Cash Flow (1986). Stultzs Free Cash Flow Model (1990). Easterbrook. Fairchild (2009/10): Signalling + moral hazard.

176 176 Behavioural Explanation for dividends Self-control. Investors more disciplined with dividend income than capital gains. Mental accounting. Case study from Shefrin. Boyesen case study.

177 177 D. Lintner Model. Managers do not like big changes in dividend (signalling). They smooth them - slow adjustment towards target payout rate. K is the adjustment rate. T is the target payout rate.

178 178 Using Dividend Data to analyse Lintner Model. In Excel, run the following regression; The parameters give us the following information, a = 0, K = 1 – b, T = c/ (1 – b).

179 179 Dividends and earnings. Relationship between dividends, past, current and future earnings. Regression analysis/categorical analysis.

180 180 Dividends V Share Repurchases. Both are payout methods. If both provide similar signals, mkt reaction should be same. => mgrs should be indifferent between dividends and repurchases.

181 181 Dividend/share repurchase irrelevance Misconception (among practitioners) that share repurchasing can create value by spreading earnings over fewer shares (Kennon). Impossible in perfect world: Fairchild (JAF).

182 182 Dividend/share repurchase irrelevance (continued) Fairchild: JAF (2006): => popular practitioners website argues share repurchases can create value for non- tendering shareholders. Basic argument: existing cashflows/assets spread over fewer shares => P !!! Financial Alchemy !!!

183 183 The Example:…. Kennon (2005): Eggshell Candies Inc Mkt value of equity = $5,000, , 000 shares outstanding => Price per share = $50. Profit this year = £1,000,000. Mgt upset: same amount of candy sold this year as last: growth rate 0% !!!

184 184 Eggshell example (continued) Executives want to do something to make shareholders money after the disappointing operating performance: => One suggests a share buyback. The others immediately agree ! Company will use this years £1,000,000 profit to but stock in itself.

185 185 Eggshell example (continued) $1m dollars used to buy 20,000 shares (at $50 per share). Shares destroyed. => 80,000 shares remain. Kennon argues that, instead of each share being 0.001% (1/100,000) of the firm, it is now.00125% of the company (1/80) You wake up to find that P from $50 to $ Magic!

186 186 Kennon quote When a company reduces the amount of shares outstanding, each of your shares becomes more valuable and represents a greater % of equity in the company … It is possible that someday there may be only 5 shares of the company, each worth one million dollars. Fallacy! CF: no such thing as a free lunch!

187 187 MM Irrelevance applied to Eggshell example At beginning of date 0: At end of date 0, with N0 just achieved, but still in the business (not yet paid out as dividends or repurchases:

188 188 Eggshell figures Cost of equity will not change: only way to increase value per share is to improve companys operating performance, or invest in new positive NPV project. Repurchasing shares is a zero NPV proposition (in a PCM). Eggshell has to use the $1,000,000 profit to but the shares.

189 189 Eggshell irrelevance (continued) Assume company has a new one-year zero NPV project available at the end of date Use the profit to Invest in the project. 2. Use the profit to pay dividends, or: 3. Use the profit to repurchase shares.

190 190 Eggshell (continued) Ex div Each year –end: cum div = $50, ex div = $

191 191 Long-term effects of repurchase See tables in paper: Share value pre-repurchase = $5,000,000 each year. Share value-post repurchase each year = $4,000,000 Since number of shares reducing, 25%, but this equals cost of equity. And is same as investing in zero NPV project.

192 192 Conclusion of analysis In PCM, share repurchasing cannot increase share price (above a zero NPV investment) by merely spreading cashflows over smaller number of shares. Further, if passing up positive NPV to repurchase, not optimal! Asymmetric info: repurchases => positive signals. Agency problems: FCF. Market timing. Capital structure motives.

193 193 Dividend/share repurchase irrelevance See Fairchild (JAF 2005) Kennons website

194 194 Evidence. Mgrs think divs reveal more info than repurchases (see Graham and Harvey Payout policy. Mgrs smooth dividends/repurchases are volatile. Dividends paid out of permanent cashflow/repurchases out of temporary cashflow.

195 195 Motives for repurchases ( Wansley et al, FM: 1989 ). Dividend substitution hypothesis. Tax motives. Capital structure motives. Free cash flow hypothesis. Signalling/price support. Timing. Catering.

196 196 Repurchase signalling. Price Support hypothesis: Repurchases signal undervaluation (as in dividends). But do repurchases provide the same signals as dividends?

197 197 Repurchase signalling: ( Chowdhury and Nanda Model: RFS 1994 ) Free-cash flow => distribution as commitment. Dividends have tax disadvantage. Repurchases lead to large price increase. So, firms use repurchases only when sufficient undervaluation.

198 198 Open market Stock Repurchase Signalling: McNally, 1999 Signalling Model of OM repurchases. Effect on insiders utility. If do not repurchase, RA insiders exposed to more risk. => Repurchase signals: a) Higher earnings and higher risk, b) Higher equity stake => higher earnings.

199 199 Repurchase Signalling : Isagawa FR 2000 Asymmetric information over mgrs private benefits. Repurchase announcement reveals this info when project is –ve NPV. Repurchase announcement is a credible signal, even though not a commitment.

200 200 Costless Versus Costly Signalling: Bhattacharya and Dittmar 2003 Repurchase announcement is not commitment. Costly signal: Actual repurchase: separation of good and bad firm. Costless (cheap-talk): Announcement without repurchasing. Draws analysts attention. Only good firm will want this

201 201 Repurchase timing Evidence: repurchase timing (buying shares cheaply. But market must be inefficient, or investors irrational. Isagawa. Fairchild and Zhang.

202 202 Repurchases and irrational investors. Isagawa 2002 Timing (wealth-transfer) model. Unable to time market in efficient market with rational investors. Assumes irrational investors => market does not fully react. Incentive to time market. Predicts long-run abnormal returns post- announcement.

203 203 Repurchase Catering. Baker and Wurgler: dividend catering Fairchild and Zhang: dividend/repurchase catering, or re-investment in positive NPV project.

204 204 Competing Frictions Model: From Lease et al: Asymmetric Information Agency Costs High Payout Low Payout Taxes High Payout Low Payout High Payout Low Payout

205 205 Dividend Cuts bad news? Fairchilds 2009/10 article. Wooldridge and Ghosh:=> ITT/ Gould Right way and wrong way to cut dividends. Other cases from Fairchilds article. Signalling/FCF hypothesis. FCF: agency cost: cutting div to take –ve NPV project. New agency cost: Project foregone to pay high dividends. Communication/reputation important!!

206 206 Venture Capital/private equity/Hedge Funds Venture capitalists typically supply start-up finance for new entrepreneurs. VCs objective; help to develop the venture over 5 – 7 years, take the firm to IPO, and make large capital gains on their investment. In contrast, private equity firms invest in later stage public companies to a) take them private: Turnarouds, or b) Growth capital. Hedge Funds: Privately-owned institutions that invest in Financial markets using a variety of strategies.

207 207 Hedge Funds Privately-owned institutions Limited range of High net worth (wealthy) investors => HF => invests in FMs Each fund has its own investment strategy Largely unregulated (in contrast to mutual funds); => debate.

208 208 HF strategies HF mgr typically commits to a strategy, using following elements Style Market Instrument Exposure Sector Method Diversification

209 209 HF Strategies (continued) Style: Global Macro, directional, event driven…. Market: equity, fixed income, commodity, currency Instrument: long/short, futures, options, swaps Exposure: directional, market neutral Sector: emerging markets, technology, healthcare Method: Discretionary/qualitative (mgr selects investments): systematic/quantitative (quants)

210 210 Leverage: HFs are marketed on the promise of making absolute returns regardless of mkt May involve hedging (long-short) plus high levels of leverage => very risky? Risk-shifting incentives made worse by HF mgr fee structure!

211 211 HF fee structure Asymmetric fees (in mutual fund, symmetric or fulcrum fees). HF mgr gets a percentage of assets under management plus a performance bonus on the upside: no loss on the downside (investor loses there!) => systemic risk? Regulation debate.

212 212 Fairchild and Puri (2011) Brand new paper on SSRN! HF mgr/ Investor negotiate (bargain) over form of contract: asymmetric or symmetric) HF mgr then chooses safe or risky strategy. He then exerts effort in trying to make strategy succeed. Paper looks at effects of BP and incetnives on contract, strategy and HF performance and risk!

213 213 Activist HFs Passive HFs just invest in FMs, an d look at portfolio decisions Activist HFs actually get involved in the companies that they invest in Members on the board Assist/interfere in mgt decisions Debate: do they add or destroy value? Myopic?

214 214 Private Equity. PE firms generally buy poorly performing publically listed firms. Take them private Improve them (turn them around). Hope to float them again for large gains Theory of private equity turnarounds plus PE leverage article, plus economics of PE articles.

215 215 Theory of PE-turnarounds ( Cuny and Talmor JCF 2007 ) Explores advantage of PE in fixing turnaround Would poorly performing mgrs want to involve PEs when they may lose their jobs?

216 216 Venture capitalists Venture capitalists provide finance to start-up entrepreneurs New, innovative, risky, no track-record… Hence, these Es have difficulty obtaining finance from banks or stock market VCs more than just investors Provide value-adding services/effort Double-sided moral hazard/Adverse selection

217 217 Venture capital process Investment appraisal stage: seeking out good entrepreneurs/business plans: VC overconfidence? Financial contracting stage: negotiate over cashflow rights and control rights. Performance stage: both E and VC exert value- adding effort: double-sided moral hazard. Ex post hold-up/renegotiation stage? Double sided moral hazard => exit: IPO/trade sale => capital gains (IRR)

218 218 VC process (continued) VCs invest for 5-7 years. VCs invest in a portfolio of companies: anticipate that some will be highly successful, some will not Value-adding? Visit companies, help them operationally, marketing etc. Empirical evidence on hours/year spent at each company => attention model of Gifford.

219 219 Venture Capital Financing Active Value-adding Investors. Double-sided Moral Hazard problem. Asymmetric Information. Negotiations over Cashflows and Control Rights. Staged Financing Remarkable variation in contracts.

220 220 Features of VC financing. Bargain with mgrs over financial contract (cash flow rights and control rights) VCs active investors: provide value-added services. Reputation (VCs are repeat players). Double-sided moral hazard. Double-sided adverse selection.

221 221 Kaplan and Stromberg Empirical analysis, related to financial contract theories.

222 222 Financial Contracts. Debt and equity. Extensive use of Convertibles. Staged Financing. Control rights (eg board control/voting rights). Exit strategies well-defined.

223 223 Game-theoretic models of Venture Capitalist/entrepreneur contracting Double-sided moral hazard models (ex ante effort/ ex post hold- up/renegotiation/stealing) – self-interest Behavioural Models (Procedural justice, fairness, trust, empathy)

224 224 Fairchild ( JFR 2004 ) Analyses effects of bargaining power, reputation, exit strategies and value-adding on financial contract and performance. 1 mgr and 2 types of VC. Success Probability depends on effort: where => VCs value- adding.

225 225 Fairchilds (2004) Timeline Date 0: Bidding Game: VCs bid to supply finance. Date 1: Bargaining game: VC/E bargain over financial contract (equity stakes). Date 2: Investment/effort level stage. Date 3: Renegotiation stage: hold-up problems Date 4: Payoffs occur.

226 226 Bargaining stage Ex ante Project Value Payoffs:

227 227 Optimal effort levels for given equity stake:

228 228 Optimal equity proposals. Found by substituting optimal efforts into payoffs and maximising. Depends on relative bargaining power, VCs value-adding ability, and reputation effect. Eg; E may take all of the equity. VC may take half of the equity.

229 229 Equity Stake Payoffs E VC 0.5 Dumb VC!

230 230 Tykvovas review paper of VC Problem is: more equity E has, less equity VC has: affects balance of incentives. Problem for VC is giving enough equity to motivate E, while keeping enough for herself

231 231 Ex post hold-up problem In Fairchild (2004): VC can force renegotiation of equity stakes in her favour after both players have exerted effort. She takes all of the equity How will this affect rational Es effort decision in the first place?

232 232 Es choice of financier Growing research on Es choice of financier VC versus banks VC versus angels VCs are formal funds with legal contracts etc Angels are wealthy individuals, often ex entrepreneurs, sometimes relations of the E!

233 233 Other Papers Casamatta: Joint effort: VC supplies investment and value-adding effort. Repullo and Suarez: Joint efforts: staged financing. Bascha: Joint efforts: use of convertibles: increased managerial incentives.

234 234 Es choice of financier VC or bank finance (Ueda, Bettignies and Brander). VC or Angel (Chemmanur and Chen, Fairchild). See slides on my paper….

235 235 Fairness Norms and Self-interest in VC/E Contracting: A Behavioral Game-theoretic Approach Existing VC/E Financial Contracting Models assume narrow self-interest. Double-sided Agency problems (both E and VC exert Value-adding Effort) (Casamatta JF 2003, Repullo and Suarez 2004, Fairchild JFR 2004). Procedural Justice Theory: Fairness and Trust important. No existing behavioral Game theoretic models of VC/E contracting.

236 236 My Model: VC/E Financial Contracting, combining double-sided Moral Hazard (VC and E shirking incentives) and fairness norms. 2 stages: VC and E negotiate financial contract. Then both exert value-adding efforts.

237 237 How to model fairness? Fairness Norms. Fair VCs and Es in society. self-interested VCs and Es in society. Matching process: one E emerges with a business plan. Approaches one VC at random for finance. Players cannot observe each others type.

238 238 Timeline Date 0: VC makes ultimatum offer of equity stake to E; Date 1: VC and E exert value-adding effort in running the business Date 2 Success Probability => income R. Failure probability =>income zero

239 239 Expected Value of Project Represents VCs relative ability (to E).

240 240 Fairness Norms Fair VC makes fair (payoff equalising) equity offer Self-interested VC makes self-interested ultimatum offer E observes equity offer. Fair E compares equity offer to social norm. Self-interested E does not, then exerts effort.

241 241 Expected Payoffs If VC is fair, by definition,

242 242 Solve by backward induction: If VC is fair; Since for both E types. =>

243 243 VC is fair; continued. Given Optimal Effort Levels: Fair VCs equity proposal (equity norm):

244 244 VC is self-interested: From Equation (1), fair Es optimal effort;

245 245 Self-interested VCs optimal Equity proposal Substitute players optimal efforts into V= PR, and then into (1) and (2). Then, optimal equity proposal maximises VCs indirect payoff =>

246 246 Examples; VC has no value-adding ability (dumb money) => => r =0 => r => 1,

247 247 Example 2 VC has equal ability to E; => r =0 => r => 1, We show that as r => 1

248 248 Fairness VCs Equity offer 1 0

249 249 Fairness Firm Value 0

250 Behavioural Corporate Finance. Standard Finance - agents are rational and self- interested. Behavioural finance: agents irrational (Psychological Biases). Irrational Investors – Overvaluing assets- internet bubble? Market Sentiment? Irrational Managers- effects on investment appraisal? Effects on capital structure? Herding.

251 251 Development of Behavioral Finance I. Standard Research in Finance: Assumption: Agents are rational self-interested utility maximisers. 1955: Herbert Simon: Bounded Rationality: Humans are not computer-like infinite information processors. Heuristics. Economics experiments: Humans are not totally self-interested.

252 252 Development of Behavioral Finance II. Anomalies: Efficient Capital Markets. Excessive volatility. Excessive trading. Over and under-reaction to news. 1980s: Werner DeBondt: coined the term Behavioral Finance. Prospect Theory: Kahnemann and Tversky 1980s.

253 253 Development III BF takes findings from psychology. Incorporates human biases into finance. Which psychological biases? Potentially infinite. Bounded rationality/bounded selfishness/bounded willpower. Bounded rationality/emotions/social factors.

254 254 Potential biases. Overconfidence/optimism Regret. Prospect Theory/loss aversion. Representativeness. Anchoring. Gamblers fallacy. Availability bias. Salience….. Etc, etc.

255 255 Focus in Literature Overconfidence/optimism Prospect Theory/loss aversion. Regret.

256 256 Prospect Theory. W U Eg: Disposition Effect: Sell winners too quickly. Hold losers too long. Risk-averse in gains Risk-seeking in losses

257 257 Overconfidence. Too much trading in capital markets. OC leads to losses? But : Kyle => OC traders out survive and outperform well-calibrated traders.

258 258 Behavioral Corporate Finance. Much behavioral research in Financial Markets. Not so much in Behavioral CF. Relatively new: Behavioral CF and Investment Appraisal/Capital Budgeting/Dividend decisions.

259 259 Forms of Irrationality. a)Bounded Rationality (eg Mattson and Weibull 2002, Stein 1996). - Limited information: Information processing has a cost of effort. - Investors => internet bubble. b) Behavioural effects of emotions: -Prospect Theory (Kahneman and Tversky 1997). -Regret Theory. -Irrational Commitment to Bad Projects. -Overconfidence. C) Catering – investors like types of firms (eg high dividend).

260 260 Bounded rationality (Mattson and Weibull 2002). -Manager cannot guarantee good outcome with probability of 1. -Fully rational => can solve a maximisation problem. -Bounded rationality => implementation mistakes. -Cost of reducing mistakes. -Optimal for manager to make some mistakes! -CEO, does not carefully prepare meetings, motivate and monitor staff => sub-optimal actions by firm.

261 261 Regret theory and prospect theory (Harbaugh 2002). -Risky decision involving skill and chance. -managers reputation. Prospect theory: People tend to favour low success probability projects than high success probability projects. -Low chance of success: failure is common but little reputational damage. -High chance of success: failure is rare, but more embarrassing. Regret theory: Failure to take as gamble that wins is as embarrassing as taking a gamble that fails. => Prospect + regret theory => attraction for low probability gambles.

262 262 Irrational Commitment to bad project. -Standard economic theory – sunk costs should be ignored. -Therefore- failing project – abandon. -But: mgrs tend to keep project going- in hope that it will improve. -Especially if manager controlled initial investment decision. -More likely to abandon if someone else took initial decision.

263 263 Real Options and behavioral aspects of ability to revise (Joyce 2002). -Real Options: Flexible project more valuable than an inflexible one. -However, managers with an opportunity to revise were less satisfied than those with standard fixed NPV.

264 264 Overconfidence and the Capital Structure (Heaton 2002). -Optimistic manager overestimates good state probability. -Combines Jensens free cashflow with Myers-Majluf Assymetric information. -Jensen- free cashflow costly – mgrs take –ve NPV projects. -Myers-Majluf- Free cashflow good – enables mgs to take +ve NPV projects. -Heaton- Underinvestment-overinvestment trade-off without agency costs or asymmetric info.

265 265 Heaton (continued). -Mgr optimism – believes that market undervalues equity = Myers-Majluf problem of not taking +ve NPV projects => free cash flow good. -But : mgr optimism => mgr overvalues the firms investment opportunities => mistakenly taking –ve NPV project => free cash flow bad. -Prediction: shareholders prefer: -Cashflow retention when firm has both high optimism and good investments. - cash flow payouts when firm has high optimism and bad investments.

266 266 Rational capital budgeting in an irrational world. (Stein 1996). -Manager rational, investors over-optimistic. - share price solely determined by investors. -How to set hurdle rates for capital budgeting decisions? - adaptation of CAPM, depending on managerial aims. - manager may want to maximise time 0 stock price (short-term). -May want to maximise PV of firms future cash flows (long term rational view).

267 267 Effect of Managerial overconfidence, asymmetric Info, and moral hazard on Capital Structure Decisions. Rational Corporate Finance. -Capital Structure: moral hazard + asymmetric info. -Debt reduces Moral Hazard Problems -Debt signals quality. Behavioral Corporate Finance. -managerial biases: effects on investment and financing decisions -Framing, regret theory, loss aversion, bounded rationality. -OVERCONFIDENCE/OPTIMISM.

268 268 Overconfidence/optimism Optimism: upward bias in probability of good state. Overconfidence: underestimation of asset risk. My model => Overconfidence: overestimation of ability.

269 269 Overconfidence: good or bad? Hackbarth (2002): debt decision: OC good. Goel and Thakor (2000): OC good: offsets mgr risk aversion. Gervais et al (2002), Heaton: investment appraisal, OC bad => negative NPV projects. Zacharakis: VC OC bad: wrong firms.

270 270 Overconfidence and Debt My model: OC => higher mgrs effort (good). But OC bad, leads to excessive debt (see Shefrin), higher financial distress. Trade-off.

271 271 Behavioral model of overconfidence. Both Managers issue debt:

272 272 Good mgr issues Debt, bad mgr issues equity. Both mgrs issue equity.

273 273 Proposition 1. a)If b) c) Overconfidence leads to more debt issuance.

274 274 Overconfidence and Moral Hazard Firms project: 2 possible outcomes. Good: income R. Bad: Income 0. Good state Prob: True: Overconfidence: True success prob:

275 275 Managers Perceived Payoffs

276 276 Optimal effort levels

277 277 Effect of Overconfidence and security on mgrs effort Mgrs effort is increasing in OC. Debt forces higher effort due to FD.

278 278 Managers perceived Indirect Payoffs

279 279 True Firm Value

280 280 Effect of OC on Security Choice Manager issues Equity. Manager issues Debt.

281 281 Effect of OC on firm Values

282 282 Results For given security: firm value increasing in OC. If Firm value increasing for all OC: OC good. Optimal OC: If Medium OC is bad. High OC is good. Or low good, high bad.

283 283 Results (continued). If 2 cases: Optimal OC: Or Optimal OC:

284 284

285 285 Conclusion. Overconfidence leads to higher effort level. Critical OC leads to debt: FD costs. Debt leads to higher effort level. Optimal OC depends on trade-off between higher effort and expected FD costs.

286 286 Future Research Optimal level of OC. Include Investment appraisal decision Other biases: eg Refusal to abandon. Regret. Emotions Hyperbolic discounting Is OC exogenous? Learning.

287 287 Overconfidence and life-cycle debt

288 288 Reverse effect of OC on debt in China?

289 289 Herding

290 290 Hyperbolic Discounting

291 Emotional Finance Fairchilds Concorde case study.

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