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1 MN20211: Corporate Finance 2011/12: 1.Revision: Investment Appraisal (NPV). 2.Investment flexibility, Decision trees, Real Options. 3.Revision: Portfolio Theory => CAPM 4. Sources of Funding. 5. Capital Structure and Value of the Firm. 6. Optimal Capital Structure - Agency Costs, Signalling. 7. Dividend policy/repurchases. 8. Mergers and Acquisitions. 9. Venture Capital and Private Equity. 10. Introduction to Behavioural Finance. 11. Revision.

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2 Corporate Finance: Three Major Decisions… Investment Appraisal (Capital Budgeting) – Which New Projects to invest in? Capital Structure (Financing Decision)- How to Finance the new projects – Debt or equity? Payout Policy – Dividends, Share Repurchases, Re- investment. => Objective: Maximisation of Shareholder Wealth.

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3 First Topic: Investment Appraisal Brief revision of static NPV. => Flexibility => Decision trees => sensitivity analysis => Real Options

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4 Investment Appraisal. Objective: Take projects that increase shareholder wealth (Value-adding projects). Investment Appraisal Techniques: NPV, IRR, Payback, ARR, Real Options…. Which one is the Best rule for shareholder wealth maximisation?

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5 Connections in Corporate Finance. Investment Appraisal: Net Present Value with discount rate (cost of capital) given. Positive NPV increases value of the firm. Cost of Capital (discount rate): How do companies derive the cost of capital? – CAPM/APT. Capital Structure and effect on Firm Value and WACC.

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6 Debate over Correct Method - Accounting Rate of Return. - Payback. - NPV. - IRR. - POSITIVE NPV Increases Shareholder Wealth. 2. Correct Method - NPV! -Time Value of Money - Discounts all future cashflows

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7 Net Present Value Perpetuities. IRR => Take Project if NPV > 0, or if IRR > r.

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8 Example. Consider the following new project: -initial capital investment of £15m. -it will generate sales for 5 years. - Variable Costs equal 70% of sales value. - fixed cost of project £200k PA. - A feasibility study, cost £5000, has already been carried out. Discount Rate equals 12%. Should we take the project?

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9 DO WE INVEST IN THIS NEW PROJECT? NPV > 0. COST OF CAPITAL (12%) < IRR (19.75%).

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10 Note that if the NPV is positive, then the IRR exceeds the Cost of Capital. NPV £m Discount Rate % 12 % 3.3m 19.7% 0

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11 CONFLICT BETWEEN APPRAISAL TECHNIQUES.

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12 NPV Discount Rate10%22.8% PROJ C 531 PROJ D % COMPARING NPV AND IRR - 1 Select Project with higher NPV: Project C.

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13 NPV Discount Rate COMPARING NPV AND IRR -2 Impossible to find IRR!!! NPV exists!

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14 COMPARING NPV AND IRR –3 Size Effect Discount Rate: 10% Project A : Date 0 Investment -£1000. Date 1 Cashflow £1500. NPV = £364. IRR = 50% Project B:- Date 0 Investment -£10 Date 1 Cashflow £18. NPV = £6.36 IRR = 80%. Which Project do we take?

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15 Mutually Exclusive project: firm can only take one (take project with highest positive NPV). Independent project: firm can take as many as it likes (take all positive NPV projects). Consider slide 10: Which project(s) would you take, and what would be the value-added, if projects are a) mutually exclusive, and b) independent? Mutually Exclusive Versus Independent Projects.

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16 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 Monte Carlo. Real Options

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17 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.

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

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19 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

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20 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).

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21 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.

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22 Real Options A new investment appraisal method, analysed by academics in the 1980s Existing NPV method: static: one-off decision to take project or throw it away: once project is taken, committed to it. Real Options: recognises flexibility in decision-making.

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23 Real Options. A digression: Financial Options 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.

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24 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!

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25 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.

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

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27 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

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28 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.

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

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30 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).

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31 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.

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32 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.

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

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

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

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

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

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38 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.

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

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40 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)

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41 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.

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42 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.

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43 Option to delay and Competition (Smit and Ankum). -Smit and Ankum present a binomial real option model: 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). Protecting Economic Rent: Innovation, barriers to entry, product differentiation, patents. Firm needs too identify extent of competitive advantage.

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44 Option to delay versus competition: Game-theoretic approach Firm 1\Firm 2Invest earlyDelay Invest early NPV = 500,NPV = 500NPV = 700, NPV = 300 Delay NPV = 300, NPV = 700 NPV = 600,NPV = 600

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45 Option to delay versus competition: effects of legal system Firm 1\ Firm 2Invest earlyDelay Invest early NPV = 500,NPV = 500NPV = , NPV = Delay NPV = , NPV = NPV = 600,NPV = 600

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46 Monte Carlo methods BBQ grills example in RWJ. Application to Qinetiq (article by Tony Bishop).

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47 Use of Real Options in Practice

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48. SECTION 2: Risk and Return/Portfolio Decision/ Cost Of Capital. The cost of capital = investors required return on their investment in a company. It provides the appropriate discount rate in NPV. Investors are risk averse. Future share prices (and returns) are risky (volatile). The higher the risk, the higher the required return. p t r t A B

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49.. An investors actual return is the percentage change in price: Risk = Variability or Volatility of Returns, Var (R). We assume that Returns follow a Normal Distribution. E(R) Var(R).

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50 Risk Aversion. Investors prefer more certain returns to less certain returns. Wealth U Risk Averse Investor prefers £150 for sure than a 50/50 gamble giving £100 or £200.

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51 Portfolio Analysis. Two Assets: Investor has proportion a of Asset X and (1-a) of Asset Y. Combining the two assets in differing proportions. E(R)

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52 Portfolio of Many assets + Risk Free Asset. E(R) * * * * * * M. Efficiency Frontier. All rational investors have the same market portfolio M of risky assets, and combine it with the risk free asset. A portfolio like X is inefficient, because diversification can give higher expected return for the same risk, or the same expected return for lower risk. X

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53 The Effect of Diversification on Portfolio Variance. Number of Assets. An assets risk = Undiversifiable Risk + Diversifiable Risk = Market Risk + Specific Risk. Market portfolio consists of Undiversifiable or Market Risk only.

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54 Relationship between Investor Portfolio Decision and Firms Cost of Capital Investors can diversify away all specific risk; therefore, should only be rewarded for holding each firms market risk => CAPM. CAPM provides the firms cost of equity.

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55 Security Market Line. Capital Asset Pricing Model

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56 Estimating Cost of Equity Using Regression Analysis. We regress the firms past share price returns against the market.

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57 Weighted Average Cost of Capital (WACC). When we have estimated Cost of Debt, and Cost of Equity- if we have market values of debt and equity, we can calculate WACC – discount rate in NPV of new investments.

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58 Lecture 5 and 6: Capital Structure and Dividends. 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

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

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

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61 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).

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62 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

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

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64 Examples Firm X Henderson Case study

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65 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

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66 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.

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

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68 Section 4: 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.

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69 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

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

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71 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

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72 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

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73 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?

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

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75 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*

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76 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).

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77 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)?

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78 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.

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79 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.

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80 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.

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81 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.

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82 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?

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83 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.

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84 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.

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85 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.

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

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

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88 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.

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89 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.

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90 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?

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91 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

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92 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?)

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93 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.

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

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95 Practical Capital Structure: case study

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96 Lecture 6: Dividend Policy Miller-Modigliani Irrelevance. Gordon Growth (trade-off). Signalling Models. Agency Models. Lintner Smoothing. Dividends versus share repurchases. Empirical examples

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97 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

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98 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

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99 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…

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

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101 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?

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102 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).

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103 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.

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104 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).

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

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

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107 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.

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108 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!

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109 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 !

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

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111 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?

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112 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.

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

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

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115 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 =

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116 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.

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117 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….)

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

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

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120 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.

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121 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.

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122 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.

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123 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.

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124 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).

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125 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.

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126 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)

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127 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

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128 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.

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129 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.

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

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

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132 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.

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133 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).

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

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135 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.

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136 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).

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137 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 !!!

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138 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% !!!

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139 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.

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140 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!

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141 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!

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142 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:

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143 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.

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144 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.

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

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146 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, P.by 25%, but this equals cost of equity. And is same as investing in zero NPV project.

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147 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.

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

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149 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.

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150 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.

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

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152 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.

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153 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.

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154 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.

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155 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

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

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157 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.

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

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

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160 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!!

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161 Lecture 9: Venture Capital/private equity 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 take them private….

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162 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 Our main focus in this course is venture capital, But will look briefly at PE later. Theory of private equity turnarounds plus PE leverage article, plus economics of PE articles.

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163 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

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164 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)

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165 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 => attention model of Gifford.

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166 C. 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.

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167 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.

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

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

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170 Fairchild (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.

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171 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.

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172 Bargaining stage Ex ante Project Value Payoffs:

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173 Optimal effort levels for given equity stake:

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174 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.

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175 Equity Stake Payoffs E VC 0.5

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176 Es choice of VC or angel-financing Explain Angels. Complementary efforts Ex post hold-up/stealing threat Fairchilds model

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177 To come Legal effects: (Fairchild and Yiyuan) => Allen and Song => Botazzi et al Negative reciprocity/retaliation.

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178 Ex post hold-up threat VC power increases with time. Exit threat (moral hazard). Weakens entrepreneur incentives. Contractual commitment not to exit early. => put options.

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179 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.

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180 Complementary efforts ( Repullo and Suarez ). Lecture slides to follow…

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181 Control Rights. Gebhardt. Lecture slides to follow

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182 Asymmetric Information Houben. PCP paper. Tykvova (lock-in at IPO to signal quality).

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183 Es choice of financier VC or bank finance (Ueda, Bettignies and Brander). VC or Angel (Chemmanur and Chen, Fairchild).

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184 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.

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185 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.

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186 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.

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187 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

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

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189 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.

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190 Expected Payoffs If VC is fair, by definition,

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

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

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

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194 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 =>

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

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

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197 Table 1.

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198 Graph

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199 Table of venture performance

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200 Graph of Venture Performance.

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201 Future Research. Dynamic Fairness Game:ex post opportunism (Utset 2002). Complementary Efforts. Trust Games. Experiments. Control Rights.

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202 Private Equity JCF paper: slides to follow… PE and leverage: slides to follow….

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203 Lecture 10: Introduction to 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.

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204 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.

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205 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.

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206 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.

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

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

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

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

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211 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.

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212 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).

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213 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.

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214 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.

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215 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.

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216 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.

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217 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.

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218 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.

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219 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).

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220 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.

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

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222 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.

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

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224 Behavioral model of overconfidence. Both Managers issue debt:

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

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

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

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228 Managers Perceived Payoffs

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229 Optimal effort levels

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

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231 Managers perceived Indirect Payoffs

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232 True Firm Value

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

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234 Effect of OC on firm Values

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235 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.

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

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237

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238 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.

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

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240 Herding

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241 Hyperbolic Discounting

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242 Emotional Finance Fairchilds Concorde case study.

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