CORPORATE FINANCIAL THEORY Lecture 5

Topic Flow Chart Goal of Finance = Maximize Value of Firm HOW? Get the most cash Steps 1. Methods to evaluate projects cash flow (NPV, IRR, etc) 2. Develop risk adjusted discount rates for use in NPV 3. Apply NPV, IRR, Decision Trees, PVI, etc to capital budgeting decisions 4. Changes in capital structure influence discount rates 5. Financial Distress can result form changes in capital structure

Efficient Capital Markets Switches gears Past lectures decided how to spend money (invest) Today’s lecture deal with raising money (financing decisions) Fisher Separation Theorem

Cost of Capital = Price of Money Efficient Capital Markets Interest Rates Quantity Supply Demand Equilibrium exists in capital markets

Market Efficiency Theory sez Risk Expected Return (%) SML

Return to NPV Example The government is lending you $100,000 for 10 years at 3% and only requiring interest payments prior to maturity. Since 3% is obviously below market, what is the value of the below market rate loan?

Return to NPV Example The government is lending you $100,000 for 10 years at 3% and only requiring interest payments prior to maturity. Since 3% is obviously below market, what is the value of the below market rate loan? Assume the market return on equivalent risk projects is 10 %.

Market Efficiency Lost Interest Rates Quantity Supply Demand Equilibrium Rate = 10 % Funding Shortage Subsidized Rate = 3 %

Efficient Market Theory  Weak Form Efficiency  Market prices reflect all historical information

Efficient Market Theory  Technical Analysts wiggle watchers –Forecast stock prices based on the watching the fluctuations in historical prices (thus “wiggle watchers”)

Random Walk Theory  The movement of stock prices from day to day DO NOT reflect any pattern.  Statistically speaking, the movement of stock prices is random (skewed positive over the long term).

Random Walk Theory $ $ $ $ $97.50 $ $95.06 Coin Toss Game Heads Tails

Random Walk Theory

S&P 500 Five Year Trend? or 5 yrs of the Coin Toss Game? Random Walk Theory

Efficient Market Theory  Weak Form Efficiency  Market prices reflect all historical information  Semi-Strong Form Efficiency  Market prices reflect all publicly available information

Efficient Market Theory Last Month This Month Next Month $ Microsoft Stock Price Cycles disappear once identified Actual price as soon as upswing is recognized

Announcement Date Efficient Market Theory

Example: How stock splits affect value Source: Fama, Fisher, Jensen & Roll

Efficient Market Theory  Weak Form Efficiency  Market prices reflect all historical information  Semi-Strong Form Efficiency  Market prices reflect all publicly available information  Strong Form Efficiency  Market prices reflect all information, both public and private

Efficient Market Theory Average Annual Return on Mutual Funds and the Market Index

IPO Non-Excess Returns Year After Offering Efficient Market Theory

The average return 1972–2001 on stocks of firms over the six months following an announcement of quarterly earnings. The 10% of stocks with the best earnings news (portfolio 10) outperformed those with the worst news (portfolio1) by about 1% per month.

Price Anomalies Deviation, % Log Deviations From Royal Dutch Shell / Shell T&T Parity

Efficient Market Theory Historical performance

Efficient Market Theory  Fundamental Analysts –Research the value of stocks using NPV and other measurements of cash flow

Lessons of Market Efficiency  Markets have no memory  Trust market prices  Read the entrails  The do it yourself alternative  Seen one stock, seen them all

Behavioral Finance Attitudes towards risk Beliefs about probabilities Sentiment Limits to Arbitrage Incentive Problems and the Subprime Crisis

Efficient Market Theory 2009 Recession

Efficient Market Theory 2000 Dot.Com Boom

Efficient Market Theory 1987 Stock Market Crash

Market Efficiency Theory  Conflicts in Theory Stock market crash of 1987 Daily fluctuations  Culprits? Arbitrage Computers Institutions

Corporate Financing READ TEXT CH 14 & 15 FOR TERMINOLOGY

Financial Markets Funds Banks Insurance Cos. Brokerage Firms Obligations Depositors Policyholders Investors Obligations Company Intermediary Investor

Financial Markets Types of Financing 1 - Equity 2 - Debt 3 - Hybrids

Holdings of Corp Equities (2014)

Holdings of Corp Debt (2014)

Initial Offering Process  Initial Public Offering (IPO)  Investment Banker  Underwriter  Broker  Prospectus & Shelf Registration  Underpricing

IPO “Friends and Family” Senator Barbara Boxer’s IPO participation (2000)

The Top Managing Underwriters January – June 2014

Underwriting Spreads

Motives For An IPO Percent of CFOs who strongly agree with the reason for an IPO

Average Initial IPO Returns

Initial Offering Average Expenses on 1767 IPOs from

IPO Proceeds IPO Proceeds and First Day Returns

Investment Vehicles (2011)

SPEs and Enron  Special-Purpose Entities (SPEs)  Raise cash through equity and debt  Do not show up on balance sheet Mahonia Enron JP Morgan

Types of Equity  Partnerships  LLP & LLPs  Public Benefit Corporations  Trusts  Real Estate Investment Trust (REIT)  Private equity

Private Equity Returns

U.S. Venture Capital Investments $ Billions

Total Direct Costs of Raising Capital

Rights Issue Rights Issue - Issue of securities offered only to current stockholders. Example – BNP Paribas Bank needs to raise €5.50 billion of new equity. The market price is €77.40/sh. BNP decides to raise additional funds via a 1 for 10 rights offer at €65.40 per share. If we assume 100% subscription, what is the value of each right?

Rights Issue

 Current Market Value = 10 x €77.40 = €  Total Shares = = 11  Amount of funds = = €  New Share Price = (839.40) / 11 = €76.31  Value of a Right = Example - BNP Paribas Bank needs to raise €5.50 billion of new equity. The market price is €77.40/sh. BNP decides to raise additional funds via a 1 for 10 rights offer at €65.40 per share. If we assume 100% subscription, what is the value of each right?

Rights Issue Slightly More Difficult Example Lafarge Corp needs to raise €1.28billion of new equity. The market price is €60/sh. Lafarge decides to raise additional funds via a 4 for 17 rights offer at €41 per share. If we assume 100% subscription, what is the value of each right?

Rights Issue  Current Market Value = 17 x €60 = €1,020  Total Shares = = 21  Amount of funds = 1,020 + (4x41) = €1,184  New Share Price = (1,184) / 21 = €56.38  Value of a Right = Example - Lafarge Corp needs to raise €1.28billion of new equity. The market price is €60/sh. Lafarge decides to raise additional funds via a 4 for 17 rights offer at €41 per share. If we assume 100% subscription, what is the value of each right?

Rights Issue - example YRU Corp currently has 9 million shares outstanding. The market price is $15/sh. YRU decides to raise additional funds via a 1 for 3 rights offer at $12 per share. If we assume 100% subscription, what is the value of each right? Current Market Value = 9 mil x $15 = $135 mil Total Shares = 9 mil + 3 mil = 12 mil Amount of new funds = 3 mil x $12 = $36 mil New Share Price = ( ) / 12 = $14.25/sh Value of a Right = 0.75

Rights Issue Rights Issue - Issue of securities offered only to current stockholders. Example – Ivanhoe Mines needs C$1.2 billion of new equity. Market price C$ Ivanhoe Mines decides to raise additional funds by offering the right to buy 3 new shares for 20 at C$13.93 per share. With 100% subscription, what is value of each right?

Rights Issue  Current Market Value = 20 x C$24.73 = C$  Total Shares = = 23  Amount of new funds = 3 x C$13.93 = C$41.79  New Share Price = ( ) / 23 = C$23.32  Value of a Right = C$23.32-C$13.93 = C$9.39 Example - Ivanhoe Mines needs C$1.2 billion of new equity. Market price C$ Ivanhoe Mines decides to raise additional funds by offering the right to buy 3 new shares for 20 at C$13.93 per share. With 100% subscription, what is value of each right?