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**MN20211: Corporate Finance: Semester 2, 2007/8**

Investment Appraisal, decision trees, and real options. Risk and Return and Cost of Capital. Capital Structure and Value of the Firm. 4. Optimal Capital Structure - Agency Costs, Signalling. 5. Mergers and Acquisitions. 6. Dividend Policy/Share Repurchases. 7. Venture Capital. 8. International differences in Corporate Finance Practices. 9. Behavioral Finance.

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**The Major Decisions of the Firm.**

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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1. 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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**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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**SECTION 1: Investment Appraisal.**

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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**Net Present Value Perpetuities. IRR =>**

Take Project if NPV > 0, or if IRR > r.

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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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**DO WE INVEST IN THIS NEW PROJECT?**

NPV > 0. COST OF CAPITAL (12%) < IRR (19.75%).

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**Note that if the NPV is positive, then the IRR exceeds the Cost of Capital.**

NPV £m 3.3m Discount Rate % 12 % 19.7%

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**CONFLICT BETWEEN APPRAISAL TECHNIQUES.**

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**Select Project with higher NPV: Project C.**

COMPARING NPV AND IRR - 1 NPV 531 519 10% 22.8% 25.4% Discount Rate PROJ D PROJ C Select Project with higher NPV: Project C.

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**Impossible to find IRR!!! NPV exists!**

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

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**COMPARING NPV AND IRR –3 Size Effect**

Discount Rate: 10% Project A : Date 0 Investment -£1000. Date 1 Cashflow £1500. NPV = £364. IRR = % Project B:- Date 0 Investment £10 Date 1 Cashflow £18. NPV = £6.36 IRR = 80%. Which Project do we take?

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**Mutually Exclusive Versus Independent Projects.**

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?

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**Which Cash-flows to use?**

Economic costs and revenues: ie take the cash when it occurs. (see depreciation treatment). Relevant Cashflows. Incremental cashflows. => NPV is a measure of value-creation for shareholders from taking new project.

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**Treatment of depreciation.**

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**Decision Trees and Sensitivity Analysis.**

Example: From RWJ. New Project: Test and Development Phase: Investment $100m. 0.75 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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**Production Stage: Base Case**

Date 1 NPV = = 1517

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Decision Tree. Date 0: -$100 Date 1: -1500 NPV = 1517 Invest P=0.75 Success Do not Invest NPV = 0 Test Do not Invest Failure P=0.25 Do Not Test Invest NPV = -3611 Solve backwards: If the tests are successful, SEC should invest, since 1517 > 0. If tests are unsuccessful, SEC should not invest, since 0 >

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Now move back to Stage 1. Invest $100m now to get 75% chance of $1517m one year later? Expected Payoff = 0.75 * *0 = 1138. 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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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. Mosher Case study. Break - even analysis examines variability in forecasts. It determines the number of sales required to break even.

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**EVA (Economic Value Added).**

EVA developed, and trade-marked, by Stern and Stewart. EVA closely related to NPV But NPV = investment decision rule, forward-looking expected value-creation over life of a project. EVA is an ongoing Annual Performance Evaluation Technique. Rewards managers on annual value-creation.

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**EVA with constant invested capital.**

Project with Initial required Capital Investment Capital Lasts forever (no depreciation). Project generates cashflow in each future period n.

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EVA example. Consider an investment opportunity requiring initial investment of 250 (no depreciation). Project is expected to produce perpetuity of 35 (ie annually forever). Discount rate

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**EVA Example EVA of investment opportunity in every year is**

Present Value of these EVAs is

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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 (later in course).

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**Types of Real Option Option to Delay (Timing Option).**

Option to Expand (eg R and D). Option to Abandon.

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**Valuation of Real Options**

Binomial Pricing Model Black-Scholes formula

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Value of a Real Option A Project’s 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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**Simplified Examples Option to Expand (page 241 of RWJ) If Successful**

Build First Ice Hotel Do not Expand If unsuccessful

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**Option to Expand (Continued)**

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?

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**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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**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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**Option to delay and Competition (Smit and Ankum).**

-benefit: wait to observe market demand. -cost: Lost cash flows. -cost: lost monopoly advantage, increasing competition. Net Operating Cashflow = opportunity cost plus economic rent; Economic Rent: Innovation, barriers to entry, product differentiation, patents. Long-run: ER = 0. Firm needs too identify extent of competitive advantage.

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**Option to delay and Competition (Smit and Ankum) – Cont’d.**

Cash inflow during deferment period = In monopoly model: constant economic rent. In competition, economic rent declines to zero. -trade-off between option value of waiting, and loss from competition.

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**Year of Survey 1975 1980 1986 1992 Technique % Payback 73 81 92 94 ARR**

The Investment Appraisal Debate. Richard Pike: Year of Survey 1975 1980 1986 1992 Technique % Payback 73 81 92 94 ARR 51 49 56 50 IRR 44 57 75 NPV 32 39 68 74 Sample size: 100 Large UK based Firms.

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**Year 1975 1980 1986 1992 No Methods 2 Single Method 31 (0) 24 (1)**

Combination of Techniques: Pike 1992: Year 1975 1980 1986 1992 No Methods 2 Single Method 31 (0) 24 (1) 8 (0) 4 (= PB) 34 (6) 40 (11) 29 (9) 28 (11) 3 22 (15) 24 (14) 29 (24) 32 (27) 4 11 12 34 36 Total 100 (32) 100 (38) 100 (67) 100 (74) ( ) = NPV

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**Some Reasons for usage of wrong techniques.**

-Managers prefer % figures => IRR, ARR Managers don’t understand NPV/ Complicated Calculations. Payback simple to calculate. Short-term compensation schemes => Payback (Levy 200 –203, Pike 1985 pg 49). Behavioural Factors (see later section on Behavioural Finance!!) Increase in Usage of correct DCF techniques: Computers. Management Education.

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**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 r A B t t

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**An investor’s actual return is the percentage change in price:**

Risk = Variability or Volatility of Returns, Var (R). We assume that Returns follow a Normal Distribution. Var(R). E(R)

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**Investors prefer more certain returns to less certain returns.**

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

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**Two Assets: Investor has proportion a of Asset X and (1-a) of Asset Y.**

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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**Portfolio of Many assets + Risk Free Asset.**

E(R) Efficiency Frontier. M * . * * X * * * 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.

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**The Effect of Diversification on Portfolio Variance.**

Number of Assets. An asset’s risk = Undiversifiable Risk + Diversifiable Risk = Market Risk + Specific Risk. Market portfolio consists of Undiversifiable or Market Risk only.

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**Relationship between Investor Portfolio Decision and Firm’s Cost of Capital**

Investors can diversify away all specific risk; therefore, should only be rewarded for holding each firm’s market risk => CAPM. CAPM provides the firm’s cost of equity.

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**Capital Asset Pricing Model**

Security Market Line.

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**Estimating Cost of Equity Using Regression Analysis.**

We regress the firm’s past share price returns against the market.

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**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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**Link to Section 3: Link between Value of the firm and NPV.**

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

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Example: = =1000. 20 = 40. Value of Debt = 500. Original Equity = = 540 New Equity = 20 = =1060. Total Firm Value

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**Positive NPV: Effect on share price.**

Assume all equity.

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**SECTION 3: 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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**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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K Without Taxes K With Taxes D/E D/E V V D/E D/E

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**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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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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**Combining Tax Relief and Debt Capacity (Traditional View).**

K V D/E D/E

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**Section 4: Optimal Capital Structure, Agency Costs, and Signalling.**

Agency costs - manager’s 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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**- self-interested manager - monetary rewards V private benefits.**

AGENCY COST MODELS. Jensen and Meckling (1976). - self-interested manager - monetary rewards V private benefits. - issues debt and equity. Issuing equity => lower share of firm’s 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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Jensen and Meckling (1976) V Slope = -1 V* A V1 B1 B If manager owns all of the equity, equilibrium point A.

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Jensen and Meckling (1976) V Slope = -1 V* A B V1 Slope = -1/2 B1 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.

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Jensen and Meckling (1976) V Slope = -1 V* A B V1 Slope = -1/2 V2 C B1 B2 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. Final equilibrium, point C: value V2, and private benefits B1.

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**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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**Issuing debt increases the manager’s fractional ownership => Firm value rises.**

-But: Debt and risk-shifting.

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**OPTIMAL CAPITAL STRUCTURE. **

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

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**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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**Effort Level High Low Required Funds Income 500 100 200**

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 High Low Required Funds Income 500 100 200 What is Optimal Capital Structure (Value Maximising)?

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**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 < D => 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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**-Managers have (negative NPV) pet projects. -Empire Building. **

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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**Jensen’s 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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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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**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 firm’s 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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**Breaking MM Risk Shifting Unspecified. Benefits of Debt Costs of Debt**

Conflict Benefits of Debt Costs of Debt Breaking MM Tax Relief Fin’l Distress/ Debt Capacity Agency Models JM (1976) Managerial Perks Increase Mgr’s Ownership Risk Shifting Jensen (1986) Empire Building Reduce Freecash Unspecified. Stultz Underinvestment. Dewatripont and Tirole, Hart. Low Effort level Bankruptcy threat =>increased effort DT- Inefficient liquidations.

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**Signalling Models of Capital Structure**

Assymetric info: Akerlof’s (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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**Asymmetric information and Signalling Models.**

- managers have inside info, capital structure has signalling properties. Ross (1977) -manager’s 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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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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**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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**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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**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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**Practical Methods employed by Companies. **

Trade off models: PV of debt and equity. Pecking order. Benchmarking. Life Cycle. Increasing Debt? time

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**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?

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**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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**Section 5: Mergers and Acquisitions.**

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

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**Synergy Value of a Merger**

Synergy comes from increases in cashflow form the merger:

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**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.

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**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.

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

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**Effects of takeovers on stock prices of bidder and target.**

Successful Bids Unsuccessful Bids Jensen and Ruback JFE 1983

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Capital Structure Decisions: Part I

Capital Structure Decisions: Part I

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