CHAPTER 14: COST OF CAPITAL ( ) WE = E/V = % financed w ...
CHAPTER 14: COST OF CAPITAL ( ) WE = E/V = % financed w/ common equity E = MV of equity = # o/s shares x share price WP = P/V = % financed w/ preferred stocks P = MV of preferred stock = # o/s shares x price WD = D/V = % financed w/ debt D = MV of Debt = # o/s bonds x bond price V = MV of firm = E + P + D COST OF EQUITY 1. Dividend Growth Model RE = (D1/P0) + g, where D1 = D0 (1+g) 2. CAPM or SML => RE = RF + βE (E(RM ) – RF) Risk Premium = (E(RM ) – RF); Market Return = RM COST OF DEBT = YTM = Cost of Debt COST OF PREFERRED SHARES = RP = D / P0 CALCULATING “G” i) Compound growth rate ex. Last 5 dividends were 1.1, 1.2, 1.35, 1.4, 1.55 So, 1.10(1+g)4 = 1.55, when you solve, g = 8.95% ii) Historical growth rate Doing % changes for years, then find the average. iii) g = Retention ratio X ROE Project more risky than firm: discount rate > WACC Project less risky than firm: discount rate < WACC - Required Rate = Discount Rate = Cost of Capital - COC of levered firm = RE + RD + RP - COC of unlevered firm = RE FLOTATION COSTS: costs of issuing new securities CALC. WEIGHTED AVERAGE FLOTATION COSTS fA = (E/V) x fE + (D/V) x fD Let x = $ needed to cover flotation costs x (1 - fA) = Initial Investment x = Amount needed to invest to cover flotation CHAPTER 22: LEASING 3 Types of Financial Leases 1. Tax-oriented/True Lease/Tax Lease: - Lessor is owner for tax purposes 2. Sale and Leaseback Agreement: - lessee buys item, sells to lessor, lease it to lessee 3. Leveraged Lease: - The lessor borrows fraction of the cost of the leased asset - The lessee enjoys the value of using the asset - The lessor enjoys lease payments, title to asset - The lender enjoys interest payments LEASING FORMULA - Net Advantage of Leasing NAL = Investment - PV of after tax Lease Payments – PV of CCA tax shields - PV of salvage +/- any misc. cash flows (i.e., maintenance) Note: d = CCA rate, T = tax rate, k = AT cost of debt, c = cost of asset, s = salvage value USING NAL – LEASE OR BUY? STEP 1: Find the after tax cost of debt RD* = RD (1 – T) STEP 2: Find the PV of After-Tax Lease Payments Using CASIO: n = # of years, I% = RD*, PMT = Lease Payments x (1 – T), FIND PV STEP 3: Find PVCCATS = [(CdT / (d+k)] x [(1+0.5k) / (1+k)] – [(SdT / (d+k)] x [1 / (1+k)n] STEP 4: Find PV of Salvage Value Using CASIO: n = # of years, I% = RD*, PMT = 0, FV = Salvage Value, FIND PV STEP 5: Find PV of Misc. Cash Flows (i.e. maintenance) If NAL > 0 = LEASE; If NAL < 0 = BUY INDIFFERENCE LEASE PAYMENTS 1) Set NAL = 0, then solve for ATLP (PMT) Find PMT = x (after-tax) | x / (1 – t) = x (pre-tax) REASONS FOR LEASING Good Reasons: 1) taxes; 2) uncertainty transferred; 3) lower trans. costs; 4) less restrictions Bad Reasons: 1) B/S better; 2) 100% financing
CHAPTER 16: CAPITAL STRUCTURE - The mix of different securities issued by the firm to finance operations. This changes market value of the firm, maximizing shareholder’s wealth - The COC varies directly with D/E ratio DEGREE OF FINANCIAL LEVERAGE (DFL) - Extent in which a firm relies on debt; higher leverage = higher WACC = higher debt - Leverage amplifies variation in both EPS + ROE; DFL = % change in EPS / % change in EBIT DFL = EBIT / EBIT – Interest Breakeven EBIT All Equity Firm (unlevered): EBIT / old # shares = (EBIT – Interest) / new # shares Debt/Equity Firm (levered): (EBIT – old interest) / old # shares = (EBIT – new interest) / new # shares Homemade Leverage (HML) The use of personal borrowing to alter the degree of financial leverage M&M PROPOSITION I VU = EBIT/REU = VL = EL + DL No Tax – The value of a levered firm is equal to the value of an unlevered firm. VU = VL - Capital Structure is irrelevant; WACC is the same no matter how it is financed With Tax – The value of a levered firm is equal to the value of an unlevered firm plus the tax shield Value of Unlevered firm: VU = EBIT (1 – T)/REU Value of Levered firm: VL = VU + TCD - Debt financing is beneficial with an extreme scenario of 100% debt financing; WACC decreases with debt financing M&M PROPOSITION II RE = RA + (RA – RD) x (D/E) Where RA = WACC No Tax - RA is the “cost” of the firm’s business risk (i.e., required return on the firm’s assets) (RA – RD) x D/E is “cost” of the firm’s financial risk RA = Rf + (RM – Rf) x βA , where βA = asset (or unlevered) beta. As if firm had no debt RE = Rf + (RM – Rf) x βE , where βE = equity (or levered) beta Relationship between βA and βE: βE = βA x (1 + D/E) or βE = βA + βA x (D/E) *The risk premium of the firm’s equity is equal to the risk premium of the firm’s assets multiplied by the equity multiplier (1 + D/E) Implications: 1) RE rises as firm increases its use of debt financing. 2) The risk of the equity depends on business risk (βA) and financial risk (βA x (D/E) With Tax – RE = RU + (RU – RD) x (D/E) X (1 – T) Where RU = unleveraged cost of capital BANKRUPTCY COSTS - Type of agency cost. As D/E ratio increases, probability that firm may not pay its bondholders |Firm is bankrupt if value of assets = the value of its debt| At some point, add. value of interest tax shield will be offset by exp. bankruptcy cost. Value of firm will decrease and WACC increases as more debt adds| Direct costs: legal and admin costs, cause bondholders to incur additional losses, disincentive to debt| Financial distress: problems in meeting debt obligations OPTIMAL CAPITAL STRUCTURE The Static Theory – firms borrow to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost coming from increased probability of financial distress. For long term goal. Case I: No Taxes & No bankruptcy costs - value of firm and WACC are NOT affected by CS Case II: Taxes & No bankruptcy costs – value of firm increases and WACC decreases as debt rises Case III: Taxes & Bankruptcy costs – value of firm (VL*) reaches a max. at D*, the optimal amount of borrowing. WACC* is minimized at D*/E*
THE PECKING-ORDER THEORY 1) Internal financing; 2) Debt; 3) Equity Consequences of Financial Distress 1. Business Failure; 2. Legal bankruptcy; 3. Technical Insolvency; 4. Accounting Insolvency LIQUIDATION & REORGANIZATION Liquidation – termination of the firm as a going concern | Reorganization – financial restructuring of a failing firm to attempt to continue operations CHAPTER 17 – DIVIDENDS & DIVIDEND POLICY Cash Dividend – made quarterly Dividend Yield = Annual Div / Stock Price (% market price) | Payout Ratio = Annual Div/EPS (% EPS) | Plowback Ratio = 1 – Payout Ratio Stock Dividend - new shares of stock to SH as a dividend instead of cash; increase # of o/s shares Special/Extra Dividends - firms with excess cash payout large dividends Stock Repurchase - often used when firm has large amount of excess cash on hand Dividend Payment Chronology Declaration Date: board declares the dividend & it becomes a liability of the firm *Ex-Dividend Date: 2 business days before date of record (if you buy stock ON or AFTER this date, you will NOT receive the dividend). Stock price drops by amount of the dividend *Date of Record: Holders of record determined Date of Payment: Cheques are mailed Dividends vs Dividend Policy Dividends MATTER – value of stock is based on PV of expected future divs. Higher div > lower div. Stock price rise if div/share rise & held constant Dividend Policy may NOT matter – If firm reinvests now, it grows & can pay higher divs later Homemade Dividends - form of investment income that comes from sale of a portion of shares held by a SH | differs from divs that a SH receive from company according to # of shares the SH has. Investors can undo firm’s div policy by reinvesting divs OR selling shares of stocks Alternatives to Paying a Dividend Select additional projects; Repurchase shares; Acquire other companies; Buy financial assets Dividends & Signals Increases: - higher div can be sustained Decreases: - no longer sustain the current div Clientele effect – stocks attract particular groups based on dividend yield and resulting tax effects Residual Dividend Policy - Firms pay div only after meeting investment needs and maintaining D/E ratio Step 1: Determine funds that can be generated without selling new equity Step 2: Find capital structure and decide whether or not to pay dividends. If funds needed exceeds funds available, then no div. Stock Splits Ex. a 2 for 1 stock split for every 1 share, receive 1 more (2-1)|Stock price reduced when stock splits IMPORTANT FORMULAS - Equity Multiplier = Total Assets / Total Equity - Equity Multiplier = 1 + D/E ROA = Net Income / Assets |ROE = Net Income / Total Equity | P/E Ratio = Price per share / EPS - EAR = [1 + (quoted rate/m)]m – 1 - # of New Shares = Funds to be raised / Subscription price - Price of a stock = P0 = D1/r – g where D1 = D0(1+g) NPV = Initial cost – PV(FCF) – PV(sal.) – PVCCATS Profitability Index = PV Cash Inflow/PV Cash Outflows
CHAPTER 15: RAISING CAPITAL Types of new issues: - Venture Capital - Public Issue (thru IPO) - General cash offer (issue on cash basis) - Rights offer (issue first offered to current SH) Procedure for New Issue 1) Board approval and red herring prospectus 2) Final prospectus with OSC approval 3) Pricing Initial Public Offering (IPO): first issue to the public Seasoned new offering: new issue from firm already previously issuing securities Syndicate: group of underwriters; help sell an issue Spread: difference btw the underwriter’s buying price and offering price. i.e. their compensation TYPES OF UNDERWRITING Regular underwriting: purchase of securities from the issuing company by an investment banker for resale to public. Market out clause gives the group the option decline the issue if the price drops. Firm commitment underwriting: underwriter buys the entire issue, assuming full responsibility for any unsold shares Best efforts underwriting: Underwriters sells as many of the issue as possible, but can return any unsold shares to the issuer. Bought Deal: One underwriter buys securities and sells them directly to a small group of investors Dutch auction underwriting: Offer price is set based on competitive bidding by investors Overallotment option: provision that permits syndicate members to purchase additional shares at the original offering price. Lockup Agreement: specifies how long insiders must wait after IPO before selling stock. i.e. 6 mths Quiet Period: 40 days after IPO – limited comm. Cost of Issuing New Securities: 1) Spread; 2) Other Direct costs; 3) Indirect costs; 4) Abnormal returns; 5) Underpricing; 6) overallotment option RIGHTS - Issue of common stock offered to existing shareholders Each shareholder has one right for every share. Number of new shares to be issued = Funds to be raised / subscription price Number of rights needed to buy one share = # of old shares / # of new shares Value of a right = R0 = (M0 – S)/(N + 1) Where M0 = common share price, S = subscription price, N = number of rights required to buy one new share EX-RIGHTS: Period when stock is selling without a recently declared right, normally 2 days before holder-of-record date. Value of ex-rights = RE = (ME – S) / N Where ME = M0 – R0 = CS price during ex-rights OR: Ex-Rights Price = PX = V / (new # of o/s shares) DILUTION – loss in existing SH value Percentage ownership – shares sold to the general public without a rights offering Market value – firm accepts negative NPV projects Book value and EPS – occurs when market-to-book value is less than one CHAPTER 23: MERGERS AND ACQUISITIONS Legal forms of acquisitions: 1) Merger or consolidation 2) Acquisition of stock 3) Acquisition of assets Merger: One firm acquiring another
Consolidation: Entirely new firm is created from combination of existing firms Tender offer: public offer to buy shares Circular bid: Takeover bid communicated to SH by direct mail | Stock exchange bid: Takeover bid communicated to SH via a stock exchange (TSX) Horizontal: Both firms are in the same industry Vertical: Firms are different stages of the production process Conglomerate: Firms are unrelated Proxy Contests: seeking SH votes to replace mgmt. Going-private: all equity repurchased from public Leveraged buyouts (LBO): going private transactions where large % of $ used is borrowed Tax-free = No cash involved (only stocks) Fair Market Value = Net Fixed Assets + NWC Goodwill = Acquisition Price – Fair Market Value SYNERGY: VAB > VA + VB | ∆V = VAB – (VA + VB) Value of Firm B to Firm A = VB* = ∆V + VB VB* can be determined by estimating VB and estimating ∆V (find ∆CF for Firm B) ∆CF = ∆EBIT + ∆Depreciation - ∆Tax - ∆Capital requirements Revenue Enhancement: 1) Marketing Gains; 2) Strategic Benefits; 3) Market Power Cost Reductions: 1) Economies of Scale; 2) Economies of Vertical Integration; 3) Complementary Resources Tax Gains: 1) Net Operating Losses; 2) Unused Debt; 3) Surplus funds; 4) Asset Write-ups EPS Growth: EPS = EA + EB / OSA + (OSA /Exchange ratio) CASH ACQUISITION NPV of cash acquisition: NPV = VB* – cash cost Value of combined firm: VAB = VA + (VB* – cost) STOCK ACQUISITION NPV of stock acquisition: NPV = VB* – cost Value of combined firm: VAB = VA + VB + V Defense Tactics for Mergers 1) Control block & corporate charter 2) Greenmail/standstill agreements (targeted stock repurchases) 3) Exclusionary offers 4) Poison pills & SH rights plans 5) Leveraged buyouts (LBO) 6) Golden parachutes, crown jewels, white knights CHAPTER 24: RISK MANAGEMENT Hedging: reducing a firm’s exposure to price or rate fluctuations Types of volatility: Interest Rate, Exchange Rate, Commodity Price Risk profile: Graph showing the relationship between changes in price vs changes in firm value Hedging short run = transactions exposure Hedging long run = economic exposure Forward contract: A contract where two parties agree on the price of an asset today to be delivered and paid for at some future date Long position – agreeing to buy the asset at the future date (buyer) Short position – agreeing to sell the asset at the future date (seller) Payoff profile: Plot showing gains and losses that will occur on a contract because of unexpected price changes. Hedging eliminates price risk. Futures contract: forward contract where gains and losses are realized each day. Hedging eliminates credit risk. Cross hedging is hedging a
related asset; Basis risk is prices not moving directly with cash price CHAPTER 25: OPTIONS & CORPORATE SECURITIES Call option: right to buy an asset* Put option: right to sell an asset* *Trading usually in multiples of 100 shares C1 = 0 if S1 ≤ E AND C1 = S1 – E if S1 > E t Call Option Value = C0 = S0 – E/(1 + Rf) Call options: In the money: S > E Out of the money: S < E Put options: In the money: S < E Out of the money: S > E Buyer of a Call Option: Payoff/Value = S – E Profit = S – E – C, C = Call premium Seller of a Call Option: Payoff = -(S - E) Profit = C – (S – E) Buyer of a Put Option: Payoff = E – S Profit = E – S – P, P = Put premium Seller of a Put Option: Payoff = -(E – S) Profit = P – (E – S) *S = underlying asset price, S1 = stock price at expiration, S0 = stock proce today, E = Strike price, C1 = Value of call option on expiration, C0 = Value of call option today, Option value = Intrinsic Value + Time Value Intrinsic Value (lower bound) = Max (0 or S – E) Time Value: =0 at expiration date Time Value = Option Price – Intrinsic Value WARRANTS Value of a Warrant = Bond Face value – PV of bond / number of warrants Warrants affect firm value New Value of firm = Value of asset + new contribution from exercised warrant Warrants add more o/s shares to the firm, where options don’t. This happens when warrants and convertible bonds are exercised. Warrants can dilute the stock price and EPS CONVERTIBLE BONDS Bonds that can be exchanged for a fixed number of shares of stock for a specified amount of time. Conversion price: The effective price paid for the stock; the dollar amount of a bond’s par value that is exchangeable for one share of stock Conversion ratio: The number of shares received when the bond is converted Conversion premium: The difference between conversion price and current stock price divided by the current stock price Straight Bond Value: Price of a bond (use CALC) Floor Value: Convertible bonds will be worth at least as much as the straight bond value or the conversion value, whichever is greater Conversion Ratio = Bond Face Value / Conversion price Conversion Value = current stock price x conversion ratio Conversion Premium = Conversion Price – Current Stock Price / Current Stock Price
CHAPTER 16: CAPITAL STRUCTURE - The mix of different securities issued by the firm to finance operations. This changes market value of the firm, maximizing shareholder’s wealth - The COC varies directly with D/E ratio DEGREE OF FINANCIAL LEVERAGE (DFL) - Extent in which a firm relies on debt; higher leverage = higher WACC = higher debt - Leverage amplifies variation in both EPS + ROE; DFL = % change in EPS / % change in EBIT DFL = EBIT / EBIT – Interest Breakeven EBIT All Equity Firm (unlevered): EBIT / old # shares = (EBIT – Interest) / new # shares Debt/Equity Firm (levered): (EBIT – old interest) / old # shares = (EBIT – new interest) / new # shares Homemade Leverage (HML) The use of personal borrowing to alter the degree of financial leverage M&M PROPOSITION I VU = EBIT/REU = VL = EL + DL No Tax – The value of a levered firm is equal to the value of an unlevered firm. VU = VL - Capital Structure is irrelevant; WACC is the same no matter how it is financed With Tax – The value of a levered firm is equal to the value of an unlevered firm plus the tax shield Value of Unlevered firm: VU = EBIT (1 – T)/REU Value of Levered firm: VL = VU + TCD - Debt financing is beneficial with an extreme scenario of 100% debt financing; WACC decreases with debt financing M&M PROPOSITION II RE = RA + (RA – RD) x (D/E) Where RA = WACC No Tax - RA is the “cost” of the firm’s business risk (i.e., required return on the firm’s assets) (RA – RD) x D/E is “cost” of the firm’s financial risk RA = Rf + (RM – Rf) x βA , where βA = asset (or unlevered) beta. As if firm had no debt RE = Rf + (RM – Rf) x βE , where βE = equity (or levered) beta Relationship between βA and βE: βE = βA x (1 + D/E) or βE = βA + βA x (D/E) *The risk premium of the firm’s equity is equal to the risk premium of the firm’s assets multiplied by the equity multiplier (1 + D/E) Implications: 1) RE rises as firm increases its use of debt financing. 2) The risk of the equity depends on business risk (βA) and financial risk (βA x (D/E) With Tax – RE = RU + (RU – RD) x (D/E) X (1 – T) Where RU = unleveraged cost of capital BANKRUPTCY COSTS - Type of agency cost. As D/E ratio increases, probability that firm may not pay its bondholders |Firm is bankrupt if value of assets = the value of its debt| At some point, add. value of interest tax shield will be offset by exp. bankruptcy cost. Value of firm will decrease and WACC increases as more debt adds| Direct costs: legal and admin costs, cause bondholders to incur additional losses, disincentive to debt| Financial distress: problems in meeting debt obligations OPTIMAL CAPITAL STRUCTURE The Static Theory – firms borrow to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost coming from increased probability of financial distress. For long term goal. Case I: No Taxes & No bankruptcy costs - value of firm and WACC are NOT affected by CS Case II: Taxes & No bankruptcy costs – value of firm increases and WACC decreases as debt rises Case III: Taxes & Bankruptcy costs – value of firm (VL*) reaches a max. at D*, the optimal amount of borrowing. WACC* is minimized at D*/E*
THE PECKING-ORDER THEORY 1) Internal financing; 2) Debt; 3) Equity Consequences of Financial Distress 1. Business Failure; 2. Legal bankruptcy; 3. Technical Insolvency; 4. Accounting Insolvency LIQUIDATION & REORGANIZATION Liquidation – termination of the firm as a going concern | Reorganization – financial restructuring of a failing firm to attempt to continue operations CHAPTER 17 – DIVIDENDS & DIVIDEND POLICY Cash Dividend – made quarterly Dividend Yield = Annual Div / Stock Price (% market price) | Payout Ratio = Annual Div/EPS (% EPS) | Plowback Ratio = 1 – Payout Ratio Stock Dividend - new shares of stock to SH as a dividend instead of cash; increase # of o/s shares Special/Extra Dividends - firms with excess cash payout large dividends Stock Repurchase - often used when firm has large amount of excess cash on hand Dividend Payment Chronology Declaration Date: board declares the dividend & it becomes a liability of the firm *Ex-Dividend Date: 2 business days before date of record (if you buy stock ON or AFTER this date, you will NOT receive the dividend). Stock price drops by amount of the dividend *Date of Record: Holders of record determined Date of Payment: Cheques are mailed Dividends vs Dividend Policy Dividends MATTER – value of stock is based on PV of expected future divs. Higher div > lower div. Stock price rise if div/share rise & held constant Dividend Policy may NOT matter – If firm reinvests now, it grows & can pay higher divs later Homemade Dividends - form of investment income that comes from sale of a portion of shares held by a SH | differs from divs that a SH receive from company according to # of shares the SH has. Investors can undo firm’s div policy by reinvesting divs OR selling shares of stocks Alternatives to Paying a Dividend Select additional projects; Repurchase shares; Acquire other companies; Buy financial assets Dividends & Signals Increases: - higher div can be sustained Decreases: - no longer sustain the current div Clientele effect – stocks attract particular groups based on dividend yield and resulting tax effects Residual Dividend Policy - Firms pay div only after meeting investment needs and maintaining D/E ratio Step 1: Determine funds that can be generated without selling new equity Step 2: Find capital structure and decide whether or not to pay dividends. If funds needed exceeds funds available, then no div. Stock Splits Ex. a 2 for 1 stock split for every 1 share, receive 1 more (2-1)|Stock price reduced when stock splits IMPORTANT FORMULAS - Equity Multiplier = Total Assets / Total Equity - Equity Multiplier = 1 + D/E ROA = Net Income / Assets |ROE = Net Income / Total Equity | P/E Ratio = Price per share / EPS - EAR = [1 + (quoted rate/m)]m – 1 - # of New Shares = Funds to be raised / Subscription price - Price of a stock = P0 = D1/r – g where D1 = D0(1+g) NPV = Initial cost – PV(FCF) – PV(sal.) – PVCCATS Profitability Index = PV Cash Inflow/PV Cash Outflows
CHAPTER 15: RAISING CAPITAL Types of new issues: - Venture Capital - Public Issue (thru IPO) - General cash offer (issue on cash basis) - Rights offer (issue first offered to current SH) Procedure for New Issue 1) Board approval and red herring prospectus 2) Final prospectus with OSC approval 3) Pricing Initial Public Offering (IPO): first issue to the public Seasoned new offering: new issue from firm already previously issuing securities Syndicate: group of underwriters; help sell an issue Spread: difference btw the underwriter’s buying price and offering price. i.e. their compensation TYPES OF UNDERWRITING Regular underwriting: purchase of securities from the issuing company by an investment banker for resale to public. Market out clause gives the group the option decline the issue if the price drops. Firm commitment underwriting: underwriter buys the entire issue, assuming full responsibility for any unsold shares Best efforts underwriting: Underwriters sells as many of the issue as possible, but can return any unsold shares to the issuer. Bought Deal: One underwriter buys securities and sells them directly to a small group of investors Dutch auction underwriting: Offer price is set based on competitive bidding by investors Overallotment option: provision that permits syndicate members to purchase additional shares at the original offering price. Lockup Agreement: specifies how long insiders must wait after IPO before selling stock. i.e. 6 mths Quiet Period: 40 days after IPO – limited comm. Cost of Issuing New Securities: 1) Spread; 2) Other Direct costs; 3) Indirect costs; 4) Abnormal returns; 5) Underpricing; 6) overallotment option RIGHTS - Issue of common stock offered to existing shareholders Each shareholder has one right for every share. Number of new shares to be issued = Funds to be raised / subscription price Number of rights needed to buy one share = # of old shares / # of new shares Value of a right = R0 = (M0 – S)/(N + 1) Where M0 = common share price, S = subscription price, N = number of rights required to buy one new share EX-RIGHTS: Period when stock is selling without a recently declared right, normally 2 days before holder-of-record date. Value of ex-rights = RE = (ME – S) / N Where ME = M0 – R0 = CS price during ex-rights OR: Ex-Rights Price = PX = V / (new # of o/s shares) DILUTION – loss in existing SH value Percentage ownership – shares sold to the general public without a rights offering Market value – firm accepts negative NPV projects Book value and EPS – occurs when market-to-book value is less than one CHAPTER 23: MERGERS AND ACQUISITIONS Legal forms of acquisitions: 1) Merger or consolidation 2) Acquisition of stock 3) Acquisition of assets Merger: One firm acquiring another
Consolidation: Entirely new firm is created from combination of existing firms Tender offer: public offer to buy shares Circular bid: Takeover bid communicated to SH by direct mail | Stock exchange bid: Takeover bid communicated to SH via a stock exchange (TSX) Horizontal: Both firms are in the same industry Vertical: Firms are different stages of the production process Conglomerate: Firms are unrelated Proxy Contests: seeking SH votes to replace mgmt. Going-private: all equity repurchased from public Leveraged buyouts (LBO): going private transactions where large % of $ used is borrowed Tax-free = No cash involved (only stocks) Fair Market Value = Net Fixed Assets + NWC Goodwill = Acquisition Price – Fair Market Value SYNERGY: VAB > VA + VB | ∆V = VAB – (VA + VB) Value of Firm B to Firm A = VB* = ∆V + VB VB* can be determined by estimating VB and estimating ∆V (find ∆CF for Firm B) ∆CF = ∆EBIT + ∆Depreciation - ∆Tax - ∆Capital requirements Revenue Enhancement: 1) Marketing Gains; 2) Strategic Benefits; 3) Market Power Cost Reductions: 1) Economies of Scale; 2) Economies of Vertical Integration; 3) Complementary Resources Tax Gains: 1) Net Operating Losses; 2) Unused Debt; 3) Surplus funds; 4) Asset Write-ups EPS Growth: EPS = EA + EB / OSA + (OSA /Exchange ratio) CASH ACQUISITION NPV of cash acquisition: NPV = VB* – cash cost Value of combined firm: VAB = VA + (VB* – cost) STOCK ACQUISITION NPV of stock acquisition: NPV = VB* – cost Value of combined firm: VAB = VA + VB + V Defense Tactics for Mergers 1) Control block & corporate charter 2) Greenmail/standstill agreements (targeted stock repurchases) 3) Exclusionary offers 4) Poison pills & SH rights plans 5) Leveraged buyouts (LBO) 6) Golden parachutes, crown jewels, white knights CHAPTER 24: RISK MANAGEMENT Hedging: reducing a firm’s exposure to price or rate fluctuations Types of volatility: Interest Rate, Exchange Rate, Commodity Price Risk profile: Graph showing the relationship between changes in price vs changes in firm value Hedging short run = transactions exposure Hedging long run = economic exposure Forward contract: A contract where two parties agree on the price of an asset today to be delivered and paid for at some future date Long position – agreeing to buy the asset at the future date (buyer) Short position – agreeing to sell the asset at the future date (seller) Payoff profile: Plot showing gains and losses that will occur on a contract because of unexpected price changes. Hedging eliminates price risk. Futures contract: forward contract where gains and losses are realized each day. Hedging eliminates credit risk. Cross hedging is hedging a
related asset; Basis risk is prices not moving directly with cash price CHAPTER 25: OPTIONS & CORPORATE SECURITIES Call option: right to buy an asset* Put option: right to sell an asset* *Trading usually in multiples of 100 shares C1 = 0 if S1 ≤ E AND C1 = S1 – E if S1 > E t Call Option Value = C0 = S0 – E/(1 + Rf) Call options: In the money: S > E Out of the money: S < E Put options: In the money: S < E Out of the money: S > E Buyer of a Call Option: Payoff/Value = S – E Profit = S – E – C, C = Call premium Seller of a Call Option: Payoff = -(S - E) Profit = C – (S – E) Buyer of a Put Option: Payoff = E – S Profit = E – S – P, P = Put premium Seller of a Put Option: Payoff = -(E – S) Profit = P – (E – S) *S = underlying asset price, S1 = stock price at expiration, S0 = stock proce today, E = Strike price, C1 = Value of call option on expiration, C0 = Value of call option today, Option value = Intrinsic Value + Time Value Intrinsic Value (lower bound) = Max (0 or S – E) Time Value: =0 at expiration date Time Value = Option Price – Intrinsic Value WARRANTS Value of a Warrant = Bond Face value – PV of bond / number of warrants Warrants affect firm value New Value of firm = Value of asset + new contribution from exercised warrant Warrants add more o/s shares to the firm, where options don’t. This happens when warrants and convertible bonds are exercised. Warrants can dilute the stock price and EPS CONVERTIBLE BONDS Bonds that can be exchanged for a fixed number of shares of stock for a specified amount of time. Conversion price: The effective price paid for the stock; the dollar amount of a bond’s par value that is exchangeable for one share of stock Conversion ratio: The number of shares received when the bond is converted Conversion premium: The difference between conversion price and current stock price divided by the current stock price Straight Bond Value: Price of a bond (use CALC) Floor Value: Convertible bonds will be worth at least as much as the straight bond value or the conversion value, whichever is greater Conversion Ratio = Bond Face Value / Conversion price Conversion Value = current stock price x conversion ratio Conversion Premium = Conversion Price – Current Stock Price / Current Stock Price
