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Goals and Governance of the Corporation:

The Investment (Capital Budgeting) Decision:

Investment decision are also called capital budgeting or capital expenditure (CAPEX) decisions.

Decision to invest in tangible assets (assets that you can touch) or intangible assets (involve
intangible assets, such as research and development (R&D), advertising, and the design of
computer software).

The investment decision is the most important of the firm’s three major decisions when it comes
to value creation. It begins with a determination of the total amount of assets needed to be held
by the firm. Picture the firm’s balance sheet in your mind for a moment. Imagine liabilities and
owners’ equity being listed on the right side of the balance sheet and its assets on the left. The
financial manager needs to determine the dollar amount that appears above the double lines on
the left-hand side of the balance sheet – that is, the size of the firm. Even when this number is
known, the composition of the assets must still be decided.

The Financing Decision:

The financial manager’s second main responsibility is to raise the money that the firm requires
for its investments and operations. This is the financing decision. When a company needs to raise
money, it can invite investors to put up cash in exchange for a share of future profits, or it can
promise to pay back the investors’ cash plus a fixed rate of interest.

In the first case, the investors receive shares of stock and become shareholders, part-owners of
the corporation. The investors in this case are referred to as equity investors, who contribute
equity financing.

In the second case, the investors are lenders, that is, debt investors, who one day must be repaid.
The choice between debt and equity financing is often called the capital structure decision. Here
“capital” refers to the firm’s sources of long-term financing.

A firm that is seeking to raise long- term financing is said to be “raising capital.” Notice the
essential difference between the investment and financing decisions. When the firm invests, it
acquires real assets, which are then used to produce the firm’s goods and services. The firm
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finances its investment in real assets by issuing financial assets to investors. A share of stock is a
financial asset, which has value as a claim on the firm’s real assets and on the income that those
assets will produce.
 The second major decision of the firm is the financing decision. Here the financial
manager is concerned with the makeup of the right-hand side of the balance sheet. If you
look at the mix of financing for firms across industries, you will see marked differences.
Some firms have relatively large amounts of debt, whereas others are almost debt free.
Dividend-payout ratio

Annual cash dividends divided by annual earnings; or, alternatively, dividends per share
divided by earnings per share. The ratio indicates the percentage of a company’s earnings
that is paid out to shareholders in cash

Asset Management Decisions:

 Efficiently managing the assets so acquired and financed

 Financial managers are more concerned with management of current assets

 Management of Fixed assets, at large, is the responsibility of operating mangers.

Forms of business:
There are four basic forms of business organization:

• Sole Proprietorships

• Partnerships (general and limited)

• Corporations

• Limited liability companies

• Sole Proprietorship – A business form for which there is one owner. This single owner
has unlimited liability for all debts of the firm.

• Oldest form of business organization.

• Business income is accounted for on your personal income tax form.

Advantages

• Simplicity

• Low setup cost

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• Quick setup

• Single tax filing on individual form

Disadvantages

• Unlimited liability

• Hard to raise additional capital

• Transfer of ownership difficulties

• Partnership – A business form in which two or more individuals act as owners.

• Business income is accounted for on each partner’s personal income tax form.

• Formed under Partnership act 1932

Types of Partnerships
General Partnership – all partners have unlimited liability and are liable for all
obligations of the partnership.

Limited Partnership – limited partners have liability limited to their capital contribution
(investors only). At least one general partner is required and all general partners have
unlimited liability.

Advantages

• Can be simple

• Low setup cost, higher than sole proprietorship

• Relatively quick setup

• Limited liability for limited partners

Disadvantages

• Unlimited liability for the general partner

• Difficult to raise additional capital, but easier than sole proprietorship

• Transfer of ownership difficulties

• Corporation – A business form legally separate from its owners.

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• An artificial entity that can own assets and incur liabilities.

• Business income is accounted for on the income tax form of the corporation.

Advantages

• Limited liability

• Easy transfer of ownership

• Unlimited life

• Easier to raise large quantities of capital

Disadvantages

• Double taxation

• More difficult to establish

• More expensive to set up and maintain

• Limited Liability Companies – A business form that provides its owners (called
“members”) with corporate-style limited personal liability and the federal-tax treatment
of a partnership.

• Business income is accounted for on each “member’s” individual income tax form.

Advantages

• Limited liability

• Eliminates double taxation

• No restriction on number or type of owners

• Easier to raise additional capital

Disadvantages

• Limited life (generally)

• Transfer of ownership difficulties (generally)

s
Who Is the Financial Manager?
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We can start with financial managers’ job titles. Most large corporations have a

Chief financial officer (CFO):

Who oversees the work of all financial staff .the CFO is deeply involved in financial
policy and financial planning and is in constant contact with the chief executive officer
(CEO) and other top management. The CFO is the most important financial voice of the
corporation and explains earnings results and forecasts to investors and the media.

Below the CFO are usually a

Treasurer:
The treasurer looks after the firm’s cash, raises new capital, and maintains relationships
with banks and other investors that hold the firm’s securities.

Controller:
The controller prepares the financial statements, manages the firm’s internal budgets and
accounting, and looks after its tax affairs.

Goals of the Corporation:

 Maximize sales

 Maximize profits

 Minimize risks

 Maximize wealth of shareholders.

Agency Problems, Executive Compensation, and Corporate Governance Agency

problem
Managers are agents for stockholders and are tempted to act in their own interests rather
than maximizing value.

Agency cost
Value lost from agency problems or from the cost of mitigating agency problems.

Stakeholder:
Anyone With a financial interest in the corporation.
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Executive Compensation:
The compensation packages of top executives are almost always tied to the financial
performance of their companies. The package typically includes a fixed base salary plus
an annual award tied to earnings or other measures of financial performance. The more
senior the manager,the smaller the base salary as a fraction of total compensation. Also,
compensation is not all in cash, but partly in shares. The shares are usually restricted
stock, which the manager is required to hold onto while employed by the corporation.
Many corporations also include stock options in compensation packages.

Corporate governance:
The laws, regulations ,institutions, and corporate practices that protect shareholders and
other investors.

Boards of Directors:

The board of directors appoints top managers, including the CEO and CFO, and must
approve important financial decisions.

Introduction to Corporate Finance

➢ Creating value with financing decisions
➢ Pattern of corporate financing
➢ Common stock

Chapter 14 Ownership of the corporation

Voting procedures
Classes of stock
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➢ Preferred stock
➢ Corporate debt
➢ Convertible securities

Creating Value with Financing Decisions

The financial manager’s second main responsibility is to raise the money that the firm
requires for its investments and operations that could increase shareholders value.
Investment decisions are also called capital budgeting or capital expenditure (CAPEX)
decisions.

Just like all investment decision does not succeed, there are no free guarantees in finance.
But you can tilt the odds in your favor if you learn the tools of investment analysis and
apply them intelligently.

In some ways, financing decisions are less important than investment decisions.

Financial managers say that “value comes mainly from the investment side of the balance sheet.”
Also, the most successful corporations sometimes have the simplest financing strategies.

Where did this market value come from? It came from organizations products, from its brand
name and worldwide customer base, from its R&D, and from its ability to make profitable future
investments.

It did not come from sophisticated financing. Some organization financing strategy is very
simple: It finances almost all investment by retaining and reinvesting operating cash flow.

Financing decisions may not add much value compared to good investment decisions, but they
can destroy value if they are stupid or ambushed by bad news.

Patterns of Corporate Financing

Firms have three broad sources of cash:

They can plow back part of their profits, or they can raise money externally by an issue of either
shares or debt.
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➢ The firm’s capital provided by the sale of shares. ➢ The issues of

long- or short-term debt.
➢ The contribution from internally generated fund (defined as
depreciation plus earnings that are not paid out as dividends),

Mostly the largest sources of cash for companies came from plowing back of profits.

The gap between this internally generated cash and the cash that the company needs is called the
financial deficit.

To make up the deficit, the company must either sell new equity or borrow.

However, some companies use cash to buy back shares that had been issued earlier.

Some companies rely on debt while other almost entirely on internal funds and have no debt.

Common Stock ;

Common stock is one of the different sources of finance for organizations. In large companies,
hundreds of thousands of different investors, each of whom holds a number of shares of common
stock. These investors are known as shareholders, or stockholders.

Treasury stock: Stock that has been repurchased by the company and is held in its treasury.
Treasury shares are said to be issued but not outstanding.

Issued shares: Shares that have been issued by the company and held by investors are said to be
issued and outstanding shares.

Outstanding shares: Shares that have been issued by the company and are held by investors.

Authorized share capital: Maximum number of shares that the company is permitted to issue
without shareholder approval is known as authorized share capital. A company can not issue
more than it without the approval of the current shareholders.

Par Value: The price at which each share is recorded in company accounts is known as its par
value.
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Additional paid-in capital: The price at which new shares are sold to investors almost always
exceeds par value and the difference between issue price and par value of stock. Also called
capital surplus.

Retained earnings: Earnings not paid out as dividends. Besides buying new stock, shareholders
also indirectly contribute new capital to the firm whenever profits that could be paid out as
dividends are instead plowed back into the company.

Net Common Equity: The sum of the par value, additional paid-in capital, and retained
earnings, less repurchased stock and some miscellaneous other adjustments, is known as the net
common equity of the firm. It equals the total amount contributed directly by shareholders when
the firm issued new stock and indirectly when it plowed back part of its earnings.

Ownership of the Corporation

A corporation is owned by its common stockholders.

Some of this common stock is held directly by individual investors, but the greater proportion
belongs to financial institutions such as mutual funds, pension funds, and insurance companies.

Shareholders have the following rights:

➢ They are entitled to profits.

➢ They have ultimate control over the company decisions.
➢ To vote on appointments to the board of directors.

The board of directors is supposed to represent the shareholders’ interests.

The board appoints and oversees management and must vote to approve important financial
decisions, including major capital investments, payment of dividends, share repurchase
programs, and new stock issues.

For public companies, the board usually includes the CEO, perhaps one or two other members of
top management, and outside directors, who are not employees.

A majority of the board consist of independent outside directors.

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The CEO has traditionally also served as the chair of the board.

Voting Procedures

In most companies, stockholders elect directors by a system of majority voting.

Majority voting: Voting system in which each director is voted on separately and stockholders
can cast one vote for each share they own.

In some companies, directors are elected by cumulative voting.

Cumulative voting: Voting system in which all the votes a shareholder is allowed to cast can be
cast for one candidate for the board of directors.

Shareholders can either vote in person or appoint a proxy to vote.

Proxy contest: Takeover attempt in which outsiders compete with management for shareholders’
votes.

Classes of Stock

Companies have one class of common stock and each share has one vote.

However, a firm may have two classes of stock outstanding, which differ in their right to vote.

➢ The A shares, which were sold to the public, had 1 vote each, while the B shares, which
were owned by the founders, had 10 votes each.
➢ Both classes of shares had the same cash-flow rights, but they had different control rights.
Preferred Stock

Preferred stock: Stock that takes priority over common stock in regard to dividends.

The sum of a company’s common equity and preferred stock is known as its net worth.

➢ Preferred stock promises a series of fixed payments to the investor

➢ They have preference in payment of dividend than common stockholders.
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➢ In case of liquidation, they get in the queue after the debtholders but before the common
stockholders.
➢ Preferred stockholders have no voting privileges.
➢ Like common stock dividends, preferred dividends are paid after-tax income.
➢ It is no surprise that most preferred shares are held by corporations.

Floating-rate preferred: Preferred stock for which the dividend rate is linked to current market
interest rates.

Corporate Debt

When Company borrow money, they promise to make regular interest payments and to repay the
principal (i.e., the original amount borrowed).

However, due limited liability, this promise is not always kept, they get the residual of the
company.

➢ They don’t normally have any voting power.

➢ Interest on debt is regarded as a cost and are therefore deducted from taxable income.
➢ This tax subsidy is given only on the use of debt, and are not provided on stock.

The major distinguishing characteristics.

Interest Rate The interest payment, or coupon, on most long-term loans is fixed at the time of
issue.

If a $1,000 bond is issued with a coupon of 10%, the firm continues to pay $100 a year regardless
of how interest rates change.

Zero-Coupon bonds: A zero-coupon bond is a bond that pays no interest and trades at a
discount to its face value.

Floating Interest Rate: A floating interest rate is an interest rate that moves up and down with
the market or an index. It can vary over the duration of the debt obligation. It is tied with prime
rate or LIBOR.
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Prime rate is the interest rate that banks charge their preferred customers, or those with the
highest credit ratings.

LIBOR (London Interbank Offered Rate) is the benchmark interest rate at which major global
banks lend to one another.

KIBOR Karachi Inter Bank Offer Rates is the average interest rate at which banks want to lend
money to other banks.

Maturity: The maturity (termination or due) date is the date on which the principal amount of a
note, draft, acceptance bond or other debt instrument becomes due.

Funded (Long-term) debt is any debt repayable more than 1 year from the date of issue.

Unfunded (short-term) debt is debt due in less than a year and is carried on the balance sheet as
a current liability.

Perpetual bonds, also known as perps or consol bonds, are bonds with no maturity date.

Repayment Provisions: The repayment provision of a debt outlines exactly the payment plan for
the loan.

A sinking fund is an account containing money set aside to pay off a debt or bond. Sinking
funds may help pay off the debt at maturity or assist in buying back bonds on the open market.

A callable bond, also known as a redeemable bond, is a bond that the issuer may redeem before
it reaches the stated maturity date.

Country and Currency: Nowadays, companies can borrow in the national as well as in the
international capital market to finance their operations throughout the world. A company can
either borrow dollars from a bank in the host country or borrow dollars from a bank in foreign.
Alternatively, it can sell the bonds to investors in several countries.

Eurodollars refers to a time deposit account that is denominated in U.S. dollars and held in
foreign banks.

Similarly, yen held outside Japan were termed euro yen.

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A Eurobond is a debt instrument that's denominated in a currency other than the home currency
of the country or market in which it is issued.

Public versus Private Placements:

Publicly (Initial Public Offering, IPO) issued bonds are sold to anyone who wishes to buy, and
once they have been issued, they can be freely traded in the securities markets.

Private placement offerings are securities released for sale only to small number of investors
such as investment banks, pensions, or mutual funds.

A Debt by Any Other Name:

Companies also arrange finances that look like debt but treated differently in accounts, for
example:

Accounts payable are simply obligations to pay for goods that have already been delivered and
are, therefore, like a short-term debt.

Instead of borrowing money to buy equipment, many companies lease or rent it on a long-term
basis. The firm promises to make a series of payments to the lessor (the owner of the equipment).

Postretirement health benefits and pension promises can also be huge liabilities for firms.
That is a debt the company will eventually need to pay.

Innovation in the Debt Market

Two examples of innovative bonds.

Asset-Backed Bonds: Instead of borrowing money directly, companies sometimes bundle a

group of loans and then sell the cash flows from these loans. This issue is known as an
assetbacked bond.

For example, automobile loans, student loans, and credit card receivables have all been bundled
together and remarketed as asset-backed bonds. However, by far the most common application
has been in the field of mortgage lending.
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Collateralized debt obligations (CDO) are debt instruments, like mortgages, bundled together
to create a new type of asset-backed security that can be traded or split. In other words, these are
groups of receivables that are insured with an asset.

Mortality Bonds: Managers of life insurance companies agonize about the possibility of a
pandemic or other disaster that results in a sharp increase in the death rate. In 2015, the French
insurance company Axa sought to protect itself against this danger by issuing €285 million of
mortality bonds. Axa’s unusual bonds offer a tempting yield, but if mortality rates in the United
States, France, and Japan exceed a predetermined threshold, the investors’ funds are used to help
pay Axa’s life insurance obligations. So, the investors are in a way betting that people will die on
schedule.

Convertible Securities

Convertible security is a bond/preferred stock that can be exchanged or converted into a

specific number of shares of the issuer's common stock.

Warrant: Right to buy shares from a company at a stipulated price before a set date.

A convertible bond gives its owner the option to exchange the bond for a predetermined number
of common shares.

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How Corporation Raise Venture Capital and Issue Securities
Venture Capital

The initial public offering

➢ Arranging a public issue

➢ Other new issue procedures
➢ The underwriters
General cash offer by public companies
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➢ General cash offer and shelf registration

Chapter 15 ➢ Cost of the general cash offer
➢ Market reaction to stock issues
The Private placement

Venture capital: Money invested to finance a new firm.

Equity capital in young businesses is known as venture capital, which is provided by specialist
venture capital firms, wealthy individuals, investment institutions such as pension funds, and
sometimes mature corporations on the hunt for new technology or new products.

Specialist venture capital (or “VC”) firms are the most likely source if your start-up is high risk
and high tech.

It is as hard to convince a venture capitalist to invest in your business.

The first step is to prepare a business plan.

This describes your product, the potential market, the production method, and the resources,
time, money, employees, plant, and equipment needed for success.

It helps if you can point to the fact that you are prepared to put your money where your mouth is.

By staking all your savings in the company, you signal your faith in the business.

The venture capital company knows that the success of a new business depends on the effort its
managers put in.

Therefore, it will try to structure any deal so that you have a strong incentive to work hard.

You are unlikely to persuade a venture capitalist to give you several years of financing all at
once.

Venture capital is rarely disbursed in one large sum payment, but instead is paid to the firm in
stages. Each stage is usually just enough to guide the firm towards its next major checkpoint.
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Example: Suppose a Venture Capital firm offers to purchase 1 million of your firm’s shares for
$.50 each, which will give them 50% ownership in the firm.

This will give the VC one-half ownership of the firm: It owns 1 million shares, and you own 1
million shares.

Because the venture capitalist is paying $500,000 for a claim to half your firm, it is placing a $1
million value on the business.

After this first-stage financing, your company’s balance sheet looks like this:

2nd Stage: Receive subsequent staged financing

After two years, you need further financing might involve the issue of a further 1 million shares
at $1 each.

Some of these shares might be bought by the original VC firm and some by other venture capital
firms.

The balance sheet after the new financing would then be as follows:
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The value of your initial investment raises to 1 million and because of your success new
investors are prepared to pay $1 to buy a share in the business.

If you could not succeed, the venture capital firm could have refused to put up more funds.

The second-stage investors have paid $1 million for a one-third share in the company.

Venture Capital Companies

Angel Investors: Investors/wealthy individuals who finance firms in their earliest stages of
growth.

Corporate Ventures: Corporations/ large technology firm that offer venture assistance to
finance young and innovative companies. For example, over the past 20 years Intel has invested
in more than 1,300 firms in 56 countries.

Crowdfunding: Some new companies have also used the web to raise money from small
investors. This development, known as crowdfunding

Private Equity Investing: Venture capital partnerships provide funds for companies in distress
or that buy out whole companies and then take them private. The general term for these activities
is private equity investing.

Two rules of success in Venture capital investment:

First, don’t shy away from uncertainty; accept a low probability of success. But don’t buy into a
business unless you can see the chance of a big, public company in a profitable market. There’s
no sense taking a big risk unless the reward is big if you win.

Second, cut your losses; identify losers early, and if you can’t fix the problem—by replacing
management, for example—don’t throw good money after bad.
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There’s an old saying in the venture capital business: “The secret of success in VC is not picking
winners, but shutting down the losers before you spend too much money on them.

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The Initial Public Offering

When a firm requires more capital than private investors can provide, it can choose to go public
through an Initial Public Offering (IPO).

➢ Primary Offering: when new shares are sold to raise additional cash for the company.
➢ Secondary Offering: When the company’s founders and venture capitalists cash in on
some of their gains by selling shares. But it does not flow to the company.

Benefits of Going Public:

➢ Enable the existing shareholders to cash out

➢ Ability to raise new capital
➢ Stock price provides performance measure.
➢ Information more widely available ➢ Diversified source of finance.
➢ Reduced borrowing costs.

Arranging Public Issues: Steps to a new public security.

1. SEC Registration: Before any stock can be sold to the public, the company must register
the issue with the Securities and Exchange Commission (SEC).
a. Prospectus – a formal summary that provides information on an issue of securities

2. Select Underwriter/ Undertake Road show: The road show attempts to gauge the
interest that potential investors would have in purchasing the new securities.
If enough public interest, the underwriters issue shares to the public.
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Typically, underwriter underprice shares upon issue.

Underpricing – Issuing securities at an offering price set below the true value of
the security.
3. Set final issue price for public.

Underwriter: Firm that buys an issue of securities from a company & resells it to the
public.

Underwriters are investment banking firms that act as financial midwives to a new issue.

Usually they play a triple role:

➢ first providing the company with procedural and financial advice,

➢ then buying the stock, and
➢ finally reselling it to the public.

Underwriter Spread:

Spread – the difference between the public offer price and the price paid by underwriter.

Example: Assume the issuing company incurs $1 million in expenses to sell 3 million shares at
$40 each to an underwriter; the underwriter sells the shares at $43 each. What is the spread for
this deal?

3 million (443 - $40) = $9 million

Underwriting Arrangements

Firm Commitment: Underwriter buy the securities from the firm and then resell them to the
public.
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Best Efforts Commitment: Underwriters agrees to sell as much of the issue as possible but do
not guarantee the sale of the entire issue.

Underpricing of an IPO

Underpricing: Issuing securities at an offering price set below the true value of the security.

Example: Assume the issuer incurs $1 million in other expenses to sell 3 million shares at $40
each to an underwriter and the underwriter sells the shares at $43 each. By the end of the first
day’s trading, the issuing company’s stock price had risen to $70. What is the total cost of
underpricing?

Cost of Underpricing: 3 million ($70 - $43) = $81 million

Floatation Costs:

Flotation Costs: The costs incurred when firm issue new securities to the public.

Example: Direct Cost

➢ legal and administrative fees for preparation of the registration statement

➢ Prospectus cost
➢ Underwriting spread.

Direct Cost ➢ Underpricing

Other New-Issue Procedures

Book building method. The underwriters build up a book of likely orders, buy the issue from
the company at a discount, and then resell it to investors.

Open auction. In this case, investors are invited to submit their bids, stating both an offering
price and how many shares they wish to buy. The securities are then sold to the highest bidders.
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The Underwriters

➢ Underwriter are always there whenever a company wishes to raise cash by selling
securities to the public.
➢ Successful underwriting requires considerable experience and financial muscle.
➢ If a large issue fails to sell, the underwriters may be left with a loss of several hundred
million dollars.
➢ Underwriting is not always fun.
➢ Companies get to make only one IPO, but underwriters are in the business all the time.
➢ Wise underwriters will not handle an issue unless they believe the facts have been
presented fairly to investors.
➢ If a new issue goes wrong and the stock price crashes, the underwriters can find
themselves very unpopular with their clients.
➢ “spinning: allocating stock in popular new issues to managers of their important
corporate clients.

General Cash Offers by Public Companies

After the IPO, successful firms may raise money by issuing stock (equity) or bonds (debt).

Seasoned Offering: An issue of additional stock by a company whose stock already is publicly
traded is called a seasoned offering.

➢ Needs to be formally approved by the firm’s board of directors.

➢ Needs consent from shareholders if it requires increase in authorized capital.

Two method of Issue:

General Cash Offer: Sale of securities open to all investors by an already-public company.

Right Issue: Issue of securities offered only to current stockholders at an attractive price.

For example, if the current stock price is $100, the company might offer investors an additional
share at $50 for each share they hold.
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General Cash Offers and Shelf Registration

Shelf Registration: A procedure that allows firms to file one registration statement for several
issues of the same security.

Advantages of Shelf Registration:

➢ Security issuance without excessive costs.

➢ Security can be issued on short notice.
➢ Timed issuance to capitalize on favorable market conditions,
➢ The issuing firm can make sure that underwriters compete for its business.

Costs of the General Cash Offer

Following are the firm cost when it makes a cash offer:

➢ Administrative costs.
➢ Underwriter spread

Issue costs are higher for equity than for debt securities. This partly reflects the extra
administrative costs of an equity issue.

In addition, the underwriters demand extra compensation for the greater risk they take in buying
and reselling equity.

Market Reaction to Stock Issues

➢ Issue of new stock in large depress the stock price.
➢ If stock price fall is due to increased supply, then that stock would offer a higher return
than comparable stocks.
➢ However, economist found that the announcement of the issue does result in a decline in
the stock price.

Manager have more information than investors:

If stock undervalued: will benefit new shareholders at the expense of the old shareholders.

If stock is overvalued: Will benefit existing shareholders at the expense of the new ones.
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Investor predict that managers issue stock when they think it is overvalued and mark the price of
the stock down accordingly.

Decrease in stock price have noting to do with increase with increased supply, but signal
that well-informed mangers believe the market has overpriced the stock.

The Private Placement

In order to avoid registering with the SEC, a company can issue a security privately.

Private Placement: the sale of securities to a limited number of investors without a public
offering.

Advantages:

➢ Do not have to register with SEC

➢ Private placements cost less than public issues.
➢ Contracts can be customized for each investor

Disadvantages:

➢ Difficult for investors to resell security.

➢ Lenders often require higher return to compensate for higher risk.

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Financial markets and institutions

The importance of financial markets and institutions
The flow of savings to corporations
The stock markets
Other financial markets
Financial intermediaries
Financial institutions
Chapter Total financing of U.S. corporations
Functions of financial markets and intermediaries
2 Transferring cash across time
Risk transfer and diversification
Liquidity
The payment mechanism
Information provided by financial markets

The Importance of Financial Markets and Institutions

➢ All corporations face important investment and financing decisions.

➢ These decisions are made in financial environment which have two main segments:
financial markets and financial institutions.
➢ Businesses have to go to financial markets and institutions for the financing they need
to grow.
➢ When they have a surplus of cash, and no need for immediate financing, they have to
invest the cash in bank accounts or in securities.
➢ A modern financial system offers financing in many different forms, depending on the
company’s age, its growth rate, and the nature of its business.

Direct and Indirect Finance:

Fund can be raised directly (direct finance) or indirectly (indirect finance)
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➢ Direct finance refers to funds that flow directly from the lender/saver to the
borrowers/investors in financial market.
➢ Indirect finance refers to funds that flow from the lender/saver to a financial
intermediary who then channels the funds to the borrower/ investor. Financial
intermediaries (indirect finance) are the major source of funds for corporations.

The Flow of Savings to Corporations

➢ The money that corporations invest in real assets comes from savings by investors. But
there can be many stops on the road between savings and corporate investment. The
road can pass through financial markets, financial intermediaries, or both.
➢ Reinvestment means additional savings by existing shareholders.
➢ The reinvested cash could have been paid out to those shareholders and spent by them
on personal consumption.
➢ By not taking and spending the cash, shareholders have reinvested their savings in the
corporation.
➢ Cash retained and reinvested in the firm’s operations is cash saved and invested on
behalf of the firm’s shareholders.
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➢ Flow of savings to investment in a closely held corporation.

➢ Investors use savings to buy additional shares.
➢ Investors also save when the corporation reinvests on their behalf

Flow of savings to large public corporations:

1. Public corporations can draw savings from investors worldwide (Direct Finance).
2. The savings flow through financial markets, financial intermediaries (Indirect Finance), or
both.
3. The corporation also reinvests on shareholder’s behalf.

The Stock Market

A financial market is a market where securities are issued and traded.

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➢ A security is just a traded financial asset, such as a share of stock.

➢ As corporations grow, their requirements for outside capital can expand dramatically.

➢ A firm will decide to “go public” by issuing shares on an organized exchange such as

the New York Stock Exchange (NYSE) or NASDAQ; with the first issue known as an

initial public offering (IPO).

➢ The buyers of the IPO are helping to finance the firm’s investment in real assets and

the buyers become part-owners of the firm and participate in its future success or

failure.

➢ A new issue of shares increases both the amount of cash held by the company and the

number of shares held by the public. Such an issue is known as a primary issue, and it

is sold in the primary market.

➢ Secondary market – is a market in which previously issued securities are traded

among investors.

➢ Stock markets are also called equity markets, since stockholders are said to own the

common equity of the firm.

Other Financial Markets

Debt securities as well as equities are traded in financial markets.

➢ A few corporate debt securities are traded on the NYSE and other exchanges, but most

corporate debt securities are traded over the counter, through a network of banks and

securities dealers.

➢ Government debt is also traded over the counter.

➢ A bond is a more complex security than a share of stock.

➢ A share is just a proportional ownership claim on the firm, with no definite maturity.
 P a g e | 29

➢ Bonds and other debt securities can vary in maturity, in the degree of protection or

collateral offered by the issuer, and in the level and timing of interest payments.

➢ Fixed-income market – is the market for debt securities.

➢ A corporation must not only decide between debt and equity finance.

➢ Capital market – is the market for long-term financing.

➢ Money markets – is a market for short-term financing, which is less than one year.

Corporations raise short-term financing in the money market by issues of commercial

paper, which are debt issues with maturities of no more than 270 days.

➢ Here are three examples of financial markets that financial managers encounter:

➢ Foreign exchange markets

➢ Commodities markets
➢ Markets for options and other derivatives
➢ Commodity and derivative markets are not sources of financing but markets where the

financial manager can adjust the firm’s exposure to various business risks.

➢ Wherever there is uncertainty, investors may be interested in trading, either to

speculator to lay off their risks, and a market may arise to meet that trading demand.

Financial Intermediaries

Financial intermediary – is an organization that raises money from investors and provides
financing for individuals, corporations, or other organizations.

➢ Intermediaries are a stop on the road between savings and real investment.
➢ Why is a financial intermediary different from a manufacturing corporation?
▪ It may raise money in different ways by taking deposits or selling
insurance policies.
▪ It invests that money in financial assets in stocks, bonds, or loans to
businesses or individuals.
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➢ A manufacturing company’s main investments are in plant, equipment, or other real

assets.

Mutual fund –is an investment company that pools the savings of many investors and invests
in a portfolio of securities.

➢ The investors’ money is pooled and invested in a portfolio of securities

➢ Mutual funds offer investors low-cost diversification and professional management.
For most investors, it’s more efficient to buy a mutual fund than to assemble a
diversified portfolio of stocks and bonds.
➢ Mutual fund managers also try their best to “beat the market”, to generate superior
performance by finding the stocks with better-than-average returns.
➢ In exchange for their services, the fund’s managers take out a management fee. ➢
Mutual funds are a stop on the road from savings to corporate investment.
➢ There are 8,000 mutual funds in the United States.

Hedge funds – are a private investment fund that pursues complex, high-risk investment

strategies.

➢ Hedge funds differ from mutual funds in at least two ways:

o Hedge funds usually follow complex, high-risk invest strategies, access is

usually restricted to knowledgeable investors such as pension funds,

endowment funds, and wealthy individuals.

o Hedge funds try to attract the most talented managers by compensating them

with potentially lucrative, performance-related fees.

➢ Mutual funds usually charge a fixed percentage of assets under management.

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➢ Hedge funds try to make a profit by identifying overvalued stocks or markets and

selling short.

➢ “Vulture funds” specialize in the securities of distressed corporations.

➢ Some hedge funds take bets on firms involved in merger negotiations, others look for

mispriced convertible bonds, and some take positions in currencies and interest rates.

➢ Hedge funds manage less money than mutual funds, but they sometimes take very big

positions and have a large impact on the market.

Pension fund – is the fund set up by an employer to provide for employees’ retirement.

➢ The most common type of pension plan is the defined-contribution plan.

➢ Pension funds are designed for long-run investment. They provide professional

management and diversification.

➢ They also have an important tax advantage: Contributions are tax-deductible, and

investment returns inside the plan are not taxed until cash is finally withdrawn.

Financial Institutions
Banks and insurance companies are financial institution.

➢ A financial institution is an intermediary that does more than just pool and invest
savings.
➢ Institutions raise financing in special ways by accepting deposits or selling insurance
policies, and they provide additional financial services.
➢ Unlike a mutual fund, they not only invest in securities but also lend money directly to
individuals, businesses, or other organizations.
Commercial Banks

➢ There are 6,300 commercial banks in the United States.

➢ Commercial banks are major sources of loans for corporations.
➢ The bank provides debt financing for the company and provides a place for depositors
to park their money safely and withdraw it as needed.
 P a g e | 32

Investment Banks
➢ Investment banks do not generally take deposits or make loans to companies.
➢ Investment banks advise and assist companies in obtaining finance.
➢ Investment banks also advise on takeovers, mergers, and acquisitions.
➢ They offer investment advice and manage investment portfolios for individual and
institutional investors.
➢ They run trading desks for foreign exchange, commodities, bonds, options, and
derivatives.
➢ Investment banks can invest their own money in start-ups and other ventures. ➢ The
largest investment banks are financial powerhouses. Insurance Companies
➢ Insurance companies are more important than banks for the long-term financing of
business.
➢ They are massive investors in corporate stocks and bonds, and they often make long-
term loans directly to corporations.
➢ The money to make the loan comes mainly from the sale of insurance policies.

Total Financing of U.S. Corporations

The pie chart given below shows the investors in bonds and other debt securities.

Holdings of corporate and foreign bonds, September 30, 2015. The total amount is $11.9
trillion.
 P a g e | 33

The pie chart given below shows holdings of the shares issued by U.S. corporations.

Holdings of corporate equities, September 30, 2015. The total amount is $34.1 trillion

The aggregate amounts is $11.9 trillion of debt and $34.1 trillion of equity behind
($34,100,000,000,000).

Functions of Financial Markets and Intermediaries

Financial markets and intermediaries provide financing for business. They channel savings to
real investment.
 P a g e | 34

1. Transporting Cash across Time

➢ Transport purchasing power to future periods (retirement funds).

➢ Transporting future income to present consumption.
➢ Financial markets and intermediaries channel fund from those who have surplus to
those with need. You may invest or borrow money.
➢ Lender transport money forward in time and borrowers transport it back.
➢ Firms, governments and even individual need money and search for those who have
surplus money to finance their expenditures.
➢ Similarly, individuals or firm with surpluses looking for counterparties with cash
shortages.
➢ But it is usually cheaper and more convenient to use financial markets and
intermediaries.

2. Risk Transfer and Diversification

➢ Financial markets and intermediaries allow investors and businesses to reduce and
reallocate risk.
➢ The insurance company allows you to pool risk with thousands of other.
➢ Index mutual funds are one way to invest in widely diversified portfolios at low cost.
➢ Another route is provided by exchange-traded funds (ETFs), which are portfolios of
stocks that can be bought or sold in a single trade.
➢ ETFs are in some ways more efficient than mutual funds.
➢ To buy or sell an ETF, you make a trade, just as if you bought or sold shares of stock.
➢ To invest is an open-end mutual fund, you have to send money to the fund in exchange
for newly issued shares.

3. Liquidity

❖ Markets and intermediaries provide liquidity, which is the ability to turn an investment
back into cash when needed.
❖ The shares of public companies are liquid because they are traded more or less
continuously in the stock market
❖ Foreign exchange markets for major currencies are exceptionally liquid.
 P a g e | 35

4. Payment Mechanism:
❖ Checking accounts, credit cards, and electronic transfers allow individuals and firms to
send and receive payments quickly and safely over long distances.
❖ Banks are the obvious providers of payment services, but they are not alone.
❖ For example, you may also write checks on your mutual fund investment just as if you
had a bank deposit.
5. Information provided by Financial Markets:
A continuous flow of information about economic levels, commodity prices, interest rates and
company stock prices aid the financial manager to make decisions that will best maximize the
log-run value of the corporation.

❖ Commodity Prices:
o The CFO can obtain information from markets by analyzing future prices and
can lock that price if he or she wishes.
❖ Interest Rates:
o CFO can determine interest on the issuance of long-term bonds by looking up
the interest rates on existing bonds traded in the financial markets.

(,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,)
 P a g e | 36

Debt Policy
How borrowing affects value in a tax-free economy
MM’s argument
How borrowing affects earnings per share
How borrowing affect risk and return
Debt and the cost of equity
Capital structure and corporate taxes
How interest tax shield contributes to the value of shareholder equity
Chapter Corporate taxes and the weighted average cost of capital

16 Cost of financial distress

Bankruptcy costs
Costs of bankruptcy vary with the type of asset
Financial distress without bankruptcy
Explaining financing choices
The trade-off theory
A pecking order theory

Introduction:

The goal of the business and the financial manager is to maximize the overall market value of all
securities issued by the firm.

The firm’s mix of securities is known as its capital structure.

Different financial managers use different methods of raising capital.

Some companies rely almost wholly on equity finance while other rely much more on debt
finance.

Capital structure is not immutable. Firms can change their capital structure.

Shareholders want management to choose the mix of securities that maximizes firm value.

But is there an optimal capital structure?

Median ratios of long-term debt to total capital, 2015

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How Borrowing Affects Value in a Tax-Free Economy

A company’s choice of capital structure does not increase the underlying value of the firm.

A firm’s capital structure is the mix of debt and equity its financial managers choose.

Does the choice of capital structure affect the value of a firm?

A simple balance sheet of a firm with all entries expressed as current market values:
Assets Liabilities & Stockholder’s
Equity Value of cash flows from firm’s real Market value of debt
assets and operations Market value of equity
Value of Firm Value of Firm

The right- and left-hand sides of a balance sheet are always equal.

The value of cash flows determines the value of the firm and determines the aggregate value of
all the firm’s outstanding debt and equity securities.

If the firm changes its capital structure by using more debt and less equity financing, overall
value should not change.

Modigliani and Miller (MM):

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Franco Modigliani and Merton Miller received Nobel Prizes for applying it to corporate
financing. Modigliani and Miller, always referred to as “MM,” showed in 1958 that the value of
a firm does not depend on how its cash flows are “sliced.”

 When there are no taxes and well-functioning capital markets exist, the market
value of a company does not depend on its capital structure.
 In other words, managers cannot increase firm value by changing the mix of
securities used to finance the company.

MM Assumptions:

 Capital markets have to be “well-functioning”

 Investors can trade securities without restrictions and can borrow/lend on the same terms
as the firms
 Capital markets are efficient, so securities are fairly priced given the information
available to investors.
 There are no taxes or costs of financial distress

However, the firm’s capital structure decision does matter if these assumptions are not true or if
other practical complications are encountered.

MM’s Argument (MM’s Irrelevance Proposition)

Example: An all-equity financed firm has 0.1 million shares outstanding, currently selling at $10
per share. It considers a restricting that would issue $5 million in debt to repurchase 500,000
shares. How does this affect overall firm values?

Restructuring – Process of changing the firm’s capital structuring without changing its real
assets.

Before Restructuring:

Value of Firm = Value of equity + Value of Debt = $10,00,000 + $0

i.e., Value of firm = $10,00,000

 P a g e | 39

Before Restructuring: Firm is entirely equity-financed & expects an income of $125,000 in

perpetuity, this income is not certain. This table shows the return to the stockholder under
different assumptions about operating income. Assume there are no taxes.

After Restructuring:

Debt outstanding = $ 500,000 Value of Equity = $500,000

i.e., Value of firm = $500,000 + $500,000 = $10,00,000

Note: In the example above, since the value of the firm is the same in both situations, common
shareholders are no better or worse off in either. So, Capital structure does not matter.

 Shares still trade at $10 each.

 Overall value of equity falls to $500,000 but shareholders also receive $500,000.

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How Borrowing Affects Earnings per Share

 Debt (borrowing) almost always increases earnings in good years and decrease
earnings in bad years.
 For example, firm issue $500,000 of debt at an interest rate of 10% and repurchase
50,000 shares. The return to shareholder under different assumptions are shown below
and are higher than if the firm were finance entirely on equity (in normal and boom
times but lower in slumps).
 P a g e | 40

 The earnings per share would vary if the company moves to equal proportions of debt
and equity.
 Borrowing increases firm earnings per share (EPS) when operating income is greater
than $100,000 but reduces it when operating income is less than $100,000. Expected
EPS rises from $1.25 to $1.50.

 But if shareholders borrow by borrowing on their own i.e., they can easily replicate a
firm’s borrowing on their own if they choose.
 Suppose firm has not restructured (does not borrow) and investor go to the bank, borrow
$10, and then invest $20 in two shares at $10 apiece. Such an investor would put up only
$10 of her own money.
 P a g e | 41

 This generates the same rates of return as given below.

 Now suppose, firm want to restructuring and investor, who owns two shares in the
company before the restructuring, buy one share in the restructured company and also
invest $10 in the firm’s debt.
 The returns vary with firm operating income and exactly the same as the investor got
before the restructuring.
 By lending half of his capital (by investing in firm debt), the investor exactly offsets the
company’s borrowing. So, if firm goes ahead and borrows, it won’t stop investors from
doing anything that they could previously do.”

This recreates MM’s original argument.

MM’s proposition I (debt irrelevance proposition): Under idealized conditions the value of a
firm is unaffected by its capital structure.

As long as investors can borrow or lend on their own account on the same terms as the firm, they
are not going to pay more for a firm that has borrowed on their behalf. The value of the firm
after the restructuring must be the same as before.
 P a g e | 42

How Borrowing Affects Risk and Return

Restructuring does not affect the size of the firm (pies) because the amount and risk of operating
income are unchanged (Total value equal to $ 1 million before and after restructuring).

Size does not change but shareholders expect to earn more than half of firm normal operating
income. They get more than half of the expected income “pie.”

Debt finance does not affect operating risk but it does add financial risk. With only half the equity
to absorb the same amount of operating risk, risk per share must double.

 Operating Risk/ Business Risk – Risk in firm’s operating income.

 Financial Risk – Risk to shareholders resulting from the use of debt.

Financial Leverage – debt financing to amplify the effects of changes in operating income on
the returns to shareholders.

The circles on the left assume “Firm” has no debt. The circles on the right reflect a
proposed restructuring that splits firm value 50-50. Shareholders get more than 50% of
expected operating income, but only because they bear additional financial risk.

Does that mean shareholders are better off? MM proposition say no. Why? Because shareholders
bear more risk.
 P a g e | 43

Issuance of debt increase financial risk for shareholders, so they expect a higher required return.
As, share price is equal to the expected dividend divided by the required return. The benefit from
the rise in dividends is exactly canceled out by the rise in the required return. The share price after
the debt issue exactly the same as before.

Thus, leverage increases the expected return to shareholders, but it also increases the risk. The two
effects cancel, leaving shareholder value unchanged.
-------------------------------------------------------------------------------------------------------------------
Debt and the Cost of Equity
 The cost of capital for firm having all equity finance is equal to expected return of
shareholders.
 This cost of equity capital, 𝑟𝑒𝑞𝑢𝑖𝑡𝑦 and also 𝑟𝑎𝑠𝑠𝑒𝑡𝑠, is the expected return and cost of capital

for the firm’s assets.

 After restructuring, the appropriate weighted average of 𝑟𝑑𝑒𝑏𝑡 and 𝑟𝑒𝑞𝑢𝑖𝑡𝑦 take you to

𝑟𝑎𝑠𝑠𝑒𝑡𝑠, the opportunity cost of capital for the company’s assets. The formula is

𝑟𝑎𝑠𝑠𝑒𝑡𝑠 = (𝑟𝑑𝑒𝑏𝑡 × 𝐷⁄𝑉) + (𝑟𝑒𝑞𝑢𝑖𝑡𝑦 × 𝐸⁄𝑉)

where D and E are the amounts of outstanding debt and equity and V equal the overall
firm value, the sum of D and E (all market values not book values).
 Since restructuring does not change operating earnings or firm value, it shouldn’t change
the cost of capital either.
The above formula match the weighted-average cost of capital (WACC) formula but ignoring
taxes.
MM’s (debt-irrelevance) proposition I: MM’s proposition I states that the firm’s choice of
capital structure does not affect the firm’s operating income or the value of its assets. So,𝑟𝑎𝑠𝑠𝑒𝑡𝑠
the expected return on the package of debt and equity, is unaffected.
 P a g e | 44

However, debt increases risk of the equity and the return that shareholders demand.
As, the expected return equity varies with debt, so by rearranging the above formula for the
company cost of capital as follows:

This in words says that:

MM’s Proposition II: the principal that the required rate of return on equity increases as the
firm’s debt-equity ratio increases
 A debt issue have both explicit cost and an implicit cost. Explicit cost of a debt issue is
the rate of interest charged on the firm’s debt. Debt also increases financial risk and
causes shareholders to demand a higher return on their investment.
 Once you recognize this implicit cost, debt is no cheaper than equity—the return that
investors require on their assets is unaffected by the firm’s borrowing decision.
 As the firm borrows more, the risk of default increases and the firm has to pay higher
rates of interest
The implications of MM’s proposition II: No matter how much the firm borrows, the expected
return on the package of debt and equity,𝑟𝑎𝑠𝑠𝑒𝑡𝑠, is unchanged, but the expected rate of return on
the separate parts of the package does change.
How is this possible? Because the proportions of debt and equity in the package are also
changing. More debt means that the cost of equity increases, but at the same time the amount of
equity is less.
In Figure given below, the rate of interest on the debt as constant no matter how much the firm
borrows. But at higher debt levels, lenders become concerned that they may not get their money
back and they demand higher rates of interest.

Graph: MM’s proposition II with a fixed interest rate on debt. The expected return on firm
equity rises in line with the debt-equity ratio. The weighted average of the expected returns on
debt and equity is constant, equal to the expected return on assets.
 P a g e | 45

When the firm borrows more, the risk of default increases and the firm has to pay higher rates of
interest. Proposition II continues to predict that the expected return on the package of debt and
equity does not change.
However, the slope of the 𝑟𝑒𝑞𝑢𝑖𝑡𝑦 line now tapers off as D/E increases. Why? Essentially because
holders of risky debt begin to bear part of the firm’s operating risk. As the firm borrows more,
more of that risk is transferred from stockholders to bondholders.
Figure: MM’s proposition II when debt is not risk free. As the debt-equity ratio increases,
debt-holders demand a higher expected rate of return to compensate for the risk of default. The
expected return on equity increases more slowly when debt is risky because the debt-holders
take on part of the risk. The expected return on the package of debt and equity,𝑟𝑎𝑠𝑠𝑒𝑡𝑠 remains
constant.
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Example: What is the expected return on equity for a firm with a 14% expected return on
assets that pays 9% on its debt, which totals 30% of assets?

𝑟𝑒𝑞𝑢𝑖𝑡𝑦 = 16.14%

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Q # 9: The common stock and debt of NS are valued at $70 million and $30 million,
respectively. Investors currently require a 16% return on the common stock and an 8%
return on the debt. If NS issues an additional $10 million of common stock and uses this
money to retire debt, what happens to the expected return on the stock? Assume that the
change in capital structure does not affect the interest rate on NS debt and that there are
no taxes.

Solution:

Data given: Common Equity = $70 Million Debt = $30 Million 𝑟𝑒𝑞𝑢𝑖𝑡𝑦 = 16%

𝑟𝑑𝑒𝑏𝑡 = 8%

𝑟𝑎𝑠𝑠𝑒𝑡𝑠 = (𝑟𝑑𝑒𝑏𝑡 × 𝐷⁄𝑉) + (𝑟𝑒𝑞𝑢𝑖𝑡𝑦 × 𝐸⁄𝑉)

30 70
𝑟𝑎𝑠𝑠𝑒𝑡𝑠 = (. 08 × ⁄100) + (.16 × ⁄100)

𝑟𝑎𝑠𝑠𝑒𝑡𝑠 = (. 024) + (.112) = .136 = 13.6%

After restructuring: Common Equity = 80 Million Debt = 20 Million 𝒓𝒆𝒒𝒖𝒊𝒕𝒚 = ?

 P a g e | 47

𝑟𝑒𝑞𝑢𝑖𝑡𝑦 = .15 = 15%

Q # 12: HPF is financed 80% by common stock and 20% by bonds. The expected return on
the common stock is 12%, and the rate of interest on the bonds is 6%. Assume that the
bonds are default free and that there are no taxes. Now assume that HPF issues more debt
and uses the proceeds to retire equity. The new financing mix is 60% equity and 40% debt.
If the debt is still default free, what happens to the following?
a. The expected rate of return on equity
b. The expected return on the package of common stock and bonds

Solution:

Data given: Common Equity = 80% Debt = 20%

𝑟𝑒𝑞𝑢𝑖𝑡𝑦 = 12% 𝑟𝑑𝑒𝑏𝑡 = 6%

𝑟𝑎𝑠𝑠𝑒𝑡𝑠 = (𝑟𝑑𝑒𝑏𝑡 × 𝐷⁄𝑉) + (𝑟𝑒𝑞𝑢𝑖𝑡𝑦 × 𝐸⁄𝑉)

𝑟𝑎𝑠𝑠𝑒𝑡𝑠 = (. 06 × .2) + (.12 × .8)

𝑟𝑎𝑠𝑠𝑒𝑡𝑠 = .012 + .096 = .108 = 10.8%

After restructuring: Common Equity = 60% Debt = 40%

Answer a. 𝒓𝒆𝒒𝒖𝒊𝒕𝒚 =?

𝑟𝑒𝑞𝑢𝑖𝑡𝑦 = .108 + .032 = .14 = 𝟏𝟒%

Answer b. After restructuring, the package of debt and equity must still provide an expected
return of10.8%

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Capital Structure & Corporate Taxes: (Debt and Taxes)
 P a g e | 48

Debt financing has one important advantage: The interest that the company pays is a
taxdeductible expense, but equity income is subject to corporate tax.

Interest tax shield: Tax savings resulting from deductibility of interest payments.

Example of tax advantages of debt: We assume that a firm has no debt and expected pretax
income is $192,308, so expected income after tax at 35% remains $125,000. The right column
shows what happens if the company borrows $500,000 at 10%.

 Leverage firm have higher income by $17500 (.35 × $50,000) because of tax shield.
 Debt holders only receive interest and benefit of this interest tax shield is captured by the
shareholders.
 However, tax shield is only safe in case that firm will earn enough income to cover the
interest deduction.

Table: Firm expects to earn $125,000 (now after tax at 35%) if there is no debt. But the
total amount earned by debt and equity investors increases to $142,500 if there is $500,000
of debt. The increase of $17,500 occurs because interest is a tax-deductible expense. The
interest tax shield reduces taxes by $17,500.
----------------------------------------------------------------------------------------------------------------
How Interest Tax Shields Contribute to the Value of Stockholders’ Equity

In a no-tax world, MM’s proposition I states that the value of the firm is unaffected by capital
structure.

But due to corporate tax, firm have some tax advantages to borrow money as interest is tax
deductible.
 P a g e | 49

This reduces the firm’s tax bill and increases the cash payments to the investors. The value of
their investment goes up by the present value of the tax savings.

But MM also modified proposition I to recognize corporate taxes:

Value of levered firm = value if all-equity-financed + present value of tax shield

This formula can be explained by following figure. It implies that borrowing increases firm
value and shareholders’ wealth.

The blue line shows how the interest tax shields affect the market value of the firm.
Additional borrowing decreases corporate income tax payments and increases the cash
flows available to investors. Thus, market value increases.

Corporate Taxes and the Weighted-Average Cost of Capital

With corporate taxes, debt provides the company with a valuable tax shield.

Because debt interest is tax deductible, the government in effect pays 35% of the interest cost.

To keep its investors happy, the firm has to earn the after-tax rate of interest on its debt plus the
return required by shareholders.

Thus, considering the tax benefit of debt, the weighted-average cost of capital formula becomes
 P a g e | 50

Notice that when we allow for the tax advantage of debt, the weighted-average cost of capital
depends on the after-tax rate of interest(1 − Tc)rdebt.

FIGURE: Changes in firm cost of capital with increased leverage when there are corporate
taxes. The after-tax cost of debt is assumed to be constant at (1 - .35)10% = 6.5%. With
increased borrowing the cost of equity rises, but the weighted-average cost of capital
(WACC) declines.
------------------------------------------------------------------------------------------------------------
Example: What is the expected rate of return to shareholders if the firm has a 35% tax
rate, a 10% rate of interest paid on debt, a 15% WACC, and a 60% debt-asset ratio?

Data Given: WACC = 15% Corporate Tax rate = 35% 𝐫𝐝𝐞𝐛𝐭 = 𝟏𝟎%

Debt = 60%, so Share equity = 40%

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Dividend Payout Policy

How corporation’s payout cash to shareholders
Paying dividends
Limitations of dividends

Chapter Stock dividends and stock splits

Stock repurchases
Why repurchases are like dividends
17 Repurchases and share valuation
How do corporate decide how much to payout?
The information content of dividends and repurchases
The payout controversy
Why dividends are irrelevant in perfect and efficient markets
The assumptions behind dividend irrelevance
Why dividends may increase value
Why dividends may decrease value
Payout Policy:

The way a firm chooses between the alternative ways to distribute free cash flow to equity
holders.

 How much should a corporation pay out in a given year?

 Should the payout come as dividends or share repurchases?

The answers to these two questions are the corporation’s payout policy.

How Corporations Pay Out Cash to Shareholders

Companies pay out cash to shareholders in two ways;
namely  Cash dividends and  Share repurchases.
Most mature, profitable companies pay cash dividends.
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By contrast, growth companies typically pay small or no dividends.

The table shows payout practices for U.S. firms from 2003 to 2014:

On average, in any year:

 Firms that paid dividend and also repurchase shares were15%.
 Firms that paid dividends but did not repurchase shares were 18%.
 Firm that repurchases shares but no dividends were 11%.
 Firms that neither paid dividends nor repurchased shares were 56%.

Figure: Dividends and stock repurchases in the United States, 1980–2014:

How Firms Pay Dividends

Some firm pay dividend in cash or give option to shareholders to reinvest the dividend in the
company.

Cash Dividend: Payment of cash by the firm to its shareholders.

To help shareholders, organization offer an automatic dividend reinvestment plan (DRIP).

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If a shareholder opt to this plan, his dividends are automatically used to buy additional shares.

As shares trade constantly, and the firm’s records of who owns its shares are never fully up to
date.

So corporations have to specify a particular day’s list of shareholders who qualify to receive
each dividend.

For example, Coca-Cola announced that it would send a dividend check on December 15 (the
payment date) to all shareholders recorded in its books on December 1 (the record date).

On November 27, two business days before the record date, Coca-Cola stock began to trade
exdividend.

Investors who bought shares on or after that date did not have their purchases registered by
the record date and were not entitled to the dividend.

Research shows that when a share “goes ex-dividend’, its price falls by the amount of the
dividend.

Figure: The sequence of the key quarterly dividend dates for Coca-Cola.

Limitations on Dividends
The law protects creditors from large dividend payouts by limiting companies that are close to
insolvency.
Also, companies are not allowed to pay a dividend if it cuts into legal capital. Legal capital is
generally defined as the par value of the outstanding shares.
Banks and other lenders may also demand dividend restrictions, particularly if they are
worried about the borrower’s creditworthiness.
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Stock Dividends and Stock Splits

Stock dividend is the distribution of additional shares to a company’s shareholders. For a 10%
stock dividend, one additional share is given to a shareholder of 10 shares.
A stock split is the issue of additional shares to a company’s shareholders. In a two-for-one
stock split, each investor receives one additional share for each share already held.
A two-for-one stock split is similar to a 100% stock dividend.
Both result in a doubling of the number of outstanding shares, but they do not affect the
company’s assets, profits, or total value.
Stock split and share dividend announcements usually result in a price increase as it may
signal management’s confidence in the future.
Example: Suppose that you own 1,000 share of Noncash Corp. And the company is about to
pay a 25% stock dividend. The stock sells at $100 per share.
A. What will be the number of shares that you hold and the total value of your equity
position after the dividend is paid? 1,000 * 1.25 = 1,250 shares
Price per share will fall to: $100/1.25 = $80
Initial value of equity is: 1,000 * $100 = $100,000
The value of the equity position remains at: 1,250 * $80 = $100,000.
B. What will happen to the number of shares that you hold and the value of your equity
position if the firm splits five for four instead of paying the stock dividend?
A 5- for- 4 split will have precisely the same effect on price per share, and the value of your
equity position as the 25% stock dividend.
In both cases, the number of shares held increases by 25%.

Stock Repurchases

An alternative way to pay cash to investors is through a share repurchase or buyback. The
firm uses cash to buy shares of its own outstanding stock.

The company can keep these reacquired shares in its treasury and resell them if it needs
money later. The shares can also be issued to managers who exercise stock options.

There are four main ways to implement a stock repurchase:

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1. Open-market repurchase. The firm announces that it plans to buy stock in the
secondary market, just like any other investor. This is by far the most common method.

2. Tender offer. The firm offers to buy back a stated number of shares at a fixed price. If
enough shareholders accept the offer, the deal is done.

3. Auction. The firm states a range of prices at which it is prepared to repurchase.

Shareholders submit offers declaring how many shares they are prepared to sell at each price,
and the firm calculates the lowest price at which it can buy the desired number of shares.

4. Direct negotiation. The firm may negotiate repurchase of a block of shares from a
major shareholder.

Example: A shareholder that owns 1000 shares before repurchase has $10,000 wealth.

If shareholder sells 100 shares he would have $1000 cash.

Shareholder is left with 900 shares worth $9000.

On the whole, share repurchase reduce the number of shares and increase future dividends per
share.

Why Repurchase are like Dividends:

To explain why share repurchase is similar to a dividend, we explain it with an example.

HP firm have total outstanding 100,000 shares @ $10 per share with total worth of $1 million
(before dividend is paid).

In case of Cash Dividend:

If firm proposing $1 a share with total payout of $100,000, so cash reduced by same amount
and market value of the firm’s assets fall to $900,000. Share price also fall to $9.

If you owned 1000 shares of HP then:

 Before dividend: 1000 shares @10 = $10,000  Total $10,000.

 After dividend: $1000 in cash and 1000 shares @ $9 = $9000  Total $10,000.

In case of Repurchase:
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Now if HP repurchase 10,000 shares @ $10 by paying out $100,000 (instead of cash
dividend).

So, here we see firm assets fall to $900,000 as just like in case of paying cash dividend, but
only 90,000 shares @ $10 remain outstanding.

Here if you owned 1000 (10%) shares:

 Own 10% share of firm before repurchase  1000 @ $10 per share = $10,000
 After sale of 100 share you still own 10% share of firm.  900 @ 10 = 9,000 + 1000
in cash  total of $10,000.

So, we see here that cash dividend and share repurchase are equivalent transaction. In both
cases the firm pays out cash, which goes into shareholders wallets. The asset left in the
company are the same in each case. The number of shares is reduced by repurchases,
however, and the price per share is higher than it is when the cash is paid out as dividends.
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Repurchases and Share Valuation:

Now, if company pay cash to shareholders in the form of repurchase, does dividend discount
model still hold? The answer is yes but we explain it with example:

What will be the value of stock of HP if it has just paid a dividend of $1 per share?

The cash dividend in year 1:

If firm expect to continue to pay annual dividends of $100,000 on 100,000 outstanding shares
@ $1 per share in perpetuity.

If the cost of equity is 11.1%, the discounted value of this dividend stream is $1/.111 = $9.

Repurchase in year 1:

HP decide to repurchase by paying $100,000 for 10,000 @ $10 per share.

As cash does not go out to shareholders, so will not affect share value in year 1 but the
number of shares fall to 90,000.

However, dividend in year 2 onward will be $100,000/90,000 = 1.11 per share. The present
value of this perpetual stream in year 1 is $1.11/1.11 = $10, and its value in year 0 is $10/1.11
= $9.

So, it proved the dividend discount model that the price of a share is the PV of future
dividends per share.

However, share repurchase reduce the number of shares and increase future dividends per
share.

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How Do Corporations Decide How Much to Pay Out?

Senior Executive Dividend Policy Features (How Dividends are determined)

1. Managers are reluctant to make dividend changes that might have to be reversed.
2. Managers “smooth” dividends and hate to cut them. Dividends changes follow shifts
in long-run, sustainable levels of earnings.
3. Mangers focus more on dividend changes than on absolute levels.
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The Information Content of Dividends and Repurchases

Dividends and stock repurchase decisions contain information

 The information contained in the decision varies

 Asymmetric information may be conveyed

The Information contents of Dividends: Dividend increases convey managers’ confidence

about future cash flow and earnings. Dividend cuts convey lack of confidence and therefore are
bad news.

 Dividend increases could mean overpriced stock or increased future profits.

 The signal varies based on prior information about the company.

Information Content of Stock Repurchase:

 Stock repurchase sends a positive signal that management believes that the current price is
low.
 Tender offers send a more positive signal than open market repurchases because the
company is stating a specific price.
 The stock price often increases when repurchases are announced.

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Dividends or Repurchases? The Payout Controversy

The objective of the firm is to maximize shareholder value. A central question regarding the
firm's dividend policy is therefore whether the dividend policy changes firm value?

As the dividend policy is the trade-off between retained earnings and paying out cash, there
exist three opposing views on its effect on firm value:

1. High dividends increase value

2. High dividends bring high taxes and therefore reduce firm value.
3. There is a middle-of-the-road party that believes payout policy makes no difference
(i.e., dividend policy is irrelevant in a competitive market.

The third view is represented by the Miller and Modigliani dividend-irrelevance proposition.

Why Dividends Are Irrelevant in Perfect and Efficient Capital Markets

Franco Modigliani and Merton Miller (MM) showed that dividend policy does not alter firm
value under the assumption of perfect financial markets.

MM’s Dividend Irrelevance Proposition: Under ideal conditions, the value of the firm is
unaffected by dividend policy. Or; in a perfect capital market the dividend policy is irrelevant.

The essence of the Miller and Modigliani (MM) argument is that investor do not need
dividends to convert their shares into cash. Thus, as the effect of the dividend payment can be
replicated by selling shares, investors will not pay higher prices for firms with higher dividend
payouts.

To understand the intuition behind the MM-argument, suppose that the firm set aside $100
million in cash to construct a new plant.

But directors now propose to use the $100 million to increase the dividend payment.

If firm still want to construct new plant by borrowing through issue of new shares, leaving
firm shareholders in exactly the same position because it put $100 million in shareholders
pocket and then taken it out again through issue of new shares.

Simply, the firm recycling cash.

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After paying dividend and issue of shares, the value of the firm is unchanged, but have
transfer of value from the old to the new stockholders.

So, investors do not need dividends to convert their shares to cash, they will not pay higher
prices for firms with higher dividend payouts. In other words, payout policy will have no
impact on the value of the firm. This is MM’s argument.

The Assumptions behind Dividend Irrelevance:

 Dividend irrelevance ignored taxes, issue costs, and risk.

 There shall be efficient capital markets i.e., sale and purchase of shares occurs at a fair
price.

Why dividend policy may increase firm value

The first view on the effect of the dividend policy on firm value argues that high dividends
will increase firm value.

The main argument is that there exists natural clienteles for dividend paying stocks, since
many investors invest in stocks to maintain a steady source of cash.

If paying out dividends is cheaper than letting investors realize the cash by selling stocks, then
the natural clientele would be willing to pay a premium for the stock.

Transaction costs might be one reason why it’s comparatively cheaper to payout dividends.
However, it does not follow that any particular firm can benefit by increasing its dividends.
The high dividend clientele already have plenty of high dividend stock to choose from.
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Why dividend policy may decrease firm value

The second view on dividend policy states that high dividends will decrease value.

The main argument is that dividend income is often taxed, which is something MM-theory
ignores. Companies can convert dividends into capital gains by shifting their dividend
policies.

Moreover, if dividends are taxed more heavily than capital gains, taxpaying investors should
welcome such a move. As a result firm value will increase, since total cash flow retained by
the firm and/or held by shareholders will be higher than if dividends are paid.

Thus, if capital gains are taxed at a lower rate than dividend income, companies should pay
the lowest dividend possible.

o bond ratings and interest rates, a financial manager can use information from
fixed-income markets to forecast the interest rate on new debt financing.
❖ Company Values
o Through stock price data, you may calculate market capitalization of a
company by simply multiply the number of shares outstanding by the price per
share in the stock market.
o Stock prices and company values provide information about its current
performance and future prospects.
o Increase in stock price sends a positive signal from investors to managers.

❖ Cost of Capital o Financial managers look to financial markets to measure the cost of
capital for the firm’s investment projects.
o The cost of capital is the minimum acceptable rate of return on the project.
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o Project with higher return than their cost add value both to firm and its
shareholders.
o The rate of return on investments outside the corporation set the minimum
return for investment projects inside the corporation.
o The minimum expected rate of return on investments in financial markets
determines the opportunity cost of capital.
o The opportunity cost of capital is the expected rate of return that investors can
achieve in financial markets at the same level of risk.
o The expected rate of return on risky securities is normally well above the
interest rate on corporate borrowing.

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Mergers, Acquisitions and Corporate Control

Sensible motives for mergers
Dubious reasons for mergers
Diversification
The bootstrap Game
The mechanics of a Merger

Chapter The form of Acquisition

Merger, antitrust law and popular opposition

21 Evaluating mergers
Mergers financed by cash
Mergers financed by stock
A warning
Another warning
The market for Corporate Control
Method 1: Proxy contests
Method 2: Takeovers
Method 3: Leveraged buyouts

Introduction

➢ When one company buys another. It is making an investment.

➢ Acquisition of one firm by another is, of course, an investment made under uncertainty.

➢ Go ahead with the purchase, if it makes a net contribution to shareholders wealth.

➢ When a firm is taken over, its management is usually replaced.

Types of Mergers

Mergers are often categorized as horizontal, vertical, or conglomerate.

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A horizontal merger is one that takes place between two firms in the same line of business; the
merged firms are former competitors.
A vertical merger involves companies at different stages of production.

The buyer expands back toward the source of raw materials or forward in the direction of the
ultimate consumer.

Thus, a soft-drink manufacturer might buy a sugar producer (expanding backward) or a fast-
food chain as an outlet for its product (expanding forward).
A conglomerate merger involves companies in unrelated lines of business.

For example, the Indian company Tata Group is a huge, widely diversified company. Its
acquisitions have been as diverse as Eight O’ Clock Coffee, Corus Steel, Jaguar Land Rover,
British Salt, and the Ritz Carlton, Boston.

Motivation for Mergers and Acquisitions:

➢ These mergers create synergies, i.e., that the two firms are worth more together than
apart.
➢ Combined company could offer consumers a comprehensive package of media and
information products.

Reasons for Failure:

➢ Sometimes managers cannot handle the complex task of integrating two firms with
different production processes, pay structures, and accounting methods.
➢ Its successfulness also depends on human assets – managers, skilled workers, scientists,
and engineers. If these people are not happy in their new roles in the merged firm, the
best of them will leave.
➢ Beware of paying too much for assets that go down in the elevator and out to the parking
lot at the close of each business day.
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Sensible Motives for Mergers

Economies of Scale
Economies of scale are the reduction in per unit costs that come as a size of company’s
operation, in terms of revenues or units of productions, increases.

➢ The opportunity to spread fixed costs across a larger volume of output.

➢ Shut down less efficient manufacturing facilities and reduce labor costs.
➢ Larger combined sales would help the company to drive better bargains with retailers
and restaurants.
➢ Sharing central services such as accounting, financial control, and top-level
management.

Economies of Vertical Integration

Large companies commonly like to gain as much control and coordination as possible over the
production process by expanding back toward the output of the raw material and forward to the
ultimate consumer.

One way to achieve this is to merge with a supplier or a customer.

Vertical integration facilitates coordination and administration.

Vertical integration has fallen out of fashion recently. Many companies are finding it more
efficient to outsource many of their activities.

Combining Complementary Resources

Many small firms are acquired by large firms that can provide the missing ingredients necessary
for the firm’s success.

Example: A small firm may have a valuable product or patent, but lack of the engineering and
sales organization necessary to produce and market it on a large scale. It could be acquired by a
larger firm with those capacities already in place.

Mergers as a Use for Surplus Funds

If firm is in mature industry with substantial amount of cash, but it has few profitable investment
opportunities.
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So, firm should either distribute surplus cash to shareholders by increasing its dividend payment
or by repurchasing its shares.

If the firm is not willing to purchase its own shares, it can instead purchase someone else’s.
Thus, firms with a surplus of cash and a shortage of good investment opportunities often turn to
mergers financed by cash as a way of deploying their capital.

Firms that have excess cash and do not pay it out or redeploy it by acquisition often find
themselves targets for takeover by other firms that propose to redeploy the cash for them.

Eliminating Inefficiencies

Organizations with unexploited opportunities to cut cost and improve revenues become takeover
targets of organizations with better management.

“better management” may simply mean the determination to force painful cuts or realign the
company’s operations.

Acquisition is simply the mechanism by which a new management team replaces the old one.

Consider Tata Motors recent acquisition of Jaguar and Land Rover. “The key here is the ability
of Tata Motors to implement cost savings at JLR.

Industry Consolidation

Industry with too many firms and too much capacity provides the biggest opportunities to
improve efficiency through mergers and acquisitions.

➢ Cut capacity and employment

➢ Release capital for reinvestment elsewhere o Example, post -cold war consolidation in
US defense firms
➢ Figure shows dozens of acquisitions by Bank of America o Restrictions on interstate
banking removed o Technologies improved.
➢ Thus, mergers to create larger banks and reduce costs.
➢ Same trend in European banking.
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Dubious/ Questionable Reasons for Mergers

Diversification
➢ Mangers of a cash rich company may prefer to see that cash used for acquisitions.
➢ Is diversification an end in itself? After all, it reduces risk – is this not a gain from
merging/ diversifying?
➢ Why should firm A buy firm B to diversify when the shareholders of firm A can buy
shares in firm B to diversify their own portfolios?
➢ No – diversification is easier and cheaper for the stockholder than for the corporation.
➢ Evidence shows that investors tend to pay a discount rather than a premium for
diversified firms.

The Bootstrap Game

The short-run increase in earnings per share which occurs in a share for share exchange when a
company trading on a higher price earnings ratio acquires a company trading on a lower price to
earnings ratio.

The bootstrap effect only occurs when:

➢ Acquirer’s P/E ratio is higher than Target’s and ➢ Acquirer’s P/E post-merger does not
decline.

Example:

➢ Acquisition of Muck & Slurry (M&S) by World Enterprises (WE) ➢ Table shows
position before and after merger.
➢ M&S has lower PE ratio than WE due to its poor growth prospects
➢ Mergers has no economic benefits → firms are worth same together as they are apart
(MV confirms this).
➢ But since WE is selling for double the price of M&S, it can acquire 100,000 M&S shares
for sale of 50,000 of its own shares.
➢ Thus, WE has 150,000 shares after merger.
➢ Total earnings double after merger, but number of shares only increases by 50%.
➢ Thus EPS ↑ from $2.00 to $2.67
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➢ This is called the bootstrap effect because there is no real gain created by the merger and
no increase in the two firms combined value.
➢ As stock price is unchanged, PE ↓

See figure: Impact of merger on market value and earnings per share of World
Enterprises
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Buying a firm with a lower P/E ratio can increase earnings per share. But the increase
should not result in a higher share price. The short-term increase in earnings should be
offset by lower future earnings growth.

The Mechanics of a Merger

Buying a company is a much more complicated affair than buying a piece of machinery.

The Form of Acquisition

➢ Merger – when the acquiring firm buys all the assets and all the liabilities of the other
firm and combines them into one firm.
➢ Tender Offer – The acquiring firm buys all the stock of the target firm.
➢ Asset Purchase – When the acquiring firm buys only the assets of the target. The target
continues to exist as firm with cash instead of assets.

Mergers, Antitrust Law, and Popular Opposition

➢ Mergers may be blocked by the federal government if they are thought to be
anticompetitive or to create too much market power. Even the threat of government
opposition may be enough to ruin the companies’ plans.
➢ Companies that do business outside the country also have to worry about foreign
antitrust laws.
➢ Mergers may also be hindered by political pressures and popular resentment even when
no formal antitrust issues arise.

Cross-Border Mergers and Tax Inversion

Some companies merge with foreign company and relocate to that country because of lower tax
rate in that foreign country. This type of merger is done for tax inversion.

Example, the corporate tax rate in the United States is much higher than in most other developed
countries, there has been a strong incentive for companies to move their domicile abroad.

Evaluating Mergers

Two question arises in mind in evaluating a proposed merger:

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1. Is there an overall economic gain to the merger? In other words, is the merger
valueenhancing? Are the two firms worth more together than apart?

2. Do the terms of the merger make a company and its shareholders better off? There is no
point in merging if the cost is too high and all the economic gain goes to the other company.

PV (A +B) > PV (A) + PV (B) → Synergy

Mergers Financed by Cash

Example: C- Foods, is considering acquisition of a smaller food company, T-Cislunar is
proposing to finance the deal by purchasing all of T outstanding stock for $19 per share.

Q 1: Why would C and T be worth more together than parts?

Suppose that operating costs can be reduced by combining the companies’ marketing,
distribution, and administration.

Revenues can also be increased in T region.

Assume that the increased earnings are the only synergy to be generated by the merger.

Data of both companies before and mergers are given in table below:

 Economic Gain = PV (increased earnings) = New cash flows from synergies

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Discount rate

Question 2 What are the terms of the merger? What is the cost to Cislunar and its shareholders?

T management and shareholders will not consent to the merger unless they receive at least the
stand-alone value of their shares.

They can be paid in cash or by new shares issued by C.

So, if cash offer of $19 per T share, $3 per share over the prior share price.

T has 2.5 million shares outstanding, so C will have to pay out $47.5 million, a premium of $7.5
million over T’s prior market value.

On these terms, T stockholders will capture $7.5 million out of the $20 million gain from the
merger.

That ought to leave $12.5 million for C.

Therefore, the merger makes sense for C for two reasons.

First, it adds $20 million of overall value.

Second, the terms of the merger give only $7.5 million of that $20 million overall gain to T
stockholders, leaving $12.5 million for C.

Cost of Acquiring C or gain for C shareholders:

Gain or NPV for C Shareholders:

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Mergers Financed by Stock

What if C decides to pay for the T acquisition with new C shares?

The deal calls for T shareholders to receive one C share in exchange for every three T shares.

It’s the same merger, but the financing is different.

The value of the merged firm is $540 million in this case because no cash is paid out to the
original T shareholders.

➢ T shareholders will get (3 for 1 share) .833 million shares in C.

This resulting in a share price of $540/10.833 = $49.85.

The value of the shares given to T original shareholders is .833 million × $49.85 = $41.5
million, representing an increase of $1.5 million over the value of their original holdings.

Following the merger, C original shareholders hold stock with total market value of 10 million ×
$49.85 = $498.5 million, an increase of $18.5 million over their original value.

In both cases, the total gains to C original shareholders and T shareholders sum to $20 million,
the economic gain of the merger.

But given the terms of this share exchange, less of the gain is captured by T shareholders.

They get 833,333 shares at $49.85, or $41.5 million, a premium of only $1.5 million over T
prior market value:

The merger’s NPV to C original shareholders is

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A Warning
➢ The cost of a merger for acquirer are sometimes measured by multiplying target stock
price by the number of outstanding shares.
➢ So, when investor expect the target to be acquired, its stock price rises, which will over
overvalue the target firm and will be costly for acquiring firm.

Another Warning

➢ Merger analyst forecast value of target firm on the basis of its future cash flow, which
also include revenue increase or cost reduction attributable to the merger. So, sometimes
analyst can make large error in valuing a business if forecasts are too optimistic.
➢ Similarly, analyst should value target on the basis of its current and stand-alone market
value, instead on the changes in cash flow that would result from the merger.
➢ Look to the competitive advantages that you can achieve that target firm’s managers
can’t achieve on their own.
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The Market for Corporate Control

The ownership and management of large corporations are almost always separated.

Shareholders do not directly appoint or supervise the firm’s managers.

They elect the board of directors, who act as their agents in choosing and monitoring the
managers of the firm.

Control of the firm is in the hands of the managers, subject to the general oversight of the board
of directors.

This system of governance creates potential agency costs.

Agency costs occur when managers or directors take actions adverse to shareholders’ interests.

The temptation to take such actions may be ever-present, but there are many forces and
constraints working to keep managers’ and shareholders’ interests in line.

But what ensures that the board has engaged the most talented managers?

What happens if managers are inadequate?

What if the board of directors is derelict in monitoring the performance of managers? Or

What if the firm’s managers are fine but resources of the firm could be used more efficiently by
merging with another firm?

Can we count on managers to pursue arrangements that would put them out of jobs?

These are all questions about the market for corporate control, the mechanisms by which firms
are matched up with management teams and owners who can make the most of the firm’s
resources. You should not take a firm’s current ownership and management for granted. If it is
possible for the value of the firm to be enhanced by changing management or by reorganizing
under new owners, there will be incentives for someone to make a change.

There are four ways to change the management of a firm:

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Method 1: Proxy Contests

Takeover attempt in which outsiders compete with management for shareholders’ votes. Also
called proxy fight.

When a group of investors believe that the board and its management team should be replaced,
they can launch a proxy contest.

A proxy is the right to vote another shareholder’s shares.

In a proxy contest, the dissident shareholders attempt to obtain enough proxies to elect their own
slate to the board of directors.

Once the new board is in control, management can be replaced and company policy changed.

A proxy fight is, therefore, a direct contest for control of the corporation.

Method 2: Takeovers

If the management of one firm believes that another company’s management is not acting in the
best interests of investors, it can go over the heads of that firm’s management and make a tender
offer directly to its stockholders.

The management of the target firm may advise its shareholders to accept the offer and sell their
shares, or it may fight the bid in the hope that the acquirer will either raise its offer or walk away
from the deal.

If the tender offer is successful, the new owner can then install its own management team.

Thus, corporate takeovers are the arenas where contests for corporate control are often fought.

Method 3: Leveraged Buyouts

Leveraged buyouts, or LBOs, differ from ordinary acquisitions in two ways.

First, a large fraction of the purchase price is debt-financed. Some, perhaps all, of this debt is
junk, that is, below investment grade.

Second, the shares of the LBO no longer trade on the open market.
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The remaining equity in the LBO is privately held by a small group of (usually institutional)
investors and is known as private equity.

When this group is led by the company’s management, the acquisition is called a management
buyout (MBO).

Many LBOs are, in fact, MBOs.

Method 4: Divestitures, Spin-Offs, and Carve-Outs

Divestiture:

When a firm sells some of the assets to another entity as a going concern.

Spin-Off
The process of a business separating the ongoing operations of a unit of that business and giving
the shareholders of the parent firm shares of the unit

Carve-Outs:

Similar to a spin-off, but issue shares of the new firm to the public.

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