CFP Notes

Estimating Cost of Capital

Debt Cost of Capital
 YTM of bond if IRR investor receives from holding to maturity and receiving promised
payments
 If little risk of default, YTM estimate of expected return. If significant risk of default, YTM
(promised payments) overstates expected payments
 Shouldn’t use debt yield as debt cost of capital unless very safe
 Using capm or y – pL both approximations for obtaining debt cost of capital

A projects cost of capital

All equity comparable

 Find all equity firm with single lines of business comparable to project and use CAPM on
firms stock (as equivalent to holding portfolio of assets)
 Unlevered cost of capital is the expected return required by the firms security holders to
hold the firms underlying assets

Unlevered cost of capital

 If firm has more cash than debt, net debt will be negative. Unlevered beta and cost of capital
exceed equity beta and cost of capital as risk of firms equity mitigated by cash holdings

Industry Asset Beta

 Can obtain average asset beta from many companies in same industry for estimate. Do this
to reduce estimation error

Project Risk Characteristics and Financing

 Firm asset betas reflect market risk of average project in a firm
 Should identify comparables for project not whole firm
 Intuition for perfect capital market capital structure not affecting cost of capital is that all
financing transactions are zero npv transactions and do not affect value

Capital Structure in a Perfect Market

 Capital structure is relative proportions of securities
 In absence of arbitrage, price of security equals present value of all future cash flows (don’t
take into account investment cost)
 With PCM, total value of firm does not depend on capital structure as cash flows still the
same and hence have the same present value (law of one price)
 Leverage increases risk of equity (even when there is no risk the firm will default) so
inappropriate to discount cash flows of levered equity at same rate as unlevered equity
(need higher rate to compensate higher risk)

Modigliani-Miller 1: Leverage Arbitrage and Firm Value

  PCM
o Investors and firms can trade same set of securities at competitive market prices
equal to the present value of their future cash flows
o There are no taxes, transaction costs or issuance costs associated with security
trading
o A firms financing decisions do not change the cash flows generated by its
investments, not do they reveal new information about them
 In a perfect capital market, the total value of a firms securities is equal to the market value of
the total cash flows generated by its assets and is not affected by its choice of capital
structure. Combination of LOOP (cash flows generated by assets same as cash flows received
by holds) and separation principle (buy / sell securities zero NPV transaction)
 Homemade leverage can be done when investors borrow or lend at same rate as firm
 If want levered equity by buying unlevered equity, subtract cash flow of debt from unlevered
equity, borrow to purchase equity
o If cash flow of unlevered equity serve as collateral for loan, loan risk free
 If company is levered but want unlevered, buy both debt and levered equity and add these
two cash flows to get unlevered equity

 Market value BS different to accounting BS as all assets and liabilities included such as
intangibles and everything shown at market value not historical cost

Modigliani Miller 2: Leverage, Risk and Cost of Capital

 Although debt is cheaper cannot consider in isolation
 E + D = U(unlevered equity) = A
 Debt increase risk equity. Investors demand higher return to compensate risk. Wacc constant
 Cash risk free, opposite effect to leverage on risk/return and hence cash reduces risk and
return

Capital Structure Fallacies

 Leverage can increase EPS. However doesn’t necessarily make shareholders better off as risk
of EPS has changed as well. Expected EPS rises with leverage, risk of EPS also increases. (risk
compensates return). Share price does not change. Graphing EPS with debt and no debt,
debt line steeper
  P = Div/ru = EPS/ ru

 Because EPS and P/E affected by leverage, cannot use as measure for shareholder
benefit/loss or compare against other firms with different capital structrues
 Another fallacy is issuing equity reduces cash flow per share and hence value per share.
Doesn’t take into account increase in value of assets
 If in question something has already been announced, in PCM no effect on share price as
already taken into account
 If firm issues equity at fair price, no gain/loss.
 Any gain / loss associated with financing transaction results from NPV of investments firm
makes with funds raised

Debt and Taxes

The Interest Tax Deduction
 Debt reduces net income but since reduces tax, total amount paid out to all investors is
higher (by interest tax shield)
 The interest tax shield is additional amount of tax that would’ve been paid without leverage
 Principal repayments not deductible, only ever take into account interest payments
  Rare that know firms future interest payments and tax savings due to changes in debt
outstanding, interest rate on debt, risk firm may default, failure to make payment, change in
tax.
 Permanent debt issued through (pot) 5 year bond then principal at end repaid by issuing new
debt to effectively keep debt constant. Permanent is fixed dollar amount

Optimal Capital Structure with Taxes

 Use of leverage varies greatly by industry
 Many firms retain lots of cash to reduce effective leverage
 Interest must be less than equal to EBIT (optimal level from tax perspective is interest = EBIT,
however EBIT not always predicted accurately so EBIT could drop, interest > EBIT no longer
optimal)
 The optimal proportion of debt in the firms capital structure will be lower the higher the
firms growth rate

Financial Distress, Managerial Incentives and Information

Default and Bankruptcy in a Perfect Market
 In a perfect capital market if value > debt in future but doesn’t have the cash to actually pay
off debt, still won’t default as can raise cash by obtaining new loan or issuing shares at fair
price (and stock price will remain same after transaction)
 In PCM, if default investors equally unhappy whether firm is levered and declares bankruptcy
or whether its unlevered and share price declines. Decline in value is not caused by
bankruptcy (same whether or not had leverage). If product fails (and value goes down), faces
economic distress which is significant decline in value of assets whether or not firm
experiences financial distress due to leverage

The costs of bankruptcy and Financial Distress

 Direct costs of bankruptcy include lawyers, accountants, consultants, investment banks,
auctioneers etc. Direct costs eat away at value of assets. If more complicated business
operations or more creditors (harder to agree), costs increase
 Can do workout or prepackaged bankruptcy to deal and agree with creditors prior to
bankruptcy to minimize costs
 Indirect costs include: loss of customers who don’t want to buy procuts whose value
depends on future support/service of firm i.e. plane tickets or parts under warranty. Low loss
of customers for producers of raw materials as once sold, doesn’t depend on seller success.
 Loss of suppliers: unwilling to provide inventory if not paid
 Loss of employees: cannot offer job security with long term contracts loss existing cant hire
new. May have to spend lots of money to retain key employees
 Loss of receivables
 Fire sale of assets: sell assets quicjly to raise cash to avoid bankruptcy and hence lower price
 Inefficient liquidation, also costs to creditors (could make them default) hence demand
better initial loan terms
 Limit of bankruptcy direct costs to cost of renogiating with firms creditors
 No limit on indirect as not borne by investors and incurred prior to bankruptcy
Financial Distress Costs and Firm Value
 When securities are fairly priced, the original shareholders of the firm pay pv of costs
associated with bankruptcy and financial distress as debt holders pay less for debt initially (to
account for chance of default) and hence less money to pay dividends, repurchase shares or
make investments
 Tradeoff theory: firm picks its capital structure by trading off the benefits of tax shield from
debt against financial distress and agency costs
 Factors determing PV(financial distress) are probability, magnitude of costs and appropriate
discount rate
o Probability depends on likelihood of default. Increases with amount of firms
liabilities relative to assets and volatility of cash flows / asset values. Steady, reliable
(utility comp) have high debt with low prob. Volatile cash (semiconductor) low debt
to avoid risk of default
o Magnitude depend on relative importance of costs. Tech firm where value from
human have high costs as loss of customers, high costs to retain employees, lack of
tangible assets to sell. Physical capital (real estate) low costs as can sell assets easily
o Discount rate depends on firm market risk. Distress cost high when firm poor so beta
of disress opposite sign to firm. Pv distress higher for high beta firms

Exploiting Debt Holders: The Agency Costs of Leverage

 Agency costs are costs that arise when there are conflicts of interest between a firms
stakeholders
 Since managers often compensated with equity and hired by board (shareholders), often try
increase equity value.
 If firm has leverage, agency costs occur if investment has different impact on debt and equity
holders (likely when risk of financial distress is high). Managers may benefit equity but harm
creditors and decrease total value

Excessive Risk Taking and Asset Substitution

 When a firm faces financial distress, shareholders can gain from decisions that increase the
risk of the firm sufficiently even if they have a negative NPV. Called asset substitution
problem. Can lead to overinvestment as shareholders may still gain

Debt Overhand and Under Investment

 Positive NPV investment could have negative NPV for equity holders (if they fund it) even if it
increases the total value of the firm
 When a firm faces financial distress, it may choose not to finance new positive NPV projects
(debt overhand underinvestment problems). Costly for debtholders and overall value of firm.
 Cost highest for firms that likely have profitable future growth opportunities that require
large investments
 Extreme case is to liquidate assets below actual value and pay dividend to equity holders
even if decrease value of firm
 Equity holders benefit only if
Agency Costs and Value of Leverage
 Ultimately, shareholders (not debt holders) bear agency costs. Debt holders always pay less
predicting possible of agency costs, causing initial decrease in share price corresponsing to -
NPV of investments
 Agency costs only arise if possibility of default

The Leverage Ratchet Effect

 When unlevered firm issues new debt, agency / financial costs borne by equity holders
 If levered firm takes on more debt, some costs fall on existing debt holders thus equity
holders could benefit from higher leverage
 Debt overhang will inhibit firms from reducing leverage once in place even if excessive
 Benefits from lowering leverage and hence financial / agency go straight to debt holders
 1. Shareholders increase leverage despite decrease value 2. Don’t decrease leverage even if
increase value

Debt Maturity and Covenants

 Agency costs decrease for shorter debt but may increase financial d costs
 Debt covenants restrict large dividends or investments as well as new debt that can be taken
on. Help reduce agency costs but can block +NPV investment so also has cost

Motivating Managers: The Agency Benefits of Leverage

 Managers may have own interest differing from equity and debt
 Managerial entrenchment is situation arising from the result of serparation of ownership and
control where managers make decisions that benefit themselves in expense of shareholders
as rarely fired and only own small percentage of total equity

Concentration of Ownership
 Debt can make original equity holders keep their stake and hence do whats best for firm
 Likely to work harder if earns 100 and likely to spend more on luxuries if only bears 60% of
cost

Reduction of Wasteful Investment

 Managers may make large unprofitable investments for empire building. Increase size but
not profitability. Earn prestige and garner publicity. Also overconfident
 Free cash flow hypothesis is the view that wasteful spending is more likely to occur when
firms have high levels of cash flow in excess of what is needed to make all +NPV investments
and debt payments. If cash is tight, manager runs efficiently
 Leverage decrease managerial entrenchment as more likely to be fired in financial distress.
Creditors also closely monitor
Agency Costs and Tradeoff Theory
Optimal Debt Level
 R&D intensive: high r&d costs and future growth opportunities have low debt as have low
FCF. Also have high human capital (indirect costs). Tech, medicine
 Low growth, mature: high debt. High FCF with few good investment opportunities. Real
estate, utilities, supermarket

Asymmetric Information and Capital Structure

Leverage as credible signal
 Credibility principle: claims in ones self interest are credible only if they are supported by
actions that would be too costly to take if claims untrue\
 Can make statements about future prospects that investors can analyse, illegal to lie
 Signaling theory of debt is use of leverage to signal information to investors about future
prospects. If good, no problem, if bad would struggle. Only if debt issued will have a risk of
financial distress

Issuing Equity and Adverse Selection

 Lemons principle: when a seller has private information about the value of a good, buyers
will discount price they are willing to pay due to adverse selection
 If issue equity, may appear that bad future prospects, hence price discounts and is a
potential cost of issuing equity
 Issuing shares when know they are underpriced is a cost for original shareholders. Don’t sell
below true value. Wait until share price rises.
o Managers who know securities have a high value (underpriced) will not sell and
those who know have a low value (overpriced) will sell. Investors only pay low price
in risk of bad news and hence price discounts (cost)

Implications for Equity Issuance

 Stock price declines on announcement of equity issue as signals equity overpriced
 Stock price tends to rise prior to announcement of equity issue
 Managers avoid price decline when smallest information asymmetry
 Firms tend to issue equity when information minimize such as after earnings annoucnements

Implications for Capital Structure

 Debt faces adverse selection but since debt not very sensitive to information but rather
interest rates, low underpricing
 Managers who perceive equity is underpriced preference to fund with retained earnings or
debt over equity
 Pecking order hypothesis is use retained earnings, then debt, then equity as last resort (due
to inevitable price decline)

Payout Policy
Cash distributions to shareholders
  Retain cash to keep in reserves or fund new investments or distribute (dividend / share
repurchase)
o Decision based on if firm can use cash better than investors (have +NPV projects to
use FCF)
 Declaration date is date when board authorizes dividend (legally obligated to make payment
after this)
 Record date is specific date set by board such that you firm pays dividend to all shareholders
on recod as of this date
 Ex dividend date is 4 days before company’s record date
 To be entitled to dividend, must purchase shares before ex dividend date
 Payable / distribution date is when firm send sthe dividends
 Special dividend much larger than regular dividend
 A return of capital / liquidation dividend (dividend paid from paidin capital or liquidation of
assets) taxed as CGT
 Shares repurchased by company held in corporate treasury but have no value while held by
firm (can be resold in future)
 Open market repurchase is firm announces to buy shares like investor and does it over time
 Off market buyback is when firm invites shareholders to sell shares in tender process. Equal
access buyback is firm repurchasing shares in same proportion of each shareholders shares.
Can be fixed price or dutch auction (firms accept lowest bids up to number of shares to be
bought). Equal access if everyone has equal chance to participate in tender. Scale back allows
firms to scale back shares repurchased if more shares tendered then sought to be bought. If
not enough shares are tendered, then the buyback can be called off. Selective buyback only
some shareholders (chosen).

Dividends versus share repurchases in perfect capital market

 Same in PCM
 Market value = Enterprise value + cash
 Enterprise Value = E + D – C = Discounted FCF. IF using discounted FCF, don’t subtract cash
 Trade cum dividend is before ex dividend date and is when you are entitled to dividend
 in PCM, share price drops by dividend when share begins to trade ex dividend
 by not paying a dividend today but repurchasing shares instead, firm raises dividend per
share in future, compensating them for dividend given up today
 open market share repurchase no effect on share price, share price same as cum dividend if
dividend paid instead
 in event of share repurchase, can sell shares to create homemade dividend (if want cash like
in dividend)
 In case of dividend, can buy shares at ex dividend price
 Issuing equity to finance larger dividend has no effect on share price (cum)
o However if pay higher dividend now, pay lower dividend per share in future
 MM dividend irrelevance, holding fixed investment policy, dividend policy is irrelevant

Dividends and share repurchases under personal taxes

 If shareholdershave preference of dividends or repurchases due to personal taxes, firm
should pick policy that matches these preferences
 Tax preference for dividends in Australia
  Off market equal access share buybacks can be structured so some portion of price is
designated as dividend and hence franking credits are attached. Done if company has excess
franking credits.
 Firms hence repurchase shares at lower than market price as franking credit can offset th4
tax payable on the CGT and is a net positive for the shareholder
 In US, share repurchase often at higher than market value to compensate CGt

Payout versus retention of cash

Retaining cash with perfect capital markets
 Payout vs retention decision irrelevant in PCM as if firm has taken all +NPV projects it can, so
invests in financial assets, since in PCM investors can invest in same investments if paid out
cash and buying selling securities is zero NPV

Retaining cash with imperfect capital markets

 Tax can vary decision. Depends on marginal tax rate of investor.

 Firms may accumulate cash to cover future cash shortfalls such as if likelihood that future
earnings will not be able to fund future positive NPV investments
o Allows firm to avoic transaction costs of raising new capital as well as agency costs
and lemons problem as per CH16
o Balance cost of holding cash (low returns on liquid investments) with potential
benefit of not raising external funds in future
o If volatile cash flows, can retain cash to avoid financial distress costs
 No benefit to shareholders if hold cash about future investment or liquidity needs however.
Could have agency costs actually: empire building, luxuries, overpaying for acquisitions.
  According to managerial entrenchment theory of payout policy, managers pay out cash only
when pressured to do so by firms investors (otherwise hold for luxuries, empire building,
avoid financial distress costs which can cause them to lose their job)

Signalling with payout policy

 Dividend smoothing is keeping relatively constant dividends
 Firms increase dividends more freqruently then cut
 Lintner (1956) suggests that managers believe investors prefer stable dividedns with
sustained growth and managers desire to maintain long term target level of dividedns as
fraction of earnings
o Firms only raise div when perceive ling term sustainable increase in future earnings
and cut as last resort

Dividend signalling
 When firm increases dividend, sends positive signal that management expects to be able to
afford higher dividend in future
 When cut, signals firm given up hope that earnings rebound in near future so need to save
cash
 Increase of dividends may also signal lack of investment opportunities
 Might cut dividends to invest in new +NPV projects
 Should interpret in context

Signalling and share repurchases

 Managers less committed to repurchases than dividends and investors expect dividends but
not repurchases
 Firms don’t smooth repurchase activites like dividends. Share repurchase today doesn’t
mean more in future so less of a signal than dividends
 Cost of share depends on market value. Share repurchase may hence signal share is
undervalued. Signal not overvalued as repurchase would be costly to current shareholders.
Should hence react favourably to repurchase announcement

Dividend policies
 Residual dividend
o Pays dividends if profits that can’t be invest profitably
o Fluctuating dividend
 Stable / progessive dividend (smoothing)
o Propotation of annual profits
o Reduces uncertainty and provides stable income
 Constant payout
o Same payout ratio every year

Overall – lecture
 Maximise after tax payout to sahreholders
 Repurchase / special divided for large infrequent distribution
 Starting and increasing dividend seen as implicit commitment to maintain this level
indefintitely (dividend stronger sign of financial strength)
  Be mindful of future investment plans

Capital Budgeting and Valuation with Leverage

WACC Method
 When the market risk of the project is similar to the average market risk of the investment,
then the cost of capital is equal to the firms WACC
 Assume constant debt-equity ratio hence constant WACC
 Implement constant debt to equity by multiplying levered value (don’t take away initial
investment) with initial debt – value ratio
 Debt capacity is the amount of debt at a particular debt that is required to maintain target
debt to value ratio
 When taking on debt (for deb capacity), can spend cash or borrow, any excess borrowing
over initial investment paid out as dividend / share repurchase to shareholders
 If borrowing is less than initial investment required remaining financed with equity.
 NPV of the project increases equity value

APV Method
 Can use pretax WACC for unlevered cost of capital if overall risk of firm is independent of
leverage. In PCM this is always the case, when taxes, if risk of tax shield is same as risk of
firm, also holds. If a target leverage ratio is held, then risk of tax shield does match risk of
firm.
 Target leverage ratio is when firm adjusts debt proportionally to a projects value or cash
flows so that constant debt-equity is a special case
 Interest calculated based on debt at end of previous year. Need to calculate debt capacity
first so know how much debt.
 When firm maintains target leverage ratio, future interest tax shields have similar risk to
projects cash flows, hence discounted at unlevered cost of capital
o Interest tax shields are expected values which will vary on actual cash flows

Project Based costs of capital

 When risk of project different to firm, use comparable rU
 Can use APV. If wanted to use WACC would need cost of equity which depends on
incremental debt firm takes on as a result. Use MM2 equation
 Can also use rwacc = ru – rdtcD/V
 For capital budgeting purposes, the projects financing is the incremental financing that
results if the firm takes on the project (change in total debt / cash with versus without
project)
 Incremental financing need not correspond to the financing directly tied into project. For
example if take on lot of debt specifically for project, can reduce debt somewhere else to
reduce overall debt ratio
 If +FCF from project increases firms cash holdings, equivalent to reducing firms leverage
 If a firm has dividend payouts and expenditure on share repurchases set in advance and not
affected by project FCF. Only source of financing is then debt or firms cash so is 100% debt
financed.
 If cash flows safe, can use 100% debt financing
APV with other leverage policies
 When relax assumption of constant debt-equity, equity cost of capital and WACC change
over time as d-e changes so hard to implement WACC method
 Constant interest coverage ratio is when firm keeps payments equal to fraction of FCF
o In this case, tax shield proportional to FCF, hence has same risk as FCF and
discounted at rU
o Vl = (1+tck)Vu
 When fixed debt schedule, tax shield less risky than project hence discounted at lower rate
 When debt levels are set according to a fixed schedule, we can discount the predetermined
interest tax shields at rD
 If risk of tax shield differs from cash flows, overall risk of firm depends on leverage and hence
pretax wacc no longer equals rU
 WACC for constant debt-equity, APV for other leverage

Other effects of financing

o Remove other costs from NPV
o If issuing equity to fund project but equity undervalued, the undervaluation cost taken away
from NPV

Mergers and Acquisitions

Background and Historical Trends
 Takeover market characterized by merger waves
 Greater during economic expansions than contractions and correlates with bull markets
 Horizontal merger is when target and acquirer in same industry
 Vertical merger is when targets industry buys or sells to acquirers industry
 Conglomerate merger when operate in different industries
 Term sheet is summary of structure of merger transaction includes details about who run
company, board, location, name
Market Reaction to a Takeover
 Bidder unlikely to acquire target company for less than current market valye.
 Usually pay substantial acquisition premium (percentage difference between acquisition
price and premerger price of target firm)
 Target share price substantially increases on announcement while not much increase in
acquierer on announcement

Reasons to acquire
 Two types of synergies: cost redutction and revenue enhancement
 Cost reduction more common and easier to achieve as generally translate into layoff of
overlapping employees and elimination of redundant resources
 Revenue enhancing occur if create possibilies to expand into new markets or gain more
custoemrs
 Economies of scale a the savings a large company can enjoynot available to a small company
from producing goods in high volume
 Economies of scope savings large companies can realise that come from combining
marketing and distribution of different types of related products
 Vertical integration is merger of two companies in same industry that make products
required at different stages of production cycle. Refers also to merger of firm and supplier or
firm and customer
o Primary benefit is coordination and common goal
 Gain expertise staff from existing firm
 Incur efficiency gains through elimination of duplication and replacing poor management (as
unhappy investors sell shares, price drops, get acquired, replace management)
 Conglomeration can be used to offset profits from oen division with losses in another to
increase overall net profit
 Diversification
o Risk reduction
 Reduce idiosyncratic risk.
 However ahreholders can do this themselves so don’t gain from this
 Also , costs associated with merging and running larger firm, also harder to
accurately measure performance so agency costs could increase and
inefficient allocation of resources
o Debt capacity and boorowing costs
 Larger firm lower probability of bankruptcy given same degree of leverage
 Hence leverage futher and greater tax savings
o Asset allocation
 Quickly reallocation assets across industries. Agency costs could cause
opposite
o Liquidity
 Oweners of private firm not very diversified but when sell, cash out in
investment so reason to agree to sell
 EPS of resulting firm can increase even if merger itself creates no economic value
 Cant look at eps/p/e to measure performance of merger
 If eps increases, growth rate lowers, p/e falls
 Manager reasons to merge
  Manager prefer to run large company due to prestige, don’t bear much cost if bad
transaction as have small percentage of equity but earn 100% of gains in compensation and
prestige if ceo of bigger company
 Managers overconfident and pursue mergers with low chance of succeeding as believe can
manage great enough to succeed

Valuation and takeover process

 Takeover synergy is value obtained from an acquisition that could not be obtained if the
target remained an independ firm (value in excess of standalone value
 Positive NPV if Value Acquired (standalone value + synergies) > Amount Paid (prebid market
cap + premium) hence synergy > premium
 Tender offer is public announcement of offer to all existing security holders to buy back
specified amount of securities at prespecified price over prespecified period of time
 Stock swap merger +NPV for acquiring shareholders if share price of merged firm >
premerger price of acquiring firm
 When tender offer annoucnaed, no guarantee that takeover at that price (could increase or
takeover could fail (due to board not accepting bid so telling shareholders not to tender or
regulartors not approving transaction)
o Because of this, market price generally doesn’t rise by amount of premium when
announced
 Friendly takeover when target board approves and negatioates for ultimate price
 Hostile takeover when target board doesn’t approve and acquierer must gain enough shares
to gain majori ycontrol and relace board
o Offer price too low (even if there is a premium). Could find someone else or bid is
increased
o Acquirer shares overvalued
o Managers own self interest (don’t want to lose job)

Who gets added value from takeover

 Target shareholders ultimately capture value added by acquirer

Why do M&A fail? • Lack of post-merger plan • Lack of accountability • Culture shock • Managerial
egos What kind of M&As are more likely to succeed? • Acquirer is a larger firm than the target firm •
Cost saving synergy • Target firm is a private company • Hostile acquisitions more likely to succeed
than friendly mergers • The most successful deals are often midsize takeovers that add 10–20
percent to the size of a company, rather than the headlinegrabbing megamergers of equals.

Raising Equity Capital

Equity Financing for Private Companies
 Angel investors are individual investors who provide entrepreneurs with initial capital to start
their business
o Rich successful entreprenurs will to help new companies get started in each for share
of business
o Angel group is group pooling money and decide investment as group
 o Often hard to value company so earn in so have convertible note which can convert
into equity (for discount on initial investment and current price) so postpone
valuation calculation till easier
 Venture capital firm is limited partnership that specialises in raising money to invest in
private equity of young firms
o Typically institutional investors (pension funds) are the limited partners
o General partners run the firm (and are called the venture capitalists)
o Benefits for limited partners over investing themselves
 Invest in startups so get diversification
 Benefit from expertise of general partners
o General partners charge substantial feeds
o Often take a large proportion of control on board
o Since want to protect investment, VC have key nurting and monitoring role for firm
 Private equity firm similar to VC but invests in equity of existing private firms rather than
startups
o Often find a public firm and purchase outstanding equity and make company private
in LBO
 Institutional investors
o Mutual funds, pensioj funds, insurance companies, etc manage large amounts of
money and invest in many assets: private firms, VC, PE
 Corporate investors
o Corporations purchasing equity into younger private companies (such as google)
o Corporate investors invest for corporate strategic objectives as well as financial
returns

Venture capital investing

 Companies typically issue preferred stock when first sell equity to investor
o Has preferential dividend, liquidation or voting rights relative to common stock
o Typically doesn’t pay regular cash divided but can be converted to common stock
o Preferred stock have senior claim on assets of firm if goes into trouble
 Premoney valuation is value of prior shares outstanding when valued at current funding
round price
 Post money adds value of shares issued
 If convertible preferred stock isn’t converted to common stock, still have features
o Liquidation preference 9minimum amount paid to preferred before common when
liquidation, sale, merger)
o Invests in later rounds demand senirority over earlier round investors to be paid first
o Participation rights mean receive liquidation preference and payments to common
stock as if converted shares
o Anti-diluatino protection when funding round at low price so convertible stock price
lowers to increase ownership percentage
o Investors can be appointed to board
 Investors exit via acquisition or IPO

The Initial Public Offering

  Main advantages: greater liquidity and better access to capital, gives private investors ability
to diversify
 When investors diversify, owners dispersed, lack of concetration undermines investor ability
to monitor company management and hence discount price they pay to reflect loss of
control. Also have to undergo all the regulation and filing processes
 Underwriter is investment banking firm that manages security issuance and designs its
structure
 Primary offering is new shares that raise new cpital and secondary offering is existing shares
sold by current shareholders (as part of exit strategy) all in IPO
 Best efforts IPO doesn’t guarantee stock sold, tries to sell for best price. All or nothing sold.
 Firm commitment ipo guarantees that all stock sold at offer price. Underwriter buys all stock
at slight discount then resell at offer price. If all not sold, underwriter must sell at lower price
and incur loss
 Lead underwriter is primary banking firm responsible for managing deal. Syndicate is group
of other underwriters
 Filing process – final prospectus contains all details of IPO such as number of shares and offer
price
 Underwriters value company
 Underwriting spread is company paid fee to underwriters based on the issue price

IPO Puzzles
 underwriters set issue price so average first day return is positive (and so reduce chance of
incurring loss from not selling all)
 new investors gain from IPO, existing shareholders bear the costs as sell stock in firm for less
than they clud in after market
 greater number of IPOS (need for capital) when there are more growth opportunities
avalable
 with more angel investors, VC, PE, firms stay private for longer could potentially explain
decrease in average number of annual IPOs. Also firms mire likely to be acquired than by
larger firm than IPO

The Seasoned Equity Offering

 SEO when public company offers new shares for sale
o Main difference between IPO is stock price already exists so price setting not
required
 Cash offer when firm offers new shares to investors at large
 Rights offer when firm offers new shares only to existing shareholders
o Rights offer protets existing shareholders from underpricing
 On average price decline (consistent with lemons problem, if sell, likely overvalued)

Private Placement • new shares sold only to a small number of institutions or wealthy investors
(existing and new investors) • retail shareholders (mom-and-dad investors) are not eligible

Different structures of rights issues: 1. Renounceable vs. non-renounceable • Shareholders who do

not want to buy additional shares could sell their rights 2. Underwritten vs. partially underwritten vs.
nonunderwritten • Similar to ‘firm-commitment’ in IPOs 3. With and without a shortfall facility •
Shareholders can apply to buy more shares that are not taken up by other shareholders
Private placements: • Prospectus is not required (low issuance cost) • Issue new shares to selected
institutional investors and/or wealthy individuals only • Maximum new shares: 15% of their current
shares outstanding New shares usually sold at a discount (< market price)

Why are private placements so attractive to firms? 1. Positive stock price on announcement •
increased monitoring, lower agency costs and lower information asymmetry 2. Popular financing
used by smaller public listed companies – quicker and cheaper 3. Potentially bring in an influential
shareholder with large ownership to discipline managers

Disadvantages of private placements: 1. Dilution of minority shareholdings 2. Large discount –

transfer wealth from minority shareholders to participating-institutional investors 3. Change in
control – a blockholder can potentially be created under a single placement - can potentially deter a
takeover 4. Entrenched managers issue private placements to themselves or a “passive” or “white
knight” that helps to solidify management’s control

Corporate Governance
Corporate Governance and Agency Costs
 Corporate governance is the system of controls, regulations and incentives designed to
minimize agency costs between managers and investors and prevent corporate fraud
 Conflict of interest between managers and shareholders derives from serpataion of
ownership and control
 Aligning interest of managers and sahreholders comes at cost as increases risk exposure of
managers
 Corp gov attempts to provides incentives from owning stock and from compensation that is
sensitive to performance and punishment when board fires manager for poor performance
or fraud or when board fails to act, sharehodlers or raiders launch control contests to replace
board and management

Monitoring by the Board and Others

 Inside directors are employees, former employees or family members of employees
 Gray directors have existing or potential business relationships with the firm
 Outside (independent) directors are everyone else
 Board elected by shareholders to monitor managers, set compensation and approve mojr
investments and M&A
 Board clear fiduciary duty to protect interest of shareholders
 Advantage of independent directors
o Don’t have connections to management, preventing captured board (board whose
monitoring duties have been compromised by connections or perceived loyalties to
management)
o More effective monitoring of managers, minimizing agency costs
 Disaqdvantages
o As personal wealth less likely to be sensitive to performance, less incentive to
actively and effectively monitor management
 Surprisingly strong correlation between smaller board and better performance (less strong
correlation between more independent directors and firm performance_)
o Psychology: small groups make better decisions than bigger groups
  Other monitors
o Security analysts produce independent valuations of firms they cover s they can
make buy and sell recommendations
 Spend lot of time researching so uncover irregularities first
o Lenders carefully monitor and apply debt covenants
o Employees most likely to detect outright fraud because of insider knowledge
o Regulator protects investing public against fraud and stock price manipulation

Compensation Policies
 Manager compensation tied to firm performance, giving them ownership stake
 Bonuses, now stocks and stock options (hence direct incentive to make stock increase)
 Negatives
o Options granted at the money so managers manipulate release of forecasts so bad
news comes out before options grants to decrease the stock price
o Backdating: choosing the grant date of a stock option retroactively so that date of
grant coincides with date stck price was lower than price at time grant was actually
awarded. Can hence receive an already in the money option

Managing agency conflicts

 Research shows greater managerial ownership associated with fewer value reducing actions
by managers
 However makes managers harder to fire
 Share holders use : to manage agency conflict
o Compensation policies or stronger board
 Share holders use direct action: when angry at managers and board do nothing
o Shareholder voice: submit resolution to put something up for a vote. Rarely receive
majority but embarrassing for board if receive any traction. Can also vote no at
board reelections
o Nonbinding Vote for compensation of managers
o Proxy contest and put new board of directors against old
 Management entrenchment
 Shareholders can mount hostile takeover

The Sarbanes-Oxley Act (SOX) (text pp.1036) • Passed in 2002 to improve the accuracy of information
given to both boards and to shareholders. • SOX attempted to achieve these goals: 1. Overhauling
incentives and independence in the auditing process. 2. Stiffening penalties for providing false
information. 3. Forcing companies to validate their internal financial control processes

The Cadbury Commission (text pp.1038) • Following the collapse of some large public companies,
the U.K. government commissioned Sir Adrian Cadbury to form a committee to develop a code of
best practices in corporate governance.

Dodd-Frank Act (text pp.1039) • After GFC, Dodd-Frank added a number of new regulations designed
to strengthen corporate governance in 2010, including: – Independent Compensation Committees –
Nominating Directors – Vote on Executive Pay and Golden Parachutes – ClawbackProvisions – Pay
Disclosure
Corporate governance is a system of checks and balances that trade off costs and benefits. – This
tradeoff is very complicated. No one structure works for all firms. • Good governance is value
enhancing and is something investors in the firm should strive for.