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# Corporate Finance

## Part I: Fundamental Concepts in Valuation 1. Discounting and Net Present Value

1.1 Present Value, Future Value, and Net Present Value Key: r = rate of return available for similar investment on the capital market (market rate of interest) Cx = expected cash flow at period x (when x = 0, Cx is the initial cash outlay) Present Value (PV): PV = C1/(1+r). Future Value (FV): FV(x) = x(1+r). Net Present Value (NPV): NPV = C0 + C1/(1+r). Project Rate of Return (y): y = (C0+C1)/-C0. Two criteria for measuring the value of a project: The value of a project can be measured by either NPV or y. NPV is the better measure because it gives you an answer in absolute dollars. [Example: Project 1 gives a \$100 payoff for an initial investment of \$10. Project 2 gives you a \$2000 payoff for an initial investment of \$2000. Project 2 is more valuable in dollars because you earn more of them, even Project 1 has a higher y.] Rule for Corporate Investing: A corporation should invest in projects with the highest NPVs (never < 0), regardless of individual shareholders wealth and tastes, because shareholders can borrow against their stakes in the corporation if they need cash immediately. 1.2 Extending Net Present Value to Multiple Periods Key: rx = market rate of return x-period investments Cx = expected cash flow at period x NPV For Multiple-Period Cash Flow: For a project that pays off in cash flows over n periods, NPV = C0 + C1/(1+r1) + C2/(1+r2)2 + C3/(1+r3)3 + . . . + Cn/(1+rn)n = Ct/(1+rt)t, where t = 0, 1, 2, 3, . . ., n Annuities and Perpetuities: An annuity is an asset that pays a fixed sum (C) each year for a specified number of years. A perpetuity is an asset that pays a fixed sum (C) each year to perpetuity. Annuities: The formula used to compute the present value of an n-year annuity: PV(annuity)1, n = C/r[1-1/(1+r)n] Growing Annuities: For an n-year annuity that grows at rate g, PV(growing annuity)1, n = [C1/(r-g)][1-(1+g)n/(1+r)n]. Perpetuities: The formula to compute the present value of a perpetuity: PV(perpetuity)1, = C/r Growing Perpetuities: For a perpetuity whose cash flows grow at rate g, PV(growing perpetuity)1, = C1/(r-g) [***note: A perpetuity can grow at rate g if and only if g < r. Otherwise, PV would be infinite, which is impossible in the real world because of the rule against money-machines.]

Annuities and Perpetuities That Begin Paying Immediately: The above formulas assume that the cash flows begin at the end of period 1. In cases were the cash flows begin immediately, all cash flows are discounted by one fewer period, so multiply the above results by (1+r) to compute present values. Computing Interest Simple Interest: Simple interest is computed by applying a rate of r each period to the initial investment. Thus, to compute the future value of an investement inv on which m simple interest payments are made at rate r, FV(inv) = inv(1+rm) Compound Interest: Interest that is compounded is reinvested to earn more interest in subsequent periods. Compounding is the norm, so assume that a given rate is compounded, unless youre told otherwise. To compute the future value of an investment inv on which m payments are made yearly at rate r, compounded annually, FV(inv) = inv(1+r)m Non-Annual Compounding: A nominal rate of r per annum, compounded m times per year, will yield an annually compounded rate of ya, where ya = [1+r/m]m-1 Continuous Compounding: Kraakman said not to worry about this. Nominal Versus Real Rates of Interest: Interest rates are generally stated in nominal terms. Expected real rates of interest are adjusted for inflation. The relationship between the two is 1 + rnominal = (1 + rreal)(1 + inflation rate) In terms of cash flows for t periods, Real cash flow = (nominal cash flow)/(1 + inflation rate)t Example: Bus Accident Problemits about the power of discounting: different discount factors can make present value vary widely. Example: Amoco Cadiz (7th Cir. 1992)Issue is how to value the prejudgment interest on damages of \$81m. Any market interest rate reflects 3 things: social return on particular investment (what it would take to bid money away from other productive uses); anticipated inflation; risk of nonpayment. Court chooses the prime rate. But which prime rate? Rate that prevailed at end of case or during litigation? Latter: the average rate. What if court had gone year-by-year? It would have made no difference whether rates started out high and declined or vice versa because of transitive principle: a x b x c = c x b x a. Worst for payor is average rate.

1.2 Extending NPV to Multiple Periods NPV for multiple periods is the summation of each periods discounted cash flow (including initial investment) n n Ct/(1 + r)t = Ct x DFt t=0 t=0 Annuities PV(annuity)1,n = C/r x [1 1/(1+r)n] This is equivalent to subtracting a perpetuity beginning in year n from a perpetuity beginning now (see below) PV(growing annuity)1,n = C/(r-g) x [1 (1 + g)n/(1+r)n] Perpetuities PV(perpetuity)1, = C/r PV of growing perpetuities = C1/(r-g) g = rate of growth Compounding Intervals Simple interest does not reinvest each interest payment whereas Compound interest reinvests each interest payment, earning more interest in subsequent periods Annual yield formula: Yannual = [1 + Ynominal/m]m - 1, where m = # of times per year that interest is paid The more frequent the compounding the higher the effective rate (semi annually<quarterly<monthly<continuous) In the real world, bonds payout semi-annually and stocks quarterly Example: if nominal rate is 8% and interest is paid quarterly, then annual rate is (1.02)4 = 1.0824 1 = 8.24%. Discounting for inflation (Nominal v. Real rate of interest): Real cash flow = (Nominal CF) /(1 + inflation rate)t The real rate of return (rnomirnal) is calculated with the following formula 1 + rnominal = (1 + rreal)(1 + inflation rate)

Bus accident settlement: Demonstrates the power of discounting the percentage that the lawyers get depends on what discount factor one applies to the future payments release agreement leaves plaintiff with little available relief city saves money by structuring the payout over 30 years as opposed to a payment in one lump sum Amoco Cadiz (7th Cir. 1992) Issue: How to value the prejudgment interest on damages of \$81m, to which is entitled b/c it was forced to devote \$ to clean-up, which it could have invested at market rate Any market interest rate reflects 3 things: Social return on an investment (what it would take to bid money away from other productive uses) Anticipated inflation Risk of nonpayment Rather than engage in refined analysis necessary to arrive at market rate, court chooses the prime rate But which prime rate? Rate that prevailed at end of case or during litigation? Latter: the average rate. What if court had gone year-by-year? It would have made no difference whether rates started out high and declined or vice versa because of transitive principle: a x b x c = c x b x a. Worst for payor is average rate. Consider simple example with 2 numbers: 6 x 10 = 60 8 x 8 = 64 Question 1: period of time over which interest is determined. 3.3162 = (1.119)x; solve for x. Express formula as logarithm: log1.1193.3162 = x x = (log 3.3162)/(log 1.119) = roughly 10.7

French and British law do not use compounding interest. Had the court applied this rule, Amoco would have saved millions of dollars through the use of a smaller multiplier. This corresponds to a significantly smaller interest rate. 1.3 Valuing Securities Distinguishing between interest and principle has little economic consequence, but significant tax consequences Bonds (interest tax deductible for corporations): types and valuations Straight: interest over several periods, plus principal back at end Value is annuity consisting of stream of interest payments plus PV of principal paid at end C/r x [1 1/(1+r)n] + P/(1+r)n Can use the table in the appendix to calculate the PV of the stream of interest payments and then add the value of the principle discounted for its time due. Zero-coupon: lump payment at end, with no coupons along the way (implicit interest): No stream of interest, but sold at less than face value with the interest in the payment of the principle How determine such a bonds internal rate of interest (y)? Purchase price Q x (1 + y)n = Payment at maturity P. All variables are known except for y; solve for y Q x (1 + y)n = P y = (P/Q)(1/n) 1 (i.e., take the nth root of P/Q and subtract 1) Mortgage: secured by assets, payments include both interest and principal Changes in external market rates effect bond value. If market rates go up, the value of already issued bonds decrease, if market rates go down, the value of already issued bonds increase. Goal is to have an investment with a rate of return that beats the market. Stocks Use of simple, constant growth discounted cash flows is a good rule of thumb but no more than that. PV(stock) = PV(expected future dividends); This is true even for investors that look for profits in capital gains. If dividend is constant, then P0 = DIV1/r (perpetuity formula) If dividend will grow at constant rate, P0 = DIV1/(r g) (growing perpetuity) Formula to use to value growth stocks

To determine g, multiply plowback rate times return on equity Plowback rate = fraction of earnings re-invested ROE = earnings / book equity Stated in words: stock is worth present assets + NPV of investment opportunities Market capitalization rate r = DIV1/ P0 + g = dividend yield plus expected rate of growth in dividends Derived from formula for growth stock valuation The link between stock price and earnings per share Expected return = dividend yield = earnings-price ratio Price = P0 = DIV1/r = EPS1/r We also think of stock price as capitalized value of average earnings under a no-growth policy, plus PVGO, the present value of growth opportunities P0 = EPS1/r + PVGO Growth opportunities can be thought of as dividend trade offs A high price-earning ratio usually signifies optimism regarding present value of growth opportunities Beware of inherent variability in book values NCR v. ATT (Ohio, 1991) The case As anti-takeover measure in response to a proxy fight, NCR establishes ESOP under which it issued preferred stock with voting rights that is convertible to common (already had poison pill and staggered board) 24,000 employees are initially to receive one preferred share each, but this empowers them to vote 229 shares (other shares to be distributed over 25 yrs.) Shares represent roughly 8% of outstanding voting shares

Shares contain reset provision according to which conversion formula changes to compensate for any decline in common stock value lack of downside risk induces holders to support incumbent management ESOP is leveraged with NCRs own \$! NCR receives promissory note from ESOP trustee to pay for shares, and NCR loans trustee the money to redeem the note. (traditional leveraged ESOP financed by bank with resulting cash influx to company) Ct. finds that plan violates primary purpose test Errors of financial analysis Goldman Sachs forecast of rise and fall violates efficient market theory: imagine investors at time before stock price is set to fall no way will anyone pay more for the stock than it will later be worth (info on which forecast is based cannot be/remain private). Price that is expected to drop in future will drop now (unless reason for future drop is big dividend payout) GS may have been accommodating client, strongly supported by lack of fairness opinion Court is wrong to say that conventional ESOP financed by bank loan guaranteed by issuer differs from what NCR did, which is essentially to cut out the middleman. No econ. difference; NCR is ultimately on the hook whether it loans funds to redeem a note or guarantees a loan. Oxford Health Plan Bad earnings surprise, and response to profit warnings Can be useful tool for rough way to value a stock Has a huge impact on the current present value of a stock Although the response was dramatic, was not unreasonable given the numbers

## 2. Valuation Under Uncertainty

2.1 Risk and Diversification

Market Risk Premium: historical evidence suggests that its roughly 8% or 9% (above risk-free rate).
Adjusting PV for risk Basic Present Value (PV) formula discounts future cash flows by 1/(1 + r), where r is opportunity cost of capital. But r is problematic in that it conflates 2 elements: (1) time value of \$ and (2) riskiness of particular investment. In evaluating particular project, these should be separated Certainty equivalent method uses 2 steps: PV = (a) sum of expected returns (b) discounted by risk-free rate of capital = ERt /(1 + rf)t. E.g., investment of \$100 has 30% chance of losing \$10, 30% chance of gaining \$10, and 40% chance of gaining \$20 in one year. First figure expected return = (0.3 x \$90) + (0.3 x \$110) + (0.4 x \$120) = \$108. Then discount this: if rf = .05, then PV of project = \$102.85 Variance & Standard Deviation: The standard statistical measures of spread are variance (2) and standard deviation () (standard deviation is simply the square root of the variance). The variance of the market return is the expected squared deviation from the expected return (dispersion between estimates of expected value). By reducing the variance, an investor reduces the risk of his portfolio. Variance: expected squared deviation from expected return: (a) take the various possible returns, (b) measure the distance between them and the expected return, (c) discount each figure by the probability that the possible return will result, and (d) sum up these discounted figures. Standard Deviation: In normal distributions, 66% of outcomes are within one standard of deviation (to positive and negative sides) of expected outcome. Another 28% are between one and two standard deviations. Measuring Variability: One could estimate the variability of a stock or bond portfolio by identifying the possible outcomes, assigning a probability to each outcome, and cranking through the arithmetic. However, most financial analysts begin by observing past variability. There is no risk in hindsight, but it is reasonable to assume that portfolios with histories of high variability also have the least predictable future performances.

Diversification and Risk Reduction: The bottom line here is that diversification brings about a reduction in variability (risk). This happens rapidly for the first few securities added to a onestock portfolio, and then more slowly as the portfolio grows. Diversification works because prices of different stocks do not move exactly togetherthey are not perfectly correlated. NOTE: The improvement is slight when the number of securities is increased beyond 20 or 30.

Risk Aversion: because of decreasing marginal utility of money, it hurts more to lose
money than it feels good to win. Therefore, of two projects with same expected return, people prefer the less risky one. Types of Risk: Systematic Risk (Market Risk): This kind of risk cannot be diversified away. It exists due to economywide perils that threaten all businesses. This is why stocks have a tendency to move together. That is why investors are exposed to market uncertainties no matter now many stocks they hold. Beta (): Sensitivity of individual security to market movements is called beta ().

1) >1: stock tends to amplify market movements 2) 0<<1: stock moves in same direction as market but not as far
Unsystematic Risk (Unique Risk): This kind of risk is company specific. One is able to reduce this risk by diversifying (the individual variability of the stocks will cancel each other out). Portfolio Risk: diversification reduces risk b/c stock prices do not move in lockstep; fluctuation in one stock can be countered by fluctuation in other direction of another stock. You can reduce the riskiness of a portfolio so that it resembles the overall market risk with 10 stocks. Covariance: measures the degree to which 2 stocks covary. Its measure is a function of correlation coefficients. Correlation Coefficients: If coefficient is +1, stocks move in lockstep, so putting stocks in one portfolio does not diversify away any risk. If coefficient is 0, stock outcomes are independent, so risk is cut in half (assuming equal portions invested in both stocks). If coefficient is 1, outcomes are opposite, so only risk left is systematic (again, assuming equal portions invested in both stocks). Mars Hypo: Pricing and Risk

1) Assume a firm is considering a project: (1) it costs \$500 million to send a spaceship on

mining operation to Mars; (2) return, if successful, in 2 years; (3) probability of success: 10%; (4) make \$10 Billion if successful; rf = .10.

2) What is Net Present Value? Use the risk characteristics of the project to assess, not those
of the firm.

a) = -\$500m + [(.10)(\$10B) x discount factor] = -\$500m + [\$1B/(1 + r?)2] b) Question is, What discount factor to use? Note that all the risk is unsystematic and
cannot be diversified away. Use r of .10. The risk of non-return has been factored into the numerator recall the certainty equivalent method.

## c) So NPV = -\$500m + [\$1B/(1 + .1)2] = \$326m.

3) OK, project has positive Net Present Value. Will bank lend money for it? Only at an exorbitant rate.

a) Bank loan rate includes 3 components: (1) risk-adjusted market rate of return; (2)
transaction costs; (3) premium to cover risk of default b) 3rd component is killer here. Assume bank normally lends at 12% rate. But note only 10% chance of payment. So NPV for bank = -\$500m + [\$500m x (1.12)2]/10 = -437.28. Bank would have to charge over 216% interest for its loan to have a positive Net Present Value.

Firm Diversification: Investors do not ask that the companies they invest in to diversify. If they were not able to hold a large number of securities, then they might ask firms to diversify for them. However, investors can diversify and do it more easily than a firm by buying a mutual or index fund. Because investors are able to diversify for themselves, they will not pay extra for firms to do it for them (diversification does not add to a firms value or subtract from it). Limits on Diversification: Corporate managers must invest in own companies projects Raises Q: should firms diversify their projects, so that they have uncorrelated ones? No, because investors wont reward them for this diversification; investors can diversify at portfolio level. Also because of the difficulty of managing uncorrelated projects (anti-synergistic effect) Principle of Value Additivity: PVA+B = PVA + PVB no additional value from combining independent projects under one corporate roof unless combination changes cash flows (determine PV of each project independently and add PVs together) Transaction costs

Monitoring costs: The larger the holding, the less monitoring you can do and the less influence you have Information Risks: Unsystematic risk correlated with information risk.

2.2 Pricing Risk: CAPM and Alternatives Risk and Return (Brealey & Myers Chapter 8). This Chapter builds on the lessons of Chapter 7 (risk and risk measurement) and presents formal models linking risk and expected return. The chapter begins with a description of the Portfolio Theory (developed by Harry Markowitz), which formed the basis for the most popular and widely used model of risk-return relationship: the Capital Assets Pricing Model or CAPM. Portfolio Theory: Individual investors are assumed to be risk-averse, meaning that they would like to be compensated for bearing more risk. This also means that they like higher returns and lower risk. The Portfolio Theory gives the basic principles of selecting the optimal portfolio in terms of risk and return. When combining securities into a portfolio and infinite number of combinations is possible. But investors would choose only those which are efficient portfolios. Portfolios are considered efficient if, for a given standard deviation, they give the highest return, or for a given return they have the lower standard deviation. Investors need only consider efficient portfolios, for all other portfolios give them a poor deal.

Introducing borrowing and lending: Suppose that you can also lend and borrow money at some risk free rate of interest (Rf). If you invest some money in Treasury Bills (i.e. lend money) and place the remainder in common stock portfolio S (see figure below), you can obtain any combination of expected return and risk along the line joining Rf and S. Since borrowing is merely negative lending, you can extend the range of possibilities to the right of S by borrowing funds at an interest rate of Rf and investing them as well as your own money in portfolio S. An investors job can be separated in two parts: first, to choose the best (risky) portfolio of stock S and, second, to combine it with the right amount of lending or borrowing to adjust to the preferred level of risk.

Capital Assets Pricing Model (CAPM): Is an extension of the Portfolio Theory. In a competitive market, the expected risk premium (Market return Risk-free rate) varies in direct proportion to beta. This means that in the figure below all investments must plot along the sloping line, known as the security market line. The expected risk premium on an investment with beta of .5 is therefore half the expected risk premium on the market; and the expected risk premium on an investment with beta of 2.0 is twice the expected risk premium on the market. We can write this relationship as: Expected risk premium on stock = beta x expected risk premium on market r rf = (rm - rf) Example: if MSFTs beta = 1.26, the T-bill rate is .04, and the expected return on the market is .10, then ER on MSFT = 1.26(.10 - .04) + .04 = .1156.

Validity of CAPM: One of the best known tests of the CAMPs validity involved analyzing portfolio returns over 1931 to 1991. The results showed a strong positive relationship between beta and returns and thus broad support to CAPM. However, it was found that the security market line was flatter than the theory predicted and it was above the risk-free rate. In recent years the relationship between beta and the risk premium has been particularly flat. There is also evidence that suggests that beta is not the only factor that affects expected returns.

Assumptions of CAPM: No transaction costs, independent corporate governance (shareholders take returns as they come), borrow and lend at the risk-free rate, a two period world, homogeneous expectations, no taxes, and beta is a complete measure of risk. Alternative Theories to CAPM: Consumption CAPM: The CAPM assumes that investors are concerned with their wealth and uncertainty about the same. The Consumption CAMP holds that risk and expected return should be related to changes in investors aggregate consumption rather than their wealth. Arbitrage Pricing Theory: It was the first serious challenger to CAPM. It postulates that each stocks return depends on several pervasive macroeconomic factors and the risk premium depends on the factor weights. The general model can be written as: Return = a + b1 (factor 1) + b2 (factor 2) Three Factor Model: This theory incorporates the small firm effect and the book to market ratio effect (small firms and those which have low market-tobook ratios seem to provide higher average returns irrespective of their betas) seen in empirical studies: r rf = bmarket(r1market-factor) + bsize(rsize-factor) + bmarket-to-book(rmarket-to-book) Capital Budgeting and Risk (Brealey & Myers Chapter 9, Sections 9.1 and 9.2): These sections discuss estimation of betas for companies using market information and the relationship between beta, financial leverage, and operating leverage. Measuring Betas (Section 9.1): Suppose that you were considering an expansion by your firm which would have about the same degree of risk as the existing business. You should discount the projected flows at the company cost of capital (the rate of return requested by the investors in the company). To estimate that, you could begin by estimating the beta of the companys stock.

An obvious way to measure the beta of a stock is to look at how its price has responded in the past to market movements. For example, in the figure above we have plotted monthly rates of return from HP stock against market return for the same months. The slope of the line is an estimate of beta. Only a small proportion of each stocks total risk comes from the movements in the market. R2 measures the proportion of the total variance in the stocks returns that can be explained by market movements. Form 1993 to 1997 the R2 for HP was .35, In other words, 35% of the stocks risk was market risk and 65% was unique risk. The variance of the returns on HP sock was 856. So we could say that the variance in stock returns

that was due to market fluctuations was .35x856=300, and that the variance of the unique returns was .65x856=556. The noise in the returns can obscure the true beta. Statisticians calculate the standard error of the estimated beta to show the extent of possible mismeasurement. Then they set up a confidence interval of the estimated value plus or minus two standard errors. For example, the standard error of HPs estimated beta is .30. Thus, the confidence interval for beta is 1.69 plus or minus 2x.30. If you state that the true beta for HP was between 1.09 and 2.29, you have a 95% chance of being right. Fortunately, estimation errors tend to cancel when you estimate betas of portfolios. That is why financial managers often turn to industry betas. Capital Structure and the Company Cost of Capital (Section 9.2): Borrowing is said to create financial leverage or gearing. Financial leverage does not affect the risk or the expected return on the firms assets, but it does push up the risk of the common stock and lead the stockholders to demand a corresponding higher return. How Changing Capital Structure Affects Expected Returns: To calculate the company cost of capital you take a weighted average of the expected returns on the debt and equity: Company Cost of capital = = rassets = rportfolio equity requity debt+equity

## debt rdebt + debt+equity

Example: a firms market value balance sheet is as follows: Assets value Assets Value 100 100 Debt Value (D) Equity Value (E) Firm Value (V) 40 60 100

Then if investors expect a return of 8% on the debt and 15% on the equity, the expected return on the assets is: (40/100 x 8) + (60/100 x 15) = 12.2% Now what would happen if the firm issued an additional 10 of equity and used the cash to repay 10 of its debt? The balance sheet would be: Asset value Assets Value 100 100 Debt Value (D) Equity Value (E) Firm Value (V) 30 70 100

The package of the debt and equity is unaffected, but the change in financial structure does affect the required return on the individual securities. Since the company has less debt than before, the debtholders are likely to be satisfied with a lower return (we will suppose 7.3%). Now, we can write down the equation: (30/100 x 7.3) + (70/100 x requity) = 12.2% and solve for the return on equity: requity = 14.3% Conclusion: Reducing the amount of debt reduced debtholder risk and led to a fall in the return that debtholders required (8% to 7.3%). The lower leverage also made the equity safer and reduced the return that

shareholders required (15% to 14.3%). However, the weighted average return on debt and equity remained at 12.2%. How Changing Capital Structure Affects Beta: We start with a similar formula: assets = portfolio = D debt + V E equity V

Example: In the example above, if the debt before the refinancing has a beta of .2 and the equity has a beta of 1.2, then: assets = (.4x.2) + (.6x1.2) = .8 Now, what happens after refinancing? The risk of the total package is unaffected, but both the debt and the equity are now less risky. Suppose the debt beta falls to .1: assets = .8 = D debt + V (.3x.1) + 1.1 E equity V (.7xequity)

equity =

Conclusion: After the refinancing both debt and equity are less risky, and therefore investors are satisfied with a lower expected return. But equity now accounts for a larger proportion of firm value than before. As a result the weighted average of both the expected return and beta on the two components is unchanged. 2.3 Decision Trees and Sensitivity Analysis A Project is Not a Black Box (Brealey & Myers Chapter 10, except 10.2): This Chapter describes commonly used techniques of project analysis which can help the financial manager to understand the projects structural strengths and weaknesses, its dependence on one or more key inputs, and interrelationships the project might have in future decisions: Sensitivity Analysis: Is the most useful and important technique. It is simple to apply and understand and can be particularly effective in identifying the need for additional information. Sensitivity analysis captures the effect on key inputs or variables on the project, one variable at a time. By taking one variable at a time and replacing its expected value with both an optimistic and a pessimistic estimate, cash flows and NPVs are recalculated. Example: Consider the following forecasts for an investment of \$20 million with an 8-year life. Pessimistic Expected Optimistic Market Size 60,000 90,000 140,000 Market Share, % 25 30 35 Unit Price \$750 \$800 \$875 Unit variable cost \$500 \$400 \$350 Fixed cost, millions \$7 \$4 \$3.5 Consider straight line depreciation, a tax rate of 35%, and an opportunity cost of capital of 14%. Calculate the NPV of the project and conduct a sensitivity analysis.

The first step is to calculate the annual cash flows from the project for the base case (the expected values): Description 1. Revenues 2. Variable cost 3. Fixed cost 4. Depreciation 5. Pretax profit 6. Tax 7. Net profit 8. Net cash flow How calculated 90,000 x 0.30 x 800 90,000 x 0.30 x 400 \$4,000,000 \$20,000,000 / 8 Item 1 (items 2+3+4) Item 5 x 0.35 Item 5 item 6 Item 7 + item 4 Value (in \$ millions) 21.600 10.800 4.000 2.500 4.300 1.505 2.795 5.295

This level of cash flow occurs for each of the 8 years of the project. The present value of an 8-year, \$1 annuity is 4.639 at 14%. So, the NPV of the project is given by: NPV = \$5,295,000 x 4.639 - \$20,000,000 = \$4,563,505 The second step is to alter the forecasts one at a time to their optimistic and pessimistic values. The easiest way to do this is to work out how much each change affects the net cash flow and then use the annuity factor as before to work out the NPV. Example: The optimistic value of the market size increases the pretax revenues by 50,000 x 0.30 x (\$800 - \$400) = \$6 million; so it increases the (after tax) net cash flow by \$6 million x 0.65 = 3.9 million, to \$9.195 million. The NPV now becomes: NPV = \$9,195,000 x 4.639 - \$20,000,000 = \$22,655,605. Scenario Analysis: It can be seen as the logical extension of the sensitivity analysis. Altering the variables one at a time, as is done for the sensitivity analysis, ignores the fact that the variables are usually interralated. One way around this problem is to look at how the project would fare under a number of different plausible scenarios of the future. Break-even Analysis: Calculates the sales level that will give zero NPV for the project (how bad sales can get before the project begins to loose money). Brake-even analysis enables managers to analyze the impact of operating leverage on the projects NPV. A project with high fixed costs will have a NPV which is more exposed to the level of sales. Many companies use the brake-even level computed not on a NPV basis, but on an accounting basis. Zero accounting profit is really a big loss as it indicates a failure to earn any return on capital, and that represents a loss equal to the opportunity cost of capital. Decision Trees: Are very useful to analyze a sequence of different uncertain events and decisions through time. Branches from points marked with squares are used to denote different possible decisions. Branches from points marked with circles denote different possible outcomes. Present values are calculated starting from the end of the most distant branches first. Roll back to the immediate decision by accepting the best decision at each of the later stages. Example: Jill-in-the-Box is evaluating a possible investment in a new plant costing \$2,000. By the end of a year, it will know whether cash flows will be \$300 a year in perpetuity or only \$140 a year in perpetuity. In either case, the first cash flow will not occur until year 2. Alternately, the company would be

able to sell its plant in year 1 for \$1,800 if demand is low and for \$2,000 if the demand is high. There is a 65% chance that the project will turn out well and a 35% chance it will turn our badly. The opportunity cost of funds is 10%. What should the company do? The problem can best be analyzed by the decision tree shown below. If things go badly, the cash flows will be worth \$140/0.1 = 1,400 in year 1. To analyze the decision tree we work backwards from the most distant branches of the tree. At the decision branch points, marked with squares, we make decision. At the uncertainty ones, marked with circles, we calculate expected values.

So, if things go well (high demand), we will decide to continue with the plant at a value of \$3,000 in year 1. However, if things go badly (low demand), we will prefer to sell it for \$1,800 rather than wait for cash flows worth only \$1,400. We can now take the expected value at the uncertainty branch point by weighting each possible outcome by its probability: Expected value in year 1 = \$3,000 x 0.65 + \$1,800 x 0.35 = \$2,580 Net present value of the investment = \$2,580/1.1 - \$2,000 = \$345.45 The project is worth pursuing. Sensitivity Analysis Example: The materials contain an excerpt from a proxy statement of Holiday Corp. which provides a set of projections of future performance prepared for a leveraged recapitalization of Holiday Corp. that was completed in early 1987. The recapitalization involved a one time \$65 per share special dividend, funded through borrowing, with some of the borrowings to be repaid through asset sales. After the dividend, Holiday stock, called sub equity because most of the value was in the dividend, was expected to be worth only about \$10 per share. Some assumptions were not explicitly stated in the proxy statement, and perhaps should have been (like the assumption of no recession, for example).

## 3. The Efficient Capital Markets Hypothesis

3.1 The Meaning of Market Efficiency (Gilson and Black, materials pp. 47-68) Efficient Capital Markets Hypothesis (ECMH): Information is widely & cheaply available to investors, and all relevant & ascertainable information is reflected in the price of publicly traded assets (i.e. stocks and bonds). Furthermore, if capital markets are truly efficient, then buying or selling stock at current market price is never a positive NPV transaction and there is no way to achieve consistently superior rates of return. (Note: Skepticism in the efficiency of capital markets has arisen after the 1987 stock market crash. There was no obvious new fundamental information to justify the significant decline. Market prices were either irrationally high before Black Monday or irrationally low afterwards.) Takeovers: Any takeover bid at a premium should be accepted (except to get a higher offer), because the assets of the firm cannot be undervalued to the extent ECMH holds true. Buying a public company at a premium to the targets market price only makes sense for the bidder if: 1) The acquisition will increase the combined cash flows to the shareholders of the bidder and target, or reduce the systematic risks associated with those cash flows (create synergies); or 2) The acquirer has private information about the targets expected cash flows or risks that the market lacks. Levels of Efficiency: 1. Weak Form: stock price reflects all past price information, so no investor can earn excess returns by trading on historical price or return information. (Note: The weak form of efficiency is subsumed in the semi-strong form, since past prices and trading history are particular types of publicly available information.)

2.

Semi-Strong Form: market prices are an unbiased forecast of future cash flows that fully reflects all public information. No excess returns from trading on basis of public information. When discussing ECMH, this is the form that is generally being referred to. Indexing: This is a strategy where investors invest in a fund that closely mirrors the return on a stock market index such as the S&P. Belief in the semi-strong form has led some investors to utilize this strategy since they do not think they can consistently beat the market unless they have information that the rest of the market does not have. Strong Form: market prices are an unbiased estimate of future cash flows that reflects all information, both public and private. There are never any excess returns.

3.

Empirical Evidence for Market Efficiency: Supporting Evidence for Weak and Semi-Strong Forms of Efficiency: Evidence for weak-form efficiency: The market has been said to act like a person in a random walk, since no pattern emerges in price changes from one day to next Evidence for semi-strong-form efficiency: professionally managed portfolios do not outperform the market. The argument was that the performance of professionally managed portfolios, if consistently superior to the market as a whole or to relevant subsets of stocks in that market, would indicate an element of inefficiency in the pricesetting process. Contrary Evidence foe Semi-Strong Form: The Semi-strong form cannot be

change in price, this otherwise inexplicable change may itself signal the presence of new information to the uniformed. Uninformed Trading (if random): This mechanism notes the difference between hard facts and soft information such as forecasts and predictions. This mechanism believes that although each traders own forecasts are skewed by unique constraints on his or her judgment, other traders will have offsetting constraints. As trading proceeds, the random biases of individual forecasts will cancel one another out, leaving price to reflect a single, best-informed aggregate forecast.

The crash of 87: Dow fell 23% in one day. There was no obvious new fundamental info. It appears that prices were either irrationally high before the crash or irrationally low afterwards. This shows how difficult it is to value common stock from scratch and this difficulty has two important consequences. 1) Investors always price a common stock relative to yesterdays price or relative to todays price of comparable securities. However, when investors lose confidence in the benchmark of yesterdays price, there may be a period of confused trading and volatile prices before a new benchmark is established. 2) The hypothesis that stock price always equals intrinsic value is impossible to test, precisely because it is so difficult to calculate intrinsic value without referring to prices. Thus, the crash did not disprove the hypothesis but many people find it now less plausible. The crash does not undermine the evidence for market efficiency with respect to relative prices. Market anomalies and the financial manager: Newly issues securities may not be sold at a fair price for two reasons, first, investors might not have all the info that the manager has, and second, even if they do have the info, they might be slow to react to it. If management believes the stock to be overpriced, they should sell more stock because it is a cheap form of financing, but never invest that capital in a project that offers a lower rate of return than you can earn elsewhere in the market. If management believes the stock to be undervalued, they should not raise capital by issuing new stock but they can still invest in new projects by borrowing. Relative v. Absolute efficiency: even though markets may not always correctly price securities on an absolute basis, the pricing or valuation is correct in a relative basis. We know that GM is reasonably valued by comparing it to Ford. The six lessons of market efficiency: financial managers should start with the assumption that security prices are fair and remember that: Markets have no memory: the sequence of past price changes contains no information about future changes. Attempts at timing the market for bond or stock issue are unlikely to result in value maximizing decisions. Trust market prices: prices impound all available info about the value of a security. This means no investor can achieve consistently superior rates unless he knows more than everyone else. Market prices reflect the collective wisdom of all investors and analysts and therefore will be the best estimate of the value of the securities. Read the entrails: Security prices reflect what investors expect to happen in the future. A very good measure of the market reaction to an event or announcement is the abnormal return, which is the net return on the stock surrounding the event after the taking into account the normal or expected return. There are no financial illusions: investors are only concerned with the firms cash flows and the portion of those cash flows to which they are entitled. Therefore, they are unlikely to be impressed by accounting gimmicks or other cosmetic changes like stock splits. (stock splits might raise the price of the stock only because they are seen as a signal that the company will raise its dividend in the coming year) The Do-It-Yourself Alternative: investors will not pay others for what they can do equally well themselves. For example, justifying mergers on the grounds that they can produce a more diversified firm does not work because investors can diversify themselves for cheaper. The same applies to the choice of the firm to issue debt or common stock. Debt should only be issued if the firm can issue debt more cheaply than the individual shareholder.

Part II: Debtholders Rights in the Going Concern 4. Debtholders Rights in the Going Concern
4.1 Introduction to Standard-Form Debt Contracts Brealey & Myers, Chapter 14, pp. 383-400: This chapter provides an introduction to corporate financing by discussing equity and debt. In addition, there is brief coverage of derivative products. 14.1 Patterns of Corporate Financing: Most of the money that firms use for investment is generated internally (i.e., funds allocated to depreciation and retained earnings). In most years firms need more money than they generate internally. The additional funds are raised through new equity issues or by borrowing. The firm thus faces two key questions regarding their finances: (1) How much profit should be retained vs. paid out as dividends? (2) How should the firm finance its financial deficit (equity or debt)? Too much reliance on internal funds? There is some concern that firm managers rely too heavily on internal funds to finance projects. Some firms demonstrate an aversion to projects that would require outside financing. On the one hand, this does not make much since, since the opportunity cost of capital is not dependent on the source of financing. On the other hand, there may be good reasons for this behavior (e.g., cost of raising funds in the securities market, investor worries that accompany the announcement that a firm will issue additional equity [shareholders know that managers will issue stock when the price is high or advantageous given the knowledge that managers have; thus, shareholders do not always react positively to an issuance]). Capital Structure of American Firms: Total capitalization is the sum of longterm liabilities and stockholders equity. There is an upward trend in the ratio of long-term liabilities to total long-term financing (i.e., the ratio of debt to total capitalization has been increasing) from the 1950s to the 1990s. Increasing Debt Ratio in Perspective: (1) The debt ratios of the 1990s are no higher than in the 1920s and 1930s. (2) Inflation has risen, especially rapidly during the 1970s and 1980s. The debt ratios are based on book values, and firms may be borrowing against market values, thereby increasing their debt ratios. (3) United States corporations debt ratios fall in the middle of the pack when compared with international corporations. (4) It is true that U.S. corporations have more debt than they used to, but that does not mean that they have too much debt. 14.2 Common Stock: The maximum number of shares that a firm can issue is known as the authorized share capital. This is specified in the firms articles of incorporation. Shares held by investors are issued and outstanding, while treasury shares are issued but not outstanding. The book value of a companys shares equals the number of shares times the par value. Par value has little significance. Shares are sold for amounts in excess of their par value, and that excess is recorded as additional paid-in capital. Stockholders Rights: The common stockholders own the firm and thus control its operations. Stockholders exercise this control by electing a board of directors, either under a majority voting system (directors elected separately with each stockholder casting a vote for each share held) or a cumulative voting system (directors are elected jointly and stockholders can pool their votes for

quality of the collateral held by the trust (e.g., in a case where a borrower securitizes its accounts receivables in a trust, the lender only has to worry about whether the accounts will be collected, because the securities that the lender obtained are ultimately tied to the payment on those accounts by the borrowers customers). The securities issued in a securitization are also known as asset-backed securities. Default Risk: Investment grade securities are those that qualify for one of the top four ratings from Moodys or Standard and Poors. Debt that is below investment grade is sometimes referred to as junk bonds. Public versus Privately Placed Debt: Publicly issued debt is issued to anyone who wants to buy and is freely tradable when issued. Privately placed debt is issued directly to certain qualified lenders and can only be traded among those qualified lenders. Floating versus Fixed Rates: Some interest payments are fixed at issuance, while others fluctuate according to some measure (e.g., prime, which is the benchmark interest rate charged by banks, or LIBOR, the London interbank offered rate, which is the rate that major banks in London lend dollars to one another). Country and Currency: A eurobond is a bond marketed internationally, usually in the London banking community. Eurodollars are dollar-denominated deposits held outside the U.S. Arrangements Equivalent to Debt: Accounts payable are functionally equivalent to short-term debt, and leases are functionally equivalent to long-term debt. The point is that these arrangements are economically like debt but are treated differently on the books. Convertible Securities: A warrant is an option to purchase a set number of shares at a set price before a set date. These are often sold with other types of securities. A convertible bond can be exchanged for a set number of shares. This allows convertible bondholders to capture the upside of the issuers equity. 14.5 Derivatives: Derivatives are not used to generate funds for a company; rather, they are used to hedge against certain risks (e.g., interest rates, exchange rates, commodity prices, etc.). Traded Options: Options give the holder the right, but not the obligation, to buy or sell an asset at a fixed price (established today) in the future. A warrant is a type of option. Futures: A futures contract establishes a price today that you will pay at some later date to purchase or sell an asset or commodity. Forwards: These are futures contracts that are customized and are not traded on an organized exchange. These are typically arranged in the foreign exchange market. Swaps: An arrangement whereby two companies lend to each other on different terms, e.g., in different currencies, or one at a fixed rate and the other at a floating rate (taken from glossary)

issues, they would not subscribe to any of them unless the issues are underpriced. Thus, underpricing induces uninformed investors to participate. 15.3 Other New-Issue Procedures: There are two ways to sell securities, by fixed price or by an auction. The fixed price method simply involves setting a price for a certain number of shares. If the price is too high, the issue will be undersubscribed; if the price is too low, it will be oversubscribed. An auction requires investors to submit bids for how many shares they will purchase and at what price. The shares are then sold to the highest bidders. In the U.S., underwriters gauge investor interest and use that to predict likely orders. This is called bookbuilding, and it roughly combines elements of both methods discussed above. Types of Auctions: A discriminatory-price auction requires each winning bidder to pay the bid price submitted. In a uniform-price auction, the winning bidders pay the price of the lowest winning bidder. The uniform-price auction protects bidders against the winners curse (lower cost to overbidding) and is generally accepted as producing higher proceeds. Brealey & Myers, Chapter 24, pp. 709-732: This chapter focuses on describing and explaining the variety of long-term debt that a firm can issue. 24.1 Domestic Bonds and International Bonds: A firm that issues foreign bonds sells them to local investors in another country. Popular foreign bonds include yankee bonds (i.e., bonds sold by foreign firms in the U.S.) and samurais (i.e., bonds sold by foreign firms in Japan). There are also international bonds that are sold world-wide. The international bond market is also known as the eurobond market. 24.2 The Bond Contract: For a bond that is publicly issued, the bond contract is contained in an indenture or trust deed between the borrower and the trust company. Most bonds in the U.S. are registered, which means that the company records the name of the owner and pays interest and principal directly to that bondholder. (Bearer bonds are the other type of bonds. The bond certificate itself evidences ownership, and the bondholder must send in coupons to be paid interest and the certificate itself to receive principal.) Bond prices are usually stated as a percentage of face value (i.e., a price of 97% on a bond with face value of \$1,000 means the bond price is \$970). U.S. bonds typically make the coupon payment, or annual interest payment, semiannually. International bonds typically pay interest annually. The return on some bonds is primarily from capital appreciation in the form of original issue discount, with the extreme example being a zero-coupon bond that pays no interest. The interest rate may be fixed or tied to some common measure (e.g., LIBOR). When rates are variable, there are sometimes minimum rates (floors) or maximum rates (caps). 24.3 Security and Seniority: Long-term, unsecured debt issues are known as debentures, while shorter-term issues are notes. Some debt is secured, with the majority of such debt constituting mortgage bonds, which usually provide a claim against all of a firms property (but they can provide security of a specific asset). Holding companies sometimes use the securities of their subsidiaries as collateral for borrowing (collateral trust bonds), but the low priority of the stock often leads to terms on the amount of debt and preferred stock that the subsidiaries may subsequently issue. Another type of secured debt is an equipment trust certificate. This debt allows the borrower to make a down payment and then pay the balance through a group of equipment trust certificates. The borrower only obtains ownership of the equipment when the debt is paid off. Senior debt is prior to subordinated debt, which may be junior to senior debt or all creditors.

24.4 Asset-Backed Securities: This is an alternative to direct borrowing. The company that needs the money forms a separate company that purchases a package of assets. The separate company then sells the cash flows to these assets to finance the purchase from the company that needed the money. The securities sold are known as asset-backed securities. This is because the security holders receive a share of the payment on the package of assets (e.g., mortgages) held by the separate company. 24.5 Repayment Provisions Sinking Funds: This involves regular repayment before the bond issue is due. The borrower pays cash or buys bonds in the market and places them in the fund to satisfy its obligation. The ability to buy in the market is favorable to the borrower where the price of the bonds is low; where the price of the bonds is high, the borrower will pay cash into the sinking fund. Lower quality issues have higher sinking fund requirements, while higher quality issues have lower sinking fund requirements with balloon payments at maturity. Call Provisions: A call option gives the borrower the right to pay back the debt before maturity. The call option can be valuable to the buyer where interest rates fall and the price of the bonds increases. Since the borrower has the option to re-purchase the bonds at a fixed price, the borrower will call the bonds and issue new securities at a lower interest rate and higher price. Whenever the market value of the bonds is greater than the call price, the borrower should call the bonds. Investors know that firms will call bonds when the price exceeds the market value and will therefore never pay more than the call price for the bonds. Thus, borrowers should call their bonds when the market price equals the call price. The ability to call the bonds provides borrowers with an out from bond indenture provisions. (Putable bonds give investors the option to sell their bonds to the borrower. These protect investors because they can never anticipate all the protection that they will need). Defeasance: This is another way of repaying bonds. The borrower establishes a trust fund that pays the interest and principal on its bonds and enables the trust fund to carry out those activities by giving it U.S. Treasury bonds that will produce cash flows to cover the payments on the bonds. Bondholders like defeasance because their bonds are backed by U.S. securities, while shareholders do not favor the repayment method because Treasury securities purchased cost more than the firms risky debt retired. 24.6 Restrictive Covenants: Bond indentures include restrictive covenants in order to prevent the borrower from purposely increasing the value of the default option. Bondholders are essentially protecting themselves from very risky behavior by the borrower. There are negative covenants (see next subheading) that prevent the borrower from undertaking particular actions, and affirmative covenants that require the borrower to protect bondholders by taking certain actions (e.g., minimum level of working capital). The most important affirmative covenants are those that allow the bondholder to declare a default and get as much money as possible while the firm still has value. Examples of Covenants: Bond indentures often restrict the borrowers ability to issue additional senior debt. This is because senior bondholders do not like the ratio of senior debt to company value to increase. Senior bondholders do not care whether equity or subordinated debt is added, because senior debt collects prior to these claimants in the event of bankruptcy. In contrast, subordinated debtholders do care how much total debt (including senior debt) the firm takes on. All bondholders also worry about the addition of secured debt, so many

indentures include negative pledge clauses that require equal protection for unsecured debtholders if the firm mortgages its assets. Secured debtholders bargain for a limit on the secured debt that a firm may take on. Since leasing is very similar to secured borrowing, indentures also limit it. Also, dividend payments reduce the firms ability to make debt payments, so indentures typically contain restrictions on these items. Changes in Covenant Protection: The RJR Nabisco takeover highlighted the problems with not covenanting for protection. Subsequently, investors began to consider event risks like the takeover in RJR and thus began to include poison put provisions that require repayment of debt if a significant amount of stock is purchased by a single person and the debt is downgraded. But, such provisions do not always provide protection. The Marriott spin-off highlights the vulnerability of bondholders. (Recall that Marriott divided the firm into Host Marriott, which owned the hotels and the real property, and Marriott International, which managed the hotels. Marriott International would realize most of the profits, but Host Marriott was saddled with the debt. This caused the debts rating and price to decline. 24.7 Private Placements and Project Finance: Private placements of debt are made with a small number of qualified buyers. What is the difference between private placement of debt and public sale? (1) Transaction costs are lower. (2) The contractual arrangements for public sale are much more complicated. If debt is privately placed with one or two financial institutions, then all that is necessary is a promissory note. (3) Publicly issued debt is standardized, while privately placed debt can be tailored to the borrowers needs. (4) The restrictions on publicly placed debt are less strenuous than for privately placed debt. This is because the borrower believes that it can renegotiate with the lender in the case of privately placed debt; that is not easily possible with publicly placed debt. (5) The interest on privately placed debt is higher because it is illiquid. Project Finance: Project finance means debt supported by the project that it funds (as opposed to the firms that undertake the project). For a lengthy example, see text pp. 723-25. Project FinanceSome Common Features: The following five items are common characteristics of project finance. (1) The project is established as a separate company. (2) The contractors and the plant manager become major shareholders in the project and thus share in the risk of the projects failure. (3) The project company enters into a complex series of contracts that distributes risk among the contractors, the plant manager, the suppliers, and the customers. (4) The government may guarantee that it will provide the necessary permits, allow the purchase of foreign exchange, and so on. (5) The detailed contractual arrangements and government guarantees allow a large part of the capital for the project to be provided in the form of bank debt or other privately placed borrowing. The Role of Project Finance: It is frequently used to finance large projects in developing countries, but it also used to fund projects in industrialized countries (e.g., power plants in the U.S.). 24.8 Innovation in the Bond Market: This section begins by highlighting the variety of debt obligations and then describing a couple of more unusual instruments, including pay-in-kind bonds (PIKs), which helped finance the takeover of RJR Nabisco. (The major characteristic of PIKs is that the regular interest payments in the early years of the bond can be satisfied by cash or more bonds of equivalent face value.)

The Causes of Financial Innovation: Investor choice, government regulation, and tax all drive the creation of new debt instruments. The text gives an example of GMAC zero-coupon bonds that were created to take advantage of an IRS mistake in calculating original issue discount. The main point of the example was what drove the innovation (tax rules) and who the beneficiaries of the innovation were (early players who got in before the market equalized and all of the gains went to market participants who were in short supply (e.g., taxexempt investors in the GMAC example)). 4.2 Contractual Protection: The Role of Protective Covenants1 Why Adopt Protective Covenants?: As noted above, the contract on debt that is traded is called an indenture. The contract is technically between the debt issuer and the indentured trustee. There is typically no negotiation between investors and issuers on the terms of the indenture for public bonds. Some negotiation does occur between the issuer and the underwriter. Implications of Lack of Negotiation: If investors on the market do not negotiate the terms of the bond indenture, then wont all of the terms of the indenture favor the corporate issuer? Not necessarily. The borrower must place the bonds in the market. If the market is reasonably efficient, then we would assume that indenture provisions will be priced. Issuers Desired Provision/ Market Efficiency: What should issuers ideally want in terms of contract provisions? The issuer wants to be able to sell the bonds and retain some flexibility. The efficiency of the market is crucial here. If the market is not efficient and the issuer is not paid for the protections that it puts in the indenture, then issuers will not have an incentive to put in the protections. Generic Protective Provisions: (1) Seniority/Priority (subordinated or higher); (2) Security; (3) Callable; (4) Sinking Funds; (5) Restrictive Covenants. These generic provisions are described above in the Brealey & Myers material. Restrictive Covenants: These address the firms future borrowing decisions. They can restrict a companys actions with respect to (a) distribution decisions, (b) future borrowing decisions, and/or (c) investment decisions. Shareholder Opportunism: Equitys Methods of Diverting Value: This section discusses equitys three methods of redistributing value form the bondholders to the shareholders: (1) claim dilution, (2) asset dilution, and (3) variance (risk) enhancement. It is even possible under all three modes of diversion for shareholders to find it in their interest to pursue negative NPV projects, thus reducing overall wealth. Claim Dilution: To understand claim dilution, it is first necessary to understand an example with a corporation with fairly typical capital structure. Then, we turn to dilution of the original debtholders claims by adding more debt and show that the addition of debt, whether senior or on par with the original debt, decreases the rate of return for the original debtholders and increases the rate of return for the shareholders. Corporation with Basic Capital Structure: Suppose the risk free rate of return is 10%; the firm has a single project: p=1/2, y=-40%; p=1/2, y=70%, so expected return is 15%. The firm has \$100 in equity and \$100 in debt. Whether or not the project succeeds, the bondholders will be paid. Success on the \$200 project produces \$340 (\$200 x 70% + \$200), while failure produces \$120 (\$200 x 40% + \$200). In either case, the debtholders are senior and will realize their \$100
1

Kraakman includes some of this material under 4.1, but it is included under 4.2 for the purposes of this outline. Thus, 4.1 exclusively summarizes the Brealey & Myers text material.

the shareholders receive the \$40 dividend regardless of whether the project fails or succeeds; in the end, this doesnt matter: the shareholders still receive more whether you factor in the \$40 or not), but \$202 if the project succeeds (\$162 from project and \$40 from the dividend). Thus, the rate of return for the shareholders exceeds the 20% that the shareholders would have received if the shareholders had not distributed a dividend (i.e., 21%). Variance Enhancement: If shareholders are free to choose their project after contracting with bondholders, the shareholders will favor riskier projects and will be indifferent to whether a project produces a positive or a negative NPV. This is because the shareholders gain a possible higher return by increasing the riskiness of the project. Put another way, shareholders give themselves the upside to projects while shifting the downside to the bondholders. This results in a transfer of all of the wealth from the bondholders to the shareholders in a high variance (i.e., risky) project. Variance Enhancement Example: Suppose there are three projects, each with equal probability of success and failure; however, suppose that the projects produce: [1] 40% (failure) and 70% success, [2] 70% (failure) and 100% (success), and [3] 100% (failure) and 100% (success). Lets ignore the mathematical computations (see Slide 14 from 41/4.2 class slides for full numbers) needed to calculate the rates of return. Instead, accept the following as the rates of return for the projects: [1] bonds (10%), shares (20%), [2] bonds (-15%), shares (45%), [3] bonds (-45%), shares (45%). So, what we see is that shareholders increase their expected return by increasing the variance or riskiness of a project at the expense of the shareholders. Restrictions to Stop Variance Enhancement: The issuer will have to balance its loss of value from restrictions on variance enhancement that it accepts and the increase in value to the bondholders that flows from such restrictions. The issuer will pick the optimal set of provisions because the equity holders ultimately bear the cost of their own optimism if they are in an efficient market or are dealing with savvy bondholders. If the shareholders dont commit themselves to a project, the bondholders will charge so much that the shareholders will ultimately bear the cost of an investment. See, e.g., Slide 17 from 41.42 on the website. Thus, shareholders will commit so that they do not have to bear the cost of their own opportunism. Put another way, bondholders and shareholders do not conflict over the bond covenants, rather the rate of interest that bondholders will demand from shareholders. If bondholders know that shareholders will choose the project after the lending, bondholders will charge shareholders for this privilege, which will shift the cost of the investment to the shareholders. Sample Indenture Analysis: The sample indenture that we examined was the Harcourt Brace Jovanovich, Inc. (hereinafter HBJ) indenture on page 22 of the materials. The questions that led our discussion of the indenture are found on page 21A, just before the sample indenture. The indenture is long and complicated; I did not read or analyze it beginning to end. Instead, I focused on my notes about the provisions emphasized by Kraakman in class. The indenture overall exhibits a balancing of the cost of opportunism and the cost of flexibility. Limits in HBJ Indenture on Asset Dilution: There are three sections of the indenture that could be seen as limits on asset dilution: 1008 (regulates share dividends, repurchases, and redemptions; i.e., the simplest form of removing assets from the corporation), 1007 (limitation on transactions with shareholders and affiliates; debtholders have to worry about self-dealing among the equity holders), 1010 (limitations on asset sales and use of proceeds; this is to make sure that the company receives the proper amount of

consideration for assets and thus may be a limit on asset dilution; this also touches on variance enhancement because of the potential for changeover in assets). Concern about Subsidiaries in the Indenture: Why does the indenture consider subsidiaries so much? If the subsidiary runs into economic trouble, then the stock of the parent in the subsidiary will decline in value. Any claim by the debt of the subsidiary is far senior, with respect to the subsidiary assets, to the claim of any debt in the parent. Put another way, any holder of debt or preferred stock in the subsidiary has a claim senior to any debt holder in the parent whose claim in the subsidiary runs through the parents common stock in the subsidiary. Limits in HBJ Indenture on Claim Dilution: There are limits on incurring debt superior to the existing bondholders debt. There are restrictions on the new debt that the company can incur based on certain ratios. Also, there are limits on leasing, because that is very much like taking on new debt, especially in the sale-and-leaseback circumstances. See 1004 (limits new senior debt and security interests (negative pledge clause)); 1006 (overall debt restrictions and ratio tests); 1005 (sale and leaseback restrictions); 1009 (limits new debt for subsidiaries); 1010 (limits the sale of sub assets or stock); 1012 (limits new subsidiary stock). Ratio Tests: What do the ratio tests accomplish in the indenture? See page 77 for the presentation of the coverage ratios. The coverage ratio relates required earnings to interest. Notice that the coverage ratio becomes harsher over time. At the outset the bondholders expect the company to be highly leveraged, but after several years the bondholders expect the financial condition of the company to improve. The ratios are readjusted if new debt is used to pay off old debt, but the company cannot borrow to pay off subordinated obligations. The concern is that such activity would restructure the priority of the firms debt. this is another example of claim dilution. Limits in HBJ Indenture on Variance Enhancement: Section 1010 limits variance enhancement in a couple of ways. First, there are limits on asset disposition. This limits the sale of assets and then reinvestment in higher risk projects. Second, there are limits on financial investments. This is the easiest way for the equity to alter the risk structure of the corporation. All the firm does to enhance risk is buy risky financial instruments. Mergers: You could classify restrictions on the ability of a company to merge with another as limits in response to claim dilution. The potential for claim dilution exists because it is impossible to know what the debt structure of the new firm will look like. In addition, merger restrictions are a form of variance enhancement, because merger is an easy way to alter the risk characteristics of the company. Guarantees: Suppose a subsidiary has several creditors already but it wants to raise additional capital. The only way that anyone will lend to the company is if the parent gives a guarantee for the debt. Are the old creditors helped or hurt by the guarantee lending arrangement? Suppose the new creditors are borrowing at the same terms as the old creditors except that they have recourse to the parent for any amount the company is unable to satisfy. This could be good or it could be bad for the existing creditors. Good for Existing Creditors: The upside for existing creditors is that there will be an infusion of cash to keep the company afloat. Bad for Existing Creditors: The equity holders might use the guaranty arrangement to extract value from the corporation. This might be a device for shifting value to the shareholders form the old creditors (i.e., claim dilution). Slide 24 provides an example of this. The upshot of the guaranty in Kraakmans

example is that the initial creditor will realize a lower rate of return because it will not be fully paid of the project fails. Of course, the new creditor with guaranty will be paid in full, regardless of what happens with the project. The increased value of the project allows shareholders to realize a bigger upside if the project succeeds, increasing their rate of return. This represents the classic shift from debtholders to shareholders. Conclusion: You cant say definitely one way or the other whether the old debt holders will favor the new bondholders investment, but guarantees are not innocuous. Conversion: Conversion serves as a check on equity. If the shareholders loot, the bondholders can simply convert their debt to stock. This is a protective incentive characteristic. Flexibility: How does the company get out of the protective provisions? The debtor must renegotiate with the bondholders, but there is the problem of numerous bondholders and the fact that such negotiations would become administratively cumbersome. The indenture is a way of collectivizing these costs. Section 1014 allows the bondholders to waive restrictive covenants by majority vote. Call Provisions: Another way to get out of protective provisions is to call the bonds. See 1101. What is the difference between redemption and a tender offer for the bonds? The redemption provision provides some price protection for the issuer. Also, the redemption provision allows the company to force the bondholders to put their bonds at a specified price. This takes care of holdout problems. Note that the bondholders do get a premium for allowing the redemption of their bonds. Enforcement Provisions: Article 6 of the indenture sets up the enforcement mechanism. The trustee is a contractual device for surmounting the collective action problem of the bondholders. The trustee can bring suit in the event of a default ( 501 sets out the default provisions) and declare the principal due and immediately begin collection ( 502 has the acceleration clause). Violation of Ratios: What happens when one of the ratios is violated? The bondholders dont want to push the company into bankruptcy if the default can be cured. The trustee doesnt even have to notify the bondholders immediately of an event of default. This makes the identity of the trustee fairly important. The trustee is often the bank of the issuer who has loans outstanding to the issuer, which creates an interesting situation. Suppose that there is an event of default and the trustee refuses to bring suit. The bondholders have to get together (25% of the bondholders) to pursue the debtor. This makes some intuitive sense, because you dont want to allow one small bondholder to be able to pursue the debtor and crash the entire thing for the everyone. Boilerplate: The trustees conflicts of interest are listed, almost directly out of the Trust Indenture Act (TIA). The TIA regulates by requiring the inclusion of certain language in the contract. USX Hypothetical: This problem was not in the materials but was presented in class. See Slides 25-26. U.S. Steel purchased Marathon Oil and later U.S. Steel was pressured to spin off Marathon. Eventually, U.S. Steel issued a tracking stock keyed to the oil company and a tracking stock keyed to the steel company. The issue in this hypothetical, though, is what would have happened if U.S. Steel had spun off Marathon. Suppose that U.S. Steel and Marathon split up, each with the same amount of debt, expected returns, and risk (although with uncorrelated outcomes). Should the creditors complain?

Creditors Should Complain: The creditors of U.S. Steel oppose the spinoff because it decreases the value of their debt. Steel and oil are not correlated in their returns, even if they have equal riskiness. Thus, U.S. Steel will only go bankrupt if the oil and the steel investments plummet. With two companies, there is a 50% chance that the firm will go bankrupt and the creditors will lose out. Kraakman says there is a shift in value from the debtholders to the equity in this case. This is most clear if you take into account expected return, which reveals a shift in expected return from the bondholders to the shareholders. For the arithmetical demonstration of this, see Slide 26. The Hunts Bid to Buy Time: Placid Oil defaulted on its debt to the banks. The banks want to liquidate Placid and get their money back, while Placid wants to invest in a new drilling project. Should the bank allow Placid Oil to complete the project? No, not even if the project has a positive NPV. On Slides 27 and 28, Kraakman completes the arithmetic demonstrating this principle. Basically, the present value of the loan if the Hunts undertake the project is not positive. The banks just want their money back. They dont benefit from allowing the Hunts to make another gamble. Smith & Warner, On Financial Contracting: An Analysis of Bond Covenants, pp. 2-21: This article examine[s] how debt contracts are written to control the bondholder-stockholder conflict. The article notes one additional source (besides those three discussed above) of conflict between the bondholders and the equity holders: [u]nderinvestment. Under this theory, [a] firm with outstanding bonds can have incentives to reject projects which have a positive net present value if the benefit from accepting the project accrues to the bondholders. The article categorizes bond covenants and describes these restrictions. My summary of this portion of article appears immediately after the discussion of the Costly Contracting Hypothesis. Costly Contracting Hypothesis: The Costly Contracting Hypothesis is that control of the bondholder-stockholder conflict through financial contracts can increase the value of the firm. This occurs because bond covenants can increase the value of the firm at the time the bonds are issued by reducing the opportunity loss which results when stockholders of a levered firm follow a policy which does not maximize the value of the firm. In addition, monitoring costs by lenders are lowered where bond covenants eliminate the claim dilution problem. The Costly Contracting Hypothesis does not posit that the firm should issue no risky debt because it is optimal to have risky debt in the firms capital structure. [1] Restrictions on the Firms Production/Investment Policy: These covenants impose restrictions on the firms holdings of financial investments, on the disposition of assets, and on the firms merger activity. Restrictions on Investments: These covenants present varying degrees of restriction on the extent to which the firm can become a claimholder in another business enterprise. This is to control asset substitution [the articles parlance for variance enhancement]. The article notes that there are opportunity costs to the firm with these provisions. Restrictions on the Disposition of Assets: These clauses can restrict the disposition of assets in a variety of degrees. These clauses increase the cost of substituting variance increasing asses for those currently owned by the firm. Secured Debt: This is discussed above. Secured debt lowers the total costs of borrowing by controlling the incentives for stockholders to take projects which reduce the value of the firm. Secured debt lowers monitoring costs for the debtholder, but requires other transaction costs (e.g., filing fees, etc.).

Restrictions on Mergers: These covenants either flatly prohibit or place certain conditions on the merger of the borrower with another entity. These merger restrictions limit the stockholders ability to use mergers to increase either the firms variance rate or the debt to asset ration to the detriment of the bondholders. Covenants Requiring the Maintenance of Assets: These require the firm to continue certain projects or actions. Violation of the working capital requirement provides a signal to the lender. This signal can result in renegotiation of the debt contract, an alternative preferable to default when bankruptcy is more costly than renegotiation. Covenants which Indirectly Restrict Production/Investment Policy: If direct restrictions on production/investment policy were sufficiently expensive to enforce, dividend and financing policy covenants would be the only efficient way of constraining the firms actions. [2] Bond Covenants Restricting the Payment of Dividends: Cash dividend payments to stockholders, if financed by a reduction in investment, reduce the value of the firms bonds by decreasing the expected value of the firms assets at the maturity date of the bonds, making default more likely. These restrictions address any attempts by the firm to distribute money on account of its capital stock. The dividend covenant usually establishes a limit on distributions to stockholders by defining an inventory of funds available for dividend payments over the life of the bonds. These covenants do not prohibit dividends outright, just those dividends that would reduce the value of the outstanding debt. [3] Bond Covenants Restricting Subsequent Financing Policy Limitations on Debt and Priority: These covenants control claim dilution either through a simple prohibition against issuing claims with a higher priority, or through a restriction on the creation of a claim with a higher priority unless the existing bonds are upgraded to have equal priority. The text describes a number of such covenants. The authors conclude that a prohibition of all debt issues would reduce the value of the firm because wealth maximizing stockholders would not take all positive net present value projects. Limitations on Rentals, Lease, and Sale-Leasebacks: There are specific covenants in this area because the obligations of rentals, leases, etc. are senior to the bondholders and thereby reduce the value of the outstanding bonds. [4] Bond Covenants Modifying the Pattern of Payoffs to Bondholders Sinking Funds: These are discussed above in the Brealey & Myers materials. The text explains the link between the sinking fund and the dividend covenants: A sinking fund reduces the possibility that the dividend constraint will require investment when no profitable projects are available. Convertibility Provisions: The text explains the provisions of convertibility rights that allow bondholders to exchange their bonds for other securities. The conversion privilege is like a call option written by stockholders and attached to the debt contract. It reduces the stockholders incentive to increase the variability of the firms cash flows, because with a higher variance rate, the attached call option becomes more valuable. Therefore the stockholders gain

from increasing the variance rate is smaller with the convertible debt outstanding than with non-convertible debt. Callability Provisions: This is the right to redeem bonds before maturity and is discussed above. The authors note the argument that a call provision places an upper limit on the gains which the bondholders can obtain. Recall, however, that the borrowers right to call bonds is not costless; there is some premium to the bondholders when the securities are called. [5] Covenants Specifying Bonding Activities by the Firm: The cost of monitoring borrowers for compliance with covenants is borne by the borrower, so the borrower has the incentive to lower these monitoring costs. Required Reports: This is the requirement for the borrower to supply the lender with certain financial and other information while the bonds are outstanding. The text describes the typical information that is provided. Providing this financial information can reduce costs and thereby increase the firms value. Specification of Accounting Techniques: This basically involves creative accounting to shift value to the shareholders from the bondholders. Specification of accounting techniques can be expensive, and the use of external auditors might be more cost efficient. Officers Certificate of Compliance: The Costly Contracting Hypothesis suggests that the certificate of compliance is a way of reducing the monitoring costs of the bondholders. It is less expensive to have officers of the firm or the firms accountants, who already will be knowledgeable of any defaults, contract to call such defaults to the attention of the bondholders than to let bondholders themselves ascertain if a default has occurred. Required Purchase of Insurance: [T]he corporate purchase of insurance is a bonding activity engaged in by firms to reduce agency costs between bondholders and stockholders (as well as between the managers and the owners of a corporation). If insurance firms have a comparative advantage in monitoring aspects of the firms activities, then a firm which purchases insurance will engage in a different set of activities from a firm which does not. Conclusion: The Role of Bond Covenants: [D]ebt covenants reduce the costs associated with the conflict of interest between bondholders and stockholders. The costs of certain covenants (e.g., those that govern production/investment policy) are high, and therefore these covenants will not be common. On the other hand, dividend policy and financing policy involve lower monitoring costs. Because they are cheaper to monitor, it is efficient to restrict production/investment policy by writing dividend and financing policy covenants in a way which helps assure that stockholders will act to maximize the value of the firm.

## 4.3 Statutory Protection: The Trust Indenture Act

Bratton & Brudney, Corporate FinanceThe Trust Indenture Act of 1939 Background The Trust Indenture Act of 1939 protects bondholders. Requires that publicly issued bonds be issued pursuant to trust indenture that meets specific standards. Trust indenturestrustee (usually one bank) holds securities for many security holders. Trusts are crucial because holders have no power to affect policies etc. acting alone. The trustee has important powers, pre 1939 the security holders had no power over trustees policies. Trustees kept their power but didnt exercise their duties as they should have, and had the bargaining power to write the terms of their trust indentures. So The Trust Indenture Act is designed to give greater protection to investors by imposing minimum statutory standards. The Trust Indenture Act Elements of the Trust Indenture Act Establishes qualifications for Trustee. Regulates some (but not all) conflicts of interest. Enforcement: no exculpation for negligenceor willful misconduct before default; prudent person rule after default. Ban on impairing principal and interest obligations to bondholders, except possible 3 year delay of interest, with 75% vote. Section 315 Trustee will not be liable except for the performance of duties [prior to default] that are expressly in the indenture agreement. Trustees duty to give notice of defaults to investors, unless notice is not in their best nterests. Prudent man standard governs trustees behavior. Trust indenture cannot relieve Trustee of liability for negligence. Senate Report 101-155 Title IV--Trust Indenture Act of 1939 Conflicts of interest Title IV changes the Acts definition of conflict.

Previously, 301b listed nine conflictual relationships and required trustee to avoid them at all times. But the conflicts are only a problem when theres a default, because trustees would protect themselves and not their investors. Prior to default, a conflict does not conflict with trustees duties. When default happens, insistence on independence is necessary so trustee will vigorously protect investor interests. So Title IV changes 301b by applying its restrictions only after default. Also: now a creditor relationship is a prohibited conflict. (e.g. the situation where a trustee has made big loans to a corporation and is trustee to its bondholders, and the corporation defaults.) Elliott Associates v. J. Henry Schroder Bank & Trust Co. (2d Cir. 1988) Appeal examines trustees duties in performance of predefault duties. Plaintiffdebenture holder representing a class of holders. Claimed Defendant Trustee waived a 50 day notice period prior to redemption of debentures without considering holders interests. Without the waiver, the class would have earned \$1.2 million more in interest. So the waiver was improper and a breach of fiduciary duties. District Courtdismissed the case. Waiver was not a breach because pre-default duties are limited to those expressly provided in the indenture. This court: agrees. Indenture allowed for waiver of the notice requirement, so the company had discretion to waive it. It acted reasonably when it waived. No conflicts of interest. No implicit duties are imposed pre-default. Distinguishes this from Dabneya case involving conflict of interest

The Trust Indenture Act Section 316 This section restricts the power of the majority to defer or forgive principal and interest payments. The system had been abused in the past because majorities would be misled/coerced into decisions that harmed other security holders. Indenture will be deemed to authorize: (unless it expressly says otherwise) majority security holders to direct the time, place, method of proceedings for remedies available to the trustee, or to: consent to waiver of past default and its consequences. May contain provisions authorizing holders of 75% of securities (measured by the principal amount) to postpone interest payments

the right of the indenture holder to receive payment of principal and interest, or to sue, will not be impaired/affected without consent, with the exception of (a) (2)s postponement of interest payments. Mark Roe, The Voting Prohibition in Bond Workouts. 97 Yale LJ 232 (1987) The Prohibition Of Majority Action Clauses By The Trust Indenture Act Of 1939 316 prevents the majority from modifying any core term of the bond. Why? Principles: only two things should change a companys obligation to repay its bonds. 1) each affected bondholder consents 2) a judge values the company, determines that its insolvent, eliminates shareholders, reduces the express obligation to bondholders. Why prevent majority action clauses? 1) --fear that insiders could get control of an issue and destroy it for their benefit because as shareholders, getting bondholders to forgive debt would enrichen them. --fear of misinformation that forces bondholders into bad decisions. The current system: Pre-bankruptcy: The regulatory system: forced judicial scrutiny of recapitalization plans. LA Lumber Productsthe requirement that a reorganization plan be fair and equitable was interpreted to require judicial scrutiny. A bondholder could only be equitably bound if he consents or the judge holds a valuation hearing. Bankruptcy: 1978 Bankruptcy Reform Act: judge has no authority to intervene if affected creditors agree to the plan by 2/3 vote. That means that the LA Lumber Products rule doesnt apply after a firm enters bankruptcy. So bankruptcy allows majority voting, but rules that apply pre-bankruptcy dont allow it. There are structural weaknesses in how bankruptcy protects bondholders, and this means that they cannot get a good deal in a pre-bankruptcy workout either. Conclusion: Roe suggests repeal of the Trust Indenture Acts prohibition on majority action clauses [316(b)] He suggests a new 316 that would allow bondholders to vote by 2/3 majority to renegotiate the terms of an indenture.

## 4. Debtholders Rights in the Going Concern

cant really be stopped since not in the indentures. However, the transaction might be attacked through fraudulent conveyance ala U.S. v. Tabor. Transaction Details: Marriott International was the management group (revenues of \$7.4B and operating cash flow of \$500M) and Host Marriott was the real estate group (revenues of \$1.7B and cash flow of \$350M with \$225M earmarked for interest payments). Marriotts bonds lost 30% of their value and one investment bank estimated that market-wide losses after the Marriott announcement totaled \$11B with 22 such spinoffs pending by early the next year. McDaniel Bondholders and Corporate Governance: Argues that indentures are not longer sufficient for protecting bondholders interests and that directors should also have a fiduciary duty to protect them. Indentures fail to regulate the conflicts that exist between bondholders and shareholders and lack restrictive covenants in many places. Further, other protections are largely ineffective and bondholders need equal protection at the Board level. Context: Corporate debt has increased steadily since World War II to the range of 6.2 to 1 (for non-financial corporations). At the same time, bond contracts have become simplified after 1983. Restrictive Covenants: Through empirical research, claims that restrictions on unsecured debt and dividends are the exception and not the rule. Indenture covenants are very expensive for parties and incentives exist on both sides to avoid them if possible. United States v. Tabor Court Realty (3d Cir. 1986): Application of the Pennsylvania Uniform Fraudulent Conveyances Act (UFCA) to a leveraged buy-out of an anthracite coal mine. Mortgage lenders lack of good faith stemmed from the knowledge (or attributed knowledge) that the funds being offered were being used to finance the purchase of stock to the detriment of creditors. Fraudulent conveyance theory is an anti-asset dilution action Kraakman believes this is as close to fiduciary duty as you can get. Facts of Case: James Durkin (president of Raymond Colliery) incorporated a holding company named Great American and assigned to it his option to purchase Raymonds stock. Great American purchased the buy-out by obtaining a loan commitment from Institutional Investors Trust (IIT) for \$8.53M between borrowing and guarantor companies. Structure of Loan: The loan was secured by mortgages on the assets of the borrowing companies but was also guaranteed by the mortgages on the guarantor companies. Then the borrowing companies transferred \$4M to Great American and in exchange IIT was provided with unsecured promissory notes. In the end, Great American paid \$6.7 for Raymond stock with shareholders receiving \$6.2M in cash and a \$500K note and \$4.8M coming from mortgaging of the underlying assets.

Part III: Options and Corporate Reorganization 5. Options (B&M Ch 20 pp. 586-610; Ch 21 pp. 619-628; Option Problem Set)
B&M Chapter 20: Spotting and Valuing Options Introduction: Reasons for a financial manager to be familiar with options: 1) hedging (ie orange futures for citrus grower), 2) Embedded option to expand or abandon capital investments, 3) corporate securities (ie. warrants, convertibles, stock option compensation) and 4) viewing borrowing as an option to pay back loan. When a firm borrows, the creditor acquires the company and shareholders get a call option to buy it back by paying off debt. Calls, Puts, and Shares: A call option gives its owner the right to buy stock at a specified exercise price on or before a specified date. A European call can be exercised only on the specified date. An American call can be exercised at any time before the exercise date. Value of call option at expiration equals market price minus the exercise price. A put option gives its owner the right to sell stock on or before a specified date. Same American and European rules apply for puts as for calls. Value of put option at expiration equals the exercise price minus the market price. Both options are worthless after the expiration date. Seller of options gets paid to bear the risk. Financial Alchemy with Options: You can combine buying and selling stock with buying and selling options to achieve your financial goal. Buying a share of IBM for \$100 and selling a put on IBM with an exercise price of \$100 protects your downside at \$100 while maintaining limitless upside. You can achieve the same result by depositing the present value of \$100(valued from exercise date) in a bank and buying a call with an exercise price of \$100. Therefore, if these are European calls, we get the following put-call parity: Value of call + present value of exercise price = value of put + share price If there is a dividend missed out on then you just subtract the present value of the dividend from the right side of the equation. If a put or call isnt available on the market then you can substitute one for the other by shifting the equation around. Difference between Safe and Risky Bonds: The asset value of a firm equals the value of the bonds plus the value of the stock. The value of the stock represents a call option to buy the firm once the debt has been paid off. The bond value is equal to the firms asset value minus the value of the call. Using the put-call parity, we get: Bond Value = Asset Value Call Value = Present Value of Promised Payments to Bondholders Put Value Stock Value = Call Value = Asset Value Present Value of Promised Payment + Put Value Another way to look at it is that the debt holders have 1) bought a safe bond and 2) given the shareholders the option to sell the firms assets for the amount of the debt. The risky bond is equal to the safe bond minus shareholders option to default (the put option). The stock can also be characterized as 1) owning the firms assets, 2) borrowing the present

value of the debt obligation and 3) buying a put on the firms assets with an exercise price equal to the value of the debt obligation. If this isnt clear, then see the Circular example in B&M pp. 592-594. Spotting the Option: Any set of contingent payoffs that is payoffs which depend on the value of some other asset can be valued as a mixture of simple options on that asset. What Determines Option Values: Value of option increases with both volatility and time to maturity. Also the higher the interest rate, the higher the value of the call since an option holder is in effect buying the stock on credit. When there is an increase in: Stock Price (P) Exercise Price (EX) Interest Rate (r) Time to Expiration (t) Volatility of Stock Price () The option price change is: Positive Negative Positive Positive Positive

Other Properties: Option price is always less than the stock price. Option price is never less than the immediate exercise value. Option is worthless when stock is worthless. As stock price becomes very large, the option price approaches the stock price minus the present value of the exercise price. Systematic and Unsystematic Risk: Generally, the more volatile a stock is the more valuable the underlying options are. As unsystematic risk increases, the values of call and put options increase, regardless of whether theyre in the money. As systematic risk increases, the value of in-themoney and out-of-the-money put options as well as out-of-the-money calls increase. However, an in-the-money calls value may decrease as systematic risk increases; the more in the money it is, the more likely it is to decrease in value as systematic risk increases. This is intuitive since a deep in-the-money call acts just like the underlying asset. Since an asset with high systematic risk is worth less than a comparable asset with low systematic risk, then we can deduce that a deep inthe-money calls value is inversely related to the magnitude of systematic risk. An Option Valuation Model: Cant use discounted cash flow method to value option since deriving opportunity cost is impossible as it changes every time the stock price does. Option is riskier than stock; it has a higher Beta and higher standard deviation. The following two methods are back of the envelope ways to value options. The third, the Black-Scholes formula, is the standard method. If the following methods are unclear, then see B&M pp. 602-608. Constructing Option Equivalents from Common Stocks and Borrowing: The goal here is to find a combination of stock and loan that replicates an investment in that option. Since the two strategies give identical payoffs in the future, they must sell for the same price today. Now for the mechanics: An option delta (or hedge ratio) represents the number of shares need to replicate one call. Option delta = (spread of possible option prices)/ (spread of possible share prices). To value the option, you multiple the option delta by the exercise price and then subtract the amount you need to borrow from the bank. This loan equals the present value (PV) of the difference between the payoffs from the option and the payoff from a fractional share measured by option delta. The following equations should (hopefully) make this more clear: Delta = (spread of possible option prices)/(spread of possible share prices) Option = (Delta x EX) PV (option payoff - payoff from delta portion of share)

Risk Neutral Valuation: Pretend that investors are risk-neutral so that expected return on stock is same as interest rate. Calculate expected future value of option and discount it at interest rate. See ex on B&M pp. 603-4. Black Scholes Formula: Uses binomial method to break down time periods indefinitely. This is the accepted option valuation formula. Though you wont be asked to use it, it is helpful to see what variables affect the options value. Value of call option = [delta x share price] [bank loan] , where Delta = N(d1), where N(d)=cumulative normal probability density function Bank loan = N(d2) x PV(EX), where PV(EX)=present value of exercise price, obtained by discounting at risk-free interest rate (rf) d1 = (log[P/PV(EX)])/(t)+( t)/2, where t=# of periods to exercise date and where = standard deviation per period of (continuously compounded ) rate of return on stock d2 = d1 - t Note that the value of call option increases with time to maturity, the stocks variability (t), and the share price. It decreases with the discounted value of the exercise price, which depends upon the time to maturity and the interest rate. B&M Chapter 21: Real Options Introduction: 4 real options in capital investment projects: 1) option to make follow-on investments if immediate project succeeds, 2) option to abandon project, 3) option to wait (and learn) before investing, and 4) option to vary firms output or its production methods. Discounted cash flow (DCF) ignores embedded option value. Option to Abandon: Option to abandon is similar to put call. For instance if you have ability to terminate project and sell the assets then you have a put option on the project with an exercise price equal to the sale value of the assets. If you use DCF to value a project, then you should add the value of the abandonment option to get the real value of the project. Example in book (B&M pp. 623-5) uses the risk-neutral method to value. The Timing Option: Opportunity to invest in a positive-NPV project is essentially an in-the-money call. You can invest now, but it is possible the investment will fail. By waiting you the lose the early cash flows, but you will have a better idea of whether the project will succeed or fail. Example in books (B&M pp. 627-8) uses the risk-neutral method to value. Problem Set Answers Question 1: The convertible bond is the equivalent of nonconvertible bond with the same interest (8%) plus a call option on Alpha stock with an exercise price of \$50. We get this result by dividing the face value (\$1,000)by the number of shares to be converted into 20. Question 2: The ranking of protections against special dividends is as follows, in increasing strength: 1) Right to exercise early and receive the \$30 dividend, 2) Antidilution clause that gives warrant holders the right to buy one share for \$10, 3) Multiplicative antidilution clause that gives warrant holder the right to buy 4 shares for \$40. We get these results by valuing the option in each scenario. The immediate exercise value of the warrant is \$10 since after all warrants are exercised the new value of the firm will increase from \$600 to \$1000 and the number of shares will double to 20. Each share will then be worth \$50, or \$10 more than \$40 exercise price of the warrants. Thus, under the first protection (right to exercise early and receive \$30 dividend), the warrant is immediately worth \$10 due to the process described above. It is not worth anymore since there is no waiting value. Under the second protection (\$10 exercise price), the immediate payoff is \$10

since after the warrants are converted, Alpha is worth \$400 thereby making each share worth \$20, or \$10 more than the exercise price. The value of the option is greater than \$10 (and therefore greater than under the first protection) since there is waiting time. Under the third protection, the immediate payoff is \$16 since after the warrants are converted, Alpha is worth \$700 thereby making each share worth \$14; since each warrant holder gets 4 shares then his payoff is 4x1440=\$16. Since there is also waiting value, then this protection is the most valuable. Question 3: Levers debt can be characterized as a combination of 1) ownership of the unlevered firm and 2) a sale of call option to the shareholder to purchase Lever at an exercise price of \$800, the value of the debt. The exercise date on this call option is the bond maturity date. The stock can be characterized as a call option to purchase the unlevered firm with a strike of \$800 and expiration date equal to the bond maturity date. There is another answer to this question. The debt can also be characterized as a combination of 1) cash equal to the principal value of the debt and 2) selling a put option to shareholders to sell the unlevered firm at an exercise price of \$800 with an expiration date equal to the bond maturity date. Similarly, the stock can be characterized as a combination of 1) owning the unlevered firm and 2) holding a put option to sell the unlevered firm to bondholders with an exercise price of \$800 and an exercise date equal to the bond maturity date. Question 4: Strategy is to buy a share at \$26, buy a put at \$1.00 and sell a call for \$2.49. If the call is in the money (ie stock > \$25), then the holder of the call option will exercise it and buy the share from you for \$25. Your profit will be 25+2.49-26-1=\$.49. If the call is out of the money at expiration (ie stock < \$25), then you will exercise the put and sell your share at \$25. Your profit will be 25+2.49-26-1=.49. The required initial investment is 26+1-2.49= \$24.51. The return on the investment is .49/24.51= 1.9992% over the 3 months. The annual return is (1+.019992)^4=8.24%. This renders a premium of 2.49% over the 3 month Treasury bill that can be achieved risk-free. Simply put, you invest \$24.51 in the arbitrage and are guaranteed to have \$25 after three months. Question 5: Under the first assumption (call and put are exercisable only at expiration, and antidilution protection), you will still get \$25 in 3 months since one of the 2 options will be exercised (giving you \$25). Moreover, youll get the \$10 from the special dividend. Under the second assumption, the call holder will exercise his option immediately or hell miss the special dividend. You will get your \$25 but will still hold a valuable put option to sell the stock at \$25. The price should drop \$16, so the put will be worth more than \$9 due to time value of money. You can either sell the put or take an offsetting position by buying a share and the exercising the put. You could also, hold the put and hope the price goes lower so as to more than offset amortization time effect of getting closer to the exercise date. Under the third assumption, youll get the \$10 dividend and \$15 at expiration when either the put or call is exercised. Under the fourth assumption, the call holder wont exercise now for two reasons. First, hell recognize the special dividend as ordinary income. Second, he can wait until the dividend is paid and exercise at \$15 when the stock is \$16. By doing that hell also get the time value of the option. As a result, you will get the \$10 dividend plus another \$15 at some time prior to the exercise date when the put or call option is exercised. Question 6: Since the comparable nonconvertible bond pays 10%, then we will use 10% as the discount rate in valuing the nonconvertible aspect of the bond. By using the bond formula for a bond that gives 10 annual payments of \$80 with a return of principal of \$1000 on the last year and a 10% discount rate, we get a present value of \$877.11. The option value of the bond is equal to the comparable value of nonconvertible bond (\$1000) minus this value (\$877.11) which gives us \$122.99 as the value of the option. Summary

The key for the exam is to spot the option and describe its role in the issue at hand. The formulas in this section shouldnt be a cause of fear. The important thing is to understand the effects of different variables (ie volatility) on the options value. In particular, be familiar with options role in the capital structure of the firm. The option questions on the exam will be easier than some of the problems above.

6. Corporate Reorganization

explanatory document are then distributed to the creditors over time. If the plan is approved by specified majorities of the creditors, it will be confirmed by the court provided that it also conforms to the requirements of 1129. Upon confirmation, the debtor is discharged from its pre-petition debts except as provided in the plan. In the Shadow of Chapter 7: All Chapter 11 negotiations are held in the shadow of Chapter 7 and, thus, of potential liquidation. The debtor usually has an absolute right to convert the case (1112(a)) and the creditors can do so upon a proper showing (1112(b)). Furthermore, conversion is required if the specified majorities do not approve the plan (1126(c)). Problems with Negotiation: One reason that non-bankruptcy agreements sometimes cannot be reached or that there are failed negotiations for a Plan in Chapter 11 is that the parties have different perceptions of the likely outcomes in Chapter 7. If, for example, the debtor believes that there is a 75% chance that a creditors security interest will be voided in Chapter 7 and the creditor believes that there is only a slight chance that this would happen, they are likely to take such divergent positions that agreement will be unlikely. The Automatic Stay: When business is going bad, and suppliers and creditors are threatening lawsuits, the prospect of an automatic stay that accompanies Chapter 11 takes on increasing importance. The stay is automatic and nationwide. Actions taken in violation of the stay (even innocent actions) are void or voidable. Stay-lifting litigation is costly. However, courts must act upon such litigation within 30 days. The Optimal Stopping Problem as Applied to Reorganizations: In a coherent reorganization regime, there must be a mechanism that the firm will be liquidated at the time when it is in everyones interest. The decision-maker must, at every moment, ask whether it is in everyones interest to liquidate the firm. The challenge he faces is known as the optimal stopping problem. Factors that Should be Considered in Valuing the Option to Liquidate: The decision-maker needs to know how much can be realized by selling the assets He also needs to know the current income the firm is generating. However, option pricing forces us to know two additional elements: (1) the average growth () of the earnings stream over time and (2) the variance of earnings () within any period of time. These characteristics of firm earnings pin down the value of the option to liquidate. How Average Growth and Variance Affect the Value of the Option to Liquidate: When the profitability of firms in a particular industry grows slowly and is fairly predictable (i.e. when and are fairly low), the value of the liquidation option is small. Because we know, more or less, what the prospects for the firms earnings are, we are better off if the decision-maker exercises the option to liquidate sooner rather than later. However, when there is long-term volatility (when there is wide variation of earnings among similar firms in the same industry i.e. high ), the decision maker is likely to increase the welfare of all parties by putting off the decision to liquidate even if the expected growth of earnings is low. That is, the value of the option to liquidate is high. Higher Profits Needed to Justify Delaying Liquidation Over Time: Because the value of the liquidation option decreases as variance decreases, and because variance decreases over time, higher profits are needed to justify delaying liquidation as time goes on. 6.2 Confirmation of the Plan Overview of Confirmation: A bankruptcy court can confirm a plan that has the voluntary acceptance of all classes of creditors, including deemed acceptances by unimpaired classes of creditors, provided that the plan meets the eleven conditions set forth in 1129(a). If the plan meets all of the requirements set forth in 1129(a), except for 1129(a)(8) (pertaining to acceptance by a class), the bankruptcy court may still confirm the plan under the cramdown provisions in 1129(b). The court will not approve the plan pursuant to the cramdown provision unless at least one class of creditors approves the plan. The cramdown provisions require a determination that adequate protection is afforded the dissenting impaired classes under the reorganization plan.

Cramdown - 1129(b): When there is a dissenting class of impaired shareholders, the court may confirm the reorganization plan provided that the plan does not discriminate unfairly class and that it is fair and equitable to each impaired class that does not accept the plan. Fair & Equitable: The fair and equitable standard is articulated in 1129(b) and includes the absolute priority rule. This rule entails that senior creditors must be paid in full before juniors are paid, that seniors cannot be paid more than the full amount of the debt they are owed, and that claims with the same priority are to be given equal treatment. The absolute priority rule is only enforced with respect to cramdowns and does not come into play through 1129(a). In re Landmark at Plaza (Bankr. D. N.J. 1980): Rule: In assessing the present value of a stream of payments for the purpose of 1129(b), the rate of interest being paid by the debtor should correspond to the interest rate that would be charged or obtained by a creditor making a loan to a third party with similar terms, duration, collateral, and risk as the debtor. The creditor, a dissenting class and secured creditor, held a \$2.25 million mortgage over the debtors only substantial asset (worth \$2.24 million). Under the terms of the debtors plan, the creditor would receive 12.5% interest payments on a note with a face amount of approximately \$2.7 million. The court held that the debtors plan did not meet the requirements of 1129(b)(2)(A)(i) because it did not provide for a stream of payments that had a present value equal to that of the property (as required by 1129(b) (2)(A)(i)(II)). The courts decision was based on the fact that the debtor, had he gone out into the market, would only have been able to secure a loan at a rate that was the equivalent to 15% and not the 12.5% it was offering. In re Landau Boat Company, (Bankr. W.D. Mo. 1981): Rule: Pursuant to 1129(b), shareholders may not retain their equity interests when an non-consenting creditor class has not been paid in full. The debtors plan provided that shareholders would be allowed to maintain their equity interest in the reorganized company without having to make any additional investments, despite the fact that a non-consenting class of creditors was not paid in full. The court held that this violated the absolute priority provision of 1129(b). Requirement with Respect to Secured Creditors: The Code provides that the secured creditor receive the present value of its allowed secured claim (i.e. that it get interest at an appropriate rate on an amount equal to the value of its collateral). Unsecured Creditors: The Bankruptcy Code, in effect, bifurcates the claim of the unsecured creditor, giving it full value for the secured portion and putting its unsecured portion in with the unsecured claims. For the unsecured portion of any claim, the creditor can vote its claim however it chooses and, as part of a dissenting class of unsecured creditors, can object to cramdown on the basis of the absolute priority rule (1111(b)). New Value Exception: The new value exception allows shareholders to retain an equity interest in the reorganized company in exchange for their adding value to the reorganized company (usually by way of a new investment). In re Landau Boat Company, (Bankr. W.D. Mo. 1981): In the aftermath of the courts decision that the shareholders could not retain their equity interest if the creditors were not paid in full, the debtor filed an amended plan that proposed canceling the existing common stock and issuing a new class for \$1 per share. The plan also required subscribers to offer a loan commitment of \$3 for each \$1 of stock purchased. The plan provided that the court had the right to allocate stock to creditors should they wish to subscribe but that existing shareholders wished to buy up this new issue. The court approved this plan over creditor objection on the ground that the shareholders had justified the retention of their stock by the new investment and the irrevocable commitment to loan operating funds.

Bank of America v. 203 North LaSalle Street Partnership, (US, 1999): Rule: Shareholders may not keep their equity interests in the reorganized company pursuant to the new value exception if the plans only permit existing shareholders to add value to the company. The creditors claimed that the reorganization plan violated the absolute priority rule because they were not being paid in full and because the opportunity to acquire equity in the reorganized company was only offered to existing shareholders. The Supreme Court held that this violated the absolute priority rule and did not fall within the new value exception even though the shareholders had made additional investments in the reorganized company. The Court reasoned that because they had the exclusive right to contribute for an equity interest, shareholders effectively had an option to buy into the new company. This right had value and could not be granted to shareholders unless creditors were paid in full. Two-Pronged Test: Some courts treat proposals for cash contributions by equity holders with a two-part test. The new capital must (1) represent a substantial contribution and (2) equal or exceed the value of the retained interest in the corporation. Election - 1111(b): The election benefits secured creditors that are under-secured. The under-secured creditors that may benefit from the election are in two distinct legal circumstances. The first type is the usual under secured creditor that has both an allowed secured claim and an allowed unsecured claim under 506(a). The second type of beneficiary is the non-recourse under-secured creditor, one that has only a secured claim at the outset of the case with no unsecured claim permitted for any deficiency. With respect to the under-secured creditor that has both an allowed secured claim and an allowed unsecured claim under 506(a), the creditor can use 1111(b)(1)(B) to waive any deficiency or unsecured claim that would result from the creditors under-security and any participation in the plan as an unsecured creditor. In exchange, the debtor is forced to pay the secured creditor over time the full number of dollars that the creditor is owed, even though the creditor is under-secured and even though unsecured creditors may be getting only a factional payment. However, the debtor is not required to pay the present value of the entire claim, only the present value of that portion of the claim equal to the value of the collateral. The non-recourse under-secured creditor can also benefit from the 1111(b) election. A loan is non-recourse if the original security agreement provided that the creditor would look only to the collateral for payment, with no right to sue the debtor for any deficiency. Absent 1111(b)(A), the result in bankruptcy would be that the non-recourse creditor ordinarily could claim against the collateral but not against the estate. However, 1111(b)(A) gives the non-recourse creditor a full recourse claim in bankruptcy. The creditor can elect to force the debtor to pay the full number of dollars of its entire claim and the payment of the present value of its secured claim. 6.3 Arriving at a Plan Creditors Committees: As soon as is practicable after the commencement of a Chapter 11 case, the bankruptcy court must appoint a creditors committee (1102(a)). This committee, which represents all creditors holding unsecured claims, is ordinarily composed of the seven largest unsecured creditors willing to serve on the committee. If a committee organized by such creditors outside of bankruptcy was fairly chosen and is representative of the different kinds of claims to be represented, the court may appoint the members of that committee (1102(b)(1)). The committees composition or size can be changed if the membership of such committee is not representative of the different kinds of claims or interests to be represented (1102(c)). Powers and Duties: The powers and duties of the creditors committee are set out in 1103. However, the committees real power comes less from 1103 and more from the fact that the committee is well-positioned to negotiate with the debtor over the shape of the reorganization plan. The committee will normally make the initial decision to ask the court order liquidation or appointment of a TIB. The committee may also conduct its own investigation of the debtor and, under 1121(c), propose its own plan of reorganization.

Trustees: Chapter 11 contains a flexible standard for determining when a trustee should be appointed (1104). If a trustee is appointed, his duties are set forth in 1106. If no trustee is appointed, the debtor, as a DIP has most of the substantive powers of a trustee (1107). If the court decides not to appoint a trustee, it must, when requested, appoint an examiner if such an appointment is in the interests of the estate or the debtors fixed, liquidated, unsecured debts, debts other than debts for goods, services, or taxes, or owing to an insider, exceed \$5 million (1104(b)). The powers of an examiner are those of a trustee under 1106(a) (3) and (4), plus whatever other duties of a trustee the court orders the DIP not to perform (1106(b)). Conditions for Appointment of a Trustee: 1104 stipulates that a trustee should be appointed either for cause (e.g. fraud, dishonesty, incompetence, or mismanagement) or if it is in the interests of creditors, any equity security holders, and other interests of the estate. With respect to this latter reason, the court does a cost-benefit analysis to determine whether the appointment of a TIB is worthwhile. Because TIBs generate costs on the estate, the court has discretion not to appoint a TIB if the benefits of appointment do not outweigh its costs. Courts have less discretion with respect to the for cause requirement. However, more than simple mismanagement is required to appoint a TIB. Exclusive Period: Only a debtor may file a reorganization plan for the first 120 days of Chapter 11 unless a TIB has been appointed under 1104 or the court, for cause, has reduced the length of the period under 1121(c). Moreover, if the debtor in fact proposes a plan within the 120 days, the exclusivity period is extended to 180 days to give the debtor time to see if it can garner acceptances. The exclusivity period is intended to allow debtors to retain control of their businesses so that they will not wait until it is too late to file for Chapter 11. Classifications of Claims: The author of the reorganization plan must group the creditors into classes. The composition of classes is important because voting to accept or reject a plan takes place on a class by class basis. There are limitations with respect to how claims may be classified, and to which claims may be grouped together. Substantially Similar Claims - 1122(a): 1122(a) requires that claims or interests placed in the same class must be substantially similar. In re US Truck Co. (Bankr. E.D. Mich., 1984): Rule: Workers compensation claims may not be grouped together with the claims of unsecured creditors. The plaintiffs were workers entitled to workers compensation from the debtor. They brought suit against the debtor claiming that the debtors classification of their claims as unsecured creditor claims contravened 1122(a). The court rules in favor of the plaintiffs and refuses to confirm the plan. The court reasons that, unlike the claims of unsecured creditors, the plaintiffs claims were post-petition claims that accrued each week. Moreover, they were legally distinct in kind from the claims made by unsecured creditors. In New Martins Point Ltd. Partnership (N.D. Ga., 1981): Rule: In determining whether a classification is proper under 1122(a), the nature of the claims that the parties have is to be considered. The claims need not be identical they need only be substantially similar. Under the debtors plan, one class of creditors consisted of two creditors who were also limited partners and a third who was not. The third creditor claimed that the classification violated 1122(a) because the other creditors status as both equity and debt-holders made their claims substantially dissimilar to his. The court holds that the classifications were proper because the creditors all had a collateral interest in the same asset. It holds that the other creditors interests as creditors would outweigh their interests as equity holders. In re Sullivan: The court held that a plan classification was improper because they were secured by mortgages on different property.

Sale of Assets - 363: The Trustee in Bankruptcy or the Debtor in Possession must have the freedom to run the business. This includes the ability to sell assets both in and out of the ordinary course of business under 363. However, this section has, on occasion, been used to sell all of the debtors assets. The senior creditors do not mind this because they are entitled to satisfy their claims before more junior creditors can satisfy theirs. The more assets get sold, the less justification there is for postponing payouts and the more this begins to resemble a Chapter 7 situation. However, more junior creditors may want the business to continue for it might be the only way in which their claims can be satisfied. In re Lionel Corp. (2d Cir. 1983): Rule: In order for there to be a pre-confirmation sale out of the ordinary course of business pursuant to 363(b), there must be some articulated business justification other than the appeasement of major creditors. Shareholders in Lionel brought suit to challenge the debtors sale of its most valuable asset prior to approval of the reorganization plan. The sale was intended to create a pot of cash for the senior creditors. The court invalidated the sale on the grounds that, while the price paid was fair, there was no reason to sell at this early stage (i.e. the asset could always be sold later on).

6.4 Reform Proposals Mark J. Roe, Bankruptcy and Debt: A New Model for Corporate Reorganization Criticisms of current Chapter 11 reorganization: cumbersome, too costly, and results in an overly complex post-confirmation capital structure. Reform needs to address these issues, as well as accuracy in valuation and compensation, predictability and fairness. Capital Structure: Because of creditor preferences and tax considerations, bargaining between debtor and creditors often leads to a capital structure that includes debt, despite the fact that an allcommon-stock structure would make for a more viable firm (one less likely to be forced back into Chapter 11). Problem of the competing goals of reorganizing the firm and getting maximum return for creditors. Creditor assent needed, and they may demand (holdout for) debt and cash over equity. Time: This all makes the whole process more time-consuming. Difficulty in valuing the enterprise, ability of creditors to create deadlock. Roe says we should look seriously at a more market-based mechanism. He says: (1) courts should only confirm plans with simplified all-common-stock capital structure, and (2) the reorganization value of a public firm could be extrapolated from the sale of a small slice of the firms common stock on the market. This would allow for a faster restructuring, more accurate valuation, and a more viable post-confirmation firm with a more simple capital structure. Capital structure: Standard should be viability of the firm, not just viability of the plan. Allcommon-stock structure is best for firm viability, least chance of a second Chapter 11 filing. Also facilitates easier market valuation. Market valuation: If the firms securities can be sold on the market, no need for the court to try to value it (which is always difficult). This of course assumes efficient capital markets, which should be the case as long as the market has all information. But is there a stigma against bankrupt companies that will cause undervaluation? No studies of this, but Roe says no evidence of systematic undervaluation (as long as the firm is big enough to have a market, small firms will still need judicial valuation). Role of the court should be to uncover information and make it public. Lucian Bebchuk, A New Approach to Corporate Reorganizations Proposes a new method of distributing rights to creditors of a bankrupt firm; these rights will be designed such that each creditor will receive no less than that to which it is entitled, regardless of the valuation of the firm. Problem with current system: Valuation of firm is difficult (no objective figure), process is left up to bargaining and litigation. How do you divide the pie when you cant determine with any certainty how big the pie is (reorganization value)? Not only is valuation itself difficult, but creditors have conflicting interests: seniors want a low valuation, equity holders want a high valuation. New method (122-129): doesnt require a determination of the value of the firm, works even when no valuation available. Key is to express value of each creditors share in new firm in terms of V, the value of the reorganized firm, whatever it may be. Senior creditors get right to V if it is less than their claims, or to their claims if V is greater. Junior creditors get right to nothing if V is less than the senior claims, to V minus the senior claims if V is enough to satisfy the senior but not the junior claims, and to their whole claims if V is enough to satisfy both the senior and junior claims. Finally, equity holders get right to whatever value is left after the creditors are paid in full. The creditors receive options for shares of the firm, which can be redeemed by the company for their pro rata value or exercised by the creditor.

Bebchuk says this system can be implemented even under the existing bankruptcy rules, but he recommends reform of the law to facilitate. Only problem might be the fact that it requires creditors to invest additional funds (by exercising their options). Douglas Baird, The Uneasy Case for Corporate Reorganizations Because of these costs, delays and valuation problems, asks whether corporate reorganizations should exist at all. Says that theyre only justified if all creditors would agree to a reorganization regime ex ante, which they wouldnt. They would prefer instead that the firm be sold off to the highest-bidding third party. Argues that third-party buyers are best able to value a firm, because they bear the costs if theyre wrong. Therefore, firms should be sold off rather than reorganized. The sale should be conducted by the class of creditors with the greatest incentive to maximize value (so some sort of judicial valuation is necessary to figure out who should conduct the sale). Firm would be sold free and clear of all claims against it (which will be satisfied out of the proceeds or discharged). Basically argues for Chapter 7 and against Chapter 11, firms can be sold as a going concern (rather than piecemeal) in a Chapter 7 liquidation.

## 6.5 Contracting Out of Bankruptcy

Steven L. Schwartz, Structured Finance: A Guide to the Principles of Asset Securitization Structured finance is essentially a way to opt out of bankruptcy, by separating certain assets from the company itself in a bankruptcy-remote vehicle. Typical structured financing: Company seeks to raise cash, sells assets (such as receivables, owed to the company by third parties, as to which there is a reasonable predictability of payment) to a special purpose vehicle (SPV), which is legally separate from the company. Assets are therefore removed from the estate of the company even in the event of the bankruptcy of the company. The SPV sells securities, backed by the receivables, to raise cash. Therefore, the buyer of the company looks at the value of the receivables, not the creditworthiness of the company. Collections on the receivables are used to pay principal and interest on the SPV-issued securities. Why do this? Enables company to raise funds at less expense (lower rate) than if it issued them directly, because they are a safer investment. Also, raises cash without incurring any debt (because theyre selling an asset). Concerns: SPV has to be completely separated from the originating company, in case the latter goes into bankruptcy. Bankruptcy-Remoteness: Want to limit the ability of the company to put the SPV into voluntary bankruptcy. Possibilities: limitations in SPV charter, requirement of independent directors. Also want to guard against involuntary filings by creditors; make sure its paying debts on time and has few creditors. Substantive Consolidation: Allows a court under appropriate circumstances to consolidate the assets and liabilities of the SPV with the company (even when SPV is not in bankruptcy). Case by case basis, and courts do it rarely. Factors listed on p25. True Sale: Sale of receivables to SPV has to be a true sale (rather than a secured loan). Question: whether the transfer of receivables effectively has removed the receivables for bankruptcy purposes. This is a court determination, balancing test. Factors considered include: SPV takes on the risks and benefits of ownership, straightforward initial method of pricing with no later adjustments, extent of recourse available to SPV against

company, rights of company to surplus, who controls (and pays costs of) collection of receivables.

## Part IV: Takeovers 7. Takeovers

7.1 Takeover Waves Takeover Motives can be studied either via event studies which look at the effect of a transaction on the price of a share based on CAPM (the capital assets pricing model), or by examining direct company data. Takeovers tend to come in waves when stock prices are high. There have been 5 waves this century, and they are chronicled in the Lipton piece. Consideration has changed in form from cash to stock over the course of the 1990s; perhaps stock has been cheap in relation to cash, though this explanation seems unlikely as it runs counter to the efficient capital market hypothesis. More likely, this is because management retains greater control when it pays in cash than stock. Also, opportunities for bust up hostile takeovers were essentially exhausted in the 1980s, leaving options as a more appealing form of consideration. Options eventually vest, paying windfall amounts in the event of a takeover. They can even exceed golden parachutes in value in the current market. In fact, high-powered compensation incentives such as options may have effectively reversed management incentive distortion: no longer under-enthusiastic about takeovers, management may even be over-eager to sell the firm. Returns from a takeover are captured almost entirely by target shareholders, while acquirers typically break even or lose money on the deal. Target firms enjoy an increase in price following the announcement of a takeover attempt. When an unsuccessful bid is not followed up by a successful offer, the target price eventually reverts to its original level. Acquiring firms face mixed results as the effect on their price is sometimes positive, sometimes negative. At any rate, the effect on the bidders stock price is typically smaller than the effect on the targets. Sources of Takeover Gains can be grouped in two major categories: Efficiency gains can come from either Synergy, as excess capacity is eliminated, economies of scale and scope are achieved by glomming assets together and generating more assets at lower cost. In the 1960s, it was argued that conglomeration generated synergy in that it both reduced bankruptcy costs and allowed for managerial synergies. This theory has since been largely abandoned. The synergy story is inconsistent with the evidence that the target enjoys all the benefit of a takeover. Conglomeration was once thought to lead to synergies, as conglomerates faced lower bankruptcy risk and enjoyed managerial synergies. This story was all but abandoned during the 1980s, which saw a move towards specialization in the wake of disappointing experiences with conglomerates, to wit, that the market could not effectively punish the poorly-performing division, and that running

unrelated business from one central inexpert office led to poor management and cross-subsidization among divisions. Better management: the market for corporate control places a check on the excesses of management. Managers know that their firm will be taken over if they fail to perform. Inconsistent with the evidence that even well-run firms are taken over; this story is not consistent with much of the merger activity of the 1990s. Redistribution gains can come from Redistribution from third parties as tax benefits (which were more substantial in the 1980s than they are today) accrued following the replacement of equity with debt and monopoly power accrue in the wake of a takeover. Tax benefits are further discussed in the sections dealing with capital structure. Takeovers allow the acquiring firm to avoid paying a dividend, and to take on debt that was, until the 1980s, taxed at a significantly more favorable rate. Monopoly power was said to have been an enormously important factor in takeovers during the first half of the century. Its importance over the last two decades has been more difficult to ascertain. Studies typically look to the effect of a takeover on the other firms in the industry on the expectation that if there are fewer firms in the industry, all firms will gain at the expense of the consumer. Such gains have not been picked up by studies. Redistributions from non-shareholder constituencies as value is transferred from employees and creditors to the firm. A typical story here is that young workers work too many hours for too little money in reliance on an implicit agreement with the firm that, as they increase in seniority, they will work increasingly less hard while being paid increasingly greater amounts, until they are working too little and being paid to much; takeovers tear such implicit contracts asunder. While it is clear that such gains occur, it is unclear how important a factor they are. Redistribution between target and acquirer can occur as a result of private information and underpricing by the share market, or hubris or overbidding on the part of the acquirer Private information can be used to exploit a weak-form efficient capital market. The acquirer can obtain information that the shares of the target are undervalued by the market. This story is not borne out by data suggesting that after five years, the price of a target reverts to normal; we would expect to see a permanent increase Over-bidding: the familiar story of the winners curse applies. As a takeover is essentially an auction, the successful acquirer is the one who was willing to pay more than anyone else, and is therefore likely wrong about the value of the target.

Empire building: this tale of acquirer hubris holds that the connection between executive rewards and status may motivate a takeover even where there are no gains for the shareholders. Roll, Richard, Empirical Evidence on Takeover Activity and Shareholder Wealth examines empirical evidence to find that a takeover bid is a per se benefit to the target, while its effect on the bidder and the public is unclear. Roll looks at seven takeover theories, none of which are mutually exclusive: The Monopoly Hypothesis is found to be inconsistent with the data The Information Hypothesis, based on strong-sense market inefficiency (price is too low because positive information is not yet known also is inconsistent with the data following an unsuccessful bid, e.g., target price reverts to normal The Synergy Hypothesis, that mergers result in reductions of production or distribution costs, is roughly equivalent with the data though it is unclear why all of the synergy benefits would accrue to the target. The Inefficient-Management Hypothesis is supported by the data, especially a DoddRuback study of clean up tender offers The Tax Hypothesis and the related bankruptcy-cost hypothesis are both consistent with the data Management Self-Interest, the story that the correlation between management compensation and firm size drives takeovers, is supported by the evidencebut correlation does not imply causation in the case of a given manager. Also, why would the target receive a premium if all takeovers were driven by management self-interest? Something else must be at work here. Hubris: when management thinks that it knows better than the market, it overbids and suffers the winners curse. Strongly supported by evidence that the premium paid the target is correlated with a drop in the value of the bidders shares Shleifer, Andrei and Robert Vishny, Takeovers in the 1980s: The Return to Speculation the evidence suggests that the 1980s represent a comeback to focused firms via bustups and intraindustry acquisitions after years of diversification following the conglomeration takeover wave of the 1960s. Perelmans acquisition of Revlon is the paradigmatic 1980s merger. The authors find the Reagan attitude towards antitrust conducive to specialization, and critique common objections to takeovers: Reduced competition: this is not likely a factor, because (i) post-takeover market share was still too small for effective control and (ii) rise in share prices among competitors that would be predicted under oligopoly theory never materialized Employment cuts: while transfer from employees clearly take place, they are small in comparison to the profit enjoyed by shareholders. There is no substantial evidence of wage cuts following takeovers; removal of excess assets from pension plans occurs, but is small; layoffs rise, but are disproportionately targeted at white-collar workers, who account for of the total number laid off and a larger percentage of cost-savings. Reduction in investment, particularly research and development: targets of hostile takeovers are not research and development intensive companies. While debt may

motivate abandonment of positive net present value projects, liquidation of assets generally allows combined firms to de-leverage themselves. Lipton, Martin, Mergers: Past, Present and Future: the legendary lawyer explains the decrease of merger activity in 2000 by explaining the motivations behind takeovers Exogenous factors affecting mergers: accounting methods, antitrust policy, arbitrage, fluctuations in the value of currency, deregulation, expertise, success rate for hostile bids, strength of the labor market, availability of leveraged buy-out funds, receptiveness of debt and equity markets, presence of new companies Autogenous factors affecting mergers: obtaining market power, sharing the benefits of an improved operating margin through reduction of operating costs, sharing the costs and benefits of eliminating excess capacity, integrating back to control the source of raw material or forward to control the means of distribution, the advantage or necessity of having a more complete product line in order to be competitive, the need to spread the risk of the huge cost of developing new technology, response to the global market, response to deregulation, concentration of energy and focus (e.g. bustups), response to changes in technology, response to industry consolidation, receptivity of both the debt and equity markets to large strategic transactions, pressure by institutional shareholders to increase shareholder value, disregard of the supposed high rate of merger failure Merger Waves in the United States 1893 to1904: time of the major horizontal mergers (creating, e.g., the major steel, oil, and telephone giants), ended with the panics of 1904 and 1907 and the First World War 1919 to 1929: further consolidation of the industries subject to the firs wave coupled with a significant interest in vertical integration. Major automobile manufacturers emerge and integrate backwards through ore boats and coalmines. Ends with 1929 crash and the Great Depression 1955 to 1969-73: this was the period of conglomeration, which ended when the conglomerate stocks crashed in 1969-1970. 1974-80 to 1989: generally referred to as the takeover wave of the 1980s, this period was marked by hostile takeovers, junk-bond financing, insider-trading scandals and growth in leveraged buy outs. It ended in 1989 with the crash of the junk bond market and the RJR Nabisco LBO. 1993 to ?: this has been the era of the mega-deal and the merger of equals as companies of unpredented size and global sweep have been created on the assumption that size matters, a belief bolstered by the market

7.2 The Federal Regulation of Bidders: The Collective Action Problem The Williams Act: Amendment to the Securities Exchange Act of 1934 passed by Congress in 1968, dealing with acquisition of control through market purchases and through tender offers. Purpose (Clark, The Corporate Law): As a result of the rise of tender offers and Saturday Night Specials, in the 1960s, investors increasingly faced situations in which they were forced to make quick and arguably ill-informed decisions about whether to sell their stock or retain it. For instance, the investor might not know the identity or goals of those who would end up in control of the corporation, making it difficult to judge the prudence of selling. Key Provisions (Full text of Rules included with course materials): General Disclosure Requirements: These allow management to mobilize early and give shareholders necessary information. 13(d): Any person who, after acquiring directly or indirectly the beneficial ownership of an equity security, is the beneficial owner of more than five percent of the class of a Section 12 company shall, within 10 days after the commission, file with the SEC a statement required by 13D. The information includes facts about the identity and background of the purchaser, the source of the funds, and the number and percentage of shares held. If the purchases intends to acquire control of the company, the purchases must divulge its plans. Keep in mind: The purchaser still has the 10 days to buy as much as she wants until any requirement kicks in. Keep in mind: This only applies to Section 12 companies, which are either public companies listed on an exchange or companies with 500 or more shareholders and at least \$10 million in assets. Keep in mind: Hart Scott Rodino Antitrust rule might kick in even before this provision in a large transaction. 13(d)(3): Definition of person includes two or more persons acting in concert for the purpose of acquiring securities. 13(d)(6): Exception: Person already passed the 5% threshold can buy up to 2% per year without disclosure requirements. Tender Offer Disclosure Rules 14d: Require any tender offeror who, if the offer were consummated, would be the beneficial owner of more than 5 percent of a security of the same class covered in 13(d), to disclose to the SEC and the target company, the same information as that required in 13(d). The offeror must disclose the purpose of the tender offer and its plans or proposals for the target. This is done by filing and updating Schedule 14D-1. SEC Rule 14d-4: Disclosure requirements also pertain to solicitations or recommendations to accept or reject the tender offer. Advice from banks (14d2(e)) are exempted, as are communication by they target if they say no more than that management is considering the offer (14d-2(f)).

14(d)(2): Mirrors 13(d)(2) in regards to definition of person. 14(d)(5): Gives target shareholders a chance to change there minds within seven days after the tender offer is published. But, Rule 14d-7 says that the tenderor can take his shares back at time during which the offer is open. Clark says the rule increased the time to 15 business days, and an additional period of ten days after a competing offer is made, but I cant tell if that is still effective. Equal Treatment Rules: At the heart of these rules is the idea that notion the equality is paramount in a tender offer. Equality is somewhat unique to corporate law because usually we allow managerial discretion to decide what is best. 14(d)(6): Pro-rata rule: When an offeror offers to purchase only a portion of the outstanding stock of an issuer and a greater number of shares than it wants are tendered, the offeror must purchase the shares on a pro rata basis from each tendering shareholder. This used to only apply to those who tendered during the first ten days, but that was changed by Rule 14d-8. 14(d)(7): Best price rule: An offeror who, before expiration of the offer, increases the consideration offered to shareholders, must pay the increased consider to each shareholder whose shares are purchased, included those who tendered already. 14(e): A general antifraud provision, similar to Rule 10b-5, that applies to statement and acts done in connection with tender offers. Rule 14e-1: Tender offer must be kept open for at least 20 business days, and if the offeror increases the price, it must keep the offer open for at least another ten days after the announcement. Rule 14d-10: Equal Treatment of Security Holders: Offer must be open to all security holders of the class. Motivation here was Unocal, where management tried to leave out Boone Pickens. Cases Applying Equal Treatment Provisions of the Williams Act Pryor v. US Steel (2nd Cir. 1986): Implicated Section: 14(d)(6). Rule: Tender offerors are not free to extend proration deadline after it has expired where effect is to diminish number of shares purchased from those who tendered before the deadline. Summary: US Steel extended its period beyond ten days. The court holds that the rules do not allow an offeror such discretion, because to do so would confront shareholders with too much pressure. The extension also diminished the value of shares sold prior to the original deadline. You cant favor some shareholders to the detriment of others. Dissent: US Steel simply extended its time and let more shareholders tender. No one has been discriminated against and this should not be actionable. The offeror is doing a nice thing for latecomers. Keep in mind: This decision came down prior to Rule 14d-8 which requires partial offers provide proration rights during the entire length of the offer. Field v. Trump (2nd Cir. 1988): Implicated Section: 14(d)(7), Best price rule. Rule: For purposes of the Williams Act best price rule, announcement of a

acquisitions, which is inefficient. Eliminating competition will eliminate the need to pay high premiums, because shareholders wont have an alternative. Acquirers are creating wealth, and we should protect them. If there is someone else out there who values the company more than the acquirers, then they perform a mutually beneficial transaction, but the federal law shouldnt be involved from the beginning. Lucian Bebchuk, The Case for Facilitating Competing Tender Offers (1984): Bebchuk responds to Easterbrook and Fischel, arguing that auctioneering (allowing competing bids) is a good thing. He likes the Williams Act for protecting shareholders. A Decrease in Beneficial Acquisitions Due to the Auctioneering Rule is Unlikely: Searches can still get a nice return. They can purchase up to 5% without disclosing, which will likely give them return even if they dont win the takeover. Also, the cost of search isnt really all that large, because it is done by investment banks and they take a fee no matter what happens. The bidders also do not really tie up cash, because they are usually done on credit. And, while they may have to spend time on an acquisition, it will not be until there is a viable candidate for takeover and such time is not unique to the first bidder. Subsequent bidders should have similar time costs. A Decrease in Takeovers Might by Desirable: While takeovers for synergy reasons are usually good, there is a basis for believing that same are done for tax savings, enhanced market power, foreknowledge, and preference for expansion. These are private benefits that do not entirely represent social gains. It might be more efficient to curtail these types of takeovers. The Auctioneering Rule Has Other Desirable Effects: It is good to have assets reach their highest valuing user and competition promotes that. The notion that a company could always be sold to another higher valuing user after the takeover ignores the high transaction costs in a resale. Also, while it may hurt the offeror, premiums are a good thing for shareholders. They promote investment in companies and return value to the shareholders for the corporation they have built and supported. To give the company to anyone less the highest valuing offeror would be to cheat the shareholders of the real worth of the company. Impeding competing bids would bring suboptimal investment, particularly in smaller companies. Lucian Bebchuk, The Pressure to Tender (1987): Problem: Efficiency required that corporate assets be put to their most productive uses. Therefore, the mechanism for determining whether a given company will be acquired is an important social policy. The mechanism governing corporate acquisitions should be the same as when a sole owner decided by himself whether to sell his company. The choice should be fully undistorted. Because the value of shares not tendered after a successful takeover are usually lower than the tender offer price, there is pressure to tender. This pressure distorts choice and makes the corporate decision to tender something very different than that of the sole owner of a company. It is rare for shareholders to rationally view a rejection of premium bid as a valuemaximizing choice, but sometimes this is the case. Sometimes the decision to tender, even with a premium, is not the most efficient choice. A higher bid can always come along, the price on the market can always rise, if a tender is rejected.

Remedy: The main idea is to enable shareholders to express their preferences concerning the bids success separately from their desire to have their shares acquired in the event of a takeover. Therefore, he proposes that shareholders have the option to tender approvingly or disapprovingly. This means most shareholders will tender and will not be stripped of value, depending on their choice of approving or not approving. They have the ability to make the right decision for the company, without the fear of being losing out. This is similar to proposals to have a vote before a bid closes, so everyone knows what the result will be. Other remedies could include: prohibiting partial bids, requiring the consideration in takeout equal the bid price, and ensuring that minority shares have value equal to the bid price. In effect, you want to ensure that those who dont choose tender arent stuck with the short straw. Counter: Easterbrook and Fischel argue that this strips the gains from search. They also argue that the pressure to tender is a good thing, because the alternative is an incentive to hold out for more money. Class Discussion: Bebchuk explains if the bid price is more than the post bid market price, then a bid will always succeed if the bid price is more than an individuals valuation (which it is often likely to be.). Even if a shareholders valuation is more than the bid price, the bid will often succeed. This has to do with a probability analysis. If an offer is conditional (I wont buy your shares unless the takeover succeeds), then shareholders are very likely to tender. This is because the premium price will exceed the pre-bid market price and the post-bid market price. If an offer is unconditional (I will buy your shares whether I win or lose), then the shareholders will have to play the probabilities. If you tender you will get the tender price whether there is success or failure. If you dont, the value will change depending on the outcome. A shareholder will have to weight the likelihood of success and the possible range of values against a guaranteed tender payment.

Part IV: Takeovers and Defensive Tactics 8. The Regulation of Targets: Defensive Tactics
8.1 The Policy Debate Gilson. The Case Against Defensive Tactics in Tender Offers (excerpt): Separation of management and control in corporation Necessity: managers have skills s/h dont. Problem: Management is agent of s/h Incentive to maximize own welfare not s/h Costs: 1) Monitoring, 2) Profit sharing, 3)General loss in corporate value 2 categories of management opportunistic discretion Management inefficiency, slacking off Constraints: a) Jobs depend on corporate viability b) Market for managerial talent measures success by corporate performance c) Depressed price in capital market incentivizes buyer purchase of enough shares to replace management Therefore no need for legal review beyond BJR Management appropriation of corporate income Constraints: Above constraints dont work One Solution: Market for corporate control displaces incumbent management Mechanisms to displace incumbent management: Merger Impossible w/o management cooperation Sale of Assets Impossible w/o management cooperation Proxy fight Unattractive incumbents can use corporate funds, challengers cant Tender offer Effective displacement mechanism, but only if incumbent management NOT allowed to use defensive tactics to prevent s/h acceptance Therefore need for legal review beyond BJR Target s/h not management must decide to accept/reject TO Only acceptable roles for target management in TO Provide s/h with information that targets value exceeds offer price Solicit white knight to make competitive offer and bargain with offeror Main Conclusions: TO = only effective mechanism for capital market policing and displacing management. Defensive tactics BAD b/c appropriate TO decision from s/h to management Kraakman Points: Acquisitions good if create value Good ex post b/c assets into hands of better managers and synergies Good ex ante b/c deter managers from not working hard enough Therefore allowing management veto of takeovers is bad Bad ex post b/c bad management stays entrenched Bad ex ante b/c possibility of management veto eliminates incentive effect that the market for corporate control is supposed to have on managers 2 strains of court review.

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1) BJR BJR IS Delaware law re. judicial interference in management decisions 2) Fairness standard Defensive tactics lie between Look at way corporate statutes treat transactions dealing w/ disposition of entire company In American tradition, corporate statutes allow transactions dealing w/ disposition or sale of entire company to be the exclusive province of management Gilsons response: Since every other mode of taking over firm requires initiation by managers, ONE safety valve is needed to allow the market to come through and to maintain the possibility of takeover in face of managerial resistance! Thats TO Lipton. Mileposts on the Takeover TrailFrom Chicago to Delaware (excerpt): Efficient market proponents argue takeovers necessary to: Protect against inefficient management Allocate assets most productively via synergies correct disparity between stock prices and underlying values BUT efficient market theory has great shortcomings: 1) Other factors than bad management and synergies drive takeovers Ready availability of cheap debt financing via junk bond market Trade imbalances and cheap dollar Industry-wide changes in technology Economies of scale or competitive pressures Foreign strategic buyers Changing regulatory approaches Emergence of sophisticated acquisition industry Changing societal attitudes toward hostile raiders 2) Short-term investor perspective versus importance of long-term value enhancement Short term institutional investors want to maximize current stock price pressures management into short-term view But corporate success depends on management having long-term horizon Good that Delaware has favorable view of poison pills 3) Too much focus on stock prices makes directors ignore other important interests Management needs to consider constituencies other than just s/h like employees, customers, suppliers, and the surrounding community These constituencies share corporate risks and are vital to corporate success Corporate growth is an important national goal Maximizing s/h value will maximize long-term economic growth Long-term economic growth only possible if: Dont allow corporations to become overburdened with debt Focus on long-term value creation Take account of other constituencies than s/h Main Conclusion: Takeover mania is NOT justified by synergies and correcting bad management; instead it is driven instead by cheap debt financing, short term investor focus, and nonconsideration of important non-s/h interests Kraakman Points

Lipton is mirror image of Gilson. There IS a case for defensive tactics (and management discretion) against takeovers 1) S/h will often make wrong decision. Focus too much on short-term returns. Undervalue firm, tender for too little 2) Ex ante and ex post waste Ex post, S/h ripped off, get too little for what assets worth. Transactions socially wasteful, not just redistributional Costs a lot to do these transactions Possible assets end up in hands of worse managers Ex ante, socially bad. Creates incentives in target s/h and management to not invest in R&D projects and not maximize long-term value 3) Externalities and 3rd party effects. Takeovers impose costs on other constituencies like customers, employees, etc. Schleifer/Sommers. Layoffs, plant closings. climate of distrust makes s/h worse off. Breaching implicit Ks with other constituencies hurts social value But Kraakman sees disjunction with proposed solution of management discretion If worried about other constituencies (e.g. plant closings), regulate plant closings but do not impede takeovers! 8.2 The Policy Debate Unocal v. Mesa (Del. 1985) Holding: Defensive tactics must be reasonable in relation to the threat posed. If so, decision merits BJR review. Here, selective TO/share repurchase meets standard. Court defers to managements decision. Kraakman Points Prior standard was Cheff: Defensive tactics not justified if principal purpose to entrench managers, but justified to protect legitimate business processes of firm Essentially BJR review Unocals new standard: To enjoy protection of BJR, i.e. to have absolute discretion, managers must satisfy threshold standard of 1) good faith 2) reasonable investigation AND 3) defensive tactic must be reasonable in response to threat (must have a threat!) Intermediate standard (between entire fairness standard for breach of fiduciary duty cases and BJR std for ordinary transactions Recognition of managements agency problem. Enhanced judicial review BEFORE protections of BJR may be inferred Ambiguities: Whats threat? How is such threat justified? Whats proportional reponse? Pickens makes hostile offer for 37% of Unocal (64 M shares) at \$54/share in cash. Plans to freeze out remaining s/h after takes control at \$54/share in junk bonds. Junk bonds at back end worth less than cash up-front b/c of probability of default.

So blended price being offered, b/c conditional partial offer for only 37% of shares, is below \$54/share, although still premium over current market price Unocals response: counter-offer, self tender and leveraged recapitalization Unconditional offers to purchase up to 30% if Pickens wins, conditional offer to purchase up to 49% if he doesnt Expressly excludes Pickens from participating (If company borrows and overpays for its own shares, value of remaining shares drops) If Unocal wins OR if Pickens wins, s/h are better off tendering to Unocal!!!! Pickens does NOT want to win This is preclusive defensive tactic Standard: defensive tactics must be reasonable in response to the threat posed. Holding: Coercive threat justifies preclusive defensive tactic 2 tiered character of Pickens tender offer (and concomitant use of junk bonds in back-end) renders it coercive, capable of distorting s/h choice. Pickens is a known greenmailer, justification treating him differentially, This is greenmail in reverse 30% unconditional offer by Unocal means Pickens will NOT want to win Weird opinion: Seemingly high standard of judicial review for defensive tactics, beyond BJR BUT celebrates punishing hostile offeror for bringing offer in the first place Defensive tactic MORE coercive than original offer

Kraakman and Gilson: DLs Intermediate Standard for Defensive Tactics: Is There Substance to Proportionality Review? The origins of Delawares proportionality test Original standard: de facto BJR under Cheff Reform: Unocal, Moran, and Revlonintermediate standard of proportionality review New standard: Defensive tactics must be reasonable in response to threat posed Does proportionality review have substance? Yes, as demonstrated by Delaware courts concern with articulating the standard What constitutes a threat? Substantive coercion. Non-coercive offer may still be coercive if: Managements assessment that offer is unfair, ill-timed, or ill-priced is right Informational disparity; target s/h disbelieve management Managers ability to generate higher prices Managers justify preclusive defenses with claims they can create higher s/h value by: Bargaining for a better price from bidder Easiest, most convincing argument Locating other higher-paying bidders Operating firm better such that share price exceeds offer price. Most aggressive, least convincing argument Shareholder mistrust Empirical data show

Unsuccessful 1st offers followed by successful 2nd offersbetter price for target

s/h Unsuccessful 1st offers never followed by 2nd offertarget price returns to preoffer levelsbig opportunity cost for target s/h Intermediate standard of review The elements of an effective proportionality test 1) Identify hostile offer threats that fix permissible range of permissible defensive tactics. 3 types of threats: 1) Opportunity loss of picking superior management alternative 2) Structural coercion from risk of disparate treatment of non-tendering s/h 3) Substantive coercion as s/h accept undervalued bid b/c disbelieve management 2) Link range of permissible responses to scope or magnitude of identified threat Only allow defensive measures that safeguard s/h choice if have threat 1) above Allow preclusive measures when threats 2) and 3) above Help courts evaluate managements assessment of threat and its defensive response Weight of managements burden in face of judicial review Why an effective proportionality test can work Valuable screening function by demanding serious justifications for defensive tactics Facilitate planning where hostile offers do not threaten substantive coercion Targets can always provide alternative plan Acquirers can reduce risk of preclusive defensive tactics by treating all s/h equally Discipline managements preclusive tactics in cases of alleged substantive coercion If claims implausible, difficult for management to construct alternative plan Secondary participants like investment bankers reluctant to agree Conscientious self-enforcement by independent directors who analyze management plan that Board of Directors expected to justify in court Harness acquisitions market to screen representations of substantive coercion Target management misrepresentation results in loss of credibility Second hostile offer would follow Little incentive to mislead Main Conclusion: Intermediate proportionality review powerful check on spurious defense tactics b/c: 1) Incentive effects on management of duty to document claim of substantive coercion 2) Prospect of market challenge to unrealistic representations Corporate players, including target management, pre-screens for the courts

Part 8: The Regulation of Targets: Defensive Tactics (Contd) 8.3 Poison Pills and Delawares Intermediate Standard
1. Wachtell Lipton Memo; The Share Purchase Rights Plan (March 1994)/Summary of Rights to Purchase Preferred Shares How a Rights Plan Works: This memo describes a rights plan that is recommended by Wachtell to be part of a poison pill program to prevent the acquisition of the firm by a hostile bidder (raider). The plan is adopted by the board of directors. It works by giving shareholders rights that are exercisable when a raider acquires a certain threshold percentage of the of the corporations stock. When the rights are exercised, the raiders interest is diluted such that it becomes nearly impossible (economically unfeasible) for the raider to take over the corporation without the approval of the board of directors. It essentially forces the raider to either abandon its aims or negotiate with the board of directors and convince the board to accept its takeover proposal. The board can redeem the rights at any time by paying the shareholders a nominal fee. Redemption clears the path for a would-be acquiror to make a tender offer and acquire control Wachtell recommends using both kinds of pills now. Triggering threshold: Generally 20% but can be as low as 10% Legal mechanism: Each right starts off as a right to be exercised for seemingly worthless preferred stock. The right then flips-in or flips-over at the occurrence of a triggering event. Flip In: Provides that when the raider crosses the threshold, the right flips in and becomes a right to buy common stock of the target company with a value equal to twice the exercise price. The key is that the raiders rights become void; therefore, its rights become diluted, as the other shareholders acquire a greater interest in the company. Possible addition: This could also contain a feature that gives the board the option to exchange one new share of common stock of the corporation for each right (other than the raiders). Benefit is that rightsholders do not have to go through the process and expense of exercising their rights. Flip Over: Provides that when raider crosses triggering threshold and merges with the company (or sells 50% of its assets after obtaining control), each right flips over and becomes a right to buy shares in the acquiring company equal in value to twice the exercise price. Raiders rights are void. Purpose of this form of the pill is to prevent a cash out merger at the back end of the two-tier front-loaded tender offer (but it doesnt prevent creeping control if the acquiror is willing to freeze-in the remaining shareholders).

response. The main threat was inadequate price (substantive, rather than structural, coercion). Proportionality: The Court here criticized the Chancery Courts holding that although the pill was reasonable in response to the threat, the repurchase program went beyond what was necessary to protect the Unitrin stockholders and that it was designed to keep the decision whether to combine with American General within the control of the board (through control of the stock) at all times. The correct test the court should have applied was whether the program was draconian (by being preclusive or coercive) and, if not draconian, whether it was in the range of reasonable responses to the threat American Generals offer posed. Moreover, where all of the target boards defensive actions are inextricably related, these actions must be scrutinized collectively as a unitary response to the perceived threat. So the court here must analyze the repurchase program together with the pill. Draconian? First, it is not true that even with greater control, the directors in this case would be able to prevent any combinationpresumably the directors would vote their shares in their best interest as shareholders. Moreover, it appeared to the Court that there were other ways a potential acquiror could obtain control, such as through a proxy contest. Unless it was mathematically impossible or realistically unattainable for American to succeed, the program was not draconian (the Court remanded on this point but strongly suggested a finding for defendants was required). Within a range of reasonableness? The Court remanded the case, telling the lower court to consider the following issues regarding the repurchase program: Whether it is a statutorily authorized form of business decision which a board may routinely make in a non-takeover context Whether as a defensive response to Americans offier it was limited and corresponded in degree or magnitude to the degree or magnitude of the threat Whether the board properly recognized that not all shareholders are alike and provided immediate liquidity to those shareholders who wanted it. Kraakman: The result of this case is that all the action is now in the proxy contest. Shareholders have to get directors that will remove the pill. This case comes close to allowing just say no. Unexplained Irony: Unitrin boards repurchase price was about the same as Americans which they had argued was too low. Quickturn Design Systems, Inc., v. Mentor Graphics Corp. (Delaware Supreme Court 1999)The Court strikes down a defensive tactic because it restricts managements powers. Facts: In response to a hostile tender offer, the board of Quickturn adopted a Deferred Redemption Provision under which no newly elected board could redeem the pill for six months after taking office, if the purpose or effect of the redemption would be to facilitate a transaction with an interested person (one who proposed, nominated or financially supported the election of the new directors to the board).

Holding The Court strikes this provision down, finding that it would prevent a newly elected board from completely discharging its fundamental management duties to the corporation and its stockholders for six months, thus causing the board to violate its fiduciary duty to the shareholders. No defensive measure can be sustained that represents a breach of the directors fiduciary duty. Plus 141(a) requires that any limitation on the boards authority be set out in the certificate of incorporation. Kraakmans Words of Wisdom: New types of pills: This is a no-hands pillprevents redemption for six months. Contrast this with a deadhand pill, one that can only be redeemed by the incumbent board of directors or its hand-picked successors. This appears to be draconian because its preclusive. It hasnt been tried in Delaware, but Georgia upheld it. Management Power is key: Note how the court didnt analyze this using the old Unocal/Unitrin buzzwords. Instead it invokes the Delaware Corporate statute. Basically, the court is saying it will not allow constraints on managerial power. Delaware courts insist on the power of management vis--vis the shareholders. Chesapeake Corp. v. Marc P. Shore (Delaware Chancery Court, 2000)The Court struck down a Supermajority Bylaw provision, adopted by a board in response to a hostile tender offer, as disproportionate to the threat presented. Facts: In anticipation of a hostile offer by Chesapeake, Shorewoods board amended its bylaws in several ways to make it more difficult for Chesapeake to amend the Shorewood by laws to eliminate the classified board structure, unseat the directors, and install a new board amenable to its offer. The most important bylaw change was the one that raised the votes required for shareholders to amend the bylaws from simple majority to 66 2/3% (especially since management owned 24% of the stock). Unocal Reasonableness: Shorewoods board identified two possible threatsinadequate price (substantive coercion) and that the shareholders would be confused about the value of the company. The Court found no evidence of the second threat, but agreed that the first one was a mild threat. Unocal Proportionality: The Court found that when the threat claimed is substantive coercion, management must do more than merely claim the offer is inadequate. It requires a showing of how and when a management expects the shareholders to do better than the terms of the hostile offerwhether by bargaining with the offeror, by securing a better bid, or by managing the company better than the market expects. Draconian--The Court finds that the boards by-law amendment failed the proportionality test because, the board did not prove that it was realistically attainable for Chesapeake to prevail in a consent solicitation to amend the Shorewood bylaws (the board did not even discuss this). It was, therefore, preclusive. Range of Reasonable Responses--The supermajority bylaw fails this as well, since it is an extremely aggressive and overreaching response to a very mild threat, especially given that the board already had a poison pill in place. Distinction from UnitrinThe Court goes out of its way to show that its decision can be reconciled with Unitrin. The supermajority bylaw set a much higher barrier than the repurchase program of Unitrin, the facts were weaker here on substantive coercion,

management was more interested in this case, and the level of attention the Shorewood board paid to the relevant issues was grossly insufficient. Kraakman Finds this case very encouraging. Its the first one in a long time to use Unocal to strike down a defensive tactic. 3. Coates: Second Generation Shareholder Bylaws: Post-Quickturn Alternatives Consequences of Quickturn: That decision probably means that shareholders attempts to adopt bylaws to strip companies of pills and make them vulnerable to hostile tender offers would not survive judicial scrutiny because such powers would conflict with the boards authority under Delaware law to manage the business and affairs of the corporation Shareholder alternatives: Coates suggests three possible by-laws that he predicts would be upheld by Delaware courts, would shift power from boards to shareholders, but would not have so dramatic an effect as to ensure a manager-induced backlash. Early Action Bylawentitling a shareholder (who owns at least 5%) to call special meetings upon the receipt of a tender offer. During the pendency of the tender offer, the bylaws can be modified only by the shareholders (not the board of directors). Shareholders or the board can make nominations for elections to the board during these meetingsthis allows shareholders to throw out directors who refuse to pull the pill. Anti Disenfranchisement Bylawfreezing governance during a hostile bid by requiring, during the pendency of a tender offer, unanimous attendance by the Board to constitute a quorum at any meeting and a unanimous vote to approve any action or other exercise of power and authority of the Board. Director Qualification Bylawrequiring directors to be large shareholders or their designees.

## 8.4 Revlon Duties and Lockups

Lock-Ups Pre-bid lock ups: managements negotiates a friendly deal and wants to protect it (QVC, Time Warner) Args for pre-bid: Covers the friendly bidders search costs which the 2nd bidder could free ride on. Args against pre-bid lockup: Precludes a second bid from coming in. Hurts SHs. Pre-bid lockups are less suspect than post-bid ones. Post-bid lock ups: management does a lock up after there is a hostile bid on the table. (Revlon) This is where the White Knights come in. Args for post-bid lockups: can be used to bring in outside bidders. Can be used to end the auction. Otherwise management has no control over it. Ex. this is last round of bidding and after this we give a lock up. This can benefit SHs. Can be used to extract more value out of the hostile bidder. Ex. hostile offers at 100/share but values at 190/share. Get white knight who values at 120/share and give him a \$2/share lockup fee. Get him to bid \$187 and hostile will still take it theoretically. Args against post-bid lockups: Co should go to the person who values it most Types of lock ups Asset lock ups: permits acquirer to purchase assets at a bargain price. These are not common now Stock option lock ups: option to purchases stock at the bid price of the friendly bidder and resell to the successor bidder at the hostile price. Break up fees: amounts of cash payable by the target to the friendly bidder if the deal fails No shop/no talk clause: to keep the target faithful, limits on what negotiations/discussions target can enter with someone other than the friendly bidder Revlon Inc. v. MacAndrews and Forbes Holdings, Del. 1986 Facts: Pearlman is a big raider in the 80s and he makes a hostile bid for Revlon at a big premium. Revlon adopts a pill and self tenders for 20% of the shares with exchange notes. The covenants with the notes are supposed to tie up the assets, but there is a provision that the Revlon Boards independent directors can waive the covenants. P keeps bidding contingent on the pill being pulled. Forceman makes a counteroffer and management decides to give F an asset lockup including an agreement to cover the notes and giving F an option

Deal protections are unenforceable if they violate the directors fiduciary duties. Should have a clause saying that the Bd. doesnt have to carry out deal protections if Delaware fiduciary laws demand it. Lockup here was just too big. Lock up was worth 500M by the time of the litigation and there was a 100M termination fee. Kraakman says: should not go over 3% for lockup fee. Comes from QVC and other lockup cases. Change in Control this is one because Redstone would be taking over control of Paramount. In Time-Warner there was no change in control so business judgment rule applied. Why is this so critical? Controlling SH can freeze out/cashout the minority SHs but isnt the big issue in both QVC and Time whether the SHs get enough \$? Arnold v. Society for Savings (Del. 1994) Facts: Small bank merges with big bank. SH in small bank sues for preliminary injunction to stop the merger. Merger is share for share. Plaintiff brings Revlon claim. Ct says Revlon enhanced scrutiny does not apply. Revlon applies when: Sale: corp initiates active bidding process seeking to sell itself or do a reorganization involving a breakup of the Co. seeking to sell itselfmeans that the target must have initiated an active bidding process ct. says this didnt happen here. Break up: in response to a bidders offer the target seeks an alternative transaction involving the break up of the Co. Change in control: when approval of a transaction results in a sale or change in control (QVC) There is no sale or change in control when control of both companies remains in a large, fluid, changeable and changing market. So they can still get a control premium at some point. Cites to article that says that the fact that control says in the hands of unaffiliated SHs, in the market, means that they SHs still have the all the SHs have the same interests wrt the new company to maximize share value. There is no change in control here. Gibson and Black article in the readings asks the Q: Why do we make it harder for a target company to protect a friendly transaction with an entrepreneurial company like Microsoft (controlled by Bill Gates) than a friendly transaction with IBM? p.111 Hypos: Merger of equal sized firms. SHs get preferred stock

That is like cash, no residual rights. Does not trigger Managements special knowledge of the firm valuation. More like Revlon but ambiguous If it were common stock this would be Time Warner. Widely held acquirer makes unconditional cash tender offer for up to 70% of target to be followed by a stock for stock merger. Probably more like Revlon, 70% cash. But this is unconditional so it could be much lower % at the end. So this is ambiguous Target is merged into a much bigger acquirer in a stock-for stock merger. It is stock so maybe Time-Warner. But target it so much smaller that the incentives of the target management are messed up, want to make acquirer happy so they will have jobs. Could argue that Revlon applies because management does not have expertise in valuing the new Company since it is so big and new to them. Note: Del. cts dont actually say this. Kraakman says this is probably Time Warner because it is stock for stock. Also, Arnold v. Society for Savings held that Revlon does not apply when Bank of Boston merged with a much smaller bank (but it seems to be for other reasons). Target and acquirer merge in a stock for stock deal that leave a single SH with 20% of stock and the rest widely held This is control for Revlon purposes. Easy case. Controlling SH (49%) in public Co. negotiates a cash merger with a third party acquirer. Was the Co. reqd under Revlon to auction off the whole firm or put it for a market test? But the controlling SH does not have a duty to the minority SHs. But this is a cash exchange. There is a case that suggests that the fact that someone who has control is doing this does not change the Revlon duty. Revlon probably applies. Revlon and Unocal Split means that some managerial decisions are burdened more than others. Distorts their decisions Theories on lockups Bainbridge there ought to be a level (ex. 10%) beyond which lockups should not be enforced. Ayres says that many lockups arent foreclosing, some are. many lockups reduce reservation prices of both bidders but unless the lock up is foreclosing it will not affect the outcome of the bidding war. You want to deter foreclosing lockups where bidder 2 never enters the contest but otherwise there is no need to intervene. Foreclosing lockups siphon \$ from SHs to the favored bidder. Non-foreclosing ones cant be used to do a deal with a favored firm so they are only used for good reasons ex. search costs, to attract bidders

Hanson argues that there are no foreclosing lockups because if the bidder who values it less gets it he will sell it to the other bidder later, so management cannot decide where the firm will ultimately go Coates evidence shows that Ayres is wrong and locks do have a considerable effect on who gets the firm and its assets why do they work if they are not foreclosing? agency costs with bidders management and SHs reputational costs of dropping a bid endowment effects feel committed to the firm and start to value it more tax effects informational effects switching costs