AC210: Corporate Finance

Norvald Instefjord
ninstef@essex.ac.uk
5NW.4.9
Introduction to Corporate Finance
What is finance?
What is the distinction between financial
and real assets?
What is corporate finance?
What is the role of financial assets in
corporate finance?
Week 1
Financial Markets and Financial
Instruments
How do firms finance their investments?
Earnings (free cash flow, internal capital)
Equity capital (external public or private)
Debt capital (external)
Public and private capital
Trading of public capital
New issues
Secondary trading
Equity Issues
First time a firm seeks public equity is
called an initial public offering (IPO)
Primary issue: new equity is issued
Secondary issue: existing private equity is
sold to outside investors (most privatisations
take this form)
Legal and underwriting services provided by
investment banks
Debt Issues
Bank loans not publicly traded
Corporate Bonds traded actively in the
secondary market
Debt capital and equity capital account for
most of the firms financial capital
Definition of Debt
Fixed claim
Specifies what needs to be repaid to the
investor and when
Default risk risk that the repayment plan is
not fulfilled
Conversion options covenants that allow
debt to be reclassified as equity
Definition of Equity
Residual claim
Does not specify a repayment plan
Repayment is defined as the residual:
whatever is not claimed by other claim
holders should go to the equity holders
Voting rights: Equity holders normally have a
right to vote on important corporate decisions
Mergers, takeovers
Large investments
Board representation
Trends in Corporate Finance
Globalisation
Deregulation
Financial innovation
Technological advances in the financial
system
Securitization
What you should take home
You should be able to
Understand the distinction between a fixed claim and
a residual claim
List the main attributes of a debt claim
List the main attributes of an equity claim
Describe the ways in which firms raise funds for new
investment
Describe the difference between private and public
equity
Describe the difference between bank loans and
corporate bonds
Readings
Grinblatt/Titman: Financial Markets and
Corporate Strategy
Ch 1: overview of the process of raising
capital for investment
Ch 2: overview of the process of raising debt
capital
Ch 3: overview of the process of raising equity
capital
Problems
1. Why do firms use underwriters when
they issue new equity?
2. In what ways do you think it matters that
debt holders have a fixed claim when
equity holders have not?
3. In what ways do you think it matters that
equity holders have voting rights when
debt holders have not?
Review problems
1. Invest 95 and sell for 102 what is the return?
2. Invest 95 and sell for 102. Each transaction is charged
a 1% trading commission what is the return?
3. Invest 95 and sell for 102. You receive additional
interest payments/dividends of 2 during the holding
period. What is the return?
4. Invest 95 and sell for 110 three years later what is
the annual return on your investment?
5. Invest 95 now and another 98 next year. In the
following year you sell your investment for a total of
202. What is the annual return on your investment?
Week 2:
Valuing Financial Assets: Portfolio
Tools
Tool box
Expected portfolio return
Portfolio variance
Covariance between the return on two assets
Optimal investment
Fair price of an asset means that the value equals
the purchasing price
Even if prices are fair there are still ways of
investing your money that is better than others
Risk Aversion
Investors demand compensation for including risk in
their portfolio
Portfolio weights
A portfolio of financial assets can be represented
in a number of ways
The number of shares held in the various stocks (e.g.
1000 shares in BT, 250 shares in Marks&Spencer
etc.)
The dollar-value held in the various stocks (e.g.
2,500 in Lloyds Bank, 10,000 in Jarvis etc.)
As portfolio weights: the dollar-weight of the various
stocks (e.g. if total portfolio is 100,000, then the
portfolio weight of Lloyds is 0.025 and the portfolio
weight of Jarvis is 0.1 etc.)
From portfolio weights to portfolio
expected return and variance
To determine the expected return and
variance of a portfolio we need to know
The portfolio weights
The expected return on the individual assets
The variance of the return on the individual
assets
The covariance between the return on any
pair of assets
Expectation, Variance and
Covariance
Expected return (average return) is a location
measure
Variance of return is a spread measure
Covariance is a measure of how the return of
two assets are related (they can move in the
same or opposite directions, or they can be
uncorrelated)
If the returns move in the same directions,
covariance is positive, if the returns move in the
opposite directions, covariance is negative, and
if uncorrelated, covariance is zero
The input data for a portfolio
of N assets
N expected returns
N variances
N(N-1)/2 covariances
Plus N portfolio weights
For FTSE100 there are therefore
100+100+100(99)/2 = 5150 data points that
need to be estimated even before working out
the portfolio weights
Formulas

= <
=
=
=
+ =
=
=
N
i j i
j i j i i i P
N
i
N
j
j i j i P
N
i
i i P
r r Cov w w r Var w r Var
r r Cov w w r Var
r E w r E
1
2
1
1
1
) , ( 2 ) ( ) (
) , ( ) (
) ( ) (
Covariance and Correlation
Covariance is a measure of relatedness
that depends on the unit of measurement,
so if the return is measured as a percent
(e.g. 10 percent) or as a desimal (e.g.
0.10) the covariance will be different
Correlation is a measure of relatedness
that is normalized to be independent of the
unit of measurement
Covariance and Correlation
j i
j i
ij
j i ij j i ij j i
r r Cov
n Correlatio
r Var r Var r r Cov
o o

o o
) , (
) ( ) ( ) , (
= =
= =
The Mean-Standard Deviation
Approach to Investment
Risk averse investors dont like risk
Variance averse investors dont like risk that comes as
variance
This is not the same in general variance aversion is a
special case of risk aversion
Portfolio theory takes the variance aversion approach
which in practice means that we assume investors wish
to maximize their expected return given a certain
variance, or minimize their variance given a certain
expected return
Mean-Standard Deviation
for Two-Asset Investments
) , ( ) 1 ( 2 ) ( ) 1 ( ) ( ) (
) ( ) 1 ( ) ( ) (
2 1 2
2
1
2
2 1
r r Cov w w r Var w r Var w r Var
r E w r wE r E
P
P
+ + =
+ =
Portfolio Frontier
Mean-Std Dev for Portfolios of the
Risk Free Asset and a Risky Asset
w r Var r Var w r Var
r r E w r r w r wE r E
P
F F F P
) ( ) ( ) (
) ) ( ( ) 1 ( ) ( ) (
2
= =
+ = + =
Covariance as Marginal Variance
We can interpret the covariance between
the return on a stock and the return on a
portfolio as the stocks marginal variance
That is, if we increase the stocks portfolio
weight marginally, the portfolio variance
will increase by approximately twice the
stocks covariance with the portfolio
Algebraic proof
) , ( 2
) (
) , ( 2 ) ( 2
) (
) , ( 2 ) ( ) ( ) (
) ) ( ( ) ( ) (
) (
0
2
i P
m
i P i
i P i P
F i P
F i P F i P
r r Cov
dm
r dVar
r r Cov r mVar
dm
r dVar
r r mCov r Var m r Var r Var
r r E m r E r E
r r m r mr mr r r
=
+ =
+ + =
+ =
+ = + =
=
What to take home
Understanding of expected values, variances,
and covariances
Understanding of expected return and variance
for a portfolio
Understanding of risk aversion and variance
aversion
Understanding of the portfolio frontier
Appreciation of the linearity of expected return
and standard deviation for portfolios consisting
of the risk free asset and a risky portfolio
Readings
Chapter 4 in Grinblatt/Titman
Problems
1. Variance: Prove that E(x-E(x))
2
=Ex
2
-
(E(x))
2
2. Covariance: Prove that E(x-E(x))(y-
E(y))=Exy-E(x)E(y)
3. Take a time series of returns 0.05, -0.03,
0.10, 0.04, -0.10, 0.20. Estimate the
expected return and the variance of
return.
Week 3:
From Mean-Variance to the CAPM
Capital Market Line
Finding the market portfolio
Two-fund Separation
Optimal diversification
Market vs idiosyncratic risk
CAPM expected returns relationship
Expected return on assets depend on their
covariance (i.e. their relatedness) with the market
portfolio
Estimating beta risk
Capital Market Line
The line that goes through the risk free
asset and the tangency portfolio
Identification?
Maximization procedure
Simplifying trick, the excess return on any
asset divided by its covariance with the
tangency portfolio, is constant
Maximization programme to find
the Capital Market Line
We can identify the frontier portfolios of
risky assets
Consider investments consisting of the risk
free asset and a frontier portfolio these
are represented by straight lines
For the frontier portfolio that is the
tangency portfolio, the angle of the straight
line is the steepest
Capital Market Line cont..
) (
) ) ( ( )) ( ) ( (
max
) ( ) 1 ( ) , ( ) 1 ( 2 ) ( ) (
) ( ) 1 ( ) ( ) (
) (
) (
max
2 2
T
F B B A
w
B B A A T
B A T
T
F T
w
r Var
r r E r E r E w
r Var w r r Cov w w r Var w r Var
r E w r wE r E
r Var
r r E
+
+ + =
+ =

Capital Market Line cont..

The maximization programme normally
leads to a fairly complicated equation
with two risky assets we get a quadratic
equation to solve
In the class exercises you will be asked to
have a go at such a problem
Simplifying trick: finding the
Capital Market Line
We know the expected return on all risky
assets and the risk free return
The difference between the two is called
the excess return for the asset
The excess return, divided by its
covariance with the tangency portfolio, is
always constant
Capital Market Line
F N N N N
F N N
F N N
F i T i
i N N i i
i i T i
r r E r Var w r r Cov w
r r E r r Cov w r r Cov w
r r E r r Cov w r Var w
r r E r r Cov
r r Cov w r Var w
r r Cov w r r Cov w r r Cov
= + +
= + +
= + +
=
+ + +
+ + =
) ( ) ( ) , (
) ( ) , ( ) , (
) ( ) , ( ) (
) ( ) , (
) , ( ) (
) , ( ) , ( ) , (
1 1
2 2 2 1 1
1 1 1 1
2 2 1 1

Example
06 . 17 .
.06 - .17
.06 - .15
Return Excess
002 . 001 . 0
001 . 002 . 001 .
0 001 . 002 .
Var/Cov

=
=
Example cont..
5 . , 1 . , 4 .
50
10
40
06 . 17 . 002 . 001 . 0
06 . 17 . 001 . 002 . 001 .
06 . 15 . 0 001 . 002 .
3 2 1
3
2
1
3 2 1
3 2 1
3 2 1
= = =
=
=
=
= + +
= + +
= + +
w w w
w
w
w
w w w
w w w
w w w
CAPM: Risk and Return
Since the excess return divided by the
covariance with the tangency portfolio is
constant across assets, we can derive
important relationships between risk and
return
The covariance with the tangency portfolio
is, if solved for the tangency portfolio itself,
equal to the variance of the tangency
portfolio
Risk and Return
( )
( )
F T i F i
F T
T
T i
F i
T
F T
T i
F i
T
F T
T i
F i
r r E r r E
r r E
r Var
r r Cov
r r E
r Var
r r E
r r Cov
r r E
r Var
r r E
r r Cov
r r E
+ =
+ =

) ( ) (
) (
) (
) , (
) (
) (
) (
) , (
) (
constant
) (
) (
constant
) , (
) (
|
Security Market Line
The expected return of securities is linear
in their beta-factors
In the (beta,expected return) plane, the
line crossing through (0,r
F
) and (1,E(r
T
)) is
called the security market line
Properties of betas
Beta is linear: the beta of a portfolio of
securities equals the portfolio-weighted
average of the betas of the individual
securities
An implication is that the beta of the
assets of the company equals the value-
weighted beta of the liabilities of the
company
Tracking portfolios
A portfolio tracks another perfectly if the
difference in the returns of the portfolios is
a constant (possibly zero)
Imperfect tracking: A portfolio consisting of
a weight (1-b) in the risk free asset and a
weight b in the tangency portfolio tracks a
stock with beta =b, because the two
should have the same expected return
Tracking Errors
The two investments should have the same
expected return, which implies that the tracking
error has zero expectation and zero value
Of course, investors do not like risk so they
choose to hold the tracking portfolio instead of
the stock
Because such diversification is free of cost, the
tracking error is also free of cost (i.e. it has zero
value)
Estimating the risk free return
For risk free return use government bond
or government bill data (long or short term
instruments backed by the government)
The return offered on such instruments is
a good proxy for the actual risk free return
Alternative, use the average return of a
zero-beta risky stock, or the intercept with
the y-axis if no zero-beta stock exists
Estimating market risk premia
Estimate the long-run average return on a broad
stock market index and subtract the risk free rate
Both the average stock market index return and
the risk free return change over time
The change in the difference is more volatile
than the changes in the individual time series.
Therefore, estimate the long-run average index
return first. Do not estimate the difference
between the market return and the risk free rate
directly
Beta estimation
A raw beta estimate can be obtained from historical
covariance and variance estimates (or by a regression)
Average beta is one (this is the beta of the market index)
If the raw estimate exceeds (is below) one, we know
there is a possibility that the raw beta is an overestimate
(underestimate)
Raw beta estimates should be adjusted i.e. they
should be pulled down if they are above one or be
bumped up if they are below one.
There are ways of optimally adjust beta estimates
Beta Adjustment
Bloomberg adjustment
Adjusted beta = .66 times Unadjusted beta +
.34 times One
Rosenberg adjustment
Adjustment also incorporates fundamental
variables (industry variables, company
characteristics such as size, etc..)
Also betas are adjusted sometimes to take
into account infrequent trading problems
What to take home
Two-fund separation
Capital Market Line vs Security Market
Line
Risk-Return relationships
Tracking portfolio
Parameter estimation: problems and
current practice
Readings
Grinblatt/Titman ch 5
Problems
What is the tracking portfolio for a real
asset?
How would you estimate the beta of the
assets of a firm that has traded debt and
equity?
How would you estimate the beta of a
company that has never traded?
Week 4: From CAPM to Arbitrage
Pricing Theory
Main purpose is to extend the valuation
approach into more advanced and flexible
valuation models
CAPM can be thought of as a one-factor model
(returns are determined by movements in the
market portfolio only) but has important
empirical problems (systematic deviations from
predictions)
APT extends to multi-factor pricing that can
mitigate some of the CAPMs empirical problems
Risk Decomposition
The Market Model
One-factor (the return on the market portfolio)
Related to the CAPM model
The regression estimates of the market model
generates raw beta-estimates for the CAPM
Risk Decomposition
Systematic (market) risk: asset risk that is explained
by market movements
Unsystematic (diversifiable, idiosyncratic) risk: asset
risk that cannot be explained by market movements
Market model regression
0 ) , cov(
) var(
) , cov(
) 1 (
=
=
=
+ + =
Mt it
Mt
Mt it
i
F i i
it Mt i i it
r
r
r r
r
r r
c
|
| o
c | o
Risk Decomposition
) var( ) var( ) var(
risk tic idiosyncra ) var(
risk market ) var( ) var(
risk total ) var(
2
2
it Mt i it
it
Mt i Mt i
it
r r
r r
r
c |
c
| |
+ =
=
= =
=
APT: The arbitrage principle
behind factor models
F j
i j
j
i
i j
j
i j
j
j i
j j i i j i
i i
i
r r
b b
b
r
b b
b
b b
b
w
b w wb
f b a w f b a w r w r w
f b a r
= =
|
|
.
|

\
|

=
= +
+ + + = +
+ =
free risk 1
solution has which
0 ) 1 ( Set
) )( 1 ( ) ( ) 1 (
~ ~
~ ~ ~ ~
~ ~
APT: Factor pricing
F M
i F i i
j
F j
i
F i
F i F j j i i j
F j
i j
j
i
i j
j
r r E
b r a r E
b
r a
b
r a
r b r b a b a b
r a
b b
b
a
b b
b
=
+ = =
= =

=
=
|
|
.
|

\
|

) ( CAPM, For
) (
constant
1

Multi-factor models
~ ~ ~
2 2
~
1 1
~
2 2 1 1
) (
model factor - K
it Kt iK t i t i i it
K iK i i F i
f b f b f b a r
b b b r r E
c

+ + + + + =
+ + + + =

We do not know what

the factors are!
Can be evaluated statistically using a
method called factor analysis
The output generates portfolios associated
with each factor
Can use firm characteristics or
macroeconomic variables as proxies for
the factors
Factor betas
The betas determine the assets sensitivity to the
factors
A high loading on factor number 2 means that
the asset is particularly sensitive to risks
associated with factor 2
Factor models extends into portfolio analysis
since the factor betas of portfolio is just the
value-weighted average factor beta for the
individual assets in the portfolio
Factor models: computing the
variance-covariance structure
Recall that computing the variance-covariance
structure requires a large number of estimates
For N assets, N variance estimates and N(N-1)/2
covariance estimates
N=100, 100 variance estimates and 100(99)/2 =
4950 covariance estimates
Using the market model, we can work out the
covariance structure from the beta estimates, i.e.
from the N beta estimates
Covariance structure estimation
) var(
) , cov( ) , cov(
) , cov( ) var(
) , cov( ) , cov(
~
~ ~ ~ ~
~ ~ ~
~ ~ ~ ~
~ ~ ~
f b b
f b
f b f b b
f b f b r r
f b a r
j i
j i i j
j i j i
j j i i j i
i i i i
=
+ +
+ =
+ + =
+ + =
c c c
c
c c
c
Variance estimation
) var( ) var( ) var(
~ ~
2
~
i i
i
f b r c + =
Tracking Portfolio
Objective: to design a portfolio that has certain
factor betas (or factor loadings)
Why? The use of tracking portfolios are many
Risk management: if the company is subject to risks
beyond its control, e.g. currency risk, it may create a
tracking portfolio that offsets the risk
Capital allocation: the company may wish to allocate
capital to investments that yield a greater return than
their tracking portfolio and to reduce its exposure to
investments that yield a smaller return than their
tracking portfolio
Designing a Tracking Portfolio
First, determine the number of relevant factors
(guesswork, statistical analysis)
Second, determine the factor betas of the
investment you wish to track (statistical analysis,
comparison with existing traded companies)
Third, gather a collection of different assets with
known factor loadings
Forth, calibrate your portfolio such that the
portfolio factor beta equals the target factor beta
for each factor
Example
8 . 0 , 3 . 0 , 1 . 0 : Output
2 2 4
1 5 . 1 3
1
: n Calibratio
2 factor for 0 2, 4, - and
1 factor for 1.5 3, 1, beta factor with assets Three
ly respective 2 and 1 factor for
2 and 1 betas target portfolio, cking factor tra - Two
3 2 1
2 1
3 2 1
3 2 1
= = =
= +
= + +
= + +
x x x
x x
x x x
x x x
Applying Pricing Theory
Use pricing models to investment analysis
(optimal investment strategies in financial
markets diversification)
Use pricing models to calibrate
investments (design of tracking portfolios)
Use pricing models as a benchmark for
real investment (comparing real
investment returns to the return on
tracking portfolios)
Readings
Chapter 6 in Grinblatt/Titman
Problem
There are three relevant factors driving
asset returns
The factor structure of the debt of the
company is (0.01, 0,0)
The factor structure of the equity of the
company is (2,5,1)
The company consists of 1/3 debt and 2/3
equity
What is the factor structure of the
companys real assets (investments)?
Week 5: Investment Analysis the
case of Risk Free Projects
Apply pricing technology to real
investment analysis
Net Present Value Rule
Complications
Sunk cost
Opportunity cost
EVA and IRR
Fisher Separation
With different tastes, why should investors agree
on investment policy?
Long-term vs short term
Risky vs Risk free
Fisher separation
Agreement is optimal regardless of taste
Net present value rule: Invest in all projects that cost
less than the value of the projects tracking portfolio
NPV = PV(future investment) Investment cost
Ingredients
Cash flows of our investment
Investment cost
Discount rates (if risk free projects use a
risk free discount rate)
Present Value = sum of discounted
cash flows
T
T
r
C
r
C
r
C
C r
r
C
C r
r
C
C C C
) 1 ( ) 1 ( ) 1 (
portfolios tracking of value the of sum lue Present va
etc...
2 year in ) 1 (
) 1 (
to grows
r) (1
C
1 year in ) 1 (
) 1 (
to grows
r) (1
C
: portfolios Tracking
, , , : flows Cash
3
2
2 1
2
2
2
2
2
2
1
1 1
2 1
+
+ +
+
+
+
=
=
= +
|
|
.
|

\
|
+ +
= +
|
|
.
|

\
|
+ +

Net Present Value

T
T
r
C
r
C
r
C
I NPV
) 1 ( ) 1 ( 1
2
2 1
0
+
+ +
+
+
+
+ =
NPV and Arbitrage
3.
period in 30 paying bond a buying 2, period in 10
paying bond a selling 1, period in 40 paying bond
a buying project, the g undertakin to Equivalent
94 . 34
05 . 1
30
05 . 1
10
05 . 1
40
20
30 , 10 , 40 , 20 : flows Cash
arbitrage ugh money thro making to equivalent is
NPV positive has it en project wh Adopt the
3 2
= + + =

NPV
Value Additivity of NPVs
B A B A
B
A
NPV NPV NPV
NPV
NPV
+ =
+
+
: lue present va net has projects) two
the of flows cash combined the (i.e. B A Project
has B Project
has A Project
Mutually Exclusive Projects
This is an either-or situation you can invest in
project A or you can invest in project B, but you
cannot invest in both at the same time
Both projects may have positive NPV so are
worthwhile on their own
Either-or situations often arise naturally. For
instance, all timing decisions are mutually
exclusive. You can invest now or you can invest
in the future, but you cannot invest both now and
in the future.
Which project to choose when they
are mutually exclusive
The choice criterion is to maximize the net
present value of investment.
Therefore, if you have two or more
mutually exclusive projects to choose from
you should choose the one with the most
positive NPV.
Capital Constraints
There are situations in which you may
have more projects with positive NPV
available than you have funds for
investment i.e. you have a budget
constraint
Then the choice criterion is to invest in the
projects that offer the greatest profitability
index
Profitability Index
0
0
0
Index ity Profitabil
lue present va Net
cost Investment
flow cash Value Present
I
PV
PI
I PV NPV
I
PV
=
=

Example
budget? within staying to
subject policy investment optimal the is What
. 100 budget investment Total
exclusive? mutually are
projects the if policy investment optimal the is What
t? independen are
projects the if policy investment optimal the is What
950 , 1000 : C Project
90 , 100 : B Project
8 , 10 : A Project
m B
m I m PV
m I m PV
m I m PV
C C
B B
A A
=
= =
= =
= =
Example cont.
11 . 12 ) 950 1000 (
950
2
) 90 100 ( ) 8 10 ( : NPV Total
C of % 2105 . 0
950
2
plus C) in invest
to 2 leaving budget, of 90 additional (using B of all
plus budget) 100 of 8 (using A of All : mix Optimal
C. and B then first, A in Invest
0526 . 1
950
1000
1111 . 1
90
100
25 . 1
8
10
: indexes ity Profitabil
= + +
=
= =
= =
= =
C
B
A
PI
PI
PI
Economic Value Added
EVA is a profitability measure that has become
widely used in corporations initially to replace
accounting earnings or profit measures
Accounting measures do not always measure
economic performance (depreciation cost, for
instance, is not a cash flow and should not be
included in project evaluation)
Accounting measures are therefore not directly
consistent with NPV
Economic Value Added is consistent with NPV
EVA: Definition
Three components
Cash flow
Change in asset base
Economic return on assets
EVA(t) = C
t
+ (I
t
I
t-1
) rI
t-1
EVA(t) = C
t
+ I
t
(1+r)I
t-1
Discounted sum of EVA(t) = Net Present
Value
EVA, cont.
Investment of 100
The first year cash flow is 50
The second year cash flow is 150
Discount rate is 10%
Assets are depreciated by 50% in the first
year and by 100% in the second year.
NPV = -100 + 50/1.1+150/1.1
2
=69.42
EVA, cont.
EVA(0) = -100(cash flow)+(100-0)(change in assets)-
0(0.1)(economic cost of initial assets) = 0
EVA(1)=50(cash flow)+(50-100)(change in assets)-
100(0.1)(economic cost of initial assets) = -10
EVA(2)=150(cash flow)+(0-50)(change in assets-
50(0.1)(economic cost of initial assets)= 95
Discounted EVA = EVA(0)+EVA(1)/1.1+EVA(2)/1.1
2
=
69.42 = NPV
IRR: Internal Rate of Return
Often managers base investment decision on
the IRR instead of the NPV
The rule is: if IRR is greater than the discount
rate (i.e. the cost of capital) then adopt the
project
In many cases this leads to the same investment
decision, as IRR is greater than the discount rate
only if the NPV is positive
In other cases this is not true however, so to be
safe always use NPV or EVA calculations
IRR
T
T
T
T
IRR
C
IRR
C
IRR
C
I
r
C
r
C
r
C
I NPV
) 1 ( ) 1 ( 1
0
) 1 ( ) 1 ( 1
2
2 1
0
2
2 1
0
+
+ +
+
+
+
+ =
+
+ +
+
+
+
+ =

Example
Investment cost = 100
First years cash flow = 150
Discount rate 10%
NPV = -100+150/1.1=36.36
IRR: 0=-100+150/(1+IRR) yields 50%
Since 50% > 10% (IRR > discount rate) it is
optimal to adopt the project
Projects that have the cash flow
profile of a loan
Investment cost = 150
Next years cash flow = -100
Discount rate = 10%
NPV = 150 100/1.1 = 59.09
IRR: 0 = 150 100/(1+IRR) yields a negative
IRR of -33.33% but this project is clearly
profitable even though IRR < discount rate
Problems with IRR
IRR criterion is sensitive to the type of cash flow
(asset or liability?)
IRR is not unique in general (for T period
projects there can be up to T different IRRs)
IRR is not appropriate for mutually exclusive
projects as small projects with high IRR and
small NPV might then be preferred to large
projects with low IRR and large NPV
IRR and mutually exclusive
projects
Discount rate 2%
Project A: -10, -16, +30
Project B: -10, 2, 11
NPV(A) = 3.149
NPV(B) = 2.534
IRR(A) = 10.79%
IRR(B) = 15.36%
Important points
Fisher separation
NPV definition
NPV with mutually exclusive projects
(either-or)
NPV with budget constraints
EVA and NPV
IRR
IRR pitfalls
Readings
Grinblatt/Titman chapter 10
Test for next week:
Readings chapter 4, 5, 6 and 10
Important formulas
CAPM: exp return = risk free plus risk adjustment
Beta-factor: covariance/variance
Factor models: exp return = risk free plus risk
adjustment
Risk free real investments
NPV rule
Profitability Index
EVA
IRR
Very important formulas
T
T
K K F
M
M
F M F
r
C
r
C
I NPV
r r E
r Var
) Cov(r,r
r r E r r E
) 1 ( 1
: lue present va Net
premium) risk denotes (where
) ( : models Factor
) (
: Beta
) ) ( ( ) ( : CAPM
1
0
1 1
+
+ +
+
+ =
+ + + =
=
+ =

| |
|
|
Sample test questions
1. The risk free return is 5% and the market index has an
average return of 12%. What is the expected return for
an asset with beta 1.5?
2. An investment costs 100,000 and offers a cash flow of
50,000 in year 1 and 150,000 in year 2. The discount
rate is 5%. What is the net present value of the
investment? Should you adopt the investment?
Explain.
3. In a two-factor market, the factor betas of asset A are 1
and 0, and the factor betas of asset B are 0 and 1,
respectively. The risk free return is 5%, and the
average return on asset A and B are 10% and 15%,
respectively. What are the risk premia associated with
factor 1 and 2?
Week 6: Investing in Risky Projects
Applying the CAPM and APT in the capital
budgeting process
Key problem: estimating the cost of capital
for risky projects
Applying CAPM and APT
Using comparison firms
The dividend discount model
Risk Adjusted Discounting
t
t
t
F M F
t
r
C E
C E PV
r r E r r
C E
) 1 (
) (
)) ( ( : Discount
) ( ( flow
cash the of return market expected the Compute
return
market the of variance over the return, market the
h return wit the of covariance the is beta (the flow
cash with this associated risk beta the Compute
t period in ) ( get) ll at we' exactly wh know
not do (we flow cash future expected the Compute
+
=
+ = |
|
Fundamental problem: Estimating
the beta factor
Betas for traded equity are easy to estimate
we simply regress equity returns on the index
return, and possibly adjust to take into account
estimation error (e.g. Bloomberg adjustment)
Betas for projects are much more difficult to
estimate as there simply does not exist a trading
history
Possible solution: use comparison firms (firms
we imagine has similar risk profile to the project
in question)
Using comparison firms
Asset base needs to be sufficiently similar
to the planned investment
We need to adjust for leverage effects (the
comparison firm may have debt)
In general, it is only the equity beta of the
comparison firm we can estimate but we are
really interested in the asset beta
The more the firm borrows, the higher the
equity beta (even though the asset beta
remains the same)
Adjusting for leverage
term leverage
a plus beta asset the equals beta equity Estimated
) (
beta
equity and debt of sum weighted - value beta Asset
D A A E
E D A
E
D
E D V
V
E
V
D
| | | |
| | |
+ =
+ =
+ =
=
Example
9 . 0
60
40
1
5 . 1
implies
) 0 (
60
40
5 . 1
0 beta debt Estimated
1.5 beta equity Estimated
60. equity value and 40, debt value 100, assets Value
=
+
=
+ =
A
A A
|
| |
Implementing risk adjusted
discounting with comparison firms
08 . 1
0 . 1
79 . 0
85 . 0 s Wendy'
00 . 1
10
7 . 7
77 . 0 McDonalds
75 . 0
100 . 0
096 . 0
72 . 0 Chicken s Church'
are betas asset The
zero. to equal assumed is companes
these of debt the of beta the and ly, respective
s), (Wendy' 0.790 and 0.210 and ) (McDonalds 7.700
and 2.300 Chicken), s (Church' 0.096 and 0.004
are companies these of ues equity val and debt The
ly. respective 1.08 and 1.00, 0.75, are companies three
these of betas equity The s. Wendy' and s McDonald'
Chicken, s Church' of beta average the has project A
=
=
=
Cont
) 084 . 0 ( 78 . 0 04 . 0 1055 . 0
is project for the rate) (discount capital of Cost
8.4%. premium risk market and 4% rate free Risk
3
85 . 0 77 . 0 72 . 0
78 . 0 beta project beta Average
+ =
+ +
= = =
Applying APT
t
K K F
t
t
r
C E
C E PV
) 1 (
) (
)) ( (
by given are lues present va so model, factor a by
capital of cost the estimates model APT The
1 1
| | + + + +
=

APT and CAPM vs Alternative

methods
A drawback with the APT and CAPM
models is that they require a number of
estimates: the risk free rate of return, the
beta factor(s), the market risk premium
and the factor risk premia.
It can in some circumstances be better to
work with simpler model. The dividend
growth model is an alternative to the APT
and CAPM.
Dividend Discount Model
yield dividend dividends in growth
) 1 (
) 1 (
) 1 ( ) 1 ( ) 1 (
etc... ,
) 1 (
) 1 (
0
1
1
0
2
1 1
2
2 1
0
2 2
1
1 1
0
+ = + =

=
+
+
+
+
+
= +
+
+
+
=
+
+
=
+
+
=
S
div
g r
g r
div
S
r
g div
r
div
r
div
r
div
S
r
S div
S
r
S div
S

What if comparison firms dont
exist?
In general there is little we can do
However, if there exist firms where one
division is similar to our project we may be
able to identify the relevant betas.
For instance, if you want to estimate the
beta of the network division of television
companies you can use the fact that these
divisions play a varying role in generating
the asset beta for these companies
Network division example
36 . 0
78 . 0 5 . 0 5 . 0
99 . 0 75 . 0 25 . 0
that
know we similar, ly sufficient are divisions network
- non If divisions. network - non from 50% division,
network from value of 50% 0.78, beta asset : Viacom
divisions. network - non from 75% division, network
from value of 25% 0.99, beta asset : Electric General
=
= + =
= + =

Network
network Non Network Viacom
network Non Network GE
|
| | |
| | |
Pitfalls in using the comparison
method
Project betas not the same as firm betas:
mature projects generally lower beta than
R&D projects etc
Growth opportunities are usually the
source of high betas: company value often
significantly linked to future growth
opportunities as opposed to current
investments
Example
Investment cost 100,000
Annual running cost 5,000 for 5 years
Expected revenue stream 50,000 for 5
years
Beta-risk of revenue stream 1.2
Risk free return 5%
Expected market return 12%
Example cont
project. adopt Therefore,
0 51 . 52 51 . 152 100
51 . 152 16 . 174 65 . 21
) 134 . 1 ( 50 ) 134 . 1 ( 50 ) 134 . 1 ( 50 ) 134 . 1 ( 50 ) 134 . 1 ( 50
) 05 . 1 ( 5 ) 05 . 1 ( 5 ) 05 . 1 ( 5 ) 05 . 1 ( 5 ) 05 . 1 ( 5
% 4 . 13 %) 5 % 12 ( 2 . 1
% 5 : stream revenue for the rate discount The
free?) risk assumed be can
costs the (as 5% : costs running for rate discount The
5 4 3 2 1
5 4 3 2 1
> = + =
= + =
+ + + + +
=
=
+


NPV
PV
Comparison method, example
A firm with equity currently valued at 100,000
and outstanding debt worth 50,000 holds 25%
cash and 75% of a risky asset on its balance
sheet
The equity beta is 1.5
You consider investing in a project very similar to
the risky asset owned by this firm
The risk free rate is 5% and the expected return
on the market is 12%
Work out the project beta and the cost of capital
for your project
Comparison method cont
14.33% 5%) - 1.33(12% 5% capital of Cost
33 . 1
75 . 0
1
75 . 0 ) 0 ( 25 . 0 beta asset Total
1
100
50
1
5 . 1
beta asset total The
0 to close beta a has balance cash that the
assume also and 0, to close very is beta debt Assume
A
A
= + =
= =
+ =
=
+
=
RiskyAsset
RiskyAsset
|
| |
|
Readings
Grinblatt & Titman chapter 11
I have not emphasized the certainty
equivalent method
Week 7: Taxes and Financing
Irrelevance in the absence of transaction
costs and taxes (Modigliani-Miller)
Financing choices not neutral to taxation:
Level: corporate vs private tax rates
Timing: dividends can be deferred whereas
interest payments on debt cannot
Modigliani-Miller
The operating cash flow is divided into two
components
Cash flow to debt holders
Cash flow to equity holders
Fundamental question: Does it matter how
the split is made?
If it does we can create value also through
financing choices (not only through
investment choices)
MM cont
Modigliani-Miller proved that capital structure
choices are irrelevant the split does not matter
This proof rests on the absence of transaction
costs of any kind: taxes, trading costs, and
bankruptcy costs
The proof of the MM theorem uses a no
arbitrage argument financial markets do not
admit free lunches, or trading strategies giving
you a positive cash flow with no prior investment
MM cont
Consider two versions of the same firm
one version is U for unlevered (with no
debt) and the other version L for levered
(with debt)
The firms have otherwise the same
operating cash flow X
The unlevered firm has value V
U
and the
levered firm value V
L
MM cont
The fundamental question is whether V
U
and V
L
differ
The cash flows of firm Us equity holders is
simply X
The cash flow of firm Ls debt holders is (1+r)D
to the firms debt holders and X-(1+r)D to the
firms equity holders, in total a cash flow of X
also
The value of L is the combined value of the debt
and the equity
MM cont
Suppose V
L
is smaller than V
U
Then an investor can buy a 10% holding of Ls debt and
a 10% holding of Ls equity, which entitles the investor to
a 10% share in the total cash flow X. He would then go
to the market and sell 10% of the cash flow X, which is
valued at 10% of the value of U. This leaves him with
zero future liability.
His trading gains are 10% of the difference between V
U
and V
L
, which we have assumed is positive
This cannot be possible in an arbitrage free market, so
we can conclude that V
L
must be equal to or greater than
V
U
MM cont
Now suppose V
U
is smaller than V
L
An investor buys 10% of the cash flow X and sells 10%
of a claim that promises the cash flow (1+r)D. The net
cash flow is 10% of a claim that pays X-(1+r)D at
maturity, which is priced at 10% of the equity in L
The net future liability is zero, and the trading gains
equal 10% of the difference between V
L
and V
U
, which
we have assumed positive
Again, this is not consistent with arbitrage free markets
In conclusion, it must be the case that V
U
= V
L
and that
capital structure is irrelevant
What about risky debt?
When the corporate debt contract is risky it may
be difficult to find a synthetic corporate debt
contract if a real one does not exist
We must assume, therefore, that the markets
are sufficiently complete in order to conclude
that financing does not matter
Complete market = a market where the
dimensionality of the asset structure equals the
dimensionality of the uncertainty structure
If there are two states of nature (e.g. good and
bad) then it suffices with two distinct assets to
make the market complete
Bankruptcy costs
The Modigliani-Miller theorem also assumes that
there are no deadweight costs of bankruptcy
The debt holders may not get all their money
back if the firm defaults, but this is not in itself
enough to jeopardise the MM-theorem
There must also be deadweight costs or
liquidation costs (i.e. the value of the assets in
default is less than the value of the assets as a
going concern)
Taxes: Another important factor
The tax system is generally fairly complex
with different tax rates for different
individuals and institutions, and for
different types of income
Therefore, it may be scope for tax
arbitrage profits in financing
After tax cash flow analysis
A constant after tax discount rate r
Tax rate for personal income from debt t
D
Tax rate for personal income from equity t
E
Corporate tax rate t
C
Earnings before taxes and interest payments X
Earnings before taxes (X kD) (k coupon rate, D
nominal amount borrowed)
After tax personal income from debt kD(1-t
D
)
After tax earnings (X-kD)(1-t
C
)
After tax personal income from equity (X-kD)(1-t
C
)(1-t
E
)
Algebra
benefits tax discounted firm unlevered Value
1
) 1 )( 1 (
1
1
) 1 (
1
) 1 )( 1 (
flow cash after tax Discounted
1
) 1 )( 1 (
1 ) 1 ( ) 1 )( 1 (
) 1 ( ) 1 )( 1 )( (
e perspectiv investor from flow cash After tax
+ =
|
|
.
|

\
|

+
+

=
|
|
.
|

\
|

+ =
+ =
D
E C D E C
D
E C
D E C
D E C
t
t t
r
t kD
r
t t X
DC
t
t t
t kD t t X
t kD t t kD X C
Equilibrium
If there is a positive discounted tax benefit firms
choose to borrow more, and investors with
higher personal tax rate on debt income is
encouraged to enter the market. This implies a
reduction of tax benefits of borrowing.
Reverse effect is there is a negative discounted
tax benefit of borrowing
In equilibrium, we expect the tax benefit from
borrowing to be equal to zero
This is the so-called Millers equilibrium
described in Appendix 14A in the textbook
Preferred stock
Preferred stock: dividends on preferred stock are
not tax deductible at the corporate level as are
interest payments on debt
This implies that corporate junior debt may be
tax efficient relative to preferred stock
However, the US tax code allows a 70% tax
exclusion for preferred dividends paid to
corporate holders, so the yield on preferred
stock is often lower (before tax) than on junior
debt even though the debt has seniority over the
preferred stock
Investor conflicts?
Tax exempt equity holders prefer in general to reduce
the borrowing of the firm so as to transfer income from
debt repayments to dividend payments
High-tax bracket investor prefer the opposite
Often tax-exempt municipal bonds (or similar
investments) offer yields that are greater than the after
tax yield on corporate bonds for high-tax bracket
investors
Thus, the firm can give these investors an advantage by
increasing the firms borrowing, as this frees capital that
the investors can use to invest in tax-exempt municipal
bonds
Inflation
We expect to see a one-to-one relationship
between inflation and nominal interest rates - if
inflation increases by one percentage point then
so do nominal interest rates
Higher inflation, therefore, leads to higher
nominal borrowing costs that yield in turn greater
tax deductions
Therefore, the tax effect has greater bite in
periods of high inflation
Empirical evidence
Do firms with greater taxable earnings borrow more?
No, but this may be because firms in general rarely issue equity
Firms that perform poorly, therefore, tend to accumulate debt to
meet their investments
Tax code changes that affect the relative tax benefit of
borrowing should have an impact on corporate financing
Yes, US tax reform of 1986 which reduced the tax benefits of
other things than debt (such as depreciation rules and
investment tax credits) gave rise to an increase in borrowing
among firms most affected
The firms less affected did not increase their borrowing to the
same extent
Taxes matter but dont explain everything
Readings
Grinblatt/Titman chapter 14, including the
appendix
14.10 Are There Tax Advantages to
Leasing not so relevant
Exercises
1. A firm has assets valued at 100, and debt valued at 50.
It plans to restructure its liability side by increasing its
borrowing to 70 and paying a dividend of 20 to its
shareholders. The debt has zero beta before and
0.001 beta after the recapitalization. The beta of the
equity is 2 before the recapitalization.
a) What are the values of the equity before and after the
recapitalization?
b) What is the beta of the assets of the firm?
c) What is the beta of the equity after recapitalization?
d) The recapitalization has increased the beta of the debt (and
therefore the cost of debt capital). Has it also increased the
beta of the equity? Does this mean that the total cost of
financing has increased? Explain.
Week 8: Taxes and Dividends
In frictionless markets dividends dont
matter
Why do firms nonetheless pay dividends?
Taxes and dividends
Stock returns and dividend yields what is
the connection?
Investment distortions caused by taxes in
dividends
Cash flow to shareholders
Shareholders earn money through holding equity that
earns a cash flow (such as dividends) and capital gains
(which can be realized through selling stock)
The cash distribution to shareholders is normally
discretional the company can decide how much cash
flow to give their shareholders
Cash distribution comes in two forms dividend
payments and share repurchase schemes
Dividend payments do not affect the number of shares
but will reduce the value of each share
Share repurchases do normally not affect the value of
each share but will reduce the number of shares
outstanding
How much of earnings is cash flow
to shareholders?
Dividend payout ratio: the ratio of dividends to
earnings
In the US, this ratio has declined from about
22% in 1980 to about 14% in 1998
Over the same period, the ratio of share
repurchases to earnings increased from 3% to
about 14%
The total ratio of cash flow to earnings has been
relatively stable at about 25% of earnings
Dividend yields
Dividend yield is the ratio of dividends per
share over price per share
Typical pattern is that high-tech growth
firms have low dividend yield and dividend
payout ratios (Microsoft paid its very first
dividend this year)
Stable, old economy companies such as
mining, oil and manufacturing pay about
half their earnings as dividends
What is the optimal dividend payout
ratio?
Assumption: frictionless economy (no
transaction costs, taxes, or other frictions)
Investment policy unaffected by dividend
payments
Modigliani-Miller Dividend Irrelevance
Theorem:
The choice between paying dividends and
repurchasing shares is a matter of
indifference to shareholders
Modigliani-Miller Irrelevance
Consider two identical equity financed
firms, the only difference is dividend policy
Firm 1 pays 10m as dividends
Firm 2 repurchases stock worth 10m
After the end of the year, the firms are
worth X
In the beginning each firm has 1m shares
outstanding
MM cont
Each share eventually sells for X divided by the number of shares
Firm 2 buys back 10m worth of stock
If share price is p, and firm 2 buys back n shares, we know that
pn=10m
We also know that p=X/(1m-n)
Suppose X = 150m
Solving both equations gives us n = (10m1m)/(X+10m), so we get n
= 62,500, and p = 150m/(1m-62,500) = 160
Firm 1: stock price is p = 150m/1m = 150, but each stock gives a
dividend worth 10m/1m = 10, so the total value of each stock is
150+10 = 160
Since shareholders get the same cash flow eventually, the shares
must sell at the same price initially, i.e. dividend policy does not
matter
Taxes and cash distribution to
shareholders
Classical tax system
Dividends taxed as ordinary income and capital gains at a lower
rate than ordinary income
Dividends are not tax deductible at corporate level, so dividends
are also subject to corporate taxation
Imputation system
Dividends are taxed as ordinary income but investors get a
partial tax credit for corporate taxes (to offset personal taxes)
Dividends are not tax deductible at corporate level
Systems that eliminate double taxation
Dividends are tax deductible at corporate level and taxed as
ordinary income at investor level
Classical tax system
The classical tax system implies a tax
disadvantage of dividend payments
Dividend $100, 35% tax implies an immediate
tax liability of $35
Share repurchase scheme: an investor sells
$100 worth of shares. Suppose original cost was
$76. This implies a taxable capital gain of $24.
Taxed at 20%, this implies an immediate tax
liability of $4.8
Share repurchase scheme much cheaper than
paying dividends
Tax avoidance schemes
In theory, investors can often invest in a scheme
that gives an immediate tax relief against a
deferred future tax liability
In practice, investors do not take advantage of
these schemes but instead choose to pay taxes
(or are unable to invest in tax avoidance
schemes) on the received dividends
The question is, therefore, why corporations
continue to pay dividends when they are so tax
inefficient
Dividend clienteles
Some investors do not pay taxes
These investors will, everything else being
equal, prefer high dividend yield firms to low
dividend yield firms as they do not pay tax on the
dividend
Firms might adopt different dividend policies to
attract different investor clienteles
Empirical evidence suggests that investors
portfolios have dividend yields that are related to
their tax status (high tax bracket investors
choose low dividend yield stocks and vice versa)
Dividend payments and stock
returns
Do stocks with high dividend yield compensate
investors for the tax disadvantage?
Higher returns should then lead to lower values,
reflecting the higher discount rates applied to
future cash flows
Research has focused on two returns effects
Ex-dividend day behaviour of stock prices
Whether cross-sectional dividend yield differences
affect expected returns
Ex-dividend day price drop
If you buy the stock on the day before the ex-dividend day, you are
entitled to the future value of the stock and the current dividend
payment
If you buy the stock on the ex-dividend day, you are entitled only to
the future value of the stock
The stock price should, therefore, drop on the ex-dividend day to
reflect the dividend payment
Empirical results from the 1960s indicate that the ex-dividend day
price drop is about 77.7% of the dividend payment on average, but
was higher (90%) for dividend payments greater than 5% of the
stock price, and lower (50%) for the smallest dividends.
These results indicate a tax effect (investors discount a tax rate of
around 22.3% on dividends), and a clientele effect (investors with
different tax rates hold portfolios with different dividend yields)
Ex-dividend day cont
Transaction cost argument
Consider buying a stock at $20 before the ex-div day, receive a $1
dividend, then sell the stock for $19.20. This yields $1 taxable profits
and $(20-19.20) = $0.80 tax deductible losses. The net profit is $0.20
less taxes, but it is still arbitrage profits. The stock needs to drop by the
full amount to preclude arbitrage profits.
If there is a $0.10 per share transaction cost, the investor receives
taxable profits of $1 in dividends, and incur $0.80 in tax deductible
losses. The net profit is $0.20, but the investor must also pay $0.10 in
transaction costs, so the net profit is only $0.10 less taxes. If the stock
drops to $19.10, therefore, there are no arbitrage profits to be made.
If the dividend payment is only $0.40, the necessary price drop is $0.30
to prevent arbitrage profits. That is, the price drop is greater for high
dividend yielding stocks in percentage terms (as the clientele effect
predicts).
Price drop less than the dividend payment is also observed in
countries that do not have a classical tax system, suggesting this is
not a tax driven phenomenon at all
Cross-sectional relation between
dividend yield and stock returns
If dividends are more heavily taxed than capital
gains, the expected return must be greater for
high dividend yield stocks.
Empirically, stocks with high dividend yields
have higher returns, but the relationship is not
straightforward
The relationship is U-shaped, with zero dividend
yield stocks have higher expected return than
stocks with low dividend yield, but for stocks
paying dividends, the expected return increases
with the dividend yield
How dividend taxes affect financing
and investment decisions
Marginal tax rate of 50%
Company has a choice between paying $1m in dividends or retain
the earnings
Retained earnings yield 6% after corporate taxes (alternative II)
Dividends yield 7% before personal taxes in corporate bonds
(alternative I)
Alternative I yields $500,000 to invest at 7%, which after tax yields
$17,500 per year
Alternative II yields $60,000 in extra dividend payments per year,
which yields $30,000 after tax to the investor
If you are a zero tax payer, however, alternative I yields $1,000,000
to invest at 7%, which equals $70,000, and alternative II only
$60,000 in additional dividends per year.
Investors with different tax rates are likely to disagree with regard to
the dividend policy the firm should pursue
The general principle
Investors prefer retained earnings if (1-corporate
tax rate) x (pretax return internally at corporate
level) > (after tax return at investor level)
This has implications for investment policy as
well
Tax-exempt and tax-paying investors agree on
externally funded projects but may disagree on
internally funded ones (tax exempt investors require
higher return on internal investment than tax-paying
investors)
Readings
Grinblatt/Titman chapter 15
Exercises
1. A stock trades at 100p per share (prior to ex-dividend
day) and the firm will pay a dividend of 10p per share.
a) Work out the ex-dividend day price if investors pay 40% tax on
dividends and the ex-dividend day price equals the initial price
less after-tax dividend payment
b) Work out the minimum transaction cost per share that
prevents tax-arbitrage by a tax-paying investor
c) Suppose the dividend payment was 50p per share. What is
your answer to a) and b) now?
d) Suppose the actual transaction cost is 2p per share. What are
the arbitrage free price drops in a) and c) above now?
e) What are the implied tax rates on dividends in d)?
Week 9: Managerial Incentives and
Corporate Finance
Manager shareholder conflicts
Occidental Petroleum and founder/CEO
Armand Hammer case in the textbook
Maxwell Communications and Robert Maxwell
How such conflicts affect investment,
financing, and ownership structure
How such conflicts can be mitigated by
executive compensation schemes
Separation of ownership and
control
The separation of ownership and control is beneficial in
terms of diversification and optimal investment while
keeping a stable management team in control of the firm
But it can be harmful if the management team is more
interested in pursuing their own interest as opposed to
their shareholders interests
In what way do their interests differ?
Managers represent investors, customers, suppliers, and
employees not just investors
Managers get utility from non-financial benefits such as status,
perks, job-security etc and are willing to spend corporate
resources on these even though they are likely to be negative
NPV projects
Factors that determine the
manager-shareholder conflict
Proportions of stock owned by the manager
Managerial entrenchment and lack of means to
control managers
Diffuse ownership structure (no individual manager
benefits enough to take action)
Proxy fights (shareholder revolt at general meeting)
are very expensive and difficult to organize
Bonus schemes not performance sensitive
enough
Changes in corporate governance have made
managers more accountable in recent years
Ownership structure
Ownership structure is on the whole more concentrated than we would
expect (CAPM advocates diversification), particularly outside the US/UK
Ownership concentration a response to weak legal protection of
shareholders interests
UK/US have the strongest protection and the most diffuse ownership
structure
Managers tend to keep a significant ownership stake in firms where the
incentive conflict with the shareholders is the greatest
In many internet IPOs, the managers kept a large share of their holding in
order to get a higher price in the IPO (lock in clauses)
Eg. Lastminute.com Martha Lane-Fox and Brent Hoberman (founders
Hoberman still manager) were still large owners after IPO and were
prevented from selling their share for a given time period after the IPO
Firms with higher concentration of management ownership have higher
market values relative to their book values, provided management share is
not too big. If it gets above 5%, managers become entrenched which
allows them to pursue own interests more
How managers distort investment
decisions
Managers prefer investments that fit the managers
expertise
Makes him (her) more indispensable
Investments in visible/fun industries
Raising the managers external profile (and his potential future
job opportunities and wages)
Investments that pay off early
Financial success in the short run can increase bonus, reduce
the risk of losing job, increase the possibility of raising more
capital
Investments that reduce risk and increase the scope of
the firm
To avoid bankruptcy the manager seeks relatively safe
investments and may take a portfolio approach to investments
Capital structure and managerial
control
Managers are likely to prefer equity to debt because they
are interested in minimizing the probability of default
Shareholders may, therefore, prefer debt financing as
debt is a good way to discipline managers (the fear of
losing job is a good motivator)
Empirical investigations show there is a positive
relationship between leverage and
Percentage of executive pay tied to performance
Percentage of equity owned by managers
Percentage of investment bankers on the board of directors
Percentage of equity owned by large individual investors
Debt is a good way to curb overinvestment
Debt engages often a bank who is a good monitor of
management
Executive compensation
The problem of incentivizing managers is often called a
principal-agent problem
Tenant farmer works the land of a land-owner. If compensated
too much in terms of output, the tenant farmer must bear all the
risk influencing output (weather etc). If compensated too little in
terms of output, the tenant farmer doesnt put in the required
effort.
Compensation is a matter of balancing the two concerns: Called
the problem of designing the optimal incentive contract
Effort (input) cannot be observed, otherwise compensation could
be tied to effort instead of output
Design objective is to minimize the agency costs of delegated
control
Performance based executive
compensation
Jensen and Murphy (1990) found that a $1000 increase in firm value is
associated with a $3 increase in CEO bonus (a $10m jet costs the CEO
$30,000 just in lost bonus payments)
Some disagreement about this result, as it may have underestimated the
real sensitivity by ignoring longer term impact on bonus payments
Substantial differences in pay-for-performance sensitivity across firms
Some explained by the agency costs of delegated control
Some explained by the risk of the firm
Over time, the pay-for-performance sensitivity has been increasing
Adoption of performance-based pay is generally a positive signal to the
investors
What about relative performance sensitivity (pay linked to the position of the
company relative to the average for the industry)? Relative performance-
pay is rarely observed, but can be costly to investors in terms of price wars
and overly aggressive competition.
Stock-based performance versus earnings-based performance. Stock
based performance is much noisier than earnings-based performance, but
in return earnings can be manipulated by the manager
Mergers, Spin-offs, Carve Outs
It may be easier to design an optimal compensation contract for a
small, single-unit, firm than for a multi-divisional conglomerate
Solution may be a spin-off (a division set up as an independent firm
by distributing shares in the new firm to the existing investors) or a
carve-out (do an IPO of the division and sell to new investors)
Spin-offs and carve-outs are positive signals
Mergers create the opposite effect, and in particular conglomerate
mergers can be seen as a negative signal to investors as they affect
managerial incentives negatively (conglomerate mergers are
relatively rare now but were popular in the 1960s and 70s)
Many spin-offs and carve-outs are reversing prior conglomerate
mergers
Readings
Grinblatt/Titman chapter 18
Exercises
1. The manager of a firm considers investing 1m
of free cash flow (earnings currently held in a
bank account) in a project that has private
value 10,000 to the manager but NPV of -
200,000 to the investors. What is the optimal
decision for the manager if
a) He has fixed pay?
b) He has in addition a bonus scheme where an
increase of 1000 in the stock value leads to an
increase of 10 to the manager?
c) What is the optimal bonus scheme for the manager
in this case?
Week 10: Information and Financial
Decisions
Key premise: managers have better information
than investors
What managers do, therefore, conveys
information to the market
Managers can
Distort accounts to manipulate the information flow
Reveal information through dividend policy, capital
structure choice, and investment decisions
Empirical evidence: how stock prices react to
various financial decisions
What can better informed
individuals do?
Signals: they act in a way that conveys their information
Difference between cheap talk and credible action
Signals need to be costly
Pooling: they act in a way that everybody else act in
order not to reveal information
It is too expensive to send a signal
Manipulation
Actions: Investors overestimate the true cost of signalling
Reporting: Bad reports attract attention it may be easier to
disguise bad outcomes by submitting an average report
Distortions to managerial incentives
Managers seek to maximize the share price
The share price may, however, deviate from the intrinsic
value (the full information price)
Long term investors prefer that managers maximize the
intrinsic value (which eventually transpires)
Short term investors prefer that managers maximize the
current share price (which may be distorted due to lack
of information)
The conflict is, therefore, essentially one of short-
termism versus long-termism
Why do managers care about the
current share price?
New issues or the managers may plan to
sell private stock
Low prices attract bidders in takeovers
Managerial compensation directly linked to
stock price
Customers or employees may flee the
company if the stock price goes too low
Earnings manipulation
The same underlying profits can be reported in different
ways as earnings
Depends on the choice of depreciation method
Choice of inventory valuation method (FIFO LIFO)
The estimates of the economic value of assets, the estimates of
the cost of guarantees or warranties issued, the estimates of the
pension liability of the firm, the discount rates used for valuation
of leases and pensions etc.
There is a tendency to inflate reported earnings to
increase the current stock price
But managers may also find it useful sometimes to
deflate reported earnings
For instance when the manager has just been hired
When applying for government subsidies or tariff protection
against foreign competitors
Short-termism in investment
Bias towards short term projects because these makes it clear very
quickly whether the investment is a good one
Example:
Project A: yr 1 cash flow 40; yr 2-11 cash flow 80 per year; PV 840
Project B: yr 1 cash flow 60; yr 2-11 cash flow 50 per year; PV 560
Project C: yr 1 cash flow 40; yr 2-11 cash flow 40; PV 440
Investors think C is much more realistic than A or B
If company chooses A, the stock price is close to 440 after yr 1
earnings are revealed, why?
If company chooses B, the stock price is close to 560 after yr 1
earnings are revealed, why?
Company has a disincentive to choose the best project which is A
because it is too similar to C in the first year
If managers seek to maximize the intrinsic value they should choose
A regardless
Dividends and Stock Repurchases:
Announcement Effects
An announcement of a dividend increase normally
increases the stock price by about 2%
If a company announces it is to cut its dividend
completely, the stock price decreases by about 9.5%
Is paying dividends therefore a good decision?
Dividends may be a costly signal conveying information that is
hidden from investors
Paying dividends is, in effect, a cost to the shareholders to
ensure that current information is reflected in current prices
The alternative: long term savings in signalling costs against the
cost of deviations between the current stock price and the
intrinsic value of equity
Dividends and Investment
Opportunities
News may be
Increased cash flow
Increase in investment opportunities
An increase in dividends signals increased cash flow (as
dividends then are more affordable) but is not consistent
with an increase in investment opportunities (as they are
then needed for investments)
An increase/cut in dividends is, therefore, a more
complex signal than is suggested in previous slides
Empirical evidence suggests that cuts are viewed more
favourably when the firms experience an increase in
investment opportunities
Capital Structure and Information
Borrowing can also be thought of as a
costly signal:
If mangers are convinced that future cash flow
is high then the most credible way of
communicating this information is to borrow
If the manager is lying, the firm is going to
default on its debt liability and the manager
will be out of a job
Firms with poor prospects find it hard to
mimic the same borrowing decisions
Empirical Evidence
Event study methodology
Leverage increasing transactions (debt-for-equity swaps)
have positive stock price response
Leverage neutral transactions (debt-for-debt) have zero
response
Leverage decreasings (equity-for-debt) have negative
stock price response
Security sales (equity, debt) have negative stock price
response, and more so for equity than for debt
Empirical evidence is consistent with information
theories (this week) but is also consistent with incentive
theories (last week)
Adverse Selection
Sick people tend to see health/life insurance as cheap
consequently they will be over-represented in the group
of buyers of this type of insurance
Example: very expensive insurance that covers 100% of
all costs or cheap insurance that covers only 80% of
all costs
In this case the sick people might migrate to the expensive type
of insurance and the healthy ones to the cheap type
This is called adverse selection buyers or sellers do
not always select themselves randomly but rather
according to their type
This also plays a role in the sale of corporate securities
Managers have inside knowledge
and at the same time sell or buy
corporate securities
Corporation can be expected to sell equity when
the stock is overvalued and buy back equity
when the stock is undervalued
This makes sell transactions a bad signal and
buy transactions a good signal
This makes equity a bad source of capital for
new investment, since it must be sold at a
discount to the current stock price (why?)
Pecking-order theory: firms prefer retained
earnings to external capital, and external debt to
external equity, when financing investments
Readings
Grinblatt/Titman chapter 19
Exercise
A firm has already made an investment and is considering an
additional investment opportunity
State of nature is good or bad, equal probabilities. Assume risk neutral
valuation with zero discount rates. Manager knows the true state of
nature
Current investment has value 150 (good) or 50 (bad)
NPV investment opportunity is 20 (good) or 10 (bad)
Currently the firm is financed by equity only
It plans to issue equity to finance the new investment, which costs 100
To do:
Set up the balance sheet before and after investment @ expected values
Work out how much of the existing equity the firm needs to sell in order to
finance the investment
Compare the value of the existing (old) equity with investment and without
investment in the good and the bad state
If the manager acts in the interests of the existing shareholders, should he
always go ahead with investment. Explain.