Financial Managers Maximize Value Questionnaire

Do Financial Managers Maximize Value?

Reduced effort

Perks

Empire building

• Entrenching investment
• Overinvestment
• Insufficient disinvestment
• Risk taking
• Corporate Governance
• Monitoring
• Incentives

Constraints

Monitoring: Can prevent the more obvious agency costs, with diminishing returns 

• Board of Directors
• Require greater independence (e.g., Sarbanes-Oxley Act)
• Delegation of monitoring to the board brings agency problems

Auditors

The board is required to hire independent accountants to audit the firm’s financial statements

• Ensure consistency with generally accepted accounting principles (GAAP)

Issue “qualified option”

• Lenders
• Bank tracks company’s assets, earnings and cash flow

Shareholders

• Activist investors

Take “Wall Street Walk”

• Takeovers.
• Monitored by other management teams
• Management Compensation

Described in Compensation Discussion and Analysis (CD&A)

• Shareholders have say-on-pay vote

Concern about “excessive” pay

• Structure is more important than amount

Compensation Tied to Stock Performance

• Stock options

give managers the right to buy their company’s shares in the future at fixed exercise price

• Restricted shares
• manager receives a fixed number of shares at the end of a vesting period as long as he is still with the company

Performance shares

• manager receives shares of company stock; the number of shares is related to his or her performance in the interim 

Issues?

• Force managers to bear risks outside their control

Encourage excessive risk taking

Tempted to withhold bad news or manage reported earnings, and etc.

”Tyranny of EPS” and short-sightedness of stock market

• Accounting profits
• Standard should be the opportunity cost for investment
• Economic Value Added (EVA)
• Bias in accounting measures

Agency Costs:

Business and market require trust to operate efficiently

All laws and regulations are costly

Governance and ethics failures have cost our economy billions if not trillions of dollars

Accounting Scandals

Misleading Research Reports

• Auditors: Watchdogs or Consultants?

Response to financial crisis?

• Solution?

Topic 9—Market Efficiency

• “Smart investment decisions create more value than smart financing decisions.”

• Efficient Market Hypothesis (EMH)

The hypothesis that prices of securities fully reflect available information about securities.

• Weak

Stock prices already reflect all information contained in the history of past trading.

• Semi-strong

Stock prices already reflect all publicly available information.

Strong

• Stock prices reflect all relevant information, including inside information.

Obstacles of Market Efficiency

• Information

Limits to arbitrage

• Behavioral bias

Behavioral Finance

• NOT process information correctly:

Overconfidence

Information overload

Forecasting errors

• Even they do, they make less-than-fully rational decisions (behavior biases)

Framing effect

Herding

Regret avoidance

• Disposition effect
• Active or Passive Management

Active Management

• Security analysis

Timing strategies

Investment Newsletters

• Passive Management

Buy and Hold portfolios

• Index Funds

Implications for Financial Managers

• If the Market Is Efficient
• Markets have no memory
• Trust market prices
• Read the entrails
• The do-it-yourself alternative
• Seen one stock, seen them all

If the Market Is NOT Efficient

What if the company’s shares are mispriced?

What if your firm is caught in a bubble?

Topic 10—Corporate Financing

Sources of Financing

Internal finance: profits that companies retain and reinvest

Sell new debt

• Sell new equity securities

Financing decisions:

Payout policy: What fraction of profits should be plowed back into the business rather than paid out to shareholders?

• Debt policy: What fraction of the financial deficit should be met with debt rather than equity?

Common Stock and Debt

Common Stock

• Cash-flow rights

residual claim

Control rights

• Complete control of the firm

stockholders’ control rights can be limited

Voting rights

Yes

• Bankruptcy
• Options stockholder have to default on the debt and gives away the cash-flow and control rights
• Dividends are paid from after-tax income

Debt

Cash-flow rights

• first claim on cash flows, but its claim is limited, risk is relatively low

Control rights

• no control rights unless firm defaults
• Voting rights
• No

Interest is paid from before-tax income (tax subsidy by government)

• Default risk

the likelihood that a firm will walk away from its obligation, either voluntarily or involuntarily.

• Financial Market and Intermediaries
• 
• Recent Trends
• Globalization

Securitization

Financial Engineering

Information and Computer Networks

• The Future?

Topic 11—Securities Markets

• Venture Capital
• Steps to obtaining venture funding:
• Prepare a business plan.

Receive first-stage financing.

• Receive subsequent staged financing.

Angel Investors

• Specialist venture-capital firms
• Corporate venturers

Crowdfunding

Two ways to cash in on their investment

Sold to a larger firm

• IPO
• How are securities issued?
• Primary Market
• New issue is created and sold

Issuer receives the proceeds from the sale

• IPO vs. seasoned equity offerings

Public offerings vs. private placement

Secondary Market

• Existing owner sells to another party
• Issuing firm doesn’t receive proceeds and is not directly involved

IPO:

Syndication

SEC approval: prospectus 

• Firm commitment
• Underwriting vs. best-efforts
• IPO allocation, road shows
• Book and book building

Offered to the public

• IPO is expensive
• –   IPO underpricing, averages about 10%

underwriting spread

Administrative costs

Short-term: underpricing on average

• Long-term: underperformance

General Cash Offer

• Sale of securities open to all investors by an already public company.

Shelf Registration: A procedure that allows firms to file one registration statement covering financing plans for up to three years in the future.

• It’s expensive

Direct costs

• Underpricing: offer price is lower than previous night’s close (average 3%)
• A decline in the stock price of 2%-4% follows the announcement of the issue (about 1/3 of new money raised by the issue!)

How are securities traded?:

• Dealer Markets (NASDAQ):

Dealer market is a market without centralized order flow

• Started as a quote system, introduced electronic trading platforms

Largest organized stock market for OTC trading; information system for individuals, brokers and dealers

• Securities: stocks, most bonds and some derivatives

No specialist, but 3 levels of subscribers Three listing options

• Exchange Markets

Auction markets are markets with centralized order flow

• Dealership function: can be competitive or assigned by the exchange (specialists)

Securities:  stock, futures contracts, options, and to a lesser extent bonds

Examples: NYSE, ASE, CBOE, CME

• NYSE

Physical location

• There is a trading process and “seats”

Investors place orders with the brokerage firms

• The brokerage firm sends order to the floor of the exchange

Floor brokers take orders to the specialists

• The specialist s “cross” the trade

Topic 12—Payout Policy

• Payout Policy

Payout Options:

• Pay dividends

Repurchase shares

• The Information Content of Dividends and Repurchases
• Managers are reluctant to make dividend changes that might have to be reversed.

Managers “smooth” dividends and hate to cut them. Dividend changes follow shifts in long-run, sustainable levels of earnings.

• Managers focus more on dividend changes than on absolute dividend levels.

Payout Policy and Value of the Firm:

Does payout policy affect value in the long run?

Payout policy is irrelevant in perfect capital markets (without taxes, transaction costs, and other market imperfections)

Miller and Modigliani (MM) dividend-irrelevant theorem

Assume constant firm’s assets, investments and borrowing policy

• Current market capitalization not affected by payout policy
• Since investors do not need dividends to convert shares to cash, they will not pay higher prices for firms with higher dividend payouts. In other words, dividend policy will have no impact on the value of the firm.

• Other Considerations
• Market Imperfections and Clientele Effect
• Tax Consequences

If dividends are taxed more heavily than capital gains, firms should pay less dividends

Pension funds are not taxed

Corporations prefer cash dividends (pay corporate income tax on only 50% of dividends received, but pay 21% on realized capital gain)

How Much to Pay Out?

Payout change over the life cycle of the firm

• Questions for the Financial Manager

Is the company generating positive free cash flow after making all investments with positive NPVs, and is the positive free cash flow likely to continue?

• Is the firm’s debt ratio prudent?

Are the company’s holdings of cash a sufficient cushion for unexpected setbacks and a sufficient war chest for unexpected opportunities?

Topic 13—Debt Policy:

• Capital structure

A firm’s mix of debt and equity financing

• Financial leverage

Finance partially or wholly with debt

• Does debt policy matter?
• Market value of the firm
• Return and risk
• MM Proposition 1 and 2

Modigliani and Miller (MM) Proposition 1

• The market value of any firm is independent of its capital structure
• Perfect capital markets: Investors can borrow or lend on their own account on the same terms as the firm

There are no taxes

Debt policy does not affect firm’s investment and operating policies

• They can undo the effect of any changes in the firm’s capital structure

?Firm value is determined by real assets, not by the portions of debt and equity securities issued to buy the assets

• Modigliani and Miller (MM) Proposition 2
• 
• The expected rate of return on the common stock of a levered firm increases in proportion to the debt-equity ratio (D/E)
• The rate of increase depends on the spread between the expected rate of return on a portfolio of all the firm’s securities, and the expected return on the debt

Modigliani and Miller (MM) Proposition 1 and 2

• D/E increases leads to increased financial risk, and higher return required by investors

Any increase in expected return is exactly offset by an increase in financial risk and therefore in shareholders’ required rate of return

• Leverage increases the expected earnings per share, but offset by a change in the rate at which the earnings are discounted ?share price doesn’t change
• ”There is no magic in financial leverage”

At higher debt levels, lenders become concerned that they many not get their money back, and demand higher rates of interest to compensate

• Holders of risky debt begin to bear part of the firm’s operating risk
• Expected return on assets does not change

• Corporate Tax

The interest is tax-deductible expense

• Since 2018, company can deduct up to 30% of EBITDA; from 2022, limit is 30% if EBIT

Value of firm=value if all-equity-financed + PV(tax shield)

• Assume fixed, permanent debt:
• Value of firm = value if all – equity – financed +  
• 

• After-tax WACC

WACC declines as debt increases

Cost of Financial Distress:

Value of firm = value if all – equity – financed +  PV(tax shield ) – PV (costs of financial distress)

• Trade-off theory of capital structure
• The theoretical optimum is reached when the PV of tax savings due to further borrowing is just offset by increases in the PV of costs of distress

Companies with safe, tangible assets and plenty of taxable income to shield–>high debt ratios

• Unprofitable companies with risky, intangible assets–>low debt ratio
• 

Bankruptcy costs

Increased leverage increases probability of default and the value of the lawyer’s claim, thus reduces present market value.

• Cost of bankruptcy comes out of shareholders’ pockets and creditors demand a higher promised interest rate.
• Financial distress without bankruptcy
• Conflict of interests between bondholders and stockholders

Cost of distress vary by type of asset

• the losses are greater for the intangible assets  linked to the health of the firm as a going concern
• 
• Peking Order

Asymmetry information—managers know more than outside investors

Implications

Firms prefer internal finance.

• Adapt target dividend payout ratios to investment opportunities while avoiding changes in dividends.
• Internally generated cash flow is sometimes more than capital expenditures, other times not.
• If more, firm pays off debt or invests in marketable securities.
• If less, firm first draws down cash balance or sells holdings of marketable securities.
• If external finance is required, firms issue the safest security first.

Issue equity when the threat of costs of financial distress is high

Topic 14—Valuation and Financing

• Net Present Value (NPV)

Invest in projects with NPV>0

• Steps:
• Forecast cash
• Determine the appropriate opportunity cost of capital (r)

Discount the project’s future cash flows

Calculate NPV:

• Extend it to include value contributed by financing decisions
• Adjust the discount rate

Adjust the present value

• Adjust Discount Rate
• Step 1: Forecast Cash Flow
• Free Cash Flow (FCF)
• The amount of cash that the firm can pay out to investors after making all investments necessary for growth

Calculated assuming the firm is all-equity-financed

Free cash flow and net income are different

calculated before interest

don’t deduct depreciation

• include capital expenditures and investments
• FCF = Profit after tax + depreciation – investment in fixed assets – investment in working capital.

Step 2. Adjust the Discount Rate

After-Tax Weighted-Average Cost of Capital

1. 
2. discount rate for the “average” project

firm’s business risk and debt ratio are expected to remain constant

1. The value of interest tax shields is picked up in the WACC formula.

Step 3 and 4: Valuing A Businesses or Project

Using WACC in Practice

When there are more than two sources of financing

• + , V=D+P+E, p is the amount of preferred stock
• Use company or industry WACC?

What if debt ratios and business risks differ?

• Adjusting WACC When Debt Ratios and Business Risks Differ
• Step 1 – Calculate the opportunity cost of capital, unlevering the WACC
• Step 2 – Estimate the cost of debt at the new debt ratio, and calculate the new cost of equity

Step 3 – Recalculate the weighted-average cost of capital at the new financing weights.

Unlevering and Relevering Betas

Step 1 – Unlever beta.

Step 2 – Estimate the betas of the debt and equity at the new debt ratio.

Step 3 – Recalculate the cost of equity and the WACC at the new financing weights.

• Companies must rebalance their capital structure to maintain the same market-value debt ratio for the relevant future.
• The firm has a 40% debt. Its cost of debt is 6% and the cost of equity is 12.5%. What’s the WACC if the project of the firm supports only 20% of debt, assume cost of debt remains the same?

       Approach A:

•        1. r = 0.06(.4) + .125(.6) = .099
•        2. rE = .099 + (.099 ? .06)(.25) = .109
•        3. WACC = .06(1 ? .21)(.2) + .109(.8) = .097, or 9.7%

       Approach B:

• +(–
• 

                       WACC =0.06*(1-21%)*0.2+0.8*0.109=0.097 , or 9.7%

1. Adjust Present Value
2. Adjusted present value (APV)
3. explore the implications of different financing strategies without locking into a fixed debt ratio

check if the project can be reduced by an alternative financing plan

pick up other financing side effects besides interest tax shield

• Step 1: Calculate base-case NPV

All-equity-financed firm NPV, discount rate is opportunity cost of capital

• Step 2: calculate present value of financing side effects

all costs/benefits directly resulting from project

• Step 3:

APV = base-case NPV + sum of PVs of financing side effects.

• Sangria is a U.S.-based company whose products aim to promote happy, low-stress lifestyles.

The book and market-value balance sheet and other financial data for Sangria are listed below.

• Sangria Corporation (Book Values, $ millions)

• Sangria Corporation (Market Values, $ millions)
• 

Sangria’s enologists have proposed investing $12.5 million in the construction of a perpetual crushing machine, which never depreciates and generates a perpetual stream earnings and cash flow of $1.487 million per year pretax. The project is average risk, so we can use WACC of Sangria. The after-tax cash flow taking no account of interest tax shields on debt supported by the perpetual crusher project is listed blow:

Pre tax cash flow.      $1.487 million

Tax at 21%        $ 0.312 million After-tax cash flow   $1.175 million

(a). Calculate the NPV of the project.

• WACC=0.06*(1-21%)*0.4+0.125*0.6=9.4%
• NPV=-12.5+1.175/9.4%=0
• (b). What are the assumptions you make when you discount the perpetual crusher’s cash flows at Sangria’s WACC?
• 1.The project’s business risks are the same as those of Sangria’s other assets and remain so for the life of the project;

2. Throughout its life, the project supports the same fraction of debt to value as in Sangria’s overall capital structure.

(c). If Sangria’s perpetual crusher project supports only 20% debt, instead of 40% for Sangria overall, how are you going to adjust the discount rate? Step 1: r = 0.06(.4) + .125(.6) = .099, or 9.9%

Step 2: rE = .099 + (.099 ? .06)(.25) = .109, or 10.9%

Step 3: WACC = .06(1 ? .21)(.2) + .109(.8) = .097, or 9.7%

(d). Calculate the project NPV using APV approach assuming the debt ratio will remain at 40% throughout the life of the project.

• Opportunity cost of capital: r = 0.06(.4) + .125(.6) = .099, or 9.9%
• Base-case NPV=-12.5+1.175/9.9%=-$0.63 million

Interest tax shield every year=12.5*0.4*0.21*6%=0.063 million

PV (interest tax shields)=0.063/9.9%=0.63 million

APV=-0.63 million +0.63 million=0

(e). Sangria has to finance the perpetual crusher by issuing debt and equity. It issues $7.5 million of equity with issue costs of 7% (0.53 million) and $ 5 million of debt with issue costs of 2% (0.1 million). Assume the debt is fixed once issued. What’s APV?

PV (interest rate)=0.063/6%=$ 1.05 million

• APV=-0.63+1.05-0.53-0,1=-$0.21 million
• The expected rate of return on the common stock of an unlevered firm is 10%. The expected return on debt is 5.5%. According to MM Proposition 2, what’s the expected rate of return on the common stock of a levered firm if the market value of debt is $200,000 and market value of equity is $500,000. Please show all your work to derive the final answer to get full credit.
• rA = rE of unlvered firm=10% rE=10%+(10%-5.5%)*200000/500000=11.8%

The market-value balance sheet and other financial data for Company XXX are listed below.

Asset value

$1,200,000      Debt    

$300,000

•      Equity

$900,000

$1,200,000

     $1,200,000

Cost of debt        5%

• Cost of equity        12.5% Marginal tax rate        21%

The financial manager of company XXX is considering a project that requires $50,000 investment today and expects to generate a perpetual earnings and cash flow of $5,000 each year (pretax). Assume no depreciation. However, the project supports only 35% debt, which is different from the debt ratio of company XXX overall. Calculate NPV of the project by adjusting WACC of the project. (keep four decimals including percentage to avoid rounding error).   

• r=5%*300000/1200000+12.5%*900000/1200000=10.625%
• rE=10.625%+(10.625%-5%)*0.35/0.65=13.6538%

WACC=5%*(1-21%)*0.35+13.6538%*0.65=10.2575%

NPV=-50000+3950/10.2575%=-11491.5915

3. You will use APV method to calculate the value of company YYY (keep four decimals). Show are your inputs to get full credit.

(a). What’s profit after tax in year 3? Show your inputs to get full credit. (73000-46080-4500)*(1-21%)=17712

(b). What’s free cash flow in year 2? Show your inputs to get full credit. 17712+4500-(10429-10286)-(75000-70000)=17069

(c). What’s after-tax WACC and cost of capital of company XXX?  

After-tax WACC=5%*(1-21%)*25%+12.5%*75%=10.3625% Cost of capital= 5%*25%+12.5%*75%=10.625%

• (d). What’s horizon value (not the present value)?
• 5495/(10.3625%-4%)=86365.4224
• (e). What’s the base-case PV of company?  What’s the PV of interest tax shields?  What’s the PV of company YYY?  

Base-case PV of company =  7021/(1+10.625%)+7177/(1+10.625%)2+17069/(1+10.625%)3+86365.4224/(1+10.625%)3=88613.1823

• PV(interest tax shield)=  30000*5%*0.21//(1+5%)+28000*5%*0.21/(1+5%)2+25000*5%*0.21/(1+5%)3=793.424

Pv (company)= 88613.1823 +793.424=89406.6063