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Finance Notes© 2008 J.V. Rizzi © COPYRIGHT J.V. RIZZI FINANCE NOTES I Finance Overview A. B. Main Decisions – finance, valuation and governance 1. Objective Function: what are we to maximize? 2. Investment Decision: how do we invest and manage and why? 3. Dividend Decision: level (and form) of funds returned to the shareholders? 4. Capital Structure: how do we fund ourselves? 5. Governance: who decides? Firm substitutes authority for prices. Fundamental Building Blocks 1. Efficient Capital Markets - price behavior in speculative markets. 2. Portfolio Theory - optimal security selection procedures. 3. Asset Pricing Models - determining asset prices by investors utilizing portfolio theory. Replicate complex securities through arbitrage free strategies involves simple instruments. 4. Option Pricing Theory - pricing of contingent claims. 5. Agency Theory - incentive conflict when benefits are concentrated but costs are disbursed. Heightened by moral hazard when you cannot observe behavior. Enhanced by behavioral bias. a) Complex Adaptive Systems Efficient learning Information asymmetries: heightened conflict between agent/mgnrs and principals/investors 1. Chance vs uncertainty 2. Ignorance vs adverse selection 3. Dishonesty vs moral hazard Note: SOX criminalizes agency conflicts b) Moral hazard = f (private benefit from misbehaving, 1/verification) (1) Insufficient (2) Over invest (3) Entrenchment Properties Disbursement Before After Behavior Adverse Monitoring cost Selection Moral hazard (4) Self dealing c) Adverse selection d) Responses e) (1) Signaling – debt level, dividends, reputation (2) Incentives (3) Monitoring (4) Contracts – warranties, deductibles, pricing Value implications – wedge between value and income pledge, between opportunity and financing 1 FINANCE NOTES Value – may not be externally determined (2) Financing – agency problems/concerns may deprive firms form financing. Borrowers may make concessions to lender to achieve funding (3) Pecking order: chose financing with lowest assymmetrics/discount 6. Game Theory: economics of decision making; uncertainty lies in the intention/reaction of others. Focus on how individuals behave, anticipate and respond. Components – players, action, motives, and rules. 7. Behavioral Finance: prices influenced by herd vs. lead steers. The issue is whether markets are inefficient or just noisy. Requirement: arbitrage limit + learning disability a) 8. C. (1) Bias: Optimism Over confidence Confirmation Illusion of control b) Heuristics: Representation l/n equal weight Availability – overweight recent Anchoring – overweight initial c) Framing – reference points d) Manifestations: Winners curse – You paid too much Gamblers fallacy – Law of small numbers Sunk cost – regret avoidance (Prospect theory), Reputation loss Valuation – Single workable scenario vs range Implications: Investors irrational Shield managers Managers irrational Limit discretion Arbitrage – law of one price – equal rate of return principle Separation Principles/Decision Rules 1. Market Value Rule: Maximize shareholder wealth. Separating ownership from management raises conflict issues. Control mechanisms: a) Management incentive compensation contract provisions b) Management ownership interest c) Management labor market (Reputation) d) Market for corporate control e) Internal control mechanisms (Board of Directors) note: resource allocation mechanism similar to the invisible hand 2. NPV Rule - choose projects whose returns exceed their cost of capital (r ≥ c*). Need to consider multiple risk adjusted discount rates and option value of strategic investments. Discount rate is a function of the risk class. Note problems re: optionality. 3. Dividend Irrelevance (except for agency cost, signaling and option pricing issues) 2 FINANCE NOTES 4. D. Capital Structure Irrelevance (except for taxes, agency costs, signaling and option pricing issues) Statistics: beware data mining, which is prevalent in non experimental sciences lacking controlled experiments 1. Reliance on past as (prolog vs history) 2. Descriptive vs predictive 3. Issues – normality, survivorship, stationary, independence 4. Movements – go beyond mean and variance to skew and tails 5. Beyond the data – out of sample issues 6. Correlations – state dependent and lack integrating model covering both default and spread widing 7. VAR – best of worst. Need expected shortfall analysis to get into tail 8. Mean reversion 9. Goodhart’s law – sociological uncertainty principle – when a measure becomes a target it cease to be a good measure (behaviour change) 10. Gamblers ruin Note: 2007 Structured Finance Meltdown E. F. Financial Markets 1. Merton – neoclassical benchmark Anomalies/inhibitions/transactions cost Institutional solutions – overcoming inefficiencies to get back to benchmark. Means of creating missing markets 2. Machines – converting danger (uncontrollable damages) into risk (decision related controllable damage) which can be traded or transferred. Focus on unintended consequences and conservation of risk principle Decisions as risk (DAR) CONTROL monitoring DAR incentives Agency problem II. Asymmetric information Bias control VALUATION: COMPETING MODELS OF THE FIRM: ACCOUNTING VS. ECONOMIC. CONVERTING PERFORMANCE ESTIMATES INTO PRICE ESTIMATES. A. Capital Markets 3 FINANCE NOTES 1. Role - opportunity cost background; comparison of returns on passive capital with returns from active capital. Capital market returns are a hurdle rate against which corporate returns must be compared. (Firm as a passbook) Efficient Frontier r r CML WACC RF σ σ Risk of Firms Existing Assets 2. Risk and Return: mkt prices risk proportionate to covariance with aggregate risk. a) Portfolio Theory - Portfolio risk is not the weighted average of individual variances. Covariances give rise to risk reduction through diversification. (Impacts denominator but not numerator; θ Ε(v) discounted at lower rate is still zero) - Remember, in a crisis, all correlations go to one (Hurricane example). b) Distinguish - Systematic from unsystematic risk. (hedge) (diversify) note: systematic risk is the only risk form compensated because diversified investors willing to pay a higher price. Note – consider 3rd/4th movements – skew/tail (tail risk created by feedback loops) 3. Interest Rates a) Determination - i = r + E (∆P) + IRP (inflation rate risk premium) b) Term Structure - yield compared to maturity/credit curve i BBB A AA 4. t Price Setting Process: cash flow, risk, timing a) Basis - risk and return i.e. share value based on expected cash return discounted at risk adjusted rate. b) Efficiency - market quickly reflects available information. Based on competition that quickly eliminates systematic deviations. (Note: Chaos mechanism: fundamental + technical factors) c) Technical factors – can overwhelm fundamentals in short term note: mkts. As efficient learning systems (complex adaptive systems). Priors are arbitrary vs. correct and are updated. d) 5. Behavioral Complex adaptative systems – complex (nonlinear) with tight coupling (amplication) Asset Pricing Models 4 FINANCE NOTES a) CAPM - r = r + B (Rm - Rf) f Units of risk b) Price per unit of risk APM - r = A + B I + B I + ... B I + E + j j 1t 2j 2 nj nt jt - factors - term structure (Bonds-Bills), ∆GNP (Survey), and default premium (Bds - Gov) F/F - r = f (1/Size, B/M, Momentum) Returns = F (market, HML, SMB, WML) Fed Model: E/P – T10 Key elements: luck, skill information, risk B. Accounting Model of the Firm: Convert from accrual to cash basis, and from cost to market value (i.e. mark to market). Balance sheets are a scorecard for money spent and not value. P/E = (1+ g)/(K -g) ⇒ 1/K when g=0 } M/B = P/E x ROE e e M/B= (ROE-g)/(Ke-g) ⇒ ROE/K when g=0 } e MTM B/S - RHS @ Public MTM B/S - LHS @ Private NWC Debt FA Equity PVGO C. Economic Model of the Firm: Firms compete in two markets, product markets for customers and financial markets for capital. They trade at two difference prices within financial markets, a lower passive intrinsic value and a higher control price. 1. Valuation Overview - V = MAX (liquidation, Going Concern, Third Party Sale) - method used depends on point of life cycle and market conditions - value of asset with no cash flow is only what someone will pay you for it [Sardine theorem] Timing Mkt Size Independent value TPS – Startup GC – Mature Liq – Decline V=f (horizon) S/T – voting L/T – Weighing V = CF r–g i 2. Buyer driven value Emerging High mature growth Mkt Stage risk Discounted Cash Flow/Going Concern 5 FINANCE NOTES a) Traditional Adjusted Cost of Capital (ACC/WACC): use after tax WACC and adjust for interest tax benefit in cash flow to that of an all equity financed firm. Developed for situations involving a constant capital structure. (measure asset cash flows independent of how financed) V EN =V +V S V = Max (0,V – x) D S V = V + NOC - V S O V = Min (V, X) D D V =(NOPAT/WACC)+[I(ROA-WACC)T÷WACC(1+WACC)] O (assets in place) (growth) FCF1 FCF2 Re sidualFCF ... (1 WACC ) (1 WACC ) 2 (1 WACC ) n (Forecast Period) (Residual / TV) Inputs: sales growth, operating profit margin, working capital rate, CAPEX rate, tax rate, and WACC NOPAT=EBIT (1-τ) = NI + Int (1- τ) = EBIAT - (Int (τ))≈EBIAT if use τ s FCF=NOPAT-WCI+DEP-I=EBDITA - (τ+WCI+CAPEX+Int(τ)) WACC=[K (1-τ)XD/D+E]+[KexE/D+E] d Weights: market or forward targets Note: leveraged firms ⇒ ∆ D/Cap use target D/Cap to avoid understating WACC assume return to BBB ≈ 50%D/Cap Application: limited to assets in the same risk class as the firm K = Rf + B (Rm-Rf) ≅ 2xR e f R m-Rf ≈ 5 - 7%; equity premium puzzle (Resolution – tail / extreme events) K =R +B (R -R ) eu F U M F note: equity risk premium as a duration measure/ DF= DA - DL = DA – (DD + DE) - expands during bear mkt. - contracts during bull mkt. Bu BL (1 [(1 ) D / Eo ]) BL Bux (1 [(1 ) D / En ]) (1 (1 )( D / E ) n ) BLn BLo (1 (1 )( D / E ) o ) 2 Adjust – B – use industry average to offset low individual R (Bloomberg, VL, …) Downside Beta Ke Weights 6 FINANCE NOTES Forecast Period: period in which ROA>WACC; REFLECT ENTIRE CYCLE; MEAN REVERSION note: length should not affect value; merely allocation Residual: normalize with cyclical firms Average margin over cycle x sales Average margin over cycle x sales Alternative Ke based on opm Ke = Kd + Put Spd Startups: Market Size x Share = Revenues; then apply OPM convergence: RV=NOPAT ÷WACC n other: book value, capitalization, liquidation NOC: non-operating capital e.g. securities, unconsolidated sub Country Risk Premium = default spread x [σ stocks / σ gov] b) Compressed: use adjusted unleveraged pretax discount rate Re and after tax cash u flows. Best for leveraged firm with rapidly changing capital structures as the debt is repaid. FCF=NI+D+A+∆DT+Int-(CAPEX+WCI) =EBITDA+∆DT-(CAPEX+WCI+TP) TP=(EBITA-I)xτ V=NI+D+A+∆DT+Int-(CAPEX+WCI)÷[Rf+7.0)-g)] =EBITDA+∆DT-(CAPEX-WCI+TP)÷[Rf+7.0)-g)] note: A limitations on use of DCF - merely a proxy for market value based on current use of assets and strategy; does not reflect takeover premium and alternative higher value added strategies B reality check: confirmation of value range by all three techniques and calibration (beware 1/n heuristic) V Economic Value Financial Value c) t EVA = (ROA - WACC) x BC - backward looking vs DCF forward looking d) EVA Capital WACC APV: V 7 FINANCE NOTES FCF1 (1 reu )1 3. FCFs (1 reu ) 2 ... FCFn (1 g ) /(reu g ) (1 rEU ) n TS APVu (1 L) Option Pricing (ROV): DCF applicable for traditional firms with cash cow characteristics (i.e. relatively predictable cash flows). Firms with high risk characteristics from either financial difficulty (telecom) or growth firms (Internet) have unpredictable cash flows that are difficult to evaluate using DCF methodology. These situations are better valued using option pricing. a) Call Option Valuation C = F(S,SD,X,T,Rf,D); C ≥ max (0,S - X -rt e -rt - De ) C = disE((S)S>X) x Prob(S>X) - dis X ⋅ Prob (S>X) C = SN (D1) – K RfT N (D2) SN ( D1) K e RfT N ( X T ) Hedge ratio Discounted Probability strike option exercised P (S>k) D1 - Hedge ratio - ∆O /∆ - approaches 1 when option is in the money P P D2 - Probability that option will finish in the money (i.e. S>X) Note: implies probability of default Intrinsic value - value of right to buy at exercise price (i.e. S-X). Time value possibility of achieving value at a later date; equal to premium minus intrinsic value (P - (S-X)). Put / call parity: S P C x /(1 R f ) t 1 b) c) 2 3 Covenants: F(S, [σ] , [D] , R , [T,X] ) f (1) Asset Sub (2) Dividend Payout (3) Payment Priority Issues: distinguish options from opportunities (1) Scope Options: enter new markets in business (2) Timing Options: reacting to new information High NPV ⇒low time option value 4. Market Value Approach - break-up analysis; even though assets generate sufficient returns, the assets may be worth more to others. a) fit test - assets are worth more to someone else b) focus test - negative synergies from dissimilar operations, reduces value (management as an off balance sheet liability) 8 FINANCE NOTES 5. LBO: affordability test 6. Strategic valuation a) Industry viability – Asset values, MTM B/S Viable – replacement value exceed BV Not viable – replacement value below BV b) Earnings power Normalized EBIT (Maintenance dep / Capex) (Taxes) Earnings power (EP) c) Economic value = EP / WACC d) Growth Value enhancing EP > Asset III PERFORMANCE: TRANSLATES INTO PRICE A. Strategic Framework: Firm policies + industry structure = financial results. Notes: golden triangle – growth, profitability and liquidity 1. Levels - Corporate: Where to compete? (BCG - firm as internal capital market) Business Unit: How to compete? 2. Questions: Where are we now? Where do we want to go? How will we get there? 3. Process a) Industry attractiveness - identify threats and opportunities (1) Forces - buyers, suppliers, entrants, substitutes, and competitors. (2) Competitive rivalry - demand growth, fixed cost intensity, exit barriers, product differentiation, switching costs, and market shares. (3) focus - risk of commodity pricing; stage in life cycle; stability. b) Competitive position - strengths and weaknesses along value chain. Issue of whether firm’s position is dominant, strong, viable, weak or nonviable. c) Competitive advantage - means chosen to gain a meaningful competitive position. (1) Options - cost leadership or differentiation. (2) Scope - across industry or within niche. (3) Tests - sustainable, comparative, active 9 FINANCE NOTES B. Market to Book Model M/B ≈ r/c* ≈ ROE/Ke = P/E x ROE Note: distortions re: intangible assets and expensing investments Per 1 ROE Ke g Ke ROExKe Ke g F ranchise factor 1. PEG PER ( g DY ) growth Shareholder value: TAX OPM Return { ATO LEV EBIT S A (1 ) (1 Payout) S A E DPR FCF – Growth Real Ind. Strength (Market) + Winners Y >1 Z 1MV/BV Losers-X liquid LBO X <1 + ROE-Ke (Position) Omega curve Profitability (π) π Mass market Low cost unique high Above Averg. Steady Innovation Niche Average high entry cost Low me too Small Medium Large Market size Note: Returns = F (industry growth, HHI) HHI ≥ 4000 concentrated ≤ 2000 fragmented 10 FINANCE NOTES Business Strategy / Life-cycle framework Industry Structure + Competitive Position Strategic choices • Target market • Product • Place • Promotion • Price Core Competencies Maneuver x Payoff = Strategic Leverage Business Plan and Resource Allocation Threat of new entrants Bargaining power of suppliers Rivalry among existing firms Operational skills • Business processes • Feedback • Knowledge creation Bargaining power of buyers Threat of substitutes Increasing CFROIs & High Reinvestment Above-average but fading CFROIs Average CFROIs Below-Average CFROIs High innovation Fading CRFOIs Mature Restructuring needed FADE CRFOIs Reinvestment rates Discount rate (investors’ required rate of return) Source: CSFB HOLT, drawing on Michael E. Porter, Competitive Strategy; Milind M. Lele, Creating Strategic Leverage; and Bartley J. Madden, CFROI ® Valuation C. Growth -focus on the quality of growth (i.e. ROA, σ) - consequence not goal of value max behavior. 1. Options - related or diversification 2. Mode - Internal or external 3. Sustainable Growth - internally sustainable with fixed capital structure and dividend policies g* = ROE (1 – Payout) 4. D. Agency Conflict - pay is strongly tied to size. Encouraged in mature firms because sustainable growth capacity exceeds available positive NPV investment opportunities. Expectations – You create value by beating expectations vs an objective hurdle. Key: EBM = A(EP) – E(EP). It is hard to beat expectations. Use to set strategy: ROIC - WACC + – Grow Harvest Transform Exit Hi Likelihood of exceeding expectation Low E. Reverse Engineering – use to uncover expectations value gap: 1. Value management plan 2. Value analysts forecasts 3. Value implied value drivers in stock price 11 FINANCE NOTES 4. IV. Resolve discrepancies between 1 and 2, and 1 and 3 CAPITAL STRUCTURE A. Overview: Value impact of financial policy is dependent on taxes, (distress) transaction costs, investment policy impact, and signaling. 1. 2. Areas a) capital structure: tax, agency, investment policy regulations (e.g Finco) and signalling b) return of funds to shareholders: agency and signaling c) financial instruments: signaling, tax and distress. Signaling - signaling future cash flow through financial policy a) model: sources = uses Operating cash flow + new securities = investments + dividends / repurchases + debt service Operating cash flow = investments + dividends + repurchases - new securities + debt service b) implication: Outflows signal higher expected future cash flows; whereas inflows signal lower expected future cash flows Note: debt-neutral-pay it back Structure - Claim on assets and income; control B. Debt Policy - the appropriate level of debt in the capital structure given the interest tax shield valuation impact (TD). Value of debt flows from tax deductibility of interest and not from leveraged EPS or ROE which is offset by increased cost of equity and decreased price/earnings ratio. 1. Issues a) b) Benefits (1) Tax benefit: estimated at 20% of nominal TD value; impact of debt related tax shield (2) Nontax benefits: operating benefits, reduced reinvestment risk and option pricing. Financial Distress - Offsetting the explicit tax cost advantage of debt is the implicit opportunity cost disadvantage from financial distress (transaction/agency costs) (1) Bankruptcy Costs - 3-5% (TA) (2) Agency Costs - indirect covenant restrictions, customer and supplier concern and susceptibility to competitive attack resulting in possible lost opportunities, suboptimal operating policies and inaccessibility to capital markets. 12 FINANCE NOTES PV of financial distress V Agency Costs r Pv of tax shield D T RF E Distress D/E d/e* D/E Bkrpt when V<X (Balance sheet test vs liquidity test – inability to pay bills as scheduled) Distress Cost Probability – quality spread Magnitude – MTM B/S re-intangible value Shape of Curve = F (economy, asset type, EBIT) V Aircraft Real Estate Reflects ability to realize value independent of firm which owns asset Software D/V D 1 D 1 1; 1 D E 1 D C 1 C E Note: c) i) distinguish financial from economic failure ii) 1980s - Financial failure (good firm / bad B/S) 1990s - Economic Failure (young firm / bad B/S) 2000s – Mispriced risk leverage does not affect asset risk Theories 2. Capital structure strategy mkt access conditions Strategic Tradeoff Pecking Order Issue securities with lowest asymmetry costs first to min discount Free Cash Flow - MDC Dynamic - lever up/paydown Factors Affecting Debt Policy D/E = f (T,1/business risk, tangible assets/total assets, liquidity, age, size, 1/market share) a) Effective Marginal Tax Rate - influenced by level and stability of taxable income. Interest tax shields are less valuable to loss or tax exempt firms. 13 FINANCE NOTES b) Risk Level - balance business and financial risk consistent with a total risk level. (1) Business Risk - variability of NOPAT income stream is influenced by sales variability and operating leverage. (2) Financial Risk - variability of NI due to increasing debt service. ∆Capital Structure impact WACC ↑D/E ⇒↑Ke but ↓ WACC as increase % of lower cost debt Total Lev Δ Sales Δ EBIT Op Lev Δ NI Fin Lev c) Asset Type - tangible assets afford lenders asset protection. They are independent of the firm as a going concern for realization. Therefore, they support increased leverage. (i.e. tangible assets have lower distress costs; lower LIED) d) Firm’s Life Cycle - Interrelationship between financing and investment decisions; distress costs as an inverse function of firm age. e) (1) Start-up - low taxable income, high business risk and the need for flexibility without covenant restriction (opportunity costs of foregone investment exceeds tax savings) necessitates low leverage. (2) Growth - begin to add debt. Still, low taxable income, high risk and need for flexibility favors low leverage. (r ≥ c* on both new and existing investments.) Strategic Capital Structure Theory - mkt leaders have lower D/E to enforce price discipline (3) Maturity - high NPV investment opportunities become scarce, taxable income increases, business risk decreases and leverage should increase. (r/c* ≥ 1 for existing assets, but r/c* ≤ 1 on new investments.) (4) Decline - favors leverage and distributing proceeds to shareholders (value transfer). (r/c* ≤ 1 for both existing assets and new investments) Liquidity - As debt levels increase, need increased level of liquidity to provide a cushion against cyclicality and markets closing e.g. HYB. Note: D/E = F(liquidity); Execution risk realised price < expected Factors – mkt depth – position size NLR RCA CMS ; DS CPLTD I > 1.5x alternatively RC =: 10-15% sales or 1-1.5 x EBITDA LI 14 FINANCE NOTES EBITDA Price Offer PO Bid Crisis Exogenous – mkt characteristics size, bid/offer spread, depth Endogenous – position size T/Posit Impact of liquidity on Asset Prices (e.g. LTCM) BKS: Arbitrage higher return illiquid assets (loans) with lower return liquid claims (deposits) RCA [(INV AR REC AR) - STD] CASH BALANCE ; Assumes negative EBITDA EBITDA Conclusions - borrow independent of need and against debt capacity. Use funds for investment, dividends, repurchases, acquisitions, or marketable securities. Beware Telecom e.g., just because bubble drives down WACC/don’t borrow and over invest in suboptimal projects. Cash Burnrate 3. Approach: Marco (peers/ratings); micro (overlay projections). a) Measuring Debt Capacity B/S < Ratios, Peers, Rating) CF < CDCF, MDC Market: KMV AR < ABL, BV (1) Comparative ratio analysis (2) Bond rating objective - (S&P ratio/rating guideline) Note: + fcf ⇒ lower rating needed and higher D/CAP - fcf ⇒ higher rating needed and lower D/CAP (3) Maximum debt capacity - assumes a temporary abnormal maximum debt level. Calculation: EBITDA (T CAPEX WCI ) 1 AS EBIT t AS 1 n i n = f (operations, amortization, cash interest, asset sales) MD externally driven Note: Structuring (commercial vs financial firms) R/C: 10-15% sales, 1-1.5xEBITDA 15 FINANCE NOTES T/L: 3-4x EBITDA A=Amortizable in 5-7 years B=S/Dx - T/L A T/D: 4-5x EBITDA Sub: TD - SDx Equity: Need - TDX (4) Asset based - Evergreen revolver with liquidation value advance against assets (5) Business value – advance against mv of business Notes: Refinancing risk mitigated by interest & asset coverages and mkt access measured by rating b) Rate - depends on rating and term Note: Target Int Exp = EBIT ÷ FCC T FCC ⇒ Rating target T Targeted Debt = TIE ÷ R = (EBIT/FCC) ÷ R R ⇒ R + QRS F QRS ⇒ Rating c) Capital Cushion Required: E(L) = ADR x (1-RR) x AL x AU x RM; σ(E(L)) Note: IDR = CS ÷ (1-RR) d) Credit Ratios Default: FOCF/P+I Default Loss: D/CAP Liquidity: P + I – (Cash + MS + RCA) = Net liq. C. Liability Management - involves not only determining the aggregate level of debt, but also the type of debt, not limited to cash markets; consider derivatives, (e.g. sale of put options as share repurchase alternative) and insurance 1. Overview a) Maturity: long or short b) Interest rate risk: fixed or floating. c) Currency risk: USD or Fx d) Covenants - D/E, FCC, NW – (early amortiz: trigger a liquidity crisis before firm becomes insolvent) e) Deferred or current pay f) Senior/subordinated: value of seniority: O/C payment priority / first loss. g) Tax status of investor or issuer - debt vs. preferred stock 16 FINANCE NOTES h) Call feature i) Straight or convertible Structuring Box Tax Accounting Bus. Plan Regulatory Fin. Char. Deal Inst. Fin. Plan Legal Competitive j) Accounting: on or off B/S k) Credit support l) Security m) Amortization - Straight; balloon; staggered; bullet (duration) n) Public vs. Private o) 2. Mkt. Cond. Focus on balance between cost and flexibility (i.e. ability to raise capital at an acceptable cost under a variety of conditions). Liquidity - ease at which a firm can convert assets into cash without value loss. (Bid Offer Spread) Refunding BER = coupon $/call price Interest Rate Risk Management - manage the amount of financing or investment which is subject to the risk that adverse movements in rates will either increase debt service or reduce ROI. Focus on mix of fixed vs. floating rate financing preserves flexibility, substitute for equity, increases debt capacity; % hedge α mgmt ownership a) Approach - Similar to bank GAP management. Focus on risk profile and instruments to alter profile. Increased importance due to rate volatility. (1) Risk Profile 17 FINANCE NOTES V Payoff Profile I Risk Profile Note: Libor SP = T + SP – Swap Cost Hedging: cannot affect value through discount rate. Rather, impact taxes, financial distress and investment policy. (2) b) Instruments (a) Forwards/Swaps. (b) Options/Caps. Fixed vs. Floating lengthen maturities increase % fixed buy Swaps E(ι) – shorten maturities decrease % fixed buy Caps (1) fixed may be more expensive due to yield curve costs. (2) beware of speculating on rates when selecting fixed vs. floating (fixed involves a gamble on future inflation rates). (3) focus on matching cash flows to rate movements. (4) Operationalize through duration (i.e. average term to maturity) calculated as weighted average amount of time to receipt of security repayment. n d t Ct /(1 r ) t Po t 1 P D I Managing Risk for Delayed Funding Needs c) (1) Prefund (2) Treasury Lock - fix treasury rate on which firm’s future funding will be based. (3) Forward Swap/Forward Cap (4) Swaption/Caption 18 FINANCE NOTES d) Currency Risk Management Techniques - control amount of financing and investment which is subject to risk that adverse movements in FX rates will produce higher debt service requirements or lower ROI. (1) Framework (a) Three types of exposure: transaction, translation, and economic. Each has a different duration, and is covered better by different tools. Note: Transactionspecific cashflow impact on AR, and Inv.; Translation - MTM with no cash flow impact; Economic - impact on firm consolidated CF’s (b) Economic exposure: risk of sales or profit decline from competition achieving an advantage based on fx movements. Usually managed through pricing, sourcing and plant location decision (e.g. Japanese auto maker location of plants in U.S.A. to hedge against a strong yen/weak USD). Forward Forward $ Forward fx i i Spot $ Fx Spot Spot Fx (2) D. Currency Swap – note FASB 133, IAS 39 (a) Defined - exchange/sale of two currencies with an agreement to pay back the same amounts at an exchange rate established at the time the contract is made. (b) Uses (i) Hedge - provides effective long-term cover (futures market is thin after 2 years; roll-exposure, but basis risk). (ii) Cost Savings/Capital Market Access (Financing) - arbitrage access to markets in which firms have relative advantage. Can be cheaper to raise dollars by issuing SF Eurobond and then sapping back into USD Name vs. rating focus/ ratings arbitrage. (iii) FASB 52 - allows translation losses to go directly to balance sheet. (mgn ROE) Financial Instruments - Design of instruments is a marketing problem concerning the packaging of claims against real assets which exploits capital market inefficiencies such as, an unserved market niche, taxes, regulation, and mgmt incentives. 1. Overview - revolution in development due to increased market volatility, deregulation, and technology. Basic components are equity, risk free bonds, puts and calls. a) Scope: high yield bonds, securitization, futures and options, and risk management. 19 FINANCE NOTES CA LT D E T BK = Growth b) Focus (1) Yield reduction/risk reallocation (a) securitized loans - liquidity improvements Note: reasons to securitize Regulatory B/S Funding Cost Risk 2. (b) loan pool - reduce risk/diversification (c) reduced transaction costs - rights offering (d) increased tax shields (i) issuer - zero coupon (ii) investor - auction rate preferred Instruments - focus on: claim on income and assets and right to participate in decisions. a) Preferred Stock - Preferred may be advantageous given the (inter corporate) 70% dividend exclusion. Used by non-taxpaying issuers who would be unable to use debt-related interest tax shields. (Note: ARPS - exchangeable into debt once firms become taxable.) b) High Yield Bonds (credit + call risk) (1) Covered Call - buying common stock and writing a call. If the stock fails to appreciate you receive the call premium. If the stock appreciates, the call is exercised through a retirement. (2) Form of senior equity - intermediate position in pecking order. Allows full utilization of debt capacity and avoids equity issuance. (Reverse convertible). c) Original Issue Discount/Zero Coupon Debt - significant tax advantages from the tax deductibility of discount (NOTE: Tax Reform Corrections, Tax Limits). d) Income Bond - tax benefit of debt without decreased flexibility from mandatory debt service e.g. PIK; DIB; Splits, Indexed. e) Dual Currency - pay interest in one currency and redeem principal in another. Firm swaps only its interest payments. Implicit currency option contained in dual currency bonds. f) Euro Capital Market - former cost advantages reduced by Rule 415 and the elimination of withholding tax. Still some advantage based on either taxes or financial market arbitrage. 20 FINANCE NOTES g) Yield Curve Notes - Long-term note with shorter term resetting of rates. h) ESOP - Similar to qualified plan; consider dilution, control and repurchase obligations. Tax advantages - largely illusory (and temporary). i) j) (1) Deductibility of principal and interest - confusing operating expense with a financial flow. Tax deduction arises from compensation expense, not from interest or principal payment. Merely substituting one benefit shield for another. Unless there is a benefit substitution, economic dilution and a value loss will occur. Net PV cost to firm = PV dividends applied to debt service less PV of wage/benefit concessions. (2) Lender interest exclusion effectively terminated. (3) Estate tax advantages: largely limited to smaller firms. Equity Linked Debt (1) Exchangeable Debt - debt convertible into the common stock of another firm. Difference between market price of third party stock and exchange price is tax deductible. Used to dispose of minority interests, e.g. Pennoil/Chevron (2) Warrant - call option issued by firm (conventional options are written by third parties). Exercise of warrant increases firm’s capital; tax advantage of warrants: value treated as a deductible discount. Recaptured, however, if warrants are not exercised. (3) Zero Coupon Convertible <Lynon> Convertibles - equivalent to straight debt with a nondetachable warrant (with an acceleration right in bankruptcy). (1) Usual Pricing - 6-8% coupon, 2-4 year break-even with a 20-25% premium (breakeven = conversion premium % ÷ (debt rate - dividend yield). (a) Value bond using market yield (b) Value warrant + Bd – (1) (c) Value cell (d) Compute cell B and Kc Bc = S N (di) x Bs C hedge Kc = Rf + Bc (MRP) (e) (2) Kcv = Kb ( B ) + Kw ( W ) B+W B+W S/B Kd < Kcv < Ke Stated Reasons (a) Less Expensive than Straight Debt - focus on accounting costs and ignores the option cost (out-of-the-money option). (b) Raising Equity at a Premium to Current Price - proper comparison is not current stock price to conversion price, but with conversion price to market price when conversion occurs. Also, no guaranty that conversion will occur. Finally, firm 21 FINANCE NOTES could achieve the same result by issuing straight debt now and refunding with equity later. (3) (4) Use (a) Impact - drop in stock price usually follows announcement. May be due to normal drop when an equity issue is announced. (b) Considerations (i) cheaper form of equity issuance (ii) control agency costs - consistent with pecking order theory. (a) relatively insensitive to issuer risk. Thus it reduces agency conflict between shareholders and bondholders for smaller and more risky firms where intangible growth value is difficult to measure. (b) limitations - primarily limited to smaller, more risky growth firms, and should not be used by large mature firms. Calling Convertibles (a) Call policy - Call convertibles whenever conversion value reaches call redemption price to minimize income to bondholders and to eliminate their option protection. (Conversion value = Conversion ratio x Current share price.) Note: Voluntary conversion when dividend rate exceeds interest yield or when the stock value exceeds the bond value. (b) k) (i) Viewed as a negative signal. (ii) Reduced tax shield. (iii) Reward sleeping investors. PERCS E. Costs of calling a bond: Preferred stock that converts into equity: used by firms considering cut in dividend/less negative signal Sell priced at C/S; limit upside in exchange for higher dividend ⇒ signal Callable at Prem which offsets lower dividend Equity Management - involves three main topics: new share issuance, dividend policy, and stock repurchases. 1. New Share Issuance a) b) Issues (1) pricing - are the shares fairly priced? (2) use of proceeds - earnings dilution unless new funds earn appropriate rate. (3) control Problem Areas 22 FINANCE NOTES (1) (2) Cheap Funds Fallacy - looking at the nominal or marginal cost of capital. (a) Marginal Cost - ignores the instrument’s impact on the capital structure. Equity in the capital structure supports debt. Need to allocate portion of the implicit equity cost used to support the new debt. (b) Nominal Cost - using E/P or D/P as surrogate Ke. New shares have same claim on earnings and assets. Earnings must be created with the new capital to prevent the stock price from falling. The return required on the new equity is Ke. Agency Problem - concerns information asymmetry. (a) Argument - Management will issue common stock when overvalued based on inside information. (b) Impact - offering dilution: outstanding stock price drops on average by 3% upon announcement of an equity issue (equal to 30% of new issue). Corporate wealth increases at shareholders expense. Note: Pecking Order Theory: issue securities with the smallest asymmetry first (i.e. instruments that are less dependent on the value of the firm as a going concern - contractual vs. residual claims). Focus on internal funds, then debt, high yield, convertibles, preferred, PIK/DIB, and finally equity. Note: underwriting costs: spread 3-6%, underpricing 2. Dividends a) Arguments (1) MM - provided investment and financing policies are fixed then dividends do not affect value. (2) Why Dividends Matter (a) Information - corporate reluctance to reduce dividends implies that dividend increases are sustainable, and based upon positive long-term earnings forecast by management. (signaling) (b) Agency Cost - reinvestment risk is lowered by reducing the assets under management control. (c) Option Pricing - dividends increase financial risk by reducing creditor’s asset cushion. (3) Setting Dividend Policy – Clientele tax effect Friction D = f(1/g, 1/D/E, 1/Ts, age, Dcf) v 3. Stock Repurchases - alternative form of shareholder distribution. Need to distinguish between repurchases based on excess corporate funds (a dividend substitute) from debt financed repurchase (a capital structure decision); Sealed Air: wealth transfer issue between tendering and nontendering shareholders. a) Reasons: 23 FINANCE NOTES b) (1) Investment - N/A ie. produces no cash flows (2) Capital Structure Change - same change is possible through debt financed extra dividend. Benefit based on interest tax shield. (3) Manage ROE - EPS - same result through extra dividend and reverse split. Smaller and more risky firm. (4) General Corporate Purpose - no reason (except dilution) why newly issued shares should not be used. (5) Reduce Dividends - can do without a repurchase. Also, saving in the future what you payout today. Thus, no real gain. (6) Tax Based Dividend Alternative - Favorable capital gains treatment. Signaling Impact: Use to reduce an expectation value gap. Set price at mgmt.’s value estimate; amount repurchased tied to max debt capacity. Form Open MKT: best for excess cash dividend type distribution Fixed price T/O: 12% valuation ∆ Dutch Auction: 8% valuation ∆. Management specifies the number of shares it will purchase within a specific range; lowest price necessary to retire all shares sought then becomes offered price. Reverse of a normal auction (i.e. instead of bidding price up - bid price down). c) Note: Cash Distribution Alternatives Distribute Cash Flow Committing to distribute future cash flows through contractual obligations (i.e. raise debt) Distribute Existing Cash Increase dividend payout Open-market share repurchase Premium selftender-offer share repurchase Leveraged recap Leveraged Buyout Degree of Cash Distribution Low F. Implied change in Capital Structure High Securities Issuance 1. Underwriting Services a) Security pricing certification - underwriter certifies that the issue price is fair based on due diligence. b) Marketing/distribution - placing power c) Risk transfer/insurance 24 FINANCE NOTES (1) (2) 2. Risks (a) Waiting/market risk (e.g. closing of internet IPO window in 3/00) (b) Pricing Risk (e.g. Lyondell offering) (c) Marketing risk. (e.g. unable to place) Committed underwritings as a put option - with spread (premium), exercise price (proceeds to firm) and exercise price plus premium (price to public) Techniques a) Traditional Underwriting (1) negotiated vs. competitive - in a negotiated offer, the issuer has less control over the terms and timing of the offer. Thus, investors have fewer worries that the issue will be structured to exploit their information disadvantage. Note: negotiated offer, higher fees, delay/shift price risk to issuer. b) (2) best efforts vs. firm commitment - best efforts acts as a red flag. (e.g. Time Warner) (3) stabilization and the green shoe option - green shoe option allows underwriters to purchase additional stock on the same terms as original offering. Provides underwriter with a cushion against covering any short provisions incurred by syndicate (adds 1/2 to 1.5% to cost). 415 - competitive underwriting, reduced costs for large frequent issuers with at least a BBB rating. 415 reduces waiting risk and constitutes a rational response to increased market volatility. Note: not used re: equity - need price certif. c) Rights Offering - option allowing shareholders to purchase shares directly from firm at below market price to maintain pro rata ownership. Involves a repackaging of stock value between value of the right and the ex-right share price. Rights offering benefits: (1) Reduced Flotation Costs - save underwriting spread. Note: underwriting cost = Fee + underpricing (2) d) Minimize Wealth Transfer - Rights offering minimize wealth transfer between existing and new shareholders. Yet: (a) there is no underwriter price certification - unless it is underwritten. (b) shareholder sale of rights serves as a bad signal. (c) risk of not receiving funds (unless underwritten). Private Placement - advantage of being flexible, quicker, lower transaction costs, and less size sensitive. Offset by covenant, rate, prepayment penalties and maturity disadvantages. Increased junk bond competition may be offset by rule 144(a) creating a secondary trading market. Note: NAIC - ratings arbitrage Note: 144A vs. Public, spread ≤ 3BP 25 FINANCE NOTES e) Risk Management: exposure measurement and tracking (1) Limits as stop loss mechanism (2) Tools – mgn Risk or effect (a) Underwriting (b) Diversification (c) Capital (d) Transfer Note – implied default rate = CDS ÷ (1 – RR) (3) Hedging value – IFF impacts investment, taxes or distress (cash flow impact) (4) Diversification – avoid over betting (reduces tail risk/keeps you in the game longer), not just in an asset class, but among asset classes (a) Cost (b) Skew and tail (c) Still lose – just not all at one time (d) Time varying corrections (e) Only one systematic risk factor (f) Ignores non linear dependencies (5) Models – economic or historic (6) Pyramids Capital structure Liquidity Risk Capital budgeting Risk Mgmt Concentration (7) V. Focus (a) Transparency (b) Multiple vs single scenarios (c) Scenario analysis vs assuming a scenario (d) Path dependency – change event splits universe (e) Beyond the data/out of sample events (f) Multi period vs single period models FUNDAMENTAL CORPORATE CHANGES 26 FINANCE NOTES A. Mergers & Acquisitions: beware of bubbles (temporary separation of price from value based on belief that historical price movements will continue). Technical swamp fundamentals/momentum. M&A as a tactic vs strategy 1. Considerations: strategy, finance (price, value and funding) and execution (tactics and integration) a) Types - horizontal, vertical, conglomerate and turnaround. b) Valuation Methods - Cost, market, and income. Distinguish cost from value. Focus on value creation through arbitrage possibilities between equity and underlying asset values. Easier to determine price than value. V = MAX (liquid, GC, TPS) (1) V EV Market - focus on multiples or premiums over trading value. Value of an asset without cash flow is only what someone will pay for it (TPS) cyclical adjustment: average firm margin over the cycle x current sales or average industry margin x current sales (a) FV (b) t Capitalization (existing public firms) (i) basis - sales, earnings, assets or book value (equity) (ii) adjustments - control premium (↑50%) and liquidity (↓ 30%) discount Comparable Transactions (2) Cost/Asset Values - appraisal or liquidation value, replacement cost or book value. Balance sheets measure money spent and not value. (3) Income/Free Cash Flow - V = fcf/c*; (4) (a) ROE Approach - ROE = E/Eq; P = E/ROE and E = P x ROE (b) Rule of Thumb - Earnings 1.5 - 2 times Rf by second year of operation. M R LBO/MDC Method: D Cap FD FD Pm EBITDA 1 EBITDA EBITDA Cap D EBITDA Note: Target Market Financial Size/Growth Scarcity Share Revenue Earnings Cash Flow Growth Competition 30% equity 70% debt Timing c) Business Personal Talent/Skills Product/Tech Distribution Milestone Risk Perf. Investor adj Customer Employee 40x= Debt % OPM % Structure - asset or stock sale; triangular (target mergers with subsidiary) or reverse triangular (subsidiary disappears/merges into target). 27 FINANCE NOTES d) Accounting - push down accounting (carryover basis) no goodwill/decrease equity; asset writeups e) Payment - cash vs. stock f) Taxes - taxable or tax free transaction premium: taxable/cash - 38% vs nontaxable stock 18% reflects tax difference to selling shareholders. g) Defense Mechanisms/Counters poison pill: condition delivery on close (beware “dead hand”) dual class: condition delivery of proxy fair price: make offer to Board vs Shareholders 2. Framework - Value creation depends on factors with unique commercial significance, created by the combination that investors could not duplicate by holding the buyer’s and seller’s stocks in their portfolio. Note: alternatives - J/V, licensing, etc. a) b) Price vs. Value (1) Price - Distinguish passive investor trading value from control price allowing buyer to alter strategy to higher valued use justifying premium. (2) Intrinsic Value - present value of cash flows plus financial, tax and off balance sheet asset values. Usually reflected in prebid price. Value added - means of closing gap between price and intrinsic value (1) synergy - cash flow from combined firms is greater than the sum of the independent cash flows due to economies of scale (vol) or scope (interrelatedness). (2) Option value - acquisition allows firm to participate in valuable growth opportunities. (3) Operating Improvements (a) Balance Sheet (i) Assets - Change mix, increase turnover or sell off. (ii) Liabilities - increase leverage to utilize unused debt capacity or deleverage over leveraged firm to reduce distress/trans costs. Note: Mergers & Acq wave bargain theory MV<RV →↑M&A Liquidity theory MV ↑→↑ M&A increased asset value to borrow against, beware giving back value to seller re over paying (b) c) Income Statement (i) Increase Revenues (ii) Reduce Costs Relationships - compare value received with value paid to determine value created. (1) Value Received - (Vr) includes stand alone value plus value added factor. 28 FINANCE NOTES (2) Value Paid (Vp) = cash + market value of stock + debt assumed + PV from off balance sheet liabilities (leases, pensions and EPA) + golden parachutes and transaction costs. (3) Market Value = stand alone value. (4) Value Added Factor = synergy + growth option value and oper. improvements. (5) Net Value Added (NVA) - Value added less premium paid. VR = Stand Alone + Value Added VP = Act Prebid MV + Premium NVA = Value Added - Premium Financial terms Buyers Max Terms Private Seller’s Min Terms Non Financial terms (6) (7) d) 3. Determining the Discount Rate (a) Business Risk - Use seller’s business risk i.e. unlevered asset beta (b) Financial Risk - Use buyer’s target capital structure to relever beta. Premium: (a) Takeover price Stupidity Competitive necessity Information Synergy Lower WACC (b) Under valuation Current price Foreign M&A: discount local currency flows at local rates; spot back to home FX. Evidence a) Who Benefits - not unlike most competitive endeavors most mergers fail from the acquirer’s viewpoint (behavioral finance: winners curse). Selling shareholders are primary beneficiaries. Distinguish, however, friendly from hostile tender offers. Need to focus on total gain, and whether assets end up in most efficient use, e.g. Campau/Federated (1) Tests - ROA>c*, ROE>Ke and buyer’s stock price outperforms peer group immediately following the acquisition. (2) Common mistakes 29 FINANCE NOTES (3) 4. (a) Overpay - e.g. Quaker/Snapple { (b) Misjudge industry risk - e.g. NWA (c) Overestimate synergies - Paramount (d) Integration problems - Novell/WordPerfect (e) Due Diligence - McKesson Common characteristics of successful acquisitions: Involve closely related businesses; Use of stock vs. borrowed funds - (incentive) - low premiums (avoid overpaying); Retain management (aids integration); Smaller transaction size (aids integration) Hostile Takeovers - struggle by competing management groups over the control of corporate assets. Companies compete in two markets, i.e. the product market for customers/revenues and in the capital markets for capital. Market changes require management and strategic adjustments. Management is, however, reluctant to change once successful strategies due to organizational interia. The delayed adjustment depresses returns and equity values relative to underlying asset values as management continues to reinvest in unattractive markets rather than return excess funds to shareholders. The depressed returns and equity values attract raiders. (profit mitigation e.g. hardware to software) Note: MV can be less than liquidation value if management refuses to change/liquidate. This creates an arbitrage opportunity between asset and stock value. (e.g. Europe) Note: overcapacity: ordinarily: ↑CAPEX →↑ V, but for industries suffering from overcapacity ↓ CAPEX →↑ V (e.g. oil) FMV Going concern value Liquidation value DCFV a) Benefit: capital market policing mechanism that controls management agency costs, and acts as an externally imposed restructuring. Part of Schumpeterian creative destruction (economic Darwinism) that revitalizes capitalistic systems. Note: 30-50% premium requires gross discrepancy before mkt correction occurs but less severe than waiting for product mkt failure re Telecom ↓ Motorola equity > HYB losses b) c) Considerations: costs of large, diversified entities may outweigh benefits of scale and synergy. This is reflected in conglomerate discounts reflecting management as an off balance sheet liability. Note: negative synergy (1) Overhead: overhead to asset ratio of industrial firms is 2% vs. 0.7% at a mutual fund. Do industrial managers add three times as much value? (2) Complexity (focus test): firms managing single or related businesses outperform those managing several unrelated businesses may reflect diseconomies of scale. Takeover risk: 30 FINANCE NOTES (1) Institutional barriers/protection (2) (3) Economic indicators ROE – Ke < 0 Dividends/FOCF < 50% (Cash is building) Cash + Marketable Securities/Market Value > 5% Debt/Cap < 20% (Under leveraged) Relative lagging stock price performance STP > MV Value Gaps Expectations Strategic Map Market Growth (4) Decline over time No defense to a fully priced/financed bid + Growth Neg FCF Winners ± FCF 0 – >1 MV/BV Losers ± FCF LBO Pos FCF <1 ROE – Ke Market Position B. Restructuring - Triggered by product market overcapacity. Note: Periodic/as needed vs. on-going value planning 1. Overview - Restructuring involves reallocating assets caused by changes in the economic environment rendering old management strategies and asset combinations obsolete. <overcapacity> e.g. retailers Walmart a) Forces: deregulation, globalized competition, changing technology, and deflation have changed the competitive environment. This necessitates changes in strategy and structure to better adapt to the new conditions. Industries affected: (1) Older industries with declining demand (steel) (2) Commodity industries relying on inflation (oil) (3) Growth industries impacted by foreign competition (semi-conductors) (4) Industries suffering from poor management/inadequate returns (conglomerates) (5) Deregulated industries (Banks) (6) Change from national to regional market (e.g. Euro) 31 FINANCE NOTES b) (7) E-commerce impact (8) Hedge funds Symptoms - ROE ≤ Ke and MV ≤ BV or BUV; value gap: (1) Expectations gap: stock price less DCF value based on management forecast. Note: may not need to correct expectation value gap - mkt will eventually get it unless - T/O or need to raise capital (2) Strategy gap: forecast value from current strategy less alternative use/strategy i.e. takeover value Note: strategy gap = T/O value - Mgmt forecast Expectation Gap = Value Based on Mgmt Forecast-current price c) Reaction - Restructure operations and financial strategy to fit changed/reduced market opportunities. Implied market and firm life cycle: d) Value Impact - Indirect operating efficiency benefits flowing from financial restructuring are the major source of increased value. Based on interdependency between financing and operating decisions. Value motives include: Tax reduction Fit/Focus Improved incentives/concentrate equity Improved transfer prices/eliminate cross subsidies/reduce reinvestment risk Increase leverage e) Reinvestment Risk - cannot assume excess cash flow will be profitably reinvested or returned to shareholders. Risk of value destroying investments i.e. FCF invested where WACC > ROA whenever ability to invest exceeds opportunity to invest. f) Managing for Value Perspective More value with your or someone else? LHS (Cash Flow) RHS (Claims) Management of assets or liabilities Better owned by you or someone else? • • • 2. Unchanged Combined with new assets – Internal Investment – Acquisition – Increasing revenues More efficient operation – Decreasing costs – Tax planning • • • • • • • Divestiture Spin-off Equity carve out Being acquired – sell off Liquidation – Total – Large dividend Leasing Securitisation Better owed by you or someone else? • • • • • Financing mix (debt, equity, preferred, etc) Swap or recapitalisation Maturity structure of debt new debt or preferred issuance New equity issue • • • Subsidiary debt debt refunding, defeasance Share repurchase – Tender – Open market Forms 32 FINANCE NOTES a) Asset Restructuring - involve ownership or management changes: (1) Divestment - asset or division sale, best used when seller is able to obtain a premium from a natural buyer with whom the assets are a better fit. (a) Basis - asset redemption to improve returns. Means of transferring assets to higher value use. Based on buyer’s ability to operate assets more efficiently (based on comparative advantages). (b) Transaction Screens (i) Dog: Sale when r<c* - to stop an economic or cash loss (dog screen). Gin Rummy approach unlikely to get attractive price if truly a dog. (ii) Star: Sale when r>c* - when NPV of remaining cash flows are less than the sale price (star screen). Note: Fit Test: firm must not only earn in excess of its Cost of Capital, but also more than could be earned by an alternative owner: (2) Liquidation - asset sales with proceeds distributed to shareholders. (3) Spinoff - shareholders hold the same assets but in a different legal form (management changes, but ownership remains the same). Shareholders receive a pro rata distribution of separate equity claims on a subset of the original firm’s net assets; similar to stock dividend (a) Benefits (i) Elimination of Cross Subsidies for Underperformers (ii) Best Used When there is no natural buyer from whom a premium could be obtained. Raise cash when subsidiary borrows to fund a special dividend, then spinoff sub with debt (beware e.g. Lanier) Notes: Distinguish from corporate dissolutions: Spinoff: distribute pro rata subsidiary shares to shareholders Split-off: exchange subsidiary shares for portion of parent shares. Split up: subsidiary shares transferred to shareholder and parent dissolves. b) (4) M&A/Joint Venture (5) Sale leaseback - Need not own asset (6) Asset Securitization - LHS vs. RHS Equity Restructuring (1) Going Private - Important incentive benefits (reduced agency costs) from combining ownership and control/management. (a) Benefits - improved managerial incentives, superior monitoring expertise by third party investors, reduced shareholder servicing costs, and increased debt capacity utilization. 33 FINANCE NOTES (b) Costs - less access to public capital markets; balance costs and benefits of public ownership; firms will find going private more attractive when they face a decline in profitable growth opportunities which reduces the value of access to the public capital markets. (c) Forms (i) Creeping tender/stock repurchase - long-term program of debt financed stock repurchases that increases management’s proportionate ownership (ii) Recapitalization (25% test) - insiders/management’s shares are effectively split thereby, diluting public shareholders’ interests. The public shareholders are compensated for the dilution by a tax advantaged cash distribution. Used by firms to avoid criticism of LBO unfairness to avoid triggering change in control auction e.g. RJR/Sealed Air. Note: negative book equity. Note: cash distribution usually equal to market price with implied stub value: cash distribution ÷ (mgmt. shares - public shares). (iii) LBO - management with third party equity investors take the firm private using the value of a firm’s assets as security, and the firm’s operating cash flow and planned asset sales to service the debt. Note: Recap vs. LBO (iv) Recap LBO Liquidity Remain Public Private Change of Control No Yes Accounting Debit Equity Purchase Act. Taxes Flexible Capital Gain Distribution Market Price Premium Equity Carve Outs - partial public offering (PPO) whereby firm sells a minority interest in a previously wholly owned subsidiary (e.g. Amex/Shearson). Differs from spinoff because of cash sale to outside investors. Creates independent market valuation of subsidiary performance and achieves better fit of financial instruments and incentives with unit’s cash flow. (a) Usually: results in complete sale of unit within 5 years i.e. temporary structure (b) Types: Primary - Subsidiary sells shares with proceeds retained; positive market reaction. 34 FINANCE NOTES Secondary - Parent sells subsidiary shares with proceeds retained by parent; negative stock market reaction. IBP/Occidental (c) Best for: small, rapidly growing dissimilar subsidiaries because: (i) reduced risk of cross subsidies (ii) increased monitoring (iii) (v) more precise financing. Return Capital to Shareholders. (a) Dividends (b) Stock Repurchase (vi) Leveraged Equity Purchase Plan (vii) Targeted Stock: used as spinoff alternative - tax, cost, credit; (a) Same Board (b) Single tax return (c) Co-Insure (d) Less impact (viii) Creation of Special Purpose Entities - Structures, such as project finance, joint ventures, LBO partnerships, MLP’s and R&D partnerships have a specific limited purpose that reduces cross subsidies and improves monitoring. They reflect the reluctance of investors to grant the privilege of permanent capital to create real asset closed end mutual fund that suffers from management as an off balance sheet liability. c) Restructuring Conclusions - Focus on improving value through either change in strategy or financial restructuring. Firms failing to voluntarily restructure will have an external restructuring imposed on them via a hostile takeover, an internal restructuring imposed by the Board of Directors or a product market failure. (1) (2) Common Restructuring Elements (a) increased leverage - increased debt financed stock repurchase as a means of acquiring control. Discipline of debt impact. (b) improved asset efficiency - r = f (Ato, PM) = ≥ asset sales and cost cuts. (c) improved accountability - with more streamlined entrepreneurial organization. (d) better incentive systems - better tailored to results. (e) increased return of funds to shareholders. Restructuring Signals (a) Multiple SIC’s = > number of unrelated SUB’s (b) Profitable Low Return Units ⇒ r ≤ c* (c) Positive FCF ⇒ reinvestment risk 35 FINANCE NOTES (3) (d) Multi - Layered /Complex Organizational Structure ⇒ poor incentives (e) Unused Debt Capacity ⇒ wasted asset (f) ROE ≤ K (or EV < AV) e Financial Restructuring Alternatives & Analysis Proactive Tactical Strategic Financial Sale of block Joint venture Acquisitions Leveraged acq. Vehicle Divestitures Leveraged disposition Divestitures Acquisitions Voting provisions Staggered board Poison pill Reactive (4) Stock repurchase Block repurchase Voting provisions Poison pill Sale of block White squire preferred Monetise undervalued nonstrategic assets Cost restructuring ESOP Spin off LBO Recapitalisation – Full or partial ESOP LBO Recap Sale Objectives driven by market 36 FINANCE NOTES 12,000 Redefinition of core business leads to spin-offs, divestitures, etc. Search for growth through global expansion. Consolidation in mature markets (“Dream Deal”). Re-engineering applied to targets 10,000 8,000 Dot Com Crash Evolution of the Conglomerate 6,000 Portfolio theory at corporate level called into question 4,000 Strength through diversification 2,000 Credit bubble Internal restructuring “right-sizing” Going private: • LBO’s benefit from low valuation in public market • Developing of high yield M&A financing Dot Com Bubble Break-up plays Growth in earnings from cost cutting 0 1960’s and 1970’s The Age of the Conglomerate (5) 1980’s – The Age of the Financial Buyer Early 90’s – Fixing the Mistakes Mid 90’s – Age 2000 – 2003 of the Strategic Correction Buyer 2004 – ? Spectrum of shareholder activity: increased shareholder focus on financial structure and capital management and allocation Aggressive capital restructuring Dynamic shareholder activism LBO recap Proxy fight management change Passive equity underperformance 37 FINANCE NOTES LHS Transaction RHS (value) (A) Income / DCF FOCF = NOPAT–(WCI + T + CAPEX) WACC (Claims) (A) Mechanics Issues Tax (A) Concerns Ratings targets Market availability - menus Ke – Rf x 2 or CAPM Legal IRR Debt = ref rate + spread Accounting MDC (B) Relative Value Comps Multiples Trading Transaction (C) Breakup Value Regulation Focus Form Payment (B) Purchase Price Multiple (C) Value Allocation Vp = PreBid Trading + Premium Vr = PreBid value + Synergy NVAs = Premium - Synergy (B) Funded Debt Multiples (FDX) (C) Framework R/C – tied to BB Senior (SDX) TL/A (amortization tied to projections) 3 – 4X FLL 0.5 – 1X SLL T/LB SDX - T/LA Other Debt FDX - SDX Equity PPX – FDX Subject to IRR constraint 38