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- MN20211 Corporate Finance 2011/12
- Revision Investment Appraisal (NPV).
- Investment flexibility, Decision trees, Real

Options. - Revision Portfolio Theory gt CAPM
- 4. Sources of Funding.
- 5. Capital Structure and Value of the Firm.
- 6. Optimal Capital Structure - Agency Costs,

Signalling. - 7. Dividend policy/repurchases.
- 8. Mergers and Acquisitions.
- 9. Venture Capital and Private Equity.
- 10. Introduction to Behavioural Finance.
- 11. Revision.

Corporate Finance Three Major Decisions

- Investment Appraisal (Capital Budgeting) Which

New Projects to invest in? - Capital Structure (Financing Decision)- How to

Finance the new projects Debt or equity? - Payout Policy Dividends, Share Repurchases,

Re-investment. - gt Objective Maximisation of Shareholder

Wealth.

First Topic Investment Appraisal

- Brief revision of static NPV.
- gt Flexibility
- gt Decision trees
- gt sensitivity analysis
- gt Real Options

Investment Appraisal.

- Objective Take projects that increase

shareholder wealth (Value-adding projects). - Investment Appraisal Techniques NPV, IRR,

Payback, ARR, Real Options. - Which one is the Best rule for shareholder wealth

maximisation?

Connections in Corporate Finance. Investment

Appraisal Net Present Value with discount rate

(cost of capital) given. Positive NPV increases

value of the firm.

Cost of Capital (discount rate) How do companies

derive the cost of capital? CAPM/APT.

Capital Structure and effect on Firm Value and

WACC.

- Debate over Correct Method
- - Accounting Rate of Return.
- - Payback.
- - NPV.
- - IRR.
- - POSITIVE NPV Increases Shareholder Wealth.
- 2. Correct Method - NPV!
- -Time Value of Money
- - Discounts all future cashflows

Net Present Value

Perpetuities.

IRR gt

Take Project if NPV gt 0, or if IRR gt r.

Example. Consider the following new project

-initial capital investment of 15m. -it will

generate sales for 5 years. - Variable Costs

equal 70 of sales value. - fixed cost of project

200k PA. - A feasibility study, cost 5000, has

already been carried out. Discount Rate equals

12. Should we take the project?

DO WE INVEST IN THIS NEW PROJECT?

NPV gt 0. COST OF CAPITAL (12) lt IRR (19.75).

Note that if the NPV is positive, then the IRR

exceeds the Cost of Capital.

NPV m

3.3m

Discount Rate

0

12

19.7

CONFLICT BETWEEN APPRAISAL TECHNIQUES.

COMPARING NPV AND IRR - 1

NPV

531

519

Discount Rate

10

22.8

25.4

PROJ D

PROJ C

Select Project with higher NPV Project C.

COMPARING NPV AND IRR -2

NPV

Discount Rate

Impossible to find IRR!!! NPV exists!

- COMPARING NPV AND IRR 3 Size Effect
- Discount Rate 10
- Project A Date 0 Investment -1000.
- Date 1 Cashflow 1500.
- NPV 364.
- IRR 50
- Project B- Date 0 Investment -10
- Date 1 Cashflow 18.
- NPV 6.36
- IRR 80.
- Which Project do we take?

Mutually Exclusive Versus Independent

Projects.

Mutually Exclusive project firm can only take

one (take project with highest positive

NPV). Independent project firm can take as many

as it likes (take all positive NPV

projects). Consider slide 10 Which project(s)

would you take, and what would be the

value-added, if projects are a) mutually

exclusive, and b) independent?

Investment Flexibility/ Real options.

- Reminder of Corporations Objective Take

projects that increase shareholder wealth

(Value-adding projects). - Investment Appraisal Techniques NPV, IRR,

Payback, ARR - Decision trees
- Monte Carlo.
- Real Options

- Investment Flexibility, Decision Trees, and Real

Options - Decision Trees and Sensitivity Analysis.
- Example From Ross, Westerfield and Jaffe

Corporate Finance. - New Project Test and Development Phase

Investment 100m. - 0.75 chance of success.
- If successful, Company can invest in full scale

production, Investment 1500m. - Production will occur over next 5 years with the

following cashflows.

Production Stage Base Case

Date 1 NPV -1500

1517

Decision Tree.

Date 1 -1500

Date 0 -100

NPV 1517

Invest

P0.75

Success

Do not Invest

NPV 0

Test

Do not Invest

Failure

P0.25

Do Not Test

Invest

NPV -3611

Solve backwards If the tests are successful, SEC

should invest, since 1517 gt 0. If tests are

unsuccessful, SEC should not invest, since 0 gt

-3611.

Now move back to Stage

1. Invest 100m now to get 75 chance of 1517m

one year later?

Expected Payoff 0.75 1517 0.25 0 1138. NPV

of testing at date 0 -100

890

Therefore, the firm should test the project.

Sensitivity Analysis (What-if analysis or Bop

analysis) Examines sensitivity of NPV to changes

in underlying assumptions (on revenue, costs and

cashflows).

Sensitivity Analysis. - NPV

Calculation for all 3 possibilities of a single

variable expected forecast for all other

variables.

Limitation in just changing one variable at a

time. Scenario Analysis- Change several

variables together. Break - even analysis

examines variability in forecasts. It determines

the number of sales required to break even.

Real Options

- A new investment appraisal method, analysed by

academics in the 1980s - Existing NPV method static one-off decision

to take project or throw it away once project

is taken, committed to it. - Real Options recognises flexibility in

decision-making.

Real Options. A digression Financial Options A

call option gives the holder the right (but not

the obligation) to buy shares at some time in the

future at an exercise price agreed now. A put

option gives the holder the right (but not the

obligation) to sell shares at some time in the

future at an exercise price agreed now. European

Option Exercised only at maturity

date. American Option Can be exercised at any

time up to maturity. For simplicity, we focus on

European Options.

Example

- Today, you buy a call option on Marks and

Spencers shares. The call option gives you the

right (but not the obligation) to buy MS shares

at exercise date (say 31/12/10) at an exercise

price given now (say 10). - At 31/12/10 MS share price becomes 12. Buy at

10 immediately sell at 12 profit 2. - Or MS shares become 8 at 31/12/10 rip option

up!

- Factors Affecting Price of European Option (c).
- -Underlying Stock Price S.
- -Exercise Price X.
- Variance of of the returns of the underlying

asset , - Time to maturity, T.

The riskier the underlying returns, the greater

the probability that the stock price will exceed

the exercise price. The longer to maturity, the

greater the probability that the stock price will

exceed the exercise price.

Options Payoff

Profiles. Buying a Call Option.

Selling a put option.

Selling a Call Option.

Buying a Put Option.

Pricing Call Options Binomial Approach.

Cu 3

uS24.00

q

q

c

S20

1- q

1- q

dS13.40

Cd0

- S 20. q0.5. u1.2. d.67. X 21.
- 1 rf 1.1.
- Risk free hedge Portfolio Buy One Share of Stock

and write m call options. - uS - mCu dS mCd gt 24 3m 13.40.
- M 3.53.
- By holding one share of stock, and selling 3.53

call options, your payoffs are the same in both

states of nature (13.40) Risk free.

Since hedge portfolio is riskless

1.1 ( 20 3.53C) 13.40. Therefore, C

2.21. This is the current price per call option.

The total present value of investment 12 .19,

and the rate of return on investment is 13.40 /

12.19 1.1.

Alternative option-pricing method

- Black-Scholes
- Continuous Distribution of share returns (not

binomial) - Continuous time (rather than discrete time).

Real Options

- Just as financial options give the investor the

right (but not obligation) to future share

investment (flexibility) - Researchers recognised that investing in projects

can be considered as options (flexibility). - Real Options Option to delay, option to

expand, option to abandon. - Real options dynamic approach (in contrast to

static NPV).

Real Options

- Based on the insights, methods and valuation of

financial options which give you the right to

invest in shares at a later date - RO development of NPV to recognise corporations

flexibility in investing in PROJECTS.

Real Options.

- Real Options recognise flexibility in investment

appraisal decision. - Standard NPV static now or never.
- Real Option Approach Now or Later.
- -Option to delay, option to expand, option to

abandon. - Analogy with financial options.

Types of Real Option

- Option to Delay (Timing Option).
- Option to Expand (eg R and D).
- Option to Abandon.

Option to Delay ( call option)

Value-creation

Project value

Investment in waiting (sunk)

Option to expand ( call option)

Value creation

Project value

Investment in initial project eg R and D (sunk)

Option to Abandon ( put option)

Project goes badly abandon for liquidation value.

Project value

Valuation of Real Options

- Binomial Pricing Model
- Black-Scholes formula

Value of a Real Option

- A Projects Value-added Standard NPV plus the

Real Option Value. - For given cashflows, standard NPV decreases with

risk (why?). - But Real Option Value increases with risk.
- R and D very risky gt Real Option element may be

high.

Simplified Examples

- Option to Expand (page 241 of RWJ)

If Successful

Expand

Build First Ice Hotel

Do not Expand

If unsuccessful

Option to Expand (Continued)

- NPV of single ice hotel
- NPV - 12,000,000 2,000,000/0.20 -2m
- Reject?
- Optimistic forecast NPV - 12M 3M/0.2
- 3M.
- Pessimistic NPV -12M 1M/0.2 - 7m
- Still reject?

Option to expand (continued)

- Given success, the E will expand to 10 hotels
- gt
- NPV 50 x 10 x 3m 50 x (-7m) 11.5 m.
- Therefore, invest.

Option to abandon.

- NPV(opt) - 12m 6m/0.2 18m.
- NPV (pess) -12m 2m/0.2 -22m.
- gt NPV - 2m. Reject?
- But abandon if failure gt
- NPV 50 x 18m 50 x -12m/1.20
- 2.17m
- Accept.

- Option to delay and Competition (Smit and Ankum).
- -Smit and Ankum present a binomial real option

model - Option to delay increases value (wait to observe

market demand) - But delay invites product market competition

reduces value (lost monopoly advantage). - cost Lost cash flows
- Trade-off when to exercise real option (ie when

to delay and when to invest in project).

- Protecting Economic Rent Innovation, barriers to

entry, product differentiation, patents. - Firm needs too identify extent of competitive

advantage.

Option to delay versus competition

Game-theoretic approach

Firm 1\Firm 2 Invest early Delay

Invest early NPV 500,NPV 500 NPV 700, NPV 300

Delay NPV 300, NPV 700 NPV 600,NPV 600

Option to delay versus competition effects of

legal system

Firm 1\ Firm 2 Invest early Delay

Invest early NPV 500,NPV 500 NPV 700- 300, NPV 300300

Delay NPV 300300, NPV 700-300 NPV 600,NPV 600

Monte Carlo methods

- BBQ grills example in RWJ.
- Application to Qinetiq (article by Tony Bishop).

Use of Real Options in Practice

SECTION 2 Risk and Return/Portfolio Decision/

Cost Of Capital. The cost of capital investors

required return on their investment in a company.

It provides the appropriate discount rate in

NPV. Investors are risk averse. Future share

prices (and returns) are risky (volatile). The

higher the risk, the higher the required return.

- .

p

r

A

B

t

t

.

An investors actual return is the percentage

change in price

- .

Risk Variability or Volatility of Returns, Var

(R). We assume that Returns follow a Normal

Distribution.

Var(R).

E(R)

Risk Aversion. Investors prefer more certain

returns to less certain returns.

U

Wealth

150

100

200

Risk Averse Investor prefers 150 for sure than a

50/50 gamble giving 100 or 200.

Portfolio Analysis. Two Assets Investor has

proportion a of Asset X and (1-a) of Asset Y.

Combining the two assets in differing proportions.

E(R)

Portfolio of Many assets Risk Free Asset.

E(R)

Efficiency Frontier.

M

.

X

All rational investors have the same market

portfolio M of risky assets, and combine it with

the risk free asset. A portfolio like X is

inefficient, because diversification can give

higher expected return for the same risk, or the

same expected return for lower risk.

The Effect of Diversification on Portfolio

Variance.

Number of Assets.

An assets risk Undiversifiable Risk

Diversifiable Risk Market Risk Specific

Risk. Market portfolio consists of

Undiversifiable or Market Risk only.

Relationship between Investor Portfolio

Decision and Firms Cost of Capital

- Investors can diversify away all specific risk

therefore, should only be rewarded for holding

each firms market risk gt CAPM. - CAPM provides the firms cost of equity.

Capital Asset Pricing Model

Security Market Line.

Estimating Cost of Equity Using Regression

Analysis. We regress the firms past share price

returns against the market.

Weighted Average Cost of Capital (WACC). When we

have estimated Cost of Debt, and Cost of Equity-

if we have market values of debt and equity, we

can calculate WACC discount rate in NPV of new

investments.

Lecture 5 and 6 Capital Structure and Dividends.

Positive NPV project immediately increases

current equity value (share price immediately

goes up!)

Pre-project announcement

New capital (all equity)

New project

Value of Debt

Original equity holders

New equity

New Firm Value

Example

5005001000.

20

60 -20 40.

500.

Value of Debt

Original Equity

50040 540

New Equity

20

1000601060.

Total Firm Value

Positive NPV Effect on share price. Assume all

equity.

Value of the Firm and Capital Structure Value of

the Firm Value of Debt Value of Equity

discounted value of future cashflows available to

the providers of capital. (where values refer to

market values). Capital Structure is the amount

of debt and equity It is the way a firm finances

its investments. Unlevered firm

all-equity. Levered firm Debt plus

equity. Miller-Modigliani said that it does not

matter how you split the cake between debt and

equity, the value of the firm is unchanged

(Irrelevance Theorem).

Value of the Firm discounted value of future

cashflows available to the providers of

capital. -Assume Incomes are perpetuities. Miller-

Modigliani Theorem

Irrelevance Theorem Without Tax, Firm Value is

independent of the Capital Structure. Note that

K

K

Without Taxes

With Taxes

D/E

D/E

V

V

D/E

D/E

Examples

- Firm X
- Henderson Case study

- MM main assumptions
- - Symmetric information.
- Managers unselfish- maximise shareholders wealth.
- Risk Free Debt.
- MM assumed that investment and financing

decisions were separate. Firm first chooses its

investment projects (NPV rule), then decides on

its capital structure. - Pie Model of the Firm

D

E

E

MM irrelevance theorem- firm can use any mix of

debt and equity this is unsatisfactory as a

policy tool. Searching for the Optimal Capital

Structure. -Tax benefits of debt. -Asymmetric

information- Signalling. -Agency Costs (selfish

managers). -Debt Capacity and Risky Debt. Optimal

Capital Structure maximises firm value.

Combining Tax Relief and Debt Capacity

(Traditional View).

K

V

D/E

D/E

Section 4 Optimal Capital Structure, Agency

Costs, and Signalling. Agency costs - managers

self interested actions. Signalling - related to

managerial type. Debt and Equity can affect Firm

Value because - Debt increases managers share

of equity. -Debt has threat of bankruptcy if

manager shirks. - Debt can reduce free

cashflow. But- Debt - excessive risk taking.

AGENCY COST MODELS. Jensen

and Meckling (1976). - self-interested manager -

monetary rewards V private benefits. - issues

debt and equity. Issuing equity gt lower share of

firms profits for manager gt he takes more perks

gt firm value Issuing debt gt he owns more equity

gt he takes less perks gt firm value

Jensen and Meckling (1976)

V

Slope -1

V

A

V1

B

B1

If manager owns all of the equity, equilibrium

point A.

Jensen and Meckling (1976)

V

Slope -1

V

A

B

V1

Slope -1/2

B

B1

If manager owns all of the equity, equilibrium

point A. If manager owns half of the equity, he

will got to point B if he can.

Jensen and Meckling (1976)

V

Slope -1

V

A

B

V1

Slope -1/2

V2

C

B

B1

B2

If manager owns all of the equity, equilibrium

point A. If manager owns half of the equity, he

will got to point B if he can. Final equilibrium,

point C value V2, and private benefits B1.

Jensen and Meckling - Numerical Example.

Manager issues 100 Debt. Chooses Project B.

Manager issues some Debt and Equity. Chooses

Project A.

Optimal Solution Issue Debt?

Issuing debt increases the managers fractional

ownership gt Firm value rises. -But Debt and

risk-shifting.

OPTIMAL CAPITAL STRUCTURE. Trade-off Increasing

equity gt excess perks. Increasing debt gt

potential risk shifting. Optimal Capital

Structure gt max firm value.

V

V

D/E

D/E

Other Agency Cost Reasons for Optimal Capital

structure. Debt - bankruptcy threat - manager

increases effort level. (eg Hart, Dewatripont and

Tirole). Debt reduces free cashflow problem (eg

Jensen 1986).

Agency Cost Models continued. Effort Level,

Debt and bankruptcy (simple example). Debtholders

are hard- if not paid, firm becomes bankrupt,

manager loses job- manager does not like

this. Equity holders are soft.

Effort Level High Low Required Funds

Income 500 100 200

What is Optimal Capital Structure (Value

Maximising)?

Firm needs to raise 200, using debt and equity.

Manager only cares about keeping his job. He has

a fixed income, not affected by firm value. a) If

debt lt 100, low effort. V 100. Manager keeps

job. b) If debt gt 100 low effort, V lt D gt

bankruptcy. Manager loses job. So, high effort

level gt V 500 gt D. No bankruptcy gt Manager

keeps job. High level of debt gt high firm

value. However trade-off may be costs of having

high debt levels.

Free Cashflow Problem (Jensen 1986). -Managers

have (negative NPV) pet projects. -Empire

Building. gt Firm Value reducing. Free Cashflow-

Cashflow in excess of that required to fund all

NPV projects. Jensen- benefit of debt in

reducing free cashflow.

Jensens evidence from the oil industry. After

1973, oil industry generated large free

cashflows. Management wasted money on unnecessary

R and D. also started diversification programs

outside the industry. Evidence- McConnell and

Muscerella (1986) increases in R and D caused

decreases in stock price. Retrenchment-

cancellation or delay of ongoing projects. Empire

building Management resists retrenchment. Takeover

s or threat gt increase in debt gt reduction in

free cashflow gt increased share price.

Jensen predicts young firms with lots of good

(positive NPV) investment opportunities should

have low debt, high free cashflow. Old stagnant

firms with only negative NPV projects should have

high debt levels, low free cashflow. Stultz

(1990)- optimal level of debt gt enough free

cashflow for good projects, but not too much free

cashflow for bad projects.

Income Rights and Control Rights. Some

researchers (Hart (1982) and (2001), Dewatripont

and Tirole (1985)) recognised that securities

allocate income rights and control

rights. Debtholders have a fixed first claim on

the firms income, and have liquidation

rights. Equityholders are residual claimants, and

have voting rights. Class discussion paper Hart

(2001)- What is the optimal allocation of control

and income rights between a single investor and a

manager? How effective are control rights when

there are different types of investors? Why do we

observe different types of outside investors-

what is the optimal contract?

Signalling Models of Capital Structure Assymetric

info Akerlofs (1970) Lemons Market. Akerlof

showed that, under assymetric info, only bad

things may be traded. His model- two car dealers

one good, one bad. Market does not know which is

which 50/50 probability. Good car (peach) is

worth 2000. Bad car (lemon) is worth

1000. Buyers only prepared to pay average price

1500. But Good seller not prepared to sell.

Only bad car remains. Price falls to

1000. Myers-Majuf (1984) securities may be

lemons too.

Asymmetric information and Signalling Models. -

managers have inside info, capital structure has

signalling properties. Ross (1977) -managers

compensation at the end of the period is

D debt level where bad firm goes

bankrupt. Result Good firm D gt D, Bad Firm D lt

D. Debt level D signals to investors whether the

firm is good or bad.

Myers-Majluf (1984). -managers know the true

future cashflow. They act in the interest of

initial shareholders.

Expected Value 190 305 New

investors 0 100 Old

Investors 190 205

Consider old shareholders wealth Good News Do

nothing 250. Good News Issue Equity Bad

News and do nothing 130.

Bad News and Issue equity

Old Shareholders payoffs Equilibrium

Issuing equity signals that the bad state will

occur. The market knows this - firm value

falls. Pecking Order Theory for Capital Structure

gt firms prefer to raise funds in this

order Retained Earnings/ Debt/ Equity.

Evidence on Capital structure and firm

value. Debt Issued - Value Increases. Equity

Issued- Value falls. However, difficult to

analyse, as these capital structure changes may

be accompanied by new investment. More promising

- Exchange offers or swaps. Class discussion

paper Masulis (1980)- Highly significant

Announcement effects 7.6 for leverage

increasing exchange offers. -5.4 for leverage

decreasing exchange offers.

- Practical Methods employed by Companies (See

Damodaran Campbell and Harvey). - Trade off models PV of debt and equity.
- Pecking order.
- Benchmarking.
- Life Cycle.

Increasing Debt?

time

Trade-off Versus Pecking Order.

- Empirical Tests.
- Multiple Regression analysis (firm size/growth

opportunities/tangibility of assets/profitability

.. - gt Relationship between profitability and

leverage (debt) positive gt trade-off. - Or negative gt Pecking order
- Why?
- China Reverse Pecking order

Capital Structure and Product Market Competition.

- Research has recognised that firms financial

decisions and product market decisions not made

in isolation. - How does competition in the product market affect

firms debt/equity decisions? - Limited liability models Debt softens

competition higher comp gt higher debt. - Predation models higher competition leads to

lower debt. (Why?)

Capital Structure and Takeovers

- Garvey and Hanka
- Waves of takeovers in US in 1980s/1990s.
- Increase in hostile takeovers gt increase in debt

as a defensive mechanism. - Decrease in hostile takeovers gt decrease in debt

as a defensive mechanism.

Garvey and Hanka (contiuned)

V

Trade-off Tax shields/effort levels/FCF/

efficiency/signalling Vs financial distress

D/E

D/E

Practical Capital Structure case study

Lecture 6 Dividend Policy

- Miller-Modigliani Irrelevance.
- Gordon Growth (trade-off).
- Signalling Models.
- Agency Models.
- Lintner Smoothing.
- Dividends versus share repurchases.
- Empirical examples

Early Approach.

- Three Schools of Thought-
- Dividends are irrelevant (MM).
- Dividends gt increase in stock prices

(signalling/agency problems). - Dividends gt decrease in Stock Prices

(negative signal non ve NPV projects left?). - 2 major hypotheses Free-cash flow versus

signalling

Important terminology

- Cum Div Share price just before dividend is

paid. - Ex div share price after dividend is paid lt Cum

div.

P

CD

CD

CD

ED

ED

ED

Time

Example

- A firm is expecting to provide dividends every

year-end forever of 10. The cost of equity is

10. - We are at year-end, and div is about to be paid.

Current market value of equity 10/0.1 10

110 - Div is paid. Now, current market value is
- V 10/0.1 100.
- So on

P

CD 110

CD

CD

ED 100

ED

ED

Time

Common Stock Valuation Model

- You are considering buying a share at price Po,

and expect to hold it one year before selling it

ex-dividend at price P1 cost of equity r.

What would the buyer be prepared to pay to you?

Therefore Continuing this process, and

re-substituting in (try it!), we obtain

Price today is discounted value of all future

dividends to infinity (fundamental value market

value).

Dividend Irrelevance (Miller-Modigliani)

- MM consider conditions under which dividends are

irrelevant. - Investors care about both dividends and capital

gains. - Perfect capital markets-
- No distorting taxes
- No transactions costs.
- No agency costs or assymetric info.

Dividend Irrelevance (MM) continued

- Intuition Investors care about total return

(dividends plus capital gains). - Homemade leverage argument
- Source and application of funds argument gt MM

assumed an optimal investment schedule over time

(ie firm invests in all ve NPV projects each

year).

Deriving MMs dividend irrelevance

- Total market value of our all-equity firm is

Sources Uses

Re-arranging

Substitute into first equation

At t 0,

Successive substitutions

- Current value of all-equity firm is present value

of operating cashflows less re-investment for all

the years (residual cashflow available to

shareholders) Dividends do not appear! - Assn firms make optimal investments each period

(firm invests in all ve NPV projects). - Firms balance divs and equity each period divs

higher than residual cashflow gt issue shares. - Divs lower than free cashflow repurchase shares.

Irrelevance of MM irrelevance (Deangelo and

Deangelo)

- MM irrelevance based on the idea that all cash

will be paid as dividend in the end (at time T). - Deangelo argues that even under PCM, MM

irrelevance can break down if firm never pays

dividend!

Irrelevance of MM irrelevance (continued)

- Consider an all-equity firm that is expected to

produce residual cashflows of 10 per year for 5

years. - Cost of equity 10.
- First scenario firm pays no dividends for the

first 4 years. Pays all of the cashflows as

dividends in year 5. - Now it is expected to pay none of the cashflows

in any year Vo 0 !

Breaking MMs Irrelevance

- MM dividend irrelevance theorem based on
- PCM
- No taxes
- No transaction costs
- No agency or asymmetric information problems.

Gordon Growth Model.

- MM assumed firms made optimal investments out of

current cashflows each year - Pay any divs it likes/ balanced with new

equity/repurchases. - What if information problems etc prevent firms

easliy going back to capital markets - Now, real trade-off between investment and

dividends?

Gordon Growth Model. Where does growth come

from?- retaining cashflow to re-invest.

Constant fraction, K, of earnings retained for

reinvestment. Rest paid out as dividend. Average

rate of return on equity r. Growth rate in

cashflows (and dividends) is g Kr.

Example of Gordon Growth Model.

How do we use this past data for valuation?

Gordon Growth Model

(Infinite Constant Growth Model). Let

18000

- Finite Supernormal Growth.
- Rate of return on Investment gt market required

return for T years. - After that, Rate of Return on Investment Market

required return.

If T 0, V Value of assets in place

(re-investment at zero NPV). Same if r

Examples of Finite Supernormal Growth.

T 10 years. K 0.1.

- Rate of return, r 12 for 10 years,then 10

thereafter.

B. Rate of return, r 5 for 10 years,then 10

thereafter.

Dividend Smoothing V optimal re-investment

(Fairchild 2003)

- Method-
- GG Model derive optimal retention/payout ratio
- gt deterministic time path for dividends, Net

income, firm values. - gt Stochastic time path for net income how can

we smooth dividends (see Lintner smoothing

later.)

Deterministic Dividend Policy.

- Recall
- Solving
- We obtain optimal retention ratio

Analysis of

- If
- If with
- Constant r over time gt Constant K over

time.

Deterministic Case (Continued).

- Recursive solution
- gt signalling equilibria.
- Shorter horizon gt higher dividends.

When r is constant over time, K is constant. Net

Income, Dividends, and firm value evolve

deterministically.

Stochastic dividend policy.

- Future returns on equity normally and

independently distributed, mean r. - Each period, K is as given previously.
- Dividends volatile.
- But signalling concerns smooth dividends.
- gt buffer from retained earnings.

Agency problems

- Conflicts between shareholders and debtholders

risk-shifting high versus low dividends gt high

divs gt credit rating of debt - Conflicts between managers and shareholders

Jensens FCF, Easterbrook.

Are Dividends Irrelevant? - Evidence higher

dividends gt higher value. - Dividend irrelevance

freely available capital for reinvestment. -

If too much dividend, firm issued new shares. -

If capital not freely available, dividend policy

may matter. C. Dividend Signalling - Miller and

Rock (1985). NCF NS I DIV Source

Uses. DIV - NS NCF - I. Right hand side

retained earnings. Left hand side - higher

dividends can be covered by new shares.

Div - NS - E (Div - NS) NCF - I - E (NCF - I)

NCF - E

( NCF). Unexpected dividend increase - favourable

signal of NCF.

E(Div - NS) E(NCF - I) 300. Date 1

Realisation Firm B Div - NS - E (Div - NS)

500 NCF - E ( NCF). Firm A Div - NS - E (Div

- NS) -500 NCF - E ( NCF).

Dividend Signalling Models.

- Bhattacharya (1979)
- John and Williams (1985)
- Miller and Rock (1985)
- Ofer and Thakor (1987)
- Fuller and Thakor (2002).
- Fairchild (2009/10).
- Divs credible costly signals Taxes or borrowing

costs.

Competing Hypotheses.

- Dividend Signalling hypothesis Versus Free

Cashflow hypothesis. - Fuller and Thakor (2002 2008) Consider

asymmetric info model of 3 firms (good, medium,

bad) that have negative NPV project available - Divs used as a) a positive signal of income, and

b) a commitment not to take ve NPV project

(Jensens FCF argument). - Both signals in the same direction (both ve)

Signalling, FCF, and Dividends. Fuller and Thakor

(2002)

- Signalling Versus FCF hypotheses.
- Both say high dividends gt high firm value
- FT derive a non-monotonic relationship between

firm quality and dividends.

Divs

Firm Quality

Fairchild (2009, 2010)

- Signalling Versus FCF hypotheses.
- But, in contrast to Fuller and Thakor, I

consider ve NPV project. - Real conflict between high divs to signal current

income, and low divs to take new project. - Communication to market/reputation.

Cohen and Yagil

- New agency cost firms refusing to cut dividends

to invest in ve NPV projects. - Wooldridge and Ghosh
- 6 roundtable discussions of CF.

Agency Models.

- Jensens Free Cash Flow (1986).
- Stultzs Free Cash Flow Model (1990).
- Easterbrook.
- Fairchild (2009/10) Signalling moral hazard.

Behavioural Explanation for dividends

- Self-control.
- Investors more disciplined with dividend income

than capital gains. - Mental accounting.
- Case study from Shefrin.
- Boyesen case study.

D. Lintner Model. Managers do not like big

changes in dividend (signalling). They smooth

them - slow adjustment towards target payout

rate.

K is the adjustment rate. T is the target payout

rate.

Using Dividend Data to analyse Lintner Model. In

Excel, run the following regression

The parameters give us the following

information, a 0, K 1 b, T c/ (1 b).

Dividends and earnings.

- Relationship between dividends, past, current and

future earnings. - Regression analysis/categorical analysis.

Dividends V Share Repurchases.

- Both are payout methods.
- If both provide similar signals, mkt reaction

should be same. - gt mgrs should be indifferent between dividends

and repurchases.

Dividend/share repurchase irrelevance

- Misconception (among practitioners) that share

repurchasing can create value by spreading

earnings over fewer shares (Kennon). - Impossible in perfect world
- Fairchild (JAF).

Dividend/share repurchase irrelevance (continued)

- Fairchild JAF (2006)
- gt popular practitioners website argues share

repurchases can create value for non-tendering

shareholders. - Basic argument existing cashflows/assets spread

over fewer shares gt P !!! - Financial Alchemy !!!

The Example.

- Kennon (2005) Eggshell Candies Inc
- Mkt value of equity 5,000,000.
- 100, 000 shares outstanding
- gt Price per share 50.
- Profit this year 1,000,000.
- Mgt upset same amount of candy sold this year as

last growth rate 0 !!!

Eggshell example (continued)

- Executives want to do something to make

shareholders money after the disappointing

operating performance - gt One suggests a share buyback.
- The others immediately agree !
- Company will use this years 1,000,000 profit to

but stock in itself.

Eggshell example (continued)

- 1m dollars used to buy 20,000 shares (at 50 per

share). Shares destroyed. - gt 80,000 shares remain.
- Kennon argues that, instead of each share being

0.001 (1/100,000) of the firm, it is now .00125

of the company (1/80) - You wake up to find that P from 50 to 62.50.

Magic!

Kennon quote

- When a company reduces the amount of shares

outstanding, each of your shares becomes more

valuable and represents a greater of equity in

the company It is possible that someday there

may be only 5 shares of the company, each worth

one million dollars. - Fallacy! CF no such thing as a free lunch!

MM Irrelevance applied to Eggshell example

At beginning of date 0

At end of date 0, with N0 just achieved, but

still in the business (not yet paid out as

dividends or repurchases

Eggshell figures

Cost of equity will not change only way to

increase value per share is to improve companys

operating performance, or invest in new positive

NPV project. Repurchasing shares is a zero NPV

proposition (in a PCM). Eggshell has to use the

1,000,000 profit to but the shares.

Eggshell irrelevance (continued)

- Assume company has a new one-year zero NPV

project available at the end of date 0. - 1. Use the profit to Invest in the project.
- 2. Use the profit to pay dividends, or
- 3. Use the profit to repurchase shares.

Eggshell (continued)

1.

2.

Ex div

Each year end cum div 50, ex div 40

3.

Long-term effects of repurchase

- See tables in paper
- Share value pre-repurchase 5,000,000 each

year. - Share value-post repurchase each year

4,000,000 - Since number of shares reducing, P .by 25, but

this equals cost of equity. - And is same as investing in zero NPV project.

Conclusion of analysis

- In PCM, share repurchasing cannot increase share

price (above a zero NPV investment) by merely

spreading cashflows over smaller number of

shares. - Further, if passing up positive NPV to

repurchase, not optimal! - Asymmetric info repurchases gt positive signals.
- Agency problems FCF.
- Market timing.
- Capital structure motives.

Dividend/share repurchase irrelevance

- See Fairchild (JAF 2005)
- Kennons website

Evidence.

- Mgrs think divs reveal more info than repurchases

(see Graham and Harvey Payout policy. - Mgrs smooth dividends/repurchases are volatile.
- Dividends paid out of permanent

cashflow/repurchases out of temporary cashflow.

Motives for repurchases (Wansley et al, FM

1989).

- Dividend substitution hypothesis.
- Tax motives.
- Capital structure motives.
- Free cash flow hypothesis.
- Signalling/price support.
- Timing.
- Catering.

Repurchase signalling.

- Price Support hypothesis Repurchases signal

undervaluation (as in dividends). - But do repurchases provide the same signals as

dividends?

Repurchase signalling (Chowdhury and Nanda

Model RFS 1994)

- Free-cash flow gt distribution as commitment.
- Dividends have tax disadvantage.
- Repurchases lead to large price increase.
- So, firms use repurchases only when sufficient

undervaluation.

Open market Stock Repurchase Signalling McNally,

1999

- Signalling Model of OM repurchases.
- Effect on insiders utility.
- If do not repurchase, RA insiders exposed to more

risk. - gt Repurchase signals
- a) Higher earnings and higher risk,
- b) Higher equity stake gt higher earnings.

Repurchase Signalling Isagawa FR 2000

- Asymmetric information over mgrs private

benefits. - Repurchase announcement reveals this info when

project is ve NPV. - Repurchase announcement is a credible signal,

even though not a commitment.

Costless Versus Costly Signalling Bhattacharya

and Dittmar 2003

- Repurchase announcement is not commitment.
- Costly signal Actual repurchase separation of

good and bad firm. - Costless (cheap-talk) Announcement without

repurchasing. Draws analysts attention. - Only good firm will want this

Repurchase timing

- Evidence repurchase timing (buying shares

cheaply. - But market must be inefficient, or investors

irrational. - Isagawa.
- Fairchild and Zhang.

Repurchases and irrational investors. Isagawa 2002

- Timing (wealth-transfer) model.
- Unable to time market in efficient market with

rational investors. - Assumes irrational investors gt market does not

fully react. - Incentive to time market.
- Predicts long-run abnormal returns

post-announcement.

Repurchase Catering.

- Baker and Wurgler dividend catering
- Fairchild and Zhang dividend/repurchase

catering, or re-investment in positive NPV

project.

Competing Frictions Model From Lease et al

Agency Costs

Taxes

Low Payout

High Payout

Low Payout

High Payout

Asymmetric Information

High Payout

Low Payout

Dividend Cuts bad news?

- Fairchilds 2009/10 article.
- Wooldridge and Ghoshgt
- ITT/ Gould
- Right way and wrong way to cut dividends.
- Other cases from Fairchilds article.
- Signalling/FCF hypothesis.
- FCF agency cost cutting div to take ve NPV

project. - New agency cost Project foregone to pay high

dividends. - Communication/reputation important!!

Lecture 9 Venture Capital/private equity

- Venture capitalists typically supply start-up

finance for new entrepreneurs. - VCs objective help to develop the venture over

5 7 years, take the firm to IPO, and make large

capital gains on their investment. - In contrast, private equity firms invest in later

stage public companies to take them private.

Private Equity.

- PE firms generally buy poorly performing

publically listed firms. - Take them private
- Improve them (turn them around).
- Hope to float them again for large gains
- Our main focus in this course is venture capital,

But will look briefly at PE later. - Theory of private equity turnarounds plus PE

leverage article, plus economics of PE articles.

Venture capitalists

- Venture capitalists provide finance to start-up

entrepreneurs - New, innovative, risky, no track-record
- Hence, these Es have difficulty obtaining finance

from banks or stock market - VCs more than just investors
- Provide value-adding services/effort
- Double-sided moral hazard

Venture capital process

- Investment appraisal stage seeking out good

entrepreneurs/business plans VC overconfidence? - Financial contracting stage negotiate over

cashflow rights and control rights. - Performance stage both E and VC exert

value-adding effort double-sided moral hazard. - Ex post hold-up/renegotiation stage? Double sided

moral hazard - gt exit IPO/trade sale gt capital gains (IRR)

VC process (continued)

- VCs invest for 5-7 years.
- VCs invest in a portfolio of companies

anticipate that some will be highly successful,

some will not - gt attention model of Gifford.

C. Venture Capital Financing

- Active Value-adding Investors.
- Double-sided Moral Hazard problem.
- Asymmetric Information.
- Negotiations over Cashflows and Control Rights.
- Staged Financing
- Remarkable variation in contracts.

Features of VC financing.

- Bargain with mgrs over financial contract (cash

flow rights and control rights) - VCs active investors provide value-added

services. - Reputation (VCs are repeat players).
- Double-sided moral hazard.
- Double-sided adverse selection.

Kaplan and Stromberg

- Empirical analysis, related to financial

contract theories.

Financial Contracts.

- Debt and equity.
- Extensive use of Convertibles.
- Staged Financing.
- Control rights (eg board control/voting rights).
- Exit strategies well-defined.

Fairchild (2004)

- Analyses effects of bargaining power, reputation,

exit strategies and value-adding on financial

contract and performance. - 1 mgr and 2 types of VC.
- Success Probability depends on effort

gt VCs value-adding.

where

Fairchilds (2004) Timeline

- Date 0 Bidding Game VCs bid to supply finance.
- Date 1 Bargaining game VC/E bargain over

financial contract (equity stakes). - Date 2 Investment/effort level stage.
- Date 3 Renegotiation stage hold-up problems
- Date 4 Payoffs occur.

Bargaining stage

- Ex ante Project Value
- Payoffs

Optimal effort levels for given equity stake

Optimal equity proposals.

- Found by substituting optimal efforts into

payoffs and maximising. - Depends on relative bargaining power, VCs

value-adding ability, and reputation effect. - Eg E may take all of the equity.
- VC may take half of the equity.

Payoffs

E

VC

Equity Stake

0.5

Es choice of VC or angel-financing

- Explain Angels.
- Complementary efforts
- Ex post hold-up/stealing threat
- Fairchilds model

To come

- Legal effects (Fairchild and Yiyuan)
- gt Allen and Song
- gt Botazzi et al
- Negative reciprocity/retaliation.

Ex post hold-up threat

- VC power increases with time.
- Exit threat (moral hazard).
- Weakens entrepreneur incentives.
- Contractual commitment not to exit early.
- gt put options.

Other Papers

- Casamatta Joint effort VC supplies investment

and value-adding effort. - Repullo and Suarez Joint efforts staged

financing. - Bascha Joint efforts use of convertibles

increased managerial incentives.

Complementary efforts (Repullo and Suarez).

- Lecture slides to follow

Control Rights.

- Gebhardt.
- Lecture slides to follow

Asymmetric Information

- Houben.
- PCP paper.
- Tykvova (lock-in at IPO to signal quality).

Es choice of financier

- VC or bank finance (Ueda, Bettignies and

Brander). - VC or Angel (Chemmanur and Chen, Fairchild).

Fairness Norms and Self-interest in VC/E

Contracting A Behavioral Game-theoretic Approach

- Existing VC/E Financial Contracting Models assume

narrow self-interest. - Double-sided Agency problems (both E and VC exert

Value-adding Effort) (Casamatta JF 2003, Repullo

and Suarez 2004, Fairchild JFR 2004). - Procedural Justice Theory Fairness and Trust

important. - No existing behavioral Game theoretic models of

VC/E contracting.

My Model

- VC/E Financial Contracting, combining

double-sided Moral Hazard (VC and E shirking

incentives) and fairness norms. - 2 stages VC and E negotiate financial contract.
- Then both exert value-adding efforts.

How to model fairness? Fairness Norms.

- Fair VCs and Es in society.
- self-interested VCs and Es in society.
- Matching process one E emerges with a business

plan. Approaches one VC at random for finance. - Players cannot observe each others type.

Timeline

- Date 0 VC makes ultimatum offer of equity stake

to E - Date 1 VC and E exert value-adding effort in

running the business - Date 2 Success Probability
- gt income R.
- Failure probability
- gtincome zero

- Expected Value of Project
- Represents VCs relative ability (to E).

Fairness Norms

- Fair VC makes fair (payoff equalising) equity

offer - Self-interested VC makes self-interested

ultimatum offer - E observes equity offer. Fair E compares equity

offer to social norm. Self-interested E does not,

then exerts effort.

Expected Payoffs

If VC is fair, by definition,

Solve by backward induction

- If VC is fair
- Since
- for both E

types. - gt
- gt

VC is fair continued.

- Given

Optimal Effort Levels

Fair VCs equity proposal (equity norm)

VC is self-interested

- From Equation (1), fair Es optimal effort

Self-interested VCs optimal Equity proposal

- Substitute players optimal efforts into V PR,

and then into (1) and (2). Then, optimal equity

proposal maximises VCs indirect payoff gt

Examples

- VC has no value-adding ability (dumb money) gt
- gt
- r 0 gt
- r gt 1 ,

Example 2

- VC has equal ability to E
- gt
- r 0 gt
- r gt 1 ,
- We show that
- as r gt 1

Table 1.

Graph

Table of venture performance

Graph of Venture Performance.

Future Research.

- Dynamic Fairness Gameex post opportunism (Utset

2002). - Complementary Efforts.
- Trust Games.
- Experiments.
- Control Rights.

Private Equity

- JCF paper slides to follow
- PE and leverage slides to follow.

Lecture 10 Introduction to Behavioural

Corporate Finance.

- Standard Finance - agents are rational and

self-interested. - Behavioural finance agents irrational

(Psychological Biases). - Irrational Investors Overvaluing assets-

internet bubble? Market Sentiment? - Irrational Managers- effects on investment

appraisal? - Effects on capital structure?
- Herding.

Development of Behavioral Finance I.

- Standard Research in Finance Assumption Agents

are rational self-interested utility maximisers. - 1955 Herbert Simon Bounded Rationality Humans

are not computer-like infinite information

processors. Heuristics. - Economics experiments Humans are not totally

self-interested.

Development of Behavioral Finance II.

- Anomalies Efficient Capital Markets.
- Excessive volatility.
- Excessive trading.
- Over and under-reaction to news.
- 1980s Werner DeBondt coined the term

Behavioral Finance. - Prospect Theory Kahnemann and Tversky 1980s.

Development III

- BF takes findings from psychology.
- Incorporates human biases into finance.
- Which psychological biases? Potentially infinite.
- Bounded rationality/bounded selfishness/bounded

willpower. - Bounded rationality/emotions/social factors.

Potential biases.

- Overconfidence/optimism
- Regret.
- Prospect Theory/loss aversion.
- Representativeness.
- Anchoring.
- Gamblers fallacy.
- Availability bias.
- Salience.. Etc, etc.

Focus in Literature

- Overconfidence/optimism
- Prospect Theory/loss aversion.
- Regret.

Prospect Theory.

U

Risk-averse in gains

W

Eg Disposition Effect Sell winners too

quickly. Hold losers too long.

Risk-seeking in losses

Overconfidence.

- Too much trading in capital markets.
- OC leads to losses?
- But Kyle gt OC traders out survive and

outperform well-calibrated traders.

Behavioral Corporate Finance.

- Much behavioral research in Financial Markets.
- Not so much in Behavioral CF.
- Relatively new Behavioral CF and Investment

Appraisal/Capital Budgeting/Dividend decisions.

- Forms of Irrationality.
- Bounded Rationality (eg Mattson and Weibull 2002,

Stein 1996). - - Limited information Information processing

has a cost of effort. - - Investors gt internet bubble.
- b) Behavioural effects of emotions
- -Prospect Theory (Kahneman and Tversky 1997).
- Regret Theory.
- Irrational Commitment to Bad Projects.
- Overconfidence.
- C) Catering investors like types of firms (eg

high dividend).

- Bounded rationality (Mattson and Weibull 2002).
- Manager cannot guarantee good outcome with

probability of 1. - Fully rational gt can solve a maximisation

problem. - Bounded rationality gt implementation mistakes.
- Cost of reducing mistakes.
- Optimal for manager to make some mistakes!
- CEO, does not carefully prepare meetings,

motivate and monitor staff gt sub-optimal actions

by firm.

- Regret theory and prospect theory (Harbaugh

2002). - -Risky decision involving skill and chance.
- managers reputation.
- Prospect theory People tend to favour low

success probability projects than high success

probability projects. - Low chance of success failure is common but

little reputational damage. - High chance of success failure is rare, but more

embarrassing. - Regret theory Failure to take as gamble that

wins is as embarrassing as taking a gamble that

fails. - gt Prospect regret theory gt attraction for low

probability gambles.

- Irrational Commitment to bad project.
- Standard economic theory sunk costs should be

ignored. - Therefore- failing project abandon.
- But mgrs tend to keep project going- in hope

that it will improve. - Especially if manager controlled initial

investment decision. - More likely to abandon if someone else took

initial decision.

- Real Options and behavioral aspects of ability to

revise (Joyce 2002). - Real Options Flexible project more valuable than

an inflexible one. - However, managers with an opportunity to revise

were less satisfied than those with standard

fixed NPV.

- Overconfidence and the Capital Structure (Heaton

2002). - -Optimistic manager overestimates good state

probability. - Combines Jensens free cashflow with Myers-Majluf

Assymetric information. - Jensen- free cashflow costly mgrs take ve NPV

projects. - Myers-Majluf- Free cashflow good enables mgs to

take ve NPV projects. - Heaton- Underinvestment-overinvestment trade-off

without agency costs or asymmetric info.

- Heaton (continued).
- Mgr optimism believes that market undervalues

equity My