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MN20211: Corporate Finance 2011/12:

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MN20211: Corporate Finance 2011/12: Revision: Investment Appraisal (NPV). Investment flexibility, Decision trees, Real Options. Revision: Portfolio Theory = CAPM – PowerPoint PPT presentation

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Title: MN20211: Corporate Finance 2011/12:


1
  • 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.

2
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.

3
First Topic Investment Appraisal
  • Brief revision of static NPV.
  • gt Flexibility
  • gt Decision trees
  • gt sensitivity analysis
  • gt Real Options

4
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?

5

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.
6
  • 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

7

Net Present Value

Perpetuities.
IRR gt
Take Project if NPV gt 0, or if IRR gt r.
8

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?

9

DO WE INVEST IN THIS NEW PROJECT?

NPV gt 0. COST OF CAPITAL (12) lt IRR (19.75).
10

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
11

CONFLICT BETWEEN APPRAISAL TECHNIQUES.

12

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.
13


COMPARING NPV AND IRR -2
NPV

Discount Rate
Impossible to find IRR!!! NPV exists!
14
  • 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?

15

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?
16
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

17
  • 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.

18
Production Stage Base Case
Date 1 NPV -1500
1517
19
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.
20
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).
21
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.
22
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.

23
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.
24
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!

25
  • 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.
26
Options Payoff
Profiles. Buying a Call Option.
Selling a put option.
Selling a Call Option.
Buying a Put Option.
27
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.

28
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.
29
Alternative option-pricing method
  • Black-Scholes
  • Continuous Distribution of share returns (not
    binomial)
  • Continuous time (rather than discrete time).

30
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).

31
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.

32
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.

33
Types of Real Option
  • Option to Delay (Timing Option).
  • Option to Expand (eg R and D).
  • Option to Abandon.

34
Option to Delay ( call option)
Value-creation

Project value
Investment in waiting (sunk)
35
Option to expand ( call option)
Value creation

Project value
Investment in initial project eg R and D (sunk)
36
Option to Abandon ( put option)
Project goes badly abandon for liquidation value.

Project value
37
Valuation of Real Options
  • Binomial Pricing Model
  • Black-Scholes formula

38
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.

39

Simplified Examples
  • Option to Expand (page 241 of RWJ)

If Successful
Expand
Build First Ice Hotel
Do not Expand
If unsuccessful
40

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?

41
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.

42
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.

43
  • 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.

44
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
45
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
46
Monte Carlo methods
  • BBQ grills example in RWJ.
  • Application to Qinetiq (article by Tony Bishop).

47
Use of Real Options in Practice

48


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
49
.
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)
50


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.
51

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)
52

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.
53

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.
54

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.

55

Capital Asset Pricing Model

Security Market Line.

56

Estimating Cost of Equity Using Regression
Analysis. We regress the firms past share price
returns against the market.

57


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.
58
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
59
Example
5005001000.
20
60 -20 40.
500.
Value of Debt
Original Equity
50040 540
New Equity
20
1000601060.
Total Firm Value
60
Positive NPV Effect on share price. Assume all
equity.
61
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).
62
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
63
K
K
Without Taxes
With Taxes
D/E
D/E
V
V
D/E
D/E
64
Examples
  • Firm X
  • Henderson Case study

65
  • 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
66
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.
67
Combining Tax Relief and Debt Capacity
(Traditional View).
K
V
D/E
D/E
68
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.
69
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
70
Jensen and Meckling (1976)
V
Slope -1
V
A
V1
B
B1
If manager owns all of the equity, equilibrium
point A.
71
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.
72
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.
73
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?
74
Issuing debt increases the managers fractional
ownership gt Firm value rises. -But Debt and
risk-shifting.
75
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
76
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).
77
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)?
78
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.
79
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.
80
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.
81
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.
82
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?
83
 
84
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.
85
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.
86
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
87
Consider old shareholders wealth Good News Do
nothing 250. Good News Issue Equity Bad
News and do nothing 130.
Bad News and Issue equity
88
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.
89
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.
90
  • 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
91
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

92
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?)

93
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.

94
Garvey and Hanka (contiuned)
V
Trade-off Tax shields/effort levels/FCF/
efficiency/signalling Vs financial distress

D/E
D/E
95
Practical Capital Structure case study

96
Lecture 6 Dividend Policy
  • Miller-Modigliani Irrelevance.
  • Gordon Growth (trade-off).
  • Signalling Models.
  • Agency Models.
  • Lintner Smoothing.
  • Dividends versus share repurchases.
  • Empirical examples

97
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

98
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
99
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

100

P

CD 110
CD
CD
ED 100
ED
ED
Time
101
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?
102

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).
103
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.

104
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).

105
Deriving MMs dividend irrelevance
  • Total market value of our all-equity firm is

Sources Uses
106
Re-arranging
Substitute into first equation
At t 0,
107
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.

108
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!

109
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 !

110
Breaking MMs Irrelevance
  • MM dividend irrelevance theorem based on
  • PCM
  • No taxes
  • No transaction costs
  • No agency or asymmetric information problems.

111
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?

112
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.

113
Example of Gordon Growth Model.
How do we use this past data for valuation?
114
Gordon Growth Model
(Infinite Constant Growth Model). Let

18000
115
  • 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
116
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.
117
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.)

118
Deterministic Dividend Policy.
  • Recall
  • Solving
  • We obtain optimal retention ratio

119
Analysis of
  • If
  • If with
  • Constant r over time gt Constant K over
    time.

120
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.
121
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.

122
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.

123
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.
124
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).
125
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.

126
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)

127
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
128
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.

129
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.

130
Agency Models.
  • Jensens Free Cash Flow (1986).
  • Stultzs Free Cash Flow Model (1990).
  • Easterbrook.
  • Fairchild (2009/10) Signalling moral hazard.

131
Behavioural Explanation for dividends
  • Self-control.
  • Investors more disciplined with dividend income
    than capital gains.
  • Mental accounting.
  • Case study from Shefrin.
  • Boyesen case study.

132
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.
133
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).
134
Dividends and earnings.
  • Relationship between dividends, past, current and
    future earnings.
  • Regression analysis/categorical analysis.

135
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.

136
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).

137
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 !!!

138
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 !!!

139
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.

140
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!

141
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!

142
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
143
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.
144
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.

145
Eggshell (continued)
1.
2.
Ex div
Each year end cum div 50, ex div 40
3.
146
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.

147
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.

148
Dividend/share repurchase irrelevance
  • See Fairchild (JAF 2005)
  • Kennons website

149
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.

150
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.

151
Repurchase signalling.
  • Price Support hypothesis Repurchases signal
    undervaluation (as in dividends).
  • But do repurchases provide the same signals as
    dividends?

152
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.

153
Open market Stock Repurchase SignallingMcNally,
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.

154
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.

155
Costless Versus Costly SignallingBhattacharya
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

156
Repurchase timing
  • Evidence repurchase timing (buying shares
    cheaply.
  • But market must be inefficient, or investors
    irrational.
  • Isagawa.
  • Fairchild and Zhang.

157
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.

158
Repurchase Catering.
  • Baker and Wurgler dividend catering
  • Fairchild and Zhang dividend/repurchase
    catering, or re-investment in positive NPV
    project.

159
Competing Frictions ModelFrom Lease et al
Agency Costs
Taxes

Low Payout
High Payout
Low Payout
High Payout
Asymmetric Information
High Payout
Low Payout
160
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!!

161
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.

162
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.

163
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

164
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)

165
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.

166
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.

167
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.

168
Kaplan and Stromberg
  • Empirical analysis, related to financial
    contract theories.

169
Financial Contracts.
  • Debt and equity.
  • Extensive use of Convertibles.
  • Staged Financing.
  • Control rights (eg board control/voting rights).
  • Exit strategies well-defined.

170
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
171
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.

172
Bargaining stage
  • Ex ante Project Value
  • Payoffs

173
Optimal effort levels for given equity stake

174
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.

175
Payoffs
E
VC
Equity Stake
0.5
176
Es choice of VC or angel-financing
  • Explain Angels.
  • Complementary efforts
  • Ex post hold-up/stealing threat
  • Fairchilds model

177
To come
  • Legal effects (Fairchild and Yiyuan)
  • gt Allen and Song
  • gt Botazzi et al
  • Negative reciprocity/retaliation.

178
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.

179
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.

180
Complementary efforts (Repullo and Suarez).
  • Lecture slides to follow

181
Control Rights.
  • Gebhardt.
  • Lecture slides to follow

182
Asymmetric Information
  • Houben.
  • PCP paper.
  • Tykvova (lock-in at IPO to signal quality).

183
Es choice of financier
  • VC or bank finance (Ueda, Bettignies and
    Brander).
  • VC or Angel (Chemmanur and Chen, Fairchild).

184
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.

185
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.

186
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.

187
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

188
  • Expected Value of Project
  • Represents VCs relative ability (to E).

189
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.

190
Expected Payoffs

If VC is fair, by definition,
191
Solve by backward induction
  • If VC is fair
  • Since
  • for both E
    types.
  • gt
  • gt

192
VC is fair continued.
  • Given

Optimal Effort Levels
Fair VCs equity proposal (equity norm)
193
VC is self-interested
  • From Equation (1), fair Es optimal effort

194
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

195
Examples
  • VC has no value-adding ability (dumb money) gt
  • gt
  • r 0 gt
  • r gt 1 ,

196
Example 2
  • VC has equal ability to E
  • gt
  • r 0 gt
  • r gt 1 ,
  • We show that
  • as r gt 1

197
Table 1.
198
Graph
199
Table of venture performance
200
Graph of Venture Performance.
201
Future Research.
  • Dynamic Fairness Gameex post opportunism (Utset
    2002).
  • Complementary Efforts.
  • Trust Games.
  • Experiments.
  • Control Rights.

202
Private Equity
  • JCF paper slides to follow
  • PE and leverage slides to follow.

203
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.

204
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.

205
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.

206
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.

207
Potential biases.
  • Overconfidence/optimism
  • Regret.
  • Prospect Theory/loss aversion.
  • Representativeness.
  • Anchoring.
  • Gamblers fallacy.
  • Availability bias.
  • Salience.. Etc, etc.

208
Focus in Literature
  • Overconfidence/optimism
  • Prospect Theory/loss aversion.
  • Regret.

209
Prospect Theory.
U
Risk-averse in gains
W
Eg Disposition Effect Sell winners too
quickly. Hold losers too long.
Risk-seeking in losses
210
Overconfidence.
  • Too much trading in capital markets.
  • OC leads to losses?
  • But Kyle gt OC traders out survive and
    outperform well-calibrated traders.

211
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.

212
  • 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).

213
  • 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.

214
  • 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.

215
  • 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.

216
  • 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.

217
  • 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.

218
  • Heaton (continued).
  • Mgr optimism believes that market undervalues
    equity My
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