1 MN50324: Corporate Finance 2011/12: 1.Investment flexibility, Decision trees, Real Options...

transcript

MN50324: Corporate Finance 2011/12:

1. Investment flexibility, Decision trees, Real Options

2. Asymmetric Information and Agency Theory

3. Capital Structure and Value of the Firm.

4. Optimal Capital Structure - Agency Costs, Signalling

5. Dividend policy/repurchases

6. Mergers and Acquisitions/corporate control

7. Venture Capital/Private Equity/hedge funds

8. Behavioural Corporate Finance.

9. Emotional Corporate Finance

10. Revision.

1: Investment Flexibility/ Real options.

• Reminder of Corporation’s Objective : Take projects that increase shareholder wealth (Value-adding projects).

• Investment Appraisal Techniques: NPV, IRR, Payback, ARR

• Decision trees• Real Options• Game-theory approach!

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.

$000 Year 1 Year 2 - 6

Revenues 6000Variable Costs -3000Fixed Costs -1791Depreciation -300

Pretax Profit 909Tax (34%) -309

Net Profit 600Cashflow 900

Initial Investment -1500

Date 1 NPV = -1500 +

2 )15.1(

= 1517

Production Stage: Base Case

Decision Tree.

Do Not Test

Success

Failure

Invest

Do not Invest

Invest

NPV = 1517

NPV = 0

NPV = -3611

Date 0: -$100 Date 1: -1500

Solve backwards: If the tests are successful, SEC should invest, since 1517 > 0.

If tests are unsuccessful, SEC should not invest, since 0 > -3611.

P=0.75

P=0.25

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 + 15.1

1138 = $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.

NPV Expected Pessimistic or Best Optimistic

Market Size -1802 1517 8154Market Share -696 1517 5942Price 853 1517 2844Variable Cost 189 1517 2844Fixed Cost 1295 1517 1628Investment 1208 1517 1903

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 digression: Financial Options (revision)

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 Spencer’s 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.

.0,0,0,02

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.

WSelling a put option.

Selling a Call Option. Buying a Put Option.

Pricing Call Options – Binomial Approach.

1- q dS=13.40

uS=24.00

S = £20. q=0.5. u=1.2. 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 => 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.

Cu = 3

Since hedge portfolio is riskless:

.))(1( uf mcuSmcSr

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 corporation’s 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)

Project value

Value-creation

Investment in waiting:

(sunk)

Option to expand (= call option)

Project value

Value creation

Investment in initial project: eg R and D (sunk)

Option to Abandon ( = put option)

Project value

Project goes badly: abandon for liquidation value.

Valuation of Real Options

• Binomial Pricing Model

• Black-Scholes formula

Value of a Real Option

• A Project’s 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: => Real Option element may be high.

Comparing NPV with Decision Trees and Real Options (revision)

t tWACC

FCFEINPV

•Dixit and Pyndyck (1994): Simple Example: Decide today to:

•Invest in a machine at end of year: I = £1,600.

•End of year: project will be worth 300 (good state forever) or 100 (bad state forever) with equal probability.

•WACC = 10%.

•Should we invest?

Dixit and Pyndyck example

• Either pre-commit today to invest in a machine that will cost £1,600 at year end.

• Or defer investment to wait and see.

• Good state of nature (P = 0.5): product will be worth £300.

• Bad state of nature (P = 0.5): product will be worth £100.

NPV of project under pre-commitment

6001.0

200200600,1

)100300(5.0)100300(5.0600,1

t tNPV

5.5451.1

6000 NPV

Value with the option to defer

• Suppose cost of investment goes up to £1,800 if we decide to wait (so, cost of waiting).

• Year end good state:

• Year-end bad state:1500

3003001800 NPV

7001.0

1001001800 NPV

Value with option to defer (continued)

• 80.681

)1500(5.00 NPV

Therefore, deferring adds value of £136.30.

Increasing uncertainty; eg price in good or bad state = 400 or zero (rather than 300 or 100)

=> Right to defer becomes more valuable.

Comparing NPV, decision trees and Real Options (continued)

600,11.0

300300

Invest

0.5 600,11.0

100300

Pre-commitment to invest

Comparing NPV, decision trees and Real Options (continued)

V= 681.8

Max{1500,0}

Max {-700,0}

Don’t Invest

Invest

Value with the option to defer

Simplified Examples

• Option to Expand (page 241 of RWJ)

Build First Ice

If Successful

Expand

If unsuccessful

Do not Expand

• 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)

Option to expand (continued)

• Given success, the E will expand to 10 hotels

• =>

• 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.

• => NPV = - 2m. Reject?

• But abandon if failure =>

• NPV = 50% x 18m + 50% x -12m/1.20

• = 2.17m

• Accept.

Real Option analysis and Game theory

• So far, analysis has assumed that firm operates in isolation.

• No product market competition

• Safe to delay investment to see what happens to economy.

• In real-world, competitors (vultures)

• Delay can be costly!

Option to delay and Competition

• Smit and Ankum model (1993)

• Option to defer an investment in face of competition

• Combines real options and Game-theory.

• Binomial real options model: lends itself naturally to sequential game approach (see exercise 1).

Option to delay and competition (continued)

• Smit and Ankum incorporate game theory (strategic behaviour) into the binomial pricing model of Cox, Ross and Rubinstein (1979).

• 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).

Policy implications of Smit and Ankum analysis.

• How can firm gain value by delaying (option to delay) in face of competition?

• Protecting Economic Rent: Innovation, barriers to entry, product differentiation, patents.

• Firm needs too identify extent of competitive advantage.

Real Options and Games (Smit and Trigeorgis 2006)

• Game theory applied to real R and D/innovation cases:

• Expanded (strategic) NPV = direct (passive) NPV + Strategic (commitment) value + flexibility Value.

• Innovation race between Philips and Sony => Developing CD technology.

P\S Wait Invest

Wait 300, 300 0, 400

Invest 400, 0 200, 200

Each firm’s dominant strategy: invest early: => Prisoner’s dilemma.

How to collaborate/coordinate on wait, wait?

Asymmetric Innovation Race/Pre-emption

• Asymmetry: P has edge in developing technology, but limited resources.

• S tries to take advantage of this resource weakness• Each firm chooses effort intensity in innovation• Low effort: technology follower, but more

flexibility in bad states• High effort: technology leader, higher

development costs, more risk in bad state.

P\S Low effort High

Low 200, 100 10, 200

High 100, 10 -100, -100

“Grab the dollar” game

Sequential Investment Game

High effort

Low effort

High effort

Low effort

-100m,-100m

100m, 10m

10m, 200m

200m, 100m

European Airport Expansion Case: Real Options Game (Smit 2003)

Two-stage Investment Game (Imai and Watanabe 2004)

Option to delay versus competition: Incorporating contracts/ Legal system (RF)

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: Incorporating contracts/ Legal system

(continued)Firm 1\ Firm 2 Invest early Delay

Invest early NPV = 500,NPV = 500 NPV = 700- 300, NPV = 300+300

Delay NPV = 300+300, NPV = 700-300

NPV = 600,NPV = 600

Use of Real Options in Practice

• In practice, NPV not always used:Why Not?.• -Agency (incentive) problems: eg Short-term compensation

schemes => Payback.• Behavioural:-• Managers prefer % figures => IRR, ARR• Managers don’t understand NPV/ Complicated Calculations.• Payback simple to calculate.• Other Behavioural Factors (see later section on Behavioural

Finance!!)• Increase in Usage of correct DCF techniques (Pike):• Computers.• Management Education.

Game-theoretic model of NPV.

• Israel and Berkovitch RFS 2004.

• NPV is seen as standard value-maximising technique.

• But IB’s game-theoretic approach considers the impact of agency and assymetric information problems

Israel and Berkovitch (continued)

• A firm consisting of two components:

• 1: Top management (Headquarters)

• 2. divisional managers (“the manager”).

• Objective of headquarters: Maximisation of shareholder value.

• Objective of manager: maximise her own utility.

Israel and Berkovitch (continued)

• HQ needs to design a monitoring and incentive mechanism to deal with these conflicting objectives.

• => capital allocation system specifying:

• A capital budgeting rule (eg NPV/IRR) and a wage compensation for divisional managers.

Israel and Berkovitch

• Paper demonstrates the ingredients of a game-theoretic approach.

• Players.

• Objectives (utility functions to maximise)

• Strategies.

• Payoffs.

2. Information Asymmetry/Agency Theory

• Chapter 12 CWS.

• We will see that info assymetry and agency theory play a large role in CF analysis.

• Investment appraisal, capital structure, dividend policy

• => Game theory

Game theory

• Players (eg managers/investors: or competing companies)

• Actions (eg invest in a project, issue debt, pay dividends etc)

• Strategies• Payoffs/ optimisation.• Equilibrium: eg good firm issues high debt, bad

firm issues low debt.• Or Good firm pays high dividends, bad firm pays

low dividends.

Information Asymmetry

• Insiders/managers better informed than investors about projects, prospects etc.

• Managerial actions (eg capital structure choices: debt/equity issues, dividends, repurchases) may reveal information to the market

• Signalling models of debt, dividends, repurchases

Asymmetric info/signalling models

• Typically, two types of firm: High quality/low quality.

• Type unobservable to outside investors• Manager of High quality firm would like to signal

his type to market.• Costly signals• Cheap-talk signals.• Eg level of investment, amount of debt, size of

dividend.

Pooling versus separating equilibria

• Separating equilibrium: good firm can separate for bad firm eg by higher debt

• Cost of signal: eg expected financial distress• Separation requires cost of signal => bad firm

cannot (or is unwilling) to mimic good firm’s debt level.

• Separation: outsiders can determine firm types• Pooling: outsiders cannot differentiate between the

two types

Corporate Finance: Signalling Models

• Based on models from Informational Economics.

• Eg Akerlof (1970): price signals of quality in used car market (mkt for Lemons!)

• Spence (1973): education as signals of skill in job market.

• Myers-Majluf (1984): equity-signalling model based on Akerlof’s Lemons market!

Major CF signalling models

• Signalling project quality with investment (Leland and Pyle 1977)

• Signalling firm quality with debt (Ross 1977)

• Signalling expected cashflows with dividends (Bhattacharya 1979)

• Signalling and the equity issue-invest decision (Myers-Majluf 1984)

Stock Split signalling

• Copeland and Brennan 1988

• Brennan and Hughes 1991.

• Debt/equity Heinkel 1982

CF and Agency Theory

• Standard CF statement: the firm aims to maximise shareholder wealth => NPV rule.

• But agency theory =>

• Separation of Ownership and control

• Principal/agent relationship

• Outside investors = Principal

• Manager = agent

Agency theory (contiuned)

• Manager self-interested.• he may takes private benefits (perks) out of the

firm• Invest in favourite (pet) projects: empire-builder

(eg rapid value-destroying growth => mergers?)• Effort-shirking• Capital structure/dividends may serve to align

managers’ and investors’ interests.

2. Cost of Capital/discount rate/investors’ required return.

• What discount rate to use in NPV/ valuation?

• Portfolio analysis => Investors’ required return as a compensation for risk

• => CAPM (capital asset pricing model) => cost of equity (risk-averse equity-holders’ required return): increases with risk.

Cost of Capital/discount rate/investors’ required return (continued).

• • Cost of debt (debt-holders’ required return).• Capital structure (mix of debt and equity).• => discount rate/cost of capital/investors’

required return=>

.*%*% ed KequityKdebtWACC

Example• New project: initial investment • Project expected to generate £150 per year forever

(perpetuity)• Kd=5%, Ke = 15% (Capital structure =50%

debt/50% equity)• Consider Market Value of firm’s debt = market value

of firms equity=> WACC = 10%.

50010.0

1501000 NPV

1000£I

Firm Valuation (CWS Chapter 14)

• Formula Approach for Valuing Companies

t0 t1 t2 tN

11 )1( ITEBIT

IIrTEBIT

ITEBIT

11 )1(N

t Ntt IIrTEBIT

Valuation of all-equity firm with growth

ITEBITV

)1( 1110

ITEBIT

ITEBITV

)1(...

Valuation of all-equity firm with growth (continued)

ITEBITV

10 )1(

•Present value of the firm is the sum of discounted cashflows from operations less new investments required for growth

•Fundamental Value (= market value? Efficient mkts/ BCF)

•Dividend policy (dividends versus investment for growth)

Valuation of all-equity firm with growth (continued)

10 )1(

)()1(t t

TEBITV

V0 = value of assets in place + value of future growth

Infinite constant growth model

))1(( TEBITKI tt

)1)(1(

))1(()1(

)1()1(

rKTEBIT

TEBITrKTEBIT

rITEBITTEBIT

11 )1)(1()1( t

t rKTEBITTEBIT

11 )1)(1()1( t

t gTEBITTEBIT

By substitution:

TEBITV

KTEBITV

)1)(1(

=> Gordon Growth Model:

Consider later in div policy lecture

3. Capital Structure.

Positive NPV project immediately increases current equity value (share price immediately goes up!)

oo EBV Pre-project announcement

New project: .IVNPV n INew capital (all equity)

Value of Debt oBIVE n 0

New Firm Value

Original equity holders

New equity

Example:

oo EBV =500+500=1000.

IVNPV n 60 -20 = 40.

oB = 500.

IVE n 0 = 500+40 = 540

I = 20

nVV =1000+60=1060.

Value of Debt

Original Equity

New Equity

Total Firm Value

Positive NPV: Effect on share price.

Assume all equity.

Market No of Price per Market No of Price per£K Value Shares Share Value Shares Share

Current 1000 1000 1 1040 1000 1.04

New Project 20 19 1.04

Project Income 60 1060 1019 1.04

Required Investment 20

NPV 40

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:

TNCFBTVV

Irrelevance Theorem: Without Tax, Firm Value is independent of the Capital Structure.

Note that ed KequitytKdebtWACC *%)1(*%

D/E D/E

Without Taxes With Taxes

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:

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).

D/E D/E

3: Optimal Capital Structure, Agency Costs, and Signalling.

Agency costs - manager’s 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 => lower share of firm’s profits for manager => he takes more perks => firm value

Issuing debt => he owns more equity => he takes less perks => firm value

Jensen and Meckling (1976)

If manager owns all of the equity, equilibrium point A.

Slope = -1

If manager owns half of the equity, he will got to point B if he can.

Slope = -1

Slope = -1/2

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.

Slope = -1

Slope = -1/2

Jensen and Meckling - Numerical Example.PROJECT PROJECTA B

EXPECTED INCOME 500 1000

MANAGER'S SHARE:100% 500 1000

VALUE OF PRIVATE 800 500BENEFITS

TOTAL WEALTH 1300 1500

MANAGER'S SHARE:50% 250 500

VALUE OF PRIVATE 800 500BENEFITS

TOTAL WEALTH 1050 1000

Manager issues 100% Debt.

Chooses Project B.

Manager issues some Debt and Equity.

Chooses Project A.

Optimal Solution: Issue Debt?

Issuing debt increases the manager’s fractional ownership => Firm value rises.

Debt and risk-shifting.

State 1 100 0 0.5

State 2 100 170 0.5

100 85

Values: Debt 50 25

Equity 50 60

OPTIMAL CAPITAL STRUCTURE.

Trade-off: Increasing equity => excess perks.

Increasing debt => potential risk shifting.

Optimal Capital Structure => max firm value.

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

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 < 100, low effort. V = 100. Manager keeps job.

b) If debt > 100: low effort, V < D => bankruptcy. Manager loses job.

So, high effort level => V = 500 > D. No bankruptcy => Manager keeps job.

High level of debt => 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.

=> Firm Value reducing.

Free Cashflow- Cashflow in excess of that required to fund all NPV projects.

Jensen- benefit of debt in reducing free cashflow.

Jensen’s 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.

Takeovers or threat => increase in debt => reduction in free cashflow => 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 => 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 firm’s 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?

Conflict Benefits of Debt Costs of Debt

Breaking MM Tax Relief Fin’l Distress/ Debt Capacity

Agency Models

JM (1976) Managerial Perks

Increase Mgr’s Ownership

Risk Shifting

Jensen (1986) Empire Building Reduce Freecash Unspecified.

Stultz Empire Building Reduce Freecash Underinvestment.

Dewatripont and Tirole, Hart.

Low Effort level Bankruptcy threat =>increased effort

DT- Inefficient liquidations.

Signalling Models of Capital Structure

Assymetric info: Akerlof’s (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)

-manager’s compensation at the end of the period is

DVCVVrM

DVVVrM

if )1(

D* = debt level where bad firm goes bankrupt.

Result: Good firm D > D*, Bad Firm D < 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.P = 0.5 Do

Nothing:

Good Bad

IssueEquity

Good BadAssetsin Place

250 130 350 230

NPV ofnewproject

0 0 20 10

Value ofFirm

250 130 370 240

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.

.69.248)370(305

Bad News and Issue equity = .31.161)240(305

Donothing

Issueandinvest

GoodNews

250 * 248.69

BadNews

130 161.31*

Old Shareholders’ payoffs EquilibriumDonothing

Issueandinvest

GoodNews

250 * 248.69

BadNews

130 140 *

Issuing equity signals that the bad state will occur.

The market knows this - firm value falls.

Pecking Order Theory for Capital Structure => 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?

Trade-off Versus Pecking Order.

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

opportunities/tangibility of assets/profitability…..• => Relationship between profitability and leverage

(debt): positive => trade-off.• Or negative => 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 => higher debt.

• Predation models: higher competition leads to lower debt. (Why?)

Capital Structure and Takeovers

• Garvey and Hanka:

• Waves of takeovers in US in 1980’s/1990’s.

• Increase in hostile takeovers => increase in debt as a defensive mechanism.

• Decrease in hostile takeovers => decrease in debt as a defensive mechanism.

Garvey and Hanka (contiuned)

V Trade-off: Tax shields/effort levels/FCF/ efficiency/signalling Vs financial distress

Practical Capital Structure: case study

Game Theoretic Approach to Capital Structure.

• Moral Hazard Model.

• Asymmetric Information Model.

• See BCF section 8 for incorporation of managerial overconfidence.

Cash-flow Rights and Control Rights

• Debt-holders: first fixed claim on cash-flows (cash-flow rights); liquidation rights in bas times (control rights)- hard investors.

• Equity-holders: residual claimants on cash-flows (cash-flow rights): voting rights in good times (control rights) – soft investors.

• => minority shareholder rights versus blockholders.

Equity-holders’ control rights

• Voting rights.• Soft: free-rider problems.• Minority holders versus block-holders.• Minority –holders versus insiders.• Separation of ownership and control.• Corporate Charter.• Dual class of shares.• Pyramids/tunelling etc.

Capital/corporate structure in emerging economies.

• Separation of ownership and control.

• Corporate Charter.

• Dual class of shares.

• Pyramids/tunelling etc.

• Weak Legal Systems.

• Cultural differences.

Game-theoretic approaches.

• JFE special issue 1988 (Grossman and Hart, Stultz, Harris and Raviv).

• Bebchuk (lecture slides to follow).

• Garro Paulin and Fairchild (2006) Lecture slides to follow.

Mergers and Acquisitions

• Acquisitions

• Divestitures

• Restructuring

• Corporate Governance

Growth Strategies

• Mergers: one economic unit formed from 2 or more previous units

• A) Tender offer

Takeovers

Acquisition

Proxy Contest

Merger

Stock Acquisition

1. Merger- must be approved by stockholders’ votes.

2. Stock acquisition- No shareholder meeting, no vote required.

-bidder can deal directly with target’s shareholders- bypassing target’s management.

- often hostile => target’s defensive mechanisms.

-shareholders may holdout- freerider problems.

3. Proxy Contests- group of shareholders try to vote in new directors to the board.

Growth Strategies

• Mergers: one economic unit formed from 2 or more previous units

• A) Tender offer

• B) Pooling of Interest

• Joint Ventures

• Other collaborations (supplier networks, alliances, investments, franchises)

Shrinkage strategies

• Divestitures

• Equity carveouts

• Spin-offs

• Tracking stock

Theories of M and A.

• Efficiency increases (restructuring)• Operating Synergies• Financial Synergy• Information• Hubris and the Winner’s curse• Agency Problems (changes in

ownership/managerialism/FCF)• Redistribution (tax, mkt power, …)

Synergy Value of a Merger

).( VVV BAAB Synergy comes from increases in cashflow form the merger:

ttt CostsREVCF

Example: Market Value after Merger.

• Firm A (bidder): cashflows = £10m, r = 20%. V = £50m.

• Firm B (target): cashflows = £6m, r = 15%. = £40m.

• If A acquires B: Combined Cashflows are expected to increase to £25m P.A. New Discount rate 25%.

• Synergy cashflows = £9m. • Total value = £100m.• Synergy Value = £10m.

Who gets the gains from mergers?

Bett VINPV arg

IVVNPV AABBidder

Depends on what the bidder has to pay! (bid premium)

If Bidder gets all of the positive NPV.

If Target gets all of the positive NPV.

,AAB VVI

Why a Bid premium?

• Hostile Bid: defensive (anti-takeover) mechanisms (leverage increases, poison pills, etc):

• Bidding wars.

• Market expectations.

Effects of takeovers on stock prices of bidder and target.

Takeover Technique

Target Bidders

Tender Offer

30% 4%

Merger 20% 0

Proxy Contest

8% n.a

TakeoverTechnique

Target Bidders

TenderOffer

-3% -1%

Merger -3% -5%

ProxyContest

8% n.a

Successful Bids Unsuccessful Bids

Jensen and Ruback JFE 1983

Game Theoretic Approach to M and A.

• Grossman and Hart (Special Issue on Corporate Control 1982).

• Harris and Raviv (Special Issue on Corporate Control 1982).

• Bebchuk (Special Issue on Corporate Control 1982)..

• Burkart (JOF 1995).• Garvey and Hanka.• Krause.

Garvey and Hanka paper

• Lecture slides to follow.

Grossman and Hart free-rider paper

• Lecture slides to follow.

Convertible Debt• -Valuation of Convertibles.• -Impact on Firm Value.• -Why firms issue convertibles.• -When are they converted (call policy)?• Convertible bond -holder has the right to exchange the

bond for common stock (equivalent to a call option).• Conversion Ratio = number of shares received for

each bond.• Value of Convertible Bond = Max{ Straight bond

value, Conversion Value} +option value.

Value of Convertible Bond.

Straight Bond Value Conversion Value

Total Value of Convertible Bond

Firm Value Firm Value

Firm Value

Face Value

• Conflict between Convertible Bond holders and

managers.• Convertible Bond = straight debt + call option.• Value of a call option increases with:• Time.• Risk of firm’s cashflows.• Implications: Holders of convertible debt maximise

value by not converting until forced to do so => Managers will want to force conversion as soon as possible.

• Incentive for holders to choose risky projects => managers want to choose safe projects.

Reasons for Issuing Convertible Debt.

Much real world confusion.

Convertible debt - lower interest rates than straight debt.

=> Cheap form of financing?

No! Holders are prepared to accept a lower interest rate because of their conversion privilege.

CD = .

)1()1(

.)1()1(

.,, DCDKKMPRII CDCD

• Example of Valuation of Convertible Bond.• October 1996: Company X issued Convertible Bonds at

October 1996: Coupon Rate 3.25%, Each bond had face Value £1000.

• Bonds to mature October 2001.• Convertible into 21.70 Shares per per bond until October

2001.• Company rated A-. Straight bonds would yield 5.80%.• Now October 1998:• Face Value £1.1 billion. • Convertible Bonds trading at £1255 per bond. • The value of the convertible has two components; The

straight bond value + Value of Option.

Valuation of Convertible Bond- Continued.

If the bonds had been straight bonds: Straight bond value =

PV of bond =83.932

)058.1(

25.163

Price of convertible = 1255.

Conversion Option = 1255 – 933 = 322.

Oct 1998 Value of Convertible = 933 + 322 = 1255. = Straight Bond Value + Conversion Option.

Alternative Analysis of Irrelevance of Convertible Debt.

Firm DoesBadly.

Firm DoesWell.

Convertible Debt.No Conversion. Conversion.

Compared with:Straight Bonds.

CD cheaperfinancing, lowercoupon rate.

CD expensive,Bonds areconverted,Existing EquityDilution.

Equity. CD expensive. CDs cheaper.

Firm Indifferent between issuing CD, debt or equity.

• Why do firms issue convertible debt?• If convertible debt is not a cheap form of financing, why is it

issued?• A. Equity through the Back Door (Stein, Mayers).• -solves asymmetric information problems (see Myers-

Majluf).• -solves free cashflow problems.• B. Convertible debt can solve risk-shifting problems.• - If firm issues straight debt and equity, equity holders have

an incentive to go for risky (value reducing) NPV projects.• Since CD contains an option feature, CD value increases

with risk.• -prevents equity holders’ risk shifting.

Convertible Debt and Call Policy.Callable Convertible debt =>firms can force conversion.When the bond is called, the holder has 30 days to either:a) Convert the bond into common stock at the conversion ratio, orb) Surrender the bond for the call price.When should the bond be called?Option Theory: Shareholder wealth is maximised/ CD holders wealth is minimised ifFirm calls the bond as soon as value = call price.

• Call Puzzle.• Manager should call the bond as soon as he can force

conversion.• Ingersoll (1977) examined the call policies of 124

firms 1968-1975.• - He found that companies delayed calling far too

long.• - median company waited until conversion value was

44% above call price - suboptimal.• Call Puzzle addressed by Harris and Raviv.• - signalling reasons for delaying calling.• - early calling might signal bad news to the market.

4: 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 => increase in stock prices

(signalling/agency problems).• Dividends => 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 < Cum div.

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…

CD = 110

ED = 100

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.

)1()1(11

What would the buyer be prepared to pay to you?

)1()1(22

0 )1()1(1 r

Therefore:

Continuing this process, and re-substituting in (try it!), we obtain:

0 )1(t tr

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 => MM assumed an optimal investment schedule over time (ie firm invests in all +ve NPV projects each year).

Deriving MM’s dividend irrelevance

• Total market value of our all-equity firm is •

10 )1(

Sources = Uses

1)1( ttttt FrIDFCF

Re-arranging:

1)1( ttttt FrIFCFD

FrIFCFFrIFCFS

10000 ...)1(

)1()1(

010 FCF

Substitute into first equation:

At t =0,

FrIFCFIFS

000 ...)1(

Successive substitutions

00 )1(

•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 => 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 !

?)1.1(

10 t tV

“Breaking” MM’s 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.

.)1)(1(001

KKrNCFg

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.£K 19x5 19x6 19x7 19x8 19x9 Average Profits After Tax (NCF) 2500 2760 2635 2900 3100Retained Profit (NCF.K) 1550 1775 1600 1800 1900

Dividend (NCF(1-K)) 950 985 1035 1100 1200

Share Capital + retentionsB/F 30000 31550 33325 34925 36725C/F (= BF + Retained Profit) 31550 33325 34925 36725 38625

Retention Rate K 0.62 0.64 0.61 0.62 0.61 0.62r on opening capital 0.083 0.087 0.079 0.083 0.084 0.083

g = Kr = 0.05.

How do we use this past data for valuation?

Gordon Growth Model (Infinite Constant Growth Model).

Let %12

05.012.0

1260)05.1(1200)1( 100

= 18000

Finite Supernormal Growth.

-Rate of return on Investment > market required return for T years.

-After that, Rate of Return on Investment = Market required return.

)(.. 1

rTNCFK

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.

A. Rate of return, r = 12% for 10 years,then 10% thereafter.

1018)1.01(1.0

)1.012.0(10).100.(1.0

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

955)1.01(1.0

)1.005.0(10).100.(1.0

Dividend Smoothing V optimal re-investment (Fairchild 2003)

• Method:-• GG Model: derive optimal retention/payout

ratio• => deterministic time path for dividends,

Net income, firm values.• => 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

.)1)(1(01

.)1)((

Analysis of

• If

• If with

• Constant r over time => Constant K* over time.

r .0* K

r ],1,0[*K .0*

Deterministic Case (Continued).

• Recursive solution:

• => signalling equilibria.

• Shorter horizon => higher dividends.

tt rKKND )*1*)(1(0

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.

• => “buffer” from retained earnings.

Agency problems

• Conflicts between shareholders and debtholders: risk-shifting: high versus low dividends => high divs => credit rating of debt

• Conflicts between managers and shareholders: Jensen’s FCF, Easterbrook.

Are Dividends Irrelevant?

- Evidence: higher dividends => 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.

Prob 0.5 0.5

Firm A Firm B E(V)

NCF 400 1400 900

New Investment 600 600 600

Dividend 0 800 400New shares 200 0 100

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 (Jensen’s 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 => high firm value

• FT derive a non-monotonic relationship between firm quality and dividends.

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.

• Jensen’s Free Cash Flow (1986).

• Stultz’s 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.

)..( 11 DivepstTKDivDiv ttt K is the adjustment rate. T is the target payout rate.

Dividend Policy -Lintner Model

1 2 3 4 5 6 7 8

FIRM A B CK 0.5 0 1

YEAR EPS DIV DIV DIV

1 30.00 13.25 11.50 15.002 34.00 15.13 11.50 17.003 28.00 14.56 11.50 14.004 25.00 13.53 11.50 12.505 29.00 14.02 11.50 14.506 33.00 15.26 11.50 16.507 36.00 16.63 11.50 18.008 40.00 18.31 11.50 20.00

Using Dividend Data to analyse Lintner Model.

In Excel, run the following regression;

ttt cEpsbDivaDiv 1

...)1( 1 epstTKDivKDiv tt

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.

• => 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):

• => popular practitioner’s website argues share repurchases can create value for non-tendering shareholders.

• Basic argument: existing cashflows/assets spread over fewer shares => P !!!

• Financial Alchemy !!!

The Example:….

• Kennon (2005): Eggshell Candies Inc

• Mkt value of equity = $5,000,000.

• 100, 000 shares outstanding

• => 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:

• => One suggests a share buyback.

• The others immediately agree !

• Company will use this year’s £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.

• => 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:

)1(100

Eggshell figures

000,000,5000,000,1

000,000,1)1(1

Cost of equity will not change: only way to increase value per share is to improve company’s 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)

50$000,000,525.0

000,000,1000,000,10 PV

40$000,000,425.0

000,000,10 PV Ex div

50$000,000,425.0

000,000,10 PV

Each year –end: cum div = $50, ex div = $40

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 => positive signals.• Agency problems: FCF.• Market timing.• Capital structure motives.

Dividend/share repurchase irrelevance

• See Fairchild (JAF 2005)

• Kennon’s 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 => 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.

• => Repurchase signals:

• a) Higher earnings and higher risk,

• b) Higher equity stake => higher earnings.

Repurchase Signalling :Isagawa FR 2000

• Asymmetric information over mgr’s 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 => 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:

Asymmetric Information

Agency Costs

Payout

High Payout

Low Payout

High PayoutLow Payout

Dividend Cuts bad news?

• Fairchild’s 2009/10 article.• Wooldridge and Ghosh:=>• ITT/ Gould• Right way and wrong way to cut dividends.• Other cases from Fairchild’s 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!!

Venture Capital/private equity/Hedge Funds

• Venture capitalists typically supply start-up finance for new entrepreneurs.

• VC’s 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 a) take them private: Turnarouds, or b) Growth capital.

• Hedge Funds: Privately-owned institutions that invest in Financial markets using a variety of strategies.

Hedge Funds

• Privately-owned institutions

• Limited range of High net worth (wealthy) investors => HF => invests in FMs

• Each fund has its own investment strategy

• Largely unregulated (in contrast to mutual funds); => debate.

HF strategies

• HF mgr typically commits to a strategy, using following elements

• Style• Market• Instrument• Exposure• Sector• Method• Diversification

HF Strategies (continued)

• Style: Global Macro, directional, event driven….• Market: equity, fixed income, commodity,

currency• Instrument: long/short, futures, options, swaps• Exposure: directional, market neutral• Sector: emerging markets, technology, healthcare• Method: Discretionary/qualitative (mgr selects

investments): systematic/quantitative (quants)

Leverage:

• HFs are marketed on the promise of making ‘absolute returns’ regardless of mkt

• May involve hedging (long-short) plus high levels of leverage

• => very risky? • Risk-shifting incentives made worse by HF

mgr fee structure!

HF fee structure

• Asymmetric fees (in mutual fund, symmetric or fulcrum fees).

• HF mgr gets a percentage of assets under management plus a performance bonus on the upside: no loss on the downside (investor loses there!)

• => systemic risk? Regulation debate.

Fairchild and Puri (2011)

• Brand new paper on SSRN!• HF mgr/ Investor negotiate (bargain) over form of

contract: asymmetric or symmetric)• HF mgr then chooses safe or risky strategy.• He then exerts effort in trying to make strategy

succeed.• Paper looks at effects of BP and incetnives on

contract, strategy and HF performance and risk!

Activist HFs

• Passive HFs just invest in FMs, an d look at portfolio decisions

• Activist HFs actually get involved in the companies that they invest in

• Members on the board• Assist/interfere in mgt decisions• Debate: do they add or destroy value?• Myopic?

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• Theory of private equity turnarounds” plus

PE leverage article, plus economics of PE articles.

Theory of PE-turnarounds (Cuny and

Talmor JCF 2007)

• Explores advantage of PE in fixing turnaround

• Would poorly performing mgrs want to involve PEs when they may lose their jobs?

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/Adverse selection

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

• => exit: IPO/trade sale => 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• Value-adding? Visit companies, help them

operationally, marketing etc.• Empirical evidence on hours/year spent at each

company• => attention model of Gifford.

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)

• VC’s 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.

Game-theoretic models of Venture Capitalist/entrepreneur contracting

• Double-sided moral hazard models (ex ante effort/ ex post hold-up/renegotiation/stealing) – self-interest

• Behavioural Models (Procedural justice, fairness, trust, empathy)

Fairchild (JFR 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:

VCiM eeP

},1,0{iwhere => VC’s value-adding.

Fairchild’s (2004) Timeline

• Date 0: Bidding Game: VC’s 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:

.0).1( PRPPRV

Optimal effort levels for given equity stake:

Optimal equity proposals.

• Found by substituting optimal efforts into payoffs and maximising.

• Depends on relative bargaining power, VC’s value-adding ability, and reputation effect.

• Eg; E may take all of the equity.

• VC may take half of the equity.

Equity Stake

Payoffs

0 Dumb VC!

Tykvova’s review paper of VC

• Problem is: more equity E has, less equity VC has: affects balance of incentives.

• Problem for VC is giving enough equity to motivate E, while keeping enough for herself

Ex post hold-up problem

• In Fairchild (2004): VC can force renegotiation of equity stakes in her favour after both players have exerted effort.

• She takes all of the equity

• How will this affect rational E’s effort decision in the first place?

E’s choice of financier

• Growing research on E’s choice of financier

• VC versus banks

• VC versus angels

• VCs are formal funds with legal contracts etc

• Angels are wealthy individuals, often ex entrepreneurs, sometimes relations of the E!

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.

E’s choice of financier

• VC or bank finance (Ueda, Bettignies and Brander).

• VC or Angel (Chemmanur and Chen, Fairchild).

• See slides on my paper….

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 other’s 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• => income R.• Failure probability • =>income zero

1],1,0[

VCEEE eeP

• Expected Value of Project

• Represents VCs relative ability (to E).

ReePRV VCEEE )(

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

• PRrePR UFEUE )(2

2])1)[(1(])1[( VCFUSUVC eRPrRPr

If VC is fair, by definition, FU

Solve by backward induction:

• If VC is fair;

• Since

• for both E types.

• =>

EFE ePR FS PP

2)1( VCFVC ePR

VC is fair; continued.

• Given FU

Optimal Effort Levels:

e EFVC

Fair VC’s equity proposal (equity norm):

VC is self-interested:

• From Equation (1), fair E’s optimal effort;

FSFU PP

e EUFUE

Self-interested VC’s optimal Equity proposal

• Substitute players’ optimal efforts into V= PR, and then into (1) and (2). Then, optimal equity proposal maximises VC’s indirect payoff =>

Examples;

• VC has no value-adding ability (dumb money) =>

• =>

• r =0 =>

• r => 1 ,

Example 2

• VC has equal ability to E; =>

• r =0 =>• r => 1 ,

• We show thatas r => 1

],1,0[ FU

Fairness

VCs Equity offer

Fairness

Firm Value

8. 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.• 1980’s: 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.• Gambler’s fallacy.• Availability bias.• Salience….. Etc, etc.

Focus in Literature

• Overconfidence/optimism

• Prospect Theory/loss aversion.

• Regret.

Prospect Theory.

Eg: Disposition Effect:

Sell winners too quickly.

Hold losers too long.

Risk-averse in gains

Risk-seeking in losses

Overconfidence.

• Too much trading in capital markets.

• OC leads to losses?

• But : Kyle => 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.

a) Bounded Rationality (eg Mattson and Weibull 2002, Stein 1996).

- Limited information: Information processing has a cost of effort.

- Investors => 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 => can solve a maximisation problem.

-Bounded rationality => implementation mistakes.

-Cost of reducing mistakes.

-Optimal for manager to make some mistakes!

-CEO, does not carefully prepare meetings, motivate and monitor staff => sub-optimal actions by firm.

Regret theory and prospect theory (Harbaugh 2002).

-Risky decision involving skill and chance.

-manager’s 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.

=> Prospect + regret theory => 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 Jensen’s 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 = Myers-Majluf problem of not taking +ve NPV projects => free cash flow good.

-But : mgr optimism => mgr overvalues the firms investment opportunities => mistakenly taking –ve NPV project => free cash flow bad.

-Prediction: shareholders prefer:

-Cashflow retention when firm has both high optimism and good investments.

- cash flow payouts when firm has high optimism and bad investments.

Rational capital budgeting in an irrational world. (Stein 1996).

-Manager rational, investors over-optimistic.

- share price solely determined by investors.

-How to set hurdle rates for capital budgeting decisions?

- adaptation of CAPM, depending on managerial aims.

- manager may want to maximise time 0 stock price (short-term).

-May want to maximise PV of firm’s future cash flows (long term rational view).

Effect of Managerial overconfidence, asymmetric Info, and moral hazard on Capital Structure Decisions.

Rational Corporate Finance.

-Capital Structure: moral hazard + asymmetric info.

-Debt reduces Moral Hazard Problems

-Debt signals quality.

Behavioral Corporate Finance.

-managerial biases: effects on investment and financing decisions

-Framing, regret theory, loss aversion, bounded rationality.

-OVERCONFIDENCE/OPTIMISM.

Overconfidence/optimism

• Optimism: upward bias in probability of good state.

• Overconfidence: underestimation of asset risk.

• My model =>

• Overconfidence: overestimation of ability.

Overconfidence: good or bad?

• Hackbarth (2002): debt decision: OC good.

• Goel and Thakor (2000): OC good: offsets mgr risk aversion.

• Gervais et al (2002), Heaton: investment appraisal, OC bad => negative NPV projects.

• Zacharakis: VC OC bad: wrong firms.

Overconfidence and Debt

• My model: OC => higher mgr’s effort (good).

• But OC bad, leads to excessive debt (see Shefrin), higher financial distress.

• Trade-off.

Behavioral model of overconfidence.

Both Managers issue debt:

.ˆ,ˆ qqpp

.)ˆ1(ˆ2

ˆ bpqp

IpRpM g

.)ˆ1(ˆ2

ˆ bqqp

IqRqM b

Good mgr issues Debt, bad mgr issues equity.

.)ˆ1(ˆ

ˆ bpIp

pRpM g

qRqM b

Both mgrs issue equity.

ˆ Iqp

pRpM g

ˆ Iqp

qRqM b

Proposition 1.

,)ˆ1()ˆ1()(

)(ˆbpbqI

}.{ DSS bg

,)ˆ1()(

)(ˆ)ˆ1( bpI

}.,{ ESDS bg

c) ,)(

)(ˆ)ˆ1()ˆ1( I

qpqbpbq

}.{ ESS bg

Overconfidence leads to more debt issuance.

Overconfidence and Moral Hazard

• Firm’s project: 2 possible outcomes.

• Good: income R. Bad: Income 0.

• Good state Prob:

• True:

• Overconfidence:

• True success prob:

].1,0()( eP .0.0

Manager’s Perceived Payoffs

.)ˆ1()(ˆˆ 2 IPDebPDRPM D

.)1(ˆˆ 2 IPReRPM E

Optimal effort levels

Effect of Overconfidence and security on mgr’s effort

• Mgr’s effort is increasing in OC.

• Debt forces higher effort due to FD.

Manager’s perceived Indirect Payoffs

bIDbDRbDR

)()(ˆ22

IDDRDR

)()(ˆ22

))(2()(ˆ22

bbDbDRb

True Firm Value

))()(()( b

bRbDRbbRPV DD

RPV EE

Effect of OC on Security Choice

))(2()0(ˆ

bbDbIRb

.0)(ˆ CDM

],,0[ C

Manager issues Equity.

Manager issues Debt.

Effect of OC on firm Values

))()(()( b

bRbDRV CD

bDRRbDbbR

)()2)(( 22

Results

• For given security: firm value increasing in OC.• If• Firm value increasing for all OC: OC good.• Optimal OC: • If • Medium OC is bad. High OC is good.• Or low good, high bad.

,0)( CDV

,0)( CDV .* max

Results (continued).

• If

• 2 cases: Optimal OC:

• Or Optimal OC:

,0)( CDV

.* max

Effect of Overconfidence on Firm Value

0 0.1 0.2 0.3 0.4 0.5

Overconfidence

1 2 3 4 5 6 7 8 9 10

Overconfidence

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9

OverconfidenceV

Conclusion.

• Overconfidence leads to higher effort level.

• Critical OC leads to debt: FD costs.

• Debt leads to higher effort level.

• Optimal OC depends on trade-off between higher effort and expected FD costs.

Future Research

• Optimal level of OC.

• Include Investment appraisal decision

• Other biases: eg Refusal to abandon.

• Regret.

• Emotions

• Hyperbolic discounting

• Is OC exogenous? Learning.

Overconfidence and life-cycle debt

Reverse effect of OC on debt in China?

Herding

Hyperbolic Discounting

9. Emotional Finance

• Fairchild’s Concorde case study.

1 MN50324: Corporate Finance 2011/12: 1.Investment flexibility, Decision trees, Real Options...

Documents