[SOLVED] finc6001 intermediate corporate finance – Business Finance

There is the assignment requirement attached below. with some other files you may need when you do the assignemnr. Thanks.The University of Sydney Business School
Finance Discipline
FINC 6001
Intermediate Corporate Finance
In-semester Assignment 2 (15% of final grade)
Due Date: Friday 13 November 2020, 17:00 (Week 11)
Part A: The IPO
1. Select a U.S. listed firm, which had its initial public offering in the last 15 years.
2. Go to U.S. Securities and Exchange Commission’s Company Filings website:
https://www.sec.gov/edgar/searchedgar/companysearch.html. Search for the
prospectus document (usually Form 424B4).
3. Provide a screenshot of the front page of the prospectus document
4. Answer the following questions (3 marks)
a. What is the ticker symbol for your stock?
b. Which exchange will the stock be listed on?
c. How many shares are issued? How many shares form part of the primary
offering? How many shares form part of the secondary offering?
d. What is the issue price?
e. Who is/are the lead underwriter(s)?
f. Is there a green shoe provision? If so, provide details of this provision.
5. Is the IPO underpriced? Explain your findings. (4 marks)
(Max: 200 words)
Part B: Capital structure
1. What is the debt-to-equity ratio for your firm over the last 3 years (1 mark)
2. The average debt-to-equity ratio for U.S. firms is currently around 1.5. Compare your
firm’s debt-to-equity ratio to the average debt-to-equity ratio for all firms. Why do the
two values differ? (3 marks)
(Max: 200 words)
Part C: Dividends
1. What is your chosen firm’s dividend yield over the last 3 years? (1 marks)
2. The average dividend yield for U.S. firms in the S&P500 is around 1.8%. Compare
your firm’s dividend yield to the average dividend yield for all firms. Why do the two
values differ? (3 marks)
(Max: 200 words)
This is an individual assignment. Please note that some marks will be awarded for
presentation and clarity of writing. Marks will be deducted if you do not adhere to the word
limits.
Chapter 16: Financial distress,
managerial incentives and
information
Amy Kwan
The University of Sydney
Page 1
Weeks 6-7 Outline
1. Perfect capital markets (Chapter 14)
a) Modigliani-Miller Proposition I: =
D
rU +
(rU − rD )
b) Modigliani-Miller Proposition II: rE =
E
2. Imperfect capital markets (Chapters 15 and 16)
a) Taxes
i. MM Proposition I with taxes: =
VL
V U + PV (Interest Tax Shield)
b) Bankruptcy and financial distress costs: Trade-off theory
i. Financial distress costs: V L =
V U + PV (Interest Tax Shield) − PV (Financial Distress Costs)
ii. Agency costs: V L =
V U + PV (Interest Tax Shield) − PV (Financial Distress Costs)
− PV (Agency Costs of Debt) + PV (Agency Benefits of Debt)
c) Asymmetric information: Pecking order hypothesis
The University of Sydney
Page 2
Chapter 16
1. Default and bankruptcy in a perfect market
2. Costs of bankruptcy and financial distress
a) Bankruptcy code
b) Direct costs
c) Indirect costs
3. Financial distress costs and firm value
a) Who pays for financial distress costs?
4. Optimal capital structure: The trade-off theory
a) The present value of financial distress costs
5. Agency costs of leverage
a) Excessive risk-taking and asset substitution
b) Debt overhang and under-investment
c) Agency costs and the value of leverage
The University of Sydney
Page 3
Chapter 16 (continued)
6. Agency benefits of leverage
a) Concentration of ownership
b) Reduction of wasteful investment
7. Agency costs and the trade-off theory
8. Asymmetric information and capital structure
a) Leverage as a credible signal
b) Issuing equity and adverse selection
c) Implications for equity issuance (Pecking order hypothesis)
The University of Sydney
Page 4
1. Default and bankruptcy in a perfect market
The University of Sydney
Page 5
Default and bankruptcy in a perfect market
– Financial Distress
– When a firm has difficulty meeting its debt obligations
– Default
– When a firm fails to make the required interest or principal
payments on its debt or violates a debt covenant
• After the firm defaults, debt holders are given certain rights
to the assets of the firm and may even take legal ownership
of the firm’s assets through bankruptcy.
The University of Sydney
Page 6
Default and bankruptcy in a perfect market
–
An important consequence of leverage is the risk of
bankruptcy.
– Equity financing does not carry this risk. Although equity
holders hope to receive dividends, the firm is not legally
obligated to pay them.
The University of Sydney
Page 7
Default and bankruptcy in a perfect market
– Example: Armin is considering a new project.
– Although the new product represents a significant advance
over Armin’s competitors’ products, the product’s success is
uncertain.
• If it is a hit, revenues and profits will grow, and Armin will
be worth $150 million at the end of the year.
• If it fails, Armin will be worth only $80 million.
The University of Sydney
Page 8
Default and bankruptcy in a perfect market
– Armin may employ one of two alternative
capital structures.
– It can use all-equity financing.
– It can use debt that matures at the end of the year with a total
of $100 million due.
The University of Sydney
Page 9
Default and bankruptcy in a perfect market
– If the new product is successful, Armin is worth $150 million.
– Without leverage, equity holders own the full amount.
– With leverage, Armin must make the $100 million debt
payment, and Armin’s equity holders will own the remaining
$50 million.
• Even if Armin does not have $100 million in cash available
at the end of the year, it will not be forced to default on its
debt.
The University of Sydney
Page 10
Default and bankruptcy in a perfect market
– With perfect capital markets, as long as the value of the firm’s
assets exceeds its liabilities, Armin will be able to repay the
loan.
– If it does not have the cash immediately available, it can raise
the cash by obtaining a new loan or by issuing new shares.
The University of Sydney
Page 11
Default and bankruptcy in a perfect market
– If a firm has access to capital markets and can issue new
securities at a fair price, then it need not default as long as the
market value of its assets exceeds its liabilities.
– Many firms experience years of negative cash flows yet
remain solvent.
The University of Sydney
Page 12
Default and bankruptcy in a perfect market
– If the new product fails, Armin is worth only $80 million.
– Without leverage, equity holders will lose $20 million.
– With leverage, Armin will experience financial distress and the
firm will default.
• In bankruptcy, debt holders will receive legal ownership of
the firm’s assets, leaving Armin’s shareholders with nothing.
– Because the assets the debt holders receive have a value of $80 million, they will suffer a
loss of $20 million.
The University of Sydney
Page 13
Default and bankruptcy in a perfect market
– Both debt and equity holders are worse off if the product fails
rather than succeeds.
– Without leverage, if the product fails equity holders lose $70
million.
• $150 million − $80 million = $70 million
– With leverage, equity holders lose $50 million, and debt
holders lose $20 million, but the total loss is the same, $70
million.
The University of Sydney
Page 14
Default and bankruptcy in a perfect market
The University of Sydney
Page 15
Default and bankruptcy in a perfect market
– If the new product fails, Armin’s investors are equally unhappy
whether the firm is levered and declares bankruptcy or whether it is
unlevered and the share price declines.
The University of Sydney
Page 16
Default and bankruptcy in a perfect market
– Note, the decline in value is not caused by bankruptcy: The
decline is the same whether or not the firm has leverage.
– If the new product fails, Armin will experience economic
distress, which is a significant decline in the value of a firm’s
assets, whether or not it experiences financial distress due to
leverage.
The University of Sydney
Page 17
Default and bankruptcy in a perfect market
– With perfect capital markets, Modigliani-Miller (MM) Proposition
I applies: The total value to all investors does not depend on the
firm’s capital structure.
– There is no disadvantage to debt financing, and a firm will have
the same total value and will be able to raise the same amount
initially from investors with either choice of capital structure.
The University of Sydney
Page 18
Default and bankruptcy in a perfect market
The University of Sydney
Page 19
Default and bankruptcy in a perfect market
The University of Sydney
Page 20
2. Costs of bankruptcy and financial distress
The University of Sydney
Page 21
Costs of bankruptcy and financial distress
– With perfect capital markets, the risk of bankruptcy is not a
disadvantage of debt; rather, bankruptcy shifts the ownership
of the firm from equity holders to debt holders without
changing the total value available to all investors.
– In reality, bankruptcy is rarely simple and straightforward. It is
often a long and complicated process that imposes both direct
and indirect costs on the firm and its investors.
The University of Sydney
Page 22
The Bankruptcy code
– The U.S. bankruptcy code was created so that creditors are
treated fairly and the value of the assets is not needlessly
destroyed.
– U.S. firms can file for two forms of bankruptcy protection:
Chapter 7 or Chapter 11.
– Australia: Voluntary Administration, Receivership, Liquidation.
The University of Sydney
Page 23
The Bankruptcy code
– Chapter 7 Liquidation
– A trustee is appointed to oversee the liquidation of the firm’s
assets through an auction. The proceeds from the liquidation
are used to pay the firm’s creditors, and the firm ceases to
exist.
The University of Sydney
Page 24
The Bankruptcy code
– Chapter 11 Reorganization
– Chapter 11 is the more common form of bankruptcy for large
corporations.
– With Chapter 11, all pending collection attempts are automatically
suspended, and the firm’s existing management is given the
opportunity to propose a reorganization plan.
• While developing the plan, management continues to operate the
business.
– The reorganization plan specifies the treatment of each creditor of
the firm.
The University of Sydney
Page 25
The Bankruptcy code
– Chapter 11 Reorganization
– Creditors may receive cash payments and/or new debt or equity
securities of the firm.
• The value of the cash and securities is typically less than the
amount each creditor is owed but more than the creditors would
receive if the firm were shut down immediately and liquidated.
– The creditors must vote to accept the plan, and it must be approved
by the bankruptcy court.
– If an acceptable plan is not put forth, the court may ultimately force
a Chapter 7 liquidation.
The University of Sydney
Page 26
Direct costs of bankruptcy
– The bankruptcy process is complex, time-consuming, and
costly.
– Costly outside experts are often hired by the firm to assist with
the bankruptcy process.
– Creditors also incur costs during the bankruptcy process.
• They may wait several years to receive payment.
• They may hire their own experts for legal and
professional advice.
The University of Sydney
Page 27
Direct costs of bankruptcy
– The direct costs of bankruptcy reduce the
value of the assets that the firm’s investors will ultimately
receive.
– The average direct costs of bankruptcy are approximately
3% to 4% of the prebankruptcy
market value of total assets.
The University of Sydney
Page 28
Direct costs of bankruptcy
– Given the direct costs of bankruptcy, firms may avoid filing
for bankruptcy by first negotiating directly with creditors.
– Workout
– A method for avoiding bankruptcy in which a firm in financial
distress negotiates directly with its creditors to reorganize
• The direct costs of bankruptcy should not substantially
exceed the cost of a workout.
The University of Sydney
Page 29
Direct costs of bankruptcy
– Prepackaged Bankruptcy (Prepack)
– A method for avoiding many of the legal and other direct
costs of bankruptcy in which a firm first develops a
reorganization plan with the agreement of its main creditors
and then files Chapter 11 to implement the plan
• With a prepackaged bankruptcy, the firm emerges from
bankruptcy quickly and with minimal direct costs.
The University of Sydney
Page 30
Indirect costs of financial distress
– Although the indirect costs are difficult to measure accurately, they are often much
larger than the direct costs of bankruptcy.
– Loss of Customers
– Loss of Suppliers
– Loss of Employees
– Loss of Receivables
– Fire Sale of Assets
– Delayed Liquidation
– Costs to Creditors
The University of Sydney
Page 31
Indirect costs of financial distress
– The indirect costs of financial distress may
be substantial.
– It is estimated that the potential loss due to financial distress is
10% to 20% of firm value pre-bankruptcy.
The University of Sydney
Page 32
Indirect costs of financial distress
– When estimating indirect costs, two important points must be
considered.
– Losses to total firm value (and not solely losses to equity
holders or debt holders or transfers between them) must be
identified.
– The incremental losses that are associated with financial
distress, above and beyond any losses that would occur due to
the firm’s economic distress, must be identified.
The University of Sydney
Page 33
3. Financial distress costs and firm value
The University of Sydney
Page 34
Financial distress costs and firm value
– Armin Industries: The Impact of Financial
Distress Costs
– With all-equity financing, Armin’s assets will be worth $150
million if its new product succeeds and $80 million if the new
product fails.
The University of Sydney
Page 35
Financial distress costs and firm value
– Armin Industries: The Impact of Financial
Distress Costs
– With debt of $100 million, Armin will be forced into
bankruptcy if the new product fails.
• In this case, some of the value of Armin’s assets will be lost
to bankruptcy and financial distress costs.
• As a result, debt holders will receive less than $80 million.
• Assume debt holders receive only $60 million after
accounting for the costs of financial distress.
The University of Sydney
Page 36
Financial distress costs and firm value
The University of Sydney
Page 37
Financial distress costs and firm value
– Armin Industries: The Impact of Financial
Distress Costs
– As shown on the previous slide, the total value to all investors is
now less with leverage than it is without leverage when the
new product fails.
• The difference of $20 million is due to financial
distress costs.
• These costs will lower the total value of the firm with
leverage, and MM’s Proposition I will no longer hold.
The University of Sydney
Page 38
Financial distress costs and firm value
The University of Sydney
Page 39
Financial distress costs and firm value
The University of Sydney
Page 40
Who pays for financial distress costs?
– For Armin, if the new product fails, equity holders lose their
investment in the firm and will not care about bankruptcy costs.
– However, debt holders recognize that if the new product fails
and the firm defaults, they will not be able to get the full value
of the assets.
– As a result, they will pay less for the debt initially (deduct the
present value of the expected bankruptcy costs).
The University of Sydney
Page 41
Who pays for financial distress costs?
– If the debt holders initially pay less for the debt, less money is
available for the firm to pay dividends, repurchase shares,
and make investments.
– This difference comes out of the equity holders’ pockets.
The University of Sydney
Page 42
Who pays for financial distress costs?
– When securities are fairly priced, the original shareholders of a
firm pay the present value of the costs associated with bankruptcy
and financial distress.
The University of Sydney
Page 43
4. Optimal capital structure: The trade-off theory
The University of Sydney
Page 44
Optimal capital structure: The trade-off theory
– Trade-Off Theory
– The firm picks its capital structure by trading off the benefits
of the tax shield from debt against the costs of financial
distress and agency costs.
– According to the trade-off theory, the total value of a levered
firm equals the value of the firm without leverage plus the present
value of the tax savings from debt, less the present value of
financial distress costs.
VL =
V U + PV (Interest Tax Shield) − PV (Financial Distress Costs)
The University of Sydney
Page 45
The present value of financial distress costs
Three key factors determine the present value of financial
distress costs:
1. The probability of financial distress
• The probability of financial distress increases with the
amount of a firm’s liabilities (relative to its assets).
• The probability of financial distress increases with the
volatility of a firm’s cash flows and asset values.
The University of Sydney
Page 46
The present value of financial distress costs
Three key factors determine the present value of financial
distress costs:
2. The magnitude of the costs after a firm is in distress
• Financial distress costs will vary by industry.
– Technology firms will likely incur high financial distress costs due to the potential for loss of
customers and key personnel, as well as a lack of tangible assets that can be easily
liquidated.
– Real estate firms are likely to have low costs of financial distress because the majority of
their assets can be sold relatively easily.
The University of Sydney
Page 47
The Present Value of Financial Distress Costs (cont’d)
Three key factors determine the present value of financial
distress costs:
3. The appropriate discount rate for the distress costs
• Depends on the firm’s market risk
–
Note that because distress costs are high when the firm does poorly, the beta of distress
costs has the opposite sign to that of the firm.
–
The higher the firm’s beta, the more negative the beta of its distress costs will be
• The present value of distress costs will be higher for high
beta firms.
The University of Sydney
Page 48
Optimal capital structure: The trade-off theory
– For low levels of debt, the risk of default remains low, and the
main effect of an increase in leverage is an increase in the
interest tax shield.
– As the level of debt increases, the probability of default
increases.
– As the level of debt increases, the costs of financial distress
increase, reducing the value of the levered firm.
The University of Sydney
Page 49
Optimal capital structure: The trade-off theory
– The trade-off theory states that firms should increase their
leverage until it reaches the level for which the firm value is
maximized.
– At this point, the tax savings that result from increasing
leverage are perfectly offset by the increased probability of
incurring the costs of financial distress.
The University of Sydney
Page 50
Optimal capital structure: The trade-off theory
– The trade-off theory can help explain
– Why firms choose debt levels that are too low to fully exploit
the interest tax shield (due to the presence of financial distress
costs)
– Differences in the use of leverage across industries (due to
differences in the magnitude of financial distress costs and the
volatility of cash flows)
The University of Sydney
Page 51
Optimal capital structure: The trade-off theory
The University of Sydney
Page 52
5. Agency costs of leverage
The University of Sydney
Page 53
The agency costs of leverage
– Agency Costs
– Costs that arise when there are conflicts of interest between
the firm’s stakeholders
– Management will generally make decisions that increase the
value of the firm’s equity. However, when a firm has leverage,
managers may make decisions that benefit shareholders but
harm the firm’s creditors and lower the total value of the firm.
The University of Sydney
Page 54
The agency costs of leverage
– Consider Baxter, Inc., which is facing financial distress.
– Baxter has a loan of $1 million due at the end of the year.
– Without a change in its strategy, the market value of its assets
will be only $900,000 at that time, and Baxter will default on
its debt.
The University of Sydney
Page 55
Excessive risk-taking and asset substitution
– Baxter is considering a new strategy.
– The new strategy requires no upfront investment, but it has
only a 50% chance of success.
– If the new strategy succeeds, it will increase the value of the
firm’s asset to $1.3 million.
– If the new strategy fails, the value of the firm’s assets will fall to
$300,000.
The University of Sydney
Page 56
Excessive risk-taking and asset substitution
– The expected value of the firm’s assets under the new strategy is
$800,000, a decline of $100,000 from the old strategy.
• 50% × $1.3 million + 50% × $300,000 = $800,000
– Despite the negative expected payoff, some within the firm have
suggested that Baxter should go ahead with the new strategy.
– Can shareholders benefit from this decision?
The University of Sydney
Page 57
Excessive risk-taking and asset substitution
– If Baxter does nothing, it will ultimately default and equity
holders will get nothing with certainty.
– Equity holders have nothing to lose if Baxter tries the risky
strategy.
– If the strategy succeeds, equity holders will receive $300,000
after paying off the debt.
– Given a 50% chance of success, the equity holders’ expected
payoff is $150,000.
The University of Sydney
Page 58
Excessive risk-taking and asset substitution
The University of Sydney
Page 59
Excessive risk-taking and asset substitution
– Equity holders gain from this strategy, even though it has a
negative expected payoff, while debt holders lose.
– If the project succeeds, debt holders are fully repaid and
receive $1 million.
– If the project fails, debt holders receive only $300,000.
• The debt holders’ expected payoff is $650,000, a loss of
$250,000 compared to the old strategy.
– 50% × $1 million + 50% × $300,000 = $650,000
The University of Sydney
Page 60
Excessive risk-taking and asset substitution
– The debt holders $250,000 loss corresponds to the $100,000
expected decline in firm value due to the risky strategy and the
equity holder’s $150,000 gain.
– Effectively, the equity holders are gambling with the debt
holders’ money.
The University of Sydney
Page 61
Excessive risk-taking and asset substitution
– Asset Substitution Problem
– When a firm faces financial distress, shareholders can gain at
the expense of debt holders by taking a negative-NPV
project, if it is sufficiently risky.
– Shareholders have an incentive to invest in negative-NPV
projects that are risky, even though a negative-NPV project
destroys value for the firm overall.
– Anticipating this bad behavior, security holders will pay less
for the firm initially.
The University of Sydney
Page 62
Debt overhang and under-investment
– Now assume Baxter does not pursue the risky strategy, but
instead the firm is considering an investment opportunity that
requires an initial investment of $100,000 and will generate a
risk-free return of 50%.
– If the current risk-free rate is 5%, this investment clearly has a
positive NPV.
– What if Baxter does not have the cash on hand to make the
investment?
– Could Baxter raise $100,000 in new equity to make the
investment?
The University of Sydney
Page 63
Debt overhang and under-investment
The University of Sydney
Page 64
Debt overhang and under-investment
– If equity holders contribute $100,000 to fund the project, they
get back only $50,000.
– The other $100,000 from the project goes to the debt holders,
whose payoff increases from $900,000 to $1 million.
– The debt holders receive most of the benefit, thus this project is
a negative-NPV investment opportunity for equity holders,
even though it offers a positive NPV for the firm.
The University of Sydney
Page 65
Debt overhang and under-investment
– Debt Overhang or Under-Investment Problem
– A situation in which equity holders choose not to invest in a
positive NPV project because the firm is in financial distress
and the value of undertaking the investment opportunity will
accrue to bondholders rather than themselves
– When a firm faces financial distress, it may choose not to finance
new, positive-NPV projects.
– This is also called a debt overhang problem.
The University of Sydney
Page 66
Debt overhang and under-investment: Cashing out
– When a firm faces financial distress, shareholders have an
incentive to withdraw money from the firm, if possible.
– For example, if it is likely the company will default, the firm
may sell assets below market value and use the funds to pay
an immediate cash dividend to the shareholders.
• This is another form of under-investment that occurs when a
firm faces financial distress.
The University of Sydney
Page 67
Estimating the Debt Overhang
– How much leverage must a firm have for there to be a significant debt overhang
problem?
– Suppose equity holders invest an amount I in a new investment with similar risk to
the rest of the firm.
– Equity holders will benefit from the new investment only if
NPV βD D
>
I
βE E
The University of Sydney
Page 68
Estimating the Debt Overhang
The University of Sydney
Page 69
Estimating the Debt Overhang
The University of Sydney
Page 70
Agency costs and the value of leverage
– Leverage can encourage managers and shareholders to act in
ways that reduce firm value.
– It appears that the equity holders benefit at the expense of
the debt holders.
– However, ultimately, it is the shareholders of the firm who bear
these agency costs.
The University of Sydney
Page 71
Agency costs and the value of leverage
– When a firm adds leverage to its capital structure, the decision
has two effects on the share price.
– The share price benefits from equity holders’ ability to exploit
debt holders in times of distress.
– The debt holders recognize this possibility and pay less for the
debt when it is issued, reducing the amount the firm can
distribute to shareholders.
• The net effect is a reduction in the initial share price of the
firm.
The University of Sydney
Page 72
Agency costs and the value of leverage
– Agency costs of debt represent another cost of increasing the
firm’s leverage that will affect the firm’s optimal capital
structure choice.
The University of Sydney
Page 73
Debt maturity and covenants
– The magnitude of agency costs often depends on the maturity of debt.
– Agency costs are highest for long-term debt and smallest for shortterm debt.
– Debt Covenants
– Conditions of making a loan in which creditors place restrictions on
actions that a firm can take
– Covenants may help to reduce agency costs; however, because
covenants hinder management flexibility, they have the potential to
prevent investment in positive NPV opportunities and can have costs of
their own.
The University of Sydney
Page 74
6. Agency benefits of leverage
The University of Sydney
Page 75
Concentration of ownership
– One advantage of using leverage is that it allows the original
owners of the firm to maintain their equity stake. As major
shareholders, they will have a strong interest in doing what is
best for the firm.
The University of Sydney
Page 76
Concentration of ownership
– Assume Ross is the owner of a firm and he plans to expand. He can
either borrow the funds needed for expansion or raise the money by
selling shares in the firm. If he issues equity, he will need to sell 40% of
the firm to raise the necessary funds.
– Suppose the value of the firm depends largely on Ross’s personal
effort.
– By financing the expansion with borrowed funds, Ross retains 100%
ownership in the firm. Therefore, Ross is likely to work harder, and
the firm will be worth more because he will receive 100% of the
increase in firm value.
– However, if Ross sells new shares, he will only retain 60% ownership
and only receive 60% of the increase in firm value.
The University of Sydney
Page 77
Concentration of ownership
– With leverage, Ross retains 100% ownership and will bear the
full cost of any “perks,” like country club memberships or private
jets.
– By selling equity, Ross bears only 60% of the cost; the other 40%
will be paid for by the new equity holders.
– Thus, with equity financing, it is more likely that Ross will
overspend on these luxuries.
The University of Sydney
Page 78
Concentration of ownership
– By issuing new equity, the firm incurs the agency costs of reduced
effort and excessive spending on perks.
– As shown before, if securities are fairly priced, the original
owners of the firm will pay these costs.
– Using leverage can benefit the firm by preserving ownership
concentration and avoiding these agency costs.
The University of Sydney
Page 79
Reduction of wasteful investment
– A concern for large corporations is that managers may make
large, unprofitable investments.
– What would motivate managers to make negative-NPV
investments?
The University of Sydney
Page 80
Reduction of wasteful investment
– Managers may engage in empire building.
– Managers often prefer to run larger firms rather than smaller
ones, so they will take on investments that increase the size, but
not necessarily the profitability, of the firm.
• Managers of large firms tend to earn higher salaries, and
they may also have more prestige and garner greater
publicity than managers of small firms.
– Thus, managers may expand unprofitable divisions, pay too much for
acquisitions, make unnecessary capital expenditures, or hire unnecessary
employees.
The University of Sydney
Page 81
Reduction of wasteful investment
– Managers may over-invest because they are overconfident.
– Even when managers attempt to act in shareholders’ interests,
they may make mistakes.
• Managers tend to be bullish on the firm’s prospects and
may believe that new opportunities are better than they
actually are.
The University of Sydney
Page 82
Reduction of wasteful investment
– Free Cash Flow Hypothesis
– Wasteful spending is more likely to occur when firms have high
levels of cash flow in excess of what is needed after making
all positive-NPV investments and payments to debt holders
The University of Sydney
Page 83
Reduction of wasteful investment
– When cash is tight, managers will be motivated to run the
firm as efficiently as possible.
– According to the free cash flow hypothesis, leverage increases
firm value because it commits the firm to making future interest
payments, thereby reducing excess cash flows and wasteful
investment by managers.
The University of Sydney
Page 84
Reduction of wasteful investment
– Leverage can reduce the degree of managerial entrenchment because managers
are more likely to be fired when a firm faces financial distress.
– Managers who are less entrenched may be more concerned about their performance and less likely
to engage in wasteful investment.
– In addition, when the firm is highly levered, creditors themselves will closely
monitor the actions of managers, providing an additional layer of management
oversight.
The University of Sydney
Page 85
7. Agency costs and the trade-off theory
The University of Sydney
Page 86
Agency costs and the trade-off theory
– The value of the levered firm can now be shown to be
VL =
V U + PV (Interest Tax Shield) − PV (Financial Distress Costs)
− PV (Agency Costs of Debt) + PV (Agency Benefits of Debt)
The University of Sydney
Page 87
Agency costs and the trade-off theory
The University of Sydney
Page 88
Agency costs and the trade-off theory
– R&D-Intensive Firms
– Firms with high R&D costs and future growth opportunities
typically maintain low debt levels.
– These firms tend to have low current free cash flows and risky
business strategies.
The University of Sydney
Page 89
Agency costs and the trade-off theory
– Low-Growth, Mature Firms
– Mature, low-growth firms with stable cash flows and tangible
assets often carry a high-debt load.
– These firms tend to have high free cash flows with few good
investment opportunities.
The University of Sydney
Page 90
Debt Levels in Practice
– Management Entrenchment Theory
– Managers choose a capital structure to avoid the discipline of
debt and maintain their own job security
– Managers seek to minimize leverage to prevent the job loss
that would accompany financial distress but are constrained
from using too little debt (to keep shareholders happy).
The University of Sydney
Page 91
8. Asymmetric information and capital structure
The University of Sydney
Page 92
Asymmetric information and capital structure
– Asymmetric Information
– A situation in which parties have different information
– For example, when managers have superior information to
investors regarding the firm’s future cash flows
The University of Sydney
Page 93
Leverage as a credible signal
– Credibility Principle
– The principle that claims in one’s self-interest are credible only
if they are supported by actions that would be too costly to
take if the claims were untrue.
• “Actions speak louder than words.”
The University of Sydney
Page 94
Leverage as a credible signal
– Assume a firm has a large new profitable project but cannot
discuss the project for competitive reasons.
– One way to credibly communicate this positive information is
to commit the firm to large future debt payments.
• If the information is true, the firm will have no trouble
making the debt payments.
• If the information is false, the firm will have trouble paying
its creditors and will experience financial distress. This
distress will be costly for the firm.
The University of Sydney
Page 95
Leverage as a credible signal
– Signaling Theory of Debt
– The use of leverage as a way to signal information to investors
• Thus a firm can use leverage as a way to convince
investors that it does have information that the firm will
grow, even if it cannot provide verifiable details about the
sources of growth.
The University of Sydney
Page 96
Issuing equity and adverse selection
– Adverse Selection
– The idea that when the buyers and sellers have different
information, the average quality of assets in the market will
differ from the average quality overall
– Lemons Principle
– When a seller has private information about the value of a
good, buyers will discount the price they are willing to pay
due to adverse selection.
The University of Sydney
Page 97
Issuing equity and adverse selection
– A classic example of adverse selection and the lemons
principle is the used car market.
– If the seller has private information about the quality of the
car, then his desire to sell reveals the car is probably of low
quality.
– Buyers are therefore reluctant to buy except at heavily
discounted prices.
The University of Sydney
Page 98
Issuing equity and adverse selection
– Owners of high-quality cars are reluctant to sell because they
know buyers will think they are selling a lemon and offer only
a low price.
– Consequently, the quality and prices of cars sold in the usedcar market are both low.
The University of Sydney
Page 99
Issuing equity and adverse selection
– This same principle can be applied to the market for equity.
– Suppose the owner of a start-up company offers to sell you
70% of his stake in the firm. He states that he is selling only
because he wants to diversify. You suspect the owner may be
eager to sell such a large stake because he may be trying to
cash out before negative information about the firm becomes
public.
The University of Sydney
Page 100
Issuing equity and adverse selection
– Firms that sell new equity have private information about the
quality of the future projects.
– However, due to the lemon principle, buyers are reluctant to
believe management’s assessment of the new projects and are
only willing to buy the new equity at heavily discounted prices.
The University of Sydney
Page 101
Issuing equity and adverse selection
– Therefore, managers who know their prospects are good (and
whose securities will have a high value) will not sell new
equity.
– Only those managers who know their firms have poor
prospects (and whose securities will have low value) are
willing to sell new equity.
The University of Sydney
Page 102
Issuing equity and adverse selection
– The lemons problem creates a cost for firms that need to raise
capital from investors to fund new investments.
– If they try to issue equity, investors will discount the price they
are willing to pay to reflect the possibility that managers have
bad news.
The University of Sydney
Page 103
Issuing equity and adverse selection
– The lemons principle directly implies the following:
– The stock price declines on the announcement of an equity issue.
– The stock price tends to rise prior to the announcement of an
equity issue.
– Firms tend to issue equity when information asymmetries are
minimized, such as immediately after earnings announcements.
The University of Sydney
Page 104
Issuing equity and adverse selection
The University of Sydney
Page 105
Implications for capital structure
– Managers who perceive the firm’s equity is underpriced will have a
preference to fund investment using retained earnings, or debt,
rather than equity.
– The converse is also true: Managers who perceive the firm’s
equity to be overpriced will prefer to issue equity, as opposed
to issuing debt or using retained earnings, to fund investment.
The University of Sydney
Page 106
Implications for capital structure
– Pecking Order Hypothesis
– The idea that managers will prefer to fund investments by first using retained
earnings, then debt, and equity only as a last resort
– However, this hypothesis does not provide a clear prediction regarding capital
structure. While firms should prefer to use retained earnings, then debt, and then
equity as funding sources, retained earnings are merely another form of equity
financing.
• Firms might have low leverage either because they are unable to issue additional debt
and are forced to rely on equity financing or because they are sufficiently profitable to
finance all investment using retained earnings.
The University of Sydney
Page 107
Implications for capital structure
Source: Federal Reserve Flow of Funds.
The University of Sydney
Page 108
Implications for capital structure
The University of Sydney
Page 109
Implications for capital structure
The University of Sydney
Page 110
Chapter 17: Payout policy
Amy Kwan
The University of Sydney
Page 1
Outline
1.
2.
3.
4.
5.
6.
7.
Distributions to shareholders
a) Dividends
b) Share repurchases
Dividends vs. share repurchases
a) Modigliani-Miller and dividend policy irrelevance
Tax disadvantage of dividends
a) Optimal dividend policy with taxes
Dividend capture and tax clienteles
Payout vs. retention of cash
a) Taxes
b) Issuance and distress costs
c) Agency costs
Signaling with payout policy (asymmetric information)
a) Dividend smoothing
b) Dividend signaling
c) Signaling and share repurchases
Stock dividends, splits and spin-offs
The University of Sydney
Page 2
Exxon Mobil April Dividend Increases (APRIL 2017)
– Some analysts doubt the logic behind the continued dividend increase given Exxon
currently pays out more cash than any other S&P 500 firm. In 2016, the payout
exceeded $12.7 billion and is expected to top $13 billion in 2017. Given that oil still
hovers around $50 a barrel this amount is perceived as risky.
– However, Exxon’s management understands the folly of slashing dividends and will
likely continue to hike dividends as long as earnings will support the strategy.
BLOOMBERG
The University of Sydney
Page 3
Rakuten Inc Buyback (FEB 2017)
– Shares of Japanese e-commerce firm Rakuten Inc. moved eleven percent higher after
the firm announced its intent to buy back stock worth about 100 billion yen. The
current price represents a significant discount on shares that were issued only 20
months ago.
– The buyback consists of just over eight percent of the firm’s outstanding stock. The
justification given for the move was the belief that its shares were undervalued, having
fallen by 46 percent since issuance. Chairman Hiroshi Mikitani indicated the cash-rich
firm would spend a fraction of its 548-billion-yen stockpile to make the purchase.
BLOOMBERG
The University of Sydney
Page 4
1. Distributions to shareholders
The University of Sydney
Page 5
Distribution to shareholders
– Payout Policy
– The amount of cash firms choose to distribute to shareholders
– The form in which the distribution takes place
The University of Sydney
Page 6
Distribution to shareholders
Note: Payout can exceed free cash flow, by raising more cash
through borrowing or issuing more shares .
The University of Sydney
Page 7
Dividends
Labelled as a “special
dividend” Why?
Price changes
due to
information
effect
The University of Sydney
Price changes
due to value
reduction
effect
Page 8
Dividends
– Special Dividend
– A one-time dividend payment a firm makes, which is usually
much larger than a regular dividend
– Stock Split (Stock Dividend or Bonus Issue)
– When a company issues a dividend in shares of stock rather
than cash to its shareholders
– Splits are primarily to change share price
– Stock dividends/Bonus issue may be tax motivated
The University of Sydney
Page 9
Dividends
Special
dividends
The University of Sydney
Page 10
Dividends
– Return of Capital
– When a firm, instead of accounting for the payment of
dividends out of current earnings (or accumulated retained
earnings), pays cash out and debits other accounts, such as
paid-in-capital or reserves.
– Taxed at capital gains rates rather than income tax rates
– Liquidating Dividend
– A return of capital to shareholders from a business operation
that is being terminated
The University of Sydney
Page 11
Dividends: Who pays dividends?
– Typically large well established firms
– The minority by number of firms listed
– A large majority in terms of value of the stock-market
– Account for most of the total $ value of dividends paid
– Dividend life-cycle
– Small firms and start-ups tend not to pay dividends
– Large well established “cash-cows” tend to pay dividends
The University of Sydney
Page 12
Share repurchases (Buybacks)
– An alternative way to pay cash to investors is through a
share repurchase or buyback.
– The firm uses cash to buy shares of its own outstanding stock.
The University of Sydney
Page 13
Share repurchases
i.
Open Market Repurchase
– When a firm repurchases shares by buying shares in the open
market
– Open market share repurchases represent about 95% of all
repurchase transactions in the USA.
The University of Sydney
Page 14
Share repurchases
ii.
Tender Offer
– A public announcement of an offer to all existing security holders to
buy back a specified amount of outstanding securities at a
prespecified price (typically set at a 10% to 20% premium to the
current market price) over a prespecified period of time (usually
about 20 days)
– If shareholders do not tender enough shares, the firm may cancel
the offer, and no buyback occurs.
– Dutch Auction: The firm lists different prices at which it is prepared
to buy shares, and shareholders in turn indicate how many shares
they are willing to sell at each price. The firm then pays the lowest
price at which it can buy back its desired number of shares
The University of Sydney
Page 15
Share repurchases
iii. Targeted Repurchase
– When a firm purchases shares directly from a specific
shareholder
– Greenmail: When a firm avoids a threat of takeover and
removal of its management by a major shareholder by buying
out the shareholder, often at a large premium over the current
market price
The University of Sydney
Page 16
2. Dividends vs. share repurchases
The University of Sydney
Page 17
Dividends vs. share repurchases
– Consider Genron Corporation. The firm’s board is meeting to
decide how to pay out $20 million in excess cash to shareholders.
– Genron has no debt, its equity cost of capital equals its
unlevered cost of capital of 12%.
– Alternative Policy 1: Pay dividend with excess cash
– Alternative Policy 2: Share repurchase (no dividend)
– Alternative Policy 3: High dividend (equity issue)
The University of Sydney
Page 18
Alternative Policy 1: Pay Dividend with Excess Cash
– With 10 million shares outstanding, Genron will be able to pay a
$2 dividend immediately.
– The firm expects to generate future free cash flows of $48
million per year; thus, it anticipates paying a dividend of $4.80
per share each year thereafter.
The University of Sydney
Page 19
Alternative Policy 1: Pay Dividend with Excess Cash
– Cum-dividend
– When a stock trades before the ex-dividend date, entitling
anyone who buys the stock to the dividend
– The cum-dividend price of Genron will be
Pcum =Current Dividend + PV (Future Dividends) =2 +
The University of Sydney
4.80
= 2 + 40 = $42
0.12
Page 20
Alternative Policy 1: Pay Dividend with Excess Cash
– After the ex-dividend date, new buyers will not receive the
current dividend and the share price and the price of Genron
will be
=
Pex
The University of Sydney
PV (Future Dividends)
=
4.80
=
0.12
$40
Page 21
Alternative Policy 1: Pay Dividend with Excess Cash
The University of Sydney
Page 22
Alternative Policy 1: Pay Dividend with Excess Cash
– In a perfect capital market, when a dividend is paid, the share
price drops by the amount of the dividend when the stock begins to
trade ex-dividend.
The University of Sydney
Page 23
Alternative Policy 2: Share Repurchase (No Dividend)
– Suppose that instead of paying a dividend this year, Genron
uses the $20 million to repurchase its shares on the open
market.
– With an initial share price of $42, Genron will repurchase
476,000 shares.
• $20 million ÷ $42 per share = 0.476 million shares
– This will leave only 9.524 million shares outstanding.
• 10 million − 0.476 million = 9.524 million
The University of Sydney
Page 24
Alternative Policy 2: Share Repurchase (No Dividend)
– The net effect is that the share price
remains unchanged.
The University of Sydney
Page 25
Alternative Policy 2: Share Repurchase (No Dividend)
– Genron’s Future Dividends
– It should not be surprising that the repurchase had no effect on
the stock price.
– After the repurchase, the future dividend would rise to $5.04
per share.
• $48 million ÷ 9.524 million shares = $5.04 per share
5.04
• Genron’s
price is$42
=
Pshare
=
rep
0.12
The University of Sydney
Page 26
Alternative Policy 2: Share Repurchase (No Dividend)
– Genron’s Future Dividends
– In perfect capital markets, an open market share repurchase has
no effect on the stock price, and the stock price is the same as
the cum-dividend price if a dividend had been paid instead.
The University of Sydney
Page 27
Alternative Policy 2: Share Repurchase (No Dividend)
– Investor Preferences
– In perfect capital markets, investors are indifferent between the
firm distributing funds via dividends or share repurchases. By
reinvesting dividends or selling shares, they can replicate either
payout method on
their own.
The University of Sydney
Page 28
Alternative Policy 2: Share Repurchase (No Dividend)
– Investor Preferences
– In the case of Genron, if the firm repurchases shares and the
investor wants cash, the investor can raise cash by selling
shares.
• This is called a homemade dividend.
– If the firm pays a dividend and the investor would prefer
stock, they can use the dividend to purchase additional shares.
The University of Sydney
Page 29
Dividends vs. share repurchases
The University of Sydney
Page 30
Dividends vs. share repurchases
The University of Sydney
Page 31
Alternative Policy 3: High Dividend (Equity Issue)
– Suppose Genron wants to pay dividend larger than $2 per
share right now, but it only has $20 million in cash today.
– Thus, Genron needs an additional $28 million to pay the
larger dividend now. To do this, the firm decides to raise the
cash by selling new shares.
The University of Sydney
Page 32
Alternative Policy 3: High Dividend (Equity Issue)
– Given a current share price of $42, Genron could raise $28
million by selling 0.67 million shares.
– $28 million ÷ $42 per share = 0.67 million shares
• This will increase the total number of shares to
10.67 million.
The University of Sydney
Page 33
Alternative Policy 3: High Dividend (Equity Issue)
– The new dividend per share will be
$48 million
= $4.50 per share
10.67 million shares
– And the cum-dividend share price will be
Pcum = 4.50 +
4.50
= 4.50 + 37.50 = $42
0.12
– Again, the share value is unchanged.
The University of Sydney
Page 34
Modigliani–Miller and dividend policy irrelevance
– There is a trade-off between current and future dividends.
– If Genron pays a higher current dividend, future dividends will
be lower.
– If Genron pays a lower current dividend, future dividends will
be higher.
The University of Sydney
Page 35
Modigliani–Miller and dividend policy irrelevance
The University of Sydney
Page 36
Modigliani–Miller and dividend policy irrelevance
– MM Dividend Irrelevance
– In perfect capital markets, holding fixed the investment policy of
a firm, the firm’s choice of dividend policy is irrelevant and does
not affect the initial share price.
The University of Sydney
Page 37
Modigliani–Miller and dividend policy irrelevance
– A firm’s free cash flow determines the level of payouts that it
can make to its investors.
– In a perfect capital market, the type of payout is irrelevant.
– In reality, capital markets are not perfect, and it is these
imperfections that should determine the firm’s payout policy.
The University of Sydney
Page 38
3. Tax disadvantage of dividends
The University of Sydney
Page 39
Tax disadvantage of dividends
– Taxes on Dividends and Capital Gains
– Shareholders must pay taxes on the dividends they receive,
and they must also pay capital gains taxes when they sell their
shares.
– Dividends are typically taxed at a higher rate than capital
gains. In fact, long-term investors can defer the capital gains
tax forever by not selling.
The University of Sydney
Page 40
Tax disadvantage of dividends
The University of Sydney
Page 41
Tax disadvantage of dividends
– Taxes on Dividends and Capital Gains
– The higher tax rate on dividends makes it undesirable for a
firm to raise funds to pay a dividend.
• When dividends are taxed at a higher rate than capital
gains, if a firm raises money by issuing shares and then
gives that money back to shareholders as a dividend,
shareholders are hurt because they will receive less than
their initial investment.
The University of Sydney
Page 42
Tax disadvantage of dividends
The University of Sydney
Page 43
Tax disadvantage of dividends
The University of Sydney
Page 44
Optimal dividend policy with taxes
– When the tax rate on dividends is greater than the tax rate on
capital gains, shareholders will pay lower taxes if a firm uses
share repurchases rather than dividends.
– This tax savings will increase the value of a firm that uses
share repurchases rather than dividends.
– Assumes the marginal shareholder pays more tax on dividends
than capital gains
The University of Sydney
Page 45
Optimal dividend policy with taxes
– The optimal dividend policy when the dividend tax rate
exceeds the capital gain tax rate is to pay no dividends at all.
– The payment of dividends has declined on average over the
last 30 years in the USA, while the use of repurchases has
increased.
The University of Sydney
Page 46
Optimal dividend policy with taxes
Source: Compustat.
The University of Sydney
Page 47
Optimal dividend policy with taxes
Source: Compustat data for U.S. firms, excluding financial firms and
utilities.
The University of Sydney
Page 48
Optimal dividend policy with taxes
– A different story in Australia
– Repurchases tend to be much less prevalent
• Historically due to legal restrictions
• More recently due to the imputation tax system
– Under imputation dividends are tax advantaged for many
investors (particularly superannuation)
– Dividend payout ratios have risen
• Historical average about 50%
• Following imputation about 70%
The University of Sydney
Page 49
Optimal dividend policy with taxes
– Dividend Puzzle
– When firms continue to issue dividends despite their apparent
tax disadvantage
• Tax is complex, many different tax clienteles
• Multiple tax avoidance strategies
The University of Sydney
Page 50
4. Dividend capture and tax clienteles
The University of Sydney
Page 51
Dividend capture and tax clienteles
– The preference for share repurchases rather than dividends
depends on the difference between the dividend tax rate and
the capital gains tax rate.
– Tax rates vary by income, by jurisdiction, and by whether the
stock is held in a retirement account.
– Given these differences, firms may attract different groups of
investors depending on their dividend policy.
The University of Sydney
Page 52
Effective dividend tax rate
– Consider buying a stock just before it goes ex-dividend and selling the stock just
after.
– The equilibrium condition must be
(Pcum − Pex ) (1 − τ g ) =
– Which can be stated as
Pcum − Pex =
1 − τd 
=
Div × 
 1 − τ 
g 

Div(1 − τ d )
Elton & Gruber Model for
classical tax system

τd − τg 
= Div × (1 − τ * )
Div × 1 −


1 − τ g 

d
– Where Pcum is the cum-dividend price, Pex is the ex-dividend price, τg is the capital gains rate tax,
and τd is the dividend tax rate.
The University of Sydney
Page 53
Effective dividend tax rate
– Thus, the effective dividend tax rate is
τ
*
d
τd − τg
= 
1 − τ
g




– This measures the additional tax paid by the investor per
dollar of after-tax capital gains income that is received as a
dividend.
The University of Sydney
Page 54
Effective dividend tax rate
– The effective dividend tax rate differs across investors for a
variety of reasons.
– Income Level
– Investment Horizon
– Tax Jurisdiction
– Type of Investor or Investment Account
– As a result of their different tax rates, investors will have
varying preferences regarding dividends.
The University of Sydney
Page 55
Clientele effects
– Clientele Effect
– When the dividend policy of a firm reflects the tax preference
of its investor clientele
• Individuals in the highest tax brackets have a preference for
stocks that pay no or low dividends, whereas tax-free
investors and corporations have a preference for stocks with
high dividends.
The University of Sydney
Page 56
Clientele effects
The University of Sydney
Page 57
Clientele effects
– Dividend-Capture Theory
– The theory that absent transaction costs, investors can trade shares at the
time of the dividend so that non-taxed investors receive the dividend
• An implication of this theory is that we should see large trading volume
in a stock around the ex-dividend day, as high-tax investors sell and
low-tax investors buy the stock in anticipation of the dividend, and then
reverse those trades just after the ex-dividend date.
– There is tax-arbitrage about ex-div dates, but it is inhibited by transactions
costs and risk.
• Eg. Less cum/ex abnormal volume in high spread stocks
The University of Sydney
Page 58
Clientele effects
The University of Sydney
Page 59
5. Payout vs. retention of cash
The University of Sydney
Page 60
Payout vs. retention of cash
– In perfect capital markets, once a firm has taken all positive-NPV
investments, it is indifferent between saving excess cash and
paying it out.
– With market imperfections, there is a trade-off: Retaining cash
can reduce the costs of raising capital in the future, but it can
also increase taxes and agency costs.
The University of Sydney
Page 61
Payout vs. retention of cash
– If a firm has already taken all positive-NPV projects, any
additional projects it takes on are zero or negative-NPV
investments.
– Rather than waste excess cash on negative-NPV projects, a
firm can use the cash to purchase financial assets.
– In perfect capital markets, buying and selling securities is a
zero-NPV transaction, so it should not affect firm value.
– Thus, with perfect capital markets, the retention versus payout
decision is irrelevant.
The University of Sydney
Page 62
Payout vs. retention of cash
The University of Sydney
Page 63
Payout vs. retention of cash
The University of Sydney
Page 64
Payout vs. retention of cash
– MM Payout Irrelevance
– In perfect capital markets, if a firm invests excess cash flows
in financial securities, the firm’s choice of payout versus
retention is irrelevant and does not affect the initial share
price.
The University of Sydney
Page 65
Taxes and cash retention
– Corporate taxes make it costly for a firm to retain excess cash.
– Cash is equivalent to negative leverage, so to extent there is a
tax advantage to leverage this implies a tax disadvantage to
holding cash.
The University of Sydney
Page 66
Taxes and cash retention
The University of Sydney
Page 67
Taxes and cash retention
The University of Sydney
Page 68
Taxes and cash retention
– The decision to pay out versus retain cash may also affect the
taxes paid by shareholders.
– When a firm retains cash, it must pay corporate tax on the
interest it earns. In addition, the investor will owe capital gains
tax on the increased value of the firm. In essence, the interest
on retained cash is taxed twice.
The University of Sydney
Page 69
Taxes and cash retention
– If the firm paid the cash to its shareholders instead, they could
invest it and be taxed only once on the interest that they earn.
• The cost of retaining cash therefore depends on the
combined effect of the corporate and capital gains taxes,
compared to the single tax on interest income.
τ =
*
retain
The University of Sydney

1 −

(1
− τ c ) (1 − τ g ) 

(1 − τ i )

Page 70
Issuance and distress costs
– Generally, firms retain cash balances to cover potential future
cash shortfalls, despite the tax disadvantage to retaining
cash.
– A firm might accumulate a large cash balance if
there is a reasonable chance that future earnings will be
insufficient to fund future positive-NPV investment
opportunities.
The University of Sydney
Page 71
Issuance and distress costs (cont’d)
– The cost of holding cash to cover future potential cash needs
should be compared to the reduction in transaction, agency,
and adverse selection costs of raising new capital through
new debt or equity issues.
The University of Sydney
Page 72
Agency costs of retaining cash
– When firms have excessive cash, managers may use the
funds inefficiently by paying excessive executive perks, overpaying for acquisitions, etc.
– Paying out excess cash through dividends or share
repurchases, rather than retaining cash, can boost the stock
price by reducing managers’ ability and temptation to waste
resources.
The University of Sydney
Page 73
Agency costs of retaining cash
The University of Sydney
Page 74
Agency costs of retaining cash
The University of Sydney
Page 75
6. Signaling with payout policy
The University of Sydney
Page 76
Signaling with payout policy
– Now we consider another market imperfection: Asymmetric
information (i.e. when managers have better information than
investors regarding the future prospects of the firm)
– Their payout decisions may signal this information
i. Dividend smoothing
ii. Dividend signaling
iii. Signaling and share repurchases
The University of Sydney
Page 77
Dividend smoothing
– Dividend Smoothing
– The practice of maintaining relatively constant dividends
• Firm change dividends infrequently, and dividends are much
less volatile than earnings.
The University of Sydney
Page 78
Dividend smoothing
Source: Compustat and CapitalIQ.
The University of Sydney
Page 79
Dividend smoothing
– Research has found that
– Management believes that investors prefer stable dividends
with sustained growth.
– Management desires to maintain a long-term target level of
dividends as a fraction of earnings.
• Thus, firms raise their dividends only when they perceive a
long-term sustainable increase in the expected level of
future earnings and cut them only as a last resort.
The University of Sydney
Page 80
Dividend signaling
– Dividend Signaling Hypothesis
– The idea that dividend changes reflect managers’ views about
a firm’s future earning prospects
• If firms smooth dividends, the firm’s dividend choice will
contain information regarding management’s expectations
of future earnings.
The University of Sydney
Page 81
Dividend signaling
– When a firm increases its dividend, it sends a positive signal to
investors that management expects to be able to afford the
higher dividend for the foreseeable future.
– When a firm decreases its dividend, it may signal that
management has given up hope that earnings will rebound in the
near term and so need to reduce the dividend to save cash.
The University of Sydney
Page 82
Dividend signaling
– Although an increase of a firm’s dividend may signal
management’s optimism regarding its future cash flows, it might
also signal a lack of investment opportunities.
– Conversely, a firm might cut its dividend to exploit new positiveNPV investment opportunities.
– In this case, the dividend decrease might lead to a positive,
rather than negative, stock price reaction.
The University of Sydney
Page 83
Signaling and share repurchases
– Share repurchases are a credible signal that the shares are
underpriced, because if they are overpriced a share repurchase
is costly for current shareholders.
– If investors believe that managers have better information
regarding the firm’s prospects and act on behalf of current
shareholders, then investors will react favorably to share
repurchase announcements.
The University of Sydney
Page 84
7. Stock dividends, splits and spin-offs
The University of Sydney
Page 85
Stock dividends, splits, and spin-offs
– Stock Dividends and Splits
– With a stock dividend, a firm does not pay out any cash to
shareholders.
• As a result, the total market value of the firm’s equity is
unchanged. The only thing that is different is the number of
shares outstanding.
– The stock price will therefore fall because the same total equity value is now
divided over a larger number of shares.
The University of Sydney
Page 86
Stock dividends, splits, and spin-offs
– Stock Dividends and Splits
– Suppose Genron paid a 50% stock dividend (a 3:2 stock split)
rather than a cash dividend.
• A shareholder who owns 100 shares before the dividend
has a portfolio worth $4,200.
$42 × 100 = $4,200
• After the dividend, the shareholder owns 150 shares.
Because the portfolio is still worth $4,200, the stock price
will fall to $28.
$4,200 ÷ 150 = $28
The University of Sydney
Page 87
Stock dividends, splits, and spin-offs
The University of Sydney
Page 88
Stock dividends, splits, and spin-offs
– Stock Dividends and Splits
– Stock dividends are not taxed, so from both the firm’s and
shareholders’ perspectives, there is no real consequence to a
stock dividend.
• The number of shares is proportionally increased, and the
price per share is proportionally reduced so that there is no
change in value.
The University of Sydney
Page 89
Stock dividends, splits, and spin-offs
– Stock Dividends and Splits
– The typical motivation for a stock split is to keep the share
price in a range thought to be attractive to small investors.
– If the share price rises “too high,” it might be difficult for small
investors to invest in the stock.
The University of Sydney
Page 90
Stock dividends, splits, and spin-offs
– Stock Dividends and Splits
– Keeping the price “low” may make the stock more attractive to
small investors and can increase the demand for and the
liquidity of the stock, which may in turn boost the stock price.
• On average, announcements of stock splits are associated
with a 2% increase in the stock price.
The University of Sydney
Page 91
Stock dividends, splits, and spin-offs
– Stock Dividends and Splits
– Reverse Split
• When the price of a company’s stock falls too low and the
company reduces the number of outstanding shares
The University of Sydney
Page 92
Stock dividends, splits, and spin-offs
The University of Sydney
Page 93
Stock dividends, splits, and spin-offs
– Spin-off
– When a firm sells a subsidiary by selling shares in the
subsidiary alone
• Non-cash special dividends are commonly used to spin off
assets or a subsidiary as a separate company.
The University of Sydney
Page 94
Stock dividends, splits, and spin-offs
– Spin-Offs offer two advantages
– It avoids the transaction costs associated with a subsidiary
sale.
– The special dividend is not taxed as a cash distribution.
The University of Sydney
Page 95
Chapter 23: Raising equity
capital
Amy Kwan
The University of Sydney
Page 1
Outline
1.
Equity financing for private companies
a) Sources of funding
b) Venture capital investing
c) Exiting an investment in a private company
2. The initial public offering (IPO)
a) Advantages and disadvantages of going public
b) Types of offerings
c) The mechanics of an IPO
3. IPO puzzles
a) Underpricing
b) Cyclicality
c) Cost of an IPO
d) Long-run underperformance
4. The seasoned equity offering (SEO)
a) Mechanics of an SEO
b) Price reaction
c) Issuance costs
The University of Sydney
Page 2
1. Equity financing for private companies
The University of Sydney
Page 3
Equity financing for private companies
– The initial capital that is required to start a business is usually
provided by the entrepreneur and the immediate family.
– Often, a private company must seek outside sources that can
provide additional capital for growth.
– It is important to understand how the infusion of outside capital
will affect the control of the company.
The University of Sydney
Page 4
Sources of Funding
1. Angel Investors: Individual Investors who buy equity in small
private firms
• Finding angels is typically difficult.
2. Venture Capital Firm: A limited partnership that specializes in
raising money to invest in the private equity of young firms
• Venture Capitalists: One of the general partners who work
for and run a venture capital firm
The University of Sydney
Page 5
Sources of funding
3. Private equity firms: Organized very much like a venture
capital firm, but it invests in the equity of existing privately
held firms rather than start-up companies.
• Private equity firms often purchase the outstanding equity
of a public firm using lots of debt. Thereby taking the
company private in a transaction commonly called a
leveraged buyout (LBO).
The University of Sydney
Page 6
Sources of funding
– Global LBO Volume and Number of Deals
Source: Dealogic
The University of Sydney
Page 7
Sources of funding
– Top 10 Private Equity Funds in 2015
The University of Sydney
Page 8
Sources of funding
4.
5.
Institutional investors: Institutional investors, such as pension funds, insurance
companies, endowments, and foundations, are active investors in private
companies.
• Institutional investors may invest directly in private firms or they may
invest indirectly by becoming limited partners in venture capital firms.
Corporate Investors: A corporation that invests in private companies
• Also known as corporate partner, strategic partner, and strategic
investor
• Although most other types of investors in private firms are primarily
interested in the financial returns of their investments, corporate
investors might invest for corporate strategic objectives, in addition to
the financial returns.
The University of Sydney
Page 9
Venture capital investing
– Venture capital firms offer limited partners advantages over
investing directly in start-ups themselves as angel investors.
– Limited partners are more diversified.
– They also benefit from the expertise of the general partners.
• As do the firms being financed
– Most deals fail or make poor returns 10% to 30% are a
success.
The University of Sydney
Page 10
Venture capital investing
– The advantage of general partners come at a cost.
– General partners usually charge substantial fees.
• Most firms charge 20% of any positive return they make
• They also generally charge an annual management fee of
about 2% of the fund’s committed capital.
The University of Sydney
Page 11
Venture capital investing
The University of Sydney
Page 12
Venture capital investing
Source: National Venture Capital Association
The University of Sydney
Page 13
Venture capital investing
– Preferred stock is often used
– Preferred stock issued by mature companies usually has a
preferential dividend and seniority in any liquidation and
sometimes special voting rights.
– Preferred stock issued by young companies has seniority in
any liquidation but typically does not pay regular cash
dividends and often contains a right to convert to common
stock (convertible preferred stock).
The University of Sydney
Page 14
Venture capital investing
– RealNetworks, which was founded by Robert Glaser in 1993,
was initially funded with an investment of approximately $1
million by Glaser.
– As of April 1995, Glaser’s $1 million initial investment in
RealNetworks represented 13,713,439 shares of Series A
preferred stock, implying an initial purchase price of about
$0.07 per share.
The University of Sydney
Page 15
Venture capital investing
– RealNetworks needed additional capital
and management decided to raise this money by selling
equity in the form of convertible preferred stock.
The University of Sydney
Page 16
Venture capital investing
– The company’s first round of outside equity funding was Series
B preferred stock. RealNetworks sold 2,686,567 shares of
Series B preferred stock at $0.67 per share in April 1995.
After this funding round the distribution of ownership was as
follows:
The University of Sydney
Page 17
Venture capital investing
– The company’s first round of outside equity funding was Series
B preferred stock. RealNetworks sold 2,686,567 shares of
Series B preferred stock at $0.67 per share in April 1995.
After this funding round the distribution of ownership was as
follows:
The University of Sydney
Page 18
Venture capital investing
– The Series B preferred shares were new shares of stock being
sold by RealNetworks. At the price the new shares were sold
for, Glaser’s shares were worth $9.2 million and represented
83.6% of the outstanding shares.
The University of Sydney
Page 19
Venture capital investing
– Pre-Money Valuation
– At the issuance of new equity, the value of the
firm’s prior shares outstanding at the price in the funding round
• $9.2 million in the RealNetworks example
– Post-Money Valuation
– At the issue of new equity, the value of the whole firm (old plus
new shares) at the price at which the new equity sold
• $11.0 million in the RealNetworks example
The University of Sydney
Page 20
Venture capital investing
– Over the next few years, RealNetworks raised three more
rounds of outside equity in addition to the Series B funding
round.
The University of Sydney
Page 21
Venture capital investing
– Liquidation Preference
– Priority payment to security holders (other than ordinary shareholders) in the event of liquidation or
sale. Typically 1 to 3 X initial investment.
– Seniority
– Often higher rankings in later rounds.
– Participation Rights
– Double dip, get liquidation preference and payoff from conversion
– Anti-Dilution Protection
.
– “ Down Round” conversion rate adjustment if issue price falls in subsequent rounds
– Board Membership
– To enhance control
The University of Sydney
Page 22
Venture capital investing
The University of Sydney
Page 23
Venture capital investing
The University of Sydney
Page 24
Exiting an investment in a private company
– Exit Strategy
– Trade sale/merger/acquisition
– Initial Public Offering
– Initial Public Offering (IPO)
– The process of selling stock to the public for the first time
The University of Sydney
Page 25
2. The initial public offering (IPO)
The University of Sydney
Page 26
The initial public offering
– Largest U.S. IPOs
The University of Sydney
Page 27
Advantages and disadvantages of going public
– Advantages
– Greater liquidity
• Private equity investors get the ability to diversify.
• Ability to cash out
– Better access to capital
• Public companies typically have access to much larger
amounts of capital through the public markets.
– Bigger public profile
The University of Sydney
Page 28
Advantages and disadvantages of going public
– Disadvantages
– The equity holders become more widely dispersed.
• This makes it difficult to monitor management.
• Agency costs reduce the price investors will pay
– The firm must satisfy all the costly regulatory and disclosure
requirements of
public companies.
• SEC filings, Sarbanes-Oxley, etc.
• Listing fees
– Substantial transaction cost
The University of Sydney
Page 29
Types of offerings
– Underwriter: An investment banking firm that manages the
security issue and pricing.
– Primary and Secondary Offerings
– Primary Offering
• New shares available in a public offering that raise
new capital
– Secondary Offering
• Shares sold by existing shareholders in an equity offering
The University of Sydney
Page 30
Types of offerings
– Best-Efforts, Firm Commitment, and Auction IPOs
– Best-Efforts Basis
• For smaller IPOs, the underwriter may not guarantee that
the stock will be sold, but instead tries to sell the sock for
the best possible price
– Often such deals have an all-or-none clause: either all of the shares are sold on the IPO or
the deal is called off.
The University of Sydney
Page 31
Types of offerings
– Best-Efforts, Firm Commitment, and Auction IPOs
– Firm Commitment (most common)
• An agreement between an underwriter and an issuing firm
in which the underwriter guarantees that it will sell all of the
stock at the offer price
• In the USA the underwriter buys the whole issue and resells
at a slightly higher price
• In Australia the underwriter guarantees to buy any unsold
shares and is paid a fee.
The University of Sydney
Page 32
Types of offerings
– Best-Efforts, Firm Commitment and Auction IPOs
– Auction IPO
• A method of selling new issues directly to the public
– Rather than setting a price itself and then allocating shares to buyers, the underwriter in an
auction IPO takes bids from investors and then takes the price that clears the market.
– The constrained open tender, where institutions are invited to bid between upper and lower
prices has been used in Australia.
» Retail investors pay the price set by the institutions less a slight discount.
The University of Sydney
Page 33
The mechanics of an IPO
– Underwriters and the Syndicate
– Lead Underwriter
• The primary investment banking firm responsible for
managing a security issuance
– Syndicate
• A group of underwriters who jointly underwrite and
distribute a security issuance
The University of Sydney
Page 34
The mechanics of an IPO
– Top Global IPO Underwriters, Ranked by 2014 Proceeds
The University of Sydney
Page 35
The mechanics of an IPO
– SEC Filings
– Registration Statement
• A legal document that provides financial and other
information about a company to investors prior to a
security issuance
– Preliminary Prospectus (Red Herring)
• Part of the registration statement prepared by a company
prior to an IPO that is circulated to investors before the
stock is offered
The University of Sydney
Page 36
The mechanics of an IPO
– SEC Filings
• The final registration statement and final prospectus are
submitted to the SEC and contains the details of the
offering, including the number of shares offered and the
offer price
The University of Sydney
Page 37
The mechanics of an IPO
Overallotment or
green shoe
provision
Source: Courtesy RealNetworks, Inc.
The University of Sydney
Page 38
The mechanics of an IPO
– Valuation
– Underwriters and the firm agree an issue price
• Certifying value by putting their cash & reputation on the
line is an important function of underwriters.
• Valuation is by DCF and comparables, particularly
comparables of recent IPOs. Supplemented by price
discovery in a “book build”
The University of Sydney
Page 39
The mechanics of an IPO
– Valuation
– Road Show
• A company’s senior management and its underwriters travel
around promoting the company and explaining their rationale for
an offer price, or price range, to the underwriters’ largest
customers, mainly institutional investors such as mutual funds and
pension funds.
• Book build institutions give feedback on the issue and how many
shares they would like to buy.
• Underwriters use the book build information to set a price at
which the issue is likely to succeed.
The University of Sydney
Page 40
The mechanics of an IPO
– Pricing the Deal and Managing Risk
– Spread
• The fee a company pays to its underwriters that is a
percentage of the issue price of a share of stock
– For RealNetworks, the final offer price was $12.50 per share, and the company paid the
underwriters a spread of $0.875 per share, exactly 7% of the issue price.
– Because this was a firm commitment deal, the underwriters bought the stock from
RealNetworks for $11.625 per share and then resold it to their customers for $12.50 per
share.
» $12.50 – $0.875 = $11.625
The University of Sydney
Page 41
The mechanics of an IPO
– Pricing the Deal and Managing Risk
– When an underwriter provides a firm commitment, it is
potentially exposing itself to the risk that it might have to sell
the shares at less than the offer price and take a loss.
• However, the majority (say 75%) of IPOs experience an
increase in share price on the first day.
• That is most issues were underpriced!
The University of Sydney
Page 42
The mechanics of an IPO
– Pricing the Deal and Managing Risk
– Underwriters initially market both the initial allotment and the
allotment in the greenshoe provision, effectively short selling
the greenshoe allotment.
• If the issue is a success, the underwriter exercises the green
shoe option, thereby covering its short position.
• If the issue is not a success, the underwriter covers the short
position by repurchasing the greenshoe allotment in the
aftermarket, thereby supporting the price.
The University of Sydney
Page 43
The mechanics of an IPO
– Pricing the Deal and Managing Risk
– Lockup
• A restriction n that prevents existing shareholders from
selling more of their shares for some period, usually 180
days, after an IPO
The University of Sydney
Page 44
3. IPO puzzles
The University of Sydney
Page 45
IPO puzzles
– Underpricing
– Generally, underwriters set the issue price so that the average
first-day return is positive.
• About 75% of first-day returns are positive.
• The average first day return in the United States is 18.3%.
The University of Sydney
Page 46
IPO puzzles
– Underpricing
– The underwriters benefit from the underpricing because it
allows them to manage their risk.
– The pre-IPO shareholders bear the cost of underpricing. In
effect, these owners are selling stock in their firm for less than
they could get in the aftermarket.
– The effect is pervasive around the world.
The University of Sydney
Page 47
IPO puzzles
Source: Adapted courtesy of Jay Ritter (bear.warrington.ufl.edu/ritter/)
The University of Sydney
Page 48
IPO puzzles
– Underpricing
– Although IPO returns are attractive, all investors cannot earn
these returns.
• When an IPO goes well, the demand for the stock exceeds
the supply. Thus the allocation of shares for each investor is
rationed.
• When an IPO does not go well, demand at the issue price is
weak, so all initial orders are filled completely.
– Thus, the typical investor will have their investment in “good” IPOs rationed while fully
investing in “bad” IPOs.
The University of Sydney
Page 49
IPO puzzles
– Underpricing
– Winner’s Curse
• The winner in a bid has paid the highest price and very
likely overestimated the value of the item being bid on
– You “win” (get all the shares you requested) when demand for the shares by others is low
and the IPO is more likely to perform poorly.
The University of Sydney
Page 50
IPO puzzles
The University of Sydney
Page 51
IPO puzzles
The University of Sydney
Page 52
Cyclicality
– The number of issues is highly cyclical.
– When times are good, the market is flooded with new issues;
when times are bad, the number of issues dries up.
The University of Sydney
Page 53
Cyclicality
Source: Adapted courtesy of Jay R. Ritter from “Initial Public Offerings: Tables Updated through
2014” (bear.warrington.ufl.edu/ritter/).
The University of Sydney
Page 54
Costs of an IPO
– A typical spread is 7% of the issue price.
– By most standards, this fee is large, especially considering the
additional cost to the firm associated with underpricing.
– It is puzzling that there seems to be a lack of sensitivity of fees
to issue size.
• One possible explanation is that by charging lower fees, an
underwriter may risk signaling that it is not the same quality
as its higher priced competitors.
The University of Sydney
Page 55
Costs of an IPO
Source: Adapted from I. Lee, S. Lochhead, J. Ritter, and Q. Zhao, “The Costs of Raising
Capital,” Journal of Financial Research 19(1) (1996): 59–74.
The University of Sydney
Page 56
Long-run underperformance
– Although shares of IPOs generally perform
very well immediately following the public
offering, it has been shown that newly listed firms subsequently
appear to perform relatively poorly over the following three to
five years after their IPOs.
The University of Sydney
Page 57
4. The seasoned equity offering (SEO)
The University of Sydney
Page 58
Seasoned equity offering
– Seasoned Equity Offering (SEO)
– When a public company offers new shares for sale
• Public firms use SEOs to raise additional equity.
• When a firm issues stock using an SEO, it follows many of
the same steps as for an IPO.
– The main difference is that a market price for the stock already exists, so the price-setting
process is not necessary.
» The issue price is commonly set at a discount to the market price.
The University of Sydney
Page 59
Mechanics of an SEO
– Primary Shares
– New shares issued by a company in an equity offering
– Secondary Shares
– Shares sold by existing shareholders in an
equity offering
The University of Sydney
Page 60
Mechanics of an SEO
– There are two types of seasoned equity offerings.
– Cash Offer
• A type of SEO in which a firm offers the new shares to investors at large;
common in the USA
– Rights Offer
• A type of SEO in which a firm offers the new shares only to existing
shareholders. Usual in Australia & the UK.
– Rights offers protect the interests of existing shareholders.
– Large discounts, eg. 30% are common BUT have no effect on wealth as long
as shareholders either sell their rights or exercise them.
The University of Sydney
Page 61
Mechanics of an SEO
The University of Sydney
Page 62
Mechanics of an SEO
The University of Sydney
Page 63
Price reaction
– Researchers have found that, on average,
the market greets the news of an SEO with a price decline.
– This is consistent with SEOs being bad news
• Eg. adverse selection & pecking order discussed in Chapter 16.
• But this may also depend on the nature & credibility of the
motive firms give for the issue.
– Furthermore poor performance, on average apparently continues after
the IPO.
The University of Sydney
Page 64
Price reaction
Source: Adapted from A. Brav, C. Geczy, and P. Gompers, “Is the Abnormal Return Following
Equity Issuances Anomalous,” Journal of Financial Economics 56 (2000): 209–249, Figure 3.
The University of Sydney
Page 65
Price reaction
– Raising capital for investment
– Converting risky growth options to less risky projects
– Beta goes down
• Returns should be lower
• Abnormal returns measured using the old beta will appear
to be negative.
The University of Sydney
Page 66
Issuance costs
– Although not as costly as IPOs, seasoned offerings are still
expensive.
– Underwriting fees amount to 5% of the proceeds of the issue.
• Rights offers have lower costs than cash offers.
The University of Sydney
Page 67

Purchase answer to see full
attachment

Why Choose Us

• 100% non-plagiarized Papers
• 24/7 /365 Service Available
• Affordable Prices
• Any Paper, Urgency, and Subject
• Will complete your papers in 6 hours
• On-time Delivery
• Money-back and Privacy guarantees
• Unlimited Amendments upon request
• Satisfaction guarantee

How it Works

• Click on the “Place Order” tab at the top menu or “Order Now” icon at the bottom and a new page will appear with an order form to be filled.
• Fill in your paper’s requirements in the "PAPER DETAILS" section.
• Fill in your paper’s academic level, deadline, and the required number of pages from the drop-down menus.
• Click “CREATE ACCOUNT & SIGN IN” to enter your registration details and get an account with us for record-keeping and then, click on “PROCEED TO CHECKOUT” at the bottom of the page.
• From there, the payment sections will show, follow the guided payment process and your order will be available for our writing team to work on it.