Ch.

14 BETAS AND COST OF CAPITAL

Promised payment = K, exercise price, what they receive at maturity (Principal*(1+y),
principal and interest.

Principal = The issuer gets as a dollar value

PV(Debt) = Value of the debt today (for example Promised payment in y=1 is PP/(1+r)^1

From expected return on equity to equity beta

E ( r i ) −r rf
E ( r i ) =r rf + β ( E ( r m ) −r rf ) =¿ β=
E (r m )−r rf

Can also be used to compute the expected debt beta, return, payoff

Market risk Premium:

MRP=(E ( r m )−r rf )
Return sensitivity
∆ r =E [ r up ] −E [r down ]

Project equity beta (think structure invested in project) -> apply in equity beta ->
WACC
D+ E D
βE= β A − ∗β D
E E
Expected payoff in year x:

E ( Value )=Sup∗Prob+ S down∗( 1−Prob . )

Expected return:
E ( Value∈ one year )
E ( return )= −1
Value∈ year 0
- Expected: always use the mathematical approach with probabilities
- Also works with debt (E3.1)

Alternative equity beta:

D
β E =β U + ( β −β D )
E U

NB: If a project is equity financed (issuing shares etc., then the beta/expected return is the
unlevered)
- Why does the equity beta increase when the leveraged acquired is risk-free:
According the M&M, the price per share “today” is fixed, so it is the expected return
in the future that will change.
o Return sensitivity is higher
- Unlevered beta = Asset beta!

Unlevered to equity beta (or change in beta due to ReCap in perfect markets 14.19)
 E D
β u= βE+ β =¿
EV EV D
β ∗( E+ D )
( ) ( )
D D∗β U D E D β
β E =β U + ( β U −β D )=¿ β E =β U + =¿ β E=β U 1+ =¿ β E= βU + =¿ β E= U =¿ β E= U
E E E E E E

Promised yield on debt (and credit spread) – not credit spread on expected return
(rarely used)
1
Principal=PV ( Debt )=Promised payment∗exp (− y∗t )
Promised yield on debt (actually used)

( )
−1
PP Promised payment t
Principal= t
=¿ y= −1
Principal
( 1+r ) 1

Promised yield (when you don’t have promised payment or yield, state prices):

1+r rf ( 1−q ) Bad value

y= − −1
q q∗P
Promised yield (when you have promised payment):
❑
Promised payment=Debt value∗(1+ yield )

Risk-neutral two-state model:

Why it works: Because no assumption on risk preference of investors is necessary to
calculate option prices using BSM/Binomial Model, the models must work for any set of
preferences, including risk-neutral.
- Model give the same option no matter risk preference and expected return
- Assumption: In the real world, investors are risk averse. Because of this, expected
return of a stock typically includes a positive risk-premium to compensate for risk
- In our hypothetical risk-neutral world, investors don’t require risk compensation.
When making a stock with a higher return fit into the risk-neutral world, one must
use more pessimistic probabilities to make the return equal risk-free

Up∗q+ Down∗(1−q)
Value=
1+r

Where
Valueup Value down
S PU = , S PD=
Initial Initial

(1+r )−S Pd
q=
S Pu−S Pd
Or
 ( 1+r rf ) S−S d
q=
Su −S d
Value of debt with state prices:
q 1−q
Debt = ∗Up+ ∗Down
1+r 1+r

Final state prices:

State prices (of good state):
q
=State price good
1+ r
State prices (of bad state):
1−q
=State price bad
1+ r

Remember: when calculating expected return after doing these calculations, the expected
value has nothing to do with risk-neutral probability (expect the PV is the PV you found of
risk-neutral). Exercise 1, additional 3 is good.

CF
=
(
q∗
CF
r up )
+C F 1 + ( 1−q )∗
CF
(
r down
+C F 1
)
r current (1+r rf )
- Real options: q and (1-q) are risk-neutral probabilities of receiving the current cash
flow in a perpetuity. No-arbitrage, set them equal

Share price with debt issuance for repurchase purposes

Equity value=q ¿ ¿

Equity value+Cash ¿ debt ¿ = price per share

Shares

State prices:

Implied cost of capital:

E(gain )
CoC =
PV (Gain with state prices)
Implied risk-free rate:
1
−1
Price for all states
- Why is the todays price lower if the economy is in a boom state? Because the
discount rate is higher due to good economic times!
- From expected value to value using state contingent claims: Multiply the state price
by the expected gain (do not include probability!)
-
Modigliani & Miller

Perfect capital markets:

 - All securities are priced at market price equal to their present value of cash flows, of
which all investors and firms have equal access
- No taxes, transaction costs, issuance costs
- A firm´s financing decision does not change the cash flows generated by its
investments, nor do they reveal new information about them.
= law of one price

With capital markets, financial transactions neither add nor destroy value, but
instead represent a repackaging of risk (and therefore return)

M&M Proposition 1: In a perfect capital market, the total firm value of a firm´s securities is
equal to the market value of the total CFs generated by its assets and is not affected by its
choice of capital structure
- If the assets are equal, then their future cash flows should be equal!
- Arbitrage opportunity: If two firms have the same expected cash flows, but different
capital structures, and these does not add up, an arbitrage opportunity exist.
Example: Unlevered is worth LESS then levered. Exploit it by borrowing the same
amount of debt as the levered firm, buy the equity of the unlevered firm with new
debt and our equity. We now recreated the unlevered firm with less money, so we
can sell the portfolio on the open market at the highest price (because they have
equal cash flows!)

Home made leverage (related to point about individual investors can manage their own risk
according to their preferences)
Assuming perfect capital markets, you can make your own leverage if you disagree with a
changed capital structure. Example: If firm delevers, you can lever by increasing your total
shares with new shares using borrowed money at the same rate as firm increased shares (given
a issuance of shares used for paying debt)

NSN ∗P
¿ =Borrow amount ¿ create home made leverage
S

Check if old D/V ratio is upheld:

Shares with leverage D
=
Old shares+ Share withleverage D+ E

M&M Proposition 2: The cost of capital of levered equity increases with the firm´s market
value D/E ratio.

Return on equity (with leverage):

r e∗E D
ru = + ∗r d
V V
r e =r u+
D
E ( )
(r u−r d )≈ 1+
D
β
E U
 - If we for example replace our debt with a new with new terms, the course of action is
to de-lever the cost of capital with old terms, and use the new to the cost of equity
capital (14.17). Remember to change D/E if ReCap
- If an expansion is funded by only equity, use unlevered cost of capital

DEBT AND TAXES (CHAPTER 15)

- Advantages of debt: Tax benefits and agency benefits (give the management a kick in
the ass)
- Tax is a market imperfection
- How to view a tax shield: X dollars paid in interest is X dollars which taxes are not
owed on (they are shielded from taxes!). The tax shield is the tax rate on the interest
rate, which is the amount they would have paid in taxes if they had kept the X dollars
within the firm.

Present value of tax shields where we are given FCF (good example: 15.15 and 15.14)

FCF
V L=
WAC C posttax −g

Interest tax shield

PV (∫ . tax shield )=T c∗PV (Future interest payments)
V L=V U + PV (∫ . TS)

Interest tax shield with permanent debt

- Assumption: debt is riskless with constant risk-free rate, and fixed tax rate
- Somewhat unrealistic. See target instead.
T ∗Interest Expense T c ∗(r rf ∗D)
PV (∫ . TS )= c = =T c∗D
r rf r rf
Effective cost of debt:
r∗( 1−T c )∗Debt
Where r*(1-T_c) is the effective post-tax borrowing rate

Value with leverage and target/maintained leverage ratio:

V L=V U + PV ( Interest Tax Shield ) +Cash ( typically before repurchase )

E=V L −D
PV (TS )=V L −V U
- In DCF valuation: Tax shield benefits will not be explicitly visible, but will
indirectly0 be incorporated into the calculation via lower WACC

- How do shareholders benefit after a levered recap, where firm value increases,
but equity value decreases? They receive the cash if they sell! Remaing
shareholders benefit from the tax shield
 o No arbitrage pricing: If the marked understood what was about to happen,
the price would immidiately reflect the tax shield value. Either way,
existing shareholders benefit.

De-lever a post-tax WACC to unlevered cost of capital (can’t just use r_e, as it is on the
basis of a levered firm 15.14):

D D
r wacc =r u− ∗T c∗r d=¿ r u=r wacc + ∗T ∗r
E+ D E+ D c d
- Tip: When calculating the difference between levered and unlevered, check the
discount rate (WACC) with and without leverage. Difference = PV(Int. TS)

Market value balance sheet with and without taxes (ReCap)

…

Leveraged debt issuance for share repurchase purpose:

Initial Announcement Issuance Repurchase
Cash 65
Original Assets 405 405 405 405
Interest TS 24.7 24.7 24.7
Total assets 405 429.7 494.7 429.7
Total liabilities 65 65
Equity (E=A-L) 405 429.7 429.7 364.7
Outstanding 27 27 27 22.92
P/S 15 15.91 15.91 15.91

1. Calculate original MrktCap, P/S and outstanding (if not given all 3)
2. Assume the market will incorporate the Int. TS value into the price immediately
3. Take on debt, but keep on cash balance sheet before repurchasing
4. Use cash for repurchasing, keep debt on balance sheet, decrease outstanding.

Effective tax advantage of debt:

Assumptions:
- Investors pay capital gains tax every year
- Tax rate on equity income is the same for dividend and capital gains
- Assumed one marginal income tax rate for investors.
= Does rarely hold in reality.

If the corporation paid (1-t*) in interest, debtholders would receive the same amount after
taxes as equity holders would receive if the firm paid $1 in profits to equity holders:

¿
(1−t e ) ( 1−t c )
t =1−
( 1−t debt )
 - As long as t* is larger than 0, a net tax advantage for leverage remains.

Flow to equity- and debtholders (when equity taxes are higher due to personal):
- Total stakeholders will gain from leverage when the taxation on equity holders is
higher.

C F equity =CF∗( 1−T c )∗( 1−T e )C F debt =CF∗( 1−T debt )

Stakeholder gain=Value before personal taxes−∑ (CF )
Bonus point:
¿
C F equity =C F d∗(1−t )

About capital gains tax:

- Taxes only paid when the stock is sold and profit is realized (deferred tax)
- Deferred taxes lowest the PV(Tax), which can be interpreted as lower effective
capital gains tax rate

Calculate value of value of tax shield for stakeholders: Value of $1,000, T_c = 30%, cost
of capital = 0.08

Leverage No leverage All leverage Excess leverage

EBIT 1,000.00 1,000.00 1,000.00 1,000.00
Int.exp 700.00 0.00 1,000.00 1,100.00
EBT 300.00 1,000.00 0 0
Tax 90.00 300.00 0 0
NI 210.00 700.00 0 100.00
Value NI 2,625.00 8,750.00 300 100.00
Value Debt 8,750.00 0.00 12,500.00 13,750.00
Total value 11,375.00 8,750.00
$
Difference 2,625.00
∆ change 30 %

- Bankruptcy with excess leverage

End notes:
- About growth and debt: The optimal level of debt should be appropriate to its
current earnings
- Other tax shields: Depreciation, investment tax credits, past operating losses etc.
Tech firms and tax deductions due to employee stock options
- Low leverage puzzle: Why not exploit the tax shield to its fullest? Debt financing can
have other indirect cost (probability of bankruptcy)
FINANCIAL DISTRESS (CHAPTER 16)
- When a firm has trouble meeting outs debt obligations
o Not to be confused to bankruptcy, which is a choice.
- Chapter 7 liquidation: assets are liquidated and distributed among creditors
- Chapter 11 reorganization: Creditors agree to let the firm keep running to try to get
up on its feet.
o Successful: Workout
o Prepacked bankruptcy: When the firm first develop a plan in agreement with
creditors, then file chapter 11. Faster recovery, less costs.

Costs of bankruptcy:
Direct:
- Legal, accounting, consultants, appraisers, auctioneers
- Costs associated with bankruptcy work is paid first (if not, nobody would do the
work)
Indirect:
- Loss of customers and suppliers (no one want´s to do business with a firm which may
cease to exist). Refuse to send supplies, why sign up with a software firm if they will
stop updating?
- Loss of employees: Brain drain
- Loss of receivables: Opportunistic motherfuckers
- Fire sale: Sell assets to try to not fall into bankruptcy, often way below market value.
- Inefficient liquidation
- Costs to creditors: Ripple effect (Lehman brothers. If you own the bank $100M, then
bank have a problem!)

Firm value with financial distress:

V L=V U + PV (∫ . TS )−PV ( Fin . Dist .Cost )

−PV ( Agency cost of Debt )+ PV ( Agency benefits of Debt )

( 1−Prob .Good )∗Bad value∗Bank .cost

PV ( Fin . dist . cost )=
(1+ r )t

- Who pay for the distress cost? If securities are fairly priced, the original shareholders
pay the present value associated with the bankruptcy costs. Why? Debtholders
recognize they would not receive all their money in case of default, so they pay less
for the debt = equity holders receive less.
- When distress costs are high when the firm does poorly, the beta of distress costs will
have the opposite sign to that of the firm. The higher the firm´s beta, the more likely
it will be in distress in a recession
o Because a negative beta leads to a lower cost of capital than the risk-free
rate, all things equal, the present value of distress costs will be higher for high
beta firms

Net benefit of leverage=PV (∫ . TS )−PV (Fin . Dist . Cost )

 - Remember to adjust for probabilities (for example if TS is only in good state and
financial distress in bad)
- Bonus points: Calculate for example net effects up until bankruptcy possibility (aka
just tax shield) to explore whether debt beyond bankruptcy risk is worth it)
o Trade-off theory

Exploiting debt holders: Agency cost of leverage

- Managers works for equity holders. Conflict of interest?

- Smallest for short-term debt -> firm is in a worse position to avoid bankruptcy

- Asset substitution: Equity holders choose a project which more risk when in face of
financial distress, as the debtholders carry the risk.
- Debt overhang/Under-investment: Equity holders forego positive-NPV projects
because the debtholders would get most of the profit.
o Cashing out: Selling off assets before debt maturity
o Value of debt overhang (left side is profitability index)
NPV β D∗D
>
Investment β E∗E
Leverage Ratchet Effect:
- If bankruptcy is on the horizon, the firm will be hesitant to lever up from an
unlevered state. However, when the firm is already levered, any risk associated with
new leverage fall on existing debtholders.
o LRE: Once the firm is already levered, and facing financial distress, SH have an
incentive to increase leverage, and have not an incentive to decrease leverage
by buying back debt
o By reducing debt, equity holders lose their incentive to take on risky negative-
NPV projects
- Think bankruptcy threats in different states (multinomial): If firm already have a
probability of bankruptcy, it will benefit by increasing leverage up until the next step
in the model, because the bankruptcy cost is the same in the interval, but the tax
shield increases!

Hurting shareholders by decreasing leverage:

1. Buy back debt at market price (debtholders know the fair value)
Debt cost=Debt intended for buying∗E( payoff )
2. Calculate equity gain (would be negative)
Equity gain=E ( payoff new )−E ( payoff old )−Debt cost
3. Debt gain
Debt gain=−Equity gain+ Firm gain
4. Calculations show that debtholders would capture all gain as they would not sell
unless offered fair price
To battle agency costs:

- Covenants: Debtholders can have rules written in their contract which states terms in
relation to not selling off assets (liquidation), not dilute the debt (issue more) etc.
- If you liquidate your assets to pay out dividends to shareholders when facing distress,
you signal to the market that you would probably do it again, making it hard to
attract debt investors.

Agency benefits of leverage

- Management entrenchment: Leverage keep the management on their toes (empire
building, wasteful management)
o FCF Hypothesis: Wasteful spending more likely to occur when the cash flows
in the firm is higher than what is needed to keep it afloat. When cash is tight,
managers run the firm efficiently.
- Original owners can get capital without giving up control (pecking-order)
- Commitment to strategies (mother lifting a car)

Promised coupon rate/yield have to “carry” the whole loan due to bad state goes
bankrupt:
Prob.∗Good state∗( 1+r )+(1−Prob .)∗Bad state
Principal= t
( 1+ r rf )

Promised coupon rate/yield have to “carry” the whole loan due to bad state goes
bankrupt (including bankruptcy cost):

Prob.∗Good state∗( 1+r )+ ( 1−Prob. )∗Bad∗(1−Fin . dist . cost )

Principal= t
( 1+r rf )

Optimal debt level

- Too little leverage: Los tax benefits, excessive perks, wasteful spending, empire
building
- Too much leverage: Excess interest, fin.dist.cost, excessive risk-taking, under-
investment

How much debt to maximize tax savings (debtor POV)

- Maximize tax savings by maximize debt and, by thereof, maximize interest rate.
Because we increase debt amount over the risk-free (over lowest possible asset value
in binomial model), the promised yield would increase as we increase debt amount.
This would continue until the total amount (principal + interest rate) reaches the max
asset value. Because of this, you both factors will keep changing, so you must solve
for both in an iteration
Max amount=Principal∗( yield)
o Goal seek by changing principal or yield.
About max tax shield:
- Acquire debt so that the interest payment = NI≥0
- When it becomes negative, there is nothing to tax!
o Point of view of firm, not shareholders!

Asymmetric information
- Leverage as credible signal: Leverage shows the market that you believe the firm can
handle its obligations (example: if test results seems promising, taking on debt along
with the news put your money where your mouth is. Must in this scenario be large
enough to cause financial distress costs)
- Adverse selection: The market thinks equity offered have some hidden downside
(why would they sell it if not?)
o Lemon principle: Buyers will therefore be less willing to pay the ask price
o News example: If you wait to expand until after good news, you can raise the
same amount by fewer new shares, resulting in a higher P/S
 Issuing new shares when management know they are underpriced is
costly for original shareholders and beneficial for new.
Pecking-order theory
Funding should be in this order (especially if the managers thinks the equity is underpriced, as
they get less for less)
1. Internal funds
2. Debt
3. Equity

Measurement of debt vs. equity:

Price per share when issuing (Under/Over)valued equity:

Value old equity withtrue price+Value new at OUvalued price

Equity raised
Old shares+
OUvalued price
Price per share when issuing debt:
VL
Shares

PAYOUT POLICY (CHAPTER 17)

Generally, about dividend:
- After declaration date, they HAVE to make the payment
- Ex-dividend date: 3 days before the record date, must own shares prior (not on) to
this date to be eligible for dividend
- Record date: Firm pays dividend on paper
- Return of capital/liquidating dividend: When the firm sell off assets and distribute the
cash received’
Generally about share repurchase:
- Open Market Repurchase: Announces intention, do it over time. 95% of all.
- Tender offer: Set price where they will buy all shares for up to their announced
volume
o Dutch auction: See IPO auction
- Targeted repurchase: Buy directly for major shareholders
o Greenmail: Threat of corporate raid may make the firm pay substantially over
market price
Dividend vs Repurchase (without taxes):
Terminology:
- Cum dividend: “With the dividend”, price before ex-dividend date.
- Given perfect capital markets, the individual investor can create its own mix of
dividend shares, buy for example selling shares in a repurchase for cash (homemade
dividend) or reinvest dividends in new shares.

M&M 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.
- While dividends do determine share prices, policy does not!
M&M Payout irrelevance: In perfect capital markets, if a firm invests excess CF’s in financial
securities, the firm’s choice of payout vs. retention is irrelevant and does not affect the initial
value of the firm

Alternative 1: Pay of all excess cash as dividend:

Price per share, including dividend:

Pcum =Current÷+ PV ¿

Price after dividend is paid out (no arbitrage!)

Pex =PV ¿

- When FCF is expected to grow with a stable percent:

V O =PV ¿
- Does this resemble a known payout policy? No, because it is not “smooth”. Also,
some “risk” in the sense that you base your payout policy to correspond with an
expected (uncertain) cash flow each year. Not predictable.
- Arbitrage opportunity:
 o If the price falls less than P_ex after dividend: Buy the stock just before it goes
ex-dividend (when dividend is still attached), sell right after.
o If price falls more than P_ex after dividend: Sell the stock just before it goes
ex-dividend, and buy just after.

Combination of dividend and retained cash for repurchase:

- Remember to accumulate retained earnings for the time up to the repurchase
- Remember to adjust FCF, retained, P_ex etc. when there is growth
- Add the accumulated earnings to the P_ex share price before dividing for calculating
amount of shares supposed to be repurchased (make assumption iteration).
- P_cum price will be equal to any other P_cum alternative, before any action is taken.
Is a dividend/retained combination is choosen, but not done yet, the P_cum price will
be equal to the P_cum price if all was paid out as dividend or retained.

Alternative 2: All FCF used to share repurchase:

- If no dividend is paid out
Pex =P cum
o Change in outstanding shares and decrease in cash is corresponding,
relatively.
- Use formula for PV(Future div) to reach P_ex, then add the retained earnings to
calculate how much cash you have to repurchase, and the price you have to buy at.

Alternative 3: High dividends with equity issuance:

- If the firm want to pay a fixed dividend higher than their current value (but they
expect the value from next year), they can raise equity for the current year.
Equity needed
Shares needed=
Price per share
Dividend next year:
Expected dividend
WACC −g
Expected dividend
Pcum =Dividend+
WACC −g

Extra alternative: Pay out a given percent of earnings each year as dividend (Gordon)
PV ¿
Retention rate:
g=retention rate∗ROI
Introducing taxes

T_dividend > T_CG

- If dividends are taxed at a higher rate than capital gains, shareholders will prefer share
repurchases to dividends.
- Optimal dividend policy when the dividend tax rate exceeds the capital gain tax rate is
to pay no dividends at all.
- A higher tax rate of dividend makes it undesirable for the firm to raise funds to pay
dividends (sole purpose)
- Can be seen in real life when looking at historical tax rates
- Dividend puzzle: Why pay dividends when it is an obvious disadvantage?
o Investors have different strategies. See below

Dividend capture and tax clienteles

Dividend capture strategy walkthrough:

- When dividend is paid, the holder receives
¿(1−T ¿ )
- The price will fall after after the dividend is paid, of which a captial loss create a tax
shield. The after-tax loss is
( Pcum −Pex ) ( 1−T CG )
- No arbitrage:

( Pcum −Pex ) ( 1−t cg ) =¿∗(1−td )

Where the gain and loss offset each other.

- If Div(1-Dividend tax) > Capital Loss Tax shield, an arbitrage exist by buying the
stock before it goes ex-dividend. Dividend-capture strategy
- If Div(1-Dividend tax) < Capital Loss Tax shield, an arbitrage exist by selling the
stock before it goes ex-dividend, and buying it afterwards (avoiding dividend)

After announcement, but before dividend is paid:

Pcum =P cum ,current + ( 1−t ¿ ) ÷−t cg ( Pex −P cum ,current )

- If share repurchase (aka the price after announcement is price plus cash expected to be
paid out)

Pcum =Cash+ P cum

- Use P_ex from difference in price drop

Price drop after dividend:

 Pcum −P ex=¿∗
( 1−t d
1−t cg ) (
=¿∗ 1−
t d −t cg
1−t g ) ¿
=¿∗( 1−t d )

After dividend:
¿
Pex =P cum−¿∗(1−t d )

Effective dividend tax rate:

¿ t d−t CG
t d=
1−t CG

- EDTR measures the additional tax paid by the investor per dollar of after-tax capital
gains income that is instead received as a dividend.
- The dividend tax rate when accounting all other factors (here: capital loss)
- If positive: tax disadvantage of debt. Each dollar paid out as dividend lose the EDTR
as a percent, as opposed to being retained in the firm.

Net tax savings (dividend vs. retaining)

¿
¿∗t d

- When valuing a share price after announcement of a share repurchase (after the market
was expecting a dividend), the price will increase with the net tax saving (the price
will not fall with a share repurchase because of the offset of outstanding vs less
capital)

- When dividend is chosen as payout method, the shareholders will receive the dividend
after tax payout. Because the dividend stems from existing equity, the share price will
not increase because of the announcement. After the payout, the decrease is now larger
than what they gained bacause of taxes. This makes the capital loss eligable for tax
savings. To compute what the share price will be after the dividend is paid (P_ex), we
must calculate the effective dividend tax rate

Investor preferences
- Income level: Different tax brackets
- Investment horizon: Long-term investors can defer capital gains taxes. Capital gain
under 1 year or dividend under 61 days (trading) are taxes at higher income tax.
o Long-term investors prefer repurchase, as they are heavily taxes on dividend
- Tax jurisdiction: Different across states. US taxes citizens who make money abroad
- Type of investor
o Retirement account + Pension funds: Not subject to taxes on dividend or
capital gain. No preference.
o Corporate held stocks: Exclude 70% of dividend received from being taxes (tax
shield). Must pay capital gains tax. Tax advantage of dividend
 - Clientele effects: To cater the payout policy to its desired investors.
o Individuals tend to hold stocks with low dividend yield
o Dividend-capture theory: Occuring when investors trade around the dividend
time, so that investors without dividend tax receive it.

Payout vs. Retention

Perfect capital markets: One the firm have taken all positive-NPV investments, it is
indifferent between saving excess cash and paying it out.
- Trade-off: Retaining cash can reduce costs of raising capital in the future, but can also
increase taxes and agency cost

- Retaining vs. Payout with taxes (example): If an pension fund (don’t pay dividend tax)
have invested $100M in a firm, and the firm invests in a 6% project, they must pay
corporate taxes on their gain. If they paid it out as dividend to the pension fund, they
don’t pay taxes, so they would prefer paying out dividend now.
- Cash is equivalent to negative leverage, so tax advantage of leverage implied a tax
disadvantage of holding cash (they must pay tax on the gain when the cash grown in
value)
o Exception: Corporations only pay US taxes on international earnings when the
cash is taken home (Think Apple)

Adjusting for investor taxes

- Pension funds etc. Rarely used as example in questions
- Firm must consider the individual tax levels, because the potential investors invest
from their perspective.
- Must consider whether or not the investor is better of investing themselves

P_cum price (paying dividend)

Pcum =P ex +¿∗
( ) 1−t d
1−t g

P_cum (retaining fixed sum and pay interest on investment as dividend)

¿∗(1−t d ) ¿∗(1−t corp )(1−t ¿ )
Pretain = =
r rf ∗(1−t i ) (1−t i )

- Where t_i is the individuals investor’s tax rate on interest income

- Note that Dividend = Fixed retained * r * (1-T_corp))

We want to compute whether the investor is better or worse of in either scenarios.

Pcum∗( 1−t corp ) ( 1−t ¿ ) ¿

Pretain = =P cum∗( 1−t retain )
( 1−t i )

- Where: Effective disadvantage of retaining cash:

 ¿
(
t retain= 1−
( 1−T c ) ( 1−T CG )
( 1−t i ) )
Notes:

- When the firm retains cash and invest it themselves, the investor is taxed indirectly for
corporate tax, in addition to paying capital gain tax (in theory, its deferred until they
sell). They are taxed twice!
- If the firm paid investors immediately, they can invest it themselves and only pay
interest tax.
o The ETDORC is the measurement of this loss!

Retention vs. spend for obtaining tax shield

Value to investors when you use money on costs you can deduct:

$ 1∗( 1−T c )∗( 1−T cg )=dollar value tax shield

We want to compute how much they have to spend to make the investor indifferent between
investing themselves and receiving tax shield value)

[ Investor personal dollar return ] −[ Firm dollar return ]

=difference
dollar value tax shield

Reasons to accumulate cash

- Save it for a rainy day

o Related: Avoid issuance costs when raising new equity
- Agency cost (a negative)
- Debt covenants
- Why do Tech firms have high cash balances? Low debt levels = little use of tax shield
(excess cash = negative debt)
o Unlikely that individual investors can invest them better

Signaling
Payout strategies

Dividend smoothing:
- Rarely adjusting dividend.
- Only correlated with earnings in the long-term growth (strong prospects over time)
- Big no-no to cut
- Can be done by instead using repurchasing and excess cash to reach preferred goals
o About a rainy day: Don’t want to set a level they can’t naturally keep up to
 - Pensioneers like this! (SDSU, Florida)
- Signaling: When they raise dividend, the market sees it as an optimistic view on the
future cash flows
o Dividend signaling hypothesis: Dividend changes reflect manager’s views
about the future prospects
o Similar to debt signaling

Share repurchases:
- Share repurchasing is not a commitment, nothing if fixed (time span, amount etc.)
- If managers believe the stock is overvalued, a repurchase is costly to firm (and
thereby existing shareholders) because they pay more then the fair worth
o If the stock is undervalued (and they buy), existing shareholders gain (who
stays for the ride)
o Null-sum game
- Not as good signal as a dividend increase, but a signal that the stock is undervalued.
- Tender offers and Dutch auctions have historically had a bigger price increase than
«normal» repurchase -> even stronger signals

Other payout alternatives

Stock dividends and splits:
- 10% stock dividend = each shareholders will receive one new share for every 10
already owned
- If the percent is 50% or higher, it is referred to as a stock split
o 50% called 3-for-2
o 100% 2:1
- Share price is decreased by the same percentage as the stock split
- Difference between share issuance and stock split: When a firm issue new shares, it
also raised cash. No new cash in a split.
- Stock dividends are not taxed (as there is no real transaction)
- Why split? Keep the stock attractive to small investors. Many have automatic splits
when it reaches $100.
- When it falls to low, it becomes unattractive because the perceived transaction costs
per share seems to big
o Course of action: Reverse split. A 1:10 reverse split = 10 shares are replaced
with a single share.

Spin-offs (non-cash special dividend)

- Setting up assets from a firm to a new subsidiary, and compensating the shareholders
of the motherfirm with shares in the subsidiary
- Advantages: Avoids transaction costs, and special dividend is not taxed as cash
distribution (they will only be taxed on capital gains when they sell their newly
received shares)
- Related to M&A: When is it better for two firms to operate as separate entities,
rather than a combined firm?

___________________________________________________________________________
One-time dividend price movement. Solve for P_ex:

¿∗( 1−t d ) ¿∗(1−t d )

Pcum =¿ ( 1−t ¿ ) +t CG ( Pcum−P ex ) + Pex =¿ Pcum =P ex + =¿ Pex =P cum−
( 1−tCG ) (1−t CG )

Share repurchase with rights per share equals X share:

- Cash/tender offer = shares attended to buy. This divided by total outstanding give
how many rights you need for the right for 1 (because it shall be fair)
( Rights )∗P cum=Tender−T CG ( Tender−P cum ) + ( Rights−1 )∗T CG ( Pcum−Pex ) + ( Rights−1 )∗P ex
- Solve for P_ex to find

Retain in firm vs investing on your own:

For the investor to choose to retain the cash at the firm instead of investing it on his own account,
the return would have to be equal (indifferent) or above. Because we know the difference between
letting the firm invest and investing themselves, we know the gap the firm have to fill.
When spending $1 on fees, the firm can deduct if with corporate taxes, and the capital loss can also
be deducted.
$ 1∗( 1−T c )∗( 1−T cg )=value¿ investors

Retain vs. dividend (Retake 2017, exe 3). E is share price after announcment
- Retain and in one year and then decide: Solve for finding arbitrage opportunity, goal
seek and solve for difference
-
E=%∗NPV good +(1−%)∗NP V bad∗( 1−t d ) +¿
- Pay out as special dividend:

% × Outstanding∗E g−( % ×t CG × ( NP V good∗E g −E ) + ( 1−% ) ×t CG × ( $ 0−E ) ) + ( 1−t ¿ ) × NPV bad =E

CHAPTER 18: CAPITAL BUDGETING WITH LEVERAGE

Target debt capacity (makes much more sense in 18.6,10,11):

L
V t =PV ( Remaining project ) ,
D D L
∨ ∗V t
EV E

Cost of capital for risk-free cash flows (usually tax deductables) (Retake17, exercise 1):
- Tax savings related to deductability is risk-free,so
E D
WAC C TS = ∗r rf + ∗r rf ∗(1−T c )
V V

FCF/DCF/NPV (18.19+18.18):
EBITDA−Depr=EBIT∗( 1−T C ) =Net Income+CapEx+ Depr + ∆ NWC=FCF

Ch. 20: Financial options

Terminology:
- Strike price/Exercise price: Agreed-upon price
- Expiration date. Days/365
- American option: Allow the holder to exercise at any date
- European option: Only allowed to exercise at expiration
- Option premium: The price of the option
- OTM/ATM/ITM: Out, on and in the money (value)
o Deep OTM/ITM: Strike price and stock price with a big difference

Call options
- The right to buy an asset (as an option buyer)
 - The obligation to sell an asset (as an option seller)
- Long call (Buy): No downside, unlimited upside form strike
- Short call (Sell): No upside, unlimited downside form strike
Value at expiration:
C=max ( S−K ,0 )
- Underlying price, minus strike price. If negative = 0.
- The more OTM, the more steep curve (higher probability of -100% percent, aka don’t
return in premium you paid, but ones in the money, the relative return in larger)
o Call options have more extreme returns than their underlying stock, so they
will have a larger beta and expected return than their underlying
Portfolio insurance: Long (buy) stock option and a bond. If price drops below, you take the
bond payment. If above, you take the bond payment and buy it at strike price.

Put option
- The right to sell an asset (as an option buyer)
- The obligation to buy an asset (as an option seller)
- Long (buy) put: Upside limited to dollar value of strike, downside limited to premium
(choose not to exercise)
- Short (sell) put: Limited downside to dollar value of strike (can’t fall below 0)
Value at expiration:
P=max ( K−S , 0 )
- Strike price minus underlying price

Borrowing for buying options:

t
Profit=max ( K −S , 0 )−P∗( 1+ r )
- The deeper OTM the put option is, the more negative is the beta and expected return
o Higher return with low stock prices
o Negatively correlated beta with underlying stock
o Because of this, put options is rarely held as an investment, but rather as a
hedging tool.
- Protective put: If you own a stock, you can insure against large price falls by going
long (buying) a put for your desired limit. Also known as portfolio insurance.

Option strategies:
Straddle: Long (buy) both a put and a call
- Return as long at underlying is not ATM at expiration (V-shape)
- Must subtract cost of buying both
- Long straddle: Volatile stock. Short straddle: You expect it to be ATM.

Butterfly spread: Return when underlying and strike are far apart (opposite from straddle,
with payoffs on both sides of ATM)
-

Put-call Parity
S+ P=PV ( K ) +C
- Law of one price makes this possible.
- PV(K) is also an expression for buying a ZCB with face value K
 C=P+ S−PV ( K )
o A levered position in the stock, plus a put insurance
Included dividend:
S+ P=PV ( K ) + PV ( ¿ ) +C
- The option holder has no right to the dividend, as they don’t own the stock (yet!)

Arbitrage strategies:
- If price on option is below the value of the replicated portfolio, it is undervalued.
o Strategy: buy option and sell replicated portfolio for its true worth. Pocket
profit
- If price on above is below the value of the replicated portfolio, it is overvalued
o Strategy: buy replicated portfolio for cheap and sell the call.

Option price movements

- Call option: Price is higher when strike price is lower
- Put option: Price is lower when strike is lower
- An American option cannot be worth less than an otherwise identical European
option
- Maximum payoff for put price: When the stock becomes worthless (bankruptcy). Put
option cannot be worth more than its strike price
- Call option: A stock option cannot be worth more than the stock itself
o If the strike price was zero, the holder would always exercise and receive the
stock at no cost
- Intrinsic value: The value it would have if it expired immediately. Value of currently
ITM
o If an American option is worth less than its intrinsic value, you can buy it and
immediately exercise it. Therefore, an American option cannot be worth less
than its intrinsic value
o Related: time value: Difference between current option price and intrinsic
value.
o American: The longer from exercise date, the more valuable the option.
o Option value generally increase with increased volatility

How much is the option to exercise early worth (American vs. European)?

Non-dividend paying stocks (Using Put-Call Parity)

ZCB Call:
PV ( K )=K−dis(K )
- Where dis(K) is the discount from face value to account for interest. Inserting into
Call
C=S−K + dis ( K )+ P
- Where S-K is intrinsic value and dis(K)+P is time value.
o As long as interest rates are positive, the time value is positive (Put must be
positive).
 o The price of any call option on a non-dividend paying stock always exceeds its
intrinsic value. Implies that it is never optimal to exercise early -> you are
better off just selling the option
 When you exercise, you get the intrinsic value. As can be seen, the call
option exceeds because time have value!
 Because this is always true (about time value), an American call on a
non-dividend paying stock will have the same price as its European
counterpart
ZCB Put:
P=K −S+C−dis(K )
- If the Put is deep ITM, the call will have so little value of could be beneficial to
exercise early.

Dividend-paying stocks:
C=S−K + dis ( K )+ P−PV ( ¿ )
- PV(Div) is part of time value.
- If PV(Div) is large enough, the time value of a European call option can be negative,
implying a value of less than intrinsic!
o Because an American option can never be worth less than its intrinsic value,
the price of an American can therefore exceed the European counterpart
- Explanation: When the firm pays dividend, the market expects a price drop for the
cash paid out. Price drop hurt owner of call option (they are not compensated). If the
call option holder exercises early, he can get the dividend!

- Opposite for put options:

P=K −S+C−dis ( K ) + PV (¿)
o When a stock pays dividend, the holder of a put option will benefit by waiting
for the stock price to drop (as the value increases)
Dividend yield:
Annual dividend
Dividend yield =
Share price
- NB: Present value vs. future value.
Option and firm value
- Equity is a call option: The right to firm assets above exercise (debt maturity)
- Debt as option portfolio: Owning the firm and short (sold) a call option with strike
equal the debt payment.
- A third way : A portfolio of risk-free debt and a short position in a put option on the
firm’s assets with a strike price equal to the required debt payment

Risky debt=Risk free debt−Put option on firm assets

o If the put is ITM, the put option holder would exercise the option (bankrupt
the firm and seize the assets), and if it is OTM it would get the debt back
- Credit default swaps (CDS): Insure the firm credit risk

Risk free debt=Risky debt+ Put option of firmassets

 o Buyer pays an insurer a periodic payment, and the insurer reimburses the
buyer if case of default.
- In relation to agency conflicts between equity and debtholders: As we have shown,
volatility increase call option prices. Asset substitution
o If the option is OTM, and the equity holders must decide whether or not to
invest their own funds on a positive NPV investment, they know most of the
value created will got to debtholders (seller of call option). Debt overhang

CHAPTER 21: Actual OPTIONS

Replicating portfolio
- A portfolio of other securities with the same payoff
- Because Law of One price, the value should be identical to the option

Binominal option pricing of options:

Payoff:
Su∗∆+ ( 1+ r rf ) B=Cu Sd ∆+ ( 1+r rf ) B=C d
Price:
Cu −Cd
∆=
Su −S d
- Interpretation: Sensitivity to options value to changes in the stock price. Equal to the
slope of the line showing the payoff in a call option graph

C d−S d ∆
B=
1+r rf

C=S ∆+ B
- Law of one price: This works because we have created an identical cash flow!
- Can also be used on put
o Delta will be a negative number

Multinomial option pricing: Working backwards

1. Calculate payoff, delta and number of bonds at last period
2. When calculating the previous, the payoff must be the call price at the next period
3. Must rebalance portfolio at each period to match the law of one price principle
a. Dynamic trading strategy

When debt is risk-free and other:

∆=1∧β U =0
∆=number of stocks ∈ portfolio , B=initial investment ∈bonds

Black-Scholes (with dividend, if not just use S)

 ¿
Call( A , T , P)=S ∗N (d 1)−PV (K )∗N (d 2)
Where
¿
S =S∗S−PV (¿).
When the stock pay a dividend proportional to the stock price:
¿ S
S=
1+ r

( ) + σ∗√ T
¿
S
ln
PV ( K )
d 1=
σ∗√T 2
d 2=d 1−σ∗√ T

About Call(A,P,T)

- When you have to apply Black-Scholes to get the Call price, it is a good idea to
calculate all parts of the equation, example from debt:
D= A−PV ( ¿ )−Call ( A , T , P )

D= A−PV ( ¿ )−¿

D= A−PV ( ¿ )−S∗N ( d 1 ) + P ( ¿ )∗N ( d 1) + PV ( K )∗N (d 2 )

- When dividend and maturity date is different, the best solution is to use the regular
VBA code, and add PV(Div) in another cell, adding up to Call(A,T,P). When you then
find the debt value, add in PV(Div) again, so they cancel each other out (depending
on the value of N(d_1), see above)

Promised yield on debt (as an option)

- Beware of firm value vs. per share basis
E=Call ( A , P , T ) + PV ( ¿ )

- When Call is given (typically as strike price), then Call(A,P,T) is already calculated, so
you only need to add PV(Div) to get E
- Note that dividend can have a different discount time frame than the option

1. Equity value (CALL(A,P,T)) = Option price

2. Debt value:
Debt value=A−PV ( ¿ ) −Call( A , P ,T )
- Price per share * Outstanding = Equity value

( )
1
( ) t Face debt t
Debt face value=Debt value∗ 1+r → r= −1
MV Debt
3. Solve for r

Promised yield on junior debt (when we have senior debt):

1. Calculate senior debt (debt value and YTM is possible) as you would normally (see
promised yield on debt)
 2. Per share promised payment junior = Total debt (think that junior is paid between
senior and exercise price)
3. Value equity: As normally, remember to use the call price from the junior debt.
4. Asset value = Underlying price
5. Junior value of debt = Assets- Senior Value of debt – Equity value
a. Check if Assets = Equity junior + Value debt junior + Value debt senior
6. Voila

Put/Call with BSM:

Price of a put option using BSM (Put-Call Parity):

P=PV ( K ) [ 1−N ( d 2 ) ] −S [ 1−N ( d 1 ) ]

Replicating portfolio with BSM (Call):

∆=N ( d 1 )
- Sensitivity. A change in the price of the option given a $1 change in the underlying
asset
B=−PV ( K ) N (d 2)
- The replicating portfolio is a straight, tangent graph to the BSM option value (P.807)
o Here we can explicitly see how one must rebalance when changes in
underlying asset is happening. Price increase -> steeper line -> higher delta ->
buy shares
- Always a long in the stock and short in the bond (aka always a leveraged position.
More risky)

Replicating portfolio with BSM (Put):

∆=−[ N ( d1 ) ]
B=PV ( K ) [ 1−N ( d 2 ) ]
- Always a long position in the bond and short in the stock

Risk-neutral probabilities and option pricing in binomial model

Useful for estimating cost of capital
- Assumption: All market participants are risk neutral. Therefore, all financial assets
would have the same cost of capital -> the risk-free rate

Expected payof f call =q1∗q2∗(S ¿ ¿ u , 2−K u , 2)¿

Price:
E( payoff )
( 1+r )t

Put: Because of the opposite of risk-neutral q is (1-q)

E¿
Price:
E( payoff )
( 1+r )t
 - Take: Probabilities in the risk-neutral world can calculate the price of every derivate
security.

Option betas:
Option beta (call) (remember that S∆+B=C)
- Calculate the beta of the replicated portfolio (you can see that it is weighted)

S∆ B
β Call = βS+ β
S ∆+ B S ∆+ B B

If bond is riskless, just

S∆ S∗N (d1 )
β Call= βS= ∗β s
S ∆+ B C
Option beta (put)
−S∗(1−∆) −S [ 1−N ( d 1 ) ]
β Put = β S= ∗β s
S ∆+ B P

Call leverage ratio:

S∆
Put leverage=
S ∆+B
- Ratio of the amount of money in the stock position
- Approaches 0 as underlying increases in value
Put leverage ratio:
S−(1−∆)
Put leverage=
S ∆+ B
- Start at zero, approaches infinite at underlying price increases

Corporate and project beta

We can again view options as a corporation
E=∆ A+ B
- Where A = E+D is stock price
- Debt overhang: Because Delta is below 1, equity holders gain less than $1 for every
$1 increase in firm value -> reduced incentive

A∆
βE=
A ∆+ B
∗β U =
( E+ D ) ∆
E
β U =∆ 1+
D
β
E U ( )
- Note: When the debt is risk-free, the equity is always ITM

βD=
A
D
E
βU− βE=
D
(1−∆ )∗A
D
β U =( 1−∆ ) A+
E
β
D U ( )
βE
βU=
(
∆ 1+
D
E )
Debt beta:
 ( 1−∆ )∗A
βD= βA
D

Minimum P-index for shareholders to equity holders to gain by funding a new investment

NPV 1−∆ β D∗D

∆ ( I + NPV )> I =¿ > =
I ∆ β E∗E
As the ∆ is a sensitivity of the call option to the underlying asset value to the firm, this means
that the equity will increase by ∆ amount of an invested amount (asset increase).
- Minimum profitability index required for equity holders to gain: Set them equal
- See asset substitution in action: Change volatility, hold call price constant and change
underlying.

CH. 22: Real options

Definition: A right (like an option) to make a business decision

- Difference from ordinary options: Underlying asset not usually traded on the market
(the project is the asset)
- Here, new information can change decision making along

Decision tree
Difference from binomial tree: Binomial trees measures outcomes, not how we are in control
of the direction. Invest or don’t invest.
- Decision nodes: What to do at each stage (options available)
- Information node: Result from decision (uncertainty is resolved, payoff learned)
o A decision tree that occurs after an information node is a real option.
- The real option is worth the difference between the max NPV and the NPV without
the possibility to decide along
- How to solve a decision tree (basics): Work backwards, compare present values of
decisions at remaining branches. Then use the present value in the previous time (as
in multinomial pricing).

Option to delay
Costs from delaying:
- Loss of profits from operating in the waiting year (think of it as dividend in options)
- Cost can rise
 - Competition can be fiercer
Benefits from delaying:
- Gain additional info
o Forget it if bad investment
- Uncertainty can change (volatility, decrease -> smaller option value)

Buying an option for a negative-NPV project

- Volatility increase option prices!
- Dividend: What you give up

Walkthrough
1. Compute the NPV value of investing today.
2. When computing the value of waiting,
a. Often you have to use S* because you forego the cash flows from year 1.
b. Strike is investment value
3. Compare
a. If Call price is larger than the NPV of investing today, it is better to wait.
b. Break-even value (indifference is equal each other)
4. NB: If option is for multiple, multiply as the last step

Option and firm risk

Project (option) beta
¿ ¿
S ∆ S ∗N (d 1 )
β Project = β Comparables = ∗β
S ∆+ B C
- If the only asset the value have is the option!

Corporate beta (comparable to WACC):

Firm value wo options Call value
β Corp= ∗β comparables + ∗β
Total firm value Total firm valuw Project
- If you choose to invest today, your beta is that of the comparable firms. Why?
Because the beta project beta you calculate is the beta for the option
- Larger option value -> smaller project beta (closer to underlying asset)
- When more of the firm value is tied up to the option, the corporate beta will be
higher

Growth and abandonment (disinvestment)

Value of waiting for changing news: By waiting, you can eliminate certain choices (for
example that you know that the interest rate will definitely rise or fall next period)
- Growth potential: Because growth options are likely OTM, the growth component of
the firm value is likely to be riskier than the ongoing assets of the firm
- Option to expand
- Option to abandon: The option to drop a project also has value in itself, when you
can adjust your outcome in the bad state in the total NPV calculation
o Behavioral bias: Managers don’t like to cut losses and indirectly admit defeat.
o Sunk cost should never be included

Staged investment:
 - Mutually dependent investments: When the value of one project depends on the
outcome of others, and one fail will fail the whole project
o If the order is indifferent, then choose the project with lowest cost first
- Optimal order to stage mutually dependent projects (by ranking):

1−PV (¿ .)
Failure cost index=
PV (Investment )
o Where PV(Succ.) is value at the start of the project of receiving $1 if the
project succeeds (Think state prices), and PV(Inv) is the projects required
initial investment

Generalizations:
- Findings not transferrable to other problems, so the invested time in exploration is
usually not worth it

Profitability index: Invest (in opposition to wait) when profitability index exceeds a pre-set
level
NPV
Profitability index=
Initial investment

Hurdle Rate: Increase discount rate when calculating NPV to make it harder to get a positive
NPV
- Multiply cost of capital by the ratio at which a callable loan could be repaid with risk-
free loan
- Measures if the firm is prepared in case of interest rate changes
o Does not measure value
CoC∗Callable Annuity Rate
Hurdle rate=
Rrf
Abandonment option
- Calculate NPV/FCF for each probability
- Find out if some of the probabilities results in abandon/sell is a better option
- Calculate value/present value (depends if it is given in PV or not)
- Option value: The difference between the NPV of the project when you go through
regardless of known outcomes, and the NPV where you abandon if NPV is negative.

Option value=NP V w value−NP V wo value

o Aka difference. If the value without is negative, it is double negative, so option
value is even bigger!

Bottom line real options:

- OTM Real options have value: Negative NPV value today =/= worthless
- ITM don’t need to be exercises right now. It could be worth more in the future
- Waiting has value. Can resolve uncertainty
- Delay investments expenses as much as possible: Because waiting has value, you
should only incur investments expense at the last possible moment
 - Create value by exploiting real options: To realize the real option value present at all
times in a firm, you must continually re-evaluate the opportunities
o Often, as much value can be created by optimally delaying or abandoning
projects as by creating or growing them

CHAPTER 23 RAISING EQUITY:

Why raise money from…
- VC: Experience (the VC´s have done it many times with start-ups). Over $10M per
deal on average
o Connections, network etc.
o What do the VC firm get in return (examples): Liquidation preference,
seniority, participation rights, anti-dilution protection, board membership
o Goes into management/board, charges carried interest
o Gets preferred stock, or convertible preferred stock. Have different rights
 Liquidation preference, guaranteed payment in case of (typically 1 to 3
times initial investment)
 Seniority. Repaid first
 Participation rights: Convertible shares without participation rights
must choose between demanding liquidation and converting. With
participation rights, you can have both (get money back and get the
share. Usually capped at 2-3 times initial investment)
 Anti-dilution protection/Down round protection: If firm raises capital
at a lower price in a later round, this protection ensures a adjusted
conversion price between preferred and common stock to keep
ownership. 80% of VC deals have this
 Board membership
- Private equity: Invests in existing private firms (or public that is taken private), not
start-ups.
- Angel Investors: Initial capital. Range (couple hundred thousand to a few mills)
o They often take a convertible note instead of equity. Converts the note to
equity when the firm first gets a valuation in a funding round (to not do the
valuation themselves)
- Crowdfunding: Lets individuals fund projects without getting equity, but instead
other perks (such as the physical product if made)
- Institutional investors: Pension funds, insurance companies, endowments,
foundations. Invest directly or through VC/PE.
- Corporate investors: Apple (invest now so you don´t have to buy expensive later).
Strategic investors.

Value investment for investors in PE/VC:

Value−Mgmt Fees=Profit∗(1−Carried interest ) =Value¿
NPV =Value ¿ −Initial investment ¿
( 1+ IRR )t
Series Funding Series
New funding=X Pre money valuation : ( Old shares∗New share price )
Post money valuation : ( New share price∗Total shares )
Ownership:
Invested amount
Post money valuation

Issuance costs: need to raise (when you have target capital need)
Capital want
Capital need =
1−iss . cost
Issuance cost: Pay underwriter
P
Capital need = ∗(1−fee )∗Issue shares
S

IPO – going public

- Advantages: Liquidity and access. Early investors can get return on their investment.
- Disadvantages: Dilution of ownership, agency costs for management (think GE from
SDSU). More regulations.
- Lead underwriter (Investment bank) arranges a group of underwriters (syndicate)
- Registration statement sent to SEC
o SEC approves the firm for trading
o Firm present final prospectus, with number of shares offered and opening
price.

IPO from the view of the underwriter:

- How issuance fees work: The underwriter “pays” the firm the price minus the fee,
and sell it at the market with the market price. Can be viewed as an arbitrage.
o Typical spread is 7%
- In many cases, the underwriter will also commit to making a market in the stock after
the issue, thereby guaranteeing that the stock will be liquid.
- Risk for the underwriting of the price falling.
o Only 9% of IPO´s did fall on the first day between ´90 and ´98, while 16%
stayed the same. This means most of the times the underwriter undervalues
the stock. Intentionally?
o Underwriters can protect themselves via over-allotment allocation/green
shoe provision, where they are allowed to issue more stock at the IPO price.
o Preexisting shareholders subject to a 180-day lockup of their shares after the
IPO.

About underpricing: Most usual movement for IPO’s.

o Winner´s curse: You get all requested shares when demand is low (IPO
performs poorly). On average the uninformed investor get a larger fraction of
their demand when the informed investors realize the IPO is overpriced.
 o Underwriters may be underwriting intentionally to let less informed investor
participate.

IPO Auction
- The firm announces the number of shares offered, and the lowest bid within the
offered share is set as the initial price, where all above get the set price.
- Set price: Match offered shares by the cumulative demand, starting from the highest
bid.
- Why auctions are not popular: Inaccurate pricing and poor aftermarket performance
o Also: Book-binding not important (underwriters make a book building where
they come up with offer price based on the road show)

Season Equity Offering (SEO)

- Difference from IPO: The market already exists, so the price-setting process is not
necessary
- Cash offer/rights offer: Offered to all vs. existing shareholders.
o Rights offers protect existing shareholders from underpricing
- Market reaction: Price decline. Signaling with share issuance.
o Hypothesis: Capital raise -> investment opportunity -> growth options ->
riskier than the project themselves, so when exercised, the firm beta
decreases.

CHAPTER 24: DEBT FINANCING

Different debt types
Public debt - prospectus
Corporate bonds securities issued by corporations.
o Issued at discount: Original issue discount (OID) bond
o Bearer bonds: whoever physically holds, have rights to the payments
o Registered bonds: Bearer bonds updated to the 21th century

Types of corporate debt: Secured have assets as collateral in the event of default.

- Notes (unsecured)
- Debentures (unsecured)
- Mortgage bonds (secured)
- Asset-backed securities (ABS) (secured)

Different classes of same type of debt: Tranches

- Seniority decided who is repaid first
- Junior debt: Subordinated debenture. In the case of default, assets not pledged as
collateral can’t be liquidated for subordinated debt before the debt with seniority is
fully paid.

Bond market:
- Domestic bonds: Issued locally, traded locally, stated with local currency, purchased
by foreigners
 - Foreign bonds: Foreigners who issue bonds in your market with your currency
(Eurobonds, Yankee Bonds, Samurai Bonds, Bulldogs)
- Global bonds: A combination
- They often carry different yields to account for currency risk.

Private debt – Bank loans

Not publicly traded.

Types of private debt:

- Term loans: Loan with a specified term
o Syndicated bank loan: A single loan that is funded by a group of banks. Usually
lead bank like with an IPO
o Revolving line of credit: Credit line in a specified time
- Private placement: Debt sold to small number of investors.

Sovereign debt: Treasuries

- Bills (discount), notes, bonds (coupon)
- Inflation indexes (coupon). Treasury Inflation-Protected Securities (TIPS). Coupon
bonds adjusted for inflation. The rate is fixed, the semiannual payments are pegged
to inflation-adjusted principal
- Sold via auction
o Noncompetitive bid: Ask and you shall receive
o Competitive bid: Sealed bids. Accept lowest as in an auction IPO. Highest is
stop-out yield.

Municipal bonds
- Issued by local governments. Income from them not taxed at federal level.
- Often serial bonds
- Revenue bonds: Pledged specific revenue generated by project that was financed by
the issuance
o Double-barred bonds: Backed by issuer in case of CF fail

Asset-backed-securities
- Security made up of other financial securities
- Mortgage-backed securities (MBS): Backed by house mortgages
o Backed by government (not explicitly, but investors think it is unlikely that the
government would let them default)
o Pre-payment risk. Unknown maturity
o Banks can make their own with their own mortgage loans
- Collateralized debt obligation (CFO). When banks back ABS by other ABS. Think junior
and senior repayment priority.

Callable bonds
Call provision: The right (think option) to buy back the debt
- Must include a call date and call price. Price generally above, or set as percentage of
par value.
- House mortgages are callable bonds
Will affect bond prices, as the owner now can retire the bond if interest rate fall, by taking on
new debt and buy the more expensive one back, effectively reducing the cost of debt. Issuers
must account for this.
- Bondholder perspective: The issuer will exercise the option when coupon rate of the
bond exceeds the market rate. In this case, the bondholder’s new investment will be
on the smaller market rate. This makes the callable bond attractive. Because of this,
they will trade at a lower price (higher yield) than the equivalent non-callable bond.
- When the bond yield is less than the coupon yield, the bond will be called at par.
o Always capped at par: Price can be low when yields are high, but does not rise
above par when yield is low.
- Market anticipates the callableness of the bond.
Sinking funds: firm make payments into a fund which will buy back debt.
- Often not enough to buy the whole debt, so a balloon payment is necessary

Convertible provisions: Bonds that can be converted into equity.

- Conversion ratio: Stocks per bond
- Gives the debtholders an option on the firm assets.
- A bond plus a call option called a warrant, which is a call option on new stock
- On maturity date:
Bond value
Warrant value= =Conversion price
Conversion ratio
o If the warrant value is above the share price, it is not optimal to convert, so
you should just let the bond mature.
o Remember non-dividend option: Never optimal to exercise early.
- Firms often issue convertible, callable bonds. Three options. Can force bondholders
to make a decision about exercising early. Transfer time value from bondholders to
shareholders.

Yield to call:
YTM on callable: calculated as a non-callable bond, the increased yield is incorporated in the
price (lower price -> higher yield)
- Not always realistic, therefore YTC. Annual yield of a callable bond assumed the bond
is called on the earliest opportunity.
Remaining coupons+ Face value
YTC =
Price on bond

CHAPTER 25: LEASING

- All walkthroughs and curveballs in excel E5 + exercise […]. Only use this for
theoretical questions!
Basics:
 Scrap Mon
PV ( Lease Payments )=Purchase Price−PV ( Residual Value ) PV ( Residual value )=
( 1+r )t
thly lease (Solve for L)
PV (Lease payments)=L+ L∗ ( )(
1
r
1−
1
( 1+ r )t−1 )
Lease-equivalent loan:

- NPV negative = better to B&B than to lease. The Loan Balance will be higher than PV
year 0. A reason may be that the lease payments are stretched out longer than the
depreciations.
- NPV positive = better to lease than to B&B.
o Rule of thumb: Beneficial to shift the tax shield receivables to the party with
the highest tax rate when the lease payments happens before the
depreciation, due to discounting.
- Can also comment on the amount saved on the decision (NPV vs. investment), if for
example a $500 savings would actually be taken into consideration if the equipment
costs $1M

- When calculating Lease-Equivalent loan and loan balance, remember to change the
tax rates to the lessee point of view!
- Effective after-tax borrowing rate (IRR): Set NPV=0 in L-E, change r_d(1-t). If it is
below, it supports that the lease is more attractive.
- If there are other expenses related to buying, these can be deducted (see 25.9)

Reasons for leasing:

- Leasing company may have a comparative advantage (network, experience, good

connections with credit institutions, lemon problem)
- If true lease: Lessor (owner) have right to the asset in case of financial distress

True Tax lease vs. non-tax lease:

- True tax lease: Lessor receives the depreciation deductions, and the lease payments
are revenue. The lessee can deduct the lease payments as an expense
o Lease must have significantly shorter time than the service life if the object.
- Non-tax lease: Lessee received depreciation deductions and can deduct the interest
portion of the lease payments.
o Accounting wise: Printers are bought by lessee, and lessor is financing the
purchase as a loan.
- Signs it is not a true tax lease: Depreciation deductions finished before the assets
loses its value.

Cap lease if (only need one):

1. Title to the property transfers to the lessee at the end of the lease term.
 2. The lease contains an option to purchase the asset at a bargain price that is
substantially less than its fair market value.
3. The lease term is 75% or more of the estimated economic life of the asset.
4. Thepresentvalueoftheminimumleasepaymentsatthestartoftheleaseis90%or more of
the asset’s fair market value.

True tax lease if (only need one to fail)

1. The lessee obtains equity in the leased asset.

2. The lessee receives ownership of the asset on completion of all lease payments.

3. The total amount that the lessee is required to pay for a relatively short period of use
constitutes an inordinately large proportion of the total value of the asset.
4. The lease payments greatly exceed the current fair rental value of the asset.
5. Thepropertymaybeacquiredatabargainpriceinrelationtothefairmarketvalue of the
asset at the time when the option may be exercised.
6. Some portion of the lease payments is specifically designated as interest or its
equivalent.

Pros and cons leasing

- Leasing company can have a comparative advantage (network, experience etc.)

- If true tax lease: Advantage over bank because the lessor owns the equipment in case
of financial distress
o Security interest: Lessor with the same right as other creditors
- Capital lease: See non-true. Buy and borrow from lessor. Listed as an asset on the
balance sheet.

Ch. 28 M&M and LBOs

- The same economic activities that drive expansion most likely also drive merger flow
(merger waves)
o Conglomerate wave: Acquiring unrelated businesses (60s)
o LBO, hostile takeovers, shake things up. (80s)
o Strategic, create global players within a industry (90s)
o Consolidation, private equity (00s)

Market reactions:
- Average premium paid: 43%. Why? Necessary to gain control, must be attractive for
shareholders to tender
- Average target price increase when announced: 15%, average acquirer price
increase: 1%
- Agency problems with managers: Conflict of interest (empire building),
overconfidence (sure I can manage)

Why merge:
In theory a zero-NPV transactions. However, aim for synergy effects
 - Cost reductions (consolidating staff, aka fire people, merge supply chains etc.).
Horizontal
o Economics of scale: More negotiation power
 Monopoly gains
o Economics of scope: Supply chain example
 Efficiency gains
- Revenue enhancements: Tax savings for operating losses (buy company with losses).
o Be aware: A merger can increase P/E without adding any economic value.
- Diversifications (conglomeration): Risk reduction, empire building.
o About risk reduction: Think about earlier curriculum about whether or not the
firm should diversify away risk, or if the individual investors should do it
themselves in their portfolio.
 Agency problem: Harder to measure performance accurately.
o Debt capacity
- Strategic: One could acquire a firm to deny a competitor the possibility. Checks and
balances of power.

M&A walkthrough:

Amount paid = Target pre-bid MrktCap + Premium

Value acquired = Target value + PV(Synergies)

- Tender offer: Public announcement with intent to purchase

- M&A dance: The time between the initial public announcement and end result.
o Risk arbitrageurs: Investors who take advantage of the situation by betting on
whether the deal will go through or not (not actually arbitrage, as it is not
risk-free)
 Merger-arbitrage spread: Difference between target’s stock price and
implied offer price
o Both board of directors must approve the deal
 Friendly takeover: Target board support the merger, cooperate and
take the bid to the shareholders
 Hostile: Board of directors fights the takeover attempt, acquirer
usually goes around the management/board directly to the
shareholders (proxy fight). Brings me to the next point
- Takeover defenses
o Poison pills: Give existing shareholders buying rights attached with extreme
special conditions, when certain conditions are met. Usually buying at deeply
discounted prices. This dilutes the shares to the point that a takeover will
become very expensive for the acquirer.
 Can cause negative effects for existing shareholders afterwards is the
takeover attempt was unsuccessful (management gets entrenched,
difficult to replace).
 Can be used as a bargaining chip in negotiations
 Answer: Support its own directors, who can cancel the pill if they are
successful. See next point
  Can be discussed whether these defenses are best for shareholders or
management (agency problem).
o Staggering boards: Board of directors serving terms, so for example not more
than 1/3 can be replaced each year.
o White knight: Find another bidder they want.
 White squire: Favorable investors acquire a large block of shars with
special rights.
o Golden parachute: Expensive costs relating to fire management, written in
their contract. Must be treated as a cost of merger.
o Recapitalization: Pay out cash as dividend, issue debt and pay out with
dividend or repurchase. Make yourself unattractive (and make the managers
run a better organization)
o Supermajority required, can be combined with large rights for minority.

Who gets the value

- Free rider problem: If a bidder offers a premium, but the perceived true value is
above, existing shareholders have an incentive to not tender their shares, wait it out
and profit on the back of the bidder who bought it at premium price and pushed it up
to true value. If all investors think like this, no one would be willing to sell their
shares at tender price.
o Toehold: Bidder can buy up shares anonymously (can do it up until 10%
ownership in the US)

Difference between cash offer a stock-swap:

- Tax. Cash received must be taxed (capital gains on profit from buy price), stock-swap
taxes are deferred until they are sold
o Spin of assets and liabilities in subsidiaries is an option to minimize exposure
to unknown risks from target
o The combined firm must market up the value assigned to the target´s assets
on the financial statements. If purchase price exceeds the fair market value of
assets, then the remained is written as goodwill (for example that you pay a
premium for a brand name)

- Make sure you have outstanding, P/S and MrktCap for both
- Compute combined value, including and excluding synergies
- Operating assets
OpAss=MrktValue+ MrktValueDebt −Cash
- Do the A buy up the T’s debt on beforehand?
OpAs s T =MrktValue+ MrktValueDebt −BoughtDebt
- Joint value:
Joint Equity value=Merged value+Cash+Synergy
Stock exchange swap:
New shares=Exchange rate∗Outstanding Target
Price per share T
Exchange rate=
Price per share A

Dollar value offer

=New shares
P
acquirer pre
S
Exchange rate=
Outstanding shares target

P V A +V T + Synergy
Acquirerer new =
S N A + New shares
- If no synergies -> only A+T (no matter what premium)
P P ValueT + Premium
target= Acquirer new ∗Exchange rate=
S S Outstanding T

- Why is market reaction for target lower with a swap than in a cash offer? The target
shareholders now have a stake in the acquirer, and is exposed to the same risks. In a
cash offer, they are “out of the game” if they tender their shares

Announcement prices
- No value don´t actually change hands after the merger is completed.
- Are they asking about price per share of price (market value)

P P
Acquiring value= post completion∗OutstandingTarget value= target∗Outstanding
S S

Positive NPV of M&A (stock-swap):

V A +V T + Synergy V A
> =P /S
N A + New shares N A

- A stock-swap merger is a positive NPV investment for the acquiring shareholders if

the share price of the merger firm exceeds the pre-merger share price
- Max exchange ratio to ensure positive NPV:
x Ptarget Synergy
< (1+ )
N t P Acquirer VT

Cash offer:

P Cash offer
target=
S Outstanding Shares Target
P Combined value−Cash offer
acquirerer =
S Outstanding A

- Remember to account for golden parachutes, debt, etc.

Stock exchange + cash offer
Value of offer New issued shares
New shares= Exchange rate=
Price per share T Existing shares T
Dollar value stock swap
=New shares
P
acquirer pre
S
Exchange rate=
Outstanding shares target
New shares=Exchange rate∗Outstanding T

P Equity value−Cash offer

acquirerer =
S Total shares
P P
target= Acquirer post∗Exchange rate+Cash offer
S S
Different share classes
- When calculating their respective P/S (implied), multiply it out so it’s easier to work
with (for example a 2:1)
- When they have to perform a SEO
Capital needed Price per share T class
New shares= Exchange rate=
Price per share Price per share Acq

- Price per share of acquirer should be adjusted for perceived value.

- Primary (for example issuance to pay for investment) is market value), secondary is
pre-determined price to buy out target shareholders.

New shares=Exchange rate∗Outstanding T class

Equity value+ Net gain
New price per share=
Old shares+ New shares+ Exch . shares

LBO’s

Instead of using cash to pay for the firm, the acquirer borrows money through a shell
corporation and pledges the firm itself as collateral
- If merger takeover fails, money is paid back (or not paid out at all, maybe only signed
intent to borrow)
- If merger is successful, the firm merges with the shell corporation, so the debt is now
under the target firm. The acquirer owns the firm, but the firm is responsible for the
liability.
o Debt often paid down by shaving the company assets, selling off.
Planned exit strategy: 5 years, taking it public again, selling its parts

Alternative to LBO: Freezeout merger: Freeze existing shareholders out of the gains by
forcing non-tendering shareholders to sell their shares for tender offer price
- Achieved by taking control of the firm and moving all assets into a new company,
essentially making the target firm non-existent. The non-tendering shareholders now
 have no other choice but to take the tender offer. Acquirer now have capturer all the
value from the deal, eliminating the free-rider problem.

LBO walkthrough (Ordinary 2017, exercise 4):

1. Loan needed
Shares needed ( % of all )∗Tender offer
2. Calculate equity value after all liabilities (you take on a loan, so subtract, see 3.)
o If shareholders hold out, their share price would decrease because the
changed capital structure would be divided by all shares (because it is not yet
taken private)
3. Calculate outstanding shares (not to be confused with shares needed/remaining (see
4.)
Perceived value−Debt
Outstanding=
Tender price
4. LBO firm will have to keep a certain number of shares to keep the share price equal
to the tender price
o Why: To make sure that the deals go through, it is crucial that the perceived
value of the firm stays at the tender price to secure enough shares. If the
market sensed that the true value was above, none would tender their
shares, and the LBO firm would not secure the necessary majority.
o Floating: The shares not bought originally. The amount LBO keeps is the
difference between what was supposed to be outstanding and the
outstanding after calculations.

LBO keeps=Outstanding−Floating Floating=Outstanding− LBO keeps

5. Firm keeps
Retained=Planned bought−LBO keeps
6. Value divide:

LBO value=Tender∗LBO keeps

Or

LBO value=( Perceived share price−Tender )∗Old shares

Exisiting EH value=( Tender−Old )∗Old shares

- This tells us that the existing shareholders profit between original share price and
tender, and the LBO profit from tender to new share price. Pretty straight forward.
- Any difference between total value divide and the added value is likely going to
liabilities (debt, golden parachutes etc.)
- Poison pill fight: if the LBO firm have to make minority shareholders indifferent
between keeping their shares or tendering, do the above calculations by setting the
tender price to the real value price per share (value of tender offer plus discounted
share divided by two = price for one).

7. Break-even price: An increase in tender price means less money in the LBO firm’s
pocket (see 6. In perceived share price minus tender). The maximum they can offer is
 therefore the maximum perceived value. The LBO will in this case receive nothing,
and the existing shareholders get all the gain.

Other:
Earnings
EPS=
Outstanding shares

P P/ S
Fwd =
E EPS
Price per share comparables:
EPS∗P P
comparable=
E S

- Low -> cheap stock. Can be manipulated

-

A ( non−cash )=D+ E−Cash→ ESO is Debt

¿+ Depr−Increase NWC−CapEx=FCF
Enterprise value=E+ D−Cash → E=EV +Cash− D
Cash is already a part of E∧ A ∈ A=D+ E
P Mrkt Value Equity
=
S Shares outstanding

E ( equity )= prob .∗(V −D)

LOSS rate=( 1+ yield )t −( 1+r d )t

Financing project with equity/debt issuance:

- If the market knows (or think they know) the value, the share price will reflect this
when the firm must figure out how many shares they need to issue
- If the issuance happened before the true value happened (it was over or
undervalued), when recalculating the share price once true value is known, the value
of raised equity is new shares * P/S when raised, not multiplied by true value price

Balance value sheet for recap for dividend (good example 15.18 i.e. no arbitrage)

Initial After borrowing After dividend

Assets Liabilites Assets Liabilites Assets Liabilites
Cash Debt Cash Debt Cash Debt
$ $ $
84.00 $ 354.00 438.00 $ - 354.00
Existing Existing
assets Equity Existing assets Equity assets Equity
$ 814.00 $ $ 814.00 $ $ 814.00 $
 730.00 730.00 460.00
$ $ $
$ 814.00 814.00 $ 1,168.00 1,168.00 $ 814.00 814.00
Shares outs. 10 10 10
Price pr
share 73 73 46

Last day focus

- Understanding arbitrage strategies (Chapter 20)
- Perfect market value balance sheet with and without taxes
- Clarify bankruptcy vs. financial distress cost
- Idiosyncratic
- Annuity formula
- Risky and risk-free debt connection (Ask Mads)
- Leasing if time
- P. 450 Loss rate