Corporate Finance Notes PDF

Chapter 1 – Portfolio and Capital Market Theory 1.1 Capital Markets and Informational Efficiency Capital: financial resources available to a company in the form of equity or debt Equity financing: company’s own resources Debt financing: outside capital (taking out a loan with a bank) Capital market...

Chapter 1 – Portfolio and Capital Market Theory 1.1 Capital Markets and Informational Efficiency Capital: financial resources available to a company in the form of equity or debt Equity financing: company’s own resources Debt financing: outside capital (taking out a loan with a bank) Capital market: a market where investors provide borrowers or investees with medium to long term financing in the form of equity or debt. Money market: money is lent to borrowers on a short term basis for up to a year (Commercial papers with max tenure of 270 days, treasury bills etc) Perfect capital market Term used in economic theory to allow financial problems to be analyzed as clearly and coherently as possible. Below are the characteristics: 1. They’re frictionless (effortless) a. Doesn’t incur costs or taxes, securities can be shared and traded perfectly, free of regulatory restrictions. 2. Perfect competition exists a. Participants are “price takers”- decisions and actions have no effect on market price b. Raise capital or invest capital at a single interest rate 3. Market participants operate with rationality a. Entities operating in this market have full information and logically act in their best interest 4. Informational efficiency exists a. All participants are having all sorts of information. Only used in theory to solve or analyze financial problems Informational Efficiency – The different channels from where the market gets info about companies. They are: -Prospectuses: a documents about a company provided to potential investors, has information about the company structure, securities for sale, business operations, risk, management and financial status. -Market Sector analyses – Market is analyzed by finance professionals, research firms etc who give reports about the market. -Company financial statements – Produced by every public company which can be quarterly or annually. -Reports in the financial press – Reports published by press.  Information is constantly sought and processed to inform the process of buying and selling assets  Role of information procurement and distribution is significant as the actual processing of information can cause market prices to change immediately  Many institutional and private investor spend a lot of time sourcing information in order to get more advantage outcome for their stock market investments  These investors are attempting “target excess returns” – higher investment returns than other market participants  Can only be gained by investors who outperform the most efficient market player by obtaining and evaluating information  Obtaining excess return is not high in liquid market – a market which always has investors and sellers in sufficient numbers to meet mutual demand  Stock market is informationally efficient - when all market participant have immediate access to the same information   Prices reacting instantly to new information, contradicts the advantage any individual market participant may have in achieving excess returns Distinction are made regarding the degree of information efficiency:  Weak-form information efficiency- exists if all past prices of a stock are reflected in the current market price and that no technical analysis can be effectively utilized to aid investors in making trading decisions. (past information is affecting current price)  Semi-strong informational efficiency exists if the current market price of a stock reflects all public information and information on past price changes. Investors can’t use either technical or fundamental analysis to gain higher returns in the market. (past+ public(current) information is affecting price)  Strong-form informational efficiency- exists if the current prices of a stock also reflect private information or “insider information”. All information, both information available to the public and any information publicly known is accounted for in current stock prices, and there is no type of information that can give an investor an advantage on the market. (past +public+ private information(info that is not disclosed to the public is insider info)) 1.2 Portfolio Theory  Assets are inevitably lined to an underlying risk-return ratio: the greater the risk an investor is prepared to take, the higher the potential returns on his or her investment.  All investors want to know how to invest their money in different securities in such a way that both minimizes the risk exposure of their investment and maximizes the level of return Creating an investment Portfolio The Markowitz diversification strategy is the foundation for reducing the risk when creating a portfolio. Diversification: investing in a variety of different financial instruments or projects in order to spread the investment risk- One theory that can help achieve your goal of reducing the risk and increasing the return  The overall volatility (or dispersion of return) of a financial asset or investment is a function of its share of diversifiable variance or risk (unsystematic risk – company specified risk like liquor ban in some state will affect liquor producing company) and its share of non-diversifiable variance (systematic risk or market risk)  Unsystematic risk in a portfolio can be reduced by adding an asset that is likely to fluctuate in its performance in ways that don’t fully correlate with the remainder of the portfolio. Variance of return is minimized by the asset added to the portfolio  Portfolio developed by Markowitz is also known as portfolio selection theory o Attempts to explain the frequently observed risk diversification behavior of investors (including rage of different securities/assets in their portfolio), how portfolio should be diversified rationally, how many securities or assets should be included in a portfolio. The model is best illustrated by two-asset portfolio example  Assume that two assets (A and B) have different rates of expected return and different standard deviations.  If the proportion of security A in the portfolio is a, then proportion of B is 1-a.  To determine the level of dependency between the two assets, the correlation coefficient is used o Correlation determines the degree of mutual dependency between two variables. The model can be expressed in equation form using the following variables: σ = standard deviation σ2 = variance r = correlation coefficient μ = expected value (return) cov = covariance This helps to explain the interrelationship between correlation and diversification  Portfolio theory addresses the following:  What should a single individual (investor) do to construct an optimized portfolio?  Which criteria are relevant to this decision-making process?  How are investments assessed in relation to this process?  What is the optimal capita-allocation strategy for any given (individual) expectations? Example Ms. Wright is delighted. She decides to invest in various stocks by constructing a portfolio. After purchasing stocks in ten different companies, she finds another stock for which the correlation coefficient between her portfolio as it currently stands and the new stock is –1. She wonders what consequence this has for the diversification effect. Based on everything she has read, she comes to the following (correct) conclusion: in this case, the overall risk—meaning the volatility linked to the level of returns from the stocks—would be diversified away. Therefore, in theory, the level of return expected from this investment need be no higher than the risk-free interest rate. 1.3 CAPM  Capital asset pricing model (CAPM- developed from the portfolio theory of Markowitz and is a classic approach in capital market theory.  Describes the relationship between systematic risk and expected return of assets, particularly stocks  CAPM isn’t about rational, individual decision-making, it’s about the way decisions aggregate to create market equilibrium.  Field of application includes evolution theory and practical company valuation. Central assumptions underlying CAPM:  Investors have single-period transaction horizon (a standard holding period used to compare returns on different investments- usually a holding period of one year)  Market participants (buyers and sellers) are risk-averse and look to maximize their utility  Investors are price takers (cannot influence prices)  Market participants have homogenous expectations regarding the returns of their securities  Risk-free investment. (i.e. risk free returns can be generated, CAPM assumes risk-free interest rate)  A perfect capital market exists  CAPM attempts to identify the part of an overall risk of an investment that can’t be eliminated through diversification.  Explains how to evaluate risk investment opportunities in the capital market  In the case of risk-free investment, the investor would only demand the market rate for a risk-free investment  If investor takes extra risk related to his/her investment, he/she will demand an additional risk premium to compensate for the extra risk  Risk premium- calculated as the difference b/w the general market return and the risk-free interest rate, which is multiplied by beta The following equation depicts the return demanded by investors, also referred to as the “cost of equity,” in accordance with CAPM: The expected (required) rate of return on the security or asset can be represented as a line, which is also called “security market line” (SML) Example Ms. Wright would like to work out the cost of capital for the company Optimize Inc. She sources the following values from the investment magazine The Economist: the company’s profit per share is 26 US dollars, with a beta of 2. The expected market return for the market portfolio is 10 %. The current interest rate for risk-free assets is 4 %. The cost of capital is calculated thus: Beta as a measure of Risk  Within CAPM, importance is attached to beta as the measure of stock’s or security’s risk exposure.  It can have an infinitely positive or negative value.  Relative measure of risk and indicates the return of an asset or security.  To calculate beta, a regression analysis is performed for a certain period.  Regression- an estimated measure of the relationship between two or more variables  Beta is used as a standardized measure of risk of stocks.  B/c beta of future is unknown, ex post values are used.  Beta is not stable and can fluctuate. If Beta = 1, then Stock will get same returns as market. If Beta > 1 then stock wil get more returns but will also be more volatile and high risk and viceversa for Beta < 1. Chapter 2 – Stock and Portfolio Analysis 2.1 Measures of Risk and Performance Risk and Risk Management  Risk is not same as loss, only unexpected potential loss constitutes risk  Market price risks are defined as changes in the price of stocks, bonds and currencies due to market movements or changes in yield curve and volatilities.  Volatility: range of fluctuation Market price risk can be broken down into foreign-exchange and inflation risk, risk of movement in interest rates, and equity price risk & risk associated with trading commodities.  Currency risk- risk of devaluation of foreign currency in which investment is denominated  Inflation risk- result of devaluation of cash due to increases in price levels- chance that cash flows from an investment won’t be worth as much in the future b/c of changes in purchasing power due to inflation.  Interest rate risk- decline in the value of an asset resulting from unexpected fluctuations in interest rate. Mostly associated with fixed-income assets (bonds)  Equity price risk – reflects possibility of negative movement in individual securities or assets or portfolio.  Commodity risk – includes all losses as a result of unfavorable movement in the prices of commodity such as metal, gas…etc. Risks such as liquidity and country risks can be grouped together:  Country risk – describes dangers related to convertibility or freezing of payments. Exists due to risk of political intervention in the financial market. (Also refers to uncertainty associated with investing in a particular country and in which that uncertainty could lead to losses for investor)  Liquidity risk – risk that a company or bank may be unable to meet short term financial demands. Investor risks:  Capital maintenance risk – possibility that an investor could lose some or all of his capital in the event of bankruptcy  Information risk – risk that the investor is not supplied with all the necessary information of a financial instrument  Settlement and management risk – misappropriation or disloyal management of capital placed by the investor  Advocacy risk – a representative exploits an investor’s interests to his or her advantage (broker’s behavior)  Conditions risk- involves the chance of acquiring an investment at unfavorable terms Risk Management is the systematic identification, assessment, and control of wide assortment of risk Sharpe Ratio Also referred to “reward-to-variability ratio” To help investors understand the return of an investment compared to its risk Helps evaluate risk and return together to help chose an investment that generates high return for optimal risk taken  The higher the Sharpe ratio, the higher the portfolio’s performance Portfolio value exceeds that of the benchmark portfolio, it means that it was managed better after adjusting for risk. Advantage:  Its intuitive interpretation of performance, simplicity of calculation and comparability.  Return and volatility can easily be calculated after determining the Sharpe ratio  Selecting a benchmark for this performance measure is critical Treynor Ratio Also referred to “reward-to-volatility ratio” Determines how much excess return was generated for each unit of risk taken on by a portfolio Advantage:  Permits comparison with other portfolios and benchmarks  Share ratio relies on standard deviations, this ratio requires determination of beta.  Disregards unsystematic risk Measures of Return A distinction made among different measures of return. Return can be both time-weighted and money-weighted. I0 denotes the value of the investments at the outset of the investment period I1 denotes the value of the investments at a later point in time. Simple return, also known as “performance” is calculated using the equation: Calculation of a time-weighted return is an approach to measure historical performance Arithmetic = Time-weighted – you invest the whole 100,000 at the first year and it doesn’t take into consideration the time when you invest. Geometric = Money – weighted – factors in difference when you invest, for example, you put in 50,000 in year one, and then 50,000 in year two. The difference between the two is time-weighted ignores time of cash flow, while money weighted factors in time of cash flow. If money-weighted return is less than time-weighted return, then the investor’s timing of ROIs and withdrawals was unfavorable. If the situation was the other way around, then timing was favorable. 2.2 Stock Analysis  First task of stock analysis is to systematically compile and analyze all information pertaining to a company and its environment.  Based on the above information, second task is to come up with short and long-term forecasts of trends in the price of that company’s stock. Method for stock-price forecasting can be broken down into objective and subjective components Objective methods include fundamental analysis, technical analysis, and innovative methods. Subjective method include surveys of experts and intuitive methods. Fundamental Analysis  Looks at the characteristics of a company to determine its value  Assumes that each share has intrinsic value- also referred to “fair value” (result of both internal and external corporate data)  Intrinsic value: measure of what an asset is worth.  Technical analysis: analyzes the price movements of company’s stock to determine company value  A share’s over or undervaluation can be determined by comparing its intrinsic value with its current market price.  If Intrinsic value > Market value = Undervalue share (Opportunity to buy the share)  If intrinsic value < Market value = Overvalue share (Opportunity to sell the share)  If intrinsic value = Market value = Equilibrium State (no pressure of buying or selling)  Influencing factors: macro and microeconomic data that needs to be analyzed to assess the accuracy of its valuation Can be calculated using the (P/E)- price to earnings:  Problem with P/E is that the current price is considered in relation to the company’s last known annual earnings. If P/E ratio is more than the market benchmark, then the stock is expensive and viceversa.  Addition to P/E is P/CF- price cash flow ratio  Advantage of P/CF = future oriented, less subject to manipulation.  Price/cash flow ratios is more meaningful for assessing a company: by taking depreciation, amortization, and provision into account.  P/CF should only be considered a complementary ratio for use when assessing true value Technical Analysis  Technical analysis deals with price and trading volume trends of securities (based on past data)  Forecasting methods include classic chart analysis and mathematical forecasting systems.  Often referred to as the “chart technique”  Can be broken down into presentation analysis, formation analysis and market analysis. o Presentation analysis follow trends in chart form, searching for specific signals o Formation analysis: examines geometric price trends such as triangles or head and shoulders formation- uses these patterns to predict future price trends o Market analysis: identifies trends and potential zone of support and resistance Technical analysis posits the following hypotheses for future developments:  Price trends are the result of supply and demand  There are numerous irrational and rational factors at play, and market continuously compensates for these  Prices tend to develop along lines of predictable phases and trends  It’s possible to forecast changes in basic direction brought on by changes in supply and demand  Past patterns brought about by certain influencing factors repeat themselves because human behavior repeats itself Innovative Methods of Analysis Chaos theory  Forecasting stock prices based on chaos theory  Assumptions that movements in stock prices are not random bur rather based on certain complex patterns  Assumes that prices follow a nonlinear, dynamic process- one in which effects are not just linear outcomes of causes but also influence the causes (feedback) Neural Networks  Neurobiologists have used a computer to try to simulate the models of learning, thinking and forgetting.  Neural network processes are not yet widely utilized. Chapter 3 - What is the Optimal Capital Structure? 3.1 Capital structure based on the traditional theorem Fundamental Principles Capital structure: refers to the composition of total funds (debt, equity, and hybrid securities) that a company has at its disposal to finance its operations and growth. Equity interest: grants specific rights to its owners such as voting rights and right to a share of company profits, right to a share of company assets in the event of liquidation. Do not entitle the owner to a compulsory return on their equity Debt securities: don’t grant creditors any rights of influence regarding company decision-making. Credit is granted for a limited duration, creditor doesn’t profit from gains made nor effected by losses incurred by company (interest payment) Leverage effect: states that a company’s equity will generate more return if the company increases its use of debt capital. But its possible only when the interest on borrowed capital (borrowing cost) remains lower than the overall income derived from the investment. The Traditional Theorem  First theory on optimal capital structure was devised by Durand.  Identified two extreme views and a middle position  Two extreme views: the net income approach and the net operating income approach Net income approach: assumes that the capital structure effects a company’s value. Based on the following assumptions:  The cost of debt is lower than the cost of equity   The risk perception of investors doesn’t change with the use of debt  No personal or corporate income taxes exist Based on these assumptions, leverage will result in the following change to company’s value:  increase of the ratio of debt to equity = decrease of the cost of capital and increase in the value of the company and the share price  In reverse: the decrease of debt of equity ratio= increase in the cost of capital and decrease in the company value and share price. o A company can minimize the cost of capital and increase the value of the company by debt financing to the max possible Net operating income approach: assumes that the capital structure is irrelevant and unrelated to company’s value. Following assumptions:  The cost of debt is lower than the cost of equity  Risk perception of lenders of debt doesn’t change with the leverage and as result, the cost of debt remains constant  The market determines the value of a company as a whole, meaning that the split between debt and equity is irrelevant  No personal or corporate income taxes exists Because of risk perception of the owners, they will expect higher returns if the amount of debt increases.  Capital costs are constant irrespective of the financing structure  Any change in the capital structure doesn’t affect the overall cost of capital , the market value doesn’t change Traditional theory: developed as a form of compromise between the net income approach and the net operating income approach. Assumptions:  An optimal debt ratio (leverage) exists for any company when the average cost of capital is minimized  An increase in a company’s debt proportion or leverage ratio increases the required rate of return for equity holders. Three effects to be observed:  Increasing use of debt ensures that expensive equity is replaced by cheaper borrowed funds. If equity capital cost and cost of borrowed capital remain constant, the weighted average cost of capital will decreases as result of an increase in the level of debt.  As company’s indebtedness increases, so does the risk related to owners tied-up equity, in turn increasing the rate of return for these equity owners. (ROE initially increases while the average weighted cost of capital continues to fall)  If company’s level of debt is high, outside creditors also view their shares in the company income as risk due to increased related risk of insolvency. (Creditors will only provide new debt capital if company is willing to accept risk premiums built into borrowing rates)   Increase use of debt = overall cost of capital falls and value of company increases  This effect is temporary because the total costs of capital rise as debt levels increase further, value of the company decreases- shown in point M  Optimal debt-equity ratio occurs at (D/VE) – The overall cost of capital is minimized and company value is maximized. 3.2 Capital structure according to Modigliani-Miller The Modigliani-Miller Theorem  Asserts that under perfect market conditions, the market value of a company can’t be increased by altering the claims on its assets (ex. By changing its debt-equity ratio)  Company capital structure is irrelevant to Modigliani and Miller  The M&M model represents the starting point of the modern thinking on capital theory Making the following assumptions in their model:  An investment policy is taken as given  Investors demand a certain average gross return on their investment. This model assumes that all investors have the same expectations of their investment  Companies can be divided into homogenous risk classes.  Allocating a company to a certain risk class permits a comparison with known market values of other companies in the same risk.  A perfect efficient capital market exists  Equity investors have expectations in terms of their effective return  Borrowing costs are independent of the debt-equity ratio, where shareholders can take on debt at the same rates as companies   The interest rate on capital investment and borrowing is uniform  Companies either can finance their operations through risk free debt capital or via equity capital that is exposed to risk  Cash flow are assumed to continue in perpetuity Irrelevance of debt-to-equity ratio  The main difference compared to traditional theory can be seen in the company’s cost of equity rate, which doesn’t remain constant even if there is a change in the amount of risk-free securities issued. Dividend Policy According to Modigliani-Miller  Dividends: portion of profits to be distributed to shareholders  Objective of dividend policy: is the targeted structuring of the payment flow between the stock corporation and its shareholders, to which the payment are reflected as a reduction of equity on the balance sheet.  Dividend policy is deemed irrelevant by M&M theorem  Assuming in a perfect market, dividend policy can be understood as a balance between self-financing by retaining earnings and profit distribution followed by issuing new shares  Direct link between an increase in the dividend and an issuing of new shares  Dividend policy has no effect on the company’s value 3.3 Neo-Institutional Capital Structure Model Modification of M&M model  Transaction costs and taxes are included in the consideration of an optimal capital structure (through purchase and sale of securities)  Level of transaction costs is dependent on the type of financing used- transaction cost are lower when debt capital is used  Total market value of company is said to increase slightly if cheaper outside capital is used  Taxes are taken into account- borrowing costs are tax deductible  Cheaper for a company to use debt rather than equity- company’s value rises as its debt financing increases Neo-Institutional Theory: The Trade-Off Theory  Neo-institutional model build on the criticism of the neo-classical approaches relating to the return and risk parameters  Agency costs- neglected in the neo-classical models.  Agency costs (Jensen and Meckling): monitoring costs, bonding costs, and residual loss, which arises because it’s no economically possible to monitor all the manager’s actions.  Neo-institutional model assumes that the various interest intensify in line with the company’s increasing indebtedness o They help minimize agency costs and reduce & optimize the cost of capital  Rising debt ratio implies problems   Taking out new debt has a negative impact on bonds already issued because it increases the risk of defaulting on the claims of creditors  When leverage of company increases, the probability exists that after a certain point the company will no longer be able to meet its payment obligations- risk of bankruptcy increases  Bankruptcy incurs high costs- insolvency cost and tax savings resulting in indebtedness  With increase of indebtedness, net present value of the tax savings initially increases more than the net present value of the bankruptcy costs The market value of the company keeps increasing until the marginal change in the net present value of the tax savings is equal to the marginal change in the capital value of the bankruptcy costs (optimal debt ratio). This approach is also called the “trade-off theory.” Dividend Policy where taxes are assumed to exist  “Pay out and plough back” policy – different tax rates for retained and distributed profits exist. o If the tax rate for distributed profits is lower than for retained profits, it makes sense to distribute profits first and to appeal to the shareholders to ask them to reinvest these profits in the company in the form of new capital. o This is different in other countries as there are taxes imposed on retained profits Capital structure in practice M&M start from the assumption of a perfect capital market in order to derive factors that lead to an optimal debt ratio. The company valuation V is calculated as follows:  But the optimal capital structure theories represented above do prove that defining an optimal debt ratio depends heavily on each individual’s perspective. Consequently, it can be said that no precise optimal debt ratio exists; it is only possible to determine an approximate value.  Debt-to-equity ratio: dependent upon so many factors that not one single optimum debt ratio can be said to exist  In practice, problems occur when determining an optimal debt-to-equity ratio due to factors such as political aspects or industry practices.  Optimal debt ratio in a financing theory contexts is not achievable in real-life scenario Chapter 4 – Types of Financing 4.1 Internal and External Financing  External financing: funds obtained from outside firm such as stockholder equity or by loan capital provided by creditors  Internal financing: money generated from business divestment (selling of assets to obtain funds)- meaning the business uses its profits as a source of capital Difference between equity-debt financing and internal-external financing results in the four basic types of financing:  External financing with debt refers to funds that are provided for a certain time in return for a rate of interest  Accrued liability reserves come from the company’s own resources and can be used to finance needed current or future assets  External financing with equity is important when a company is starting up or expanding- by existing or new shareholders  Funds from retained earnings as a combination of internal and equity financing refer to the surplus of financing resources flowing into the company from business activities and out of the company for goods used or dividend payments Mezzanine financing: hybrid of financing from equity and debt - a loan can be converted to ownership or equity if not paid on time and in full. 4.2 Debt Financing Creditors: obtain a right to repayment of capital they provide, payment of interest in agreed amounts at agreed time  Creditors enjoy great security through loaned capital than equity investors  If company goes bankrupt, claims of creditors are settled first before those of equity investors  Interest owed is classified as borrowing costs  Creditors have no say in how company runs its business  Creditors don’t benefit from company’s profits nor are they impacted by its losses Equity investors: have a say in how the company runs while creditors don’t Loan financing via banks and other financial institutions  Creditors are often banks or financial institutions that attach special conditions to the loans they grant   They require collateral as security for the loan, impose obligations to provide information and often demand personal liability of owners or partners of the firm  Loan collateral secures creditors against scenarios that can happen with the borrower  Types of collateral: agreements and legal mechanisms, such as liens on movable property and rights, retention of title, and transfer of title for security purposes as well as mortgages Collateral refers to secured lending and hast two primary functions:  Risk sharing function: if the investment project fails, the creditor obtains the value of the security (collateral)- position of creditor is strengthened while the borrower is weakened  Incentive function: collateral encourages the borrower to adopt certain behavior- opportunistic behavior on the part of the borrower is less problematic for the creditor if they’re sure of receiving the value of the collateral  Collateral serves to reduce behavioral risk- it’s also binding the borrower to behave in a certain way  Another way to reduce behavioral risk- Loan covenants  Covenants are included in loan agreement and contain strict terms and conditions that have to be followed by the borrower  They Impose lending conditions such as: disclosure of financial information or restrictions of certain business activities Legal capacity to contract debts and creditworthiness: are pre-requisites to a loan agreement  Differentiation is made between a natural person, legal person, and business partnerships  Natural person (human beings as opposed to corporations) are able to contract debts provided they have full legal capacity  Legal person (Stock Corporation or Limited Liability Company) and business partnership (general partnership or limited partnership) – these business types must be verified prior to determining their credit worthiness  Determinations of creditworthiness asses how likely a person or partnership is to default on their loan  Based on many factors: the potential borrower’s history of repayment, availability of assets, extent of liabilities and their credit rating Checking creditworthiness of companies is carried out by examining the following documentation:  Annual financial statement (with explanation and profit & loss statement)  Credit status or interim balance sheet at the time of application  Audit report by auditors or experts  Excerpts from registers (eg. Commercial register, land registry, Cadaster)  Presentation of sales performance/trends, volume of orders, and investment activities  A financial plan for the duration of the requested loan or atleast for the following few months after loan application.  A schedule of the available collateral Loan financing via capital markets  Obtaining funds via the financial and capital market – using corporate bonds  Larger companies issue bonds or debt securities that have a fixed interest rate, a fixed term, a fixed repayment terms and notice periods.  Maturity of bonds is at least one year  Bonds can also be issued with a shorter maturity Long-term and short-term loan financing  Trade credit: a business to business agreement where a company is allowed to defer payment to a supplier for goods received until a later date- (buy now pay later.)   Often credit supplier will give discount for earlier payment (7 days) or customer can chose to pay within 30 days. Customer loan: a down payment is provided by the buyer prior to receiving their goods or services Lombard lending: a loan that is backed by assets. Lombard loans can be granted against collateral pledged where the bank may sell the assets to get the money back IOUs and warrants: are long-term debt financing instruments- a form of debt issued with a certificate stating the amount of the security/collateral pledged  Can only be issued to top-rated borrowers  Financing term is usually no longer than 15 years 4.3 Equity Financing Equity occurs when founding a new company, when a company acquires a new shareholder/partner, when company increases their capital, or when a company goes public. Legal form of company plays a decisive role in the type of equity financing it opts for First group are personal companies – sole proprietorships and partnerships Sole proprietor: a business whose single owners bears personal and unlimited liability for the company Obtaining equity capital for these companies is difficult Strengthening equity based is often only possible via internal financing Partnership: established by at least two company partners which bear personal liability for the company General partnership: characterized by the fact that all partners bear personal and unlimed liability for the company Limited partnership are very similar to general partnership but they have two groups of partners, with at least one partner in each groups Equity financing for personal companies  Equity financing for partnership takes the same form as for sole proprietorships, except that individual assets from at least two partners are put at the disposal of partnership  General partnership: equity financing can be obtained either by increasing the equity stake held by existing partners or by bringing in new partners  For a limited partnership: equity financing can be arranged by adding general partners who are fully liable as well as limited partners who are partly liable and whose liability is limited to their respective share of partnership in capital o A significant increase in the equity capital base is possible because limited partners don’t carry out the management of company Equity financing for corporations  Sole limited liability companies and stock corporations  Due to its limited liability, it is easier for limited liability Company to raise capital compared with other partnerships  However, a stake in a limited liability company is less marketable (tradeable) than other assets  Stock corporations: its capital stock appears in its balance sheet under liabilities as share capital and reserves  Equity financing is crucial for start ups because their equity capital position forms the basis upon which subsequent funding such as loan financing is usually obtained Anglosphere corporations such as LLC and Ltd, there is no minimum share capital requirements. Some European countries followed this rule such as the Société anonyme de responsabilité limitée (S.A.R.L.) in France An advantage of stock corporation is that it allows different options when designing shares and raising equity capital. Specifics can differ from country to country but following are general concepts and structures:   Common stock (ordinary shares): entitle shareholders to all typical rights of company owners  Preferred stock: holders of this have preferential rights over the holders of common stock- typically they are entitled to higher dividend pay-out or are granted other financial rights. o However, preferred stocks have restricted or no voting rights  Bearer instrument: they are unregistered securities whose owners have a physical share with them - maybe transferred by agreement and delivery  Registered stocks: only through registration in the share register 4.4 Additional financing options Finance and operating lease agreements Leasing: an alternative for obtaining capital equipment  It’s a type of leasing in which a finance company is the legal owners of an asset (lessor) during the duration of the lease but the user (lessee) has not only the operational control over the asset but also shares the economic risks and rewards of the asset  On expiry of the agreed rental term of the lease, the lessee typically buys the asset or must return the leased property or renews the lease The lease contract can, depending on how it’s designed, contain elements of a rental agreement, an installment purchase agreement, or a rent-to-own agreement.   Lease agreements can take many different contractual forms.  Some leases are short-term or cancellable during the contract period at the discretion of the lessee, which is referred to operating lease. Operating lease: a lease agreement that is shorter than the operating life of the asset- has the following features  The lease term is significantly less than the economic life of the asset  The lessee can terminate the lease at short notice without a significant penalty  The lessor usually provides the operating know-how and any related services such as insuring and maintaining the equipment  No substantial transfer of risk and rewards to the lessee Financial lease: if the lease extends over most of the economic life of the asset and there is no option for the lessee to cancel the lease- also called capital lease or full-pay-out lease There are different way that different types of leasing can be classified or grouped. Contracts can be divided into two forms: full amortization contract and partial amortization contracts. Full amortization contract -The lessor’s acquisition costs for the asset are repaid during the base lease term in the form of lease payments -Neither party may terminate the lease contract during the basic lease terms -Depreciation risk lies with the lessee -At the end of the lease period, that are 3 options: (1) no option to purchase, (2) option to purchase for a fixed price, (3) option to renew the lease.  No option contract: if no contractual provision was made, the relationship between the lessee and lessor expires at the end of the rental period. Lessee returns asset, has no more influence on the use of the leased asset but can have a right to a share of any profit from the sale of the asset.  A fixed price purchase option grants the lessee the right to purchase the leased asset after the lease term expires at a price agreed upon at the time of signing the contract.  The lease extension options grants the lessee the right to continue using the leased asset at a rental price agreed upon but doesn’t grant the lessor any further option rights Benefits of amortization contract: Lease payments are fixed and lessee already knows the purchase price should he wish to purchase the asset Partial amortization contracts Do not feature the repayment of investment costs during the contract term Within the lease period, only a certain amount is repaid by the lessee- depending on the contractual agreed lease payments Lessee is liable for full amortization 1. Contract with a lessor’s right to require purchase by lessee a. The lessor is accorded the contractual right to sell the leased asset after base rental term b. Alternatively, a contract extension in the form of a lease extension can also be an option 2. Contract with lessee participation in revenue surplus or shortfall from sale a. The leased asset is returned upon expiry of the basic rental period b. The leasing company sells the leased asset and covers the remaining amortization with the sale proceeds – the surplus revenue will be paid to the lessee c. Should proceeds from the sale are not enough for full amortization, the lessee must pay the difference 3. Terminable contracts a. Maybe terminated as specified on the lease agreement although a notice period is agreed upon b. Possible that the residual value risk lies with lessor Sale-and-leaseback: when a company sells an asset and leases it back on a long-term basis A company sells an asset it already owns to a financial institutions and leases it back from the buyer Factoring and forfaiting Factoring: is the purchase of receivables by an organization that specializes in the administration of sales ledgers and collection of receivables. Company B purchase receivables so that the company B can make use of the cash that it needs. Factoring offers the following advantage:  Ability to take advantage of discount offered by suppliers  Save costs in terms of accounts receivable and credit checks as well as collection process  Eliminates costs for the recovery of claims  Prevents losses from customer insolvencies  Releases capital by reducing amounts owed  Improves balance sheet through reduction of receivables and liabilities  Potentially leads to revenue expansion if a credit shortage previously existed  A popular factoring is export factoring – where an exporting company sells or transfers the title of its account receivables to a factor. The factor bears the credit risk and assumes responsibility for collecting the receivables.  However, most contracts grant the factor the right to reject certain receivables in the case that they are deemed too risky Forfaiting: involves the purchase of receivables for goods or services mostly supplied by an exporter against a promissory note.  Forfaiting arrangement: the importer issues a promissory note or a bill of exchange to pay the exporter for the goods sold.  The exporter sells the promissory note to a forfaiting bank at a discount  The forfeiter bears the credit risk but every often the forfaiting transaction is supported by a bank guarantee or letter of credit by the importer’s bank Forfaiting is advantageous for the supplier (of the receivables) as it:  Improves liquidity  Unburdens balance sheet of short-term receivables and/or contingent liabilities  Transfers risk ( e.g., currency risk, political risk, transfer risk) Chapter 5 Capital Budgeting 5.1 Fundamental concepts  Investment is made with the aim of receiving returns in the future that are greater than the initial outlay of finances- in the form of income or appreciation of assets.  Investments can be fixed (bonds, fixed deposits) or variable (property, equity stakes in a business)  Evaluating potential investments is important to the success of every business and using the right methods is also an important economic tasks. The following questions need to be answered for majority of investment projects:  Does it make sense to invest?  If multiple investment options are present, which one is most desirable?  What should be the duration of an investment?  Investment programs can consist of multiple individual investment projects, which may be dependent on each other. Which should be selected in different circumstances?  Investment calculations are used to determine the value and the financial effect of specific investment projects  To reach a conclusion about the desirability of an investment, its cash flow (monetary inflows and outflows) must be known  Cash flow is measured according to 3 basic characteristics: amount, length, and degree of payment security  If cash flow has been identified for each potential investment, the value of these investment can be compared  For accurate comparison, both the time of maturity for the investment (earlier payments are more valuable than later payments) and the degree of payment security for income or sale of assets (secure payments are more valuable than insecure payments) need to be taken into consideration Static capital budgeting methods  Focus on a single period when calculating the value of an investment  The reference time period is typically a “hypothetical average period” of one year  Data is derived from the entire investment period  Various static methods for capital budgeting differ from one another with regards to their target parameter – some measure cost and profit while others measure rate of return (ROI) or payback period Dynamic capital budgeting methods  Take the timing of cash flows into consideration  Cash flow today doesn’t have the same value as it has in the future  This reason for this (timing of cash flow) is the assumption that money can earn interest, and consequently any amount of money is worth more the sooner it is received  Cash flows are not considered in the same manner by dynamic methods as they are by static methods, even if the cash flows equate the same amount  Taking the time value of money into account, dynamic methods are based on multiple period models, which make cash flow at different point in time comparable by calculating compound interest or discounted interest  Dynamic method focus on the cash flow of an investment  Every investment is characterized by incoming and outgoing payments as anticipated over time  Mathematical transformations need to be performed since the payments take place at different points in time and are also dependent upon the time of payment. 5.2 Static capital budgeting methods Cost comparison method and profit comparison method  Two basic capital budgeting methods are the cost comparison method and the profit comparison method  Cost comparison method: compares the cost of investment- option with the lowest cost is selected.  Decision of the investment project can be based on per period basis (C ) or per unit (c ). Comparison per unit is when investment projects produce different quantities so as to avoid distortions of the calculation. Comparing two investment projects A and B, project A is better investment than project B if the costs of project A are lower o For a comparison of costs per period: CA < CB o For a comparison of cost per unit: cA < cB Profit comparison method: compares profits of investments – can only be applied if the revenues from the investment projects under consideration are identical, otherwise results are distorted P = R- C A single investment project is accepted if its average expected profit is positive or, in other words, greater than zero, when P >0 In the context of mutually exclusive investment projects, the investment project A is better investment than project B if its profit is larger, that is when Pa > Pb Return on investment (ROI) Calculated by dividing the earnings before interest by the average investment cost (Earnings/Cost) When comparing multiple alternatives, the best option is the one with the highest profitability and exceeds the expected minimum profitability In comparison to other static methods, the profitability comparison calculation is an improvement because:  It can be used despite different capital requirements between the alternatives  It enables the comparison of different types of investment objects  It allows for the comparison of alternative capital investment It has the following shortcomings:  The calculated profitability is based on short-term assumption- over time changes can take place that could distort the calculated results  The profitability calculation requires a constant capital investment  By taking into consideration the average annual earnings, the first-year earnings are put on a level with the earnings in the following year  It’s required that the earnings are attributable to individual investment projects  It assumes that the financial means can be invested into the minimum return Example Mr. Xiao uses the ROI method to answer his investment questions. The following depicts the alternatives A (undeveloped property) and B (complete logistics warehouses):. Static Payback Period o Static payback period or amortization calculation: estimates how long it takes until the costs of an investment (Io) have fully flowed back or returned via revenues (CF) o Plays a special role compared to all other static methods because it takes multiple periods into consideration and doesn’t calculate based on costs but on revenues and expenditures The project anticipated by the investor to have the shortest payback period is the preferable choice The amortization calculation  can be used for the risk evaluation of investments since the longer the planning period is, the higher the insecurity of the assumptions and forecasts  Risk from insecurity can be minimized via short payback period  The amortization calculation shouldn’t be used as the decision making tool – best to use it as a supplement to other methods Disadvantages of amortization calculation  No consideration is given to the time period and the development of earnings beyond the time of amortization  Should only be used as a calculation of the average if the returns remain constant during the time of use  The lack of consideration of diverse periods of use of individual investment projects results in limited ability to compare projects with one another  The attributability of proceeds can also become problematic, in particular, if a product is created using multiple machines There are several major disadvantages of static capital budgeting method:  Static methods ignore the decline or increase in value that occurs over time  Static methods fail to consider uncertainties  They often rely on unrealistic assumptions 5.3 Dynamic capital budgeting methods Net Present Value (NPV) The net present value (NPV) method is considered to be the classic dynamic method for capital budgeting and is built upon the following premises: 1. a perfect capital market exists (debit and credit interest are identical and capital investment and raising capital are possible at any time and in any amount) 2. the investor act rationally and is pursuing a return on the invested capital 3. all necessary data is known at any given point If the earnings value exceed the investment payment - if the NPV is positive, the investment project will assist in increasing the value of the company If the earnings value is lower than the investment value, pursuing the investment will lower the value of the company 1. invest if NPV of the project is above or equal to zero 2. if there are multiple investment projects, the project with the highest NPV should be chosen Example Mr. Xiao would now like to determine the net present value for the investment option B. The following payment surpluses exist for the first four periods: What does this result mean for Mr. Xiao? The net present value of €1.47 million allows for three conclusions  The net present value indicates the net surplus of an investment expressed as today’s value of all future cash flows.  The interest of the capital employed is higher than the discount rate.  The present value is the immediately realized growth of the investor’s assets due to the investment project. The third statement can be interpreted to mean that Mr. Xiao would take on a credit amounting to €10.47 million at an interest rate of 10 %. He requires €9 million for the investments in his property and the remaining €1.47 million are a surplus for him, which he can use for other purposes. Internal Rate of Return (IRR)  Internal rate of return: the return or the effective interest rate of an investment – it means the speed that money comes back to you after you invest it.  If the IRR is used as a discount rate, this results in a net present value of zero  One should select the alternative with the highest internal rate of return  IRR can be used to evaluate projects with diverse revenues and expenditures   As stated, this is only an approximation. When selecting a smaller interval, the error can be further reduced. For the above example, an internal rate of return of roughly 16.49 % would result from estimated interest rates of 15 % and 18 %.  Mr. Xiao wonders what exactly this means.  It means that the average capital employed has an internal rate of return of 16.49 %. Put another way, if Mr. Xiao had financed a loan of €9 million at 16.49 %, his cash flow surplus at the time of the investment t0= 0, would be 0.  Mr. Xiao wonders if the investment is advantageous.  The investment is advantageous if the internal rate of return is higher than the capital market interest rate.  In our example, the capital market interest rate amounted to 10 %, while the internal rate of return amounts to 16.49 %. Therefore, in this case, the investment should be made. IRR has the following disadvantages:  The attributability of the series of cash flows  The uncertainty of the series of cash flows that must be foreseen according to the amount and the time of their occurrence  The comparison of investments, with different acquisition values or different periods of use  The unambiguity of the results Formula IRR as per Mam = ra + NPVa x (rb – ra) / NPVra – NPvrb Ra = lower rate Rb = higher rate Annuity method: average period surplus of an investment Chapter 6 Business Valuation 6.1 Purpose and methods for business valuation  Purpose: to determine the economic value of a company at a specific point in time  Business value: subjectively measured future utility of an enterprise  Valuation can be performed for many reasons such as preparation for a round of equity financing or for the purpose of value based management  Strategic rationale: an assessment of alternative strategic concepts under consideration, or the assessment of synergies when considering the purchase of a subsidiary or setting up a joint venture  Specific rationale: can be broken down into decision-dependent occasions that can change ownership structure, and decision-independent occasions that leave the existing ownership structure intact “Functional valuation” categorizes the various purposes of company valuation into primary and secondary functions Advisory: business valuation supplies key value for use in negotiations- providing upper and lower value limits for potential acquisition or sale Argumentation: values are openly introduced into negotiations and are designed to substantiate the perspective of the negotiated party Brokerage: objective is to settle on a fair price also referred to “arbitral value” in conflict situations.   Total valuation methods are dominant in modern-day valuation practice  While the individual valuation method value the company according to the sum of the individually valued assets minus relevant debts, total valuation methods value the company as “greater than the sum of its parts”  Discounted cash flow method: determine the value of the company on the basis of expected future performance  Another option is comparison-based valuation 6.2 Individual valuation methods Net Asset Value Method – the idea behind determining is that a company must be worth as much as the amount that a potential buyer, through its purchase, would save expenditures to build an exact replica of that company from scratch Definition: sum total of all value of a company individual assets and debts 6.3 Total valuations methods Comparative-value method (multiples method) – used to estimate the market price that the valuation object can potentially fetch if sold in a particular market Company’s value is calculated based on the stock market price or the transaction volume of a comparable company Discounted cash flow methods  Discounted cash flow (DCF) methods (aka future cash flow method)- future oriented method that take cash flow into account and discounts these to compute the value of company.  Definition: estimating what a company is worth today using projected cash flows- it tells you how much money you can spend now in order to get the desired return in the future  The projected cash flow reflect the company’s expected profitability  The expected cash flows are also significant indicator of a company’s self-financing and dividend-distribution capacities  Cash flow = benefit – costs Discount cash flow = cash flow x discount factors NPV= adding all the years of discounted cash flow shown below. If positive, the project is good and if negative, shouldn’t go with the project If using NPV to compare projects, the one with the highest NPV is chosen. Example years 1 2 3 4 5 Cash flow 100m 100m 100m 100m 100m Interest at 10%.9.83 75.68.62 (using formula 1/(1+r)^(year periods) DCF = CF x 90mil 83mil 75mil 68mil 62mil discount factors NPV = 90 +83+75+68+62 = 378mil Economic Value Added EVA: used to determine the annual performance of company as well as purpose for company valuation Can be calculated in two ways: “capital charge equation” as the different between operating profit and cost of capital:   Weighted average cost of capital WACC- a concept used in company valuation to compute the average cost of equity and debt  Not a method of company valuation by itself rather an input required in discounted cash flow and economic value added  NOPAT refers to net operating profit after tax, meaning adjusted profit before interest after tax Second option to calculate EVA- “value spread equation” The simplification of the above formula results in the following equation: If the rate of return on the invested capital or ROCE exceeds the cost of capital, then additional enterprise value has been added during the period analyzed. If ROCE is below cost of capital, then company value has been wiped out EVA= NOPAT – (WACC X INVESTED CAPITAL) Dividend Discount Model (DDM)  Another method of company valuation  This model identifies the dividends to be paid to stockholders in the future  The discount rate applied is the rate of interest that reflects the rate of return that the investor requires  This is used more commonly for the valuation of shares of stock than for valuation of companies 6.4 Weighted Average Cost of Capital (WACC) WACC is the average rate that a company pays for capital It’s not a method of company valuation but it’s used in the future cash flow methods such as discounted cash flow and EVA Determinants internal to the company  The higher the risk, the higher the risk premium to be paid  High degree of indebtedness on the part of the company also means a risky commitment on part of the provider of capital  Capital structure is also critical to determine the total cost of capital and to weigh equity and debt Determinants external to the company  Situation of money and capital markets is crucial to the amount of the risk premium and the amount of the risk-free rate of interest factored into the valuation. Corporate tax rate remains decisive for WACC. Individual components of WACC  Market values of equity and debt must be determined  Cost of capital would also have to be adapted to the current capital structure of the company  In practice, usually a single WACC is determined for future valuation period  Circularity problem of equity: states that the cost of capital can’t be weighted until the value of equity is known, however, this value can only be determined using the calculated cost of capital o Cost of capital, total company value, and capital structure are dependent on each other  without a target capital structure, a valuation of the company would be possible only by means of iterative approach o the capital structure of comparable companies can also be used to calculate target capital structure (benchmarking)  Market value are more difficult to determine for companies that are not listed o in this case market value must be determined on the basis of outflows of payments to capital providers o calculations of debt are based on the contractual arrangements on interest rates and methods of+ payment o Borrowing cost can be calculated either on a purely capital market-oriented basis or as an average of existing debt obligations o Capital market-oriented means that costs are geared towards the return requirements of outside creditors in the capital market o The lower a company’s credit rating, the higher the interest that creditor will require Summary There is no such thing as one correct company value. Instead, subjective factors are used to determine the value that a company has for an investor. A company valuation can be performed by means of different methods and geared to different occasions. Company valuation can be undertaken in the pursuit of a number of different goals. o The net asset value method is an individual valuation method that is static and presents only the value of the individual assets less debt. o The comparative-value method is a total valuation method and is also referred to as the multiples method. It is based on certain values for a similar company. o Discounted cash flow (DCF) methods are also total valuation methods based not on past but future- oriented payment flows. DCF methods take into account the market value of equity and debt in expected future cash flows. o The economic value added (EVA) method explicitly considers the cost of capital, which is determined using the weighted average cost of capital (WACC) approach. o WACC takes account of tax savings due to debt that lead to increased present values of future cash flows. Due to the circularity problem, a given capital structure is a prerequisite for the application of the WACC method. Chapter 7 Corporate control and M&A 7.1 The “Market for Corporate Control”: Mergers and Acquisitions  Mergers and acquisitions (M&A): refers to different types of corporate takeovers, mergers, cooperation arrangements, and agreements.  Also referred to “market for corporate control”  Market for corporate control: a collection of takeover targets: those underdeveloped or undervalued companies that are attractive target for companies Mergers and Acquisitions  Merger: involves the combination of business – two existing companies into one economically and legally.  After mergers, only a single legal entity exists  If just one of the companies, typically the one acquired, loses its legal independence, it’s referred to merger through absorption o In this case the assets of the acquired company transfer over to the receiving company  Mergers through amalgamation is the fact that both companies transfer their assets to a newly created company Acquisition  Acquisition: purchase of company ownership  Majority of share capital or a major portion of the assets of the acquisition target is transferred over to the acquirer   As a result, the acquirer has the option of exercising control over the acquisition target without the acquisition target losing its independence as a legal entity  Unlike merger there is no consolidation to become one company Acquisition in the form of an asset deal or share deal:  Asset deal: the target enterprise sells its individual assets to the acquirer by way of singular succession  Maximizes cash flow as the purchase price can be distributed across individual assets & liabilities.  Disadvantage: regarding tax (eg. Transfer taxes on sales of land) and often time consuming since third-party approvals are required for transfers of leaseholds, rentals, lease agreements, and licenses – making contractual design extremely complex  With these complexities, takeover is usually extended in form of a share deal Share deal: involves the acquisition of shares - purchaser acquires the company by buying all or almost all of the shares Process of share deal:  The acquiring company conveys a tender offer (public offer to the shareholders of the target company), the object of which is the purchase of the target company’s shares outside the stock exchange via an agreement under civil law  If offer is valid for a short time, this will put pressure on shareholder to accelerate their decision-making  Tender offer usually exceeds the current market value of company  Tender offer includes a condition that a sufficient number of shareholders must accept the offer in order to give the buyer the necessary controlling majority interest  Shareholder who don’t want to approve the offer can by excluded by means of a “cash-out merger” or “squeeze out” : In this scenario, Acquirers can use legal provision to arrange a settlement that is lower than the offered takeover price  In exchange of their shares of stock, the excluded shareholders receive cash, shares of stock in other companies, or newly issued bonds Cooperation  Cooperation: refer to join ventures – strategic alliances and supply agreements  Joint venture: where two or more companies agree to come together to use their resources for purpose of accomplishing specific tasks  Joint venture can be divided into “contractual joint ventures” and “equity joint ventures” o Equity joint venture: bilateral cooperation that comes about through the establishment of a new, independent enterprise by multiple parent companies. This new company is independent of its parent companies o Contractual joint ventures: no merger takes place- the agreement between the companies involves legal obligations Strategic alliances: it’s an alternative to traditional acquisitions or mergers – this model is based on capital-related or contractual cooperation elements  In the formation of network, one company will generally dominate and control this network  Objective of strategic alliances:  Improved access to difficult markets  Improved capabilities through innovation  Financial benefits through improve economies of scale or reduced costs   Improved distribution capacities Supply agreements: a contract under the law of obligations between two companies acting as network partners is formed  In transactions with third parties, a network partner does business as a general contractor and sole contractual partner of the customer or of the buyer  General contractor has performance obligation, fully liable to the buyer, and has the sole claim for remuneration  Internally within the network partnership: the general contractor enter into terms of trade with other network partners giving rise to contractual networks.  Example of supply agreements: automobile, sporting goods, retail sector 7.2 Motivations for M&A Transactions  Motivation for M&A from a buyer’s standpoint, related to enhancing market value or not related to market value Motivations for M&A – enhancing market value  According to portfolio theory, an undervalued company will be taken over in the interest of diversification  Majority of cases, management of Target Company will remain in place even after the takeover  Takeover of Target Company may be undertaken with the expectation of achieving increased value through reorganization  First step in takeover with this motivation is usually replacing the management (presumably inefficient)  Business processes are optimized, and an effort is made to achieve operational improvements through process optimization and new technologies  Under spin-off, business divisions that are often not part of a company core business are split off and sold  Added value can be achieved through liquidation of hidden reserves  Reorganization measure are often used to dissolve industrial companies where synergy effect hasn’t been fulfilled  Reason for achieving synergies (synergy hypothesis) is improving competitiveness at the divisional level o First: Competitive advantages can be brought about via transfer of expertise (transfer of knowledge and experience) o Second: competitive advantages can be achieved through centralization of tasks (tangible integration)  Exploiting the opportunity of arbitrage can also be a reason for mergers and acquisitions o Example: Buyer can profit greatly if company value is underestimated – for this to happen market needs to be imperfect and better information needs to be available to the buyer o Arbitrage profit results from the different between purchase price and the higher selling price Motivations not related to enhancing market value  Takeovers that occur independently of motivations to increase market value are usually initiated by management  To management, an increase of company size means improved company image, increased public prestige, and political power  Takeovers motivated by personal interest can be problematic – especially where company size determines management remuneration and additional benefits  This leads to investments that increase company size but have lower net returns compared to alternatives  High level of unrestricted cash flow gives management the autonomy that allows them to neglect effective cost control and unnecessarily increase bureaucracy which will reduce enterprise value From seller’s point of view, the main motivations for a merger and acquisition include:  Solve financial problems   Gain new opportunities for expansion (through using resources available via strong partner)  Procuring investment funds  Converting assets tied up in the company into available cash  Launching corporate reorganization  Resolving disagreement among shareholders  Solving problem of succession 7.3 Phases of M&A Transactions The “textbook” merger or acquisition generally breaks down into 3 phases: pre-merger phase, transaction phase, and integration phase Pre-merger phase  Involves strategic analysis and conceptual design.  This Planning phase involves preliminary considerations regarding the decision-making process for the actual transaction- first thing discussed is the economic expediency  This stage is used to identify one’s own core competencies in order to then identify potential takeover targets  A checklist can be made for locating and selecting suitable candidates  Once the acquisition strategy has been determined and a candidate has been identified, then the contract takes place Transaction phase  Target company’s value is determined and a transaction agreement is drawn up – known as transaction phase  Non-disclosure agreements are signed before an extensive review is done – these agreements contain provision that doesn’t allow the use of any of the information exchanged in the transaction phase  If both parties agree, letter of intent (LOI) is signed – this document states sustained purchase intent of both parties and includes preliminary offer of purchase with non-binding price  Before contract is finalized, due diligence is performed o Due diligence: involves detailed and comprehensive analysis of the target company designed to reveal opportunities and risk associated with the company  Along with classic forms of takeovers, bidding and auction processes are also involved or acquisition through the stock exchange or via public takeover offer o Public takeover of listed companies- financial due diligence is usually conducted in an abbreviated form because the information provided to the potential buyer must be limited to publicly accessible information  Once due diligence has been conducted, purchase agreement is signed which obliges parties to engage in a business transfer on predetermined date – referred to as closing Integration Phase This phase has a strong influence on the success of the M&A transaction Critical to this phase is  Careful preparation  Coordination and control of the integration process  Existing corporate culture and internal organization  Communication and logistic within the company  Identification of key personnel  Existing management  customers  Knowledge management  Role of corporate culture is essential consideration as when companies merge together or change, potential hazards can arise  Clash of corporate culture can pose difficulties along with conflict and stress.  “Merger syndrome” – refers to the collective experience of stress, sense of crisis, trends towards centralization, rumors etc.  Post-merger- is mainly the result of uncertainties associated with anticipated changes  Mounting discontent can result in a rise of absenteeism and increased staff turnover o Which results in hidden costs that are difficult to quantify – such as severance pay, recruitment of new staff, and training expense all linked to merger syndrome  First sign of merger syndrome is increased self-interest on the part of the employees  During the M&A process, communication is usually good at the management level but not the level of employees  Withholding information from employees such as job security, income, working environment and career opportunities lead to uncertainties and tensions  Once merger is announced, usually employees in both companies begin computing the differences between the two companies and viewing the other company as the culturally inferior partner  Clash of culture: where employees defend their own point of view by keeping their existing practices, preferring not to abandon the existing culture for the new corporate culture  Important factors to address during integration phase include o Distinct and efficient management that makes quick and clear decisions o High standards of complete realization of growth and synergy potential o Creation of new shared culture  Success of integration can be determined through the comparison of targeted and actual degrees of integration or through measurements related to the effectiveness of individual measure Chapter 8 Specific forms of M&A, Private Equity, Due Diligence, and IPOs 8.1 Due Diligence  Due Diligence: the basis for company valuation – a process of scrutinizing a company (financial position and the market it’s operating in) that results in an assessment of whether a takeover should happen  Based on the process of due diligence, a purchase prices is determined and purchase agreement can be carried out  Term due diligence stems from US legislation on capital markets and investor protection  Under American liability law, a defendants due diligence is considered counter-evidence or exculpatory evidence when attempting to demonstrate that no breach in the obligatory duty of care has occurred  Due diligence review can take a variety of forms and vary considerably in scope, detail, and depth Criteria that can be considered minimum thresholds of due diligence: The collection and analysis of information and data for the process of assessing opportunities and risk A dedicated analysis of a company or project prior to planning and decision-making Purpose of Due Diligence Main goal: to create a basis for decision-making when implementing a transaction Some potential underlying reasons for failure of M&A transactions: 1. Insufficient knowledge of the planned strategy behind the transaction 2. Overestimation of synergy potential resulting in high purchase price 3. Lack of integration of the merger strategy into the parent company corporate structure  The first two risk can be minimized through systematically analyzing the object of the merger and acquisition  Information obtained must not be limited to the financial – all divisions must be factored into the review  Before contract is signed, an information asymmetry between the parties usually exists o Given such information asymmetry, performing due diligence can be viewed as a process combining knowledge transfer (signaling) on the part of the seller with knowledge acquisition on the part of the buyer (screening) Process of Due Diligence  First step is information gathering  Assessment of the target company is initially directed by the goals motivating the acquisition (example: if the purchase motivated to owning certain divisions of a target company, information about these division may be more relevant than others)  Beginning the negotiation phase by drawing up a list of information required and sending it to the company  The list shouldn’t be limited to the company’s business-related data- it should also include data about economic environment in which the company is operating in  External sources can be consulted for initial information but the detailed information and review of company can only be obtained through direct contact with company  The overall object must be divided into individual areas of review  Planning and execution of due diligence must be properly documented A due diligence review usually results in three alternatives:  Deal-breaker have been found and negotiations are discontinued  The due diligence review identified a changed purchase price or other payment related details that influence the purchase prices- usually purchase price is reduced as a result  Target Company provides additional contractual guarantees Manifestations of Due Diligence Due diligence can be divided into three categories: basic due diligence, strategic due diligence, and external due diligence The following forms of due diligence are important:  Financial due diligence is the most important- often the primary focus on the entire due diligence process  As a result of this process, the company’s value is determined and potential investors can weigh up the opportunities and risk involved  Marketing due diligence is to examine the target company range of services and sales areas in order to assess its innovativeness and potential sales risk  Human resource (HR) is important because the motivation of employees in the target company is significant factor influencing the success of such venture  Taxation due diligence is of major importance- two areas are important, one is minimizing tax obligations for both buyer and seller and second buyer needs to protect themselves against potential financial risk associated with company’s tax history  Legal due diligence- providing legal safeguards for the economic aspect of the transaction  Environment due diligence is to identify and asses environmental risk – risk such as contaminated facilities and often requires considerable financial resources to address contamination 8.2 Friendly & Hostile Takeovers, LBO’s, MBO’s and MBI’s, and IPO’s The type of the takeover will affect the number of managers that remain in their positions following the takeover of their company Friendly takeover  Management of Target Company agrees to takeover  Takeover price negotiations in a friendly takeover must result in an offer that is acceptable to both parties  If agreement is reached, management of Target Company will recommend to its stockholder that they accept the offer  Management of Target Company is partially or fully retained after takeover and believe that takeover will make positive contribution to the development of the company Hostile takeover  A takeover is hostile if it was announced without prior discussion with the management of target company or has been rejected by the mgmt of target company  Hostile takeover is only related to listed companies because manager of private companies usually own a large portions of stock in their company, which gives them majority vote regarding any purchase of stock or assets  Potential parent company submits a direct offer to the shareholders of target company to purchase their shares (tender offer)  There is a risk that third parties will try to acquire a controlling stake through a far higher tender offer than the market value  Involves lengthy acquisition process that often proves expensive for both parties Company takeover can be broken down into management buyout (MBO), management buy-ins (MBI), and leveraged buyouts (LBO) Management buyout: takeover of a company or parts of a company by the overall management of that company.  This form of takeover is only an option for companies that can leverage existing management and funding structures- managers who were previously company employees now become owners of the company  Often rely on venture capitalist for financing Management buy-in: takeover of company or parts of it where the majority of management comes from outside of that company  Only marginal amounts of the buyer’s own capital are used for financing the transaction Leveraged buyouts (LBO): company takeover is financed using significant amounts of borrowed money- usually over 50% of the purchase price using borrowed capital  Objective is to repay the large amount of debt via company profits and cash flow of the acquired company  MBO’s and MBI’s carried out via leveraging are thus known as LMBO’s and LMBI’s Initial Public Offering (IPO) Initial public offering (IPO): when a company is first listed on the stock exchange Reasons for IPO are:  Spin-off: selling off part of an existing company and continuing as a separate business  Privatization: a government-run company is listed on the stock market/goes public  Capital injection: a private corporation wants to expand and requires money to do so- this is very typical for start-up companies like Facebook and good in their early stages Companies listed on stock exchange enjoy many benefits such as:  Improved access to liquidity  Better financing opportunities for the future  Better options regarding company acquisitions   The opportunity to set up an employee share ownership scheme  Enhance company image and reputation  A more advantageous position when dealing with customer and suppliers Drawback of going IPO  Loss of control over the company  Requirement to share future company profits  Loss of privacy for the company as it has become open to the scrutiny of its shareholders and the public Launching an IPO typically involves five phases:  Planning and preparations: requirements are specified, required formalities are carried out and business plan is drawn up  Structuring: involves hiring consultants to perform the due diligence process and company valuation as well as putting corporate governance principles and practices into place (corporate governance: refers to the rules, relationships, policies, and systems that enables a company to be directed and managed)  Marketing: dedicated to activities that aim to promote that IPO  Pricing, allocation, and stabilization: offering price of the stocks is set, stocks are sold usually to institutional and private investors  Life as a public company: required to comply with a host of requirements once listed, such as publishing ad-hoc notifications and reports and complying with legal regulations. o Nurturing relationship between the company and its stockholders 8.3 Private Equity and Venture Capital Companies  Private equity: refers to funds injected directly into private companies by investors  Used for all company financing that not traded via public exchange  A common term for private equity is “venture capital”  Private equity can come from institutional investors, sovereign wealth funds, or high net-worth individuals (angel investors)  This is the type of equity that is frequently used in the context of buyouts or start-up in their early stages The participants involved in private-equity financing can be divided into three groups  The investors who are provides of capital  The portfolio company that received the financing capital  The private equity firms (investors in the broad sense) that service the financial investors by acting as intermediaries b/w them and the companies Added to these groups are two additional groups  Advisor and consultants who support the three main groups by supplying information and brokerage services  The funds of funds (FoF) that occupy position b/w investors and private equity companies FoF: is an umbrella investment strategy utilized by investors who invest only indirectly in diff private equity funds   As a rule, capital provided by investors is not invested directly by the borrower but is managed in fund by financial intermediaries  These intermediary companies assist in harmonizing the individual interest of the capital users and portfolio companies  Suppliers of the capital are usually interested in rates of return, security and liquidity  Private-equity firms can manage several funds, and each of these funds typically has share in 20-30 companies  Private-equity firms also offer the company other support and advisory services  To cover costs, the investors companies generally charge an annual management fee of 1.5% to 2.0% of the capital provided  Private-equity firms receives a performance fee to 20% of the gains from any sale of the company Reasons for wanting to sell to a financial investor through buyout or buy-in financing are often strategic The main motivation is to achieve maximum gains from the sale; a buyout via a financial investor can often be a change for a “fast exit” Sources of value generation can split into two groups: the value capture group and the value creation group   Value creation: can be directly linked to a fundamental change in the financial performance of a company (eg. Changed business strategy, better operational efficiency or other measures)  Value capturing reflects the fact that the value of a company can increase without any changes in the performance drivers- instead value is generated by other factors such as right timing or outperforming industry sector The success of a buyout is very dependent on the respective market conditions, however private equity, which characterized by a significant lack of transparency and high level of information asymmetry, offer ample opportunities for arbitrage Chapter 9 Corporate Governance 9.1 Internal and External Corporate governance  Corporate governance deals with the relationship between shareholders as the owners of the corporation and the management as the holders of executive authority in the company  Conflict of interest that arise from the sepearation of ownership, management, and supervision can be minimized with effective corporate governance- meaning agency costs can be lowered  Definition: corporate governance refers to a framework of rules and practices by which a company is direct and controlled while it balances the interests of multiple stakholders of the company  Goal: to create optimal institutional structure  good corporate governance results from an optimal perforamnce of the legally mandated functions of the board of directors Corporate governance – international  There is no single internationally accepted set of regulations  There are country specific principles for running a responsible business  Corporate governance systems can include legal requirements, such as those mandated by a specific legal system Corporate governance can be divided into external and internal systems: External corporate governance systems: are achieved through capital market mechanisms  It can be assumed that managers will make their decisions according to the rules and expectation of the capital markets  Capital markets have a disciplinary effect on management and control the behavior of company executives. Internal corporate governance systems: are implemented inside the company itself. Internal corporate governance is achieved through legislation and voluntary organizational measures.  Key factor: applicable legislations in the respective country  The supervision of the executive of the company can either be carried out by an independent administrative body (supervisory board) or by a supervisory committee from within the organization such as board of directors (BOD)  In the latte