Introduction To Corporate & Entrepreneurial Finance PDF 2024

Introduction to Corporate & Entrepreneurial Finance (MSc Banking & Finance PiE) Building Competence. Crossing Borders. Prof. Dr. Mehdi Mostowfi [email protected] Introducing myself….. Prof. Dr. Mehdi Mostowfi Deputy Director of the Institute for Financial Management Head of...

Introduction to Corporate & Entrepreneurial Finance (MSc Banking & Finance PiE) Building Competence. Crossing Borders. Prof. Dr. Mehdi Mostowfi [email protected] Introducing myself….. Prof. Dr. Mehdi Mostowfi Deputy Director of the Institute for Financial Management Head of Center for Corporate Finance & Capital Markets, SML/ZHAW Main Academic Positions − Professor of Finance at ZHAW (since 2012) − Professor of Finance and Capital Markets, Wiesbaden Business School, RheinMain University (2005 - 2012) Main Professional Positions − Chief Investment Officer, Sigla Zürichfinanz AG (since 2006) − Senior Investment Manager, Equity Department, DEG – German Investment and Development Company (2003 - 2005) − Senior Associate in Mergers & Acquisitions Team, Morgan Stanley, Investment Banking Division (2000 - 2003) − Associate in Corporate Finance & Strategy Practice, McKinsey & Co. (1998 - 2000) 2 Agenda 1 Course Outline and Assessment 2 Corporate Finance, Entrepreneurial and Family Business Finance 3 Traditional Capital Structure Theory 4 Payout/Dividend Policy 5 Exercises (Homework) 3 Main Questions Addressed in this Course How to determine the optimal capital structure? Has family ownership an impact on financing decisions? How do (corporates and) entrepreneurial firms raise capital? Why and how do firms go public? Corporate & Entrepreneurial Finance How do M&A transactions work and how to value firms? How to structure LBOs and use LBO analysis as a valuation method. 4 Assessment Group presentation and final exam Assessment: − Group presentation on November 28th (25% of the course grade) − Final exam at the end of the semester (75% of the course grade) Group presentation: Each group prepares (and gives) a presentation (15 min. + 5 min. Q&A) summarizing the methodology, data and empirical results (including a critical assessment of methodology/data) of a certain paper (area: Family Business Capital Structure, for details please be referred to the Group presentation Assignment file) concluding with an assessment to what extent the empirical findings are in support or in contradiction of the “traditional” capital structure theories. 5 Content and Learning Objectives Session 1&2 Content Goals Course Outline 1. Knowing the objectives/object of Corporate Finance Course Assessment Definition and 2. Knowing the main characteristics Characteristics of of entrepreneurial and family Entrepreneurial and Family businesses and the foci of the Businesses corresponding finance research Traditional Capital areas Structure Theory and 3. Refreshing your knowledge in Dividend/Payout Policy traditional capital structure theory Relevance and Limitations and dividend policy of Capital Structure Theory for Family Businesses 4. Assess relevance of traditional capital structure theories for family businesses 6 Recommended Literature on Capital Structure Theory − Brealey, Myers & Allen: Principles of Corporate Finance 14th edition, chapter 17 and 18 − Graham & Leary: A Review of Empirical Capital Structure Research and Directions for the Future, , Vol. 3 (2011) 309-345. Annual Review of Financial Economics, 3 pp. 309-345. 7 Agenda 1 Course Outline and Assessment 2 Corporate Finance, Entrepreneurial and Family Business Finance 3 Traditional Capital Structure Theory 4 Payout/Dividend Policy 8  The Objective of Corporate Finance and Key Decision Areas Corporate Finance is centered around the financial decision making of companies Source: Aswath Damodaran, Corporate Finance Theory and Practice 9 The Object of Corporate Finance Corporation Loans Interest/Principal Repaymnet Banks Fees CEO & BoD Advice Trading/ Advice Internal Reporting Financing Operating Business External Reporting Funding Equity/Debt Financing Financial Financial Markets Returns Manager Returns Other Stake- holders 10 Entrepreneurial and Family Business Finance Two important research sub-areas of Corporate Finance Entrepreneurial Finance Family Business Finance Application of financial tools/methods Deals with the impact of family to funding, budgeting and valuation of ownership on financing decisions of entrepreneurial firms (new ventures family firms. and founder owned high growth firms). Research focus mainly on capital Focus of literature mainly on how structure of family firms and reasons entrepreneurial firms raise capital behind this …Entrepreneurial and Family Business Finance are two closely related research and application sub- ares of Corporate Finance …while EF research mainly focuses on funding aspects of new ventures (mainly on how companies raise equity/equity-like capital), FBF is concerned with capital structure decisions of (more established) family firms 11 Entrepreneurship Schumpeter’s definition Schumpeter describes five basic ways that entrepreneurs find opportunities to create new businesses: Using a new technology to produce a new product Using an existing technology to produce a new product Using an existing technology to produce an old product in a new way Finding a new supply of resources (that might enable the entrepreneur to produce a product more economically) Developing a new market for an existing product 12 Entrepreneurship Howard Stevenson’s Definition According to Howard Stevenson (HBS) Entrepreneurship can be defined as “the pursuit of opportunity beyond resources controlled”. Aspects Beyond Resources Pursuit Opportunity Controlled Singular, Offering that is This aspect points relentless focus novel/innovative to resource constraints The combination of these characteristics implies for different kinds of risks: demand risks, technological risks, execution risks and financing risks. 13 Entrepreneurship Types of Entrepreneurial Ventures Salary Substitute Firms that basically provide their owner(s) with the same level of Firms income to what they could earn in a conventional job Firms that provide the owners with the opportunity to pursue a certain Lifestyle Firms lifestyle and make a living at it Firms that bring new products and services to the market by creating Entrepreneurial and seizing opportunities regardless of the resources they currently Firms control. Barringer & Ireland (2015) 14 It is not easy to define the term Family Business… “Defining the family firm is the first and most obvious challenge facing family business researchers” (Handler, 1989). “To date, there is no widely accepted definition of a family business” (Littunen & Hyrsky, 2000).  F-PEC Scale to assess the “familyness” of a potential family business (Astrachan, Klein & Smyrnios, 2002). 15 F-PEC differentiates three Subscales F-PEC Subscales Power Experience Culture Subscale most relevant to assess «familyness» in FB Finance context 16 Dimensions of the F-PEC Power Subscale Most relevant subscale for research in Family Business Finance F-PEC Power Subscales Ownership Governance Management Board Members Management family and family and Holding Nonfamily nonfamily (external) (external) Source: Astrachan, Klein & Smyrnios, 2002: 47 17 Characteristics of Family Businesses in the Context of Financing Decisions Ideas/Hypotheses: − Strong control preference of the family members (implies a preference for debt financing over external equity financing). − Family business owners have substantial parts of their wealth invested in the firm and they are for this reason usually underdiversified. This implies that they are expected to be more risk averse than other kinds of investors (implies a preference for equity financing over debt financing). − Socio-Economic aspects may also play a role 18 Types of Family Businesses Private vs. listed Family Business Private Family Listed Family Business Business With minority Without minority Family members in No family members shareholders shareholders executive board executive board majority of family firms 19 Some important and well known Family Firms Management Role of Family Owner Family Industry Listed members Wal-Mart Stores Walton Discount retail chain yes executive BMW Quandt/Klatten Auto manufacturer yes non-executive Samsung Lee Conglomerate yes non-executive Robert Bosch GmbH Bosch Auto parts no non-executive Tengelmann Group Haub Retailing no executive Roche Group Hoffmann and Oeri Pharmaceuticals yes non-executive Bertelsmann Mohn Publishing, media no non-executive L’Oréal Bettencourt Cosmetics yes non-executive Groupe Danone Riboud Food products yes executive IKEA Kamprad Furniture no non-executive H&M AB Persson Clothing retailer yes executive 20 Agenda 1 Course Outline and Assessment 2 Corporate Finance, Entrepreneurial and Family Business Finance 3 Traditional Capital Structure Theory 4 Payout/Dividend Policy 5 Exercises (Homework) 21 Traditional Capital Structure Theory Overview Traditional Pecking Order Modigliani/Miller Theory - Modigliani/Miller (1958) - Myers (1984) - MM with tax (1963) - Myers and Majluf (1984) - MM with tax (1963) and - Principle/Agency Model inclusion of bankruptcy costs (trade off-Theory: Leland 1994) 22 Basic Model of Modigliani/Miller (MM): Assumptions Capital structure in a world without taxes and bankruptcy costs Main assumptions of the basic MM model − Capital markets are perfect and have the following characteristics: Individuals can borrow and lend at the risk-free rate. No transaction costs, (in the basic model) no taxes and no bankruptcy costs. − Firms can be categorized into classes in which all have the same risk (operating risk). − Firms issue only two types of capital: debt (in the basic model assumed to be risk- free) and (risky) equity. − All cash flow streams are perpetuities (i.e. no growth). − Corporate insiders (management) and outsiders (investors) have the same information (i.e. no hidden action/information problems and no signaling opportunities). 23 MM Proposition I No taxes and no bankruptcy costs MM Proposition I: The irrelevance of the capital structure − The market value (of total assets) A of a company does not depend on its capital structure and can be calculated (assuming perpetuities) by discounting the earnings before interest with the weighted average cost of capital ra, which is affected by the risk class of the company (with respect to operating risk) but not by the capital structure: 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐴𝐴 = 𝐸𝐸 + 𝐷𝐷 = 𝑟𝑟𝑎𝑎 − The average cost of capital ra is defined as: 𝐸𝐸 𝐷𝐷 WACC: 𝑟𝑟𝑎𝑎 = ∗ 𝑟𝑟𝑒𝑒 + ∗ 𝑟𝑟𝑑𝑑 𝐸𝐸+𝐷𝐷 𝐸𝐸+𝐷𝐷 re = cost of equity rd = cost of debt (assumed as risk free) E = market value of equity D = market value of debt 24 Proof of MM Theorem I Introduction We consider two otherwise identical companies CU and CL, of which CU is unlevered and CL is partly debt financed. For the unlevered company we assume: AU = EU = 1.0 Mio CHF (D = 0) For the levered company we assume: D = 500’000 CHF: Now we would like to know: AL = ? EL = ? AL = 1.0 Mio. CHF EL = 1.0 Mio. CHF – 500’000 CHF= 500’000 CHF 25 Proof of MM Theorem I Alternative 1  An investor buys 10% of the shares of the levered firm: Transaction Payment in t = 0 Payments in t = 1,…..,∞ Buy 0.1*CL -0.1 (AL – 500’000) 0.1 (EBIT – i*500’000) Please note that EBITU = EBITL = EBIT, because both firms have the same operating activities and are in the same risk class. Since the MM model assumes perpetuities, the firm will earn (and distribute) the same profit each year to infinity. 26 Proof of MM Theorem I Alternative 2 (and Comparison with Alternative 1)  An investor buys 10% of the shares of the unlevered firm. To (partly) finance the purchase price, the investor takes on a loan of 0.1*500’000 with interest (p.a.) i. Transaction Payment in t = 0 Payments in t = 1,…..,∞ Buy 0.1*CU -0.1*AU 0.1*EBIT Loan 0.1*500’000 -0.1*i*500’000 Sum -0.1 (AU – 500’000) 0.1 (EBIT – i*500’000) Both alternatives induce the same return in t = 1,…..,∞. This implies that both alternatives must have the same price (in t = 0) based on the non-arbitrage argument: -0.1 (AL - 500’000) = -0.1 (AU - 500’000) and therefore: AU = AL (q.e.d.) 27 MM Theorem II No taxes and no bankruptcy costs MM Proposition II: Leverage-effect Cost of D re capital 𝑟𝑟𝑒𝑒 = ra + ra − rd ∗ E ra rd Gearing (D/E) 28 Leverage Effect Illustrative Example Starting point: two companies with the same operating activities/risks Unlevered company CU Levered company CL A 1.000.000 1.000.000 D 0 500.000 E 1.000.000 500.000 rd 10% Conditional return on equity Company CU Company CL Scenario I II III I II III EBIT 50.000 150.000 250.000 50.000 150.000 250.000 ROA Interest (rd*D) EBIT- rd*D ROE 29 Graphical Illustration of the Leverage Effect ROE as a function of EBIT 45% ROE CL 40% 35% 30% 25% ROE CU 20% Critical profit 15% 10% 5% 50 100 150 200 250 - 5% -10% EBIT in thousands 30 What about the Equity Risk? The total risk of a firm (asset-risk) can be viewed as a portfolio of equity and debt risk (the same is true for Beta or standard deviation as specific risk measures): 𝐸𝐸 𝐷𝐷 𝐸𝐸 𝐷𝐷 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑎𝑎 = × 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑒𝑒 + × 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑑𝑑 𝛽𝛽𝑎𝑎 = × 𝛽𝛽𝑒𝑒 + × 𝛽𝛽𝑑𝑑 𝐷𝐷 + 𝐸𝐸 𝐷𝐷 + 𝐸𝐸 𝐷𝐷 + 𝐸𝐸 𝐷𝐷 + 𝐸𝐸 If we solve the equations for the equity risk we get the following equations: 𝐷𝐷 𝐷𝐷 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑒𝑒 = 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑎𝑎 + × (𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑎𝑎 − 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑑𝑑 ) 𝛽𝛽𝑒𝑒 = 𝛽𝛽𝑎𝑎 + × (𝛽𝛽𝑎𝑎 − 𝛽𝛽𝑑𝑑 ) 𝐸𝐸 𝐸𝐸 If we further assume risk-free debt (also the practitioner’s view) we get the following equations: 𝐷𝐷 𝐷𝐷 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑒𝑒 = 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑎𝑎 × (1 + ) 𝛽𝛽𝑒𝑒 = 𝛽𝛽𝑎𝑎 × (1 + ) 𝐸𝐸 𝐸𝐸 We have to be well aware that the risk origins in the firm’ investment (not observable) whereas only the equity risk is observable. Therefore we need a formula to derive the asset risk based on the observed equity risk. Only asset risk can be compared between different firms: 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑒𝑒 𝛽𝛽𝑒𝑒 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑎𝑎 = 𝛽𝛽𝑎𝑎 = 𝐷𝐷 𝐷𝐷 (1 + ) (1 + ) 𝐸𝐸 𝐸𝐸 31 Company Cost of Capital (without Tax): Conclusion Generally the cost of debt is lower than the cost of equity. Can‘t we substitute the cheaper debt for the more expensive equity? Question Put differently: Is it possible to lower the firm’s WACC and, hence, increase firm value by increasing leverage? E D WACC The firm’s WACC (without taxes) is: = re + rd E+D E+D Leverage and According to MM1, WACC is independent of leverage Company Cost Increasing D/(E+D) increases the weight of “cheaper” debt but it also of Capital increases the opportunity cost of equity re. As a result, the second effect exactly offsets the first with the overall effect being that the WACC remains unchanged. 32 MM Model including tax Introducing a simple corporate tax rate MM model including tax − Given the case of a simple corporate tax rate 𝑡𝑡𝑐𝑐 the market value of the total assets of a firm now depends on its capital structure, since interest on debt is tax deductible. The market value of the assets therefore is: 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸(1 − 𝑡𝑡𝑐𝑐 ) 𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 𝐴𝐴 = 𝐸𝐸 + 𝐷𝐷 = = 𝑟𝑟𝑎𝑎 𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 − The average cost of capital ra is know defined as: 𝐸𝐸 𝐷𝐷 𝑟𝑟𝑎𝑎 = ∗ 𝑟𝑟𝑒𝑒 + ∗ 𝑟𝑟 (1 − 𝑡𝑡𝑐𝑐 ) (standard WACC-formula) 𝐸𝐸 + 𝐷𝐷 𝐸𝐸 + 𝐷𝐷 𝑑𝑑 By rearranging the formulas we can conclude: MV levered firm = MV unlevered firm + PV tax shield (tc * D) 33 MM Model including tax Leverage effect Leverage-effect with tax Cost of 𝐷𝐷 capital 𝑟𝑟𝑒𝑒 = 𝑟𝑟𝑈𝑈 + (𝑟𝑟𝑈𝑈 −𝑟𝑟𝑑𝑑 ) 1 − 𝑡𝑡𝑐𝑐 re (model without tax) 𝐸𝐸 re (model with tax) rU ra (model without tax) ra (model with tax) rD ·(1-𝑡𝑡𝑐𝑐) Gearing (D/E) 𝑟𝑟𝑈𝑈 : Cost of Capital of the Unlevered Firm 34 What about the Equity Risk with taxes? If we assume that the amount of debt stays constant over time, the tax shield can be seen as risk- free (as seen in the valuation ot the tax shield. Therefore our risk-leverage formulas can be adjusted as follows: 𝐷𝐷 𝐷𝐷 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑒𝑒 = 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑎𝑎 + × (1 − 𝑡𝑡𝑐𝑐 ) × (𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑎𝑎 − 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑑𝑑 ) 𝛽𝛽𝑒𝑒 = 𝛽𝛽𝑎𝑎 + × (1 − 𝑡𝑡𝑐𝑐 ) × (𝛽𝛽𝑎𝑎 − 𝛽𝛽𝑑𝑑 ) 𝐸𝐸 𝐸𝐸 If we again assume risk-free debt (also the practitioner’s view) we get the following equations: 𝐷𝐷 𝐷𝐷 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑒𝑒 = 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑎𝑎 × (1 + × (1 − 𝑡𝑡𝑐𝑐 )) 𝛽𝛽𝑒𝑒 = 𝛽𝛽𝑎𝑎 × (1 + × (1 − 𝑡𝑡𝑐𝑐 )) 𝐸𝐸 𝐸𝐸 If we again solve it for the asset risk we get the following formulas 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑒𝑒 𝛽𝛽𝑒𝑒 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑎𝑎 = 𝛽𝛽𝑎𝑎 = 𝐷𝐷 𝐷𝐷 (1 + × (1 − 𝑡𝑡𝑐𝑐 )) (1 + 𝐸𝐸 × (1 − 𝑡𝑡𝑐𝑐 )) 𝐸𝐸 These formulas are used in practice: − Recalculation of cost of equity for a new capital structure − Calculation of cost of equity with the peer group approach (see firm valuation) 35 Further modifications to the basic model Introduction of risky debt and bankruptcy costs Lawyers and bankruptcy administrators incur direct costs of financial distress Direct Costs of Financial However, these direct costs are relatively low and appear to be too Distress small to justify the low debt ratios observed in practice Conclusion: Indirect costs might be more important Managerial attention changes to managing liabilities rather than assets Firm loses flexibility when monitored closely by creditors Indirect Costs Threat of fire-sales. Highly specific assets will get poor prices when a firm of Financial has to sell them on short notice (e.g. oil rig) Distress Intangible assets may be destroyed if a firm has to be winded up or sold Low debt ratios in industries with high R&D expenditures (tech firms) High ratios in industries with large expenditures on property, plant & equipment (e.g. hotels) These costs are partly (but not fully) reflected in higher cost of debt. However, higher cost of debt is not sufficient to offset the positive tax impact of leverage. 36 Model with tax and bankruptcy costs: Trade-off Theory Debt finance has both benefits (tax shield) and costs (expected costs of financial distress) Market Value Combining these benefits and costs we have: of the Levered Firm MV levered firm = MV unlevered firm + PV tax shield – PV expected costs of financial distress A low to medium level of leverage has benefits (tax shield) but virtually no costs of financial distress as likelihood of bankruptcy remains negligible Optimal As leverage increases beyond a certain point, the likelihood of financial Capital distress increases and the associated costs can no longer be ignored Structure At one point, expected costs of financial distress become so large that the firm value starts decreasing if leverage is further increased. At this point, the firm has reached its optimal capital structure 37 Further modifications to the basic model Graphic illustration Market PV of costs of Value financial distress PV of firm PV of tax shield Value if all equity financed Optimal debt Debt Ratio ratio 38 Asymmetric Information and Capital Structure Modigliani/Miller have assumed that managers, shareholders, and creditors have the same information. This assumption is not realistic in practice, because there is information asymmetry between managers and investors. Reaction of share prices on share issue The asymmetric information (capital increase) announcements problem manifests in a number of empirical phenomena, the most prominent of which are: Empirical observations on dividend policy (eg, constant dividend policy). Pecking Order Theory (highlighting the importance of signaling) 39 Signaling by Raising Equity: Example Outset Consider two listed firms A and B which currently trade at $100 each Both companies need to raise money to fund an important investment They can issue debt or equity Prospects and fair valuation of the firms Firm A’s financial manager knows that the prospects of her firm are great and that the value of the stock should actually be $120 The other financial manager knows that things do not look good for her firm. The fair price of the stock would in fact be $80 Firm A announces that it will issue debt and firm B announces that it will issue equity  What do you learn from this? 40 Signaling with Dividends A firm’s dividend policy can be used to signal information about the firm’s prospects to the market Dividend Policy Managers want the market to think highly of their firm but cannot & Signaling simply tell investors that prospects look good Paying a (high) dividend however is a credible signal as regards the future cash flow prospects Is a dividend cut a credible signal that a firm has profitable investment opportunities? In 1984, ITT announced a 64% cut in its dividend. The firm claimed Empirical that it was conserving cash to enable it to fund profitable investments. Evidence The market reacted by lowering ITT’s stock price by 32%. The value of the firm’s equity fell by roughly $1 billion. This market response is typical: stock prices often rise after dividend increases and fall when the dividend is lowered  Conclusions for an optimal dividend policy? 41 Pecking Order Theory Firms prefer retained earnings as their main source of finance and try to avoid issuing shares. The observed capital structure of each firm will depend on its history. For example, an unusually profitable firm in an industry with relatively slow growth (few investment opportunities) will end up with an unusually low debt-to-equity ratio. It has no incentive to issue debt and retire equity. An unprofitable firm in the same industry will end up with a high debt ratio. Manager of listed companies prefer − internal financing (retained earnings) to external financing − debt financing to external equity financing (share issues) − private debt (bank loans) to “public debt” (bond issues) − public debt (bond issues) to public equity (share issues)  Pecking order theory is supported by empirical observations and can be explained by information asymmetry 42 Capital Structure Decision: Where do we stand? Internal financing preferable to external financing, thus no clear target debt-equity mix Trade-off between tax benefits and costs of financial distress  Taxes  bankruptcy costs Debt financing preferred (tax deductibility of interest)  asymmetric information  Taxes  bankruptcy costs Capital structure irrelevance Pecking  asymmetric information  taxes Order  bankruptcy costs  asymmetric information Theory Trade-off  taxes  bankruptcy costs Theory  asymmetric information MM with tax MM1 & MM2 43 Relevance & Limitations of Modigliani/Miller for Family Firms MM models do not account for certain ff specific aspects (control preference, higher risk aversion and socio-economic aspects). Beyond these aspects: Relevance depends on whether a family firm is listed or not listed and on whether there is information asymmetry between managers and shareholders. For an owner managed non-listed family firm information asymmetry does not matter, for this reason, you can assume that MM/ToT is well applicable. For a listed family firm the applicability depends on the information asymmetry between family shareholders and non-family shareholders (if owner managed) and between managers and shareholders in general (if not owner managed) 44 Relevance & Limitations of POT for Family Firms POT does either not account for certain ff specific aspects (control preference, higher risk aversion and socio-economic aspects). Beyond these aspects: Relevance depends also on whether a family firm is listed or not listed and on whether there is information asymmetry between managers and shareholders. For listed family firms some (or high) relevance of POT if information asymmetry between managers and shareholders matters. For non-listed, owner managed firms, no or very limited relevance. 45 Agenda 1 Course Outline and Assessment 2 Corporate Finance, Entrepreneurial and Family Business Finance 3 Traditional Capital Structure Theory 4 Payout/Dividend Policy 5 Exercises (Homework) 46 Motivation and Payout Possibilities Question: Why should firms payout profits/cash flows to shareholders? Idea/main goal: Shareholder value creation Value has to be transfered to the shareholder at some time Question: What are potential ways/possibilities for payouts? - Dividends (paid out of the earnings generated in a certain period) - Share repurchases 47  Some Empirical Findings − Main source of corporate financing is retained earnings (as known from POT) − Dividends concentrated among the largest, most profitable firms (Denis & Osobov 2008) − In the US, the announcement of an equity issue often causes a negative market reaction − In the US, the announcement of an increase in dividends often prompts a rise in the stock price Source: Brealey, Myers, Marcus (2012, p. 403) 48 Initial Thoughts on Dividend Decisions The dividend decision is closely linked to the financing decision of a company. The dividend decision must take into account the views and expectations of shareholders. Retained earnings are preferred as a source of investment funds (as we know from empirical observations and the pecking order theory). Dividend payments reduce the earnings available for investment, increasing the need for external funds to meet investment plans. 49 Some Practical Aspects − Dividends can only be paid from accumulated net realised profits (=distributable profits). − Regulations such as accounting standards define the meaning of Legal distributable profits. Constraints − Governments impose restrictions on dividend payments. − Restrictions may be imposed on dividend payments by loan agreements or covenants. − Dividends are cash payments so managers need to consider their impact on liquidity Liquidity − High levels of profit may not mean large dividends, as profit is not Constraints the same as cash. 50 Dividend Payments: Mechanics Union Pacific’s Quarterly Dividend Payment: Key Dates What would you expect to happen with the share price on the day it goes ex-dividend? Dividend payment out of retained earnings which is part of Equity => MV of Equity decreases by amount of dividend payment => Share price (= MV of Equity / # shares) decreases Due to the no arbitrage argument, we would expect a decrease in the stock price by the amount of the dividend payment at the ex-dividend date. 51 Dividend Payments: Mechanics – Example Zurich Drop ca. 19.- 52 Share Repurchases Firm buys back own shares - Afterwards it has two possibilities: − The shares are being destroyed: − This leads to a partial liquidation of the firm and a decrease in share capital − The firm uses the shares as treasury shares: − e.g. for employee compensation, for acquisitions or flexibility. − Accounting wise the repurchase leads to a minus position “equity reduction” in equity and short-term assets (cash outflow) (reduction of balance sheet) What happens to the remaining shareholders: − No cash payment − What will happen to the share price? In a perfect world/market it remains unchanged (see Ex. 3 & 4) (but due to signaling effect, share repurchases often lead to increase in stock price) 53 Payout Policy and Company Value: Theories Payout policy is concerned with whether payouts to investors affect the market value of the firm. Different theories arrive at different conclusions Dividends − Based on Modigliani & Miller (MM) set of assumptions Irrelevance − Investors don’t care about payout policy − Investors prefer a safe dollar today to an uncertain dollar tomorrow Bird in the Hand − Cash dividends are more certain than stock appreciations (“Rightists”) => Prefer higher dividends − Investors prefer a low payout due to taxes Tax Effects − Investors payout preferences depend on how dividends are taxed (“Leftists”) relative to capital gains => Prefer higher share price to dividends − Dividend payments signal that a company is in good shape Signaling Theory − Dividends as a means for managers to communicate their (POT) information advantage to the market 54 Dividend Irrelevance: Example 1 (Basic Case) The following firm has 100 shares outstanding: (book value = market value; values in $) Surplus Cash 150 Debt 0 Asset Value 850 Equity 1’000 How does the wealth situation of an investor holding 1 share look like? 𝑀𝑀𝑀𝑀 𝑜𝑜𝑜𝑜 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 1′ 000 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑝𝑝𝑝𝑝𝑝𝑝 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 = = = $10 # 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 100 55 Dividend Irrelevance: Example 2 The following firm has 100 shares outstanding: (book value = market value; values in $) Surplus Cash 50 Debt 0 Asset Value 850 Equity 900 The firm now wants to pay out a dividend of total $100. How does the wealth situation of an investor holding 1 share look like? 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 100 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑝𝑝𝑝𝑝𝑝𝑝 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 = = = $1 # 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 100 = $10 𝐸𝐸𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞 900 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑝𝑝𝑝𝑝𝑝𝑝 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 = = = $9 # 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 100 Surplus cash & Equity decrease by $100 56 Dividend Irrelevance: Example 3 The following firm has 100 shares outstanding: (book value = market value; values in $) Surplus Cash 50 Debt 100 Asset Value 850 Equity 800 The firm now wants to pay out a dividend of total $200. $100 is taken from surplus cash, the other $100 are financed through additional debt. How does the wealth situation of an investor holding 1 share look like? 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 200 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑝𝑝𝑝𝑝𝑝𝑝 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 = = = $2 # 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 100 = $10 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 800 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑝𝑝𝑝𝑝𝑝𝑝 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 = = = $8 # 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 100 57 Dividend Irrelevance: Example 4 The following firm has 100 shares outstanding: (book value = market value; values in $) Surplus Cash 50 Debt 0 Enterprise Value 850 Equity 900 The firm now wants to buy back shares for a total amount of $100. How does the wealth situation of an investor holding 1 share look like? 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 100 # 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 = = = 10 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 10 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 # 𝑜𝑜𝑜𝑜 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 = 100 − 10 = 90 900 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑝𝑝𝑝𝑝𝑝𝑝 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 = = $10 90 58 Remember the Importance of Signaling with Dividends − Asymmetry of information means dividend decisions may contain information that is new for shareholders. Information Asymmetry, − The information content depends on: Signaling and − direction of the dividend change Dividends − difference between the actual dividend and the dividend expected by the market. − A firm’s dividend policy can be used to signal information about the firm’s prospects to the market Signaling by Increasing the − Managers want the market to believe in their firm’s prospects but Dividend cannot simply tell investors that prospects look good − Paying a high dividend is however regarded as a credible signal 59 Conclusion: Some Stylized Facts Highly established, low-growth firms often pay a dividend and also repurchase shares. Firms regularly buy back shares after having accumulated a large amount of unneeded cash or if they wish to change their capital structure by replacing equity with debt. Once a firm starts paying a dividend, it usually tends to maintain the same dividend level (with small growth rates) going forward (“constant dividend policy”). In cases where a firm stops paying a dividend (or significantly reduces the dividend), the firm typically experiences a large drop in its share price. Share repurchases are much more volatile than dividends and usually fall sharply during crises and recessions (e.g. in 2000-2002, 2008). Repurchases can also convey a signal about the fair value of the stock: When companies offer to repurchase their stock at a premium, this may indicate an undervaluation of the stock. 60 Agenda 1 Course Outline and Assessment 2 Corporate Finance, Entrepreneurial and Family Business Finance 3 Traditional Capital Structure Theory 4 Payout/Dividend Policy 5 Exercises (Homework) 61 Exercise 1: Equity Return and Leverage The common stock and debt of Northern Sludge are valued at $70 million and $30 million, respectively. Investors currently require a 16% return on the common stock and an 8% return on the debt. If Northern Sludge issues an additional $10 million of common stock and uses this money to retire debt, what happens to the expected return on the stock? Assume that the change in capital structure does not affect the risk of the debt and that there are no taxes. 62 Exercise 2: Leverage and Cost of Capital Schiraff AG, a producer of animal food, is located on a tropical island where it does not have to pay taxes. Its equity is worth CHF 300 million and Schiraff AG has no debt. The firm now considers issuing CHF 100 million in debt in order to reduce its equity (share repurchase). The CEO wants to know the impact of this transaction on the investment strategy and, therefore, on the WACC of the company. Risk-free rate (borrowing rate): 2% Market return: 6% Beta of Schiraff AG: 0.5 a) What is Schiraff’s WACC before the transaction? b) What happens to Schiraff’s cost of equity and its WACC after the transaction? Should Schiraff AG carry out the transaction and if so, why? 63 Exercise 3: Tax Shields and WACC Here are the book- and market-value balance sheets of the United Frypan Company: Assume that MM’s theory holds except for taxes. There is no growth, and the $40 of debt is expected to be permanent. Assume a 35% corporate tax rate. 1. How much of the firm’s value is accounted for by the debt-generated tax shield? 2. What is United Frypan’s after-tax WACC if rdebt = 8% and requity = 15%? 3. Now suppose that Congress passes a law that eliminates the deductibility of interest for tax purposes after a grace period of 5 years. What will be the new value of the firm, other things equal? Assume an 8% borrowing rate 64 Exercise 4: Trade-off Theory Smoke and Mirrors currently has EBIT of $25,000 and is all-equity-financed. EBIT is expected to stay at this level indefinitely. The firm pays corporate taxes equal to 35% of taxable income. The discount rate for the firm’s projects is 10%. a. What is the market value of the firm? b. Now assume the firm issues $50,000 of debt paying interest of 6% per year, using the proceeds to retire equity. The debt is expected to be permanent. What will happen to the total value of the firm (debt plus equity)? c. Recompute your answer to (b) under the following assumptions: The debt issue raises the probability of bankruptcy. The firm has a 30% chance of going bankrupt after 3 years. If it does go bankrupt, it will incur bankruptcy costs of $100,000. The discount rate is 10%. Should the firm issue the debt? 65 Exercise 5: Questions on Pecking Order Theory 1. If the pecking order theory is correct, what types of firms would you expect to operate at high debt levels? 2. What does the pecking order theory tell us about the optimal debt-equity mix? 66 Exercise 6: Dividend Policy Which of the following statements is correct (only one)? a) Since investors anticipate dividend payments, the share price is not influenced by dividend payments. b) In absence of other price-impacting news the share price should decrease at the ex- dividend date by the dividend amount. c) Since investors anticipate dividend payments, the share price should increase by the amount of the dividend payment shortly before the dividend payment date. d) Since investors anticipate dividend payments, the share price should decrease by the dividend amount shortly before the dividend payment date. e) None of the other statements is correct. 67 Exercise 7.1: Share Repurchase and the EPS Illusion The following numbers (book value = market value) are given for firm A: − Debt $50 mio. − Equity $50 mio. − Operating assets $100 mio. − βEquity 1 − Cost of debt = risk free rate 4% − Market return 10% − Taxes 0 − Share price $50 − Shares outstanding 1 Mio. − EBI = NOPAT (constant) $7 mio. − Payout Ratio 100% => dividend growth rate g = 0 Calculate the EPS and the equity value of firm A using a dividend growth model. 68 Exercise 7.2: The Share Repurchase and EPS Effect Now assume that the firm wants to repurchase 0.2 mio. of the shares (for $50 each). The firm finances the share repurchase with additional debt of $10 mio. What happens to the capital structure and the EPS of the firm? What happens to cost of equity and WACC? What happens to the fair equity value, the share price, and the total firm value? 69