Modigliani Miller Theorem & Goodwill Methods PDF

M&A, Restructuring & L.B.O. This document may not be photocopied, reproduced or distributed to third parties without the prior written consent of Hubble Finance Frédéric CWILING Reproduction prohibited, all rights reserved Theorem of neutrality Modigliani / Miller : (Franco Modigliani (1918-2003), I...

M&A, Restructuring & L.B.O. This document may not be photocopied, reproduced or distributed to third parties without the prior written consent of Hubble Finance Frédéric CWILING Reproduction prohibited, all rights reserved Theorem of neutrality Modigliani / Miller : (Franco Modigliani (1918-2003), Italian-American economist, was awarded the 1985 Nobel Prize in Economics ; Merton Howard Miller (1923 – 2000), American economist, and the co-author of the Modigliani–Miller theorem (1958), shared the Nobel Memorial Prize in Economic Sciences in 1990) Modigliani-Miller theorem : « in a world without taxes, exempt from transaction costs and under the assumption of market efficiency, the value of economic assets is not affected by the choice of a financing structure » 1) « Dividend policy can not influence the value of the company as it does not affect its investment policy. » 2) « The shareholder is indifferent between receiving 1 € in dividend or capital gain » => So why do activists ask for dividends ?! => To demonstrate Frédéric CWILING Reproduction prohibited, all rights reserved Theorem of neutrality Example : Assumption: the Value of company A: V = 11 M€, 100.000 shares (=> V 1 share = 110 €) 1st case : Div = 1 M€ => 2nd case : Financing by capital increase : 3rd case : Share buyback for 1 M€ Frédéric CWILING Reproduction prohibited, all rights reserved Theorem of neutrality Example : Assumption: the Value of company A: V = 11 M€, 100.000 shares (=> V 1 share = 110 €) 1st case : Div = 1 M€ => V = 10 M€, V (1 share) = 100 €. => The shareholder receives 10 € / share => net assets = 110 € / share 2nd case : Financing by capital increase : V (1 share) = 110 => 1 M€ / 110 ≈ 9091 shares to issue. But V company A remains unchanged after dividends. => unit dividend = 1.000.000 / 109.091 actions = 9.17 € (vs 10). V (1 action) = 11 M€ / 109091 = 100,83 => net assets = 9.17 + 100.83 = 110 € / share 3rd case : Share buyback for 1 M€ : buyback 1 M€ / 110 = 9091 shares (canceled shares / capital reduction) => V company = 10 M€. 100.000 – 9091 = 90.909 shares remaining => V (1 share) = 10.000.000 / 90.909 = 110 €. => So effectively, in a perfect capital market, the dividend policy and the ways it can be implemented have no impact on the wealth of the shareholder. => So again: why do activists ask for dividends ?! Frédéric CWILING Reproduction prohibited, all rights reserved Theorem of neutrality In a perfect capital market, the dividend policy and the ways it can be implemented have no impact on the wealth of the shareholder. But with so many assumptions …! A perfect capital markets context assumes the following: - No tax (or tax distortion capital gain / dividends) - Free access to the financial market - No fees on certain transactions (capital increase, transaction cost) - No asymmetry of information (managers / shareholders) - No conflicts of interest (managers / shareholders) … Assumptions not always in line with the economic reality … Frédéric CWILING Reproduction prohibited, all rights reserved « Goodwill » methods  Idea: value of the company = What it owns + a « super-profit » or « goodwill » (when the net profit is higher than the « potential » profit from investing the net asset value at a risk-free rate « i » ; otherwise there is a so-called «badwill»), discounted over a certain period (usually 3 to 6 years).  Method: set up and discount of the goodwill, then valuation of the company V = NAV + [ (Net profit – i NAV) discounted over 3 to 6 years ]  Which companies: - companies with quite high level of fixed assets - and sometimes a rather low profitabiity  Problems: - gives a rather low value for high-profit companies - question of the duration? Frédéric CWILING Reproduction prohibited, all rights reserved « Goodwill » methods: many alternatives  UECE Method (Union of European Accountants):  V = NAV + GW = NAV + K (Net profit - iV)  Anglo-saxon or direct method :  => V = NAV + 1/t (Net profit – i x NAV)  Practitioners method:  V = ½ (NAV + Net profit / i) = NAV + 1/2i (Net profit – i x NAV) … Each method has a proper logic, according to the... interests of the parties! 7 Frédéric CWILING Reproduction prohibited, all rights reserved « Goodwill » methods / Activists asking for dividends  Exercise Question 1: Calculate the value of the company using the Goodwill formula Goodwill & dividends Question 2: What is the amount of the Goodwill within A company whose characteristics are as follows: this valuation? Net asset Net Profit before tax Cash t (Return on Equity) i (risk free rate) n (duration of goodwill) 10000 1000 4000 10% 4% 3 Assumptions Income Tax will not be taken into account Cash is invested at the risk-free rate Frédéric CWILING Question 3: if the company distributes a dividend of 4000 a) Intuitively, will Goodwill then be lower or higher than in the previous case? b) Recalculate the value of the company using the Goodwill formula c) Check your intuition by calculating d) Is the result surprising? Question 4: a) Compare ROE before, and after the distribution b) What would be your position as a shareholder c) What are the potential risks of such a distribution? Reproduction prohibited, all rights reserved