Corporate Finance Lectures PDF

Corporate Finance Lectures Lecture 4 – 12/11/2024 Approach in ﬁnance academia (#4-1) 1. Clearly state assumptions in a formal mathematical model 2. Formal analysis based on these assumptions -Bond value and stock value sum up to ﬁrm value -Equity is like a call option on the company’s assets with a strike equal to the face value of the debt -Understand general payo diagram well, makes the rest much easier Pre Modigliani-Miller views The typical pre-MM view says that “debt is cheaper than equity” because 1. Interest rate on debt < required return on equity 2. Equity issues are dilutive => decreases earnings per share, hurting shareholders -However, too much debt might lead to high interest payments and eventual bankruptcy. -Modigliani Miller tells us these assumptions are not correct If the assumptions are unrealistic, why is this interesting? -It is a benchmark -It shows us how basic “debt is cheap” intuition is misleading - It forces us to think what factors make capital structure relevant Assumptions behind the MM propositions (world without friction) No taxes and ﬁnancial distress costs, no asymmetric information, no transaction costs, ﬁrm value maximizing employees, consumers and ﬁrms borrow & lend at the same rates -In a frictionless world, the choice of capital structure is irrelevant for the value of a ﬁrm. => This result is known as the Modigliani-Miller theorem Modigliani-Miller propositions without taxes 1. In a perfect capital market, the total value of a ﬁrm is equal to the market value of the total cash ﬂows generated by its assets and is not a ected by its choice of capital structure. - If investors prefer an alternative capital structure to the ﬁrms choice, investors can borrow / lend on their own and achieve the same result (homemade leverage) -Applies to any form of ﬁnancing, not just debt and equity -Note: MM 1 is about the market value of ﬁrm assets and liabilities (not book value) Market value of equity = market value of asset – market value of debt & liabilities 2. The cost of capital of levered equity increases with the ﬁrm’s market value debt- to-equity ratio. In other words: The weighted average cost of capital is equal to the expected return on unlevered equity and not a ected by the ﬁrm’s capital structure. -MM proposition 2 implies that the ﬁrm’s WACC is independent of its capital structure The bottom line of MM When a ﬁrm wants to increase its leverage because “debt is relatively cheaper than equity”, it makes the leftover equity riskier than before. -The cost of equity will increase, leading to the same WACC as before -When increasing debt to extreme levels, the debt is no longer risk free meaning the cost of debt will also increase next to the cost of equity increase => WACC does not change Fallacies that are debunked with the help of MM (#4-2) 1. Debt is cheap fallacy => “Debt is cheaper than equity as1 it has a low interest rate.” -Debt indeed has a low required return (theoretically) equal to the risk-free rate. -However, increasing leverage comes at the cost of increasing the cost of equity. -Increasing debt further to a level where debt is risky, the ROR on debt also increases. => MM proposition 2: the weighted average cost of capital is equal to the expected return on unlevered equity and not a ected by the ﬁrm’s capital structure 2. The EPS fallacy => “Debt is desirable when it increases earnings per share.” -Using debt to buy back shares indeed increases EPS, but the share price remains unchanged as the risk has also increased and with it the required return on equity. 3. Equity issue dilution => “Equity is more expensive than debt because equity issues (or deleveraging) dilute earnings per share and drive down the stock price.” -In fallacy 2 we see that EPS is lower when leverage is lower, but the value of the shares remains the same. The extra EPS in a levered ﬁrm is a compensation for risk. -Original shareholders are not worse o when the ﬁrm issues new shares -Consider the ﬁrm below that raises €1bln by issuing €62.5m shares at €16.00: 4. Repurchases vs dividends => “Paying out cash through share repurchases is better than dividends because repurchases support the share price.” -In order to repurchase shares, the cash balance is decreased by the same amount, meaning there is no increase or decrease in value. -When paying out dividends, the cash balance AND the share price decrease equally. This makes sense as the “loss” in value is compensated for by the dividend. 5. Cash hoarding fallacy => “The company should pay out its cash rather than just invest in government bonds at a low interest rate. This would increase investor returns.” -If the cash is paid out, investors gain a dividend, if the cash is not paid out and the ﬁrm invests in government bonds, investors lose the dividend but gain the increased future cash ﬂow from the bond interest. -If retained cash earns a market return, net payments to ﬁnancial markets do not matter. -Important principle: deciding how much debt to take on and deciding how much cash to pay out is essentially the same decision. Cash = negative debt - This is why we consider Net Debt = Debt – Excess Cash when evaluating cap structure -Under the MM assumptions, markets are perfect, so that internal and external funds have the same cost. The impact of taxes and distress (#4-3) -The picture changes once we introduces taxes and bankruptcy costs -If taxes are paid on earnings after interest payments, debt is cheaper than equity -At the bottom line, more income will be available to all investors combined -Equity investors lose a marginal level, while debt investors gain heavily -But high leverage increases bankruptcy costs => leads to trade-o theory -Trade-o Theory: the ﬁrm picks its capital structure by trading o the beneﬁts of the tax shield from debt against the costs of ﬁnancial distress -The total value of a levered ﬁrm equals the value of the ﬁrm without leverage plus the present value of the tax savings from debt, less present value of ﬁnancial distress costs: -Di erences in the use of leverage across industries (due to di erences in the magnitude of ﬁnancial distress costs and the volatility of cash ﬂows). Modigliani-Miller with taxes 1. The total value of the levered ﬁrm exceeds the value of the ﬁrm without leverage due to the present value of the tax savings from debt. 2. With tax-deductible interest, the e ective after-tax borrowing rate is (1 −𝜏) and the weighted average cost of capital becomes: MM and bankruptcy costs -If taxes were the only issue, most ﬁrms would be 100% ﬁnanced by debt. -But common sense suggests otherwise. High debt levels => risk of bankruptcy. -Financial distress costs can lead to value destruction only present due to high debt. -Note: MM allows ﬁnancial distress & bankruptcy – just cannot lead to any extra costs -MM assumption: when the value of equity falls to zero (limited liability), debt holders take over the ﬁrm at no cost Bankruptcy of a ﬁrm -Default: ﬁrm fails to make required payments to debt holders => debt holders can take legal action -Bankruptcy proceedings: Liquidation => sell all assets & use proceedings to pay debtholders. This is very costly for large ﬁrms leading to bankruptcy costs. -Reorganization: management proposes reorganization plan & continues operations => creditors receive cash payments and new securities in ﬁrm. Can vote to accept/reject the plan for reorganization. Bankruptcy costs (shareholders pay, see slide 24-29 of #4-3) -Direct costs (expenses & fees): 2-5% of ﬁrm value, but probability of 0.07% per year. -Indirect costs: Missed opportunities, ability to compete, loss of stakeholders, ﬁre sale of assets, delayed liquidation, loss of receivables, costs to creditors. -For distressed ﬁrms: having to cut new proﬁtable investments => lower R&D. -Firms in ﬁnancial distress may have a harder time responding to competition. -Shareholders pay for the ﬁnancial distress costs as the value of equity decreases. -Ex post the debt holders pay as well, but this is priced in ex ante => higher interest rate. -MM no longer holds as: Vu > Vl + Vd The value-additivity principle states that the NPV of a project is the sum of the NPVs of its individual cash ﬂows Lecture 5 – 19/11/2024 Trade-o theory: With taxes and ﬁnancial distress costs, ﬁrms trade o the tax beneﬁt of debt against the cost of ﬁnancial distress (see lecture 4). Other costs and beneﬁts of debt: -Agency costs 1. Leverage Ratchet E ect: excessive leverage can build up over time 2. Excessive risk-taking (risk shifting) 3. Under-investment due to debt overhang -Agency beneﬁts 1. E ort incentivization with equity ﬁnancing Economic frictions can lead to deviations from MM. -The frictions here are moral hazards: Shareholders have control over the ﬁrm’s actions, but shareholders actions are unobservable and therefore not contractible. Even if shareholders want to commit to a certain action, they cannot write a contract to enforce this action. Any action needs to be incentive-compatible. Simplifying assumptions for all 3 phenomena explanation 1. Risk neutral pricing => No need to compensate for risk (no risk premium) 2. No management-shareholder conﬂict => all decisions in shareholder best interest -Not necessarily in the best interest of debt holders #5-1 Leverage ratchet e ect Leverage ratchet e ect. Once existing debt is in place: 1. Shareholders may have no incentive to decrease leverage, even if it increases ﬁrm value 2. Shareholders may have an incentive to increase leverage even if it decreases ﬁrm value Leverage Ratchet E ect: over time, this can lead to a gradual increase in leverage ⇒ can explain many contractual features in debt contracts often observed in practice, such as: short maturities, restrictive covenants, collateral Example (also see slide 9-26 of #5-1): -Avoiding ﬁnancial distress costs is very advantageous -However, issuing equity to pay o debt is not necessarily advantageous for shareholders as equity value increases by less than the capital requirement -Even if the beneﬁt to the ﬁrm is a net positive, it might not happen as shareholders will incur a net “negative”. Instead, the beneﬁt mostly goes to debtholders. Commitment problem -Leverage ratchet implies ﬁrms cannot commit to a future capital structure -Creditors need to worry shareholders will not decrease or increase leverage To overcome the commitment problem, ﬁrms/creditors use: 1. Shorter maturities → automatic reduction in leverage 2. Collateral → exclusive access to asset, not vulnerable to future leverage changes 3. Seniority provisions → avoid dilution through new debt issuance 4. Restrictive covenants → prohibit increases in leverage (at cost of lower operational ﬂexibility) 5. Relationship banking → bank has market power over borrower 6. Reputation building → overcome commitment problem by building a reputation #5-2 Risk shifting Why would shareholders prefer a value-destroying (lower/negative NPV) project? -Because of limited liability -When the ﬁrm defaults (state L), shareholders’ payo s are capped at 0, but in state H, shareholders enjoy the entire beneﬁt from higher payo s. -Shareholders can shift risk on debt holders: “Heads I win, tails you lose” There is a stronger incentive for shareholders to take excessive risk when: -Firm has large amount of outstanding debt -Firm can shift value from default states to non-default states Option analogy -Equity is like a call option on the ﬁrm’s assets with strike price (1+r)D -Risky debt is like risk-free debt with face value D and a short position in a put option on the ﬁrm’s assets with strike price (1+r)D -Shareholders like risk because they are “long in a call option” -Debt holders dislike risk because they are “short in a put option” Cost of issuing debt when debtholders are aware of risky project: Ex-ante, shareholders are better o if they can credibly convince debt investors that they will invest in S Ex-post, they prefer to take the risky project R (→ time inconsistency) -Investors and ﬁrms try to limit this problem through contracting, does not always work -Moral hazard: ex-post agents (shareholders/managers) may take an undesirable action May lead to credit rationing -Worse because ﬁrms might not receive funding at all -If shareholders cannot commit to refrain from undertaking project R ex-post, their expected payo net of the cash contribution 𝐶 = €15𝑚 is negative ex-ante: -Result: shareholder prefer to not raise ﬁnancing at all & don’t make an investment Bottom line result 1. Limited liability gives equity a call option-like payo function 2. Shareholders have an incentive to invest in risky projects & shift risk on debt holders 3. Anticipating this behaviour, debt holders charge higher interest rates ex-ante 4. To avoid high i rates, shareholders want to commit to less risky projects ex-ante 5. This may be impossible under asymmetric information about project choice (= moral hazard) 6. In this case, shareholders can only commit to non-risky strategies ex-post if doing so is incentive-compatible 7. As a result, positive NPV projects may not be undertaken (credit rationing) 8. Issuing equity instead of debt can overcome this problem (see appendix) ⇒ MM does not hold #5-3 Debt overhang Debt overhang: shareholders may forgo positive NPV projects -The problem arises when undertaking new projects mostly beneﬁts existing debt holders -Similar to risk shifting, most relevant for ﬁrms with relatively high leverage (close to ﬁnancial distress) -In contrast to risk shifting, debt overhang implies that shareholders may choose to forego positive NPV investments → under-investment Shareholders do not undertake the positive NPV investment if debt is too high -Problem: by undertaking the investment, shareholders give up the option value of defaulting in state L -When the ﬁrm defaults, the residual value of assets after repaying debt is negative: 𝑉−1+𝑟𝐷=−€2𝑚 -But due to limited liability, shareholders’ payo is capped at 0 Debt overhang can be overcome by renegotiating the principal of the debt to a lower level D’ < D Debt overhang & risk shifting in practice -It may be hard to ﬁnd evidence of ﬁrms literally taking on “risky projects” or “forgo investments” -But we do observe instances where ﬁrms take more subtle actions that dilute their debt 1. Spin-o s of safer part of business (Marriott) 2. Play for time => postpone e icient liquidation in hope of a miracle 3. Making excessive dividends or share repurchases (banks during 2008 crisis) 4. Using cash or senior debt to take over a (risky) ﬁrm Lecture 6 – 26/11/2024 #6-1 Agency beneﬁts of debt Simplifying assumptions 1. Risk neutral pricing => No need to compensate for risk (no risk premium) (e.g., because the ﬁrm has a beta of 0, so ﬁrm risk is fully diversiﬁable) 2. Firm run by original owner/managers (not necessarily in the best interest of shareholders) See practical example slide 5 to 21 Debt vs equity ﬁnancing -Debt ﬁnancing will provide a better incentive to put in high e ort due to the alignment of values => no agency costs conﬂict when using debt. -This is because under equity ﬁnancing, the owner only captures (1- equity) of the gain in ﬁrm value. Under debt ﬁnancing, the owner captures 100% of gains => bigger incentive -In the model we have assumed risk neutrality -Not very realistic for individual managers or entrepreneurs -Extended model: trade o the beneﬁt from higher e ort incentivization against the cost of exposing owner/manager to risk Management in large corporations -The model applies most directly to smaller entrepreneurial ﬁrms, in which founders have a signiﬁcant equity stake -In large corporations, managers are also often paid in the form of stock (option) compensation to align incentives => Note: managers only own a very small fraction of the ﬁrm => But relative to their own income and wealth, the value of equity in the ﬁrm may be signiﬁcant, so it still provides incentives to maximize shareholder value Free cash ﬂow hypothesis -Extra (informal) argument why higher leverage reduces wasteful spending by managers -Idea: wasteful spending is more likely to occur when ﬁrms have high levels of cash ﬂow in excess of what is needed after making all positive-N P V investments and payments to debt holders. -When cash is tight, managers will be motivated to run the ﬁrm e iciently ⇒ contrast to #4-2, Fallacy 5: Cash Hoarding! -See Jensen (1986): Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers Problems with high powered incentives Stock based compensation has grown substantially. -Problem: high-powered incentives may lead CEOs to focus excessively on ﬁrm value. -Aligning with “shareholder interests” mean maximizing shareholder ﬁnancial value. -Exacerbated by risk-shifting incentives, especially when costs are carried by society. Agency costs and the trade-o theory Agency costs: once a ﬁrm has debt… 1. Risk shifting: Shareholders may invest in excessively risky (negative NPV) projects 2. Debt overhang: Shareholders may forego positive NPV projects 3. Leverage ratchet: Shareholders may not reduce or increase leverage even if that increases ﬁrm value Agency beneﬁts of debt 1. Motivating e ort: Leverage can align the incentives of owners/managers to maximize ﬁrm value and run the ﬁrm in the best interest of shareholders Implications of optimal leverage with taxes, ﬁnancial distress, and agency costs More leverage when there is less risk shifting / debt overhang potential: -Regulated public utilities with less managerial discretion -Firms in mature industries with few growth opportunities Risk shifting / debt overhang issues are greater close to ﬁnancial distress because limited liability kicks in (gambling for resurrection) -Example: managers may delay ﬁling for bankruptcy to keep equity’s option value alive Risk shifting incentives are particularly strong for banks -Depositors are inattentive creditors. This allows banks to take on leverage and shift risk -When banks fail, the government picks up the bill => Motivates capital regulation. Two examples R&D intensive ﬁrms -Firms with high R&D costs and future growth opportunities typically maintain low debt. -These ﬁrms tend to have low current free cash ﬂows and risky business strategies. Low growth, mature ﬁrms -Firms with stable cash ﬂows and tangible assets often carry a high debt load. -These ﬁrms tend to have high free cash ﬂows with few good investment opportunities. #6-2 Raising equity ﬁnancing Initial capital often provided by entrepreneur and his/her friends and family Soon, ﬁrms require outside ﬁnancing through: 1. Angel investors 5. Corporate investors 2. Venture capital 6. Initial public o ering (IPO) 3. Private equity 7. Seasoned equity o ering (SEO) 4. Institutional investors Angel investors Individual investors (rich successful entrepreneurs like Mark Cuban, shark tank) -Buy equity in small, early-stage ﬁrms often in exchange for a convertible note or simple agreement of future equity (SAFE) that are convertible (at a discount) when the company raises equity ﬁnancing for the ﬁrst time -Reason: value of early-stage ﬁrms is hard to assess -Angel investors are usually hard to ﬁnd Venture Capital (VC) ﬁrms Limited partnership specialized in raising investment in the private equity of young ﬁrms 1. Limited partners (LPs): hold shares in the VC ﬁrm but have limited voting rights -Often institutional investors => pension funds, insurance companies, mutual funds -Investing in venture capital ﬁrms, limited partners beneﬁt from diversiﬁcation and the expertise of the general partners in selecting ﬁrms 2. General partners (GPs): managers of the VC ﬁrms (“Venture capitalists”) -Earn fees paid by limited partners -General annual management fee (usually around 2% of the fund’s committed capital) -Carried interest: 20-30% of any positive return they make Venture capital ﬁnancing terms -Liquidation preference: Minimum amount paid to preferred stock before common stock if the ﬁrm needs to be liquidated -Seniority: preference over investors in earlier & future rounds, but typically no dividend -Participation rights: liquidation preference and rights to payments of common shares -Anti dilution protection: right to purchase common stock at better price in down rounds -Board membership: investors appoint board members to secure control rights to prevent any moral hazard problems Exit strategy In later funding rounds, the value of shares may increase substantially. Problem: early investors cannot easily realize gains by selling shares when the ﬁrm is private due to current illiquid nature of the equity. Exit strategies: 1. Initial public o ering (IPO): start selling shares on the stock market 2. Acquisition: start-up is purchased by a larger ﬁrm Institutional and Corporate investors Institutional investors: pension funds, insurance ﬁrms, endowments, mutual funds -Institutional investors may invest directly in private ﬁrms or may invest indirectly by becoming limited partners in VC ﬁrms Corporate investors: A corporation investing in private companies (Microsoft => OpenAI) -Also known as corporate partner, strategic partner, and strategic investor -Might invest for Corporate strategic objectives, in addition to the ﬁnancial returns Private equity (PE) ﬁrm Organized like a VC ﬁrm but invests in the equity of existing ﬁrms rather than start-ups. -Leveraged buyout (LBO): PE ﬁrms often buy the outstanding equity of publicly-traded ﬁrms to make the company private again -In most cases, the PE ﬁrms uses debt and equity to ﬁnance their purchases IPO: Advantages and disadvantages -Primary o ering: ﬁrst shares available in a PO to raise high amounts of new capital. -Secondary o ering: new shares sold by existing shareholders in an equity o ering. Advantages -Greater liquidity allows PE investors and initial founders to diversify their holdings. -Better access to large amounts of capital for the ﬁrm through the capital markets. Disadvantages -The equity holders become more widely dispersed => di icult to monitor management. -The ﬁrm must adhere to requirements of public companies (disclosure regulations). Types of IPO Underwriter: An investment bank that manages a security issuance and designs its structure -Best e orts basis: The underwriter does not guarantee that the stock will be sold, but instead tries to sell the stock for the best possible price. -Firm commitment: underwriter guarantees that it will sell all the stock at the o er price -Underwriter purchases all shares below o er price & sells them at o er price -Underwriter takes a loss if not all shares are sold at o er price -Auction IPO: underwriter in an auction IPO takes bids from investors and then sets the price that clears the market (example: Google in 2004) Special purpose acquisition companies & syndicates SPACs ﬁrst raise ﬁnancing in an IPO, and then ﬁnd a private ﬁrm to merge with -With this structure, SPACs take private ﬁrms public -A syndicate is a group of underwriters who jointly underwrite and distribute a security issuance with a lead underwriter: the primary IB ﬁrm responsible for managing the security issuance Road show During an IPO, when a company’s senior management and its underwriters travel around promoting the company and explaining their rationale for an o er price to the underwriters’ largest customer (mainly institutional investors such as mutual funds and pension funds). -Book building: o er a price estimate based on customers’ expressions of interest -This information is used to value the company -First-day trading: o er price is set the day before the ﬁrst trading day -Underwriter allocates shares at o er price to accredited investors, then trading starts Seasoned equity o ering SEO: a public company o ers new shares for sale to raise additional equity -Cash o er: ﬁrm o ers the new shares to investors at large -Rights o er: ﬁrm o ers the new shares only to existing shareholders -Protects existing shareholders from underpricing 4 puzzles of IPO/SEO Puzzle 1: Underpricing Generally, underwriters set o er price too low, so the average ﬁrst day return is positive -This is because underwriters beneﬁt from under -pricing because it allows them to reduce risk and charge high commission from clients who buy the underpriced shares -The pre-IPO shareholders bear the cost of this underpricing (non-optimal price) Why are IPOs underpriced? Although IPO returns are attractive, not all investors can earn high returns -When an IPO goes well, the demand for the stock exceeds the supply => Thus, the allocation of shares for each investor is rationed -When an IPO does not go well, demand at the issue price is weak, so all initial orders are ﬁlled completely Thus, the typical investor will have their investment in good IPOs rationed while fully investing in bad IPOs Puzzle 2: Costs of an IPO A typical spread (bank fees) is 7% of the issue price -Large fee, especially considering the additional underpricing costs -Although not as costly as IPOs, SEOs are still expensive with fees of 5% of proceeds -Possible explanation: charging lower fees may risk signalling of a low quality o ering Puzzle 3: Cyclicality The number of issues is highly cyclical: good times = ﬂood of issues, bad times = drought -Magnitude of the swings is most surprising & unlikely explained by growth options only -Cyclicality in the supply of capital likely plays a role too Puzzle 4: SEO price reactions – adverse selection On average, the market reacts to the news of an SEO with a price decline -The stock price tends to rise prior to announcement & ﬁrms issue after earnings report #6-3 Pecking order under adverse selection We have seen that moral hazard problems can be more (risk shifting, debt overhang) or less severe under debt ﬁnancing (incentivizing owners/managers) -Moral hazard is associated with asymmetric information about an action Now we look at a di erent type of asymmetric information problem: adverse selection -Adverse selection: asymmetric information about the type of an individual/asset/ﬁrm/… Adverse selection has several implications for ﬁrm ﬁnancial choices -Pecking order: to reduce adverse selection problems, ﬁrms may prefer to ﬁrst issue the least-information sensitive securities -Signalling: ﬁrms may engage in costly signalling (for example, posting collateral) to convince investors they are a good ﬁrm -Equity issuance cost and market breakdowns: investors may perceive a ﬁrm announcing equity issuance as over-valued, resulting in negative stock price response. -Winner’s curse: IPOs tend to be underpriced because investors may be concerned about buying into a bad ﬁrm Pecking order under adverse selection To ﬁnance investments, ﬁrms prefer to ﬁrst use internal resources (cash), then senior debt (little default risk), then junior debt & convertibles, then equity. -Reason: least information-sensitive source of ﬁnancing reduces the adverse selections costs (cross-subsidy from good to bad ﬁrms) -Most relevant when there is asymmetric information about the value of new investment -May explain negative stock price reaction to SEOs: investors suspect ﬁrm may be a “lemon” (See IPO Puzzle #4) See slide 5-12 for example of symmetric & asymmetric information ﬁnancing See slide 13-24 for example of forms of ﬁnancing comparison Implications for equity issuance (SEO price reaction puzzle) -The stock price declines on the announcement of an equity issue as the market suspects the issuing ﬁrm may be a lemon -The stock price also tends to rise prior to the announcement of an equity issue => ﬁrms may wait to issue until positive news becomes public -Firms tend to issue equity when information asymmetries are minimized, which happens around / immediately after earnings announcements. Lecture 7 – 03/12/2024 #7-1 Winners curse and IPO underpricing Some informed investors have superior information about which ﬁrms are good or bad, so they only buy shares in good ﬁrms. -As a result, IPOs in bad ﬁrms are under subsidised while good ﬁrms are over subsidised -Uninformed investors will end up receiving more shares in bad ﬁrms (or higher price) -Lower share price of bad ﬁrms compensates uninformed investors IPO process Stage 1 -The ﬁrm announces it will sell 100m shares at an initial public o ering price of P0 -Investors place order Su, Si for how many shares they want to purchase Stage 2 -After collecting the orders, the ﬁrm allocates shares to investors -If the total demand exceeds supply (Su + Si > S), shares are allocated pro rata -Then investors can start trading at price P1 => the ﬁrst day IPO price increase is P1 – P0 Winners curse – see slides for detailed example #7-2 Underwriter incentives and prospect theory -Underwriters have an incentive to underprice IPOs because it enables them to earn higher commission form buy side clients -Issuers are not upset about underpricing due to mental accounting (prospect theory) Exam formula: Why do underwriters leave money on the table? -Underwriters should desire a higher o er price given that percentage gross spreads are largely ﬁxed at 7% on moderate size IPOs, so a higher o er price generates higher underwriter revenue. -What are underwriters getting in return for the millions in proﬁts per IPO that they are handing out to money managers, hedge funds, etc. Beneﬁts 1. Lower o er prices reduce marketing costs since it is easier to ﬁnd buyers 2. Potential IPO investors (buy side clients) will overpay for commissions to improve their priority of getting shares in hot IPOs (?) -Underwriters gain from leaving money on the table because it induces buy-side clients to compete for favourable allocations -Many IPOs are heavily oversubscribed (demand exceeds supply), and underwriters can then choose which of their clients receive share allocation Why underwriters prefer a low issue price: -Suppose hedge funds and other IPO investors overpay on commissions (“soft dollars”) by 30 cents for every dollar of money left on the table that they get -When underwriters raise an o er price by $1 per share, they gain 7 cents in gross spread revenue but lose 30 cents in “soft dollar revenue” Why do issuers leave money on the table? -An academic study found that issuing ﬁrms do not view a large amount of money left on the table as an important consideration in choosing the underwriter for a follow-on o ering -Why? => Ritter and Loughran: mental accounting (prospect theory) explanation -Prospect theory assumes that issuers/managers focus on the change in their wealth, rather than on the level of the wealth -In many IPO situations, managers (i.e., issuers) will integrate the two events from the ﬁrst day. Issuers will sum the wealth loss from leaving money on the table (bad news event) with the much larger wealth gain from the ﬁrst-day returns (good news event). -Underwriters take advantage of this correlation of the amount of money left on the table and the unanticipated wealth changes. Mental accounting fallacy (consistent with prospect theory): -Compare wealth to reference point: initial ﬁling range before book building -Integrate gain from reference point with loss due to money left on the table -Fallacy: they could have issued less shares at a higher price, leading to higher ﬁrst close #7-3 Payouts Distributing cash to shareholders Opposite of raising equity capital => increase in leverage -Payouts may be positive signal for the market -Di erence in tax treatment and signalling drive payout policy Does dividend policy matter? (slide is bullshit but whatever) A compelling case can be made that dividend policy is irrelevant -Investors do not need dividends to convert shares to cash => they will not pay higher prices for ﬁrms with higher dividends -In other words, dividend policy will have no impact on the value of the ﬁrm because investors can create whatever income stream they prefer by using homemade dividend Example: Investor Bob owns 80 shares of Genron stock and prefers a $3 dividend -Instead of $80 x $2 = $160 in cash, Bob wants 80 x $3 = $240 -Sell ($240 - $160) / $40 = sell 2 shares of stock ex dividend To get the result that dividend policy is irrelevant, we need 0 taxes or transaction costs Why may investors like dividends? -Transaction costs: Homemade dividends require time and fees involved in selling stock -Mental accounting: Spend the interest (dividends), save the principal -Agency costs: Committing to dividends keeps managers from spending excess cash on themselves or investing in pet projects See slide 13-15 for share repurchase example Share repurchase vs dividend payment tax treatment -Investors pay dividend tax on cash received through dividend payments (higher) -If investors sell shares during a repurchase, they pay capital gains tax (lower) Even if capital gains and dividend taxes were equal, share repurchases have tax beneﬁt -Investors can time the sale of stock when most advantageous from a tax perspective -For example, sell when gains can be o set against losses Signalling with dividends Given the tax disadvantage, why do ﬁrms pay dividends? -Dividend signalling hypothesis: dividend changes reﬂect managers’ views about a ﬁrm’s future earnings prospects -If ﬁrms smoothen dividends, the ﬁrm’s dividend choice will contain information regarding management’s expectations of future earnings Signalling with repurchases Repurchases are perceived as a more ﬂexible way of making payouts -In contrast to dividends, investors do not perceive repurchase as a strong commitment that ﬁrms maintain a level of payout (no smoothening). Arbitrary, but true. -Repurchases may be seen as signal that management believes the ﬁrm is under-valued - “Inverse” of logic for share issuance (see #6-3 on pecking order) Empirical Evidence Consistent With Signalling Dividends -Increases in dividends are associated with positive returns. -Decreases in dividends are associated with negative returns, thus managers are reluctant to cut dividends. Repurchases -Repurchase announcements are associated with positive returns, especially the ﬁrst time a ﬁrm issues repurchases. -Repurchase suspensions are associated with negative returns

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