Notesale: Turn your study into money

Document Preview

Extracts from the notes are below, to see the PDF you'll receive please use the links above

---

Advanced Corporate Finance
Total Course Summary-Key Words, Analysis and Readings
...
The theories surrounding this can be classified as either supply based or demand side
...
If the adverse selection costs associated with such asymmetric information
go up during downturns, then firms will desire to issue less informationally-sensitive securities
...

-Supply: Downturns can create a ‘credit crunch’ effect whereby the total available funds are reduced,
particularly for lower rated firms
...
This then changes the relative prices of
risky and safe assets
...

-Erel et al find debt to be counter cyclical for investment grade firms and pro-cyclical for lower rated
firms, suggesting that investment grade firms raise debt capital as a result of their falling marginal
cost of borrowing, a product of the flight to quality
...

-While investment grade firms equity raising does not change across the business cycle, lower rated
firms see a pro-cyclical issuance of equity
...
Further evidence on the use of capital
suggests that the security issuance is based on supply factors
...
Lower quality firms spend a larger proportion of
capital raised even as their precautionary demand for cash rises in recessions
...
Overall it appears that the supply of
capital has greater sway over firm’s access to capital markets, than demand side considerations
...
Therefore debt capacity
of an industry is in part determined by its assets liquidation value
...
E
...
However many industries have highly specialized assets, that
are not readily deployable outside their intended use
...
But if the industry has highly homogenous exposure to shocks, ie cash flows across
firms within an industry are highly correlated, then those firms are less likely to be able to purchase
the asset given their heightened liquidity constraints
...

-Alternatively an industry ‘deep pocket’ outside investor could purchase the asset
...
Further, they will
suffer agency costs of hiring mangers to oversee the assets production
...

-Therefore creditors to a firm whose assets are specialized, but whose quality is hard to value by an
outsider and whose competitors would either be unable or unwilling to purchase its assets would face
much higher asset illiquidity in the event of financial distress
...

-The prospects of ex post losses of the resale of the asset generates an ex ante incentive to adjust
leverage to mitigate the possibility of forced asset sales at prices below value in best use
...
Either
the buyer of the asset has a lot of debt, is unable to purchase the asset in the event of a liquidity shock
and then the seller maintains good liquidity to avoid such an eventuality, or the seller has debt, in
which case the buyer avoids debt to be ready to acquire the seller
...

iii) Managerial Incentives and Debt Financing
-Entrenched CEO’s seek to avoid debt
...

-Managers who are looking to maximise their utility over their tenure, may either take on too little
debt or too much, depends on the circumstance
...

-Notably however, when attempting to maximise tenure, managers may adopt a greater than optimal
level of debt, in order to inflate their voting power of equity and reduce the possibility of takeover
attempts through a less flattering capital structure
...

-The paper finds that managers change capital structure significantly after a threat to their job
security, such as dismissal of the previous CEO, a takeover attempt or the arrival of a major
stockholder-director
...

-Since debt intrest commitments requires a level of firm performance, mangers usually have to
undertake the operating improvements a potential acquirer would have to make, benefiting
shareholders in the process
...

-Leverage also increases after managers who receive large incentive compensation awards
...

iv) Capital Structure and Firms Bargaining with Organized Labour
-A firm can use its capital structure strategically to enhance its bargaining power in negotiations with
organized labour
...

-Therefore a firm with external financing constraints has an incentive to use cash flow demands of
debt to reduce its financially flexibility to improve it bargaining position, as it is able to credibly take
a tougher stance over wage demands
...
However there are more subtle strategic roles for
capital structure that affect the product and input markets of a firm
...
Delta had too much financial flexibility
following 9/11, and too much liquidity reduced the need to cut costs and hurt the firms bargaining
position with workers
...

-Unions claim a portion of a firms realized excess liquidity-its operating cash flow net any required
debt payments
...
Because the union only earns the rent on inframarginal realizations of a
liquidity shock, the firm will always have a higher debt level with greater profit variability
...
Growth increases a
manager’s power through expanding the resources under his control, and is associated with increases
in compensation, regardless of the efficiency of that growth
...
The costs to shareholders from these activities are known as
agency costs
...
Therefore in such conditions the competitive forces of the product and factor markets that
usually ensure manager performance will be weaker and hence corporate governance mechanisms are
particularly important to minimise agency costs
...
Therefore firms with substantial
free cash flow are more suceptable to agency costs
...
Since dividends are controlled by
managers any promise to pay out cash with a ‘permanent dividend’ is intrinsically weak
...


-However by issuing debt and using the proceeds to repurchase shares from equity holders, the firm’s
managers effectively bind their promise to pay out future cash flows
...
Furthermore the threat of dismissal as a result of failing to make debt
repayments incentivises managers to make the organizations more efficient and exert a first-best level
of effort
...
Also note that a manager who issues debt but does not
use it to repurchase shares is effectively increasing the cash under his control, exacerbating agency
issues
...

-Overall we are looking to a range of conflicts of interest surrounding corporations and how to make
decisions concerning these conflicts of interest
...
(MM Proposition I)
-Capital Structure then matters only if it affects the cash flows generated by a firm
...

-In an investor can ‘undo’ a firms capital structure decision, then it cannot create value
...

-But when introducing taxes and financing decisions then capital structure does matter
...
But they react negatively to a decrease
in leverage-has a signalling effect for investors over the discipline of the companies managers
...
See also the managerial implications of debt (benefit) and strategic
implications of debt (cost/benefit)
Pecking Order Theory: Assumption of asymmetries in information when issuing securities
...
As buyers discount their
prices, sellers of good products will be more likely to drop out of the market
...
Outside investors do know the
fraction of the personal wealth committed to the project, and set their valuation accordingly
...

-If managers equity is overvalued it is more likely to issue shares, conversely if it is undervalued it
will issue debt
...
Therefore the informational asymmetries favour debt over equity,
leaving it higher in the ‘pecking order’ of types of securities desired by managers
...
When information asymmetries are severe enough firms save up a precautionary level of
cash holdings
...
This is because debt holder’s payoffs are less variable across states of the world
...

vii) Capital Structure and Corporate Strategy
-Indirect Costs of Finanical Distress
Example: Unilever and Kraft Heinz bid
...
Even though Kraft Heinz is only half the size of Unilever it tried a
takeover bid
...
Even though Unilever
saw off the bid, it should be a wake up improve the working margin of Unilever
...

E
...
(Classic issue of a bank runNorthern Rock)
...

-The firm’s environment is made up of employees, competitors, suppliers, community
...

Equally with suppliers, if you go bankrupt it can force them to liquidate specialist assets, they may
refuse to fill orders made or make longer term investments
...

-Example of this is Chrysler
...
This is in part due to the high
incentives for a company to cut costs in the face of higher cost of capital (as they are nearing financial
distress), lowering product quality, particularly when product quality is unobservable
...

-Crucially note the reading with Favara et al (2016) whereby customers, as a major influence of the
firms cash flows, can affect the debt contract of the firm
...
Leverage effects the
competitive dynamics of an industry
...

-If a company makes an announcement it will increase production, its competitors can respond in one
of two ways: 1
...
If they don’t find it
credible they maintain their current level of production
...

Therefore competitors will believe that the highly leveraged firm’s threat is credible
...
Furthermore, unless the firm has cash reserves, can they
really expand production with limited debt capacity? How will the finance the acquisition of assets to
produce more?

Financial Distress
i) Summary
-Financial distress occurs when promises to creditors are broken or honoured with difficulty
...
(Note𝑉 𝑡 = 𝑉 𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑔𝑒𝑑 + 𝑃𝑉(𝑡𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑) − 𝑃𝑉(𝑑𝑖𝑠𝑡𝑟𝑒𝑠𝑠 𝑐𝑜𝑠𝑡𝑠))
-There are direct and indirect costs of bankruptcy
...
Lehman Brothers fee’s just reached $2bn
...
Note that ultimately shareholders pay the
price of agency costs of debt, because creditors will discount the amount they are willing to pay for
corporate debt, ie charge higher interest to cover the likely agency costs
...
There may be an opportunity with a new projects to save the frim from bankruptcy
...
Japanese banks overcome this by
buying large equity stakes in the firms they lend to
...
Since debt capacity has been reached equity holders need to raise the
capital to finance a positive NPV project that would avoid bankruptcy
...

Shareholders put up the capital but share the gains with bondholders
...

iii) Asset Substitution Problem
-Furthermore, when the economy is in a ‘bust’ the equity holders will get nothing from the project,
regardless of its risk, as they have inferior claims to the firm’s assets in liquidation
...
An example of this is the FedEx founder who took the firm last $5000 and turned it
into $32,000 in Las Vegas, since the bondholders would have gained this anyway
...

vi) Debt Enforcement and Financial Distress Costs
-As firms approach financial distress, key corporate decisions surrounding a firms investment projects
become distorted away from the standard ‘invest in all positive NPV projects’
...
g
...
These agency costs of debt arise when the equity holders face limited recovery in default, i
...

when debt enforcement is strict
...
They find that as debt enforcement rules become stricter across countries firms nearly default

invest less than comparison firms, their total equity volatility is higher, and their overall asset growth is
lower than distressed firms in countries with more lax enforcement
...

-If the costs of financial distress highlighted above can be avoided by less strict debt enforcement rules,
it is possible to make both shareholders and bondholders better off
...

-The issue protective covenants on the debt, limiting dividend payments under certain conditions, the
extent of M&A activity etc
...

-The use of short term debt as opposed to long term debt ensures that the firm must go back to creditors
regularly to be ‘re-screened’ allows more opportunities for the capital markets (or private banks) to
monitor the firms behaviour
...
Campello and Gao show how a firms
customer concentration affects security design, with larger interest rate spreads, greater use of secured
debt ie back by tangible assets) or increased stringency of loan covenants
...


Equity Financing
-Case Study: Snap Inc
...
(Note that in the UK all shares have voting rights)
...
(See below for full analysis)
...
The firm sold them for $17 a share and by 11am they were trading at
$24 a share, a 44% jump
...
8% over the last 50 years
...
3%
...

i) Incentives of underwriters and firm going public
-Firms go public for three main reasons
...
2) To
achieve liquidity in the secondary market, making subsequent issues more attractive to investors who
wish to diversify their portfolios, as well as using their now valuable stock as currency in M&A
transactions
...

3) Signal stability to customers and suppliers-more credibility including having to comply with
enhanced rules and regulations (see Securities and Exchange Act 1933, and Sarbanes-Oxley 2002),
regularly disclosing financial information to investors
...
Alibaba raised £20bn with total fees of around
$400m dollars
...

-First day under-pricing is a large cost, as seen by Snap Inc and others
...
However the lower
the offered price, the more ‘money left on the table’ for the firm, hence a clear conflict of interest
...
The price that the IPO is set as will balance this discounting with the desired
capital raising of the firm
...
(See also concepts of asset liquidity and M&A activity below)
...

This caused a political upset in 2013 when Goldman Sachs and UBS where the underwriters of Royal
Mail, and subsequently they faced criticism for costing taxpayers hundreds of millions of potential
revenue
...
They could have been bluffing, however the investment
bank would not take the risk to find out
...

-‘Winner’s Curse’, if some investors are more informed than others, uniformed investors fear they will
only be allotted shares in bad/overpriced IPO’s
...

-There can be cases when the investors have information the issuer doesn’t have, namely that the offer
price is well below what you would be willing to pay for the IPO, even after the information
asymmetries etc
...

-The incentives for issuers to drive for less under-pricing in IPO’s may also be limited, often
founder/manager gets significantly wealthier during the IPO, and can be as risk averse to a flop as the
investment bank
...

-Some brief insights around the growing PIPO market;
1) PIPO’s allow firms to avoid the organization and governance problems that can plague publically
traded companies
...
PE helps to align the owners and management of the firm, with high powered interests

and the ability to impose superior governance to reduce agency costs
...

2) Private equity is often more driven to find operational efficiencies, while retaining the enhanced PE
related management and governance procedures in place for longer
...

4) There are significant implications of the trend toward private funding
...

This necessarily makes any IPO by a ‘Unicorn’ less successful, as its stock price performance will be
worse
...
If many firms wait until they are larger to go public, small cap equity
funds will suffer as there will be fewer small cap businesses listed
...

Demand Side (note this is the firms demand for PIPO capital)
-Heavy handed regulation of public firms (See costs of IPO’s above) can deter managers, particularly
those of small/midsized firms for whom the compliance costs would be a significant portion of revenue
...

-IPO’s also contain substantial costs and risk’s both direct and indirect
...
The direct costs are as above (underwriting fee’s etc
...

Supply Side (investor’s willingness to supply private capital)
...

-Previous small IPO’s have often performed poorly, leading investors to put their faith in PE superior
governance mechanisms, while privately held firms can fully develop operating models and do not have
to disclose potentially strategic financial information that could be used by competitors
...
Institutional investors believe private markets to be less efficient, less frequently
traded, with high costs of information acquisition
...


Mergers and Acquisitions
Why Merge?
-Looking for synergies, that is when the combined value of the two companies is greater than the sum
of its parts
...
Or it comes from fewer outflows, economies of scale
diminishing fixed costs, enabling the two firm to consolidate their PPE etc
...

i) Conflicts of interest between bidder managers and shareholders
-When managers of firms have free cash flow, they will want to expand the productive assets under
their control, both for the prestige of empire building, but also for the increased compensation packages
that come with greater firm size
...

-Mergers may also face specific agency issues, if managers receive merger related bonuses,
incentivising them to complete the merger even if it is a negative NPV project
...
Looking at
acquisition performance, there are considerable agency costs
...

-Valent Pharmaceuticals is renowned for acquiring promising early stage drug developers, and then
raising the price of those drugs considerably
...

-There are several motives for wanting to undertake a merger, including to gain the strategic benefits
associated with the combined market power of the two companies
...
g
...
Finally there are diversification acquisitions to boost a
conglomerates cash flows
...

ii) Explaining Merger Waves
-M&A activity tends to cluster by time and industry
...

-One of the reasons for acquisition waves is due to the perceived liquidity of a firms assets, and hence
their resale value
...
Due to greater ability to source financing for potential
acquisitions, firms are more willing to bid close to ‘value in best use’ for a firms assets
...
The
feedback effect can culminate within a specific industry at a specific point leading to M&A waves
...

-Industry shocks that require consolidation and restructuring (see Jensen 1986-oil industry requiring
consolidation)
...
They can block mergers they
deem to be against the national interest, and the political party of the time can largely determine the
appetite for mergers
...
Therefore the expected NPV $10bn of
synergies and operating improvements may be hard to materialise
...

-This is in part due to the excessively large premiums the acquiring shareholders need to pay in order
to complete the deal, such as Bayer’s $66bn takeover of Monsanto, which are often in excess of realized
synergy savings
...

They avoid private targets which tend to create value, they also avoid using all equity offers when
acquiring firms with block holders, so as to avoid the transfer to governance and monitoring of their
bidding firm to the block holder
...

-Blocks to realising synergies include widely different corporate cultures, less ability to consolidate
plants and equipment that previously thought
...
(Note 3G the Brazilin PE firm involved, is notorious for cost cutting to gain the most out of
M&A activity)
...
By assuming a large amount of debt, the high interest payments and the threat of
bankruptcy keep the managers incentivised to achieve a high leverage of operating effiency
...

iv) Empirical Evidence on M&A’s
-M&A tends to pay well for target shareholders, who gain more than 20% on average
...

-CEO overconfidence tents to help explain merger decisions
...

-Difference in premiums paid by private and publicly owned firms only occurs when the publically
owned firm has low managerial ownership, suggestive of agency costs of acquisitions not present in
private firms
...
Hedge funds have stronger financial
incentives with significant proportions of manager’s wealth in the hedge fund, while the performance
fee’s they receive are substantially larger than other fund managers
...
As a result they face light regulation,
and are able to maintain undiversified portfolios, allowing them to build large concentrated stakes in
their target firms
...
This
provides them with greater bargaining power when negotiating with management of senior companies
...


ii) What kind of firms do hedge funds target?
-Hedge funds target ‘value’ firms who have low valuations given their fundamentals, including ROA
ROE and M/B ratios
...
These target firms are generally smaller than other firms but will exhibit relatively high
liquidity and institutional ownership, enabling the hedge fund to get other sophisticated investors on
board with their governance strategy
...
Hedge funds target firms with general problems, without firm
specific issues or fundamentally challenging operational issues, as indicated by sound cash flows and
profitability
...
Other
actions such as changes in capital structure and corporate governance pose lower returns
...
They may actively press for a more concerted business strategy, or look at specific
corporate governance issues that detract from the maximisation of shareholder wealth
...
Furthermore there is limited evidence of mean reversion of
the stock price, suggesting that these hedge funds do create long term value
...
The safety of a firm’s debt claims increase while the ROA cash
flows and Tobins q increase
...
Overall
hedge funds are able to reduce agency costs, increase leverage and increase cash pay-outs through
greater share repurchases, while also improving a firms operation performance
...
However the empirical evidence is mixed, suggesting that
the act of intervention is what creates the value
...
Overall hedge
funds create value through the removal of agency costs and the increased bargaining power they have
over a target firm’s subsequent acquirer
...

i) Signalling
-A buyback singals what managers think about a company’s prospects, ie company is very confident in
its prospects, and therefore its best investment is its own shares
...
E
...
HP attempted to buy back their shares at $64 a share, yet there was
new of an aborted acquisitions, a set of poor financial results and a decay in profitability that lead to a
stock price plummet
...

-If the managers choose to participate in a share buyback themselves then by ‘not putting their money
where their mouth is’ damages the credibility of the signal
...

-This may be inappropriate if the firm has few profits to shield from tax, and could push the firm into a
state of financial distress
...

-A firm with high FCF who uses share buybacks to increase leverage can see a significant increase in
stock price, as it has successfully utilised this to curtail agency costs facing the firm
...

-In order for the buyback to send a strong signal it much breach a ‘materiality level’
...

-A buyback can be through open market purchases, a fixed price tender offer, or auction based tender
offer
...


Dual Class Firms LIKELY TO BE IN THE EXAM_USE SNAP EXAMPLE)
iii) Agency Problems in Dual Class Firms
-A dual class structure is one where superior shareholders (often managerial insiders) own a portion of
voting rights that substantially exceed their cash flow rights
...
As a result agency issues within a DC firm are substantially exacerbated
...
As the investors will discount the offered securities appropriately, the issue
ultimately internalizes this cost
...

-The agency problems associated with DC structures are limited when there is strong investor
protection
...
This cash gives the controlling
insiders the most scope to pursue wasteful spending practises
...


-However the majority of standard corporate governance mechanisms do not bond the DC manager
...
Managers also have almost complete design control over their
own compensation contracts
...

-Acquisition decisions are more likely to be value destroying
...
Capital expenditures in general are another opportunity for empire building
...
When owners of a firm
need to be highly response to changes in factor and product markets, DC structure can alleviate some
of the co-ordination problems that might impair long term strategic management
...

ii) Debt as the key corporate governance mechanism in DC firms
-Debt benefits the inferior class of shareholders by reducing the incentives and ability of controlling
insiders to expropriate firm wealth for their private consumption
...

--Debt holders can provide active monitoring outside of financial distress
...

-This extra benefit of debt in DC firms is shown in their higher M/B ratios for a given level of leverage
...
DC firms can attenuate the agency issues associated with their governance structure through the
use of debt
...


Labour Protection and Leverage
i) How labour protection laws influence firms financing decisions
Labour protection laws effectively increase operational leverage, thereby crowding out financial
leverage
...
The rigidity of these cash flows increase with labour protection laws
...
Increases in employment
protection increases restructuring costs, hence increasing the costs of financial distress
...

-Strong labour protection laws often entails significant costs in firing employees
...
Here leverage should rise with increased labour protection
...

-The implications of this are that labour may stifle growth if it crowds out external financing while
conversely incentivising firms to potentially take on riskier levels of debt, which could have a dynamic
impact on the level of unemployment in the economy
...
This enables creditors to transfer
part of the credit risk to the CDS market
...

ii) CDS and corporate cash holdings
-However CDS contracts change the nature of the relationship between firms and their creditors
...
e
...
This is the ex post
impact of CDS contracts
...

-The anticipation of greater costs of financial distress may push firms to increase their liquidity in order
to avoid these tough negotiations as the reduced risk of creditors lead them to extract more from their
debtors during renegotiations
...

-Conversely if creditor monitoring is less strict after CDS contracts, the borrowing firm may engage in
risk shifting and hold less liquidity
...
This is the ex-ante
impact of CDS contracts
...
However the extent to which CDS affect a firm’s liquidity policy is also dependant on how
likely the negotiations are to happen, i
...
how close to financial distress the firm is
...
It is highest in the external
financing regime due to the asymmetrical information issues related to equity issuance
...

iii) Empirical Evidence on CDS contracts
-Reference firms hold more cash after CDS trading starts on their debt, this cash increase is more
pronounced for firms displaying a greater precautionary demand for cash, that is those who don’t pay
dividends (as cash substitute) and those who have a higher marginal value of liquidity
...

iv) Effect of CDS on Credit Risk
-Credit risk of firms increases significantly upon the inception of CDS
...

-CDS affects the creditor borrower relationship, affecting the debts payoff
...

-CDS can also affect a firms fundamentals, leading to a higher leverage and lower interest burden
...
The
insured creditors can be incentivised to push the firm into bankruptcy rather than keeping it going
particularly when the payoff from the CDS contract is greater than the creditors would receive after a
renegotiation
...
This then imposes an agency cost of CDS contracts on the uninsured creditors
...
Having to sell assets, namely its Nand chip business to recover from
financial distress
...

The fact that they might by unable to sell their Nand chip business to the highest bidder is of serious
concern to Toshibas creditors
...




---