Management Engineering - Finance Lab + Corporate FInance

Complete Lecture Notes

Complete course

CORPORAT E FINANCE FULL LEC TURE NOTES 2019 Contents 1 – FINANCIAL ST RUC TURE ................................ ................................ ................................ ................................ ................................ ................... 5 1. INTRODUCTIO N ................................ ................................ ................................ ................................ ................................ .............................. 5 1.1. Sources of cash ................................ ................................ ................................ ................................ ................................ ...................... 5 1.2. Financial markets ................................ ................................ ................................ ................................ ................................ ................... 5 1.2.1. Taxono my of fin ancial markets ................................ ................................ ................................ ................................ ....................... 5 1.3. Capital structure ................................ ................................ ................................ ................................ ................................ .................... 6 2. MODIGLIA NI & MILLER MOD EL ................................ ................................ ................................ ................................ ................................ ... 6 2.1. Modigli ani & Miller’s model = ................................ ................................ ................................ ................................ .............................. 6 2.1.1. Demons tration (1) ................................ ................................ ................................ ................................ ................................ .............. 7 2.1.2. Demons tration (2) ................................ ................................ ................................ ................................ ................................ .............. 7 2.2. Modigli ani & Miller’s model == ................................ ................................ ................................ ................................ ............................. 7 3. THE EFF ECT OF RISK ................................ ................................ ................................ ................................ ................................ ...................... 8 3. THE EFF ECT OF TAXATIO N ................................ ................................ ................................ ................................ ................................ ........... 9 3.1. Modigli ani and M iller II wi th taxes ................................ ................................ ................................ ................................ ..................... 9 3. PROBLEM OF RAIS ING DEBT ................................ ................................ ................................ ................................ ................................ ...... 10 ................................ ................................ ................................ ................................ ................................ ................................ ........................ 11 3.1. Pecking order Theory ................................ ................................ ................................ ................................ ................................ .......... 11 3.1.1. Akerlof – The market for lemons ................................ ................................ ................................ ................................ .................. 11 4. GOVERNA NCE ISSUES ................................ ................................ ................................ ................................ ................................ ................. 12 5. EVIDENC ES ................................ ................................ ................................ ................................ ................................ ................................ .... 13 2 – DEBT AND BOND FI NANCI NG ................................ ................................ ................................ ................................ ................................ ...... 14 1. DEB T SEC UR ITI ES ................................ ................................ ................................ ................................ ................................ ......................... 14 1.1. Interest rate ................................ ................................ ................................ ................................ ................................ .......................... 14 1.1.1. Equivalence formula ................................ ................................ ................................ ................................ ................................ ........ 14 1.1.2. Continuously co mpounded rates ................................ ................................ ................................ ................................ .................. 15 1.1.3. Financial Mathe ma tics ................................ ................................ ................................ ................................ ................................ .... 15 1.1.4. Interest rate term structure ................................ ................................ ................................ ................................ ........................... 16 1.1.4. No minal and real interest rates ................................ ................................ ................................ ................................ ..................... 18 2. BONDS ................................ ................................ ................................ ................................ ................................ ................................ ........... 18 2.1. Ratin g ................................ ................................ ................................ ................................ ................................ ................................ ..... 19 2.1.1. Ra tings for countries and corporation ................................ ................................ ................................ ................................ ......... 19 2.1.2. Credit default S waps (C DS) ................................ ................................ ................................ ................................ ............................. 20 2.2. Currency ................................ ................................ ................................ ................................ ................................ ................................ 20 2.3. Ma turity ................................ ................................ ................................ ................................ ................................ ................................ 20 2.4. Coupons ................................ ................................ ................................ ................................ ................................ ................................ 21 2.5. Particular options ................................ ................................ ................................ ................................ ................................ ................ 21 2.6. Seniori ty ................................ ................................ ................................ ................................ ................................ ................................ 22 3. HOW TO EVALAUTE BO NDS ................................ ................................ ................................ ................................ ................................ ....... 22 ................................ ................................ ................................ ................................ ................................ ................................ ........................ 22 3.1. Zero Coupons ................................ ................................ ................................ ................................ ................................ ....................... 22 3.2. Coupon -paying bond s ................................ ................................ ................................ ................................ ................................ ......... 22 3.2.2. Dirty Price (prezzo tel quel P 0) ................................ ................................ ................................ ................................ ....................... 23 3.2.1. Clean Price ................................ ................................ ................................ ................................ ................................ ......................... 23 3.3. Pricing risky / illiquid bonds ................................ ................................ ................................ ................................ ............................... 24 3.4. Yield to ma turity ................................ ................................ ................................ ................................ ................................ .................. 24 3.5. Duration ................................ ................................ ................................ ................................ ................................ ................................ 24 3.6. Vola tility ................................ ................................ ................................ ................................ ................................ ................................ 24 3.7. Taxa tion ................................ ................................ ................................ ................................ ................................ ................................ . 25 3.8. Exa mple Campari ................................ ................................ ................................ ................................ ................................ ................. 25 4. BOND I SSUE AND LIS TI NG ................................ ................................ ................................ ................................ ................................ .......... 26 4.1. Bond Issue ................................ ................................ ................................ ................................ ................................ ............................. 26 4.1.1. Data abou t issu ance of bonds in the market ................................ ................................ ................................ .............................. 26 4.2. Bond listin g ................................ ................................ ................................ ................................ ................................ ........................... 27 4.3. Ita lian govies ................................ ................................ ................................ ................................ ................................ ......................... 27 5. MI NI -BO NDS ................................ ................................ ................................ ................................ ................................ ................................ . 27 3 – BONDS EXAMPLES ................................ ................................ ................................ ................................ ................................ ......................... 29 1. BOT ................................ ................................ ................................ ................................ ................................ ................................ ................. 29 2. CCT ................................ ................................ ................................ ................................ ................................ ................................ ................. 30 3. BTP ................................ ................................ ................................ ................................ ................................ ................................ ................. 31 4. PRIVATE BO ND ................................ ................................ ................................ ................................ ................................ ............................. 32 4 – SHARES ................................ ................................ ................................ ................................ ................................ ................................ ............. 33 1. EQUITY FI NANCI NG ................................ ................................ ................................ ................................ ................................ ..................... 33 1.1. Different types of shares ................................ ................................ ................................ ................................ ................................ .... 33 1.1.1. Exa mple - TI M ................................ ................................ ................................ ................................ ................................ ................... 34 1.1.2. Exa mple – FACEBOOK ................................ ................................ ................................ ................................ ................................ ...... 34 2. TAX IMPACT O N SHAR ES ................................ ................................ ................................ ................................ ................................ ............ 34 3. HOW TO EVALUATE S HARES ................................ ................................ ................................ ................................ ................................ ...... 35 3.1. Dividend Discount Model (D DM) ................................ ................................ ................................ ................................ ...................... 35 3.2. The Gordon & Shapiro model ................................ ................................ ................................ ................................ ............................ 36 3.2.1. Useful sh are ratios ................................ ................................ ................................ ................................ ................................ ........... 36 3.2.2. Explainin g value wi th profitability ................................ ................................ ................................ ................................ ................. 37 3.2.3. Profitabili ty vs. growth ................................ ................................ ................................ ................................ ................................ .... 38 3.2.4. Present Value of grow th opportunity ................................ ................................ ................................ ................................ .......... 38 3.3. Value vs Growth ................................ ................................ ................................ ................................ ................................ ................... 39 3.4. Ratio s examples ................................ ................................ ................................ ................................ ................................ ................... 39 3.4.1. P/E ................................ ................................ ................................ ................................ ................................ ................................ ....... 39 3.4.2. M/B ................................ ................................ ................................ ................................ ................................ ................................ ..... 40 4. AN EQ UITY R ESEARC H ANALYSIS ................................ ................................ ................................ ................................ .............................. 40 5. EST IMATION OF K E................................ ................................ ................................ ................................ ................................ ....................... 40 5.1. Arbitrage pricing theory (apt) ................................ ................................ ................................ ................................ ........................... 41 5.2. Fama e French three -factor model ................................ ................................ ................................ ................................ .................. 41 5.3. Haugen & B aker ................................ ................................ ................................ ................................ ................................ ................... 41 5.4. Technical analysi s ................................ ................................ ................................ ................................ ................................ ................ 42 6. BEHA VIOURAL FINANC E ................................ ................................ ................................ ................................ ................................ ............. 42 7. SECONDARY MARK ET ................................ ................................ ................................ ................................ ................................ .................. 42 7.1. Ita lian Exchange ................................ ................................ ................................ ................................ ................................ ................... 42 8. REAL SITUATIO N I N I TALY ................................ ................................ ................................ ................................ ................................ .......... 43 5 – INTERACTIO NS VALUE vs F INA NCE ................................ ................................ ................................ ................................ ............................. 45 1. VALUE AND FI NANC ING ................................ ................................ ................................ ................................ ................................ ............. 45 2. APV ................................ ................................ ................................ ................................ ................................ ................................ ................. 45 3. WACC ................................ ................................ ................................ ................................ ................................ ................................ ............. 45 3.1. The Miles & Ezzell formul a ................................ ................................ ................................ ................................ ................................ 46 3.2. The Modigli ani & Mil ler formula ................................ ................................ ................................ ................................ ...................... 46 4. HINTS ................................ ................................ ................................ ................................ ................................ ................................ ............. 46 6 – STOCK MARKET ................................ ................................ ................................ ................................ ................................ .............................. 48 1. HOW DOES STOK MARKET WORK? ................................ ................................ ................................ ................................ .......................... 48 1.1. Definitions and curiosity ................................ ................................ ................................ ................................ ................................ .... 48 1.2. Real case ................................ ................................ ................................ ................................ ................................ ............................... 48 7 – DERIVA TIVES ................................ ................................ ................................ ................................ ................................ ................................ ... 50 1. INTRODUCTIO N ................................ ................................ ................................ ................................ ................................ ............................ 50 1.1. History ................................ ................................ ................................ ................................ ................................ ................................ ... 50 1.2. Types of derivatives ................................ ................................ ................................ ................................ ................................ ............ 50 2. FORWARD ................................ ................................ ................................ ................................ ................................ ................................ ..... 50 2.1. Evalu ation ................................ ................................ ................................ ................................ ................................ ............................. 51 2.1.1. Value a t ti me 0 ................................ ................................ ................................ ................................ ................................ ................. 52 2.1.2. Exa mple - Oil ................................ ................................ ................................ ................................ ................................ .................... 52 2.1.2. If f is different there is arbitrage ................................ ................................ ................................ ................................ ................... 53 2.2. The forward price of the underlying ................................ ................................ ................................ ................................ ................ 53 2.3. Case wi th cas h flo w ................................ ................................ ................................ ................................ ................................ ............. 53 2.3.1. Oil with cos t of carry ................................ ................................ ................................ ................................ ................................ ........ 53 2.4. Exa mple of forward prices ................................ ................................ ................................ ................................ ................................ . 54 2.5. Currency ................................ ................................ ................................ ................................ ................................ ................................ 54 2.5.1 Example ................................ ................................ ................................ ................................ ................................ ............................... 55 2.6. Futures ................................ ................................ ................................ ................................ ................................ ................................ ... 55 2.6.1. Marking -to-market ................................ ................................ ................................ ................................ ................................ .......... 55 2.6.2. Exa mple – FIB future ................................ ................................ ................................ ................................ ................................ ....... 56 2.7. SWAP contract ................................ ................................ ................................ ................................ ................................ ..................... 56 2.7.1. Why a compan y should be interested in entering such a contract? ................................ ................................ ...................... 57 2.8. Hedging u sing forward and fu tures ................................ ................................ ................................ ................................ .................. 57 2.8.1. Exa mples ................................ ................................ ................................ ................................ ................................ ............................ 58 3. OPTIONS ................................ ................................ ................................ ................................ ................................ ................................ ........ 58 3.1. Payoff ................................ ................................ ................................ ................................ ................................ ................................ ..... 58 3.1.1. Long ................................ ................................ ................................ ................................ ................................ ................................ .... 58 3.1.2. Short ................................ ................................ ................................ ................................ ................................ ................................ ... 59 3.2. American vs. European options ................................ ................................ ................................ ................................ ........................ 59 3.3. How to evalua te options ................................ ................................ ................................ ................................ ................................ .... 60 3.3.1. American option ................................ ................................ ................................ ................................ ................................ ............... 61 3.3.2. Binomi al model – evaluation model ................................ ................................ ................................ ................................ ............. 61 3.3.3. Black & Scholes Model – evaluation model ................................ ................................ ................................ ................................ 62 3.4. Summary ................................ ................................ ................................ ................................ ................................ ............................... 63 3.4. Correlations ................................ ................................ ................................ ................................ ................................ .......................... 64 3.5. Hedging wi th options ................................ ................................ ................................ ................................ ................................ .......... 64 4. DER I VATIVES ON ITALIAN S TOCK EXC HANG E ................................ ................................ ................................ ................................ ......... 64 1 – FINANCIAL STRUCTURE 1. INTRODUCTION The main objective of this course is to analyze how companies finance their operations. Companies need short -term finance (for operations) and long -term finance (for investments), and also for other operations such as: R&D, to buy raw materials, to react against delayed payment . There are different instruments to raise finance: o equity capital : risk capit al provided by the shareholders o debt capital : provided by banks. Is it better to have equity capital or debt capital? Companies create value through their investments . In fact, efficient investments may create cash flows in the future. But that investments are costly (because y ou need technology, ra w materials, machinery, labor ...) and they need money in the present . In the opposite side, there are investors/f inancer s that provide cash to companies : they have money in excess in the present, they are not wi lling to consume this cash now so they want to invest it giving money to company in exchange of a return in the future . Cash is paid back, and remunerated thank to the future cash flows of the company. Investors may be individuals, banks, investment funds that have a capital surplus and they are available to offer cash on the market in exchange for a remuneration in the future. This expected profitabil ity is balanced against the risk of the business (not certain profitability, volatility, the outcome is uncertain) . 1.1. Sources of cash When a company needs cash , there are 2 different sources: • The company can sell some inv estments assets to raise money ( but this does not increase the value of the company ). • The company can raise cash wi thout touching any other assets, through debt or equ ity capital 1.2. Financial markets Thank to financial markets, the companies’ demand for capital is matched with the investors’ supply of cash . The more efficient are financial markets, more easily companies can access to capital and grow (and hire people, create valuable products or services, improve the quality of our life). Markets are not always efficient due to: o Information asymmetries : not all the people have the same information at the same time, especially for small uninformed investors o mark et imperfections create problems to financial markets and challenge this ‘virtuos’ cycle. Transactions on financial markets are regulated by contracts , which are called securities (‘titoli’) e.g. bonds, loans, shares, derivatives (forward, swaps, future, options, ...). 1.2.1. Taxonomy of financial markets • PRIMARY MARKET : dire ct channel of financing through the issuance of securities (seldom). A primary market is when a company is issuing a new security on the market and is raising money . Big companies are not alone doing this everyday because it is a complex, risky and expensive action. The companies are not even sure if investors want their securities, moreover could happen a mark et crash. To do these transactions companies has to spend a lot of money because they need tax advisors, legal advisors, private banks supporting them in this process. • SECONDARY MARKET : financial market in which financial in struments as shares and bonds (issued in the past on the primary market) are bought and sold. Each time a security is traded on the stock exchange, the company is not really interested, it just sees a change in the ownership structure of the change, but the money is not going to the com pany because money were issued on the past, it is just a continuous portfolio reallocation . • FINANCIAL INTERMEDIARIES 1: collect deposits on the market and convey it to busin esses that need to be finances. Intermediaries as banks, have an important role also in the securities market (vertical line in the scheme) . The company has to ask to the bank, that will help the company to raise this money. The bank/post office/whatever, supports the meet between the d emand of supply and money. 1.3. Capital structure Typically , a firm finances its ass ets through a combination of: • EQUITY (E): capital provided by shareholders. Equity is a title of ownership of the firm and the remuneration is residual (there is not an agreement about that). Indeed , shareholders are the last ones in the priority list of the company. Starting from the revenues of the company, then in the P&L there are the payment for the suppliers, employees, suppliers of external services, debt holders, taxes to the government, and then , at the bottom line we come to the net profit, that is for shareholders. If the company is efficient, there will be a lot of money for shareholders (think about cash cow in the BCG matrix), but this is not contractually dr iven: the bottom line can be zero or even negative . When the company raise s equity capital, it offer s to the investors the possibility to become owner of the capital of the company. They the n have the power to decide the management of the company (with different weight). The investment is associated with the payoff (or rate of return that depends on oppor tunity cost of capital ). • DEBT (D): capital raised on the market by third parties . The remunerat ion for the debt is contractually fixed at the time of signing the contract; it may not be constant, but it is known . =t doesn’t provide the right of ownership • HYBRID: convertible bonds, debt security but converti ble in equity security (like in the case of bankruptcy) From the investors point of view, it is riskier to subscribe equity capital than debt capital, because the volatility is larger and therefore the risk is larger. “Is it better to finance our projects with E or D? Does an ‘optimal’ capital structure exist?” 2. MODIGLIANI & MILLER MODEL Modigliani and Miller developed the famous Propositions I and II about capital structure irrelevance : in perfect markets and under some key assumptions, it does not matter which capital st ructure a firm decides to adopt → there is no optimal capital struct ure, the % fo r D or E is irrelevant. o D: debt of the company o E: is not the accounting value of the equity but the market value o V: market value of the asset of the company o I: investment in a specific company 2.1. Modigliani & Miller’s model I The k ey assumptions (that are not valid in the real world) are : 1) No corporate taxes : This condition actually is sufficient but not necessary, we just need tax conditions and a system that are neutral for the company when it raise s money from E or D. Typically the t ax system is not neutral, because interest on debt are tax adaptab le ( riducibili fiscalmente ): the company can account them as a cost and so it has a tax saving. If the company raise s money with E, the net profit is net of taxes, there is no tax advantage. 2) There is a unique interest rate (r%) for companies and investors. T his is not happening in the real world: banks charge different interest rate for different customers (differences between small savers, startups, big companies and so on) 3) No asymmetric inf ormation and no transaction costs : everyone have access to the same info in stantaneously and without costs or commissions. In the real world, there is info asymmetry and there are transaction costs since companies has to buy securities through a bank, a broker, with always trading commissions charged. 4) Firms can choose how to finance their operations with no endogenous limits . In the real world, us ually a bank is willing to finance a project but only up to a certain threshold. 1 Banks , funds, private banks (bank with no agencies around, they just work with companies and wealthy customers) 2.1.1. Demonstration (1) De monstration: we have two firms. They are identical from an operating point of view (sa me EBIT , same plants, same market, same employees, same prices, same product, same cost structure ), with one exception: o UNLEVERED (U): financed only with Equity → ⤲⥈⥙ ⥕⥐⥕⥎⥚ ⷙ= ⤲⤯⤶⥁ o LEVERED (L): financed with Equity and als o Debt → ⤲⥈⥙⥕⥐⥕⥎⥚ ⷐ= ⤲⤯⤶⥁ −⥙⟦⤱ⷐ Assume that we have two different portfolios: 1) In the first case, we buy 5% of the company (we buy the 5% of the shares of the E) ⤶ⵀ=▂△ (⤲ⷙ) → ⧳ⵀ= ▂△ (⤲⥈⥙⥕⥐ ⥕⥎⥚ ⷙ)= ▂△ (⤲⤯⤶⥁ ) 2) In the second case, we buy both 5% of Equity and Debt. ⤶ⵁ= ▂△ (⤲ⷐ)+▂△ (⤱ⷐ) → ⧳ⵁ=▂△ (⤲⥈⥙⥕⥐⥕⥎⥚ ⷐ)+▂△ (⥙⟦⤱ⷐ)= ▂△ (⤲⤯⤶⥁ −⥙⟦⤱ⷐ)+▂△ (⥙⟦⤱ⷐ)= ▂△ (⤲⤯⤶⥁ ) The final outcome depends only on the EBIT . In finance, each time we have two different portfolios with the same payoffs, it means that also the initial values of the two portfolio must the same (V L = VU). R aising debt, the company didn’t create any adding values in the asset of the company. In conclusion, there are two different portfolio s with the same payoff → in an equilibrium market ▂△ (⤲ⷙ)= ▂△ (⤲ⷐ)+▂△ (⤱ⷐ) → ⤲ⷙ= ⤲ⷐ+⤱ⷐ → ⥃ⷙ= ⥃ⷐ 2.1.2. Demonstration (2) In this case there are again two different portfolios: 3) Invest in the equity capital of the levered compan y ⤶ⵂ= ▂△ (⤲ⷐ) → ⧳ⵂ=▂△ (⤲⥈⥙⥕⥐⥕⥎⥚ ⷐ)=▂△ (⤲⤯⤶⥁ −⥙⟦⤱ⷐ) 4) invest in the equity capital of the unlevered company, and we borrow money from the market (for an amount equal to the 5% of the debt of the levered company). We have a minus because the profit is affected by the “self financing”, the money that I borrow from the market u sed to buy the shares of E U (is like reducing the investment in the debt of the levered company) . ⤶ⵃ= ▂△ (⤲ⷙ)−▂△ (⤱ⷐ) → ⧳ⵃ= ▂△ (⤲⥈⥙⥕⥐ ⥕⥎⥚ ⷙ)−▂△ (⥙⟦⤱ⷐ)=▂△ (⤲⤯⤶⥁ )−▂△ (⥙⟦⤱ⷐ)= ▂△ (⤲⤯⤶⥁ −⥙⟦⤱ⷐ) Again, we have 2 portfolios with the same payoff → in an equilibrium market 2 ▂△ (⤲ⷐ)=▂△ (⤲ⷙ)−▂△ (⤱ⷐ) → ⤲ⷐ=⤲ⷙ−⤱ⷐ → ⤲ⷙ=⤲ⷐ+⤱ⷐ → ⥃ⷙ= ⥃ⷐ From this example, we can say that the reason why a company can’t create value with debt is that in the market everyone can create his own optimal fina ncial structure. In portfolio n° 4 I am repli cating the financial structure of the levered company → payoff of levered company is always replicable by investing in shared of an unlevered company and borrowing for the money from the market . firms raising debt do not create value because investors have the same opportunity to raise debt at the same conditions 2.2. Modigliani & Miller’s model II 3 Modigliani & Miller’s Tradeoff Theory of Leverage : as the proportion of Debt in the firm’s capit al structure increases, the profitability expected by shareholders increases in a linear function under the assumption that the return of investments is larger than the interest rate on debt (r). o kE= expected profitability of equity capital o kA = expected profitability of the company assets For sake of simplicity consider a company that every year exhibits the same constant operating margin EBIT. Under this assumption we have: 2 on financial market, if we have two portfolios with the same outcome but different initial value, there is an arbitrage opportunity : we can earn money with no risk by selling one portfolio and buying the other one 3 see exercise 1 ⥒ⷉ= ⷒⷣⷲ ⷔⷰⷭⷤⷧⷲ ⷉ and ⥒ⷅ= ⷉⷆⷍ ⷘ ⷚ ⥒ⷉ= ⥌⥈⥙⥕⥐⥕⥎⥚ ⤲ⷐ =⤲⤯⤶⥁ −⥙⟦⤱ⷐ ⤲ⷐ ⟦⤱ⷐ+⤲ⷐ ⤱ⷐ+⤲ⷐ= ⤲⤯⤶⥁ ⤲ⷐ ⟦⤱ⷐ+⤲ⷐ ⤱ⷐ+⤲ⷐ−⥙⟦⤱ⷐ ⤲ⷐ ⟦⤱ⷐ+⤲ⷐ ⤱ⷐ+⤲ⷐ= ⤲⤯⤶⥁ ⤲ⷐ ⟦⤱ⷐ+⤲ⷐ ⤱ⷐ+⤲ⷐ−⥙⟦⤱ⷐ ⤲ⷐ = = ⤲⤯⤶⥁ ⤲ⷐ+⤱ⷐ⟦(⤱ⷐ ⤲ⷐ+╾)−⥙⟦⤱ⷐ ⤲ⷐ= ⤲⤯⤶⥁ ⤲ⷐ+⤱ⷐ+⤱ⷐ ⤲ⷐ⟦(⤲⤯⤶⥁ ⤲ⷐ+⤱ⷐ−⥙)= ⤲⤯ ⤶⥁ ⥃ +⤱ⷐ ⤲ⷐ⟦(⤲⤯⤶⥁ ⥃ −⥙)= ⥒ⷅ+⤱ⷐ ⤲ⷐ⟦(⥒ⷅ−⥙) The result of the demonstration is similar to the financial leverage with the accountin g value (not the market one): ⤿⤼⤲ = ⤿⤼⤮ +⤱ ⤲⟦(⤿⤼⤮ −⥙) • KA = the profitability of assets : is nothing else than the weighted average (ratio between D/V and E/V ) of K E and r . • The firm is financed with both E capital and D capital. The debt is risen with an interest rate r. The expected profitability for shareholder is therefore residual. ⤿⤼⤲ = ⤿⤼⤮ ⟦(╾− ⵀ ⷍ ⷇ⷖ )⟦(╾+ ⷢⷣⷠⷲ ⷉⷯⷳⷧⷲⷷ ) where ⤶⤰⤿ = ⷭⷮⷣⷰ⷟ⷲⷧⷬⷥ ⷮⷰⷭⷤⷧⷲ (ⷉⷆⷍ ⷘ ) ⷤⷧⷬ⷟ⷬⷡⷧ⷟ⷪ ⷧⷬⷲⷣⷰⷣⷱⷲⷱ ROE (shareholders point of view); ROA (overall company p.v.); 1/ICR (stakeholders p.v.) • The relation between ROA and ROE is mediated by the effects of debts • ROE is directly connected to ROA, it is very important to be efficient by creating EBIT with the lowest amount of resources • Increasing D/E (increasing bank debts or issuing new bonds) amplifi es ROE over ROA • Increasing D/E ratio also reduces ICR as increases the amount of interest to be paid. In this way, the company can become riskier , because it is necessary to generate more revenues in order to cover all the interest costs. The more you are in debt, the most the bank will be skeptical that you will be able to reply it (the more you increase D, the more you decrease ICR). If the ICR decrease, ROE decrease. So it is very important to consider the trade -off between the debts and the equity . 3. THE EFFECT OF RISK 4 The ultimate reason why the value of the share is constant (albeit the expected profitabilit y increases), is related to risk . Every time the company raise s the debt , it is increasing also the risk for shareholders, the volatility of their outcome. For this reason , the price of the s hares is not changing (we are increasing the profitability but risk is increasing as well) → the t wo effects are counterbalanced → the company is not creating va lue. The volatility of shareholders increases if the Debt increases. In case of unlevered company, the volatility of the business i s exactly the volatility of shareholders. In case of leverage, the shareholders profitability is residual. A change in EBIT causes a change in the profit more or less pronounced because of the leverage effect. In the real world, the future EBIT can be estimated, but is affected by risk (volatility). Assume that: ⥒ⷅ= ⷉⷆⷍ ⷘ ⷚ has variance ⫗⳦, r is known and does not have variance: then 5... ⧵ⵁ(⥒ⷉ)=⧵ⵁ⽯⥒ⷅ+⤱ ⤲⟦(⥒ⷅ−⥙)⽳= ⧵ⵁ⽯⥒ⷅ⟦(╾+⤱ ⤲)−⤱ ⤲⟦⥙⽳= ⧵ⵁ⟦⥒ⷅ⟦(╾+⤱ ⤲) ⵁ 4 2008 financial crisis . From that moment on, the bank started to ask company to reduced the debt because they were lending money to many companies and it was too risk y. After the crisis, the profit of the companies were going down with a consequent negative PIL grow rate; than profitability of investment started to go down and many levered companies disappeared because of the dark side of the leverage effect. Many company had t o bargain with banks to postpone the payment of debt or even to transform the debt into equity capital. The ideal situation in which you can leverage with debt is when the cash flows are stable because are guaranteed by a state e ntity (like renewable energy sector) 5 see exercise 1 - the dark side of the leverage 3. THE EFFECT OF TAXATION When we remove any of the key assumptions, the M&M theory fails. Assuming that there is a taxation and tc is the tax rate on corporate income . Each time a company has an income, the company has to pay taxes. Considering the two cases: 1) Unlevered company: ⥛⥈⥟⥌⥚ = ⥛ⷡ⟦⤲⤯⤶⥁ ⥌⥈⥙⥕⥐⥕⥎⥚ = ⤲⤯⤶⥁ ⟦(╾−⥛ⷡ)= ⧳ⷙ (total cash distributed to investors ) 2) Levered company: ⤲⤯⥁ = ⤲⤯⤶⥁ −⥙⟦⤱ ⥛⥈⥟⥌⥚ = ⥛ⷡ⟦(⤲⤯⤶⥁ −⥙⟦⤱)=⥛ⷡ⟦⤲⤯⥁ ⥌⥈⥙⥕⥐⥕⥎⥚ = (⤲⤯⤶⥁ −⥙⟦⤱)⟦(╾−⥛ⷡ) ⧳ⷐ= (⤲⤯⤶⥁ −⥙⟦⤱)⟦(╾−⥛ⷡ)+⥙⟦⤱ =⤲⤯⤶⥁ ⟦(╾−⥛ⷡ)+(⥛ⷡ⟦⥙⟦⤱) The total payoff of the levered company to all investors is larger than the unlevered . The delta is ◊⧳= ⥛ⷡ⟦⥙⟦⤱ The levered company pay less than the unlevered, and the difference is equal to the extra payoff that the levered company is able to pay investors. The higher is the tax rate, the higher is the advantage for the company to increase the debt because i t increa ses also the effect of the tax shield . The Levered firm generates each year an extra aggregate cash flow for its investors (shareholders and debtholders, due to tax savings) thus new value is created . Cash flow distributed to Debtholders is tax -deductible, whereas cash flow distributed to Equityholders is not. ◊⧳=⥛ⷡ⟦⥙⟦⤱ is the annual differential cash flow . We are interested to evaluate the value today of all the future cash flow, so we have to discount the cash flow from the k (cost of capital ). It is the interest rate that the company require from each investor. ⤽⥃ (⥛⥈ ⥟ ⥚⥈⥝⥐⥕⥎⥚ )=⥛ⷡ⟦⥙⟦⤱ ╾+⥒ +⥛ⷡ⟦⥙⟦⤱ (╾+⥒)ⵁ+⢹ If tax savings do not depend on the business risk (i.e. the level of debt each year is pre -determined), then k = r If we assume that debt D is constant and equal for each year i ndefinitely and we will not be reimbursed, it means that the PV of the tax savings is the sum of an infinity number of cash flow: ⤽⥃ =◎ ⥛ⷡ⟦⥙⟦⤱⟦ ⵀ (ⵀⵉⷰ)⻪ ⷁⷲⵋⵀ =ⷲ⻙⟦ⷰ⟦ⷈ ⷰ → considering the geometric series → ⤽⥃ = ⥛ⷡ⟦⤱ Indeed the sum is converging to a certain limit. The company is raising money for the amount of D, and the D is fixed each year (it is constant). We can say that the levered company is generating money. Thus the assets of the levered company are more valuable (M&M proposition n°1) : ⥃ⷐ= ⥃ⷙ+⥛ⷡ⟦⤱ VL is larger because of tax savings of each yea r in the future up to infinity. So the expected profitability of assets K A will be different and will depend on D. Under the previous M&M assumptions, K A is a constant (if the EBIT is given ) because it doesn’t depend on financial structure (because EBIT doesn’t depend on financial structure as well and the value of assets is the same ). Now we discover that the value of the assets is no more the same because the financial structure matters and consequently K A can not be constant → with taxe s the profitability of assets k A will depend on D . 3.1. Modigliani and Miller II with taxes Are we able to adjust M&M proposition n°2 as a consequence of what has been said before? It is necessary to take into account the debt and the fact that the Net Profit has to be taxed . ⥒ⷅ⟦= ⷉⷆⷍ ⷘ ⷚ⻈ → Asset expected return gross of taxes ⥒ⷉ⟦= ⷒⷣⷲ ⷔⷰⷭⷤⷧ ⷲ ⷉ =(ⷉⷆⷍ ⷘ ⵊⷰ⟦ⷈ)⟦(ⵀⵊ⥛⥊) ⷉ ⟦ⷈⵉⷉ ⷈⵉⷉ= [⥒⤮⟦+ ⤱ ⤲⟦(⥒⤮− ⥙)]⟦(╾−⥛⥊)= ⥒⤮⟦⟦(╾− ⥛⥊)+ ⤱ ⤲⟦(⥒⤮− ⥙)⟦(╾− ⥛⥊) → Equity expected return with taxation effect Remember that, with taxes, ⥒ⷅ⟦ will depend on the company leverage (wh ile under the M&M assumptions ⥒ⷅ is constant wit h the leve rage). This because V L is depending on the company leverage. And moreover, we have to consider taxation for investors (personal burden) We are considering only the taxation the level of the company, but in the real worl d, we have to consider the taxation also for the profits of the investors. If we consider the effect of the D, we understand that for company is favorable to have a higher level of D as they can, but in the real world we don’t see company that every day tray to r aise the debt. Indeed we have to take into account more things: 1) Tax savings are limited and the limit is operating margin: if the operativ e margin of the company is zero or close to zero, increasing the debt has no sense because the company is not paying taxes. 2) Most countries impose restrictions on the deduction of interests (‘anti thin -capitalization rules’) like =taly: the reason is that if you have a profitable company and you want to save on taxes , many company issued debt (bonds) and the debt was subscribed by the family members with a very high interest rate. The larger is the corporate inter est rate, the higher is the tax shield . Th e marginal tax rate in Italy is 30%, but up to the ’90 it was 53.2% so the incentive for small company to rise the debt and save on taxes was very large. The government understand the cheating so it putted a limit in the interest rate and so a limit in the tax saving and secondly they said that since the debt was rise from the owner, it was a hidden distribution of profits, so it was considered equity capital and not rising of debt. 3) When Debt is too high, a number of problems arise , as we see in the follow ing chapter 3. PROBLEM OF RAISING DEBT When the level of Debt is too high, some costs for the firm arise: 1) COSTS OF FINANCIAL DISTRESS – BANKRUPTCY COSTS : As the debt increases, the probability of a default increases: the company may not be able to pay back debt. When D≈V there is an high risk/probability of default, and in these condition could be very difficult to pay back the debt. When a default occurs, all the assets of the firm are sold and creditors receive the cash collected according to a hi erarchy: suppliers – employees – debtholders. Even if assets are not sold, debt must be re -negotiated. This implies a number of costs: • legal fees : litigations, administrative procedure, consultants, advisors. • liquidation costs : you have to sell your assets in order to rise money at a lower price in comparison to the market price. This is due to the fact that the acquirers know that the seller is on trouble and so they offer a price lower than the real market value (the bargaining power of the seller i s really low) • image damages : when you are not sure if the company is going to default and so you do not have trust on it and you don’t invest on it or even buy its service/products 6 • tight payment conditions imposed by suppliers and other financiers : they want to be payed immediately Such bankruptcy 7 costs are discounted in advance, even if the company at the current moment is not in default (but it’s getting clos e and the probability increases ). In financial market expectation are always very important (p rices today are created based on future expectations). 2) AGENCY COSTS 8: They refer when there is a Principal -Agent problem (there is a principle and an agent and the principle is telling to the agent to make something in his interests, the principal is the debtholder and the agent is the manager of the company) . This problem usually arise s when the company is close to bankruptcy. The Agent is delegated by the Principal (in 6 Alitalia 7 Lehman has to pay 1bn$. So when the company goes in defaulf ha salso to pay some money 8 see exercise 1 → risk shifting our case the Debth older invests in the company managed by Equity investors), but the Agent may act opportunistically maximizing his interests and not the Principal’s interest. Reasons: • Information asymmetry : the Principal is not able to totally control the Agent or correctl y judge his actions (if he is behaving in a good way, respecting the Principal) ; • Moral hazard : the Agent has an incentive to maximize his utility function. The manager usually want to max imize the advantages for equity holders rather than debt holders. The debt holders want to see the money back and wa nt their interests to be payed back; the shareholders want to se e the value of the shares rising up. If the company i s wealthy there are no problems, the problems arise when the company is close or in default. Agency costs do generally characterize the relationship between Debtholders and Equityholders (and also between Controlling and Non -controlling Shareholders, but if the company is close to default the problems are more relevant... • x: value of the debt • y: value of the assets • green line : is the line related to the M&M proposition → the V of the assets depend on financial policy • blue line : is the benefit of debt (tax saving) that is quantifiable as t c*(r*D) under the assumptions that D is constant and that tax benefits are applicable for the company . The blue line will not increase indefinitely, at a certain point, the tax benefits are over. • Red line : is the actual firm value; it takes into consideration that after a certain threshold of the level of the debt, some costs are arising ( bankruptcy costs and agency costs ). If the level of the debt is reasonably low, the tax savings can help, but if the level become too large, costs occurs. • D* : is the optimal level of debt that maximizes the Value of the firm. That’s the best trade -off between tax savings and costs of Debt. The level of the optimal amount of Debt depends also from the characteristics of the firm → TRADE -OFF THEORIES 3.1. Pecking order Theory There is not an optimal financial structure, but there is a kind of priority/classification that help the manager to choose the financial structure. The Pecking order theory is a competing theory and states that the cost of financing increases with asymmetric information (means that in the market there is somebody that have better information, or better access to information) → it means that with asymmetric information, the market is not efficient. Companies priori tize their sources of financing in this order: 1. Avoid the market preferring internal financing ( bootstrapping ) 2. Raise debt 3. Raise equity as a last choice. Equity is less preferred because when managers issue new equity, investors believe that managers know that the firm is overval ued and managers are taking advantage of this over -valuation. This is clearly demonstrated by Akerlof... 3.1.1. Akerlof – The market for lemons A lemon is a car found defective only after it has been bought.In the market of used cars , buyer can’t distingu ish a good quality car (G) from a lemon (B) ; the value of the latter is much lower than the first → ⥃ⷆ⠲ ⥃ⷋ. Sellers perfectly know whether they propose a go od car or a lemon; they have an incentive to say that they are type -G cars, and sell them at the largest price. The information given by sellers is not credible (due to information asymmetry) , so buyers are not able to distinguish good from bad cars and they automatically discount the cars and attribute a medium expected value → e.g. (if probabili ty is 50%/50% ⷚ⻃ⵉⷚ⺾ⵁ ) For the buyer is not convenient to sell the good quality car because he sells it at a lower price, it is more convenient to s ell the bad quality car because he will have a gain. Buyer s submit an offer at this value → Sellers wil l sell only lemon cars and good cars exit from the market. So buyers offer ⥃ⷆ when buying car ( signalling effect ) The final equilibrium is the Nash Equilibrium (suboptimal), is not an optimal equilibrium because: • Good quality car will exit from the market → the seller has no incentive to sell the good quality car because the price is too low . This is due to the fact that the seller can’t credibly tell the buyers if tha t car is good. • In the market, there will be onl y low quality cars Companies raising capital are like cars : there are good companies that look for money to fund projects with positive NPV, while there are companies that want to raise money to invest in bad quality projects (NPV < 0). This can be a con sequence of managers’ opportunistic behaviors; but the point is that we can’t distinguish good companies from lemons (the younger is the company, the bigger is the risk). Good companies will not go to the market and rise money because they cannot point out to the investors that they are good companies, and investors are not able to “cherry pick” ( =choosing the winner), and they will bid an average price, that is not fair fo r good companies → good quality project are under valuated. The signal in this situation is that if one company goes to the market to raise money, it means that its project is bad. For this reason, companies prefer to rely on bootstrapping, trying to manag e efficiently receivables and payables for example. To show that the company is a good one, there are different methods: • Ratings : the company will select an external auditor and ask to him for an assessment/certification about the wealth of the company a nd attesting the fact that this company is not cheating • Disclosing the financial statement : listed company are obliged to disclosure the financial statement . Some companies, like in the star segment in the stock exchange, have to disclose accounts each quarter, to be as transparent as possible. Also, companies attach non -mandatory documents , but important t o reduce info asymmetry (notes) • Independent directors: External members in the board of the company . The company appoint some people that are not directly linked to the controlling shareholders, that are know as experts in the fields, can pr ovide the signal about what the company is doing (in the interest of shareholders and investors ) The commo n thing that all this provisions have , is the high cost . Again the equilibrium is not the pareto -efficient equilibrium, because the companies that want to signal they wealth in the market, have to spend money. 4. GOVERNANCE ISSUES Governance issues impact on the process of firm financing. • EXTRACTION OF PRIVATE BENEFITS : controlling shareholders may extract private benefits from the company (i.e. inefficient use of company cash); such danger is discounted by small minority shareholders - see Jensen & Meckling model 9 (the larger is the separation between ownership and control, the larger will be the probability that the manager wil