Corporate Finance: Key Concepts and Applications
Shareholder Control vs. Managerial Influence: Over time, shareholders may have lost control over corporations relative to managers. Managers have access to firm resources and may use them to enact changes in corporate governance rules or laws that benefit them. Most common stockholders, except for large institutional shareholders, have little financial incentive to lobby their interests due to the small size of their investment compared to the firm’s overall size. Shareholder rights initiatives are often led by institutional or large individual investors.
Internal Funds: Firms rely heavily on internal funds because depreciation plus retained earnings make up a large portion of funds invested by U.S. corporations each year. The high cost of issuing new equity is a primary reason, as corporations try to minimize these costs. Another reason might be to avoid the discipline of the security market.
Sources of Corporate Financing
Major sources of financing available to corporations include:
- Common and preferred stock
- Debt, including bonds and convertible bonds
Shareholder Voting Rights
Common stockholders have the right to vote, either in person or by proxy, in the election of directors to the board. Important decisions like mergers must be submitted for shareholder approval. Different classes of common stock can have different voting rights.
Features Increasing Corporate Bond Value
Features that increase the value of a corporate bond include the bond’s convertible provision and the collateral associated with the bond. A conversion feature allows the bondholder to exchange the bond for a predetermined number of shares. A firm may also set aside some of its assets specifically for the protection of particular bondholders. This is called collateral, and such bonds are called secured bonds. Both of these features increase the value of bonds that have them.
Functions of Financial Institutions
The various functions of financial institutions include:
- The payment mechanism
- Borrowing and lending
- Pooling risk
Venture Capital
Equity investment in start-up private companies is commonly known as venture capital. Venture capital organizations help provide venture capital to deserving start-up firms. Some large technology firms like Intel and Sun Microsystems also provide venture capital to new innovative firms.
Initial Public Offering (IPO)
When a firm issues securities to the public for the first time, it is called an IPO. This is an important decision for the firm as it involves disclosing a lot of information to the public. Generally, IPOs are underpriced.
Conversion Ratio
The number of shares received for each bond is called the conversion ratio. This is fixed for the life of the bond.
Bond Indenture Provisions
A typical bond indenture is a written agreement between the corporation and a trust company representing the bondholders. The trust company ensures that the provisions of the indenture are observed and generally looks after the interest of the bondholders. The indenture includes the basic terms of the bond, a description of property used as security, details of the restrictive covenants, and other provisions.
Using Industry Beta to Estimate Cost of Capital
Generally, an industry beta can be estimated more precisely than a company’s beta. This is similar to the estimate of the beta of a portfolio being more precise than the estimate of the beta of a single stock. The estimated industry cost of capital must be suitably adjusted before using it as the company’s cost of capital. For example, one must account for differences in the capital structure of the firm versus the industry.
Estimating Cost of Equity Using CAPM
The first step estimates the beta of the firm’s common stock by regressing the returns on the stock on the market returns using historical data. The expected stock return is estimated using CAPM [E(R) = rf + (beta)(rm – rf)]. Expected return is the estimate of the firm’s cost of equity.
Factors Determining Asset Betas
Factors that determine asset betas include the cyclical nature of the cash flows. Cyclical firms have higher betas. Operating leverage also affects the asset beta of a firm. Firms with high fixed costs tend to have higher asset betas.
SEC Rule 10b-18
SEC Rule 10b-18 protects repurchasing firms from accusations of share-price manipulation. Open-market repurchases are subject to several restrictions, however. For example, repurchases can’t exceed a small fraction of daily trading volume. Before this, firms that repurchased their shares were liable for prosecution for manipulating their share price.
Methods of Paying Dividends
Different ways in which a firm can pay dividends to its shareholders:
- Firms pay a regular cash dividend each quarter.
- Occasionally, firms pay extra or special dividends.
- Firms declare stock dividends, where shareholders receive additional shares of stock instead of cash.
- Many times firms might repurchase their own stock in lieu of paying dividends.
Information Conveyed by Share Repurchases
Share repurchases convey the following information to investors:
- Firms repurchase shares when they have accumulated cash that they are not able to invest profitably.
- Share repurchases may indicate an underpriced stock.
- Share repurchase may also be used to signal management’s confidence in the future of the firm.
Miller and Modigliani’s Proposition on Dividend Irrelevance
In a world without taxes, transaction costs, or other market imperfections, the firm’s choice of dividend policy is irrelevant to the value of the firm.
Arguments for Increasing Dividends
Dividend proponents argue that increasing a firm’s dividend will increase its value. Key points:
- Investors prefer cash to capital gains as cash dividends are certain and capital gains are uncertain.
- Many investors prefer cash, as they need it for living expenses.
- Investors see the information contained within dividend payments as objective evidence of a firm’s good performance.
Tax Advantage View on Dividends
If dividends are taxed at a higher rate than capital gains, firms should pay the lowest cash dividends. By shifting their distribution policy, corporations can transform dividends into capital gains. They favor low dividend payouts.
Middle-of-the-Roaders’ Position on Dividend Policy
Middle-of-the-roaders hold that a firm’s value is not affected by its dividend policy.
Sequence of Events in Dividend Payment
The sequence of events of a firm’s dividend payment is as follows:
- The board of directors sets the dividend for a firm.
- The date on which the board of directors announces the dividend is called the declaration date.
- Dividends will be paid to those who are registered shareholders as of the record date.
- One business day prior to the record date is the ex-dividend date. Shares bought on the ex-dividend date or later do not come with the dividend.
- Dividend checks are mailed to shareholders on the payment date.
Interest Tax Shields and Stockholders’ Equity
Generally, levered firms pay less tax than equivalent unlevered firms. The savings in taxes is called the interest tax shield. U.S. firms can deduct interest payments as pre-tax expenses, thereby reducing the level of taxable income. Hence levered firms have lower tax payments. This in turn increases the value of the firm.
MM Proposition I Modified with Taxes and Financial Distress
Financial distress occurs when bondholder contracts are broken or fulfilled with great difficulty. Financial distress could lead to bankruptcy and is costly. This is reflected in the market value of the levered firm. Value of a levered firm = value of an equivalent unlevered firm + PV(tax shield) – PV(cost of financial distress).
Trade-Off Theory of Capital Structure
A firm’s debt-equity decision can be thought of as a trade-off between interest tax shields and the present value of the costs of financial distress. These two interact to provide an optimal capital structure for a firm.
Credit Risk
Credit risk, or default risk, is the risk that payments on a security will not be made under the original contract terms.
Junk Bonds
Junk bonds have high default risk compared to higher-rated bonds, and the yield on these bonds is also high. Junk bonds have been commonly issued to finance LBOs.
WACC Advantages and Limitations
Advantages and limitations of using the weighted average cost of capital (WACC) as a discount rate to evaluate capital budgeting projects:
- WACC is simple to calculate and use.
- A disadvantage is that it applies only to projects having the same business risk as the firm.
- It also implies that the debt-equity ratio is held constant.
- It can only be used when the debt-ratio is known, but the value of the debt need not be known.
- It automatically takes into account the tax-shield effect of debt.
Credit Default Swaps (CDS)
A credit default swap (CDS) is an arrangement by which investors can insure corporate bonds. If an investor buys a credit default swap, he/she commits to pay a regular insurance premium or spread. In return, if the firm subsequently defaults on its debt, the seller of the swap pays the investor the difference between the face value of the debt and its market value. Credit default swaps have proved very popular, particularly with banks that need to reduce the risk of their loan portfolios.
Bond Ratings
Bond ratings are a qualitative measure of a bond’s default risk. Moody’s, Standard & Poor’s, and Fitch assign these ratings for a fee. AAA (S&P) or Aaa (Moody’s) rated bonds have the least default risk. Bonds rated BBB (Baa) and above are known as investment-grade bonds. Bonds rated below BBB (Baa) are known as junk bonds as these have much higher default probabilities.
APV for Valuing a Business
The value of a business can be estimated by calculating the present value of free cash flows (FCF) generated by a firm using the firm’s opportunity cost of capital as the discount rate for the life of the firm. This gives the base-case NPV. Business debt levels, interest, and interest tax shields are calculated. If the debt levels are fixed, then the interest tax shields are discounted at the borrowing rate to get the present value of interest tax shields. The value of the firm is the base-case NPV plus the present value of interest tax shields.
Credit Scoring
Credit scoring is used to distinguish between good credit risks and bad credit risks. Analysts use credit scoring models for this purpose. These models are used by banks, credit card companies, and businesses to assess the credit rating of their clients or customers before providing loans or extending credit facilities.
Predicting Firm Failure
Beaver, McNichols, and Rhie developed an empirical model to predict the chance of failure of a firm during the next year relative to the chance of not failing. It is given by the following model: Log(relative chance of failure) = -6.445 – 1.192 ROA + 2.307 (liabilities/assets) – 0.346(EBITDA/liabilities). It is based on three ratios: ROA, liabilities/assets, and EBITDA/liabilities.
Swap Contracts
A swap contract involves an exchange of securities or currencies between two firms. It consists of a bundle of forward agreements spanning some predefined period. At each point (e.g., quarterly) one party will deliver, for example, a fixed interest payment in exchange for a floating interest payment. The swap arrangement allows the two parties to offset unwanted risks with counterparties better economically situated to bear that risk. Swaps don’t eliminate counterparty risk.
Using Swaps for Interest Rate Exposure
A firm desiring a floating rate investment but with a comparative advantage in obtaining a fixed-rate investment can invest in a fixed-rate investment and then enter into a swap arrangement with a counterparty to exchange the fixed rate of return for a floating rate return.
Double Taxation of Shareholders’ Returns in the USA
Shareholders’ returns are taxed at the corporate level as corporate tax. Distributions of the remaining earnings are taxed a second time at the shareholders level as either tax on dividends tax or as capital gains tax.
Imputation Tax System (ITS)
In an ITS, shareholders are taxed on dividends, but they receive a tax deduction, which is equal to their share of the corporate tax that the company has paid.
Using WACC for Valuing a Business
The value of a business can be estimated by calculating the present value of free cash flows (FCF) generated by a firm using WACC as the discount rate. FCFs are estimated by accounting for profits after taxes, plus depreciation, less investments in fixed assets, and investments in working capital. From a practical point of view, FCFs are estimated for a few years and the present value of the horizon value is calculated using a reasonable constant growth rate for the rest of the horizon. The value of the firm is the present value of free cash flows plus the present value of its horizon value.