Corporate Finance Final

Two objectives of the board to design CEO compensation

1. Alleviate problems with separation of ownership and contorl (agency problems)

2. Attract and retain better managers

Variation of Law of One Price

If two investments provide the same future cash flows, they must have the same current value. Otherwise, arbitrage will occur to eliminate the price difference.

Why do investors borrow personally when a levered firm is overvalued?

To replicate the cash flows of the overpriced levered firm more cheaply by mimicking its capital structure. Investors borrow the same amount as the firm’s debt and use it to buy the unlevered firm, creating the same payoff for a lower price — resulting in arbitrage.

What do investors do when a levered firm is undervalued?

They sell the unlevered firm and replicate it by buying the undervalued levered firm and lending money (equivalent to the firm's debt). This creates the same future cash flows for a lower cost, resulting in arbitrage.

M&M without taxes: Does adding debt and using less equity, lower wacc

No because savings from using cheaper debt are exactly offset by an increase in required return (and risk) of remaining equity.

M&M without taxes: Does wacc vary based on capital structure without taxes

no

Who pays more in taxes. Levered firm or unlevered firm?

Unlevered firm. Thus the sum of the debt plus equity of the levered firm is greater than the equity of the unlevered firm.

Is Interest Expense tax deductible?

Yes

Are dividends tax deductible

No

M&M with taxes: Will adding debt and using less equity lower wacc

Yes; cost of equty rises, but less due to the tax deductibility of interest. After tax cost of debt is also lower due to deductibility of interest. These combine to offset the increase in cost of remaining equity

Financial Distress

difficulty or failure in making promised payments to creditors

Direct costs of distress

legal and administrative costs

Indirect Costs of Distress

1. Impaired ability to conduct business. eg lost sales

2. costs associated with shareholder/creditor conflicts
   - Incentives to take large risks
   - incentives to underinvest
   - Milking the property

What is "Incentives to take large risks" in financial distress?

➔ When near bankruptcy, shareholders prefer high-risk projects.
➔ If successful, shareholders gain; if not, losses are limited because the company is already distressed and shareholders get $0 anyways.

What is "Incentives to underinvest" in financial distress?

➔ Distressed firms may avoid funding good projects because the benefits mainly help creditors, not shareholders.
➔ Shareholders have little reason to invest their own money if they won't personally capture the rewards.

What is "Milking the property" in financial distress?

➔ Shareholders and managers extract value (via dividends, bonuses, asset sales) before bankruptcy.
➔ Leaves less for creditors upon default.

static tradeoff theory

firms find an optimal debt level that carefully trades off the tax benefits of debt against the risks and costs of too much debt.

The Pecking Order Theory

Firms prefer to use internal funds first, then debt, and issue new equity only as a last resort — all because of concerns over asymmetric information.

What is the main idea of Modigliani and Miller’s Dividend Policy Irrelevance?

In perfect markets, a firm’s dividend policy does not affect its overall value — whether dividends are paid now or later, or funded by new equity, shareholder value stays the same.

What happens to old shareholders when new shares are issued at fair value?

Issuing new shares at fair value does not harm old shareholders because the money raised fully offsets the dilution.

When does issuing new shares hurt old shareholders?

Issuing undervalued shares (priced too low) hurts old shareholders by diluting their ownership and reducing the firm's value for them.

When does issuing new shares help old shareholders?

Issuing overvalued shares (priced too high) benefits old shareholders because new investors overpay, increasing the value for existing owners.

Why is issuing new stock to pay a dividend a bad idea

Issuing stock to fund dividends can hurt shareholders because taxes and issuance costs reduce their after-tax income. The operation benefits the IRS and bankers but offers no economic gain to the shareholders.

When should firms consider paying a dividend or repurchasing shares

When Free Cash Flow is greater than 0

How can shareholders manage many risks easily?

Shareholders can manage many risks through portfolio diversification, which is cheap and easy to implement.

What must corporate risk management achieve to be valuable to shareholders?

Corporate risk management must provide benefits that portfolio diversification alone cannot.

What important risk does portfolio diversification not solve for shareholders?

Portfolio diversification does not prevent the loss of wealth from firms passing up positive NPV projects, causing deadweight loss.

What is one benefit of using stock in a merger for target shareholders?

Target shareholders can defer capital gains taxes when stock is used instead of cash.

What risk do target shareholders face in a stock deal?

They face adverse selection risk — the acquirer's stock may be overvalued.

How does the market usually react to bidders using stock in mergers?

Bidders using stock see lower announcement returns (about 3% lower) compared to cash deals.

What is one advantage of using cash in a merger?

It’s easy for target shareholders to value, and they get guaranteed, immediate payment.

What is a downside for target shareholders in a cash deal?

hey must pay capital gains taxes immediately upon receiving cash.

What is a risk for bidders in cash deals?

Adverse selection — the buyer might overpay if the target misrepresents its value (e.g., HP–Autonomy case).

What is synergy in M&A?

When the combined value of two companies is greater than the sum of their parts due to increased revenues, reduced costs, or tax benefits.

What is a spinoff?

A spinoff is when a parent company gives shares of a business unit directly to its existing shareholders on a pro-rata basis, without raising cash. A spinoff turns an existing part of a business into a completely independent, publicly traded company, but the operations themselves are not new — just newly separated.

What is a carve-out?

A carve-out is when a parent company sells shares of a business unit to the public through a public offering, raising cash.

Why do companies do spinoffs?

Companies do spinoffs to unlock value by making each business more focused, to let investors value the businesses separately, and to improve management efficiency by giving each unit independent leadership.