corporate finance

What are the most important features of a corporation that are different from those of all other organizational forms?

A corporation is a legal entity separate from its owners.

As such, it has many of the legal powers that people have:

• It can enter into contracts, acquire assets, incur obligations, and is protected by law against seizure of its property.

• It is solely responsible for its own obligations.

What does the phrase limited liability mean in a corporate context?

Owners’ liability is limited to the amount they invested in the firm.

Equity holders are not responsible for any encumbrances of the firm; in particular, they cannot be required to pay back any debts incurred by the firm.

Caveats:

1. Corporations and limited liability companies give owners limited liability.

2. Limited partnerships provide limited liability for the limited partners, but not for the general partners.

What are the main advantages and disadvantages of organizing a firm as a corporation?

• Advantages: Limited liability, liquidity, infinite life.

• Disadvantages: Double taxation, separation of ownership and control.

Discuss the set of conditions (assumptions) required for the MM proposition.

1. Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows. (No arbitrage)

2. There are no taxes, transaction costs, or issuance costs associated with security trading. (No friction)

3. A firm’s financing decisions do not change the cash flows generated by its investments, nor do they reveal new information about them. (Zero NPV)

Comment: later in this course, study violations of these assumptions.

Which of the following statements is TRUE?

C) In corporations, shareholders are protected by limited liability.

Limited Partnership like venture capitalist firms

• General partner manages the business

• General partner = unlimited liability

• Limited partners = liability limited to investment

• Ownership transfer often harder

• Profits often pass directly to partners

Corporation

• Owned by shareholders

• Shareholders = limited liability

• Managed by directors/executives

• Easier transfer of ownership through shares

• Separate legal entity

What do private equity (PE) firms specialize in investing in?

PE firms invest in relatively mature private firms and often take public firms private through buyouts.

They do not primarily focus on young innovative start-ups (that is more typical of venture capital).

Which of the following statements is FALSE?

C) In perfect capital markets, an open market share repurchase has no effect on the stock price, and the stock price is the same as the ex-dividend price if a dividend were paid instead.

8. Which of the following statements is NOT true regarding venture capitalists?

D) They might invest for strategic objectives in addition to the desire for investment returns.

Which of the following statements is FALSE?

D) Researchers have found that, on average, the market greets the news of an SEO with a price increase.

Which of the following statements is FALSE?

The WACC method is more complicated than the APV method because we must compute two separate valuations: the unlevered project and the interest tax shield.

What is the average market reaction to a takeover announcement?

The price of the target increases by 15%, while the price of the

acquirer increases by 1%.

Agency costs are best defined as:

The costs that arise when there are conflicts of interest between a firm's

stakeholders.

Focusing on shareholder value, two agency conflicts of interest in our course:

1. Conflicts between managers and shareholders.

2. Conflicts between controlling shareholders (often related to management) and dispersed shareholders.

⇒ Arises due to separation of ownership and control.

Which of the following statements regarding shareholder actions is FALSE?

If managers have large ownership stakes, then shareholders are more likely to use compensation policies or a stronger board to create the desired incentives.

State the Free Cash Flow hypothesis and why leverage can increase firm value according to the Free Cash Flow hypothesis.

Free Cash Flow Hypothesis: Wasteful spending is more likely to occur when firms have high levels of cash flow in excess of what is needed after making all positive-NPV investments and payments to debt holders. When cash is tight, managers will be motivated to run the firm as efficiently as possible. According to the free cash flow hypothesis, leverage increases firm value because it commits the firm to making future interest payments, thereby reducing excess cash flows and wasteful investment by managers.

State three types of agency costs and two types of agency benefits associated with debt and briefly explain the main intuition behind them.

Agency costs arise when there are conflicts of interest between stakeholders. A highly levered firm with risky debt faces the following agency costs:

• Asset Substitution: Shareholders can gain by making negative-NPV investments or decisions that sufficiently increase the firm’s risk.

• Debt Overhang: Shareholders may be unwilling to finance new, positive- NPV projects.

• Cashing Out: Shareholders have an incentive to liquidate assets at prices below their market values and distribute the proceeds as a dividend.

State three types of agency costs and two types of agency benefits associated with debt and briefly explain the main intuition behind them.

Leverage has agency benefits and can improve incentives for managers to run a firm more efficiently and effectively due to:

• Increased ownership concentration: Managers with higher ownership concentration are more likely to work hard and less likely to consume corporate perks.

• Reduced free cash flow: Firms with less free cash flow are less likely to pursue wasteful investments.

• Reduced managerial entrenchment and increased commitment: The threat of financial distress and being fired may commit managers more fully to pursue strategies that improve operations.

Suppose management expects good news to come out, (i) will they undertake the repurchase before or after the news comes out? (ii) When would management undertake the repurchase if they expect bad news to come out? (iii) What effect would an announcement of a share repurchase have on the stock price?

Here investors don’t know if there is going to be good or bad news. *If management expects good news to come out, they would prefer to do the repurchase first, at $50/share (<$70). **If they expect bad news to come out, they would prefer to do the repurchase after the news comes out, at $30/share (<$50). (Intuition: Management prefers to do a repurchase if the stock is undervalued—they expect good news to come out—but not when it is overvalued because they expect bad news to come out.)

• We expect managers to do a share repurchase before good news comes out and after any bad news has already come out.

• Therefore, if investors believe managers are better informed about the firm’s future prospects, and that they are timing their share repurchases accordingly, a share repurchase announcement would lead to an increase in the stock price.

For which investors is there a personal tax disadvantage of debt?

Debt has a personal tax disadvantage when:

τi >τ e

​where:

τi = tax rate on interest income

τe = tax rate on equity income

Meaning: investors pay more tax on bond interest than on stock returns.

Corporate taxes favor debt → interest is tax deductible.

Personal taxes can oppose debt → interest income may be taxed more heavily than equity income.

How does a personal tax disadvantage of debt affect the value of leverage?

If:

τi > τe

​(interest tax > equity tax)

then investors prefer equity returns over interest income.

Result:

τ∗ < τc

​so the effective tax benefit of debt decreases.

Firm value becomes:

VL = VU + τ∗D

instead of:

VL = VU + τcD

Key memory sentence:

Higher interest taxes → smaller debt tax shield → smaller leverage benefit → lower leveraged firm value (than it would otherwise be).

τ∗ is the effective tax advantage of debt after considering both corporate and personal taxes together.

Although the major benefit of debt financing is easy to observe – the tax shield – many of the indirect costs of debt financing can be quite subtle and difficult to observe. Describe some of these costs.

Although the indirect costs are difficult to measure accurately, they are often much larger than the direct costs of bankruptcy.

Examples of these costs are:

– Loss of Customers

– Loss of Suppliers

– Loss of Employees

– Loss of Receivables

– Fire Sale of Assets

– Delayed Liquidation

– Costs to Creditors

For an existing fixed-coupon debt issue, do we use the old coupon rate or the current interest rate to calculate the annual interest tax shield?

Use the old coupon rate because the annual tax shield is based on the actual interest payment being made.

Interest Tax Shield = τ c × Interest Expense

Example:

Debt = $10m, Coupon = 6%, Tax = 21%

10 × 6% × 21% = 0.126 million

Memory: Coupon determines the cash paid → current interest rate determines discounting/PV.

In order for debt to offer a tax advantage, 𝜏∗ must be larger than zero,

i.e. 𝜏∗ = 1 − ((1−𝜏𝑐 )(1−𝜏𝑒 ))/1−𝜏𝑖 > 0

𝜏𝑐 > 1 − 1−𝜏𝑖/1−𝜏𝑒

What is the tradeoff theory of capital structure?

Firms balance the benefits and costs of using debt.

Benefits of debt:

Tax savings from interest payments

Costs of debt:

Financial distress and bankruptcy risk

Lost customers or suppliers

Other costs from being highly leveraged

A firm should increase debt only if the benefits are greater than the costs.

Key idea: Debt can increase firm value through tax shields, but too much debt can reduce value because of financial distress costs.