BA 323 FINAL

expected returns

the probability weighted sum of all these different potential outcomes

portfolio

group of different assets held together to reduce risk

systematic risk

market wide risk that affects all stocks in the system and market

unsystematic risk

the risk is unique to the company/group of comapnies

beta β

tells us how volatile a stock is compared to the overall market and what surprises to expect

• =1.0 asset has average risk

• >1.0 asset is riskier than average

• <1.0 asset is less risky than average

capital asset pricing model

defines the relationship between risk and return for a stock

• as beta increases, shareholders require a higher return from the stock

• security market line

risk free return

return with zero risk (T-bills)

cost of capital

require return investors demand to invest in a company

• the weighted average of cost of equity, debt, preferred stock in a company’s capital structure

• same as discount rate and required return

key idea of cost of capital

the cost to a company of its capital is equal to the return received by the providers of those funds

cost of equity

the return required by shareholders given the risk of the cash flows from the firm

• dividend growth model

• security market line approach

cost of debt

the required return on a company’s debt

• the same as the yield to maturity

preferred stock

considered a perpetuity which pays a constant dividend every period and expected to be paid forever

E

market value of equity

D

market value of debt

P

market value of preferred stock

weights

percentages of the company or project that will be financed by each component

tax shield of debt

interest on debt is tax-deductible which lowers taxes because the government pays part of a company’s use of debt

subjective approach

adjust WACC up or down based on project risk relative to the firm

pure play approach

use similar companies to estimate risk

capital structure

description of the amount of debt and equity used to fund the firm’s assets

leverage

the use of debt in a company’s capital structure

• magnifies both gains and losses because debt is a fixed obligation

debt/equity ratio

key measure of the capital structure

capital restructuring

changing the amount of leverage (debt) without changing the firm’s assets

• increase leverage: issue debt, buy back stock

• decrease leverage: issue stock, pay off debt

what are the two ways to maximize shareholder wealth?

1. increasing cash flow

2. minimizing the cost of capital

break even EBIT

the point where EPS is the same with or without debt

• above: debt is good

• below: debt is bad

what are cases in capital structure theory?

different assumptions about the world (taxes, bankruptcy) that change how debt affects firm value

what are M&M propositions?

rules/conclusions about how debt affects value within each case

case 1

a world with no taxes and no bankruptcy risk (perfect market)

M&M proposition I (no taxes)

the firm value does not change with debt or capital structure because cash flows don’t change

M&M proposition II (no taxes)

as debt increases, cost of equity increases offsetting cheap debt so WACC stays the same

case 2

a world with taxes but no bankruptcy risk

• interest on debt is tax deductible so when a firm adds debt, it reduces debt » increases the cash flow

M&M proposition I (with taxes)

firm becomes more valuable when using debt because of tax savings

bankruptcy costs

what a company loses when it has too much debt

direct bankruptcy costs

actual out-of-pocket costs from bankruptcy such as legal and administrative costs (court costs, lawyer fees, administrative expenses)

• visible and can be calculated

indirect bankruptcy costs

hidden costs that damage the business when a firm is in financial distress such as lost sales, employee turnover, low morale

• difficult to estimate but very important and usually larger

case 3

world with taxes and bankruptcy risk (real world)

static theory

there is a limit to a company’s ability to increase value through leverage the limit is the actual expected cost of bankruptcy

optimal capital structure

occurs where the benefit from an additional dollar of debt is equal to the PV of the expected bankruptcy costs from that debt

accounting insolvency

when a firm’s equity is negative (liabilities exceed assets) but it may still be operating

• warning sign !

technical insolvency

when a firm is unable to meet its debt payments (cash flow problem)

business failure

when the business shuts down and creditors suffer losses

legal bankruptcy

when a firm files for bankruptcy in court

absolute priority rule

the order in which creditors and investors are paid in bankruptcy

• first bankruptcy/admin costs » last common stockholders

liquidation bankruptcy

firm shuts down, sells assets, pays creditors

• ch 7

reorganization bankruptcy

firm continues operating and restructures its debt

• ch 11

prepack

prearranged bankruptcy plan agreed on before filing

cram down

when a court forces creditors to accept a reorganization plan

section 363

process where assets are sold quickly like an auction

workout

negotiated agreement with creditors outside of court

cash dividend

cash payment made from a company’s retained earnings to its shareholders

regular cash dividend

normal recurring cash payments made directly to stockholders, usually each quarter

• signals stable, healthy company

• investors expect these to continue

extra cash dividend

paid when company has extra profits or cash

• company is saying the “extra” amount may not be repeated in the future so don’t expect it

special cash dividend

often from something unusual like a huge one-time profit

• def wont happen again

liquidating dividend

some or all of the business has been sold or terminated and the remaining cash is returned to the shareholders in a one-time transaction

• giving back invested money

• company is shrinking or ending

what happens on the declaration date?

board of directors announces the dividend and it becomes a legal liability of the firm

• company sets: payment date, date of record, ex-dividend date

date of record

company determines/confirms who qualifies to receive the dividend

• must be a shareholder on this date

• bought before the ex-dividend date

ex-dividend date

occurs 1 business day before the date of record

why is the ex-dividend date important?

if you buy on or after this date » no dividend

• to receive, you must buy at least 2 business days before record date

date of payment

company pays the dividends, checks are mailed to those who were holders on the day before the ex-dividend date

ex-dividend day price drop

stock price drops at the start of the ex-dividend date and it is approximately equal to the dividend amount

why do dividends matter?

the value of the stock is based on the present value of expected future dividends since dividends are the actual cash flows investors receive

• if the market is not at equilibrium

why does dividends not matter (in theory)?

because changing when dividends are paid (now vs later) doesn’t change the total present value of cash flows to shareholders

what is the most important part of dividend policy?

dividend policy is about timing, whether we pay a dividend today or some time in the future, after the reinvested cash has grown, should not affect the stock price

what are the three market inefficiencies favoring a low dividend payout?

1. taxes

2. flotation costs

3. covenant restrictions

negative tax policies

• tax on dividends are paid on the full amount of the dividend

• upper income tax brackets might prefer lower dividend payouts in favor of reinvestment for higher capital gains

• historically, dividends have been taxed at higher tax rates than capital gains

• when a company pays a dividend, investors have no option but to pay the tax in that year

flotation costs

retaining funds in the company rather than paying dividends will decrease the amount of capital that needs to be raised later, lowering flotation costs

• by paying out dividends, the firm may need to issue stock or debt later on

dividend restrictions

bondholders and banks often have debt covenants that limit the percentage of income that can be paid out as dividends

what are the three market inefficiencies favoring high dividend payouts?

1. positive tax policies

2. uncertainty (future is unpredictable)

3. desire for current income

positive tax policies

corporations who invest/hold stock in other companies can exclude at least 50% of dividend income from tax (cutting tax in half)

uncertainty

future dividends are not guaranteed so investors may prefer cash now rather than uncertain future cash

desire for current income

• individuals in low tax brackets

• some retirees

• groups prohibited from spending the principle of their investments (trusts and endowments)

clientele effect

investors prefer different dividend policies (high vs low payouts) and buy stocks that match their preference

• companies attract a clientele of investors based on their dividend policy

stock repurchase

instead of paying a taxable cash dividend to their investors, companies can use the same funds to buy back shares of stock instead

open market

company buys its own stock in the open market

tender offer

company states a purchase price and a desired number of shares to be bough and investors voluntarily offer their shares

targeted repurchase

firm repurchases shares from specific individual shareholders

repurchase vs cash dividends

both return cash to shareholders but a repurchase allows investors to decide if they want a current cash flow by selling the stock or hold on and pay tax later when they decide to sell

pros of cash dividends

they underscore good results and provide support to stock price, may attract institutional investors, stock price usually increases with a new dividend

cons of cash dividends

they are taxed to recipients, can reduce internal sources of funding, cuts are hard to make without adversely affecting a firm’s stock price

stock dividends

distribution of additional shares of stock instead of cash

• increases the number of outstanding shares

• lowers price per share proportionally

• total value doesn’t change

regular stock splits

increases the number of shares and reduces the price per share proportionally

• total value doesn’t change

• same effect as a stock dividend

reverse stock splits

reduces the number of shares and increases the price per share proportionally

• raise stock price

• improve perception

business start ups

led by entrepreneurs/inventors who bear most of the risk and expect most of the return

• cash investment is crucial but maby fail

what is the most important part of a business start up?

being able to do what is necessary to attract investment early on, even before the business concept is proven

initial internal sources of capital

personal investment (lines of credit, 2nd mortgages), family/friends, cash from operations (rarely enough)

venture capital

private financing for new, high-risk businesses, usually in exchange for stock with high return (and risk)

• very high risk investment, many fail! » very high cost of equity

main stages of venture capital financing

seed/angel, series A, series B, series C (and beyond0

angel investors

provide early (seed) funding when risk is highest

how does cash flow behave over time for startups?

early: negative cash flow (heavy investment) later: turns positive as company grows

seed money

structure: debt (convertible notes)

common purpose: develop prototypes and proof of concept

source: self, family, friends, sometimes crowdfunding

series A

structure: stock, often preferred

common purpose: finalize product, pay salaries, and other expenses to begin sales

source: individuals and VC firms

series B

structure: common stock along with convertible instruments

common purpose: create and finance rapid growth and expansion, get to profit

source: individuals. VC firms, insurance companies

late stage, series C and beyond

structure: common stock and maybe mezzanine

common purpose: increase market share, fund acquisitions, and get ready for IPO

source: VC firms and investment banks

crowdfunding

raising small amounts of capital from a large number of people

• typically raised through the internet

• designed to match small investors with entrepreneurs desperate for capital

initial public offering (IPO)

first time that a private company often backed by investors such as venture capital, sells its shares to the public

• can be used to generate funds for the company’s growth, pay off debts, allow angel investors

• going public is highly regulated by the SEC to protect public investors

• private investors are expected to understand the risks better

• “unseasoned new issue”

private issue

selling securities to fewer than 35 sophisticated investors (no public offering)

• no SEC registration required

general cash offer

shares sold to the general public (most common in the U.S.)

rights offer

shares are offered only to current stakeholders

seasoned equity offering

company already public sells additional new shares

• stock price usually goes down

securities exchange act of 1933

regulates the initial sale of securities in the primary market