Corporate Finance
Weight: 5%~15%
SS7: Corporate Finance
SS8: Financing and Control Issues
Introduction of the course
Study Session 1-2 Ethics & Professional Standards 10 -15%
Study Session 3 Quantitative Analysis 5 -10%
Study Session 4 Economics 5 -10%
Study Session 5-6 Financial Reporting and Analysis 15 -20%
Study Session 7-8 Corporate Finance 5 -15%
Study Session 9-11 Equity Investment 15 -25%
Study Session 12-13 Fixed Income 10 -20%
Study Session 14 Derivatives 5 -15%
Study Session 15 Alternative Investments 5 -10%
Study Session 16-17 Portfolio Management and Wealth Plan 5 -10% Weights: 100%
Ø Exam tips:
• 17年公司金融的考纲相较16年没有发生任何变化，仍然可 以沿用之前的准备思路。
• 根据统计，二级的公司金融科目是考生得分率最低的科目 之一，条件繁多，计算繁琐且环环相扣是二级公司金融考 题的特点。因此，在学习和复习时需要一定要结合大量的 操练来熟悉计算的流程。
• 从考试内容来看，Session 7中包含大量公司金融的核心知 识点以及计算考点，是考试主要涉及的部分。需要大家重 点关注。
Summary
Evaluate Expansion & Replacement Projects
Tasks:
Capital budgeting decisions Ø Often use NPV or IRR
CF: based on incremental, after-tax cash flows r: discounted at the opportunity cost of funds
• Financing costs are ignored because both the cost of debt and the cost of other capital are captured in the discount rate.
Basic Capital Budgeting Approach
Ø |CF0| is Initial outlay
Ø CFt is annual after-tax operating cash flow
Ø CFTNO is terminal year after-tax non-operating cash flow
Evaluate Capital Projects
Initial Outlay in Detail
Ø Outlay = FCINv + NWCInv – Sal0 + T(Sal0 – B0) • FCInv: investment in new fixed capital • NWCInv: investment in net working capital • Sal0: salvage value from sale of old fixed capital • T: marginal tax rate
• B0: book value of old fixed capital
Evaluate Capital Projects
Annual After-tax Operating Cash Flow in Detail
Ø CF = (S− C − D)( 1−T ) + D, or CF = ( S−C )( 1−T ) + TD• S: sales
• C: cash operating expenses • D: depreciation
• T: marginal tax rate
Terminal Year After-tax Non-operating Cash Flow in Detail Ø TNOCF = SalT + NWCInv − T(SalT − BT)
• SalT: sal. value from sale of fixed capital on termination date
• NWCInv: recovery of investment in net working capital
• T: marginal tax rate
• BT: book value of fixed capital on termination date
Evaluate Capital Projects
Ø Equipment to expand production will cost $450 million, depreciated straight-line to zero over three years for tax purposes.
Ø Salvage value for financial statement purposes is $30 million.
Ø Paid outside consultant $2 million for detailed market share and cost analysis.
Ø Expected to generate incremental revenue of $350 million in each year for three years.
Example 1: Evaluate Expansion Project
Ø Additional annual cash operating expenses associated with project are $150 million
Ø Investment in net working capital of $25 million will be recovered in three years
Ø Expect to sell equipment in three years for $50 million
Ø Project cost of capital is 20% and marginal tax rate is 40%
Calculate NPV&IRR, determine appropriate investment
Example 1: Evaluate Expansion Project
Solution Step 1: Calculate Incremental Cash Flows Ø Outlay = FCINv + NWCInv – Sal0 + T(Sal0 – B0)
=$450 + $25 – 0 + 0 = $475
Ø Depreciation: depends on method for tax purpose =$450 / 3 = $150
Ø CF = ( S−C )( 1−T ) + TD
=($350 – $150)(1 – 0.4) + (0.4)($150) = $180 Ø TNOCF = SalT + NWCInv − T(SalT − BT)
Solution Step 2: Calculate NPV and IRR
Example 1: Evaluate Expansion Project
0 1 2 3
Example 2: Evaluate Replacement Project
Ø If the new equipment replaces the old equipment, an additional investment of $80,000 in net working capital will be required. The tax rate is 30 percent, and the required rate of return is 8 percent. Whether to replace or not?
Solution Step 1: Calculate Incremental Cash Flows Ø Outlay = FCInv + NWCInv – Sal0 + T(Sal0 – B0)
Example 2: Evaluate Replacement Project
Solution Step 2: Calculate NPV and IRR
ØØ
Ø Decision: Accept the replacement project
Ø Reason: NPV>0, IRR>8%
Example 2: Evaluate Replacement Project
Ø Importance: ☆☆☆
Ø Content:
• 主要掌握扩张项目和替代项目NPV以及IRR的计算
ü 正确理解增量现金流的概念
ü 能计算不同Stages的增量现金流
Ø Exam tips:
• 这部分知识是考查重点，且多考计算题，需要通过大量 操练提高正确率。
Summary
Evaluate Capital Projects
Tasks:
Ø Evaluate capital projects and determine the optimal capital project in situations of 1) mutually exclusive projects with unequal lives, using either the least com- mon multiple of lives approach or the equivalent annual annuity approach, and2) capital rationing.
Ø Calculate and interpret accounting income and economic income in the context of capital budgeting
Evaluate Capital Projects
Evaluate Mutually Exclusive Projects with Unequal Lives Ø Least Common Multiple of Lives Approach (最小公倍数法)
• e.g. For 2-year project S and 3-year project L, replicate their CFs in a 6-year horizon.
Ø Equivalent Annual Annuity Approach (等效年金法)
• A simple two-step procedure: 1) find NPV; 2) find PMT
Evaluate Capital Projects
Evaluate Projects Under Capital Rationing
Ø Capital rationing is the case in which the company’scapital budget has a size constraint, i.e. fixed money amount.
Ø Use profitability index (PI) since it shows the profitability of each investment per currency unit invested:
1 N P V
P I
I n i t i a l I n v e s t m e n t
Example 3: Evaluate Projects Under Capital Rationing
Ø Omni Corporation has a $3,000 capital budget
Investment
Outlay NPV Profitability Index
Project A 1,650 $700 1.42
Project B 1,400 $670 1.48
Project C 1,100 $400 1.36
Project D 600 $200 1.33
Project E 300 $60 1.20
Highest Total NPV(B+C+E)= $670 + $400 + $60 = $1,130 Total Outlay = 1,400 + 1,100 + 300 = $2,800 < $3,000 budget
Evaluate Capital Projects
Evaluate Projects with Real Options Ø Types of real options• Timing Options
• Sizing Options
• Flexibility Options
• Fundamental Options
Ø Evaluate approaches
• Simple add: NPV(no option) + Net value of options
• More complicated: decision trees or option pricing models
Risk Analysis of Capital Investments
Stand-Alone Methods (Assume Total Risk) Ø Sensitivity Analysis• change one input variable at a time in base case
• more resultant change in NPV -> more sensitive -> riskier
Ø Scenario Analysis
• change several input variables for each scenario -- “pessimistic”, “most likely”(base), and “optimistic”
Ø Monte Carlo Simulation Analysis
• stochastic variables -> probability distribution of NPV
Risk Analysis of Capital Investments
Market Risk Methods (Assume Only Systematic Risk) Ø Consider only market risk for a diversified investor: β (“beta”)
Ø Discount rate = required rate of return
Ø Use CAPM and SML to find required rate of return:
• Notice: we use PROJECT beta here to get the PROJECT discount rate (NOT company WACC)
• employ "pure-play" method to get beta: identify other publicly traded stocks in the same business as the project
[ ( ) ]
i F i M F
Effects of Depreciation Method on Analysis :
Ø NPV with Accelerated depreciation is larger than calculated with Straight-line depreciation.
• CF = ( S−C )( 1−T ) + TD
• Why? Larger depreciation in early years are assigned with bigger weight, and so does the tax shield TD, and therefore CF&NPV.
Ø As a result, many countries specify the depreciation methods that are acceptable for tax purposes in their jurisdictions.
Factors That Affect Evaluation
Effects of Inflation on Analysis
Ø The cash flows and discount rate used should both be nominal or both be real.
Ø Higher than expected inflation:
• Reduces value of depreciation tax shelter if tax system doesn’t adjust
• Decreases value of fixed payments to bondholders • Revenues and costs not affected uniformly
Factors That Affect Evaluation
Common Capital Budgeting Pitfalls
Ø Not incorporating economic responses into the investment analysis
Ø Misusing capital budgeting templates
Ø Pet projects
Ø Basing investment decisions on EPS, net income, or return on equity
Ø Using IRR to make investment decisions
Ø Bad accounting for cash flows
Factors That Affect Evaluation
Common Capital Budgeting Pitfalls Ø Overhead costs
Ø Not using the appropriate risk-adjusted discount rate
Ø Spending all of the investment budget just because it is available
Ø Failure to consider investment alternatives
Ø Handling sunk costs and opportunity costs incorrectly
Other Income Measures
Economic Income V.S. Accounting Income
Ø Accounting income: net income on financial statements
Ø Economic Income = Cash flow + Change in market value or Economic income = Cash flow – Economic depreciation
Difference Economic Income Accounting Income
Depreciation Beginning Market Value
- Ending Market Value Beginning - Ending BookBook Value Value
Interest
Expense ignored interest expense to already deducted
debt holders
Ø
Omni Corporation project costs $25,000
Ø
Cost of capital = 12%
Ø
After-Tax Cash flows:
•
Year 1: $10,000
Example 4 : Compute Economic Income
PV of remaining CFs
Not accounting income Must equal to project cost of capital
Example 4 : Compute Economic Income
Year 1 Year 2 Year 3
Beginning MV $29,172 $22,672 $13,393
Ending MV 22,672 13,393 0
Change in MV – 6,500 – 9,279 – 13,393
After-tax CF 10,000 12,000 15,000
Economic Income $3,500 $2,721 $1,607
Economic ROR =
Econ Inc./Beg MV 12% 12% 12%
Other Valuation Models
Economic ProfitØ Used in asset valuation, performance measurement and management compensation. Focus on return to all investors.
Ø EP = NOPAT – $WACC
• NOPAT = net operating profit after tax = EBIT(1 – tax rate)
• $WACC = WACC × Capital
Ø Market value added (MVA) is NPV based on economic profit
Other Valuation Models
Ø Focus on return to equity holders Ø RIt = NIt – reBt–1
• NIt = net income during period t • reBt–1 = equity charge for period t
= required return on equity × beginning book value of equity
Other Valuation Models
Claims ValuationØ Focus on return to debt holders and equity holders separately
• CFs to debt holders = interest and principal, discounted at cost of debt
• CFs to equity holders = dividends and share repurchases, discounted at cost of equity
Balance Sheet
Assets Liabilities
Equity
Summary of Capital Budgeting
Who Likes to Use Which ModelØ Corporate managers often focus on total after-tax cash flows
• e.g. Basic capital budgeting approach
Ø Security analysts use cash flows to stockholders
• e.g. Free cash flow to equity
Ø Real estate investors use cash flows to the equity investor after payments to creditors, which is like the claims valuation approach.
Ø Importance: ☆☆ Ø Content:
• Mutually exclusive projects with unequal lives
ü最小公倍数法
ü等效年金法
• Factors affect evaluation
• Other valuation models Ø Exam tips:
Capital Structure
Tasks:
Ø Explain the Modigliani–Miller propositions regarding capital structure.
Ø Explain factors an analyst should consider in evaluating the effect of capital structure policy on valuation.
Ø Describe the role of debt ratings in capital structure policy.
Preface
Capital Structure Decision Objective
Ø Optimal capital structure maximizes the firm’s value by minimizing the weighted average cost of capital:
• D = market value of debt, E = market value of equity
• V = D + E = market value of the firm
• rd = before-tax marginal cost of debt, t = marginal tax rate
• re = marginal cost of equity
marginal cost
(raise additional capital) (the past is irrelevant)current cost
Theory
Modigliani and Miller Assumption
Ø Homogeneous expected cash flows
Ø Perfect capital markets
(no transactions costs, no taxes, no bankruptcy costs, and symmetric information)
Ø Investors can borrow and lend at the risk-free rate
Ø No agency costs
Ø Independent financing decision & investment decision
Theory
Modigliani and Miller Theory
Ø MM Proposition I (without taxes):• VLevered = VUnlevered
The market value of a company is not affected by the capital structure of the company.
Ø MM Proposition II (without taxes): •
Theory
Modigliani and Miller Theory
Ø MM Proposition I (with taxes):• VLevered = VUnlevered+ tD
t = marginal tax rate, D = debt value
Ø MM Proposition II (with taxes): •
• rwacc < r0
WACC for the company with debt must be lower than that for the all-equity company
0 ( 0 )(1 )( )
e d D
r r r r t E
Theory
Impact from Various Costs Ø Costs of Financial Distress
• Direct & indirect costs
• Leverage increases -> Probability of bankruptcy increases
Ø Agency costs
• Monitoring costs, bonding costs, and residual loss
• Michael Jensen: higher debt level gives less free cash flow to managers to misuse -> lower agency costs
Ø Costs of Asymmetric Information
• Pecking order theory: internal capital > debt > external equity
Theory
Optimal Capital Structure
Ø Static trade-off theory of capital structure
• VL = VU + tD – PV(Costs of financial distress)
dynamic target
Theory
Optimal Capital Structure
Ø Static trade-off theory of capital structure
• rWACC = (D/V)rd(1-t)+(E/V)re
Practical Issues
Debt RatingsØ leverage rises->rating lowered->higher demanded costs
Ø with status as “Nationally Recognized Statistical Rating Organizations” from (SEC), the 3 largest are Moody’s, Standard & Poor’s, and Fitch
Practical Issues
Evaluating Capital Structure Policy
Ø Changes in its own capital structure over timeØ Capital structure of competitors with similar business risk
Ø Industry-specific factors
• volatility of opearating cash flows • need for financial flexibility • regulatory aspects
Ø Company-specific factors
• quality of corporate governance (affects agency costs)
Practical Issues – international differences
Summary of Capital Structure
Theory V.S. Practice
Ø MM theory and various costsØ Static trade-off theory
• Pursue optimal (target) capital structure
Ø Importance: ☆☆☆ Ø Content:
• Modigliani and Miller Theory (Proposition 1 & 2) ü Without tax
ü With tax
• Optimal capital structure
• Debt ratings Ø Exam tips:
• MM理论以及相关推论是二级公司金融常考的知识点，结 合图像来记忆相关要点会起到事半功倍的效果。
Summary
Dividend and Share Repurchases
Tasks:
Ø Compare theories of dividend policy and explain implications of each for share value given a description of a corporate dividend action.
Ø Explain factors that affect dividend policy.
Preface
Why do we study this?
Ø Capital budgeting: how to spend money efficiently
Ø Capital structure: how to get money effectively
Ø Dividends&share repurchases: how to distribute money wisely
Effects of Dividend Policy
Theories
Ø Dividend policy does not matter (MM)
Ø It does matter: bird-in-hand argument & tax argument
Effects of Dividend Policy
Information Signaling
Ø Dividend declaration resolves information asymmetry • initiations or increases convey positive information • omissions or reductions convey negative information
Ø Companies that consistently increase their dividends have: • dominant or niche positions in their industry • global operations
• relatively high returns on assets • relatively low debt ratios
Effects of Dividend Policy
Clientele EffectØ Defined as "the existence of groups of investors (clienteles) attracted by companies with specific dividend policies"
• institutional investors
• individual investors
Ø Not contradict the hypothesis of dividend policy irrelevance
Ø Consider tax: Pw – (Pw – Pb)(TCG) = Px – (Px – Pb)(TCG) + D(1 – TD)
• $1 dividend is worth $(1 – TD)/(1 – TCG) in capital gains 1
1 D
w x
C G
T
P P D
T
Effects of Dividend Policy
Agency Costs
Ø Between shareholders and managers
• Dividends payout reduces free cash flow for managers to overinvest and run out of control
Ø Between shareholders and bondholders
• Dividends transfer wealth from bondholders to shareholders
Factors Affecting Dividend Policy
Six Factors that Affect a Company’s Dividend Policy
Ø Investment opportunitiesØ Expected volatility of future earnings
Ø Financial flexibility
Ø Tax considerations Ø Flotation costs
Factors Affecting Dividend Policy
Tax ConsiderationsØ Double taxation system
• Dividend = NIpretaxpayout% (1-tcorporate)(1-tindividualon dividend)
• Effective tax rate = tcorporate + (1-tcorporate) tindividualon dividend Ø Dividend imputation tax system
• Dividend = NIpretaxpayout% (1-tindividualon dividend) Ø Split-rate tax system
• Dividend = NIpretaxpayout%
*(1-tcorporate on dividend)(1-tindividualon dividend)
Dividend Policy
Types of Dividend Policies Ø Stable Dividend Policy• most common, based on long-term forecast of earnings
• Expected dividend = Last dividend + (Expected increase in earnings × Target payout ratio × Adjustment factor)
Ø Constant Dividend Payout Ratio Policy
• infrequently used, fluctuate with short-term earnings
Ø Residual Dividend Policy
• rarely used, highly volatile dividend payments
• Dividend = Earnings – (Capital budget × Equity%)
Dividend Policy
Dividend V.S. Share Repurchase Ø Share repurchase wins in aspects of
• potential tax advantages
• share price support/signaling that the company considers its shares a good investment
• added managerial flexibility
• offsetting dilution from employee stock options
• increasing financial leverage
Dividend Policy
Global Trends in Payout Policy
Ø 1978 to 2000 U.S. first tier 100 large companies have a fairly stable payout ratio of around 42%, second tier use share repurchase as a substitute
Ø The fraction of companies paying cash dividends has been in long-term decline in most developed markets (e.g. US, Canada, EU,UK, JP).
Dividend Policy
Analysis of Dividend SafetyØ High coverage ratio may indicate safety but not always
Ø Warning signals for dividend cut:
• negative external stock market indicators
• extremely high dividend yields
Summary of Dividend Policy
One of the Longest Running DebatesØ Payout decisions, along with financing (capital structure) decisions, generally involve the board of directors and most senior level of management and are closely watched by investors and analysts
• theories of the effects of dividend policy
• factors that affect dividend policy
• types of dividend policies, the dividend-share repurchase decision, global trends and analysis of dividend safety
Ø Importance: ☆☆ Ø Content:
• Effects of dividend policy
• Factors affecting dividend policy (重点掌握税收)
• Analysis of dividend policy Ø Exam tips:
• 这部分的知识点比较零散，可以拆解成一个一个小的考 点，在考试时主要以定性 判断为主，考查考生快速甄别 知识点的能力。
Summary
Corporate Performance,
Governance, and Business Ethics
Tasks:
Ø Compare theories of dividend policy and explain implications of each for share value given a description of a corporate dividend action.
Preface
Specific Financing and Control Issues
Ø Session 8 introduced main theories and practical issues related to capital budgeting, capital structure, dividends and share repurchase
Ø Session 9 focuses on specific financing and control issues stemmed from the corporate finance study.
Ø In this reading, we take a close look at the governance mechanisms that shareholders put in place to make sure that managers are acting in their interests and pursuing strategies that maximize shareholder value.
Governance Mechanisms
Compare Interests of Key Stakeholder Groups
Governance Mechanisms
Stakeholder Impact Analysis Ø Identify stakeholdersØ Identify stakeholders’ interests and concerns.
Ø As a result, identify what claims stakeholders are likely to make on the organization.
Ø Identify the stakeholders who are most important from the organization’s perspective.
Ø Identify the resulting strategic challenges.
Governance Mechanisms
Principal–Agent Relationships Problems
Ø The agency problem
Ethics and Strategy
Roots of Unethical Behavior
Ø Flawed personal ethicsØ Fail to realize
Ø Culture that de-emphasizes business ethics
Ø Focus on unrealistic performance goals
Ø Unethical leadership
Ethics and Strategy
Philosophical Approaches to Ethics Ø Friedman Doctrine
• only one social responsibility of business: increase profits
Ø Utilitarian
• greatest good for the greatest number of people
Ø Kantian Ethics
• people have dignity and need to be respected as such
Ø Rights Theories
• human beings have fundamental rights and privileges
Ø Justice Theories (justice decided under a "veil of ignorance")
Ø Importance: ☆
Ø Content:
• Compare Interests of Key Stakeholder Groups
• Business ethics Ø Exam tips:
• 这部分内容主要是介绍利益相关者理论，作为对于传统 公司金融理论的扩充，并不是考试主要考查方向，掌握 到了解的程度即可。
Summary
Corporate Governance
Tasks:
Ø Compare major business forms and describe the conflicts of interest associated with each.
Preface
Corporate Governance
Ø Defined as "the system of principles, policies, procedures, and clearly defined responsibilities and accountabilities used by stakeholders to overcome the conflicts of interest inherent in the corporate form"
Corporate Governance
Major ObjectivesØ To eliminate or mitigate conflicts of interest
Ø To ensure that the assets of the company are used efficiently
Core Attributes of Effective Corporate Governance System Ø Delineation of the rights of stakeholders
Ø Clearly defined manager responsibilities
Ø Identifiable and measurable accountabilities
Ø Fairness and equitable treatment
Ø Complete transparency and accuracy in disclosures
Corporate Governance
Major Business FormsCorporate Governance
Agency Relationships
Ø Areas of primary concern:• Managers vs. shareholders
Corporate Governance
Board of Directors Have the Responsibility to: Ø Establish ethical, competent, fair, and professional values
Ø Ensure legal and regulatory requirements are met
Ø Ensuring that the best interests of shareholders come first
Ø Establish clear lines of responsibility and a strong system
Ø Hire the chief executive officer
Ø Ensure sufficient information symmetry
Ø Meet frequently enough
Ø Acquire adequate training
Corporate Governance
Assess Attributes of BoardØ Composition of board; at least 75% of directors independent
Ø Independent chairman on board (not CEO)
Ø Qualifications of directors
Ø Annual election of directors
Ø Annual board self-assessment
Ø Separate sessions of independent directors
Ø Audit committee and audit oversight (only independent directors)
Corporate Governance
Assess Attributes of BoardØ Nominating committee (only independent directors)
Ø Compensation committee and management compensation (mostly performance-based)
Ø Use of independent and expert legal counsel
Ø Disclosure and transparency
Ø Insider or related-party transactions
Ø Responsiveness of board of directors to shareholder proxy votes
Corporate Governance
Assess Attributes of Board Ø Statement of governance policies• codes of ethics
• statements of the oversight, monitoring, and review responsibilities of directors
• statements of management’s responsibilities
• reports of directors’ examinations
• board and committee performance self-assessments
• management performance assessments
Corporate Governance
Environmental, Social, and Governance Risk Exposure
Ø Legislative and regulatory riskØ Legal risk
Ø Reputational risk
Ø Operating risk
Ø Financial risk
Corporate Governance
Valuation Implications Posed by Weak Systems
Ø Accounting riskØ Asset risk
Ø Liability risk
Ø Strategic policy risk
Summary of Corporate Governance
Keys of corporate governance
Ø Purpose is to minimize conflicts of interest
Ø Major business forms differ in several aspects
Ø Attributes of effective governance
Ø How to establish effective governance
Ø Possible risks
Ø Importance: ☆
Ø Content:
• Major business forms
• Agency relationships
• Assess attributes of board Ø Exam tips:
Introduction of Mergers & Acquisitions
Tasks:
Ø Classify merger and acquisition (M&A) activities based on forms of integration.
Ø Explain common motivations behind M&A activity.
Ø Explain bootstrapping of earnings per share (EPS) and calculate a company’s post-merger EPS.
Preface
M&A
Ø Companies enter into merger and acquisition activities for a variety of reasons:
• to achieve growth
• to diversify their businesses, etc.
Ø It involves a variety of complexities and risks
Mergers and Acquisitions
Mergers and Acquisitions
Classification
Mergers and Acquisitions
ClassificationØ Subsidiary Merger: The target company becomes a subsidiary of the acquirer. Often used when target has strong brand identity
Company A
(Bidder) Company B(Target) Company A(Acquirer)
Company B (Subsidiary)
+
Mergers and Acquisitions
ClassificationØ Consolidation: Acquirer and target cease to exist in their prior form but come together to form a completely new company.
Company A
+
Company B (Newly Formed)Company CMergers and Acquisitions
ClassificationØ Horizontal merger: Two firms operate in the same business, usually as competitors. (in the pursuit of economies of scale)
Small Clothing
Retailer
Medium-sized Clothing
Retailer
Large Clothing
Retailer
+
Mergers and Acquisitions
ClassificationØ Vertical merger: Target company is along the production chain of the acquiring company. (backward/forward integration)
Electronics Retailer
Electronics Retailer/ Computer Manufacturer Computer
Mergers and Acquisitions
ClassificationØ Conglomerate merger: acquirer purchases another company
that is unrelated to its core business.
Organic Food Restaurant
Shoe Manufacturer Shoe
Manufacturer & Organic
Food Restaurant
Mergers and Acquisitions
Motivations
Ø Synergy
Ø Internally (organic growth) or external growth
Ø Increasing market power
Ø Acquiring unique capabilities and resources
Ø Diversification
Ø Bootstrapping earnings
Ø Managers’ personal incentives
Mergers and Acquisitions
MotivationsØ Tax considerations
Ø Unlocking hidden value
Ø Cross-border motivations
• Exploiting market imperfections
• Overcoming adverse government policy
• Technology transfer
• Product differentiation
• Following clients
Mergers and Acquisitions
Bootstrapping Earnings
Ø When a company’s earnings increase as a consequence of the merger transaction itself (rather than real benefits), as an illusion of synergies or growth.
Example of Bootstrapping Earnings
Ø Importance: ☆☆
Ø Content:
• Classification of mergers and acquisitions
• Motivations of mergers and acquisitions üBootstrapping earnings Ø Exam tips:
• 这部分内容主要会考查各种并购的类型以及为什么企业 会从事并购业务，Bootstrapping earnings这个知识点有可 能会考计算题。
Summary
Forms of Acquisitions & Takeover Defense
Tasks:
Ø Contrast merger transaction characteristics by form of acquisition, method of payment, and attitude of target management . Ø Distinguish among pre-offer and post-offer takeover defense
mechanisms.
Ø Calculate and interpret the Herfindahl–Hirschman Index .
Mergers and Acquisitions
Industry Life Cycles’ ImpactIndustry Life
Cycle Stage Industry Description Motives for Merger Types of Mergers
Pioneering development
Substantial development costs and
has low, but slowly increasing, sales growth
Sell themselves to larger companies in mature or declining industries allowing them to pool management and capital resources
High profit margins caused by few participants in the market
Explosive growth in sales may require
Mergers and Acquisitions
Industry Life Cycles’ ImpactIndustry Life
Cycle Stage Industry Description Motives for Merger Types of Mergers
Mature growth
Experiences a drop in the entry of new competitors, but
growth potential remains
Mergers may be undertaken to achieve economies
of scale, savings, and operational may acquire smaller companies to improve
management and provide a broader financial base
üHorizontal
Mergers and Acquisitions
Industry Life Cycles’ ImpactIndustry Life
Cycle Stage DescriptionIndustry Motives for Merger Types of Mergers
Deceleration
Horizontal mergers may be undertaken to ensure survival; Vertical mergers may be carried
out to increase efficiency and profit margins; Companies in related industries
may merge to exploit synergy; Companies in this industry may acquire companies in young
industries
üHorizontal
üVertical
üConglomerate
Mergers and Acquisitions
Forms of AcquisitionStock Purchase Asset Purchase
Payment To shareholder To target
Approval Shareholders None for “small”
Corporate taxes None Target pays CG
S/H taxes S/H pay CG None
Liabilities Acquirer assumes Usually avoids
assuming
Method of Payment Ø Cash offering
• pay for the merger with cash
Ø Securities offering
• exchange ratio
• target shareholders receive shares of the acquirer’s common stock as compensation, might offer other securities, such as preferred shares or even debt securities.
Ø Mixed offering
Mind-Set of Target Management
Ø Friendly mergers• approach target management directly (secrectly) • merger discussions and due diligence (secrectly) • definitive merger agreement (public announcement) • proxy statement given to shareholders to vote • attorneys file the required documentation with
securities regulators
Mergers and Acquisitions
Mind-Set of Target Management Ø Hostile Mergers
• Bear hug: approach target board of directors (bypass CEO)
• Turn to friendly merger
• Or approach shareholders of target company
ü Tender offer (often use cash to quickly finish deal)
ü Proxy fight (vote for acquirer’s slate to replace manager).
Mergers and Acquisitions
Pre-Offer Takeover Defense Mechanisms
Ø Poison pill (flip-in pill & flip-over pill, “dead-hand” provision)
Ø Poison puts
Ø In a state with restrictive takeover laws (U.S.)
Ø Staggered board of directors
Ø Restricted voting rights
Ø Supermajority voting provisions
Ø Fair price amendments
Ø Golden parachutes
Mergers and Acquisitions
Post-Offer Takeover Defense Mechanisms Ø “Just Say No” defense
Ø Litigation
Ø Greenmail
Ø Share repurchase
Ø Leveraged recapitalization
Ø “Crown Jewel” defense
Ø Pac-Man defense
Ø White knight defense
Antitrust
Ø Herfindahl–Hirschman Index: model market concentration
Mergers and Acquisitions
2
Post-Merger HHI Concentration Change in HHI Government Action
Less than 1,000 Not concentrated Any amount No action Between 1,000
and 1,800 concentratedModerately 100 or more challengePossible
More than 1,800 concentratedHighly 50 or more Challenge
Ø Importance: ☆☆☆
Ø Content:
• Forms of acquisition
• Takeover defense
• Herfindahl – Hirschman index Ø Exam tips:
• 这部分内容涉及到各种并购的支付形式以及防止恶意收 购的各种策略，是考试时常常考到的知识点。
Summary
Valuation of Mergers & Acquisitions
Tasks:
Ø Compare the discounted cash flow, comparable company, and comparable transaction analyses for valuing a target company . Ø Explain how price and payment method affect the distribution of risks
and benefits in M&A transactions.
Ø Describe characteristics of M&A transactions that create value.
Target Company Valuation-DCF Ø Net income + Net interest after tax
Unlevered net income + Change in deferred taxes
Net operating profit less adjusted taxes (NOPLAT) + Net noncash charges – Change in net working capital – Capital expenditures (capex)
Ø Seuss Publishing is considering acquiring Boynton Books. Seuss’ analysts have determined that a two-stage FCFF model is appropriate for their analysis and have developed pro forma financials for Boynton.
Ø Calculate Boynton’s free cash flows and estimate Boynton’s value. Pro forma financials are shown on following slides.
Example of DCF
Example of DCF
Income Statement 2007 2008 2009 2010 Revenues $9,600 $10,368 $11,301 $12,318 COGS 5,760 6,221 6,781 7,391 Gross profit 3,840 4,147 4,520 4,927 SGA expenses 1,075 1,161 1,265 1,379 Depreciation 336 363 396 431 EBIT 2,429 2,623 2,859 3,117 Net interest exp. 445 422 401 380 EBT 1,984 2,201 2,458 2,737 Taxes (35%) 694 770 860 958 Net income 1,290 1,431 1,598 1,779
Example of DCF
Other Data 2007 2008 2009 2010
Change in NWC 307 332 362 394
Change in deferred
taxes 13 14 16 18
Capital expenditures 960 1,037 1,130 1,232
Tax rate 35.0%
WACC 10.0%
WACCadjusted 9.0%
Terminal growth rate 5.5%
Example of DCF
2007 2008 2009 2010
Net Income 1,290 1,431 1,598 1,779
+ Net interest exp.
× (1 – T) 289 274 261 247
Unlevered NI 1,579 1,705 1,859 2,026
+ Δ Deferred tax 13 14 16 18
NOPLAT 1,592 1,719 1,875 2,044
+ Depreciation 336 363 396 431
– Δ NWC 307 332 362 394
– CAPEX 960 1,037 1,130 1,232
Example of DCF
Target Company Valuation-DCF
Ø Advantages of Discounted Cash Flow Analysis
• Expected changes in cash flows readily modeled
• Estimate of intrinsic value based on forecast fundamentals
• Changes in assumptions can be modified
Ø Disadvantages of Discounted Cash Flow Analysis
• Free cash flows is not profitability (heavy capex to expand)
• Estimate cash flow too far into future
• WACC is volatile
• Terminal value estimates too sensitive to WACC and g
Merger Analysis
Target Company Valuation-Comparable Company Ø Collect a sample of comparable companies (similar size and
capital structure, as many as possible)
Ø Determine enterprise multiples or equity multiples
• EV/FCF, EV/EBITDA, EV/EBIT, EV/sales
• P/CF, P/S, P/E, P/BV
Ø Produce an estimate for the target’s value (use sample mean)
Ø
Ø takeover price = estimated value x (1+takeover premium)
Merger Analysis
( D e a lP r i c e S t o c k P r i c e ) T a k e o v e r P r e m i u m
S t o c k P r i c e
Example of Comparable Company Method
An analyst has identified three companies that they believe are comparable to a firm under evaluation as a takeover candidate. The relative value measures that they have selected are price-to-earnings (P/E) and price-to-sales (P/S), and the average values of these ratios are 13.2 and 1.3. The target firm has earnings per share of $3.75, and sales per share of $36.08. If the estimated takeover premium is 25%, what is the estimated takeover price per share?Solution:
The estimated value based upon P/E is $49.50 = (3.75 × 13.2). The estimated value based upon P/S is $46.90 = (36.08 × 1.3).
The average of these two values is $48.20.
Target Company Valuation-Comparable Company Ø Advantages of Comparable Company Analysis
• a reasonable approximation of a target’s relative value
• most of the required data are readily available
• estimates of value are derived directly from the market
Ø Disadvantages of Comparable Company Analysis
• sensitive to market mispricing
• must additionally estimate a fair takeover premium
• difficult for the analyst to incorporate any specific plans
• past premiums may not be timely or accurate
Merger Analysis
Target Company Valuation-Comparable Transaction
Ø Collect a relevant sample of recent takeover transactionsØ Calculate relative value multiples (already contain premium)
Ø Derive an estimate for the target’s value (use sample mean) • Don’t double add takeover premium!
Merger Analysis
Target Company Valuation-Comparable Transaction Ø Advantages of Comparable Transaction Approach
• Not necessary to separately estimate a takeover premium.
• Takeover value estimates recently established in the market
• Reduces litigation risk.
Ø Disadvantages of Comparable Transaction Approach
• Real takeover values in past transactions were not accurate.
• Not adequate number of comparable transactions to use.
• Difficult for the analyst to incorporate any specific plans.
Merger Analysis
Bid Evaluation
Ø Target shareholders’ gain = Premium = PT – VT
• PT = price paid for the target company
• VT = pre-merger value of the target company Ø Acquirer’s gain = Synergies – Premium = S – (PT – VT)
• S = synergies created by the business combination
Ø VA* = VA + VT + S – C
• VA* = post-merger value of the combined companies
• VA = pre-merger value of the acquirer
Big Steel is considering making a bid for Small Steel. The following data applies to the analysis:
Big Steel Small Steel Pre-merger stock price $75 $100 Number of shares outstanding 500m 40m Pre-merger market value $37,500m $4,000m Estimated synergies $600m
If Big Steel buys Small Steel by exchanging 1.45 shares of its stock for each share of Small Steel, what are the gains to Big Steel and Small Steel, respectively?
Example of Bid Evaluation Method
Solution:
Value after takeover = $37,500 + $4,000 + $600 = $42,100m. Shares exchanged for Small Steel = 1.45 x 40m = 58m. Post-takeover share price = value after takeover / shares outstanding = 42,100m / 558m = $75.45.
Takeover price = number of shares to small steel x post-takeover share price = 58m x $75.45 = $4,376.1m.
Gains to Small Steel = takeover premium = $4,376.1 - $4,000 = $376.1m.
Gains to Big Steel = synergies - takeover premium = $600 - $376.1 = $223.9m.
Example 4: Bid Evaluation
Risk Shifting of Synergy Misestimating
Ø Cash offering: acquirer enjoys or suffers more exposure to synergy volatility.
Ø Stock offering: more risks and benefits of realizing synergies will be passed on to the target shareholders.
Merger Analysis
Characteristics of M&A Deals that Create Value Ø Buyer is strong
Ø Transaction premiums are relatively low
Ø Number of bidders is low
Ø Initial market reaction is favorable
The empirical evidence suggests that
Ø Merger transactions create value for target company.
Ø Acquirers, in contrast, tend to accrue value in the years following a merger.
Ø Synergies are often overestimated or difficult to achieve.
Common Reasons for Restructuring Ø Change in strategic focus
Ø Poor fit
Ø Reverse synergy
Ø Financial or cash flow needs
Three Basic Ways that a Company Divests Assets Ø Sell the assets of a division or offer an “equity carve-out”
Ø “Spin-off” (similar “split-off”)
Ø Liquidation
Merger Analysis
Summary of M&A
Keys of Mergers and Acquisitions Ø Target company valuation
• Discounted cash flow
• Comparable company
• Comparable transaction
Ø Bid evaluation
• Post-merger value
• Gains of each party
Ø Empirical evidence suggests that synergies are often overestimated or difficult to achieve.
Ø Importance: ☆☆ Ø Content:
• Valuation of mergers and acquisitions ü Discounted cash flow method ü Comparable company method ü Comparable transaction method
• Evaluation and analysis of mergers & acquisitions Ø Exam tips:
• 这部分内容涉及到各种并购估值的策略，需要考生理解 其中的估值理念以及局限性。
