1

FINANCE 711 C01. MERGERS, RESTRUCTURING, AND
CORPORATE CONTROL (Fall 2021)

© 2021 Sarkar, S.
Not to be reprinted without permission.



Table of Contents

Page
Chapter 1. Capital Budgeting Recap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Chapter 2. Capital Structure Recap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Chapter 3. Bondholder-Stockholder Conflicts (Agency Problems) . . . . . . . . . . . . . . . 26
Chapter 4. Asymmetric Information and Signaling . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
Chapter 5. Valuation for Mergers & Acquisitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
Chapter 6. Mergers & Acquisitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
Chapter 7. Leveraged Buyouts (LBO) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72
Chapter 8. Corporate Divestitures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
Chapter 9. Financial Restructuring . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
Chapter 10. Share Repurchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97

Answers to Chapter Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
Case Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112




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FINANCE 711 C01. MERGERS, RESTRUCTURING, AND
CORPORATE CONTROL (Fall 2021)

Chapter 1. CAPITAL BUDGETING RECAP

Capital budgeting refers to the real investment decisions of the firm – from new products or projects to simple
replacement decisions. Real investments are important because they are the primary means by which shareholder
value is created by the corporation.
Capital budgeting rules tell us how to choose investment projects. A good investment rule should have
certain properties: it should (i) maximize firm value, (ii) balance subjective assessment and consistency (i.e., not be
too mechanical or too malleable), and (iii) work for all kinds of investments. Capital budgeting is crucial in M&A
analysis and in restructuring decisions such as LBOs, Leveraged Recapitalizations and Divestitures.

Important Measures in Capital Budgeting
A number of methods are used when making capital budgeting or investment decisions: Net Present Value (NPV),
Profitability Index (PI), Internal Rate of Return (IRR), Payback period, Accounting Rate of Return, Economic
Value Added (EVA) and Equivalent Annuity (EA). These are discussed in detail below.

1. Net Present Value, NPV = , where tCF = cash flow in period t, and k = discount rate.
The decision rule is:
For Investing: invest in a project if NPV > 0.
For Ranking: rank projects according to NPV.

Note the following regarding the NPV approach:
a) Intermediate cash flows are assumed to be reinvested at the discount rate;
b) NPV is the most appropriate measure of a project’s attractiveness; there is a direct link between NPV and
stock price, and positive/negative NPV results in a higher/lower stock price;
c) NPV is an additive measure, i.e., NPV1+2 = NPV1 + NPV2; no other investment rule has this property; this
means firm value can be expressed as the sum of PV of projects in place and NPVs of future projects
(growth opportunities); thus, if the firm shuts down a negative-NPV project, the stock price should rise; and
d) Technical advantage of the NPV method: we can take into account changing discount rates (yield curve
effects), which is not possible with the IRR.

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Practical issues when using the NPV method
- How to adjust for risk? There are two ways of adjusting for risk: (i) Risk-adjusted discount rate, and (ii)
Certainty-equivalent cash flows (see below for examples); if done correctly, both give same results.
- Which cash flows to discount? Incremental cash flows only (those affected by the decision); sunk costs
should be excluded.
- How to handle inflation? Must be consistent – nominal (real) cash flows should be discounted at nominal
(real) rates.

Risk measure
There are two measures of financial risk – Total Risk (σ) and Systematic Risk (β). They are related by the equation:
   22M22  or Total risk = Systematic risk + Unique risk
Diversified (undiversified) investors are concerned with systematic (total) risk. Unique or idiosyncratic risk is
diversifiable, so there is no reward for bearing it; as a result, required return or expected return or cost of capital
depends solely on systematic risk or beta (as specified by the CAPM).

Risk adjustment
Risk can be incorporated in two ways:
(i) Use a Risk Adjusted Discount Rate (RADR) when discounting the cash flows,
(ii) Use Certainty Equivalent Cash Flows but discount at the risk-free rate.

RADR: The discount rate is adjusted to match the risk of the cash flows being valued. Thus, Ri = Rf + βi(Rm–Rf),
from the CAPM, where i is the systematic risk of the project. In this method, the denominator (discount rate) is
adjusted for risk. Keep in mind that all reported betas are equity betas, hence betas must be unlevered and then re-
levered to take into account difference in leverage ratios. Also, since most firms use some debt financing, we must
take into account the valuation effects of leverage in the discount rate.

Certainty Equivalent Cash Flows: Instead of increasing the discount rate (the denominator) to account for higher
risk, the cash flow (the numerator) is adjusted downward for risk; and the risk-free rate is used for the discount rate.
This method is useful when systematic risk is difficult to estimate, or when the manager wants to incorporate
his/her own risk aversion.
The certainty equivalent cash flow is the certain (risk-free) amount that would be equivalent (i.e., would
make the manager indifferent) to the risky cash flow. Suppose, for example, the manager feels that a risky cash flow
next year with an expected value of $200 is equivalent to a riskless cash flow of $180. Then the certainty equivalent
cash flow is $180, and .

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2. Profitability Index, PI =

This measure is conceptually similar to the NPV, but it is normalized by the investment cost. The decision rule is:
For Investing: invest in the project if PI > 1,
For Ranking: rank projects according to PI.

The PI is a way to approximate the “bang for the buck” from the project. It is useful for ranking projects,
particularly under capital rationing (when firms cannot choose all good projects because there will not be enough
capital, as is often the case is real life).
In theory, there should be no capital constraints in efficient markets; if it is a good project, the firm can
always raise funds in capital markets. In practice, however, capital constraints exist because of various reasons, e.g.,
lack of management credibility and uncertainty of prospects of the new project, underpricing of new securities
(particularly equity) setting limits on how much can be raised in financial markets, flotation costs and other costs of
external financing, and budgetary (management) control.

Example of PI
Project A Project B
Investment 1 10
NPV 1 5

NPV is higher for project B, but PI is higher for project A (2) than for project B (1.5). If there are no capital
constraints, we should pick project B (higher NPV), but if the firm is capital-constrained, it is better to pick project
A (because of the higher PI).

3. Internal Rate of Return, IRR: this is the discount rate that gives a zero NPV, i.e., . It is
generally identified numerically. Decision Rule:
For Investing: invest if IRR > cost of capital or discount rate,
For Ranking: ranking: by IRR (higher IRR denotes more attractive project)

There are some potential problems with IRR:
(i) Multiple IRRs: when cash flow changes sign more than once (e.g., if a large cash injection is needed late in
the project, as in shipping or mining), we get multiple IRRs.
(ii) Mutually exclusive projects: for mutually exclusive projects, one project might have higher NPV over a
range of discount rates, but the other project might have higher NPV for discount rates outside this range.
(iii) Term structure effects.
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Points worth noting about the IRR:
a) IRR is a rough proxy for “average return over life of project;”
b) Intermediate cash flows are assumed to be reinvested at the IRR;
c) We do not need a discount rate to compute the IRR;
d) For well-behaved projects, IRR gives exactly the same results as NPV;
e) Unlike the NPV, IRR is not additive, i.e., IRRA+B ≠ IRRA+ IRRB;
f) In spite of its drawbacks, IRR is more popular with managers than NPV.

4. Payback Period: the number of years required to recoup the investment. Note that this is a non-DCF method.
The decision rule is to invest in the project if the payback period is shorter than some critical value, e.g., 3 years.
Projects are ranked by payback period (shorter payback period is better).
This measure has a few drawbacks:
(i) it ignores the time value of money,
(ii) it ignores cash flows after the payback period,
(iii) it is based on an arbitrary standard, e.g., why 3 years?
(iv) it does not necessarily lead to firm value maximization,
(v) it does not work with certain types of projects, e.g., shipping, mining (when there might be
negative cash flows after t = 0),
(vi) it biases the decision towards the short term, i.e., leads to rejection of good long-term projects and
acceptance of worse projects with early cash flows.

The payback period is popular with managers (although used mostly as a coarse screen) because of its simplicity;
also, managerial risk aversion can be incorporated in the decision-making process, since later cash flows are
discounted harder. This method is widely used by small and/or unsophisticated firms, and for small projects, e.g.,
replacement of standard equipment such as pumps.

Discounted Payback Period
Under the discounted payback period method, the project will be accepted if the sum of the discounted cash inflows
equals the initial investment before a specified cutoff period. This is of course very similar to the Payback Period
rule except that the time value of money is incorporated. However, it might actually worsen the bias against long-
term projects.

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5. Accounting Rate of Return (AROR): average return on book investment. This is also a non-DCF method.
This measure is based on accounting numbers, hence it is unreliable. Moreover, it ignores the (opportunity) cost of
capital, hence it tends to over-value projects.

6. Economic Value Added (EVA): Variation of AROR.
EVA is defined as: EVA = Profit – Value of Capital Used (i.e., cost of capital is included in costs)
Since EVA incorporates the cost of capital, it is superior to AROR. It is similar to the NPV for the year, and Project
NPV . Since EVA ≈ NPV for the year, it is used widely for evaluating managerial performance and
for rewarding (and incentivizing) managers.

7. Equivalent Annuity (EA): this method used to evaluate projects of different durations, for which NPV is not a
fair comparison. Firms often have to choose among projects with different lives, in which case NPV is not a good
comparison because the longer-term projects are likely to have higher NPVs. In this situation, the correct approach
is to annualize the NPVs, or to convert all the project cash flows to equivalent annuities, under the assumption that
projects can be replicated: thus, EA = NPV/PVIFA.

Example. You have to choose between a 5-year project and a 10-year project, using a discount rate of 12%. The
former requires an initial investment of $1,000 and returns $400 per year for 5 years. The latter requires an initial
investment of $1,500 and returns $350 per year for 10 years. Which is the more attractive project?

With a discount rate of 12%, NPV = 441.91 (for first project) and 477.58 (for second project).
Convert to EA by annualizing the NPV (divide by the present value interest factor for annuity or PVIFA):
EAV(1) = 441.91/3.6048 = 122.59, EAV(2) = 477.58/5.6502 = 84.52. Therefore, the first project is better.











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The Real Option Approach to Investment Decisions

As discussed earlier in this chapter, the generally accepted decision rule (in textbooks) is as follows: an investment
project should be accepted if its IRR exceeds the cost of capital or if its NPV is positive. In practice, however, it is
observed that managers seem to have much more stringent requirements. The “hurdle rates” that are used for new
projects are much larger than the cost of capital (typically three times). A study by Lawrence Summers found that
companies used hurdle rates as high as 30%, with a mean of 17% and a median of 15%. The cost of capital during
this period was much smaller. In other words, managers’ required returns are higher than the theory recommends,
that is, managers delay investment until conditions are significantly better than prescribed by the theory.
This does not necessarily mean that managers are irrational or excessively risk averse. The explanation lies
in the fact that most investment projects share three characteristics:
(i) The investments are partially or completely irreversible. This is caused by sunk costs (e.g., firm-specific
investments such as marketing or advertising expenses), informational asymmetries between buyers and
sellers (the “lemons” problem), government regulations or institutional arrangements (e.g., high costs of
hiring or firing employees), etc.
(ii) The future benefits from the investment are uncertain. This is essentially business risk or industry risk, and
results from uncertainty or randomness in business conditions, revenues and costs.
(iii) Managers have significant leeway over the timing of the project. If the manager can time the decision, then
it is no longer an Accept/Reject decision; the options then become Accept/Reject/Defer. When conditions
improve sufficiently, it will be optimal to invest; until then, the firm is better off if it just waits and defers
the decision.
Because of the manager’s ability to time the project, there is an “option” aspect to the investment decision. We can
think of the firm as holding an American Call Option – the option to invest in the project (with an exercise price
equal to the investment cost). The decision to invest is equivalent to exercising the option; thus, the decision is not
whether to invest, but when to invest, as in the case of an American call option. As a result, this branch of the
investment literature is called the “real option” approach to investment.
When the investment decision is viewed as a real option, the firm (at investment) receives the value of the
project and pays the investment cost; in addition, it gives up the option to invest. This results in the investment
being delayed relative to the NPV or IRR policy, hence it makes the investment policy more stringent. Thus, the
observed “hurdle rates” mentioned above are significantly higher than the cost of capital or WACC (as
recommended by the IRR rule).
What is the “option premium” (i.e., what does it cost the company to acquire the real option)? Very often,
the premium is zero, because the company gets the option for free by virtue of being in the business, e.g., the option
to expand is free because the company is already in the business. What is the “option exercise price” (i.e., what
does it cost the company to exercise the option)? For expansion it is the investment required to expand, for new
investments it is the investment cost.
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A Simple Example
A firm has an investment project that is completely irreversible (i.e., no part of the initial investment can be
recovered). There is an initial investment requirement of $1600; once the project is (instantaneously) implemented,
it will produce 1 unit of the output per year, and the operating cost is zero. The current output price is $200 per unit,
but the price will change next year to either $300 or $100 (with equal probabilities); and will remain unchanged
thereafter (that is, uncertainty is resolved after 1 period). The appropriate discount rate is 10%. Should the firm
make the investment?

The project’s NPV if accepted today (using expected future price of $200 per unit) is: 400
1.0
2001600NPV0  .
According to the traditional decision rule, the project should be accepted right away, since the NPV is positive.
However, let us see how the firm will fare if it decides to postpone its decision. If it waits, and the price falls to
$100 next year, it will clearly reject the project, since NPV = –1600+100/0.1 = –600. On the other hand, if the price
rises to $300 per unit, it will invest since NPV = –1600+300/0.1 = 1400.
Then the expected NPV (today) of postponing the decision is 36.636
1.1
)01400(5.0NPVP 
 . This is
substantially larger than the NPV of accepting it right away ($400). Then the optimal decision rule is: (i) at time t =
0, postpone the decision; (ii) at t = 1, invest if price has risen (to 300) and reject if price has fallen (to 100).
The project value with no timing flexibility is 400, and project value with timing flexibility is 636.36. Thus,
the value of the manager’s flexibility (to time the investment) is the difference = 636.36 – 400 = $236.36. If the
uncertainty extends to multiple periods, the optimal investment policy will of course be more complicated, and the
value of the timing ability will also be larger.

Real Option vs Financial Option
There are some strong similarities between Real and Financial Options; therefore, the well-developed theory of
financial options can be utilized to analyze investment decisions as real options.
Call Option on Stock Real Option on Project
Stock price ENPV of project cash flows
Exercise price Investment cost (cost of the project)
Time to expiration Time until investment opportunity vanishes (competition, etc)
Stock price volatility Volatility of project value or project cash flows
Risk-free interest rate Risk-free interest rate

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Some General Remarks on Real Options
The real option approach is superior to the traditional methods such as DCF, which cannot incorporate the
flexibility inherent in a project. Real option analysis is particularly valuable whenever flexibility has a significant
role. From survey information, the important real options seem to be the timing option (option to defer) and the
option to abandon; less important are options to expand, to switch inputs, to shut down temporarily, etc. When is
real option analysis useful? Some examples:
1. Contingent investment decisions, e.g., when decisions are contingent on the state of nature.
2. High level of uncertainty.
3. When future growth opportunities are a large component of current value.
4. When flexibility is valuable.
5. When the manager has the ability to make changes after project acceptance.

In practice, real options have not been completely ignored. Very often, real options have been handled by using
coarse “rules of thumb,” e.g., set the required return at approximately double the cost of capital. However, it is a
good idea to have a solid understanding of real options (since rules of thumb are typically opaque and arbitrary),
particularly when large investments are being contemplated.
Since real options are options on non-financial (real) assets, such as land, technology, patents, machinery,
etc., they tend to be more long-lived and more complex and illiquid than financial assets (and very often non-traded
too); hence it is much more difficult to value real options than standard financial options. Nevertheless, we need to
be familiar with real options analysis, in capital budgeting as well as mergers and acquisitions because real options
are ubiquitous – any kind of managerial flexibility is an implicit real option; and managerial flexibility cannot be
valued by the traditional DCF methods. Also, real options account for a significant fraction of the equity value of
growth companies (resulting in high market-to-book ratios for such companies), hence cannot be ignored in
valuation analysis.
The value of a real option comes from two elements – (i) capacity of a firm to learn from new information,
and (ii) ability to modify behavior based on that learning; for instance, to temporarily shut down a copper mine
when copper price falls. An NPV calculation only uses information that is known at the time of the appraisal,
whereas the real option approach incorporates the ability to make mid-course changes or adjustments as more
information becomes available, i.e., it incorporates managerial flexibility. Clearly, the real option approach is a
superior method of valuing uncertain projects.
However, for all its advantages, the real option approach has not yet become very popular with managers.
In some cases, it gives excessively ambitious managers a license to overinvest in risky projects and gamble with
shareholders’ money. Another potential problem is that, when applying the real option approach, it is necessary to
make simplifying assumptions; we must ensure that these assumptions are not unrealistic.


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Types of real options
Entry option: option to enter a business or a segment of a business, resulting from R&D work, new product
development, oil drilling rights, other resources, etc. These are call options on the underlying business.
Exit option: the ability to shut down operations permanently and exit the industry. This is valuable because without
this option, shareholders would be forced to keep alive the firm even if it suffers huge losses and its prospects are
bad. These are put options. These include option to divest assets or subsidiaries, and option to default or declare
bankruptcy.
Timing option: the right to delay an investment; probably the most common real option. This is especially important
for new or expansion projects. The delay might provide additional information about the market (price history, pilot
project, etc).
Growth option (expansion): option to expand into the same or related product market; sequential investment: when
to invest, how large an investment, etc.
Replacement option: option to replace existing plant and machinery with new (more efficient) machinery, or
existing technology with new and better technology.
Switching options: the flexibility to switch from one operating mode to another (on either the input or the output
side). An example is a power generating plant that can use either coal or gas; the ability (option) to switch to the
cheaper fuel is valuable; and might justify the investment in a more expensive flexible plant than a cheaper coal-
based or gas-based plant. Or a hybrid car, where the inputs can be gas or electricity. Or a car manufacturer can
switch to a high-margin SUV when gas prices are expected to decline.

Real Options and Strategic Decisions
Because traditional valuation tools such as NPV ignore the value of flexibility, real options are important in
strategic and financial analysis. Consider the example of an oil company, which has the opportunity to acquire a
five-year license on a block. When developed, the block is expected to yield 50 million barrels of oil. If the current
price of a barrel of oil from this field is $10, and the present value of the development cost is $600 million, then the
NPV of the opportunity is: $500 million - $600 million = -$100 million. Based on NPV analysis, the company
would obviously pass up the opportunity.
Real Option analysis would recognize the importance of uncertainty in this situation. The major source of
uncertainty here is the price of oil, and we have historical data on the variability of oil prices. Suppose that its
volatility or standard deviation (σ) is 30% per year. Holding the option also obliges the company to incur the annual
fixed costs of keeping the reserve active – let us say, $15 million. This represents a dividend-like payout of 3%
(that is, 15/500) of the value of the asset. The duration of the option, t, is 5 years and the risk-free interest rate, r, is
5%, leading us to estimate option value at (using the Black-Scholes formula):
ROV = (500e-0.03*5)*(0.58) – (600e-0.05*5)*(0.32) = $251 million – $151 million = +$100 million.
Thus, the value goes from –100 to +100. Where does this $200 million difference come from? Consider a
simple financial option, available at $17 for an exercise price of $70 when the stock is trading at $83. A buyer who
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exercised the option immediately would have a payoff of $13 but would be $4 out of pocket, having paid $17 for
the option. The $4 represents the value of the flexibility inherent in not having to decide whether to make the full
investment immediately, a flexibility whose value an NPV analysis would recognize as zero. So too in this case: the
$200 million in the real option is the equivalent of the $4 in the financial option.
Ultimately, then, the option valuation recognizes the value of learning. This is important because strategic
decisions are rarely one-time events, particularly in investment-intensive industrial sectors. NPV, which relies on
all-or-nothing, "go/no go" decisions and doesn’t properly recognize the value of learning more before a full
commitment is made, is for that reason often inadequate. In fact, NPV’s inadequacy can be stated in the precise
terms of the real-options model. Of the six variables in that model, NPV analysis recognizes only two: the present
value of expected cash flows and the present value of fixed costs. The real option approach offers greater
comprehensiveness, capturing NPV plus the value of flexibility – that is, the expected value of the change in NPV
over the option’s life.

A General Decision Rule for Investment Timing
If we cannot use the traditional rules (IRR, NPV, etc), how do we decide when or whether to invest in such
situations? We will illustrate a general decision rule under this type of uncertainty with another simple example.
Suppose the main source of uncertainty is output price P. Then, the general form of the optimal decision
rule for investment decisions under uncertainty (when the timing option exists) is as follows: invest when P exceeds
some critical value or investment trigger, say P*. Clearly, a higher (lower) P* implies delayed (accelerated)
investment. When the option value rises relative to the value of the underlying asset, it is better to delay option
exercise, that is, the critical price, the critical price P* will rise.
From option theory, we know that the value of the option is an increasing function of uncertainty (price
volatility), window for option exercise (or time to expiry of the option), asset value, flexibility, and a decreasing
function of exercise price. Thus, the critical investment trigger P* will depend on all these factors; of these, the most
important factor in practice is uncertainty (or risk or volatility). A higher volatility results in a higher option value,
thus it will give a higher P* (i.e., will delay investment); in other words, volatility has a negative effect on
investment.

Example
In our earlier example, suppose the current output price is P, and the price will either rise to 1.5P or fall to 0.5P next
year (with equal probabilities). Then the NPV of accepting the project right away (again using the average or
expected output price of $P) is: 1600P10
1.0
P1600NPV0  .
If the decision is postponed and the price rises next year, the NPV of accepting the project then will be:
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–1600+1.5P/0.1 = 15P–1600. If the price falls next year, then the project will be rejected next year (i.e., NPV = 0).
Then the expected NPV (today) of postponing the decision is
1.1
)1600P15(5.0NPVP
 . The project should be
accepted today if P0 NPVNPV  . Using the expressions for 0NPV and PNPV , this condition simplifies to P >
274.3. Thus, the trigger price is P* = 274.3, and the decision rule is: invest immediately if P > 274.3, otherwise
postpone decision. This gives us the general form of decision rule in investment decisions under uncertainty when
the timing option exists, i.e., invest if P exceeds some critical trigger P*, else postpone the decision.1

Determinants of Investment Timing (or P*)
1. Volatility or Uncertainty: This is the most important determinant of the trigger price (or time of investment).
Volatility is usually measured by the standard deviation of the price process or the earnings process. Recall
that when the firm invests it gives up the option to invest; also recall that option value always increases with
volatility. Thus, higher volatility means the firm is giving up a more valuable option (to invest) while the
project value is the same; as a result, the firm is more reluctant to invest, and the trigger price is higher
(investment is delayed) when volatility is higher. Volatility therefore has a negative effect on investment.
In the above example, if volatility was higher (that is, the spread 0.5P – 1.5P was wider) the critical price P*
would be higher (as you can verify).
2. Discount rate: A higher discount rate will reduce the project value, making the firm more reluctant to invest.
Thus, a higher discount rate results in higher trigger price or delayed investment.
3. Investment Cost: A higher investment cost will of course delay investment (or raise the trigger price).
4. Level of competition: (this is not considered in our above examples, but is important in real life). Competition
might force the firm to invest earlier than it would otherwise do (resulting in a lower trigger price), thus
competition has a positive effect on investment.

Public-Private Partnerships and Real Options
A Public Private Partnership (PPP or P3) is defined by the Canadian Council for Public-Private-Partnerships as “a
cooperative venture between the public and private sectors, built on the expertise of each partner, which best meets
clearly defined public needs through the appropriate allocation of resources, risks and rewards.”2 In recent years, P3
has become the most popular means of delivering infrastructure projects (transportation, healthcare, education,
water and sewage treatment, garbage disposal, etc.) around the world, including the federal government and all
provinces and territories in Canada. We can expect to see an increase in infrastructure projects in Canada because

1 If there is ongoing uncertainty, then the problem becomes more complicated because the project might not necessarily be
rejected if the price falls, so the NPV will not be 0 but rather the option value at that point (which will be a function of the price
at that time). This problem can be solved using more advanced methods; for an introduction, you can read (i) Dixit, A. and R.S.
Pindyck (1994) Investment Under Uncertainty, Princeton University Press, Princeton, NJ, or (ii) McDonald, R. and D. Siegel
(1986) The Value of Waiting to Invest, Quarterly Journal of Economics 101, 707-727.
2 Allan, J.R. (2000) Public Private Partnerships: A Review of Literature and Practice, Saskatchewan Institute of Public Policy,
Public Policy Paper No. 4.
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the government has prioritized it as a key growth area (see, for instance, the $53 billion New Building Canada
Plan). Some examples of P3 infrastructure projects in Canada:
 Confederation Bridge, Government of Canada and Strait Crossing Development Inc.
 Highway 407 ETR, Province of Ontario and 407 International Inc. (consortium of private firms)
 William Osler Health Centre, Province of Ontario and The Healthcare Infrastructure Company of Canada
 Moncton Water Treatment Facility, City of Moncton and USFilter Canada

Why P3?
Most infrastructure projects have the following characteristics:
1. Irreversibility
2. Significant risk (uncertainty)
3. Large investment requirement
4. Long payback period

Traditionally, these projects were built, operated and maintained by the public sector. But in recent years,
governments have been more interested in partnering with the private sector, which can provide (i) capital (which
most governments have trouble raising because of budgetary constraints), and (ii) technical expertise, specialization
and efficiency (which are in short supply in the public sector). These factors make the P3 an attractive
organizational form for the government.
However, private firms are hesitant to invest in projects that require large investments, have high levels of
risk or uncertainty, and long payback periods. In order to make these projects attractive enough to both the private
sector and the government, the contracts generally contain a number of clauses not observed in other organizations,
e.g., investment subsidy, revenue guarantee, buyback clause. These clauses make the P3 organizational form unique
and interesting.

Real options involved in a P3 project
Firstly, the project itself can be viewed as a real option, like most other investment projects, because of the
uncertainty and irreversibility mentioned above. In addition, there are the special clauses in a P3 contract that are
necessary to attract private investment. Take, for instance, the revenue guarantee, which might specify that if
revenues fall below operating costs, then the government will make up the shortfall. Suppose the monthly revenue
is given by a random variable R~ and the monthly operating cost given by a constant C.3 Then, because of the
revenue guarantee, the private firm’s monthly payoff will be (R – C) if R > C and 0 if R < C; in other words, its
payoff is Max (R – C, 0). This exactly the payoff from a call option on the project’s monthly revenue with an

3 Of course, both revenues and operating costs are likely to be random in real life. However, the degree of uncertainty is far
greater in the revenue stream than the cost stream, hence it is reasonable to assume, as an approximation, that C is constant.
14

exercise price of $C, hence a Revenue Guarantee is equivalent to the government giving the private firm a call
option.
Also look at the buyback option, which is usually included in the P3 contract and specifies that, after a
specified number of years the government can buy back the project at a pre-specified price.4 This is clearly an
option held by the government – a call option on the project with an exercise price equal to the buyout price. While
this option is easy to value in principle, it is difficult in practice because long-term predictions are required (up to
30-40 years) for this valuation. It is important to identify and appropriately value all such clauses in a P3 contract
for two reasons:
1) These (implicit) real options account for a large fraction of the total value of the project, thus they should
not be ignored.
2) If not properly valued and allocated, we might end up with one party getting extraordinarily high returns
and the other party being unfairly burdened with large financial obligations.

If the various embedded options are not properly valued and accounted for, the payoffs to the two parties will not
be equitable given the level of risk they bear. This has happened many times in the past, resulting in great
dissatisfaction, sometimes even premature termination of the project. These projects have, at times, placed
excessive burdens on taxpayers.5 Governments find it difficult to reduce their risk exposure and often end up
making large windfall payments to the private party (Alonso-Conde, footnote 4). Therefore, it is very important that
all implicit real options in the contract be rigorously valued, and the contract designed so that each party is
appropriately compensated for the risk it bears.
A typical P3 project might be a toll road built by a private firm, with the investment cost being shouldered
by both the private firm and the government (in the form of an investment subsidy), which the private company
operates (and collects tolls), and the private firm pays the government a certain concession fee per month; if the toll
collection is so small that operating costs are not covered, the government makes up the shortfall to the private firm
(whose cash flow is therefore zero that period); finally, after a certain number of years, the government can (if it
wants) acquire the project by paying the private firm a pre-determined “buyout price.” Such a contract has a
number of embedded options (which you should be able to identify and evaluate).


4 Obviously, the higher the buyout price, the more willing the private party will be to invest in the project.
5 Alonso-Conde, A.B., C. Brown and R. Rojo-Suarez (2007) Public-private Partnerships: Incentives, Risk Transfer and Real
Options, Review of Financial Economics 16, 35-349.
Brown, C. (2005) Financing Transportation Infrastructure: For whom the Road Tolls, The Australian Economic Review 38,
431-438.
15

Capital Budgeting Exercise

You have just joined the real-estate subsidiary S of a large conglomerate C. The subsidiary S is responsible for
purchasing and managing the real estate used by various units of C, and it acts as a private real estate firm,
acquiring and managing properties and providing space to the other divisions of C. It also rents out excess space to
other tenants.
S makes its own decisions, but gets funds from the corporate Treasury department of C. The management at S
receive bonuses based on the profit of their division. Traditionally, IRR has been the primary tool for decision-
making regarding acquisition of buildings. This often led to S buying smaller, older, less efficient buildings,
resulting in increased customer complaints about building quality. It is now planning another building acquisition,
and must choose between two options:
(1) An older building that costs $7 million and gives an imputed rent savings of $1.5 million the first year,
growing at 3% per year; of this, a third would go toward operating expenses and taxes; the after-tax sale
price at the end of the 10-year planning horizon would be $5 million.
(2) A new building that costs $10.1 million and gives an imputed rent savings of $1.65 million the first year,
growing at 5% per year; of this, a third would go toward operating expenses and taxes; the after-tax sale
price at the end of the 10-year planning horizon would be $12 million.
The company cost of capital is 15%, but the risk of the real-estate division S is lower; in fact, the return on similar
real-estate investments is 12%.

Questions
1. Compute NPV, IRR, PI and Payback Period for both projects. For NPV, assume mid-year cash flows,
except for initial outlay and terminal value. Which project would you pick and why?
2. Does the company currently have a good method for evaluating and rewarding success? How would you
change their incentive system?
3. Do you agree that using the IRR approach can lead to “ . . . buying smaller, older, less efficient buildings, .
. .?” Explain.

16

Chapter 1. Questions

1. ABC Construction is considering the acquisition of new construction equipment. Management estimates that it
will cost $10,000 to acquire the equipment, whose availability will increase cash revenues by $9,000 per year for
each of the next two years. However, cash expenses (additional labor, income taxes, etc.) will increase by $4,000
by year. The equipment is expected to have a useful life of two years. At the end of two years, the equipment is
expected to have a salvage value of $3,000. Assuming an opportunity cost of 12%, should the investment be made?

2. Consider an investment with an initial investment of $10,000 and the following cash inflows: $2,000, $5,000,
$3,000 and $6,000 at the end of years 1, 2, 3 and 4 respectively. What is the payback period? According to the
payback period rule, should the investment be accepted?

3. There are two mutually exclusive investments, X and Y, with the following cash flows:
X: ( -200, 100, 300, 400)
Y: (-5000, 4000, 1000, 2000)
According to the IRR rule, which project is more desirable? According to the NPV rule (if the discount rate is
10%), which project is more desirable? What is the cross-over rate (i.e., the IRR of (Y – X))?

4. Compute the IRR of a project with the following cash flows: (-51, 100, -50).

5. Your company is considering the purchase of either machine X or machine Y. The two machines provide the
same benefit and the machine selected will be replaced at the end of its useful life. The lives and annual costs for
each are:
Year Machine X Machine Y
0 $100 $70
1 10 15
2 10 15
3 10
The opportunity cost is 10%. Ignoring taxes, which machine should be selected?

6. Growth option: you must decide whether to invest $1 million in an R&D program. If the program succeeds (the
probability of which is only 20%), it is expected to generate business worth $10 million; if it fails, there will be no
payoff. Should you invest in the R&D project?
17

Chapter 2. CAPITAL STRUCTURE RECAP

This chapter looks at the firm’s capital structure (or leverage or financing) decision, which can vary widely across
industries or even firms. For instance, Boeing Corporation has a debt-to-capital ratio of about 20% while Home
Depot’s debt-to-capital ratio is only 4.5%. In this chapter, we will address the following questions: How does debt
financing affect equity holders? Does debt financing create value for a firm? What is the right (optimal) amount of
debt for a firm?
Changing the capital structure is called “restructuring,” which we will discuss in more detail later in this
course. From earlier courses, we know debt has: (i) a positive effect on value because of the tax shield, disciplining
effect and signaling effect; and (ii) a negative effect on value because of bankruptcy cost and agency problems.
[There are also other effects of debt on firm value, e.g., agency problems and signaling, which we will discuss later
in this course]. Thus, the net effect of debt financing on firm value can be positive or negative, depending on the
capital structure decision (or the amount of debt used by the firm). The significance of the leverage decision comes
from the fact that a good decision can add value and a bad decision can destroy value and might even lead to
financial distress and bankruptcy.


Basics of Capital Structure: Miller-Modigliani (M&M)

M&M and Leverage Irrelevance in a Frictionless World (no taxes or bankruptcy costs).
M & M Proposition I: In perfect markets (no taxes, no transactions costs, no bankruptcy costs, etc), the value of a
firm is independent of its leverage ratio, or , because investors can use homemade leverage just like a
corporation can. Thus, the leverage ratio is irrelevant.

M & M Proposition II: In perfect markets (no taxes, no transactions costs, no bankruptcy costs, etc), the cost of
equity (or the required return to equity) is an increasing function of the leverage ratio, as follows:
,
where rA, rE and rD denote the returns to the project, to equity and to debt respectively, and D and E are the values
of debt and equity respectively. Thus, the cost of equity increases in a linear manner with the leverage ratio. When
more debt is issued, the cost of capital falls because debt is cheaper than equity; on the other hand, the cost of
capital rises because equity becomes more expensive as shown above. The net effect is zero, and overall cost of
capital remains unchanged; as a result, the total value of the firm remains unchanged.

18

M & M with constant corporate taxes
Leverage affects firm value via the tax shield, hence the above propositions need to be revised slightly.

Proposition I: With corporate taxes, the value of a firm depends on leverage, as follows: , where
cT is the corporate tax rate and D is the amount of debt. The term DTc denotes the value of the tax shield of
permanent debt. It is therefore optimal to use as much debt as possible.

Proposition II: With corporate taxes, the cost of equity (or the required return to equity) is given by:

The overall cost of capital falls as leverage increases; hence it is optimal to use as much debt as possible.

Therefore, the after-tax cost of debt is Dc r)T1(  . For a company with large accumulated losses, cost of
debt will be greater than Dc r)T1(  , and the tax shield will be worth less than DTc , because it is unlikely that the
full benefits of debt will be exploited.

There are 4 predictions that arise from the above discussion:
1. High-tax companies will use more leverage.
2. Firms with substantial non-debt tax shield (depreciation, accumulated losses, etc) should use less leverage.
3. If corporate tax rates rise, leverage ratios should also rise.
4. Cross-country: firms in countries with lower tax rates should have lower leverage ratios.
All four predictions are supported by empirical evidence, thus corporate behavior is consistent with the above
predictions.

M & M with Corporate and Personal Taxes
Effective corporate tax rate decreases with leverage, for two reasons: (i) as more debt is used the taxable income
shrinks and probability of loss rises, which reduces the effective tax rate, and (ii) more debt means firms have to
target higher-tax-bracket bondholders, raising TD, which results in a lower effective corporate tax rate.

Miller’s Hypothesis (1977): Suppose the personal tax rates on equity income and debt income are ET and DT . Then
the relationship between firm value and leverage is:
,
where the second term denotes the tax benefit from leverage. As more debt is issued, DT increases and the tax
benefit falls.
19

The tax benefit or the effective corporate tax rate generally falls as the firm issues more debt. From the
above equation, it is clear that the firm should stop issuing debt when there is no further benefit from leverage, that
is, when , or .
Thus, personal taxes provide an explanation for the fact that companies restrict their use of debt financing
(apart from the traditional bankruptcy-cost explanation). Note that all the earlier situations were special cases of the
above formula, e.g., with no taxes, we have τD = τe = τc = 0, which gives VL = VU; with no personal taxes, we have
τD = τe = 0, which gives .

The Trade-Off Theory of Capital Structure
This is the traditional model for the determination of optimal leverage ratio with taxes and financial distress
(bankruptcy) costs, trading off tax benefits and financial distress costs associated with additional debt.
Financial distress can lead to filing for chapter 11 reorganization or bankruptcy, hence there are costs
associated with financial distress: direct bankruptcy costs plus indirect costs. Direct costs of bankruptcy are small
and fairly easy to estimate; indirect costs are much larger, and more difficult to quantify. If the perceived
bankruptcy risk is greater, the company will lose customers when there is a need for after-sales service or parts (as
in the case of durable goods), suppliers will impose stricter (hence more expensive) credit terms, higher cost of
borrowing from banks, etc. These are part of indirect costs of financial distress.
These bankruptcy or financial distress costs offset the tax advantage of debt. As more debt is added to a
firm’s capital structure, the probability of financial distress increases, and this makes debt less attractive. The
optimal amount of leverage is determined by the trade-off between the tax advantages of debt and the financial
distress costs associated with debt.
The relationship between firm value and leverage now becomes:
– Prob(Fin. Dist.) * Fin. Dist. Costs.
What determines the probability of bankruptcy? The two major factors are:
(i) size of operating cash flows relative to debt obligations: the smaller the ratio, the higher the
probability of bankruptcy. Lower coverage ratio or TIE (times interest earned), or equivalently,
higher leverage ratio, will result in higher bankruptcy risk (or risk of financial distress).
(ii) variance of operating cash flows: the larger the variance, the higher the probability of bankruptcy.
The variance of operating cash flows (or earnings) depends on the line of business and the degree
of operating leverage (DOL).6


6 Recall from “Break-even Analysis” in earlier course(s) that the DOL is determined by the ratio of fixed to variable costs.
20

Costs of Financial Distress
Financial distress costs can be direct or indirect.
Direct costs: Examples of direct bankruptcy costs are legal and administrative costs, such as accountant and lawyer
fees, or losses in selling assets in the event of liquidation. Direct bankruptcy costs tend to be quite small. Empirical
studies with samples of large firms have estimated direct costs at 5.3% of total firm value (Warner, 1977), 3.1% of
total firm value (Weiss, 1990), etc. Direct bankruptcy costs are also fixed by nature, so it can be high (as a
percentage of firm value) for small firms; Ang, Chua and McConnell (1982) and Altman (1984), using samples of
small firms, estimate bankruptcy cost at 20-25% of firm value.7 If the company is forced to liquidate, then the
nature of its assets (tangible versus intangible, for instance) will affect the bankruptcy cost. Direct bankruptcy costs
tend to be quite small in comparison to indirect costs.
Indirect costs: Examples of such costs are loss in revenues because of customers’ perceptions and need for after-
sales service and maintenance, stricter credit terms from suppliers, and higher costs of raising funds. Indirect costs
are very important for firms that sell durable products that require replacement parts, after-sales service, etc., since
customers will be more unwilling to buy these products from a firm with a higher probability of default.
Indirect costs are of much greater magnitude than direct costs; they are therefore more important in capital
structure decisions. Unfortunately, it is very difficult to accurately quantify them. Thus, in practice it is not easy to
estimate either the probability of financial distress or the costs resulting from financial distress; as a result, the
optimal leverage ratio using this trade-off model is quite difficult to identify precisely. The model, however, is
useful as a description of the trade-offs and as a way to approach the capital structure decision. Moreover, we have
only looked at two factors here (taxes and financial distress costs); in practice, there are other factors which might
affect the leverage decision, such as agency problems, or asymmetric information, which we will discuss later.

Some General Implications of the Trade-off Theory
1. Companies with intangible assets (growth options or patents) should use less debt.
2. Companies with mostly tangible assets (steel or chemical manufacturers, utilities) should use more debt.
3. Companies with low-volatility (stable) cash flows should use more debt, e.g., utilities; and companies with
volatile cash flows should use less debt, e.g., Mattel Corporation.
4. Companies with higher tax rates should use more debt.
5. Companies with more non-debt tax shields (depreciation, tax credits, etc) should use less debt.
6. Firms with too much equity should issue debt, and firms with too much debt should issue equity.



7 Altman, E. (1984) A Further Empirical Investigation of the Bankruptcy Cost Question, Journal of Finance 39, 1067-1089.
Ang, J., J. Chua and J. McConnell (1982) The Administrative Costs of Bankruptcy: A Note, Journal of Finance 37, 219-226.
Warner, J. (1977) Bankruptcy Costs: Some Evidence, Journal of Finance 32, 337-347.
Weiss, L. (1990) Bankruptcy Resolution: Direct Costs and Violations of Priority of Claims, Journal of Financial Economics
27, 285-314.
21

Empirical Evidence on Leverage Ratio
1. Negative correlation between earnings volatility and leverage ratio.
2. Negative correlation between R&D/Advertising (proxy for intangibles) and leverage ratio.
3. Negative correlation between non-debt tax shields and leverage ratio.
4. Similar firms (e.g., in the same industry) have similar leverage ratios.
5. Negative relationship between earnings level and leverage ratio.

Examples of Leverage Ratios (D/V)
Grocery stores 66%, Airlines 57%, Computer software 10%, Drugs & Pharmaceuticals 5%.

What Factors do Managers Consider when Deciding on the Leverage Ratio?
From survey information, we know that managers look at the following (not necessarily in order of importance):
 tax liability (greater tax liability → higher leverage ratio)
 variability of cash flows or earnings (greater variability → lower leverage ratio)
 maintain good debt rating (if rating is falling, reduce leverage ratio)
 future financing requirements, long-term reputation and survivability
 financial flexibility or slack (if more flexibility is desired, use less debt)
 corporate control (use less equity so as not to dilute ownership, hence this leads to higher leverage ratios)
 competitive strategy (easier to compete with lower leverage ratio)
 signaling implications (higher leverage ratio sends more favorable signal)

An Additional Benefit of Debt: The Discipline of Debt
One way to tighten managerial discipline is to force the company to borrow more money, since borrowing creates
the commitment to make interest and principal payments. More debt means there will be less leeway, which will
force managers to increase efficiency wherever possible. This difference between the forgiving nature of the equity
commitment and the inflexibility of the debt commitment has led some to call equity a cushion and debt a sword.
Debt acts as a prod to force managers to maximize shareholder value because bad investments will lead to
bankruptcy and loss of employment. This is one reason for the positive effect that debt issues have on stock prices.
Managers might generally not maximize shareholder wealth, particularly in widely held public companies.
High leverage ratio, because of the large interest payment burden, prevents frivolous expenditures by the manager.
Empirical evidence mostly confirms this hypothesis. This implies that optimal leverage ratio is higher than the
trade-off theory predicts.

22

Dynamic Capital Structure
The previous discussion on capital structure (trade-off theory) has been a static analysis. That is, we looked at a
one-time single-period decision. A dynamic theory would explain how these decisions are made over time. A well-
known example of a dynamic theory is the Pecking Order Model of Capital Structure. According to the pecking
order theory, there is a well-defined financing hierarchy:
1. The first financing preference is retained earnings (or internal funds). Outside funds are sought only when
investment needs exceed internal funds.
2. Because of point 1, firms tailor their dividend policies to their anticipated investment needs.
3. If the firm has surplus cash, it will pay off debt and then repurchase stock (in that order).
4. If the firm faces a shortage of funds, it will tap external markets in the following order: straight debt,
convertible debt, and equity (i.e., in increasing order of risk).

The pecking order hypothesis started as a descriptive behavioral model, based on observed corporate behavior,
without going into the reasons for such behavior. It was not based on a rational (optimizing) analysis, unlike the
trade-off theory. However, a number of explanations/rationales have been offered for this type of corporate
behavior, such as taxes and transactions costs, managerial incentives (managers value flexibility and control, and
are averse to being scrutinized), asymmetric information and signaling (negative effect of new security issue,
particularly large for equity), and shareholder-bondholder agency conflicts.



23

Capital Structure Exercise

Your company has decided to go ahead with a $20 million plant modernization program that will have to be
externally funded. The modernization will not increase output but will increase Net Operating Income by $5 million
per year and depreciation by $1 million per year. Table 1 shows the company’s financial data. The Treasury
department has prepared a list of competitors with available data (see Table 2 below).
The two financing options are:
(1) Selling 20-year bonds at an interest rate of 9.8%; these would be retired through equal annual payments
over the life of the bonds. The existing long-term debt is selling at a YTM (yield to maturity) of 8.9% and
is being repaid at a rate of $5 million a year; the interest rates on Treasury Bills and Treasury Bonds are
5.76% and 7.11% respectively.
(2) Selling common stock at a price of $25 per share, after flotation costs; the company has a Beta (β) of 1.1.

Questions
1. How does your company compare with the industry with regard to Times Interest Earned (TIE) and Long-
term Debt to Total Capital ratio, for both financing alternatives? Would either alternative place it outside of
industry norms?
2. Suppose there is no change in sales from 1992, and also no change in the ratios (Current Assets/Sales) or
(Current Liabilities/Sales). Assume the new equipment is placed in service at the beginning of 1993. What
level of net operating income is needed to meet the financial obligations if debt financing is used? If equity
financing is used?
3. Find the cross-over point in net operating income (the net operating income level above which earnings per
share will be higher with debt financing and below which earnings per share will be higher with equity
financing).
4. Study the relationships between financial leverage and weighted average cost of capital (WACC) for the
industry. Based on this information, what conclusions can you reach regarding the effect of capital structure
in this industry?
5. Study your company’s profitability and leverage ratio trends, and indicate any positive or negative trends
you observe; how does this help with your financing decision, if at all?
6. Should you use debt or equity financing? Why?




24

Table 1. Financial Performance, 1986-1992 (in $ 000s)

Year 1986 1987 1988 1989 1990 1991 1992
Sales 591,823 607,812 572,988 582,688 589,101 501,997 484,823
Net Op. Income 33,046 47,330 49,868 44,270 44,138 47,197 55,575
Interest 8,772 8,674 8,676 14,950 15,378 7,601 7,430
Other Expenses 20,704 25,403 25,386 9,851 9,985 8,355 10,959
Earnings before tax 3,570 13,253 15,806 19,469 18,775 31,241 37,186
Tax 29 4,758 4,916 4,906 3,473 10,154 13,201
Net Income 3,541 8,495 10,890 14,563 15,302 21,087 23,985
Depreciation 8,521 8,368 9,176 9,198 8,903 9,911 10,487

Current assets 223,472 224,086 224,982 201,539 222,467 181,889 203,865
Fixed assets 84,025 64,716 67,670 67,799 69,463 77,116 92,565
Total assets 307,497 288,802 292,652 269,338 291,930 259,005 296,430

Current liabilities 167,272 148,486 145,082 50,739 71,801 60,576 74,249
Long term debt 60,771 55,683 56,414 116,132 123,784 67,713 70,192
Equity 79,454 84,633 91,156 102,467 96,345 130,716 151,989
Total Liab. & NW 307,497 288,802 292,652 269,338 291,930 259,005 296,430
----------------------------------------------------------------------------

EPS 0.35 0.78 1.05 1.35 1.49 1.82 2.05
Div per share 0.13 0.13 0.13 0.28 0.35 0.44 0.55
P-E ratio 9.28 4.31 5.89 7.58 5.42 6.87 14.1
P-E/Industry 1.23 0.83 1.05 0.94 0.69 0.56 0.82


Table 2. Industry Data for 1992

% of capital Book Market/
Co. Beta Pfd. Debt TIE Val/Share Book EPS P-E WACC

A 0.91 0.00 0.47 3.70 10.81 1.26 1.29 10.59 10.98%
B 1.36 0.00 0.36 1.70 12.21 1.81 0.71 31.21 14.56%
C 0.64 0.00 0.12 9.70 22.37 0.96 0.96 22.35 12.05%
D 1.01 0.00 0.18 7.80 17.51 1.43 1.20 20.81 13.87%
E 1.34 0.00 0.00 NA 5.62 7.03 2.00 19.74 17.37%
F 1.04 0.02 0.43 NA 13.61 1.03 -0.10 NA 11.31%
G 0.81 0.00 0.44 2.70 8.60 1.56 0.58 23.19 11.24%
H 0.94 0.00 0.12 6.40 12.21 1.19 0.93 15.68 13.89%
I 0.86 0.00 0.10 9.50 27.24 1.41 3.00 12.82 13.60%
J 1.06 0.00 0.13 20.50 6.34 2.44 1.08 14.32 14.90%
K 0.91 0.06 0.02 22.00 21.01 1.36 2.65 10.79 14.19%
L 0.74 0.16 0.14 0.10 8.49 1.11 1.35 7.01 11.94%
M 0.61 0.00 0.36 1.30 18.16 0.73 0.50 24.97 9.64%
N 1.06 0.01 0.26 10.30 5.78 2.73 1.32 11.94 14.33%
O 1.01 0.00 0.16 13.70 11.26 2.74 2.05 15.03 14.55%















































25

Chapter 2. Questions

1. ABC Corp is currently an all-equity firm with 20,000 shares trading at $25. The CFO would like to issue
$300,000 of debt (at an interest rate of 10%) to buy back 12,000 of the shares. The EBIT of the company will be
$40,000 if there is a recession, $60,000 if the economy remains unchanged, and $100,000 if the economy does
better than expected. Compute the ROE and EPS with and without the restructuring for each possible state of the
world. What is the “indifference EBIT,” i.e., the EBIT for which the EPS would be the same for both capital
structures?

2. ABC, Inc. is an all-equity firm that is considering borrowing $250,000 at 8%. It expects a perpetual pre-tax
earnings stream of $500,000 and faces a 46% corporate tax rate. What is the current value of the firm? If the
personal tax rate on equity distributions is 25%, the personal tax rate on interest income is 48%, and the discount
rate is 14%, what is the advantage to leverage if personal taxes are ignored? If personal taxes are considered?

3. MFF Corp expects to earn $365,000 in perpetuity before interest and taxes from its line of gourmet TV dinners.
Its leverage ratio (debt to total capital) is 40%, cost of debt is 10%, and corporate tax rate is 30%. If the company
had no debt, its cost of capital would have been 15%. What is the value of the firm? The value of its equity? The
required rate of return on its equity? The weighted average cost of capital?
Suppose the firm decides to issue equity in order to retire all its debt. What will happen to the value of the
firm? (Assume that, under the current capital structure, there are 100,000 shares outstanding).
Now, assume that the personal tax rate on equity income is 20% and the tax rate on interest income is 35%.
How will this affect the value of the company?

26

Chapter 3. BONDHOLDER-STOCKHOLDER CONFLICTS (AGENCY PROBLEMS)

Agency Problem
The agency problem is caused by the conflict of interest between shareholders and bondholders/creditors or
between shareholders and managers. In this chapter we discuss the former. Shareholder-bondholder agency
problems are an important factor in corporate restructuring, because restructuring often involves coinsurance
effects, differing incentives for shareholders and bondholders, and transfers of wealth between the two sets of
security holders.
What is the relationship between prices (or returns) of a company’s stocks and bonds? If the stock price
rises, how would you expect the bond price to change, if at all? We find that a company’s stock price and bond
price are generally positively correlated, that is, stocks and bonds issued by the same company generally move in
the same direction. However, there are exceptions – the best-known being the response during certain corporate
events like LBOs and recapitalizations. Agency problems between shareholders and bondholders arise during these
situations, because these events affect shareholders and bondholders in opposite directions.

Level effect vs. Volatility effect in stock/bond returns: the correlation between stock and bond returns is positive for
the former and negative for the latter.

Example of agency problem
In 1989, Kohlberg, Kravis & Roberts (KKR) was declared the winner in a contested bid for the leveraged buyout
(LBO) of RJR Nabisco. The LBO was to be financed primarily with debt – junk bonds, bank loans, and bridge
financing (private placements). Shareholders gained substantially: they received a total (in cash and securities) of
about $109 per share for stock that sold for $53 before the bidding began one month earlier. The effect on
bondholders was very different, however. As a result of the LBO, the company’s leverage ratio increased
significantly (24% to 63% of total assets, or 32% to over 100% of tangible assets). At the outset of the bidding war,
the value of RJR’s public debt fell approximately 14% in anticipation of this huge increase in leverage.

The KKR-RJR example illustrates a conflict of interest between shareholders and bondholders in corporations.
Shareholders and risky debt holders claim different portions of a firm’s return distribution. Bondholders have a
fixed claim representing the lower portion of the firm’s returns, and shareholders hold claims to any cash flows
remaining after creditors’ claims are satisfied (the upper portion of the return distribution). As each group seeks to
maximize its own wealth, conflicts of interest arise that can lead shareholders to expropriate the wealth of
bondholders. Managers, acting on behalf of shareholders, have incentives to undertake actions whose costs are
borne by bondholders and whose benefits are reaped by shareholders. Such actions expropriate wealth from
bondholders. These conflicts give rise to the Agency Problems of Debt (see below).
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Types of bondholder-stockholder agency problems
There are three well-known methods of wealth expropriation: under-investment, asset substitution, and claim
dilution: (i) Underinvestment or Debt overhang, (ii) Asset substitution or Risk shifting, and (iii) Claim dilution.


Under-Investment (Debt Overhang)

The general investment rule is to invest if Project NPV > 0. However, in the presence of risky debt, shareholders
have an incentive to under-invest – that is, to fail to invest in positive-NPV projects (if most of the benefits from the
new projects might go to bondholders rather than shareholders).
Suppose the new project, which is financed by equity, has a net present value of NP (> 0). Since it is
financed by equity, the leverage ratio will fall, hence default risk will be smaller, and the value of debt will rise, say
by ND; then we can say the net present value of the project to debt holders is ND. The value of the project to
shareholders will thus be the difference, i.e., the net present value of the project to shareholders will be NS = NP –
ND. Clearly, the net benefit from the project to the shareholders is smaller than the project NPV; this is because they
share the benefits (with bondholders) but bear the entire cost of the new project. Now, if the new project has low
risk and a small NPV, it is possible that ND exceeds NP, which would mean NS < 0. In such an event, the manager
(on behalf of shareholders) will reject the project when it should clearly be accepted (since NP > 0). This is an
example of underinvestment caused by existing debt.
Thus, in the presence of risky debt, NPV to shareholders ≤ project NPV, and if bondholders benefit
sufficiently from the new project (because of reduction in default risk), it is possible that Project NPV > 0 but
Equity NPV < 0, in which case shareholders will reject the project even though it should be accepted.
We can also view the investment as a real option (discussed in Chapter 1); then the firm will invest when
the output price P rises to a high enough level (the trigger price). Suppose the optimal trigger price when there is no
outstanding debt is PF. Now, if the company has (risky) debt financing, it will be less willing to invest because of
the reason discussed above. That is, a levered firm will have a higher trigger price, or will invest when P rises to a
level PS, where PS > PF. Obviously, the higher the leverage ratio, the greater will be the above effect, and the higher
the investment trigger. Thus, underinvestment is not just the rejection of positive-NPV projects but also (more often
in real life) delayed investment. Leverage clearly has a negative effect on investment.

How to reduce the underinvestment problem?
(i) Maintain some surplus cash: this increases the likelihood that the manager will invest (or reduces the
likelihood of underinvestment) since cash is an idle asset and earns no returns.
(ii) Use partial debt financing (if possible) for the new project: partial debt financing ensures that bondholders
also bear part of the cost of the project, not just reap the benefits. We can also think of it as follows. If the
new project is financed with both equity and debt, leverage ratio will not fall as much, hence bondholders
28

will not benefit as much; as a result, shareholders will capture a larger share of the benefits from the new
project. In fact, by ensuring the leverage ratio stays the same, shareholders can capture all the benefits from
the new project. However, there are generally limits on the ability of a firm to issue equal-seniority debt; if
the firm issues too much, it might lead to Claim Dilution (see below).
(iii) Renegotiate with bondholders/creditors; easier to do with bank or private debt because of the free-rider
problem. This way, the benefits from the project can go to both shareholders and bondholders. This might,
however, be difficult because of restrictive covenants.

Examples of underinvestment
(i) Assume no time value of money, no uncertainty, and a two-year horizon. A firm starts out with a $100
investment. The initial asset base generates cash flows of $150 at the end of year 1 and $50 at the end of year 2. An
opportunity exists to invest $75 at the end of year 1 and receive additional return of $100 at the end of year 2.
Clearly, both the firm and the economy are better off if the $75 investment is made, since it adds $25 to value.
Now suppose the initial investment was raised partly through debt, so that there is a bond face value
payment of $100 due at the end of year 2. If they make the investment, equity holders will receive $150 – $75 =
$75 in year 1 and $150 – $100 = $50 in year 2, for a total of $125 over two years. If they do not make the
investment, equity holders receive $150 in year 1 and nothing in year 2. Equity holders are better off rejecting the
project, although it is clearly value-additive (since project NPV > 0). This is an outcome of the existing debt (hence
debt overhang).
(ii) A company with equity value E = 2 and debt value D = 8 (i.e., leverage ratio of 80%) is considering a new
(large and safe) project with NPV = 0.5. If the new project is accepted, debt value will increase to 8.6.
Total firm value is V = E + D = 10. If the investment is made, V = 10+0.5 = 10.5, D = 8.6, hence E = V–D = 10.5–
8.6 = 1.9. Since equity value falls from 2 to 1.9, shareholders will reject the (value-additive) project. The reason
equity value falls is that all the benefits from the new project are going to the bondholders (because of reduced
default risk), and debt value rises by more than the project NPV.


Asset Substitution (Risk Shifting)

Asset substitution or “risk shifting” represents a second potential conflict of interest in a levered firm. If the
operating risk of the company is increased, wealth is indirectly transferred from bondholders to shareholders. This
is because equity is analogous to a call option on the assets of the firm with an exercise price equal to the face value
of debt. Since an option value increases with the volatility (risk) of the underlying asset, equity value is an
increasing function of the risk of the firm’s assets. If volatility is higher and total asset value unchanged, then equity
value will be higher and debt value will be lower by the same amount. Thus, by increasing earnings (or asset)
volatility, the manager can essentially transfer wealth from bondholders to shareholders; this is called Risk Shifting
29

or Asset Substitution. The risk shifting incentive is an outcome of limited liability, and increases with the firm’s
leverage ratio; shareholders of highly leveraged companies are more likely to go for broke since they have less to
lose.

Example of risk shifting
Suppose a project generates $200 if successful and $100 otherwise (both are equally likely). If the firm is carrying
$100 of debt, the value of its debt is 0.5(100) + 0.5(100) = $100 and the value of its equity is 0.5(0) + 0.5(100) =
$50, and total firm value = 0.5(100) + 0.5(200) = $150.
If the cash flows had been $250 and $50 in the two states (i.e., the project is more risky), then debt value
would be 0.5(50) + 0.5(100) = $75, equity value 0.5(0) + 0.5(150) = $75, and total firm value 0.5(250) + 0.5(50) =
$150 (same as above). Shareholders would choose the second project because it leaves them better off, although the
first project is superior (has the same value and lower risk).

Do managers in real life actually increase the operating risk of the firm? Although it might seem counter-intuitive,
there is substantial empirical evidence that they do. Eisdorfer (2008) found significant evidence of corporate risk-
shifting in a sample of financially-distressed firms; Esty (1997), Brown et al. (2001) and Basak et al. (2007)
documented risk-shifting in banking and financial firms; and Danielova et al. (2013) found a significant jump in
operating risk right after a debt issue, in a sample of industrial firms.8
Operating volatility (or earnings volatility) can be increased by, for instance, acquiring companies in (or
investing in new projects in) highly risky industries, or by increasing operating leverage (most modernization
investments result in higher operating leverage because fixed cost rises).


Claim Dilution

If the firm issues additional debt of equal seniority, it dilutes the existing bondholders’ claim (since more debt is
supported by the same asset base). The old bonds become more risky, hence their value falls (see RJR example
above). Since debt value falls and asset value remains unchanged, equity value rises; thus there is transfer of wealth
from bondholders to shareholders. In addition, shareholders benefit from the tax shield associated with the
additional debt.

8 Basak, S., A. Pavlova, and A. Shapiro (2007) Optimal Asset Allocation and Risk Shifting in Money Management, Review of
Financial Studies 20, 1583–1621.
Brown, S., W. Goetzmann, and J. Park (2001) Careers and Survival: Competition and Risk in the Hedge Fund and CTA
Industry, Journal of Finance 56, 1869–1886.
Eisdorfer, A. (2008) Empirical Evidence of Risk Shifting in Financially Distressed Firms, Journal of Finance 63, 609–637.
Danielova, A., G. Hong and S. Sarkar (2013) Empirical Evidence on Corporate Risk-Shifting, Financial Review 48, 443-460.
Esty, B.C. (1997) Organizational Form and Risk Taking in the Savings and Loan Industry, Journal of Financial Economics 44,
25–55.
30

In theory, the claim dilution incentive is easy to handle – simply prohibiting all future debt issues will
eliminate this problem. However, this is not a practical solution because companies need to raise funds on an
ongoing basis, and few firms would be able to operate with such a draconian restriction. The practical solution is to
place certain restrictions on future debt issues (not eliminate them altogether) so as to offer adequate (not
necessarily perfect) protection to bondholders, without jeopardizing the company’s future operations.

Example of claim dilution
A company has 6 million shares trading at $20 a share. It pays an annual interest of $8 million on its (perpetual)
debt, which has a yield to maturity (YTM) of 10%. There is a proposal to issue $20 million of new (equal-seniority,
perpetual) debt, at a YTM of 11% (the new debt costs more than the old debt because of higher default risk). How
will shareholders and old bondholders be affected?

Equity value E = 20(6) = 120. Debt value D = 8/0.1 = 80.
Additional interest because of the new debt = 20(0.11) = 2.2 million. Total interest = 8+2.2 = 10.2.
Since the new debt is of equal seniority as the old debt, the YTM for both old and new debt will be 11%. Thus, total
value of debt = 10.2/0.11 = $92.73 million. Of this, new debt is worth $20 million, hence old debt value is 92.73 –
20 = 72.73. Thus, old bondholders’ wealth falls from 80 to 72.73, or approximately 9%. (Equity value will rise by
the same amount).

Of course, the claim dilution problem can be reduced if the new debt has lower priority (is junior) to the old debt,
because that would protect the old bondholders from dilution (old YTM would not rise, hence old debt value would
not fall).

Question: If the new debt (in the above example) was junior rather than equal-seniority, would its YTM have been
higher than, lower than, or same as 11%?

Net Effect of Agency Problems on Capital Structure
The agency problems discussed above imply that shareholders can take actions that enrich themselves at the
expense of bondholders, so it is good for shareholders. However, while shareholders are not directly hurt by these
acts (underinvestment, asset substitution, claim dilution) they will be affected by higher borrowing costs. Rational
bondholders will anticipate these actions and will therefore demand a higher coupon rate in order to compensate
them for this risk. Therefore, shareholders will end up paying for these conflicts of interest, in the form of higher-
cost debt or an “agency cost” premium in the cost of borrowing. In other words, agency costs are eventually borne
by shareholders. These agency costs add up to significant indirect costs resulting from debt financing, are an
increasing function of the leverage ratio. The net effects of these costs would be to make debt financing less
attractive. The firm will now try to maximize the following:
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{Unlevered firm value + Tax shield – Bankruptcy costs – Agency costs}
The resulting optimal level of debt will be smaller than that suggested by the trade-off theory. Thus, observed
leverage ratios are smaller than those predicted by a simple tax-bankruptcy-cost trade-off.
An important implication of the agency problem is that investment and financing decisions are not
necessarily independent of each other. As seen above, a firm that uses more debt will make different investment
decisions than a low-debt firm. Therefore, investment and financing decisions are inter-related.
Some specific implications arising from agency problems between shareholders and bondholders are given
below:
1. Leverage distorts investment incentives, because of leverage-induced agency problems. High-growth firms
have more of their value coming from growth options. Since investment distortions resulting from agency
problems would affect such companies more, high-growth companies should use less debt financing. This
prediction is consistent with observed corporate leverage behavior.
2. Higher leverage ratio leads to greater underinvestment incentive. Therefore, highly leveraged firms should
invest less (under-invest) than other firms. Consistent with observed corporate behavior.
3. Small firms are more likely to be affected by these agency problems (because it is easier to increase risk,
and managers tend to be dominant shareholders, in small firms). Hence small firms should use less debt, or
use convertible or short-term debt (to reduce these problems). Consistent with observed behavior.
4. Bank lending reduces agency problems (because of more intense monitoring, and the possibility of
renegotiation). This explains why agency costs are significantly smaller (and leverage ratios lower) in
Japan and Germany, where bank debt plays a much more important role than it does in the U.S.A.

Mitigation of Agency Problems
A number of ways have been proposed to tackle the agency problem between shareholders and bondholders. Some
of these might have unintended side effects. For instance, issuing additional equal-seniority debt would mitigate
underinvestment (because shareholders would then share both benefits and costs of the new investment). However,
issuing equal-seniority debt might lead to Claim Dilution.

Covenants: In theory, covenants can be written to protect bondholders from problems such as risk shifting or under-
investment. But it is impossible to write such comprehensive covenants in practice. Therefore, we do not observe
covenants that directly limit a company’s ability to increase risk. Most companies use indirect covenants, such as
restrictions on dividends (to reduce the underinvestment problem), restrictions on takeovers and mergers (to reduce
the asset substitution problem), scheduled maintenance of assets, restrictions on sale of assets, etc.

Bank Debt or Private Debt: Partial solution to the under-investment problem. This is because renegotiation is
possible with bank or private debt holders, but not possible with dispersed bondholders because of the free-rider
problem.
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Short-term Debt (rather than long-term): It is more difficult to expropriate wealth from bondholders if the debt
maturity period is close. That is, short-term debt values are less sensitive to equity holder manipulation. (However,
short-term debt has its own problems, e.g., illiquidity, interest rate risk, frequent flotation costs).

Convertible bond: This is a hybrid of debt and equity (convertible bond = straight bond + option to convert to
equity). Because of the conversion feature, anything that increases equity value will also increase convertible value.
Hence the incentive to transfer wealth from bondholders to equity holders will largely disappear. Increasing risk
would benefit both equity holders and convertible bondholders (since the option value increases with volatility).
Not surprisingly, convertible debt is issued mostly by high-growth, high-leverage firms.

Management compensation contracts: Since a significant part of managers’ compensation is fixed (partly
dependent on firm size), managers do not always maximize the value of equity holder’s stake at the expense of
other stakeholders. A properly designed management compensation package can mitigate the above agency
problems.

Additional debt: Underinvestment can be eliminated by additional debt (equal-seniority), because this will ensure
bondholders also contribute to the new project(s).

Project financing: With project financing, the project’s assets and liabilities are separated from the rest of the firm
(may not be possible unless the new project is unrelated to existing assets), e.g., PPP. With the new project
separated from existing projects, it will not be possible to transfer wealth from bondholders to shareholders.

Puttable Debt: A puttable bond contains a put option, which allows the bondholder to put (sell back) the bond to
the company in certain situations (acquisition, restructuring, LBO, etc), at a pre-specified price (the put price,
usually at or close to the face value). If the operating risk of the company rises because of the specified event,
bondholders (who would normally be hurt by it) can simply exit with no cost, by exercising the put option. Thus,
puttable debt mitigates the risk-shifting problem. Companies started issuing these bonds after the RJR-Nabisco
LBO. Of course, since the option belongs to the bondholder, puttable debt will be more expensive (or its yield will
be lower) than similar non-puttable debt.

Callable Debt: A callable bond contains a call option, which allows the company to call (buy back) the bond prior
to maturity, at a pre-specified call price (usually par value plus a call premium). If a company has a good project to
invest in, but is worried that the benefits will go disproportionately to bondholders, it can call the bonds and then
invest in the project. This will ensure that all the benefits go to shareholders, which will reduce the shareholders
incentive to under-invest. Therefore, callable debt mitigates the underinvestment problem. Of course, callable debt
will have a lower price (higher yield), because the option is held by the company.
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Performance-sensitive Debt (PSD): In this type of debt, the coupon rate will depend on default risk (or
performance) of the company. The idea is to ensure that lenders receive a return that is appropriate for the level of
risk; thus, if the company’s default risk rises after the debt issue, the coupon rate should be raised accordingly.
Default risk is usually measured by bond rating. In a PSD, when the rating is downgraded by the rating agency, the
coupon rate “steps up” to a pres-specified level (hence PSD is also known as step-up bond). In most cases, the
coupon rate is also reduced when the rating is upgraded. Since an increase in default risk will result in greater
reward to creditors, this deters the company from engaging in risk-shifting. PSD is particularly popular in bank
loans and corporate bonds in the European telecom sector.

Bond Covenants
Bondholders contribute to the capital of the firm; however, they have no explicit control over how the firm is run;
absent safeguards, equity holders can expropriate wealth from bondholders. Thus, bondholders would like to have
some protection, which usually comes in the form of protective covenants written into the debt contract. Covenants
help bondholders, but they also help shareholders (indirectly) because they support better bond ratings, thereby
reducing the company’s cost of borrowing. However, covenants cannot solve all agency problems, because many of
these incentives cannot be eliminated by contractual provisions.

Types of covenants:
Investment/Asset covenants: (a) limiting ownership or participation in other enterprises such as buying stock in
other firms, restrictions on mergers and acquisitions, etc. (b) restricting sale of assets except for replacement of
existing assets or for prepayment of debt (c) governing disposition of assets in default, e.g., collateralized, secured,
senior, and subordinate. Determines bond risk, rating and yield. Lower security implies higher yield (more costly
debt).

Dividend covenants: limiting amount and sources of dividends, e.g., dividends only out of current earnings or
dividend reservoirs, not more than 50% of earnings can be distributed as dividends, etc. This mitigates the
underinvestment problem, and explains the common practice of maintaining dividend reservoirs.

Financing covenants: for instance, no dilution of existing debt. If new debt is of same seniority as existing debt,
current debt value will fall; hence any new debt must be junior to existing debt (i.e., at a higher cost) unless
performance has been very good and leverage has fallen significantly.

Financial Ratio covenants: to maintain certain ratios within pre-specified limits, e.g., Current Ratio > 2, Interest
Coverage > 12, Leverage Ratio < 60%, etc, in order to ensure the company does not come close to financial
distress. Why are these ratios used? Because they have been found to be useful in predicting financial distress (e.g.,
Altman’s Z-score).
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Sinking Fund provision: percentage of bonds to be retired annually. This ensures the company is not caught
unprepared (with insufficient cash) when the debt matures and the balloon payment is due.

Bonding covenants: specifying how the indentures will be enforced, e.g., appointment of Trustee, specifying the list
and frequency of statement to be submitted by the borrowing firm, appointment of independent auditor, etc.
Objective is to minimize monitoring costs.

Covenants modifying cash flows to bondholders: convertibility feature, call option, put option.

Some points worth noting regarding covenants:
1. Direct covenants (e.g., accept all positive-NPV projects) very often not feasible (because of measurement and
enforceability issues), hence bondholders generally rely on indirect covenants. Example: dividend constraint is used
to mitigate the under-investment problem.
2. Covenants generally impose direct and indirect costs on the borrowing company, e.g., monitoring costs, loss of
flexibility, etc.
3. Covenants help shareholders by improving bond ratings, and thereby reducing the cost of borrowing; in fact, it
might be difficult for many firms to even borrow without such covenants in the debt contract.
4. Covenants reduce agency problems.
5. Some covenants do NOT receive protection from bankruptcy courts, something bondholders need to be aware of.
6. A firm that violates a covenant is in “technical default,” that is, the lender can demand repayment of loan even if
the firm has not defaulted on any interest payment.

Quantifying Agency Cost
We have mentioned agency cost, that is, the cost borne by the shareholders because of sub-optimal investment
decisions made by the manager resulting from agency problems between shareholders and bondholders. It is
possible, though not always easy, to quantify these agency costs. An example is given below.
- A firm is considering two mutually exclusive $50 projects, R and S, where S is a safe project that returns
$60 with certainty next year and R is a risky project which returns $20 or $90 with equal probability next
year. Assume an interest rate of k = 0.
- Then, project NPVS is 60–50 = 10, and NPVR = 0.5(20+90)–50 = 5. If the project is equity-financed,
shareholders will pick S.
- If, however, it is debt-financed, how much will bondholders be willing to lend? Suppose the bondholders
are naïve and agree to a face value of F = 50 (since k = 0). Then, equity NPVS = 60–50 = 10, and NPVR =
.5(0)+.5(40) = 20, hence shareholders will choose R. But then the expected payoff to bondholders =
.5(20)+.5(50) = 35, much smaller then their loan (50). Since bondholders are rational, they will not agree to
this.
35

- What face value F will bondholders require? They will want .5(20)+.5F = 50, or F = 80. With F = 80,
equity NPVR = .5(0)+.5(10) = 5, and NPVS = 60–80 = –20, so they will choose R.
- If the project is equity-financed, equity NPV = 10, if debt-financed, equity NPV = 5. Thus, because of debt
financing, shareholder wealth is reduced by 5. This is the magnitude of the agency cost associated with
debt financing.

Credit Rationing
Credit rationing is a consequence of the risk-shifting agency problem between creditors (bondholders) and
borrowers (shareholders). As we saw above, higher leverage ratio leads to greater incentive for shareholder risk-
taking, which in turn leads to higher cost of debt, which leads to higher leverage ratio, which leads to greater risk-
taking incentive, and so on. As this cycle continues, at some point the risk-increasing incentive (and the probability
of lenders not getting their money back) becomes large enough for creditors to stop further lending. At this point,
the firm is not able to borrow any more money even if it offers very high interest rates. This is known as Credit
Rationing, and basically sets an upper limit on the amount that a company can borrow.

Example of credit rationing and the role of interest rate:
The company has to choose between two projects, T and E, and the investment will be financed with debt.
Project T: at t = 0, invest $100; at t = 1, receive $115 with no uncertainty.
Project E: at t = 0, invest $100; at t = 1, receive $142 with probability 1/3 and $60 with probability 2/3.

If interest rate k = 0, project NPVT = 15, and NPVE = {(1/3)142+(2/3)60 –100} = –12.67. Hence, T is the better
project.
If the bondholders agree to lend the $100 for the investment and get back $100 (since k = 0), then Equity NPVT =
115–100 = 15, and NPVE = {(1/3)42+(2/3)0} = 14, so shareholders will pick T, and bondholders will get their
money back, and there will be no default. Thus, with k = 0, the company will be able to raise funds and make the
investment, and all parties will be satisfied.

If k = 10%, if bondholders agree to lend the $100 for the investment and get back $110 (since k = 10%), then
Equity NPVT = 115–110 = 5, and NPVE {(1/3)(142–100)+(2/3)0} = 10.67, so shareholders will pick E.
But if E is picked, at t = 1 bondholders will {(1/3)110+(2/3)60} = $76.67, the present value of which is $69.70, less
than the $100 they would lend. Therefore, they will have to increase the face value of debt. But what face value of
debt (say F) would make it worthwhile for the bondholders to lend the money? To identify this, we use the
requirement: {(1/3)F+(2/3)60}/1.1 = 100, which gives F = $210. But with this face value of debt, default is
guaranteed, since the firm will not have this much money in either state of the world.
36

Therefore, if the face value of debt is set at a fair level, the company will default with certainty and the bondholders
will not get their money back. Thus, if k = 10%, the firm will not be able to borrow money to invest in a project
(Credit Rationing).
Clearly, credit rationing becomes more severe when interest rate is higher.

37

Chapter 3. Questions
(Ignore time value of money for these questions)

1. Your firm, which has $100 of debt outstanding, has to choose between two projects, A and B, both one-year
projects (high-risk and low-risk respectively). A can deliver year-end cash flows of $60 or $120 with equal
probability, while B will generate a year-end cash flow of $101. Which project would maximize firm value? Which
project would equity holders prefer?

2. A company can invest $6 in project A (which will generate year-end payoff of $2 or $9 with probability 0.3 and
0.7 respectively) or project B (which will generate year-end payoff of $7 or $6 with probability 0.3 and 0.7
respectively). Which project will be selected by the equity holders if the firm has no debt outstanding? Which
project will be selected by the equity holders if the firm has $5 debt outstanding? At what level of debt will the
decision switch?

3. A firm can invest $75 in project A (payoff $85 and $150 with probability 20% and 80% respectively). What is
the NPV of the project? If there is $70 of debt outstanding, what is the NPV to equity holders? Will equity holders
accept the project?

4. A firm can choose between a high-risk project (H) and a low-risk project (L). The high-risk project will generate
year-end cash flows of $250 and $2250 with equal probability, and the low-risk project will generate $500 and
$2000 with equal probability. Which project will equity holders select if (i) there is no debt outstanding (ii) if there
is $1000 of debt outstanding?

5. A firm has a leverage ratio (debt to total capital) of 80%, and the market value of its equity is $4 million. It has
the opportunity to make a new investment at a cost of $10 million, with an NPV of $3 million. Because the new
project will reduce the default risk substantially, the market value of its debt will rise by 25%. Will equity holders
accept or reject this investment?



38

Chapter 4. ASYMMETRIC INFORMATION AND SIGNALING

In this chapter, we discuss how a company’s investment/financial decisions (regarding dividends, capital structure,
etc.) affect its stock price, how its decisions are affected when managers are better informed than outsiders about
the firm’s prospects, and why managers have an incentive to “manage” corporate results and reports. These are all
issues related to asymmetric information and signaling.
“Informational asymmetry” occurs when one party in a contract or an agreement has more information than
the other, e.g., worker vs. employer, manager vs. investor, seller vs. buyer. Asymmetric information leads to two
types of problems:
1. Adverse Selection: when different-quality products are sold at the same price since buyers do not have
enough information to distinguish between the two. Low-quality goods end up driving high-quality goods
out of the market, in extreme cases leading to market failure.
2. Moral Hazard: when the action/effort of the agent cannot be observed by the principal but affects the size
and probability of cash flow, e.g., the manager’s shirk vs. work decision.

Because of asymmetric information, the parties will not agree on the values of assets. In corporate finance,
informational asymmetry exists between managers (insiders) and investors or the market (outsiders) because
managers have more information about the company than outsiders. Thus, the company and its equity might not be
correctly valued by the market. Often, the market may be unaware of (or might not give credence to) the company’s
growth opportunities or its ability to service debt, and (as a result) under-value the company. Or the market might
be unable to differentiate a company with good prospects from a company with poor prospects, and under-value the
good company or over-value the bad company.
Informational asymmetry can theoretically be resolved directly by the company releasing relevant
information or through an appraisal, or indirectly through methods such as signaling or contingent payments.
However, in corporate finance, direct methods generally do not work because managers cannot directly
communicate their private information to the market for various reasons, e.g., for competitive reasons, or because
the information may be unfavorable, or there may be too much uncertainty. Moreover, direct communication might
not be credible since the manager has an incentive to report only good news and not the bad news. Also, appraisal
usually does not work in such situations because the characteristic about which information is asymmetric (growth
or future cash flow) can only be resolved in the future, there is considerable uncertainty regarding it, and it is not
objectively verifiable at the present time. Therefore, signaling with corporate/managerial decisions is the most
popular method of resolving the problem of asymmetric information in corporate finance.
Corporate decisions often reveal information that the manager cannot otherwise reveal, and these decisions
are viewed as signals by outsiders, who use the signals to make inferences about the firm’s prospects. Examples of
such decisions are: investment decisions, capital structure decisions, dividend decisions, stock splits, and
39

management purchase or sale of shares. Stock prices often move significantly when firms announce changes in
their dividend or capital structure choices. This happens because investors re-evaluate the firm in light of these
changes/announcements.
Managers’ decisions, in turn, are interpreted by the market in terms of the firm’s prospects and expected
future performance, in order to re-value the firm (or its stock). Managers have to take into account this effect when
they make their decisions. For example, managers are very reluctant to reduce dividends because dividend-
reduction announcements are viewed negatively by the market, resulting in lower stock price. Also, in mergers and
acquisitions, the payment terms offered by the bidding firm (cash or stock) have signaling implications, which
usually affect the way the market perceives the proposed acquisition; hence the payment terms can be an important
part of the deal package.
Thus, the market uses the manager’s decisions to make inferences about the firm’s prospects, while the
manager makes decisions based on his/her inferences about the market’s response. In equilibrium, the two sets of
inferences are consistent with one another.
An important managerial implication of informational asymmetry in corporate finance is that managers
might not maximize the intrinsic (long-term) value of the stock, because they have to take into account the market’s
response to the company’s announcements (particularly if the managers have a short horizon).

Information Content (Signaling Effect) of Corporate Announcements
From event studies, we have the following evidence on market response to corporate announcements:9
 Dividend increase: Stock price rises (approximately 2% on average)
 Dividend initiation: Stock price rises (much larger reaction than above)
 Dividend decrease or omission: Stock price falls (about 9.5% on average); note the asymmetric response
 Equity issue: Stock price falls (about 3.1%)
 Debt issue: Stock price falls (about 0.2%)
 Convertible issue: Stock price (about falls 2.1%)
 Stock repurchase: Stock price rises (about 16%)

Dividend Change Announcements
When a company announces a change in dividend, the stock price rises (falls) not because of the higher (lower)
dividend, but because of what it implies. A dividend increase conveys positive information because it implies
higher earnings in future. With a dividend cut, however, the market is not sure whether it happens because the
company needs money to invest in a positive-NPV investment project (which is good news) or because of
worsening prospects (bad news). The market will therefore assume the worst (the “bad news principle”) and mark
down the stock price. If the firm can convince investors that a dividend reduction is necessary for increased

9 Note that all figures are sample averages; there might be significant within-sample variability.
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investment, stock price might actually rise, although this happens very rarely (because markets tend to be skeptical
of corporate announcements). There are few examples of stock price rising on a dividend-cut announcement, and
only for firms that are highly regarded by the market. For instance, Ford Motor Co reduced quarterly dividend from
$0.80 to $0.60 in 1975 because it wanted to make new investments, and the price rose 1.9% as a result; on the other
hand, when ITT Corp. cut quarterly dividend from $0.69 to $0.25 a share in 1984 in order to invest in high-tech
products, its stock price fell about 32%.
A dividend cut is sometimes accompanied by some other action (e.g., stock repurchase) which offsets the
dividend effect; an example is Whittaker Corp.’s announcement of a dividend cut from $0.40 to $0.15, when stock
price went up from $18.50 to $18.625 (because it also announced a share repurchase plan at the same time). Such
cases obviously do not accurately reflect the signaling effect of dividend changes.
The stock price response (to dividend changes) reduces the attractiveness of a positive-NPV investment
that has to be financed by cutting dividends, because a drop in the stock price (the market’s usual response to a
dividend cut) reduces firm value. This increases the incentive to pass up unobservable good projects, since the
manager will generally not be penalized if stock price does not fall. Thus, how the market responds to certain
announcements can have significant managerial implications.

Example
A company can invest in a new project with NPV = $10 million only by reducing dividend. The signaling effect is
expected to be 2%. If the company’s equity is worth $1 billion, then the market’s response would reduce equity
value by 2% of 1 billion = $20 million. Hence the overall effect of the investment will be 10 – 20 = –10 million,
causing the project to be rejected.

Cash Dividend versus Stock Repurchase
Companies usually return money to shareholders by means of dividends. But the firm can also return money by
means of stock repurchases, when it buys back a certain number of shares from shareholders. A stock repurchase
conveys positive information, because it is similar to a special dividend; however, it is more effective in raising the
stock price, because (i) a stock repurchase is subject to a more favorable tax treatment than a special dividend, (ii)
stock repurchase conveys more favorable information (since repurchase is more permanent and usually larger in
scope), and (iii) relative price effect (the stock would not be bought back unless it was under-valued). Because of
these reasons, a stock repurchase sends a stronger positive signal than a dividend increase.

“Firm Commitment” versus Market Repurchase
The former (where the firm commits to a pre-specified repurchase price and quantity) sends a more credible signal
than the latter (where the firm has the option to buy back stock in the future at then then-prevailing market price),
hence the former has a larger price impact.

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Equity Issue
This is exactly the opposite of stock repurchase. If prospects are good, shareholders would not want to share
ownership, hence will not issue equity. The fact that the company is issuing equity implies that prospects are not
good, and this drives down the price.

Capital Structure
Leverage choice has information content because (i) leverage has consequences for the manager through financial
distress and bankruptcy, as we saw in Chapter 2; and (ii) capital structure is based on future (expected) cash flows,
hence there is asymmetric information between managers and outsiders. Leverage decisions, therefore, are a useful
way to signal to the market.
If a firm issues debt, the implication is that the manager is confident about the firm’s ability to repay debt,
hence financial distress is not likely (positive signal); if it issues equity, the implication is that the manager is
unsure of the firm’s ability to service debt (negative signal). Also, if the manager believes that the current stock
price exceeds the intrinsic value (over-priced stock), the firm is more likely to issue equity, hence an equity issue
generally leads the market to conclude that the stock is over-priced. These effects make higher leverage ratio better
than lower leverage ratio, in terms of signaling.
So, any decision that increases the leverage ratio (such as Leveraged Recapitalization) sends a positive
signal, resulting in stock price appreciation. But what is to prevent a bad firm from doing the same (to mimic a
good firm)? For leverage increase to be a credible signal, a firm with poor prospects must find it expensive to
mimic a firm with good prospects. In this case, the fact that it is costly for a bad firm (and for the manager
personally) to add too much debt because of increased probability of bankruptcy, makes it a credible signal. Since it
is costly for bad firms to mimic good firms, using a high leverage ratio is a credible signal. The signaling effect
provides an additional positive (value-increasing) impact of debt financing in the capital structure model, and this
increases the optimal leverage ratio. Therefore, for optimal capital structure decisions, the signaling effect is just the
opposite of the agency problem effect.

Current Stock Price vs. Intrinsic Value
It is generally accepted that the manager’s objective is to maximize stock price. However, because of asymmetric
information, the intrinsic (long-term) value of the stock might be different from the current (short-term) market
price. This is because the current market price reflects only public information while the intrinsic value (which is
the expected present value of all future cash flows) reflects all relevant information including the manager’s private
information. Very rarely are the two valuations exactly equal.
When the market price of the stock is different from the intrinsic value, what should the shareholders (or
managers) try to maximize? For shareholders, it would depend on whether they are long-term or short-term
shareholders. Institutional shareholders (mutual funds, hedge funds, etc) tend to have a short-term horizon, while
“inside” shareholders (company founder, founder’s family, etc) tend to have a more long-term horizon. Short-term
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shareholders would prefer that the manager take actions that immediately signal positive information, even at the
cost of reducing intrinsic value; long-term shareholders would like to maximize the intrinsic value. Thus, there
might be a conflict of interest between the two sets of shareholders.
For the manager, the objective ideally would be to maximize the long-term or intrinsic value. However, in
practice, the manager’s objective would depend on a number of factors:
 How is the manager compensated? If his/her compensation is tied to current stock price, then it is more
likely that the manager will have a short-term horizon.
 How long does the manager expect to stay with the firm? If not long, the manager’s horizon is likely to be
short, hence he/she would likely want to maximize market price.
 The mix of shareholders (institutional shareholders such as mutual funds tend to be focused on the short
term, since mutual fund managers are evaluated on a yearly basis; thus, if there are more institutional
shareholders, the focus will be more likely short-term).
 Other reasons for maximizing current value, e.g., (i) company’s need to raise equity or manager’s plan to
sell equity for reasons of diversification or liquidity, (ii) possibility of being an acquisition target, (iii)
higher current stock price might help business indirectly, e.g., by increasing customer confidence.

Thus, there are reasons why maximizing the current stock price rather than the long-term intrinsic value might
make sense for the manager. But a short-term focus would bias decision-making towards short-term projects, and
would probably lead to decisions that are not optimal in the long run. A manager with short-term focus would
rather accept a low-NPV project that pays off quickly than a higher-NPV project that pays off later. Thus, there will
be a bias towards short-term projects and against long-term projects.
Managers might also want to maximize the intrinsic value. A general managerial objective would be to
maximize both the current price and the intrinsic value, but to varying degrees, i.e., maximize a weighted
combination of intrinsic value and current price. Different managers would attach different weights to the two. We
can then write the manager’s general objective function as follows:
Maximize a weighted average of current stock price and intrinsic value, where the
weights are determined by management compensation structure, manager’s job
security, takeover risk, type of shareholders, degree of monitoring, need to enter
the equity market, etc.
If the degree of monitoring or the manager’s job security is high, the manager would pay more attention to
the intrinsic value. On the other hand, the manager would be more interested in the current stock price if there is
significant takeover risk (because a higher current stock price would make acquisition more expensive and
therefore less likely). If the company plans to enter the secondary stock market to raise equity funds, then the
manager would be more interested in maximizing the current stock price, in order to minimize the financing cost.

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Empirical Evidence on Signaling
To test for signaling effects on the stock price, we need to examine stock price response to these announcements,
while eliminating the effects of irrelevant factors. This is done by means of Event Studies. An Event Study
examines the movement of the stock price around the time of the announcement; that is, it compares the pre-
announcement and post-announcement prices to compute the announcement effect or the signaling effect or the
information content of the announcement. While conducting an event study, we need to keep in mind the following:
1. A large sample should be used. This is because there is substantial variation in the market’s response to
corporate announcements; for instance, a dividend increase announcement generally results in a higher
stock price, but the amount of the increase varies widely; also, in some cases, the stock price might even
fall. Because of the variation, the results obtained from a small sample will not be reliable.
2. The one-day (or announcement-day) stock price response (that is, the difference between the post-
announcement opening price and the pre-announcement closing price) does not capture the entire effect.
This is because the announcement may have been partially anticipated (leakage, analysis, etc). Moreover,
there is often under-reaction or over-reaction in the market’s response to these announcements. Therefore,
we need to look at the cumulative (pre- and post-announcement) response, usually over the event window
(e.g., a week) bracketing the announcement date, e.g., from 3 days prior to 3 days after the announcement.
3. Because of the announcement window, the behavior of the market must be taken into account. For instance,
if the market index has gone up significantly over the event window, it would be difficult to say whether
the stock price went up because of the announcement or because of the rise in the market.
4. Risk must be accounted for. For instance, if the beta of a firm is greater than 1, it will rise faster than the
market portfolio, and the announcement effect must be adjusted accordingly.

To incorporate all these factors, we examine not the change in the stock price (or the raw return), but the CAR
(Cumulative Abnormal Return) or the Market-adjusted Excess Return:
CAR or Market-adjusted Excess Return = )( fMifi RRRR  
where are the returns on the stock, the risk-free asset, and the market portfolio respectively, and i is the
systematic risk of the firm. This represents the return in excess of the expected return (from the CAPM).

Evidence on capital structure changes: leverage-increasing events (e.g., stock repurchase) tend to drive up stock
price, and leverage-reducing events (e.g., bond call without replacement) tend to drive down stock price. The
reason is that a higher leverage ratio sends a positive signal.

Evidence on security issuance: In general, raising external finance (all types) conveys negative information to the
market, resulting in a drop in the stock price. But the magnitude of the price decline varies across securities: –0.2%
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for debt, –1.6% for equity, and somewhere in between for convertible debt (consistent with the Pecking Order
Hypothesis).

Evidence on dividends and stock repurchases: A dividend increase usually results in a jump in the stock price,
along with stock split and stock repurchase; and a dividend cut results in a drop in the stock price.

Thus, any announcement that implies an increase in the firm’s leverage ratio or cash distribution tends to be
received favorably by the market.

How to Use Event Study information for managerial decisions?
Two-step process:
1. First, event study of the entire sample; this gives the aggregate effect.
2. Then, cross-sectional regression to identify the determinants of event return (e.g., volatility, beta, capital
structure). The regression coefficients help predict market response for a particular company, based on the
company’s characteristics. This can be used to predict the market response for a known company (i.e., with
known characteristics).

Rule of Thumb
Stock prices react favorably to an increase in the cash distribution and an increase in leverage ratio, and negatively
to decreases in cash distribution or leverage ratio. However, there is often under-reaction, so that the long-term
response is in the same direction as the short-term response, e.g., for dividend initiation (dividend omission), in
addition to the short-term CAR, the 2-year CAR is +15% (-15%).

The Role of Growth Opportunities
The market’s view also matters in the stock price response to announcements. For instance, if two firms’ growth
prospects are different, then the response to a dividend decrease announcement would generally be different,
because the market would assume a high-growth company reduces dividend to invest in positive-NPV projects
while a low-growth company reduces dividend because earnings outlook has worsened. When the high-growth and
low-growth companies are compared, we get the following market response:
M/B > 1, Dividend increase → 2-day CAR = +0.3% M/B > 1, Dividend decrease → 2-day CAR = -0.3%
M/B < 1, Dividend increase → 2-day CAR = +0.8% M/B < 1, Dividend decrease → 2-day CAR = -2.7%
(Note: M/B or the market-to-book ratio is a generally-accepted proxy for growth opportunity).
These results illustrate two points:
(i) Market’s response is often asymmetric (higher for dividend reduction than for increase).
(ii) Stock price response is usually dependent on market’s prior beliefs.

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Post-Announcement Drift
The event study results discussed above assume that markets are efficient and react fully to the announcement.
However, a number of studies have documented post-announcement drift; that is, the market under-reacts to the
announcement, and the stock price subsequently keeps adjusting for a significant length of time. For instance, price
might rise on a higher-than-expected earnings announcement, and then continue rising well after the announcement.
One study found a 15% CAR over a 2-year period following dividend initiation and a –15% CAR following
dividend omission. Also, stock returns realize negative returns over a 5-year period following a secondary stock
issue.
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Chapter 4. Questions

1. What signal does a firm send when it increases its leverage ratio by means of a leveraged recap? Why is the
signal credible?

2. What signal does a firm send when it issues equity (or repurchases stock)? Why is it a credible signal?

3. An increase in the dividend payout is normally treated as a positive signal. Why? When might it be perceived as
a negative signal?

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Chapter 5. VALUATION FOR MERGERS & ACQUISITIONS

This chapter can be viewed as an extension of capital budgeting, but the focus is on target firm valuation rather than
deciding on whether to accept or reject a project. Target firm valuation is critical to M&A. It is important to keep in
mind that valuation is not pure science, and that judgment and experience are critical in the valuation of the target
firm, because of uncertainty in future earnings and cash flows. Therefore, valuation is a critical part of M&A
analysis, knowledge and judgement are very important in valuation, and multiple valuation methods should be used
whenever possible, to reduce probability of error, because of the uncertainty involved.
An important question in valuation is the following: what determines values, earnings or cash flows?
Empirical studies have found that the correlation between stock price changes and earnings (EPS) changes is
+0.024, while the correlation between stock price changes and cash flow changes is +0.94. Clearly, cash flow is a
better predictor of value, hence cash flow-based valuation methods (e.g., DCF) are generally preferred.
Also, keep in mind that basic valuation is not enough in M&A because of synergies; the value of a firm to
the potential buyer will generally be different from the value to the seller. In addition, the potential acquirer also
needs to ask: how will not acquiring the target company affect the cash flows and value of my ongoing operations?
This is because of the effect of competition (of course, it is not relevant for monopolies).


Basic Valuation

1. Direct valuation methods: direct or cash-flow-based estimate of the company’s value. Examples include
NPV and the Real-option model.

2. Indirect valuation methods: relative valuation, that is, relative to some other company or group of
companies that have similar characteristics. Example: the Multiples or Comparables approach.

In principle, direct valuation methods are superior because they are derived from the fundamentals. However, their
performance is heavily dependent on the underlying assumptions and estimates, and not always reliable in practice.
To reduce uncertainty and increase confidence in our valuation estimates, it is always advisable to use both
valuation methods.


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The Comparables or Multiples approach

Valuation information from a sample of similar firms is used to value the target firm. “Similar firms” would include
direct competitors or firms in closely related industries, and similar in size, growth rate, capital structure, stage in
the growth cycle, etc. The steps in the Comparables approach are:
1. Use a sample of companies (or transactions) comparable in size and products, recent trends and future prospects
(growth, leverage, beta, etc).
2. Calculate key ratios (price to earnings, Enterprise-value to EBITDA) for each company.
3. Average the valuation ratios for the group. If there is too much dispersion, it is better to narrow the sample by
eliminating outliers, e.g., by winsorizing the data.
4. Apply the average ratios to the appropriate data for target company, to get the estimated market value.
5. Make necessary adjustments, based on experience and judgment.

Which Ratio to Use?
Depends on the primary value driver. Any ratio that establishes value satisfactorily can be used, e.g., if
value comes from assets then use market-to-book ratio, if value comes from profits use price-earnings
ratio, and if value comes from cash flow use enterprise value to EBITDA ratio. The most commonly used
ratio is price-earnings. There are some uncommon ratios that have been used, e.g., value to number of season-ticket
holder (for sports franchises), and value to number of subscribers (for internet/telecom firms).

Advantages of the Comparables Approach
(i) It is a common-sense approach
(ii) Real (marketplace) transactions are used
(iii) Widely used in legal cases, fairness evaluation, etc.
(iv) Allows valuation of private firms
(v) Can be used to value a company or a transaction

Limitations of the Comparables Approach
(i) May be difficult to find companies comparable by key criteria
(ii) Ratios may differ widely for comparables
(iii) Different ratios may give widely different results
(iv) If too much dispersion in the ratios, there cannot be confident in the means (recall Confidence Interval = mean
± 2*standard error). (Perhaps better to delete outliers)


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Transaction-based Comparables Approach
- Valuation that is based on companies involved in similar merger transaction
- It may be difficult to find truly similar transactions within relevant time period
- It may not take into account synergies and other unique factors
- Advantage: Premium already incorporated, hence don’t have to worry about size of premium

Comparables often fail to arrive at definitive values – because companies differ in:
• Revenue growth rates
• Growth of cash flows
• Riskiness (beta)
• Stage in the life cycle of industry or firm
• Competitive pressures
• Opportunities for expansion


NPV and Real-option methods

This was done in Chapter 1.
To recap: FCF = EBIT – Tax + Non-cash expenses (D&A) – Capital Expenditure – Increase in working capital.
In the above, we do not subtract interest payments when the cash flows are discounted at the WACC (hence they
are the cash flows to the enterprise). If we consider cash flows to shareholders only, then interest payments must be
subtracted, and the resulting cash flows discounted at the cost of equity. Also, terminal value must be added;
usually by assuming a constant (low) growth rate in perpetuity, discounted as in the Gordon model.

Inputs for the Discount Rate in NPV Calculations
Cost of equity (Re)
This depends on the equity risk or beta, and comes from the Capital Asset Pricing Model (CAPM):
Re = Rf + β(Rm – Rf ).
The risk-free rate Rf is proxied by the yield on a long-term (10 years or more) Treasury bond, since most projects
are long-term, and the equity risk premium (Rm – Rf ) is based in historical experience, but depends on the user;
usually between 5 and 7%.

As a reality check, we can also look at two other figures:
Check 1: Expected return on a company’s equity is greater that of its debt, and the spread is very stable over time
(usually by 3 to 5 percent). This can give us only a crude estimate, but is useful as a reality check.
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Check 2: We can also use the Gordon growth model to verify: Re = Div1/P0 + g, where g = long-term dividend
growth rate.

Cost of debt (Rb)
After-tax cost of debt = Rd(1-Tc), where Tc = corporate tax rate and Rd = pre-tax cost of debt.
Rd is given by the yield to maturity of the company’s bonds10 (or weighted average, if more than one bond issued
by the company). If the company’s debt is not traded, the cost of debt can be estimated from the bond rating.

Cost of preferred stock (Rp)
Yield on preferred stock, or Rp = Pref Div/Price.

Weighted Average Cost of Capital (WACC)
What is the appropriate capital structure? (Using book-value ratios or market-value ratios?).
Target ratios should reflect best judgment of firm’s financial structure in the future.
Finally, WACC = R = Rd(1-Tc)(D/V) + Re(E/V) + Rp(P/V).

Key Inputs in the NPV Method
Revenues – basic driver of firm value
Growth rate – rate of change in revenues
Net operating income margin – revenues less COGS, SGA, depreciation, etc.
Tax rate
Investment in WC and fixed assets
Period of supernormal growth – when firm expects competitive advantage
Cost of capital –WACC
Terminal value

Of these inputs, growth rate is estimated from historical data (using time-series methods), and the rest estimated
from sales (using regression analysis).

Estimating Growth Rate
Start with historical growth rate, and make necessary adjustments.
Historical growth rate estimation:
- Arithmetic versus Geometric Average: geometric average is better for estimating historical returns or growth
Rates; arithmetic averages can be misleading

10 However, this is not correct for Junk Bonds, which we will discuss later.
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- Linear Regression: ln(Xt) = a + bt
Continuous compounded growth rate for revenues X, given by slope of regression
Regression method considers fluctuations; takes into account all data points
- Relation between discrete and continuously compounded rate
d = ec – 1
where e = base of the natural system of logarithms; thus, c = ln(1+d)

Estimating Other Inputs (COGS, margin, working capital requirement, etc)
Use linear regression with Sales (or Revenues) as the predictor variable:  ~S~X~

Sensitivity Analysis
Important as a reality check, to test the effects of uncertainty on valuation.

Best practices in Valuation
From survey results, we find:
- Dominant valuation method – NPV; but most companies use multiple methods
- Discount rate – WACC; weights – target capital structure
- Cost of equity – from CAPM
- Risk-free interest rate – 10-year Treasury yield
- Market risk premium – wide range used (4% to 7.5%)
- When valuing a multi-unit company: which unit’s WACC to use?


Valuation of Private Firms

Although privately held firms are generally ignored by textbooks, a large fraction of acquisition targets are private
firms. Private firms are more difficult to value because:
• There is no market value to serve as benchmark
• Significantly less information is available, since reporting requirements for private firms are less
stringent
• Lack of liquidity (since private firm shares are not traded), because of which private firms are
valued less than public companies; hence there is a “marketability discount.” It is very difficult to
determine the size of this discount, but some studies (using restricted stock sales as a proxy)
suggest that it is over 33%
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• Owners of private firms are usually undiversified, hence their valuation will be different from that
of a diversified investor (the valuation models in Finance, e.g., CAPM or APT, are based on
diversified investors)

Market Response to Private Firm Acquisition
Target company: N.A., since they are not traded.
Acquiring company: very few studies have been conducted, but they find that it depends on the method of financing
• Cash acquisition: no significant effect, event return ≈ 0
• Stock acquisition: significant positive effect, event return > 0
Thus, the market response to acquisition of private firms is quite different from acquisitions of public firms. This
probably reflects the uncertainty around the valuation of private firms: when uncertainty is important, risk sharing
is desirable, hence stock financing is viewed positively and cash financing viewed as risky (don’t know if
overpaying); will discuss this in the next chapter.
Also, recall that the value to the buyer usually exceeds the value to the seller, because sellers tend to be
non-diversified (hence use a higher discount rate). Thus, the type of over-payment that is often observed in the
acquisition of public companies is very rare when acquiring private companies.

Three valuation methods for Private companies
1. The DCF method: This is the standard approach and is widely used for public companies, but it not always
helpful for private companies, because there is limited information regarding cash flow projections; also, the
appropriate discount rate not always known or obvious.
2. The Multiples/Comparables approach: This method uses accounting ratios or valuation multiples such as the P-E
ratio or the Enterprise Value to EBIT ratio; this is popular for valuing private firms because the information is more
easily available. However, when using this method, we must adjust for illiquidity with an appropriate marketability
discount. This approach is widely used in legal cases when value of private firm is an issue, primarily because of its
simplicity and the fact that it is based on market values.
3. The Asset-Based Valuation approach: Here, we start with reported balance sheet figures (which are book values)
and make the necessary adjustments to arrive at market value. This gives the “break-up value” of the company, and
takes into account what others would pay to gain control over each piece of the company. While balance sheet
figures are easily known and others easy to adjust (e.g., we can set market value of goodwill to zero), this method
also requires knowledge of liquidation values of assets, real estate values, intangibles, off-balance-sheet assets and
liabilities, which are much more difficult to value. For instance, it is very difficult to accurately value accumulated
tax shields like NOL (net operating losses) or TLC (tax loss carryforwards).



53

Chapter 6. BASICS OF MERGERS AND ACQUISITIONS

A merger is a combination of two firms resulting in one firm; an acquisition is a process where one firm buys
another.11 Mergers and acquisitions have played an important role in the growth strategy of many firms. Companies
can use mergers to maintain growth when there are insufficient internal growth opportunities. We will use the terms
“merger” and “acquisition” interchangeably (the differences are relevant for legal purposes only – in a financial
sense, the differences are insignificant). They both basically imply transfer of control of a firm from one group of
shareholders to another. Some well-known acquisitions involving Canadian companies are:
 The acquisition of Seagram by Vivendi for $41.65 billion in 2000
 The acquisition of Newbridge Networks by Alcatel for $10.8 billion in 2000
 The acquisition of Clarica Life Insurance by SunLife for $6.8 billion in 2001
 The acquisition of Hollingers (newspapers) by CanWest for $3.2 billion in 2000
An acquisition decision is generally similar to an investment decision (capital budgeting), and the standard
principles of valuation can be used to evaluate acquisition (or any type of restructuring) decisions as well. However,
there are certain factors that make such a decision more complicated than the standard capital budgeting decision:
 accounting, tax and legal implications (accounting: pooling vs. purchase, legal: regulatory clearance, effect
on competition, rules regarding oppression of minority shareholders).
 synergies (operating and financial) make valuation more difficult than in capital budgeting.
 corporate control issues (shareholders disagreements, preventive measures, maintaining control of joint
company, etc).
 agency problems between shareholders and bondholders (relative value of equity and debt might change) or
between shareholders and managers (alignment of incentives).
 value to buyer might be different from value to seller (particularly for private firms).
 others: friendly vs. hostile, cash vs. stock, defensive measures, etc.
 finally, very important to ask: if acquisition does not go through, how (if at all) will value of bidding
company be affected (because of competitive pressures)? That is, doing nothing might not be costless.

Do Mergers and Acquisitions Create Value?
Theory
1. Some theories say “yes,” because of synergies (operating synergies or financial synergies), greater efficiency
resulting from reduced agency problems, lower cost of capital, tax savings, reduction of transaction costs, etc. This
would be the case if the combined benefit (wealth creation) for acquired and target companies is positive.

11 The usual procedure is that the acquiring company (A) buys a controlling share of the equity of the target company (T) and
thereby become owners of T. Sometimes, however, A buys the assets of T (could be only a subset of the assets); in such cases,
A might also assume some or all of the liabilities of T as part of the deal. The details of the procedure depend on the
jurisdiction.
54

2. Other theories say “no,” mergers and acquisitions happen because managers engage in empire-building,
managers want to reduce bankruptcy risk to increase their own job security, managerial hubris, too much surplus
cash, etc. In this case, the acquiring company shareholders would be worse off after the acquisition (because the
firm would have to pay a premium to acquire the target company).

Empirical Evidence
There is a large body of research on how shareholders are affected by acquisitions. The general conclusion is that
target company shareholders earn significant (positive) abnormal returns, and also do much better than acquiring
company shareholders. In fact, target company shareholder returns have not declined over time, changing from
about 19% in the 1960s to about 35% in the 1970s and 30% in the 1980s.12 The acquiring company’s shareholders,
on the other hand, have done quite poorly, and their abnormal returns have been declining over time, from 4.4% in
the 1960s to 2% in the 1970s and –1% in the 1980s.12 In fact, most acquirers today have negative event returns
around the acquisition announcement.
A large study in 2011 examined 26,000 acquisitions during the period 1988-2010, and computed CARs
over a 7-day window (-3, +3). The CARs were +15.5% for target companies and -1.0% for acquiring companies.
However, the net event return (taking into account both target and acquirer) was positive on average. Therefore, it
seems that wealth is created overall, but acquiring companies lose money while target companies make money.
This is probably because acquiring companies tend to pay too high a price (the “winner’s curse”).
Thus, the overall conclusion is: yes, mergers generally add value, but the value added has been declining
over time (indicates that the corporate sector is becoming more efficient, perhaps because of the threat of M&A?).
While wealth is created in aggregate, there are large variations within the sample. For instance, the acquiring
company does better (i) if the target company is a foreign corporation than a domestic one, (ii) in a cash-financed
acquisition than a stock-finance one, and (iii) if the target is in the manufacturing sector than the telecom sector. On
the other hand, the target company does better (i) if there is a tender offer, (ii) in a cash-financed acquisition, and
(iii) when there are more bidders. Also, acquiring company returns are negative for most stock-financed
acquisitions.
The above figures tell us about short-term (7-day) performance. In the long run, the performance is not quite
so good. In about half the cases, the actual synergies turned out to be negligible or much smaller than anticipated.
Also, in about half of the cases, the acquisition resulted from a reversal of a previous acquisition (i.e., divestiture of
a previously acquired business), which implies that the earlier acquisitions were failures. The post-merger
performance is positively correlated with the total (target plus acquirer) announcement return, hence the market
seems to be quite good at anticipating improvements in future performance. Also, most studies find that market
(monopoly) power is not significantly higher after merger, implying that regulators are doing their job.

12 Jarrell, G.A., J.A. Brickley and J.M. Netter (1988) The Market for Corporate Control: The Empirical Evidence Since 1980,
Journal of Economic Perspectives 2, 49-68.
55

How do bondholders fare vis-à-vis shareholders in acquisitions? In the case of the bidding company,
bondholders do better than shareholders (co-insurance effect); in the case the target company, shareholders do
better than bondholders (control premium).

Types of Acquisitions
In the traditional literature, there are three types of acquisitions: horizontal, vertical and conglomerate. In Finance,
we are primarily interested in the source of the value created, hence the categorization is slightly different:
1. Strategic acquisition: these are driven by operating synergies, where the combined value exceeds the sum
of individual values. They are usually friendly acquisitions.
2. Financial acquisition: these are driven by financial motives, e.g., under-valued firm or assets (bad
management), under-utilization of tax shields, under-utilization of debt capacity, problematic management
compensation structure (agency problems). They are often hostile in nature.
3. Conglomerate acquisition: acquiring an unrelated business, the main objective being diversification or risk
reduction. These can be friendly or hostile.

Strategic acquisitions are usually horizontal (that is, acquirer and target are in the same industry); they have been
the dominant type of acquisition since the 1990s. Financial acquisitions used to be important in the 1980s, but have
declined in importance, since such opportunities (undervalued firms, underutilized tax shields) are very difficult to
find now. Conglomerate acquisitions were very popular in the 1960s and 1970s, when firms like ITT and Gulf &
Western made large numbers of unrelated acquisitions (which were mostly unsuccessful, only to be reversed later);
but they are not popular today because firms are more interested in focus than diversification.

Acquisition Motives
Factors behind acquisitions:
1. Underpriced target company: It is generally difficult to find such a company, because financial markets are
quite efficient. However, some firms may be temporarily underpriced because of bad management
(although if the market has already figured this out and priced it, then it will no longer be underpriced).
Some firms might be underpriced because of lack of information (implying some inefficiency in the
market). Also, private firms might be relatively under-valued by their current owners because the owners
are not diversified investors (hence they discount at a higher rate than the market).
2. Synergies: Operating synergies or Financial synergies, where the combined firm value exceeds the sum of
the individual values, or VA+B > VA + VB. [Both synergies are discussed below]
3. Diversification or risk-reduction: This is the motivation behind conglomerate acquisitions. [Discussed
below].
56

4. Higher earnings (EPS) or Bootstrapping: As shown below, acquiring a firm with a lower P-E ratio can
result in a higher EPS, which will presumably make the firm more valuable. However, with efficient
markets, such benefits are generally illusory.
5. Managerial Benefits: When the top managers (not shareholders) benefit from the acquisition. Examples:
- empire-building, or increasing the firm size, which helps managers because it generally leads to
higher earnings and perks (club memberships, private airplane, etc) or greater job security (because
larger firms are less likely to go bankrupt); also, more employees usually result in more leeway in
the case of Chapter 11 filing, since judges are hesitant to do anything that might worsen
unemployment.
- managerial hubris, impressing peers, etc.
- a larger firm would also be a less attractive takeover target in the future, which is desirable for
managers because it increases their job security.
(Note: the last three are rather dubious motives for mergers and acquisitions).

Dubious Rationales
Example 1: The EPS (Bootstrap) Game
Take two companies A (acquirer) and T (target), with the following details:
A T
EPS 2 2
P/E 20 10
Price 40 20
# Shares 100 100
Net Income 200 200

Suppose A acquires T (a low P-E ratio firm) by offering an exchange ratio of 1 for 2, and no synergies are
expected. Then, after acquisition, total net income = 2*100 + 2*100 = 400, total number of shares = 100 + 50 =
150, so EPS of the post-acquisition firm A will be 400/150 = $2.67. The EPS thus rises from $2 to $2.67, and the
company might claim improved performance because of the higher EPS. But will A’s shareholders be better off
after the acquisition (or would value be created by the higher EPS)?
Value would be created if stock price rises. In this case, the EPS rises, but whether that leads to a higher
stock price will depend on what happens to the P-E ratio. If the P-E ratio stays unchanged, a higher EPS implies a
higher stock price. But what will happen to the P-E ratio in this case? Since A is acquiring low-P-E assets (recall
firm T has a low P-E), the P-E ratio of the post-acquisition firm will be lower. Thus, a higher EPS will not
necessarily translate to a higher stock price because it is accompanied by a lower P-E ratio. That is, no value is
created by this acquisition and shareholders are not better off.
57

In fact, if the P-E ratio of the combined firm is the average (or 15), then the post-acquisition stock price
will be 15*2.67 = $40, that is the same price as before. If the market is reasonably efficient, this will be the post-
acquisition stock price.
Now, suppose A paid a premium of 20% (a more realistic scenario), that is, offered an exchange ratio of 1.2
for 2. Then there will be 60 new shares, so total number of shares = 160, and EPS = 400/160 = $2.50. Thus, even
with a premium offered, the EPS rises significantly. However, the stock price will actually fall to (15*2.50 =
$37.50), so A’s shareholders will be worse off because of the acquisition.

Example 2: The Conglomerate Acquisition
The stated rationale for a conglomerate acquisition is “diversification” or “risk reduction.” However, from a
shareholders’ perspective, this is not a valid rationale for the following reasons:
1. Recall from portfolio theory that diversification reduces total risk but not systematic risk [that is,
)( 2211P  but )( 2211P  ], where σ1, σ2, σp are the volatility of asset 1, asset 2 and the
portfolio, respectively; β1, β2, βp are the beta of asset 1, asset 2 and the portfolio, respectively; and ω1, ω2
are the weights of asset 1 and asset 2 in the portfolio. Since shareholders are concerned with systematic (not
total) risk, they do not benefit from corporate diversification.13
2. Even if shareholders desire diversification for whatever reason, they can diversify more effectively and
cost-efficiently through the stock market, since stocks are actively traded and investors have to pay just the
market price whereas the firm has to pay the acquisition premium.
3. Since diversification reduces default risk, bondholders benefit from diversification. Therefore,
diversification by itself (without any additional value added) results in a transfer of wealth from
shareholders to bondholders (reverse asset substitution); this is known as the “co-insurance effect.”

Example of the coinsurance effect: Consider two firms A and B with cash flows that are independent
(uncorrelated). The cash flow to each firm will be $100 with probability ½ or $200 with probability ½. The interest
obligation to bondholders is $150 for each firm. Then the probability of default for each set of bondholders is ½,
and the probability of one or both firms defaulting is ¾. Now, if the two firms were to merge, the cash flow to the
merged firm would be $200 with probability ¼, $300 with probability ½ or $400 with probability ½, while the
interest obligation of the new firm would be $300. Therefore, the probability of default of the new firm is ¼. Since
default risk is significantly lower, both sets of bondholders are better off as a result of the merger. The lower default
risk means bond value will be higher, which implies equity value will be lower (in the absence of operating
synergies) since total firm value remains unchanged. Alternatively, from option pricing theory, when firm risk falls,

13 Reduced total risk does reduce bankruptcy risk, which helps managers and bondholders. Thus, managers and bondholders do
benefit from conglomerate mergers. There is substantial evidence that systematic risk does not fall after mergers; see, for
instance, (i) Firth, M. (1978) Synergism in Mergers: Some British Results, Journal of Finance 33, 670-672; (ii) Haugen, R.A.
and T.C. Langetieg (1975) An Empirical Test for Synergism in a Merger, Journal of Finance 30, 1003-1014; and (iii) Choi, D.
and G.C. Philippatos (1983) An Examination of Merger Synergism, Journal of Financial Research 6, 239-256.
58

equity value will also fall (since equity is equivalent to a call option on the firm’s assets). Therefore, pure
diversification is actually bad for shareholders, because it transfers wealth from shareholders to bondholders.
It is clear that reduction of total risk by the company does not benefit shareholders; it is therefore not a
valid reason to justify conglomerate mergers from the shareholders’ perspective. Moreover, there are some other
negative effects associated with a conglomerate merger, e.g., lack of focus, coinsurance effect, managers’ lack of
expertise in different industries. However, as we will see under “Financial synergies,” shareholders can benefit
indirectly from conglomerate mergers, because of the valuation effects of the reduction in total risk (higher debt
capacity, additional debt-related tax shields, lower cost of capital, etc).

Synergies
There are two types of synergies – financial synergies and operating synergies. Value creation in strategic
acquisitions is driven mainly by operating synergies (economies of scale and scope, learning curve, operating
improvements, greater market power, etc). In conglomerate acquisitions, on the other hand, value comes mainly
from financial synergies (coinsurance effect, better debt utilization, etc).

Financial Synergies
If a company with large amounts of NOL (net operating losses) or TLC (tax loss carryforwards) is acquired by a
profitable company, then the accumulated tax benefits can be exploited immediately (since the acquiring company
can reduce taxes on its profits, by an amount given by tax rate times accumulated tax losses). This tax benefit
creates value for the company at the expense of the tax collection agency; this is why an acquisition just to take
advantage of the tax benefit will usually be vetoed by tax authorities.
The tax bill can also be reduced by other means, such as increasing debt capacity by reducing total risk
(which is what happens in a conglomerate acquisition). A conglomerate acquisition will reduce default risk, which
will allow the company to issue additional debt; the additional debt creates value by means of the resulting tax
shield. In fact, debt levels have been found to rise after mergers and acquisitions, and there is a significant positive
relationship between the increase in the amount of debt and the value created (Seth, 1990).14 The higher debt level
also results in lower cost of capital (WACC) because debt is cheaper than equity.
Also, an acquisition will result in a larger company, hence the firm can benefit from lower flotation costs
when issuing securities (since flotation costs decrease with issue size). Finally, an acquisition often allows for more
efficient transfer of financial slack. When the acquiring company has surplus cash but no growth opportunities (is a
mature company) and the target has little cash but significant growth opportunities (is a growth company), the
acquisition will reduce the cost of capital because it eliminates the need for external financing (recall external
financing is more costly because of flotation costs and asymmetric information). Note that some of the financial
synergies will result from conglomerate acquisitions.

14 Seth, A. (1990) Sources of Value Creation in Acquisitions: An Empirical Investigation, Strategic Management Journal 11,
431-446.
59

Example:
How significant are financial synergies in a conglomerate acquisition? It depends on the correlation between the
two firms (earnings or values), which determines the additional debt capacity created by the acquisition. Suppose
the optimal leverage ratio of each firm is 40%, and cost of equity ke = 15%, cost of debt kd = 8%, and corporate tax
rate τc = 40%. Then the pre-acquisition WACC is 0.4(8)(1–0.4) + 0.6(15) = 10.92%.
After the acquisition, suppose the optimal leverage ratio rises somewhat to 50%, and there is no change in
ke, kd and τc. Then the WACC becomes 0.5(8)(1–0.4) + 0.5(15) = 9.9%. [Note: ke and kd can stay unchanged since
both debt capacity and leverage ratio go up].
If we use a simple (perpetual) valuation model, then the firm value is given by EBITDA/WACC. In this
acquisition, if there are no operating synergies, EBITDA remains unchanged, and WACC falls from 10.92% to
9.9%. Thus, firm value will rise from 1/0.1092 to 1/0.099, an increase of 10.3%. Given that there are no operating
synergies, this represents a significant rise in firm value. Thus, financial synergies can be non-trivial in magnitude.

Operating Synergies
Operating synergies come from operating improvements (higher earnings or cash flows) resulting from increased
revenues or reduced costs or both. Examples of cost-reducing factors include economies of scale in production and
marketing, cutting manpower by eliminating duplication of functions, vertical integration (better coordination,
lower transactions costs), better capacity utilization (seasonal effects), improved managerial incentives (reducing
the agency problems between equity holders and managers), and moving down the learning curve. Examples of
revenue-increasing factors are strategic options (beach head) to new products and markets, higher prices because of
increased market power,15 improved bargaining position with respect to suppliers, complementary strengths (e.g.,
firm A in engineering and T in marketing), and technology transfer.
Synergies create value by harvesting benefits from a merger or acquisition that the company would be
unable to gain on its own. For instance, the acquiring company might state that a merger will result in economies of
scale, which will reduce average operating costs. However, it needs to look at the alternative, that is, could the
economies of scale be achieved on its own (by building rather than acquiring)? The build-versus-buy decision
(when does it make sense to acquire versus expand or build?) hinges on a number of factors, e.g., state of the
market (Tobin’s q-ratio), construction lag, and market saturation (possible cannibalization).
It is important to value the expected synergies appropriately and realistically. As in most valuation
exercises, the usual approach is to convert the synergies to cash flows, to discount the cash flows, and aggregate the
discounted cash flows. The discount rate should be based on the risk of the cash flows, e.g., cost savings are less

15 Note, however, that there are legal limits to market power. Excessive concentration of market power is limited by regulators
in most countries; in Canada, the limits are specified by the Federal Competition Act, and administered by the Competition
Bureau and the Competition Tribunal. Usually, mergers are not disallowed because of competition reasons; rather, the
companies are told to sell off certain parts in order to preserve competition.
60

uncertain, hence they should be discounted at a lower rate, whereas revenue increases are more uncertain, hence
should be discounted at a higher rate. All cash flows should, of course, be on an after-tax basis.
In general, operating synergy values are largest in strategic (horizontal) mergers and smallest in
conglomerate mergers. Thus, the main source of value in a conglomerate acquisition is financial synergies and the
main source of value in a strategic acquisition is operating synergies. However, Seth (1990)13 finds no significant
difference between strategic and conglomerate acquisitions as far as value-added is concerned.




























Economies of Scope
Economies of scope apply when the joint output from a single firm is greater than the
output produced by two firms each producing a single product (with identical total inputs).
Economies of scope are not necessarily related to economies of scale. The degree of
economies of scope is given by the following formula:
)q,q(C
)q,q(C)q(C)q(C
ESC
21
2121 
where C(q1) = cost of producing only output q1, C(q2) = cost of producing only output q2,
and C(q1,q2) = joint cost of producing both outputs.
If ESC > 0, there are economies of scope; and the higher the value of ESC, the
greater are the economies of scope.

Learning Curve
The learning curve shows the inputs necessary to produce a unit of output as a function of
the cumulative output. The long-run average cost of production often declines over time
because workers and managers become better at their jobs (hence “learning”). Therefore,
as the firm produces more, it “learns” more about how to produce the good(s) efficiently,
as a result of which the average production cost falls.
In practice, the learning curve can make a huge difference, particularly for high-
tech products. A study of the Chemical industry found that for each doubling of plant size
the average production cost falls 11% (economies of scale) but for each doubling of
cumulative output the average production cost falls 27% (learning curve). Thus, for the
Chemical industry, the learning curve is more important than economies of scale.

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Unsuccessful Mergers/Acquisitions
Not all mergers or acquisitions are successful. Merger failure would include (i) reversal, or divestiture of the
acquired company, within a few years; (ii) bankruptcy; (iii) synergies turning out to be negligible or significantly
smaller than anticipated.
There have been some highly successful mergers/acquisitions, e.g., Exxon-Mobil or JPMorgan-Chase. But
there have also been spectacular failures, ending in bankruptcy or reversal (subsequent divestiture). For instance,
Quaker Oats purchased Snapple in 1994 for $1.7 billion and sold it in two years for only $300 million; Daimler
Corp. purchased Chrysler in 1998 for $36 billion and sold 80% of it in 2007 for $7.4 billion.
Most studies find that a significant fraction (approximately 50%) of all acquisitions ends in failure. A study
by Copeland et al. (1994) that examined 116 acquisitions found that 61% of them were failures and 23% were
successes; the outcome for the remaining 16% could not be ascertained. Mitchell and Lehn (1990) report that over
20% of all acquisitions between 1982 and 1986 were divested by 1988. Over a 10-year period, the divestiture rate
was found to be about 50%.16

Why do so many acquisitions end in failure?
- Overestimating target value (bad forecasting), particularly for synergies.
- Managerial overconfidence (in ability to improve performance).
- Overbidding (especially if in an auction) and the “winner’s curse;” paying too much.
- Failure to do due diligence.
- Failure to integrate, cultural differences, e.g., Daimler-Chrysler.

Potential negative effects of M&A on firm performance:
 Misallocation of capital (e.g., using additional debt capacity or surplus funds to subsidize money-losing
business segments, because the manager might be unwilling to fire personnel or admit past mistake), which
results in destruction of value.
 Dilution of information content of stock prices because the stock price now represents multiple businesses;
might be more difficult to identify which activities in a multi-unit firm are most value-additive.
 Executive compensation becomes more difficult.
 Transfer of wealth from equity holders to bondholders (co-insurance and reverse agency).



16 Copeland, T.E., T. Koller and J. Murrin (1994) Valuation: Measuring and Managing the Value of Companies, John Wiley
Publishing, New York, NY.
Mitchell, M.L. and K. Lehn (1990) Do Bad Bidders Become Good Targets? Journal of Political Economy 98, 372-398.
Damodaran, A. (2001) Corporate Finance: Theory and Practice, John Wiley Publishing, New York, NY.
62

The Acquisition Process

There are three major steps in the acquisition decision:
1. Value the target company along with the synergies that will result from the acquisition.
2. Decide on the premium to be paid.
3. Decide on the financing method (cash, stock or a combination of the two).

The difference between the purchase price and the pre-announcement market price is called the premium. (The
difference between the purchase price and the book value is listed under Goodwill in the acquiring company’s
balance sheet).

Valuation of Target Firm and Synergies
This was covered in chapter 5.

Merger/Acquisition Premium
After valuation of target company (and synergies), the bidding firm must determine the size of the premium to
offer. This is an important decision because if the premium is set too low, the offer will not be taken seriously and it
will reduce the probability of the acquisition being completed in the future; if the premium is too high, it will result
in a transfer of wealth from its own shareholders to the target company’s shareholders and will therefore be a
negative-NPV decision.
There is no formula for appropriate or “optimal” premium. In practice, the premium is usually finalized by
means of a bargaining process, and depends on a number of factors, e.g., synergies, bargaining position(s) of the
two parties, number of bidders, anti-takeover provisions, and control issues. For a controlling interest, the premium
tends to be quite high, about 40-50%; bit for minority interest, the premium is smaller, at 25-35%. Also, the
premium is remarkably stable and constant over time, only falling slightly during economic downturns.
If the acquisition premium is too large, the acquisition becomes a value-destroying (negative NPV) decision
for the acquiring firm. In the end, the actual premium is decided by a number of factors, including personal and
non-economic factors; for instance, the CEO might really want to complete the acquisition to assure the market that
the company is a major player, or to maintain a positive impression of top management’s negotiating ability. In this
course, the best we can do is decide on a rational range (in an economic sense) for the premium, which would
depend on things like expected synergies, required event returns of target company shareholders and acquiring
company shareholders, effect on target and acquirer EPS, etc. The larger the expected synergies the higher the
possible premium, the higher the target (acquirer) shareholders’ required event return the higher (lower) the
premium, etc.


63

Financing an Acquisition – Cash vs. Stock
(Actually, cash financing is usually supported by bank loans or debt issues, so it could also be viewed as debt
financing).
Historically, most acquisitions have been financed by cash, although that has been changing over time.
Cash deals have accounted for about 80% of all acquisitions (based on number of deals) and about 60% (based on
dollar value). As reported by Rappaport and Sirower (1999), in 1988 about 60% of large deals (over $100 million in
size) were entirely cash-financed and less than 2% were entirely stock-financed; however, in 1998, over 50% were
entirely stock-financed while only 17% were entirely cash-financed.17
The form of payment in an acquisition is important because it has a significant impact on ownership and on
shareholder event returns. Even the actual value of the deal might depend on how it is financed; not surprisingly,
the price and the form of payment are often a joint decision. The form of payment depends on a number of factors,
and these are discussed below.

Does the Form of Payment Matter to Shareholders?
Target company event return is significantly higher for cash-financed acquisitions than for stock-financed
acquisitions (this is not surprising, because of the tax implication discussed below). A large-scale study found that
target company shareholder CAR was, on average, 30% for cash-financed acquisitions and 15% for stock-financed
acquisitions.
Acquiring company’s event return behaves in a similar manner. For stock-financed acquisitions, the
acquiring company’s event return is negative on average; for cash-financed acquisitions, acquiring company’s
event return is positive (but smaller than target company event return). In three different studies, the acquiring
company’s event return was found to be:
(i) +1.38% for cash-financed and +0.15% for stock-financed;
(ii) +0.88% for cash-financed and -0.79% for stock-financed; and
(iii) +0.3% for cash-financed and -1.81% for stock-financed.
Therefore, how an acquisition is financed matters greatly to shareholders, as evidenced by event returns.
However, there is no significant difference in post-acquisition operating performance (measured by ROI, ROA,
Sales Turnover, etc) between cash-financed and stock-financed acquisitions, so the financing method does not
affect future operating performance.

How is the Form of Payment Determined?
A number of factors affect this decision:
1. Tax implications: Tax liabilities should be minimized. A cash-financed acquisition is treated as a sale of
shares, hence the acquired firm’s shareholders are subject to capital gains tax. A stock-financed acquisition,

17 Rappaport, A. and M.L. Sirower (1999) Stock or Cash? The Trade-offs for Buyers and Sellers in Mergers and Acquisitions,
Harvard Business Review, November-December, 147-158.
64

on the other hand, is treated as an exchange, and therefore attracts no such taxation. Cash financing is
therefore more expensive because the acquired firm’s shareholders would demand a higher price to
compensate them for the tax; this is consistent with empirical evidence. How much higher? Depends on the
capital gains tax rate of the marginal shareholder.
2. Information/signaling effects: The acquiring firm is more (less) likely to use stock financing if it feels its
stock is overpriced (underpriced). Thus, a stock-financed acquisition signals to the market that the
acquiring firm’s stock is overpriced, as a result of which its stock price falls. Stock financing therefore
sends a negative signal and cash financing sends a positive signal regarding the acquiring firm.
3. Level of uncertainty (Asymmetric Information) and risk-sharing: In a stock-financed acquisition, if the
benefits from the acquisition are larger (smaller) than anticipated, the acquiring company ends up paying
too much (too little), ex-post. In this sense, stock financing results in risk sharing, while cash financing puts
the risk on the acquiring company. Thus, in highly volatile industries, it might be better to make
acquisitions with stock financing, because of its risk-sharing properties.
4. Capital structure implications: Prior to the acquisition, if the acquiring firm has too much debt, it is more
likely to use stock financing. If it had too little debt, it is more likely to use cash financing (backed by
debt).
5. Control Issues: A cash transaction will not affect the composition of the acquiring company’s ownership,
while a stock transaction could have a significant effect (depending, of course, on the relative valuations).
For a stock-financed merger, this could be a problem if the target company shareholders have a large stake
in the combined firm.
6. Size: Target firm size is important simply because most firms are unable to raise huge amounts of cash
without incurring large costs, hence large acquisitions tend to be stock-financed.
7. Competition (or Potential Competition): Cash offers tend to be more effective at pre-empting competing
offers than stock offers, and also when the target company’s ownership is concentrated.
8. Effect on EPS or DPS (Dilution): This is a consideration for stock-financed acquisitions. Managers, in
general, try to avoid reducing the EPS. Although, in principle, a reduction in EPS in itself is not detrimental
(if EPS falls but the P-E ratio rises to offset that, the stock price will remain unchanged, hence no value is
being destroyed), managers in practice are very reluctant to allow the EPS to fall after a merger/acquisition.
This is because the EPS is widely reported and used by investors and financial analysts to evaluate short-
term managerial performance. When does EPS dilution become a problem? When the target company’s P-
E ratio exceeds the bidding company’s P-E (e.g., if it is a high-growth company), because this will cause
the acquirer’s EPS to fall. Similarly for dividend per share (DPS).
9. Liquidity of bidder: If the bidding company does not have sufficient liquidity, it will not be able to use cash
financing for the acquisition.
10. Recent stock price performance of the bidding firm: If bidder’s stock price has been falling, then its stock
becomes an undesirable currency for the acquisition, and it makes sense to use cash financing.
65

11. State of the economic cycle: Stock financing is more popular when the stock market is doing well.
12. Type of acquisition: A friendly acquisition is more likely to be financed by stock, and a hostile acquisition
is more likely to be financed by cash.

These factors have to be balanced when deciding on how to finance the acquisition. They might be more important
or less important in different situations. Sometimes exogenous factors may restrict the acquiring company’s
options, e.g., if the target company shareholders happen to be predominantly high-tax-bracket investors, they might
reject even an attractive cash offer because it is taxable.

The Actual (Effective) Premium in a Stock-Financed Acquisition
In a stock-financed acquisition, it is often not clear what the actual premium is. This is because the stock does not
have a fixed value, and its value changes depending on the terms of the acquisition; therefore, the premium
computed on the basis of the pre-offer stock prices can be highly misleading. If the acquiring company pays a
premium, it will lead to a dilution of its stock (hence a lower acquiring company stock price), which will lower the
effective premium it is offering; thus, the actual premium will be smaller simply because there is a premium being
offered. We can try to figure out the expected premium in one of two ways: (i) look at ownership changes resulting
from the acquisition, or (ii) based on our expectations regarding how the acquisition will work out.

Example
Company A’s stock (1 million shares outstanding) is trading at $46. It wishes to acquire company T whose stock
(500,000 shares outstanding) is trading at $40. A offers T’s shareholders 1 share of A for every one of T. What is
the premium offered to T’s shareholders?

(Incorrect method, based on pre-offer prices): 1 share of A is worth $46, 1 share of T is worth $40; since the offer
is 1:1, the premium is 46/40 – 1 = 15%. This is incorrect because it assumes A’s stock price remains unchanged
after the acquisition, which is unlikely since it is paying a premium.

Correct method (based on ownership pre- and post-acquisition):
Pre: market values: B 46, T 20, total 66. T’s stake in joint company = 20/66 = .3030
Post: #shares = 1.5 million, of which T’s shareholders hold .5, or .5/1.5 = .3333
Therefore, as a result of the acquisition, T’s shareholders’ ownership of the combined entity will rise from 30.30%
to 33.33%.
Then, Premium = .3333/.3030 – 1 = 10%.
(Note that this is significantly smaller than the premium computed above).


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What Exchange Ratio to Offer in a Stock-Financed Acquisition?
In a stock-financed acquisition, deciding on the exact offer is more complicated than in a cash-financed acquisition.
This is because the currency of the acquisition is the acquiring company’s stock, the value of which changes
because of the acquisition. Therefore, the expectations about the stock price changes have to be taken into account
when deciding on the offer terms.

Example
A has 100 million shares, trading at $0.8 each; T has 10 million shares, trading at $4.00 each. Synergies are
expected to be worth $8 million. Firm A decides to make an offer with the synergy value split equally between A
and T. What cash offer should it make? What stock offer? If, after the stock offer, actual synergies turn out to be
worth half the expected synergies, how much would A end up paying, ex-post? What if synergies turn out to be
double the expected level?

Market values: A 80, T 40, Synergies 8; Total expected post-acquisition market value = 128.
Want to offer 4 (half the synergies) to T; therefore, offer should be worth 40 + 4 = 44.
Cash offer, easy to decide: 44 in cash.
Stock offer: have to decide on number of shares; say, offer x shares of A.
Then, number of shares in the combined firm = (100+x), so post-acquisition expected price = 128/(100+x)
Value of offer: x times expected price = 128 * x/(100+x). This should be worth 44, hence:
128 * x/(100+x) = 44, giving x = 52.38 million shares.
If it turns out that synergies = 4 (instead of 8), total value is 124 instead of 128, hence A is effectively paying
124*52.38/152.38 = 42.62 (less than 44).
If synergies = 16, effectively paying 136 * 52.38/152.38 = 46.75 (more than 44). This illustrates the risk-sharing
property of stock financing.

Stock-Financed Acquisition: Earnings Dilution
If A acquires T using stock financing, the EPS to both sets of shareholders will generally change. If too many (too
few) shares are offered, the acquisition will reduce A’s (T’s) shareholders’ EPS. This earnings dilution is
undesirable because the market and shareholders are generally averse to a fall in earnings per share.

Example 1:
Take the two companies below:
Company EPS P-E ratio Price No. of shares Net Income
A $2 10 $20 200 400
T $1 20 $20 100 100

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If A offers a 25% premium on current market prices, i.e., 1.25:1, total shares = 200+125 = 325.
Total Net Income = 500 (if no synergies), hence EPS of combined firm = 500/325 = $1.54.
The acquiring company’s EPS falls from $2 to $1.54 because of the acquisition.
In general, acquiring a higher P-E-ratio company will result in a lower EPS (opposite of the bootstrap effect).

Example 2: How EPS limits exchange ratio offered
Suppose acquiring company A has net income = $18 million, and target company T has net income = $15 million,
and each company has 10 million shares outstanding. Also, operating synergies are expected to increase net income
by $7 million per year. A’s offer is x for 1.
Pre-acquisition: EPS of T = 1.5, EPS of A = 1.8.
Post-acquisition: net income of resulting company = 18 + 15 + 7 = $40 million. Number of shares = 10+10x.
Therefore, EPS = 40/(10+10x). Also keep in mind that T’s shareholders get x for 1, so their effective EPS is
40x/(10+x).
Then, in order to keep both sets of shareholders satisfied (i.e., to ensure that EPS does not fall for either), we must
have:
For T’s shareholders: 40x/(10+x) > 1.5, giving x > 0.6.
For A’s shareholders: 40/(10+x) > 1.8, giving x < 1.22.
This sets upper and lower limits on the exchange ratio that can be offered (because shareholders do not want a
reduction in EPS), i.e., 0.6 < x < 1.22. This will be a factor in A’s offer, but other factors will of course have to be
considered. For instance, A will not want to give up control of the combined company, so x < 1. This further
narrows down the range to 0.6 < x < 1. They will also have to consider the minimum event returns that will be
acceptable to A’s and T’s shareholders.

Cash vs. Stock Financing: Short-term Pricing Risk
If firm A uses cash financing and finds out (post-acquisition) that there are unforeseen problems with the valuation
of T, the entire loss falls upon A. If stock-financed, T’s shareholders would bear part of this loss. Thus, valuation
risk is mitigated by stock rather than cash financing. On the other hand, if benefits are larger than expected, then a
stock exchange would result in A paying too much for the acquisition. This is the risk-sharing property of stock
financing.
While stock financing does reduce valuation risk, it introduces another type of risk: Short-term Pricing Risk.
Suppose A offers an exchange ratio of X, based on T’s stock price. If T’s price falls significantly after the offer, A’s
shareholders will feel X is too generous an exchange ratio. Thus, with stock offer, A is subject to the risk of short-
term price movements. Similarly, if A’s price falls after the offer, T’s shareholders might not find the offer
attractive enough and reject it. Therefore, because of stock price fluctuations, a fixed (unprotected) exchange offer
leads to uncertainty regarding the value (and fate) of the offer.

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Possible solutions for valuation risk:
(i) Floating-rate offer: specify that the exchange ratio or number of shares be such that they would be worth a
certain dollar value, i.e., a fixed-value offer,
(ii) Use a cap: firm A can put an upper limit on the number of shares, so that it does not end up giving too many
shares resulting in loss of control.

Some Mechanics in a Tender Offer
Tender Offer: this is an offer made by the bidding company directly to shareholders of the target company T,
bypassing T’s management and board of directors in a hostile acquisition. It usually succeeds if 50% or more of T’s
shareholders accept the offer. Often T’s management will form a committee to make recommendations to its
shareholders.
T’s shareholders will have to be given sufficient time to decide (longer if there are multiple bidders). Even
if a minority of shareholders do not accept the offer, the majority can force them to accept the offered terms (known
as “cram down” or “freeze out”) as long as it does not constitute oppression of minority shareholders (such as
forcing them to accept a very low price) since courts do not allow oppression.

Two-Tier Tender Offer: in this tender offer, the first tier (first round) offer is more generous (e.g., higher price) and
is used to get control, say 51% of the equity; the second tier is less generous (e.g., lower price, combination of cash
and securities instead of just cash) and is used to close out the deal.

Three-piece Suit: there are three tiers; the first tier is used to get a toehold, the second tier to gain control, and the
third to freeze out the remaining shareholders and complete the deal.

In two- and three-tier offers, minority shareholders of T do not have much of a choice as T might cease to exist in
its current form after being acquired. These offers are used mainly to overcome the free-rider problem. But even
with all these innovations, there is no guarantee that a large enough premium will necessarily ensure success in a
tender offer, because of, for instance, legal or anti-trust restrictions, conflicts of interest or agency problems, target
company management’s opposition, or anti-takeover provisions.

Bidding Strategies in Hostile Takeovers
Hostile takeovers can be difficult because small shareholders often have an incentive not to tender their shares.
Take the following example: Company A realizes that company B, with current stock price at $20, can be run more
efficiently. Under A’s management, it share price would be $30. Therefore, A would like to acquire enough shares
of B to gain control (say 51%), so that it can make the improvements that would raise the price to $30. Suppose A
makes a conditional offer of 51% of B’s shares at a price of $25 (conditional offer means A will buy only if 51% of
the shares are offered). Although this price represents a significant premium over the current price, the offer is
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likely to fail. To see why, consider the table below, showing the value B’s shareholders would receive in the two
scenarios (if they tender and if they do not tender):

Value if shareholder
Tenders Does not tender
Bid succeeds $25 $30 18
Bid fails $20 $20

In both outcomes, shareholders are better off (or at least not worse off) not tendering; that is, not tendering
dominates tendering as a strategy. Thus, small shareholders whose decisions have no impact on the outcome of the
offer have an incentive not to tender. Clearly, if company B has mostly small shareholders, the offer is unlikely to
succeed, unless A offers such a high price, e.g., the expected post-acquisition price, that it becomes unprofitable for
A. [Of course, the above argument will not hold if there are some large shareholders capable of affecting the
outcome].

Solutions:
1. Accumulating shares in the open market; however, this might not be very effective, since it has to be announced
once the shareholding reaches a certain threshold.
2. Two-tiered offers: here, the bidder offers two prices – the initial offer for a specified number of shares and the
follow-up offer for the remaining shares at a different price. The first price is generally higher and paid in cash,
while the second price is lower and usually paid in securities. As a result, shareholders are coerced into tendering
with the first offer. In the above example, if A had made a two-tiered offer (say, $25 and $22) it would succeed.
(Note, however, that the second-tier price has to be a “fair price.”) This was very popular in the 1980s and 1990s,
but has been facing many legal challenges in recent years.

Topping Fees or Bust-up Fees
These are fees paid by the target company to the bidding company, to compensate for potential losses if a new
bidder usurps the deal or if the target terminates the deal (without a valid reason). Of course, this means the
winning bidder will have to bear the burden of these fees. Topping fees were introduced basically to compensate
bidders for out-of-pocket expenses, and have the effect of discouraging other bids. It is therefore a way to increase
the likelihood of success of an acquisition bid.
Topping fees can be quite large (up to $50 million), and are usually in the range 1-5% of the acquisition
value. So far, they have largely survived judicial scrutiny, and are likely to be accepted unless they are
unreasonably high. Thus, the target company has to be careful in making its accept/reject decisions, because it

18 If shareholder holds on, after A acquires 51% of B’s equity.
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might be expensive to reverse an “accept” decision. This is often another reason why buyers over-pay in a multiple-
bid auction.

Defensive (Anti-Takeover) Tactics
Managers of target companies often resist being acquired, either because they feel the offer is not good enough for
the shareholders or for more selfish reasons (they usually lose some benefits or perquisites or even their jobs).
Some measures used by target company managers to defeat an attempted acquisition:
1. Amend corporate charter to make acquisition more difficult, e.g., normally a 2/3 majority is required for an
acquisition to succeed but some companies change this required majority to 80% or higher (supermajority).
2. Increase board tenures and stagger board elections, to thwart proxy fights for board seats.
3. Greenmail: A targeted stock repurchase from potential bidders at (usually) large premiums, in order to
eliminate takeover attempts.
4. Use dual-class stock (non-voting), so that the management shareholders hold most of (or all) the voting
stock.
5. Poison pills and poison puts make it very difficult or expensive to acquire the company. A poison pill is a
warrant issued to existing shareholders that gives them the right to buy surviving firm securities at very low
prices in the event of a merger. Such a warrant’s exercise might be triggered by an event such as a 10-20%
acquisition or a tender offer for 20-30% of the stock. On the other hand, a poison put’s function is to
protect bondholders; it allows bondholders to sell their bonds back to the company at par (or even at a
premium) in the event of an acquisition.
6. Take the company private (by means of an LBO or MBO).
7. Look for a “White Knight” (friendly bidder who will not fire top management).
8. Get rid of the most attractive assets of the company (the “crown jewels”), so the bidder loses interest.
9. Buy back stock and increase debt and/or dividends significantly.
10. Golden parachutes.

Question: If a company introduces some of these provisions, will stock price change? If so, in which direction?

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Chapter 6. Questions

1. Firm A has a market value of 600 and 30 shares outstanding. Firm B has a market value of 200 and 20 shares
outstanding. Firm A is considering acquiring B, and estimates that the value of the combined entity will be 1000.
The CEO of firm A expects that B can be acquired at a premium of 100.
(a) If A offers 15 shares to exchange for the 20 existing shares of B, what will be the after-acquisition stock price of
A?
(b) To make the stock offer equivalent to a cash offer of 300, what will be the proper exchange ratio?

2. Firm A has a market value of $2000 and 100 shares outstanding, and firm B has a market value of $1000 and 60
shares outstanding. A is considering acquiring B, and estimates that synergies from the acquisition would amount to
$600.
(a) What is the maximum price A should be willing to pay?
(b) B is willing to accept cash or shares (of firm A) worth $1400. What exchange ratio must A offer?
(c) If the actual synergies turn out to be worth $800, what amount will firm A end up paying?

3. Firm A (the acquiring company) has a market value of $80 million, and is planning a bid for firm T (the target
company), which is valued at $40 million. The merger will result in synergies valued at $8 million.
(a) What is the maximum cash offer that firm A can offer firm T’s shareholders? What is the minimum offer that
would be acceptable to T’s shareholders?
(b) If the actual offer is the mid-point of the above prices, what is the NPV of the deal to each firm?
(c) If firm A decides to make a stock offer, what fraction of the stock would it have to offer in order to generate the
same NPV as in part (b)?

4. The bidding company B has the following: EPS = $2, P-E ratio = 10, and Number of shares = 200 million. The
target company T has: EPS = $1, P-E ratio = 20, and Number of shares = 100 million. B offers T’s shareholders 1.5
shares of B for each share of T. What will firm B’s EPS be after the acquisition is completed?

5. Firm A has a market value of 600 and 30 shares outstanding. Firm B has a market value of 200 and 20 shares
outstanding. Firm A is considering acquiring B, and estimates that the value of the combined entity will be 1000.
The CEO of firm A expects that B can be acquired at a premium of 100.
(a) If A offers 15 shares to exchange for the 20 existing shares of B, what will be the after-acquisition stock price of
A?
(b) To make the stock offer equivalent to a cash offer of 300, what will be the proper exchange ratio?
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Chapter 7. LEVERAGED BUYOUTS (LBO)

A Leveraged buyout (LBO) is the purchase of a company (or part of a company) by a small investor group or
financial buyer (KKR, Blackstone, Carlyle, Texas Pacific Group, etc.) using a high percentage of debt financing.
LBOS are similar to leveraged recaps in that both result in significantly higher leverage ratio, but there are some
differences: (i) there is a change in ownership in an LBO but not in a Leveraged Recap, (ii) LBO is generally on a
much larger scale, (iii) the firm is usually taken private in LBO (in most cases, to be taken public again through a
SIPO a few years later).

Characteristics of LBO
a. Like M&A, it involves transfer of control of a company, but unlike M&A there is only one company in the
transaction (hence there are no synergies in an LBO) and the firm is taken private.
b. A large fraction of the purchase price is debt-financed, with some or most of the debt being low-grade or
junk debt; the small amount of equity is held mostly by managers.
c. In virtually all LBOs, the company is taken private; that is, its shares are no longer traded in the open
market, and the remaining shares are held by a small group of shareholders (with significant management
shareholding).
d. If the LBO is executed by the managers of the company, it is known as MBO (management buyout).
e. The investors (buyers) are not another company, but an outside financial group or managers/executives of
the company.
f. MBOs targets are often under-performing units of diversified companies.
g. LBOs usually result in turnaround in operating performance, not just the stock price.

Some well-known examples of LBOs:
- KKR’s $31 billion acquisition of RJR Nabisco in 1989, discussed in chapter 3 of this courseware;
- The acquisition of utility company TXU by a consortium led by KKR, Texas Pacific Group (TPG Capital)
and Goldman Sachs, in 2007;
- The Blackstone Group’s LBO of Hilton Hotels in 2007.

Economic and Financial Environments Favorable to LBOs
 Sustained economic growth (high leverage ratio not feasible during economic downturns).
 Availability of debt.
 Financing innovations (e.g., high-yield or junk bonds made financing available to firms below investment
grade).
 High inflation rate.
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How Does High Inflation Rate Facilitate LBOs?
1. High inflation means high interest rates (recall, iNominal = iReal + inflation rate), which leads to lower
corporate bond values and thereby lower leverage ratios;
2. High inflation led to the development of the junk bond market, widely used to finance LBOs;
3. High inflation reduces Tobin’s q;19 if q < 1 it is cheaper to buy a company in the financial market (i.e., buy
financial assets) than build it from scratch (i.e., buy real assets); thus, high inflation makes it easier to buy
than to build, which encourages mergers/acquisitions and LBOs.

Typical Target Industries
• Basic, non-regulated industry – stable earnings, predictable/low financing requirements (low
growth) because going private reduces access to outside capital.
• High-tech industry less appropriate – more risk, no track record, fewer assets, high P/Es.
• Half of LBOs are in 5 industries – retail, textiles, food, apparel, soft drinks (Lehn, Poulsen, 1988).

Typical Target Firms
• Main requirement is the ability to generate a lot of cash (thus, from a mature industry).
• Strong market position within industry.
• Liquid balance sheet (with tangible assets).
• Predictable cash flows (can support a lot of debt), hence LBOs are concentrated in stable industries.
• Under-leveraged.
• Low P/E ratio.
• Helps if management is viewed as capable, since management generally owns a significant portion
of the equity.
• Many of the target companies are private or controlled by family members who want to exit.
• MBOs are generally planned divestitures or subsidiaries that are being mismanaged by the parent
company.

Steps in an LBO Operation
1. Financing
As the name suggests, an LBO is mostly debt-financed (this is why asset tangibility is a necessary requirement
for an LBO candidate). For instance, only about 10% could be cash from investor group (equity), 50-60% bank
loans (senior), and the balance from senior and junior subordinated debt, convertible bonds, junk bonds, and
mezzanine debt. Mezzanine debt generally has “sweeteners” (payment in kind or PIK, warrants) attached, to
compensate for the low coupon rate. There are so many different levels of seniority of the debt, because there is

19 Tobin’s q = Market Value of Co/Replacement Value of Assets.
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so much debt. The senior debt usually comprises bank loans with tight covenants, and carry low interest rates
(floating at 2-3% above LIBOR). The mezzanine (junior most) debt comes mostly from specialty finance
companies, with interest rates about 4-5% above LIBOR, as well as warrants, PIK (payment in kind) features,
etc., since even the higher coupon rate is not sufficient to compensate for the high default risk level, Mezzanine
debt generally has very flexible (or no) covenants.

2. Finalize management incentives
Managers’ fixed salaries are very low, and their compensation is mostly in the form of stock-based incentives
(restricted stock, options), for two reasons: (i) to provide strong incentives for management to maximize equity
value, and (ii) because of the high interest payments (debt level), there is usually very little cash left for
managerial salaries.

3. Take firm private
By buying all outstanding shares and form a new privately held corporation.

4. Improve performance
 Sell off under-performing units
 Cut operating costs and spending
 Easier to do because managers are shareholders
 Disciplinary role of debt
 Extract more favorable terms from employees/suppliers

5. Reduce debt to prepare for SIPO
Buy back some debt (not very difficult to do, since there are no dividend payments and managerial fixed
salaries are low), If necessary, sell off assets to reduce debt (of course, cannot sell assets for other purposes
such as payment of dividends). This step is important, because the company wants to reduce debt to normal
levels, else it will be difficult to do a SIPO (secondary IPO).

6. Reverse LBO (or SIPO)
 After a few years (3-5 years), the investor group takes the improved company public again through
a public equity offering (SIPO).
 There are some exceptions to the SIPO, because certain companies might prefer to remain private,
such as family-held firms.
 SIPO is the means by which the LBO investors get their return; these returns are usually very high,
e.g., annualized return of 268.4% in the sample of Muscarella and Vetsuypens, (1990).
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Empirical Evidence on LBOs
 Premiums tend to be quite high (often higher than M&As, which is surprising because there are no
synergies in an LBO); different studies have found premiums of 56%, 41% and 56%.
 Announcement returns are generally positive, but they can vary widely. Studies have found high
announcement returns of 22% and 20%, but also low returns of 0.55% and 1.98%
 Premiums are higher (generally exceeding 50%) when multiple bidders participate in an auction, not
surprisingly.
 Like Leveraged Recaps (discussed in chapter 9), LBOs also create significant value in general. However,
LBOs create value on a much larger scale than Leveraged Recaps; a recent study of the grocery industry
found a 5-year abnormal return of 483% for LBO versus 24% for Leveraged Recap, and value creation of
$653 million for LBO versus $170 million for Leveraged Recap.
 A number of LBOs are unsuccessful. Of 136 LBO transactions from 1980-89, 31 had defaulted by 1996,
and 8 others were financially distressed. This is not surprising because, with so much debt, any economic
downturn makes financial distress likely.

We have three take-aways from the empirical evidence:
(i) Old shareholder wealth increases significantly (because of the large premium paid),
(ii) New shareholders do well (because of the SIPO), but this return has been declining over time,
(iii) Default risk is higher than normal.

Sources of Gains in LBOs
(Keep in mind there are no synergies, since there is just one firm involved in an LBO)
1. Tax Benefits
a. Interest tax shelter or tax shield: this is fairly easy to compute (approximately TcD).
b. However, the tax savings are generally used to finance most or all of the premium paid, thus most
of the tax shield is captured by the old shareholders. This is because the value of the tax shield is
fairly predictable (see point (a) above).
c. Depending on the assumptions regarding tax rate and debt maturity, the value of tax benefit is
between 1.297 and 0.263 times the premium; that is, the premium can be smaller or larger than the
tax shield.

2. Management incentives and agency cost effects
a. After an LBO, managers own a significant fraction of the company’s equity. This increased
ownership provides additional incentives for improved firm performance (by better aligning
manager/shareholder interests), helps reduce agency costs, etc.
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b. The discipline of debt: the high debt level resulting from an LBO forces the managers to commit
cash flows to debt, and puts pressure on them to improve firm performance (to ensure interest
payments are made and to thereby avoid bankruptcy); it also discourages managerial empire-
building and unnecessary perks like corporate airplanes.
c. Empirical evidence indicates that operating performance of firms improve after LBO, and the size
of the improvement is directly related to management ownership and pay-for-performance
sensitivity.

3. Wealth transfer from bondholders
Wealth transfer from existing bondholders and preferred stockholders
- Claim dilution, e.g., 20% in the RJR Nabisco case (but much smaller today)
- Covenants may not completely protect bondholders from control changes and debt issue
- Evidence indicates significant bondholder losses

4. Other wealth transfer effects
Wealth transfer from current employees or suppliers to new investors; renegotiation of labor
contracts, using the high debt level as a bargaining chip (because of the high debt level,
bankruptcy becomes a more credible threat, hence the management is in a better bargaining position).

5. Asymmetric information and underpricing
a. Managers and investor groups have better information on value of firm than shareholders.
b. Asymmetric information effects: buyer expects future operating income to be larger than expected,
hence the new company worth more than the purchase price.
c. However, failed MBO proposals are not followed by higher returns.

6. Other efficiency considerations
a. Private firms tend to have more efficient decision process (quicker decisions, lower reporting
burden).
b. Influence of favorable economic environment (since LBOs generally take place when the economy
is rising).

7. Debt is cheaper than equity
Even with high-yield (junk) debt, the actual cost of debt is quite low (since cost of debt is substantially
below the YTM).


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How do LBO owners do? Quite well
 Comparison of LBO firm value and SIPO
- Median increase in firm value was 89%
- Median annualized rate of return was 36.6%
- Correlated with ownership share of management

 Comparison with S&P Index
- Median excess return 26.1% higher in LBO
- Excess return similar to premium earned by prebuyout shareholders
- Excess return relates to change in operating income, not to potential tax benefits

 CAR of 4.7%, 22.0%, 21.1% in first 3 years after SIPO

 Firms outperform industries in 4 years following SIPO
- Reduction of leverage loosened cash constraints
- Capital expenditures increased

Overall, firms outperform the market after an LBO, but firm risk is substantially higher than the market.

Effect of LBO on stock prices
 Premium offered is substantial (40-60% above market price 1-2 months prior to offer).
 Announcement effect is also substantial.
 There is a lot of variation in the premium: higher premiums are offered for firms with high cash flows, low
growth opportunities, high tax liabilities (which indicates that tax gains from LBOs are mostly passed on to
original shareholders), when there are competing bids (more than 3 bids → 69% average premium;
otherwise, 50% average).

Operating performance after LBO (as opposed to stock price performance)
 How is operating performance measured? By cash flow/sales, sales per employee, number of employees,
etc., over a longer period of time (typically, two years following the LBO); by all these measures, operating
performance improved significantly; thus, there are significant productivity gains after LBO, which is an
important source of value.
 Cash flow/Sales increased significantly after LBO, ranging from 9% to 24% in different industries; Sales
per employee rose 3 – 18%; Investment/sales fell sharply, 12 – 47%.
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 The improvement in operating performance is a result of lower management-shareholder agency cost, the
disciplining effect of debt, etc.
 However, default risk also increased sharply; some studies found that up to 35% of LBOs ended in default.
 In the year before SIPO, there was a 6.9% rise in industry-adjusted operating performance; but in the year
following, there was a 2.59% decline; this provides evidence of information asymmetries – management
will do SIPO in exceptional years, i.e., managers tend to time the SIPO.
 How does LBO affect investment/disinvestment/plant closings? Depends on competition: in less-
competitive (or high-concentration) industries, the firm is less likely to invest and more likely to close
plants after LBO (Kovenock and Phillips, 1997)20. Leverage therefore has strategic/competitive
implications.

The Role of Junk Bonds
 Junk bonds: high-yield bonds rated below investment grade
S&P ratings: rated below BBB
Moody's ratings: rated below Baa3
 Financing innovation allowing high risk firms to obtain public financing
 Size of junk bond market
• 3-4% of public straight debt for most of 1970s – usually “fallen angels” ratings were lowered
(fallen angels are bonds that did not have junk status when issued)
• Firms began issuing below investment grade bonds – almost 20% of new bonds by 1985
• 1986, Drexel Burnham Lambert had 45% share
• By 1993, junk bond market achieved record highs
 Return on junk bonds
• Promised yield spread between 10.5% and 2.8% over 10-year treasuries (1978-2001)
• Realized return spread approximately 2%
• Thus, cost of debt for junk bonds is significantly smaller than the YTM (promised yield)
 Cost of debt (Kd) for junk bonds
In general, cost of debt = YTM or Rf (which is justified if we set bond beta = 0); in case of junk
debt, both are wrong, since YTM is the promised (not expected) yield and beta is not zero
Thus, Kd < YTM because of the significant default risk, or Rf < Kd < YTM
Best estimate of Rf is from CAPM using bond beta


20 Kovenock, D.and G. Phillips (1997) Capital Structure and Product Market Behavior: An Examination of Plant Exit and
Investment Decisions, Review of Financial Studies 10, 767-803.
79

Some Corporate Bonds Statistics
Cumulative 10-year default or mortality rates of corporate bonds for period 1971-2001
AAA: 0.03%
A or AA: slightly above 0.5%
BB: 17%
B: 33%
CCC: 51%
Average promised yields for period 1978-2001
High-yield debt: 12.87%
10-year Treasury: 8.0%
Spread 4.87%
Yield spread (high-yield debt over 10-yr Treasury)
1978: 2.81%
1990: 10.5%
1999: 4.9%
2000: 9.44%
2001: 7.27%
Annual average, 1978-2001
Compound average: 1.88%
Arithmetic average: 1.86%

Valuation of LBOs
Note: leverage ratio changes significantly over time following LBO.

Two methods of valuing LBO firm:
1. Free Cash Flow (FCF) method: this is the basic DCF valuation; WACC must be re-calculated every period
to reflect leverage changes (because weights in WACC change with leverage, also costs of equity and debt
change with leverage); thus, FCFs are discounted at the appropriate WACC
2. Capital Cash Flow (CCF) method: CCF = FCF + interest tax shield, or CCF = (FCF + τckDD), where τc is
the company’s tax rate and kDD is the interest amount paid on debt; the capital cash flow is discounted at
the cost of capital appropriate for the project risk, or kA, which from M&M depends only on project risk
and is constant; kA comes from the CAPM and project risk βA and is independent of leverage ratio

Both methods give the same valuation, if done correctly. In the first, tax benefits are incorporated in the
denominator; in the second, tax benefits are incorporated in the numerator.

80

Chapter 8. CORPORATE DIVESTITURES

Corporate restructuring includes any form of restructuring – of assets (e.g., divestiture), of ownership (e.g., dual
class recapitalization), or of financing (e.g., distressed exchange). In this chapter we focus on divestitures, and in
the next chapter we look at the other types of restructuring. Corporate Divestiture is a form of asset restructuring,
when a company sells (divests) part of its business; thus, it is the exact opposite of an acquisition. Most divestitures
are voluntary, but some are involuntary, such as when a firm is forced to sell off some of its units by antitrust
authorities after an acquisition, in order to fight monopoly power.
There are many reasons for companies to divest assets:
1. Involuntary divestiture (forced by regulators, mentioned above).
2. Change in corporate strategy, focus on one core area and get rid of non-core businesses; or if two segments
of a company are strategically incompatible, e.g., Humana Inc. (USA) had two segments, Hospital and
Health Insurance, with the result that customers for one segment were competitors for the other.
3. Changing market conditions.
4. Reversing past acquisition mistakes, particularly conglomerate mergers; eliminate negative synergy.
5. Increase focus, reduce diversification discount.
6. Unbundling, or creating “pure play” business; two advantages: adds value and helps pricing.
7. Send positive signal (e.g., in a carve-out), hence alleviate undervaluation caused by asymmetric
information.
8. Repel potential acquirers by selling “crown jewels” to make company less attractive.
9. Get rid of “deep pocket” units in case of future liability, e.g., the tobacco unit of a multi-unit company.
10. If parent firm is capital-constrained, divestitures allow the firm to relax such constraints; this is supported
by evidence that divesting firms have higher leverage ratio and/or poor financial performance prior to
divestiture.

The above can be summarized as two main reasons:
1. The unit is worth more to another firm.
2. The unit is actively interfering with the firm’s operations.

In the period 1980-2000, over 1500 U.S. companies went through divestitures, in the processing creating over $700
billion in new publicly traded equity.




81

Do divestitures create value?
Yes. The magnitude of value added is significant (measured by event return or CAR), but there is a lot of variation.
The magnitude depends on size of assets sold vis-à-vis the rest of the company, whether focus has increased, how
the proceeds are used, etc. For instance, if the proceeds are used to pay a special dividend, the CAR is higher (i.e.,
more value is created) because reinvestment is generally not viewed as a good signal for a divesting firm.

Types of Divestitures
- Asset sale
- Spinoff
- Equity Carve-out
- Split-up
- Tracking Stock

1. Asset sale: This is the sale of a division of the company or other (substantial) assets to another firm, usually
for cash. An asset sale implies that the unit is more valuable to the buyer than the seller. The value created
is shared by both buyer and seller, the distribution being determined by market conditions and bargaining
power (however, seller generally does better than buyer). The assets can be sold by auction or negotiation;
in an auction, sellers benefit substantially more than buyers. An asset sale is effectively a reversal of merger
or acquisition; it takes place because the asset is worth more to the buyer than to the seller, perhaps because
the buyer can utilize the asset more efficiently.
Empirical evidence on asset sales: the empirical evidence indicates that asset sales create value for both
buyer and seller. Both buyer and seller are found to have positive CARs, the buyer averaging a CAR of
0.4% to 2.1%, and seller averaging 0.5% to 3%). The CARs are higher for larger-sized asset sales. Also, the
seller is found to so better than the buyer. Even the longer-term operating (plant-level) performance is
found to improve after an asset sale, not just the stock price.

2. Spinoff: This is done when a company wants to divest a subsidiary. A spinoff is a pro-rata distribution of
100% of the shares of the subsidiary company (S) to shareholders of parent company (P), creating a new,
separate and independent, firm. S is separated from P legally and physically, and becomes an independent
entity, its stock is traded (and valued) separately by the stock market. The original shares of P become
claims against the company’s remaining assets. A new pure-play company is created, in a break with the
rest of the company (this helps improve the valuation of both P and S). No cash is raised in a spinoff, since
it is just a distribution of securities. Just after the spinoff, both P and S are held by identical shareholders,
but that changes once trading of S starts. The spinoff is a tax-exempt transaction if P owns 80% or more of
S. The scale of a spinoff is generally larger than an asset sale. A spinoff helps with market completeness,
which adds value. In a spinoff, personnel/assets/liabilities must be re-assigned and allocated such that
82

neither P nor S benefits at the expense of the other. Asset allocation is relatively straightforward; liability
allocation is more complicated. If there is a business relationship between P and S (e.g., supplier-customer)
then it must be re-evaluated, after which the relationship might be terminated or continued with revised
terms; pricing, in particular, is a tricky issue in these relationships.
In a spinoff, bondholders might suffer (agency problem) for two reasons: (i) debt might be allocated
disproportionately or in a manner not consistent with risk, e.g., S is allotted a larger proportion of debt than
assets, and (ii) reversal of co-insurance.
Empirical evidence on spinoffs: The available empirical evidence indicates that P’s shareholders achieve
significant abnormal returns (2-4% CAR over a 3-day window); however, there is a lot of variation (by
size, focus, etc.). The combined post-spinoff value (P+S) is significantly higher than the pre-spinoff value.
The long-term post-spinoff operating performance is also superior. Focus-increasing spinoffs do much
better than other spinoffs; for the former, the average CAR is about 4%, for the latter the average is about
1%. The investment efficiency also increases after a spinoff (since firms invest more in high-q businesses)
and the diversification discount falls after spinoff (Ahn and Denis, 2004).21 The event return (CAR) at
spinoff is positively related to the subsequent increase in investment efficiency. The evidence also shows
that the gains from spinoffs are greater than from asset sales, possibly because asset sales generally follow
period of poor performance, and assets sales are generally smaller in magnitude.

3. Equity Carve-out: An equity carve-out is a sale of a part (usually 20% or less)22 of the subsidiary (S) to the
public by means of an IPO, thus creating a new firm. As a result of the carve-out, P receives a positive cash
flow, both P (parent) and S are traded, and the price of P rises. The main objectives of a carve-out are (i) to
raise money, (ii) to establish the valuation (market) of S,23 (iii) to increase the total value (S has better
growth prospects, or is more valuable by itself), (iv) to take advantage of cheaper equity if S has better
growth prospects, and (v) send a positive signal regarding P.24 A carve-out is generally followed by a
spinoff or asset sale after the value had been established; the market’s anticipation of such a follow-up
divestiture might be another reason for the positive event return (CAR) at carve-out.
Empirical evidence on carve-outs: P’s shareholders receive significant abnormal returns, mainly for the
same reasons as in a spinoff (in addition, there is the signaling effect). Increase in focus is an important
factor, as in a spinoff. Also, the CAR is higher when creating a pure-play unit.


21 Ahn, S. and D.J. Denis (2004) Internal Capital Markets and Investment Policy: Evidence from Corporate Spinoffs, Journal
of Financial Economics 71, 489-516.
22 A carve-out is generally followed by a spinoff or asset sale. Since a spinoff is tax-exempt if P owns at least 80% of S, the
parent sells less than 20% of S in the carve-out.
23 It is important to get a market value for S before a spinoff or asset sale (one of which usually follows a carve-out).
24 When P issues S’s stock in the carve-out IPO, it signals that P is undervalued by the market (hence it is not issuing P’s
stock).
83

4. Split-up: A split-up is a separation of a firm into 2 or more firms, often via spinoff or asset sale. It is more
of a “strategic break-up” of a company, whether voluntary (e.g., ITT) or regulator-mandated (e.g., AT&T).
The usual reason for a voluntary split-up is to dismantle an inefficient conglomerate (with large a
diversification discount) and thereby add value; an involuntary split-up is usually driven by regulators
attempting to break up a non-competitive monopoly to increase consumer welfare.

5. Tracking Stock: This requires the creation of a new class of stock whose value is based on cash flows of a
division or subsidiary (that is, if the division were a separate company, what price would its stock trade
at?). It is often issued by means of an IPO (with remaining shares allocated to P’s shareholders); sometimes
issued pro-rata like in a spinoff. Thus, tracking stock represents a claim against profits generated by a
particular segment of the firm’s operations, while the segment continues to remain a part of the company;
management must decide how to allocate the corporate overheads. The purpose of tracking stock is to track
the performance of the particular division (ignoring the rest of the company). Tracking stock is nominal
(not real) stock, and holders of tracking stock cannot vote; moreover, there is no change of control and no
separate entity. As a result, it is possible for the parent company to manipulate the price of the tracking
stock. Therefore, it is not surprising that tracking stock is not very popular today. It is useful, however, for
(i) managerial compensation, and (ii) stand-alone valuation of a unit of the company.

These Methods are Often Used Sequentially
- An Equity Carve-out is usually the first stage of a broader divestiture, preceding either an Asset Sale (of the
remaining interest of the subsidiary to another firm) or a Spinoff of the remaining ownership to
shareholders.
- Split-ups employ a variety of methods.
- Tracking stock may be first step of a spinoff or exchange offer.

Which Divestiture Method to Use?
 If the company requires cash, use a carve-out or asset sale (or both, in sequence).
 If the company wants to set market valuation (perhaps for future asset sale), use a carve-out.
 If S has higher growth rate than P (therefore a lower cost of capital), use a carve-out followed by spinoff or
asset sale.
 When there is a conflict of interest between P and S (e.g., both are pursuing the same customers), use a
spinoff.
 When P wants to send a positive signal, use a carve-out.
84

 Carve-out will be under greater scrutiny (because of the IPO), hence lower-quality (or higher-leverage)
firms prefer spinoffs; Michaely and Shaw (1995) report that riskier, smaller, more leveraged, and less
profitable firms tend to choose spinoff.
 Carve-out is more expensive, with direct costs (investment banking, reporting requirements, etc.) being
three times as high as that for a spinoff (Michaely and Shaw, 1995).25

Miscellaneous Points
1. Very often, divestitures are done by companies with the largest diversification discount.
2. Divestitures done to avoid regulation do better than others, e.g., CAR of 5.07% to 2.29%.
3. There might be bondholder wealth expropriation in a divestiture, e.g., if asset sale reduces effective
collateral, or if debt is not shared equitably in a spinoff.
4. It has been noticed that there is a reduction in analyst forecast errors after divestiture (i.e., informational
asymmetry is lowered), and event return (CAR) is positively related to degree of asymmetric information;
thus, informational asymmetry seems to play an important role in many divestiture decisions.
5. Divesting firms have lower cash flows, lower capital expenditures, and lower Tobin’s q; and higher book-
to-market ratio, leverage ratio, dividend yield, informational asymmetry, and diversification, than their
industry- and size-matched peers

Sources of Wealth Gains
1. Efficiency: assets end up with companies that can better utilize them.
2. Information: the fact that another company is willing to pay a premium sends a positive signal.

Evidence on Efficiency vs. Information Explanation
Empirical evidence supports the “efficiency” explanation for value creation in divestitures:
a) Asset sales that fail: prices rise at announcement but fall at failure; thus, actual transfer needed for increase
in value. This implies efficiency is a better explanation than information.
b) Relative size of subsidiary should have no effect on event return if it was information-driven. However,
empirical studies find that the size of the divested asset impacts event return, which points to efficiency.
c) Effect on rival firms: if information-driven, rival firm stock prices should rise; if efficiency-driven, rival
firm stock prices should fall. Rival stock prices usually fall, hence efficiency explanation seems to be better
supported by data.




25 Michaely, R. and W.H. Shaw (1995) The Choice of Going Public: Spinoffs versus Carve-outs, Financial Management 24, 5-
21.
85

Corporate Focus
 Corporate focus is a possible source of gains:
- executives are better able to monitor a firm with narrow scope and better able to concentrate on
firm’s core business operations, hence make better decisions;
- executives are more familiar with the industry and the operations;
- more financial discipline (less opportunity to subsidize losing units from profits of good units);
- focus makes it easier to tie managerial compensation to performance;
- value might increase because of the “pure play’ effect;
- improved internal capital allocation (i.e., better investments when less diversified);
- unrelated segments might have conflicting operating styles or organizational cultures.

 How to test whether focus adds value? Studies compare related and unrelated divestitures (that is,
companies divesting assets that are unrelated to the core business or focus-increasing divestitures versus
divesting assets related to the core business or non-focus-increasing divestitures) – usually using SIC
(Standard Industrial Classification) codes, which are perhaps an imperfect measure of focus, but the best
available at this time.

 Evidence indicates that divestiture of unrelated subsidiaries (leading to increase in focus) has higher event
returns than divestiture of related subsidiaries (no increase in focus).

 However, corporate focus cannot explain all gains in divestitures, since related divestitures also result in
higher prices.

 Focus increased in 1980s – firm value also increased.

 Multi-segment firms tend to have lower values.

 Overall, the evidence indicates that focus seems to add value.

Therefore, focus is an important determinant of event return – when focus increases, shareholder gains are higher.
However, there are other factors that also affect shareholders’ event returns:
a. Size of divestiture relative to rest of the company: larger divestiture leads to larger gain.
b. Financial condition or bargaining power of seller: poor financial condition suggests a fire-sale and that
seller might not be getting a good price, hence lower seller return.
c. How the proceeds from the divestiture are used: if the funds are used for paying dividends, greater value is
created, because reinvestment not generally seen as a positive event for a shrinking firm.
86

Focus vs. Diversification
 If focus adds value, diversification should destroy value, hence the term “Diversification Discount” (in
spite of financial synergies); however, it is difficult to quantify “diversification discount.”
 Does diversification destroy value? It is difficult to say conclusively, since diversification is generally
endogenous along with value, e.g., low-value firms diversify, hence value is lower for diversified firms;
however, Lamont and Polk (2002)26 examine how exogenous changes in diversification (changes in
industry investment) affect value, and find a negative effect.
 Focus effects dominate financial synergies, and focused firms are found to be more valuable; Berger &
Ofek estimated the diversification discount at 13-15%, Lamont and Polk at 6%, Servaes at 19% (for 1960s)
and 6% (for 1970s).
 In a diversifying acquisition, the acquiring company’s event return is usually negative (Morck, Shleifer and
Vishny, 1990).27
 Overall, there is no consensus in the literature; probably varies case by case.

Example of divestiture(s)
A company carved out 14% of a subsidiary for $107 million. This was followed by an asset sale of the subsidiary
three years later for $2.2 billion. Was this a good financial decision? Why/why not?

It received $107 million and gave up 14% of 2.2 billion = 308 million 3 years later. It might seem like a bad
financial decision, but note the following: (i) It would almost certainly not have been able to sell the subsidiary for
2.2 billion without the carve-out; and (ii) The (positive) signaling effect of the carve-out has not been taken into
account. So, overall, it was probably the right decision.

26 Lamont, O.A. and C. Polk (2002) Does diversification destroy value? Evidence from the industry shocks, Journal of
Financial Economics 63, 51-77.
27 Morck, R., A. Shleifer and R.W. Vishny (1990) Do Managerial Objectives Drive Bad Acquisitions? Journal of Finance 45,
31-48.
87

Chapter 9. FINANCIAL RESTRUCTURING

Financial restructuring refers to the restructuring of the liabilities side of the balance sheet. Examples of financial
restructuring include Leveraged Recap, Dual-class Recap, Exchange Offer, Reorganization, Bankruptcy and
Liquidation. The objective in restructuring is to increase firm value. The value of the levered firm is given by:
VL = VU + PV(Tax Shield) + PV(other benefits of debt) + PV(future benefits from M&A)
+ Valuation effect of signaling – PV(bankruptcy cost) – PV(agency costs associated with debt),
where VL and VU represent value of levered and unlevered firm, respectively. “Other benefits of debt” would
include the disciplining effect of debt. Note that, in a financial restructuring decision (that is, before debt is issued),
the company should maximize total firm value. In a bankruptcy decision or a distressed-exchange decision,
bondholder interests are not important to the manager, hence the objective is to maximize equity value.

Leveraged Recapitalization (LR)

A Leveraged Recap is a change in capital structure resulting in a higher leverage ratio; it involves the issue of a
large amount of debt, the proceeds of which are used to repurchase shares or pay a large dividend. Leveraged
Recaps first appeared in 1985 (Bae and Simet, 1998).28 The primary objective is a higher stock price, and the
secondary objective is greater management control. The stock price rises because of the signaling effect, tax shield,
and the disciplining effect of debt. Note that the popular dilution argument is not valid.
The procedure is to issue debt, and buy back stock with the proceeds (pure capital structure change; no
investment effects). Alternatively, the firm can issue debt and use the proceeds to pay special dividends to non-
management shareholders while giving additional shares to management shareholders; in this case, the stock price
usually falls (of course, management shareholders are not hurt because they end up holding more shares). If the
resulting stock price is smaller than a quarter of the original price, the new stock is called a “stub.”
After a LR, the leverage ratio increases significantly, not surprisingly. Management ownership rises
significantly, and total payout (cash dividend plus stock repurchase) also rises sharply. An added benefit of
leveraged recap is that it reduces the probability of the firm being acquired, because (i) the high level of debt
discourages potential acquirers, and (ii) management ownership increases, and management shareholders are
unlikely to sell to a potential acquirer.





28 Bae, S.C. and D.P. Simet (1998) A Comparative Analysis of Leveraged Recapitalizations versus Leveraged Buyouts as a
Takeover Defense, Review of Financial Economics 7, 157-172.
88

Leveraged Recapitalization vs. LBO
 Both are used as a defensive anti-takeover tactic.
 Both generally result in positive event return (CAR), but the CARs are much larger for LBO than for Lev
Recap (Bae and Simet, 1998, Gupta and Rosenthal, 1991).
 However, Lev Recap sometimes results in negative event return, particularly in the case of defensive Lev
Recap.
 In both cases, existing equity is bought back, leverage ratio rises, and management holding increases.
 In LBO the company goes private, so its stock is not traded any more; that is not the case in a Lev Recap.
 In LBO the management is often replaced, unlike in Lev Recap.

Example of LR
You are given the following information about an unlevered company: #shares = 100, stock price= $30,
management ownership = 20%, and tax rate = 40%. The company now decides to do a LR by issuing debt worth
20% of current market value and buying back stock with the proceeds of the debt issue.
What would be a fair price for the buyback? How many shares should it buy back? What would the
management ownership be after the LR is completed? What would the stock price be after the LR is completed?
(Ignore bankruptcy costs for simplicity). What if the company decided on a 40% LR instead of 20%?

Answer: Post-LR Firm value V = 3000+(.4)(600) = 3240, debt value D = 600, so equity value E = V–D= 2640.
Suppose we buy back N shares at price P. Then, NP = 600 and (100–N)P = 2640. Gives P = 32.40 and N = 18.52.
Management ownership = 20/(100–18.52) = 24.55%.
With 40% LR, we get P = 34.80, N = 34.38, and management ownership = 20/(100–34.48) = 30.53%.

Now, suppose that, instead of buying back the stock with the proceeds of the debt issue, the above company decides
to pay a special dividend to the non-management shareholders, and bonus shares to the management shareholders.
What would be the special dividend per share? How many bonus shares should be issued to the management
shareholders? What would the management ownership be after the LR is completed? What would the stock price be
after the LR is completed? (Again, ignore bankruptcy costs for simplicity). What if the company decided on a 40%
LR instead of 20%?

Answer: Special dividend = 600/80 = 7.50. Bonus shares to management shareholders = 7.50/30 = 1 for 4 (5 for
20). Management ownership = 25/105 = 23.81%. Post-LR P = 2640/105 = $25.14
With 40% LR, the same procedure gives Special dividend = $15, Bonus shares to management shareholders = 1 for
2, or 10 for 20; Management ownership = 30/110 = 27.27%, and Post-LR P = 2280/110 = $20.73.

89

Example of LR with Stub
A company has 10 million shares outstanding, of which management shareholders held 10%. The stock price is
$24, and the market leverage ratio is 4%. It also has $40 million in cash. There is a LR proposal that would issue
replace the current stock with stubs – management shareholders to receive 7 stubs for each share and non-
management shareholders to receive 1 stub per share plus a special dividend of $24 per share. This will be financed
by all the available cash plus an issue of debt. The company’s tax rate is 30%.
If this LR is fair to both management and non-management shareholders, what is the value of a stub? What is the
event return for non-management shareholders? For management shareholders? How much value has been created
by the LR? What is the post-LR leverage ratio? What is your estimate of increased bankruptcy cost resulting from
the new debt?

Answer: Non-management: $24+1 stub; Management 7 stubs. To be fair, each stub must be worth $4.
Event return for non-management shareholders = 28/24 – 1 = 16.67% (Same for management shareholders).
Since initial equity value = 240, value created = 16.67% of 240 = $40 million.
Post-LR: D = 10+176 = 186. E = (7+9)4 = 64. Leverage = 186/(186+64) = 74.4%.
Tax shield is worth (0.3)(176) = 52.8. Then bankruptcy cost = 52.8 – 40 = $12.8 million.

Market response to LR announcements
• The market response is generally positive (Gupta and Rosenthal, 1991).29
• The exact response depends on whether the LR is defensive or pro-active; it is larger for pro-active
and smaller (sometimes negative) for defensive LR, e.g., 33% for pro-active versus 5.5% for
defensive in Gupta and Rosenthal’s sample.
• When used as takeover defense – both positive and negative returns have been observed, in
different samples.
• For proactive LRs (part of a long-term strategy to increase firm’s value):
– Cumulative abnormal return is around +30% for most samples
– Surprisingly, return to bondholders is +5%
– The likelihood of success is much higher (avoiding financial distress, etc.)
• For defensive LRs, the market response is so varied (both positive and negative) that overall results
are inconclusive. There are opposing effects: higher debt level results in more valuable tax shields,
but it also increases probability of financial distress; moreover, higher management shareholding
reduces probability of being acquired, which results in a lower stock price. Therefore, in a
defensive LR, the event return might be negative, e.g., -2.33% CAR in Dann and DeAngelo

29 Gupta, A. and L. Rosenthal (1991) Ownership Structure, Leverage, and Firm Value: The Case of Leveraged
Recapitalizations, Financial Management (Autumn), 69-83.
90

(1988).30 For bonds, event return in a defensive LR is always negative (Handa and Radhakrishnan,
1991)31

Note: When leverage ratio is increased (as in a leveraged recap), bondholders’ CAR is usually negative. In this
case, however, we note that CAR > 0 for a pro-active LR because operating efficiency increases (the disciplining
effect of debt), hence total firm value increases, resulting in lower default risk and higher debt value.

Sources of Value in a Leveraged Recapitalization
- Additional tax shield resulting from the new debt; this is the most obvious source of value.
- Reduction in agency problems resulting from greater management shareholding, and disciplining effect of
high debt level (from having to meet debt service payments).
- Appropriation of bondholder wealth.
- Better allocation of internal resources.

Subsequent Performance
• High rate of financial distress; one study found 31% of firms doing LR between 1985 and 1988
encountered financial distress by 1994 (particularly defensive LRs).
• Debt plays positive disciplinary role.
• Success affected by business economic conditions, achievement of operating improvements, etc.
• Post-LR investment and growth falls, and the decrease in investment is larger in low-q segments;
thus, there is a favorable reallocation of internal resources among segments.

When is a LR Useful in Repelling a Potential Acquirer?
 When the current leverage ratio is low (unutilized debt capacity)
 Predictable cash flows (if cash flows are too volatile, it would be difficult to service the debt)
 Tangible assets (otherwise debt would be very costly), i.e., mature, low-R&D firms
 The LR must be able to capture most of the benefits from the alternative (e.g., acquisition: if there are
significant synergies, then a LR will not work)
 Management must have good reputation, else shareholders (and market) will assume it is a defensive LR.




30 Dann, L. and H. DeAngelo (1988) Corporate Financing Policy and Corporate Control: A Study of Defensive Adjustments in
Assets and Ownership Structure, Journal of Financial Economics 20, 87-128.
31 Handa, P. and A.R. Radhakrishnan (1991) An Empirical Investigation of Leveraged Recapitalizations with Cash Payout as
Takeover Defense, Financial Management (Autumn), 58-68.
91

In general, LR very effective at countering takeover threats, because
1. its basis cannot be challenged in court (unlike many other takeover defenses) since it is accepted by
the market (i.e., shareholders vote for it);
2. it significantly increases the cost of acquisition (both price and management ownership are higher
after LR);
3. Remaining shareholders have higher reservation price (value the stock more), hence are less likely
to sell to an acquirer.
Not surprisingly, Leveraged Recapitalizations are frequently used as a takeover defense.

Dual-Class Recapitalization (DCR)

A DCR is a restructuring of equity, creating additional classes of shares (with differential voting rights).

Characteristics of DCRs
 They create a second class of stock with limited (or no) voting rights, but with a preferential claim on cash
flows.
 Example: Class A (superior dividend rights) – 1 vote, high dividends; Class B (superior voting rights) –
multiple votes, low dividends; Class B shares are generally held by management shareholders.
 Pattern: officers and directors own 55-65% of voting rights but only 25% of cash flow claims, to solidify
management control.
 Many DCRs are used to consolidate control in the hands of a founding family or their descendants.

Reasons for DCRs
 Management solidifies control to implement long-run programs (this can also be achieved by means of an
LBO, but that would rule out external equity financing, hence high-growth firms prefer DCR).
 Helpful in complex operations where managers may have superior understanding of the business.
 There is a possible negative reason – strengthen management entrenchment.
 What kind of firm does DCR? High growth, high R&D, high market-to-book, low payout, low tax
liabilities.

Market Response
The market’s reaction is, in general, quite favorable. Shareholders do not seem to be hurt by the loss of voting
rights. The average CAR is about +6% in in a 90-day window, and about +1% in a 1-day announcement window.
The major benefit for Class A shares is the higher dividend level. The major benefits for Class B shares are (i) more
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control over important decisions, and (ii) shareholders with superior voting rights receive a higher premium in a
takeover.

If DCRs lead to managerial entrenchment, why are they approved by shareholders?
• Wealth transfer of higher dividends is incentive to accept lower compensation in takeover (Ruback,
1988);32
• DCRs often accompanied by increase in external control: increase in outside directors, little change
in dividend policy, etc. (Moyer et al, 1992);32
• Firm’s investment and operating performance, as well as R&D expenditures, improve after DCR;
• DCR is done by high-growth firms, hence managers need more control for good long-run
investment decisions.


Exchange Offers

An exchange offer is a right or option to exchange certain holdings for different class(es) of the firm’s securities,
e.g., debt for equity. Since the recipient has the option to reject the offer, the new securities must have a higher
market value, to induce security holders to agree to the exchange (for a distressed exchange, this is not a restrictive
requirement because securities would be trading at low prices anyway). Exchange offers are motivated by a desire
to stay close to the optimal capital structure, or to stay away from financial distress; that is, when things are good
(bad) the firm wants more (less) debt. Therefore, when the value of the firm rises sufficiently, it will carry out a LR,
and when the firm value falls, it will carry out a distressed exchange.

Distressed Exchange
A distressed exchange is one that is driven by the need to avoid financial distress. In a distressed exchange, firms
restructure assets and liabilities due to deteriorating financial condition (thus, the motivation is the opposite of a
LR).
It is usually done by means of a debt-reducing exchange offer, the objective being to avoid Chapter 11 and
preserve value for stockholders (therefore, they are also known as pre-packaged bankruptcy). In general, event
return or CAR for a distressed exchange is negative, with the magnitude depending on the q-ratio; for q < 1 the
CAR is negative and generally large and significant, for q > 1 the CAR is insignificant; thus, the perceived growth
opportunities matter.


32 Ruback, R.S. (1988) Coercive Dual-Class Exchange Offers, Journal of Financial Economics 20, 153-173.
Moyer, R.C., R. Rao and P.M. Sisneros (1992) Substitutes for Voting Rights: Evidence from Dual Class Recapitalizations,
Financial Management 21, 35-47.
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Empirical Evidence
 Positive returns
Debt for common stock +14.0%
Preferred for common stock +8.2%
Debt for preferred stock +2.2%
Characteristics:
• Leverage increasing, e.g., LR
• Imply high future cash flows, undervaluation
• Increase management ownership
• Positive signaling

 Negative returns
Common stock for debt -9.9%
Preferred stock for debt -7.7%
Common for preferred stock -2.6%
Characteristics:
• Leverage decreasing, mostly distressed exchange
• Imply low future cash flows, overvaluation
• Decrease in mgmt. Ownership
• Negative signaling


Reorganization Processes

While the possibility of financial distress or bankruptcy might seem remote for most firms, the possibility of
bankruptcy in the long run and its effects should not be ignored. In the U.S., for instance, there were over 2,000
companies filing for Chapter 11 in the period 1980–2000, with assets worth over $700 billion. Approximately an
equal number of companies did some kind of out-of-court restructuring.

Financial distress – 1. Assets < Liabilities (liquidation value of firm < creditor claims).
2. Cash flow < Coupon obligation (Illiquidity).
3. If cash flow < Coupon but Assets > Liabilities, shareholders keep the
company alive by contributing their own cash (e.g., new equity)



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Out-of-court procedures (e.g., distressed exchanges)
 Exchange – equity claim for debt (priority claim)
 Extension — maturity of debt can be postponed
 Composition — obligations can be scaled down (bondholders accept this because the alternative, i.e.,
bankruptcy, will leave them worse off)
 Voluntary liquidation (very uncommon)

Merger into another firm
 Bidder return tied to post-merger performance.
 Financial distress easier to restructure than poor operating performance.
 Takeovers usually don’t work long-term with economically distressed firm, but may be best alternative at
the time.

Legal Proceedings – Bankruptcy
Chapter 11 reorganization (followed by survival or liquidation) or Chapter 13 liquidation.

Bankruptcy
Bankruptcy is mostly driven by bad industry conditions. Bad financing decisions such as over-leveraging are not
the main cause of bankruptcy, and can be handled by distressed exchange, etc., without having to resort to
bankruptcy filing.

 Types of legal outcomes (after bankruptcy filing)
Firm allowed to continue – Chapter 11 reorganization – formal court procedures supervise
modification of financial claims; objective is to give the management some leeway by temporarily
protecting the company from creditors: (i) Stop payments temporarily, (ii) Issue senior debt (DIP),
and (iii) Violate APR
Management has to offer a plan to take company out of bankruptcy, and court can approve or
modify the plan; Chapter 11 gives management extraordinary power (violating APR), and
bondholders generally suffer as a result; an important objective is to keep company alive.
Why is it necessary to violate APR? Because if shareholders get nothing, they would be more
likely to engage in harmful activities such as risk-shifting.

Firm ceases to exist
– Statutory assignment – assignee liquidates assets under formal legal procedures
– Liquidation under Chapter 7 – bankruptcy court supervised liquidation
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Key Elements of the Bankruptcy Procedure
 Automatic stay – creditors must wait, managers can run the company for a while without interference.
 Restructuring steps – management proposes plan, creditors vote, with majority rule (within each class) and
all classes must approve.
 Interim funding – company stops payments on existing debt, but can borrow from super-senior creditors
(DIP or debtor in possession).
 Re-contracting – can break existing contracts.
 Violations of APR (absolute priority rule) – bondholders can be paid after shareholders (although not often
done).
 The exact procedure varies from country to country -
 UK: in administration, accountant or lawyer runs the firm; in receivership, secured (senior)
creditors run the firm; in general, assets are liquidated
 Sweden: court-appointed official auctions the firm
 France: court-appointed official helps the managers generate a reorganization plan
 Canada: courts have traditionally been more creditor-friendly. Most bankruptcy cases are
governed by two Acts:
(1) Companies’ Creditors Arrangement Act (CCAA)
(2) The more recent Bankruptcy & Insolvency Act (BIA) of 1993
However, it is now becoming more creditor-friendly, with recent changes that facilitate
restructuring. Private work-outs and pre-packaged bankruptcies (which are very popular in the
US) are becoming more popular in Canada.

Chapter 11
How does Chapter 11 help the company continue operations?
• It stops payments to creditors temporarily (sometimes even stops accrual of interest)
• It helps the company get out of burdensome contracts (lease, licensing, etc)
• It allows firms to raise much-needed cash at reasonable interest rates by issuing senior debt or super-
priority debt (DIP or debtor-in-possession), which would not be possible if the firm was not in Chapter 11
• It allows the firm to violate the APR
• It protects the company from legal liabilities (tobacco, asbestos, etc.)
• Most courts are very supportive of management efforts to keep the company alive (very often, this is the
main objective of the court)
• Reorganization plan may be approved by judge even if creditors disapprove
• It makes it easier for the company to sell assets if necessary

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How does Chapter 11 hurt the company?
• It slows down decision-making because it allows creditors to question management decisions/actions in
court and might result in enforced waiting periods while the court deliberates.
• It ties the management’s hands, since many regular decisions might have to be cleared with the judge.
• Much higher costs.33
• The majority of managers are fired/replaced.


33 How large are bankruptcy costs? Earlier studies focused on direct bankruptcy costs (professional fees for lawyers and
accountants, court costs and filing fees, etc.) and obtained estimates of not more than 5% of total assets value. This cost was
partly fixed and partly variable, i.e., was higher for smaller firms. Later studies looked at indirect bankruptcy costs (losing
customers, increased costs and difficulties of doing business, other restrictions, agency costs, etc.) and obtained much higher
estimates, close to 25-35% of total asset value. The costs associated with out-of-court restructuring are much lower, hence the
strong incentive to avoid chapter 11. In fact, stock price rises when the company announces out-of-court restructuring while it
falls when it files for Chapter 11 reorganization.
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Chapter 10. SHARE REPURCHASES

Stock repurchase or buyback is an alternative to cash dividends. In this chapter, we look at pure repurchase, that is,
no debt is issued at the same time (as in a leveraged recapitalization). In stock repurchase, cash offers are made by
companies for outstanding shares of their own common stock. A share repurchase affects the company in a number
of ways:
• Capital structure is changed (leverage ratio rises).
• Stock price generally rises.
• Management ownership fraction increases.

Growth of Share Repurchases
 Share repurchases were uncommon before 1980; in the U.S. market, they have become very popular since
the 1980s, and in Canada and the U.K., they have been used since the 1990s.
 Share repurchases have increased in absolute terms and in relation to cash dividends (which also increased
over the years); for instance:
- the U.S. corporate sector announced repurchases worth over $750 billion between 1995 and 1999,
- 1253 NYSE companies repurchased stocks worth $181 billion in 1999 alone,
- Between 2003 and 2012, the 449 publicly listed companies on the S&P500 bought back stocks
worth $2.4 trillion (54% of their earnings),
- U.S. companies bought back stocks worth $730 billion in 2019 alone.
 In 1998, for the first time, more cash was distributed to shareholders through repurchases than regular
dividends.
 Repurchase as a percentage of earnings went from 4.5% in 1972-83 to over 25% between 1984 and 1998.
 Between 1994 and 2001, 16 of 30 Dow Jones Industrial firms reduced their number of shares outstanding
(because of stock repurchases).

Reasons for Popularity of Stock Repurchase
1. Tax benefit relative to cash dividends: (a) a repurchase is subject to capital gains tax, and the capital gains
tax rate is lower than the ordinary income tax rate, and (b) shareholders have the option not to sell (thus
avoiding the capital gains tax), while benefiting from the rise in stock price resulting from the repurchase
(the tax timing option).
2. Positive signal: Two channels for a positive signal: (a) management expects higher cash inflows in the
future, hence does not need to hoard cash; (b) stock is underpriced, otherwise company would not
repurchase it; moreover, this would be a “separating equilibrium” because the signal is credible, since it
would be prohibitively expensive for a bad firm to mimic.
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However, in some cases (quite infrequent), a stock repurchase might send an implicit negative signal – for
instance, if a high-growth company decides to buy back stock, it might imply that good growth
opportunities are drying up. An example is the Merck stock buyback in 2000; when Merck announced a
$10 billion buyback the stock price fell 15%, because the market interpreted the announcement as an
admission that growth rate was expected to fall.
3. Reduction in agency cost, since it makes it more difficult for management to over-invest (invest in bad
projects that managers, rather than shareholders, benefit from, e.g., because of empire-building incentives
or reduction in bankruptcy risk).
4. Improved capital market allocation: returning any surplus cash to shareholders increases economic
efficiency because it allows shareholders to deploy their capital more productively; if this is a valid
argument, companies should shrink after a repurchase, which is very often the case.
5. Management ownership rises, since management shareholders do not participate in the repurchase.
6. Takeover defense, because (i) higher-reservation-price shareholders remain after repurchase, (ii) stock price
is higher, and (iii) management ownership is higher.
7. No transactions costs (brokerage fees): for shareholder, it is like selling the stock without incurring
brokerage fees.
8. Convenient and inexpensive way to adjust capital structure towards the optimal level, by increasing the
leverage ratio.
9. Useful in arresting decline of stock price; very effective after a stock market crash.34
10. Offset ESOP exercises (since it is not desirable to issue new equity as ESOPs are exercised).
11. The company can take advantage of underpriced stock.

Of course, some repurchases do not work out. As mentioned above, in 2000 Merck announced a $10 billion
repurchase plan. Over the next few days, however, its stock price fell about 15%. Why? Probably because it was
seen as an implicit (negative) signal that growth opportunities were drying up. This makes it difficult for firms in
high-growth or high-tech industries to carry out stock buybacks successfully.

Repurchase Motivations
A survey carries out by Tsetsekos et al. (1991)35 found the following motives given by managers who carried out
stock repurchases:
33% of managers: to change the firm’s capital structure;
25% : to increase the stock price;

34 Almost 600 publicly traded firms announced repurchase programs in the two weeks following the stock market crash of
1987; this led to a rebound in the stock price for most of these companies. However, a relatively small number of shares were
actually repurchased.
35 Tsetsekos, G.P., D.J. Kaufman and L.J. Gitman (1991) A Survey of Stock Repurchase Motivations of Major U.S.
Corporations, Journal of Applied Business Research 7(3), 15-21.
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18% : to send a positive signal;
4% : to reduce tax burden;
20% : other reasons.
The survey also found that 61% of all repurchases were financed by available cash balance, 38% by the proceeds of
a debt issue, and 1% by the proceeds of a preferred stock issue.

Price Rise at Repurchase
It has been widely documented that stock price rises significantly at repurchase (Bradley and Wakeman, 1983,
Dann and DeAngelo, 1983, Klein and Rosenfield, 1988, etc.);36 thus, stock repurchases result in wealth creation for
shareholders. Reasons for the price rise:
 Disciplining effect (greater efficiency, free cash flow hypothesis, etc.) and wealth transfer from
bondholders (risk shifting) associated with higher leverage ratio.
 Repurchase generally moves the firm closer to its optimal capital structure.
 Positive signal: (i) higher leverage ratio means firm is confident about the future, (ii) buying back stock
indicates it is underpriced, (iii) the company is buying back the stock because it thinks the best investment
is its own stock, thus its prospects are promising.
 Reduced tax burden on shareholders.

Repurchase and EPS
One reason (often the most important one) given by managers, investment bankers and practitioners is “EPS jump,”
or the idea that a stock repurchase boosts EPS by reducing the denominator (# shares), hence a stock repurchase
increases value. But this turns out to be not a valid argument, because:
 Even if EPS jumps, it does not necessarily add value (increase stock price) because the P/E ratio does not
remain unchanged (in fact, the P/E ratio falls since the repurchase results in a higher leverage ratio).
 The EPS would rise if the money returned was idle (earning an ROI lower than cost of equity), otherwise
the reduction in # shares would be accompanied by a reduction in net income, and the effect on EPS is not
clear.
 If the cash was indeed idle or not deployed productively, the EPS would rise; but that would be the result of
increasing efficiency by shrinking the asset base.


36 Bradley, M. and L. Wakeman (1983) The Wealth Effects of Targeted Share Repurchases, Journal of Financial Economics,
April, 301-327.
Dann, L. and H. DeAngelo (1983) Standstill Agreements, Privately Negotiated Stock Repurchases and the Market for
Corporate Control, Journal of Financial Economics, April, 275-300.
Klein, A. and J. Rosenfield (1988) The Impact of Targeted Shera Repurchases on the Wealth of Non-participating
Shareholders, Journal of Financial Research, Summer, 89-97.
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Four Ways of Repurchasing Stock37
1. Fixed Price Tender (FPT)
2. Dutch Auction Repurchase (DAR
3. Transferable Put Right (TPR)
4. Open Market Repurchase (OMR)


Fixed Price Tender (FPT)

In a fixed price tender:
• The company announces the time period, price, and number of shares it will repurchase.
• Thus, the repurchase price is announced at the beginning of the process.
• Officers and directors of repurchasing firm do not participate in tender offer.
• On average, about 15% of the existing stock is repurchased.

Repurchase Price
In a FPT, the repurchase price averages 20% over the market price; this is not necessarily the “fair” price discussed
in LR, because:
(i) shareholders will generally not sell to the company at just the market price, and
(ii) managers tend to be risk-averse; therefore, with volatile stock price and the requirement that the company
give shareholders some time to decide (the “notice period”), managers usually decide to offer a premium
above the fair price, the size of the premium depending on their risk-aversion, the length of the notice
period and the volatility of stock price.

Number of Shares Repurchased
• If the repurchase is oversubscribed, the firm usually buys on a pro rata basis (leaving some shareholders
unhappy), but it can also increase the size of the repurchase.
• If undersubscribed, company can buy all tendered shares, extend the offer period, or cancel the repurchase.

Empirical evidence on FPT
The event return to both exiting and remaining shareholders is positive and significant. Various empirical studies
fund that the premium offered (i.e., event return to selling shareholders) ranges from 16% to 23%, while the

37 There is a fifth way of buying back stock (Direct Negotiation), where the company will negotiate the price and number of
shares with a large block holder, usually at a significant premium over the market price; this is usually motivated by a desire to
thwart potential takeover attempts. However, this happens very infrequently and is of no analytical significance.
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remaining shareholders achieve event returns ranging from 11% to 15% (because of higher post-repurchase stock
prices). Exiting shareholders achieve higher event returns than remaining shareholders.
Clearly there is significant addition to firm value because of FPT. However, low-q firms are found to
outperform high-q firms. This suggests high-growth firms should not buy back stocks.

Why is value created by the repurchase?
• Benefits of increased leverage (tax shield, discipline of debt, debt is cheaper than equity).
• Signaling – tender offers associated with higher future cash flow levels; also, company would not
buy back stock if overpriced.
• However, there is no merit to the argument that price rises because there are fewer shares (i.e.,
opposite of dilution): (i) as number of shares falls, so does value of assets; (ii) the company is
paying a premium for the repurchased stock, so the price of the remaining shares should fall if
anything; (iii) shares are not a differentiated product, so there are millions of substitutes (perfectly
competitive market) and withdrawing a few shares should have no effect on the price; (iv) an
involuntary (or forced) change in number of shares, e.g., when forced by regulators, has no effect
on stock price.


Dutch Auction Repurchase (DAR)

This is the most recent technique for buying back stock. In a DAR, shareholders tender their shares in an auction,
the company aggregates the shareholder bids and decides what price to pay (the same price to all shareholders, even
if they ask for different prices), depending on the number of shares it wants to buy back.
The repurchase price is not specified at the beginning of the process, but towards the end (after hearing
from shareholders). The firm specifies the number of shares it wants to buy back as well as the range of prices.
Then, shareholders can tender their shares at any price within the stated range (sometimes the firm specifies a dollar
value of the repurchase instead of the number of shares). Next, the firm aggregates the bids from shareholder
responses into a supply schedule. It then repurchases all shares that make the cut, at the market-clearing price
(lowest price that allow company to buy back the specified number of shares).
Shareholder heterogeneity (regarding their reservation price, or the minimum price they are willing to sell
at) results in an upward sloping supply curve, which is necessary for a DAR to work. Shareholder heterogeneity is
caused by (i) different shareholder expectations regarding future price, (ii) different shareholder valuations, (iii)
different tax bases and tax rates (for capital gains).



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Advantages of DAR
(i) Lower premium than FPT: not surprising, since company knows shareholders’ reservation prices (from
their bids) which it does not know in FPT (hence, in a FPT, it has to offer a premium to make sure that the
shareholders are willing to sell the requisite number of shares);
(ii) No pro-rating, because there is no over-subscription (unless there is a step ladder supply curve); therefore,
there will be no unhappy shareholders remaining.
(iii) Lowest-reservation-price shareholders will exit, which makes the company more difficult to acquire.
(iv) Shareholders have a strong incentive to honestly bid their reservation price and avoid playing bidding
games; if they bid below their reservation price to increase the probability making the cut, they risk
reducing the market-clearing price and being forced to sell below reservation price; if they bid above their
reservation price to push up the market-clearing price, they risk not making the cut and not being able to
sell at a price above the reservation price

Disadvantage of DAR
Weaker signal (therefore, smaller wealth effect)

What kind of company would benefit from using DAR?
Large, heavily analyzed companies with low management ownership, because such companies do not have too
much informational asymmetry, thus there is not much need to signal.

Example of Linear Supply Curve: V(r) = a + br
Note:
 Each share is assumed to be held by an individual shareholder.
 V(r) indicates reservation price of the rth shareholder.
 Intercept term a represents the prevailing market price of the stock.
 More steeply sloped (slope b) schedule indicates higher reservation price schedule.


Transferable Put Right (TPR)

In a TPR, the firm issues put options to shareholders in proportion to the number of shares owned and the number it
wants to repurchase. If the exercise price is high enough to ensure that the put option will be in-the-money at the
end of the exercise period, the put-holders will exercise the options and sell the stocks to the company, and the
buyback is completed. Shareholders not wishing to sell their shares (i.e., high-reservation-price or HR shareholders)
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may sell the rights on an open market to LR shareholders, hence all shareholders benefit from a TPR. If there is a
significant premium of put price over the prevailing market price, TPRs have value and trading will take place.
Like the DAR, this also depends on an upward-sloping supply curve, or shareholder heterogeneity, for its
success. Of course, the exercise price is critical, it is like the firm price in FPT; in this sense, TPR is like the FPT
but without the pro-rating.

Advantages of TPR
(i) All shareholders benefit, irrespective of their reservation price;
(ii) Pro-rating is not necessary (preventing arbitrager from driving up prices by accumulating shares and
ensuring a strong bargaining position);
(iii) Remaining shareholders are high-reservation-price shareholders;
(iv) Management ownership percentage increases.


Open Market Repurchase (OMR)

In an OMR, the firm announces a program to buy back up to a certain number of shares in the open market within a
certain time horizon (at prevailing market prices). An OMR announcement is not a firm commitment; the company
could end up buying fewer shares than specified (possibly buying no shares at all) in the specified time period; in
fact, the actual number of shares repurchased is generally much smaller than the upper limit specified.
The size of the repurchase in an OMR is much smaller than in the other methods, averaging around 5%;
hence it is not a very useful method if the company’s objective is to make capital structure changes. It is used when
the company wishes to return cash to shareholders, to counter irrational market crashes, or to meet employee stock
option exercises, rather than to make changes in the capital structure.
The OMR is the most popular buyback method now; in fact, more than 90% of all repurchase programs
today are OMRs, and in the period 1996-2000 the U.S. corporate sector announced over $100 billion in OMRs. In
an OMR, the firm buys back the stock when price drops; right after the stock market crashes of 1987 and 1998,
hundreds of firms announced OMR programs.
The market’s response to an OMR announcement is positive, but weak at announcement; however, it
becomes more pronounced when the stocks are actually purchased. This is not surprising, since the announcement
itself is not a strong signal because of the lack of commitment, while the actual repurchase sends a stronger signal.
To prevent price manipulation, the SEC limits daily repurchase to 25% of the average daily traded volume over the
previous four weeks.
The details of the OMR can differ in different markets, e.g., in the U.S. the regulations are more flexible,
and there are no reporting or filing or registration requirements after the initial announcement (which makes it
difficult to keep track of how many shares are actually bought back).
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The OMR has a number of advantages: (i) the firm can suspend the repurchase if it finds a better use for its
cash or if an attractive investment project becomes available, (ii) an OMR allows the firm to take advantage of
underpriced stock without paying a premium, (iii) it is cheaper than the other methods, (iv) it can help arrest
irrational drops in stock price, (v) it does not result in wealth transfer from remaining shareholders to selling
shareholders. It also has some disadvantages: (i) it is not useful for signaling, (ii) it is not useful for capital structure
adjustments (because of the small size).

The role of ESOPs in OMR
In recent years, as ESOPs have become increasingly popular, companies with ESOPs are repurchasing more stock:
 Because of potential ESOP exercises, the company needs to have stocks in hand in the form of Treasury
stock (otherwise it would have to issue new equity, which is undesirable because of the negative signal).
 Recall that options are not adjusted for dividends.
 Buybacks result in higher price, so it is good for the option-holder.

Stock Repurchase as an Investment
If the company repurchases stock instead of investing in a new project, then the repurchase can be viewed as an
investment competing with other (real) investments. Then the company would like to know if the repurchase is
better or worse than other investments. For this, it would need to know the ROI of the repurchase.
ROI of repurchase =
tionUndervalua1
k e

or
V/P
k e , where ke = cost of equity, P = market price and V = intrinsic
value. For instance, if cost of equity = 10%, intrinsic stock value = $10, market price = $8, then the ROI of
repurchase is 10/(1– 2/10) = 12.5%. This should be compared to ROI of a competing investment project to see
which of the two the company should spend its cash on.

Repurchase versus Project Investment
 Non-selling shareholders earn a rate of return greater than the cost of equity if a firm’s shares are
repurchased at an undervalued price.
 Repurchase should be financed by foregoing value-creating investments only if investment yields return
less than the return on share repurchase.
 Some form of market inefficiency is required for undervaluation to persist.

Empirical Evidence on Repurchases
 The bulk of the empirical studies are on Open Market Repurchases, since these are the most numerous,
accounting for over 95% of repurchase activity since 1994; OMRs generate smaller returns than other types
of repurchase.
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 In the 1970s, firms were more likely to be undervalued, hence there were large announcement returns and
wealth effects.
 Repurchases around the 1987 stock market drop had positive CARs – consistent with undervaluation.
 Markets treats OMR announcements with skepticism, so prices adjust slowly over time; the event return is
very small when the announcement is made, and price goes up slowly (presumably as the company is
actually buying back the stock).
 OMR: CAR ranges from 1.5% to 3.5% in event window (–2,+2) which is small because announcement
does not necessarily imply repurchase:
DAR: CAR averages 7.7% over window (–1, +1)
FPT: CAR averages 17% over window (–1, +1)
 Firms lost millions in repurchases at peak of late 1990s market – questionable motives of some firms
(implies that these stocks were not really under-valued, but firm tried to send positive signal anyway),
confirms that false signaling can be very expensive.
 Implications of gains and losses from share repurchases:
- Long-term returns to OMRs may result from repurchases being part of a program, not an isolated event.
- Other factors: insider ownership, market undervaluation, etc.
 In recent years, a major reason for repurchases is to offset maturing ESOs; when an ESO is exercised, the
firm would rather have stock in hand than issue new stock.

Repurchase vis-a-vis Dividends
Dividends and stock repurchase are both forms of cash distribution to shareholders. They perform different
functions for different types of investors; for instance, large mature low-growth firms tend to use dividend payouts
while small growing firms tend to use repurchases to offset option grants. Repurchase is a more tax-efficient way to
return capital to shareholders than dividends (because repurchases are subject to capital gains taxes while dividends
are subject to ordinary income taxes), and the advantage is greater for higher-tax-bracket shareholders. Therefore,
companies with higher-tax shareholders are more likely to use repurchase.
Also, regular dividends require a steady stream of earnings, hence firms with volatile earnings should be
less likely to pay regular dividends and more likely to repurchase. This was verified empirically by Jagannath,
Stephens and Weisbach (2000),38 who found that firms that repurchase have higher earnings volatility than firms
that pay dividends.
While the total payout ratio for the U.S. corporate sector has remained more or less constant over the years,
the dividend payout has been falling and repurchases increasing (Grullon and Michaely, 2002);39 thus, there has

38 Jagannath, M., C.P. Stephens and M.S. Weisbach (2000) Financial Flexibility and the Choice between Dividends and Stock
Repurchases, Journal of Financial Economics 57, 355-384.
39 Grullon, G. and R. Michaely (2002) Dividends, Share Repurchases, and the Substitution Hypothesis, Journal of Finance 57,
1649-1684.
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been a substitution effect between the two forms of payout. There seems to be a “clientele effect” because certain
shareholders are interested in regular dividends rather than unpredictable stock repurchases and they don’t care
much about the tax disadvantage of dividends because they are subject to a low (or zero) tax rate. These
shareholders will buy stocks of companies with steady earnings stream that pay regular cash dividends, while other
(high-tax) investors are more likely to invest in volatile companies which repurchase stock. This is supported by
empirical evidence: Petit (1977) and Lewellen, Stanley, Lease and Schlarbaum (1978) show that dividend yields of
investor portfolios are indeed related to their marginal tax rates; investors with high marginal tax rates tend to select
stocks with low dividend yields (e.g., biotech companies) and investors with low (or zero) marginal tax rates tend to
select stocks with high dividend yields (e.g., utilities).
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Chapter 10. Questions

1. A company with a stock price of $30 uses FPT to buy back 20% of its stock at a tender price of $37.50. After the
repurchase is completed, the stock price is $34. What is the event return to selling stockholders? To remaining
stockholders? The total event return?

2. Suppose a company wants to repurchase 200 of its 1000 outstanding shares using a DAR. It aggregates
shareholders’ bids and comes up with the following supply curve: V(r) = 80 + 0.04r.
At what price will the company buy back its stock? What will be the post-DAR supply curve?

3. A company has 8 million shares (of which management owns 0.5 million) trading at $25; it wants to buy back
25% of the shares at a premium of 20%. If the intrinsic value of the stock is $26, what would be the signaling cost
of the repurchase?

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Answers to Chapter Questions

Chapter 1
1. Incremental cash flows:
Net cash inflow = $5,000 per year for 2 years;
Time 0 cash outflow = $10,000; Salvage value (time 2) = +$3,000
Net cash flows: t = 0: -10,000
t = 1: +5,000
t = 2: +8,000
NPV @ 12% is +841.84. Investment should be made.
2. Payback period = 3 years. Cannot say whether project should be accepted, since we don’t know the cutoff payback
period.
3. Using a spreadsheet package or a financial calculator, IRR(X) = 87.2% and IRR(Y) = 22.8%. According to the IRR
rule, X is the better project.
With a discount rate of 10%, NPV(X) = 439.37 and NPV(Y) = 965.44. Using the NPV rule, Y is the superior project.
The cross-over rate (IRR of Y-X) is 17.7%.
4. This is one of those projects for which there is no IRR, because the NPV of the project is always negative.
5. With a discount rate of 10%, PV of costs = 124.87 (for X) and 96.03 (for Y).
Convert to EAC by annualizing the PV (divide by the PVIFA):
EAC(X) = 124.87/2.48685 = 50.21 EAC(Y) = 96.03/1.7355 = 55.33
Choose X since Y is more costly.
6. If invest in the R&D project, payoff is 10 (prob 0.2) and 0 (prob 0.8). Expected payoff = 10 (0.2) + 0 (0.8) = 2
Cost of R&D project = 1. Therefore, net expected payoff = 2 – 1 = $1 million
Payoff from not investing = 0.
Therefore, you should invest in the R&D project.

Chapter 2.
1. Current Capital Structure (No Debt)
Recession Expected Expansion
EBIT 40,000 60,000 100,000
Interest 0 0 0
Net Income 40,000 60,000 100,000
ROE 8% 12% 20%
EPS $2 $3 $5

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Proposed Capital Structure (With Debt)
Recession Expected Expansion
EBIT 40,000 60,000 100,000
Interest 30,000 30,000 30,000
Net Income 10,000 30,000 70,000
ROE 5% 15% 35%
EPS $1.25 $3.75 $8.75
EPS (old) = EBIT/20,000 EPS (new) = (EBIT – 30,000)/8,00
We get the indifference EBIT by equating old and new EPS; this gives $50,000, with which the EPS comes to $2.50
in both cases.
2. Without debt, firm value = 500,000(1-0.46)/0.14 = $1,928,571
Without personal taxes, tax shield = 0.46(250,000) = $115,000
With personal taxes, tax shield = [1-(1-.46)(1-.25)/(1-.48)] 250,000 = $55,288.50.
3. Unlevered firm value = 365,000(1-.3)/.15 = $1,703,333
Let levered firm value be V(L). Then, debt value = .4V(L) and equity value = .6V(L)
Tax shield = .3 times .4V(L) or .12 V(L)
V(L) = 1,703,333 + .12V(L), which gives V(L) = 1,935,606, and equity value = .6V(L) = 1,161,363.
R(A) = 15%. R(E) = R(A) + (1-T) [R(A)-R(D)] (D/E) = 15+.7(5).4/.6 = 17.3%
WACC = .4(1-.3)10+.6(17.3) = 13.2%
Stock price = 1,161,363/100,000 = $11.61
Debt value = .4(1,935,606) = 774,242.40
# shares issued = 774,242.40/11.61 = 66,687.55 shares
After recap, each share gets 365,000(1-.3)/166,687.55 = $1.5328
Price = 1.5328/.15 = $10.2187
Total equity = 10.2187 X 166687.55 = $1,703,333.
From Miller’s Hypothesis,
V(L) = V(U) + [1 – (1-Tc)(1-Te)/(1-Td)] D = 1,703,333+[1-.7 X .8/.65] 774,242.40 = $1,810,536.

Chapter 3. (Ignoring time value of money for these questions)
1. Project A: Value = .5(60+120) = 90 Project B: Value = 101 Project B maximizes value
With $100 of debt, Equity value with A is .5(0+20) = $10, and Equity value with B is .5(1+1) = $1.
Equity holders will choose project A.
2. Project A: Value = .3(2)+.7(9) = $6.90 Project B: Value = .3(7)+.7(6) = $6.30 Project A has greater
value
With $5 of debt, Equity value (A) = .3(0)+.7(4) = $2.80 and Equity value (B) = .3(2)+.7(1) = $1.30
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Here, project A is preferred by equity holders too.
3. NPV = .2(85)+.8(150)-75 = $62 With $70 of debt, NPV to Equity holders = .2(15)+.8(80) = $67
If equity holders must provide the entire financing ($75), they will Reject.
4. Expected value of both projects same, at $1250. Without any debt, equity holders will choose the lower-risk
project L.
With $1000 in debt, equity value (H) = .5(0+1250) = $625 and equity value (L) = .5(0+1000) = $500, and equity
holders will choose the high-risk project H.
5. D/V = 80% E = 4, D = 16, V = 20
New V = 20+3 = 23, New D = 16*1.25 = 20, thus New E = 23-20 = $3. Since Equity value would fall, equity
holders will reject the positive-NPV project (under-investment).

Chapter 4.
1. Positive signal (manager expects earnings to be higher). Credible because there is a significant cost to mimicking
if expectations are different (since manager will lose his/her job in the event of a bankruptcy).
2. Issue equity: either over-valued stock, or project was not great
Repurchase: under-valued stock
Credible, because mimicking is costly.
3. Positive signal because it tells the market that management is confident regarding future earnings.
It might be a negative signal if driven by the fact that there are no good projects to invest in (no growth options).

Chapter 6.
1. A: 30 shares @ $20 = $600 B: 20 shares @ $10 = $200 Post-merger value = $1000
(a) Post-merger #shares = 30+15 = 45. Then, post-merger stock price = 1000/45 = $22.22
(b) If offer x shares, total post-merger #shares = 30+x, and total value = 1000. We need 




 x30
x *1000 = 300.
Solving, we get x = 12.86, or an exchange ratio of 0.643 for 1.
2. A: 100 shares @ $20 = $2000 B: 60 shares @ $16.67 = $1000 Post-merger value = $3600
(a) Maximum Price = $1600.
(b) If offer x shares, total post-merger #shares = 100+x, and total value = 3600. We need 




 x100
x *3600 = 1400.
Solving, we get x = 63.64, or an exchange ratio of 1.06 for 1.
(c) If post-merger value = 3800, A is actually paying 




64.163
64.63 *3600 = 1478.
3. (a) Maximum = 48 and Minimum = 40
(b) NPV = 4 for each firm.
(c) Let the fraction be x. Then, x(128) = 44, or x = 0.34375 of the post-merger company.
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4. Post-acquisition Income = 2*200+1*100 = 500
Post-acquisition #shares = 200+1.5*100 = 350
Post-acquisition EPS = 500/350 = $1.43.
5. A: 30 shares @ $20 = $600; B: 20 shares @ $10 = $200; Post-merger value = $1000
(a) Post-merger #shares = 30+15 = 45. Then, post-merger stock price = 1000/45 = $22.22
(b) If offer x shares, total post-merger #shares = 30+x, and total value = 1000. We need 




 x30
x *1000 = 300.
Solving, we get x = 12.86, or an exchange ratio of 0.643 for 1.

Chapter 10
1. Exiting: 37.50/30 – 1 = 25%. Remaining: 34/30 – 1 = 13.33%.
Overall event return = 25(.2)+13.33(.8) = 15.67%.
2. Buy back at: 80+(.04)200 = $88.
Post-DAR supply curve: V(r) is a valuation, hence if the number of shares is reduced by 20%, V(r) should rise by
the ratio 1/.8, i.e., new V(r) = [80+.04r]/0.8 = 100+.05r. But the company also pays out cash: $88(200). Since this
cost is borne by the remaining 800 shareholders, the loss per share is 88(200)/800 = $22. Then we get V(r) = 100–
22+.05r = 78+.05r.
Finally, since 200 shareholders have left, we need to start with the 201st shareholder, so we need to replace r by
(200+r), which gives: V(r) = 88+.05r. This is the post-DAR supply curve.
3. Pays $30 for something worth $26, hence the cost of signaling = $4 per share bought back, or 4(2) = $8 million.
This is the total cost of signaling.
However, since management holds 0.5 million shares out of the remaining 6 million, the cost to management will
be 8(.5)/6 = $666,667.

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Case Questions

Rushway Brothers Lumber
1. As the seller, what price would you ask for the company?
2. Why would the buyer’s valuation be different from the seller’s valuation? In this case, which would you
expect to be closer to the transaction price, and why?
3. As the acquirer, how would you finance the acquisition?

The Empire Group Limited – The Oshawa Group Limited Proposal
1. Does this acquisition make sense? Explain.
2. Assess the value of Oshawa on a “stand alone” basis as well as the separate value of the proposed synergies
with The Empire Group.
3. As James Vaux, would you recommend making a bid? If so, at what price? Would you make a distinction
between Class A and Common shareholders in terms of the offer price? How should the offer, if made, be
financed?



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