NEW YORK UNIVERSITY FINANCIAL ECONOMICS II Spring 2003 Franklin allen and douglas gale January 24, 2003 Topic 1: What is Corporate Finance?(cont 1 2 Financing Decisions In the previous section the focus was on investment decisions. It was assumed throughout that the firm was financed with equity. In this section we discuss financing decisions. As a prelude to this we will briefly discuss the notion of efficient markets and some of it's implications for corporate financing decisions. After that we will briefly mention some of the securities that are issued Then we will consider the main financial decisions of the firm, capital structure and payout policy. We will apply these ideas to valuation. Finally we will discuss real options very briefly 2. 1 Efficient Markets and Corporate Finance We have argued that all shareholders should agree if a firm uses the net present value rule to make capital budgeting decisions. How does the stock market view such decisions? What is the relationship between a firm s stock market value and its use of the NPv rule? Efficient Markets Hypothesis A firm' s stock market value is determined by the discounted value of its cash flows
1 NEW YORK UNIVERSITY FINANCIAL ECONOMICS II Spring 2003 Franklin Allen and Douglas Gale January 24, 2003 Topic 1: What is Corporate Finance? (cont.) 2 Financing Decisions In the previous section the focus was on investment decisions. It was assumed throughout that the firm was financed with equity. In this section we discuss financing decisions. As a prelude to this we will briefly discuss the notion of efficient markets and some of it’s implications for corporate financing decisions. After that we will briefly mention some of the securities that are issued. Then we will consider the main financial decisions of the firm, capital structure and payout policy. We will apply these ideas to valuation. Finally we will discuss real options very briefly. 2.1 Efficient Markets and Corporate Finance We have argued that all shareholders should agree if a firm uses the net present value rule to make capital budgeting decisions. How does the stock market view such decisions? What is the relationship between a firm's stock market value and its use of the NPV rule? Efficient Markets Hypothesis: A firm's stock market value is determined by the discounted value of its cash flows
This is based on stock markets being competitive and having n many profit-seekins investors. The following example illustrates the basic idea Example Consider a firm which for simplicity only lasts for two periods and that has per share cash flows which are paid out to shareholders as follows 125 140 The opportunity cost of capital is 10 percent Discounted cash flow 2.29 1.11.12 What would happen if the stock was selling in the market at 2.00? How could investors make money? Suppose an investor borrowed 2.00 and bought one share. Since the discounted present value of the payments on the stock is 2.29 the investor will be able to pay back the loan and make a profit in term s of today's dollars of 0. 29. To see this another way Debt to buy share 2.00 2x1.1=2.2 0.95x1.1=1.045 (including interest) Less pay 1.25 End of period debt 0.95 0.355 In other words the investor is left with 0.355 at date 2 which is equivalent to 55/1.12=0.29 at date 0. Everybody will therefore try to borrow and buy shares. The price will be bid up to 2.29
2 This is based on stock markets being competitive and having many profit-seeking investors. The following example illustrates the basic idea. Example Consider a firm which for simplicity only lasts for two periods and that has per share cash flows which are paid out to shareholders as follows: C1 C2 1.25 1.40 The opportunity cost of capital is 10 percent. What would happen if the stock was selling in the market at 2.00? How could investors make money? Suppose an investor borrowed 2.00 and bought one share. Since the discounted present value of the payments on the stock is 2.29 the investor will be able to pay back the loan and make a profit in term's of today's dollars of 0.29. To see this another way t= 0 1 2 Debt to buy share 2.00 2x1.1 = 2.2 0.95x1.1 = 1.045 (including interest) Less payment - 1.25 - 1.40 End of period debt = 0.95 = - 0.355 In other words the investor is left with 0.355 at date 2 which is equivalent to 0.355/1.12 = 0.29 at date 0. Everybody will therefore try to borrow and buy shares. The price will be bid up to 2.29. = 2.29 1.1 1.40 + 1.1 1.25 Discounted cash flow = 2
Suppose the price was 2.35 what should somebody who owns the stock do? The owner should clearly sell since this gives 2. 35 whereas if the stock was held onto it would pay off 2.29 in terms of today's money. If everybody who owns the stock tries to sell the price will fall until it is equal to 2.29 Whenever prices get out of line with discounted cash flows there will be profit opportunities. The efficient markets hypothesis is essentially arguing these can't last for long. In other words arbitrage ensures that prices reflect discounted cash flows If stock market prices reflect discounted cash flows then this implies the following Implication of Efficient Markets Hypothesis la positive NPV project is accepted the value of the firm will increase by the amount of the project's NPk Hence accepting positive NPv projects leads to an increase in stock price and the creation of shareholder wealth. Rejecting negative NPV projects avoids a fall in share price and the destruction of shareholder wealth This fundamental view of the stock market is at the heart of most corporate finance theories. An alternative view is a technical perspective. What is this? One of the activities that some market analysts, known as technical analysts, undertake is to plot the movement of stock prices against time and try to predict future cycles 3
3 Suppose the price was 2.35 what should somebody who owns the stock do? The owner should clearly sell since this gives 2.35 whereas if the stock was held onto it would pay off 2.29 in terms of today's money. If everybody who owns the stock tries to sell the price will fall until it is equal to 2.29. Whenever prices get out of line with discounted cash flows there will be profit opportunities. The efficient markets hypothesis is essentially arguing these can't last for long. In other words arbitrage ensures that prices reflect discounted cash flows. If stock market prices reflect discounted cash flows then this implies the following. Implication of Efficient Markets Hypothesis: If a positive NPV project is accepted the value of the firm will increase by the amount of the project's NPV. Hence accepting positive NPV projects leads to an increase in stock price and the creation of shareholder wealth. Rejecting negative NPV projects avoids a fall in share price and the destruction of shareholder wealth. This fundamental view of the stock market is at the heart of most corporate finance theories. An alternative view is a technical perspective. What is this? One of the activities that some market analysts, known as technical analysts, undertake is to plot the movement of stock prices against time and try to predict future cycles
STOCK PRICE NOV TIME Suppose you discover a cycle, and at the present moment the stock is at the bottom of a trough. What should you do? You should buy the stock in anticipation of it going up. But what happens if there are a lot of technical analysts and many people do this? The price rises until it offers only a normal rate of return. In other words, any cycles will self-destruct because many people will be doing this. People will arbitrage away profit opportunities Competition in technical research will tend to ensure that current prices reflect all information in the past sequence of prices and that price changes cannot be predicted from past prices This is called the weak form of market efficiency: Current prices reflect all the information contained in the record of past prices. Predictable cycles are eliminated because otherwise positive NPV transactions would exist. If this is the case, why do stock prices change? Efficient markets theory argues they change because new information is received They must change as soon as the information is received and fully reflect this information otherwise positive NPV transactions would again exist. The semi-strong form of market efficiency is that current prices reflect not only past prices but all other published
4 Suppose you discover a cycle, and at the present moment the stock is at the bottom of a trough. What should you do? You should buy the stock in anticipation of it going up. But what happens if there are a lot of technical analysts and many people do this? The price rises until it offers only a normal rate of return. In other words, any cycles will self-destruct because many people will be doing this. People will arbitrage away profit opportunities. Competition in technical research will tend to ensure that current prices reflect all information in the past sequence of prices and that price changes cannot be predicted from past prices. This is called the weak form of market efficiency: Current prices reflect all the information contained in the record of past prices. Predictable cycles are eliminated because otherwise positive NPV transactions would exist. If this is the case, why do stock prices change? Efficient markets theory argues they change because new information is received. They must change as soon as the information is received and fully reflect this information, otherwise positive NPV transactions would again exist. The semi-strong form of market efficiency is that current prices reflect not only past prices but all other published STOCK PRICE NOW TIME
information. The strong form of efficiency is when prices reflect not just public information but all the information such as that which can be acquired by painstaking fundamental analysis of the company and the economy New information cannot by definition be predicted ahead of time since otherwise it would not be new information. Therefore, price changes cannot be predicted ahead of time Series of price changes must be random. To put it another way, if stock prices already reflect all that is predictable, then stock price changes must reflect only the unpredictable--they must e random What sort of path of prices do you get if price changes are random and occur only when there is new information? Prices follow a random walk. In the 1970s there was an immense amount of empirical work done by Fama and others to determine whether the evidence supports market efficiency or a technical view. The interpretation of the evidence amassed was that it provided substantial support for weak-form market efficiency. Semi- strong efficiency also had substantial support. The evidence for strong-form efficiency was more in dispute To summarize, we have said that theoretically prices should reflect available information since otherwise people would be able to make arbitrage trades and profit from hem. Another way of thinking about efficient markets is that the purchase or sale of a ecurity at the prevailing market price is a zero NPv transaction. Most finance academics would agree that empirically there appears to be strong support for this proposition The efficient market hypothesis has a number of implications that go against what many practitioners commonly suppose about financial markets. We shall now take a brief look at some of the most important of these
5 information. The strong form of efficiency is when prices reflect not just public information but all the information such as that which can be acquired by painstaking fundamental analysis of the company and the economy. New information cannot by definition be predicted ahead of time since otherwise it would not be new information. Therefore, price changes cannot be predicted ahead of time. Series of price changes must be random. To put it another way, if stock prices already reflect all that is predictable, then stock price changes must reflect only the unpredictable--they must be random. What sort of path of prices do you get if price changes are random and occur only when there is new information? Prices follow a random walk. In the 1970’s there was an immense amount of empirical work done by Fama and others to determine whether the evidence supports market efficiency or a technical view. The interpretation of the evidence amassed was that it provided substantial support for weak-form market efficiency. Semistrong efficiency also had substantial support. The evidence for strong-form efficiency was more in dispute. To summarize, we have said that theoretically prices should reflect available information since otherwise people would be able to make arbitrage trades and profit from them. Another way of thinking about efficient markets is that the purchase or sale of a security at the prevailing market price is a zero NPV transaction. Most finance academics would agree that empirically there appears to be strong support for this proposition. The efficient market hypothesis has a number of implications that go against what many practitioners commonly suppose about financial markets. We shall now take a brief look at some of the most important of these
1. Values of stocks depend on cash flows. We have argued that the value of stocks depends on expectations of cash flows not on the supply and demand on any particular day. In other words, you should be able to issu large blocks of stocks at close to the market price as long as you can convince other investors that you have no private information, i. e,, that you're not selling while the going is good 2. There are no financial illusions In an efficient market there are no financial illusions. Investors are concerned with their entitlement to a firms cash flow. This implies that any attempt to mislead investors by, for example, changing accounting conventions to boost EPS will be unsuccessful 3. Markets have no memory. We have argued that there are no true cycles hence the notion that now is a good time or now is a bad time to issue securities is essentially false. For example, there may just have been a long series of rises so that you think it is the top of the market and therefore a good time to issue. However, we know if this was true, investors would already have sold and the market would not be where it now is. You cannot outguess the market using information available to every body else 4. Trust market prices. In an efficient market you can trust prices. They incorporate all the available information about the value of each security. This means that in an efficient market firms can issue securities at any time. The amount that they will receive is a fair value 6
6 1. Values of stocks depend on cash flows. We have argued that the value of stocks depends on expectations of cash flows not on the supply and demand on any particular day. In other words, you should be able to issue large blocks of stocks at close to the market price as long as you can convince other investors that you have no private information, i.e., that you're not selling while the going is good. 2. There are no financial illusions. In an efficient market there are no financial illusions. Investors are concerned with their entitlement to a firm's cash flow. This implies that any attempt to mislead investors by, for example, changing accounting conventions to boost EPS will be unsuccessful. 3. Markets have no memory. We have argued that there are no true cycles. Hence the notion that now is a good time or now is a bad time to issue securities is essentially false. For example, there may just have been a long series of rises so that you think it is the top of the market and therefore a good time to issue. However, we know if this was true, investors would already have sold and the market would not be where it now is. You cannot outguess the market using information available to everybody else. 4. Trust market prices. In an efficient market you can trust prices. They incorporate all the available information about the value of each security. This means that in an efficient market firms can issue securities at any time. The amount that they will receive is a fair value
2.2 Tvpes of security We mentioned in Section I that originally in MBa programs corporate finance was taught as a law subject. Nowadays law has been deemphasized but a knowledge of the different types of security that are used and the legal rights of the owners is very important The basic types are outlined below. You should read Chapter 14 in Brealey and Myers to obtain a more detailed knowledge Common Stock The common stockholders are the owners of the corporation. they therefore have a general preemptive right to anything of value that the company may wish to distribute. They also have the ultimate control of the company's affairs. In practice this control is limited to a right to vote either in person, or by proxy, on appointments to the board of directors Long Term Debt and Preferred Stock Long term debt and preferred stock are fixed income securities in that they both provide the investor with a stipulated promised series of payments in the future. The interest and face value are specified for the bonds, and a given dividend rate is stipulated for the preferred stock. The firm must pay the interest and the maturity values on its debt as agreed upon in the original debt contract or the company defaults and is subject to legal action. Junk bonds are high yield bonds With preferred stock the firm promises to pay dividends on the preferred stock. If it fails to it is not bankrupt, however. It cannot pay dividends to common stockholders until the dividends to preferred stock are paid. Bondholders have a prior claim to the company's
7 2.2 Types of Security We mentioned in Section 1 that originally in MBA programs corporate finance was taught as a law subject. Nowadays law has been deemphasized but a knowledge of the different types of security that are used and the legal rights of the owners is very important. The basic types are outlined below. You should read Chapter 14 in Brealey and Myers to obtain a more detailed knowledge. Common Stock The common stockholders are the owners of the corporation. They therefore have a general preemptive right to anything of value that the company may wish to distribute. They also have the ultimate control of the company's affairs. In practice this control is limited to a right to vote either in person, or by proxy, on appointments to the board of directors. Long Term Debt and Preferred Stock Long term debt and preferred stock are fixed income securities in that they both provide the investor with a stipulated promised series of payments in the future. The interest and face value are specified for the bonds, and a given dividend rate is stipulated for the preferred stock. The firm must pay the interest and the maturity values on its debt as agreed upon in the original debt contract or the company defaults and is subject to legal action. Junk bonds are high yield bonds. With preferred stock the firm promises to pay dividends on the preferred stock. If it fails to it is not bankrupt, however. It cannot pay dividends to common stockholders until the dividends to preferred stock are paid. Bondholders have a prior claim to the company's
income and to the firms assets if the company liquidates. The claim of holders of preferred stock comes after bondholders but before that of equityholders The relative importance of the three types of security is that debt is by far the most important in terms of quantity issued, equity is next and finally preferred stock is relatively insignificant. The quantitie d vary significantly over time but the le In average Is about 80% debt, 15% equity and 5% preferred stock Convertible Securities Corporations often issue securities with terms that can be altered subsequently at the option of the holder of the security. For example, convertible bonds can be transformed into the common stock of the corporation at the option of the holder. The purchase of a warrant entitles the holder to purchase the company' s common stock at a specified price on any date preceding the warrant's expiration 2.3 Capital structure Decisions The assumption behind most of the analysis we have done so far is that the firm is all equity financed. In practice, of course, firms use debt and many other types of security to finance themselves. In this section we are interested in whether using different types of ecurity, in particular debt and equity, creates value for shareholders Motivation Example The Saw Company is reviewing its capital structure. It pays no taxes and has access to perfect capital markets. The interest rate on debt is 10 percent. Its current position is as follows 8
8 income and to the firm's assets if the company liquidates. The claim of holders of preferred stock comes after bondholders but before that of equityholders. The relative importance of the three types of security is that debt is by far the most important in terms of quantity issued, equity is next and finally preferred stock is relatively insignificant. The quantities issued vary significantly over time but the long run average is about 80% debt, 15% equity and 5% preferred stock. Convertible Securities Corporations often issue securities with terms that can be altered subsequently at the option of the holder of the security. For example, convertible bonds can be transformed into the common stock of the corporation at the option of the holder. The purchase of a warrant entitles the holder to purchase the company's common stock at a specified price on any date preceding the warrant's expiration. 2.3 Capital Structure Decisions The assumption behind most of the analysis we have done so far is that the firm is all equity financed. In practice, of course, firms use debt and many other types of security to finance themselves. In this section we are interested in whether using different types of security, in particular debt and equity, creates value for shareholders. Motivation Example The Saw Company is reviewing its capital structure. It pays no taxes and has access to perfect capital markets. The interest rate on debt is 10 percent. Its current position is as follows:
Data Number of shares Price per $20 Market value of shares $2000 Market value of debt Examples of Possible Outcomes Sit 2 Sit 3 (Expected Outcome) Operating income 100 250 300 Earnings per share S 2.5 Return on equity 12.5 The company has no leverage and all the operating income is paid out as dividends to the common stockholders The expected earnings and dividends per share are $2.50. This is an average, actual earnings could turn out to be more or less than $2.50. The price of each share is $20. Since the firm expects to produce a level stream of earnings in perpetuity, the expected return is given by EPS 2.50 Mr. Modigliani, a Harvard MBA and the firms president, has come to the conclusion that shareholders would be better off if the company had equal proportions of debt and equity. He therefore proposes to issue $1000 of debt at the risk free lending and
9 Data Number of shares 100 Price per share $20 Market value of shares $2000 Market Value of debt $0 Examples of Possible Outcomes: Sit 1 Sit 2 Sit 3 (Expected Outcome) Operating income $ 100 250 300 Earnings per share $ 1 2.5 3 Return on equity % 5 12.5 15 The company has no leverage and all the operating income is paid out as dividends to the common stockholders. The expected earnings and dividends per share are $2.50. This is an average; actual earnings could turn out to be more or less than $2.50. The price of each share is $20. Since the firm expects to produce a level stream of earnings in perpetuity, the expected return is given by: Mr. Modigliani, a Harvard MBA and the firm's president, has come to the conclusion that shareholders would be better off if the company had equal proportions of debt and equity. He therefore proposes to issue $1000 of debt at the risk free lending and =12.5% 20 2.50 = P EPS r =
borrowing rate of 10% and use the proceeds to repurchase 50 shares. To support his proposal Mr. Modigliani has analyzed the situation under the various different assumptions about operating income. The results are as follows t a Number of shares Market value of debt $1000 utcome Sit 2 Sit 3 (Expected Outcome) Operating income 100 250 300 Interest S 100 100 Equity Earnings S 150 200 EPS S Return on equity 15 Return on debt 10 10 10 We can plot this data on the following diagram 10
10 borrowing rate of 10% and use the proceeds to repurchase 50 shares. To support his proposal Mr. Modigliani has analyzed the situation under the various different assumptions about operating income. The results are as follows: Data Number of shares 50 Market value of debt $1000 rD = 10% Possible Outcomes Sit 1 Sit 2 Sit 3 (Expected Outcome) Operating income $ 100 250 300 Interest $ 100 100 100 Equity Earnings $ 0 150 200 EPS $ 0 3 4 Return on equity % 0 15 20 Return on debt % 10 10 10 We can plot this data on the following diagram: