CFDM Flashcards
mid sem (109 cards)
1
Q
Advantages of going Public
A
- Access to additional capital
- Allow venture capitalists to cash out
- Current stockholders can diversify
- Liquidity is increased (shares can be rapidly sold with little impact on the stock price)
- Going public established firm value
- Makes it more feasible to use stock as employee incentives (may give 1000 shares as a bonus → personal wealth is tied directly to the company share price)
- Increases customer recognition
2
Q
Adverse selection
A
Adverse selection is a situation in which one party in a transaction possesses information that the other party does not. It occurs when investors or lenders end up with riskier assets because they can’t accurately distinguish between high‐ and low-quality opportunities.
3
Q
After tax cost of borrowing formula
A
interest rate x (1-corporate tax rate)
4
Q
Business risk
A
Business risk is the uncertainty inherent in a company’s operations. It arises from factors such as industry conditions, competition, demand fluctuations, cost variability, and overall economic conditions.
5
Q
Costs of IPO’s - direct and indirect
A
Direct:
- Underwriters receive payment in the form of a spread (the difference between the underwriters’ buying price and the offering price)
- Usually, the underwriting spread on a new issue amounts to 7% of the proceeds to the issuer.
- Direct admin costs to management, lawyers, accountings as well as fees for registering the new securities etc.
Indirect:
- Underpricing
Issuing securities are an offering price set below the actual market value of the security (captured by first-day closing price)
Cost because it represents the opportunity cost of not capturing the full market value of the shares issued. When shares are underpriced, the company raises less capital than it potentially could (money left on the table)
6
Q
Coupon rate - bonds
A
The coupon rate is the fixed annual interest rate that the bond issuer agrees to pay.
7
Q
Debt Covenants
A
Specific provisions in the debt contract.
Designed to protect interests of lenders.
Debt covenants are terms in debt contracts that direct and restrict the behaviour
of a company.
Positive debt covenants can be included to specify things that a company must
do.
Negative debt covenants can be included to specify things that a company must
not do.
Covenants → Giving the company directions to what it can and can not do / conditions attached!! Lenders get to have this say to protect their own interest.
Negative (or restrictive) covenants (”not to do”)
- Limit access to further debt (debt issuers don’t want to be pushed further down chain if business goes into liquidation)
- Restrict holdings of certain investments (e.g. restrict company building an empire)
- Restrict dividends paid
Positive (or affirmative) covenants (”to do”)
- Maintain assets (working capital or collateral)
- Provide audited financial statements to the lenders
8
Q
Default risk
A
The risk that a borrower may fail to make the repayments that are due to lenders.
Both financial risk and default risk are associated with debt finance.
8
Q
Disadvantages of going public
A
- IPO creates substantial fees (smaller firms → more costly relatively bc lower negotiating power)
legal, accounting, investment banking fees are often 10% of funds raised in the offering - Greater degree of disclosure and scrutiny
- Dilution of control and existing owners
- Special “deals” to insiders will be more difficult to undertake
- Managing investor relations is time-consuming
9
Q
Dividend drop off ratio
A
(Pcum - Pex)/dividend
10
Q
dividends are sticky?
A
Once companies start paying dividends, they roughly will continue to keep paying dividends with out really any change from one year to the next.
11
Q
Explanations for Underpricing an IPO
A
1) WINNERS CURSE (information asymmetry)
(2) MARKET FEEDBACK HYPOTHESIS
- An issuer may be uncertain as to the “true” value of the firm
- An initial bookbuilding process offers the issuer an opportunity to find out from the market the “true” value
- To induce institutional investors to reveal this information, the issuer must underprice the issue
(3) INVESTMENT BANKING CONFLICTS
- Investment banks arrange for underpricing as a way to benefit themselves and their other clients
Underpricing can reduce an investment bank’s own costs
Underpricing can be used by IBs to develop unethical relationships with other clients
(4) LITIGATION INSURANCE
- There is potential liability faced by the issuer and underwriter for material misstatements and omissions made in connection with the IPO (for instance information contained in prospectus may be biased)
- Underpricing ensures that subscribers earn a positive return from their investment
- This may reduce the likelihood of them suing the underwriter and company if shares subsequently do poorly
(5) SIGNALLING
- As CEO - you know that the IPO is only the first stage in a multi-stage strategy for expansion.
- You know that in the future you will have to go back to the market to raise more capital.
- Leaving a “good-taste” with investors provides a mechanism to signal the quality of the issue.
- Makes it easier to subsequently raise funds at higher prices.
12
Q
Financial risk
A
Financial risk is the additional risk imposed on shareholers which arises from the use of debt financing (or leverage). It relates to the obligation of making fixed interest and principal repayments.
12
Q
lambda
A
the proportion of corporate tax claimed by shareholders
12
Q
Information assymetry
A
Information asymmetry occurs when one party in a transaction has significantly more or better information than the other, leading to potential market inefficiencies such as adverse selection.
13
Q
Lessee
A
the asset user
14
Q
Lessor
A
legal owner/financier of asset
15
Q
M-M Dividend Irrelevance Theorem
A
In perfect capital markets the value of a firm is independent of its payout policy.
Under assumptions of no taxes, no bankruptcy or agency costs, and perfect information, capital structure doesn’t change firm value: 𝑉_L = 𝑉_U
??
→ M-M’s theorem implies:
- A firms investment policies (and hence cash flows) don’t change, the value of the firm cannot change as it changes its dividends. A firm that is valued less cannot manipulate its dividend policy in the expectation that it will be valued higher, the only thing that matters is the numerator (= cash flows).
- Paying dividends is a zero NPV transaction - so the value of the firm before paying dividends must equal the value of the firm after paying dividends plus the value of the dividends
- Investors can implement their own “homemade” dividend policy (sell shares in companies that don’t pay dividends, which translates to cash inflow and is identical to receiving dividends i.e. selling shares every 6months)
- In PCM’s investors who don’t want dividends can replicate a no-dividend stock by reinvesting their dividends
16
Q
Pecking order
A
internal equity > debt > hybrids > external equity
16
Q
Reasons for long-run (IPO) underperformance
A
“Clientele effects”
the IPO is often priced low enough to attract a group of overly optimistic investors. Their initial enthusiasm pushes up the first-day trading price, but as more information becomes available over time, that optimism fades, and the share price tends to normalize or decline relative to its initial surge.
“Impresario hypothesis”
investment bankers will attempt to create the appearance of excess demand by initially underpricing IPOs → investors are taken in by this, but then we would expect to subsequently see a fall in the share price as efforts are withdrawn/people start selling bc realise company was propped up.
investment banks support the company’s share price temporarily, for the first 3-6months, then go away.
“Window of opportunity”
Focuses on timing the issue when market conditions are most favourable. Management aims to secure the highest possible share price by taking advantage of a period when investor sentiment is high (“hot market”). Here, the goal is to capture maximum value at the time of the offering.
Temporary “window” of opportunistic pricing then closes»_space; market participants recalibrate their expectations based on more typical economic conditions»_space; downward adjustment of the share price in the LT
16
Q
Relationships between tax rates and ex-dividend day behaviour
A
If dividends and capital gains are taxed equally:
Price change = dividend
If dividends are taxed at a higher rate than capital gains:
Price change < dividend
If dividends are taxed at a lower rate than capital gains:
Price change > dividend
17
Q
residual claim
A
what’s left over
18
Q
Trade off theory
A
Balancing the tax advantages of debt (the tax shield) against the costs of financial distress (including bankruptcy and agency costs), to acheive the optimal target capital structure.
19
Q
Trade off theory: implications
A
Firms should:
issue equity when leverage rises above the target level
buy back stock when leverage falls below the target capital structure
20
Underpricing percentage
(first day closing price - offer price) / offer price
21
Value of the right(R)
N(M - S)/N+1
22
Why buy back shares?
Improved performance measures, e.g. EPS
SIGNALLING AND UNDERVALUATION
- Managers buying back company stock indicates that they believe the stock is undervalued by the market (up the value of the firm by reducing the number of shares outstanding → will reduce perceived underpricing).
A buyback gives shareholders the opportunity to realise their capital gains. Buybacks are cost free, no transaction fee, all costs are borne by the company.
- Alternatively, a buyback announcement could be accompanied by some new information e.g. sale of an unprofitable asset/division
- Stock market response to a share repurchase seems roughly similar to that for a dividend payment for similar amount of cash involved
FINANCIAL FLEXIBILITY
- Payment of dividends is a long-term commitment as sudden major changes (especially decreases) in dividend policy are unappreciated by market.
- Buy-backs offer an alternate way to make distributions that may not be permanent.
EMPLOYEE SHARE OPTIONS
- Unlike paying dividends, share repurchases do not lead to a price drop like the ex-dividend price drop off
- Often the share price will rise at buyback announcement. So stock call option holders (e.g. managers) prefer a share repurchase to a dividend payout
23
Why share price may not necessarily fall to theoretical ex-rights price (X) on the ex-rights date
Option value of the right isn't considered in the formula.
There may be transaction costs/taxes related to exercising the right.
New information about the company may arrive on the ex rights date or the whole stock market may have moved on that day.
24
Advantages of Private placement
- Quicker to complete (a few weeks)
- Lower issue costs (no need for underwriting normally)
- Do not generally require a prospectus
24
Disadvantages of private placement
- Shares issued at a discount -> transfer of wealth from existing shareholders to new investors
- Dilute control (votes) of existing shareholders
25
Options for unlisted firms to raise equity
* Private equity financing (professional and private sources of financing / not the bank of mum and dad. once exhausted → IPO, can be good bc shows the company is growing)
- 'angel’ finance
- venture capital
* Initial Public Offering (IPO)
- listing shares first time
25
Options for listed firms to raise equity
* Private placement
- To small group of investors
* Rights issue
- To existing shareholders
* Dividend reinvestment plan
- To existing shareholders (offered to reinvest dividend to apply for new shares)
26
Ads and disads of book building
Ads: generally results in an issue price that is closer to the market price when trading commences. Information provided by informed (institutional) investors can be used in setting the issue price, the risk of under subscription is virtually eliminated.
Disads: significant costs so only really only viable for large issues. Possible investment banking conflicts, that is investment bankers may allocate hot IPO shares to their favoured clients.
27
Sensitivity analysis (project risk finance tool)
Analyse the effects of changing an input variable, holding all else constant.
Estimate NVP using optimistic estimate of variable.
Estimate NVP using pessimistic estimate of variable.
Calculate the range of NVP estimates from optimistic to pessimistic.
Repeat the process for each variable turn.
28
Benefits of sensitivity analysis
- Identifies the underlying key variables.
- Indicates where additional information may be useful.
- Gives managers a chance to think about possible consequences of using incorrect forecasts.
29
Scenario Analysis
- A specific form of sensitivity analysis.
- Imagine a scenario - for example when best (worst) values are simultaneously realised for all variables of interest, optimistic SP, VC and SV.
- Compute the NVP under the imagined scenario.
30
Limitations of sensitivity analysis
- Reliance on ambiguous or subjective estimates.
You must choose “base,” “optimistic,” and “pessimistic” values for each input . Those optimistic/pessimistic bounds often come from gut feel, past experience, or loosely defined scenarios rather than rigorous, data-driven probability distributions.
- Interdependence of variables
Assumes that only one variable changes at a time.
Most inputs are correlated (or dependent) rather than independent “one-at-a-time." / multiple variables often shift togeth.er
An unexpected change in a variable may have implications for the reliability of estimates of other variables in that period and future periods.
- Difficulty in Specifying the Precise Relationship Between an Input and NPV.
The relationship between input and NPV isn't perfectly linear or easily captured by a single formula.
31
Break even analysis
Also assumes that only one variable changes at a time.
“How bad can sales or costs get such that the resulting NPV is zero?”
32
Decision tree analysis (simulation analysis)
Method of evaluating alternatives involving a sequence of decisions over time.
Necessary to obtain estimates of the probability of an event occurring and the cash-flows associated with the event.
If there is more than one decision to make, the ROLL-BACK procedure is used.
33
Roll-back procedure
1. Involves assessment of the most distant decision first
2. once this decision is analysed, next most distant decision is assessed
3. procedure is repeated until we reach today’s decision
34
Possible problems with decision tree analysis
- Can become very complex very quickly (multiple decisions/outcomes and it’s impossible to account for all branches
- By discounting at same real rate of return we have implicitly assumed cash flows associated with each decision are equally risky.
- Should the discount rate change over time? Should the discount rate be different on different paths (branches)
By d
35
Call Option
The right to buy something in the market
Value of underlying asset: PV of expected incremental cash flows from expansion (V)
Exercise price: the cost of expansion (X)
Option exercise decision: expansion decision only if V > X; payoff on exercise = V – X
36
Put Option
Gives you the right to sell something in the market at a predetermined price.
Value of underlying asset: PV of expected project cash flows (V)
Exercise price: Salvage (recovery) value of assets (X)
Option exercise decision: abandonment (exit) decision only if V < X ;
payoff on exercise = X – V
37
What are real options
- Any strategic flexibility to wait and see, invest further, shrink or abandon the project, or switch it to another in response to new information
- These options are a right but not an obligation
- The option exercise decisions can be optimally made to maximise project value after receiving new information in the future
38
Standard NVP vs Real option analysis
- Standard NVO analysis is static Treats each project decision as “now or never” decision.
Only based on the information available now.
- Real option analysis is dynamic
Captures managements flexibility.
Expands project value by assuming that at each stage in the future, management will actively improve its upside potential while limiting downside losses.
39
Conditions for a real option to exist
1. news will arrive in the future
2. when it arrives, the news may affect managers’ decisions
40
Types of real options
* Option to delay making an investment (a timing option)
* Option to expand operations by making follow up investments (a growth option)
* Option to abandon the project (an exit option)
* Option to vary the output or production methods (a flexibility option)
41
Option to vary the output or production methods (a flexibility option)
- Firms often have the right to determine the timing of their investment in a project.
- Advantage: delaying provides the chance to response to new market information (e.g. market demand or new technology).
- Disadvantage: delaying may reduce the PV of cash flows (due to firm missing early cash flows due to competitors’ moving first etc.)
- This option may not come without costs as the firm may need to maintain access to market information or obtain a licence/patent so that it can act in the future.
Call Option
42
Option to expand operations by making follow up investments (a growth option)
o Taking a project today may allow a firm to expand its operations later if the original project is successful
e.g. Why did Amazon sell millions of Kindle Fire tablet at almost zero profit?
o Even though the original project itself may have a negative NPV, it may be worth taking if it provides the firm with a chance (option) to make follow-up investments in the future
Call Option
43
Option to abandon the project (an exit option)
- A firm may sometimes have the option to abandon the project if it turns out to be unsuccessful
- This option exists when
1. A firm retains the right to abandon a project and realise salvage values associated with the project’s assets.
2. There is a “get-out” clause if things don’t go to plan.
Put Option
44
Option to vary the output or production methods (a flexibility option)
- A flexibility option arises when a firm can revise its operating decisions for a fixed cost in response to market conditions
- Examples
Option to alter production rate
respond to chances in demand
Option to differentiate/alter production → switch product lines
Option to switch inputs/technology → ability to incorporate more efficient production process
Call Option
45
Financial vs. Real Options
Financial:
- short maturity
- underlying assets are financial assets - stocks, commodities
- underlying market price drives value; limited opportunity to manipulate
- marketable and traded in exchanges and OTC
- well established trading and pricing conventions
Real:
- long maturity
- underlying assets are real assets (project cash flows)
- managements forecasts and degree of flexibility affect value
- not traded, are firm specific
- not comparable with other options/assets in the market
- not clear how rigorously firms value real options
46
Evidence of Real Option
- Firms absorb losses before abandoning negative NPV projects
Reflecting option to resume production
- Foreign importers/exporters slow to withdraw from markets even after an adverse currency movement. (exchange rates change consistently)
Option to participate in market if currency rates rebound is lost after withdrawal
47
Horizontal takeovers
- Target and acquirer are in the same industry
- E.g. Facebook’s WhatsApp acquisition; Bank of America’s acquisition of Merrill Lynch.
48
synergy
the increased value created when two companies merge or acquire each other, exceeding the sum of their individual values
49
Verticle takeover
- Target industry buys from or sells to acquirers’ industry
- E.g. acquisition of Tele Atlas (digital map data) by TomTom (car navigation device manufacture)
- E.g. Buy own supplier to increase synergy (the increased value created when two companies merge or acquire each other, exceeding the sum of their individual values)
50
Conglomerate takeovers
- Target and acquirer operate in unrelated industries
- E.g. Wesfarmers acquisition of Coles
51
Friendly takeovers
- Typically approved by the targets management
52
Hostile takeovers
- Typically resisted/not approved by the target’s management
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Reverse takeovers
- A private company acquires a public company
- Easier route to becoming publicly listed than by doing a proper UPO
e.g. Sigma Healthcare’s takeover of Chemist Warehouse
54
Financing a takeover: Cash bid
* Pays cash to the target’s shareholders for their shares
55
Ads of a cash bid
- Certain and clearly understood by the target management and shareholders
- Improves the chance of a successful bid
56
Disads of a cash bid
- Raising the necessary cash can be difficult for the bidder if the target is large
- It’s possible that the bidder’s debt rating will do down if it issues new bonds or borrows more to fund this transaction
57
Financing a takeover: share (scrip) bid
* The bidder issues new shares to swap them with target shares (called a stock-swap transaction/share-exchange bid)
58
Ads of a share bid
- Avoids strain on the cash position of the bidder
- Has a relative tax advantage because cash acquisitions may create immediate tax labilities for the target shareholders
59
Disads of a share bid
- Equity issue is an expensive way of raising capital
60
Sensible reasons for a takeover
* Operating synergies (costs decrease, revenues increase)
- Economies of scale – produce more of the same (or a very similar) product (leading to lower per-unit costs)
- Economies of scope – share expertise and//or complementary resources across firms
* Replace poor current target management (company being poorly run)
* Market power (good reason, but cannot be the primary reason)
- Acquiring a major rival reduced price competition and increases profits, but these types of acquisitions are subject to regulation due to antitrust laws
* Tax savings
- A conglomerate may have a tax advantage over a single-product firm because losses in one division can offset profits in another division
61
Dubious reasons for Takeovers
* Diversification
- Like a diversified portfolio, diversified firms can bear lower unsystematic (idiosyncratic) risk (risk reduction)
- But shareholders can diversify themselves by purchasing shares in different companies, so they don’t need managers to diversify the firm through (costly) takeovers
* Managerial motives
- Empire-building behaviour (managerial agency costs)
- Overconfidence (hubris hypothesis)
62
Market capitalisation
= no. of shares outstanding * current stock price
63
Acquisition premium (net cost)
offer price paid for the target – the target’s stand-along value (its pre-bid market capitalisation if public).
64
Off-market bid (to pass 20% threshold)
Written offer (cash or scrip) made to ALL shareholders for a fixed proportion of their shareholding.
Offer must remain open from 1-12 months and conditions can be attached.
Acquirer may increase offer but must pay increased price to all shareholders including those who have already accepted the offer.
65
On-market bid (to pass 20% threshold)
Cash offer made to ALL shareholders.
The offer must remain open from 1 to 12 months and NO conditions can be attached.
If the acquirer increase their offer, the increased price does not need to be paid to those who have already accepted.
66
Schemes of arrangement (to pass 20% threshold)
Court approved arrangement between company and another party that can include a reconstruction or re-organisation of assets, liabilities and share capital.
Target shareholders vote for 100% acquisition by bidder
- At a convened meeting:
* It requires approval by 75% of the voting shares at the meeting PLUS 50%
by number of members at the meeting.
67
Creeping bid (to pass 20% threshold)
- Ability to increase shareholding by up to 3% every 6 months.
- No public statement is necessary.
68
Takover defences
(1) Poison Pills (for example, with a 20% trigger)
e.g. if a bidder buys more than 20% shares of a company, the existing shareholders are issued rights that give them the chance to purchase additional shares in the company at a discount, thereby severely limiting bidder’s voting rights.
(2) Staggered Board (Classified Board)
The board is classified into three equal groups, each of which is elected each year. So, the bidder cannot sufficiently change the board (that is, appoint its own nominated directors) immediately and try to gain control of the target.
(3) Golden Parachutes
Offering lucrative benefits to the target firm’s top executives who may lose their jobs because of a takeover.
Discourages takeover attempts by increasing the cost of takeover.
Effectiveness is limited by ASX listing rules and the courts under s. 1325C
- Court may declare void a benefit given to a director within 12 months of a takeover where the benefit was unfair/unconscionable.
(4) White Knight
The target looks for another, friendlier company to acquire it.
(5) White Squire
A large, passive investor or firm agrees to purchase a substantial block of shares in a target with special voting rights.
Presence of a white squire frustrates the ability of a hostile acquirer to buy the target.
(6) Other defensive strategies
- Require supermajority (typically 80%) of votes for takeover
- Require that a “fair” price be paid for the company
- Restrict the voting rights of very large shareholders
- Appeal to national interests, ACCC, the Takeovers Panel
69
Business restructuring
Significant changes in the mix of assets owned by a firm or the lines of business in which a firm operates (redefining the optimal boundary of the firm).
Contraction: divestitures, spin-offs, equity carve-outs.
70
Organisation restructuring
Significant changes in the organisational structure of the firm.
Divisional redesign and employment downsizing.
70
Financial restructuring
Improvements in the capital structure and/or ownership/control of the firm.
Leveraged transactions (LBO/MBOs) and debt restructuring.
71
Why restructure?
- To better align the interests of shareholders and managers (agency problem)
- To transfer assets to owners who can better utilize these assets
- To provide a sharper focus for management who may lack the skill set to manage different types of business
- To correct strategic mistakes of management
- Reflects new information about the value of various parts of the company to another party
- To prevent cross-subsidisation (where poor performing units are kept afloat by the star
performers)
So – breaking up business lines can sometimes create value, almost as if there are negative synergies in grouping assets together.
This process is often referred to as unlocking the diversification discount!
72
Types of business restructuring: Divestitures
- The sale of assets (or business segment) to a third party that can manage them most effectively
- Funds from the sale of assets are retained by the firm
- No control over the assets after the sale
- The simplest way to make a company’s business simpler and more focused
Divestitures could occur because of
- Negative synergy arising from poor decisions on past acquisitions
- Management’s lack of the expertise to run the company in its current state
- Needs for funds for the company (e.g., pursuing other investments or paying off some of existing debt, in particular after LBOs)
- Regulatory authorities (e.g., ACCC) demanding divestiture, for example, in order to create competition
73
Types of business restructuring: Spin-Offs
- In a “spin-off” a firm will establish one of its operating units as a separate listed entity.
- All of the shares in the newly established listed entity are distributed to existing shareholders on a pro-rata basis (so managers have no money coming in).
- No money comes into the parent company
- Widen investors’ choice by allowing them to invest in just one part of the business
- Better alignment of interests of management with shareholders (easier to monitor and reward managers. If it’s a high growth business shareholders want you to generate higher returns/low growth business – stable returns)
- For companies with multiple lines of business it increases transparency for investors
- Sometimes, a demerger can precede a takeover (e.g., Foster's demerged from its Treasury Wine and was acquired by British beverage giant SAB Miller)
74
Types of business restructuring: Equity carve-outs
Instead of having 100% ownership of the asset, now the parent firm has the majority ownership (typically 80%) in the subsidiary and the cash from selling part of subsidiary’s shares.
Total value of the parent firm may be higher because of the restructuring.
Shareholders are not worse off because their ownership in the parent firm is not affected, and they still benefit from the subsidiary because of the parent’s ownership in the carved-out subsidiary.
- A company establishes a new listed entity – like spin-offs – but shares in the new entity are sold off to the market (minority) (via an IPO)
- Parent company typically maintains a significant shareholding in the new entity.
- Similar to spin-offs, except that parent company sells a percentage of the equity of a subsidiary to the public stock market (partial IPO – it’s not an IPO because that division was already a part of a publicly listed firm, but because now a standalone company in the public markets can think about it like a partial IPO).
- Parent company receives cash for the percentage of shares sold in the new entity and retains the remaining shares.
- Can sell any percentage, often sell just less than 20% (minority portion) is chosen so that it retains control.
Why sell a partial stake?
- Alternative to equity financing: the parent company can get funds by issuing its subsidiary’s equity (when it has some difficulty in raising capital in a usual way)
- Showcase the subsidiaries to prospective future buyers as part of a two-stage process:
* Get the stock market to understand the subsidiary business
* Once the subsidiary is re-valued, the parent may also be re-valued because it still owns the remaining shares
* May subsequently spin off the remaining shares to existing shareholders
75
Financial restructuring: leveraged transactions
- When a small group of investors purchase a company by using high proportion of debt.
- The company (if a public company) goes private (not permanently though)
* If these investors are institutional (private equity firms), it is a leveraged buyout (LBO)
* If these investors mostly include the existing management, it is a management buyout (MBO)
- Greater focus to cut expenses, dispose non-core assets, tax benefits, increase efficiency.
- Can only be done in certain firms: Need assets with debt capacity + stable cash flows.
- Target firms are mainly existing or mature firms with low risk that have enough assets and can generate stable cash flows
76
Financial restructuring: debt restructuring
- Debt restructuring is the reorganization of companies’ outstanding liabilities when they are facing difficulties in repaying their debt payments (in financial distress)
o This process is usually less expensive and a preferable alternative to bankruptcy for creditors
- Debt may be settled at the time of restructuring
* Debt-for-equity swap: creditors agree to accept the company’s equity instead of receiving debt payments
- Debt may still exist but with modified terms
* Bondholder haircuts: reduce or delay the promised interest payments and principal repayment
77
Behavioural finance
- Rationality Assumption
Traditional View: Managers are fully rational, profit-maximising agents who act solely in shareholders’ interests.
Behavioural Insight: Real managers exhibit biases—especially overconfidence—that can lead to suboptimal decisions.
- Winner’s Curse in M&A
Core Idea: “If you win the auction, you probably overpaid.”
In a competitive bidding process, each bidder estimates the target’s value.
The highest bid comes from the bidder whose estimate errs most on the upside.
Result: Winning reflects the largest valuation mistake.
Why It Matters: Overpaying erodes the acquiring firm’s returns and destroys shareholder value.
- Overconfident CEOs
Option Exercise: Tend not to exercise (cash-in) “in-the-money” stock options, believing they can drive even higher share prices.
M&A Behavior:
Pursue more—and often diversifying—mergers.
Overestimate synergies; neglect potential costs and integration challenges.
Frequently fall victim to the winner’s curse.
- Market Reaction to Overconfidence
Investor Skepticism: Markets spot overconfident CEOs and discount their bids.
Share Price Impact:
Announcements of deals by overconfident CEOs often trigger larger share-price drops in the acquirer.
Reflects investors’ belief that the deal is overvalued and value-destructive.
- Debt Piling by Overconfident CEOs
Behavioral Tendency: Load the firm with debt, expecting to generate enough future cash flows to service it comfortably.
Risk: Overleveraging increases financial distress costs if cash‐flow forecasts prove too optimistic.
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Overoptimism
Overoptimism is usually modelled as an overestimation of an outcome – overestimating the probability of a good outcome or underestimating the probability of a bad outcome.
Associated with higher investment.
Overconfidence and overoptimism have obvious costs, but they can also help shareholders by encouraging risk-averse managers to take good risky or innovative projects
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Financial Distress
Financial distress is a situation where a firm’s operating cash flows are not sufficient to satisfy current obligations, and the firm is forced to take corrective action.
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What happens in financial distress?
Financial distress does not usually result in the firm’s death.
Firms deal with distress by:
- Selling major assets.
- Merging with another firm.
- Reducing capital spending and research and development.
- Issuing new securities.
- Negotiating with banks and other creditors.
- Exchanging debt for equity.
- Filing for bankruptcy.
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Liquidation
Liquidation means termination of the firm as a going concern.
- It involves selling the assets of the firm for salvage value.
- The proceeds, net of transactions costs, are distributed to creditors in order of priority.
Choice between liquidation and reorganisation typically depends on the judgement whether the firm is worth more ‘dead’ or ‘alive’
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Reorganisation
Reorganisation is the option of keeping the firm a going concern.
- Reorganisation sometimes involves issuing new securities to replace old ones and selling assets to pay off debt
Choice between liquidation and reorganisation typically depends on the judgement whether the firm is worth more ‘dead’ or ‘alive’
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Absolute priority rule
Proceeds of liquidation are distributed as per the absolute priority rule (APR)
- Higher you are on this list, more likely your claim will be paid
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Investment distortions when a firm is close to bankruptcy
Excessive risk-taking (asset substitution)
- Shareholders have unlimited upside potential but bounded losses
- When a firm faces financial distress, shareholders are tempted to gain by gambling (negative NPV projects) at the expense of debt holders
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Debt overhang (underinvestment)
- When a firm is in financial distress, managers may prefer to pay out cash to shareholders - perhaps in the form of a dividend - than fund projects (even positive NPV projects) because most of the benefits would go to the firm’s existing creditors
- New shareholders will not buy equity at existing prices but require a substantial discount
- Existing shareholders will reject this as their interests are diluted.
These distortions are likely to occur when there is a significant probability of bankruptcy.
*The deeper the discount on issued shares the more existing shareholders ownership is diluted + proceeds from project will first flow to debtholders.
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Corporate risk
The exposure of a company’s earnings, cash flows, or market value to uncertain external factors or events.
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Sources of corporate risk: market risk
- Price movement in financial market
* Such as interest rate, exchange rate and commodity price risks
* Can be managed using financial derivatives or other financial contracts
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Sources of corporate risk: Commercial (operational risk)
- Inherent in the operations of the firm
- Generally subject, to a certain extent, to management’s control or influence
- Failures of internal processes and unanticipated actions by competitors
- Cannot be managed with derivatives or other kinds of financial contracts
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Sources of corporate risk: External event risks
- Not necessarily firm-specific
- Stem from non-market events such as natural catastrophes or changes in tax or regulatory policies (insurance companies not issuing policies)
- Can be managed using insurance products in many cases
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Risk management
Risk management tries to reduce the uncertainty associated with a firm’s future outcomes.
- The ideal objective of risk management is to remove bad outcomes without affecting good outcomes
- Similar to options that give us the ability to cut losses (future payoff is bounded at zero)
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Value-at-Risk (VaR)
- VaR is an attempt to quantify (downside risk)
- VaR asks what an unexpectedly bad outcome is
* VaR of $1 million over the next day at a probability of 0.05 means only with 5% chance, there will be a loss over $1 million
* It is one number that says what a bad loss means
* For given p: “What is a dollar amount VaR such that the probability of an outcome worse than VaR is no more than p?”
- Financial institutions use VaR a lot for capital adequacy requirements
* How much capital is needed to be able to handle the p%-tile bad outcome?
- Specify a probability of loss, p%
- VaR is the cut-off point such that the area to its left is p%
- This is just a quantile of the distribution
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Risk management tools: derivatives
- Financial security whose payoffs are derived from performance of underlying assets, e.g., shares, commodities, bonds, interest rates, exchange rates or indices
- Derivatives are also used for speculation and executive pay
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natural hedge
- Reducing the undesired risk by matching cash flows
- Suppose you make stuff in Australia to sell in Germany
* If you open a production facility in Germany, you can match revenues and costs in the same currency
* If I borrow money from somewhere else in the EU, I can use the sales from the German market to help cover interest costs in the same currency
* So, you can reduce “net exposure” and need much less hedging
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Winners curse (IPO underpricing)
Information asymmetry (winner’s curse) suggests that IPOs should be
underpriced on average to ensure that uninformed investors stay in the market.
This is because informed investors have an information advantage over
uninformed investors.
Also, uninformed investors are important because informed investors may have capital constraints.
Def: The highest bidder tends to be the one who most overestimates the asset’s true value—so “winning” usually means you paid too much.
Each bidder has a private estimate of value with some error.
The bid errors are random; the largest positive error wins the auction.
That positive error means the winner overpaid relative to the asset’s actual worth.
“If you win, you’re the biggest loser”—because your valuation mistake exceeded everyone else’s.
Informed: possess firm-specific insights, bid when they spot underpricing.
Uninformed: lack inside information, bid “blind” and risk being the unlucky over-payer.
At a “fair” price, only informed investors participate, leaving uninformed sidelined and shrinking demand.
Firms set the IPO price below expected true value so:
Uninformed investors get a guaranteed Day-1 “pop”.
Their expected payoff turns non-negative.
Broad demand (larger, more diversified investor base) is secured and adverse selection is mitigated.
Underpricing is a deliberate “discount” to neutralise the winner’s curse—ensuring uninformed investors aren’t deterred and the offering succeeds.
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Diversification discount
The “diversification discount” is the market’s penalty on firms that run too-many unrelated businesses. Investors fear (a) inefficient cross-subsidies, (b) harder monitoring of managers and (c) overinvestment in low-return units. As a result, a multi-segment group trades at a lower multiple than each division would on its own. By carving out or spinning off a subsidiary, the parent sheds complexity, so both the parent and the stand-alone subsidiary command higher valuations. Existing shareholders keep the same economic stake yet capture the uplift once the discount is removed.
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Beta
Measures a security’s sensitivity to overall market movements—in other words, its systematic (undiversifiable) risk.
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Value of the real option
NPV with option - NPV without option
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Stock based insolvency
The value of the firm’s assets is less than the value of the debt.
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Flow based insolvency
Occurs when the firms cash flows are insufficient to cover contractually required payments.
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Z Score < 1.81
Indicates high probability of bankruptcy
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Z Score between 1.81 and 2.99
Is a grey area
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Z Score > 2.99 indicates a low probability of bankruptcy
Indicates low probability of bankruptcy
