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Erasmus University > Corporate Finance > Flashcards

Corporate Finance Flashcards

1
Q

Who are the claimants of a firm?

A

NOT JUST EQUITY AND DEBT, but government claims, non-financial liabilities (e.g., A/P), pension liabilities, etc.

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2
Q

Name the 2 rights for equity and debt holders

A

2 types of rights:
- cash flow rights: contracts how the cash flows will be allocated between different types of investors
- control rights: allow the claim holders to enforce their cash flow rights

EQUITY:
- cash flow rights: usually last dibs, but unlimited upside
- control rights: shareholders can elect the corporate board, which appoints and supervises the management

DEBT:
- cash flow rights: bonds are like loans that promise a specific payoff
- control rights: typically no control rights, unless the firm is in default. then they can file for bankruptcy

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3
Q

What is the MM Theorem?

A

In perfect capital markets, borrowing and lending can happen at the same rates. Under these assumptions, capital structure has no influence on the firm value.

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4
Q

What is MM Proposition 1?

A

In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure. This follows from a no-arbitrage argument.

Note: this is about market values, not book values!

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5
Q

What is MM Proposition 2?

A

The weighted-average return is equal to the return on unlevered equity.

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6
Q

In a MM world, why is the capital structure irrelevant?

A

If investors would prefer an alternative capital structure to the one the firm has chosen, investors can borrow or lend on their own and achieve the same result (using homemade leverage).

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7
Q

Give the formula for return on equity following from MM Proposition 2

A

rE = rU + (D/E)*(rU-rD)

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8
Q

Give the formula for pricing risky debt

A

(E(R) - Rf) / (rH - rL)

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9
Q

What are the 6 assumptions behind the MM propositions?

A
  1. No taxes
  2. No financial distress costs > financial distress and bankruptcy may still arise, but this does not lead to additional costs or a reduction in cash flows generated by the firm
  3. No asymmetric information
  4. No transaction costs
  5. Managers/employees always maximise firm value
  6. Borrow/lending at the same rate
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10
Q

Name the 4 fallacies

A
  1. Debt is cheap fallacy
  2. EPS fallacy
  3. Equity issue dilution
  4. Payout fallacy
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11
Q

Explain the ‘debt is cheap fallacy’

A

Fallacy: ”Debt is cheaper than equity because it has a low interest rate”

  • Indeed, often debt has a lower interest rate than equity
  • But increasing leverage comes at the cost of increasing the cost of equity capital
  • Increasing leverage to a point where debt is risky, the required return on debt also increases!

This follows from MM P2

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12
Q

Explain the ‘EPS fallacy’

A

Fallacy: “Debt is desirable when it increases EPS”

  • EPS can go up (or down) when a company increases its leverage (TRUE)
  • Companies should choose their financial policy to maximise their EPS (FALSE)

Suppose a firm issues debt to buy back shares. This does not benefit shareholders. While the E(EPS) goes up, the share price remains unchanged. But, this is due to an increase in the required rate of return on equity (higher risk). This explains the same share price despite higher EPS!

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13
Q

Explain the ‘equity issue dilution’ fallacy

A

Fallacy: “Equity is more expensive than debt because equity issues dilute the EPS and drive down the stock price”

  • Earnings per share are lower under equity financing rather than debt (see EPS fallacy)
  • But the value of the shares are the same after an equity issue; extra EPS in levered firm is compensation for risk (see EPS fallacy)
  • As long as investment is positive NPV, original shareholders will be happy to issue shares
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14
Q

Explain the ‘payout fallacy’

A

Fallacy: “The company should pay out its cash rather than just invest in government bonds at a low interest rate. This would increase investor returns”

A firm can choose to pay out a dividend, or retain the cash and invest in gov’t bonds. If the cash is not paid out and the firm invests in gov’t bonds, investors lose the dividend but gain the increased future cash flow from the bond interest. As long as excess cash retained earns a market return, net payments to financial markets do not matter!
- €100𝑚 of excess cash today is worth €100𝑚 regardless of whether it is paid out now or later

Total payout policy does not matter under MM, as long as retained cash flow earns a fair market return!

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15
Q

Give the formula for the effective tax advantage of debt

A

T* = 1 – (1-Tc)(1-Te)/(1-Ti)

Gives: vL = vU + D x T*

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16
Q

Explain the Low Leverage Puzzle

A

If capital structure was only about taxes, firms should have relatively high leverage. This is not the case: it would appear that firms, on average, are under-leveraged. There seems to be more costs:
- Bankruptcy costs
- Agency costs
- Asymmetric information costs

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17
Q

Name the 2 bankruptcy proceedings

A
  1. Liquidation = sell all assets of the firm and use proceedings to pay debt holders
  2. Reorganization = continue to operate the business
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18
Q

What is the difference between financial distress and economic distress?

A
  • A firm that makes significant losses is in economic distress
  • Whether economic distress results in financial distress depends on the firm’s leverage
  • An all-equity (unlevered) firm can be in economic distress, but it will never face bankruptcy
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19
Q

What are direct costs of bankruptcy and what are indirect costs?

A

Direct costs (less than 1% when weighted with probability of bankruptcy)
- legal expenses
- court costs
- advisory fees

Indirect:
- missed investment opportunities
- ability to compete in product markets
- loss of customers, employees and suppliers
- fire sale of assets > explains why tech-firms have low leverage
- delayed liquidation
- loss of receivables
- costs to creditors

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20
Q

Who pays for the costs of financial distress, and explain why

A
  • Ex-post debt holders pay for the cost of financial distress
  • But this is priced in ex-ante (higher interest rate on debt)
  • In equilibrium, shareholders pay the cost of financial distress!
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21
Q

Which 3 factors determine the PV(financial distress)?

A
  1. Magnitude of the costs after a firm is in distress > higher for firms with more intangible assets and important employee and customer relationships (e.g., tech firms)
  2. The probability of financial distress > increases when leverage, CF volatility and asset volatility increases.
  3. The appropriate discount rate for the distress costs > depends on the firm’s market risk
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22
Q

Explain risk shifting

A

An incentive for shareholders to take excessive risky projects. Shareholders can benefit even if projects have a negative NPV (OVER-INVESTMENT). This is most relevant fro firms with relatively high leverage, or close to financial distress.

Also referred to as asset substitution because it often involves replacing low risk assets with riskier assets.

The key friction here: moral hazard > actions by agents are unobservable > any action needs to be incentive-compatible!

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23
Q

Name 2 situations when shareholders have a stronger incentive to take risky projects, and give the main reason why they would do this. Also give a solution to this problem

A
  1. Debt level is too high (high D)
  2. Firm is able to shift value from default states to no-default states (high X)

If this is the case, shareholders will choose the risky project, even though it has a lower NPV than the safe project!

Reason: limited liability > when the firm defaults, payoff of shareholders is capped at 0. That way they are able to shift risk on debt holders.

Solution: finance the investment with equity. Then, the manager will choose the right project.

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24
Q

Explain risk shifting with the option analogy

A

Equity holders are long a call option on the firms assets with strike D
Debt holders are short a put option on the firms assets with strike D

Shareholders like risk because they are long in the call
Debt holders dislike risk because they are short in the put

The value of the options increase in risk (volatility) increases.

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25
Q

Explain debt overhang and how to overcome the problem

A

Shareholders may not undertake positive NPV projects
- The problem arises when undertaking new projects mostly benefits existing debt holders
- Similar to risk shifting, most relevant for firms with relatively high leverage (close to financial distress)
- In contrast to risk shifting, debt overhang implies that shareholders may choose to forego positive NPV investments > UNDER-INVESTMENT

Shareholders will forego a positive NPV project if D is too large and increase leverage (by paying out cash), even though this reduces firm value.

Issuing new equity to finance the project or issue new debt will not benefit shareholders, so will not help.

Solution: renegotiate the principal to a lower level D’ < D

26
Q

Explain what the Leverage Ratchet Effect is

A

Once existing debt is in place…
1. Shareholders may have an incentive to increase leverage even if it decreases firm value
2. Shareholders may have no incentive to decrease leverage, even if it increases firm value

Over time, this can lead to a gradual increase in leverage!

27
Q

What is the coordination problem of debt forgiveness?

A

The debt of a company is widely dispersed. So everyone needs to agree to write down their debt claim (D’ < D). A coordination problem arises due to strong free-riding incentives:
- Suppose all other investors write down debt and the debt overhang problem is resolved
- Best to be the one investor who continues to hold a claim 𝐷
But if everyone tries to do that, there will not be sufficient write-down of debt

28
Q

Name the 2 agency costs of debt and 1 agency benefit of debt

A

Costs:
- Risk shifting
- Debt overhang

Benefits:
- Motivating effort: leverage can align the incentives of owners/managers to maximise firm value and run the firm in the best interest of shareholders

29
Q

What is the difference between moral hazard and adverse selection?

A

Moral hazard: is associated with asymmetric information about an action

Adverse selection: asymmetric information about the type of an individual/asset/firm/…

30
Q

Name 2 ways how a separating equilibrium is possible

A
  1. Certification
  2. Signaling > must satisfy no-mimicking constraint!
31
Q

Explain the pecking order hypothesis under adverse selection

A
  • To finance investments, firms prefer to first use internal resources (cash), then debt, then equity.
  • Reason: least information-sensitive source of financing reduces the cross-subsidy from good to bad types.
  • Most relevant when there is asymmetric information about the value of new investment.
32
Q

Does a pooling/separating equilibrium lead to over- or underinvestment?

A

Pooling equilibrium: leads to over-investment because negative NPV projects of bad firms are also financed!

Separating equilibrium: leads to under-investment because positive NPV projects of good firms are not financed!

33
Q

Suppose the owner has access to an investment opportunity. He can either exert high effort or low effort, with the probability of ending up at vH is much higher under high effort. To what extent is incentive related to the degree of effort for 1) risk-free debt, 2) risky debt, 3) equity financing?

A
  1. Risk-free debt > high effort
  2. Risky debt > medium effort
  3. Equity financing > low effort

With (1), all the upside potential in the High state is for the owner himself. So, he has a big incentive to exert high effort. If the project was financed with risky debt, the owner would have to partly give up some upside potential to pay-off the risky debt. So the owner has medium effort to exert high effort. If the project was financed with equity, a big part of the upside potential will go to the other equity holders. Therefore, the owner has limited incentive to exert high effort.

34
Q

Are shareholders better off if they can expropriate bondholders?

A

Shareholders are only better off ex post. Bondholders are not “stupid” and, ex ante, firms have to pay higher interest rates which can only make them worse off.

35
Q

Explain 3 forces that can make debt cheaper than equity for corporate financing

A
  1. the tax advantage of debt
  2. the reduction of money wasting (free cash flows)
  3. the managerial signal of confidence that a debt issue implies.
36
Q

Briefly explain costs of financial distress with respect to firm-supplier relationships. What industries might be affected the most?

A

If suppliers fear that company can go bankrupt, they may not extend trade credit. Alternatively, suppliers might be less willing to make specific investments (e.g., buying or adjusting a machine that can only produce product for that customer). Examples are industries where trade credit is important (e.g., many retailers) or firms/industries that use very specific, tailor-made products in the production process.

37
Q

What does the fee structure of a VC fund look like?

A
  • management fee (2% of AUM)
  • carried interest (20%-30% of any positive return they make)
38
Q

Explain how VCs invest in mature companies vs young companies

A

Mature companies: preferred stock issued by mature companies usually has a preferential dividend and seniority in any liquidation and sometimes special voting rights.

Young companies: preferred stock issued by young companies has seniority in any liquidation but typically does not pay regular cash dividends and often contains a right to convert to common stock.

39
Q

Name 2 exit strategies how private investors can sell their shares

A
  1. IPO
  2. Acquisition by a larger firm
40
Q

IPO: 2 types of offerings

A
  1. Primary offering = new shares available in a public offering that raise new capital
  2. Secondary Offering = shares sold by existing shareholders in an equity offering
41
Q

Name 2 pros and 2 cons for an IPO

A

Pro:
- Greater liquidity: private equity investors and initial founders get the ability to diversify.
- Better access to capital: public companies typically have access to much larger amounts of capital through the public markets.

Cons:
- The equity holders become more widely dispersed. This makes it difficult to monitor management.
- The firm must satisfy all of the requirements of public companies (for example, disclosure regulations).

42
Q

Name the 3 types of IPO

A
  1. Best-Effort Basis: underwriter does not guarantee that the stock will be sold, but instead tries to sell the sock for the best possible price.
  2. Firm Commitment: underwriter guarantees that it will sell all of the stock at the offer price. Underwriter purchases all shares (below offer price), and then sells them at offer price. They also take the loss if not all shares are sold.
  3. Auction IPO: underwriter in an auction IPO takes bids from investors and then sets the price that clears the market.
43
Q

What is an SEO, how is it different to an IPO, and what are the 2 types of offerings?

A

SEO: a public company offers new shares for sale to raise additional equity

Main difference to IPO: market price for the stock already exists, so the price-setting process is not necessary

2 types of offerings:
- Cash offer = firm offers the new shares to investors at large
- Rights offer = firm offers the new shares only to existing shareholders (protects existing shareholders from underpricing)

44
Q

Name 4 IPO puzzles

A
  1. IPO underpricing
  2. High IPO/SEO underwriter fees
  3. Cyclicality in IPOs
  4. Negative stock price reaction to SEOs

Adverse selection can help explain these puzzles!

45
Q

IPO underpricing: who benefits and how bears the costs?

A

Benefit: underwriters, since it allows them to reduce risk

Bear the costs: pre-IPO shareholders since they essentially sell their shares for less

46
Q

What could be one explanation for high IPO/SEO fees?

A

One possible explanation is that by charging lower fees, an underwriter may risk signaling that it is not the same quality as its higher- priced competitors.

47
Q

When do firms generally issue equity?

A

Firms tend to issue equity when information asymmetries are minimized, such as immediately after earnings announcements.

48
Q

How can adverse selection help explain negative stock price reaction to SEOs?

A
  • We will consider different types of firms that differ in the quality of their assets (good firms /bad firms).
  • In a pooling equilibrium, good firms cross-subsidise bad firms and both issue equity > happens when issuing equity has a positive payoff for both firms.
  • In a separating equilibrium, good firms may stay out of the market since the cross-subsidisation is so large that the expected payoff of issuing equity is actually negative (leads to under-investment).
  • Understanding that now only bad firms issue, investors revise a firm’s value downwards when it issues shares.
  • If the NPV of a bad firm is actually negative, no investor would invest in a bad firm since he would require an equity stake e > 1 to break-even, which is not possible. This leads to a market breakdown and under-investment.
49
Q

How can the Winner’s Curse help explain IPO underpricing? Also explain what the Winner’s Curse means

A
  • We will consider different IPO candidate firms that differ in their value (good/bad).
  • Some informed investors have superior information about which firms are good or bad, so they only buy shares in good firms and buy no shares in bad firms.
  • As a result, uninformed investors will end up over-subscribing to bad firms.
  • The initial offering price 𝑃0 must be below the expected firm value to compensate uninformed investors for the winner’s curse problem.
  • The stock price of good firms on the first day rises, while the stock price of bad firms on the first day drops. But on average the price increases, which also explains the average positive first-day return.

Winner’ Curse: the bid by uninformed investors is most “successful” (i.e., they receive the most shares) when the firm is a bad type. When the firm is a good type, uninformed investors only receive a fraction 𝑏 < 1 of the shares.

50
Q

What is the Private Equity Investment Cycle?

A
  1. Investors
  2. Invest in PE funds
  3. PE funds invest in companies
  4. PE funds exit their investment and distribute profits
51
Q

Name the formulas for Post-/Pre-Money valuation

A

Post:
1. price per share * fully diluted share count
2. investment / proposed ownership

Pre:
1. Post money valuation - investment
2. Price per share * pre-transaction fully diluted share count

52
Q

Which steps are there to value a VC opportunity are there?

A
  1. Construct pro-forma CFs
  2. APV/DCF analysis
    - taking deal as given -> minimum probabilities
    - taking probabilities as given > maximum pre-money valuation
  3. VC method / IRR analysis
    - taking deal as given -> is the IRR>VC hurdle rate
    - discounting exit value at hurdle rate -> maximum pre-money valuation
    - exit value from FCF or multiples
53
Q

What are some conflicts that contracts address?

A
  • Provide incentives to work towards value maximization
  • Screen for entrepreneurs willing to work towards this goal
  • Overcome differences in perceived valuation
  • Give VC the ability to make decisions if things go badly
  • Make sure the founder and employee stay within the firm
54
Q

What does ‘vesting’ mean?

A

The founder loses shares upon departure.

55
Q

What is a ‘drag-along right’ and ‘tag-along right’?

A

Drag-along: if VC sells shares, the entrepreneur has to sell as well. It helps to free up additional cash

Tag-along: if entrepreneur sells, the VC has the right to sell at the same terms

56
Q

What are the 2 types of staging investments?

A
  1. Ex-ante (within rounds) = only part of committed funds paid out up front, the rest in subsequent closings (tranches) at predetermined terms
  2. Ex-post (between rounds) = committed funding will only last a limited period, after which need to raise a new round of financing
57
Q

What are the effects of staging an investment?

A
  • Capture the real option value
  • Lowers the ability of the entrepreneur to waste funds
  • Increases the ability of the VC to get control when the manager runs out of funds and bad performance.
  • Even stronger incentives for managers to perform well
58
Q

What are the pros and cons to syndicate an investment?

A

PROS:
- Bring in different skills to the VC team
- Firm is not dependent on a singe VC
- Diversification for the VC fund (GP cares more about this!)
- Bring in “objective” VC to price follow-on round

CONS:
- Free-riding of VCs when their stake becomes too small
- VCs may disagree with each other (continue/liquidate)

Contracts try to mitigate this:
- Pay-to-play provisions = if majority of VCs decide to do a new round, non-participating VCs will be punished (loses anti-dilution protection or has to sell shares).
- Drag-along rights
- Need super majority to veto important decisions.

59
Q

Kaplan & Stromberg: they identified 3 risks VCs face

A
  1. Internal risks > management, previous performance, waste of funds
  2. External risks > market, competition, IPO environment
  3. Complexity / difficulty of execution > technology or strategy
60
Q

Name some common options and 3 important implications from option pricing models

A
  1. Option to stage investment
  2. Option to abandon
  3. Option to expand (! but if you wait to expand, it may not be available anymore if competitors step in !)
  4. Option value of flexible technology (e.g., Flexi-fuel cars use fuel that’s cheapest right now)

Implication 1: option value increases with volatility
Implication 2: option value increases with time-to-maturity
Implication 3: option value decreases if there are current dividends

61
Q

Explain how the value of a firm may change if a firm decides to increase its dividend payout? Link them to different capital structure theories in imperfect markets

A

If the firm increased its dividend payouts, its expected financial distress costs would go up as the probability of entering financial distress increases (tradeoff-theory). At the same time, agency/signaling costs would go down. Dividend policy can be a positive signal about private information. Increasing dividends can reduce excess cash and forces a firm to operate more efficiently. But they are not as credible as interest payments.

There might be other links as well, so the net change is not clear!

62
Q

Explain 3 forces that can make equity cheaper than debt for corporate financing

A
  1. Reduced likelihood of financial distress with associated deadweight costs
  2. Overvalued equity
  3. Bond holder expropriation

Erasmus University (18 decks)

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