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295 Cards in this Set

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Advantages to a company of putting debt into their capital structure
-lower corporate taxes
-forces managers to pay out excess cash (keeps them from wasting money)
Disadvantages to a company of putting debt into their capital structure
-higher personal taxes
-bankruptcy costs
-conflicts of interest between debt & equity holders
-debt covenants restrict freedom of action
2 reasons managers waste money
-empire build because of overconfidence in ability to generate profit
-better to be a manager running a big rather than a small company - more power & prestige & higher social status
Bankruptcy Costs - definition and examples
extra costs triggered by legal state of bankruptcy: legal fees, accounting costs, cost of bankruptcy specialists, etc.
What is the conflict of interest between debt and equity?
-bondholders don't care about the upside (how the company is doing); stockholders do care about the upside
-stockholders like risk because they gain on the upside and don't lose on the downside; bondholders don't like risk because they don't lose on the downside, and don't gain anything on the upside
Key factors for a profitable firm to consider regarding adding debt to the capital structure
-taxes are a big cost, so consider the tax benefit of debt
-consider bankruptcy costs as well
Key factors for an unprofitable firm to consider regarding adding debt to the capital structure
-bankruptcy costs are the key factor here
-you don't want to borrow when you're already losing money
Key factors for firms that generate a lot of cash to consider regarding adding debt to the capital structure
-forces managers to pay out cash
-in this type of firm, there is a capacity to waste large amounts of money, so these firms tend to borrow a lot
Key factors for R&D stage firms to consider regarding adding debt to the capital structure
-conflicts of interest between debt & equity
-these companies tend to avoid debt
What is the relationship between the bond rating on a company and the interest a company would have to pay?
the rating is more of a symptom, rather than a cause of the interest a company has to pay
How are bond ratings determined?
-a lot of it is based on financials: interest coverage ratios, debt to capital ratios, etc.
-also a subjective element, making it impossible to predetermine what rating a company would get
What does A/R have to do with the cash cycle?
Low A/R means a shorter cash cycle, and vice versa
What are two risks associated with holding a lot of cash?
-potential waste by managers
-could expose the firm to hostile takeover
What is the implication when a company enters into a lot of debt?
It indicates confidence in the company's future
What is the primary difference between public and private debt?
With public debt, companies can generate large amounts of funding, but with private debt, terms are more easily negotiated
What does the spread over LIBOR reflect, and can it be reset?
-it reflects the risk of the loan
-can be reset quarterly depending on cash flow or debt/cash flow rating (leverage ratio & debt/net worth are less important)
Can a credit limit be reset?
Credit amounts can be reset automatically depending on the same factors as the spread over LIBOR
What are common debt renegotiations?
-most are to increase the amount borrowed
-second most common is regarding maturity of the debt
Debt vs. Equity regarding dividend payouts
stockholders prefer dividend payouts, whereas bondholders prefer no payouts at all
How can you dilute bondholders' claims?
-by issuing other bonds with higher priority
-bond covenants generally protect against this
How can companies' acting in the interest of stockholders affect their choice of projects?
-if acting in the interest of stockholders, companies may take on higher risk projects and/or pass on lower risk, positive NPV projects after acquiring bondholder funds
Why do bond covenants usually restrict changes in accounting policy?
-because this ensures adherence to restrictions in dividend payout percentages
-dividend payout restrictions as a percentage of income aren't very effective if companies can play with the numbers to achieve higher payouts anyway
What is the difference in the cost of bankruptcy to companies with mostly tangible vs. intangible assets?
-bankruptcy is more costly to firms with mostly intangible assets
-it's more difficult to switch into riskier products when the firm has mostly tangible assets, as opposed to R&D being the primary asset
Why would borrowing from a subsidiary make sense in some cases?
it forces the subsidiary to pay out cash, rather than hoarding and ultimately wasting it
2 reasons why, on IPO, a stock would fall 2.5%
-the company feels their stock is overpriced, so they're dumping shares as quickly as possible
-if that isn't the case, the reduced price is just considered a cost of the IPO - maybe people think there's something wrong, even if there isn't
What does a debt rating indicate?
amount of leverage
Why has leverage been so high in the airline industry?
-capital intensive business
-makes sense to finance an airplane b/c the useful live is long
-may be a reaction to the labor situation:this could be the only way to raise capital (investors don't want to buy equity in a company that has to enter into union negotiations as soon as it becomes profitable)
Do low bankruptcy costs and high taxes have anything to do with the high leverage in the airline industry?
No
How can an airline regain power in union negotiations when it is doing well financially?
-could take on debt and make earnings lower
-could make steep interest payments in order to look less profitable
Benefits of bankruptcy for airlines
-abrogate leases & reduce equipment
-terminate pension plans
-abrogate less desirable labor contracts
-DIP financing available
-can sell assets to generate cash
-automatic stay
Costs of bankruptcy to airlines
-loss of contracts in derivatives markets, which have allowed them to hedge fuel costs
-direct costs of bankruptcy
-shareholder wealth is gone
-restricted as to the ability to make material changes in business like routes, etc.
-loss in sales
-more difficult to forecast sales, b/c people won't buy tickets a long way out from an airline in bankruptcy
The Pecking Order Theory of Capital Structure
*important*
-basically says companies don't care very much about capital structure, but they do care about the cost of raising funds
5 Alternative Ways to Issue Equity
-payment for mergers
-employee options or share grants
-convertible bonds
-dividend reinvestment & other direct repurchase plans
-warrants
How are convertible bonds an alternative way to issue equity?
the stock price will depreciate and bondholders will convert
Warrant
-like call options: right-to-buy options
-difference is that new shares are issued when warrants are issued
Typical payments received by bondholders
-regular coupon payment every six months
-principle back at maturity
What type of return to bonds have?
-stated return
-will not make more if company does well, but may make less if company does poorly and enters bankruptcy
Convertible Bond
-can be exchanged for stock at the discretion of the bondholder
Difference between bonds and convertible bonds
convertibles can offer a greater rate of return than the yield if the firm does well and it becomes worthwhile to convert to stock
Why is debt inherently less risky than equity?
bondholders & lenders must be paid off before shareholders receive anything
How much control do debtholders have in the running of a corporation?
-none: no vote for board, no say in how it is run
-as long as bond covenants and interest payments are fulfilled
Advantage of privately issued vs. publicly issued debt
can be more easily renegotiated
Types of Debt
-debenture
-mortgage bonds
-equipment trust certificates
-subordinated debt
What secures a debenture bond?
-the firm does not pledge specific assets
-backed by firm's good name
Where in the hierarchy of debt, is a debenture, in the event of a liquidation?
debenture must be paid off before stockholders are paid
What secures a mortgage bond?
firm's real estate holdings
Where, in the hierarchy, is a mortgage bond?
the bondholder gets first claim on the real estate, but must stand in line if the assets are not sufficient to pay off their claims
What secures an equipment trust certificate?
equipment like railroad cars or airplanes
Where, in the hierarchy, is an equipment trust certificate?
same as mortgage bond
Where in the hierarchy is subordinated debt?
paid after senior or unsubordinated debt
What is an indenture or trust deed?
-agreement between issuing firm and trustee representing bondholders in a public debt issuance
What restrictions are placed on a firm by an indenture?
-limits ability to sell assets
-limits dividends
-spells out timing and amount that must be paid to bondholders
What is a sinking fund provision?
-rather than paying off the whold bond issue at once, this forces the firm to pay off the bonds over a period of several years.
-most allow the firm to either call the bonds at par or repurchase them in the market
Fundamental question in corporate finance
how to raise funds for investments
Capital structure question
How should the firm's capitalization be structured over debt and equity?
Modigliani & Miller Proposition I
given perfect capital markets, capital structure is irrelevant
-means that the firm's financing decisions do not affect its value
What is the implication if investors can undo a financial policy, or, if they can do it themselves?
the financial policy is irrelevant
What is WACC?
return on firm's assets
Formula for WACC
=(D/(D+E)rD)+(E/(D+E)rE)
How does a firm's WACC or required ROR change with capital structure?
-it doesn't
-if two firms, one entirely financed with debt, the other with equity, have the same value today, and the same value in the future, they must have the same returns, so their WACCs will be the same
Modigliani & Miller Proposition II
the risk and required rate of return on equity increase in proportion to the debt/ equity ratio
Formula for M&M Proposition II
rE = rA + (rA - rD)(D/E)
What is the implication of M&M Proposition II?
-rA is constant
-because debt is paid before equity, it is less risky than the firm as a whole, so rD<rA
what is the relationship between rD and rA
rD<rA
what happens to the required return on equity as the firm borrows more?
it rises
When may capital structure become important?
if market imperfections prevent investors from being able to replicate or undo the firm's financial decisions
What is an example of an imperfection that favors debt?
corporate taxes
How do corporate taxes favor debt?
a cash payment to bondholders that is labeled interest is deductible from corporate income for tax purposes, while an otherwise identical payment to stockholders that is labeled dividend is not
Why is the tax advantage of debt exaggerated?
personal taxes are not considered
How may the tax savings from debt be lost?
if a higher before tax ror is required to induce investors sto buy debt and thus pay higher personal taxes
What are two reasons the effective tax rate on equity is less than on debt?
-both dividends and long-term capital gains are taxed at 15%, lower than the tax rate on interest
-investors can delay paying capital gains taxes for years by simply not realizing the gains; also, they can realize losses to offset gains
What happens to the control of the firm's assets when the firm is unable to make required payments to creditors? Is this a bankruptcy cost?
-controld of the assets reverts to the creditors
-this is not a bankruptcy cost
Why do stockholders get paid more upfront for the bonds they issue?
because bondholders get first claim on the assets in bankruptcy
Bankruptcy costs
-real costs associated with entering the legal state of bankruptcy
-court costs, attorney fees, bankruptcy consultants, costs of mgt. time devoted to bankruptcy
-also indirect costs like lost customers and employees
What do bankruptcy costs mean to bondholders?
-even less is available to pay out to bondholders in the event of bankruptcy, and so bondholders require a higher yield for their debt
What impact on bondholder yield is implied the more debt a firm has?
the more debt the firm has, the greater likelihood of bankruptcy and incurring bankruptcy costs, and the greter yield bondholders demand
Does management protect the interests of stockholders or bondholders more?
they pursue interests of stockholders even if the net loss to bondholders exceeds the benefit to stockholders
Do stockholders want to take negative NPV projects?
Yes - if there is enough debt outstanding and the projects are sufficiently risky
Why don't stockholders care how poorlly a firm does when it is bankrupt?
because their shares are worth nothing anyway
Do bondholders care about the downside or the upside of the firm?
-downside
-if a firm is barely bankrupt, they get most of their money back
-if it is deep in bankruptcy, they get very little back
What is a primary cost of conflicts of interest between stockholders and bondholders?
-management, acting for shareholders, may take negative NPV projects because the projects are risky
-with debt outstandig, shareholders gain when a firm does well; bondholders lose with a firm does poorly
-with no debt, shareholders do not gain from taking negative NPV projects - therefore, this is a cost of debt
Who ultimately pays the cost of the conflict of interest between debt and equity?
the shareholders, because bondholders demand a higher yield on their debt
Debt overhang
-the possibility of not taking safe, positive NPV projects
-a cost of having debt in the capital structure
When are conflicts of interest most relevant in practice?
when firms are highly levered
2 benefits of leverage
-lowers corporate taxes
-forces managers to pay out cash
3 costs of leverage
-higher personal taxes
-bankruptcy costs
-conflicts of interest between debt & equity
which has the lower tax rate: dividends & capital gains or interest?
dividends & capital gains
4 considerations in determining the maturity structure of debt
-matching maturities of assets and liabilities
-private information about the firm's risk
-liquidity risk
-conflicts of interest between debt & equity
How can debt maturity act as a signal of the company's risk?
-short-term debt can mean management's private info leads them to believe their debt is less risky than potential investors believe
-long term debt can mean management ghinks their debt is more risky than is known by potential investors
How could a firm minimize risk of liquidity troubles?
-issuing longer-term debt
What type of debt do firms with the lowest ranked bonds, lower ranked debt, who may be more likely to encounter liquidity problems hold on to?
longer-term debt
How can conflicts of interest lead firms to issue short-term debt?
-firms that have longterm debt may have to forego good but safe projects; if they have short term debt, however, the project is probably still available when the debt matures
-when a firm has long-term debt, they are tempted to take risky, negative NPV projects; but, if they have short-term debt, it has to be repaid before the outcome of the project is known. stockholders bear teh risk - if they refinance with debt, after the short-term debt has matured, the new debt demands a risk premium consistent with the actual risk of the project
What is the main benefit of public debt?
-when debt is issued publicly through a bond issue, there are a lot of bondholders
-large amounts can be raised this way
-each owns a relatively small amount, so the risk of any creditor is limited
Who buys private debt?
small group of lenders - insurance companies, banks, etc.
-each creditor has more exposure
-lower borrowing amount
Main advantage of private debt
more easily renegotiated
What does the spread over LIBOR reflect?
the risk of the loan
6 Factors the spread over LIBOR depends on
-cash flow variable
-debt/cash flow
-coverage ratio
-credit rating
-leverage ratio
-debt/net worth
2 factors the borrowing base depends on
-accounts receivable
-inventories
8 factors the covenants for default depend on
-debt/cash flow
-coverage ratio
-net worth
-tangible net worth
-debt/capitalization
-debt/net worth
-current ratio
-quick ratio
Do contingencies in the original agreement reduce the likelihood of renegotiation?
no - they seem instead to shape later renegotiations
How does controlling conflicts of interest through bond covenants increase the value of the firm?
-they make it difficult for managers to pursue policies which lower the total value of the firm while transferring wealth from debtholders to equityholders
-these constraints make stockholders better off when debt is issued because bondholders will be willing to pay more for the debt
4 major sources of conflict between stockholders and bondholders
-dividend payment (reduces quantity of assets backing debt)
-claim dilution (value of debt is reduced if debt of same or higher priority is issued)
-switching to high variance projects after bondholders have lent the firm money assuming that a lower risk project is being taken
-avoiding low-risk, positive NPV projects
Covenants that minimize conflicts over payout policy
-limit the company to paying out dividends from a portion of earnings and from equity issues
-restrict changes in accounting methods
Covenants that minimize claim dilution
-forbid the issuance of debt with higher priority
-subsidiaries forbidden from issuing debt
-borrowing by the subsidiary from the parent company or another subsidiary is forbidden
Covenants that minimize switching to high variance projects
-indentures require firm to purchase insurance to the same extent as its competitors
-limit extent that a firm can become a claimholder in another enterprise: applies to common stock investments, loans, extentions of credit, etc.
-sales of assets restricted
-restrict mergers outright or allow them only if certain conditions are met
Covenants taht force firms to take positive NPV projects
-almost impossible to do in practice
-restrictions on dividend payouts require firms to retain cash which should be reinvested in positive NPV projects
-debt covenants ususally require investment in maintenance & upkeep of assets
what happens to parent debt when subsidiaries can issue debt?
-makes parent debt riskier
-adds a layer of debt between the subsidiary and the parent
Firms with which types of assets are affected most by bankruptcy?
-bankruptcy leads to larger loss of value for firms made up of mostly intangible assets
-these assets lose their value entirely if the firm is no longer a going concern
How much do taxes affect tangibles?
not much
Who has more leverage - tangible asset or intangible asset companies?
-a lot of intangibles - less leverage
-a lot of leverage = more tangibles
-profitability isn't very important here
2 costs of having debt in the capital structure
-bankruptcy costs
-managers, acting in interests of shareholders, take risky projects even if they have 0 or negative NPVs
What is the benefit of divisional debt?
forces managers to pay out cash they don't need
What is the benefit of forcing subsidiaries that are large cash generators issue debt?
avoids managers of other divisions using time to do intrafirm politicing to direct capital away from the profitable division
2 alternatives to debt
-preferred stock
-leasing
Preferred stock
-hybrid security that shares characteristics with common stock and debt, but is more like debt
characteristics of preferred stock
-regular payments (dividends) that increase if firm does well
-if firm misses dividend, does not go into reorganization, as is true if they miss a coupon payment to bondholders
-claim on assets is junior to bondholders but senior to stockholders
critical difference between preferred stock and bonds
payments to bondholders are tax deductible, but payments to preferred stockholders are not
how do firms get an indirect tax break from issuing preferred stock?
-investors have lower (15%) personal tax rate on dividends, so they're willing to receive lower before tax yield on preferred stock than bonds
Lease
rental agreement that extends over a year and involves a series of fixed payments
what type of assets are commonly leased?
resalable, unspecialized equipment; you have to be able to sell or lease equipment to another party if the lessee doesn't pay
how are leases similar to secured debt?
-tax deductible payments are made at regular intervals
-in the event of financial difficulty, the creditor or lessor has first rights to the asset
4 differences between leasing and secured debt
-salvage value (if company issues secured debt to buy a machine, they get salvage value. if they lease, the lessor gets the salvage value)
-if a firm is borrowing, the lender has a higher priority claim on other assets if the firm is in financial distress, than is the lessor
-tax benefits of depreciation go to the lessor rather than the company that uses the machine
-maintenance provided by lessor
on what does the decision to lease or borrow and buy turn, making it sometimes worthwhile to lease?
market imperfections
6 market imperfections that make it worthwhile to lease
-convenience of short term leases (costs of buying and then reselling may be high)
-cancellation option
-maintenance provided by lessor
-administrative & transaction costs lower
-taxes
-may reduce problem of underinvestment that arises from debt overhang
Explain the tax benefit of leasing
-if the lessee is in a lower tax bracket than the lessor, the benefits of depreciation are larger for the lessor than they would be for the lessee
-in this case, it is useful for the lessor to borrow for the lessee because of the larger tax saving
-if some but not all of the additional tax savings are passed on to the lessee, both lessee and lessor benefit
why is stock riskier than the debt of the firm as a whole?
because stockholders (equity owners) are paid after bondholders
2 parts of returns to stockholders
-dividends
-capital gains
capital gains
occur if the level of dividends is expected to rise in the future
how can shareholders get rid of management that owns 25% or more stock?
it is almost impossible
if management owns less than 25% of the stock, how can they retain control?
-by issuing shares with diminishing voting rights
-implement anti-takeover amendments or incorporate measures in teh corporate charter to make proxy fights difficult
why is issuing equity expensive?
not everyone has the same information about the value of a stock
for IPO's, where is the main information asymmetry?
between smart investors who have a pretty good idea of a company's value and others
for seasoned equity offerings, where is the main information asymmetry?
-between corporate insiders and potential investors
-asymmetries are smaller
IPO
first issue of stock to public by a formerly private company
who can buy an IPO?
really good customers and brokers only
biggest cost of IPO
underpricing
costs of an IPO
-underpricing
-underwriter fee (7%)
-admin (2-3%)
why is underpricing so severe recently?
influence of IPOs of internet companies, which averaged 80.67%
what is the amount of underpricing related to?
amount of uncertainty about firm value
what types of firms are underpriced the most?
-firms with small sales and earnings
-young firms
-firms that are in R&D stage
rule of thumb regarding good vs. bad IPOs
-if it's a good IPO, you can't get any shares
-if it's a bad IPO, you can't get as many shares as you want
waht happens with uninformed investors in IPO buys?
they buy all the shares in overpriced IPOs but are allocated fewer shares when IPOs are underpriced
what has to happen to keep uninformed investors participating in the IPO market?
IPOs must be underpriced on average
how likely is the uninformed investor to get shares in the bad IPO?
twice as likely
what purpose does underpricing serve in the model from Benveniste and Spindt?
it's a way of getting institutions to reveal their information about an IPOs value
what are the two purposes of a road show?
-sell the IPO
-find out how much companies are willing to pay
SEO
-seasoned equity offering
-sale of additional stock to the public by a company that is already publicly traded
-less expensive than IPO
why does the stock price decline when an SEO is announced?
-the company is selling equity because they think their stock is overpriced (or at least that's the perception)
if stock price is below true value, will managers issue equity to take a positive NPV project? what if the stock price is above true value?
-no; they will forego the project because the equity issuance dilutes wealth too much
-if stock price is above true value, managers will issue equity to take on the project
what can companies do to reduce the costs of issuing equity?
issue right after an annual or quarterly report
SEOs are ______ expensive when made by Nasdaq companies
more
how are nasdaq SEOs priced, as opposed to NYSE SEOs?
-Nasdaq SEOs are priced relative to the bid price on the day before the SEO
-NYSE SEOs are priced relative to the last trade
Costs of SEOs
-underwriter fee (5.41%)
-admin (1.53%)
-underpricing (2.21%)
Alternative to SEO
-private placement
private placement
placing a large block of stock with a single investor
2 benefits of private placement to the firm
-doesn't have to register offering with the SEC
-avoids registration costs
what does the buyer of private placement have to do in order to sell the shares?
hold the shares for two years or pay to register with the SEC
why will you pay 13% less for unregistered private placement stock?
because it is illiquid
what is the market reaction to private placement?
-positive, unlike public offerings of stock
why is the reaction to private placement positive?
-signal of firm value in that a large, sophisticated investor deemed it worth buying
-a large blockholder could also serve to oversee management
rule of when to issue equity
only when you are desperate
for most firms, how important is capital structure?
unimportant except when the firm is near financial distress
for firms where capital structure is unimportant, what is more important: costs of issuing securities or debt/equity ratio?
costs of issuing securities
what does the pecking order theory of capital structure say?
-for firms where capital structure is unimportant, costs of issuing securities is a more important consideration than the debt/equity ratio
-internal funds are cheapest, so firms prefer to raise funds through retained earnings
-if firm has to go to outside capital markets, issue costs are lower if the firm sells debt than equity
-equity is especially costly because management will be reluctant to sell it if market price of stock is too low, but eager to sell if it is too high
-SO - when a company attempts to sell equity, the market assumes the market price of the stock is too high
5 ways to issue equity other than IPO and SEO
-payment for mergers
-employee stock options or share grants
-convertible bonds
-dividend reinvestment and other direct repurchase plans
-warrants
payment for mergers as an equity issuance
when a company buys another, it gives shareholders of acquired company shares of stock instead of cash
-shareholders avoid taxes until they sell shares in acquiring company
employee stock options or share grants as equity issuance
by giving employees options, they issue equity as an alternative to cash salary
DRIP
dividend reinvestment plan
-dividends are automatically used to purchase more shares from the company
warrants
-like call options
-allow holder to buy specified number of shares at a given price, referred to as teh exercise price, on or before a given day
-often issued with IPOs or other securities
what will warrant holders do if the stock price exceeds the exercise price when the option is expiring?
use their warrants to purchase shares directly from the company
how common are SEOs?
costly and unusual
private equity
ownership of companies by a small number of private investors
-not publicly traded
2 areas in which private equity operates
-ownership and funding of startup companies (VC)
-buyouts, and leveraged buyouts of mature companies
traditional form for private equity organizations
limited partnership
who are the parties involved in a limited partnership?
-GP (general partner) like Bain Caital, Berkshire Partners, etc.
-LP (limited partner): institutional investor or wealthy individuals like Notre Dame
what is the role of the GP in a limited partnership?
-contributes small amoutn of capital and acts as manager of partnership
what is the role of the LP in a limited partnership?
-contriputes capital
-has some say in terminations of partnerships and changes in partnership structure
-essentially powerless
for how long are limited partnerships established?
10 years (usually)
how do GPs cash out of investments in companies?
through IPOs or sales of companies to other investors
how much are GPs paid?
-2% management fee based on fund's assets
-20% capital gains (rest goes to LPs)
how do LPs contribute capital to a fund?
over three or four years
-missed payments carry stiff penalties
how do LPs cash ot of investments in companies?
-LP investmetns are illiquid
-cashing out before the end of teh partnership is difficult and costly
why would GPs look out for LPs best interest?
reputation is everything for a GP
what types of companies get most of the venture capital?
small, high-tech companies
how long does it take for VCs to see significant returns?
5-10 years
why do VCs employ staged capital infusions?
-prevents misuse of funds (entrepreneurs' incentives to conserve capital arise from teh fact that capital infustions dilute management's equity share at an increasing rate)
-allows VC firms to shut down operations by denying funds (then mgt. has a hard time obtaining funds from other VCs)
8 stages at which VCs supply capital to firms
-seed investment
-startup
-first stage
-second stage
-third stage
-fourth stage
-mezzanine financing
-liquidity or cashout stage
seed investment
provides money to entrepreneur or inventor to see if further investment is warranted
startup money is used for:
product development and test marketing
first stage financing used for:
start manufacturing and shipping
second stage financing used for:
some market feedback has been received but production should be expanded and streamlined
third stage financing used for
-profitable but cash poor
-rapid expansion requires more working capital than can be generated from operations
fourth stage financing used for:
-approaching liquidity poit
-company may prefer debt financing at this point
mezzanine financing used for:
mcash is needed until IPO or other cash infustion that is expected in the near future
liquidity or cashout stage of VC financing
usually an IPO
what is the typical form of VC investment?
-convertible preferred stock
-dividends paid at board's discretion
-securities are senior to management's
what does the conversion feature allow VCs to do?
exercise and obtain voting rights
what is the conversion price for VCs?
not fixed - varies with company's performance
what, in compensation, aligns management's interests with that of the VCs?
management is paid small salaries, but reeceive options and keep stock
what type of stock to managers usually hold?
unvested stock
can managers sell stock any time?
no - they are usually prevented from selling stock before VCs
what is a primary contribution of VCs?
contacts in the financial community
4 ways VCs protect their investments
-providing capital in stages
-sitting on the board
-structuring managerial incentives to align with those of the VC
-holding senior securities
5 considerations for VCs to invest
-potential for huge profits
-unique technology or long lead time
-firm's product market must be capable of providing sales and earnings within a reasonable time frame
-management
-what the VCs can bring to the operation
what form of business are VCs, usually?
limited partnerships
2 benefits for VCs to be partnerships
-avoid corporate income tax
-distribute securities without triggering taxes
4 conditions for partnership in VC org
-agreed on termination date
-limited transferability
-no early withdrawal
-limited partners can't participate in management
how much responsibility to GPs bear?
unlimited
how much of the capital do GPs contribute?
about 1%
how are GP and LP interests aligned?
-GP compensation is tied to payments made to limited partners
-GPs start new partnerships over time; investment success determines how easily they attract new investors later
who finds the companies to invest in, GP or LP?
GP
how are acquisitions financed by a private equity firm, after raising capital from LPs?
equity of capital raised and three or four times as much in borrowed funds
3 types of companies acquisitions can include
-public companies brought private
-divisions of public companies
-private firms
4 things a private equity partnership usually does after they acquire a company
-add a lot of debt to the company's capital structure
-appoint new managers
-give managers large equity stake in company
-create new board from GPs
4 differences between a private equity fund and a publicly traded conglomerate
-central admin in private equity fund is smaller
-no cross-subsidation of firms (each lives or dies on its own)
-lilmited time frame for private equity fund
-debt and equity of private equity divisions are at the division level
5 characteristics of management of companies owned by private equity firms (size of board, social customs of board, CEO, active investors' role, board members' information)
-small board
-social customs of boards - more forthright
-CEO is only manager on board and is not the chairman
-active investors sit on board
-board members have better info than a typical public company
what is a major way to create value in a firm?
expense reduction
6 criteria for a private equity fund buyout candidate
-steady, predictable cash flow
-clean balance sheet w/ little debt
-heavy asset base for loan collateral (things you can borrow against)
-divestible assets
-viable exit strategy
-potential for expense reduction
what type of industry is private equity?
-management industry
-you want to find companies you can manage better
3 things that make a successful GP
-expertise to analyze deals and add value
-ability to attract the best executives and others to companies
-strong network to search for deals
7 ways a private fund acquisition adds value to a mature company
-taxes are reduced (bc firms are highly levered & high interest payments cut taxes)
-heavy debt loads force managers to reduce costs & focus on CF
-managerial incentives are improved
-oversight of managers is improved
-GPs have a better sense of what is valued by capital markets, so can set strategies to maximize value
-less game playing and dishonesty than what is exhibited between public companies and capital markets
-focus on the medium term (3-7 years); no need to worry about quarterly earnings
-avoid costs of being public
why can't public firms achieve the same results as private?
-shareholders are dispersed
-it's only worthwhile to be closely involved with overseeing managers and setting strategy if they have large equity stakes
3 exit strategies for private equity funds with mature company acquisitions
-sale (may be to other private equity firm)
-IPO
-Recapitalization
Recapitalization
firm is leveraged again with new borrowing and cash is extracted from the company
3 worrisome trends in private equity funds
-more non-equity based fees to GPs, creating conflict of interest with LPs
-hedge funds are entering the private equity business (they are in the transactions business, not the governance business)
-private equity firms are going public (usually public firms aren't good at this sort of conglomerate investment)
what does less working capital imply?
less cash tied up in operations
what is the decision to be made regarding excess cash?
how much to pay in dividends and how much to retain
with perfect capital markets, what is the relationship between dividend and investment decisions?
-they are separable
-the firm takes all positive NPV investments and decides separately how much to pay in dividends
Miller & Modigliani dividend irrelevance:
with perfect capital markets, the firm's payout policy is irrelevant
why is the payout policy irrelevant iwth perfect capital markets?
in perfect capital markets, investors can undo dividend decisions
how do investors undo dividend decisions?
-if you want to consume now and firm isn't paying dividends, sell shares
-if you don't want to consume now and the firm is paying large dividends, use the dividends to buy back stock
how does dividend policy determine the form of returns to shareholders?
-if a firm retains more cash, dividends grow more quickly in the long run
-in the short run, investors will receive a larger proportion of returns from capital gains that reflect the higher future dividend payments
3 benefits of paying dividends that accrue to all shareholders
-prevents management from wasting money on poor investments
-earnings can be faked but dividends are real
-it effectively takes money from bondholders and gives it to stockholders
what is the most significant benefit of paying dividends?
prevents management from wasting money on poor investments
pool of funds approach
-places legal restrictions on teh amount that can be paid out in dividends
-there is a set amount of money in the pool that can be paid out in dividends
how is the pool increased in the pool of funds approach?
-by some percent of additional earnings
-and by the amount raised by selling additional stock
how is the pool decreased in the pool of funds approach?
-by the amount paid out in dividends
-and by any money lost
4 indirect features of bond covenants that restrict dividend payouts
-minimum level of net worth
-minimum level of working capital
-ratio of total liabilities to total assets
-ratio of current liabilities to current assets
what are the biggest factors in determining the dividend policy of firms?
-costs of raising money externally
-tendency of managers to waste money
-firms likely to find new investment opporutnities are more likely to value flexibility & retain cash
how big are the costs of paying out dividendsfor a firm that is unlikely to uncover new investments or that can borrow easily or fund future investments through future earnings
small cost
What is the benefit of paying dividends that accrue to some but not all shareholders?
it minimizes transaction costs for those investors who relly on investment income for consumption
What is the cost of paying out dividends that accrue to some but not all shareholders?
taxes
why is the effective tax rate on capital gains lower?
because you can delay taking the gains for years
why don't younger people like dividends?
-they are taxed
-young people aren't living off investments; they are trying to build wealth
what is the firm effectively choosing when it chooses a dividend policy?
who will buy the stock because different investors want different things
What two considerations are made in setting a dividend?
-FIRST: should the amount of the dividend be changed?
-how much should we change the dividend?
what do dividends reflect?
sustainable, permanent level of earnings for the firm
what happens to stock prices when dividends are changed?
stock prices increase when the payout is increased and fall when the payout is reduced
what has happened to the number of firms paying dividends in the last few years?
it has declined from historic levels
what is an alternative to paying dividends?
repurchasing shares
4 reasons for the decline in companies that pay dividends
-more firms that have traditionally avoided dividends (small firms, firms with low earnings, firms with many investment opportunities)
-newly listed firms are themselves different than in the past; fewer are profitable; they tend to have a lot of growth opportunities
-large, profitable firms are less likely to pay dividends than in the past
does an increase in repos explain the decline in dividend paying?
no - companies that repo also tend to be the ones that pay dividends
primary explanation for decline in dividends
-increased use of management and employee stock options
2 reasons firms may shift toward repos if they have issued executive options
-when options are exercised, employee purchases shares from company; if company wants to prevent dilution of EPS, they will repo shares rather than issue new ones
-dividends decrease value of options
firms with more executive options pay _______ dividends
more
firms with more executive options purchase ______ stock
more
market reaction to repo announcement is _______ for firms with a lot of employee options than for firms with few options
lower
how much does stock price fall when you pay a dividend?
by about the amount of the dividend
why, even though the 2003 tax act reduced personal tax on dividends from 38% to 15%, did we not see an increase in dividends paid?
-firms with low CF still avoid paying dividends
-capital gains still more tax efficient because they can be delayed
-dividends hurt option holders, and most managers are option holders
3 considerations to determine if a firm should pay a dividend or repurchase shares
-can a cash payment be sustained?
-do the firm's managers and employees have options?
-is the stock over or underpriced
if stock is underpriced, a repurchase is ________
worthwhile
if a stock is overpriced, a repurchase is _________
to be avoided
why else would managers prefer a repo, even if they don't have options?
-if their bonuses or salaries are tied to teh share price and the share price is too low
4 ways to repurchase stock
-open market transactions
-targeted share repurchases
-fixed price tender offers
-dutch auction tender offers
open market transactions
-usually done to acquire a relatively small number of shares
-often done so options can be exercised so there will be shares for acquisitions
most common type of repo
open market transactions
targeted share repos are usually done for
large blockholder or insider
fixed price tender offers
-firm announces repo price, number of shares it intends to buy, and length of time offer is outstanding
-if investors tender more shares than the company is prepared to buy, it purchases them on a pro-rata basis (everyone who offered shares has some repo'd in proportion to the number tendered)
dutch auction tender offers
-firm announces number of shares wants to repo and range of possible purchase prices
-shareholders specify price they will accept and number of shares they will offer
-firm repos announced number of shares at the one lowest price that will allow them to complete the repo
2 benefits of dutch auction tender offer
-much more efficient
-you take out teh shareholders who value the stock the least, which can be valuable in a takeover situation
why would shareholders have different stock valuations?
-differences in opinion
-different tax bases
what is the best strategy for potential shareholders in a dutch auction tender offer?
tell the truth and tender at your actual valuation
firms that increase dividends have higher _________ CF, whereas firms that repo stock have higher _______ CF. Why?
-increase dividends: higher operating CF
-repo stock have higher nonoperating CF
-because non-op CF aren't sustainable
What is the relationship between standard deviation of operating income and the repo/dividend decision?
standard deviation of operating income is twice as high for repo firms
firms that increase dividends are (larger/smaller)
larger
firms that increase dividends have a _____ level of institutional ownership than repo firms. Why?
-higher
-they are taxed less on dividends
-they are looking for sustainable CF, which a dividend indicates
firms that increase dividends have an average return on stock of _______. what is it for a repo firm?
26%
-for a repo firm, it is -1.1%
why is EPS riskier when you repo?
you are shrinking your cash cushion
why are repos growing in importance?
increased use of stock options
what is an alternative way to take advantage of underpriced shares?
issuing puts
put options
give holder the right to sell shares at prespecified strike price on or before a given date
if you buy a put with a strike price of $50, and at expiration, the price of shares is $70, what do you do?
don't sell; your options are worthless
if you buy a put with a strike price of $50, and at expiration, the price of shares is $40, what do you do?
sell; your options are worth $10 more
when is a put better than a repo?
-when the company doesn't have the extra cash needed for investments
-they retain cash unless they were wrong and the stock price falls
when is it better to repo than issue put options?
-when the company doesn't have good investments for its cash, and may otherwise waste it
-little flexibility
-spends cash right away
collar
-another alternative to repos
-company issues puts with option to use proceeds from the sale to purchase calls
in a vacuum, which is cheaper, debt or equity?
equal
is debt always cheaper than equity?
no
what is the source of costs of equity?
uncertainty of the value
second cheapest way to fund investments
debt
what is the implication if you issue put options?
you think the stock will go up
2 advantages of accelerated share repo
-immediate increase in eps
-anti-takeover maneuver
accelerated share repo
-ibank borrows shares and sells to you
-ibank is in short position; he repos over next few months
-you reimburse him for any losses
advantage of open mkt transaction
flexibility - can watch mkt and cf and buy when time is right
how often do dividend increases occur relative to decreases?
4x as often