Financing Decisions vs. Investment Decisions: Differences and Efficient Markets, Apuntes de Finanzas Corporativas

¡Descarga Financing Decisions vs. Investment Decisions: Differences and Efficient Markets y más Apuntes en PDF de Finanzas Corporativas solo en Docsity! UNIT 1 1.1 CAN FINANCING DECISIONS CREATE VALUE? There are basic similarities in the criteria of making financing and investment decisions. - They both involve valuation of a risky asset - In both cases we end up computing net present value Rate of return (r): net gain or loss of an investment The market return on equivalent-risk projects = the opportunity cost of capital (r) If NPV > 0 outcome above the rate of return  added value If NPV < 0 outcome below the rate of return which is the minimum/ maximum Differences between financing and investment decisions  The number of different securities and financing strategies is well into the hundreds.  There are ways in which financing decisions are easier than investments decisions: o It’s harder to make money by smart financing strategies: financial markets are more competitive than product markets.  In short: it is more difficult to find positive NPV-financing opportunities than positive NPV- investment opportunities.  In general securities are fairly priced (NPV = 0). 1.2 WHAT IS AN EFFICIENT MARKET? In a financial market the NPV = 0  Efficient market An efficient market is one in which share prices reflect all available information. Three conditions for market efficiency: (a market is efficient if one of these conditions holds) - Investors are rational: investors value the securities with respect to their fundamental value. o Is the result of the present value of all the expected future cash flows. Co= C1 (1+r) + C 2 (1+r ) … - The deviations from rationality are independent. The thoughts of investors are uncorrelated. - There are no arbitrage opportunities (that is, investment strategies that guarantee superior returns without any risk). The market is not efficient, and you take profits from that situation. What the EMH SAYS and does NOT SAY Does say:  Prices reflect underlying value.  Financial managers will not profit from timing equity and bond sales (they are fairly priced by the market)  Managers cannot boost share prices through creative accounting (no financial illusions). Does not say:  Markets are perfect (They are not due to the existence of taxes, transaction costs…)  All shares of equity have the same expected returns. (It depends on the risks)  Investors should throw darts to select their shares. (Due to diversification)  There is no upward trend in share prices. (In the long run there is an upward trend, we do not know when, but we do know it exists) Implications of the EMH  Investors should expect a normal rate of return.  The price adjusts before the investor has time to trade on it.  Firms should expect to receive fair value for securities that they sell.  Fair means that the price they receive from issuing securities reflects the present value of its expected future cash flows.  Valuable financing opportunities that arise from fooling investors are unavailable in efficient capital markets. (They are not correlated, they do not agree, because when one thinks upward the other thinks downward, so it stays the same) 1.3 THE DIFFERENT TYPES OF MARKET EFFICIENCY Three forms of market efficiency:  Weak Form Efficiency. Market prices reflect all historical information.  Semistrong Form Efficiency. Market prices reflect all publicly available information. (+historical)  Strong Form Efficiency. Market prices reflect all information, both public and private. (+historical) Weak form efficiency and the random walk theory  The drift of this coin toss game is equal to the expected outcome: (in the long run it is positive)  Successive changes in prices are independent. It is useless to know the previous share price movement in order to know the next share price movement.  No memory.  The odds each time are the same, regardless of previous results. In general, if stock prices follow a random walk: - The movement of stock prices for day to day DO NOT reflect any pattern (RANDOM) - Information about past returns is useless to predict future returns. - Statistically speaking, the movement of stock prices is random (skewed positive over the long term) Important question: Why do prices in competitive markets must follow a random walk? o If past price changes could be used to predict future changes, investors could make easy profits. o It would be possible for investors to take advantage of this possibility to make profits. o Therefore, stock prices adjust immediately to past information and today’s prices reflect all the information in past prices. Mathematical model: Serial correlation coefficients for share price returns near to zero would be consistent with weak form hypothesis. Semi-strong form efficiency To analyze the semi-strong form of the efficient market hypothesis:  Event studies: researchers have measured how rapidly security prices respond to different items of news, such as: o Earnings or dividends announcements. o News of a takeover. o Macroeconomic information.  We measure the abnormal stock returns (ASR) of securities.  Information: o Information released at time t – 1  ASRt – 1 o Information released at time t  ASRt o Information released at time t +1 ASRt + 1 Important: we have to isolate the effect of an announcement on the price of a stock. Expected stock return = a + b x return on market index 2 UNIT 2 2.1 CORPORATE FINANCING OVERVIEW - Internal financing: retained earnings and depreciation - External financing: firm can issue debt/equity or can go to the banks 2.2 COMMON STOCK Corporations raise cash in two principal ways: - Issuing equity - Issuing debt Equity: - Consists largely of common stock - Companies may also issue preferred stock Debt: there is a much greater diversity of debt securities 2.3 THE EQUITY ACCOUNT The authorized share capital: the maximum number of shares that can be issued. Shares issued and outstanding: shares held by investors. Shares issued but not outstanding: Repurchased shares that are held in the company’s treasury until they are either canceled or resold. Treasury stock (shares): number of shares repurchased from the open market. - No dividends. - No voting rights. Additional paid-in capital or capital surplus: Price of new shares sold to the public – par value Common shares (par value) + additional paid-in capital + retained earning – Treasury stock Net common equity 2.4 OWNERSHIP OF THE CORPORATION A corporation is owned by its common stockholders. Who owns the stocks? - Some of this common stock is held directly by individual investors, but the greater proportion belongs to Financial Institutions:  Monetary financial institutions (blue)  banks  Mutual funds  Pension funds  Insurance companies Insurance corporations and pension funds: compared with debt securities it is much lower, why? Because it is less risky that is why they have got less stock than the securities. Insurance companies must have a safe price that is why they avoid risk. 5 Why are they reducing debt securities in the portfolio in order to increase the listed shares? Nowadays interest rates are decreasing, in debt securities it is very low, so the return is very low. This is why they are increasing in listed shares, this is not good because they are increasing risks. Who owns most of the stock of corporations? Investment funds. Very important. 2.5 COMMON STOCKHOLDERS’ VS OTHER STAKEHOLDERS Why are stakeholders the owner of the corporation?  Common stockholders have the residual cash flow rights.  They are assuming most of the risk of the investment of the corporation.  Thereby they have the residual control rights over certain operating and investment decision: (They make decisions) - They can decide the selling price of the firm´s products - To hire temporary rather than permanent employees - To upgrade the firm´s facilities 2.6 WIDELY HELD CORPORATIONS But do common shareholders always make those decisions? No. In widely held corporations they are not going to make the decisions because their share in the corporation is very low. Very difficult to reach to an agreement. In practice their control is limited to an entitlement to vote. The corporation is run by professional managers (Agency problem). Agency problem: managers can make decisions against shareholders because they have a benefit against shareholders, they have the political power. 2.7 PREFERRED STOCK  Offers a series of fixed payments to the investor. (dividends)  The company can choose not to pay a preferred dividend, but in that case it may not pay a dividend to its common stockholders.  If the company does miss a preferred dividend, the preferred stockholders generally gain some voting rights.  Cumulative preferred stock (most issues): the firm must pay all past preferred dividends before common stockholders get a cent. Example: technology corporations; apple, Microsoft  do not pay dividends. Cash cows: pays dividends all the years. Iberdrola. Difference between preferred stockholders and common stockholders? Preferred stockholders: Own preferred stock, risk is lower, do not have voting rights. 2.8 DEBT Main difference between debt and equity? Debt receives interests, they receive money on a regular basis. The firm has to pay dividends and also repay the principal. Equity is forever. But debt not, you have to pay back your debts. The liability is limited. 6 What happens when the market value of stocks is lower that the market value of debts? Shareholders entitled to not pay back their debts, here are my assets, and try to do the best to recover your money, otherwise, they will lose a lot of money. Shareholders not willing to pay back their debts, why? Because liability is limited. As long as market value of assets is higher than the market value of debt shareholders are willing to pay back their debts. Which one is riskier? (Considering the same firm, same assets) In situation 1: E>D and in situation 2: E<D Situation 2. In this situation the expected rate of equity rE is going to be higher due to its capital structure  riskier. It is more likely that the value of assets in the future will go below the market value of equity, under situation 2 compared to situation 1. So, it is riskier. r E=r A+(r A−rD ) ∙ D E - r E = Expected rate of equity - r A = Expected rate of assets - rD = Expected rate of debt - D/E = debt over equity ratio  If increase D in relation to E  increase r E  If increase (D/V) ratio  increase (D/E) ratio since V = E + D The stockholders have the right to default. Lenders are not considered to be owners of the firm. The government provides a tax subsidy on the use of debt (not on equity)  Interests paid before-tax. (Tax shield)  Dividends on common and preferred stock are paid after-tax. (Higher interests = lower profits and pay less taxes) Higher debt (increase of risk) = higher interest = lower profits = lower the taxes you pay (this is good) How to reduce the amount of taxes? Increase the interests by increasing debt. Is situation 1 always better than situation 2? No. Because of the reasons above, it depends. 2.9 FINANCIAL MANAGER QUESTIONS Should the company borrow short-term or long-term? It depends. (It is an open question) being a financial manager is difficult. Basically, it will depend on your assets. If you are investing in long term assets, it is not very wise to borrow all the money short term, but of course in one firm there are fixed assets and current assets. (libreta) HIGHER THE NWC (net working capital)  higher the risks. Should the debt be fixed or floating rate? (Interest rate risk) It depends. If you know for sure interest rates are going to be down, borrow floating rate. On the other hand, you can borrow fixed rate, the risk is cero and in the case the interest goes down you will be angry since you will be paying over rate. Should you borrow euros or some other currency? 7 DIFFERENCE: The investment bank does not buy the shares (it is going to be an agent and will receive a commission for every sold share) Green shoe provision (overallotment option)  Gives the members of the underwriting group the option to purchase additional shares at the offering price.  Reason: to cover excess demand and oversubscription.  It is a cost for the issuer and a benefit for the underwriters. INVESTMENT BANKS They have the responsibility of Pricing fairly - Problem with IPO is that we do not know the market price. If the Price decreases/increases suddenly this will be a problem since probably the issue price is not similar to the market price. - Increases  good situation for investors - Decreases  bad situation for investors (overpricing) Investors must rely on the judgement of the investment bank. Asymmetry of information. The IB has a: - Short-run incentive to price high, but - Long-run incentive to make sure that its customers (new investors) do not pay too much It is in the IBs self-interest to price fairly THE OFFERING PRICE It is the most difficult thing the lead investment bank must do for an IPO.  If the price is too high, the issue may be unsuccessful and be withdrawn.  If the price is below the market price, existing shareholders will experience an opportunity loss in favor of new shareholders. UNDERPRICING: POSSIBLE EXPLANATIONS - A low offering price on an IPO raises the price when it is subsequently traded in the market and enhances the firm’s ability to raise further capital. - The winner’s curse: o You are successful because you may have overpaid. - The underwriters want to reduce the risk. If they underprice the stocks, it will be easier to sell all the stocks. IN SUM: In theory: PRICE FAIRLY In practice: they underprice 3.3 GENERAL CASH OFFERS BY PUBLIC COMPANIES Stock is sold to all interested investors. Investment banks are usually involved.  Financial intermediaries. 10  Deutsche Bank, Goldman Sachs, Barclays Bank, Nomura Holdings...  They provide services for corporate issuers such as: - Formulating the method used to issue securities. - Pricing the new securities. - Selling the new securities. 3.4 PRIVATE PLACEMENTS AND PUBLIC ISSUE Public offering: The company sells the stock to more than 35 investors. The firm is obliged to register the issue with the SEC. Private placements: the company sells the shares privately (to no more than 35 investors), without registering the issue in the SEC.  It costs less to arrange a private placement than to make a public issue.  Drawbacks: the investor cannot easily resell the security. 3.5 THE PRIVILEDGED SUBSCRIPTION OR RIGHTS ISSUE  Rights offering: an issue of common stock to existing shareholders.  Preemptive right: the firm must first offer any new issue of common stocks to existing shareholders. - WHY? To avoid the anti-dilusion effect. ?????  This assures each owner his or her proportionate owner’s share.  Each shareholder has an option to buy a specified number of shares from the firm at a specified price within a specified time. One right for each share of stock the existing stockholders own. - (1 SHARE = 1 RIGHT always) Stockholders have several choices: - Suscribe for the full number of entitled shares. - Order all the rights sold. - Do nothing and let the rights expire. Subscription price: the price that existing shareholders are allowed to pay for a share of stock. Subscription price < market price: the rights offering will succeed. Number of rights needed to buy a share of stock = - “OId” shares (Existing shares) / “New” shares. THE MODEL (theoretically) Why is the value of the right given by that number? If you are an investor and you want to sell the right  minimum price willing to sell the right If you are a new investor and you need the rights to buy new shares, this is the maximum amount of money you are willing to pay to buy the right. 11 UNIT 4 4.1 INTRODUCTION Financial managers goal: maximizing firms market value  How much cash should the corporation pay out to its shareholders? Two methods: paying out dividends and/or repurchasing shares/stocks.  Should the cash be distributed by paying out dividends or by repurchasing shares? It depends on the situation; one method is better than the other. The financial manager decides to pay out dividends he has to consider three points: - CASHFLOW . Is there enough cashflow remaining after undertaking all investments? NPV>0 Is there any money remaining after that? If any, is the remaining money going to be permanent or not? (higher Value) - DEBT  (D/V) ratio. Risk is related to indebtedness. The higher the debt the higher the risk. - 60% Equity and 40% Debt (NOT BAD SITUATION AT SIGHT) - However, is this really a good situation or not? (DEPENDS) According to what you expect (imagine you expect bad times at the short term), if your assets are going to be reduced a lot, even though the situation was not bad, we need to reduce even more the debt, have more equity. If you do not expect bad times in the short term, then this is a good situation, so you can pay out your dividends. PAYOUT POLICY: Relates earnings and dividends. This is a financing decision because dividends payments have to be financed. What does the price of a stock depend on? - Dividends - Growth opportunities Some firms do not pay out dividends, but their value is high, how is that possible? Because price depends on both, dividends and growth opportunities. “What is the effect of a change in payout policy, given the firm’s capital budgeting and borrowing decisions?” - Capital budgeting: investments, computing the NPV - Borrowing decisions is the debt policy, related to value. Given both investment and borrowing decisions: (given=fixed)  If you want to increase the dividends: the only way is to issue stock  If you want to reduce the dividends: cannot reinvest money because the investment policy is given, you cannot reduce the debt because the policy is given and you are not going to pay out dividends, so what will you do? repurchase stock 4.2 DIVIDENDS AND SHARE REPURCHASE Corporations can pay out cash in two ways: - Pay out dividends - Shares repurchase or stock buyback (outstanding shares) Different types of dividends 12 - Managers believe the stock is undervalued (why? Because they repurchase stock in order to sell the repurchase stocks in a future at a higher value, also the existing shareholders are increasing their wealth) - Firm wants to change the capital structure  They want to increase their debt levels (D/E) RATIO is going to be higher Example: we are in 2021, we know in 2022 the earning will fall and be the same as in 2020, we do not have NPV>0, we want to give the money to our shareholders because we do not want to increase the dividend nor reinvest the money. What is the alternative? To repurchase stock. - When they want to increase their debt levels. - When the managers believe that the firm´s stock is substantially undervalued. 4.5 THE CONTROVERSY ABOUT DIVIDEND POLICY DOES DIVIDEND POLICY MATTER? Dividend policy is value irrelevant in perfect capital markets.  It does not matter under some assumptions. A. DIVIDEND POLICY IN PERFECT CAPITAL MARKETS MILLER AND MODIGLIANI (1961) • Perfect capital markets: - There are neither taxes nor brokerage fees. - No single participant can affect the market price of the security through his/her trades - Borrowing rates = lending rates • Firm assets, investments and borrowing policy are fixed. CONCLUSIONS  In perfect capital markets investors do not need dividends to get their hands on cash (they can sell the shares).  In perfect capital markets (borrowing rates = lending rates), as long as the present value of shareholdrs’ cash flow is constant dividend policy is irrelevant (investors can create whatever income stream they prefer by using homemade dividends).  Dividends are relevant.  MM is a starting point. B. STOCK REPURCHASE AND VALUATION C. DIVIDENDS AND THE MM MODEL - No transaction costs - No taxes - No uncertainty Then dividend policy is IRRELEVANT  BUT there is a PROBLEM in MM model:  It does not consider real, important factors  Among those factors you have to consider taxes  Cash dividends are taxed as ordinary income D. DIVIDENDS AND TAXES 15 MM model is our benchmark: - PROBLEM: real world factors such as taxes have not been considered - Dividends and capital gains are taxed differently: o Dividends: are taxed when distributed o Capital gains: are taxed when the shares are sold (can be deferred) No taxes: - P(ex-dividend)=P(cum-dividend)-DPS* - What is the price before dividend? Price (share market) = P(ex-dividend) + DPS (dividend) With taxes: - Cash flow of selling the stock just before it goes ex-dividend: - Cash flow of selling the stock just after it goes ex-dividend: CONCLUSIONS In the presence of dividend taxes: 1. A firm should not issue stock to pay dividends. 2. Managers have an incentive to seek alternative uses for funds to reduce dividends. 3. Though personal taxes mitigate against the payment of dividends, these taxes are not sufficient to lead firms to eliminate all dividends. 4.6 REAL WORLD FACTORS FAVORING A HIGH-DIVIDEND POLICY - Desire for current income (clientele effect) - Uncertainty resolution. A bird in the hand is worth two in the bush - Agency costs - Dividends and signals 16 UNIT 5 5.1 INTRODUCTION Capital structure: firm mix of debt and equity financing. Does debt policy matter? Again Modigliani and Miller:  Financing decisions do not matter in perfect capital markets.  The value of the firm is determined by its real assets.  Capital structure is irrelevant as long as firm’s investment decisions are taken as given.  Complete separation between investment and financing decisions. 5.2 THE EFFECT OF FINANCIAL LEVERAGE ON THE VALUE OF THE FIRM. Managers should try to maximize the market value of the firm. Maximizing firm’s value = maximizing shareholders’ wealth? Conclusion: any policy that maximices the market value of the firm is also best for firm’s shareholders. This example rests in two assumptions: - We can ignore dividend policy. - Old and new debt together end up worth $35,000. PROPOSITION I OF MM (1958) “The market value of any firm is independent of its capital structure and is given by capitalizing its expected return at a rate r0 appropiate to its class” The law of one price: two investments that offer the same payoff must have the same price: Vu=VL A riskier strategy: same payoff Vu=VL “The average cost of capital to any firm is completely independent of its capital structure and is equal to the capitalization rate of a pure equity stream of its class” Assumptions 1. No taxes. 2. No transactions costs. 3. Individuals and corporations can borrow at the same rate. 5.3 THE EFFECT OF LEVERAGE ON STOCKS RETURNS. PROPOSITION II OF MM Two important concepts: Financial risk and default risk. - Financial risk: increased volatility of the rate of return. - Default risk: the risk that companies or individuals will be unable to make the required payments on their debt obligations. Proposition II of MM: The rate of return the investors can expect to receive on their shares increases as the firm’s debt-equity ratio increases. 17 - Agency costs o Incentives to take large risks o Incentive to underinvestment o “Cash in and run” o “Playing for time” o “Bait and switch” The trade-off theory Value of the firm = value if all-equity-financed + PV(tax shield) – PV(costs of financial distress) Objetive of the financial manager: Max: E + D or, min: G + C CONCLUSIONS: The trade-off theory succesfully explains many industry differences in capital structure. - Example: High-tech growth companies, intangible and risky assets; relatively little debt. - Airlines: tangible assets; borrow heavily. But it fails to explain why the most profitable companies commonly borrow the least. - Under Trade-off theory, high profits should mean more debt- servicing capacity and more taxable income to shield: higher debt ratio. 5.8 THE PECKING ORDER OF FINANCIAL CHOICES  The starting point: asymetric information  Managers know more about their companies’ prospects, risks, and value than outside investors.  Managers’ strategies: o Undervalued stock: they don’t issue stocks because it will benefit new shareholders against current shareholders. o Overvalued stock: they issue stock because they can take advantage of the situation. New investor: (They know about the managers Strategies so they have two assumptions) - If the firm issues stoks it might be overvalued. - If the firm issues debt it might be undervalued. 20 RESULT:  Undevalued firms allways issue debt.  Even overvalued firms issue debt. CONCLUSIONS Therefore, the problem with stocks also happens with debt, it may be under/over-valued, so managers face the same problem with debt as with stock, however the problem with debt is lower, since the problem with stocks is riskier. (Most of the time debt is at fair price) - Firms finance their projects firstly with internal financing. - Issue the safest securities first. o Issue debt. o Issue stocks. IMPLICATIONS - There is no target amount of leverage. - Profitable firms uses less debt. o Exactly the opposite of the trade-off theory, this was a problem in the Trade- off theory. - Companies like financial slack. o You have a lot of money, are you using this money correctly? if you do not have NPV positive projects then, give out dividends, or repurchase stock, but invest it in something —> this is an agency problem 21 UNIT 6: Interrelation between financing and investment decisions 6.1 THE AFTER-TAX WEIGHTED-AVERAGE COST OF CAPITAL: REVIEW OF THE ASSUMPTIONS We are going to introduce value contributed by financial decisions. - There are two ways to do this: 1. Adjust the discount rate: WACC 2. Adjust the present value: Adjusted Present Value = base value + value of financing side effects. Capital structure  Value (both related)  Under MM assumptions, investment decisions are separated from financing decisions.  Why can’t these decisions be separated?  Taxes imply that financing and investment interact (they are not separated anymore): value is related to financing decisions. 1st assumption The after tax WACC formula refers to the firm as a whole and works for the average project. 2nd assumption You can only use this formula to discount projects that are just like the firm undertaking them. - It is incorrect for projects that are safer or riskier than the average of the firm’s existing assets. - It is incorrect for projects whose acceptance would lead to a change in the firm’s target debt ratio. 6.2 VALUING COMPANIES: AFTER TAX WACC VERSUS THE FLOW TO EQUITY METHOD After-tax WACC - Treat the Company as if it were one big Project (the project is a small firm it must have same structure and same risks as the firm) - Forecast the company’s free cash flows (FCF) assuming all-equity financing Why do we use FCF, instead of the cash flow of shareholders (pre-tax CF), why do we not take into account the interest of debt? If you take into account the interest of debt in FCF and WACC at we will be using the interest TWICE. the interest is already being taken account in WACC so no need to include it in FCF. - WACCafter tax = rD(1-Tc) (D/V) + rE (E/V). - After tax interest = rD*(1-Tc) *D 22