1 NEW YORK UNIVERSITY FINANCIAL ECONOMICS II Spring 2003 Franklin Allen and Douglas Gale January 24, 2003 Topic 1: What is Corporate Finance? (cont.) 2 Financing Decisions In the previous section the focus was on investment decisions. It was assumed throughout that the firm was financed with equity. In this section we discuss financing decisions. As a prelude to this we will briefly discuss the notion of efficient markets and some of it’s implications for corporate financing decisions. After that we will briefly mention some of the securities that are issued. Then we will consider the main financial decisions of the firm, capital structure and payout policy. We will apply these ideas to valuation. Finally we will discuss real options very briefly. 2.1 Efficient Markets and Corporate Finance We have argued that all shareholders should agree if a firm uses the net present value rule to make capital budgeting decisions. How does the stock market view such decisions? What is the relationship between a firm's stock market value and its use of the NPV rule? Efficient Markets Hypothesis: A firm's stock market value is determined by the discounted value of its cash flows. 2 This is based on stock markets being competitive and having many profit-seeking investors. The following example illustrates the basic idea. Example Consider a firm which for simplicity only lasts for two periods and that has per share cash flows which are paid out to shareholders as follows: C 1 C 2 1.25 1.40 The opportunity cost of capital is 10 percent. What would happen if the stock was selling in the market at 2.00? How could investors make money? Suppose an investor borrowed 2.00 and bought one share. Since the discounted present value of the payments on the stock is 2.29 the investor will be able to pay back the loan and make a profit in term's of today's dollars of 0.29. To see this another way t= 0 1 2 Debt to buy share 2.00 2x1.1 = 2.2 0.95x1.1 = 1.045 (including interest) Less payment - 1.25 - 1.40 End of period debt = 0.95 = - 0.355 In other words the investor is left with 0.355 at date 2 which is equivalent to 0.355/1.1 2 = 0.29 at date 0. Everybody will therefore try to borrow and buy shares. The price will be bid up to 2.29. 2.29 = 1 1. 1.40 + 1.1 1.25 =flow cash Discounted 2 3 Suppose the price was 2.35 what should somebody who owns the stock do? The owner should clearly sell since this gives 2.35 whereas if the stock was held onto it would pay off 2.29 in terms of today's money. If everybody who owns the stock tries to sell the price will fall until it is equal to 2.29. Whenever prices get out of line with discounted cash flows there will be profit opportunities. The efficient markets hypothesis is essentially arguing these can't last for long. In other words arbitrage ensures that prices reflect discounted cash flows. If stock market prices reflect discounted cash flows then this implies the following. Implication of Efficient Markets Hypothesis: If a positive NPV project is accepted the value of the firm will increase by the amount of the project's NPV. Hence accepting positive NPV projects leads to an increase in stock price and the creation of shareholder wealth. Rejecting negative NPV projects avoids a fall in share price and the destruction of shareholder wealth. This fundamental view of the stock market is at the heart of most corporate finance theories. An alternative view is a technical perspective. What is this? One of the activities that some market analysts, known as technical analysts, undertake is to plot the movement of stock prices against time and try to predict future cycles. 4 Suppose you discover a cycle, and at the present moment the stock is at the bottom of a trough. What should you do? You should buy the stock in anticipation of it going up. But what happens if there are a lot of technical analysts and many people do this? The price rises until it offers only a normal rate of return. In other words, any cycles will self-destruct because many people will be doing this. People will arbitrage away profit opportunities. Competition in technical research will tend to ensure that current prices reflect all information in the past sequence of prices and that price changes cannot be predicted from past prices. This is called the weak form of market efficiency: Current prices reflect all the information contained in the record of past prices. Predictable cycles are eliminated because otherwise positive NPV transactions would exist. If this is the case, why do stock prices change? Efficient markets theory argues they change because new information is received. They must change as soon as the information is received and fully reflect this information, otherwise positive NPV transactions would again exist. The semi-strong form of market efficiency is that current prices reflect not only past prices but all other published STOCK PRICE NOW TIME 5 information. The strong form of efficiency is when prices reflect not just public information but all the information such as that which can be acquired by painstaking fundamental analysis of the company and the economy. New information cannot by definition be predicted ahead of time since otherwise it would not be new information. Therefore, price changes cannot be predicted ahead of time. Series of price changes must be random. To put it another way, if stock prices already reflect all that is predictable, then stock price changes must reflect only the unpredictable--they must be random. What sort of path of prices do you get if price changes are random and occur only when there is new information? Prices follow a random walk. In the 1970’s there was an immense amount of empirical work done by Fama and others to determine whether the evidence supports market efficiency or a technical view. The interpretation of the evidence amassed was that it provided substantial support for weak-form market efficiency. Semi- strong efficiency also had substantial support. The evidence for strong-form efficiency was more in dispute. To summarize, we have said that theoretically prices should reflect available information since otherwise people would be able to make arbitrage trades and profit from them. Another way of thinking about efficient markets is that the purchase or sale of a security at the prevailing market price is a zero NPV transaction. Most finance academics would agree that empirically there appears to be strong support for this proposition. The efficient market hypothesis has a number of implications that go against what many practitioners commonly suppose about financial markets. We shall now take a brief look at some of the most important of these. 6 1. Values of stocks depend on cash flows. We have argued that the value of stocks depends on expectations of cash flows not on the supply and demand on any particular day. In other words, you should be able to issue large blocks of stocks at close to the market price as long as you can convince other investors that you have no private information, i.e., that you're not selling while the going is good. 2. There are no financial illusions. In an efficient market there are no financial illusions. Investors are concerned with their entitlement to a firm's cash flow. This implies that any attempt to mislead investors by, for example, changing accounting conventions to boost EPS will be unsuccessful. 3. Markets have no memory. We have argued that there are no true cycles. Hence the notion that now is a good time or now is a bad time to issue securities is essentially false. For example, there may just have been a long series of rises so that you think it is the top of the market and therefore a good time to issue. However, we know if this was true, investors would already have sold and the market would not be where it now is. You cannot outguess the market using information available to everybody else. 4. Trust market prices. In an efficient market you can trust prices. They incorporate all the available information about the value of each security. This means that in an efficient market firms can issue securities at any time. The amount that they will receive is a fair value. 7 2.2 Types of Security We mentioned in Section 1 that originally in MBA programs corporate finance was taught as a law subject. Nowadays law has been deemphasized but a knowledge of the different types of security that are used and the legal rights of the owners is very important. The basic types are outlined below. You should read Chapter 14 in Brealey and Myers to obtain a more detailed knowledge. Common Stock The common stockholders are the owners of the corporation. They therefore have a general preemptive right to anything of value that the company may wish to distribute. They also have the ultimate control of the company's affairs. In practice this control is limited to a right to vote either in person, or by proxy, on appointments to the board of directors. Long Term Debt and Preferred Stock Long term debt and preferred stock are fixed income securities in that they both provide the investor with a stipulated promised series of payments in the future. The interest and face value are specified for the bonds, and a given dividend rate is stipulated for the preferred stock. The firm must pay the interest and the maturity values on its debt as agreed upon in the original debt contract or the company defaults and is subject to legal action. Junk bonds are high yield bonds. With preferred stock the firm promises to pay dividends on the preferred stock. If it fails to it is not bankrupt, however. It cannot pay dividends to common stockholders until the dividends to preferred stock are paid. Bondholders have a prior claim to the company's 8 income and to the firm's assets if the company liquidates. The claim of holders of preferred stock comes after bondholders but before that of equityholders. The relative importance of the three types of security is that debt is by far the most important in terms of quantity issued, equity is next and finally preferred stock is relatively insignificant. The quantities issued vary significantly over time but the long run average is about 80% debt, 15% equity and 5% preferred stock. Convertible Securities Corporations often issue securities with terms that can be altered subsequently at the option of the holder of the security. For example, convertible bonds can be transformed into the common stock of the corporation at the option of the holder. The purchase of a warrant entitles the holder to purchase the company's common stock at a specified price on any date preceding the warrant's expiration. 2.3 Capital Structure Decisions The assumption behind most of the analysis we have done so far is that the firm is all equity financed. In practice, of course, firms use debt and many other types of security to finance themselves. In this section we are interested in whether using different types of security, in particular debt and equity, creates value for shareholders. Motivation Example The Saw Company is reviewing its capital structure. It pays no taxes and has access to perfect capital markets. The interest rate on debt is 10 percent. Its current position is as follows: 9 Data Number of shares 100 Price per share $20 Market value of shares $2000 Market Value of debt $0 Examples of Possible Outcomes: Sit 1 Sit 2 Sit 3 (Expected Outcome) Operating income $ 100 250 300 Earnings per share $ 1 2.5 3 Return on equity % 5 12.5 15 The company has no leverage and all the operating income is paid out as dividends to the common stockholders. The expected earnings and dividends per share are $2.50. This is an average; actual earnings could turn out to be more or less than $2.50. The price of each share is $20. Since the firm expects to produce a level stream of earnings in perpetuity, the expected return is given by: Mr. Modigliani, a Harvard MBA and the firm's president, has come to the conclusion that shareholders would be better off if the company had equal proportions of debt and equity. He therefore proposes to issue $1000 of debt at the risk free lending and 12.5% = 20 2.50 = P EPS =r 10 borrowing rate of 10% and use the proceeds to repurchase 50 shares. To support his proposal Mr. Modigliani has analyzed the situation under the various different assumptions about operating income. The results are as follows: Data Number of shares 50 Market value of debt $1000 r D = 10% Possible Outcomes Sit 1 Sit 2 Sit 3 (Expected Outcome) Operating income $ 100 250 300 Interest $ 100 100 100 Equity Earnings $ 0 150 200 EPS $ 0 3 4 Return on equity % 0 15 20 Return on debt % 10 10 10 We can plot this data on the following diagram: 11 100 200 300 $1 $2 $3 $4 Equal Proportions of Debt and Equity All Equity Operating Income $ EPS $ 250 $2.50 Mr Modigliani argues as follows: "It can be seen from this diagram that the effect of leverage depends on the company's operating income. If this is greater than $200, the EPS are increased by leverage and our shareholders are better off. If it is less than $200, the EPS are reduced by leverage. Our capital structure decision, therefore, depends on what we think operating income will be. Since on average we expect operating income to be $250 which is above the critical level of $200, the shareholders will be better off with levered capital structure." Is this argument correct do you think? Ms. Miller, who has recently graduated from the Stern School and is a young executive on the fast track, counters Mr. Modigliani's argument as follows: "Leverage will help the shareholders as long as operating income is above $200. But your argument ignores the fact that shareholders have the alternative of borrowing on their own account. For 12 example, suppose that a person borrows $20 and then invests a total of $40 in two unlevered Saw shares. This person has to put up only $20 of his own money. The payoff on the investment is as follows: Possible Outcomes Sit 1 Sit 2 Sit 3 (Expected Outcome) Earnings on the 2 shares $ 2 5 6 Less interest at 10% on $20 2 2 2 Net earnings on inv. $ 0 3 4 Return on $20 inv, % 0 15 20 By buying two shares in the unlevered company and borrowing $20 the returns are exactly the same as buying 1 share of the levered firm. Therefore a share in the levered company must sell for (2 x 20 - 20) = $20. If the company goes ahead and borrows, it will not allow its investors to do anything that they could not already do and so will not increase value." It is this idea that is behind: Modigliani Miller Proposition I With perfect capital markets and no taxes, the total value of any firm is independent of its capital structure. 13 The expected return on a firm's assets, r A , is equal to the expected operating income divided by the total value of the firm which must be equal to the total market value of the firm's securities (otherwise there would be an arbitrage opportunity) so: The firm's borrowing decision does not affect its operating income; that is determined by the markets the firm operates in. It follows from Proposition I that it does not affect the total market value of its securities. Therefore r A is independent of its debt decision. Suppose that somebody were to hold a portfolio consisting of all of a firm's debt and all of its equity. The interest on the debt would cancel out and the investor would simply receive the firm's operating income. It follows from this that the expected return on the portfolio would be equal to r A . The expected return on a portfolio of two stocks is equal to a weighted average of the expected returns on the individual securities. Therefore the expected return on a portfolio consisting of all the firm's debt and equity is where D and E are the amount of the firm's debt and equity respectively. Rearranging, gives MM Proposition II securities irmsf of ueMarket val income operating Expected = r = assets on return Expected A ′ r E+D E + r E+D D = r EDA 14 We can see the general implications of MM II graphically as below. The figure assumes that the bonds are essentially risk free at low debt levels. Thus r D is independent of D/E and r E increases linearly as D/E increases. As the firm borrows more, the probability of default increases and some of the risk is transferred from stockholders to bondholders. The firm is required to pay higher rates of interest on debt. Proposition II predicts that when this occurs, the slope of the line is reduced so it flattens out. The Risk-Return Trade-off We know from Proposition I that a firm's borrowing does not affect its value. We also know from Proposition II that the rate of return on equity increases as leverage increases. At first sight these results seem rather contradictory. How can they be reconciled? ) r - r ( E D + r = r DAAE E D r r r A RATES OF RETURN RISK FREE DEBT RISKY DEBT D/E 15 What is happening is that risk is increasing as leverage increases. The beta of the firm's assets is a weighted average of the betas of the individual securities: Rearranging, Importance of MM propositions MM's propositions are again a starting point. Their importance is in indicating what we should and should not look for in determining optimal capital structure. Earnings per share and return on equity are not important in determining optimal capital structure. We can always make these large by borrowing more. We are not any better off, however, risk has gone up and this offsets the increase in expected return. What are important in determining optimal capital structure are market imperfections and taxes. Corporate Taxes Under the U.S. corporate tax code and in many countries, there is an important difference in the way in which interest and dividends are treated. Historically, interest has been regarded as a cost of doing business and as a result it is tax deductible. In contrast dividends have been treated as the return to the owners and are therefore not tax deductible. This difference in treatment causes a bias toward debt finance. βββ EDA E+D E + E+D D = )-( E D += DAAE ββββ 16 Corporate and Personal Taxes So far we have concentrated on the effects of corporate taxes. But what is it that holders of securities are interested in? They are interested in the money they can actually spend. Since they must pay income tax on the receipts from securities, we must also consider the effects of personal taxes. If the tax rate on income from equity is the same as the tax rate on the income from debt, then there is no change in our theory since personal taxes do not favor debt or equity. It can be shown that they do not alter present value since they simply "wash out". The Modigliani-Miller Theorem with Taxes If interest is deductible for corporations then PV of firm = PV if all-equity financed + PV tax shield. The implication of this result is that firms should borrow as much as possible to gain the maximum possible tax shield. But in fact they do not borrow very much. On average corporations debt ratio (i.e. debt/total value) has been around 30-40% in recent decades. How can we explain why firms do not borrow more? To do this we must turn to capital market imperfections: the costs of financial distress such as bankruptcy costs and agency costs. Costs of Financial Distress If firms have a capital structure with a high proportion of debt, they have a high probability of bankruptcy. How did bankruptcy figure into our Modigliani Miller analysis? 17 There was nothing in our derivation of the MM propositions that said that firms could not go bankrupt in some situations. In an ideal world with perfect capital markets, what happens when a firm cannot pay its debt obligations? It would go bankrupt in the evening and during the night it would issue new securities and the bondholders would receive the proceeds. In the morning, the firm would continue as normal. Bankruptcy would not be costly at all. Thus with perfect capital markets the possibility of bankruptcy does not affect the debt/equity decision at all. In practice, of course, bankruptcy does not work like this. It is a lengthy and costly process. In other words capital markets are imperfect. If a firm goes bankrupt it incurs the costs of bankruptcy that are discussed in greater detail below. However, even if they don't go bankrupt they may incur what are known as agency costs. We will consider what these are below. Together bankruptcy costs and agency costs are known as costs of financial distress. We can incorporate these into our analysis as follows. The Modigliani-Miller Theorem with Taxes and Costs of Financial Distress The value of the firm is: PV of firm = PV if all-equity financed + PV tax shield - PV costs of financial distress The costs of financial distress depend on the probability of distress and the magnitude of costs encountered if distress occurs. 18 Taking the costs as given, the greater the leverage of the firm the greater the probability of financial distress. Hence there is a trade-off between the tax advantage of leverage and the disadvantage of leverage caused by the costs of financial distress. The figure shows how optimal capital structure is determined. The PV of the tax shield increases as the firm borrows more. At low levels of debt, the debt is risk free and there are no costs of financial distress. As debt levels rise, bankruptcy becomes a real possibility and the costs of financial distress rise. The optimal capital structure is when the PV of the firm is maximized. Another way of thinking about this is in terms of the weighted average cost of capital. Without taxes and bankruptcy costs we showed Modigliani and Miller Proposition II. The return on assets could be found from r E+D E + r E+D D = r EDA PV of tax shield Debt Ratio PV of costs of financial distress PV of firm Value if all equity financed Optimal debt ratio 19 From Section 1 we know that we could use r A as the opportunity cost of capital for projects that had the same risk as the firm. Graphically we had With taxes and bankruptcy cost the line representing the cost of debt is changed. Now the cost of debt is no longer r D . Instead After tax cost of debt = (1 – T c )r D * The (1 – T c ) term represents the fact that interest is tax deductible at the corporate level. The r D * term differs from r D because it incorporates costs of financial distress as well as systematic risk. In other words when the firm is in financial distress or bankrupt the bondholders will bear costs. They recognize this when the debt is issued and demand a higher return to compensate them for these costs. i.e. r D * = r D + premium to cover expected cost of financial distress The weighted average cost of capital for the firm is then given by E * DcWACC r E+D E +r)T1( E+D D =r ? E D r r r A RATES OF RETURN RISK FREE DEBT RISKY DEBT D/E 20 The effect of replacing r D by (1 – T c )r D * is to make the weighted average cost of capital a u- shaped function of the debt ratio. r Debt Ratio r E r (1-T )r * c D Optimal debt ratio WACC r D The optimal debt ratio is where the weighted average cost of capital is minimized. This corresponds to the point at which the total PV of the firm is maximized in our previous diagram. To see this suppose the firm produces a constant cash flow C in perpetuity then WACC r C firmPV = . The smaller r WACC the larger is the value of the firm. The value of the firm is maximized when r WACC is minimized. 2.4 Payout Policy How much cash should firms give back to their shareholders? And what form should payment take? Should corporations pay their shareholders through dividends or by repurchasing their shares, which is the least costly form of payout from a tax perspective? 21 Firms must make these important decisions over and over again (some must be repeated and some need to be reevaluated each period), on a regular basis. Six empirical observations play an important role in discussions of payout policies: 1. Large, established corporations typically pay out a significant percentage of their earnings in the form of dividends and repurchases. 2. Historically, dividends have been the predominant form of payout. Share repurchases were relatively unimportant until the mid-1980s, but since then have become an important form of payment. 3. Among firms traded on organized exchanges in the U.S., the proportion of dividend- paying firms has been steadily declining. Since the beginning of the 1980s, most firms have initiated their cash payment to shareholders in the form of repurchases rather than dividends. 4. Individuals in high tax brackets receive large amounts in cash dividends and pay substantial amounts of taxes on these dividends. 5. Corporations smooth dividends relative to earnings. Repurchases are more volatile than dividends. 6. The market reacts positively to announcements of repurchase and dividend increases, and negatively to announcements of dividend decreases. The challenge to financial economists has been to develop a payout policy framework where firms maximize shareholders’ wealth and investors maximize utility. In such a framework payout policy would function in a way that is consistent with these observations and is not rejected by empirical tests. The seminal contribution to research on dividend policy is that of Miller and Modigliani (1961). Prior to their paper, most economists believed hat the more dividends a 22 firm paid, the more valuable the firm would be. This view was derived from an extension of the discounted dividends approach to firm valuation, which says that the value V 0 of the firm at date 0, if the first dividends are paid one period from now at date 1, is given by the formula: )r + (1 D = V t t t 1=t 0 ∑ ∞ (1) where D t = the dividends paid by the firm at the end of period t r t = the investors' opportunity cost of capital for period t Gordon (1959) argued that investors’ required rate of return r t would increase with retention of earnings and increased investment. Although the future dividend stream would presumably be larger as a result of the increase in investment (i.e., D t would grow faster), Gordon felt that higher r t would overshadow this effect. The reason for the increase in r t would be the greater uncertainty associated with the increased investment relative to the safety of the dividend. Similarly to their work on capital structure, Miller and Modigliani pointed out that this view of dividend policy incomplete and they developed a rigorous framework for analyzing payout policy. They show that what really counts is the firm’s investment policy. As long as investment policy doesn’t change, altering the mix of retained earnings and payout will not affect firm’s value. The Miller and Modigliani framework has formed the foundation of subsequent work on dividends and payout policy in general. It is important to note that their framework is rich enough to encompass both dividends and repurchases, as the only determinant of a firm’s value is its investment policy. 23 The payout literature that followed the Miller and Modigliani article attempted to reconcile the indisputable logic of their dividend irrelevance theorem with the notion that both managers and markets care about payouts, and dividends in particular. The theoretical work on this issue suggests five possible imperfections that management should consider when it determines dividend policy: (i) Taxes If dividends are taxed more heavily than capital gains, and investors cannot use dynamic trading strategies to avoid this higher taxation, then minimizing dividends is optimal. (ii) Asymmetric Information If managers know more about the true worth of their firm, dividends can be used to convey that information to the market, despite the costs associated with paying those dividends. (However, we note that with asymmetric information, dividends can also be viewed as bad news. Firms that pay dividends are the ones that have no positive NPV projects in which to invest.) (iii) Incomplete Contracts If contracts are incomplete or are not fully enforceable, equityholders may, under some circumstances, use dividends to discipline managers or to expropriate wealth from debtholders. (iv) Institutional Constraints. If various institutions avoid investing in non- or low-dividend-paying stocks because of legal restrictions, management may find that it is optimal to pay dividends despite the tax burden it imposes on individual investors. 24 (v) Transaction Costs. If dividend payments minimize transaction costs to equityholders (either direct transaction costs or the effort of self control), then positive dividend payout may be optimal. 3 Valuation Valuation is one of the most important topics in finance. The need for valuation arises in many areas. For example, in mergers and acquisitions (M&A) where one firm is acquiring another, valuing the target correctly is one of the most critical tasks facing the acquirer. In IPOs the investment bank must evaluate how much the firm is worth. Much of what analysts who do not believe in efficient markets do is to value firms in order to assess whether the current stock market value is correct. There are commonly used methods of valuing firms. These are: (i) discounted cash flow (DCF); (ii) comparable M&A deals; (iii) comparable publicly traded firms; (iv) liquidation. DCF identifies the marginal cash flows and discounts them back to the present at an appropriate discount rate. It is essentially similar to the standard evaluation of investment projects that we discussed in Section 1. Now the project is the firm as a whole. The method of comparable M&A deals looks at similar companies that have recently been acquired. It bases the estimate of value on various ratios such as the premium over stock market value two months before the acquisition was announced. The method of comparable publicly traded firms identifies similar firms and uses various ratios such as the price/earnings ratios 25 to value the firm. Liquidation value gives the value of the firm if it were broken up and sold piece by piece. Each method has advantages and disadvantages in particular circumstances. (i) Discounted Cash Flow Analysis The basic idea behind the DCF analysis is that the firm has value because it generates cash for the shareholders. It is this stream of cash flows and the rate at which they should be discounted which determines how much it is worth paying for a firm. The discounted cash flow thus involves two steps. The first is to find the cash flows and the second is to discount them at the appropriate discount rate. Finding the cash flows The first problem is to go from this accounting data to the cash flows that are the relevant ones for shareholders. What should be included and what should be left out? The basic rules here are essentially the same as in Section 1.2 on finding the cash flows. Rule 1: Cash flow after taxes, not net income, is the proper basis for analysis. Rule 2: The timing of cash flows is critical. Rule 3: Only incremental cash flows are analyzed (those which occur on the margin because you invest in the firm). Rule 4: Be consistent in the treatment of inflation. Using rules gives the net cash flow or “free cash flow” as it is sometimes called. It is the cash that is available to the owners of the firm including equity and debtholders that is generated on an ongoing basis. To summarize, the basic rule is: Net cash flow = (1 - T c )Earnings Before Interest and Taxes + Depreciation and Amortization + Change in deferred taxes 26 - Change in working capital - Capital expenditures Discounting the cash flows using WACC Finding the appropriate discount rate for valuations is similar to finding the discount rate in standard investment decisions. The most widely used formula for calculating the cost of capital is the weighted average cost of capital. The formula is based on MM with taxes and bankruptcy costs theory. As we saw above E * DcWACC r E+D E +r)T1( E+D D =r ? where r D is the cost of debt, T c is the firm's corporate tax rate, D is the value of the firm's debt, E is the value of the firm's equity and D + E is the total value of the firm. The WACC is just the weighted average of the after-tax cost of debt r D (1 - T c ) and the after-tax cost of equity r E , where the weights depend on the proportions of debt and equity in the firm's capital structure. (ii) Comparable M&A Deals One of the most widely used methods of valuation when there is an acquisition is to look at situations where comparable firms have been acquired. The basic idea behind the method is that in a competitive market similar firms should sell for similar amounts. This is because if there is a wide difference in selling prices buyers will tend to hold back and wait until a cheap firm comes along. There are at least two major problems in applying this method to valuing firms. The first is that it is often very difficult to find firms which have been sold in the recent past and which are reasonably similar. The second is that even if such firms can be identified it will 27 often not be possible to obtain reliable information on the terms of the transaction. These problems limit the usefulness of the method. The first step in applying the method is to identify comparable firms. There are at least eight points of comparison. 1. The type of business activity in which the firm is engaged. 2. The size of the business. 3. The form of ownership - closely held or publicly held. 4. The capital structure. 5. The degree of profitability. 6. The competitive position within the industry. 7. The historical growth rate. 8. The physical facilities. Having identified comparable firms using these criteria, the usual procedure is to look at various ratios and see what values this implies for the value of the firm of interest. For example, by looking at the ratio of the selling price to the stock price before the merger was announced, and multiplying this ratio by the pre-announcement stock market price it is possible to arrive at a value. If the firm's stock market valuation was $100M and the ratio of the selling price to the stock price before announcement was 1.35 (i.e. a premium of 35 percent), this would suggest: The value of the firm’s equity = $100M × 1.35 = $135M. Other statistics concerning the selling price of the firm such as the multiple of sales, the multiple of book, the multiple of earnings, the multiple of cash flow and so on can be used to get some idea of what the firm's value is in a similar way. If there are a number of comparable transactions that are used in this exercise the weighting of these should be on the basis of how comparable the firms are. 28 (iii) Comparable Publicly Traded Firms Another source of information on firm value is to look at the stock market valuation of comparable firms. Although the prices quoted are for shares in such companies rather than the company as a whole so the control premium is excluded they nevertheless provide useful information especially if there are very few or no comparable deals available. The principles for identifying comparable public firms and for using them as a basis of valuation is similar to that for comparable deals. The important point to remember in applying these comparisons of value when the entire business is being sold is that whole companies usually sell at a substantial premium to their stock market valuation. This is because the price on the stock exchange is for a small number of shares and does not include a control premium. (iv) Liquidation Value The basic idea of the liquidation valuation approach is to look at a business as the sum of its component parts. The first thing to do is to compile a list of the firm's assets. This is usually difficult to do particularly if the management of the firm is not cooperating. Even if they are it is sometimes difficult to assemble the necessary information. Having arrived at a list of assets, they can be valued either in terms of replacement value or in terms of liquidation value. The replacement value technique provides an upper bound to firm value and the liquidation value technique a lower bound. The usefulness of this approach depends heavily on the quality of the information it is based on. 4 Real Options The basic NPV approach to investment decisions takes the expected cash flow and discounts at an appropriate risk adjusted rate. However, without suitable modification it does not take into account subsequent chances to make decisions as a result of undertaking the original project. 29 To see this, consider a simple example of constructing a plant. Example The plant costs 4,800. If demand turns out to be high, which occurs with probability 0.5, the cash flow turns out to be 600 per period in perpetuity. If demand turns out to be low, which also occurs with probability 0.5, the cash flow is 300 per period in perpetuity. Everybody is risk neutral and the discount rate is 10%. 300 1.0 6005.03005.0 800,4NPV ?= ×+× +?= Clearly it is not worth building the plant on its own. Suppose next that the plant can be replicated so you can build another one. This is not worthwhile at date 0 but it would be at date 1 if demand turned out to be high. In that case the value of the additional plant at date 1 is 200,1 1.0 600 800,4NPV =+?= Given this option for expansion, undertaking the original plant becomes worthwhile. 245 1.1 200,15.0 300NPV = × +?= In this example it was assumed that everybody is risk neutral. When there is risk aversion the issue of how to adjust for risk comes to the fore. Since the possibility of expansion is an option it is possible to use option pricing techniques to do this. There is a very interesting literature that has developed to do this. In this course we will not cover this area. If you wish to read more, two good books that may be of interest to you are the following. 30 Avinash K. Dixit and Robert S. Pindyck (1994). Investment Under Uncertainty. Princeton University Press. Lenos Trigeorgis (2000). Real Options: Managerial Flexibility and Strategy in Resource Allocation. MIT Press.