Corporate Financial Policy 2004-2005 Introduction Professor André Farber Solvay Business School Université Libre de Bruxelles

Corporate Financial Policy2004-2005Introduction

Professor André Farber

Solvay Business School

Université Libre de Bruxelles

Cofipo 2005 01 Introduction |204/18/23

How to finance a company?

• Should a firm pay its earnings as a dividends?

• When should it repurchase some of its shares?

• If money is needed, should a firm issue stock or borrow?

• Should it borrow short-term or long-term?

• When should it issue convertible bonds?


Some data – Benelux 2004

MktCap€m

Free Float NetDebt€m

NetD/BEq NetD/(D+E)all

NetD/(D+E)NetD>0

DivYield Payout Ratio

Mean 3,125 60% 710 38% 16% 36% 3.0% 29%Median 771 56% 154 42% 15% 29% 2.7% 34%Standard deviation 6,195 26% 1,777 78% 54% 34% 1.9% 43%Minimum 30 10% -1,423 -241% -357% 0% 0.1% -283%Maximum 46,706 100% 12,555 220% 166% 166% 12.7% 100%Percentile 0.25 321 41% -18 -9% -4% 13% 1.6% 7%

0.50 763 56% 156 43% 15% 29% 2.7% 34%0.75 3,468 82% 609 81% 39% 44% 4.0% 49%

# observations 101 101 100 97 100 70 78 99


Divide and conquer: the separation principle

• Assumes that capital budgeting and financing decision are independent.

• Calculate present values assuming all-equity financing

• Rational: in perfect capital markets, NPV(Financing) = 0

• 2 key irrelevance results:

– Modigliani-Miller 1958 (MM 58) on capital structure

The value of a firm is independent of its financing

The cost of capital of a firm is independent of its financing

– Miller-Modigliani 1961 (MM 61) on dividend policy

The value of a firm is determined by its free cash flows

Dividend policy doesn’t matter.


Market imperfections

• Issuing securities is costly

• Taxes might have an impact on the financial policy of a company

• Tax rates on dividends are higher than on capital gains

• Interest expenses are tax deductible

• Agency problems

• Conflicts of interest between

– Managers and stockholders

– Stockholders and bondholders

• Information asymmetries


Course outline

09/02/2005 1. Introduction – MM 1958, 1961

16/02/2005 2. Debt and taxes

23/02/2005 3. Adjusted present value

02/03/2005 4. WACC

09/03/2005 5. Case study

16/03/2005 6. Option valuation: Black-Scholes

23/03/2005 7. Capital structure and options: Merton’s model

13/04/2005 8. Optimal Capital Structure Calculation: Leland

20/04/2005 9. Convertible bonds and warrants

27/04/2005 10. IPO/Seasoned Equity Issue

04/05/2005 11. Dividend policy

11/05/2005 12. Unfinished business/Review


Practice of corporate finance: evidence from the field

• Graham & Harvey (2001) : survey of 392 CFOs about cost of capital, capital budgeting, capital structure.

• « ..executives use the mainline techniques that business schools have taught for years, NPV and CAPM to value projects and to estimate the cost of equity. Interestingly, financial executives are much less likely to follows the academically proscribed factor and theories when determining capital structure »

• Are theories valid? Are CFOs ignorant?

• Are business schools better at teaching capital budgeting and the cost of capital than at teaching capital structure?

• Graham and Harvey Journal of Financial Economics 60 (2001) 187-243


Finance 101 – A review

• Objective: Value creation – increase market value of company

• Net Present Value (NPV): a measure of the change in the market value of the company

NPV = V

• Market Value of Company = present value of future free cash flows

• Free Cash Flow = CF from operation + CF from investment

• CFop = Net Income + Depreciation - Working Capital Requirement


The message from CFOs: Capital budgeting

How freqently does your firm use the following techniques when deciding which project or acquisition to pursue?

Source: Graham Harvey JFE 2001 n=392

0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00%

APV

Profitability index

Simulation analysis

Book rate of return

Real options

Discounted payback

P/E multiple

Sensitivity analysis

Payback

Hurdle rate

NPV

IRR

Ev

alu

ati

on

te

ch

niq

ue

% always or almost always


From Markowitz to CAPM

jfMfj rrrr )(

rf 8%

rM 14%

1 2 Beta

M

P

8%

14%

20%

Sigma

Expected ReturnExpected Return

M

P

2

)~,~cov(

M

Mjj

rr

Security Market Line


The message from CFOs : cost of equity

How do you determine your firm's cost of equity capital?

0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00%

Regulatory decisions

Investor expectations

Dividend discount model

Multibeta CAPM

Arithmetic average historical return

CAPM

% always or almost always


CAPM – an other formulation

)(1

)(

fMf rrr

CEV

2

),cov(

M

Mrr

2

),cov()(

)( :Here

M

MfMf

V

rCrrr

CEV

V

VCr

Consider a future uncertain cash flow C to be received in 1 year.PV calculation based on CAPM:

with:

)()),cov(

1( CEV

rCrV M

f

2 :Define

M

fM rr

ff

M

rr

rCCEV

1

equivalentCertainty

1

),cov()(

See Brealey and Myers Chap 9


Binomial option pricing model

• Used to value derivative securities: PV=f(S)

• Evolution of underlying asset: binomial model

• u and d capture the volatility of the underlying asset

• Replicating portfolio: Delta × S + M

•

• Law of one price: f = Delta × S + M

SdS

uS fu

fd

Δt

dtr

utr

fMedSDelta

fMeuSDelta

tu

d

teu t

11

1

M is the cash positionM>0 for investmentM<0 for borrowing

r is the risk-free interest rate with continuous compounding


Risk neutral pricing

• The value of a derivative security is equal to risk-neutral expected value discounted at the risk-free interest rate

• p is the risk-neutral probability of an up movement

trdu

e

fppff

)1(

du

dep

tr

tredppu )1(


State prices – Digital options

• Consider digital options with the following payoffs:

• Using the binomial option pricing equation:

uS dS

Up: vu 1 0

Down: vd 0 1

true

pv

trde

pv

1

Calculation of present values using state prices:

dduu

dutr

du

fvfvf

vve

dSvuSvS

1


Using state prices

Calculation of present values using state prices:

dduu

dutr

du

fvfvf

vve

dSvuSvS

1


Cost of capital with debt

• CAPM holds – Risk-free rate = 5%, Market risk premium = 6%

• Consider an all-equity firm:

• Market value V 100

• Beta 1

• Cost of capital 11% (=5% + 6% * 1)

• Now consider borrowing 20 to buy back shares.

• Why such a move?

• Debt is cheaper than equity

• Replacing equity with debt should reduce the average cost of financing

• What will be the final impact

• On the value of the company? (Equity + Debt)?

• On the weighted average cost of capital (WACC)?


Modigliani Miller (1958)

• Assume perfect capital markets: not taxes, no transaction costs

• Proposition I:

• The market value of any firm is independent of its capital structure:

V = E+D = VU

• Proposition II:

• The weighted average cost of capital is independent of its capital structure

WACC = rAsset

• rAsset is the cost of capital of an all equity firm


MM 58: Proof by arbitrage

• Consider two firms (U and L) with identical operating cash flows X

VU = EU VL = EL + DL

Current cost Future payoff

• Buy α% shares of U αEU = αVU αX

______________________________

• Buy α% bonds of L αDL αrDL

• Buy α% shares of L αEL α(X – rDL)

______________________________

• Total αDL + αEL = αVL αX

• As the future payoffs are identical, the initial cost should be the same. Otherwise, there would exist an arbitrage opportunity


MM 58: Proof using CAPM

• 1-period company

• C = future cash flow, a random variable

• Unlevered company:

• Levered (assume riskless debt):

• So: E + D = VU

f

MU r

rCCEV

1

),cov()(

f

M

r

rDivDivEE

1

),cov()(

Dr

rCCE

r

rDrCDrCEE

f

M

f

Mff

1

),cov()(

1

)],)1(cov([])1([

=VU


MM 58: Proof using state prices

• 1-period company, risky debt: Vu>F but Vd<F

• If Vd < F, the company goes bankrupt

Current value Up Down

Cash flows VUnlevered Vu Vd

Equity E Vu – F 0

Debt D F Vd

dduuUnlevered VvVvV

0)( duu vFVvE

ddu VvFvD Unlevered

dduu

dduuu

V

VvVv

VvFvFVv

DEV

][)]([


Weighted average cost of capital

Value of all-equity firm

Value of equity

Value of debt

V (=VU ) = E + D

rEquity

rDebt

rAsset

V

Dr

V

Err DebtEquityAsset

WACC


Using MM 58

• Value of company: V = 100

• Initial Final

• Equity 100 80

• Debt 0 20

• Total 100 100 MM I

• WACC = rA 11% 11% MM II

• Cost of debt - 5% (assuming risk-free debt)

• D/V 0 0.20• Cost of equity 11% 12.50% (to obtain WACC =

11%)

• E/V 100% 80%


Why are MM I and MM II related?

• Assumption: perpetuities (to simplify the presentation)

• For a levered companies, earnings before interest and taxes will be split between interest payments and dividends payments

EBIT = Int + Div

• Market value of equity: present value of future dividends discounted at the cost of equity

E = Div / rEquity

• Market value of debt: present value of future interest discounted at the cost of debt

D = Int / rDebt


Relationship between the value of company and the WACC

• From the definition of the WACC:

WACC * V = rEquity * E + rDebt * D

• As rEquity * E = Div and rDebt * D = Int

WACC * V = EBIT

V = EBIT / WACC

Market value of levered firm

EBIT is independent of leverage

If value of company varies with leverage, so does WACC in opposite direction


MM II: another presentation

• The equality WACC = rAsset can be written as:

• Expected return on equity is an increasing function of leverage:

E

Drrrr DebtAssetAssetEquity )(

rA

D/E

rEquity

11%

rDebt

5%

0.25

12.5%

WACC

Additional cost due to leverage


Why does rEquity increases with leverage?

• Because leverage increases the risk of equity.

• To see this, back to the portfolio with both debt and equity.

• Beta of portfolio: Portfolio = Equity * XEquity + Debt * XDebt

• But also: Portfolio = Asset

• So:

• or

DE

D

DE

EDebtEquityAsset

E

DDebtAssetAssetEquity )(


Back to example

• Assume debt is riskless:

• Beta asset = 1

• Beta equity = 1(1+20/80) = 1.25

• Cost of equity = 5% + 6% 1.25 = 12.50

E

V

E

DAssetAssetEquity )1(


Summary: the Beta-CAPM diagram

E

DAssetAssetEquity )( FMF rrrr

D/E

Beta

r 0

βAsset

βEquity

rEquity rAsset

D/E

rDebt=rf

rEquityrDebtWACC

E

Drrrr DebtAssetAssetEquity )(

L

U

Documents

Corporate Financial Policy 2004-2005 Introduction Professor André Farber Solvay Business School Université Libre de Bruxelles