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125 Cards in this Set
- Front
- Back
Investment outlay
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for a new project = fixed capital investments (land + depreciable assets) + net working capital investment (current assets – current liabilities)
for a replacement project = FCInv + NWCInv – Sal0 + T(Sal0 – B0), where Sal0 could be termed the current market value of an asset |
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After-tax operating CFs over a projects life
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= operating sales less expenses less depreciation less taxes + add back depreciation for annual after-tax operating cash flow
If a replacement project – make sure to apply incremental sales, costs, and depreciation to annual CF calculation, not just the new CFs |
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Terminal Year after-tax non-operating CF
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First determine the salvage value of the fixed investments (what they are sold for) less the remaining book value (what hasn’t been or wasn’t depreciated yet) = gain on sale
Tax the gain on sale + recovered initial working capital investment TNOCF = SalT + NWCInc – T(SalT – BT) – here BT may be termed “accounting salvage value” If a replacement project, SalT must be the incremental salvage value between the old and new asset, not just the salvage value of the new asset |
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Effects of inflation on capital budget analysis
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Must determine whether to use nominal cash flows and the nominal discount rate or real cash flows and the real discount rate – cannot mix and match
Inflation reduces the value of depreciation tax savings, thereby essentially shifting wealth from the taxpayer to the government Inflation reduces the value of fixed payments to bondholders – when bonds are issued, bondholders pay a price with embedded inflation expectations – if inflation is higher than expected, then the payments to the bondholder are lower than expected, thereby shifting wealth from the bondholders to the issuing corporations Inflation will have a varying impact on revenues and costs, affecting annual after-tax operating cash flows |
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Least common multiple of lives approach
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Used to make a decision among mutually exclusive projects with unequal lives
Extend the time horizon of each project until they match, i.e. the least common multiple of 2 and 3 is 6 years (2 is replicated 3x; 3 is 2x) with each repeated "initial" outlay occurring in conjunction with the final year cash flow |
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Equivalent annual annuity (EAA) approach
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Used to make a decision among mutually exclusive projects with unequal lives
Find the PV of all cash flows for an investment and then determine the annuity payment (PMT) over the specified time horizon; or stated differently, find the annuity payment that is equal to NPV and pick the higher annuity |
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Capital rationing
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when a company’s budget has a size constraint
Optimize your budget with only positive NPV projects – determine the optimal NPV based on needed outlay within a restricted budget Use PI to determine the best projects when budget constraints bring outlay into the analysis PI = PV of future cash flows / Initial investment Violate the NPV rule, if budget constraints limit the company’s selection – go with the next best |
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Sensitivity Analysis
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calculates the effect on NPV of changes in one input variable at a time
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Scenario Analysis
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creates scenarios that consist of changes in several of the input variables and calculates NPV for each scenario (typically three scenarios are done –bear, base, bull)
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Monte Carlo simulation
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where an analyst can assume several variables to be stochastic, following their own probability distributions, determining distributions for NPV and IRR on high volume of potential outcomes
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CAPM "basics" equation =
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systematic risk (market risk or beta) + unsystematic risk (non-market risk that can be diversified away)
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SML (security market line)
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expresses the asset’s required rate of return as a function of Beta
i. Ri = RFR + Beta * (Market Risk Premium) where the MRP = E(R) - RFR (this is CAPM) ii. Diversified investors can demand a risk premium for systematic risk, but not unsystematic risk iii. Should use project betas as opposed to company betas whenever available |
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Real Options
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are capital budgeting options that allow managers to make decisions in the future that alter the value of capital budgeting investment decisions made today – sequential decisions;
Are similar to financial options, just with real assets instead of financial assets Provide the right to make a decision, but NOT THE OBLIGATION |
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Evaluation of real options
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DCF excluding the option – if it produces +NPV, the option is gravy
Project NPV = NPV (based on DCF alone) – Cost of Options + Value of Options Decision trees - can capture the “essence” of sequential decision making problems Option pricing models – less cost effective for simple options |
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Common capital budgeting pitfalls
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a. Not incorporating economic responses into the investment analysis that later have an impact on profitability (new competition is often unanticipated appropriately)
b. Misusing capital budgeting templates c. Pet projects – should receive the same type of scrutiny d. Basing investment decisions on EPS, net income, or return on equity – often an issue when investors are too short-sighted or in need of managing earnings for personal gains e. Using IRR to make investment decisions – use NPV instead – this bias often results in choosing shorter-term, smaller projects with high IRR, at the expense of larger, longer-term, high NPV f. Bad accounting for cash flow g. Overhead costs – forgetting to include overhead costs for implementation and future support h. Not using the appropriate risk-adjusted discount rate – use the projects required rate of return, not the cost of debt (or the cost of equity) for the firm i. Overspending and under-spending the capital budget – fear of losing it, if you don’t use it j. Failure to consider investment alternatives k. Handling sunk costs and opportunity costs incorrectly |
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Claims valuation models
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valuing the liabilities (debt payments) and the equity (dividend distributions), and the claims against the assets, where the value of the claims should meet the value of the assets
Similar to the Free Cash Flow to Equity valuation approach |
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The value of equity ='s
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the PV of cash distributions to equity (i.e. dividends) discounted at the cost of equity
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Capital structure
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the mix of debt and equity used to finance the business – looking to use an appropriate amount of leverage that maximizes the value of the company by minimizing the WACC
WACC = (D/V)rd(1 – T) + (E/V)re |
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Modigliani-Miller: Proposition I without taxes
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Capital structure is irrelevant, assuming risk-free borrowing and lending, and investment and financing decisions independent of each other
In this environment, regardless of what the company’s capital structure is, an investor can borrow money to finance his /her ownership of the company to reflect a preferred debt financing The value of a company is determined solely by its cash flows, not by the relative reliance on debt and equity capital The increase in equity returns is exactly offset by increase in the risk and the associated increase in the required rate of return on equity Value of the company levered = value of the company unlevered |
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Modigliani-Miller: Proposition II without taxes
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The cost of equity is a linear function of the company’s d/e ratio
leverage raises the cost of equity– in order to maintain a constant WACC; as the company increases its use of debt financing, the cost of equity rises WACC excluding taxes = (D / V)rd +(E/V)re Asset beta – represents the amount of the assets’ risk that is non-diversifiable According to M&M, the company’s cost of capital does not depend on its capital structure but rather is determined by the business risk of the company |
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Modigliani-Miller: Proposition I with taxes
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M&M prove that due to the tax shield, the value of a company with debt is greater than that of the same company without debt, for the same level of operating income
Requires that the WACC for a company with debt is lower than a company with all equity Proposition I with taxes = VL = VU + tD |
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Modigliani-Miller: Proposition II with taxes
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M&M prove that due to the tax shield, the value of a company with debt is greater than that of the same company without debt, for the same level of operating income
Requires that the WACC for a company with debt is lower than a company with all equity re = ro + (ro – rd)(1 - t)(D/E) |
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Impact of financial distress
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adds costs, both explicit and implicit – may lose customers, creditors, suppliers, and valuable employees to more secure competitors – may go into bankruptcy
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Agency costs
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costs associated with the fact that all public companies and the larger private companies are managed by non-owners; costs that arise when an agent makes decisions for a principal – caused by a conflict of interests between managers, shareholders, and bondholders
The better a company is governed, the less agency costs Monitoring costs (owners monitoring management), bonding costs (management assuring owners that they are working in the owners’ best interest); residual loss (costs incurred even when there is sufficient monitoring and bonding) Free cash flow hypothesis – the more financially leveraged a company is, the less freedom management has to either take on more debt or unwisely spend cash |
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Asymmetric information
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an unequal distribution of information, when managers have more information about the company than outsiders such as owners and creditors
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Pecking order theory
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suggests that managers choose methods of financing according to a hierarchy that gives first preference to methods with the least potential information content (internally generated funds) and lowest preference to the form with the greatest potential information content (public equity offering)
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Optimal capital structure
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the point at which further increasing value-enhancing effects (i.e. leverage) becomes value-reducing (i.e. financial distress costs) – considering these costs and the tax shield, there is an optimal capital structure where the value of the company is maximized
VL = VU + tD – PV(costs of financial distress) |
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Static trade-off theory of capital structure
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when debt constitutes less than 100% of the company’s capital structure – where you have to balance the expected costs from financial distress against the tax benefits of debt service payments
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Target capital structure
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represents the most appropriate capital structure for the company based on the company’s risk appetite and/or stability of the business environment
Because short-term opportunities may arise, a company’s capital structure may fluctuate from time to time around the target |
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The role of debt ratings in capital structure policy
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Debt ratings provide an independent evaluation of the company’s creditworthiness, the stability of the industry to which the company belongs, and an analysis of legal, institutional, and macroeconomic environment in which the company operates
As leverage rises, rating agencies tend to lower the ratings of the company’s debt to reflect higher credit risk from increasing leverage – a lower rating signals higher risk to both equity and debt capital providers, who would then demand higher returns AAA is the highest rating to BBB (all investment grade – typically a 100bps spread between the best and the bottom of investment grade), and BB to DDD are speculative grade (big yield difference between spec and investment grade) Moody’s, Standard & Poor’s and Fitch all operate separately from one another |
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Factors to consider when evaluating the impact of capital structure policy on valuation
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The company’s capital structure over time, the capital structure of competitors that have similar business risk, and company-specific factors (quality of corporate governance)
Determine your own optimal capital structure for the company based on its ability to service debt |
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International differences with regard to financial leverage
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Countries differ in their preference for leverage, short vs. long-term debt issuances, and their access to capital
France, Italy, and Japan tend to be more highly levered than the US and UK NA tend to use longer-term debt than Japan Developed markets tend to use longer-term debt than emerging markets |
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Country-specific factors that may impact their appetite for leverage
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Institutional and legal environment – taxation, accounting standards, even the level of corruption would impact a company’s optimal capital structure
Financial markets and banking sector – the size and activity of the financial markets within a given country – crucial for access to capital Macroeconomic environment – general economic and business environment, addresses the influence of economic growth and inflation on the capital structure |
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Theories of dividend policy
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Dividend policy does not matter – only investments in working and financial capital impact shareholder’s wealth
Under M&M assumptions there is no meaningful distinction between dividends and share repurchases – relates closely to the homemade dividend, suggesting that if shareholders wanted or needed income, they could construct their own dividend policy by selling sufficient shares to create their desired cash flow stream Dividend policy does matter – do investors value a unit of dividend more highly than equal amounts of uncertain capital gains? Bird in the hand argument: less risky to have the dividend in hand, than just the prospect of future cash flows Tax argument – capital gains vs. dividend tax rates vs. share repurchase |
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Signals insinuated from changes or lack thereof dividend policy
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Increasing a dividend could suggest a sound future – but may signal limited growth opportunities (i.e. no better use for that cash?)
Decreasing a dividend could suggest a bleak outlook – needing the cash to pay creditors, or could signal the need for cash to invest in growth opportunities (typically the former) No dividend could suggest heavy growth phase, or an unfavorable tax climate |
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Clientele effects
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the existence of groups of investors (clienteles) attracted by (and drawn to invest in) companies with specific dividend policies – retired investors looking for a steady income, tax considerations (dividends vs. capital gains), institutional investors
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Alleviating agency issues with dividends
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Agency issues may be alleviated by a dividend payment – some sense of security by investors that the agents (management) are not squandering capital
But paying a dividend when a company is highly leveraged, could create a conflict of interest when wealth is essentially shifting from bondholders to shareholders |
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Factors that affect dividend policy
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Investment opportunities
The expected volatility of future earnings Financial flexibility Tax consideration Flotation costs Contractual and legal restrictions |
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Double-taxation
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when corporate earnings are taxed at the corporate level and then taxed again at the shareholder level if they are distributed to taxable shareholders as dividends
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Split rate
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corporate earnings that are distributed as dividends are taxed at a lower rate at the corporate level than earnings that are retained. And for the individual investor, dividends are taxed as ordinary income (still double taxation, but to a lesser degree at the corporate level)
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Tax imputation dividend tax regimes
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ensures that corporate profits distributed as dividends are taxed just one, at the shareholder’s tax rate; taxed first at the corporate level, but then shareholders receive a credit (franking credit) for the taxes that the corporation paid on those distributed earnings
If the shareholder’s marginal tax rate is higher than the company’s, the shareholder pays the difference between the two rates, and vice versa |
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Stable dividend
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regular dividends are paid that generally do not reflect short-term volatility in earnings; most common form, because it reduces the risk of dividend cuts
Expected dividend = last dividend + (expected increase in earnings x target payout ratio X adjustment factor) Adjustment factor = 1/# of years for adjustment |
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Target payout dividend
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paying out a percentage of net income; DPS/EPS = % payout ratio
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Residual dividend payout
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Paying out as dividends any internally generated funds remaining after such funds are used to finance positive NPV projects; rarely used in practice
Dividend = earnings – (capital budget x equity percent in capital structure) or zero |
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Global trends in corporate dividend/shareholder return policies
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the number of companies paying dividends has been in a long-term decline in most developed markets: US, CAD, EU, UK, and Japan
meanwhile, the number of companies repurchasing shares is on an upward trend |
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Share repurchasing advantages compared to cash dividends
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Potential tax advantages
Share price support – signals the company’s shares are a good investment Added managerial flexibility (you don’t have to be consistent, like you do with dividends) Offsetting dilution from employee stock options Increasing financial leverage Increasing EPS – often problematic, bc share repurchase increases leverage and bc lower share count does not affect shareholder wealth as FCF is unchanged Cash dividends and repurchasing shares are considered to have an equal effect on shareholder wealth, all other things being equal |
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Signals that a company may not be able to sustain its dividend
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The level of the dividend ratio
Whether the company has to borrow to pay the dividend Company’s past dividend record: i. although past financial data does not always predict dividend safety ii. for the vast majority of common stocks, the dividend record and prospects have always been the most important factor controlling investment quality and value |
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Corporate governance
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is the system of principles, policies, procedures, and clearly defined responsibilities and accountabilities used by stakeholders to overcome the conflicts of interest inherent in the corporate form
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Two main objectives of corporate governance
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To eliminate or mitigate conflicts of interest, particularly those between managers and shareholders
To ensure that the assets of the company are used efficiently and productively and in the best interests of its investors and other stakeholders |
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Attributes of an effective corporate governance system
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Delineation of the rights of shareholders and other core stakeholders
Clearly defined manager and director governance responsibilities to stakeholders Indentifiable and measurable accountabilities for the performance of the responsibilities Fairness and equitable treatment in all dealings between managers, directors, and shareholders Complete transparency and accuracy in disclosures regarding operations, performance, risk, and financial position |
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Sole partnership
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sole owner, few legal requirements, entity is easily formed, no legal distinction between the owner and the business; unlimited liability by the owner; very limited ability to raise capital; non-transferable (except by sale) ownership; essential that the owner is an expert in his/her business
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Partnership
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multiple owners, few legal requirements, entity is easily formed, no legal distinction between the owner and the business; unlimited but at least shared liability among owners/partners; limited ability to raise capital; non-transferable ownership; essential that the owners are experts in the business
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Corporation
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unlimited ownership; numerous legal and regulatory requirements; legal separation between owners and business; limited liability to owners; nearly unlimited access to capital; easily transferable ownership; unnecessary to be an expert in the business
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Conflicts that arise in agency relationships
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Agency problem: when manager and shareholder/director interests are not aligned
Managers and shareholders: whether management will act for the good and value creation for shareholders, or in their own best interests Directors and shareholders: directors should serve as agents of the shareholders, to ensure that interests are being well served – directors review M&A, review/audit financials, set compensation + bonus, and discipline poor performing managers The main conflict that can arise, is when directors come to identify with the managers’ interests rather than the shareholders – occurs when the board is not independent, or when there are personal relationships between managers and the board, or inter-linkage between boards; overpayment of directors is also a frequent problem |
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Responsibilities of the board of directors
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Establish corporate values and governance structure for the company to ensure that the business is conducted in an ethical, competent, fair, and professional manner
Ensure that all legal and regulatory requirements are met and complied with fully and in a timely fashion Establish long-term strategic objectives for the company with a foal of ensuring that the best interests of shareholders come first and that the company’s obligations to others are met in a timely and complete manner Establish clear lines of responsibility and a strong system of accountability and performance measurement in all phases of a company’s operations Hire the CEO, determine the compensation package, and periodically evaluate the officer’s performance Ensure that management has supplied the board with sufficient information for it to be fully informed and prepared to make the decisions that are its responsibility, and to be able to adequately monitor and oversee the company’s management Meet frequently enough to adequately perform its duties, and meet in extraordinary session as required by events Acquire adequate training so that members are able to adequately perform their duties |
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Desired director qualifications & core competencies
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Independence – at least a majority (3/4 recommended)
Skill & Experience – expertise in the industry, or within business matters; experience in strategic planning and risk management Indication of ethical soundness Other board experience with companies regarded as having sound governance practices Resources – authority to hire external auditors and other outside consultants without management’s intervention or approval Accurate information about the company’s financial and operating position Dedication and commitment to serving the board and investors’ interests – serving on multiple boards may be a conflict, want solid attendance records, and limited other commitments) |
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Lack of independence "qualities/examples" of a board
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former employment at the company
business and/or personal relationships interlocking directorships ongoing banking or other creditor relationship |
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Effective corporate governance practices
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Independence
Not best practice when the CEO is also Chairman of the board Annual or staggered elections (staggered is often preferred by companies, less of a disruption, also helps with continuity of knowledge, but best practice generally supports annual – so as not to be stuck with a “dud” for three years) Annual board self-assessment – as a whole, as individuals, a review of activities, an evaluation of qualities to achieve in the future, and a final report within the proxy Separate sessions of independent directors at least annually, preferably quarterly Establishment of an independent audit committee with sufficient expertise in accounting + legal matters, oversees the internal audit function with the internal audit staff reporting directly to the committee , have sufficient resources, the cooperation of management, the authority to hire auditors, meet with auditors independently of management or other insiders, have full authority to review the audit and financial statements – determining the quality and transparency of financial reporting choices Nominating committee – establish criteria for evaluating director candidates or senior management positions, identify candidates, review qualifications of the nominees, document reasons for the selection of candidates recommended Compensation committee – determining salary generally set by contractual commitments between company and the executive/director; prerequisites, additional comp with benefits; bonus awards – normally aligned with company performance and long-term goals and objectives; stock options, awards, restricted stock (etc.) Repricing options when they are out of the money (above the current stock price) – must expense the difference in the IS |
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Elements of a company's statement of corporate governance policies that an analyst should analyze
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Quality, clarity, timeliness, and completeness of financial information in valuing securities and assessing risk
Code of ethics Statements of oversight, monitoring, and review responsibilities of directors, including internal control, risk management, audit and accounting and disclosure policy, compliance assessment, nominations, compensation awards, and other responsibilities Statements of management’s responsibilities to provide complete and timely information to the board members prior to board meetings, and to provide directors with free and unfettered access to control and compliance functions within the company Reports of directors’ examinations, evaluations, and findings in their oversight and review function Board and committee performance self-assessments Management performance assessments Training provided to directors prior to joining the board and periodically thereafter |
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Accounting risk
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financial statements are incomplete, misleading, or materially misstated
will have a material impact on valuation |
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Asset risk
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assets will be misappropriated by mangers or directors in the form of excessive compensation or other perquisites
will have a material impact on valuation |
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Liability risk
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that management will enter into excessive obligations, committed to on behalf of shareholders, that effectively destroy the value of SE; frequently take the form of off-balance sheet obligations
will have a material impact on valuation |
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Strategic policy risk
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that managers may enter into transactions, such as M&A, or incur other business risks that may not be in the best long-term interest of shareholders, but which may result in large payoffs for management or directors
will have a material impact on valuation |
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Acquisition
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is the purchase of some portion of one company by another
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Merger
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the absorption of one company by another
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Statutory merger
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one of the companies ceases to exist as an identifiable entity and all its assets and liabilities become part of the purchasing company
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Subsidiary merger
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company being purchased becomes a subsidiary of the purchases (often occurs when the company being purchased has a strong brand or good image among consumers that the acquiring company wants to retain)
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Consolidation
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similar to statutory merger, but here, both companies terminate their previous legal existence and become part of a newly formed company (common when both companies are approximately the same size)
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Horizontal M&A
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when merging companies are in the same kind of business, usually as competitors; often in pursuit of economies of scale – savings achieved through the consolidation of operations and the elimination of duplicate resources
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Vertical M&A
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when the acquirer buys another company in the same production chain (i.e. a supplier or distributor) to gain greater control over the production process in terms of quality or procurement of resources, or the distribution of finished goods
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Backwardation integration
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if the acquirer purchases up the value chain, a supplier
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Forward integration
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if the acquirer purchases down the value chain, a distributor
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Conglomerate
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when an acquirer purchaser another company that is unrelated to its core business for company level diversification (GE example)
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Common motivations behind M&A
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Basic motivations include: search for economies of scale in a horizontal merger, or cost savings through integration in a vertical merger
Synergy – where the combined company should be worth more than the sum of its parts – often will either reduce costs or enhance revenues Growth – external growth vs. organic growth, sometimes is safer than green-fielding Increasing Market Power – gaining share with horizontal integration, or even creating a captive market with vertical integration Acquiring unique capabilities and resources – for competitive purposes or to shore up lacking resources (acquiring strong R&D, sales team, intellectual capital, creative talent) Diversification – often with conglomerates; not always in the best interest of shareholders Managers’ personal incentives – often because compensation is based on size, so managers are incentivized to get bigger and acquire Tax considerations – to lower the tax liability Unlocking hidden value through reorganization, access to better management, or synergy – often done at less than break-up value (if you sold the company into its parts) Cross-border motivations – to extend market reach and gain international expertise |
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Bootstrapping
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when a company’s earnings increase as a consequence of the merger transaction itself (rather than b/c of resulting economic benefits of the combination)
Occurs when the shares of the acquirer trade at a higher P/E than those of the target, and the acquirer’s P/E does not decline following the merger Calculation – determine the market value of equity for each portion (based on P/E*total earnings (total earnings = EPS*total shares outstanding) Determine how many shares would need be issued to acquire the target company: target market value / stock price of acquirer = shares needed to issue Calculate the “new” earnings (due to bootstrapping) by summing the total earnings of acquirer + target and divide by total shares outstanding (acquirer + shares needed to issue) Accretion = new earnings – acquirer earnings (all due to the difference in P/E) |
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Pioneering development M&A
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industry has substantial development costs and has low, but slowly increasing sales growth
Motives: younger, smaller companies acquired by larger companies that have the resources, but lack growth; or younger companies combining together for scale Types: Conglomerate or Horizontal |
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Rapid accelerating growth M&A
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industry has high profit margins caused by few market participants
Motives: explosive growth in sales requires large capital requirements to expand capacity Types: Conglomerate or Horizontal |
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Mature growth M&A
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industry has a drop in the entry of new competition, but growth remains
Motives: mergers for economies of scale, savings, and operational efficiencies Types: horizontal and vertical |
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Stabilization and market maturity M&A
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industry has increasing competition and capacity constraints
Motives: economies of scale in operations to improve competitive low cost positioning and or pricing (domestically and foreign) Types: horizontal |
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Deceleration of growth and decline M&A
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overcapacity and eroding profit margins
Motives: to ensure survival (horizontal), increase efficiency and profit margins (vertical), companies in related industries may merge to exploit a synergy, companies in this industry may acquire companies in young industries Types: horizontal, vertical, conglomerate |
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Stock purchase acquisition
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when the acquirer gives the target company’s shareholders some combination of cash and securities in exchange for the shares of the target company’s stock (must have at least 50% shareholder approval); no corporate-level taxes, target shareholders are taxed on capital gains, acquirer assumes the target’s liabilities
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Asset purchase acquisition
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the acquirer purchases the target company’s assets and payment is made directly to the target company (is quicker and normally does not require approval) – and enables the buyer to buy only the assets they want/need; target company pays taxes on any capital gains, no direct tax consequence for the target company’s shareholders, and acquirer often avoids acquiring liabilities
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Methods of M&A payment
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Cash offering – either from acquirer’s existing assets or a debt issuance
Mixed offering – combination of cash and stock Securities offering – target shareholders receive shares of the acquirer’s common stock |
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Exchange ratio for securities offerings
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determines the number of shares the stockholders in the target company receive in exchange for each of their shares in the target company – typically negotiated in advance for a range of stock prices
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Method of payment impact on the distribution of risk and reward between acquirer and targer
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often when management is confident in the value creation opportunity, they will do all cash offer to capture all of the upside
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Definitive merger agreement
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a contract written by both companies’ attorneys and is ultimately signed by each party to the transaction
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Friendly Merger attributes
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have a definitive merger agreement
proxy statement for instances when a shareholder vote is required |
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Hostile takeover types
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bear hug
tender offer proxy fight - trying to take control through a shareholder vote |
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Bear hug
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submitting a merger proposal directly to the target company’s board, bypassing management/CEO
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Tender offer
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the acquirer invites target shareholders to submit their shares in return for the proposed payment (can be cash or stock transactions)
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Pre-offer defense mechanisms
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rights-based defenses: poison pills and poison puts, changes to the corporate charter (staggered boards and super majority provisions); shark repellents; incorporation in a state with restrictive takeover laws; staggered board of directors; restricted voting rights; supermajority voting provisions; fair price amendments; golden parachutes
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poison pills
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a pre-offer defense mechanism: a legal device that makes it prohibitively costly for an acquirer to take control of a target without the prior approval of the target’s board of directors
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flip-in pill
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when the common shareholder or the target company has the right to buy its shares at a discount
a pre-offer defense mechanism |
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Dead-hand provision
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allows the board of the target to redeem or cancel the poison pill only by a vote of the continuing directors
a pre-offer defense mechanism |
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Poison puts
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a pre-offer defense mechanism
give rights to the target company’s bondholders – allow the bondholders to put the bonds to the company and force the acquirer to refinance the target’s debt immediately |
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iIncorporation in a state with restrictive takeover laws (US)
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a pre-offer defense mechanism
– enables flexibility in dealing with unwanted suitors – target friendly states: OH, PA |
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Staggered board of directors
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a pre-offer defense mechanism
only a portion of the board comes up for election each year, requiring an acquirer to wait at least two years |
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Restricted voting rights
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a pre-offer defense mechanism
in-place triggers, restricting someone from acquiring large amounts of shares over a certain amount (typically 15-20%) |
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Supermajority voting provisions
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a pre-offer defense mechanism
requiring a high % of shareholder approval above the typical 51% majority (often as high as 80%) |
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Fair price amendments
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a pre-offer defense mechanism
disallow mergers below some predetermined threshold |
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Golden parachutes
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a pre-offer defense mechanism
compensation agreements between the target company and its senior managers, providing managers with lucrative pay days if they leave the target company after a change in control (more for management “safety” less related to deal deterrent) |
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POST-OFFER defense mechanisms
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not always upheld in court, but typically used in conjunction with a pre-offer defense:
“Just say no” defense Litigation Greenmail Share repurchase - sometimes they go so far as to take private, a leveraged buyout Leveraged recapitalization “Crown jewel” defense “Pac-man” defense White knight defense White squire defense |
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Litigation - defense mechanism
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a post-offer defense mechanism
file a lawsuit against the acquiring company based on alleged violations or securities or antitrust laws (more to delay…) |
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Greenmail
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a post-offer defense mechanism
allows the target to repurchase its own shares back from the acquiring company, usually at a premium to the market price |
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Share repurchase - M&A defense mechanism
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a post-offer defense mechanism
acquiring shares from other shareholders, not just the acquiring company - sometimes they go so far as to take private, a leveraged buyout |
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Leveraged recapitalization
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a post-offer defense mechanism
the assumption of a large amount of debt that is then used to finance share repurchases, but some shares remain in the hands of public shareholders |
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“Crown jewel” defense
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a post-offer defense mechanism
the target sells off a subsidiary or asset to a third party (often the main motivation behind the takeover offer) |
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“Pac-man” defense
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a post-offer defense mechanism
making a counteroffer to the acquire the hostile bidder (rare because the acquirer is often much bigger than the acquirer) |
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White knight defense
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a post-offer defense mechanism
target company seeks a third party to purchase the company in lieu of the hostile bidder (coming to the aid of the target company) |
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White squire defense
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a post-offer defense mechanism
target seeks a friendly party to buy a substantial minority stake in the target – enough to block the hostile takeover without selling the entire company |
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Antitrust
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to ensure that markets remain competitive
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SEC "purpose"
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to maintain both fairness in merger activities and confidence in the financial markets
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Herfindal-Hirschman index
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is a measure of market power/concentration = the sum of market shares (in % form) squared
If HHI is less than 1,000, the market is not considered to be concentrated and a challenge is unlikely unless other anti-competitive issues arise If HHI is between 1,000 and 1,800, a market is considered moderately concentrated If HHI is 1,800 or more is a concentrated market and would require a comparison of post-merger and pre-merger HHI If this comparison results in an increase of 100 points in a moderating concentrated or 50 points in a highly concentrated market, it is likely to evoke antitrust concerns Smaller increases would likely not cause a problem |
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Discounted cash flow method - advantages and disadvantages
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discounts the company’s expected future free cash flows to the present in order to derive an estimate for the value of the company
Advantages: changes in a company’s cash flows can be readily modeled; estimate of intrinsic value based on forecast fundamentals is provided by the model; changes in assumptions and estimates can be incorporated by customizing and modifying the model Disadvantages: difficult to apply when FCFs do not align with profitability within the first stage (in fact FCFs may be negative); estimating FCFs and earnings is not an exact science; discount rate estimates can change over time (based on the market); terminal value estimates are often subject to acquisition values – and can have varying degrees of estimation error – plus have a dramatic impact on DCF final output (WACC estimate too) |
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Comparable company method - advantages and disadvantages
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defines a set of other companies that are similar to the target company under review – may include other companies within the primary industry, as well as similar industries
Advantages: assumes “like” assets should be valued on a similar basis; most of the required data are readily available; estimates are derived directly from the market (not from assumptions or estimates) Disadvantages: sensitive to market mispricing, this approach determines fair market price and then requires an additional assumption for a takeout premium; difficult for the analyst to incorporate and specific plans of the target (changing capital structure, etc.); data for past premiums may be stale |
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Comparable Transaction method - advantages and disadvantages
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similar to comparable company, but the analyst uses details from recent takeover transactions
Advantages: not necessary to separately estimate a takeover premium; estimates come directly from actual market transactions, and this reduces litigation risk because there is price basis in the market Disadvantages: assumes M&A market has properly valued assets; there may be no comparable transactions in the market; may be inaccurate, bc hard to determine the plans for the target (changing capital structure, etc) |
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Premiums in acquisitions
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Acquirers must typically pay a premium to induce the owners of the target company to relinquish control – premium is the portion of the compensation received by the target company’s shareholders that is in excess of the pre-merger market value of their shares
Target Shareholders’ Gain = Premium = Price Paid by acquirer – pre-merger value of target Acquirers will pay in excess of the target company’s value in anticipation of reaping its own gains – typically cost savings and/or revenue enhancements Acquirer’s gain = synergies – Premium = S – (Pt – Vt) Post merger value of the combined company = pre-merger value of the acquirer + value of the target + synergies – cash paid to target shareholders |
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Cash offer
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take the $ per share offered for the target company and compute the premium, and then subtract that premium from expected synergies to determine the stock appreciation to the acquirer
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Stock offer
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use the announced ratio to find the target’s premium and post-merger value
take the offered ratio x the share price of the acquirer determine the needed shares to issue: ratio x the target’s shares outstanding – or the dilutive impact to acquirer shareholders Find the post-merger market value = pre-merger value of the acquirer + value of the target + synergies – cash paid (should be zero), and then divide by new shares outstanding (inclusive of the issuance) for the new “share price of the acquirer” Target’s premium is then the new share price of the acquirer x the # of shares issued, less the pre-merger value of the company Acquirer’s $ accretion is then the synergies less the target’s premium |
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Mixed offer
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shares and cash – some dilution but not as much to the acquirer’s shareholders
Determine the cash portion first: value of the acquirer + value of the target + synergies - $ per share offered (costs) Find the share count dilution by taking the ratio x the target’s pre-merger shares outstanding + the acquirer’s pre-merger shares outstanding, then divide the value found in step one by the new acquirer’s share count = the $ per share of the acquirer + accretion Target’s premium is found by adding the cash per share value + the acquirer’s new share price X the number of shares issued less the pre-merger value of the target company Acquirer’s gain is then synergies less target premium |
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Empirical evidence related to the distribution of benefits in a merger
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The more confident managers are in estimated synergies, the more acquiring managers will prefer to pay in cash, and the more target companies will prefer to receive stock; BUT the more of the price paid in stock, the greater the risks and benefits of realizing synergies is passed on to the target shareholders
Relative values of the companies is also a factor to consider, the more confident managers are in the estimate of the target company’s value, the more they would prefer to pay in cash and the more the target would prefer stock Target shareholders reap 30% premiums over the stock’s pre-announcement market price, and the acquirer’s stock price falls, on average between 1-3% But on average, both the acquirer and target tend to see higher stock returns surrounding cash acquisition offers than around stock offers |
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Equity Carve Out
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the creation of a new legal entity and sales of equity in it to outsiders
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Spin-Off
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shareholders of the parent company receive a proportional number of shares in a new, separate entity vs. the sale of a division, which is typically a cash inflow to the parent company
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Split-Off
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similar to a spin-off, but where some of the parent company’s shareholders are given shares in a newly created entity in exchange for their shares of the parent company
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Liquidation
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breaking up a company, division, or subsidiary and selling off its assets piecemeal (typically associated with bankruptcy)
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