Corporate Finance

Introduction
Ways shareholders can encourage goal congruence of maximising Shareholders wealth By : 1. Monitor managers actions. Devices are: - Independently audited accounting statements - Cash dividends But this is very expensive and time consuming, Alternatively 2. Incorporate clauses in managerial contracts to reduce goal congruence, eg. Bonuses for good performance.
Drawbacks, profits are not cash. This does not have direct link to shareholders wealth.

3. Pay bonuses using share options.

Drawback, fluctuation of share price is also based on external factors such as the economy.

Equity Capital

.is the funds raised from owners of the company. Advantage - No specific time period to repay the capital. - No need to make fixed repayments. - Only pay dividends, when the company is doing well. Disadvantage - Lose control of the company. - It time consuming to raise funds as potential investors needs lot of information. - The dividends obligation is for the whole life of the entity.

Debt Capital

.is funds supplied by lenders which are part of a firm's capital structure. Advantage - It allows the company to retain ownership and control - Debt obligations are limited to the loan repayment period. - It less time consuming than equity capital. Disadvantage - It requires regular cash repayments regardless whether the company is doing well or not. - Risk of financial distress and bankruptcy.

The Stock Exchange (SE)

A market in which securities are bought and sold and it is regulated by Financial Services Authority (FSA). 2 sections of SE - Main Market. E.g. for established and Larger companies. - Alternative Investment Market (AIM) .E.g. new comers and small businesses.

Listing requirement Main Market Minimum 25% of the shares in public hands. 3 years trading records required. Prior Shareholders approval required for large acquisition and disposal. Minimum Market capitalisation required (750K). AIM No Minimum shares required to be in public hands. No trading records required.

No prior Shareholders approval required for large acquisition and disposal. No minimum Market capitalisation required. Only nominates advisor required for all transactions.

Roles of Sponsors

Roles of Brokers Reasons for issuing shares

Sponsor required for certain transactions. Is to make sure the company seeking a listing is abiding by all relevant regulations and also responsible for managing the listing process. Sponsors are regulated by the UKLA. Is to market and advice on the appropriate issue price for new shares. To raise capital either for - new projects, - take-over bids - to repay debt To reduce market price of the shares. Bonus or scrip issue.

Method of issuing shares

Public Offer issuing house, sold at fixed priced or nominal value, open to anyone, underwritten at agreed price to institutional investors, expensive (sponsor, broker and audited figures required). Placing issuing house, offered to selective institutional investors at fixed price (who offers it to their own clients). Tender Offer issuing house, investors are invited to bid, minimum price accepted if the adequate amount of shares has been sold. So the final price is the maximum price at which all the shares can be sold. Rights Issue offered to existing shareholders according to their size of the ownership, right can be sold, no issuing house. Offered at a price that is lower than the current market price.

Scrip dividends Why dividend growth model WACC calculations and Rate of return WACC calculations give different results?

Bonus or Scrip Issue issued to existing shareholders for free, no cash inflows and reduces share prices. Offering new shares as an alternative to cash dividends. Difference caused by different methods of calculating cost of capital equity. The dividend growth model uses internal information and assumes that the risk of a new project is the same as the risk of the company. The CAMP uses external information and the cost of equity can be adjusted to reflect risk by using a different value for BETA. CAMP It is generally seen as a much better method of calculating the cost of equity than the dividend growth model because it takes into accounts the companys level of systematic risk relative to the stock market as a whole. How much does a company have to pay for its capital. All providers of finance require returns. The return will reflect the risk of the investment and the returns of alternatives. Companies needs to know the total cost of capital in order to make appropriate financial and investment decisions.

Cost of Capital

WACC

Assumptions: - Capital structure will not change - It assumes that all projects within the company carries the same risk.

The Traditional approach

Theory of Capital structure Assumptions: - No tax exists - Companies only have 2 options of finance. - Any increase in debt finance is accompanied by decrease of the same amount in equity finance. - Corporate risks stay the same all the time. - Optimum capital structure do exists (50/50). Cost of equity raises due to increase of gearing as the business faces more risk. Cost of debt only rises at very high levels. A company totally finance by equity will at point A, and a company totally financed with Debt will be at point C. The WACC of the company will fall initially due to the cost of cheaper debt capital outweighing any increases of cost of the remaining equity capital.

Miller & Modigiliani (1) = net income approach

Assumptions: - Perfect capital market - Companies can borrow any amount of finance they like, so no bankruptcy risk. - No tractions cost for buying and selling shares. - Cost of personal finance and corporate finance are same. - No optimum capital structure Theory Market value of the company depends on expected performance and commercial risk not its capital structure. Cost of equity increases as shareholders face more risk due to increase in gearing. As debt holder dont face any risk as there is no bankruptcy risk as result the cost of debt stay the same. The WACC stay the same as the net income does not change.

Miller & Modigiliani (2) : Corporate tax

In 1963, M & M acknowledged tax shields for debt capital, which in fact reduces the WACC. Therefore, the optimum capital structure is 100% debt capital.

But in practice companies do not adopt on all-debt capital structure. So they refined their theory again and included bankruptcy risk in their theory.

Reasons for companies do not employ 100% debt capital.

Because -

Bankruptcy costs: as high geared company face bankruptcy risk investors require high returns. Direct costs pay more interest as lenders required higher return for compensating for high risk of investments. Indirect costs loss of goodwill for operating high geared company. Agency costs: at high levels of gearing equity shareholders has lower stake and they would prefer the company to take high risk projects. Whereas debt holders return is not dependant on companys profit. So they would like the company to take less risky projects. To do this they could restrict the managements activities by exercising their condition of their debt contact .i.e. restrictive covenants to restrict dividends payments. Also increasing managements monitoring to disclose comprehensive details regarding managements activities, this increases costs and eats into the tax shield benefits.

Myers ranking Pecking order theory

Tax Exhaustion : when a company is highly geared, it fails to fully benefit from tax shield because companies generally do not make enough profit as highly geared companies have high WACC and this is known as Tax Exhaustion. Ranking is that use Internal funds first (retained profits); Than external funds debt, convertibles; Finally equity. Managers prefer funds where the monitoring and justification is less, this explains their ranking.

Dividend Irrelevance

Dividend Policy Miller & Modigliani theory Dividend is irrelevant to determine the market value of the company. As they state that valuation is based on level of corporate earnings, which reflects the companys investment policy, rather than how much the companys earnings are paid out as dividends.

Their assumptions: - No transaction costs for buying and selling shares for investors. - No costs for issuing shares for the company. - No tax both for company and investors. - Perfect market efficiency. Miller and Modigliani believe that investors are rational and indifferent whether they receive dividends or capital gains. They also state if investors want dividends than they can just sell few of their to get some homemade dividends. Dividend Relevance Lintner (1956) argued that dividends are preferred than to capital gains because of their certainty. As investors prefer regular certain cash dividends rather than leaving the same amount in projects whose future value is uncertain. Research by Pettit (1972) and Kwan (1981) shows that in a semiefficient market dividend change do convey new information to shareholders. - Fixed percentage payout ratio (company pays out fixed percentage of annual profit). - Zero dividends policy (pay no dividends) - Constant increasing dividends (slowly increasing dividends) - Scrip dividends (offering ordinary shares equivalent to dividends) - Share repurchases (to increase the share price/capital gains for investors). - Special dividends (paying dividends that are extremely higher than what investor expected generally this happens when company sells a huge asset). Fama (1970) - Efficient Financial Market as "one in which prices always fully reflect available information. Fama identified three levels of market efficiency: 1. Weak-form efficiency share prices instantly and fully reflect all information of the past prices. Therefore, abnormal returns are very possible with fundamental analysis as the current market price do not reflect current publicly available

Dividend policies

Alternative to cash dividends

Levels of market efficiency

information. 2. Semi-strong efficiencyshare prices fully reflect all of the publicly available information. Therefore, only investors with additional inside information can make abnormal returns. 3. Strong-form efficiencyshare prices fully reflect all of the public and inside information available. Therefore, no one can make abnormal return as the current market price reflect all information.

Benefit of using financial intermediary for swaps

Benefit of using financial intermediary for swaps

Advantages - Its Easy and less time consuming than finding a counter party for the swaps. - The financial intermediary will be able to find a counter party that will be able to match 100% of the finance that the company is looking for. - Less risky because if the counter party defaults than the bank will have to make any outstanding interests. Disadvantages - The bank will require a fee. - Changes in base interest rates are unknown, so sometimes Libor rate could fluctuations could eliminate any arbitrage profit. Advantages - Its Easy and less time consuming than finding a counter party for the swaps. - The financial intermediary will be able to find a counter party that will be able to match 100% of the finance that the company is looking for. - Less risky because if the counter party defaults than the bank will have to make any outstanding interests. Disadvantages - The bank will require a fee. - Changes in base interest rates are unknown, so sometimes Libor rate could fluctuations could eliminate any arbitrage profit.

Compare and contrast CAPM and APT? Capital asset pricing model (CAPM) and arbitrage pricing theory (APT) are both methods of assessing an investment's risk in relation to its potential reward and whether the potential investment yield is worthwhile. CAPM developed by Sharpe 1964. The basic theory behind this model is that investor needs to be compensated for Time Value of Money and the risk that they are taking.

The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk. This is calculated by taking a risk measure of the market (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf). APT developed by Ross 1978. The basic theory of arbitrage pricing theory is the idea that the price of a security is driven by a number of factors such as macro factors, and company specific factors. Formula: r = rf + 1f1 + 2f2 + 3f3 + Where r is the expected return on the security, rf is the risk free rate, Each f is a separate factor and each is a measure of the relationship between the security price and that factor.

The CAPM bases the price of stock on the time value of money (risk-free rate of interest (rf)) and the stock's risk, or beta (b) and (rm) which is the overall stock market risk. APT does not regard market performance when it is calculated. Instead, it relates the expected return to fundamental factors. APT is more complicated to calculate compared to CAPM because more factors are involved. CAPM uses the formula: expected rate of return (r) = rf +b (rm - rf). The formula for APT is: expected return = rf + b1 (factor 1) + b2 (factor 2) + b3 (factor 3). APT uses a beta (b) for each particular factor regarding the sensitivity of the stock price.