Corporate Finance A Theoretical Approach by Joo Amaro

Corporate Finance A Theoretical Approach by João Amaro de Matos

0. INTRODUCTION • Audience and Philosophy – To whom we address and why • Structure of the Course – Topics and Contents • References – Empirical; Theoretical; Textbooks; Journals

Audience and Philosophy • Corporate Finance – Theory: The concept of Value – The determinants of Capital Structure and its relation to Value – Why and how restructure – Review of different empirical evidences – Historical perspective of development – Research oriented

Structure of the Course • Value • Capital Structure as Determinant of Value: – MM; Agency Costs; Information Asymmetry • Payout Policy and Capital Structure • Debt Contracts and the Structure of Debt • Restructuring: – Going Public; Going Private; Mergers and Acquisitions

References • Theoretical Foundations of Corporate Finance – J. Amaro de Matos, Princeton UP, 2001

1. VALUE • • Value under certainty Value under uncertainty Extension to Multiperiods Flexibility under uncertainty

Value under Certainty • • Robinson Crusoe Economy Time Preferences Production Opportunities Consumption and Investment with Capital Markets • The concept of Value of a Project

Robinson Crusoe Economy • • Two points in time Endowments today and tomorrow Consume x today and y tomorrow Utility – Continuous – increasing and – concave • Uniqueness of optimal consumption

Time Preferences • For a given level of utility, how much current consumption can we sacrifice for future consumption? • Marginal rate of substitution – Ratio: increase in future consumption over decrease in prsent consumption • Marginal rate is negative, less than -1

Production opportunities • Productive investments that may increase future endowments • Allows future additional consumption • Rate of return of the investment as a critical parameter • Increases the consumption choice set, allowing for more future consumption

Capital Markets • • For simplicity, ignore production opportunities Market for trading time preferences Demand supply for endowments Premium for postponing consumption Future value Present Value Enlargement of consumption set

Consumption and Investment with Capital Markets • Now consider investment opportunities and capital markets together • Rational agent maximizing utility invests in all projects with rate of return larger than r • Decision does not depend on utility • Market rate is the cost of opportunity or cost of capital

Value of a Project • How much more may I consume today with the project as compared with the situation without the project? • Net Present Value • It is rational to invest in a project only if its NPV is positive

Valuation under Uncertainty • • • One period model Value and Arbitrage Opportunities and Investment Value and Martingale Measure Beta Values

One Period Model • Uncertainty about the future • Future described by different states of Nature • Uncertainty about cash flows • Requires a probabilistic setting • What is the present value of future, uncertain cash flows?

One Period Model • • • Future consumption is uncertain Contingent consumption plan Utility and risk aversion Payoff matrix and investment portfolio Complete and incomplete markets Optimization problem for investors on uncertain projects

Value under Uncertainty • Value and discount rates • The notion of certainty equivalent • Uncertainty reduces value due to risk aversion • Na equivalent statement: uncertainty increases the discount rate • Positive risk premium and value as expected discounted payoff

Value and Arbitrage • Arbitrage: a portfolio such that initial consumption is not reduced but future consumption can increase • No equilibrium with increasing utilities • Absence of arbitrage is equivalent to a strictly positive vector of state prices

Value and Martingales • Value can be written as – expected payoff – discounted at the risk free rate • Here, expectations are taken with respect to a special probability measure • Risk neutral probabilities • Relation with real probabilities

Beta Values • Total return under uncertainty • How much more return is expected from a risky portfolio as compared to risk free asset • Depends on the correlation between return and a market portfolio • Definition of risk premium

2. OPTIMAL CAPITAL STRUCTURE • The cost of money and the strategic financing choice • The structure of financial sources • The world of Modigliani and Miller • The role of imperfections: taxes • Bankruptcy costs • Miller´s equilibrium

Bonds • • • Bonds: the concept Payoff of Bonds at maturity Value of Bonds under no arbitrage Possibilty of bankruptcy and value Summing payoff over states Bankruptcy and increasing yield

Equity • Equity as a residual claim • Value of equity as the sum of residual claims over states • Total value of the firm at each state is distributed between shareholders and creditors • State value of the firm can be decomposed as payoff to debtholders plus residual claim

Proposition I: no taxes • Present value of the firm is obtained by – summing over states the state value generated by the firm in each state • Sum over states can be decomposed as – Sum over bond payoff plus sum over residual claim • Since total value generated at each state is not dependent of the structure, it follows that • Present value does not depend on structure!!

Proposition II: no taxes • Expected return on equity for unlevered firms • Expected return on debt for unlevered firms • Expected return on equity for levered firms can be written in terms of the two above • Average cost of capital • Average beta

Proposition I: taxes • • • From residual claim, tax is paid Payoff of bonds does not change State value generated by the levered firm Summing over states Rewriting as a function of value of unlevered firm • Premium due to tax shield (pays less taxes) • Leveraged firm is worth more!!

Proposition II: taxes • Expected return on levered equity • Decomposition in 3 terms: unlevered, Bonds and Taxes • Use of definition of Value • Extension of final result • Systematic risk of levered equity

Empirical Evidence • Relation between debt-equity ratio and tax shield is mixed (Barclay, Smith, Watts 95) – No conclusion: tax rates may be crude proxies of effective marginal rate • Mackie-Mason (90) and Graham (96) – Positive relation between marginal rates and debt-equity ratio • However, firms are never 100% debt • Role of banruptcy costs

Miller´s Equilibrium • • • Clientele effect: personal and corporate Demand for Bonds Supply of Bonds The equilibrium Changes in Taxations Empirical Evidence

Demand for Bonds • Two types of bonds: tax-exempt and nonexempt, providing different rates of returns • Demand for non-exempt exists if after-tax return is higher than for tax-exempt • As aggregate debt increases, – marginal tax on bonds’ returns increases, – generates an increasing demand curve on debt level for required rate of return on bonds

Supply of Bonds • Supply of bonds is considered comparing with equity issues • Because this is the supply side, we consider before tax returns! • Before-tax returns on supplied bonds should equal at most before-tax required return on equity • Firms may afford supplying bonds at a constant return rate equal to before-tax required return on equity

Equilibrium • Equilibrium is achieved at a level of aggregate debt such that – Before-tax rate of return on equity equals before -tax aggregate debt rate of return – Actually this is an equilibrium for marginal tax rates – No tax advantage to issue either debt or equity under this equilibrium

An Alternative Equilibrium • Alternative source of debt advantage – Companies in default will not yield the whole interest deduction on debt – Rate of return on supplied bonds will be lower as aggregate debt level increases – Effective corporate taxes decreases with total debt level, reducing equilibrium optimal debt – Generates a decreasing curve on debt level for supplied rate of return on bonds

Empirical Evidence • How significant are costs under a generalized tax model: empirical issue • Testable implications: – in unfavorable economic situation firms are not willing to pay high rates of return on issued bonds • Buser and Hess (1996) have shown evidence

Empirical Evidence • Testable Implications – Higer bankruptcy probability leads to lower debt level. • Castanias (1983) found negative relation between observed leverage and historical failure rate – Long-run average debt ratios negatively related to earnings volatility. • Bradley, Jarrell, Kim (1984)

3. AGENCY, INFORMATION AND CAPITAL STRUCTURE • Agency costs: • monitoring, fee schedule, risk shifting, underinvestment, cost of issuing equity • Information asymmetries: • Capital structure used as 1) a signal and 2) to mitigate inefficiencies in the financing decisions

Agency Costs • Cost of outside equity • Utility for managers-owners: fraction of firm plus nonpecuniary benefits • Second part reduces effective value of the firm • Issuing equity reduces the effective value of the firm

Principal-Agent Problems • • Decisions depend on three types of agents: Shareholders, Managers, Creditholders Different utilities being maximized Problem can be seen as maximizing utilities of shareholders under constraints • Leads to a second-best type of solution • Difference in value between first and second -best is the agency cost

Principal-Agent Problems • Managers expend lower effort than desirable • Managers underinvest due to risk aversion and/or short time horizons • Managers more interested in their jobs’ stability than in implementing changes in corporate control (and others) that may increase value of firm.

Optimal Fee Schedule • Unobservable actions of managers determine the probabilities of observable payoffs • Payment is a function of observable payoff • Fee schedule aligns incentive of managers • Shareholders choose fee maximizing their utilities • Managers max utility choosing actions constrained by (a) fee; (b) providing a minimum expected utility.

Executive Stock Options • Offer package of at-the-money options as part of management’s compensation • Options cannot be transacted for a period • Aligns incentive • Reduces the base pay, reducing differences between employees • Managers’ payment is at risk

The Sarbanes-Oxley Law • Is a US law passed in 2002 to strengthen Corporate Governance and restores investor confidence • Act was sponsored by US Senator Paul Sarbanes and US Representative Michael Oxley

The Sarbanes-Oxley Law • The Sarbanes-Oxley law (SOX) passed in response to a number of major corporate and accounting scandals involving prominent companies in the United States • Enron, World. Com. . . • These scandals resulted in a loss of public tust in accounting and reporting practices

The Sarbanes-Oxley Law • Legislation is wide ranging and establishes new or enhanced standards for all US public company Boards, Management, and public accounting firms. • SOX contains 11 titles, or sections, ranging from additional Corporate Board responsibilities to criminal penalties. Requires Security and Exchange Commission (SEC) to implement rulings on requirements to comply with new law

What does SOX address? • New standards for Corporate Boards and Audit Committees • New accountability standards and criminal penalties for Corporate Management • New independence standards for External Auditors • Creates a Public Company Accounting Oversight Board (PCAOB) under the SEC to oversee public accounting firms and issue accounting standards

SOX initial provisions • Prohibits audit firms to do non-audit work for their clients • Requires companies to establish independent audit committees • Calls on top executives to certify company accounts • Extends protection to insiders who help by denouncing frauds or irregular situations

SOX initial provisions • More relevant provision: Section 404 • Makes managers responsible for mantaining adequate internal control structure and procedures for financial reporting • Demands that companies’ auditors attest to the management’s assessment of these controls and disclose any material weaknesses • New criminal penalties

The Cost of SOX • Net private costs amount to $1. 4 trillion • Ivy Xiying Zhang (2005) • Econometric estimate of loss in total market value around the most significant legislative events • Costs minus the benefits as perceived by the stockmarket as the new rules were enacted • SOX would have to prevent an awful lot of unforeseen losses due to fraud before it could be judged a good buy.

Costs of SOX • Direct costs: – companies paid an average of $2. 4 m more for their audits last year than they had anticipated – large firms have on average spent nearly 70, 000 additional man-hours complying with new law. – Value accountants and auditors – shortage of personnel in a profession on whose shoulders the law placed heavy new responsibilities

Costs of Sox • More direct costs: Unhealthy degree of concentration of accounting firms • “Last Four” audit 97% of all large US firms – Ernst & Young – Deloitte – Pricewaterhouse. Coopers (PWC) – KPMG

Costs of Sox • Some direct costs may disappear or be diluted next year (learning costs) • Indirect costs (much bigger) – Delisted firms from US stock exchange – Firms avoiding going public – Firms going private – Less information available to the market – Discouraging risk perhaps too much

Benefits of SOX • benefits are intangible, harder to quantify and longer term • companies are strengthening their accounting controls and investing in the infrastructure needed to support quality financial reporting • a “chilling effect” on the relationship between managers and auditors • company books are sounder than they were before

The future of SOX • Most costs will be diluted with time • Company books will be sounder in future • Firms now make their own accounting decisions • Reinvestment in accounting personnel • Maybe not addressing the real causes • Waiting for next scandal to disclose limitations of SOX!

Agency Costs of Debt • Overinvestment: taking risks with others’ money! • The value of the firm as the value of a call option: value of the option and riskiness • Underinvestment: why use your money to benefit creditholders? • Monitoring and Bonding

Empirical Evidence • Most evidence points to the existence of something like an optimal capital structure • Schwartz and Aronson (1967) found that it changes from industry to industry • Firms within industries cluster around average values of debt-equity ratio • Evidence that ratios tend to relate to factors that are proxies for growth opportunities

Empirical Evidence • Large growth opportunities leads to problems of underinvestment for highly leveraged firms • Large growth opportunities leads to low debt-equity ratio • No growth opportunities leads to large problems of overinvestment • No growth opportunities leads to high debtequity ratio

Empirical Evidence • Barclay, Smith, Watts (1995) find strong supporting evidence in the US – High market/book ratio => low debt ratio • Rajan and Zingales (1995) found support outside the US, providing robustness – High market/book ratio => low debt ratio – Higher leverage for higher ratio fixed assets to total assets

Empirical Evidence • Parrino and Weisbach (1999): to what extent debt conflicts explain cross-sectional differences in observed capital structures – Incremental cost of debt higher for firms with larger investments – High debt leads to underinvestment problems – Costs of longer maturity debt contracts – Risky firms do not issue short-term debt to avoid inefficient liquidation

Informational Asymmetries • Managers have better information • Act in the interst of shareholders • Information cannot be transferred directly in a credible way • Informational flow is necessary for market to exist, otherwise market value average quality and good projects disappear. • Types of equilibria: pooling and separating

Signaling type with Debt • Model by Ross (1977) – Fee schedule with penalty for bankruptcy – Debt level chosen maximizing expected fee – Debt level signals the quality of the firm – No incentive to signal a false type – Allows full descrimination of types • Capital structure is signalling quality of project

Managers as Investors • Model by Leland Pyle (1977) – Risk averse manager-owners sell fraction of the firm to diversify their portfolios – The more they retain, the better the signal about quality of the project – In equilibrium, managers hold larger proportion than desired • Capital structure is signalling the quality of the project

Investment Opportunities • Model by Myers and Majluf (1984) – Problematic to issue stock to finance a project, due to information asymmetry – May ignore some positive NPV projects – Prefer use of (valuable) internal funds – Pecking order: funds, debt, equity • Contrasts with free cash flow hypothesis • Financing signals quality of project

Stock Repurchase • Papers by Vermaelen (1981, 1984) – The opposite reasoning to Myers & Majluf – Suggests market is underpriced – Spend cash and debt capacity to buy back – Contrasts with Pecking order Theory. . . – Two signals: price and number of shares • Process increases debt-equity ratio • Capital structure signals information

Empirical Evidence • Smith (1986) indicates that issuing equity on average conveys negative info – Consistent with Myers and Majluf • Issues due to good projects may also exist – Wruck (1989), Hertzel and Smith (1993): increases in stock for some announcements • Thakor (1993): mixed evidence

Empirical Evidence • Myers and Majluf imply greater price drop for equity issues, less for convertible debt and least for straight debt • Factor: sensitivity on the value of the firm • Not confirmed empirically • For example, Mikkelson and Partch (1986) show equity drop depends on debt quality • But there is also opposite evidence (Rajan and Zingales, 1995) consistent with Myers and Majluf

Empirical Evidence • Regarding share repurchases • Vermaelen (1981, 1984) provides evidence that – Premium is higher than value of information – Insider-holding value is relevant – Confirms the initial hypothesis that share repurchases reveal information

Empirical Evidence • Dynamic Pecking Order Theory, proposed by Loughran and Ritter (1995) – Issue shares when overvalued and buy back when undervalued – Opportunistic deviation from long run target – Opportunistic timing consistent with long-term event studies and makes it almost not possible to test capital structure theories

4. PAYOUT POLICY • Payout affects capital structure – Reduces equity • Dividend Policy – Under certainty – Under uncertainty • Dividends and Taxes • Dividends and Information • Stock Repurchases

Dividends under certainty • Dividends affect capital structure – Less equity • Under certainty and perfect markets: – No transaction costs – No information costs – No tax differentials • For a given investment schedule, value of the firm is independent of the dividend level

Relaxing Certainty • Random payoff at maturity implies – Random dividends – Random share value – Cashflow to shareholders: S+Div • Play the role of equity in the MM case with no dividends • Therefore value of firm is independent of dividend policy

Dividends and Taxes • Most important imperfection that may affect MM conclusions are personal taxes • Advantage to capital gains (vs dividends) • Tax disadvantage of dividends may generate a clientele effect • Not necessarily true, argue Miller and Scholes (1989) • Investors can transform dividend into capital gains

Dividends and Taxes • Borrowing an amount at risk free rate such that interest expense equal dividend income. • Invest that amount at risk-free. Since interest payment are deducted from dividend, there is no effective tax to be paid! • Of course there may be transaction costs! • The point here is that tax disadvantage may be reduced to nothing • Empirical issue to be verified!!

Empirical Evidence • Two effects of dividend policy: wealth of investors and stock prices • Regarding wealth of investors: clientele effect • Empirical evidence by Pettit (1977) • Now, let us turn to impact on stock prices

Empirical Evidence • Regressing returns and dividend yield • Brennan (1973) • According to CAPM, after-tax return should be mean-variance efficient. E(Ri)=rf+γ 0β+γ 1[Div/P- rf] • Brennan cannot reject hypothesis that γ 1 =0 or expected return does not depend on Div/P

Empirical Evidence • Problems with Brennan’s work: • Error in variables estimating betas • Dividend yield Div/P should not reflect long term expectation, since may hide omitted risk variable • For example, high Div/P can happen because of low P. This may have been originated by high discount rate, implied by high risk. . . • Returns are estimated using announcement of dividends, ignoring informational effects.

Empirical Evidence • Litzenberger and Ramaswamy (1979) use short term measures of dividend yield (data from exdividend dates) • Found that for every dollar in dividends, investors require 0. 236 additional return • Also evidence of clientele effect • Miller and Sholes (1982) argue that results are biased: did not correct for informational content

Empirical Evidence • Elton and Gruber (1970) provide marginal tax rate of investors in different firms • Evidence for clientele: increasing yields are correlated with decreasing tax brackets • Kalay (1982): For given firm there may be a marginal tax-payer and many infra-marginal shortterm traders. • May lead to tax-arbitrage around ex-dividend day

Empirical Evidence • If such arbitrage exists => positively related to yield, and negatively to transaction costs • Lakonishok and Vermaelen (1986) verified both effects. • Explains in part why dividends are paid if not relevant for value of the firm: • Natural market of infra-marginal investors who can make some tax-based arbitrage profit

Dividends and Information • Change in dividends as a signal regarding future expected cashflows • Bhattacharya (1979): commitment with certain level as a signal of quality; – If payoff not sufficient to cover payout, have to incur in transaction costs (borrow) – Good firms (with good projects) can commit with high payout more easily and with more credibility

Dividends and Information • John and Williams (1985) – Equilibrium: larger dividends are paid by firms that expect higher future cashflows – Level of dividends related to tax disadvantage relative to capital gains – Conclude that dividends variability should be smaller than cashflow variability • Dividends as signal about cashflows

Dividends and Information • Miller and Rock (1985) – Future returns as function of investment plus a random noise – Raised amount (B) plus returns (X) equals – Amount invested (I) plus dividends (D) B+X=I+D – Value of the firm depends on amount invested

Dividends and Information • First order conditions for maximizing value leads to optimal level of investment • Value of firm determined once D, X and I are announced • Pure dividend D is not enough to forecast X because X=I+(D-B) • Need to announce net dividends D-B

Dividend and Information • Possibility of profit from knowledge of optimal level of investment • Some insiders willing to sell may induce managers to increase D, lowering I • I is no longer optimal, but insiders are not hurt, since are compensated by higher D • No reason to force I to optimal level • Model does not sustain optimal investment

Dividends and Information • To be stable, model has to maximize the balanced value for sellers and stayers – Maximize in D-B and I a linear combination of both values – assume results depend on net div: X(D-B) – Optimal solution leads to X’(D-B)>0 – implies underinvestment • This underinvestment is cost of signalling

Stock Repurchase • Instead of paying cash dividends • Distribute excess cashflow to shareholders in the form of shre repurchase • Substitution hypothesis • Used in USA, UK, Canada, now in Europe • Compatible with MM • Compatible with Jensen’s Free cash flow

Trends in Stock Repurchases • Puzzle: for many years more dividends than share repurchases, in spite of tax advantage • Change in 80’s (Bagwell and Shoven, 1989) • Grullon and Michaely (2000) showed that – For the first time, in 1998, for each dollar in dividends, 1. 04 dollars where paid in buybacks – Total payout increased – Total payout yield relatively stable

Reasons for Stock Repurchases • Effective way to employ free cash flow • Exploit asymmetry of information between insiders and the market, conveying information • A way to transfer wealth from creditholders to stockholders (as with dividends) • Effective restructuring of firm’s capital

Reasons for Stock Repurchases • All four reasons are also valid for dividends payments • There are two important differences: – Different tax treatments: dividends are taxed as ordinary income; repurchase as capital gain – Repurchases do not affect all shareholders equally, implying a potential change in the ownership structure of the firm.

Empirical Evidence • Typical image: fixed-price tender offer • Average premium from 16. 7% (Hertzel and Jain, 1991) to 24% (Dann Masulis and Mayers, 1991) • Average fraction of shares bought back from 14. 8% (Hertzel and Jain, 1991) to 18. 8% (Comment and Jarrell, 1991) • Remaining have excess return from 10. 1% to 18. 5% (Dann, 1981)

Empirical Evidence • Most common: open market repurchase • Firm buys back at market price over a long period if time: pays lower premia (if any) • Fraction bought goes from 5% (Vermaelen , 1981) to 7% (Comment and Jarrell, 1991) • Impact on remaining shares: 2. 3% (Vermaelen , 1981) to 3. 3% (Comment and Jarrell, 1991) • Signaling power of this type of operation is lower

Empirical Evidence • Recent alternative: Dutch auction • Premium lower than with tender offers, around 13% (Jarrell, 1991; Bagwell, 1992) • Fraction of sought shares: around 15. 5% • wealth impact on remaining shares: from 6. 7% (Bagwell, 1991) to 8. 3% (Comment and Jarrell, 1991) – less than for tender offers • In an auction, prices are determined by outsiders

Empirical Evidence • Tender offers may be directed to a specific group of shareholders • A single, large-block shareholder: premium is negotiated, leading to higher premium (Dann and De Angelo, 1985; Mikkelson and Ruback, 1991) • Report negative returns: 4% to 6% • This form of tender offer is a defense mechanism against hostile takeovers

Empirical Evidence • Relation between dividends and repurchases • Grullon and Michaely (2000): evidence consistent with substitution hypothesis • Growing repurchase activity has been financed with potential increase in dividends: • Difference between actual and expected dividends (following model of Lintner, 1965) is negatively correlated resources spent in repurchases. • Market reaction to decrease in dividends for firms repurchasing stock is statistically zero

5. FINANCIAL CONTRACTING • • Financial Structure and Control Managing decisions imply costs Capital structure helps mitigate these costs More specific: control and ownership in different hands may lead to suboptimal decisions for shareholders • Existence of debt contracts may help to mitigate these costs

Incomplete Contracts • • Contracts cannot specify all contingencies They are incomplete!! Grossman, Hart and Moore (GHM) 86, 90 Variables that are ex-post observable for the parties under contract; not for third parties • Not verifiable => not enforceable • Must stay out of the contract

Financial Contracts • Explicitly introduces wealth constraint as opposed to GHM’s original approach • Capital structure is not simply a mix debtequity, rather – A set of contractual relationships – An instrument to reduce agency costs – Leading to a optimal control structure • In second part: different characteristics of debt contracts in more detail.

Contracting and allocation of control • • Model of Aghion and Bolton (1992) Bilateral contract between – – • Risk neutral entrepreneur with no initial wealth Risk neutral investor with resources K at t=0 3 period model: t=1, public signal: state of the world revealed (good/ bad) t=2, investment provides return (r=0 or r=1) t=0, agrees who acts (controller) between t=1 and t=2, affecting the return

General Setting • Follows GHM: incomplete contracts • Ex-ante contract cannot be contingent on state of the world • However, at t=1 this model assumes a publicly verifiable signal correlated with the state of the world • Contract may be contingent on that signal

General Setting • Utility of entrepreneur: – Monetary fee, depending on returns – Non-monetary private benefits, depending on action taken by controller and state of the world • Utility of investor: – Return – Minus monetary fee paid to investor

General Setting • Optimal action: maximizes expected wealth (total expected revenues) conditional on the state of Nature • Contract is efficient if chosen action is optimal for realized state of the Nature • Contract is feasible if investor expects to recover at least as much as K

Entrepreneur Control • If non-monetary benefits are maximized under optimal action, they are said to be comonotonic with total revenues. • If non-monetary benefits are comonotonic with total revenues, then – There is a constant fee schedule such that entrepreneur control is always efficient and feasible • If assumption is not satisfied, then a constant fee schedule may be a second best, not maximizing the total value of project

Entrepreneur Control • There is room for renegotiating fee schedule • Under renegotiation, – All gains revert to the entrepreneur – Entrepreneur control can be shown to be efficient and feasible if and only if the (ex-ante expected) net present value for investor is positive • For high values of K, entrepreneur control is not feasible.

Investor Control • Here, investor chooses action • Opportunistic behavior of entrepreneur is avoided • If action chosen is not first-best, there is room for renegotiation • However, wealth constraints may be barrier to renegotiation, since they do not allow entrepreneur to compensate investor.

Investor Control • If conditional expected return is comonotonic with total revenues, then – There exists a proportional fee schedule (proportional to the realized return) such that investor control is always efficient and feasible • If not, renegotiation can redirect action: – Investor control is efficient and feasible iff investor’s expected NPV under renegotiation is positive

Contingent Control • • If neither private benefits nor expected returns are comonotonic, there may be a dominating contingent allocation of control In that case there are values of K such that 1. Entrepreneur control is not feasible; 2. Investor control is not first-best efficient 3. Both unilateral allocations are dominated by contingent control such that actions follow signal, as contracts become less incomplete.

Financing Contracts • Investor control: capital in exchange for decision power – equivalent to issue voting equity • Entrepreneur control: investors benefit from project without voting rights – Equivalent to preferred stock • As contract becomes complete, optimal design contingent upon public signal – Essential feature of debt contract

Financing Contracts • Financing with debt is a natural way to implement contingent control • Entrepreneur keeps control only if has the ability to meet required payments of debt • If he fails, control passes to investor • Change of control is typical of debt contracts, but general properties of debt are still not explained

Debt Contracts • Observable cash flow at t=1 signals state of Nature (it is zero in bad states) • Not verifiable by third party => incomplete • Manager may divert cash flow, declaring zero cash flow at t=1 even if it was positive • Manager unable after actual zero cash flow • Credit holder able to liquidate part of the assets’ value with state-dependent probability

Debt Contracts • At t=1 project is either liquidated or continued • Optimal contract: there is no liquidation under the good state • Two types of liquidation – After a zero cash flow: liquidity default, selling reduced future cash flow – After a positive cash flow: strategic default, leading to renegotiation, sharing second period returns with credit holders.

Debt Contracts • For the optimal contract the probability of liquidating the assets in bad state is – Decreasing as the probability of positive cash flow increases: incompleteness’ inefficiency decreases with lower risk of bankruptcy – Decreasing as reduction of future cash flows is minored: less damage in reorganization procedure

Many Creditors • • Bolton and Scharfstein (1996) Number, nature and type of credit holders Private or public, Banks, or issuing bonds Nature of governance structure among creditors • Simple model: with two creditors strategic default is more efficiently prevented, but at more costly financial distress

Many Creditors • How to reduce the inefficiency of liquidation: – When risk of bankruptcy is low, increase number of creditors – When risk of bankruptcy is high, reduce number of creditors – As the complementarity of activities is reduced, increase number of creditors – As reduction in future cash flows under renegotiation is stronger, firm should increase number of creditors

Maturity • Long-term debt avoids liquidation in the favorable state, when there are no resources to pay shortterm debt • Short-term debt avoids strategic default, (entrepreneur incentive to go bankrupt early) if it implies loss in value as compared to continuation of the firm • Optimal Financial Structure is a mix of short- and long-term debt chosen at t=0

Maturity • Model by Diamond (1991) • If management has no control rent at t=2, all entrepreneurs of good projects prefer short-term debt, independently of their credit rating. • If there is a control rent, entrepreneurs of good projects prefer short-term to long-term debt, only for high credit rating. Otherwise, long-term debt is preferred.

Maturity • Credit rating can be updated at t=1. • After downgrade, – Entrepreneurs of good projects may prefer liquidation to refinancing if probability of good state is below a critical value – Lenders with short-term debt liquidate if that probability is below a (different) critical value – If probability of good state is between critical values, an optimal maturity mix can be found.

Seniority • Diamond (1993) • At t=1 there is possibility of default • Optimality of a mix of both maturities implies that short-term debt is senior and long-term debt is junior • Long-term debt allows new issues of debt that dilute its value or are senior to it at t=1.

Seniority • Hart and Moore (1995): public company’s security structure (with agency problems) • Intermediate investment at t=1 • t=1 earnings are not sufficient to refinance short-term debt internally • On-going value superior to liquidation value Then, optimal level of short-term debt is zero!

Seniority • Therefore, focus on long-term debt as a mechanism to control management’s ability to finance future investments • Underinvestment: highly leveraged firms may found difficult to raise new debt • Overinstment: low levels of debt makes it easy to get new debt to finance bad projects, lowering value of firm

Seniority • Hart and Moore derive optimal capital structure considering those tradeoffs • May be optimal to issue mix of seniorities • Role of covenants in debt contracts • This optimal structure is compatible with – Financial leverage is negatively correlated with profitability – Increases in leverage raise market value

Covenants • Protecting shareholders – Callable debt • Protecting creditors – Convertible debt – Seniority – Collateral – Payout restrictions – Others

6. GOING PUBLIC • The notion of going public • Going public for the first time: IPOs and asymmetry of information • Reasons for IPOs – Diversification of large investors – Financing through equity markets may have larger value than banks or venture capitalists

IPOs • Four main agents – Issuing firm – Investment bank for pricing – Intermediaries (underwriters) for placing issue in the market – Investors in the market

IPOs • Our questions are – Why firms go public? – When do firms go public? – Once decision is made, what is the informational content? – Empirical evidence? – Explanations?

The Going Public Decision • Two-periods model • Risk neutral entrepreneur needs funds for a project • Financing alternatives: – venture capitalist or – public market

Information Asymmetry • Project is either good or bad quality • Quality known only to the entrepreneur, not to the investor(s) • At a cost, outsiders can evaluate the project – Good project always well identified – Bad project may not be well identified

Future cash flows • Cash flows at t=1 depend on – Invested capital – Productivity of capital (technology); this productivity depends on the quality of the project – White noise: uncertainty in the investment technology

Venture Capitalist • Enough wealth to finance the project in full • Risk averse agent with quadratic utility • Looks for information depending on – Cost – Precision of evaluation technology • Investor is offered one of these: – Unconditional price contract, no cost evaluation – Share price depending on evaluation outcome

Public Offer • Given public offer, we assume that distribution will be extremely diluted • Investors taken as risk neutral • Investors may either – Invest all their wealth in risk-free asset – Bid without information – Bid conditional on paid information

Private Financing Equilibrium • If risk aversion is sufficiently low • If evaluation cost is sufficiently low – The equilibrium where firm chooses to offer VC a contract implies: • Both good and bad entrepreneurs offer the VC a contract with information production • The VC accepts the contract

Comparative Statics • The fraction of equity offered to the VC is – Increasing in the capital intensity – Increasing in the uncertainty about the firm’s investment technology – Increasing in the evaluation cost – Increasing in the VC’s risk aversion

Public Financing Equilibrium • If firm chooses to go public, equilibrium is: – Good firms issue a number of firms at a price that is sufficient to raise the required capital – Bad firms pool with a given probability, raising less capital than required; with remaining probability separate, raising the required capital – Only a fraction of investors bid informed – Equilibrium sustains only if cost is not too high and evaluation errors do not occur too often.

Public Financing Equilibrium • The equilibrium pooling price is – Decreasing in the outsiders’ cost of information production – Decreasing in the error probability of outsiders’ evaluation – Increasing in the capital intensity of the firm

Choice: Public vs. Private • For very low evaluation costs firm goes public; for intermediate range of costs, firm uses private equity • With private equity, financing saves large amount in aggregate evaluation cost • But a single investor is less diversified and requires a higher premium • Equilibrium balances this trade-off

Comparative Statics • Firms that have great capital intensity go public earlier, because the cost threshold becomes more flecxible; • Firms with large uncertainty in t=1 cash flows go public earlier; • Shock in industry increasing productivity (technology) leads firms to go public earlier

Underpricing of IPOs • Origins of underpricing – may be originated by speculative bubble: no evidence to support – Risk-averse underwriters. Why issuers do not react? – Monopoly power of underwriters: big banks do not go for IPOs, leave to small banks who have bargaining power, favoring customers – Asymmetric information effect

Issuers and underwriters • Baron (1982) • Investment banker is better informed about market conditions • Bank has compensation for information, being allowed to offer lower price • Muscarella and Vetsuypens (1989) destroy argument with empirical evidence: selfunderwritten is more underpriced

Asymmetry betweemn investors • • • Rock (1986) Both underwriters and firms are uninformed Some investors in the market are informed Uninformed investors have no criterion Informed investors go only for underpriced – Underpricing required to keep uninformed investors interested in the issues

Reputation of Bankers • Beatty and Ritter (1986) • Firm needs the investment bank as certifier • Banks are repeatedly in the market and must protect their reputation – If bank does not underprice enough, returns will be low and uninformed won’t go back – Too underpriced get no new issuers • Trade-off defines equilibrium underpricing

Integrated view • Benveniste and Spindt (1989) • Asymmetry between banker and issuer not enough • Asymmetry between investors required • A banker with info disadvantage uses reputation to induce investors to reveal info • Model premarket as auction where investors indicate their interest, affecting prices

Legal Liabilities • Tiniç (1988) • Underpricing may work as an insurance against legal liability for firm and bank • Difficulties estimating true value of shares – Misleading info, material omission • Consequences of possible overpricing • Benefits may compensate damage in law liabilities and reputation

8. MERGERS AND ACQUISITIONS • • What forces justify corporate restructuring Defined and implemented by managements Aimed to obtain control of corporations Traditional view: financiers and stock holders fight for control to ensure optimal resource allocation • Alternative: management teams compete

Mergers and Acquisitions • Under this alternative view, stockholders become passive agents: sellers of shares • Fight for corporate control constrains mgmt to closely follow shareholders’ wealth • Simultaneously, incentivates synergies from reorganizing control and mgmt of corporate resources

Mergers and Acquisitions • Different styles of expansion: – Merger – Tender offer (takeover) – Hostile takeover: usually replaces management – White knight: alternative buyer under hostile takeover – Proxy contests: outsiders want representation in the board against the existing management

Mergers and Acquisitions • Anti-takeover devices – Anti-takeovers amendments: make acquisition more expensive – Greenmail: buyback at a high premium from potential interested in taking over the firm – Divestitures: spin-off, company is splitted between all shareholders; split-off only some shareholders have shares from second firm – Equity carve-out: only part of the firm is sold

Largely Diffused Ownership • Grossman and Hart (1980) • Large number of shareholders, each with a very small proportion of outstanding shares • Maximum value per share under current management is: maxa f(a)=f(a*)=q

Largely Diffused Ownership • Raider offers p>f(a*) • Raider can generate value v=maxa f(a)=f(a*)+Z, with Z>0 • If v>p>q=f(a*) offer is good for both sides • However it does not succeed!! • Individual shareholder decision has no impact • Each shareholder is better off not tendering • Attempt to free ride!

Largely Diffused Ownership • How could takeovers exist in this context? • Shareholders evaluate differently from raiders (asymmetric information) • Shareholders may be willing to dilute their rights to penalize current management: accept the price p=max(v- , q) Where represents the dillution factor.

Largely Diffused Ownership • If cost of raider is c, then his profit is Π=v-p-c=min( , v-q)-c • Chosen action a’ of current management depends on the acceptable level of dilution. • Therefore q=f(a’) depends on • Probability of a raid is φ( , q)=Pr[min( , v-q)>c]

Largely Diffused Ownership • Increase in leads to – Current market value q increases (good) – Probability of raid increases (good) – Tender price decreases (bad) • GH show that if shareholders know the cost c to the raiders and can set >c, then it is optimal to exploit the threat of raids

Largely Diffused Ownership • Two-tier offer (Dunn and Spatt, 1984) – cash tender offer at a premium for a limited number of shares, followed by a second (lower price) offer, to take control. – to tender first ensures reasonable outcome – Not to tender risks worst outcome, tendering at lower price later – Optimal that no one tenders. If not enforceable, better to tender immediately

A Large Shareholder • • Shleihfer and Vishny (1986) There is one large, minority shareholder (L) Holds proportion α<1/2 of shares Tender at a premium p=q+π where π must satisfy 0. 5 Z-(0. 5 - α) π-c>0

A Large Shareholder • Improvement Z is a random variable • For small shareholders expected benefit is E[Z| 0. 5 Z-(0. 5 - α) π-c≥ 0] • To tender is the best strategy if E[Z| 0. 5 Z-(0. 5 - α) π-c≥ 0] π –E[Z| 0. 5 Z-(0. 5 - α) π-c≥ 0] ≥ 0 • L defines tender price by choosing π minimizing the left hand side above

A Large Shareholder • Optimal value is π*(α); satisfies π*(α)=E[Z| 0. 5 Z-(0. 5 - α) π*(α )-c≥ 0] • π*(α) is unique and is a decreasing function • For α=0, back to Grossman and Hart – Requires Z> π as necessary condition for raid • Let Zc(α) satisfy 0. 5 Z-(0. 5 - α) π*(α )=c – Zc(α) is a decreasing function

A Large Shareholder • The higher the proportion α hold by L – The more he is willing to pay to increase the chances of a takeover; – The lower is the premium he is willing to pay – The lower is the required improvement to make the takeover interesting for him – The more probable the takeover is – The less share he needs to buy, providing him more bargaining power.

A Large Shareholder • Shleifer and Vishny show that na increase in the proportion of shares held by L leads to – a decrease in the takeover premium; – an increase in the market value of the firm • It is also proved that na increase in the costs c has the opposite effect.

A Large Shareholder • L can change management and firm policy (and value) with alternative ways: • Proxy fight: profit is αZ-cp with cp <c; • Jawboning: negotiate improvement βZ • Tender offer preferred to jawboning if 0. 5 Z-(0. 5 - α) π-c> α βZ>0

Uncertain Outcome • • Hirshleifer and Titman (1990) The decision of shareholders is random P(π): probability that bid is accepted P(π) is constructed so as to ensure that, in equilibrium, the bid is fully revealing: π=Z • Expected gain to bidder (c=0 and ω= 0. 5 - α) [0. 5 Z-(0. 5 - α) π] P(π)= [α Z+(Z- π)ω] P(π)

Uncertain Outcome • First order condition [α Z+(Z- π)ω] P´(π)-P(π)ω=0 • Imposing π=Z: P´απ=Pω ⇒ P(π)=(π/Zmax)w/a • Expected profit for bidder must be positive α ZP(π)-c≥ 0 Leading to the cutoff value of Z.

Uncertain Outcome • Probability of success of offer increases with – Bid premium – Holdings of the bidder • Average bid premium – Declines with holdings of the bidder – Increases with number of shares required for control

Optimal size of L • Jegadeesh and Chowdry (1994) • Both premium π and α are signals • Shareholder tenders if (free rider condition) π ≥E(Z|α, π) • Choose π and α to maximize gain [0. 5 Z-(0. 5 - α) π] P(π) subject to π ≥E(Z|α, π)

Optimal size of L • • Optimal π increases with α Value of the bid increases with Z Value of bidding high increases with Z Benefit from bidding low is higher for low Z bidders: reduces the cost but reduces probability of success (hurts more high Z’s). • In the absence of constraint, cost of choosing α does not depend on Z

Merger Bids • Until now bid was made to shareholders • Now we are going to consider: – Competition between bidders – The influence of means of payment – How cash payment can be a preemptive instrument in the competition above – How na alternative management can be na instrument to resist hostile takeovers

Competition between bidders • • Fishman (1988) Two bidders Successive bids until only one remains Remaining bid is accepted provided is above current market value v • Evaluation cost for bidder i=1, 2: ci • Value for bidder i: vi such that E(vi)<v • Bidders do not know each other’s valuations

Competition between bidders • Bidder 1 tries to bid with price p such that – v 1 ≥p ≥v – makes competition unnatractive to bidder 2 • Preemptive bid: ∃ critical value r for bid such that if bidder 1 bids above r, bidder 2 will not even incur the evaluation cost • Only posible if v 1 ≥r

Competition between bidders • In preemptive bid, let p*(v 1)=Ev 2{min[max(v, v 2), v 1]} • It is equilibrium for bidder 1 – Offer p*(r) if v 1 >r – Offer v otherwise • It is equilibrium for bidder 2 – Not to bid in the first case – Bid in the second case

Competition between bidders • It is in the interest of target to lower costs and improve competition • But if costs of bidder 2 are too low, bidder 1 will be discouraged from competition • Expected payoff to target increases with value of initial bid • Disclosure regulations improve competition and decrease first mover advantage

Means of payment • Hansen (1987) • Preference for cash or stock based on information asymmetry • Acquirer owns a firm with known value x • Target is worth v to itself • Has value w(v) ≥ v to acquirer • Acquirer taks v as a random variable distributed in [vl, vh]

Means of payment • Given cash offer C raider makes profit w(v)-C • Conditional expected profit E(w|C): – integrate under density f(v) in interval [vl, C] – E(Π|C)=F(C)[E(w|C)-C] • Maximize in C and get first order condition w(C)-C-F(C)/f(C)=0 • If optimal C is C>E(w|C): no cash offer

Means of payment • If bidder offers fraction of stock in merged firm (β) instead of cash, trade may occur. • Intersting for target if final value in hands of initial owners is worth more than v β[x+w(v)] ≥v • Interesting for acquirer only if (1 -β)[x+E(w|v)] ≥x

Means of payment • These conditions bound x • Expectd wealth to acquirer is F(v) (1 -β)[x+E(w|v)]+[1 -F(v)]x – Choose v*, maximum value of v optimizing the wealth of acquirer, for fixed β. – Now, choose β maximizing wealth of acquirer – Probability of success F(v*) decreases with x

Means of payment • wealth of acquirer is larger here: – Stock trade seems to dominate cash trade • Also, note that expected gain from optimal stock offer decreases with x • However, cash and stock are differently taxed: may introduce advantage to cash • More information asymmetry: if x is not known, acquirer has to signal, leading to costs in stock offer. May prefer cash!!