Corporate Finance – (Real) Option Pricing Prof. Dr. Christoph Kaserer Chair for Financial Management and Capital Markets Technische Universität München Arcisstr. 21 D-80290 München Tel.: +49 89 / 289 - 25489 Fax: +49 89 / 289 - 25488 Mail: christoph.kaserer@tum.de URL: www.fm.wi.tum.de 1 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Agenda “Real option pricing" Repetition of basic option pricing models to options Application 1: Equity as call option (Merton 1974) Application 2: Real option analysis Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | (Real) Option Pricing 2 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München What is a Financial Option? Option = Right to buy/sell an asset in the future at some predetermined price Call / Put option Underlying Strike or exercise price X Expiration date Option to buy / sell Asset which can be bought or sold Price at which underlying can be bought or sold Date the option matures Some important distinctions Option price Price of underling S Exercise value Market price of the option contract Market price of underlying asset in contract Option value if exercised today = Max(0, Current S - X) American option European option Exercise possible any time until expiration Exercise possible at expiration only In-the-money call Out-of-the-money call At-the-money call Call where currently strike X < S Call where currently strike X > S Call where currently strike X ≈ S Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | (Real) Option Pricing 3 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München How do options work in principle? Graphical representation of option pay-offs Profit Profit X Calls Buy a call ST X Profit ST Sell a call Profit Sell a put Puts X ST X ST Buy a put Note: X = strike price, ST = Stock price, = long in leveraged stock, = short in deleveraged stock Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | (Real) Option Pricing 4 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Put-Call-Parity Consider a portfolio consisting of • One stock S • One put P with strike X • One sold/written call C with strike X Portfolio value today is S0 + P0 - C0 Portfolio value at maturity (T) is Stock Put Call Portfolio if S < X if S > X S X-S 0 S + (X-S) – 0 = X S 0 (S - X) S + 0 – (S – X) = X Therefore, in order to exclude arbitrage opportunities it must hold: S + P −C = X (1+ rf )T with risk-free zero-bond B of value PV(X) S-B=C-P C-P corresponds to leveraged stock position Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | (Real) Option Pricing 5 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Binomial model assumes stock price can move up or down One-step Binomial Model: Set-up (I/II) Specific assumptions of the binomial model • Stock price S follows multiplicative binomial process - Two possible states of the world in each time step • Trading occurs only at discrete times Consider the following examplve • S = $20 = Stock Price • X = $21 = Exercise Price • q = 0.9 = Objective probability, that stock will move upward • u = 1.2 = multiplicative upward movement in the stock price • d = 0.67 = multiplicative downward movement in the stock price • rf = 10% = risk -free rate p.a. Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | (Real) Option Pricing 6 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Stock price and call payoff can be determined in a simple way One-step Binomial Model: Set-up (II/II) A one-period binomial process for S: uS = $24.00 q $20=S 1-q dS = $13.40 Payoffs for a one-period call option: c u = MAX [0, us - X ] = $3 q c 1-q c d = MAX [0, ds - X ] = $0 Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | (Real) Option Pricing 7 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Pricing method constructs risk-free arbitrage portfolio One-step binomial model: Pricing (I/II) Basic idea: Construct risk-free hedge portfolio, composed of • one share of stock S • m shares of call option on the stock S The payoffs for this hedge portfolio are constructs risk-free arbitrage portfolio q uS - mc u S-mc 1-q dS - mc d For portfolio to be risk-free, end-of-period payoffs must be equal in each state uS - mc u = dS - mc d m is number of options needed for hedge (hedging ratio) m= uS - dS cu - cd Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | (Real) Option Pricing 8 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Call pricing equation can be determined One-Step Binomial Model: Pricing (II/II) Because hedge portfolio is constructed to be risk-less it must hold (1 + r )(S - mc ) = uS - mc f Ûc= u S[(1 + rf ) - u ] + mc u m(1 + rf ) Substituting the hedge ratio m into this pricing equation yields é æ (1 + rf ) - d ö æ u - (1 + rf ) öù c = êc u ç ÷ + cd ç ÷ ÷ (1 + rf ) è u - d øúû ë è u -d ø Defining =p =(1 - p) as risk-neutral probabilities, gives a simplified formula for the value of the call c c= pcu + (1 - p )cd 1 + rf Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | (Real) Option Pricing 9 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Pricing equation is simplified by introducing risk-neutral probabilities One-Step Binomial Model: Example Solving for the hedge ratio m gives the number of call options to be written against the stock m= S (u - d ) $20(1.2 - .67) = = 3.53 cu - cd $3 - $0 And a value of the put p and call c p= c= (1 + r f ) - d u-d = (1 + 0.1) - 0.67 = 0.81 1.2 - 0.67 pcu + (1 - p )cd 0.81 ´ 3 + (1 - 0.81) ´ 0 = = 2.21 1 + rf 1 + 0.1 Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | (Real) Option Pricing 10 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München One-step binomial model can be easily extended to several periods Two-Step Binomial Model: Setting (I/II) Stock prices with a two-period binomial process • Recombining binomial tree • S=$20, u=1.2, d=0.67 as before q uS=$24.00 q² u²S=$28.80 q(1-q) udS=$16.08 S=$20 1-q dS=$13.40 q(1-q) (1-q)² d²S=$8.98 Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | (Real) Option Pricing 11 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Call payoffs determined in analogue to one-step model Two-Step Binomial Model: Setting (II/II) • Assume option is European • Two-period binomial European call payoffs are - Strike X=$21 q² q cu cuu=MAX[0,u²S-X]=$7.80 q(1-q) c cud =cdu =MAX[0,udS-X]=$0 1-q cd q(1-q) (1-q)² cdd =MAX[0,d²S-X]=$0 Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | (Real) Option Pricing 12 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Price of the call is determined recursively Two-step binomial model: Pricing (I/II) Solving for the option values in period 1 cu and cd c u = [pc uu + (1 - p )c ud ] ÷ (1 + rf ) c d = [pc du + (1 - p )c dd ] ÷ (1 + rf ) The present value of the call c is given by c = [pc u + (1 - p )c d ] ÷ (1 + rf ) 2 ( c = [ p 2c uu + 2 p(1 − p)c ud + (1 − p) c dd ] ÷ 1+ rf ) 2 € Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | (Real) Option Pricing 13 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Call price formula by substituting second step result in first step Two-Step Binomial Model: Pricing (II/II) Substituting the values of cu and cd 2 ( c = [ p 2c uu + 2 p(1 − p)c ud + (1 − p) pc dd ] ÷ 1+ rf Where € € ) 2 c uu = MAX [0,u 2 S − X ] c ud = c du = MAX [0,udS − X ] c dd = MAX [0,d 2 S − X ] For the numerical example given above we get € € 2 ( c = [ p 2c uu + 2 p(1 − p)c ud + (1 − p) c dd ] ÷ 1+ rf 2 2 ) 2 = [(.8113) $7.80 + 2(.8113)(.1887)$0 + (.1887) $0] ÷1.12 = $4.2430 € € Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | (Real) Option Pricing 14 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Black-Scholes Option Pricing Formula as generalization in cont. time Black-Scholes Option Pricing Model Assumptions • Stock price moves randomly in continuous time - Stock price modeled as geometric Brownian motion (return normally distributed, constant volatility) • No dividends • No market frictions: No arbitrage opportunities, no transaction costs, constant interest rate, no short-sale restrictions Then: Continuous-time option pricing formula for a European call Fischer Black 1938-1995 Myron Scholes Nobel prize '97 (with R. Merton), Founder of LTCM c = S × N (d1 ) - X × e - rf T × N (d 2 ) ln(S / X ) + rrT 1 d 2 = d1 - s T + s T 2 s T Note, BSM is equivalent to Binomial model, if a large number of steps is used and the following holds: u = es DT where d1 = Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | (Real) Option Pricing 15 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Black-Scholes Option Pricing Model Example (I/II) What is the value of the following Call Option according to the BlackScholes Model? - S = $50 = Stock Price X = $45 = Exercise Price rf = 0.06 = annual risk-free rate T = 0.25 = Time to maturity (in years) σ2 = 0.2 = Return Variance (per year) Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | (Real) Option Pricing 16 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München The Black-Scholes Option Pricing Model Example (II/II) Substituting the values of the parameters into d1 we get d1 = ln(50 / 45) + 0.06 × 0.25 1 + × 0.2 × 0.25 = 0.65 2 0.2 × 0.25 Using this result we can solve for d2 d 2 = 0.65 - 0.2 × 0.25 = 0.4264 The values N(.) from a normal distribution table are1 N (d1 ) = N (0.65) = 0.5 + 0.242 = 0.742 N (d 2 ) = N (0.4264) = 0.5 + 0.1652 = 0.6651 Using these result the value of the call option turns out to be: c = 50 × 0.742 - 45 × e -0.06×0.25 × 0.6651 = 37.10 - 29.48 = $7.62 1) Attention: Two types of normal distribution tables exist. One provides one-sided values ("+0.5"), one provides two-sided values. Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | (Real) Option Pricing 17 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Agenda “Real option pricing" Repetition of basic option pricing models to options Application 1: Equity as call option (Merton 1974) Application 2: Real option analysis Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | (Real) Option Pricing 18 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Equity is call option on market value of firm with debt value as strike Merton (1974): Equity can be seen as a Call Option on firm value (I/II) Setting • Firm with firm value V - Consisting of risky equity S and debt • Debt is zero coupon bond - With face value D and maturity in T years from now • Debt is secured by assets of firm • Firm pays no dividends Value of equity S at maturity T is given by S = MAX [0, V - D ] • At maturity T, equity holders get value of the firm V in excess of debt value D • If V < D, the firm will default Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | (Real) Option Pricing 19 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Equity payoff diagram same as call option diagram Merton (1974): Equity can be seen as a Call Option (II/II) Price Firm Value Debt value at maturity 30 25 20 15 10 5 Equity value at debt maturity 5 10 15 20 25 30 35 Default Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | (Real) Option Pricing 40 45 50 Firm Value Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Example: Equity and debt value calculated in option pricing framework Assumptions Firm value V is € 5 m Firm has zero-bond D with principle € 4 m with maturity 10 years Continuous risk free interest rate r = 2% Firms asset variance is 25% Firm pays no dividends What is the value of the firm's equity and firm’s debt? S = V × N ( d1 ) - D × e d1 = - rf T × N (d 2 ) ln(V / D ) + rrT 1 + s T s T 2 d 2 = d1 - s T !" = 0.9305; !* = 0.1400; - !" = 0.8240; - !* = 0.5557; 1 = 2.300; 2 = 2.700; 345 = 67 4 − 1 = 4.01%; 2.700 4 : 0.5557 + 4 : <<= 1 − 0.5557 = 2.7 : > ?.?*:"? ; → <<= = 60.49% Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | (Real) Option Pricing 21 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Agenda “Real option pricing" Repetition of basic option pricing models to options Application 1: Equity as call option (Merton 1974) Application 2: Real option analysis Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | (Real) Option Pricing 22 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Reminder NPV-Method The net present value (NPV) rule states: Project should be accepted if it increases shareholders wealth E ( FCFt ) >0 t t =1 (1 + WACC ) N NPV = - I 0 + å where I0 = initial investment FCFt = Free cash flow in period t WACC = Weighted average cost of capital N = Number of years of the project Implicit assumption: Pre-commitment to a deterministic course of action • NPV-method not suitable for flexible, multi-period decision making under uncertainty • Real option explicitly model this flexibility Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | (Real) Option Pricing 23 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München First Example: The Gas Turbine Power Station Operating Mode Stand-by Mode Abandon The flexibility in this project is reflected in three options (two switching options plus an abandonment option). Note that the value of these options depends on the switching strategy pursued. Example: assume the average electricity price to be €30/MWh and the operating cost of the GTPS to be €27/MWh. With 400MW capacity and 8,766 operating hours per year, you would have earned a net profit of 400MW · €3/MWh · 8,766h = €10.5 mn. Taking into account that the GTPS can change into stand-by modus (Flexibility) makes this calculation widely incorrect. To simplify assume that you can only shut down once a week and without cost. Assume over 30 weeks the electricity price is above €27/MWh. The average price in these weeks is €34/MWh. If you had operated only during these weeks, total operating hours would be 30 · 24 · 7 = 5,040 hours. Hence, you would have earned 400MW · €7/MWh · 5,040h = €14.1 mn. Ignoring the real option to shut down and reopen would not have been a forgivable valuation mistake! Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | (Real) Option Pricing 24 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Many corporate decisions alternatives can be modeled as real options Types of Real Options Expansion option: Growth option on an underlying asset that assumes precommitment of a series of investments to growing demand over time • American call with 'cost of expandable investment' as exercise price and 'multiple of the value of the underlying risky asset' as option value Contraction option: Option to receive cash for partially giving up the use of asset • American put with present value of cash as exercise price and fraction of the value of operations given up as value of the underlying Abandonment option: Right to sell an asset for given price, which can change through time rather than continuing to hold it (American put) Extension option: Allows manager to pay a cost for the ability to extend the life of a project (European call with cost of extension as exercise price) Deferral option: Right to defer the start of a project (American call) Switching option: Right to turn a project on and off Compound options: Options on options • Many corporate investment decisions, as equity can be regarded as an option on firm value Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | (Real) Option Pricing 25 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Second Example: Decision-Tree Analysis (I) • Assume United Studios holds the movie rights for a national best-seller and an option to produce a sequel based on the same book. • It believes that shooting both movies simultaneously (in t=0) could be produced for a total budget of $500 million. • If instead the movies are produced sequentially, the total expected cost will be $575 million, where the production of the first movie costs $350 million. • The present value of expected earnings for the first movie in t=1 are $450 million, the cost of capital applied to stand-alone movie projects is 15%. • The present value of expected earnings in t=1 are $628.7 million, if both movies are produced. • In a regular NPV analysis the company would choose simultaneous production as this maximizes the NPV. 628.7 − 500 = $46.701 1.15 • Note, that producing only the first movie would lead to an NPV of $41.3 million. NPV = Chair for Financial Management and Capital Markets– Prof. Dr. Christoph Kaserer (Slides based on Berk/deMarzo, Corporate Finance) 26 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Example: Decision-Tree Analysis (II) • United Studios, however, knows that the probability for a sequel to become a blockbuster strongly depends on whether the first movie was one. • Specifically, the company believes that there is a 50% probability for the first movie to be a blockbuster. In this case the PV of earnings in t=1 is 600. Otherwise the earnings would only be 300. • In case the first movie is a blockbuster, there is a 75% probability that the sequel will also be one. In this case the PV of earnings in t=1 (relative to the sequel) is 400, otherwise earnings would only be 11. In case the first movie is a flop, the probability that the sequel will also be a flop is 75%. • The stand alone production of the first movie in t=0 has a cost of $350 million; continuing with the production of the sequel in t=1 has a cost of $258.75 million. • How would the decision of United Studios look like? Chair for Financial Management and Capital Markets– Prof. Dr. Christoph Kaserer (Slides based on Berk/deMarzo, Corporate Finance) 27 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Example: Decision-Tree Analysis (III) 50 % S BB N 600258,75 600 % 400 % 11 75 25 -350 N 50 % Flop S 300 300278,75 25 75 % % 400 11 S = United decides to produce the sequel N = United decides not to produce the sequel Chair for Financial Management and Capital Markets– Prof. Dr. Christoph Kaserer (Slides based on Berk/deMarzo, Corporate Finance) 28 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Example: Decision-Tree Analysis (IV) • Based on the resolution of uncertainty shown in the tree on the slide before, United can define four different conditional strategies. 1.If the first movie is a BB, produce the sequel, and if it is a flop, do not produce the sequel 2.Produce the sequel in any case 3.Produce the sequel under no circumstance 4.If the first movie is a BB, do not produce the sequel, and if it is a flop, produce the sequel • The NPVs of these four strategies can be calculated as follows: ,--./01.203-.2045--3-./0466 7-+ 0.5 = $9:;< 6.60 6.60 ,--./01.203-.2045--3-./0466 7--./01.203-./045--3-.20466 0.5 + 0.5 6.60 6.60 1. #$% = −350 + 0.5 2. #$% = −350 + − $5=> ,-7-3. #$% = −350 + 0.5 + 0.5 = $41=> 4. #$% = −350 + 6.60 ,-0.5 + 6.60 6.60 7--./01.203-./045--3-.20466 0.5 6.60 = = −$24=> Chair for Financial Management and Capital Markets– Prof. Dr. Christoph Kaserer (Slides based on Berk/deMarzo, Corporate Finance) 29 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Decision-Tree Analysis (DTA) • • • • • • • The example shows that the pre commitment implicitly assumed in the NPV-method ignores the value of flexibility. In this case, the value of flexibility is 60-46.7=$13.3 million. Effectively, the company had an extension as well as an abandonment option, which was ignored in the NPV calculation in the first place. Companies can increase their value by flexibly adjusting to new information revealed on the market. This is especially important in the context of innovations as uncertainty is much larger than on mature markets. Moreover, intangible assets (like IP-rights) often have a build-in optionality. Typical examples: R&D-intensive projects (pharmaceuticals, biotech, etc.), where the investment decision depends on the achievement of specific milestones. Chair for Financial Management and Capital Markets– Prof. Dr. Christoph Kaserer (Slides based on Berk/deMarzo, Corporate Finance) 30 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Decision-Tree Analysis vs. Real Options • In the example before we used objective probabilities and the company’s WACC for calculating the conditional NPVs. • This is, however, wrong, as the exploitation of flexibility changes the risk profile of a firm. Therefore, branchdependent WACCs have to be used. However, it is often very hard (impossible?) to estimate them. • Alternatively, risk-neutral valuation methods could be applied. If risk-neutral probabilities are used, discounting could be done with the risk-free rate and, hence, WACC estimation is not a problem anymore. • This risk-neutral approach is called the Real Option Approach (ROA). The value of flexibility is then calculated with option pricing models. Chair for Financial Management and Capital Markets– Prof. Dr. Christoph Kaserer (Slides based on Berk/deMarzo, Corporate Finance) 31 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Example: Real Option Analysis (I) • EXOIL is an oil company considering a greenfield investment in a new oilfield. The following information is given. • The oilfield is assumed to have total reserves of 2 million barrel. • The current price for comparable crude oil is $62.5/bbl. • The necessary investment for starting oil drilling is $90 million. The cost for buying the drilling rights from the competent authorities is $15 million (onetime payment). These right expire without any compensation, if the EXOIL does not start with drilling after two years, at the latest. • To simplify, we assume that stock markets are valuing oil drilling companies at 80 percent of the market value of its in-ground reserves. • The oil price is assumed to follow a binomial distribution with u=1.2 and d=0.8. The risk-free rate is 0%. The physical probability of the oil price to increase is assumed to be q=0.75. ü Would the company buy the drilling right on the basis of a pure mNPVanalysis? ü What if the company does a real option analysis? In this case use a binomial model with one year corresponding to one binomial step. Chair for Financial Management and Capital Markets– Prof. Dr. Christoph Kaserer (Slides based on Berk/deMarzo, Corporate Finance) 32 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Example: Real Option Analysis (II) Binomial tree for the market value of the drilling company • Recombining binomial tree • Oil drilling right is like a call option with an exercise price of $90 million • Risk-neutral probability: p=0.5 q S=$100mn C=$16.5mn 1-q uS=$120mn Cu=$30mn dS=$80mn Cd=$3mn q² u²S=$144mn Cuu=$54mn q(1-q) q(1-q) (1-q)² udS=$96mn Cud=$6mn d²S=$64mn Cdd=0 Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | (Real) Option Pricing 33 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Example: Real Option Analysis (III) ü The NPV of the project is negative as the price of the drilling right plus the investment cost is larger than the market value of the asset (NPV=100-105=$5 million). ü However, taking into account the flexibility of the drilling right (i.e. investment decision can be postponed for two years) things change. The value of the oil drilling company including the drilling right expiring in two years is $116.5 million. Hence, taking flexibility into account it follows NPV=116.5-105=$11.5 million. • What if the drilling right would have a cost of $30 million? ü In this case the NPV of the projects remains negative, even if flexibility is taken into account: NPV=116.5-120=-$3.5 million. Chair for Financial Management and Capital Markets– Prof. Dr. Christoph Kaserer (Slides based on Berk/deMarzo, Corporate Finance) 34 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Analysing the EXOIL decision using DTA (I) ü In a DTA the value of the drilling right would be derived by using the physical probability of an upward movement of the oil price and discounting the future asset values with the WACC of EXOIL. ü Note that the following relationship must hold on an efficient market for the asset values of any firm: $!% + (1 − $)!+ !" = 1 + ,-.. ü This relationship can be re-written as 1 + ,-.. = $ / 0 + (1 − $) / 1 or $= 1 + ,-.. − 1 0−1 Chair for Financial Management and Capital Markets– Prof. Dr. Christoph Kaserer (Slides based on Berk/deMarzo, Corporate Finance) 35 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Analysing the EXOIL decision using DTA (II) ü Assuming WACC=10% it follows q=0.75. ü Doing now a DTA the value of the drilling right turns out to be $26.96 million. ü Hence, the value of the oil drilling company including the drilling right expiring in two years according to DTA is $126.96 million, which is significantly more than the $116.5 million derived under ROA. ü One can easily see that this might change the decision. In case the price of the drilling right is $30 million, the company would not do the investment, if it is basing the decision on ROA, but it would do the decision, if it uses DTA. ü Economically spoken DTA is wrong, because it uses the same WACC for valuing a company with and without flexibility. But flexibility changes the risk profile, therefore the WACC has to be adjusted. ü In our example the company with the drilling right is a portfolio of an underlying asset (oil reserves) and a call option (decision to drill). The expected return of such a portfolio by definition is different than the expected return of the underlying asset only. Chair for Financial Management and Capital Markets– Prof. Dr. Christoph Kaserer (Slides based on Berk/deMarzo, Corporate Finance) 36 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Difference to decision tree is branch-dependent discount rate Comparison real options with decision trees • Note, decision tree approach (DTA) adjusts discount rate for risk (by using the WACC) and uses physical probabilities • Real options approach (ROA) discounts with risk-free discount rate and adjusts probabilities for risk by using the risk-neutral probability • Note, call value formula can be modified to pCu (1 - p )Cd qCu (1 - q )Cd qCu (1 - q )Cd + = + = + 1 + rf 1 + rf (1 + rf ) q (1 + rf ) (1 - q ) (1 + ru ) (1 + rd ) (1 - p ) p Decision tree method uses single discount rate for both branches real option approach implicitly uses branch-dependent discount rates (ru and rd) C= • Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | (Real) Option Pricing 37 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Comparing NPV with decision trees and real options + NPV method Decision tree method Simple to implement + Incorporates flexibility - + + NP V - Real option method + No flexibility after investment decision Underestimates the value of a project - Incorporates flexiblity Arbitrage-free valuation Valuation is not based on physical probability Does not obey to the law of one price A constant WACC is assumed Physical probabilities? Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | (Real) Option Pricing 38 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München DTA or ROA? 1. In principle ROA is always the better choice as it is the only consistent(arbitrage free) approach to value flexibility. 2. Problem: there must be an observable market price for the project without flexibility. This is often not the case (think about innovations, which are not yet traded by definition). 3. In such case the only solution is to use DTA, even though one has to be aware of all the problems associated with this method. But most likely it is better to accept this problem rather to ignore flexibility at all. 4. In practice, must approaches labelled as real options, in reality, are a DTA. Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | (Real) Option Pricing 39 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Staging Investments is a Real Option • Companies often have to stage investment tranches, because of technological or capacity reasons. This is a typical problem in R&D investments. • By doing so real options are realized (deferral, abandonment, expansion, etc.). • Of course, there is also a downside, for instance because there is a loss in the time value of money of future cash flows. Moreover, it could also be that future investments become more expensive or that a competitive advantage is lost. • However, staging give additional flexibility leading to a potential additional value. • The company has to find a way to maximize this value. Chair for Financial Management and Capital Markets– Prof. Dr. Christoph Kaserer (Slides based on Berk/deMarzo, Corporate Finance) 40 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Example: Staging Investments (I) • Eclectic motors is developing a new electric car. • To be successful they have to overcome three technological hurdles: ü Developing lighter material in order to reduce the weight of the car ü Developing a rapidly recharging battery ü Increase the storage capacity of the battery without increasing weight • The project will only be successful, if all three hurdles are passed. If development is successful, the NPV (excluding the development costs) of the project is $4.4 billion. • The development costs and time frames for each stage as well as its success probabilities are given in the following table. Note, that success probabilities in each stage are independent from the outcome of the other stages. • The WACC of the company is 6% ü In which order should the company stage the investments? ü What is the maximum NPV the company can achieve by optimally staging the investments? Chair for Financial Management and Capital Markets– Prof. Dr. Christoph Kaserer (Slides based on Berk/deMarzo, Corporate Finance) 41 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Example: Staging Investments (II) Technology Cost Time Probability of success Materials (M) $100 million 1 year 50% Recharger (R) $400 million 1 year 50% Battery (B) $100 million 4 years 25% • The NPV of doing the stages simultaneously would be !"# = −100 − 500 ) 1.06,- + 0.5 ) 0.5 ) 0.25 ) 4.400 ) 1.06,1 = −302 • However, this is not an optimal way to proceed, as the company could postpone the investment in a new development stage until it knows whether the preceding development investment was successful. • The question is then, how the company should optimally stage the investments. Chair for Financial Management and Capital Markets– Prof. Dr. Christoph Kaserer (Slides based on Berk/deMarzo, Corporate Finance) 42 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Example: Staging Investments (III) • In this example the problem could be solved by brute force. There are 3!=6 ways to order the three investment stages. • Lets start with the ordering BMR. The NPV can then be calculated as follows: !"#(%&') = −100 + 0.25 1 1.0634 −100 + 0.50 1 1.0635 −400 + 0.50 1 4,400 1 1.0635 = 37 • BMR is the optimal ordering as the NPVs for the other alternatives are: !"#(%'&) = −100 + 0.25 1 1.0634 −400 + 0.50 1 1.0635 −100 + 0.50 1 4,400 1 1.0635 =5 !"# &'% = −100 + 0.50 1 1.0635 −400 + 0.50 1 1.0635 −100 + 0.25 1 4,400 1 1.0634 = −117 !"# &%' = −100 + 0.50 1 1.0635 −100 + 0.25 1 1.0634 −400 + 0.50 1 4,400 1 1.0635 =9 !"# '&% = −400 + 0.50 1 1.0635 −100 + 0.50 1 1.0635 −100 + 0.25 1 4,400 1 1.0634 = −276 !"# '%& = −400 + 0.50 1 1.0635 −100 + 0.25 1 1.0634 −100 + 0.50 1 4,400 1 1.0635 = −262 Chair for Financial Management and Capital Markets– Prof. Dr. Christoph Kaserer (Slides based on Berk/deMarzo, Corporate Finance) 43 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München A General Rule for Staging Investments (I) • Intuitively we have seen in the example before that it is not a good idea to start with the most expensive stage. • Intuitively we can also infer that it is better to start with the most risky (least successful) investment stage, as the outcome of this stage is most informative regarding the overall viability of the project. • Finally, starting with the most lengthy project tends to be an advantage as the PV of the investments for the succeeding stages is smaller (provided that there is no cost of postponing, which is not so clear, for instance because of inflation). • In general, it seems to be beneficial to invest in less capital intensive, riskier and lengthier projects first. Chair for Financial Management and Capital Markets– Prof. Dr. Christoph Kaserer (Slides based on Berk/deMarzo, Corporate Finance) 44 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München A General Rule for Staging Investments (II) • Typically it will be impossible to monotonically order the projects according to the three criteria mentioned before. • Therefore, we are looking for an ordering taking all three dimensions into account. This is fulfilled by the following failure cost criteria: 1 − #$(&'(()&&) #$(+,-)&./),.) • PV(success) is the expected marginal present value contribution of $1 revenue (which will only be generated, if the overall project is successful). • PV(investment) is the present value of the necessary investment for the specific stage. • Note that this rule is similar to the profitability index, which was defined as NPV/Investment. • The approach can be used in a ROA or DTA setting. Chair for Financial Management and Capital Markets– Prof. Dr. Christoph Kaserer (Slides based on Berk/deMarzo, Corporate Finance) 45 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Example: Staging Investments (IV) • Using the failure cost index the ordering is exactly as we have determined it according to our brute force approach, i.e. BMR: • This can be checked by calculating the failure cost index for all three stages: #.% Materials: !"&.#' !(( Recharger: Battery: !" !" #.% &.#' .(( #.1% &.#'2 !(( = 0.00528 = 0.00132 = 0.00802 • By starting with the stage with the highest failure cost index and finishing with the project with the lowest one the ordering BMR results. • Of course, in reality it might be difficult to get all the relevant parameters, so that companies are often using more simple rules of thumb. Chair for Financial Management and Capital Markets– Prof. Dr. Christoph Kaserer (Slides based on Berk/deMarzo, Corporate Finance) 46 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München To recognize real options look for flexibility and future rights Aristoteles accounts in 'Politica' of Thales of Miletos "He was reproached for his poverty, which was supposed to show that philosophy was of no use. [...] He knew by his skill in the stars while it was yet winter that there would be a great harvest of olives in the coming year; so, having a little money, he gave deposits for the use of all the olive-presses in Chios and Miletus, which he hired at a low price because no one bid against him. When the harvest-time came, and many were wanted all at once and of a sudden, he let them out at any rate which he pleased, and made a quantity of money. Thus he showed the world that philosophers can easily be rich if they like, but that their ambition is of another sort." Thales von Miletos (624-546 B.C.) Usual structure of real options (here: European call) • Exercise price = investment required (here: normal rental) • Maturity = duration of right (here: time to harvest) • Underlying = PV of project without flexibility (here: rental rate) Source: Aristoteles (350 B.C.) Politica Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | (Real) Option Pricing 47 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Lessons learned "Real options" • Binomial option pricing model • Closed-form pricing with Black-Scholes formula • Assumptions: continuous time, stock price as geometric Brownian motion, no frictions • Application of formula • Equity can be modeled as a call option on the asset value of a firm • Real options can be found in many corporate decisions • Capture flexibility of decision in response to arrival of new information - Flexibility contrasts with precommittment in NPV-model - Difference to decision tree is branch-dependent discount rate • Types: expansion, contraction, abandonment, extension, deferral, compound • Real options can be priced using option pricing techniques • Real option analysis does not depend on subjective probabilities, as decision tree analysis does, but model assumptions (incl. MAD) must be obeyed. Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | (Real) Option Pricing 48 Corporate Finance – Capital Structure Prof. Dr. Christoph Kaserer Chair for Financial Management and Capital Markets Technische Universität München Arcisstr. 21 D-80290 München Tel.: +49 89 / 289 - 25489 Fax: +49 89 / 289 - 25488 Mail: christoph.kaserer@tum.de URL: www.fm.wi.tum.de 1 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Schedule Capital Structure Introduction Modigliani, Miller (1961): Perfect capital markets Trade-off theory: Taxes and bankruptcy cost Pecking-order theory: Signaling Free cash flow theory: Agency cost Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 2 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München What makes debt and equity different? Financing types Mechanics/Waterfalls Liabilities Equity Common stock Preferred stock Debt Subordinated debt Ordinary debt Secured debt high Mezzanine financing Control rights low low Priority of being served (seniority) high high Risk and return low Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 3 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München How is capital structure correctly measured? Market and Book debt ratios Debt/ EBITDA ratios As a similar measure the ICR=EBIT/Int.Exp. is often used. Source: Damodaran’s Homepage Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 4 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Capital structure varies between countries and over time Equity Ratios of Non-Financial Listed Companies [1992-2013] Equity Ratios of EU15 Companies [2000-2012] Belgium Germany +9% USA Europe Germany France +44% 44 40 43 2000-02 2005-07 +21% 34 31 24 Italy +19% 32 34 2005-07 2010-12 28 20 19 2000-02 2005-07 24 +4% 53 +13% 55 40 +39% 45 44 2010-12 31 2000-02 2005-07 2010-12 Austria Portugal +29% 1992-2002 2003-2013 1992-2002 2003-2013 1992-2002 26 30 2000-02 2005-07 2000-02 Spain +37% 34 32 37 2010-12 +16% 43 39 39 2000-02 2005-07 45 2003-2013 2010-12 2000-02 2005-07 2010-12 2010-12 Source: Thomson/Reuters, BACH, own calculations Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 5 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Business risk is a major driver for the capital structure R&D expenditures and equity ratios of German listed manufacturing companies (2008) Debt ratios in % Business risk and equity ratios of German listed manufacturing companies (2006) Source: CEFS, Thomson Financial Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 6 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Large scale empirical analysis Frank, Goyal (1999): Capital Structure Decisions: Which Factors are Reliably Important? This study analyses US non-financial firms over the period 1950 to 2003. It includes more than 180,000 firm-year-observations. The following six core factors explain 27% of variation in (market) leverage, while all other factors add only a further 2%: • Industry median leverage (+) • Tangibility (ratio of tangible assets) (+) • Profitability (+) • Firm size (+) • Market-to-book assets ratio (-) • Expected inflation (+) Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 7 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München What determines capital structure decisions? E.ON will Aktienrückkauf bis Ende 2008 abschließen - Kein neues Programm DÜSSELDORF (AWP International) - Der Energieversorger E.ON hält an seinen bisherigen Plänen zum Aktienrückkauf fest. Bis Anfang November oder spätestens bis zum Ende des Jahres würden Aktien in Höhe von bis zu 7 Milliarden Euro gekauft und eingezogen, sagte Finanzvorstand Marcus Schenck am Donnerstag in Düsseldorf und bestätigte damit frühere Aussagen. Bis Anfang August hätte der Konzern Papiere im Wert von 5,2 Milliarden Euro zurückgekauft. Nun sei bis 2010 bisher kein neues Programm absehbar, sagte Schenck. Mit dem aktuellen Programm habe E.ON die Kapitalstruktur in Richtung eines höheren Verschuldungsgrades umgestalten wollen, und das sei gelungen. Die Nettoverschuldung gemessen am bereinigten Ergebnis vor Zinsen, Steuern und Abschreibungen werde bis zum Ende des Jahres den Faktor drei erreichen. Dies sei nötig für ein Single A Rating bei den Ratingagenturen./sc/sk Source: Handelszeitung vom 07.08.2008 Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 8 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Value maximization: How companies think about capital structure (I) Source: EON Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 9 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Value maximization: How companies think about capital structure (II) Source: Bayer (2016) Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 10 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Schedule Capital Structure Introduction Modigliani, Miller (1961): Perfect capital markets Trade-off theory: Taxes and bankruptcy cost Pecking-order theory: Signaling Free cash flow theory: Agency cost Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 11 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München MM: Capital structure is irrelevant in perfect capital markets Modigliani, Miller (1961): Overview and assumptions Main question: What is the effect of leverage on firm value in a perfect capital market? Main assumption: Perfect capital markets 1. No taxes 2. No cost of bankruptcy – Debt can be risky, but no extra cost of bankruptcy besides non-repayment of debt 3. Perfect information 4. No transaction costs for issuing debt and equity 5. Investment decision not affected by capital structure – F. Modigliani 1918-2003 Nobel price 1985 M. H. Miller 1923-2000 Nobel price 1990 "Separation of financing and investment decision" Main result: Firm value is independent of its capital structure1) • Any value from leverage must results from violations of above assumptions 1) "The value of the pie is independent of how it is sliced" Source: Modigliani, Miller (1961) "The Cost of Capital, Corporation Finance and the Theory of Investment", American Economic Review Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 12 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Expected ROE increases with leverage... Exp. return on assets ru equals the WACC VD VE rU = rD + rE V V ... however, risk increases, too Beta of the firm is weighted average beta • Asset beta βU measures variability of cash flows against market portfolio Therefore, expected ROE is VD rE = rU + ( rU − rD ) VE Return on equity increases in proportion to leverage (MM proposition II) βU = VD V βD + E βE V V • βU equals beta of unlevered firm € β E = βU + (βU − β D ) VD VE • Equity betas βE must be larger than debt beta βD, because equity holders bear extra risk In perfect capital markets the increase in expected return exactly compensates for the increase in risk Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 13 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München The Cost of Risky Debt – Using the Option Pricing Model • Even though risky debt without bankruptcy costs does not alter the basic Modigliani- Miller results, it is still interesting how the cost of risky debt is affected by changes in the capital structure • One way to solve this problem is to apply a structural model (e.g. Merton model), where equity is modeled as a call option on the firm value, i.e. S = MAX [0, V - D ] • Assumptions - Firm issues zero-coupon bonds that prohibit any capital distribution (such as dividend payments) until the bonds mature T time periods later - Firm value follows a geometric Brownian motion - No transaction costs or taxes - Thus, the value of the firm is unaffected by its capital structure - Risk-free interest rate is non-stochastic and known - Homogeneous expectations about the stochastic process of value of the firm‘s assets Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 14 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Using the CAPM to solve the problem The continuous-time version of the CAPM developed by Merton [1973] is compatible with the option pricing model. The continuous-time CAPM states RE = R f +[RM − R f ]β E Where: RE= the instantaneous expected rate of return on risky equity βs= the instantaneous equity beta, RM= the expected instantaneous rate of return on the market portfolio Rf= the nonstochastic instantaneous annualized rate of return on the risk-free asset Note the market determines the cost of capital as the expected rate of return of an asset; hence we can write rU≈RU, rE≈RE and rD≈RD (as the discrete return is not exactly equal to the instantaneous return) Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 15 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München cont. From the CAPM we know that the beta of the unlevered firm is: RU − R f βU = RM − R f Substituting this into the CAPM equation for the stock yields RE = R f + (RU − R f ) βE βU • Note, if M is the value of the market portfolio the following transformation applies: βE ≡ ∂VE M ∂VE ∂V V M V = = N ( d1 ) βU ∂M VE ∂V ∂M VE V VE • Substituting this result into the former equation yields RE = R f + N (d1 )(RU − R f ) V VE Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 16 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München cont. The same transformation can be applied to the expected return on the bonds. Because of the Put-Call-Parity it must hold: ∂VD = N (−d1 ) = 1− N (d1 ) ∂V Using this relationship and proceeding a before yields the following equation for the cost of debt: RD = R f + (RU − R f )N (−d1 ) V VD Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 17 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Example • A numerical example can be used to illustrate how the cost of debt, in the absence of bankruptcy costs, increases with the firm‘s utilization of debt • Example • Suppose the current value of a firm, V, is $3 million; the face value of debt is $1.5 million; and the debt will mature in T = 8 years. The variance of returns on the firm‘s assets, s2, is 0.09; its required return on assets is RU = 12%; and for the riskless rate Rf = 5% holds. • From the Black-Scholes option pricing model, we know: d1 = = ln(V / D ) + R f T s T 1 + s T 2 ln(3 / 1.5) + .05(8) + .5(.3) 8 = 1.7125 .3 8 Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 18 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Example (cont.) For the normal cumulative density function N(x), the value of N(-1.7125) is approximately 0.0434. Substituting this into the cost of debt, we get RD = .05 + (.12 −.05)(.0434) 3 = .05 +.0097 = .0597 0, 9408 The following figure shows the relationship of the cost of debt and the ratio of the face value of debt to the current market value of the firm. % .08 .07 .06 R f = .05 .04 0.5 1.0 VD V Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 19 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Of course, the MM-theorem holds also in the OPM context To arrive at a weighted average cost of capital, the cost of debt, is multiplied by the percentage of debt in the capital structure, VD/V, Then this result is added to the cost of equity, multiplied by VE/V, the percentage of equity in the capital structure. The result is: RD VD V " V %V " V %V + RE E = $ R f + (RU − R f )N (−d1 ) ' D + $ R f + N (d1 )(RU − R f ) ' E V V # VD & V # VE & V ! V + VE $ = Rf + # D & + (RU − R f )[N (−d1 ) + N (d1 )] " V % = R f + (RU − R f )[1− N (d1 ) + N (d1 )] = RU = WACC Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 20 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Cost of capital in case of risky debt and no taxes in the OPM No taxes RE = RU + ( RU − RD ) RU Rf VD VE WACC = RU RD = R f + ( RU − R f ) N (−d1 ) V VD 1.0 VD V Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 21 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München What is value-impact of relaxing the MM assumptions? Violations of MM-assumptions Subsequent discussion 1 Taxes Tax shield 2 Cost of bankruptcy Trade-off-theory 3 Asymmetric information Pecking-order theory 4 Transaction costs 5 Moral hazard Free cash-flow theory Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 22 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Schedule Capital Structure Introduction Modigliani, Miller (1961): Perfect capital markets Trade-off theory: Taxes and bankruptcy cost • Tax shield • Empirical evidence • Bankruptcy cost • Trade-off theory • Excursus: Ratings Pecking-order theory: Signaling Free cash flow theory: Agency cost Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 23 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München What is value-impact of relaxing the MM assumptions? Violations of MM-assumptions Subsequent discussion 1 Taxes Tax shield 2 Cost of bankruptcy Trade-off-theory 3 Asymmetric information Pecking-order theory 4 Transaction costs 5 Moral hazard Free cash-flow theory Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 24 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München How the tax shield affects the WACC In general, the following relationship holds: !" = !$ + !& = !' + (!)* Where VL and VU are the enterprise values of the levered and unlevered firm. PVTS is the present value of the tax shield. Note, however, that deriving the unlevered cost of capital rU in general is not obvious, as for an investor holding all the outstanding claims of a firm the following relationship applies (rT is the expected return associated with the tax shield): +$ !$ + +& !& = +' !' + +, (!)* Assume a constant leverage ratio (case I) In this case rT=rU, as debt is proportional to firm value and tax shields. Therefore, debt has the same risk as free cash flows. 1 (!)* = ./0 +& !&,. ) !$ !& !& ; + = + + + ; 5677 = + − + ) ; ' $ & ' & 1 + +' . !" !" !" Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 9' = 9$ !$ !& + 9& ; !" !" 25 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Assume a constant debt level (case II) In this case rT=rD, as debt is constant and the tax shield has the same risk as debt. Combining this result with the well-know WACC-formula yields: 4 -.,/ = 0 123 5* .* , ; 1 + 5* 1 5$ = 5" ." .* 1 − , + 5* ." + .* 1 − , ." + .* 1 − , Combining this with the WACC-formula yields: 7899 = 5$ 1 − , .* ." + .* Finally, taking into account that expected returns can be expressed in terms of the CAPM& equation, this result can also be expressed in the following way: !" = !$ + &' !$ − !* 1 − , ( & This is known as the Hamada equation. If debt is riskless, this yields: !" = !$ 1 + &' 1 − , ( Note, the results presented above are just two special solutions to the following general relationship .* 7899 = 5$ − , 5* + : 5$ − 5* ." + .* where k measures the permanence of the debt level, i.e. k=0 in case I and k=1 in case II Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 26 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Example I: constant leverage ratio Assume a firm with rE=10%, rD=6% and T=35%. The debt-to-equity-ratio is fixed at 1. Moreover, rf=2% and MRP=6%. What is the firm’s WACC, what is the unlevered cost of capital? What do Betas look like? 0.5 0.5 !"## = 6% 1 − 0.35 + 10% = 6.95% 1.0 1.0 0.5 0.5 /0 = 6% + 10% = 8% 20 = 1 23 = 1 4 26 = 7 1.0 1.0 5 5 Now, assume that the company changes to a permanent debt-to-equity-ratio of 1/3. By doing so, the debt-beta decrease to 1/3. What happens to the WACC and the equity beta? 1 /6 = 2% + 6% = 4% 3 ; 20 − 26 ;6 1 − 1 1 2 1 34 = 12 < 23 = = /3 = 2% + 1 6% = 9 % ;3 3 9 9 3 ;< 4 1 1 3 !"## = 4% 1 − 0.35 + 9 % = 7.65% 4 3 4 Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 27 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Example II: constant debt level Assume a firm with rE=10%, rD=6% and T=35%. The firm has a constant debt level which currently leads to a debt-to-equity-ratio of 1. Moreover, rf=2% and MRP=6%. What is the firm’s WACC, what is the unlevered cost of capital? How do Betas look like? 0.5 !"## = 8.42% 1 − 0.35 = 6.95% 1.0 0.5 1 − 0.35 0.5 12 = 6% + 10% = 8.42% 0.5 + 0.5 1 − 0.35 0.5 + 0.5 1 − 0.35 9 1 2 75 + 78 8 1 − : 1 + 3 1 1 − 0.35 95 3 72 = = = 1.07 98 1 + 1 1 − 0.35 1+9 1−: 5 Now, assume that the company changes to a new permanent debt level which leads to a current debt-to-equity-ratio of 1/3. By doing so, the debt-beta decrease to 1/3. What happens to the WACC and the equity beta? 75 = 1.07 + 1 1 1.07 − 3 3 1 − 0.35 = 1.23 15 = 2% + 1.23 6 6% = 9.38% 1 3 !"## = 4% 1 − 0.35 + 9.38% = 7.68% 4 4 Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 28 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Leverage also increases probability of financial distress • As cash-flows are volatile, increasing debt will also increase the probability of failure in debt interest payments • Failure in debt interest payments result in financial distress • Result of limited liability • Ultimate result is firm bankruptcy • Financial distress incurs additional cost on top of non-payment of debt interest • • Direct costs: Administrative costs; fees for layers, accountants, consultants; revenue loss, because customers walk away; additional working capital, because suppliers lower or cut payment periods; lost management time Indirect costs: Lost business; additional working capital, because suppliers lower or cut payment periods; lost investment opportunities,... • The levered firm value then becomes VL = VU + PVTS - PV(costs of financial distress) Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 29 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Total cost of bankruptcy are empirically substantial, esp. indirect costs Warner (1977): Direct costs are too low to be significant • Sample: Direct costs (lawyers, accountants, managerial time,...) in 11 railroad bankruptcies between 1933 and 1955 • Result: Direct costs are 1% of firm value 7 years prior and 5% immediately prior to bankruptcy Altman (1984): Indirect costs are substantial, but economies of scale • Method: Indirect costs calculated from comparing expected with actual profits in a time-series regression • Results: Average indirect costs are 8.1% of firm value 3 years prior and 11% in year of bankruptcy; relative costs are lower for large firms Lawrence and Weiss (1990): Direct costs are too low to be significant • Sample: 31 bankruptcies in 1980-86 • Result: Direct costs are 3% of firm value in year prior to bankruptcy Andrade and Kaplan (1998): Total costs are substantial • Sample of troubled and highly leveraged firms • Costs are 10-20% of pre-distressed market value Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 30 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Enterprise value According to Trade-off Theory the optimal debt level is achieved where the marginal benefit (tax shield) equals the marginal cost (financial distress) PV cost of financial distress PVTS Value of the unlevered firm D* Debt Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure I&F Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Does the trade-off theory of debt explain capital structure in reality? Pros • Predicts moderate leverage – Avoids extreme predictions • Successfully explains industry differences in capital structure – Example: High tech companies with high risk and high intangible assets with low salvage value have little debt – Example: Airlines with tangible assets borrow heavily • Corresponds to management behavior – Surveys indicate, that managers follow a target capital structure, which is in accordance with tradeoff theory Cons • Some successful companies have little debt – Some of these companies even have negative debt • Relation between tax-shield and value is not empirically evident – Fama, French (1998) • There is an ongoing empirical debate how tax sensitive capital structure really is ded e e is n y r theo l a ion t i d Ad Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 32 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Schedule Capital Structure Introduction Modigliani, Miller (1961): Perfect capital markets Trade-off theory: Taxes and bankruptcy cost • Tax shield • Empirical evidence • Bankruptcy cost • Trade-off theory • Excursus: Ratings and bankruptcy Pecking-order theory: Signaling Free cash flow theory: Agency cost Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 33 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Subinvestment grade Investment grade Moody’s: Long Term Ratings Definitions 5yr 10yr 0,08 0,36 0,15 0,34 0,41 0,87 1,60 2,87 7,86 11,40 20,66 24,59 39,32 41,18 Cumulative default rates (in %); sample period: 1970-2005. Source: Moody’s Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 34 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Ratings of Moody's, S&P and Fitch Investment grade Sub-investment grade ("junk bond") Fitch ratin g S&P ratin g Moody's rating AAA AAA Aaa Highest credit quality AA AA Aa Very high credit quality A A a High credit quality BBB BBB Baa Good credit quality BB BB Ba Speculative B B B Highly speculative CCC CCC Caa Real default probability CC CC Ca Probable default C C C Imminent default RD CI C Partial default D D C Bankruptcy Description Additional common assumption is 50 % loss given default Note: Fitch and S&P ratings are differentiated with + and -, Moody's with 1 to 3 Source: Rating websites Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 35 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München The Rating Methodology Source: Standard & Poor’s (2015) Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 36 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Source: Standard & Poor’s (2015) The Rating Methodology: Important Financial Ratios Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 37 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Practically, the ICR is a central determinant for the ratings Source: Damodaran’s website; Data as of January 2019; only firms with a market cap larger than $ 5 bn Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 38 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Empirically, ratings work somehow well Source: Standard & Poor’s (2015) Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 39 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Ratings are a critical determinant for the cost of debt Spread (in %) of BBB-rated US corporate bonds Spread (in %) of sub-investment grade US corporate bonds Source: FRED (2010) Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 40 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Schedule Capital Structure Introduction Modigliani, Miller (1961): Perfect capital markets Trade-off theory: Taxes and bankruptcy cost Pecking-order theory: Signaling • Background • Intuitive explanation • Formal model Free cash flow theory: Agency cost Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 41 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München What is value-impact of relaxing the MM assumptions? Violations of MM-assumptions Subsequent discussion 1 Taxes Tax shield 2 Cost of bankruptcy Trade-off-theory 3 Asymmetric information Pecking-order theory 4 Transaction costs 5 Moral hazard Free cash-flow theory Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 42 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München The Lemon Problem: How to signal the true value of an asset? Akerlof (1970) examined market for cars • Four types available: New, old and good, bad • Information asymmetry: Only owner knows true value of the car Result • Market pays same price for good and bad cars • Good cars get not priced at true value • Good cars will not be traded, only "lemons" are on the market (adverse selection) Georg A. Akerlof Nobel price 2001 (together with Michael Spence and Joseph Stiglitz) = What is the effect of asymmetric information and signaling on capital structure? Reference: George Akerlof: The Market for 'Lemons': Quality Uncertainty and the Market Mechanism, The Quarterly Journal of Economics, Vol. 84 No. 3 (Aug. 1970) Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 43 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Example: Mayers/Maijluf (1984) Two possible states of the world • • Outcome can be either good (i=G) or bad (i=B) Each state has equal probability (=50%) Stewart Myers MIT Sloan Asymmetric information • • Only management knows true state of the world Management acts in the best interest of shareholders (= no agency problems) Nicolas Majluf U de Chile Management has two alternative strategies: 'Issue equity' worth 100 or 'do nothing' True firm values are given by Do nothing Issue equity Good state V1 = 250 V1 = 250 + 100 = 350 Bad state V1 = 150 V1 = 150 + 100 = 250 Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 44 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Optimal strategy is to issue equity if stock is overvalued (bad state) If firm does nothing, market determines current firm value as the expected value • Equals unconditional firm value ( !" = $ )% !% = 200 %&' If total firm is valued at 200, then payout to old shareholders is Do nothing Issue equity Good 250 233.33 Bad 150 166.67 !,-. |0 = !" 200 | ! 0+2 = 350 = 233.33 !" + 2 ' 300 !,-. |6 = !" 200 !' |6 + 2 = 250 = 166.67 !" + 2 300 Rational expectation equilibrium result • Management chooses best strategy in each state (= ) • Management issues equity if market value is higher than true value, i.e. if the firm is overvalued Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 45 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Adverse selection cost of equity financing However, market now uses issue as signal of bad state • Market knows, that management will only issue equity if equity overvalued !" |$%%&' = 150 Payout to old shareholders then is Do nothing Issue equity Good 250 210 Bad 150 150 !,-. |/ = !" 150 !2 |/ + 1 = 350 = 210 !" + 1 250 !,-. |5 = !" 150 !2 |5 + 1 = 250 = 150 !" + 1 250 True firm value is revealed and rational expectation equilibrium results Note, this mechanism may prevent company from financing new positive NPV projects => Underinvestment problem due dot adverse selection costs of equity financing Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 46 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Pecking-order theory of debt suggests preferences in financing sources • Positive NPV projects are carried out if financed by retained earnings Thus, firms might carry excess liquid assets for future growth • Positive NPV projects will be carried out if financed by debt Debt financing has payoffs less correlated with future states of nature, therefor adverse selection cost is a minor problem • Result: Pecking order theory suggests preference in financing sources 1. Retained earnings (internal equity) 2. Debt financing 3. External equity financing Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 47 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Further implications of pecking-order theory • Capital structure dynamically depends on firm history • Explains, why successful companies have little debt Because they don't need external financing • There is no defined optimal debt-equity mix • Because equity ratio depends on the availability of retained earnings • Tax-shield effects are assumed to be of second order • Note: debt financing cannot always solve the adverse selection problem of equity financing because of the debt overhang problem. Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 48 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Transaction costs of financing reinforce pecking-order Transaction cost of financing choice in % of financing volume (indicative) 6 - 20% 2 - 5% 0% Retained earnings ~0,5 % Debt Equity reraise (SEO) New equity issue Cost depend on financing volume and exchange, for details see chapter „Initial Public Offerings (IPO)“ Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 49 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Survey empirical evidence is mixed Source: Graham/Harvey (2002) Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 50 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Empirical evidence favors pecking order theory over trade-off theory … Shyam-Sunder and Myers (1999) Trade-off theory Pecking order theory Type • Static theory • Dynamic theory Main prediction • Changes in debt will revert towards the firm‘s target • Change in debt depends on the fund flow deficit that year ( ) DDi ,t = a + bi Di*,t - Di ,t -1 + e i ,t Regressio n equation – ∆D = change in debt each year – D* = target capital structure – D = current debt DDi ,t = a + bi DEFi ,t + e i ,t – ∆D = change in debt each year – DEF = firm‘s cash flow deficit Expected results • Speed of adjustment b is high and >0 • Debt issue if deficit (b=1) and nothing unexplained (a=0) Results • Low speed of adjustment (b = 0.33) • Low explanatory power (R2 = 21%) • High slope (b = 0.75) • Higher explanatory power (R2 = 68%) Sample: 157 industrial firms for year endings of 1971, 1981, and 1989 Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 51 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München … or vice versa Frank, Goyal (2003): Testing the Pecking Order Theory of Capital Structure This study analyses US industrial firms over the period 1971 to 1998. It includes more than 140,000 firm-year-observations. Interestingly, net equity issuances track financing deficits much closer than net debt issuances Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 52 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Is the evidence in favor of the Pecking Order Theory an artefact? Frank, Goyal (2003): Testing the Pecking Order Theory of Capital Structure Here, the same period as in Shyam-Sunder and Myers (1999) is used; however, the number of firms is much larger (768 firms over 19 years). While Shyam-Sunder and Myers (1999) use only firms with continuously reported variables, here also firms with data gaps are considered as a robustness test. Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 53 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Is the evidence in favor of the Pecking Order Theory an artefact? Frank, Goyal (2003): Testing the Pecking Order Theory of Capital Structure Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 54 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Schedule Capital Structure Introduction Modigliani, Miller (1961): Perfect capital markets Trade-off theory: Taxes and bankruptcy cost Pecking-order theory: Signaling Free cash flow theory: Agency cost • Intuitive explanation • Agency cost of debt and equity Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 55 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München What is value-impact of relaxing the MM assumptions? Violations of MM-assumptions Subsequent discussion 1 Taxes Tax shield 2 Cost of bankruptcy Trade-off-theory 3 Asymmetric information Pecking-order theory 4 Transaction costs 5 Moral hazard Free cash-flow theory Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 56 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Investment decision when firm actions are non-observable Jensen and Meckling (1976) argue optimal leverage minimizes total agency cost • Agency cost arise from debt and equity • Agency costs influence probability distribution of cash flows Risk shifting: an example of agency costs of debt • Firm’s investment decisions are non-observable • Firm has two possible investment projects - Investment of $8,000 for each - Same systematic risk but different variances - Project payoffs and expected returns are State Probability CF project 1 CF project 2 1 0.5 9,000 2,000 2 0.5 11,000 18,000 10,000 10,000 Expected return Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 57 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Agency cost of debt because of risk-shifting Firm shows project 1 to lenders and asks to borrow $7,000 • Lenders accept, because project 1 can always pay back loan Investment project payoffs with debt of $7,000 for shareholders are State Probability CF project 1 CF project 2 1 0.5 2,000 0 2 0.5 4,000 11,000 3,000 5,500 Expected return • Project 2 with higher expected shareholder return • If possible, owners switch to project 2 • Wealth transfer from bond-holders to shareholders Therefore, bondholders will install protective covenants and monitoring devices • Cost of writing and enforcing such covenants may be nontrivial • Debtholders must charge higher ex ante yields to compensate them (=agency costs of debt) Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 58 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Agency cost of equity: excess cash leads to inefficiencies Jensen (1986): How to motivate managers? – Enough cash avoids underinvestment (pecking order theory) – Excess cash leads to inefficiencies Michael C. Jensen • Overinvestment (below cost of capital), Prof. Emeritus, HBS e.g., empire building, or organizational slack, e.g. perks • Solution: Proper incentives (e.g. stock options) or more debt, as debt exerts financial pressure on managers Main assumptions • Separation of ownership and control (= management) • Asymmetric information between management and investors • Managers can maximize their wealth at expense of shareholders Source: Jensen (1986) "Agency Costs of Free Cash Flow, Corporate Finance and Takeovers", American Economic Review 26 Downloadable at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=99580 Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 59 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Optimal capital structure minimizes total agency costs Firm Value Total agency costs Agency cost of debt Agency cost of equity Optimal 100% capital structure Debt Ratio Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 60 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Google Founders’ Ultimate Perk: A NASA Runway Free cash flow theory – An example? SAN FRANCISCO, In the annals of perks enjoyed by America’s corporate executives, the founders of Google may have set a new standard: an uncrowded, federally managed runway for their private jet that is only a few minutes’ drive from their offices. For $1.3 million a year, Larry Page and Sergey Brin get to park their customized wide-body Boeing 767-200, as well as two other jets used by top Google executives, on Moffett Field, an airport run by NASA that is generally closed to private aircraft. [...] It is a perk that is likely to turn other Silicon Valley tycoons green with envy, as no other private jets have landing rights there. [...] The Google founders’ jet has been the talk of Silicon Valley since 2005, when the pair purchased the plane [...] the contractor described requests for modifying the plane to include California king-size beds for the founders. At one point, the founders asked whether hammocks could be hung from the ceiling. The contractor said that Mr. Schmidt had described the jet as “party airplane.” Source: online, Sept 13th 2007, www.nytimes.com/2007/09/13/technology/13google.html Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 61 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Bringing Theory to Practice – An Minicase Problem: You have been appointed as new CFO of Smart Thinking Inc. You first job is to check whether the capital structure of the company is value maximizing. It takes you just a few hours to collect the following information: The company has a net debt of 10bn € and a market cap of 40bn €. EBIT is 3.8bn € and assumed to stay rather constant; tax rate is 30%. The company has a AA-rating. Moreover, you figure out that the current beta of the firm 0.7, the market risk premium is 4% and the risk free rate is 3%. Spread on corporate bonds are determined by an illiquidity spread of 1% plus the default risk spread according to the rating of the bond. From a research study you learn that ratings are mostly determined by the Interest Coverage Ratio (EBIT/Net interest payments) and that as of the year 2011 there is an empirical relationship according to the table given here: Source: Damodaran’s Website Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 62 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Minicase cont. Q#1: What is the current WACC of the firm? A#1: According to the table give above rD=3%+1%+0.65%=4.65%. Interest payments are 465mn €, ICR=First, note that ICR=8.17; rE=3%+0.7x4%=5.8%. Hence it follows: WACC=0.2x0.7x4.65%+0.8x5.8%=5.29% Q#2: Could the firm reduce the WACC by changing the leverage? Check this question by looking at the following two alternatives. First, what happens with the WAAC, if the company aims at getting a AAA-rating by eliminating all the debt through a share issue. Second, the company considers a debt financed share repurchase in a way that the resulting rating is BBB (ICR=2.53). A#2a: Unlevered beta is given by 0.7/(1+0.7x10/40)=0.5957. Therefore, in case of a 100%-equity financing the cost of equity would be rE=3%+0.5957x4%=5.38%=WACC. Decreasing the debt ratio from 20% down to zero would increase the WACC by about 9 bp. In case of a non-growing firm this would imply a change in market value of about -1.7%=5.29/5.38-1. Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 63 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Minicase cont. A#2b: ICR=2.53 implies interest payment of 3.8/2.53=1.5bn €; according to the rating table now kD=5.6% holds. Additional debt capacity is (1500-465)/0.056=18.5bn €, hence net debt raises to 28.5bn €, market cap falls to 21.5bn €. Unlevered beta is given by 0.7/(1+0.7x10/40)=0.5957. Therefore, debt increase would make stock beta equal to 0.5957(1+0.7x28.5/21.5)=1.15. It follows: kE=3%+1.15x4%=7.6%. Therefore: WACC=28.5/50x0.7x5.6%+21.5/50x7.6%=5.5%. Increasing the debt ratio from 20% to 57% would not be optimal either, as the WACC would increase by 21 bp. Q#3: Why does an optimal capital structure exist? What are the economic determinants? Discuss! Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 64 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Capital Structure: Lessons learned 1. Trade-off theory: Optimal capital structure trades-off bankruptcy cost and tax shield Tax shield is the higher the higher the debt ratio Direct and indirect bankruptcy cost have to be considered 2. Pecking-order theory Understand model of Myers and Majluf (1984): Information asymmetry, rational expectation equilibrium, signaling Information asymmetry causes adverse selection costs of equity financing as an equity issued is considered as a signal for overvaluation It might cause an underinvestment problem Firms have a pecking-order of financing sources 1. Retained earnings (internal equity) 2. Debt 3. External equity As consequence, capital structure depends on firm history 3. Free cash flow theory: Optimal capital structure minimizes total agency costs Agency cost resulting from monitoring to prevent bondholder expropriation Agency cost of external equity resulting from monitoring managerial slack Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Capital Structure 65 Corporate Finance – Payout Policy Prof. Dr. Christoph Kaserer Chair for Financial Management and Capital Markets Technische Universität München Arcisstr. 21 D-80290 München Tel.: +49 89 / 289 - 25489 Fax: +49 89 / 289 - 25488 Mail: christoph.kaserer@tum.de URL: www.fm.wi.tum.de 1 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Agenda Distributions to Shareholders Irrelevance of Payout Policy Payout Policy and the Clientele Effect Payout Policy and Signaling Payout Policy and Agency Costs 2 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Source: Staista Dividend Payments of DAX companies since 2003 (€bn) Note that the current (April 2019) DAX market cap is about 1.2 €trn; therefore, the value weighted average dividend yield is about 3.3%. 3 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München How to pay out Earnings Dividends vs. share repurchases Payout* Share repurchase ( 71 AktG) - Decision by the ASM Max. retained earnings plus free reserves Max. 10% of equity Equality principle must be obeyed Repurchased shares typically are used to reduce share capital The company does not have any rights out of its own shares Dividend - Decision by the ASM Max. retained earnings plus free reserves *Note: stock dividends (stock splits) are not a mean of payout policy but just an instrument to deflate stock prices While dividends are expected to stay constant or steadily increase over time, share repurchases are considered to be a one-time pay-out. This is important when considering the signalling impact of a pay-out announcement. 4 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München The Changing Composition of Shareholder Payouts in the US Source: Berk/de Marzo (2017), Compustat data for U.S. firms, excluding financial firms and utilities. 5 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Agenda Distributions to Shareholders Irrelevance of Payout Policy Payout Policy and the Clientele Effect Payout Policy and Signaling Payout Policy and Agency Costs 6 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Dividends Deliver and do not Generate Value Modigliani and Miller (1961) proved irrelevance of dividend policy in perfect capital markets - No taxes or transaction costs - Perfect information: Everyone fully informed about the distribution of the firm‘s future cash flows - Investment decision is independent of dividend policy (all positive NPV projects will be executed) Dividends are way to deliver, not to generate value. There is no optimal dividend. The same reasoning applies to share repurchases But markets react to dividend changes and share repurchases, so what are possible explanations? Reference: Miller and Modigliani (1961) Dividend Policy, Growth and the Valuation of Shares, Journal of Business 7 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Example: Pay Dividend with Excess Cash The company decided to pay a $2 dividend. Black Cum-Dividend Balance Sheet Ex-Dividend Balance Sheet Cash 20 0 Other assets 400 400 Total market value 420 400 Shares(millions) 10 10 share price $42 $40 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Example: Repurchase Stocks with Excess Cash The company decided to use the cash to repurchase 20mn/42=476,190 stocks. Black Before Repurchase Balance Sheet After Repurchase Balance Sheet Cash 20 0 Other assets 400 400 Total market value 420 400 Shares(millions) 10 9.524 share price $42 $42 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Irrelevance of Payout Policy • In perfect capital markets, an open market share repurchase has no effect on the stock price, and the stock price is the same as the cumdividend price if a dividend were paid instead. • In perfect capital markets, investors are indifferent between the firm distributing funds via dividends or share repurchases. By reinvesting dividends or selling shares, they can replicate either payout method on their own (homemade dividend). 10 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Three Alternative Explanations for Relevance of Payout Policy Violations of MM-assumptions Subsequent discussion 1 Taxes Clientele effect 2 Asymmetric information Signaling theory 3 Agency cost Agency theory 11 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Agenda Distributions to Shareholders Irrelevance of Payout Policy Payout Policy and the Clientele Effect Payout Policy and Signaling Payout Policy and Agency Costs 12 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Three Alternative Explanations for Relevance of Payout Policy Violations of MM-assumptions Subsequent discussion 1 Taxes Clientele effect 2 Asymmetric information Signaling theory 3 Agency cost Agency theory 13 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München The Tax Disadvantage of Dividends Taxes on Dividends and Capital Gains - In many countries dividends are taxed at a higher rate than capital gains. - There is an economic reason: stock prices already reflect the future tax burden due to dividend taxation. If an investor sells the stock before dividend payment, he implicitly pays the dividend tax as the stock price is reduced by the present value of this tax. Hence, a capital gains tax leads to a double taxation of dividends. - However, by reducing the capital gains tax stock repurchases are becoming more attractive leading to a change in the firm’s payout policy. - Its hard to say anything about a tax structure making payout policy irrelevant from a tax perspective. 14 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Tax Rate depends on Type of Investor Excursus: Capital income taxation in Germany All capital income taxed equally at 25+% ('Abgeltungssteuer') • = 25% + 'Solidaritätszuschlag' (5.5%) • Includes interest, dividends and other capital income – Removes tax exemption of long-term investment gain (until 2008) • Deducted at source (i.e. banks) • No tax progression beyond allowable deduction Differs to taxation regime in many countries • In many countries dividends are taxed higher than capital gains • Taxation of foreign capital gain depends on individual double taxation agreements For qualified corporate investors 95% of dividend income is tax free. Capital gains are threated similarly. Under the current German system choice between dividends and share repurchases seems to be irrelevant at best (at least over a one year investment horizon). 15 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Altana Pays High Special Dividend Lessons from a Real Live Case "Altana – Sonderdividende lohnt sich nicht für jeden" Aktionärsschützer raten sogar zu Verkauf der Aktie Nach der Ankündigung der Altana AG, eine Sonderdividende von 33 Euro auszuschütten, hat die Deutsche Schutzvereinigung für Wertpapierbesitz (DSW) zu einer differenzierten Strategie geraten. Es sei vorhersehbar, dass der Aktienkurs [...] um diese 33 Euro nachgeben werde [...]. Darum sei es nicht unbedingt ratsam, vor der Hauptversammlung am 3. Mai Altana-Papiere zu kaufen, um die hohe Dividende mitzunehmen. Aktionäre müssten nicht nur Abschläge hinnehmen, sondern die Dividende auch versteuern [...]. Altana hatte [...] angekündigt, dass der Gewinn aus dem Verkauf der Pharmasparte – 4,5 Mrd € – in Form einer Sonderdividende […] vollständig an die Aktionäre weitergereicht werde. […] Fast die Hälfte davon fällt an Mehrheitsaktionärin Susanne Klatten. Für Altana-Aktionäre, die seit mindestens einem Jahr Aktien des Chemieunternehmens hielten, könne es sich angesichts des hohen Aktienkurses lohnen, vor der Ausschüttung steuerfrei zu verkaufen […]. Nach der Ausschüttung und dem erwarteten Kursabschlag könnten die Aktionäre die Aktie dann deutlich billiger zurück erwerben, sagte er [, das sogenannte] „DividendenStripping". Tagesspiegel vom 15.03.2007 „AltanaAktionäre sauer wegen Sonderdividende Da Altana einen Großteil seiner Kriegskasse ausschüttet, geht allerdings auch Kursfantasie verloren. Capital vom 17.11.2007 Susanne Klatten "Volksaktionär" Fokus online 16 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München High Price Decline and High Volume at Ex-Dividend Date Altana stock price (01.01.2007 - 14.11.2007) Ex-dividend date * S1 = S0 - 33 € - 1.8 € 19,69 * Special dividend of € 33 and regular dividend of € 1.80 Note: at that time a retail investor could have avoided taxation on dividends by simply selling the stock right before the dividend payment. This is because capital gains, in principle, were tax exempted at that time. => Tax Arbitrage 17 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Clientele Effect • Ignoring transaction costs investors could sell the shares on the cumdate to those investors that have the lowest marginal tax rate on dividends, provided that capital gains tax-wise are treated more favorably than dividends. • Taking transaction costs and risk considerations into account, aggregated tax burden can also be minimized by a dividend policy that reflects the tax preference of its investor clientele - Investors in the highest tax brackets select into those companies that pay no or low dividends. - Investors in the lowest tax brackets select into those companies that pay high dividends. • Firms should follow a constant dividend policy. 18 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Empirical Approach with an Event Study on Ex-Dividend Date Elton and Gruber (1970) tried to measure clientele effect • Method: Observe average price decline on ex-dividend date - Sample: 4,148 observations in 01.04.1966 - 31.03.1967 • To prevent arbitrage profits, it must hold PB - t g (PB - PC ) = PA - t g (PA - PC ) + div(1 - t0 ) Where: PC = Original stock purchase price PB = Stock price before it goes ex-dividend PA = Ex-dividend price t g = Capital gains tax rate t0 = Ordinary tax rate div = Dividend per share • Therefore, tax rate of marginal investor can be estimated PB − PA 1− t0 = ≈ 78% div 1− t g • Implies marginal tax bracket for dividends of average investor of 36.4%, because at that time capital gains tax was half of the ordinary tax. 19 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Empirical Evidence is in Favor of Clientele Effect Elton and Gruber (1970): Results ' Dividend Yield Statistics Ranked by Decile' High dividend yield (div/P) corresponds to high relative price decline, i.e. low tax-brackets 20 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München The US Dividend Tax Cut in 2003 Consider an individual investor in the highest U.S. tax bracket who plans to hold a stock for more than one year. What was the effective dividend tax rate for this investor in 2002? How did the effective dividend tax rate change in 2003? (Ignore state taxes.) From Berk/de Marzo (2017), Table 17.2, in 2002: td = 39% and tg = 20%. Thus td* = 0.39 - 0.20 = 23.75% 1 - 0.20 This indicates a significant tax disadvantage of dividends; each $1 of dividends is worth only $0.7625 in capital gains. However, after the 2003 tax cut, td = 15% and tg = 15%, and 0.15 - 0.15 t = = 0% 1 - 0.15 * d Therefore, the 2003 tax cut eliminated the tax disadvantage of dividends for a one-year investor. 21 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Taxes and Cash Retention Source: Berk/de Marzo (2017) Cash is equivalent to negative leverage, so the tax advantage of leverage implies a tax disadvantage to holding cash. 22 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Agenda Distributions to Shareholders Irrelevance of Payout Policy Payout Policy and the Clientele Effect Payout Policy and Signaling Payout Policy and Agency Costs 23 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Three Alternative Explanations for Relevance of Payout Policy Violations of MM-assumptions Subsequent discussion 1 Taxes Clientele effect 2 Asymmetric information Signaling theory 3 Agency cost Agency theory 24 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Signaling Assumes Asymmetric Information and Proper Incentives Ross (1977) assumptions 1. Managers as insiders have privileged access to information about the firm • Assumption of asymmetric information 2. Managers will choose unambiguous signals about firm's future, • If proper incentives in place 3. Managers are reluctant to decrease dividends (because of the clientele effect, for instance) 4. Under assumptions 1. to 3. dividend announcements help to better predict future returns, i.e. they should have an impact on share prices ÞDividend Signaling Hypothesis ÞEmpirical evidence supports this hypothesis. However, the effect is economically rather weak 25 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München GMʼs Earnings and Dividends per Share, 1985–2008 Source: Berk/de Marzo (2017), Compustat and CapitalIQ. 26 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Stock Splits and Stock Dividends According to the Dividend Signaling Hypothesis stock dividends and splits should have a positive impact on share prices. The number of shares increase, i.e. under the assumption of a constant dividend per share the payout volume is expected to increase. Under this perspective the effect is the same as for a dividend increase. 27 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Source: Berk/de Marzo (2014) Share repurchases are a credible signal that the shares are underpriced, because if they are overpriced a share repurchase is costly for current shareholders 28 Source: Berk/de Marzo (2017) Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München 29 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Agenda Distributions to Shareholders Irrelevance of Payout Policy Payout Policy and the Clientele Effect Payout Policy and Signaling Payout Policy and Agency Costs 30 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Three Alternative Explanations for Relevance of Payout Policy Violations of MM-assumptions Subsequent discussion 1 Taxes Clientele effect 2 Asymmetric information Signaling theory 3 Agency cost Agency theory 31 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Optimal dividend balances reduced agency costs with higher transaction costs Rozeff (1982): Optimal dividend policy trades off between the transaction costs of raising external capital and the benefit of reduced agency costs • Increasing dividend reduces agency costs - More dividend increases need for external capital - External capital provides additional monitoring of management - Relates to Jensen’s Free Cash Flow Theory Michael Rozeff U of Buffalo • Increasing dividend increases transaction costs - More dividend increases need for external capital - Raising external capital is costly • Trade-off: Value optimizing dividend balances reduced agency cost against higher transaction costs - Similar to free cash-flow theory of debt Reference: Rozeff (1982) Growth, Beta and Agency Costs as Determinants of Dividend Payout Ratios, Journal of Financial Research 32 Corporate Finance – Raising Capital Prof. Dr. Christoph Kaserer Chair for Financial Management and Capital Markets Technische Universität München Arcisstr. 21 D-80290 München Tel.: +49 89 / 289 - 25489 Fax: +49 89 / 289 - 25488 Mail: christoph.kaserer@tum.de URL: www.fm.wi.tum.de 1 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Agenda Raising Debt: Corporate Bonds and their Structure Raising Equity by Private Firms: Venture Capital Raising Equity by Public Firms: IPOs The IPO-Process IPO Puzzles SEOs 2 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Bond Markets are a significant Source of Financing - Corporate debt outstanding in the Eurozone was estimated to be about €4.5 trn in 2016 (compared to more than $6 trn in the US). - Unfortunately, European corporate debt markets are very illiquid. On average, 6 days after issuance bonds trade less than twice a day. - European bond markets are still fragmented (lack of standardization, lack of harmonization in insolvency rules, etc.) Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Features of Public Debt • Prospectus - Legal document accompanying any public debt issue - Technically it works similar to a stock issue • Bearer vs. registered bonds • Bond characteristics - Volume, face value, coupon, payment frequency, maturity • Special features - Secured (e.g. mortgage bonds, ABS - Unsecured - Senior vs. junior - Zero bonds - Call provisions - Convertibility/Warrant - Covenants (e.g. Debt/EBITDA-ratio is restricted) Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Top 10 Underwriters in International Bond Markets Source: Global Capital, April 2019, Year to Date 5 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Top 10 Underwriters of Syndicated Loans Source: Global Capital, April 2019, Year to Date 6 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Features of Private Debt • Bank loans • Syndicated bank loans • Private placements/Schuldscheine - Sold to a small group of investors - Rules for public debt issues do not apply - Less liquid than public debt • Loans by debt funds (a new market player emerged since the financial crisis) Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Call Provision (I/II) • A call feature allows the issuer of the bond the right (but not the obligation) to retire all outstanding bonds on (or after) a specific date (the call date), for the call price. - The call price is generally set at or above the face value, and expressed as a percentage of, the bond’s face value. • A firm may choose to call a bond issue if interest rates have fallen. - The issuer can lower its borrowing costs by exercising the call on the callable bond and then immediately refinancing the issue at a lower rate. Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Call Provision (II/II) • Holders of callable bonds understand that the issuer will exercise the call option only when the coupon rate of the bond exceeds the prevailing market rate. - If a bond is called, investors must reinvest the proceeds when market rates are lower than the coupon rate they are currently receiving. - This makes callable bonds relatively less attractive to bondholders than identical non-callable bonds. - A callable bond will trade at a lower price (and therefore a higher yield) than an otherwise equivalent non-callable bond. Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Prices of Callable (at par) and Non-Callable Bonds on the Call Date Source: Berk/de Marzo (2017), Figure 24.2 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Prices of Callable and Non-Callable Bonds Prior to the Call Date Source: Berk/de Marzo (2017), Figure 24.3 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Convertible Provisions • Convertible bond • Conversion ratio. - A corporate bond with a provision that gives the bondholder an option to convert each bond owned into a fixed number of shares. - The number of shares received upon conversion of a convertible bond per a given face value. • Conversion price • Conversion period - The conversion ratio determines a conversion price, which is equal to the face value divided by the number of shares received upon conversion - The period over which the conversion option can be exercised. Often, this period is equal to the lifetime of the bond. Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Convertible Provisions: Example Assume you have a convertible bond with a $1000 face value and a conversion ratio of 15. • • If you convert the bond into stock, you will receive 15 shares. If you do not convert, you will receive $1000. - By converting you essentially “pay” $1000 for 15 shares, implying a price per share of $66.67. - If the price of the stock exceeds $66.67, you will choose to convert; otherwise, you will take the cash. Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Convertible Bond Value Source: Berk/de Marzo (2017), Figure 24.4 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Convertible Provisions: Warrants • A call option written by the company itself on new stock - When a holder of a warrant exercises it and thereby purchases stock, the company delivers this stock by issuing new stock. - Convertible debt carries a lower interest rate because it has an embedded warrant. Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Agenda Raising Debt: Corporate Bonds and their Structure Raising Equity by Private Firms: Venture Capital Raising Equity by Public Firms: IPOs The IPO-Process IPO Puzzles SEOs 16 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Introduction – The Financial Lifecycle Public Equity Private Equity Venture Capital Entpreneurs, Public Subsidizes, Business Angels, Family&Friends Venture Capital Firms (incl. CVC) Private Equity Firms Institutional and Private Investors (incl. Hedge Funds) low Seed Early Stage Expansion Late Stage Development IPO Buyout Revenues Investor s Risk high high low Firm stage 17 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Some Important Terms in Private Equity • • • • • • • • VC firm PE firm general partner (GP) VC fund Fund of Funds (FOF) limited partner (LP) raised, closed vintage year • • • • • • • • private placement memorandum (PPM) fees carried interest=carry hurdle returns capital call = drawdown = takedown distributions=dividends committed capital contributed capital 18 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Structure of a PE/VC Limited Partnership 19 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Top 10 Private Equity Funds in 2017 Rank Firm name Headquarters Five-Year Fundraising Total (in $ billion) 1 Blackstone New York 58.3 2 Kohlberg Kravis Roberts New York 41.6 3 The Carlyle Group Washington D.C. 40.7 4 TPG Capital Fort Worth 36.1 5 Warburg Pincus New York 30.8 6 Advent International Boston 27.0 7 Apollo Global Management New York 24.0 8 EnCap Investments Houston 21.2 9 Neuberger Berman Group New York 20.4 10 CVC Capital Partners London 19.9 Source: Private Equity International, www.peimedia.com Note: there is not a single German based PE firm in this ranking. The first two Continental European firms are Ardian (Paris, 24, $11.3 bn) and EQT (Stockholm, 31, $10 bn). Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Some Important Terms in Venture Capital Financing • • • • • • • • • Closing date Pre-money-/Post-money-valuation (Financing) Rounds Fully diluted share count Proposed ownership percentage Tranch Milestones • • • • • • • Deemed liquidation event (Participating) Liquidation preference (2X, 3X, etc.) Dividend preference Cumulative vs. non-cumulative dividends Stock dividends = Payment-in-kind (PIK) dividends Step vesting, cliff vesting Right of first refusal, Right of first offer Drag-along rights Take-me-along = tag-along rights 21 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Top 10 Venture Capital Firms in 2017 Rank Firm name Headquarters Ten-Year Fundraising Total (in $ billion) 1 Tiger Global Management New York 12.0 2 New Enterprise Associates Menlo Park 8.2 3 Sequoia Capital Menlo Park 7.9 4 DST Global Hong Kong 7.2 5 Kleiner Perkins Caufield & Bayers Menlo Park 7.1 6 Andreessen Horowitz Menlo Park 5.5 7 Accel Partners Palo Alto 5.5 8 IDG Capital Bejing 5.0 9 Index Ventures London 4.7 10 Lightspeed Venture Partners Menlo Park 4.6 Source: Preqin Special Report 2017 Note: the first German based VC firm in this ranking is Rocket Internet with a fundraising volume of $1 bn. Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Agenda Raising Debt: Corporate Bonds and their Structure Raising Equity by Private Firms: Venture Capital Raising Equity by Public Firms: IPOs The IPO-Process IPO Puzzles SEOs 23 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Most active IPO markets in 2018 by proceeds Source: E&Y 24 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Top 10 IPOs world-wide and in Germany World-wide Year Company 2014 Alibaba 2018 Germany Exchange Value $bn Year Company Value €bn NYSE 21.8 1996 Deutsche Telekom Softbank TYO 21.3 2000 Deutsche Post 5,8 1998 NTT DoCoMo Inc. TYO 18,1 2000 Infineon 5,4 2008 VISA NYSE 17,9 2016 innogy 4,6 2010 AIA HK 17,8 1999 Enel Euronext 16,5 2018 Healthineers 4,2 2012 Facebook Nasdaq 16,0 2018 Knorr Bremse 3,8 2010 GM NYSE 15,8 2000 T-Online 2,5 2006 ICBC HK 14,0 2013 Evonik* 2,2 1996 Deutsche Telekom FSE/NYSE 14,0 2007 Tognum 2,0 2004 Deutsche Postbank 1,6 Source: Renaissance Capital 10,4 * This, effectively, was a private placement Source: Deutsche Börse, own calculations 25 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Some Important Terms in IPO Financing • • • • • • • • • • new issue placing introduction dual listing global IPO prospectus / offering document primary offering secondary offering underpricing lock-up • • • • • • • • • • • beauty contest (lead) underwriter syndicate best effort / firm commitment greenshoe (over-allotment) road show equity story bookbuilding / fixed offering / auctioning offer price gross spread total flotation costs 26 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Agenda Raising Debt: Corporate Bonds and their Structure Raising Equity by Private Firms: Venture Capital Raising Equity by Public Firms: IPOs The IPO-Process IPO Puzzles SEOs 27 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München What reasons are generally most important? IPO Motivation – Empirical survey among 335 CFOs in the US Pros Cons Maintain control M&A Establish market price Avoid ownership dilution Image Bad market conditions Loss of confidentiality Minimize cost of capital Reporting requirements Broaden ownership base Have enough capital Allow principles to diversify Costs/fees Attract analyst attention Officer liabilities Allow VCs to cash-out Low stock price Requires new equity Prefer to be acquired New debt too expensive Avoid EPS dillution 1 2 3 4 5 1 2 3 4 5 Note: 1 = not important, 5 = very important Source: Brau, Fawcett (2006) "Initial Public Offerings: An Analysis of Theory and Practice", Journal of Finance 28 - Regulated markets The European regulatory capital market landscape Prime Standard (DBAG): - Bilingual investor communication - Quarterly reports - Yearly analyst meetings - Interim reports - IFRS Financial Statements - Prospectus - Ad-hoc disclosure Insider rules Market abuse ban Disclosure of directors‘ dealings Disclosure of ownership percentages Takeover rules Exchangeregulated markets Listing - Offering document - Financial Statements according to local GAAP (e.g. HGB) Entry Standard (DBAG): - Interim reports - Company calendar and portrait on website - Ad-hoc disclosure Insider rules Market abuse ban Disclosure of directors‘ dealings MiFID II, MiFIR, Prospectus Directive, Market Abuse Directive, Transparency Directive, Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München 29 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Preparation period for an IPO is around 4-5 months Typical time schedule: IPO at Prime or General Standard of Deutsche Börse 1 2 3 Kick-off Selection of advisors Selection of investment bank Due Diligence (2-4 Weeks) Determination of Prospectus English Translation (3 Weeks) Preparation analyst presentation 4 5 6 Premarketing Preparation Research (2-3 Weeks) Publication Research Approval of Prospectus by BaFin (min. 20 days) Publication of Print Prospectus preliminary Bookbilding Prospectus Allocation//Pricing First day of trading 1. Month 2. Month 3. Month 4. Month 5. Month 30 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Bookbuilding mechanics are determined by discretionary allocation Investment bank manages the process • Sets indicative price range • Solicits indication of interest from institutional investors – Not legally binding from investor, but rare deviations • Constructs demand curve • Sets price to generate oversubscription (demand > supply) • Allocates shares to bidders at discretion Example of curves for a real issue Demand Allocation is used by IB to reward investors • ... for providing better information – Indication of interest provides information to IB from investors Supply – Limit price indication favored over quantity indication • ... for being regular investor – Providing insurance to IBs by also bying bad-received issues • ... for submitting bids directly to the bookrunner – Favored over bids to other syndicate members – Maximizes internal bookrunner fees Source: Cornelli (2001) "Bookbuilding and Strategic Allocation", Journal of Finance 31 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Top 10 underwriters in global equity markets Source: Global Capital, April 2019 32 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Listing / post-IPO: Price stabilization for long-term shareholders Lock-up period • Defines no-sale period for old shareholders • Usually 6-12 months • Important for signalling of existing shareholders Greenshoe option • Stabilizes post-IPO price • Also called over-allotment option • Named after company "Greenshoe Manufacturing" where first applied in 1963 • Underwriter issues a maximum of 15% more stocks than initially available (short position) - If price falls, underwriter buys back shares - If price rises, underwriter can increase issue to fulfil demand • Strictly regulated Quiet period • Press and brokers can start covering stock after 25th day 33 The Facebook IPO – A Brief Case Study • On May 18th, 2012, Facebook‘s stocks were traded for the first time on the Nasdaq trading system. • Within the IPO 421 mn shares were offered, of wich180 mn were primary shares. After the IPO the company had a total of 2,138 mn shares outstanding. • In the bookbuilding process preceding the IPO shares were offered within a bookbuilding range of 32 to 38 $. At the end of the bookbuilding process the company together with the lead underwriter (J.P. Morgan) decided to allocate the shares at 38 $. • After the end of the black-out period (end of June) J.P. Morgan issued a research report stating that the target price of the Facebook stock should be 45 $. However, other more independent analysts at the same time came up with a lower target price (Macquarie: 34 $; RBC Capital Market: 40 $; Wells Fargo: 37-40 $; Morgan Stanley: 38 $). All these analysts used different valuation approaches including a DCF as well as a multiple approach. • J.P. Morgan had a greenshoe-option on an additional 15% of shares. • The company determined a lock-up period timetable allowing incumbent shareholders to start selling their shares in the following steps: on August 15th 2012 10% of outstanding shares, on October 14th 2012 9%, on November 13th 2012 49%, on December 13th 2012 5% and on May 17th 2013 2%. 34 Prof. Dr. Christoph Kaserer, Department of Financial Markets and Capital Markets 18 .0 5. 1 25 2# .0 5. 1 01 2# .0 6. 1 08 2# .0 6. 1 15 2# .0 6. 1 22 2# .0 6. 1 29 2# .0 6. 1 06 2# .0 7. 1 13 2# .0 7. 1 20 2# .0 7. 1 27 2# .0 7. 1 03 2# .0 8. 1 10 2# .0 8. 1 17 2# .0 8. 1 24 2# .0 8. 1 31 2# .0 8. 1 07 2# .0 9. 1 14 2# .0 9. 1 21 2# .0 9. 1 28 2# .0 9. 1 05 2# .1 0. 1 12 2# .1 0. 1 19 2# .1 0. 1 26 2# .1 0. 1 02 2# .1 1. 1 09 2# .1 1. 1 16 2# .1 1. 1 23 2# .1 1. 12 # Stock Prices and Trading Facebook's*Stock*Price*(IPO*to*11/27/12)* 40# 160%# 140%# 36# 120%# 32# 100%# 28# 80%# 24# 60%# 40%# 20# 20%# 16# 0%# Volume#(%#of#stocks#offered)# Closing#Price# Offering#Price# 35 Prof. Dr. Christoph Kaserer, Department of Financial Markets and Capital Markets Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Agenda Raising Debt: Corporate Bonds and their Structure Raising Equity by Private Firms: Venture Capital Raising Equity by Public Firms: IPOs The IPO-Process IPO Puzzles SEOs 36 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Four IPO characteristics are puzzling to financial economist 1. Underpricing • Positive return on first day – why? 2. Number of issues is cyclical • Swings are larger than the magnitude of growth opportunities – why? 3. Costs of IPOs are very high • Costs are substantially larger than for other securities – why? • See section on issue costs 4. Poor long-run post-IPO performance • 3-5 year returns post return are (debatably) negatively abnormal – why? • See also chapter on efficient markets 37 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München International Comparison of Flotation Costs Median (first) and average (second) total flotation costs 1999 – March 2011 Small Cap Market Segments Large Cap Market Segments Source: Kaserer/Schiereck (2011) 38 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München What explains the difference in the distribution of US vs. European IPO gross spreads? (1998-2007) Source: Abrahamson et al. (2011) 39 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Underpricing is a time-varying phenomenon in all capital markets Empirical studies worldwide of underpricing (=positive first-day return) Underpricing represents money "left on the table" Source: Berk/de Marzo (2017) 40 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München However, underpricing is yet unexplained (I/II) Possible explanations: UP positively related to degree of asymmetric information Asymmetric information Possible explanation Description Source • Signaling • Lemmon market problem and underpricing profit as signal • Mixed evidence • Allen, Faulhaber (1989), Grinblatt, Hwang (1989), Welch (1989) • Ex-ante Uncertainty • Unknown demand for stock • Beatty/Ritter (1986) • Winner's curse • Protection against getting issue exactly when being overoptimistic • Rock (1986) • Negative cascade • Investors buy if others buy • UP induces positive cascade • Welch (1992 • Institutional aspects of allotment • Revealing demand at bookbuilding will increase final issue price lowering ret. • UP is compensation for info revelation • Only partial explanation for magnitude • Benveniste, Spindt (1989), Benveniste, Wilhelm (1990), Spatt, Srivastava (1991) • Substitute for marketing expense • UP as marketing method • Only partial explanation for magnitude • Habib and Ljungqvist (2001) Source: Ritter, Welch (2002) "A Review of IPO Activity, Pricing, and Allocations", Journal of Finance 41 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München However, underpricing is yet unexplained (II/II) Possible explanations: Asymmetric info. and allocation process determinants Allocation process Symmetric info. Possible explanation • Insurance against legal liability Description • UP reduces probability of issuer being sued • Disputed, because UP also outside US • After market support • Conflict of interest betw. underwriter and issuer • Strategic ownership control • Underwriter reputation • UP & oversubscription increases aftermarket trading • Underwriter benefits from market making fee, issuer if increased liquidity persistent Source • Tinic (1988), Hughes, Thakor (1992) • Boehmer, Fishe (2001), Ruud (1993), Aggarwal (2000), Zhang (2001) • Loughran and Ritter (2002) • Underwriters favor buy-side clients • Issuers tolerate if firm is worth more than thought before (prospect theory) • Several • UP creates oversubscription allowing strategic allotment to specific shareholders • Institutionals provide monitoring, small investors provide liquidity • Carter, Manaster (1990) • UP is compensation for reputation Source: Ritter, Welch (2002) "A Review of IPO Activity, Pricing, and Allocations", Journal of Finance 42 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München The Winner’s Curse: Example (1 of 4)* Problem Thompson Brothers, a large underwriter, is offering its customers the following opportunity: Thompson will guarantee a piece of every IPO it is involved in. Suppose you are a customer. On each deal you must commit to buying 2000 shares. If the shares are available, you get them. If the deal is oversubscribed, your allocation of shares is rationed in proportion to the oversubscription. Your market research shows that typically 80% of the time Thompson’s deals are oversubscribed 16 to 1 (there are 16 orders for every 1 order that can be filled), and this excess demand leads to a price increase on the first day of 20%. However, 20% of the time Thompson’s deals are not oversubscribed, and while Thompson supports the price in the market (by not exercising the green shoe provision and instead buying back shares), on average the price tends to decline by 5% on the first day. Based on these statistics, what is the average under pricing of a Thompson IPO? What is your average return as an investor? * Example is taken from Berk/de Marzo (2017), Example 23.5 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München The Winner’s Curse: Example (2 of 4) Solution First, note that the average first-day return for Thompson Brothers deals is large: 0.8(20%) + 0.2(−5%) = 15%. If Thompson had one IPO per month, after a year you would earn an annual return of 1.1512 - 1 = 435%! In reality, you cannot earn this return. For successful IPOs you will earn a 20% return, but you will only receive 2000 = 125 shares. 16 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München The Winner’s Curse: Example (3 of 4) Assuming an average IPO price of $15 per share, your profit is $15 per share × (125 shares) × (20% return) = $375 For unsuccessful IPOs you will receive your full allocation of 2000 shares. Because these stocks tend to fall by 5%, your profit is $15 per share × (2000 shares) × (−5% return) = −$1500 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München The Winner’s Curse: Example (4 of 4) Because 80% of Thompson’s IPOs are successful, your average profit is therefore 0.80($375) + 0.20(−$1500) = $0 That is, on average you are just breaking even! As this example shows, even though the average IPO may be profitable, because you receive a higher allocation of the less successful IPOs, your average return may be much lower. Also, if Thompson’s average under pricing were less than 15%, uninformed investors would lose money and be unwilling to participate in its IPOs. Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Agenda Raising Debt: Corporate Bonds and their Structure Raising Equity by Private Firms: Venture Capital Raising Equity by Public Firms: IPOs The IPO-Process IPO Puzzles SEOs 47 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Seasoned Equity Offerings (SEOs) • When a public company offers new shares (primary shares) for sale - Public firms use SEOs to raise additional equity. - When a firm issues stock using an SEO, it follows some of the same steps as for an IPO. - The main difference is that a market price for the stock already exists, so the price-setting process is not necessary. - As a consequence SEOs are much cheaper than IPOs - Two main ways to offer the shares: ü Rights offering (still common in Europe, especially Germany) ü Cash offering or Bookbuilding (common in the US) 48 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München The mechanics of SEOs • Primary Shares New shares issued by a company in an equity offering • Secondary Shares Shares sold by existing shareholders in an equity offering • Tombstones A newspaper advertisement in which an underwriter advertises a security issuance 49 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Short term announcement effects (+/- 1d) of SEOs Source: Eckbo et al. (2007) 50 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Long term announcement effects of SEOs relative to a Source: Eckbo et al. (2007) risk-adjusted portfolio 51 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Post-SEO Performance Source: Berk/de Marzo (2017), Figure 23.7, adapted from A. Brav, C. Geczy, and P. Gompers, “Is the Abnormal Return Following Equity Issuances Anomalous,” Journal of Financial Economics 56 (2000): 209–249, Figure 3. Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Flotation costs are significantly lower as for IPOs Source: Bühner/Kaserer (2002) 53 Corporate Finance – Practical Valuation Prof. Dr. Christoph Kaserer Chair for Financial Management and Capital Markets Technische Universität München Arcisstr. 21 D-80290 München Tel.: +49 89 / 289 - 25489 Fax: +49 89 / 289 - 25488 Mail: christoph.kaserer@tum.de URL: www.fm.wi.tum.de 1 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Agenda § DCF Valuation § Practical Example § The APV Method § Multiple Valuation Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 2 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München The fundamentals of corporate valuation In a complete and arbitrage free capital market the market value of any asset (V) can be expressed as the expected present value of its future cash flows (FCF) using the risk-free rate (rf) as the discount factor and the risk-neutral probability measure E* (Fundamental Asset Pricing Theorem – FAPT) ' !=# $%& ( ∗ *+*$ 1 + ./ $ For company valuation, under the assumption that a constant stochastic discount factor exists, this is equivalent to the DCF entity approach: ' !=# $%& ( *+*$ 1 + 01++ $ Ø E() denotes the objective probability measure Ø WACC denotes the firm’s cost of capital on a complete and arbitrage free capital market Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 3 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Corporate valuation – A synthesis Corporate Valuation DCF WACC APV Multiples Equity Approach Entity Multiples Equity Multiples Asset Stripping Liquidation Asset Values Entity Approach Going Concern Values Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 4 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München DCF – Entity vs. equity approach Free Cash Flow to the Firm 6,0 Value of debt* 7,0 6,5 5,0 0,2 t=1 t=2 0,2 t=3 0,2 0,2 0,2 0,3 t=4 t=5 t=6 t=7 Cost of the firm’s debt capital Entity value 2,0 1,0 t=2 0,2 Free Cash Flows to Equityholders 3,0 t=1 Cash Flows to Debtholders t=3 t=4 t=5 t=6 Cost of equity6,7 Value of equity** t=7 Weighted cost of capital (WACC) 5,8 6,3 4,8 2,8 1,8 0,8 t=1 V0 = € E [ FCFF1 ] 1 + (1+ WACC) E [ FCFF2 ] (1+ WACC) Entity Approach 2 + E [ FCFF3 ] (1+ WACC) 3 + ... t=2 t=3 t=4 t=5 t=6 t=7 * often approximated by the book E [ FCFE1 ] E [ FCFE2 ] E [ FCFE3 ] value of debt VE = + + +... 1 2 3 (1+ rE ) (1+ rE ) (1+ rE ) ** value of equity = # shares multiplied by the share price Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation Equity Approach 5 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München How to derive the FCFF Earnings before Interest and Taxes (EBIT) - - Taxes are determined based on EBIT à Taxes = Tax Rate * EBIT Taxes = Net Operating Profit after Taxes (NOPAT) + Depreciation - Investment (fixed assets) - Increase in Net Operating Working Capital (NOWC=receivables + inventory – payables – operational provisions) This is a virtual “FREE CASH FLOW” which you generally cannot observe in practice!!! = Free Cash Flow to the Firm (FCFF - Entity Approach) Essentially, free cash flow to the firm (FCFF) is the amount of money that can be distributed to all suppliers of capital Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 6 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München How to derive the FCFE Earnings before Taxes (EBT) - Taxes = Net Income (NI) = Free Cash Flow to Equity (FCFE - Equity Approach) Essentially, free cash flow to equity (FCFE) is the amount of money that can be distributed to equityholders Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 7 + Depreciation - Investments (fixed operating assets) - Increase in Net Operating Working Capital (NOWC=receivables + inventory – payables – operational provisions) - Cash flow to debt (Repayment of debt – new debt issued) Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Entity Value (Firm Value) vs. Enterprise Value Entity Value = Enterprise Value (=Value of operations) ∞ VOp = ∑ t =1 FCFFt (1+WACC) t + Value of non-operating assets § Marketable securities § Ownership of non-controlling interest in another company § Firm value or entity value are used interchangeably; they indicate the value of all operating and non-operating assets, i.e. VOp+VNOA=VD+VE § Enterprise value reflects the value of operating assets only, i.e. !"# = !% + !' − !)"* = !% + +,- .,/§ Debt reduced by the market value of non-operating assets (mostly cash) is called net debt, i.e Net Debt = VD-VNOA. Therefore, when calculating the DCF enterprise value the capital structure has to be measured on the basis of the net debt. Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 8 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Cash flow projection as a two step procedure Phase I: detailed planning Phase II: (Constant) growth 6,5 7,0 6,0 5,0 3,0 2,0 1,0 2012 2013 TV17 = 2014 2015 2016 2017 FCFF18 FCFF18 1 ⇒ TV12 = ⋅ WACC − g WACC − g (1+ WACC )5 Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 2018 Q: How to calculate the terminal value? A: By using the GordonGrowth Formula 9 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Issues in cash flow projection Detailed forecast of next three years CFs with three alternative methods • Historical estimates – Sensitive to choice of method and time period – Possibly no good proxy for future (esp. if CFs negative) • Expert estimates: Analysts forecasts – Better for larger, better covered firms – Not necessarily accurate, possibly positively biased • Fundamental business modeling – Delivers most accurate, subjective value estimate – Takes time, skill and insight Terminal value (TV) determined by long-term future CF and long-term growth • Growth rate g assumption essential – Usually inflation plus long-term growth of economy • Different terminal value methods possible – Perpetuity growth model: TV = CF / (k – g) – Exit multiple approach Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 10 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München How to estimate the cost of equity Cost of equity estimation is (mostly) based on CAPM Issues in implementing this model Rational investors tend to diversify their risks - Market risk premiums are highly disputued … thus only the market risk component is compensated by the market. - IDW currently recommends 5.5 to 7% (pre-tax) - Beta estimation is not very robust and subject to discretion CAPM pricing formula rE = rriskfree + β stock ⋅ ( rmarket return − rriskfree ) From the CAPM pricing formula it follows that … securities are not priced with respect to their stand-alone risk but their with respect to their market risk only! Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation - Sampling frequency (daily, monthly, etc.) - Estimation window (250 days, 60 months, etc.) - Market geography (national, world-wide) - Market index - Alternative market models (CAPM, FF3FM, etc.) - Individual vs. industry betas - Problem of de- and releveraging 11 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Betas are not very robust Rolling 60 months beta of Lanxess based on mid of month and end of month prices (2005 to 2015) Lanxess$ 1,9$ 1,8$ 1,7$ 1,6$ ≈0,4 1,5$ 1,4$ 1,3$ 2010.01$ 2010.07$ 2011.01$ 2011.07$ 2012.01$ 2012.07$ End$of$month$ 2013.01$ 2013.07$ 2014.01$ 2014.07$ 2015.01$ Mid$of$month$ Source: ThomsonReuters, own calculations Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 12 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München How to de-/re-leverage beta §Betas of different companies need to be re-leveraged to make them comparable ØBecause company-specific leverage has large influence ØBeta with leverage of target company has to be calculated ØAlternatively, adjustment can be done via the WACC-formula §For firms with constant risk-free debt de-leveraged equity (asset) beta can be calculated according to the Hamada-Equation " VD % β E = βU $1+ (1− T ) ' # VE & Example Firm Daimler Volkswagen Renault FCA BMW Avg.%Beta Beta 1,14 0,98 1,54 1,46 1,31 1,29 Tax+Rate 30% 30% 35% 40% 30% Debt/to/ Equity+Ratio 0,77 0,79 1,39 1,25 1,05 Asset+ Beta 0,74 0,63 0,81 0,83 0,76 0,75 Notes: Example is based on information as of July 2015 Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 13 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Industry asset betas Source: Berk/deMarzo, Figure 12.4 Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 14 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Calculating the WACC If a firm is financed by debt and equity simultaneously, then the discount rate in the entity approach must reflect this fact è weighted average cost of capital (WACC) VD VE WACC = rD (1− T ) + rE V V where - rD is the cost of debt, § è WACC provides a tool to determine V and VE but both parameters are needed as inputs to determine WACC è may use rollback methods to solve the problem § Problem 2: Debt regime § è The left hand side WACC assumes a constant leverage (based on market values) § Alternative method: APV Approach - T is the corporate tax rate, - rE is the cost of equity, Problem 1: circularity problem - VD the market value of outstanding net debt, è APV splits the entity value of a debt finance firm into the value as if it would be fully equity financed and the tax shield of debt - VE the market value of outstanding equity è may use rollback methods to solve the problem Note that V=VD+VE holds by definition Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 15 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Risk-free rate and term structure Estimating the term structure • Ideally the term structure should be reflected in the discount rate – This can be done by looking at the empirical term structure of forward rates – Alternatively, the Svensson-method can be applied 0 0 1 − -./ − 1 1 − -./ − 1 0 + + !"# $ 100 = () + (+ + ( − -./ − 2 0 0 1+ 1+ 1+ + (3 0 1 − -./ − 1 0 2 − -./ − 0 12 12 – This gives the continuously compounded risk-free rate for maturity t; all parameters are daily reported by the Bundesbank or the FED Practitioners, however, often operate with a single discount rate • This discount rate k is derived by solving (numerically, t≈250) the equation ∞ ∑ t =1 (1+ g) t (1+ kt ) t 1+ g = k −g Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 16 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Problems with the Svensson-method • Note, however, that applying the Svensson-Method beyond the observable 30year maturity can lead to strange patterns in the term structure: 3.5" 3.5" 3" 3" 2.5" 2.5" R 2" a t e% 1.5" R 2" a t e% 1.5" 1" 1" 0.5" 0.5" 0" 0" 5" 10" 15" 20" 0" 0" Maturity(in(years( 50" 100" 150" 200" 250" Maturity(in(years( • One solution is to estimate an ultimate forward rate (UFR). • Alternatively, it is often assumed that beyond the year 30 the term structure is flat. Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 17 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Valuation and personal taxes - Hitherto we have looked at corporate taxes only, personal taxes were ignored Taking into account personal taxes • According to IDW S1, cif. 28, personal taxes on any distribution made by the company has to be taken into account (after tax valuation). • The after tax cost of equity is calculated according to the tax CAPM. Under the current tax regime (Abgeltungssteuer) it follows: AT rEAT = (1− π ) rriskfree + β stock ⋅ ( rmarket return − (1− π ) rriskfree ) where p is the personal tax rate (26.4%) and AT stands for after tax • According to IDW the after tax market risk premium should be around 5 to 6% Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 18 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Agenda § DCF Valuation § Practical Example § The APV Method § Multiple Valuation Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 19 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Practical example: DCF Valuation of Facebook • The valuation is done by the beginning of the year 2012 in order to prepare for the IPO consumed on May 18th, 2012 • For conducting a DCF valuation (entity approach) the estimates provided by the lead investment bank (J.P. Morgan) are used. These estimates are summarized on the following page. • Moreover, use and discuss the following assumptions: a) Risk-free rate: 2% b) Beta (unlevered): 1,2 c) Market risk premium: 7% d) Tax rate: 41% e) Terminal growth rate: 2% f) #shares: 2,138 mn Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 20 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Balance Sheet All numbers are in $ million unless mentioned otherwise Assets Current Assets: Cash & Cash Equivalents Marketable Securities Accounts Receivable Prepaid Expenses & Other Current Assets Total Current Assets FY 10 FY 11 FY 12 FY 13 FY 14 FY 15 FY 16 1.785 373 88 2.246 1.512 2.396 547 149 4.604 1.199 2.396 1.264 252 5.111 2.534 2.396 1.281 427 6.638 3.685 2.396 2.924 723 9.728 7.936 2.396 3.399 1.225 14.956 14.481 2.396 6.377 2.074 25.328 574 59 37 74 2.990 1.475 80 82 90 6.331 1.992 3.365 149 215 82 82 179 250 7.513 10.549,435 5.066 350 82 414 15.640 7.979 529 82 622 24.168 12.054 816 82 962 39.242 Liabilities and Stockholders’ Equity Current Liabilities: AccountsPayable PlatformPartners Payable Accrued Expenses & Other Current Liabilities Deferred Revenue & Deposits Current Portion of Capital Lease Obligations Total Current Liabilities 29 75 137 42 106 389 63 171 296 90 279 899 104 267 640 90 279 1.379 141 382 1.382 90 279 2.274 244 633 2.985 90 279 4.231 358 958 6.450 90 279 8.135 553 1.449 13.936 90 279 16.308 Non-Current Liabilities: Capital Lease Obligations, Less Current Portion Long-Term Debt Other Liabilities Total Liabilities 117 250 72 828 398 135 1.432 322 135 1.836 228 135 2.637 109 135 4.475 17 135 8.287 11 135 16.454 615 947 (6) 606 2.162 615 2.684 (6) 1.606 4.899 2.684 (6) 2.999 5.677 2.684 (6) 5.235 7.913 2.684 (6) 8.487 11.165 2.684 (6) 13.203 15.881 2.684 (6) 20.111 22.789 2.990 6.331 7.513 10.549,435 15.640 24.168 39.242 Source: www.edupristine.com Non-Current Assets: Property & Equipment, net Intangible Assets, net Goodwill Other Assets Total Assets Stockholders’ Equity Convertible Preferred Stock Common Stock Additional Paid-in Capital Accumulated Other Comprehensive Loss Retained Earnings Total Stockholders’ Equity Total Liabilities and Stockholders’ Equity Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 21 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Income Statement All numbers are in $ million unless mentioned otherwise FY 09 Revenue Advertising Revenue 764 Payments & Other Fees Revenue 13 Total Revenue 777 FY 10 FY 11 FY 12 FY 13 FY 14 FY 15 FY 16 1.868 106 1.974 3.154 557 3.711 5.231 557 5.788 8.518 557 9.075 13.615 557 14.172 21.355 557 21.912 32.853 557 33.410 223 115 87 90 262 493 184 144 121 1.032 860 427 388 280 1.756 1.483 687 695 487 2.436 2.231 989 1.270 668 3.915 3.467 1.620 2.268 1.102 5.717 5.453 2.498 3.944 1.721 8.295 8.234 3.756 6.682 2.561 12.177 Interest Expense Other Income (Expense), net EBT (10) 2 254 (22) (2) 1.008 (42) (19) 1.695 (68) (7) 2.361 (104) (22) 3.790 (163) (41) 5.512 (253) (48) 7.994 (384) (84) 11.709 Provision for Income Taxes Net Income 25 229 402 606 695 1.000 968 1.393 1.554 2.236 2.260 3.252 3.278 4.716 4.801 6.908 * Cost of Services include depreciation and Amortizaton Expenses Depreciation & Amortization 78 139 323 497 736 1.200 1.839 2.782 Cost & Expenses Cost of Revenue* Marketing and Sales Research and Development General andAdministrative Income from Operations (EBIT) Source: www.edupristine.com Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 22 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München All numbers are in $ million unless mentioned otherwise Cash Flow from Operating Net Income Accounts Receivable Prepaid Expenses & Other Current Assets Accounts Payable Platform Partners Payable Accrued Expenses & Other Current Liabilities Deferred Revenue & Deposits Cash Flow From Operation Cash Flow Statement FY 10 Cash Flow from Investment Property and Equipment Intangible Assets Goodwill Marketable Securities Other Assets Cash from Investing Activities Cash Flow from Financing Capital Lease Obligations Long-Term Debt Other Liabilities Convertible Preferred Stock Common Stock Additional Paid-in Capital Accumulated Other Comprehensive Loss Retained Earnings Cash from Financing Activities Net Change in Cash Cash Balance Opening Balance Net Change in Cash Closing Balance 1.785 FY 11 FY 12 FY 13 FY 14 FY 15 FY 16 1.000 (174) (61) 34 96 159 48 1.102 1.393 (717) (103) 41 96 344 0 1.052 2.236 (17) (175) 38 115 742 0 2.939 3.252 (1.643) (296) 102 252 1.604 0 3.271 4.716 (475) (501) 114 324 3.465 0 7.643 6.908 (2.978) (849) 195 492 7.486 0 11.253 (901) (21) (45) (2.396) (16) (3.379) (517) (69) (89) (674) (1.373) (66) (71) (1.510) (1.701) (135) (164) (2.000) (2.913) (180) (208) (3.300) (4.075) (287) (340) (4.702) 454 (250) 63 1.737 2.004 (76) (615) (691) (94) (94) (119) (119) (92) (92) (6) (6) (273) (313) 1.335 1.151 4.251 6.545 1.785 (273) 1.512 1.512 (313) 1.199 1.199 1.335 2.534 2.534 1.151 3.685 3.685 4.251 7.936 7.936 6.545 14.481 Source: www.edupristine.com Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 23 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München DCF-Valuation of Facebook Valuation (Entity Approach) Risk free rate Beta Expected return from market WACC Tax Rate Terminal Growth Rate No. of Equity Shares 2% 1,20 9% 10,4% 41% 2% 2.138 All numbers are in $ million, except per share data FY 12 FY 13 FY 14 FY 15 FY 16 DCF Valuation using FCFE EBIT Less: Taxes Add: Depreciation Less: Capex Less: Increase in Working Capital Free Cashflow to the Firm (FCFF) 2.436 (999) 497 (586) (341) 1.008 3.915 (1.605) 736 (1.439) 704 2.311 5.717 (2.344) 1.200 (1.836) 18 2.755 8.295 (3.401) 1.839 (3.092) 2.927 6.568 12.177 (4.992) 2.782 (4.362) 4.345 9.949 4 4.421 120.813 5 79.733,1 Terminal Value No. of Years Total Present Value of cash flow 1 913 Enterprise Value (Operating assets) 89.012 Net Debt (3.465) Stock Price 2 1.896 3 2.048 43,25 Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 24 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Calculating the WACC for Orange plc The mobile telecommunication company Orange plc shall be listed on the LSE. For preparing their valuation reports financial analysts are wondering what the appropriate WACC might be in the DCF valuation models. For assessing Orange’s WACC the following information is available: The company has a target debt-to-equity ratio of 0.35. Net debt is equal to GBP 400 mn. The pre-tax cost of debt is 7%. Tax rate is 33%, the risk-free rate is 4.6% and the market risk premium is 4%. Vodafone is listed and widely comparable company. For this company we know: The stock beta is 1.24, the tax rate is 28%, net debt is equal to GBP 1.4 bn and the market value of equity is GBP 7.1 bn. üWhat is the WACC of Orange financial analysts’ should use in the DCF valuation models? Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 25 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Agenda § DCF Valuation § Practical Example § The APV Method § Multiple Valuation Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 26 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München WACC- and APV-method E [ FCFF1 ] E [ FCFF2 ] E [ FCFF3 ] Enterprise Value (WACC): V0 = Enterprise Value (APV): E [ FCFF1 ] E [ FCFF2 ] E [ FCFF3 ] V0 = + + +... + PVTS 1 2 3 (1+ rU ) (1+ rU ) (1+ rU ) € 1 (1+ WACC) + (1+ WACC) 2 + (1+ WACC) 3 + ... The Adjusted Present Value Method (APV) is a general approach for valuing firms that do not have constant debt ratios. The enterprise value is split-up into a value of the unlevered firm VU and present value of the tax shield PVTS. Note, however, that deriving the unlevered cost of capital rU in general is not obvious, as for an investor holding all the outstanding claims of a firm the following relationship applies (rT is the expected return associated with the tax shield): !" = !$ + !& = !' + (!)* +$ !$ + +& !& = +' !' + +, (!)* Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 27 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München The APV-method leads to simple solutions only in specific cases Assume a constant leverage ratio (case I) In this case rT=rU, as debt is proportional to firm value and tax shields. Therefore, debt has the same risk as free cash flows. * +, ",,' # "2 ", ", !"#$ = & ; + = + + + ; 3455 = + − + # ; 0 2 , 0 , 1 + +0 ' " " " '() Assume a constant debt level (case II) In this case rT=rD, as debt is constant and the tax shield has the same risk as debt. * +, ", # "2 ", 1 − # !"#$ = & ; + = + + + 0 2 , 1 + +, ' " + " 1 − # "2 + ", 1 − # 2 , '() Combining this result with the well-know WACC-formula yields: 3455 = +0 ", 1−# "2 + ", These are two special solutions to the following general relationship ", 3455 = +0 − # +, + 7 +0 − +, "2 + ", where k measures the permanence of the debt level, i.e. k=0 in case I and k=1 in case II Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 28 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Example I: constant leverage ratio Assume a firm with FCFF1=4.25mn€ and g=4%, rE=10%, rD=6% and T=35%. The debt-toequity-ratio is fixed at 50%. Calculate the enterprise value according to the WACC- and the APV-method. Using the WACC-method !"## = 6% 1 − 0.35 0= 0.5 1 + 10% = 7.97% 1.5 1.5 4.25 = 10734€ 0.0797 − 0.04 Using the APV-method 0.5 1 67 = 6% + 10% = 8.67% 1.5 1.5 07 = 90:; = 4.25 = 9134€ 0.0867 − 0.04 1 107 < 3 < 0.06 < 0.35 0.0867 − 0.04 = 1634€ 0 = 91 + 16 = 10734€ Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 29 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Example II: constant debt level Assume a firm with FCFF1=4.25mn€ and g=0%, rE=10%, rD=6% and T=35%. The debt level is fixed at 17.775mn€, which equals one third of the current firm value. Calculate the enterprise value according to the WACC- and the APV-method. Using the WACC-method !"## = 6% 1 − 0.35 0= 0.5 1 + 10% = 7.97% 1.5 1.5 4.25 = 53.3434€ 0.0797 Using the APV-method 67 = 7.97% = 9.02% 1 1 − 0.35 8 3 4.25 07 = = 47.1234€ 0.0902 90:; = 17.775 8 0.35 = 6.2234€ 0 = 47.12 + 6.22 = 53.3434€ Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 30 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Agenda § DCF Valuation § Practical Example § The APV Method § Multiple Valuation Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 31 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Multiples as an outcome of the DCF-approach If two firms have the same WACC and growth rate, the ratio of the enterprise value to the FCFF is the same for both. This ratio can be labelled as a multiple. EV = FCFF1 × M ∞ t EV = ∑ FCFFt ⋅ (1+ g) ⋅ (1+ WACC ) t=1 ⇒ −t FFCF1 = WACC − g 1 M= WACC − g For a non-growing firm, FCFF=EBIT(1-T) holds; hence, for firms with the same WACC and growth rate the ratio EV/EBITDA should be the same. Similarly, For firms with equal risk, growth rates and capital structure the cost of equity is the same; hence, they should have the same price/earnings ratio. Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 32 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Most important multiples used in practice EV / Sales EV / EBITDA EV / EBIT P/E § Applicable to young companies with negative Annual Net Profit § Good availability of data + + + § Reflects operating profitability § Influence of accounting because of depreciation eliminated § Reflects operating profitability § Independent from capital structure decision à high international comparability § Easy to communicate § High degree of aggregation § Suitable if capital structure is similar Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation § Sales is a bad indicator of profit situation § Problems with ccounting effects (e.g. non-cash sales) § EV reflects the tax shield of comparables à multiple relates pre-tax earnings figure to after tax market value § Problems due to differences in CAPEX and change in NWC § EV reflects the tax shield of comparables à multiple relates pre-tax earnings figure to after tax market value § Influence of depreciation policy § EV reflects the tax shield of comparables à multiple relates pre-tax earnings figure to after tax market value § Annual Net Profit distorted due to depreciation, taxes, capital structure - 33 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Enterprise vs. Equity multiples Value of a firm Value of net debt Enterprise value Enterprise multiples based on measures of overall performance (e.g. EBIT, EBITDA, Sales, Customers, etc) Often approximated by the book value of debt Value of equity market value of equity = # shares multiplied by the price per share Share price multiples based on measures of equity return (e.g. Price per share /Earnings (P/E-multiple)) Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 34 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Finding peer group firms is the fundamental problem in multiple valuation Trading multiples § Multiples are derived from share prices of companies listed on stock exchange § „Peer Group“ usually based on firms of same industry (same size, etc) § Implies „correct“ valuation of comparable companies by the market § For valuation of acquisitions: share prices usually do not contain a control premium; thus it has to be taken into account separately as a premium Transaction multiples § Multiples are derived from observed acquisitions prices of recent comparable transactions / from observed IPOs from recent IPOs § Acquisition prices usually contain control or strategic premia: thus no need to be taken into account separately! Problems § It is often hard to find comparable firms. § The average ratio for the sample of comparable firms often has a wide range. § For example, the average P/E ratio might be 20, but the range could be from 10 to 50. How do you know whether your firm should be compared to the low, average, or high performers? Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 35 Chair of Financial Management and Capital Markets TUM School of Management Technische Universität München Adjusting multiples is another important problem in multiple valuation Various key figures can be used for calculating multiples (e.g.: Sales Revenue, EBITDA, EBIT, NOPLAT, Net Profit,...) Unique events and discretionary accounting policy may distort key data and thus company values calculated Key figures should be standardized and/or adjusted. Adjustments • Extraordinary expenses/earnings • Disposition-contingent expenses/earnings (e.g. stock options, R&D expenses, non cash -revenues, pension reserves) Prof. Dr. Christoph Kaserer (TUM) | Corporate Finance | Practical Valuation 36