Accounting

1. AC210: Corporate Finance
Norvald Instefjord
ninstef@essex.ac.uk
5NW.4.9

2. Introduction to Corporate Finance
• What is finance?
• What is the distinction between financial
and real assets?
• What is corporate finance?
• What is the role of financial assets in
corporate finance?

3. Week 1
Financial Markets and Financial
Instruments
• How do firms finance their investments?
– Earnings (free cash flow, internal capital)
– Equity capital (external – public or private)
– Debt capital (external)
• Public and private capital
• Trading of public capital
– New issues
– Secondary trading

4. Equity Issues
• First time a firm seeks public equity is
called an initial public offering (IPO)
– Primary issue: new equity is issued
– Secondary issue: existing private equity is
sold to outside investors (most privatisations
take this form)
– Legal and underwriting services provided by
investment banks

5. Debt Issues
• Bank loans – not publicly traded
• Corporate Bonds – traded actively in the
secondary market
• Debt capital and equity capital account for
most of the firm’s financial capital

6. Definition of Debt
• Fixed claim
– Specifies what needs to be repaid to the
investor and when
– Default risk – risk that the repayment plan is
not fulfilled
– Conversion options – covenants that allow
debt to be reclassified as equity

7. Definition of Equity
• Residual claim
– Does not specify a repayment plan
– Repayment is defined as the residual:
whatever is not claimed by other claim
holders should go to the equity holders
– Voting rights: Equity holders normally have a
right to vote on important corporate decisions
• Mergers, takeovers
• Large investments
• Board representation

8. Trends in Corporate Finance
• Globalisation
• Deregulation
• Financial innovation
• Technological advances in the financial
system
• Securitization

9. What you should take home
• You should be able to
– Understand the distinction between a fixed claim and
a residual claim
– List the main attributes of a debt claim
– List the main attributes of an equity claim
– Describe the ways in which firms raise funds for new
investment
– Describe the difference between private and public
equity
– Describe the difference between bank loans and
corporate bonds

10. Readings
• Grinblatt/Titman: Financial Markets and
Corporate Strategy
– Ch 1: overview of the process of raising
capital for investment
– Ch 2: overview of the process of raising debt
capital
– Ch 3: overview of the process of raising equity
capital

11. Problems
1. Why do firms use underwriters when
they issue new equity?
2. In what ways do you think it matters that
debt holders have a fixed claim when
equity holders have not?
3. In what ways do you think it matters that
equity holders have voting rights when
debt holders have not?

12. Review problems
1. Invest 95 and sell for 102 – what is the return?
2. Invest 95 and sell for 102. Each transaction is charged
a 1% trading commission – what is the return?
3. Invest 95 and sell for 102. You receive additional
interest payments/dividends of 2 during the holding
period. What is the return?
4. Invest 95 and sell for 110 three years later – what is
the annual return on your investment?
5. Invest 95 now and another 98 next year. In the
following year you sell your investment for a total of
202. What is the annual return on your investment?

13. Week 2:
Valuing Financial Assets: Portfolio
Tools
• Tool box
– Expected portfolio return
– Portfolio variance
– Covariance between the return on two assets
• Optimal investment
– “Fair” price of an asset means that the value equals
the purchasing price
– Even if prices are “fair” there are still ways of
investing your money that is better than others
• Risk Aversion
– Investors demand compensation for including risk in
their portfolio

14. Portfolio weights
• A portfolio of financial assets can be represented
in a number of ways
– The number of shares held in the various stocks (e.g.
1000 shares in BT, 250 shares in Marks&Spencer
etc.)
– The dollar-value held in the various stocks (e.g.
£2,500 in Lloyds Bank, £10,000 in Jarvis etc.)
– As portfolio weights: the dollar-weight of the various
stocks (e.g. if total portfolio is £100,000, then the
portfolio weight of Lloyds is 0.025 and the portfolio
weight of Jarvis is 0.1 etc.)

15. From portfolio weights to portfolio
expected return and variance
• To determine the expected return and
variance of a portfolio we need to know
– The portfolio weights
– The expected return on the individual assets
– The variance of the return on the individual
assets
– The covariance between the return on any
pair of assets

16. Expectation, Variance and
Covariance
• Expected return (“average” return) is a location
measure
• Variance of return is a spread measure
• Covariance is a measure of how the return of
two assets are “related” (they can move in the
same or opposite directions, or they can be
uncorrelated)
• If the returns move in the same directions,
covariance is positive, if the returns move in the
opposite directions, covariance is negative, and
if uncorrelated, covariance is zero

17. The input data for a portfolio
of N assets
• N expected returns
• N variances
• N(N-1)/2 covariances
• Plus N portfolio weights
• For FTSE100 there are therefore
100+100+100(99)/2 = 5150 data points that
need to be estimated even before working out
the portfolio weights

18. Formulas
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19. Covariance and Correlation
• Covariance is a measure of relatedness
that depends on the unit of measurement,
so if the return is measured as a percent
(e.g. 10 percent) or as a desimal (e.g.
0.10) the covariance will be different
• Correlation is a measure of relatedness
that is normalized to be independent of the
unit of measurement

20. Covariance and Correlation
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21. The Mean-Standard Deviation
Approach to Investment
• Risk averse investors don’t like risk
• Variance averse investors don’t like risk that comes as
variance
• This is not the same in general – variance aversion is a
special case of risk aversion
• Portfolio theory takes the variance aversion approach –
which in practice means that we assume investors wish
to maximize their expected return given a certain
variance, or minimize their variance given a certain
expected return

22. Mean-Standard Deviation
for Two-Asset Investments
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23. Portfolio Frontier

24. Mean-Std Dev for Portfolios of the
Risk Free Asset and a Risky Asset
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25. Covariance as Marginal Variance
• We can interpret the covariance between
the return on a stock and the return on a
portfolio as the stock’s marginal variance
• That is, if we increase the stock’s portfolio
weight marginally, the portfolio variance
will increase by approximately twice the
stock’s covariance with the portfolio

26. Algebraic “proof”
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27. What to take home
• Understanding of expected values, variances,
and covariances
• Understanding of expected return and variance
for a portfolio
• Understanding of risk aversion and variance
aversion
• Understanding of the portfolio frontier
• Appreciation of the linearity of expected return
and standard deviation for portfolios consisting
of the risk free asset and a risky portfolio

28. Readings
• Chapter 4 in Grinblatt/Titman

29. Problems
1. Variance: Prove that E(x-E(x))2=Ex2-
(E(x))2
2. Covariance: Prove that E(x-E(x))(y-
E(y))=Exy-E(x)E(y)
3. Take a time series of returns 0.05, -0.03,
0.10, 0.04, -0.10, 0.20. Estimate the
expected return and the variance of
return.

30. Week 3:
From Mean-Variance to the CAPM
• Capital Market Line
– Finding the market portfolio
• Two-fund Separation
– Optimal diversification
– Market vs idiosyncratic risk
• CAPM expected returns relationship
– Expected return on assets depend on their
covariance (i.e. their relatedness) with the market
portfolio
– Estimating beta risk

31. Capital Market Line
• The line that goes through the risk free
asset and the tangency portfolio
• Identification?
– Maximization procedure
– Simplifying “trick”, the excess return on any
asset divided by its covariance with the
tangency portfolio, is constant

32. Maximization programme to find
the Capital Market Line
• We can identify the frontier portfolios of
risky assets
• Consider investments consisting of the risk
free asset and a frontier portfolio – these
are represented by straight lines
• For the frontier portfolio that is the
tangency portfolio, the angle of the straight
line is the steepest

33. Capital Market Line cont..
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34. Capital Market Line cont..
• The maximization programme normally
leads to a fairly complicated equation –
with two risky assets we get a quadratic
equation to solve
• In the class exercises you will be asked to
have a go at such a problem

35. Simplifying “trick”: finding the
Capital Market Line
• We know the expected return on all risky
assets and the risk free return
• The difference between the two is called
the “excess return” for the asset
• The excess return, divided by its
covariance with the tangency portfolio, is
always constant

36. Capital Market Line
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37. Example
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38. Example cont..
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39. CAPM: Risk and Return
• Since the excess return divided by the
covariance with the tangency portfolio is
constant across assets, we can derive
important relationships between risk and
return
• The covariance with the tangency portfolio
is, if solved for the tangency portfolio itself,
equal to the variance of the tangency
portfolio

40. Risk and Return
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41. Security Market Line
• The expected return of securities is linear
in their beta-factors
• In the (beta,expected return) plane, the
line crossing through (0,rF) and (1,E(rT)) is
called the security market line

42. Properties of betas
• Beta is linear: the beta of a portfolio of
securities equals the portfolio-weighted
average of the betas of the individual
securities
• An implication is that the beta of the
assets of the company equals the value-
weighted beta of the liabilities of the
company

43. Tracking portfolios
• A portfolio tracks another perfectly if the
difference in the returns of the portfolios is
a constant (possibly zero)
• Imperfect tracking: A portfolio consisting of
a weight (1-b) in the risk free asset and a
weight b in the tangency portfolio tracks a
stock with beta β=b, because the two
should have the same expected return

44. Tracking Errors
• The two investments should have the same
expected return, which implies that the tracking
error has zero expectation and zero value
• Of course, investors do not like risk so they
choose to hold the tracking portfolio instead of
the stock
• Because such diversification is free of cost, the
tracking error is also free of cost (i.e. it has zero
value)

45. Estimating the risk free return
• For risk free return use government bond
or government bill data (long or short term
instruments backed by the government)
• The return offered on such instruments is
a good proxy for the actual risk free return
• Alternative, use the average return of a
zero-beta risky stock, or the intercept with
the y-axis if no zero-beta stock exists

46. Estimating market risk premia
• Estimate the long-run average return on a broad
stock market index and subtract the risk free rate
• Both the average stock market index return and
the risk free return change over time
• The change in the difference is more volatile
than the changes in the individual time series.
• Therefore, estimate the long-run average index
return first. Do not estimate the difference
between the market return and the risk free rate
directly

47. Beta estimation
• A raw beta estimate can be obtained from historical
covariance and variance estimates (or by a regression)
• Average beta is one (this is the beta of the market index)
• If the raw estimate exceeds (is below) one, we know
there is a possibility that the raw beta is an overestimate
(underestimate)
• Raw beta estimates should be adjusted – i.e. they
should be pulled down if they are above one or be
bumped up if they are below one.
• There are ways of optimally adjust beta estimates

48. Beta Adjustment
• Bloomberg adjustment
– Adjusted beta = .66 times Unadjusted beta +
.34 times One
• Rosenberg adjustment
– Adjustment also incorporates fundamental
variables (industry variables, company
characteristics such as size, etc..)
• Also betas are adjusted sometimes to take
into account infrequent trading problems

49. What to take home
• Two-fund separation
• Capital Market Line vs Security Market
Line
• Risk-Return relationships
• Tracking portfolio
• Parameter estimation: problems and
current practice

50. Readings
• Grinblatt/Titman ch 5

51. Problems
• What is the tracking portfolio for a real
asset?
• How would you estimate the beta of the
assets of a firm that has traded debt and
equity?
• How would you estimate the beta of a
company that has never traded?

52. Week 4: From CAPM to Arbitrage
Pricing Theory
• Main purpose is to extend the valuation
approach into more advanced and flexible
valuation models
• CAPM can be thought of as a “one-factor” model
(returns are determined by movements in the
market portfolio only) but has important
empirical problems (systematic deviations from
predictions)
• APT extends to “multi-factor” pricing that can
mitigate some of the CAPM’s empirical problems

53. Risk Decomposition
• The Market Model
– One-factor (the return on the market portfolio)
– Related to the CAPM model
– The regression estimates of the market model
generates raw beta-estimates for the CAPM
• Risk Decomposition
– Systematic (market) risk: asset risk that is explained
by market movements
– Unsystematic (diversifiable, idiosyncratic) risk: asset
risk that cannot be explained by market movements

54. Market model regression
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55. Risk Decomposition
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56. APT: The arbitrage principle
behind factor models
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57. APT: Factor pricing
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58. Multi-factor models
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59. We do not know what
the factors are!
• Can be evaluated statistically – using a
method called factor analysis
• The output generates portfolios associated
with each factor
• Can use firm characteristics or
macroeconomic variables as proxies for
the factors

60. Factor betas
• The betas determine the asset’s sensitivity to the
factors
• A high loading on factor number 2 means that
the asset is particularly sensitive to risks
associated with factor 2
• Factor models extends into portfolio analysis
since the factor betas of portfolio is just the
value-weighted average factor beta for the
individual assets in the portfolio

61. Factor models: computing the
variance-covariance structure
• Recall that computing the variance-covariance
structure requires a large number of estimates
• For N assets, N variance estimates and N(N-1)/2
covariance estimates
• N=100, 100 variance estimates and 100(99)/2 =
4950 covariance estimates
• Using the market model, we can work out the
covariance structure from the beta estimates, i.e.
from the N beta estimates

62. Covariance structure estimation
)
var(
)
,
cov(
)
,
cov(
)
,
cov(
)
var(
)
,
cov(
)
,
cov(
~
~
~
~
~
~
~
~
~
~
~
~
~
~
~
f
b
b
f
b
f
b
f
b
b
f
b
f
b
r
r
f
b
a
r
j
i
j
i
i
j
j
i
j
i
j
j
i
i
j
i
i
i
i
i



















63. Variance estimation
)
var(
)
var(
)
var(
~
~
2
~
i
i
i f
b
r 



64. Tracking Portfolio
• Objective: to design a portfolio that has certain
factor betas (or factor loadings)
• Why? The use of tracking portfolios are many
– Risk management: if the company is subject to risks
beyond its control, e.g. currency risk, it may create a
tracking portfolio that offsets the risk
– Capital allocation: the company may wish to allocate
capital to investments that yield a greater return than
their tracking portfolio and to reduce its exposure to
investments that yield a smaller return than their
tracking portfolio

65. Designing a Tracking Portfolio
• First, determine the number of relevant factors
(guesswork, statistical analysis)
• Second, determine the factor betas of the
investment you wish to track (statistical analysis,
comparison with existing traded companies)
• Third, gather a collection of different assets with
known factor loadings
• Forth, calibrate your portfolio such that the
portfolio factor beta equals the target factor beta
for each factor

66. Example
8
.
0
,
3
.
0
,
1
.
0
:
Output
2
2
4
1
5
.
1
3
1
:
n
Calibratio
2
factor
for
0
2,
4,
-
and
1
factor
for
1.5
3,
1,
beta
factor
with
assets
Three
ly
respective
2
and
1
factor
for
2
and
1
betas
target
portfolio,
cking
factor tra
-
Two
3
2
1
2
1
3
2
1
3
2
1













x
x
x
x
x
x
x
x
x
x
x

67. Applying Pricing Theory
• Use pricing models to investment analysis
(optimal investment strategies in financial
markets – diversification)
• Use pricing models to calibrate
investments (design of tracking portfolios)
• Use pricing models as a benchmark for
real investment (comparing real
investment returns to the return on
tracking portfolios)

68. Readings
• Chapter 6 in Grinblatt/Titman

69. Problem
• There are three relevant factors driving
asset returns
– The factor structure of the debt of the
company is (0.01, 0,0)
– The factor structure of the equity of the
company is (2,5,1)
– The company consists of 1/3 debt and 2/3
equity
• What is the factor structure of the
company’s real assets (investments)?

70. Week 5: Investment Analysis – the
case of Risk Free Projects
• Apply pricing technology to real
investment analysis
• Net Present Value Rule
• Complications
– Sunk cost
– Opportunity cost
– EVA and IRR

71. Fisher Separation
• With different tastes, why should investors agree
on investment policy?
– Long-term vs short term
– Risky vs Risk free
• Fisher separation
– Agreement is optimal regardless of taste
– Net present value rule: Invest in all projects that cost
less than the value of the project’s tracking portfolio
– NPV = PV(future investment) – Investment cost

72. Ingredients
• Cash flows of our investment
• Investment cost
• Discount rates (if risk free projects – use a
risk free discount rate)

73. Present Value = sum of discounted
cash flows
T
T
r
C
r
C
r
C
C
r
r
C
C
r
r
C
C
C
C
)
1
(
)
1
(
)
1
(
portfolios
tracking
of
value
the
of
sum
lue
Present va
etc...
2
year
in
)
1
(
)
1
(
to
grows
r)
(1
C
1
year
in
)
1
(
)
1
(
to
grows
r)
(1
C
:
portfolios
Tracking
,
,
,
:
flows
Cash
3
2
2
1
2
2
2
2
2
2
1
1
1
2
1



































74. Net Present Value
T
T
r
C
r
C
r
C
I
NPV
)
1
(
)
1
(
1 2
2
1
0








 

75. NPV and Arbitrage
3.
period
in
30
paying
bond
a
buying
2,
period
in
10
paying
bond
a
selling
1,
period
in
40
paying
bond
a
buying
project,
the
g
undertakin
to
Equivalent
94
.
34
05
.
1
30
05
.
1
10
05
.
1
40
20
30
,
10
,
40
,
20
:
flows
Cash
arbitrage
ugh
money thro
making
to
equivalent
is
NPV
positive
has
it
en
project wh
Adopt the
3
2








NPV

76. Value Additivity of NPVs
B
A
B
A
B
A
NPV
NPV
NPV
NPV
NPV




:
lue
present va
net
has
projects)
two
the
of
flows
cash
combined
the
(i.e.
B
A
Project
has
B
Project
has
A
Project

77. Mutually Exclusive Projects
• This is an “either-or” situation – you can invest in
project A or you can invest in project B, but you
cannot invest in both at the same time
• Both projects may have positive NPV so are
worthwhile on their own
• “Either-or” situations often arise naturally. For
instance, all timing decisions are mutually
exclusive. You can invest now or you can invest
in the future, but you cannot invest both now and
in the future.

78. Which project to choose when they
are mutually exclusive
• The choice criterion is to maximize the net
present value of investment.
• Therefore, if you have two or more
mutually exclusive projects to choose from
you should choose the one with the most
positive NPV.

79. Capital Constraints
• There are situations in which you may
have more projects with positive NPV
available than you have funds for
investment – i.e. you have a budget
constraint
• Then the choice criterion is to invest in the
projects that offer the greatest profitability
index

80. Profitability Index
0
0
0
Index
ity
Profitabil
lue
present va
Net
cost
Investment
flow
cash
Value
Present
I
PV
PI
I
PV
NPV
I
PV





81. Example
budget?
within
staying
to
subject
policy
investment
optimal
the
is
What
.
100
budget
investment
Total
exclusive?
mutually
are
projects
the
if
policy
investment
optimal
the
is
What
t?
independen
are
projects
the
if
policy
investment
optimal
the
is
What
950
,
1000
:
C
Project
90
,
100
:
B
Project
8
,
10
:
A
Project
m
B
m
I
m
PV
m
I
m
PV
m
I
m
PV
C
C
B
B
A
A








82. Example cont.
11
.
12
)
950
1000
(
950
2
)
90
100
(
)
8
10
(
:
NPV
Total
C
of
%
2105
.
0
950
2
plus
C)
in
invest
to
2
leaving
budget,
of
90
additional
(using
B
of
all
plus
budget)
100
of
8
(using
A
of
All
:
mix
Optimal
C.
and
B
then
first,
A
in
Invest
0526
.
1
950
1000
1111
.
1
90
100
25
.
1
8
10
:
indexes
ity
Profitabil













C
B
A
PI
PI
PI

83. Economic Value Added
• EVA is a profitability measure that has become
widely used in corporations – initially to replace
accounting earnings or profit measures
• Accounting measures do not always measure
economic performance (depreciation cost, for
instance, is not a cash flow and should not be
included in project evaluation)
• Accounting measures are therefore not directly
consistent with NPV
• Economic Value Added is consistent with NPV

84. EVA: Definition
• Three components
– Cash flow
– Change in asset base
– Economic return on assets
• EVA(t) = Ct + (It – It-1) – rIt-1
• EVA(t) = Ct + It – (1+r)It-1
• Discounted sum of EVA(t) = Net Present
Value

85. EVA, cont.
• Investment of 100
• The first year cash flow is 50
• The second year cash flow is 150
• Discount rate is 10%
• Assets are depreciated by 50% in the first
year and by 100% in the second year.
• NPV = -100 + 50/1.1+150/1.12=69.42

86. EVA, cont.
• EVA(0) = -100(cash flow)+(100-0)(change in assets)-
0(0.1)(economic cost of initial assets) = 0
• EVA(1)=50(cash flow)+(50-100)(change in assets)-
100(0.1)(economic cost of initial assets) = -10
• EVA(2)=150(cash flow)+(0-50)(change in assets-
50(0.1)(economic cost of initial assets)= 95
• Discounted EVA = EVA(0)+EVA(1)/1.1+EVA(2)/1.12 =
69.42 = NPV

87. IRR: Internal Rate of Return
• Often managers base investment decision on
the IRR instead of the NPV
• The rule is: if IRR is greater than the discount
rate (i.e. the cost of capital) then adopt the
project
• In many cases this leads to the same investment
decision, as IRR is greater than the discount rate
only if the NPV is positive
• In other cases this is not true however, so to be
safe always use NPV or EVA calculations

88. IRR
T
T
T
T
IRR
C
IRR
C
IRR
C
I
r
C
r
C
r
C
I
NPV
)
1
(
)
1
(
1
0
)
1
(
)
1
(
1
2
2
1
0
2
2
1
0





















89. Example
• Investment cost = 100
• First year’s cash flow = 150
• Discount rate 10%
• NPV = -100+150/1.1=36.36
• IRR: 0=-100+150/(1+IRR) yields 50%
• Since 50% > 10% (IRR > discount rate) it is
optimal to adopt the project

90. Projects that have the cash flow
profile of a loan
• “Investment cost” = 150
• Next year’s cash flow = -100
• Discount rate = 10%
• NPV = 150 – 100/1.1 = 59.09
• IRR: 0 = 150 – 100/(1+IRR) yields a negative
IRR of -33.33% but this project is clearly
profitable even though IRR < discount rate

91. Problems with IRR
• IRR criterion is sensitive to the type of cash flow
(asset or liability?)
• IRR is not unique in general (for T period
projects there can be up to T different IRRs)
• IRR is not appropriate for mutually exclusive
projects as small projects with high IRR and
small NPV might then be preferred to large
projects with low IRR and large NPV

92. IRR and mutually exclusive
projects
• Discount rate 2%
• Project A: -10, -16, +30
• Project B: -10, 2, 11
• NPV(A) = 3.149
• NPV(B) = 2.534
• IRR(A) = 10.79%
• IRR(B) = 15.36%

93. Important points
• Fisher separation
• NPV definition
• NPV with mutually exclusive projects
(either-or)
• NPV with budget constraints
• EVA and NPV
• IRR
• IRR pitfalls

94. Readings
• Grinblatt/Titman chapter 10

95. Test for next week:
• Readings chapter 4, 5, 6 and 10
• Important formulas
– CAPM: exp return = risk free plus risk adjustment
– Beta-factor: covariance/variance
– Factor models: exp return = risk free plus risk
adjustment
• Risk free real investments
– NPV rule
– Profitability Index
– EVA
– IRR

96. Very important formulas
T
T
K
K
F
M
M
F
M
F
r
C
r
C
I
NPV
r
r
E
r
Var
)
Cov(r,r
r
r
E
r
r
E
)
1
(
1
:
lue
present va
Net
premium)
risk
denotes
(where
)
(
:
models
Factor
)
(
:
Beta
)
)
(
(
)
(
:
CAPM
1
0
1
1

























97. Sample test questions
1. The risk free return is 5% and the market index has an
average return of 12%. What is the expected return for
an asset with beta 1.5?
2. An investment costs 100,000 and offers a cash flow of
50,000 in year 1 and 150,000 in year 2. The discount
rate is 5%. What is the net present value of the
investment? Should you adopt the investment?
Explain.
3. In a two-factor market, the factor betas of asset A are 1
and 0, and the factor betas of asset B are 0 and 1,
respectively. The risk free return is 5%, and the
average return on asset A and B are 10% and 15%,
respectively. What are the risk premia associated with
factor 1 and 2?

98. Week 6: Investing in Risky Projects
• Applying the CAPM and APT in the capital
budgeting process
• Key problem: estimating the cost of capital
for risky projects
– Applying CAPM and APT
– Using comparison firms
– The dividend discount model

99. Risk Adjusted Discounting
t
t
t
F
M
F
t
r
C
E
C
E
PV
r
r
E
r
r
C
E
)
1
(
)
(
))
(
(
:
Discount
)
(
(
flow
cash
the
of
return
market
expected
the
Compute
return
market
the
of
variance
over the
return,
market
the
h
return wit
the
of
covariance
the
is
beta
(the
flow
cash
with this
associated
risk
beta
the
Compute
t
period
in
)
(
get)
ll
at we'
exactly wh
know
not
do
(we
flow
cash
future
expected
the
Compute




 


100. Fundamental problem: Estimating
the beta factor
• Betas for traded equity are easy to estimate –
we simply regress equity returns on the index
return, and possibly adjust to take into account
estimation error (e.g. Bloomberg adjustment)
• Betas for projects are much more difficult to
estimate as there simply does not exist a trading
history
• Possible solution: use comparison firms (firms
we imagine has similar risk profile to the project
in question)

101. Using comparison firms
• Asset base needs to be sufficiently similar
to the planned investment
• We need to adjust for leverage effects (the
comparison firm may have debt)
– In general, it is only the equity beta of the
comparison firm we can estimate but we are
really interested in the asset beta
– The more the firm borrows, the higher the
equity beta (even though the asset beta
remains the same)

102. Adjusting for leverage
term
leverage
a
plus
beta
asset
the
equals
beta
equity
Estimated
)
(
beta
equity
and
debt
of
sum
weighted
-
value
beta
Asset
D
A
A
E
E
D
A
E
D
E
D
V
V
E
V
D
















103. Example
9
.
0
60
40
1
5
.
1
implies
)
0
(
60
40
5
.
1
0
beta
debt
Estimated
1.5
beta
equity
Estimated
60.
equity
value
and
40,
debt
value
100,
assets
Value






A
A
A




104. Implementing risk adjusted
discounting with comparison firms
08
.
1
0
.
1
79
.
0
85
.
0
s
Wendy'
00
.
1
10
7
.
7
77
.
0
McDonalds
75
.
0
100
.
0
096
.
0
72
.
0
Chicken
s
Church'
are
betas
asset
The
zero.
to
equal
assumed
is
companes
these
of
debt
the
of
beta
the
and
ly,
respective
s),
(Wendy'
0.790
and
0.210
and
)
(McDonalds
7.700
and
2.300
Chicken),
s
(Church'
0.096
and
0.004
are
companies
these
of
ues
equity val
and
debt
The
ly.
respective
1.08
and
1.00,
0.75,
are
companies
three
these
of
betas
equity
The
s.
Wendy'
and
s
McDonald'
Chicken,
s
Church'
of
beta
average
the
has
project
A




105. Cont…
)
084
.
0
(
78
.
0
04
.
0
1055
.
0
is
project
for the
rate)
(discount
capital
of
Cost
8.4%.
premium
risk
market
and
4%
rate
free
Risk
3
85
.
0
77
.
0
72
.
0
78
.
0
beta
project
beta
Average








106. Applying APT
t
K
K
F
t
t
r
C
E
C
E
PV
)
1
(
)
(
))
(
(
by
given
are
lues
present va
so
model,
factor
a
by
capital
of
cost
the
estimates
model
APT
The
1
1 


 






107. APT and CAPM vs Alternative
methods
• A drawback with the APT and CAPM
models is that they require a number of
estimates: the risk free rate of return, the
beta factor(s), the market risk premium
and the factor risk premia.
• It can in some circumstances be better to
work with simpler model. The dividend
growth model is an alternative to the APT
and CAPM.

108. Dividend Discount Model
yield
dividend
dividends
in
growth
)
1
(
)
1
(
)
1
(
)
1
(
)
1
(
etc...
,
)
1
(
)
1
(
0
1
1
0
2
1
1
2
2
1
0
2
2
1
1
1
0























S
div
g
r
g
r
div
S
r
g
div
r
div
r
div
r
div
S
r
S
div
S
r
S
div
S



109. What if comparison firms don’t
exist?
• In general there is little we can do
• However, if there exist firms where one
division is similar to our project we may be
able to identify the relevant betas.
• For instance, if you want to estimate the
beta of the network division of television
companies you can use the fact that these
divisions play a varying role in generating
the asset beta for these companies

110. Network division example
36
.
0
78
.
0
5
.
0
5
.
0
99
.
0
75
.
0
25
.
0
that
know
we
similar,
ly
sufficient
are
divisions
network
-
non
If
divisions.
network
-
non
from
50%
division,
network
from
value
of
50%
0.78,
beta
asset
:
Viacom
divisions.
network
-
non
from
75%
division,
network
from
value
of
25%
0.99,
beta
asset
:
Electric
General










Network
network
Non
Network
Viacom
network
Non
Network
GE








111. Pitfalls in using the comparison
method
• Project betas not the same as firm betas:
mature projects generally lower beta than
R&D projects etc
• Growth opportunities are usually the
source of high betas: company value often
significantly linked to future growth
opportunities as opposed to current
investments

112. Example
• Investment cost 100,000
• Annual running cost 5,000 for 5 years
• Expected revenue stream 50,000 for 5
years
• Beta-risk of revenue stream 1.2
• Risk free return 5%
• Expected market return 12%

113. Example cont…
project.
adopt
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PV

114. Comparison method, example
• A firm with equity currently valued at 100,000
and outstanding debt worth 50,000 holds 25%
cash and 75% of a risky asset on its balance
sheet
• The equity beta is 1.5
• You consider investing in a project very similar to
the risky asset owned by this firm
• The risk free rate is 5% and the expected return
on the market is 12%
• Work out the project beta and the cost of capital
for your project

115. Comparison method cont…
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of
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.
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RiskyAsset
RiskyAsset
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

116. Readings
• Grinblatt & Titman chapter 11
• I have not emphasized the certainty
equivalent method

117. Week 7: Taxes and Financing
• Irrelevance in the absence of transaction
costs and taxes (Modigliani-Miller)
• Financing choices not neutral to taxation:
– Level: corporate vs private tax rates
– Timing: dividends can be deferred whereas
interest payments on debt cannot

118. Modigliani-Miller
• The operating cash flow is divided into two
components
– Cash flow to debt holders
– Cash flow to equity holders
• Fundamental question: Does it matter how
the split is made?
• If it does we can create value also through
financing choices (not only through
investment choices)

119. MM cont…
• Modigliani-Miller proved that capital structure
choices are irrelevant – the split does not matter
• This proof rests on the absence of transaction
costs of any kind: taxes, trading costs, and
bankruptcy costs
• The proof of the MM theorem uses a “no
arbitrage” argument – financial markets do not
admit “free lunches”, or trading strategies giving
you a positive cash flow with no prior investment

120. MM cont…
• Consider two “versions” of the same firm –
one version is U for unlevered (with no
debt) and the other version L for levered
(with debt)
• The firms have otherwise the same
operating cash flow X
• The unlevered firm has value VU and the
levered firm value VL

121. MM cont…
• The fundamental question is whether VU and VL
differ
• The cash flows of firm U’s equity holders is
simply X
• The cash flow of firm L’s debt holders is (1+r)D
to the firm’s debt holders and X-(1+r)D to the
firm’s equity holders, in total a cash flow of X
also
• The value of L is the combined value of the debt
and the equity

122. MM cont…
• Suppose VL is smaller than VU
• Then an investor can buy a 10% holding of L’s debt and
a 10% holding of L’s equity, which entitles the investor to
a 10% share in the total cash flow X. He would then go
to the market and sell 10% of the cash flow X, which is
valued at 10% of the value of U. This leaves him with
zero future liability.
• His trading gains are 10% of the difference between VU
and VL, which we have assumed is positive
• This cannot be possible in an arbitrage free market, so
we can conclude that VL must be equal to or greater than
VU

123. MM cont…
• Now suppose VU is smaller than VL
• An investor buys 10% of the cash flow X and sells 10%
of a claim that promises the cash flow (1+r)D. The net
cash flow is 10% of a claim that pays X-(1+r)D at
maturity, which is priced at 10% of the equity in L
• The net future liability is zero, and the trading gains
equal 10% of the difference between VL and VU, which
we have assumed positive
• Again, this is not consistent with arbitrage free markets
• In conclusion, it must be the case that VU = VL and that
capital structure is irrelevant

124. What about risky debt?
• When the corporate debt contract is risky it may
be difficult to find a “synthetic” corporate debt
contract if a real one does not exist
• We must assume, therefore, that the markets
are sufficiently complete in order to conclude
that financing does not matter
• Complete market = a market where the
dimensionality of the asset structure equals the
dimensionality of the uncertainty structure
• If there are two states of nature (e.g. “good” and
“bad”) then it suffices with two distinct assets to
make the market complete

125. Bankruptcy costs
• The Modigliani-Miller theorem also assumes that
there are no deadweight costs of bankruptcy
• The debt holders may not get all their money
back if the firm defaults, but this is not in itself
enough to jeopardise the MM-theorem
• There must also be deadweight costs or
liquidation costs (i.e. the value of the assets in
default is less than the value of the assets as a
going concern)

126. Taxes: Another important factor
• The tax system is generally fairly complex
with different tax rates for different
individuals and institutions, and for
different types of income
• Therefore, it may be scope for “tax
arbitrage” profits in financing

127. After tax cash flow analysis
• A constant after tax discount rate r
• Tax rate for personal income from debt tD
• Tax rate for personal income from equity tE
• Corporate tax rate tC
• Earnings before taxes and interest payments X
• Earnings before taxes (X – kD) (k coupon rate, D
nominal amount borrowed)
• After tax personal income from debt kD(1-tD)
• After tax earnings (X-kD)(1-tC)
• After tax personal income from equity (X-kD)(1-tC)(1-tE)

128. Algebra
benefits
tax
discounted
firm
unlevered
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(
1
1
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(
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129. Equilibrium
• If there is a positive discounted tax benefit firms
choose to borrow more, and investors with
higher personal tax rate on debt income is
encouraged to enter the market. This implies a
reduction of tax benefits of borrowing.
• Reverse effect is there is a negative discounted
tax benefit of borrowing
• In equilibrium, we expect the tax benefit from
borrowing to be equal to zero
• This is the so-called “Miller’s equilibrium”
described in Appendix 14A in the textbook

130. Preferred stock
• Preferred stock: dividends on preferred stock are
not tax deductible at the corporate level as are
interest payments on debt
• This implies that corporate junior debt may be
tax efficient relative to preferred stock
• However, the US tax code allows a 70% tax
exclusion for preferred dividends paid to
corporate holders, so the yield on preferred
stock is often lower (before tax) than on junior
debt even though the debt has seniority over the
preferred stock

131. Investor conflicts?
• Tax exempt equity holders prefer in general to reduce
the borrowing of the firm so as to transfer income from
debt repayments to dividend payments
• High-tax bracket investor prefer the opposite
• Often tax-exempt municipal bonds (or similar
investments) offer yields that are greater than the after
tax yield on corporate bonds for high-tax bracket
investors
• Thus, the firm can give these investors an advantage by
increasing the firm’s borrowing, as this frees capital that
the investors can use to invest in tax-exempt municipal
bonds

132. Inflation
• We expect to see a one-to-one relationship
between inflation and nominal interest rates - if
inflation increases by one percentage point then
so do nominal interest rates
• Higher inflation, therefore, leads to higher
nominal borrowing costs that yield in turn greater
tax deductions
• Therefore, the tax effect has greater bite in
periods of high inflation

133. Empirical evidence
• Do firms with greater taxable earnings borrow more?
– No, but this may be because firms in general rarely issue equity
– Firms that perform poorly, therefore, tend to accumulate debt to
meet their investments
• Tax code changes that affect the relative tax benefit of
borrowing should have an impact on corporate financing
– Yes, US tax reform of 1986 which reduced the tax benefits of
other things than debt (such as depreciation rules and
investment tax credits) gave rise to an increase in borrowing
among firms most affected
– The firms less affected did not increase their borrowing to the
same extent
• Taxes matter but don’t explain everything

134. Readings
• Grinblatt/Titman chapter 14, including the
appendix
• 14.10 Are There Tax Advantages to
Leasing not so relevant

135. Exercises
1. A firm has assets valued at 100, and debt valued at 50.
It plans to restructure its liability side by increasing its
borrowing to 70 and paying a dividend of 20 to its
shareholders. The debt has zero beta before and
0.001 beta after the recapitalization. The beta of the
equity is 2 before the recapitalization.
a) What are the values of the equity before and after the
recapitalization?
b) What is the beta of the assets of the firm?
c) What is the beta of the equity after recapitalization?
d) The recapitalization has increased the beta of the debt (and
therefore the cost of debt capital). Has it also increased the
beta of the equity? Does this mean that the total cost of
financing has increased? Explain.

136. Week 8: Taxes and Dividends
• In frictionless markets dividends don’t
matter
• Why do firms nonetheless pay dividends?
• Taxes and dividends
• Stock returns and dividend yields – what is
the connection?
• Investment distortions caused by taxes in
dividends

137. Cash flow to shareholders
• Shareholders earn money through holding equity that
earns a cash flow (such as dividends) and capital gains
(which can be realized through selling stock)
• The cash distribution to shareholders is normally
discretional – the company can decide how much cash
flow to give their shareholders
• Cash distribution comes in two forms – dividend
payments and share repurchase schemes
• Dividend payments do not affect the number of shares
but will reduce the value of each share
• Share repurchases do normally not affect the value of
each share but will reduce the number of shares
outstanding

138. How much of earnings is cash flow
to shareholders?
• Dividend payout ratio: the ratio of dividends to
earnings
• In the US, this ratio has declined from about
22% in 1980 to about 14% in 1998
• Over the same period, the ratio of share
repurchases to earnings increased from 3% to
about 14%
• The total ratio of cash flow to earnings has been
relatively stable at about 25% of earnings

139. Dividend yields
• Dividend yield is the ratio of dividends per
share over price per share
• Typical pattern is that high-tech growth
firms have low dividend yield and dividend
payout ratios (Microsoft paid its very first
dividend this year)
• Stable, old economy companies such as
mining, oil and manufacturing pay about
half their earnings as dividends

140. What is the optimal dividend payout
ratio?
• Assumption: frictionless economy (no
transaction costs, taxes, or other frictions)
• Investment policy unaffected by dividend
payments
• Modigliani-Miller Dividend Irrelevance
Theorem:
– The choice between paying dividends and
repurchasing shares is a matter of
indifference to shareholders

141. Modigliani-Miller Irrelevance
• Consider two identical equity financed
firms, the only difference is dividend policy
• Firm 1 pays 10m as dividends
• Firm 2 repurchases stock worth 10m
• After the end of the year, the firms are
worth X
• In the beginning each firm has 1m shares
outstanding

142. MM cont…
• Each share eventually sells for X divided by the number of shares
• Firm 2 buys back 10m worth of stock
• If share price is p, and firm 2 buys back n shares, we know that
pn=10m
• We also know that p=X/(1m-n)
• Suppose X = 150m
• Solving both equations gives us n = (10m1m)/(X+10m), so we get n
= 62,500, and p = 150m/(1m-62,500) = 160
• Firm 1: stock price is p = 150m/1m = 150, but each stock gives a
dividend worth 10m/1m = 10, so the total value of each stock is
150+10 = 160
• Since shareholders get the same cash flow eventually, the shares
must sell at the same price initially, i.e. dividend policy does not
matter

143. Taxes and cash distribution to
shareholders
• Classical tax system
– Dividends taxed as ordinary income and capital gains at a lower
rate than ordinary income
– Dividends are not tax deductible at corporate level, so dividends
are also subject to corporate taxation
• Imputation system
– Dividends are taxed as ordinary income but investors get a
partial tax credit for corporate taxes (to offset personal taxes)
– Dividends are not tax deductible at corporate level
• Systems that eliminate double taxation
– Dividends are tax deductible at corporate level and taxed as
ordinary income at investor level

144. Classical tax system
• The classical tax system implies a tax
disadvantage of dividend payments
• Dividend $100, 35% tax implies an immediate
tax liability of $35
• Share repurchase scheme: an investor sells
$100 worth of shares. Suppose original cost was
$76. This implies a taxable capital gain of $24.
Taxed at 20%, this implies an immediate tax
liability of $4.8
• Share repurchase scheme much cheaper than
paying dividends

145. Tax avoidance schemes
• In theory, investors can often invest in a scheme
that gives an immediate tax relief against a
deferred future tax liability
• In practice, investors do not take advantage of
these schemes but instead choose to pay taxes
(or are unable to invest in tax avoidance
schemes) on the received dividends
• The question is, therefore, why corporations
continue to pay dividends when they are so tax
inefficient

146. Dividend clienteles
• Some investors do not pay taxes
• These investors will, everything else being
equal, prefer high dividend yield firms to low
dividend yield firms as they do not pay tax on the
dividend
• Firms might adopt different dividend policies to
attract different investor clienteles
• Empirical evidence suggests that investors’
portfolios have dividend yields that are related to
their tax status (high tax bracket investors
choose low dividend yield stocks and vice versa)

147. Dividend payments and stock
returns
• Do stocks with high dividend yield compensate
investors for the tax disadvantage?
• Higher returns should then lead to lower values,
reflecting the higher discount rates applied to
future cash flows
• Research has focused on two returns effects
– Ex-dividend day behaviour of stock prices
– Whether cross-sectional dividend yield differences
affect expected returns

148. Ex-dividend day price drop
• If you buy the stock on the day before the ex-dividend day, you are
entitled to the future value of the stock and the current dividend
payment
• If you buy the stock on the ex-dividend day, you are entitled only to
the future value of the stock
• The stock price should, therefore, drop on the ex-dividend day to
reflect the dividend payment
• Empirical results from the 1960s indicate that the ex-dividend day
price drop is about 77.7% of the dividend payment on average, but
was higher (90%) for dividend payments greater than 5% of the
stock price, and lower (50%) for the smallest dividends.
• These results indicate a tax effect (investors discount a tax rate of
around 22.3% on dividends), and a clientele effect (investors with
different tax rates hold portfolios with different dividend yields)

149. Ex-dividend day cont…
• Transaction cost argument
– Consider buying a stock at $20 before the ex-div day, receive a $1
dividend, then sell the stock for $19.20. This yields $1 taxable profits
and $(20-19.20) = $0.80 tax deductible losses. The net profit is $0.20
less taxes, but it is still arbitrage profits. The stock needs to drop by the
full amount to preclude arbitrage profits.
– If there is a $0.10 per share transaction cost, the investor receives
taxable profits of $1 in dividends, and incur $0.80 in tax deductible
losses. The net profit is $0.20, but the investor must also pay $0.10 in
transaction costs, so the net profit is only $0.10 less taxes. If the stock
drops to $19.10, therefore, there are no arbitrage profits to be made.
– If the dividend payment is only $0.40, the necessary price drop is $0.30
to prevent arbitrage profits. That is, the price drop is greater for high
dividend yielding stocks in percentage terms (as the clientele effect
predicts).
• Price drop less than the dividend payment is also observed in
countries that do not have a classical tax system, suggesting this is
not a tax driven phenomenon at all

150. Cross-sectional relation between
dividend yield and stock returns
• If dividends are more heavily taxed than capital
gains, the expected return must be greater for
high dividend yield stocks.
• Empirically, stocks with high dividend yields
have higher returns, but the relationship is not
straightforward
• The relationship is U-shaped, with zero dividend
yield stocks have higher expected return than
stocks with low dividend yield, but for stocks
paying dividends, the expected return increases
with the dividend yield

151. How dividend taxes affect financing
and investment decisions
• Marginal tax rate of 50%
• Company has a choice between paying $1m in dividends or retain
the earnings
• Retained earnings yield 6% after corporate taxes (alternative II)
• Dividends yield 7% before personal taxes in corporate bonds
(alternative I)
• Alternative I yields $500,000 to invest at 7%, which after tax yields
$17,500 per year
• Alternative II yields $60,000 in extra dividend payments per year,
which yields $30,000 after tax to the investor
• If you are a zero tax payer, however, alternative I yields $1,000,000
to invest at 7%, which equals $70,000, and alternative II only
$60,000 in additional dividends per year.
• Investors with different tax rates are likely to disagree with regard to
the dividend policy the firm should pursue

152. The general principle
• Investors prefer retained earnings if (1-corporate
tax rate) x (pretax return internally at corporate
level) > (after tax return at investor level)
• This has implications for investment policy as
well
– Tax-exempt and tax-paying investors agree on
externally funded projects but may disagree on
internally funded ones (tax exempt investors require
higher return on internal investment than tax-paying
investors)

153. Readings
• Grinblatt/Titman chapter 15

154. Exercises
1. A stock trades at 100p per share (prior to ex-dividend
day) and the firm will pay a dividend of 10p per share.
a) Work out the ex-dividend day price if investors pay 40% tax on
dividends and the ex-dividend day price equals the initial price
less after-tax dividend payment
b) Work out the minimum transaction cost per share that
prevents tax-arbitrage by a tax-paying investor
c) Suppose the dividend payment was 50p per share. What is
your answer to a) and b) now?
d) Suppose the actual transaction cost is 2p per share. What are
the arbitrage free price drops in a) and c) above now?
e) What are the “implied” tax rates on dividends in d)?

155. Week 9: Managerial Incentives and
Corporate Finance
• Manager – shareholder conflicts
– Occidental Petroleum and founder/CEO
Armand Hammer case in the textbook
– Maxwell Communications and Robert Maxwell
• How such conflicts affect investment,
financing, and ownership structure
• How such conflicts can be mitigated by
executive compensation schemes

156. Separation of ownership and
control
• The separation of ownership and control is beneficial in
terms of diversification and optimal investment while
keeping a stable management team in control of the firm
• But it can be harmful if the management team is more
interested in pursuing their own interest as opposed to
their shareholders’ interests
• In what way do their interests differ?
– Managers represent investors, customers, suppliers, and
employees – not just investors
– Managers get utility from non-financial benefits such as status,
perks, job-security etc and are willing to spend corporate
resources on these even though they are likely to be negative
NPV projects

157. Factors that determine the
manager-shareholder conflict
• Proportions of stock owned by the manager
• Managerial entrenchment and lack of means to
control managers
– Diffuse ownership structure (no individual manager
benefits enough to take action)
– Proxy fights (shareholder revolt at general meeting)
are very expensive and difficult to organize
• Bonus schemes not performance sensitive
enough
• Changes in corporate governance have made
managers more accountable in recent years

158. Ownership structure
• Ownership structure is on the whole more concentrated than we would
expect (CAPM advocates diversification), particularly outside the US/UK
• Ownership concentration a response to weak legal protection of
shareholders’ interests
• UK/US have the strongest protection and the most diffuse ownership
structure
• Managers tend to keep a significant ownership stake in firms where the
incentive conflict with the shareholders is the greatest
• In many internet IPOs, the managers kept a large share of their holding in
order to get a higher price in the IPO (lock in clauses)
• Eg. Lastminute.com – Martha Lane-Fox and Brent Hoberman (founders –
Hoberman still manager) were still large owners after IPO and were
prevented from selling their share for a given time period after the IPO
• Firms with higher concentration of management ownership have higher
market values relative to their book values, provided management share is
not too big. If it gets above 5%, managers become “entrenched” which
allows them to pursue own interests more

159. How managers distort investment
decisions
• Managers prefer investments that fit the manager’s
expertise
– Makes him (her) more indispensable
• Investments in visible/fun industries
– Raising the manager’s external profile (and his potential future
job opportunities and wages)
• Investments that pay off early
– Financial success in the short run can increase bonus, reduce
the risk of losing job, increase the possibility of raising more
capital
• Investments that reduce risk and increase the scope of
the firm
– To avoid bankruptcy the manager seeks relatively safe
investments and may take a portfolio approach to investments

160. Capital structure and managerial
control
• Managers are likely to prefer equity to debt because they
are interested in minimizing the probability of default
• Shareholders may, therefore, prefer debt financing as
debt is a good way to discipline managers (the fear of
losing job is a good motivator)
• Empirical investigations show there is a positive
relationship between leverage and
– Percentage of executive pay tied to performance
– Percentage of equity owned by managers
– Percentage of investment bankers on the board of directors
– Percentage of equity owned by large individual investors
• Debt is a good way to curb overinvestment
• Debt engages often a bank who is a good monitor of
management

161. Executive compensation
• The problem of incentivizing managers is often called a
principal-agent problem
– Tenant farmer works the land of a land-owner. If compensated
too much in terms of output, the tenant farmer must bear all the
risk influencing output (weather etc). If compensated too little in
terms of output, the tenant farmer doesn’t put in the required
effort.
– Compensation is a matter of balancing the two concerns: Called
the problem of designing the optimal incentive contract
– Effort (input) cannot be observed, otherwise compensation could
be tied to effort instead of output
– Design objective is to minimize the agency costs of delegated
control

162. Performance based executive
compensation
• Jensen and Murphy (1990) found that a $1000 increase in firm value is
associated with a $3 increase in CEO bonus (a $10m jet costs the CEO
$30,000 just in lost bonus payments)
• Some disagreement about this result, as it may have underestimated the
real sensitivity by ignoring longer term impact on bonus payments
• Substantial differences in pay-for-performance sensitivity across firms
– Some explained by the agency costs of delegated control
– Some explained by the risk of the firm
• Over time, the pay-for-performance sensitivity has been increasing
• Adoption of performance-based pay is generally a positive signal to the
investors
• What about relative performance sensitivity (pay linked to the position of the
company relative to the average for the industry)? Relative performance-
pay is rarely observed, but can be costly to investors in terms of price wars
and overly aggressive competition.
• Stock-based performance versus earnings-based performance. Stock
based performance is much noisier than earnings-based performance, but
in return earnings can be manipulated by the manager

163. Mergers, Spin-offs, Carve Outs
• It may be easier to design an optimal compensation contract for a
small, single-unit, firm than for a multi-divisional conglomerate
• Solution may be a spin-off (a division set up as an independent firm
by distributing shares in the new firm to the existing investors) or a
carve-out (do an IPO of the division and sell to new investors)
• Spin-offs and carve-outs are positive signals
• Mergers create the opposite effect, and in particular conglomerate
mergers can be seen as a negative signal to investors as they affect
managerial incentives negatively (conglomerate mergers are
relatively rare now but were popular in the 1960s and 70s)
• Many spin-offs and carve-outs are reversing prior conglomerate
mergers

164. Readings
• Grinblatt/Titman chapter 18

165. Exercises
1. The manager of a firm considers investing £1m
of free cash flow (earnings currently held in a
bank account) in a project that has private
value £10,000 to the manager but NPV of -
£200,000 to the investors. What is the optimal
decision for the manager if
a) He has fixed pay?
b) He has in addition a bonus scheme where an
increase of £1000 in the stock value leads to an
increase of £10 to the manager?
c) What is the optimal bonus scheme for the manager
in this case?

166. Week 10: Information and Financial
Decisions
• Key premise: managers have better information
than investors
• What managers do, therefore, conveys
information to the market
• Managers can
– Distort accounts to manipulate the information flow
– Reveal information through dividend policy, capital
structure choice, and investment decisions
• Empirical evidence: how stock prices react to
various financial decisions

167. What can better informed
individuals do?
• Signals: they act in a way that conveys their information
– Difference between “cheap talk” and “credible action”
– Signals need to be costly
• Pooling: they act in a way that everybody else act in
order not to reveal information
– It is too expensive to send a signal
• Manipulation
– Actions: Investors overestimate the true cost of signalling
– Reporting: “Bad” reports attract attention – it may be easier to
disguise bad outcomes by submitting an “average” report

168. Distortions to managerial incentives
• Managers seek to maximize the share price
• The share price may, however, deviate from the “intrinsic
value” (the full information price)
• Long term investors prefer that managers maximize the
intrinsic value (which eventually transpires)
• Short term investors prefer that managers maximize the
current share price (which may be distorted due to lack
of information)
• The conflict is, therefore, essentially one of short-
termism versus long-termism

169. Why do managers care about the
current share price?
• New issues or the managers may plan to
sell private stock
• Low prices attract bidders in takeovers
• Managerial compensation directly linked to
stock price
• Customers or employees may flee the
company if the stock price goes too low

170. Earnings manipulation
• The same underlying profits can be reported in different
ways as earnings
– Depends on the choice of depreciation method
– Choice of inventory valuation method (FIFO LIFO)
– The estimates of the economic value of assets, the estimates of
the cost of guarantees or warranties issued, the estimates of the
pension liability of the firm, the discount rates used for valuation
of leases and pensions etc.
• There is a tendency to inflate reported earnings to
increase the current stock price
• But managers may also find it useful sometimes to
deflate reported earnings
– For instance when the manager has just been hired
– When applying for government subsidies or tariff protection
against foreign competitors

171. Short-termism in investment
• Bias towards short term projects because these makes it clear very
quickly whether the investment is a good one
• Example:
– Project A: yr 1 cash flow 40; yr 2-11 cash flow 80 per year; PV 840
– Project B: yr 1 cash flow 60; yr 2-11 cash flow 50 per year; PV 560
– Project C: yr 1 cash flow 40; yr 2-11 cash flow 40; PV 440
• Investors think C is much more realistic than A or B
• If company chooses A, the stock price is close to 440 after yr 1
earnings are revealed, why?
• If company chooses B, the stock price is close to 560 after yr 1
earnings are revealed, why?
• Company has a disincentive to choose the best project which is A
because it is too similar to C in the first year
• If managers seek to maximize the intrinsic value they should choose
A regardless

172. Dividends and Stock Repurchases:
Announcement Effects
• An announcement of a dividend increase normally
increases the stock price by about 2%
• If a company announces it is to cut its dividend
completely, the stock price decreases by about 9.5%
• Is paying dividends therefore a good decision?
– Dividends may be a costly signal conveying information that is
hidden from investors
– Paying dividends is, in effect, a cost to the shareholders to
ensure that current information is reflected in current prices
– The alternative: long term savings in signalling costs against the
cost of deviations between the current stock price and the
intrinsic value of equity

173. Dividends and Investment
Opportunities
• News may be
– Increased cash flow
– Increase in investment opportunities
• An increase in dividends signals increased cash flow (as
dividends then are more affordable) but is not consistent
with an increase in investment opportunities (as they are
then needed for investments)
• An increase/cut in dividends is, therefore, a more
complex signal than is suggested in previous slides
• Empirical evidence suggests that cuts are viewed more
favourably when the firms experience an increase in
investment opportunities

174. Capital Structure and Information
• Borrowing can also be thought of as a
costly signal:
– If mangers are convinced that future cash flow
is high then the most credible way of
communicating this information is to borrow
– If the manager is “lying”, the firm is going to
default on its debt liability and the manager
will be out of a job
• Firms with poor prospects find it hard to
“mimic” the same borrowing decisions

175. Empirical Evidence
• Event study methodology
• Leverage increasing transactions (debt-for-equity swaps)
have positive stock price response
• Leverage neutral transactions (debt-for-debt) have zero
response
• Leverage decreasings (equity-for-debt) have negative
stock price response
• Security sales (equity, debt) have negative stock price
response, and more so for equity than for debt
• Empirical evidence is consistent with information
theories (this week) but is also consistent with incentive
theories (last week)

176. Adverse Selection
• Sick people tend to see health/life insurance as cheap –
consequently they will be over-represented in the group
of buyers of this type of insurance
• Example: very expensive insurance that covers 100% of
all costs – or – cheap insurance that covers only 80% of
all costs
– In this case the sick people might migrate to the expensive type
of insurance and the healthy ones to the cheap type
• This is called adverse selection – buyers or sellers do
not always select themselves randomly but rather
according to their “type”
• This also plays a role in the sale of corporate securities

177. Managers have inside knowledge
and at the same time sell or buy
corporate securities
• Corporation can be expected to sell equity when
the stock is overvalued and buy back equity
when the stock is undervalued
• This makes sell transactions a bad signal and
buy transactions a good signal
• This makes equity a bad source of capital for
new investment, since it must be sold at a
discount to the current stock price (why?)
• Pecking-order theory: firms prefer retained
earnings to external capital, and external debt to
external equity, when financing investments

178. Readings
• Grinblatt/Titman chapter 19

179. Exercise
• A firm has already made an investment and is considering an
additional investment opportunity
– State of nature is good or bad, equal probabilities. Assume risk neutral
valuation with zero discount rates. Manager knows the true state of
nature
– Current investment has value 150 (good) or 50 (bad)
– NPV investment opportunity is 20 (good) or 10 (bad)
– Currently the firm is financed by equity only
– It plans to issue equity to finance the new investment, which costs 100
– To do:
• Set up the balance sheet before and after investment @ expected values
• Work out how much of the existing equity the firm needs to sell in order to
finance the investment
• Compare the value of the existing (old) equity with investment and without
investment in the good and the bad state
• If the manager acts in the interests of the existing shareholders, should he
always go ahead with investment. Explain.