Chapter 17: Capital Structure: Limits to Debt
Investors view debt as a signal of firm value:
- If a firm has high level of debt, investors will think that the firm has high anticipated profits.
- If a firm has low level of debt, investors will think that the firm has low anticipated profits.
* The firm’s capital structure optimization: Marginal benefit of debt = Marginal cost of debt.
*Firms with high anticipated profits have lower expected bankruptcy cost; hence want to have more debt.
*If Managers want to fool investors:
- the more valuable firms will want to issue more debt than less valuable firms. The cost of extra debt increases with the amount of debt will prevent less valuable firms from issuing more debt than the more valuable firms.
** The Free Cash Flow Hypothesis says that:
An increase in dividends should benefit the stockholders by reducing the ability of managers to pursue wasteful activities.
An increase in debt will reduce the ability of managers to pursue wasteful activities more effectively than dividend increases.
** The Pecking-order Theory: “the firms prefer to issue debt rather than equity if internal finance is insufficient.” Order of capital for an investment project: Internal funds, following by new debt issue, then new equity issue.
1. If manager believes that equity is overpriced, he wants to issue more equity
2. If manager believes that equity is underpriced, he wants to use alternative source of financing
Result: market sees equity issue as a signal that equity is overpriced, which results in the drop of the share price. Same is true for debt but at a lesser degree
If bonds are overprized (i.e., yield is too low because the market underestimates the true probability of bankruptcy), manager wants to issue debt. This results in downward shift in the belief about the wellbeing of the firm, which leads to the drop of the share price.
Chapter 30: Mergers and Acquisitions
A merger refers to the absorption of one firm by another. The acquiring firm retains its name and identity, and acquires all the assets and liabilities of the acquired firm. After the merger, the acquired firm ceases to exist as a separate entity. Pros: Legally straightforward, and does not cost as much as other forms of acquisitions. Cons: must be approved by vote of shareholders of each firm
A consolidation is the same as a merger except that an entirely new firm is created. In a consolidation, both the acquiring firm and the acquired firm terminate their previous legal existence.
An Acquisition of Stock: A firm can acquire another firm by purchasing target firm’s voting stock in exchange for cash, shares of stock, or other securities. A tender offer: A public offer to buy shares made by one firm directly to the shareholders of another firm.
An Acquisition of Assets: One form can acquire another by buying all of its assets. A formal vote by shareholders is required. Pros: avoids problems of having minority shareholders that may occur in an acquisition of stock. Cons: It involves costly legal process of transferring title.
*Synergy: Sources of Synergy: Revenue Enhancement, Cost Reduction, tax gains, and Capital requirements
∆V = VAB - (VA + VB) . - The synergy can be determined by the discounted cash flow model:
- Value f Firm B to firm A is: VB* = VB + ∆ V
- The NPV from merger for firm A is: NPV = VB* - Cost to Firm A of the acquisition.
Example of merger with common stock:
Since shareholders of firm A gain $100-$80=$20, share price = $20/100=$0.20 from $700/100=$7 per share to $7+$0.20=$7.20 per share. I.e., the after-merge share price will be PAB=$7.20. Since shareholders of firm B must receive $280, we should give them N shares so that N*$7.20=$280, this, N=280/7.20=38.88 shares.
About synergy, a firm will use stocks if synergy is small and cash if synergy is high:
̶ Implication 1: cash offer may signal a high synergy level to the market and lead to increase in the acquirer’s stock price
̶ Implication 2: cash offer may signal a high synergy level to the target firm and lead to increase in price demanded by the target
* Cash vs Common Stock:
̶ Implication 1: using stock as method of payment sends the “bad” signal to the market and results in the drop in the acquirer’s share price.
̶ Implication 2: using stock as method of payment sends the “bad” signal to the target and results in the higher price demanded by the target firm.