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FIN448-Final-Exam-Fall2020-Review - MC
FIN448-Final-Exam-Fall2020-Review - MC
Review for
Final Exam
Final Exam
Tuesday, December 22 or Monday, January 4
Start by clicking “Final Exam” under “Quizzes”
on our course site in Canvas
Open-book and open-notes
Individual effort, collaboration not permitted
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time, turn on webcam video during the exam
BEST OF LUCK!
3. Group Assignments #4 – #6
Practice Problem Sets #6 – #9
Practice Final Exam
“Real” Invested
Investment capital
Valuation Financing
Capital Return to
raising investors
Financing’s key differences from Valuation:
Sources of value relevance less clear
No easy formula for optimal policies
𝑊𝑊𝐶𝐶1
Perpetuity Constant cash flows forever 𝑃𝑃𝑃𝑃𝑃𝑃0 =
𝑟𝑟
𝐷𝐷
Constant cash flows for 𝑛𝑛 𝑊𝑊𝐶𝐶1 1
Annuity 𝑃𝑃𝑃𝑃𝑊𝑊0 = 1−
periods of time 𝑟𝑟 1 + 𝑟𝑟
𝐷𝐷
Growing Cash flows for 𝑛𝑛 periods of time 𝑊𝑊𝐶𝐶1 1 + 𝑔𝑔
𝑃𝑃𝑃𝑃𝑊𝑊0 = 1−
Annuity growing at a constant rate 𝑔𝑔 𝑟𝑟 − 𝑔𝑔 1 + 𝑟𝑟
Financing
Financial • Cash flow uncertainty Low debt ABS debt Low payout
Distress Costs • Nature of assets (e.g., Repurchases
real estate vs. brand)
Asymmetric • Firm reputation Internal funds Short-term debt Low payout to build
Information • Nature of assets (e.g., Debt Private/bank debt internal funds
real estate vs. R&D) Rights offers Private equity Signaling
Manager- • Extent of “free” cash flow High debt Private/bank debt High payout
Shareholder • Corporate governance (e.g., covenants) Dividends
Agency Conflicts • Investor power Private equity
Debtholder- • Value of future growth Low debt Covenants
Equityholder opportunities Convertible debt
Agency Conflicts
Debt Equity
Implies: V = D + E
Intuition:
Tax shields become part of the firm’s (and equityholders’)
cash flows.
If rTS = rU, then adding tax shields does not change the
riskiness of the firm’s overall cash flows.
But, if rTS = rD, then the tax shields are less risky than the
firm’s operating cash flows. This should be reflected in a
lower cost of equity.
Two formulas for rE, depending on your tax-shield discount
rate assumption:
𝐷𝐷
𝑟𝑟𝐸𝐸 = 𝑟𝑟𝑈𝑈 + 𝑟𝑟𝑈𝑈 − 𝑟𝑟𝐷𝐷 Assumes rTS = rU
𝐸𝐸
𝐷𝐷
𝑟𝑟𝐸𝐸 = 𝑟𝑟𝑈𝑈 + 𝑟𝑟𝑈𝑈 − 𝑟𝑟𝐷𝐷 1 − 𝜏𝜏𝑃𝑃 Assumes rTS = rD
𝐸𝐸
Approach 1:
PVTS = VL – VU
𝐷𝐷 𝐸𝐸
Pre-tax WACC = rU = 𝑟𝑟 + 𝑟𝑟
𝐷𝐷+𝐸𝐸 𝐷𝐷 𝐷𝐷+𝐸𝐸 𝐸𝐸
0.5 1
= × 6% + × 10% = 8.67%
0.5+1 0.5+1
𝐷𝐷 𝐸𝐸
After-tax WACC = rL = 𝑟𝑟 1 − 𝜏𝜏𝑐𝑐 + 𝑟𝑟
𝐷𝐷+𝐸𝐸 𝐷𝐷 𝐷𝐷+𝐸𝐸 𝐸𝐸
0.5 1
= × 6% × 1 − 0.35 + × 10% = 7.97%
0.5+1 0.5+1
Approach 2:
Define the effective tax advantage of debt as: The % difference in after-
tax cash flows received by investors when the firm pays $1 of EBIT to
investors as dividends/capital gains relative to interest.
After Corporate Tax After Personal Tax
$1 interest 1 1 − 𝜏𝜏𝐸𝐸
$1 dividend/capital gain 1 − 𝜏𝜏𝑃𝑃 1 − 𝜏𝜏𝑃𝑃 1 − 𝜏𝜏𝑃𝑃
Difference (annual CF benefit
𝜏𝜏𝑃𝑃 1 − 𝜏𝜏𝐸𝐸 − 1 − 𝜏𝜏𝑃𝑃 1 − 𝜏𝜏𝑃𝑃
per dollar of interest)
% difference (effective tax 𝜏𝜏𝑃𝑃 1 − 𝜏𝜏𝐸𝐸 − 1 − 𝜏𝜏𝑃𝑃 1 − 𝜏𝜏𝑃𝑃
advantage) 1 − 𝜏𝜏𝐸𝐸
1 − 𝜏𝜏𝑃𝑃 1 − 𝜏𝜏𝑃𝑃
=1− ≡ 𝜏𝜏 ∗
1 − 𝜏𝜏𝐸𝐸
𝐷𝐷 𝐸𝐸
No change to the WACC formula: 𝑟𝑟𝐿𝐿 = 𝑟𝑟𝐷𝐷 1 − 𝜏𝜏𝑐𝑐 + 𝑟𝑟𝐸𝐸
𝑉𝑉 𝑉𝑉
Recall, debt investors will increase their required 𝑟𝑟𝐷𝐷 to
compensate themselves for the extra tax burden
Book and market value balance sheets before and after the
recapitalization
E: 5,060 E: 5,060
E: 5,060 E: 1,060
Effects of recapitalizations:
Don’t affect total book value, just allocation between debt and equity
Increase total market value by PV of tax shields
Equity stock price should increase by approximately PV of tax shields
divided by shares (based on pre-transaction # of shares)
Definitions:
𝑝𝑝
𝑃𝑃𝑃𝑃 𝐸𝐸 Distress Cost = 𝑐𝑐
𝑝𝑝 + 𝑟𝑟𝑓𝑓
Or, based on Average D/V Ratio: Credit Rating Avg. D/V Debt ($mm)
AAA 0.5% 33
D / VL = D / (VU + D × τ*) = Rating Avg.
AA 8.1% 527
D = Rating Avg. × (VU + D × τ*) A 17.2% 1,118
BBB 27.2% 1,768
BB 43.2% 2,808
B 55.9% 3,634
This cost needs to be weighed against the potential tax benefits of debt
Leverage increases the value of debt interest tax shield but it also increases
financial distress costs.
For low levels of debt, the risk of default is low and the main effect of an increase
in debt is an increase in interest tax shield.
As the level of debt increases, the probability of default increases; consequently,
the costs of financial distress increase, reducing the value of the levered firm.
Both the tax benefit and the distress cost are borne by existing shareholders.
Shareholders would prefer if we balance the two effects.
Ex-ante, this maximizes shareholder value as well as firm value.
Tradeoff theory: Firms should increase their leverage until it reaches the level
for which the firm value is maximized.
At this point, the tax savings that result from increasing leverage are perfectly
offset by the increased probability of incurring the costs of financial distress.
In a given industry, there are good quality firms (“stars”) and bad quality firms
(“duds”).
But insiders probably know more about the firm’s true value than you do.
One of these firms announces they will issue equity. What’s your assessment of
the likelihood this firm is a star/dud?
The star firm may not be willing to issue since they will be forced to sell shares for
less than fair value, which will lead to real dilution. On the other hand, dud firms
will be happy to issue at inflated prices. If this is the case, if I see a firm willing to
issue new equity, it is more likely they are a dud firm.
VDud VStar
Intuition: Suppose the lottery ticket in our earlier example paid off $51 if heads, $49 if tails.
What would happen to the price when the seller announced he was willing to sell?
MONTREAL, June 17 /CNW Telbec/ - Cancor Mines Inc. is pleased to announce that
it will be offering rights to holders of its common shares of record at the close of
business on June 27, 2008 (the "Record Date")… Under the offering, each eligible
shareholder will receive, for each common share held as of the Record Date, one
right evidenced by a fully transferable certificate. Four rights and $0.14 will entitle
the holder to subscribe for one common share of the Company at any time up to
4:00 p.m. on July 31, 2008. A fully subscribed rights offering would raise gross
proceeds of approximately $1,486,680. The proceeds of the offering will be used
for general working capital.
Each shareholder issued an option to buy additional shares at a price below the
current market price ($0.18/share at time of announcement).
One advantage of a bank (or “relationship lender”) over dispersed (or “arms-length”) lenders is their
ability to gather information about the firm before making a loan. Since they will typically make a
larger investment than a smaller investor, they have greater incentives to spend resources gathering
information. And the firm may be more willing to let one bank come in and do their due diligence
rather than disseminating private information to the broader market (where competitors will also see
it). Finally, banks develop expertise in gathering information about firms by specializing in credit
evaluation and may already have information about the firm as a result of their existing relationship.
There is likely to be less uncertainty about a firm’s ability to pay back a loan next year than
over their ability to pay back a loan 10 years from now. In that sense, the price investors
are willing to pay for short-term debt is likely to be less sensitive to asymmetric information
than the price of long-term debt.
Potential solutions:
Issue the least informationally sensitive securities.
Use a rights offer to issue new shares to existing shareholders.
Issue debt to signal you are a strong firm.
Access private sources of capital (i.e., bank debt).
Use short-term debt.
Agency tradeoff:
1. High debt mitigates incentive conflicts between managers and
outside investors
2. But high debt exacerbates conflicts between debt and equity
⇒ Need to think about which types of firms are more/less
exposed to each friction
Agency tradeoff:
1. High debt mitigates incentive conflicts between managers and
outside investors
2. But high debt exacerbates conflicts between debt and equity
⇒ Need to think about which types of firms are more/less
exposed to each friction
ABS debt
May increase debt capacity or lower cost of debt
Equity Equity
Purchase V2010
Price Debt Debt
EBITDA EBITDA
Assumptions about
operating EBIT EBIT
improvements - Interest expense - Interest expense
EBT EBT
2) do not add back after-tax
interest expenses (which - Taxes - Taxes
1) start with Net Income (not NOPAT)
goes to the debtholders
= Net income = Net income
Assume they use all = CF available to pay down debt = CF available to pay down debt
available FCFE to pay
down debt Debt (end of year) Debt (end of year)
evals.wustl.edu