Corporate Financial Policy Introduction Professor André Farber Solvay Business School 2003-2004 30/11/2018 Cofipo 2003-2004 Introduction

Today in the Financial Times (Feb 04, 2004) Grandvision board backs €600m offer The French optician group looks set to go private TRW shares fall on market debut TRW opened at $27.35 below its $28 offering price. Shoppers buy Peretkriostok IPO chance Russia’s second-largest retailer prepares itself to float in London ICBC offering to pay for HK unit purchase Industrial & Commercial Bank of China placed new shares worth $180m to fund the purchase of the HK business of Fortis UK PFI raises £680m for new army garrison A private finance initiative joint venture launched bonds maturing in 2038. S&P assigned a Triple A to the issue. 30/11/2018 Cofipo 2003-2004 Introduction

PSA Peugeot Citroën Price guidance for the bulk of French vehicle maker PSA Peugeot Citroën’s €1bn bond indicated a spread of 17 bp above Euribor. The main tranche accounts for €970m of the bonds, which are all secured on German car loans originated by Peugeot’s financing unit. ABN Amro and Deutsche Bank are joint leads for the asset-backed security sale through special purpose vehicle Auto ABS. The main tranche will have a 4.5-year weighted average life and a coupon about 17 basis points above three-month Euribor. It is Triple A by Moody’s and Standard & Poor’s. The remaining €30m will have an average life of 1.8 years and carry a coupon in the low forties over the same benchmark. It is rated A2 by Moody’s and A by S&P. 30/11/2018 Cofipo 2003-2004 Introduction

Bankers in ranking razzmatazz Jockeying for investment bank league table position has become more important N° issues Proceeds $bn Mkt share % Goldman Sachs 178 46.2 11.8 Citigroup 219 41.1 10.5 Morgan Stanley 156 39.6 10.1 JP Morgan 141 33.0 8.5 UBS 163 28.8 7.4 Deutsche Bank 115 22.2 5.7 CSFB 130 21.7 5.6 Lehman Brothers 87 14.5 3.7 Nomura 111 12.1 3.1 Source: Thomson Financial as reported in the FT 04-02-2004 30/11/2018 Cofipo 2003-2004 Introduction

Course outline 1. Financing in perfect capital markets 2. Initial public offering/Seasoned equity issue 3. Dividend policy 4. Optimal capital structure 5. Financing and valuation 6. Modeling risky debt (Merton/Leland) 7. Capital structure: empirical evidence 8. Convertible bonds, warrants 9. Debt structure/Leasing 30/11/2018 Cofipo 2003-2004 Introduction

Practice of corporate finance: evidence from the field Graham & Harvey (2001) : survey of 392 CFOs about cost of capital, capital budgeting, capital structure. « ..executives use the mainline techniques that business schools have taught for years, NPV and CAPM to value projects and to estimate the cost of equity. Interestingly, financial executives are much less likely to follows the academically proscribed factor and theories when determining capital structure » Are theories valid? Are CFOs ignorant? Are business schools better at teaching capital budgeting and the cost of capital than at teaching capital structure? Graham and Harvey Journal of Financial Economics 60 (2001) 187-243 30/11/2018 Cofipo 2003-2004 Introduction

Finance 101 – A review Objective: Value creation – increase market value of company Net Present Value (NPV): a measure of the change in the market value of the company NPV = V Market Value of Company = present value of future free cash flows Free Cash Flow = CF from operation + CF from investment CFop = Net Income + Depreciation - Working Capital Requirement 30/11/2018 Cofipo 2003-2004 Introduction

The message from CFOs: Capital budgeting 30/11/2018 Cofipo 2003-2004 Introduction

Cost of Capital - All equity firm An opportunity cost Expected return that can be expected on a stock with same risk Capital Asset Pricing Model (CAPM) Risk-free rate Systematic risk Market risk premium 30/11/2018 Cofipo 2003-2004 Introduction

CAPM- Security market line Expected return r rM rf 1 Beta 30/11/2018 Cofipo 2003-2004 Introduction

From Markowitz to CAPM Expected Return Expected Return P 20% P M 14% 8% 8% 2 Sigma 1 Beta 30/11/2018 Cofipo 2003-2004 Introduction

The message from CFOs : cost of equity 30/11/2018 Cofipo 2003-2004 Introduction

Cost of capital with debt Up to now, the analysis has proceeded based on the assumption that investment decisions are independent of financing decisions. Does the value of a company change the cost of capital change if leverage changes ? 30/11/2018 Cofipo 2003-2004 Introduction

An example CAPM holds – Risk-free rate = 5%, Market risk premium = 6% Consider an all-equity firm: Market value V 100 Beta 1 Cost of capital 11% (=5% + 6% * 1) Now consider borrowing 20 to buy back shares. Why such a move? Debt is cheaper than equity Replacing equity with debt should reduce the average cost of financing What will be the final impact On the value of the company? (Equity + Debt)? On the weighted average cost of capital (WACC)? 30/11/2018 Cofipo 2003-2004 Introduction

Weighted Average Cost of Capital An average of: The cost of equity requity The cost of debt rdebt Weighted by their relative market values (E/V and D/V) Note: V = E + D 30/11/2018 Cofipo 2003-2004 Introduction

Modigliani Miller (1958) Assume perfect capital markets: not taxes, no transaction costs Proposition I: The market value of any firm is independent of its capital structure: V = E+D = VU Proposition II: The weighted average cost of capital is independent of its capital structure rwacc = rA rA is the cost of capital of an all equity firm 30/11/2018 Cofipo 2003-2004 Introduction

An aside: CAPM – an other formulation Consider a future uncertain cash flow C to be received in 1 year. PV calculation based on CAPM: with: See Brealey and Myers Chap 9 30/11/2018 Cofipo 2003-2004 Introduction

MM 58: Proof using CAPM 1-period company C = future cash flow, a random variable Unlevered company: Levered (assume riskless debt): So: E + D = VU =VU 30/11/2018 Cofipo 2003-2004 Introduction

MM 58: Proof (II) If levered (assuming riskless debt): But: Div = C - (1+rf) D So: =VU 30/11/2018 Cofipo 2003-2004 Introduction

Using MM 58 Value of company: V = 100 Initial Final Equity 100 80 Debt 0 20 Total 100 100 MM I WACC = rA 11% 11% MM II Cost of debt - 5% (assuming risk-free debt) D/V 0 0.20 Cost of equity 11% 12.50% (to obtain rwacc = 11%) E/V 100% 80% 30/11/2018 Cofipo 2003-2004 Introduction

Why is rwacc unchanged? Consider someone owning a portfolio of all firm’s securities (debt and equity) with Xequity = E/V (80% in example ) and Xdebt = D/V (20%) Expected return on portfolio = requity * Xequity + rdebt * Xdebt This is equal to the WACC (see definition): rportoflio = rwacc But she/he would, in fact, own a fraction of the company. The expected return would be equal to the expected return of the unlevered (all equity) firm rportoflio = rA The weighted average cost of capital is thus equal to the cost of capital of an all equity firm rwacc = rA 30/11/2018 Cofipo 2003-2004 Introduction

Why are MM I and MM II related? Assumption: perpetuities (to simplify the presentation) For a levered companies, earnings before interest and taxes will be split between interest payments and dividends payments EBIT = Int + Div Market value of equity: present value of future dividends discounted at the cost of equity E = Div / requity Market value of debt: present value of future interest discounted at the cost of debt D = Int / rdebt 30/11/2018 Cofipo 2003-2004 Introduction

Relationship between the value of company and WACC From the definition of the WACC: rwacc * V = requity * E + rdebt * D As requity * E = Div and rdebt * D = Int rwacc * V = EBIT V = EBIT / rwacc Market value of levered firm EBIT is independent of leverage If value of company varies with leverage, so does WACC in opposite direction 30/11/2018 Cofipo 2003-2004 Introduction

MM II: another presentation The equality rwacc = rA can be written as: Expected return on equity is an increasing function of leverage: requity 12.5% Additional cost due to leverage 11% rA rwacc 5% rdebt D/E 0.25 30/11/2018 Cofipo 2003-2004 Introduction

Why does requity increases with leverage? Because leverage increases the risk of equity. To see this, back to the portfolio with both debt and equity. Beta of portfolio: portfolio = equity * Xequity + debt * Xdebt But also: portfolio = Asset So: or 30/11/2018 Cofipo 2003-2004 Introduction

Back to example Assume debt is riskless: Beta asset = 1 Beta equity = 1(1+20/80) = 1.25 Cost of equity = 5% + 6%  1.25 = 12.50 30/11/2018 Cofipo 2003-2004 Introduction