1. Corporate Financial Policy Introduction
Professor André Farber
Solvay Business School
30/11/2018
Cofipo Introduction

2. 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 S&P assigned a Triple A to the issue.
30/11/2018
Cofipo Introduction

3. 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 Introduction

4. 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
30/11/2018
Cofipo Introduction

5. 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 Introduction

6. 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)
30/11/2018
Cofipo Introduction

7. 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 Introduction

8. The message from CFOs: Capital budgeting
30/11/2018
Cofipo Introduction

9. 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 Introduction

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

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

12. The message from CFOs : cost of equity
30/11/2018
Cofipo Introduction

13. 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 Introduction

14. 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 Introduction

15. 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 Introduction

16. 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 Introduction

17. 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 Introduction

18. 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 Introduction

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

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

21. 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 Introduction

22. 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 Introduction

23. 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 Introduction

24. 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 Introduction

25. 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 Introduction

26. 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 Introduction