FINA3070

CORPORATE FINANCE: THEORY AND PRACTICE

DR. ANSON C. K. AU YEUNG

Table of Content
1. Topic 1 – Capital Structure: Modigliani and Miller Theorem ..................................... 9
1.1. Opening Vignette ............................................................................................... 9
1.2. Introduction ...................................................................................................... 11
1.2.1. Measuring Leverage................................................................................. 11
1.3. The Modigliani-Miller Irrelevance of Capital Structure .................................. 12
1.3.1. The Intuition behind the Invariance Result .............................................. 12
1.3.2. MM Proposition I..................................................................................... 13
1.3.3. Homemade Leverage ............................................................................... 15
1.3.4. Proof of MM Proposition I ...................................................................... 16
1.3.5. MM Proposition II ................................................................................... 18
1.3.6. Financial Leverage and Risk .................................................................... 20
1.3.6.1. The Risk Profile of a Firm ....................................................... 22
1.3.6.2. The Effect of Leverage on Beta ............................................... 23
1.3.6.3. The Effect of Leverage on the Cost of Equity ......................... 23
1.3.6.4. The Link between WACC, Beta and Leverage ........................ 24
1.4. Summary .......................................................................................................... 25
1.5. The Road Map Ahead ...................................................................................... 25
1.6. Appendix: Levering and Unlevering Beta ....................................................... 26
2. Topic 2 – Capital Structure: Static Tradeoff Theory .................................................. 28
2.1. The Effect of Corporate Taxes ......................................................................... 28
2.1.1. The Value of Tax Shield ........................................................................... 29
2.1.2. Weighted Average Cost of Capital with Taxes ......................................... 30
2.1.3. Return on Equity with Taxes .................................................................... 31
2.2. Personal Taxes.................................................................................................. 34
2.3. Costs of Financial Distress............................................................................... 36
2.4. Optimal Capital Structure ................................................................................ 36
2.5. Implications from the Static Tradeoff Theory.................................................. 38
3. Topic 3 – Capital Structure: Leverage and Agency Conflicts .................................... 39
3.1. The Debt Overhang Problem ........................................................................... 40
3.2. The Asset Substitution Problem ....................................................................... 43
3.3. The Shortsighted Investment Problem ............................................................. 45
3.4. The Reluctance to Liquidate Problem.............................................................. 48
3.5. Mitigating the Agency Conflicts ...................................................................... 50
3.6. Agency Benefits of Debt .................................................................................. 52
3.7. Agency Conflicts and the Tradeoff Model ....................................................... 53
3.8. Appendix: Convertible Bonds.......................................................................... 53
3.8.1. Features of a Convertible Bond ............................................................... 53

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 3.8.2. Call and Put Features ............................................................................... 55
3.8.3. Convertible Bond Market ........................................................................ 55
3.8.4. Why Firms Issue Convertible Bonds? ..................................................... 56
3.8.5. Advantages and Disadvantages to Issuing Firms and Investors .............. 57
3.8.6. Hong Kong Examples .............................................................................. 58
3.8.6.1. Case #1 ..................................................................................... 58
3.8.6.2. Case #2 ..................................................................................... 59
3.8.6.3. Case #3 ..................................................................................... 59
4. Topic 4 – Capital Structure: Pecking Order Theory .................................................. 60
4.1. Pecking Order Theory ...................................................................................... 60
4.2. An Example ..................................................................................................... 61
4.2.1. Case I – The Project is Financed with Internal Equity ............................ 61
4.2.2. Case II – The Project is Financed with External Equity and the
Informational Environment is Symmetric ............................................................... 62
4.2.3. Case III – The Project is Financed with External Equity and the
Informational Environment is Asymmetric ............................................................. 64
4.2.4. Summary .................................................................................................. 65
4.2.5. Adverse Selection .................................................................................... 65
4.2.6. Case IV – The Project is Financed with Debt .......................................... 67
4.3. Implications of the Pecking Order Theory....................................................... 69
5. Topic 5 – Initial Public Offering ................................................................................... 71
5.1. Part 1 – Deciding to Go Public ........................................................................ 71
5.1.1. Benefits and Burdens of Going Public..................................................... 72
5.1.2. Is the Company Ready for Listing? ......................................................... 72
5.1.3. Why List in Hong Kong? ......................................................................... 73
5.1.4. Expenses of a Hong Kong IPO ................................................................ 74
5.1.5. Overview of the Listing Process .............................................................. 75
5.1.5.1. Pre-listing ................................................................................. 75
5.1.5.2. During the Listing .................................................................... 75
5.1.5.3. Post-listing ............................................................................... 76
5.2. Part 2 – Key Requirements for a Listing in Hong Kong.................................. 76
5.2.1. Regulatory Background ........................................................................... 76
5.2.2. Listing Criteria ......................................................................................... 77
5.2.3. Track Record Requirement ...................................................................... 77
5.2.4. Financial Requirement ............................................................................. 78
5.2.5. Shareholding Requirement....................................................................... 80
5.2.6. GEM Listing Requirement ....................................................................... 80
5.2.6.1. Transfer of Listing from GEM to Main Board ........................ 81

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 5.2.7. Other Salient Features of the Main Board and the GEM Rules ............... 81
5.2.7.1. Appointment of Compliance Adviser / Compliance Officer ... 81
5.2.7.2. Accounting Standard ................................................................ 82
5.2.7.3. Financial Reporting .................................................................. 82
5.3. Part 3 – The Key Parties .................................................................................. 83
5.3.1. Board of Directors and Management ....................................................... 83
5.3.2. Sponsor .................................................................................................... 84
5.3.3. Property Valuers ....................................................................................... 85
5.3.3.1. Methods of Valuation ............................................................... 85
5.3.4. Accountants.............................................................................................. 87
5.3.5. Lawyers .................................................................................................... 87
5.4. Part 4 – Pre-IPO Reorganization...................................................................... 88
5.4.1. Commercial Reasons ............................................................................... 89
5.4.2. Legal Ownership ...................................................................................... 89
5.4.3. Tax Efficient Structure ............................................................................. 90
5.4.4. Personal or Family Reasons ..................................................................... 90
5.4.5. The Planning of Future Restructuring...................................................... 90
5.4.6. Major Steps in Restructuring ................................................................... 91
5.4.6.1. Step 1 – Streamline the Structure............................................. 92
5.4.6.2. Step 2 – Insert a Holding Company ......................................... 93
5.4.6.3. Step 3 – Insert an Appropriate Listing Vehicle ........................ 94
5.4.7. Assets Acquisition and Divestiture: Some Considerations ...................... 94
5.5. Part 5 – The IPO Process ................................................................................. 95
5.5.1. An Overview ............................................................................................ 96
5.5.2. The Early Phase ....................................................................................... 97
5.5.2.1. Due Diligence .......................................................................... 97
5.5.3. The Marketing Phase ............................................................................... 98
5.5.3.1. Sell-side Research .................................................................... 98
5.5.3.2. Valuation .................................................................................. 99
5.5.3.3. Management Roadshow ........................................................... 99
5.5.3.4. Underwriting .......................................................................... 100
5.5.3.5. Pricing and Allocating an IPO ............................................... 101
5.5.3.6. Price Setting Mechanism ....................................................... 102
5.5.3.7. Pricing the Offer .................................................................... 102
5.5.4. Post-listing ............................................................................................. 103
5.5.4.1. How “Greenshoe” Works? ..................................................... 104
5.6. Part 6 – The IPO Performance ....................................................................... 105
5.6.1. Short-run Performance Measure ............................................................ 105

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 5.6.2. Long-run Performance Measure ............................................................ 105
5.6.3. The Issue of Benchmarking ................................................................... 107
5.7. Short-run Underpricing of IPOs..................................................................... 107
5.7.1. Explanations of Underpricing ................................................................ 109
5.7.1.1. Dynamic Information Acquisition ......................................... 109
5.7.1.2. Prospect Theory ..................................................................... 110
5.7.1.3. Corruption .............................................................................. 111
5.7.1.4. The Winner’s Curse ............................................................... 112
5.7.1.5. Informational Cascades .......................................................... 113
5.7.1.6. Lawsuit Avoidance ................................................................. 113
5.7.1.7. Signalling ............................................................................... 114
5.7.1.8. The IPO as a Marketing Event ............................................... 114
5.7.1.9. Conclusions of the Reasons for Underpricing ....................... 115
5.7.2. Long-run Performance ........................................................................... 115
5.7.2.1. Evidence ................................................................................. 115
5.7.2.2. Reasons of Long-run Underperformance............................... 116
5.7.3. Summary ................................................................................................ 117
6. Topic 6 – Seasoned Equity Offering ........................................................................... 118
6.1. Rights Offer ................................................................................................... 118
6.1.1. Setting the Terms of a Rights Offering .................................................. 119
6.1.1.1. Number of Rights Needed to Purchase One New Share........ 120
6.1.1.2. Value of a Right ..................................................................... 121
6.1.1.3. Effects on Position of Shareholders ....................................... 122
6.1.2. Practical Aspects of Rights Issue ........................................................... 123
6.1.2.1. Rights Ratio ........................................................................... 123
6.1.2.2. Issuing Discount..................................................................... 123
6.2. Placing............................................................................................................ 124
6.2.1. Public Placement .................................................................................... 124
6.2.2. Private Placement................................................................................... 124
6.3. Flotation Method Trends Around the World .................................................. 125
6.4. Flotation Costs and Rights Offer Puzzle in the U.S. ...................................... 127
6.4.1. Direct Flotation Costs ............................................................................ 127
6.4.2. Indirect Flotation Costs .......................................................................... 128
6.4.3. Rights Offer Puzzle ................................................................................ 128
6.5. Announcement Effects of SEO ...................................................................... 129
6.5.1. Explanations of Announcement Effects ................................................. 131
6.6. Long Term Underperformance after SEO ...................................................... 132
6.7. Rights Issues and Placings in Hong Kong: A Comparison ............................ 134

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 6.7.1. Number of Placings and Dollar Amount Placed .................................... 134
6.7.2. Issue and Firm Characteristics of Placings ............................................ 135
6.7.3. Announcement Effects of Placings ........................................................ 136
6.7.4. Number of Rights Issues and Dollar Amount Floated ........................... 137
6.7.5. Issue and Firm Characteristics of Rights Issues .................................... 137
6.7.6. Announcement Effects of Rights Issues ................................................ 138
6.7.7. Why Do Firms Choose Value-destroying Rights Offerings? ................. 139
6.7.7.1. The Idea ................................................................................. 139
6.7.7.2. Empirical Implications ........................................................... 140
6.8. Summary ........................................................................................................ 140
7. Topic 7 – Dividend Policy ............................................................................................ 141
7.1. The Miller and Modigliani Dividend Irrelevancy Theorem .......................... 142
7.1.1. Case I – Residual Dividend Policy ........................................................ 142
7.1.2. Case II – Managed Dividend Policy ...................................................... 143
7.1.3. Proof of MM Dividend Irrelevancy Theorem ........................................ 144
7.2. The Tax Effects .............................................................................................. 145
7.2.1. Personal Taxes........................................................................................ 145
7.2.2. Corporate Taxes ..................................................................................... 146
7.2.3. Dividend Clientele ................................................................................. 148
7.2.4. The Ex-Dividend Day Studies ............................................................... 149
7.2.4.1. The Procedure of Cash Dividend ........................................... 149
7.2.4.2. Price Behavior Around the Ex-dividend Day ........................ 150
7.2.5. A Summary on Dividends and Taxes ..................................................... 152
7.3. Asymmetric Information and Dividend Signaling ......................................... 152
7.3.1. Dividend Signaling Example ................................................................. 153
7.3.1.1. The Individual Firm ............................................................... 153
7.3.1.2. The Value of Old Equity ........................................................ 155
7.3.1.3. The Value of New Equity ....................................................... 157
7.3.1.4. The Market ............................................................................. 158
7.3.1.5. Good Firms Versus Bad Firms ............................................... 158
7.3.1.6. Pooling Equilibrium ............................................................... 159
7.3.1.7. Signaling ................................................................................ 160
7.3.1.8. Separating Equilibrium .......................................................... 162
7.4. Incomplete Contract and Agency Models ...................................................... 164
7.4.1. Stockholders Versus Bondholders.......................................................... 164
7.4.2. Management Versus Stockholders ......................................................... 164
7.5. Conclusion ..................................................................................................... 165
7.6. Share Repurchase ........................................................................................... 165

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 7.6.1. Dividends, Repurchases and Total Payout ............................................. 165
7.6.2. Motivations for Share Repurchases ....................................................... 167
7.6.2.1. The Signaling Argument ........................................................ 167
7.6.2.2. Anti-dilution of Employee Stock Options ............................. 167
7.6.2.3. Tax Benefits of Repurchase ................................................... 167
7.6.2.4. A Response to the Threat of Takeover ................................... 167
8. Topic 8 – Valuation I: WACC, APV and FTE Approach.......................................... 168
8.1. WACC Approach ........................................................................................... 168
8.2. APV Approach ............................................................................................... 169
8.3. FTE Approach ................................................................................................ 170
8.4. Example ......................................................................................................... 170
8.4.1. APV Method .......................................................................................... 171
8.4.2. FTE Method ........................................................................................... 172
8.4.3. WACC Method....................................................................................... 173
8.5. Summary ........................................................................................................ 174
9. Topic 9 – Valuation II: Real Options .......................................................................... 176
9.1. Comparing NPV with Real Options .............................................................. 176
9.1.1. Static NPV Approach ............................................................................. 176
9.1.2. Expanded NPV Approach ...................................................................... 177
9.1.3. NPV and Managerial Flexibility ............................................................ 177
9.2. Valuing Real Options ..................................................................................... 178
9.2.1. One-step Binomial Model ...................................................................... 178
9.2.2. A Generalization .................................................................................... 179
9.3. Elements in a Real Option ............................................................................. 181
9.4. Static NPV Analysis ....................................................................................... 181
9.5. The Option to Defer ....................................................................................... 182
9.6. The Option to Expand .................................................................................... 184
9.7. The Option to Contract .................................................................................. 185
9.8. Implications for Capital Budgeting ................................................................ 186
9.9. Appendix ........................................................................................................ 187
10. Topic 10 – Mergers and Acquisitions ................................................................. 188
10.1. Opening Vignette ........................................................................................... 188
10.2. Terminology ................................................................................................... 189
10.2.1. Merger .................................................................................................... 190
10.2.2. Acquisitions ........................................................................................... 190
10.3. Takeovers in Hong Kong ............................................................................... 191
10.3.1. Proxy Fight............................................................................................. 191
10.3.2. General Offer ......................................................................................... 191

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 10.3.2.1. Voluntary Offer ...................................................................... 192
10.3.2.2. Mandatory Offer .................................................................... 192
10.3.3. Scheme of Arrangement ......................................................................... 192
10.3.4. An Illustration ........................................................................................ 193
10.3.4.1. Conditional Offer ................................................................... 193
10.3.4.2. Offer Price .............................................................................. 193
10.3.4.3. Three Possible Outcomes ....................................................... 194
10.4. Motivations for a Takeover ............................................................................ 195
10.4.1. Revenue Enhancement ........................................................................... 195
10.4.1.1. Marketing Gains..................................................................... 196
10.4.1.2. Strategic Benefits ................................................................... 196
10.4.1.3. Market Power ......................................................................... 196
10.4.2. Cost Reduction ....................................................................................... 196
10.4.3. Lower Taxes ........................................................................................... 196
10.4.3.1. Use of Tax Losses .................................................................. 197
10.4.3.2. Use of Unused Debt Capacity ................................................ 197
10.4.3.3. Use of Surplus Funds ............................................................. 197
10.4.4. Lower Capital Requirements ................................................................. 197
10.5. Questionable Motives .................................................................................... 198
10.5.1. Earnings Growth .................................................................................... 198
10.5.2. Diversification........................................................................................ 199
10.6. The NPV of a Deal ......................................................................................... 200
10.6.1. Consideration in Cash ............................................................................ 200
10.6.2. Acquisition Premium ............................................................................. 201
10.6.3. Consideration in Stocks ......................................................................... 202
10.7. Empirical Perspective in M&A ...................................................................... 204
10.7.1. Stock Market Reaction to Merger Announcements ............................... 204
10.7.1.1. Do Acquisitions Benefit Shareholders? ................................. 205
10.7.1.2. Does the Method of Payment Matter? ................................... 206
10.7.1.3. Long-run Performance ........................................................... 207
10.8. Strategic Issues............................................................................................... 207
10.8.1. The Free Rider Problem and a Public Offer .......................................... 208
10.8.2. No Free Rider Problem in Mergers ........................................................ 209
10.9. Takeover Defense ........................................................................................... 210
10.9.1. Defense Mechanisms ............................................................................. 210
10.9.2. Poison Pills............................................................................................. 211
10.9.2.1. A Flip-in Poison Pill Example ............................................... 211
10.9.3. Corporate Charter Amendments ............................................................ 212

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 10.9.3.1. Staggered Boards ................................................................... 212
10.9.3.2. Dual-class Share Recapitalization.......................................... 212
10.9.4. Golden Parachutes ................................................................................. 213
10.9.5. Greenmail, Standstill, and Reverse Greenmail ...................................... 213
10.9.6. White Knights ........................................................................................ 213
10.9.7. Scorched Earth Defense ......................................................................... 213
10.9.8. Defense Measures in Asia ...................................................................... 214

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1. Topic 1 – Capital Structure: Modigliani and Miller Theorem

1.1. Opening Vignette

Ping An Drops Amid Concerns over 160b yuan Share-bond Sale

South China Morning Post
22 January 2008

Shares of Ping An Insurance (Group), the mainland's second-biggest insurer, slumped

yesterday amid concerns about its planned 160 billion yuan share and bond sale - the
mainland's biggest fund-raising deal - to fund acquisitions.

The company's H shares fell 6.33 per cent to close at HK$68.05 in Hong Kong while
its Shanghai-listed A shares dropped their 10 per cent daily limit to 88.39 yuan.

"Ping An has picked a wrong timing for the share placement and bond offering," said
Louis Tse Ming-kwong, a director of VC Brokerage.

"The share placement and bond offering it announced are so big they have shaken
the market.

"Insurance stocks would suffer from the poor investment market as insurers get a
major part of their income from investment returns on premiums collected from
policyholders."

Analysts said investors were also turned off by Ping An's frequent fund-raising activity,
the last one being the 38.87 billion yuan Shanghai listing in February last year, without
showing more major investment plans other than the stake purchase in Fortis Group.

The acquisition of 4.2 per cent of the Belgian-Dutch financial services group for
US$2.7 billion in November last year has been Ping An's only overseas purchase so
far.

"Investors would question what acquisition targets Ping An has on its mind. [It] does
not have much overseas acquisition experience," an analyst at a European bank said.

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With the proposed 160 billion yuan deal and its 80 billion yuan cash on hand, Ping An
would have the financial muscle to snap up many foreign financial giants but might
lack the expertise to handle such deals, brokers said.

Ping An said last Friday it would sell up to 1.2 billion new A shares, or 16.34 per cent
of its issued share capital, and raise as much as 41.2 billion yuan by selling convertible
bonds and warrants. It said proceeds would be used for acquisitions but did not identify
any targets.

Shareholders will vote on the plan at a meeting in March.

Yesterday's closing price of 88.39 yuan represents a 15.35 per cent discount to Ping
An's average share price in the past 20 days.

A Goldman Sachs report yesterday said the deal should be positive, helping the firm
establishes a more comprehensive financial platform. It estimated Ping An's profit
could rise 5 per cent to 14 per cent next year.

But if Ping An could not carry out a merger or acquisition after the offering, its growth
prospect would become uncertain, Goldman said.

Financing decisions go hand in hand with investment decisions. That is, a firm needs
sufficient funds to support its activities resulting from its investment decisions. Capital
structure refers to the sources of financing employed by the firm.

We begin with a brief discussion of Ping An 中國平安 (2318.HK) share-bond sale and focus
on one major aspect of financial management – how capital structure and financing decisions
can contribute to maximizing the value of the firm.

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Specifically, we would like to address the following issues:

1. When Ping An needs funds for investment, how does it raise the funds?

2. Given a level of total capital necessary to support Ping An’s activities, is there a way of
dividing up that capital into debt and equity that maximizes current firm value? And if
so, what are the critical factors in setting the leverage ratio for Ping An?

3. The sources of capital have important consequences for the firm and affect its value and
hence shareholder wealth. What is the impact of share-bond sale on Ping An’s share
price?

Throughout this topic, financial theory will be integrated with the case.

1.2. Introduction

When firms need to raise new funds to undertake their investment, they can raise funds in
several ways:

 Borrow from banks.

 Issue various kinds of debt, preferred stock, warrants, and common equity.

In this topic, we will explore how do firms decide their capital structure – the proportions of
debt and equity used by firms to finance their operations. Supposing that firms seek to
maximize value, is there a capital structure that will maximize the value of the firm or, in
equivalent terms, minimize its cost of capital?

Capital structure at the most basic level refers to a company’s mix of two basic types of
securities: debt and equity. To focus on the key issues involved in capital structure choice,
we consider simple debt and equity contracts, ignoring for the moment many real-world
features of each, as well as so-called hybrid securities that combine features of both.

1.2.1. Measuring Leverage

When the only claims that a firm may issue are debt and equity, the term leverage simply
reflects the extent to which a company finances its operations with debt: more debt corresponds
to greater leverage, all else being equal.

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There are many ways to measure or quantify degrees of leverage using financial ratios.
Examples include:

1. Debt-to-Equity ratio

D market value of outstanding debt


E market value of equity

2. Debt-to-Value ratio

D D

V DE

1.3. The Modigliani-Miller Irrelevance of Capital Structure

One of the key results in understanding leverage stems from the “invariance result”, as revealed
in Modigliani and Miller’s (1958) seminal paper on capital structure. They show that in a
perfect capital market, firm value is unaffected by changes in capital structure.

Broadly, perfect capital market includes the following assumptions:

 No taxes, transaction costs and bankruptcy costs.

 No asymmetric information.
 Capital markets are efficient.
 Firms and investors can borrow and lend at the same rate.

1.3.1. The Intuition behind the Invariance Result

Imagine you plan to buy an apartment near the University. The apartment costs $4,000,000.
You have three options of buying this apartment.

Option 1 Option 2 Option 3

Mortgage 0 1,000,000 3,000,000
Down Payment 4,000,000 3,000,000 1,000,000
D/V 0% 25% 75%

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Does the value of your apartment depend on the size of mortgage?

 No matter how you finance your house by choosing different size of mortgage, it will
not affect the value of the house.
 This is the intuition behind the MM Proposition.

The fact is that the value of your apartment depends only on the cash flow it will generate, but
not on how it is financed. Imagine that you decide to rent out the apartment after purchasing,
the rental income and the maintenance costs will not be determined by your mortgage scheme.

Financial leverage only affects how the cash flow is being distributed among different fund
providers but the aggregate cash flow being distributed does not change.

1.3.2. MM Proposition I

MM Proposition I states that the total value of a firm is equal to the market value of the total
cash flows generated by its assets and is not affected by its choice of capital structure. Under
the conditions set forth by MM, the value of the firm is entirely determined by its operations
and not at all by how it is capitalized.

The idea of MM Proposition I can be illustrated by the pie model. The pie in question is the
sum of the financial claims of the firm, simply debt and equity in this case. Hence, the value
of the firm is:

V=D+E

V is the value of the firm, D is the market value of debt and E is the market value of the equity.

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The choice of capital structure is equivalent to how we slice the pie between debt and equity.
No matter how we cut, we cannot make the pie bigger.

Example 1.1

Currently the firm has no debt. The firm proposes to issue debt and use the proceeds to buy
back half of its equity.

Current Proposed
Assets 5,000,000 5,000,000
Debt 0 2,500,000
Equity 5,000,000 2,500,000
Debt to Equity Ratio (D/E) 0 1

Share Price 10 10
Shares Outstanding 500,000 250,000
Interest Rate 10% 10%

The effect of economic conditions on the returns to shareholders is shown below.

Recession Expected Expansion

Panel A: Current Capital Structure (D/E = 0)
EBIT 300,000 650,000 1,000,000
Interest 0 0 0
Net Income 300,000 650,000 1,000,000
ROE
EPS

Panel B: Proposed Capital Structure (D/E = 1)

EBIT 300,000 650,000 1,000,000
Interest 250,000 250,000 250,000
Net Income 50,000 400,000 750,000
ROE
EPS

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Note that:

 The effect of financial leverage depends on EBIT.

 When EBIT is high, financial leverage raises ROE and EPS.
 The variability of ROE and EPS is increasing with financial leverage.
 Overall, higher the financial leverage magnifies the effect of changes in EBIT on
ROE and EPS. Using more debt makes ROE and EPS riskier.

1.3.3. Homemade Leverage

We can use the homemade leverage argument to illustrate why capital structure decision does
not affect the value of a firm.

Homemade leverage is the use of personal borrowing / lending to change the overall amount
of financial leverage to which the individual is exposed.

Example 1.2

Suppose the firm does not change its capital structure. We will show that an investor can
replicate the returns from the proposed capital structure by his own.

If an investor wants to invest $500 in the firm and prefers the proposed rather than the current
capital structure, he can buy 50 shares with his own money and an additional 50 shares by
borrowing at 10% interest.

Recession Expected Expansion

Panel A: Proposed Capital Structure (D/E = 1)
EPS 0.2 1.6 3.0
Earnings (50 Shares)

Panel B: Original Capital Structure (D/E = 0)

with Homemade Leverage
EPS 0.6 1.3 2.0
Earnings (100 Shares)
Interest
Net Income

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Note that:

 In a perfect capital market, investors can borrow or lend at the same rate as the firm.
 They can always use homemade leverage to undo in their own portfolios any change
in a firm’s capital structure choice.
 They can attain the same cash flows that they would have attained without the firm’s
leverage change.
 Therefore, investors are indifferent to changes in the firm’s capital structure and
share prices should be the same regardless of the firm’s capital structure.

1.3.4. Proof of MM Proposition I

Consider a one-period economy with two identical firms except their capital structure. Firm
U is financed by equity only and Firm L is financed by both debt and equity.

At t = 1, the liquidating cash flow for the two firms will be $120m.

Firm U Firm L
Payoff at t = 1 120 120

Since the liquidating cash flow for the two firms are identical, you are indifferent from holding
either Firm U or Firm L as both firms give you the same future payoff at t = 1.

Our claim is that the values of the two firms at t = 0 must be the same.

We prove MM Proposition I by contradiction. Suppose that the values of the two firms at t =
0 are different:

 Firm U is financed totally with equity and is worth $100m ($1 × 100m shares
outstanding).
 Firm L is financed with $40m in equity ($1 × 40m shares outstanding) and $50m in
debt ($1 × 50m shares outstanding).
 The interest rate for debt is 10%.

16
 Balance Sheet ($m)
Firm U Firm L
t=0 t=1 t=0 t=1
Debt
Equity
Total

Firm U is more expensive than Firm L at t = 0. Modigliani and Miller argue that the arbitrage
opportunities will eventually equalize the values of the two firms.

How arbitrage works?

If you can short sell 1% of total interest, then at t = 0:

1. Short sell 1m equity shares of Firm U.

2. Purchase 0.5m debt and 0.4m equity shares of Firm L.

Cash Flow ($m)

t=0 t=1
Short Sell of U’s Equity
Purchase of L’s Debt
Purchase of L’s Equity
Net Cash Flow

You immediately realize a cash flow of $0.1m ($1m – $0.5m – $0.4m). However, you have
no obligation at t = 1. The net cash flow at t = 1 is zero. The initial $0.1m inflow can be
considered a risk-free profit. You can earn arbitrage profits when the Modigliani-Miller
theorem fails to hold.

Note that the arbitrageurs in the market will also exploit this opportunity. They will also short
sell Firm U’s equity which push down the share price of Firm U. The buying demand for
Firm L’s equity will push up its share price.

Eventually, the buying and selling forces will balance the share prices of the two firms until
their values become identical.

17
1.3.5. MM Proposition II

MM Proposition I tells us that leverage is irrelevant to firm value. MM Proposition II

concerns the effect of leverage on a firm’s cost of equity. In fact, MM Proposition II follows
from Proposition I. It tells us how leverage must affect the cost of equity in order for MM
Proposition I to hold.

MM Proposition II states that the cost of equity for a levered firm rises with its market value
debt-to-equity ratio, leaving its weighted average cost of capital unchanged.

MM Proposition II requires us shift our perspective from the value of the firm to the firm’s cost
of capital. Because, under MM Proposition I, a company’s borrowing decisions have no
effect on the value of its assets, we can infer that leverage must have no effect on its ra. We
can use this fact to derive an expression for re.

Because the value of the firm is determined by the value of its assets, regardless of how it is
capitalized, we know that the value of the firm’s assets, denoted as A, must equal the value of
all of its securities, D + E, and this must be so for both the levered and unlevered firms.

Therefore:

A  EU  DL  EL

Assume that a single investor holds all of a levered firm’s debt and equity, and is therefore
entitled to receive all of its operating income. The expected return on a portfolio of securities
equals the value-weighted average of the expected returns for each element of the portfolio.
In this case, our investor owns a portfolio composed of the levered firm’s debt and equity, each
with expected returns of rd and re, respectively. So we can state the investor’s expected return
as follows.

D E
ra   rd   re
V V

In other words, the expected return on the firm’s assets is equal to the expected returns on its
debt and equity, each in proportion to their percentage of the firm’s total assets. This equation
is the same formula we use to calculate a firm’s weighted average cost of capital (WACC).

18
We can use it to solve for the return on levered equity, re, and obtain the following expression1.

D
re  ra   ra  rd 
E

This is MM Proposition II, which states that the expected return on levered equity increases as
the firm’s debt-to-equity ratio rises. As leverage rises, so must the expected return on equity,
to compensate shareholders for the increased risk they bear.

We also invoked MM Proposition I to show that the expected return on equity rises by just the
right amount to keep the overall WACC constant. Firms cannot reduce their WACC by
replacing equity with debt, even though the cost of debt can be lower.

1
This is done by rearranging the WACC formula.

D E
ra   rd   re
V V
V D
 re   ra   rd
E E
DE D
  ra   rd
E E
D D 19
 ra   ra   rd
E E
D
 ra   ra  rd 
E
We can use this graph to summarize our discussion. The green line represents the WACC of
a company. You can see it does not depend on the debt-equity ratio. It is the same no matter
what the debt-equity ratio is. So this green line is another way of stating MM Proposition I:
The firm’s overall cost of capital is unaffected by its capital structure.

The red line represents the cost of equity capital. MM Proposition II indicates that the cost
of equity is given by a straight line with a slope of ra – rd. The y-intercept corresponds to a
firm with debt-to-equity ratio of zero, so return on firm’s asset is equal to the required return
on equity in this case. The red line suggests as the firm raises its debt-to-equity ratio, the
increase in leverage raises the risk of the equity and therefore the required return or cost of
equity.

1.3.6. Financial Leverage and Risk

The presence of debt in a firm’s capital structure has an impact on the risk borne by its
shareholders.

Why levered equities are riskier?

Debt increases the expected rate of return on the equity simply because the levered investments
are riskier than unlevered ones.

Example 1.3

Suppose there are three economic conditions: Recession, Expected and Expansion. The three
conditions are equally likely. Consider two firms with the same payoff (EBIT) but different
capital structure:

Firm A Firm B
Asset 2,000 Equity 2,000 Asset 2,000 Debt 1,000
Equity 1,000

The risk-free rate is 10%.

20
Consider the following three conditions:

Firm A Firm B
Recession Expected Expansion Recession Expected Expansion
EBIT 300 400 500 300 400 500
Interest 0 0 0 –100 –100 –100
Earnings 300 400 500 200 300 400

ROE

What are the expected returns and standard deviations on Firm A’s and Firm B’s equity?

The example shows that levered equities are riskier than unlevered equities. Can we pin down
where does the risks come from?

21
1.3.6.1. The Risk Profile of a Firm

In the absence of debt, shareholders are subjected only to basic business risk. The business
risk is determined by factors such as the volatility of a firm’s sales. The addition of debt to a
firm’s capital structure increases the financial risk borne by its shareholders. One source of
additional risk is the increased risk of bankruptcy. A second source is the effect of financial
leverage on the volatility of shareholder’s returns.

In short, the risk profile of a firm consists of:

 Business risk, which is related to asset beta.

 Financial risk, which is related to D/E.

Note:

1. If we assume riskless debt, rd  rf .

2. From MM Proposition II, re  ra   ra  rf  DE . The difference re  ra   ra  rf  DE is a

premium for the additional financial risk that results from the financial structure.

22
1.3.6.2. The Effect of Leverage on Beta

According to MM Proposition II, it is important to adjust required returns for the level of
financial risk. One common way the adjustment is done in practice is to adjust the beta used
in the CAPM of equity returns.

The unlevered beta, U , is the beta of the equity in the absence of any debt financing. The
levered beta,  L , is given by:

 D
 L  1  1  tc    U
 E

This formula relates a company’s leverage to the beta of its equity2. The levered beta captures
the additional financial risk associated with leverage.

1.3.6.3. The Effect of Leverage on the Cost of Equity

If a company has debt and therefore its beta is levered, then we can summarize the relationship
between required return, business risk, and financial risk with an expression:

 D
re  rf  U  rm  rf   1  tc    U  rm  rf 
 E

This equation has a neat intuition. It says that when holding equity, investors require return
for three reasons.

 For the time value of money: rf

 For bearing business risk: U  rm  rf 

 D
 For bearing financial risk: 1  tc    U  rm  rf 
 E

2
See appendix.

23
1.3.6.4. The Link between WACC, Beta and Leverage

We can link the CAPM and the weighted average cost of capital to learn how changing capital
structure affects beta.

Starting with WACC and substituting the expected return from CAPM, we have:

D E
ra   rd   re
V V
rf   a  rm  rf    rf   d  rm  rf     rf   e  rm  rf  
D E
V V
D 
 rf     d    e   rm  rf 
E
V V 
D E
a   d   e
V V

We can also see how unlevered beta goes with leverage. Analogous to MM Proposition II,
equity beta is increasing with leverage.

D
e  a   a  d 
E

Some key points to note:

On Required Return On Risk

MM Proposition I  The required return of the  The business risk, captured
asset is not affected by the by asset beta, is not affected
borrowing decisions. by the borrowing decisions.
D E D E
 ra   rd   re  a   d   e
V V V V

MM Proposition II  Investors required higher  Equity beta is increasing

returns on levered equity. with leverage.
D D
 re  ra   ra  rd   e  a   a  d 
E E

24
1.4. Summary

1.5. The Road Map Ahead

25
1.6. Appendix: Levering and Unlevering Beta

Modigliani and Miller tell us that the value of a levered firm can be written as the value of the
unlevered firm plus the present value of the interest tax shield.

VL  VU  D  tc

Since VL  D  E is also true, the following equality holds:

D  E  VU  D  tc

An important property of beta is that the beta of a portfolio is the weighted average of the betas
of the individual assets comprising the portfolio. Applying this insight to both sides of the
equation above:

D E V D  tc
 d   L  U U  d
VL VL VL VL

Multiplying both sides by VL ,

D d  E  L  VU U  D  tc   d

Rearranging terms we get:

1
L  VU U  D  tc   d  D d 
E

Substitute VL  D  tc for VU and we get:

1
L  VL U  D  tc  U  D  tc   d  D d 
E
DE D D D
 U  tc U   d  tc  d
E E E E
D
 U   U   d 1  tc 
E

26
Now assume that  d  0 , the above equation simplifies to:

 D
 L  1  1  tc    U
 E

27
2. Topic 2 – Capital Structure: Static Tradeoff Theory

The MM Propositions are the logical starting point for any discussion of optimal capital
structure because they tell us under what conditions capital structure does not matter. Any
theory purporting to show that capital structure does matter must incorporate violations of one
or more of the MM conditions. Perhaps the simplest theory of optimal capital structure comes
from relaxing two conditions that obviously do not characterize the real world: no tax and no
costs to bankruptcy. When taxes and bankruptcy costs are introduced, the value of the firm is
related to its capital structure.

2.1. The Effect of Corporate Taxes

In a world with taxes, leverage can reduce a company’s taxes. The less a company pays to
the government in taxes, the more it retains for the benefit of its owners. Specifically, the
interest payments on debts are tax deductible. The ability of interest to shield taxes makes
debt a desirable security choice.

Example 2.1

Suppose a firm has an EBIT of $10,000. The corporate tax rate is 34%.

There are two scenarios: (1) the firm is all equity financed; (2) the firm is partly debt financed
with interest expenses of $2,000.

Without Leverage With Leverage

EBIT 10,000 10,000
Less: Interest 0 –2,000
Taxable Income 10,000 8,000
Less: Taxes @34% –3,400 –2,720

Earnings after Tax

Note:

 The difference in the earnings after tax is equal to $7,280 – $6,600 = $680.
 This is exactly equal to $2,000 × 34% = $680.
 In general, the saving of taxes = the amount of deduction allowed × tax rate.

28
2.1.1. The Value of Tax Shield

Suppose a firm has a perpetual debt outstanding of D (face value) and the coupon rate is r.
The required rate of return on this debt is also r. The tax rate is tc .

Then in each year, the firm has a tax shield of D  r  tc . Since the debt is perpetual, it offers
the same tax shield forever.

Using the perpetuity formula, the total present value of the tax shield is:

D  r  tc
 D  tc
r

Therefore, we have:

VL  VU  PV  tax shield 
 VU  D  tc

This equation says that a levered firm is worth more than an otherwise identical firm without
leverage.

Example 2.2

Consider two firms with the same payoff (EBIT) but different capital structure:

Firm A Firm B
Asset 2,000 Equity 2,000 Asset 2,000 Debt 1,000
Equity 1,000

The risk-free rate is 10% and the tax rate is 40%.

29
 Firm A Firm B
EBIT
Interest
Earnings after Interest
Taxes
Earnings after Interest & Taxes

From the table, Firm B’s net income is lower. Thus, the debt obligations reduced the value
of the equity.

But more importantly, the total amount available to all investors is higher.

Suppose the retention rate is zero:

Firm A Firm B
Interest Paid to Debtholders
Dividend Paid to Equityholders
Total

2.1.2. Weighted Average Cost of Capital with Taxes

When a firm uses debt financing, the cost of interest it must pay is offset to some extent by the
tax savings from the interest tax shield.

In Example 2.2, with a 40% tax rate borrows $1,000 at 10% interest:

Interest Expense rd 1, 000  100

Tax Savings tc  rd 1, 000  –40

Effective after-tax Cost of Debt rd  1  tc  1, 000  60

With tax-deductible interest, the effective after-tax cost of debt is:

rd  1  tc 

30
We can account for the benefit of the interest tax shield by calculating the WACC using the
effective after-tax cost of debt:

E D
WACC   re   rd  1  tc 
V V

2.1.3. Return on Equity with Taxes

MM Proposition II under no taxes posits a positive relationship between the expected return
on equity and leverage. This result occurs because the risk of equity increases with leverage.
The same intuition also holds in a market with corporate taxes.

The formula of MM Proposition II with taxes:

D
re  ra   ra  rd 1  tc 
E

To derive this formula, we start with a levered firm’s market value balance sheet:

Tax Shield D  tc Debt D

Value of Unlevered Firm VU Equity E

The expected cash flows from the left-hand side of the balance sheet is:

Vu  ra  D  tc  rd

Assuming all cash flows are paid out as dividends and the cash flows are perpetual, the
expected cash flow to debtholders and equityholders together is:

D  rd  E  re

The cash flows going into the firm equal those going to the stakeholders:

Vu  ra  D  tc  rd  D  rd  E  re

31
Dividing both sides by E , and rearranging yields:

Vu  ra  D  tc  rd D  rd  E  re

E E
V  r  D  tc  rd D
re  u a   rd
E E
V D
 u  ra  1  tc   rd
E E

Since VL  VU  D  tc  D  E and VU  E  1  tc   D ,

E  1  tc   D D
re   ra  1  tc   rd
E E
D D
 ra  1  tc   ra  1  tc   rd
E E
D
 ra   ra  rd 1  tc 
E

Example 2.3

Using the same setting as Example 2.2 and assuming perpetual cash flows:

Firm A Firm B
Asset 2,000 Equity 2,000 Asset 2,000 Debt 1,000
Equity 1,000

The risk-free rate is 10% and the tax rate is 40%.

Firm A Firm B
EBIT 400 400
Interest 0 –100
Earnings after Interest 400 300
Taxes –160 –120
Earnings after Interest & Taxes 240 180

32
What is the required return on equity for Firm A?

What is the market value of Firm A?

What is the market value of Firm B?

What is the required return on equity for Firm B?

Earnings available for equityholders =

Market value of equity of Firm B =

Alternatively,

33
2.2. Personal Taxes

Personal taxes have the potential to offset some of the corporate tax benefits of leverage. To
determine the true tax benefit of leverage, we need to evaluate the combined effect of both
corporate and personal taxes.

Consider a firm with $1 of earnings before interest and taxes (EBIT). The firm can either pay
this $1 to debtholders as interest, or it can use the $1 to pay equityholders as dividend.

Let td  35% be the interest tax and te  15% be the equity income tax. The corporate tax
rate, tc  35% . The tax consequences of each option:

After-Tax Cash Flows After-Tax Cash Flows

To Debtholders 1  td  1  0.35  0.65

To Equityholders 1  tc 1  te  1  0.351  0.15  0.5525

The tax advantage to debt remains, however, it is not as large as we calculated based on
corporate taxes alone. To express the comparison in relative terms, note the equityholders
receive 15% less after taxes than debtholders:

0.65  0.5525

0.65
 15%

The effective tax advantage of debt:


1  td   1  tc 1  te 
1  td 
 1
1  tc 1  te 
1  td 

34
As long as   0 , then despite any tax disadvantage of debt at the personal level, a net tax
advantage for leverage remains.

VL  VU  D  
 1  tc 1  te  
 VU  D  1  
 1  td  

Several remarks:

1. If there are no taxes at all so that tc  td  te  0 , then VL  VU , which is exactly the result
of MM Proposition I.

2. If there are no personal taxes, so that td  te  0 , then VL  VU  D  tc .

3. If 1  td   1  tc 1  te  , then VL  VU .

 To understand this result, note that 1  td  is the after-tax interest income on every

dollar of debt, while 1  tc 1  te  is the after-tax income from dividends and / or

capital gains.

 If 1  td   1  tc 1  te  , then the after-tax incomes from debt and equity are the

same, so investors should be indifferent to the firm’s capital structure meaning that
the firm will have nothing to gain by using one type of securities rather than another.

4. Debt is preferred to equity if and only if 1  td   1  tc 1  te  .

35
2.3. Costs of Financial Distress

Formally, the costs of financial distress denote value lost or destroyed by conflicts between
claimants when a firm defaults, or is even near to defaulting, on its obligations. We say that
a firm is financially distressed when the firm itself or the parties with whom it does business
feel that it may not be able to meet all of its financial obligations. When a firm cannot meet
its obligations, some will get less than they expected or were promised. Consequently, people
begin to take actions to protect themselves. Customers may seek another vendor, suppliers
may demand cash on delivery, lenders may move to seize collateral, key employees may leave
to join more financially secure firms. Such actions harm the firm – they reduce its value.

There are two kinds of costs of financial distress:

1. Direct costs of bankruptcy

 It includes the legal expenses, court costs and advisory fees typically involved in debt
restructurings or bankruptcy proceedings.

2. Indirect costs of bankruptcy

 It includes the opportunity costs arising from the treat of liquidation, even if the firm
never defaults.
 For example, a firm will operate less efficiently or force to pass up positive NPV
projects due to tightening credit.

2.4. Optimal Capital Structure

Empirical evidence broadly suggests stable or target leverage ratios. How can we explain this?
Myers’ (1984) discussion of the static trade-off theory, where the tax advantages of debt are
offset by the bankruptcy costs, provides one avenue. As debt increases, interest payments
increase so that debt carries some default risk.

The static tradeoff theory suggests that when we balance the marginal costs and benefits of
debt, we obtain an optimal capital structure.

VL  VU  PV  tax shield   PV  financial distress 

36
This simple expression says that the value of the levered firm equals the value of the unlevered
firm plus the value of interest tax shield less the present value of the costs of financial distress.

The optimal capital structure is a point at which the benefits of additional debt through the
increase in the tax shield are offset by the costs due to the increased probability of incurring
the costs of financial distress. For most firms, the optimum is typically some combination of
debt and equity.

The static tradeoff theory is illustrated in this graph, which plots the value of the firm against
the amount of debt. In this figure, we have drawn lines corresponding to three different stories.
The first represents MM Proposition I. The horizontal green line indicates that the value of
the firm is unaffected by its capital structure. In this case, there will be no optimal capital
structure.

The second case is captured by the blue upward-sloping straight line. It shows that the value
of a levered firm exceeds the value of an unlevered firm by the interest tax shield. Each
additional dollar of debt increases the cash flow of the firm.

The third case illustrates our current discussion. The pink line shows that the value of the
firm rises to a maximum and then declines beyond that point. This represents the static
tradeoff theory. The maximum value of the firm V* is reached at D*, so this point represents
the optimal amount of borrowing. It occurs where the benefit from an additional dollar of
debt is just offset by the increase in expected bankruptcy costs.

37
2.5. Implications from the Static Tradeoff Theory

1. The cost of financial distress should be most serious for firms with valuable intangible
assets and growth opportunities.

 Mature firms holding mostly tangible assets should borrow more, while growth firms
which depend heavily on R&D should borrow less.
 Airline companies are usually highly leveraged since they borrow a lot of money to
finance their operation.
 Empirical evidence confirms that there is a negative relation between proxies for
intangible assets and financial leverage.

2. Almost all leverage-increasing transactions are good news.

 The announcements of common stocks issues drive down stock prices but repurchase
push them up.
 Exchanges of debt-for-equity3 securities drive up stock prices but equity-for-debt
exchanges4 depress them.
 The empirical evidence can be interpreted as proving investors’ appreciation of the
value of interest tax shields.

3. However, leverage-decreasing transactions are bad news which challenges the static
tradeoff theory.

 If firms seek to achieve optimal capital structure, then some firms will issue debt and
some firms will issue equity.
 Therefore, both movements should be value-increasing.

4. Moreover, the most telling evidence against static trade-off theory is the strong inverse
relationship between profitability and leverage.

 Highly profitable firms have more dollars for debt service. They should have
higher debt ratios since they have more taxable income to shield.
 However, we observe more profitable firms borrow less and less profitable firms
borrow more, which is opposite to the prediction of static trade-off theory.

3
Shareholders in a company are given bonds to replace their shares.
4
Debt is exchanged for a predetermined amount of equity.

38
3. Topic 3 – Capital Structure: Leverage and Agency Conflicts

The incentives of equityholders to maximize the value of their shares are not necessarily
consistent with the incentive to maximize the total value of the firm’s debt and equity. Indeed,
shareholders of a leveraged firm often have an incentive to implement investment strategies
that reduce the value of the firm’s outstanding debt.

To understand this concept, remember that the total value of a firm equals the value of its debt
plus the value of its equity. Therefore, strategies that decrease the value of a firm’s debt
without reducing its total value increase the firm’s share price. Equityholders have an
incentive to carry out these kinds of strategies if permitted to do so. Similarly, they also may
implement strategies that reduce the total value of the firm’s debt and equity claims if these
strategies transfer a sufficient amount from the debtholders to the equityholders.

Firms acting to maximize their stock prices make different decisions when they have debt in
their capital structures than when they are financed completely with equity.

How equityholders can expropriate debtholders’ wealth?

There are various distortions in investment strategies that might arise because of conflicts of
interest between equityholders and debtholders:

1. The debt overhang problem

 Equityholders may underinvest.

 They pass up profitable investments because the firm’s existing debt captures most
of the project’s benefits.
 This is sometimes referred to as the underinvestment problem.

2. The asset substitution problem

 Equityholders tend to take on overly risky projects, even when they have negative
NPV.

39
3. The shortsighted investment problem

 Equityholders tend to pass up profitable investment projects that pay off over a long-
time horizon in favor of less profitable (lower NPV) projects that pay off more
quickly.

4. The reluctance to liquidate problem

 Equityholders may want to keep a firm operating when its liquidation value exceeds
its operating value.

3.1. The Debt Overhang Problem

A debt overhang problem arises when the burden of existing debt on a firm’s balance sheet
grows so large that the firm faces a high risk of default. Equityholders of a firm with a
significant probability of bankruptcy often find that new investment helps the debtholders at
the equityholders’ expense.

Example 3.1

Consider a firm must decide whether to accept or reject a new project. The project’s cost is
$1,000. The firm receives cash inflows of $5,000 and $2,400 under a boom and a recession,
respectively. Boom and recession are equally likely. The new project will bring $1,700 in
either state. However, the firm has an outstanding debt of $4,000.

Should the firm take this project?

40
The NPV of this project is positive. Clearly, accepting this project can increase the value of
the firm.

If the firm must raise $1,000 for this project, will the existing equityholders contribute $1,000
from their own pocket to fund this project?

Firm without Project Firm with Project Costing

$1,000
Boom Recession Boom Recession
(prob. = 0.5) (prob. = 0.5) (prob. = 0.5) (prob. = 0.5)
Firm Cash Flows
Debtholder’s Claim
Equityholder’s Claim

Do Not Take the Project Take the Project

Payoff to Equityholders

Equityholders have an incentive to reject the project.

Can the firm raise fund in the debt market?

Noted that the additional debts the firm issued must have lower priority.

Firm without Project Firm with Project Costing

$1,000
Boom Recession Boom Recession
(prob. = 0.5) (prob. = 0.5) (prob. = 0.5) (prob. = 0.5)
Firm Cash Flows 5,000 2,400
Old Debtholder’s Claim 4,000 2,400
New Debtholder’s Claim
Equityholder’s Claim 1,000 0

41
The face value of the new debt:

Again, the equityholders are worse off even if they borrow the $1,000 from the debt market.

Firm without Project Firm with Project Costing

$1,000
Boom Recession Boom Recession
(prob. = 0.5) (prob. = 0.5) (prob. = 0.5) (prob. = 0.5)
Firm Cash Flows 5,000 2,400
Old Debtholder’s Claim 4,000 2,400
New Debtholder’s Claim
Equityholder’s Claim 1,000 0

Why?

 Shareholders make investment decisions that will maximize their own benefit.
They do not figure benefits to the firm’s debtholders into their decisions.
 The key here is that the equityholders contribute the full $1,000 investment, but the
debtholders and equityholders share the benefits.
 The equityholders take the entire gain if boom time occurs. Conversely, the
debtholders reap most of the cash flow from the project in a recession.

Too much debt will distort a firm’s investment policy. Even though the project is good for
the firm, equityholders do not have enough incentive to capture the gain from the project.

42
3.2. The Asset Substitution Problem

Debt provides an incentive for firms to take on unnecessary risk, substituting riskier investment
projects for less risky projects.

Example 3.2

Consider a firm that plans to manufacture memory chips and has borrowed the money to build
a factory. The manager now must decide on one of the two designs for the production process.
Each process costs $70m, but the firm’s management knows that process 2 is riskier than
process 1.

Debtholders are aware of the two alternatives and can forecast the possible payoffs of each, but
they cannot observe which process the firm will decide upon until after they lend the money.
Assume investors are risk neutral and want to maximize expected returns.

The payoff table:

Bad (prob. = 0.5) Good (prob. = 0.5) Expected Value

Process 1 50 100 75
Process 2 25 115 70

From the perspective of an all-equity firm, say, the firm has $70m internal fund for this
investment, which process is better?

If the firm only has $30m internal fund and has to raise $40m debt to finance the investment,
which process will the equityholder select?

43
The payoff table after repayment of the $40m debt obligation becomes:

Bad (prob. = 0.5) Good (prob. = 0.5) Expected Value

Process 1
Process 2

After repayment of the $40m debt obligation, the equityholders’ payoff in the Bad state for
process 2 is given as $0 instead of –$15m ($25 – $40) because limited liability implies that
equityholders can do no worse than receive zero.

The equityholders of a levered firm may prefer a high-risk, low (or even negative) NPV project
to a low-risk, high NPV project.

Why debt provides an incentive for firms to take on unnecessary risk?

Option pricing theory provides one way to think about the asset substitution problem. The
payoff to equityholders is similar to the payoff from a call option on the firm’s assets.
Equityholders can realize an unlimited upside, but in the event of an unfavorable outcome, they
can do no worse than lose their entire investment because they have unlimited liability.

For example, a firm has an outstanding debt of $100. The payoff to equityholders will be
either the firm’s cash flows less its debt obligation (when cash flows from assets exceed the
debt obligation), or zero (when the debt obligation exceeds the cash flows).

Cash Flows 80 90 100 110 120 130

Debt (FV = 100) 80 90 100 100 100 100
Equity 0 0 0 10 20 30

44
Levered equity can thus be viewed as a call option where the strike price is the payoff of the
debt.

Payoff

D St

ST 80 90 100 110 120 130

X  100 100 100 100 100 100 100

CT  max  ST  X , 0  0 0 0 10 20 30

The implication of the option pricing model – that option values increase with increases in the
volatility of the underlying stock – can thus be applied to show that a firm’s equity will be more
valuable if the firm’s managers select more risky investments.

Hence, increasing a firm’s risk transfers wealth from the firm’s debtholders to its equityholders.

3.3. The Shortsighted Investment Problem

Debt can lead firms to favor lower NPV investment projects that pay off quickly over higher
NPV projects with lower initial cash flows. The intuition is that firms with large debt
obligations need to pay high borrowing rates on new subordinated debt used to refinance the
portion of their existing debt that is maturing. Thus, firms have an incentive to generate cash
quickly to minimize the amount of debt that they will need to refinance at high rate.

45
Example 3.3

A firm has debt obligations that are due in Year 1 and Year 2. The firm has a debt obligation
of $100m due next year and $40m due the following year. The firm is considering two equally
costly mutually exclusive projects:

 A short-term project that generates $50m in Year 1 and zero cash flows thereafter.
 A long-term project with $20m cash inflow in Year 1 and $40m in Year 2.

Cash Flow from:

Debt Due Existing Assets Short-term Long-term
Project Project
Year 1 100m 50m 50m 20m
Year 2 40m 60m if Good (prob. = 0.5) 0 40m
10m if Bad (prob. = 0.5)

Assume zero discount rate. Which project should the firm choose?

How the debt obligations affect the investment decision?

If the firm selects the short-term project:

If the firm selects the long-term project:

46
If the firm takes the long-term project, how much the firm must offer to pay the new lenders?

Good (prob. = 0.5) Bad (prob. = 0.5)

Cash Flows at Year 2
Payoff to Old Debt
Payoff to New Debt

The face value of the new debt:

The new lenders will require:

Good (prob. = 0.5) Bad (prob. = 0.5)

Cash Flows at Year 2
Payoff to Old Debt
Payoff to New Debt

Which project will the equityholder select?

In the Bad state:

Short-term Project Long-term Project

Debt obligation
Cash flow

The firm will be unable to meet its Year 2 debt obligation if the Bad state of the economy occurs,
regardless of whether the firm chooses the long-term or short-term project.

In the Good state:

Short-term Project Long-term Project

Debt obligation
Cash flow
Equity value

47
Hence, the firm’s equityholders are better off selecting the short-term project even though it
has a lower NPV.

How do the shareholders benefit from taking the lower NPV investment?

Since the firm’s existing debtholders are made worse off when the firm selects the short-term
project, the gain to the equityholders comes at the expense of the original debtholders whose
debt is due at the end of year 2. These debtholders are paid in full in the unfavorable state of
the economy if the firm takes the long-term project, but they receive only $10m of their $40m
obligation in the unfavorable state of the economy when the short-term project is selected.

Firms with large amounts of debt tend to pass up high NPV projects in favor of lower NPV
projects that pay off sooner.

3.4. The Reluctance to Liquidate Problem

One of the most difficult decisions a firm must make is whether to remain in business. It must
decide whether to continue to operate or to dismantle the business and sell its property and
equipment for its liquidation value. Like the investment decision, the liquidation decision is
affected by how much debt the firm has outstanding.

Managers of financially sound firms have an incentive to continue operating their firm even
when the liquidation values of the firm exceed its going concern value (Titman, 1984; Gertner
& Sharfstein, 1991).

When a firm has more than one class of debt, the determinants of its bankruptcy decisions
become considerably more complicated. In practice, a firm will go bankrupt if the following
conditions hold:

 It has insufficient cash flow to meet its debt obligations.

 It is unable to borrow a sufficient amount to meet its debt obligations.

48
Example 3.4

Suppose a firm has no cash flow in the current period, but will have cash flows of $1.5m next
year if the economy is good and $0.5m if the economy is bad. Assume zero discount rate and
equal probabilities of the two events. Assume that if it liquidates immediately, it will generate
$1.2m.

What is the going concern value of the firm?

If the firm were financed entirely with equity, which option (liquidate immediately or continue
to operate) would the equityholders select?

The firm’s capital structure consists of both debt and equity. The debt obligations and the
liquidation proceeds for the firm are shown below.

Immediate Next Year

Senior Debtholders 150,000 1,000,000
Venture Capitalist 0 200,000

Payoff in the Event of Liquidation

Senior Debtholders 1,150,000
Venture Capitalist (junior claimant) 50,000
Equityholders 0

The firm will be forced into bankruptcy if it cannot meet its $150,000 current debt obligation.
If this happens, all of its debt obligations become due immediately and the debtholders will
take control of the firm.

Clearly, the senior debtholders will liquidate the firm in this situation because they are paid in
full. However, the equityholders receive nothing from the liquidation proceeds and only
$50,000 of the venture capitalist’s junior claim is paid.

49
Both firm’s equityholders and its venture capitalist have an incentive to keep the firm going
even though the firm’s total value is maximized by immediately liquidating its assets.

Given the firm’s weak condition, the firm is willing to pay the venture capitalist $100,000 in
interest for one-year loan that provides an additional $150,000 in financing.

Would the venture capitalist provide the new funding?

Payoff in the event of a cash infusion:

Next Year State of the Economy

Immediate Good Bad
Senior Debtholders

Venture Capitalist

Equityholders

Venture capitalist will find it worthwhile to make the loan since a 50% chance of receiving
$450,000 is worth more than $200,000 investment ($150,000 in new financing + $50,000 in
forgone liquidation proceeds).

Note that the senior debtholders are made worse off when the more junior venture capitalist
injects additional capital into the firm. The debtholders receive only $500,000 next year if
the firm continues to operate and the Bad state occurs.

3.5. Mitigating the Agency Conflicts

How can firms minimize the debtholder – equityholder incentive problems?

The problems are of course eliminated if the firm is all equity financed. However, there are
offsetting advantages to the inclusion of debt in a firm’s capital structure, for example, tax
advantages.

Therefore, firms have incentives to include debt in their capital structures and to design their
debt in ways that minimize the potential conflicts between borrowers and lenders.

50
There are several ways that a firm can minimize the incentive costs associated with debt
financing.

1. Protective covenants

 Debtholders may restrict wealth appropriating behavior on the part of equityholders

through contracts.
 The covenants specify the amount that firms can distribute to shareholders as a
dividend or repurchase.
 Require the firm to satisfy restrictions on various accounting ratios, such as the
debt/equity ratio, interest coverage and working capital.
 Restrict the sale of assets and the issuance of additional debt.

2. Bank and privately placed debt

 Banks are better to monitor the investment decisions of firms and enforce protective
covenants.
 The conflict between debt and equity is less in Germany and Japan than in the U.S.

3. The use of short-term instead of long-term debt

 Short-term debt is much less sensitive to changes in a firm’s investment strategy than
the value of long-term debt.
 The frequent renegotiation of lending rate can mitigate the incentive of equityholder
from taking too much risk.

4. The use of convertible bonds5

 These can be exchanged for a pre-specified number of shares of the firm’s common
stock at the debtholder’s option.
 Debtholders can benefit from the upside potential of successful risky investments.

5
See Appendix.

51
5. Project financing

 Project finance is capital to finance an investment project for which both the project’s
assets and the liabilities attached to its financing can effectively be separated from
the rest of the firm.
 By segregating a risky project and financing it in a separate firm, managers can
ensure that failure of the project does not take down the entire firm.
 By giving lenders a direct equity stake – tying their investment return to the returns
from project assets, the lenders will receive an enhanced return to compensate for the
higher risk if the project is successful.

3.6. Agency Benefits of Debt

There are several benefits of leverage:

1. Managerial entrenchment occurs from the separation of ownership and control in which
managers make decisions to benefit themselves at the expense of investors.

 Leverage can preserve ownership concentration and mitigate agency costs.

 Issuing debt can maintain the original shareholders stake, while issuing equity can
dilute original shareholders incentives because any agency costs are shared with
others.

2. Leverage can mitigate empire building tendencies arising from incentives to run large
firms such as salary structure and perquisites.

 Leverage imposes discipline by pre-committing the cash flows and by creditor

monitoring.

52
3.7. Agency Conflicts and the Tradeoff Model

Finally, we can adjust the value of the firm to include the costs and benefits of the incentives
that arise when the firm has leverage.

VL  VU  PV  tax shield   PV  financial distress 

 PV  agency benefits of debt   PV  agency costs of debt 

Issue of debt has a range of associated costs and benefits. There is a tradeoff between costs
and benefits in determining optimal capital structure. Other things being equal, the greater
the agency problems associated with lending to a firm, the less debt the firm can afford to use.

3.8. Appendix: Convertible Bonds

Convertible bond is a traditional corporate bond with the additional feature of being convertible,
at the investor’s discretion, into a pre-determined number of shares of common stock. As
such, convertibles are hybrid securities that combine both equity and debt characteristics.
Through the equity characteristic, investors in convertible securities have the potential to
participate in appreciation of the underlying stock, while the debt characteristic offers the
potential for a more limited downside than equities.

3.8.1. Features of a Convertible Bond

53
On July 2013, Kingsoft Corporation Limited 金山軟件 (3888.HK) issued the following
convertible bond.

Size: HK$ 1.356 billion

Term: 5 years
Redemption Date: 23 July 2018
Nominal Value: HK$ 1 million
Interest Coupon: 3.0%
Conversion Price: HK$ 16.9363
Conversion Ratio: 59,044.77
Market Price at Issue (%): 100
Bloomberg Ticker: KINSF 3 07/23/18

The bond has a nominal (or par) value of HK$ 1 million. The market price is quoted as
percentage of the nominal value, which means the price at issue is HK$ 1 million. Like a
straight bond, the convertible bond pays interest semi-annually (on 23 January and 23 July each
year). For each bond, the stated interest will be HK$ 1 million × 3.0% ÷ 2 = $15,000.

The convertible bond contract states either a conversion ratio or a conversion price. A
conversion ratio directly specifies the number of shares of the issuing firm’s common stock
that can be obtained by surrendering the convertible security. In this example, Kingsoft
allows the holder in exchange for 59,044.77 shares from 2 September 2013 to 10 days before
maturity date (13 July 2018). If the bond is not converted, it will be redeemed at par on
maturity.

Alternatively, the conversion ratio may be expressed in terms of a conversion price – the price
paid per share to acquire the underlying common stock through conversion. The conversion
ratio is equal to the nominal value divided by the conversion price. Since the conversion price
is HK$ 16.9363, the holder will receive 59,044.77 shares of common stock in conversion, given
a par value of HK$ 1 million for the bond.

The full conversion will generate 80,061,473 shares at the stated conversion price, HK$
16.9363, which accounts for 6.36% of the total issued shares. In some cases, the conversion
price is not always fixed. For example, the conversion price of this convertible bond has been
adjusted from HK$ 16.9363 to HK$16.7 in May 2015.

54
3.8.2. Call and Put Features

Many convertible bonds are callable by the issuer, which may lead to “forced conversion”. In
other words, the company has the right to forcibly convert them. Forced conversion usually
occurs when the price of the stock is higher than the amount it would be if the bond were
redeemed. In our case, the contract stated that after 23 July 2016 that, if the daily volume
weighted average price of the share exceeds at least 30% of the conversion price for 20 out of
30 consecutive trading days before the redemption announcement is made, then the bond will
be callable by the company. With the new conversion price at HK$16.7, the call will be
triggered if the bond rises to $21.71 and meets the stated requirements.

Some convertible bonds may offer a put feature which allows the holder to put back the bonds
to the issuer. This feature is also available for this bond. Kingsoft will repay the principal
plus the accrued interest to the holder on 23 July 2016, offering downside protection.

3.8.3. Convertible Bond Market

The convertible bond market is a relatively small market in comparison to straight corporate
bond market.

No of No of
Newly Listed Amount Raised Newly Listed Amount Raised
Year Debt Security (HK$ Billion) CB (HK$ Billion)
2011 50 152.49 2 2.34
2012 109 341.24 0 0
2013 170 576.40 2 7.78
2014 281 961.35 6 6.76
2015 177 750.76 2 3.24

The table shows the number and amount raised of newly debt securities and convertible bonds
from 2011 to 2015. There are few convertible bonds listed and traded on the HKEx since
most bond trading is done via the over-the-counter (OTC).

55
3.8.4. Why Firms Issue Convertible Bonds?

In theory, convertible bond helps to resolve some conflicts between equity and debtholders.
Shareholder can hurt debtholder by taking more risk or issuing senior debt. To compensate
for this risk, debtholders will charge a very high interest rate, which may give shareholder
incentives to take even more risk and eventually destroy firm value. However, this problem
is alleviated in the case of convertible bond since debtholders may also become shareholders.
From an informational point of view, issuing convertible bond signals management’s
confidence in the company and leads to less price discount due to asymmetric information.

Convertible bond issue can be regarded as a contingent issue of equity. If a company’s

investment opportunity expands, its stock price is likely to increase, leading to conversion.
Thus, the company gets fresh equity when it is most needed for expansion.

Small and growth firms are typically less known and have more expansion opportunities.
Therefore, it is not surprising to see they are the main issuers of convertible bonds. In addition,
the relatively low coupon rate on convertible bonds may also be attractive to small growth
firms facing heavy cash constraints.

56
3.8.5. Advantages and Disadvantages to Issuing Firms and Investors

In practice, there are a number of benefits for issuers and investors in convertible bonds.
There are, of course, downsides for both parties to consider.

Issuer
Advantages Disadvantages
• The company receives upfront payment • The company is forward selling its
for ordinary shares to be issued at a later ordinary shares through the equity call
date, customarily at a premium to their option, which, if exercised, will lead to
market price. To the extent that a dilution of existing shareholders’ sakes in
company considers its ordinary shares to the company – this may be a sensitive
be undervalued at the time of pricing of area from a relationship perspective for
the bonds, the issue of convertible bonds the company and put downward pressure
may be an attractive alternative to issuing on the company’s share price. In the
ordinary shares. extreme, the dilution can challenge the
control over ownership. (See Case #2)
• Investors will accept a lower interest rate
on convertible bonds than plain vanilla • The ordinary shares of the company may
bonds, given the additional value of the not perform during the life of the bonds.
equity call option – this will be helpful In this case, holders of the bonds may not
for a company seeking to better manage exercise their conversion rights and the
its debt service and leverage ratios. company will be forced to pay interest on
(See Case #1) the bonds during their entire tenor and, on
their final maturity date, return principal
• If the price of the company’s ordinary through new financing or available cash.
shares increases above the conversion (See Case #3)
price, the bonds will convert into
ordinary shares and the company will not • The hedging strategies of certain
need to repay its borrowings. investors may lead to downward pressure
on the company’s ordinary shares, as
• The company is provided with access to some investors that purchase the
a broader investor base, as convertible convertible bonds may “short” the
bond investors consist of both hedge ordinary shares to hedge their respective
funds and “long-only” equity investors. positions.

57
 Investor
Advantages Disadvantages
• Irrespective of the performance of the • If the ordinary shares of the company do
ordinary shares of the company, the not perform, the investor will have
bonds continue to provide a fixed rate of achieved a poor return on its investment
income for investors through the coupon, (represented by the lower coupon
and a protected return of principal on payable on convertible bonds as against
their final maturity date. the coupon payable on plain vanilla
bonds of a similar credit) as at the final
• If the company were to become insolvent maturity date. This opportunity cost
or be liquidated, an investment in may be partially offset by gains made by
convertible bonds would have even rank shorting the ordinary shares.
with the company’s unsecured debt and
rank ahead of an investment in the • The value of convertible bonds can be
ordinary shares of the company in eroded by corporate actions taken by the
insolvency proceedings. company or negative events which occur
in the life of its business. Whilst
• The investor has, as mentioned above, customary protections are contained in
upside participation in the performance the terms of convertible bonds, it is not
of the ordinary shares of the ordinary possible to protect the investor from all
shares of the company, as its option to events which might erode the value of
convert its holding of the bonds into their convertible bonds.
ordinary shares is set at a fixed price, and
the holder of the bonds therefore benefits
from any increase in the market value of
the ordinary shares above that fixed
conversion price.

3.8.6. Hong Kong Examples

3.8.6.1. Case #1

In May 2011, The Wharf (Holdings) Ltd 九龍倉集團 (0004.HK) issued a 3-year convertible
bond of 2.3% coupon, with a conversion price of HK$ 90 (about 60% premium of current
market price). The issuance has raised HK$ 6.2 billion to finance Hong Kong and China’s
properties development. The low interest cost – in comparison to the funding cost of Chinese
real estate companies that over 10% – is a favorable financing method.

58
3.8.6.2. Case #2

In 2010, Huang Guangyu 黃光裕, a major shareholder of Gome Electrical Appliances Holding
Ltd 國 美 電 器 (0493.HK) persuaded shareholders to dismiss Chen Xiao 陳 曉 , the
chairperson, and overturn the management board of the firm. Before the shareholders’
meeting, Bain Capital, who was in favor of the management, converted Gome’s convertible
bond (matured in 2016) at the conversion price of $1.108 into 1.6 billion shares. This move
made Bain Capital own 11% of company shares, and become the second largest shareholder.
Eventually, the motion of dismissal was overruled by a 3% difference.

3.8.6.3. Case #3

Convertible bond holders have the right to convert the bond into shares if share price exceeds
conversion price, otherwise, they continue to receive a fixed rate of income through the coupon,
and a protected return of principal on the final maturity date. Fu Ji Food and Catering Services
Holdings Limited 福記食品 (1175.HK) issued convertible bonds to finance their expansion
when the market is good. And upon maturity, the firm issued a new batch of convertible
bonds to roll-over the old bonds. The idea of “financing circulation” eventually broke down
in 2008. The plummet in share price and the tightening of credit made Fu Ji unable to issue
another convertible bond or borrow from a bank to repay the old bonds. Fu Ji eventually
liquidated in 2009.

59
4. Topic 4 – Capital Structure: Pecking Order Theory

Asymmetric information occurs when managers have more information about the firm than
outside investors do. In a pure MM world, this is assumed not to occur. But in the real
market, manager obviously know more than investors, and asymmetric information does exist.
In this topic, we consider how asymmetric information may motivate managers to alter a firm’s
capital structure.

4.1. Pecking Order Theory

Asymmetric information affects the choice between internal and external financing, and
between new issues of debt and equity securities. This leads to a pecking order. Pecking
order is a financing hierarchy – firms prioritize their sources of financing in which investment
is financed first with internal funds; then by new issues of debt; and finally with new issues of
equity.

Why do firms follow the pecking order?

The pecking order theory is motivated by the following story:

1. Managers are reluctant to issue stock when they believe their shares are undervalued.
They are more likely to issue when their shares are overpriced.

2. Investors understand the managers know more about their values of firms and believe they
have an incentive to “time” the issues.

3. Investors therefore interpret the decision of issue as bad news, and firms which issue
equity can do so only at a discount.

4. Faced with this discount, managers may not be able to sell shares at a fair price. They
may force to pass up good investment opportunities.

5. The pecking order theory suggests there is an order of preference for capital source when
financing is needed. Managers prefer internal equity than external equity. When
external equity is used, they prefer issuing debt than equity.

60
4.2. An Example

Given that:

 There are 2 equally likely states of nature: Good (prob. = 0.5) and Bad (prob. = 0.5).
 There are 2 periods: t = 0 and t = 1.
 The firm has $10m in debt, payable in next period.
 The firm has assets-in-place which will be worth $10m at t = 1 if the Bad state occurs,
but will be worth $120m at t = 1 if the Good state happens.
 The firm has 130m shares outstanding.
 Assume that the required rate of return on equity is constant at 10% (this is not
possible in practice but it simplifies the analysis).

Suppose now at t = 0, the firm has an opportunity to do a project which costs $100m and has a
payoff at t = 1:

 $99m if Bad state occurs.

 $154m if Good state occurs.

The key question in this example is: Should the firm take this project?

The answer depends on:

 The choice of financing method, whether the firm uses internal or external financing.
 The degree of information asymmetry when external financing is used.

4.2.1. Case I – The Project is Financed with Internal Equity

How much is this project worth?

Result 1: If the firm has sufficient internal funds, it will be good to invest in this project since
NPV > 0.

61
4.2.2. Case II – The Project is Financed with External Equity and the
Informational Environment is Symmetric

In this case, neither the manager nor the market knows whether the Good or Bad state will
occur.

Should the firm take this project if the firm must finance the investment with external equity?
What is the payoff to equityholder at t = 1?

Do Not Take Take

Good Bad Good Bad
(prob. = 0.5) (prob. = 0.5) (prob. = 0.5) (prob. = 0.5)
Debt
Equity
Total

The present value of equity:

Expected Value of Equity

PV  Equity  
1  re

Do Not Take Take

PV(Equity)

The present value of equity is greater when firm takes this project ($165m) than not ($50m).
However, some of this increase in equity value goes to the new shareholders.

The real question becomes: Will the existing shareholders, those who make the decision
whether to take the project, be better off?

62
In order to calculate the position of the old shareholders, we must first calculate the proportion
of the equity to which the new shareholders are entitled.

The project requires $100m, the fraction of total equity owned by new shareholders:

100   fraction of total equity owned by new shareholders    present value of equity 

Thus, the number of new shares that the firm has to issue is:

Under symmetric information, the payoff table:

PV(Equity)
Old Shareholders New Shareholders
Do Not Take

Take

Result 2: Since the PV(Equity) is higher when old shareholders take the project, the old
shareholders are better off. Therefore, under symmetric information, the firm will take the
project.

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4.2.3. Case III – The Project is Financed with External Equity and the
Informational Environment is Asymmetric

In this case, manager knows which state will occur but the market does not.

Recall the payoff at t = 1:

Do Not Take Take

Good Bad Good Bad
(prob. = 0.5) (prob. = 0.5) (prob. = 0.5) (prob. = 0.5)
Debt 10 10 10 10
Equity 110 0 264 99
Total 120 10 274 109

However, the manager now knows exactly which state will occur at t = 0. They can use the
actual information than just expected values. Therefore, manager can calculate the following:

PV(Old Equity)
Good Bad
(prob. = 0.5) (prob. = 0.5)

Do Not Take

Take

As the manager is better informed and knows the exact state that will occur at t = 1, he will
make the decision (whether to take the project or not) based on the above table.

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The decision will be:

PV(Old Equity)
Good Bad
(prob. = 0.5) (prob. = 0.5)
Do Not Take
Take

Result 3: The existing shareholders will only do the project whenever Bad state will occur.

4.2.4. Summary

1. When the firm has sufficient internal earnings, it will go ahead for the project for sure; the
$15 NPV will go to the old shareholders.

2. When the firm can raise fund only in equity market, without asymmetric information, the
old shareholders will still take the project.

3. However, in a market with asymmetric information, the old shareholders will only take
the project whenever Bad state occurs.

4.2.5. Adverse Selection

Why existing shareholders only take the project whenever Bad state occurs?

1. In order to finance the project, they diluted their holdings in the firm in return for a chunk
of the new project payoffs.

2. But the new project is more valuable than the market that is willing to pay; the newly
issued shares are much underpriced.

Remember that if the informational environment is asymmetric, only the manager will
know which state will occur but the market does not. As a result, the manager will use
the full information to evaluate the value of project; but the market can only rely on
expected payoff for evaluation.

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 Good Bad
E(Payoff)
(prob. = 0.5) (prob. = 0.5)

Firm

Market

Suppose the state of the economy will be “Good” for sure, then the firm will be forced to
issue huge underpriced securities (1.0769 – 0.5 = 0.5769).

Evaluated under “Market Expectation” Evaluated under “True Value”

3. This underpricing is severe enough to remove the old shareholders’ profits from the new
investment since dilution causes the new shareholders end up holding part of the original
assets-in-place.

To understand this point, if the firm can successfully convince the market to believe that
the Good state is coming, then the new shareholders will get a zero NPV. In this case,
the old shareholders will reap the entire $40 NPV of this project.

Do not Take Take

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 However, the market will only evaluate according to its own expectation. In such the
case, the old shareholders will receive $45.45 ($140 - $94.55) less. The new
shareholders will reap the entire $40 NPV plus $5.45 the original assets-in-place because
of the severe share dilution.

Do not Take Take

4. Market is smart and realizes that managers will only go ahead with the project if they
know the Bad state will occur.

5. In the Bad state, equity is only worth $99m, and managers are trying to raise $100m by
selling a portion of equity that is worth less than $100m.

6. This is not possible as the market knows managers have an incentive to issue overvalued
securities. There is no way to raise $100m in this case. If there are no other financing
available, managers will have no choice but to forgo the project.

4.2.6. Case IV – The Project is Financed with Debt

How debt financing can solve this underinvestment problem?

Now, suppose the firm uses subordinated debt, which requires a 5% rate of return. The payoff
table if the firm takes the project:

Good Bad
(prob. = 0.5) (prob. = 0.5)
Total Payoff

Payoff to Old Debt

Payoff to New Debt
Payoff to Equity

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In order to raise $100m, the present value of new debt must be $100m:

The face value of the new debt is $111m. The new payoff table becomes:

Good Bad
(prob. = 0.5) (prob. = 0.5)
Total Payoff

Payoff to Old Debt

Payoff to New Debt
Payoff to Equity

Again, the existing shareholders will make the decision based on the payoff to equity.

PV(Equity)
Good Bad
(prob. = 0.5) (prob. = 0.5)

Do Not Take

Take

With debt financing, whenever there is Bad state, the firm will not take the project. It will
take it only when Good state occurs. In this case, the market can infer nothing upon seeing
the issue of the debt. This case says one important message: When firm must seek outside
financing, it will prefer debt to equity.

To summarize the insights from the example:

1. When information is asymmetric, the firm knows the true value of the shares, while the
market does not. If the outlook is very favorable (i.e., Good state will occur), then the
true value of the shares exceeds the current price since the market does not know that a
very favorable state is expected.

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2. Since the current price is very low relative to its true value, the firm must issue a large
number of shares, each of which is much underpriced. If the true value is much higher
than the issue price, then many shares need to be issued that the old shareholders’ stake in
the firm is reduced so much. If the loss due to dilution exceeds gain from their share of
the new project, they are better forgoing the new project even if it is profitable.

3. If the outlook is bad, managers who act on behalf of the old shareholders will issue equity
for sure. The market will infer from manager’s action and discount the share price
accordingly.

4. But when the firm issues debt instead of equity, the underpricing will be reduced since the
new bondholders are quite sure of what they will get. The shareholders will not suffer
much from the dilution effect.

4.3. Implications of the Pecking Order Theory

1. Internal equity is better than external equity.

 Internal equity refers to internally generated funds, that is, retained earnings.
 Internal equity is the cheapest since it has no issuance costs and requires no private
information release.

2. Financial slack is valuable.

 Financial slack means cash, marketable securities, and readily saleable real assets.
 It relieves managers’ fear of passing up positive NPV projects when external
financing is required.

3. Debt is better than equity if external financing is required.

 Asymmetric information drives the firm to issue the type of security with least
adverse selection effect.
 If equity is overvalued, managers will issue equity. If equity is undervalued,
managers will issue debt to minimize the bargain handed to investors.

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4. The pecking order theory explains why stock price falls when equity is issued.

 If firm acts in the interest of existing shareholders, then the announcement of an

equity issue is always bad news.
 The same is true in an equity-for-debt exchange offer. It amounts to a new issue of
common stock.

5. The pecking order theory also explains the inverse relationship between profitability and
leverage.

 Highly profitable firms have large retained earnings to fund their investments.
 They rely less on external financing and thus have low leverage ratio.

6. However, small growth firms, which suffer most from the asymmetric information, rely
more on equity financing.

 The fact that a lot of small and high growth firms issue equity during the internet
boom is a challenge to the pecking order theory.

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5. Topic 5 – Initial Public Offering

The transition from private to public ownership is a major step in the lifecycle of a company,
involving a complex and often challenging process of dealing with regulators, investors and
professional parties, while continuing to run the company’s business. As one of the world’s
preeminent international financial centers, Hong Kong has become a destination of choice for
many companies seeking to make this transition through an initial public offering (IPO) and
listing on the Hong Kong Stock Exchange.

This topic aims to help companies and their advisers successfully navigate this transition by
providing a comprehensive overview of the IPO process in Hong Kong, with an emphasis on
listings on the Main Board of the Hong Kong Stock Exchange.

This topic covers the IPO process from the preliminary planning stages and pre-IPO
considerations all the way up to, and including, a listed company’s post-IPO obligations.

The structure of this topic is divided into six parts:

 Part 1 – Deciding to Go Public

 Part 2 – Key Requirements for a Listing in Hong Kong
 Part 3 – The Key Parties
 Part 4 – Pre-IPO Reorganization
 Part 5 – The IPO Process
 Part 6 – The IPO Performance

5.1. Part 1 – Deciding to Go Public

Going public is a monumental decision for any company. The preparation for “being public”
is just as crucial as the preparation for “going public”. When considering an IPO, a company
should carefully evaluate both the benefits and the burdens of becoming, and maintaining itself
as, a public company. A company may also wish to evaluate alternatives to achieving capital
raising, liquidity or other goals.

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5.1.1. Benefits and Burdens of Going Public

The benefits of being a public company:

 Raise capital and provide liquidity for current investors.

 Increase market value and name recognition.
 Research analyst coverage.
 Future access to capital for growth.
 Securities become attractive currency to potential acquisition targets.
 Improve corporate governance and transparency.

The costs of being a public company:

 Increased expenses.
 Significant disclosure obligations.
 Pressure for financial performance.
 Restrictions on insider dealing.
 Increased risk of legal exposure.
 Investor relations management.

5.1.2. Is the Company Ready for Listing?

To become a listed company is a significant decision and milestone for the development of a
company and this provides great access to equity and debt capital markets for growth.
Nevertheless, there are many key matters to consider before making such a decision.

Before embarking on an IPO, a company’s board and management should objectively assess
their readiness for life as a public company. The company shall ask the following questions
in order to know if it is ready for listing.

1. What is the rationale for listing the company?

2. Are the company and its management aware of the time and cost involved in a listing
exercise?

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3. Are the shareholders ready to accept a degree of loss of control in the company, where
certain transactions may require the prior approval of the company’s independent
shareholders?

4. Is the management prepared to accept the rigorous on-going obligations that is demanded
of a listed company and accept closer scrutiny by the public?

5. Are the directors aware that any changes of personnel at the board level may affect the
company’s share price and investor confidence?

6. Is the company’s management willing to commit time to meeting and communicating

with its investors and research analysts?

7. Will the management be able to balance the company’s short term performance such as
maximizing shareholders’ value with its longer term corporate strategy?

8. Are the directors aware of their fiduciary duties and restrictions on dealings once a
company is listed?

5.1.3. Why List in Hong Kong?

Once a company decided to pursue a listing, the next step is to choose the most suitable market
for listing. The Hong Kong Stock Exchange is an attractive listing venue for many local and
international businesses.

The advantages of listing in Hong Kong include:

 Hong Kong acts as a gateway to Mainland China and Asia and offers opportunities
for greater exposure to China and the rest of Asia.
 Hong Kong has a well-established legal system based on English common law, as
well as a sound regulatory framework that promotes a high level of disclosure from
listed companies.
 The Exchange promotes the use of international accounting standards, as well as
other recognized accounting standards under certain circumstances, such as
secondary listings.
 Hong Kong provides for the free flow of capital, with tax advantages, currency
convertibility and the free transferability of securities.

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  Hong Kong has continued to develop as an offshore RMB fundraising center, which
provides future fundraising opportunities for companies seeking to expand in
Mainland China.

5.1.4. Expenses of a Hong Kong IPO

In order for a company to list, many tasks have to be completed, and for each of these tasks
there is a cost. Many factors play a role in determining the cost of an IPO, but in all cases,
the costs of going public are significant. Professional fees must be paid to sponsors, legal
counsels, accountants and other experts. The total fees are highly dependent on the size and
complexity of the offering, as well as the quality and reputation of the professionals.

The main categories of expenses for a Hong Kong IPO are as follows:

 Sponsors and underwriters.

 Company legal counsel.
 Underwriters’ legal counsel.
 Local counsel, if any.
 Auditors.
 Internal control consultants.
 Property valuers, if any.
 Technical consultants, if any.
 Financial printer.
 Public relations firm.
 Roadshow expenses, including travel and accommodation.
 Share registrars and transfer agents.
 Market research firm, if any.
 The Exchange’s initial listing fee.

Among the cost components, the underwriting fee is the biggest cost item. It is about 2.5%
of the funds raised. Professional fees are the next largest item, they include Company legal
counsel; Underwriters’ legal counsel; Auditors; Internal control consultants; Property valuers;
Financial printer; and Public relations firm. The HKEx’s initial listing fee, share registrars
and transfer agent are generally a relatively small component.

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5.1.5. Overview of the Listing Process

An initial public offering is actually a series of related processes culminating in the sale of
stock to the public and the establishment of a public market for the company’s securities. The
IPO process, in general, contains three stages: the pre-listing; during the listing; and the post-
listing. Each process can be challenging. It requires a large commitment and realistic
timelines.

5.1.5.1. Pre-listing

At the pre-listing stage, the managers first determine the listing business. They discover the
equity story and realize the company has a business with a proven track record and exciting
business prospects. They have some ideas about how to go for a listing to raise funds and to
enhance the company’s reputation.

Once the managers have determined the listing business, the company will assess the readiness
for a public listing. At this stage, the firm may be re-organized under various companies with
a different ownership structure. Certain businesses will not be included in the listing plan
have to be taken out. It is important to conduct a corporate restructure to streamline the
company and put all relevant business under a single listing vehicle. In addition, companies
may have funding needs before going public. Some of them will seek angel or strategic
investors at this stage to obtain funding on the one hand and to access their business experience
on the other.

After the company has decided to go public, there are still various important issues to consider.
The company has to strengthen its corporate policies as necessary to become a public company.
It generally undertakes a comprehensive review of its financial, legal and business processes
in order to meet public market expectations.

5.1.5.2. During the Listing

Once the company has decided to go public, the IPO process begins with forming an internal
working team to deal with the demands of listing. The company has to appoint various
professional parties for the IPO, including sponsors and underwriters, the reporting accountant,
lawyers, and a valuer.

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The professionals will prepare the offering document to apply for the listing. The regulatory
authorities will review the offering document and pose questions throughout the vetting process
until the document is finally approved. Only after the offering document is approved, the
company can start marketing roadshow to sell the shares.

5.1.5.3. Post-listing

The IPO process does not end after the company has listed. From time to time, a listed
company will be under strict public scrutiny to disclose up-to-date information to investors.
Regulatory authorities require at least an interim report and an annual report to be published
and issued to shareholders within a given timeframe.

5.2. Part 2 – Key Requirements for a Listing in Hong Kong

In Hong Kong, our Exchange operates two markets on which companies may choose to list
their shares:

1. Main Board

 A market for more established businesses that fulfill profit or other financial
requirements.

2. GEM Board

 A second board and a stepping stone towards the main board, for those companies
that cannot or do not yet fulfill the main board listing requirements.

The Listing Rules sets out the basic qualifications which have to be met as a prerequisite for
the listing of equity securities on the Main Board of the Exchange. To satisfy the HKEx that
it and its business are suitable for listing, the company must have a track record that meets
prescribed benchmarks.

5.2.1. Regulatory Background

Stock Exchange of Hong Kong (HKEx) receives IPO applications and administers the listing
process. It is the primary regulator of Hong Kong listed companies.

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While the HKEx is the front-line regulator of Hong Kong listed companies, the Securities and
Futures Commission (SFC) is the principal regulator responsible for administering the laws
governing the securities and futures markets in Hong Kong. Under the so called “dual-filing”
regime established by the listing rules, copies of all listing documents and all on-going
disclosure documents filed with the HKEx must also be filed with the SFC.

The SFC reviews draft listing documents and may object to a company listing on the Exchange
if it considers the disclosure in the listing document to be inadequate. The inclusion of false
or misleading information in listing documents, or in any documents filed under the on-going
disclosure requirements, is potentially a criminal offence under the Securities and Futures
Ordinance and the SFC may investigate and bring prosecutorial actions in appropriate cases.

5.2.2. Listing Criteria

The basic qualifications for listing on the Main Board and GEM are detailed in Chapter 8 and
Chapter 11 of the Main Board and GEM Rules, respectively. The principal requirements are
set out below.

5.2.3. Track Record Requirement

A Main Board new applicant must have an adequate trading record under substantially the same
management and ownership. It must satisfy the following:

 Have a trading record of not less than three financial years.

 Have management continuity for at least the three preceding financial years.
 Have ownership continuity and control for at least the most recent audited financial
year.

This trade record period is intended to enable the HKEx and investors to make an informed
assessment of the management’s ability to manage the applicant’s business and the likely
performance of that business in the future.

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In the case of Main Board listing applicants, HKEx will accept a shorter trading record period
under substantially the same management, if the applicant qualifies for listing under the Market
Capitalization / Revenue Test (see below) and it is able to demonstrate that its directors and
management have sufficient and satisfactory experience of at least three years in the line of
business and industry of the applicant and there is management continuity for the most recent
audited financial year.

HKEx may also accept a shorter trading record period for a Main Board listing applicant if:

 The applicant is a mineral company and its directors and senior management have
sufficient and satisfactory experience of at least five years in relevant mining and/or
exploration activities.
 The applicant is a newly formed “project” company engaged in infrastructure
projects with long-term concession or mandates awarded by the government and its
directors and management have sufficient and satisfactory experience of at least three
years in the line of business and industry.
 The applicant has a trading record of at least two financial years and HKEx is
satisfied that the listing of the applicant is desirable in the interests of the issuer and
investors and the investors have the necessary information to enable to arrive at an
informed assessment concerning the applicant and the securities for which listing is
sought.

5.2.4. Financial Requirement

Main Board listing applicants must also meet one of the following three financial tests:

 Profit Test
 Market Capitalization / Revenue Test
 Market Capitalization / Revenue / Cash Flow Test

78
 Market
Market
Capitalization /
Profit Test Capitalization /
Revenue / Cash
Revenue Test
Flow Test
At least HK$50m in
the last three
financial years (with
profits of at least
HK$20m recorded
Profit Attribute to
in the most recent --- ---
Shareholders
year, and aggregate
profits of at least
HK$30m recorded
in the two years
before that)
At least HK$500m At least HK$500m
for the most recent for the most recent
Revenue ---
audited financial audited financial
year year
Positive cash flow
from operating
activities of at least
Cash Flow --- --- HK$100 million in
aggregate for the
three preceding
financial years
Market At least HK$200m At least HK$4b at At least HK$2b at
Capitalization at the time of listing the time of listing the time of listing

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5.2.5. Shareholding Requirement

The shareholding requirements aim to maintain an open and adequate market in the securities
for which a listing is sought.

 The expected market capitalization of a new applicant at the time of listing must be
at least HK$200 million.
 At least 25% of the issuer’s total issued share capital must at all times be held by the
public. The Exchange may, at its discretion, accept a lower percentage of between
15% and 25% in the case of issuers with an expected market capitalization at the time
of listing of over HK$10 billion.
 The equity securities in the hands of the public should be held among at least 300
holders.
 Not more than 50% of the securities in public hands at the time of listing can be
beneficially owned by the three largest public shareholders.

5.2.6. GEM Listing Requirement

GEM is designed to provide capital formation opportunities for emerging companies. The
major difference in respect of the listing requirements between the Main Board and GEM is
the lowered financial criteria for GEM applicants.

A GEM listing applicant must satisfy the following listing criteria:

 A market capitalization of at least HK$100 million at the time of listing.

 A positive cash flow from operating activities of at least HK$20 million in the
aggregate for the two financial years before listing.
 A trading record of at least two financial years, with management continuity in the
two financial years before listing and ownership continuity and control in the full
financial year before listing.
 At least 25% of the issuer’s total issued share capital, subject to a minimum of
HK$30 million, must at all times be held by the public.

The Exchange may also accept a shorter trading record period and waive or vary the ownership
and management requirements for natural resources exploitation companies or newly formed
“project” companies, provided that the applicant must nevertheless meet the cash flow
requirement of HK$20 million for that shorter trading record period.

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5.2.6.1. Transfer of Listing from GEM to Main Board

An issuer may apply for a transfer of listing of its securities from GEM to the Main Board if:

 It meets all the qualifications for listing on the Main Board set out in the Exchange
Listing Rules (listed on GEM for one year).
 Once it complies with GEM rule in respect of its financial results for the first full
financial year commencing after the date of its initial listing.
 In the 12 months preceding the transfer application and until the commencement of
dealings in its securities on the Main Board, it has not been the subject of any
disciplinary investigation by the Exchange in relation to a serious breach or potential
serious breach of any GEM Listing Rules or Exchange Listing Rules.

No sponsor is required. But it requires an announcement by the issuer, to be pre-vetted by the

Listing Division and approved by the Listing Committee. An issuer may not effect any
acquisition or disposal which would result in a fundamental change in its principal business
activities.

5.2.7. Other Salient Features of the Main Board and the GEM Rules

5.2.7.1. Appointment of Compliance Adviser / Compliance Officer

Main Board:

 An issuer must appoint a compliance adviser acceptable to the Exchange for the
period commencing on its listing date and ending on publication of financial results
for the first full financial year after listing.

GEM Board:

 One of a GEM issuer’s executive directors must be designated as a compliance

officer to ensure that the company complies with the GEM Rules and other relevant
laws and regulations, and to respond promptly and efficiently to enquiries directed
to him by the Exchange.

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5.2.7.2. Accounting Standard

A listing applicant’s accounts must be prepared in accordance with one of the following
standards:

 Hong Kong Financial Reporting Standards.

 International Financial Reporting Standards.
 China Accounting Standards for Business Enterprises (in the case of a PRC-
incorporated issuer).

An applicant must apply one of these standards consistently and not change from one body of
standards to another.

5.2.7.3. Financial Reporting

Main Board and GEM listed companies are required to post their annual reports, interim reports
and financial statements for public viewing.

Main Board:

 The reporting deadline for publishing results announcements is three months after
the period ends. The reporting deadline for issuing annual reports is four months
after the period ends.
 The reporting deadline for publishing results announcements is two months and for
interim reports is three months after the period ends.

GEM Board:

 For annual reports, the reporting deadline for publishing results announcement and
issuing reports is three months after the period ends.
 For quarterly and interim reports, the reporting deadline for publishing results
announcement and issuing reports is 45 days after the period ends.

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5.3. Part 3 – The Key Parties

Staging a successful IPO typically involves expert direction and assistance from a team of
professionals, including a sponsor, lawyers, auditors, underwriters and various other
professional parties. The new applicant should carefully consider the ability, experience and
commitment of the working group it appoints, given the importance of the advice and
assistance they will provide throughout the process. For this reason, assembling a high-
quality team is one of the more important tasks the issuer will undertake at the beginning of
the IPO process.

It is also worth noting that both the Exchange and the SFC play a significant part in the IPO
vetting and approval process. Keeping in mind the impact they can have on the IPO process
is also an important factor when choosing the working group.

Before describing the process of going public, it is useful to review the members of the public
offering team and their various roles.

5.3.1. Board of Directors and Management

The applicant’s board of directors and its management, usually led by the chief executive
officer and chief financial officer, play a critical role in the listing process.

In consultation with the sponsor and the company’s legal counsels, they make the major
structural and timing decisions affecting the IPO. The directors are collectively, and each
director is individually, responsible for the accuracy and completeness of the information
contained in the prospectus. Key responsibilities include:

 Assisting the working group to understand and describe in the prospectus the
business, strategies and strengths, as well as the risk factors, of the listing applicant.
 Providing the working group with information and documents about the company
for due diligence, drafting sessions and the prospectus verification process.
 Reviewing the draft prospectus and submissions to the Exchange and the SFC.
 Making presentations to the financial and investor community during roadshows.

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5.3.2. Sponsor

Every new application for listing must be sponsored. The Exchange considers the role of
sponsor critical in bring a new applicant to listing, and the sponsor forms an integral part of the
IPO assessment process. Sponsor is the overall management of the IPO.

Recent changes have been made to the Hong Kong regulatory regime that governs sponsors to
enhance various aspects of the sponsor's role in the IPO process and ensure that sponsors
thoroughly understand the listing applicant's business prior to filing a listing application.

Under the new rules, the emphasis will be on early, comprehensive due diligence and a properly
drafted and substantially complete prospectus to accompany the application.

The changes also include amendments to the Hong Kong Companies Ordinance to clarify that
statutory civil and criminal liability for misleading information in a prospectus applies to IPO
sponsors. Criminal liability will depend on whether a sponsor firm knowingly or recklessly
approved a prospectus containing an untrue statement (including an omission) that was
materially adverse from an investor's perspective.

The sponsor is the first professional party appointed by a listing applicant in the IPO. The
key responsibilities include:

 Performing due diligence to assess whether the listing applicant is fit for listing in
Hong Kong.
 Preparing the prospectus and other listing documents.
 Working with the listing applicant to select other professional advisers to build up an
IPO team.
 Advising the listing applicant on the reorganization of the group structure and
management structure.
 Acting as the primary channel of communication with HKEx regarding all matters
relating to the listing application.
 Submitting all formal listing application forms and supporting documents to HKEx.
 Liaising with all professional parties to reply to HKEx’s comment letters.
 Organizing roadshows and investor meetings.
 Working with all underwriters to market the offer shares to investors.
 Determining offer-timing and final offer price.

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5.3.3. Property Valuers

The independent property valuer is responsible for determining the valuations of, and providing
information on, certain property interests of the applicant for inclusion in the prospectus.

Chapter 5 of the Listing Rules sets out the specific valuation requirements for listing applicants.
Different valuation requirements are set for the “property interests” of “property activities” and
those of “non-property activities”.

If the listing applicant engages in property activities, the carrying amount of property interests
below 1% of total assets is exempted from independent valuation. The exemption clause is
subject to a cap which means that the total non-valued property interests must not exceed 10%
of total assets.

If the listing applicant engages in non-property activities and the carrying amount of property
interests is 15% of the total assets or above, an independent property valuation report is required.

5.3.3.1. Methods of Valuation

The aim of valuation for IPO is to appraise the market value for those properties whereas
assessment is required corresponding to the Rules. In practice, the property valuer uses the
following approaches in valuation.

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1. Direct comparison or market approach

 The most widely used method in Hong Kong.

 The property under consideration is directly compared with similar properties which
have been sold recently.
 It formulates realistic adjustments regarding time, location, building age, size, design,
quality, plot ratio and other relevant factors.

2. Replacement cost approach

 It is used to value the type of properties which rarely change hands and for which
there are few or no comparable.
 The buyer will not pay more for a property than it would cost to build an equivalent.
 Make reference to the current construction costs for similar buildings and structures
in the locality.

3. Income approach

 It determines the future actual rents the property will produce.

 It capitalizes all future discounted rental income over the remaining tenure of the
property.

4. Residual approach

 Used for properties ripe for development or redevelopment or for bare land only.
 Ascertain the development proposal, work out the gross development value of a
property upon completion. Deduct the cost of development including construction
cost, professional fee, interest payment, developer’s profit and other factors.
 The basic formula for a residual appraisal is (Gross Development Value – Cost –
Developer’s Profit).

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5.3.4. Accountants

Under the Main Board listing rule, reporting accounts must be appointed for the preparation of
various public reports and letters for inclusion in the prospectus. The reporting accountant
plays an indispensable role in the IPO process. The role contains three main elements:

 Expressing an independent opinion on the financial information of the listing

applicant, including the opinion in the prospectus.
 Providing various public reports and letters for inclusion in, or private letters in
connection with, the prospectus.
 Assisting the sponsor in conducting their due diligence investigation of the listing
applicant’s affairs.

5.3.5. Lawyers

In every IPO project, at least two teams of lawyers are engaged. One team acts as the advisor
for the listing applicant and the other team advises the sponsor.

The listing applicant’s legal advisers advise and guide the directors throughout the IPO process.
Their major duties include:

 Advising and guiding the directors throughout the IPO process.

 Advising on the corporate structures and steps required to effect any group
reorganization.
 Drafting and preparing the listing documents.
 Assisting the applicant in drafting responses to questions from the Exchange and the
SFC.
 Reviewing and negotiating the underwriting agreements on behalf of the applicant.
 Drafting lockup agreements.

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The other team advises the sponsor. Their duties include:

 Being involved in gathering and reviewing information about the applicant in order
to assist the underwriters in meeting their due diligence obligations.
 Assisting the sponsor in addressing all matters raised by the Exchange in connection
with the listing application.
 Drafting and negotiating underwriting agreements on behalf of the sponsor and
underwriters.
 Negotiating the content of comfort letters with the reporting accountants.
 Leading the prospectus verification process.

5.4. Part 4 – Pre-IPO Reorganization

Group restructuring may be defined as the significant reorganization of a group’s assets and
liabilities. It would involve a change to the existing group, whether in terms of the holding
structure, operating structure, organization structure or financing structure.

In most cases, a group restructuring is required to prepare for an IPO. Many private groups’
shareholding and operating structures are not set up for an IPO, and it is not uncommon that
the group companies are owned directly by individuals and not through holding companies.
Structures like this would result in difficulties in IPO and it is normally necessary to consolidate
the operating companies under one or more intermediate holding companies. Consolidating
operating companies under the ownership of different holding companies provide flexibility as
spinning off or listing certain divisions of the private group is normally desirable.

Ahead of listing, a company will often undergo a reorganization, not only to ensure compliance
with the Listing Rules but also to ensure that the structure of the business meets public market
expectations. The restructuring steps undertaken in preparation for an IPO will vary,
depending on the existing and intended group structure.

Pre-IPO restructuring aims at resolving the following issues:

 Commercial
 Personal or family
 Legal
 Taxation
 The planning of future restructuring

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5.4.1. Commercial Reasons

A company should consider its group structure, including which business divisions to include
in the listing and how business operations should be divided amongst legal entities.

Pre-IPO restructuring may enhance the prospective listing group’s profitability and market
value by:

 Injecting quality assets into the group.

 Spinning off non-profitability subsidiaries and inactive companies from the group.
 Merging of several entities.
 Transferring assets from one legal entity to another to make sure the business
divisions align and that all the relevant assets and contractual rights are owned by the
company group that is being listed.
 Reorganizing internal governance and controls.

5.4.2. Legal Ownership

Due to various reasons such as personal reasons and foreign participation rules, the control or
legal titles of the investments under the pre-listing group may not be all held under the names
of the appropriate entity. Some of these investments may be held by the owner’s family
members, and some may be held through specific arrangements. To ensure that the listing
structure is all under proper legal ownership, legal titles of the relevant investments should, if
feasible, be transferred back to holding companies which are held by the original owner.

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5.4.3. Tax Efficient Structure

A pre-IPO restructuring also aims at building an operationally effective and tax efficient listing
structure. In general, the following should be taken in consideration when designing the
listing structure:

 Income tax implications – Examples would be the income tax rate and the availability
of preferential tax treatments for setting up a particular business, such as a high and
new technology enterprise in a particular location like the Industrial Park or Software
Park in China.
 Turnover tax implications – Examples would be value added tax and sales tax.
 Tax implications for profit repatriation – This is important when selecting an
appropriate intermediate holding company for the group’s operating companies. A
company incorporated in a tax jurisdiction with a beneficial double tax treaty rule
may enjoy a more preferential withholding tax rate on its overseas passive income
derived, in terms of dividends, royalties and interest. For example, if a Chinese
entity’s foreign investors are Hong Kong companies with commercial substance, the
China withholding tax rate on dividend repatriation can be reduced from 10% to a
preferential rate of 5%.
 The transfer pricing regulations and the related reporting requirements.
 The future exit strategy of investors and the related tax implications.

These specific tasks call for experience in IPO tax issues, which become more complex when
more foreign jurisdictions are involved.

5.4.4. Personal or Family Reasons

Personal or family reasons such as asset protection – where, for example, the initial owner sets
up a trust for his family before the IPO – may also be one of the considerations for pre-IPO
restructuring.

5.4.5. The Planning of Future Restructuring

The pre-IPO restructuring plan needs to look to the future. When the company considers the
organizational structure, it needs to operate at the most efficient – both legal and tax level
possible. For example, the company will incur stamp duty and capital duty when it spin-offs
its group assets wholly or partly.

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5.4.6. Major Steps in Restructuring

Below is a typical pre-IPO structure of a company for the purpose of listing in Hong Kong. It
assumes that all investments are under proper legal ownership. The individual investors with
investments in different countries are shown:

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5.4.6.1. Step 1 – Streamline the Structure

In order to streamline the group structure, certain companies such as inactive companies or
companies which are not intended to be put in the listing group would be spun out.

First, it is essential to ensure that the listing group will hold all assets necessary to carry on a
focused line of business operations. In this case, that would be the DVD business. Certain
companies, such as the restaurant business which is not intended to be put in the listing group
would be separated.

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5.4.6.2. Step 2 – Insert a Holding Company

An appropriate group holding company is inserted. The following factors may be considered
when choosing the countries to incorporate the group holding company:

 Taxation system.
 Applicability of withholding tax on dividends, interest and royalties.
 Sufficiency of legal protection.
 Political stability.

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5.4.6.3. Step 3 – Insert an Appropriate Listing Vehicle

An appropriate listing vehicle, such as a Bermuda or Cayman Island company which is

accepted by HKEx is selected.

5.4.7. Assets Acquisition and Divestiture: Some Considerations

Recall that during the pre-IPO reorganization, the issuer has to transfer assets from one legal
entity to another to make sure the business divisions align and that all the relevant assets and
contractual rights are owned by the company group that is being listed. If the transfer involves
connected transactions, the terms of the connected transaction must be fair and reasonable, and
have proper disclosure to investors.

The shareholders should also consider whether the business under the non-listing business
entities is competing against the listing company. In addition, the company after restructuring
should be capable of carrying business independently.

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5.5. Part 5 – The IPO Process

An IPO typically requires a few months of intensive preparatory work before the A1
submission. The new sponsor regime, which came into effect in 2013, requires sponsors to
be formally appointed for a minimum period of two months prior to the submission of the
listing application.

In general, the duration of IPOs will last from six to twelve months and can be generally divided
into three main stages: the early phase, the marketing phase, and the post listing phase. This
graph summarizes some key milestones for the IPO process.

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5.5.1. An Overview

IPO projects typically commence with an all parties kick-off meeting, at which multiple
appointed professional parties are introduced and the preliminary background of the potential
issuer is presented, as well as the overall timetable is set out.

This shall be followed by a series of due diligence meetings to cover all areas including but not
limited to business, financial and legal aspects. The A1 submission comprises of a bundle of
documents, including a draft prospectus with various appendices of the accountants’ report and
property valuation report.

During the marketing phase, research analysts of syndicate underwriters will attend an analyst
presentation initiated by the issuer’s management to understand the detail background of the
issuer for the purpose of drafting a detailed pre-deal research report, which is to be distributed
to institutional investors globally.

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It usually takes four weeks between a listing hearing and commencement of trading. It begins
with an investor education period of around one week when research analysts of syndicate
underwriters travel to meet the institutional investors and receive feedback thereafter. It will
then come to a bookbuilding period of one to two weeks, during which the issuer’s management
will typically travel around the world to conduct roadshow presentations to institutional
investors. At the end of the bookbuilding period, depending on the overall market sentiment,
demand of the offered shares and price sensitivity of potential institutional investors, and the
joint global coordinators and joint bookrunners will consider the above factors and give their
recommendation to the issuer and agree on the final offer price.

Finally, the joint global coordinators and joint bookrunners will distribute allocations of shares
to sales and subsequently investors from international placing tranche and settlements of funds,
which is then followed by the commencement of trading on the Exchange.

5.5.2. The Early Phase

5.5.2.1. Due Diligence

When an issuer applies to list on the Exchange, sponsors are required to conduct due diligence
on the listing applicant. Sponsors are required by the HKEx to make declarations that the
listing applicant has established adequate procedures, systems and controls. The sponsors
must exercise its judgement as to what investigations or steps are appropriate for a particular
new applicant and the extent of each step.

There are three aspects to due diligence in an IPO:

 Business due diligence.

 Financial due diligence.
 Legal due diligence.

Both the business and financial due diligence generally consist of a series of interviews of or
question-and-answer sessions with senior management from relevant divisions of the issuer.

Understanding what constitutes reasonable due diligence inquiries and a reasonable ground for
belief, in the context of establishing a defense against liability, turns on understanding what
constitutes adequate due diligence.

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The following due diligence actions, among others, are advisable as appropriate:

 Interviewing company officers from various departments to explore all aspects of the
company’s business.
 Contacting major customers, suppliers, distributors, licensees and/or bankers to
verify management’s representations.
 Inspecting the factory in which the company’s products are manufactured.
 Reviewing the internal financial model with the company’s management and
inquiring about expected financial results.
 Reviewing trade journals and industry-related publications to ascertain industry
trends, market trends and competitive information.
 Subjecting the company’s budget to line-by-line scrutiny.
 Reviewing material contracts, board minutes and other corporate documents.
 Maintaining close involvement of management throughout the prospectus-drafting
process.

5.5.3. The Marketing Phase

One of the most important part of the IPO process is to sell the shares. Starting from
marketing preparation, pre-deal research and investor education till investor roadshow, pricing
and allocation, and finally listing, the whole process will usually takes around 10 weeks.

5.5.3.1. Sell-side Research

Research is important to assist in the marketing of IPOs to investors. Pre-deal research reports
are typically prepared by the research departments of the syndicate of underwriters and provide
an analysis of a listing applicant, its business and prospects. Such research reports can play
an important role in price discovery in the IPO process.

Pre-deal research reports are checked for factual accuracy against the contents of the prospectus.

Pre-deal research reports are important because all circulars are legal documents which include
many statements which are useful in limiting the liability of issuer, but they do not necessarily
offer a condensed and easy-to-read summary of the investment case.

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5.5.3.2. Valuation

Valuation is an important consideration for all issuers since this is what will, ultimately, drive
most of the demand and the offer price paid by investors.

There are many ways to value a business. Underwriters frequently use comparable firm
multiples to come up with a preliminary price. If a similar firm sells at a P/E of 20, and the
firm going public has a $2m in earnings, then it should be valued at $40m. Some common
multiples:

 Earnings multiples: P/E

 Sales and cash flow multiples: EV/Sales, EV/EBITDA
 Growth multiples: PEG
 Normalized multiples: P/B, P/NAV

However, sometimes several valuation methodologies are used because the issuer is involved
in distinct businesses to which separate valuation techniques need to be applied.

For example: MTR Corporation valued at the time its US$1.4 billion IPO in 2000 through a
sum-of-the-parts valuation:

 A discounted cash flow analysis was used to assess the value of its railway operations.
 A price-to-NAV valuation was separately used for its real estate business.
 In addition, a variety of other techniques were used to value peripheral assets.

5.5.3.3. Management Roadshow

The management roadshow is the process through which the senior management of the issuer
travels around the world to present the investment case to investors.

Four types of meetings can take place during an IPO roadshow:

 Large scale presentations.

 Small group presentations.
 One-on-one meetings.
 Internet roadshows.

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The IPO roadshow usually lasts around 9 days for the management to meet investors which are
most interested in the IPO as revealed by the syndicate’s sales and investor education feedback.

The roadshow is intended to present the investment story of the issuer, in order to confirm the
understanding and interest of the potential investors to place their orders. At the end of each
roadshow day, the joint global coordinators and joint book-runners will meet with the
management of the issuer to summarize and highlight the performance of the management in
the roadshow, including feedback from investors that were met. This would allow the issuer
to incorporate appropriate adjustments to facilitate better communications with investors for
the rest of the roadshow.

5.5.3.4. Underwriting

To distribute the shares, the managing underwriters may form a syndicate composed of other
investment banks. The syndicate members may agree to participate by either purchasing and
reselling the shares, or just marketing the shares to their institutional and individual clients.
The deal can be structured in a variety of ways.

1. Best efforts:

 Investment banks agree to help but do not actually purchase the shares.
 They act as intermediary between the issuing company and public investors. They
do not bear the risk of not being able to sell all new shares.

2. Firm commitment:

 Investment banks purchase all new shares issued by the company and resell to the
public.
 The investment banks get compensated by a discount on their purchase price, or a
spread between their purchase price and public offering price.
 The investment banks assume the full risk of not being able to sell shares to the public
at the stipulated offering price.

For Hong Kong IPOs, it is common for the issuers to enter best effort underwriting agreement
with the underwriters who do not have a commitment for the portion of shares to be
underwritten at the launch of the bookbuilding.

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Therefore, if the market condition and the demand on the shares offered are not satisfactory
after the investor education process, the issuer may consider entering into a firm commitment
arrangement to secure a portion of shares which are committed to be underwritten. For such
arrangement, the issuer agrees to pay an extra commission fee on the committed portion to the
hard underwriters.

5.5.3.5. Pricing and Allocating an IPO

HKEx uses a “Double Tranche” offering mechanism, which simultaneously contains a “Public
Tranche” for retail subscription and a “Placing Tranche” for international institutional investors
using bookbuilding methods. The hybrid system increases flexibility for underwriter in
determining the offer structure and selecting the potential shareholders, while retains a channel
for retail investors to participate in IPO investments.

The initial minimum allocation of shares to the public subscription tranche is 10%. The
policy is to ensure a sufficient supply of shares to satisfy the demand of Hong Kong retail
investors while otherwise allowing issuers and underwriters a sufficient degree of flexibility to
determine their offer structures.

Where the Hong Kong public offer tranche is oversubscribed, certain clawback arrangements
whereby given proportions of the shares will be transferred from the international placing
tranche to the Hong Kong public offer tranche. However, the Exchange will accept lower
clawback levels where the size of the offering is sufficiently large.

 A clawback mechanism that increases the number of shares to 30% when the total
demand for shares in the subscription tranche is 15 times but less than 50 times the
initial allocation.
 A clawback mechanism that increases the number of shares to 40% when the total
demand for shares in the subscription tranche is 50 times but less than 100 times the
initial allocation.
 A clawback mechanism that increases the number of shares to 50% when the total
demand for shares in the subscription tranche is 100 times or more the initial
allocation.

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5.5.3.6. Price Setting Mechanism

In Hong Kong, more than one type of price-setting mechanism is used in a single offer, where
a bookbuilding is followed by a fixed price offer. The underwriters direct the bookbuilding
towards institutional and international investors. Once the price has been set via the
bookbuilding, the shares are offered at the same price to the domestic retail investor base in a
fixed price offering.

1. Bookbuilding

 Book building is a mechanism in which underwriters canvas potential buyers and

then set an offer price. A key feature of bookbuilding is that the underwriter has
complete discretion in allocating shares.
 Institutional investors, who might be expected to buy and hold the securities, would
be favored.
 Also, investors who were willing to buy issues when demand was weak would be
rewarded with favorable allocations when demand was strong.

2. Fixed-price offer:

 A fixed-price offer has the offer price set prior to requests for shares being submitted.
If there is excess demand, shares are typically rationed on a pro rata or lottery basis.
 Frequent requests for large numbers of shares are cut back more than requests for
moderate numbers.
 Thus, there is no way for the underwriter to reward investors who provide
information.
 With a fixed-price offer investors must submit the money to purchase the requested
shares, without knowing whether they will receive any shares.

5.5.3.7. Pricing the Offer

The offering price is typically negotiated by the company, the sponsor, the underwriters and
the selling shareholders, if any. Generally speaking, the company will aim for the highest
price that will facilitate the distribution of the offer shares. In contrast, the underwriters tend
to seek a price that will assure that the offering will be oversubscribed to ensure a strong
secondary market.

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The offer price is normally disclosed as an indicative offer price range, instead of a fixed price,
to allow greater flexibility in pricing the offer according to rapidly changing market conditions.
The indicative offer price range is determined after a careful price discovery process, taking
into account the valuation of the business and future development.

5.5.4. Post-listing

In every IPO there is the possibility of immediate instability in the aftermarket, when the stock
is traded between short-term buyers and sellers. This may affect the share price, which may
temporarily fall below the offer price. It is common for the issuer to appoint a stabilizing
agent to maintain the price of the securities during the initial period after listing.

Stabilization can be conducted through the use of an over-allotment option. This is also called
a “Greenshoe”:

 Upon allotment of the book of demand, an additional amount of stock is allocated at

the same time and at the same offer price to institutional investors.
 The amount of additional stock is typically 15% of the base offer size.
 If the investment bankers expect aftermarket demand to be hot, they will typically
presell 115% of the issue, with the expectation that they will exercise the
overallotment option.
 If the investment bankers expect aftermarket demand to be weak, they will typically
presell 135% of the offering, with the shares above the over-allotment option
representing a naked short position in the stock.

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When an IPO is priced, the underwriters typically will create a syndicate short position in the
company’s shares by accepting orders for more shares than are to be sold (i.e., by overallocating
shares). The underwriters may then do one of two things to cover these overallocations during
the stabilization period:

 If the share price increases during after-market trading, the underwriters typically
will cover their short position by exercising the over-allotment option and delivering
to investors the additional securities purchased from the company or controlling
shareholder at the lower IPO offer price.
 If the share price decreases during after-market trading, the underwriters typically
will cover their short position by purchasing shares from the secondary market
following the commencement of trading, which helps create buying power and
support the share price in the after-market.

5.5.4.1. How “Greenshoe” Works?

Suppose the underwriter hopes the investor will hold 10,000 shares for the long-run. Suppose
the investor will on average hold 75% of the shares allocated to them.

Allocation Hold
10,000
11,500
13,500

Therefore, there will be higher chance of allocating shares to long-term investors who have
less incentive to sell the shares immediately aftermarket. The total demand to hold the stock
may be larger if more shares are allocated initially.

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5.6. Part 6 – The IPO Performance

Below is a typical time-line of an IPO:

Extrawell Pharmaceutical Holdings (858.HK)

T=0 T=1 T=365

st th
offer day 1 trading day 250 trading day

P0 = $1.0 P1 = $1.1 P250 = $0.2

10/3/98 11/3/98 10/3/99

5.6.1. Short-run Performance Measure

For 858.HK:

P1  Poffer
Initial Return 
Poffer
1.1  1.0

1.0
 10%

5.6.2. Long-run Performance Measure

First, calculate the monthly market adjusted excess return:

ERit  Rit  Rmt

 where i = IPO firm i and t = IPO month t

Second, calculate the average market adjusted excess return:

1 N
ARt   ERit
N i 1

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Third, the cumulative average market adjusted excess return from month 1 to month 36 after
the IPO is:

36
CAR1,36   ARt
t 1

Example 5.1

Ri RHSI ERi
Stock 1 t=0 8% 20% –12%
t=1 10% 21% –11%
t=2 15% 25% –10%
Stock 2 t=0 –1% 21% –22%
t=1 4% 25% –21%
t=2 5% 25% –20%

Stock 1:

Stock 2:

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5.6.3. The Issue of Benchmarking

1. IPOs are typically small. For example, IPOs in Hong Kong are smaller than those firms
in the Heng Seng Index component stocks.

2. IPOs are from different industries; each IPO should be compared with its own industrial
benchmark.

3. Each IPO is unique in certain sense. We know stocks with different B/M, E/P, C/P ratio
will have different returns. Therefore:

 Each IPO should be matched by its ratio of B/M, E/P, C/P or has its own matching
firm as a benchmark, instead of using Hang Seng Index for all IPOs.

5.7. Short-run Underpricing of IPOs

On average, the closing market price on the first day of trading of an IPO is higher than the
offer price. In every country with a stock market, IPOs are underpriced. While on average
there are positive initial returns on IPOs, there is a wide variation on individual issues.

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108
5.7.1. Explanations of Underpricing

It is useful to think of the IPO process as a game involving three players: issuing firms,
investment bankers, and investors. The objectives of the three players are quite different. A
number of reasons for the short-run underpricing of IPOs have been advanced which give
different weights to the objectives of the three players. In general, these reasons are not
mutually exclusive, and their relative importance differs across countries, contractual
mechanisms, and time.

5.7.1.1. Dynamic Information Acquisition

Investment bankers where book building is used may underprice IPOs to induce regular
investors to reveal information during the pre-selling period, which can then be used to assist
in pricing the issue.

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The regular investors can be thought of as institutions. Each regular investor observes private
information, which is not known to the issuing firm and its underwriter.

In order to induce regular investors to truthfully reveal their valuations, the investment banker
compensates investors through underpricing.

5.7.1.2. Prospect Theory

In some circumstances, issuers do not object to severe underpricing, even though pre-issue
shareholders could have retained a larger fraction of the equity if the same amount of money
had been raised by selling few shares at a higher price.

This was most apparent during the internet bubble of 1999 and early 2000, when over a dozen
U.S. firms agreed to offer prices that resulted in first-day returns exceeding 300%. For
example, Akamai Technologies sold 9 million shares at $26 per share and saw a first-day
closing price of over $145, leaving over $1 billion on the table.

At the pricing meeting, their lead underwriter, Morgan Stanley, told the executives of the firm
that a market price of over $100 was anticipated.

Prospect theory, developed by Kahneman & Tversky (1979), is a descriptive theory of behavior
that asserts that people focus on changes in their wealth, rather than the level of their wealth.

Loughran & Ritter notice that most of the money left on the table (= number of shares offered
× (closing price on the first day – offer price)) is by the minority of firms where the offer price
is revised upward during the book building period.

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This can be seen in the Table below. Those IPOs for which the offer price is revised upwards
will be more underpriced than those for which the offer price is revised downwards.

For these issuing firms, the executives are seeing a personal wealth increase relative to what
they had expected based on the file price range.

Loughran & Ritter argue that the issuing firm’s executives bargain less hard for a higher offer
price in this circumstance than they otherwise do.

5.7.1.3. Corruption

Loughran & Ritter (2001) argue that there is an agency problem between the decision makers
at issuing firms (the top executives and venture capitalists) and other pre-issue shareholders.

This also contributes to the willingness to hire underwriters with a history of leaving large
amounts of money on the table.

While underpricing results in excessive dilution of all pre-issue shareholders, an underwriter

with other hot IPOs to allocate can make side payments to the decision maker of an issuing
firm.

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This is done by setting up a personal brokerage account for these individuals, and then
allocating hot IPOs to these accounts, a practice known as “spinning”.

Loughran & Ritter (2001) argue that underwriters competed for IPO business during 1999 –
2000 partly through promising to allocate hot IPOs to the personal account of the chief
executive of an issuing firm.

The executive would be willing to hire an underwriter that was expected to underprice the
firm’s IPO because, in return, the executive would receive other hot IPOs.

U.S. House of Representatives Financial Services Committee documents (August 2002) show
that Salomon Smith Barney allocated hot IPOs to the chief executives of many
telecommunications firms during 1996-2000.

During this period, Salomon Smith Barney had a large market share of equity underwriting and
M&A business in this industry.

5.7.1.4. The Winner’s Curse

With fixed-price offers, potential investors face an adverse selection, or “winner’s curse”
problem.

Since a more or less fixed number of shares are sold at a fixed offering price, rationing will
result if demand is strong.

Rationing itself does not lead to underpricing, but if some investors are at an informational
disadvantage relative to others, some investors will be worse off. If some investors are more
likely to buy shares when an issue is underpriced, then excess demand will be higher when
there is more underpricing. Other investors will be allocated a smaller fraction of the most
desirable new issues, and a larger fraction of the least desirable new issues.

They face a winner’s curse: if they get all of the shares which they ask for, it is because the
informed investors do not want the shares.

Faced with this adverse selection problem, the less informed investors will only submit
purchase orders if, on average, IPOs are underpriced sufficiently to compensate them for the
bias in the allocation of new issues.

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Example 5.2

Suppose the initial offering of 100 shares is at $80.

 Informed investors know aftermarket price will be $90. They place bid of 900
shares.
 Uninformed investors place bid of 100 shares.

Total bid of 1,000 shares: 10 times oversubscription.

 Informed investors receive 9/10 of the offer.

 Uninformed receive only 1/10.

Suppose informed know that the aftermarket price will be $70.

 They place no bids.

 Uninformed investors still place a bid of 100 shares.

5.7.1.5. Informational Cascades

Welch (1992) suggests that if potential investors pay attention not only to their own information
about a new issue, but also to whether other investors are purchasing.

Bandwagon effects, or informational cascades, may develop.

If an investor sees that no one else wants to buy, he or she may decide not to buy even when in
possession of favorable information.

To prevent this from happening, an issuer may want to underprice an issue to induce the first
few potential investors to buy, and induce a cascade in which all subsequent investors want to
buy irrespective of their own information.

5.7.1.6. Lawsuit Avoidance

The frequency and severity of future class action lawsuits can be reduced by underpricing,
since only investors who lose money are entitled to damages.

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However, underpricing the IPO is a very costly way of reducing the probability of a future
lawsuit.

Furthermore, others countries in which securities class actions are unknown, such as Finland,
have just as much underpricing as in the U.S. Fear of lawsuits has been mentioned as one
rationale for why internet IPOs were underpriced so much in 1999 – 2000.

This explanation is not plausible because after the stock price went up by hundreds of
percentage once it started trading, managing underwriters still have their analysts issue “buy or
“strong buy”.

5.7.1.7. Signalling

Some people argue that underpriced IPOs “leave a good taste” with investors, allowing the
firms and insiders to sell shares in the future at a higher price than would otherwise be the case.

However, various empirical studies find that the hypothesized relation between initial returns
and subsequent seasoned new issues is not present, casting doubt on the empirical relevance of
signaling as a reason for underpricing.

5.7.1.8. The IPO as a Marketing Event

Publicity is generated by a high first-day return. This publicity could generate additional
investor interest or additional product market revenue from greater brand awareness.

One has to wonder how expensive this advertising is compared to traditional advertising venues.

There is one piece of evidence, however, that is consistent with the IPO as a marketing event.
Habib & Ljungqvist (2001) note that the smaller the fraction of the firm sold, the lower is the
opportunity cost of a big first day runup.

In 1999 – 2000, many of the internet IPOs with large first-day price jumps sold less than 20%
of the shares in their IPOs.

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5.7.1.9. Conclusions of the Reasons for Underpricing

None of the explanations above can be the whole story but most of them have some element of
truth. Furthermore, the underpricing phenomenon has persisted for decades with no signs of its
imminent demise.

5.7.2. Long-run Performance

5.7.2.1. Evidence

Poor stock price performance of IPOs in the long-run (3 Years).

Most firms going public have relatively high market-to-book ratios, and most are "small-cap"
stocks.

 But small growth stocks in general have very low future returns.

The low returns in the aftermarket for IPOs partly reflect the pattern that IPO volume is high
near market peaks when market-to-book ratios are high. The underperformance is concentrated
among firms that went public in the heavy-volume years, and for younger firms.

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5.7.2.2. Reasons of Long-run Underperformance

1. The divergence of opinion hypothesis:

 Investors who are most optimistic about an IPO will be the buyers.
 If there is a great deal of uncertainty about the value of an IPO the valuations of
optimistic investors will be much higher than those of pessimistic investors.
 As time goes on and more information becomes available, the divergence of opinion
between optimistic and pessimistic investors will narrow, and consequently, the
market price will drop when the hot market is over.

2. The impresario hypothesis:

 The market for IPOs is subject to fads and that IPOs are underpriced by investment
bankers (the impresarios) to create the appearance of excess demand, just as the
promoter of a rock concert attempts to make it an "event".
 The hypothesis predicts that companies with the highest initial returns should have
the lowest subsequent returns. There is some evidence of this in the long run, but in
the first six months, momentum effects seem to dominate.

3. The windows of opportunity hypothesis:

 If there are periods when investors are especially optimistic about the growth
potential of companies going public, the large cycles in volume may represent a
response by firms attempting to "time" their IPOs to take advantage of these swings
in investor sentiment.
 This hypothesis predicts that firms going public in high volume periods are more
likely to be overvalued than other IPOs. This has the testable implication that the
high-volume periods should be associated with the lowest long-run returns. This
pattern indeed exists.

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5.7.3. Summary

Companies going public, especially young companies, face a market that is subject to sharp
swings in valuations. Pricing can be difficult, even in stable market conditions, because for
one thing insiders presumably have more information than potential outside investors. For
another, we even do not agree who have more accurate information: managers or institutional
investors.

To deal with these potential problems, market participants and regulators insist on the
disclosure of material information.

Regardless of theories, three patterns have been documented for IPOs:

 New issues underpricing.

 Cycles in volume (hot and cold markets) and the extent of underpricing.
 Long-run underperformance.

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6. Topic 6 – Seasoned Equity Offering

The need for external capital rarely ends at the IPO. Once a company is public, it is still able
to raise capital through what is called a seasoned equity offering (SEO). SEO is a broad term
that refers to any sale of shares by listed companies after the IPO.

The most common types of secondary issue in Hong Kong are rights issues (供股) and placings
(配股).

6.1. Rights Offer

In a rights issue, the company offers the shareholders the right to buy more shares at a
subscription price that is usually at a substantial discount to the market price.

Rights issues build upon pre-emptive rights. Pre-emptive right is the right, but not the
obligation, to existing shareholders to buy the new shares before they are offered to the public.
In this way, existing shareholders can maintain their proportional ownership of the company,
preventing stock dilution.

The example of HSBC’s 5-for-12 rights issue in 2009 clarifies the rights issue mechanism.
This 5-for-12 rights issue means an HSBC shareholder will be entitled to buy 5 new HSBC
ordinary shares for every 12 HSBC shares held, at a subscription price of HKD 28 per share.
If you have 1,200 HSBC shares, the number of new shares you are entitled to receive is 500.

Shareholders of HSBC will have three options in the rights issue:

 Exercise the rights.

 Sell the rights in the stock market.
 Do nothing.

Rights issues are favored in Hong Kong and other Commonwealth jurisdictions but are much
less popular in the United States. Rights offerings usually expire within a short time frame.
To address potentially unsubscribed rights offerings, there exist various underwriting methods.

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1. Uninsured rights offer

 There is no third-party agreement to pre-purchase the unsubscribed rights.

 The issuer only sells the number of shares evidenced by the exercised rights.
 However, a poorly subscribed uninsured rights offering may leave an issuer
undercapitalized.

2. Standby rights offer

 The issuing firm hires an underwriter to guarantee the proceeds on any unsubscribed
shares.
 The burden on the underwriter is lessened by two factors. First, existing
shareholders can apply for excess rights at the time of issue. Second, major
shareholders may guarantee the purchase of their pro rata allocation.

3. Open offer

 The rights offered to an existing shareholder under an open offer cannot be traded on
the open market.
 Shareholders can either take up and exercise the rights to purchase new shares at the
offer price or allow the rights to lapse upon expiration.

6.1.1. Setting the Terms of a Rights Offering

Several issues confront a financial manager who is setting the terms of a rights offering.
Various considerations can be illustrated with data from CU Corporation, whose partial balance
sheet and income statement are given below.

Partial Balance Sheet

Assets 100,000,000 Debt 40,000,000
Common Stock 10,000,000
Retained Earnings 50,000,000

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 Partial Income Statement
Earnings before Interest and Taxes 16,121,212
Interest on Debt 4,000,000
Income before Taxes 12,121,212
Taxes (34%) 4,121,212
Net Income 8,000,000

EPS (1,000,000 shares) 8

Market Price (P/E = 12.5) 100

CU Corporation earns $8 million after taxes, and it has 1 million shares outstanding, so EPS is
$8. The stock sells at 12.5 times earnings, or for $100 a share.

The company announces plans to raise $10 million of new equity capital through a rights
offering, and it decides to sell the new stock to shareholders for $80 a share. The questions
facing the financial manager are these:

 How many rights will be required to purchase a share of the newly issued stock?
 What is the value of each right?
 What effect will the rights offering have on the price of the existing stock?

We now analyze each of these questions.

6.1.1.1. Number of Rights Needed to Purchase One New Share

CU Corporation plans to raise $10 million in new equity and to sell the new stock at a price of
$80 a share. Dividing the total funds to be raised by the subscription price gives the number
of shares to be issued.

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The next step is to divide the number of previously outstanding shares by the number of new
shares to get the number of rights required to subscribe to one share of the new stock.

6.1.1.2. Value of a Right

It is clearly worth something to be able to buy for $80 a share of stock selling for $100. The
right provides this privilege, so the right must have value. To see how the theoretical value
of a right is established, we continue with the example of CU Corporation.

What is the number of new shares?

What is the amount raised?

What is the value of the firm before and after the issue?

 Before the issue, firm value is

 After the issue, firm value is

What is the new share price?

 New share price =

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What is the value of each right?

To simplify the procedures, equations have been developed to determine the value of rights.
Using the following formula:

This agrees with the value of the rights we found by the long procedure.

6.1.1.3. Effects on Position of Shareholders

Shareholders have the choice of exercising their rights or selling them. Those who have
sufficient funds and a desire to own more shares will exercise their rights. Other investors
can sell theirs. In either case, the shareholders will neither benefit nor lose by the rights
offering.

Assume the shareholder has 8 shares of CU Corporation before the rights offering. Each share
has a market value of $100 per share, so the shareholder has a total market value of $800 in the
company’s stock.

If the rights are exercised:

 One additional share can be purchased at $80 a share, a new investment of $80.
 The total investment is now $880.
 The investor owns 9 shares which have a value of the company’s stock, which has a
value of $97.78 a share after the rights offering.
 The value of the stock is 9 × 97.78 = $880, exactly what is invested in it.

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If the rights are sold:

 The investor will receive $17.78, ending up with 8 shares of stock plus $17.78 in
cash.
 The original 8 shares of stock now have a market price of $97.78 a share.
 The market value of the stock is 8 × 97.78 = $782.24.
 This $728.24 market value of the stock plus the $17.78 in cash, is the same as the
original $800 market value of the stock except for a rounding error.

6.1.2. Practical Aspects of Rights Issue

There are two important terms in a rights offering: namely (1) the rights ratio, and (2) the
issuing discount.

6.1.2.1. Rights Ratio

In Hong Kong, rights offer can be classified into small-scale rights offerings (小比例供股) and
large-scale rights offerings (大比例供股). Small-scale rights offerings are those issues in any
proportion below 1-for-2 while large-scale rights offerings have a rights ratio above the 1-for-
2 proportion.

According to the Listing Rule in Hong Kong, where the issued share capital or market
capitalization will increase by more than 50%, taking into account rights issues and open offers
announced in the previous 12 months or earlier where dealing in shares issued commenced in
the previous 12 months, the approval of independent shareholders in general meeting would
need to be obtained where controlling shareholders and their associates must abstain from
voting in favor of the resolution approving the rights issue.

Therefore, any large-scale rights offerings must obtain independent shareholders’ approval.

6.1.2.2. Issuing Discount

New shares in rights offerings are typically sold at substantial discounts to prevailing market
prices. This discount is strongly related to the size of the offering and the level of the issue
price itself.

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For example, in a 10-for-1 large-scale rights offering, if the issuing discount is 20%, then a
shareholder who owns $10,000 worth of stocks is entitled to purchase $80,000 worth of new
stocks. In this case, the shareholder may not be willing to subscribe since the cash
consideration is substantial. However, if the issuing discount becomes 85%, then the
shareholder will only consider subscribing $15,000 worth of new stocks.

6.2. Placing

Placing is another way in which listed companies can raise capital, and is the issue of securities
to selected persons. Listed companies usually employ a placing broker to help identify
interested investors.

6.2.1. Public Placement

Listed companies may ask shareholders for a general mandate allowing the board of directors
to increase the company's share capital by up to 20% each year. Most listed companies ask
the shareholders to approve this kind of mandate at the annual general meeting. Once it has
this mandate and provided it does not exceed the limit approved by the shareholders, the board
does not need to ask the shareholders for approval before making a placing at any time during
the year. If the board wants to issue more than the approved amount, it must get approval
from the shareholders first.

When a listed company wants to conduct a placing, it must publish an announcement disclosing
the details, such as the reasons for the placing and how the proceeds will be used.

In the case of a placing of securities for cash consideration, the issuer may not issue any
securities pursuant to a general mandate if the relevant price represents a discount of 20% or
more to the benchmarked price of the securities.

6.2.2. Private Placement

Private placement is the process of raising capital directly from institutional investors. In the
absence of a formalized definition, the market practice has suggested that the offer in Hong
Kong should be made to a limited number of offerees and as a rule of thumb, 50 is taken as the
maximum number of persons who may be approached without the offer being treated as made
to the public.

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Compared to public placement, private placement provides an alternative avenue to raise
capital from a limited number of investors in a quicker and less expensive way. It also enables
a company to specifically target investors possessing the relevant knowledge and experience
in the business sectors in which the company operates so that the management of the company
may benefit from the assistance offered by these investors.

6.3. Flotation Method Trends Around the World

In the U.S., publicly traded companies have switched from the uninsured rights and standby
flotation methods to the firm commitment placings. By 1980, the rights method has virtually
disappeared in the group of large publicly traded industrial firms.

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Today, rights issues are still popular in many other countries. Domestic issues in the Canadian,
the European and most Pacific Rim capital markets are predominantly sold through rights. In
some countries such as in the U.K., Hong Kong, Japan, Norway, and Sweden, both rights issue
and public placement are used.

There is a worldwide trend towards firm commitment underwritten offers for placings.

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6.4. Flotation Costs and Rights Offer Puzzle in the U.S.

6.4.1. Direct Flotation Costs

The empirical evidence indicates that the direct flotation costs on average are:

 Lowest for uninsured rights.

 Highest for firm commitments underwritten placement, with standby rights in
between.

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6.4.2. Indirect Flotation Costs

The average price change at the announcement in the U.S.:

 Firm commitment placings: -2.22%

 Rights offerings: close to 0%

Eckbo & Masulis (1995) conclude that rights offers appear to be cheaper.

6.4.3. Rights Offer Puzzle

The evidence suggested that a pure rights issue is the cheapest. If corporate executives are
rational, they will raise equity in the cheapest manner. Thus, the evidence suggests that issues
of pure rights should dominate. Surprisingly, almost all new equity issues in the U.S. are sold
with rights.

The preference by U.S. executives for the relatively expensive firm commitment flotation
method over rights offers is puzzling.

Why don’t managers select the cheaper rights method?

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1. Agency problem

 Managers may receive personal benefits from underwriters who are selected to
handle the equity issue.
 Herman (1981) finds that 21% of the largest non-financials and 27% of the 100
largest industrial companies have one or more investment bankers on their board of
directors. The resulting conflict of interest may lead to an excessive use of the
underwritten flotation methods.
 A sale to the public through an underwriter can increase shareholder dispersion and
therefore reduce shareholder monitoring on managers, thereby enhancing potential
manager welfare.

2. Hidden costs of rights offer

 Capital gains taxes. In a rights offer, shareholders who do not wish to purchase
shares of the issue must sell their rights in order to avoid losing the value of the
subscription price discount. The sales are subject to capital taxes.
 Rights issues usually create odd lots for both rights and new shares. Odd lots have
to be sold at discounts.
 Stock liquidity. Kothare (1997) argue that bid-ask spreads increase after rights
offering while decreases after placing, which shows that firm commitment offers
increase stock liquidity while rights offers decrease stock liquidity.

6.5. Announcement Effects of SEO

A large number of studies provide estimates of the valuation effects of security issue
announcements by exchange listed firms. The table below summarizes the main findings of
the literature, classified by the flotation method.

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Valuation effects of SEO announcement internationally:

 Positive for private placements.

 About -2.22% in the U.S. for firm commitment placings but can be positive in Japan
and Hong Kong.
 Zero to positive for rights offerings in U.S., Korea, Japan, and Norway; but negative
in Hong Kong and U.K.

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6.5.1. Explanations of Announcement Effects

1. Optimal capital structure hypothesis

 Theories of optimal capital structure generally imply a nonnegative market reaction

to capital structure changes.
 These theories emphasize various debt and equity issuance tradeoffs such as between
the corporate tax advantage of debt and the costs of financial distress.
 The evidence of a non-positive market reaction to SEO announcements of equity-
for-debt exchange fails to support these optimal capital structure effects.
 However, tests of optimal capital structure effects using offer announcements are
complicated because these announcements can also indicate to the market a shift in
the issuer’s economic situation which implies that issuer’s leverage-value function
has shifted (Masulis, 1983).
 In the presence of transaction costs, optimal capital structure adjustments are
observed only when the benefit of the adjustment exceeds the required transaction
cost and hence occur infrequently (Fischer, Heinkel & Zechner, 1989).

2. Effects of changes in ownership structure

 A large stock ownership position subjects the manager to the loss of significant
diversification, so increasing management stock ownership acts as a credible signal
of firm quality (Leland & Pyle, 1977; Grinblatt & Hwang, 1989).
 Owner / manager sales of equity in SEOs creates greater incentives for managers to
sell overvalued stock to outsiders. Prices drop more when management sales are
involved.
 The two-day announcement effect is -2.22% without management sales and -4.54%
with management sales (Masulis & Korwar, 1986).

3. Price pressure hypothesis

 Selling equity causes a firm’s stock price to fall, a view labeled the price-pressure
hypothesis by Scholes (1972).
 They argue that an increase in the supply of shares causes a decline in a firm’s stock
price because the demand curve for shares is downward sloping.

131
4. Implied cash flow hypothesis

 It predicts a negative relation between issuing volume and market capitalization.

 I  t   X  t   Div  t   S  t 

 Any larger-than-expected external financing by the firm, S  t  , reveals a smaller-

than-expected current operating cash flow, X  t  , conveying the negative news to

the market about current and expected future cash flows.

 The market reaction to external financing is more negative the greater the size of the
offer.

5. Information asymmetry hypothesis

 In the adverse selection environment, the issuing firm knows more than the market
about the true value of the issuer’s assets-in-place.
 Managers have an incentive not to sell underpriced securities; the market now
demands a price discount in order to hedge against the risk that the security offered
is overvalued.
 Hence, announcements of equity offers are likely to be accompanied by share price
decline. The price decline around the announcement date is often referred to as
adverse selection cost.

6.6. Long Term Underperformance after SEO

Stocks generate surprisingly low returns over holding periods of three to five years following
an equity issue date.

The typical buy-and-hold experiment involves buying the issuing firm’s stock in the month
following the issue month and holding the stock for a period of three to five years.

The table below shows average buy-and hold returns following security offerings. The
matched-firm technique equates the return to issuing firms with the return to a non-issuing firm,
where the non-issuing firm is matched on firm characteristics such as industry, size, and book-
to-market ratio.

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133
6.7. Rights Issues and Placings in Hong Kong: A Comparison

Placings are the vehicle through which the bulk of seasoned equity funding is generated.
Rights issues lag some way behind but always generate substantial amounts of funding for the
companies that use them. Wu, Wang & Yao (2005) and Wu & Wang (2002) summarize the
SEO activities in Hong Kong.

6.7.1. Number of Placings and Dollar Amount Placed

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6.7.2. Issue and Firm Characteristics of Placings

135
6.7.3. Announcement Effects of Placings

136
6.7.4. Number of Rights Issues and Dollar Amount Floated

6.7.5. Issue and Firm Characteristics of Rights Issues

137
6.7.6. Announcement Effects of Rights Issues

138
6.7.7. Why Do Firms Choose Value-destroying Rights Offerings?

In contrast to value-enhancing equity placements, rights offerings create appalling

announcement effects in Hong Kong.

6.7.7.1. The Idea

1. The controlling shareholders maximize their self-interested wealth objective function that
includes:

 The value of their own equity holdings.

 The private benefits of control from new investments.

2. When financing new investments with new equity, placements dilute controlling
shareholders’ equity holdings and thus weaken their control of the firm.

3. But rights issues do not.

139
4. If the private benefits from the new investments are large, the possibility of intruders to
occur will increase.

 Through new share placements, the intruders become substantial shareholders.

They may exert sufficient pressure to share in the private benefits of control with the
incumbents.
 In the extreme case, if control changes hands, the incumbents will lose all private
benefits.

5. If the private benefits are large, it is crucial for the incumbent controlling shareholders to
carefully the change of ownership structure in order to prevent the loss of private benefits.

6. It follows that the choice of flotation methods can signal the level of private benefits of
control in the firm. The signaling cost is the expected loss of private benefits of control.

6.7.7.2. Empirical Implications

1. When private benefits in rights issues are larger and growth prospects of the corresponding
issuers are worse, it is more likely to observe negative announcement effects of rights
issues.

2. Issuers with worse investment prospects and less impressive management track records
are more likely to choose rights issues rather than placements.

6.8. Summary

There are various types of flotation methods in SEOs, which include rights offer, firm
commitment placing, and private placement. There is a trend toward increased use of firm
commitment underwritten offer.

While direct floatation costs are lower for rights offer and higher for firm commitment offer,
rights offer may incur some indirect floatation costs.

There are several theoretical hypotheses that can explain announcement effects, among which
information asymmetry hypothesis is well accepted.

140
7. Topic 7 – Dividend Policy

Dividend policy is the set of guidelines a company uses to decide how much of its earnings it
will pay to its shareholders. In Hong Kong, dividends are typically paid semi-annually, in the
form of interim and final dividend payments. Companies can also, occasion, declare special
dividends over and above payments normally made at the interim and final dividend stages.

Dividend policy is important because:

1. The money involved in the payout decision is substantial.

2. Management and the board of directors must repeatedly decide the level of dividends,
what repurchase to make, and the amount of financial slack the firm carries which may be
a non-trivial amount.

3. Dividend policy is closely related to, and interacts with, most of the financial and
investment decisions firms make.

Under real world conditions, determining an appropriate dividend policy often involves a
difficult choice because of the need to balance many potentially conflicting forces. Paying
dividends affects both shareholder wealth and the firm’s ability to retain earnings to exploit
growth opportunities. Because investment, financing, and dividend decisions are interrelated,
management cannot consider dividend policy in isolation from these other decisions.

A key question for the financial manager is whether dividend payment patterns affect the value
of the company’s underlying stock. Dividend distributions are typically determined, in the
first instance, by a company’s directors. Such proposed dividends are then subject to the
ratification of the entity’s shareholders at a specially-convened Annual General Meeting or
Extraordinary General Meeting. A firm’s financial managers are instrumental in advising the
directors on key areas of corporate policy, including areas relating to dividend distributions.

141
7.1. The Miller and Modigliani Dividend Irrelevancy Theorem

Prior to Miller and Modigliani (1961), most economists believe that the more dividends a firm
paid; the more valuable the firm would be as suggested by the dividend discount model.


Dt
V0  
1  rt 
t
t 1

However, Miller and Modigliani (1961) point out as long as investment policy does not change,
altering the payout will not affect the firm’s value.

The MM model results are derived with the following key assumptions:

 There are no taxes.

 There are no transaction costs.
 Information is costless and equally available to everyone. There are no information
asymmetries.
 There are no contracting or agency costs.

Under perfect market, the firm’s choice of dividend policy is irrelevant; that is, dividend policy
has no impact on shareholders’ wealth.

To illustrate this idea, given:

 There are 2 periods: t = 0 and t = 1.

 At t = 0, the managers are able to forecast cash flows with perfect certainty.
 The firm will receive a cash flow of $10,000 at t = 0 and t = 1.
 The firm has no additional positive NPV projects.
 The firm has 1,000 shares outstanding.
 Assume the discount rate is 10%.

7.1.1. Case I – Residual Dividend Policy

The residual policy distributes whatever is left from internal cash flow. In this example,
dividends are set equal to the cash flow.

142
The value of the firm:

Since there are 1,000 shares outstanding, the value of each share becomes 19,090.91 / 1,000 =
$19.09.

Assume the shareholders do not satisfy with the current dividend policy. Could they enhance
the firm value by altering the dividend policy?

7.1.2. Case II – Managed Dividend Policy

Initial dividend is greater than cash flow. Suppose the firm pays a dividend of $11 per share
at t = 0, which is, a total dividend of $11,000.

Since the cash flow at t = 0 is only $10,000, the extra $1,000 must be raised. Assume stock
is issued, the new shareholders will demand $1,100 at t = 1, leaving only $8,900 to the old
shareholders.

The value of the firm under managed dividend policy:

In present value terms, what is gained in extra dividend today is offset exactly by future
dividends lost.

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7.1.3. Proof of MM Dividend Irrelevancy Theorem

The present value of firm:

T
Dt
V0  
1  r 
t
t 0

D1 D2
 D0    ...
1  r  1  r 2

Recall that the total sources of funds for a firm must equal to the total uses of funds:

Sources = Uses
CFt  Ft  Dt  I t  (1  r ) Ft 1
where:
CF  operating cash flow
F  new funds raised
I  investment

Rearranging the above equation, we obtain:

Dt  CFt  Ft  I t  (1  r ) Ft 1

Substituting Dt from above into the first equation, we have:

CF1  F1  I1  (1  r ) F0
V0  CF0  F0  I 0  (1  r ) F1 
1 r
CF2  F2  I 2  (1  r ) F1
  ...
1  r 
2

CF1  I1 CF2  I 2
 CF0  I 0  (1  r ) F1    ...
1 r 1  r 
2

We assume F1 and FT are zero since the firm cannot raise any fund before startup and at
liquidation.

144
We finally arrive at:

CF1  I1 CF2  I 2
V0  CF0  I 0    ...
1 r 1  r 
2

T
CFt  I t

1  r 
t
t 0

Immediately we can see that dividend policy does not enter into equation. From this equation,
the value of the firm only depends on investment.

7.2. The Tax Effects

The tax affects dividend policy in a number of ways. The key tax feature has to do with the
taxation of dividend income and capital gains.

7.2.1. Personal Taxes

The tax laws in U.S. are complex. For individual investors, dividends are taxed at a higher
rate than capital gains from share repurchases.

Dividends received are taxed as ordinary income. As of 2006, the top individual tax rate on
ordinary income is 35% while the maximum tax rate on realized long-term capital gains (held
for more than 18 months) is only 20% for individuals.

Example 7.1

A firm chooses to distribute $100 million in the form of dividends versus share repurchases.

Assume that an individual investor currently owns 10% outstanding shares and plans on
maintaining 10% ownership.

Assume the shares were originally purchased at $38 per share and the repurchase price is $50.

The tax rate on dividends is 35% and 20% on capital gains.

145
The tax consequences:

Dividend Alternative:
Dividend
Tax Rate

Immediate Tax Liability

Share Repurchase Alternative:

Proceed from Sale of 2 million Shares
Less: Original Cost
Taxable Capital Gain
Tax Rate

Immediate Tax Liability

Rational individual who minimizes his tax liability will prefer share repurchases over dividends.
In addition, capital gains are not taxed until the gains are realized. But why it does not
necessarily to pay no dividends because of the tax disadvantage?

7.2.2. Corporate Taxes

The tax system in the U.S. double-taxes corporate profits. Shareholders do not receive tax
credits, offsetting the taxes paid by corporations.

What is the effect of corporate taxation on dividend policy?

Example 7.2

A company has $1,000 of extra cash (after-tax).

It can retain the cash and invest it in T-bills yielding 10% or it can pay the cash to shareholders
as a dividend.

Shareholders can also put the money in T-bills with the same yield.

Assume that the corporate tax rate is 34% and the individual rate is 28%.

146
What is the amount of cash that investors will have after 5 years under each of the following
scenarios:

 Pay dividends.
 Retain the cash for investment in the firm.

1. Scenario I – Pay Dividends:

Now, shareholders will receive the dividend:

After 5 years, the after-tax income on T-bills:

2. Scenario II – Retain Cash and Invest in T-bills:

At the end of year 5, the after-tax investment:

If the proceeds are then paid as dividend, then:

In this example, dividends will be greater after taxes if the firm pays them now. The reason
is that the firm simply cannot invest as profitably as the shareholders can on their own (on an
after-tax basis).

147
Finally, the dividend payout decision will depend on personal and corporate tax rates:

 Pay low dividends if corporate rate is less than the individual rate.
 Pay high dividends when the individual rate is less than the corporate rate.

7.2.3. Dividend Clientele

The fact that the method of payout depends on the tax preference of investors leads to what is
called dividend clienteles. That is, firms attract a clientele of investors who favor the payout
policies adopted by the firm.

Firms with high payouts will attract investors who pay low taxes on dividends, while firms
with low payouts or payouts through repurchases attract investors who pay low taxes on capital
gains.

Because the investors have chosen investments based on their current payout policy, the firm
does not benefit from changing its policy.

Suppose there are three groups that hold stocks:

 Individual ( Td  0.5 , Tg  0.2 )

 Corporation ( Td  0.1 , Tg  0.35 )

 Institution ( Td  0 , Tg  0 )

Assume that these groups are risk neutral and all that matters are the after-tax returns to the
stocks. There are three types of stock. Each stock is assumed to have earnings per share of
$100. The only difference between these shares is the form of payout. If they held each
type of stock, the after-tax cash flow for each group is:

148
 High Medium Low
Payout Payout Payout
Before Tax EPS $100 $100 $100

Payout Policy:
- Dividend $100 $50 $0
- Capital Gain $0 $50 $100

After Tax Payoff:

- Individual
- Corporation
- Institution

Equilibrium Price $1,000 $1,000 $1,000

In equilibrium, the prices of the three stocks should be the same, independent of payout policy,
and dividend policy is irrelevant, as in the original MM theory.

What happens if the prices of the stocks are different? (Say low payout stock is worth $1,050
instead of $1,000)

Institution will sell low dividend stocks and therefore there will be downward pressure on them.

While the dividend clientele argument has some appeal, but as the above discussion suggests,
in United States most investors prefer capital gains, yet many firms still pay dividends.

7.2.4. The Ex-Dividend Day Studies

7.2.4.1. The Procedure of Cash Dividend

25 Oct. 3 Nov. 5 Nov. 7 Dec.

…
Declaration Ex-dividend Record Payment
Date Date Date Date

149
A public company’s board of directors determines the amount of the firm’s dividend.

Declaration date:

 The board of directors declares a payment of dividends.

 After the board declares the dividend, the firm is legally obligated to make the
payment.

Record date:

 The firm will pay the dividend to all shareholders of record on a specific date, set by
the board, called the record date.
 Because it takes three business days for shares to be registered, only shareholders
who purchase the stock at least three days prior to the record date receive the dividend.

Ex-dividend date:

 A share of stock goes ex-dividend on the date the seller is entitled to keep the
dividend.
 Shares are traded ex-dividend on and after the second business day before the record
date.
 Anyone who purchases the stock on or after the ex-dividend date will not receive the
dividend.

Payment date:

 The dividend checks are mailed to shareholders of record.

7.2.4.2. Price Behavior Around the Ex-dividend Day

It is important to isolate who receives the dividend due to the stock price reaction following
the payment. The stock should fall by the amount of the dividend with no taxes.

 Before ex-date: Dividend = 0; Price = P + D

 After ex-date: Dividend = D; Price = P

150
When investors were about to sell a stock around its ex-dividend date, they would calculate
whether they were better off selling just before it goes ex-dividend, or just after in the presence
of tax differentials.

Assuming investors are risk-neutral and there are no transaction costs, then:

Pc  Tg  Pc  P0   Pe  Tg  Pe  P0   D 1  Td 
where:
Pc  stock price cum dividend
Pe  expected ex dividend price
P0  stock price when purchased initially
Td  personal tax on dividend
Tg  personal tax on capital gain

Or:

Pc  Pe 1  Td

D 1  Tg

The theoretical analysis of stock price behavior around the ex-dividend day compares the
expected price drop to the dividend per share. In perfect capital market, the stock price drop
should follow this ratio. Any other stock price behavior provides potential arbitrage
opportunities.

Example 7.3

XYZ Company is selling for $50 at close of trading May 3. On May 4, XYZ goes ex-dividend;
the dividend amount is $1. Assume that you are a tax-exempt investor, and that you know
that the price drop on the ex-dividend day is only 90% of the dividend. How would you
exploit this differential if you have 50 million?

 Buy 1 million shares of XYZ stock cum-dividend at $50/share.

 Wait till stock goes ex-dividend; Sell stock for $49.10/share (50 – 1 × 0.90).
 Collect dividend on stock.
 Net profit =

151
7.2.5. A Summary on Dividends and Taxes

Differential taxes affect both prices (at least around the ex-dividend day) and investors’ trading
decisions.

On average, in most periods examined, the price drop is less than the amount of dividend paid,
implying a negative effect on value. So, from a tax perspective, dividends should be
minimized.

The volume of trade around the ex-day is much higher than usual, indicating that the shares
change hands from one investors’ group to the other. This evidence show that taxes affect
behavior and a perfect holding clientele doesn’t exist.

7.3. Asymmetric Information and Dividend Signaling

Previously, we argued that firm value does not depend on payout policy, as long as investment
policy is fixed. But, if the market is poorly informed about the firm’s prospects, would firms
have an incentive to give up some of their investment?

The market will interpret a dividend payment as a signal of quality, which will create an
incentive for the firm to underinvest, so that more funds are available to signal quality. The
dividend signaling theory has several implications:

1. Firms will pay dividends to signal quality to the market.

2. Firms will be very reluctant to cut their dividend because that will provide a negative
signal.

3. Firms will not increase their dividend unless they feel comfortable that they can maintain
the dividend in the future; as a result, the pattern in dividend payments will be much
smoother than the pattern in earnings.

4. Dividend increases are associated with positive stock price changes. Dividend cuts are
associated with negative stock price changes.

5. Firms may forego projects that add value to the firm in order not to have to cut the dividend.

152
7.3.1. Dividend Signaling Example

7.3.1.1. The Individual Firm

We are living in a risk-neutral world. For simplicity, assume the discount rate is 5%.

You are an entrepreneur and need to raise $10 for a project. The market believes that the
project will pay $5 with probability p and $20 with probability (1 – p). But you believe that
the true probabilities are q and (1 – q) respectively. And q may be different from p.

You decide to raise $10 by issuing debt, new equity, or both.

The market value of debt with a face value of F is:

p  min  F ,5   1  p   min  F , 20 
D
1.05

Depending on the face value F, the market value of debt:

If F  5 : F
D
1.05
If 5  F  20 : p  5  1  p   F
D
1.05
If F  20 : p  5  1  p   20
D
(we do not care about this case) 1.05

And the market value of equity:

p  max  5  F , 0   1  p   max  20  F , 0 
E
1.05

Suppose you raise $10 partly through issuing debt and partly through issuing new equity. The
amount of new equity is 10 – D.

153
Let  be the new equity the firm offers to the market. It must satisfy:

10  D   E
 p  max  5  F , 0   1  p   max  20  F , 0  
  
 1.05 

If F  5 : F  p   5  F   1  p    20  F  
10    
1.05  1.05 
10.5  F
 
20  15 p  F
If 5  F  20 :
p  5  1  p   F  1  p    20  F  
10    
1.05  1.05 
10.5  5 p  F 1  p 
 
1  p  20  F 
If F  20 :  0
(we do not care about this case)

Let us suppose the market believes that p = 0.5. Graphically, the market value of debt and
equity:

154
The share of new equity that needs to issue to new shareholders decreases with the face value
of debt.

When F  16,   0 . This is because you have already raised sufficient amount of new
0.5  5  0.5 16
capital from the debt market, D   10 .
1.05

7.3.1.2. The Value of Old Equity

You will receive the fraction of equity not shared to the new investors. That is, 1   .

If F  5 : 10.5  F
1  1
20  15 p  F
9.5  15 p

20  15 p  F
If 5  F  20 :
10.5  5 p  F 1  p 
1  1
1  p  20  F 
9.5  15 p

1  p  20  F 
If F  20 : 1  0
(we do not care about this case)

155
Note:

1. The expression for 1   above depends on the market’s belief p . This is because 
is set by the market and outside investors agree to invest based on what they believe about
the firm.

2. However, your belief about the total value of equity depends on q because your total

payoff is 1     E  (where E  is the value that you believe your equity is worth).

q  max  5  F , 0   1  q   max  20  F , 0 
Thus, E  
1.05

Your perceived payoff:

If F  5 : 9.5  15 p  q   5  F   1  q    20  F  
1    E    
20  15 p  F  1.05 
20  15q  F 9.5  15 p
 
20  15 p  F 1.05
If 5  F  20 : 9.5  15 p  1  q    20  F  
1    E    
1  p  20  F   1.05 
1  q 9.5  15 p
 
1 p 1.05

156
7.3.1.3. The Value of New Equity

Suppose you are right. q is the true probability even though market uses p .

The NPV of the new equity:

NPV   E   10  D 

The new shareholders payoff:

If F  5 : 10.5  F  q   5  F   1  q    20  F  
 E   
20  15 p  F  1.05 
20  15q  F 10.5  F
 
20  15 p  F 1.05

NPV   E   10  D 
20  15q  F 10.5  F  F 
   10  
20  15 p  F 1.05  1.05 
15  p  q   F 
  10  
20  15 p  F  1.05 

If 5  F  20 :
10.5  5 p  F 1  p   1  q    20  F  
 E  
1  p  20  F   1.05


1  q 10.5  5 p  F 1  p 
 
1 p 1.05

NPV   E   10  D 
1  q 10.5  5 p  F 1  p   p  5  1  p   F 
   10  
1 p 1.05  1.05 
p  q  10.5  5 p  F 1  p  
  
1 p  1.05 

157
7.3.1.4. The Market

Suppose the market is unconditionally correct. If you look across all firms in the economy,

p of them will produce $5 and 1  p  will produce $20.

Insiders have more information than outsiders. That is, the insider of each firm knows that
its probability of producing $5 is q which is not always equal to p .

Outsiders will lose on some deals q  p and win on other deals q  p . But will break

even on average. By assumption, the average q across all firms must equal to p .

7.3.1.5. Good Firms Versus Bad Firms

Suppose half of all firms have q  0.1 and the others have q  0.9 .

When q  0.1 (good firm), insider is better off by raising as much safe debt as possible.
When q  0.9 (bad firm), insider is better off by raising as much equity as possible.

But outsiders are not idiots. Although they do not know the type of firm, they can infer from
insiders’ actions.

158
If outsiders observe firm raising all equity, they must assume that it is a bad firm and deduce
q  0.9 . If outsiders observe firm rising all debt, they must assume that it is a good firm and
deduce q  0.1 .

Let us consider an illustration.

If bad firm raises all equity:

 0.9  5  0.1 20 
10    
 1.05 
   1.62

This is impossible since   1 . This firm will not receive funding.

If good firm raises safe debt F  5 , and the rest with new equity:

5  0.1 0  0.9 15 

10    
1.05  1.05 
   0.41

But the managers of bad firm will pretend to be good firm by raising safe debt since they cannot
get funding otherwise.

The outsiders will no longer accept   0.41 . They will account for the fact that bad firm
will imitate good firm and will demand a larger share.

7.3.1.6. Pooling Equilibrium

All firms raise safe debt F  5 , and the rest with new equity. Since outsiders cannot
differentiate, they will use unconditional probabilities:

5  0.9  0  0.115   0.1 0  0.9 15 

10   0.5      0.5    
1.05  1.05   1.05 
   0.73

Good firms will hurt by this and bad firms will benefit.

159
7.3.1.7. Signaling

What if good firms do something that the bad firms refuse to imitate it?

C
Suppose the firm has cash today (so that it will be worth C tomorrow). The good firm
1.05
can burn money so that the bad firm cannot imitate.

Below we go through the same numerical example as above but we assume the firms have cash.

The market value of debt with a face value of F is:

p  min  F ,5  C   1  p   min  F , 20  C 
D
1.05

Depending on the face value F , the market value of debt:

If F  5  C : F
D
1.05
If 5  C  F  20  C : p   5  C   1  p   F
D
1.05

And the market value of equity:

p  max  5  C  F , 0   1  p   max  20  C  F , 0 
E
1.05

The fraction (  ) of the new equity that the firm offers to the market:

If F  5  C : F  p   5  C  F   1  p    20  C  F  
10    
1.05  1.05 
10.5  F
 
20  C  15 p  F
If 5  C  F  20  C :
p   5  C   1  p   F  1  p    20  C  F  
10    
1.05  1.05 
10.5  5 p  Cp  F 1  p 
 
1  p  20  C  F 

160
The fraction of equity not shared to the new investors:

If F  5  C : 10.5  F
1  1
20  C  15 p  F
9.5  C  15 p

20  C  15 p  F
If 5  C  F  20  C :
10.5  5 p  Cp  F 1  p 
1  1
1  p  20  C  F 
9.5  C  15 p

1  p  20  C  F 

Again, E  is the value of equity given your own belief.

q  max  5  C  F , 0   1  q   max  20  C  F , 0 
E 
1.05

Your perceived payoff:

If F  5  C :

9.5  C  15 p  q   5  C  F   1  q    20  C  F  
1    E    
20  C  15 p  F  1.05 
20  C  15q  F 9.5  C  15 p
 
20  C  15 p  F 1.05

If 5  C  F  20  C :

9.5  C  15 p  1  q    20  C  F  
1    E    
1  p  20  C  F   1.05 
1  q 9.5  C  15 p
 
1 p 1.05

161
7.3.1.8. Separating Equilibrium

It is still the case that good firms are better off by issuing safe debt F  5 C and bad firms

are better off by issuing equity. But bad firms are crafty. They will imitate good firms. In
the market, all firms will issue debt.

When all firms raise safe debt F  5 C and the rest with equity, the outsiders have to use

unconditional probabilities since they cannot differentiate the type of firms.

5C  0.9  0  0.115   0.1 0  0.9 15 

10   0.5      0.5    
1.05  1.05   1.05 
5.5  C
 
7.5

Managers of good firms ( q  0.1 ) will burn cash. But bad firms ( q  0.9 ) will not dare to
follow. Outsiders will realize this and set   0.41 just as in the simple world where q is
known and C  0 .

Suppose C  2 .

If good firms do not burn cash, old equity will get:

0.1 0  0.9 15 

1    E   1     
 1.05 
 5.5  2  0.9 15 
 1   
 7.5  1.05 
 6.8571

162
If good firms burn money and investors believe it, old equity will get:

0.1 0  0.9 15 

1    E   1     
 1.05 
 0.9 15 
 1  0.41  
 1.05 
 7.6190

Good firms would like to burn money.

If bad firms imitate good firms and burn money, old equity will get:

0.9  0  0.115 
1    E   1     
 1.05 
 0.115 
 1  0.41  
 1.05 
 0.8466

But bad firms can decide not to issue, old equity will get:

C 2

1.05 1.05
 1.9048

Bad firms do not want to imitate good firms. The signal is credible.

In practice, when firms choose to payout with dividend rather than share repurchases, they are
actually burning money.

Let us redo the above example and assume the firms only burn T  C amount of money, and

keep only 1  T   C .

Bad firms find it optimal not to burn if:

C  1  0.41   0.1 15   1  T   C
 T  0.44

163
With a dividend tax rate of 44%, firms could use dividend as costly signals. This may explain
why firms choose to use dividend for payouts even though share repurchases are cheaper.

7.4. Incomplete Contract and Agency Models

The three groups: stockholders, bondholders and management, whose interests may conflict
within a firm, may be affected the most by a firm’s dividend policy.

7.4.1. Stockholders Versus Bondholders

Bondholders view dividend increases as bad news. It makes the bonds much riskier. To the
extent that the dividend increase was unanticipated and was not built into interest rate, this
transfers wealth from bondholders to stockholders.

The agency problem comes from wealth expropriation. If the above action is not anticipated
by debtholders, the bond value will go down and the market value of equity will rise.

Dhillon & Johnson (1991) find that:

 Following announcement of dividend initiation – on average, share price rose 0.72%,

while bond prices fell 0.70%.
 Following announcement of dividend increase of at least 30% – on average, share
price rose 1.82%, while bond prices fell 0.50%.

7.4.2. Management Versus Stockholders

If managers are assumed to be self-interested, then free cash flow will be invested and
overinvestment results.

According to agency models, dividends are good news since they resolve agency problems.
When a firm pays out dividends, it will need to raise external funds more often. The primary
market acts as a control against managers deviating from shareholders’ best interests. The
costs of issuing new equity shares are offset by lower agency costs. Even if a firm does not
need to raise external funds, paying out dividends reduces the amount of free cash flow
available to managers and will also reduce agency costs. The less discretionary cash
management has, the harder it is for them to invest in negative NPV projects.

164
7.5. Conclusion

In perfect and complete capital markets, firms can not alter their value by changing dividend
policy.

Because markets are less than perfect, dividends, or more generally, payout policy, represents
one of the most important financial decisions faced by corporate financial managers.

The theoretical work on this issue tells us that there are three potential imperfections to be
considered when dividend policy is determined.

 Taxes. If dividends are taxed more heavily than capital gains, and investors can’t
avoid this higher taxation by dynamic trading strategies, then minimizing dividends
is optimal.
 Asymmetric information. If managers know more about the true worth of their firm,
dividends may be used to convey that information to the market, despite the costs
associated with paying those dividends.
 Incomplete contracts. If contracts are incomplete, or not fully enforceable,
dividends may, under some circumstances, be used by equityholders to discipline
managers or to expropriate wealth from debtholders.

7.6. Share Repurchase

Share repurchases are often viewed as a cheaper and more flexible way to distribute cash to
shareholders. Repurchases have become more popular over time.

7.6.1. Dividends, Repurchases and Total Payout

U.S. is without doubt the most active market for share repurchases. Large, established
corporations typically pay out a significant percentage of their earnings in the form of dividends
and repurchases. From 1972 to 1998:

 The average dividend payout ratio is 45.2%.

 The average repurchase payout ratio is 15.0%.
 The average total payout ratio is 60.2%.

165
Historically, dividends have been the predominant form of payout. Share repurchases were
relatively unimportant until the mid-1980s, but since then have become an important form of
payment.

 In 1970s, the average dividend payout was 38.3% and the average repurchase was
3.2%.
 In 1990s, the average dividend payout was 50.9% and the average repurchase was
23.5%.

166
7.6.2. Motivations for Share Repurchases

A greater concentration of repurchase activity is always likely in bear market periods.

7.6.2.1. The Signaling Argument

Oyon, Markides & Ittner (1994) suggest that buybacks signal favorable information about
corporate earnings prospects. Since directors with favorable earnings expectations realize
that underlying share prices will rise once this information is released, planned repurchases can
be carried out at lower cost by scheduling them prior to the relevant disclosures.

7.6.2.2. Anti-dilution of Employee Stock Options

The exercise of employee stock options forces the underlying companies to issue new stock, a
dilution in corporate EPS may result. In this environment, repurchases could function to mop
up a surfeit of new shares – and, by connection – counter a material dilution in EPS.

The buyback, by offsetting any dilution in EPS, helps preserve the value of remaining
unexercised options.

7.6.2.3. Tax Benefits of Repurchase

In the U.S., the so-called double-taxation effect on dividends – where payments are subject to
both federal corporate income taxes and personal income taxes – means that buybacks may
feature as a tax-effective substitute to cash dividends.

7.6.2.4. A Response to the Threat of Takeover

Repurchases may also be driven by the threat of takeover. As virtually all corporate buybacks
are conducted on-market and involve the underlying company buying stock from parties with
relatively small holdings, repurchases tend to raise the percentage stakes of major shareholders.

167
8. Topic 8 – Valuation I: WACC, APV and FTE Approach

Valuation of a firm or project hinges on measurement of two basic parameters:

 Future cash flow

 Discount rate

When evaluating a project, the standard procedure is to forecast incremental after-tax cash
flows and discount them at the cost of capital to obtain an estimate of the project’s net present
value.

Measurements of the two parameters have resulted in several alternative methods for project
and firm valuations. In this topic, we discuss three valuation methods:

 The weighted average cost of capital (WACC) method

 The adjusted present value (APV) method
 The flow to equity (FTE) method

8.1. WACC Approach

The most popular approach to project evaluation is the WACC method. This method
estimates a project’s value by discounting its unlevered cash flows (UCF) using a constant
WACC. In estimating unlevered cash flow, it is assumed that the project is fully financed by
equity, and tax liability is estimated using earnings before interest payment.

n
UCFt
NPV   I 0  
1  rWACC 
t
t 1

If the project is simultaneously financed with debt and equity, the interest paid to the debtholder
qualifies for tax exemption. These tax shields are accounted for in the discount rate. The
discount rate is a weighted average of the after-tax cost of debt and cost of equity. The benefit
of the tax shield is incorporated in the WACC discount rate by multiplying the (1 – tax rate)
factor in the cost of debt.

E D
rWACC   re   rd  1  tc 
V V

168
In the above WACC formula, the values of equity and debt are expressed in terms of market
values, not at their book values.

The advantage of the WACC approach lies in its simplicity. It embeds all financing
considerations in a single discount rate and thus simplifies decision making.

However, the risks involved in project cash flows are not always amenable to being measured
with a single discount rate. The discount rate WACC changes when the debt to equity ratio
of the firm varies on a year-to-year basis. Also, the measure provides little guidance when
the tax structure also changes with time.

8.2. APV Approach

APV is a valuation method to determine the levered value of an investment by first calculating
its unlevered value (the base case NPV) and then adjusting it by the effects of financing: adding
the value of the interest tax shield and deducting any costs that arise from other market
imperfections.

The value of a project to the firm can be thought of as the value of the project to an unlevered
firm ( NPVU ) plus the net present value of the financing side effects (NPVF).

APV  NPVU  NPVF

APV has the conceptual advantage of separating the value of the unlevered investment from
the value that comes from the financing effects.

NPVU is defined as the net present value of the project to an all-equity or unlevered firm:

n
UCFt
NPVU   I 0  
1  rU 
t
t 1

UCF is the unlevered cash flow. The discount rate is the unlevered cost of capital.

169
NPVF is the net present value of financial effects, which include:

 The tax subsidy to debt (tax shield).

 The costs of issuing new securities (flotation costs).
 The costs of financial distress.
 Subsidies to debt financing.

8.3. FTE Approach

Flow-to-equity is a valuation method that calculates the free cash flow available to shareholders
after taking into account all payments to and from debtholders.

As cash flow is measured from the shareholders’ perspective, the suitable discount rate is the
shareholders’ required rate of return, re . The advantage of using this method is that cash
flows accruing to debtholders are not directly considered. In cases where the debt amount
varies on a year-to-year basis, this method becomes handy.

8.4. Example

A firm has an investment with the following characteristics:

 The initial cost of project is I 0  $100, 000 .

 The assets of this project generate an expected EBIT of $15,000 per year forever.
 This project can be financed either with $100,000 in equity (assume from internally
generated cash flow) or with $40,000 of debt and $60,000 of equity.
 The discount rate on an all-equity financed project in this risk class is rU  10% .
 The cost of debt is rd  5% before taxes. The coupon rate and cost of debt equal
(assume the bond is trading at par).
 The marginal tax rate is tc  40% .

Unlevered Levered
EBIT
Interest
Taxable Income
Tax
Net Income

170
8.4.1. APV Method

In the APV method, we first estimate the value of the firm using all-equity financing; and in
the second step, we include the benefits and the costs of debt financing. With debt financing,
the primary benefit of borrowing is the tax benefit of interest tax shield.

Step 1: Calculate the unlevered NPV ( NPVU ):

Since NPVU  0 , the all-equity firm should reject the project.

Step 2: Calculate the financing side effects (NPVF):

Step 3: Calculate the adjusted present value of the project (APV):

After including the value of the tax shield, shareholders can now expect to gain $6,000. The
firm should accept this project if it is financed with $40,000 in debt at 5%.

171
Note:

1. Think of this project as a separate firm. The value of the unlevered firm is the value of
the original $100,000 investment plus the negative $10,000 NPV, that is,

VU  100, 000  10, 000

 90, 000

2. The value of the levered firm is:

VL  VU  D  Tc
 90, 000  16, 000
 106, 000

3. The value of debt is D = $40,000 (par value since the coupon rate and cost of debt equal),
and the entire tax shield is captured by the shareholders:

E  VL  D
 106, 000  40, 000
 66, 000

4. The shareholders originally invested $60,000 of equity.

8.4.2. FTE Method

The value of the equity component of a project can be calculated by discounting the project’s
levered cash flows at the project’s cost of equity capital.

Step 1: Calculate the levered cash flows to the equity:

172
Step 2: Estimate the cost of levered equity:

We can use MM Proposition II with corporate taxes to estimate the cost of levered equity.

Step 3: Find the NPV of the project for the shareholders:

8.4.3. WACC Method

The value of any firm or project, whether levered or unlevered, can always be calculated by
discounting the unlevered cash flows at the weighted average cost of capital.

Step 1: Find the WACC for a levered firm:

Step 2: Calculate the NPV:

Note:

1. The benefit that is associated with the tax shield of debt is already incorporated into the
WACC.

2. We always calculate the project’s cash flows as if they are unlevered.

173
8.5. Summary

All three approaches attempt the same task: valuation in the presence of debt financing. The
three methods are equivalent. If valuation methods are applied correctly, the choice of
valuation method should not affect the NPV estimate.

APV FTE WACC

Initial Investment All Book Equity All
Cash Flows UCF LCF UCF
Discount Rates rU rL rWACC
PV of Financing Effect Yes No No

However, one method may be easier to estimate than another method under certain
circumstances.

1. The APV method:

 It can be easier to apply when the firm does not maintain a constant leverage ratio.
It is particularly useful when capital and tax structures are uncertain. The firm is
valued as a whole without consideration for its debt to equity ratio.
 It explicitly values market imperfections and therefore allows managers to measure
their contribution to value.
 In some cases, the APV approach gives a certain advantage. In a leverage buyout,
a large amount of debt is taken initially and debt is paid back over a predetermined
number of years. Since the schedule of debt repayment and interest payments is
known, tax shields for each year in the future can be estimated.

174
2. The FTE method:

 It may be simpler to use when calculating the value of equity for the entire firm if
the firm’s capital structure is complex and the market values of other securities in the
firm’s capital structure are not know.
 It may be viewed as a more transparent method for discussing a project’s benefit to
shareholders by emphasizing a project’s implication for equity.
 It assumes a constant leverage.

3. The WACC method:

 An advantage of the WACC method is that we only need to care about budgeting and
do not need to worry about financing.
 It assumes that firm maintains a constant leverage.
 It assumes that the project has the same leverage as the rest of the firm.
 For the WACC method to be valid, a firm must continuously rebalance its capital
structure to maintain a constant market debt-to-value ratio.
 Any large change in capital structure, which changes leverage ratio, makes the
WACC method invalid.

We suggest the following guideline for choosing between these methods:

 Use the WACC or FTE method if the target debt ratio will be constant throughout the
life of the project.
 Use the APV method if the debt level will be constant throughout the life of the
project.

175
9. Topic 9 – Valuation II: Real Options

Many financial managers recognize that the classic NPV approach to capital budgeting is
inadequate in that it ignores, or cannot properly capture, management’s flexibility to adapt and
revise later decisions in response to unexpected market developments.

In the actual marketplace, the realization of cash flows will probably differ from what managers
expected initially. As market conditions changed, managers may have valuable flexibility to
alter their operating strategy in order to capitalize on favorable future opportunities or mitigate
losses. For example, managers may be able to defer, expand, contract or abandon a project at
different stages during its useful operating life. The real option approach to capital budgeting
provides a new tool to quantify the value of flexibility from active management.

9.1. Comparing NPV with Real Options

At Year 0, a firm is deciding to invest in a machine that costs $1,600. Once pre-committed,
one unit of good is produced at the end of Year 1 and the capital cost will be paid immediately.
Each year, the machine will produce one unit of good which is assumed to be operated forever.
The price of the good is uncertain at Year 1. It will be worth either $300 or $100 with a 50/50
probability. But once the price level becomes known at Year 1, it stays there forever. The
discount rate is 10%.

Should the firm invest?

9.1.1. Static NPV Approach

The NPV of this investment is:

According to the NPV criterion, the firm should invest as the NPV is positive.

176
Knowing that the price is only uncertain at Year 1, what if the firm has an option to decide at
the end of Year 1 instead of pre-committing now?

9.1.2. Expanded NPV Approach

Suppose the cost of investment goes up to $1,800 if the firm waits to decide. The firm will
invest when the price is $300. If the price becomes $100, the firm will choose not to invest.
Then the NPV with this right to defer becomes:

Obviously, it is better for the firm to wait since the NPV is higher. The value of the right to
do so is worth 145.45 (545.45 – 400).

9.1.3. NPV and Managerial Flexibility

In the example, the managerial flexibility to decide later in response to altered future market
conditions expands the investment value by improving its upside potential while limiting
downside losses relative to the firm’s initial expectations under passive management.

The expanded NPV approach can reflect the traditional (static) NPV of cash flows and a
premium for the flexibility inherent in the real options.

That is,

Expanded NPV = Static NPV + Option Premium

177
9.2. Valuing Real Options

9.2.1. One-step Binomial Model

Consider a very simple illustration. A stock price is currently $20, and it is known that at the
end of 3 months it will be either $22 or $18. Given a European call option with an exercise
price of $21, at maturity, this option will have one of two values.

If the stock price turns out to be $22, the call option will be worth $1. If the stock price turns
out to be $18, the call will become worthless.

S1  $22
C1  $1

S0  $20

S1  $18
C1  $0

The logic to price this option in the illustration rests on the assumption that arbitrage
opportunities do not exist. If we can set up a portfolio of the stock and option in such a way
that there is no uncertainty about the value of the portfolio at the end of the 3 months, this
portfolio must earn a return equal to the risk-free interest rate.

Now consider a portfolio consisting of Δ shares of stock and a short position in one call option.
Our objective is to find the value of Δ that makes the portfolio riskless. That is, no matter the
stock price moves up to $22 or moves down to $18, the final value of the portfolio is the same
for both alternatives.

Mathematically,

22  1  18  0
   0.25

178
Thus, this riskless portfolio is to:

 Long 0.25 shares.

 Short 1 call option.

If the stock price goes up to $22, the value of the portfolio is:

22  0.25   1  4.5

If the stock price drops to $18, the value of the portfolio is:

18  0.25   0  4.5

Regardless of whether the stock price moves up or down, the value of the portfolio is always
4.5. Therefore, this portfolio must earn a risk-free interest; otherwise, there will be arbitrage
opportunities. Suppose that the risk-free rate is 12% p.a. The present value of this portfolio:

4.5
 4.3743
1.120.25

And the value of the option is:

20  0.25   C0  4.3743
 C0  0.6257

9.2.2. A Generalization

S0u
Cu
S0
C
S0 d
Cd

179
We can generalize the illustration. Let:

S0  the stock price

C  the option value
u  the multiplicative upward movement in the stock price  u  1
d  the multiplicative downward movement in the stock price  d  1

As before, we can form a portfolio with a long position in Δ shares of stock and a short position
in one call option so that this portfolio is riskless.

The value of Δ that makes the portfolio riskless when:

S0u  Cu  S0 d   Cd
Cu  Cd

S 0u  S 0 d

The cost of setting up the portfolio is:

S0u   Cu
S0   C 
1  rf
S0  1  rf   S0u   Cu
C
1  rf
 u  Cu
 S0  1  
 1  rf  1  rf

Substitute Δ into above equation and simplify the expression6, we get:

1
C  pCu  1  p  Cd 
1  rf 
where:
1  rf  d
p
ud

6
See appendix.

180
9.3. Elements in a Real Option

The options models used to value real options are borrowed from financial options pricing
models. The characteristics of the real options resemble those of the financial options. The
table below summarizes the inputs for the valuation of the real options.

Financial Option Real Option

Price of the underlying asset PV of expected cash flows
Exercise price Future capital investment
Time to expiration Time until opportunity
Stock value volatility Project value uncertainty

9.4. Static NPV Analysis

Consider an opportunity to invest $104 to build a plant that a year later will have a value of
either $180 or $60 with equal probability. Assume the discount rate k is 20% and the risk-
free interest rate is 8%.

  0.5
V1  $180

V0

1  0.5 V1  $60

The traditional NPV approach would discount the expected cash flows using the discount rate:

181
Using the NPV rule, we should reject the investment.

Should we only rely on standard NPV rule? With uncertainty and irreversibility, NPV rule is
not correct. Real option gives better answer.

9.5. The Option to Defer

Suppose the firm has a one-year license granting it the exclusive right to construct a new plant.
What is the value of the investment opportunity provided by the license, given that undertaking
the project immediately was shown to have a negative NPV?

This license is like giving the firm a call option with an exercise price equal to the investment
outlay. The firm has the right to invest when the market condition is good; at the same time,
it has no obligation to invest in unfavorable market circumstances.

Assume the investment cost grows at the risk-free rate, 8%. The investment outlay next year
will be:

I1  104 1  0.08 
 112.32

The intrinsic value of this call option if the market turns out to be:

Good  Cu  max V0u  I1 , 0 

 max 180  112.32 , 0 
 67.68

Bad  Cd  max V0 d  I1 , 0 

 max  60  112.32 , 0 
0

182
The payoff structure:

p  0.4
V0u  $180
Cu  $67.68

V0
C

V0 d  $60
1 p  0.6
Cd  $0

Applying the risk neutral probability formula:

1  rf  d
p
ud
1.08  0.6

1.8  0.6
 0.4

The total value of the investment opportunity, that is, the expanded NPV that incorporates the
value of the option to defer:

1
C  pCu  1  p  Cd 
1  rf 
1
 0.4  67.68  0.6  0
1.08
 25.07

With managerial flexibility, the investment criterion is similar to the standard NPV analysis.
This flexibility calls for an expanded NPV criterion that reflects both sources of a project’s
static NPV and a premium for the flexibility embedded in its operating options.

Recall that,

Expanded NPV  Static NPV  Option Premium

25.07  4  29.07

183
Since the option premium is worth 29.07, although the project per se has a negative (static)
NPV of $4 if taken immediately, the investment proposal should not be rejected because the
opportunity to invest in the project within a year is worth a positive $25.07.

9.6. The Option to Expand

Once a project is undertaken, the manager may find it desirable to invest more as the product
is more enthusiastically received in the market than originally expected.

Suppose that in the example, the firm has the option to invest an additional I1  $80 one year
after the initial investment which would double the scale and value of the plant.

The payoff structure:

The firm will only exercise its option to expand if market turns out to be good, but will leave
it unexercised otherwise.

The value of the option to expand:

1
C0   pCu  1  p  Cd 
1  rf 
1
  0.4 100  0.6  0
1.08
 37.04

Expanded NPV  Static NPV  Option Premium

33.04  4  37.04

184
9.7. The Option to Contract

Sometimes, if the product is not as well received in the market as initially expected, it is worth
to contract the scale of a project’s operation by cutting down future expenditures.

The option to contract is like a put option on part of the project with an exercise price equal to
the value of the planned expenditures that can be forgone.

Suppose that in the example part of the investment cost having a $104 present value necessary
to initiate and maintain the given scale of the plant’s operation is to be spent next year.
Assume $50 has to pay immediately and I1  $58.32 (the future value of $54) is the planned
investment in next year.

Suppose also that in one year, as an alternative to making the full $58.32 investment necessary
to maintain the current scale of operations, management has the option to halve the scale and
value of the project by not making the $58.32 outlay.

Clearly, if market condition next year turns out unfavorably, the firm may find it valuable to
exercise its option to contract the scale of the project’s operation.

The payoff structure:

185
The option to contract is worth:

1
P  pPu  1  p  Pd 
1  rf 
1
 0.4  0  0.6  28.32
1.08
 15.73

Expanded NPV  Static NPV  Option Premium

11.73  4  15.73

9.8. Implications for Capital Budgeting

The real option approach offers new insights in decision making by expanding the traditional
NPV analysis such that it incorporates an option premium that reflects the value of managerial
flexibility.

Recognizing the option value in real investments,

1. The conventional, static NPV may indeed undervalue projects by suppressing the “option
premium” component.

2. It may be correct to accept projects with negative NPVs if the option premium associated
with the value of managerial flexibility exceeds the negative NPV of the project’s
measurable expected cash flows.

186
9.9. Appendix

The cost of setting up the portfolio is:

 u  Cu
C  S0  1  
 1  rf  1  rf

Cu  Cd
Substituting   into the cost of portfolio:
S 0u  S 0 d

 C  Cd   u  Cu
C  S0  u  1  
 0
S u  S 0 
d  1  r  1  rf
f 

C  Cd Cu  Cd u C
 u    u
ud u  d 1  rf 1  rf
Cu C u C C C u
  u   u  d  d 
u  d u  d 1  rf 1  rf u  d u  d 1  rf
 1 u 1   u 1 
 Cu      Cd   
 u  d  u  d 1  rf 1  rf    u  d 1  rf u  d 
1  1  rf u   u 1  rf  
 Cu    1  Cd   
1  rf   u  d u  d   u  d u  d  
1  1  rf u ud   u 1  rf  
 Cu      Cd   
1  rf   u  d u  d u  d   u  d u  d  
1  1  r  d   u  1  rf   
   Cd 
f
Cu  
1  rf   u  d   u  d  

1  rf  d u  1  rf  , the value of the call can be simplified

By setting p  and 1  p 
ud ud
into:

1
C  pCu  1  p  Cd 
1  rf 

187
10. Topic 10 – Mergers and Acquisitions

10.1. Opening Vignette

Anheuser-Busch Completes Purchase of Harbin Stake

The Wall Street Journal
May 19, 2004

Anheuser-Busch Co. completed its purchase of a 29.07% stake in Harbin Brewery

Group Ltd. for US$139 million, giving it greater leverage in its takeover battle for the
Chinese brewer against global rival SABMiller.

The purchase bolstered investor expectations that Anheuser-Busch's next step will be
a general offer for all of the shares of Harbin Brewery.

Hong Kong securities law requires a company to make a general offer for the
remaining shares of company after achieving a 30% stake. Now just shy of that trigger,
investors are anticipating Anheuser-Busch's next move. A spokesman for Anheuser-
Busch in Hong Kong declined to comment on the company's plans.

Anheuser-Busch said it paid 3.70 Hong Kong dollars a share for a total purchase price
of HK$1.08 billion, or about US$139 million. SABMiller, which already is Harbin's
largest shareholder with 29.4%, has made its own general offer. Anheuser-Busch and
SABMiller -- the world's No. 1 and 2 brewers, respectively, by volume -- are eager to
increase their role in China's beer market, the world's largest by volume.

Nigel Fairbrass, spokesman for SABMiller, said that the company remained
determined to buy Harbin Brewery, but would still have a strong position in China if its
takeover of Harbin Brewery fell through. "SABMiller remains 100% confident in its offer
for Harbin," he said.

Investor expectations of a bidding war have buoyed Harbin Brewery's share price
since the first attempted hostile takeover by a foreign company of listed Chinese firm
began several weeks ago.

Harbin Brewery's shares were unchanged at HK$4.75 Wednesday in Hong Kong

trading.

188
The battle began in early May, when Anheuser-Busch announced its conditional
purchase of Harbin Brewery shares from Global Conduit Holdings Ltd., a British Virgin
Islands-registered company. Days later, SABMiller launched a hostile bid for Harbin
Brewery, offering HK$4.30 a share.

In the days following the launch of SABMiller's general offer, Harbin Brewery's
management criticized SABMiller's role in the partnership, casting doubt on whether
SABMiller would win a protracted battle for control.

The fast and continuous economic development since the late 1990s has made China one of
the most appealing places for international investments in a number of industries. China’s
huge population coupled with very low per capita beer consumption has tempted nearly every
big multinational brewery, which seeks to boost sales away from the relatively saturated
markets in the developed countries. In this context, Anheuser-Busch and SABMiller, the
world’s top two beer breweries were involved in a fierce acquisition war for China’s fourth-
largest brewery and the most dominant one in the north eastern region, Harbin Beer.

This case brings up two important issues:

1. Why Anheuser-Busch and SABMiller resort to hostile takeovers?

2. What are the major defensive strategies adopted by Harbin Brewery to prevent a hostile
takeover?

In this topic, we first define the key terms and the distinction between mergers and acquisitions
(M&A). We then review the M&A process in Hong Kong. Next, we discuss some of the
reasons why a corporate financial manager may decide to pursue an M&A. We also address
the question of who gets the value that is added when an M&A occurs. Finally, we highlight
some strategic issues and describe some takeover defense mechanisms.

10.2. Terminology

Mergers and acquisitions (M&A) are common in Hong Kong and continue to represent a
significant means by which corporations pursue the objectives of economic growth, expansion,
diversification and wealth realization.

189
The terms mergers and acquisitions are often used interchangeably and cause some confusion.
In general business usage, the term acquisition is merely a synonym for takeover. This leaves
the key question: what is the difference between a merger and an acquisition (or a takeover)?

10.2.1. Merger

Broadly defined, a merger represents a transaction in which the board of directors of two
underlying companies – for example, A and B – reach agreement on terms to combine the assets
and share ownership of the two respective companies. A successful outcome, requiring that
the directors’ proposed terms be approved by both sets of shareholders, leads to the creation of
a new or merged entity, C.

One of the recent deals is the merger of China CNR Corporation Limited (中國北車股份有限
公 司 ) and CSR Corporation Limited ( 中國南 車股份有限公司 ). The two companies
published the joint announcement dated 30 December 2014 announcing that they have entered
into a merger agreement with respect to the merger proposal. On implementation, the merger
proposal will involve a merger by absorption by CSR issuing, on the basis of a single exchange
ratio. Following completion of the merger, the post-merger new company will be renamed
CRRC Corporation Limited (中國中車股份有限公司).

Other notable and high-profile deals included the merger of CK Hutchison Holdings Limited
which replaced Cheung Kong (Holdings) Limited as the holding company of the Cheung Kong
Group and Hutchison Whampoa Limited.

Sometimes, shareholders resist the merger. The attempted merger of Cheung Kong
Infrastructure Holdings Limited and Power Assets Holdings Limited was an example.
Shareholders of Power Assets voted down the proposed merger, suggesting that Power Assets
was worth more than Cheung Kong Infrastructure was offering.

10.2.2. Acquisitions

In contrast, an acquisition involves a bidding party offering to buy shares directly from
shareholders in a designated target. A successful conclusion to a takeover would see the target
shareholders receiving either securities or cash for their shares. Where a stock payment is
involved the target shareholders completely give up all interest in the target but receive an
ownership interest in the new parent.

190
In Hong Kong, most takeovers take place through an off-market transaction between the seller
of a target company’s shares and the bidding party. In the case of an acquisition, the offer
constitutes a formal invitation to all other holders of outstanding shares to sell to the bidder at
a fixed price. The key consideration is the “trigger” to such an offer, which occurs when a
party or group of “parties acting in concert” increases their holding in an underlying stock to
a level breaching the 30% control threshold. This arrangement is supervised by the Securities
and Futures Commission (SFC) through its Codes on Takeovers and Mergers and Share
Repurchases (the Codes).

10.3. Takeovers in Hong Kong

Mergers entail explicit agreement between both respective parties’ boards, occur only
occasionally in Hong Kong. In most cases, the acquirer goes directly to the target firm’s
controlling shareholder. There are three ways of doing this in Hong Kong: through a proxy
fight, a general offer or a scheme of arrangement.

10.3.1. Proxy Fight

In a proxy fight, the bidder can seek the support of the firm’s shareholders in relation to a
specially convened voting arrangement. A proxy vote is where a vote is cast by one person
on behalf of another. However, proxy fights rarely figure in Hong Kong. First and foremost,
they are hostile by nature. Second, they are expensive and necessitate considerable
organizational effort.

10.3.2. General Offer

This is by far the most popular method of acquisition locally and occurs where the acquirer
makes a general offer to the target firm’s shareholders to buy-out all their voting interest.

General offers may be voluntary or mandatory. General offers and other takeovers are subject
to the Securities and Futures Commission’s (SFC) The Codes on Takeovers and Mergers and
Share Repurchases. “Control” exists where 30% or more of an entity’s voting rights are held
by one party or group of connected parties. Crossing the 30% threshold or trigger point can
lead to a mandatory general offer (see Rule 26 of the Codes).

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10.3.2.1. Voluntary Offer

A bidder can make a voluntary offer to all shareholders to acquire their shares in the target.
One example is the voluntary general offer by Citigroup Global Markets Asia Limited on behalf
of ENN Energy and Sinopec Corporation to acquire all of the outstanding shares in the issued
share capital of China Gas.

10.3.2.2. Mandatory Offer

Under Rule 26 of the Codes, a party or parties acting in concert rising from an interest from a
level below 30% to one above it, that is, breaching the 30% control threshold would trigger
such an offer. This holds unless the buying parties receive a waiver from the provisions.

In addition, a mandatory offer occurs when a party or parties acting in concert holding not less
than 30% and not more than 50% of the voting rights of a company, acquires additional voting
rights that increase its ownership interest by more than 2% within any given 12-month period.
This is commonly referred to as the “creeper” provision.

10.3.3. Scheme of Arrangement

In contrast with the offer process, which is led by the bidder, the scheme process is controlled
by the target company. A scheme of arrangement is a court approved process used by
companies in Hong Kong to reorganize their corporate structure. This is a statutory procedure
involving a court sanctioned arrangement between the target and its shareholders. It is
typically implemented by cancelling all the shares of the target for cash, or for securities with
or without a cash alternative, followed by issuing new shares to the bidder.

The Codes require that a scheme of arrangement can only be implemented if approved by at
least 75% of the votes attaching to the shares not already held by the bidder and parties acting
in concert with it (disinterested shares) cast at a meeting of the holders of the disinterested
shares. The number of votes cast against the resolution to approve the scheme at the meeting
cannot be more than 10% of the votes attaching to all disinterested shares.

Contrary to a general offer which is made by the bidder to the target’s shareholders directly
and may therefore be either a recommended offer or a hostile takeover, a scheme of
arrangement is technically an arrangement entered into with the target’s shareholders and is
not normally used for effecting a hostile takeover.

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10.3.4. An Illustration

Consider CU Corporation has the following ownership structure:

Percentage Number of Shares

Controller 35% 700 million
City Corporation 15% 300 million
Poly Corporation 10% 200 million
Public Float 40% 800 million
Total 100% 2,000 million

Suppose Poly agrees with Controller, through private negotiation, to buy Controller’s shares
through an off-market purchase agreement. Suppose the agreed purchase price for this
transaction is $8 per share.

After the transaction, Poly’s voting interest rises from 10% to 45%. Poly is required,
according to the Codes, to make a “General Offer” to all other shareholders in CU. That is,
to make an offer to buy-out the remaining 55% of shares not currently in its ownership, as held
by the Public Float shareholders and City. This reflects Rule 26 of the Codes. The ensuing
offer would constitute a Conditional General Offer.

10.3.4.1. Conditional Offer

In this case, the offer triggered is contingent upon the acceptance condition which requires that
sufficient acceptances be generated from the offer to raise the acquirer’s interest to a level of
more than 50% of the voting shares. Barring this, the offer fails, with all acceptances from
the offer void. Poly is therefore left with the same level of holdings obtaining at the outset of
the offer. When the conditional general offer becomes unsuccessful, Poly’s interest remains
at 45%.

10.3.4.2. Offer Price

If Poly only transacted to purchase shares in CU at the price of $8 per share, and did not buy
any other shares in CU during the six-month period prior to the change of control, the minimum
price Poly would need to offer to buy-out all the remaining shareholders would be $8 per share.

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Rule 26 states that in respect of each class of equity share capital involved, be in cash or be
accompanied by a cash alternative at not less than the highest price paid by the offeror or any
person acting in concert with it for shares of that class of the offeree company during the offer
period and within six months prior to its commencement.

10.3.4.3. Three Possible Outcomes

In the conditional general offer relevant to this illustration, there are three possible outcomes:

1. Acceptances at the end of the general offer period raise Poly’s equity interest to less than
50% of CU’s outstanding shares.

 Suppose Poly’s offer generates acceptances for only 90 million shares, suggesting a
change in Poly’s interest in CU from 45% to 49.5% of all outstanding voting shares.
 In this case, the offer would lapse and be withdrawn, leaving Poly’s interest at the
pre-offer level of 45%.
 Moreover, Poly would not be required to make a further offer. Specifically, a
revised offer should not be formulated within one year of the original offer date.

2. Acceptances from the general offer raise Poly’s interest above the 50% threshold.

 Suppose acceptances for 120 million shares are signaled in the illustration, thus
raising Poly’s stake in CU from 45% to 51%.
 It becomes successful. All acceptances are therefore consummated with full
payment at $8 per share.

3. Acceptances from the offer raise Poly’s interest to more than 75% of CU’s outstanding
equity.

 Again, the offer is successful, so all acceptances are paid for by Poly at the offer price.
 However, the stock of CU cannot be re-listed on the exchange unless at least 25% of
its stock is held in “public hands”.
 Either Poly will not re-list CU or it will be forced to reduce its interest to a level of
75% or below. The latter will arise, if prior to the offer, Poly had indicated its
intention to maintain CU’s listing.
 A subsequent sell-down of Poly’s interest would most likely occur through an off-
market placing. This would have to be made to third-party investors.

194
10.4. Motivations for a Takeover

We now examine why firms are acquired. The reasons for a takeover are manifold but the
primary reason should be the creation (or exploitation) of synergy.

Synergy is the amount by which the value of the combined firm exceeds the sum value of the
two individual firms. That is:

Synergy  Vcombined  Vacquirer  Vtarget 

The key question becomes: where does the synergy come from? From the fundamental

concepts of capital budgeting, increases in cash flow create value. We define CFt as the

difference between the cash flows at date t of the combined firm and the sum of the cash flows
of the two separate firms.

And we know that the cash flow in any period t can be written as:

CFt  Revenuet  Costt  Taxest  Capital Requirementt

This equation suggests that the possible sources of synergy fall into four basic categories:

 Revenue enhancement
 Cost reduction
 Lower taxes
 Lower capital requirements

Improvements in at least one of these four categories create synergy. We are going to discuss
these categories in detail below.

10.4.1. Revenue Enhancement

A combined firm may generate greater revenues than two separate firms. Increased revenues
can come from marketing gains, strategic benefits, and market power.

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10.4.1.1. Marketing Gains

It is frequently claimed that due to improved marketing, mergers and acquisitions can increase
operating revenues.

10.4.1.2. Strategic Benefits

Some acquisitions promise a strategic benefit, which is more like an option than a standard
investment opportunity. For example, imagine that an automobile company acquires an AI
technology firm. The company will be well positioned if technological advances allow AI-
driven autos in the future.

10.4.1.3. Market Power

One firm may acquire another to reduce competition. If so, prices can be increased,
generating monopoly profits. However, mergers that reduce competition do not benefit
society, and the government may challenge them.

10.4.2. Cost Reduction

A combined firm may operate more efficiently than two separate firms. A merger can increase
operating efficiency in the following ways:

 Economies of scale and scope

 Economies of vertical integration
 Technology of transfer
 Complementary resources
 Elimination of inefficient management

10.4.3. Lower Taxes

Tax reduction may be a powerful incentive for some acquisitions. This reduction can come
from the use of tax losses, the use of unused debt capacity, and the use of surplus funds.

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10.4.3.1. Use of Tax Losses

A firm with a profitable division and an unprofitable one will have a lower tax bill because the
loss in one division offsets the income in the other.

Potential Acquirer Target Merged Firm

A B C AC BC
EBIT 100 –100 100
Taxes @34% –34 0 –34
NI 66 –100 66

The tax saving of BC is $34. Anticipated with the future tax savings, B may takeover C by
issuing junk bond. The message of this example is that firms need taxable profits to take
advantage of potential losses. Mergers can sometimes bring losses and profits together.

10.4.3.2. Use of Unused Debt Capacity

There are at least two cases where mergers allow for increased debt and a larger tax shield. In
the first case, the target has too little debt, and the acquirer can infuse the target with the missing
debt. In the second case, both the target and acquirer have optimal debt levels. A merger
leads to risk reduction, generating greater debt capacity and a larger tax shield.

10.4.3.3. Use of Surplus Funds

We have already seen in our previous discussion of dividend policy that an extra dividend will
increase the income tax paid by some investors. Instead, the firm might make acquisitions
with its excess funds. Here, the shareholders of the acquiring firm avoid the taxes they would
have paid on dividend.

10.4.4. Lower Capital Requirements

Mergers can reduce capital requirements. When two firms merge, the managers will likely
find duplicate facilities. For example, if both firms had their own headquarter, all executives
in the merged firm could be moved to one headquarters building, allowing the other
headquarters to be sold.

197
The same goes for working capital. The inventory-to-sales ratio and cash-to-sales ratio often
decrease as firm size increases. A merger permits these economies of scale to be realized,
allowing a reduction in working capital.

10.5. Questionable Motives

10.5.1. Earnings Growth

An acquisition can create the appearance of earnings growth, perhaps fooling investors into
thinking that the firm is worth more than it really is.

A B AB
EPS $1 $1
Stock Price $25 $10
Shares Outstanding 100 100
MV(Equity) $2,500 $1,000
P/E 25 10

Suppose there is no synergy and assume that A acquires B using its own stock.

At current market price, how many shares must A offer to B’s shareholders in exchange for
their shares?

Because the takeover adds no value, the post-takeover value of AB is just the sum of the values
of the two separate companies:

To acquire B, A must pay 1,000. At its pre-takeover stock price of $25 per share, the deal
requires issuing 40 shares. As a group B’s shareholders will then exchange 100 shares in B
for 40 shares in A or 1 share of A for 2.5 shares of B.

198
What is the new EPS for AB? The combined corporation earns 1100  1100  200 and
the new shares outstanding are 140.

Note:

 Buying a firm with a lower P/E can increase EPS in the short-run.
 But the short-term increase in earnings should be offset by the lower future earnings
growth (represented by the depressed P/E) in the long-run.

What is the P/E ratio of A before and after the takeover?

Buy for “growth” by increasing EPS is just an earnings growth magic. Can we expect this
magic to work in the real world? It appears that the market is too smart to be fooled this easily.

10.5.2. Diversification

Diversification is often mentioned as a benefit of one firm acquiring another. However,

diversification by itself, cannot produce increases in value.

Recall that risk can be categorized into two forms: systematic and unsystematic. Systematic
risk cannot be eliminated by diversification, so mergers will not eliminate this risk at all. By
contrast, unsystematic risk can be diversified away through mergers. However, the investors
do not need widely diversified companies to eliminate unsystematic risk. They can diversify
more easily than corporations by simply purchasing common stock in different corporations.

199
10.6. The NPV of a Deal

Firms typically use NPV analysis when making acquisitions. What the acquiring company
pays for a target in a deal is called “consideration”. The analysis is relatively straightforward
when the consideration is cash. The analysis becomes more complex when the consideration
is stock.

10.6.1. Consideration in Cash

Suppose Firm A and Firm B have values as separate entities of $500 and $100 respectively.
They are both all-equity firms. If Firm A acquires Firm B, the merged Firm AB will have a
combined value of $700 due to synergies of $100. The board of Firm B has indicated that it
will sell Firm B if it is offered $150 in cash.

Should Firm A acquire Firm B?

Value of Firm A after acquisition  Value of combined firm  Cash paid




Because Firm A was worth $500 prior to the acquisition, the NPV of Firm A’s shareholder is:

NPV 


Now, assume that there are 25 shares in Firm A and 10 shares in Firm B, each A’s share is
worth $20 and B’s share is worth $10 prior to the merger.

Before Acquisition After Acquisition

Firm A Firm B Firm A
Market value $500 $100
No of shares 25 10
Price per share $20 $10

After the merger, Firm A is worth $22. Looking at the rise in stock price, Firm A should make
the acquisition.

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10.6.2. Acquisition Premium

We discussed both the synergy and the premium of a merger. In general, the total synergy
gain from merger (TG) is the difference between the value of a new merged company and the
sum of values of an acquirer (A) and a target (B) before the merger:

TG  PV  A & B    PV  A  PV  B  

Acquisition premium (AP) is the difference between the acquisition price the acquirer pays for
the target and the pre-merged value of the target firm:

AP  P  B   PV  B 

The distribution of the merger gains between the acquirer and the target:

TG  TG  AP  AP
 PV  A & B    PV  A   PV  B     P  B   PV  B     P  B   PV  B  
 PV  A & B    PV  A   P  B    P  B   PV  B 
gain for acquirer gain for target

In our case, merging Firm A and Firm B creates synergy of $100:

Synergy  PV  AB    PV  A   PV  B  



The acquisition premium to market:

AP  P  B   PV  B 



The gain to shareholders of B is the cost to shareholders of A.

201
In summary:

 NPV to A = Synergy – Cost =

 NPV to B = Acquisition Premium =
 Total Merger NPV = Synergy =

Graphically:

10.6.3. Consideration in Stocks

Of course, Firm A could purchase Firm B with common stock instead of cash. Suppose Firm
A exchanges 7.5 of its shares for the entire 10 shares of Firm B. The exchange ratio is 0.75:1.
The value of each share of Firm A’s stock before the acquisition is $20. Because 7.5 × $20 =
$150, this exchange appears to be the equivalent of purchasing Firm B in cash for $150.

However, this is incorrect! The true cost to Firm A is greater than $150. Why?

To see this, Firm A has 32.5 (25 + 7.5) shares outstanding after the merger.

Firm B shareholders own 23% (7.5 / 32.5) of the combined firm. Their holdings are valued
at $161 (23% × $700). Because these shareholders receive stock in Firm A worth $161, the
cost of the merger to Firm A’s shareholders becomes $161, not $150.

202
What should be the correct exchange ratio?

We begin by defining α, the proportion of the shares in the combined firm that Firm B’s
shareholders own. Because the combined firm’s value is $700, the value of Firm B
shareholders after the merger is:

In other words, Firm B’s shareholders will receive stock worth $150 if they receive 21.43% of
the firm after the merger.

Now, we determine the number of shares issued to Firm B’s shareholders. The proportion
that Firm B’s shareholders have in the combined firm can be expressed as follows:

New shares issued


Old shares  New shares issued
New shares issued
0.2143 
25  New shares issued
 New shares issued 

Total shares outstanding after the merger are 31.819 (25 + 6.819). Because 6.819 shares of
Firm A are exchanged for 10 shares of Firm B, the exchange ratio is 0.6819:1.

To summarize the results:

Firm A After Acquisition

Exchange Ratio Exchange Ratio
Cash
0.75:1 0.6819:1
Market value $550
No of shares 25
Price per share $22

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1. The exchange ratio 0.75:1 is incorrect. The value of each share of Firm A’s stock after
a stock-for-stock transaction is only $21.54 (700 / 32.5), which is lower than the value of
a cash-for-stock transaction.

 The result occurs because the exchange ratio of 7.5 shares of Firm A for 10 shares of
Firm B was based on the premerger prices of the two firms. However, because the
stock of Firm A rises after the merger, Firm B shareholders receive more than $150
in Firm A stock.

2. The 0.6819:1 is the fair exchange ratio. Because there are 31.819 shares after merger,
each share of common stock is worth $22 (700 / 31.819), exactly what it is worth in the
cash-for-stock transaction.

10.7. Empirical Perspective in M&A

From the firm’s point of view, M&A represents an extraordinary event. It is important to
examine the value creation or destruction resulting from the deal and to determine how this
incremental value is distributed among the acquirer and the target.

10.7.1. Stock Market Reaction to Merger Announcements

The most statistically reliable evidence on whether mergers create value for shareholders comes
from traditional short-window event studies, where the average abnormal stock market reaction
at merger announcement is used as a gauge of value creation or destruction.

We will measure the “abnormal” stock price change (return) around the announcement of the
merger (release of information). Positive abnormal return means that a merger creates value
to investors

Stock price is the present value of all future expected cash flows to stockholders discounted at
the appropriate discount rate. When new information is released about a firm, it changes
investors’ expectations about future cash flow and/or discount rate change. Thus, stock prices
should change accordingly. Favorable news about the firm future cash flows and/or discount
rate thus should increase stock price today and generate positive stock returns. Unfavorable
news should lead to negative stock returns.

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10.7.1.1. Do Acquisitions Benefit Shareholders?

Target firm shareholders are clearly winners in merger transactions. The average three-day
abnormal return for target firms is 16%, which rises to 24% over the longer event window.

The evidence on value creation for acquiring firm shareholders is not so clear cut. The
average three-day abnormal return for acquirers is -0.7%, and over the longer event window,
the average acquiring firm abnormal return is -3.8%. It is difficult to claim that acquiring
firm shareholders are losers in merger transactions, but they clearly are not big winners like the
target firm shareholders.

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10.7.1.2. Does the Method of Payment Matter?

The negative announcement period stock market reaction for acquiring firms is limited to those
that finance the merger with stock. Acquiring firms that use at least some stock to finance
their acquisition have reliably negative three-day average abnormal returns of -1.5%, while
acquirers that abstain from equity financing have average abnormal returns of 0.4% which are
indistinguishable from zero.

These findings are consistent with the notion that the announcement period reaction for the
acquirer to a stock-financed merger represents a combination of a merger announcement and
an equity issue announcement.

Target firm shareholders also do better when there is no equity financing. The three-day
average abnormal return for target firms is 13% for stock-financed mergers and just over 20%
for mergers financed without stock.

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10.7.1.3. Long-run Performance

Long-term stock returns can provide additional evidence on long-term merger benefits to
shareholders of acquiring firms. However, it is difficult studying stock prices over long-time
periods largely because we cannot isolate effects of a single event being studied.

Mitchell and Stafford (2000) provide estimates of long-term abnormal returns that are robust
to the most common statistical problems, including cross-sectional dependence. The table
displays three-year post-merger abnormal returns for acquiring firms. The abnormal returns
are calculated for both equal- and value-weight portfolios of acquiring firms in the three-years
following the merger completion.

Significant abnormal returns are only found for the equal-weight portfolios, suggesting that
post-merger abnormal stock price performance is limited to the smallest acquirers.

10.8. Strategic Issues

There is a fundamental problem with takeovers. If each of the existing shareholders holds a
small amount of shares, then no takeover will ever take place.

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10.8.1. The Free Rider Problem and a Public Offer

Suppose:

 Target Company is headed by the “incumbent” management C, who owns 30% of

the target shares.
 Bidder Company is headed by the “bidder” management B, who owns 10% of the
target shares.
 Remainder of the shares (60%) is held by the public at large.
 Number of shares outstanding = 100.

When C controls the Target Company, the value of Target:

 SC  $800 [Shares Outstanding (100) × Price Per Share ($8)].

 ZC  $600 [Value of the strategic importance of Target (Private Benefits) for C].

In such the case:

 C receives:
 B receives:

Bidder Company believes that the value of Target under B’s control becomes:

 S B  $1,300
 Z B  $700

Suppose a once in a life time “conditional offer” of B on all the remaining shares which B does
not own at $10 per share, would the public at large tender their shares?

The payoff of a small shareholder:

B Succeeds B Does Not Succeed

(Acquires > 50% of the Shares)
Tender
Not Tender

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Note:

1. Although the $10 conditional offer is higher than the $8 current value under C’s control,
“Not Tender” is more profitable for the small individual shareholder.

2. Because the offer of $10 is less than the value share of target under B’s control, B’s bid
will fail if every small shareholder takes the strategy “Not Tender”.

3. This is a free rider problem even for all small shareholders that it is better if B wins.

What if B proposes an “unconditional offer”?

The payoff for the small shareholder becomes:

B Succeeds B Does Not Succeed

(Acquires > 50% of the Shares)
Tender
Not Tender

Note:

1. “Not Tender” does not dominate.

2. B wins or not remains uncertain.

3. If B loses, the failed takeover will be very expensive for B because B is obligated to buy
all the shares tendered at $10 without getting the control over Target.

10.8.2. No Free Rider Problem in Mergers

In a merger, the free rider problem does not really occur.

 B proposes the merger of Target and a subsidiary of B. As soon as B obtains a

sufficient number of votes at the general meeting of shareholders, the merger will go
through.
 After the voting, the merger is implemented often via exchange of shares and the
“Tender or Not Tender” decision problem does not occur.

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The payoff of a small shareholder of voting for or against the merger is different from that in a
takeover case. Assume that the exchange rate implies a takeover price at $10 for Target shares.

The decision of a small shareholder:

B Succeeds B Does Not Succeed

Vote “Yes”
Vote “No”

Note:

1. Each individual small shareholder is indifferent between voting “Yes” or “No”; but for all
small shareholders it is better that if B wins in this case.

2. Target managers may or may not ask small shareholders to vote on the merger proposal.

10.9. Takeover Defense

The inflated costs of takeover are driven, in large part, by the resistance of incumbent
management, which might involve managers pressuring companies to buy back their own share.
This not only helps in consolidating the percentage control of the major shareholder but also
bids-up share prices, making it costly for the bidder to acquire more shares.

10.9.1. Defense Mechanisms

There are two defense measures: preventive and reactive.

1. Preventive defense strategies:

 Poison pills.
 Corporate charter amendments (shark repellents).
 Golden parachutes.

2. Reactive defense strategies:

 Greenmail, standstill, and reverse greenmail.

 White knights.
 Scorched earth defense.

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10.9.2. Poison Pills

A poison pill is a rights offering that gives existing target shareholders the right to buy shares
in either the target or the acquirer at a deeply discounted price once certain conditions are met.
Because target shareholders can purchase shares at less than the market price, existing
shareholders of the acquirer effectively subsidize their purchase. This subsidization makes
the takeover so expensive for the acquiring shareholders that they choose to pass on the deal.

10.9.2.1. A Flip-in Poison Pill Example

CU Corporation currently has 90.5 million shares outstanding at $71. Its total market value
is $6,426 million. It has a flip-in poison pill that gives non-hostile shareholders the right to
buy an additional share at half price when a hostile bidder acquires 10% of CU’s shares.

Suppose a hostile bidder buys 10% of shares for a total of $643 million, what will be the effect
on the bidder’s toehold?

Before the poison pill kicks in:

# Shares (million) % Shares MV (million)

Friendly Shareholders
Hostile Bidder
Total
Per Share

After the poison pill kicks in:

# Shares (million) % Shares MV (million)

Friendly Shareholders
Hostile Bidder
Total
Per Share

Once the poison pill is triggered, CU will issue 81.45 million shares at $35.50 per share, thereby
receiving $2,891 million. Thus, the total number of shares outstanding becomes 171.95
million, with a market value of $9,317 million.

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To sum up, if a triggering event occurs, the effect is to dilute the bidder’s toehold and thereby
increase the cost of acquiring control.

The hostile bidder’s position:

 Its ownership drops to 5.3%.

 Its equity value drops from $643 million to $490 million.
 A transfer of $153 million plus additional voting rights to existing shareholders.

10.9.3. Corporate Charter Amendments

The corporate charter dictates the operational procedures for a corporation’s board of directors.
Amendments to the charter that make it more difficult to achieve board of director consensus,
or the replacement of a majority percentage of the board, are effective tools against unwanted
takeover, and are called “shark repellents”.

10.9.3.1. Staggered Boards

A typical charter amendment might stagger the election of board members so that no single
majority voting block of board members can be changed at one time.

In a typical staggered board, every director serves a three-year term and the terms are staggered
so that only one-third of the directors are up for election each year. Thus, even if the bidder’s
candidates win board seats, it will control only a minority of the target board.

A bidder’s candidate would have to win a proxy fight two years in a row before the bidder had
a majority presence on the target board. The length of time required to execute this maneuver
can deter a bidder from making a takeover attempt when the target board is staggered.

10.9.3.2. Dual-class Share Recapitalization

Dual-class recapitalization with disparate voting rights may allow control of the firm to be
concentrated in the hands of management without a corresponding capital investment. This
control can make it difficult, if not impossible, for hostile bidders to take over the firm.

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10.9.4. Golden Parachutes

Management votes itself highly lucrative severance packages which become available upon the
transfer of company ownership. Golden parachute is designed to raise the bidder’s cost of the
acquisition. But it is not a truly effective antitakeover strategy unless coupled with a poison
pill and corporate charter amendments.

10.9.5. Greenmail, Standstill, and Reverse Greenmail

Greenmail is the practice of paying a potential acquirer to leave you alone. It consists of a
payment to buy back shares at a premium price in exchange for the acquirer’s agreement not
to initiate a hostile takeover.

In exchange for the payment, the potential acquirer is required to sign a standstill agreement,
which specifies the amount of stock, if any, the investor can own and the circumstances under
which the raider can sell such stock.

The reverse greenmail reduces number of target shares available for purchase by bidder. The
target repurchases some shareholders’ shares at premium, while excluding the potential bidder.

10.9.6. White Knights

A white knight is a friendly investor that acquires a corporation at a fair consideration with the
support from the corporation’s board of directors and management. This may be during a
period while it is facing a hostile acquisition from another potential acquirer.

10.9.7. Scorched Earth Defense

When a target firm implements this provision, it will make an effort to make itself unattractive
to the hostile bidder. For example, a company may agree to liquidate or destroy all valuable
assets, also called crown jewels, or schedule debt repayment to be due immediately following
a hostile takeover.

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10.9.8. Defense Measures in Asia

Golden parachutes and other well-known poison pill strategies are quite foreign to Hong Kong,
although one or two cases resembling greenmail can be found. “Cross-holdings” of shares
provide a more common form of takeover defense in Asia. They are, perhaps, the most
effective means of eliminating takeover. Companies adopting such structures become like
citadels, almost impenetrable to outsiders. Japan’s keiretsu and South Korea’s chaebol are
the best examples of this arrangement.

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