Theory of corporate finance

MM assumptions frictionless capital markets, homogeneous expectations, atomistic market participants, a firm's cashflows do not depend on its financial policy (no distress costsI

consequences of control problems insufficient effort, overinvestment, entrenchment strategies, expropriation of investors' funds (managerial self-dealing)

solutions to control problems legal protection, incentive alignment, delegated monitoring (active vs. passive), the market for corporate control

direct bankruptcy costs legal, administrative and accounting costs, costs associated with the debt liquidation (fire sale)

indirect bankruptcy costs loss of competitiveness (pass up positive NPV, sell valuable assets, loss of key employees), concession to suppliers (denied trade credit, increased prices), concession to customers (reduced prices, loss of business)

key determinants of maturity maturity matching principle, agency costs, adverse selection/information asymmetries

debt contract design placement and maturity, provisions of security, transfer of control rights and other provisions, seniority

consolidation both firms ceases, an entirely new entity is formed and takes the balance sheets of both merging firms

buyout a group of investors purchase an entire public firm and take it private

horizontal merger merging firms operate in the same line of business

vertical merger merging firms operate at different stages of production within same industry

economic motives for mergers synergies, market power

market friction motives for mergers taxes, bankruptcy costs, agency costs of equity/managerial self-interest, information asymmetry/adverse selection, undervaluation, diversification

corporate inversion a domestic company acquires a foreign company and adopts its tax jurisdiction to avoid taxation on repatriated profits

co-insurance effect diversifying mergers always increase the value of the debt at the expense of shareholders via a reduction in the option value of equity

takeover defenses corporate charter defences (shark repellants), poison pills, post-bid repellants

corporate charter defences (shark repellants) staggered boards, supermajority rules, fair price amendments, differential voting rights

poison pills call options exercisable in case of a hostile takeover, covenants or poison puts making all debt payable upon change of control

post-bid repellants white knight, greenmail (repurchase bidder's stock at a premium), pacman (launch counter-bid for the hostile bidder), scorched-earth policies

determinants of value creation from mergers whether or not the bid is contested, merger class (horizontal mergers most likely to realise synergies), payment method (cash), time period (cyclicality of mergers)

primary offering new shares are issued and offered to the public

secondary offering existing shares are sold off by current owners

firm commitment underwriter acts as a dealer, underwriter bears the risk

best-efforts method underwriter acts as a broker, issuing firm bears the risk

pure (Dutch) auction offer price is the highest price at which all shares are sold (replication of a demand curve)

CRAs as delegated monitors firms buy ratings when monitoring costs are not internalised by lender, centralise information and monitoring services, independent signalling of credit risk, signalling requires credibility of CRAs

determinants of payment method (mergers) agency costs of equity (management overinvest using stock which dilute shareholders), asymmetric information (stock offer may signal that acquirer's stock is overvalued, cash offer signals higher degree of confidence in the value of the target)

motives for IPO exit/diversification for entrepreneur and private investors, reduce risk and bankruptcy costs, risk pooling, reduce cost of equity making investments more profitable (liquidity), reduce information asymmetry

book building polling institutional investors to gauge investor demand for the issue, determine size, price and allocation of the offering

powers of large debtholders as active monitors substantial cashflow rights, contingent control rights in case of default, necessity for firms to roll over debt, proxy voting rights

drawbacks of large debtholders as monitors excessive conservatism, holdup problem, little incentive to expend monitoring if firm is far from default

discipline of debt contingent control to force firm into bankruptcy, covenants expand states of nature in which control rights are transferred, Jensen's free cashflow, firms need to regularly roll over debt which gives periodic monitoring opportunities

limitations to debt as governance mechanism nuclear option, debt overhang, covenants may lead to underinvestment, owner-creditor conflicts, illiquidity costs and financial distress costs

drawbacks of takeovers as a governance mechanism expensive and require liquid markets, free-riding problems, incentives for management to underinvest in long-term investments

limitations of LBOs as a governance mechanism transitory form of organisation, high leverage means it is only successful in mature industries with stable cashflows, debt overhang

fisher separation optimal real investment decision is independent of subjective preferences for current/future consumption and only depends on the discount factor

characterisations of public debt low information asymmetries, dispersed lenders with limited monitoring incentives, arm's-length relationship, standardised and inflexible contracts, low interest costs, high fixed costs

characteristics of private debt high information asymmetries, concentrated lenders, closer relationship, flexible contracts, high interest costs, low fixed costs

determinants of placement (debt contracting) degree of information asymmetry

merger combination of two firms into a single entity

agency costs of debt costs arising from debt- and equity-holder conflict, can be borne by either claimant depending on their ability to enforce control rights

free cashflow and agency costs of equity free cashflow increase manager's opportunity for perk consumption, engage in privately beneficial projects (pet projects, diversifying projects), empire building

debt overhang if firm is highly leveraged, most benefits of positive NPV projects will go to debtholders and shareholder's claim to the surplus will be small which leads to foregoing the project and preferring a cash payout (underinvestment)

negative incentive of takeovers management replaced, reorganisation of firm, capital structure and investor influence

advantages of LBO as governance mechanism partners have means and incentives for intervention, high leverage means effective disciplining, management stake in MBO or is replaced from within LBO partners aligns interests

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