MBA 540 Maximizing Shareholder Wealth

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MBA 540 Maximizing Shareholder Wealth

• Week 5
• Peggy Determeyer

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Tonight

• Weighted Average Cost of Capital
• Leases
• Step 4 Identify the Alternatives
• Step 5 Evaluate Alternatives
• Step 6 Identify and Assess Risks

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Weighted Average Cost of Capital

• Rate of return expected on average risk
  investments
• Higher or lower risk projects discounted with
  rates above or below WACC
• Caution debt ceiling is not infinite
•  Where
• D Market Value of Debt
• E Market Value of Equity
• Tc Corporate avg tax
• r required rate of return for debt or equity

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Practice Problem

• United Business Forms' capital structure is as
  follows
• Debt 35
• Preferred stock 15
• Common equity 50
• The aftertax cost of debt is 7 percent the cost
  of preferred stock is 10 percent and the cost of
  common equity (in the form of retained earnings)
  is 13 percent.
• Calculate the cost of debt

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Solution
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Problem

• As an alternative to the capital structure in the
  previous problem for United Business Forms, an
  outside consultant has suggested the following
  modifications.
• Debt 65
• Preferred stock 5
• Common equity 30
• Under this new, more debt-oriented arrangement,
  the aftertax cost of debt is 9.8 percent the
  cost of preferred stock is 12 percent and the
  cost of common equity (in the form of retained
  earnings) is 15.5 percent.
• What is the revised cost of capital?

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Solution
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Types of Leases

• The Basics
• A lease is a contractual agreement between a
  lessee and lessor.
• The lessor owns the asset and for a fee allows
  the lessee to use the asset.

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Operating Leases

• Usually not fully amortized.
• Usually require the lessor to maintain and insure
  the asset.
• Lessee enjoys a cancellation option.

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Financial Leases

• The exact opposite of an operating lease.
• Do not provide for maintenance or service by the
  lessor.
• Financial leases are fully amortized.
• The lessee usually has a right to renew the lease
  at expiry.
• Generally, financial leases cannot be cancelled.

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Sale and Lease-Back

• A particular type of financial lease.
• Occurs when a company sells an asset it already
  owns to another firm and immediately leases it
  from them.
• Two sets of cash flows occur
• The lessee receives cash today from the sale.
• The lessee agrees to make periodic lease
  payments, thereby retaining the use of the asset.

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Leveraged Leases

• A leveraged lease is another type of financial
  lease.
• A three-sided arrangement between the lessee, the
  lessor, and lenders.
• The lessor owns the asset and for a fee allows
  the lessee to use the asset.
• The lessor borrows to partially finance the
  asset.
• The lenders typically use a non-recourse loan.
  This means that the lessor is not obligated to
  the lender in case of a default by the lessee.

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Accounting and Leasing

• In the old days, leases led to off-balance-sheet
  financing.
• Today, leases are either classified as capital
  leases or operating leases.
• Operating leases do not appear on the balance
  sheet.
• Capital leases appear on the balance sheetthe
  present value of the lease payments appears on
  both sides.

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Accounting and Leasing

• Balance Sheet
• Truck is purchased with debt
• Truck 100,000 Debt 100,000
• Land 100,000 Equity 100,000
• Total Assets 200,000 Total DE 200,000
• Operating Lease
• Truck Debt
• Land 100,000 Equity 100,000
• Total Assets 100,000 Total DE 100,000
• Capital Lease
• Assets leased 100,000 Obligations - capital
  lease 100,000
• Land 100,000 Equity 100,000
• Total Assets 200,000 Total DE 200,000

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Capital Lease

• A lease must be capitalized if any one of the
  following is met
• The present value of the lease payments is at
  least 90 percent of the fair market value of the
  asset at the start of the lease.
• The lease transfers ownership of the property to
  the lessee by the end of the term of the lease.
• The lease term is 75 percent or more of the
  estimated economic life of the asset.
• The lessee can buy the asset at a bargain price
  at expiry.

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Taxes, the IRS, and Leases

• The principal benefit of long-term leasing is tax
  reduction.
• Leasing allows the transfer of tax benefits from
  those who need equipment but cannot take full
  advantage of the tax benefits of ownership to a
  party who can.
• Naturally, the IRS seeks to limit this,
  especially if the lease appears to be set up
  solely to avoid taxes.

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Taxes, the IRS, and Leases

• The lessee can deduct lease payments if the lease
  is qualified by the IRS.
• The term must be less than 30 years.
• There can be no bargain purchase option.
• The lease should not have a schedule of payments
  that is very high at the start of the lease and
  low thereafter.
• The lease payments must provide the lessor with a
  fair market rate of return.
• The lease should not limit the lessees right to
  issue debt or pay dividends.
• Renewal options must be reasonable and reflect
  fair market value of the asset.

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The Cash Flows of Leasing

• Consider a firm, ClumZee Movers, that wishes to
  acquire a delivery truck.
• The truck is expected to reduce costs by 4,500
  per year.
• The truck costs 25,000 and has a useful life of
  5 years.
• If the firm buys the truck, they will depreciate
  it straight-line to zero.
• They can lease it for 5 years from Tiger Leasing
  with an annual lease payment of 6,250.

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The Cash Flows of Leasing

• Cash Flows Buy
• Year 0 Years 1-5
• Cost of truck 25,000
• After-tax savings 4,500(1-.34) 2,970
• Depreciation Tax Shield 5,000(.34) 1,700
• 25,000 4,670

• Cash Flows Lease
• Year 0 Years 1-5
• Lease Payments 6,250(1-.34) 4,125
• After-tax savings 4,500(1-.34) 2,970
• 1,155

• Cash Flows Leasing Instead of Buying
• Year 0 Years 1-5
• 25,000 1,155 4,670 5,825

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The Cash Flows of Leasing

• Cash Flows Leasing Instead of Buying
• Year 0 Years 1-5
• 25,000 1,155 4,670 5,825
• Cash Flows Buying Instead of Leasing
• Year 0 Years 1-5
• 25,000 4,670 1,155 5,825
• However we wish to conceptualize this, we need to
  have an interest rate at which to discount the
  future cash flows.
• That rate is the after-tax rate on the firms
  secured debt.

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NPV Analysis of the Lease-vs.-Buy Decision

• A lease payment is like the debt service on a
  secured bond issued by the lessee.
• In the real world, many companies discount both
  the depreciation tax shields and the lease
  payments at the after-tax interest rate on
  secured debt issued by the lessee.

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NPV Analysis of the Lease-vs.-Buy Decision
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Debt Displacement and Lease Valuation

• Considering the issues of debt displacement
  allows for a more intuitive understanding of the
  lease versus buy decision.
• Leases displace debtthis is a hidden cost of
  leasing. If a firm leases, it will not use as
  much regular debt as it would otherwise.
• The interest tax shield will be lost.

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Reasons for Leasing

• Good Reasons
• Taxes may be reduced by leasing.
• The lease contract may reduce certain types of
  uncertainty.
• Transactions costs can be higher for buying an
  asset and financing it with debt or equity than
  for leasing the asset.
• Bad Reasons
• Accounting

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Step 4 - Identify the Alternatives

• Long-term debt financing
• Corporate debentures
• Secondary offering of common stock
• Offering preferred stock
• Convertible debt offering
• Debt offering with warrants
• Equity offering of convertible preferred shares
• Use retained earnings

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Step 5 - Evaluate Alternatives

• How do alternatives stack up against the goals?
• What scoring system would you use?
• Are there any conflicts between goals and
  alternatives?

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Step 6 Identify and Assess Risks

• What are the risks?
• What are the consequences of the risks?
• Are the potential consequences worth the risks?
• What are possible mitigants?

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Different Types of Dividends

• Many companies pay a regular cash dividend.
• Public companies often pay quarterly.
• Sometimes firms will throw in an extra cash
  dividend.
• The extreme case would be a liquidating dividend.
• Often companies will declare stock dividends.
• No cash leaves the firm.
• The firm increases the number of shares
  outstanding.

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Repurchase of Stock

• Instead of declaring cash dividends, firms can
  rid itself of excess cash through buying shares
  of their own stock.
• Recently share repurchase has become an important
  way of distributing earnings to shareholders.

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Stock Repurchase versus Dividend
Consider a firm that wishes to distribute
100,000 to its shareholders.

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Stock Repurchase versus Dividend
If they distribute the 100,000 as cash dividend,
the balance sheet will look like this
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Stock Repurchase versus Dividend
If they distribute the 100,000 through a stock
repurchase, the balance sheet will look like this
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Share Repurchase

• Lower tax (but the IRS is watching)
• Tender offers - If offer price is set wrong, some
  stockholders lose.
• Open-market repurchase
• Targeted repurchase
• Greenmail
• Gadflies
• Repurchase as investment - Long-term stock price
  performance of securities after a buyback is
  significantly better than the stock price
  performance of comparable companies that do not
  repurchase.

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What We Know and Do Not Know About Dividend Policy

• Corporations Smooth Dividends.
• Dividends Provide Information to the Market.
• Firms should follow a sensible dividend policy
• Dont forgo positive NPV projects just to pay a
  dividend.
• Avoid issuing stock to pay dividends.
• Consider share repurchase when there are few
  better uses for the cash.

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Summary of Dividends

• The optimal payout ratio cannot be determined
  quantitatively.
• In a perfect capital market, dividend policy is
  irrelevant due to the homemade dividend concept.
• A firm should not reject positive NPV projects to
  pay a dividend.
• Personal taxes and issue costs are real-world
  considerations that favor low dividend payouts.
• Many firms appear to have along-run target
  dividend-payout policy. There appears to be some
  value to dividend stability and smoothing.
• There appears to be some information content in
  dividend payments.

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Options

• Many corporate securities are similar to the
  stock options that are traded on organized
  exchanges.
• Almost every issue of corporate stocks and bonds
  has option features.
• In addition, capital structure and capital
  budgeting decisions can be viewed in terms of
  options.

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Options Contracts Preliminaries

• An option gives the holder the right, but not the
  obligation, to buy or sell a given quantity of an
  asset on (or perhaps before) a given date, at
  prices agreed upon today.
• Calls versus Puts
• Call options gives the holder the right, but not
  the obligation, to buy a given quantity of some
  asset at some time in the future, at prices
  agreed upon today. When exercising a call option,
  you call in the asset.
• Put options gives the holder the right, but not
  the obligation, to sell a given quantity of an
  asset at some time in the future, at prices
  agreed upon today. When exercising a put, you
  put the asset to someone.

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Options Contracts Preliminaries

• Exercising the Option
• The act of buying or selling the underlying asset
  through the option contract.
• Strike Price or Exercise Price
• Refers to the fixed price in the option contract
  at which the holder can buy or sell the
  underlying asset.
• Expiry
• The maturity date of the option is referred to as
  the expiration date, or the expiry.
• European versus American options
• European options can be exercised only at expiry.
• American options can be exercised at any time up
  to expiry.

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Options Contracts Preliminaries

• In-the-Money
• The exercise price is less than the spot price of
  the underlying asset.
• At-the-Money
• The exercise price is equal to the spot price of
  the underlying asset.
• Out-of-the-Money
• The exercise price is more than the spot price of
  the underlying asset.

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Options Contracts Preliminaries

• Intrinsic Value
• The difference between the exercise price of the
  option and the spot price of the underlying
  asset.
• Speculative Value
• The difference between the option premium and the
  intrinsic value of the option.

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Call Options

• Call options gives the holder the right, but not
  the obligation, to buy a given quantity of some
  asset on or before some time in the future, at
  prices agreed upon today.
• When exercising a call option, you call in the
  asset.

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Put Options

• Put options gives the holder the right, but not
  the obligation, to sell a given quantity of an
  asset on or before some time in the future, at
  prices agreed upon today.
• When exercising a put, you put the asset to
  someone.

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Basic Put Option Pricing Relationshipsat Expiry

• At expiry, an American put option is worth the
  same as a European option with the same
  characteristics.
• If the put is in-the-money, it is worth E ST.
• If the put is out-of-the-money, it is worthless.
• P MaxE ST, 0

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Option Summary

• The most familiar options are puts and calls.
• Put options give the holder the right to sell
  stock at a set price for a given amount of time.
• Call options give the holder the right to buy
  stock at a set price for a given amount of time.
• Put-Call parity

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More About Options.

• The value of a stock option depends on six
  factors
• 1. Current price of underlying stock.
• 2. Dividend yield of the underlying stock.
• 3. Strike price specified in the option contract.
• 4. Risk-free interest rate over the life of the
  contract.
• 5. Time remaining until the option contract
  expires.
• 6. Price volatility of the underlying stock.
• Much of corporate financial theory can be
  presented in terms of options.
• Common stock in a levered firm can be viewed as a
  call option on the assets of the firm.
• Real projects often have hidden option that
  enhance value.

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Final Word on Options.

• Options appear in a variety of corporate
  settings.
• We describe four types of options found in common
  corporate finance decisions.
• Executive stock options
• The option to expand embedded in a start-up.
• The option in simple business contracts.
• The option to shut down and reopen a project.
• We have the methodology to value them.