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MN50324: Corporate Finance 2011/12: Investment flexibility, Decision trees, Real Options Asymmetric Information and Agency Theory 3. Capital Structure and Value of the Firm. 4. Optimal Capital Structure - Agency Costs, Signalling 5. Dividend policy/repurchases

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MN50324: Corporate Finance 2011/12:

  • Investment flexibility, Decision trees, Real Options
  • Asymmetric Information and Agency Theory
  • 3. Capital Structure and Value of the Firm.
  • 4. Optimal Capital Structure - Agency Costs, Signalling
  • 5. Dividend policy/repurchases
  • 6. Mergers and Acquisitions/corporate control
  • 7. Venture Capital/Private Equity/hedge funds
  • 8. Behavioural Corporate Finance.
  • 9. Emotional Corporate Finance
  • 10. Revision.
1 investment flexibility real options
1: Investment Flexibility/ Real options.
  • Reminder of Corporation’s Objective : Take projects that increase shareholder wealth (Value-adding projects).
  • Investment Appraisal Techniques: NPV, IRR, Payback, ARR
  • Decision trees
  • Real Options
  • Game-theory approach!

Investment Flexibility, Decision Trees, and Real Options

  • Decision Trees and Sensitivity Analysis.
  • Example: From Ross, Westerfield and Jaffe: “Corporate Finance”.
  • New Project: Test and Development Phase: Investment $100m.
  • 0.75 chance of success.
  • If successful, Company can invest in full scale production, Investment $1500m.
  • Production will occur over next 5 years with the following cashflows.

Production Stage: Base Case

Date 1 NPV = -1500 +

= 1517


Decision Tree.

Date 1: -1500

Date 0: -$100

NPV = 1517




Do not Invest

NPV = 0


Do not Invest



Do Not Test


NPV = -3611

Solve backwards: If the tests are successful, SEC should invest, since 1517 > 0.

If tests are unsuccessful, SEC should not invest, since 0 > -3611.


Now move back to Stage 1.

Invest $100m now to get 75% chance of $1517m one year later?

Expected Payoff = 0.75 *1517 +0.25 *0 = 1138.

NPV of testing at date 0 = -100 +

= $890

Therefore, the firm should test the project.

Sensitivity Analysis (What-if analysis or Bop analysis)

Examines sensitivity of NPV to changes in underlying assumptions (on revenue, costs and cashflows).


Sensitivity Analysis.

- NPV Calculation for all 3 possibilities of a single variable + expected forecast for all other variables.

Limitation in just changing one variable at a time.

Scenario Analysis- Change several variables together.

Break - even analysis examines variability in forecasts.

It determines the number of sales required to break even.


Real Options.

A digression: Financial Options (revision)

A call option gives the holder the right (but not the obligation) to buy shares at some time in the future at an exercise price agreed now.

A put option gives the holder the right (but not the obligation) to sell shares at some time in the future at an exercise price agreed now.

European Option – Exercised only at maturity date.

American Option – Can be exercised at any time up to maturity.

For simplicity, we focus on European Options.

  • Today, you buy a call option on Marks and Spencer’s shares. The call option gives you the right (but not the obligation) to buy MS shares at exercise date (say 31/12/10) at an exercise price given now (say £10).
  • At 31/12/10: MS share price becomes £12. Buy at £10: immediately sell at £12: profit £2.
  • Or: MS shares become £8 at 31/12/10: rip option up!

Factors Affecting Price of European Option (=c).

  • -Underlying Stock Price S.
  • -Exercise Price X.
  • Variance of of the returns of the underlying asset ,
  • Time to maturity, T.

The riskier the underlying returns, the greater the probability that the stock price will exceed the exercise price.

The longer to maturity, the greater the probability that the stock price will exceed the exercise price.


Options: Payoff Profiles.

Buying a Call Option.

Selling a put option.

Selling a Call Option.

Buying a Put Option.


Pricing Call Options – Binomial Approach.

Cu = 3






1- q

1- q



  • S = £20. q=0.5. u=1.2. d=.67. X = £21.
  • 1 + rf = 1.1.
  • Risk free hedge Portfolio: Buy One Share of Stock and write m call options.
  • uS - mCu = dS – mCd => 24 – 3m = 13.40.
  • M = 3.53.

By holding one share of stock, and selling 3.53 call options, your payoffs are the same in both states of nature (13.40): Risk free.


Since hedge portfolio is riskless:

1.1 ( 20 – 3.53C) = 13.40.

Therefore, C = 2.21.

This is the current price per call option. The total present value of investment = £12 .19, and the rate of return on investment is

13.40 / 12.19 = 1.1.

alternative option pricing method
Alternative option-pricing method
  • Black-Scholes
  • Continuous Distribution of share returns (not binomial)
  • Continuous time (rather than discrete time).
real options
Real Options
  • Just as financial options give the investor the right (but not obligation) to future share investment (flexibility)
  • Researchers recognised that investing in projects can be considered as ‘options’ (flexibility).
  • “Real Options”: Option to delay, option to expand, option to abandon.
  • Real options: dynamic approach (in contrast to static NPV).
real options1
Real Options
  • Based on the insights, methods and valuation of financial options which give you the right to invest in shares at a later date
  • RO: development of NPV to recognise corporation’s flexibility in investing in PROJECTS.
real options2
Real Options.
  • Real Options recognise flexibility in investment appraisal decision.
  • Standard NPV: static; “now or never”.
  • Real Option Approach: “Now or Later”.
  • -Option to delay, option to expand, option to abandon.
  • Analogy with financial options.
types of real option
Types of Real Option
  • Option to Delay (Timing Option).
  • Option to Expand (eg R and D).
  • Option to Abandon.
option to delay call option
Option to Delay (= call option)


Project value

Investment in waiting:


option to expand call option
Option to expand (= call option)

Value creation

Project value

Investment in initial project: eg R and D (sunk)

option to abandon put option
Option to Abandon ( = put option)

Project goes badly: abandon for liquidation value.

Project value

valuation of real options
Valuation of Real Options
  • Binomial Pricing Model
  • Black-Scholes formula
value of a real option
Value of a Real Option
  • A Project’s Value-added = Standard NPV plus the Real Option Value.
  • For given cashflows, standard NPV decreases with risk (why?).
  • But Real Option Value increases with risk.
  • R and D very risky: => Real Option element may be high.
comparing npv with decision trees and real options revision
Comparing NPV with Decision Trees and Real Options (revision)
  • Dixit and Pyndyck (1994): Simple Example: Decide today to:
  • Invest in a machine at end of year: I = £1,600.
  • End of year: project will be worth 300 (good state forever) or 100 (bad state forever) with equal probability.
  • WACC = 10%.
  • Should we invest?
dixit and pyndyck example
Dixit and Pyndyck example
  • Either pre-commit today to invest in a machine that will cost £1,600 at year end.
  • Or defer investment to wait and see.
  • Good state of nature (P = 0.5): product will be worth £300.
  • Bad state of nature (P = 0.5): product will be worth £100.
value with the option to defer
Value with the option to defer
  • Suppose cost of investment goes up to £1,800 if we decide to wait (so, cost of waiting).
  • Year end good state:
  • Year-end bad state:
value with option to defer continued
Value with option to defer (continued)

Therefore, deferring adds value of £136.30.

Increasing uncertainty; eg price in good or bad state = 400 or zero (rather than 300 or 100)

=> Right to defer becomes more valuable.

comparing npv decision trees and real options continued
Comparing NPV, decision trees and Real Options (continued)





Pre-commitment to invest


Comparing NPV, decision trees and Real Options (continued)




V= 681.8



Max {-700,0}

Don’t Invest

Value with the option to defer


Simplified Examples

  • Option to Expand (page 241 of RWJ)

If Successful


Build First Ice


Do not Expand

If unsuccessful


Option to Expand (Continued)

  • NPV of single ice hotel
  • NPV = - 12,000,000 + 2,000,000/0.20 =-2m
  • Reject?
  • Optimistic forecast: NPV = - 12M + 3M/0.2
  • = 3M.
  • Pessimistic: NPV = -12M + 1M/0.2 = - 7m
  • Still reject?
option to expand continued
Option to expand (continued)
  • Given success, the E will expand to 10 hotels
  • =>
  • NPV = 50% x 10 x 3m + 50% x (-7m) = 11.5 m.
  • Therefore, invest.
option to abandon
Option to abandon.
  • NPV(opt) = - 12m + 6m/0.2 = 18m.
  • NPV (pess) = -12m – 2m/0.2 = -22m.
  • => NPV = - 2m. Reject?
  • But abandon if failure =>
  • NPV = 50% x 18m + 50% x -12m/1.20
  • = 2.17m
  • Accept.
real option analysis and game theory
Real Option analysis and Game theory
  • So far, analysis has assumed that firm operates in isolation.
  • No product market competition
  • Safe to delay investment to see what happens to economy.
  • In real-world, competitors (vultures)
  • Delay can be costly!
option to delay and competition
Option to delay and Competition
  • Smit and Ankum model (1993)
  • Option to defer an investment in face of competition
  • Combines real options and Game-theory.
  • Binomial real options model: lends itself naturally to sequential game approach (see exercise 1).
option to delay and competition continued
Option to delay and competition (continued)
  • Smit and Ankum incorporate game theory (strategic behaviour) into the binomial pricing model of Cox, Ross and Rubinstein (1979).
  • Option to delay increases value (wait to observe market demand)
  • But delay invites product market competition: reduces value (lost monopoly advantage).
  • cost: Lost cash flows
  • Trade-off: when to exercise real option (ie when to delay and when to invest in project).
policy implications of smit and ankum analysis
Policy implications of Smit and Ankum analysis.
  • How can firm gain value by delaying (option to delay) in face of competition?
  • Protecting Economic Rent: Innovation, barriers to entry, product differentiation, patents.
  • Firm needs too identify extent of competitive advantage.
real options and games smit and trigeorgis 2006
Real Options and Games (Smit and Trigeorgis 2006)
  • Game theory applied to real R and D/innovation cases:
  • Expanded (strategic) NPV = direct (passive) NPV + Strategic (commitment) value + flexibility Value.
  • Innovation race between Philips and Sony => Developing CD technology.

Each firm’s dominant strategy: invest early: => Prisoner’s dilemma.

How to collaborate/coordinate on wait, wait?

asymmetric innovation race pre emption
Asymmetric Innovation Race/Pre-emption
  • Asymmetry: P has edge in developing technology, but limited resources.
  • S tries to take advantage of this resource weakness
  • Each firm chooses effort intensity in innovation
  • Low effort: technology follower, but more flexibility in bad states
  • High effort: technology leader, higher development costs, more risk in bad state.
sequential investment game
Sequential Investment Game

High effort



High effort

Low effort

100m, 10m


High effort

10m, 200m

Low effort


Low effort

200m, 100m

In practice, NPV not always used:Why Not?.
  • -Agency (incentive) problems: eg Short-term compensation schemes => Payback.
  • Behavioural:-
  • Managers prefer % figures => IRR, ARR
  • Managers don’t understand NPV/ Complicated Calculations.
  • Payback simple to calculate.
  • Other Behavioural Factors (see later section on Behavioural Finance!!)
  • Increase in Usage of correct DCF techniques (Pike):
  • Computers.
  • Management Education.
game theoretic model of npv
Game-theoretic model of NPV.
  • Israel and Berkovitch RFS 2004.
  • NPV is seen as standard value-maximising technique.
  • But IB’s game-theoretic approach considers the impact of agency and assymetric information problems
israel and berkovitch continued
Israel and Berkovitch (continued)
  • A firm consisting of two components:
  • 1: Top management (Headquarters)
  • 2. divisional managers (“the manager”).
  • Objective of headquarters: Maximisation of shareholder value.
  • Objective of manager: maximise her own utility.
israel and berkovitch continued1
Israel and Berkovitch (continued)
  • HQ needs to design a monitoring and incentive mechanism to deal with these conflicting objectives.
  • => capital allocation system specifying:
  • A capital budgeting rule (eg NPV/IRR) and a wage compensation for divisional managers.
israel and berkovitch
Israel and Berkovitch
  • Paper demonstrates the ingredients of a game-theoretic approach.
  • Players.
  • Objectives (utility functions to maximise)
  • Strategies.
  • Payoffs.
2 information asymmetry agency theory
2. Information Asymmetry/Agency Theory
  • Chapter 12 CWS.
  • We will see that info assymetry and agency theory play a large role in CF analysis.
  • Investment appraisal, capital structure, dividend policy
  • => Game theory
game theory
Game theory
  • Players (eg managers/investors: or competing companies)
  • Actions (eg invest in a project, issue debt, pay dividends etc)
  • Strategies
  • Payoffs/ optimisation.
  • Equilibrium: eg good firm issues high debt, bad firm issues low debt.
  • Or Good firm pays high dividends, bad firm pays low dividends.
information asymmetry
Information Asymmetry
  • Insiders/managers better informed than investors about projects, prospects etc.
  • Managerial actions (eg capital structure choices: debt/equity issues, dividends, repurchases) may reveal information to the market
  • Signalling models of debt, dividends, repurchases
asymmetric info signalling models
Asymmetric info/signalling models
  • Typically, two types of firm: High quality/low quality.
  • Type unobservable to outside investors
  • Manager of High quality firm would like to signal his type to market.
  • Costly signals
  • Cheap-talk signals.
  • Eg level of investment, amount of debt, size of dividend.
pooling versus separating equilibria
Pooling versus separating equilibria
  • Separating equilibrium: good firm can separate for bad firm eg by higher debt
  • Cost of signal: eg expected financial distress
  • Separation requires cost of signal => bad firm cannot (or is unwilling) to mimic good firm’s debt level.
  • Separation: outsiders can determine firm types
  • Pooling: outsiders cannot differentiate between the two types
corporate finance signalling models
Corporate Finance: Signalling Models
  • Based on models from Informational Economics.
  • Eg Akerlof (1970): price signals of quality in used car market (mkt for Lemons!)
  • Spence (1973): education as signals of skill in job market.
  • Myers-Majluf (1984): equity-signalling model based on Akerlof’s Lemons market!
major cf signalling models
Major CF signalling models
  • Signalling project quality with investment (Leland and Pyle 1977)
  • Signalling firm quality with debt (Ross 1977)
  • Signalling expected cashflows with dividends (Bhattacharya 1979)
  • Signalling and the equity issue-invest decision (Myers-Majluf 1984)
stock split signalling
Stock Split signalling
  • Copeland and Brennan 1988
  • Brennan and Hughes 1991.
  • Debt/equity Heinkel 1982
cf and agency theory
CF and Agency Theory
  • Standard CF statement: the firm aims to maximise shareholder wealth => NPV rule.
  • But agency theory =>
  • Separation of Ownership and control
  • Principal/agent relationship
  • Outside investors = Principal
  • Manager = agent
agency theory contiuned
Agency theory (contiuned)
  • Manager self-interested.
  • he may takes private benefits (perks) out of the firm
  • Invest in favourite (pet) projects: empire-builder (eg rapid value-destroying growth => mergers?)
  • Effort-shirking
  • Capital structure/dividends may serve to align managers’ and investors’ interests.
2 cost of capital discount rate investors required return
2. Cost of Capital/discount rate/investors’ required return.
  • What discount rate to use in NPV/ valuation?
  • Portfolio analysis => Investors’ required return as a compensation for risk
  • => CAPM (capital asset pricing model) => cost of equity (risk-averse equity-holders’ required return): increases with risk.
cost of capital discount rate investors required return continued
Cost of Capital/discount rate/investors’ required return (continued).
  • Cost of debt (debt-holders’ required return).
  • Capital structure (mix of debt and equity).
  • => discount rate/cost of capital/investors’ required return=>
  • New project: initial investment
  • Project expected to generate £150 per year forever (perpetuity)
  • Kd=5%, Ke = 15% (Capital structure =50% debt/50% equity)
  • Consider Market Value of firm’s debt = market value of firms equity=> WACC = 10%.
firm valuation cws chapter 14
Firm Valuation (CWS Chapter 14)
  • Formula Approach for Valuing Companies





valuation of all equity firm with growth continued
Valuation of all-equity firm with growth (continued)
  • Present value of the firm is the sum of discounted cashflows from operations less new investments required for growth
  • Fundamental Value (= market value? Efficient mkts/ BCF)
  • Dividend policy (dividends versus investment for growth)
valuation of all equity firm with growth continued1
Valuation of all-equity firm with growth (continued)

V0 = value of assets in place + value of future growth

by substitution
By substitution:



Gordon Growth Model:

Consider later in div policy lecture


3. Capital Structure.

Positive NPV project immediately increases current equity value (share price immediately goes up!)

Pre-project announcement

New capital (all equity)

New project:

Value of Debt

Original equity holders

New equity

New Firm Value





60 -20 = 40.

Value of Debt

= 500.

Original Equity

= 500+40 = 540

New Equity

= 20


Total Firm Value


Value of the Firm and Capital Structure

Value of the Firm = Value of Debt + Value of Equity = discounted value of future cashflows available to the providers of capital.

(where values refer to market values).

Capital Structure is the amount of debt and equity: It is the way a firm finances its investments.

Unlevered firm = all-equity.

Levered firm = Debt plus equity.

Miller-Modigliani said that it does not matter how you split the cake between debt and equity, the value of the firm is unchanged (Irrelevance Theorem).


Value of the Firm = discounted value of future cashflows available to the providers of capital.

-Assume Incomes are perpetuities.

Miller- Modigliani Theorem:

Irrelevance Theorem: Without Tax, Firm Value is independent of the Capital Structure.

Note that



Without Taxes


With Taxes







  • Firm X
  • Henderson Case study

MM main assumptions:

  • - Symmetric information.
  • Managers unselfish- maximise shareholders wealth.
  • Risk Free Debt.
  • MM assumed that investment and financing decisions were separate. Firm first chooses its investment projects (NPV rule), then decides on its capital structure.
  • Pie Model of the Firm:





MM irrelevance theorem- firm can use any mix of debt and equity – this is unsatisfactory as a policy tool.

Searching for the Optimal Capital Structure.

-Tax benefits of debt.

-Asymmetric information- Signalling.

-Agency Costs (selfish managers).

-Debt Capacity and Risky Debt.

Optimal Capital Structure maximises firm value.


3: Optimal Capital Structure, Agency Costs, and Signalling.

Agency costs - manager’s self interested actions. Signalling - related to managerial type.

Debt and Equity can affect Firm Value because:

- Debt increases managers’ share of equity.

-Debt has threat of bankruptcy if manager shirks.

- Debt can reduce free cashflow.

But- Debt - excessive risk taking.



Jensen and Meckling (1976).

- self-interested manager - monetary rewards V private benefits.

- issues debt and equity.

Issuing equity => lower share of firm’s profits for manager => he takes more perks => firm value

Issuing debt => he owns more equity => he takes less perks => firm value


Jensen and Meckling (1976)


Slope = -1






If manager owns all of the equity, equilibrium point A.


Jensen and Meckling (1976)


Slope = -1





Slope = -1/2



If manager owns all of the equity, equilibrium point A.

If manager owns half of the equity, he will got to point B if he can.


Jensen and Meckling (1976)


Slope = -1





Slope = -1/2






If manager owns all of the equity, equilibrium point A.

If manager owns half of the equity, he will got to point B if he can.

Final equilibrium, point C: value V2, and private benefits B1.


Jensen and Meckling - Numerical Example.

Manager issues 100% Debt.

Chooses Project B.

Manager issues some Debt and Equity.

Chooses Project A.

Optimal Solution: Issue Debt?


Issuing debt increases the manager’s fractional ownership => Firm value rises.


Debt and risk-shifting.



Trade-off: Increasing equity => excess perks.

Increasing debt => potential risk shifting.

Optimal Capital Structure => max firm value.






Other Agency Cost Reasons for Optimal Capital structure.

Debt - bankruptcy threat - manager increases effort level. (eg Hart, Dewatripont and Tirole).

Debt reduces free cashflow problem (eg Jensen 1986).


Agency Cost Models – continued.

Effort Level, Debt and bankruptcy (simple example).

Debtholders are hard- if not paid, firm becomes bankrupt, manager loses job- manager does not like this.

Equity holders are soft.

What is Optimal Capital Structure (Value Maximising)?


Firm needs to raise 200, using debt and equity.

Manager only cares about keeping his job. He has a fixed income, not affected by firm value.

a) If debt < 100, low effort. V = 100. Manager keeps job.

b) If debt > 100: low effort, V < D => bankruptcy. Manager loses job.

So, high effort level => V = 500 > D. No bankruptcy => Manager keeps job.

High level of debt => high firm value.

However: trade-off: may be costs of having high debt levels.


Free Cashflow Problem (Jensen 1986).

-Managers have (negative NPV) pet projects.

-Empire Building.

=> Firm Value reducing.

Free Cashflow- Cashflow in excess of that required to fund all NPV projects.

Jensen- benefit of debt in reducing free cashflow.


Jensen’s evidence from the oil industry.

After 1973, oil industry generated large free cashflows.

Management wasted money on unnecessary R and D.

also started diversification programs outside the industry.

Evidence- McConnell and Muscerella (1986) – increases in R and D caused decreases in stock price.

Retrenchment- cancellation or delay of ongoing projects.

Empire building Management resists retrenchment.

Takeovers or threat => increase in debt => reduction in free cashflow => increased share price.


Jensen predicts:

young firms with lots of good (positive NPV) investment opportunities should have low debt, high free cashflow.

Old stagnant firms with only negative NPV projects should have high debt levels, low free cashflow.

Stultz (1990)- optimal level of debt => enough free cashflow for good projects, but not too much free cashflow for bad projects.


Income Rights and Control Rights.

Some researchers (Hart (1982) and (2001), Dewatripont and Tirole (1985)) recognised that securities allocate income rights and control rights.

Debtholders have a fixed first claim on the firm’s income, and have liquidation rights.

Equityholders are residual claimants, and have voting rights.

Class discussion paper: Hart (2001)- What is the optimal allocation of control and income rights between a single investor and a manager?

How effective are control rights when there are different types of investors?

Why do we observe different types of outside investors- what is the optimal contract?



Benefits of Debt

Costs of Debt

Breaking MM

Tax Relief

Fin’l Distress/ Debt Capacity

Agency Models

JM (1976)

Managerial Perks

Increase Mgr’s Ownership

Risk Shifting

Jensen (1986)

Empire Building

Reduce Freecash



Empire Building

Reduce Freecash


Dewatripont and Tirole, Hart.

Low Effort level

Bankruptcy threat =>increased effort

DT- Inefficient liquidations.


Signalling Models of Capital Structure

Assymetric info: Akerlof’s (1970) Lemons Market.

Akerlof showed that, under assymetric info, only bad things may be traded.

His model- two car dealers: one good, one bad.

Market does not know which is which: 50/50 probability.

Good car (peach) is worth £2000. Bad car (lemon) is worth £1000.

Buyers only prepared to pay average price £1500.

But: Good seller not prepared to sell. Only bad car remains.

Price falls to £1000.

Myers-Majuf (1984) – “securities may be lemons too.”


Asymmetric information and Signalling Models.

- managers have inside info, capital structure has signalling properties.

Ross (1977)

-manager’s compensation at the end of the period is

D* = debt level where bad firm goes bankrupt.

Result: Good firm D > D*, Bad Firm D < D*.

Debt level D signals to investors whether the firm is good or bad.


Myers-Majluf (1984).

-managers know the true future cashflow.

They act in the interest of initial shareholders.

Expected Value 190 305

New investors 0 100

Old Investors 190 205


Consider old shareholders wealth:

Good News + Do nothing = 250.

Good News + Issue Equity =

Bad News and do nothing = 130.

Bad News and Issue equity =


Old Shareholders’ payoffsEquilibrium

Issuing equity signals that the bad state will occur.

The market knows this - firm value falls.

Pecking Order Theory for Capital Structure => firms prefer to raise funds in this order:

Retained Earnings/ Debt/ Equity.


Evidence on Capital structure and firm value.

Debt Issued - Value Increases.

Equity Issued- Value falls.

However, difficult to analyse, as these capital structure changes may be accompanied by new investment.

More promising - Exchange offers or swaps.

Class discussion paper: Masulis (1980)- Highly significant Announcement effects:

+7.6% for leverage increasing exchange offers.

-5.4% for leverage decreasing exchange offers.


Practical Methods employed by Companies (See Damodaran; Campbell and Harvey).

  • Trade off models: PV of debt and equity.
  • Pecking order.
  • Benchmarking.
  • Life Cycle.

Increasing Debt?


trade off versus pecking order
Trade-off Versus Pecking Order.
  • Empirical Tests.
  • Multiple Regression analysis (firm size/growth opportunities/tangibility of assets/profitability…..
  • => Relationship between profitability and leverage (debt): positive => trade-off.
  • Or negative => Pecking order:
  • Why?
  • China: Reverse Pecking order
capital structure and product market competition
Capital Structure and Product Market Competition.
  • Research has recognised that firms’ financial decisions and product market decisions not made in isolation.
  • How does competition in the product market affect firms’ debt/equity decisions?
  • Limited liability models: Debt softens competition: higher comp => higher debt.
  • Predation models: higher competition leads to lower debt. (Why?)
capital structure and takeovers
Capital Structure and Takeovers
  • Garvey and Hanka:
  • Waves of takeovers in US in 1980’s/1990’s.
  • Increase in hostile takeovers => increase in debt as a defensive mechanism.
  • Decrease in hostile takeovers => decrease in debt as a defensive mechanism.
garvey and hanka contiuned
Garvey and Hanka (contiuned)


Trade-off: Tax shields/effort levels/FCF/ efficiency/signalling Vs financial distress



game theoretic approach to capital structure
Game Theoretic Approach to Capital Structure.
  • Moral Hazard Model.
  • Asymmetric Information Model.
  • See BCF section 8 for incorporation of managerial overconfidence.
cash flow rights and control rights
Cash-flow Rights and Control Rights
  • Debt-holders: first fixed claim on cash-flows (cash-flow rights); liquidation rights in bas times (control rights)- hard investors.
  • Equity-holders: residual claimants on cash-flows (cash-flow rights): voting rights in good times (control rights) – soft investors.
  • => minority shareholder rights versus blockholders.
equity holders control rights
Equity-holders’ control rights
  • Voting rights.
  • Soft: free-rider problems.
  • Minority holders versus block-holders.
  • Minority –holders versus insiders.
  • Separation of ownership and control.
  • Corporate Charter.
  • Dual class of shares.
  • Pyramids/tunelling etc.
capital corporate structure in emerging economies
Capital/corporate structure in emerging economies.
  • Separation of ownership and control.
  • Corporate Charter.
  • Dual class of shares.
  • Pyramids/tunelling etc.
  • Weak Legal Systems.
  • Cultural differences.
game theoretic approaches
Game-theoretic approaches.
  • JFE special issue 1988 (Grossman and Hart, Stultz, Harris and Raviv).
  • Bebchuk (lecture slides to follow).
  • Garro Paulin and Fairchild (2006) Lecture slides to follow.
mergers and acquisitions
Mergers and Acquisitions
  • Acquisitions
  • Divestitures
  • Restructuring
  • Corporate Governance
growth strategies
Growth Strategies
  • Mergers: one economic unit formed from 2 or more previous units
  • A) Tender offer



Stock Acquisition


Proxy Contest

1. Merger- must be approved by stockholders’ votes.

2. Stock acquisition- No shareholder meeting, no vote required.

-bidder can deal directly with target’s shareholders- bypassing target’s management.

- often hostile => target’s defensive mechanisms.

-shareholders may holdout- freerider problems.

3. Proxy Contests- group of shareholders try to vote in new directors to the board.

growth strategies1
Growth Strategies
  • Mergers: one economic unit formed from 2 or more previous units
  • A) Tender offer
  • B) Pooling of Interest
  • Joint Ventures
  • Other collaborations (supplier networks, alliances, investments, franchises)
shrinkage strategies
Shrinkage strategies
  • Divestitures
  • Equity carveouts
  • Spin-offs
  • Tracking stock
theories of m and a
Theories of M and A.
  • Efficiency increases (restructuring)
  • Operating Synergies
  • Financial Synergy
  • Information
  • Hubris and the Winner’s curse
  • Agency Problems (changes in ownership/managerialism/FCF)
  • Redistribution (tax, mkt power, …)
synergy value of a merger
Synergy Value of a Merger

Synergy comes from increases in cashflow form the merger:

example market value after merger
Example: Market Value after Merger.
  • Firm A (bidder): cashflows = £10m, r = 20%. V = £50m.
  • Firm B (target): cashflows = £6m, r = 15%. = £40m.
  • If A acquires B: Combined Cashflows are expected to increase to £25m P.A. New Discount rate 25%.
  • Synergy cashflows = £9m.
  • Total value = £100m.
  • Synergy Value = £10m.
who gets the gains from mergers
Who gets the gains from mergers?

Who gets the gains from mergers?

Depends on what the bidder has to pay! (bid premium)

If Bidder gets all of the positive NPV.

If Target gets all of the positive NPV.

why a bid premium
Why a Bid premium?
  • Hostile Bid: defensive (anti-takeover) mechanisms (leverage increases, poison pills, etc):
  • Bidding wars.
  • Market expectations.

Effects of takeovers on stock prices of bidder and target.

Successful Bids

Unsuccessful Bids

Jensen and Ruback JFE 1983

game theoretic approach to m and a
Game Theoretic Approach to M and A.
  • Grossman and Hart (Special Issue on Corporate Control 1982).
  • Harris and Raviv (Special Issue on Corporate Control 1982).
  • Bebchuk (Special Issue on Corporate Control 1982)..
  • Burkart (JOF 1995).
  • Garvey and Hanka.
  • Krause.
garvey and hanka paper
Garvey and Hanka paper
  • Lecture slides to follow.
grossman and hart free rider paper
Grossman and Hart free-rider paper
  • Lecture slides to follow.
convertible debt
Convertible Debt
  • -Valuation of Convertibles.
  • -Impact on Firm Value.
  • -Why firms issue convertibles.
  • -When are they converted (call policy)?
  • Convertible bond -holder has the right to exchange the bond for common stock (equivalent to a call option).
  • Conversion Ratio = number of shares received for each bond.
  • Value of Convertible Bond = Max{ Straight bond value, Conversion Value} +option value.

Value of Convertible Bond.


Straight Bond Value

Conversion Value

Face Value

Firm Value

Firm Value

Total Value of Convertible Bond

Firm Value

Conflict between Convertible Bond holders and managers.
  • Convertible Bond = straight debt + call option.
  • Value of a call option increases with:
  • Time.
  • Risk of firm’s cashflows.
  • Implications: Holders of convertible debt maximise value by not converting until forced to do so => Managers will want to force conversion as soon as possible.
  • Incentive for holders to choose risky projects => managers want to choose safe projects.

Reasons for Issuing Convertible Debt.

Much real world confusion.

Convertible debt - lower interest rates than straight debt.

=> Cheap form of financing?

No! Holders are prepared to accept a lower interest rate because of their conversion privilege.

CD =

D =

Example of Valuation of Convertible Bond.
  • October 1996: Company X issued Convertible Bonds at October 1996: Coupon Rate 3.25%, Each bond had face Value £1000.
  • Bonds to mature October 2001.
  • Convertible into 21.70 Shares per per bond until October 2001.
  • Company rated A-. Straight bonds would yield 5.80%.
  • Now October 1998:
  • Face Value £1.1 billion.
  • Convertible Bonds trading at £1255 per bond.
  • The value of the convertible has two components; The straight bond value + Value of Option.

Valuation of Convertible Bond- Continued.

If the bonds had been straight bonds: Straight bond value =

PV of bond =

Price of convertible = 1255.

Conversion Option = 1255 – 933 = 322.

Oct 1998 Value of Convertible = 933 + 322 = 1255. = Straight Bond Value + Conversion Option.


Alternative Analysis of Irrelevance of Convertible Debt.

Firm Indifferent between issuing CD, debt or equity.


Why do firms issue convertible debt?
  • If convertible debt is not a cheap form of financing, why is it issued?
  • A. Equity through the Back Door (Stein, Mayers).
  • -solves asymmetric information problems (see Myers-Majluf).
  • -solves free cashflow problems.
  • B. Convertible debt can solve risk-shifting problems.
  • - If firm issues straight debt and equity, equity holders have an incentive to go for risky (value reducing) NPV projects.
  • Since CD contains an option feature, CD value increases with risk.
  • -prevents equity holders’ risk shifting.

Convertible Debt and Call Policy.

Callable Convertible debt =>firms can force conversion.

When the bond is called, the holder has 30 days to either:

a) Convert the bond into common stock at the conversion ratio, or

b) Surrender the bond for the call price.

When should the bond be called?

Option Theory: Shareholder wealth is maximised/ CD holders wealth is minimised if

Firm calls the bond as soon as value = call price.

Call Puzzle.
  • Manager should call the bond as soon as he can force conversion.
  • Ingersoll (1977) examined the call policies of 124 firms 1968-1975.
  • - He found that companies delayed calling far too long.
  • - median company waited until conversion value was 44% above call price - suboptimal.
  • Call Puzzle addressed by Harris and Raviv.
  • - signalling reasons for delaying calling.
  • - early calling might signal bad news to the market.
4 dividend policy
4: Dividend Policy
  • Miller-Modigliani Irrelevance.
  • Gordon Growth (trade-off).
  • Signalling Models.
  • Agency Models.
  • Lintner Smoothing.
  • Dividends versus share repurchases.
  • Empirical examples
early approach
Early Approach.
  • Three Schools of Thought-
  • Dividends are irrelevant (MM).
  • Dividends => increase in stock prices (signalling/agency problems).
  • Dividends => decrease in Stock Prices (negative signal: non +ve NPV projects left?).
  • 2 major hypotheses: Free-cash flow versus signalling
important terminology
Important terminology
  • Cum Div: Share price just before dividend is paid.
  • Ex div: share price after dividend is paid < Cum div.









  • A firm is expecting to provide dividends every year-end forever of £10. The cost of equity is 10%.
  • We are at year-end, and div is about to be paid. Current market value of equity = 10/0.1 + 10 = £110
  • Div is paid. Now, current market value is
  • V = 10/0.1 = £100.
  • So on…


CD = 110



ED = 100




common stock valuation model
Common Stock Valuation Model
  • You are considering buying a share at price Po, and expect to hold it one year before selling it ex-dividend at price P1: cost of equity = r.

What would the buyer be prepared to pay to you?



Continuing this process, and re-substituting in (try it!), we obtain:

Price today is discounted value of all future dividends to infinity (fundamental value = market value).

dividend irrelevance miller modigliani
Dividend Irrelevance (Miller-Modigliani)
  • MM consider conditions under which dividends are irrelevant.
  • Investors care about both dividends and capital gains.
  • Perfect capital markets:-
  • No distorting taxes
  • No transactions costs.
  • No agency costs or assymetric info.
dividend irrelevance mm continued
Dividend Irrelevance (MM): continued
  • Intuition: Investors care about total return (dividends plus capital gains).
  • Homemade leverage argument
  • Source and application of funds argument => MM assumed an optimal investment schedule over time (ie firm invests in all +ve NPV projects each year).
deriving mm s dividend irrelevance
Deriving MM’s dividend irrelevance
  • Total market value of our all-equity firm is

Sources = Uses

re arranging

Substitute into first equation:

At t =0,

successive substitutions
Successive substitutions
  • Current value of all-equity firm is present value of operating cashflows less re-investment for all the years (residual cashflow available to shareholders) Dividends do not appear!
  • Assn: firms make optimal investments each period (firm invests in all +ve NPV projects).
  • Firms ‘balance’ divs and equity each period: divs higher than residual cashflow => issue shares.
  • Divs lower than free cashflow: repurchase shares.
irrelevance of mm irrelevance deangelo and deangelo
Irrelevance of MM irrelevance (Deangelo and Deangelo)
  • MM irrelevance based on the idea that all cash will be paid as dividend in the end (at time T).
  • Deangelo argues that even under PCM, MM irrelevance can break down if firm never pays dividend!
irrelevance of mm irrelevance continued
Irrelevance of MM irrelevance (continued)
  • Consider an all-equity firm that is expected to produce residual cashflows of £10 per year for 5 years.
  • Cost of equity 10%.
  • First scenario: firm pays no dividends for the first 4 years. Pays all of the cashflows as dividends in year 5.
  • Now it is expected to pay none of the cashflows in any year: Vo = 0 !
breaking mm s irrelevance
“Breaking” MM’s Irrelevance
  • MM dividend irrelevance theorem based on:
  • PCM
  • No taxes
  • No transaction costs
  • No agency or asymmetric information problems.
gordon growth model
Gordon Growth Model.
  • MM assumed firms made optimal investments out of current cashflows each year
  • Pay any divs it likes/ balanced with new equity/repurchases.
  • What if information problems etc prevent firms easliy going back to capital markets:
  • Now, real trade-off between investment and dividends?

Gordon Growth Model.

Where does growth come from?- retaining cashflow to re-invest.

Constant fraction, K, of earnings retained for reinvestment.

Rest paid out as dividend.

Average rate of return on equity = r.

Growth rate in cashflows (and dividends) is g = Kr.


Example of Gordon Growth Model.

How do we use this past data for valuation?


Finite Supernormal Growth.

  • Rate of return on Investment > market required return for T years.
  • After that, Rate of Return on Investment = Market required return.

If T = 0, V = Value of assets in place (re-investment at zero NPV).

Same if r =


Examples of Finite Supernormal Growth.

T = 10 years. K = 0.1.

  • Rate of return, r = 12% for 10 years,then 10% thereafter.

B. Rate of return, r = 5% for 10 years,then 10% thereafter.

dividend smoothing v optimal re investment fairchild 2003
Dividend Smoothing V optimal re-investment (Fairchild 2003)
  • Method:-
  • GG Model: derive optimal retention/payout ratio
  • => deterministic time path for dividends, Net income, firm values.
  • => Stochastic time path for net income: how can we smooth dividends (see Lintner smoothing later….)
deterministic dividend policy
Deterministic Dividend Policy.
  • Recall
  • Solving
  • We obtain optimal retention ratio
analysis of
Analysis of
  • If
  • If with
  • Constant r over time => Constant K* over time.
deterministic case continued
Deterministic Case (Continued).
  • Recursive solution:
  • => signalling equilibria.
  • Shorter horizon => higher dividends.

When r is constant over time, K* is constant. Net Income, Dividends, and firm value evolve deterministically.

stochastic dividend policy
Stochastic dividend policy.
  • Future returns on equity normally and independently distributed, mean r.
  • Each period, K* is as given previously.
  • Dividends volatile.
  • But signalling concerns: smooth dividends.
  • => “buffer” from retained earnings.
agency problems
Agency problems
  • Conflicts between shareholders and debtholders: risk-shifting: high versus low dividends => high divs => credit rating of debt
  • Conflicts between managers and shareholders: Jensen’s FCF, Easterbrook.

Are Dividends Irrelevant?

- Evidence: higher dividends => higher value.

- Dividend irrelevance : freely available capital for reinvestment. - If too much dividend, firm issued new shares.

- If capital not freely available, dividend policy may matter.

C. Dividend Signalling - Miller and Rock (1985).

NCF + NS = I + DIV: Source = Uses.

DIV - NS = NCF - I.

Right hand side = retained earnings. Left hand side - higher dividends can be covered by new shares.


Div - NS - E (Div - NS) = NCF - I - E (NCF - I)

= NCF - E ( NCF).

Unexpected dividend increase - favourable signal of NCF.

E(Div - NS) = E(NCF - I) = 300.

Date 1 Realisation: Firm B: Div - NS - E (Div - NS) = 500 = NCF - E ( NCF).

Firm A : Div - NS - E (Div - NS) = -500 = NCF - E ( NCF).

dividend signalling models
Dividend Signalling Models.
  • Bhattacharya (1979)
  • John and Williams (1985)
  • Miller and Rock (1985)
  • Ofer and Thakor (1987)
  • Fuller and Thakor (2002).
  • Fairchild (2009/10).
  • Divs credible costly signals: Taxes or borrowing costs.
competing hypotheses
Competing Hypotheses.
  • Dividend Signalling hypothesis Versus Free Cashflow hypothesis.
  • Fuller and Thakor (2002; 2008): Consider asymmetric info model of 3 firms (good, medium, bad) that have negative NPV project available
  • Divs used as a) a positive signal of income, and b) a commitment not to take –ve NPV project (Jensen’s FCF argument).
  • Both signals in the same direction (both +ve)
signalling fcf and dividends fuller and thakor 2002
Signalling, FCF, and Dividends.Fuller and Thakor (2002)
  • Signalling Versus FCF hypotheses.
  • Both say high dividends => high firm value
  • FT derive a non-monotonic relationship between firm quality and dividends.


Firm Quality

fairchild 2009 2010
Fairchild (2009, 2010)
  • Signalling Versus FCF hypotheses.
  • But, in contrast to Fuller and Thakor, I consider +ve NPV project.
  • Real conflict between high divs to signal current income, and low divs to take new project.
  • Communication to market/reputation.
cohen and yagil
Cohen and Yagil
  • New agency cost: firms refusing to cut dividends to invest in +ve NPV projects.
  • Wooldridge and Ghosh
  • 6 roundtable discussions of CF.
agency models
Agency Models.
  • Jensen’s Free Cash Flow (1986).
  • Stultz’s Free Cash Flow Model (1990).
  • Easterbrook.
  • Fairchild (2009/10): Signalling + moral hazard.
behavioural explanation for dividends
Behavioural Explanation for dividends
  • Self-control.
  • Investors more disciplined with dividend income than capital gains.
  • Mental accounting.
  • Case study from Shefrin.
  • Boyesen case study.

D. Lintner Model.

Managers do not like big changes in dividend (signalling).

They smooth them - slow adjustment towards target payout rate.

K is the adjustment rate. T is the target payout rate.


Using Dividend Data to analyse Lintner Model.

In Excel, run the following regression;

The parameters give us the following information,

a = 0, K = 1 – b, T = c/ (1 – b).

dividends and earnings
Dividends and earnings.
  • Relationship between dividends, past, current and future earnings.
  • Regression analysis/categorical analysis.
dividends v share repurchases
Dividends V Share Repurchases.
  • Both are payout methods.
  • If both provide similar signals, mkt reaction should be same.
  • => mgrs should be indifferent between dividends and repurchases.
dividend share repurchase irrelevance
Dividend/share repurchase irrelevance
  • Misconception (among practitioners) that share repurchasing can ‘create’ value by spreading earnings over fewer shares (Kennon).
  • Impossible in perfect world:
  • Fairchild (JAF).
dividend share repurchase irrelevance continued
Dividend/share repurchase irrelevance (continued)
  • Fairchild: JAF (2006):
  • => popular practitioner’s website argues share repurchases can create value for non-tendering shareholders.
  • Basic argument: existing cashflows/assets spread over fewer shares => P !!!
  • Financial Alchemy !!!
the example
The Example:….
  • Kennon (2005): Eggshell Candies Inc
  • Mkt value of equity = $5,000,000.
  • 100, 000 shares outstanding
  • => Price per share = $50.
  • Profit this year = £1,000,000.
  • Mgt upset: same amount of candy sold this year as last: growth rate 0% !!!
eggshell example continued
Eggshell example (continued)
  • Executives want to do something to make shareholders money after the disappointing operating performance:
  • => One suggests a share buyback.
  • The others immediately agree !
  • Company will use this year’s £1,000,000 profit to but stock in itself.
eggshell example continued1
Eggshell example (continued)
  • $1m dollars used to buy 20,000 shares (at $50 per share). Shares destroyed.
  • => 80,000 shares remain.
  • Kennon argues that, instead of each share being 0.001% (1/100,000) of the firm, it is now .00125% of the company (1/80)
  • You wake up to find that P from $50 to $62.50. Magic!
kennon quote
Kennon quote
  • “When a company reduces the amount of shares outstanding, each of your shares becomes more valuable and represents a greater % of equity in the company … It is possible that someday there may be only 5 shares of the company, each worth one million dollars.”
  • Fallacy! CF: no such thing as a free lunch!
mm irrelevance applied to eggshell example
MM Irrelevance applied to Eggshell example

At beginning of date 0:

At end of date 0, with N0 just achieved, but still in the business (not yet paid out as dividends or repurchases:

eggshell figures
Eggshell figures

Cost of equity will not change: only way to increase value per share is to improve company’s operating performance, or invest in new positive NPV project. Repurchasing shares is a zero NPV proposition (in a PCM).

Eggshell has to use the $1,000,000 profit to but the shares.

eggshell irrelevance continued
Eggshell irrelevance (continued)
  • Assume company has a new one-year zero NPV project available at the end of date 0.
  • 1. Use the profit to Invest in the project.
  • 2. Use the profit to pay dividends, or:
  • 3. Use the profit to repurchase shares.
eggshell continued
Eggshell (continued)



Ex div

Each year –end: cum div = $50, ex div = $40


long term effects of repurchase
Long-term effects of repurchase
  • See tables in paper:
  • Share value pre-repurchase = $5,000,000 each year.
  • Share value-post repurchase each year = $4,000,000
  • Since number of shares reducing, P .by 25%, but this equals cost of equity.
  • And is same as investing in zero NPV project.
conclusion of analysis
Conclusion of analysis
  • In PCM, share repurchasing cannot increase share price (above a zero NPV investment) by merely spreading cashflows over smaller number of shares.
  • Further, if passing up positive NPV to repurchase, not optimal!
  • Asymmetric info: repurchases => positive signals.
  • Agency problems: FCF.
  • Market timing.
  • Capital structure motives.
dividend share repurchase irrelevance1
Dividend/share repurchase irrelevance
  • See Fairchild (JAF 2005)
  • Kennon’s website
  • Mgrs think divs reveal more info than repurchases (see Graham and Harvey “Payout policy”.
  • Mgrs smooth dividends/repurchases are volatile.
  • Dividends paid out of permanent cashflow/repurchases out of temporary cashflow.
motives for repurchases wansley et al fm 1989
Motives for repurchases (Wansley et al, FM: 1989).
  • Dividend substitution hypothesis.
  • Tax motives.
  • Capital structure motives.
  • Free cash flow hypothesis.
  • Signalling/price support.
  • Timing.
  • Catering.
repurchase signalling
Repurchase signalling.
  • Price Support hypothesis: Repurchases signal undervaluation (as in dividends).
  • But do repurchases provide the same signals as dividends?
repurchase signalling chowdhury and nanda model rfs 1994
Repurchase signalling: (Chowdhury and Nanda Model: RFS 1994)
  • Free-cash flow => distribution as commitment.
  • Dividends have tax disadvantage.
  • Repurchases lead to large price increase.
  • So, firms use repurchases only when sufficient undervaluation.
open market stock repurchase signalling mcnally 1999
Open market Stock Repurchase Signalling:McNally, 1999
  • Signalling Model of OM repurchases.
  • Effect on insiders’ utility.
  • If do not repurchase, RA insiders exposed to more risk.
  • => Repurchase signals:
  • a) Higher earnings and higher risk,
  • b) Higher equity stake => higher earnings.
repurchase signalling isagawa fr 2000
Repurchase Signalling :Isagawa FR 2000
  • Asymmetric information over mgr’s private benefits.
  • Repurchase announcement reveals this info when project is –ve NPV.
  • Repurchase announcement is a credible signal, even though not a commitment.
costless versus costly signalling bhattacharya and dittmar 2003
Costless Versus Costly Signalling:Bhattacharya and Dittmar 2003
  • Repurchase announcement is not commitment.
  • Costly signal: Actual repurchase: separation of good and bad firm.
  • Costless (cheap-talk): Announcement without repurchasing. Draws analysts’ attention.
  • Only good firm will want this
repurchase timing
Repurchase timing
  • Evidence: repurchase timing (buying shares cheaply.
  • But market must be inefficient, or investors irrational.
  • Isagawa.
  • Fairchild and Zhang.
repurchases and irrational investors isagawa 2002
Repurchases and irrational investors.Isagawa 2002
  • Timing (wealth-transfer) model.
  • Unable to time market in efficient market with rational investors.
  • Assumes irrational investors => market does not fully react.
  • Incentive to time market.
  • Predicts long-run abnormal returns post-announcement.
repurchase catering
Repurchase Catering.
  • Baker and Wurgler: dividend catering
  • Fairchild and Zhang: dividend/repurchase catering, or re-investment in positive NPV project.
competing frictions model from lease et al
Competing Frictions Model:From Lease et al:

Agency Costs




High Payout

Low Payout

High Payout

Asymmetric Information



Low Payout

dividend cuts bad news
Dividend Cuts bad news?
  • Fairchild’s 2009/10 article.
  • Wooldridge and Ghosh:=>
  • ITT/ Gould
  • Right way and wrong way to cut dividends.
  • Other cases from Fairchild’s article.
  • Signalling/FCF hypothesis.
  • FCF: agency cost: cutting div to take –ve NPV project.
  • New agency cost: Project foregone to pay high dividends.
  • Communication/reputation important!!
venture capital private equity hedge funds
Venture Capital/private equity/Hedge Funds
  • Venture capitalists typically supply start-up finance for new entrepreneurs.
  • VC’s objective; help to develop the venture over 5 – 7 years, take the firm to IPO, and make large capital gains on their investment.
  • In contrast, private equity firms invest in later stage public companies to a) take them private: Turnarouds, or b) Growth capital.
  • Hedge Funds: Privately-owned institutions that invest in Financial markets using a variety of strategies.
hedge funds
Hedge Funds
  • Privately-owned institutions
  • Limited range of High net worth (wealthy) investors => HF => invests in FMs
  • Each fund has its own investment strategy
  • Largely unregulated (in contrast to mutual funds); => debate.
hf strategies
HF strategies
  • HF mgr typically commits to a strategy, using following elements
  • Style
  • Market
  • Instrument
  • Exposure
  • Sector
  • Method
  • Diversification
hf strategies continued
HF Strategies (continued)
  • Style: Global Macro, directional, event driven….
  • Market: equity, fixed income, commodity, currency
  • Instrument: long/short, futures, options, swaps
  • Exposure: directional, market neutral
  • Sector: emerging markets, technology, healthcare
  • Method: Discretionary/qualitative (mgr selects investments): systematic/quantitative (quants)
  • HFs are marketed on the promise of making ‘absolute returns’ regardless of mkt
  • May involve hedging (long-short) plus high levels of leverage
  • => very risky?
  • Risk-shifting incentives made worse by HF mgr fee structure!
hf fee structure
HF fee structure
  • Asymmetric fees (in mutual fund, symmetric or fulcrum fees).
  • HF mgr gets a percentage of assets under management plus a performance bonus on the upside: no loss on the downside (investor loses there!)
  • => systemic risk? Regulation debate.
fairchild and puri 2011
Fairchild and Puri (2011)
  • Brand new paper on SSRN!
  • HF mgr/ Investor negotiate (bargain) over form of contract: asymmetric or symmetric)
  • HF mgr then chooses safe or risky strategy.
  • He then exerts effort in trying to make strategy succeed.
  • Paper looks at effects of BP and incetnives on contract, strategy and HF performance and risk!
activist hfs
Activist HFs
  • Passive HFs just invest in FMs, an d look at portfolio decisions
  • Activist HFs actually get involved in the companies that they invest in
  • Members on the board
  • Assist/interfere in mgt decisions
  • Debate: do they add or destroy value?
  • Myopic?
private equity
Private Equity.
  • PE firms generally buy poorly performing publically listed firms.
  • Take them private
  • Improve them (turn them around).
  • Hope to float them again for large gains
  • Theory of private equity turnarounds” plus PE leverage article, plus economics of PE articles.
theory of pe turnarounds cuny and talmor jcf 2007
Theory of PE-turnarounds (Cuny and Talmor JCF 2007)
  • Explores advantage of PE in fixing turnaround
  • Would poorly performing mgrs want to involve PEs when they may lose their jobs?
venture capitalists
Venture capitalists
  • Venture capitalists provide finance to start-up entrepreneurs
  • New, innovative, risky, no track-record…
  • Hence, these Es have difficulty obtaining finance from banks or stock market
  • VCs more than just investors
  • Provide ‘value-adding’ services/effort
  • Double-sided moral hazard/Adverse selection
venture capital process
Venture capital process
  • Investment appraisal stage: seeking out good entrepreneurs/business plans: VC overconfidence?
  • Financial contracting stage: negotiate over cashflow rights and control rights.
  • Performance stage: both E and VC exert value-adding effort: double-sided moral hazard.
  • Ex post hold-up/renegotiation stage? Double sided moral hazard
  • => exit: IPO/trade sale => capital gains (IRR)
vc process continued
VC process (continued)
  • VCs invest for 5-7 years.
  • VCs invest in a portfolio of companies: anticipate that some will be highly successful, some will not
  • Value-adding? Visit companies, help them operationally, marketing etc.
  • Empirical evidence on hours/year spent at each company
  • => attention model of Gifford.
venture capital financing
Venture Capital Financing
  • Active Value-adding Investors.
  • Double-sided Moral Hazard problem.
  • Asymmetric Information.
  • Negotiations over Cashflows and Control Rights.
  • Staged Financing
  • Remarkable variation in contracts.
features of vc financing
Features of VC financing.
  • Bargain with mgrs over financial contract (cash flow rights and control rights)
  • VC’s active investors: provide value-added services.
  • Reputation (VCs are repeat players).
  • Double-sided moral hazard.
  • Double-sided adverse selection.
kaplan and stromberg
Kaplan and Stromberg
  • Empirical analysis, related to financial contract theories.
financial contracts
Financial Contracts.
  • Debt and equity.
  • Extensive use of Convertibles.
  • Staged Financing.
  • Control rights (eg board control/voting rights).
  • Exit strategies well-defined.
game theoretic models of venture capitalist entrepreneur contracting
Game-theoretic models of Venture Capitalist/entrepreneur contracting
  • Double-sided moral hazard models (ex ante effort/ ex post hold-up/renegotiation/stealing) – self-interest
  • Behavioural Models (Procedural justice, fairness, trust, empathy)
fairchild jfr 2004
Fairchild (JFR 2004)
  • Analyses effects of bargaining power, reputation, exit strategies and value-adding on financial contract and performance.
  • 1 mgr and 2 types of VC.
  • Success Probability depends on effort:

=> VC’s value-adding.


fairchild s 2004 timeline
Fairchild’s (2004) Timeline
  • Date 0: Bidding Game: VC’s bid to supply finance.
  • Date 1: Bargaining game: VC/E bargain over financial contract (equity stakes).
  • Date 2: Investment/effort level stage.
  • Date 3: Renegotiation stage: hold-up problems
  • Date 4: Payoffs occur.
bargaining stage
Bargaining stage
  • Ex ante Project Value
  • Payoffs:
optimal equity proposals
Optimal equity proposals.
  • Found by substituting optimal efforts into payoffs and maximising.
  • Depends on relative bargaining power, VC’s value-adding ability, and reputation effect.
  • Eg; E may take all of the equity.
  • VC may take half of the equity.


Dumb VC!




Equity Stake

tykvova s review paper of vc
Tykvova’s review paper of VC
  • Problem is: more equity E has, less equity VC has: affects balance of incentives.
  • Problem for VC is giving enough equity to motivate E, while keeping enough for herself
ex post hold up problem
Ex post hold-up problem
  • In Fairchild (2004): VC can force renegotiation of equity stakes in her favour after both players have exerted effort.
  • She takes all of the equity
  • How will this affect rational E’s effort decision in the first place?
e s choice of financier
E’s choice of financier
  • Growing research on E’s choice of financier
  • VC versus banks
  • VC versus angels
  • VCs are formal funds with legal contracts etc
  • Angels are wealthy individuals, often ex entrepreneurs, sometimes relations of the E!
other papers
Other Papers
  • Casamatta: Joint effort: VC supplies investment and value-adding effort.
  • Repullo and Suarez: Joint efforts: staged financing.
  • Bascha: Joint efforts: use of convertibles: increased managerial incentives.
e s choice of financier1
E’s choice of financier
  • VC or bank finance (Ueda, Bettignies and Brander).
  • VC or Angel (Chemmanur and Chen, Fairchild).
  • See slides on my paper….
fairness norms and self interest in vc e contracting a behavioral game theoretic approach
Fairness Norms and Self-interest in VC/E Contracting: A Behavioral Game-theoretic Approach
  • Existing VC/E Financial Contracting Models assume narrow self-interest.
  • Double-sided Agency problems (both E and VC exert Value-adding Effort) (Casamatta JF 2003, Repullo and Suarez 2004, Fairchild JFR 2004).
  • Procedural Justice Theory: Fairness and Trust important.
  • No existing behavioral Game theoretic models of VC/E contracting.
my model
My Model:
  • VC/E Financial Contracting, combining double-sided Moral Hazard (VC and E shirking incentives) and fairness norms.
  • 2 stages: VC and E negotiate financial contract.
  • Then both exert value-adding efforts.
how to model fairness fairness norms
How to model fairness? Fairness Norms.
  • Fair VCs and Es in society.
  • self-interested VCs and Es in society.
  • Matching process: one E emerges with a business plan. Approaches one VC at random for finance.
  • Players cannot observe each other’s type.
  • Date 0: VC makes ultimatum offer of equity stake to E;
  • Date 1: VC and E exert value-adding effort in running the business
  • Date 2 Success Probability
  • => income R.
  • Failure probability
  • =>income zero
Expected Value of Project
  • Represents VCs relative ability (to E).
fairness norms
Fairness Norms
  • Fair VC makes fair (payoff equalising) equity offer
  • Self-interested VC makes self-interested ultimatum offer
  • E observes equity offer. Fair E compares equity offer to social norm. Self-interested E does not, then exerts effort.
expected payoffs
Expected Payoffs

If VC is fair, by definition,

solve by backward induction
Solve by backward induction:
  • If VC is fair;
  • Since
  • for both E types.
  • =>
  • =>
vc is fair continued
VC is fair; continued.
  • Given

Optimal Effort Levels:

Fair VC’s equity proposal (equity norm):

vc is self interested
VC is self-interested:
  • From Equation (1), fair E’s optimal effort;
self interested vc s optimal equity proposal
Self-interested VC’s optimal Equity proposal
  • Substitute players’ optimal efforts into V= PR, and then into (1) and (2). Then, optimal equity proposal maximises VC’s indirect payoff =>
  • VC has no value-adding ability (dumb money) =>
  • =>
  • r =0 =>
  • r => 1 ,
example 2
Example 2
  • VC has equal ability to E;


  • r =0 =>
  • r => 1 ,
  • We show that

as r => 1


Firm Value



8 behavioural corporate finance
8. Behavioural Corporate Finance.
  • Standard Finance - agents are rational and self-interested.
  • Behavioural finance: agents irrational (Psychological Biases).
  • Irrational Investors – Overvaluing assets- internet bubble? Market Sentiment?
  • Irrational Managers- effects on investment appraisal?
  • Effects on capital structure?
  • Herding.
development of behavioral finance i
Development of Behavioral Finance I.
  • Standard Research in Finance: Assumption: Agents are rational self-interested utility maximisers.
  • 1955: Herbert Simon: Bounded Rationality: Humans are not computer-like infinite information processors. Heuristics.
  • Economics experiments: Humans are not totally self-interested.
development of behavioral finance ii
Development of Behavioral Finance II.
  • Anomalies: Efficient Capital Markets.
  • Excessive volatility.
  • Excessive trading.
  • Over and under-reaction to news.
  • 1980’s: Werner DeBondt: coined the term Behavioral Finance.
  • Prospect Theory: Kahnemann and Tversky 1980s.
development iii
Development III
  • BF takes findings from psychology.
  • Incorporates human biases into finance.
  • Which psychological biases? Potentially infinite.
  • Bounded rationality/bounded selfishness/bounded willpower.
  • Bounded rationality/emotions/social factors.
potential biases
Potential biases.
  • Overconfidence/optimism
  • Regret.
  • Prospect Theory/loss aversion.
  • Representativeness.
  • Anchoring.
  • Gambler’s fallacy.
  • Availability bias.
  • Salience….. Etc, etc.
focus in literature
Focus in Literature
  • Overconfidence/optimism
  • Prospect Theory/loss aversion.
  • Regret.
prospect theory
Prospect Theory.


Risk-averse in gains


Eg: Disposition Effect:

Sell winners too quickly.

Hold losers too long.

Risk-seeking in losses

  • Too much trading in capital markets.
  • OC leads to losses?
  • But : Kyle => OC traders out survive and outperform well-calibrated traders.
behavioral corporate finance
Behavioral Corporate Finance.
  • Much behavioral research in Financial Markets.
  • Not so much in Behavioral CF.
  • Relatively new: Behavioral CF and Investment Appraisal/Capital Budgeting/Dividend decisions.

Forms of Irrationality.

  • Bounded Rationality (eg Mattson and Weibull 2002, Stein 1996).
  • - Limited information: Information processing has a cost of effort.
  • - Investors => internet bubble.
  • b) Behavioural effects of emotions:
  • -Prospect Theory (Kahneman and Tversky 1997).
  • Regret Theory.
  • Irrational Commitment to Bad Projects.
  • Overconfidence.
  • C) Catering – investors like types of firms (eg high dividend).

Bounded rationality (Mattson and Weibull 2002).

  • Manager cannot guarantee good outcome with probability of 1.
  • Fully rational => can solve a maximisation problem.
  • Bounded rationality => implementation mistakes.
  • Cost of reducing mistakes.
  • Optimal for manager to make some mistakes!
  • CEO, does not carefully prepare meetings, motivate and monitor staff => sub-optimal actions by firm.

Regret theory and prospect theory (Harbaugh 2002).

  • -Risky decision involving skill and chance.
  • manager’s reputation.
  • Prospect theory: People tend to favour low success probability projects than high success probability projects.
  • Low chance of success: failure is common but little reputational damage.
  • High chance of success: failure is rare, but more embarrassing.
  • Regret theory: Failure to take as gamble that wins is as embarrassing as taking a gamble that fails.
  • => Prospect + regret theory => attraction for low probability gambles.

Irrational Commitment to bad project.

  • Standard economic theory – sunk costs should be ignored.
  • Therefore- failing project – abandon.
  • But: mgrs tend to keep project going- in hope that it will improve.
  • Especially if manager controlled initial investment decision.
  • More likely to abandon if someone else took initial decision.

Real Options and behavioral aspects of ability to revise (Joyce 2002).

  • Real Options: Flexible project more valuable than an inflexible one.
  • However, managers with an opportunity to revise were less satisfied than those with standard fixed NPV.

Overconfidence and the Capital Structure (Heaton 2002).

  • -Optimistic manager overestimates good state probability.
  • Combines Jensen’s free cashflow with Myers-Majluf Assymetric information.
  • Jensen- free cashflow costly – mgrs take –ve NPV projects.
  • Myers-Majluf- Free cashflow good – enables mgs to take +ve NPV projects.
  • Heaton- Underinvestment-overinvestment trade-off without agency costs or asymmetric info.

Heaton (continued).

  • Mgr optimism – believes that market undervalues equity = Myers-Majluf problem of not taking +ve NPV projects => free cash flow good.
  • But : mgr optimism => mgr overvalues the firms investment opportunities => mistakenly taking –ve NPV project => free cash flow bad.
  • Prediction: shareholders prefer:
  • Cashflow retention when firm has both high optimism and good investments.
  • cash flow payouts when firm has high optimism and bad investments.

Rational capital budgeting in an irrational world. (Stein 1996).

  • -Manager rational, investors over-optimistic.
  • - share price solely determined by investors.
  • How to set hurdle rates for capital budgeting decisions?
  • adaptation of CAPM, depending on managerial aims.
  • manager may want to maximise time 0 stock price (short-term).
  • May want to maximise PV of firm’s future cash flows (long term rational view).

Effect of Managerial overconfidence, asymmetric Info, and moral hazard on Capital Structure Decisions.

  • Rational Corporate Finance.
  • -Capital Structure: moral hazard + asymmetric info.
  • -Debt reduces Moral Hazard Problems
  • -Debt signals quality.
  • Behavioral Corporate Finance.
  • managerial biases: effects on investment and financing decisions
  • Framing, regret theory, loss aversion, bounded rationality.
overconfidence optimism
  • Optimism: upward bias in probability of good state.
  • Overconfidence: underestimation of asset risk.
  • My model =>
  • Overconfidence: overestimation of ability.
overconfidence good or bad
Overconfidence: good or bad?
  • Hackbarth (2002): debt decision: OC good.
  • Goel and Thakor (2000): OC good: offsets mgr risk aversion.
  • Gervais et al (2002), Heaton: investment appraisal, OC bad => negative NPV projects.
  • Zacharakis: VC OC bad: wrong firms.
overconfidence and debt
Overconfidence and Debt
  • My model: OC => higher mgr’s effort (good).
  • But OC bad, leads to excessive debt (see Shefrin), higher financial distress.
  • Trade-off.

Behavioral model of overconfidence.

Both Managers issue debt:


Proposition 1.

  • If


Overconfidence leads to more debt issuance.

overconfidence and moral hazard
Overconfidence and Moral Hazard
  • Firm’s project: 2 possible outcomes.
  • Good: income R. Bad: Income 0.
  • Good state Prob:
  • True:
  • Overconfidence:
  • True success prob:
effect of overconfidence and security on mgr s effort
Effect of Overconfidence and security on mgr’s effort
  • Mgr’s effort is increasing in OC.
  • Debt forces higher effort due to FD.
effect of oc on security choice
Effect of OC on Security Choice

Manager issues Equity.

Manager issues Debt.

  • For given security: firm value increasing in OC.
  • If
  • Firm value increasing for all OC: OC good.
  • Optimal OC:
  • If
  • Medium OC is bad. High OC is good.
  • Or low good, high bad.
results continued
Results (continued).
  • If
  • 2 cases: Optimal OC:
  • Or Optimal OC:
  • Overconfidence leads to higher effort level.
  • Critical OC leads to debt: FD costs.
  • Debt leads to higher effort level.
  • Optimal OC depends on trade-off between higher effort and expected FD costs.
future research
Future Research
  • Optimal level of OC.
  • Include Investment appraisal decision
  • Other biases: eg Refusal to abandon.
  • Regret.
  • Emotions
  • Hyperbolic discounting
  • Is OC exogenous? Learning.
9 emotional finance
9. Emotional Finance
  • Fairchild’s Concorde case study.