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Debt, Eqity, & Economic Value

Debt, Eqity, & Economic Value. State corporation statutes, such as Del § 151 give corporate promoters and boards enormous discretion to tailor the rights of stockholders in dividends, voting and just about anything else. Common vs. Preferred Stock. Common stock – usually has voting rights

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Debt, Eqity, & Economic Value

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  1. Debt, Eqity, & Economic Value

  2. State corporation statutes, such as Del § 151 give corporate promoters and boards enormous discretion to tailor the rights of stockholders in dividends, voting and just about anything else.

  3. Common vs. Preferred Stock • Common stock – usually has voting rights • Preferred Stock – generally has fixed dividends and its dividends are preferred in the sense that they must be paid before common gets any dividends. Voting rights normally attach only after dividends are not paid. Preferred is sort of a soft, flexible kind of debt. In pure debt, failure to pay yields default + creditor rights to secure judgment.

  4. Present and Future Values • A bird in hand is worth more than one in the bush • One who has money can charge rent for its use by others.

  5. Hierarchy of Claims on the Corporation’s Cash Flows More Junior Common Stock Preferred Stock Subordinated Debt Debt (or Notes) Secured Debt Equity Debt More Senior

  6. Future and Present Values Formulae FV = PV (1 + r)n PV = FV / (1 + r)n r = (FV / PV)1/n – 1 where: FV = future value PV = present value r = annual interest rate (or discount factor) n = number of years

  7. Discounting Exercises (p.117) • FV=$1.10; r=5%; n=1 => PV=$1.048 • FV=$1.00; r=10%; n=10 => PV=$0.386 • r => PV • FV = $100; r=7%; n=1 => PV=$93.46 • FV = $100; r=8%; n=1 => PV=$92.59 • PV=$120; FV=$150; n=1 => r=25%

  8. A Question on Net Present Value (p.118) Part 1: What is the present value of the $10,850 you have to repay a year from now? FV = $10,850, n=1: r=7% => PV=$10,140.19 r=8.5% => PV=$10,000.00 r=10% => PV=$9,863.64

  9. $10,000 t=1 t=0 $10,850 A Question on Net Present Value (cont) Part 2: What is the net present value of borrowing $10,000 at an 8.5% interest rate, and repaying it in a year, given the same discount rates? [note rephrasing of question] r=7%: NPV = $10,000 - $10,140.19 = -$140.19 r=8.5%: NPV = $10,000 - $10,000 = $0 r=10%: NPV = $10,000 - $9,863.64 = $136.36

  10. Two Stories About Risk Aversion • Declining marginal utility of wealth. Imagine giving $1,000 to Bill Gates versus giving it to you. If money is worth more the less you have, losses give more pain than identical gains give pleasure. • 2. Variable outcomes inflict large transactions costs. Preparing for losses costs money.

  11. Two Ways to Value Risk Two step method: First, find the certainty equivalent (CE), thereby incorporating risk as a smaller numerator. Then, discount the CE by the risk-free discount rate, i.e., the market interest rate on 1 year T-bill. Single step method: Increase the the discount rate, thereby incorporating risk as a larger denominator. Specifically, discount by (rf + risk premium)

  12. Questions on Risk and NPV (p.120) • FV = $11.3m; PV = $10.0m => r=13% • FV = $11.3m x 95% + $0 x 5% = $10.735m • PV = $10.0m => r = 7.35% • FV = $10.735; r = 6.5% => PV = $10.080m • NPV = -$10.0m + $10.080m = +$80,000 • FV= $10.735; r=8.5% => PV = $9.894m • NPV = -$10.0m + $9.894m = -$105,991 Note: n=1 in all questions

  13. What the Bank Does • When the bank values the hotel loan as an investment with a risky future payout, it completes three conceptually distinct operations: • It calculates the EV of the payment it is promised, i.e., it adjusts for loss of EV arising from the hotel’s risk of default • It adjusts the EV downward to reflect the intrinsic unpleasantness of the risk of default, i.e., to reflect its risk aversion • It discounts to adjust for the time value of money. • The bank does (2) and (3) simultaneously by using the 8.5% discount rate. It could do all three simultaneously by using an even higher discount rate, say, 14% or so.

  14. Questions on Systematic and Unsystematic Risk (p.122) • (a) $1,060; (b) $75; (c) $75; (d) $84 (= $300 x 20% + $30 x 80%). • All but the government bond involve risk • Risk associated with Mets/Yankee stock is fully diversifiable; risk associated with hotel company is not. • 3. Mets/Yankee stock: FV=$75; r=6% => PV = $70.75 • Phantasia stock: FV=$84; either figure out CE and then discount by risk-free rate, or use a higher discount rate to compensate for risk. • 4. Now all investments (including hotel stock) have fully diversifiable risk. Note: n=1 in all questions; risk-free rate is 6%

  15. ECMH Example: Oracle-PeopleSoft (2004) The Delaware trial began on October 4, 2004 in downtown Wilmington, Delaware. Strine’s courtroom overflowed with reporters, arbitrageurs, and lawyers. The proceedings were simulcast into adjoining rooms so arbs could use their cell phones without disrupting the proceedings. When Ellison declared on the stand that “there are more discussions about lowering the [offer] price than raising the price,” and Catz similarly announced that Oracle might reduce its bid “somewhere between a third and a quarter,” arbs scrambled to sell shares. Anyone getting service on a PDA could watch the stock prices jump in response to every turn in the testimony. From: Millstone & Subramanian, Oracle vs. PeopleSoft (B) (Harvard Business School case study, Aug. 2005)

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