DIVIDEND POLICY _______________________
A corporation is not legally obligated to declare a dividend of any
specific amount. Thus, the board of directors actually has a
specific decision every time a dividend is declared. However, once
the Board declares a dividend, the corporation is legally obligated
to make the payments. Therefore, a dividend should not be declared
unless a corporation is in a financial position to make the
payment.
The expectation of receiving dividends (broadly defined as any
distribution of value) ultimately determines the market value of
the common stock. By declaring a dividend, the board of directors
is not only turning over some of the assets of the corporation
to its stockholders, but it may be influencing the expectations
stockholders have about the future dividends they can expect
from the corporation. If expectations are affected, the dividend
decision and the underlying dividend policy will have a short term
impact on the value the market places on the common stock of
the corporation.
Many financial experts believe that a highly stable but growing
dividend is advantageous to a company. The most common reason
stated for this belief is that stockholders prefer a steady income
from their investments. There is at least one other important reason
for thinking that a highly variable dividend rate may not be in the
best interest of a company. In the long run, the value of a share of
stock tends to be determined by the discounted value of the expected
dividends. Insofar as this is the case, a widely fluctuating
dividend rate will tend to make it difficult for stockholders to determine
the value of the stock to them and as a result, the stock is
likely to sell at a somewhat lower price than comparable stocks
paying the same average dividend through time, but making the
payments at a steady rate. This conclusion assumes investors are
risk averse.
Reasons for Paying Dividends
There have been two rules of thumb with respect to dividend policy
of publicly held corporations; first, that it is necessary for the firm to
pay cash dividends to common stockholders and second, the dividends
through time must increase. It is far from obvious that the
above policies are optimum from the point of view of maximizing
the well-being of stockholders. In this chapter we consider the effect
of different dividend policies on the well-being of the common
stockholders. Private equity capital offers complete flexibility regarding
dividend policy.
The board of directors of an average publicly owned company
knows that a significant percentage of its investors want dividends
and others do not. Unfortunately, what the company knows is frequently
wrong. With private equity capital the desires of the stockholders
are more easily determined and their objectives are more
likely to be identical. The private equity shareholders are likely to
want capital gains and are likely to want these capital gains realized
in the future, not realized now.
The primary reasons for paying dividends are:
■ Zero tax investors (or low tax)
■ Have done it in the past
■ Trust legal list
■ Few good investments (too much cash)
■ Raiders
■ Do right by investors (investors need cash for consumption)
If investors do not pay taxes (or have a very low tax rate),
then cash dividends are a sensible way of a corporation's distributing
cash.
The argument that a corporation should increase its dividend
payment because it has done so in the past finds its justification in
the fact that investors wanting dividends would incur transaction
costs switching investments if the policy were changed.
If a firm does not have good investment alternatives, it should
consider a dividend. All investors have opportunity costs for money.
They can invest the funds to earn an expected return consistent with
what the market has to offer. The corporation should distribute the
cash to its stockholders if it cannot invest it to beat the investor's
opportunity cost.
The attitudes of investors are important factors to be considered.
Consistently increasing dividends are generally welcomed by investors
as indicators of profitability and safety. Uncertainty is increased
by lack of dividends or dividends that fluctuate widely. Also
dividends are thought to have an informational content; that is, an increase
in dividends means that the board of directors expects the firm
to do well in the future. Another important reason for the payment of
dividends is that a wide range of investors need the dividends for
their holdings, this latter transaction has relatively high transaction
costs compared to cashing a dividend check. The presence of investors
desiring cash for consumption makes it difficult to change the
current dividend policy, even where such a change is dictated by the
logic of the situation. Though one group of investors may benefit
from a change in dividend policy, another group may be harmed.
While we will see that income taxes tend to make a retention policy
more desirable than cash dividends, the presence in the real world of
zero tax and low tax investors dictates that we consider each situation
individually and be flexible in arriving at a distribution policy.
Reasons for Not Paying Dividends
The motivations for not paying cash dividends are:
■ There are better forms of distribution than cash dividends, given
tax considerations. ■ There are transaction costs with an
investor receiving cash and
then having to reinvest. ■ The firm has transaction costs if it
needs to raise an equivalent
amount of cash to substitute for the dividend. ■ Retention may
be better than a dividend when the firm has good
investments and the tax law favors retention compared to cash
dividends.
The advantage of private equity is that the cash distribution decision
can be made purely on the grounds of maximizing the value
of the firm's common stock values.
Irrelevance of Dividend Policy
Let us assume that there are:
■ No transaction costs
■ No taxes
Miller and Modigliani (1961) argue that with no income taxes
and other well defined assumptions (such as perfect knowledge
and certainty) a dollar retained is equal in value to a dollar distributed;
thus dividend policy is not a relevant factor in determining
the value of a corporation. However, when taxes are
allowed in the analysis, dividend policy very much affects the
value of the stockholders' equity. In practice, corporations appear
to be influenced in setting dividend policy by the behavior
of other corporations, and by a desire to have a relatively stable
dividend.
The theoretical solution is for a corporation to invest in all desirable
investments. If any cash is left over after the investments
are made, the excess cash is distributed to the stockholders. In the
real world, the dividend is frequently considered to be a firm
obligation, and this obligation will affect the amount available for
dividends.
Since private equity capital is most beneficial for investors in
the higher tax brackets, we will assume for the investors a .396
tax rate on ordinary income and a .20 tax rate on long term capital
gains.
The Value: One-Period Horizon
Assume a firm pays a $1 dividend and the investor nets after tax
(1 - tp ) and invests to earn an after tax return of rp so that after one
year the investor has:
With retention by the corporation of the $ 1 where the corporation
earns r and then pays a dividend the investor has:
There is indifference for dividends and retention if r = rp . If r is
larger than rp , then retention is better than an immediate dividend.
Assume rp = .0604 and r = .10. We would expect retention to be
better than an immediate dividend. Assume the firm has $100 available.
With a dividend the investor has after one year:
100(1 - tp)(l + rp) = 60.40(1.0604) = $64.048
If the firm retains for one year and earns .10 and then pays a
dividend, the investor has:
100(1.10)(1-.396) = $66.44
If the firm could earn only r = rp = .0604, the investor would
again have $64.048.
100(1.0604)(.604) = $64.048
The relationships hold if there are n time periods instead of
one. If rp = r there is indifference for dividends and retention. If
the firm retains and does not pay a cash dividend, the required return
is reduced if there is a capital gain.
The Value with a Dividend: Five-Year Horizon
Assume a firm has $100 that it can either invest or pay a dividend.
The investor can earn a return of .0604 after investor tax on investments
in the market.
The investor nets $60.40 after tax from the $100 dividend
and after five years the investor who invests in the market will
have $80.98:
60.40(1.0604)5 = $80.98
The Value with Retention and Sale
Now assume the firm reinvests the $100 for five years and earns .10
per year. After five years the firm will have $161.05:
100(1.10)5 = $161.05
Assume the firm is sold at time 5 for $161.05 and the investor is
taxed at .20:
(1-.20)(161.05) = $128.84
This strategy is consistent with the manner in which private equity
is managed. The advantage of the retention strategy compared
to a dividend is $47.86 for the example or an increase of .59 above
the future value with the annual dividend.
Most corporations have a mixed strategy of paying out a percentage
of their earnings and retaining the remainder. Thus the
actual difference in value for a typical dividend-paying corporation
will not be as dramatic as for the example. But if we consider
the change in value for the dividend component only, the example
is accurate.
With the corporation retaining all the $100 of earnings the investor
gives up $60.40 at time 0 and gets $128.84 at time 5. This is
an IRR for the investor of .164.
60.40(1 + IRR)5 = $128.84
IRR = .164
The advantage of the retention strategy is highlighted by the fact
that in a situation where the corporation can earn only .10 (after
corporate tax and before investor tax), the investor earns .164 from
the corporation after all taxes following a retention strategy rather
than a dividend strategy.
Next, we want to consider the effect of lengthening the planning
horizon from five years to 10 years.
A Ten-Year Horizon with Sale of Corporation
First assume the firm pays out the $100 as a dividend and the investor
nets $60.40 after the .396 tax. After 10 years the investor
will have $108.58.
60.40(1.0604)10 = $108.58
If the firm retains $100 for 10 years earning .10 per year and
then the firm is sold, the investor nets
100(1.10)10(1-.20) = $207.50
The advantage of retention is $98.92, which is a .91 increase
over $108.50, the future amount with a dividend.
If the corporation retains, the investor gives up $60.40 at time 0
and then nets $207.50 after tax at time 10. This is an IRR of .131.
60.40(1 + IRR)10 = 207.50
IRR = .131
This IRR is smaller than with the shorter time horizon. But let
us consider the present value. With a five-year horizon the present
value of the $47.86 advantage of retention is $35.70.
PV = (1.0604)-5 47.86 = $35.70
With a 10-year horizon the present value of the $98.22 advantage
of retention is $55.03:
PV = (1.0604)-10 98.22 = $55.03
The present value of the advantage of retention increases as the
horizon is increased, but the IRR earned by the investor decreases if
the corporation retains rather than pays a dividend and the horizon
is increased.
Dividends of Many Periods
In the preceding example we consider only the dividend of one year.
But assume a $100 dividend for five years (first dividend is at time 0).
The future value for five years is:
Future value = [100(1.0604)5 + 100B(4, .0604)(1.0604)5](1 - .396)
TABLE 4.1 Value at Time 5
Time Value at Time 5
0 100(1.10)5 $161.05
1 l00(l.l0)4 146.41
2 100(1.10)3 133.10
3 100(1.10)2 121.00
4 l00(l.l0)1 110.00
Value $671.56
Future value = [134.08 + 346.19(1.3408)].604 = $361.33
If the corporation retains $100 a year for five years and earns .10
per year it will have $671.56 at time 5 (see Table 4.1). The investor
will net after tax $537.25:
(1-.2)671.56 = $537.25
The advantage of retention compared to dividends is now
$175.92 or an increase of
CONCLUSIONS__________________________
Private equity is not likely to attract investors who want the corporation
to pay cash dividends. The advantages of retention and then
capital gains compared to immediate cash dividends are very large
for investors paying a high tax rate.
Private equity allows a corporation to follow a 100 percent retention
policy without harming those investors who want cash
dividends. The cash dividend preferring investors should place
their funds elsewhere. The strategy for firms with private equity
capital is to avoid cash dividends and have the investors benefit
from future capital gains.
A board of directors acting in the interests of the stockholders of
a public corporation sets the dividend policy of a firm to please
many different types of investors. The ability of an investor to defer
income taxes as a result of the company's retaining earnings is an
important consideration. In addition, the distinction between ordinary
income and capital gains for purposes of income taxation by
the federal government accentuates the importance of the investors
knowing the dividend policy of the firms whose stock they are considering
purchasing or have already purchased. Some investors face
zero or low tax rates and have different objectives from the high tax
rate investors. This means that a corporation (and its board) has a
responsibility to announce its dividend policy, and attempt to be
consistent in its policy, changing only when its economic situation
changes significantly.
Private equity simplifies the task of a firm's board of directors
since the equity investors are likely to have similar investment objectives.
There is value added since the board of directors does not
have to follow a distribution policy aimed at pleasing the average
investor, given a narrow range of preferences among the private equity
investors.
Thursday, December 20, 2007
Structuring and Selling the Deal
SOURCES OF CAPITAL ____________________
■ Debt: equity capital firms, banks, pension funds, seller of firm
■ Debt with equity kicker: same as above and add insurance companies
and rich people
■ Preferred stock: insurance companies
■ Convertible preferred stock: insurance companies or other corporations
■ Common stock: LBO or private equity firms, LBO funds, and
rich people
BID FOR ACQUISITION ____________________
Assume there are no agency costs and no costs of financial distress.
The objective of the private equity buyers is to maximize the
net value.
Let Assets = the total value of the firm including any outstanding
debt, but before new debt Bid = the amount of
the bid for the firm Bo = outstanding debt assumed by
new corporation VL = equal to cash raised by debt issue
to finance
acquisition
t = the corporate tax rate S = the value of
equity before refinancing
where
S = Assets - Bo
and the net to the equity investor with no new debt issued by the
firm but the Bo debt assumed is:
Net = S - Bid
But assume VL of maximum new debt is issued
where t = the corporate tax rate:
the investor (if maximum debt is issued, the value of the firm's stock
is zero).
Since Bid is set, the larger the value of VL (the value of the leveraged
firm), the larger the value of the equity of the investors (though
the value of the firm's stock equals zero). The investors receive cash
or the debt being issued.
Example 1
t = .35, S = Assets = $650,000, no initial debt
Assume $700,000 is Bid and $1,000,000 of the debt is issued.
VL = $1,000,000
Net = VL - B Net =
$1,000,000 - 700,000 = $300,000
The $1,000,000 of debt proceeds are given to the new shareholders
and they pay $700,000 for the firm.
The net gain is $300,000. This is the largest feasible Net and
$1,000,000 is the largest VL that is feasible, without other sources
of values. The maximization of VL is consistent with the maximization
of the buyer's value. The firm is being financed with 100 percent
debt.
Realistically less than maximum debt ($1,000,000) will be issued
and the net gain will be less than $300,000, unless there are
improvements in operations.
Example 2
Same assumptions as Example 1 but the firm (with Assets =
$650,000) initially has S = $260,000 and Bo = $390,000.
If the maximum amount of debt is issued, then $400,000 will be
given to the shareholders.
Assuming a $270,000 bid for the equity, the net gain to the
shareholders after the issuance of the debt is $130,000.
For the first example the bid was $50,000 larger than the initial
stock value, but $1,000,000 of the debt was issued.
For the second example, the bid was $10,000 larger than the
initial stock value but only $400,000 of the debt was issued (there is
already $390,000 of debt outstanding).
In the second example we assumed the firm's assets had a value
of $650,000. This number is normally hard to determine accurately
and is apt to be the measure that gives rise to a deal's being done.
The buyer and seller are likely to have different expectations and estimates
of value.
STRUCTURING A DEAL ___________________
To simplify the presentation we assume that the acquisition will be
financed by a mix of debt and common stock and that no other
types of capital are feasible.
There are two primary issues to be resolved:
1. The split between debt and equity
2. The percentage of equity to be kept by the deal's promoter and
the percentage to be given to the other equity contributors
Generally there is a maximum amount of debt that banks and
other debt sources are willing to provide. This maximum changes
through time but promoters of private equity deals normally have
a good idea of this maximum. The normal amount of debt can be
increased by adding an equity kicker to the debt security. This
kicker may be in the form of a conversion feature, warrants on
stock, or a bonus based on the firm's future earnings or cash
flows. But there must be recognition that the nominal amount
of hybrid debt of this nature is not all debt but a mix of debt
and equity.
The percentage of the equity to be given to the other equity
providers must result in an expected internal rate of return (IRR)
that is large enough to attract the equity. This implies that it is
necessary to estimate the firm's future value and split the value
among all the capital contributors so that each investor class can
compute the return that is expected to be earned and be pleased
with that return.
An Example
Assume that a firm can be acquired for $78,000,000 and the expected
cash-out date is three years. The firm's value at that time (the
sale price) is estimated to be $162,400,000. The underlying internal
rate of return (IRR) of the firm is
78(1 + IRR)3 = 162.4
IRR = .2769
The firm's underlying IRR of .2769 is reasonably impressive.
But assume $60,000,000 of debt costs .18 and that the payment of
the debt at time 3 would be $98,600,000.
60,000,000(1.18)3 = $98,600,000
Since the proceeds at time 3 from the sale of the firm are expected
to be $162,400,000 the return to the equity contributors is
$63,800,000.
162,400,000 - 98,600,000 = $63,800,000
The equity contributors of $18,000,000 earn
18(1 + IRR)3 = 63.8 IRR
= .525
Assume the equity contributors of $17,000,000 want a return of
.35 (the promoters contribute $1,000,000).
The $17,000,000 requires proceeds of $41,800,000 at time 3.
17(1.35)3 = $41.8 million
This leaves $22,000,000 for the promoters.
63,800,000 - 41,800,000 = $22,000,000
The promoters expect to earn an IRR of 1.8 or 180 percent on
their $1,000,000 investment.
1(1 + IRR)3 = 22
IRR = 1.80 or 180% per year
With the given assumptions, the equity contributors of
$17,000,000 to earn their .35 per year have to be awarded .655 of
the equity.
The promoters receive .345 of the equity and contribute 1/18 or
.056 of the equity capital.
Now assume that only $38,000,000 of .18 debt can be raised
(rather than $60,000,000). At time 3 the debt payment will be
$38,000,000(1.18)3 = $62,400,000 and the stockholders will net
$100,000,000.
162,400,000 - 62,400,000 = $100,000,000
While this is larger than the $63,800,000 previously available,
the amount of equity investment is now increased to $40,000,000.
The $39,000,000 of external equity now requires $96,000,000 at
time 3 to earn .35.
39(1.35)3 = $96.0 million
This leaves $4,000,000 of return at time 3 for the promoters.
The promoters investing $1,000,000 now earn an internal rate of
return of .587.
1(1 + IRR)3 = 4
IRR = .587
The promoters' IRR is reduced from 1.80 to .587 as a result of
reducing the amount of debt. The equity split is now .96 for the new
equity suppliers and .04 for the promoters (down from .345).
With the facts as given, the more debt at a cost of . 18 the better
for the promoters. However, we can expect the cost of debt to increase
as debt is substituted for equity; thus generalizations are not
feasible. The promoters must determine the cost of debt for the different
amounts of debt. Also, the equity return requirements must
be determined since the cost of equity capital will change as the percentage
of debt capital is changed. Asquith and Wizman (1990) give
data regarding bondholder returns in leveraged buyouts.
To simplify the presentation, we have assumed zero taxes. If
taxes are included the analysis must consider the fact that interest is
tax deductible each time period, thus will change the firm's terminal
value if there is reinvestment of the savings.
Some analysts predict the equity value at the end of the planning
horizon independent of the capital structure. This is faulty since the
equity value is affected by the capital structure. The model illustrated
assumed zero taxes and made no interim cash outlays to the
capital contributors; thus the firm's value at time 3 is affected by operations
and not by the capital structure decisions.
Obviously the promoter would like to keep as large a percentage
of ownership as is feasible. The percentage is limited by the firm's
prospects (the terminal value), the amount of debt that can be
raised, and the costs (required expected returns) of the debt and
other common stock investors. The percentage of ownership that is
kept by the promoters is the residual results of the requirements of
the investors that the promoters are trying to attract.
SELLING THE DEAL ______________________
For making capital budgeting decisions the net present value
method has several advantages over the use of the IRR method.
While the two methods will frequently lead to the same decision,
there are also situations where they lead to different decisions unless
they are carefully used.
In the present context the objective of the promoters is to sell a
deal to investors, and the easiest measure to understand and persuade
potential investors is an internal rate of return. It is more impressive
to be told the IRR over a three year period is .587 than that
the NPV is $626,000 (for the promoters) when the debt amount is
$38,000,000 and the equity is $40,000,000.
A Partial LBO
The conventional LBO buys 100 percent of the common stock. If
management is part of the LBO group, it will own a significant percentage
of the private equity capital. The main problems are raising
the private equity and accomplishing the LBO without attracting
competition.
Now assume management has a different strategy. The corporation
will repurchase its own shares. The stockholders who want
cash receive it by selling some of their stock and having the gain on
the stock sale taxed at a capital gains rate.
Assume that management currently owns or has rights (options)
to 20 percent of the firm's 1,000,000 outstanding shares. The firm
repurchases 30 percent of the 1,000,000 outstanding shares. There
are 700,000 shares outstanding after the share repurchase. If management
does not sell any of their shares, they will now own 28.57
percent of the shares (before the buyback they owned 20 percent).
Obviously, if the firm continues the buyback strategy, and if
management does not sell any of its shares, its percentage of ownership
will increase. In a few years management will have the same
percentage of ownership that it would have obtained with an immediate
LBO. An important advantage of the partial LBO strategy is
that management's investment is highly liquid compared to an investment
in a LBO. We will discuss this strategy in greater depth in
Chapter 9.
CONCLUSIONS__________________________
After valuing the target firm and deciding on the amount to be bid
there remains the decision to split the capital needs among the different
forms of capital. In this chapter we limit the choice to either
debt or equity. The next calculation is to determine the
percentage of equity that must be allocated to the external investors
so that the investors can expect to earn the return they require
given the alternative returns available, the risks of the
enterprise being financed, and the amount of debt (and other senior
securities) being issued.
It is important to remember that the amount (or value) of equity
at the termination date will depend on the amount of debt
being used.
QUESTIONS AND PROBLEMS _______________
1. Why are insurance companies more likely to buy preferred stock
than individuals?
2a. Assume the market capitalization of a firm's stock is $6,500,000
and there is $10,000,000 of debt outstanding. How much additional
debt can be issued if the $6,500,000 is accepted as being
reasonable? There is a .35 corporate tax rate.
■ Debt: equity capital firms, banks, pension funds, seller of firm
■ Debt with equity kicker: same as above and add insurance companies
and rich people
■ Preferred stock: insurance companies
■ Convertible preferred stock: insurance companies or other corporations
■ Common stock: LBO or private equity firms, LBO funds, and
rich people
BID FOR ACQUISITION ____________________
Assume there are no agency costs and no costs of financial distress.
The objective of the private equity buyers is to maximize the
net value.
Let Assets = the total value of the firm including any outstanding
debt, but before new debt Bid = the amount of
the bid for the firm Bo = outstanding debt assumed by
new corporation VL = equal to cash raised by debt issue
to finance
acquisition
t = the corporate tax rate S = the value of
equity before refinancing
where
S = Assets - Bo
and the net to the equity investor with no new debt issued by the
firm but the Bo debt assumed is:
Net = S - Bid
But assume VL of maximum new debt is issued
where t = the corporate tax rate:
the investor (if maximum debt is issued, the value of the firm's stock
is zero).
Since Bid is set, the larger the value of VL (the value of the leveraged
firm), the larger the value of the equity of the investors (though
the value of the firm's stock equals zero). The investors receive cash
or the debt being issued.
Example 1
t = .35, S = Assets = $650,000, no initial debt
Assume $700,000 is Bid and $1,000,000 of the debt is issued.
VL = $1,000,000
Net = VL - B Net =
$1,000,000 - 700,000 = $300,000
The $1,000,000 of debt proceeds are given to the new shareholders
and they pay $700,000 for the firm.
The net gain is $300,000. This is the largest feasible Net and
$1,000,000 is the largest VL that is feasible, without other sources
of values. The maximization of VL is consistent with the maximization
of the buyer's value. The firm is being financed with 100 percent
debt.
Realistically less than maximum debt ($1,000,000) will be issued
and the net gain will be less than $300,000, unless there are
improvements in operations.
Example 2
Same assumptions as Example 1 but the firm (with Assets =
$650,000) initially has S = $260,000 and Bo = $390,000.
If the maximum amount of debt is issued, then $400,000 will be
given to the shareholders.
Assuming a $270,000 bid for the equity, the net gain to the
shareholders after the issuance of the debt is $130,000.
For the first example the bid was $50,000 larger than the initial
stock value, but $1,000,000 of the debt was issued.
For the second example, the bid was $10,000 larger than the
initial stock value but only $400,000 of the debt was issued (there is
already $390,000 of debt outstanding).
In the second example we assumed the firm's assets had a value
of $650,000. This number is normally hard to determine accurately
and is apt to be the measure that gives rise to a deal's being done.
The buyer and seller are likely to have different expectations and estimates
of value.
STRUCTURING A DEAL ___________________
To simplify the presentation we assume that the acquisition will be
financed by a mix of debt and common stock and that no other
types of capital are feasible.
There are two primary issues to be resolved:
1. The split between debt and equity
2. The percentage of equity to be kept by the deal's promoter and
the percentage to be given to the other equity contributors
Generally there is a maximum amount of debt that banks and
other debt sources are willing to provide. This maximum changes
through time but promoters of private equity deals normally have
a good idea of this maximum. The normal amount of debt can be
increased by adding an equity kicker to the debt security. This
kicker may be in the form of a conversion feature, warrants on
stock, or a bonus based on the firm's future earnings or cash
flows. But there must be recognition that the nominal amount
of hybrid debt of this nature is not all debt but a mix of debt
and equity.
The percentage of the equity to be given to the other equity
providers must result in an expected internal rate of return (IRR)
that is large enough to attract the equity. This implies that it is
necessary to estimate the firm's future value and split the value
among all the capital contributors so that each investor class can
compute the return that is expected to be earned and be pleased
with that return.
An Example
Assume that a firm can be acquired for $78,000,000 and the expected
cash-out date is three years. The firm's value at that time (the
sale price) is estimated to be $162,400,000. The underlying internal
rate of return (IRR) of the firm is
78(1 + IRR)3 = 162.4
IRR = .2769
The firm's underlying IRR of .2769 is reasonably impressive.
But assume $60,000,000 of debt costs .18 and that the payment of
the debt at time 3 would be $98,600,000.
60,000,000(1.18)3 = $98,600,000
Since the proceeds at time 3 from the sale of the firm are expected
to be $162,400,000 the return to the equity contributors is
$63,800,000.
162,400,000 - 98,600,000 = $63,800,000
The equity contributors of $18,000,000 earn
18(1 + IRR)3 = 63.8 IRR
= .525
Assume the equity contributors of $17,000,000 want a return of
.35 (the promoters contribute $1,000,000).
The $17,000,000 requires proceeds of $41,800,000 at time 3.
17(1.35)3 = $41.8 million
This leaves $22,000,000 for the promoters.
63,800,000 - 41,800,000 = $22,000,000
The promoters expect to earn an IRR of 1.8 or 180 percent on
their $1,000,000 investment.
1(1 + IRR)3 = 22
IRR = 1.80 or 180% per year
With the given assumptions, the equity contributors of
$17,000,000 to earn their .35 per year have to be awarded .655 of
the equity.
The promoters receive .345 of the equity and contribute 1/18 or
.056 of the equity capital.
Now assume that only $38,000,000 of .18 debt can be raised
(rather than $60,000,000). At time 3 the debt payment will be
$38,000,000(1.18)3 = $62,400,000 and the stockholders will net
$100,000,000.
162,400,000 - 62,400,000 = $100,000,000
While this is larger than the $63,800,000 previously available,
the amount of equity investment is now increased to $40,000,000.
The $39,000,000 of external equity now requires $96,000,000 at
time 3 to earn .35.
39(1.35)3 = $96.0 million
This leaves $4,000,000 of return at time 3 for the promoters.
The promoters investing $1,000,000 now earn an internal rate of
return of .587.
1(1 + IRR)3 = 4
IRR = .587
The promoters' IRR is reduced from 1.80 to .587 as a result of
reducing the amount of debt. The equity split is now .96 for the new
equity suppliers and .04 for the promoters (down from .345).
With the facts as given, the more debt at a cost of . 18 the better
for the promoters. However, we can expect the cost of debt to increase
as debt is substituted for equity; thus generalizations are not
feasible. The promoters must determine the cost of debt for the different
amounts of debt. Also, the equity return requirements must
be determined since the cost of equity capital will change as the percentage
of debt capital is changed. Asquith and Wizman (1990) give
data regarding bondholder returns in leveraged buyouts.
To simplify the presentation, we have assumed zero taxes. If
taxes are included the analysis must consider the fact that interest is
tax deductible each time period, thus will change the firm's terminal
value if there is reinvestment of the savings.
Some analysts predict the equity value at the end of the planning
horizon independent of the capital structure. This is faulty since the
equity value is affected by the capital structure. The model illustrated
assumed zero taxes and made no interim cash outlays to the
capital contributors; thus the firm's value at time 3 is affected by operations
and not by the capital structure decisions.
Obviously the promoter would like to keep as large a percentage
of ownership as is feasible. The percentage is limited by the firm's
prospects (the terminal value), the amount of debt that can be
raised, and the costs (required expected returns) of the debt and
other common stock investors. The percentage of ownership that is
kept by the promoters is the residual results of the requirements of
the investors that the promoters are trying to attract.
SELLING THE DEAL ______________________
For making capital budgeting decisions the net present value
method has several advantages over the use of the IRR method.
While the two methods will frequently lead to the same decision,
there are also situations where they lead to different decisions unless
they are carefully used.
In the present context the objective of the promoters is to sell a
deal to investors, and the easiest measure to understand and persuade
potential investors is an internal rate of return. It is more impressive
to be told the IRR over a three year period is .587 than that
the NPV is $626,000 (for the promoters) when the debt amount is
$38,000,000 and the equity is $40,000,000.
A Partial LBO
The conventional LBO buys 100 percent of the common stock. If
management is part of the LBO group, it will own a significant percentage
of the private equity capital. The main problems are raising
the private equity and accomplishing the LBO without attracting
competition.
Now assume management has a different strategy. The corporation
will repurchase its own shares. The stockholders who want
cash receive it by selling some of their stock and having the gain on
the stock sale taxed at a capital gains rate.
Assume that management currently owns or has rights (options)
to 20 percent of the firm's 1,000,000 outstanding shares. The firm
repurchases 30 percent of the 1,000,000 outstanding shares. There
are 700,000 shares outstanding after the share repurchase. If management
does not sell any of their shares, they will now own 28.57
percent of the shares (before the buyback they owned 20 percent).
Obviously, if the firm continues the buyback strategy, and if
management does not sell any of its shares, its percentage of ownership
will increase. In a few years management will have the same
percentage of ownership that it would have obtained with an immediate
LBO. An important advantage of the partial LBO strategy is
that management's investment is highly liquid compared to an investment
in a LBO. We will discuss this strategy in greater depth in
Chapter 9.
CONCLUSIONS__________________________
After valuing the target firm and deciding on the amount to be bid
there remains the decision to split the capital needs among the different
forms of capital. In this chapter we limit the choice to either
debt or equity. The next calculation is to determine the
percentage of equity that must be allocated to the external investors
so that the investors can expect to earn the return they require
given the alternative returns available, the risks of the
enterprise being financed, and the amount of debt (and other senior
securities) being issued.
It is important to remember that the amount (or value) of equity
at the termination date will depend on the amount of debt
being used.
QUESTIONS AND PROBLEMS _______________
1. Why are insurance companies more likely to buy preferred stock
than individuals?
2a. Assume the market capitalization of a firm's stock is $6,500,000
and there is $10,000,000 of debt outstanding. How much additional
debt can be issued if the $6,500,000 is accepted as being
reasonable? There is a .35 corporate tax rate.
Valuing the Target Firm
MARKET CAPITALIZATION
In some situations the only completely objective value measure is
the market capitalization. This is equal to the number of outstanding
shares of common stock times the market price per share, assuming
the market price is observable and there are no complexities
in computing the number of outstanding shares. Any acquirer
would have to expect to pay a premium to the current market capitalization.
The market value of the common stock sets a floor for an
offering price by a buyer. Rarely would a buyer consider submitting
a bid less than current market price and expect to acquire a majority
of the outstanding shares. In fact, one would expect the acquirer to
have to pay a premium over the market price. Thus the market price
of the common stock is an important measure of value since it sets a
minimum-offering price.
It can be argued that, with a closely held corporation, if the
stockholders desire to unload their stock, they may not be able to,
because the market is too thin. In such a situation the seller might accept
the market price or even marginally less than the market price,
since the market price does not fairly represent the firm's value.
Can one obtain the value of the stockholders' equity by using
the market value for a few shares traded on the stock market? It
should be remembered that the entire universe of investors is available
as possible purchasers of the stock and that the present owners
are not bidding up the stock price to acquire more shares. Normally
it will not take a large price increase to cause the present investors
to sell their shares of stock assuming the price before the bid was set
by the market. Premiums paid by the acquirers in most deals are less
than .30.
MULTIPLIERS___________________________
The use of multipliers for valuation is common practice. A multiplier
is applied to some type of flow measure. The multiplier is frequently
based on the observed relationships of comparable firms.
The following multipliers are used:
■ Price-earnings multiplier.
■ Cash flow multiplier (EBITDA and free cash flow multipliers).
EBITDA is earnings before interest, taxes, depreciation, and
amortization.
Free cash flow is cash flow from operations after maintenance
capital expenditures. Sometimes free cash flow is computed
after all investment outlays.
■ Cash flow multipliers applied to the next period's flows (e.g.,
NEBITDA).
If one takes the current earnings and multiplies by the current
price-earnings multiplier, one obtains the current market
price. The expected earnings of the current year or an adjusted
earnings can be used rather than the observed earnings of the past
year. Another variation is to use the expected earnings of the next
year.
The use of the expected earnings times a price-earnings multiplier
is a common technique for evaluating prospective acquisitions.
It may be a shortcut method of applying discounted
cash flows. The following mathematical model illustrates this
position.
The price-earnings ratio (P/E) that is expected is equal to the
dividend payout rate (1 - b) divided by - g. The larger the
value of the growth rate (g), the larger the value of the P/E ratio
that will be justified.
Assume the P/E of comparable firms is computed to be 8 and
the earnings to the stockholders of the target firm are $10,000,000.
The valuation of the stock is $80,000,000. But the following complexities
exist:
■ Were the other firms really comparable?
■ Were the earnings really $10,000,000 or should
adjustments be made?
■ Does the firm have excess assets? ■
Does the firm have unrecorded liabilities?
■ Is there reason to expect that next year's earnings will differ
sig nificantly from $10,000,000? ■ Is the average P/E of 8 for
comparable firms reasonable?
Instead of using an earnings multiplier many merchant bankers
prefer to use a cash flow (or EBITDA or free cash flow) multiplier.
Again the multiplier is obtained from observing comparable firms.
Assume the cash flow (EBITDA) multiplier of comparable firms is 6
and the firm's cash flow (EBITDA) is $20,000,000. Now the firm's
estimated value is $120,000,000. If the debt is $40,000,000 this
value is consistent with the $80,000,000 value of the stockholders'
position obtained previously. The value normally obtained using
EBITDA is the firm's value (debt plus equity) rather than the stockholders'
value.
Now let us consider the average P/E of 8 for 10 comparable
firms. Assume that 9 firms have a P/E of 5 and one firm has a P/E
of 35.
The harmonic average takes an average of the reciprocals and
then takes the reciprocal of the average.
Is a P/E of 8 or 5.47 the correct average for purposes of computing
the firm's value?
The conventional average (the P/E of 8) tends to weight extreme
values higher than is appropriate. For example, assume there are 3
comparable firms, 2 with P/Es of 10 and 1 with a P/E of 100. The
conventional average P/E is 40.
It is not obvious that 40 is the correct measure. The example
could be more extreme by having the P/E of the third firm 10,000
(as might occur if earnings were unusually low for the observed
year). The average P/E is
The 14.99 P/E multiplier would seem to be more useful for valuation
purposes than the 3,340 P/E multiplier.
Multipliers: Theoretical Basis
The use of the average P/E of comparable firms has the complexities
of determining firms that are actually comparable and computing
the average P/E. An alternative approach is to compute a theoretical
target P/E based on the firm's economic characteristics. We will consider
three different multipliers, all of which will be used to compute
the value of the stock.
M0 applied to after-tax earnings: M0(E) M1 applied to earnings
before interest and taxes: M1(EBIT) M2 applied to earnings
before interest, taxes, depreciation, and amortization:
M2(EBITDA)
Determination of M0
Let P be the value now of a share of common stock. Then by definition
of M0:
P = M0E
Remember the above example assumes zero debt. With outstanding
debt the formulation becomes more complex.
The above multipliers cannot be applied to a different firm with
a different cost of equity and a different growth rate. The multipliers
were computed based on specific information, and other information
will lead to different multipliers.
Since all the above measures are based on objective measures of
earnings, EBIT and EBITDA, they appear to be objective, but in fact
all the calculations have a significant subjective input. However, the
appearance of objectivity makes them popular methods of valuation.
Since all the methods are implicitly assuming future benefits, it is
sensible to also compute the present value of these benefits.
MEASURES OF PRESENT VALUE __________
We consider six different present value calculations that are actually
all equivalent, thus are actually one method:
1. Present value of future dividends for perpetuity
2. Present value of discretionary (free) cash flows
3. Present value of future earnings minus the present value of new
investments
4. Present value of an earnings perpetuity plus the present value of
growth opportunities (PVGO)
5. Present value of dividends for n years plus present value of the
firm's value at time n
6. Present value of economic incomes
For the infinite life situation with the firm earning $65 and paying
$39 of dividends, a .12 cost of equity and a .02 growth rate, the
value is:
The firm is retaining .4 of earnings and has a growth rate of .02.
This implies that incremental investments earn .05. Since .05 is less
than the cost of equity, the undertaking of the growth opportunities
actually reduces value.
Instead of assuming one growth rate for perpetuity one could
assume a series of changing growth rates. The calculations and formulations
are more complex, but the logic is perfectly consistent
with the infinite life and one growth rate model.
FREE CASH FLOW _______________________
If free cash flow is defined to be equal to the cash flows as defined
(after all investments), then there are no complexities. The preceding
calculations apply.
If the free cash flow is after maintenance cap-ex, but is not equal
to the preceding cash flows, both sets of calculations would require
adjustment to reflect the additional investments.
CHANGING THE CAPITAL STRUCTURE_________
If the people valuing the firm intend to substitute debt for equity,
then the changes in capital structure can give rise to an increase in
value. This potential increase in value is discussed in Chapter 5.
EARNINGS VERSUS DIVIDENDS VERSUS CASH
FLOWS: PRESENT VALUE CALCULATIONS
Assume the objective is to compute the value of a firm using present
value calculations. Should earnings be used? Since earnings fail to
consider the funds necessary to be reinvested to generate future
earnings, earnings cannot be used without adjusting for reinvestment
or alternatively using the present value of economic incomes
illustrated previously in this chapter.
The risk-adjusted present value of future dividends is a theoretically
correct method of computing the value of a firm's stock
equity, if dividends are defined to include all cash flowing from
the firm to the stockholders, whatever the form of the flow. Despite
the correctness of using dividends, there are complexities.
First, the amount of dividends is a derived measure. It is derived
from the projections of future cash flows or earnings of the firm.
Second, in a situation where there are no cash dividends it is very
difficult (but not impossible) to estimate the future dividends.
Third, an acquirer tends to be more comfortable with the use of
the target firm's cash flows or earnings. Where the target firm is
paying a dividend, the difficult estimation problem is to determine
the growth rate for perpetuity. An alternative calculation is to estimate
the growth for n years and multiply the dividend at time n
by a multiplier to represent the firm's value at that time. Since the
target firm's dividend is likely to be changed (or eliminated) after
the restructuring, the dividend calculation is likely to be viewed as
misleading.
ESTIMATION PROBLEMS __________________
If the economic incomes as illustrated are used to compute value,
then the various accounting conventions do not affect the value
measure. It appears that the initial book value and the allocation
of costs to time periods affect the value calculation using earnings,
but the appearances are misleading. Among the accounting
conventions that do not affect the theoretical value calculation
adjustment are:
■ Depreciation method
■ Expensing or capitalizing of expenses (including R&D)
■ Write-off or not of goodwill
Income with a multiplier cannot be used easily if:
■ The firm has a loss or very small income compared to assets. ■
The firm has a large amount of noncash utilizing expenses
(goodwill and depreciation expense) compared to income. ■
The accounting income measure is not reliable. ■ There are
extra assets recorded or not recorded. ■ There are
unrecorded or recorded excess liabilities.
For any method where the future benefits are being discounted
to the present there are the problems of determining the discount
rate and estimating the growth rate.
If the firm is not investing any of the earnings, then dividends
equal the earnings and there is not likely to be large expected
growth. This simplifies the value calculation but also is likely to result
in a lower valuation, compared to a growth situation.
BUYING FOR LIQUIDATION _________________
In some situations a target firm is acquired so that it can be liquidated.
In 1988 American Brands Corporation acquired E-II Holdings,
Inc. for $1.1 billion plus the assumption of E-II's debt. It
acquired 18 different operating units plus 7.1 million shares of its
own stock (with a value of $320 million). American immediately
sold nine of the units for $950 million of cash (plus $250 million
of preferred stock that was worth very little), plus the E-II debt
was assumed by the buyer. In acquiring E-II an important consideration
for American Brands was how much it would be able to
obtain for the units to be sold. It also wanted to purchase its own
shares and repel a raid. American Brands was employing a Pac-
Man strategy. Since E-II acquired American shares, American acquired
E-II. E-II's probable intention was to liquidate American
(American consisted of tobacco, office products, liquor, and financial
services).
CONCLUSIONS__________________________
Valuation is very much an art. This is particularly true when the
firm does not have a long history of earnings and cash flows.
The difficult part of valuing a firm is to obtain reasonable estimates
of future cash flows or earnings, but it is important that once
these measures are obtained they be summarized correctly.
There are a variety of measures all with some highly subjective
element that can be used by the decision makers in attempting to determine
the value of a firm. There are exact methods of calculation,
but there are not exact reliable measures of value.
The going concern value of the assets, with the assets gaining
their value from the cash flow, is the relevant measure. The prime
advantage to be gained by using cash flow versus conventional income
is that it is theoretically correct and it does not tie us to the results
of accounting procedures that are not designed for this specific
type of decision. If the decision makers want to use the current income
as the basis for making their investment decision, care should
be taken, since the computation may not be equivalent to the use of
cash flows. However, even if they do not use the income measure directly,
the decision makers will use it indirectly as the basis for their
evaluation of future dividends.
Remember that in no case is the value determined by calculating
the present value of the accounting earnings. This calculation is not
theoretically correct. The present value of economic incomes can be
used, as long as the initial book value, ending book value, and terminal
value are all included in the calculation.
But even when the firm has a long history, there is always the
question of whether there has been a significant change in the business
environment; thus the firm's past history may not give a good
indication of the firm's future performance.
In many situations the verbal description of the reasons why
the firm has value is more relevant for valuation than a value derived
from growth rate assumptions that cannot be adequately
justified.
In conclusion, you should do calculations, but fully describe the
assumptions, the basis of the assumptions, and also estimate the
value of the firm if these assumptions are not valid.
In some situations the only completely objective value measure is
the market capitalization. This is equal to the number of outstanding
shares of common stock times the market price per share, assuming
the market price is observable and there are no complexities
in computing the number of outstanding shares. Any acquirer
would have to expect to pay a premium to the current market capitalization.
The market value of the common stock sets a floor for an
offering price by a buyer. Rarely would a buyer consider submitting
a bid less than current market price and expect to acquire a majority
of the outstanding shares. In fact, one would expect the acquirer to
have to pay a premium over the market price. Thus the market price
of the common stock is an important measure of value since it sets a
minimum-offering price.
It can be argued that, with a closely held corporation, if the
stockholders desire to unload their stock, they may not be able to,
because the market is too thin. In such a situation the seller might accept
the market price or even marginally less than the market price,
since the market price does not fairly represent the firm's value.
Can one obtain the value of the stockholders' equity by using
the market value for a few shares traded on the stock market? It
should be remembered that the entire universe of investors is available
as possible purchasers of the stock and that the present owners
are not bidding up the stock price to acquire more shares. Normally
it will not take a large price increase to cause the present investors
to sell their shares of stock assuming the price before the bid was set
by the market. Premiums paid by the acquirers in most deals are less
than .30.
MULTIPLIERS___________________________
The use of multipliers for valuation is common practice. A multiplier
is applied to some type of flow measure. The multiplier is frequently
based on the observed relationships of comparable firms.
The following multipliers are used:
■ Price-earnings multiplier.
■ Cash flow multiplier (EBITDA and free cash flow multipliers).
EBITDA is earnings before interest, taxes, depreciation, and
amortization.
Free cash flow is cash flow from operations after maintenance
capital expenditures. Sometimes free cash flow is computed
after all investment outlays.
■ Cash flow multipliers applied to the next period's flows (e.g.,
NEBITDA).
If one takes the current earnings and multiplies by the current
price-earnings multiplier, one obtains the current market
price. The expected earnings of the current year or an adjusted
earnings can be used rather than the observed earnings of the past
year. Another variation is to use the expected earnings of the next
year.
The use of the expected earnings times a price-earnings multiplier
is a common technique for evaluating prospective acquisitions.
It may be a shortcut method of applying discounted
cash flows. The following mathematical model illustrates this
position.
The price-earnings ratio (P/E) that is expected is equal to the
dividend payout rate (1 - b) divided by - g. The larger the
value of the growth rate (g), the larger the value of the P/E ratio
that will be justified.
Assume the P/E of comparable firms is computed to be 8 and
the earnings to the stockholders of the target firm are $10,000,000.
The valuation of the stock is $80,000,000. But the following complexities
exist:
■ Were the other firms really comparable?
■ Were the earnings really $10,000,000 or should
adjustments be made?
■ Does the firm have excess assets? ■
Does the firm have unrecorded liabilities?
■ Is there reason to expect that next year's earnings will differ
sig nificantly from $10,000,000? ■ Is the average P/E of 8 for
comparable firms reasonable?
Instead of using an earnings multiplier many merchant bankers
prefer to use a cash flow (or EBITDA or free cash flow) multiplier.
Again the multiplier is obtained from observing comparable firms.
Assume the cash flow (EBITDA) multiplier of comparable firms is 6
and the firm's cash flow (EBITDA) is $20,000,000. Now the firm's
estimated value is $120,000,000. If the debt is $40,000,000 this
value is consistent with the $80,000,000 value of the stockholders'
position obtained previously. The value normally obtained using
EBITDA is the firm's value (debt plus equity) rather than the stockholders'
value.
Now let us consider the average P/E of 8 for 10 comparable
firms. Assume that 9 firms have a P/E of 5 and one firm has a P/E
of 35.
The harmonic average takes an average of the reciprocals and
then takes the reciprocal of the average.
Is a P/E of 8 or 5.47 the correct average for purposes of computing
the firm's value?
The conventional average (the P/E of 8) tends to weight extreme
values higher than is appropriate. For example, assume there are 3
comparable firms, 2 with P/Es of 10 and 1 with a P/E of 100. The
conventional average P/E is 40.
It is not obvious that 40 is the correct measure. The example
could be more extreme by having the P/E of the third firm 10,000
(as might occur if earnings were unusually low for the observed
year). The average P/E is
The 14.99 P/E multiplier would seem to be more useful for valuation
purposes than the 3,340 P/E multiplier.
Multipliers: Theoretical Basis
The use of the average P/E of comparable firms has the complexities
of determining firms that are actually comparable and computing
the average P/E. An alternative approach is to compute a theoretical
target P/E based on the firm's economic characteristics. We will consider
three different multipliers, all of which will be used to compute
the value of the stock.
M0 applied to after-tax earnings: M0(E) M1 applied to earnings
before interest and taxes: M1(EBIT) M2 applied to earnings
before interest, taxes, depreciation, and amortization:
M2(EBITDA)
Determination of M0
Let P be the value now of a share of common stock. Then by definition
of M0:
P = M0E
Remember the above example assumes zero debt. With outstanding
debt the formulation becomes more complex.
The above multipliers cannot be applied to a different firm with
a different cost of equity and a different growth rate. The multipliers
were computed based on specific information, and other information
will lead to different multipliers.
Since all the above measures are based on objective measures of
earnings, EBIT and EBITDA, they appear to be objective, but in fact
all the calculations have a significant subjective input. However, the
appearance of objectivity makes them popular methods of valuation.
Since all the methods are implicitly assuming future benefits, it is
sensible to also compute the present value of these benefits.
MEASURES OF PRESENT VALUE __________
We consider six different present value calculations that are actually
all equivalent, thus are actually one method:
1. Present value of future dividends for perpetuity
2. Present value of discretionary (free) cash flows
3. Present value of future earnings minus the present value of new
investments
4. Present value of an earnings perpetuity plus the present value of
growth opportunities (PVGO)
5. Present value of dividends for n years plus present value of the
firm's value at time n
6. Present value of economic incomes
For the infinite life situation with the firm earning $65 and paying
$39 of dividends, a .12 cost of equity and a .02 growth rate, the
value is:
The firm is retaining .4 of earnings and has a growth rate of .02.
This implies that incremental investments earn .05. Since .05 is less
than the cost of equity, the undertaking of the growth opportunities
actually reduces value.
Instead of assuming one growth rate for perpetuity one could
assume a series of changing growth rates. The calculations and formulations
are more complex, but the logic is perfectly consistent
with the infinite life and one growth rate model.
FREE CASH FLOW _______________________
If free cash flow is defined to be equal to the cash flows as defined
(after all investments), then there are no complexities. The preceding
calculations apply.
If the free cash flow is after maintenance cap-ex, but is not equal
to the preceding cash flows, both sets of calculations would require
adjustment to reflect the additional investments.
CHANGING THE CAPITAL STRUCTURE_________
If the people valuing the firm intend to substitute debt for equity,
then the changes in capital structure can give rise to an increase in
value. This potential increase in value is discussed in Chapter 5.
EARNINGS VERSUS DIVIDENDS VERSUS CASH
FLOWS: PRESENT VALUE CALCULATIONS
Assume the objective is to compute the value of a firm using present
value calculations. Should earnings be used? Since earnings fail to
consider the funds necessary to be reinvested to generate future
earnings, earnings cannot be used without adjusting for reinvestment
or alternatively using the present value of economic incomes
illustrated previously in this chapter.
The risk-adjusted present value of future dividends is a theoretically
correct method of computing the value of a firm's stock
equity, if dividends are defined to include all cash flowing from
the firm to the stockholders, whatever the form of the flow. Despite
the correctness of using dividends, there are complexities.
First, the amount of dividends is a derived measure. It is derived
from the projections of future cash flows or earnings of the firm.
Second, in a situation where there are no cash dividends it is very
difficult (but not impossible) to estimate the future dividends.
Third, an acquirer tends to be more comfortable with the use of
the target firm's cash flows or earnings. Where the target firm is
paying a dividend, the difficult estimation problem is to determine
the growth rate for perpetuity. An alternative calculation is to estimate
the growth for n years and multiply the dividend at time n
by a multiplier to represent the firm's value at that time. Since the
target firm's dividend is likely to be changed (or eliminated) after
the restructuring, the dividend calculation is likely to be viewed as
misleading.
ESTIMATION PROBLEMS __________________
If the economic incomes as illustrated are used to compute value,
then the various accounting conventions do not affect the value
measure. It appears that the initial book value and the allocation
of costs to time periods affect the value calculation using earnings,
but the appearances are misleading. Among the accounting
conventions that do not affect the theoretical value calculation
adjustment are:
■ Depreciation method
■ Expensing or capitalizing of expenses (including R&D)
■ Write-off or not of goodwill
Income with a multiplier cannot be used easily if:
■ The firm has a loss or very small income compared to assets. ■
The firm has a large amount of noncash utilizing expenses
(goodwill and depreciation expense) compared to income. ■
The accounting income measure is not reliable. ■ There are
extra assets recorded or not recorded. ■ There are
unrecorded or recorded excess liabilities.
For any method where the future benefits are being discounted
to the present there are the problems of determining the discount
rate and estimating the growth rate.
If the firm is not investing any of the earnings, then dividends
equal the earnings and there is not likely to be large expected
growth. This simplifies the value calculation but also is likely to result
in a lower valuation, compared to a growth situation.
BUYING FOR LIQUIDATION _________________
In some situations a target firm is acquired so that it can be liquidated.
In 1988 American Brands Corporation acquired E-II Holdings,
Inc. for $1.1 billion plus the assumption of E-II's debt. It
acquired 18 different operating units plus 7.1 million shares of its
own stock (with a value of $320 million). American immediately
sold nine of the units for $950 million of cash (plus $250 million
of preferred stock that was worth very little), plus the E-II debt
was assumed by the buyer. In acquiring E-II an important consideration
for American Brands was how much it would be able to
obtain for the units to be sold. It also wanted to purchase its own
shares and repel a raid. American Brands was employing a Pac-
Man strategy. Since E-II acquired American shares, American acquired
E-II. E-II's probable intention was to liquidate American
(American consisted of tobacco, office products, liquor, and financial
services).
CONCLUSIONS__________________________
Valuation is very much an art. This is particularly true when the
firm does not have a long history of earnings and cash flows.
The difficult part of valuing a firm is to obtain reasonable estimates
of future cash flows or earnings, but it is important that once
these measures are obtained they be summarized correctly.
There are a variety of measures all with some highly subjective
element that can be used by the decision makers in attempting to determine
the value of a firm. There are exact methods of calculation,
but there are not exact reliable measures of value.
The going concern value of the assets, with the assets gaining
their value from the cash flow, is the relevant measure. The prime
advantage to be gained by using cash flow versus conventional income
is that it is theoretically correct and it does not tie us to the results
of accounting procedures that are not designed for this specific
type of decision. If the decision makers want to use the current income
as the basis for making their investment decision, care should
be taken, since the computation may not be equivalent to the use of
cash flows. However, even if they do not use the income measure directly,
the decision makers will use it indirectly as the basis for their
evaluation of future dividends.
Remember that in no case is the value determined by calculating
the present value of the accounting earnings. This calculation is not
theoretically correct. The present value of economic incomes can be
used, as long as the initial book value, ending book value, and terminal
value are all included in the calculation.
But even when the firm has a long history, there is always the
question of whether there has been a significant change in the business
environment; thus the firm's past history may not give a good
indication of the firm's future performance.
In many situations the verbal description of the reasons why
the firm has value is more relevant for valuation than a value derived
from growth rate assumptions that cannot be adequately
justified.
In conclusion, you should do calculations, but fully describe the
assumptions, the basis of the assumptions, and also estimate the
value of the firm if these assumptions are not valid.
The Many Virtues of Private Equity
SIMPLICITY_______________________________
Because there are no public equity investors the private equity firm's
financial reporting requirements to all the relevant governmental entities
are reduced. This simplifies management's responsibilities and
results in transaction cost savings for the firm.
With private equity there are no requirements that management
keep Wall Street informed of the firm's expected earnings and then
provide an explanation of the actual earnings and why they differ
from the expected earnings. Decisions are not affected by short term
earnings and the anticipated stock market's reactions to the earnings;
thus the firm's decision making may be improved.
The firm's board of directors can be chosen for effectiveness
rather than appearances or public relations.
ALIGNMENT OF MANAGEMENT AND OWNERSHIP
With the average publicly held firm the interests of management and
the firm's ownership are not always perfectly aligned. An entire area
of study called agency theory has been created with the objectives of
studying and reducing the conflicts between a firm's management
and its owners. The classic papers on agency theory are Jensen and
Mecking (1976) and Jensen (1986).
We assume the common stock of the private equity firm discussed
in this book is to a significant extent owned by management.
Management has an incentive to act in a manner consistent with
maximizing the well-being of the equity owners.
DIVIDEND POLICY OF A PRIVATE EQUITY FIRM
The owners of a private equity firm tend to be paid for their services
as members of management, consultants, or members of the firm's
board of directors. They also hope for a value accretion to their
stock holdings.
If the owners are also employees of the firm, the incomes earned
for services will be taxed at ordinary income tax rates. But there is
only one level of tax since the corporation gets a tax deduction for
the amounts paid for service. This is the first tax advantage.
The gain from the value accretion of the stock will be taxed in
the future at a capital gains rate when the gain is realized for tax
purposes. Thus there are two tax advantages from value accretion
and the use of private equity; one is tax deferral and the second is
the lower capital gains tax rate compared to the tax rate on ordinary
income.
The private equity firm has little or no incentive to pay cash dividends
on the common stock. The investors would rather be paid as
employees or have their equity investment gains be converted into
capital gains and have these gains taxed at the lower capital gains
tax rate in the future.
CAPITAL STRUCTURE_____________________
The normal public corporation has managers and owners. While the
managers may also be stockholders, the total value of their stock investment
in the corporation tends to be much less than the present
value of their salaries and bonuses. The senior managers of public
corporations have a significant incentive to act in such a way as to
not jeopardize the stream of salaries that will be earned if the managers
are not dislodged from their jobs.
With a private equity firm the relative values of salaries and
ownership are changed. Now the owners have an incentive to substitute
debt for equity both to gain (or maintain) control and to add
value. The use of debt becomes a much more important tool for
adding value with a private equity firm than with a public firm.
VENTURE CAPITAL _______________________
This is not a book on venture capital though many of the conclusions
of this book apply equally to venture capital activities, since
venture capital is a form of private equity.
It is assumed in this book that the firm being taken private has
a track record and its value can be estimated based on objective
financial measures of the results of operations. Frequently, a venture
capitalist is evaluating the story told by an entrepreneur.
While there may be projected financial results, they frequently are
not backed up by actual results. The valuation of such a firm is
more an art than a science.
MBOs_______________________________
DeAngelo and DeAngelo (1987) review the early history of managerial
buyouts (MBOs). From 1973-1982 they identify 64 buyout
proposals made by managers of New York and American Stock Exchange
listed firms. They identify eight factors that are important in
the decision to effect a management buyout. These are:
1. Potential improvement in managerial incentives
2. Save costs of disseminating information to stockholders
3. Company secrets are better protected
4. Tax savings of interest tax shields and other tax savings
5. Avoidance of hostile takeovers
6. Difficulty to raise capital
7. Illiquid stock (leading to greater difficulty attracting managers)
8. Disagreements among stockholders (because of illiquid in
vestments)
Diamond (1985) put together a team of practitioners of the
LBO art to construct a book that explores the legal, tax, accounting,
operational, and financial considerations of an LBO transaction.
It is a handy reference book regarding the practical aspects of
the LBO deal.
THE J.P. MORGAN CHASE FUND ____________
In February 2001 J.P. Morgan Chase announced that its J.P. Morgan
Partners unit was raising $13 billion for a private equity fund
(see the Wall Street Journal of February 6, 2001). While $8 billion
was to be the bank's own funds, $5 billion was to be raised from
other investors. These investors were to include pension funds, university
endowments, and foundations. This fund raising effort followed
the creation within a few months of Thomas Lee's $6.1
billion buyout fund and KKR's raising of a $6 billion fund.
Private equity funds primarily invest in leveraged buyouts but
they are not precluded from investing in venture capital activities.
Their main investment destination is the LBO but private equity investment
can take many different forms.
J.P. Morgan Chase and its predecessors investing in private equity
had earned a 40 percent annual return on equity capital. To
evaluate this return we would need to know the amount of debt and
other senior securities used, as well as the status and age of deals
that have been undertaken, but are not yet completed (thus there is
not yet an objective measurable internal rate of return). Also, the 40
percent return was earned on a smaller amount of capital than was
now being raised. Investing a large sum of capital in firms of larger
size has its own set of challenges for a private equity operation. The
number of eligible targets is reduced. On the other hand the number
of firms competing for those larger targets is also reduced.
CONCLUSIONS__________________________
There are several reasons why value may be added by a firm converting
from being organized as a publicly owned firm to be a private
equity firm. First, there are operational reasons why a private
equity firm may have more value. Second, two financial decisions
(dividends and capital structure) are likely to be different with a private
equity firm than with a publicly owned firm. The set of financial
decisions with the private equity firm is likely to add value to
the investors owning the stock.
QUESTIONS AND PROBLEMS _______________
1. What are the advantages of private equity?
2. Of the eight factors listed by DeAngelo and DeAngelo, which
one do you consider most important?
Because there are no public equity investors the private equity firm's
financial reporting requirements to all the relevant governmental entities
are reduced. This simplifies management's responsibilities and
results in transaction cost savings for the firm.
With private equity there are no requirements that management
keep Wall Street informed of the firm's expected earnings and then
provide an explanation of the actual earnings and why they differ
from the expected earnings. Decisions are not affected by short term
earnings and the anticipated stock market's reactions to the earnings;
thus the firm's decision making may be improved.
The firm's board of directors can be chosen for effectiveness
rather than appearances or public relations.
ALIGNMENT OF MANAGEMENT AND OWNERSHIP
With the average publicly held firm the interests of management and
the firm's ownership are not always perfectly aligned. An entire area
of study called agency theory has been created with the objectives of
studying and reducing the conflicts between a firm's management
and its owners. The classic papers on agency theory are Jensen and
Mecking (1976) and Jensen (1986).
We assume the common stock of the private equity firm discussed
in this book is to a significant extent owned by management.
Management has an incentive to act in a manner consistent with
maximizing the well-being of the equity owners.
DIVIDEND POLICY OF A PRIVATE EQUITY FIRM
The owners of a private equity firm tend to be paid for their services
as members of management, consultants, or members of the firm's
board of directors. They also hope for a value accretion to their
stock holdings.
If the owners are also employees of the firm, the incomes earned
for services will be taxed at ordinary income tax rates. But there is
only one level of tax since the corporation gets a tax deduction for
the amounts paid for service. This is the first tax advantage.
The gain from the value accretion of the stock will be taxed in
the future at a capital gains rate when the gain is realized for tax
purposes. Thus there are two tax advantages from value accretion
and the use of private equity; one is tax deferral and the second is
the lower capital gains tax rate compared to the tax rate on ordinary
income.
The private equity firm has little or no incentive to pay cash dividends
on the common stock. The investors would rather be paid as
employees or have their equity investment gains be converted into
capital gains and have these gains taxed at the lower capital gains
tax rate in the future.
CAPITAL STRUCTURE_____________________
The normal public corporation has managers and owners. While the
managers may also be stockholders, the total value of their stock investment
in the corporation tends to be much less than the present
value of their salaries and bonuses. The senior managers of public
corporations have a significant incentive to act in such a way as to
not jeopardize the stream of salaries that will be earned if the managers
are not dislodged from their jobs.
With a private equity firm the relative values of salaries and
ownership are changed. Now the owners have an incentive to substitute
debt for equity both to gain (or maintain) control and to add
value. The use of debt becomes a much more important tool for
adding value with a private equity firm than with a public firm.
VENTURE CAPITAL _______________________
This is not a book on venture capital though many of the conclusions
of this book apply equally to venture capital activities, since
venture capital is a form of private equity.
It is assumed in this book that the firm being taken private has
a track record and its value can be estimated based on objective
financial measures of the results of operations. Frequently, a venture
capitalist is evaluating the story told by an entrepreneur.
While there may be projected financial results, they frequently are
not backed up by actual results. The valuation of such a firm is
more an art than a science.
MBOs_______________________________
DeAngelo and DeAngelo (1987) review the early history of managerial
buyouts (MBOs). From 1973-1982 they identify 64 buyout
proposals made by managers of New York and American Stock Exchange
listed firms. They identify eight factors that are important in
the decision to effect a management buyout. These are:
1. Potential improvement in managerial incentives
2. Save costs of disseminating information to stockholders
3. Company secrets are better protected
4. Tax savings of interest tax shields and other tax savings
5. Avoidance of hostile takeovers
6. Difficulty to raise capital
7. Illiquid stock (leading to greater difficulty attracting managers)
8. Disagreements among stockholders (because of illiquid in
vestments)
Diamond (1985) put together a team of practitioners of the
LBO art to construct a book that explores the legal, tax, accounting,
operational, and financial considerations of an LBO transaction.
It is a handy reference book regarding the practical aspects of
the LBO deal.
THE J.P. MORGAN CHASE FUND ____________
In February 2001 J.P. Morgan Chase announced that its J.P. Morgan
Partners unit was raising $13 billion for a private equity fund
(see the Wall Street Journal of February 6, 2001). While $8 billion
was to be the bank's own funds, $5 billion was to be raised from
other investors. These investors were to include pension funds, university
endowments, and foundations. This fund raising effort followed
the creation within a few months of Thomas Lee's $6.1
billion buyout fund and KKR's raising of a $6 billion fund.
Private equity funds primarily invest in leveraged buyouts but
they are not precluded from investing in venture capital activities.
Their main investment destination is the LBO but private equity investment
can take many different forms.
J.P. Morgan Chase and its predecessors investing in private equity
had earned a 40 percent annual return on equity capital. To
evaluate this return we would need to know the amount of debt and
other senior securities used, as well as the status and age of deals
that have been undertaken, but are not yet completed (thus there is
not yet an objective measurable internal rate of return). Also, the 40
percent return was earned on a smaller amount of capital than was
now being raised. Investing a large sum of capital in firms of larger
size has its own set of challenges for a private equity operation. The
number of eligible targets is reduced. On the other hand the number
of firms competing for those larger targets is also reduced.
CONCLUSIONS__________________________
There are several reasons why value may be added by a firm converting
from being organized as a publicly owned firm to be a private
equity firm. First, there are operational reasons why a private
equity firm may have more value. Second, two financial decisions
(dividends and capital structure) are likely to be different with a private
equity firm than with a publicly owned firm. The set of financial
decisions with the private equity firm is likely to add value to
the investors owning the stock.
QUESTIONS AND PROBLEMS _______________
1. What are the advantages of private equity?
2. Of the eight factors listed by DeAngelo and DeAngelo, which
one do you consider most important?
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