BMAN71152

Corporate Finance
Roberto Mura
roberto.mura@mbs.ac.uk
https://www.research.manchester.ac.uk/portal/Roberto.Mura.html
www.robertomura.com

M37 Crawford House

Semester II 2017
1
 A bit about myself
• Associate Professor (S. L.) in Finance
• Director of MSc Finance (used to be director
of F&E and FBE)
• Acting Director of all MAFG PGT
• PhD in Economics (University of York) but I
specialise in Corporate Finance
• Research interests: ownership structure of
firms, financial structure, determinants of
performance, risk taking, banking, M&As,
credit ratings, behavioral finance

2
 A bit about myself: Research
• Some Key Publications (“orthodox”)
– Shareholder diversification and bank risk-taking, Journal
of Financial Intermediation
• Semifinalist for the Best Paper Award at FMA 2013 Chicago.
– Shareholder diversification and corporate risk-taking,
Review of Financial Studies
• Black Rock/Brennan Award for outstanding paper in the
Review of Financial Studies
• Semifinalist for the Best Paper Award at FMA 2010 New York.
– Financial Flexibility, Investment Ability and Firm
Value: Evidence from Firms with Spare Debt Capacity,
Financial Management

3
 A bit about myself: Research
• Some Key Publications (less “orthodox”)
– CEO Gender, Corporate Risk-Taking, and the Efficiency
of Capital Allocation

– Rating Friends: The Effect of Personal Connections on

Credit Ratings

– The Effect of 'Underwriter - Issuer' Personal

Connections on IPO Underpricing and Performance

4
 A little bit about myself

• Teaching Experience:
– Capital Markets (UG)
– Corporate Finance UG/PGT/PhD
– Financial Management and Project Appraisal (PGT)
– M&A negotiations (MBA)
– Stata PGT/PhD

5
 Office Hours-SOHOL
• Staff are usually available for office hours to
answer questions or offer support
• You typically book this through SOHOL

6
 Overview

• In the first part we look at ways to raise capital

– Equity and Debt

• In the second part we look at ownership and control

– Agency Costs

• In the third part we look at spending decisions

– Dividend Policy
– Investment Policy

7
 Case Studies
• There are three case studies. These are meant to
link theory with practice
- L&H Speech Products (IPO)
- Arcelor Undervaluation (Capital Structure)
- Accounting Fraud & Restoring Trust at Worldcom
(Corporate Governance)

• These will be discussed in class, at the end of the

course, in weeks 8, 9 and 10.

• The Case Studies are a great opportunity to

interact and for me to give you feedback
8
 Calendar
Date Time Topics Venue
Tuesday January 31 10-13 Simon Building (Theatre A)
Lecture 1 IPO
Wednesday February 1 11-14 Crawford House (Theatre 2)

Tuesday February 7 10-13 Simon Building (Theatre A)

Lecture 2 CAPITAL STRUCTURE 1
Wednesday February 8 11-14 Crawford House (Theatre 2)

Tuesday February 14 10-13 Simon Building (Theatre A)

Lecture 3 CAPITAL STRUCTURE 2
Wednesday February 15 11-14 Crawford House (Theatre 2)

Tuesday February 21 10-13 Simon Building (Theatre A)

Lecture 4 CAPITAL STRUCTURE 3
Wednesday February 22 11-14 Crawford House (Theatre 2)

Tuesday February 28 10-13 Simon Building (Theatre A)

Lecture 5 CORPORATE GOVERNANCE
Wednesday March 1 11-14 Crawford House (Theatre 2)

Tuesday March 7 10-13 Simon Building (Theatre A)

Lecture 6 DIVIDENDS
Wednesday March 8 11-14 Crawford House (Theatre 2)

Tuesday March 14 10-13 Simon Building (Theatre A)

Lecture 7 INVESTMENT
Wednesday March 15 11-14 Crawford House (Theatre 2)

Tuesday March 21 10-13 Simon Building (Theatre A)

Case Study 1 CASE STUDY IPO
Wednesday March 22 11-14 Crawford House (Theatre 2)
Tuesday March 28 10-13 Simon Building (Theatre A)
Case study 2 CASE STUDY CS
Wednesday March 29 11-14 Crawford House (Theatre 2)
Tuesday April 25 10-13 Simon Building (Theatre A)
Case study 3 CASE STUDY CORP GOVERNANCE
Wednesday April 26 11-14 Crawford House (Theatre 2)
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 Readings
• Academic Papers

• There is one suggested book which is Berk J. and

P. DeMarzo (2010), Corporate Finance (global
edition), 2nd edition (the 1st edition is fine as well)

• Some suggested readings will also come from:

– T.E. Copeland, J.F. Weston and K. Shastri (2005),
Financial Theory and Corporate Policy, 4th ed., Pearson
Addison Wesley
In BB you will find a document called “General
Reading List From Books”
10
• Assessment:
– End of the course written unseen exam (2 hrs)
– Counts for 100% of final mark
– Past exams are available in BlackBoard
– In preparing for the exam focus on understanding
things rather than memorizing/replicating them

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 Aims of the Course
• Provide knowledge of core issues in CF
• Develop an analytical way of thinking!
• We want to learn about the “real world” but in Social
Sciences we have a big “handicap” compared with
Empirical Scientists:
– What is it?

– ….hint: if you were to summarize it with an acronym,

it would be CV
12
 Aims of the Course
• This is why solid understanding of Statistics and
Econometrics is crucial in Social Sciences

• Most immediate example: Cross Causality

– Links between ownership and performance

– Determinants of financial policy
– CM imperfections and investment decisions

13
 Aims of the Course
• In this sense the knowledge and skills you will
acquire with this module link very well with other
(econometric) modules in your MSc
‒ M&As
‒ Current Issues in Empirical Finance
‒ Portfolio Investment
‒ Time Series Econometrics
‒ Business Economics
• Also, they will prove crucial for the MSc
Dissertation (60 Credits)
• In your future (professional) life, this training to
analytical thinking will prove invaluable!
14
 Lecture 1
The Sale of Equity Securities
(IPOs and SEOs)

15
 Overview of Today’s class
• What are the sources of capital?
– Internal funds
– External Capital:
• Equity
• Debt
• Hybrids
• How to raise equity capital?
• Listing on the stock exchange  IPOs
• Anomalies associated with IPOs
• How to Value an unlisted stock  Tutorial

16
External Capital: Debt vs Equity

17
 Debt vs Equity
• Bondholders:
– Contracted claims
– Priority claim must be met in full before equity holders
– Interest payments are costs and are tax-deductible
– Fixed maturity
– Passive (some veto power covenants)
• Shareholders (owners):
– Dividends (firm not obliged Microsoft 28 years
before 1st dividend in 2003)
– Residual claims
– Dividends are profits and so they are taxed
– No maturity
– Voting rights 18
 Typical “Timeline”
Birth Maturity
Public debt and
LARGE
equity markets
Longer-term (bank) debt
MEDIUM
Later stage PE (“VC”)
Early stage VC, short-term debt
Friends, family, business angels SMALL
Self financed

19
 Venture Capitalists
• Companies specialized in raising money to invest in the
private equity of young firms:
– Typically set up as Limited Partnerships
– Limited Partners put the capital (Institutional Investors)
– General Partners run the VC firm 1.5-2.5%
management fees + 20/30% of profits
– GPs know the mkts where they invest very well  they
target young high growth firms
• Recently the focus has been on internet and high tech
firms see Case Study 1
– LPs can have a more diversified investment with high
upside potential (high risk)

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‒ Required rate of return on investment is high: between 5
to 20 times the initial investment in about 5-7 years

‒ Often VCs require seats in the BoD

– Gompers and Lerner (1999) report that VCs

typically
• control 33% of the board seats
• often represent the largest voting block on the board

21
• The most typical exit strategy for VCs is to take firms
public: IPO
• Two types of shares can be sold in an IPO:
– Primary (new shares)
– Secondary (held by existing owners)
• After listing firms can do SEOs.
• In the UK a rights issue is the most prevalent method

Existing shareholders have the right to buy a specified

number of new shares from the firm at a specified
price within a specified time frame
22
 Reasons to go Public?
• New capital for the company (Case Study 1)
• Liquidity transaction costs are minimized
• Method of payment for acquisitions (Case Study 3)
• Raising new finance in the future
– A stronger equity base reduces leverage (D/E) therefore
reducing the debt overhang problem (Myers 1977)
– Trading generates a set of information, which make it
easier to raise more capital (both debt/equity)
• Exit strategy for VCs but also for managers (Google,
Microsoft to quote a few)
• Diversification strategy for original owners (liquidity vs
control)

23
 Reasons not to go Public?
• Expensive undertaking
– Management fees to UWs
– Underpricing (on average 15%)
• Increase in legal requirements (Corporate Governance)
– There is increasing evidence that the SOX Act has lead
numerous firms to delist from NYSE and list elsewhere
(AIM)
• Stock price emphasis may lead to short-termism
• Increased Agency Costs (liquidity vs control)
• Increased risk of Takeover
• Higher information disclosure obligation to divulge
information (i.e. annual reports) and inform your rivals

24
• We could summarize all this with
– Their first cheque came from a Business Angel who
had no idea himself how the “PageRank” algorithm
would eventually generate money
– Then 2 big players in the VC world came along,
Kleiner Perkins Caufield & Byers and Sequoia
Capital who chipped in 12.5 million each
– When they did that, they immediately required seats
on the BoD and the appointment of an external CEO
– KPCB managed to have Google appoint a CEO of
their liking (Eric Schmidt)

25
– Google however, required a personal investment
from the future CEO as a token of commitment to
the firm (until April 2011 he was still the CEO and
is still Exec CH)
– After 6 years from the first cheque Google went
public in NASDAQ (in a very original way)
– They issued dual class shares: Class A shares 1
share 1 vote while the founders retained Class B 1
share 10 votes in order to retain control
– The original investment by VCs of 25mil became 4
Billion at float
– Google said that one of the most important reason
for going public was to provide liquidity to its
26
employees and senior management
 The process of IPOs
• Enlist an investment bank to “underwrite” the issue
• Often UWs work in syndicates
– In this case one bank will be the lead underwriter or book
runner and the others are co-managers.
– this may ensure higher analyst coverage post IPO
• UWs perform numerous tasks:
‒ Help the firm with all the legal documents, especially the
registration statement and the prospectus
‒ This contains pretty much everything you should know about the
firm (see L&H’s prospectus, Case Study 1)
‒ Estimate the value of the securities it will sell on behalf of
the firm (clearly much easier for debt and SEOs than IPOs)
‒ Advise the firm on various aspects such as BoD, method of
floating, timing of the issue
27
 Pricing IPOs
Book Building vs Fixed Price
• “Road Show”: once the initial price range has been set,
UWs start the “road show” to promote the stock with
some of their largest customers
• “Book Building Method”: during the road show, the
UW builds a “book” of non-binding orders for the stock
• These bids (how many shares they would like to buy and
at what price) allow UWs to have a “demand
function” for the stock
‒ relatively easy to set a clearing price/total number of
shares for the IPO
• It is not uncommon however that the price is fixed in
advance (“Fixed Price Method”)

28
 UWR Commitment
• Firm Commitment: The UWRs typically will have to
buy all the shares from the company so it is in its best
interest to sell them all in the market
– For this reason the investment banker has the incentive
to oversubscribe the IPO

• Best Effort: a less common way. The investment bank

promises to give its best effort to sell the firms’
securities
– If the demand is insufficient, the firm withdraws the
issue from the market

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 Cost of IPO
Security Type Average Number Total Gross Fees
Fee (%) of issues ($ Millions)
Debt
Corporate Investment Grade 0.758 226 504

LT Corporate High Yield 1.377 45 344

Domestic Bonds 0.272 4539 1,372

Municipal Bonds 0.232 161 344

Common Stock

IPOs 6.739 224 2,843

SEOs 4.408 376 2,891

Source: Underwriting Fees, Investment Dealer’s Digest (Jan 21, 2008)

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 Cost of IPO

https://site.warrington.ufl.edu/ritter/files/2016/01/Gross-Spread-for-Moderate-Size-IPOs-1980-2012.pdf
31
 Who gets the shares?
• The lead UW has a certain discretion about the
distribution of shares among its clients.
• This can create a number of problems. For instance,
EBAY used Goldman Sachs as an UW.
• It later emerged that the CEO and CH of EBAY in the
past had received shares of other (underpriced) IPOs
where GS was the UW which they could resell for a
large profit (this is called spinning).
• So the CEO and CH of EBAY chose GS as an UW for
the IPO in a sort of “quid pro quo”.
• EBAY’s shareholders then sued the CEO and CH and
received near 3.5 million compensation.
32
 Who gets the shares?
• Also, the bank may engage in price stabilization after
listing if the new issue is faltering
• It is rather uncommon (but Google did it this way) to
have an online auction to set the price
– This is called “Open IPO”
• Suppose that Google wants to sell 500,000 shares in
the market
• Investors place bids online opening an account through
the UW. Suppose that this demand function looks like
this:

33
Share Price Number of Shares Cumulative
Demand

£8 25,000 25,000

£7.75 100,000 125,000

£7.5 75,000 200,000

£7.25 150,000 350,000

£7 150,000 500,000

£6.75 275,000 775,000

£6.5 125,000 900,000

34
• The equilibrium price is £7.
– All investors who have placed a bet of at least £7 or
more will be able to buy the stock even if their bidding
price was higher

• In this particular example demand and supply are

equal. What if, say, for the price of £7, there is excess
demand (say 300,000 and not 150,000)?

• In this case, all those who bid higher would be

satisfied in full while those who bid £7 would be
satisfied on a pro-rata basis
35
 ticker

Spread 7%
Discretionary
Allocation of shares
Fixed Fee

Green Shoe

Syndicate
36
 PRIMARY
SECONDARY SHARES
SHARES
CLASS A

CLASS B VR≠ CR

Spread
2.805%
Green Shoe
Auction

Syndicate
37
Spread 3.25%

Green Shoe

Syndicate 38
 Greenshoe
• Suppose that firm A goes public using UW U

• A and U set the price at £12 and the spread is £1 and 100
shares are made available to the market

• Suppose they also arrange a Greenshoe provision which

allows U to buy an extra 15 shares at £11 from A

• Now U short-sells (naked) the extra 15 shares

(sometimes they s-s more than the GS allows)

• That means that U receives the £12 at IPO for these

extra 15 shares
39
• Now, suppose that the mkt buys the 100 shares and
investor X buys the 15 shorted shares
• At this stage, there are still only 100 shares in the market
• If the IPO is oversubscribed, the stock price is likely to
increase significantly and possibly quickly
• U will supply the extra 15 shares exercising the GS option
with A and therefore closing the short position with X
• Now there are 115 shares outstanding

• If P drops after IPO, U can try to stabilize it by buying

back the extra shares and use those to close s-s
– The total shares outstanding would then be 100
40
 IPO Anomalies
• There are a number of “puzzles” concerning IPOs
which the literature has documented

• We usually refer to them as anomalies as they

challenge the EMH
– Short Run Underpricing
– Long Run Underperformance
– Share Price Reactions to Lock in Agreements

41
 Short Run Underpricing
• The ‘short-run’ is usually taken as the first day of
trading or the first week of trading and sometimes the
first month of trading
• The return for stock ‘i’ at the end of the first trading
day is calculated as:

Ri1 = (Pi1 / Pi0)  1

Pi1 is the price of the stock ‘i’ at the close of the first
trading day, Pi0 is the offer price and Ri1 is the total
first-day return on the stock

42
 Average first-day returns on (mostly) European IPOs
60%

50%
Average first-day returns

40%

30%

20%

10%

0%

Source: Prof. Jay Ritter, University of Florida, July 2014

 150%
Average first-day returns on non-European IPOs

125%
Average first-day returns

100%

75%

50%

25%

0%

Source: Prof. Jay Ritter, University of Florida, July2014

 Initial Public Offering volume in the U.S. since 2000
In 1980-2000, an average of 310 firms went public every year
In 2001-2015, an average of 111 firms went public every year
800 80

700 70

600 60

Average First-day Returns

Number of IPOs

500 50

400 40

300 30

200 20

100 10

0 0

Number of Offerings (bars) and Average First-day Returns (line) on US IPOs, 1980-2015

Source: Jay Ritter, University of Florida, using data from Dealogic and Thomson Reuters. Only
operating company IPOs with an offer price of at least $5 per share are included. Banks and
S&Ls, natural resource limited partnerships, and ADRs are also not counted.
45
Number of Offerings and Average First-Day Returns on German IPOs, 1980-2011
 Number of Offerings and Average First-day Returns on UK IPOs, 1980-Oct. 2011

Average First-day Returns

Number f IPOs
• The return on the market index during the same time
period is: Rm1 = (Pm1 / Pm0)  1
• Pm1 is the market index value at the close of first
trading and
• Pm0 is the market index value on the offer day of the
appropriate stock
• Rm1 is the first day’s comparable market return
• The market adjusted abnormal return for each IPO on
the first day of trading is computed as:
 
MAARi1  100  1  Ri1  1  Rm1   1

Can easily generalise 1 with (any) t

48
 Quick Example

Date Open High Low Close

07/11/2013 45.1 50.09 44 44.9
08/11/2013 45.93 46.94 40.69 41.65
11/11/2013 40.5 43 39.4 42.9
12/11/2013 43.66 43.78 41.83 41.9
13/11/2013 41.03 42.87 40.76 42.6
14/11/2013 42.34 45.67 42.24 44.69
15/11/2013 45.25 45.27 43.43 43.98
• Pi0 [IPO price] was set at $26
• Pi1 $44.9 ; Pi7 $44.69 ;
• Ri1 = 72.69% ; Ri7 = 71.88%

49
 Quick Example
NYSE Composite Index
Date Open High Low Close
06/11/2013 10045.12 10083.47 10034.22 10059.49
07/11/2013 10068.96 10072.05 9920.31 9924.37
08/11/2013 9911.97 10032.82 9909.54 10032.14
11/11/2013 10029.14 10049.39 10008.94 10042.94
12/11/2013 10022.58 10037.62 9982.29 10009.82
13/11/2013 9969.45 10079.89 9963.74 10079.89
14/11/2013 10079.28 10135.28 10071.71 10130.51

• Pm0 [Closing Mkt day before] was 10059.49

• Pm1 9924.37 ; Pi7 10130.51;
• Rm1 = -1.343% ; Rm7 = 0.706 %
• MAARi1= 75.04% ; MAARi7 = 70.67%
50
 Reasons for Underpricing:
Risk Averse UWR
• UWRs voluntarily underprice to reduce the risk of
unsuccessful IPOs
• They have significant stakes most IPOs are
through Firm Commitment
– Their reputation is also at stake
BUT
• UWs could simply adjust the spread according to
their risk exposure
• Also, we should observe Firm Commitment IPOs to
be more underpriced than Best Effort ones
– inconsistent with the existing empirical evidence
51
 Reasons for Underpricing:
Winner’s Curse
• Suppose you have only 2 kinds of investors, perfectly
informed and completely uninformed
• Informed investors will only try to buy shares when they
are underpriced (or, at best, fairly priced)
• Uninformed investors on the other hand, cannot
discriminate ex ante and will always demand the stock
– Will have a fraction of the shares if the issue is underpriced
– They will buy all the stocks ONLY if the issue is
overpriced Winner’s curse
– If they can learn from trading, they will impose a
“discount” on the price they will be willing to pay
– To ensure subscription UWRs will price the stock below
fair price 52
 Reasons for Underpricing:
Ownership Structure
• Underpricing ensures oversubscription

• This way shares allocation can be rationed and

managers can discriminate between investors and
allocate shares to many small investors (Brennan-
Franks, 1997)

• This, in turn may be beneficial for several reasons:

– Managerial entrenchment
– Reduced likelihood of hostile takeovers

53
 Reasons for Underpricing:
Signalling
• Issuers have an incentive to underprice, to leave a
“good taste” with investors (The Google Story,
pg.169!!!)

54
 Reasons for Underpricing:
Signalling
• Buying at a low prices and then seeing P increase will
be a signal of a good investment for buyers

• This may prove useful in case firms of future SEOs

allowing firms to sell at a higher price than would
otherwise be the case
– Welch (1989) finds that IPO firms are more likely to
conduct SEOs in the next few years than a control
random sample

55
Test your knowledge

56
Test your knowledge

57
 There are many more…
• Underpricing as a form of insurance (Tinic, 1988)
– window dressing of the accounts

• The UWRs monopsony power

– UWRs underprice to reduce their marketing effort and
maintain good relationship with their big buyers

• Bandwagon/cascade hypothesis [herd behavior]

investors have no initial incentives to reveal their
demand for the stock because it may affect the offer
price.

58
 Empirical Literature
• Why do companies go public?

• Very difficult topic for Social Scientists to study

• A typical empirical design would consist of gathering

data from newly listed firms
– Study their use of funds
– Study their performance

• There is a huge potential issue here

– Sample Selection Bias
– Self Selection

59
 Empirical Literature
• Survey study by Brau and Facett (2008)
• Data from 37 withdrawn IPOs, 87 successful IPOs and
212 firms that are large enough that they could go
public

• This approach is not free from issues

– One can easily argue that this approach in itself could
suffer from self selection issues (often referred to as
“attrition”)
– Incentives of CFOs to reveal (truthful) information
– The survey is a picture (Cross Section). Can the results
be generalized?

60
Reasons to go Public

61
Reasons not to go Public Liquidity
vs
Control

62
Reasons for Underpricing

63
Signalling

64
 Long Returns on IPOs during
the five years after issuing, US (1980-2014)

20
18
16
14
12
10
8
6
4
2
0 SIZE
Year1 MATCH
Year2
Year3 IPO
Year4
Year5

IPO SIZE MATCH

Source: https://site.warrington.ufl.edu/ritter/files/2016/03/Initial-Public-Offerings-
65
Updated-Statistics-on-Long-run-Performance-2016-03-08.pdf
 Measures of LRUP
• Market adjusted buy and hold returns for a firm i
(MABHRi) are calculated as follows
t 36 t 36
MABHRi   1  Ri ,t    1  Rm,t 
t 1 t 1

• Cumulative Abnormal Returns (CAR)

– Market adjusted cumulative abnormal returns
(MACAR) are calculated as
t 36
MACAR   ARit
t 1
– where ARit  Rit  Rmt is the abnormal return for firm i
in month t 66
 Lock-in agreements
• “An arrangement between the existing shareholders of
the issuing firm (managers, directors, employees,
venture capitalist and other individual and institutional
shareholders) and the underwriter, whereby the
shareholders agree not to sell a certain percentage of
their holdings for a specified length of time after the
IPO” (Espenlaub et al., 2001)
• So what’s the “anomaly”?
– Around the expiration date of the agreement the share
price of IPO firms fall between –1% and –3% (US
evidence)
– However, all the information about the lock-in
agreement is in the IPO prospectus. So this is known to
the market  EMH would entail no reaction
67
 Lock-in agreements

68
http://www.wsj.com/mdc/public/page/2_3021-lockupexp.html
Lock-in agreements

69
• Why do lock-ins exist?
– Signalling hypothesis: High(er) quality firms should be
able to have longer lock-ins (Brav-Gompers, 2003)
• Insiders (managers) hold undiversified portfolios. So,
restricting the sale of stock for a longer period of time
imposes a cost on them

– Commitment hypothesis: Lock-in is a mechanism to

prevent managers from expropriating the (new) minority
shareholders (Espenlaub et al., 2001)

– Sponsor’s reputation hypothesis: Sponsors write lock-in

agreements to signal their reputation
70
Fundamentals of
Equity Valuation

71
How Investment Bankers
Value Companies

72
Source: Dennis and Cain, 2009
1) The Free Cash Flow Approach
The estimated current market value of debt and equity
(V) i.e. the total firm value is given by
n
[ Freecashflow]t Vn
V  
t 1 (1  WACC ) t
(1  WACC ) n

The first term of the equation is the NPV of the future

cash flows using WACC as the discount rate. Vn is the
expected total firm value at the end of the n-year
planning period (also called the terminal value of the
firm).

73
• First, we need to identify the correct measure of FCF
• In general, we try to look for the “free cash flow to the
firm” which will allows us to estimate the value of the
firm (not of its equity alone):
• So we use the cash flow to all claimholders
FCF=EBIT(1-t)+DEPR-CAPEX-NWC+other
EBIT = Earnings before interest and Taxes
t = corporate tax rate
DEPR = depreciation charges
CAPEX = capital expenditures
NWC = increases in net working capital
other = wages payable (stock based compensation)
74
• Second, we need to identify the appropriate discount factor
E D
WACC  re    rd 1   c   
V  V 
• We assume for simplicity that WACC remains constant
• Vn can be estimated as a growing or constant perpetuity

• From the above equation we can calculate

VE = V + Cash – VD
where
VE is the value of outstanding equity
VD is the value of outstanding debt

75
 Steps involved in the DCF approach

• Step 1. We need to have reasonable planning

horizon over which we make forecasts.

• These forecasts involve variables such as earnings,

working capital changes, capital expenditures etc.
which can be used to estimate net cash flows.

76
• Step 2. We then need to calculate the WACC of
the firm.
 E  D
WACC  r    r (1 - T ) 
e V  d c V

• For this, first we calculate the debt/equity ratio and

assume that this will remain constant over the
estimation period. For instance the firm may have
a target D/E (D/V) ratio
• Then, we calculate the cost of equity capital using
the CAPM:
re = rf + β(market risk premium).

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• We estimate the levered beta of the firm by using the
following Hamada equation:

D
 L  u[1 (1 Tc ) ]
E

βu is approximated using the betas of peer firms.

• Finally after calculating the cost of debt rd, the WACC

is calculated.

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 • Step 3. We then need to make an assumption about
the growth rate of the revenues, beyond the planning
horizon and then use Gordon's formula to find the
terminal value of the firm (Vn). The terminal value
of a firm is calculated as:

Vn = last projected FCF x (1+ expected growth rate of FCF)

WACC – expected growth rate of FCF

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• Step 4. Having calculated the FCF, WACC and Vn,
we use the given formula to calculate the total value
of the firm at the time of the IPO.

• If we subtract the value of outstanding debt (and

add the value of cash) then we get the value of
outstanding equity.

• When this is divided by the number of outstanding

shares before the IPO, we get the estimated price of
the share.

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• This method has numerous advantages
– It recognizes the time value of cash flows
– It is future oriented and estimates what an owner
may achieve in the future

• However
– Forecasting of cash flows can be very difficult
– Same is for growth rate of cash flow and therefore
the terminal value
– Always hard to find “peer companies”

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2) The ‘comparable firms’ approach
• How do you decide how much a house is worth?
• Most likely you look at recent sale of similar homes
in the neighbourhood
• Likewise, analysts and investment bankers get a
rough idea about the value of a firm by looking at
market prices of similar firms that are listed

• Steps:
– Identify a set of peer companies
– Work out ‘average’ P/E or P/S or (and) M/B ratios
– Apply these to estimates of EPS or BE for the firm
undertaking the IPO.
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 • The financial press seemed to associate these firms to
Twitter as “peers”: Amazon, Facebook, Groupon,
Linkedin, Netflix, Yelp, Zinga.
Book Value
Company Name SIC MB MS Sales Twitter Twitter SharesTwitter
Amazon.com Inc 5961 15.758 2.930 422,215,000 705,045,000 70,000,000
Facebook Inc 7370 9.443 23.310 422,215,000 705,045,000 70,000,000
Groupon Inc 7370 9.232 4.147 422,215,000 705,045,000 70,000,000
LinkedIn Corp 7370 11.594 27.140 422,215,000 705,045,000 70,000,000
Netflix Inc 7841 15.214 5.727 422,215,000 705,045,000 70,000,000
Yelp Inc 7370 22.227 26.896 422,215,000 705,045,000 70,000,000
Zynga Inc 7372 1.596 4.289 422,215,000 705,045,000 70,000,000

Price
Average MS 13.49116 5,696,168,853 81.37
Median MS 5.727185 2,418,103,415 34.54
Industry (7370)
median MS 4.202176 1,774,221,740 25.35

Average MB 12.15214 8567804035 122.40

Median MB 11.59445 8174609000 116.78
Industry (7370) 83
median MB 2.62376 1849868869 26.43
• This method has some advantages:
– It’s quick and easy and therefore gives an immediate
rough idea about firm value
– However, for instance most of the IPOs are young
(and sometimes small) firms which may very well
have negative earnings
– Relying on listed peers must be done with caution.
Most listed firms are larger than private firms. Greater
size means greater stability and less risk
– Most listed companies are already “elite performers”
compared to the entire universe of listed firms and
therefore may not be directly comparable

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 The VC Method
• VCs often deal with firms at very early stages of their
life cycle.
– Often firms lose money in their early stages
• Also, since they are very young, the time series of data
available is very limited
• Entrepreneurs are, by nature very optimistic. Their
forecasts of future earnings may not be very reliable
• So, given that they invest in so many risky projects, the
typical required rate of return VCs demand is very high
• They use the traditional methods of peer valuation or
DCF but, they won’t use WACC to discount
– Rather, they use their own required rate of return
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• For instance, “Man United.plc” intends to go public in
3 years time
• Suppose that the earnings of MU are expected to be
fixed at 4 mil in next 3 years
• Suppose that, on average, the P/E ratio of similar (but
listed) firms is 25, then MV=100.
• Discount this to PV using the “target” discount factor
– Suppose MU is perceived as mildly risky by VCs, and
they would require a 30% return
Estimated Exit Value
Disc Terminal Value= (1+ Target Rate of Return) n
100
3
 45.52
DTV = (1+0.3) 86
• Now the structure of the deal can be worked out.
• For instance, how much money is the VC prepared to
put in the firm and for what fraction of the equity?
• Assume that our VC is prepared to put 15 million into
MU, then the fraction of equity they will require is
approx 33%
15
– Ownership Proportion = 45.52  0.329 control

• Evidence (Hochberg, 2005) that VC-Backed IPO firms:

– perform better than non VC-Backed ones
– engage less in aggressive accounting prior to IPO
– are more likely to have an independent board
– more likely to split CH from CEO 87
 Core readings
• Chapters 2,9, 23 Berk DeMarzo
• Brau, J. and S. E. Fawcett, (2006), “IPOs: An
Analysis of Theory and Practice”, Journal of Finance
61, 399-436.
• Espenlaub, S., Goergen,M., Khurshed, A., (2001),
“IPO lock-in agreements in the UK”, Journal of
Business Finance and Accounting 28, 1235–1278.
• Ritter J. (1998), “Initial Public Offerings”

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