Corporate Finance II

Yogesh Chauhan
Why Finance?
Requirements for the course

Common sense
Course objectives

• To give you the capacity to understand the theory and apply, in real world
situations, the techniques that have been developed in corporate finance
• Motto for class: If it cannot be applied, who cares?
• To give you the big picture of corporate finance so that you can understand how
things fit together.
• To show you that corporate finance is fun and we face every day.
Don’t mistake accounting for finance
Accounting Balance sheet
Liabilities Assets
Equity (Book value) Fixed assets (long-lived real assets)

Debt (Book value) Current Assets (Short-lived assets)

Other liabilities Financial investment

Current assets Intangible assets (Patents
&trademarks)
What do I miss?

Nifty Price to book value Ratio is 3.36 on 11-Jan-2019

The financial balance sheet
Liabilities
Equity (Residual Claim on cash
flows, Perpetual lives)
Debt (Fixed claim on cash
flows, Fixed life)
Assets
Assets in place (Existing
investments (Assets side of
balance sheet)
Growth assets (Expected value
that will be created by future
investments)
 Corporate Finance: The Big Picture

Maximize the value of the business (firm)

The Investment Decision The Financing Decision The Dividend Decision

Invest in assets that earn a Find the right kind of debt for If you cannot find investments that
return greater than the your firm and the right mix of make your minimum acceptable rate,
minimum acceptable hurdle debt and equity to fund your return the cash to owners of your
rate operations business

The optimal mix of

The hurdle rate should The return should How you choose to return cash
debt and equity
reflect the riskiness of reflect the magnitude to the owners will depend on
maximizes firm value.
the investment and the and the timing of the whether they prefer dividends or
The right kind of
mix of debt and equity cashflows as well as buybacks
debt matches the tenor
used to fund it. all side effects of your assets
The choice of financing

• There are only two ways in which a business can raise money.
• The first is debt: The essence of debt is that a debt claim entitles the holder of
the claim to a contracted set of cashflows (interest payments and repaying
principle). If you fail to make those payments, you lose control of your
business.
• The second is equity: With equity, you do get whatever cashflows are left
over after you made debt and tax (government) payments.
 Debt versus Equity

1. Fixed claim 1. Residual claim

2. Tax Deductible 2. Not Tax Deductible
3. High priority in 3. Low priority in
financial trouble financial trouble
4. Fixed maturity 4. Infinite
5. No management 5. Management control
control (why?) (why?)

Equity
Debt
Hybrid securities Owner’s equity
Bank debt
Convertible Debt Venture capital
Commercial paper
Preferred stock Common stock
Corporate Bonds
Option-linked bonds Warrants
Financing pattern of Indian firms
Dilemma

• Ramesh is having an idea and now he wants to operate on this idea. However, he
does not enough funds to operate it. Please suggest him, how to finance its idea?
Problems with a new venture

• Almost all assets of a new venture are growth assets, therefore, the investor has to
produce a lot of information in order to reduce uncertainty.
• Given this fact, the investor should have capacity to produce information,
otherwise he/she can underestimate the value of the new venture.
Equity financing for private firms

• Owner’s equity.
• Angel financing.
• Venture Capital (Private equity) refers to a pool of equity capital which is
professionally managed. Wealthy investors may invest in these funds as limited
partners. The general partner manages the pool in exchange for a fee and a
percentage of the gains on investments
• Venture capitalists often make investments in several private firms in the same
business. How would this lack of diversification affect the way in which
venture capitalists evaluate their investments?
 VC Deal Flow by Stage
6000

5000

4000

3000

2000

1000

0
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Angel/Seed Early VC Later VC
Equity choices for publicly traded firms
• Initial public offering (IPO) or stock market launch is a type of public offering in
which shares of a company are sold to institutional investors and usually also
retail (individual) investors.
• An IPO is underwritten by one or more investment banks, who also arrange for
the shares to be listed on one or more stock exchanges.
• For each stock, each investor holds two rights: Cash flow right and Voting right.
• Typically, each stock has one voting right and one cashflow right. However,
the firm can issue differential voting right (DVR) stocks.
• Typically, Tata motor’s each stock has one voting right and one voting right
• However, Tata motor’s DVR has 0.10 voting right and 1.05 cashflow right.
Tata Motor and Tata Motor (DVR) (stock prices)

225
200
175
150
125
100
75
50
25
0

Tata Motor (DVR) Tata Motor

Initial public offering …
• Advantages
• Enlarging and diversifying equity base, and therefore, enabling cheaper access
to capital (why?)
• Increasing exposure, prestige, and public image and thus, attracting and
retaining better management and employees through liquid equity participation
• Facilitating acquisitions (potentially in return for shares of stock)
• Creating multiple financing opportunities: equity, convertible debt, cheaper
bank loans, etc.
• Disadvantages
• Significant legal, accounting and marketing costs, many of which are ongoing
• Loss of control and stronger agency problems due to new shareholders
Name of the issue Issue Price LTP Issue Start Date Issue End Date Price Range Listing date
Aavas Financiers Limited 821 850 9/25/2018 9/27/2018 Rs 818 to Rs 821 10/8/2018
Garden Reach Shipbuilders & Engineers Limited 118 94.65 9/24/2018 10/1/2018 Rs 114 to Rs 118 10/10/2018
Ircon International Limited 475 410.3 9/17/2018 9/19/2018 Rs 470 to Rs 475 9/28/2018
CreditAccess Grameen Limited 422 405.95 8/8/2018 8/10/2018 Rs 418 to Rs 422 8/23/2018
TCNS Clothing Co. Limited 716 721 7/18/2018 7/20/2018 Rs.714 to Rs.716 7/30/2018
Varroc Engineering Limited 967 730 6/26/2018 6/28/2018 Rs 965 to Rs 967 7/6/2018
Fine Organic Industries Limited 783 1190.45 6/20/2018 6/22/2018 Rs 780 to Rs 783 7/2/2018
RITES Limited 185 262.1 6/20/2018 6/22/2018 Rs 180 to Rs 185 7/2/2018
IndoStar Capital Finance Limited 572 352 5/9/2018 5/11/2018 Rs 570 to Rs 572 5/21/2018
Lemon Tree Hotels Limited 56 69.5 3/26/2018 3/28/2018 Rs 54 to Rs 56 4/9/2018
ICICI Securities Limited 520 262.55 3/22/2018 3/26/2018 Rs 519 to Rs 520 4/4/2018
Mishra Dhatu Nigam Limited 90 132.3 3/21/2018 3/23/2018 Rs 87 to Rs 90 4/4/2018
Sandhar Technologies Limited 332 273 3/19/2018 3/21/2018 Rs 327 to Rs 332 4/2/2018
Karda Constructions Limited 180 200.9 3/16/2018 3/21/2018 Rs 175 to Rs 180 4/2/2018
Hindustan Aeronautics Limited 1215 772 3/16/2018 3/20/2018 Rs 1215 to Rs 1240 3/28/2018
Bandhan Bank Limited 375 452.05 3/15/2018 3/19/2018 Rs 370 to Rs 375 3/27/2018
Bharat Dynamics Limited 428 281.05 3/13/2018 3/15/2018 Rs 413 to Rs 428 3/23/2018
Aster DM Healthcare Limited 190 165.5 2/12/2018 2/15/2018 Rs 180 to Rs 190 2/26/2018
Galaxy Surfactants Limited 1480 1175.95 1/29/2018 1/31/2018 Rs 1470 to Rs 1480 2/8/2018
Amber Enterprises India Limited 859 914.1 1/17/2018 1/19/2018 Rs 855 to Rs 859 1/30/2018
Newgen Software Technologies Limited 245 304.85 1/16/2018 1/18/2018 Rs 240 to Rs 245 1/29/2018
Apollo Micro Systems Limited 275 121.65 1/10/2018 1/12/2018 Rs 270 to Rs 275 1/22/2018
Right issue..

• A rights issue or rights offer is a dividend of subscription rights to buy additional

securities in a company made to the company's existing security holders.
• A right offering allows existing stockholders to keep control of the firm, if they so
desire, by giving them the right to buy additional stock in the firm at the price
below the market price.
Right issue..

Right Face Record

Alok Industries Ltd (Announcement Date) Premium(Rs) Ex-Right Date
Ratio Value Date
4/9/1996 2:1 0 10 3/1/1997 9/12/1996
Equity Shares of Rs. 10/- each for cash at a premium of Rs. 10/- per share aggregating Rs.14,98,03,840/-
on rights basis to the equity shareholders in the ratio of two equity shares for every equity share held as
on 3rd January, 1997, the Record Date.
25/03/20
3/1/2009 83:40 0 1 18/03/2009
09
Note: Rights issue in the ratio of the eighty three equity shares for every forty equity shares held by the
shareholders at Rs 10/- each at a premium of Re 1/- per equity share.
19/02/20
25/09/2012 2:3 0 0 15/02/2013
13
Rights issue of equity shares in the ratio of 2:3
of Rs. 10/- each at par.
Follow public offer and offer for sale…

• FPO:-A public firm issues fresh shares to the pubic

• Offer for sale:- When the promoter sales his/her holding to the public.
Value of right..

Rights can generally be freely bought and sold by investors in the stock. In general,
the value of a right should be equal to the difference between the stock price with
the rights attached, right-on-price, and the stock without the rights attached, the ex-
rights price.
Expected price after ex-right date=(3*11.64725+2*10)/5=Rs. 10.988
Value of right=11.64-10.988=0.652
Alok Industries Ltd’s stock prices
Close Price
14
13.5
13
12.5
12
11.5
11
Axis Title

10.5
10
9.5
9
8.5
8
7.5
7

Axis Title
Borrowing (Debt)

• Banks (private debt) specialize and spend resources to acquire information and
monitor borrowers, which typically results in a higher cost of lending
• Bonds (public debt) are commonly referred to as “unmonitored” lending because
of the dispersed pool of bond investors who cannot or choose not to “monitor,” or
influence, the business activities of the bond issuers.
• On average, the bond yield is lower than the bank interest rate for the lowest-risk
borrowers (why?)
• What is the significance of bond ratings?
A firm has a choice of taking on bank debt or issuing bonds. Under what condition
will take on bank debt?
Why bond rating matters? CRISIL default (%)
Rating category Default rate

AAA 0.00%
AA 0.20%
A 1.90%
BBB 3.89%
BB 11.17%
B 20.99%
C 39.01%
Why bond rating matters?
Rating-wise spreads over 10 years benchmark G-sec as on March end
AAA AA AA AA-
F06 0.96% 1.21% 1.63% 2.17%
F07 1.68% 1.98% 2.35% 2.89%
F08 1.40% 1.80% 2.17% 2.66%
F09 2.02% 2.69% 3.06% 3.55%
F10 0.86% 1.06% 1.44% 1.84%
F11 0.94% 1.09% 1.50% 1.90%
F12 0.69% 0.84% 1.36% 1.76%
F13 0.61% 0.94% 1.42% 1.82%
F14 0.30% 0.63% 1.11% 1.51%
F15 0.27% 0.61% 1.09% 1.49%
Public vs. Private debt

• While issuing public debt, the firm has to disclose enormous information to the
market and stock exchange. It is costly, for instance, the firm has a information
that cannot be leaked to the competitors. In such a case, banks’ loans would be
preferred because they have ability to produce more information, and keep
sensitive information confidential. As a result, bank can better price the firm’s
claims (can provide loans at lower rate).
• For instance, small, growth, intangible, and undervalued firm should use private
debt.
• Can a firm be financed entirely with debt? Why or why not?
Convertible bond

• A convertible bond is a type of debt security that can be converted into a

predetermined amount of the underlying company's equity at certain times during
the bond's life, usually at the discretion of the bondholder.
• A company issues a $1,000 face value convertible bond paying 4% interest
with a convertible ratio of 100 shares of the company for every convertible
bond and a maturity of 10 years for $1,000. At the end of year nine, a year
before maturity, the investor is entitled to $1,000 in principal plus $40 in
interest payments, a total of $1,040 if the investor does not convert the bond
into equity. However, the company's shares are now trading at $11 after a
successful quarter; thus, 100 shares of the company are now worth $1,100
(100 share x $11 share price), surpassing the value of the bond. The investor
is likely to convert the bond into equity, receiving 100 shares in the process,
and he could sell them in the market for $1,100 in total.
Convertible bond

• Conversation ratio= 100 equity stock for each bond (the number of stock for
which bond may be exchanged).
• Market conversion value is the current value of stocks for which bond may be
exchanged ($100*11=$1100).
• Conversion premium is excess of bond value over its conversion value ($1100-
$1040=$60)
Value of convertible bond

Value of convertible bond=Value of straight bond value + value of call option.

• A firm issues convertible bonds with a coupon of 3.25%, and face value is $1000
on 2018. The time to maturity is 3 years and Conversation ratio is 21.70 per bond
• The same firm also issued straight bonds of similar rating and similar maturity
were yielding 5.8%.
The market price of convertible bond is $1,255 per bond
The corporate life cycle
Measuring a firm’s financing mix

• My firm is having Rs 10 million debt. Is it high or low

• The simplest measure of how much debt and equity a firm is using currently is to
look at proportion of debt in the total financing: This ratio is called the debt to
capital ratio:
• Debt to Capital ratio=Debt/(debt+capital)
• Debt includes all interest bearing liabilities, short-term as well long term. It should
also include other commitments that meet the criteria for debt: contractually pre-
set payments that have to be made, no matter what the firm’s financial standing.
• Equity can be defined either accounting terms (book value of equity) or in market
value terms (based on the current price). The resulting debt ratios can be very
different.
The financing mix question

• In deciding to raise financing for a business, is there an optimal mix of

debt and equity?
• If yes, what is the trade off that lets us determine this optimal mix?
• What are the costs of using debt instead of equity?
The illusory benefits of debt

• At first sight, the benefit of debt seems obvious. The cost of debt is lower than the
cost of equity (why ?).
• The benefit is an illusion , though, because debt is cheaper than equity for a simple
reason. The lender gets both first claim on cashflows and a contractually pre-set
cashflows. The equity investor is last in line and has to demand a higher rate of
return than the lender does.
• By borrowing money at a lower rate, you are not making a business more
valuable, but moving the risk around.
• Total risk of equity holders=business risk + financial risk
• Levered beta and unlevered beta
 Determinates of beta (equity risk)
Assuming that total
Beta of equity (Levered Beta) risk is born by only
equity holders
Beta of Business
(Unlevered Beta) Financial leverage
𝐷
𝛽𝑒 = 𝛽𝑎 (1 + 𝐸 ∗ 1 − 𝑡 )
Nature of product or
service offered by firm: Operating leverage
High elasticity (Fixed Costs as % of total
(discretionary) of demand costs)
of your product would have
higher beta
1. Cyclical firms should have higher beta 1. Firms with high infrastructure needs and rigid costs structures
than non-Cyclical firms . should have higher betas than firms flexible cost structures
2. Luxury Goods firms should have higher 2. Smaller firms should have higher betas than larger firms.
beta than basic goods 3. Young firms should have higher betas than more mature
3. High priced goods/service firms should firms
have higher betas than low prices
goods/service.
4. Growth firms should have higher beta
 Cost of equity=Ku+(Ku-Kd)*D/E

Case 1 Case 2 Case 3 Case 4

Operating Profit 1000 1000 1000 1000
Cost of capital (Unlevered
firm) 12% 12% 12% 12%
Value of Cost of equity 12% 16.00% 24.00% 13.33%
firm Bank Interest rate 0 8% 8% 8%
Debt\Equity 0 1.00 3 0.33
Debt\total capital 0 0.50 0.75 0.25
Cost of capital 12% 12.00% 12.00% 12.00%
Value of Firm 8333.33 8333.33 8333.33 8333.33
Debt: The Basic Trade Off
Advantages of Borrowing
Tax Benefit:
Higher tax rates --> Higher tax benefit
Added Discipline:
Greater the separation between
managers and stockholders --> Greater
the benefit
Disadvantages of Borrowing
Bankruptcy Cost:
Higher business risk --> Higher Cost
Agency Cost:
Greater the separation between
stockholders & lenders --> Higher
Cost
Loss of Future Financing Flexibility:
Greater the uncertainty about future
financing needs --> Higher Cost
 Costs and Total investment 10,000 10,000
benefits of debt ROI 10% 10%
Debt @8% 0 5000
• Benefits of debt Equity 10000 5000
• Tax benefits: The tax code is
tilted in favor of debt, with
interest payments being tax EBIT 1000 1000
deductible in most parts of Less Interest 0 400
the world, while cashflows to
equity are not EBT 1000 600
Less Tax @30% 300 180
PAT 700 420
A pizza size cannot be changed, but I can reduce the
share of my brother by borrowing
Pizza Pizza

180
300 400

700 420

Govt Equity Debt

Govt Equity
 Firm A Firm B Difference

Return on equity (PAT/equity

investments) 700/10000=7.00% 420/5000=8.40% 1.4%

Return on assets (EBIT*(1-t))/Total

investments (1000*(1-.30))/10000=7% 1000*(1-.30))/10000=7% 0%

ROE=ROA+(ROA-Interest rate*(1-t))*D/E
5000
8.4% = 7% + 7% − 8% ∗ 1 − 30% ∗
5000
Operating
decisions
Financing decisions
(Financial leverage)
Tax benefits of debt
• When you borrow money, you are allowed to deduct interest expenses from your
income to arrive at taxable income. This reduces your taxes. When you use equity,
you are not allowed to deduct payments to equity (such as dividends) to arrive at
taxable income
• The dollar tax benefits from the interest payment in any year is a function of your
tax rate and the interest payment:
• Tax benefit each year=Tax rate*Interest payments
The caveat is that you need to have the income to cover interest payments to get this
tax benefit.
• Proposition 1: Other things being equal, the higher the marginal tax rate of a
business, the more debt it will have in its capital structure.
Tax Rate in India

35 34.61 34.61 34.61 34.61

34.5 33.99 33.99 33.99 33.99 33.99
34
33.5
Tax Rate

33
32.44 32.45
32.5
32
31.5
31
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Year
Debt adds discipline to management (Monitoring)

• If you are managers of a firm with no debt, and you generate high income and
cashflows each year, you tend to become complacent. The complacency can lead
to inefficiency and investing in poor projects. There is little or no cost born by the
managers.
• Forcing such a firm to borrow money can be an antidote to the complacency. The
managers now have to ensure that the investments they make will earn at least
enough return to cover interest expenses. The cost of not doing so is liquidation
and loss of such a job.
• The returns on capital earned by European firms have traditionally been lower
than the returns on capital earned by firms in the US. European firms also tended
to use less debt and to hold more cash than US firms. Is there a possible link
between these two phenomena. What might explain them?
Debt and discipline

• Assume that you into this argument that debt adds discipline to management.
Which of the following types of firms will most benefit from debt adding this
discipline?
1. Conservatively financed (very little debt), privately owned firms.
2. Conservatively financed, publicly traded firms, with stocks held millions of
investors, none of whom hold a large percent of the stock.
3. Conservatively financed, publicly traded firms, with an activist and primarily
institutional holding.
Cost associated with borrowing: Bankruptcy cost

• Bankruptcy cost= The probability of bankruptcy* Cost of bankruptcy cost.

Bankruptcy cost
• The expected bankruptcy cost is a function of two variables:
• The probability of bankruptcy, which will depend on how uncertain you are
about future cashflows.
• The size of operating cashflows relative to size of cashflows on debt
obligations.
• Variance in operating cashflows (business risk; the sensitivity of the
demand of the firm’s products with the economic condition)
• The cost of going bankrupt
• Direct costs: the outflows of cash during bankruptcy, such as legal and
admin costs, at the time of bankruptcy. The bankruptcy cost of Leman
brother $2 billion
• Indirect costs: Costs arising because people perceive you to be in financial
trouble.
On Oct 1 2008, A strong rumor that ICICI Bank has gone bankrupt sent several
depositors rushing for ATMs to withdraw money. The ICICI Bank stock is down
37.47% from its recent high of Rs 551.45 on 1 October 2008.
Bankruptcy cost

• Proposition 2: firms with more volatile earnings and cashflows should use debt
less than otherwise similar firms with stable cashflows.
• Proposition 3: Other things being equal, the greater the indirect bankruptcy cost,
the less debt the firm can afford to use for any given level of debt.
• In Indian system, business groups operate multiple independent firms, where one
firm provide insurance to another firms. What are the implications of this structure
on financing mix?
Debt & Bankruptcy cost

• Rank the following firms on the magnitude of bankruptcy costs from the most to
least, taking into account both explicit and implicit costs:
a. A Grocery store
b. An Airplane Manufacture
c. High Technology firm
Bankruptcy cost

• Firms with following products are likely to have greater bankruptcy (indirect)
costs
• Firms that sell durable products with long lives that require replacement parts
and service: Tata motor would have greater indirect costs associated with
bankruptcy than Avenue supermarts.
• Firms that provide goods or service for which quality is an important attribute
that is difficult to determine in advance: Manipal Hospitals would have more
indirect costs associated with bankruptcy than Jubilant Foodworks.
• Firms that provide service after sale:
Agency cost
• An agency cost arises whenever you hire someone else to do something for you. It
arises because your interests(as the principal) may deviate from those of the
person you hired (as the agent).
• When you lend money to a business, you are allowing the stockholders to use that
money in the course of running that business. Stockholders interests are different
from your interests, because
• You (as lender) are interested in getting your money back.
• Stockholders are interested in maximizing their wealth
• In some cases, the clash of interests can lead to stockholders
• Investing in riskier projects than you would want them to
• Paying themselves large dividends when you would rather have them keep the
cash in the business.
Proposition 4: Other things being equal, the greater the agency problems associated
with lending to a firm, the less debt the firm can afford to use.
Debt and Agency Costs

• Assume that you are a bank. Which of the following businesses would you
perceive the greatest agency costs?
• A Large Technology firm
• A Large Regulated Electric Utility
Why?
Loss of future financing flexibility

• When a firm borrows up to its capacity, it loses the flexibility of financing future
projects with debt.
• Proposition 5: Other things remaining equal, the more uncertain a firm is about its
future financing requirements and projects, the less debt the firm will use for
financing current projects.
 Promoter
Year % Equity Value Depreciation/PBDIT PBDIT/Sales fixed asset/sales Equity Beta Holding
Bajaj Auto Ltd.

2014 99.998% 6% 20% 21% 0.83 50%

2015 100.000% 5% 23% 21% 0.83 50%
2016 100.000% 5% 23% 21% 0.83 50%
Dr. Reddy'S Laboratories Ltd.
2014 70% 20% 25% 83% 0.52 25%
2015 79% 22% 28% 96% 0.52 25%
2016 71% 38% 19% 112% 0.52 25%
Hindustan Unilever Ltd.
2014 99% 5% 20% 16% 0.51 67%
2015 97% 5% 19% 10% 0.51 67%
2016 96% 6% 20% 14% 0.51 67%
Bharti Airtel Ltd.
2014 43% 55% 37% 217% 0.75 65%
2015 59% 43% 42% 269% 0.75 65%
2016 57% 51% 41% 285% 0.75 65%