1. Values of stocks depend on cash flows. We have argued that the value of stocks depends on expectations of cash flows not on the supply and demand on any particular day. In other words, you should be able to issu large blocks of stocks at close to the market price as long as you can convince other investors that you have no private information, i. e,, that you're not selling while the going is good 2. There are no financial illusions In an efficient market there are no financial illusions. Investors are concerned with their entitlement to a firms cash flow. This implies that any attempt to mislead investors by, for example, changing accounting conventions to boost EPS will be unsuccessful 3. Markets have no memory. We have argued that there are no true cycles hence the notion that now is a good time or now is a bad time to issue securities is essentially false. For example, there may just have been a long series of rises so that you think it is the top of the market and therefore a good time to issue. However, we know if this was true, investors would already have sold and the market would not be where it now is. You cannot outguess the market using information available to every body else 4. Trust market prices. In an efficient market you can trust prices. They incorporate all the available information about the value of each security. This means that in an efficient market firms can issue securities at any time. The amount that they will receive is a fair value 6
6 1. Values of stocks depend on cash flows. We have argued that the value of stocks depends on expectations of cash flows not on the supply and demand on any particular day. In other words, you should be able to issue large blocks of stocks at close to the market price as long as you can convince other investors that you have no private information, i.e., that you're not selling while the going is good. 2. There are no financial illusions. In an efficient market there are no financial illusions. Investors are concerned with their entitlement to a firm's cash flow. This implies that any attempt to mislead investors by, for example, changing accounting conventions to boost EPS will be unsuccessful. 3. Markets have no memory. We have argued that there are no true cycles. Hence the notion that now is a good time or now is a bad time to issue securities is essentially false. For example, there may just have been a long series of rises so that you think it is the top of the market and therefore a good time to issue. However, we know if this was true, investors would already have sold and the market would not be where it now is. You cannot outguess the market using information available to everybody else. 4. Trust market prices. In an efficient market you can trust prices. They incorporate all the available information about the value of each security. This means that in an efficient market firms can issue securities at any time. The amount that they will receive is a fair value
2.2 Tvpes of security We mentioned in Section I that originally in MBa programs corporate finance was taught as a law subject. Nowadays law has been deemphasized but a knowledge of the different types of security that are used and the legal rights of the owners is very important The basic types are outlined below. You should read Chapter 14 in Brealey and Myers to obtain a more detailed knowledge Common Stock The common stockholders are the owners of the corporation. they therefore have a general preemptive right to anything of value that the company may wish to distribute. They also have the ultimate control of the company's affairs. In practice this control is limited to a right to vote either in person, or by proxy, on appointments to the board of directors Long Term Debt and Preferred Stock Long term debt and preferred stock are fixed income securities in that they both provide the investor with a stipulated promised series of payments in the future. The interest and face value are specified for the bonds, and a given dividend rate is stipulated for the preferred stock. The firm must pay the interest and the maturity values on its debt as agreed upon in the original debt contract or the company defaults and is subject to legal action. Junk bonds are high yield bonds With preferred stock the firm promises to pay dividends on the preferred stock. If it fails to it is not bankrupt, however. It cannot pay dividends to common stockholders until the dividends to preferred stock are paid. Bondholders have a prior claim to the company's
7 2.2 Types of Security We mentioned in Section 1 that originally in MBA programs corporate finance was taught as a law subject. Nowadays law has been deemphasized but a knowledge of the different types of security that are used and the legal rights of the owners is very important. The basic types are outlined below. You should read Chapter 14 in Brealey and Myers to obtain a more detailed knowledge. Common Stock The common stockholders are the owners of the corporation. They therefore have a general preemptive right to anything of value that the company may wish to distribute. They also have the ultimate control of the company's affairs. In practice this control is limited to a right to vote either in person, or by proxy, on appointments to the board of directors. Long Term Debt and Preferred Stock Long term debt and preferred stock are fixed income securities in that they both provide the investor with a stipulated promised series of payments in the future. The interest and face value are specified for the bonds, and a given dividend rate is stipulated for the preferred stock. The firm must pay the interest and the maturity values on its debt as agreed upon in the original debt contract or the company defaults and is subject to legal action. Junk bonds are high yield bonds. With preferred stock the firm promises to pay dividends on the preferred stock. If it fails to it is not bankrupt, however. It cannot pay dividends to common stockholders until the dividends to preferred stock are paid. Bondholders have a prior claim to the company's
income and to the firms assets if the company liquidates. The claim of holders of preferred stock comes after bondholders but before that of equityholders The relative importance of the three types of security is that debt is by far the most important in terms of quantity issued, equity is next and finally preferred stock is relatively insignificant. The quantitie d vary significantly over time but the le In average Is about 80% debt, 15% equity and 5% preferred stock Convertible Securities Corporations often issue securities with terms that can be altered subsequently at the option of the holder of the security. For example, convertible bonds can be transformed into the common stock of the corporation at the option of the holder. The purchase of a warrant entitles the holder to purchase the company' s common stock at a specified price on any date preceding the warrant's expiration 2.3 Capital structure Decisions The assumption behind most of the analysis we have done so far is that the firm is all equity financed. In practice, of course, firms use debt and many other types of security to finance themselves. In this section we are interested in whether using different types of ecurity, in particular debt and equity, creates value for shareholders Motivation Example The Saw Company is reviewing its capital structure. It pays no taxes and has access to perfect capital markets. The interest rate on debt is 10 percent. Its current position is as follows 8
8 income and to the firm's assets if the company liquidates. The claim of holders of preferred stock comes after bondholders but before that of equityholders. The relative importance of the three types of security is that debt is by far the most important in terms of quantity issued, equity is next and finally preferred stock is relatively insignificant. The quantities issued vary significantly over time but the long run average is about 80% debt, 15% equity and 5% preferred stock. Convertible Securities Corporations often issue securities with terms that can be altered subsequently at the option of the holder of the security. For example, convertible bonds can be transformed into the common stock of the corporation at the option of the holder. The purchase of a warrant entitles the holder to purchase the company's common stock at a specified price on any date preceding the warrant's expiration. 2.3 Capital Structure Decisions The assumption behind most of the analysis we have done so far is that the firm is all equity financed. In practice, of course, firms use debt and many other types of security to finance themselves. In this section we are interested in whether using different types of security, in particular debt and equity, creates value for shareholders. Motivation Example The Saw Company is reviewing its capital structure. It pays no taxes and has access to perfect capital markets. The interest rate on debt is 10 percent. Its current position is as follows:
Data Number of shares Price per $20 Market value of shares $2000 Market value of debt Examples of Possible Outcomes Sit 2 Sit 3 (Expected Outcome) Operating income 100 250 300 Earnings per share S 2.5 Return on equity 12.5 The company has no leverage and all the operating income is paid out as dividends to the common stockholders The expected earnings and dividends per share are $2.50. This is an average, actual earnings could turn out to be more or less than $2.50. The price of each share is $20. Since the firm expects to produce a level stream of earnings in perpetuity, the expected return is given by EPS 2.50 Mr. Modigliani, a Harvard MBA and the firms president, has come to the conclusion that shareholders would be better off if the company had equal proportions of debt and equity. He therefore proposes to issue $1000 of debt at the risk free lending and
9 Data Number of shares 100 Price per share $20 Market value of shares $2000 Market Value of debt $0 Examples of Possible Outcomes: Sit 1 Sit 2 Sit 3 (Expected Outcome) Operating income $ 100 250 300 Earnings per share $ 1 2.5 3 Return on equity % 5 12.5 15 The company has no leverage and all the operating income is paid out as dividends to the common stockholders. The expected earnings and dividends per share are $2.50. This is an average; actual earnings could turn out to be more or less than $2.50. The price of each share is $20. Since the firm expects to produce a level stream of earnings in perpetuity, the expected return is given by: Mr. Modigliani, a Harvard MBA and the firm's president, has come to the conclusion that shareholders would be better off if the company had equal proportions of debt and equity. He therefore proposes to issue $1000 of debt at the risk free lending and =12.5% 20 2.50 = P EPS r =
borrowing rate of 10% and use the proceeds to repurchase 50 shares. To support his proposal Mr. Modigliani has analyzed the situation under the various different assumptions about operating income. The results are as follows t a Number of shares Market value of debt $1000 utcome Sit 2 Sit 3 (Expected Outcome) Operating income 100 250 300 Interest S 100 100 Equity Earnings S 150 200 EPS S Return on equity 15 Return on debt 10 10 10 We can plot this data on the following diagram 10
10 borrowing rate of 10% and use the proceeds to repurchase 50 shares. To support his proposal Mr. Modigliani has analyzed the situation under the various different assumptions about operating income. The results are as follows: Data Number of shares 50 Market value of debt $1000 rD = 10% Possible Outcomes Sit 1 Sit 2 Sit 3 (Expected Outcome) Operating income $ 100 250 300 Interest $ 100 100 100 Equity Earnings $ 0 150 200 EPS $ 0 3 4 Return on equity % 0 15 20 Return on debt % 10 10 10 We can plot this data on the following diagram: