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Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This subject guide is for a 300 course offered as part of the University of London
International Programmes in Economics, Management, Finance and the Social Sciences.
This is equivalent to Level 6 within the Framework for Higher Education Qualifications in
England, Wales and Northern Ireland (FHEQ).
For more information about the University of London International Programmes
undergraduate study in Economics, Management, Finance and the Social Sciences, see:
www.londoninternational.ac.uk
This guide was prepared for the University of London International Programmes by:
Dr. P. Frantz, Lecturer in Accountancy and Finance, The London School of Economics and
Political Science
R. Payne, Former Lecturer in Finance, The London School of Economics and Political Science
Dr. J. Favilukis, Lecturer, The London School of Economics and Political Science
This is one of a series of subject guides published by the University. We regret that due to
pressure of work the authors are unable to enter into any correspondence relating to, or aris-
ing from, the guide. If you have any comments on this subject guide, favourable or unfavour-
able, please use the form at the back of this guide.
Contents
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92 Corporate finance
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Contents
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92 Corporate finance
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Introduction to the subject guide
Learning outcomes
At the end of this course, and having completed the Essential reading and
activities, you should be able to:
• explain how to value projects, and use the key capital budgeting
techniques (NPV and IRR)
• understand the mathematics of portfolios and how risk affects the
value of the asset in equilibrium under the fundaments asset pricing
paradigms (CAPM and APT)
• know how to use recent extensions of the CAPM, such as the Fama
and French three-factor model, to calculate expected returns on risky
securities
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92 Corporate finance
Syllabus
Note: A minor revision was made to this syllabus in 2009.
Students may bring into the examination hall their own hand-held
electronic calculator. If calculators are used they must satisfy the
requirements listed in the Regulations.
If you are taking this course as part of a BSc degree, courses which must
be passed before this course may be attempted are 2 Introduction to
economics and 5A Mathematics 1 or 5B Mathematics 2 or 174
Calculus.
Project evaluation: Hirschleifer analysis and Fisher separation; the NPV rule
and IRR rules of investment appraisal; comparison of NPV and IRR; ‘wrong’
investment appraisal rules: payback and accounting rate of return.
Risk and return – the CAPM and APT: the mathematics of portfolios; mean-
variance analysis; two-fund separation and the CAPM; Roll’s critique of the
CAPM; factor models; the arbitrage pricing theory; recent extensions of the
factor framework.
Derivative assets – characteristics and pricing: definitions: forwards and futures;
replication, arbitrage and pricing; a general approach to derivative pricing
using binomial methods; options: characteristics and types; bounding and
linking option prices; the Black–Scholes analysis.
Efficient markets – theory and empirical evidence: underpinning and definitions
of market efficiency; weak-form tests: return predictability; the joint
hypothesis problem; semi-strong form tests: the event study methodology
and examples; strong form tests: tests for private information; long-horizon
return predictability.
Capital structure: the Modigliani–Miller theorem: capital structure irrelevancy;
taxation, bankruptcy costs and capital structure; weighted average cost
of capital; Modigliani-Miller 2nd proposition; the Miller equilibrium;
asymmetric information: 1) the under-investment problem, asymmetric
information; 2) the risk-shifting problem, asymmetric information; 3) free
cash-flow arguments; 4) the pecking order theory; 5) debt overhang.
Dividend theory: the Modigliani–Miller and dividend irrelevancy; Lintner’s
fact about dividend policy; dividends, taxes and clienteles; asymmetric
information and signalling through dividend policy.
Corporate governance: separation of ownership and control; management
incentives; management shareholdings and firm value; corporate governance.
Mergers and acquisitions: motivations for merger activity; calculating the gains
and losses from merger/takeover; the free-rider problem and takeover
activity.
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Introduction to the subject guide
Essential reading
There are a number of excellent textbooks that cover this area. However,
the following text has been chosen as the core text for this course due
to its extensive treatment of many of the issues covered and up-to-date
discussions:
Hillier, D., M. Grinblatt and S. Titman Financial Markets and Corporate Strategy.
(Boston, Mass.; London: McGraw-Hill, 2008) European edition
[ISBN 978007119027].
At the start of each chapter of this guide, we will indicate the reading that
you need to do from Hillier, Grinblatt and Titman (2008).
Detailed reading references in this subject guide refer to the editions of the
set textbooks listed above. New editions of one or more of these textbooks
may have been published by the time you study this course. You can use
a more recent edition of any of the books; use the detailed chapter and
section headings and the index to identify relevant readings. Also check
the virtual learning environment (VLE) regularly for updated guidance on
readings.
Further reading
Please note that as long as you read the Essential reading you are then free
to read around the subject area in any text, paper or online resource. You
will need to support your learning by reading as widely as possible and by
thinking about how these principles apply in the real world. To help you
read extensively, you have free access to the VLE and University of London
Online Library (see below).
Other useful texts for this course include:
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass., London: McGraw-Hill, 2008) ninth international edition [ISBN
9780071266758].
Copeland, T., J. Weston and K. Shastri Financial Theory and Corporate Policy.
(Reading, Mass.; Wokingham: Addison-Wesley, 2005) fourth edition
[ISBN 9780321223531].
Journal articles
Asquith, P. and D. Mullins ‘The impact of initiating dividend payments on
shareholders’ wealth’, Journal of Business 56(1) 1983, pp.77–96.
Ball, R. and P. Brown ‘An empirical evaluation of accounting income numbers’,
Journal of Accounting Research 6(2) 1968, pp.159–78.
Bhattacharya, S. ‘Imperfect information, dividend policy, and “the bird in the
hand” fallacy’, Bell Journal of Economics 10(1) 1979, pp.259–70.
Blume, M., J. Crockett and I. Friend ‘Stock ownership in the United States:
characteristics and trends’, Survey of Current Business 54(11) 1974,
pp.16–40.
Bradley, M., A. Desai and E. Kim ‘Synergistic gains from corporate acquisitions
and their division between the stockholders of target and acquiring firms’,
Journal of Financial Economics 21(1) 1988, pp.3–40.
Brock, W., J. Lakonishok and B. LeBaron ‘Simple technical trading rules and
stochastic properties of stock returns’, Journal of Finance 47(5) 1992,
pp.1731–64.
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92 Corporate finance
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Introduction to the subject guide
Books
Allen, F. and R. Michaely ‘Dividend policy’ in Jarrow, R., W. Maksimovic and
W.T. Ziemba (eds) Handbook of Finance. (Amsterdam: Elsevier Science,
1995) [ISBN 9780444890849].
Haugen, R. and J. Lakonishok The Incredible January Effect. (Homewood, Ill.:
Dow Jones-Irwin, 1988) [ISBN 9781556230424].
Ravenscraft, D. and F. Scherer Mergers, Selloffs, and Economic Efficiency.
(Washington D.C.: Brookings Institution, 1987) [ISBN 9780815773481].
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92 Corporate finance
The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a sense
of community. It forms an important part of your study experience with the
University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
• Self-testing activities: Doing these allows you to test your own
understanding of subject material.
• Electronic study materials: The printed materials that you receive from
the University of London are available to download, including updated
reading lists and references.
• Past examination papers and Examiners’ commentaries: These provide
advice on how each examination question might best be answered.
• A student discussion forum: This is an open space for you to discuss
interests and experiences, seek support from your peers, work
collaboratively to solve problems and discuss subject material.
• Videos: There are recorded academic introductions to the subject,
interviews and debates and, for some courses, audio-visual tutorials and
conclusions.
• Recorded lectures: For some courses, where appropriate, the sessions from
previous years’ Study Weekends have been recorded and made available.
• Study skills: Expert advice on preparing for examinations and developing
your digital literacy skills.
• Feedback forms.
Some of these resources are available for certain courses only, but we are
expanding our provision all the time and you should check the VLE regularly
for updates.
Examination advice
Important: the information and advice given here are based on the
examination structure used at the time this guide was written. Please
note that subject guides may be used for several years. Because of this
we strongly advise you to always check both the current Regulations for
relevant information about the examination, and the VLE where you
should be advised of any forthcoming changes. You should also carefully
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92 Corporate finance
check the rubric/instructions on the paper you actually sit and follow
those instructions.
Remember, it is important to check the VLE for:
• up-to-date information on examination and assessment arrangements
for this course
• where available, past examination papers and Examiners’ commentaries
for the course which give advice on how each question might best be
answered.
This course will be evaluated solely on the basis of a three-hour
examination. You will have to answer four out of a choice of eight
questions. Although the Examiners will attempt to provide a fairly
balanced coverage of the course, there is no guarantee that all of the
topics covered in this guide will appear in the examination. Examination
questions may contain both numerical and discursive elements. Finally,
each question will carry equal weight in marking and, in allocating your
examination time, you should pay attention to the breakdown of marks
associated with the different parts of each question.
8
Chapter 1: Present value calculations and the valuation of physical investment projects
Aim
The aim of this chapter is to introduce the Fisher separation theorem, which
is the basis for using the net present value (NPV) for project evaluation
purposes. With this aim in mind, we discuss the optimality of the NPV
criterion and compare this criterion with alternative project evaluation
criteria.
Learning outcomes
At the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• analyse optimal physical and financial investment in perfect capital
markets setting and derive the Fisher separation result
• justify the use of the NPV rules via Fisher separation
• compute present and future values of cash-flow streams and appraise
projects using the NPV rule
• evaluate the NPV rule in relation to other commonly used evaluation
criteria
• value stocks and bonds via NPV.
Essential reading
Hillier, D., M. Grinblatt and S. Titman Financial Markets and Corporate Strategy.
(Boston, Mass.; London: McGraw-Hill, 2008) Chapters 9 (Discounting
and Valuation), 10 (Investing in Risk-Free Projects), 11 (Investing in Risky
Projects).
Further reading
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass.; London: McGraw-Hill, 2008) Chapters 2 (Present Values), 3 (How to
Calculate Present Values), 5 (The Value of Common Stocks), 6 (Why NPV
Leads to Better Investment Decisions) and 7 (Making Investment Decisions
with the NPV Rule).
Copeland, T. and J. Weston Financial Theory and Corporate Policy. (Reading,
Mass.; Wokingham: Addison-Wesley, 2005) Chapters 1 and 2.
Roll, R. ‘A critique of the asset pricing theory’s texts. Part 1: on past and potential
testability of the theory’, Journal of Financial Economics 4(2) 1977,
pp.129–76.
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92 Corporate finance
Overview
In this chapter we present the basics of the present value methodology
for the valuation of investment projects. The chapter develops the
NPV technique before presenting a comparison with the other project
evaluation criteria that are common in practice. We will also discuss the
optimality of NPV and give a number of extensive examples.
Introduction
For the purposes of this chapter, we will consider a firm to be a package
of investment projects. The key question, therefore, is how do the
firm’s shareholders or managers decide on which investment projects to
undertake and which to discard? Developing the tools that should be used
for project evaluation is the emphasis of this chapter.
It may seem, at this point, that our definition of the firm is rather limited.
It is clear that, in only examining the investment operations of the firm,
we are ignoring a number of potentially important firm characteristics.
In particular, we have made no reference to the financial structure or
decisions of the firm (i.e. its capital structure, borrowing or lending
activities, or dividend policy). The first part of this chapter presents what
is known as the Fisher separation theorem. What follows is a statement
of the theorem. This theorem allows us to say the following: under
certain conditions (which will be presented in the following section), the
shareholders can delegate to the management the task of choosing which
projects to undertake (i.e. determining the optimal package of investment
projects), whereas they themselves determine the optimal financial
decisions. Hence, the theory implies that the investment and financing
choices can be completely disconnected from each other and justifies our
limited definition of the firm for the time being.
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Chapter 1: Present value calculations and the valuation of physical investment projects
Figure 1.1
The financial investment allows firms to borrow or lend unlimited
amounts at rate r. Assuming that the firm undertakes no physical
investment, we can define the firm’s consumption opportunities quite
easily. Assume the firm neither borrows nor lends. This implies that
current consumption (c0) must be identically m, whereas period 1
consumption (c1) is zero. Alternatively, the firm could lend all of its funds.
This leads to c0 being zero and c1 = m (1 + r). The relationship between
period 0 and period 1 consumption is therefore:
c1 = (1 + r)(m – c0). (1.1)
This implies that the curve which represents capital market investments is
a straight line with slope –(1 + r). This curve is labeled CML on Figure 1.2.
Again, we have on Figure 1.2 plotted the optimal financial investments for
two different sets of preferences (assuming that no physical investment is
undertaken).
Figure 1.2
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92 Corporate finance
The firm’s physical investment policy takes it to point I, from where it can
borrow or lend on the capital market. Borrowing will move the firm to
the south-east along a line starting at I and with slope –(1+r); lending will
take the firm north-west along a similarly sloped line. Two possible optima
are shown on Figure 1.3. The optimum at point X is that for a firm whose
owners prefer period 1 consumption relative to period 0 consumption (and
have hence lent on the capital market), whereas a firm locating at Y has
borrowed, as its owners prefer date 0 to date 1 consumption.
Figure 1.3 demonstrates the key insight of Fisher separation. All firms,
regardless of preferences, will have the same optimal physical investment
policy, investing to the point where the PPF and capital market line are
tangent. Preferences then dictate the firm’s borrowing or lending policy
and shift the optimum along the capital market line. The implication of
this is that, as it is physical investment that alters firm value, all agents
(i.e. regardless of preferences) agree on the physical investment policy that
will maximise firm value. More specifically, the shareholders of the firm
can delegate choice of investment policy to a manager whose preferences
may differ from their own, while controlling financial investment policy in
order to suit their preferences.
Figure 1.3
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Chapter 1: Present value calculations and the valuation of physical investment projects
where Π(I0) is the date 1 income from the firm’s physical investment.
Maximising this is equivalent to the following maximisation problem:
.
The prior objective is the NPV rule for project appraisal. It says that an
optimal physical investment policy maximises the difference between
investment proceeds divided by one plus the interest rate and the
investment cost. Here, the term ‘optimal’ is being defined as that which
leads to maximisation of shareholder utility. We will discuss the NPV rule
more fully (and for cases involving more than one time period) later in
this chapter.
The assumption of perfect capital markets is vital for our Fisher separation
results to hold. We have assumed that borrowing and lending occur at the
same rate and are unrestricted in amount and that there are no transaction
costs associated with the use of the capital market. However, in practical
situations, these conditions are unlikely to be met. A particular example
is given in Figure 1.4. Here we have assumed that the rate at which
borrowing occurs is greater than the rate of interest paid on lending (as
the real world would dictate). Figure 1.3 shows that there are now two
points at which the capital market lines and the production opportunities
frontier are tangential. This then implies that agents with different
preferences will choose differing physical investment decisions and,
therefore, Fisher separation breaks down.
Figure 1.4
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(1.3)
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Chapter 1: Present value calculations and the valuation of physical investment projects
You can see the present and future value concepts pictured in Figure 1.2.
If you recall, Figure 1.2 just plots the CML for a given level of initial funds
(m) assuming no funds are to be received in the future. The future value
of this amount of money is simply the vertical intercept of the CML (i.e.
m(1+r)), and obviously the present value of m(1+r) is just m.
The present and future value concepts are straightforwardly extended
to cover more than one period. Assume an annual compound interest rate
of r. The present value of $100 to be received in k year’s time is:
(1.4)
whereas the future value of $100 received today and evaluated k years
hence is:
Activity
Below, there are a few applications of the present and future value concepts. You should
attempt to verify that you can replicate the calculations.
Assume a compound borrowing and lending rate of 10 per cent annually.
a. The present value of $2,000 to be received in three years time is $1,502.63.
b. The present value of $500 to be received in five years time is $310.46.
c. The future value of $6,000 evaluated four years hence is $8,784.60.
d. The future value of $250 evaluated 10 years hence is $648.44.
. (1.6)
Note that the cash flows to the project can be positive and negative,
implying that the notation employed is flexible enough to embody both
cash inflows and outflows after initiation.
Once we have calculated the NPV, what should we do? Clearly, if the NPV
is positive, it implies that the present value of receipts exceeds the present
value of payments. Hence, the project generates revenues that outweigh its
costs and should therefore be accepted. If the NPV is negative the project
should be rejected, and if it is zero the firm will be indifferent between
accepting and rejecting the project.
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Example
Consider a manufacturing firm, which is contemplating the purchase of a new piece of
plant. The rate of interest relevant to the firm is 10 per cent. The purchase price is £1,000.
If purchased, the machine will last for three years and in each year generate extra revenue
equivalent to £750. The resale value of the machine at the end of its lifetime is zero. The
NPV of this project is:
Activity
Assume an interest rate of 5 per cent. Compute the NPV of each of the following projects,
and state whether each project should be accepted or not.
• Project A has an immediate cost of $5,000, generates $1,000 for each of the next six
years and zero thereafter.
• Project B costs £1,000 immediately, generates cash flows of £600 in year 1,
£300 in year 2 and £300 in year 3.
• Project C costs ¥10,000 and generates ¥6,000 in year 1. Over the following years, the
cash flows decline by ¥2,000 each year, until the cash flow reaches zero.
• Project D costs £1,500 immediately. In year 1 it generates £1,000. In year 2 there is a
further cost of £2,000. In years 3, 4 and 5 the project generates revenues of £1,500
per annum.
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Chapter 1: Present value calculations and the valuation of physical investment projects
overall cost of capital. The firm can raise funds via equity issues and
debt issues, and it is likely that the costs of these two types of funds will
differ. Later on in this chapter and in those that follow, we will present
techniques by which the firm can compute the overall cost of capital for its
enterprise.
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92 Corporate finance
(1.7)
where Ci is the project cash flow in year i, and I is the initial (i.e. year 0)
investment outlay. Comparison of equation 1.7 with 1.6 shows that the
project IRR is the discount rate that would set the project NPV to zero.
Once the IRR has been calculated, the project is evaluated by comparing
the IRR to a predetermined required rate of return known as a hurdle
rate. If the IRR exceeds the hurdle rate, then the project is acceptable,
and if the IRR is less than the hurdle rate it should be rejected. A graphical
analysis of this is presented in Figure 1.5, which plots project NPV against
the rate of return used in the NPV calculation. If r* is the hurdle rate used
in project evaluation, then the project represented by the curve on the
figure is acceptable as the IRR exceeds r*. Clearly, if r* is also the correct
required rate of return, which would be used in NPV calculations, then
application of the IRR and NPV rules to assessment of the project in Figure
1.5 gives identical results (as at rate r* the NPV exceeds zero).
Figure 1.5
Calculation of the IRR need not be straightforward. Rearranging equation
1.7 shows us that the IRR is a solution to a kth order polynomial in r.
In general, the solution must be found by some iterative process, for
example, a (progressively finer) grid search method. This also points to
a first weakness of the IRR approach; as the solution to a polynomial,
the IRR may not be unique. Several different rates of return might satisfy
equation 1.7; in this case, which one should be used as the IRR? Figure 1.6
gives a graphical example of this case.
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Chapter 1: Present value calculations and the valuation of physical investment projects
Figure 1.6
The graphical approach can also be used to illustrate another weakness
of the IRR rule. Consider a firm that is faced with a choice between two
mutually exclusive investment projects (A and B). The locus of NPV-rate of
return pairings for each of these projects is given on Figure 1.7.
The first thing to note from the figure is that the IRR of project A exceeds
that of B. Also, both IRRs exceed the hurdle rate, r*. Hence, both projects
are acceptable but, using the IRR rule, one would choose project A as
its IRR is greatest. However, if we assume that the hurdle rate is the
true opportunity cost of capital (which should be employed in an NPV
calculation), then Figure 1.7 indicates that the NPV of project B exceeds
that of project A. Hence, in the evaluation of mutually exclusive projects,
use of the IRR rule may lead to choices that do not maximise expected
shareholder wealth.
Figure 1.7
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92 Corporate finance
Example
Below are the equity values, debt values, and earnings (in billions) for several large US
retailers. Additionally provided is earnings growth for the past 10 years.
Walmart’s (WMT’s) equity value is excluded as this is the quantity we wish to estimate.
We can first calculate the market value of equity to earnings ratio for the average firm
in the industry (excluding Walmart), this is: [(17.48/1.1) + (24.08/1.1) + (82.08/6.01) +
(50.14/2.58)]/4 = 17.72
We now multiply this number by Walmart’s earnings to get Walmart’s equity value
estimate: 17.72*11.88=210.49. Walmart’s actual equity value was $192.48 billion.
may have very different value to earnings ratios. We will learn how to
adjust the multiples method for the effects of leverage later.
The multiples method allows us to check whether the value of a
conglomerate is equal to the sum of its parts. To estimate the value of
each business division of a conglomerate we can calculate each division’s
earnings and multiply it by the average value to earnings multiple of stand
alone firms in the same sector. Adding up the value of all divisions gives
us an estimated value for the conglomerate, this estimate is on average
12% greater than the traded value of the conglomerate. This is called the
conglomerate discount. The reasons for the conglomerate discount
are not fully understood. It is possible that conglomerates are a less
efficient form of organisation due to inefficient capital markets. It is also
possible that the multiples method is inappropriate here because single
segment firms are too different from divisions of a conglomerate operating
in the same industry.
The strength of the multiples approach is that it incorporates a lot of
information in a simple way. It does not require assumptions on the
discount rate and growth rate (as is necessary with the NPV approach)
but just uses the consensus estimates from the market. A weakness is
the assumption that the comparable companies are truly similar to the
company one is trying to value; there is no simple way of incorporating
company specific information. However, its strength is also its biggest
weakness. By using market information, we are assuming that the market
is always correct. This approach would lead to the biggest mistakes
in times of biggest money making opportunities: when the market is
overvalued or undervalued.
The lesson of this section is therefore as follows. The most commonly
used alternative project evaluation criteria to the NPV rule can lead to
poor decisions being made under some circumstances. By contrast, NPV
performs well under all circumstances and thus should be employed.
Stocks
Consider holding a common equity share from a given corporation. To
what does this equity share entitle the holder? Aside from issues such as
voting rights, the share simply delivers a stream of future dividends to
the holder. Assume that we are currently at time t, that the corporation is
infinitely long-lived (such that the stream of dividends goes on forever)
and that we denote the dividend to be paid at time t+i by Dt+i. Also
assume that dividends are paid annually. Denoting the required annual
rate of return on this equity share to be re, then a present value argument
would dictate that the share price (P) should be defined by the following
formula:
. (1.8)
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92 Corporate finance
. (1.10)
The first term in 1.10 is the expected dividend yield on the stock, and the
second is expected dividend growth. Hence, with empirical estimates of
the previous two quantities, we can easily calculate the required rate of
return on any equity share.
Activity
Attempt the following questions:
1. An investor is considering buying a certain equity share. The stock has just paid a
dividend of £0.50, and both the investor and the market expect the future dividend to
be precisely at this level forever. The required rate of return on similar equities is 8 per
cent. What price should the investor be prepared to pay for a single equity share?
2. A stock has just paid a dividend of $0.25. Dividends are expected to grow at
a constant annual rate of 5 per cent. The required rate of return on the share
is 10 per cent. Calculate the price of the stock.
3. A single share of XYZ Corporation is priced at $25. Dividends are expected
to grow at a rate of 8 per cent, and the dividend just paid was $0.50. What is
the required rate of return on the stock?
Bonds
In principle, bonds are just as easy to value.
• A discount or zero coupon bond is an instrument that promises
to pay the bearer a given sum (known as the principal) at the end of
the instrument’s lifetime. For example, a simple five-year discount bond
might pay the bearer $1,000 after five years have elapsed.
• Slightly more complex instruments are coupon bonds. These not
only repay the principal at the end of the term but in the interim entitle
the bearer to coupon payments that are a specified percentage of
the principal. Assuming annual coupon payments, a three-year bond
with principal of £100 and coupon rate of 8 per cent will give annual
payments of £8, £8 and £108 in years 1, 2 and 3. 4
In our notation a
In more general terms, assuming the coupon rate is c, the principal is P coupon rate of 12
per cent, for example,
and the required annual rate of return on this type of bond is rb, the price implies that c = 0.12;
of the bond can be written as:4 the discount rate used
here, rb , is called the
. (1.11) yield to maturity of the
bond.
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Chapter 1: Present value calculations and the valuation of physical investment projects
Activity
Using the previous formula, value a seven-year bond with principal $1,000, annual
coupon rate of 5 per cent and required annual rate of return of 12 per cent.
(Hint: the use of a set of annuity tables might help.)
Key terms
capital market line (CML)
consumption
Fisher separation theorem
Gordon growth model
indifference curve
internal rate of return (IRR) rule
investment policy
net present value (NPV) rule
payback rule
production opportunity frontier (POF)
production possibility frontier (PPF)
time value of money
utility function
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92 Corporate finance
2. Describe two methods of project evaluation other than NPV. Discuss the
weaknesses of these methods when compared to NPV. (10%)
3. The CEO and other top executives of a firm with no nearby commercial
airports make approximately 300 flights per year with an average
cost per flight of $5,000. The firm is considering buying a Gulfstream
jet for $15 million. The jet will reduce the cost of travel to $300,000
(including fuel, maintenance, and other jet-related expenses).
The firm expects to be able to resell the jet in five years for $12.5
million. The firm pays a 25% corporate tax on its profits and can offset
its corporate liabilities by using straight line depreciation on its fixed
assets. The opportunity cost of capital is 4%.
a. Should the firm buy this jet if it has sufficient taxable profits in
order to take advantage of all tax shields?
b. Should the firm buy this jet if it does not have sufficient taxable
profits in order to take advantage of new tax shields?
c. Suppose the firm could lease an airplane for the first year, with
an option to extend the lease. Within that year they would find
out whether the local government has decided to build an airport
nearby which would reduce travel costs. How would this change
your calculations?
4. Suppose that you have a £10,000 student loan with a 5 per cent
interest rate. You also have £1,000 in your zero interest checking
account which you do not plan to use in the foreseeable future. You are
considering three strategies: (i) payoff as much of the loan as possible,
(ii) invest the money in a local bank at 3.5 per cent interest, (iii) invest
in the stock market. The expected return on the stock market is 6 per
cent for the foreseeable future. Your personal discount rate is 4 per
cent for risk-free investments. For simplicity assume all investments are
perpetuities.
a. What is the NPV of strategy (i)?
b. What is the NPV of strategy (ii)?
c. What is the NPV of strategy (iii) if you are risk neutral?
d. What is the NPV of strategy (iv) if your subjective market risk
premium is 3 per cent?
24
Chapter 2: Risk and return: mean–variance analysis and the CAPM
Learning outcomes
At the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• discuss concepts such as a portfolio’s expected return and variance as
well as the covariance and correlation between portfolios’ returns
• calculate portfolio expected return and variance from the expected
returns and return variances of constituent assets with confidence
• describe the effects of diversification on portfolio characteristics
• derive the CAPM using mean–variance analysis
• describe some theoretical and practical limitations of the CAPM.
Essential reading
Hillier, D., M. Grinblatt and S. Titman Financial Markets and Corporate Strategy.
(Boston, Mass.; London: McGraw-Hill, 2008) Chapters 4 (The Mathematics
and Statistics of Portfolios) and 5 (Mean-Variance Analysis and the CAPM).
Further reading
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass.; London: McGraw-Hill, 2008) Chapters 8 (Introduction to Risk,
Return, and the Opportunity Cost of Capital) and 9 (Risk and Return).
Copeland, T. and J. Weston Financial Theory and Corporate Policy.
(Reading, Mass.; Wokingham: Addison-Wesley, 2005) Chapters 5 and 6.
Roll, R. ‘A critique of the asset pricing theory’s texts. Part 1: on past and
potential testability of the theory’, Journal of Financial Economics 4(2)
1977, pp.129–76.
Introduction
In Chapter 1 we examined the use of present value techniques in the
evaluation of physical investment projects and in the valuation of primitive
financial assets (i.e. stocks and bonds). A key input into NPV calculations
is the rate of return used in the construction of the discount factor but,
thus far, we have said little regarding where this rate of return comes
from. Our objective in this chapter is to demonstrate how the risk of a
given security or project impacts on the rate of return required from it and
hence affects the value assigned to that asset in equilibrium.
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92 Corporate finance
Activity
Calculate the portfolio weight for Microsoft, using the method presented above.
26
Chapter 2: Risk and return: mean–variance analysis and the CAPM
(2.3)
. (2.4)
, (2.5)
that is, the correlation between the two random variables is simply the
covariance, divided by the product of the respective standard deviations.
Clearly, knowledge of the correlation and the variances of the two random
variables allows one to retrieve the covariance between the two random
variables.
If we again define a linear combination of the two random variables, P,
using arbitrary constants a and b, the expression for the variance of the
27
92 Corporate finance
(2.7)
. (2.8)
Activity
Assume that xy = – 0.5. Calculate the portfolio return variance in this case, using the
data on portfolio weights and asset return variances given above.
Now, given the expected returns, return variances and covariances for
any set of assets, we should be able to calculate the expected return and
variance of any portfolio created from those assets. At the end of this
chapter, you will find activities that require you to do precisely this, along
with solutions to some of these activities.
Diversification
A point that we noted from the calculations of expected portfolio returns
and variances above was that, in all of our calculations, the variance of the
portfolio return was lower than that on any individual component’s asset
return.2 Hence, it seems as though, by forming bundles of assets, we can 2
Note that this result
eliminate risk. This is true and is known as diversification: through holding does not hold in general
portfolios of assets, we can reduce the risk associated with our position. (i.e. it may be the case
that the return variance
Why is this the case? The key is that, in our prior analysis and in real stock of a portfolio exceeds
return data, the correlations between returns are less than perfect. If two the return variance of
returns are imperfectly correlated it implies that when returns on the first are one of the component
assets).
above average, those on the second need not be above average. Hence, to an
extent, the returns on such assets will tend to cancel each other out, implying
that the return variance for a portfolio of these stocks will be smaller than
the corresponding weighted average of the individual asset variances.
28
Chapter 2: Risk and return: mean–variance analysis and the CAPM
. (2.10)
. (2.11)
. (2.12)
Now we ask the following question. How does the portfolio variance
change as the number of assets combined in the portfolio increases
towards infinity (i.e. N ). It is clear from equation 2.12 that, as the
number of assets held increases, the first term will shrink towards zero.
Also, as N increases the second term in equation 2.12 tends towards C.
Together, these observations imply the following:
1. The portfolio variance falls as the number of assets held increases.
2. The limiting portfolio return variance is simply the average covariance
between asset returns: this average covariance can be thought of as
the risk of the market as a whole, with the influence of individual asset
return variances disappearing in the limit.
The moral of the preceding statistical story is clear. Holding portfolios
consisting of greater and greater numbers of assets allows an investor
to reduce the risk that they bear. This is illustrated diagrammatically in
Figure 2.1.
Figure 2.1
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92 Corporate finance
Mean–variance analysis
In the preceding two sections, we have demonstrated two important facts:
1. The expected return on a portfolio of assets is a linear combination of
the expected returns on the component assets.
2. An investor holding a diversified portfolio gains through the reduction
in portfolio variance, when asset returns are not perfectly correlated.
In this section, we use these facts to characterise the optimal holding of
risky assets for a risk-averse agent. Our fundamental assumption is that all
agents have preferences that only involve their expected portfolio return
and return variance. Utility is assumed to be increasing in the former
and decreasing in the latter. For illustrative purposes we begin using the
assumption that only two risky assets are available. The results presented,
however, generalise to the N asset case.
To begin, assume there is no risk-free aset. The investor can hence only
form their portfolio from risky assets named X and Y. These assets have
expected returns of E(Rx) and E(Ry) and return variances of σ2x and σ2y.
The first question the investor wishes to answer is how the characteristics
of a portfolio of these assets (i.e. portfolio expected return and variance)
change as the portfolio weights on the assets change. Given equation 2.6,
the answer to this question is obviously dependent on the correlation
between the returns on the two assets.
First assume that the assets are perfectly correlated and, further, assume
asset X has lower expected returns and return variance than asset Y. We
form a portfolio with weights α on asset X and 1 – α on asset Y. Equation
2.6 then implies that the portfolio variance can be written as follows:
σ2P = (ασx + (1 – α)σy)2. (2.13)
Taking the square root of equation 2.13, it is clear that the portfolio
standard deviation is linear in α. As the portfolio expected return is linear
in α, the locus of expected return–standard deviation combinations is a
straight line. This is shown in Figure 2.2.
Figure 2.2
If the correlation between returns is less than unity, however, the investor
can benefit from diversifying their portfolio. As previously discussed, in
this scenario, portfolio standard deviation is not a linear combination of
σx and σy. The reduction of portfolio risk through diversification will imply
that the mean–standard deviation frontier bows towards the y-axis. This
30
Chapter 2: Risk and return: mean–variance analysis and the CAPM
is also shown on Figure 2.2. The final curve on Figure 2.2 represents the
case where returns are perfectly negatively correlated. In this situation, a
portfolio can be constructed, which has zero standard deviation.
Activities
1. Assuming asset returns are perfectly negatively correlated, use equation 2.6 to find
the portfolio weights that give a portfolio with zero standard deviation. (Hint: write
down 2.6 with the correlation set to minus one and a = and b = 1 – . Then
minimise portfolio variance with respect to .)
2. Assume that the returns on Microsoft and Bethlehem Steel have a correlation of 0.5.
Using the data provided earlier in the chapter, construct the mean–variance frontier
for portfolios of these two assets. Start with a portfolio consisting only of Microsoft
stock and then increase the portfolio weight on Bethlehem Steel by 0.1 repeatedly,
until the portfolio consists of Bethlehem Steel stock only.
From here on we will assume that return correlation is between plus and
minus one. The expected return–standard deviation locus for this case
is redrawn in Figure 2.3. In the absence of a risk-free asset, this locus is
named the mean–variance frontier. As our investor’s preferences are
increasing in expected return and decreasing in standard deviation, it
is clear that their optimal portfolio will always lie on the frontier and to
the right of the point labelled V. This point represents the minimum-
variance portfolio. They will always choose a frontier portfolio at or to
the right of V, as these portfolios maximise expected return for a given
portfolio standard deviation. In the absence of a risk-free asset, this set of
portfolios is called the efficient set.
Figure 2.3
We can now, given a set of preferences for the investor, find their optimal
portfolio. The condition characterising the optimum is that an investor’s
indifference curve must be tangent to the mean–variance frontier.3 Two 3
In technical terms, the
such optima are identified on Figure 2.3 at R and S. The investor locating optimum is characterised
by the marginal rate of
at equilibrium point R is relatively risk-averse (i.e. their indifference curves
substitution being equal
are quite steep), whereas the equilibrium at S is that for a less risk-averse to the marginal rate of
individual (with correspondingly flatter indifference curves). Figure 2.3 transformation (i.e. the
also shows suboptimal indifference curves for each set of preferences. slope of the indifference
curve equals the slope of
Hence, as Figure 2.3 demonstrates, in a world of two risky assets and no the frontier).
risk-free asset, the optimal portfolio of risky assets held by an investor
depends on their preferences towards risk and return. The same is true
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92 Corporate finance
when there are N risky assets available. Figure 2.4 depicts the same type of
diagram for the N asset case.
Figure 2.4
Note that the mean–variance frontier is of the same shape as that in
Figure 2.3. However, unlike the two-asset case, the interior of the frontier
now consists of feasible but inefficient portfolios (i.e. those that do not
maximise expected return for given portfolio risk). The mean–variance
frontier now consists of those portfolios that minimise risk for a given
expected return, whereas those portfolios on the efficient set (i.e. on the
frontier but to the right of V) additionally maximise expected return for a
given level of risk.
We now reintroduce a risk-free asset to the analysis (i.e. we assume the
existence of an asset with return rf and zero return–standard deviation).
A key question to address at this juncture is as follows. Assume that
we form a portfolio consisting of the risk-free asset and an arbitrary
combination of risky assets. How do the expected return and return–
standard deviation of this portfolio alter as we vary the weights on the
risk-free asset and the risky assets respectively?
Denote our arbitrary risky portfolio by P. We combine P with the risk-free
asset using weights 1 – a and a to form a new portfolio Q. The expected
return and variance of Q are given by:
In order to analyse the variation in the risk and expected return of the
portfolio Q with respect to changes in the portfolio weights, we construct
the following expression:
. (2.16)
. (2.17)
Figure 2.5
We now have all the components required to describe the optimal portfolio
choice of an investor faced with N risky assets and a risk-free investment.
Figure 2.6 replots the feasible set of risky asset portfolios. The key question
to answer is, what portfolio of risky assets should an investor hold? Using
the analysis from Figure 2.5, it is clear that the optimal choice of risky asset
portfolio is at K. Combining K with the risk-free asset places an investor on
a capital market line (labelled rf KZ), which dominates in utility terms the
CML generated by the choice of any other feasible portfolio of risky assets.4 4
That is, choosing
The optimal portfolio choice and a suboptimal CML (labelled CML2) are portfolio K places an
investor on a CML with
shown on Figure 2.6 along with the indifference curves of two investors.
greater expected returns
at each level of return
variance than does any
other.
Figure 2.6
Recall that we previously defined the efficient set as the group of portfolios
that both minimised risk for a given level of expected return and maximised
expected return for a given level of risk. With the introduction of the risk-
free asset, the efficient set is exactly the optimal CML.
The key result that is depicted in Figure 2.6 is known as two-fund
separation. Any risk-averse investor (regardless of their degree of risk-
aversion) can form their optimal portfolio by combining two mutual funds.
The first of these is the tangency portfolio of risky assets, labelled K, and the
second is the risk-free asset. All that the degree of risk-aversion dictates is
the portfolio weights placed on each of the two funds. The investor with the
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92 Corporate finance
(2.18)
Using the same method as shown in equation 2.16 to derive the risk–
return trade-off at the point represented by portfolio I, we get:
. (2.21)
(2.22)
. (2.23)
34
Chapter 2: Risk and return: mean–variance analysis and the CAPM
.
(2.24)
(2.25)
Definition
The market portfolio is the portfolio comprising all assets, where the
weights used in the construction of the portfolio are calculated as
the market capitalisation of each asset divided by the sum of market
capitalisations across all assets.
Under the prior assumptions, the following relationship holds for all
expected portfolio returns:
E(Rj ) = Rf + βj [E(rM ) – rf ], (2.27)
where E(RM ) is the expected return on the market portfolio, and βj is the
covariance of the returns on asset j with those on the market divided by
the variance of the market return.
Equation 2.27 gives the equilibrium relationship between risk and return
under the CAPM assumptions. In the CAPM framework, the relevant
35
92 Corporate finance
measure of an asset’s risk is its β, and equation 2.27 implies that expected
returns increase linearly with risk.
To clarify the source of the CAPM equation, note that the identification of
the tangency portfolio and the linear β-representation are implied by mean–
variance analysis. The CAPM then imposes equilibrium on capital markets
and identifies the market portfolio as identical to the tangency portfolio.
Figure 2.7
36
Chapter 2: Risk and return: mean–variance analysis and the CAPM
Activities8 8
You will find the
solutions to these
1. An investor forms a portfolio of two assets, X and Y. These assets have expected activities at the end of
returns of 9 per cent and 6 per cent and standard deviations of 0.8 and 0.6 this chapter.
respectively. Assuming that the investor places a portfolio weight of 0.5 on each
asset, calculate the portfolio expected return and variance if the correlation between
returns on X and Y is unity.
2. Using the data from Question 1, recalculate the portfolio expected return and
variance, assuming that the correlation between returns is 0.5.
3. An investor forms a portfolio from two assets, P and Q, using portfolio weights of
one-third and two-thirds respectively. The expected returns on P and Q are
5 per cent and 7 per cent, and their respective return standard deviations are 0.4 and
0.5. Assuming that the return correlation is zero, calculate the expected return and
variance of the investor’s portfolio.
4. Assuming identical data to that in Question 3, recalculate the statistical properties of
the portfolio, assuming the return correlation for P and Q is –0.5.
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92 Corporate finance
empirical test rejects the CAPM. Second, our proxy for the market might
be efficient whereas the market portfolio itself is not. In this case our test
will falsely indicate that the CAPM is valid. Put simply, the fact that we
can’t guarantee the quality of our proxy for the market implies that we
can’t place any faith in the results that tests based upon it generate, and
hence it’s impossible to test the CAPM.
The Roll critique is clearly damaging in that it implies that we can’t judge
the predictions of the CAPM against reality and trust the results. However,
many researchers have disregarded the prior discussion and estimated
the empirical counterpart of equation 2.27. From these estimates, such
researchers pass judgement on the CAPM.
38
Chapter 2: Risk and return: mean–variance analysis and the CAPM
The data are generally not supportive of the CAPM. The relationship
between an asset’s β and its average return is usually positive, as the CAPM
suggests, but typically flatter than it should be, as can be seen in Figure 2.8.
In this figure the β’s are plotted against average returns for 17 portfolios
based on industry (such as food, chemicals or transportation). The dotted
line plots β against β*E[Rm – Rf ], this is the CAPM predicted expected
return. The solid line plots the actual relationship between β and industry
returns, this relationship is positive but flatter than the dotted line. That is
high β stocks have returns that are lower than predicted by the CAPM while
low β stocks have returns that are higher than predicted by the CAPM.
Furthermore, there are certain assets (to be discussed in the next chapter)
that appear to consistently have non-zero Ai in time series regressions.10 10
See pp.185–86 of
Brealey and Myers
0.9 (2008).
0.85
0.8
0.75
0.7
E[R]
0.65
0.6
0.55
0.5
0.45
0.4
0.7 0.8 0.9 1 1.1 1.2 1.3 1.4
β
Figure 2.8
One possible explanation for the too flat relationship between β and
average return is measurement error. Suppose we do not observe an asset’s
true β, but rather its true β plus some measurement error which is mean
zero. Then assets with very high observed β are likely to be assets with very
positive measurement error; therefore their true β is below their observed
β, perhaps consistent with the low observed expected return. Similarly,
assets with very low observed β are likely to be assets with very negative
measurement error and therefore their true β is above the observed β.
It is also possible that one factor is simply not enough to explain all of the
variation in expected returns. The CAPM implies that the a firm’s loading
on the market (β) is the only variable that should cause expected returns to
differ. Adding extra explanatory variables to regression 2.34 will not result
in significant coefficients. In the next chapter we will see that loadings on
other factors, including firm size, book-to-market ratios, P/E ratios and
dividend yields have been shown to explain ex-post realised returns.
Amalgamating the above evidence implies that, if you are willing to
disregard the Roll critique, you should probably conclude that the CAPM
does not hold. This has led certain authors to investigate other asset-pricing
pradigms such as the APT (which we discuss in the next chapter). An
alternative viewpoint would be to argue that such results tell us little or
nothing about the validity of the CAPM due to the insight of Roll (1977).
39
92 Corporate finance
Key terms
beta (β)
capital asset pricing model (CAPM)
correlation
covariance
diversification
expected return
market portfolio
mean–variance analysis
Roll critique
security market line
standard deviation
systematic risk
two-fund separation
unsystematic risk
variance
Showing all your workings, compute the β for ABC’s equity. (7%)
4. Assume that the risk-free rate is 5 per cent. What is the expected return
on ABC’s stock? (3%)
5. The risk-free rate is 4 per cent, firm A has a market β of 2 and an
expected return of 16 per cent.
a. What is the expected return on the market according to the CAPM?
40
Chapter 2: Risk and return: mean–variance analysis and the CAPM
b. Draw a graph with β on the x-axis and the expected return on the
y-axis. Indicate the risk-free rate, the market, and firm A. What is
the slope of the securities market line?
c. The standard deviation of the market return is 16 per cent and the
standard deviation of the return of firm A is 40 per cent. What is the
standard deviation of A’s idiosyncratic component?
6. You have 50 years of monthly data on short-term treasury rates and
portfolios of 10-year bond returns, an aggregate index of US equities,
a mutual fund focusing on tech firms, a mutual fund focusing on
commodities, a mutual fund focusing on manufacturing, and a hedge
fund index. Describe how you would test the CAPM and the results you
would expect to find.
Solutions to activities
1. The expected return on the equally weighted portfolio is 7.5 per cent.
The portfolio return variance is 0.49, and hence the portfolio return
standard deviation is 0.7.
2. Obviously, the expected return is the same as in Question 1. With
correlation of 0.5, the portfolio return variance is 0.37.
3. The expected return on the portfolio is 6.33 per cent, and the portfolio
has a return variance of 0.1289.
4. When the correlation changes to –0.5, the portfolio return variance
drops to 0.0844. The expected return on the portfolio doesn’t change
from that calculated in Question 3.
41
92 Corporate finance
Notes
42
Chapter 3: Factor models
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• understand single-factor and multi-factor model representations
• derive factor-replicating portfolios from a set of asset returns
• understand the notion of arbitrage strategies and that well-functioning
financial markets should be arbitrage-free
• derive arbitrage pricing theory and calculate expected returns using the
pricing formulas
• know how to test multifactor models.
Essential reading
Hillier, D., M. Grinblatt and S. Titman Financial Markets and Corporate Strategy.
(Boston, Mass.; London: McGraw-Hill, 2008) Chapter 6 (Factor Models and
the APT).
Further reading
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass.; London: McGraw-Hill, 2008) Chapter 9 (Risk and Return).
Chen, N-F. ‘Some empirical tests of the theory of arbitrage pricing’, The Journal
of Finance 38(5) 1983, pp.1393–414.
Chen, N-F., R. Roll and S. Ross ‘Economic forces and the stock market’, Journal
of Business 59 1986, pp.383–403.
Copeland, T., J. Weston and K. Shastri Financial Theory and Corporate Policy.
(Reading, Mass.; Wokingham: Addison-Wesley, 2005) Chapter 6.
Fama, E. and K. French ‘The cross-section of expected stock returns’, Journal of
Finance 47(2) 1992, pp.427–65.
Fama, E. and K. French ‘Common risk factors in the returns on stocks and
bonds’, Journal of Financial Economics 33 1993, pp.3–56.
Fama, E. and J. MacBeth ‘Risk, return, and equilibrium: empirical tests’, Journal
of Political Economy 91 1973, pp.607–36.
Gibbons, M.R., S.A. Ross and J. Shanken ‘A test of the efficiency of a given
portfolio’, Econometrica 57 1989, pp.1121–52.
Jegadeesh, N. and S. Titman ‘Returns to buying winners and selling losers’,
Journal of Finance 48 1993.
Overview
Empirically, expected returns appear to depend on several factors. For
this reason, multifactor models, such as the Fama and French three-factor
model are commonly used in practice to calculate expected returns. The
arbitrage pricing theory gives a theoretical basis for using such models.
As its name suggests, it rests on the notion that well-functioning financial
markets should be arbitrage-free. This, using a factor model of asset
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92 Corporate finance
Introduction
As we saw in the previous chapter, the CAPM was not sufficient to explain
the cross-section of expected asset returns. The CAPM was a one-factor
model and we can improve on the CAPM by including additional factors.
However, the CAPM was derived from micro-economic foundations, why
should additional factors matter for risk?
The arbitrage pricing theory (APT) gives an alternative to the CAPM as a
method to compute expected returns on stocks. The basis for the APT is a
factor model of stock returns, and we will define and discuss these models
first. From there we will demonstrate how to derive expected returns using
the idea that the returns on stocks, which are exposed to a common set of
factors, must be mutually consistent, given each stock’s sensitivity to each
factor.
To give structure to what we mean by ‘mutually consistent’, we need to
define the notion of an arbitrage. An arbitrage strategy is a strategy that
delivers non-negative returns in all states of the world, and strictly positive
returns in at least one state of the world. For example, a strategy that
yields an immediate, positive cash inflow and, further, is guaranteed not to
make a loss tomorrow. Faced with an investment strategy with this payoff
structure, any investor who prefers more to less would try to invest on an
infinite scale.
The idea that underpins the APT is that investment situations, such
as those described above, should not be permitted in well-functioning
financial markets. Then, if financial markets do not permit the existence
of arbitrage strategies, this places restrictions on the relationships between
the expected returns on assets given the factor structure underlying
returns.
Although the APT gives justification for why there may be multiple factors,
it does not identify specific factors. Factors should proxy for risk and may
be identified from economic fundamentals (such as the CAPM), or from
empirical observation. Eugene Fama and Ken French identified three
factors that do a relatively good job at explaining much of the variation
in expected stock returns. We will learn about their model, as well as
improvements on it, at the end of the chapter.
Single-factor models
Before using the notion of absence of arbitrage to provide pricing
relations, we need a basis for the generation of stock returns. Within
the context of the APT, this basis is given by the assumption that the
population of stock returns is generated by a factor model. The simplest
factor model, given below, is a one-factor model:
ri = αi + βi F + εi E(εi) = 0. (3.1)
In equation 3.1, the returns on stock i are related to two main components:
1. The first of these is a component that involves the factor F. This
factor is posited to affect all stock returns, although with differing
sensitivities. The sensitivity of stock i’s return to F is βi. Stocks that
have small values for this parameter will react only slightly as F
changes, whereas when βi is large, variations in F cause very large
movements in the return on stock i. As a concrete example, think of F
44
Chapter 3: Factor models
Application exercise
Consider an economy in which the risk-free rate of return is 4 per cent and the expected
rate of return on the market index is 9 per cent. The variance of the return on the market
index is 20 per cent. Two portfolios A and B have expected return 7 per cent and 10 per
cent, and variance 20 per cent and 50 per cent, respectively.
a. Work out the portfolios’ β coefficients.
According to the CAPM:
E(rA) = rF + βA [E(rM) – rF ]
and
E(rB) = rF + βB [E(rM) – rF ].
Hence:
βA = [E(rA) – rF]/[E(rM) – rF ] = (7% − 4%)/(9% − 4%) = 0.6
βB = [E(rB) – rF]/[E(rM) – rF ] = (10% − 4%)/(9% − 4%) = 1.2.
b. The risk of a portfolio can be decomposed into market risk and idiosyncratic risk.
What are the proportions of market risk and idiosyncratic risk for the two portfolios
A and B?
From the market model:
rA = αA + βA rM + εA
rB = αB + βB rM + εB
with cov(rM , εA) = cov(rM , εB) = 0.
It hence follows that the variance of portfolio A’s returns, σ2A, has two
components, systematic and idiosyncratic risk:
σ2A = β2A σ2M + σ2εA.
Similarly:
σ2B = β2B σ2M + σ2εB.
The returns of portfolios A and B are hence (positively) correlated even though their
idiosyncratic return components are not. These returns are positively correlated
because they are positively correlated with the returns of the market index.
Multi-factor models
A generalisation of the structure presented in equation 3.1 posits k factors
or sources of common variation in stock returns.
ri = αi + β1iF1 + β2iF2 + .... + βkiFk + εi E(εi) = 0. (3.2)
Again, the idiosyncratic component is assumed uncorrelated across stocks
and with all of the factors. Further, we’ll assume that each of the factors
has a mean of zero. These factors can be thought of as representing news
on economic conditions, financial conditions or political events. Note that
this assumption implies that the expected return on asset i is just given by
the constant in equation 3.2 (i.e. E(ri) = αi). Each stock has a complement
of factor sensitivities or factor βs, which determine how sensitive the
return on the stock in question is to variations in each of the factors.
A pertinent question to ask at this point is how do we determine the return
on a portfolio of assets given the k-factor structure assumed? The answer
is surprisingly simple: the factor sensitivities for a portfolio of assets are
calculable as the portfolio weighted averages of the individual factor
sensitivities. The following example will demonstrate the point.
Example
The returns on stocks X, Y, and Z are determined by the following two-factor model:
rX = 0.05 + F1 – 0.5F2 + εX
rY = 0.03 + 0.75 F1 + 0.5F2 + εY
rz = 0.04 + 0.25 F1 – 0.3F2 + εz
Given the factor sensitivities in the prior three equations, we wish to derive the factor
structure followed by an equally weighted portfolio of the three assets (i.e. a portfolio
with one-third of the weights on each of the assets). Following the result mentioned
above, all we need to do is form a weighted average of the stock sensitivities on the
individual assets. Subscripting the coefficients for the equally weighted portfolio with
a p we have:
αp = (1/3) (0.05 + 0.03 + 0.04) = 0.04
46
Chapter 3: Factor models
and hence; the factor representation for the portfolio return can be written as:
rp = 0.04 + 0.5F1 – 0.1F2 + εp
where the final term is the idiosyncratic component in the portfolio return. Note that
the idiosyncratic volatility of the portfolio is εp = (1/3)(εX + εY + εz) smaller than the
idiosyncratic volatilities of portfolios X, Y or Z because the idiosyncratic components are
independent.
Activity
Using the data given in the previous example, compute the return representation for a
portfolio of assets X, Y and Z with portfolio weights –0.25, 0.5 and 0.75.
y y .
Factor-replicating portfolios
An important application of the technology developed previously in this
chapter is the construction of a factor-replicating portfolio. A factor-
replicating portfolio is a portfolio with unit exposure to one factor and
zero exposure to all others. For example, the portfolio replicating factor
1 in model 3.2 would have β1 = 1 and βj = 0 for all j = 2 to k. We will use
factor-replicating portfolios to show that a factor structure for asset returns
implies a β pricing model. In such a model, expected returns depend only
on βs, or risk loadings.
Activity
Assume that stock returns are generated by a two-factor model. The returns on three
well-diversified portfolios, A, B and C, are given by the following representations:
rA = 0.10 + F1 – 0.5F2
rB = 0.08 + 2F1 + F2
rC = 0.05 + 0.5F1 + 0.5F2.
Determine the portfolio weights you need to place on A, B and C in order to construct
the two factor-replicating portfolios plus a portfolio which has zero exposure to both
factors. What are the expected returns of the factor-replicating portfolios and what is the
expected return of the risk-free portfolio?
The question to ask at this point is: why bother constructing factor-
replicating portfolios? The reason is as follows. Suppose I want to build
a portfolio that has identical factor exposures to a given asset, X. Assume
a two-factor world and that asset X has exposure of 0.75 to factor 1
and –0.3 to factor 2. Assume also that I know the two factor-replicating
portfolios.
Building a portfolio with the same factor exposures as X is now simple.
Construct a new portfolio, Y, which has portfolio weight 0.75 on the
replicating portfolio for the first factor, portfolio weight –0.3 on the
replicating portfolio for the second factor and the rest of the portfolio
weight (i.e. a weight of 1 – 0.75 + 0.3 = 0.55) on the risk-free asset. Via
the results on the factor representations of a portfolio of assets and
the definition of a factor-replicating portfolio it is easy to see that Y is
guaranteed to have identical factor exposures to X.
The replication in the preceding paragraph forms the basis for the APT. For
absence of arbitrage we require all assets with identical factor exposures
to earn the same return. If they did not, then we would have the chance to
make unlimited amounts of money. For example, assume that the expected
return on the replicating portfolio Y was greater than that on asset X.
Then I should short X and buy Y. The risk exposures of the two portfolios
are identical and hence risks cancel out and I am left with an excess return
that is riskless (i.e. an arbitrage gain).
In order to progress, let us introduce some notation. Denote the risk-
free rate with rf. Denote the expected return on the ith factor-replicating
portfolio with rf + λi such that λi is the risk premium associated with the
ith factor. Again, for simplicity, assume that the world is generated by a
two-factor model, and assume that I wish to replicate asset X, which has
sensitivity β1X to the first factor and β2X to the second factor. Finally, we will
assume that the primary securities being worked with are well-diversified
portfolios themselves. Hence, we will ignore any idiosyncratic risk in this
derivation.
48
Chapter 3: Factor models
rit – rf = β1i (λ1 +F1t )+β2i (λ2 + F2t ) + εit = β2t(λ1 + F1t ) + β2i(λ2 + F2t ) + εit ,
(3.8)
where j+Fjt is the excess return on the jth factor-replicating portfolio
(plus some idiosyncratic risk if markets are incomplete). Thus a time series
regression of rit – rf on excess factor returns implies that the intercept must
be zero; this must be true for each asset.
A practical question is how close to zero must the intercept be in both the
first and second stages in order for us to accept a model as being ‘close’ to
the data? Consider the first stage which states that every asset must have
a zero intercept. Suppose we found that 15 out of 100 tested assets had
intercepts different from zero at 5 per cent significance. A naïve application
of statistics would suggest rejection of the factor model. However, rejection
is not as clear cut as it might appear.
Suppose you were told that one of the assets with a non-zero intercept was
McDonalds. It would then not be surprising if we also found Burger King to
have a non-zero intercept because the two are likely to be highly correlated
even when controlling for standard factors. The 100 tested assets may not
all be truly independent and we are likely to see highly correlated assets
both be rejected or both not be rejected. If the 15 assets that are rejected
are all highly correlated, while the remaining 85 are not, we should not
reject the model. Gibbons, Ross and Shanken (1989) provide a procedure
to test the intercepts jointly for many assets, some of which are potentially
correlated.
Let us now turn to the second stage test which also states that the intercept
(this time in a cross-sectional regression) must be zero. We can check for
the significance of the intercept in the usual way. However, when doing
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92 Corporate finance
Example
In the previous two-factor example, we determined the expected returns on the two
factor-replicating portfolios. Denoting the expected return on the i th factor-replicating
portfolio by E(ri) we have:
E(r1) = 8.29% E(r2) = 1.71% E(r3) = 5.14%.
Hence, the premiums associated with the two factors are:
λ1 = 8.29 – 5.14 = 3.15%, λ2 = 1.71 – 5.14 = 3.43%.
This implies that the expected return on any asset in this world can be written as:
E(ri) = 5.14 + 3.15β1i – 3.43β2i .
To check that this works, substitute (for example) portfolio C’s factor sensitivities into the
preceding expression. This gives:
E(rC) = 5.14 + 3.15 (0.5) – 3.43 (0.5) = 5%,
and hence, agrees with the expected return implied by the original representation for
asset C. Check that the expected returns on assets A and B also come out correctly.
50
Chapter 3: Factor models
Activity
Assume that a new well-diversified portfolio, D, is added to our world. This asset has
sensitivities of 3 and –1 to the two factors and an expected return of 15 per cent.
Using the equilibrium expected return equation given above, derive the equilibrium
expected return on an asset with identical factor exposures to D. Is there now an
arbitrage opportunity available? If so, dictate a strategy that could be employed to exploit
the arbitrage opportunity.
Fama and French augmented the CAPM by these two additional factors,
creating what is known as the Fama and French three-factor model. As
before with the CAPM, multifactor models can be tested by a first stage
time series test, in which each asset’s return is regressed on the factors;
each should be near zero. The Fama and French three-factor model
performed much better than the CAPM on the 25 portfolios defined
above, Fama and French could not statistically reject that the 25 αs
were different from zero. The Fama and French model is commonly
used as a replacement to the CAPM to assess risk as well as managerial
performance.
Narasimhan Jegadeesh and Sheridan Titman found another set of
portfolios whose returns could not be explained by the CAPM or the Fama
and French three-factor model. Jegadeesh and Titman sorted stocks into
portfolios based on their past performance, they held these portfolios for
a year and then reassigned stocks to new portfolios. They found that a
portfolio long in stocks that performed well in the past, and short in stocks
that performed poorly in the past, had positive αs in both CAPM and
three-factor regressions, they called this portfolio MOM (momentum). The
momentum factor was added to the Fama and French three-factor model
by Mark Carhart. This augmented four-factor model does a somewhat
better job than the three-factor model at explaining the cross-section
of expected stock returns, it is also commonly used to assess risk and
managerial performance.
Summary
The APT gives us a straightforward, alternative view of the world from
the CAPM. The CAPM implies that the only factor that is important
in generating expected returns is the market return and, further, that
expected stock returns are linear in the return on the market. The APT
allows there to be k sources of systematic risk in the economy. Some
may reflect macroeconomic factors, like inflation, and interest rate risk,
whereas others may reflect characteristics specific to a firm’s industry or
sector.
Empirical research has indicated that some of the well-known empirical
problems with the CAPM are driven by the fact that the APT is really the
proper model of expected return generation. Chen (1983), for example,
argues that the size effect found in CAPM studies disappears in a multi-
factor setting. Chen, Roll and Ross (1986) argue that factors representing
default spreads, yield spreads and gross domestic product growth are
important in expected return generation. Fama and French (1992, 1995),
show that size and book-to-market factors can help explain the cross-
section of stock returns while other factors, such as momentum, also
appear to be important. Work in this area is still progressing.
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Chapter 3: Factor models
• derive arbitrage pricing theory and calculate expected returns using the
pricing formulas
• know how to test multifactor models.
Key terms
arbitrage pricing theory
factor-replicating portfolio
factor sensitivity
multi-factor model
single-factor model
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92 Corporate finance
Notes
54
Chapter 4: Derivative securities: properties and pricing
Learning outcomes
At the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• discuss the main features of the most widely traded derivative securities
• describe the payoff profiles of such assets
• understand the absence-of-arbitrage pricing of forwards, futures and
swaps
• construct bounds on option prices and relationships between put and
call prices
• price options in a binomial framework using the portfolio replicating
and the risk-neutral valuation.
Essential reading
Hillier, D., M. Grinblatt and S. Titman Financial Markets and Corporate
Strategy. (Boston, Mass.; London: McGraw-Hill, 2008) Chapters 7 (Pricing
Derivatives) and 8 (Options Part III).
Further reading
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass.; London: McGraw-Hill, 2008) Chapters 21 (Understanding Options),
22 (Valuing Options) and 23 (Real Options).
Copeland, T., J. Weston and K. Shastri Financial Theory and Corporate Policy.
(Reading, Mass.; Wokingham: Addison-Wesley, 2005) Chapters 8 and 9.
Overview
A derivative asset is one whose payoff depends entirely on the value of
another asset, usually called the underlying asset. In the last 20 years,
traded volume in these assets has increased tremendously. Derivatives
are widely used for hedging purposes by financial institutions and are
also used for speculative purposes. In this chapter we discuss the most
commonly traded types of derivative. We go on to introduce the underlying
principles of derivative pricing. We devote the final section of the chapter
to a more detailed description of the features and pricing of options.
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92 Corporate finance
Varieties of derivatives
Forwards and futures
Perhaps the oldest type of derivative asset is the simple forward
contract. A forward is an agreement between two parties (called A and
B) and has the following features:
• Party A agrees to supply party B with a specified amount of a specified
asset, k periods in the future.
• In return, party B agrees to pay party A $F (the forward price) when
the goods are received.
• Party A is said to hold a short position in the contract and party B a
long position.
Hence, the forward is just an agreement made today to undertake a given
transaction at some specified future date, known as the settlement
date. Currency and commodities are often traded using forwards, the
advantage of such transactions being that they allow an agent to remove
any price uncertainty regarding a transaction that must be undertaken in
the future.
Example
Assume that party B is American and that in three months he must pay ¥250,000 for
a Japanese machine he has purchased. Party B enters into a contract to buy yen three-
months forward. Party A (the agent who is to supply the yen) specifies that the cost of
¥100 will be $1.20. The total price that party B must pay in three months is therefore
$3,000.
Options
The option is a less straightforward type of derivative. Although the
forward or future contract implies an obligation to trade once the contract
is entered into, the option (as its name suggests) gives the agent who is
long a right but not an obligation to buy or sell a given asset at a pre-
specified price. This price is known as the exercise price and is specified in
the option contract. Just as with the forward, another factor specified in
the contract is the date on which the exchange is to take place. If, on the
maturity date, the holder of an option decides to buy or sell in line with
56
Chapter 4: Derivative securities: properties and pricing
the terms of the contract, they are said to have exercised their right. A
big difference between options and forwards is that, with an option, the
agent who is long must pay a price (or premium) at the outset. This is
essentially a price paid by the holder for the exercise choice they face at
maturity.
Options to buy the specified asset are called call options. Options to sell
are called puts. Another distinction is made on the timing of the exercise
decision. With European options, the right can only be exercised on the
maturity date itself. With American options, in contrast, the option can be
exercised on any date at or before maturity. American options are traded
far more frequently than their European counterpart, but for reasons of
simplicity, we will focus on the European variety.
Example
A 12-month European call option on IBM has exercise price $45. It gives me the right
to purchase IBM stock in one year at a cost of $45 per share. In line with the prior
discussion, I am under no obligation to buy at $45 such that, if the market price were less
than this amount, I could choose not to exercise and buy in the market instead.
Swaps
Swaps are another type of derivative, which do exactly what their name
says. Two counterparties agree to exchange (or swap) periodic interest
payments on a given notional amount of money (the notional principal)
for a given length of time.
A very common type of swap involves an exchange of interest payments
based on a market-determined floating rate (such as the London InterBank
Offer Rate (LIBOR)) for those calculated on a fixed-rate basis. Another
frequently traded variety of swap involves the exchange of interest
payments in different currencies. For example, fixed sterling interest
payments may be exchanged for fixed dollar interest payments.2 2
The notional principal
is not exchanged in an
interest rate swap (they
Derivative asset payoff profiles would net out anyway)
but are generally
For now we are going to concentrate on forwards and options. As exchanged in currency
mentioned above, futures are closely related to forwards, and their pricing swaps.
is based on the technique presented below. The relationship between
forwards and swaps will be made clear later.
Before getting on to the principles of derivative pricing, let us take a look
at the payoff profiles of the basic forward and option contracts. The payoff
profile of a long forward position is shown in Figure 4.1. In the figure, F
is the price agreed upon in the forward contract, and S is the spot price
of the asset at the settlement date. Note that the payoff profile is linear,
positive for values of S greater than F and negative when S is less than F.
Understanding the forward payoff is simple. If the spot price for the asset
at maturity exceeds the forward price, then the party that is long has
gained by entering into the forward (i.e. they have got the asset for a
lower price than it would have cost if bought in the spot market). If the
spot price at maturity is lower than the forward price, then the long payoff
is negative, as it would have been cheaper for the long party to buy the
asset in the spot market rather than entering into the forward. Obviously,
the payoff of a short forward position is the negative of that shown in
Figure 4.1.
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92 Corporate finance
St – F
Payoff
F St
–F
Figure 4.1
Let’s now consider the payoff to a holder of a European call option.
This is given in Figure 4.2 where the option’s exercise price is labelled
X. Remember that a call option gives the holder the right but not the
obligation to purchase the asset. What occurs when the price of the
spot asset at maturity exceeds the exercise price of the option? Well it is
cheaper to buy the asset using the option than in the spot market; hence
the option is exercised, and the holder makes a gain of the spot price less
the exercise price. When the spot price is lower than the exercise price,
then the holder would find it cheaper to buy the asset at spot and hence
does not exercise the option. The payoff to the holder is then zero.
Payoff
[St – X]
0
X St
Figure 4.2
The payoff to the holder of a European put is given in Figure 4.3. As the
put gives the holder the right to sell the underlying asset, the holder gains
when the exercise price exceeds the spot price and has a zero payoff when
the spot price at maturity is greater than or equal to the exercise price.
Each option must have one agent who is long and one who is short, with
the payoffs to the long position given in Figures 4.2 and 4.3. An agent
who is short is said to have written the option, and their payoffs are the
negative of those given above. Note that an agent with a long option
position never has a negative payoff, whereas an agent who has written an
option never has a positive payoff at maturity. The option price, paid at the
outset by the agent who is long to that who is short, is the compensation
to the writer of the option for holding a position that exposes them to
weakly negative cash flows.
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Chapter 4: Derivative securities: properties and pricing
Payoff
X [X – St ]+
0
X St
Figure 4.3
The key to pricing options, and other derivative assets, is constructing
a portfolio of assets that is priced in the market and that has a payoff
structure identical to that of the derivative. As the derivative and
replicating portfolio have identical payoffs, absence-of-arbitrage arguments
imply that the cost of these portfolios must be identical. The no-arbitrage
price of the derivative is hence just the initial investment cost needed to
set up the replicating portfolio.
Why is this the case? Well, consider the following pair of investment
strategies.
• The first is simply a long position in the forward contract. This costs
nothing at the present time and yields Sk – Fk at maturity.
• The second strategy involves buying a unit of the asset at spot and
borrowing Fk(1+r)–k at the risk-free rate for k-periods. The k-period
payoff of this strategy is also Sk – Fk, and its net current cost is
S0 – Fk(1+r)–k.
The payoffs of the two strategies are identical. This implies that the two
investments should have identical costs. As the cost of investment in the
forward is zero, this implies that the following condition must hold:
S0 – Fk(1+r)–k = 0. (4.2)
Rearranging equation 4.2 we derive the no-arbitrage price for the k-period
forward contract, which is precisely that given in equation 4.1.
Activity
The current value of a share in Robotronics is $12.50.
1. The one-year riskless rate is 6 per cent. What are the prices of three- and five-year
forward contracts on Robotronics stock?
2. Three-year forward contracts are currently being sold for $16 in the market.
Outline an investment strategy that could take advantage of the opportunities
this presents.
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92 Corporate finance
Some of the most active forward markets are those for foreign currency.
The forward pricing analysis above, however, is suited only for assets
valued in the domestic currency (e.g. individual stocks or stock indices).
To illustrate the pricing of currency forwards, consider the following
analysis. A domestic investor (assumed to be located in the UK such that
the domestic currency is £) is assumed to face a spot exchange rate of
S and a k-period forward rate of Fk. These rates are constructed as the
domestic currency price of one unit of foreign currency (i.e. the spot rate
implies an exchange rate of £S for $1). The one-period domestic interest
rate is denoted r and its foreign counterpart rf .
Again, let us compare two investment strategies that can be undertaken
assuming an investor currently holds £S. The first involves depositing this
cash in a domestic risk-free account for k-periods. This yields £S(1+r)k at
the maturity date of the investment. Alternatively, the investor could swap
their sterling for dollars at the spot exchange rate and invest the funds
at the US rate. As their £S is equivalent to $1 at the spot exchange rate,
this investment yields $(1+rf )k in k-periods. The investor can then sell the
proceeds for sterling using a forward contract yielding £Fk(1+rf )k.
Note that both of these investments are riskless, assuming that the interest
rates are known and fixed and given that the spot and forward exchange
rates are known at the current date. Further, both investments cost £S.
This implies that the payoffs from the two strategies should be identical.
Equating these returns we get:
S(1 + r)k = Fk(1 + rf )k. (4.3)
Rearranging equation 4.3, we get the no-arbitrage k-period currency
forward price:
. (4.4)
Activity
The current spot exchange rate is £0.64 = $1. The riskless rate in the UK is currently 6
per cent and that in the USA is 4 per cent. Using equation 4.4, derive the implied five-
and 10-year forward exchange rates.
60
Chapter 4: Derivative securities: properties and pricing
Let us now consider a one-period derivative asset. If the state of the world
is good tomorrow, then the derivative will pay KH, and if the state of the
world is bad tomorrow the derivative will pay KL. Finally, we assume that
the one-period risk-free interest rate is rf (i.e. a safe bond costing one unit
of currency pays 1+ rf units of currency tomorrow). In order to price this
derivate asset, we will consider two different methods:
• the portfolio replicating method
• the risk-neutral valuation method.
. (4.7)
and
. (4.8)
We now know how to construct a portfolio, which has a payoff profile that
replicates that of the derivative (i.e. regardless of the state of the world,
the portfolio and the derivative have the same value). If two assets have
identical payoffs then absence-of-arbitrage arguments tell us that the
price/cost of the two assets must be identical. The cost of the replicating
portfolio is aS0 + b. It hence follows that:
K0 = aS0 + b. (4.9)
A practical example of how this technique might work for a European call
option is given below.
Example
A one-period European call option on ABC stock has an exercise price of 120. The current
price of ABC stock is 100 and, if things go well, the price in the following period will be
150. If things go badly over the coming period, the future price will be 90. The risk-free
rate is 10 per cent. What is the no-arbitrage price of this option?
First, we need to know the option payoffs. In the bad state it pays zero, as the underlying
price is less than the exercise price. In the good state it pays the excess of the underlying
price over the exercise price (i.e. 30).
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92 Corporate finance
Next we construct the replicating portfolio. Using equations 4.3 and 4.4, the quantities of
the underlying and risk-free asset we must buy are 0.5 and –40.91 (i.e. we buy half a unit
of stock and short 40.91 units of the risk-free asset).5 This portfolio replicates the option 5
You should check
payoff, and therefore the option price is given by the cost of constructing the portfolio. all these calculations
and further check that
The call price (c) is hence:
the portfolio we’ve
c = 0.5(100) – 40.91 = 9.09. constructed does indeed
replicate the option
Activity payoff.
Using the stock price data from the previous example, price a European put option on
ABC stock with a strike price of 100.
. (4.10)
. (4.11)
. (4.12)
. (4.13)
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Chapter 4: Derivative securities: properties and pricing
Activity
Using the risk-neutral valuation method, price both a European call option and a European
put option on the ABC stock (introduced in the previous example) with a strike price of 100.
Activity
Show that the current price of the derivative obtained from the portfolio replicating
method in equation 4.9 is the same as the one obtained from the risk-neutral valuation
method in equation 4.13.
Example
In this example we will see how to extend the binomial approach to a more realistic multi-
period problem. We will also see that sometimes it is best to exercise an American put
option early.
Consider an underlying security which is worth 100 today and will either increase by 25
per cent or decrease by 20 per cent in value in six months. In the following six months,
it will again either increase in value by 25 per cent or decrease in value by 20 per cent.
There is a risk-free asset with a 1 per cent semi-annual return. We will first price a one-year
European put on this security with a strike of 105, we will then price an American put with
the same strike but the option to exercise at the six-month interval.
It is often best to draw a tree diagram of the payout for the put and the underlying
security, as in Figure 4.4. After six months the underlying security is worth either 100*1.25
= 125 (node 1.1) or 100*.8 = 80 (node 1.2). If in node 1, it will subsequently either
increase to 125*1.1 = 156.25 (node 1.1.1) or decrease to 125*.8 = 100 (node 1.1.2). If
in node 2, it will subsequently either increase to 80*1.1 = 100 (node 1.2.1) or decrease
to 80*.8 = 64 (node 1.2.2). Note that nodes 1.1.2 and 1.2.1 have the same payoff but
different histories; the probability of having this ‘medium’ payoff of 100 is higher than
either of the ‘extreme’ payoffs of 156.25 or 64.
At maturity the put option pays max(0,105 – 156.25) = 0 in node 1.1.1, max(0,105 –
100) = 5 in nodes 1.1.2 and 1.2.1, and max(0,105 – 64) = 41 in node 1.2.2.
We can replicate its payoff at each node to calculate the price of the option using
equations 4.7, 4.8, and 4.9.
In node 1.1, K0 = 125, KH = 0, KL = 5, SH = 156.25, SL = 100. Equation 4.7 gives
a = –0.089. Equation 4.8 gives b = 13.75. Equation 4.9 gives 2.64 as the option’s price
in node 1.1.
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92 Corporate finance
Figure 4.4
64
Chapter 4: Derivative securities: properties and pricing
65
92 Corporate finance
for X) or ST (when exercise isn’t optimal and you’re left with the stock, as
the put expires with zero value). We can then write the value of portfolio
1 as:
max(X,ST).
Portfolio 2 is always worth X at the date when the put matures and is
hence weakly dominated in payoff terms by portfolio 1. Therefore, to
prevent arbitrage, portfolio 1 should cost more to set up than portfolio 2,
implying:
p + S > Xe–rT p > Xe–rT – S. (4.21)
Finally, again we know that the worst that can happen for a put option is
for it to expire, worth nothing. This implies that its value must exceed zero
in all circumstances. Thus:
p ≥ max[0, Xe–rT –S]. (4.22)
Figure 4.5
price of the call option. This is the instantaneous volatility of the stock
price, and we denote this parameter . It is the standard deviation of the
change in the logarithm of the stock price.
The famous Black–Scholes formula for the price of a European call option
is given below:
c = SN(d1) – Xe–rT N(d2) (4.23)
where
7
The values of the
(4.24) cumulative standard
normal distribution
(4.25) function can be found
in tables in the back
and N(.) represents the cumulative normal distribution function.7 of any good statistical
textbook.
Example
The current price of Glaxo Wellcome share is £2.88. An investor writes a two-year call
option on Glaxo with exercise price £3.00. If the annualised, continuously compounded
interest rate is 8 per cent, and the volatility of Glaxo’s stock price is 25 per cent, what is
the Black–Scholes option price?
First, we need to derive the values d1 and d2 as defined above. Using equations 4.24
and 4.25 these are 0.5139 and 0.1603. The values of the cumulative normal distribution
function at 0.5139 and 0.1603 are 0.696 and 0.564. Then, plugging all the available
data into equation 4.23 yields a call price of £0.5644.
What does equation 4.23 tell us about the determinants of call prices?
Well, there are clearly a number of influences on the price of an option,
and these are summarised below.
• The effect of the current stock price: the Black–Scholes equation
tells us that call option prices increase as the current spot asset price
increases. This is pretty unsurprising as a higher underlying price
implies that the option gives one a claim on a more valuable asset.
• The effect of the exercise price: again, as you would expect,
higher exercise prices imply lower option prices. The reason for this is
clear: a higher exercise price implies lower payoffs from the option at
all underlying prices at maturity.
• The effect of volatility: Figure 4.2 gives the payoff function of a
European call option. Note that, although extremely good outcomes
(underlying price very high) are rewarded highly, extremely bad
outcomes are not penalised due to the kink in the option payoff
function. This would imply that an increase in the likelihood of extreme
outcomes should increase option prices, as large payoffs are increased
in likelihood. The Black–Scholes formula verifies this intuition, as it
shows that call prices increase with volatility, and increased volatility
implies a more diverse spread of future underlying price outcomes.
• The effect of time to maturity: call option prices increase with
time to maturity for similar reasons that they increase with volatility.
As the horizon over which the option is written increases, the relevant
future underlying price distribution becomes more spread-out, implying
increased option prices. Furthermore, as the time to maturity increases,
the present value of the exercise that one must pay falls, reinforcing the
first effect.
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92 Corporate finance
• The effect of riskless interest rates: call option prices rise when
the risk-free rate rises. This is due to the same effect as above, in that
the discounted value of the exercise price to be paid falls when rates
rise.
Put–call parity
The Black–Scholes formula gives us a closed-form solution for the price of
a European call option under certain assumptions on the underlying asset
price process. However, as yet, we have said nothing about the pricing of
put options. Fortunately, a simple arbitrage relationship involving put and
call options allows us to do this. This relationship is known as put–call
parity. In what follows we assume the options have the same strike price
(X), time to maturity (T) and are written on the same underlying stock.
Consider an investment consisting of a long position in the underlying
asset and a put option, called portfolio A. The cost of this position is
S0 + p. A second portfolio, denoted B, comprises a long position in a call
option and lending Xe–rT. Hence the cost (c) of this position is c + Xe–rT.
What are the possible payoffs of these positions at maturity? Given the
payoff structure on the put shown in Figure 4.3, the payoff on portfolio A
can be written as follows:
max[X – ST,0] + ST = max[X,ST]. (4.26)
Similarly, the payoff on portfolio B can be written as:
max[0,ST – X] + X = max[X,ST]. (4.27)
Comparison of equations 4.26 and 4.27 implies that the two portfolios
always pay identical amounts. Hence, using no-arbitrage arguments,
portfolios A and B must cost the same amount. Equating their costs we
have:
S + p = c + Xe–rT. (4.28)
Equation 4.28 is the put–call parity relationship. Given the price of a call,
the value of the underlying asset and knowledge of the riskless rate, we
can deduce the price of a put. Similarly, given the put price, we can deduce
the price of a call with similar features.
Example
A call option on BAC stock, with an exercise price of £3.75, costs £0.25 and expires
in three years. The current price of BAC stock is £2.00. Assuming the continuously
compounded (annual) risk-free rate to be 10 per cent, calculate the price of a put option
with three years to expiry and exercise price of £3.75.
From equation 4.28 we have:
p = c + Xe–rT – S.
Plugging in the data we’re given yields:
p = 0.25 + 3.75e–0.1(3) – 2 = 1.03.
Hence, the no-arbitrage put price is £1.03.
68
Chapter 4: Derivative securities: properties and pricing
Activity
ABC corporation’s shares currently sell at $17.50 each. The volatility of ABC stock is 15
per cent. Given a risk-free rate of 7 per cent, price a European call with strike price of
$15 and time to maturity five years. Use put-call parity to price a put with similar
specifications. What are the no-arbitrage prices of the call and the put if the risk-free
rate rises to 10 per cent?
Summary
This chapter has treated the nature and pricing of the most important
and heavily traded derivative securities. We have looked at the basic
specifications of forward, futures, option and swap contracts and what
these specifications imply for the payoff functions of long and short
positions. Further, we have looked at methods that can be used to price
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92 Corporate finance
Key terms
American option
binomial method
Black–Scholes
call option
covered interest rate parity relationship
derivative
European option
exercise price
forward contract
futures contracts
long position
marked-to-market
notional pricing
put option
risk-neutral method
settlement date
short position time to maturity
underlying price
70
Chapter 4: Derivative securities: properties and pricing
71
92 Corporate finance
Notes
72
Chapter 5: Efficient markets: theory and empirical evidence
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• understand the concept of market efficiency
• distinguish among varieties of efficiency
• understand the methodologies used to test for market efficiency
• explain the joint hypothesis problem
• present empirical evidence on varieties of market efficiency.
Essential reading
Hillier, D., M. Grinblatt and S. Titman Financial Markets and Corporate Strategy.
(Boston, Mass.; London: McGraw-Hill, 2008) no specific chapters.
Further reading
Asquith, P. and D. Mullins ‘The impact of initiating dividend payments on
shareholders’ wealth’, Journal of Business 56(1) 1983, pp.77–96.
Ball, R. and P. Brown ‘An empirical evaluation of accounting income numbers’,
Journal of Accounting Research 6(2) 1968, pp.159–78.
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass., London: McGraw-Hill, 2008) ninth edition, Chapter 14 (Efficient
Markets and Behavioral Finance).
Brock, W., J. Lakonishok and B. LeBaron ‘Simple technical trading rules and
stochastic properties of stock returns’, Journal of Finance 47(5) 1992,
pp.1731–764.
Campbell, J. and R. Shiller ‘The dividend-price ratio and expectations of future
dividends and discount factors’, Review of Financial Studies 1 1988.
Cochrane, J.H. ‘Explaining the variance of price-dividend ratios’, Review of
Financial Studies 5 1992, pp.243–80.
Copeland, T. and J. Weston Financial Theory and Corporate Policy. (Reading,
Mass., Wokingham: Addison-Wesley, 2005) Chapters 10 and 11.
DeBondt, W. and R. Thaler ‘Does the stock market overreact?’, Journal of
Finance 40(3) 1985, pp.793–805.
Fama, E. ‘The behavior of stock market prices’, Journal of Business 38(1) 1965,
pp.34–105.
Fama, E. ‘Efficient capital markets: a review of theory and empirical work’,
Journal of Finance 25(2) 1970, pp.383–417.
Fama, E. ‘Efficient capital markets: II’, Journal of Finance 46(5) 1991,
pp.1575–617.
Fama, E. and K. French ‘Dividend yields and expected stock returns’, Journal of
Financial Economics 22(1) 1988, pp.3–25.
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92 Corporate finance
Overview
In this chapter, we define and explore empirical evidence for informational
efficiency in financial markets. We begin by defining varieties of efficiency.
We then examine tests of weak-form efficiency and semi-strong-form
efficiency, and then move briefly on to strong-form efficiency tests.
We examine the issues surrounding a single set of questions, which are
of interest to finance academics and practitioners alike. Do market-
determined financial asset prices reflect all information relevant to that
asset? Do stock prices speedily and accurately react to data on corporate
earnings and dividends? Do foreign exchange rates move quickly to adjust
to interest rate movements and capital flows?
These issues are of interest to finance practitioners, as violations of
efficiency will lead to situations where markets display unexploited profit
opportunities. Finance academics, on the other hand, have generated
reams of studies testing the efficient markets hypothesis. In this chapter
we provide an introduction to the notions underlying informational
efficiency and a summary of some of the empirical tests of financial market
efficiency.
Varieties of efficiency
The basic definition of market efficiency, which we will use in our
discussion, is as follows1: 1
This definition is based
on that contained in
A market is said to be efficient with respect to a given information set if no agent Jensen (1978).
can make economic profit through the use of a trading rule based on . Economic
profit is defined as the level of return after costs are adjusted appropriately for risk.
74
Chapter 5: Efficient markets: theory and empirical evidence
Throughout the rest of this chapter we will use the definitions of market
efficiency employed in a famous survey of such issues by Fama (1991).
Fama works with three varieties of market efficiency which are repeated
below.
• Weak-form efficiency: a market is said to be weak-form efficient if
prices fully reflect all historical information. Such historical information
will include past prices (and returns) plus past data on the financial
characteristics of firms and information on macroeconomic conditions.
• Semi-strong-form efficiency: a market is said to be semi-strong-
form efficient if price fully, accurately and speedily reflects all new
public information releases. Further, price must reflect all past public
information.
• Strong-form efficiency: a market is strong-form efficient if prices
reflect all information, both public and private.
Note the scopes of the information sets used in the prior definitions.
That for strong form is the largest, containing any relevant information
whether known only to a few insiders (e.g. company directors who know
that a takeover is just around the corner) or to everyone. The next largest
information set is associated with the semi-strong form, containing all
information in the public domain. Examples of such information would
be corporate price-to-earnings ratios, past dividends, interest rates
and inflation rates. Finally, the most restricted information set is that
associated with the weak form (i.e. past data only).
The vast majority of academic empirical work on market efficiency has
concentrated on the first two varieties of efficiency. This is not to say
that the final definition is less important, just that it’s more difficult to
test. However, if one rejects either weak- or semi-strong-form efficiency,
then a rejection of strong-form efficiency is automatic. In the following
sections we will follow the empirical finance literature and concentrate
on the weak and semi-strong forms. We present the implications of each
for models of financial asset prices, the relationship between prices and
information announcements and, finally, the results from empirical studies
of efficiency.
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92 Corporate finance
long small stocks and short large stocks, and a portfolio long value stocks
and short growth stocks.
This then gives us a time-series of expected returns for stock i. Risk-
adjusted or abnormal or excess returns are then just calculated as the
difference between the actual returns on stock i and expected returns,that
is,
rtX = rt – E(rt) (5.1)
where rtx is the excess return and rt the actual stock return at time t. The
efficient markets hypothesis is concerned with the ability to make excess
returns based on a certain information set. Hence, the object of our
attention when testing market efficiency is the excess return derived in
equation 5.1. Throughout the rest of this chapter, we will discuss tests of
market efficiency and, unless explicitly stated otherwise, use of the word
return will mean excess return.
First, there is one further important point to be made at this juncture.
Empirical researchers do not know the true model that generates expected
returns in the economy. Hence, their choice of expected return-generating
mechanism, used to adjust actual returns, may be wrong. This implies
that abnormal returns may be incorrectly measured. These (inaccurate)
abnormal returns are then used in tests of market efficiency. Let’s assume
that the tests indicate that abnormal returns can be earned on the basis
of a given piece of information. We would then conclude that markets are
not efficient with respect to this information. However, it might be the
case that markets are actually efficient and that our use of an incorrect
risk-adjustment technique is driving the result that abnormal returns can
be gained.
Therefore, we are left in a position where we are not sure whether markets
are inefficient or our model of expected returns is wrong. This is known as
the joint hypothesis problem associated with testing market efficiency. The
null hypothesis of any test of efficiency is comprised of two components:
• informational efficiency
• the accuracy of one’s model for expected returns.
As the true model of expected returns is unknown, a rejection of this null
hypothesis cannot be immediately taken as evidence that markets are not
efficient. The existence of the joint hypothesis problem should be kept at
the forefront of your mind when discussing empirical results on efficiency.
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Chapter 5: Efficient markets: theory and empirical evidence
that is, the expectation of next period’s return conditional on the entire
history of returns is zero. An implication of this statement is that returns
are uncorrelated with their own past values. This can be written as:
A
Cov(rt , rt–s) = 0, s > 0. (5.3)
Tests of weak-form efficiency or return predictability can be based upon 2
The autocorrelation at
5.3. Take a time-series of stock returns and compute the autocorrelations displacement s is simply
the autocovariance at
of returns.2 Weak-form efficiency implies that all autocorrelations of
displacement s divided
returns should be statistically indistinguishable from zero.3 Otherwise, by the sample variance
current or past returns have a systematic relationship with future returns of returns where the
and can hence be used in prediction. autocovariance at
displacement s is given
The random walk model by 5.3.
A popular model for asset prices is based on 5.2. This is the random walk
model (RWM) of stock prices and it is given in equation 5.4. Denoting the 3
A statistical test can be
log of the stock price by P we have, formed by using the
A result that the
Pt = Pt–1 + εt, E(εt ) = 0, Cov(εt , εs ) = 0, t t ≠ s. (5.4) asymptotic variance
Equation 5.4 says that the change in price from time t–1 to t is a mean of an estimated
autocorrelation is T–1
zero, serially uncorrelated innovation, εt. We can think of this innovation
where T is the number
as representing new public information arriving at market during period t. of return observations in
As it represents new information that is equally likely to be good or bad, it the sample.
has zero mean. Further, new information is by definition unpredictable,
such that εt is uncorrelated with its own past values. Hence, past price 4
Note that, while past
changes carry no information about current or future price changes.4 price changes can’t be
used to forecast current
Note that the stock price return is just the first difference of the log stock price changes, past
price (i.e. rt = Pt – Pt-1) and equation 5.4 then implies that rt = εt. Via the prices give non-zero
properties of the innovation, εt, it is clear that returns have zero mean and forecasts of current and
are uncorrelated over time in line with equation 5.3. Hence, tests of return future prices. Indeed,
if the price at time t
autocorrelation can be viewed as tests of the random walk model.5
is Pt then the optimal
In the preceding discussion, we concentrated on predicting future returns forecast of all future
using the history of returns only. Weak-form efficiency would also be prices is Pt also. This
can be checked from
violated, however, if any information available at time t or before allowed
equation 5.4.
us to forecast returns. As a result, researchers have run regressions of the
following type in order to assess weak-form efficiency: 5
Other tests of the
rt+1 = α + βXt + ut, E(ut) = 0, Var(ut) = σ2. (5.5) usefulness of past
returns for prediction of
Here, Xt is the forecasting variable for returns and ut is a regression error
future returns include
term. Weak-form efficiency would imply that the coefficient β in equation those which examine
5.5 should be statistically indistinguishable from zero reflecting the whether the sign of
inability of Xt to forecast returns. returns is predictable.
These tests are based
Calendar effects on the likelihood of
observing sequences of
A last group of studies that we will treat in empirical analysis of weak-form positive and negative
efficiency is that looking for calendar effects in stock returns. A calendar returns over time.
effect is defined as a pattern in stock returns related to either the day of
the week, the week of the month or the month of the year. An example
of such an effect would be the idea that stock returns were consistently
greater on Wednesdays than on other days of the week. Alternatively, a
researcher might examine whether stock returns are lower in the first
week of every month relative to all other weeks of the month. Tests of this
type fit into the statistical testing framework developed around equation
5.5. In the case of calendar effects, Xt would be defined as a dummy
variable (or set of dummy variables) that picks out the desired calendar
effect. Using the Wednesday effect example mentioned above, Xt would be
defined to take the value 1 if rt+1 was realised on a Wednesday and zero
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92 Corporate finance
otherwise. Hence, the regression 5.5 then picks out the systematic effect
on stock returns of the fact that the day is Wednesday.
Calendar effects
One of the most famous empirical findings in finance is the so-called
‘incredible January effect’. This result is that stock/portfolio returns are
statistically positive and greater in January than in any other month of
the year. Again, this result is most pronounced for small stocks. Hence, it
would seem that a trading rule that indicated that one should buy (small)
stocks at the end of December and sell them at the end of January would
make money. Potential explanations for the January effect include:
• taxation impacts
• year-end effects
• effects from the remuneration packages of fund managers.
None of these seems completely plausible. Another point to note is that the
January effect seems to be an international phenomenon.
The existence of the January effect is puzzling to economists because of
the following logic. Assume that all agents in the economy observe that a
trading strategy consisting of being in the market in January only makes
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Chapter 5: Efficient markets: theory and empirical evidence
excess returns. Then, all agents would follow such a strategy. However,
the impact of this would be that stock prices would be bid up at the end
of December due to buying pressure. Similarly stock prices at the end of
January would drop due to extra sales of equity. This would tend to erode
the abnormal return that could be earned in January until, ultimately, it
was zero. Hence, the actions of rational agents should eliminate these
types of effects. The continued existence of the January effect is therefore
extremely puzzling.
Other calendar effects that have been uncovered include:
• day of the week effects (French (1980))
• holiday effects (Haugen and Lakonishok (1988)).
These are, however, not as well known as the January effect and are less
consistent. All in all, the calendar-effects literature gives strong indications
of market inefficiencies. It is difficult to invent stories that suggest there
should be calendar effects in expected returns (so we can’t turn to the
joint hypothesis problem as a way out) and we are left with the possibility
that profits are available on this basis.
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92 Corporate finance
returns, the value portfolio is found to be quite risky. The difference in risk
between the value and glamour portfolios is, however, not remotely high
enough to justify the observed differences in subsequent average portfolio
returns.
An examination of the value portfolio reveals that value stocks tend to
experience poor performance in previous years, as measured by growth
in sales, earnings or cash flows, resulting in highly negative excess stock
returns. Value stocks also tend to have small market capitalisations. In
contrast, glamour stocks tend to experience high performance in previous
years, resulting in highly positive excess stock returns, and tend to have
large market capitalisations. In a period of two to five years following the
allocation of the stocks to the portfolios, the performance of the glamour
stocks, as measured by growth, tends to deteriorate while the performance
of the value stocks tends to improve to the point where it exceeds many
attributes of the glamour stocks.
By comparing the actual earnings growth rates with the expected earnings
growth rates implicit in stock prices, Lakonishok, Shleifer and Vishny find that
the high expected earnings growth rate of glamour stocks is only validated
for one to two years. Lakonishok, Shleifer and Vishny therefore argue that
their empirical evidence is consistent with investors pursuing naïve strategies
by always treating a well-run company as a good investment, extrapolating
trends and overreacting. This interpretation is furthermore consistent with
evidence from the psychology literature suggesting that as individuals we
tend to rely too much on very recent data when making decisions.
Fama and French (1992) have a different interpretation for the 10 to 11
per cent per annum excess return of value over glamour stocks. Fama and
French recognise that variables like size (market capitalisation), earnings
yield, dividend yield, leverage, and book-to-market are all scaled versions
of a firm’s stock price and are hence correlated.7 When trying to explain 7
The earnings yield and
portfolios’ average stock returns (proxying for expected returns), Fama the dividend yield are
respectively the inverse
and French find that size and book-to-market capture the cross-sectional
of the price-to-earnings
variation in average stock returns associated with size, earnings yield, ratio and the inverse of
dividend yield, book-to-market, leverage and other fundamentals. Fama the price-to-dividend
and French therefore argue that a stock’s size and book-to-market proxy ratio.
for the firm’s exposure to risks are priced by the capital market.8 8
According to the CAPM,
According to Fama and French, the reason for value strategies’ superior b is the only factor that
returns is that they are fundamentally riskier (higher average returns are should cause expected
simply a compensation for these risks). The debate about the returns to differ (i.e. no
interpretation for the 10 to 11 per cent per annum excess return of value other variable should
over glamour stocks illustrates again the joint hypothesis problem. explain expected returns
once we have accounted
for the effects of b). Fama
Technical trading rule applications and French, however,
Finally, we will discuss briefly weak-form tests, which are pretty much show that, when allowing
direct examinations of market efficiency according to definition 1. for variations in b that
One of the things that finance academics find most puzzling is finance are unrelated to size,
there is no reliable
practitioners’ reliance on technical trading rules to generate trading
relation between b and
signals. Via the logic used above, if a trading rule actually did generate average portfolio return.
profits, then its adoption by the masses would eliminate the gains it had
generated in the past. Hence, technical-trading rules would appear to be
valueless and practitioners’ trust in them is misguided.
However, recently, certain academics have tested this argument by
examining how very simple technical-trading rules would have worked on
historical-data spans. An example of a simple technical rule is the moving
average cross-over.
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Chapter 5: Efficient markets: theory and empirical evidence
example, is just the sum of the date –50 abnormal return across all
firms divided by the number of firms in the sample. This operation
is repeated for every date in the event window (i.e. for all dates
between –50 and 50). In general, these average abnormal returns are
accumulated from date –50 to 50, and a plot of the cumulative average
abnormal return against the date is formed.
Figure 5.1
If stock markets were efficient with respect to the positive earnings
surprises we are studying, then we would hope to see a cumulative
abnormal return diagram as shown in Figure 5.1. Why is this the case?
Well, on the announcement date (date 0), we see a large increase in
cumulative abnormal returns. This reflects the assimilation of the
unexpected earnings information into prices.11 Note that there is no 11
Of course, if we were
systematic increase in the cumulative abnormal return after the studying a sample
of negative earnings
announcement date. If one were to see continued systematic increases in
surprises (i.e. bad news),
abnormal returns after the announcement date, this would imply that it then we would hope for
was taking time for the earnings information to be reflected in prices and a picture which looked
hence informational inefficiency. Such a situation is shown in Figure 5.2. like the mirror image of
Figure 5.1 in the x-axis.
One feature of such a diagram that we haven’t yet mentioned is the
systematic rise in prices prior to the announcement. This can occur for
several reasons.
• The earnings information may be partially leaked prior to the official
announcement, and (in line with informational efficiency) the leaked
information is reflected in price.
• Certain announcements are only made after increased prices (i.e. the
announcement date is chosen by firm management to be just after a
price rise). Stock splits, for example, generally occur after rising stock
prices and hence would demonstrate the pre-event pattern shown in
Figure 5.2.
Figure 5.2
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Chapter 5: Efficient markets: theory and empirical evidence
Strong-form efficiency
Strong-form efficiency has received the least attention in empirical work
and we will only briefly mention it here. Certain studies examine whether
corporate insiders (e.g. company directors) make gains from trading in
their own company’s stock. Results suggest that insider trades can
generally be used to predict subsequent stock price changes, and hence
such work concludes that markets are not strong-form efficient.12 Other 12
Insiders tend to buy
work shows there to be information in the forecasts of professional prior to stock price rises
analysts and surveys (for example the Value Line survey). Again, this and sell prior to stock
price drops.
would seem to indicate the existence of private information in the hands
of professional or privileged agents.
On the other hand, however, work on mutual fund performance shows
that these actively managed portfolios underperform other broad-based
portfolios with similar risk. A recent study on UK funds by Blake and
Timmermann, for example, indicates that, over a 23-year span, funds
underperformed the market by about 2 per cent per annum.
Hence, evidence of private information on stock prospects is also mixed.
Results on mutual fund performance would certainly suggest that fund
managers are no better informed than the average investor, whereas
company directors seem to trade in a way that betrays the fact that they
possess information that markets do not. The latter finding of private
information is strengthened by results on the information content of
analyst forecasts.
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92 Corporate finance
We have already seen that assets that are more risky have higher expected
returns as compensation for that risk. For example, the CAPM implies that
any asset with a higher β must also have a higher expected return. This is a
cross-sectional implication. However, this can also happen in time series. If
certain times are riskier than other times then investors will not be willing
to pay a high price for risky assets, therefore prices of risky assets will be
low and expected returns on risky assets will be high. Thus, if risk is time
varying, then expected returns should also be time varying; if a variable
can describe the quantity of risk, this variable should also predict stock
returns.
Economists do not agree on what exactly is the right benchmark for
calculating abnormal returns; it may be correlation with the market
(CAPM), changes to the growth rate of productivity as suggested by Bansal
and Yaron (2004), changes to the standard of living we are used to as in
Campbell and Cochrane (2000), or a liquidity crunch. However, regardless
of what exactly constitutes risk, risk is likely to be changing through time.
For example, Robert Engle and Clive Granger won the 2003 Nobel Prize
in Economics for improving our understanding of how volatility of asset
returns moves through time.
Time varying risk implies that prices of risky assets should be relatively
low during risky times and that this should also forecast high expected
returns. We can look at ratios of prices relative to fundamentals to check
when prices are low, such ratios include the price dividend ratio, the price
earnings ratio, the wealth to consumption ratio, and the price to rent
ratio when considering housing. Indeed, such ratios are high some times
and low other times, as can be seen in Figure 5.3, which plots the price
dividend ratio for the aggregate US equity market over an 80-year period.
140
120
100
80
60
40
20
1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
Figure 5.3
Consider the price dividend ratio, according to the Gordon growth model,
P/D = 1/(r–g). If the price dividend ratio is low today, it must be either
that expected growth rates are low, or that expected discount rates are
high. John Cochrane showed that variation in price dividend ratios comes
mostly from variation in discount rates rather than growth rates. That is,
price dividend ratios are low when discount rates are high.
Several studies have shown that such ratios do forecast asset returns, but
only at longer horizons. Both the significance of coefficients and the R2
increase as the time period over which returns are calculated increases. For
example, at horizons of three to five years, the combination of the price to
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Chapter 5: Efficient markets: theory and empirical evidence
dividend ratio and the consumption to wealth ratio can forecast aggregate
stock returns with R2 of nearly 40 per cent.
However, here too, we cannot tell if movements in the aforementioned
ratios and the predictability of returns are due to market inefficiencies or
time varying risk driving expected returns. For example, consider a world
in which public sentiment, independent of fundamentals, can affect stock
prices. That is, in certain times people are very optimistic about stocks
for no fundamental reason, and at other times they are overly pessimistic
about stocks. Then, during times of such optimism, the price earnings ratio
would be high and would forecast low future returns as eventually everyone
would realise that the market is overvalued and sell. Similarly in times of
pessimism the price earnings ratio would be low and forecast high future
returns.
Summary
The evidence given above provides much food for thought. Results from
event studies tend to indicate that markets are close to (if not perfectly)
informationally efficient. Return predictability tests, on the other hand,
indicate some striking departures from weak-form efficiency. Research on
these issues is still progressing. Some more recent event study results (on
initial public offerings and new stock market listings, for example) seem to
be less supportive of efficiency. At the same time, more careful statistical
procedures are indicating that at least some of the weak-form efficiency
rejections may be dubious. Putting together this diverse group of results
with the joint hypothesis problem and the problems in modelling expected
returns means that a definitive answer on market efficiency is difficult
to come by. Indeed, although we have dichotomised results as indicating
‘efficiency’ or ‘inefficiency’, it may be more sensible to talk about degrees of
efficiency and classify certain markets or markets at certain times as being
more efficient than others.
Key terms
calendar effect
contrarian strategies
economic profit
efficient markets hypothesis
event study
excess return
glamour stocks
market model
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92 Corporate finance
momentum strategies
moving average cross-over
random walk model
return autocorrelation
semi-strong-form efficiency
strong-form efficiency
value stocks
weak-form efficiency
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Chapter 5: Efficient markets: theory and empirical evidence
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92 Corporate finance
Notes
88
Chapter 6: The choice of corporate capital structure
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• outline the main features of risky debt and equity
• derive and discuss the Modigliani–Miller theorem
• draw the link between Modigliani–Miller and Black–Scholes
• analyse the impact of taxes on the Modigliani–Miller propositions.
Essential reading
Hillier, D., M. Grinblatt and S. Titman Financial Markets and Corporate Strategy.
(Boston, Mass.; London: Macmillan, 2008) Chapters 14 (How Taxes Affect
Financing Choices) and 16 (Bankruptcy Costs and Debt–Holder–Equity-
Holder Conflicts).
Further reading
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass.; London: McGraw-Hill, 2003) Chapter 19 (How Much Should a Firm
Borrow?).
Copeland, T. and J. Weston Financial Theory and Corporate Policy. (Reading,
Mass.; Wokingham: Addison-Wesley, 2005) Chapter 15.
Modigliani, F. and M. Miller ‘The cost of capital, corporation finance and the
theory of investment’, American Economic Review (48)3 1958, pp.261–97.
Modigliani, F. and M. Miller ‘Corporate income taxes and the cost of capital: a
correction’, American Economic Review (5)3 1963, pp.433–43.
Warner, J. ‘Bankruptcy costs: some evidence’, Journal of Finance 32(2) 1977,
pp.337–47.
Overview
In most of the preceding chapters of this guide we have examined
the pricing of assets – both physical investment projects and financial
securities. With respect to the latter, we examined the pricing of stocks
and bonds using present value techniques and equilibrium financial asset
pricing via the CAPM and APT.
Thus far, however, we have said nothing about the mix of securities
actually issued by corporations. Should firms aim to use a large proportion
of debt in their financing or, conversely, should they employ equity
financing in the main? In this chapter and the next we examine the
firm’s decision over which types of claim to issue. The most important
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92 Corporate finance
result we will find is that, under a certain set of assumptions, the firm is
indifferent about the mix of debt and equity that it uses in its financing.
This result is the first Modigliani–Miller theorem (MM1). We go on
to explore deviations from the MM1 assumptions and how this affects
the debt–equity choice through the introduction of taxation effects, costly
bankruptcy and information asymmetries.
B [Xt , B] –
0 B Xt
Figure 6.1
The horizontal axis of the graph above represents the cash flow to the firm
(X), and the vertical axis shows the payoff to debt assuming the amount
promised to the group of all debt-holders (the face value) is denoted B.
When the cash flow to the firm is less than the face value, the debt-holders
gain the entire amount. For values of the cash flow at and above the face
value, the payoff to debt-holders is constant at B.
90
Chapter 6: The choice of corporate capital structure
The holders of corporate equity receive the residual cash flow accruing to
the firm after payments to debt-holders. However, despite having a claim
that is junior to that of debt-holders, equity-holders elect the board of a
firm and have voting rights over corporate activities and are hence the true
owners of the corporation. Equity also comes in many forms, but we will
focus on the characteristics of common stock.2 2
Other types of equity
include preferred stock
Stock-holders receive cash income in the form of dividend payments. and warrants.
These payments, unlike payments to service debt, are not deductible from
corporation tax obligations. Given the residual nature of the equity claim,
the payoff to equity is as given in Figure 6.2.
Payoff
[Xt – B, 0]+
0 B Xt
Figure 6.2
When the firm’s cash flow (X) is at or less than the face value of debt (B),
equity-holders receive nothing. However, they receive every dollar of cash
flow greater than B. This gives the kinked payoff function shown in Figure
6.2, which (anticipating future developments) is of precisely the same
form as that of a European call option.
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92 Corporate finance
Table 6.1
The price of the position in the unlevered firm is just αVU where the
value of the unlevered firm is denoted VU. The value of the position in
the levered firm is αE + αD = α(E+D), where E is the market value of the
levered firm’s equity, and D is the market value of the levered firm’s debt.
Of course, the total value of the levered firm (VL) must be the sum of E and
D. Hence, the price of the levered position is αVL. Equating the price of
levered and unlevered position yields the result that VU = VL, which is the
MM capital structure irrelevance proposition.
The key to the above result is that financing decisions do not affect
investment outcomes. Hence, two firms with identical investment policies
will derive identical returns regardless of their financing. As their 3
You can think of this
investment proceeds are the same, they should have the same value.3 result in the following
Another key point is that none of their cash flow goes to anyone outside way: when you slice a
those who own debt and equity. cake, you do not reduce
the size of the cake you
An alternative way to show the MM capital structure irrelevance sliced. Debt and equity
proposition is to show that stake-holders in the firm are indifferent to are just different slices
changes in the firm’s capital structure. The reason for this is that stake- of firm cash flow and,
based on the preceding
holders can, without cost, undo any changes the firm makes through their
logic, the value of the
own trading in the firm’s securities. firm (size of the cake)
Consider once more an investor who owns a proportion α of firm L’s is independent of the
equity. The payoff associated with this position is α(X – B(1+rd)). Firm leverage ratio (way in
which you slice the cake).
L now chooses to repurchase half of its equity (costing E/2) and funds
92
Chapter 6: The choice of corporate capital structure
the repurchase with the issue of new debt. Hence, the face value of debt
outstanding becomes B1 = B + E/2. Assuming that none of our investor’s
equity was repurchased, the payoff would be 2α(X – B1(1 + rd)) after the
repurchase. This is obviously different to that prior to the capital structure
change.
However, our investor can restore their original payoff profile using the
following strategy. Sell one-half of the equity stake and use the proceeds to
buy debt. The payoff from the new position is α(X – B1(1+rd)) + α(1 + rd)E/2
= α(X – B(1 + rd)). Hence our investor can, without cost, undo any change
the firm makes in its capital structure. This implies that investors will be
indifferent to such changes, and hence the valuation of a firm will not
depend on the specific debt–equity ratio it chooses (i.e. the MM irrelevance
proposition is valid).
Example
Consider an entrepreneur with a project which requires an initial investment of $100m
and which will have perpetual cash flows of $20m forever or $5m forever with equal
probability. Assume that all investors are risk neutral and require a 10 per cent expected
rate of return. We can show that the entrepreneur is indifferent between raising $100m
with debt, equity, or a mix of debt and equity.
• Debt: the entrepreneur must promise investors a coupon such that in expectations
they receive interest of 100*.1 = $10m every year. Since in the bad state of the world
investors will receive no more than $5m, it must be the case that .5*c + .5*5 = 10
and c = 15. The entrepreneur will receive the remainder: 0 in the bad state of the world
and 20 – 15 = 5 in the good state of the world. In expectation, the present value of
this is .5*5/.1 = $25m.
• Equity: the entrepreneur must promise investors a fraction of future equity payouts.
In expectation, outside equity investors will receive *(.5*5 + .5*20) = 12.5 each
year. The present value of this is 12.5/.1 = 125. This must equal to the amount they
put in: 100 = 125and = 80 per cent. The entrepreneur receives the remainder of
the equity, (1 – )*12.5 = $2.5m every year. The present value of this is $25m.
• Mix: the entrepreneur raises $50m through debt. She must promise investors a coupon
such that in expectations they receive interest of 50*.1 = $5m every year. Since even in
the bad state of the world the firm can pay $5m, they promise them a coupon of $5m.
The total equity payout is the remainder: 0 in the bad state of the world and 20 – 5 =
$15m in the good state of the world; this is equal to .5*15 = $7.5m in expectation.
The entrepreneur promises equity investors a fraction of future equity payouts. In
expectation outside equity investors will receive 7.5, per year, or 7.5/.1 = 75
in present value. This must equal to the $50m they have contributed, resulting in
= 66.7 per cent. The entrepreneur is left with (1 – )*75 = $25m.
The entrepreneur is indifferent to the choice of capital structure because capital structure
does not affect total cash flows produced by the firm.
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92 Corporate finance
Given put–call parity, the sum of the values of debt and equity (i.e. a
position consisting of a call option less a put option (both struck at B) plus
lending B/(1 + rd)) must be equal to the value of the firm’s assets. This
holds whatever the specific value taken by B, and hence, as the face value
of debt varies firm value is unchanged.4 4
This argument is also
robust to the issue
The Black–Scholes analysis of the MM proposition also gives us a simple
by the firm of more
way in which to value debt and equity claims on firms. Knowing the face complex securities (e.g.
value of debt, the maturity of debt, the risk-free rate and the parameters of warrants, convertible
the process governing the value of the firm’s assets, we can use the Black– debt and subordinated
Scholes equation and put–call parity to gain the market values of debt and debt).
equity. An example is given below.
Example
Assume a levered firm has current market value of assets equal to $100m. This firm has
issued zero coupon debt with face value $80m, which matures in five years. Assume that
the risk-free rate is 0.05 and that the volatility of the firm asset value process is 0.5.
Using the Black–Scholes option pricing analysis from Chapter 4 and the fact that equity
can be treated as a call option, you should be able to verify that the market value of
equity is:
E = $55.97m.
Obviously then, as the total firm value is $100m, the market value of debt is equal to:
D = $44.03m.
Do the calculations yourself, and make sure you get the correct answer.
cash flow Xt in period t. The second term is the gain made by the levered
firm in saving on its corporation tax bill through using debt in the capital
structure. This is known as the tax shield advantage of debt finance.
As our firm is infinitely lived, its market value is calculated as the present
value of the perpetual stream of payments to investors. Discounting and
adding up the stream of payments represented by the first term on the
right-hand side of equation 6.1 gives us the value of an unlevered firm
(VU), with identical cash flows to our levered firm. Discounting the stream
of payments represented by the second term on the right-hand side of
equation 6.1 gives τcD, where D is the market value of debt. Hence the
value of the levered firm can be written as:
VL = VU + τcD. (6.2)
The value of a firm increases linearly with the market value of its debt
and, as such, firms should aim to have as high a leverage as possible.
Note that, when the corporation tax rate is zero, the MM proposition is
satisfied once more. In the following section, we show how firm valuation
is affected by the introduction of personal taxes on investor income as well
as taxes on corporate profits.
Example
Consider the same entrepreneur as in the previous example but now living in a world
where corporate taxes are 15 per cent. We can show that the entrepreneur wishes to
raise as much money as possible through debt.
• Debt: the coupon payment offered to creditors is c = $15m, exactly as before. The
entrepreneur will receive the remainder, but must pay taxes on it. This is 0 in the bad
state of the world and (20 – 15)*(1 – .15) = 4.25 in the good state of the world. In
expectation the present value of this is .5*4.25/.1 = $21.25m.
• Equity: the entrepreneur must promise investors a fraction of future equity
payouts. In expectation, outside equity investors will receive α*(.5*5 + .5*20)
(1 – .85) = 10.625 each year. The present value of this is 10.625α/.1=106.25α.
This must equal to the amount they put in: 100 = 106.25α and α= 94.12%. The
entrepreneur receives the remainder of the equity, (1 – α)*10.625 = $.625m every
year. The present value of this is $6.25m.
• Mix: the coupon payment offered to creditors is $5m, exactly as above. The total
equity payout is the remainder: 0 in the bad state of the world and (20 – 5)*
(1 – .15) = $12.75m in the good state of the world; this is equal to .5*12.75 =
$6.375m in expectation. The entrepreneur promises equity investors a fraction of
future equity payouts. In expectation outside equity investors will receive 6.375, per
year, or 6.375α/.1 = 63.75α in present value. This must equal to the $50m they have
contributed, resulting in = 78.43%. The entrepreneur is left with (1 – α)*63.75 =
$13.75m.
The entrepreneur is best off raising money with 100 per cent debt, next best off with a
50/50 mix, and worst off raising money with 100 per cent equity.
Figure 6.3
As a result, we once more modify our analysis to allow for the effects of
bankruptcy costs. We assume that firms with higher levels of debt in their
capital structure incur greater costs of financial distress and that, at very
high debt levels, the effect of such costs may outweigh tax shield effects.7 7
High debt levels imply
You will find a diagrammatic analysis of this situation in Figure 6.3, which large fixed nominal
payments every period
plots firm value against leverage under three different scenarios. The first
and hence expose
is when corporation tax and bankruptcy costs are both zero. The second the firm to financial
scenario introduces non-zero corporation tax, and the third allows for distress if cash flows are
non-zero costs of bankruptcy. unexpectedly low.
Figure 6.3 makes the point quite well. When debt levels become too large,
the costs of financial distress outweigh tax shield gains and imply a finite
optimal leverage ratio. This is in contrast to the case when bankruptcy is
costless as firm value then increases without bound as leverage rises.
Example
Consider the same entrepreneur as in the previous examples who still faces a 15 per
cent corporate tax, but now also a drop of 40 per cent in all future income in case of
bankruptcy. We can show that the entrepreneur wishes to raise money through a mix of
debt and equity because using all equity results in losses of tax shields while too much
debt results in paying bankruptcy costs.
• Debt: the entrepreneur must promise investors a coupon such that in expectations
they receive interest of 100*.1 = $10m every year. In the bad state of the world
the firm is unable to fully pay its creditors and the firm will default. At this point, the
creditors will take over the firm, but 20 per cent is lost to bankruptcy costs so their
annual payout is 5*(1 – .4) = 3. It must be the case that .5*c + .5*3 = 10 and c
= 17. The entrepreneur will receive the remainder, after taxes. This is 0 in the bad
state of the world and (20 – 17)*(1 – .15) = 2.55 in the good state of the world. In
expectation the present value of this is .5*2.55/.1 = $12.75m.
• Equity: the firm cannot be bankrupt since it carries no debt, therefore the solution is
identical to the previous example. The entrepreneur receives $6.25m.
• Mix: note that in the previous example the coupon payment was just low enough
for the firm to not default (in the bad state of the world equity is left with zero but
creditors are fully paid, this is not default). Since no bankruptcy costs are paid, the
solution is identical to the previous example. The entrepreneur receives $13.75m
The entrepreneur is best off raising money by a mix of debt and equity so that they can
take advantage of the tax benefits of debt without having leverage so high as to suffer
bankruptcy costs.
96
Chapter 6: The choice of corporate capital structure
. (6.7)
Investors are willing to hold debt as long as, after adjusting for risk
premiums, the return after personal income taxes offered by debt is weakly
higher than the return after personal taxes on equity income offered by
equity, that is, as long as:
rD (1 – τd) ≥ rE (1 – τe). (6.9)
In order to understand the Miller equilibrium, let us first assume that the
pre-tax return on debt, rD, offered by firms is equal to the pre-tax return
on equity, rE. In this case, firms are willing to issue debt which tax-exempt
investors are willing to buy as both inequalities (equations 6.8 and 6.9) are
satisfied. Firms have an incentive to increase leverage and will continue to
replace equity with debt, moving up the demand curve by increasing the
return rD they offer to attract investors with higher personal income tax rates,
until:
rD = [rE (1 – τe)]/(1 – τd) = rE /(1 – τc). (6.10)
If the rate of return offered on debt is lower than rE /(1 – τc), firms have still
incentives to issue more debt as, at this point, it is still profitable to issue
debt to investors with marginally higher personal income tax rates. In
contrast, if the rate of return offered on debt is higher than rE/(1 – τc), firms
would be better off issuing equity than debt as it is cheaper.
In equilibrium, there is thus no advantage for firms to issue debt as the
equilibrium rate of return offered to debt-holders is such that firms are
indifferent between issuing debt and equity. In equation 6.7, the value of the
levered firm, VL, is equal to the value of the unlevered firm, VU, as:
(1 – τc) (1 – τe) = 1 – τd. (6.11)
Summary
In this chapter we have presented a fundamental analysis of the capital
structure of a firm. Initially we show that, under the MM assumptions,
capital structure does not affect firm value. We then present relaxations of
the MM assumptions and demonstrate how the MM result is altered. With
the introduction of corporate taxation it becomes clear that firm value is
increasing with the level of debt in the capital structure. Also allowing for
costly bankruptcy, we find that an optimal, finite capital structure may result.
When personal taxes and corporate taxes are included, then the prescriptions
for optimal capital structure are unclear. The optimum depends on the
particular constellation of corporate and personal taxation rates.
98
Chapter 6: The choice of corporate capital structure
In the next chapter we will explore the same relationships but from the
perspective of returns rather than values. In the following chapter we will
examine how conflicts between debt and equity-holder interests will also
imply that the MM result is violated. The analysis presented focuses on
simple cases in which the choices of equity-holders (those who dictate the
firm’s investment policy) are not aligned with the interests of debt-holders.
Key terms
bankruptcy costs
Black–Scholes
capital structure
corporate taxes
leverage
Miller equilibrium
Modigliani–Miller irrelevance theorem
personal taxes
tax shield of debt
100
Chapter 7: Leverage, WACC and the Modigliani-Miller 2nd proposition
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• write down the relationship between debt, equity, the unlevered return
on the firm, and the levered return on the firm
• understand what happens to equity returns, and the weighted average
cost of capital as leverage increases with and without taxes
• draw a link between Modigliani and Miller’s 1st and 2nd propositions
• find the equity beta of a firm by unlevering and relevering the equity
beta of a comparable firm with different capital structure.
Essential reading
Hillier, D., M. Grinblatt and S. Titman Financial Markets and Corporate Strategy.
(Boston, Mass.; London: McGraw-Hill, 2008) Chapters 13 (Corporate Taxes
and the Impact of Financing on Real Asset Valuation), 14 (How Taxes
Affect Financing Choices) and 15 (How Taxes Affect Dividends and Share
Repurchases).
Further reading
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass.; London: McGraw-Hill, 2008) Chapters 18 (Does Debt Policy
Matter?) and 20 (Financing and Valuation).
Miles, J. and J. Ezzell ‘The weighed average cost of capital, perfect capital
markets and project life: a clarification’, Journal of Financial and
Quantitative Analysis (15) 1980, pp.719–30.
Modigliani, F. and M. Miller ‘The cost of capital, corporation finance and the
theory of investment’, American Economic Review (48)3 1958, pp.261–97.
Modigliani, F. and M. Miller ‘Corporate income taxes and the cost of capital: a
correction’, American Economic Review (5)3 1963, pp.433–43.
Overview
In Chapter 1 we learned how to calculate the value of a project by computing
the present value of the project’s future cash flows. This was done by
discounting the cash flows by the appropriate discount rate. In Chapter 2 we
learned that this discount rate depends on the project’s risk. In this chapter
we will see how this discount rate changes as the capital structure of the firm
changes.
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92 Corporate finance
We will see that as the firm increases its leverage, its equity becomes more
risky. The required rate of return on equity therefore increases. However
the overall return on the firm’s assets (WACC) does not change if there
are no corporate taxes. This is analogous to results from the previous
chapter: Modigliani–Miller’s 1st proposition stated that the firm’s value
did not change with leverage when there were no corporate taxes. We will
see that because taxes result in a safe cash flow returned to the firm in
the form of a tax refund, in the presence of corporate taxes the expected
return on the firm’s assets decreases with leverage as the assets become
safer due to increased tax shields. This is also analogous to results from
the previous chapter: as the firm increases leverage, its value increases in
the presence of corporate taxes.
102
Chapter 7: Leverage, WACC and the Modigliani-Miller 2nd proposition
Example
The historic risk-free rate is 4 per cent and the historic market premium is 5 per cent.
Walmart has an equity β of 0.9, implying an expected equity return of re = 4 + 0.9*5 =
8.5% according to the CAPM.
Walmart has AA debt which matures in 2023 and has a yield of 5.9 per cent. Walmart’s
tax rate is 35 per cent so Walmart is paying (1 – τC )rd =(1 – .35)*5.9 = 3.835% to raise
money through debt.
Walmart’s outstanding debt has a value of $22.7 billion. Walmart has 4,269 million shares
outstanding with a price of $55.69 per share, implying an equity market capitalisation of
4.269*55.69 = $237.7 billion. Walmart’s weight of debt in the capital structure is 22.7/
(237.7 + 22.7) = 8.7% and its weight of equity is 237.7/(237.7 + 22.7) = 91.3%.
Walmart’s WACC is 0.087*3.835 + 0.913*8.5 = 8.09%.
20
15
E[R]
10
0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
D/ V
Figure 7.1
We will now derive a more general version of the MM 2nd proposition, in
the presence of taxes. Consider a firm that lives for one period. It has both
debt and equity in its capital structure and its value is V0 = E0 + B0 today
and V1 = E1 + B1 next period. Also note that from the definition of return,
E1 = (1 + re)E0 and B1 = (1 + rd)B0 as there are no intermediate payments.
104
Chapter 7: Leverage, WACC and the Modigliani-Miller 2nd proposition
This firm will have a cash flow X1 which it will distribute to its debt and
equity holders in period 1. Also consider a similar firm that is all equity
owned. This unlevered firm has value V0U today; for this firm B = 0.
Since next period the cash flows will be distributed first to creditors, and
then to equity-holders (after taxes), we can write the value of the firm as
the value of the total distributions:
V1 = (X1 – B1)(1 – τC ) + B1 = X1 (1 – τC ) + τC B1 = V1U + τC B1, (7.10)
where the first term is the payout to equity-holders and the second term is
the payout to creditors. The last equality uses the fact that the value of the
unlevered firm next period is just equal to its after-tax cash flows.
From the definitions of debt and equity we know that:
V1 = E1 + B1 = (1 + re )E0 + (1 + rd )B0. (7.11)
Setting equations 7.10 and 7.11 equal to each other and substituting
V1U = (1 + ru)V0U and B1 = (1 + rd )B0 we get the following equation:
(1 + ru)V0U + τC (1 + rd )B0 = (1 + re )E0 + (1 + rd )B0. (7.12)
Now, we can rearrange the terms of this to solve for the return on equity:
1 + re = (1 + ru)(V0U/E0 ) – (1 – τC )(1 + rd)(B0 /E0). (7.13)
Finally, we can use the fact that V0U = V0 – CB0 = E0 + B0 – C B0 (this is just
the present value of equation 7.10) to rewrite this as:
re = ru + (1 – τC)(B0 / E0)(ru – rd). (7.14)
Equation 7.14 is the MM 2nd proposition in the presence of corporate
taxes. When C = 0 this equation becomes identical to equation 7.9.
However when C > 0, the expected return on equity rises by less in
comparison to equation 7.9 as leverage (B/E) increases. This is because
even though extra leverage makes equity more risky for the same
arguments as before, tax shield reduce some of this risk. This can also be
seen by comparing the equity return in Figure 7.1 to that of Figure 7.2
which has the same returns in the presence of taxes.
25
Debt
WACC
Equity
20
15
E[R]
10
0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
D/V
Figure 7.2
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92 Corporate finance
Activity
Combine equations 7.14 and 7.8 to derive equation 7.15.
We can split up the risk investors of a firm face into two types of risk. The
first is business risk, this depends on the risk of the firm’s underlying assets
and activities. All similar firms should have similar business risk regardless
of capital structure. The second is financial risk, this is additional risk
that the firm faces due to its choice of capital structure. The return on an
unlevered firm ru is based on the firm’s business risk, since this firm has no
leverage. WACC is the return on the levered firm, this combines business
and financial risk. From equation 7.15, it is evident that without taxes
financial risk is irrelevant. The WACC of any firm is equal to the return on
an unlevered firm, regardless of the amount of leverage. This is analogous
to the 1st proposition of MM: the value of any firm is equal to the value of
an unlevered firm, regardless of the amount of leverage. In the presence
of taxes, the WACC decreases as we add leverage because of additional
tax shields. With more leverage, the firm becomes safer, its borrowing rate
decreases (equation 7.15), and its value increases (equation 6.2). The MM
1st and 2nd propositions are flip sides of the same coin.
Example
Consider two firms with the same unlevered (asset) β of 0.5. The risk-free rate is 3 per
cent and the market premium is 6 per cent. The corporate tax rate is 35 per cent.
Firm A has no debt. Current pre-tax earnings are $23 million with no growth prospects.
Firm B has AAA-rated long-term debt with 4 per cent yield to maturity and market value
$50 million. Current pre-tax earnings are $8.75 million with no growth prospects.
What are the WACC, equity return, total firm value, and equity value for each firm?
The FCF of firm A is 23*(1 – .35) = $23.98 million. We use ru = 4.5% as the discount
rate and find an unlevered firm value of VU = 23.98/.045 = $332.2 million.
Since this firm is debt free, its equity value and its total value are the same as the
unlevered value. Again, because this firm is unlevered, its WACC and its equity return are
both equal to ru.
The FCF of firm B is 8.75*(1 – 0.35) = $5.69 million. We use ru = 4.5% as the discount
rate and find an unlevered firm value of VU = 5.69/ 0.045 = $126.4 million.
Using the MM 1st proposition, we can calculate the levered value as the unlevered value
plus the present value of tax shields where the present value of tax shields is given by cB:
V = 126.4 + 0.35*50 = $143.9 million. The equity value is the total firm value minus
the value of the debt: 143.9 – 50 = $93.9 million.
106
Chapter 7: Leverage, WACC and the Modigliani-Miller 2nd proposition
We can use the MM 2nd proposition (7.14) to calculate the return on equity:
We can now calculate the WACC either through equation 7.8 or 7.15. Both give the same
answer. First using equation 7.8:
A CAPM perspective
So far we have looked at the relationships between returns implied by the
MM 2nd proposition. We can instead look at the relationships between βs.
Recall that the CAPM implies that every security lies on the security market
line. We can write down CAPM equations for the unlevered, equity, and
bond returns.
ru = rf + βu (rm – rf ) (7.16)
re = rf + βe (rm – rf ) (7.17)
rd = rf + βd (rm – rf ) (7.18)
By plugging equation 7.16 into equation 7.14 (MM 2nd proposition) and
then rearranging terms, we can rewrite the return on equity as:
re = rf + [βu+ (1 – τC )(B/E)(βu – βd )](rm – rf ). (7.19)
This itself is a CAPM equation, by comparing equation 7.19 to 7.17 we can
see that βe must equal to the term in brackets from equation 7.19:
βe = βu + (1 – τC )(B/E)(βu – βd ). (7.20)
In the special case when the firm’s debt is riskless and therefore βd = 0, this
equation simplifies to:
βe = βu (1 + (1 – τC )(B/E)). (7.21)
With equation 7.21 we can compare the β of an unlevered firm to the β of a
levered firm. We can also use the equation backwards to find the unlevered
β for a levered firm. Suppose you wish to find the expected equity return
for a firm with no past financial data. It is possible to find a comparable
publically trading firm with the same business risk (for example a firm in
the same industry), however this firm may have different financial risk
(different leverage).
Using historical market information we can find the β of the comparable
firm by running a regression, analogous to equation 2.32. The slope from
this regression is the equity β of the comparable firm. However, due to
different leverage, the β we are looking for may be different from this β.
Using equation 7.21 with the capital structure of the publically traded
firm, we can unlever this β and find the unlevered (asset) β, which is the
same for both firms. We can then again use equation 7.21, this time with
the leverage ratio of the firm whose β we wish to know, to get the desired
equity β.
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Example
Firm A is looking to do an IPO with a debt to value ratio of 0.7. The average equity beta
of similar, publically traded firms is 0.85 and the average debt to value ratio is 0.22. The
tax rate is 35 per cent. What rate of return should we use to discount Firm A’s expected
equity cash flows?
Using equation 7.21 backwards with the capital structure of the comparables, we find
that the unlevered (asset) β of this industry is:
Now we can use equation 7.21 forwards, with the target leverage of firm A:
With a 4 per cent historical risk-free rate and a 6 per cent historical market premium, the
required equity return is: 4 + 1.81*6 = 14.86%.
Summary
In this chapter we derived relationships between the return on a firm’s
equity, a firm’s debt and a firm’s total assets. We saw that if there are no
taxes, increasing leverage makes equity riskier and increases expected
returns. However, the return on the firm’s total assets does not change
because more weight is given to the safe debt return. However, in the
presence of taxes, the increase of expected equity returns with leverage
was smaller, due to a tax refund. The return on the firm’s total asset
actually declined with leverage in the presence of taxes, because tax
refunds make the firm safer. This is analogous to firm value rising with
leverage in the presence of taxes, as we saw in the previous chapter.
Key terms
business risk
financial risk
leverage
tax shields
weighted average cost of capital (WACC)
unlevered (asset) return
unlevered β
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Chapter 7: Leverage, WACC and the Modigliani-Miller 2nd proposition
Year –5 –4 –3 –2 –1 0 +1 +2
A –11 0 1 2 21 22 23 23
B 5 13 7 4 15 13 3 10
Both firms pay out nearly 100 per cent of their after-tax cash flows
to the owner. A has no debt. B has AAA-rated long-term debt with 4
per cent yield to maturity and market value of 50 million. The asset
(unlevered) β for firms in the same industry as A and B is 0.5. The
corporate tax rate is 35 per cent, assume no personal taxes. The
historical risk-free rate is
3 per cent and the historical return on the stock market is 6 per cent.
a. For each firm calculate the WACC, the firm (enterprise) value, and
the equity value. Give justification for your calculation.
b. What changes to capital structure would you make for firm A? Firm
B?
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Notes
110
Chapter 8: Asymmetric information, agency costs and capital structure
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• understand the concept of agency costs and governance problems in
general
• discuss the intuition behind the agency costs of debt, equity and free
cash-flows
• calculate the agency cost of debt in stylised settings
• discuss the effects of asymmetric information on capital structure
• explain the intuition behind the pecking order theory of finance.
Essential reading
Hillier, D., M. Grinblatt and S. Titman Financial Markets and Corporate Strategy.
(Boston, Mass.; London: McGraw-Hill, 2008) Chapters 16 (Bankruptcy
Costs and Debt–Holder–Equity-Holder Conflicts), 17 (Capital Structure
and Corporate Strategy), 18 (How Managerial Incentives Affect Financial
Decisions) and 19 (The Information Conveyed by Financial Decisions).
Further reading
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass.; London: McGraw-Hill, 2008) Chapters 13 (Agency Problems,
Management Compensation, and the Measurement of Performance) and 19
(How Much Should a Firm Borrow?).
Copeland, T. and J. Weston Financial Theory and Corporate Policy. (Reading,
Mass.; Wokingham: Addison-Wesley, 2005) Chapter 15.
Jensen, M. ‘Agency costs of free cash flow, corporate finance, and takeovers’,
American Economic Review 76(2) 1986, pp.323–29.
Jensen, M. and W. Meckling ‘Theory of the firm: managerial behaviour, agency
costs and capital structure’, Journal of Financial Economics 3(4) 1976,
pp.305–60.
Masulis, R. ‘The impact of capital structure change on firm value: some
estimates’, Journal of Finance 38(1) 1983, pp.107–26.
Miller, M. ‘Debt and taxes’, Journal of Finance 32, 1977, pp.261–75.
Modigliani, F. and M. Miller ‘The cost of capital, corporate finance and the
theory of investment’, American Economic Review 48(3) 1958, pp.261–97.
Myers, S. ‘Determinants of corporate borrowing’, Journal of Financial Economics
5(2) 1977, pp.147–75.
Myers, S. and N. Majluf ‘Corporate financing and investment decisions when
firms have information that investors do not have’, Journal of Financial
Economics 13(2) 1984, pp.187–221.
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92 Corporate finance
Overview
In the previous chapter we introduced the capital irrelevance proposition
first put forward by Miller and Modigliani (1958). We also explored cases
in which the capital structure of a firm did matter in its valuation due to
relaxations of the MM assumptions (e.g. the introduction of corporation
tax and bankruptcy costs). In this chapter we will focus on two classes of
problem in which MM1 does not hold. In the first, firms are subject to agency
problems between outside stakeholders and insiders (managers). The second
class of problem allows the possibility that insiders to the firm are better
informed about its quality than the market or potential external investors.
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Chapter 8: Asymmetric information, agency costs and capital structure
Jensen and Meckling argue that the agency cost of outside equity is
decreasing in the leverage ratio of the firm (where leverage is the ratio of
debt to equity values). The argument runs as follows: assume that the firm
repurchases some of the equity held by outsiders, funding this with a debt
issue – hence, leverage is increased. Also, the proportion of outstanding
equity held by the manager is now increased. Thus, as his share of the
residual value of the firm is increased, the manager chooses to supply
more effort, leading to increased firm value. Then, as leverage rises,
agency costs of outside equity fall.
Example
In this example we will see that when issuing outside equity, a project’s owner is worse
off because she uses too little effort. On the other hand, when using debt, she uses
optimal effort.
Consider an entrepreneur with a project that next year pays $10 million with probability p
and $20 million with probability 1 – p. This project requires an initial investment of
$11 million.
The entrepreneur can pick the probability of success p to be any number they want
between 0.25 and 0.75. However, choosing a higher p requires effort e, which the
entrepreneur dislikes; e = k*p. In this case k = 4 is the disutility of raising probability of
success by 1 expressed in millions of dollars. In particular, if X is the monetary the utility
function is:
U = E[X] – k*e
The required discount rate is zero and everyone is risk neutral.
Suppose the entrepreneur finances the project with equity by promising a share of
equity to outside investors in return for them paying the $11 million necessary for the
initial investment. Then the expected payoff is:
E[X] = (1 – )(20p + 10(1 – p)) = (1 – )(10p + 10),
and the utility is:
U = E[X] – e = (1 – )(10p + 10) – k*p = 10*(1 – ) + [10*(1 – ) – k]*p.
Therefore, the entrepreneur will choose p to be as small as possible if 10*(1 – ) – k
< 0. Suppose outside investors believe that the entrepreneur will choose p = 0.75, then
their expected payout is: (0.75*20 + 0.25*10) = 17.5.
This must equal to their initial investment of 11, implying = 62.9%. However, that
implies that 10*(1 – ) – k = 3.71 – k < 0 and the entrepreneur would choose
p = 0.25, therefore this cannot be an equilibrium.
Suppose outside investors believe our investor will choose p = 0.25, then their expected
payout is: (0.25*20 + 0.75*10) = 12.5
This must equal their initial investment of 11, implying = 88%. Indeed 10*(1 – ) – k
= 1.2 – k < 0, thus the entrepreneur will choose p = 0.25, consistent with the beliefs of
outside equity-holders.
The entrepreneur’s utility is:
U = 10*(1 – ) + [10*(1 – ) – k]*p = 1.5 – k*p = 0.5.
Suppose instead the entrepreneur financed this investment with debt by promising a face
value F to creditors in return for $11 million to cover the initial investment. In this case
the entrepreneur’s equity will always be bankrupt in the bad state of the world and they
will receive zero; in this case creditors receive the full $10 million. In the good state of the
world, the entrepreneur will receive 20 – F. Their utility is:
U =E[X] – e = p(20 – F) – k*p = (20 – F – k]*p.
They will choose p to be as large as possible as long as 20 – F – k > 0.
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Suppose creditors believe that p = 0.25. Then their expected payout is:
p*F + (1 – p)*10 = 0.25F + 7.5
This must equal their initial investment of 11, implying F = 14. However, this implies that
20 – F – k > 0 and the entrepreneur would choose p = 0.75, therefore this cannot be
an equilibrium.
Suppose creditors believe that p = 0.75. Then their expected payout is:
p*F + (1 – p)*10 = 0.75F + 2.5.
This must equal to their initial investment of 11, implying F = 11.33. Indeed, 20 – F – k
> 0 and the entrepreneur chooses p = 0.75, consistent with the beliefs of outside equity-
holders.
The entrepreneur’s utility is:
U = (20 – F – k)*p = 6.50 – k*p = 3.5.
Note that this is much higher than when the entrepreneur uses equity. In this example
the MM proposition did not hold because one type of security was better than another.
As we increased the proportion of debt used to finance the firm, the entrepreneur chose
to exert more effort and increased value. Increasing leverage reduced the agency cost of
outside equity because it aligned the payoff to the entrepreneur with their cost of effort.
With a fraction of outside equity, for every dollar of value they took out of the firm due
to decreased effort, the entrepreneur lost only (1 – ) of wealth.
Activity
First, show that in the above example, if the entrepreneur could commit to using the
optimal amount of effort, then they could get maximum utility even when using equity.
Next, show that in the above example if the entrepreneur is less averse to effort, for
example k = 3, then two possible equilibria can arise in the equity financing case. Thus
market beliefs may play an important role.
Example
Assume that a firm that is financed by both debt and equity. A manager runs the firm in
the interest of current equity-holders (i.e. the manager sets investment policy in order
to maximise the expected shareholder payoff). The manager is faced with the choice
between two investment projects, A and B. These projects are assumed to have zero cost
and are mutually exclusive. The cash flows to projects A and B are given in Table 8.1.
State 1 State 2 State 3
Cash flow A 40 50 60
Table 8.1
Clearly, both projects have positive expected NPV. Project A has the lowest risk and the
higher expected NPV (50), whereas project B is the riskier and its expected NPV is 45.1 1
When we say that
project B is riskier, we
We assume that debt-holders have a claim of 50 that must be repaid out of mean that it has higher
the cash flow to the chosen project. Given this debt claim, which project cash-flow variance than
will the manager choose? project A.
Example
In this example we will see that when issuing debt, a project’s owner is worse off because
they choose to take on too much risk. On the other hand, when using outside equity, they
choose the optimal amount of risk.
Consider an entrepreneur with a choice of one of two projects. Project A pays $5
million or $15 million with equal probability. Project B pays 0 or $18 million with equal
probability.
Each project requires an initial investment of $3 million. The entrepreneur will have the
freedom to choose the project after they raise financing.
The required discount rate is zero and everyone is risk neutral. There are no taxes or
bankruptcy costs.
Note that the expected value of project A is 0.5*5 + 0.5*15 = 10 while the expected
value of project B is 0.5*0 + 0.5*18 = 9 so project A is better. Project A is also less
volatile; in this example investors are risk neutral but typically they would prefer less
volatile projects.
Consider debt financing. For any face value of debt F shareholders receive the residual
after creditors have been paid. From project A their expected payout is:
0.5*(5 – F) + 0.5*(15 – F) = 10 – F if F < 5
0.5*0 + 0.5*(15 – F) = 7.5 – 0.5F if 5 < F < 15.
From project B their expected payout is:
0.5*(18 – F) = 9 – 0.5F if F < 18.
Comparing these two equations we can see that project B is preferred by equity-holders
for any F > 2, this can also be seen graphically in Figure 8.1. Project B is preferred
because equity-holders have a limited downside but care very much about the upside.
On the other hand, creditors expected payout from project A is:
F if F < 5
0.5*5 + 0.5*F = 2.5 + 0.5F if 5 < F < 15.
From project B their expected payout is:
0.5*F if F < 18.
Comparing these two equations we can see that project A is preferred by creditors for any
F, this can also be seen graphically in Figure 8.1. Project A is preferred because creditors
have no upside, and care only about limiting losses in the downside.
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Since the necessary initial investment is 3, the face value of debt will have to be at least
3. This leads equity-holders to choose project B. Knowing this, creditors will ask for a face
value of debt such that they receive their initial investment back in expectation:
3 = 0.5*F and F = 6.
With this F, the initial entrepreneur’s payout is:
0.5*(18 – 6) = $6 million.
Suppose the entrepreneur could credibly commit to choose project A. In that case
creditors would ask for a smaller face value of debt, F = 3, because even in the bad
scenario, project A will be more than enough to repay the initial investment. The payout
to equity-holders would be:
10 – F = $7 million.
The shareholders would be better off if they could ex-ante commit to invest in A because
A has higher NPV. However, as we saw earlier, with F = 3 they are ex-post better off
choosing B. Since the creditors have no reason to trust them, creditors will assume B will
be chosen and ask for F = 6.
Now consider using outside equity to finance this project. Outside equity-holders
are promised a fraction of the project and the entrepreneur receives the rest. The
entrepreneur’s payoff from choosing A is:
(1 – )[0.5*5 + 0.5*15] = (1 – α)*10,
and from choosing B it is:
(1 – α)[0.5*0 + 0.5*18] = (1 – α)*9.
Clearly the entrepreneur always chooses A. Knowing this, outside equity-holder will ask
for such that their expected payoff 10α is equal to their initial investment of 3. This
implies that α= 30% and the entrepreneur’s share is worth (1 – 0.3)*10 = 7. This is just
as good as the commitment case and better than the debt financing case.
In this example the MM proposition did not hold because one type of security was better
than another. Debt financing caused the entrepreneur to choose a very risky project (risk
shift) because their downside was limited. As a result, creditors asked for a very high
interest rate to protect their investment and the entrepreneur was worse off for this.
Equity financing did not face this problem because the entrepreneur was just receiving
a fixed share of total profits, therefore it was in their interest to maximise total profits
both ex-ante and ex-post. Commitment was a possible substitute to equity, but it may be
difficult to implement in a real world situation.
Figure 8.1
Jensen and Meckling argue that the agency costs of debt are increasing in
the level of debt outstanding and hence in corporate leverage. Combining
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Chapter 8: Asymmetric information, agency costs and capital structure
the two agency costs then allows us to argue that an optimal (in the sense
of maximising firm value) capital structure might exist. We contended
that the agency cost of outside equity was decreasing in leverage, whereas
the agency cost of debt increased with leverage. Firm value would be
maximised where total agency costs are minimised, and this leads to the
optimal leverage ratio shown on Figure 8.2.
Figure 8.2
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Activity
Compute the expected payoff to equity-holders if the required debt repayment is 90. Will
the manager accept or reject the project?
118
Chapter 8: Asymmetric information, agency costs and capital structure
. (8.1)
(8.2)
To compute the optimal level of debt, we compute the first order condition
of 8.2 with respect to B. After rearrangement this yields:
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92 Corporate finance
. (8.3)
. (8.5)
(8.6)
. (8.7)
. (8.8)
Equation 8.8 gives us the key results from the Ross (1977) model. Debt
level (B) is increasing in firm quality (t). Clearly then, firms with higher
debt levels will have greater date 0 market values and MM1 is violated
once more.
In more loose terms, the arguments in Ross (1977) are that debt is a
costly signal (due to the possibility of bankruptcy it entails), and hence its
use implies higher-quality firms. From an empirical standpoint, evidence
that supports this notion can be found in Masulis (1983). This paper
demonstrates that firms which swap debt for equity (hence increasing
leverage) experience positive stock price returns whereas firms swapping
equity for debt experience negative stock returns. The stock price reactions
are interpreted as implying that leverage-increasing transactions are good
news whereas leverage-decreasing transactions are bad news, consistent
with the asymmetric information story.
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Chapter 8: Asymmetric information, agency costs and capital structure
Only managers know whether the equity of their firm is over- or under-
priced though, and this creates an opportunity for them to exploit the
market in order for existing shareholders to profit. The existence of
information asymmetries thus implies that the market can misprice
corporate equity: some firms’ equity may be over priced and others will be
under priced.
In this setting, managers may raise equity for two reasons.
• They may wish to invest in a positive NPV investment, which would
result in an increase in the value of the firm’s equity.
• Alternatively, they may wish to issue overpriced equity, which would
result in a transfer of wealth from the new to the old equity-holders.
Given rational expectations, the financial market correctly recognises
both incentives to raise equity. In equilibrium, managers of low-quality
firms (i.e. managers of firms with assets in place whose true worth is low
enough – and are hence overvalued), raise equity in order to take projects
with a small but negative NPV. The benefit to the existing equity-holders
that results from issuing overvalued equity exceeds the cost resulting
from taking the negative NPV project. Similarly, managers of high-quality
firms (i.e. managers of firms with assets in place whose true worth is high
enough – and are hence undervalued), abstain from raising equity and
hence from taking projects with a small but positive NPV. The dilution to
the existing equity-holders that results from issuing undervalued equity
exceeds the benefit resulting from the positive NPV generated by taking
the project. The presence of information asymmetries between managers
and equity-holders hence leads to distortions in investments.
Issue decisions affect prices as they reveal information on firm quality.
Managers are more likely to issue equity when their firm’s assets in place
are overvalued, as opposed to undervalued. On average, equity issues thus
lead to stock price drops. Furthermore, the highest quality firms avoid
issues at all costs.
Generalising the above somewhat, we can fit riskless debt, risky debt and
other securities into our pecking order. Obviously, issuing riskless debt to
finance investments conveys no information to the market, as there is no
possibility of exploitation (as there is no risk). Thus, stock prices should
not react to riskless debt issues and the highest quality firms will issue risk-
less debt in order to finance any investments. Low-quality firms don’t issue
riskless debt, as they cannot exploit new investors through its issue. Risky
debt comes with a possibility of default and hence could be overpriced if
the market underestimates the probability of default. Issues of risky debt,
therefore, convey some information, but clearly less than issues of equity.
Putting this all together leads to a model in which equity issues cause
stock prices to drop a lot (as the market infers that firms that issue are
very poor quality), risky debt issues cause small price decreases (as fairly
low-quality firms issue risky debt) and riskless debt issues cause no price
impact (as only high-quality firms issue riskless debt). Hence, in a dynamic
sense, Myers–Majluf implies that capital structure decisions do affect firm
values. This is the pecking order theory of finance.
There is a fair amount of empirical evidence that supports the pecking
order theory. First, the event study results on exchange offers detailed
above are consistent with the pecking order theory. Second, event study
evidence on new security issues confirms the theory too. Common stock
issues lead to price impacts of around –3 per cent, for example, whereas
risky debt issues cause small price drops, which are not statistically
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92 Corporate finance
different from zero. Hence, the intuition that underlies the model is
regarded by many as very plausible.
Example
Project Universe Industries (PUI), an all equity firm, currently has 20 million shares
outstanding. The value of the company is the sum of the value of the assets in place and
the NPV of the project. As shown in the following table, both the value of the assets in
place and the NPV from the project crucially depend on the price of oil:
Valuation
Assets State A (cheap oil) State B (expensive oil)
Assets in place £130m £220m
NPV of the project’s cash flows £10m £40m
The manager, when informed about the realisation of the state of nature, will issue
equity and invest in the positive NPV project in state A as (1 − 75%)*£740m =
£185m is strictly higher than £130m and refrain from issuing equity and forego
the positive NPV project in state B as (1 − 75%)*£860m = £215m is strictly lower
than £220m.
The manager of the firm hence abstains from issuing any equity and does not invest
in the strictly positive NPV project in the favourable state of nature. The intuition
behind this result is as follows. Although taking this project would increase the value
of the firm overall as it has a strictly positive NPV, it also leads to a reduction in the
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Chapter 8: Asymmetric information, agency costs and capital structure
wealth of the existing shareholders. The reason for this is that, in the favourable
state of nature, the financial market undervalues both the NPV of the project and
the intrinsic value of the firm’s existing assets. The effect of the dilution of the
existing shareholders, resulting from issuing undervalued shares, turns out to be so
high that the existing shareholders are better off without the project whenever the
project has to be financed through outside equity.
c. Now let us assume that the market knows that managers will make a decision after
observing the state of the world. When managers announce that they will not issue
equity to fund the project, the stock price of the firm may change. How would you
expect it to change? In order to answer this question, let us assume that the firm
does not have any other source of capital to take the project and that the market
does not know the state of the world.
Upon the announcement that equity will not be issued and the investment project
will not be taken, the market updates its estimate of the value of the firm, infers
that state B is obtaining, and hence prices the firm’s stock at £11 per share
(£220m/20m), hence rises by 10 per cent.
Summary
In this chapter we have examined theoretical models (and examples),
which imply that firm value does depend on the financing choices it
makes and on capital structure choices in particular. First, we examined
arguments based on agency costs and then looked at a model of
asymmetric information. The empirical evidence for these models is
mixed. Evidence for agency problems can be found in the specification
of corporate debt contracts, which contain clauses aimed specifically at
preventing debt overhang and asset substitution problems. The previously
discussed evidence on exchange offers is supportive of asymmetric
information models (although it would contradict the implications of a
debt overhang model). Research in these areas still proceeds. The most
recent strand of literature on capital structure builds on the agency cost
approach and examines incomplete contracts as the source of violations of
MM1.
Key terms
agency costs of debt
agency costs of free cash flows
agency costs of outside equity
asset substitution problem
asymmetric information
capital structure
debt-overhang problem
event study
governance problems
overinvestment
pecking order theory
risk-shifting problem
separation of ownership and control
signalling
underinvestment
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92 Corporate finance
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Chapter 8: Asymmetric information, agency costs and capital structure
d. Suppose the outside investors are aware of the CEO’s penchant for
spending time with celebrities. What share of equity would they
demand? What would be the present value of the entrepreneur’s
total payoff?
6. A firm’s productive assets will be worth either $100 million in a good
state or $10 million in a bad state with equal probability. Additionally,
the firm has $15 million in cash, which it could pay out as a dividend,
and outstanding debt with a face value of $35 million due next year.
The firm also has a project which would require an investment of $15
million this year and produce $22 million with certainty regardless of
the state of the world. Assume risk neutrality and a 10% cost of capital.
a. Do stockholders choose to take this positive NPV project? What is
the present value of the creditors payoff?
b. Suppose creditors suggest to financially restructure by reducing the
face value of debt to 24 if the shareholders promise to use the $15
million to invest. Will the shareholders agree? Will the creditors
prefer to do this?
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92 Corporate finance
Notes
126
Chapter 9: Dividend policy
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• show that dividend policy (and share repurchases) are irrelevant to
firm valuation under the Modigliani–Miller assumptions
• discuss the stylised facts of dividend policy as provided by Lintner
• present the clientele model of dividends
• discuss the effects of asymmetric information and agency costs on
dividend behaviour.
Essential reading
Hillier, D., M. Grinblatt and S. Titman Financial Markets and Corporate Strategy.
(Boston, Mass.; London: Macmillan, 2008) Chapters 15 (How Taxes Affect
Dividends and Share Repurchases) and 19 (The Information Conveyed by
Financial Decisions).
Further reading
Allen, F. and R. Michaely ‘Dividend Policy’ in Jarrow R.A., V. Maksimovic and
W.T. Ziemba (eds) Handbooks in Operational Research and Management
Science: Volume 9: Finance. (Amsterdam: North Holland, 1995).
Bhattacharya, S. ‘Imperfect information, dividend policy, and “the bird in the
hand” fallacy’, Bell Journal of Economics 10(1) 1979, pp.259–70.
Blume, M., J. Crockett and I. Friend ‘Stock ownership in the United States:
characteristics and trends’, Survey of Current Business 54(11) 1974,
pp.16–40.
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass.; London: McGraw-Hill, 2008) Chapter 17 (Payout Policy).
Copeland, T. and J. Weston Financial theory and corporate policy.
(Reading, Mass; Wokingham: Addison-Wesley, 2005) Chapter 16.
Healy, P. and K. Palepu ‘Earnings information conveyed by dividend initiations
and omissions’, Journal of Financial Economics 21(2) 1988, pp.149–76.
Jensen, M. and W. Meckling ‘Theory of the firm: managerial behaviour, agency
costs and capital structure’, Journal of Financial Economics 3(4) 1976,
pp.305–60.
Lintner, J. ‘Distribution of incomes of corporations among dividends, retained
earnings and taxes’, American Economic Review 46(2) 1956, pp.97–113.
Myers, S. ‘Determinants of corporate borrowing’, Journal of Financial Economics
5(2) 1977, pp.147–75.
Ross, S. ‘The determination of financial structure: the incentive signalling
approach’, Bell Journal of Economics 8(1) 1977, pp.23–40.
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Overview
The dividend is a cash payment (usually made on an annual or semi-
annual basis) to the owners of corporate equity and is the basic financial
inducement for individuals to hold shares. In Chapter 1, when analysing
discounted cash-flow techniques, we demonstrated how to price an
equity share, given knowledge of the future dividend stream that would
accrue to the share. Such an analysis might be undertaken by an investor
in order to assess the ‘value’ of an equity share. The current chapter
analyses dividends from the opposite perspective, that of the manager
of a corporation who must decide on the level of dividends to pay out.
In a similar vein to the analysis of capital structure in Chapters 6 and 7,
the fundamental question we wish to answer is: what dividend policy is
optimal for management in that its adoption results in maximum
firm value?
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Chapter 9: Dividend policy
Activity
A firm has current share price of £2.50 and will pay a £0.15 per share dividend
tomorrow. What is the share price immediately after dividend payment?
Consider the cash position of an individual who originally held five shares
in our firm. The value of their shareholding was originally $250. After
the dividend payment, they have cash of $50, and the value of their
shareholding is $200. Hence, the dividend has just altered the composition
of their wealth rather than changing its dollar amount.
What happens if, instead, the firm decides to use the cash it had originally
earmarked for dividend payment for a share repurchase instead? As
mentioned above, the total dividend amount was $20,000. As the
original share price was $50, this implies that the firm can repurchase
$20,000/$50 = 400 shares. As a result, after the share repurchase, there
are 1,600 shares outstanding, and the firm is again worth $80,000 in total.
Therefore, the post-share repurchase share price must be $80,000/1,600
= $50. Note that a share repurchase (at a fair price) does not alter share
prices.
Again, consider the position of our individual who originally owned
five shares. The firm repurchases 400 shares, which is one-fifth of all
equity. Now, assume that one share of this individual’s holding of five
is repurchased. The repurchase thus gives them $50 and, after the
repurchase, their four remaining shares are worth $200 in all. As a result,
in this case also, their $250 invested in equity has been changed into
$50 of cash and $200 still in equity. This is identical to the case where
dividends were paid.
Thus, the individual is indifferent between dividends and share
repurchases. The manner in which the firm chooses to distribute cash does
not matter to them and, as a result, they will not discriminate (in value
terms) between stocks that do and do not pay dividends.
Perhaps the most famous set of results on actual dividend policy was
compiled and presented by John Lintner (1958). Lintner interviewed the
management of a sample of US corporations in order to determine what
lay behind their dividend-setting decisions. His research led to the four
following stylised facts.
1. Managers seem to have a target dividend payout level.
2. This payout level is determined as a proportion of long-run
(i.e. sustainable) earnings of the firm.
3. Managers are more concerned with changes in dividends rather than
the actual level of dividends.
4. Managers prefer not to make dividend changes that might need to
be reversed (e.g. cutting dividends after having raised them in the
previous period).
As the second fact implies, it is not current but long-run earnings
that matter in setting dividends such that dividends can be seen to be
smoothed relative to earnings. These observations led Lintner to develop
the characterisation of dividend behaviour that is given in equation 9.1. It
is a simple partial adjustment model:
ΔDt = λ(αEPSt – Dt–1 ), 0 < α < 1, 0 < λ < 1 (9.1)
where Dt is the time t dividend per share, EPSt is earnings per share at t, α
is the target payout ratio, and λ is the parameter governing the degree of
dividend smoothing. In line with facts 1 and 2, equation 9.1 embodies a
target payout, which is a simple proportion of earnings. Also, the change
in dividends appears on the left-hand side of 9.1 in line with fact 3.
Note that, if λ was equal to one, then the dividend change at time t would
always ensure that dividends were at precisely their target level (i.e. we
would have Dt = α EPSt ). However, for values of λ less than one, dividends
change towards their target level gradually. This reflects the smoothing of
dividends that Lintner’s stylised facts indicate.
The other major source of empirical observations on the effects of dividend
policy has been the event study literature, which has also emphasised the
vast importance of changes in dividends.1 A wide range of studies for 1
The event study
equity from many different countries has demonstrated that dividend cuts was introduced in
lead to drops in stock price on average, whereas dividend increases on Chapter 5 as the basic
testing methodology for
average lead to stock price rises.2 The interested reader can consult Healy
semi-strong-form market
and Palepu (1988), among other writers. efficiency.
Clearly then, putting together the empirical evidence from interviews and 2
No change in dividends
event studies yields an impressive case for the relevance of dividend policy. is (as one might expect)
The results of Lintner (1956) indicate that corporate managers do not associated with little or
perceive dividend policy as irrelevant. Rather, they seem to follow similar no effect on stock prices
plans in their payout policy. Further, the event study evidence tells us that on average.
130
Chapter 9: Dividend policy
Payout policy
High Medium Low
Dividend 100 50 0
Capital gain 0 50 100
After tax payoffs
Individuals 50 60 80
Corporations 90 77.5 65
Institutions 100 100 100
Equilibrium price 1,000 1,000 1,000
Table 9.1
Clearly, given the after-tax payoffs to each group, individuals will hold low
payout stocks, corporations will hold high payout stocks, and institutions
are indifferent. Assume that in equilibrium the total holdings of each
group are as given in Table 9.2.
Payout policy
High Medium Low
Individuals 0 0 320
Corporations 110m 0 0
Institutions 500m 730m 220m
Total 610m 730m 540m
Table 9.2
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92 Corporate finance
Note that in Table 9.1 we displayed the equilibrium price of each equity
share as 1,000. Why is this the case? To see this, assume that the price of
low payout stock is 1,050, whereas the price of all other stock is 1,000.
This would imply that high and medium dividend level firms have an
incentive to switch to low dividend policies (to take advantage of the high
share prices). Such actions would increase the supply of low dividend
stocks and hence depress their price.
A reinforcing effect comes from the demand side. The return that
individuals get from holding low payout stock is 80/1,050 = 7.62%.
This exceeds the returns they would gain from holding medium and high
payout stocks (which are 6.5 per cent and 5 per cent respectively), and
hence individuals continue to demand low dividend stocks. Institutions, on
the other hand, only get a return of 9.52 per cent from holding low payout
stock (100/1,050 = 9.52 per cent), whereas they get a return of 10 per
cent on other types of equity. Thus, institutions rationally sell their low
dividend equity. This further depresses the price. It is only when the price
of low dividend stock is 1,000 that equilibrium is reached.
The clientele model leads to the same main result as MM. Firm values (or
stock prices) are unaffected by dividend policy. There are obviously
underlying differences to these theories though. For example, the clientele
theory implies that investors in high tax brackets should hold portfolios
with low dividend yields and vice versa.4 4
The dividend yield on
a stock is the ratio of
dividend payment to
Asymmetric information and dividends stock price. Evidence for
this prediction is given
A popular version of the asymmetric information story for the relevance in Blume, Crockett and
of dividends is very similar to the reasoning underlying the relevance Friend (1974).
of capital structure in Ross (1977). This model argued that debt policy
was relevant as, in a world where firm quality was not observable to the
market, the level of debt chosen by a firm’s management signalled the
quality of the firm. High-quality firms would choose high debt levels (as
they could afford the interest payments without running into cash-flow
problems), whereas poor firms would choose low levels of debt. Hence,
debt acted as an observable signal of firm quality upon which the market
would base its valuation of a firm.
Exactly the same type of logic can be applied to dividend policy. If we
again assume that corporate managers’ objective function is increasing in
expected firm value but decreasing in expected bankruptcy costs then, in
a world where firm quality is not observable to outsiders, dividend policy
can be used as a signal. High-quality firms (i.e. firms with large average
cash flows) can afford to pay large dividends, as they worry less about
bankruptcy than low-quality firms. The latter pay low dividends to avoid
bankruptcy. Interpretation of such signals by investors means that firms
paying high dividends are valued more highly in the market than those
paying low amounts.
In empirical terms, the prior argument would then imply a positive
relationship between dividend levels and firm value. Further, we might
also expect that cuts in dividends would result in share price reductions,
as this might be interpreted as a signal of reductions in a firm’s quality.
Conversely, dividend increases should correlate with share price rises. Such
empirical predictions fit quite nicely with those empirical results discussed
earlier in the chapter.
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Chapter 9: Dividend policy
Summary
We started this chapter by arguing that, like capital structure, dividend
policy should not affect firm value. Subsequent to this, however, we
pointed out several sources of real world imperfection that might lead to
optimal dividend policies (in the sense of firm value maximisation). Such
imperfections included taxation, information asymmetries and agency
costs.
We also explored some of the empirical results on dividend policy.
Empirical evidence shows that equity prices tend to rise after unexpected
dividend increases and fall after unexpected dividend cuts (with bond
prices following a similar pattern). This, we argued, seemed most
supportive of dividend models based on asymmetric information.
The dividend puzzle is far from resolved, however. Much research
work remains to be done in the area to clarify our understanding of the
fundamental determinants of corporate dividend policy. Lintner’s stylised
facts and results from event studies have given us a good empirical basis
upon which to construct realistic theories of dividend behaviour, and it is
precisely this task that currently confronts finance theorists.
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92 Corporate finance
Key terms
agency costs
asymmetric information
capital structure
clientele model
dividend policy
frictionless markets
Lintner’s stylised facts
Modigliani–Miller irrelevance theorem
personal taxes
share repurchases
target dividend payout level
taxes on capital gains
taxes on dividends
134
Chapter 10: Mergers and takeovers
Learning outcomes
By the end of this chapter, and having completed the Essential reading,
you should be able to:
• discuss motivations for merger activity
• analyse simple numerical examples of efficient takeover activity
• detail the argument of Grossman–Hart (1980) regarding the
impossibility of efficient takeovers
• present ways in which this analysis can be modefied to permit
takeovers to occur.
Essential reading
Hillier, D., M. Grinblatt and S. Titman Financial Markets and Corporate Strategy.
(Boston, Mass.; London: Macmillan, 2008) Chapter 20 (Mergers and
Acquisitions).
Further reading
Bradley, M., A. Desai and E. Kim ‘Synergistic gains from corporate acquisitions
and their division between the stockholders of target and acquiring firms’,
Journal of Financial Economics 21(1) 1988, pp.3–40.
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass.; London: McGraw-Hill, 2008) Chapter 32 (Mergers).
Copeland, T. and J. Weston Financial Theory and Corporate Policy.
(Reading, Mass.; Wokingham: Addison-Wesley, 2004) Chapter 18.
Grossman, S. and O. Hart ‘Takeover bids, the free-rider problem and the theory
of the corporation’, Bell Journal of Economics 11(1) 1980, pp.42–64.
Healy, P., K. Palepu and R. Ruback ‘Does corporate performance improve after
mergers?’, Journal of Financial Economics 31(2) 1992, pp.135–76.
Jarrell, G., J. Brickley and J. Netter ‘The market for corporate control: the
empirical evidence since 1980’, Journal of Economic Perspectives 2(1) 1988,
pp.49–68.
Jarrell, G. and A. Poulsen ‘Returns to acquiring firms in tender offers: evidence
from three decades’, Financial Management 18(3) 1989, pp.12–19.
Jensen, M. ‘Agency costs of free cash flow, corporate finance, and takeovers’,
American Economic Review 76(2) 1986, pp.323–29.
Jensen, M. and W. Meckling ‘Theory of the firm: managerial behaviour, agency
costs and capital structure’, Journal of Financial Economics 3(4) 1976,
pp.305–60.
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92 Corporate finance
Jensen, M. and R. Ruback ‘The market for corporate control: the scientific
evidence’, Journal of Financial Economics 11(1–4) 1983, pp.5–50.
Myers, S. and N. Majluf ‘Corporate financing and investment decisions when
firms have information that investors do not have’, Journal of Financial
Economics 13(2) 1984, pp.187–221.
Ravenscraft, D. and F. Scherer Mergers, selloffs, and economic efficiency.
(Washington D.C.: Brookings Institution, 1987).
Shleifer, A. and R. Vishny ‘Large shareholders and corporate control,’
Journal of Political Economy 94(3) 1986, pp.461–88.
Shleifer, A. and R. Vishny ‘Managerial entrenchment: The case of management-
specific investment’, Journal of Financial Economics 25 1989, pp.123–39.
Travlos, N. ‘Corporate takeover bids, methods of payment, and bidding firms’
stock returns’, Journal of Finance 42(4) 1987, pp.943–63.
Overview
The post-Second World War period has seen an unprecedented amount
of corporate activity resulting in the combination of two or more firms
under a single corporate banner and legal status. Such activity comes in
many forms and is initiated for varying reasons. This chapter gives an
introduction to the concepts underlying merger/takeover/acquisition
activity and provides a basic review of the theory of takeover activity, and
supplies empirical evidence on returns to takeovers.
In line with the arguments presented throughout this guide, we argue
that merger activity should be judged in terms of the value it delivers.
Mergers should be undertaken if they are positive NPV transactions. A
mathematical way of stating this is that:
VXY > VX + VY, (10.1)
that is, the value of the merged firm created from firms X and Y (VXY)
exceeds the sum of pre-merger values of X and Y (i.e. VX + VY). Such value
may come about through the exploitation of scale economies or elimination
of inefficiencies. We will give a classification of merger and acquisition
behaviour based on the source of value in the following section.
Merger motivations
Following Hillier, Grinblatt and Titman (2008), we will split merger and
takeover activity into three distinct sub-groups:
• financial activity
• strategic activity
• conglomerate activity.
1. Financial mergers: these are takeovers or acquisitions that are
initiated to take advantage of corporate inefficiencies that lead to the
under-valuation of firms. This allows an acquiring firm to buy assets
cheaply, implement strategies that increase the value of the acquired
firm and then sell on the acquired assets at a profit (if so desired).
Such activity yields a positive NPV. Opportunities for financial mergers
1
This is because, if
a takeover occurs,
are likely to come about due to managers of acquired firms following
incumbent management
their own, rather than shareholders’, goals and hence not maximising are likely to lose their
firm value. In this way, the market for corporate control is said to exert jobs. Hence, assuming
discipline on a firm’s management.1 The merger wave of the 1980s may management would prefer
be thought of as largely comprised of such activity. An active market to retain their jobs, the
possibility of takeover
for corporate control (in the form of hostile takeovers) is therefore an
limits managerial scope for
important force that mitigates the problems arising from the separation inefficiency.
of ownership and control in modern corporations.
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Chapter 10: Mergers and takeovers
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92 Corporate finance
Note that, quite obviously, the sum of the gains to X and Y shareholders is
the total value creation of $3m.
Another way in which this merger could have been financed is if firm Y
offered to issue a certain amount of new shares and gave these to the
shareholders of firm X instead of cash. Consider the following offer as an
example. One new share in firm Y is exchanged for every four existing firm
X shares. Note that this freshly issued equity will be a claim on the value of
the merged enterprise and hence priced as such.
The value of the merged firm will be the sum of the pre-merger values of X
and Y plus the value created of $3m. The pre-merger value of X is $2m
and that of Y is $5m. Hence the total value of the firm after the merger is
$10m. After the merger there are 0.75m shares in issue. This comprises
the original 0.5m shares in firm Y plus the 250,000 new shares issued.5 5
One new share was
Hence the share price of the merged enterprise is: offered for every four old
X shares. As there were
$ originally one million X
. (10.2) shares outstanding, this
implies 250,000 new Y
The original shareholders of Y hold two-thirds of the equity of the merged shares must be issued.
enterprise, which has a value $6.67m. The value of their original position
is $5m and hence they gain to the tune of $1.67m. The old X shareholders
own one-third of the equity of the merged enterprise, which is worth
$3.33m. Their gain is hence $1.33m, as the value of firm X pre-merger
was $2m. Both sets of shareholders are winners therefore, and hence the
merger goes ahead. Again, note that the sum of the gains is $3m, the total
value created.
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Chapter 10: Mergers and takeovers
Dilution
Grossman and Hart (1980) first pointed out the free-riding problem we
discussed in the preceding section. In the same paper they also indicated a
solution to the free-riding problem. This solution was dilution.
Dilution is the ability of a raider to extract value from the target, if they
successfully complete the takeover. This might be done by placing themself
in charge and paying themself an astronomical salary, selling the firm’s
output to another corporation they own at a very low price, and other
diverse means. Hence, if the takeover is successful and the raider dilutes
the firm, the firm’s market value ends up being less than y + z (to use the
notation of the previous section).
To make the prior argument concrete, assume the raider can appropriate
an amount of firm value if the takeover is successful. Hence, if
shareholders believe the bid will be successful, they will be willing to
tender their shares if offered a premium (over current value) that satisfies
the following condition:
p > z – . (10.8)
The raider makes money if equation 10.4 holds, and this leads to the
following condition for profitable takeover activity to occur:
z – c > p > z – | > c. (10.9)
The interpretation of equation 10.9 is simple – takeovers can be
profitable if the amount the raider can grab through dilution exceeds the
administrative cost of takeover. Note also that, once they gain control,
the raider need not actually dilute the firm. Merely the threat of dilution
allows the takeover to proceed.
A final issue about dilution that should be addressed is the source of the
raider’s ability to dilute. Grossman and Hart assume that the target firm is
originally a private enterprise. The original owners of the firm then decide
to take the firm public and write provisions that allow dilution into the
corporate charter. These individuals do this in order to ensure that the firm
is efficiently run in future years (i.e. they write in dilution provisions to
allow efficient future takeover activity).
Empirical evidence
Are mergers and acquisitions value-enhancing? This section reviews
empirical evidence from two types of studies: accounting and event studies.
The first type, accounting studies, examine financial results
(accounting data) to draw inferences about the underlying economic
impact of mergers and acquisitions. These studies tend to investigate
whether acquirers outperform their non-acquirer peers. Alternatively,
these studies compare the performance of the combined firm following
a merger or an acquisition with the performance obtaining prior to the
transaction. Performance tends to be measured by net income, operating
margin, or return on equity or assets.
The second type, event studies, do not directly measure performance.
Instead, these studies attempt to measure the value created by the merger
or acquisition through abnormal stock returns around the announcement
date of a tender offer. Hence, event studies rely on financial markets being
efficient.
Accounting studies
The empirical evidence from accounting studies is mixed. Ravenscraft and
Scherer (1987) investigate more than 5,000 mergers occurring between
1950 and 1975, calculate and compare the post-merger performance of
acquiring firms with that of non-acquiring firms in the same industries,
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92 Corporate finance
Event studies
Empirical evidence from event studies suggests that shareholders from
target firms gain from takeovers. This should not come as a surprise as
target shareholders require a premium in order to induce them to sell
their shares to the acquiring firm. Jensen and Ruback (1983) report
that target share prices increase, on average, by about 16 to 30 per
cent around the date of the announcement of a tender offer. Empirical
evidence reported by Jarrell, Brickley and Netter (1988) suggests that
these returns increased substantially during the 1980s to an average of
about 53 per cent. Jensen and Ruback (1983) furthermore report that the
average return to shareholders from target firms in negotiated mergers is,
however, only about 10 per cent.
The empirical evidence from event studies on returns to shareholders of
bidding firms tends to be quite mixed: returns to bidders are, on average,
small, time-varying, but may be positive or negative. For instance, Jarrell
and Poulsen (1989) show that the announcement return to bidder in
tender offers dropped from a statistically significant 5 per cent gain in
the 1960s to an insignificant 1 per cent loss in the 1980s. The means of
payment used for the transaction is furthermore shown to have a major
effect on returns to bidders. For instance, Travlos (1987) finds that the
average return on the two days around the announcement of a cash offer
is only marginally different from zero (+0.24 per cent). In contrast, in
acquisitions financed by an exchange of equity, stock prices of bidding
firms fall, on average, by about 1.5 per cent. The means of payment may
hence act as a signal for the quality of the bidder. Consistent with the
pecking order theory reviewed in Chapter 7 (Myers and Majluf (1984)),
bidders offer stock when they believe that their stock is overvalued. A
stock offer may furthermore indicate that the bidder was unable to get any
financial backing from a bank or another financial institution.
Adding the bidder and target returns generates positive returns, implying
that, on average, there is a net gain to shareholders around the time of the
merger or acquisition. For instance, Bradley, Desai and Kim (1988) provide
evidence suggesting that successful tender offers increase the combined
value of the merging firms by an average of 7.4 per cent or $117m (stated
in 1984 dollars). The empirical evidence from event studies hence suggests
that mergers and acquisitions are, on average, value enhancing.
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Chapter 10: Mergers and takeovers
Summary
In this chapter we have given you an overview of the facts involved in,
and theory surrounding, mergers and takeovers. The main lesson of
this chapter is that mergers that should go ahead (i.e. efficient merger
activity) are those that are positive NPV transactions. See equation 10.1.
Such positive NPV can come from exploitation of economies of scale in
production or sales (strategic mergers), removal of bad management and
elimination of inefficiencies (financial mergers) or possibly through the
purchase of firms in an unrelated industry but with a strong portfolio of
possible investment projects (conglomerate mergers).
We discussed theoretical models indicating that such efficient merger
activity may be blocked in economies without frictions or information
asymmetries. The source of problems here is shareholder free riding.
The prevention of profitable takeovers by free riding is shown to
disappear when allowances are made for dilution, large shareholders and
asymmetric information.
Towards the end of the chapter, we investigate whether mergers and
acquisitions are value-enhancing. Empirical evidence from event studies
suggests that mergers and acquisitions create, on average, joint value.
Most of the value created is, however, appropriated by the shareholders of
target firms.
Key terms
asymmetric information
bidders
capital structure
clientele model
conglomerate mergers
corporate governance
dilution
disciplinary takeover
efficient takeovers
event studies
financial mergers
free-riding
frictionless markets
Grossman–Hart model
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92 Corporate finance
large shareholders
mergers and acquisitions
strategic mergers
targets
takeover premium
toehold
This short appendix gives some formulae that will allow you to compute
the present value of certain types of income stream quickly and easily.
The mathematics behind these formulas is based upon the summation
of convergent geometric progressions, a topic that should be treated in
any basic mathematics text. Throughout our examples we will think of
cash flows as being received on an annual basis (but this is obviously not
critical).
Perpetuities
A perpetuity is an income stream that promises us a payment of a fixed
amount, X, at the end of every year from now until the end of time. Hence,
the income stream is perpetual. Assuming that the appropriate positive
rate for discounting this income stream is r, then the present value of the
income from the perpetuity is given by:
A1
where the sum extends out forever. The summation in A1 is a very simple
progression and has a straightforward closed-form solution, which is:
X
A2 PVP = –r
(i.e. the present value of the income stream associated with a perpetuity is
just the ratio of the fixed payment to the interest rate).
Activity
Calculate the present value of a perpetuity stream that promises a cash payment of
$15,000 per year, assuming that the annual interest rate is 8 per cent.
Growing perpetuities
The preceding example can be generalised to permit the annual cash
payment to grow at a fixed percentage rate. Again, denote the first cash
payment by X, and let g be the annual growth rate of the payment. We
assume that the growth rate of the payment is less than the interest rate, r.
Then the present value of the perpetuity income stream can be written:
A3
A4
Activity
Calculate the present value of a perpetuity stream that promises an initial cash payment of
$15,000 and growth of 5 per cent. Assume that the annual interest rate is 8 per cent.
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92 Corporate finance
Annuities
The two income streams above are assumed to be infinite in nature.
Quite clearly, however, it is very important to be able to value projects/
assets which have finite lifetimes (in terms of years). An annuity is such
an income stream and promises fixed annual cash payments for the next
T years only. Hence, one can think of an annuity as a kind of truncated
perpetuity (as the perpetuity would go on paying annual cash flows after
the annuity had expired). The present value of an annuity paying £K per
year for the next T years is:
A5
where the interest rate is again denoted r. The term in square brackets in
A5 is known as the annuity factor, and tables of such factors (for various T
and r) are widely available.
The derivation of A5 can be performed using the formula for the present
value of a perpetuity. An annuity can be thought of as the cash-flow
difference between a perpetuity with cash flows beginning in one year and
a perpetuity with cash flows beginning in T+1 years. The present value
of the first stream is just K/r from equation A2. The value of the second
perpetuity is K/r at time T, which yields a present value of K/[r(1+r)T].
Taking the difference between the two present values yields the expression
in A5.
Activity
What is the present value of a 15-year annuity promising an annual payment of
£250,000 assuming that the interest rate is 10 per cent? What is the future value of this
annuity at a 15-year horizon? (Hint: the factor which should be used to calculate the
future value is just (1+r)T.)
146
Appendix 2: Sample examination paper
Section A
Answer one question from this section and not more than a further
two questions. You are reminded that four questions in total are to be
attempted with at least one from Section B.
1. a. Derive and explain the Fisher separation result, which implies
that firm owners can delegate choice of investment projects to firm
managers. (10 marks)
b. Using the Fisher separation analysis, justify the use of the net
present value rule as a project evaluation criterion. (10 marks)
c. Show how the Fisher separation result breaks down in a world
in which capital markets are not perfect in that the interest rate
charged on borrowed funds exceeds the rate paid on loaned
monies. (5 marks)
2. a. Stock X has an expected return of 6 per cent and a return variance
of 36 per cent. Stock Y has expected return 12 per cent and return
variance of 81 per cent. An investor forms a portfolio of these two
stocks, placing one-third of his wealth in stock X and the remainder
in stock Y. Showing all of the steps in your calculations, compute
the expected return and return standard deviation of this portfolio,
assuming that returns on the two stocks are perfectly correlated.
Graph the points representing the portfolio and the two stocks in
mean–standard deviation space. (8 marks)
b. Assume now that the returns on stocks X and Y are uncorrelated.
Recompute the expected return and return standard deviation
of the investor’s portfolio. Plot the point now represented by the
portfolio on the previously constructed graph. (7 marks)
c. Using the results derived above, discuss the impact of diversification
on the characteristics of investors’ portfolios. Give a mathematical
treatment of the effect of diversification on portfolio variance.
(10 marks)
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92 Corporate finance
Section B
Answer one question from this section and not more than a further
two questions. You are reminded that four questions in total are to be
attempted with at least one from Section A.
5. a. What is the free-rider problem in corporate takeovers? In reality,
how do acquiring firms get around this problem? (15 marks)
b. Describe briefly two takeover defence strategies. Can they ever
benefit shareholders? (10 marks)
6. a. Certain authors have recently found evidence of positive
autocorrelation in short-term stock returns and negative
autocorrelation in longer horizon returns. What are the implications
of these findings for weak-form efficiency? (10 marks)
b. Discuss how one might use information on mutual fund
performance or the predictive accuracy of investment analyst
expectations to evaluate the hypothesis that markets are strong-
form efficient. (7 marks)
c. Is event-study evidence of positive abnormal returns prior to stock
splits consistent with semi-strong form efficiency? How might these
abnormal returns be explained? (8 marks)
148
Appendix 2: Sample examination paper
END OF PAPER
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92 Corporate finance
Notes
150