!1!

Corporate Finance Notes !

Raising'Capital'–'Equity'.................................................................................................................................'4!The'Nature'of'Capital'................................................................................................................................'4!Initial'Public'Offerings'(IPO)'–'The'Process'................................................................................................'4!

Step!1!–!Engage!an!Investment!Banker!........................................................................................................!5!Step!2!–!Roadshow!.......................................................................................................................................!5!Step!3!–!Setting!the!price!&!list!....................................................................................................................!5!

Initial'Public'Offerings'(IPO)'–'Underpricing'..............................................................................................'6!Underpricing!.................................................................................................................................................!6!Explanations!of!Demand!for!Underpricing!...................................................................................................!7!

LongErun'Performance'of'IPO'....................................................................................................................'8!Explanations!of!LongGrun!Underperformance!..............................................................................................!9!

Seasoned'Equity'Offerings'(SEO)'...............................................................................................................'9!Private!Placements!.....................................................................................................................................!10!Rights!Issues!................................................................................................................................................!10!Accelerated!Entitlement!Offers!..................................................................................................................!13!Dividend!Reinvestment!Plans!(DRP)!...........................................................................................................!13!

Regulatory'Environment'.........................................................................................................................'13!Corporations!Act!.........................................................................................................................................!13!Prospectus!..................................................................................................................................................!14!Underwriting!...............................................................................................................................................!14!

Raising'Capital'–'Debt'&'Leasing'..................................................................................................................'15!The'Nature'of'Debt'.................................................................................................................................'15!

Issued!vs!Bank!Debt!....................................................................................................................................!15!Debt!&!Financial!Risk!..................................................................................................................................!15!

Debt'&'Equity'as'Options'........................................................................................................................'17!Leasing'...................................................................................................................................................'19!

Finance!Leases!............................................................................................................................................!19!Financial!Evaluation!of!Leases!....................................................................................................................!20!Setting!Lease!Rentals!..................................................................................................................................!23!Suggested!Advantages!of!Leasing!...............................................................................................................!24!Asset!Characteristics!&!The!Propensity!to!Lease!........................................................................................!25!

Issues'with'WACC'&'Capital'Structure'Policy'...............................................................................................'26!Revision'..................................................................................................................................................'26!Weighted'Average'Cost'of'Capital'(WACC)'..............................................................................................'26!

Treatment!of!Imputation!in!WACC!.............................................................................................................!27!Calculation!of!WACC!...................................................................................................................................!27!WACC!–!Issues!with!Implementation!..........................................................................................................!30!Capital!Structure!.........................................................................................................................................!31!Impact!of!leverage!on!earnings!per!share!..................................................................................................!31!

Modigliani'&'Miller’s'(M&M)'Assumptions'.............................................................................................'32!M&M!Proposition!One!–!Conservation!of!Value!........................................................................................!32!M&M!Proposition!Two!–!Conservation!of!Risk!...........................................................................................!33!

Impact'of'Taxes'on'Capital'Structure'.......................................................................................................'34!Classical!Tax!System!....................................................................................................................................!34!M&M!Proposition!One!with!Taxes!.............................................................................................................!34!Imputation!System’s!impact!on!M&M!........................................................................................................!35!

NonETax'Impacts'on'Capital'Structure'.....................................................................................................'35!The!TradeGoff!Theory!–!Bankruptcy!Costs!..................................................................................................!35!PeckingGOrder!Theory!–!Asymmetric!Information!......................................................................................!36!NonGtax!impacts!on!capital!structure:!........................................................................................................!37!Consequences!of!Agency!Costs!..................................................................................................................!39!

!2!

Payout'Policy'...............................................................................................................................................'40!Dividends'................................................................................................................................................'40!

Key!dates!....................................................................................................................................................!40!Dividend!DropGOff!.......................................................................................................................................!41!M&M!Dividend!Irrelevance!Theory!............................................................................................................!42!

Factors'Affecting'the'Payment'of'Dividends'............................................................................................'43!Resolution!of!uncertainty!...........................................................................................................................!43!Shareholders!preference!for!current!income!.............................................................................................!43!Issue!&!transaction!costs!............................................................................................................................!43!Information!content!of!dividends!&!information!asymmetry!....................................................................!44!Agency!Problems!........................................................................................................................................!44!Taxation!–!Dividends!...................................................................................................................................!45!Taxation!–!CGT!............................................................................................................................................!46!Does!Imputation!Affect!Dividend!Payout!Policy!Preference!......................................................................!47!Taxation!–!Special!Cases!.............................................................................................................................!47!

Share'buybacks'.......................................................................................................................................'48!Share!buybacks!&!taxes!..............................................................................................................................!48!Reasons!for!Share!BuyGback!.......................................................................................................................!50!Empirical!evidence!–!Dividend!vs!Share!BuyGbacks!....................................................................................!50!

Mutually'Exclusive'Projects'with'Different'Lives'..........................................................................................'52!NPV'Analysis'Basics'................................................................................................................................'52!Constant'Chain'of'Replacement'(CCR)'.....................................................................................................'53!

Lowest!Common!Multiple!(LCM)!Technique!..............................................................................................!53!Perpetuity!Technique!.................................................................................................................................!54!LCM!vs!Perpetuity!Technique!.....................................................................................................................!54!Equivalent!Annual!Value!(EAV)!Technique!.................................................................................................!55!

Retirement'vs'Replacement'Decisions'....................................................................................................'55!Retirement!Decisions!..................................................................................................................................!55!Replacement!Decisions!...............................................................................................................................!56!

Alternative'Approach'to'CCR'&'Treatment'of'Inflation'............................................................................'57!

Sensitivity,'BreakEeven'&'Decision'Tree'Analysis'.........................................................................................'58!Sensitivity'Analysis'.................................................................................................................................'58!BreakEEven'Analysis'................................................................................................................................'60!Sensitivity'Simulation'Analysis'................................................................................................................'60!DecisionEtree'Analysis'.............................................................................................................................'61!

Real'Options'................................................................................................................................................'64!Concept'of'Options'.................................................................................................................................'64!NPV'Misuse'............................................................................................................................................'64!Types'of'Real'Options'.............................................................................................................................'64!

Option!to!Invest!(Delay!Investment)!..........................................................................................................!64!Option!to!Expand!........................................................................................................................................!66!Option!to!Abandon!Operations!..................................................................................................................!67!Example!–!Option!to!Abandon!....................................................................................................................!68!

Early'Exercise'of'an'Option'.....................................................................................................................'68!Valuation'of'Real'Options'.......................................................................................................................'69!

DecisionGTree!Analysis!................................................................................................................................!69!Limitations!to!the!decision!tree!approach!..................................................................................................!70!

Value'of'Real'Option'vs'Risk'....................................................................................................................'71!Evidence'on'Real'Options'........................................................................................................................'72!

Anecdotal!Evidence!....................................................................................................................................!72!Empirical!Evidence!......................................................................................................................................!72!

When'Might'Real'Options'be'Important?'................................................................................................'73!

Analysis'of'Takeovers'..................................................................................................................................'74!Types'of'Acquisitions'&'Terminology'......................................................................................................'74!

Types!of!Acquisitions!..................................................................................................................................!74!

!3!

Forms!of!Acquisitions!.................................................................................................................................!74!Methods'of'Payment'..............................................................................................................................'74!Regulation'of'Takeovers'.........................................................................................................................'76!

Important!Regulators!..................................................................................................................................!76!Acquisitions!of!over!20%!............................................................................................................................!76!On!&!Off!Market!Bids!..................................................................................................................................!77!Schemes!of!Arrangement!...........................................................................................................................!77!

Takeover'Defences'..................................................................................................................................'78!Case'Examples'........................................................................................................................................'79!

Case!1!–!No!Synergies!&!Purchase!Price!of!$20M!......................................................................................!79!Case!2!–!$10M!Synergies!&!Purchase!Price!of!$25M!..................................................................................!79!Case!3!–!$10M!Synergies!&!Purchase!Price!of!$35M!..................................................................................!80!

Financial'Evaluation'of'Takeover'.............................................................................................................'80!Possible!Challenges!.....................................................................................................................................!82!

Economic'Rationale'for'Takeovers'..........................................................................................................'82!Valid!Reasons!for!Takeovers!.......................................................................................................................!82!Questionable!Reasons!for!Takeovers!.........................................................................................................!84!

Empirical'Evidence'..................................................................................................................................'85!Why!do!managers!do!it?!.............................................................................................................................!86!Where!are!the!synergies?!...........................................................................................................................!86!To!Diversify!or!not?!.....................................................................................................................................!86!What!are!the!Wealth!Effects?!.....................................................................................................................!87!

Corporate'Restructuring'..............................................................................................................................'89!Corporate'Restructuring'.........................................................................................................................'89!

Why!Restructure?!.......................................................................................................................................!89!Diversification'Discount'..........................................................................................................................'90!

Limitations!of!Diversified!Firm!....................................................................................................................!90!Benefits!of!Diversification!...........................................................................................................................!90!

Types'of'Restructuring'............................................................................................................................'91!Divestitures!.................................................................................................................................................!91!SpinGoffs!......................................................................................................................................................!91!Equity!CarveGouts!........................................................................................................................................!92!Leverage!BuyGouts!......................................................................................................................................!92!

Empirical'Evidence'..................................................................................................................................'93!

Risk'Management'.......................................................................................................................................'94!The'Concept'of'Risk'................................................................................................................................'94!Hedging'..................................................................................................................................................'95!

Probability!of!Distress!.................................................................................................................................!95!Costs!of!Financing!.......................................................................................................................................!96!Managerial!SelfGInterest!.............................................................................................................................!96!NonGlinear!Taxes!.........................................................................................................................................!97!

Risk'Management'Methods'....................................................................................................................'97!Hedging!Using!Derivatives!..........................................................................................................................!98!Natural!Hedges!.........................................................................................................................................!100!Value!at!Risk!(VaR)!....................................................................................................................................!100!

!! !

!4!

Raising'Capital'–'Equity''

The!Nature!of!Capital!!!The!basic!resource!of!a!company!is!the!stream'of'future'cashflows'generated!by!its!assets.!!

G! Companies!raise!external!capital!by!issuing!financial!securities!–!claims!over!these!cashflows!(note:!not!about!profit)!

G! A!financial!security!evidences!the!rights!&!obligations!of!both!the!issuer!&!investor!!!Time'value'is!made!up!of:!

G! Risk!!o! Total!Risk!(total!variability!!!G!try!to!reduce!this!average!weighed!risk)!!o! Market!Risk!(covariance!risk!–!risk!that!cannot!be!minimalized)!!

G! Opportunity!Cost!!G! Inflation!!

!!Equity'characteristics:'

G! Permanent!contribution!of!capital!–!assumed!to!have!infinite!life!(ongoing'concern)!!G! There!are!many!different!forms!of!equity!–!the!most!common!being!ordinary!shares!

o! Ordinary!shareholders!having!full!voting!rights!(paid!dividend!last)!G! Shareholders!hold!a!residual!claim:!

o! Subordinated!right!to!a!return!on!capital!o! Subordinated!right!to!a!return!of!capital!on!liquidation!!

G! Most!risky!form!of!investment!o! Higher!risk!=!higher!rate!of!return!required!o! Assumes!investors/companies!are!risk!averse!–!demands!compensation!for!

the!exposed!risk!!! Prefers!lower!returns!with!known!risks!rather!than!higher!returns!

with!unknown!risks!!!! Among!various!investments,!giving!the!same!return!with!different!

level!of!risks,!risk!averse!investors!will!prefer!alternative!with!least!interest!!

!! Note!riskEseeking'investors'are!those!willing!to!give!up!return!for!risk!!!Initial!Public!Offerings!(IPO)!–!The!Process!!!Many!companies!choose!to!float'via!an!Initial!Public!Offering!(IPO)!due!to!various!reasons:!!

G! To!create!public!shares!for!use!in!future!acquisitions!G! To!establish!a!market!price/value!for!our!firm!!G! To!enhance!the!reputation!of!the!company!G! To!broaden!the!base!of!ownership!G! To!allow!one!or!more!principals!to!diversify!personal!holdings!G! To!minimise!our!cost!of!capital!G! To!allow!VCs!to!cash!out!G! To!attract!analysts’!attention!!

!5!

Step'1'–'Engage'an'Investment'Banker''!The!investment!banker!will!manage!the!float!process,!helping!to!prepare!the!prospectus!as!well!as!providing!services!such!as!underwriting:!'Prospectus'–!legal!document!detailing!the!IPO!that!is!also!used!to!market!the!float''Underwriter'–!for!a!fee,!guarantees!that!all!issued!shares!will!be!sold!&!is!liable!to!purchase!any!shares!that!remain!unsold!at!the!conclusion!of!the!float!!

G! Has!clear!incentive!to!have!the!shares!sold!to!prevent!overhand'where!supply!pressure!makes!share!price!drop!'

G! Will!often!conduct!a!market'roadshow'for!potential!investors!''A!firm!decides!on!its!subscription/issue!price!either!via:!

1.! Fixed'pricing'–'traditional'method'o! Price!is!set!–!prospectus!is!sent!out!&!offers!are!received!o! There!are!risks!to!this!approach!–!if!the!subscription!price!is!set:!

!! Too!high!–!market!will!not!subscribe!to!the!shares!hence!float!will!be!a!failure!

!! Too!low!–!original!owners!of!firm!will!have!suffered!an!opportunity!cost!in!that!the!shares!could!have!been!sold!at!a!higher!price!!!

2.! Bookbuilding'''o! Competitive!bidding!by!institutional!investors!–!takes!select!group!of!

institutions!to!set!nonGbinding!price!&!qty!which!gauges!demand!&!helps!price!the!share!!

o! Results!in!more!narrow/certain!outcomes!than!fixed!pricing!method!!!Step'2'–'Roadshow''!The!bankers!will!hit!the!streets!to!market!the!float!&!attempt!to!gauge!investor!interest!–!common!to!elicit!nonGbinding!orders!from!institutional!investors!via!bookbuilding.!!Example'–!In!Early!Sep!2014,!Alibaba!filed!a!statement!with!the!regulators!indicating!that!they!expect!the!subscription!price!to!be!somewhere!between!$60!G!$66!per!share.!!!Step'3'–'Setting'the'price'&'list'''!The!subscription!price!is!set!which!determines!the!price!to!be!paid!by!those!who!have!subscribed!to!the!issue.!!The!shares!are!first!issued!in!the!primary'market!–!the!funds!that!are!received!by!the!issuing!firm!&!goes!to!the!company!itself!(e.g.!Alibaba)!!The!firm’s!shares!then!start!trading!on!the!stock!exchange!which!is!the!secondary'market'–!the!funds!paid!by!buyers!of!the!shares!don’t!go!to!the!firm!but!to!the!share!seller.!!

G! Trading!is!determined!by!interaction!of!demand!&!supply!G! A!trade!only!takes!place!when!the!buyer!&!seller!agree!as!to!price!

!6!

Initial!Public!Offerings!(IPO)!–!Underpricing!!'Underpricing'''Example'–!On!18!Sep!2014,!Alibaba!announces!a!subscription!price!of!$68/share!&!on!19!Sep!2014,!shares!begin!trading!on!NASDAQ!&!closed!at!a!price!of!$93.89!–!implying!a!return!of!38%!to!IPO!subscribers!who!immediately!sold!on!market.!That’s!$8.3bn!potentially!left'on'the'table''Alibaba’s!share!prices!one!month!postGlisting!show!that!the!share!price!of!the!IPO!was!underpriced'–!the!set!subscription!price!for!an!IPO!is!below!the!true!value!of!the!shares:!!

!!!!

''''''''''''''IPO'underpricing:''

'!!!!!

The!economic!consequence!of!underpricing!is!significant'for!the!original'owners'of!the!firm:!!!!!!!!!!!

•! Proceeds!weighted!(18.5%)!=!$155.16bn/$840.12bn!!This!is!not'to'say!that!all!IPOS!are!good'investments:''

!7!

Explanations'of'Demand'for'Underpricing''!

1.! Information'asymmetry'(Winner’s'Curse)'!Imagine!that!investors!come!in!two!categories:!

G! Informed'investors'–!able!to!judge!whether!an!IPO!is!over/under!priced!G! Uninformed'investors'–!not!able!to!judge!the!true!value!of!an!IPO!

!As!each!IPO!comes!to!the!market,!the!uninformed!will!bid!for!overpriced!IPOs!&!the!informed!will!succeed!in!getting!shares!in!underpriced!IPOs!–!natural'bias'for'uninformed'to'leave'the'market.'''To!ensure!the!uninformed!investors!stay!in!the!market,!IPOs!need!to!on!average!be!significantly!underpriced!since!needs!to!have!enough!funds!in!the!market!to!fund!all!IPOs.!This!assumes!the!market!is!in!equilibrium!which!assumes!capital!constraints!on!informed!investors.!!'

2.! Market'Feedback'Hypothesis'''An!issuer!may!be!uncertain!as!to!the!true!value!of!the!firm!–!an!initial!bookGbuilding!process!offers!the!issuer!an!opportunity!to!find!out!from!the!market!the!true!value.!To!induce'institutional'investors!to!reveal!this!information,!the!issuer!must!underprice!the!issue!!''''!!!

3.! Market'Bandwagon'(Cascade'Hypothesis)'''

Investors!are!more!likely!to!subscribe!to!a!float!that!they!perceive!as!popular!with!other!investors.!!!This!explanation!assumes!that!shares!are!sold'in'trenches:'

G! In!order!to!induce!the!first!wave!of!popularity,!issuers!first!underprice!the!issue!to!set!up!demand!so!that!investors!are!more!likely!to!jump!on!the!bandwagon!

G! This!may!result!in!positivelyGsloped!demand!curves!&!hence!subscription!prices!at!the!2nd!trench!&!so!on!will!continue!to!increase!

!4.! Investment'Banker'Monopsony'Power''

'As!investment!bank/underwriter!advices!on!the!subscription!price,!there!is!potential!conflict!for!at!least!two!reasons:!

G! Underpricing!can!reduce!their!own!costs!"takes!less!effort!to!market!cheaper!share!G! IPO'spinning:'Underpricing!can!be!used!(unethically)!to!develop!relationships!with!

other!potential!clients!&!is!illegal!in!many!jurisdictions!!

!8!

5.! Lawsuit'Avoidance'&'Implicit'Insurance''!The!prospectus!is!partly!a!market!document!–!there!is!a!chance!that!some!forecasts!may!be!a!little!biased:!

G! Underpricing!ensures!that!subscribers!enjoy!a!gain!from!the!investment!"!if!everyone!is!happy,!management!won’t!be!sued!!

G! Management!have!essentially!purchased!implicit'insurance'"!paid!by!the!existing!shareholders!who!have!‘left!money!on!the!table’!for!new!shareholders!!

!6.! Signalling'as'part'of'a'long'term'strategy''

'As!the!CEO,!you!know!that!the!IPO!is!only!the!next!stage!in!a!multiGstage!strategy!for!expansion!–!you!know!that!in!the!future!you!will!have!to!go!back!to!the!market!to!raise!more!capital.!Hence,!you!can!‘hit’!them!in!the!future!by!underpricing!this!time!!!!

7.! Ownership'Dispersion'''There!exists!an!agency'problem'between!managers!&!owners!of!the!company!–!more!dispersed!ownership!makes!it!harder!for!shareholders!to!get!together!&!kick!managers!from!their!job!(job'entrenchment)'!!It!is!also!better!for!shareholders!since!there!is!greater'liquidity'–!shares!are!easier!to!sell!&!hence!smaller!transaction!costs!(spread)!involved!!!Note:'Oversubscription'='scaling!back!(shareholders!receive!less!shares!than!subscribed!=!less!power)!!!!!!

!Long>run!Performance!of!IPO!!

G! Market'adjusted'return'"!how!IPO!company!performs!after!3!years!relative!to!the!general!market!(assumes!beta!=!1)!!

G! StyleEadjusted'"!adjusted!for!risks!!

!9!

Explanations'of'LongErun'Underperformance''!

1.! Divergence'of'opinion'hypothesis'''The!market!for!IPO!consists!of!both!optimistic!&!pessimistic!investors.!Successful!IPO!subscribers!are!naturally!optimistic!however!overtime,!this!optimism!adjusts'(reverts!to!mean)!resulting!in!a!fall!in!share!price!!!

2.! Impresario'hypothesis'''

Investment!bankers!may!attempt!to!create!the!appearance!of!excess!demand!by!initially!underpricing!the!IPOs!–!investors!are!initially!taken!in!by!this!but!as!efforts!are!withdrawn,!we!would!expect!to!subsequently!see!a!fall!in!share!price!!!

3.! Windows'of'opportunity'hypothesis''!Management!is!able!to!time!the!issue!of!shares!–!management!has!opinion!to!issue!when!the!market!is!in!boom!&!wants!to!hold!more!equity:!

G! Generally,!management!will!take!advantage!of!high!demand!for!IPOs!by!the!market!!G! A!decline!in!demand!for!IPOs!will!be!correlated!with!a!reduction!in!equity!prices!

generally!(financial!cycle)!!Seasoned!Equity!Offerings!(SEO)!!Unseasoned'Equity'Offerings'–'Offering!where!shares!were!not!previously!listed!on!market!(e.g.!IPO)!!Seasoned'Equity'Offerings'–'!Shares!already!exist!in!market!&!additional!shares!are!issued:!

G! Rights!Issues!to!existing!shareholders!!G! General!offers!to!the!public!(similar!to!IPO!but!share!price!can!be!observed!in!market!

as!it!already!exists!in!market)!G! Private!Placements!to!financial!institutions!!

!Firms!differentiate!between!these!alternative!types!of!SEOS!by!considering:!

G! The!costs!associated!!G! Time!to!implement!it!–!are!funds!required!immediately!or!over!the!long!run!G! Potential!transfers!from!old!to!new!shareholders!–!existing!shareholders!may!suffer!

dilution!in!shares!&!change!in!voting!power!!!Example'E'Equity'Issuance'&'Dilution'''You!and!two!friends!are!about!to!drink!your!pint!of!beer!when!lecturer!arrives!with!only!a!glass!of!beer.!You!do!the!right!thing!&!get!new!schooner!glasses!to!redistribute!the!beer!evenly!amongst!the!four!people:!!

!!!!Becomes!!

!10!

Private'Placements''!Example'–'Daffy!Ltd.!has!10!million!shares!on!issue!with!a!current!share!price!of!$10!each.!Daffy!then!raises!$9M!by!placing!1M!shares!at!$9!each!to!a!group!of!financial!institutions.!The!preG!&!postGplacement!capital!structure!of!the!company!is!set!out!below:!!!!!!!!!!The!existing!shareholders!may!agree!to!this!because!the!company!needs!the!capital!to!invest!in!a!positive!NPV!project!that!may!potentially!result!in!a!share!price!far!above!$10.!!!Advantages:''

G! Timeliness!–!can!get!in!together!with!an!institution!investment!in!a!quick!time!!G! Transaction!costs!are!low!–!dealing!with!sophisticated!investor!means!less!regulation!

required!(e.g.!no!prospectus)!&!no!need!for!underwriter!(minimal!risk)!'Disadvantages:'

G! Potential!dilution!in!voting!power!'G! Potential!dilution!in!value!of!the!company!(per!share!value)!–!due!to!the!discount!'

o! Note:!Are!placements!always!undertaken!at!a!discount?!It!depends…discount!to!what?'

'Key'Notes:'

G! Separation!of!ownership!&!control!"!potential!conflict!between!existing!shareholders!&!management!(otherwise,!could!hand!over!control!of!the!firm!without!shareholder!approval)'

G! ASX!Listing!Rule!7.1!prohibits!a!company!from!issuing!more!than!15%!of!its!issued!capital!within!a!given!12Gmonth!period!without!first!obtaining!approval!of!its!shareholders'

o! Exception!to!this!includes!right!issues!&!smallGcap!firms!(to!allow!for!greater!costs)'

'Rights'Issues''!Rights'issue:'

G! An!offer!by!a!company!of!new!shares!to!its!existing!shareholders!at!a!fixed!price!&!on!a!proGrata!basis'

G! Each!shareholder!receives!an!entitlement!to!new!shares!at!a!fixed!proportion!of!the!number!of!shares!already!held!'

G! The!issue/offer!price!is!usually!at!a!10G30%!discount!to!the!share!price!at!the!time!the!issue!is!announced!–!takes!at!least!23!days!to!complete!(for!renounceable!offer)'