CORPORATE FINANCE AND GOVERNANCE -
2025
Inhoud
1. Debt policies...........................................................................................................................................................................2
1.1 Financing a firm with debt and equity.............................................................................................................................2
1.2 The Interest Tax Deduction..............................................................................................................................................5
1.3 Default and Bankruptcy in Perfect Market....................................................................................................................10
1.4 Exploiting debt holders: agency costs of leverage.........................................................................................................13
2. Payout policies......................................................................................................................................................................18
2.1 Dividends versus share repurchases..............................................................................................................................18
2.2 Payout versus retention of cash.....................................................................................................................................24
2.3 Dividend signaling..........................................................................................................................................................26
2.4 Stock dividends and stock splits.....................................................................................................................................29
3. IPO’s......................................................................................................................................................................................30
3.1 Why do firms go public?.................................................................................................................................................31
3.2 Why do companies delist and why are there fewer IPOs?............................................................................................31
3.3 (Under)pricing of initial public offerings........................................................................................................................35
4. Valuation..............................................................................................................................................................................41
4.1 Discounted Free Cash Flow Model.................................................................................................................................41
4.2 Valuation Multiples........................................................................................................................................................52
5. Mergers and acquisitions.....................................................................................................................................................54
5.1 Do M&A create value?...................................................................................................................................................55
5.2 Reasons to acquire.........................................................................................................................................................56
5.3 Other reasons.................................................................................................................................................................59
6. Corporate Governance.........................................................................................................................................................68
6.1 Corporate governance: what and why?.........................................................................................................................68
6.2 Mechanisms to restrict expropriation by management................................................................................................72
6.2.1 Monitors..................................................................................................................................................................72
6.2.2 Executive compensation.........................................................................................................................................73
6.2.3 Legal protection.......................................................................................................................................................75
7. Corporate governance: Separation of ownership and control............................................................................................76
7.1 How?...............................................................................................................................................................................76
7.2 Agency costs...................................................................................................................................................................78
7.3 Private benefits from new acquisitions: Evidence from the Italian stock market.........................................................80
1
, 1. Debt policies
- Modigliani & Miller: debt policy does not matter
- But! Taxes
- But! Financial distress, managerial incentives, information asymmetric
1.1 FINANCING A FIRM WITH DEBT AND EQUITY
Modigliani and Miller (M&M) argued that with “perfect” capital markets, the total value of firm should not depend on
how it is financed
- Investors and firms can trade same set of securities at competitive market prices equal to present value of their
future cash flows
- There are no taxes, transaction costs, or issuance costs associated with security trading
- Firm’s financing decisions do not change cash flows generated by its investments, nor do they reveal new
information about them
Debt is cheaper than equity for firm BUT raises cost of capital for equity
Levered equity has higher risk
levered (50%D, 50%E) higher return on equity
% stdev higher
- To compensate for this risk, more levered equity
holders must receive higher expected return
- Leverage increase risk of equity even when there is no risk that firm will default
o Thus, while debt may be cheaper, its use raises cost of capital for equity
- Leverage will not affect total value of firm!
o Instead, only changes allocation of cash flows between debt and equity, without changing total cash
flows of firm
M&M proposition I: In a perfect capital market, the total value of a firm is equal to the market value of the total cash
flows generated by its assets and is not affected by its choice of capital structure.
Application: leveraged recapitalization
- When firm uses borrowed funds to pay large special dividend or repurchase significant amount outstanding
shares In M&M world, this will not affect value of firm
- Harrison Industries is currently all-equity firm operating in perfect capital market, with 50 million shares
outstanding that trading for $4 per share.
- Harrison plans to increase its leverage by borrowing $80 million and using the funds to repurchase 20 million of
its outstanding shares. This transaction can be viewed in two stages.
o First, Harrison sells debt to raise $80 million in cash.
o Second, Harrison uses the cash to repurchase shares
Sell debt to raise $80 mio cash/issuing debt
repurchase shares
2
, 80mio/4 = 20mio shares repurchased
50 – 20 = 30 OR 120/4 = 30
Change in capital structure (increase leverage) does not affect value for shareholders!
M&M proposition II: total cost of capital is not influenced by capital structure & always equals unlevered cost of capital
(100% equity)
Leverage and equity cost of capital: M&M proposition I states: E + D = U = A
- E: Market value of equity in a levered firm
- D: Market value of debt in a levered firm
- U: Market value of equity in an unlevered firm
- A: Market value of the firm’s assets
The return on unlevered equity (RU) is related to the returns of levered equity (RE) and debt (RD):
solving for RE
Levered equity return equals unlevered return, plus premium due to leverage amount of premium depends
amount of leverage, measured by firm’s market value debt-equity ratio, D/E
(more debt: premium bigger D/E, higher return on equity Re)
M&M proposition II: The cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a
premium that is proportional to the market value debt-equity ratio
Cost of capital of levered equity:
Weighted Average Cost of Capital (WACC)
- If firm is levered, , rA is equal to the firm’s weighted average cost of capital (no taxes!!!)
Levered and Unlevered Betas
3
, - Effect of leverage on risk of firm’s securities can also be expressed in terms of beta:
- Unlevered beta = measure of risk of firm as if it did not have leverage, which equivalent to beta of firm’s assets
(CAPM: only systemic risk (=β) matters)
leverage amplifies the market risk of a firm’s assets , βU , raising the market risk of its equity
risk for shareholders depends on: firm activities (βU) & firm debt policy: debt rises, risk shareholders (β E) rises (D/E)
Be ↑ E/(E+D)↓
Bd ↑ D/(E+D) ↑
Cash and Net Debt
- Holding cash has opposite effect of leverage on risk and return and can be viewed as equivalent to negative debt
(debt: pay a fixed interest & cash: earn fixed interest)
- EV = E + (D – CASH) with (D-CASH) is net debt
βU > βE ➜ very unusual
risk of operations higher than risk of equity because of
negative net debt
(βE = 2,57 + (-16/110)*(2,57-0) = 2,20)
Equity issuances and Dilution
- Eg. Tesla issuing 2 billion of shares: announcement had negative impact on shares, later stock price increased
(Musk bought shares of own company: good signal to market)
Dilution = increase in total of shares that will divide a fixed amount of earnings
- It is sometimes (incorrectly!) argued that issuing equity dilutes existing shareholders’ ownership, so debt
financing should be used instead
(this will lower value per share, in M&M reasoning is wrong: total value will increase as well)
4
2025
Inhoud
1. Debt policies...........................................................................................................................................................................2
1.1 Financing a firm with debt and equity.............................................................................................................................2
1.2 The Interest Tax Deduction..............................................................................................................................................5
1.3 Default and Bankruptcy in Perfect Market....................................................................................................................10
1.4 Exploiting debt holders: agency costs of leverage.........................................................................................................13
2. Payout policies......................................................................................................................................................................18
2.1 Dividends versus share repurchases..............................................................................................................................18
2.2 Payout versus retention of cash.....................................................................................................................................24
2.3 Dividend signaling..........................................................................................................................................................26
2.4 Stock dividends and stock splits.....................................................................................................................................29
3. IPO’s......................................................................................................................................................................................30
3.1 Why do firms go public?.................................................................................................................................................31
3.2 Why do companies delist and why are there fewer IPOs?............................................................................................31
3.3 (Under)pricing of initial public offerings........................................................................................................................35
4. Valuation..............................................................................................................................................................................41
4.1 Discounted Free Cash Flow Model.................................................................................................................................41
4.2 Valuation Multiples........................................................................................................................................................52
5. Mergers and acquisitions.....................................................................................................................................................54
5.1 Do M&A create value?...................................................................................................................................................55
5.2 Reasons to acquire.........................................................................................................................................................56
5.3 Other reasons.................................................................................................................................................................59
6. Corporate Governance.........................................................................................................................................................68
6.1 Corporate governance: what and why?.........................................................................................................................68
6.2 Mechanisms to restrict expropriation by management................................................................................................72
6.2.1 Monitors..................................................................................................................................................................72
6.2.2 Executive compensation.........................................................................................................................................73
6.2.3 Legal protection.......................................................................................................................................................75
7. Corporate governance: Separation of ownership and control............................................................................................76
7.1 How?...............................................................................................................................................................................76
7.2 Agency costs...................................................................................................................................................................78
7.3 Private benefits from new acquisitions: Evidence from the Italian stock market.........................................................80
1
, 1. Debt policies
- Modigliani & Miller: debt policy does not matter
- But! Taxes
- But! Financial distress, managerial incentives, information asymmetric
1.1 FINANCING A FIRM WITH DEBT AND EQUITY
Modigliani and Miller (M&M) argued that with “perfect” capital markets, the total value of firm should not depend on
how it is financed
- Investors and firms can trade same set of securities at competitive market prices equal to present value of their
future cash flows
- There are no taxes, transaction costs, or issuance costs associated with security trading
- Firm’s financing decisions do not change cash flows generated by its investments, nor do they reveal new
information about them
Debt is cheaper than equity for firm BUT raises cost of capital for equity
Levered equity has higher risk
levered (50%D, 50%E) higher return on equity
% stdev higher
- To compensate for this risk, more levered equity
holders must receive higher expected return
- Leverage increase risk of equity even when there is no risk that firm will default
o Thus, while debt may be cheaper, its use raises cost of capital for equity
- Leverage will not affect total value of firm!
o Instead, only changes allocation of cash flows between debt and equity, without changing total cash
flows of firm
M&M proposition I: In a perfect capital market, the total value of a firm is equal to the market value of the total cash
flows generated by its assets and is not affected by its choice of capital structure.
Application: leveraged recapitalization
- When firm uses borrowed funds to pay large special dividend or repurchase significant amount outstanding
shares In M&M world, this will not affect value of firm
- Harrison Industries is currently all-equity firm operating in perfect capital market, with 50 million shares
outstanding that trading for $4 per share.
- Harrison plans to increase its leverage by borrowing $80 million and using the funds to repurchase 20 million of
its outstanding shares. This transaction can be viewed in two stages.
o First, Harrison sells debt to raise $80 million in cash.
o Second, Harrison uses the cash to repurchase shares
Sell debt to raise $80 mio cash/issuing debt
repurchase shares
2
, 80mio/4 = 20mio shares repurchased
50 – 20 = 30 OR 120/4 = 30
Change in capital structure (increase leverage) does not affect value for shareholders!
M&M proposition II: total cost of capital is not influenced by capital structure & always equals unlevered cost of capital
(100% equity)
Leverage and equity cost of capital: M&M proposition I states: E + D = U = A
- E: Market value of equity in a levered firm
- D: Market value of debt in a levered firm
- U: Market value of equity in an unlevered firm
- A: Market value of the firm’s assets
The return on unlevered equity (RU) is related to the returns of levered equity (RE) and debt (RD):
solving for RE
Levered equity return equals unlevered return, plus premium due to leverage amount of premium depends
amount of leverage, measured by firm’s market value debt-equity ratio, D/E
(more debt: premium bigger D/E, higher return on equity Re)
M&M proposition II: The cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a
premium that is proportional to the market value debt-equity ratio
Cost of capital of levered equity:
Weighted Average Cost of Capital (WACC)
- If firm is levered, , rA is equal to the firm’s weighted average cost of capital (no taxes!!!)
Levered and Unlevered Betas
3
, - Effect of leverage on risk of firm’s securities can also be expressed in terms of beta:
- Unlevered beta = measure of risk of firm as if it did not have leverage, which equivalent to beta of firm’s assets
(CAPM: only systemic risk (=β) matters)
leverage amplifies the market risk of a firm’s assets , βU , raising the market risk of its equity
risk for shareholders depends on: firm activities (βU) & firm debt policy: debt rises, risk shareholders (β E) rises (D/E)
Be ↑ E/(E+D)↓
Bd ↑ D/(E+D) ↑
Cash and Net Debt
- Holding cash has opposite effect of leverage on risk and return and can be viewed as equivalent to negative debt
(debt: pay a fixed interest & cash: earn fixed interest)
- EV = E + (D – CASH) with (D-CASH) is net debt
βU > βE ➜ very unusual
risk of operations higher than risk of equity because of
negative net debt
(βE = 2,57 + (-16/110)*(2,57-0) = 2,20)
Equity issuances and Dilution
- Eg. Tesla issuing 2 billion of shares: announcement had negative impact on shares, later stock price increased
(Musk bought shares of own company: good signal to market)
Dilution = increase in total of shares that will divide a fixed amount of earnings
- It is sometimes (incorrectly!) argued that issuing equity dilutes existing shareholders’ ownership, so debt
financing should be used instead
(this will lower value per share, in M&M reasoning is wrong: total value will increase as well)
4
