I. Capital Structure, Accounting and Valuation

Corporate Finance is about capital formation; people putting money together in large pools and putting it to use in enterprises to create more wealth
Sources of Capital
Debt used for leverage purposes
Equity interest would require sharing in the profits
Line of credit may be drawn for working capital
Venture capital – funds available from investment companies that pool the funds of numerous investors and seek out promising businesses in which to make substantial investments

1. Present Day Value of Money: To earn $100 in ten years, that $100 is not worth $100 today, its less

R: Since interest rates are positive – a dollar in the future is always worth less than a dollar today
R: The higher the interest that can be earned on a riskless investment, the lower is the current value of a right to receive a future payment
Seven approaches to valuation
Scrap value – income? liquidation value
One year’s income – future income?
15 years * one year’s income – present value? risk?
Other offers: liquid market/Speculative component/Control premium
Book value – cost? Depreciated asset?
Discounted cash flow
Capitalized earnings
Flaws with some of these approaches
Risk - $100 in 10 years is worth less because it is a risk that the production will not continue to pay out
N: US Treasury bonds is the benchmark for risk allocation of future money
R: Value must be discounted to reflect risk
Opportunity Cost - Value must be discounted for forgoing other investments to enter into this deal

2. P/E Ratio: Price for which a SH would pay for Corporate earnings

Ratio between market price per share and the earnings per share of the publicly held stock for the last available accounting period
Be careful in using P/E: If the P/E ratio is not extremely high and has been reasonably stable over the last few years it is probably a reliable indicator of the appropriate capitalization rate
N: P/E of publicly held corporations reflect investment value of securities and not any premium that represents control of business
Same as inverse of multiplier or capitalization factor
Ex: When P/E is high, the more you are paying for a dollar of earnings
20/1 P/E = 5% Discount Rate
50/1 P/E means that there is an underlying future expectation that it will go up b/c its at 2% now and that there is an extremely low risk, seller would like this P/E

3. Discounted Cash Flow: Discount to the present value of future receipts including salvage value, depending on rate of discount

Use a higher discount rate than the government rate offered on treasury bonds to compensate for risk
Flaw: Easy to discount cash flows when steady, but not so helpful when dealing with large expenses that do not recur
N: Different from earnings based valuation – earnings do not reflect ability of the company to distribute cash to investors
Possible for company to have increasing earnings but not enough cash to pay its bills
N: Discounted cash flow takes into account in flows and out flows when they are to occur in the future
Where an accountant would be making depreciation deductions over the next five years

4. Capitalization of Earnings:takes into account risk and uncertainty; also the opportunity cost (other investments passed on for this investment)

Must know two things to calculate:
Size of payments each year AND
Appropriate discount or interest rate by which the future payments can be discounted to present value
Fxn of Market interest rate of riskless loans AND Risk premium
N: Earnings are what’s left over after depreciation has been deducted; it is not free cash flow

5. Capitalization Rate/Discount Rate/Multiplier

The riskier the business, the higher the discount rate, the smaller the multiplier, and the lower the value place on the cash flow

A. Capitalization Rate/Multiplier

Usually the capitalization rate/multiplier is established from the actual relationships between average earnings and sales prices of similar businesses in the recent past rather than from a Market IR + Risk premium

B. Discount Rate

Interest rate v Discount rate
When speaking of the earning power of a present amount over time, one usually speaks of the interest rate
When going the other way, computing present value of a future payment, one usually speaks of the discount rate
N: It’s the same calculation just in different directions

6. CAPMThe capital asset pricing model is widely used to estimate a company's value. The model is based on:

Risk-free rate of return - Only things above this are worth investing in
Rate of return for the market for securities of similar companies
Other companies in same industry
Company’s beta
measures the variance in the company's stock price relative to the market for securities of similar companies.
Market risk premium - Higher the risk premium the higher return demanded for taking on the risk

A. Formula: E(PR) = RF + Beta * (E(RM)-RF)

E(PR) = return you are demanding; discount rate
RF = risk free rate of return, assume 5%, derived from government treasury obligations
Beta = start at 1 and adjusted for discount rate for market
Firm’s relative volatility of a subject firm’s stock price relative to the movement of the market (market for that stock, something to be argued!!!) generally
If a stock has a beta of 2.0 then on average it swings twice as far as the market
E(RM) = market risk
E(RM)-RF = market risk premium
GR: The model produces an estimated discount rate for the company that, when divided into the company's earnings or cash flow, provides an estimated value for the company.
S: Low discount rate => low risk; Low beta => low risk

B. Risk

Systematic risk – risk of the market for the particular company you are valuating; also called market risk/Beta – captures the reaction of individual stocks
Diversification cannot eliminate systematic risk
Non-systematic risk – risk from investing in the market in general; can be eliminated by modern portfolio theory; this is not what is being compensated for when a risk premium is made
Modern portfolio Theory – to the extent that stocks don’t move in tandem all the time, variations in the returns from any one security will tend to be washed away or smoothed out by complementary variation in the returns from other securities
Beta: CAPM model says that returns (and therefore risk premiums) for any stock will be related to beta, the systematic risk that cannot be diversified away

C. Litigation context - Majority SH’s squeezing out minority SH’s

Minority SH opposed the merger and file an Appraisal claim
Majority argues that the company is worth less than the tender offer price it just made
Minority agues that the company is worth more
Issues to litigate – test the assumptions of the expert!!
What is the risk-free rate of return, what period to look at to determine this, what kind of treasury instruments

D. Technicolor case

F: Second step of two step cash out merger; 17% of target company common stock now owned by acquiror was converted into a right to receive $23. Minority holder dissented from the merger and filed for an appraisal of the stock’s FMV.
Two experts used the discounted cash flow technique and came to very different results
Debt. How is long-term debt incorporated into the valuation process?
The expert using the 10-K had the better figure; expert with unaudited working paper is not as reliable
The minority SH will argue for lower debt so there will be a higher valuation; majority SH argues for higher debt
Debt was deducted from the present value of the sum of projected net cash flows and terminal value
But, what about debt as ongoing expense that reduces earnings?
Cash flow and residual value. The court discusses the experts' projections of cash flow over time. What is its analysis?
Majority SH expert used value growth duration which means a period during which a company’s net returns can be predicted to exceed its cost of capital.
Does not mean there is no value after period is over just mean no value growth
Residual value estimation
Majority expert – capitalized a constant cash flow, assuming no new value creation beyond the forecast period
Minority expert – Increases the last forecasted year’s net cash flow by 5% each year into infinity, then capitalized cash flows
Difference: one expert believes there will come a time when while it may make profits Target will not be increasing in value
Cost of capital and beta (51 - 53): The court discusses the experts' different estimates of the appropriate discount rate to use for various business lines, as well as the appropriate beta.
R: Cost of capital supplies the discount rate to reduce projected future cash flows to present value
CAPM – estimates the cost of company debt by estimating the expected future cost of borrowing; it estimates the future cost of equity and then proportionately weighs and combines the cost of equity and cost of debt to determine cost of capital
CAPM estimates a firm’s cost of capital by attempting to identify a risk-free rate of return and to identify a risk premium that would be demanded for investment in the particular enterprise
Beta used by majority SH’s included short period of high volatility that ensued after merger announcement
Minority SH expert did not use this period
Small cap effect (52 - 53): The court briefly discusses the premium that small capitalization companies have paid for capital
The small cap effect is the CAPM inability to replicate with complete accuracy the historic returns of stocks using historic beta, thus a premium is used to reflect the cost of equity
Court did not use the small cap number b/c T was old and stable, but when small cap is calculated the pool of companies used are old and name recognized
It had nothing to do with the basis of Rappaport’s analysis; Court effectively made a argument for lower beta when dismissing the small cap premium
Market price (53 - 55): How does the court view the role of market price in the valuation of the company?
The market price role is based on degree, one in which the court must determine. The court was wary not to allow an inflation of the market price value used to come from the effects of the MAF tender offer
I: Why does person buy the stock, b/c its worth what it is now OR what the expected increase in value to be realized in the future
Different states have different standards
DE – don’t get the future benefit

7. Efficient Market Theory

8. Risk premium – additional amount of interest dependent on the degree of risk presented by specific transaction

9. Dilution

Byrne v Lord - issuance of treasury stock effect on vote

Treasury stock – after corporation issues shares to public then decides to buy back shares
Shares allowed to be issued are authorized shares; issued shares are those issued out of the pile of authorized shares
Importance – treasury stock cannot vote with these shares, prevents board from becoming self-perpetuating entity
R: Treasury stock does not get voted
Π arg: dilution of corporate assets by issuing stock below par
R: Dilution is independent of par concepts
∆ arg: issued shares at a price to get capital, in desperate straights
Court: The issuance of treasury over authorized stock is arbitrary, it makes no difference

Issuance of shares by a closely held corporation subsequent to the initial issuance of shares upon formation necessarily involves dilution of the interests of current SH’s unless the issue is distributing proportionally to the current SH’s

Dilution occurs IF voting shares are issued:
to third persons
some but not all the current SH’s
to all the current SH’s but not in their pre-issuance proportions
Dilution also occurs when common shares are issued at bargain price, original holders shares are dilute
Watered stock – when SH pays too much for share, the stock is watered
Current application of this - when corporations want to raise funds due to being in dire straights, normally would borrow money, but when credit markets are frozen, the company will sell more stock

Katzowitz v Sidler – Two in closely held gang up on the third member

F: S and L may an offer to K for all three to purchase more shares in order to raise capital. Book value of one share at this point was $1800 a share; originally $100 a share.
N: IF all three buy in for $100 a share then there is no change to voting and value
K refuses and SL goes forward. SL own 30 shares each, K only has 5. They paid $100 a share for the additional 25 shares. SL Ownership in corp went from 1/3 to almost 1/2. And only paid $2500 to get there. They have taken away nearly all of K’s ownership
I: K’s interest in the corporation dramatically diluted
R: Pre-emptive rights has two interests
Right to protection against dilution of their equity in the corporation AND protection against dilution of their proportionate voting control
Closely Held Corporation angle

Even if a SH could find a buyer for his shares the value would be less then FMV, also if he is not offered to buy more shares or he does not want to invest additional funds his interest will be diluted

Π’s Burden to show
When the issuing price is shown to be markedly below book value in a close corporation AND
When the remaining SH-Directors benefit from the issuance
∆’s must show
Directors must show that issuing price falls within some range which can be justified on the basis of valid business reasons
∆’s arg: Even if the shares are purchased at less than FMV, as long as all SH’s were given an equal opportunity to purchase additional shares, no stockholder can complain simply b/c the offering dilutes his interest in the corporation
Corollary: SH’s right to maintain his proportionate equity in a corporation by purchasing additional shares is the right not to purchase additional shares w/o being confronted with dilution of his existing equity if no valid business justification exists for the dilution
A: Circumstances combined to reach the outcome of protecting K
Disparity in issuing price of the stock and its true value
Nature of the corporation – closely held
Business necessity for establishing an offering price at a certain amount to facilitate raising new capital AND
Ability of SH’s to sell their own shares
Remedy: Two theories
Take back the $5000 put in by SL and divide KSL interests by three OR
Take into account the economic benefit created by SL and give it to them
Court used the former method not the latter in order to serve as a deterrence to other SL’s from entering the venture
Exit Strategy – how to avoid this
How to protect K
Get unanimous vote in writing for issuance of new shares
How to protect SL
Discount the buyout for K; take 10% off the top of 1/3 ownership stake
Remove the gun to the head incentive
Also discount for illiquid assets listed at book value
OR mirror right of K buying out the other 2 at 10% discount

“you cut, I choose”

10. Risk-Reward Characteristics of Debt/Equity

11. Delaware Block Method

12. Motivations in an appraisal

Gibbons: A higher capitalization rate (aka discount rate) would mean that the investment was riskier and worth less, thereby favoring the majority shareholders

II. Interests in Corporations

Contractual/Fiduciary Duties
Equity carries a fiduciary duty while debt carries K duties
Risk/Reward Characteristics
The higher the risk the higher the reward
Entity Theory - Competing interests for claim on corporate assets
Promoters/Management
Subscribers
Creditors
Subsequent Investors
No general reverse preemptive right in closely held corporation
Corporation made distributions and salaries to exclusion of minority SH. Minority SH low balled by corporation for her shares. Remedy was not an appraisal and forced purchase. The remedy was a derivative proceeding on behalf of the corporation to require the majority to return to the corporation payments that comprise constructive dividends
Claim/Bankruptcy Priority
Law protects creditors before stated capital goes away; indenture would help trigger this protection – demanding repayment giving them control of corporation
Secured creditors, unsecured creditors, preferred, common
Bankruptcy – everything in finance has an eye on bankruptcy; how much of the business’s risk are you exposed to; end game planning
GR: Risk/Reward potential on your money is inversely proportional to priority in bankruptcy
Tax Considerations

1. Closely Held Companies

A. What is a Closely Held

Donahue – closely held corporation is one in which there is no ready market for shares and that a minority SH in a closely held corporation depends on the GF of the majority in order to participate financially in the corporation

B. Business Judgment Rule (No-Win)

C. Entity Tax Considerations

Double Taxation for Corporations
Taxed at corporate level as ordinary income and taxed at shareholder level when dividends are issued
Taxable: Dividends paid to SH’s
Dividend – pro-rata basis of paying out to SH’s
Deductible – expenses at the corporate level
Interest…debt
Compensation…put owner on payroll
Pass-through entity – LLC
Owners are liable for the tax when income is recognized by the firm
Squeeze out may be effective here, minority holder forced to pay taxes on income that has not been actually received

D. Adequate Capitalization – Fazio

F: bankruptcy proceeding, shareholder being attacked by creditor
Three equity holders: 43/6/2 among three when it was a partnership
43k person held a great risk but took greater portion of the profits
Pre-incorporation: Three holder split equity at 2/2/2. Two equity holders loan partnership 41/4k.
Incorporated and business went south
Court’s findings
Inadequate capital –
Archaic and old rule that there is some concept of adequate capitalization
IF F knew corporation would fail and withdrew then you might have inadequate capitalization but the lenders still should have protected themselves
Fazio acted for his own benefit
Lenders complain that Fazio is taking a place in lender line in bankruptcy; lenders knew of the corporation’s financing post corporation
Lenders knowingly walked into 45:6 Debt to equity ratio
Good reasons for doing this
Equalize risk amongst the equity holders
Tax angle – company better off paying the interest on debt and getting tax deduction for it.
F wanted to rearrange the Risk-reward characteristics of his investment
Time component
Restructuring business with an eye on bankruptcy is good not manipulative
Although if it were on the eve of bankruptcy then it may have been recaptured

E. Preemptive Rights – Closely held