1. Texas Roadhouse (TXRH) is rapidly expanding into new markets and had sales of $1,263M in 2012. Suppose you expect sales to grow at a 15% rate in 2013, but this rate will slow by 2% per year to a long-run growth rate for the restaurant industry of 5% by 2018. You expect EBIT to be 9% of sales, increases in net working capital requirements to be 5% of any increase in sales, and net investment (capital expenditures in excess of depreciation) to be 25% of any increase in sales. TXRH has $82M in cash, $224M in debt ($52M conventional debt plus $172M operating leases), 71M shares outstanding, a tax rate of 37%, and a weighted average cost of capital of 8%.

a. Using a spreadsheet, find the free cash flows for 2013-2018. (Hint: the 2018 FCF is $94.63M)

b. Estimate the terminal value as of year-end 2017.

c. Estimate the enterprise value of the firm in early 2013.

d. What is the value of equity? What is the estimated value of a share of TXRH stock?

e. Estimate the value per share under a less optimistic scenario where EBIT margin is only 5% of sales each year, and growth is only 4% in 2018 and following.

f. Estimate the value per share under a more optimistic scenario where EBIT margin is 15% of sales each year, and growth is 5% in 2018 and following.

Ticker TXRH Name Texas Roadhouse DRI PNRA BLMN EAT DIN CBRL CAKE BWLD BOBE BH BJRI RUTH DFRG CHUY IRG BBRG LUB DAVE Darden Restaurants Panera Bread Co Bloomin' Brands Brinker International DineEquity Cracker Barrel Cheesecake Factory Buffalo Wild Wings Bob Evans Biglari Holdings BJ's Restaurants Ruth's Hospitality Gp Del Frisco's Rest Gp Chuy's Holdings Ignite Rest Group Bravo Brio Rest Gp Luby's Famous Dave's Market Stock Price Capitalization ($) ($M) 16.80 1185 45.07 158.83 15.64 30.99 67.00 64.26 32.71 72.82 40.20 390.02 32.90 7.27 15.59 22.34 13.00 13.43 6.69 9.19 5885 4445 1947 2077 1275 1530 1661 1368 1064 671 929 259 370 366 333 261 190 68 Total Enterprise Debt Value ($M) ($M) 224 1322 3859 1006 2142 1245 2050 1016 796 361 372 335 300 257 144 94 334 248 88 121 9659 5257 3905 3267 3230 2488 2374 1692 1431 912 1214 510 505 457 666 507 276 187 Average: Enterprise Enterprise Value/ Value/ P/E Price/ Book Sales EBITDA 16.12 2.01 1.05 8.07 14.29 25.63 38.94 12.71 9.98 13.04 16.88 23.87 17.09 4.78 29.58 15.78 26.80 67.02 38.28 16.24 57.63 15.51 2.86 5.69 4.61 17.31 4.11 3.22 2.85 3.09 2.03 1.19 2.34 2.62 1.93 3.74 3.17 2.42 1.07 1.85 1.13 2.47 0.98 1.15 3.80 0.94 1.31 1.63 0.89 1.21 1.71 1.28 2.17 2.64 1.43 1.24 0.71 1.21 9.30 14.05 11.45 8.11 11.43 9.30 10.66 11.03 7.76 18.20 14.50 11.29 13.32 20.75 14.67 10.90 11.45 14.84 24.67 3.67 1.55 12.39 Venture Capital, Private Equity, and Mergers and Acquisitions Finance 435 Course Packet Spring 2016 Time: TR 8:00-9:15 a.m. Location: 1127 Gerdin Professor Travis Sapp Venture Capital, Private Equity, and Mergers and Acquisitions Finance 435 Spring 2016 Course Syllabus Professor: Travis Sapp Office: 3362 Gerdin Phone: 294-2717 Email: trasapp@iastate.edu Office Hrs: W 12:30-2:30, R 10:30-11:30 Course Objective This is an advanced investments class that focuses on alternative investments. Topics include venture capital finance, techniques for valuing public and private firms, the nature and scope of investment banking, private equity finance, leveraged buyouts, hedge funds, the structure and financing of mergers and acquisitions, and divestitures. The course provides not only a comprehensive overview of these important topics, but gives a framework for evaluating and implementing large scale investments in corporate assets. Course Requirements Investments (Fin 320) and Corporate Finance (Fin 310) are required preparation for this class. This course is based primarily on assigned readings, including cases. You are expected to read all assigned material and come to class prepared to discuss what you have read. For every hour of class, you should expect to devote 2+ hours outside of class to reading. There will be two exams during regular class hours. There are several required texts, and due to time constraints we will only be able to cover a portion of each. Having laid a strong foundation in this class, you are encouraged to explore the remaining sections on your own. Course Materials (Amazon price) Venture Capital and the Finance of Innovation, 1st or 2nd ed., by Metrick and Yasuda ($55) Venture Capital and Private Equity: A Casebook, 5th ed. by Lerner, Hardymon, & Leamon ($102) Introduction to Investment Banks, Hedge Funds, and Private Equity, 2nd ed. by Stowell ($61) Applied Mergers and Acquisitions by Bruner ($59) Deals from Hell: M&A Lessons that Rise Above the Ashes by Bruner ($13) Course Packet, distributed by email. The class web page at http://www.bus.iastate.edu/trasapp If the total cost of the textbooks imposes a hardship, then please note that the books marked with a are electronically available for viewing through Parks library. Grade Distribution Homework Two Exams Final Exam 35% 35% 30% Course grades will be based on a curve. 2 Other Required Readings Betton, Eckbo, and Thorburn, \"Corporate Takeovers,\" Handbook of Corporate Finance vol. 2, 2008, pp. 291-429. Eckbo and Thorburn, \"Corporate Restructuring: Breakups and LBOs,\" Handbook of Corporate Finance vol. 2, 2008, pp. 431-495. Baker and Wruck, \"Lessons from a Middle Market LBO: The Case of O.M. Scott\" Journal of Applied Corporate Finance 4, 1991, pp. 46-58. Lerner, Hardymon, and Leamon, \"Brazos Partners and Cheddars Inc.\" Available from Harvard Business Publishing for $3.95. Instructions will be emailed for purchasing this article. Kaplan, \"The Future of Private Equity\" Journal of Applied Corporate Finance 21, 2009, pp. 8-20. Recommended Further Reading Mergers, Acquisitions, and Other Restructuring Activities 5th ed. by DePamphilis Valuation: Measuring and Managing the Value of Companies 5th ed. by McKinsey and Co. Investment Valuation: Tools and Techniques for Determining the Value of any Asset 3rd ed. by Damodaran Venture Capital: Investment Strategies, Structures, and Policies edited by Cumming Private Equity: Fund Types, Risks and Returns, and Regulation edited by Cumming Corporate Takeovers: Modern Empirical Developments, vols. 1 & 2, edited by Eckbo 3 Finance 435 Tentative Schedule Spring 16 Dates Issues Readings Due Jan. 12, 14 Introduction and Background Issues The Venture Capital Landscape (Metrick Chs. 1-3) Lerner Chs. 1-3 Jan. 19, 21 Analysis of VC Investments (Metrick Chs. 7-8) Lerner Chs. 4-7 PSet 1 QSet 1a Jan. 26, 28 VC Compensation Participating Convertible Preferred Stock (Metrick Ch. 9) Lerner Chs. 12, 19, 20 QSet 1b Feb. 2, 4 The VC Method Cash Flows and Comparables (Metrick Chs. 10-12) Lerner Chs. 23, 25 QSet 2 Feb. 9, 11 Overview of Investment Banking Regulation, Financings, M&A, and Trading Asset Management, International Banking (Stowell Chs. 1-10) Stowell Case Studies 1, 2, 4 QSet 3 PSet 2 Feb. 16, 18 Overview of Hedge Funds HF Investment Strategies (Stowell Chs. 11-13) Stowell Case Studies 5-8 Exam 1 Feb. 23, 25 HF Shareholder Activism HF Risk, Regulation, and Performance Mar. 1, 3 Overview of Private Equity Buyouts Mar. 8, 10 PE LBOs and Corporate Governance PE Regulation, Structure, and Compensation Mar. 15, 17 (Stowell Chs. 13-15) QSet 4 Stowell Case Study 10 Baker \"Case of O.M. Scott\" QSet 5a (Stowell Chs. 18-20) Lerner \"Brazos & Cheddars\" Lerner Ch. 28 \"Blackstone IPO\" Kaplan \"Future of PE\" QSet 5b Bruner Chs. 3, 6, 17 PSet 3 Betton \"Corporate Takeovers\" (Bruner Chs. 25-28, 31-34) QSet 6 Bruner Chs. 9, 11, 13, 15 QSet 7 Exam 2 Spring Break! No class. Mar. 22, 24 Introduction to Mergers and Acquisitions Strategy and the Uses of M&A Mar. 29, 31 Governance, Regulatory Considerations Auctions in M&A Takeover Tactics and Defenses Apr. 5, 7 Valuation: Cash Flows, Comparables, and Options Valuing Synergies, Liquidity, and Control Valuing Highly Leveraged Transactions Apr. 12, 14 Form of Acquisition and Payment Analyzing Gains and Losses Apr. 19, 21 Risk Management: Collars and Earnouts Social Issues Deals from Hell Apr. 26, 28 Divestitures, Spin-offs, Carve-outs, Split-ups Bankruptcy and Liquidation May 2- 6 Final Exam Bruner Chs. 19-20 Bruner \"Hell\" Chs. 7-9 Bruner Chs. 22-24 Bruner \"Hell\" Chs. 10-12 Eckbo \"Corporate Restructuring\" PSet 4 QSet 8 QSet 9 PSet 5 4 Venture Capital and the Finance of Innovation by Metrick and Yasuda Part I: VC Basics. Chapter 1: The VC Industry. Chapter 2: VC Players. Chapter 3: VC Returns. Chapter 4: The Cost of Venture Capital. Chapter 5: The Best VCs. Chapter 6: VC Around the World. Part II: Total Valuation. Chapter 7: The Analysis of VC Investments. Chapter 8: Term Sheets. Chapter 9: Preferred Stock. Chapter 10: The VC Method. Chapter 11: Discounted-Cash-Flow Analysis of Growth Companies. Chapter 12: Comparables Analysis. Part III: Partial Valuation. Chapter 13: Option Pricing. Chapter 14: The Valuation of Preferred Stock. Chapter 15: Later-Round Investments. Chapter 16: Participating Convertible Preferred Stock. Chapter 17: Implied Valuation. Chapter 18: Complex Structures. Part IV: The Finance of Innovation. Chapter 19: R&D Finance. Chapter 20: Monte Carlo Simulation. Chapter 21: Real Options. Chapter 22 Binomial Trees. Chapter 23 Game Theory. Chapter 24 R&D Valuation. Appendix A Information Sources for Venture Capital. Appendix B Sample Term Sheet. Appendix C The VCFI Spreadsheets. Appendix D Guide to Crystal Ball. 5 Venture Capital and Private Equity: A Casebook 5th ed. by Lerner, Hardymon, and Leamon Introduction 1. Private Equity Today and Tomorrow 2. Iris Running Crane: December 2009 Module 1: Fund-Raising 3. Yale University Investment Office: August 2006 4. Altoona State Investment Board and Permira: December 2008 5. Note on Private Equity Partnership Agreements 6. Grove Street Advisors: September 2009 7. A Note on the Private Equity Fund-Raising Process 8. The Canada Pension Plan Investment Board Module 2: Investing 9. Firm Strategy Vignettes 10. Hardina Smythe and the Healthcare Investment Conundrum 11. Avid Radiopharmaceuticals and Lighthouse Capital Partners 12. Metapath Software: September 1997 13. Note on Valuation in Private Equity Settings 14. Note on European Private Equity 15. Investcorp and the Moneybookers Bid 16. Note on Private Equity in Developing Countries 17. Hony, CIFA, and Zoomlion 18. Gobi Partners and DMG 19. Note on Private Equity Securities Module 3: Exiting 20. Warburg Pincus and emgs: The IPO Decision (A) 21. Motilal Oswal Financial Services Ltd.: An IPO in India 22. Note on the Initial Public Offering Process 23. Between a Rock & a Hard Place: Valuation & Distribution in Private Equity Module 4. New Frontiers 24. Village Ventures 25. Microsoft's IP Ventures 26. Abraaj Capital 27. Actis: January 2008 28. The Blackstone Group's IPO Appendix. Note on Private Equity Information Sources 6 Investment Banks, Hedge Funds, and Private Equity, 2nd ed. by Stowell Section I. Investment Banking 1. Overview of Investment Banking 2. Regulation of the Securities Industry 3. Financings 4. Mergers and Acquisitions 5. Trading 6. Asset Management, Wealth Management, and Research 7. Credit Rating Agencies, Exchanges, and Clearing and Settlement 8. International Banking 9. Convertible Securities and Wall Street Innovation 10. Investment Banking Careers, Opportunities, and Issues Section II. Hedge Funds and Private Equity 11. Overview of Hedge Funds 12. Hedge Fund Investment Strategies 13. Shareholder Activism and Impact on Corporations 14. Risk, Regulation, and Organizational Structure 15. Hedge Fund Performance and Issues 16. Overview of Private Equity 17. LBO Financial Model 18. Private Equity Impact on Corporations 19. Organization, Compensation, Regulation, and Limited Partners 20. Private Equity Issues and Opportunities Section III. Case Studies 1. Investment Banking in 2008 (A): Rise and Fall of the Bear 2. Investment Banking in 2008 (B): A Brave New World 3. Freeport-McMoRan: Financing an Acquisition 4. The Best Deal Gillette Could Get?: Procter and Gamble's Acquisition of Gillette 5. A Tale of Two Hedge Funds: Magnetar and Peloton 6. Kmart, Sears, and ESL: How a Hedge Fund Became One of the World's Largest Retailers 7. McDonald's, Wendy's, and Hedge Funds: Hamburger Hedging? Hedge Fund Activism and Impact on Corporate Governance 8. Porsche, Volkswagen and CSX: Cars, Trains, and Derivatives 9. The Toys "R" Us LBO 10. Cerberus and the U.S. Auto Industry 7 Applied Mergers and Acquisitions by Bruner PART ONE: INTRODUCTION AND KEY THEMES. Chapter 1: Introduction and Executive Summary Chapter 2: Ethics in M&A Chapter 3: Does M&A Pay? PART TWO: STRATEGY AND THE ORIGINATION OF TRANSACTION PROPOSALS Chapter 4: M&A Activity Chapter 5: Cross-Border M&A Chapter 6: Strategy and the Uses of M&A to Grow or Restructure the Firm Chapter 7: Acquisition Search and Deal Origination: Some Guiding Principles PART THREE: DILIGENCE, VALUATION, AND ACCOUNTING Chapter 8: Due Diligence Chapter 9: Valuing Firms Chapter 10: Valuing Options Chapter 11: Valuing Synergies Chapter 12: Valuing the Firm across Borders Chapter 13: Valuing the Highly Levered Firm, Assessing the Highly Levered Transaction Chapter 14: Real Options and Their Impact on M&A Chapter 15: Valuing Liquidity and Control Chapter 16: Financial Accounting for Mergers and Acquisitions Chapter 17: Momentum Acquisition Strategies: An Illustration of Why Value Creation is the Best Financial Criterion PART FOUR: DESIGN OF DETAILED TRANSACTION TERMS Chapter 18: An Introduction to Deal Design in M & A. Chapter 19: Choosing the Form of Acquisitive Reorganization Chapter 20: Choosing the Form of Payment and Financing Chapter 21: Framework for Structuring the Terms of Exchange: Finding the \"Win-Win\" Deal Chapter 22: Structuring and Valuing Contingent Payments in M&A Chapter 23: Risk Management in M&A Chapter 24: Social Issues PART FIVE: RULES OF THE ROAD: GOVERNANCE, LAWS, AND REGULATIONS Chapter 25: How a Negotiated Deal Takes Place Chapter 26: Governance in M&A: The Board of Directors and Shareholder Voting Chapter 27: Rules of the Road: Securities Law, Issuance Process, Disclosure, and Insider Trading Chapter 28: Rules of the Road: Antitrust Law Chapter 29: Documenting the M&A Deal PART SIX: COMPETITION, HOSTILITY, AND BEHAVIORAL EFFECTS IN M&A Chapter 30: Negotiating the Deal Chapter 31: Auctions in M&A Chapter 32: Hostile Takeovers: Preparing a Bid in Light of Competition and Arbitrage Chapter 33: Takeover Attack and Defense Chapter 34: The Leveraged Restructuring as a Takeover Defense: The Case of American Standard PART SEVEN: COMMUNICATION, INTEGRATION, AND BEST PRACTICE Chapter 35: Communicating the Deal: Gaining Mandates, Approvals, and Support Chapter 36: Framework for Postmerger Integration Chapter 37: Corporate Development as a Strategic Capability: The Approach of GE Power Systems Chapter 38: M&A \"Best Practices\": Some Lessons and Next Steps 8 Deals From Hell: M&A Lessons that Rise Above the Ashes by Bruner 1. Introduction I. The Foundations of M&A Failure 2. Where M&A Pays and Where It Strays: A Survey of Research 3. Profiling the Outlying M&A Deals 4. Real Disasters and M&A Failure II. Case Studies of M&A Failure 5. February 1968: Merger of the Pennsylvania and New York Central Railroads 6. December 1986: The Leveraged Buyout of Revco Drug Stores 7. September 1989: The Acquisition of Columbia Pictures by Sony Corporation 8. September 1991: The Acquisition of NCR by AT&T (and Merck Acquires Medco) 9. December 1993: Renault's Proposed Merger with Volvo 10. December 1994: The Acquisition of Snapple by Quaker Oats 11. May 1999: Mattel's Acquisition of The Learning Company 12. January 2001: Merger of AOL and Time Warner 13. December 2001: Dynegy's Proposed Merger with Enron 14. January 2002: Acquisition Program of Tyco International III. Avoiding the Deal from Hell 15. Conclusions and Implications 16. Memo to the CEO: A Coda on Growth 9 Formula Sheet RA is the unlevered (all-equity) cost of capital A is the unlevered risk of the firm's assets D E RD (1 TC ) + RE D+E D+E RWACC = RWACC = R A D RD TC D+E RA = D E RD + RE D+E D+E RE = RA + D (RA RD ) E A = D E d + e D+E D+E E = A + D ( A D ) E FCF = EBIT(1 - TC ) + Dep - CAPEX - DNWC EV = t =1 EV = E + D Cash FCFt FCF1 = (if g is constant) t (1 + RWACC ) RWACC g FCF @ RWACC = FCFE @ RE + Debt @ RD = FCF @ RA + Tax Savings @ RA FCFE = Net Income + Dep - CAPEX - DNWC + DDebt = (EBIT - Int )(1 - TC ) + Dep - CAPEX - DNWC + DDebt Equity = (E = (N FCFE1 RE g Buyer Buyer EV = Value Unlevered + PV(Tax Shields) = FCF1 TC RD D1 + RA g RA g + ETarget ) + N Buyer ) EBuyer N Buyer 1 VCombined = VBuyer + VTarget + Synergies - Cash Paid Break-even Synergy = Exchange Ratio x NTarget x PBuyer + Cash Paid - VTarget Arbitrage Spread = PBid - PCurrent PCurrent = (PBid) + (1 - )PStand-alone PControl = (1 d Illiquidity )(1 + Control )PBase PMinority = (1 d Illiquidity )[1 (1 + 1a Control )a ] PBase 10 Formula Sheet Investment Capital = Committed Capital - Lifetime Fees Dollar Carried Interest = Percent Carried Interest * (Ending Value - Beginning Value) Dollar Carried Interest = Percent Carried Interest * (GVM*investment capital - carry basis) The IRR on a fund is the rate that sets PVContributions = PVWithdrawals Gross Value Multiple = Total Distributions to LPs +LP Value of Unrealized Investments + Carried Interest Invested Capital (Net) Value Multiple = Total Distributions to LPs +LP Value of Unrealized Investments Invested Capital + Management Fees Realized Value Multiple = Total Distributions to LPs Invested Capital + Management Fees Unrealized Value Multiple = LP Value of Unrealized Investments Invested Capital + Management Fees Cash Flow to LPs = Distributions to LPs - New Investments - Management Fees Post-Money Valuation = Price-per-share * Fully-diluted share count Pre-money valuation = Post-money valuation - VC $Investment or Pre-money valuation = Price-per-share * Pre-transaction fully diluted share count Present Value = Exit Valuation p (1 + RVC ) T Target Value Multiple = M p (1 + RVC ) = 1 M = 1 (1 + RTarget ) T T and M = (1 + RTarget ) T Total Valuation = Present Value % Retention = Exit Valuation % Retention M Partial Valuation = Proposed Ownership % * Total Valuation Standard VC Method Step 1: What is the required investment today? ( $I ) Step 2: What is the exit valuation for this company? ($ exit valuation) Step 3: What is the target multiple-of-money on our investment? (M) Step 4: What is the expected retention percentage? (retention %) Step 5: Estimate the total valuation for the company today: Total Valuation = $ Exit Valuation * Retention % / M. Step 6: What is the proposed ownership percentage today? (proposed %) Step 7: Estimate the partial valuation for this investment: Partial Valuation = Proposed % * Total Valuation. Step 8: Investment Recommendation: Compare partial valuation to $I. Modified VC Method Step 8: Estimate the LP cost for the investment: LP cost = $I (committed capital / investment capital) Step 9: What is the expected GP% for this investment? GP% = carry% * (GVM*investment capital - carry basis) / (GVM * investment capital). Step 10: Estimate the LP valuation from this investment: LP valuation = (1 - GP%) * partial valuation. Step 11: Investment Recommendation: Compare LP valuation to LP cost. 11 Venture Capital, Private Equity, and Mergers and Acquisitions Finance 435 Major Topics Introduction Dr. Travis Sapp, Iowa State University Course Materials Venture Capital and the Finance of Innovation, 1st or 2nd ed. by Metrick and Yasuda Venture Capital and Private Equity: A Casebook 5th ed. by Lerner, Hardymon, and Leamon An Introduction to Investment Banks, Hedge Funds, and Private Equity, 1st or 2nd ed. by Stowell Applied Mergers and Acquisitions by Bruner Deals from Hell: M&A Lessons that Rise Above the Ashes by Bruner Course Packet, distributed via email. The class web page at http://www.bus.iastate.edu/trasapp Login: positive Password: $NPV Venture Capital: Industry Landscape, Players, Cost of Capital, Returns, Contracts, Compensation Structure, Investment Analysis and Valuation Investment Banking: Regulation, Financings, M&A, Trading, Creditrating Agencies, Recent Changes Hedge Funds: Industry Landscape, Regulation, Structure, Compensation, Investment Strategies, Activism, Risk, Performance Private Equity: Industry Landscape, Regulation, Structure, Compensation, LBOs, Corporate Governance M&A Overview: History and Performance of M&A, Strategy and the Uses of M&A, Corporate Governance, Regulatory Considerations M&A Auctions, Takeover Tactics and Defenses M&A Valuation: Cash Flows, Comparables, Options, Liquidity, Control M&A Organizational Form, Form of Payment and Financing: Cash vs. Stock, Exchange Ratios, Leverage M&A Risk Management: Collars, Contingent Payments, Earnouts M&A Alternative Exit and Restructuring Strategies: Divestitures, Spinoffs, Carve-outs, Split-ups, Bankruptcy, Liquidation Grading Homework Quizzes Final Exam 40% 30% 30% Course grades will be based on a curve. Value Additivity Background Material Suppose Project A has present value PV(A) and Project B has present value PV(B) The value additivity principle says that the present value of the sum of A and B is the sum of the present values: PV(A + B) = PV(A) + PV(B) Example: The market value of Lexar Corp. equity is $8 million, and the market value of Lexar debt is $4 million. By value additivity, the total value of the firm is $12 million. 12 3 Basic Principles of Finance \"Give me a place to stand, and I will move the Earth\" -Archimedes on leverage When it comes to people and money: More is better than less Sooner is better than later Sure is better than risky Financial Leverage, EPS, and ROE Consider an all-equity firm that is contemplating going into debt. (Maybe some of the original shareholders want to cash out.) Assets Debt Equity Debt/Equity ratio Interest rate Shares outstanding Share price Current $20,000 $0 $20,000 0.00 n/a 400 $50 Proposed $20,000 $8,000 $12,000 2/3 8% 240 $50 EPS and ROE Under Current Structure Recession Expected EBIT $1,000 $2,000 Interest 0 0 Net income $1,000 $2,000 EPS $2.50 $5.00 ROA 5% 10% ROE 5% 10% Current Shares Outstanding = 400 shares Expansion $3,000 0 $3,000 $7.50 15% 15% EPS and ROE Under Proposed Structure How is ROA related to ROE? Recession Expected EBIT $1,000 $2,000 Interest 640 640 Net income $360 $1,360 EPS $1.50 $5.67 ROA 1.8% 6.8% ROE 3.0% 11.3% Proposed Shares Outstanding = 240 shares If the firm were all equity financed, ROA = ROE. The presence of debt leverages (magnifies) the returns to equity. When there is debt, |ROE| > |ROA|. Expansion $3,000 640 $2,360 $9.83 11.8% 19.7% ROE ROA Equity Multiplier Equity Multiplier Total Assets 1 Total Debt 1 Common Equity 1 Debt Ratio Common Equity Notice the three alternative definitions of Assets , Equity Debt , Assets : Debt Equity 13 Financial Leverage and EPS Expected Return 12.00 Investors must be compensated for Debt 10.00 The value of money (the risk-free interest rate) EPS 8.00 Expected No Debt 6.00 Break-even point 4.00 Advantage to debt The first two are straightforward to measure Measuring and pricing risk requires some additional structure (e.g. CAPM, APT) 2.00 Disadvantage to debt 0.00 1,000 2,000 3,000 EBIT in dollars (2.00) Diversifiable Risk Systematic Risk Since investors can eliminate firm-specific risk by simply holding a well-diversified portfolio, the market offers no compensation for bearing this type of risk. Only systematic risk cannot be gotten rid of, and so only systematic risk is priced by the market. Alternatively stated, well-diversified investors bid up the price of every asset to the point where only systematic risk earns a positive return. In order to systematic risk, we must first be able to it. Variance NonSystematic Systematic 49 47 45 43 41 39 37 35 33 31 29 27 25 23 21 19 17 15 13 11 9 7 5 3 1 Number of Assets Measuring Systematic Risk Measuring Systematic Risk Since systematic risk affects the entire market, when the market does poorly we would like to know whether a particular stock tends to Perform more poorly than the market Less poorly than the market The same as the market In essence, we want to know how a particular stock with the market portfolio. One measure of systematic risk is called beta, and is defined as the covariance between the return of a stock and the return on the market portfolio, divided by the variance of the return on the market portfolio: i CovRi , Rm Var Rm The beta of the market portfolio is . 14 The Capital Asset Pricing Model ER i R f i E(R m ) R f Beta of a Portfolio of Assets The beta of a portfolio of assets is the weighted average of the individual betas. Risk Premium If i = 0, we have a risk-free asset If i = 1, we have the same risk as the market portfolio If i = 2, we have an asset two times as risky as the market portfolio If i = 0.5, we have an asset half as risky as the market portfolio p w i i where the weights must sum to one. Portfolio Beta Example What is Arbitrage? You have the following invested: The Law of One Price in Economics says that two goods that are perfect substitutes must sell for the same price. A violation of this principle indicates . An arbitrage opportunity involves the simultaneous sale and purchase of equivalent assets in order to profit from discrepancies in their price relationship. Specifically, arbitrage is a -investment strategy that yields a profit. This means that it is Company Amount Beta 0.89 Walmart $1,000 Dell Computer $2,000 2.25 Starbucks $2,000 1.25 What is your portfolio beta? p w1 1 w2 2 w3 3 Arbitrage: Example Suppose a Treasury bond gives the following cash flows: Today Cashflow: 6 mo $10,000 1 yr $1,000,000 Suppose two Treasury bills give the following cash flows: Date: Today Cashflow: Date: Cashflow: 6 mo 1 yr 6 mo Since the T-note and the two T-bills together give the same future cash flows, an arbitrage opportunity exists if the sum of the T-bill prices differs from the T-note price. For example, suppose: 1 yr $1,000,000 Price T-note = $980,000 Price 6 mo T-bill = $9,500 Price 1 yr T-bill = $970,000 Then you can profit by $10,000 Today : a combination of long and short positions : there is no chance of losing money To find an arbitrage opportunity is to find a free lunch. Arbitrage: Example Date: Selling the T-note short (generates $980,000 cash) and Buying both T-bills (costs $979,500) Notice, it cost you nothing (it is self-financing) and the future cash flows offset each other (it is riskless). Then figure out how to spend the extra $500. 15 The Cost of Capital Bond Valuation The discount rate reflects the riskiness of the project. A project with higher risk will have a higher required return (i.e., a higher cost of capital). Consider the firm as a whole. Given the riskiness of the firm's existing operations, what is the firm's cost of capital? We can measure the firm's cost of capital by measuring the cost of the different securities that the firm has already issued to the market. These typically include equity, debt, and preferred stock. We can measure the required rate of return on a bond by its yield to maturity (its internal rate of return). YTM is defined as the return that equates the price of the bond and the present value of its coupon payments and par value. Preferred Stock Valuation Common Stock Valuation For most public firms, preferred stock pays a constant, pre-determined cash flow, forever. Thus, preferred stock is a perpetuity and we can find its required rate of return, given its price: Recall, the value of common stock can be written as: D RP P C RD 1 FV 1 t t 1 1 R RD D Note that if a firm has bonds outstanding at a price P, then RD reflects the cost of debt. Interest payments are tax deductible, making debt cheaper. The aftertax cost of debt is given by RD (1 - TC). P D1 RE g If a firm has preferred stock at price P, then RP reflects the cost of these funds. Note that if a firm has issued common stock for financing, then RE reflects the cost of these funds. A common alternative to finding RE , especially for a firm that does not pay dividends, is to use an asset pricing model such as the CAPM: The Weighted Average Cost of Capital (WACC) Leverage and Equity Risk P The WACC is the average cost of funds from all sources. A firm's WACC represents: The individual costs of capital from each source. The financing mix of the firm. These proportions should be based on the of each financing type. RW ACC = D P E RD 1 TC RP RE DPE DPE DPE RE R f i Rm R f The business risk of a firm is the risk of the cash flows generated by its assets and has a systematic component We can measure this risk with the firm's asset beta A For a firm that is all equity financed, What if the firm is levered? The firm may be viewed as a portfolio of its securities. The beta of a portfolio is just a weighted average: Business Risk of Firm ( A ) = Or rearranging, E A D E D E DE DE D A D E Note: We assume tax shields are discounted at the all-equity discount rate. It can be shown that the tax rate does not appear in the formula under this assumption. 16 Leverage and Equity Risk Leverage and Equity Risk A is unaffected by changes in capital structure. As leverage (D/E) is increased, equity becomes riskier. In other words, E goes up. The increase in the risk of equity due to the presence of debt is referred to as risk. E A D A D E Stockholder Risk = Business Risk + Financial Risk The impact on required returns is given by RA = D E RD RE DE DE or RE RA D R A RD E RE RA D RA RD E This says the cost of equity depends on three things: The required return on the firm's assets, RA The firm's cost of debt, RD The firm's debt-to-equity ratio, D/E It also shows that the return on equity can be broken into two components Compensation for business risk; RA Compensation for financial risk; (D / E) (RA - RD) Business risk is independent of capital structure; RA does not change when the debt-to-equity ratio changes For an all-equity firm, there is no financial risk; RE = RA Example 1: Leverage and Equity Risk Example 1: Leverage and Equity Risk Hitek Corp. is an all equity firm with a beta of 1.15 and a 9% cost of capital. What is A? What is E? What is RA? What is RE? What is RWACC? For an all equity firm, A = E and RA = RE = RWACC. Therefore, A = E = 1.15 and RA = RE = RWACC = 9%. Suppose Hitek repurchases 40% of its equity using 6% debt that has a beta of 0.2. The tax rate is 40%. Find E, RE, and RWACC under the new capital structure. The debt ratio is now 40% and D/E is .40/.60 = .67. Example 2: Leverage and Equity Risk Example 2: Leverage and Equity Risk Your firm is considering expanding its household products division. You identify Proctor and Gamble (PG) as a firm with comparable investments. Suppose PG's equity has a market capitalization of $144B and a beta of 0.57. PG has $37B of AA-rated debt outstanding, with an average yield of 3.75%. The beta of debt is 0.15. Estimate the cost of capital and beta of your firm's investment given a risk-free rate of 3% and a market risk premium of 5%. First, what is PG's cost of equity? RE = 3% + 0.57(5%) = 5.85% Now find the unlevered cost of capital: D A D E 1.15 .671.15 .2 1.79 D RE R A R A RD E 9% .679% 6% E A 11% D E RD 1 TC RE DE DE .406% 1 .40 .6011% 8.04% RWACC RA = 37 144 3.75 5.85 5.42% 144 37 144 37 Alternatively, we can estimate PG's unlevered beta: A = 37 144 0.15 0.57 0.484 144 37 144 37 Taking this as the risk of our project, we use the CAPM: RA = 3% + 0.484(5%) = 5.42% 17 CAPM Refinements CAPM Refinements Over the years, it has become apparent that the CAPM fails to correctly price all stocks. Certain characteristics in addition to overall market exposure have been found to matter. In particular, Over 1980-2014, the annualized return on a zero-cost long-short portfolio according to each of the characteristics, as well as the market, is given below. Firm market capitalization (\"Size\") - Fama & French, 1993 Firm book-to-market (\"Value\") - Fama & French, 1993 Prior 1-year stock return (\"Momentum\") - Carhart, 1997 Stock tradability (\"Liquidity\") - Pastor & Stambaugh, 2003 Suppose we sort all stocks according to one of these characteristics. Then we go long in the top 30% and short in the bottom 30%. This is called a long-short portfolio. Each of these characteristics produces abnormal returns that are too large to be explained by chance alone. Market premium Size premium Value premium Momentum premium Illiquidity premium Mkt-RF 6.75% SIZE 1.01% VALUE 3.13% MOM 6.19% LIQ 5.72% These portfolios are called factors. The SIZE factor, for example, has a long position in small-company stocks and a short position in large-company stocks. These long-short factor portfolios can be used as refinements to the single market factor CAPM. CAPM Refinements Why does a stock have value? One popular extension is the Fama-French three factor model: A share of equity represents a claim on the current and future free cash flows of the firm. It has value because of the expected eventual payout of these free cash flows. Payout can take the following forms: Ri R f Rm R f size SIZE value VALUE The \"typical\" stock would have a factor loading (beta) of 1 on the market factor and zero on the other two factors. For some stocks, however, the Fama-French model can give a very different estimate from the CAPM. Additional factors for momentum and/or liquidity may be included as deemed appropriate: Ri R f Rm R f size SIZE value VALUE liq LIQ Enterprise Value Firms with Large Cash Balances* The Enterprise Value of the firm is the sum of its market value of equity and its market value of net debt: EV E D Cash Cash belongs to the equity holders. Cash came from past earnings and is a non-operating asset. Hence, we remove it from the estimate of the value of the firm as an ongoing enterprise. Cash can also be thought of as debt. Special distributions or regular ongoing payments. Share Often at a slight premium over current market value. /Buyout The best form of payout, as the acquirer pays a significant premium over the current market value of the shareholders' claim on future cash flows. Implies failure as an ongoing concern. This is a last resort form of payout, where the shareholders have probably incurred substantial overall losses. Ticker Company Cash ($B) Market Cap ($B) Cash % of Market Cap Debt ($B) Enterprise Value ($B) $12.1 DELL Dell $14.8 $17.7 84% $9.3 GM General Motors $31.6 $43.8 72% $13.2 $25.4 PC Panasonic Corp. $7.4 $14.0 53% $19.1 $25.7 CSCO Cisco $48.7 $104.4 47% $16.3 $72.0 KYO Kyocera $5.8 $16.5 35% $0.4 $11.1 S Sprint Nextel $5.6 $16.9 33% $20.3 $31.6 AMGN Amgen $20.6 $66.2 31% $21.3 $66.9 ATVI Activision Blizzard $3.5 $11.8 30% $0.0 $8.3 HPQ Hewlett-Packard $8.0 $27.6 29% $30.6 $50.2 $63.0 $227.1 $176.0 MSFT 28% $12.0 BA Boeing $11.3 $57.2 20% $12.4 $58.3 GOOG Google Microsoft $44.6 $232.1 19% $4.2 $191.6 * As of January 2014. 18 Enterprise Value vs. Cash The Value of Sprint Nextel Debt + Equity = Enterprise Value + Cash = $37.2 B Dell General Motors Enterprise Value Panasonic Corp. Cash Cisco Enterprise Value Kyocera Cash Sprint Nextel Amgen Debt Equity Activision Blizzard Hewlett-Packard 0 5 10 15 20 25 Firm Value ($ Billion) Microsoft 30 35 40 Boeing Google $0.0 $50.0 $100.0 $150.0 $200.0 $250.0 $300.0 $ Billion Free Cash Flow Valuation Free Cash Flow Valuation What is a firm worth? The present value of its expected cash flows. To find the Enterprise Value of the firm, we discount the stream of Free Cash Flows (FCFs) to the firm at the WACC: To find the value of equity, subtract the market value of net debt (net debt = debt - cash). Lowtech Corp.'s operating income before depreciation, interest, and taxes is expected to be $2 M and it is expected that this will grow at 3% per year forever. The firm re-invests 20% of pretax cash flow each year. The tax rate is 35%. Depreciation will be $200,000 and is expected to grow at the same rate as operating cash flow. The required return on equity is 12%. The firm's target (i.e. long-run) debt ratio is 50%. The firm currently has $8.3 M (market value) in zerocoupon bonds outstanding with a yield-to-maturity of 8%. The firm holds $400,000 in cash balances. Estimate the value of equity. Free Cash Flow Valuation Free Cash Flow Valuation FCF = EBIT(1 - TC) + Depreciation - CAPEX - NWC Value of Firm t 1 FCFt 1 RW ACC t FCF1 if g is constant RW ACC g Operating Income Before Dep Depreciation EBIT Taxes (@35%) EBIT after tax Depreciation Operating Cash Flow New Investment Free Cash Flow 2,000,000 -200,000 1,800,000 -630,000 1,170,000 +200,000 1,370,000 -400,000 970,000 We need to find the WACC: RWACC = wD x RD x (1 - TC) + wE x RE RWACC = .5 x .08 x (1 - .35) + .5 x .12 RWACC = .026 + .06 = .086 Then we can find the value of equity: Value of Equity FCF1 Value of Net Debt RW ACC g 970,000 8,300,000 400,000 .086 .03 17,321,429 7,900,000 9,421,429 19 Enterprise Value What, exactly, is dilution? To summarize, the Enterprise Value of the firm is the sum of its market value of equity and its market value of net debt: Though they seek to avoid dilution, managers often seem confused about its meaning or effect. We can identify three different types of dilution: EV FCF1 RWACC g EV E D Cash Where g is the constant \"steady-state\" growth rate. A common estimate for the growth rate of the firm's free cash flows is g = ROC * OI where OI is the firm's reinvestment rate: OI = (CAPEX - Dep + NWC)/ EBIT(1-TC) Accounting (EPS): A reduction in EPS following an equity issue or stock-for-stock acquisition. This change in reported results does not necessarily imply a reduction in economic value. In acquisitions, this arises when target shareholders are paid proportionally more than the target's contribution to the earnings of the combined firm. Economic (NPV): A reduction in shareholder . Control (Voting): A reduction in voting (i.e. the percentage of total votes held by the investor). These three types do not necessarily move together. The opposite of dilution is . Dilution Example 1 Dilution Example 2 Alpha Corp. is projected to have EPS1 of $1.85. Suppose Alpha Corp. acquires Zeta Corp. in a pure stock exchange. The combined firm now has expected earnings of $38.4M and the new number of shares outstanding is 18.55M. Have the acquiring shareholders experienced accounting dilution? The post acquisition EPS1 is $38.4/18.55 = $2.07. This acquisition is to EPS. Jamtek has 6M shares outstanding. To expand its operations, the firm has decided to issue 3M new shares at a 6% discount from the current stock price. Have the shareholders suffered economic dilution? Since the new shareholders have bought claims on the firm's assets while contributing less cash than the full market value of the shares, there is a wealth transfer from the existing shareholders to the new shareholders. In fact, letting N = # of shares and = % discount, the stock price should decline in value by the following predictable amount: N New Stock Price Decline N New N Old Classes of Investors Information Economics Investors may be divided into three categories that have different treatment under certain securities laws: Qualified institutional buyers (QIBs) are institutional investors managing or more. Accredited investors are banks, brokers, insurance companies, or individuals with a net worth in excess of $1M. Average investors are everyone else. Average investors are generally afforded the most precautions and protections under the law. Certain investments, such as private equity and hedge funds, are only available to accredited investors or QIBs. Asymmetric Information: When two counterparties, e.g. and , do not have access to the same information. Principal-Agent Problem: An agency relationship exists whenever a principal must an agent to act on their behalf. Conflicting interests inevitably arise. Examples: Shareholders trust managers to maximize firm value, but managers may pursue other goals. Bondholders trust managers/shareholders to avoid extremely risky projects, but debt provides an incentive for (gambling with other people's money). 20 Information Economics Event Studies Moral Hazard: A consequence of information asymmetry where a contract or relationship places incentives upon one party to take (or not take) unobservable steps which are to another party. When information material to valuing the stock of a firm arrives, the stock price will change in response. Examples of announcements that may impact share valuations include Examples: 1. CEO wastes money, 2. highly levered firm takes very risky projects, 3. poor care of insured items. Possible Solutions: 1. compensate CEO with 2. strict debt , 3. deductibles. , Adverse Selection: A consequence of information asymmetry where one party benefits in an exchange by taking advantage of knowing more than the other party. Example: Buyer cannot tell good from bad, willing to pay average; good sellers do not sell at this price, so only left with bad sellers (called the problem). Possible Solution: (provide free Carfax report) Earnings Dividend changes Share repurchases Mergers or acquisitions Debt or equity issues An event study is an examination of stock prices and returns surrounding the arrival of a corporate news event. Event Studies Event Studies How do we know if the observed return is \"abnormal\"? Simple approach: The Abnormal Return (AR) on a stock for a particular day can be calculated by subtracting the market's return (RM) from the actual return (R) on the stock for that day: AR= R - RM More Precise Approach: The abnormal return each day can also be calculated using the market model: AR= R - ( + RM) The & are usually estimated from a CAPM regression using daily return data over the preceding year. RM is a broad-based market series such as the valueweighted portfolio of all NYSE/AMEX/Nasdaq stocks. We refer to the news event day as time t = 0 t= -3 -2 -1 0 +1 +2 +3 Suppose we are interested in looking at the 5 days surrounding the event: t = [-2, +2] Then we estimate and using the 252 trading days over t = [-255, -3] and use these to find the ARs Cumulative Abnormal Return - Finally, we sum the 5 ARs to get the total market effect of the news event: CAR = AR-2+AR-1+AR0+AR+1+AR+2 Event Studies Private Equity Cumulative Abnormal Returns for Companies Announcing Dividend Omissions 1 Return (%) 0 0.03 0.11 0.15 -0.72 -1 -0.48 -0.24 -2 -3 -3.62 -4 -5.02 -5 -5.18 -5.41 -6 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 -4.56 -4.69 -4.90 -4.75 4 5 6 -4.49 7 8 Event Time 21 Private Equity Categories ALTERNATIVE INVESTMENTS Private Equity can be divided into four main types: Private Equity Venture Capital: Early-stage, pre-IPO financing Mezzanine Financing: Later-stage, unsecured debt or preferred equity financing for firms with stable cash flows. More expensive but more flexible than senior debt. Bridges pure debt and equity. Buyout: Highly leveraged financing (LBO) of an established public or private firm which often results in the firm being privately held. Distress: Financing for firms that are troubled. Venture Capital Buyout Distress Hedge funds are similar in organizational structure to private equity funds. The main difference is that hedge funds tend to invest in public securities. Hence, they offer their investors shorter lock-ups and more liquidity. Private equity has a long-term horizon compared to the short-term horizon of hedge funds. PE Fundraising Reaches Record High in 2013 ($ Billions) Mezzanine Hedge Funds PE Fundraising Reaches Record High in 2013 ($ Billions) $1,200 $1,000 Other $800 VC Real Estate $600 Mezzanine Growth $400 Distressed Buyout $200 $0 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: The Wall Street Journal, June 15, 2014 Private Equity Partnership Investment Phase Payout Phase General Partner put up 1% of capital General Partner gets carried interest in 20% of profits Mgmt fees Limited partners put in 99% of capital Partnership Investment in diversified portfolio of companies Partnership Company 1 Company 2 Limited partners get investment back, then 80% of profits Sale or IPO of companies Company N Source: http://mba.tuck.dartmouth.edu/pecenter/about/index.html 22 Venture Capital vs. Buyouts Venture Capital Finance Venture Capital Buyouts startup mature Stage Revenues? no yes Positive Cash Flow? no yes convertible preferred common stock Security Debt? Syndicated? rarely often nearly always seldom Industries new all Failure Rate 50%