Term
| Describe the Efficient Markets Hypothesis, the three forms of efficiency and their implications |
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Definition
EMH: At all times, a security's market price reflects the true, rational value of the security - fairly priced Weak Form: price refelcts all info contaiend in historical prices (identify mispricing with technical analysis)
Semi-Strong: price reflects all public info (identify mispricing with fundamental analysis)
Strong Form: price reflects all info, public and private (insiders earn abnormal returns) |
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Term
| What is the paradox of market efficiency and how can you explain it? |
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Definition
If the market is already efficient with respect to the information gathered investors will not benefit from engaging in costly security analysis but the market can't be efficient if no one gathers info. The market cannot be absolutely efficient because prices deviate from true values. Should judge efficiency on a scale of large vs. small deviations rather than as an absolute.
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Term
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Definition
Cannot use past price movement to predict future price movement because stocks follow a random pattern, which is evidence against weak form.
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Term
| Rationale behind Event Study |
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Definition
Based on semi-strong efficiency. As new info about a firm arrvies, the market price of the firm's stock should immediately and unbiasedly change to reflect this information. By studying the market's reactions to management's announcements, shareholders can judge the efficacy of management's decisions and performance and managers can better understand how the market determines prices, and thus will be in a better position to make decisions that maximize market price.
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Term
| Examples of Value-Relevant Info |
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Definition
- Governement Press Release
- Earnings Announcement
- Dividends and Stock Repurchases
- Investment
- External Financing (debt vs. equity)
- Merger or acquisition
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Term
| Price Reactions to New Info |
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Definition
Good News: Overreaction to "good news" with reversion or delayed response to "good news" vs. EMH increase on day 0 Bad News: Overreaction to "bad news" with reversion or delayed response to "bad news" vs. EMH drop on day 0
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Term
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Definition
- If managers rely on public info to pick stocks on average their risk-adjusted returns should not outperform the market
- Can test semi-strong by comparing mutual fund and market performance and if there is a "stock picking ability" should observe that good funds continue to perform well, but evidence shows this is not true which supports semi-strong
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Term
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Definition
| Index funds have become popular in recent years because of an increasing belief in EMH. |
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Term
| Tests and Studies of Strong Form EMH |
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Definition
- Tests of strong-form efficiency investigate insider trading
- A number of studies support the view that insider trading is abnormally profitable (so there are laws)
- Strong-form efficiency does not seem to be substantiated by evidence
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Term
| What firms want to conduct a SEO and what firms are not welcome by the market to do so? |
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Definition
- Conduct SEO because internal equity funds are insufficient to pursue all positive-NPV projects
- Good Candidate: a firm whose exisiting projects are profitable and that has profitable investment opportunities whose capital outlays exceed available internal fund
- Bad Candidate: a firm whose exisiting projects are not profitable, but that has profitable investment opportunities, is a logical but problematic candidate OR a firm whose exisiting projects are profitable but which has few profitable investment opportunities
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Term
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Definition
- Private Placement: rare, issuers small and wealthy, discount, market greet announcement of private equity sales because it conveys a good value becasue of valuable private info, strong insider holders improves corporate governance so management performs better
- Grant: good option, to new CEO
- ESOP: employee stock ownership plan, incentives to improve productivity, tax advantage, many companies incorporated in Deleware because of strong takeover defense (85% shares not held by insiders) - rater has a hard time obtaining info about employee shares
- DRIP: dividend reinvestment plan, maybe to attract passive small investors, cap for plan, take money or have new shares, federal treatment, no commission for new shares, sold at discount
- Rights Offering: current shareholders are issued short-term warrants to purchase new shares on a pro-rate basis, exercise price set at deep discount, prevents ownership reduction, not used much becasue large price drop right before it happens - cost to firm and existing shareholders, favorable for current shareholders
- General Public Offering
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Term
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Definition
- Choosing an underwriter: negotiation (most common) vs. competitive bidding (lower cost but concern about sharing private info)
- Compensating the underwriter: spread, warrant (profit, good signal, call option and demonstrates underwriters believe there will be value in the future, risky)
- Firm Commitment or Best Efforts: certification hierarchy - firm commitment > best efforts, negotiation > competitive bidding
- Traditional or Shelf Registration: shelf allows up to two years to issue filed securities but is very restrictive (flexible, market timing, more underwriter competition and lower costs because wait for best offer, BUT depressed market price), most firms choose traditional
- Mix of Primary and Secondary Shares: secondary = transfer between shareholders
- Stock-Only Offering or Units: unit is combo of shares and warrants
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Term
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Definition
Market generally reacts negatively to a SEO announcement (-1.5%- -3%) |
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Term
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Definition
External equity is at the bottom of the pecking order, and would be offered only if the firm's insiders have private info that the the firm's equity is overpriced. However, may conduct if cash is available and rational if firms equity is overpriced. Firm with lower value willing to issue higher equity price and higher valued firm doesn't want to decrease its value (market realizes and will only pay low price). Higher valued firm will raise debt or pass up projects (explains debt preference and RE). Profitable firms have low debt becasue only use RE. There is value to having financial slack - cash, securities, unused credit. |
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Term
| Market Expeectations and SEO |
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Definition
Market values a firm by estimating earnings and assumes that the firm's earnings generally are sufficient to fund all investments. An SEO announcement reveals lower earnings than expected, and the market price falls. However, the market's reaction depends on pre-announcement expectations of optimal investment versus earnings. Higher M/B = higher average abnormal return. Price changes means market adjusts expectations. More investment opportunities means not as ad of reaction becasue there is a reason for SEO. |
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Term
| Agency Expectations and SEO |
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Definition
- Leverage: managers may use SEO to lower leverage and decrease risk of bankruptcy and losing compensation.
- Overinvestment: raise money for empire building, managers receive proceeds from primary shares so underperform benchmarks compared to secondary shares.
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Term
| Performance before and after SEO |
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Definition
SEO firms have positive run-up 1-2 years before and underperform 1-5 years after
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Term
| Earnings Management and SEO |
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Definition
Earnings managementt may explain because firm inflates earnings in advance to hype up price. Manipulate through discretionary accounting. Market learns truth after offering.
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Term
| Why is payout policy irrelevant for a firm's value in an ideal world and what are the assumptions and intuition behind it? |
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Definition
- Payout policies are irrelevant in an ideal world, but becomes relevant when considering real-world factors such as principal-agent problem, info asymmetry, and taxes/transaction costs.
- Dividend policy is irrelevant as long as the firm's capital investments and debt policy are fixed. Dividend payments are simply financed over time by a combination of excess retained earnings and, as neccesary, new equity.
- Intuitions: size of the pizza is the same since investment plan is fixed, debtholders' share of pizza is the same since debt policy is fixed, shareholders' share of pizza does not depend when they eat it
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Term
| Irrelevance of Dividend Policy and "Homemade Dividend" strategy |
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Definition
- Share price remains the same because timing doesn't affect value just means when money will be paid (higher dividend means borrowing money now and paying lower dividend later instead of equal at each time)
- Homemade Dividend: sell shares after dividend payment to create equal total wealth
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Term
| Empirical Features of Dollar Amount Dividends and Share Repurchases Over Time |
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Definition
Evidence is consistant with pecking order theory, when financing > internal cash flow - debt increases. Equity financing is very low. Dividends form the most stable series but grow slowly (4.5% annually). Stock repurchases are much more volatile and exhibit a much higher growth rate (17.7%).
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Term
| Popularity of Dividends vs. Stock Repurchases |
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Definition
- 1980-2000: dividend payouts decreasing and stock repurchases increasing
- Phenomenon may contribute to the decreasing popularity of dividends: (1) shift toward a greater prevalence of firms that have always paid few or no dividends, (2) firms have simply decided either to pay out a smaller proportion of their earnings in dividends or to pay no dividends
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Term
| Why dividends became less popular? |
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Definition
- Dividends provide shareholders with periodic cash returns that they can use for consumption: If dividends are not paid then shareholders would be forced to sell shares periodically for consumption purposes, and would incur transaction costs. However, if transaction costs for selling stocks have fallen over time, the relative benefit of a dividend is correspondingly reducded.
- Managers have increased their holdings of stock options that are not protected against the price-reducing effect of a dividend. Thus, they have a private preference not to pay dividends. (agency problem)
- Dividends may be less essential as a tool of corporate governance, because of the advent of alternative mechanisms for controlling principal-agent problems between shareholders and managers. (i.e. executive stock options)
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Term
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Definition
- Regular Cash Dividend: public companies often pay quarterly, sometimes firms will throw in an extra cash dividend, the extreme case would be a liquidating dividend
- Stock Dividends: no cash leaves firm, the firm increases the number of shares outstanding, incur costs in doing so but stock is more liquid and increases purchase patterns because of associations with price by investors
- Dividend in Kind: wrigley's gum sends around a box of chewing gum
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Term
| Procedure of Cash Dividend Payment |
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Definition
- Declaration Date: the board of directors declares a payment of dividends
- Cum-Dividend Date: the last day that the buyer of a stock is entitled to the dividend
- Ex-Dividend Date: the first day that the seller of a stock is entitled to the dividend
- Record Date: the corporation prepares a list of all individuals believed to be stockholders.
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Term
| Price Behavior around the Ex-Dividend Date |
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Definition
- In a perfect world, the stock price will fall by the amount of the dividend per share on the ex-dividend date (net nominal price drop)
- Taxes: DPS is greater than the price drop because of taxes on dividends. In anticipation of the upcoming dividends(which incurs higher taxes), the current price is already discounted to reflect the fact that some firm value will flow to the government.
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Term
| Traditional Residual Dividend Policy |
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Definition
Dividends should be paid only if the firm has excess cash after all cash needs are met. (volatile)
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Term
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Definition
- Keep dividends stable relative to earnings
- If earnings are greater than past year dividend then there is a higher dividend
- p = speed of adjustment (1=full adjustment, dividends are always equal to a fraction of current earnings) , (0<p<1 - the firm only partially adjusts dividends to deviations of current earnings from the trend)
- target payout = EPS*payout ratio
- Smooth yearly curve for dividends even if earnings are volatile
- Can be costly if earnings drop but still want toraise dividends because market doesn't like dividend reduction.
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Term
| Dividends and Principal-Agent Conflicts |
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Definition
- Free Cash Flow: the firm should impose dividends (despite tax effect) to curb management's empire building and force out FCF
- Expropriation of Creditors' Wealth: By increasing dividends, the firm has fewer assets against which creditors have a priority claim, and thus the value of a creditors' claim is lower - (acting in shareholders' best interests). The above problems lead creditors to demand a debt covenant that restricts the amount of dividends that the firm can pay. Such restriction can serve both to protect creditors and to mitigate the underinvestment problem by using money to finance projects instead of paying out dividends
- Management vs. Board: For a levered firm, the conflict over dividend policy may be particularly severe. Both prefer lower dividends and lower leverage, but for different reasons (less risky, more perks, FCF). Board presses for higher dividends and leverage for disciplining - acting in shareholders interests to force out FCF.
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Term
| Dividends and Info Asymmetry |
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Definition
Theoretical models show that dividends can be an effective signal of a firm's true value. As in every signaling model, the signal must be costly to prevent mimicking. The cost of dividends can be (1) increased probability of bearing costs of issuing shares in the future because paid out FCF (2) forgone investment in profitable projects (3) tax costs
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Term
| Market Reaction to Dividend Changes |
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Definition
- The market generally reacts positively to dividend increase announcements, and negatively to dividend cuts. Dividends don't predict future earning increaes but rather that the management is confident in permenant current earnings increase rate. Increase means no empire building or FCF and an expropriation of wealth from creditors.
- Opposite can be true: Firm cuts dividends because of an increase in capital expenditures for profitable investments. Dividend increases could indicate that firm's supply of profitable projects is gone.
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Term
| Market Reaction to Dividend Initiation and Omission |
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Definition
- Initiations: 3.7% abnormal return, which is greater because it is a surprise, earnings volatility decreases (firm is mature, lower risk)
- Omissions: -6.94% return
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Term
| Forms of Share Repurchase |
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Definition
- Open Market: gradual, open-market purchase (common)
- Dutch Auction: shareholder can submit an offer to sell a specified number of shares at a specified price, firm calculates average price and purchases all shares at that price
- Fixed Price Self-Tender: firm collects offers after specifying price and amount of shares (quick)
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Term
| Market Reaction to Share Repurchases |
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Definition
- Market reacts favorable because of value relevant info
- Signaling: management does so when stock is underpriced
- FCF: less wasted money for empire building
- Expropriation: steal value from creditors
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Term
| Share Repurchase vs. Dividends |
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Definition
- In a perfect world, an investor can sell shares/purchase shares to change her total equity position in the firm - it looks like the choice is irrelevant.
- Signaling: stock repurchase eliminates underpricing, dividends signal stability
- Cash Flow Permanence and Financial Flexibility: cash flow is temp. (one time) = stock repurchases, dividends = permanent (bc not good to cut them)
- Tax: repurchases have a favorable tax consequence
- Managerial Preference: managers with stock options prefer repurchases bc not accompanied with stock price drop
- Tax Clienteles: good firms pay dividends to attract the scrutiny of instiutional investors
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Term
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Definition
Two firms combine to form a single firm. In most cases, the shares of one firm are extinguished while the shares of the other firm continue. Initiated when the bidder's board approves an offer of stock and/or cash in exchange for the shares of the target. Deal is completed when offer is accepted.
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Term
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Definition
The shareholders of the defunct firm receive shares of the surviving firm and/or cash, while the surviving firm acquires the assets (and liabilities) of the defunct firm. The surviving firm is the acquiring firm or bidder, and the defunct firm is the acruired firm or target. Deal accepted in the same way as in merger.
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Term
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Definition
Both firms cease to exist and a new firm is establighed with a new name, a new board, and/or new management.
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Term
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Definition
- Horizontal: two competitors in the same line of business combine. Motive is to create economie of scale or scope, or to enhance market power. (i.e. Daimler-Chrysler)
- Vertical: Two firms in different stages of the production process in a given industry combine. Motives: stabilize the supply of raw materials, stabilize customer demand for the finished product of hte firm that is further up in the production process. (i.e. GM and auto parts mfg.)
- Conglomerate: Two firms in unrelated industries combine. Most difficult to justify. Motive - diversification. Prime example of empire building.
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Term
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Definition
- Operating Synergy: obtains if the merger results in imporvements in management, labor costs, production or distribution, resource acquisition and allocation, market power. [current stock price = current operating value + (expected takeover premium)*(takeover probability)]
- Financial Synergy: obtains if the financial structure of the merged firm causes its market equity value to be greater than the sum of the market equity values of the separate firms. In an ideal world, there should be none because capital structure is irrelevant and investor can just buy both stocks on own. However, the diversification effect may increase debt capacity and brings tax benefits - increase leverage so that benefit doesn't just go to creditors - lesss risky, lower distress costs.
- Bankruptcy avoidance for target: agree to be acuired to avoid deadweight costs of bankruptcy- results in restructure
- Internal Capital Markets or Financial Slack: a cash-poor firm with substantial profitable investment opportunities faces the difficult choice of raising funds in external market or passing up profitable investments (pecking order). REsolve problem by merging with cash-rich, investment-poor firm.
- Hubris hypothesis: bidder's management overvalues the target because they overestimate their ability to create value.
- Mitigating Management self-interest: (agency theory) mangaement of cash-rich, investment poor firm has incentive to overinvest in unprofitable investments. Merging mitigates risk.
- Taxes: if have tax benefis but not enough earnings to enjoy benefits
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Term
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Definition
Antitrust laws, monoplies outlawed, actions against vertical and conglomerate mergers, recent focus on horizontal mergers. However, mergers are better for failing companies than bankruptcies and liquidations. Frequency of acquisitions in an industry is a measure of vitality because competiveness drives out firms. Research found no significant evidences of anticompetitive efforts after mergers.
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Term
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Definition
- No pooling of interest allowed, only purchase method
- form of compensation depends on concerns of loss of control and equity value of merged companies
- Stock: Benefits: do not need to raise external financing and tax free; Drawbacks: approval of shareholders of both firms needed, time delay, neg. announcement returns
- Cash: Benefits: can be quick, private targets prefer cash, advantage if competing tender offers; Drawbacks: often need to raise debt, tax
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Term
| Announcement Effects of M&A |
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Definition
- merger means positive abnormal return for target (20%) and acquiring firm is unaffected or has a small loss
- Target shareholders earn higher returns if the offer is made in cash than stock or a mix
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Term
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Definition
Managers with more equity-based compensation made better acquisition decisions on average. Biggest merger failures involve large firms. Cash rich firms are more likely to attempt acquisitions and destroy values and returns. Overconfident managers are more likely to make acquisitions and the market's reactions are more negative.
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Term
| Post-Merger Performance of Acquiring Firms |
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Definition
Merging firms exhibit imporvements in asset productivity, leading to higher operating returns. Post-acquisition stock return performance of acquiring firms is generally poor for a period of five years after a merger. However, bidders in cash tender offers over-perform on a long-term basis after an acquisition.
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Term
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Definition
- A takeover is the purchase of an entire firm by another firm.
- A friendly takeover is an acquisition made directly to management
- In a hostile takeover the bidder's intention is to acquire the target and replace the target's incumbent mangagement, who vigorously resist the attempt. The acquirer bypasses the target's management and approaches shareholders directly with an offer.
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Term
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Definition
- Failure of target management
- bust-up
- hubris
- industry shocks
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Term
| Takeover Bidding: the free rider problem |
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Definition
- Emerges when target-firm shareholders withhold their shares, forseeing that they will gain more after the takeover than in the tender offer. However, the takeover will fail if all shareholders withhold shares.
- Resolution: establish n equity position before the tender offer ("toehold"), two-tier offer allowing the bidder to dilute the value of the shares of those who do not tender
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Term
| Reasons for Takeover Defense |
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Definition
- Target-firm CEOs are more likely to be replaced if a takeover succeeds than if it fails so self-interest to resist.
- Bidder may have to increase bid so resistance can be in best interest of shareholders, but it also reduces the chance of a successful takeover.
- Takeover defenses do no more than keep entrenched managers in power - (1) a high bid premium tends to lower management resistance because no longer an excuse (2) resistance is associated with both an icnrease in the likelihood of a competing offer arising and a larger increase in target shareholder wealth
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Term
| Types of Takeover Defenses |
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Definition
- Golden Parachutes: generous severance packages to management but may not be enough money
- Greenmail/Standstill Agreement: target management may offer to repurchase the bidder's accumulated shares at a large premium if the bidder promises to cease and desist. Bribery - high premium to buyback.
- Poison Pills: (common) - (1) a shareholder rights plan that can be issued at the management's discretion can make shareholders buy new shares cheaper to dilute raider's shares (2) a put provision in debt contract that makes the debt due and payable immediately upon completion of takeover - raider sees a large debt contract so must have lots of cash on hand or will default
- Staggered Board: onyl a fraction of the baord is elected each year
- Supermajority provisions: 2/3 required
- Anti-takeover legislation: limits voting power of controllign shareholders and delays process of combining business (longer and more costly)
- White Knight: Warren Buffett takes stake
- Recapitalization and repurchases: raise leverage becasue too much FCF and makes less attractive
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Term
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Definition
- Different from acquisition because a group of individuals purchase target and a buyout often converts a public firm into a private one
- Motives: increasing management's incentives, averting a takeover, tax benefits
- Types: LBO - financed by debt (private, unfavorable investment opportunities and high cash flow), MBO/EBO - involve management or employee
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Term
| Market's Reaction and Performance of Buyouts |
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Definition
- Market reacts favorably
- Stakeholders' returns: selling shareholders gain 14-22% and bondholders suffer
- Post-buyout performance: efficacy of operating performance
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