M&A: Question & Answer - Deal Structuring and Financing

Q&A: Deal Structure & Financing

• Why are terms a very important component of any M&A transaction? How do terms influence price?
• Price can't significantly deliver control, but by implementing terms as subject to negotiations, acquirer could dictate the negotiation situations in order to better deliver control and push target company to accept the deal.
• Terms could influence price by using it as a bargaining chips. For example: 
• Final price bid --> final offer, acquirer's final decisions, price will not going up no more, exit  negotiations if target continue to ask more.
• Deadline: timing of the offer price, not valid any more in certain due date.
• Multiple offer --> increase offer price by stages of bidding.
• Offer reasonable price for more synergies and benefits. Push more target to negotiation table.
• Penalty and limit of the offer.
• Terms can change the offer price. For example: 
• Conditions of the purchase --> Off-market and on-market, whether involve special considerations such as special dividend, stock repurchase, options to sell the stock.
• Timing and proceeding of the purchase --> Whether in the bad or good macroeconomic conditions, final date of acquisition will define how much new share to issue, etc.
• Financing of the purchase --> market and target company dislike acquirer with lots of debt level, considering the cash and liquidity of the acquirer, financing by stock is less desirable.
• Payment forms and contingencies --> is there any liquid cash? is acquirer leave any contingencies clause to target?
• Legal structure of the combined entity after the purchase --> how former target management will involve? Is the new legal form will cultivate more benefits to shareholders and perform well in the longer term?
• Why is stock offer less desirable than cash offer from an acquirer's standpoint? And from a target shareholder's standpoint?
• Acquirer will prefer Cash Offer, because:
• Quick executions, faster to implement, reduce uncertainty about the deal overcome.
• Market reactions: Positive --> buyer stock price will go-up, since market suspect undervalued of buyer's intrinsic firm. Also, thanks to adverse selection, market suspect buyer's optimism about the future value of merger synergies.
• Stock Offer will bring ownership dilution as the acquirer share control and risk with target shareholders.
• But, the negative side effects are: 
• increase leverage/reduce acquirer's liquidity --> raising risk of bankruptcy.
• Increase overpayment risk --> bidder's cash offer usually higher than target's stock price.
• Tax payment directly after the announcement.
• Target will probably prefer Stock Offer, because: 
• Gain from acquirer's overpayment and asking for higher price than current stock price.
• Still have control over a new entity and could earn more profits by selling the stock at better price in the future.
• Deferred tax liabilities, since no cash involvement.
• But, the negative side effects is: 
• If the performance of new entity is worsen thus this could drive slump fall in the stock price and so the potential benefits will loss. 
• Driving uncertainty in the outcome of the deal and often trigger drawn battle due to target's board play for time.
• Due to adverse selection, Stock Offer could trigger Negative Market reactions, since market suspect of buyer's lack of financial capabilities and overvalued buyer's intrinsic value.

• What firm and market conditions predict financing choice? Why?
• Prefer Cash Offer : in high market volatility, strong acquirer's firm capital structure and unused debt capabilities, uncertainty about macroeconomic conditions (negative outlook signal), acquirer prefer for quick executions and save more by reducing time wasting. Strongly offer in the undervaluation of buyer's intrinsic value or uncertainty in the synergies and benefits post-merger. Also, in the small size of target's relative size compare to acquirer.
• Prefer Stock Offer : in good/more stable market conditions (positive outlook signal), acquirer lack of financial strength due to their limitation of cash and unused debt. Short-term profits, due to target could sell their stock in the future with better price. In overall large target's relative size, due to difficulty to fund acquisition with internal funding. 

• Why do acquirers sometimes use contingent payments?
• Uncertainty about the share price and market reaction in the final agreement date (highly volatility).
• Potentially acquirer's share price will fall significantly and so acquirer will issue more shares to maintain the same offer price --> ownership will diluted for something that wasn't the fault of acquirer.
• Wide disagreement about target's current value and benefits/costs of new legal entity after the merger.
• No guarantee about the new entity stock's future value 

• How can acquirers ameliorate target shareholder's risk aversion in stock deals?
• Minimum purchase price guarantee --> buyer gives put option (right to sell stock back to buyer at certain price)
• Purchase price collar --> with a fixed exchange risk, target get a minimum $ purchase price and also maximum $ price.
• Walk away clause --> deal is cancelled if Buyer's stock price falls too far.

M&A: Deal Structuring and Financing

Structuring choice

• Straight merger --> buyer merges with target and target ceases to exist
• Buyer absorbs all target's asset and liabilities.
• buyer shareholders must approve merger
• Triangular merger --> Buyer subsidiary and target merge
• Buyer absorbs all target's asset and liabilities --> cabins all in buyer subsidiary
• Not require buyer's parent shareholder vote.
• Target shareholders receive cash, notes or buyer parent stock
• Forward triangular merger: target ceases to exist.
• Reverse triangular merger: buyer subsidiary ceases to exist.
• Stock acquisition/purchase (including tender offer) --> buyer acquires all (or some of) target's stock for cash, acquirer's debt or stock.
• Target becomes a subsidiary of Buyer (not the case in partial acquisition)
• Target financial liabilities remain in target subsidiary.
• Asset acquisition --> buyer acquires specific target assets for cash, debt or stock
• Buyer only buy target's selected asset, not absorb their liabilities.
• Issues: tax implication --> identify existing double tax-system (from capital gain and dividend payment)
• In general, differences between purchase price and fair value of assets could be allocated as goodwill, of which the amortisation can create tax saving.

Price versus Terms

Price is the headline of M&A transactions, but secondary to terms
If one of the terms changes, price will changes. Both of them is subject to intense negotiation.
Bidding sends stronger signal than talking. Better by using the time limits, withdrawals, threats and other bargaining chips.

• M&A Terms:
• Condition of the purchase.
• Timing and proceeding of the purchase.
• Financing of the purchase.
• Payment forms and contingencies.
• Legal structure of the combined entity after the purchase.

Main concern of M&A participants --> to negotiate on terms

• Objectives / desirable:
• value creation.
• control and incentives
• financing flexibilities
• minimising transaction risks and adverse market signals
• enhancing governance, social responsibility.
• Constraints:
• Counter party objectives / desirables --> Zone of potential agreement (ZOPA)
• Owner's collective action: free-rider problems.
• Other stakeholders interests --> cost pay to lawyers, consultant, or government regulations.
• Contracting and financing costs.
• governance and tax regulations.
• Adverse selection:
• Outside investors cannot ascertain the true value of the firm.
• But suspect: managers issue shares --> if the firm is currently overvalued.
• Issue shares are "bad" signal --> high cost, share ownership of the firm, or as last resort (the firm cannot borrow any debt).

Payment choice

• Fixed payment: 
• often in the form of cash or debt securities.
• resolving uncertainty about the transaction.
• Semi-fixed payment:
• often in the form of junk bonds (very low credit worthiness), preferred stock and common stock.
• value may change upon the announcement of the deal --> different time of announcement date and arrival of other news?
• uncertainty about the realisation of the deal.
• may reveal negative investors reaction.
• Contingency payment:
• in the form of: earn-outs (additional payment to be made to target depend on performance in the future), warrants (a right, without obligation, to buy or sell something at an agreed price), convertible debts (the holder can convert into a specified number of shares of common stock in the issuing company or cash of equal value).
• value may change depending on the future target performances.
• Side payment:
• payments parties other than target owners
• Example: parties that influence in design & consummation of transaction to success of post-merger. Payment to union, guarantee of work rules, job security, government.

Financing choice (bidder financing decisions):

• New debt or reduce cash
• Effect: increase leverage, raising risk of bankruptcy and raise target taxes.
• Increase overpayment risk --> usually target's market share price is lower than the bidder's cash offer, thus no real measurement about under or overpayment.
• quick conclusion, reduce uncertainty about the deal overcome.
• Market reactions --> POSITIVE (buyer stock price will go up) due to market suspect: buyer's optimism about the future value of merger synergies and undervalued buyer's intrinsic firm value.
• Requires buyer financial strength --> must have sufficient excess of liquid assets or unused debt capacity.
• New debt will influence management discipline and increase monitoring of performance.
• Faster executions.
• Avoid buyer shareholder vote to approve deal.
• New equity
• Effect: dilute ownership, share deal risk with target (reflected in future share price, performance low --> share price decrease), raise stock liquidity (how easy it is to buy and sell shares without seeing a change in price).
• Floatation costs --> paid by the company that issues the new securities and includes expenses such as underwriting fees, legal fees and registration fees.
• Drawn out battle --> lots of effort, more difficulty and time consuming.
• Market reactions --> NEGATIVE (buyer stock price will go down) due to market suspect: buyer's lack of internal financial capabilities (last resort) and overvalued buyer's intrinsic firm value. 
• Reduce buyer's risk of overpaying for a target. Performance of target decreasing --> stock price will decrease as well, target sharing risk of lower stock price between announcement of takeover and final due date.
• Buyer shareholders may have right to vote on the deal (because have a large block share  which meet the criteria to vote).
• Floatation exchange rate: adjusting the ratio price the acquirer decrease by 35%, thus price M&A will decrease by 35% (always remaining the same proportion).
• Risk bearing impact of financing choice
• Cash Deal:
• Buyer shareholders bear all deal risk --> overpayment risk (unrealised expected synergies & operating improvement)
• Target: no risk
• Stock Deal:
• Target shareholders bear short-term purchase price risk --> acquirer stock price will change up/down until deal completion date.
• Target overpayment shortfalls cause acquirer share price will fluctuate as investors learn about the true value of synergies & control benefits.
• What are potential problems if Buyer's share price falls substantially?
• Acquirer will issue more share to maintain the same offer price --> ownership will diluted for something that wasn't the fault of acquirer.
• Solution?
• Minimum purchase price guarantee --> buyer gives target owners put options on its stock (right to sell stock back to buyer)
• Purchase price Collar --> with a fixed exchange rate, target owners get a minimum $ purchase price, but they also accept a maximum $ price.
• Walk away clause --> deal is cancelled if Buyer's stock price falls too far.
• Special dividend --> shareholder is happy because excess of imputation credit --> get back to shareholders as dividend and also transferring tax credit.
• Equity-linked contingent Financing:
• M&A payments are contingent on Buyer or Target stock price or on Target asset value or profitability after deal completion.
• Contingent contract mechanisms are often used when:
• wide disagreement exists about a Target's current value & target will be operated as a separate subsidiary or division of Buyer.
• Target shareholders retain a minority interest in Target --> than fear expropriation by Buyer (ex: buyer purchase only 50.1% control)
• In stock deals where Buyer stock is highly risky, Buyer can offer a long term price guarantee on it's stock future value.

Customer Profitability and Lifetime Value Analysis

As the growth of customer-centric strategic management become more beneficial to the company, thus there's an increasing needs to assess customer profitability and value.

Customer Profitability Analysis (CPA):

• Based on the principal of Activity Based Accounting (ABC).
• Takes into account the profitability of product mix purchased by customers and customer-driven costs generated by servicing these customers.
• Another way to understand how resources can be allocated most effectively to cultivate the most profitable customers.
• Ability to price on basis of cost-to serve a particular customer or segment.
• Nature and targeting of advertising and marketing campaigns (to target profitable customer segments).
• Reconfiguring & classifying a firm's customer portfolio.

Strength & Weaknesses of CPA:

• Strength:
• Focus better on customers and generate greater SHV: optimise allocation of scarce resources, pricing decisions, discount (when necessary). concede permanent loss customers.
• Weakness:
• Static, single period snapshot of customer profitability.
• Historical performance only.
• Does not consider how customer profitability may change over time.

Types of customer to consider:

• High Profitability & Short Term Customers --> Butterflies
• Good fit between company's offering and customer's needs.
• High profit potential
• Action:
• Aim to achieve transactional satisfaction, not attitudinal loyalty.
• Milk the accounts only as long as they are active.
• Key challenge is to cease investing soon enough.
• High Profitability & Long Term Customers --> True Friends
• Good fit between company's offering and customer's needs.
• Highest profit potential
• Actions:
• Communicate consistently but not too often.
• Build both attitudinal and behavioural loyalty.
• Delight this customers to nurture, defend and retain them.
• Low Profitability & Short Term Customers --> Strangers
• Little fit between company's offerings and customers needs.
• Lowest profit potential
• Actions:
• Make no investment in these relationship.
• Make profit on every transactions.
• Low Profitability & Long Term Customers --> Barnacles
• Little fit between company's offerings and customers needs.
• Low profit potential
• Actions:
• Measure both the size and share of wallet.
• If share of wallet is low, focus on cross-selling and up-selling.
• If size of wallet is small, impose strict cost controls.

Lifetime Value (LTV)

• Focus on multi period, future oriented economic value rather than single period profitability of customer/segment.
• Measured as the present value of net expected future cash flows that are expected over the life time of firm's relationship with a customer.

Pros and Cons of LTV:

• Advantages :
• Future oriented
• Multi-period analysis
• Considers relative profitability changes according to the customer's lifecycle stage with the firm
• Considers impact of tenure on value a customer represents.
• Limitations :
• Not as well-grounded as CPA (not based on ABC concepts)
• Difficult to estimate impact of LTV factors
• Difficult to operationalise some of LTV factors.

M&A: Restructuring and Leveraged Transactions

Definition:

• Wikipedia: (http://en.wikipedia.org/wiki/Restructuring)
• "Restructuring is the corporate management term for the act of reorganizing the legal, ownership, operational, or other structures of a company for the purpose of making it more profitable, or better organised for its present needs. Other reasons for restructuring include a change of ownership or ownership structure, demerger, or a response to a crisis or major change in the business such as bankruptcy, repositioning, or buyout. Restructuring may also be described as corporate restructuring, debt restructuring and financial restructuring."
• Investopedia: (http://www.investopedia.com/terms/r/restructuring.asp)
• "A significant modification made to the debt, operations or structure of a company. This type of corporate action is usually made when there are significant problems in a company, which are causing some form of financial harm and putting the overall business in jeopardy. The hope is that through restructuring, a company can eliminate financial harm and improve the business."

Major restructuring transaction:

• Asset restructuring --> asset sales, merging division, adding division
• Ownership restructuring --> changing the ownership structure of either parent or division
• Liabilities restructuring --> changing the debt/equity ratio
• Rationale: to create value by reversing the negative consequences of:
• conglomeration/corporate diversification.
• value destroying M&A or over-investment --> hubris mgt, agency issues.
• sub-optimal capital structure --> has not borrow enough or not capture optimal benefits of debt.
• financial distress --> too much debt/equity ratio.

Benefits and costs of corporate diversification

• Benefits of conglomeration (non-core business and unrelated divisions):
• More synergy by sharing a common headquarter.
• Create internal capital markets (could trade each others and makes profit)
• Tax advantages (tax-loss acquisitions, interest tax shield, basis step-up)
• Avoid dependence on one product line and greater stability of profits since if one division experience losses, other may create profits.
• Costs of conglomeration:
• Lack of diverse capabilities, lack of focus, duplication and wastes.
• Cross-subsidisation and inter-division politics.
• Symptomatic of over-investment or free cash flow problems.
• Twin-agency problems: difficulties in monitoring divisional managers --> lack of information to capture division/individual performance.
• Opportunity costs of potentially greater synergies if the assets are deployed elsewhere.
• Do the costs outweigh the benefits?
• Contra: 
• reduces value by 13-15%
• often forced to sell units to return to a more manageable structure.
• performance decline - segment/whole company.
• Pro:
• divestiture announcement usually increase shareholders wealth, greater than zero.
• divestiture announcement have a negative effect on competitors share price.
• larger divestment --> larger price increase
• Divestment of unrelated non-core business --> larger price increase
• asset sold --> larger price increase.

Ownership Restructuring:

• Divestiture (by auction or negotiated sale): 
• a sale of a subsidiary, division or product line to a 3rd party, generally in a private transaction.
• Raising cash to strengthen seller's financial conditions.
• Assets are revalued to reflect expected CF under buyer mgt.
• Subject to taxable capital gain/losses --> tax liability can be huge.
• Control benefits: better use of assets --> assets are undervalued, target not efficiently using them or may be in financial distress situations.
• Equity Carve Out: 
• initial public offering (IPO) of stock in a wholly owned subsidiary.
• New public shareholders own control of subsidiary.
• parent firm typically retains a controlling interest in the carved out subsidiary (median 80%).
• means of raising funds (cash) in the capital market
• after carve-out, subsidiary has its own board of directors.
• tax free spin-off --> differ tax paid (no cash involvement)
• Corporate Spin-Off:
• Distribution of shares in a subsidiary to existing shareholders of parent firms as a (non-cash) dividend --> usually pro rata (not change ownership structure)
• No cash inflows to parent firms.
• creates publicly held stock in subsidiary and reduces or eliminates parent ownership in subsidiary.
• established an independent board of directors and grant decision making authority to subsidiary management.
• Divest asset - on a tax efficient basis (subsidiary shares distributed to shareholders are not taxed)

Rationale for Leveraged Buyout (LBOs) and Leverage Recapitalisations

• Major leveraged transactions:
• Debt-to-equity and equity-to-debt swaps --> involve major debt-holders and shareholders and not public investors.
• Leverages acquisition: --> target become a private firm
• Leverage Buyout (LBO) --> control transferred to an LBO fund or syndicate. 
• An acquisition where the purchase price is financed through a combination of equity and debt and in which the cash flows or assets of the target are used to secure and repay the debt.
• LBOs have become very attractive as they usually represent a win-win situation --> the financial sponsor can increase the returns on his equity by employing the leverage; banks can make substantially higher margins due to higher interest chargeable.
• The management of the target is usually retained and often takes an equity interest in new company.
• Management Buyout (MBO) --> control transferred to existing management.
• the incumbent management team acquires a sizeable portion of the shares of the company.
• Face a conflict of interest, being interested in a low purchase price personally while at the same time being employed by the owners who obviously have an interest in a high purchase price.
• To minimize conflict of interest: Owner (offer a deal fee if certain price threshold is reached); Financial sponsor (offer compensation of lost deal fee); or earn-outs scheme (purchase price being contingent on reaching certain future profitabilities).
• Leverage recapitalisation: --> self tender; target remains a public firm
• Large scale buyback funded by debt issue
• Control concentrated in the hands of existing management.
• Target remain a public firm.
• LBO Source of value:
• Not significantly from: losses employees, tax savings, market inefficiency.
• But, restructuring benefits come from:
• Breakup values can be realised.
• Corporate governance is improved.
• Change of corporate governance, allow manager to have better incentives.
• better compensation structure and management are kept on their toes through threat of bankruptcy, reduced free cash flow.
• Profile of ideal LBO Target:
• Asset structure: more assets, so it can be sold to pay debt.
• Capital structure: low debt --> reduce financial distress.
• Operating performance: strong performance --> less value creation to repay debt
• Cash holdings: large amount of cash to pay debt.
• Management incentives: less incentives and use available cash to pay debt.
• Ownership structure: concentrated --> easier to negotiate and to control major shareholders.

M&A: Hostile Takeover, Defensive Strategies and Merger Arbitrage

Hostile Takeover:

• Mostly are off-market purchase, can turn friendly and vise versa.
• Hostile threats have a disciplining effect on target's managers but also bring higher premium (benefit for target).
• Hostile carry element of surprise, allow bidder to take advantage of poor target valuation, reduce the likelihood of competing bidders, limit hold-out problems (target's board play for time), bypass highly entrenched board, create pressure for board to go back to the negotiation table (opportunistic benefits for acquirer).
• Costs: 
• no due diligence
• protracted (lasting longer than expected), difficult to win control, high premium.
• Tougher merger integration --> strong enough to withstand adverse conditions, lots difficulty, require great efforts. 

Merger Arbitrage

• Arbitrageur's strategy:
• Long position on target shares --> buy target shares, hoping the price will go-up since the competitive bids will drive-up acquirer's offer price and arbitrageur will earn more.
• Until the acquisition is completed, the stock of the target typically trades below the purchase price. An arbitrageur buys the stock of the target and makes a gain if the acquirer ultimately buys the stock.
• Short position on bidder shares (usually for stock deal) --> short the acquirer shares, hoping the price will go-down for unexplained reasons.
• The acquirer proposes to buy the target by exchanging its own stock for the stock of the target. An arbitrageur may then short sell the acquirer and buy the stock of the target. This process is called "setting a spread." After the merger is completed, the target's stock will be converted into stock of the acquirer based on the exchange ratio determined by the merger agreement. The arbitrageur delivers the converted stock into his short position to complete the arbitrage.
• Collar --> the exchange ratio is not constant but changes with the price of the acquirer.
• Net position is highly leveraged.
• Risks: 
• The deal will fail and the price will go down significantly.
• Degree of exposure amplified through leverage.
• Arbitrage spread:
• Difference between the offer price and the target's post announcement market price.
• Positive: higher offer.
• Roles of Arbitrageur
• Providing liquidity: merger arbitrageurs provide liquidity that target shareholders demand to avoid blow-up risk.
• Ameliorating shareholder hold-out problems: Arbitrageurs round up free float shares in the market, making the coordination problem less severe.
• Information revelation: Is another higher offer forthcoming? What is the probability of deal failure?

Takeover Defence Strategies

• Why do targets need to defend against hostile takeovers?
• Keeping management entrenched (firmly established and difficult to change)
• Protecting stakeholders (eg employees) welfare.
• Deterring (prevent the occurrence of) opportunistic and not serious bidders.
• Providing a fair M&A playground for all shareholders
• Extracting more value for target's shareholders.
• Buying more time.
• Wrestling control of the process back to the target.
• Reducing shareholder holdout by forcing target shareholders to coordinate.
• Giving the board more bargaining power at the negotiation table
• Making acquirers to offer higher premium.
• Common Strategies:
• Pre-emptive defences: 
• Implemented before a hostile bid.
• Legal mechanisms and some strategic & financial defences.
• Reactive Defences:
• Defences put in place after a hostile bid is made.
• Tailored to defeat or discourage a specific bidder.
• Defensive strategies in Australia:
• Poison pills not widely used (Takeover Panel Guidance Note 12) such as:
• issues new share/repurchase shares significantly in the context of the bid.
• Acquiring major asset or disposing one.
• Undertaking significant liabilities or materially changing terms of its debt.
• Declaring a special or abnormally large dividend.
• Significantly changing company share plan.
• Entering into joint venture.
• Staggered Board
• Board recommendations: significant impact on shareholders decisions, often accompanied by independent expert valuation reports, can be supported by marketing campaign in the media.
• Value diversion: special dividend, share buyback.
• Information management: updating profit forecasts, bring forward the release of confidential information.
• Restructuring: sale of non-core assets, increasing leverage, de-merger.
• Creating an auction environment: approaching potential white knights, setting up an auction for an asset/division.
• Taking advantage of resistance from regulators/public: Takeover Panel/Foreign Investment Review Board rulings.
• Most importantly, asking for a higher price --> pointing out that price < synergy, attacking acquirer's financing, stock price potential (in stock deals)
• Empirical Results for Australia (Maheswaran and Pinder, 2005):
• Bid resistance increases target shareholder wealth in post announcement period.
• Bid hostility associated with larger targets, weak target performance.
• Hostility unrelated to size of premium offered.
• Hostility decreases probability of success, increases likelihood of revision, does not scare off competitors.

International Capital Budgeting

Driving the NPV of Free Cash Flow

• Incremental profit --> free cash flow represents the incremental profit of the project, as investors interested in how much new cash is coming into the firm in return. 
• Export cannibalisation: losing profit from export sales to foreign market due to establishing new plant in foreign country.
• Forecast of revenue --> depend on the corporate future economic environment, demand: company's pricing and advertising policies. Also, future exchange rates.
• Forecast of costs --> measures as the cost of goods sold (COGS)
• Depreciation --> legal tax shield; subtracted out before taxes are calculated.
• Capital expenses --> money spent on property, plant and equipment (PPE).
• Net working capital --> inventory and cash on hand to run business.

Financial side effects:

• The cost of issuing securities: monetary fee (compensation to financial intermediaries in issuing securities), underwriting discount (the spread between what the firm receives from issuing securities and what the public pays for the securities).
• Tax shield for certain securities: interest tax shield (the value of the ability to deduct interest expense for tax purposes)
• The proper discount rate: rate should reflect the appropriate riskiness of the project's cash flows.
• Cost of financial distress: Direct costs (legal consulting and accounting fees -- 3%); indirect costs (loss of value due to the expectation of failure) -- creditors unwilling to extend more credit, inability to attract skilled labor. 

Pros and Cons of alternative approach to capital budgeting

• WACC predict the project will perpetually provide the expected level of CFs.
• D/VL constant
• ANPV Pro: allows managers to make informed decisions about the economic profitability of a project versus other sources of value.
• ANPV Pro: works well for international projects and nicely with hedging foreign exchange risk.
• ANPV Con: problematic if D/E ratio os going to be held constant.
• WACC and FTE Con: problematic if D/E ratio is going to change.

Tax implication of borrowing in a foreign currency (FC):

• If the borrowed (foreign currency) strengthens against domestic currency, borrower owes more.
• If the foreign currency weakens against domestic currency, borrower owes less.
• Because high interest rate currencies are expected to depreciate relative to lower interest rate currencies, the borrower expects to have a capital gain on the repayment of the principal.
• Capital gain tax offsets the higher interest tax shield and prevents the existence of a tax incentive to borrow in high interest rate currencies.

Conflicts between bondholders and stockholders

• The incentives to take risks: stockholders have the incentives to take on risk.
• Bondholders want low variance projects.
• Equity holders want high variance projects.
• The underinvestment problems: no incentives to take +NPV project, because bondholders will get all of the value.
• Other managerial problems: cash distribution for shareholders and misrepresentation of earnings.

International Capital Market Equilibrium

Two risks of investing abroad:

• Return of the international asset in its local currency.
• Variations in the value of the foreign currency relative to investor's currency.
• Return of investment = return of asset + return of currency

Sharpe ratios:

• measured as the average excess return relative to the volatility of the return.
• Risk adjusted excess return.

Nonsystematic variance = idiosyncratic variance (changes over time --> implication on how many firms it takes to diversify)
Systematic variance = Beta.
p < 1; the lower the better, firms more diversify.

What drive correlation of returns?

• Trade
• Geographic proximity
• Industrial structure: firms in the same industry --> buffeted by the same shocks, their systematic risk also move together.
• Irrational investors : contagion phenomenon.

Investment hurdle rates --> lowest possible expected return that allows for an improvement in the Sharpe ratio when they invest in that foreign market.

Risk premium of the market --> how much the market compensates investors for systematic risk.

Home bias --> local investors hold a disproportionately large share of local assets compared to global assets.

• Issues: Investors should not hold foreign equities because they are more volatile and have been yielding lower return than US stocks. --> False. 
• You should add foreign equities as soon as the foreign sharpe ratio exceeds the American sharpe ratio times the correlation between US portfolio and foreign security retun.
• Issues: Home bias arises because investors face an additional risk when investing internationally - currency risk. Because currency risk makes return more volatile but does not lead to a higher expected return, investing more in domestic assets is rational.
• Issues: Home bias arises because investors have a non-traded domestic assets that they care about as well - namely human capital. The returns to this asset can be thought of as labor income.