University of Iowa College of Law
2 Major Themes: Efficiency (cut Transaction Costs and Agency Costs; predictability/consistency/uniformity; ), and Sophisticated investors (no implied fiduciary duty, strict construction). Also consider Tax Advantage (income tax, & what is not taxed twice? Buy-back = no tax), .
 Efficiency-related issues: strict construction of indenture provisions;
 Sophisticated investors-related issues: debentures (trust indenture act);
Exam: Friday, Oct. 28, 4pm in 225; 3 hour, open book.
The Efficient Market Hypothesis, …. Comment:
Better answer is: Efficient Market Hypo is more persuasive in these … circumstances, but not so persuasive in these other circumstances => Since we have encountered this Hypothesis in different contexts.
Don’t just put down a number but illustrate that you know …
(1) Annuity & perpetuity. [formula]
(5) How to come up w/ the rate.
a. Discount rate.
b. Capitalization rate.
d. Industry specific analysis [high-tech; food; fuel; air-line; mining; well-established; GE; …; Amazon compared underarmor; Amazon compared to a recent high-tech start-up]
Capital structure related issues: consider industry-specific factors. [High-tech; slow-growing biz like printing]
Birdthistle: Read the book, but primarily focus on the materials covered in class.
[Think: How these theories are applied in the legal context, especially in, shareholder disputes, etc.]
[Why is he, a law professor, telling us about all this?]
RETURN & RISK – hand in hand.
Part I: Valuation => Options => Decision-making.
How much a firm is worth? What standard of value should be applied to derive the value of the business interest at issue? (e.g. tri-Continental Corp) And what investment should you make, A or B, now or later?
Part II: Various disputes involving all types of securities (terms, rates, rights – voting etc., redemption, conversion) Negotiate & protect yourself
Conflict of interest b/w common and debt, common and preferred, common and convertible, and
Issuers’ Fiduciary Duty to debt-holders, convertible bond-holders, and preferred stock holders.
Wealth transfer – from bond holders to commons.
Part III: … Stock Options; Takeovers. [Stock Options incentivize good profit-making behavior; Takeovers police & disincentive bad behavior]
Business associations – picking a form is like suiting up – tailoring is more expensive; however, buying and then altering fits better and is less costly => State laws put in place the basic form of the suit.
Goal: State laws make it efficient in starting businesses – by paying taxes, you can do minimal when you start a business.
Partnerships are more malleable than corporations – you can contract for a partnership to look like a corporation in any other ways. Corporations have a lot of restrictions and regulations on them.
Advantages of a corporation (as opposed to a partnership):
– SHs no need to engage in mgmt or control, but still expected to get profit.
– SHs are not personally liable for the debts of the corporation.
– Easier to trade part of a corporation (more transferrable); whereas partnerships are very dissimilar and therefore not easy to trade.
[B/C corporations are … expectable – and thus cuts Transaction Costs, and agency costs, and thus more EFFICIENT]
However, cannot change (1) 3rd party liability (2) Fiduciary Duties (loyalty, care & good faith). Birdthistle’s comment: ill-defined analogy – insulation & padding.
Aligning divergent interest b/w (P) and (A):
Market condition decides whether (P) really needs (A), and whether business is going up or down.
(1) Compensation (e.g. Stock options)
(2) Monitoring: determine Rights & Duties, and Practices.
“Inherently equitable” (what context?)
I. Valuing Firms, Projects & Securities
A. Market Value & Fundamental Value
(1) Financial Reports.
Shareholder disputes involving: the appropriate standard of value to be applied in deriving the value of the business interest at issue.
Tri-Continental Corp. v. Battye: Negative asset value occurs in an entity when the liabilities exceed the assets. If the value of the assets declined, the common stock of the company would then be considered to be ‘under water’ as assets would not be equal to the outstanding senior securities, and in such a case, the common stock would be said to have a negative asset value.
(2) Efficient Markets & Behavioral Finance
Information in the mkt travels very quickly. One may deduce (a price closer to the real one) … from how others are acting.
 Weak form: past has zero predictability of the future.
 Semi-strong form: price reveals/processes all published (public) information.
Empirically: always some friction/impediment in the mkt.
Implication: even professionals can’t make money b/c information runs very fast.
 Strong: mkt price reflects all information instantly; some more sophisticated investors may
l to throw a $30,000 graduation party (gift) every year. How much is it going to cost (to write a check right now)? (How to figure it out)
– Intuition says it’ll be a little more than $30,000 => This is perpetuity. (PV = Present Payment/Rate)
– What is the rate for perpetuity? How do we determine this categories? And how this is going to affect the present payment?
— Maybe CD (a specific period of time), WHY the rate of CD? Relatively, it’s high, b/c the liquidity is low. (Retail, not too high a rate)
— Treasury rate. (Why T-rate?) The school won’t choose T-rate, b/c the rate is too low. (forgo a lot of potential return)
— Hedge fund (what portion? NOT ALL) => Diversify.
— Real Estate.
* What do endowments make? They do pretty well. (1) Large amount (2) Well managed (3) The Alternatives make better … in bad years.
If go with 8%, then 375,000.
Summary: (1) Perpetuity is triggered when the payment is going out every year.
Hypo (a): What if start the party 1 year from now – what’s the amount you need when you’re ready to throw out the money?
– PP still 375,000 – b/c the PP/R has no temporal component.
– What you get is an extra year: PUT a portion in a high-yielding hedge fund.
– 1 year from now: 347,222.22 => The PV of 375,000.
– How do you make sure the 30,000 right now offers the same amount of “awesomeness” in the future?
=> now we need a growing perpetuity.
How do we work this? Reduce the R (rate) to reflect the growing amount of perpetuity needed every year. => Back out of the rate you’re getting right now, subtract the inflation rate,
Hypo (b): [PREMISE: Bond, face value 1,000, annual payment is 10% for 10 years.
If you increase the rate => Total decrease (value of bond moves inversely to the interest rate)
Amount of payment of Bond is 100*10 + 1000 (Principal) = 2,000. Risk free, and no opportunity cost (no inflation), might make sense. => They go to the rate.
You’ll need a 0% interest rate to get the 2000 amount.
Future values discount very quickly. (Why is this concept here?)