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Corporate Finance
University of Mississippi School of Law
Bullard, Mercer E.

CORPORATE FINANCE

BULLARD

I. VALUATION:

A.

§ Two Main Methods: both methods reflect two components—dollars generated and the measure of risk

o Discounted Cashflow (DCF)

§ A year-by-year approach that looks at how much cash the business has on hand to use for general expenditures and paying creditors.

§ This method ascertains the present value of the income stream, which depends on the risk of getting that stream in the future.

§ Ex: If a business buys a truck in its first year, it decreases its cash flow by the amount of the check paying for the truck. Cashflow takes a big hit.

o Capitalized Earnings Method (CEM)

§ The earnings method gives a better picture of how the business is doing in the long term.

§ This method uses a single earnings amount and assumes that will be repeated every year. Divide the earnings by the discount rate to get a valuation.

§ This method gets us to an earnings number, but we also need to have a capitalization rate (discount rate)

§ Ex: If a business buys a truck in its first year, the cost of the truck is spread over a number of years.

o Risk: both methods must consider risk

§ Risk can be thought of as the rate of return demanded for investing in a business. When you invest in a business you are buying Cashflow and earnings. You want to know the likelihood of getting those earnings year after year.

§ The term discount rate can refer either to the rate of return demanded on an investment or to the rate expected on U.S. government debt (the riskless rate of return).

Essential Formula:

§ *** value of business = earnings / discount rate*** This is the same as Earnings x Multiplier = value because the multiplier is the inverse of the discount rate

o Example: Take a $100 bond with an expected 10% return.

§ A Price to Earnings Ratio (PE ratio) reveals what investors are paying for a given amount of earnings

§ Take a stock with $1 in earnings per share (EPS), with 1 million shares outstanding and a price of $1 per share. The return on this stock would be 100% because each $1 share produces $1 of earnings. The discount rate is $100. ($1,000,000 / 1 = $1,000,000).

§ As the PE ration goes down, the investment gets less risky

§ The discount rate can also be framed as Earnings per share/ Price, the inverse of PE

§ The inverse of the discount rate is called the multiplier (aka the capitalization factor) ***so is the multiplier the same as the PE ratio, if both are the inverse of the discount rate?

o ** Multiplier x Earnings = Value. 1/Multiplier = Discount Rate**

§ So if a company is bought for 5X earnings, investors are expecting a 20% return (1/5 = 20%).

o P/E is the price per share / earnings per share

§ The PE ratio is the same as the multiplier???

§ PE ratios and discount rates:

o PE 20/1 : Discount rate 5%

o PE 10/1 : Discount rate 10%

B.

§ Gibbons –Valuing a Company

o The minority SHs want to argue for a higher valuation so that they get more money for their shares. The company is arguing that it’s not that valuable so it doesn’t have to pay minority shareholders very much in the squeeze out.

o Looking at the Distiller’s Index could have helped the court because it shows a range of values for businesses in the same industry. It gives a view of the riskiness of companies in the industry.

o If we are going with our in class example of this company being a huge Dow company and the Distiller’s Index being comprised of small companies:

§ The minority SHs might argue that the smaller companies in the index should be taken out, which would make the index less risky, and therefore the company would be seen as more valuable (less risk=lower discount rate=higher value)

o Chancellor Marvel used a higher capitalization rate than the court-appoin

that CAPM fails with regard to small co.’s. It says there are too many differenced b/t this co. and others to take the small cap premium into account

II. CLOSELY HELD CORPORATIONS AND DILUTION

§ When courts deal with closely held corporations, they tend to use equity and fiduciary duty principles in order to solve disputes between family members and friends where the business has gone bad.

o **Note—always a good idea to have a buyout clause

A.

§ Dilution Formula:

§ 1 / (# of old shares outstanding) * Old Capitalization =

1/(# of new shares outstanding) * New Valuation

o Ex: 1/10 * 100 = 1/11 * 110

§ Watered Stock—the selling of new, overpriced shares of a corporation. Stock, the price of which is artificially inflated. Purchasers of watered stock incur losses to the benefit of sellers.

B.

§ Katzowitz—Financial Dilution

o Three men participate equally in controlling the corporation, but the other two want to oust Katzowitz. The have a secret board meeting where they issue new shares diluted to 1/18th the book value. The two buy the underpriced shares and make a good deal of money upon dissolution of the corporation.

o They lose as current shareholders (dilution of their shares), but they make a lot on the other side as buyers of the new undervalued shares.

o Court says that along with Katzowitz’s preemptive rights to buy new shares comes a right not to buy new shares if confronted with the dilution of his existing shares if no valid business justification exists for dilution.