Great explanation by Bchad and spoon fed explanation by greengrape. Lord knows how the guy got a job in a bb. Although I must say it matters more what analyst you work for than if you work at so and so investment bank
Thanks for the compliments, but I am going to change my answer on the P/E and say that it stays the same, except if the company is perceived to have taken on too much debt, in which case the PE ratio will go down to reflect the additional risk of bankruptcy. I stand by the earlier parts of my post, but I got things mixed up a bit when putting it together to a conclusion about the P/E ratio. It’s probably an obvious question to people who do this stuff on a daily basis, I’d think, but for the rest of us who have to think it through, it’s tricky. The total earnings go down, the total shares outstanding go down, but the EPS goes up and the individual share price goes up. Whether you use total earnings and total shares or EPS and price/share figures in computing the forward PE, both are going to change by the same percentage, leaving you with the same PE. It’s easy to get confused on this question, because if you mix an analysis on a per share basis with an analysis on total earnings or total shares, you can get the PE going either way, depending on how you’ve mixed them up. Another way to look at is to take the justified PE formula from L1 PE=k/(rce-g) and realize that none of those variables are affected by the capital structure (at least in a CAPM world or world where rce is not influenced by leverage). Although, technically, this formula only works for mature dividend-paying companies, there’s no reason to think that this particular analysis wouldn’t also apply to other companies. So the key lesson is that P/E is an equity metric that should be more or less independent of capital structure, except to the extent that a ridiculous capital structure puts the company at a substantially higher risk of bankruptcy.
"Another way to look at is to take the justified PE formula from L1 PE=k/(rce-g) and realize that none of those variables are affected by the capital structure (at least in a CAPM world or world where rce is not influenced by leverage). " although if i understand your reasoning correctly, you’re making the assumption that the dividend payout ratio remains constant, which in combination with the lower total earnings because of the interest payments, results in a lower dividend. not sure how realistic it is to say that the company will finance share repurchase with debt and as a result they will lower the dividend? better assumption in my opinion is that dividend remains the same, dividend payout ratio in your fomula goes up, P/E ratio increases
Let’s face it, question 3 is a stupid question. This area is covered extensively in Level 2 and even then it was unconvincing.
All questions are grey area. they are all “it depends” which i think the hardest questions to answer concisely and logically. below is how I would answer. 1. Company CFO will look at capital structure and WACC for equity and debt markets, if equity premium is low, equity may be the best option. If I was company CFO and saw equity cost 9% and HY debt was 8% I would go with equity b/c historically equity premium is on average much higher then that (I think 3-5% for IG and maybe even 6-10% for HY if I recall from research I saw years ago) 2. Having worked as a convertible arb trader for 5+ years, this I answer different then how the real world works. Typically convertible bonds are issued b/c issue size, volatility premiums, demand for product, and so on… The question is open ended… convertible debt vs high yield is different answer then convertible debt vs equity, or what about convertible debt vs warrant + high yield… but the answer to an average interviewer is lower coupon rate vs straight and less dilution vs equity. 3.my best answer: numerator lower, denominator unchanged (to higher)… therefore P/E is lower…but must give reason. since typical P/E is market Cap / trailing 12 month earnings/share , the market cap is reduced while the TRAILING earnings are unchanged using a typical SS EPS measurements which also use average outstanding shares for past 12 months (or use current # shares which increases EPS) typically straight from the companies 10-K.
for #3 i dont buy how P/E is lower. assuming management is not retarded (i.e. comany is not already overleveraged and they put more debt to buy back shares - stupid), then the most likely situation is company is underleveraged, management thinks they can reduce their weighted average cost of capital by increasing debt, and they do that so they move towards optimal cap structure - positive signal they use the proceeds from debt issuance to buy back shares, meaning they are confident in their stock performance - positive signal. their actions are consistent and sending positive signals to the market, as a result P/E should go up. thats purely qualitative reasoning, now you can do some algebra to justify it numerically but whatever the calculation methodology if you end up with an answer “P/E is lower”, i’d like to hear how you explain this. the numerator-denominator-blah-blah argument can go either direction as we have seen, not a real answer.
Jonnyboi Wrote: ------------------------------------------------------- > wake2000 Wrote: > -------------------------------------------------- > ----- > > Oh Johnny Boi you got a long way to go > > > I already have my CFA, its just been a while since > I was dealing with certain aspects of the > material. Its in my brain somewhere You can add me to this category - a case of use it or lose it. I’m getting dumber every day and I didn’t start out so smart either…
Maybe this is a good case to hold onto your books/study notes for future reference? Can’t hurt to crack 'em open every once in awhile as a refresher, especially if you got an interview coming up!
Jonnyboi Wrote: ------------------------------------------------------- > I recently had an Ibanking interview and I was > wondering what the best/correct answer would be to > the following > > 1) A company is going to build a mine, why would > the company finance debt as oppose to equity or > vice versa? > > 2) Why would a company issue convertible debt? > What is the benefit? > I think that they would pay a lower interest rate, > but not sure > > 3) what effect would re-capitalizing debt for > equity (buy back shares and issue debt) have on > the P/E ratio? 1. debt finance would be cheaper than issing equity. further, there wouldnt be any equity dilution to current holders and with a good M&A transaction they would work hard to reduyce negative covenants for the company but still have some there for the debt holders. also, leverage juices returns and with a storng mining company it is the cheaper, better option. Further, think about the tax shield it provide 2. much lower rate would be available, conversion price could be set high which is good for the equity holders becuse it avoids significant dillution but then increases their possible return in a bankruptcy if the debt holder converts in the end. 3. debt money could be used to buy back shares which would also reduce WACC since less equity outstanding at required rate of return so if they needed to reissue the rate would be even lower. think modlignia miller and 100% debt finacing and the massive tax shield it provide, assuming the mine can cover interest costs also, equity might be too costly for the company and not worth it
greengrape Wrote: ------------------------------------------------------- > comp_sci_kid Wrote: > -------------------------------------------------- > ----- > > 3) E - doesn’t change, P - might or might not > > change, depending on market perception, usually > it > > will go up, as equity purchase is a positive > sign. > > > > > > No, you are totally wrong about the “E”. If the > firm buys back shares, of course E will change. E > stands for “earnings PER SHARE” in case you didn’t > know. It doesn’t stand for “All of earnings”. oh > god. > > So, if the firm buys shares back, shares > outstanding drops, so the E = “earnings PER SHARE” > will increase, which will DROP your P/E multiple. > Which is attractive for investors. > > — > > Now from here, you can speculate what the market > will do now that the PE looks cheaper. Yes > investors may be tempted to buy more, which will > raise the PE. Very unlikely investors will sell, > so the PE will not go down. you also need to take into account the price they buy back equity at. if its above BVPS, then its not as good for the company than if they buy back at less than BVPS. EPS after Buyback = Earnings Less After-Tax Cost of Funds / Shares Outstanding after Buyback - when after-tax cost of borrowing = the earnings yield (E/P) of the shares, the share repurchase has no effect on the company’s EPS. If after-tax cost of borrowing > than (E/P), share repurchase will decrease the EPS, vice-versa. - when MVPS > BVPS, BVPS decreases after buyback - when MVPS < BVPS, BVPS increases after buyback
In general, the corporation would prefer to finance with debt rather than equity because it is the cheapest source of capital, especially since it often has the tax shield. Debt also doesn’t surrender corporate control the way equity does. Aside from this, it often makes sense to finance highly capital intensive industries and industries with substantial long-lived assets with debt. Not only does it keep costs down with interest payments (as opposed to required equity returns) while capital investments are being put in place, it offers a natural way to amortize these capital investments over time. The separation theorem says that one should undertake projects without regard to specific financing terms (other than the WACC), but in practice, land and other fixed investments can be used as collateral to lower the interest rate even further vs. unsecured loans, and that makes sense from a corporate point of view. Even if you are not specifically factoring the financing into the go/no-go decision, the CFO might well decide that now that the land is acquired, it makes sense to use it as collateral to lower the company’s total WACC.
Hahaha, this thread… #3 is actually a great interview question. I use vague questions all the time, like “how do you price a bond?” The correct answer starts with “how detailed of an explanation would you like?” It is not advantageous to go off the deep-end, exposing huge gaps in one’s knowledge. A simple response like “Debt financing is generally better perceived than equity financing, so the P/E will generally go up” is concise and, just as importantly, consistent with the lead-in questions. If the interviewer asks for more detail, then go into how E and P will change.
^+1 keep it concise, and give an answer that makes sense rather than 2 pages of algebra producing some gibberish conclusion that you are unsure of anyway
Great question indeed. It touches on several corporate finance issues, many of which have been raised here, but unfortunately the red herrings are also abundant. I’ll first answer the question and then finish up by correcting some misconceptions. It’s useful to divide the levered recap into (a) buying shares from company cash, and (b) issuing debt to raise cash. (a) should not change the price of shares. (Proof by contradiction: if buying a share increased its value, then the firm could risklessly increase its value by buying shares. This holds whether the firm buys shares in another firm or in itself.) A mild complication is that market cap is the sum of surplus cash and value of earnings. Buying $1 of your own shares reduces your MC by $1, but share price is unmoved. P/E of course goes down because there’s less surplus cash contributing to MC (and P). (b) In the absence of taxes and distress, issuing debt doesn’t change the value of the firm. Thus if we ignore taxes and distress, the overall effect of a levered recap (combining (a) and (b)) is to lower P/E. Adding tax shield and distress (offsetting influences) will often raise EV of the firm, increasing P/E (for low distress costs). There’s no general way to calculate these offsetting influences properly. (See discussion of distress below.) So the best answer to the original question is: It depends. Additional topics: 1. Signaling. Generally equity investors respond positively both to share repurchase announcements and to leverage increases. 2. Agency costs. Shareholders often discount the value of surplus cash, so returning it may remove a MC haircut. 3. Distress. It’s often misidentified with default likelihood. In practice, bankruptcy costs are quite low. The real costs of distress arise in lost revenues (customer runs) and/or increased costs (vendor runs) – these distress costs can be 10x or more greater than the costs associated with increased default likelihood. Note that WACC fails to treat these distress costs appropriately because the framework (like M-M) ignores the possibility of reduction in operating earnings due to financial (leverage-induced) distress. Misconceptions: 1. “than if they buy back at less than BVPS” – economics of recapitalizations are uninfluenced by book values. 2. “whether the interest on the debt is < the long term earnings yield”. This is always true – debt has priority in the capital structure. 3. “none of those variables are affected by the capital structure (at least in a CAPM world or world where rce is not influenced by leverage)”. In both the CAPM and real worlds, required equity return increases with riskiness, which in turn increases with leverage. 4. “debt finance would be cheaper than issing equity” / “debt rather than equity because it is the cheapest source of capital”: maybe, maybe not. Ignoring taxes and distress, no form of financing is cheaper or richer than any other form (on a risk-adjusted basis). This is just M-M. (Changing the division of investors’ claims doesn’t change the cash flows to investors.) 5. “100% debt finacing and the massive tax shield it provide” – you’re forgetting that at higher risk of default (and/or negative earnings), the value of the tax shield falls. When you combine this with leverage-induced operating earnings haircuts, you find that 100% debt financing doesn’t work well. (In fact, 100% debt isn’t possible – you can’t have fixed claims that exceed the EV of the firm; if you try to get close, the value of debt drops dramatically, thus restoring value to equity claims. Another way to view this: at higher leverage, debt becomes equity.)
- Besides the cost associated with equity, you must also take into account operational leverage. Mines typically have high operating leverage, so going with a lot of equity may be their best option for due to high cost of debt and the equity may simply price better due to risk reduction, not to mention executives have an interest in long run viability. Whether or not the mine’s business model incorporates hedging and to what extent to lock in forward prices would have a MAJOR impact on capital structure in my mind. Basically, key to looking at risks (primarily reflected in proper capital structure) is to break down your mental barriers and stop segregating them, pool them together into enterprise wide view. 2) You’re right, as has been pointed out, embedded option has value to debt buyer, so lower rate. Downsides are always worth mentioning to show understanding. They are, potentially equity / growth dillusion, that will be priced into your equity, so you may save on debt interest just to get hit on the equity pricing. 3) One factor here is the relative historical price the buy back is done at (in terms of long run impact). But as far as we’re concerned, P/E would generally go up at first as debt generally pays a better yield and you’re basically leveraging your earnings. However, as you continue to do so, you’re P/E will fall again as you pass the market perceived optimum structure. Due to excess leverage, earnings may become unstable, your dividend may be threatened, etc, all of these things will kill your P/E. Not to mention that as you begin to roll old debt, your average cost of debt is gonna rise to reflect your new structure, so E is gonna fall. Moving pieces here, as mentioned before: P- price is going to increase as you leverage (assuming you’re nearing optimal capital structure) due to increased concentration of per share ownership rights, growth prospects, lower capital costs, etc. EPS would initially rise too. These effects will reverse as you pass optimal capital structure.
Further evidence that the CFA exams have gotten significantly more rigorous post 2003. The fact that charter holders don’t know these questions is pretty disgusting. What’s even worse is that I’m sure if we dredged the depths of non-charter holders it’d be even worse. And people wonder how markets crash, I always just tell them they’d be surprised at some of the asshats I encounter managing others’ money.
Markets don’t crash because of asshats.
justin88 Wrote: ------------------------------------------------------- > Markets don’t crash because of asshats. Apparently you’re not familiar with the great asshat bubble of 1742…
Black Swan Wrote: ------------------------------------------------------- > justin88 Wrote: > -------------------------------------------------- > ----- > > Markets don’t crash because of asshats. > > > Apparently you’re not familiar with the great > asshat bubble of 1742… my grandfather still refuses to tell me the story.
Probably summarizing some older posts, but my take on the P/E question: Really just two factors 1) Does the market like the leveraged recap? If so, stock price should go up. 2) Does EPS go up? If cost of debt is lower than E/P, then yes. Otherwise, no. For high P/E companies (assuming E doesn’t skyrocket up within the period we’re considering), it’s possible the repurchase lowers EPS. Combine 1 and 2 and depending on the magnitude of each, there’s your change in P/E. I’m not talking about P/E way out in the future or historical P/E, but more short-term P/E.