I know these may sound silly but please help me clarify the following points: 1. Under MM, increased used of debt is not associated with an increased expected default rate, right? Then why does it increase the cost of equity? 2. Do post-offer defenses increase acquisition cost or only pre-offer ones do? 3. When a high-growth firm acquires a low-growth firm, per-share profits are temporarily boosted, thus lowering future growth prospects on a per-share basis. Please explain this. 4. If after the merger, the cost of financing is lower, why would that decrease the share price? 5. ATCO’s earnings last year was 2.25 per share and dividend was .55 per share. The firm has a 25% target payout ratio and plans to bring the dividend up to the target payout ratio over three years. While next year’s earnings are expected to increase 54%, why would next year’s payout ratio actually decrease? Can you use common sense to answer this without calculation? Thanks a lot!
freakingout Wrote: ------------------------------------------------------- > I know these may sound silly but please help me > clarify the following points: > > 1. Under MM, increased used of debt is not > associated with an increased expected default > rate, right? Then why does it increase the cost of > equity? Increasing debt increases the risk of equity investors as in a liquidation, debt holders get the scraps before equity investors. Therefore increasing debt increases risk/pressure on the company and this maks equity investment more risky. Equity investor want more compensation for that increased risk (due to increasing debt), hence, cost of equity goes up. > 2. Do post-offer defenses increase acquisition > cost or only pre-offer ones do? Both would increase acquisition cost (I’m assuming you mean directly increasing costs) Pre-Offer: Fair Price Amendment, Golden Parachute (minimal in the overall sense, but still extra cost), Post-Offer: I would say these are more indirectly affecting cost as leverage recapitalization, litigation and even a white knight/squire (to create a bidding war) would increase the acquisition cost. > 3. When a high-growth firm acquires a low-growth > firm, per-share profits are temporarily boosted, > thus lowering future growth prospects on a > per-share basis. Please explain this. The per-share profits are temporarily boosted b/c the boost is paper only. Even though on paper it looks > 4. If after the merger, the cost of financing is > lower, why would that decrease the share price? (Dont know… maybe include the reference page so ppl can look it up to see if there are any assumption/scenario?) > > 5. ATCO’s earnings last year was 2.25 per share \> and dividend was .55 per share. The firm has a > 25% target payout ratio and plans to bring the > dividend up to the target payout ratio over three > years. While next year’s earnings are expected to > increase 54%, why would next year’s payout ratio > actually decrease? Can you use common sense to > answer this without calculation? (dont know will look into it) > Thanks a lot!
As you numbered it: 1. You are essentially increasing risk of equity stakeholders because you are allocating a larger amount of cash flow to debt holders, and therefore would require a higher return. 2. All defensive and anti-takeover mechanisms would deter an investor from acquiring a particular company and therefore would increase the cost of the transaction. Post-offer mechanisms would typically cost more than Pre-offer mechanisms. 3. EPS bootstrapping effect. Economic value does not increase, despite the accretion in EPS because operating cash flows do not fundamentally change unless synergies are realized by the firm. 4. Cost of equity is higher than cost of debt. As such, even if earnings yield is higher than the cost of debt, that does not particularly mean that the earnings yield is higher than the required return on equity. 5. Because of the smoothing effect on the dividend yield. You are actually tagging on the increase in dividends to the long-term (i.e., 3 years in this case) payout ratio target. Because of the increase in earnings, the payout ratio temporarily dips as it tries to catch up to the target over the time horizon being contemplated.
Wow you guys are really good! Thanks all for the explanations!