[MUSIC] In this model, we're going to talk a lot about debt. It turns out that an M&A deal, is one of the most important events in the financing history of a company. An M&A deal can cause significant increases in leverage. An obvious example, is a leverage buyout, right? But also large deals funded by cash. We for example, AT&T and DTV is one example of this situation in which no name and I do. You can have a very significant effect on the, on a company's leverage rations. So, that forces us as a financial analyst. That forces us to answer a very important question. How does leverage affect firm value? All right, if leverage changes, what's going to happen to the value of the business? It's one of the most important research topics in corporate finance, and it has practical applications as well, right? Where we need to be able to successfully design an M&A deal, you have to learn how to deal with changes in leverage. How how do we incorporate changes in leveraging our valuation models. And what I'm going to try to do in this module, is to use easy methods as easy as possible. But also state of the art, I don't want to teach you methods that are old and are not consistent with the most current finance research. I'm going to try to bring this to state of the art financial methods. So, there is no compromise. It might make it a little bit harder, but I am going to try to teach you what is most current in terms of finance research. And one important idea we're going to talk about in this module is that, M&A is an exception to a rule which you might have learned before in other finance courses. Which is that companies typically don't issue equity, companies do not issue stock to finance investment. But M&A is an exception. So, there's a lot of evidence and you're going to see examples in this module showing that in many cases acquires do issue equity to finance them and ideals. And we're going to learn why. Another distinct feature of M&A financing is that, it creates demand for different types of debt. So, many companies just have one type of debt. For example, a company might just tissue bonds. And we're going to learn that M&A might create the need for companies to have different types of debt. So bonds but also bank there, so subordinated debt for example. So, we're going to use what we call the tradeoff model of capital structure, which links leverage and values. So, there is a tradeoff, right? Leverage can destroy value because of financial distress, but leverage can also create value because of taxes. What's going to happen, is that in some cases an M&A deal is going to cause a very high significant increase in leverage, which can destroy value. And I'm going to show you evidence that these are small magnitudes in percentage terms of 1% of value for example. But it turns out that they can be comparable to the gains from M&A to the acquirer. So, even though they're small, the gains from M&A for the acquired to the acquiring particular also relatively small. So, it becomes very important for the acquired to think carefully about capital structure. Then we're going to also go beyond leverage. The tradeoff model focuses mostly on the optimal leverage ratio. But, we're also going to learn that credit ratings matter above and beyond leverage ratios, right? So, it's not only about finding what's the best leverage ratio. In practice, acquires also have to think about the impact of the deal on the target on a credit rating. And we're going to learn, why this is the case and how firms can target specific credit rating. In particular In this model, we're going to learn how the weighted average cost of capital. Which is the main model we used to do company evaluation. We're going to learn how the WACC can incorporate the effect of leverage on firm value. So, we're going to continue using the WACC valuation model but we're going to incorporate changes in leverage, okay. And there are some very common mistakes that you can do that are easy to make when using the WACC model. And I'm going to show you how to avoid those, okay. We're going to talk about another model that's called the adjusted present value model that can also capture the effect of leverage on value. But this is, I think it's good for illustration purposes and to understand what's going on. But in the end of the day, I'm going to show you that the WACC model is typically a better choice than APV in practice. So, you're probably not going to be using APV in your financial models in the future. But I think it's too good to know because it's going to create, it probably makes the WACC model make more sense once you see adjusted present value as well, okay. So, we're going to do examples but we're also going to talk about the real world. We're going to talk about empirical evidence on what we know about about how leverage changes value. And like I said, using state of the art no compromise is going to try to bring the most current finance research into your valuation and capital structure model. And an interesting conclusion, is actually that in some cases it's reasonable to assume that leverage doesn't matter. Assuming that leverage has no effect on WACC and value is actually a reasonable approximation. But that's not always the case, as we're going to learn in this module as well. As I talked about in this introduction, M&A is an exception to the rule, right. That firms actually issue equity to finance M&A deals. We're going to see how the tradeoff model can help explain why and how to estimate the impact of an M&A deal on capital structure. All right. So, we're also going to talk about credit ratings, how credit ratings can summarize the effect of M&A deals on the firm's financial health beyond leverage. And why firms try to avoid credit rating downgrades, in particular downgrades to junk ratings. All right. And then of course to do that to incorporate that in the financial analysis, you have to be able to estimate the impact of an M&A deal on credit ratings. Which is something we're going to talk about as well. The other exception to the rule, as I mentioned before, is that highly leveled M&A deals generate demand for different types of debt. Such as bank debt, subordinated that and preferred equity, which as you are going to learn now in this module, it's a kind of a type of debt as well. And the principal you're going to learn, is that these different types of debt can help forms reduce the risk of financial distress. And that's why they are important in the financial model of an M&A deal, and also in the real world. The evidence shows that there is different flavors of debt are very important for for M&A financing.
