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Abstract:
This short note discusses the link between the certainty equivalent approach of modern asset pricing theory and the cost of capital approach in DCF-models in a capital market model. Therefore we distinguish two notions of cost of capital: (a) risk-adjusted discount rates for a particular cash flow and (b) risk-adjusted returns of the project. In order to account for the flow of information both types are defined with respect to the valuation date.

Risk neutral valuation, capital budgeting

Abstract:
In his recent article "Valuation with or without personal income taxes" Richter analyzes the impact of introducing income taxes into the calculus of corporate valuation. His major result is that, if correctly specifying the model, the income tax rate is only of minor importance for corporate values and asset prices. In this note we want to demonstrate that the sensitivity analysis of Richter (2004) has to be treated with some caution and highlight some problems occurring when introducing personal income taxes that are not fully reflected in Richter's analysis.

In a first step we show, that presuming that the analysis of Richter (2004) is theoretical correct, it is highly sensitive with respect to the parameters of the dividend process and choosing slightly different parameters suggests opposite conclusions. Second, we show that in general the analysis of taxation effects is characterized by circularity problems, since the empirical as well as the theoretical analysis of Richter requires the assumption that the market price of the market portfolio is independent from the tax rate. Our analysis based on a consumption based asset pricing model shows that equilibrium asset prices depend on the income tax rate even if we presume an idealized tax system with uniform tax rates that taxes the economic income.

valuation, personal taxes

Abstract:
We are interested in the effect of capital income taxes upon security prices when investors face locally segmented stock markets and a global bond market. Therefore, we analyze an equilibrium model of an economy with binomial uncertainty, an exogenous risk-free interest rate and a representative stand-in household. In this setting, the pricing effect for domestic securities is shown to be a function in three determinants: the covariance between pre-tax payoffs of securities and the aggregated market portfolio, the exogenous pre-tax interest rate and the effect of taxation (and redistribution) on the aggregate welfare of the stand-in household. We find that taxation of capital income is non-distorting if tax proceeds are immediately redistributed within the cohort of capital market participants. If, however, taxation represents a policy tool to transfer wealth from capital market participants to non-market participants, the level of the statutory tax rate is reflected in equilibrium security prices and taxation affects households portfolio decisions, which in turn may affect investment decision of firms.

Taxation, valuation, risk neutral probability measure

Abstract:
In a recent contribution Jorg Wiese discusses the problem of how to adopt a version of the single-period Tax-CAPM of Brennan (1970) for multiperiod valuation problems. With this short note, we would like to demonstrate the following problems of Wiese's analysis:

(1) the valuation calculus proposed by Wiese does not account for capital gains taxes in period T,

(2) if capital gains are consistently considered in each period, then there exists a period-independent relation between the certainty equivalent and the risk premium approach, and

(3) Wiese's claim that valuation results are insensitive with respect to assumptions concerning the timing of capital gains taxes [as long as tax deferral effects are reinvested at the (perfect) capital market] does not hold for positive interest rates.

CAPM, personal taxes

Abstract:
Based on an example Loffler claims in his recent paper "Miles-Ezzell's WACC Approach Yields Arbitrage", that the application of the Miles/Ezzell-WACC may offer arbitrage opportunities. He concludes that the Miles/Ezzell-WACC is not applicable without restrictions. We discuss the example of Loffler and show that not the application of the Miles/Ezzell-WACC but the assumption of a constant cost of capital in the fully equity finance case yields to the arbitrage opportunity.

WACC, risk neutral valuation

Abstract:
For investment projects with finite horizon and deterministic leverage the idea of weighted average cost of capital (wacc) was introduced 1980 by Miles/Ezzell under restrictive assumptions. In this paper we deal with the wacc idea in the context of arbitrage-free capital markets by relaxing the assumptions of Miles/Ezzell. In particular we allow for general cash flow structures and risky debt. Following Miles/Ezzell we restrict ourselves to the situation of a linear tax on corporate level and debt financing according to a deterministic leverage. Under these conditions we derive an arbitrage-free relation that links the discount rates of a particular cash flow of a fully equity financed project with discount rates of the cash flow of a debt-financed project. Furthermore we show that in general this relation may not be employed to expected returns of the project.

capital budgeting, wacc, risk neutral valuation

Abstract:
While in the US stock-based incentives are commonly used since the 50s of the last century, in Germany they were invented only some ten years ago. Even in 1996 firms faced considerable regulatory difficulties when willing to grant such incentives. In the meantime the legal environment has changed significantly and today even the German Corporate Governance Code encourages firms to grant stock-based long-term incentives. However, examining a hand-collected unique data-set we find that even only 37% of all German Prime Standard firms have used stock-based long-term incentives in 2006. In these firms stock-based long-term incentives account for less that 23% of the overall compensation to members of the management board. Our empirical analysis reveals that in particular large firms with high RnD expenditures, substantial opaqueness and high free-float are likely to grant stock-based long-term incentives. Furthermore, we find that high inside ownership and large blockholders are negatively correlated with the probability of granting stock-based long-term incentives. Finally, we find that an externally hired CEO increases the likelihood of stock-based incentives, in particularly if the chairman of the supervisory board is a former executive of the firm. In sum, our evidence is consistent with the view that shareholders use stock-based incentives as a governance mechanism to mitigate the agency problem in complex firms with high information asymmetry.

Executive compensation, incentives, corporate governance, Germany

Abstract:
There is a heated debate about executive remuneration in Germany. However, so far there is little more than anecdotic evidence about the structure and size of compensation packages for executives in Germany. In this paper, we provide evidence on remuneration practices in the average German Prime Standard firm. In particular, we show that only analyzing DAX blue chips produces biased results, since there are substantial size effects.

Executive compensation, remuneration, Germany

Abstract:
Control over a firm is gained by acquiring voting rights. When 5% or more of voting rights change hands it is called a block trade. Franks & Mayers (2001) find that block trades frequently happen in Germany. Based on their findings we predict the probability of the occurrence of block trades with regard to first layer ownership structures, Faccio & Lang (2002) ultimate ownership structures, and firm characteristics. We use probit regression models on two samples of block trades for a panel of German non-financial firms listed in the DAX30 between 1997 and 2006. We find that block trades are more likely to occur in firms having German financials, German government entities, or foreign investors as owners at the first layer. The impact of German government entities, however, vanishes when using ultimate ownership data. Further, the probability of block trades is significantly lower for firms committed to R&D and for firms whose IPO is not longer than 10 years ago.

block trades, ownership structure, ultimate ownership, Germany

Abstract:
We present selective results of an analysis of compensation practices in German Prime Standard firms in the period between 2005 and 2007. Four results emerge. First, analyses based on DAX30 firms lead to a biased view, since the amount as well as the structure of the executive compensation is characterized by substantial size effects. Second, despite the very positive market environment during the analysed time period, more than 50% of an average executive's remuneration is determined by the fixed salary. Third, the relevance of stock based compensation (both with respect to the prevalence as well as the relative weight) is commonly overestimated. Finally, deficits reveal concerning the transparency of reporting, with regard to performance measures to evaluate the bonus or the information shown in the fair value of stock based compensation.

Executive compensation, remuneration, Germany

Abstract:
New shares of seasoned equity offerings are often issued with a sustainable discount. This discount implies a dilution in the sphere of old shareholders. Now, at least in Germany the old shareholders are commonly compensated for the dilution effect by issuing rights. However, the dilution also affects the owners of equity derivatives.

In a simple model we propose economic reasonable conditions for adjustments of European equity call option contracts after a seasoned equity offering issuing new shares. Therefore, we separate the effect of the equity increase and the effect of altering the leverage and operational risk. In particular, we discuss two suggested methods to adjust the contract terms of call options and analyse the dilution effects for the adjustments proposed by the 'Wiener Borse' and the EUREX.

Seasoned equity offfering, equity option, option contract

Abstract:
We analyze the role of agency costs and corporate governance on the existence and relative weight of stock-based incentives in large European firms. Using a unique, manually-collected set of data covering all non-financial firms listed in the MSCI Europe, we are able to distinguish between internal governance mechanisms and external governance structures. In line with the hypothesis of governance substitution, we find that firm size and complexity foster the application of stock-based incentives, while strong stakeholders such as large block-holders and employee representatives on the board of directors decrease the likelihood of their existence. Examining institutional differences, we find that that the origin of law affects the probability of stock-based incentives and that high standards of transparency are a prerequisite for the application of stock-based incentives. Overall, our results indicate that firms use stock-based incentives to better align the interests of management and shareholders thereby taking into account the institutional environment.

Stock-Based Incentives, Executive Compensation, Corporate Governance, Europe

Abstract:
Already a standard instrument in US transactions for some time, fairness opinions have recently gained increasing popularity in other countries as well. While the benefits of fairness opinions for board members are evident, as they contribute to reduce the risk of shareholder lawsuits, potential benefits for shareholders of the acquiring or the target company are less obvious. We study the certification role of fairness opinions in corporate transactions for shareholders of the acquiring company. In a setting with asymmetric information between management and shareholders and misaligned managerial incentives, we show that: (i) in a world without fairness opinions an optimal equilibrium, i.e. one in which the management realizes all "good" transactions and abstains from making "bad" ones, is generally not feasible; (ii) in a world with mandatory fairness opinions, the unique sequential equilibrium is optimal; and (iii) when fairness opinions are voluntary there exists an optimal sequential equilibrium but other, non-optimal sequential equilibria may also exist. We also discuss the implications of the above results to issues of optimal regulation of takeovers.

Fairness opinion, acquisition, management incentives

Abstract:
We examine performance implications of stock-based incentive programs. While agency theory makes a strong case for stock-based incentives, empirical evidence of the effect on firm performance so far is mixed. Using a novel hand-collected data-set of German Prime Standard firms, we also find that on average stock-based long-term incentives do not improve firm performance. However, when we take a closer look at the design of the incentive structures, we find that ill-designed programs go along with poor post performance, while ambitious programs boosts firm performance. We confirm these findings by using different performance measures, addressing endogenity concerns, and controlling for various governance mechanisms like ownership and board structures, as well as other design dimensions of the stock-based incentive plans.

Incentives, management compensation, stock-based compensation, corporate governance

Abstract:
Building on a unique panel data set of German Prime Standard companies for the period 2005-2008, this paper investigates the influencing factors of both director compensation levels and structure, i.e. the probability of performance-based compensation. Drawing on agency theory arguments and previous literature, we analyze a comprehensive group of determinants, including detailed corporate performance, ownership and board characteristics. While controlling for unobserved heterogeneity, we find director compensation to be set in ways consistent with optimal contracting theory. I.e. compensation is systematically structured to mitigate agency conflicts and to encourage effective monitoring. Thus, our results indicate that similar types of agency conflicts exist in the German two-tier setting.

Director Compensation, Corporate Governance, Outside Directors, Two-tier System, Agency Costs

Abstract:
Based on an example Loeffler claims in a recent FINANZ BETRIEB-article that the application of the Miles/Ezzell-WACC may offer arbitrage opportunities. He concludes that the Miles/Ezzell-WACC is not applicable without restrictions. We discuss the example of L¿ffler and show that either (a) the example offers arbitrage even in the case of fully equity finance, or (b) the example violates the assumptions made by Miles/Ezzell.

WACC, risk neutral valuation

Abstract:
With respect to valuation there are two effects of taxation. On the one hand taxation directly affects the cash flows of an investment distributed to investors. On the other hand it indirectly affects the equilibrium pricing mechanism of the economy. Applying the consumption based asset pricing framework in a two-date security market model with heterogeneous agents we analyze the second effect. Establishing a tax authority with revenues (security income and consumption taxes) and expenditures (redistribution) enables the government to alter the wealth distribution of the economy. Allowing for frictions in this re-allocation process we discuss the implications for the equilibrium pricing mechanism. Introducing the concept of weak and strong invariance we present two invariance statements, one for economies with homogeneous agents and a second for economies satisfying the aggregation property. As an application we discuss two problems of coporate valuation. Especially we revisit the neutrality result of Samuelson (1964).

Asset pricing, taxation, valuation, equilibrium