· finance function allocates resources, which includes acquiring, investing, and managing the...
Transcript of · finance function allocates resources, which includes acquiring, investing, and managing the...
“Corporate Finance”.
: Introduction And Overview
Topic Objective:
At the end of this topic the student will be able to:
Define the field of finance and its areas.
Describe major types of corporate financial management decisions.
Compare three major types of business organizations.
Compare and contrast three models of the firm.
Understand the objective of the firm.
Definition/Overview:
Finance: Finance is a discipline concerned with determining value and making decisions. The
finance function allocates resources, which includes acquiring, investing, and managing the
resources.
Financial management: Financial management is an area of finance that applies financial
principles within an organization to create and maintain value through decision making and
proper resource management.
Dividend right: Dividend right is defined as the right shareholders get an identical per-share
amount of any dividends.
Voting rights: Shareholders have the right to vote on certain matters, such as the election of
directors.
Liquidation rights: Shareholders have the right to a proportional share of the firm=s residual
value in the event of liquidation. The residual value is what remains after all of the corporation=s
other obligations have been settled.
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Preemptive rights: In some corporations, shareholders have the right to subscribe
proportionately to any new issue of the corporation=s shares. Such offerings are called rights
offerings.
Limited liability: Shareholder liability for corporate obligations is limited to the loss of the
shares.
Permanency: A corporation=s legal existence is not affected when a shareholder dies or sells
his/her shares.
Transferability of ownership: Selling shares in a corporation is normally easier then selling a
proprietorship or a general-partnership interest.
Key Points:
1. Types of Financial Securities
The two basic types of financial securities that firms issue are equity and debt.
Equity: Equity is the firms ownership and is typically represented by shares of common stock.
Common stock is a proportional form of equity. Debt is a legal obligation to make contractually
agreed upon future payments, identified as interest and repayment of the principal (original debt
amount). Debtholders loan the firm money but have no claim of ownership as long as the firm
meets its payment obligations. The firm controls the use of the funds.
The three problems associated with using profit maximization as the goal of the firm are the
following: First, profit maximization is vague. Profit has many different definitions such as
accounting profit based on book value or economic profit based on market value. Second, profit
maximization ignores differences in when we get the money. It does not distinguish between
getting a dollar today and getting a dollar one year from today.
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The time value of money plays an important role in valuing an asset or liability. Third, profit
maximization ignores risk differences among alternative courses of action. When given a choice
between two alternatives that have the same return but different risk, most people will take the
less risky one. This makes the less risky one more valuable. Profit maximization ignores such
differences in value.
Shareholder wealth maximization: Shareholder wealth maximization is maximizing the value
of the firm to its owners. The ownership value of the firm is the market value of the shares
owned. Shareholder wealth maximization deals with these three problems by focusing profit
motives squarely on the owners. First, shareholder wealth is unambiguous. It is based on the
present value of the future cash flows that are expected to come to the shareholders, rather than
an ambiguous notion of profit or other revenues. Second, shareholder wealth depends explicitly
on the timing of future cash flows. Finally, our process for measuring shareholder wealth
accounts for risk differences.
Investment Decisions: Investment decisions are primarily concerned with the asset or left side
of the balance sheet. Such decisions include whether to introduce a new product. Financial
decisions are primarily concerned with the liabilities and stockholders equity or right side of the
balance sheet. Such decisions include whether to issue new stock in the firm.
Examples of a firms stakeholders in the set-of-contracts view of the firm include banks,
customers, governments, preferred stockholders, communities, short-term creditors, managers,
suppliers, society at large, common stockholders, the environment, employees, and bondholders.
An explicit contract is a specific agreement among two or more parties. An example is a
contract with a debt holder that specifies the repayment schedule. An implicit contract is a
generally accepted agreement among two or more parties. An example is a managers obligation
to act honestly and in the best interest of the shareholders. Sometimes a court of law is necessary
to define the components and obligations of an implicit contract.
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A contingent claim is contingent on the value of some other asset or a particular occurrence. An
example of a contingent claim is a manager receiving a bonus after reaching a certain objective.
The bonus is contingent on a certain event, that is, the objective being reached. Preemptive rights
are often left out of modern corporate charters.
2. The Science of Finance
Finance is a science.
Like other sciences, it has fundamental concepts, principles, and theories.
3. The Art of Finance
In some situations, precise models cannot be created.
That does not mean that we cannot make decisions in these situations.
People may refer to using intuition to make decisions.
Decision makers are often using intuition from the Principles of Finance.
They are using scientific valuation concepts, but not exact numbers.
4. Three Types of Decisions
4.1. Investment Decisions
o What assets should the firm invest in?
4.2. Financing Decision
o How should the purchase of assets be financed?
4.3. Managerial Decisions
o How large should the firm be?
o How fast should it grow?
o Should the firm grant credit to a customer?
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o How should the managers be compensated?
5. Financial Markets and Intermediaries
The study of markets where financial securities (such as stocks and bonds) are bought and sold
The study of financial institutions (such as commercial banks, investment banking firms, and
insurance companies) that help the flow of money from savers to demanders of money
6. Investments
The study of financial transactions from the investors outside the firm, for example:
How do we place a dollar value on a share of stock or a bond issued by the corporation?
How do we assess the risk of these financial securities?
How do we manage a portfolio of financial securities to achieve a stated objective of the
investor?
7. The Corporate Form of Organization
Ownership: The shareholders (also known as stockholders or equityholders) are the owners of
the corporation.
Control: Ultimate control rests with the shareholders, but the managers control the day-to-day
operations.
Risk Bearing: While all parties associated with the corporation bear the risk, shareholders bear
all residual risk.
7.1. Advantages of Corporate Form of Organization
o Limited Liability
o Permanency
o Transferability of Ownership
o Better Access to Capital Markets
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8. Rights of Ownership
Dividend Rights
Voting Rights
8.1. Majority voting
o One vote per share per director
o Cannot combine votes
8.2. Cumulative voting
o Directors are voted on jointly
o Can cast all votes for a single candidate
8.3. Liquidation Rights
o Owners have the right to a proportional share of the firms residual value in the event of
liquidation, after other senior claims are paid.
8.4. Preemptive Rights
o Owners have the right to subscribe proportionally to any new shares issued by the firm.
9. The Goal of the Firm
Between defined than profits
Considers timing of profits
Considers risk differences among alternative courses of action
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10. The Investment Vehicle Model of the Firm
Investors provide financing to the firm in exchange for financial securities.
Firm invests these funds in assets.
Income generated by the firm is distributed to the investors.
Managers act in the best interest of the shareholders, and take actions to maximize shareholder
wealth.
11. The Firm as an Investment Vehicle
12. The Accounting Model of the Firm
Balance sheet view of the firm
Investment decisions are represented on the asset (i.e. left hand) side of the balance sheet.
Financing decisions are represented on the liabilities and equity (i.e. right hand) side of the
balance sheet.
13. Set of Contracts Model of the Firm
The firm has contracts with a large number of stakeholders.
These contracts may be explicit or implicit.
Contracts may also be contingent on particular future outcomes.
The model recognizes that conflicts of interest may exist between the various stakeholders.
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14. The Evolution of Finance
14.1. Globalization
o Every firm operates in a global marketplace.
o Financial markets transcend national boundaries.
14.2. Technology
o Information can be readily obtained / disseminated.
o Need to use computing technology to maintain a competitive edge.
14.3. Corporate Reorganization and Restructuring
o Your first job will not be the job you retire from.
: The Financial Environment: Concepts And Principles
Topic Objective:
At the end of this topic the student will be able to:
Understand the Principles of Finance.
Apply the Principles of Finance to real world situations.
Understand the characteristics of the most common financial securities.
Describe the role of brokers, dealers, investment bankers and financial intermediaries.
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Definition/Overview:
Opportunity cost: The difference between the value of one action and the value of the best
alternative action
Principal-Agent relationship: A situation in which one participant, the agent, makes decisions
that affect another participant, the principal
Moral hazard: A situation in which an agent can take unseen actions for personal benefit even
though such actions are costly to the principal
Zero-sum game - A situation in which one player can gain only at the expense of another player
Sunk Cost: A cost that has already been incurred and cannot be altered by subsequent decisions
Hubris: Arrogance due to excessive pride and an insolence toward others.
Adverse Selection: When offering something to the market seems to indicate something
negative about what is being offered.
One principal-agent relationship in which a moral hazard could arise is the relationship between
an owner and a manager. A manager could take a nap while on the job, or use the firms car for
personal business. These actions benefit the manager at the expense of the owner without the
owner ever knowing.
Portfolio: A portfolio is a group of investments, as opposed to a single investment.
Diversification is the act of spreading your wealth across multiple investments instead of
concentrating them in a single investment. This is beneficial because all your wealth won=t be
lost unless all of the investments fail. Diversifying lowers risk by limiting the amount of the
investment lost if one or more fail.
Spot market: A spot market is a market in which assets are bought and sold for immediate
delivery. A futures market is a market in which standardized forward contracts are traded.
Option contract: An option contract is the right, without any obligation, to buy or sell
something. A futures contract is a standardized forward contract that is traded in a futures
market.
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Broker: A person that helps investors buy or sell securities, charging a sales commission but
without taking ownership of the shares. A dealer actually takes ownership of the shares before
selling them to someone else.
Primary market: A primary market is a market in which firms sell newly created securities to
raise capital. A secondary market is a market in which previously created securities are traded.
Initial Public Offering (IPO): An initial public offering (IPO) refers to the first time a firm
issues shares to sell to the public. A seasoned equity offering refers to any offering of additional
new shares for a firm that already has shares outstanding.
Forward contract: A forward contract is a contract to exchange an asset for cash at a specific
future date. A futures contract is a standardized forward contract that is traded in a futures
market.
Key Points:
1. Ethics
Ethics consists of standards of conduct or moral judgment. Following all applicable rules and
regulations does not necessarily make one an ethical person. No set of rules and regulations can
account for everything that can and will happen. A code of ethics can reduce unethical behavior
by providing a set of guidelines that can be applied generally to situations that arise.
Ethical behavior avoids fines and legal expenses.
It builds customer loyalty and sales.
It helps attract and keep high-quality employees and managers.
It builds public confidence and adds to the economic development of the communities in which
the firm operates.
A good reputation enhances relations with the firms investors.
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2. Longer lived securities are riskier
Much of this risk depends on inflation expectations, which are an important determinant of
interest rates. Therefore, if all else is equal, the Principle of Risk-Return Trade-Off implies that
investors will require a higher interest rate (return) to bear the extra risk. This is the basis for the
idea that the term structure should be upward sloping.
If investors believe that long-term interest rates are going to be lower next year, they will want to
make long-term investments today. If investors don=t have the funds to make the investment
today, they will borrow short-term and repay the money in the future with income from the
investments. This decreases the supply of short-term funds and, at the same time, increases the
supply of long-term funds. The shift in these supplies raises the short-term rate and lowers the
long-term rate. This can result in a downward-sloping term structure.
3. Major Distinction between Debt and Equity
The major distinction between debt and equity is that debt is what a firm owes whereas equity is
ownership in a firm. This distinction is important because the owners will determine how a firm
is run, and will make decisions that impact the debt holders.
4. The Principle of Self-Interested Behavior
With all else equal, people choose the action that is financially most advantageous to themselves
Does not imply that making money is the most important criteria
Consider charitable contributions
Taking the most advantageous course of action requires us to forego other possible actions.
Every action has an Opportunity Cost
The difference in value of the chosen action and the next best alternative
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5. Agent
A person who makes a decision that affects the principal.
Managers are agents, stockholders are principals.
o Managers are self-interested: may want an expensive car for business use; stockholders want
managers to use an economy model, and pay off a bank loan with the money saved
Stockholders are agents, bondholders are principals.
o Stockholders seek risk, bondholders want the firm to make low risk investments.
The agent can take unseen actions that are costly to the principal.
o The manager might make personal long distance calls using the office telephone.
o The principal thus faces a Moral Hazard problem.
o The principal can reduce the severity of this problem through more effective contract provisions.
6. Agency Theory
There are costs connected with controlling conflicts of interest
o Monitoring (audits)
o Incentives (stock options and bonuses)
o Missing a good investment
o Loss due to misbehavior
o Excessive expense account, personal time, wasted resources
The principal can reduce the total cost by balancing monitoring and incentive costs against other
costs.
Primary goal is to control such problems by using good contracts.
7. Principal-Agent Relationships
7.1. The Principle of Two-Sided Transactions
While we act in our best interest, there is at least one other person in this transaction who is
acting in his/her best interest.
Underestimating the counterparty can lead to sub-optimal decisions.
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Corporate executives often suffer from hubris.
Most financial transactions are Zero-Sum.
One party gains only at the expense of another.
Non-zero-sum transactions often result from provisions in the tax code.
A transaction may be structured so that both parties pay less in taxes to the government.
When we add the government as a party, were back to a zero-sum game.
Media reports of stock market transactions sometimes refer to profit takers selling off their
holdings and thereby causing a drop in stock prices.
There cant be more selling than buying.
The same news story could have instead spoke of investors making a huge mistake buying into a
dropping stock.
7.2. The Signaling Principle
o When a firm increases its dividend, it is generally signaling a more optimistic future for the firm.
o When actions conflict with words, pay attention to the actions
▪ The CEO announces optimistic future for the firm, but at the same time
top executives are selling large amounts of stock they own in the firm.
▪ If one party has information not known to the other party, there is
asymmetric information.
▪ Asymmetric information can lead to the problem of adverse selection.
7.3. The Behavioral Principle
Analyzing complex transactions can be very difficult and/or expensive.
In such cases, look at what others are doing.
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But be aware of the blind leading the blind!
In a competitive environment, this principle can lead to the free-rider problem:
▪ The leader expends resources to determine the best course of action.
▪ The followers imitate the leader and reap the benefits without expending
the resources.
McDonalds does extensive research and analysis concerning the placement of its restaurants.
Other fast-food chains have at times chosen their new restaurant locations simply by building
near a McDonalds restaurant.
7.4. The Principle of Valuable Ideas
Over time, the value of merely imitating others is driven out by competition from others doing
the same thing.
Truly successful people / businesses have used at least one new idea.
Every new idea not automatically valuable: Consider the dot-com craze.
7.5. The Principle of Comparative Advantage
This is the basis for our economic system.
Economic efficiency results from everyone doing what they do best.
7.6. The Options Principle
An option is the right (without the obligation) to take some action.
Depending on circumstances, the optionholder may decide to:
▪ Take the action (exercise the option) or
▪ Forego the action (let the option expire).
Explicit Option Contracts:
▪ Call Option:
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Gives the holder the right to buy the specified asset at a pre-specified price (within a specified
time period)
▪ Put Option:
Gives the holder the right to sell the specified asset at a pre-specified price (within a specified
time period)
Hidden or Embedded Options:
▪ These options may be a part of another financial contract:
▪ Bankruptcy laws provide debtors legal protection from creditors - the
limited liability provision.
Debtors have the option to not fully repay the debt IF they declare bankruptcy.
Privately negotiated options
Corporate options: expand, shrink, delay, abandon, etc.
Real options: hotel reservations, rain checks, tickets, etc.
▪ The most common option is insurance, which is a form of put option.
7.7. The Principle of Incremental Benefits
Incremental costs and benefits are those that occur with a particular action, minus those that
occur without the action.
Sunk costs (costs that have already been incurred) are irrelevant to financial decision making.
7.8. The Principle of Risk-Return Trade-Off
In order to earn higher returns, you must be willing to bear higher risk.
High risk brings with it a greater chance of a really good outcome as well as a greater chance of a
really bad outcome.
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7.9. Risk Averse Behavior
When all else is equal, people prefer higher returns and lower risk.
People will choose the high-risk alternative only if they expect to earn a sufficiently high return.
Individuals would accept a lower return in exchange for lower risk.
7.10. The Principle of Diversification
Dont put all your eggs in one basket!
Spreading your investments (diversifying) can reduce risk without decreasing the return.
A prudent investor will not invest her entire wealth in a single asset (for example, one firm).
7.11. The Principle of Capital Market Efficiency
Capital markets are markets in which financial securities like stocks and bonds are bought and
sold (traded).
Market prices of financial assets that are traded regularly in the capital markets:
▪ Reflect all available information
▪ Adjust quickly to new information
New information is information that was not previously known. Note that information may
thought possible, expected, or even anticipated.
▪ Markets dont wait for the supply to be interrupted; prices fall or rise as
soon as a change in supply is possible, the greater the chance, the greater
the price change.
Prices are made on expectations.
Trading by astute investors in response to new information causes prices to change quickly.
8. Capital Market Efficiency
Competition among a large number of participants
The information revolution
Trading convenience
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Low cost of trading
Rapid execution of trades
The price of an asset is the same everywhere in the market.
The law of one price holds.
Equivalent securities must sell at the same price.
Arbitrage opportunities cannot exist.
Arbitrage allows you to earn riskless profits without any capital commitments.
9. The Time Value of Money Principle
A dollar today is worth more than a dollar tomorrow.
The time value of money derives from the opportunity to earn interest on it.
10. Security Markets
Money versus Capital Markets
Primary versus Secondary Markets
Market for short-term claims with original maturity of one year or less
High-grade securities with little or no risk of default
10.1. U.S. Treasury Bills
Issued by the U.S. Treasury
Original maturities of 13, 26 and 52 weeks
Generally sold in $10,000 denominations
Sold on a discount basis - at a discount from their face value
Difference between the face value and the purchase price represents interest earned by the
investor
10.2. Commercial Paper
A promissory note sold by very large, creditworthy corporations
Original maturity up to 270 days
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Face value is generally $100,000
Backed by a standby letter of credit from a bank
10.3. Certificates of Deposit (CDs)
Written by commercial banks
Issuing bank promises to pay the face value plus a fixed interest rate
Negotiable CDs have denominations of $100,000 or more and can be traded in the market
10.4. Bankers Acceptances
Short-term loans made by banks to importers and exporters.
Bank promises to pay the face amount when the acceptance is presented to it.
Banks customer uses this acceptance to finance the purchase of goods and services.
Holder of the acceptance (seller of goods) can hold the acceptance to maturity or sell it at a
discount from its face value.
11. Capital Markets
Market for long-term securities with original maturity of more than one year
Securities may be of considerable risk.
11.1. Stocks
Shares of a stock represent equity (or ownership) in a corporation.
Stockholders have the right to vote and the right to dividends.
Common stock shares represent residual ownership in the firm.
Dividends on preferred stock shares are usually fixed, and generally must be paid before
dividends are paid to common stockholders.
11.2. Bonds
Represent long-term debt securities - a promise to pay interest and repay the borrowed money
(principal) on prespecified terms..
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Issued by corporations as well as governments
Notes are like bonds, but have a maturity between 1 and 10 years
Bonds are also referred to as fixed income securities
12. Derivative Securities
These derive their value from another security.
Options
Futures
Forward contracts
12.1. Options
Grants the holder the right to buy (or sell) the underlying security at a fixed price, within a fixed
time period
There is no obligation on the part of the option holder
There is obligation on the part of the option seller
A call option gives the holder the right to buy the underlying security
A put option gives the holder the right to sell the underlying security
12.2. Forward and Futures Contracts
An agreement to buy (or sell) something at a fixed price at a fixed point in the future
Unlike options, this entails an obligation - both parties to the transaction must fulfill their
obligations
You can lock in a buying (selling) price for the underlying asset
Futures contracts are similar to forward contracts, but are usually standardized and are traded in
the markets
13. Primary Markets
A primary market is a market for newly created securities.
The proceeds from the sale of securities in primary markets go to the issuing entity.
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A security can trade only once in the primary market.
14. Secondary Markets
A secondary market is a market for previously issued securities.
The issuing firm is not directly affected by transactions in the secondary markets.
A security can trade an unlimited number of times in secondary markets.
The volume of trade in secondary markets is much higher than in primary markets.
15. Investment Bankers
An investment banker specializes in marketing new securities in the primary market.
15.1. Brokers and Dealers
These generally participate in the secondary markets.
A broker helps investors in buying or selling securities.
A broker charges commissions, but never takes title to the security.
A dealer buys securities from sellers, and sells them to buyers (hopefully at a higher price!)
15.2. Financial Intermediaries
These are institutions that assist in the financing of firms.
Examples include: commercial banks and pension funds.
These institutions invest in securities of other firms, but they are themselves financed by other
financial claims
: Accounting, Cash Flows, And Taxes
Topic Objective:
At the end of this topic the student will be able to:
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Understand the firms accounting statements.
Explain the inherent limitations of historical accounting information.
Understand the difference between net income and cash flow.
Understand the difference between book value and market value.
Definition/Overview:
Income Statement: A summary of income and expenses over a given time period. In addition to
cash income and expenses, it takes into account non-cash expenses like depreciation.
Balance Sheet: A record of the financial situation of an institution on a particular date by listing
its assets and the claims against those assets
Cash flow: The transfer of money into and out of an enterprise. In accounting terms, it is the
amount of cash generated by a business after expenses (including interest) and principal
repayment on financing are paid.
Current assets are assets that are expected to become cash within one year. Other classes of
assets are not expected to become cash within one year.
Current liabilities are liabilities that mature or are expected to be paid off within one year.
Other classes of liabilities have a longer maturity.
Key Points:
1. Interest Rates, Inflation and Economic Income
An increase in interest rates would cause the market value of a firms liabilities to decrease
relative to the book value. This is because higher interest rates would lower the present value of
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the future payments. For example, the present value of $1,000 one year from today at 10% is
$909.09, but at 15 % the present value is $869.57. High inflation would cause the market value
of a firms assets to increase relative to the book value. This is because the book value is falling
each period by the amount of depreciation that is fixed at the time the asset was purchased,
whereas the decline in market value each period will turn out to be smaller (bigger) the more
(less) inflation there is. Economic income measures the total realized change in wealth for an
investment. It includes changes in the market values of assets and liabilities. Accounting net
income ignores changes in the market values of assets and liabilities.
2. Focus on Principles
Two-Sided Transactions: Recognize that the accounting system always records two sides to
every transaction.
Incremental Benefits: Use financial statements and the accounting system to help identify and
estimate the incremental expected cash flows for making financial decisions.
Risk-Return Tradeoff: Keep in mind that managerial decisions are based on future risks and
returns.
Behavioral Principle: Use the wealth of financial information available from thousands of other
firms to apply this principle.
Signaling: Recognize that financial information provides many signals about customers,
competitors, and suppliers.
3. The Annual Report
Narrative description of the firms activities during the year
The firms accounting statements:
The balance sheet
The income statement
The statement of cash flows
Notes to the financial statements
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4. The Auditors report
4.1. Financial Statements
Prepared according to Generally Accepted Accounting Principles (GAAP)
GAAP guidelines established in the U.S. by the Financial Accounting Standards Board (FASB)
Used by the firm to:
1. Communicate with stakeholders outside the firm.
2. Help plan and organize the firms activities.
3. Monitor and evaluate the firms performance.
4. Used by the Internal Revenue Service to determine the firms taxes.
4.2. The Balance Sheet
Reports the financial position of a firm at a particular point in time
Shows assets held by the firm on the left hand side.
Shows the liabilities and the stockholders equity on the right hand side
The balance sheet identity always holds:
Assets = Liabilities + Shareholders Equity
4.3. Current Assets
Fixed, Intangible & Other Assets
Current Liabilities
Long Term Liabilities
Shareholders Equity
The Income Statement
Reports revenues, expenses, and profit (or loss) during the year
Also reports earnings and dividends on a per share basis.
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5. The Statement of Cash Flows
Reports how the cash position of the firm changed during the year.
It itemizes the cash flows experienced by the firm.
Increase (decrease) in an asset consumes (provides) cash flow.
Decrease (increase) in a liability consumes (provides) cash flow.
6. Notes to Financial Statements
Other income, interest expenses, provision for income taxes.
Earnings per share calculations
Inventories, property, plant and equipment, and other assets
Employee pension and stock option plans
Business segment information
Five-year summary of financial performance
7. Market Values versus Book Values
Accounting statements are invaluable aids to analysts and managers.
But the statements do not provide certain critical information, and have inherent limitations.
8. Taxes
Taxes are very important because they affect value and therefore affect decisions
Interest is an expense, dividends are not an expense
Capital gains tax-timing option
Tax laws change from time to time
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9. Ratios and Ratio Analysis
There are an unlimited number of alternatives.
They are not useful for picking winners.
They are useful for understanding the current situation and perhaps how it developed to this
point.
9.1. Widely cited ratios in finance
Market-to-book ratio
Market value per share divided by book value per share
P/E: price-earnings ratio
Market value per share divided by earnings per share
Historical
Forward looking (based on expectations)
Dividend yield
Dividend divided by market value
: The Time Value Of Money
Topic Objective:
At the end of this topic the student will be able to:
Understand the concept of Net Present Value.
Distinguish among required, expected, and realized rates of return.
Calculate present and future values of any set of expected future cash flows.
Calculate payments on a debt contract.
Compute the APR and APY for a contract.
Value special financing offers.
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Definition/Overview:
Present Value: The present value of a cash flow is inversely related to the discount rate because
a higher discount rate requires less money to be invested now to obtain a given future value at a
particular point time. A lower discount rate requires more money to be invested now to obtain
the same result. An ordinary annuity is a series of equal, periodic cash flows occurring at the end
of each period. An annuity due is a series of equal, periodic cash flows occurring at the
beginning of each period.
The present value of an annuity due is greater than the present value of an ordinary annuity
because each payment occurs one period earlier and thus has a higher present value. The value is
a present value because it is less than the nominal amount (10 x $100 = $1,000) received. In
order for the value to be less than the nominal amount, it must have been discounted. A business
should undertake an investment with a positive net present value because it will increase the
value of the firm by that amount. In effect, the firm is expecting to earn a return above the return
required by the risk of the project, and therefore the project should be accepted.
Key Points:
1. Principles of Present Value
Time Value of Money: The value of a cash flow depends on when it will occur.
Two-Sided Transactions: To be fair to both parties, be specific about the size and timing of cash
flows.
Risk-Return Tradeoff: A higher risk investment has a higher required return
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Capital Market Efficiency: Use efficient capital markets to estimate an investments expected and
required returns.
Rates of Return and Net Present Value: Most investors want to know about an investments value.
It is the return a person requires to be willing to make the investment.
The required rate of return is the return that exactly reflects the risk of the expected future cash
flows.
It reflects the opportunity cost of the investment.
It is determined by market conditions.
2. Expected Rate of Return
The return an investor expects to earn from the investment. For conventional investments:
If it equals the required return, the NPV is zero.
If it exceeds the required return, the NPV is positive.
If its less than the required return, the NPV is negative.
2.1. Realized Rate of Return
The return actually earned on the investment during a given time period.
It can only be observed after the fact.
It is disconnected from the expected (and required) returns by the risk of the cash flows.
2.2. Net Present Value (NPV)
NPV measures the value created.
Positive NPV increases wealth.
A zero NPV decision earns the fair rate of return.
A positive NPV decision earns more than the fair rate of return.
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3. Valuing Single Cash Flows
3.1. Key Assumptions
Cash flows occur at the end of the time interval.
The compounding frequency is the same as the cash flow frequency.
For example, monthly payments assumes monthly compounding.
3.2. Selected Notation
APR Annual Percentage Rate APR = rm
APY Annual Percentage Yield (effective annual rate)
CFt The net Cash Flow at time t.
PV Present Value
FV Future Value
r The discount rate per period
m The number of compounding periods per year
t A time period
FVAF (r,n) Future-value-annuity-factor for an n-period annuity at an interest rate r per period
3.3. The Time Line
3.4. Future Value Formula
o Let PV = Present Value
o FVn = Future Value at time n
o r = interest rate (or discount rate) per period.
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3.4.1. Future Value Factor
3.4.2. Present Value Formula
Let:
PV Present Value
FVn Future Value at time n
r Interest rate (or discount rate) per period.
4. Annuities
An annuity is a series of identical cash flows that are expected to occur each period for a
specified number of periods.
Thus, CF1 = CF2 = CF3 = CF4 = ... = CFN
4.1. Three Types of Annuities
o Ordinary Annuity: An annuity with end-of-period cash flows, beginning one period from today.
o Annuity Due: An annuity with beginning-of-period cash flows.
o Deferred Annuity: An annuity that begins at a time different from today.
o For example, a student loan with a 1-year deferral
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: Valuing Bonds And Stocks
Topic Objective:
At the end of this topic the student will be able to:
Understand typical features of bonds & stocks.
Learn how to obtain information about bonds and stocks.
Identify the main factors that affect the value of these securities.
Learn how to value these securities.
Understand how changes in the underlying factors affect the value of these securities.
Definition/Overview:
Required return: A required return is a rate of return that would be required to be
willing to make an investment. The required return exactly reflects the riskiness of the
expected future cash flows of the investment. It reflects the opportunity cost of making
the investment. It is the return that the market would require from an investment of
identical risk and therefore the required return is determined by market conditions. An
expected return is a rate of return that is expected to be earned if an investment is made.
Coupon payments: Coupon payments are the interest payments made on a bond by the
firm that issued the bond. A coupon rate determines the coupon payments. It is the
percentage of the bonds par value that is paid out in total coupon payments during a year.
Bond indenture: The legal contract between the issuing corporation and the
bondholders.
Par value: The amount of money that must be repaid by the issuing corporation to the
bondholders at the end of the bonds life.
Principal: The total amount of money being borrowed.
Maturity: The amount of time until the end of the bonds life. Original maturity is the
amount of time the bond is scheduled to exist. Remaining maturity is the amount of time
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remaining until the end of the bonds life. Often remaining maturity is referred to simply
as maturity.
Call provision: Allows the issuing firm to pay off the bonds prior to their maturity.
Sinking fund: A provision that requires the bonds to be repaid in multiple installments
that are specified in the indenture.
Payout ratio: A payout ratio is the amount a firm pays out in cash dividends divided by
the firms earnings during the same time period.
Value of a share of stock: The value of a share of stock is the present value of the
expected future dividends, P0 = D1 / (r g).
Required Return for a Stock: The required return for a stock (also called the
capitalization rate) is the rate of return that exactly reflects the riskiness of the stocks
expected future dividends. Note that the dividend growth model can be rearranged to
estimate a stocks required return: r = D1 / P0 + g.
Key Points:
1. Bonds
Bonds represent loans extended by investors to corporations and/or the government.
Bonds are issued by the borrower, and purchased by the lender.
The legal contract underlying the loan is called a bond indenture.
1.1. Key Features of Bonds
The par (or face or maturity) value is the amount repaid (excluding interest) by the borrower to
the lender (bondholder) at the end of the bonds life. The par value for U.S. corporate bonds is
$1000.
The coupon rate determines the interest payments. Total annual amount = coupon rate x par
value. U.S. corporate bonds pay semi-annually.
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A bonds maturity is its remaining life, which decreases over time. Original maturity is its
maturity when its issued. The firm promises to repay the par value at the end of the bonds life
(also called maturity).
A sinking fund requires principle repayments (buying bonds) prior to the issues maturity.
Convertible bonds can be converted into a prespecified number of shares of stock. Typically,
these are shares of the issuers common stock.
The call provision allows the issuer to buy the bonds (repay the loan) prior to maturity for the
call price. Calling may not be allowed in the first few years.
1.2. Bond Valuation
The bonds fair value is the present value of the promised future coupon and principal payments.
At issue, the coupon rate is set such that the fair value of the bonds is very close to its par value.
Later, as market conditions change, the fair value may deviate from the par value.
1.3. Yield to Maturity (YTM)
The Yield to Maturity is the APR (Annual Percentage Rate) that equates the
bonds market price to the present value of its promised future cash flows.
This assumes that promised payments will be made in full and exactly on time.
1.4. Bond Riskiness
The YTM is the bonds promised return.
But what if the bond issuer defaults?
Another source of risk lies with changing interest rates.
As the interest rate rises, the price of a fixed-coupon bond falls.
2. Interest Rate Risk
Bond values are inversely related to interest rates.
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Changes in bond values as interest rates change is known as interest rate risk.
It depends on the maturity of the bond.
2.1. Interest Rate Risk of a Bond
2.2. Bond Values and Call Provisions
Call Provision allows the issuer to pay off the bonds prior to maturity.
When bonds are called by the issuer, they are purchased from the holder at the call price.
The bonds are then retired.
The Yield-to-Call (YTC) is the bonds expected return up to the call date.
3. Zero-Coupon Bonds
A zero-coupon bond does not pay any coupon (periodic) interest.
The par value is paid to the bondholder at maturity.
Zero-coupon bonds are also known as pure-discount bonds.
4. Stock Valuation
There are two basic types of stock: common and preferred.
Common stock represents the residual ownership interest in a firm.
Common stockholders get whatever is left over in the event of a bankruptcy.
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4.1. Preferred Stock
Claims of preferred stockholders are junior to claims of debtholders, but senior to those of
common stockholders.
Limited voting rights compared to common stock.
Preferred stock has a par value and a dividend rate.
Failure to pay the dividend does not force the issuing firm into bankruptcy.
4.2. Common Stock
Represents residual ownership of the firm.
Common stockholders have important voting rights.
The issuer may pay dividends to common stockholders. However, it is not required to do so.
Moreover, there is no pre-set dividend rate.
Future dividends are uncertain.
5. The Dividend Discount Model
The fair value depends only on the stocks expected future cash flows, which are dividends and a
future sale price.
Each subsequent future selling price depends on the expected subsequent dividends.
Astocks fair value can be expressed in terms of only the stocks expected future dividends.
5.1. Applying the Dividend Valuation Model
Investors look at a firm as a source of growing wealth.
They are interested in the underlying growth of a firm and the implications of that growth rate
for the stocks value.
The value of a share of stock is the present value of the expected dividends over the holding
period plus the expected sale price at the end of the holding period.
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5.2. The Dividend Discount Model
Future Dividends depend on:
The firms earnings
Dividend policy
Payout Ratio = Dividends / Earnings
6. Common Stock Valuation
The per share annual dividend on a common stock is expected to be $3.00 one year from today.
Stockholders require a 12% rate of return. Find the fair value of stock for each of the following
cases:
Zero Growth: dividends are constant every year.
Five-Percent Growth: dividends are growing at a constant rate of 5% per year forever.
Super-Normal Growth: dividends will grow at 25% for 3 years and then at 5% per year forever.
7. Present Value of Dividends
7.1. Important Features of the Constant Growth Model
The growth rate in dividends (g) is always less than the required rate of return (r).
Otherwise, the firms growth would exceed the economys growth forever, which is not possible.
Also, the fair value would be negative or infinity, which makes no sense.
The growth rate in dividends is also the capital gains yield on the stock.
The capital gains yield is the rate of price appreciation.
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7.2. Source of Dividend Growth
If the Payout Ratio (POR) is constant, growth in dividends depends on the growth in earnings.
The growth in earnings depends on:
▪ The amount of earnings retained (1 - POR), and
▪ The return earned on that money, i.
▪ g = (1 - POR) i
7.3. Obtaining Common Stock Information
Sources of information include on-line sources, such as Yahoo! Finance and Google Finance (go
to more and then even more).
Traditional sources include newspapers, such as The Wall Street Journal and stock and bond
guides, such as Standard & Poors.
8. The Price-Earnings Ratio
Like participants in conversations about football and the weather, many investors will join into a
discussion concerning the investment potential of a stock and feel good about their contribution,
regardless of any knowledge they might have about the stock.
These types always bring up the P-E ratio.
Conventional wisdom holds that a high P/E is good and a low P/E is bad.
The bracketed amount is the E/P ratio. Holding r and POR constant, the smaller the E/P ratio,
the larger i must be. A smaller E/P ratio is a larger P/E.
Therefore, higher P/E implies higher expected return on the earnings reinvested by the firm.
8.1. Some Warnings about the P/E
The logic of the P/E depends on expectations, but the P/E is usually based on historical numbers.
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Currently reported accounting earnings do not reflect the actual timing of the earnings.
The P/E may be high because recent earnings are low!
8.2. Measuring the NPV of Future Investments
The value due to assets already in place
The NPV of future investments expected to be made by the firm.
: Risk And Return: Stocks
Topic Objective:
At the end of this topic the student will be able to:
Estimate expected returns from securities and portfolios.
Estimate the standard deviation of returns on securities and for portfolios.
Explain why diversification is beneficial.
Describe the efficient frontier and the Capital Market Line.
Definition/Overview:
Expected Return: The expected return of an asset is the mean of its future possible returns
Mean: A mean is a long-term average of a random variable. It is found by multiplying the value
of each outcome by the probability of occurrence and summing the resulting products together.
Risk of an Asset: The risk of an asset is the standard deviation of its future possible returns.
Efficient frontier: The efficient frontier is the set of all efficient portfolios, portfolios with the
highest possible expected return for a given level of risk. Investors should only invest in
portfolios that lie on the efficient frontier because those portfolios produce the highest expected
returns when compared to other portfolios of similar risk.
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Capital Market Line: The capital market line is a line that connects the riskless return to the
efficient frontier at point M. It represents various percentages of capital invested in the riskless
asset and the market portfolio. The line can be extended past point M to represent borrowing at
the riskless return and investing the proceeds in M. The line produces a better risk-return
relationship than the portfolios that are on the efficient frontier. With the right investment
proportions, the two assets would produce exactly the opposite return in every economic
scenario. The net return would be constant, or riskless.
Key Points:
1. Probability and Statistics
Random variable: Something whose value in the future is subject to uncertainty.
Probability: The relative likelihood of each possible outcome (or value) of a random variable.
Probabilities of individual outcomes cannot be negative nor greater than 1.0.
Sum of the probabilities of all possible outcomes must equal 1.0.
2. Probability Concepts
Mean: The long run average of the random variable. Equals the expected value of the random
variable.
Variance (and Standard Deviation): Measure the dispersion in the possible outcomes. Standard
deviation is the square-root of the variance. Higher variance implies greater dispersion in the
possible outcomes.
Covariance: Measures how two random variables vary together (or co-vary). Covariance can be
negative, positive or zero. Its magnitude has no bounds.
Correlation Coefficient: A standardized measure of co-variation between two random variables.
Always lies between -1.0 and +1.0.
Positive Covariance (or correlation): When one random variables outcome is above the mean, the
other is also likely to be above its mean.
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Negative Covariance (or correlation): When one random variables outcome is above the mean,
the other is likely to be below its mean.
Zero Covariance (or correlation): There is no relationship between the outcomes of the two
random variables.
3. Expected Return and Specific Risk
The mean return is a measure of the expected return from the security. The expected return on
DSC is 1.7 times higher than the expected return on CGI.
The standard deviation is a measure of the specific risk of the security. The specific risk of DSC
is 3 times higher than the specific risk of CGI.
The returns on DSC and CGI are negatively correlated.
4. Investment Portfolios
DSC has higher returns and higher risk than CGI.
Without going further, the only recommendation that we have is a variation on the old Wall
Street saying you can sleep well or eat well.
5. Portfolios of Securities
A portfolio is a combination of two or more securities.
Combining securities into a portfolio reduces risk.
An efficient portfolio is one that has the highest expected return for a given level of risk.
5.1. Portfolio Risk
The risk of the portfolio (as measured by its standard deviation) is:
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5.2. Diversification of Risk
Note that while the expected return of the portfolio is between those of CGI and DSC, its risk is
less than either of the two individual securities.
Combining CGI and DSC results in a substantial reduction of risk - diversification!
This benefit of diversification stems primarily from the fact that CGI and DSCs returns are
negatively correlated.
5.3. Portfolio Expected Return
o The expected return of the portfolio depends on:
▪ The expected return of the securities in the portfolio.
▪ The portfolio weights.
o The risk of the portfolio depends on:
▪ The risk of the securities in the portfolio.
▪ The portfolio weights.
▪ The correlation coefficient of the returns on the securities.
All else being the same, the lower the correlation coefficient, the lower is the risk of the
portfolio. Thus, lower the correlation coefficient, greater is the diversification of risk.
6. Perfect Positive Correlation
When the returns on two stocks are perfectly positively correlated, there is no diversification of
the risk.
The risk of the portfolio is then simply the weighted average of the risk of the individual assets.
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7. Perfect Negative Correlation
When the returns on two stocks are perfectly negatively correlated, it is possible to diversify
away All of the risk by appropriate weighting of the two stocks.
8. Many Asset Portfolios
The above framework can be expanded to the case of portfolios with a large number of stocks. In
forming each portfolio, one can vary
The number of stocks that make up the portfolio,
The identity of the stocks in the portfolio, and
The weights assigned to each stock.
9. Efficient Portfolios
A portfolio is an efficient portfolio if
No other portfolio with the same expected return has lower risk, or
No other portfolio with the same risk has a higher expected return.
Investors prefer efficient portfolios over inefficient ones.
The collection of efficient portfolio is called an efficient frontier.
10. A Prescription for Investing
Investors prefer efficient portfolios over inefficient ones.
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There is no uncertainty about the future value of this asset (that is, the standard deviation of
returns is zero). Let the return on this asset be rf.
For practical purposes, 90-day U.S. Treasury Bills are (almost) risk free.
In combination with the riskless asset, the best portfolio provides the highest slopethe most
return for the risk taken.
11. The Capital Market Line (CML)
Assume investors can lend and borrow at the riskless rate.
Borrowing entails a negative investment in the riskless asset.
Because every investor holds a part of the best risky asset M, M is the market portfolio.
The Market portfolio consists of all risky assets.
Each asset weight is proportional to its market value (capitalizationnot the stock price).
In Section 2 of this course you will cover these topics:Risk And Return: Asset Pricing Models
Cost Of Capital
Business Investment Rules
Capital Budgeting Cash Flows
Capital Budgeting In Practice
Options
You may take as much time as you want to complete the topic coverd in section 2.There is no time limit to finish any Section, However you must finish All Sections before
semester end date.
If you want to continue remaining courses later, you may save the course and leave.You can continue later as per your convenience and this course will be avalible in your
area to save and continue later.
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: Risk And Return: Asset Pricing Models
Topic Objective:
At the end of this topic the student will be able to:
Explain the importance of asset pricing models.
Demonstrate choice of an investment position on the Capital Market Line (CML).
Understand the Capital Asset Pricing Model (CAPM) and its uses.
Describe the arbitrage pricing model and differentiate it from the CAPM.
Definition/Overview:
Beta: Beta is a variable used in the capital-asset-pricing model. It is the correlation of an assets
returns with market returns multiplied by the assets standard deviation of returns and divided by
the markets standard deviation of returns. Beta is a measure of non-diversifiable risk.
Market price: The market price of risk refers to the market risk premium, rm - rf. It is a measure
of the extra return required for undertaking a unit of market risk.
CAPM: CAPM is a model for estimating the expected return of an asset. The minimum
expected return is the risk free rate. The expected returns increases with risk, which is measured
by the assets covariance with the market. For every unit of market risk, the expected return
increases by the market risk premium, rm - rf.
Diversifiable Risk: Diversifiable risk is risk that is specific to one asset. For example, a
companys products may be a failure or an asset may be destroyed in a natural disaster. Non-
diversifiable risk is risk that affects all assets. For example, the global economy may enter a
prolonged depression. The difference is that diversifiable risk can diversified away. By
investing in many assets, the failure or destruction of one asset will have little effect on the
overall portfolio. Non-diversifiable risk cannot be diversified away because it affects all assets.
A simple way to look at this is that the market need not pay for taking risk that can be easily and
virtually costlessly eliminated. Another way to view this is that the market will not pay investors
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for taking on diversifiable risk because prices are set by diversified investors. Diversified
investors will value an asset at a higher price than a non-diversified investor because diversified
investors have lower-risk and therefore a lower required return. Based on the Principle of Self-
Interested Behavior, people will sell to the highest bidders. Thus a non-diversified investor
buying at these prices can only expect to make the required return set by a diversified investor.
Key Points:
1. The Capital Asset Pricing Model (CAPM)
Asset pricing models provide a relationship between an assets required rate of return and its risk.
The capital asset pricing model (CAPM) is the most popular such model. Later, we present
multi-factor and arbitrage pricing models.
It allows us to determine the required rate of return for an individual security.
Individual securities might not lie on the Capital Market Line (CML).
The CAPM can be developed from the CML.
When applied to financial securities, the relationship in the CAPM between risk and return for an
individual asset is referred to as the Security Market Line (SML).
1.1. Assumptions of the CAPM
The probability distributions of security returns can be described by the mean and the variance of
returns.
All investors have the same assessment of expected returns, variances, and co-variances of all
securities.
Capital markets are in equilibrium.
The Principle of Market Efficiency applies.
All investors have a one-period horizon.
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1.2. What does the SML tell us?
The required rate of return on a security depends on:
The risk-free rate
The beta of the security
The market price of risk
▪ The required return is a linear function of the beta coefficient.
▪ All else being the same, the higher the beta coefficient, the higher is the
required return on the security.
1.3. What does the CAPM tell us?
The required return for a risky asset is composed of two parts:
Graphical Representation of the SML
2. Estimating the Beta Coefficient
Generally, these quantities are not known.
We usually rely on their historical values to provide us with an estimate of beta.
3. Arbitrage and the SML
If an asset has a [beta/expected return] combination on the SML, the asset is fairly priced.
If the [beta/expected return] combination of an asset is above the SML, the asset is under priced
(has a high return for its beta).
If the [beta/expected return] combination of an asset is below the SML, the asset is overpriced
(has a low return for its beta).
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Competition among investors will tend to force stocks [beta/expected returns] towards the SML.
4. Diversifiable and Non-diversifiable Risk
Beta measures the risk that an individual asset adds to the market portfolio.
Since the market portfolio is fully diversified, beta measures the risk that cannot be diversified
away.
Thus, beta is a measure of the assets non-diversifiable risk.
Total Risk = Diversifiable risk + Non-diversifiable risk.
4.1. Diversifiable Risk
It is also known as unsystematic, or asset specific, risk and can be eliminated by diversification.
It can be caused by:
Failure (or success) of a firm in launching a new product.
Failure (or success) to get a contract
Failure (or success) in settling a strike or a lawsuit.
Such events are random across firms and their effects tend to cancel each other out.
4.2. Non-diversifiable Risk
It also known as systematic, or market, risk and cannot be eliminated by diversification.
It can be caused by:
▪ Recession
▪ Sharp change in monetary policy
▪ Outbreak of war
It reflects the degree to which an assets returns move systematically with those of other assets.
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4.3. Consequences of Not Diversifying
A non-diversified investor bears both types of risk: diversifiable and non-diversifiable.
A diversified investor bears only systematic risk.
The value of the asset to the diversified investor will be higher than to the non-diversified
investor.
Since the diversified investor bears less risk than the non-diversified one, she will demand a
lower risk premium.
The lower the risk premium, the lower the required rate of return.
The lower the required rate of return, the higher is the value of the asset.
Since the value of the asset is higher to the diversified investor, she will always out-bid the non-
diversified one.
The price she is willing to offer will be the market clearing price.
5. Arbitrage Pricing Theory
The APT relies on the principle of Capital Market Efficiency.
The assets returns are linear in the factor returns.
The number and type of factors are not pre-specified by theory.
They must be determined empirically.
The APT is more general than the CAPM.
6. International Considerations
Investing in domestic as well as foreign markets expands the investment opportunity set
available to investors.
If the returns in the two markets are imperfectly correlated, additional diversification of risk is
possible.
The market portfolio is now defined as the world portfolio.
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: Cost Of Capital
Topic Objective:
At the end of this topic the student will be able to:
Understand the concept of cost of capital.
Understand the major determinants of the components of the cost of capital.
Identify the important differences between operating and financial leverage.
Estimate cost of capital for a capital budgeting project.
Definition/Overview:
Financing Decision: The financing decision refers to how a firm will pay for its assets, with
debt or equity. The investment decision is which assets a firm chooses to invest in. The other
side of the financing decision consists of equity holders and debt-holders. The other side of the
investing decision is made up of the entities that have sold assets to the firm.
Operating leverage: Operating leverage is the mix of fixed and variable costs required to
produce a product or service. Financial leverage is the mix of debt and equity used in financing
an asset.
Operating risk: Operating risk is the risk associated with a firms choice between fixed and
variable production costs. It is different from financial risk in that it is unique for each of the
firms investments and affects both the diversifiable and nondiversifiable risk of the firm. It
therefore affects a projects beta and its cost of capital. Sometimes a firm has little choice in
choosing its operating leverage, thus making operating risk very difficult to manage.
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Key Points:
1. The Cost of Capital
The Cost of Capital is often misinterpreted.
It is NOT the firms historical cost of funds that determines the cost of capital.
The relevant cost is the opportunity cost.
The Cost of Capital is the required return for a capital budget.
It is the opportunity cost of funds tied up in the project.
It is the rate of return at which investors are willing to provide financing for the project today.
It reflects the risk of the project.
2. Corporate Valuation
The market value of the firm (or simply, the firm value) can be viewed in two ways:
Firm value equals the sum of the market values of the claims on the firms assets.
Firm value equals the sum of the market values of its assets.
These two views are simply the balance-sheet accounting identity, but in market values:
Assets = Liabilities + Owners Equity
2.1. Financing Decisions and Firm Value
In a perfect capital market, value of the firm does not depend on its capital structurethe way in
which its assets are financed.
The mix of debt versus equity is irrelevant in determining firm value.
In imperfect capital markets, capital structure can affect the value of the firm.
2.2. Investment Decisions and Firm Value
The value of the firm does depend on:
The expected future cash flows to be generated by the firms assets, and
The required return on these cash flows.
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An asset will add value if its expected return (the Internal Rate of Return or
IRR) exceeds its required return (its cost of capital).
2.3. Value and the Risk-Return Trade-Off
The value of a project depends on:
The expected future cash flows
The cost of capital:
▪ An increase in the expected future cash flows may be offset by a
corresponding increase in risk because an increase in risk increases the
projects cost of capital.
▪ This is like the stated price and special financing interest rate, you can
have the same payment with different price rate combinations.
▪ An offset like this is simply a risk-return trade-off.
3. Leverage
According to the CAPM, the required return depends only on the non-diversifiable risk. The non-
diversifiable risk borne by shareholders can be split into two parts:
Operating (business) Risk that results from operating leverage
Financial Risk that results from financial leverage.
3.1. Operating Leverage
Operating leverage arises from the mix of fixed versus variable costs of
production.
High fixed costs (and correspondingly lower variable costs per unit) results in
high-operating leverage.
The firms profits are more sensitive to changes in sales.
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Conversely, low fixed costs (and correspondingly higher variable costs per
unit) result in low-operating leverage.
Operating leverage affects the risk of the firms investments, and is unique for
each investment.
It affects both the diversifiable as well as the non-diversifiable risk of the
investment.
Through its effect on non-diversifiable risk, it also affects the investments cost
of capital.
The firms choice of operating leverage may be limited by the number of
alternative production methods.
3.2. Financial Leverage
The presence of fixed costs associated with debt financing results in financial
leverage.
As financial leverage increases, the variability of shareholder returns
increases.
This increases shareholders risk.
4. The Weighted Average Cost of Capital
The Weighted Average Cost of Capital, WACC, is the weighted average rate of return required
by the suppliers of capital for the firms investment project.
The suppliers of capital will demand a rate of return that compensates them for the proportional
risk they bear by investing in the project.
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4.1. A Potential Misuse of the WACC
Assume new projects being considered have the same risk as the average risk
of the firms existing operations.
If the firm uses its current WACC, it will accept projects with above average
risk and reject projects with below average risk.
Over time, the risk of the firm would then increase.
5. Financial Risk
Financial risk is due to the presence of debt financing used by the firm.
An all-equity financed firm has no financial risk.
A firm can control its financial risk by its choice of capital structure and the maturities of its
obligations.
6. Financial Leverage and the Cost of Capital
In perfect capital markets, financial leverage has no effect in the WACC.
WACC is independent of the capital structure.
In which case, a projects value is not affected by the way in which its financed.
However, even then, financial leverage does alter how the risk of the project is borne by the
debtholders and the shareholders.
As financial leverage increases, the risk borne by both the debtholders and the shareholders
increases.
In the limit, the debt holders become shareholders, except for taxes and contracting
considerations.
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7. WACC for a Different Business
Consider a firm that intends to expand into a new line of business. What WACC should it use for
evaluating this proposal?
If the new line of business is of different risk than the firms existing assets, the firms WACC
cannot be used.
7.1. Operating Leverage and the WACC
In contrast to financial leverage, higher operating leverage increases asset risk,
A, and therefore directly increases the WACC.
Also, like financial leverage higher operating leverage leads to a higher beta.
Given technology, a firm may not have much choice over its operating
leverage, and therefore not much choice about its WACC.
: Business Investment Rules
Topic Objective:
At the end of this topic the student will be able to:
Describe the process of capital budgeting.
Calculate various investment criteria.
Understand the strengths and weaknesses of NPV, IRR, and other investment criteria.
Explain why an NPV profile is the most useful investment criterion.
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Definition/Overview:
Capital Budgeting Process: The five steps in the capital budgeting process are:
Generating ideas for new projects, which can be extremely valuable to the firm.
Reviewing existing projects and facilities to see if any should be added, combined, or
abandoned.
Preparing informal or formal proposals based on the type of firm and the classification of the
project.
Evaluating the proposed projects and choosing which projects to approve as part of the capital
budget.
Preparing appropriations requests.
Key Points:
1. The Capital Budgeting Process
The capital budget is made up of the firms planned capital expenditures. Capital budgeting
projects can be classified into several categories:
Maintenance Projects
Cost Savings/Revenue Enhancement
Capacity Expansions in Current Business
New Products and New Businesses
Projects Required by Government Regulation or Firm Policy
1.1. Preparing Proposals
Generally, the originator presents a written proposal.
Most large firms use standard forms, and these are typically supplemented by
written memoranda.
There may be consulting studies prepared by outside experts.
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2. Internal Rate of Return
The internal rate of return is the discount rate that sets NPV of the expected cash flows to zero.
The internal rate of return is the projects expected return.
Undertake a project if the IRR exceeds r, the projects cost of capital.
3. Using NPV and IRR
Most of the time NPV and IRR are both valuable guides to making decisions.
There are occasions, however, where NPV and IRR disagree.
3.1. NPV Profile
An NPV profile plots the projects NPV as a function of the discount rate.
It shows both the NPV and the IRR of the project.
It can be used to identify the range of cost of capital at which the project
would add value to the firm.
3.2. Types of Projects
A conventional project is one that has an initial cash outflow, followed by one
or more expected future net cash inflows.
A non-conventional project may have several net cash outflows and inflows.
Two projects are independent if undertaking one does not affect the other.
IRR and NPV methods agree for conventional, independent projects.
Two projects are mutually exclusive if undertaking one precludes taking the
other.
IRR and NPV methods can yield conflicting decisions when choosing
between mutually exclusive projects.
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3.3. When IRR and NPV Can Disagree
Mutually exclusive projects with:
Differences in size.
Differences in cash flow timing.
Reverse conventional projects.
4. Cash Flow Timing Differences
The conflict between the NPV and the IRR arises because of differences in each methods
assumption regarding the re-investment rate.
The NPV method assumes that future cash flows from the project will be reinvested at the
projects cost of capital.
The IRR method assumes that future cash flows from the project will be reinvested at the IRR.
Plot each projects NPV profile.
Find each projects IRR.
5. Other Capital Budgeting Criteria
Profitability Index
Modified Internal Rate of Return (MIRR)
Payback
Discounted Payback
Urgency
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5.1. Profitability Index
Decision Rule: Undertake the project if the payback is less than a preset
amount of time.
Discounted Payback Method: The discounted payback is the length of time it
takes for the projects discounted cash flows to equal its investment.
5.2. Urgency
This method says invest in the project when you absolutely have to.
Replacement decisions: replace the asset only after it has broken down!
It ignores planning ahead.
: Capital Budgeting Cash Flows
Topic Objective:
At the end of this topic the student will be able to:
Explain the importance and difficulty of incorporating the effects of erosion and enhancement on
the firms existing operations.
Incorporate effects of inflation into an NPV calculation.
Explain importance of using current tax laws.
Definition/Overview:
Net Cash Flow: The net cash flow for the initial investment is made up of cash paid for
new capital assets, change in net working capital, cash received on the sale of old
equipment, and tax paid (saved) on the sale of old equipment.
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Net salvage value: Net salvage value = S -T(S - B) - (1 - T)REX + ΔW is the equation
for net salvage value. S is the cash received from the sale of the equipment. The tax paid
on this sale, T(S - B), is subtracted as a cash outflow. Note that if B exceeds S, there is a
negative tax that, when subtracted, creates a tax credit. After-tax cleanup and removal
expenses, (1 - T)REX, are also subtracted as a cash outflow. Finally, the release of
working capital, ΔW, from the project is a cash inflow to the firm.
Nominal Rate of Return: The nominal rate of return can be broken down into its two
components, the real rate of return and inflation. (1 + rn) = (1 + rr)(1 + i) is the
relationship between the nominal rate of return, the real rate of return and inflation, which
reduces to Equation (7.5): rn = rr + i + i rr
Taxes: Taxes are large expenses for firms. Current tax laws are important to the
evaluation of a capital investment project because they affect the value of the project. A
change in tax laws could potentially turn a positive-NPV project into a negative-NPV
projector the reverse, and tax laws change frequently.
Key Points:
1. Overview of Estimating Cash Flows
Costs and benefits are measured in terms of cash flownot income.
Cash flows are incremental (marginal).
The cash flows with the project minus the cash flows without the project.
Cash flows are after tax.
Cash flow timing affects the projects value.
Financing costs are included in the cost of capital.
2. Tax Considerations
Taxes and the timing of tax payments significantly affect the incremental cash flows. The
relevant tax rate is the firms marginal tax rate, T.
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Revenues, represented by R, increase tax liability by TR. When the revenue and the tax
treatment occur simultaneously, the after-tax cash flow is the revenue minus the tax liability:
After-tax revenue cash flow = R T x R
After-tax revenue cash flow = (1 T) R
Less obvious is that expenses, represented by E, reduce tax liability.
When the revenue and the tax treatment occur When the expense and the tax treatment occur
simultaneously, the algebraic signs carry through and the after-tax cash flow is minus the
expense plus the reduced tax liability:
After-tax expense cash flow = E + T x E
After-tax expense cash flow = (1 T) E
In some cases the cash flow and tax treatment are separated. This complicates the analysis.
The most common situation where they are separated is when an asset is capitalized
(depreciated).
Let I0 be a net expenditure to be capitalized, and Dt be its depreciation expense to be claimed in
year t.
The separated incremental after-tax cash flow for each depreciation expense is +T Dt. (This is
just like the +T E for an expense.)
3. Calculating Incremental Cash Flows
Net initial investment outlay.
Future net operating cash flows.
Non-operating cash flows required to support the initial investment outlay.
Net salvage value received upon termination of the project.
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3.1. Changes in Net Working Capital
At the start of a project, an investment of net working capital may be required.
Operating cash
Inventory
Accounts receivable
But, an increase in accounts payable offsets some of the net working capital
needs.
A project could also reduce the net working capital requirements.
3.2. Net Cash Flow from Sale of Old Asset
If an existing asset is being replaced by a new one, the sale of the old asset
may generate a cash flow.
If the selling price is greater than the net book value of the old asset, taxes will
have to be paid on this sale.
If the selling price is less than the net book value of the old asset, a tax credit
is generated.
Let S0 be the selling price of the old asset, and B0 be its net book value.
Taxes on the sale will be T (S0 B0). So the net cash flow from the sale of old
asset is: S0 - T (S0 B0)
3.3. Net Initial Outlay
Let C0 be the net initial outlay. Let DW be the change in the net working
capital. Let Ic be the investment tax credit. Then,
C0 = I0 DW (1 T) E0 + S0 T(S0 B0) + Ic
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3.4. Net Salvage Value
Let S be the selling price of the asset and B its book value. Let REX be the
cleanup and removal expenses (to be expensed) and DW the net working
capital recovered upon termination of the project.
Net salvage value = S - T(S - B) - (1 - T)REX + DW
4. Inflation
Inflation affects the projects expected cash flows.
Inflation also affects the cost of capital.
So effects of inflation must be properly incorporated in the NPV analysis.
4.1. Effect of Inflation on the Cost of Capital
Inflation increases the nominal amounts of both revenues and expenses, even
though their real values may stay the same.
However, depreciation expense is fixed. It is based on historical cost.
If expected future cash flows are given in nominal terms, then we must use the
nominal cost of capital to calculate their present value.
If expected future cash flows are given in real terms, we must use the real cost
of capital to calculate their present value.
4.2. Inflation and NPV Analysis
The NPV of the project is unchanged as long as the cash flows and the cost of
capital are expressed in consistent terms.
If inflation is expected to affect revenues and expenses differently, these
differences must be incorporated in the analysis.
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4.3. Depreciation
The total amount of depreciation tax credits over the life of the project is
independent of the depreciation method used.
The present value of these tax credits are dependent on the depreciation
method.
A firm should use the depreciation method that results in the largest present
value of depreciation tax credits.
5. Evaluating Replacement Cycles
Certain assets need to be replaced after the original is worn out.
The initial choice may involve alternative models that essentially do the same job but differ in
their costs and usable life.
: Capital Budgeting In Practice
Topic Objective:
At the end of this topic the student will be able to:
Describe the important role of capital budgeting options in valuing projects.
Distinguish between hard and soft capital rationing.
Describe the important role in capital budgeting of factors that are difficult to quantify.
Explain the drawbacks of simple mechanical rules in complex capital budgeting cases.
Apply the principles of finance to capital budgeting.
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Definition/Overview:
Expansion Option: An expansion option is the ability to change the size of a project. A
price-setting option is the ability to change the cash flows of a project by changing a
products price. An abandonment option is the ability to quit a project if it is more
profitable than continuing. A postponement option is the ability to wait for more
information before making a decision. The replacement option is the ability to continue
using equipment or buy new equipment. Future investment options arise because a
capital budgeting project may not be profitable in and of itself, but it may give rise to
future positive-NPV projects.
Post-audits: Post-audits are important because actual cash flows can be compared to the
estimates. This comparison can help improve the ability of the analysts that made the
estimates. One of the pitfalls of post-audits is the difficulty of measuring opportunity
costs and options. Also, measuring and identifying cash flows from a decision may be
impossible.
Pricing of a product: The pricing of a product has important implications for capacity
because price affects demand. If a firm raises the price of its product, it will sell less of
the product. Likewise, if a firm lowers the price, it will sell more of the product. The
pricing of a product can affect the decision of whether to expand or not because the
decision to raise the price and not expand may have a higher NPV than the decision to
keep pricing constant and expand plant capacity.
Key Points:
1. Real Options
Option to replace an asset
Future investment opportunities
The abandonment option
The postponement option
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1.1. Future Investment Opportunities
These are options to identify future, more valuable investment possibilities
resulting from current opportunities.
Manufacturing and distributing a new product now puts a
marketing/distribution network in place for future use.
Money spent on research and development of a new idea gives the option to
develop the product later on.
Not all future investment possibilities can be accurately measured in terms of
their value.
1.2. The Abandonment Option
The abandonment option is the option to stop the project earlier than
originally planned.
The abandonment value of assets is enhanced by the presence of active used-
equipment markets.
1.3. The Postponement Option
The option to postpone a project is widely used. If anything, it might be used
when it shouldnt be used.
Decision trees can be used to analyze the value of postponement.
Evaluate three mutually exclusive projects:
▪ Start the project today.
▪ Start the project in one year.
▪ Start the project in two years.
▪ Calculate the NPV at time zero for each one and pick the highest
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2. Problems Defining Incremental Cash Flows
Cash flows for a capital budgeting project are computed on an incremental basis.
Incremental cash flows are measured with respect to the status quo.
But this assumes there are not differences in risk.
If two alternative manufacturing processes differ only in their levels of operating leverage, sales
revenues are not affected by the choice of the process.
This does not imply that sales revenues can be ignored in the analysis.
The high-risk projects total cash flows are riskier than the low-risk projects:
With lower sales, the project with the lower operating leverage will also have lower cost.
2.1. Capital Rationing
Capital rationing limits the firms capital expenditures during a given time
period.
The first method reflects managerial desire to be conservative:
In a perfect capital market, a firm can always obtain the necessary funds for a
positive-NPV project.
In practice, obtaining necessary funds may be difficult
2.2. Hard versus Soft Capital Rationing
With hard capital rationing, the limit on total capital rationing is strictly
enforced.
With soft capital rationing, the firm sets a target limit on capital expenditures.
Exceptions may be made if a particularly desirable project becomes available.
Alternatively, the firm might under-spend if conditions warrant.
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2.3. Project Choice Under Capital Rationing
The objective is to select the set of projects that maximize the total NPV of
the capital budget, subject to the constraints on the invested capital.
The Profitability Index (PI) can help in this process.
PI measures the NPV per dollar invested.
2.4. Managing the Firms Capital Budget
Capital rationing can be used as a planning tool for capital expenditures.
A divisional manager must have some leeway in approving capital projects.
If managers are evaluated and rewarded for their performance, self-interested
behavior leads to optimal performance for the good of the firm.
2.5. Post-Audits
A post-audit is a procedure for evaluating the performance of a capital
budgeting decision after its implementation.
Abandonment option.
Advantage of hindsight.
: Options
Topic Objective:
At the end of this topic the student will be able to:
Explain the importance of asset pricing models.
Demonstrate choice of an investment position on the Capital Market Line (CML).
Understand the Capital Asset Pricing Model (CAPM) and its uses.
Describe the arbitrage pricing model and differentiate it from the CAPM.
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Definition/Overview:
Option: An option is the right to do something, without the obligation to it. A call option
is the right to buy an asset and a put option is the right to sell an asset.
Strike Price: The strike price is the price at which the option holder may buy or sell the
underlying asset when the option is exercised. In-the-money means that it is
advantageous to exercise an option as opposed to buying or selling the underlying in the
open market. Out-of-the-money means that it is not advantageous to exercise an option
because the option holder could get a better price by buying or selling the underlying in
the open market. Exercise value is the amount of advantage an in-the-money option
offers over buying or selling the underlying in the open market. The time value of an
option is its price minus its exercise value.
American Call Option: An American call option traded in an efficient capital market
will never be worth less than its exercise value because of arbitrage. If a call was selling
below its intrinsic value, traders would simultaneously buy the call, exercise it, and sell
the underlying asset to get a riskless profit. Traders will do this until their buying causes
the price of the call to equal the exercise value and they can no longer profit from such a
transaction.
The exercise value is determined by the price of the underlying, the strike price, and whether the
option is a put or call. The greater the value of the underlying minus the strike price, the greater
the exercise value of a call. The greater the value of the strike price minus the underlying, the
greater the value of a put. The time premium is affected by time until expiration, the risk of the
underlying asset, and the riskless return. A longer time until expiration results in a higher time
value. A greater risk in the underlying asset also causes a higher time value. A higher riskless
return increases the time value of a call and decreases the time value of a put.
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The time premium for an American option can never be negative because an American call
option can never be worth less than its exercise value. An American call option can never be
worth less than its exercise value because of the arbitrage transactions of simultaneously buying
the call, exercising it, and selling the underlying to realize a riskless profit.
An American option is never worth less than a comparable European option because the holder
of an American option can exercise the option at any time during the options life whereas the
holder of a European option can only exercise on the expiration date. The American option
offers more optionality, because the choice of when to exercise is an option is itself an option,
and as always, options are valuable.
At expiration, each option on an individual asset can be in-the-money or out-of-the-money. An
owner will discard all the out-of-the-money options (bad outcomes) and take the exercise value
of all the in-the-money options (good outcomes). But with a single option on a comparable
portfolio the good and bad outcomes for the assets can partly cancel each other out (because of
diversification) before value of the option is determined. The result is that bad outcomes of
assets are included and hurt the single options value, whereas bad outcomes for options on
individual assets are discarded (no obligation). Therefore the single option on a portfolio is
never worth more (and almost always worth less) than a portfolio of comparable options on
individual assets.
Key Points:
1. Options: Basic Terminology
An option is the right to do something, without the obligation to do it.
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A call option is the right to buy an asset at a fixed price, within a fixed time period.
A put option is the right to sell an asset at a fixed price, within a fixed time period.
Exercising the option involves exchanging cash for the underlying asset.
When a call option is exercised by the holder, the underlying asset is purchased by paying the
exercise price.
When a put option is exercised by the holder, the underlying asset is sold for the exercise price.
An option is in-the-money if exercising it provides an advantage over directly buying or selling
the underlying asset in the open market.
A call option is in-the-money if the open market price of the underlying asset is more than the
exercise price.
A put option is in-the-money if the open market price of the underlying asset is less than the
exercise price.
An option is out-of-the-money if directly buying or selling the underlying asset in the open
market provides an advantage over exercising it.
A call option is out-of-the-money if the open market price of the underlying asset is less than the
exercise price.
A put option is out-of-the-money if the open market price of the underlying asset is more than
the exercise price.
The exercise value is the amount of advantage that an in-the-money option provides over buying
or selling the asset at the open market price.
The exercise value of out-of-the-money options is zero.
2. Valuing an Option
At maturity, the value of an option is either zero (if the option is out-of-the-money) or the
positive difference between the value of the underlying asset and the options exercise price (if
the option is in-the-money).
Prior to maturity, the value of the option is generally greater than its exercise value.
This excess value is called the time premium of the option.
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3. The Time Premium of an Option
It arises since the option gives the holder the right to claim certain outcomes and reject others
and is dependent on:
The time until expiration of the option
The risk of the underlying asset
Riskless rate of return (think put-call parity)
4. Asset Risk and Option Values
The higher the risk of an asset, the greater the time premium.
With higher risk, the probability of extremely good outcomes increases.
This increases the probability that the option will be in-the-money at expiration.
Even though the probability of extremely bad outcomes increases, the option will be worthless
anyway.
4.1. Riskless Return and Option Values
The higher the riskless rate of return, the lower the present value of a known future
amount. Exercising the option involves either
The payment of the exercise price by the option holder (in the case of a call),
or the receipt of the exercise price (in the case of a put).
A call holder will pay the exercise price to receive the asset. With higher
riskless returns, the present value of this payment is lower and the call option
value is higher.
A put holder will receive the exercise price to receive the asset. With higher
riskless returns, the present value of this payment is lower and the put option
value is lower.
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5. Hidden Options
Common stock as a call option on the firms assets.
Stakeholder relationships in financial contracting.
Refunding a home mortgage.
Tax-timing options.
Options connected with capital investments.
Variable cost reduction.
6. Portfolios of Options
The value of an option on a portfolio of assets cannot be greater than the sum of the values of
options on the individual assets.
The risk of a portfolio is less than the sum of the risks of the individual assets.
In Section 3 of this course you will cover these topics:Derivatives Applications
Agency Theory
Capital Market Efficiency
Why Capital Structure Matters
Managing Capital Structure
You may take as much time as you want to complete the topic coverd in section 3.There is no time limit to finish any Section, However you must finish All Sections before
semester end date.
If you want to continue remaining courses later, you may save the course and leave.You can continue later as per your convenience and this course will be avalible in your
area to save and continue later.
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: Derivatives Applications
Topic Objective:
At the end of this topic the student will be able to:
Describe four basic types of derivative securities.
Use the BlackScholes option pricing model (BSOPM) to value call and put options on common
stock, and also to value warrants.
Explain how a firm can force conversion of its outstanding convertible securities.
Explain how a firm can use derivatives to hedge specific risks.
Definition/Overview:
A derivative is a financial instrument whose value depends on the value of another asset.
The variables that affect the value of a call option are the options strike price, the time to
expiration, the underlyings price, the underlyings volatility, and the riskfree rate.
The exercise value of a put option has an inverse relationship with the exercise value of a
call option. As the exercise value of a call option increases, the exercise value of a put
option decreases.
A warrant is a long-term call option that is issued by a firm. It entitles the holder to buy
shares of the firms common stock at a stated price for cash.
A convertible security is a security that can be converted into common stock at the
option of the holder. Convertible bonds are bonds that can be converted into common
stock at the option of the bondholder and convertible preferred stock is preferred stock
that can be converted to common stock at the option of the holder.
A convertible bond can be viewed as a package consisting of a straight bond and
warrants. The straight bond represents the cash flows to the investor assuming the
investor decides not to convert the bond into common shares. The investors option to
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convert the bond into common shares at a specific conversion ratio can be represented by
a warrant.
An interest rate swap is a contract that obligates two parties to exchange cash flows that
are determined by two different interest rates. The swap contract specifies a notional
amount and the two interest rates. The counterparties calculate the amount of their
payment obligations at the end of each interest period, and the one that owes the greater
amount writes a check to the other counterparty for the difference.
Warrants are options to purchase the firms common stock at a specified price for a
specified period of time. Since options are valuable, warrants are not costless for the firm
to include in the bond issue.
Futures contracts are similar to forward contracts because they obligate two parties to
contract at a price that is set today no matter what the price in the future is. Futures are
different than forward contracts in that they are standardized and are traded on
exchanges.
Key Points:
1. Options
A call option gives the holder the right to buy one share of the underlying stock at a specified
price within a stated time period.
A put option gives the holder the right to sell one share of the underlying stock at a specified
price within a stated time period.
The fixed price is called the exercise or strike price.
1.1. Some Properties of Options
As stock price increases, value of call option increases and value of put option
increases.
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As exercise price increases, value of call option decreases, value of put option
increases.
As the time to maturity increases, value of call option increases, value of put
option increases.
2. Warrants
A warrant is a long-term call option issued by the firm.
Entitles holder to buy a fixed number of shares from the firm, at a stated price, within a stated
time period.
When a warrant is exercised, the number of outstanding shares increases.
3. Convertible Debt
At the option of the bondholder, a convertible bond can be converted into a pre-specified number
of shares of the firms common stock.
Each bond can be converted into common stock at a stated conversion price.
Conversion price exceeds issuers share price at the time of issue by about 10% to 20%.
Conversion price is adjusted for stock splits, stock dividends, rights offerings, and other
distributions.
Conversion ratio is the number of shares that can be purchased with one bond.
Bondholders who convert do not receive accrued interest.
If bonds are called, conversion option expires just before the redemption date.
The market value of a convertible bond always exceeds its conversion value (unless the
conversion option is about to expire).
The difference in the market value and the bonds conversion value is the time premium of the
conversion option.
Time premium is zero at option expiration.
As long as the underlying stock does not pay any dividends, bondholders would never convert
voluntarily.
Sell the bond in the open market since the market value exceeds the conversion value.
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If the stock does pay dividends, bondholders would not convert as long as the interest on the
bond exceeds the total dividends from the stock.
3.1. Forced Conversion
As long as the call price exceeds the market value of the underlying stock,
bondholders will not voluntarily convert.
Calling the bonds merely transfers wealth from stockholders to bondholders.
To force conversion, the firm should call the bonds when the conversion value
reaches the effective call price.
The effective call price = optional redemption premium plus accrued interest.
3.2. Convertible Preferred Stock
Similar to convertible bonds:
Can be exchanged into shares of common, at the option of the preferred
stockholder.
Convertible exchangeable preferred stock can be converted into convertible
debt.
4. Valuing Warrants
Warrants are long-term call options written by the firm.
When a warrant is exercised, the number of shares outstanding increases.
The value of the warrant before it is issued is simply C/(1+ ) where C is the value of a call
option to buy one share.
After the warrant is issued, an efficient market will reflect the dilution in the firms stock price,
and the warrants value is equal to that of the call option.
5. Interest Rate Swaps
An interest rate swap obligates two parties to exchange specified cash flows at specified time
intervals.
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The cash flows are determined by two different interest rates.
The simplest interest rate swap involves swapping fixed interest rates for floating interest rates,
and vice versa.
Only net cash flows are paid by one party to the other.
The amount on which the interest cash flows are based is called the notional amount.
The notional amount is never exchanged.
5.1. Why Swaps Exist
Comparative advantage
Information asymmetries
Transaction costs
6. Forward Contracts
A forward contract obligates the holder to buy a specified amount of a particular asset at a stated
price on a particular date in the future. All terms of the contract are fixed at the time the contract
is entered into:
The amount of the asset.
The specified price (the exercise price).
The delivery date and location.
At contract origination, the NPV if the forward contract is zero.
A forward contract has default risk.
There are no intermediate cash flows during the life of the contract.
Most forward contracts require physical delivery, although some may be cash settled.
7. Futures Contracts
Futures contracts are similar to forward contracts.
A long position in a futures contract obligates you to take delivery of the underlying asset.
A short position in a futures contract obligates you to make delivery of the underlying asset.
The agreed-upon price at which the asset will be traded in the future is called the futures price.
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8. Differences between Forward and Futures Contracts
Forward contract profits (or losses) are recognized only at maturity. Futures profits (or losses)
are recognized daily.
Futures contracts are traded on exchanges, while forward contracts are traded over-the-counter.
Futures contract obligations can be offset by a reversing trade on the exchange.
Active markets exist for futures contracts.
Futures contracts have low default risk.
Futures contracts have greater liquidity.
9. Hedging
A firm engages in hedging to reduce its sensitivity to changes in the price of a commodity, a
foreign exchange rate, or an interest rate.
As interest rates increase, value of the firm falls.
Profits are made on a short position in interest rate futures.
A perfect interest-rate hedge neutralizes the effect of changes in interest rates.
Hedging may be accomplished by using:
Options
Interest rate swaps
Futures or forward contracts
9.1. Hedging with Interest Rate Swaps
A floating-interest-rate borrower can hedge against adverse movements in
interest rates by entering into a swap to pay fixed and receive floating.
An interest rate cap pays the holder if a specified interest rate rises above a
specified value.
An interest rate floor places a lower limit on interest rates.
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9.2. Hedging with Forwards and Futures
Hedge by buying oil futures.
Hedge by selling yen futures (short position).
: Agency Theory
Topic Objective:
At the end of this topic the student will be able to:
Identify and understand contractual relationships in a corporation.
Describe various corporate situations in a principal-agent framework.
Analyze the principal-agent relationships in terms of decision making, control, and incentives.
Identify conflicts of interest when incentives diverge.
Definition/Overview:
Principal-agent Relationship: A principal-agent relationship is a relationship where
an agent makes decisions that affect the principal. Examples of explicit principal-agent
relationships are the relationships between a client and a lawyer and between an investor
and a money manager. Examples of implicit principal-agent relationships are an
employee acting on behalf of its employer and a consumer making decisions, such as
copying and selling a product, that can affect a manufacturer.
Free rider: A free rider is one who receives benefit from someone elses expenditure
simply by imitation. One free-rider problem is the copying of pharmaceuticals. Drug
companies spend hundreds of millions of dollars on research and development to
discover new drugs. Other drug firms are able to duplicate the drug and produce it
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themselves, without the research and development costs. In the United States, patents
protect pharmaceutical companies for a limited time from facing competition from the
free-riding firms.
Agency Problem: An agency problem is a potential conflict of interests between the
agent and the principal. One agency problem is the ability of an employee to slack off
during working hours. Another agency problem is the ability of a manager to make the
decision to grow a company to a large size rather than maximizing shareholders wealth.
Another agency problem is the ability of the stockholders to gamble with the bondholders
money by means of asset substitution.
Agency Costs: Agency costs are the costs of making agents act in the best interest of the
principal. The components are direct contracting costs, monitoring costs, and the
misbehavior costs of agents not acting in the best interest of the principal. An example of
direct contracting costs is an employee bonus. An audit is an example of a monitoring
cost. Shirking by employees is a cost caused by agents not acting in the best interest of
their employer.
Key Points:
1. Principal-Agent Relationships
An agent has decision-making authority that affects the well-being of the principal. Examples of
agents are:
1.1. Agents
Money managers
Lawyers
Corporate managers
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1.2. Principals
Investors in a money market fund
Clients of lawyers
Stockholders of the firm
2. Agency Problem
An agency problem arises when there is a conflict of interest between agents and principals.
It can also arise due to asymmetric information
The principal cannot monitor the agents behavior perfectly.
Moral hazard can occur when agents take actions in their own best interest that are unobservable
by and detrimental to the principal.
3. The Role of Monitoring
The principal can monitor the agents actions, but not perfectly.
Costs are incurred in monitoring the agents behavior.
Perfect monitoring of all actions of the agent can eliminate the agency problem.
This can be prohibitively costly.
There is a trade-off between resources spent on monitoring and the possibility of agent
misbehavior.
3.1. Alternatives to Monitoring
Alternatives to monitoring include:
Constraints on agents behavior
Incentives to align agents interests with the principals interests
Punishments for agent misbehavior
Principal-agent contracts that eliminate all agency problems cannot be
designed
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4. Agency Costs
These are costs incurred in an attempt to push agents to act in the principals best interest.
They are the incremental costs of working through others.
They consist of three types:
Direct contracting costs
Monitoring costs
Loss of principals wealth due to residual, unresolved agency problems
4.1. Direct Contracting Costs
Transaction cost of setting up a contract.
Opportunity costs imposed by constraints that preclude otherwise optimal
decisions
Incentive fees paid to agents to encourage behavior consistent with the
principals goals
5. Role of Financial Contracting
To design financial contracts between agents and principals that minimize total agency costs.
Perfect contracts that eliminate all agency problems are not feasible.
Periodic misbehavior may be less costly than the cost of eliminating it.
The optimal contract transfers decision-making authority from the principal to the agent in the
most efficient manner.
6. Stockholder-Manager Conflicts
Created by the separation of ownership and control of the corporation
Stockholders elect the Board of Directors, who in turn appoint managers
The self-interested behavior of managers may be at conflict with the interest of stockholders
Managers may favor growth and larger size of the firm:
Greater job security
Larger compensation
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Greater prestige
Larger discretionary expense accounts
Consumption of excessive perquisites
7. Non-Diversifiability of Human Capital
Managers expertise is closely tied to the firm.
This leads to a divergence of goals.
7.1. Capital Investment Choices
Preference for low-risk projects even though their NPV may be lower than
other riskier projects. If the firm ceases to operate as a result of bad outcomes
of risky projects, managers lose their jobs.
Asset Uniqueness: If a managers human capital is closely tied to the firm and
the firms assets (and products and services) are unique, a managers human
capital may not be transferable to other firms.
8. Debtholder-Stockholder Conflicts
When a firm issues risky debt, stockholders have an option against the debtholders.
The option to default on debt
Now, stockholders are the agents and the debtholders are the principals.
Debtholders want to protect themselves against adverse decisions taken by stockholders.
This conflict can manifest in three ways:
Asset substitution
Underinvestment
Claim Dilution
8.1. Asset Substitution Problem
Occurs when riskier assets are substituted for the firms existing assets.
This appropriates wealth from the firms existing debtholders.
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Stockholders have the option to default on debt. As the risk of the firms
investments increases, the value of this option increases the expected payment
to debtholders decreases.
With risky debt, stockholders can gain even if the new, risky project has a
negative NPV.
This happens as long as the debt holders loss exceeds the (negative) NPV of
the project.
Stockholders wealth declines by the (negative) NPV.
Stockholders wealth increases by the loss of the debtholders.
A levered position in common stock can be viewed as a call option on the
firms assets.
The exercise price of the call is the amount of money promised to the
bondholders.
If the option is in the money, the shareholders exercise their option and pay
off the bondholders.
If the option is out of the money, the shareholders elect not to exercise and
default on the debt.
A major determinant of the value of a call option is the riskiness of the value
of the underlying assets.
8.2. The Underinvestment Problem
With risky debt outstanding, if stockholders gain from an increase in the risk
of the firms investments, they lose from a decrease in the risk of the firms
investments.
Value of an option declines as the risk of the underlying asset decreases.
Thus, stockholders may refuse to invest in a low-risk but positive NPV
investment.
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8.3. Claim Dilution Problem
Claims of existing debtholders can be diluted in two ways:
Via dividend policy
Via new debt
8.3.1. Claim Dilution via Dividend Policy
▪ Paying out cash dividends has two effects:
▪ It reduces the firms cash and its owners equity.
▪ It increases the risk of the remaining assets (since cash is riskless).
▪ Reduction in owners equity enlarges the firms proportion of debt
financing.
▪ This increases the risk of the debt, and decreases its value.
▪ Increase in the risk of the firms assets also increases stockholder wealth.
▪ Newly issued debt can reduce the chance that existing debtholders will
not be paid the promised amount.
▪ This occurs if the new debts claims are at least as senior as the old debts
claims.
▪ This increased risk of existing debt reduces its value.
▪ Stockholders get the benefit from this decline in value.
9. Consumer-Firm Conflicts
These can be of two types, depending on who is the agent and who is the principal.
Guarantees and Service after Sale
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The Free Rider Problem
9.1. Guarantees and Service After Sale
The firm is the agent, and the consumer is the principal.
If the principal does not expect the agent to fulfill its promise, it will not pay
full value for the firms products and services.
9.2. The Free Rider Problem
The firm is the principal and the consumer is the agent.
The agent has the option to duplicate the firms products/services at a lower
cost.
Examples include copying of computer software, books, videotapes etc.
Copyright and patent laws are designed to protect and encourage the
development of valuable ideas.
10. Working in Contractual Relationships
Financial distress increases the conflicts between the various stakeholders of the firm.
Firms in financial distress have a greater incentive to engage in asset substitutions and
underinvestment - they have little to lose, and a lot to gain.
Stakeholders may form coalitions to act in their best interest, even though these actions may
conflict with shareholder interests.
11. Agency Costs of Overvalued Equity
This is a danger that a firms equity could be overvalued (the opposite of distress).
Much of top management compensation and wealth can depend on the firms stock price.
If a high stock valuation cannot be justified by the firms cash flows, managers may take steps to
justify the high valuation even thought it cannot be sustained.
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Actions managers might take to create a smoke screen include:
Earnings management and earnings manipulation
Massive capital investment campaign
Use overvalued equity to purchase other firms
Managers with overvalue equity are in a difficult position.
12. Mitigating Stockholder-Manager Conflicts
Agents with good reputation can demand higher prices for their products /
services. Management contracts can include monetary incentives:
Stock options
Performance shares
Bonuses:
Threat of takeovers and replacement can induce managers to act in
shareholder interests.
Debt-holders may restrict wealth appropriating behavior on the part of
stockholders through debt contracts.
An indenture is the explicit legal contract for a publicly traded bond.
The indenture contains covenants:
▪ Negative covenants restrict certain actions of the firm.
▪ Positive covenants require certain actions on the part of the firm.
▪ Covenants benefit the bondholders by lowering the risk of the bonds.
▪ They also benefit the stockholders since the reduced risk of the bonds
implies lower interest rates.
▪ Covenants can be costly to the stockholders:
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13. Monitoring Devices
13.1. New External Financing
When a firm seeks new external financing, it is subject to special scrutiny.
The willingness of investment bankers to underwrite the issue acts as a
certification device.
Firms that frequently raise capital from external sources are monitored more
efficiently.
Other devices include:
▪ Financial statements and auditors reports
▪ Cash dividends
▪ Bond ratings
▪ Bond covenants
▪ Government regulation
▪ The legal system
▪ Reputation effects
▪ Multi-level organizations
: Capital Market Efficiency
Topic Objective:
At the end of this topic the student will be able to:
Explain why it makes sense that capital markets should be efficient.
Describe factors that help make capital markets efficient.
Describe sufficient conditions for a perfect capital market.
Explain how market imperfections affect capital market efficiency.
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Definition/Overview:
Public securities: Public securities provide a measure of value because the prices at
which they are traded are quickly reported to the public. The price of the last transaction
reflects all current information and is a good measure of the value of the security.
Perfect Market: A perfect market can be defined as a market in which there are never
any arbitrage opportunities.
A zero NPV does not mean that the investor does not earn any money, rather, it means
that the investors earns a percentage return that is fair according to the risk of the
investment.
Asymmetric taxes, asymmetric information, and transaction costs are capital market
imperfections that can impact corporate decisions. Asymmetric taxes mean that the
parties to a transaction have different tax treatment, such as having different rates or even
methods of taxation. Because of this, both parties can be better or worse off because they
make a transaction in a particular way. For example, asymmetric taxes can make it
beneficial to both a corporation and its investors to use at least some debt contracts for
the investment in the corporation. Thus, asymmetric taxes can affect the type of security
a corporation decides to issue. Asymmetric information means that participants do not all
have the same information. In such cases, if participants refuse to make transactions,
market prices may be incorrect. For example, participants might refuse to purchase new
shares of stock unless they believe they are buying the stock for less than its true value.
Thus, asymmetric information might cause a firm to use internal rather than external
financing for a capital budgeting project. Transaction costs are the time, effort, and
money required to make a transaction. Transactions costs discourage transactions
because they reduce the value of a transaction by draining of part of its value. For
example, transaction costs usually make it better for a corporation to borrow larger
amounts of money less frequently, even if some of the borrowed money must be
temporarily invested in low return/low risk investments. Thus, transaction costs might
cause a corporation to temporarily alter its capital structure.
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Key Points:
1. Efficiency
Even if capital markets are not perfect, they can be efficient. Efficiency refers to the amount of
wasted energy. Efficient machines work without frictions, without a loss of energy.
1.1. Frictions in Capital Markets
Frictions in the capital markets prevent these markets from being perfectly efficient.
Frictions include:
Transaction Costs: time, effort, and money required to make a transaction.
Asymmetric taxes
Asymmetric information
1.2. Liquidity and Value
In an efficient capital market, the transfer of assets occurs with little loss of
wealth.
In such markets, prices reflect all available information.
Thus, financial asset prices are fair prices.
They are neither too high, nor too low.
1.3. Three Forms of Capital Market Efficiency
Strong form of capital market efficiency: Current prices reflect all information that can possibly
be known to anyone.
Semi-strong form of capital market efficiency: Current prices reflect all publicly available
information.
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Weak form of capital market efficiency: Current prices reflect only the information contained in
past prices.
1.4. Why Capital Markets Exist
Capital markets facilitate the transfer of capital (i.e. financial) assets from one owner to another.
They provide liquidity.
Liquidity refers to how easily an asset can be transferred without loss of value.
A side benefit of capital markets is that the transaction price provides a measure of the value of
the asset.
1.5. Implication of Efficiency for Investors
Future market prices cannot be predicted based on available information.
Investments in these markets have a zero NPV.
The expected rate of return equals the required rate of return.
The expected rate of return compensates the investor for the risk borne.
Abnormally high returns are earned by pure chance.
1.6. Arbitrage: Striving for Efficiency
Arbitrage refers to buying an asset in one market and selling it at a higher
price in another market.
People who engage in arbitrage are known as arbitrageurs (or simply, arbs).
In a perfect market, there are no arbitrage opportunities.
As soon as one is discovered, competition among arbitrageurs will eliminate
it.
1.7. Arbitrage versus Speculation
In an arbitrage transaction, the asset is bought and sold immediately.
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Speculators hold the asset for some time period, and thereby incur risk.
Speculators try to anticipate future prices and trade on their beliefs.
The future price is based on imperfect information that they receive about the
value of the asset.
2. Signaling and Information Gathering
Market participants react quickly to events that convey useful information.
Actions convey asymmetric information.
Watch what management does.
Interpreting signals is a valuable talent.
Deductive reasoning: a general fact provides information about a specific situation.
Inductive reasoning: a specific situation is used to draw general conclusions.
3. The Collective Wisdom
In an efficient capital market, prices reflect all available information.
When new information arrives, prices react instantaneously to it.
Since new information is that which cannot be predicted, it would arrive at random points in
time.
Price movements are random (i.e. cannot be predicted).
4. Value Conservation
In a perfect market, value is conserved across transactions.
Imperfections (taxes, transaction costs) may appear to violate the law of value conservation.
Value conservation holds if all losses due to frictions are included.
5. Implications for corporate financing
Firms create most of their value with positive-NPV real investments.
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Positive NPV financing can occur due to
Tax savings from a tax asymmetry
Reducing flotation or transactions costs
Financing that reduces agency costs
Designing securities that reduce or reallocate risk
Fooling or lying to investorsbackfires.
6. Perfect Capital Markets
No barriers to entry.
Perfect competition.
Each participant is sufficiently small and cannot affect prices by her/his actions.
Financial assets are infinitely divisible.
No transaction costs.
All information is fully available to every participant, at no cost.
No tax asymmetries.
No restrictions on trading.
6.1. The three persistent imperfections
Asymmetric taxes
Asymmetric information
Transaction costs
7. Empirical Challenges to the Efficient Market Hypothesis (EMH)
Tests of the weak-form EMH
Serial correlation tests
Runs tests
Trading rules
Momentum indicators
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Tests of semistrong-form EMH
8. Behavioral Challenges to Market Efficiency
Psychological behaviors may interfere with market rationality
Investors remember winners and forget losers
Investors trade too much
Sell winners early and hang on to losers (disposition effect)
Investors hang on to get their money back
Investors dont rebalance or diversify appropriately.
There are many anomalies in investor and manager behavior.
Recognize and avoid psychological biases in your own decision making.
Biases of others may provide opportunities to profit. Not all markets are as efficient as financial
markets.
: Why Capital Structure Matters
Topic Objective:
At the end of this topic the student will be able to:
Describe six different views of capital structure.
Describe how these views depend on the three capital market imperfections.
Explain how capital market imperfections lead to a preference ordering of financing alternatives.
Evaluate the effect of capital structure on the firms weighted average cost of capital.
Definition/Overview:
Corporate Tax View: The corporate tax view of capital structure is the view that since interest
payments on debt are tax deductible and dividend payments are not, the after-tax cost of capital
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is cheaper for debt than for equity. Optimally, a firm should be 100% debt financed. According
to the perfect market view, the WACC curve is a horizontal line. The WACC does not change
with the mix of debt and equity financing because there is no asymmetric tax or transaction cost
causing one type of financing to be advantageous to the other. The capital market imperfections
view of capital structure incorporates the several other views into an overall view of capital
market capital structure. It states that debt financing is generally valuable, but a companys
optimal choice of capital structure is a dynamic process in a complex environment that involves
a mixture of financing methods. The exact mix at any particular point results from considerations
of asymmetric taxes, asymmetric information, and transaction costs.
Key Points:
1. Capital Structure
Capital structure refers to how a firm is financed.
In simple terms, capital structure refers to the proportion of debt financing used by the firm.
1.1. Perfect Market View of Capital Structure
In perfect capital markets, capital structure does not affect firm value.
Capital structure choice is a pure risk-return tradeoff.
Leverage does not affect the firms cost of capital.
1.2. Arbitrage Argument for Capital Structure Irrelevance
If firm value varies with leverage, arbitrage profits can be made.
In perfect markets, arbitrage opportunities cannot exist.
The arbitrage profits are eliminated when firm value is independent of capital structure.
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2. Capital Market Imperfections: Corporate Income Taxes
Interest payments made by a corporation are tax deductible, while dividend payments are not.
This tax asymmetry makes debt financing cheaper than equity financing.
The corporate tax view of capital structure implies that firm value is maximized when the firm is
all-debt financed.
2.1. Personal Income Taxes
Interest and dividend income received by investors in the firm is taxed immediately upon receipt.
Capital gains are taxed only when the shares are sold.
Capital gains taxes can be postponed by not selling the shares.
Capital losses can be deducted immediately by realizing the gain.
Tax timing option is valuable.
The capital gains timing option lowers the effective tax rate on shareholder income.
The differential between tax rates on personal income from debt and equity cancels out the effect
of corporate tax asymmetry.
The personal tax view is that capital structure is again irrelevant.
2.2. Capital Structure with Corporate and Personal Taxes
With corporate and personal taxes, the firm value and shareholder wealth is independent of the
firms capital structure.
The personal tax asymmetry cancels the effect of the corporate tax asymmetry.
This occurs only for a particular set of tax rates.
3. Agency Costs View of Capital Structure
Capital market imperfections resulting from agency cost considerations create a complex
environment in which capital structure affects firm value. There are four types of costs:
Debt
Equity
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Employee
Consumer
3.1. Agency Costs of Debt
Asset substitution
Claim dilution
Underinvestment problem
Asset uniqueness
As leverage increases, the potential for these conflicts increases.
The cost of resolving these conflicts increases.
There are agency costs associated with obtaining any financing.
Agency costs are also associated with other firm claimants:
▪ Employees
▪ Customers
▪ Society
4. Bankruptcy Cost View of Capital Structure
Capital market imperfections associated with financial distress and bankruptcy offset the other
benefits from leverage created by taxes and agency costs.
At the optimal capital structure, the marginal expected costs of financial distress and bankruptcy
equal the marginal benefits of leverage.
Firm value is at a maximum.
4.1. Direct Costs of Bankruptcy
Notification costs, court costs, legal fees.
Paid only if bankruptcy occurs.
Generally small when compared to the indirect costs.
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4.2. Indirect Costs of Bankruptcy
Lost tax credits.
Lost sales and goodwill.
4.3. Expected Costs of Bankruptcy
The expected costs of bankruptcy depend on:
The degree of specialization of a firms assets.
Type of assets - tangible versus intangible.
Personal and corporate taxes.
Agency costs.
5. Pecking Order View of Capital Structure
The firm incurs transaction costs when external financing is obtained.
There are both direct and indirect costs.
In the pecking order view, the firm should use the method of financing with the least amount of
transaction costs first.
Financing methods with higher transaction costs are used next.
Retained earnings (internal equity) have the least cost.
Debt-Equity combinations are third in the pecking order.
New external equity comes last in the pecking order.
6. Signaling and Capital Structure Decisions
A firms decision about a projects financing reflects its choice of capital structure.
It also conveys information about the project.
If a project has a large positive NPV, financing it internally will allow the current owners of the
firm to get all of the benefits.
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If a project has a small (or zero) NPV, the current owners would be indifferent to allowing
outside investors to share in the gains.
Thus, how a project is financed (internal versus external funds) conveys information about the
projects value.
Alternatively, if the firm is currently overvalued, existing owners may want to seek outside
partners so as to share the decline in value.
If the firm is currently undervalued, the firm might use debt financing to keep the gains to
themselves.
Thus, new equity issues signal overvaluation, while new debt issues signal undervaluation.
7. Financial Leverage Clienteles
Investors will take into account their own tax situations into account in deciding which firm to
invest in.
The clientele effect refers to the investors choice of a particular security or a firm with a
particular capital structure.
Investors in high tax brackets may find debt securities less attractive.
Debt income is taxed at a higher rate than equity income.
Investors in low tax brackets may prefer corporate leverage to personal leverage because of the
higher corporate tax rate.
When a firm selects its capital structure, it attracts investors with a certain personal-tax driven
incentive for investment.
High leverage firm will attract investors in lower tax brackets and vice versa.
If the demand for each type of leverage is satisfied, there is no gain from changing the current
capital structure.
8. Capital Market Imperfections View of Capital Structure
Debt is generally valuable.
At low levels of leverage, the expected costs of financial distress are low.
As leverage increases, these costs increase and at some level will exceed the benefits of leverage.
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: Managing Capital Structure
Topic Objective:
At the end of this topic the student will be able to:
Apply concepts of capital structure theory to choose a firms capital structure.
Explain why a firms senior debts rating indicates the firms exposure to default risk.
Use debt ratings to choose and manage the firms capital structure.
Definition/Overview:
Pro forma analysis: Pro forma analysis is important when choosing a capital structure to make
sure that the firm will be able to service the debt and use its tax credits.
Selecting a target senior debt: Selecting a target senior debt rating is a reasonable approach to
choosing a capital structure because it ensures that the firm has access to the debt markets. A
single-A rating is prudent because it is more likely that the firm will have access to the debt
markets at all stages in the economy. Below a single-A rating, the company may not be able to
raise capital during economic downturns, a time when the firm may need capital the most.
Key Points:
1. Industry Effects
There are systematic differences in capital structures across industries. These are largely due to
differences in:
The degree of operating risk.
Non-debt tax shelters such as depreciation, tax credits and operating tax loss carryforwards.
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The ability of assets to support borrowing.
2. Debt Ratings
Two major debt rating services:
Moodys Investor Service, Inc.
Standard & Poors Corporation.
These ratings are indicators of the likelihood of financial distress.
The lower the rating, the higher the risk.
The highest four rating categories are known as investment grade ratings.
Various state laws impose minimum ratings standards and other restrictions that bonds must
meet to qualify as legal investments.
2.1. Choosing a Bond Rating Objective
The choice of a bond rating objective involves a decision about:
The chance of future financial distress, and
Desire to maintain access to capital markets.
When a firm that uses less than value-maximizing debt, the missed value can be seen as a margin
of safety.
The desired margin of safety depends on the firms willingness to bear financial risk.
2.2. Bond Rating Criteria
Ratings agencies use many different criteria to rate a bond, including financial ratios
including:
Market position
Strength of management
Improving credit ratings requires a proven track record.
Standards and averages may change over time.
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Operating risk
Profitability
Conservatism of accounting policies
Fixed-charge coverage
Adequacy of cash flow to meet future debt service obligations
Future financial flexibility
3. Factors Affecting a Firms Choice of Capital Structure
Ability to service debt
Ability to use interest tax shields fully
Protection against illiquidity
Desired degree of access to capital markets
Dynamic factors and debt management over time
3.1. Choosing an Appropriate Capital Structure
Comparative Credit Analysis
Ability to service debt.
Ability to use interest tax shields fully.
Protection against illiquidity.
4. Comparative Credit Analysis
Select the desired rating objective.
Identify a set of comparable firms that also have the desired senior debt rating.
Perform a comparative credit analysis of these firms to define a range of capital structures
consistent with the rating objective.
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4.1. Selected Items for Comparative Credit Analysis
Profitability measures
Capitalization measures
Capitalization ratios
Fixed charge coverage ratios
Current year
Prior years
5. Pro-Forma Analysis
The objective is to project the firms ability to maintain the desired bond rating in the future.
The analysis is conducted under various assumptions about the growth in pre-interest taxable
income:
The final decision also depends on the managements willingness to bear the risk of financial
distress.
6. Other Aspects of Capital Structure Decisions
Subordinated debt
Convertible debt
Capitalized lease obligations
Preferred equity
6.1. Changing the Capital Structure
Issue new securities of the desired type and amount.
Exchange offer
Recapitalization offer
Debt or share repurchase
Stock-for-debt swap
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6.2. The Projects Cost of Capital
The WACC (an opportunity cost) can be expressed as: WACC = (1 - L)re + L(1 - T)rd
However, L, T, re, and rd are more easily measured for the firm than for a specific project.
Financing cannot be accounted for on a project-by-project basis.
Loans also can be tied to specific assets or projects, and the firms capital structure will change
over time.
Many corporations, therefore, use the Adjusted Present Value method for capital budgeting
projects.
6.2.1. Adjusted Present Value
▪ Consider the case where a firms debt is tied to one or more specific asset:
▪ The interest and principal payments occur within the assets life.
▪ The assets value declines over time with use.
▪ The capital structure (i.e. remaining debt) changes over time as debt is
repaid.
▪ In such cases, the Adjusted Present Value (APV) accounts for the
changing capital structure over the assets life.
▪ The APV is the present value of the project as if it were financed solely
with equity plus the net benefits from debt financing.
6.2.2. Leverage Rebalancing
▪ A firms actual capital structure may deviate from the optimal capital
structure.
▪ Adjusting the capital structure to bring it back to the optimal level is
called leverage rebalancing.
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▪ If the firm has perpetual debt, and its leverage ratio is constant (at the
optimal level of L*), then the net gain from leverage is T*rdD.
▪ The present value of these net gains is
▪ With leverage rebalancing, only the first years benefit can be discounted
at rate rd.
▪ The net benefit in subsequent periods must be discounted at the
unleveraged rate r.
▪ The net benefit will vary as the project value varies in the future.
▪ The net benefit from leverage in period 1 is T*rdD = T*rd(LVL) =
▪ The net benefit in each subsequent period t (t > 1) is: T*rdD =
T*rd(LEVL) = h
7. Estimating the WACC for a Capital Budgeting Project
Choose one or more publicly traded firms that are comparable in risk and return to the project.
Estimate L
Estimate rd as the yield to maturity of the firms outstanding debt
Estimate re
Estimate the firms marginal tax rate, T
Estimate the net benefit to leverage factor, T*
For each comparable firm, use the parameter estimates from above to estimate
Make a single estimate of r. Usually an average can be used, but use your judgment.
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In Section 4 of this course you will cover these topics:Why Dividend Policy Matters
Issuing Securities And The Role Of Investment Banking
Long-Term Debt
Leasing And Other Asset-Based Financing
Liquidity Management
You may take as much time as you want to complete the topic coverd in section 4.There is no time limit to finish any Section, However you must finish All Sections before
semester end date.
If you want to continue remaining courses later, you may save the course and leave.You can continue later as per your convenience and this course will be avalible in your
area to save and continue later
: Why Dividend Policy Matters
Topic Objective:
At the end of this topic the student will be able to:
Describe common dividend policy characteristics.
Explain the mechanics of dividend payments.
Apply the three-step approach to dividend decisions.
Distinguish special dividends from regular dividends and stock dividends from cash dividends.
Describe five methods of share repurchase.
Definition/Overview:
Dividend policy: Dividend policy is irrelevant in a perfect capital market because no wealth is
transferred through the payment of a dividend. When a dividend is paid, the stockholder
receives cash, but the value of the equity decreases by the amount of the dividend. The signal of
paying a dividend can cause dividend policy to affect a firms value because it mitigates the
information asymmetry between owners and management. The payment (or non-payment) or
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increase (or decrease) of a dividend sends a signal to the owners about the financial health of the
firm.
Dividend Clientele: A dividend clientele is a group of investors with the same preference for
dividends because of their similar tax status. The existence of dividend clienteles can eliminate
the tax differential view of dividend policy because each clientele will purchase securities with
the type of preferred dividend policy. As long as there is a sufficient supply of all types of
securities, investors will not pay a premium for a security with a specific type of dividend policy.
Share repurchase programs and dividend payments can be viewed as substitutes for each other
because both are methods of distributing cash to the shareholders, and neither have an effect
shareholder wealth in a perfect capital market environment. A share repurchase program will
distribute cash to the shareholders that choose to sell their holdings. A dividend payment will
distribute cash to all shareholders. A share repurchase program and a dividend payment can be
perfect substitutes for each other in a perfect capital market. The major advantages of share
repurchase over a cash dividend are that the distributions are taxed at the capital gains tax rate
instead of the ordinary income tax rate and that the shareholder has the option of whether to
participate or not. In a share repurchase, the shareholder sells stock holdings to the company,
resulting in capital gain, whereas a dividend payment is treated as ordinary income. A share
repurchase also creates a valuable tax timing option because shareholders with a low cost basis
can choose not to sell shares and thus avoid a large tax liability.
A firms share price falls on the ex-dividend date because new shareholders will not be able to
receive the dividend. Since the value of a stock is the present value of the future cash flows, new
investors that do not receive the dividend will value the stock at a lower price. The price should
fall by the amount of the dividend. A stock dividend should have the same effect as a cash
dividend because the number of shares increases and dilutes the value of each share.
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Key Points:
1. Dividend Policy in Practice
1.1. Preference for paying common dividends
Smaller and younger firms
Mature firms
1.2. Stability of dividends
Dividends are more stable from year to year than are earnings.
They follow the trend in cash flow more closely.
Review dividend policy at least annually, and at about the same time each year.
Quarterly payments most common.
Annual, semi-annual and monthly payments are less common.
Dividend cut is interpreted as a negative signal.
1.3. Industry Differences in Dividend Policy
Payout ratios vary systematically across industries.
Investment opportunities are comparable within an industry, but vary across industries.
Behavioral principle suggests using payout ratios similar to those of other firms in the industry.
Firm-specific information must be taken into account.
1.4. Dividend Payment Mechanics
Dividends are declared by the board of directors:
Amount of dividend
Record date
Payment date
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1.5. Irrelevance of Dividend Policy
A compelling case can be made that dividend policy is irrelevant.
Since investors do not need dividends to convert shares to cash, they will not pay higher prices
for firms with higher dividend payouts.
In other words, dividend policy will have no impact on the value of the firm because investors
can create whatever income stream they prefer by using homemade dividends.
1.6. Why Does Dividend Policy Matter?
Dividend policy is not irrelevant.
Actual capital markets are not perfect.
Capital market imperfections affect our conclusions about dividend policy.
However, when there is an open flow of information (transparency) and reasonably efficient
capital markets, a firms value is less affected by its dividend policy than it is by its capital
budgeting decisions.
2. Asymmetric Information
Asymmetric information is the main reason why dividend policy matters.
Dividends can provide a monitoring device.
2.1. Transaction Costs
Flotation costs and brokerage commissions vary inversely with the size of the transaction.
This makes it cheaper for the firm to sell a large block of shares than for individual shareholders
to make small purchases to reinvest their dividends.
Restrictions in bond indentures, loan agreements, and preferred stock agreements, designed to
prevent excessive payments of dividends.
Often prohibit dividends to exceed a legally defined surplus
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2.2. DRIPs
Dividend Reinvestment Plans offer shareholders the option to reinvest their dividends with little
or no brokerage commission.
This reduces the transaction-cost penalty a high-dividend-payout policy would otherwise impose
on shareholders who wish to reinvest their dividends.
DRIPs permit firms to reduce issuance costs substantially.
They do not, however, eliminate the tax bias in favor of capital gains because shareholders must
recognize the dividend income.
2.3. The Role of Income Taxes
Investor income taxes have historically created a bias in favor of capital gains and against
dividends.
This also reinforces the clientele effect.
3. Dividend Policy Guidelines
Earnings and cash flow projections for the next few years.
Include depreciation generate funds.
Deduct capital expenditures.
Determine an appropriate target payout ratio.
Range of payout ratios.
Set the quarterly dividend.
Evaluate alternative dividend policies.
4. Share Repurchases
Factors Influencing Share Repurchase Tax advantage to share repurchases
Reaction of investors
Impact on debt ratings
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Effect on accounting for acquisitions
4.1. Implementing a Share Repurchase Program
Open-market purchases
Cash tender offers
Transferable put rights
Privately negotiated block purchases
Exchange offers
4.2. Transferable Put Rights
Serve as a mechanism for reducing the cost of share repurchase program.
A Transferable Put Right is the right to sell the firm one share of its common stock at a fixed
price (the strike price) within a stated period (the time to maturity of the option).
Its transferable because the option can be sold independent of its birth share.
The put right can be bought or sold on the open market.
In this way, shareholders can get the option value by selling the put if they do not want to
exercise it.
Shareholders with a low cost basis would sell the option to avoid triggering a capital gains tax.
These shareholders would not have participated in a traditional share repurchase.
4.2.1. Valuing Transferable Put Rights
▪ Transferable put rights are usually issued deep-in-the-money to induce
shareholders (or the eventual put option holders) to sell the shares to the
firm.
▪ The time to maturity is usually small, and the options time premium is
typically small. For convenience, we will ignore it.
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5. Stock Dividends
The fair market value of these new shares is transferred from retained earnings to paid-in capital
and capital contributed in excess of par value.
Total common stockholders equity remains unchanged.
5.1. Financial Impact of Stock Distributions
Apart from any informational effects, the total market value of the stock remains unchanged after
a stock dividend or a stock split.
Since the number of shares outstanding increases in either case, the per-share price will drop
correspondingly.
A popular rationale for stock dividends and stock splits is to bring the stock price to a more
popular trading range (about $10 to $30 per share).
This may broaden the ownership of the firms shares
: Issuing Securities And The Role Of Investment Banking
Topic Objective:
At the end of this topic the student will be able to:
Describe methods for issuing new securities.
Explain differences between general cash offers and rights offerings.
Describe the role of the investment banker in the issuance of securities.
Describe going private transactions.
Definition/Overview:
Dilution: Dilution can refer to dilution in percentage ownership, dilution in price, or dilution in
book value or earnings per share. The meanings are different because each type of dilution
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refers to a different effect caused by the issuance of new securities. Shareholders should only
care about shareholder wealth and the dilution in market value caused by the issuance of new
securities.
Public and private differ in many respects. One way that the financing methods differ is that
firms use underwriters for public offerings while they sell securities directly to investors in
private placements. Another difference is that almost anyone can purchase publicly offered
securities while only a few sophisticated investors can participate in private placements.
Some of the advantages of a private placement are that private placements can be placed quickly,
private placements offer flexibility in terms of size, and that private placements offer flexibility
in terms of security arrangements. The main disadvantage of a private placement is that it is
costly because investors demand a high yield to compensate for low liquidity.
The principal features of common stock are voting rights, dividend rights, liquidation rights, and
preemptive rights. The principal features of preferred stock are different from the principal
features of common stock in that preferred stock has a par value, a stated dividend rate, a
cumulative dividend feature, and may be redeemable. Under Rule 144A, more investors are
capable of participating in the offer. This increases the liquidity of the securities relative to a
typical private placement and enables the firm to offer a lower yield on the investment.
Key Points:
1. Main Sources of Raising Long-Term Funds Externally
Common stock
Preferred stock
Debt
Flotation costs
Fixed costs
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Variable costs
Public offering
Private placement
1.1. Public Offering
General cash offer
Rights offering
1.2. General Cash Offers
Decide what to issue:
Obtain required approvals.
File a registration statement:
Determine initial pricing and file an amended registration statement.
Close the offering.
1.3. Primary and Secondary Offerings
In a primary offering, the firm sells newly issued shares to investors.
In a secondary offering, insiders and large institutional shareholders sell shares they hold in a
registered public offering.
1.4. Role of the Underwriters
An intermediary between the issuer and the purchaser.
Provide advice regarding type of security, terms, and price.
Help prepare documentation.
Underwriters bear the price risk.
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1.5. Flotation Costs
Include both the gross underwriting spread and the out-of-pocket expenses.
Economies of scale
Vary by security type:
Holding issue size constant,
Common stock has the highest flotation cost.
Bonds have the lowest flotation cost.
Flotation cost of preferred stock is in between.
2. Negotiated versus Competitive Offerings
In a negotiated offering, the issuer selects one or more firms to manage the offering and works
closely with them in designing and pricing the issue.
In a competitive offering, the issuer, specifies the type and amount of security to be sold and
selects the investment banker through a competitive bidding process.
3. Private Placements
Securities are sold directly to institutional investors.
Exempt from registration requirements.
Private placements are restricted:
Limited number of investors may be offered the securities.
Restrictions on resale.
3.1. Advantages of Private Placements
Lower issuance costs.
Issue can be placed quickly.
Greater flexibility of issue size.
Greater flexibility of security arrangements.
More favorable share price reaction than a public offering.
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Lower cost of resolving financial distress.
3.2. Disadvantages of Private Placements
Higher yield required by investors.
More stringent covenants and restrictive terms.
4. Main Features of Common Stock
Perpetual security
Not redeemable
May or may not have a par value
Outstanding shares
Treasury shares
Multiple classes of common stock are possible
4.1. Rights and Privileges of Common Stock
Dividend rights
Voting rights
Cumulative
Noncumulative
Voting by proxy
Liquidation rights
Preemptive rights
4.2. Public Offering of Common Stock
Gross underwriting spread
Out-of-pocket expenses
A firms share price often declines upon the announcement of a public offering.
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Managers sell new shares when shares are overpriced.
5. Rights Offerings
Firm issues one right per share outstanding.
Rights are call options on newly issued shares:
Rights are issued in-the-money.
Rights offerings are frequently underwritten.
5.1. Advantages
Allows shareholders to retain their proportionate ownership in the firm.
Protects existing shareholders from loss of wealth resulting from a public offering.
Beneficial if firm does not have broad ownership.
5.2. Disadvantages
Takes longer to complete.
Cannot sell large blocks of new shares to institutional shareholders.
6. Dividend Reinvestment Plans (DRiPs)
A DRIP allows each shareholder to use the dividends received to purchase additional shares of
the firms stock.
Purchase price is often below market price (5% discount).
Resemble rights offerings.
Lower transaction costs for purchaser than open market purchase.
7. Initial Public Offering (IPO)
Subsequent issues of common stock are called seasoned issues.
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Underwriters try to price the IPO issue at 10% to 15% below the expected trading price.
7.1. Advantages of Going Public
Raise new capital
Achieve liquidity and diversification for current shareholders
Create a negotiable instrument
Increase the firms equity financing flexibility
Enhance the firms image
7.2. Disadvantages of Going Public
Disclosure requirements
Accountability to public shareholders
Market pressure to perform short-term
Pressure to pay dividends
Dilution of ownership interest
Expense of going public
Higher estate valuation
8. Features of Preferred Stock
Claims senior to common stock, junior to debt.
Dividends must be paid to preferred before they can be paid to common.
Usually have a par or stated value.
Dividend rate is usually specified.
8.1. Financing with Preferred Stock
Sinking fund preferred is like debt:
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The interest payments are not tax-deductible, but this is offset by the fact that missing a
scheduled payment does not lead to bankruptcy.
Preferred stock dividends also qualify for the 70% dividends-received deduction when the
preferred shareholder is another corporation.
Because of this, preferred-stock yields are usually lower than the yields of comparable debt
instruments.
Plus, if the firm is not paying taxes currently due to poor operating results, the forgone interest
tax deduction is not an issue.
Utility companies have been the heaviest issuers of fixed-rate preferred stock.
Regulated utilities can pass the cost of preferred dividends through to their customers.
: Long-Term Debt
Topic Objective:
At the end of this topic the student will be able to:
Describe the four main classes of corporate long-term debt.
Briefly explain the features of long-term debt.
Describe the main characteristics of a Eurobond.
Explain the debt service parity approach to bond refunding.
Definition/Overview:
The difference between secured debt and unsecured debt is that secured debt is backed by
specific assets whereas unsecured debt is not. Debt covenants impose restrictions, intended to
protect bondholders, on the firm that issued the bonds. Debt covenants may limit the issuance of
additional debt, the payment of dividends, liens, subsidiary borrowing, asset disposition,
mergers, and sale and leaseback. Ideally, a firm would choose a debt maturity that causes its cash
outflows to match its expected cash inflows.
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Key Points:
1. Types of Long-Term Debt
Secured debt
Unsecured debt
Tax-exempt corporate debt
2. Main Features of Corporate Debt
Stated maturity
Stated principal amount
State coupon rate of interest
Mandatory redemption (or sinking fund) schedule
Optional redemption provision
Protective covenants
3. Sinking Fund Requirements
A sinking fund requires the firm to repay the debt in installments, rather than in a lump sum.
Serves as a monitoring device
Reduces the effective life of the debt.
3.1. Setting the Coupon Rate
Coupon rate is set to zero.
Reduces lenders reinvestment risk.
Borrowers benefited from tax asymmetry (until 1982).
Fixed versus floating rate bonds
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3.2. Optional Redemption Provisions
Call provisions
Put options
4. Recent Innovations in the Bond Market
Commodity-linked bonds
Collateralized mortgage obligations (CMOs)
Floating-rate notes
Credit-sensitive notes
Extendible notes
5. International Debt Financing
Eurobonds
Yields may be lower than U.S. domestic bond yields.
Shorter maturity, smaller issue size.
Eurobond market is essentially unregulated.
6. Bond Refunding
Methods of retiring outstanding bonds:
Call the bonds
Open market repurchase
Exchange new securities for the bonds
Exchanging new bonds for old is called bond refunding.
Take advantage of lower interest rates.
Eliminate restrictive bond covenants.
Lengthen maturity of outstanding issue.
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6.1. Debt Service Parity (DSP) Approach
Debt refunding can change the capital structure of the firm.
To neutralize the effect of a change in the capital structure, construct a hypothetical replacement
debt obligation that has the same after-tax cash flows as the outstanding debt obligation.
6.2. Tax Considerations in Debt Refunding
All expenses incurred with a refunding are tax-deductible.
Expenses connected with retiring the old issue may be deducted in the year of refunding.
Expenses connected with the new issue must be amortized over the new issues life.
6.3. Immediately Deductible Expenses
Call premium
Unamortized balance of issue expenses plus original issue discount (or minus original issue
premium) on old debt.
Net overlapping interest cost (income) is deductible (taxable).
6.4. Refunding High-Coupon Debt
From this gross savings, deduct the after-tax transaction costs:
Call premium
Tax credit for unclaimed issue costs
New issue expense
Call option time premium
Immediate expenses of new issue
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6.5. Accounting Considerations
If the bonds reacquisition price is greater than its carrying (or par) value, the difference is
recorded as a loss even if the NAR is positive.
Agency problem occurs when managers forego the refunding to avoid this book loss.
6.6. Refunding in Practice
Cost of overlapping interest is small.
Interest rate differential between new conventional debt and installment debt is small.
7. Callable Bonds
Asymmetric information and the possibility of wealth expropriation
Most high-yield bonds are callable.
7.1. Timing Considerations When Refunding Debt
Calling the old bonds when the call price exceeds the market price expropriates wealth from
shareholders to bondholders.
Optimal time to call the bonds is when the market price equals the effective call price.
Effective call price = stated call price + accrued interest.
Wealth transfer is avoided if called optimally.
If old debt is called at the optimal time, the options time premium is zero.
7.2. Sinking Fund Complications
If bonds are selling at a premium, redeeming them at par under the sinking fund provisions may
be advantageous.
Double-up options allow the issuer to increase the amount of bonds retired at par.
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8. Tender Offers and Open Market Purchases
If the bonds contain a no-call period, the issuer can still purchase the bonds through a tender
offer or through open market purchase.
Usual method of analysis applies.
Issuer pays market price instead of the call price.
Bondholders are free to reject offer.
Amount of debt refunded is uncertain.
Transaction costs are higher if fees are paid to soliciting dealers.
: Leasing And Other Asset-Based Financing
Topic Objective:
At the end of this topic the student will be able to:
Describe and compare three different types of lease financing.
Explain the concept of the net advantage to leasing.
Explain project financing and its advantages.
Definition/Overview:
Lease: A lease is a rental agreement that extends for one year or longer. The owner of the asset
that is being rented is the lessor, and the entity that is renting the asset is the lessee.
The advantages of leasing are efficient use of tax deductions and tax credits, reduced risk,
reduced costs of borrowing, flexibility under bankruptcy, circumvention of debt covenants, and
off balance sheet financing. The disadvantages of leasing are that the lessee forfeits the tax
deductions associated with ownership and usually forgoes the residual value. The advantages of
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leasing that are of dubious value are trying to fool investors through accounting games,
achieving 100% financing, and circumventing debt covenants. A dollar of lease financing
replaces a dollar of debt financing because a firm must meet its lease payment obligations on
time in order to have uninterrupted use of the leased asset. If the lessee misses a lease payment,
the lessor can reclaim the asset and sue for the missed lease payment. The consequences are
similar to those of missing an interest or principal repayment.
Key Points:
1. Lease Financing
A lease is a rental agreement that extends for one year or longer.
The owner of the asset (the lessor) grants exclusive use of the asset to the lessee for a fixed
period of time.
In return, the lessee makes fixed periodic payments to the lessor.
At termination, the lessee may have the option to either renew the lease or purchase the asset.
2. Types of Leases
Full-service lease
Net lease
Operating lease
Financial lease
Direct leases
Sale-and-lease-back agreements
Leveraged leases
2.1. Synthetic Leases
Firms have used synthetic leases to get the use of assets but keep debt off their balance sheets.
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An unrelated financial institution invests some equity and sets up a special-purpose-entity that
buys the assets and leases it to the firm under an operating lease.
Since the Enron bankruptcy, firms have been reluctant to use synthetic leases.
2.2. Advantages of Leases
Efficient use of tax deductions and tax credits of ownership
Reduced risk of obsolescence
Reduced cost of borrowing
Bankruptcy considerations
Tapping new sources of funds
Circumventing restrictions
2.3. Disadvantages of Leasing
Lessee forfeits tax deductions associated with asset ownership.
Lessee usually forgoes residual asset value.
2.4. Valuing Financial Leases
Basic approach is similar to debt refunding.
Lease displaces debt.
Missed lease payments can result in the lessor claiming the asset.
Risk of a firms lease payments is similar to that of its interest and principal payments.
2.5. Analyzing Leases
The Net Advantage to Leasing (NAL) equals the purchase price (P) minus the present value of
the incremental after-tax cash flows (CFAT) associated with the lease:
NAL = P PV(CFATs)
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2.5.1. Analyzing Leases - the Discount Rate
▪ The discount rate should be the lessees after-tax cost of similarly secured
debt.
▪ Since the lease obligation is not overcollateralized, the secured debt rate
should reflect this.
▪ Use weighted average of secured and unsecured debt rates.
2.5.2. Analyzing Leases - the Cash Flows
▪ Cost of asset (saving)
▪ Lease payments (cost)
▪ Incremental differences in operating and other expenses (cost or savings)
▪ Depreciation tax shelter (foregone benefit)
▪ Expected net residual value (foregone benefit)
▪ Investment tax credits (foregone benefit)
3. NPV of Lease to the Lessor
In a perfect market, leasing is a zero-sum game.
The NPV of the lease to the lessor will be - (NAL to the lessee).
If lessee and lessor have the same marginal income tax rates, leasing is still a zero sum game.
4. Tax Treatment of Financial Leases
Internal Revenue Service has established guidelines for distinguishing between true leases and
installment sales agreements.
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If lessor meets these guidelines, lessor is entitled to tax deductions and credits of asset
ownership. The lessee can deduct full amount of lease payment for tax purposes.
5. IRS Guidelines for Financial Leases
Term of lease < 80% of assets useful life.
Lessor must maintain an equity investment of at least 10% of assets original cost.
Exercise price of the purchase option must equal the assets fair market value at the time the
option is exercised.
Lessee does not pay any portion of the assets purchase price.
Lessor must hold title to the property.
6. Advantages and Disadvantages of Project Financing
6.1. Advantages
Risk sharing
Expanded debt capacity
Lower cost of debt
6.2. Disadvantages
Significant transaction costs and legal fees
Complex contractual agreements
Lenders require a higher yield premium
7. Limited Partnership Financing
Another form of tax-oriented financing.
Allows the firm to sell the tax deductions and credits associated with asset ownership to the
limited partners.
Income (or loss) for tax purposes flows through to the limited partners.
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Limited partners are passive investors.
General partner operates the limited partnership and has unlimited liability.
8. Limited Partnership Cash Flows
8.1. Initial cash flows
Net proceeds from sale of limited partnership interests (inflow).
The investment tax credit (if any) allocated to limited partners (outflow).
8.2. Annual cash flows
Taxes payable on the portion of partnership taxable income allocated to limited partners (inflow).
Cash distributions to limited partners and tax shields from losses allocated to limited partners
(outflow).
: Liquidity Management
Topic Objective:
At the end of this topic the student will be able to:
Explain working capital and the cash conversion cycle.
Describe motives for holding cash.
Describe and apply float management techniques.
Describe the mechanics of different types of short-term borrowings and evaluate their costs.
Definition/Overview:
Cash conversion cycle: The cash conversion cycle is the length of time between the
payment of accounts payable and the receipt of cash from accounts receivable. It is
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important to working capital management because a firm may choose to finance its raw
materials and inventories through trade credit.
Float: Float is the difference between the available balance at the bank and the firms
book balance. It arises from the time that it takes for transactions, such as checks and
credit card payments, to be processed.
Cash Conversion Cycle: The cash conversion cycle is the length of time between
payment of accounts payable and the receipt of cash from accounts receivable.
Inventory Conversion Period: The inventory conversion period is the length of time
from the purchase of inventory to the time the sales are made on credit.
Receivables Collection Period: The receivables collection period is the average number
of days it takes to collect on accounts receivable. This is equal to days sales outstanding
(DSO)
Payables Deferral Period: The payables deferral period is the average length of time
between the purchase of materials and labor and the payment of cash for the same.
The three philosophies of working capital management are the maturity-matching approach, the
conservative approach, and the aggressive approach. In the maturity-matching approach, the
firm hedges its risk by matching the maturities of its assets and liabilities. The conservative
approach guards against the risks of a credit shutoff by using more long-term financing and less
short-term financing. The aggressive approach seeks to increase profitability by using less long-
term financing and more short-term financing because short-term financing often has a lower
interest cost. Of course, lower (higher) interest cost comes with greater (less) risk, so the three
approaches are on a continuum of a risk-return tradeoff.
The three basic motives for holding cash are the transactions demand, the precautionary demand
and the speculative demand. The transactions demand is the need for cash to make everyday
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payments. The precautionary demand is the margin of safety required to meet unexpected
needs. The speculative demand is the desire to take advantage of unexpected opportunities.
A firm with short term funds could invest in a treasury bill, which is a short-security issued by
the U.S. government. A firm could also invest in federal agency securities which are backed to
varying degrees by the U.S. government. Negotiable certificates of deposits and Eurodollar
certificates of deposits are promises to pay written by commercial banks and are another form of
short-term investment. Another investment is a bankers acceptance which is a guarantee to pay
the face amount of the security. Commercial paper is a promissory note sold by a very large
creditworthy company.
Key Points:
1. Working Capital Management
Working capital management refers to choosing the levels and mix of:
Cash, marketable securities, receivables and inventories.
Different types of short-term financing.
2. Considerations in Liquidity Management
Sales impact
Liquidity
Relations with stakeholders
Short-term financing mix
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3. Approaches to Working Capital Management
3.1. Maturity Matching Approach
Hedge risk by matching the maturities of assets and liabilities.
Permanent current assets are financed with long-term financing, while temporary current assets
are financed with short-term financing.
There are no excess funds.
3.2. Conservative Approach
Long-term funds are used to finance both permanent as well as some temporary short-term
assets.
When there are excess funds, they are invested in marketable securities.
4. Cost and Risk Considerations
Yield curve is usually upward sloping.
Short-term rates are more volatile than long-term rates.
Firm's ability to obtain needed short-term financing.
5. Cash Management
As long as we have the money, we can choose.
Payment at time of service.
Use of credit cards
Verifying insurance coverage
Harassing insurance companies and clients/collection agency
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5.1. Demands for Cash
Transactions demand
Precautionary demand
Speculative demand
Compensating balances
5.2. Short-Term Investment Alternatives
U.S. Treasury securities
U.S. federal agency securities
Negotiable certificates of deposit
Short-term tax-exempt municipals
Bankers acceptances
Commercial paper
Preferred stock & money market preferred stock
5.3. Other Factors in Cash Management
Compensating balance requirements
Optimal amount of marketable securities
Transaction costs
Maturity
Risk
Yield
Special tax situations
6. Float
Float is the difference between the available (or collected) balance at the bank and the firms book
or ledger balance.
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Disbursement float occurs when the firm writes a check but the check has not yet cleared the
banking system.
Collection float occurs when a check has been deposited but the funds are not yet credited to the
firms bank account.
6.1. Float Management Techniques
Wire transfers
Zero balance accounts (ZBAs)
Controlled disbursing
Centralized processing of payables
Lockboxes
6.2. Short-Term Financing
Trade Credit
Secured Bank Loans
Unsecured Bank Loans
Commercial Paper
Cost of Trade Credit
6.3. Effective Use of Trade Credit
6.3.1. Advantages
▪ Readily available
▪ Informal
▪ Flexible
▪ Stretching payments
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6.3.2. Disadvantages
▪ High cost of discounts foregone
▪ Stretching of payments can hurt reputation
6.4. Bank Loans
6.4.1. Short-term unsecured loans
▪ Transaction loan
▪ Line of credit
▪ Revolving credit agreement
6.4.2. Short-term secured loans
▪ Inventory
▪ Accounts receivable
6.4.3. Short, medium, and long-term loans
▪ Secured or unsecured
▪ Bullet, balloon, or installment
6.5. Factors Affecting the Short-Term Financing Mix
Cost of the source of funds
Desired level of current assets
Seasonal component of current assets
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Flotation costs
Restricted access to sources of long-term capital
Bankruptcy costs
Firm's choice of risk level
In Section 5 of this course you will cover these topics:Accounts Receivable And Inventory Management
Financial Planning
Mergers And Acquisitions
Financial Distress
International Corporate Finance
You may take as much time as you want to complete the topic coverd in section 5.There is no time limit to finish any Section, However you must finish All Sections before
semester end date.
If you want to continue remaining courses later, you may save the course and leave.You can continue later as per your convenience and this course will be avalible in your
area to save and continue later.
: Accounts Receivable And Inventory Management
Topic Objective:
At the end of this topic the student will be able to:
Explain the reasons for granting credit.
Evaluate credit granting decisions using the NPV rule.
Describe important accounts receivable management tools.
Identify and compute inventory management costs.
Apply inventory management models to optimize the firms inventory.
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Definition/Overview:
5 Cs of credit: The 5 Cs of credit are character, capacity, capital, collateral, and conditions.
Character is relevant for estimating the probability of whether or not the borrower will pay.
Capacity is relevant because it measures the ability of the borrower to pay from cash flows.
Capital is also relevant for determining the ability of the borrower to pay from net worth.
Collateral is relevant for determining what possible recourse the lender has if the borrower
doesnt pay. Economic conditions are also relevant in determining the risk of the loan.
Suppliers are better able to handle the collateral because when the collateral is repossessed in the
event of default, it is more valuable to the supplier who has expertise in producing, maintaining,
and marketing this collateral.
A supplier may have accumulated information about its customers through its normal business
relations. The supplier has a cost advantage over a bank because the bank must collect
information on the creditworthiness of a borrower.
Trade credit sends a positive signal about the quality of a product because it is in essence a
quality guarantee. If the customer finds the product defective, the customer can ship the product
back and refuse to pay.
Trade credit can reduce employee opportunism because it helps to separate the employees who
handle products and who handle payments.
Trade credit is pervasive because of the advantages associated with financial intermediation,
collateral, information costs, product quality, and employee opportunism. Financial
intermediation allows for the interest rate of a trade credit loan to benefit both parties. Suppliers
are better able to handle the collateral because when the collateral is repossessed in the event of
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default, it is more valuable to the supplier who has expertise in producing, maintaining, and
marketing this collateral. A supplier has an information cost advantage over a bank because the
supplier may have accumulated information about its customers through its normal business
relations. Trade credit sends a positive signal about the quality of a product because it is in
essence a quality guarantee. If the customer finds the product defective, the customer can ship
the product back and refuse to pay. Trade credit can also reduce employee opportunism because
it helps to separate the employees who handle products and who handle payments.
Key Points:
1. Accounts Receivable Management
Credit sales create accounts receivable
Trade credit
Consumer credit
1.1. Why Grant Credit?
To facilitate business and promote efficiency
Financial intermediation
Collateral
Information costs
Product quality information
Employee theft
Steps in the distribution process
Convenience, safety, and buyer psychology
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1.2. The Basic Credit Granting Decision
Credit should be granted if the NPV of granting credit is positive. The NPV depends on:
Amount of the sale
Investment in the sale
Probability of payment
Payment period
Required return
Collection efforts
1.3. Credit Policy Decisions
Choice of credit terms
Setting evaluation methods and credit standards
Monitoring receivables
Taking actions for slow payments
Controlling & administering the firms credit functions
1.4. Sources of Credit Information
A credit application, including references
Applicants payment history
Information from sales representatives
Financial statements for recent years
Reports from credit rating agencies
Credit bureau reports
Industry association credit files
1.5. Judgmental Approach to Credit Decisions
Character
Capacity
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Capital
Collateral
Conditions
2. Credit Scoring Models
These combine several financial variables to create a single score or index: S = w1X1 + w2X2
+ . . .
Credit is granted if the score is above a pre-specified cut-off value.
2.1. Advantages
Easy to compute
Easy to change standards
Avoids bias or discrimination
2.2. Disadvantages
Requires large samples to calibrate.
Can be gamed if parameter values are known
3. Monitoring Accounts Receivables
Aging schedules
Average age of receivables
Collection fractions and receivables balance fractions
Pursuing delinquent credit customers
Changing credit policy
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4. Inventory Management
Types of inventories:
Raw materials
Work-in-process
Finished goods
4.1. Quantity Discounts
Quantity discounts can impact the optimal order size.
Suppose Acer were offered a discount of $0.02 per unit if it ordered in lots of 500.
Total cost with this order size = Annual Ordering Cost + Annual Carrying Cost Total Discount
4.2. Inventory Management with Uncertainty
4.2.1. Types of uncertainty:
▪ Future demand
▪ Inventory usage rate
▪ Delivery time
4.3. ABC System of Inventory Management
Inventory items are classified into three groups on the basis of critical needs.
Group A items are most critical.
Group C items are least critical.
Critical items are managed very carefully.
5. Objectives of Materials Requirement Planning Systems
MRPs are computer-based inventory planning and management systems.
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Smooth production
No interruptions
Handle complex inventory requirements
5.1. Just-In-Time (JIT) Inventory Systems
Materials should arrive exactly as they are needed in the production process.
Reduces inventory holding costs
5.1.1. Important factors determining success of JIT systems
▪ Planning requirements
▪ Supplier relations
▪ Setup costs
▪ Other cost factors
▪ Impact on credit terms
: Financial Planning
Topic Objective:
At the end of this topic the student will be able to:
Describe the financial planning process.
Forecast the firms future financing needs on the basis of sales growth.
Describe the usefulness of pro forma financial statements.
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Definition/Overview:
Financial Plan: At a minimum, a complete financial plan includes clearly stated
objectives, assumptions, strategies, contingency plans, budgets, a financing program, and
pro forma financial statements. The benefits of financial planning are that it standardizes
assumptions, focuses on the future, is objective, helps develop employees, meets lender
requirements, provides a benchmark to measure performance, and helps prepare for
contingencies.
Key Points:
1. The Financial Plan
Financial planning is the process of evaluating the impact of alternative investing and financing
decisions of the firm. Every financial plan has three components:
model
Inputs
Outputs
The model is a set of mathematical relationships between the inputs and the outputs.
Inputs to the model may include:
Projected sales
Collections
Costs
Interest rates
Exchange rates
The outputs of the financial plan are:
Pro forma financial statements
A set of budgets including:
Sales budget
Advertising budget
Cash budget
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1.1. Short-term financial plans
Usually have a planning horizon of one year or less.
Are detailed and very specific.
1.2. Long-term financial plans
Usually have a five- or ten-year planning horizon.
Tend to be less detailed.
1.3. Components of the Financial Plan
Clearly stated strategic, operating and financial objectives.
Assumptions on which the plan is based.
Description of underlying strategies.
Contingency plans for emergencies.
Budgets, classified by
▪ time period
▪ division
▪ type
The financing program, classified by
▪ Time period
▪ Source of funds
▪ Types of funds
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2. Planning Cycles
A planning cycle specifies how frequently plans are reviewed and updated.
The planning horizon is also renewed with each update.
Short-term plans are updated more frequently than long-term plans.
2.1. Bottom-Up and Top-Down Planning
A bottom up planning process starts at the production level and proceeds upwards through the
corporate hierarchy.
A top-down planning process starts with top management making strategic decisions.
These decisions are then implemented by managers further down the corporate hierarchy.
2.2. Phases of the Financial Planning Process
Formulating the plan
Implementing the plan
Evaluating performance
2.3. Benefits of Financial Planning
Standardizing assumptions
Future orientation
Objectivity
Employee development
Lender requirements
Better performance evaluation
Preparing for contingencies
3. Cash Budgets
Project and summarize cash inflows and outflows.
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Show monthly cash balances.
Show any short-term borrowing needed to cover cash shortfalls.
They are usually based on sales forecasts.
They are usually constructed on a monthly basis.
More frequent planning may be warranted.
4. Percent of Sales Forecasting Method
Allows firm to estimate funds required to finance growth. Sales growth results in:
increase in current and fixed assets.
increase in spontaneous short-term financing.
increase in profitability.
The increase in current assets must be financed from internally generated funds or external
funds.
If internally generated funds are insufficient to finance the growth, the firm may:
Reduce the growth rate.
Sell assets not required to run the firm.
Obtain new external financing.
Reduce or stop paying cash dividends.
: Mergers And Acquisitions
Topic Objective:
At the end of this topic the student will be able to:
Understand valid motives for merging.
Explain why a corporate acquisition can be analyzed as a complex capital investment.
Describe differences in the methods of acquisitions.
Estimate the value of a potential acquisition using different methods.
Explain the significance of paying for an acquisition with common stock.
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Definition/Overview:
Vertical Merger A vertical merger is a merger of two firms involved in the same
industry but operating at different points in the supply chain.
Conglomerate Merger: A conglomerate merger is a merger of two firms in unrelated
businesses. A tender offer is an offer made by the acquiror to purchase stock from the
shareholders of the acquiree. The acquiror can gain control of the acquiree by purchasing
enough of the outstanding shares. The main advantages are that it is fast, flexible, simple
and allows the original acquiror to profit even if another bidder emerges.
Proxy Contest: A proxy contest is an effort by one or more individuals to oppose
incumbent management by obtaining sufficient shareholder votes to elect a new board of
directors. Control of a firm can be gained if the opposing board of directors is elected.
The disadvantage of a proxy contest relative to a tender offer is that few succeed, as
shareholders prefer to receive cash for their shares instead of a new management team.
Key Points:
1. Mergers and Consolidations
A merger involves a combination of two firms: the acquirer and the acquiree.
The acquirer is the surviving firm and it absorbs all the assets and liabilities of the target firm.
In a consolidation, two or more firms combine to form a new entity.
1.1. When Do Mergers Create Value?
Mergers create value when the merging firms are worth more in combination than separately.
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The Net Advantage to Merging (NAM) is the net benefit to the acquirer's shareholders.
1.2. Types of Mergers
Horizontal mergers: Combination of two firms in the same line of business.
Vertical mergers: Integrating forward towards the consumer, or backwards towards the supplier,
in a particular line of business.
Conglomerate mergers: Combination of firms in unrelated lines of business.
1.3. Valid Motives for Merging
Achieving economies of scale
Operating efficiencies and economies of scale are the main source of synergy.
Realize tax benefits
Free up surplus cash
Grow more quickly or more cheaply
1.3.1. Questionable Motives for Merging
▪ Diversification
▪ Corporate versus personal diversification.
▪ Enhanced Earnings per Share
▪ Financial synergy
2. Methods of Acquisition
Merger or consolidation: In a merger, the acquirer absorbs the acquiree and emerges as the
surviving firm. In a consolidation, a new business entity is created from the combination.
Acquisition of stock: Executed via a tender offer.
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Acquisition of assets: Acquirer purchases only the assets. Acquirees liabilities are not assumed.
2.1. Antitrust Considerations
A transaction must comply with
Federal antitrust laws (The Clayton Act)
State anti-takeover statutes
Federal and state securities laws
Corporate charter of each firm
2.2. Tax Considerations
In a tax-free acquisition, the selling shareholders are treated as having exchanged their old shares
for similar new shares.
Selling shareholders do not have to pay any taxes on the gain realized as a result of the exchange,
until the shares are sold.
Tax basis of each asset acquired is the same for the two firms.
In a taxable acquisition, the selling shareholders are treated as having sold their shares.
Selling shareholders must pay taxes on the gain immediately.
Acquirer can step-up the tax basis of the assets acquired to their fair market value.
2.3. Requirements for Tax-Free Treatment
Business Purpose Test
Continuity of Business Test
Mode of Acquisition Test
Medium of Payment Test
2.4. Accounting Considerations
One firm is identified as the acquirer.
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Purchase price, after adding the fair market value of the liabilities acquired, is allocated to the
acquired assets.
Excess of purchase price over fair market value of net assets acquired is recorded as goodwill.
2.5. Valuing Corporate Acquisitions
Infer the value from the prices paid for firms in comparable transactions.
Provides an estimate of a reasonable price to pay.
Impact of acquisition on acquirer's shareholder wealth, given the acquisition cost.
3. Discounted-Cash-Flow Analysis
An acquisition is a special type of capital budgeting decision.
Weighted average cost of capital approach
Adjusted present value approach
4. Merger Tactics
Merger: Merger requires approval of target management
Tender offer: It is made directly to targets stockholders, it can bypass target management and
executed quickly. The tender offer must be open for at least 20 days. The tender offer is subject
to regulation through the Williams Act amendments to the Securities Exchange Act of 1934
Proxy contests: Initiated by individuals who oppose incumbent management
4.1. Anticipatory Defensive Tactics
Dual class recapitalization
ESOPs
Poison pills
Staggered election of directors
Supermajority voting / fair price provisions
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4.2. Responsive Defensive Tactics
Asset purchases / sales
Litigation
Pac-Man defense
Leveraged recapitalization
Share repurchase / sale
Standstill agreement
4.3. Leveraged Buyouts (LBOs)
Acquisition is financed principally by borrowing.
Debt is secured by a lien on the assets.
Operating cash flow from assets is used to service the debt.
LBOs often take the firm private.
: Financial Distress
Topic Objective:
At the end of this topic the student will be able to:
Explain the main causes of financial distress.
Describe differences between reorganization and liquidation under the bankruptcy code.
Describe differences between reorganization outside of, and in, bankruptcy.
Explain prepackaged bankruptcy.
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Definition/Overview:
Absolute Priority Doctrine: The absolute priority doctrine means that a senior claim
must be paid in full before a junior claim is permitted to receive any distribution. The
argument for enforcing the doctrine is that the senior creditors have a legal claim to be
paid before the junior creditors. The argument against enforcement of the doctrine is that
a small payment to a junior class may speed up the reorganization process.
Holdouts: Holdouts are holders of outstanding securities who refuse to exchange their
securities for new ones. Holdouts frustrate the financial reorganization process by
attempting to get a better deal for themselves
The five basic conditions necessary to confirm a plan of reorganization are that the plan
must be feasible, the plan cannot discriminate unfairly among creditors of equal classes,
at least one creditor must accept the plan, the plan must satisfy the fair-and-equitable test,
and the plan must satisfy the best-interests-of-creditors test.
The purpose of the bankruptcy code is to allow debtors and creditors to negotiate to
achieve a consensual plan of reorganization. A firm should file for bankruptcy
protection when the going-concern value of the reorganized debtor exceeds its liquidation
value.
Key Points:
1. Four Aspects of Financial Distress
A firm is bankrupt when it has filed a petition for relief from its creditors.
A firm is in default when it violates one of the terms of a loan agreement or a bond indenture.
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A firm is said to have failed when it ceases operations or otherwise voluntarily withdraws from
obligations.
A firm is insolvent when it is unable to pay its debts.
1.1. Causes of Financial Distress
Poor management
Unwise expansion
Intense competition
Excessive debt
Massive litigation
Unfavorable contracts
1.2. Early Detection of Financial Distress
Losses increase as financial distress sets in.
Interest coverage declines.
Operations absorb more cash than they generate.
Debt-to-equity ratio increases.
Other key ratios worsen.
1.3. Other Indicators of Distress
When credit-default swaps written on a firms debt rise sharply in price.
When the firms debt falls sharply in price.
When a firm suddenly has to draw down all of its standby credit lines to pay off commercial
paper which it was unable to roll over.
When a firm engages one of the leading bankruptcy-advisory investment banks.
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2. Reorganization Outside Bankruptcy
Bankruptcy is time consuming and expensive. A firm can restructure its liabilities outside
bankruptcy in three ways:
Exchange new securities for existing ones.
Solicit security holders consent to modify the terms of existing securities.
Repurchase existing securities for cash.
Higher interest rate
More senior ranking
Stronger covenants
Cash incentive
Structure exchange offers such that non-exchanged securities are subordinated to the new
securities.
Try to avoid the holdout problem
3. Reorganization in Bankruptcy
According to Chapter 11 of the bankruptcy code, a plan is developed to reorganize the debtors
business and restore its financial health.
According to Chapter 7 of the bankruptcy code, the assets of the firm are liquidated and the cash
proceeds paid to the firms creditors according to strict rules of priority.
4. Guiding Principle of Chapter 11
A debtor should be given the opportunity to reorganize provided that the going concern value of
the reorganized debtor exceeds its liquidation value.
Protection from creditors
Voluntary filings
Involuntary filings
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4.1. The Chapter 11 Process
Firm files for Chapter 11 protection.
Bankruptcy judge issues an automatic stay.
Firm becomes debtor in possession.
Firm seeks additional financing for working capital.
Different creditor classes form committees.
The committees and the debtor negotiate a plan of reorganization.
Creditors approve the proposed plan of reorganization.
Bankruptcy court confirms the plan of reorganization.
Reorganized firm emerges from bankruptcy.
Firm executes the plan of reorganization.
Firm must satisfy all the conditions in the plan.
4.2. Plan of Reorganization
Includes a business plan for the firm.
Establishes new capital structure.
Shows how old debts will be paid off.
Provides for the distribution of cash and or new securities to the firms creditors and
shareholders.
4.3. Priority of Claims
Administrative expenses
Priority claims such as small trade claims and unpaid taxes, etc.
Secured debt
Unsecured senior debt
Subordinated debt
Preferred stock
Common stock
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4.4. Absolute Priority Doctrine
Distributions must be made among claimants according to the priority of their claims.
A more senior claim must be paid in full before a junior claim is permitted to receive any
distribution.
Reorganization plans often deviate from absolute priority.
4.5. Requirements for Confirmation
Proposed plan must be feasible.
Cannot discriminate unfairly among creditors with equal seniority of claims.
Must be accepted by at least one class of creditors.
Must satisfy the fair-and-equitable test.
Must satisfy the best-interests-of-creditors test.
5. Cramdown
Cramdown procedure permits confirmation of a plan over the objections of one or more classes
of creditors provided that:
The plan provides the holders with property whose value is at least equal to the allowed amount
of their claims, and
No junior class receives anything.
6. Bankruptcy
6.1. Advantages of Bankruptcy
Automatic stay of all creditor collection efforts.
Debtor can negotiate within a single forum - the bankruptcy court.
Court can allow debtor to reject unfavorable contracts.
All claims can be dealt with at one time.
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Interest stops accruing on unsecured claims.
Bankruptcy court can affirm plan over the objections of dissenting creditors.
Cramdown rules apply.
Upon confirmation, all creditors and stockholders are bound by the plan.
Avoid taxes on income that results when debt is retired at less than face value.
6.2. Disadvantages of Bankruptcy
Business is disrupted.
Debtor in possession must meet stringent reporting requirements.
Bankruptcy court must approve all transactions outside the ordinary course of business.
Bankruptcy filing can trigger other claims.
Legal and administrative expenses paid by the debtor.
7. Prepackaged Plans of Reorganization
In prepackaged bankruptcy, the debtor and creditors negotiate and file the plan of reorganization
with the bankruptcy petition.
7.1. Advantages
Alleviates holdout problem.
Confirmed plan is binding on all debtholders.
Tax advantages that are not available in out-of-court restructuring.
Allows debtor to reject burdensome leases and contracts.
8. Liquidation in Bankruptcy
Bankruptcy petition with intent to liquidate is filed under Chapter 7.
Liquidation is preferable when liquidation value of debtors assets exceeds their value under a
plan of reorganization.
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Liquidation value must be estimated by asset class.
Liquidation by assignment
Court-supervised liquidation
: International Corporate Finance
Topic Objective:
At the end of this topic the student will be able to:
Learn about five basic foreign exchange transactions.
Learn about two key parity relationships.
Definition/Overview:
Forward Contract: A forward contract for a foreign currency is a customized
agreement between two parties to exchange a specified amount of currency at a specified
exchange rate on a specified day. A futures contract is similar to a forward contract
except that it is standardized and traded on an exchange. The advantage of a forward
contract is that it can be tailored to meet the needs of the two parties. The advantage of
the futures contract is that positions can quickly be opened and closed as the needs of a
party change.
Interest rate parity: Interest rate parity is the relationship between the spot rate, forward
exchange rates, and interest rates for two countries.
Purchasing power parity: Purchasing power parity is the relationship between the spot
rate, expected future spot rate, and inflation rates for two countries.
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Unbiased forward exchange rate: An unbiased forward exchange rate is the
relationship between the forward rate and the expected future spot rate.
Equality of expected real returns: Equality of expected real returns is the relationship
between real interest rates, expected inflation rates, and nominal interest rates in two
countries.
Key Points:
1. Eurocurrency
Eurocurrency represents funds deposited in a bank outside the country in whose currency the
funds are denominated.
Eurodollars are U.S. dollar deposits in a bank outside the U.S.
Euroyen represent Japanese yen deposits in a bank outside Japan.
Eurocurrencies represent all major world currencies.
2. The Euro
The euro () is the currency of the European Monetary Union.
As time goes on, more states will become members and the euro currency zone will widen.
3. Foreign Bonds
A foreign bond is a bond issued by a foreign firm or government in the country in whose
currency the bond is denominated.
A Yankee bond is denominated in U.S. dollars and is issued in the U.S. by foreign firms or
governments.
Other foreign bonds include:
Bulldog bonds - issued in Britain
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Matador bonds - issued in Spain
Samurai bonds - issued in Japan
Rembrandt bonds - issued in the Netherlands
3.1. Eurobonds
A Eurobond is a bond issued outside the country in whose currency it is denominated.
Eurodollar bonds are dollar-denominated bonds issued outside of the U.S.
Eurobonds exists in many currencies:
▪ U.S. dollars
▪ Canadian dollars
▪ Japanese yen
▪ British pounds
4. London Interbank Offer Rate (LIBOR)
The LIBOR is the interest rate at which large international banks lend funds to each other in the
London money market.
Not unlike the U.S. Federal Funds rate, the rate at which member banks of the Federal Reserve
System lend to each other.
Different LIBOR rates prevail for overnight loans or longer.
5. American Depository Receipts (ADRs)
ADRs represent ownership of shares of a foreign company.
The shares are held in trust, usually by a U.S. bank.
ADRs are issued and traded in the U.S.
Price is expressed in U.S. dollars.
ADRs may be firm-sponsored or unsponsored.
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6. Foreign Exchange Markets
A market where foreign currencies are traded.
Most trading takes place in five currencies:
U.S. dollar ($)
Euro ()
British pound ()
Swiss franc (SF)
Japanese yen ()
7. Types of Foreign Exchange Transactions
Spot transactions
Forward transactions
Currency futures
Currency options
Currency swaps
7.1. Spot Transactions
These involve exchange of currencies with immediate delivery by all parties.
The exchange rates used are called spot rates.
7.2. Forward Transactions
These involve exchange of currencies at an exchange rate determined today, but delivery to take
place at a fixed point in the future.
The specified exchange rate is called the forward rate.
Different forward rates may exist for each future delivery time.
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If the forward rate is less (more) than the spot rate, the currency is trading at a forward discount
(premium).
7.3. Currency Futures and Options
Currency Features
This is a standardized forward contract that is traded on an exchange.
A position in the futures contract can be closed by taking an opposite position in the same
contract.
Like options on common stock.
Call (put) options give holder the right to buy (sell) the underlying currency at a fixed exchange
rate.
7.4. Currency Swaps
Two parties swap currencies and agree to exchange payments of specified amounts in one
currency for receipt of specified amounts in another.
Two firms seeking to borrow in each others home currency can engage in a currency swap
directly.
Swaps can also be negotiated by a firm with a swap bank.
It may be cheaper to borrow in the home country and enter into a swap than to borrow in the
foreign country.
Cost savings are due to market imperfections:
▪ Tax asymmetries
▪ National regulations restricting international capital flows
▪ Asymmetric information
▪ Comparative advantage
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8. International Parity Relationships
Law of One Price: An asset traded in two markets must have the same price in both markets.
Law of one price can be applied to international markets. This results in equilibrium
relationships for exchange rates, interest rates, and inflation rates. These relationships are called
parity relationships.
8.1. Types of Parity Relationships
Interest rate parity.
Purchasing power parity.
Expectations theory of forward exchange rates.
International Fisher effect.
8.1.1. Interest Rate Parity
▪ Differences between the forward and spot exchange rates offset the
difference between the interest rates between two countries.
▪ The higher interest rate in one country is offset by the forward discount.
▪ If interest rate parity does not hold, arbitrage profits are available.
8.1.2. Purchasing Power Parity
▪ This gives an equilibrium relationship between expected inflation rates
in two countries and the exchange rate.
▪ The higher inflation rate in one country is fully offset by the expected
rate of depreciation of that countrys currency.
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