Example: NetOne Inc. expects free cash flows of $5 million each year. NetOne's corporate tax rate is 35%, and its unlevered cost of capital is 15%. The firm also has outstanding debt of $19.05 million, and it expects to maintain this level of debt permanently. What is value of NetOne without leverage? VU = PV(of FCF)= $5mil/0.15 = $33.333 million What is the value of NetOne's equity with leverage? E = VL - D = VU + PV(ITS) - D = VU + TC D - D = VU + D(TC - 1)= $33.333 + $19.05(0.35 - 1) = $20.951 million. Example: A firm has $50 million in equity and $20 million of debt, it pays a dividend of $3 million, and has a net income of $10 million. ROA = Net Income / Beginning Assets ROE= Net Income / Beginning Equity Old Retention Rate = (1-payout policy) New Retention Rate= (1-New Payout Percent) What is the firm's sustainable growth rate? SGR=10/50 (1 - 3/10) = 14% What is the firm's internal growth rate? IGR =10/70 (1 - 3/10) = 10% Example: Sales: 122,800 Cost of Goods Sold: 104,380 Accounts Receivable: 10,900 Inventory: 1,420 Accounts Payable: 22,640 Cromwell Incorporated has the information shown above on its annual Income Statement and Balance Sheet (all numbers shown are in thousands). What is Cromwell's cash conversion cycle? Inventory Days = Inventory/Ave. Daily COGS = 1,420/104,380/365 = 4.97 A/R Days = A/R / Ave. Daily Sales = 10,900/122,800/365 = 32.4 A/P Days = A/P / Ave. Daily COGS = 22,640/104,380/365 = 79.17 CCC = Inventory Days + A/R Days - A/P Days = 4.97 + 32.4 -79.17 = -41.8 days Example: A firm offers its customers 3/5 net 25. What is the cost of trade credit to a customer who chooses to pay on day 25? r = 3/97 = 0.0309 EAR = 1.0309365/20 - 1 = 74.35% What is the cost to the customer if the firm stretches its accounts payable to 45 days? EAR = 1.0309365/40 - 1 = 32% Example: Luther Industries needs $1 million to finance a buildup of its inventories. It can get a loan for four months at an APR of 9%, and with a 2% origination fee. If Luther's bank requires that the firm maintain a compensating balance equal to 10% of the loan amount in a non-interest-earning account, what is the effective annual rate EAR for this loan? Loan amount = $1 mil /( 0.9*0.98) = $1,133,787 Cash received at time 1 = $1mil Cash paid back at the end of the four months =1.03*1,133,787 - 0.1*1,133,787 = $1,054,422 Effective rate for the period = ($1,054,422 - $1mil)/ $1mil = 5.44% EAR = 1.05443- 1 = 17.22% Example: Suppose a project financed via an issue of debt requires six annual interest payments of $20 million each year. If the tax rate is 30% and the cost of debt is 8%, what is the value of the interest rate tax shield? Annual Tax Shield = Int. expense * TC = $20mil*0.3 = $6mil N=6; PMT=6; I/YR = 8%; PV-? PV of TS = $27.74mil Example: Consider two firms, X and Y that have identical assets that generate identical cash flows. Y is an all-equity firm, with 1 million shares outstanding that trade for a price of $24 per share. X has 2 million shares outstanding and $12 million in debt at an interest rate of 5%. The corporate tax rate is 30%. What is the total value of X? VX = VY + PV(Tax Shields) =EY + TC*DX = $24*1mil + 0.3*$12mil = $27.6 mil What is the price per share of X's stock? PX = EX / #shrs = (VX - DX) / #shrs = ($27.6 - $12)/2 =$7.8 per share Example: A 20-year, callable bond with a 6% annual coupon rate and $1,000 face value is selling at par. The bond can be called in three years or any time after that on a coupon payment date. The call price is $110 per $100 of face value. What is the yield to worst? Since the bond is selling at par, the YTM = coupon rate = 6% YTC = 9% ( PV=-1000, PMT = 60, FV = 1100, N=3, I/YR-?) Since YTM < YTC, YTW = YTM = 6%. Example: David founded a company and goes through the investment rounds shown below:
Round Source Price Number of Shares
Series A Self $0.50 400,000
Series B Angel $1.00 500,000
Series C Venture Capital $1.50 300,000
Series D Venture Capital $2.25 400,000 Year | 0 | 1 | 2 | 3 | 4 | 5 | After-tax Lease Pmt.(1-0.35)*$500,000 | (325,000) | (325,000) | (325,000) | (325,000) | (325,000) | | Purchase Price | 2,000,000 | | | | | | Depr. Tax Shield(2mil/5)*0.35 | | (140,000) | (140,000) | (140,000 ) | (140,000) | (140,000) | Lease-Buy | 1,675,000 | (465,000) | (465,000) | (465,000) | (465,000) | (140,000) |
He decides to take the company public through an IPO, issuing 2 million new shares. Assuming that he successfully completes the IPO, the net income for the next year is estimated to be $8 million. His banker informs him that the price of shares should be set using average price-earnings ratios for similar businesses, which is 15.0. What will be the IPO price per share? Total shares = 0.4 + 0.5 + 0.3 + 0.4 + 2 = 3.6 mil EPS = $8/3.6 P/EPS = 15 => P = 15*EPS = 15* $8/3.6 = $33.33 What share of the company will David own after the IPO? % ownership = 0.4/3.6 = 1/9 = 11% Example: Franklin Industries has a current net working capital of $2.5 million. It expects that this will grow at a rate of 3.5% annually forever. If it could slow that growth to 3% per year, how would that affect the value of the firm, given that it has a cost of capital of 11%? If NWC grows at 3.5% annually, the increase in NWC one-year from now will be: ΔNWC3.5% = 2.5mil x 0.035 =$0.0875 mil Increases in NWC reduce FCF and firm value, thus the effect of a perpetual 3.5% rate of increase in NWC, reduces PV of the FCF by: ΔFCF = ΔV = -$0.0875/(0.11-0.035) = -$1,166,667 If NWC grows at 3% annually, the increase in NWC one-year from now will be: ΔNWC3% = 2.5mil*0.03 =$0.075 mil and the reduction in firm value will be: ΔFCF = ΔV = -$0.075/(0.11-0.03)=-$937,500. Thus, decreasing the rate of growth of NWC from 3.5% to 3% per year, increases the firm value by:-$937,500 - (-$1,166,667) = $229,167. Example: A firm has $300 million of assets that includes $50 million of cash and 10 million shares outstanding. If the firm uses $30 million of its cash to repurchase shares, what is the new price per share? Prior to repurchase the stock price is equal to: P = $300/10 = $30 per share. Share repurchase at the market price does not change stock price, thus after repurchase stock price is still $30 per share. # repurchased shrs = $30mil/$30 = 1mil P = ($300 - $30)/(10 - 1) = $30 per share. Example: The JRN Corporation will pay a constant dividend of $3 per share per year in perpetuity. Assume that all investors pay a 20% tax on dividends and that there is no capital gains tax. The cost of capital for investing in JRN stock is 12%. What is the price of a share of JRN's stock? P = D(1-T)/RE = $3(1-0.2)/0.12 = $20 What will the price of JRN stock be if instead of paying the dividend, the company will use the cash to repurchase stock? P = After-tax Payout per share/RE = $3/0.12 = $25 Example: Consider two firms, Thither and Yon. Both companies will either make $30 million or lose $10 million every year with equal probability. The companies' profits are perfectly negatively correlated. What are the expected after-tax profits of Thither in any year, assuming a corporate tax rate of 35% and no tax loss carry back or carry forward? Expected After-Tax Profit = 0.5(1-0.35)30 + 0.5(-10) = $4.75 mil What are the expected after-tax profits of the combined company (Thither and Yon) in any year, assuming a corporate tax rate of 35% and no tax loss carry back or carry forward? Combined firm will make ($30 + (-$10))(1-0.35) = $13 mil per year after-tax. Example: KT corporation has announced plans to acquire MJ corporation. KT is trading for $45 per share and MJ is trading for $25 per share, with a premerger value for MJ of $3 billion dollars. If the projected synergies from the merger are $750 million, what is the maximum exchange ratio that KT could offer in a stock swap and still generate a positive NPV? Exchange Ratio < PT / PA x (1+S/T) = 25/45 x (1+(750/3)) = 0.694 Example: Suppose you are looking to exploit opportunities in the options markets. The price of a call option on Apple computers with a maturity of one year and strike price $150 is $15, and the price of the stock is $140. What should the price of a put option be to preclude profitable opportunities? The risk-free rate of interest is 5%. Put-call parity: P+S = C + PV(Strike Price) => P = C + PV(Strike Price) – S P = 15 + 150/1.05 - 140 = $17.86 Example: Suppose the purchase price of a bulldozer is $90,000, its residual value in four years is certain to be $15,000, and there is no risk that the lessee will default on the lease. Assume that capital markets are perfect and the risk-free interest rate is 6% APR with monthly compounding. What are the monthly lease payments for a four year lease of the bulldozer? R = APR / 12 = 6%/12 = ).05% PV= L + L/0.005 (1 – 1/1.00547) + (15000/1.00548)= $90000 = L = $90000 – (15000/1.00548) / 1+1/0.005 x (1 – 1/1.00547) = $1827.24 Alternatively: Set financial calculator to BEG mode (for annuity due): PV = 90,000 FV=-15,000 I/YR = 6%/12=0.5% N = 48 Solve for PMT = $1827.24 Example: An operator of an oil well has a 0.5% chance of experiencing a catastrophic failure. This failure will cost the operator $500 million. If the risk-free rate is 2%, the expected return on the market is 8% If beta of the risk is 0, what is the actuarially fair insurance premium? Actuarially fair premium = (0.005*$500mil)/1.02 = $2,450,980 If the beta of the risk is -1.2, what is the actuarially fair insurance premium? r = rf + beta*(E(rM) - rf) = 2% - 1.2(8% - 2%) = -5.2% Actuarially fair premium = (0.005*$500mil)/(1 - 0.052) = $2,637,131 Example: St. Martin's Hospital plans to purchase or lease a $2 million dollar CT scanner. If purchased, the CT scanner will be depreciated on a straight-line basis over five years, after which it will be worthless. If leased, the annual lease payments will be $500,000 per year for five years. St. Martin's borrowing cost is 8%, and its tax rate is 35%. Should St. Martin lease the scanner or borrow the funds and buy the scanner? (TABLE TO LEFT) What is the NPV of the lease-vs-borrow-and-buy decision? The NPV is the cash flows discounted at the after tax borrowing rate (.08)(1 - .35) = 5.2% NPV = $1675000 – ($465000 / 1.052) - ($465000 / 1.0522) - ($465000 / 1.0523) - ($465000 / 1.0524) – ($140000 / 1.0525) = $74890 Since the NPV of lease-vs-buy is negative, St. Martin's should not lease the scanner, but purchase it instead. Example The Effect of Exchange Rate Risk: In June 2008, when the exchange rate was $1.96 per British pound (GBP), a U.S. company ordered parts for next year’s production from a British Company. They agreed to a price of 500,000 GBP, to be paid when the parts were delivered in one year’s time. One year later, the exchange rate was $1.64 per GBP. What was the actual cost in dollars for the US firm when the payment was due? With the price set at 500,000 GBP US firm had to pay ($1.64/GBP)x(500,000 GBP) = $820,000. This cost is $160,000, or 16.3% lower than it would have been if the price had been set in dollars. If the price had instead been set at $980,000 (which had equivalent value at the time of the agreement), how many GBP would the UK firm have received? If the price had been set in dollars, the US firm would have paid $980,000, which would have been worth $980,000x($1.64/GBP) = 597,560.98 GBP to the UK firm, or about 19.5% more. Example Using a Forward Contract to Lock in an Exchange Rate: In June 2008, banks were offering one-year currency forward contracts with a forward exchange rate of $2.00/GBP. Suppose that at that time, the US firm placed the order with the UK firm with a price of 500,000 GBP and simultaneously entered into a forward contract to purchase 500,000 GBP at a forward exchange rate of $2.00/GBP in June 2009. What payment would the US firm be required to make in June 2009? Although the exchange rate fell to $1.64/£ in June 2009, making the GBP less expensive, the US firm would be required to pay $2.00/£ for 500,000 GBP using the forward contract: 500,000 GBP x $2.00/GBP = $1,000,000 in June 2009 Example Computing the No-Arbitrage Forward Exchange Rate: In May 2009, the spot exchange rate for the Japanese yen was ¥99.26/$. At the same time, the one-year interest rate in the United States was 1.86% and the one-year interest rate in Japan was 0.90%. Based on these rates, what forward exchange rate is consistent with no arbitrage? Forward Rate= Spot Rate x (1+r¥)/(1+r$)= ¥99.26/$ x (1.009)/(1.0186)= ¥98324/$ in one year The forward exchange rate is lower than the spot exchange rate, offsetting the higher interest rate on dollar investments. If the forward exchange rate instead was ¥98.0/$, arbitrage profits would be available: borrow $1 million at 1.86% interest, exchange it into ¥99,260,000 ($1 million × 99.26 ¥/$), deposit the yen at 0.90% interest. In one year, we get ¥100,153,340 and owe $1,018,600. Having locked a forward exchange rate of ¥98/$, we would need ¥99,822,800 ($1,018,600 × ¥98/$) to pay off the loan, leaving us with a no-risk profit of ¥330,540! We (and everyone else) would do this until the forward rate came into line with the no-arbitrage rate of ¥98.324. Chapter 14: Example: You founded a drug company 5 years ago, contributing $50,000 of your money for 500,000 shares of stock. You have also sold 500,000 shares to angel investors. You now need more funding from VCs. The VC would invest $100 million and would receive 100,000,000 newly issued shares. The VC is paying $1 per share ($100mil/100mil shares). Pre-money valuation—the value of the old shares at the price at which the new shares are sold. $1×1mil shares = $1mil Post-money valuation—the value of the old plus new shares at the price at which the new shares are sold. $1×101mil shares = $101 mil VC owns 100mil/101mil = 99% of the firm The founder owns 0.5mil/101mil = 0.00495% of the firm. Chapter 15: Example: Consider a convertible bond with a $1000 face value and a conversion ratio of 20, If you converted the bond into stock on its maturity date, you would receive 20 shares, If you did not convert, you would receive $1000 Conversion Price: By converting the bond you essentially “paid” $1000 for 20 shares, implying a conversion price per share of $1,000/20 = $50. Chapter 16: Example: Suppose ECB borrows $2 billion by issuing 10-year bonds. ECB’s cost of debt is 6%, so it will need to pay $120 million in interest each year for the next 10 years, and the $2 billion principal in year 10. ECB’s marginal tax rate is 35% throughout this period. By how much does the interest tax shield increase the value of ECB? The interest tax shield each year is 35% x $120 million = $42 million. Valued as a 10-year annuity with a discount rate of 0.06, we have: PV(Interest Tax Shield): $42 million x 1/0.06 x (1 – 1.0610)= $309 million. Because only interest is tax deductible, the final repayment of principal in year 10 is not deductible, so it does not contribute to the tax shield. Chapter 17: Example: How does payout policy affect the value of the firm? Assume Genron has $20 million in excess cash and no debt. The firm expects to generate additional free cash flows of $48 million per year in subsequent years. If Genron’s unlevered cost of capital is 12%, then the enterprise value of its ongoing operations is: Enterprise Value: PV(Future FCF) = $48million / 12% = $400 million Example: Genron has 10 million shares outstanding and can pay a $2 dividend immediately. Because the firm expects to generate future free cash flows of $48 million per year, it anticipates paying a dividend of $4.80 per share each year thereafter Genron’s share price just before the stock pays its dividend (cum-dividend): Pcum = Current Dividend + PV(Future Dividend)= 2+ 4.80/12% = $4 Genron’s share price just after the stock goes ex-dividend: Pex = PV(Future Dividend) = $4.80/12% = $40 Example: Suppose that Genron instead uses the $20 million to repurchase its shares on the open market. At $42 per share Genron will repurchase $20mil/$42 = 0.476 mil shares. There will be 10 mil – 0.476 mil = 9.524 mil shares outstanding In future years, Genron expects to have $48 million in free cash flow and will be able to pay a dividend of $5.04 per share ($48 mil ÷ 9.524 mil shares). Thus, Genron’s share price today is: Prep= $5.04/12% = $42 In perfect capital markets, an open market share repurchase has no effect on the stock price. The stock price is the same as the cum-dividend price if a dividend were paid instead. Example: Suppose Hershey must pay corporate taxes at a 35% rate on the interest it will earn from the one-year Treasury bill paying 4% interest. Would pension fund investors (who do not pay taxes on their investment income) prefer that Hershey use its excess cash to pay the $100,000 dividend immediately or retain the cash for one year? If Hershey pays $100,000 dividend, the pension fund investors would invest $100,000 at 4% and receive a total of $104,000 in one year tax-free. If Hershey retains the cash for one year, it will earn an after-tax return on the Treasury bills of 4% x (1 – 0.35) = 2.60%. And at the end of the year, Hershey will pay a dividend of $100,000 x (1.026) = $102,600. Example: Aaron Corp. is an all-equity firm with 15 mil shares outstanding. Aaron has $14 mil in cash and expects future FCF of $5 mil per year. Management plans to use the cash to expand the firm’s operations, which will increase future FCF to $6 mil per year. If the cost of capital of Aaron’s investments is 8%, how would a decision to use the cash for a share repurchase rather than the expansion change the share price? Value of Aaron if it invests: PV(FCF) = $6 mil / 8% = $75 mil or $75 mil/15 mil shares = $5.00 per share Value of Aaron if it doesn’t expand and repurchases: PV(FCF) = $5mil / 8% = $62.5 mil Adding $14 mil in cash, V = 62.5 + 14 = $76.5 mil; or $76.5 mil / 15 mil shares = $5.10 per share. Chapter 18: Example: If instead of paying out 30% of earnings as dividends, KMS decides to pay out 50% of earnings as dividends, how will its net new financing change? KMS will retain $8,226 x 50% = $4,113. This will decrease retained earnings (compared to $8,226 x 30% = $5,758), increasing the net new financing. The reduction in retained earnings is $5,758-$4,113=$1,645. Stockholders’ equity will be $79,892 - $1,645=$78,247. Total Liabilities and Equity will also be $1,645 lower, falling to $96,886 (=$98,531-$1645). Net new financing, the difference between the assets and liabilities and equity, will increase to $8,396 + $1,645 = $10,041. Chapter 19: Example: Vitamin Soda Corp. purchases goods from a supplier at 2/10 net 40. If the firm requires the entire 40 days to pay back its supplier, would it be better to take a loan from the bank after the discount or just pay the EAR given by the trade credit? Using a $100 purchase as an example, the loan interest rate is: R = $2/$98 = 2.04% for 30 days. There are 365/30 = 12.17 thirty-day periods in a year. EAR = (1.0204)12.17-1 =27.86%. The company would be better off borrowing from a bank to pay off the supplier within 10 days. Example: What is the effective annual cost of credit terms of 2/10, net 30, if the firm stretches the accounts payable to 60 days? The interest rate per period is $2/$98 = 2.04%. If the firm delays payment until the sixtieth day, it has use of the funds for 50 days beyond the discount period. There are 365/50 = 7.3 50-day periods in one year. Thus the effective annual cost is (1.0204)7.3 – 1 =15.88%. Paying on time corresponds to a 20-day credit period and there are 365/20 = 18.25 20-day periods in a year. Thus, if it pays on the 30th day, the effective annual cost is (1.0204)18.25-1= 44.56%. By stretching its payables, the firm substantially reduces its effective cost of credit. The minimum NWC represents permanent working capital. The difference between the maximum and the minimum NWC reflects the temporary NWC. Example: $1 million committed line of credit with 10% EAR and 0.5% EAR commitment fee. Firm borrows $800,000 and repays at year-end. Total Cost= Interest on Borrowed Funds + Commitment Fee Paid on Unused Portion= ($800000 x 10%) + ($200000 x 0.5%) = $81000 Example: Timmons Towel and Diaper Service is offered a $500,000 loan for three months at an APR of 12% with a loan origination fee of 1%. The origination fee is charged on the principal, so the fee is 0.01 x $500,000 = $5000, so the actual amount borrowed is $495,000. The interest payment for three months is $500,000 (0.12/4) = $15,000. $500000+15000 / 495000 – 1 = 4.04% EAR= (1 + 4.04%)4 – 1 = 17.17% Example: Timmons Towel and Diaper Service’s keeps 10% of the loan principal in a non-interest-bearing account with the bank. The loan was for $500,000, so this means that Timmons must hold 0.10x500,000 = $50,000 in an account at the bank. Thus the firm has only $450,000 of the loan proceeds actually available for use, although it must pay interest on the full loan amount. At the end of the loan period, the firm owes $500,000 x (1 + 0.12/4) = $515,000, and so must pay $515,000 – 50,000 = $465,000. Thus the actual three-month interest rate paid is: $465000/450000 -1 = 3.33% EAR= (1+3.33%)4 -1 = 14.01% Example: Bills, Inc. has a 3-month $750,000 loan from its bank. The interest is 8% (APR with quarterly compounding) and the bank requires a 10% compensating balance. The bank pays 1% (APR with quarterly compounding) on its compensating balance accounts. What is the EAR of Bills’ $750,000 3-month loan? The balance held in the compensating balance account will grow to (75,000)(1 + 0.01/4) = $75,187.50. The interest owed on the loan at the end of the 3-month period is $15,000=($750,000 x (0.08/4)). The final loan payment will be 750,000 + 15,000 – 75,187.50 = $689,812.50. Since Bills only has the use of $675,000=($750,000 - $75,000), the actual 3 month rate paid is (689,812.50 / 675,000) – 1 = 2.19%. EAR is 1.02194 – 1 = 9.05% If the bank had not paid interest on the compensating balance, would have paid back $765,000 - $75,000 = $690,000. 3 month rate would have been $690,000/$675,000-1=2.22% EAR is 1.02224-1=9.19% Example: Bills, Inc needs to borrow $2,000,000 for one month. Using its Inventory as collateral, it can obtain a 10% (APR) loan. The lender requires a warehouse arrangement be used. The warehouse fee is $10,000 payable at the end of the month. Calculate the EAR of this loan. The monthly interest rate is 10%/12 = 0.833%. At the end of the month, will owe $2,000,000 x 1.00833 = $2,016,667 plus the warehouse fee of $10,000 The actual one month rate paid is ($2,026,667/$2,000,000) – 1 = 1.33% EAR gives 1.013312 – 1 = 17.18% Chapter 22: Example: FAT Corporation stock price is $40 per share. There are 20 million shares outstanding, and the company has no debt. If the managers were replaced with more capable ones, the value of the company would increase by 50%. You decide to initiate a LBO and issue a tender offer for at least 50% of the outstanding shares. What is the maximum amount of value you can extract and still complete the deal? Currently, the value of the company is $40 × 20 million = $800 mil. You can add an additional 50%, or $400 million, by borrowing $400 million, taking control of the company and installing new management. The value of the equity once the deal is done is the total value minus the debt outstanding: Total Equity = $1200 million - $400 million = $800 million Example: Two corporations have EPS of $8. One firm, Beenaround, a mature company with few growth opportunities, has 2 million shares outstanding, priced at $50 per share. The other firm, Movenin Corporation, is a young company with much more lucrative growth opportunities. Although it has the same number of shares outstanding, its stock price is $80 per share. Assume Movenin acquires Beenaround using its own stock, and the takeover adds no value. In a perfect market, what is the value of Movenin after the acquisition? Because the takeover adds no value, the post-takeover value of Movenin is just the sum of the values of the two separate companies: 50 × 2 million + 80 × 2 million = $260 million. At current market prices, how many shares must Movenin offer to Beenaround’s shareholders in exchange for their shares? To acquire Beenaround, Movenin must pay $100 million. At its pre-takeover stock price of $80 per share, the deal requires issuing: $100 million / $80 = 1,250,000. Beenaround’s shareholders are exchanging 2 mil shares in Beenaround for 1,250,000 shares in Movenin. The exchange ratio is the ratio of issued shares to exchanged shares: 1,250,000/2 million = 0.625. What are Movenin’s earnings per share after the acquisition? Prior to the takeover, both companies earned $8/share ×2 million shares = $16 million. The combined earnings are $32 million. There are 3.25 million shares outstanding after the takeover, so Movenin’s post-takeover EPS= $32 million / 3.25 million shares = $9.85 per share As a result of the takeover, Movenin has raised its earnings per share by $1.85. Web Chapter 2: Example: A firm faces a potential $200 million loss that it would like to insure. Because of tax benefits and the avoidance of financial distress and issuance costs, each $1 received in the event of a loss is worth $1.55 to the firm. Two policies are available: One pays $125 million and the other pays $200 million if a loss occurs. The insurance company charges 15% more than the actuarially fair premium to cover administrative expenses. To account for adverse selection, the insurance company estimates a 4% probability of loss for the $125 million policy and a 5% probability of loss for $200 million policy. Suppose the beta of the risk is zero and the risk-free rate is 2.5%. Which policy should the firm choose if its risk of loss is 4%? Which should it choose if its risk of loss is 5%? The premium for each policy will be based on the expected loss using the insurance company’s estimate of the probability of loss: $125 million policy: 4% chance of loss $200 million policy: 5% change of loss. Because it is charging 15% more than the actuarially fair premium, the insurance company will set the premium at 1.15 times the present value of expected losses. Premium($125million)=((4%x$125million)/ 1.025)x1.15=$5.61million Premium($200million) = ((5%x$200million)/1.025)x1.15=$11.22million Because each $1 of insured loss benefits the firm by $1.55, it is willing to pay 1.55 times the present value of the expected loss. If the true risk of a loss is 4%, the NPV of each policy is: NPV($125million)= -$5.61million+((4%x$125million)/1.025)x1.15=$1.95million. NPV($200million)= -$11.22million+((5%x$200million)/1.025)x1.15=$0.88million. Thus, with a 4% risk, the firm should choose the policy with the lower coverage. Example: A gasoline refiner will need 10 mil barrels of oil next year. The current market price of oil is $70 per barrel. At this price, the firm expects EBIT of $250 million next year. What will the firm’s EBIT be if the price of oil rises to $85 per barrel? At $85 per barrel, the firm’s costs will increase by ($85 – $70) x 10,000,000 = $ 150 million. Other things equal, EBIT will decline to $250 million – $150 million = $100 million. What will EBIT be if the price of oil falls to $65 per barrel? If the price of oil falls instead to $65 per barrel, EBIT will rise to $250 million – ($65 – $70) x 10,000,000 = $300 million. What will EBIT be in each scenario if the firm enters into a supply contract for oil for a fixed price of $75 per barrel? By entering into the supply contract that fixes the price at $75 per barrel, the firm fixes its EBIT at: $250 million– ($75–$70) x 10,000,000=$200 million. The firm can completely reduce its risk by entering into the supply contract. The cost is accepting lower (by $50 million) operating income for certain. Example: Scott Industries wants to borrow $7 million. Currently, long-term AA rates are 8%. Bolt can borrow at 9% given its credit rating. The company is expecting interest rates to fall so it wants to borrow short-term and refinance later at lower rates. Bolt’s credit rating may worsen due increasing the spread it must pay on new loans. How can Bolt benefit from declining interest rates without worrying about changes in its credit rating? Scott can borrow at the long-term rate of 9%. And enter into a swap in which it receives the long-term AA fixed rate of 8% and pays the short-term rate. Its net borrowing cost will then be: Long-Term Loan Rate + Floating Rate Due on Swap – Fixed Rate Received from Swap = Net Borrowing Cost = 9%+rt–8%= rt+1% In this way, Scott locks in its current credit spread of 1% but gets the benefit of lower rates as rates decline. The tradeoff is that if rates increase instead, it is worse off. Chapter 23: Example: In June 2008, when the exchange rate was $1.96 per British pound (GBP), a U.S. company ordered parts for next year’s production from a British Company. They agreed to a price of 500,000 GBP, to be paid when the parts were delivered in one year’s time. One year later, the exchange rate was $1.64 per GBP. What was the actual cost in dollars for the US firm when the payment was due? With the price set at 500,000 GBP US firm had to pay ($1.64/GBP)x(500,000 GBP) = $820,000. This cost is $160,000, or 16.3% lower than it would have been if the price had been set in dollars. If the price had instead been set at $980,000 (which had equivalent value at the time of the agreement), how many GBP would the UK firm have received? If the price had been set in dollars, the US firm would have paid $980,000, which would have been worth $980,000/($1.64/GBP) = 597,560.98 GBP to the UK firm, or about 19.5% more. Example: In June 2008, banks were offering one-year currency forward contracts with a forward exchange rate of $2.00/GBP. Suppose that at that time, the US firm placed the order with the UK firm with a price of 500,000 GBP and simultaneously entered into a forward contract to purchase 500,000 GBP at a forward exchange rate of $2.00/GBP in June 2009. What payment would the US firm be required to make in June 2009? Although the exchange rate fell to $1.64/£ in June 2009, making the GBP less expensive, the US firm would be required to pay $2.00/£ for 500,000 GBP using the forward contract: 500,000 GBPx$2.00/GBP = $1,000,000 in June 2009 Example: In May 2009, the spot exchange rate for the Japanese yen was ¥99.26/$. At the same time, the one-year interest rate in the United States was 1.86% and the one-year interest rate in Japan was 0.90%. Based on these rates, what forward exchange rate is consistent with no arbitrage? Forward Rate = Spot Rate x (1+r¥/1+r$)= ¥99.26/$ x 1.009/1.0186 = ¥98.324/$ in one year The forward exchange rate is lower than the spot exchange rate, offsetting the higher interest rate on dollar investments. If the forward exchange rate instead was ¥98.0/$, arbitrage profits would be available: borrow $1 million at 1.86% interest, exchange it into ¥99,260,000 ($1 million × 99.26 ¥/$), deposit the yen at 0.90% interest. In one year, we get ¥100,153,340 and owe $1,018,600. Having locked a forward exchange rate of ¥98/$, we would need ¥99,822,800 ($1,018,600 × ¥98/$) to pay off the loan, leaving us with a no-risk profit of ¥330,540!
Chapter 23: A firm considering making a foreign investment will have to address the following 3 key issues: 1.While the project will generate CFs denominated in foreign currency, the firm cares about its value in domestic currency. 2.Interests rates and costs of capital may be different in other countries due to different risks and macroeconomic environment.3.Firm’s cash flows will be subject to both domestic and foreign tax codes. Exchange Rate Risk: Exchange Rate Fluctuations- Floating Rate: An exchange rate that changes constantly depending on the supply and demand for each currency in the market. The supply and demand for each currency is driven by three factors: Firms trading goods, Investors trading securities, The actions of the central banks in each country Importer–Exporter Dilemma- If companies set prices in a certain currency, they risk losing money if the exchange rate rise or fall Currency Forward Contract: A contract that sets a currency exchange rate, and an amount to exchange, in advance of a future delivery date Forward Exchange Rate: The exchange rate set in a currency forward contract, it applies to an exchange that will occur in the future Where does the risk go? Initially, the risk passes to the bank that has written the forward contract. The bank is willing to bear this risk? Often the bank will enter into another forward contract that offsets the risk. Cash-and-Carry Strategy—eliminates exchange rate risk- A strategy used to lock in the future cost of a currency by buying it today, and depositing it at a risk-free rate (or “carrying”) it until a future date. Consists of three simultaneous trades: 1.Borrow dollars today using a one-year loan at the dollar interest rate. 2.Exchange the dollars for euros today at the spot exchange rate. 3.Deposit the euros today for one year at the euro interest rate. In one year’s time, we will owe dollars (from the loan in transaction 1) and receive euros (from the deposit in transaction 3) Covered Interest Parity: States that the difference between the forward and spot exchange rates is related to the interest rate differential between the currencies: Forward Rate (€ in one year/$ in one year)=Spot Rate (€ today/$ today) x (1-r€)/(1-r$) Covered interest parity equation expresses the forward currency exchange rate at time T in terms of the spot rate and the domestic and foreign interest rates: Ft= Sx(1+r$)t/(1+r€)t Advantages of Forward Contracts: Forward Contracts are simpler, Requires one transaction rather than three, Lower transaction fees, Don’t have to borrow in other currencies, May be harder with poor credit, Cash-and-carry is typically used by large banks to hedge their currency exposures from forward contracts. Currency Forward Contracts: Allows firms to lock in a future exchange rate. Must pay the rate it locks in, whether advantageous or not. Currency Options: Allows firms to insure themselves against the exchange rate moving beyond a certain level. Can pay the current rate or rate in the option contract, whichever is better Advantages of Options: Option holders can always sell the position at a gain rather than demanding delivery of the currency, Benefit if the exchange rate moves in their favor, Allows them to walk away from the exchange if there is an unfavorable rate or the exchange might not take place. If capital markets are internationally integrated, the value of an investment is independent of the currency used for its analysis. Internationally Integrated Capital Markets can exchange currencies in any amount at the spot or forward rates and can purchase or sell any security in any amount in any country at its current market prices. Repatriated refers to the profits from a foreign project that a firm brings back to its home country. Single Foreign Project with Immediate Repatriation of Earnings: Tax policy in the US requires US corporations to pay taxes on their foreign income at the same rate as profits earned in the US. A full tax credit is given for foreign taxes paid up to the amount of the U.S. tax liability. If the foreign tax rate is lower than the US rate, the firm will first pay the foreign tax rate and then pay the additional amount of tax to the US up to the US rate. If the foreign tax rate is higher than the US rate, the firm pays the higher rate and will owe no taxes in the US; however, it cannot apply the unused portion of the credit to its domestic earnings. Multiple Foreign Projects and Deferral of Earnings Repatriation: Pooling Multiple Foreign Projects: Multinational corporations may use any excess tax credits generated in high-tax foreign countries to offset their net U.S. tax liabilities on earnings in low-tax foreign countries. Deferring Repatriation of Earnings: U.S. tax liability is not incurred until the profits are brought back home if the foreign operation is set up as a separately incorporated subsidiary (rather than as a foreign branch). Segmented Capital Markets—capital markets that are not internationally integrated. The existence of segmented capital markets makes many decisions in international corporate finance more complicated but potentially more lucrative for a firm that is well positioned to exploit the market segmentation Differential Access to Markets: Firms may face differential access to markets if there is asymmetry of information about them. Using currency swaps, a firm can borrow in the market where it has the best access to capital, and then “swap” the coupon and principal payments to whichever currency it would prefer to make payments in. Macro-Level Distortions- Many countries create capital market segmentation by regulating or limiting capital inflows or outflows, not allowing their currencies to be freely converted into dollars. Political, legal, social, and cultural characteristics that differ across countries may require compensation in the form of a country risk premium. If the return difference results from a market friction such as capital controls, corporations can exploit this friction by setting up projects in the high-return country/currency and raising capital in the low-return country/currency. Chapter 14: VCs and other investors in private equity capital have two primary options for liquidating their investment: 1.Acquisition by a larger company- 85% of VC exits occurred through M&A from 2001 to 2005 2.Initial public offering (IPO)- The process of selling stock to the public for the first time. Advantages and Disadvantages of Going Public: Advantages: Greater liquidity—founders and employees can sell their shares and diversify. Better access to capital—the firm can issue more shares in the future and has access to much larger amounts of capital. Disadvantages: Equity holders more dispersed—harder to monitor management. Must satisfy requirements of public companies—expensive disclosure and compliance requirements. IPO Process: IPO involves a sale of a large block of shares to the public. Primary offering refers to the sale of new shares with proceeds going to the corporation. Secondary offering—the sale of shares by existing shareholders. 1. The corporation hires an investment bank to be the lead underwriter of the IPO. 2. To spread the risks the lead underwriter typically forms a syndicate with other underwriters. Managing the IPO, promoting the company to investors. Advice on valuation. 3. The underwriters together with the firm prepare a registration statement and file it with SEC. Contains financial information about the company and the security issue. A part of the registration statement, called preliminary prospectus, or red herring, is provided to potential investors before the stock offering. 4. SEC reviews the registration statement and approves the stock sale. 5. The company prepares the final registration statement and the final prospectus which provides all the details of the IPO. 6. The underwriters together with the firm’s management determine the price range for the stock: Discounted cash flow methods or Comparables method 7. The underwriters and top managers take the IPO on the road show- Travel around the country and promote the company to large investors and Get a sense of what these investors think of the valuation. Book building refers to preliminary customer orders at the end of the road show. The underwriters can gage the demand for shares at the current price range Firm Commitment IPO: the underwriter guarantees that it will sell all of the stock at the offer price. Over-allotment allocation, or Greenshoe provision: allows the underwriter to issue more stock, up to 15% of the original offer size, at the IPO offer price. The syndicate buys the entire issue from the company for the offer price minus a spread, which typically is 7% of the issue price. In a firm commitment IPO underwriters take on the risk of not being able to sell all the shares to the investors at the offer price. Appear to intentionally underprice the IPO during book building to limit their risk exposure. Best-Efforts Basis: the underwriter does not guarantee that the stock will be sold, but instead tries to sell the stock for the best possible price. Auction IPO: The company or its investment bankers auction off the shares, allowing the market to determine the price of the stock. Avoid IPO underpricing Underpriced IPOs: On average, between 1960 and 2003, the price in the U.S. aftermarket was 18.3% higher at the end of the first day of trading Who wins and who loses because of underpricing? The underwriters limit their risk. The IPO investors make a quick profit. The firm and the existing shareholders “leave money on the table.” Potential Explanations for Underpricing: Underwriters underprice IPOs to limit their risk—easier to sell all shares if they are underpriced. Large first day pop creates good publicity for the firm’s stock and makes investors more receptive for subsequent stock offers. Winner’s Curse- The highest bidder in an auction is most likely to have overestimated the value of the object. IPO Puzzles—High Issuance Costs: In the US the underwriter’s spread is typically 7% of the issue price for issues ranging from $20 to $80 mil. Poor Long-Run Stock Performance: Newly listed firms appear to perform relatively poorly over the following three to five years after their IPOs. Shares of 513 US IPOs between 2007 and June of 2011 on average were 6.6% below the IPO price one year after the IPO. The underperformance might not result from the issue of equity itself, but rather from the conditions that motivated the equity issuance in the first place. Two kinds of seasoned equity offerings: Cash offer—new shares are offered to all investors Rights offer—new shares are offered only to existing shareholders and protects existing shareholders from losses due to shares being underpriced. Market Price Reaction to SEOs- Researchers have found that, on average, the market greets the news of an SEO with a price decline (about 1.5%). Often the value lost can be a significant fraction of the new money raised. Adverse selection (the lemons problem)- Managers will only sell new shares if the stock price is fair or overvalued. When SEO is announced, investors infer that the firm’s stock is overpriced. SEO underwriting fees are typically 5% of the issue amount. Chapter 15 - Unsecured Corporate Debt: Notes—unsecured debt with maturities up to 10 years: Debentures—unsecured debt with maturities of10 years or longer Secured Corporate Debt: Mortgage Bonds—secured by real property Asset-Backed Bonds—can be secured by any type of asset. Indenture specifies bond’s covenants: Restrictive clauses in a bond contract that limit the issuer from taking actions that may undercut its ability to repay the bonds. Limit on the amount of dividends, Limit on the ability to sell or pledge assets, No mergers, no additional long-term debt, Maintaining working capital and collateral assets, Financial auditing Advantages of Covenants: With more covenants, a firm firms can reduce its costs of borrowing. The reduction in the firm’s borrowing cost can more than outweigh the cost of the loss of flexibility associated with covenants. If the firm violates any of the covenants, it is considered to be in technical default and bondholders can demand immediate repayment or renegotiate the terms of the bond. Sinking Fund: A company makes regular payments into a fund administered by a trustee over the life of the bond. These payments are then used to repurchase bonds, usually at par. Balloon Payment: A large payment that must be made on the maturity date of a bond when the sinking fund payments are not sufficient to retire the entire bond issue. Convertible Bonds and Stock Prices: When a firm’s stock price is much higher than the conversion price, conversion is very likely and the convertible bond’s price is close to the price of the converted shares. Leveraged Buyout (LBO): opposite of an IPO, and involves making a public company private. A group of private investors purchases all the equity of a public corporation and finances the purchase primarily with debt. These investors typically target underperforming companies and try to fix them in order to sell them at a profit or take them public at later date and a higher price. High debt load and interest payments force management to focus on efficiencies and cash flow. Chapter 16: Since shareholders can create their own leverage, it doesn’t matter what leverage the firm chooses. Therefore, the firm’s capital structure does not affect its value (if there are no taxes and capital markets are perfect). MM Proposition I: In a perfect capital market and in the absence of taxes the value of the firm is independent of its capital structure and is equal to the market value of the free cash flows generated by its assets. VL = E+D = VU Another way of stating MM I is that the WACC of the firm doesn’t depend on its debt-equity ratio. Remember that the WACC is the required return on the company’s assets—RU. If we continue to ignore taxes: WACC= RU=(E/V) RE + (D/V) RD Solve for RE: RE=RU+(RU-RD)(D/E) MM Proposition II: A firm’s cost of equity is a positive linear function of the firm’s leverage. Notice, even though firm value and the WACC do not change as the D/E ratio changes, the cost of equity does change. RE increases with leverage because shareholders are facing a greater risk since they now have to pay interest to the bondholders no matter what. Interest tax shield is the tax saving attained by a firm from interest expense. Interest Tax Shield = TC x Interest Payments Cash flows of the levered firm are equal to the sum of the cash flows from the unlevered firm plus the interest tax shield. By the Valuation Principle the same must be true for the present values of these cash flows. PV of unlevered CFs = VU. From the perpetuity model we can find the PV of all the future tax shields (assuming the tax rate and the capital structure remain the same): PV of tax shield=(TC × D × RD) / RD = TC × D MM Proposition I with corporate taxes: The value of the levered firm (firm that has debt in its capital structure) equals the value of the unlevered firm plus the PV of tax shields. VL = VU + TC× D Tradeoff Theory: Total value of a levered firm equals the value of the firm without leverage plus the present value of the tax savings from debt, less the present value of financial distress costs: VL = VU + PV(Interest Tax Shield) – PV(Financial Distress Costs). firms should increase their leverage until it reaches the maximizing level. The Tradeoff Theory helps to resolve two important facts about leverage: The presence of financial distress costs can explain why firms choose debt levels that are too low to fully exploit the interest tax shield. Differences in the magnitude of financial distress costs and the volatility of cash flows can explain the differences in the use of leverage across industries. The pecking order hypothesis: Managers have a preference to fund investment using retained earnings, followed by debt, and will only choose to issue equity as a last resort. Profitable firms will use retained earnings to finance investments and will not issue debt or equity. Highly profitable firms will have little debt in their capital structure. Firms should almost never issue equity. However, firms will issue equity when the agency costs or financial distress costs of debt are too high. Capital Structure: Putting It All Together: Use the interest tax shield if your firm has consistent taxable income. Balance tax benefits of debt against costs of financial distress. Consider short-term debt for external financing when agency costs are significant. Increase leverage to signal confidence in the firm’s ability to meet its debt obligations. Be mindful that investors are aware that you have an incentive to issue securities that you know are overpriced. Rely first on retained earnings, then debt, and finally equity. Do not change the firm’s capital structure unless it departs significantly from the optimal level. Chapter 17: Declaration date—the date on which a firm’s board of directors declares the payment of a dividend. Record date—investors who are shareholders of record on this day will receive the declared dividend. Ex-dividend date—two business days prior to the record date the stock begins to trade ex-dividend, i.e. without the dividend. Because it takes three business days to register the purchase of the stock, investors who buy the stock on ex-dividend date will not be shareholders of record on the record date. Payable (distribution) date—the day when the dividend payment is made. Usually within a month of the record date. In a perfect capital market, when a dividend is paid, the share price drops by the amount of the dividend when the stock begins to trade ex-dividend. In perfect capital markets, investors are indifferent between the firm distributing funds via dividends or share repurchases. By reinvesting dividends or selling shares, they can replicate either payout method on their own. In perfect capital markets, holding fixed the investment policy of a firm, the firm’s choice of dividend policy is irrelevant and does not affect the initial share price. A firm’s free cash flows determine the level of payouts that it can make to its investors. In a perfect capital market, whether these payouts are made through dividends or share repurchases does not matter Investment Horizon- Capital gains on stocks held less than 1 year and dividends on stocks held less than 61 days are taxed as ordinary income. Pension funds and other institutional investors do not pay taxes on dividends or capital gains. Corporations can shield 70-80% of dividends they receive from stock they hold, but not capital gains. Individual retirement accounts are not taxed on either dividends or capital gains. Clientele Effects- When the dividend policy of a firm reflects the tax preferences of its investor’s clientele. MM Payout Irrelevance: In perfect capital markets, if a firm invests excess cash flows in financial securities, the firm’s choice of payout versus retention is irrelevant and does not affect the initial value of the firm. Dividend Smoothing—the practice of maintaining relatively constant dividends. Firms raise their dividends only when they perceive a long-term sustainable increase in the expected level of future earnings, and cut them only as a last resort. Stock Splits and Share Price: The typical motivation for a stock split is to keep the share price in a range thought to be attractive to small investors Making the stock more attractive to small investors can increase the demand for and the liquidity of the stock, which may in turn boost the stock price. On average, announcements of stock splits are associated with a 2% increase in the stock price. Most firms use splits to keep their share prices from exceeding $100. Advice for the Financial Manager: For a given payout amount, try to maximize the after-tax payout to the shareholders Repurchases and special dividends are useful for making large, infrequent distributions to shareholders. Starting and increasing a regular dividend is seen by shareholders as an implicit commitment to maintain this level of regular payout indefinitely. Because regular dividends are seen as an implicit commitment, they send a stronger signal of financial strength to shareholders than do infrequent distributions such as repurchases Be mindful of future investment plans—costs of both distributing and raising capital are substantial. Chapter 18: The difference between Assets and L+E indicates the net new financing to fund growth Percent of sales method ignores real-world “lumpy” investments in capacity. Sales = Market Size x Market Share x Average Sales Price When we forecast L+E>A, excess cash is available. When L+E<A, additional financing is needed. The maximum growth rate a firm can achieve by reinvesting its earnings and without external financing is called internal growth rate. Retention ratio is also known as plowback ratio The maximum growth rate the firm can achieve without raising new equity and maintaining its D/E ratio constant is called sustainable growth rate. SGR assumes that debt increases at the same rate as equity (to keep D/E ratio constant). Chapter 19: Net working capital includes: The cash needed for operations (not including cash reserves not required for running the business), Accounts receivable, Inventory, Accounts payable Operating Cycle: The average length of time between when a firm originally purchases its inventory and when it receives the cash back from selling its product. Cash Cycle: The length of time between when the firm pays cash to purchase its initial inventory and when it receives cash from the sale of the output produced from that inventory. Firms offer trade credit because: Providing financing at below-market rates is an indirect way to lower prices for only certain customers. A supplier may have an ongoing business relationship with its customer, it may have more information about the credit quality of the customer than a bank would have. If the buyer defaults, the supplier may be able to seize the inventory as collateral. Establishing a credit policy involves three steps: 1.Establishing credit standards 2.Establishing credit terms 3.Establishing a collection policy 5 C’s of Credit: Character—trustworthiness, credit history Capacity—cash flow sufficiency Capital—adequate net worth Collateral—assets securing the loan Conditions—business and macro-economic. Value Companies using the formula for a growing perpetuity: PV=(Cash Flow / (r – g)) Cash Flow= Net Income + Depreciation – CAPEX – Change in Net Working Capital Chapter 20: Negative Cash Flow Shocks- A circumstance in which cash flows are temporarily negative for an unexpected reason. Firm will have to arrange for other financing to cover the shortfall. Positive Cash Flow Shocks- Increased expected sales often require increased short-term financing for items like marketing and production. Negative cash flow is created before the positive cash flow arrives. Seasonality- When sales are concentrated during a few months, sources and uses of cash are also likely to be seasonal. Short-term needs should be financed with short-term debt and long-term needs should be financed with long-term sources of funds. Permanent working capital- The amount that a firm must keep invested in short-term assets to support continuing operations. Temporary working capital- The difference between the actual level of investment in short-term assets and the permanent working capital investment. Aggressive Financing Policy: Financing part or all of the permanent working capital with short-term debt. Pros: lower interest rates and agency costs, Cons: funding risk of not being able to roll over the short-term debt Conservative Financing Policy: Financing short-term needs with long-term debt, Nonproductive use of cash Short-Term Financing with Bank Loans: Promissory note- Single, End of Period Payment Loan, Benchmark rate, such as prime rate or LIBOR Line of Credit: Uncommitted—availability of funds is not guaranteed, Committed—funds are guaranteed by the bank, Revolving—a committed line of credit for several years, Evergreen—revolving line of credit with no fixed maturity Bridge Loan: Short-term financing until long-term financing is arranged. Often discount loan with fixed interest rate Commitment Fees: A percentage of the unused portion of the loan charged by the bank. Loan Origination Fee: A percentage of the total loan amount charged for credit checks and legal fees. Subtracted from the proceeds of the loan. Compensating Balance Requirements: A percentage of the loan the bank requires the borrower to keep in its account at the bank. Reduces the usable proceeds of the loan. Commercial paper: Short-term, unsecured debt used by large corporations, Usually cheaper than a short-term bank loan. Minimum face value is $25,000 Most has a face value of at least $100,000. Interest on commercial paper is typically paid by selling it at an initial discount. Maximum maturity of 270 days (SEC regulations) Direct paper: Firm sells directly to investors. Dealer paper: Dealers sell to investors in exchange for a spread (or fee) for their services. The spread decreases the proceeds that the issuing firm receives, increasing the effective cost. Secured loans: Loans collateralized with short-term assets, Usually accounts receivables or inventory. Most common sources: Commercial banks, Finance companies Chapter 21: Financial Option: A contract that gives its owner the right (but not the obligation) to purchase or sell an asset at a fixed price at some future date. Call Option is an option to buy an asset Put Option is an option to sell an asset Expiration Date—the last day on which the option can be exercised. American Option—can be exercised anytime before or on the expiration date. European Option—can be exercised only on the expiration date. Option Buyer/Option Holder: Long Position Option Seller/Option Writer: Short Position Warrants—a call option, written by a company on its new stock. Exercising the option—the act of buying or selling the underlying asset via the option contract. Strike Price (exercise price)—the fixed price specified in the option contract at which the holder can buy or sell the underlying asset. Chicago Board Options Exchange (CBOE) is the largest organized options market, but options are also traded on other exchanges. All option trading takes place in terms of contracts. One contract is the right to buy or sell 100 shares. Prices, however, are quoted on a per-share basis. Stock Option Quotations: At-The-Money—option strike price is equal to the stock price. In-The-Money—payoff from exercising an option immediately is positive. For call options—stock price is above the exercise price of the call option. For put options—stock price is below the exercise price of the put option. Out-Of-The-Money—payoff from exercising an option immediately is negative. For call options—stock price is below the exercise price of the call option. For put options—stock price is above the exercise price of the put option. Open Interest—total number of contracts of a particular option that have been written and not yet closed. Prices are higher for options with the same strike price but longer expirations. Call options with strikes less than the current price are worth more than the corresponding puts. Call options with strikes greater than the current price are worth less than the corresponding puts. Option Payoffs at Expiration: Long Position in an Option Contract: When the stock price on the expiration date exceeds the strike price, the value of the call is the difference between the stock price and the strike price. When the stock price is less than the strike price at expiration, the holder will not exercise the call, so the option is worth nothing.Call Value at Expiration: Call Value = Stock Price – Strike Price, if Stock Price > Strike= 0, if Stock Price ≤ Strike Put Price at Expiration Put Value = Strike Price – Stock Price, if Stock Price < Strike = 0, if Stock Price ≥ Strike Short Position in an Option Contract: An investor holding a short position in an option has an obligation. The short position’s cash flows are the negative of the long position’s cash flows. Because an investor who is long an option can only receive money at expiration, a short investor can only pay money. Profits for Holding an Option to Expiration: Although payouts on a long position in an option contract are never negative; the profit from purchasing an option and holding it to expiration could be negative. The payout at expiration might be less than the initial cost of the option Factors Affecting Option Prices: As the strike price increases, the call price decreases and the put price increases. For a given strike price, the value of a call option increases as the stock price increases. For a given strike price, the value of a put option decreases as the stock price increases. Option Prices and the Exercise Date: For American options, the longer the time to the exercise date, the more valuable the option. A European option with a later exercise date may potentially trade for less than an otherwise identical option with an earlier exercise date. Option Prices and the Risk-Free Rate: The value of a call option increases as the risk-free rate increase because the PV of paying the strike price is lower. The value of a put option decreases as the risk-free rate increase because the PV of receiving the strike price is lower. Option Prices and Volatility: The value of an option (both put and call) increases as the volatility of the stock increases because of the higher probability of a large swing in stock price. Put-Call Parity: Protective Put: Purchasing a put option on a stock you already own Portfolio Insurance: A protective put written on a portfolio rather than a single stock Put-Call Parity: Non-Dividend-Paying Stock Consider the two different ways to construct portfolio insurance illustrated in the example: Purchase the stock and a put and a Purchase a bond and a call: Because both positions provide exactly the same payoff, the Law of One Price, requires that they must have the same price: Put-Call Parity: Stock Price + Put Price = PV(Strike Price) + Call Price For a European call option: Call Price = Put Price + Stock Price – PV(Strike Price) Types of Mergers: Horizontal merger- Target and acquirer are in the same industry Vertical merger- Target’s industry buys or sells to acquirer’s industry Conglomerate merger- Target and bidder are in different industries Most acquirers pay a substantial acquisition premium. Market Reaction to a Takeover: Most acquirers pay a substantial acquisition premium. 43% is the average premium paid over pre-merger price, 15% is the average post-announcement target firm’s stock price reaction, 1% is the average post-announcement acquirer’s stock price reaction Reasons to Acquire: Acquirer might be able to add economic value as a result of the acquisition due to synergies. Synergies: Cost reductions - Easier to achieve and elimination of redundant resources and layoffs Revenue enhancements - Potential to expand customer base or enter into new markets. Economies of scale: Savings from producing goods in high volume Economies of scope: Savings from combining the marketing and distribution of related products Vertical Integration: Merger of two companies in the same industry that make products required at different stages of the production cycle; the principle benefit is coordination. Expertise: May be more efficient to purchase a company for its talent pool that is already a functioning unit Monopoly Gains: Reduce competition within industry and increase profits, while society bears the cost so antitrust laws enacted. Limiting factor - All firms in the industry enjoy the benefits of reduced competition, but only the bidder pays the cost. Efficiency Gains: Elimination of duplication, Improvement in poor management—stockholders are more likely to sell the stock than fight to replace the CEO. Tax Savings from Operating Losses: Can’t write off a tax loss unless you have a profit elsewhere. IRS allows a carry-back of losses up to 2 years and a carry-forward of up to 20 years to offset earnings. Tax avoidance cannot be the principal reason for a takeover. Diversification: Risk reduction - Investors can achieve diversification on their own and agency costs of running a conglomerate are higher Debt capacity and borrowing costs and Liquidity Earnings growth: Merger may increase EPS without creating any additional economic value Managerial motives to merge: Conflicts of interest: Running a larger company involves greater pay and prestige. Boards tend to increase CEO’s pay along with the size of the firm, even if acquisitions perform poorly. “Hubris Hypothesis”—CEOs pursue mergers with low chance of creating value because they are overconfident in their abilities. Stock swap is positive NPV if: (A+T+S / N+X) > A / N A+T+S = Total Value of Firm N+X = Total shares of new company Where: A = premerger value of acquirer, T = premerger value of target, S = value of synergies, N= shares outstanding of acquirer premerger, x = number of shares issued in the merger. Takeover Defenses: Proxy fight: Acquirer attempts to convince target shareholders to use proxy votes to support acquirers’ candidates for election to the target board. Several strategies to stop this process: Can force a bidder to raise the bid. Can entrench management more securely. Poison Pills: Rights offering that gives existing target shareholders the right to buy shares in the target at a deeply discounted price under certain conditions. Makes it more difficult to replace bad managers, Firm’s stock price drops when poison pill is adopted, Firms with poison pills have below average financial performance Staggered Boards: Board of directors’ terms are staggered so that only one-third of the directors are up for election each year. White Knights: Target looks for a friendlier company to acquire it. White squire—a large investor agrees to purchase a large block of shares with special voting rights (without exercising them). Golden Parachutes: Lucrative severance package guaranteed to senior managers in the event that the firm is taken over and the managers are let go. Empirical evidence suggests that it is value-increasing because management is more likely to be receptive to a takeover. Recapitalization - Company changes capital structure to make itself less attractive. Getting Around the Free Rider Problem: Toeholds: An initial ownership stake in a firm that a corporate raider can use to initiate a takeover attempt. Who Gets the Value Added from a Takeover? Competition in the takeover market means that most of the benefit to the merger goes to target shareholders. If the premium is not high enough, another company will submit a higher bid. Web Chapter 3: Corporate Governance and Agency Costs: Corporate Governance: The system of controls, regulations, and incentives designed to minimize agency costs between managers and investors and prevent corporate fraud Role is to mitigate the conflict of interest that results from the separation of ownership and control Avoid unduly burdening managers with the risk of the firm. In the US, the board of directors has a clear fiduciary duty to protect the interests of the shareholders. Types of Directors Inside Directors: Employees, former employees, or family members of employees Gray Directors: Not as directly connected to the firm as insiders are, but have existing or potential business relationships with the firm Outside (Independent) Directors: Any member of a board of directors other than an inside or gray director Board Independence: The role of the independent director is really that of a watchdog, but they have less incentive to closely monitor the firm. Personal wealth is likely to be less sensitive to firm performance. Captured - a board of directors whose monitoring duties have been compromised by connections or perceived loyalties to management. Smaller boards are associated with greater firm value and performance. Also, smaller boards tend to be in younger firms that recently went public. Securities analysts produce independent valuations so that they can make buy and sell recommendations to clients. Lenders carefully monitor firms to which they are exposed as creditors. Employees are most likely to detect outright fraud because of their inside knowledge. The SEC protects the investing public against fraud and stock price manipulation. Compensation Policies: Managers’ bonuses can be based on performance metrics Stock and Options: give managers a direct incentive to increase the stock price and ties managerial wealth to the wealth of shareholders. Pay and Performance Sensitivity: The use of stock and option grants in the 1990s has led to a substantial increase in management compensation. Some negative consequences: Manipulation of news releases - Options are often granted “at the money” (exercise price is equal to current stock price) and managers have an incentive to manipulate news releases so that bad news comes out before option grants and good news comes out after options grants. Backdating - choosing the grant date retroactively, to a date when the stock price was lower than its price at the time the grant was actually awarded and executive receives a stock option that is already in-the-money. Managing Agency Conflict - greater managerial ownership is associated with fewer value-reducing actions by managers. But it also makes managers harder to fire, reducing the effect of the threat of firing. For managers with smaller ownership stakes, other incentives may be used such as compensation policies. Thus, without being able to control for other, often unobservable, characteristics of the governance system, we will not necessarily see a positive relationship between insider ownership and firm value. Direct Action by Shareholders Shareholder Voice: Any shareholder can submit a resolution that is put to a vote at the annual meeting. Recently, unhappy shareholders have started to refuse to vote to approve the slate of nominees for the board. Activist shareholders Shareholder Approval: Shareholders must approve many major actions taken by the board. For example, target shareholders must approve merger agreements. “Say-on-pay” vote Proxy Contests: Disgruntled shareholders can introduce a rival slate of directors for election to the board. This gives shareholders an actual choice between the nominees put forth by management and the current board and a completely different slate of nominees put forth by dissident shareholders. Management Entrenchment: Large investors have become interested in the balance of power between shareholders and managers The Investor Responsibility Research Center (IRRC) has collected information on 24 different characteristics that can entrench managers. The Threat of Takeover: Many of the IRRC provisions concern protection from takeovers. One motivation for a takeover can be to replace poorly performing management. An active takeover market is part of the system through which the threat of dismissal is maintained The Sarbanes-Oxley Act (SOX): The overall intent was to improve the accuracy of information given to boards and shareholders. Three main components: 1.Overhauled incentives and independence in the auditing process, 2.Stiffened penalties for providing false information, 3.Forced companies to validate their internal financial control processes. Insider Trading: Occurs when a person makes a trade based on privileged information. Penalties for violating insider trading laws include jail time, fines, and civil penalties. The Tradeoff of Corporate Governance: Corporate governance is a system of checks and balances that trades off costs and benefits. No one structure works for all firms. Good governance is value enhancing and is something investors in the firm should strive for.