AEM2241 Final

implications of the time value of money

1. accelerate cash inflows 2. defer cash outflows if possible

discount factor

1/(1+r)^t, the rate used in calculating present value

stock option quotations

1973- chicago board of options exchange, open and began organized trading in stock options. put and call options involving stock in some of the best known corporations in the US are traded here. also traded in NYSE and NASDAQ, almost all such options are american. one option contract involves the right to buy, for a call option or sell for a put option. 100 shares of stock and all trading actually takes place in contracts. option prices are quoted on a per share basis

annual percentage rate

= the interest rate per period multiplied by the number of periods in a year

defensive merger

a target company combines with another organization that would create antitrust or other regulatory problems if the original, unwanted takeover proposal was consummated

tender offers

an offer to buy all or part of the stock of a given firm, over a stated period, usually for the purpose of taking the firm over.

two tier tender offer

an offer to buy part of a target firm's stock at a stated price, often in cash, and the balance in a different transaction that may be less attractive to the target company stockholders, such as an exchange for securities of the tenderer

lock up

an option granted to a friendly suitor giving it the right to purchase stock or some of the assets of a target firm at a fixed price in the event of an unfriendly takeover.

Bankruptcy costs

as the debt/equity ratio rises, so too does the probability that the firm will be unable to pay its bondholders what was promised to them. When this happens, ownership of the firm's assets ultimately are transferred from stockholders to bondholders. A firm becomes bankrupt when the value of its assets equals the value of its debt. this makes the value of equity zero and stockholders turn over control to bondholders. when this takes place, the bondholders hold assets whose value is exactly equal to what is owed on the debt. in a perfect world, there are no costs associated with this transfer of ownership and the bondholder's don't lose anything. it is expensive to go bankrupt= costs associated with bankruptcy many eventually offset the tax related gains from leverage.

strategic options

companies sometimes undertake new projects just to explore possibilities and evaluate potential future business strategies. such projects are difficult to analyze using conventional DCF methods because most of the benefits come in the form of strategic options- options for future related business moves, projects that create such opportunities maybe very valuable but that value is difficult to measure.

acquisition of assets

firm can affectively acquire another firm by buying most of all of your assets. this accomplishes the same thing as buying the company. the target firm will not necessarily cease to exist, it will just be sold off by its assets. the shell will exist unless its stockholders choose to dissolve it. requires a formal vote of the shareholders of the selling firm. there is not problem with minority shareholders holding out. acquisition of assets may involve transferring titles to individual assets. legal process of transforming assets can be costly.

capital restructuring

firm can choose any capital structure it wants, decisions that alter the firm's existing capital structure, take place whenever the firm substitutes one capital structure for another while leaving the firm's assets unchanged will change the capital structure of the firm with no direct effect on the firm's assets the change in the value of the firm is the same as the net effect on stockholders. financial managers can therefore try to find the capital structure that maximizes the value of the firm. change in the value of the overall firm is the NPV of a re-structuring

Rule of 72

for reasonable rates of return, the time it takes to double your money is given approximately by 72/r% this rule is fairly accurate for discount rates in the 5-20% range.

put warrant

from company, a put option issued by a company on its own common stock. when the put warrant is exercised, the issuing company must buy its own common stock from the exercising put warrant holder. effectively a share repurchase

the hemline effect

hemline is up, the market is up the hemline is down, the market is down

exercise price

higher the exercise price, E, the less the call is worth, the exercise price is what we have to pay to get the stock

old debt and debt additions/reductions

if a firm has debt outstanding and then issues new debt or retires some of the old debt, the valuation principles are the same but care has to be taken to apply them correctly, ignore investor taxes VL'= VL +Value in -Value out +TcB value in and value out refer to non tax related cash or other assets coming into or going out of the firm. to estimate the share price, simply divide SL by the number of shares outstanding after the transaction, N +DeltaN. if all the additional debt proceeds are used to pay a cash dividend, then change in N=0, if the additional debt proceeds are used to repurchase shares, then change in N is less than 0 when you reduce debt, you diminish shareholder value

time to expiration

longer the time to expiration, the bigger t is, the more the option is worth. once again, this is obvious, because the option gives us the right to buy for a fixed length of time, its value goes up as that length of time increases.

volume effects

low volume winners become high volume winners become high volume losers become low volume losers

complementary resources

making better use of existing resources or to provide the missing ingredients to success

the investment timing decision

management must decide whether to may an investment outlay to acquire new assets for a project. managers have the right, not the obligation to pay some fixed amount, the initial investment and thereby acquire a real asset for the project identify and analyze the relevant cash flows and assess the NPV of the proposal. if the NPV is positive, you would recommend taking the project, where taking the project amounts to exercising the option. two or more investments are said to be mutually exclusive if we can only take one of them. just because a project has a positive NPV, doesn't mean we should take it today, if we take a project today, we can;t take it later. almost all projects compete with themselves in time. we have to compare the NPV of taking the project now vs. taking it later. deciding when to take a project is called the investment decision. the value of the option to wait is the extra value created by deferring the start of the project as opposed to taking it today. just because a project has a negative NPV today doesn't mean we should permanently reject it. as long as there is some possible future scenarios under which a project has a positive NPV, then the option to wait is valuable, and we should just shelve the proposal for now

forward contract

money doesn't change hands until delivery month a forward contract is a contract conveying the obligation to buy or sell an asset at a fixed price, the forward price, at some future date. cash is exchanged only at the future date. the party short the forward contract delivers the commodity and the party long the contract pays the forward price. they settle up in cash.. if the price is up, the long side wins, down short side wins.

return on equity

net income/ total equity

the cost of an acquisition

net incremental gain from a merger: deltaV= Vab- (Va+Vb) the firm value of B to Firm A, V*b, IS: V*b=Vb + deltaV NPV of the merger is: NPV= V*B- cost to firm A of acquisition merger premium- the amount paid above the stand alone value

market power

one firm may acquire another firm to increase its market share and market power. in such mergers, profits can be enhanced though higher prices and reduced competition for customers antitrust could be looked at

expiration date

option usually has a limited life. option is said to expire at the end of its life. the last day on which the option may be exercised is called the expiration date

futures options

options on futures contracts

caveat

price fluctuations can be good or bad depending on which way they go. if we hedge with forward contracts, we eliminate the risk associated with an adverse price change. we also eliminate the potential gain from a favorable move

exercise/strike price

purchaser of a call option pays for the right, but not the obligation to buy an asset for a fixed time at a fixed price. the purchaser of a put option pays for the right to sell an asset for a fixed time at a fixed price. the fixed price is called the exercise or strike price

the purchase method

requires that assets of the target firm be reported at their fair market value on the books of the bidder. with this method, an asset called good will is created for accounting purposes. good will is the difference between the purchase price and the estimated fair market value of the net assets (assets less liability acquired) pre 2001 guidelines required firms to amortize goodwill, meaning that a portion of it was deducted as an expense every year over time. the good will, like any asset, had to be depreciated until it was completely written off in 2001, FASB eliminated the requirement that goodwill be amortized and put in place a new rule. in essence, the new rule says that each year, the firm has to assess the value of good will on its balance sheets. if the value has gone down, the firm must decide the difference, otherwise, no amortization is required

fair price provision

requiring a bidder to pay the same price to all shareholders, this raises the stakes and discourages tender offers designed to attract only those shareholders most eager to replace management.

value of a call option at expiration

s= stock price at expiration S0= stock price today C= value of the call option on the expiration date C0= value of the call option today E= exercise price on the option if the stock price (S) ends up below the exercise price (E) on the expiration date, then the call option is worth zero. C1= 0 if S<E this is the case in which the option is out of the money when it expires if the option finishes in the money, then S1>E and the value of the option at expiration is equal to the difference. C1= S1-E if S1>E or C1= S1-E if S1-E>0 for every stock price less than e, the value of the option is zero. for every stock price greater than E, the value of the call option is S1-E. once the stock price exceeds the exercise price, the option's value goes up dollar for dollar with the stock price.

credit default swaps

sheet of paper- right to future cash flows. if the bond issuer makes payments- you get 0 dollars from the credit default swap seller the they miss payments you get >$0 the buyers are bond buyers and speculators. like buying insurance they get paid if they default.

long straddle

simultaneously buying a call and a put on the same stock you win if the stock price moves a lot in either direction you are better on volatility you might expect a big move but you don't know which way

dual class capitalization

some firms have more than one class of common stock and that voting power is typically concentrated in a class or stock not held by the public. such a capital structure means that an unfriendly bidder will not succeed in gaining control

the swap dealer

swap contracts are not traded on organized exchanged. they are not sufficiently standardized. swap dealer plays a key role. in the absence of a swap dealer, a firm that wished to enter into a swap would have to track down another firm that wanted the opposite end of the deal. this search would be expensive and time consuming. a firm wishing to enter into a swap contract contacts a swap dealer and the swap dealer takes the other side of the agreement. swap dealer with then try to find an offsetting transaction with some other party or parties. failing this, a swap dealer will hedge its exposure using futures contracts. commercial banks are the dominant swap dealers in the US total collections of contracts in which a dealer is involved is called the swap book. the dealer will ry to keep a balanced book to limit its net exposure, a balanced book is often called a matched book. swap dealer's book is perfectly balanced in terms of risk and has no exposure to interest rate volatility. One company pays a fixed payment for a floating payment while the other changes a floating payment for a fixed one. swap dealer acts as an intermediary and profits from the spread between the rate it charges and the rate it receives

(1+R)^t

the future value fact for $1 invested at r percent for t periods

larger

the more you compound, shorter intervals, EARs do keep getting _____ but the differences get very small

is not

the static model (is/is not) capable of identifying a precise optimal capital structure.

the traditional position

the traditional position is that the weighted average cost of capital can be minimized because for moderate amounts of debt, the cost of equity does not rise fast enough to offset the advantage of cheap debt. for large amounts of debt, the cost of equity gets very high, offsetting debt's advantage and causing WACC to increase x variable is the fraction of debt on the right hand side of the balance sheet there is a capital structure where WACC is minimized, fraction of debt is between 0 and 1, where WACC is minimized one argument in support of the traditional position relies on the existence of market imperfections whereby firms can borrow more cheaply than individuals due to economies of scale for any debt to capital ratio, b/b+s, why is the cost of equity, ke, higher than the cost of debt ki because the equity is more risky- bondholders get paid first. debt is senior to equity so equity is riskier and stockholders require a higher return. why does the cost of debt ki increase as the leverage ratio increases from 0 to 1? the more debt a company has, it is riskier because they will have more debt to pay back, they demand more return for that risk why does the cost of equity (ke) increase as the leverage ratio increases from 0 to 1 risk- the more debt less equity stockholders are pushed further back in line behind all those bondholders. they demand compensation for this risk. when l equals "0" why does the WACC= ke if there is no debt, the WACCat is just the cost of equity, there would no no weight on equity. when l equals 1, why does WACCat= (1-tc)(ki) if l=1, there is no equity, it is all debt, the aacc must be the cost of debt, equity would have a weight of 0. why does the wacc curve initially go down as we go from no debt to some debt when you go from left to right on x axis, debt for equity transaction, debt goes up, equity goes down, issuing debt but buying back shares, more debt is costing the firm less than the equity costs (ke curve is higher than ki), more of the lower cost security and less of the higher cost security in the context of the traditional position, why does the WACCat curve bottom out and then start increasing for modest amounts of debt, equity gets riskier but not too risky and they don't demand too much extra return. then, when there is a lot of debt they start demanding a much higher return and this pulls aacc UP. stockholders perception at some point is that stock gets very risky and they want a much higher return still substituting cheap debt but there is even more cost. the new debt means you have remaining equity that is more expensive, more expensive remaining equity no longer offsets the cheap debt. explicit coupon and higher cost of equity, all of it gets so expensive and this pulls up WACC in the context of the traditional position, what are the implications of this bottoming out for the firm's capital structure decision? this is the optimum and management should seek to go to that fraction of debt financing on right hand side of balance sheet. does the traditional position suggest that there's an optimal capital structure? if so, does the theory tell us what the optimal capital structure is? yes theres an optimal, theory doesn't tell us what the optimal is why is the cost of equity ke for an all equity firm the same as the before tax cost cost of debt for an all debt firm if the firm is all equity, it is all stockholders and they bear all the risk. with the before tax, the bondholders bear all the risk, it is the same risk and same assets and a question of who has financed these assets. required that the two should be the same the bondholders get all the current and future cash flows from assets= all debt firm. what kinds of firms can prudently take on more debt and thus have larger debt to capital ratios people that have lots of assets and low liabilities, someone who does not have a good net work but they have a decent income/salary bank will want to see pay stubs and tax returns the context of this course, 100% debt is an economic concept, not a legal concept, what does 100% debt mean in an economic sense? the bondholders get all the current and future cash flows from assets= all debt firm the amount of financial risk (leverage) that a firm takes on should be inversely proportional to the firm's business risk, stable cash flows= less risky, more business risk, you should not take on as much debt, variable cash flows= risky, probably should not take on a lot of debt the full cost of debt-interest and also what it does to the cost of equity- more debt makes all of our equity more expensive.

currency swaps

two parties agree to exchange a specific amount of one currency for a specific amount of another at some point in the future. each firm obtains the best possible rate and then arranges to eliminate exposure to exchange rate changes by agreeing to exchange currencies, a neat solution.

growth vs. value stocks

value stocks have, over the long term, outperformed growth stocks. small cap stocks tend to outperform large cap stocks

technical insolvency

when a firm is unable to meet its financial obligations

the tiger effect

when tiger woods was playing in the PGA tournament in the continental U.S. on wednesday before tournament, market is up

applications of capital structure theory

1. maximization of shareholder value by issuing debt to reduce the corporate tax bill 2. issuing debt to finance share repurchases 3. mergers and acquisitions -available debt capacity may be a source of value for the raider -the issuance of debt by current management may help deter a raider 4. leveraged buyouts and management buyouts 5. exchange offers (issue debt in exchange for outstanding equity)

target capital structure

A particular debt-to-equity ratio represents the optimal capital structure if it results in the lowest possible WACC

futures exchanges

Chicago Board of Trade (CBT) Chicago mercantile exchange (CME) London international financial futures and options exchange. (LIFFE) NYMEX- New York Mercantile Exchange Open Interest- number of contracts outstanding at the end of the day.

break even point or the indifference point

EPS is exactly the same for both capital structures, find the EBIT where the two structures are the same. if EBIT is above this level, the leverage is beneficial, it is is below, it is not the firm earns a return that is just sufficient to pay the interest. the effect of financial leverage depend's on the company's EBIT. When EBIT is relatively high, leverage is beneficial. under the expected scenario, leverage increases returns to shareholders, as measured by both ROE and EPS. shareholders are exposed to more risk under the proposed capital structure because the EPS and ROE are much more sensitive to changes in EBIT in this case. Because of the impact that financial leverage has on both the expected return to stockholders and the riskiness of stock, capital structure is an important consideration

marketing gains

M&A can produce operating cost reductions form improved marketing previously ineffective media and programming and advertising efforts, a weak existing distribution network, an unbalanced product mix.

basic present value equation

PV= FVt/(1+r)^T given any three of these four factors, you can find the fourth.

capital structure summary

Traditional- 0<debt to capital <100 mm w/o corporate taxes- one capital structure is as good as any other mm w/ corp taxes- go to 100% debt financing mm w/ corporate taxes, bankruptcy costs and agency costs- <100% debt financing even in the absence of bankruptcy costs and agency costs, is there a reason to use much less than 99.99 debt financing? the debt should be lower than the cash flow in a bad year. EBIT isn't constant, it fluctuates, you only want to go to the part of the debt that you still have enough cash flow to service the debt

enterprise value

VL= B+P+S enterprise value= b-nonoperating assets +p+s= theoretical takeover cost. =Vl-nonoperating assets

convertible bonds

a bond with warrants can be separated into distinct securities ( a bond and some warrants) but a convertible bond cannot. a convertible bond gives the holder the right to exchange the bond for a fixed number of shares of stock anytime up to and including the maturity date of the bond. preferred stock can frequently be converted into common stock. a convertible preferred stock is the same as a convertible bond except that is has an infinite maturity date

Time value of money

a dollar in hand today is worth more than a dollar promised at some time in the future

targeted repurchase

a firm buys a certain amount of its own stock from an individual investor, usually at a substantial premium. these premiums can be thought of as payments to potential bidders to eliminate unfriendly takeover attempts. critics of such payments view them as bribes and label them greenmail

split up

a firm separates into several parts, distributes each part to its shareholders and ceases existence.

ordinary annuity

a series of constant or level cash flows that occur at the end of each period for some fixed number of periods

call provision on a bond

allows a corporation to buy the bonds at a fixed price for a fixed period of time. has a call option on the bonds, cost of the call feature is the cost of the option. convertible bands are almost always callable. makes it a package of three securities- straight bond, a call option held by the bondholders, conversion feature, and a call option held by the corporation, call provision

shark repellent

any tactic designed to discourage unwanted merger offers

standstill agreements

are contracts wherein the bidding firm agrees to limit its holdings in the target firm. these agreements usually lead to the end of a takeover attempt often occur at the same time that a target repurchase is arranged

put price

at expiration, the price of an american and european put option is the larger of 0 and the difference between the exercise price and the stock price

call price

at expiration, the price of an american, and european call option is the larger of $0 and the difference between the stock price and the exercise price. if you have a stock price above the exercise price you should exercise. ignore sunk costs such as transaction costs.

discounted cash flow valuation

calculating the present value of a future cash flow to determine its worth today

financial engineering

create a way to hedge a risk by using available financial instruments to create new ones

spin off

divestiture that results in a subsidiary or division becoming an independent company. in a traditional spin off, shares in the new entity are distributed to the parent corporation's shareholders of record on a pro rata basis.

(future value factor- 1)/r

future value factor for an annuity

call option

gives the owner the right to buy an asset at a fixed price during a particular time period. gives you the right to call in an asset

option pay off profiles

horizontal axis shows the difference between the asset's value and the strike price on the option. as illustrated, if the price of the underlying asset rises above the strike price, then the overrun of the option will exercise the option and enjoy a profit. if the value of the asset falls below the strike price, the owner of the option will not exercise it, notice that this payoff does not consider the premium the buyer paid for the option. a call option is zero sum game so the seller's pay off profile is exactly the opposite the buyer's put options, if the asset's value falls below the strike price, then the buyer profits because the seller of the put must pay the strike. seller of the put option loses when the price falls below the strike price

option to expand

if we find a truly positive NPV project, this is a consideration because we ignore the option to expand in our analysis, we underestimate NPV

exchange offers

in an exchange offer, a company offers to exchange one corporate security for another. for instance, the company may offer to take back some common stock in exchange for some new debt. or for another example, the company may offer to take back some debt for newly issued preferred. the same valuation principles discussed earlier apply when a firm does an exchange offer

M&M propositions 1 and 2 with corporate taxes

interest paid on debt is tax deductible. this is good for the firm and it may be an added benefit of debt financing second, failure to meet debt obligations can result in bankruptcy. this is not good for the firm and it may be an added cost of debt financing

debt is risky

interest rate is higher, this exceeds the risk free rate, because debt is now risky

the pay off profile

is a plot showing the gains and losses on a contract that result from unexpected price changes.

annuity

is a series of equal cash flows received in consecutive periods

annuity due

is an annuity for which the cash flows occur at the beginning of each period. if you assume ordinary annuity, you discount by one period too many. therefore, you can multiply by (1+r) to get the right value Annuity due value= ordinary annuity x (1+r)

a supermajority provision

might increase from a simple majority to two thirds or three fourths the shareholder vote required to ratify a takeover by an outsider

the world cup soccer effect

most investors act irrationally when their favorite sports team loses to isolate the role that mood plays in investing, the researchers analyzed the returns of a given country's stock markets immediately following losses of its national teams in international competition. they focused primarily on soccer matches in the world cup, but they also studied crick, rugby and basketball matches as well. the researchers found, on average, that if a country's team loses in the world cup elimination stage, the stock market the next day produces a reduce that is 38 basis points lower than normal. to be sure, 38 basis points might not seem like that big of a deal, but from a statistical point of view it is huge, it is equalivsant to annualized losses of more than 60%

defensive measures

park common stock with a friendly investor increase management's ownership of common stock start an employee stock ownership plan since trustees are generally more loyal to management buy shares from unfriendly investor issue common with no voting rights or limited voting rights incorporate in states with laws less favorable to potential raiders right the parties helping a raider finance the raid- drexel sue a raider turn the public relations effort against a raider

the hart scott radian anti trust improvements act of 1976

pre merger notification of the justice department and the federal trade commission FTC is required if merging firms meet size criteria. Justice and the FTC can stop a merger before it is consummated. applies if: one company has assets or sales of more than 100 million and the second company has assets or sales of more than 10 million a raider must wait 15 days after notifying the justice department and the ftc before making a tender offer the raider must wait 30 days after notifying the justice department and the ftc before consummating the merger. the 30 days may be extended to 50 days by the justice or the FTC any merger in violation of the previous conditions is illegal and the merging firms may face penalties. the target firm must tell its stockholders its position regarding a tender offer within 10 business days. a raider must reveal its source of funds and what it plans to do with the target if the raid is successful

future value

refers to the amount of money an investment will grow over some period of time at some given interest rate, cash value of an investment at some time in the future

the stock price

since a call option or warrant gives its holder the option to purchase a share of stock at a fixed price, the call or warrant is more valuable the higher the price of the underlying stock. since a put option gives its holder the option to sell a share of stock at a fixed price, the put is more valuable the lower the price of the underlying stock.

the sunshine effect

sunshine is positively correlated with daily stock returns

taxes

tax benefits from leverage is important only to firms that are in a tax paying position. firms with substantial accumulated losses will get little value from the interest tax shield. further, firms that have substantial tax shields from other sources such as depreciation, will get less benefit from leverage. also, not all firms have the same tax rate. the higher the tax rate, the greater the incentive to borrow.

the option to suspend or contract operations

temporary shut down of an activity of some sort. companies also sometimes choose to permanently scale back an activity this is called the option to contract

exercising the option

the act of buying or selling the underlying asset via the option contract

pure discount loan

the borrower receives money today and repays a single lump sum at some time in the future

merger

the complete absorption of one firm by another. the acquiring firm retains its name and its identity, and it acquires all the assets and liabilities of the acquired firm. after the merger, the acquired firm ceases to exist as a separate business entity.

cash acquisition (merger)

the cost of an acquisition when cash is used if just the cash itself. NPV of cash acquisition is: NPV= V*B- cost The value of firm A after the merger is: Vab= VA + (V*B-cost)

forward price or futures price

the forward price and the futures price of a commodity or financial instrument are prices agreed upon today for delivery of a commodity or financial instrument at some time in the future. the forward price and the futures price of an asset need not be equal. money and the commodity do not change hands until some point in the future. price is negotiated now. you don't want to worry about the uncertainty of what the price will be.

futures pricing and types of contracts

the futures contract specifies the underlying asset, the delivery month and acceptable delivery locations. the initial value of the contract is set at zero and the futures price is agreed upon to equate supply and demand for the product

momentum strategies

the price momentum phenomenon is quire robust. it makes little difference whether you form portfolios on the basis of returns over 3,6,9, or 12 months system of buying stocks or other securities that have had high returns over the past three to twelve months, and selling those that have had poor returns over the same period

compounding

the process of leaving your money and any accumulated interest in an investment for more than one period, thereby re-investing the interest means earning interest on interest (compound interest)

stated rate

the rate that is quoted

effective annual rate

the rate you will actually earn compounding during the year can lead to a significant difference between the quoted rate and the effective rate. EAR= (1+quoted rate/m)^m - 1 an annual percentage yield is an ear

proof of annuity of PV

the time 0 present value of a $1 N-period annuity starting at time 1 can be expressed as: the time 0 present value of a $1 perpetuity starting a time 1 minus the time 0 present value of a $1 perpetuity starting at time N+1

lower taxes

the use of tax losses 2. use of unused debt capacity 3. use of surplus funds 4. the ability to write up the value of depreciable assets

economies of vertical integration

vertical acquisitions make it easier to coordinate closely related operating activities. technology transfer is another reason for vertical integration a company will decide that the cheapest and fastest way to acquire another firm's technological skills is to simply buy the firm.

personal finance

what defines the best mutual funds is usually the one's with the lowest expense rations. the investor gets what he doesn't pay for. picking individual stocks- probably is not appropriate for most people but if you do, pick assets that tell castles in the air. credit reports and fico scores- WNW annual credit report, equinox, experian, fico score- 300-850, 723 median step 1: 3-12 months of energy cash, in a checking account, savings account, money market account, CD's REITs- hedge against inflation

implications of the pecking order

1. no target capital structure- no optimal debt/equity ratio, capital structure is determined by its need for external financing, which dictates the amount of debt that the firm will have 2. profitable firms use less debt- because profitable firms have more internal cash flow, they will need less external financing and will have much less debt 3. companies will want financial slack- to avoid selling new equity, companies will want to stock pile internal generated cash. such a cash reserve is known as financial slack, gives management the ability to finance programs as they appear and to do so more quickly if necessary pecking order theory is more concerned with the shorter run, tactical issue of raising external funds to finance investments

assumptions needed for present and future value

1. nominal interest rates (rates which are not adjusted for inflation) are positive and 2. an investor prefers more wealth to less

sequence of events for bankruptcy liquidation

1. petition is filed under a federal court. corporations may file a voluntary petition or involuntary petition may be filed against the corporation by several of its creditors. 2. trustee in bankruptcy is elected by creditors to take over the assets of the debt corporation. the truce will attempt to liquidate the assets. 3. when the assets are liquidated, after payment of the bankruptcy administrative costs, provides were distributed to creditors 4. if any proceeds remain, after expenses and payments to creditors, they are distributed to shareholders. distribution of the proceeds of the liquidation occurs according to the following priority list 1. administrative expenses associated with bankruptcy. 2. other expenses after the filing of the bankruptcy petitions but before appointment of the trustee 3. wages, salaries, commissions 4. contributions to employee benefit plans 5. consumer claims 6. government tax claims 7. payment to unsecured creditors 8. payment to preferred stockholders 9. payment to common stockholders

three forms of market efficient theory

1. prices reflect all information contained in the record of past prices. this is called weak form efficiency. the random walk research shows that the market is the least efficient in the weak sense. 2. the second level of efficiency is the case in which prices reflect not only past prices but all other published information. this is called semi strong form of efficiency, researchers have tested this by looking at specific items of news such as announcements of earnings and dividends, forecasts of company earnings, changes in accounting principles and practices, and mergers. most of this information was rapidly and accurately impounded in the price of the stock. 3. a strong form of efficiency in which prices reflect not just public information but all information that can be acquired by painstaking fundamental analysis of the company and the economy. in such a case, the stock market would be like our ideal action house: prices would always be fair and no investor would be able to make consistently superior forecasts of stock prices. most tests of this view have involved an analysis of performance of professionally managed portfolios. these studies have concluded that, after taking account of differences in risk, no group of institutions has been able to outperform the market consistently and that even the differences between the performance of individual funds are no greater than you would expect from chance.

accounting for acquisitions

2001- FASB determined that the buyer had to treat all acquisitions under the purchase accounting method. prior to 2001, firms were allowed to choose from more than one method

M&M proposition 2

Although changing the capital structure of the firm does not change the firm's total value, it does cause important changes in the firm's debt and equity. examine whether returns to a firm financed with debt and equity when the debt-equity ratio is changed (ignore taxes) WACC= (E/V) x Re + (D/V) x Rd V= E+D we also saw that one way of interpreting the WACC is as the required return on the firm's overall assets. to remind us of this, we will use the symbol RA to stand for the WACC and write: RA= (E/V) x Re + (D/V) x Rd if we re-arrange this to solve for the cost of equity capital, we see that Re= Ra + (Ra-Rd) x D/E this is the famous M&M proposition 2, which tells us that the cost of equity depends on 3 things: the required rate of return on the firm's assets (Ra), the firm's cost of debt, Rd, and the firm's debt/equity ratio. the cost of equity, Re, is given by a straight line with a slope of Ra-Rd. the y intercept corresponds to a firm with debt equity ratio of 0, so Ra=Re in that case. as the firm raises its debt-equity ratio, the increase in leverage raises the risk of the equity and therefore the required cost of equity. the WACC doesn't depend on the debt/equity ratio. it is the same no matter what the debt/equity ratio is. M&M proposition 1: the firm's overall cost of capital is unaffected by its capital structure, the cost of debt is lower then the cost of equity is exactly offsetting the increase in the cost of equity from borrowing. in other words, the change in the capital structure weights (E/V and D/V) is exactly offset by the change in the cost of equity Re so the WACC stay the same

continous compounding

EAR depends on compounding freqencu EAR with continuous compounding is.. EAR= e^q - 1 we can just calculate the present and future values directly. in particularly, FV of $1 for t periods at a continuously compounded rate of R per period is simply FV= $1 x e^RT pV of $1 TO BE received in t periods at a continuously compounded: PV= $1 X E^-RT if we assume that r is the continuously compounded RF rate per year, then one could write this up as: S+P= Ex e^-rt +c supposed we are given an ear and we need to convert it to a continuously compounded rate: EAR= e^q -1 Ln(e^q) = q

ESO repricing

ESOs are almost always at the money when they are issued. stock price is equal to exercise price. the intrinsic value is zero, so there is no value from immediate exercise. ESO is still valuable because of its very long life. if the stock fall significantly after an EDO is granted, then the option is said to be underwater. on occasion, a company will decide to lower the strike price on underwater options such options are said to be re-strick or repriced. repricing ESOs is controversial ESO becomes deeply out of the money, it loses its incentive value because EEs recognize that there is only a small chance that the option will finish in the money. employees may leave and join other companies where they receive a fresh options grant. critics say that a lowered strike price is a reward for failing. if employees know that options will be repriced, then much of the incentive effect is lost. because of this, many companies do not reprice options or have voted against repricing options. some well known companies have been labeled, "serial repricers" such companies routinely drop strike prices following strike price declines. an option exchange is a variation on repricing. underwater ESOs are exchanged for a smaller number of new ESOs with a lower exercise price, although this is not always the case. frequently, option exchanges, are structured such that the value of the new options is approximately equal to that of the old ones, in essence a large number of underwater options are exchange for a smaller number of at the money options.. today, many companies award options on a regular basis so that employees will always have at least some options that are near the money, even if others are underwater. regular grants ensure that employees have vested options which gives them an incentive to stay with their current employer rather than forfeit potentially valuable options.

bankruptcy reorganization

Federal Bankruptcy Reform Act of 1978- Ch. 11 general objective of a proceeding under chapter 11 is to plan to restructure the corporation with some provision for repayment of creditors. 1. sequence of events 1. a voluntary petition can be filed by the corporation or an involuntary petition filed by creditors 2. federal judge either approves or denies the petition, if approved, at time for filing proofs of claims is set. 3. in most cases, the debtor, the corporation continues to run the business. 4. the corporation plus sometimes creditors submits a reorganization plan 5. creditors and shareholders are divided into classes. a class of creditors accepts the plan if a majority of the class agrees to the plan. 6. after acceptance by its creditors, the plan is confirmed by the court 7. payments in cash, property and securities are made to creditors and shareholders. plan may provide for the issuance of new securities. 8. for some fixed length of time, the firm operates according to the pressures of the re-organization plan. corporation may wish to allow the old stockholders to retain some participation in the firm. pre-packaged bankruptcies- corporation seeks the necessary approval of a bankruptcy, plan from a majority of its creditors first and then files for bankruptcy. the company entered bankruptcy and re-emerges almost immediately. in some cases, the bankruptcy procedure is needed to involve the cram down power of the bankruptcy court. under certain circumstances, a class of creditors can be forced to accept a bankruptcy plan even if they vote not to approve it- thus the description cram down

the three models in perspective

With no taxes or bankruptcy costs, the value of the firm and WACC are not affected by capital structures. With corporate taxes, and no bankruptcy costs, value of the firm increases and the WACC decreases as the amount of debt goes up. Firm's value critically depends on debt policy, the more the firm borrows, the more it is worth. this happens because interest payments are tax deductible and the gain in firm value is just equal to the PV of the interest tax shield. WACC declines as the firm uses more and more debt financing. as the firm increases its financial leverage, cost of equity does increases, but this increase is more than offset by tax benefits associated with debt financing. as a result, the firm's overall cost of capital declines with corporate taxes and bankruptcy costs, the value of the firm VL reaches a maximum at D*, the point representing the optimal amount of borrowing. the firm's value is reduced by the present value of the potential future bankruptcy costs. these costs grow as the firm borrows more and more and they eventually overwhelm the tax advantage of debt financing. optimal capital structure occurs at the point at which the tax saying from an additional dollar in debt financing is exactly balanced by the increased bankruptcy costs associated with the additional borrowing. at this level of debt financing, the lowest possible WACC occurs. at the same time, the WACC is minimized by D*/E*

interest rate caps

a call option on an interest rate if the loan payment ever rises above an agreed upon limit/ceiling, the bank will pay the difference between the actual payment and the ceiling to the firm in cash floor- a put option on an interest rate- if a firm buys a cap and sells a floor, it is called a collar. by selling the put and buying the call, the firm protects itself against increases in the interest rates beyond the ceiling by the cap. however, if interest rates drop between the floor, the put will be exercised against the fir. the result is that the rate the firm pays will not drop below the floor rate, the rate will always be between the floor and the ceiling swaptions- options on a swap compound options- options on options caption- option on a cap

employee stock options

a call option that a firm gives to employees giving them the right to buy shares of stock in the company ESO are basically call options typically has a 10 year life, which is longer than most ordinary options. ESOs cannot be sold. they also have what is know as a vesting period- often for up to three years or so, an EDO cannot be exercised and also must be forfeited if an EE leaves the company. after this period,the options vest, which means they can be exercised. sometimes, employees who resign with vested opines are given a limited time to vest their options. shareholders face the basic problem of aligning shareholder and management interests and also of providing incentives for employees to focus on corporate goals. they are a powerful motivator because, as we have seen, the payoffs on options can be very large. high level executives in general stand to gain enormous wealth if they are successful in creating value for stockholders. ESO has no immediate up front out of pocket cost to the employer. in smaller companies, they are a substitute for ordinary wages. Is are willing to accept them instead of cash, hoping for big payoffs in the future. ESOs are a major recruiting tool, allowing business to attract talent that they otherwise could not afford

takeover

a change in the controlling interest of a corporation. may be a friendly acquisition or an unfriendly bid the target company might fight with shark repellent techniques. a hostile takeover aiming to replace existing management is usually attempted through a public tender offer. other approaches might be unsolicited merger proposals to directors, accumulations of shares in the open market, or proxy fights that seek to install new directors.

cost reductions

a combined firm may operate more efficiently than two separate firms. a firm can allow greater operating efficiency in several different ways through a merger or acquisition

option

a contract that gives its owner the right to buy or sell some asset at a fixed price on or before a given date they give the buyer the right, not the obligation, to do something. the buyer used the option only if it is profitable to do so. otherwise, the option can be thrown away.

warrants

a corporate security that looks like a call option. gives the holder the right, not the obligation to buy shares of common stock directly from a company at a fixed price for a given time period. each one specifies the number of shares of stock the holder can buy, the exercise price and the expiration date. warrants usually have much longer maturity periods however. some are perpetual and have no fixed expiration date. warrants are often called sweeteners or equity kicks because they are issued in combination with privately placed loans or bonds. throwing in some warrants is a way of making the deal more attractive to the lender and it is a common practice. warrants are often attached to bonds when issued. the loan agreement will state whether the warrants are detachable from the bond. usually, the warrant can be detached immediately and sold by the holder as a separate security.

derivative securities

a financial asset that represents a claim to another asset, financial engineering frequently involves creating new derivative securities, or else combining existing derivatives to accomplish specific hedging goals. to effectively manage financial risk, financial managers need to identify the types of price fluctuations that have the greatest impact on the value of the firm.

the optimal capital structure

a firm will borrow because the interest tax shield is available and valuable. at relatively low debt levels, the probability of bankruptcy and financial distress is low and the benefit from debt outweighs the cost at very high debt levels, the possibility of financial distress is a chronic, ongoing problem for the firm, so the benefit from debt financing may be more than offset by the financial distress costs. Optimal capital structure exists somewhere in between these two extremes

capital structure decision

a firm's choice of how much debt it should have relative to equity is known as a capital structure decision, decisions about a firm's debt-to-equity ratio choose the course of action that maximizes the value of a share of stock/maximizes the value of the whole firm

economic exposure

a firm's exposure to LR financial risks because a firm's LT exposure is rooted in fundamental economic forces, it is much more difficult if not impossible to hedge on a permanent basis price fluctuations can also be longer run, more permanent changes. the result from fundamental shifts in the underlying economics of a business in the long run, either a business is economically viable or it will fail. no amount of hedging can change this. nonetheless, by hedging over the short term, a firm gives itself time to adjust to operations and thereby adapt to new conditions without expensive disruptions. managing financial risks accomplishes two things 1. firm insulates itself from otherwise troublesome transitory price fluctuations 2. the firm gives time little breathing room to adapt to fundamental changes in market conditions

futures contract

a futures contract is a contract conveying the obligation to buy or sell property at a fixed price (the futures price) at some point in the future 1. the seller of the futures contract decides which day during the delivery month to deliver the assets. 2. the purchaser of a futures contract, who has a long position, agreees to buy the asset at the futures price during the delivery month. the seller of the futures contract, who has a short position, agrees to sell the asset at the futures price during the delivery month. both the buyer and the seller of a futures contract must open margin accounts with their broker and deposit money to ensure that they can fulfill their contractual obligations. gains and losses are added to margin accounts daily. the seller's broker might request that the seller add more money to the seller's margin account. brokers request you to put a small amount of money in an account as good faith deposit, in case you lose so you have money in the margin account. guarantees integrity of contract. no money changes and when you enter into the contract. leverage= magnify gains and losses the old contract is torn up and a new contract is market to market. making to market does not occur with a forward contract. how could you get out of the position if you are long- you sell the same contract, same commodity, same expiration month. 1. if you are short, you buy the same contract, same commodity, same expiration month

forward contract

a legally binding agreement between two parties calling for the sale of an asset or product in the future at a price agreed upon today. terms of a contract call for one party to deliver the goods to another, on a certain date in the future, called the settlement date. the other party pays the previously agreed upon forward price and takes the goods. forward contracts can be bought or sold. the buyer of a forward contract has the obligation to take delivery and pay for goods. the seller has the obligation to make deliver and accept payment. buyer of a forward contract benefits if prices increase because the buyer will have locked in a lower price. the seller wins if prices fall because a higher selling price has been locked in. one party to a selling contract can win only at the expense of the other. so a forward contract is a zero sum game.

shark repellent

a measure undertaken by a corporation to discourage unwanted takeover attempts porcupine provision

reduction in capital needs

a merger may reduce the combined investments needed by the two firms in working capital and fixed assets. acquiring firms may see ways of more effectively managing existing assets. this can occur with a reduction in working capital resulting from the more efficient handling of cash, accounts, receivables and inventory. the acquiring firm may also sell off certain assets not needed in the combined firm.

chewable pill

a pill that is instilled by shareholder vote and can be redeemed by shareholder vote. dead hand pill- which explicitly gives the directors who installed the pills of their handpicked successors the authority to remove the pill. this type of pill is controversial because it makes it virtually impossible for new directors elected by shareholders to remove an existing poison pill. hedge funds or other large investors, all of whom have the same agenda, such as removing a company's management or changing the way the company operates, band together and purchase a large block of stock. they then vote to remove the board of directors and company management without triggering the poison pill.

put call parity condition

a protective put strategy can be exactly duplicated by a combination of a call option with the same strike price as the put option and a rissoles investment. put call parity condition (PCP): share of stock + put option= PV of strike price + a call option S+P= PV(E) + C because the present value of the exercise price is calculated using the Rf rate, you can think of it as the price of a risk free pure discount investment such as T bill with a face value equal to the strike price. easier way to remember: stock plus put equals tbill plus call the PCP condition really says that between a riskless asset like a t bill, a call option, a put option and a share of stock, we can always figure out the price of any one of the other four given the prices of the other three

in play

a publicly held corporation is said to be in play if as a result of one or more threatened takeovers and the resulting acquisition of a large portion of the corporation's stock by risk arbitrageurs, it is virtually certain that the corporation will ultimately be taken over by one entity or another.

fair price provision

a requirement that all selling shareholders receive a same price from a bidder. two tier offer- bidder would offer a premium price only for a percentage of the shares large enough to gain control. it offers a lower price for the remaining shares. such an offer can set off a stampede among shareholders as they rush to get the better price.

poison pill

a right issued to stockholders of a company threatened by takeover, granting them privileges that are contingent on the possession by an aggressor of a gated percentage of the company's stock. the rights are designed to make the completion of a takeover much more expensive, perhaps prohibitively so, for the aggressor.

golden parachute

a special seperation agreement that provides for a payment to a corporate executive only in the event that he loses his job as a result of a takeover of his company.

speculator

a speculator is an individual or institution betting on future price movements through the futures market and thereby absorbing risk. if a speculator trades with a hedger, the speculator absorbs the risk a hedger eliminates.

poison pills

a tactic designed to repel would be suitors. it is a financial device designed to make it impossible for a firm to be acquired w/o managements consent- unless the buyer is willing to commit financial suicide intention is to force a bidder to negotiate with management. frequently, merger offers are made with the contingency that the rights will be cancelled by the target firm.

scorched earth policy

a technique used by a company that has become the target of a takeover attempt to make itself unattractive to the acquirer. it may agree to sell off the most attractive parts of its business, called the crown jewels, or it may schedule all debt to become due immediately after a merger

white knight

a third company solicited by a takeover target to outbid the original aggressor, because the white knight is more acceptable to the target than the original aggressor

poison put

a variation on the poison pill, forces the firm to buy securities back at some set price

hedging

a way that firms reduce their expose to price and rate fluctuations

staggered board of directors

a way to make it more difficult for a corporate raider to install a majority of directors sympathetic to his or her views

functions of capital markets

a. facilitate the transfer of capital between parties with projects and little cash and parties with cash and few investment opps facilitate the transfer of risk facilitate the process of price discovery derivatives- options, forwards, futures, etc- afford the opportunity to transfer risk forwards and futures are a window to future prices and thus facilitate the process of price discovery

option contract

agreement that gives the owner the right but not the obligation to buy or sell some asset at a specified point in the future call option- has the right but not the obligation to buy an underlying asset at a fixed price, called the strike price or exercise price, for a specified time. put option- has the right but not the obligation to sell an underlying asset at a fixed price for a specified time. the act of buying or selling the underlying using the option contract is called exercising the option. because the buyer of a call option has the right to buy the underlying asset by paying the strike price, the seller of a call option is obligated the deliver the asset and accept the strike price if the option is exercised. similarly, the buyer of the put option has the right to sell the underlying asset and receive the strike price. in this case, the seller of the put option must accept the asset and pay the strike price.

halloween effect

all US stock market sectors and industries perform better during winter than during the summer in a sample. winter is defined as november through april and summer is may through october. they also note that they found this to be true in 36 of the 37 developed and emerging markets studied

exercise price

all else equal the higher the strike price or exercise price, the less valuable a call option all else equal, the higher the strike price or exercise price the more valuable the put option

going private transactions

all of the equity shares of a public firm are purchased by a small group of investors, usually the group includes members of incumbent management and some outside investors. such transactions have come to be known generally as levered buy outs. (LBOs) because a large percentage of the money needed to buy up the stock is usually borrowed. such transactions have also been termed management buyouts- when existing management is heavily involved. shares of the firm are delisted from the stock exchanges and can no longer be purchased in the open market

swap contracts

an agreement by two parties to exchange or swap specific cash flows at specific intervals swap contract is really just a portfolio or series of forward contracts. with a swap, there are multiple exchanges, instead of just one. in principle, a swap contract could be tailored to exchange just about anything.

commodity swaps

an agreement to exchange a fixed quantity of a commodity at fixed times in the future.

american and european options

an american option may be exercised any time up to and including the expiration date. a european option may be exercised only on the expiration date.

option

an arrangement that gets its owner the right to buy or sell an asset at a fixed price anytime on or before a given date. stock options- options to buy and sell shares of common stock all corporate securities have implicit or explicit option features and the use of such features of growing.

pac man defense

an attempt by a company for which a tender offer has been made to defend itself against takeover by making a counter tender offer for the aggressor company

golden handcuff

an incentive package designed to get executives to stay on board once the acquisition is completed

raider

an individual or group that acquires a block of stock in a target company with an eye to making a tender offer, forcing a proxy fight or forcing a green mail repurchase by the target company

hedger

an individual or institution using the futures market to bet on future price movements in order to decrease the risk they bear a long hedger buys a futures contract in order to guarantee the cost of some commodity in the future, any other firm buying futures on a commodity which is used as an input in a production process. a short hedger sells a futures contract in order to guarantee the price received from the same of some commodity in the future. if a trader thinks they can pick the right direction, they can highly profit. users hedge by buying and producers hedge by selling locked in a sale price and has thus eliminated risk, if the farmer instead closes out her short futures position before delivery by buying the same futures contract prior to the expiration month, the gain or loss on the futures position offsets the change in price she can sell for, so the price risk is lessened.

time value

an option's time value equals the option's price minus the option's intrinsic value

bear hug

an unfriendly takeover offer designed to be so attractive that the target firm's management has little choice but to accept

the modigliani miller theory with issuer taxes

an unlevered firm has no debt outstanding, a levered firm has debt outstanding. the market value of a firm is the sum of the market values of all the outstanding securities of the firm. Vu= the market value of an unlevered firm VL= the market value of the levered firm Assume that the book value and the market value of debt are the same, given some modest assumptions, it can be shown that for a no growth firm with debt (having a market value of B dollars) substituted for equity, VL= VU +TcB note that it is assumed that the debt is outstanding forever that the debt is outstanding forever, or if the debt matures new debt of the same amount is issued in its place. the issuer is also assumed to always have taxable income greater than interest expense so that the interest payments result in tax savings. further, the corporate tax rate is assumed to equal Tc now and in the future. what is the source of value on any financial assets? those securities give you a claim on potential future cash flows. ownership of that asset will get you some possible future cash flows. tax savings is not risk free- only serve you if you are going to pay taxes in the first place. why do cash flows increase in the world of taxes- interest payments are tax deductible and then there are many funds to pay to shareholders. before tax cost of debt is the appropriate discount rate. tcB= present value of tax savings due to the outstanding debt. if debt with a book and market value of B is substituted for equity with the annual interest payment equals KiB. the annual tax savings associated with the annual interest payments equals TcKiB, the present value of the annual tax savings equals the present value of a perpetuity, it could be argued that the riskiness of the tax savings equals the riskiness of the tax payments which give rise to those tax savings. the rate ki is appropriate for the riskiness of those interest payments so it is also appropriate for the tax savings associated with those interest payments. therefore, discounting the annual tax savings at the rate Ki gives the present value of the tax savings due to the interest payments on the new debt. since the only value created from the substitution of B dollars of debt for equity is due to the annual tax savings, the value of the levered firm equals the value of the unlevered firm plus TcB. VL= VU +TcB the value of the firm and the market cap are the same as there is no debt. SL=VL-B PS= SV/N the equity increases by the amount that the debt increases. then you have a value enhancement. with debt, the cash outflows to the shareholders are smaller than before, as well as outflows to IRS. however, the stockholders are made better off by substitution as the value of the firm increases. the bondholders are just getting fair price for their investment the implication of the MM theory with corporate taxes is that to maximize the firm value, the firm should be 100% debt financed. is debt cheaper than equity after considered the total incremental costs of debt? coupon on debt, the higher cost of equity for the equity that still remains yes, because if you go from left to right along x axis, WACC is going down, so debt must be cheaper. if debt was as costly, WACC would be flat. if debt was more expensive, it would increase. to minimize WACC, we need to maximize debt financing.

present value of growing perpetuity

annuities commonly have payments that grow over time C/(r-g) the cash flow in the formula, C, is the cash flow that is going to occur exactly one period from today

acquisition of stock

another way to acquire another firm is simply to purchase the firm;s voting stock with an exchange of cash, shares of stock or other securities, this process will often start as the private offer from management of one firm to that of another. the offer is taken directly to the target firm's stockholders. can be accomplished by a ______ ____- a public offer to buy shares. it is made by one firm directly to the shareholders of another firm. those shareholders who choose to accept the offer tender their shares by exchanging them for cash or securities or both, depending on the offer. a tender offer is frequently contingent on the bidder's obtaining some percentage of the total voting shares. if not enough shares are tendered, the offer might be withdrawn or reformulated. the tender offer is communicated to target firm's shareholders by public announcements. sometimes, a general mailing is used in a tender offer. factors involved in choosing between acquisition by stock and a merger: 1. in acquisition by stock, no shareholder meetings need to be held and no vote is required. if the shareholders of the target firm don't like the offer, they are not required to accept it. 2. in an acquisition by stock, the bidding firm can deal directly with the shareholders of the target firm by using a tender offer. the target firm's management and board of directors can be bypassed. 3. acquisitions can be unfriendly in such cases, a stock acquisition is used in an effort to circumvent the target firm's management, which is usually actively resisting acquisition resistance by the target firm's management often makes the cost of acquisition by stock higher than the cost of a merger 4. frequently, a significant minority of shareholders will hold out in a tender offer. the tender firm cannot be completely absolved when this happens and thus may delay realization of the merger benefits or may be costly in some other way. 5. complete absorption of one firm by another requires a merger. making acquisition by stock are followed by a formal merger later.

modigliani miller theory without taxes

as long as investors can borrow or lend on their own account on the same terms as the firm, they can undo the effect of any changes in the firm's capital structure. this is the basis of MM's proposition 1 the market value of any firm is independent of its capital structure the capital structure does not change the value of the firm, could be 100% debt, 70% debt, 50% and the firm value is the same. every capital structure is optimal, they are all the same. is debt cheaper than equity? no it is equivalent, if debt was cheaper, WACC would never dip back up an investor's ability to undo the firm's capital structure choice to suit the investor's preference is at the core of the capital structure irrelevance argument assume there are no taxes and transaction costs and investors can borrow and lend at the same terms as the firm can. consider a firm with only common stock outstanding and then reconsider the same firm with a proposed capital structure change involving the substitution of debt for 50% of the outstanding equity. a substitution of debt for equity means that the proceeds to debt issuance are used to pay a common stock cash dividend or to repurchase shares. if the company chooses the capital structure that is not consistent with your preferences, you can fix it. with a combination of personal borrowing, and the purchase of shares in the all equity firm, you're able to replicate the annual returns you would have achieved through purchase of shares in the levered firm. since with personal borrowing and an investment in the common stock of the unlevered firm, you have replicated the annual returns you would have earned with an investment in common stock of the levered firm, you have effectively levered the unlevered firm. now suppose instead that you like the risk return possibilities associated with owning common stock in an all equity firm. however, the firm is currently levered. with a vertical slice strategy- you're able to replicate the returns you'd achieve through purchase of shares in an unlevered firm. the vertical slice strategy involves buying the same percentage of the bonds and the common stock of the unlevered firm, buy the same percentage as you'd buy of the stock in an all equity firm. you need to lend money to reduce the risk- buy this company's bonds. take some of the company's stock and then put some money in the company's bonds. you have effectively unlevered or delevered the levered firm with the vertical slice. you have have had x% of all the equity firm's equity. you buy x% of debt and x% of the equity and then you get x% of the cash flows. debt for equity substitution- moving from left to right on RH side, issue debt and take cash proceeds to reduce equity by some dollar amount. how to reduce equity- share repurchase, pay dividends since you have the ability to lever the unlevered firm with personal borrowing, and since you can delver the levered firm through the vertical slice strategy you can undo the firm's capital structure choice. you can effectively create whatever capital structure you want. you will therefore not pay a premium for a firm with a capital structure consistent with your preferences. nor will you penalize a firm choosing a capital structure inconsistent with your preferences. firm value is thus independent of the firm's capital structure in this world without taxes. one capital structure is as good as another. if it is not consistent with your choices, you can fix it. one capital structure is as good as another.

asset write ups

assets in the acquired firm will be re-valued. if the value of the asset increases, tax deductions for depreciation will be a benefit, but this benefit will usually be more than offset by taxes due on the write up.

the interest tax shield

assume depreciation is zero. we will also assume that capital spending is zero and there are no changes in NWC. in this case, cash flow from assets is simply EBIT-taxes. cash flows from levered and unlevered firms are not the same even though the two firms have identical assets. total cash flow to levered is $x more with $x being the number of dollars saved in taxes. the fact that interest is deductible for tax purposes has generated a tax saving equal to the interest payment multiplied by the corporate tax rate. we call this tax saving the ___ ___ ___

more complicated case

assume the stock price in one year will be anything greater than or equal to the exercise price. we don't know how likely the different possibilities are but we are certain we will finish somewhere in the money. when we investigate the combined value of the option and the rissoles asset, we observe something interesting... Combined value= Riskless asset value + Option Value = S1 buying a share of stock has exactly the same value/ payoff as buying a call option and investing the present value of the exercise price in the riskless asset to prevent abrogated, these two strategies must have the same cost. so, the value of the call option is equal to the stock price less the PV of the exercise price C0= S0- E/(1+Rf) determining the value of a call option is not difficult as long as we are certain that the option will finish somewhere in the money

call price restrictions

at any time, the time t price of a call, Pct must be less than or equal to the time t price of the underlying stock. the owner of a call has the right to buy a share of stock for $e, even if e=0, that call owner would not pay more for the call than the cost of the stock on the open market Pc,t <= Ps,t Pc,t > Max(Ps,t-E, 0) the price of an american call cannot be less than zero and cannot be less than the difference between the stock price and the exercise price. an american call cannot have a negative price because its owner cannot have negative cash flows at maturity- either the call has a positive payoff or a zero payoff at maturity an american call cannot sell for less than the difference between the stock price and the strike price because if so, an investor could earn riskless profits. this is what is known as an arbitrage opportunity and cannot exist if the market is efficient.

MM Proposition 1 with corporate taxes

because the debt is perpetual, the same $x will be greeted every year forever. levered firms worth more than the unlevered firms, the difference being the $x perpetuity that is the interest tax shield. because the tax shield is generated by paying interest, it has the same risk as the debt, and that gives the appropriate discount rate. present value of the interest tax shield= Tx x D we have seen that the value of a firm, V, VL, exceeds the value of the firm U, Vu, by the present value of the interest tax shield. (TcB) M&M Proposition 1 states that: VL= VU + TcB implies that the relationship is a straight line with a slope of Tc and a y-intercept of Vu. unlevered cost of capital, Ru, used to represent it. We can think of Ru as the cost of capital of a firm with no debt: VU= EBIT x (1-Tc)/Ru once we include taxes, capital structure definitely matters. however, we immediately reach the illogical conclusion that the optimal capital structure is 100% debt.

debt is risk free

because the debt is risk free, the appropriate discount rate and interest rate on the debt is the risk free rate

forward contracts in practice

because the exchange rate fluctuates can have disastrous consequences for firms that have significant import or export operations, forward contracts are routinely used by such firms to hedge exchange rate risk

financial options

because they involve the right to buy and sell financial options/assets such as shares of stock. real options- involve real assets. almost all capital budgeting decisions involve numerous implicit options

Bankruptcy Abuse and Consumer Protection Act of 2005

before this, a bankrupt company had the exclusive right to submit re organization plans to the court. it has been argued that this right is the reason that some companies have remained in bankruptcy so long. under the new law, after 18 months, creditors can submit their own plans for the court's consideration. this change is likely to speed up bankruptcy and also lead to more prepacks

business failure

business has terminated with a loss to creditors, but even an all equity firm can fail

protective calling

buy a call option on the stock and invest in a rissoles asset such as a t-bill no matter what the stock price is a year from now, the two strategies will always have the same value. this explains why they have the same cost today. if one were cheaper than the other today, there would be an arbitrage opportunity involving buy the one that is cheaper and simultaneously selling the one that is more expensive.

basic approach

buying a share of stock or buying a call and investing in risk free asset- have exactly the same payoffs in the future. because these two strategics have the same future payoffs, they must have the same value today or else there would be arbitrage opportunity. S0= C0 + E/(1+Rf) C0= S0 - E/(1+Rf) the value of the call option is equal to the stock price minus the present value of the exercise price.

option hedging

by buying a put option, the firm eliminates the downside risk, the risk of an adverse price movement. however, the firm has retained the upside potential. put options act as an insurance policy, this insurance is not free. the firm pays for it when it pays for the put option

no convert period for a convertible bond

call option for american option in the money- you exercise and make money if you want to hold the stock long term, you should never exercise a call option prior to maturity. if there any advantage to exercising a call several days, weeks or months before maturity, assuming that you want to hold the stock well after the maturity date of the call? whenever you exercise, whether prior to maturity or at maturity, you'll pay the same exercise price E to obtain each share of stock. thus there is no advantage to exercising early is there any potential disadvantage to exercising a call several days, weeks or months before maturity, assuming that you want to hold the stock well after the maturity of the call? if you exercise prior to maturity, you'll pay E for each share of stock. if you don't exercise early, and if the stock price is above E at maturity, your optimal action is to exercise the call and you'll pay E for each share, so there was no disadvantage to exercising early, except for the time value of money, which for a few weeks will be small. if you don't exercise early and the stock price is below E at maturity, your optimal action is not the exercise the call. you would simply buy on the open market at a price less than E, you are better off not exercising early because by waiting you'll be paying less than E for each share. so there is no advantage but there is a potential disadvantage to exercising prior to maturity, if the stock is below the exercise price at maturity, you would regret having having exercising early. don't give up your option by exercising unnecessarily before maturity, the one exception to this there is compensation for you to do so. if you want to hold the stock long term, should you ever convert a convertible bond prior to maturity? if you wait.. you choose the more valuable of n shares of stock, the face value of the bond if the value of n shares of stock at maturity of the bond is greater than 1000, you don't regret converting to the common stock early. either way, before maturity or at maturity, you'll end up trading the convertible bond for the n shares of stock. you haven't gained anything by converting early, but you're no worse off either. however, if the value of the stock at maturity is less than 1000, you will regret having exercised early. would have been better off waiting and collecting 1000, if you want the stock, you could use your bond proceeds to buy N shares and still have money left over. may want to exercise early if there is a dividend involved

in and out of the money options

call options are in the money if the asset price is greater than the exercise price. they are at the money if the asset price equals the exercise price. they are out of the money if the asset price is less than the exercise price put options are in the money if the asset price is less than the exercise price, puts are at the money if the asset price equals the exercise price, they are out of the money when the asset price is greater than the exercise price

difference between warrants and call options.

call options are issued by individuals and warrants are issued by firms when a call option is exercised, an investor buys stock from another investor, company is not involved. when a warrant is exercised, the firm must issue new shares of stock. each time a warrant is exercised, the firm receives some cash and the number of shares outstanding increases when a call option is exercised, one investor gains and the other loses. the total number of shares outstanding of the company remains constant and no new funds are made available to the company.

interest only loans

calls for the borrower to pay interest each period and to repay the entire principal (the original loan amount) at some point in the future same as the pure discount loan is there is only one period

american option

can be exercised at any time up to and including the expiration day

restructuring

can involve a broad range of actions relating to a firm's investment and financial policy. assets may be sold, a large dividend may be paid, shares may be repurchased, and/or the firm's capital structure may be changed. the restructuring may be implemented by a raider after a successful takeover, or by management who may be fighting off a hostile takeover attempt.

european option

can only be exercised on the expiration day

taxable vs. tax free accounting

capital gains effect refers to the fact that the target firm's shareholders may have to pay capital gains taxes in a taxable acquisition. they may demand a higher price as compensation. thereby increasing the cost of the merger. this is a cost of a taxable acquisition. the tax status of an acquisition also affects the appraised value of the assets of the selling firm. in a taxable acquisition, the assets of the selling firm are revalued or written up from their historic book value to their estimated current market value. this is the ___ ____ effect- it means that the depreciation expense on the acquired firms assets can be increased in taxable acquisitions. an increase in depreciation is a non cash expense but it has the desirable effect of reducing taxes. tax reform act of 1986- the increase in value from writing up these assets is now considered a taxable gain. before this change, taxable mergers were much more attractive because the write up was not taxed

merger

combination of two or more companies, either through a pooling of interests, where the accounts are combined, a purchase, where the amount paid over and above the acquired company's book value is carried on the books of the purchaser as goodwill, or a consolidation, where a new company is formed to acquire the net assets of the combining companies. only combinations in which one of the companies survives as a legal entity are called mergers so consolidations and statutory consolidations are technically not mergers, though the term merger is commonly applied to them. mergers meeting the legal criteria for pooling of interests, where common stock is exchanged for common stock, are non taxable and are called tax free mergers. where an acquisition takes place by the purchase of assets or stock using cash or a debt instrument for payment, the merger is a taxable capital gain to the selling company or its stockholders. there is a potential benefit to such taxable purchase acquisitions, however, in that the acquiring company can write up the acquired company's assets by the amount by which the market value exceeds the book value that difference can then be charged off to depreciation with resultant tax savings. horizontal merger is one combining direct competitors in the same product lines and markets, a vertical merger combines customer and company or supplier and company. a market extension merger combines same products but different markets a product extent merger combines the same market different products and a conglomerate merger combines companies with non of the above relationships or similarities

equity as a call option on the firm's assets

common stock in a levered firm is effectively a call option on the assets of the firm. firm has debt outstanding w/ a face value 1000. debt is coming due in a year, there are no coupon payments, in a year, stockholders will have a choice, they can pay off their debt for 1000 and acquire the assets of the firm free and clear, or they can default on the debt. if they default, the bondholders will own the assets of the firm. stockholders have a call option on the assets of the firm with an exercise price 1000. they can exercise by paying or they can choose not the exercise by defaulting. if the value of the firm's assets exceeds $1000, then the option is in the money, shareholders will exercise by paying off the debt. if the value of the firm's assets is less than $1000, then the option is out of the money and the shareholders will optimally choose to default

hedging with futures

conceptually identical to hedging with forward contracts and the payoff profile on futures contracts is drawn just like the profile of a forward contract. the only difference in hedging with futures is that the firm will have to maintain an account with a broker so that gains and losses can be credited or debited each day as part of the marking to market process. even though many types of futures contracts exist it is unlikely that a particular firm will be able to find the precise hedging instruments it needs. cross hedging- using a contract on a related but not identical asset. when a firm does cross hedge, it does not actually want to buy or sell the underlying asset. this creates no problem because the firm can reverse its futures position at some point before maturity. if a firm sells a futures contract to hedge something, it will buy the same contract at a later date, thereby eliminating the futures position. in fact, futures contracts are rarely held by anyone to maturity. actual physical delivery rarely takes place. a firm might wish to hedge over a long period of time but the available contracts could have shorter maturities. a firm could therefore decide to roll over ST contracts, but this entails some risks.

the impact of personal taxes on the capITAL structure decision

consider personal taxes, if a stockholder's return is in the form of a dived and/or a long term capital gain, there is a currently a tax rate advantage versus interest income since dividends and long term capital gains may be taxed at a lower rate (15%) than interest income, 35%, for some investors. short term capital gains are taxed at 35%, the same as interest income. short term gains and losses are currently defined as those gains and losses on assets held for less than one year. there may also be a deferral advantage to equity since a capital gain is not taxed until the stock is sold and the gain is realized. thus, while there is a tax advantage to debt at the corporate level because of the deductibility of interest payments, there is potentially a personal tax advantage to equity because of the tax rate and deferral advantages. the relative magnitudes of the equity tax advantages and tax disadvantages depend on the tax rules in effect at any given time. since interest payments are tax deductible at the corporate level, the corporate tax on earnings which go toward interest payments of the bond issuer is zero. interest received is currently taxable at a max rate of 35% if the investor is an individual, 35% if the investor is a corporation in the top tax bracket and 0% if the investor is a tax exempt entity. for top tax bracket firms, before tax corporate earnings are currently taxed at a max of 35% before dividends are paid or earnings are retained. that is, dividends and retained earnings come out of corporate after tax dollars of the stock issuer. dividends received by an investor are taxed at a maximum marginal rate of 15% if the investor is an individual, 10.5 is the investor is in a top tax bracket corp eligible for the dividend received deduction or 0% if the investor is a tax exempt entity. capital gains received by an individual are taxed at a maximum rate of 15% whereas it is 35% by corporation, tax exempt entity = 0%. however, since the tax on capital gains is deferred until the gains are realized, the present value of the capital gains is between 0% and the max capital gains rate any potential tax advantage for the equity at the investor level due to capital gains or the corporate dividend received deduction if often, but not always, superseded by the tax advantage of debt at the corporate issuer level. therefore, there is currently a strong incentive to minimize taxes and maximize overall firm (debt plus equity) value by substituting debt for equity capital.

the put call parity theorem

consider two portfolios at time 0 a long european call with an exercise price of E and expiration at time t a share of underlying stock, a long european put with an exercise price of e and expiration at time t, and borrowing in the amount of E/(1+RF). t is the time to expiration of the options and rf is the risk free rate. same exercise price, same expiration rate. is there a relationship between the price of a call and a price of a put on the same underlying stock? since the cash flows at expiration are the same for both portfolios no matter what the stock price, in an efficient market, both portfolios should have the same cost at time 0 when the portfolios are purchased you get a positive cash flow- think of a call option like being stock with borrowed money, put option is like insurance for when something goes down in value. two portfolios that always give you the same future cash flows, need to be the same price today the profit diagram of a long stock + long put longs like the profit diagram of a long call combining a long stock position with a long put is called a protective put, the put is protecting your stock position, if you lose money on the call, you make money of the put what is riskier- a long stock position of the long stock/long put combination stock + the put, downside of the stock alone is lower than the downside of the stock and the put

the corporate charter

consists of all the articles of incorporation and corporate by laws that establish governance rules of the firm. establishes the rules and conditions that allow for a takeover. firms frequently amend corporate charters to make acquisitions more difficult super majority agreements- changing the percent of shareholders of record to approve a merger. another defense is to stagger the election of the board members. this makes it more difficult to elect a new board of directors quickly- called a classified board

commodity futures

convenience yield is defined by noting that unlike a spot purchase a futures contract gives no convenience yield, which is the value of being able to get your hands on the real thing.

feature of a convertible bond

conversion price- price to convert into stock conversion ratio- number of shares per bond conversion premium- higher stock price that reflects the fact that the conversion options in bonds was out of the money at the time of issuance which was usually the case

insider trading

corporate insiders typically do well when trading stocks of their own companies. stocks purchased by insiders outperform stocks in a randomly selected group. secondary distributions by knowledgeable sellers have often preceded significant price delcines

price limits

daily trading limit, the amount the futures price is allow to vary from day to day, may have come into effect to enforce stability

beware

dealing with auto dealers and repair shops, contractors dry cleaners, mail order purchases, phone solicitors, investments and others giving out your credit card or social security numbers guaranteed returns, especially high ones. off shore investments. hot tips on message boards, pump and dumb, buy, lie, and sell high internet dating late night 800 numbers nigerian schemes if it's too good to be true...

circuit breakers

designed to give the markets a breather in case of sharp price movements, curbs trading of futures or stocks at various trigger points, at certain points during the fridya the 13th drop, circuit breakers kicked in on the futures market, slowing trading at times reassess the position of the market conditions, but not trying for a little while, hour, day etc they stop trading if they move to much in a certain period of time

divestitures

disposition of an asset or investment by outright sale, employee purchase, liquidation and so on ownership of the divested asset is transferred to an individual, group or organization other than the original owners of the asset. the receipt of assets by the divesting firm and the discontinuity of ownership of the divested assets distinguish divestitures from spin offs one corporation's orderly distribution of large blocks of another corporation's stock, which were held as an investment.

continuous compounding

e^q-1 interest is being credited the instant it is earned so the amount of interest grows continuously

tax advantaged savings vehicles

education savings accounts (formerly educational IRA's) 529 college savings plans- after tax contributions at the federal level and in some states, tax deferred compounding, tax free withdrawals if for approved educational expenses. save for retirement before education! no financial aid for retirement. 529's- after tax contribution to education related expenses, covered all educational savings accounts (formerly educational IRA's, $2000 a year, 529 college savings plans)

white knight

firms facing an unfriendly takeover might arrange to be acquired by a different friendly firm or a firm may arrange for a friendly entity to acquire a large block of stock. white knights can increase the amount paid to the target firm. white squires or big brothers are individual firms or even mutual funds involved in friendly transactions of these types. granted exceptional terms or compensation (white mail)

crown jewel

firms often sell or threaten to sell major assets- crown jewels- when faced with a takeover threat. also called the scorched earth strategy. involves lock up usually.

legal bankruptcy

firms or creditors bring petitions to a federal court for bankruptcy. this is a legal proceeding for liquidating or re-organizing the business

liquidation re-organization

firms that cannot or choose not to make contractually required payments to creditors have two basic options _____- termination of the firm is a growing concern, and it involves selling off the assets of the firm. the proceeds, net of selling costs, are distributed to creditors in order of established priority _____- keeping the firm is a growing concern, involves selling new securities to replace old securities. these are the result of a bankruptcy proceeding, which occurs is dependent on whether the firm is worth more dead or alive.

net operating losses

firms that lose money on a pre tax bassi will not pay taxes, such firms can end up with tax losses they can not use. these tax losses are referred to as net operating losses a firm with NOL may be an attractive merger partner for a firm with significant tax liabilities the combined firm will have a lower tax liability then the two firms considered separately. good example of how a firm can be more valuable merged than standing alone. 1. federal tax law permits firms that experience periods of profit and loss to even things out through loss carry back and carry forward provisions. a firm that has been profitable in the past but has a loss in the current year can get refunds of income taxes paid in the past three years. after that, losses can be carried forward 20 years. thus, a merger to exploit unused tax shields must offer tax savings over and above what can be accomplished by a firm via carry over 2. the IRS can disallow an acquisition if the principal purpose is to avoid federal tax by acquiring a deduction or credit that would not otherwise be available.

indirect bankruptcy costs

firms will spend resources to not go bankrupt. when is firm is having significant problems meeting its debt obligations, we say that it is experiencing financial distress. some financially distressed firms ultimately file for bankruptcy but most do not because they are able to recover or otherwise survive. the costs of avoiding a bankruptcy filing are called......

financial distress

firms with greater risk of experiencing financial distress will borrow less than firms with a low risk of financial distress. financial distress is more costly for some firms that others. the costs of financial distress depend on primarily the firm's assets. determined by how easily the ownership of these assets can be transferred

the joel greenblatt result

firms with high returns on capital "good businesses" as measured by EBIT/net WC + net fixed assets and good prices as measured by EBIT/Enterprise value do very well relative to the market high returns on capital and good prices

accounting insolvency

firms with negative net worth are insolvent on the books , when total book liabilities exceed total book assets

reducing risk exposure

fluctuations in the price of any particular good or service can have very different effects on different types of firms if two firms get together, sometimes risk can be eliminated. usually a firm that hedges risk won't be able to create a completely flat risk profile. with the most financial risk management, the goal is to reduce the risk to a manageable level and thereby flatten out the risk profile, not necessarily to eliminate risk altogether. price fluctuations have two components- short run , essentially temporary changes are the first component. the second component has to do with more long run, essentially permanent changes.

value line recommendations

following the advice of the value line investment survey would have produced above average market returns for investors, to some extent the higher returns can be explained by the risk level of the stocks, Value line sell;acted. the stock sections of the survey have been far less impressive in recent years and the investment results for the funds actually managed by value line have been distinctively mediocre there has also been a self fulfilling aspect to value lines apparently success- the behavior of investors acting on the recommendations has often pushed the market prices well above the previously published prices as of the official date of the recommendation. it remains to be seen if value line stock selections can consistently beat the averages in the future.

intrinsic value

for a call, its intrinsic value equals the larger of Ps,t-E and 0 for a put, its intrinsic value equals the larger of E- Ps,t and 0 an option's intrinsic value is the value it would have if its expiration date was today.

the weighted average cost of capital

for a firm with debt, preferred stock and common stock outstanding, the before tax weighted average cost of capital is defined by the following expression: WACCbt= Ki(b/b+p+s) + kp/(1-tc)(p/b+P+s) + (ke/1-tc)(s/b+p+S) for a firm with debt, preferred stock and common stock outstanding, the after tax weighted average cost of capital is defined by the following expression WACCat= ki(1-tc)(b/b+p+s) + kp(p/b+p+s) ke(s/b+p+S) if an investor buys the debt, preferred and common in amounts proportional to their total market values, the investor's before tax return is... before tax return= ki(b/b+p+s) + kp(p/b+p+S) + ke(s/b+p+s) if the firm value is a function of the proportions of debt and equity securities issued by the firm, then the capital structure that maximizes the value of the firm also minimizes the weighted average cost of capital, provided that operating income is independent of capital stucture

Surplus funds

free cash flow- cash flow available after all taxes have been paid and after positive net present value prospects have been financed. in such a situation, aside from purchasing fixed income securities, the firm has several ways to spend the free cash flow, including: paying dividends, buying back its own shares, acquiring shares in another firm an extra dividend will increase the income tax paid by some investors. a share repurchase will reduce the taxes paid by shareholders as compared to paying dividends, but this is not a legal option if the sole purpose is to avoid taxes that would have otherwise been paid by shareholders. to avoid these problems the firm can buy another firm. by doing this, the firm avoids the tax problems associated with paying a dividend. also, the dividends received from the purchased firm are not taxed in a merger.

determinants of tax status

general requirements for tax free status are that the acquisition be for a business purpose and not to avoid taxes and that there be a continuation of equity interest in the bidder if the buying firm offers the selling firm cash for its equity, it will be a taxable acquisition. if shares of stock are offered, the transaction will generally be a tax free acquisition. in a tax free acquisition, the selling shareholders are considered to have exchanged their old shares for new ones of equal value so that no capital gains or losses are experienced.

put bonds

gives the owner the right to force the issuer to buy the bond back at a fixed price for a fixed time. combo of a put and a straight bond- liquid yield option note- a callable putable convertible pure discount bond. it is a package of a pure discount bond, two call options and a put option loan guarantees are a form of insurance- if you lend money to someone and they default- with a guaranteed loan, you can collect from someone else, usually the government. from the lenders point of view- loans are as risk free as treasury bonds. loan guarantees are not cost free U.S. government with a loan guarantee, has provided a put option to the holders of risky bonds. value of put options is the cost of the loan guarantee. example- air transportation stabilization bond

Key employee retention plans

giving bonuses to executives, intended to keep valuable players from moving to more successful firms. critics argue these are abused. new law permits KERPs only if the employee in question actually has a job offer from another company. in a traditional chapter 11 filing, the bankruptcy plan is described to creditors and shareholders in a prospective like disclose. the plan must be approved by a vote involving the interested parties. a section 363 bankruptcy is like an auction. an initial bidder known as a stalking horse bids on all or part of the company's assets. the main advantage of a section 363 bankruptcy is speed, since a traditional bankruptcy requires the approval of the interested parties it is not uncommon for the process to take several years, where a section 363 bankruptcy is generally much quicker.

going private and leverage buyout

going private is what happens when the publicly owned stock in a firm is replaced with complete equity ownership by a private group, which may includes elements of existing management as a consequence, the firm's stock is taken off the market and is no longer traded. one result of going private is that takeovers via tender offer can no longer occur because there are no publicly traded shares. in this scenario, a leveraged buy out can be a takeover defense. however, it is a defense only for manager. in the stockholders point of view, the LBO is a takeover because they are bought out.

avoiding mistakes

great deal of room for error because so much of the value can come from intangible or difficult to quantify benefits 1. do not ignore market values- it represents a consensus opinion of investors concerning the firm's value under existing management 2. estimate any incremental cash flow- these are the only ones that will add value 3. use the correct discount rate- should be the required rate of return for the incremental cash flows associated with the acquisition. it should reflect the risk associated with the use of funds, not the source. the firm being acquired's cost of capital is the appropriate discount rate because it reflects the risk of firm B's cash flows 4. beware of transaction costs a note about efficient management- there are firms whose value could be increased with a change in management. these firms are poorly run or otherwise do not effectively use their assets to create shareholder value. mergers are a means of replacing management.

warren buffet

he had never had a down year even in the severe bear markets of 1957, 1962, 1966, 1969 intrinsic value estimated as the present value of future cash flows- the value of the company is determined by projecting its future cash flows and discounting them back to the present with the rate of long term US government bonds. after determining a company's value, then look at stock price, he compares the value to the price and determines the margin of safety. in other words, if a stock is selling for just under what the company is worth, there is a small margin of safety, and he doesn't buy. if it sells for well under the company's worth, there is a large margin of safety and he buys. its a straightforward use of Graham's margin of safety

cash flow hedging

hedging ST financial exposure, hedging transaction exposure and hedging near term cash flows amount to much the same thing. it will usually be the case that directly hedging the value of the firm is not really feasible. instead, the firm will try to reduce uncertainty of its near term cash flows. if the firm is thereby able to avoid expensive disruptions, then cash flow heading will act to hedge the value of the firm, but the linkage is indirect. in such cases, care must be taken to ensure that a cash flow heading does have the desired effect cash flow hedging should not be done in isolation. instead, a firm needs to worry about its net exposure. any hedging activities should probably be done on a centralized or at least cooperative basis

retirement planning

how much annual income do you need during your retirement years tax advantaged saving on your own: IRA's vs. Roth IRA's tax advantaged saving through your employer- 401k versus roth 401k a certain percentage of your contribution, up to a cap, may be matched by an employer 403b versus roth 403b for employees of certain educational institutions for employees of certain non profit organizations for certain ministers 457 plans for employees of state and local governments and for employees of tax exempt employers 70-80% of what you live on in your last working years. on your own: IRA's vs. Roth IRA's through employer: 401K vs. Roth 401 K 457, 403b and Roth 403b's if you are going to be in a high tax bracket at retirement, you want the roth after tax version. but, you still won't know what the tax will be in the future. when do you want to pay the tax? before tax- reduces your taxable income by the contribution 401k and IRA with the after tax contribution- you pay tax on the contribution you have to put money in them and decide how the money is invested why would you consider at WHEN YOU TAKE MONEY OUT IN RETIREMENT, THAT MONEY IS FULLY TAXABLE AS ORDINARY INCOME, that after tax contribution is not taxed when it is taken out later. 401K- contributions are before tax, it is taxable as ordinary income, 2015 maximum contribution is 18000 or 24000 if over 50. 10% penalty if funds removed before (except allowable withdrawals) 59.5, must start making withdrawals by 70.5 Roth 401k- contributions are after tax, the tax status of withdrawals is tax free, the 2015 maximum contribution is 18000 or 24000 if over 50, 10% penalty is funds removed before 59.5, must start making withdrawals by 70.5 what do you do if your employer matches a certain percentage of your 401k contribution? do everything you can to max the match. it is free money e.g. 50% of your contribution until you contribute 6000

hedging with forwards

identify the firm's exposure to financial risk using a risk profile.. we then try to find a financial arrangement such as a forward contract that has an offsetting pay off profile

higher

if a firm with a high P/E ratio acquires another firm with a lower P/E ratio in a stock for stock exchange, the earnings per share of the post merger firm will be higher than the earnings per share of the pre merger acquirer. this result holds if the earnings of the post merger firm equals the sum of the earnings of the two pre merger firms

the Super Bowl effect

if a team in the old american football league wins, the market is down that ear. if a team in the NFL wins the Super Bowl, the market is up that year. but there is no logical link, you should not trade on this, it may be a statistical abberation.

capital market efficiency

if capital markets are efficient, then purchase or sale of any security at the prevailing market price is never a positive NPV transaction, they mean that information is widely and cheaply available to investors and that all relevant and ascertainable information is already reflected in the security prices. that is why purchases or sales in an efficient market cannot be positive NPV transactions. price changes in an efficient market are random, if prices always reflect all relevant information, then they will change only when new information arrives but new information by definition cannot be predicted ahead of time (otherwise it would not be new information). therefore, price changes cannot be predicted ahead of time. to put it another way, if stock prices already reflect all that is predictable, then stock price changes must reflect only the unpredictable. the series of price changes must be random. some people say prices are just wrong sometimes and the market overreacts. but people say that it is not inefficient, it accurately reflects prices at that time.

cash vs. common stock

if cash is used, the cost of an acquisition is not dependent on the acquisition gains all other things being the same, if CS is used, the cost is higher because Firm A's shareholders must share the acquisition gains with the shareholders of Firm B. however, if the NPV of the acquisition is negative, then the loss will be shared among the two firm. 1. sharing gains- if cash is used to finance an acquisition, the selling firm's shareholders will not participate in the potential gains from the merger. if the acquisition's not a success, the losses will not be shared, and shareholders of the acquiring firm will be worse off then if stock had been used. 2. taxes- acquisition by paying cash results in a taxable transaction. acquisition by exchanging stock is generally tax free. 3. control- acquisition by paying cash does not affect the control of the acquiring firm. acquisition with voting shares many have implications for control of the merged firm

taxes and acquisitions

if one firm buys another firm, the transaction may be taxable or tax free. in a taxable acquisition, the shareholders of the target firm are considered to have sold their shares and they will have capital gains or lesses that will be taxed. in a tax free acquisition, the acquisition is considered an exchange instead of a sale so no capital gains or losses occurs at the time of the transaction

option pay offs

if the stock is selling for less than the exercise price, then the option is not worth anything and you throw it away. you say the option finished out of the money because the stock price is less than the exercise price. if the stock is selling for more than the exercise price, then you need to exercise the option and it is in the money. gains and losses from buying call options can be quite large. the option position clearly magnifies the gains and losses on a stock by a substantial amount. the option can never be worth less than zero because you can always just throw it away. stock options are a zero sum game. whatever the buyer of the stock option makes, the seller loses, vice versa.

factors determining option values

if we continue to supposed that our option is certain to finish in the money, then we can readily identify 4 factors that determine an option's value. if we assume that the option expires in T periods, the PV of the exercise price is E/(1+Rf)^t and the value of the call is: call option value = stock value- PV of the exercise price

call option

if you bought it from another investor who has the other side of the option the holder of a call option has the right but not the obligation to buy a share of stock for a fixed price, the strike price or exercise price, on or before a fixed ate. the expiration date. when a call is exercised, no new shares are created since the seller, the writer, of the call is not the firm but some other investor. the call writer must either deliver shares he or she already owns or else must purchase the shares on the open market for delivery to the call holder upon exercise they trade over the counter or on an exchange, the chicago board options exchange, the new york stock exchange, the american stock exchange, the philedelphia stock exchange, or the pacific exchange. like a warrant, a call is more valuable the higher the stock price, the lower the strike price, and the lower the time to expiration. also the cannot cannot have a price less than 0

insurance

if you can't afford to insure the asset, you can't afford the asset. types of insurance life insurance term insurance- pay less to get savings and invest on your own. all recommend term insurance because it is cheaper cash value- has an investment account attached to it. you will have some cash left at the end- large part of the expense in early years is the commission health insurance disability insurance homeowners/renter's insurance automobile insurance liability insurance collision umbrella policies how much insurance do you need, what kinds of risks should you insure against? what are your agent's incentives?

Modigliani Miller Proposition 1

imagine two firms that are identical on the left side of the balance sheet. their assets and operations are exactly the same. the right sides are different because the two firms finance their operations differently. in this case, we can view the capital structure question in terms of the pie model. the size of the pie is the same for both firms because the value of the assets is the same. this is precisely what M&M Proposition 1 states: the size of the pie does not depend on how it is sliced

capital structure problem solving strategy

in ALL of these problems where there is only debt and common stock, please remember 1. use the description of the transactions to calculate the new total value of the form Vafter= Before +value of assets in - value of assets out +TcB assets in and assets out are left hand side of the balance sheet assets. for instance, if the firm repurchases shares, Value in equals 0 since we ignore the treasury stock which impacts the right side of the balance sheet. however, value out equals the amount of cash expended to repurchase the shares, since cash is an asset on the left side of the balance sheet. subtract total debt from the total firm value to find the total value of the common stock, i.e. the market cap. Safter= Vafter-Bafter = Vafter- (Bbefore +deltaB) divide the total common stock value by the number of shares outstanding Nafter to estimate the price per share PsAfter= Safter/Nafter

managerial options

in reality, depending on what actually happens in the future, there will always be opportunities to modify a project these opportunities to which are an important type of real option are called managerial options. there are a great number of these options. the ways in which a product is priced, manufactured, advertised and produced can all be changed and these are just a few of the possibilities

flip in provision

in the event of an unfriendly takeover attempt, the holder of a right can pay the exercise price and receive common stock in the target firm worth twice the exercise price. in other words, holders of the rights can buy stock in the target firm at half price. simultaneously, the rights owned by the raider, the acquirer, are voided. this is to massively dilute the raider's ownership position. doing so greatly increase the price of the merger to the bidder, because the target firm's shareholders end up with a much larger percentage of the merged firm. a flip in provision, doesn't prevent someone from acquiring control of a firm by purchasing a majority interest it just acts to vastly increase the cost of doing so.

the extended pie model

in the extended pie mode, taxes just represent another claim on the cash flows of the firm. because taxes are reduced as leverage is increased, the value of the government's claim (G) on cash flows decreases with leverage. bankruptcy costs are also a claim on the cash flows. they come into play as the firm closes to bankruptcy and has to alter behavior in an attempt to stave off the event itself. they become larger when bankruptcy actually takes place. thus, the value of this claim (B) on the cash flows rises with the debt/equity ratio. the extended pie theory simply holds that all of these claims can be paid from only one source: the cash flows of the firm. CF= payments to stockholders and to creditos +payments to the government + payments to bankruptcy courts and lawyers + payment to any and all other claimants to the CF of the firm. notice the change in the relative size of the slices as the firm's use of debt financing is increased. the value of the firm depends on the total cash flow of the firm. the firm's capital structure just cuts the cash flow into slices without altering the total. stockholders and bondholders may not be the only ones who can claim a slice

strong form efficiency

insider trading- prices reflect all information including insider information the 38 fund average return for pooled pension fund portfolios managed by banks- was less than the return on the S&P 500. in only 4 of the 114 possible situations did a fund outperform the market for four straight years. the possibility of achieving consistently superior performance is questioned. if the pros can't beat the market then who can? consistent with market efficiency- if someone can beat the market, this is not even clear that it is skill. warranted P/E ratios- Nifty fifty had average P.E of 41.9 in 1972, more than double the s&P 500 and their dividend yield was 1.1 was than than half of other large stocks. in the 1973-1974 bear market, the nifty 50 were devasted (P/e's of 60-90 in 1972 dropped to teens by 1980) , overpriced? during this time, an equally weighted portfolio returned 12.4% annually. could reject strong form efficiency.

personal financial considerations

invest in your own human capital save early and often- how much, increase income, decrease spending make it automatic- have it automatically taken out of your paycheck. some people who live very modestly often have very high net worth if they save asset allocation- stocks vs. bonds vs. cash. real estate vs. commodities should it vary with age younger, more risk you can afford to take. Put 100-age in stocks, the rest in bonds. if you are more aggressive, you can change the rule. should it vary with your investment horizon is it affected by your overall financial situation what are probability assessments home ownership- own when you can, every mortgage payment builds equity on the one. but in some situations renting would be smart. credit cards- pay off your credit card bill every month. if you can't at least pay the minimum on time. fundamentals- does not involve technicals, only technicals they may use is for timing. technical analysis- charts infer price movements from post charts. short term investments use charts, LT normally wouldn't credit cards phone services maintenance

taxes

invest tax free or tax deferred whenever possible should you put assets generation taxable income in your IRA and 401k and tax free or tax deferred assets in your taxable accounts? are there exceptions? common stock tax considerations growth vs income stocks dividends vs capital gains short term gains vs. long term gains should you buy a mutual fund with large unrealized capital gains- when sold, there will be a realized gain that will increase the tax bill should you buy a mutual fund shortly before a december capital gains distribution- going to get some of the tax liability so it may make sense to wait until after the distribution

dollar cost averaging

investing a constant dollar amount at regular time intervals pitfalls of investing in high p/e stocks- earnings grow, P/E lower, but still high, you're losing money. what moves markets supply and demand? fear and greed? major news items? individual stocks surprising corporate profits changing growth prospects a change in interest rates the stock market is designed to distribute money to the patient. bonds issuers- the federal government, the state and local government, corporations, foreign governments invest for preservation of principal or capital gains? fixed rate vs. variable rate inflation protection- TIPs (or in canada- real return bonds) series 1 savings bonds cash and cash equivalents real estate gold, silver and other commodities baseball cards, beer cans, ceramics, dolls, fine arts, hummel figurines, persian rugs, stuffed animals, wine and other collectibles. what moves markets, wars, but not always obvious what made the market move real estate- a good investment? does it produce a good return? does it diversify your portfolio? types of real estate investments -direct investments of commercial properties (shopping centers, apartments, land, etc) REITs limited partnerships homes, townhouses, condominiums, coops home ownership - get an inspection before buying to make sure it is a good investment is a time share a good investment is a time share a good investment- often overprices when they are brand new can buy used time shares in some area you are going for. should you put assets in the child's name? tax considerations financial aid considerations what if the child doesn't go to college?

Accruals

investors focus on earnings and often ignore information contained in cash flow and accrual components of earnings. CFO= net income- (deltaWC-depreciation and amortization) arnings performance attributable to the accrual component of earnings exhibits lower persistence than earnings performance attributable to the cash flow component of earnings.

exchange offer

involves the exchange of one type of security for another some common stockholders may exchange their common shares for preferred shares. in another case, the common stockholders may exchange their common shares for debt. the restructuring may be voluntary or forced.

insurance

is the most widely used risk management tool generally sued to protect against hazard risks, can be used to provide protection against losses due to damage to a firm's property and any associated loss of income. it also protects against liabilities that may arise as a result of interactions with third parties. commercial liability insurance-protects against costs that can occur because of damage to others caused by the company's products operations or employees business interruption insurance- protects against the loss of earnings if business operations are interrupted by an insured event such as fire or natural disaster. key personnel insurance- protects against losses due to loss of critical employees worker's compensation and employer's liability insurance- protects against costs a firm is required to pay in connection with work related injuries sustained by employees important that companies and their risk managers fully understand the policy limits, policy conditions and perils covered by insurance policies they purchase. firms must also abide by policy conditions, risk manager does not want to become familiar with a firm's insurance policy exclusions after a loss occurs. whether to purchase insurance is an NPV question. insurance premium is the cost. benefit is the PV of the expected payment by the insurance company to the firm assuming that the cost of completely eliminating the risk is greater than the present value of the expected loss, the firm can purchase insurance firm's decision to purchase insurance or what types of insurance a firm decides to purchase, depends on the nature of the firm's business, size of the firm, firm's risk aversion, as well as legal and third party requirements that may demand proof of insurance. large firms will often forgo insurance against less costly events opting to self insurance. when looking across all the smaller risks faced by a big firm, it can be less expensive to sustain a certain loss rate then to pay the insurance premium. firms may opt to purchase insurance with larger deductibles, the firm will have losses up to some level before the insurance kicks in, this approach protects the firm from true catastrophic losses.

restructuring defensive measures

issue a large amount of debt increase or decrease dividend if appropriate repurchase common stock sell or close divisions

valuing a call option when the call will possibly finish out of the money

it is possible to combine the call option and the risk free investment in a way that exactly duplicates the pay off from holding the stock? suppose we bought one call and invested the PV of the exercise price in a rissoles asset as we did before. this doesn't work. this case, investing the PV of the lower stock price in a riskless asset, and buying two call options, exactly duplicates owning the stock. because the two strategies have exactly the same value in the future, they must have the same value today or an arbitrage would be possible S0= 2 x C0 + (lower stock price)/(1+Rf)

market anomalies

it would be wrong to pretend that there are no puzzles or apparent exceptions. these appear to suggest strategies generating abnormally high risk adjusted returns

peter lynch

manager of the fidelity magellan fund, until his retirement in 1990, it was the top ranked general equity fund. an investment of 1000 in magellan in 1977 was worth 28000 in 1990. perfect stocks.. other investors overlook it or avoid it it sounds dull or even better ridiculous it does something dull it does something disagreeable there's something depressing about it the rumors abound- its involved with toxic waste and or the mafia its a spin off- companies spun off from a parent company are often left in a good position to do well on their own the institutions don't own it and the analysts don't follow it- neglected firm effect- stocks like this tend to do well in the future, big boys have not pushed up the price, they may never discover it but the downside is limited its a no growth industry- you can still grow! stealing market share from other buyers in the same industry its got a niche- local newspapers control a large fraction of the supply people have to keep buying the product- would rather sell the paper/ink than the copier because the copier is a one time sale. it's a user of technology- don't overlook users. the insiders are buyers- they know best about the company itself. if they are buying, could be loyalty, or because they are required to, but also cause they are optimistic about future stock price movement. insider sales are not always negative, but insider buys are usually a positive signal the company has a modest amount of debt which optimally cannot be called at any time at the option of the lender. the company is buying back shares- you may need cash

ESO backdating

many companies had a practice of looking backward in time to select the grant date. they would pick a date on which the stock price (looking back) was low, thereby leading to option grants with low strike prices relative to the current strike price. not illegal or unethical as long as there is full disclosure and various tax and accounting issues are handled properly because of the sarbanes oxley act, companies are now required to report option grants within 2 business days of the grant date, thereby limiting the gains from any backdating.

pecking order theory

many large, financially sophisticated and profitable firms use little debt. under the status theory, these are the firms that should use the most debt because there is little risk of bankruptcy and the value of the tax shield is substantial this theory says that firms prefer to use internal financing whenever possible. a reason is, selling securities to raise cash can be expensive, so it makes sense to avoid doing so if possible. if a firm is very profitable, it might never need external financing, so it would end up with little or not debt. if you try to raise money by selling equity, you run the risk of signaling to the market that the price is too high. companies rarely sell more equity, and the market reacts negatively to such sales when they occur. so, we have a pecking order, companies will use internal financing first. then, will use debt. equity will be used pretty much as a last result

marketed claims vs. non marketed claims

marketed claims can be bought and sold in financial markets and non marketed claims cannot. if we write Vt for the total value of all claims against a corporations CF's: Vt= E+D+G+B =Vm +Vn total value, VT of all the claims to the firm's cash flows is unaltered by capital structure. value of the marketed claims, Vm may be affected by changes in the capital structure. based on the pie theory, an increase in Vm means an identical decrease in Vn. the optimal capital structure is thus the one that maximizes marketed claims or minimizes the value of non marketed claims such as taxes/bankruptcy costs.

critiques of MM

model fails to hold as soon as we add in real world issues and that the M&M theory is really just that: a theory that doesn't leave much to say about the real world we live in

observed capital structures

most corporations seek to have relatively low debt-equity ratios. in fact, most corporations use much less debt financing than equity financing. corporations have not in general, issued debt up to the point that tax shields have been completely used up. there must be limits to the amount of debt corporations can use.

semi strong form efficiency-

most studies pre 1980s- public info doesn't allow you to beat the market after adjusting for risk. keeping up will not give you an edge because the price is already reflected in all information

synergy

need to identify the relevant incremental cash flows, or more generally, the source of value. acquiring another firm makes sense if there is some concrete reason to believe that the target firm will somehow be worth more in our hands than it's not ____- acquisition will be beneficial if the combined firm will have greater value than the sum of values of the separate firms. Vab= value of the combined firm. the merger makes sense only if... Vab > Va + Vb where Va and Vb are the separate values. A successful merger this requires that the value of the whole exceed the sum of the parts. the difference between the value of the combined firm and the sum of the firms as separate entities is the incremental net gain from the acquisition, deltaV: deltaV=Vab- (Va +Vb) where deltaV is position, the acquisition is said to have synergy if firm A buys firm b, it gets a company worth Vb plus the incremental gains, deltaV. the value of firm B to firm a, (v*b), IS THUS: VALUE OF FIRM B TO FIRM A: deltaV + Vb to determine the incremental value of an acquisition, we need to know the incremental cash flows. these are the cash flows for the combined firm less the cash flows that a and b could have generated separately. in other words, it is the difference between the CF for the combined company and the sum of the cash flows for the two companies considered separately. incremental cash flow= deltaCF deltaCF= deltaEBIT + deltaDepreciation -deltaTax - delta Capital requirements = delta Revenue - delta cost - delta tax- delta CR delta CR equals new fixed assets and net working capital. the merger will make sense only if one or more of these cash flow components are beneficially affected by the merger. the possible cash flow benefits of mergers and acquisitions thus fall into 4 basic categories-revenue enhancement, cost reduction, lower taxes, reductions in capital markets

the weekend effect

negative stock returns were observed between the close of trading friday and the opening on monday. he also found that weekends in january are different from others. during january, weekend and monday returns were positive. not surprisingly, in light of other results, the january returns are also related to firm size. the smallest firms have the highest monday returns and the highest returns on all other days

credit risk

no money changes hands when a forward contract is initiated. the contract is simply an agreement to transact in the future. so, there is no up front cost to the contract. however, because a forward contract is a financial obligation, there is credit risk. when the settlement date arrives, the party on the losing end of the contract has a significant incentive to default on the agreement

runs tests

number of consecutive price moves in the same direction. the number of consecutive weeks the market is up. the number of consecutive days the market is down. the pattern of runs is consistent with what one would find if runs were determined randomly- disproves weak form efficiency this is not an obvious way to beat the market. if price movements are random in an efficient market, how are there runs? not an obvious way to beat the market

divestureprof

occurs when a firm sells assets, operations, divisions and or segments to a third party. they are an important part of M&A activity. one company's acquisitions are usually another divestiture. following a merger, it is very common for assets or divisions to be sold. such sales may be required by an anti trust legislation, they may be needed to raise cash to help pay for a deal, or the divested units may simply be unwanted by the acquirer divestures also occur when a company decides to sell off a part of itself for reasons unrelated to mergers and acquisitions. this can help in particular units where they are unprofitable or not a good strategic fit. or a firm may decide to cash out of a very profitable operation finally, a cash strapped firm may have to sell assets just to raise capital, commonly occurs in bankruptcy. a divestiture usually occurs like any other sale- a company makes it known that it has assets for sale and seeks offers. if a suitable offer is forthcoming a sale occurs. in some cases, particularly when a desired divestiture is relatively large, companies will elect to do an equity carve out- a parent company first creates a completely separate company of which the parent is the sole shareholder. next the parent company arranges an initial public offering in which a fraction of the parent's stock is sold to the public, thus creating a publicly held company. instead of a carve out, a company can elect to do a spin off- the company simply distributes shares in the subsidiary to its existing shareholders at a pro rata basis. shareholders can help the shares or sell them as they see fit. commonly, a company will first do an equity carve out to create an active market for the shares and then subsequently do a spin off of the remaining shares at a later date. many well known companies were created by this way split up- a company splits itself into two or more known companies. SHs have their shares in the old company swapped for shares in the new company. (companies) split ups are touted as a way of "unlocking" value, meaning a situation where the whole is worth less than the sum of its parts

acquisition

occurs when one company takes over controlling interest in another company, investors are always looking out for companies that are likely to be acquired, because those who want to acquire such companies are often willing to pay more than the market price for the shares they need to complete the acquisition

things trading futures

on US exchanges, futures contracts and or futures options are traded on.. agricultural products chemicals energy products financial products metals weather traded on chicago board of trade... chicago mercantile exchange coffee sugar and cocoa exchange kansas city board of trade mid american commodity exchange minneapolis grain exchange new york board of trade new york cotton exchange new york mercantile exchange

split off

one or more of the parent firm's shareholders receive stock of a subsidiary in exchange for parent company stock

put option

opposite of a call, instead of giving the holder the right to buy some asset, it gives the holder the right to sell that asset for a fixed exercise price. if you buy a put option, you can force the seller of the option to buy the asset from you for a fixed price and thereby put it to them. investor who sells a call option- sell receives money up front and has the obligation to sell the asset at the exercise price if the option holder wants it. an investor who sells a put option receives cash up front and then is obligated to buy the asset at an exercise price if the option holder demands it. asset involved in an option can be anything, usually stock options. these are options to buy and sell shares of stock.

hedging commodity price risk with options

options that are typically traded on commodities are actually options with futures contracts. they are called futures options- when the futures call option on a commodity is exercised, the owner of the option receives two things, a futures contract on the commodity at the current futures price. this contract can immediately be closed at no cost. the second thing the owner receives is the difference between the strike price of the option and the current futures price. the difference is paid in cash

the option to abandon

options to scale back or even abandon a project is also valuable. if a project does not break even on a cash flow basis, then it can't even cover its own expenses. we would be better off it we just abandon it. if sales demand falls significantly below expectations, we might be able to sell of some capacity to put it to other use. maybe the product of service could be redesigned or otherwise improve. we underestimate NPV if we assume the project must last for some fixed number of years no matter what happens in the future.

LEAPS long term equity anticipation securities

options with long times to expiration when trading is initiated, up to three years maturities currently

strike price

or exercise price, the fixed price specified in the option contract at which the holder can buy or sell the underlying asset, often also called the striking price.

compound interest

over the second period you earn interest on the original principal, (PV) however, you also earn interest on the earn earned over the first period (which is the principal at the beginning of the second period) interest in compounded.

annual percentage rate vs. effective annual rate

p= the number of compounding periods in a year k= the one period interest rate APR= rk= the nominal annual interest rate or quoted rate or stated rate or annual percentage rate if compounding occurs monthly, one period equals one month and k is the monthly interest rate. if the compounding occurs quarterly, one period equals three months and k is the quarterly interest rate. the if the money compounds more than once per year, the APR understates the annual rate that you earn. if a bond's coupon rate equals the market interest rate, the bond will sell at its face value. this is independent of the bond's time to maturity as interest rates rise, the bond price falls. note that all else equal, the shorter the time to maturity, the less responsive a bond's price is to changes in interest rates. `

counter tender off

pac man defense the target responds to an unfriendly takeover offer by offered to buy the bidder. rarely happens because target firms are usually too small to realistically buy the bidder

portfolio insurance

portfolio managers who are concerned about the possibility of adverse market moves may try to insure their portfolio against stock market declines. such portfolio insurance schemes can take at least three forms.. the portfolio manager might purchase put options on some market index, the put option will be worthless is the market goes up. however, if the market declines, the increase value of the index put will hedge the decline in the manager's portfolio the portfolio manager might replicate the put option, the insurance, with a dynamic strategy involving positions in t bills and a broad based group of stocks, trading a broad based group of stocks simultaneously is known as program trading. portfolio insurance schemes are only one source of program trades. alternatively, the portfolio manager might delicate the put option with a strategy utilizing treasury bills and futures on a market index. although the futures position will generate losses if the market goes up, the futures position will generate profits and thus hedge the portfolio losses when the market goes down. common stock as an option on the firm's assets stock ownership in a firm with bonds outstanding can be interpreted as ownership of a call option on the firm's assets at maturity, the sum of the payoffs to the holder of the options on the individual stocks is at least as great and possibility greater than the payoff to the holder of the option on the portfolio. an implication of this option portfolio result follows from the interpretation of stock as a call option on the assets of the firm. since stock is a call option on a firm's assets, and since a portfolio of calls is worth more than a call on a portfolio then it follows that the total value of stock in each of several small companies with debt outstanding is more valuable than stock in a single firm with all of the debt formed by the merger of all the small companies. the money losing division in a large firm soaks up the profits from the money making divisions. however, if that unprofitable division were a separate company, the shareholders of that company could declare bankruptcy, leave the bondholders of that bankrupt company to take a loss, and thus avoid bleeding profits from the other companies which are making money.

put option valuation

pretend a put option is a call option and use the b&s formula to value it. we then use PCP to solve for the put value. re-arrange to solve for put.. P= E x e^-rt + c -s b&s formula is for european style options, which can be exercise only on the final day, whereas american style options can be exercised any time. PCP condition only holds for european style options. american style options is worth more than a european style option. it often pays to exercise a put option once it is well into the money because any additional protective gains are limited. so, american style options are valuable. as long as we stick to non dividend paying stocks, never optimal to exercise a call option early. it is worth more alive than dead. you would be better of selling then exercising, exercise style if irrelevant for calls.

filter rules and weak form efficiency

prices contain all info contained in the record of past stock prices and volumes. the trend is your friend. charting is fruitless if this is true. filter rules- if it goes up, that is a signal to buy, it goes up from some trough. if it goes down from a peak, sell or short an additional amount. when it bottoms out and then gain goes up x%, cover and buy. win= you need more than 2x, but real market does not get enough of these. may work pre transaction cost but not post. exception- filter of .5%- appears to work but involves a lot of transaction commissions. found that filter rules don't let you beat the market correcting for risk.

benjamin graham

ranks as this century's and perhaps history's most important thinker on applied portfolio investment, taking it form an art based on impressions, inside information and flair to a proto science, an orderly discipline the Graham Newman corporation investing 10000 in 1936, received an average of 2100 a year for the next twenty years and recovered one's original 10000 at the end. the company simultaneously employed six different investment techniques a. buying stocks for two thirds or less of their net current assets, usually over 100 different issues at a time. b. buying companies in liquidation, where there seems an 80 percent or better changes of making at least a 20 percent annual return c. risk arbitrade- buying the stock of one company and simultaneously selling the stock of another that it is merging with. d. the convertible hedge- buying a convertible bond or preferred stock and at the same time selling short the common it converts into. the convert should be bought close the conversion parity, so that if the position is closed out by converting little is lost. the further the common an the convertible pull apart, the more the profit. e. buying control of a company selling for less than it is wort, to force realization of assets hedged investing- being long one security and being short another that has no relation to the first- balancing out so to speak. if one chooses rightly, the issues one has bought will improve and those one has shorted will decline, so one prospers from their relative movement without regard to the general market. margin of safety is the difference between the low/cheap, tries to find undervalued assets. a stock should be bought for less than two thirds of its net quick assets, working capital minus all debt and sold at 100 percent of net current assets the company should owe less than it is worth (the debt to tangible equity ratio should be less than one, counting preferred stock as debt) the earnings yield that is the reciprocal of the price earnings ratio, should be twice the prevailing aaa bond yield or the company should owe less than it is worth and the dividend yield should be no less than two thirds of the AAA bond yield. stocks conforming to the first two of these three criteria had provided an average annual appreciate rate of about 19 percent over the 50 year period, excluding dividends and commissions, as compared to 3.5 percent for the DOW, 7.5 percent including dividends. combining the second and third criteria gave much the same result: 18.5 percent combined. the selling rules were simplified: 1. sell your stock after it has gone up 50 percent. or 2. sell after two years, whichever comes first 3. sell if the dividend is omitted 4. sell when earnings decline so far that the current market price is 50 percent over the new target buying price (selling rule number one applied to a hypothetical new purchase)

economics of scale

relates to the average cost per unit of producing goods and services. if the per unit cost of production falls as the level of production increases, then an economy of scale exists. spreading overhead- sharing of control facilities such as corporate HQ, top management and computer services

the small firm effect

returns on the stocks of small firms have been substantially higher than returns for the stocks of larger firms, even after attempts are made to adjust for risk. However, the size effect varies over time and may be negative in some periods, and it has been shown that a large part of the abnormally high return from stocks of small companies occurs in the first few days of January

present value

reverse of future value, instead of compounding the money forward into the future, we discount it back to the present. the PV of $1 to be received in one period is generally given as follows: PV= $1/(1+R) The PV of $1 to be received t periods into the future at a discount rate of r is: $1/(1+R)^t declines as the length of time until payment grows higher the discount rate is, the lower is the present value

financial management and the bankruptcy process

right to go bankrupt is very valuable. when a firm files for bankruptcy, this is a immediate stay on creditors, making payments to creditors will crease and creditors will have to await the outcome of the bankruptcy process to find out if and how much they will be paid. this stay gives the firm time to evaluate its options and it causes what is usually known as a race to the courthouse steps by creditors and others

the neglected firm effect

risk adjusted returns to stocks followed by few security analysts were significantly higher than risk adjusted returns on stocks followed by many security analysts. similarly, the risk adjusted returns earned on stocks held by a few financial institutions were significantly higher than the risk adjusted returns earned on stocks held by many financial institutions

Bill miller

runs the egg mason value trust, which beat the S&P 500 from calendar years 1991-2005, although he notes that using other 12 month periods between january 1 and december 31st would have found his streak shortened. - look forward, not back. don't just compare a stock current valuation with its past valuation. the past does not determine the future. look ahead at future prospects to see if its cheap compared to those. the question is not growth or value, but where is the best value, if traditional growth stocks are cheap, buy them. if traditional value stocks are cheap, buy them. cheap doesn't necessarily mean bargain. if could mean worthless or in stock jargon, value trap. in many cases, a stock's dropping price is just the market noticing its deteriorating prospects. it might be cheap compared to its past for a reason. and that's why you must look ahead. 100 percent of the value depends on the future. use the present value of the future free cash flow to determine whether a stock is a bargain. if a good stock goes down in price- buy more, lowest average cost. just because something has gone up in value does not mean it is overpriced. be contrarian by looking at the long term in a short term world. there are three types of competitive advantages - analytical- when you take the same information that others have, but process it differently and reach different conclusions informational- when you know something important that others don't behavioral- when you understand human behavior better than others and can use that understanding to exploit stock price movements. prospect theory shows that people hate losing more than they love winning- that makes them too risk averse so they overweight recent trends relative to their long term significance, and give greater weight to dramatic events often out of all proportion to the probability of their occurrence. use these tendencies to find bargains. myopic loss aversion afflicts most investors- making them focus on the short term. however, a lot of short term information is irrelevant in the long term. if you've bought solid companies, the best advice is often don't just do something, sit there. if you must do something though, buy a good value as it gets even cheaper. hopes that stock he has started buying drop quickly and dramatically so that there is a chance to buy additional shares at lower prices, lowest average cost wins.

static theory of capital structure

says that firms borrow up to the point where the tax benefit from an extra dollar in debt is equal to the cost that comes from the increased possibility of financial distress. this assumes that the firm is fixed in terms of its assets and operations and it considered only possible changes in the debt/equity ratio. the value of the firm rises to a maximum and then declines beyond that point. the firm's optimal capital structure is composed of D*/Vc' in debt and (1- D*/V* in equity) the difference between the value of the firm in our static theory and the M&M theory of the firm with taxes is the loss in value from the possibility of financial distress. also, the difference between the static theory value of the firm and the M&M value with no taxes, is given from leverage, net of distress costs.

january effect

seasonal patterns in an equal weighted index of the NYSE prices of the period of 1904-1974. specifically, the average monthly return in janaury was about 3.5 percent while other months it was about .5 percent. over one third of the annual returns occurred in janaury alone. interestingly, the high returns in january are not observed in an index that is composed only of large firms... this suggests that the january effect is primarily a small firm phenomenon. in an investigation of the small firm effect, small firms earn higher than expected returns found that the excess returns to small firms were temporally concentrated. half of the excess returns came in january and half of the january returns came in the first five trading days. january returns were higher for small firms who had prices that declined in the previous year and the excess returns in the first five days were not observed for small winners. capital gains- can net out losses against the gains, might do this at the end of december

futures contracts

serve as a forward contract with one exception, with a forward contract, the buyer and the seller realize gains only on the settlement date. with a futures contract, gains and losses are realized daily the daily resettlement feature in forward and future contracts is called marking to market. default risk is greatly reduced with this. financial futures- underlying foods are financial assets such as stocks, bonds or currencies commodity futures- underlying goods can be just about anything other than a financial asset. whenever there is price volatility. there may be a demand for a futures contract and new futures are introduced on a fairly regular basis

homemade leverage

shareholders can adjust the amount of financial leverage by borrowing and lending on their own. this use of personal borrowing to alter the degree of financial leverage is called.... the stockholder who prefers the proposed capital structure will simply create it to replicate this structure at the personal level, the stockholder must borrow enough to create this same debt-equity ratio. investors can always increase financial leverage to create a different pattern of payoffs

hedging short run exposure

short run temporary changes in prices result from unforeseen events or shocks. price fluctuations of this sort are called transitory changes. short run price changes can drive a business into financial distress even though, in the long run, business is fundamentally sound. this happens when a firm finds itself with sudden cost increases that it cannot pass on to its customers immediately. a negative cash flow position is created and the firm may be unable to meet financial obligations. short run financial risks are often called transaction exposure- ST financial exposure ARISES because a firm must make transactions in the near future at uncertain prices or rates. ex. firm may have a bond issue that it will need to replace as it will be maturing next year but the interest rate that the firm will have to pay is unknown

dividends

since stock prices generally drop on the ex dividend day , large dividends have a negative effect on call option prices, calls are more valuable the larger the stock price. it can also be shown that in some situations, it may be optimal to exercise an american call option before an ex-dividend day since stock prices generally drop on the ex dividend day, large stock dividends have a positive effect on put option prices, puts are more valuable the lower the stock price, it can also be shown that in some situations, it may be optimal to refrain from exercising an American put option until the ex dividend day

strategic benefit

some acquisitions provide a strategic advantage, this is an opportunity to take advantage of the competitive environment if certain things occur, or more greatly to enhance management flexibility with regard to the company's future operations. in this latter sense, a strategic benefit is more like an option than a standard investment opportunity. beach head- the process of entering a new industry to exploit perceived opportunities

unused debt capacity

some firms do not use as much debt as they are able. this makes them good acquisition candidates. adding debt can provide important tax savings and many acquisitions are financed with debt. the acquiring company can deduct interest payments on the newly created debt and reduce taxes

contingency planning

some of the possible futures that could come about and what actions we might take if they do investigation of some of the managerial options implicit in a project

golden parachute

some target firms provide compensation to top level management if a takeover occurs can be viewed as a payment to management to make it less concerned for its own welfare and more interest in stockholders when considering a takeover

risk arbitrade

stock speculation by individuals or firms, based on whether or not announced or rumored merger or related transactions such as leveraged buyouts and corporate reorganizations will in fact take place.

the overreaction effect

stocks that had above average risk adjusted returns for five years- the market had overreacted and that these so called winners would subsequently do poorly. confirming this hypothesis, they found that over the next five years, the winners did 10 percent worse than they should have given their level of risk. stocks which had below average risk adjusted returns for five years and predicted that these losers would subsequently do well. they found that over the next five years, the losers did 30 percent better than they should have given their level of risk. interestingly, most of the excess returns for losers occur in january

price to sales ratios

stocks with low price to sales ratios tend to do well and those with high price to sales ratios tend to do poorly

the dividend yield effect

stocks with very high dividend yields, earn abnormal returns after normal risk adjustments

the price to book value effect

stocks with very low price to book values earn abnormal returns after normal risk adjustments

value of a convertible bond

straight bond value- what the convertible bond would sell for if it could not be converted into common stock. this value will depend on the general level of interest rates and debentures and on the default risk of the issuer. is a minimum value in the sense that the bond is always worth at least this amount. will usually be worth more conversion value- what the bond would be worth if it were immediately converted into common stock multiply the current price of stock by the number of shares that will be received when the bond is converted a convertible cannot sell for less than its conversion value, or an arbitrage opportunity exists.

protective puts

strategy of buying a stock and also buying buying a put on the stock is called a protective put because it protects you against losses up to a certain point. put option acts as an insurance policy that pays off in the event that an asset you own (the stock) declines in value. a higher strike price, would mean that you would need to pay more money for the put option, so there is a trade off between the amount of protection and the cost of that protection

desirable characteristics of takeover candidates

synergies with potential acquirer -products, markets, assets, managerial expertise you want to enter a target's industry and it would be time consuming and expensive to build form scratch financial characteristics steady or better yet growing revenues and free cash flows disposable liquid undervalued assets little debt undervalued by the market low price to earnings ratio low price to cash flow ratio the target is run inefficiently and thus is an easy turn around situation. the target pays a lot of income taxes which can be reduced by substituting debt for equity, thus enhancing the value of the acquisition, VL= VU +TCB the target is in the same industry as the acquirer so a takeover would eliminate a competitor but be aware of anti trust the acquirer and the target have common corporate culture the target has no effective shark repellent or poison pills the acquirer and potential takeover candidate are on friendly terms ownership of the target is: not concentrated or if concentrated, is friendly to a potential acquirer or is disloyal to current management of the target, for example professional money managers

defensive tactics

target firm managers frequently resist take over attempts resistance usually starts with press releases and mailings to shareholders that present management's view point. it can eventually lead to legal action and solicitation of competing bids. managerical action to defeat a takeover attempt may make target firm shareholders better off if it elicits a higher offer premium from the bidding firm or another firm managerial resistance may simply reflect pursuit of the self interest at the expense of shareholders. at times, managerial resistance has greatly increased the amount ultimately received by shareholders. at other times, managerial resistance appears to have defeated all takeover attempts to the detriment of shareholders.

Weighted average cost of capital (WACC)

tells us the firm's overall cost of capital is a weighted average of the costs of the various components of the firm's capital structure. value of the firm is maximized when WACC is minimized. WACC is the appropriate discount rate for the firm's overall cash flows because values and discount rates move in opposite directions, minimizing the WACC will maximize the value of the firm's cash flows. one capital structure is better than another if it results in a lower weighted average cost of capital.

bidder target firm consideration

term merger is often used regardless of the actual form of the acquisition refer to the acquiring firm as the ____. this is the company that offers to distribute cash or services to obtain the stock or assets of another company. the firm that is sought and perhaps acquired is often called the ____ ____. the cash or securities offered to the target firm are the _____ in the acquisition

call option boundaries

that lower bound at any time t is exactly the value the call would have at expiration. if the call is in the money Ps,t>E, the lower bound is the value of the call if it were exercised today. Given that lower bound, one can say that any time t, the call will sell for its current exercise value, Max 0, Pst-E or higher if you want to close your in the money call position before the option expiration, you are at least as well off, and often better off, selling your call option as you would be exercising the call and selling the stock. this is because the sale price of the call will be equal to or greater than the value from exercising Ps,t-E

mergers and acquisitions

the acquisition of one firm by another is, of course, an investment made under uncertainty and the basic principles of valuation apply. one firm should acquire another only if doing do generates a positive net value for the shareholders acquiring the firm. 1. benefits from acquisition can depend on such things as strategic fits. strategic fits are difficult to define precisely and its not easy to estimate the value of strategic fits using discounted cash flow techniques 2. there can be complex accounting, tax and legal effect that must be taken into account when one firm is acquired by another 3. acquisitions are an important control device, for shareholders. some acquisitions are a consequence of an underlying conflict between the interests of existing managers and those of shareholders. agreeing to be acquired by another firms is a way to remove existing managers. 4. M&A situations can involve unfriendly transactions. in such cases, when one firm attempts to acquire another, the activity does not always conform itself to quiet and gentile negotiations. the sought after firm often resists takeover and may resort to defensive tactics with exotic names

the risk profile

the basic tool for identifying and measuring a firm's exposure to financial risk a plot showing the relationship between changes in the price of some goods, service or rate and changes in the value of the firm constructing a risk profile is conceptually similar to performing a sensitivity analysis line slopes up, increases in x variable will increase the value of the firm. the the line has a steep slope, the firm has a significant exposure to this risk and it may wish to take steps to reduce that exposure.

optimal capital structure and the cost of capital

the capital structure that maximizes the value of the firm is also the one that minimizes the cost of capital. WACC falls initially because the after tax cost of debt is cheaper than equity. so, initially, the overall cost of equity declines. at some point, the cost of debt begin to rise and the fact that debt is cheaper than equity is more than offset by financial distress costs. from this point, further increases in debt actually increase the WACC.

cash or spot price

the cash or spot price of a commodity or financial instrument is the price of that commodity or instrument agreed upon today for delivery immediately. both the money and the commodity change hands immediately

revenue enhancement

the combined firm may generate greater revenues than the two separate firms increases in revenue come from marketing gains, strategic focusing and increases in market price.

financial leverage

the extent to which a firm relies on debt the more debt financing a firm uses in its capital structure, the more financial leverage it employs can dramatically alter the payoffs to the shareholders in the firm, but it may not affect the overall costs of capital. if this is true, then the firm's capital structure is irrelevant because changes in capital structure won't affect the value of the firm.

factors limiting debt utilization

the firm may want to maintain flexibility to issue additional debt in the future, perhaps to finance investment opportunities which are currently unforeseen. as such, management may not push debt to the limit right now. management may be concerned that excessive debt will cause a reduction in their bond rating, and that the cost of that rating reduction is higher than the benefits of that incremental debt causing the ratings reduction management may want to limit debt to lessen the potability of incurring costs of financial distress. the tax incentive in favor of debt at the corporate level may be offset by a tax incentive in favor or equity capital gains and dividends for corporate investors at the investor level. at a certain point, lenders may stop lending money to the firm. management may be more risk averse than investors and thus seek to limit the amount of debt outstanding. excessive debt may constraint managerial actions, especially is debt convenience are restrictive. if management is pessimistic about future prospects they might prefer to issue common stock rather than be saddled with large interest payments at times when cash may be hard to come by. the new stockholders will share the bad times should they materialize

absolute priority

the higher a claim is on the list, the more likely it is to be paid. secured creditors are entitled to the proceeds from the sale of security and are outside this ordering however, if the secured property is liquidated and provides cash insufficient to cover the amount owed, the secured creditor joins with the unsecured creditor in dividing the remaining liquidating value. in contrast, if the secured property is liquidated for proceeds greater than the secured claim, the net proceeds are used to pay unsecured creditors and others. what happens and who gets what is the subject of much negotiating during bankruptcy and APR is typically not followed

risk free rate

the higher the Rf is, the more the call is worth, exercise price a cash outflow, a liability, the current value of that liability goes down as the discount rate goes up.

the risk free rate

the higher the risk free rate, the higher the price of a european call because the present value of the strike price paid upon the exercise is lower the higher the risk free rate, the lower the price of a european put because the present value of the strike price receive upon exercise is lower. stock dividends and stock splits will be adjusted to be fair to both sides of the stock splits and stock dividends.

stock price

the higher the stock price, S0, the more the call is worth, this comes as no surprise because the option gives us the right to buy back the stock at a fixed price

put option

the holder of a put option has the right, but not the obligation, to sell a share of stock for a fixed price, the strike price or the exercise price, on or before a fixed date, the expiration date. when a put is exercised, no new shares are created since the put owner either sells shares already owned or shares purchased on the open market. put options trade over the counter or on exchange. a put is more valuable the lower the stock price, the higher the strike price, and the longer the time to expiration. a put is like insurance since its payoffs are higher when bad events result in the fall in the stock price. a put cannot have a negative price.

warrant

the holder of a warrant has the right but not the obligation to buy a share of stock for a fixed price, the strike price or the exercise price, on or before a fixed date, the expiration rate, if the warrant is exercised, the firm issues new shares so that the firm's capital structure changes. executive stock options are usually warrants. a warrant is more valuable the higher the stock price, the lower the strike price, the longer the time to expiration, a warrant cannot have a negative value since the investor does not have to exercise it if it would be disadvantageous to do so (when the stock price is less than the exercise price) BOUGHT FROM COMPANY

EPS vs. EBIT

the impact of leverage is evident when the effect of restructuring on EPS and ROE is examined. the variability in both EPS and ROE is much larger under the proposed capital structure. this illustrates how financial leverage seeks to magnify gains and losses to shareholders. EPS is more sensitive to changes in EBIT because of the financial leverage employed.

financial distress cost

the indirect and direct costs associate with going bankrupt or avoiding a bankruptcy filing they are larger when the stockholders and bondholders are different groups. until the firm is legally bankrupt, the stockholders control it. they will take actions in their own economic interest. because the stockholders can be wiped out in a legal bankruptcy, they have a very strong incentive to avoid a bankruptcy filing. bondholders are primarily concerned with protecting the value of the firm's assets and will try to take control away from the stockholders. they have a strong incentive to seek bankruptcy to protect their interests and keep stockholders from further dissipating the assets of the firm long and expensive legal battle. assets of the firm lose value because management is trying to avoid bankruptcy instead of running the business. normal operations are disrupted and sales are lost, valuable employees leave, potentially fruitful programs are dropped to preserve cash and otherwise profitable investments are not taken. whether or not the firm goes bankrupt, the net effect is a loss of value because the firm chose to use debt in its capital structure. it it this possibility of loss that limits the amount of debt that a firm will choose to use.

simple interest

the interest is not reinvested so interest earned each period is only on the original principal

amortized loans

the lender may require the borrower to repay parts of the loan amount over time. making regular principal reductions- amortizing the loan have the borrower pay the interest each period plus some fixed amount the total payment will decline each year because as the loan balance goes down, resulting in a loan interest change each year. in each year, the interest paid is given by the beginning balance multiplied by the interest rate. also, notice that the beginning balance is given by the end balance from the previous years. the most common way of amortizing a loan is to make the borrower make a simple, fixed payment every year. the interest paid declines each period. this is not surprising because the loan balance is going down. given the total payment is fixed, the principal paid must be rising each period

perpetuity

the level stream of cash flows continues forever, the cash flows are perpetual has an infinite number of cash flows PV for a perpetuity: C/R

time to maturity

the longer the time to maturity, the more valuable the call option. this is because the longer the time to maturity, the more likely it is that the price of the underlying stock will move dramatically higher. also, the longer the time to maturity, the lower the present value of the exercise price which would be paid if the call is exercised at maturity an american put option will be more valuable the longer the time to maturity, however it can be shown that a european put option may be more or less valuable the longer the time to maturity, although a longer time to maturity increases the probability of very low stock prices, it also means that the present value of the strike price received upon exercise of a european put at maturity is lower.

put option value boundaries

the lower bound at any time t is exactly the value the put would have at expiration. if the put is in the money, Ps,t<E, the lower bound is the value the put would have if it were exercised today. given that lower bound, one can say that at any time t, the put will sell for its current exercise value Max 0 or E-Pst or higher if you want to close your in the money put option before the option expiration, you are at least as well off and often better off selling your put option as you would be exercising your put, this is because the sale price of the put will be equal to or greater than the value of exercising the put E-Ps,t including commissions would not change the answer since you pay 1 commission to sell at put but possibly 2 commissions to buy the stock and exercise the put

stock return volatility

the more volatile the price of the underlying stock, the more valuable the call option. large volatility increases the chance of a very high stock price and high profit for the owner of a call option. of course, the change of a very low stock price is also high for a volatile stock however since the call option does not have to be exercised, the call owner ends up with 0$ whether the stock price at maturity is 10 less than the exercise price or 50 less the more volatile the price of the underlying stock, the more valuable the put option, large volatility increases the chance of a very low stock price and high profit for the owner of a put option. the chance of a very high price for the owner of a put option is possible however since the put does not have to be exercised, the lower bound on the put is 0

open interest

the number of contracts of each type currently outstanding

volume

the number of option contracts that were traded that day. you can look up option prices many places on the web.

williams act of 1968

the objective of the legislation is to protect the target and all of its shareholders a firm owning 5% or more of another firm's shares must file a schedule 13d with the SEC revealing its holdings and its intentions including plans for the target the share purchaser must file within 10 days of the purchase which pushes their ownership to 5% must inform the target must inform the securities exchanges must inform other bidders must inform the stockholders of the target all tender offers must be held open at least 20 business days. was extended 30 days by hart scott radian act defines pro rata acceptance of oversubscribed shares and all receive the highest price offered the bidder may not purchase shared in the market during the period of the tender offer

convertible bonds

the owner of a convertible bond has the option to hold the bond or to convert the bond into some stated number of shares of common stock. some convertibles may be convertible into a security other than the issuer's common stock. the owner of the convertible bond can be thought of as owning a non convertible bond plus a warrant. that is the common stock price goes up far enough, the owner of the convertible bond will print by converting to the common, just as a warrant holder would exercise the owner of convertible preferred stock has the option to hold the preferred stock or to convert the preferred share into some stated number of shares of common stock. the owner of the convertible preferred can be thought of as owning non convertible preferred plus a warrant. as for the convertible bond, if the common stock price goes up far enough, the owner of the convertible preferred will profit by converting to the common

C x (1- present value factor/r)

the present value of an annuity of C dollars per period for t periods when the rate of return of interest rate is given

Enterprise risk management

the process of identifying and assessing risks and where financially sensible, seeking to mitigate potential damage. companies have always taken steps to manage risks change in recent years has been to view risk management more as a holistic integrated exercise rather than as something to be done on a piece wise basis hazard risks-involve damage due to outside forces such as natural disasters, theft and lawsuits financial risks- arise from things such as adverse exchange rate changes, commodity price fluctuations and interest rate movements operational risk- impairments or disruptions in operations from a wide variety of business related sources including HR, product development, distribution and marketing and supply chain management. strategic risk- large scale issues such as competition, changing customer needs, social and demographic changes, regulatory and political trends, and technological innovation. damage done to company reputation from product problems, fraud, or other unfavorable publicity. ERM says that you should view risks in the context of the entire company. a risk damages one division of a company might benefit another such that they more of less offset each other. in this case, mitigating the risk in one division makes the overall company worse off. similarly, for a multinational with operations in many countries, exchange rate fluctuations may have limited impact at the overall company level. not all risks are worth eliminating . prioritize and eliminate risks that have the greatest potential for economic and social harm. prevention is more of an operating activity than a financial activity

limits of put options

the put cannot sell for more than the exercise price itself the time t price of a put Pp,t must be less than or equal to the exercise price, E. the owner of a put has the right to sell a share of stock for $E, even if the stock costs its minimum 0, the put owner's maximum gain is $E from owning the put, this maximum gain puts an upper limit on the bound of the put's value Pp,t>Max(E-Ps,t, 0) the price of an american put cannot be less than zero and cannot be less than the difference between the exercise price and the stock price, an american put cannot have a negative price because its owner cannot have negative cash flows at maturity, either the put has a positive payoff or a zero payoff at maturity. an american put cannot sell for less than the difference between the exercise price and the stock price because if so, an investor could earn riskless profits. this is what is known as an arbitrage opportunity and cannot exist if the market is efficient.

Ke(L)= Ke(0) + [Ke(0) - Ki(L)](BL/SL)

the relationship between the cost of equity of the levered firm and the cost of equity of the unlevered firm is given by.... cost of equity as a function of the leverage ratio, list the fraction of debt on the right hand side of the balance sheet. cost of debt at the leverage ratio= Ki term to the right will be rising with no taxes, the weighted average cost of capital of the levered firm equals the cost of equity of the unlevered firm WACC= Ke(0) Since there are no taxes, the WACC is both the both tax and after tax weighted average cost of capital. the point at which the firm value is maximized is the point at which the value of the debt equals the total value of the firm, that is also the point at which the firm's pre-tax cash flow goes to interest payments, since there is no taxable income and thus no taxes paid, payouts to investors are maximized, however since all pre tax cash flow goes to bondholders nothing goes to stockholders and the value of the stock is zero. the maximum amount of debt and maximum value of the firm, Bmax is.... Bmax= VU/(1-TC) the percentage increase in value relative to the value of the unlevered firm is... tc/1-tc x 100

greenmail

the repurchase by the corporation of the stockholdings of a raider, through an above the market offer not made to any other stockholders. in exchange the raider agrees to desist from further takeover efforts.

the turn of the month effect

the returns of the four days around the turn of the month starting with the last day of the prior month is .473 percent, the average return for a four day period is .0612. also, the turn of the month four day return is greater than the average total monthly return which is .35.

the holiday effect

the returns on days before holidays were significantly higher than the returns on other days. the size of these numbers is highlighted by the fact that over the last 90 years: 51 percent of capital gains in the DJIA have occurred on approximately ten pre holidays per year.

rosh hashanah and yom kippur effects

the s&P 500 exceeds its daily average return of 4 basis points around rosh hashanah, the festive jewish new year, while underperforming by 29 basis points around yom kippur, the solemn day of atonement. could be due to mood swings of large numbers of jewish trades, but other religious holidays on which markets are open, jewish or not, show little or no effect

consolidation

the same as a merger except that an entirely new girl is created. both the acquiring firm and the acquired firm terminate their previous legal existence and become part of a new firm. the distribution between the two firms is not as important. acquisition by merger or consolidation results in a combination of the assets and liabilities of the acquired and acquiring firms. the only difference is whether a new firm is created. 1. primary advantage is that a merger is legally simple and does not cost as much as other forms of acquisition. no need to transfer title to the individual assets of the acquired firm to the acquiring firm. the firms simply agree to combine their entire operations. the primary disadvantage is that a merger must be approved by a vote of the stockholders of each firm. typically two thirds of the share of votes are required for approval. obtaining the necessary votes can be time consuming and difficult. the cooperating of the target firm's existing management is a necessity for a merger. this cooperation may not be easily or cheaply obtained

the P/E effect

the strategy of buying stocks with low price to earnings per share ratios yields abnormal returns over and above the normal required returns that represent compensation for risk (Similarly, firms with high P/E's earn below normal returns) The price-ratio hypothesis- companies with low P/E's are temporarily undervalued because the market gets inappropriately pessimistic about current or future earnings. Eventually, however, actual earnings growth differs predictably from the growth rate impounded in the price. price corrections and the P/E anomaly inexorably follow.

thomas rowe price

the t. rowe price approach has been heard on wall street almost as often as a real ben graham situation. both phrases are instantly understood. price also created the largest pool of capital of any of our subjects from the firm he founded price's thesis, briefly, was that the investor's best hope of doing well is seeking the fertile fields for growth and then holding growth stocks for long periods of time, he defined a growth stock company as one with long term growth of earnings, reaching a new high level per share at the peak of each succeeding major business cycle and which gives indications of reaching new high earnings at the peak of future business cycles. it may have declining earnings within a business cycle. since industries and corporations both have life cycles, the most profitable and least risky time to own a share is during the early stages of growth, after a company reaches maturity, the investor's opportunity falls and his risk rises. they willl grow into and or beyond the price you paid. requirements for growth companies a. superior research to develop products and markets b. a lack of cut throat competition c. comparative immunity from government regulation d. low total labor costs, but well paid employees e. a 10 percent return on invested capital, sustained high profit margins and a superior growth of earnings per share. requirements for superior companies 1. superior management 2. outstanding research 3. patents 4. strong finances e. a favorable location reasons for decaying growth a. management may change for the worse b. markets may become saturated c. patents may expire or new inventions render them less valuable d. competition may intensify e. the legislative and legal environment may deteriorate f. labor and raw materials costs or taxes may rise. price did not believe in specific predictions for a company's future, as a result the valuation models that are popular on wall street, which give a theoretical price today which can be compared with the market price, are highly suspect if not worthless. the right approach is to just to stick with the best companies in the highest growth industries as long as their progress continues. do not try for a pinpointed mathematical approach that creates an illusory certainty out of an unknowable future.

leveraged buy out

the takeover of a company, using borrowed funds, the target company's assets serve as security for the loans taken out by the acquiring firm, which repays the loans out of cash flow of the acquired company. management may use this technique to retain control by converting a company from public to private. a group of investors may also borrow from banks, using their own assets as collateral, to take over another firm. in almost all leveraged buyouts, public shareholders receive a premium over the current market value for their shares.

the present value of an n-year cash flow stream growing at a constant rate

the time 0 present value of a growing N year cash flow stream starting at time 1 can be expressed as the difference between the present value of a growing cash flow stream between times 1 and +infinitty and the present value of the same cash flows occurring only between times N+1 and +infinity

takeover

the transfer of control of a firm from one group of shareholders to another a takeover thus occurs whenever one group of shareholders takes control from another can occur through: acquisitions, proxy contests and going private transactions in merger and tender offers, the bidder buys the voting common stock of the target firm. proxy contest- when a group attempts to gain control by controlling seats on the board of directors by voting in new directors. a proxy is a right to cast someone else vote. in a proxy context, proxies are solicited by an unhappy group of shareholders from the rest of the shareholders.

the upper and lower bounds on a call options value

the upper bound- the call option gives you the right to buy a share of stock, so it can never be worth more than the stock itself. this tells us the upper bound on a call's value: a call option will always sell for no more than the underlying asset Upper bound: Co< S0 the lower bound the call can't sell for less than zero, so C0>= 0 if the stock price is greater than the exercise price, the call option is worth at least S0-e. opportunites for rissoles profits are called arbitrages. one who arbitrages is called an arbitrageur, they arbitrate prices. in a well-organized market, significant arbitrage will be rare. in the case of a call option, to prevent arbitrage, the value of the call today must be greater than the stock price less the exercise price. C0>= S0-E if we put our two conditions together C0>0 if S0-E<0 C0> So-E if S0-e>0 these conditions say that the lower bound on a call value is either zero or S0-E, whichever is bigger. Lower bound is called the intrinsic value- what the option would be worth if it were about to expire. at expiration, an option is worth its intrinsic value, it will generally be worth more than that at anytime before expiration

intraday effect

the weekend effect spills over into the first 45 minutes of trading on monday, with prices falling during this period, on all other days, prices rise sharply during the first 45 minutes. also returns are high near the very end of the day, particularly on the last trade of the day. the day end price changes are greatest when the final transaction is within the last five minutes of trading,

serial correlation

there is not an obvious pattern that is predictable and that you can exploit. serial correlation. is there a predictable pattern to returns? from one day to the next? from one week to the next? from one month to the next? form one year to the next? if the market is up today, it is more likely to be up or down tomorrow? weak form efficiency

actual use of derivatives

they don't appear on financial statements knowledge comes from surveys, large firms are more likely to use derivatives than are small firms. derivatives can be helpful in reducing variability of cash flow. which reduces the various costs associated with financial distress. firms occasionally use derivatives to speculate future prices and not just to hedge risk. derivatives are more frequently used by firms where financial distress costs are high and access to capital markets is constrained

some financial side effects to acquisitions

things that occur regardless of whether the merger makes any economic sense or not: eps growth- can create the appearance of growth in EPS. may fool investors into thinking the firm is doing better than it is doing. diversification- diversicating does not create value. it reduces unsystematic risk. the value of an asset depends on it systematic risk and systemic risk is not directly affect by diversification. because the unsystematic risk is not especially important, there is no particular benefit from reducing it. stakeholders can get all the diversification they want by buying stock in different companies. as a result, they won't pay a premium for a merged company just for the benefit of diversification.

horizontal acquisitions vertical acquisitions conglomerate acquisitions

this is an acquisition of a firm in the same industry as the bidder this is an acquisition of firm from different steps of the production process when the bidder and the target firm are in unrelated lines of business, popular in technology area

interest rate swaps

two firms could accomplish their objectives by agreeing to exchange each others loan payments. this is an example of an interest rate swap. the two firms would make each other's loan payments. interest rate swaps and currency swaps are often combined. one firm obtains floating rate financing in a particular currency and swaps it for a fixed rate financing in another currency.

floor value

two floor value of convertible bonds: the straight bond value and the conversion value, minimum value of a convertible bond is given by the greater of these two values. the conversion value is determined by the value of the firm's underlying common stock. as the value of the common stock rises and falls, the value of the conversion rises and falls with it. default free- in this case, the straight bond value does not depend on the stock price, given the straight bond value, the minimum value of the convertible depends on the value of the stock. when the stock price is low, the minimum value of a convertible is mostly significantly influenced by the underlying value as a straight debt. however, when the value of the firm is very high, the value of a convertible bond is mostly determined by the underlying conversion value.

costs of financial distress

two of the costs of financial distress relate to bankruptcy costs and bondholder/ stockholder conflicts bankruptcy costs are defined as including: the accounting, investment banking and legal fees which must be paid due to the firm going through bankruptcy proceedings. the management time which is lost of as result of re-organization, re-organization diverts management's attention away from producing a product or providing a service. lost sales because a potential bankruptcy may motivate customers to buy from competitors. this indirect bankruptcy cost could be much greater. this indirect bankruptcy cost could be much greater than the direct bankruptcy costs such as in i and ii conflicts between bondholders and stockholders of a firm in financial distress may result in decisions being made which do not increase overall firm value. risk-shifting involves changing the asset structure of the firm. financial managers who act strictly in their shareholders interests (and against the interests of creditors) will favor risky parodists with negative NPVs the warped strategy for capital budgeting clearly is costly to the firm and to the economy as a whole. why do we associate the costs with financial distress, because the temptation to play is strongest when the odds of default are high. in the event of financial distress, bondholders may enforce extremely restrictive debt covenants, for example, management may not be allowed to sell assets to raise cash and may not be allowed to move valuable assets from one subsidiary to another. management may also face constraints on the payment of dividends, the issuance of additional debt and/or making investment outlays. if could be disadvantageous for stockholders to put up equity capital for positive net present value projects because such projects would enhance the position of bondholders. in the framework of the MM theory with corporate taxes... VL=Vu +tcB -PV of bankruptcy costs -PV of stockholders/bondholder conflicts. the second two argue for less debt. since the third and fourth terms on the right of the equals sign get large as the amount of debt outstanding increases, the implication is that the optimal capital structure will involve less than 100% debt financing

alternatives to merger strategic alliance joint venture

two or more firms can simply agree to work together. they can sell each other's products, perhaps under different brand names or jointly develop a new product or technology ____ ____- usually formed to cooperate in pursuit of a joint goal. ___ ____- two firms putting up the money to establish a new firm

hedging interest rate risk with options

use of options to hedge against interest rate risk. some are futures options and they are traded on organized exchanges. OTC market in interest rate options. some interest rate options are on interest bearing assets such as bonds. most of the options that are traded on exchanges fall into this category. some others are actually options on interest rates. if you want to protect yourself against an increase in interest rates using options, we need to buy an option that increases in value as interest rate goes up. one thing we can do is buy a put option on a bond, when interest rates go up, bond values go down, so one way to hedge against interest rate increases is to buy put options on bonds. other way to hedge is to buy a call option on interest rates. remember that the call provision gives the issuer the right to buy back the bond at a set price, known as the call price. what happens is that if interest rates fall, the bond prices will increase. if it rises above the call price, the issue will exercise the option and acquire the bond at a bargain price. the call provision continues to be viewed as either a call option on a bond or a put option on interest rates

reasons for mergers and acquisitions

value creation -synergies -improved management operating assets more efficiently -purchased undervalued assets and taking actions to have their value realized -increase riskiness of assets which may lead to reduction of debt value -addition/substitution of debt to reduce taxes -one firm's unused tax loss carry forwards may have value to another firm with taxable income growth- assets, sales, profits if a high P/E firm acquires a low P/E firm in a stock for stock exchange, the earnings per share of the acquirer will increase. a way to acquire resources quickly -plants -products -raw materials- patent technological expertise distribution channels cash managerial expertise diversification diversification might be good for investors might be good for managers in order to change industries - a merger may facilitate a redeployment of assets from a low growth industry to a high growth industry a merger may facilitate a redeployment of assets from a highly regulated industry to a less regulated industry a merger may facilitate a move away from an industry subject to the risk of lawsuits merging with a competitor eliminates that firm as a competitor merging with another firm may make a firm less desirable as a takeover candidate acquisitions may satisfy management's desire to build an empire investor tax considerations relative to a sale of a firm for cash, a stock for stock acquisition affords tax deferral possibilities

option value

value of a convertible bond will always exceed the straight bond value and the conversion value unless the firm is in default or the bondholders are forced to convert. the reason is that the holders of the convertibles do not need to convert immediately, instead by waiting they can take advantage of whichever is greater in the future, the straight bond value of the conversion value. option to wait has value and it raises the value of the bond over its floor. total value of the convertible is thus equal to the sum of the floor value and the option value

black and scholes model

value of a european style call option on a non-dividend paying stock, C, can be written as follows: C= S x N(d1)- E x e^-rt x N(d2) where s, e AND e-RT are presently defined and N(d1) and n(d2) are probabilities that need to be calculated. n(d1) is the probability that a standardized normally distributed random variable is less than or equal to d1 and n(d2) is the probability of a value less than d2. these probabilities can be found in a table. if we are given the values for d1 and d2 then it is not a difficult formula... generally, we must calculate them. d1= ln(s/e) + (rf + sd^2/2)t/(sd(sqrt(t)) sd is the standard deviation of the return on the underlying asset. also, ln s/e is the natural logarithm of the current stock price divided by the exercise price. price of a call option depends on five factors, stock price, strike price, time to maturity, risk free rate, standard deviation of return on the stock. Nd1 and Nd2 do not really correspond to anything in the real world. Nd2 is frequently thought to eb the probability that the stock price will exceed the strike price on the expiration day, unfortunately that not correct unless the expected value on the return of the stock equals the risk free rate.

fifth factor

variance of return on the underlying asset. the greater the variance is, the more the option is worth, increasing the risk, as measured by return variance, on the underlying asset increases the value of the option. increasing the variance on the possible future prices on the underlying assets doesn't effect the options value when the option finishes out of the money. the value is always zero in this case. on the other hand, increasing the variance increases the possible payoffs when the option is in the money, so the net effect is to increase the options value. put another way, because the downside risk is always limited, the only effect is to increase the upside potential. the number of options that you need to buy to replicate the value of the stock is always equal to deltaS/deltaC where deltaS is the difference in the possible stock price and deltaC is the difference in the possible option values. when the stock is certain to finish in the money, deltaS/deltaC is always equal to 1, so one call option is needed. Otherwise, deltaS/deltaC is greater than 1 so more than one call option is needed.

earnings dilution

warrants and convertible bonds cause the number of shares to increase. happens when 1. the warrants are exercised and 2. when bonds are converted causing the firm's net income to be spread among a larger number of shares. EPS decreases. firms with significant numbers of warrants and convertible issues outstanding generally calculate and report EPS on a diluted basis. the calculation is based on a number of shares that would be outstanding if all the warrants were exercised and all the convertibles were converted. because this increases the number of shares, diluted EPS will be lower than "basic" EPS" which is calculated online the basis of shares actually outstanding

MM Proposition 2 with corporate taxes

we can also conclude that the best capital structure is 100 percent debt by examining the WACC: WACC= (E/V) x Re + (D/V) x Rd x (1-Tc) to calculate this, we need to know the cost of equity M&M Proposition 2 w/ corporate taxes states that the cost of equity is: Re= Ru + (Ru-Rd)x (D/E) x(1-Tc) WACC increases as the debt/equity ratio grows. the more debt the firm uses, the lower is the WACC

should you use a financial planner?

what is your expertise? how are they being compensated? what are their incentives if they earn money on transactions, they may have an incentive to buy and sell a lot of stuff. hire for a fixed fee- they have an incentive to do what is good for you because then you will hire services the next year.

game show strategies

wheel of fortune- buy vowels if you don't know the puzzle who wants to be a millionaire let's make a deal0 mathematically it's in your best interest to switch, you'll win 2/3 of the time. what should your goal be? making money? reducing risk? cutting taxes? something else? live a life rich in interesting experiences. money should be a means to an end but not the end itself.

share rights plans

when a company adopts an SRP, it distributes share rights to its existing stockholders these rights allow shareholders to buy shares of stock or preferred stock at some fixed price. the exercise or subscription price on the right is usually set high enough so that the rights are well out of the money, meaning that the purchase price is much higher than the current stock price. rights will often be good for 10 years and the purchase or exercise price is usually a reasonable estimate of what the stock will be worth at the end of that time. in addition, unlike ordinary stock rights, these right's can't be exercised immediately and they can't be bought and sold separately from the stock, also they can essentially be cancelled by management at any time, often they can be redeemed or bought back for a penny a piece or some similarly trivial amount. triggered- means that the rights have become exercisable.. they can be bought or sold sportily from the stock and they are not easily cancelled, or redeemed. typically, the rights will be triggered when someone acquires 20% of the common stock or announces a tender offer. when the rights are triggered, they can be exercised. because they are out of the money, this fact is not especially important.

agreements to avoid bankruptcy extension, composition

when a firm defaults on an obligation, it can avoid a bankruptcy filing. because the legal process of bankruptcy can be lengthy and expensive, it is often in everyones best interest to devise a workout that avoids a bankruptcy filing much of the time, creditors can work with the management of a company that has defaulted on a long contract voluntary arrangements to restructure or reschedule a company's debt are often made. these may involve ____- which postpones the date of payment or ____- which involves a reduced payment

debt in addition to equity

when debt was issued it was assumed to be issued in substitution for equity, that is, the proceeds of the debt issuance were immediately used to pay a cash dividend or repurchase shares. no new assets were purchased so the left side of the balance sheet was unchanged. the right side of the balance sheet was reconfigured to increase a debt increase and an equity decrease of the same amount. cash equal to B dollars is brought into the firm, cash equal to B dollars is paid out to stockholders (by a cash dividend or a share repurchase) and firm value is enhanced by the present value of the tax savings TcB associated with the interest payments. therefore, in a world without investor taxes the value of the levered firm can be calculated as.... Vl= Vu +TcB now assume that debt is issued in addition to equity. that is the proceeds of the debt issuance are kept within the firm so the value of the asset accounts increase by the amount of cash raised. investor taxes will again be ignored. when debt is issued in addition to equity, then cash equal to B dollars is brought into the firm but there is no offsetting payout to stockholders. therefore.. VL= Vu +B +TcB B doesn't get subtracted! this new cash is on top of all the other assets that the firm previously had. VL= Vu +B+ NPVnewassets +TcB

direct bankruptcy costs

when the value of the firm's assets equals the value of its debts, then the firm is economically bankrupt in the sense that equity has no value. however, the formal turnover over of the assets to the bondholders is a legal process, not an economic one. there are legal and administrative costs to bankruptcy. because of the expenses associated with bankruptcy, bondholders won't get all that they are owed, some fraction of the firm's assets will disappear in the legal and administrative expenses associated with bankruptcy. these direct bankruptcy costs are a disincentive to debt financing. if a firm goes bankrupt, then suddenly a piece of the firm disappears. this amounts to a bankruptcy tax. trade off: borrowing saves a firm money on its corporate taxes, but the more a firm borrows, the more likely it is that a firm will become bankrupt and pay a bankruptcy tax.

stock acquisition (merger)

when you do a cash merger, the shareholder in B receive cash for their stock and they no longer participate in the company. in a stock merger, no cash actually changes hands. instead the shareholders of firm B are in as new shareholders of the merged firm in this case will be equal to the pre merger values of A and B plus the incremental gain from the merger, deltaV Vab= Va + Vb + deltaV the price per share after the merger is lower under the stock purchase option, the reason has to do with the fact that B's shareholders own stock in the new firm. true cost= shares given to firm b x new stock price. NPV of the merger to firm A: NPV= V*B-cost cash acquisition is better in this case, because a gets to keep all of the NPV if it pays in cash. if it pays in stock, firm B's stockholders share in the NPV by becoming new stockholders in it.

relationships between spot and future prices

while the holder of the underlying financial contract may receive dividends or interest, between time 0 and time t, the holder of the futures contract does not receive any dividend or interest payments if this relationship between spot and future prices is violated, traders seek to profit on the price discrepancy by executing an index arbitrage strategy, involves program trades a program trade is a simultaneous trade of a basket of stocks the term program does not refer to trading triggered by a computer program, but refers to trading associated with a strategy or plan. program trading antedates computer trading. the primary role of computers in program trading concerns the designed order turnaround system at NYSE. DOT allows a trader to send orders to many trading posts simultaneously, thereby lowering trading costs and speeding execution. arbitage entails the simultaneous sale and purchase of the same asset in separate markers, generating profit without risk or net investment. in practice, index arbitrage occurs when the futures price prices above (falls below) its fair value reaction to stock prices, promoting the purchase or sale of the stocks in an index and the sale or purchase of the futures contract that underlies the index. the effect of index arbitrade is to return stock and futures prices to their fair value relation. in the popular press term index arbitrage is often used interchangeably with program trading. in some months surround the market crash, index arbitrage generally accounted for the majority of program funding.

cash flow perpetuity with constant growth

why does this formula only hold if r is greater than g? then the denominators are getting bigger faster than numerators PV= (CF1)/(1+r) + (CF1)(1+G)/(1+R)^2..... The infinite series only converses if r>g if r=g or if r is less than g, then the series approaches infinity. if r is greater than g, as n gets large, the numerator gets big fast but the denominator gets big faster. terms start approaching zero and the infinite series converges

estate planning

wills- concerns relevant to leaving assets to children, one you have enough assets. if you die without leaving them the state law decides who gets your assets and this might not be the same as your preferences trusts- revocable living trusts how to minimize taxes

options vs forwards

with a forward contract, both parties are obliged to transact, one party delivers the asset and the other party pays for it. with an option, transaction occurs only if the owner of the option chooses to exercise it. no money changes hands if a forward contract is created by the buyer of an option contract gives a valuable right and must pay the seller for that right. the price of the option is frequently called the option premium

hedging exchange rate risk with options

work exactly the same way as commodities futures options. there are other traded options for which the underlying assets just currency rater than a futures contract on some currency. firms with significant exposure to exchange rate risk frequently purchase put options to protect against adverse exchange rate changes

volatility index

you can buy this if you think the volatility is going to go up implied volatilities are calculated by plugging in the option price in the BS formula along with the stock price, the exercise price, the time to maturity and the risk free rate then solve for the implied standard deviation