FI 414 Final Exam

Cost to Stockholders from Reduction in Risk

*mergers increase the safety of bonds, raising the value of these bonds and hurting the stockholders *ch.11- we considered an individual adding one security after another, all of equal risk, to a portfolio -> as long as the securities were less than perfectly positively correlated w/ each other, the risk of this portfolio fell as the number of securities rose. This risk reduction reflected diversification. Diversification also happens in a merger. When 2 firms merge, the volatility of their combined value is usually less than their volatilities as separate entities. * an individual benefits from portfolio diversification, diversification from a merger may actually hurt the stockholders -> the bondholders are likely to gain from the merger becasue their debt is now "insured" by two firms, not just one. Turns out that this gain to the bondholders is at the stockholders' expense

Short Hedge

*reduces risk by selling a futures contract, very common in business

Consolidation

*same as a merger, except that an entirely new firm is created *both the acquiring firm and the acquired firm terminate their previous legal existence and become part of the new firm

Coinsurance effect

*when one of the divisions of the combined firm fails, creditors can be paid from the profits of the other division, mutual guarantee is called this *there is no net benefit to the firm as a whole, bondholders fain coinsurance effect, and the stockholders lose the coinsurance effect Conclusions 1. Mergers can help bondholders. The size of the gain to bondholders depends on the reduction in the probability of bankruptcy after the combination. That is, the less risky the combined firm is, the greater are the gains to bondholders. 2. Stockholders are hurt by the amount that bondholders gain. 3. Conclusion 2 applies to mergers without synergy. In practice, much depends on the size of the synergy.

Acquisition of Stock

- 2nd way to acquire another firm (purchase firm's voting stock in exchange for cash, shares of stock, or other securities) -may start as a private offer from the management of one firm to another, at some point the offer is taken directly to the selling firm's stockholders, often by a tender offer

Reduced Capital Requirements

-Mergers can reduce operating costs, follows that mergers can reduce capital requirements as well. -Accountant typically divide into two components: Fixed capital & working capital *when two firms merge, managers will find duplicate facilities. If both firms had their own headquarters, all executives in the merged firm could be moved to one headquarters building, allowing the other headquarters to be sold *Plants could be redundant as well, or two merging firms in the same industry might consolidate their R&D, permitting some R&D facilities to be sold *same goes for working capital, Inventory/Sales & Cash/Sales ratios often decrease as firm size increases, a merger permits these economies of scale to be realized, allowing a reduction in working capital

Swap Pricing

-Swaps, like forwards & futures, are essentially zero-sum transactions, which is to say that in both cases the market sets prices at a fair level, and neither party has any substantial bargain or loss at the moment the deal is struck -Similarly, the currency swap can also be viewed as a series of forward contracts. In a credit default swap, the swap rate is a market expectation of the default rate for a particular bond over a particular time

Cash vs. Common Stock

-When do bidders want to pay w/ cash and when do they want to pay w/ stock? -decision hinges on a few variables: 1. price of the bidders stock (managers often have more info than the market, so their view of price is diff.) *an overvaluation would have no impact on a merger in a cash deal, but overvaluation would have a big impact on a stock-for-stock deal (empirical evidence suggests firms are more likely to acquire w/ stock when their own stocks are overvalued (target company learns from this & may ask for a better deal or cash offer, market also learns, evidence shows the acquirer's stock price generally falls upon the announcement of a stock-for-stock merger

Credit Default Swaps

-a credit default swap (CDS) is like insurance against value loss due to a firm defaulting on a bond - a person involved in a CDS is called a counterparty, there are always 2 counterparties in a CDS, -->in a typical CDS, counterparty 1 pays counterparty 2 a periodic payment. In exchange, Counterparty 2 agrees to pay par for a particular bond issue if default occurs. Counterparty 1 is called the protection buyer and Counterparty 2 is called the protection seller. The periodic payment is called the CDS spread (each counterparty will attempt to negotiate the best possible agreement

Convertible Bond (Finale)

-a package of straight debt and an option to buy common stock. The difference between the market value of a convertible bond and the value of a straight bond is the price investors pay for the call option feature. In an efficient market, the price is fair.

Earnings Growth

-an acquisition can create the appearance of earnings growth, perhaps fooling investors into thinking that the firm is worth more than it really is.

Acquisition of Assets

-another way one firm can acquire another -selling firm does not vanish because its "shell" can be retained -formal vote of target stockholders is required in an acquisition of assets -advantage here is that although the acquirer is often left w/ minority shareholders in an acq of s, this does not happen ins an acq of a. Minority shareholders often present problems, such as holdouts vs acq of a involves transferring title to individual assets, which can be costly

Proxy Contest

-can result in takeovers -occur when a group of shareholders attempts to gain seats on the board of directors *proxy is written authorization for one shareholder to vote the stock of another shareholder **in a contest, an insurance group of shareholders solicits proxies from other shareholders

Revenue Enhancement

-combined firm may generate greater revenues than two separate firms. Increased revenues can come from marketing gains, strategic benefits, and market power

Cost Reduction

-combined firm may operate more efficiently than two separate firms -Merger can increase operating efficiency in the following ways: 1. Economy of Scale- the average cost of production falls as the level of production increases (spreading overhead) 2. Economies of Vertical Integration- main purpose of vertical acquisition is to make coordination of closely related operating activities easier 3. Technology Transfer- another reason for a merger 4. Complementary Resources- some firms acquire others to improve usage of existing resources 5. Elimination of Inefficient Management- can often increase firm value, some managers overspend on perquisites & pet projects, some managers may not understand changing market conditions or new technology and the board of directors is unable to act independently to replace them. M&A can be viewed as part of the labor market for top management

Option Value

-holders of convertibles do not need to convert immediately, by waiting they can take advantage of whichever is greater in the future: straight bond value or conversion value -when value of a firm is low, the value of convertible bonds is most significantly influenced by their underlying values as straight debt -when value of a firm is high, the value of convertible bonds is mostly determined by their underlying conversion value (value of a convertible bond is the sum of its floor value and it option value)

Target firm

-if bid offer is accepted than this firm will give up control over its stock or assets to the bidder in exchange for consideration Takeovers can occur by acquisition, proxy contests, and going-private transactions If takeover is achieved by acquisition it will be by: merger, tender offer for shares of stock, or purchase of assets. In mergers & tender offers, the acquiring firm buys the voting common stock of the acquired firm

Life insurance companies receiving premiums

-legally obligated to provide death benefits in the future -actuaries view these future benefits as analogous to interest and principal payments of fixed-income securities (duration of these expected benefits can be calculated) (insurance firms frequently invest in bonds where the duration of the bonds is matched to the duration of the future death benefits)

Strategic Benefits

-more like an option vs. a standard investment opportunity

Synergy

-occurs if the value of the combined firm after the merger is greater than the sum of the value of the acquiring firm and the value of the acquired firm before the merger -4 sources: revenue enhancement, cost reduction, lower taxes, and lower capital requirements

Market or Monopoly Power

-one firm may acquire another to reduce competition -if this happens, prices can be increased, generating monopoly profits -mergers that reduce competition do not benefit society, U.S. Department of Justice or the Federal Trade Commission may challenge them

Pricing of Forward Contracts

-pay for item (in this case bond) on the date of purchased not the date you agreed to a future purchase

Backdoor Equity

-popular theory of convertibles views them as backdoor equity -young, small, high-growth firms cannot issue debt on reasonable terms due to high financial distress costs (However, the owners may be unwilling to issue equity if current stock prices are too low)

Convertible Bond

-similar to a bond with warrants, difference is that a bond w/ warrants can be separated into distinct securities and a convertible bond gives the holder the right to exchange it for a given 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. -are almost always protected against stock splits and stock dividends Summary: A convertible bond is a combination of a straight bond and a call option. The holder can give up the bond in exchange for shares of stock

Street Sweep

-strategy to gain control of a hostile target -acquirer may continue to buy more shares in open market until control is achieved -infrequently used **tendered offers often allow the acquirer to return the tendered shares if fewer shares than the desired number are tendered. Contrast, shares purchased in the open market cannot be returned

Other motives for a merger besides synergy?

-synergy is source of benefit to stockholders *Managers likely to view a potential merger differently, even if the synergy from the merger is less than the premium paid to the target, the managers of the acquiring firm may still benefit greater revenues= possibly higher compensation once they managing a larger firm larger firm= greater prestige & power (also experience) Down's- manager of the target could lose their jobs after acquisition, might oppose the takeover even if stockholders would benefit from the premium

Factors involved in choosing between an acquisition of stock & a merger

1. In an acquisition of stock, shareholder meetings need not be held and a vote is not required. If the shareholders of the target firm do not like the offer, they are not required to accept it and need not tender their shares 2. (in an acq) the bidding firm can deal directly with the shareholders of a target firm via a tender offer. The target firm's management and board of directors are bypassed 3. Target managers often resist acquisition. In such cases, acquisition of stock circumvents the target firm's management. Resistance by the target firm's management often makes the cost of acquisition of stock higher than the cost by merger 4. Frequently a minority of shareholders will hold out in a tender offer, and thus, the target firm cannot be completely absorbed. 5. Complete absorption of one firm by another requires a merger. Many acquisitions of stock end w/ a formal merger

Futures Contract

A variation of a forward contract that has essentially the same basic definition but with some additional features: 1. Futures contracts are traded on an exchange, forward contracts are generally traded off an exchange (because of this there is generally a liquid market in futures contracts, -a buyer can net out her futures position with a sale -a seller can net out his futures position with a purchase -if a buyer of a futures contract does not subsequently sell her contract, she must take delivery) 2. The prices of futures contracts are marked to the market daily 3. seller has a period of time to deliver vs. a specific day; gives the seller leeway not seen in a forward contract 4. generally a liquid market for futures contract at any time ( a seller can buy back her futures contract at any time vs. forward markets are generally quite ill-liquid, traders cannot easily net out their positions) (popularity of the T-bond futures contract has produced liquidity even higher than that on other futures contracts, positions in that contract can be netted out quite easily)

Matching CFs

If financing is costly, it makes sense to issue securities whose cfs match those of the firm. -young, risky, growing firm might prefer to issue convertibles or bonds w/warrants because these will have lower initial interest costs -when the firm is successful the convertibles or warrants will be converted (this causes expensive dilution, but it occurs when the firm can most afford it)

Derivatives

a financial instrument whose payoffs and values are derived from, or depend on, something else -an option is a derivative (val. of a call option depends on the value of the underlying stock on which it is written -most are forward or future agreements or swaps

Tender offer

a public offer to buy shares of a target firm -made by one firm directly to the shareholders by public announcements -sometimes general mailing is used as a tener offer

Going-private transactions

a small group of investors purchases all the equity shares of a public firm -group usually includes members of incumbent management and some outside investors -shares of the firm are delisted from stock exchanges and can no longer be purchased in the open market

Horizontal Acquisition

both acquirer and acquired are in the same industry

Conversion Price

calculated as the ratio of the face value of the bond to the conversion ratio *(conversion price & conversion premium assume the bond is selling at par)

Bidder

firm that has decided to take over another

Change

movement in the settlement price since the previous trading session

Net price to buyer

must be the price at which she bough originally+

Long Hedge

one purchases a futures contract to reduce risk, one takes a long position in the futures market (*argued that firms can hedge risk by trading in futures. because some firms are subject to interest rate risk, they can hedge with interest rate futures contracts. firms may also hedge interest rate risk by matching liabilities with assets)

Proxy Fight

procedure involving corporate voting *victor to a proxy fight does not gain additional shares, the reward is simply share price appreciation if the victor's policies prove effective *just the threat of a proxy fight may raise share prices because management may improve operations to head off the fight

Floor

provides a floor below which the interest rate impact is insulated

Warrants

securities that give holders the right, but not the obligation, to buy shares of common stock directly from a company at a fixed price for a given period -each warrant specifies the # of shares of stock that the holder can buy, the exercise price, and the expiration date >>a warrant gives the holder the right to buy shares of common stock at an exercise price for a given period. Typically warrants are issued in a package with privately placed bonds. Afterwards they become detached and trade separately

Deliverable instrument

something you are getting for example a book: *cashier acting on behalf of bookstore is selling a forward contract (writing a forward contract)

Settlement Price

the closing price for the day

Open interest

the number of contracts outstanding at the end of the day

Effect of Changing interest rate

the percentage price changes of long-term pure discount bonds are greater than the % changes of short-term pure discount bonds

Speculation

the use of derivatives to change or increase the firm's risk exposure -on the movement of some economic variables (those that underlie the derivative) Example: If a derivative is purchased that will rise in value if interest rates rise, (and if firm has no offsetting exposure to interest rate changes) the firm is speculating that interest rates will rise and give it a profit on its derivatives position *if opinion on which the derivatives position is based turn out to be incorrect, then the consequences are costly (most negative experiences with derivatives have occurred from their use as instruments for speculation)

Cash Transaction

transaction where exchange is immediate

Risk Enhancing

using derivatives to translate an opinion about whether interest rates or some other economic variable will rise or fall (opposite of hedging)

Conversion Value

what the bonds would be worth if they were immediately converted into common stock at current prices -typically computed by multiplying the # of shares of common stock that will be received when the bond is converted by the current $ of the common stock -the minimum, or floor, value of a convertible bond is either a straight bond value or its conversion value, whichever is greater -a convertible cannot sell for less than its conversion value (convertible bonds have two minimum values: straight bond value & the conversion value) -conversion value is determined by the firm's underlying common stock (price of common stock increases, conversion value increases)

Straight Bond Value

what the convertible bonds would sell for if they could not be converted into common stock -this straight bond value of a convertible bond is a minimum value -(dependant on general level of interest rates & the default risk)

Hedging

when a firm reduces its risk exposure with the use of derivatives -offsets a firm's risk, by one or more transactions in the financial markets

Making Delivery

you receiving the product (you get the book)

Cap

it puts an upper limit or cap on the impact of a rise in interest rates

Defensive Tactics

*Target firm managers frequently resist takeover attempts, actions to defeat takeover may benefit target shareholders if the bidding firm raises its offer price or another firm makes a bid. Though, resistance may simply reflect self-interest at the shareholders' expense. -> target managers may fight a takeover to preserve their jobs.

Cleanup mergers

*after hostile takeover, acquirer proposes merger to obtain remaining shares it does not already own, now friendly because board will approve it

Diversification

*by itself, may not produce increases in value (unsystematic risk) -Unsystematic risk can be diversified away through mergers. However, inventory does not need widely diversified companies, like GE, to eliminate unsystematic risk --> shareholders can diversify more easily than corporations by simply purchasing common stock in different corporations *diversification through conglomerate merger may not benefit shareholders Diversification can produce gains to the acquiring firm if one of 3 is true: 1. Diversification decreases the unsystematic variability at lower costs than by inves- tors' adjustments to personal portfolios. This seems very unlikely. 2. Diversification reduces risk and thereby increases debt capacity. This possibility was mentioned earlier in the chapter. 3. Internal capital or labor allocations are better for diversified firms than would be true otherwise. *Otherwise, one should be cautious in accepting diversification as a benefit in a merger or acquisition.

Swaps Contracts

*close cousins to forwards & futures -arrangements between two counter-parties to exchange cash flows over time -enormous flexibility in the forms that swaps can take, 3 basic types: interest rate swaps, currency swaps, and credit default swaps (often these are combined when interest received in one currency is swapped for interest in another currency)

Debt Capacity

-2 cases in which M allows for increased debt and a larger tax shield 1. the target has too little debt, and the acquirer can infuse the target w/ the missing debt. 2. Both target & acquirer have optimal debt levels. A merger leads to risk reduction, generating greater debt capacity and a larger tax shield Case 1: Unused Debt Capacity *greater debt leads to a greater tax shield (every firm can borrow a certain amount before the marginal costs of financial distress equal the marginal tax shield) Function of: risk of the firm, (firms w/ high risk cannot borrow as much as firms w/ low risk) *is it bad for a firm to have too little debt? YES, optimal level of debt occurs when the marginal cost of financial distress equals the marginal tax shield. Too little debt reduces firm value (a firm w/ little or no debt is an inviting target, an acquirer could raise the target's debt level after the merger to create a bigger tax shield) Case 2: Increased Debt Capacity *risk of the combined is less than that of either one separately, banks should be willing to lend more money to the combined firm than the total of what they would lend to the two separately. ->risk reduction that the merger generates leads to greater debt capacity *debt generates a tax shield, if debt rises after the merger, taxes will fall -> this is because of the greater interest payments after the merger, the tax bill of the combined firm should be less than the sum of the tax bills of the two separate firms before the merger -> increased debt capacity form a merger can reduce taxes *target has too little leverage-> the acquirer could infuse target w/ more debt generating a greater tax shield *both target & acquirer began w/ optimal debt levels -> merger leads to more debt even here, the risk reduction form the merger creates greater debt capacity and thus a greater tax shield

Currency Swaps

-FX stands for foreign exchange, and currency swaps are sometimes called FX swaps. Currency swaps are swaps of obligations to pay cash flows in one currency for obligations to pay in another currency -arise as a natural vehicle for hedging risk in international trade

Two Financial Side Effects of Acquisitions

1. Earnings Growth 2. Diversification

Duration

-commonly used word for effective maturity *the percentage price changes of a bond with high duration are greater than the percentage price changes of a bond with low duration (*many of the funds available for mortgage lending were financed by short-term credit, especially savings accounts. the duration of such instruments is quite small) -duration & immunization strategies are useful in other ares of finance, for example: a. many firms establish pension funds to meet obligations to retirees, if the assets of a pension fund are invested in bonds and other fixed-income securities, the duration of the assets can be computed. Similarly, the firm views the obligations to retirees as analogous to interest payments on debt, the duration of these liabilities can be calculated as well. the manager of a pension fund would commonly choose pension assets so that the duration of the assets is matched with the duration of the liabilities. In this way changing interest rates would not affect the net worth of the pension fund. -business of a leasing company: firm issues debt to purchase assets which are then leased, the lease payments have a duration, as does the debt. Leasing companies frequently structure debt financing so that the duariton of the dbet matches the duration of the lease, if a firm does not do this the market value of its equity could be eliminated by a quick change in interest rates

Exotics

-complicated blends of these that often produce surprising results for buyers *one type of exotic is called an inverse floater, in our fixed-for-floating swap, the floating payments fluctuated with LIBOR. An inverse floater is one that fluctuates inversely with some rate such as LIBOR. *both floaters and inverse floaters have supercharged versions called super-floaters and super-inverses that fluctuate more than one for one with movements in interest rates **sometimes derivatives are combined with options to bound the impact of interest rates, the most important instrument is called caps & floors

Risk Synergy

-convertible bonds & warrants are useful when it is very costly to assess the risk of the issuing company (if you could be sure the risk was high, you would price the bonds for a high yield) -convertible bonds & bonds w/ warrants can protect somewhat against mistakes of risk evaluation. 2 components: ----> straight bonds and call options on the company's underlying stock, if the company turns out to be a low-risk company, the straight bond component will have high value and the call option will have low value. If the company turns out to be a high-risk company, the straight bond component will have low value and the call option will have high value (although risk has effects that cancel out value in convertibles and bonds w/ warrants, the market and the buyer must make an assessment of the firm's potential to value securities, and it is not clear that the effort involved is that much less than is required for a straight bond

Derivatives

-designed to meet marketplace needs, and the only binding limitation is the human imagination -large firms are far more likely to use derivatives than small firms -can be very helpful in reducing the variability of firm cash flows, which in turn, reduces the various costs associated with financial distress -most evidence is consistent with the theory that derivatives are most frequently used by firms where financial distress costs are high and access to the capital markets is constrained

Marketing Gains

-due to improved marketing, M&A can increase operating revenues Improvements in following areas: 1. Ineffective media programming & advertising efforts 2. weak distribution network 3. unbalanced product mix

Conversion Policy

-firms are frequently granted a call option on the bond. Typical arrangements for calling are -> when bond is called, the holder has about 30 days to choose between the following: 1. converting the bond to common stock at the conversion ratio 2. surrendering the bond and receiving the call price in cash What should bondholders do? -if the conversion value of the bond is greater than the call price, conversion is better than surrender; if the conversioni value is greater than the call price, the call is said to force conversion What should financial managers do? -calling bonds does not change the value of the firm as a whole. However, an optimal call policy can benefit the stockholders at the expense of the bondholders. ->do whatever the bondholders do not want you to do. >bondholders would love the stockholders to call the bonds when the bonds' market value is below the call price -->shareholders would be giving bondholders extra value >should the value of the bonds rise above the call price, the bondholders would love the stockholders not to call the bonds because bondholders would be allowed to hold onto a valuable asset Call the bond when its value is equal to the call price: (Median company waited until the conversion value of its bonds was 44% higher than the call price) Why? 1. if firms attempt to implement the optimal strategy, it may not be truly optimal (bondholders have 30 days to decide whether to convert bonds to common stock or to surrender bonds for the call price in cash. In 30 days the stock price could drop, forcing the conversion value below the call price. If so, the convertible is "out of the money" and the firm is giving away money. The firm would be giving up cash for common stock worth much less. Because of this possibility, firms in the real world usually wait until the conversion value is substantially above the call price before they trigger the call. (it is sensible)

NPV of a Merger

-firms typically use NPV analysis when making acquisitions -analysis is relatively straightforward when the consideration is cash, becomes more complex when the consideration is stock *market value of firm is the best estimate of true value

Why are Warrants & Convertibles Issued

-from studies it is known that firms that issue convertible bonds are different from other firms. 1. The bond ratings of firms using convertibles are lower than those of other firms 2. Convertibles tend to be used by smaller firms with high growth rates and more financial leverage 3. Convertibles are usually subordinated and unsecured --The kind of company that uses convertibles provides clues to why they are issued.

Takeover

-general & imprecise term referring to the transfer of control of a firm from one group of shareholders to another

Hostile Takeover

-target's management may resist the merger, the acquirer must decide whether to pursue the merger and, if so, what tactics to use -facing resistance the acquirer may begin by purchasing some of the target's stock in secret. This position is often called a toehold. *must file a schedule 13D within 10 days of obtaining a 5% hold in targets stock, must provide detailed information -> price of target's shares will most likely rise after filing, w/ new stock price reflecting the possibility that the target will be bought at a premium *although acquirer may purchase shares in the open market, an acquisition is unlikely to be effectuated in this manner. More likely the acquirer will make a tender offer (offer made directly to the stockholders to buy shares at a premium above current market price) Tender offer may specify that the acquirer will purchase all shares that are tendered - that is, turned in to the acquirer *or the offer may state that the acquirer will purchase all shares up to, say, 50% of the number of shares outstanding. * if more shares are tendered, prorating will occur... EX: all of the shares are tendered, each stockholder will be allowed to sell one share for every two shares tendered. Acquirer may also say it will accept the tendered shares only if a minimum number of shares have been tendered. * A tender offer must be held open for at least 20 days, gives target time to respond *control--over board of directors, stockholders elect board, who approves mergers

Tax Gains

-tax reduction may be a powerful incentive for some acquisitions. Reductions can come from: 1. Use of tax losses 2. use of unused debt capacity 3. use of surplus funds -Net Operating Losses- firm w/ profitable division & unprofitable division will have a low tax bill because the loss in one division offsets the income in the other *if the two divisions are separate companies, the profitable firm will not be able to use the losses of the unprofitable one to offset its income **hence, in the right circumstances a merger can lower taxes (1. Federal tax laws permit firms that experience alternating periods of profits and loss- es to equalize their taxes by carryback and carryforward provisions. The accounting rules are complicated but generally a firm that has been profitable but has a loss in the current year can get refunds of income taxes paid in the two previous years and can carry the loss forward for 20 years. Thus, a merger to exploit unused tax shields must offer tax savings over and above what can be accomplished by firms via carryovers. 2. IRS may disallow an acquisition if the principal purpose of the acquisition is to avoid federal tax (catch-22 of the Internal Revenue code))

Why do firms use derivatives?

-they are tools for changing the firm's risk exposure By using these the firm can cut away unwanted portions of risk exposure and transform the exposures into different forms

Pricing of Treasury Bonds

-treasury bond pay semiannual interest over its life -face value of the bond is paid at maturity

Difference between Warrants and Call Options

-warrants have longer maturity periods -some are actually perpetual (they never expire) -referred to as equity kickers, because they are usually issued in combination with privately placed bonds (in most cases warrant are attached to the bonds when issued, loan agreement will state whether the warrants are detachable from the bond-that is, whether they can be sold separately) usually the warrant can be detached immediately *From a holder's point of view, warrants are similar to call options on common stock -A warrant, like a call option, gives its holder the right to buy common stock at a specified price -warrant usually have an expiration date, in most cases they are issued w/ longer lives than call option. *From the firm's point of view **call options are issued by individuals and warrants are issued by firms -when a warrant is exercised, a firm must issue new shares of stock, each time a warrant is exercised the number of shares outstanding increases -when a call option is exercised there is no change in the number of shares outstanding -when a call option is exercised one investor gains and the other loses

Mark to Market on Futures Contracts Effects

1. differences in the NPV, for example: a. a large price drop immediately following purchase means an immediate out payment for the buyer of a futures contract though net outflow is still the same, the present value of CFs is greater to the buyer of a futures contract. Of course, the present value of the cash outflows is less to the buyer of a futures contract if a price rise follows purchase b. the firm must have extra liquidity to handle a sudden outflow prior to expiration (this added risk may make the futures contract less attractive)(whichever way the price of the deliverable instrument moves, one party has an incentive to default) * mark-to-the-market provisions minimize the chance of default on a futures contract a. if the price rises, the seller has an incentive to default on a forward contract (however, after payment, the seller has little reason to default) b. if the price falls, the same argument can be made for the buyer *because changes in the underlying asset are recognized daily, there is no accumulation of loss, and the incentive to default is reduced, because of default issue forward contracts usually involve individuals that can trust each other

How can shareholders reduce their losses from the coinsurance effect?

1. shareholders of Firm A could retire its debt before the merger announcement date and reissue an equal amount of debt after the merger ->because debt is retired at the low premerger price, this type of refinancing transaction can neutralize the coinsurance effect to the bondholders. *debt capacity of combined firm is likely to increase because the acquisition reduces the probability of financial distress -> shareholders' second alt. is to issue more debt after merger. This will have 2 effects (even w/out prior action of debt retirement) 1. Interest tax shield from new corporate debt raises firm value 2. An increase in debt after the merger raises the probability of financial distress, thereby reducing or eliminating the bondholders' gain from the coinsurance effect

Height of warrant price above the lower limit will depend on:

1.variance of stock returns 2.time to expiration date (maturity) 3.risk-free rate of interest 4.stock price of AIG 5.exercise price (same factors determine the value of a call option)

Hedging

2 types long & short

Conglomerate Acquisition

Acquiring firm & the acquired firm are not related to each other (popular in the technology arena) *Financial analysts typically classified acquisitions into 3 types: horizontal, vertical, and conglomerate

Forward Contracts

Agreeing to something at a later date (buying/selling) *every time a firm orders an item that cannot be delivered immediately a forward contract take place, sometimes when an order is small an oral agreement will suffice, other times when an order is large a written agreement is necessary *a forward contract is not an option, both buyer & seller are obligated to perform under the terms of the contract vs. the buyer of an option chooses whether to exercise the option

Agency Costs

Convertible bonds can resolve agency problems associated with raising money (straight bonds are like risk-free bonds minus a put option on the assets of the firm, this creates an incentive for creditors to force the firm into low-risk activities. -In contrast, holders of common stock have incentives to adopt high-risk projects, high risk projects w/ negative NPC transfers wealth from bondholders to stockholders -->if conflicts cannot be resolved, firm may be forced to pass up profitable investment opportunities (but, because convertible bonds have an equity component, less expropriation of wealth can occur when convertible debt is issued instead of straight debt)(convertible bonds mitigate agency costs, one implication is that convertible bonds have less restrictive debt covenants than do straight bonds in the real world)

Convertible Debt vs. Straight Debt

Convertible debt pays a lower interest rate that otherwise identical straight debt -investors will accept a lower interest rate on convertible debt because of the potential gain from conversion

Surplus Funds

Ex: a firm that has FCF, it has CF available after payment of all taxes and purchasing securities, the firm can either pay dividends or buy back shares -an extra dividend will increase the income tax paid by some investors. investors pay lower taxes in a share repurchase. however, a share repurchase is not a legal option if the sole purpose is to avoid taxes on dividends **Instead, the firm might make acquisitions w/ its excess funds. Here, the shareholders of the acquiring firm avoid the taxes they would have paid on a dividend and no taxes are paid on dividends remitted from the acquired firm

Convertible Debt vs. Common Stock (Issuing Convertibles)

If the stock price later rises: the firm is better off having previously issued a convertible instead of equity, by issuing convertible the firm will effectively receive substantially more for a share upon conversion If the stock price falls or does not rise enough to justify conversion: the firm would have been better off if it had previously issued stock instead of a convertible, the firm would have benefited by issuing stock above its later market price. The firm would have received more than the subsequent worth of the stock, however the drop in stock price did not affect the value of the convertible much because the straight bond value serves as a floor (abstracting form taxes & bankruptcy costs, the firm is indifferent to whether it issues stock or issues debt, according to MM. )

Convertibles vs. Straight Debt (issuing convertibles)

If the stock price later rises: the firm would've benefited more from the issuance of straight debt, even though they paid out a lower interest rate than straight debt, it was obligated to sell the convertible holders a chunk of equity at a below-market price If the stock price later falls or does not rise enough to justify conversion: if this happens the firm is only glad because the interest rate was lower than straight debt, because conversion does not take place the only comparison needed is that of interest rates

LIBOR

London Interbank Offered Rate -it is the rate that most international banks charge one another for dollar-denominated loans in the London market. -commonly used as the reference rate for a floating-rate commitment, and, depending on the creditworthiness of the borrower, the rate can vary from LIBOR to LIBOR plus one point (or more) over LIBOR

Merger

absorption of one firm by another -the acquiring firm retains its name & identity, and it acquires all of the assets & liabilities of the acquired firm *after a merger, the acquired firm ceases to exist as a separate business entity 2 key points: 1. merger is legally straightforward and does not cost as much as other forms of acquisition. It avoids the necessity of transferring title of each individual asset of the acquired firm to the acquiring firm 2. stockholders of each firm must approve a merger. Typically 2/3 of share owners must vote in favor for it to be approved -shareholders of the acquired firm have appraisal rights->they can demand that the acquiring firm purchase their shares at a fair value. Often, the acquiring firm and the dissenting shareholders of the acquired firm and the dissenting shareholders of the acquired firm cannot agree on a fair value, which results in expensive legal proceedings

Immunized

immune to interest rate risk

Vertical Acquisition

involves firms at different steps of the production process