FINA 6212
US Treasury Face Value
$1000
Effective Annual Rate (EAR)
(1+interest rate)^(periods per year)-1
accounts payable days
accounts payable / daily COGS
accounts receivable days
accounts receivable / daily sales
one advantage of the corporate organizational structure?
allows those who have the capital to fund an enterprise to be different from those who have the expertise to manage the enterprise. This critical separation allows a wide class of investors to share the risk of the enterprise.
equity value with leverage
asset value with no leverage - value of debt **do not include bankruptcy costs**
how to calculate yield to maturity of a bond? given: coupon rate, coupon payment frequency, term, present value, face value
financial calc: input N, - PV, PMT, FV and solve for I/Y **multiply by the number of periods to get annual rate excel: =rate(nperiods, pmt, -PV, FV)
Identify one disadvantage of increasing the options granted to CEOs?
increase a CEO's incentives to game the system by timing the release of information to fit the option granting schedule or to artificially smooth earnings.
initial value with 4 outcomes equally weighted with 25% probability
initial value = (.25*(outcome 1 + outcome 2 + outcome 3 + outcome 4))/(1+risk free rate)
expected agency costs
the decline in the expected total firm value from its optimal level that results from a change in strategy based on management's or equity holders incentives
one disadvantage of the corporate organizational structure?
the separation between ownership and management comes at a cost-the managers will act in their own best interests, not in the best interests of the shareholders who own the firm.
Identify one advantage of increasing the options granted to CEOs?
the CEO's wealth and incentives will be more closely tied to the shareholders' wealth.
Why is the yield on a convertible bond is lower than the yield on an otherwise, identical bond without a conversion feature?
this option for a bond to convert to a stock is valuable, hence its price will be lower and its yield higher
What are a board's options when confronted with dissident shareholders?
- Ignore the shareholder, which will result in either the shareholder going away or launching a proxy fight, in which case the board will need to expend resources in an attempt to convince shareholders not to side with the dissident. - Negotiate with the dissident shareholder to come to a solution on which the board and the shareholder can agree. - Buy out the shareholder.
How can a proxy contest be used to overcome a captured board?
- Proxy contests are simply contested elections for directors. In a proxy contest, there are two competing slates of directors rather than just one slate proposed by the company. - If a board has become captured or unresponsive to shareholder demands, shareholders can put their own slate of new directors up for election. - If the dissident slate wins, then shareholders will have succeeded in placing new directors, presumably not beholden to the CEO, on the board
Diversification is good for shareholders. So why shouldn't managers acquire firms in different industries to diversify a company?
- Shareholders can efficiently achieve diversification on their own by purchasing shares in different companies. - When managers achieve diversification by creating a conglomerate through purchasing other companies it is often done at a premium over market prices. - Because it may be harder to measure performance accurately in a conglomerate, agency costs may increase and resources may be inefficiently allocated across divisions. As a result, it is cheaper for investors to diversify their own portfolios than to have the corporation do it through acquisition.
How do the carryforward and carryback provisions of the U.S. tax code affect the benefits of merging to capture operating losses?
- Since the tax loss motivation is based on the ability of a larger firm to capture the tax deduction from the losses of the target, it requires that the target not be able to capture the value of that deduction itself. - Carryforward and carryback provisions give the target more opportunities to capture the deduction either through recapture of previously paid taxes or by applying the deduction in the future when the company returns to profitability. - Carryforward and carryback provisions generally reduce the attractiveness of tax losses as a motivation to merger. - The IRS can disallow a tax break if it can show that the primary motivation of the merger was tax avoidance.
Why do you think shareholders from target companies enjoy an average gain when acquired, while acquiring shareholders on average often do not gain anything?
- The acquiring firm has to compete against other firms, thus reducing the gains it can obtain from the transaction. - Target shareholders benefit from this competition, as they obtain higher bids for the company. - In some cases the acquiring firm may present an initial offering price that is high enough to forestall a bidding war, effectively handing the gain from the offer to the shareholders of the target company.
What is the role of the board of directors in corporate governance?
- hire and fire mgrs. and set compensation contracts - approves major investment decisions and acquisitions - primary internal control mechanism and first line of defense to prevent fraud, agency conflicts, and mismanagement
what are the main advantages of going public?
1) increased liquidity, easier to buy and sell the company's shares 2)increased access to capital markets is primary advantage
what are the main disadvantages of going public?
1) public companies must satisfy all requirements of being a public company such as SEC filings and listing requirements of exchanges 2) investors diversify their holdings across companies and can discount the price willing to pay for a company as a result of the lack of control over mgmt
Internal Rate of Return (IRR)
=(gross return/principal)^(1/N)
PV (Residual Value)
=(residual value)/(1+(rate/annual pmts)^(# of periods)
expected return of debt with zero coupon
=risk free rate expected future cash flows with the possibility of default
what is the difference between a secured corporate and unsecured corporate bond?
A secured corporate bond give the bondholder the right over particular assets that serve as collateral in case of default. An unsecured corporate bond does not offer such protection to the bondholder. These unsecured bondholders are residual claimants in the case of bankruptcy after the secured assets have been given to the corresponding bondholders.
why do bonds with lower seniority have higher yields than equivalent bonds with higher seniority?
A) Debentures and notes are unsecured. Because more than one debenture might be outstanding, the bondholders' priority in claiming assets in the event of default, known as the bond's seniority is important. B) Most debenture issues contain clauses restricting the company from issuing new debt with equal or higher priority than existing debt. Your answer is correct. D) When a firm conducts a subsequent debenture issue that has a lower priority than its outstanding debt, the assets not pledged as collateral for outstanding bonds cannot be used to pay off the holders of subordinated debentures until all more senior debt has been paid off. E) Most debenture issues contain clauses restricting the company from issuing new debt with equal or lower priority than existing debt. F) Because holders of lower seniority debt are likely to receive less in the event of default, the yield on the lower seniority debt is higher than that of more senior equivalent debt.
Which type of asset is more likely to be liquidated for close to its full market value in the event of financial distress: An office building or a brand name?
An office building is more likely to be liquidated for close to its full market value
Real estate purchases are often financed with at least 80% debt. Most corporations, however, have less than 50 % debt financing. Provide an explanation for this difference using the trade-off theory.
Real estate assets can generally be easily resold at their full market value, whereas corporations typically face much higher distress costs.
Assets
Existing Assets + Tax Shield
Value Unlevered
Free Cash Flow / Unlevered Cost of Capital
Although the major benefit of debt financing is easy to observe —the tax shield—many of the indirect costs of debt financing can be quite subtle and difficult to observe. Describe some of these costs. Related to Employee Job Security
Highly leveraged firms run the risk of bankruptcy and so cannot write long term employment contracts and offer job security.
yield to maturity
IRR of an investment (assuming all payments are made; ignoring the possibility of debt) YTM = ((Face Value of Debt) / (initial value of debt))-1
During the Internet boom of the late 1990's, the stock prices of many Internet firms soared to extreme heights. As CEO of such a firm, if you believed your stock was significantly over-valued, would using your stock to acquire non-Internet stocks be a wise idea, even if you had to pay a small premium over their fair market value to make the acquisition?
If the firm must pay 10% more than the target firm was worth and used its shares that were over-valued by more than 10%, the firm would gain from the acquisition.
Although the major benefit of debt financing is easy to observe —the tax shield—many of the indirect costs of debt financing can be quite subtle and difficult to observe. Describe some of these costs. Related to Overinvestment
Investing in negative NPV projects.
PV (after tax lease PMT)
LPMT * (1-Tc) * (1+(1/r)*(1-(1/(1+r)^N))
You work for a large car manufacturer that is currently financially healthy. Your manager feels that the firm should take on more debt because it can thereby reduce the expense of car warranties. To quote your manager, "If we go bankrupt, we don't have to service the warranties. We therefore have lower bankruptcy costs than most corporations, so we should use more debt." Is he right?
No, customers will anticipate the effect of leverage on the soundness of the warranty and will be less likely to purchase cars, thereby imposing costs on the firm.
Although the major benefit of debt financing is easy to observe —the tax shield—many of the indirect costs of debt financing can be quite subtle and difficult to observe. Describe some of these costs. Related to Underinvestment
Not investing in positive NPV projects
How to Find Lease Payment?
PV Lease PMT= LPMT*(1+(1/(rate/annual pmts))*(1-(1/(1+(rate/annual pmts)^(# of periods)))
Which type of asset is more likely to be liquidated for close to its full market value in the event of financial distress: Patent rights or engineering "know-how"?
Patent rights are more likely to be liquidated for close to its full market value.
Although the major benefit of debt financing is easy to observe —the tax shield—many of the indirect costs of debt financing can be quite subtle and difficult to observe. Describe some of these costs. Related to Cashing Out
Paying out dividends instead of investing in positive NPV projects.
WACC (Interest Tax Shield
Pretax WACC - (D/(D+E))*(Corp Tax Rate)*(Interest Rate of Debt)
PV (Lease PMT)
Purchase Price - PV (Residual Value)
Which type of asset is more likely to be liquidated for close to its full market value in the event of financial distress: Product inventory or raw materials?
Raw materials are more likely to be liquidated for close to its full market value.
What happens when the acquirer announces it will pay a premium for the target?
The target stock goes up but not as much as it would have since the acquirer's stock will drop some. Therefore, the premium relative to the cash offer will be reduced some.
Value with Leverage
Value Unlevered +(Debt * Tax Rate)
Acquiring a company using stock to fund the transaction results in the P/E ratio of the combined company ______
being between the P/E ratios of the two companies prior to the merger
what is a foreign bond?
bond issued by a foreign company in a local market and is intended for local investors
what is a Eurobond?
bonds denominated in a difference currency than that of the country in which they are issued. No connection between the physical location of the market on which they trade and the location of the issuing entity.
the decision to pay a dividend given how close the company was to financial distress is an example of what kind of cost?
cashing out
An acquisition target company that has a higher price-earnings ratio than the acquiring firm will cause EPS of the combined firm to_______
decline
PV (Interest Tax Shield)
interest tax shield / interest rate
inventory days
inventory / Daily COGS
cash conversion cycle (CCC)
inventory days + Accounts receivable days - accounts payable days
Why bond issuers might voluntarily choose to put restrictive covenants into a new bond issue?
issuers can get a lower interest rate
How are lenders part of corporate governance?
monitor mgmt. by checking and enforcing covenants
new share price after repurchase
new equity value / number of shares outstanding after repurchase
What is a say-on-pay vote?
non-binding vote whereby the shareholders indicate whether they approve of executives' pay packages or not
number of shares after repurchase
original shares - (amount to spend on repurchase/share price offered)