Finance Final Exam

Capital Structure decision

Choice of a target capital structure, the average maturity of its debt, and the specific types of financing it decides to use at any particular time.

interlocking board of directors

Company A's CEO sits on Company B's board and B's CEO sits on A's Board.

Market Multiple Analysis

Multiplies a market-determined ratio (called a multiple) to some value of the target firm to estimate the target's value. The market multiple can be based on net income, earnings market multiple can be based on net income, earnings per share, sales, book value, or number of subscribers.

Operating leverage

implies that a relatively small change in sales results in a relatively large change in EBIT, NOPAT and ROIC. Positively correlated with fixed costs.

Stocks value

namely the future cash flow streams which is determined by the dividends expected in each year and the price investors expect to receive when they sell the stock.

Publicly held company

one whose stock is owned by a relatively large number of individuals who are not actively involved in the firm's management. Usually regulated by SEC or other governmental bodies.

Strong form of the EMH

states that current market prices reflect all pertinent information, whether public or private where even insiders would find it impossible to consistently earn abnormal returns in the stock market.

Semistrong form of the EMH

states that current market prices reflect all publicly available information. Looking over annual reports and data is no good since the current prices have already been adjusted for when that information was released. (typically only if its information that's different than what was already expected)

Anchoring bias

tendency to "anchor" too closely on recent events when predicting future events.

Retention ratio

the complement of the payout ratio (1 - Payout ratio)

Equilibrium

the condition under which the expected return on a security as seen by the marginal investor is (1) just equal to its required return. Also, (2) the stock's intrinsic value must be equal to its market price

growth options

the opportunities the firm has to increase sales (e.g., R &D expenditures, customer relationships)

Payout ratio

the percent of net income that the firm pays out in dividends

Preemptive right

the right to purchase any additional shares sold by the firm; protects the present stockholders' control and prevents dilution of their value.

Stick

threat of removal

Market equilibrium

when the stock's price equals its intrinsic value.

Classified stock

Sometimes created by a firm to meet special needs and circumstances. Generally when special classifications of stock are used, on type is designated "class A" and another "class B" and so on. Ex. Class A has rights to dividends and Class B has voting rights.

Greenmail

Targeted share repurchases: A stock buyer offers company for rest of company stocks for specific price and instead company offers to buyback raiders stock for even higher price where the stock will be purchased only from the raider and not from any other shareholder

Project financing

a special situation in which a large project, such as an oil refinery, is financed with debt plus other securities that have a specific claim on the project's cash flows.

Weak Form of the EMH

argue that all infomration contained in past price movements is fully reflected in current market prices.

Technical Analysts

believe that past trends or patterns in stock prices can be used to predict future stock prices.

classified boards

boards with staggered terms

Tracking stock or target stock

classes of stock with dividends tied to a particular part of a company in order to separate the cash flows and to allow separate valuations.

Carrot

compensation

Reserve borrowing capacity

firms should, in normal times, use more equity and less debt than is suggested by the tax benefit-bankruptcy cost trade-off model so that debt can be used if an especially good investment opportunity comes along.

Examples of fixed costs

highly automated, capital intensive firms Businesses that employe highly skilled workers that must be retained Firms with high product development costs that need to be maintained for R&D

Efficient Markets Hypothesis (EMH)

holds that (1) stocks are always in equilibrium and (2) it is impossible for an investor who does not have inside information to consistently "beat the market." Therefore, according o the EMH, stocks are always fairly valued and have a required return equal to their expected return

Symmetric information

Investors have the same information about the firm's prospects as its managers

Capital Structure

Mixture of debt and equity

Restricted voting rights

Cancels the voting rights of any shareholder who owns more than a specified amount o the company's stock.

6 ways managers could harm intrinsic value

1. Do not expend time and effort 2. Use corporate resources to own benefit rather than shareholders 3. avoid making value enhancing decisions that harm friends 4. Take too much risk or not enough risk 5. May stockpile CF instead of returning it to investors 6. Might conceal information from investors

Steps to the Analysis of Capital Structure

1. Estimate the interest rate the firm will pay 2. Estimate the cost of equity 3. Estimate the weighted average cost of capital 4. Estimate the value of operating, which is the present value of FCF discounted by the new WACC

Three Factors Firms can't control

1. State of financial markets (general stock prices and interest rates) 2. Investor risk aversion 3. Tax rates as set by congress

Three Factors Firms can Control

Capital Structure Policy Dividend Policy Investment Policy

Pecking order hypothesis

A firm first raises capital internally by reinvesting its net income and selling its short-term marketable securities. Next it will issue debt and perhaps preferred stock. Only as a last resort will it issue common stock.

Opportunity Cost

A firm should earn on its reinvested earnings at least as much as its stockholders themselves could earn on alternative investments of equivalent risk. So r_s is the amount a company should earn with reinvested funds, if not, they should pay the earnings as dividends.

Employee Stock Ownership Plans

A type of retirement plan in which employees own stock in the company

Assets-in-Place

An Operating Asset that includes Tangible assets as land, buildings, machines and inventory as well as intangible assets such as patents, customer lists, reputation and general know-how

Proxy fight

An attempt to take over a company in which an outside group solicits existing shareholders' proxies, which are authorizations to vote shares in a shareholders' meeting, in an effort to overthrow management take control of the business.

Growth options

An operating asset that includes Opportunities to expand that arise form the firm's current operating knowledge, experience, and other resources

unleveraged beta

Beta a company would have if it had no debt.

Modigliani and Miller II

Company value is equal to stock plus debt and any additional side effects such as tax exemptions.

Modigliani and MIller: No taxes

Company value is purely stock plus debt

Capital Structure Issues

Debt increases the cost of stock Debt reduces the taxes a company pays Debt increases rIsk of bankruptcy reducing FCF Bankruptcy risk affects agency costs Equity issuing implies future fall in stock price

Two models for estimating intrinsic value

Discounted dividend model and the corporate valuation model .

Supernormal or non-constant, growth firms

Firms in a the early part of their growth cycle

Poison Pill

Give the shareholders o target firms the right to buy a specified number of shares in the company at a very low price if an outside group or firm acquires a specific percentage of the firm's stock; If takeover occurs, shareholders can purchase additional shares at the bargain price.

Bankruptcy Costs

High legal and accounting expenses, customer, supplier and employee retainment and higher lender interest rate demands

Bond the cash Flow

High levels of debt keep mangers from agent expenses from its precommmitment to debt.

Nonpecuniary benefits

Manager perks that are not actually cash payments to the managers (e.g., country club memberships, corporate jets, lavish offices)

Window of Opportunity Theory

Managers don't believe in market efficiency and instead stock prices and interest rates are sometimes either too low or too high relative to their true fundamental values causing managers to issue equity when stock is overpriced and buybacks with debt if under priced. Large empirical evidence

Asymmetric information

Managers have better information than outside investors

Signaling Theory

Managers have inside information and therefore an announcement of a stock offering is generally taken as a signal that the firm's prospects as seen by its own management are not good; conversely a debt offering is taken as a positive signal.

Leveraged Buyout (LBO)

One way to bond cash flow where a large amount of debt and a small amount of cash are used to finance the purchase of a company's shares.

Closely held company

One whose stock is owned by a few individuals who are typically associated with the firm's management

Shareholder-friendly charter

Prohibits greenmail, and has poison pill provisions and restricted voting rights.

Environmental Factors that affect Corporate Governance

Regulations and Laws Block Ownership Patterns Competition in Product Markets Media and Litigation

Diversifiable risk

Risk that can be eliminated

Three methods used for estimating the cost of equity

The Capital Asset Pricing Model (CAPM) The discounted cash Flows method (DCF) The over-own-bond-yield-plus-judgmental-risk-premium approach

Financial Risk

The additional risk placed on the common stockholders as a result o the decision to finance with debt.

Business RIsk

The risk a firm's common stockholders would face if the firm had no debt. Risk inherent in the firm's operations, which arises form uncertainty about future operating profits and capital requirements

Animal Spirits

The tendency of investors to become excited and let their emotions affect their behavior

Herding Instincts

The tendency of investors to follow the crowd, relying on others rather than their own analysis.

Entity Multiple

The total value of a company (the market value of its equity plus that of its debt) divided by EBITDA

Trade-off Theory

The value of a leveraged firm is equal to the value of an unleveraged firm plus the value of any side effects, which include the tax shield and the expected costs due to financial distress.

WACC (Weighted Average Cost of Capital)

The weighted average of the after-ta component costs of capital- debt, preferred stock, and common equity. Each weighting factor is the proportion of that type of capital in the optimal or target capital structure.

Takeover

When a person or group succeeds in ousting a firm's management and takes control of the company

Cliff vesting

When options all vest at the same date

underinvestment problem

When taking on high levels of debt, managers might not be willing to undertake positive NPV, but risky projects.

Proxy

a document giving one person the authority to act for another, typically the power to vote shares of common stock which is typically given to management.

Marginal investor

a representative investor whose actions reflect the beliefs of those people who are currently trading a stock. It is the marginal investor who determines a stock's price.