Finance

Capital Budgeting

- "strategic asset allocation" - What fixed assets should we buy - What services will we offer or what will we sell? In what markets will we compete? What new products will we introduce? o The answer to any of these questions will require that the firm commit its scarce and valuable capital to certain types of assets - the capital budgeting question is probably the most important issue in corporate finance - the fixed assets define the business of the firm. - the capital budgeting process can be viewed as a search for investments with positive net present values. o investment decisions are greatly simplified when there is a market for assets similar to the investment we are considering o Capital budgeting becomes much more difficult when we cannot observe the market price for at least roughly comparable investments. The reason is that we then face the problem of estimating the value of an investment using only indirect market information.

Flat Tax Rate

- , there is only one tax rate, so the rate is the same for all income levels.

Choosing a Venture Capitalist

- 1. Financial strength is important: o The venture capitalist needs to have the resources and financial reserves for additional financing stages should they become necessary. o This doesn't mean that bigger is necessarily better, however, because of our next consideration. - 2. Style is important: o Some venture capitalists will wish to be very much involved in day-to-day operations and decision making, whereas others will be content with monthly reports. o Which are better depends on the firm and also on the venture capitalists' business skills. In addition, a large venture capital firm may be less flexible and more bureaucratic than a smaller "boutique" fi rm. - 3. References are important: o Has the venture capitalist been successful with similar firms? Of equal importance, how has the venture capitalist dealt with situations that didn't work out? - 4. Contacts are important: o A venture capitalist may be able to help the business in ways other than helping with financing and management by providing introductions to potentially important customers, suppliers, and other industry contacts. o Venture capitalist firms frequently specialize in a few particular industries, and such specialization could prove quite valuable. - 5. Exit strategy is important: o Venture capitalists are generally not long-term investors. o How and under what circumstances the venture capitalist will "cash out" of the business should be carefully evaluated.

Costs of Issuing Securities

- 1. Gross spread o The gross spread consists of direct fees paid by the issuer to the underwriting syndicate—the difference between the price the issuer receives and the offer price. - 2. Other direct expenses o These are direct costs, incurred by the issuer, that are not part of the compensation to underwriters. These costs include fi ling fees, legal fees, and taxes—all reported on the prospectus. - 3. Indirect expenses o These costs are not reported on the prospectus and include the costs of management time spent working on the new issue. - 4. Abnormal returns o In a seasoned issue of stock, the price of the existing stock drops on average by 3 percent on the announcement of the issue. o This drop is called the abnormal return. - 5. Underpricing o For initial public offerings, losses arise from selling the stock below the true value. - 6. Green Shoe option o The Green Shoe option gives the underwriters the right to buy additional shares at the offer price to cover overallotments.

Implications of the Pecking Order

- 1. No target capital structure: o Under the pecking-order theory, there is no target or optimal debt-equity ratio. Instead, a firm's capital structure is determined by its need for external financing, which dictates the amount of debt the firm will have. - 2. Profitable firms use less debt: o Because profitable firms have greater internal cash flow, they will need less external financing and will therefore have less debt. As we mentioned earlier, this is a pattern that we seem to observe, at least for some companies. - 3. Companies will want financial slack: o To avoid selling new equity, companies will want to stockpile internally generated cash. Such a cash reserve is known as financial slack. It gives management the ability to finance projects as they appear and to move quickly if necessary. - The pecking-order theory is more concerned with the shorter-run, tactical issue of raising external funds to finance investments.

Specialist

- A NYSE member acting as a dealer in a small number of securities on the exchange fl oor; - often called a market maker o because they are obligated to maintain a fair, orderly market for the securities assigned to them - acts as an assigned dealer for a small set of securities - Specialists post bid prices and ask prices for securities assigned to them. - Specialists make a market by standing ready to buy at bid prices and sell at asked prices when there is a temporary disparity between the flow of buy orders and that of sell orders for a security.

Zero Coupon Bonds

- A bond that makes no coupon payments and is thus initially priced at a deep discount. - Even though no interest payments are made on the bond, zero coupon bond calculations use semiannual periods to be consistent with coupon bond calculations. - For tax purposes, the issuer of a zero-coupon bond deducts interest every year even though no interest is actually paid. - Similarly, the owner must pay taxes on interest accrued every year, even though no interest is actually received.

Call-protected bond

- A bond that, during a certain period, cannot be redeemed by the issuer.

Regular Cash Dividend

- A cash payment made by a firm to its owners in the normal course of business, usually paid four times a year. - cash payments made directly to shareholders, and they are made in the regular course of business - management sees nothing unusual about the dividend and no reason why it won't be continued.

Simulation Analysis

- A combination of scenario and sensitivity analysis - With scenario analysis, we let all the different variables change, but we let them take on only a few values. - If we want to let all the items vary at the same time, we have to consider a very large number of scenarios, and computer assistance is almost certainly needed. - Once we have values for all the relevant components, we calculate an NPV. We repeat this sequence as much as we desire, probably several thousand times. The result is many NPV estimates that we summarize by calculating the average value and some measure of how spread out the different possibilities are. For example, it would be of some interest to know what percentage of the possible scenarios result in negative estimated NPVs.

Initial Public Offering

- A company's first equity issue made available to the public. - Also called an unseasoned new issue or an IPO. - occurs when a company decides to go public. - Obviously, all initial public offerings are cash offers.

Green Shoe Provision

- A contract provision giving the underwriter the option to purchase additional shares from the issuer at the offering price. - Also called the overallotment option - Many underwriting contracts contain a Green Shoe provision - The stated reason for the Green Shoe option is to cover excess demand and oversubscriptions. - Green Shoe options usually last for 30 days and involve 15 percent of the newly issued shares. - In practice, usually underwriters initially go ahead and sell 115 percent of the shares offered o If the demand for the issue is strong after the offering, the underwriters exercise the Green Shoe option to get the extra 15 percent from the company. o If demand for the issue is weak, the underwriters buy the needed shares in the open market, thereby helping to support the price of the issue in the aftermarket.

Sunk Costs

- A cost that has already been incurred and cannot be removed and therefore should not be considered in an investment decision. - Such a cost cannot be changed by the decision today to accept or reject a project. o Put another way, the firm will have to pay this cost no matter what. - Sunk costs must be EXCLUDED from incremental cash flow analysis

Percentage of Sales Approach

- A financial planning method in which accounts are varied depending on a firm's predicted sales level. - The basic idea is to separate the income statement and balance sheet accounts into two groups—those that vary directly with sales and those that do not. - Given a sales forecast, we will then be able to calculate how much financing the firm will need to support the predicted sales level

Choosing an Underwriter

- A firm can offer its securities to the highest bidding underwriter on a competitive offer basis, or it can negotiate directly with an underwriter. - Except for a few large firms, companies usually do new issues of debt and equity on a negotiated offer basis. - The exception is public utility holding companies, which are essentially required to use competitive underwriting.

Proxy

- A grant of authority by a shareholder allowing another individual to vote his or her shares. - Shareholders can come to the annual meeting and vote in person, or they can transfer their right to vote to another party - Obviously, management always tries to get as many proxies as possible transferred to it. - However, if shareholders are not satisfied with management, an "outside" group of shareholders can try to obtain votes via proxy. o They can vote by proxy in an attempt to replace management by electing enough directors. o The resulting battle is called a proxy fight .

Portfolio

- A group of assets such as stocks and bonds held by an investor.

Syndicate

- A group of underwriters formed to share the risk and to help sell an issue. - In a syndicate, one or more managers arrange, or co-manage, the offering. The lead manager typically has the responsibility of dealing with the issuer and pricing the securities. - The other underwriters in the syndicate serve primarily to distribute the issue and produce research reports later on.

Prospectus

- A legal document describing details of the issuing corporation and the proposed offering to potential investors.

Bankruptcy

- A legal proceeding for liquidating or reorganizing a business.

Indirect Agency Cost

- A lost opportunity

Efficient Capital Market

- A market in which security prices reflect available information. - First, prices appear to respond rapidly to new information, and the response is at least not grossly different from what we would expect in an efficient market. - Second, the future of market prices, particularly in the short run, is difficult to predict based on publicly available information. - Third, if mispriced stocks exist, then there is no obvious means of identifying them.

Dividend Growth Model

- A model that determines the current price of a stock as its dividend next period divided by the discount rate less the dividend growth rate. the answers we get from the dividend growth model are nonsense unless the growth rate is less than the discount rate

Seasoned Equity Offering

- A new equity issue of securities by a company that has previously issued securities to the public - A seasoned equity offering of common stock can be made by using a cash offer or a rights offer.

Protective Covenants

- A part of the indenture limiting certain actions that might be taken during the term of the loan, usually to protect the lender's interest.

Distribution

- A payment made by a firm to its owners from sources other than current or accumulated retained earnings.

Stock Dividend

- A payment made by a firm to its owners in the form of stock, diluting the value of each share outstanding.

Dividend

- A payment made out of a firm's earnings to its owners, in the form of either cash or stock.

Red Herring

- A preliminary prospectus distributed to prospective investors in a new issue of securities.

Oversubscription Privilege

- A privilege that allows shareholders to purchase unsubscribed shares in a rights offering at the subscription price.

Rights Offer

- A public issue of securities in which securities are first offered to existing shareholders. - Also called a rights offering.

Relevant Cash Flows

- A relevant cash flow for a project is a change in the firm's overall future cash flow that comes about as a direct consequence of the decision to take that project. - Also called "incremental cash flows"

Unsystematic Risk

- A risk that affects at most a small number of assets. - Also, unique or asset specific risk - An unsystematic risk is one that affects a single asset or a small group of assets. Because these risks are unique to individual companies or assets, they are sometimes called unique or asset-specific risks - the announcement of an oil strike by a company will primarily affect that company and, perhaps, a few others (such as primary competitors and suppliers). It is unlikely to have much of an effect on the world oil market, however, or on the affairs of companies not in the oil business, so this is an unsystematic event - Unsystematic risk is essentially eliminated by diversification, so a portfolio with many assets has almost no unsystematic risk. - Also called diversifiable risk, unique risk, or asset-specific risk.

Systematic Risk

- A risk that influences a large number of assets. - Also, market risk - Systematic risk is one that influences a large number of assets, each to a greater or lesser extent. - Because systematic risks have marketwide effects, they are sometimes called market risks. - uncertainties about general economic conditions (such as GDP, interest rates, or inflation) are examples of systematic risks. o These conditions affect nearly all companies to some degree - systematic risk and nondiversifiable risk are used interchangeably.

Registration Statement

- A statement fi led with the SEC that discloses all material information concerning the corporation making a public offering.

Reverse Split

- A stock split in which a firm's number of shares outstanding is reduced. - Reasons: o First, transaction costs to shareholders may be less after the reverse split. o Second, the liquidity and marketability of a company's stock might be improved when its price is raised to the popular trading range. o Third, stocks selling at prices below a certain level are not considered respectable, meaning that investors underestimate these firms' earnings, cash flow, growth, and stability. - There are two other reasons for reverse splits. o First, stock exchanges have minimum price per share requirements. ♣ A reverse split may bring the stock price up to such a minimum. o Second, companies sometimes perform reverse splits and, at the same time, buy out any stockholders who end up with less than a certain number of shares.

Dividend Yield

- A stock's expected cash dividend divided by its current price.

Normal Distribution

- A symmetric, bell-shaped frequency distribution that is completely defined by its mean and standard deviation. - with a normal distribution, the probability that we will end up within one standard deviation of the average is about 2/3. - The probability that we will end up within two standard deviations is about 95 percent.

Warrant

- A warrant gives the buyer of a bond the right to purchase shares of stock in the company at a fixed price. - Such a right would be very valuable if the stock price climbed substantially - Because of the value of this feature, bonds with warrants are often issued at a very low coupon rate.

Marginal tax Rate

- Amount of tax payable on the next dollar earned. - The percentage tax rates shown on tax tables are all marginal rates

Sinking Fund

- An account managed by the bond trustee for the purpose of repaying the bonds. - The company makes annual payments to the trustee, who then uses the funds to retire a portion of the debt. - The trustee does this by either buying up some of the bonds in the market or calling in a fraction of the outstanding bonds.

Tombstone

- An advertisement announcing a public offering.

Broker

- An agent who arranges security transactions among investors - A broker brings buyers and sellers together but does not maintain an inventory. - The distinctive characteristic of security brokers is that they do not buy or sell securities for their own accounts. Facilitating trades by others is their business

Dealer

- An agent who buys and sells securities from inventory - A dealer maintains an inventory and stands ready to buy and sell at any time. - The price the dealer is willing to pay is called the bid price - The price at which the dealer will sell is called the ask price

Standby Fee

- An amount paid to an underwriter participating in a standby underwriting agreement.

Annuity Due

- An annuity for which the cash flows occur at the beginning of the period. - For example, apartment lease is due at the beginning of the month - Almost any type of arrangement in which we have to prepay the same amount each period is an annuity due. - To change calculation: 2nd + BGN + 2nd + ENTER/Set - Can calculate both PV and FV this way

Perpetuity

- An annuity in which the cash flows continue forever. - Called a perpetuity because the cash flows are perpetual - Also called 'consols' - Perpetuity PV = C/r = $500/.08 = $6,250

Proxy Fight

- An important mechanism by which unhappy stockholders can act to replace existing management - A proxy is the authority to vote someone else's stock - A proxy fight develops when a group solicits proxies in order to replace the existing board and thereby replace existing managers

Stock Split

- An increase in a firm's shares outstanding without any change in owners' equity.

Net Present Value Rule

- An investment should be accepted if the net present value is positive and rejected if it is negative. - In the unlikely event that the net present value turned out to be exactly zero, we would be indifferent between taking the investment and not taking it.

Average Accounting Return

- An investment's average net income divided by its average book value. - Accounting Average Return = Average Net Income/Average Book Value - As long as we use straight-line depreciation, the average investment (book value) will always be one-half of the initial investment. - The AAR is not a rate of return in any meaningful economic sense. o Instead, it is the ratio of two accounting numbers, and it is not comparable to the returns offered, for example, in financial markets. 5 o ignores time value of money - lack of an objective cutoff period o Because a calculated AAR is really not comparable to a market return, the target AAR must somehow be specified. - The third, and perhaps worst, fl aw in the AAR is that it doesn't even look at the right things. Instead of cash flow and market value, it uses net income and book value. These are both poor substitutes. o As a result, an AAR doesn't tell us what the effect on share price will be of taking an investment

General Cash Offer

- An issue of securities offered for sale to the general public on a cash basis.

Debenture

- An unsecured debt, usually with a maturity of 10 years or more - Debenture holders have a claim only on property not otherwise pledged—in other words, the property that remains after mortgages and collateral trusts are taken into account.

growing annuities

- Annuities commonly have payments that grow over time.

Bond Values

- As time passes, interest rates change in the marketplace. - The cash flows from a bond, however, stay the same. - As a result, the value of the bond will fluctuate - When interest rates rise, the present value of the bond's remaining cash flows declines, and the bond is worth less. When interest rates fall, the bond is worth more. - To determine the value of a bond at a particular point in time, we need to know the number of periods remaining until maturity, the face value, the coupon, and the market interest rate for bonds with similar features. This interest rate required in the market on a bond is called the bond's yield to maturity (YTM)

Auction Markets

- Auction markets differ from dealer markets in two ways. o First, an auction market or exchange has a physical location (like Wall Street). o Second, in a dealer market, most of the buying and selling is done by the dealer. The primary purpose of an auction market, on the other hand, is to match those who wish to sell with those who wish to buy. Dealers play a limited role. o The equity shares of most of the large firms in the United States trade in organized auction markets

Average Accounting Return Rule

- Based on the average accounting return rule, a project is acceptable if its average accounting return exceeds a target average accounting return.

Discounted Payback Rule

- Based on the discounted payback rule, an investment is acceptable if its discounted payback is less than some prespecified number of years. - If a project ever pays back on a discounted basis, then it must have a positive NPV. o This is true because, by definition, the NPV is zero when the sum of the discounted cash flows equals the initial investment. - In general, if we use a discounted payback rule, we won't accidentally take any projects with a negative estimated NPV. - cutoff still has to be arbitrarily set, and cash flows beyond that point are ignored.

Marketed vs Unmarketed Claims

- Based on the pie theory, any increase in Vm must imply an identical decrease in Vn - The optimal capital structure is thus the one that maximizes the value of the marketed claims or, equivalently, minimizes the value of nonmarketed claims such as taxes and bankruptcy costs.

The Subjective Approach

- Because of the difficulties that exist in objectively establishing discount rates for individual projects, firms often adopt an approach that involves making subjective adjustments to the overall WACC.

Transparency

- Because the bond market is almost entirely OTC, it has historically had little or no transparency. - A financial market is transparent if it is possible to easily observe its prices and trading volume. - On the New York Stock Exchange, for example, it is possible to see the price and quantity for every single transaction. - In contrast, in the bond market, it is often not possible to observe either. - Combined with the lack of transparency in the bond market, means that getting up-to-date prices on individual bonds can be difficult or impossible, particularly for smaller corporate or municipal issues. - Instead, a variety of sources of estimated prices exist and are commonly used.

Risk-Free Return

- Because the government can always raise taxes to pay its bills, the debt represented by T-bills is virtually free of any default risk over its short life Used as a benchmark

Repayment

- Bonds can be repaid at maturity, at which time the bondholder will receive the stated, or face, value of the bond; or they may be repaid in part or in entirety before maturity. - Early repayment in some form is more typical and is often handled through a sinking fund.

Break-even analysis

- Break-even analysis is a popular and commonly used tool for analyzing the relationship between sales volume and profitability.

Discount

- Calculate the present value of some future amount

Cash Flow Identity

- Cash flow from assets = Cash flow to creditors + Cash flow to stockholders - It says that the cash flow from the firm's assets is equal to the cash flow paid to suppliers of capital to the firm - What it reflects is the fact that a firm generates cash through its various activities, and that cash is either used to pay creditors or paid out to the owners of the firm. - A negative cash flow means that the firm raised more money by borrowing and selling stock than it paid out to creditors and stockholders during the year. - Not unusual for growing corporations to have negative cash flows

Classes of Stock

- Companies often have many different classes - Often the classes are created with unequal voting rights - A primary reason for creating dual or multiple classes of stock has to do with control of the firm. o If such stock exists, management of a firm can raise equity capital by issuing nonvoting or limited-voting stock while maintaining control.

Gross Spread

- Compensation to the underwriter, determined by the difference between the underwriter's buying price and offering price. - Underwriting discount - Sometimes, on smaller deals, the underwriter will get noncash compensation in the form of warrants and stock in addition to the spread

Control of the Firm

- Control of the firm ultimately rests with stockholders. - They elect the board of directors, who in turn hire and fi re managers

Double Taxation

- Corporate profits are taxed twice: at the corporate level when they are earned and again at the personal level when they are paid out

Variable Costs

- Costs that change when the quantity of output changes. - zero when production is zero - Total variable cost = Total quantity of output x Cost per unit of output

Fixed Costs

- Costs that do not change when the quantity of output changes during a particular time period. - they do not depend on the amount of goods or services produced during a period (at least within some range of production). - any fixed cost can be modified or eliminated given enough time; so, in the long run, all costs are variable. - TC = VC + FC

Floating Rate Bonds

- Coupon payments are adjustable - The adjustments are tied to an interest rate index such as the Treasury bill interest rate or the 30-year Treasury bond rate. - The value of a floating-rate bond depends on exactly how the coupon payment adjustments are defined. In most cases, the coupon adjusts with a lag to some base rate.

Term Loans

- Direct business loans of typically one to five years.

Percentage Return

- Dividend Yield - Let Pt be the price of the stock at the beginning of the year and - Let Dt+1 be the dividend paid on the stock during the year - Dividend Yield = Dt+1 / Pt

Dividend Yield

- Dividends as a percentage of market price

Dividend Payout

- Dividends as a percentage of net income or earnings per share

Cumulative Vs Non-Cumulative Dividends

- Dividends payable on preferred stock are either cumulative or noncumulative; most are cumulative. - If preferred dividends are cumulative and are not paid in a particular year, they will be carried forward as an arrearage. - Usually, both the accumulated (past) preferred dividends and the current preferred dividends must be paid before the common shareholders can receive anything. - Unpaid preferred dividends are not debts of the fi rm. Directors elected by the common shareholders can defer preferred dividends indefinitely

Inflation and Present Values

- Either discount nominal cash flows at a nominal rate or discount real cash flows at a real rate. - As long as you are consistent, you will get the same answer

Common Stock

- Equity without priority for dividends or in bankruptcy

Dividend Growth Model Approach

- Estimating g o To use the dividend growth model, we must come up with an estimate for g, the growth rate. o There are essentially two ways of doing this: ♣ (1) Use historical growth rates, or ♣ (2) use analysts' forecasts of future growth rates. - the dividend growth model is obviously applicable only to companies that pay dividends. o This means that the approach is useless in many cases. - Furthermore, even for companies that pay dividends, the key underlying assumption is that the dividend grows at a constant rate. - A second problem is that the estimated cost of equity is very sensitive to the estimated growth rate. - Finally, this approach really does not explicitly consider risk. Unlike the SML approach (which we consider next), there is no direct adjustment for the riskiness of the investment.

What can planning accomplish?

- Examining interactions o if the firm is planning on expanding and undertaking new investments and projects, where will the financing be obtained to pay for this activity? - Exploring Options o The financial plan allows the firm to develop, analyze, and compare many different scenarios in a consistent way. Various investment and financing options can be explored, and their impact on the firm's shareholders can be evaluated. Questions concerning the firm's future lines of business and optimal financing arrangements are addressed. Options such as marketing new products or closing plants might be evaluated. - Avoiding surprises o Financial planning should identify what may happen to the firm if different events take place. o In particular, it should address what actions the firm will take if things go seriously wrong or, more generally, if assumptions made today about the future are seriously in error. - Ensuring feasibility and internal consistency o the linkages between different goals and different aspects of a firm's business are difficult to see. Not only does a financial plan make explicit these linkages, but it also imposes a unified structure for reconciling goals and objectives o Conflicting goals will often exist. To generate a coherent plan, goals and objectives will therefore have to be modified, and priorities will have to be established - Probably the most important result of the planning process is that it forces managers to think about goals and establish priorities.

Noncash Items

- Expenses charged against revenues that do not directly affect cash flow, such as depreciation. - for the financial manager, the actual timing of cash inflows and outflows is critical in coming up with a reasonable estimate of market values so we need to learn how to separate the cash flows from the noncash accounting entries

Reorganization

- Financial restructuring of a failing firm to attempt to continue operations as a going concern - the option of keeping the firm a going concern; it often involves issuing new securities to replace old securities

Balance Sheet

- Financial statement showing a firm's accounting value on a particular date. - There are three particularly important things to keep in mind when examining a balance - sheet: liquidity, debt versus equity, and market value versus book value.

Income Statement

- Financial statement summarizing a firm's performance over a period of time.

Pro Forma Financial Statements

- Financial statements projecting future years' operations. - To prepare these statements, we will need estimates of quantities such as unit sales, the selling price per unit, the variable cost per unit, and total fixed costs. We will also need to know the total investment required, including any investment in net working capital.

Venture Capital

- Financing for new, often high-risk ventures. - So-called "angels" are usually individual VC investors, but they tend to specialize in smaller deals. - Venture capital firms specialize in pooling funds from various sources and investing them. - Venture capitalists and venture capital firms recognize that many or even most new ventures will not fly, but the occasional one will. - The potential profits are enormous in such cases. To limit their risk, venture capitalists generally provide financing in stages. o At each stage, enough money is invested to reach the next milestone or planning stage. \ ♣ For example, the first-stage financing might be enough to get a prototype built and a manufacturing plan completed. ♣ Based on the results, the second-stage financing might be a major investment needed to actually begin manufacturing, marketing, and distribution. - Venture capital fi rms often specialize in different stages. Some specialize in very early seed money," or ground floor, financing. In contrast, financing in the later stages might come from venture capitalists specializing in so-called mezzanine-level financing, where mezzanine level refers to the level just above the ground floor. - Access to venture capital is really very limited - Personal contacts are important in gaining access to the venture capital market; it is very much an "introduction" market. - Another simple fact about venture capital is that it is incredibly expensive. In a typical deal, the venture capitalist will demand (and get) 40 percent or more of the equity in the company. Venture capitalists frequently hold voting preferred stock, giving them various priorities in the event that the company is sold or liquidated. The venture capitalist will typically demand (and get) several seats on the company's board of directors and may even appoint one or more members of senior management.

Pecking Order Theory

- Firms prefer to use internal financing whenever possible o Selling securities to raise cash can be expensive o If a firm is very profitable, it may never need external financing o if you try to raise money by selling equity, you run the risk of signaling to investors that the price is too high. In fact, in the real world, companies rarely sell new 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, they will issue debt if necessary. Equity will be sold pretty much as a last resort.

Takeovers

- Firms that are poorly managed are more attractive as acquisitions than well-managed firms because a greater profit potential exists. - Thus, avoiding a takeover by another firm gives management another incentive to act in the stockholders' interests

Rule of 72

- For reasonable rates of return, the time it takes to double your money is given approximately by 72/ r % .

Flotation Costs

- If a company accepts a new project, it may be required to issue, or float, new bonds and stocks. - This means that the firm will incur some costs, which we call flotation costs.

Dollar Returns

- If you buy an asset of any sort, your gain (or loss) from that investment is called the return on your investment (ROI) - This return will usually have two components. o First, you may receive some cash directly while you own the investment. ♣ This is called the income component of your return. ♣ i.e. Dividends o Second, the value of the asset you purchase will often change. ♣ In this case, you have a capital gain or capital loss on your investment. - Total dollar return = Dividend income + Capital gain (or loss) - Total cash if stock is sold = Initial investment + Total return - Even if you don't sell the stock, The capital gain is every bit as much a part of your return as the dividend, and you should certainly count it as part of your return

Preemptive Right

- In addition, stockholders sometimes have the right to share proportionally in any new stock sold. This is called the preemptive right. - a preemptive right means that a company that wishes to sell stock must first offer it to the existing stockholders before offering it to the general public. - The purpose is to give stockholders the opportunity to protect their proportionate ownership in the corporation.

Financing Costs

- In analyzing a proposed investment, we will not include interest paid or any other financing costs such as dividends or principal repaid because we are interested in the cash flow generated by the assets of the project. - As we mentioned in Chapter 2, interest paid, for example, is a component of cash flow to creditors, not cash flow from assets.

Extended Pie Model

- In the extended pie model, taxes just represent another claim on the cash flows of the fi rm. Because taxes are reduced as leverage is increased, the value of the government's claim (G) on the firm's cash flows decreases with leverage. - Bankruptcy costs are also a claim on the cash flows. o They come into play as the firm comes close to bankruptcy and has to alter its behavior to attempt to stave off the event itself, and they become large when bankruptcy actually takes place. o Thus, the value of this claim (B) on the cash flows rises with the debt-equity ratio. - CF = Payments to stockholders + Payments to creditors + Payments to the government + Payments to bankruptcy courts and lawyers + Payments to any and all other claimants to the cash flows of the firm

Real Interest Rates

- Interest rates or rates of return that have been adjusted for inflation.

Nominal Rates

- Interest rates or rates of return that have not been adjusted for inflation. - The nominal rate on an investment is the percentage change in the number of dollars you have. The real rate on an investment is the percentage change in how much you can buy with your dollars—in other words, the percentage change in your buying power. - financial rates, such as interest rates, discount rates, and rates of return, are almost always quoted in nominal terms.

Uses of Financial Statements

- Internal Uses o Management performance evaluation o Comparison of divisions o Planning for the future - External Uses o Financial statements are useful to parties outside the firm, including short-term and long-term creditors and potential investors o Use the information on deciding whether to give credit to a customer

Sensitivity Analysis

- Investigation of what happens to NPV when only one variable is changed. - freeze all of the variables except one and then see how sensitive our estimate of NPV is to changes in that one variable. - If our NPV estimate turns out to be very sensitive to relatively small changes in the projected value of some component of project cash flow, then the forecasting risk associated with that variable is high. - sensitivity analysis is useful in pinpointing which variables deserve the most attention. o If we find that our estimated NPV is especially sensitive to changes in a variable that is difficult to forecast (such as unit sales), then the degree of forecasting risk is high. - Sensitivity analysis is useful for pointing out where forecasting errors will do the most damage, but it does not tell us what to do about possible errors.

Underwriters

- Investment firms that act as intermediaries between a company selling securities and the investing public. - Underwriters perform services such as the following for corporate issuers: o 1. Formulating the method used to issue the securities. o 2. Pricing the new securities. o 3. Selling the new securities. - the underwriter buys the securities for less than the offering price and accepts the risk of not being able to sell them. - Because underwriting involves risk, underwriters usually combine to form an underwriting group called a syndicate to share the risk and to help sell the issue.

Standby Rights Offer

- Like the direct rights offer, this contains a privileged subscription arrangement with existing shareholders. - The net proceeds are guaranteed by the underwriters.

Dilution

- Loss in existing shareholders' value in terms of ownership, market value, book value, or EPS. - 1. Dilution of percentage ownership. - 2. Dilution of market value. - 3. Dilution of book value and earnings per share.

Managerial Compensation and Incentives

- Management will frequently have a significant economic incentive to increase share value for two reasons. First, managerial compensation, particularly at the top, is usually tied to financial performance in general and often to share value in particular. - This helps to better align management and shareholder interests - Also, managers who are successful in pursuing stockholder goals will be in greater demand in the labor market and thus command higher salaries

Agreements to Avoid Bankruptcy

- Much of the time, creditors can work with the management of a company that has defaulted on a loan contract. Voluntary arrangements to restructure or "reschedule" the company's debt can be and often are made. - This may involve extension, which postpones the date of payment, or composition, which involves a reduced payment.

Comments on NPV

- NPV is one of the two or three most important concepts in finance, and we will refer to it many times in the chapters ahead. When we do, keep two things in mind: o (1) NPV is always just the difference between the market value of an asset or project and its cost, and o (2) the financial manager acts in the shareholders' best interests by identifying and taking positive NPV projects. - Finally, we noted that NPVs can't normally be observed in the market; instead, they must be estimated. Because there is always the possibility of a poor estimate, financial managers use multiple criteria for examining projects. The other criteria provide additional information about whether a project truly has a positive NPV.

Commission Brokers

- NYSE members who execute customer orders to buy and sell stock transmitted to the exchange floor.

Net Working Capital

- Normally a project will require that the firm invest in net working capital in addition to long-term assets. - As a project winds down, inventories are sold, receivables are collected, bills are paid, and cash balances can be drawn down. These activities free up the net working capital originally invested. So the firm's investment in project net working capital closely resembles a loan. The firm supplies working capital at the beginning and recovers it toward the end. - whenever we have an investment in net working capital, that same investment has to be recovered; in other words, the same number needs to appear at some time in the future with the opposite sign.

The Quiet Period

- Once a firm begins to seriously contemplate an IPO, the SEC requires that a firm and its managing underwriters observe a "quiet period." This means that all communications with the public must be limited to ordinary announcements and other purely factual matters. - ends 40 calendar days after an IPO. - BECAUSE all relevant information should be included in the prospectus - The underwriter's analysts are prohibited from making recommendations to investors. - As soon as the quiet period ends, however, the managing underwriters typically publish research reports, usually accompanied by a favorable "buy" recommendation.

Bankruptcy Costs

- One limiting factor affecting the amount of debt a firm might use comes in the form of 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. - In principle, a firm becomes bankrupt when the value of its assets equals the value of its debt. When this occurs, the value of equity is zero, and the stockholders turn over control of the firm to the bondholders.

Straggering

- Only a fraction of directorships are up for election at a particular time o 1. Staggering makes it more difficult for a minority to elect a director when there is cumulative voting because there are fewer directors to be elected at one time. o 2. Staggering makes takeover attempts less likely to be successful because it makes it more difficult to vote in a majority of new directors. - provides "institutional memory"—that is, continuity on the board of directors.

Internal Equity and Flotation Costs

- Our discussion of flotation costs to this point implicitly assumes that firms always have to raise the capital needed for new investments. In reality, most firms rarely sell equity at all.

Dividends

- Payments by a corporation to shareholders, made in either cash or stock. - Dividends paid to shareholders represent a return on the capital directly or indirectly contributed to the corporation by the shareholders. - The payment of dividends is at the discretion of the board of directors.

Du Pont Identity

- Popular expression breaking ROE into three parts: operating efficiency, asset use efficiency, and financial leverage. - ROE = Profit margin x Total asset turnover x Equity multiplier

Stated Value

- Preferred shares have a stated liquidating value - usually $100 per share. - The cash dividend is described in terms of dollars per share. o For example, General Motors "$5 preferred" easily translates into a dividend yield of 5 percent of stated value.

Direct Placement

- Private - Securities are sold directly to the purchaser, who, at least until recently, generally could not resell securities for at least two years.

Project Cash Flows

- Project Cash Flows = Project Operating Cash Flow - Project change in Net Working capital - project capital spending

Capital Structure and Stock Value

- Put another way, the NPV rule applies to capital structure decisions, and the change in the value of the overall firm is the NPV of a restructuring. - You may recall that the WACC tells us that the firm's overall cost of capital is a weighted average of the costs of the various components of the firm's capital structure. - When we described the WACC, we took the firm's capital structure as given. o This chapter will explore what happens to the cost of capital when we vary the amount of debt financing, or the debt-equity ratio - A primary reason for studying the WACC is that the value of the firm is maximized when the WACC is minimized. o To see this, recall that the WACC is the appropriate discount rate for the firm's overall cash flows. o Because values and discount rates move in opposite directions, minimizing the WACC will maximize the value of the firm's cash flows - Thus, we will want to choose the firm's capital structure so that the WACC is minimized. - For this reason, we will say that one capital structure is better than another if it results in a lower weighted average cost of capital. Further, we say that a particular debt-equity ratio represents the optimal capital structure if it results in the lowest possible WACC. - We have seen that there is nothing special about corporate borrowing because investors can borrow or lend on their own. o As a result, whichever capital structure Trans Am chooses, the stock price will be the same. - 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

Shelf Cash Offer

- Qualifying companies can authorize all shares they expect to sell over a two-year period and sell them when needed.

Total Return = Expected Return + Unexpected Return

- R = E® + U - R = E® + Systematic Portion + Unsystematic Portion o R = E (R ) + m + e(Epsilon) - What this says is that the actual return, R, differs from the expected return, E(R), because of surprises that occur during the year. - In any given year, the unexpected return will be positive or negative; but, through time, the average value of U will be zero. This simply means that on average, the actual return equals the expected return.

Practice of Capital Budgeting

- Recall that we are trying to make an investment decision and that we are frequently operating under considerable uncertainty about the future. - We can only estimate the NPV of an investment in this case. - firms would typically use multiple criteria for evaluating a proposal. - Ultimately a good capital budgeting criterion must tell us two things. First, is a particular project a good investment? Second, if we have more than one good project, but we can take only one of them, which one should we take? o The main point of this chapter is that only the NPV criterion can always provide the correct answer to both questions.

Life Cycle Theory

- Relatively young and less profitable firms generally should not make cash distributions. o They need the cash to fund investments (and flotation costs discourage the raising of outside cash). - As a firm matures, it begins to generate free cash flow (which, you will recall, is internally generated cash flow beyond that needed to fund profitable investment activities). o Significant free cash flow can lead to agency problems if it is not distributed - Firms trade off the agency costs of excess cash retention against the potential future costs of external equity financing. o A firm should begin making distributions when it generates sufficient internal cash flow to fund its investment needs now and into the foreseeable future.

OTC market (over the counter)

- Securities market in which trading is almost exclusively done through dealers who buy and sell for their own inventories.

Collateral

- Securities that are pledged as security for payment of debt

Seniority

- Seniority indicates preference in position over other lenders, and debts are sometimes labeled as senior or junior to indicate seniority. Some debt is subordinated, as in, for example, a subordinated debenture. - In the event of default, holders of subordinated debt must give preference to other specified creditors. Usually, this means that the subordinated Lenders will be paid off only after the specified creditors have been compensated. - Debt cannot be subordinated to equity.

Pure Discount Loan

- Simplest form of loan - The borrower receives money today and repays a single lump sum at some time in the future.

Stakeholders

- Someone other than a stockholder or creditor who potentially has a claim on the cash flows of the firm. - Employees, customers,suppliers, and even the government all have a financial interest in the firm.

Principle of Diversification

- Spreading an investment across a number of assets will eliminate some, but not all, of the risk.

New Equity Sales and the Value of the Firm

- Stock prices tend to decline following the announcement of a new equity issue, although they tend to not change much following a debt announcement. A number of researchers have studied this issue. Plausible reasons for this strange result include the following: o 1. Managerial information: ♣ If management has superior information about the market value of the firm, it may know when the firm is overvalued. ♣ If it does, it will attempt to issue new shares of stock when the market value exceeds the correct value. ♣ This will benefit existing shareholders. However, the potential new shareholders are not stupid, and they will anticipate this superior information and discount it in lower market prices at the new-issue date. o 2. Debt usage: ♣ A company's issuing new equity may reveal that the company has too much debt or too little liquidity. ♣ One version of this argument says that the equity issue is a bad signal to the market. After all, if the new projects are favorable ones, why should the firm let new shareholders in on them? It could just issue debt and let the existing shareholders have all the gain. o 3. Issue costs: ♣ there are substantial costs associated with selling securities.

Preferred Stock

- Stock with dividend priority over common stock, normally with a fixed dividend rate, sometimes without voting rights. - Preferred shares have a stated liquidating value

Listing

- Stocks that trade on an organized exchange are said to be listed on that exchange. - To be listed, firms must meet certain minimum criteria concerning, for example, asset size and number of shareholders. - These criteria differ from one exchange to another.

Agency Relationship

- Such a relationship exists whenever someone (the principal) hires another (the agent) to represent his or her interests.

Blume's Formula

- Suppose we have calculated geometric and arithmetic return averages from N years of data, and we wish to use these averages to form a T -year average return forecast, R ( T ), where T is less than N . - Blume's formula says that if you are using averages calculated over a long period (such as the 82 years we use) to forecast up to a decade or so into the future, then you should use the arithmetic average. If you are forecasting a few decades into the future (as you might do for retirement planning), then you should just split the difference between the arithmetic and geometric average returns. Finally, if for some reason you are doing very long forecasts covering many decades, use the geometric average.

Real World Factors Favouring a LOW Dividend Payout

- Taxes o For individual shareholders, effective tax rates on dividend income are higher than the tax rates on capital gains. ♣ the tax on a capital gain is deferred until the stock is sold. ♣ This second aspect of capital gains taxation makes the effective tax rate much lower because the present value of the tax is less. - Flotation Costs o Selling new stock can be very expensive. If we include flotation costs in our argument, then we will find that the value of the stock decreases if we sell new stock. ♣ More generally, imagine two firms identical in every way except that one pays out a greater percentage of its cash flow in the form of dividends. Because the other firm plows back more, its equity grows faster. If these two firms are to remain identical, then the one with the higher payout will have to periodically sell some stock to catch up. ♣ Because this is expensive, a firm might be inclined to have a low payout. - Dividend Restrictions o a corporation may face restrictions on its ability to pay dividends o i.e. debt covenants

Liquidation

- Termination of the firm as a going concern - involves selling off the assets of the fi rm. - The proceeds, net of selling costs, are distributed to creditors in order of established priority

Future Value

- The amount an investment is worth after one or more periods. - the amount of money an investment will grow to over some period of time at some given interest rate - the cash value of an investment at some time in the future.

Call Premium

- The amount by which the call price exceeds the par value of a bond. - Generally, the call price is above the bond's stated value (that is, the par value). - The amount of the call premium may become smaller over time. o One arrangement is to initially set the call premium equal to the annual coupon payment and then make it decline to zero as the call date moves closer to the time of maturity.

Beta Coefficient

- The amount of systematic risk present in a particular risky asset relative to that in an average risky asset - tells us how much systematic risk a particular asset has relative to an average asset. - By definition, an average asset has a beta of 1.0 relative to itself. o An asset with a beta of .50, therefore, has half as much systematic risk as an average asset; an asset with a beta of 2.0 has twice as much. - Because assets with larger betas have greater systematic risks, they will have greater expected returns

Payback Period

- The amount of time required for an investment to generate cash flows sufficient to recover its initial cost. - Based on the payback rule, an investment is acceptable if its calculated payback period is less than some pre-specified number of years - A particular cutoff time is selected—say, two years—and all investment projects that have payback periods of two years or less are accepted, whereas any that pay off in more than two years are rejected. There is no discounting involved, so the time value of money is completely ignored

Coupon Rate

- The annual coupon divided by the face value of a bond.

Stand-Alone Principal

- The assumption that evaluation of a project may be based on the project's incremental cash flows. - once we have determined the incremental cash flows from undertaking a project, we can view that project as a kind of "minifirm" with its own future revenues and costs, its own assets, and, of course, its own cash flows. - We will then be primarily interested in comparing the cash flows from this minifirm to the cost of acquiring it. - An important consequence of this approach is that we will be evaluating the proposed project purely on its own merits, in isolation from any other activities or projects.

Geometric Average Return

- The average compound return earned per year over a multiyear period. - Geometric average return = [(1+ R1) x (1 + R2) x · · · x (1 x RT)]1/T - 1 AKA time value of money

Variance

- The average squared difference between the actual return and the average return. - Essentially measures the average squared difference between the actual returns and the average return. - The bigger this number is, the more the actual returns tend to differ from the average return. o i.e. more volatile - Also, the larger the variance or standard deviation is, the more spread out the returns will be.

Ex-rights Date

- The beginning of the period when stock is sold without a recently declared right, normally two trading days before the holder-of-record date. - Following stock exchange rules, the stock typically goes ex rights two trading days before the holder-of-record date. - If the stock is sold before the ex-rights date—"rights on," "with rights," or "cum rights"—the new owner will receive the rights. - After the ex-rights date, an investor who purchases the shares will not receive the rights.

Private Equity

- The broad term private equity is often used to label the rapidly growing area of equity financing for nonpublic companies.

Bylaws

- The bylaws are rules describing how the corporation regulates its existence

Marginal (Incremental) Costs

- The change in costs that occurs when there is a small change in output. - The SLOPE of the plotted line on a graph of variable + fixed costs

Marginal (Incremental) Revenue

- The change in revenue that occurs when there is a small change in output.

Competitive Firm Cash Offer

- The company can elect to award the underwriting contract through a public auction instead of negotiation

Dutch Auction Cash Offer

- The company has investment bankers auction shares to determine the highest offer price obtainable for a given number of shares to be sold.

Best Efforts Cash Offer

- The company has investment bankers sell as many of the new shares as possible at the agreed-upon price. - There is no guarantee concerning how much cash will be raised.

Firm Commitment Cash Offer

- The company negotiates an agreement with an investment banker to underwrite and distribute the new shares. - A specified number of shares are bought by underwriters and sold at a higher price.

Shareholder Rights

- The conceptual structure of the corporation assumes that shareholders elect directors who, in turn, hire managers to carry out their directives. - Shareholders, therefore, control the corporation through the right to elect the directors - "one share one vote" not one person one vote - Directors are elected at an annual shareholders' meeting by a vote of the holders of a majority of shares who are present and entitled to vote. - However, the exact mechanism for electing directors differs across companies. - The most important difference is whether shares must be voted cumulatively or voted straight. - In addition to the right to vote for directors, shareholders usually have the following rights: o 1. The right to share proportionally in dividends paid. o 2. The right to share proportionally in assets remaining after liabilities have been paid in a liquidation. o 3. The right to vote on stockholder matters of great importance, such as a merger. Voting is usually done at the annual meeting or a special meeting.

Unlevered Cost of Capital

- The cost of capital for a firm that has no debt. - Ru = the unlevered cost of capital

Indirect Bankruptcy Costs

- The costs of avoiding a bankruptcy filing incurred by a financially distressed firm.

Direct Bankruptcy Costs

- The costs that are directly associated with bankruptcy, such as legal and administrative expenses. - The formal turning over of the assets to the bondholders is a legal process, not an economic one. - These direct bankruptcy costs are a disincentive to debt financing - Borrowing saves a firm money on its corporate taxes, but the more a firm borrows, the more likely it is that the firm will become bankrupt and have to pay the "bankruptcy tax".

Present Value

- The current value of future cash flows discounted at the appropriate discount rate. - The reverse of future value - Instead of compounding money into the future, we DISCOUNT it into the present

Date of Record

- The date by which a holder must be on record to be designated to receive a dividend.

Holder-of-Record Date

- The date on which existing shareholders on company records are designated as the recipients of stock rights. - Also, the date of record. - Following stock exchange rules, the stock typically goes ex rights two trading days before the holder-of-record date.

Declaration Date

- The date on which the board of directors passes a resolution to pay a dividend. - The decision to pay a dividend rests in the hands of the board of directors of the corporation. - When a dividend has been declared, it becomes a debt of the firm and cannot be rescinded easily.

Date of Payment

- The date on which the dividend checks are mailed.

Bond Ratings

- The debt ratings are an assessment of the creditworthiness of the corporate issuer. - Based on how likely the firm is to default and the protection creditors have in the event of a default.

Operating Leverage

- The degree to which a firm or project relies on fixed costs. - A firm with low operating leverage will have low fixed costs compared to a firm with high operating leverage. o Generally speaking, projects with a relatively heavy investment in plant and equipment will have a relatively high degree of operating leverage. Such projects are said to be capital intensive - Fixed costs act like a lever in the sense that a small percentage change in operating revenue can be magnified into a large percentage change in operating cash flow and NPV. This explains why we call it operating "leverage." - The higher the degree of operating leverage, the greater is the potential danger from forecasting risk. The reason is that relatively small errors in forecasting sales volume can get magnified, or "levered up," into large errors in cash flow projections.

Scenario Analysis

- The determination of what happens to NPV estimates when we ask what-if questions.

Shareholders Equity

- The difference between a company's total assets and total liabilities - This feature of the balance sheet is intended to reflect the fact that, if the firm were to sell all its assets and use the money to pay off its debts, then whatever residual value remained would belong to the shareholders

Incremental Cash Flows

- The difference between a firm's future cash flows with a project and those without the project - Also called 'relevant cash flows' - The incremental cash flows for project evaluation consist of any and all changes in the firm's future cash flows that are a direct consequence of taking the project. - Any cash flow that exists regardless of whether or not a project is undertaken is NOT relevant.

Net Present Value

- The difference between an investment's market value and its cost. - net present value is a measure of how much value is created or added today by undertaking an investment

Bid-Ask Spread

- The difference between the bid price and the asked price.

Financial Distress Costs

- The direct and indirect costs associated with going bankrupt or experiencing financial distress

Internal Rate of Return

- The discount rate that makes the NPV of an investment zero.

Capital Gain Yield

- The dividend growth rate, or the rate at which the value of an investment grows.

Abnormal Return

- The drop in value of the existing stock following the announcement of a new issue is an example of an indirect cost of selling securities.

Capital Asset Pricing Model

- The equation of the SML showing the relationship between expected return and beta - Estimate the cost of equity - Depends on 3 things: o 1. The pure time value of money: ♣ As measured by the risk-free rate, Rf, this is the reward for merely waiting for your money, without taking any risk. o 2. The reward for bearing systematic risk: ♣ As measured by the market risk premium, E(Rm) - Rf , this component is the reward the market offers for bearing an average amount of systematic risk in addition to waiting. o 3. The amount of systematic risk: ♣ As measured by Bi, this is the amount of systematic risk present in a particular asset or portfolio, relative to that in an average asset.

Financial Risk

- The equity risk that comes from the financial policy (the capital structure) of the fi rm. - The second component in the cost of equity, (Ra - Ra) x (D / E), is determined by the firm's financial structure. For an all-equity firm, this component is zero. - As the firm begins to rely on debt financing, the required return on equity rises. o This occurs because the debt financing increases the risks borne by the stockholders. o This extra risk that arises from the use of debt financing is called the financial risk of the firm's equity.

Business Risk

- The equity risk that comes from the nature of the firm's operating activities. - risk inherent in a firm's operations - depends on the systematic risk of the firm's assets. - The greater a firm's business risk, the greater Ra will be, and, all other things being the same, the greater will be the firm's cost of equity.

Risk Premium

- The excess return required from an investment in a risky asset over that required from a risk-free investment - The difference between virtually risk-free return on T-bills and the very risky return on common stocks. - Risky assets, on average, earn a risk premium. Put another way, there is a reward for bearing risk.

Systematic Risk Principle

- The expected return on a risky asset depends only on that asset's systematic risk. - the reward for bearing risk depends only on the systematic risk of an investment. - Because unsystematic risk can be eliminated at virtually no cost (by diversifying), there is no reward for bearing it. - The expected return on an asset depends only on that asset's systematic risk.

Sources of Value

- The first line of defense against forecasting risk is simply to ask, "What is it about this investment that leads to a positive NPV?" - We should be able to point to something specific as the source of value. - A key factor to keep in mind is the degree of competition in the market. o A basic principle of economics is that positive NPV investments will be rare in a highly competitive environment. - It is also necessary to think about potential competition. o need to keep in mind that success attracts imitators and competitors

Order Flow

- The flow of customer orders to buy and sell securities. - Fundamentally, the business of the NYSE is to attract and process order flow .

Bearer Form

- The form of bond issue in which the bond is issued without record of the owner's name; - payment is made to whomever holds the bond. - Two drawbacks: o Difficult to recover if they are lost or stolen. o Because the company does not know who owns its bonds, it cannot notify bondholders of important events.

Registered Form

- The form of bond issue in which the registrar of the company records ownership of each bond; - payment is made directly to the owner of record. - Registrar company records changes in ownership

Efficient Market Hypothesis

- The hypothesis that actual capital markets, such as the NYSE, are efficient. - If a market is efficient, then there is a very important implication for market participants: All investments in that market are zero NPV investments. The reason is not complicated. - If prices are neither too low nor too high, then the difference between the market value of an investment and its cost is zero; hence, the NPV is zero. - The logical consequence of all this information gathering and analysis is that mispriced stocks will become fewer and fewer. In other words, because of competition among investors, the market will become increasingly efficient. - More than anything else, what efficiency implies is that the price a firm will obtain when it sells a share of its stock is a "fair" price in the sense that it reflects the value of that stock given the information available about the firm.

Annual Percentage Rate (APR)

- The interest rate charged per period multiplied by the number of periods per year.

EAR

- The interest rate expressed as if it were compounded once per year. - we computed the EARs in three steps: o first divide the quoted rate by the number of times that the interest is compounded o Then add 1 to the result and raised it to the power of the number of times the interest is compounded. o Finally, subtract the 1. o If we let m be the number of times the interest is compounded during the year, these steps can be summarized simply as: o - EVERY TIME we do a present value calculation, you must use an ACTUAL or EFFECTIVE rate

Stated Interest Rate

- The interest rate expressed in terms of the interest payment made each period. - Also known as the quoted interest rate

Amortized Loan

- The lender requires the borrower to repay parts of the loan amount over time. - The process of providing for a loan to be paid off by making regular principal reductions is called amortizing the loan - A simple way of amortizing a loan is to have the borrower pay the interest each period plus some fixed amount

Security Market Line

- The line that results when we plot expected returns and beta coefficients - used to describe the relationship between systematic risk and expected return in financial markets - A positively sloped straight line displaying the relationship between expected return and beta.

Planning Horizon

- The long-range time period on which the financial planning process focuses (usually the next two to five years).

Information Content Effect

- The market's reaction to a change in corporate dividend payout. - a dividend cut is often a signal that the firm is in trouble. o usually signals that management does not think that the current dividend policy can be maintained. o As a result, expectations of future dividends should generally be revised downward. - an unexpected increase in the dividend signals good news. o Management will raise the dividend only when future earnings, cash flow, and general prospects are expected to rise to such an extent that the dividend will not have to be cut later. A dividend increase is management's signal to the market that the firm is expected to do well. o The stock price reacts favorably because expectations of future dividends are revised upward, not because the firm has increased its payout. - In both of these cases, the stock price reacts to the dividend change. o The reaction can be attributed to changes in the expected amount of future dividends, not necessarily a change in dividend payout policy.

Sustainable Growth Rate

- The maximum growth rate a firm can achieve without external equity financing while maintaining a constant debt-equity ratio.

Cost of Capital

- The minimum required return on a new investment. - The appropriate discount rate on a new project is the minimum expected rate of return an investment must offer to be attractive - the required return is what the firm must earn on its capital investment in a project just to break even. - It can thus be interpreted as the opportunity cost associated with the firm's capital investment. - The cost of capital depends primarily on the use of the funds, not the source. - the cost of capital associated with an investment depends on the risk of that investment. - a firm's overall cost of capital will reflect the required return on the firm's assets as a whole. - required return, appropriate discount rate, and cost of capital can be used interchangeably - Given that a firm uses both debt and equity capital, this overall cost of capital will be a mixture of the returns needed to compensate its creditors and those needed to compensate its stockholders. o In other words, a firm's cost of capital will reflect both its cost of debt capital and its cost of equity capital.

Capital Structure

- The mixture of debt and equity maintained by a firm. - How much should the firm borrow? - What mixture of debt/equity is the best? - Whether one structure is better than any other for a particular firm is the heart of the capital structure issue.

Opportunity Costs

- The most valuable alternative that is given up if a particular investment is undertaken. - the opportunity cost that we charge the project is what the mill would sell for today (net of any selling costs) because this is the amount we give up by using the mill instead of selling it

The Clientele Effect

- The observable fact that stocks attract particular groups based on dividend yield and the resulting tax effects. - some groups (wealthy individuals, for example) have an incentive to pursue low-payout (or zero-payout) stocks. Other groups (corporations, for example) have an incentive to pursue high-payout stocks. - Companies with high payouts will thus attract one group, and low-payout companies will attract another.

Lockup Agreement

- The part of the underwriting contract that specifies how long insiders must wait after an IPO before they can sell stock. - Although they are not required by law, almost all underwriting contracts contain them - usually 180 days o ensures that they maintain a significant economic interest in the company going public - Lockup periods are also important because it is not unusual for the number of locked-up shares to exceed the number of shares held by the public, sometimes by a substantial multiple. On the day the lockup period expires, there is the possibility that a large number of shares will hit the market on the same day and thereby depress values.

Degree of Operating Leverage

- The percentage change in operating cash flow relative to the percentage change in quantity sold. - DOL = 1 + FC/OCF - Notice that zero fixed costs would result in a DOL of 1, implying that percentage changes in quantity sold would show up one for one in operating cash flow. In other words, no magnification, or leverage, effect would exist.

Portfolio Weight

- The percentage of a portfolio's total value that is in a particular asset.

The Aftermarket

- The period after a new issue is initially sold to the public - During this time, the members of the underwriting syndicate generally do not sell securities for less than the offering price. - The principal underwriter is permitted to buy shares if the market price falls below the offering price. The purpose of this would be to support the market and stabilize the price against temporary downward pressure. - If the issue remains unsold after a time (for example, 30 days), members can leave the group and sell their shares at whatever price the market will allow.

Inflation Premium

- The portion of a nominal interest rate that represents compensation for expected future inflation.

Standard Deviation

- The positive square root of the variance. - The square root of the variance is used because the variance is measured in "squared" percentages and thus is hard to interpret. - The standard deviation is an ordinary percentage

Agency Problem

- The possibility of conflict of interest between the stockholders and management of a fi rm. - E.g.) Suppose you hire someone to sell your car and agree to pay that person a flat fee when he or she sells the car. The agent's incentive in this case is to make the sale, not necessarily to get you the best price

Forecasting Risk

- The possibility that errors in projected cash flows will lead to incorrect decisions. - Also, estimation risk - The possibility that we will make a bad decision because of errors in the projected cash flows - Because of forecasting risk, there is the danger that we will think a project has a positive NPV when it really does not

Profitability Index

- The present value of an investment's future cash flows divided by its initial cost. - Also called the benefit-cost ratio. - How do we interpret the profitability index? In our example, the PI was 1.1. This tells us that, per dollar invested, $1.10 in value or $.10 in NPV results. - The profitability index thus measures "bang for the buck"—that is, the value created per dollar invested.

Bid Price

- The price a dealer is willing to pay for a security.

Ask Price

- The price a dealer is willing to take for a security

Dirty Price

- The price of a bond including accrued interest, also known as the full or invoice price. - This is the price the buyer actually pays.

Clean Price

- The price of a bond net of accrued interest; this is the price that is typically quoted.

Trading Range

- The price range between the highest and lowest prices at which a stock is traded. - When the security is priced above this level, many investors do not have the funds to buy the common trading unit of 100 shares, called a round lot. o Although securities can be purchased in odd-lot form (fewer than 100 shares), the commissions are greater. o Thus, firms will split the stock to keep the price in this trading range.

Face Value

- The principal amount of a bond that is repaid at the end of the term. - Also called par value .

Capital Budgeting

- The process of planning and managing a firm's long term investments. - financial manager tries to identify investment opportunities that are worth more to the firm than they cost to acquire.

Discounted Cash Flow Valuation

- The process of valuing an investment by discounting its future cash flows o We will first try to estimate the future cash flows we expect the new business to produce. o We will then apply our basic discounted cash flow procedure to estimate the present value of those cash flows. o Once we have this estimate, we will then estimate NPV as the difference between the present value of the future cash flows and the cost of the investment.

M&M Proposition I

- The proposition that the value of the fi rm is independent of the firm's capital structure. - The size of the pie is the same because the size of the assets are the same - The size of the pie doesn't depend on how it is sliced.

Stock Repurchases

- The purchase, by a corporation, of its own shares of stock; also known as a buyback. - Share repurchases are typically accomplished in one of three ways. o First, companies may simply purchase their own stock, just as anyone would buy shares of a particular stock. In these open market purchases, the firm does not reveal itself as the buyer. o Thus, the seller does not know whether the shares were sold back to the firm or to just another investor. - Second, the firm could institute a tender offer. o Here, the firm announces to all of its stockholders that it is willing to buy a fixed number of shares at a specific price. o Tender price is always higher than market price to entice shareholders to sell the stock - Finally, firms may repurchase shares from specific individual stockholders. o This procedure has been called a targeted repurchase

Term Structure of Interest Rates

- The relationship between nominal interest rates on default-free, pure discount securities and time to maturity; that is, the pure time value of money. - These rates are, in essence, "pure" interest rates because they involve no risk of default and a single, lump sum future payment. - The term structure tells us the pure time value of money for different lengths of time.

The Fischer Effect

- The relationship between nominal returns, real returns, and inflation.

What determines the required return on investment?

- The required return depends on the risk of the investment. o The greater the risk, the greater is the required return. - At a minimum, the return we require from a proposed nonfinancial investment must be greater than what we can get by buying financial assets of similar risk.

Arithmetic Average Return

- The return earned in an average year over a multiyear period. - Calculate year by year change

Expected Value

- The return on a risky asset expected in the future.

Cost of Equity

- The return that equity investors require on their investment in the firm. - The easiest way to estimate the cost of equity capital is to use the dividend growth model - "Re"

Cost of Debt

- The return that lenders require on the firm's debt. - Unlike a firm's cost of equity, its cost of debt can normally be observed either directly or indirectly: The cost of debt is simply the interest rate the firm must pay on new borrowing, and we can observe interest rates in the financial markets. o For example, if the firm already has bonds outstanding, then the yield to maturity on those bonds is the market required rate on the firm's debt. o Alternatively, if we know that the firm's bonds are rated, say, AA, then we can simply find the interest rate on newly issued AA-rated bonds. Either way, there is no need to estimate a beta for the debt because we can directly observe the rate we want to know. o NOTE: The coupon rate on the firm's outstanding debt is irrelevant here. That rate just tells us roughly what the firm's cost of debt was back when the bonds were issued, not what the cost of debt is today.

The Fundamental Result

- The reward-to-risk ratio must be the same for all the assets in the market. o The situation we have described for Assets A and B could not persist in a well-organized, active market, because investors would be attracted to Asset A and away from Asset B. As a result, Asset A's price would rise and Asset B's price would fall. Because prices and returns move in opposite directions, A's expected return would decline and B's would rise. o This buying and selling would continue until the two assets plotted on exactly the same line, which means they would offer the same reward for bearing risk

Interest Rate Risk

- The risk that arises for bond owners from fluctuating interest rates - How much interest rate risk a bond has depends on how sensitive its price is to interest rate changes. - This sensitivity directly depends on two things: the time to maturity and the coupon rate.

Absolute Priority Rule (APR)

- The rule establishing priority of claims in liquidation. - The higher a claim is on this list, the more likely it is to be paid - secured creditors are outside this ordering - in reality, who gets what in bankruptcy proceedings is often up for negotiation and APR is not generally followed

Financial Break Even

- The sales level that results in a zero NPV - What we do is first determine what operating cash flow has to be for the NPV to be zero. We then use this amount to determine the sales volume. - Use PMT button to determine OCFs needed for break-even point - Plug PMT(OCF) into break -even point equation - Financial break-even is substantially higher than the accounting break-even.

Accounting Break Even

- The sales level that results in zero project net income. - include depreciation in calculating expenses here, even though depreciation is not a cash outflow. o That is why we call it an accounting break-even. - we break even when revenues are equal to total costs. - Q = (FC + D) / (P - v)

Divisional Cost of Capital

- The same type of problem with the WACC can arise in a corporation with more than one line of business. Imagine, for example, a corporation that has two divisions: a regulated telephone company and an electronics manufacturing operation. The first of these (the phone operation) has relatively low risk; the second has relatively high risk. - In this case, the firm's overall cost of capital is really a mixture of two different costs of capital, one for each division. - Many companies work to develop separate divisional costs of capital.

the SML and cost of capital

- The security market line tells us the reward for bearing risk in financial markets. - At an absolute minimum, any new investment our firm undertakes must offer an expected return that is no worse than what the financial markets offer for the same risk - The only way we benefit our shareholders is by finding investments with expected returns that are superior to what the financial markets offer for the same risk. o Such an investment will have a positive NPV - So, if we ask, "What is the appropriate discount rate?" the answer is that we should use the expected return offered in financial markets on investments with the same systematic risk. o In other words, to determine whether an investment has a positive NPV, we essentially compare the expected return on that new investment to what the financial market offers on an investment with the same beta.

Capital Rationing

- The situation that exists if a firm has positive NPV projects but cannot find the necessary financing.

Hard Rationing

- The situation that occurs when a business cannot raise financing for a project under any circumstances. - Hard rationing can occur when a company experiences financial distress, meaning that bankruptcy is a possibility. - Also, a firm may not be able to raise capital without violating a preexisting contractual agreement.

Soft Rationing

- The situation that occurs when units in a business are allocated a certain amount of financing for capital budgeting. - This occurs when, for example, different units in a business are allocated some fixed amount of money each year for capital spending. Such an allocation is primarily a means of controlling and keeping track of overall spending. The important thing to note about soft rationing is that the corporation as a whole isn't short of capital; more can be raised on ordinary terms if management so desires. - If we face soft rationing, the first thing to do is to try to get a larger allocation. Failing that, one common suggestion is to generate as large a net present value as possible within the existing budget. - Ongoing soft rationing means we are constantly bypassing positive NPV investments. This contradicts our goal of the firm.

Market Risk Premium

- The slope of the SML—the difference between the expected return on a market portfolio and the risk-free rate

Maturity

- The specified date on which the principal amount of a bond is paid.

Coupon

- The stated interest payment made on a bond.

Homemade Dividend Policy

- The tailored dividend policy created by individual investors who undo corporate dividend policy by reinvesting dividends or selling shares of stock. - stockholders can alter the firm's dividend policy to suit themselves - As a result, there is no particular advantage to any one dividend policy the firm might choose

Interest Tax Shield

- The tax saving attained by a firm from interest expense.

Depreciation Tax Shield

- The tax saving that results from the depreciation deduction, calculated as depreciation multiplied by the corporate tax rate.

Static Theory of Capital Structure

- The theory that a firm borrows up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress.

Total Risk

- The total systematic risk of the firm's equity thus has two parts: business risk and financial risk. - The first part (the business risk) depends on the firm's assets and operations and is not affected by capital structure. - Given the firm's business risk (and its cost of debt), the second part (the financial risk) is completely determined by financial policy. o As we have illustrated, the firm's cost of equity rises when the firm increases its use of financial leverage because the financial risk of the equity increases while the business risk remains the same.

Standby Underwriting

- The type of underwriting in which the underwriter agrees to purchase the unsubscribed portion of the issue

Financial Leverage

- The use of debt in a firm's capital structure - The more debt a firm has (as a percentage of assets), the greater is its degree of financial leverage. - debt acts like a lever in the sense that using it can greatly magnify both gains and losses - financial leverage increases the potential reward to shareholders, but it also increases the potential for financial distress and business failure.

Homemade Leverage

- The use of personal borrowing to change the overall amount of financial leverage to which the individual is exposed.

MV vs Book Value

- The values shown on the balance sheet for the firm's assets are book values and generally are not what the assets are actually worth - The difference between market value and book value is important for understanding the impact of reported gains and losses - the market value of an asset depends on things like its riskiness and cash flows, not accounting

Indenture

- The written agreement between the corporation and the lender detailing the terms of the debt issue - Sometimes called "deed of trust" - Is a legal document that contains the following information: o 1. The basic terms of the bonds. o 2. The total amount of bonds issued. o 3. A description of property used as security. o 4. The repayment arrangements. o 5. The call provisions. o 6. Details of the protective covenants.

Average Tax Rate

- Total taxes paid divided by total taxable income.

Real World Considerations for a Repurchase

- Under current tax law, a repurchase has a significant tax advantage over a cash dividend. - A dividend is taxed, and a shareholder has no choice about whether or not to receive the dividend. - In a repurchase, a shareholder pays taxes only if (1) the shareholder actually chooses to sell and (2) the shareholder has a capital gain on the sale.

Rights

- When new shares of common stock are sold to the general public, the proportional ownership of existing shareholders is likely to be reduced. - However, if a preemptive right is contained in the firm's articles of incorporation, the firm must first offer any new issue of common stock to existing shareholders. - An issue of common stock offered to existing stockholders is called a rights offering (or offer, for short) or a privileged subscription. - In a rights offering, each shareholder is issued rights to buy a specified number of new shares from the firm at a specified price within a specified time, after which the rights are said to expire - The terms of the rights offering are evidenced by certificates known as share warrants or rights o Such rights are often traded on securities exchanges or over the counter. - they appear to be cheaper for the issuing firm than cash offers. o a firm can do a rights offering without using an underwriter; ♣ whereas, as a practical matter, an underwriter is almost a necessity in a cash offer - The early stages of a rights offering are the same as those for the general cash offer. The difference between a rights offering and a general cash offer lies in how the shares are sold. - In a rights offer, the company's existing shareholders are informed that they own one right for each share of stock they own. o The company will then specify how many rights a shareholder needs to buy one additional share at a specified price. - - - It is obvious that after the rights offering, the new market price of the firm's stock will be lower than the price before the rights offering. As we have seen, however, stockholders have suffered no loss because of the rights offering. o Thus, the stock price decline is very much like that in a stock split. o The lower the subscription price, the greater is the price decline resulting from a rights offering. - How do we set the subscription price in a rights offering? o If you think about it, you will see that the subscription price really does not matter. It has to be below the market price of the stock for the rights to have value; but beyond this, the price is arbitrary. In principle, it could be as low as we cared to make it as long as it was not zero. o In other words, it is impossible to underprice a rights offer.

Discount Bond

- When the bond sells for less than face value When interest rates increase

Premium Bonds

- When the bond sells for more than face value - When interest rates decrease

Dilution: Book vs Market Value

- When the market-to-book ratio is less than 1, increasing the number of shares does cause EPS to go down. Such a decline in EPS is accounting dilution, and accounting dilution will always occur under these circumstances.

SML and WACC

- When we are evaluating investments with risks that are substantially different from those of the overall firm, use of the WACC will potentially lead to poor decisions. - Suppose our firm uses its WACC to evaluate all investments. This means that any investment with a return of greater than 15 percent will be accepted and any investment with a return of less than 15 percent will be rejected. - We know from our study of risk and return, however, that a desirable investment is one that plots above the SML. - using the WACC for all types of projects can result in the firm's incorrectly accepting relatively risky projects and incorrectly rejecting relatively safe ones. - the second error that will arise if we use the WACC as a cutoff is that we will tend to make unprofitable investments with risks greater than those of the overall fi rm.

Make-whole bond

- With such a feature, bondholders receive approximately what the bonds are worth if they are called. - Because bondholders don't suffer a loss in the event of a call, they are "made whole." - To determine the make-whole call price, we calculate the present value of the remaining interest and principal payments at a rate specified in the indenture.

Current Yield

- a bond's annual coupon divided by its price

Net Working Capital

- a firm's short term assets less short term liabilities - The structure of the assets for a particular firm reflects the line of business the firm is in and also managerial decisions about how much cash and inventory to have and about credit policy, fixed asset acquisition, and so on. - The liabilities side of the balance sheet primarily reflects managerial decisions about capital structure and the use of short-term debt.

Strong Form Efficiency

- all information of every kind is reflected in stock prices. - In such a market, there is no such thing as inside information.

Put Bond

- allows the holder to force the issuer to buy back the bond at a stated price. - The put feature is just the reverse of the call provision

Dilution of Proportionate Ownership

- can arise whenever a firm sells shares to the general public Because a rights offering would ensure Joe Smith an opportunity to maintain his proportionate 10 percent share, dilution of the ownership of existing shareholders can be avoided by using a rights offering

Convertible bonds

- can be swapped for a fixed number of shares of stock anytime before maturity at the holder's option. - Convertibles are relatively common, but the number has been decreasing in recent years.

Closer Look at NWC

- cash costs equal costs less the increase in accounts payable. - cash income is sales minus the increase in accounts receivable. - including net working capital changes in our calculations has the effect of adjusting for the discrepancy between accounting sales and costs and actual cash receipts and payments.

Unmarketed Claims

- claims of government, potential litigants, and lawsuits - cannot be bought and sold in financial markets

Marketed Claims

- claims of stockholders and bondholders - can be bought and sold in financial markets - When we speak of the value of the firm, we are generally referring to just the value of the marketed claims

Dividend Smoothing

- dividend growth lags earnings growth and - dividend growth will tend to be much smoother than earnings growth.

Pure Play Approach

- examine other investments outside the firm that are in the same risk class as the one we are considering, and use the market required return on these investments as the discount rate. - In other words, we will try to determine what the cost of capital is for such investments by trying to locate some similar investments in the marketplace. - For example, going back to our telephone division, suppose we wanted to come up with a discount rate to use for that division. What we could do is identify several other phone companies that have publicly traded securities. We might find that a typical phone company has a beta of .80, AA-rated debt, and a capital structure that is about 50 percent debt and 50 percent equity. Using this information, we could develop a WACC for a typical phone company and use this as our discount rate. In the language of Wall Street, a company that focuses on a single line of business is called a pure play - The use of a WACC that is unique to a particular project, based on companies in similar lines of busines

Profitability Measures

- intended to measure how efficiently a firm uses its assets and manages its operations. - The focus in this group is on the bottom line, net income.

Ly Target Est

- is the average estimated stock price one year ahead based on estimates from security analysts who follow the stock.

Extra Cash Dividend

- management is indicating that the "extra" part may or may not be repeated in the future.

Liquidating Dividend

- means that some or all of the business has been liquidated - may reduce paid-in capital

Non-diversifiable Risk

- minimum level of risk that cannot be eliminated simply by diversifying. - systematic risk and nondiversifiable risk are used interchangeably.

Cost of Preferred Stock

- preferred stock has a fixed dividend paid every period forever, so a share of preferred stock is essentially a perpetuity - Alternatively, because preferred stocks are rated in much the same way as bonds, the cost of preferred stock can be estimated by observing the required returns on other, similarly rated shares of preferred stock.

Income Bond

- similar to conventional bonds, except that coupon payments depend on company income. - Specifically, coupons are paid to bondholders only if the firm's income is sufficient. - This would appear to be an attractive feature, but income bonds are not very common.

Automatic Dividend Reinvestment Plans (DRIP)

- stockholders have the option of automatically reinvesting some or all of their cash dividend in shares of stock. - In some cases, they actually receive a discount on the stock, which makes such a plan very attractive.

Optimal Capital Structure and Cost of Capital

- the capital structure that maximizes the value of the firm is also the one that minimizes the cost of capital - Taxes o First of all, the tax benefit from leverage is obviously important only to firms that are in a tax-paying position. o Firms with substantial accumulated losses will get little value from the interest tax shield. Furthermore, firms that have substantial tax shields from other sources, such as depreciation, will get less benefit from leverage. o Also, not all firms have the same tax rate. The higher the tax rate, the greater the incentive to borrow. - Financial Distress o Firms with a greater risk of experiencing financial distress will borrow less than firms with a lower risk of financial distress. o For example, all other things being equal, the greater the volatility in EBIT, the less a firm should borrow. o In addition, financial distress is more costly for some firms than others. The costs of financial distress depend primarily on the firm's assets. In particular, financial distress costs will be determined by how easily ownership of those assets can be transferred. o For example, a firm with mostly tangible assets that can be sold without great loss in value will have an incentive to borrow more. For firms that rely heavily on intangibles, such as employee talent or growth opportunities, debt will be less attractive because these assets effectively cannot be sold.

Prepackaged Bankruptcies

- the corporation secures the necessary approval of a bankruptcy plan from a majority of its creditors first, and then it files for bankruptcy. - As a result, the company enters bankruptcy and reemerges almost immediately.

Weak-form efficiency

- the current price of a stock reflects the stock's own past prices. - In other words, studying past prices in an attempt to identify mispriced securities is futile Although this form of efficiency might seem rather mild, it implies that searching for patterns in historical prices that will be useful in identifying mispriced stocks will not work (this practice is quite common).

Cash Flow

- the difference between the number of dollars that came in and the number that went out

Side Effects

- the incremental cash flows for a project include all the resulting changes in the firm's future cash flows

Semi-strong efficiency

- the most controversial. - all public information is reflected in the stock price. - The reason this form is controversial is that it implies that a security analyst who tries to identify mispriced stocks using, for example, financial statement information, is wasting time because that information is already reflected in the current price.

The SML approach

- the required or expected return on a risky investment depends on three things o 1. The risk-free rate, Rf. o 2. The market risk premium o 3. The systematic risk of the asset relative to average (beta coefficient)

Corporate Finance

- the study of the relationship between business decisions and value of the stock in the business

Dividend Policy

- the time pattern of dividend payout. - In particular, should the firm pay out a large percentage of its earnings now or a small (or even zero) percentage? - This is the dividend policy question.

Special Dividend

- usually indicates that this dividend is viewed as a truly unusual or one-time event and won't be repeated

Projected vs Actual Cash Flow

- we don't really expect a projected cash flow to be exactly right in any one case. - What we do expect is that if we evaluate a large number of projects, our projections will be right on average.

Underpricing

- when the price is too low, the issue is often "oversubscribed." o This means investors will not be able to buy all of the shares they want, and the underwriters will allocate the shares among investors. - Determining the correct offering price is the most difficult thing an underwriter must do for an initial public offering. The issuing firm faces a potential cost if the offering price is set too high or too low. o If the issue is priced too high, it may be unsuccessful and have to be withdrawn. o If the issue is priced below the true market value, the issuer's existing shareholders will experience an opportunity loss when the issuer sells shares for less than they are worth. - Underpricing is fairly common. o It obviously helps new shareholders earn a higher return on the shares they buy. o However, the existing shareholders of the issuing firm are not helped by underpricing. - the underpricing tends to be higher for firms with few to no sales in the previous year. These firms tend to be young firms, and such young firms can be very risky investments. - Arguably, they must be significantly underpriced, on average, just to attract investors, and this is one explanation for the underpricing phenomenon. - The second caveat is that relatively few IPO buyers will actually get the initial high average returns observed in IPOs, and many will actually lose money. Although it is true that, on average, IPOs have positive initial returns, a significant fraction of them have price drops - The average investor will find it difficult to get shares in a "successful" offering (one in which the price increases) because there will not be enough shares to go around. On the other hand, an investor blindly submitting orders for IPOs tends to get more shares in issues that go down in price. - underpricing is a kind of insurance for the investment banks. o Conceivably, an investment bank could be sued successfully by angry customers if it consistently overpriced securities. o Underpricing guarantees that, at least on average, customers will come out ahead. - A final reason for underpricing is that before the offer price is established, investment banks talk to big institutional investors to gauge the level of interest in the stock and to gather opinions about a suitable price. Underpricing is a way that the bank can reward these investors for truthfully revealing what they think the stock is worth and the number of shares they would like to buy.

Risk Class

- whether or not we can use the firm's WACC to value a project depends on whether the project is in the same risk class as the fi rm. - projects that are intimately related to the firm's existing operations are often viewed as being in the same risk class as the overall firm.

Real World Factors Favouring a HIGH Dividend Payout

1. "The discounted value of near dividends is higher than the present worth of distant dividends." 2. Between "two companies with the same general earning power and same general position in an industry, the one paying the larger dividend will almost always sell at a higher price." 3. Desire for current income a. many individuals desire current income b. this argument is not relevant in our simple case. An individual preferring high current cash flow but holding low-dividend securities can easily sell off shares to provide the necessary funds. c. Similarly, an individual desiring a low current cash flow but holding high-dividend securities can just reinvest the dividend. i. In a world of no transaction costs, dividend policy doesn't matter ii. Here the sale of low-dividend stocks would involve brokerage fees and other transaction costs. These direct cash expenses could be avoided by an investment in high-dividend securities. 4. Resolution of uncertainty 5. Overall, individual investors (for whatever reason) may have a desire for current income and may thus be willing to pay the dividend tax. In addition, some very large investors such as corporations and tax-free institutions may have a very strong preference for high dividend payouts.

Bankruptcy Liquidation

1. A petition is fi led in a federal court. Corporations may fi le a voluntary petition, or involuntary petitions may be fi led against the corporation by several of its creditors. 2. A trustee-in-bankruptcy is elected by the creditors to take over the assets of the debtor corporation. The trustee will attempt to liquidate the assets. 3. 3. When the assets are liquidated, after payment of the bankruptcy administration costs, the proceeds are distributed among the creditors. 4. 4. If any proceeds remain, after expenses and payments to creditors, they are distributed to the shareholders.

Bankruptcy Reorganization

1. A voluntary petition can be filed by the corporation, or an involuntary petition can be filed by creditors. 2. A federal judge either approves or denies the petition. If the petition is approved, a time for fi ling proofs of claims is set. 3. In most cases, the corporation (the "debtor in possession") continues to run the business. 4. The corporation (and, in certain cases, the 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 its acceptance by creditors, the plan is confirmed by the court. 7. Payments in cash, property, and securities are made to creditors and shareholders. The plan may provide for the issuance of new securities. 8. For some fixed length of time, the firm operates according to the provisions of the reorganization plan.

Priority List for Bankruptcy Liquidation

1. Administrative expenses associated with the bankruptcy. 2. Other expenses arising after the filing of an involuntary bankruptcy petition but before the appointment of a trustee. 3. Wages, salaries, and 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.

Basic Elements of a Firm's Financial Policy

1. The firm's needed investment in new assets: a. This will arise from the investment opportunities the firm chooses to undertake, and it is the result of the firm's capital budgeting decisions. 2. The degree of financial leverage the firm chooses to employ a. This will determine the amount of borrowing the firm will use to finance its investments in real assets. This is the firm's capital structure policy. 3. The amount of cash the firm thinks is necessary and appropriate to pay shareholders a. This is the firm's dividend policy. 4. The amount of liquidity and working capital the firm needs on an ongoing basis a. This is the firm's net working capital decision.

Deferred Call Provision

A call provision prohibiting the company from redeeming a bond prior to a certain date

Erosion

A negative impact on the cash flows of an existing product from the introduction of a new product is called erosion o The cash flows of a new project that come at the expense of a firm's existing projects. o In this case, the cash flows from the new line should be adjusted downward to reflect lost profits on other lines o In accounting for erosion, it is important to recognize that any sales lost as a result of launching a new product might be lost anyway because of future competition. Erosion is relevant only when the sales would not otherwise be lost.

Straight Voting

A procedure in which a shareholder may cast all votes for each member of the board of directors

Cumulative Voting

A procedure in which a shareholder may cast all votes for one member of the board of directors

Private Placements

Loans (usually long-term) provided directly by a limited number of investors

Project Operating Cash Flow

Operating cash flow = EBIT + Depreciation - Taxes

Ex-dividend Date

The date two business days before the date of record, establishing those individuals entitled to a dividend

Discounted Payback Period

The length of time required for an investment's discounted cash flows to equal its initial cost.

Aggregation

The process by which smaller investment proposals of each of a firm's operational units are added up and treated as one big project

Interest Rate Risk Premium

_ The compensation investors demand for bearing interest rate risk.

IRR Rule

an investment is acceptable if the IRR exceeds the required return. It should be rejected otherwise.

Product Costs

include such things as raw materials, direct labor expense, and manufacturing overhead. These are reported on the income statement as costs of goods sold, but they include both fixed and variable costs.

Direct Agency Cost

o Costs that benefit management but not shareholders - Expenses that arises from the need to monitor management actions

Time Trend Analysis

o One standard we could use is history. Suppose we found that the current ratio for a particular firm is 2.4 based on the most recent financial statement information. Looking back over the last 10 years, we might find that this ratio had declined fairly steadily over that period.

M&M Proposition II

o The proposition that a firm's cost of equity capital is a positive linear function of the firm's capital structure. o tells us that the cost of equity depends on three 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, D/E o The firm's overall cost of capital is unaffected by its capital structure

WACC

o the overall return the firm must earn on its existing assets to maintain the value of its stock. o It is also the required return on any investments by the firm that have essentially the same risks as existing operations. o So, if we were evaluating the cash flows from a proposed expansion of our existing operations, this is the discount rate we would use. o The WACC for a firm reflects the risk and the target capital structure of the firm's existing assets as a whole. As a result, strictly speaking, the firm's WACC is the appropriate discount rate only if the proposed investment is a replica of the firm's existing operating activities - financial analysts frequently focus on a firm's total capitalization, which is the sum of its long-term debt and equity. This is particularly true in determining cost of capital; short-term liabilities are often ignored in the process

Expected Return for a Portfolio

x = % of each portfolio asset - This says that the expected return on a portfolio is a straightforward combination of the expected returns on the assets in that portfolio.

Period Costs

- are incurred during a particular time period and might be reported as selling, general, and administrative expenses. - Once again, some of these period costs may be fixed and others may be variable.

Asset Management or Turnover Ratios

- asset utilization ratios - intended to describe is how efficiently or intensively a firm uses its assets to generate sales.

Dealer Markets

- brokers and agents match buyers and sellers, but they do not actually own the commodity that is bought or sold. A real estate agent, for example, does not normally buy and sell houses. - Dealer markets in stocks and long-term debt are called over-the-counter (OTC) markets. - Most trading in debt securities takes place over the counter.

Corporation

- business created as a distinct legal entity composed of one or more individuals or entities - Corporations can borrow money and own property, can sue and be sued, and can enter into contracts. - A corporation can even be a general partner or a limited partner in a partnership, and a corporation can own stock in another corporation. - Forming a corporation involves preparing articles of incorporation (or a charter) and a set of bylaws

Sole Proprietorship

- business owned by a single individual - The owner of a sole proprietorship keeps all the profits - the owner has unlimited liability for business debts - all business income is taxed as personal income. - The life of a sole proprietorship is limited to the owner's life span - the amount of equity that can be raised is limited to the amount of the proprietor's personal wealth - Ownership of a sole proprietorship may be difficult to transfer because this transfer requires the sale of the entire business to a new owner.

Interest Only Loan

- 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 - if there is just one period, a pure discount loan and an interest-only loan are the same thing.

Debt vs Equity

- distinguishing between debt and equity important for tax purposes - interest paid on debt is deductible, dividends paid to shareholders is not - equity represents an ownership interest, and it is a residual claim. This means that equity holders are paid after debt holders.

Financial Planning

- formulates the way in which financial goals are to be achieved - a statement of what is to be done in the future - requires inputs in the form of alternative sets of assumptions about important variables - The financial planning process might require each division to prepare three alternative business plans for the next three years (worst case, normal case, best case)

Compounding

- leaving your money and any accumulated interest in an investment for more than one period, thereby reinvesting the interest

Goal of Financial Management

- maximize the current value per share of the existing stock. - Stockholders in a firm are residual owners, they get what is left after everyone else is paid - So, if the stockholders are winning in the sense that the leftover, residual portion is growing, it must be true that everyone else is winning also. - In other words, the total value of the stock in a corporation is simply equal to the value of the owners'equity.

Financial Managers

- owners (the stockholders) are usually not directly involved in making business decisions, particularly on a day-to-day basis - corporation employs managers to represent the owners' interests and make decisions on their behalf.

Agency Cost

- refers to the costs of the conflict of interest between stockholders and management. - These costs can be indirect or direct.

Time Value of Money

- refers to the fact that a dollar in hand today is worth more than a dollar promised at some time in the future. - one reason for this is that you could earn interest while you waited; o so a dollar today would grow to more than a dollar later. - The trade-off between money now and money later thus depends on, among other things, the rate you can earn by investing

Liquidity

- refers to the speed and ease with which an asset can be converted to cash - actually has two dimensions: ease of conversion versus loss of value.

Mortgage Securities

- secured by a mortgage on the real property of the borrower - the property involved is usually real estate

Peer Group Analysis

o identify firms similar in the sense that they compete in the same markets, have similar assets, and operate in similar ways. o There are obvious problems with doing this because no two companies are identical. Ultimately the choice of which companies to use as a basis for comparison is subjective.

Limited partnership

o one or more general partners will run the business and have unlimited liability, but there will be one or more limited partners who will not actively participate in the business o A limited partner's liability for business debts is limited to the amount that partner contributes to the partnership

Simple Interest

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

Ordinary Annuity

- a series of constant or level cash flows that occur at the end of each period for some fixed number of periods - more correctly, the cash flows are said to be in ordinary annuity form

Callable Bonds

- allows the company to repurchase or "call" part or all of the bond issue at stated prices over a specific period. - An agreement giving the corporation the option to repurchase a bond at a specified price prior to maturity

Internal Growth Rate

The maximum growth rate a firm can achieve without external financing of any kind.

growing perpetuities

The notion of a growing perpetuity may seem a little odd because the payments get bigger every period forever; but, as we will see in a later chapter, growing perpetuities play a key role in our analysis of stock prices

Yield to Maturity

The rate required in the market on a bond.

General Partnership

o all the partners share in gains or losses, and all have unlimited liability for all partnership debts, not just some particular share o gains (and losses) are divided is described in the partnership agreement