Intermediate Finance Exam 3

Target Payout ratio

% of net income paid as a cash dividend; must be less than distribution ratio

Types of Mergers

(1)Horizontal (2) Vertical (3) Congeneric (4) Conglomerate

Underpricing

- reduces risk to underwriter - the ipo is an easy way for the underwriter to reward preferred customers for pas and future commissions -possible way to secure the interest from institutional investors

Refunding Operations

Corporations that issue callable debt or preferred stock during high interest rate periods often replace the issue with a lower cost issue when interest rates drop Cost involved in refunding: - call premium - flotation costs - unexpected portion of the old flotation costs on old issues - additional interest -total after tax investment

FCFE Approach

FCF to equity approach: is the cash flow available for distribution to common shareholders (aka equity residual model)

Multinational Financial Mgmt.

1. Cash flows will be denominated in different currencies, hence the effects of exchange rates mush be addressed in all financial analyses 2. Economic and legal differences among countries can cause significant problems when a corporation tries to coordinate and control its worldwide operations 3. Language differences 4. Different countries have unique cultural heritages that shape values and influence the conduct of business 5. Role of governments: financial models based on traditional assumption of a competitive marketplace must often be modified to include political and other noneconomic facets of the decision 6. Political risk

Advantages of Holding Companies

1. Control with fractional ownership-effective control of a company may be achieved with far less than 50% ownership of the common stock 2. Isolation of risks 3. Partial multiple taxation 4. If parent company holds at least 80% of subsidiary's voting stock, dividends received are not taxed 5. Firms that own more than 20% but less than 80% of corp can deduct 80 of dividends received 6. Firms that own less than 20% may deduct only 70% of the dividends recieved

Disadvantages of IPO

1. Cost of reporting 2. Disclosure 3. Inactive market and/or low price 4. Control 5. Managing investor relations is time-consuming

Risk Exposure for Multinational Companies

1. Exchange rate risk 2. Political risk -however international diversification may result in lower risk

Advantages of IPO

1. Increases liquidity and allows founders to harvest their wealth 2. Permits founders to diversity 3. Facilitates raising new corporate cash 4. Establishes a value for the firm 5. Facilitates merger negotiations 6. Increase potential markets

Motivation for Mergers (MM)

1. Synergy 2. Tax Consideration 3. Purchase of Assets below Replacement Costs 4. Diversification 5. Mangers Personal Incentives 6. Breakup Value

Merger Valuation Discounted Cash Flow (DCF) Methods:

1. The corporate FCF valuation method 2. The adjusted present value method (APV) 3. The free cash flow to equity approach (FCFE)

Reasons Companies "Go Global"

1. To broaden their markets. 2. To seek raw material 3. To seek new technology 4. To seek production efficiency 5. To avoid political and regulatory hurdles 6. To diversify

Carve out Divestitures

A minority interest in a corporate subsidiary is sold to new shareholders, so the parent gains new equity financing yet retains control

Tax Considerations

A profitable firm in the highest tax bracket could acquire a firm with large accumulated tax losses which then could be turning into immediate tax savings. A firm with excess cash and a shortage of internal investment opportunities might seek a merger rather than pay the cash out as dividend

Dividend Preference Theory

Argues that stock risk declines as dividend increases--> a return in form of div is a sure thing while capital gain is more risky shareholders that prefer div are willing to accept a lower required return on equity high payout ratios reduce agency costs

Tax Effects Theory

Capital gains are preferred Jobs Growth Act (2003)-reduced tax on div income to same as capital gain tax (which was lower) Rise in stock price is taxable only after a sale Investors should be willing to pay more money for a stock with a low payout ratio than for a similar company with a high payout ratio.

Declaration Date

date in which firm's directors issue a statement declaring a dividend

Payment Date

date on which a firm actually mails check

Ex dividend date

date when right to the dividend leaves the stock; If the stock sale is made prior to (on or after) the ex-dividend date, then the dividend is paid to the buyer (seller).

Spin off Divestiture

firm's existing stockholders are given new stock representing separate ownership rights in the division that was divested --> establishes own board of directors/officers/becomes separate company

Dividend Irrelevance Theory

firms value is only determined by its basic earnings power and business risk --> not on how net income is split between the dividend and retained earnings

Underwriters

Investment banks that buy IPO's

Friendly Takeover

Management of target company approves the merger and recommends it to their stockholders - a suitable price is determined an the acquiring company will simply buy the target companies shares through a friendly tender offer -Payment will be made in either cash or in the stock or debt of the acquiring firm.

Diversification

Managers: diversification helps stabilize a firm's earnings and thus benefits owners Stabilization of earnings is beneficial to employees, suppliers, and customers, but its value to stockholders is less certain (stockholders can simply buy the stock from both firms) A diversification merger might be the best way to achieve personal diversification for a privately held firm.

Personal Incentives

Many business decisions are based more on managers' personal motivations than on economic analysis. Managers want to increase the size of their firm, gain more power, prestige, and monetary compensation. Other mergers occur because managers want to keep their job (make company less attractive to hostile suitors)

Divestitures

Opposite of acquisition-company sells its assets-often a whole division Reasons for: -stick to own knitting; company needs cash; unload losing assets; market reacts favorably to these Types: 1. Sale to another firm 2. Spin off 3. Carve out 4. Liquidation

Private Placements

Securities are sold to one or a few investors generally institutional investors. Most common with bonds, but can occur with stocks. Primary advantages of private placements are (1) lower floatation costs and (2)greater speed.

Taxable offer

if the offer includes a significant amount to cash or bonds then the IRS views it as a sale and it is a taxable transaction. The gain between the offer price and the original purchase price of the target stock is taxed in the year of the merger.

Residual Div. Policy

When deciding how much cash to distribute to stockholders must consider: (1) Objective is to maximize shareholder value (2) FCF belongs to shareholders Optimale distribution ratio based on: 1) Investor preference for div vs cap gains 2) Firms investment opportunity 3) Target cap structure 4) Availability and cost of external capital Residual distribution model based on 2,3,&4

Going Private

When the entire equity of a publicly held firm is purchased by a small group of investors Advantages: 1. Administrative cost savings 2. Increased managerial incentives 3. Increased managerial flexibility 4. Increased shareholder oversight and participation 5. Increased use of financial leverage which reduces taxes

Leverage Buyout (LBO)

When the financing for going private involves substantial borrowing (which it usually does)

Synergy (MM)

When two companies merge to form a single company and that single company's value exceed the value of the the former two companies combined Can arise from (1) Operating economies (2) Financial economies (3) Differential efficiency (4) increased market power (undesirable)

APV Approach

adjusted present value: similar to corporate valuation model except that it allows for the capital structure to change over time. Breaks value of firm into 2 components: 1) value if it had no debt 2) Value of the interest tax shield

The Roadshow

after registration statement has been filed for an IPO the management team will make three to seven presentations each day to potential institutional investors. Management team may not give any information that is not in registration statement.

Liquidation Divestitures

assets of a division are sold off piecemeal to many purchasers rather than as a single operating entity to one purchaser

Clientele Effects

attraction of companies with specific dividend policies to those investors whose needs are best served by those policies. -Investors who want high investment income should own shares in high dividend payout firms (retirement, pension, university) -Investors with no need for current investment income should own shares in low-div payout firms

Target Distribution Ratio

percentage of net income distributed to shareholders through cash dividends or stock repurchases

Holding Company

corporations that are formed for the sole purpose of owning the stocks of other companies -parent company

Purchase of Asset Below their replacement costs

sometimes a firm will become an acquisition candidate because of the cost of replacing its assets is considerably higher than its market value. Ex. an oil company's reserves might be worth more on paper than the company's stock

Exchange Rates:

specifies the number of units of a given currency that can be purchased with one unit of another currency direct quotation: the number of US dollars required to purchase 1 unit of foreign currency indirect quotation: the number of a foreign currency that can be purchased for 1 US dollar

Vertical Merger

when a company acquires another firm that is "upstream" or "downstream"

Horizontal Merger

when one firm combines with another in its same line of business

Congeneric Merger

when the merging companies are somewhat related, but not to the extent required for a horizontal or vertical merger

Hostile Takeover

when the target firm's management resists the takeover: -target firm either believes offered price is too low or it may simply want to remain independent -acquiring company may make a hostile tender offer for the target company's shares - a direct appeal to the target firm's stockholders asking them to exchange their shares for cash, bonds, stock in the acquiring firm -Hostile bids often fail -an all cash offer is that is generally high enough will generally overcome any resistance.

Conglomerate

when unrelated enterprises combine

Breakup Value

--> the value of the individual parts of the firm if they were sold off separately If this value is higher than the firm's current market value, then a takeover specialist could acquire the firm at or even above its current market value, sell it off in pieces, and earn a profit.

Dividend Reinvestment Plans:

1) involves stock that is already outstanding -->div of all participants and the stock is purchased on the open market --->benefits small stockholders who do not need cash div. 2) other involves newly issued stock -->company issues new shares to the participants -->company offers discounts as a trade off against floatation costs

Defensive Tactics to Fight off Mergers

1. changing the bylaws 2. Trying to convince the target firm's stockholder that the price being offered is too low 3. Raising antitrust issues 4. Repurchasing stock in the open market 5. Finding a "white knight" (who is acceptable to the target firms mgmt to compete with the potential acquirer) 6. Finding a "white squire" (who is friendly to current mgmt and can buy enough of the target firm's shares to block the merger)

Advantages to Repurchases

1. viewed as positive signal 2. stockholder have a choice when the firm distributes cash by repurchase 3. dividends are "sticky" in the short run temporary excess cash flow 4. residual model: target cash distribution level 5. Repurchases: large-scale changes capital structure 6. Companies that grant stock options repurchase shares in the secondary market

Shelf Registration

Frequently when companies have a master registration statement they will put new securities "on the shelf" and then sell them to investors when they feel the market is "right" 2 advantages: lower flotation costs and more control over timing of issue

Holder of record date

If company lists stockholder as an owner on the holder of record date, then stockholder receives the dividend

Underwritten Issues

The bank agrees to buy the entire issue and then resell the stock to its customers

Seasoned Equity Offering (SEO)

When a company with publicly traded stock issues additional shares. Offering price will be based on market price. Often taken as a negative signal

nontaxable offer

one in which the form of the payment is predominately stock. target shareholders who receive shares of the acquiring company's stock do not have to pay any taxes at the time of the merger. Stockholders prefer nontaxable offers.

Best Effort Sale

the bank does not guarantee that the securities will be sold or that the company will get the cash it needs

Sale to another Firm Divestitures

the sale of an entire division or unit, usually for cash but sometimes for stock in the acquiring firm