STUDY GUIDE

BMCF5103

Corporate Finance

Topic 1:
1.1

Information Asymmetry and Agency Theory

An Overview of Corporate Finance Corporate finance includes three main areas of concern: (a) Capital budgeting: What long-term investments should the firm choose? (b) Capital structure: Where will the firm get the long-term financing to pay for its investments? (c) Working capital: How should the firm manage its daily financial activities? The Balance Sheet model is used to address the three basic questions that corporate finance managers must answer: (a) Capital budgeting: Long-term investment decisions determine the level of fixed assets. (b) Capital structure: Financing policy determines the liabilities and equity side of the balance sheet. (c) Working capital: Short-term asset management choices (e.g., conservative versus aggressive) affect the level of net working capital. Financial Managers should make decisions that increase firm value, which effectively involves three primary categories of financial decisions: (a) Capital budgeting: process of planning and managing a firms investments in fixed assets. The key concerns are the size, timing, and risk of future cash flows. (b) Capital structure: mix of debt (borrowing) and equity (ownership interest) used by a firm. What are the least expensive sources of funds? Is there an optimal mix of debt and equity? When and where should the firm raise funds? (c) Working capital management: managing short-term assets and liabilities. How much inventory should the firm carry? What credit policy is best? Where will we get our short-term loans? These broad categories, however, can be summarised to two concrete responsibilities: (a) Selecting value creating projects (b) Making smart financing decisions The Financial Managers are: (a) The Chief Financial Officer (CFO) or Vice-President of Finance, who coordinates the activities of the treasurer and the controller. (b) The controller, who handles cost and financial accounting, taxes, and information systems (i.e., data processing). (c) The treasurer, who handles cash and credit management, financial planning, and capital expenditures.

STUDY GUIDE

BMCF5103

Corporate Finance

1.2 The Importance of Cash Flows To create value, the firm must generate more cash than it uses. Stated differently, the firm must generate sufficient cash flow, after taxes, to compensate investors for providing the firm with financing. Additionally, the value of the cash flows generated by the firm must be analysed in light of both the timing of the cash flows, as well as the risk of the cash flows. 1.3 The Goal of Financial Management
(a) Possible Goals Profit maximization is an imprecise goal. Do we want to maximize long-run or short-run profits? Do we want to maximize accounting profits or some measure of cash flow? Because of the different possible interpretations, this should not be the main goal of the firm. Other possible goals include minimising costs or maximising market share. Both have potential problems. We can minimise costs by not purchasing new equipment today, but that may damage the long-run viability of the firm. Many dot.com companies got into trouble in the late 1990s because their goal was to maximize market share. They raised substantial amounts of capital in IPOs and then used the money on advertising to increase the number of hits" on their site. However, many firms failed to translate those hits" into enough revenue to meet expenses, and they quickly ran out of capital. The stockholders of these firms were not happy. Stock prices fell dramatically, and it became difficult for these firms to raise funds. In fact, many of these companies have gone out of business. (b) A More General Goal The more general goal is to maximize the market value of owners equity. But it does not mean that firms should do anything" to maximize stockholder wealth. It is important to note that unethical behaviour does not ultimately benefit owners. There are a number of ethical issues which can be related to wealth maximization. One good example that we can relate to is the issue of the responsibility of the managers and stockholders of tobacco firms. Is it ethical to sell a product that is known to be addictive and dangerous to the health of the user even when used as intended? Is the fact that the product is legal relevant? Do recent court decisions against the companies matter? What about the way companies choose to market their product? Are these issues relevant to financial managers?

STUDY GUIDE

BMCF5103

Corporate Finance

1.4 The Agency Problem (a) Information Asymmetry Informational asymmetry arises as a result of the separation of ownership and management. The distinguishing feature of a corporation is that the ownership of the firm is separated from its management. In theory, the objective of a firm should be determined by the firm's owners. Information asymmetry is chief among violations of the homogenous expectations assumption of an ideal capital market. It occurs when buyers and sellers have different amounts of information about a market transaction. (b)Agency Relationships The relationship between stockholders and management is called the agency relationship. This occurs when one party (principal) hires another (agent) to act on their behalf. The possibility of conflicts of interest between the parties is termed the principal- agent (agency) problem. (c) Agency Costs Agency costs arise in a corporation as a result of principal-agent problems. Managers may not act in the best interests of the shareholders while making decisions. Hence the shareholders incur monitoring and bonding costs which are a part of agency costs. It arises as result of informational asymmetry between managers and other stakeholders of a firm. Agency costs tend to reduce the value of a firm. An optimal financial contract between agents and principals that minimises total agency costs. The optimal contract transfers decision-making authority from the principal to the agent in the most efficient manner. Stock options can be used to align the interests of managers with those of shareholders, in the belief that those managers will then make decisions, which will enhance the wealth of all stockholders, including those executives. In countries and cultures in which the ownership of the firm has continued to be an integral part of management, agency issues and failures have been less of a problem. On the contrary, in countries like the United States, in which ownership has become largely separated from management (and widely dispersed), aligning the goals of management and ownership is much more difficult.
(d)Do Managers Act in the Stockholders Interests? Managerial compensation can be used to encourage managers to act in the best interest of stockholders. One commonly cited tool is stock options. The idea is that if management has an ownership interest in the firm, they will be more likely to try to maximize owner wealth. A 1993 study performed at the Harvard Business School indicates that the total return to shareholders is closely related to the nature of CEO compensation. Specifically, higher returns were achieved by CEOs whose pay packages included more option and stock components. However, this may not even be the best way to encourage managers to act in the stockholders best interest. Stern Stewart & Company has developed a tool called EVA, which measures how much economic value is being added to a corporation by management decisions. According to Stern- Stewarts web site (www.sternstewart.com),

STUDY GUIDE BMCF5103 Corporate Finance companies that tie management compensation to EVA significantly outperform competitors that do not. They are conducting ongoing studies to measure this performance, but the preliminary data indicate that the stock returns for these companies have outperformed their competitors by a significant amount. Both of these examples illustrate that carefully crafted compensation packages can reduce the conflict between management and stockholders. According to The National Centre for Employee Ownership, broad based stock option plans have increased dramatically, not only for technology firms, but also for non-tech firms such as Starbucks and the Gap. Some firms have found a way to provide stock- based incentive to employees without giving them equity ownership at all. As reported in the October 26, 1998, issue of Fortune, phantom stock is used by private companies such as Kinkos and Mary Kay, Inc., as well as public companies, to provide employees with an incentive to work harder. Generally, an employee is awarded shares" on a bonus basis, and the share values increase if the value of the business increases. (For a private firm, this means obtaining outside appraisals of value based on earning multiples, etc.) At some future point, the employee has the right to cash in his shares." Stockholders technically have control of the firm, and dissatisfied shareholders can oust management via proxy fights, takeovers, etc. However, this is easier said than done. Staggered elections for board members often make it difficult to remove the board that appoints management. Poison pills and other antitakeover mechanisms make hostile takeovers difficult to accomplish. (e) Stakeholders The management and its shareholders are not the only parties with an interest in the firms decisions. Stakeholders, besides stockholders, also have a vested interest in the firm and potentially have claims on the firms cash flows. Stakeholders can include creditors, employees, customers, and the government. Consideration should also be given to the interests of non- stockholder stakeholders which results in the decentralisation of management. By giving more consideration to other stakeholder interests (as opposed to a discussion exclusively geared toward stockholder interests) would provide a better understanding of the nature of the corporate form of organisation, the role of the corporation in society (and the question of corporate social responsibility), as well as the role of contracting in the labour and financial markets. Theories of ethical behaviour focus on the rights of all parties affected by a decision, not just one or two. The utilitarian model defines an action as acceptable if it maximizes the benefit, or minimises the harm, to stakeholders in the aggregate. The golden rule model deems a decision ethical if all stakeholders are treated as the decision maker would wish to be treated. Finally, the Kantian basic rights model defines acceptable actions as those that minimise the violation of stakeholders rights. 1.5 Regulation Historically, most regulation has focused on the disclosure of relevant information, which is intended to put all investors on an equal playing field, and thereby to reduce conflicts of interest. On the other hand, regulation imposes costs on corporations and any analysis of regulation must include both benefits and costs. (a) The Securities Act of 1933 and the Securities Exchange Act of 1934

STUDY GUIDE BMCF5103 Corporate Finance These Acts provide the basic regulatory framework for the public trading of securities in the United States. The 1933 Act focuses on the issuance of securities, while the 1934 Act established the SEC and addressed other regulatory issues, such as insider trading and corporate reporting. (b) Sarbanes-Oxley Following the scandals at Enron, WorldCom, and Tyco, among others, Sarbox was enacted in 2002. This Act significantly increased the auditing and reporting requirements that public firms face, and it also explicitly placed the responsibility for any fraud on the corporate directors. As with any law, however, there is a cost. In response to the added burden, many (particularly small) firms have delisted and others have foregone going public. For others, the cost of compliance has significantly increased, thereby reducing profits.

Topic 2:
1.1

Company Valuation

Content Summary
Adjusted Present Value Method The adjusted present value (APV) for a project with debt financing is best described by the following formula:
APV has the conceptual advantage of separating the value of the unlevered investment NPV ! rom the value of financing side effects NPVF. NPV is the net present value of the project to an all-equity firm: NPV = present value of unlevered cash flows initial investment for entire project; unlevered cash flows = cash flows from operating capital spending added net working capital; the discount rate used is the unlevered cost of capital. NPVF is the net present value of financial side effects, which include: (1) tax subsidy to debt, (2) the costs of issuing new debt and equity securities, (3) the costs of financial distress arising from the use of debt, and (4) subsidies to debt financing. One of these side effects has been introduced in some introductory financial management course, the tax shield from debt in Modigliani-Miller Proposition I, Value of levered firm ULB = Value of unlevered firm (+ ) + value of tax benefits (TcB). Flow to Equity Method This method focuses on value to equity holders. Its calculation involves computing free cash flow to equity holders, excluding all payments made to debt. The FTE method has an advantage primarily in that it emphasises the value to equity holders. The three steps in the flow to equity approach are: (a) Determine the free cash flow to equity; (b) Determine the equity cost of capital; and (c) Compute the equity value by discounting the free cash flow to equity using the equity cost of capital.

STUDY GUIDE 2.3

BMCF5103

Corporate Finance

Weighted Average Cost of Capital Method A firm's overall WACC is a market value weighted average of the after tax cost of debt and cost of equity:

The intuition of the WACC approach is simple and appealing. If a projects expected after tax return is higher than the weighted average of the after tax required returns on debt and equity capital, it is a positive NPV project. 2.4 A Comparison of Methods These three methods for calculating the value of a proposed project should be viewed as complementary. The following table summarises the similarities and differences between the three methods.

Topic 3:

Financing Decisions and Market Efficiency

Content Summary
Pay strategies generally vary and are designed to bridge the organisations critical challenges in attracting, motivating and retaining their key personnel. There are some common elements used as basic building blocks, namely, compensation objectives, pay policy, work content and value in designing pay structure. 3.1

Efficient Market Hypothesis An efficient capital market is one in which stock prices fully reflect available information. The efficient market hypothesis (EMH) has implications for investors and firms: (a) Since information is reflected in security prices quickly, knowing information when it is released does an investor little good; and (b) Firms should expect to receive the fair value for securities that they sell. Firms cannot profit from fooling investors in an efficient market. According to Andrei Shleifer, there are three conditions which will lead to efficiency: (a) Rationality all investors respond in a rationale way to new information; (b) Independent deviations from rationality investor deviations are countervailing and unrelated; and (c) Arbitrage competition among investors (professionals) and traders makes a market efficient. An efficient market is one in which information is quickly and costlessly disseminated to all participants. And while the markets are not efficient to that extent, the advancement of information technology has resulted in it being closer to an ideal capital market. Some analysts believe that required returns have fallen because the cost of obtaining information has dropped so dramatically. This would lead to higher sustainable P/E ratios. No one is certain for sure that markets are more efficient, but the changes in the last few years seem to be moving the markets in that direction, assuming the theories of what makes a market efficient are correct.
The Different Types of Efficiency (a) Weak form efficiency Security prices reflect all information found in past prices and volume. If the weak form of market efficiency holds, then technical analysis is of no value. Since stock prices only respond to new information, which by definition arrives randomly, stock prices are said to follow a random walk. Evidence suggests that markets are weak form efficient based on the trading rules that we have been able to test. (b) Semistrong form efficiency All public information is already incorporated in the price. Publicly available information includes historical price and volume information, published accounting statements, and information

(c)

found in annual reports. It argues that investors cannot consistently earn excess returns using available information to do fundamental analysis. Evidence is mixed, but suggests that it holds for widely held firms. Strong form efficiency All information, both public and private is already incorporated in the price. Empirical evidence indicates that this form of efficiency does not hold.

3.3

The Behavioural Challenges to Market Efficiency Efficiency is built on investor rationality, independence, and arbitrage; however, these may not hold in practice. Behavioural finance suggests that investors deviate from these assumptions in predictable ways. As such, efficiency may not hold. A primary example is speculative bubbles. Studies have found evidence inconsistent with efficiency. For example, small stocks tend to outperform large stocks, and value 3.4 stocks tend to outperform growth stocks. Also, investors appear to react slowly to earnings announcements. In addition, arbitrage has transactional limits. Lastly, the existence of bubbles and crashes is inconsistent with efficiency.
Implications for Corporate Finance

(a)

Accounting choices, financial choices, and market efficiency: Early studies find that stock prices do not react to changes in accounting methods, such as last-in first-out (LIFO) versus first-in firstout (FIFO). These findings are consistent with the semi- strong form EMH and suggest that Gilding the lily" by restating financial performance in a deceptively favourable light is unlikely to increase value unless it can also decrease taxes, bankruptcy costs or agency costs. (b) The timing decision Studies find that firms that issue new equity have negative abnormal returns in following years, and firms that repurchase equity have positive abnormal returns in following years, suggesting that managers time" equity sales (repurchases) correctly. If managers use information not publicly available to time security sales, the evidence is consistent with the strong form. (c) Speculation and efficient markets If financial markets are efficient, firms should not waste their time trying to forecast the issues of debt and equity. Their forecasts will likely be no better than chance. This is not to say, however, that firms should randomly choose the maturity or the denomination of their debt. A firm must choose these parameters carefully. However, the choice should be based on other rationales, not an attempt to beat the market. (d)Information in market prices Managers can reap many benefits by paying attention to market prices. For example, managers should pay attention to the stock price reaction to any of their announcements, whether it concerns a new venture, a divestiture, a restructuring etc.

Topic 4:
4.1

Issuing Securities to the Public

Content Summary
The Procedure for a New Issue The first step of any issue of securities to the public is to obtain approval from the board of directors. Next, the firm prepares and files a registration statement with the Securities and Exchange Commission (SEC). The SEC requires a 20-day waiting period and studies the registration statement during the waiting period. The firm prepares and files an amended registration statement with the SEC. If everything is copasetic with the SEC, a price is set and a full-fledged selling effort gets underway. The Cash Offer There are two kinds of public issues: (a) The general cash offer; and (b) The rights offer. Cash offer refers to securities offered for sale to the general public on a cash basis and rights offer is public issue in which securities are first offered to existing shareholders on a pro rata basis. Equity is sold by both the cash offer and the rights offer but almost all debt is sold in general cash offerings. Initial Public Offering (IPO) refers to a companys first equity issue made available to the public. A seasoned equity offering refers to a new equity issue of securities by a company that has previously issued securities to the public. There are three methods for issuing securities for cash: (a) Firm commitment; (b) Best efforts; and (c) Dutch auction. (i) Firm commitment underwriting Under this method, the underwriting syndicate purchases the shares from the issuing company and then sells them to the public. The syndicates profit comes from the spread between the prices, and it bears the risk that the actual spread earned will not be as high as anticipated (or may not even cover costs). This is the most common type of underwriting. Best efforts underwriting The underwriters are legally bound to make their best effort to sell the securities at the offer price, but they do not actually purchase the securities from the issuing firm. In this case, the

4.2

issuing firm bears the risk of the market being unwilling to buy at the offer price. Dutch auction underwriting The underwriter does not set the offer price. Instead, a series of bids is solicited from potential investors, and the price that is paid by everyone is the price that will result in all shares being sold. The incentive is to bid high to guarantee that you get in on the offer price, knowing that you will only pay the lowest accepted price. The U.S. Treasury has sold bills, bonds, and notes using the Dutch auction process for many years. Google was the first large Dutch auction IPO. Determining the correct offering price is difficult because there is no current market price available. Private companies tend to have more asymmetric information than companies that are already publicly traded. Underwriters want to ensure that, on average, their clients earn a good return on lPOs. Underpricing causes the issuer to leave money on the table." The underpricing (there is a large increase above the offer price the first day of trading) of lPOs is very common. The record year is still 1999, with an average first day return of almost 70%. There are many possible explanations for underpricing, but there is no consensus among scholars as to which explanation is correct. Two points, however, are worth noting. First, much of the underpricing appears to be concentrated in smaller issues. Second, when the issue price is too low, the issue is often oversubscribed. 4.3

The Announcement of New Equity and the Value of the Firm The market value of existing equity drops on the announcement of a new issue (a seasoned equity offering) of common stock. Why? Much of the decline may be due to the private information known by management (called asymmetric information) and the signals that the choice to issue equity sends to the market. Some possible reasons to explain that phenomenon include: Managerial information concerning value of the stock: Since the managers are the insiders, expectation that managers will issue equity only when they believe the current price is overpriced. Debt capacity: Expectation that a firm will issue debt as long as it can afford to (allows stockholders to benefit more from good projects); consequently, a stock issue indicates that management believes that the firm is too highly leveraged. Falling earnings: Unanticipated financing tends to be roughly equal to unanticipated shortfalls in earnings.

4.4

The Cost of New Issues The costs of issuing securities can be divided into six categories: (a) Spread; (b) Other direct expenses; (c) Indirect expenses; (d) Abnormal returns; (e) Underpricing; and (I) Green Shoe option. 4.5 Rights If a preemptive right (or privileged subscription) is contained in the firms articles of incorporation, the firm must offer any new issue of common stock first to existing shareholders. This allows shareholders to maintain their percentage ownership if they so desire. Rights are often traded on securities exchanges or over the counter. The Mechanics of Rights Offering Early stages are the same as for a general cash offer, i.e., obtain approval from directors, file a registration statement, etc. The difference is in the sale of the securities. Current shareholders get rights to buy new shares. They can subscribe (buy) the entitled shares, sell the rights or do nothing. In rights offering, the subscription price is the price that existing shareholders are allowed to pay for a share of stock. In the context of options, this is similar to an exercise price. The management of the firm must decide the exercise price (the price existing shareholders must pay for new shares) and the number of rights will be required to purchase one new share of stock. To avoid under subscription, rights offerings are typically arranged by standby underwriting. Here the firm makes a rights offering and the underwriter makes a commitment to "take up (purchase) any unsubscribed shares. In return, the underwriter receives a standby fee. In addition, shareholders are usually given oversubscription privileges (the right to purchase unsubscribed shares at the subscription price).

(a)

b. The Rights Puzzle A pure rights offering is typically cheaper than underwriting or a rights offer with standby underwriting. However, over 90% of offerings are underwritten. A few possible explanations exist: (1) underwriter increases stock price, (2) underwriter provides guaranteed price, and (3) the proceeds from underwriting may be available sooner than the proceeds from a rights offering. All these arguments are confusing, none seems convincing.

4.6

The Private Equity Market The previous sections of this topic assumed that a company is big enough, successful enough, and old enough to raise capital in the public equity market. For start-up firms and firms in financial trouble, the public equity market is often not available. The market for venture capital is part of the private equity market. Private placements avoid costly registration procedures by placing securities directly with qualified investors. The SEC typically restricts private placement issues to less than one hundred qualified investors, including institutions such as insurance companies and pension funds. The biggest drawback of privately placed securities is that the securities cannot be easily resold. Most private placements involve debt securities. Equity securities can also be privately placed especially for small companies. Smaller firms tend to use the private placement market mainly because they face the highest costs in a public issue and often require specialised, flexible loan arrangements. On the other hand, the costs of investigation and negotiation may be higher, and lenders in private placements expect some compensation for holding an instrument with limited liquidity. Private equity firms are typically set up as limited partnerships. Institutional investors and qualified individuals act as the limited partners, and professional managers serve as the general partners. The limited partnership is the dominant form of intermediation in the private equity market. There are four types of suppliers of venture capital: (a) Old-line wealthy families; (b) Private partnerships and corporations; (c) Large industrial or financial corporations have established venturecapital subsidiaries; and (d) Individuals, typically with incomes in excess of $100,000 and net worth over $1,000,000. Often these angels have substantial business experience and are able to tolerate high risks.

Topic 5:

Options

Content Summary
5.1 Options An option gives the holder the right, but not the obligation, to buy or sell a given quantity of an asset on (or before) a given date, at prices agreed upon today. Call options gives the holder the right, but not the obligation, to buy a given quantity of some asset on or before the expiration date, at prices agreed upon today. When exercising a call option, you call in the asset. Put options gives the holder the right, but not the obligation, to sell a given quantity of an asset on or before the expiration date, at prices agreed upon today. When exercising a put, you put the asset to someone. 5.2 Option Pricing Models There are two types of option pricing models. The binomial option pricing model is a two-state single-period model. For the value option using the binomial model, we need to create a replicating portfolio, and show that the price is not a function of the probabilities of the states in the binomial tree. The binomial model can be extended to a continuous model; the Black-Scholes option pricing model. The derivation of the Black-Scholes formula is not required in this course. The Black-Scholes formula can be used to value a call or put option. The price of a European put on a non-dividend-paying stock can be valued using putcall parity. 5.3 Stocks and Bonds as Options The underlying asset is the value of the firm (the value of its assets). The stockholders have a call on this value with a strike price equal to the face value of the firms debt. If the firms assets are worth more than the debt, the option is in-the-money and stockholders exercise the option by paying off the debt. If, however, the face value of the debt is greater than the value of the firms assets, the option expires unexercised (i.e., the company defaults on its debt). Thus, the bondholders can be viewed as owning the firms assets and having written a call against them. Alternatively, we could view owners as having a put option that gives them the right to put the firm to the creditors in the case of bankruptcy. Specifically, if at the maturity of their debt, the assets of the firm are less in value than the debt, shareholders have an in-the-money put. They will put the firm to the bondholders. If at the maturity of the debt the shareholders h a v e an out-of-themoney p u t , they will not exercise the option (i.e. not declare bankruptcy) and let the put expire.

5.4

Application of Options to Corporate Finance (a) Mergers and Diversification Diversification is a frequently mentioned reason for mergers. We can use option valuation to investigate whether diversification is a good reason for a merger from a stockholders viewpoint. Diversification reduces risk. If diversification is the only benefit then a merger will reduce volatility without increasing cash flow. Decreasing volatility decreases the value of the call option (equity) and the put option. Since risky debt can be viewed as risk-free debt minus a put option, decreasing the value of the put increases the value of the risky debt. Thus, mergers for diversification only transfer wealth from the stockholders to the bondholders. The standard deviation of returns on the assets is reduced, thereby reducing the option value of the equity. If managements goal is to maximize stockholder wealth, then mergers for reasons of diversification should not occur. (b) Options and Capital Budgeting If a firm has a substantial amount of debt, stockholders may prefer riskier projects, even if they have a lower NPV. The riskier project increases the volatility of the asset returns. The increased volatility increases the value of the call (equity) and the put. The increased put value decreases the value of the debt. This transfers wealth from the bondholders to the stockholders. Stockholders may even prefer a negative NPV project if it increases volatility enough. The wealth transfer from bondholders to stockholders may outweigh the negative NPV. Bondholders recognise the desire of stockholders to take on riskier projects. Consequently, provisions are typically put into the bond indentures to try to prevent this wealth transfer. These provisions add to the firms cost either directly through a higher interest rate or through additional monitoring costs. These costs are all considered agency costs. 5.5
Real Options Real options provide the right to buy or sell real assets. These options often apply in capital budgeting situations and can be very valuable. These options can be in forms of explicit options where contracts giving the holder the right to buy or sell the asset or implicit options that exist in many capital budgeting situations and are often hidden. Option to wait is particularly valuable when the economy or market is expected to be bigger in the future. It is not valuable when trying to capitalise on current fads. The option to wait may actually turn a bad project into a good project. By waiting a year or two may allow the firm to capture higher cash flows.

Managerial options are options to modify a project once it has been implemented. Classic NPV calculations generally ignore the flexibility that real-world firms typically have. These include: (a) Option to expand: ability to make the project bigger if it is a successful. We underestimate the NPV if we ignore this option. (b) Option to abandon: ability to shut down the project if things do not go as planned. The NPV could have been underestimated if we ignore this option. Option to suspend or contract: ability to downscale when the market is weaker than expected. Strategic options: using a project to explore possible new ventures or strategies. These projects open up a wide number of future opportunities but are more difficult to analyse with traditional discounted cash flow analysis.

(d)

Topic 6:

Application of Options to Corporate Finance

Content Summary
6.1 Executive Stock Options Executive Stock Options (ESOs) exist to align the interests of shareholders and managers. ESOs are call options (technically warrants) on the employers shares. They typically have these characteristics: (a) Inalienable (cannot be sold); (b) Typical maturity is 10 years; and (c) Typical vesting period is three years, and most include implicit reset provisions to preserve incentive compatibility. Executive Stock Options give executives an important tax break. Grants of atthe-money options are not considered taxable income. Taxes are due if the option is exercised. However, the economic value of a long-lived call option is enormous, especially given the propensity of firms to reset the exercise price after drops in the price of the stock. Valuing Executive Compensation Since ESOs are essentially like a call option, they can be valued using the Black-Scholes Model, or other option pricing models. However, due to the intricacies of some contracts, the value provided by the models may only be good estimates of true value. For example, due to the inalienability, the options are worth less to the executive than they cost the company. The executive can only exercise, not sell his options. Thus he can never capture the speculative value but only the intrinsic value. This dead weight loss is overcome by the incentive compatibility for the grantor. 6.2 Valuing Start-Up When estimating the value of a start-up firm, the option to expand is of great importance in determining the underlying value of the venture. 6.3 An Application of Binomial Model The binomial option pricing model is an alternative to the Black-Scholes option pricing model. Especially in cases of path dependence, it is a superior alternative. Path dependency is when how you arrive at a price (the path you follow) for the underlying asset is important. One example of a path dependent security is a no regret call option where the exercise price is the lowest price of the stock during the options life. Further, although we still consider only two possible movements (up or down), we extend the model to illustrate multiple periods, which essentially creates a tree with many branches. For example, the 2-period binomial model can be extended to 3- period or more. 6.4 Shut Down and Reopening Decisions The true value of a project is equal to its NPV plus any embedded option value, such as the option to abandon, wait, or expand. We can calculate the market value of a project as the sum of the NPV of the project without options and the value of the managerial options implicit in the project. A good example would be comparing the desirability of a specialised machine versus a more versatile machine. If they both cost about the same and last the same amount of time, the more versatile machine is more valuable because it comes with options.

Topic 7:

Derivatives and Hedging Risk

Content Summary
7.1 Hedging with Futures and Forward Contracts Forward contract is an agreement between a buyer (long) and a seller (short) for future delivery of an asset at a price specified today. The forward price is the price agreed upon today to be paid at a future date when delivery occurs. Settlement date is the date when delivery occurs and the forward price is paid (received). In a forward contract, both parties are legally bound to execute the transaction in the future at the agreed-upon price, but no money changes hands at the inception of the contract. Futures contract is forward contract traded only on an exchange with gains and losses recognised on a daily basis. A futures contract is like a forward contract. It specifies that a certain commodity will be exchanged at a specified time in the future at a price specified today. Futures are standardised contracts trading on organised exchanges with daily resettlement (marking to market") through a clearinghouse. Typically, futures contracts are divided into two broad categories: (a) Commodity contracts such as oil, gold, or wheat; and (b) Financial contracts such as T-bond or S&P SOO. One problem with forward contracts is enforcing the agreement on the delivery date. If the cash price on the delivery date is higher than the agreed price, the seller has the incentive to default, and vice versa. Futures contracts greatly reduce the risk of default relative to forward contracts by: (1) having an exchange clearinghouse take one side of every transaction, (2) requiring an initial and a maintenance margin, and (3) marking to market on a daily basis. Hedging and Speculating Hedging is the process of reducing risk, whether it be the risk of changing prices, currency fluctuations, or changes in interest rates. Speculating is the opposite of hedging, which implies it is the process of increasing risk. Both hedgers and speculators are necessary for an active, liquid derivatives market. While forward and futures contracts can be used for speculative purposes, the topic focuses on the use of these derivative securities to reduce risk. Either side of a forward or futures contract can be used to hedge: (a) A short futures hedge involves selling a futures contract. Short hedges are used when you will be making delivery of an asset at a future date (e.g., a farmer anticipating a harvest of wheat) and wish to minimise the risk of a drop in price. (b) A long futures hedge involves buying a futures contract. Long hedges are used when you must purchase an asset at a future date (e.g., a bakery with a demand for wheat) and wish to minimise the risk of a rise in price. 7.2 Interest Rate Futures (a) Pricing of Treasury Bonds Recall the general expression for the value of a bond: Bond value = present value of coupons + present value of par

This formula assumes a flat yield curve. If this is not the case, then each cash flow must be discounted at the rate specific to the timing of the cash flow.

Pricing of Forward Contracts With the forward contract, you are agreeing to purchase the bond at a specified point in the future. The value of the bond at that time is just the present value of the subsequent cash flows. This price can then be discounted to the present to find the value at time 0. Futures contracts are priced similarly to forwards, with the exception of the daily resettlement. 7.3

Duration Hedging As an alternative to hedging with futures or forwards, one can hedge by matching the interest rate risk of assets with the interest rate risk of liabilities. Duration is the key to measuring interest rate risk. Duration measures the combined effect of maturity, coupon rate, and yield to maturity (YTM) on a bonds price sensitivity to interest rates. The duration of an asset with cash payments (C 1. . ,CT) as the weighted average maturity of an asset stated in terms of present values:

It represented the price elasticity of an asset with respect to a change in the level of interest rates. The relationship between changes in interest rate, changes in bond prices, and duration is:

Matching Liabilities and Assets By matching the duration of financial assets and liabilities, a change in interest rates has the same impact on the value of the assets and liabilities, leaving the value of equity unchanged. Duration as a measure of price elasticity is important in many portfolio management applications. In banking, matching the duration of financial assets and liabilities is referred to as "asset-liability management." In insurance, duration hedging is used in "insulating" a portfolio of assets and liabilities against changes in interest rates. The basic concept has applications in corporate finance as well.
7.4 Swaps Contracts Swaps are arrangements between two counterparties to exchange cash flows over time. Thus, swaps are essentially a series of forward contracts. The swap bank acts as either a broker (matching counterparties) or dealer (serving as one of the counterparties). Just as two companies can agree to exchange currencies at specific future dates, they can also agree to exchange the cash flows associated with respective loan agreements. Interest rate swaps are generally used to convert a fixed rate obligation to a floating rate obligation, or vice versa, depending on the needs of the company. Only the net interest payment is exchanged since the swap contract involves with one currency. As for currency swaps, two firms agree to exchange a specific amount of one currency for a specific amount of another currency at specific future dates.

Topic 8:
8.1

Mergers and Acquisitions

Content Summary
The Basic Forms of Acquisitions There are three basic legal procedures that one firm can use to acquire another firm: (1) Merger or consolidation; (2) Acquisition of stock; and (3) Acquisition of assets. (a) Merger or Consolidation Merger refers to the complete absorption of one company by another (assets and liabilities). The bidder remains, and the target ceases to exist. As for consolidation, a new firm will be created and joined firms cease their previous existence. (b) Acquisition of Stock A second way to acquire another firm is by buying the voting stock of another firm with cash, securities or both. A tender offer is an offer by one firm or individual to buy shares in another firm from any shareholder. Such deals are often contingent on the bidder obtaining a minimum percentage of the shares; otherwise, no go. Some factors involved in choosing between a tender offer and a merger: (i) No shareholder vote is required for a tender offer. Shareholders choose to sell or not. The tender offer bypasses the board and management of the target firm. In unfriendly bids, a tender offer may be a way around unwilling managers. In a tender offer, if the bidder ends up with less than 80 0/ of the target firms stock, it must pay taxes on a portion of the dividends paid by the target. Complete absorption requires a merger. A tender offer is often the first step toward a formal merger. Acquisition of Assets In an acquisition of assets, one firm buys most or all of anothers assets, but liabilities are not involved as with a merger. Transferring titles can make the process costly. The selling firm may remain in business.
Synergy Most acquisitions fail to create value for the acquirer. The main reason why they do not lies in failures to integrate two companies after a merger. Intellectual capital often walks out the door when acquisitions are not handled carefully. Traditionally, acquisitions deliver value when they allow for scale economies or market power, better products and services in the market, or learning from the new firms. Suppose firm A is contemplating acquiring firm B. The difference between the value of the combined firms (VAB) and the sum of the individual firms (GA + IBM is the incremental gain. The synergy from the acquisition is IV = TAB UA + IBM. Synergy occurs if the value of the

whole exceeds the sum of the parts (IV > 0). The possible benefits of an acquisition come from the following: (1) revenue enhancement, (2) cost reduction, (3) lower taxes, and (4) reduced capital requirements. When calculating the gains from synergy, avoid the following mistakes: (a) Do not ignore market values. Use the current market value as a starting point and ask, What will change if the merger or acquisition takes place?" (b) Estimate only incremental cash flows. These are the basis of synergy. Use the correct discount rate. Make sure to use a rate appropriate to the risk of the cash flows. Be aware of transaction costs. These can be substantial and should include fees paid to investment bankers and lawyers, as well as disclosure costs.

(d)

8.3 Two Financial Side Effects of Acquisitions a. Earnings Growth An acquisition may give the appearance of growth in EPS without actually changing cash flows. This happens when the bidders stock price is higher than the targets, so that fewer shares are outstanding after the acquisition than before. b. Diversification A firms attempt at diversification does not create value because stockholders can buy the stock of both firms, probably more cheaply. Firms cannot reduce their systematic risk by merging. Using option pricing theory in an earlier chapter, it is shown that conflicts of interest may exist between stockholders and managers in publicly traded firms. As noted above, diversificationbased mergers do not create value for shareholders. However, these mergers may increase sales and reduce the total variability of firm cash flows. If managerial compensation and/or prestige is related to firm size, or if less variable cash flows reduce the likelihood of managerial replacement, then some mergers may be initiated for the wrong reasons. They may be in the best interest of managers but not stockholders.

8.4 A Cost to Stockholders from Reduction in Risk The coinsurance effect in a merger or acquisition occurs because even if one of the pre-merger firm fails, bondholders will be still be paid by the surviving firm. The coinsurance effect can reduce the costs of financial distress if the cash flows between two firms are not perfectly correlated. While this can increase total stakeholders value, there may also be a transfer of value from the stockholders to the bondholders through the coinsurance effect. In the topic on options, stocks can be valued as a call option on the firms debt. In this view, bondholders own the firm but sell shareholders an option to buy the firm at an exercise price equal to the face value of debt. Recall that one of the inputs to the option pricing model is the variability of the underlying asset. When the variability of the underlying asset decreases, so does the value of the call option. Stapleton (1982) has shown that this is exactly what occurs when two firms merge. Because of the coinsurance effect, the value of equity (a call option) falls and there is a transfer of wealth from stockholders to bondholders. The coinsurance effect, however, can also result in greater debt capacity. This in turn means greater interest tax shields and lower taxes.

8.5 Friendly versus Hostile Takeovers In a friendly merger, both companies management are receptive. In a hostile merger, the acquiring firm attempts to gain control of the target without their approval. For examples, (1) tender offer attempt to purchase enough shares to gain control and (2) proxy fight attempt to gather enough votes to force the merger. Some defensive tactics in hostile takeover battles include: poison pills, golden parachutes, crown jewels, and greenmail. 8.6 Do Mergers Add Value?
Available evidence suggests that target stockholders make significant gains more in tender offers than in mergers. On the other hand, bidder stockholders earn comparatively little (breaking even on mergers and making a few percent on tender offers).

Topic 9:
9.1

Corporate Culture and Compensation

Content Summary
Corporate Financial Distress Financial distress is a situation where a firms operating cash flows are not sufficient to satisfy current obligations, and the firm is forced to take corrective action. Financial distress may lead a firm to default on a contract, and it may involve financial restructuring between the firm, its creditors, and its equity investors. The definition of financial distress has two general themes: (i) Stock-based insolvency; and (ii) Flow-based insolvency. Stock-based insolvency occurs when the value of assets is less than the value of promised payments to debt. The stock-based insolvency is commonly regarded as a signal of financial distress. Flow-based insolvency occurs when operating cash flows are insufficient to cover contractually required payments. This type of insolvency typically results in more immediate actions, and often leads to bankruptcy. Financial distress can serve as the firms "early warning" signal. Ironically, firms with high financial leverage often face financial distress earlier and, therefore, have more time to reorganise. Firms with low leverage may not recognise they are in distress until it is too late. (a) Responses to Financial Distress A firm can respond to financial distress by increasing available cash flows (asset restructuring) or by reducing liabilities (financial restructuring). Low leverage firms have very limited options in financial restructuring, and, due to delay in their response, the asset values have often deteriorated. For these reasons, firms with low financial leverage are more likely to liquidate than firms with high leverage. Financial distress may involve both asset restructuring and financial restructuring in several ways such as these: selling major assets, merging with another firm, and reducing capital spending and R&D spending asset restructuring; issuing new securities, negotiating with banks and other creditors, exchanging debt for equity, and filing for bankruptcy financial restructuring.

9.2

Bankruptcy Liquidation and Reorganization Firms that cannot meet their obligations have two choices: liquidation or reorganization. Liquidation means termination of the firm as a going concern. It involves selling the assets of the firm for salvage value. The proceeds, net of transactions costs, are distributed to creditors in order of priority. Reorganization is the option of keeping the firm a going concern. Reorganization sometimes involves issuing new securities to replace old ones. a. Bankruptcy Liquidation An involuntary bankruptcy liquidation petition may be filed by creditors if both of the following conditions are met: (i) The corporation is not paying debts as they come due; and (ii) If there are more than 12 creditors, at least three with claims totalling $13,475 or more must join in the filing. If there are fewer than 12 creditors, then only one with a claim of $13,475 is required to file. b. Absolute Priority Rule The absolute priority rule (APR) determines priority of claim in bankruptcy liquidation and reorganization. The rule states that senior claims must be fully satisfied before junior claims are serviced. Exceptions to the APR are possible such as a mortgage secured by real estate property. c. Bankruptcy Reorganization Chapter 11 petitions can be filed by the corporation or by its creditors. In the Chapter 11 reorganization, the bankruptcy judge has responsibility for major business decisions, although management input and cooperation is essential to a smooth reorganization.

9.3 Private Workout or Bankruptcy

In order to avoid the costs and delays of formal bankruptcy, firms can try to negotiate a private workout with creditors. If creditors cooperate in a private workout and forego a part of their original claim, they are betting that their ultimate payoff will be higher than if the firm were to be dragged through the bankruptcy courts. Gilson (1989) estimates that only 30% of senior managers (CEO, chairman, and president) survive the four-year period starting two years prior to a Chapter 11 bankruptcy

filing. The survival rate of senior management in private workouts was only slightly higher at 40 0/ (a) Advantages of Formal Bankruptcy versus Private Workout (i) Formal bankruptcy allows firms to issue new debt ("debtor in possession" or "DIP" debt) that is senior to all previously issued debt. This new senior debt can provide enough cash for the firm to continue to conduct its business. (ii) Interest on pre-bankruptcy unsecured debt stops accruing after formal bankruptcy is recognised. (iii) An automatic stay provision protects the firm from its creditors during bankruptcy proceedings. (iv) There are tax advantages to formal bankruptcy relative to private workouts. (v) While a private workout requires acceptance of the plan by all creditors, formal bankruptcy requires acceptance of the plan by one half of creditors owning 2/3 of outstanding claims. (b)

Disadvantages of Formal Bankruptcy versus Private Workout (i) Legal and professional fees have top priority according to the absolute priority rule. Because legal fees accrue on an hourly basis, lawyers and investment bankers have little reason to work toward a rapid reorganization of the firm. (ii) In a bankruptcy reorganization through Chapter 11, judges are required to approve all major business decisions. All stakeholders can be adversely affected if judges make financing and investment decisions that are not based on maximising firm value. Lost investment opportunities represent one form of opportunity costs in bankruptcy proceedings. (iii) Similarly, if managers attention is diverted by the bankruptcy proceedings, they may not pursue all positive NPV investment opportunities. (iv) Stockholders may be able to hold out for a better deal in Chapter 11 bankruptcy than in a private workout because interest on pre-bankruptcy debt has stopped accruing and the availability of "debtor in possession" debt.

Both formal bankruptcy and private workouts involve exchanging new financial claims for old financial claims. Usually, senior debt is replaced with junior debt, and debt is replaced with equity. When they work, private workouts are better than a formal bankruptcy. Complex capital structures and lack of information make private workouts less likely.

(c)

9.4

Prepackaged Bankruptcy Prepackaged bankruptcy is a combination of a private workout and legal bankruptcy. The firm and most of its creditors agree to private reorganization outside the formal bankruptcy. After the private reorganization is put together (pre-packaged) the firm files a formal bankruptcy (under Chapter 11). The main benefit is that it forces holdouts to accept a bankruptcy reorganization. It offers many of the advantages of a formal bankruptcy, but is more efficient. McConnell and Servaes (1991) view prepackaged bankruptcies as an administrative extension of an informal reorganization, with the following advantages: (i) Because only one half of creditors holding at least two thirds of the firms liabilities are needed for approval of a bankruptcy plan, holdouts can be reduced. (ii) In addition to reducing holdout disputes, prepackaged bankruptcies can capture all of the advantages of formal bankruptcy (including tax advantages) while minimising the disadvantages. Predicting Corporate Bankruptcy Credit scoring models provide a quick, objective way to assess the creditworthiness of prospective borrowers by assessing factors that have historically been associated with the risk of default. Altmans Z score is found using the following equation: Z = 3.3(EBIT/Total Assets) + 1.2(Net Working Capital/Total Assets) + 1.0(Sales/Total Assets) + 0.6(Market Value of Equity / Book Value of Debt) + 1.4(Accumulated Retained Earnings / Total Assets) A Z-score less than 2.675 is indicative of a high probability (95%) of declaring bankruptcy within the next year. However, 1.81 to 2.99 is really a grey area, with the critical high and low probabilities of bankruptcy being below 1.81 and above 2.99, respectively. The above model requires a firm to have publicly traded equity and be a manufacturer. A revised model can be used on private firms and nonmanufacturing companies: Z = 6.56(Net Working Capital/Total Assets) + 3.26(Accumulated Retained Earnings / Total Assets) + 1.05(EBIT/Total Assets) + 6.72(Book Value of Equity / Total Liabilities) The critical levels for this model are 1.23 and 2.90, respectively.

Topic 10: International Corporate Finance

Content Summary
10.1 The Foreign Exchange Market The foreign exchange market (FOREX) is highly efficient and is the worlds largest financial market. In this market, one countrys currency is traded for anothers. Most of the trading takes place in some major currencies including U.S. dollar ($), British pound sterling (), Japanese yen (Y) and Euro ( ). Market participants include importers and exporters, international portfolio managers, brokers, market markers, and central banks. An exchange rate is the price of one countrys currency in terms of another. There are two types of transactions in the FOREX; spot and forward trades. The spot trade is an exchange of currencies at immediate prices (spot rate). The forward trade is a contract for the exchange of currencies at a future date at a price specified today (forward rate). If the forward rate is greater than the spot rate (based on direct quotes), then the foreign currency is expected to appreciate and is selling at a premium. If the forward rate is below the spot rate (based on direct quotes), then the foreign currency is expected to depreciate and is selling at a discount 10.2 International Parity Relations a. Purchasing Power Parity Absolute purchasing power parity (PPP) indicates that a commodity should sell for the same real price regardless of the currency used. This is often referred to as the law of one price. The absolute PPP can be violated due to transaction costs, barriers to trade and differences in the product. According to the relative PPP, the change in the exchange rate depends on the difference in inflation rates between countries. This relationship provides information about what causes changes in exchange rates. b. Covered Interest Arbitrage A covered interest arbitrage exists when a riskless profit can be made by borrowing in the domestic market at the risk-free rate, converting the borrowed dollars into a foreign currency, investing at that country's rate of interest, taking a forward contract to convert the currency back into the domestic currency and repaying the loan. Unbiased forward rates refers to that the forward rate, Fo. is equal to the expected future spot rate, E[Set. That is, on average, the forward rate

neither consistently underestimates nor overestimates the future spot rate. That is, Ft - E[Set. The International Fisher Effect tells us that the real rate of return must be constant across countries. If it is not, investors will move their money to the country with the higher real rate of return. 10.3 International Capital Budgeting To evaluate an overseas investment, two methods are available; home currency approach and foreign currency approach. The home currency approach involves converting foreign cash flows into the domestic currency and finding the NPV, while in the foreign currency approach we determine the comparable foreign discount rate, find the NPV of foreign cash flows, and convert the NPV to dollars. 10.4 Exchange Rate Risk Exchange rate risk is the natural consequence of international operations in a world where relative currency values move up and down. It refers to the risk of loss arising from fluctuations in exchange rates. There are three different types of exchange rate risk or exposure: short-term exposure, long-term exposure, and translation exposure. (a) Short-term Exposure Risk from day-to-day fluctuations in exchange rates and the fact that companies have contracts to buy and sell goods in the short run at fixed prices. One way to offset the risk from changing exchange rates and fixed terms is to hedge with a forward exchange agreement. Another hedging tool is to use foreign exchange options. An option will allow the firm to protect itself against adverse exchange rate movements and still benefit from favourable exchange rate movements. (b) Long-term Exposure Long-run fluctuations come from unanticipated changes in relative economic conditions. It may be due to changes in labour markets or government policies. These long-run changes in exchange rates can be partially offset by matching foreign assets and liabilities, inflows and outflows. Translation Exposure Income from foreign operations must be translated back to home currency for accounting purposes, even if foreign currency is not actually converted back to the domestic currency. If gains and losses from this translation flowed through directly to the income statement, there would be significant volatility in EPS. Current accounting regulations require that all cash flows be converted at

(d)

the prevailing exchange rates, with currency gains and losses accumulated in a special account within shareholders equity. Translation gains and losses are accumulated in the special equity account and are not recognised in earnings until the underlying assets or liabilities are sold or liquidated. Managing Exchange Rate Risk Large multinational firms may need to manage the exchange rate risk associated with several different currencies. The firm needs to consider its net exposure to currency risk instead of just looking at each currency separately. Hedging individual currencies could be expensive and may actually increase exposure.

10.5 Political Risk Political risk refers to the changes in value due to political actions in the foreign country. Investment in countries that have unstable governments should require higher returns. Blocking funds and expropriation of property by foreign governments are among the routine political risks faced by multinationals. Terrorism is also a concern. Financing the subsidiarys operations in the foreign country can reduce some risk. Another option is to make the subsidiary dependent on the parent company for supplies; this makes the company less valuable to someone else.