· finance function allocates resources, which includes acquiring, investing, and managing the resources. Financial management: Financial management is an area of finance that applies

“Corporate Finance”.

: Introduction And Overview

Topic Objective:

At the end of this topic the student will be able to:

Define the field of finance and its areas.

Describe major types of corporate financial management decisions.

Compare three major types of business organizations.

Compare and contrast three models of the firm.

Understand the objective of the firm.

Definition/Overview:

Finance: Finance is a discipline concerned with determining value and making decisions. The

finance function allocates resources, which includes acquiring, investing, and managing the

resources.

Financial management: Financial management is an area of finance that applies financial

principles within an organization to create and maintain value through decision making and

proper resource management.

Dividend right: Dividend right is defined as the right shareholders get an identical per-share

amount of any dividends.

Voting rights: Shareholders have the right to vote on certain matters, such as the election of

directors.

Liquidation rights: Shareholders have the right to a proportional share of the firm=s residual

value in the event of liquidation. The residual value is what remains after all of the corporation=s

other obligations have been settled.

www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in

1www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in

WWW.BSSVE.IN

Preemptive rights: In some corporations, shareholders have the right to subscribe

proportionately to any new issue of the corporation=s shares. Such offerings are called rights

offerings.

Limited liability: Shareholder liability for corporate obligations is limited to the loss of the

shares.

Permanency: A corporation=s legal existence is not affected when a shareholder dies or sells

his/her shares.

Transferability of ownership: Selling shares in a corporation is normally easier then selling a

proprietorship or a general-partnership interest.

Key Points:

1. Types of Financial Securities

The two basic types of financial securities that firms issue are equity and debt.

Equity: Equity is the firms ownership and is typically represented by shares of common stock.

Common stock is a proportional form of equity. Debt is a legal obligation to make contractually

agreed upon future payments, identified as interest and repayment of the principal (original debt

amount). Debtholders loan the firm money but have no claim of ownership as long as the firm

meets its payment obligations. The firm controls the use of the funds.

The three problems associated with using profit maximization as the goal of the firm are the

following: First, profit maximization is vague. Profit has many different definitions such as

accounting profit based on book value or economic profit based on market value. Second, profit

maximization ignores differences in when we get the money. It does not distinguish between

getting a dollar today and getting a dollar one year from today.



WWW.BSSVE.IN

The time value of money plays an important role in valuing an asset or liability. Third, profit

maximization ignores risk differences among alternative courses of action. When given a choice

between two alternatives that have the same return but different risk, most people will take the

less risky one. This makes the less risky one more valuable. Profit maximization ignores such

differences in value.

Shareholder wealth maximization: Shareholder wealth maximization is maximizing the value

of the firm to its owners. The ownership value of the firm is the market value of the shares

owned. Shareholder wealth maximization deals with these three problems by focusing profit

motives squarely on the owners. First, shareholder wealth is unambiguous. It is based on the

present value of the future cash flows that are expected to come to the shareholders, rather than

an ambiguous notion of profit or other revenues. Second, shareholder wealth depends explicitly

on the timing of future cash flows. Finally, our process for measuring shareholder wealth

accounts for risk differences.

Investment Decisions: Investment decisions are primarily concerned with the asset or left side

of the balance sheet. Such decisions include whether to introduce a new product. Financial

decisions are primarily concerned with the liabilities and stockholders equity or right side of the

balance sheet. Such decisions include whether to issue new stock in the firm.

Examples of a firms stakeholders in the set-of-contracts view of the firm include banks,

customers, governments, preferred stockholders, communities, short-term creditors, managers,

suppliers, society at large, common stockholders, the environment, employees, and bondholders.

An explicit contract is a specific agreement among two or more parties. An example is a

contract with a debt holder that specifies the repayment schedule. An implicit contract is a

generally accepted agreement among two or more parties. An example is a managers obligation

to act honestly and in the best interest of the shareholders. Sometimes a court of law is necessary

to define the components and obligations of an implicit contract.



WWW.BSSVE.IN

A contingent claim is contingent on the value of some other asset or a particular occurrence. An

example of a contingent claim is a manager receiving a bonus after reaching a certain objective.

The bonus is contingent on a certain event, that is, the objective being reached. Preemptive rights

are often left out of modern corporate charters.

2. The Science of Finance

Finance is a science.

Like other sciences, it has fundamental concepts, principles, and theories.

3. The Art of Finance

In some situations, precise models cannot be created.

That does not mean that we cannot make decisions in these situations.

People may refer to using intuition to make decisions.

Decision makers are often using intuition from the Principles of Finance.

They are using scientific valuation concepts, but not exact numbers.

4. Three Types of Decisions

4.1. Investment Decisions

o What assets should the firm invest in?

4.2. Financing Decision

o How should the purchase of assets be financed?

4.3. Managerial Decisions

o How large should the firm be?

o How fast should it grow?

o Should the firm grant credit to a customer?



WWW.BSSVE.IN

o How should the managers be compensated?

5. Financial Markets and Intermediaries

The study of markets where financial securities (such as stocks and bonds) are bought and sold

The study of financial institutions (such as commercial banks, investment banking firms, and

insurance companies) that help the flow of money from savers to demanders of money

6. Investments

The study of financial transactions from the investors outside the firm, for example:

How do we place a dollar value on a share of stock or a bond issued by the corporation?

How do we assess the risk of these financial securities?

How do we manage a portfolio of financial securities to achieve a stated objective of the

investor?

7. The Corporate Form of Organization

Ownership: The shareholders (also known as stockholders or equityholders) are the owners of

the corporation.

Control: Ultimate control rests with the shareholders, but the managers control the day-to-day

operations.

Risk Bearing: While all parties associated with the corporation bear the risk, shareholders bear

all residual risk.

7.1. Advantages of Corporate Form of Organization

o Limited Liability

o Permanency

o Transferability of Ownership

o Better Access to Capital Markets



WWW.BSSVE.IN

8. Rights of Ownership

Dividend Rights

Voting Rights

8.1. Majority voting

o One vote per share per director

o Cannot combine votes

8.2. Cumulative voting

o Directors are voted on jointly

o Can cast all votes for a single candidate

8.3. Liquidation Rights

o Owners have the right to a proportional share of the firms residual value in the event of

liquidation, after other senior claims are paid.

8.4. Preemptive Rights

o Owners have the right to subscribe proportionally to any new shares issued by the firm.

9. The Goal of the Firm

Between defined than profits

Considers timing of profits

Considers risk differences among alternative courses of action



WWW.BSSVE.IN

10. The Investment Vehicle Model of the Firm

Investors provide financing to the firm in exchange for financial securities.

Firm invests these funds in assets.

Income generated by the firm is distributed to the investors.

Managers act in the best interest of the shareholders, and take actions to maximize shareholder

wealth.

11. The Firm as an Investment Vehicle

12. The Accounting Model of the Firm

Balance sheet view of the firm

Investment decisions are represented on the asset (i.e. left hand) side of the balance sheet.

Financing decisions are represented on the liabilities and equity (i.e. right hand) side of the

balance sheet.

13. Set of Contracts Model of the Firm

The firm has contracts with a large number of stakeholders.

These contracts may be explicit or implicit.

Contracts may also be contingent on particular future outcomes.

The model recognizes that conflicts of interest may exist between the various stakeholders.



WWW.BSSVE.IN

14. The Evolution of Finance

14.1. Globalization

o Every firm operates in a global marketplace.

o Financial markets transcend national boundaries.

14.2. Technology

o Information can be readily obtained / disseminated.

o Need to use computing technology to maintain a competitive edge.

14.3. Corporate Reorganization and Restructuring

o Your first job will not be the job you retire from.

: The Financial Environment: Concepts And Principles

Topic Objective:


Understand the Principles of Finance.

Apply the Principles of Finance to real world situations.

Understand the characteristics of the most common financial securities.

Describe the role of brokers, dealers, investment bankers and financial intermediaries.



WWW.BSSVE.IN


Opportunity cost: The difference between the value of one action and the value of the best

alternative action

Principal-Agent relationship: A situation in which one participant, the agent, makes decisions

that affect another participant, the principal

Moral hazard: A situation in which an agent can take unseen actions for personal benefit even

though such actions are costly to the principal

Zero-sum game - A situation in which one player can gain only at the expense of another player

Sunk Cost: A cost that has already been incurred and cannot be altered by subsequent decisions

Hubris: Arrogance due to excessive pride and an insolence toward others.

Adverse Selection: When offering something to the market seems to indicate something

negative about what is being offered.

One principal-agent relationship in which a moral hazard could arise is the relationship between

an owner and a manager. A manager could take a nap while on the job, or use the firms car for

personal business. These actions benefit the manager at the expense of the owner without the

owner ever knowing.

Portfolio: A portfolio is a group of investments, as opposed to a single investment.

Diversification is the act of spreading your wealth across multiple investments instead of

concentrating them in a single investment. This is beneficial because all your wealth won=t be

lost unless all of the investments fail. Diversifying lowers risk by limiting the amount of the

investment lost if one or more fail.

Spot market: A spot market is a market in which assets are bought and sold for immediate

delivery. A futures market is a market in which standardized forward contracts are traded.

Option contract: An option contract is the right, without any obligation, to buy or sell

something. A futures contract is a standardized forward contract that is traded in a futures

market.



WWW.BSSVE.IN

Broker: A person that helps investors buy or sell securities, charging a sales commission but

without taking ownership of the shares. A dealer actually takes ownership of the shares before

selling them to someone else.

Primary market: A primary market is a market in which firms sell newly created securities to

raise capital. A secondary market is a market in which previously created securities are traded.

Initial Public Offering (IPO): An initial public offering (IPO) refers to the first time a firm

issues shares to sell to the public. A seasoned equity offering refers to any offering of additional

new shares for a firm that already has shares outstanding.

Forward contract: A forward contract is a contract to exchange an asset for cash at a specific

future date. A futures contract is a standardized forward contract that is traded in a futures

market.

Key Points:

1. Ethics

Ethics consists of standards of conduct or moral judgment. Following all applicable rules and

regulations does not necessarily make one an ethical person. No set of rules and regulations can

account for everything that can and will happen. A code of ethics can reduce unethical behavior

by providing a set of guidelines that can be applied generally to situations that arise.

Ethical behavior avoids fines and legal expenses.

It builds customer loyalty and sales.

It helps attract and keep high-quality employees and managers.

It builds public confidence and adds to the economic development of the communities in which

the firm operates.

A good reputation enhances relations with the firms investors.



WWW.BSSVE.IN

2. Longer lived securities are riskier

Much of this risk depends on inflation expectations, which are an important determinant of

interest rates. Therefore, if all else is equal, the Principle of Risk-Return Trade-Off implies that

investors will require a higher interest rate (return) to bear the extra risk. This is the basis for the

idea that the term structure should be upward sloping.

If investors believe that long-term interest rates are going to be lower next year, they will want to

make long-term investments today. If investors don=t have the funds to make the investment

today, they will borrow short-term and repay the money in the future with income from the

investments. This decreases the supply of short-term funds and, at the same time, increases the

supply of long-term funds. The shift in these supplies raises the short-term rate and lowers the

long-term rate. This can result in a downward-sloping term structure.

3. Major Distinction between Debt and Equity

The major distinction between debt and equity is that debt is what a firm owes whereas equity is

ownership in a firm. This distinction is important because the owners will determine how a firm

is run, and will make decisions that impact the debt holders.

4. The Principle of Self-Interested Behavior

With all else equal, people choose the action that is financially most advantageous to themselves

Does not imply that making money is the most important criteria

Consider charitable contributions

Taking the most advantageous course of action requires us to forego other possible actions.

Every action has an Opportunity Cost

The difference in value of the chosen action and the next best alternative



WWW.BSSVE.IN

5. Agent

A person who makes a decision that affects the principal.

Managers are agents, stockholders are principals.

o Managers are self-interested: may want an expensive car for business use; stockholders want

managers to use an economy model, and pay off a bank loan with the money saved

Stockholders are agents, bondholders are principals.

o Stockholders seek risk, bondholders want the firm to make low risk investments.

The agent can take unseen actions that are costly to the principal.

o The manager might make personal long distance calls using the office telephone.

o The principal thus faces a Moral Hazard problem.

o The principal can reduce the severity of this problem through more effective contract provisions.

6. Agency Theory

There are costs connected with controlling conflicts of interest

o Monitoring (audits)

o Incentives (stock options and bonuses)

o Missing a good investment

o Loss due to misbehavior

o Excessive expense account, personal time, wasted resources

The principal can reduce the total cost by balancing monitoring and incentive costs against other

costs.

Primary goal is to control such problems by using good contracts.

7. Principal-Agent Relationships

7.1. The Principle of Two-Sided Transactions

While we act in our best interest, there is at least one other person in this transaction who is

acting in his/her best interest.

Underestimating the counterparty can lead to sub-optimal decisions.



WWW.BSSVE.IN

Corporate executives often suffer from hubris.

Most financial transactions are Zero-Sum.

One party gains only at the expense of another.

Non-zero-sum transactions often result from provisions in the tax code.

A transaction may be structured so that both parties pay less in taxes to the government.

When we add the government as a party, were back to a zero-sum game.

Media reports of stock market transactions sometimes refer to profit takers selling off their

holdings and thereby causing a drop in stock prices.

There cant be more selling than buying.

The same news story could have instead spoke of investors making a huge mistake buying into a

dropping stock.

7.2. The Signaling Principle

o When a firm increases its dividend, it is generally signaling a more optimistic future for the firm.

o When actions conflict with words, pay attention to the actions

▪ The CEO announces optimistic future for the firm, but at the same time

top executives are selling large amounts of stock they own in the firm.

▪ If one party has information not known to the other party, there is

asymmetric information.

▪ Asymmetric information can lead to the problem of adverse selection.

7.3. The Behavioral Principle

Analyzing complex transactions can be very difficult and/or expensive.

In such cases, look at what others are doing.



WWW.BSSVE.IN

But be aware of the blind leading the blind!

In a competitive environment, this principle can lead to the free-rider problem:

▪ The leader expends resources to determine the best course of action.

▪ The followers imitate the leader and reap the benefits without expending

the resources.

McDonalds does extensive research and analysis concerning the placement of its restaurants.

Other fast-food chains have at times chosen their new restaurant locations simply by building

near a McDonalds restaurant.

7.4. The Principle of Valuable Ideas

Over time, the value of merely imitating others is driven out by competition from others doing

the same thing.

Truly successful people / businesses have used at least one new idea.

Every new idea not automatically valuable: Consider the dot-com craze.

7.5. The Principle of Comparative Advantage

This is the basis for our economic system.

Economic efficiency results from everyone doing what they do best.

7.6. The Options Principle

An option is the right (without the obligation) to take some action.

Depending on circumstances, the optionholder may decide to:

▪ Take the action (exercise the option) or

▪ Forego the action (let the option expire).

Explicit Option Contracts:

▪ Call Option:



WWW.BSSVE.IN

Gives the holder the right to buy the specified asset at a pre-specified price (within a specified

time period)

▪ Put Option:

Gives the holder the right to sell the specified asset at a pre-specified price (within a specified

time period)

Hidden or Embedded Options:

▪ These options may be a part of another financial contract:

▪ Bankruptcy laws provide debtors legal protection from creditors - the

limited liability provision.

Debtors have the option to not fully repay the debt IF they declare bankruptcy.

Privately negotiated options

Corporate options: expand, shrink, delay, abandon, etc.

Real options: hotel reservations, rain checks, tickets, etc.

▪ The most common option is insurance, which is a form of put option.

7.7. The Principle of Incremental Benefits

Incremental costs and benefits are those that occur with a particular action, minus those that

occur without the action.

Sunk costs (costs that have already been incurred) are irrelevant to financial decision making.

7.8. The Principle of Risk-Return Trade-Off

In order to earn higher returns, you must be willing to bear higher risk.

High risk brings with it a greater chance of a really good outcome as well as a greater chance of a

really bad outcome.



WWW.BSSVE.IN

7.9. Risk Averse Behavior

When all else is equal, people prefer higher returns and lower risk.

People will choose the high-risk alternative only if they expect to earn a sufficiently high return.

Individuals would accept a lower return in exchange for lower risk.

7.10. The Principle of Diversification

Dont put all your eggs in one basket!

Spreading your investments (diversifying) can reduce risk without decreasing the return.

A prudent investor will not invest her entire wealth in a single asset (for example, one firm).

7.11. The Principle of Capital Market Efficiency

Capital markets are markets in which financial securities like stocks and bonds are bought and

sold (traded).

Market prices of financial assets that are traded regularly in the capital markets:

▪ Reflect all available information

▪ Adjust quickly to new information

New information is information that was not previously known. Note that information may

thought possible, expected, or even anticipated.

▪ Markets dont wait for the supply to be interrupted; prices fall or rise as

soon as a change in supply is possible, the greater the chance, the greater

the price change.

Prices are made on expectations.

Trading by astute investors in response to new information causes prices to change quickly.

8. Capital Market Efficiency

Competition among a large number of participants

The information revolution

Trading convenience



WWW.BSSVE.IN

Low cost of trading

Rapid execution of trades

The price of an asset is the same everywhere in the market.

The law of one price holds.

Equivalent securities must sell at the same price.

Arbitrage opportunities cannot exist.

Arbitrage allows you to earn riskless profits without any capital commitments.

9. The Time Value of Money Principle

A dollar today is worth more than a dollar tomorrow.

The time value of money derives from the opportunity to earn interest on it.

10. Security Markets

Money versus Capital Markets

Primary versus Secondary Markets

Market for short-term claims with original maturity of one year or less

High-grade securities with little or no risk of default

10.1. U.S. Treasury Bills

Issued by the U.S. Treasury

Original maturities of 13, 26 and 52 weeks

Generally sold in $10,000 denominations

Sold on a discount basis - at a discount from their face value

Difference between the face value and the purchase price represents interest earned by the

investor

10.2. Commercial Paper

A promissory note sold by very large, creditworthy corporations

Original maturity up to 270 days



WWW.BSSVE.IN

Face value is generally $100,000

Backed by a standby letter of credit from a bank

10.3. Certificates of Deposit (CDs)

Written by commercial banks

Issuing bank promises to pay the face value plus a fixed interest rate

Negotiable CDs have denominations of $100,000 or more and can be traded in the market

10.4. Bankers Acceptances

Short-term loans made by banks to importers and exporters.

Bank promises to pay the face amount when the acceptance is presented to it.

Banks customer uses this acceptance to finance the purchase of goods and services.

Holder of the acceptance (seller of goods) can hold the acceptance to maturity or sell it at a

discount from its face value.

11. Capital Markets

Market for long-term securities with original maturity of more than one year

Securities may be of considerable risk.

11.1. Stocks

Shares of a stock represent equity (or ownership) in a corporation.

Stockholders have the right to vote and the right to dividends.

Common stock shares represent residual ownership in the firm.

Dividends on preferred stock shares are usually fixed, and generally must be paid before

dividends are paid to common stockholders.

11.2. Bonds

Represent long-term debt securities - a promise to pay interest and repay the borrowed money

(principal) on prespecified terms..



WWW.BSSVE.IN

Issued by corporations as well as governments

Notes are like bonds, but have a maturity between 1 and 10 years

Bonds are also referred to as fixed income securities

12. Derivative Securities

These derive their value from another security.

Options

Futures

Forward contracts

12.1. Options

Grants the holder the right to buy (or sell) the underlying security at a fixed price, within a fixed

time period

There is no obligation on the part of the option holder

There is obligation on the part of the option seller

A call option gives the holder the right to buy the underlying security

A put option gives the holder the right to sell the underlying security

12.2. Forward and Futures Contracts

An agreement to buy (or sell) something at a fixed price at a fixed point in the future

Unlike options, this entails an obligation - both parties to the transaction must fulfill their

obligations

You can lock in a buying (selling) price for the underlying asset

Futures contracts are similar to forward contracts, but are usually standardized and are traded in

the markets

13. Primary Markets

A primary market is a market for newly created securities.

The proceeds from the sale of securities in primary markets go to the issuing entity.



WWW.BSSVE.IN

A security can trade only once in the primary market.

14. Secondary Markets

A secondary market is a market for previously issued securities.

The issuing firm is not directly affected by transactions in the secondary markets.

A security can trade an unlimited number of times in secondary markets.

The volume of trade in secondary markets is much higher than in primary markets.

15. Investment Bankers

An investment banker specializes in marketing new securities in the primary market.

15.1. Brokers and Dealers

These generally participate in the secondary markets.

A broker helps investors in buying or selling securities.

A broker charges commissions, but never takes title to the security.

A dealer buys securities from sellers, and sells them to buyers (hopefully at a higher price!)

15.2. Financial Intermediaries

These are institutions that assist in the financing of firms.

Examples include: commercial banks and pension funds.

These institutions invest in securities of other firms, but they are themselves financed by other

financial claims

: Accounting, Cash Flows, And Taxes

Topic Objective:




WWW.BSSVE.IN

Understand the firms accounting statements.

Explain the inherent limitations of historical accounting information.

Understand the difference between net income and cash flow.

Understand the difference between book value and market value.


Income Statement: A summary of income and expenses over a given time period. In addition to

cash income and expenses, it takes into account non-cash expenses like depreciation.

Balance Sheet: A record of the financial situation of an institution on a particular date by listing

its assets and the claims against those assets

Cash flow: The transfer of money into and out of an enterprise. In accounting terms, it is the

amount of cash generated by a business after expenses (including interest) and principal

repayment on financing are paid.

Current assets are assets that are expected to become cash within one year. Other classes of

assets are not expected to become cash within one year.

Current liabilities are liabilities that mature or are expected to be paid off within one year.

Other classes of liabilities have a longer maturity.

Key Points:

1. Interest Rates, Inflation and Economic Income

An increase in interest rates would cause the market value of a firms liabilities to decrease

relative to the book value. This is because higher interest rates would lower the present value of



WWW.BSSVE.IN

the future payments. For example, the present value of $1,000 one year from today at 10% is

$909.09, but at 15 % the present value is $869.57. High inflation would cause the market value

of a firms assets to increase relative to the book value. This is because the book value is falling

each period by the amount of depreciation that is fixed at the time the asset was purchased,

whereas the decline in market value each period will turn out to be smaller (bigger) the more

(less) inflation there is. Economic income measures the total realized change in wealth for an

investment. It includes changes in the market values of assets and liabilities. Accounting net

income ignores changes in the market values of assets and liabilities.

2. Focus on Principles

Two-Sided Transactions: Recognize that the accounting system always records two sides to

every transaction.

Incremental Benefits: Use financial statements and the accounting system to help identify and

estimate the incremental expected cash flows for making financial decisions.

Risk-Return Tradeoff: Keep in mind that managerial decisions are based on future risks and

returns.

Behavioral Principle: Use the wealth of financial information available from thousands of other

firms to apply this principle.

Signaling: Recognize that financial information provides many signals about customers,

competitors, and suppliers.

3. The Annual Report

Narrative description of the firms activities during the year

The firms accounting statements:

The balance sheet

The income statement

The statement of cash flows

Notes to the financial statements



WWW.BSSVE.IN

4. The Auditors report

4.1. Financial Statements

Prepared according to Generally Accepted Accounting Principles (GAAP)

GAAP guidelines established in the U.S. by the Financial Accounting Standards Board (FASB)

Used by the firm to:

1. Communicate with stakeholders outside the firm.

2. Help plan and organize the firms activities.

3. Monitor and evaluate the firms performance.

4. Used by the Internal Revenue Service to determine the firms taxes.

4.2. The Balance Sheet

Reports the financial position of a firm at a particular point in time

Shows assets held by the firm on the left hand side.

Shows the liabilities and the stockholders equity on the right hand side

The balance sheet identity always holds:

Assets = Liabilities + Shareholders Equity

4.3. Current Assets

Fixed, Intangible & Other Assets

Current Liabilities

Long Term Liabilities

Shareholders Equity

The Income Statement

Reports revenues, expenses, and profit (or loss) during the year

Also reports earnings and dividends on a per share basis.



WWW.BSSVE.IN

5. The Statement of Cash Flows

Reports how the cash position of the firm changed during the year.

It itemizes the cash flows experienced by the firm.

Increase (decrease) in an asset consumes (provides) cash flow.

Decrease (increase) in a liability consumes (provides) cash flow.

6. Notes to Financial Statements

Other income, interest expenses, provision for income taxes.

Earnings per share calculations

Inventories, property, plant and equipment, and other assets

Employee pension and stock option plans

Business segment information

Five-year summary of financial performance

7. Market Values versus Book Values

Accounting statements are invaluable aids to analysts and managers.

But the statements do not provide certain critical information, and have inherent limitations.

8. Taxes

Taxes are very important because they affect value and therefore affect decisions

Interest is an expense, dividends are not an expense

Capital gains tax-timing option

Tax laws change from time to time



WWW.BSSVE.IN

9. Ratios and Ratio Analysis

There are an unlimited number of alternatives.

They are not useful for picking winners.

They are useful for understanding the current situation and perhaps how it developed to this

point.

9.1. Widely cited ratios in finance

Market-to-book ratio

Market value per share divided by book value per share

P/E: price-earnings ratio

Market value per share divided by earnings per share

Historical

Forward looking (based on expectations)

Dividend yield

Dividend divided by market value

: The Time Value Of Money

Topic Objective:


Understand the concept of Net Present Value.

Distinguish among required, expected, and realized rates of return.

Calculate present and future values of any set of expected future cash flows.

Calculate payments on a debt contract.

Compute the APR and APY for a contract.

Value special financing offers.



WWW.BSSVE.IN


Present Value: The present value of a cash flow is inversely related to the discount rate because

a higher discount rate requires less money to be invested now to obtain a given future value at a

particular point time. A lower discount rate requires more money to be invested now to obtain

the same result. An ordinary annuity is a series of equal, periodic cash flows occurring at the end

of each period. An annuity due is a series of equal, periodic cash flows occurring at the

beginning of each period.

The present value of an annuity due is greater than the present value of an ordinary annuity

because each payment occurs one period earlier and thus has a higher present value. The value is

a present value because it is less than the nominal amount (10 x $100 = $1,000) received. In

order for the value to be less than the nominal amount, it must have been discounted. A business

should undertake an investment with a positive net present value because it will increase the

value of the firm by that amount. In effect, the firm is expecting to earn a return above the return

required by the risk of the project, and therefore the project should be accepted.

Key Points:

1. Principles of Present Value

Time Value of Money: The value of a cash flow depends on when it will occur.

Two-Sided Transactions: To be fair to both parties, be specific about the size and timing of cash

flows.

Risk-Return Tradeoff: A higher risk investment has a higher required return



WWW.BSSVE.IN

Capital Market Efficiency: Use efficient capital markets to estimate an investments expected and

required returns.

Rates of Return and Net Present Value: Most investors want to know about an investments value.

It is the return a person requires to be willing to make the investment.

The required rate of return is the return that exactly reflects the risk of the expected future cash

flows.

It reflects the opportunity cost of the investment.

It is determined by market conditions.

2. Expected Rate of Return

The return an investor expects to earn from the investment. For conventional investments:

If it equals the required return, the NPV is zero.

If it exceeds the required return, the NPV is positive.

If its less than the required return, the NPV is negative.

2.1. Realized Rate of Return

The return actually earned on the investment during a given time period.

It can only be observed after the fact.

It is disconnected from the expected (and required) returns by the risk of the cash flows.

2.2. Net Present Value (NPV)

NPV measures the value created.

Positive NPV increases wealth.

A zero NPV decision earns the fair rate of return.

A positive NPV decision earns more than the fair rate of return.



WWW.BSSVE.IN

3. Valuing Single Cash Flows

3.1. Key Assumptions

Cash flows occur at the end of the time interval.

The compounding frequency is the same as the cash flow frequency.

For example, monthly payments assumes monthly compounding.

3.2. Selected Notation

APR Annual Percentage Rate APR = rm

APY Annual Percentage Yield (effective annual rate)

CFt The net Cash Flow at time t.

PV Present Value

FV Future Value

r The discount rate per period

m The number of compounding periods per year

t A time period

FVAF (r,n) Future-value-annuity-factor for an n-period annuity at an interest rate r per period

3.3. The Time Line

3.4. Future Value Formula

o Let PV = Present Value

o FVn = Future Value at time n

o r = interest rate (or discount rate) per period.



WWW.BSSVE.IN

3.4.1. Future Value Factor

3.4.2. Present Value Formula

Let:

PV Present Value

FVn Future Value at time n

r Interest rate (or discount rate) per period.

4. Annuities

An annuity is a series of identical cash flows that are expected to occur each period for a

specified number of periods.

Thus, CF1 = CF2 = CF3 = CF4 = ... = CFN

4.1. Three Types of Annuities

o Ordinary Annuity: An annuity with end-of-period cash flows, beginning one period from today.

o Annuity Due: An annuity with beginning-of-period cash flows.

o Deferred Annuity: An annuity that begins at a time different from today.

o For example, a student loan with a 1-year deferral



WWW.BSSVE.IN

: Valuing Bonds And Stocks

Topic Objective:


Understand typical features of bonds & stocks.

Learn how to obtain information about bonds and stocks.

Identify the main factors that affect the value of these securities.

Learn how to value these securities.

Understand how changes in the underlying factors affect the value of these securities.


Required return: A required return is a rate of return that would be required to be

willing to make an investment. The required return exactly reflects the riskiness of the

expected future cash flows of the investment. It reflects the opportunity cost of making

the investment. It is the return that the market would require from an investment of

identical risk and therefore the required return is determined by market conditions. An

expected return is a rate of return that is expected to be earned if an investment is made.

Coupon payments: Coupon payments are the interest payments made on a bond by the

firm that issued the bond. A coupon rate determines the coupon payments. It is the

percentage of the bonds par value that is paid out in total coupon payments during a year.

Bond indenture: The legal contract between the issuing corporation and the

bondholders.

Par value: The amount of money that must be repaid by the issuing corporation to the

bondholders at the end of the bonds life.

Principal: The total amount of money being borrowed.

Maturity: The amount of time until the end of the bonds life. Original maturity is the

amount of time the bond is scheduled to exist. Remaining maturity is the amount of time



WWW.BSSVE.IN

remaining until the end of the bonds life. Often remaining maturity is referred to simply

as maturity.

Call provision: Allows the issuing firm to pay off the bonds prior to their maturity.

Sinking fund: A provision that requires the bonds to be repaid in multiple installments

that are specified in the indenture.

Payout ratio: A payout ratio is the amount a firm pays out in cash dividends divided by

the firms earnings during the same time period.

Value of a share of stock: The value of a share of stock is the present value of the

expected future dividends, P0 = D1 / (r g).

Required Return for a Stock: The required return for a stock (also called the

capitalization rate) is the rate of return that exactly reflects the riskiness of the stocks

expected future dividends. Note that the dividend growth model can be rearranged to

estimate a stocks required return: r = D1 / P0 + g.

Key Points:

1. Bonds

Bonds represent loans extended by investors to corporations and/or the government.

Bonds are issued by the borrower, and purchased by the lender.

The legal contract underlying the loan is called a bond indenture.

1.1. Key Features of Bonds

The par (or face or maturity) value is the amount repaid (excluding interest) by the borrower to

the lender (bondholder) at the end of the bonds life. The par value for U.S. corporate bonds is

$1000.

The coupon rate determines the interest payments. Total annual amount = coupon rate x par

value. U.S. corporate bonds pay semi-annually.



WWW.BSSVE.IN

A bonds maturity is its remaining life, which decreases over time. Original maturity is its

maturity when its issued. The firm promises to repay the par value at the end of the bonds life

(also called maturity).

A sinking fund requires principle repayments (buying bonds) prior to the issues maturity.

Convertible bonds can be converted into a prespecified number of shares of stock. Typically,

these are shares of the issuers common stock.

The call provision allows the issuer to buy the bonds (repay the loan) prior to maturity for the

call price. Calling may not be allowed in the first few years.

1.2. Bond Valuation

The bonds fair value is the present value of the promised future coupon and principal payments.

At issue, the coupon rate is set such that the fair value of the bonds is very close to its par value.

Later, as market conditions change, the fair value may deviate from the par value.

1.3. Yield to Maturity (YTM)

The Yield to Maturity is the APR (Annual Percentage Rate) that equates the

bonds market price to the present value of its promised future cash flows.

This assumes that promised payments will be made in full and exactly on time.

1.4. Bond Riskiness

The YTM is the bonds promised return.

But what if the bond issuer defaults?

Another source of risk lies with changing interest rates.

As the interest rate rises, the price of a fixed-coupon bond falls.

2. Interest Rate Risk

Bond values are inversely related to interest rates.



WWW.BSSVE.IN

Changes in bond values as interest rates change is known as interest rate risk.

It depends on the maturity of the bond.

2.1. Interest Rate Risk of a Bond

2.2. Bond Values and Call Provisions

Call Provision allows the issuer to pay off the bonds prior to maturity.

When bonds are called by the issuer, they are purchased from the holder at the call price.

The bonds are then retired.

The Yield-to-Call (YTC) is the bonds expected return up to the call date.

3. Zero-Coupon Bonds

A zero-coupon bond does not pay any coupon (periodic) interest.

The par value is paid to the bondholder at maturity.

Zero-coupon bonds are also known as pure-discount bonds.

4. Stock Valuation

There are two basic types of stock: common and preferred.

Common stock represents the residual ownership interest in a firm.

Common stockholders get whatever is left over in the event of a bankruptcy.



WWW.BSSVE.IN

4.1. Preferred Stock

Claims of preferred stockholders are junior to claims of debtholders, but senior to those of

common stockholders.

Limited voting rights compared to common stock.

Preferred stock has a par value and a dividend rate.

Failure to pay the dividend does not force the issuing firm into bankruptcy.

4.2. Common Stock

Represents residual ownership of the firm.

Common stockholders have important voting rights.

The issuer may pay dividends to common stockholders. However, it is not required to do so.

Moreover, there is no pre-set dividend rate.

Future dividends are uncertain.

5. The Dividend Discount Model

The fair value depends only on the stocks expected future cash flows, which are dividends and a

future sale price.

Each subsequent future selling price depends on the expected subsequent dividends.

Astocks fair value can be expressed in terms of only the stocks expected future dividends.

5.1. Applying the Dividend Valuation Model

Investors look at a firm as a source of growing wealth.

They are interested in the underlying growth of a firm and the implications of that growth rate

for the stocks value.

The value of a share of stock is the present value of the expected dividends over the holding

period plus the expected sale price at the end of the holding period.



WWW.BSSVE.IN

5.2. The Dividend Discount Model

Future Dividends depend on:

The firms earnings

Dividend policy

Payout Ratio = Dividends / Earnings

6. Common Stock Valuation

The per share annual dividend on a common stock is expected to be $3.00 one year from today.

Stockholders require a 12% rate of return. Find the fair value of stock for each of the following

cases:

Zero Growth: dividends are constant every year.

Five-Percent Growth: dividends are growing at a constant rate of 5% per year forever.

Super-Normal Growth: dividends will grow at 25% for 3 years and then at 5% per year forever.

7. Present Value of Dividends

7.1. Important Features of the Constant Growth Model

The growth rate in dividends (g) is always less than the required rate of return (r).

Otherwise, the firms growth would exceed the economys growth forever, which is not possible.

Also, the fair value would be negative or infinity, which makes no sense.

The growth rate in dividends is also the capital gains yield on the stock.

The capital gains yield is the rate of price appreciation.



WWW.BSSVE.IN

7.2. Source of Dividend Growth

If the Payout Ratio (POR) is constant, growth in dividends depends on the growth in earnings.

The growth in earnings depends on:

▪ The amount of earnings retained (1 - POR), and

▪ The return earned on that money, i.

▪ g = (1 - POR) i

7.3. Obtaining Common Stock Information

Sources of information include on-line sources, such as Yahoo! Finance and Google Finance (go

to more and then even more).

Traditional sources include newspapers, such as The Wall Street Journal and stock and bond

guides, such as Standard & Poors.

8. The Price-Earnings Ratio

Like participants in conversations about football and the weather, many investors will join into a

discussion concerning the investment potential of a stock and feel good about their contribution,

regardless of any knowledge they might have about the stock.

These types always bring up the P-E ratio.

Conventional wisdom holds that a high P/E is good and a low P/E is bad.

The bracketed amount is the E/P ratio. Holding r and POR constant, the smaller the E/P ratio,

the larger i must be. A smaller E/P ratio is a larger P/E.

Therefore, higher P/E implies higher expected return on the earnings reinvested by the firm.

8.1. Some Warnings about the P/E

The logic of the P/E depends on expectations, but the P/E is usually based on historical numbers.



WWW.BSSVE.IN

Currently reported accounting earnings do not reflect the actual timing of the earnings.

The P/E may be high because recent earnings are low!

8.2. Measuring the NPV of Future Investments

The value due to assets already in place

The NPV of future investments expected to be made by the firm.

: Risk And Return: Stocks

Topic Objective:


Estimate expected returns from securities and portfolios.

Estimate the standard deviation of returns on securities and for portfolios.

Explain why diversification is beneficial.

Describe the efficient frontier and the Capital Market Line.


Expected Return: The expected return of an asset is the mean of its future possible returns

Mean: A mean is a long-term average of a random variable. It is found by multiplying the value

of each outcome by the probability of occurrence and summing the resulting products together.

Risk of an Asset: The risk of an asset is the standard deviation of its future possible returns.

Efficient frontier: The efficient frontier is the set of all efficient portfolios, portfolios with the

highest possible expected return for a given level of risk. Investors should only invest in

portfolios that lie on the efficient frontier because those portfolios produce the highest expected

returns when compared to other portfolios of similar risk.



WWW.BSSVE.IN

Capital Market Line: The capital market line is a line that connects the riskless return to the

efficient frontier at point M. It represents various percentages of capital invested in the riskless

asset and the market portfolio. The line can be extended past point M to represent borrowing at

the riskless return and investing the proceeds in M. The line produces a better risk-return

relationship than the portfolios that are on the efficient frontier. With the right investment

proportions, the two assets would produce exactly the opposite return in every economic

scenario. The net return would be constant, or riskless.

Key Points:

1. Probability and Statistics

Random variable: Something whose value in the future is subject to uncertainty.

Probability: The relative likelihood of each possible outcome (or value) of a random variable.

Probabilities of individual outcomes cannot be negative nor greater than 1.0.

Sum of the probabilities of all possible outcomes must equal 1.0.

2. Probability Concepts

Mean: The long run average of the random variable. Equals the expected value of the random

variable.

Variance (and Standard Deviation): Measure the dispersion in the possible outcomes. Standard

deviation is the square-root of the variance. Higher variance implies greater dispersion in the

possible outcomes.

Covariance: Measures how two random variables vary together (or co-vary). Covariance can be

negative, positive or zero. Its magnitude has no bounds.

Correlation Coefficient: A standardized measure of co-variation between two random variables.

Always lies between -1.0 and +1.0.

Positive Covariance (or correlation): When one random variables outcome is above the mean, the

other is also likely to be above its mean.



WWW.BSSVE.IN

Negative Covariance (or correlation): When one random variables outcome is above the mean,

the other is likely to be below its mean.

Zero Covariance (or correlation): There is no relationship between the outcomes of the two

random variables.

3. Expected Return and Specific Risk

The mean return is a measure of the expected return from the security. The expected return on

DSC is 1.7 times higher than the expected return on CGI.

The standard deviation is a measure of the specific risk of the security. The specific risk of DSC

is 3 times higher than the specific risk of CGI.

The returns on DSC and CGI are negatively correlated.

4. Investment Portfolios

DSC has higher returns and higher risk than CGI.

Without going further, the only recommendation that we have is a variation on the old Wall

Street saying you can sleep well or eat well.

5. Portfolios of Securities

A portfolio is a combination of two or more securities.

Combining securities into a portfolio reduces risk.

An efficient portfolio is one that has the highest expected return for a given level of risk.

5.1. Portfolio Risk

The risk of the portfolio (as measured by its standard deviation) is:



WWW.BSSVE.IN

5.2. Diversification of Risk

Note that while the expected return of the portfolio is between those of CGI and DSC, its risk is

less than either of the two individual securities.

Combining CGI and DSC results in a substantial reduction of risk - diversification!

This benefit of diversification stems primarily from the fact that CGI and DSCs returns are

negatively correlated.

5.3. Portfolio Expected Return

o The expected return of the portfolio depends on:

▪ The expected return of the securities in the portfolio.

▪ The portfolio weights.

o The risk of the portfolio depends on:

▪ The risk of the securities in the portfolio.

▪ The portfolio weights.

▪ The correlation coefficient of the returns on the securities.

All else being the same, the lower the correlation coefficient, the lower is the risk of the

portfolio. Thus, lower the correlation coefficient, greater is the diversification of risk.

6. Perfect Positive Correlation

When the returns on two stocks are perfectly positively correlated, there is no diversification of

the risk.

The risk of the portfolio is then simply the weighted average of the risk of the individual assets.



WWW.BSSVE.IN

7. Perfect Negative Correlation

When the returns on two stocks are perfectly negatively correlated, it is possible to diversify

away All of the risk by appropriate weighting of the two stocks.

8. Many Asset Portfolios

The above framework can be expanded to the case of portfolios with a large number of stocks. In

forming each portfolio, one can vary

The number of stocks that make up the portfolio,

The identity of the stocks in the portfolio, and

The weights assigned to each stock.

9. Efficient Portfolios

A portfolio is an efficient portfolio if

No other portfolio with the same expected return has lower risk, or

No other portfolio with the same risk has a higher expected return.

Investors prefer efficient portfolios over inefficient ones.

The collection of efficient portfolio is called an efficient frontier.

10. A Prescription for Investing

Investors prefer efficient portfolios over inefficient ones.



WWW.BSSVE.IN

There is no uncertainty about the future value of this asset (that is, the standard deviation of

returns is zero). Let the return on this asset be rf.

For practical purposes, 90-day U.S. Treasury Bills are (almost) risk free.

In combination with the riskless asset, the best portfolio provides the highest slopethe most

return for the risk taken.

11. The Capital Market Line (CML)

Assume investors can lend and borrow at the riskless rate.

Borrowing entails a negative investment in the riskless asset.

Because every investor holds a part of the best risky asset M, M is the market portfolio.

The Market portfolio consists of all risky assets.

Each asset weight is proportional to its market value (capitalizationnot the stock price).

In Section 2 of this course you will cover these topics:Risk And Return: Asset Pricing Models

Cost Of Capital

Business Investment Rules

Capital Budgeting Cash Flows

Capital Budgeting In Practice

Options

You may take as much time as you want to complete the topic coverd in section 2.There is no time limit to finish any Section, However you must finish All Sections before

semester end date.

If you want to continue remaining courses later, you may save the course and leave.You can continue later as per your convenience and this course will be avalible in your

area to save and continue later.



WWW.BSSVE.IN

: Risk And Return: Asset Pricing Models

Topic Objective:


Explain the importance of asset pricing models.

Demonstrate choice of an investment position on the Capital Market Line (CML).

Understand the Capital Asset Pricing Model (CAPM) and its uses.

Describe the arbitrage pricing model and differentiate it from the CAPM.


Beta: Beta is a variable used in the capital-asset-pricing model. It is the correlation of an assets

returns with market returns multiplied by the assets standard deviation of returns and divided by

the markets standard deviation of returns. Beta is a measure of non-diversifiable risk.

Market price: The market price of risk refers to the market risk premium, rm - rf. It is a measure

of the extra return required for undertaking a unit of market risk.

CAPM: CAPM is a model for estimating the expected return of an asset. The minimum

expected return is the risk free rate. The expected returns increases with risk, which is measured

by the assets covariance with the market. For every unit of market risk, the expected return

increases by the market risk premium, rm - rf.

Diversifiable Risk: Diversifiable risk is risk that is specific to one asset. For example, a

companys products may be a failure or an asset may be destroyed in a natural disaster. Non-

diversifiable risk is risk that affects all assets. For example, the global economy may enter a

prolonged depression. The difference is that diversifiable risk can diversified away. By

investing in many assets, the failure or destruction of one asset will have little effect on the

overall portfolio. Non-diversifiable risk cannot be diversified away because it affects all assets.

A simple way to look at this is that the market need not pay for taking risk that can be easily and

virtually costlessly eliminated. Another way to view this is that the market will not pay investors



WWW.BSSVE.IN

for taking on diversifiable risk because prices are set by diversified investors. Diversified

investors will value an asset at a higher price than a non-diversified investor because diversified

investors have lower-risk and therefore a lower required return. Based on the Principle of Self-

Interested Behavior, people will sell to the highest bidders. Thus a non-diversified investor

buying at these prices can only expect to make the required return set by a diversified investor.

Key Points:

1. The Capital Asset Pricing Model (CAPM)

Asset pricing models provide a relationship between an assets required rate of return and its risk.

The capital asset pricing model (CAPM) is the most popular such model. Later, we present

multi-factor and arbitrage pricing models.

It allows us to determine the required rate of return for an individual security.

Individual securities might not lie on the Capital Market Line (CML).

The CAPM can be developed from the CML.

When applied to financial securities, the relationship in the CAPM between risk and return for an

individual asset is referred to as the Security Market Line (SML).

1.1. Assumptions of the CAPM

The probability distributions of security returns can be described by the mean and the variance of

returns.

All investors have the same assessment of expected returns, variances, and co-variances of all

securities.

Capital markets are in equilibrium.

The Principle of Market Efficiency applies.

All investors have a one-period horizon.



WWW.BSSVE.IN

1.2. What does the SML tell us?

The required rate of return on a security depends on:

The risk-free rate

The beta of the security

The market price of risk

▪ The required return is a linear function of the beta coefficient.

▪ All else being the same, the higher the beta coefficient, the higher is the

required return on the security.

1.3. What does the CAPM tell us?

The required return for a risky asset is composed of two parts:

Graphical Representation of the SML

2. Estimating the Beta Coefficient

Generally, these quantities are not known.

We usually rely on their historical values to provide us with an estimate of beta.

3. Arbitrage and the SML

If an asset has a [beta/expected return] combination on the SML, the asset is fairly priced.

If the [beta/expected return] combination of an asset is above the SML, the asset is under priced

(has a high return for its beta).

If the [beta/expected return] combination of an asset is below the SML, the asset is overpriced

(has a low return for its beta).



WWW.BSSVE.IN

Competition among investors will tend to force stocks [beta/expected returns] towards the SML.

4. Diversifiable and Non-diversifiable Risk

Beta measures the risk that an individual asset adds to the market portfolio.

Since the market portfolio is fully diversified, beta measures the risk that cannot be diversified

away.

Thus, beta is a measure of the assets non-diversifiable risk.

Total Risk = Diversifiable risk + Non-diversifiable risk.

4.1. Diversifiable Risk

It is also known as unsystematic, or asset specific, risk and can be eliminated by diversification.

It can be caused by:

Failure (or success) of a firm in launching a new product.

Failure (or success) to get a contract

Failure (or success) in settling a strike or a lawsuit.

Such events are random across firms and their effects tend to cancel each other out.

4.2. Non-diversifiable Risk

It also known as systematic, or market, risk and cannot be eliminated by diversification.

It can be caused by:

▪ Recession

▪ Sharp change in monetary policy

▪ Outbreak of war

It reflects the degree to which an assets returns move systematically with those of other assets.



WWW.BSSVE.IN

4.3. Consequences of Not Diversifying

A non-diversified investor bears both types of risk: diversifiable and non-diversifiable.

A diversified investor bears only systematic risk.

The value of the asset to the diversified investor will be higher than to the non-diversified

investor.

Since the diversified investor bears less risk than the non-diversified one, she will demand a

lower risk premium.

The lower the risk premium, the lower the required rate of return.

The lower the required rate of return, the higher is the value of the asset.

Since the value of the asset is higher to the diversified investor, she will always out-bid the non-

diversified one.

The price she is willing to offer will be the market clearing price.

5. Arbitrage Pricing Theory

The APT relies on the principle of Capital Market Efficiency.

The assets returns are linear in the factor returns.

The number and type of factors are not pre-specified by theory.

They must be determined empirically.

The APT is more general than the CAPM.

6. International Considerations

Investing in domestic as well as foreign markets expands the investment opportunity set

available to investors.

If the returns in the two markets are imperfectly correlated, additional diversification of risk is

possible.

The market portfolio is now defined as the world portfolio.



WWW.BSSVE.IN

: Cost Of Capital

Topic Objective:


Understand the concept of cost of capital.

Understand the major determinants of the components of the cost of capital.

Identify the important differences between operating and financial leverage.

Estimate cost of capital for a capital budgeting project.


Financing Decision: The financing decision refers to how a firm will pay for its assets, with

debt or equity. The investment decision is which assets a firm chooses to invest in. The other

side of the financing decision consists of equity holders and debt-holders. The other side of the

investing decision is made up of the entities that have sold assets to the firm.

Operating leverage: Operating leverage is the mix of fixed and variable costs required to

produce a product or service. Financial leverage is the mix of debt and equity used in financing

an asset.

Operating risk: Operating risk is the risk associated with a firms choice between fixed and

variable production costs. It is different from financial risk in that it is unique for each of the

firms investments and affects both the diversifiable and nondiversifiable risk of the firm. It

therefore affects a projects beta and its cost of capital. Sometimes a firm has little choice in

choosing its operating leverage, thus making operating risk very difficult to manage.



WWW.BSSVE.IN

Key Points:

1. The Cost of Capital

The Cost of Capital is often misinterpreted.

It is NOT the firms historical cost of funds that determines the cost of capital.

The relevant cost is the opportunity cost.

The Cost of Capital is the required return for a capital budget.

It is the opportunity cost of funds tied up in the project.

It is the rate of return at which investors are willing to provide financing for the project today.

It reflects the risk of the project.

2. Corporate Valuation

The market value of the firm (or simply, the firm value) can be viewed in two ways:

Firm value equals the sum of the market values of the claims on the firms assets.

Firm value equals the sum of the market values of its assets.

These two views are simply the balance-sheet accounting identity, but in market values:

Assets = Liabilities + Owners Equity

2.1. Financing Decisions and Firm Value

In a perfect capital market, value of the firm does not depend on its capital structurethe way in

which its assets are financed.

The mix of debt versus equity is irrelevant in determining firm value.

In imperfect capital markets, capital structure can affect the value of the firm.

2.2. Investment Decisions and Firm Value

The value of the firm does depend on:

The expected future cash flows to be generated by the firms assets, and

The required return on these cash flows.



WWW.BSSVE.IN

An asset will add value if its expected return (the Internal Rate of Return or

IRR) exceeds its required return (its cost of capital).

2.3. Value and the Risk-Return Trade-Off

The value of a project depends on:

The expected future cash flows

The cost of capital:

▪ An increase in the expected future cash flows may be offset by a

corresponding increase in risk because an increase in risk increases the

projects cost of capital.

▪ This is like the stated price and special financing interest rate, you can

have the same payment with different price rate combinations.

▪ An offset like this is simply a risk-return trade-off.

3. Leverage

According to the CAPM, the required return depends only on the non-diversifiable risk. The non-

diversifiable risk borne by shareholders can be split into two parts:

Operating (business) Risk that results from operating leverage

Financial Risk that results from financial leverage.

3.1. Operating Leverage

Operating leverage arises from the mix of fixed versus variable costs of

production.

High fixed costs (and correspondingly lower variable costs per unit) results in

high-operating leverage.

The firms profits are more sensitive to changes in sales.



WWW.BSSVE.IN

Conversely, low fixed costs (and correspondingly higher variable costs per

unit) result in low-operating leverage.

Operating leverage affects the risk of the firms investments, and is unique for

each investment.

It affects both the diversifiable as well as the non-diversifiable risk of the

investment.

Through its effect on non-diversifiable risk, it also affects the investments cost

of capital.

The firms choice of operating leverage may be limited by the number of

alternative production methods.

3.2. Financial Leverage

The presence of fixed costs associated with debt financing results in financial

leverage.

As financial leverage increases, the variability of shareholder returns

increases.

This increases shareholders risk.

4. The Weighted Average Cost of Capital

The Weighted Average Cost of Capital, WACC, is the weighted average rate of return required

by the suppliers of capital for the firms investment project.

The suppliers of capital will demand a rate of return that compensates them for the proportional

risk they bear by investing in the project.



WWW.BSSVE.IN

4.1. A Potential Misuse of the WACC

Assume new projects being considered have the same risk as the average risk

of the firms existing operations.

If the firm uses its current WACC, it will accept projects with above average

risk and reject projects with below average risk.

Over time, the risk of the firm would then increase.

5. Financial Risk

Financial risk is due to the presence of debt financing used by the firm.

An all-equity financed firm has no financial risk.

A firm can control its financial risk by its choice of capital structure and the maturities of its

obligations.

6. Financial Leverage and the Cost of Capital

In perfect capital markets, financial leverage has no effect in the WACC.

WACC is independent of the capital structure.

In which case, a projects value is not affected by the way in which its financed.

However, even then, financial leverage does alter how the risk of the project is borne by the

debtholders and the shareholders.

As financial leverage increases, the risk borne by both the debtholders and the shareholders

increases.

In the limit, the debt holders become shareholders, except for taxes and contracting

considerations.



WWW.BSSVE.IN

7. WACC for a Different Business

Consider a firm that intends to expand into a new line of business. What WACC should it use for

evaluating this proposal?

If the new line of business is of different risk than the firms existing assets, the firms WACC

cannot be used.

7.1. Operating Leverage and the WACC

In contrast to financial leverage, higher operating leverage increases asset risk,

A, and therefore directly increases the WACC.

Also, like financial leverage higher operating leverage leads to a higher beta.

Given technology, a firm may not have much choice over its operating

leverage, and therefore not much choice about its WACC.

: Business Investment Rules

Topic Objective:


Describe the process of capital budgeting.

Calculate various investment criteria.

Understand the strengths and weaknesses of NPV, IRR, and other investment criteria.

Explain why an NPV profile is the most useful investment criterion.



WWW.BSSVE.IN


Capital Budgeting Process: The five steps in the capital budgeting process are:

Generating ideas for new projects, which can be extremely valuable to the firm.

Reviewing existing projects and facilities to see if any should be added, combined, or

abandoned.

Preparing informal or formal proposals based on the type of firm and the classification of the

project.

Evaluating the proposed projects and choosing which projects to approve as part of the capital

budget.

Preparing appropriations requests.

Key Points:

1. The Capital Budgeting Process

The capital budget is made up of the firms planned capital expenditures. Capital budgeting

projects can be classified into several categories:

Maintenance Projects

Cost Savings/Revenue Enhancement

Capacity Expansions in Current Business

New Products and New Businesses

Projects Required by Government Regulation or Firm Policy

1.1. Preparing Proposals

Generally, the originator presents a written proposal.

Most large firms use standard forms, and these are typically supplemented by

written memoranda.

There may be consulting studies prepared by outside experts.



WWW.BSSVE.IN

2. Internal Rate of Return

The internal rate of return is the discount rate that sets NPV of the expected cash flows to zero.

The internal rate of return is the projects expected return.

Undertake a project if the IRR exceeds r, the projects cost of capital.

3. Using NPV and IRR

Most of the time NPV and IRR are both valuable guides to making decisions.

There are occasions, however, where NPV and IRR disagree.

3.1. NPV Profile

An NPV profile plots the projects NPV as a function of the discount rate.

It shows both the NPV and the IRR of the project.

It can be used to identify the range of cost of capital at which the project

would add value to the firm.

3.2. Types of Projects

A conventional project is one that has an initial cash outflow, followed by one

or more expected future net cash inflows.

A non-conventional project may have several net cash outflows and inflows.

Two projects are independent if undertaking one does not affect the other.

IRR and NPV methods agree for conventional, independent projects.

Two projects are mutually exclusive if undertaking one precludes taking the

other.

IRR and NPV methods can yield conflicting decisions when choosing

between mutually exclusive projects.



WWW.BSSVE.IN

3.3. When IRR and NPV Can Disagree

Mutually exclusive projects with:

Differences in size.

Differences in cash flow timing.

Reverse conventional projects.

4. Cash Flow Timing Differences

The conflict between the NPV and the IRR arises because of differences in each methods

assumption regarding the re-investment rate.

The NPV method assumes that future cash flows from the project will be reinvested at the

projects cost of capital.

The IRR method assumes that future cash flows from the project will be reinvested at the IRR.

Plot each projects NPV profile.

Find each projects IRR.

5. Other Capital Budgeting Criteria

Profitability Index

Modified Internal Rate of Return (MIRR)

Payback

Discounted Payback

Urgency



WWW.BSSVE.IN

5.1. Profitability Index

Decision Rule: Undertake the project if the payback is less than a preset

amount of time.

Discounted Payback Method: The discounted payback is the length of time it

takes for the projects discounted cash flows to equal its investment.

5.2. Urgency

This method says invest in the project when you absolutely have to.

Replacement decisions: replace the asset only after it has broken down!

It ignores planning ahead.

: Capital Budgeting Cash Flows

Topic Objective:


Explain the importance and difficulty of incorporating the effects of erosion and enhancement on

the firms existing operations.

Incorporate effects of inflation into an NPV calculation.

Explain importance of using current tax laws.


Net Cash Flow: The net cash flow for the initial investment is made up of cash paid for

new capital assets, change in net working capital, cash received on the sale of old

equipment, and tax paid (saved) on the sale of old equipment.



WWW.BSSVE.IN

Net salvage value: Net salvage value = S -T(S - B) - (1 - T)REX + ΔW is the equation

for net salvage value. S is the cash received from the sale of the equipment. The tax paid

on this sale, T(S - B), is subtracted as a cash outflow. Note that if B exceeds S, there is a

negative tax that, when subtracted, creates a tax credit. After-tax cleanup and removal

expenses, (1 - T)REX, are also subtracted as a cash outflow. Finally, the release of

working capital, ΔW, from the project is a cash inflow to the firm.

Nominal Rate of Return: The nominal rate of return can be broken down into its two

components, the real rate of return and inflation. (1 + rn) = (1 + rr)(1 + i) is the

relationship between the nominal rate of return, the real rate of return and inflation, which

reduces to Equation (7.5): rn = rr + i + i rr

Taxes: Taxes are large expenses for firms. Current tax laws are important to the

evaluation of a capital investment project because they affect the value of the project. A

change in tax laws could potentially turn a positive-NPV project into a negative-NPV

projector the reverse, and tax laws change frequently.

Key Points:

1. Overview of Estimating Cash Flows

Costs and benefits are measured in terms of cash flownot income.

Cash flows are incremental (marginal).

The cash flows with the project minus the cash flows without the project.

Cash flows are after tax.

Cash flow timing affects the projects value.

Financing costs are included in the cost of capital.

2. Tax Considerations

Taxes and the timing of tax payments significantly affect the incremental cash flows. The

relevant tax rate is the firms marginal tax rate, T.



WWW.BSSVE.IN

Revenues, represented by R, increase tax liability by TR. When the revenue and the tax

treatment occur simultaneously, the after-tax cash flow is the revenue minus the tax liability:

After-tax revenue cash flow = R T x R

After-tax revenue cash flow = (1 T) R

Less obvious is that expenses, represented by E, reduce tax liability.

When the revenue and the tax treatment occur When the expense and the tax treatment occur

simultaneously, the algebraic signs carry through and the after-tax cash flow is minus the

expense plus the reduced tax liability:

After-tax expense cash flow = E + T x E

After-tax expense cash flow = (1 T) E

In some cases the cash flow and tax treatment are separated. This complicates the analysis.

The most common situation where they are separated is when an asset is capitalized

(depreciated).

Let I0 be a net expenditure to be capitalized, and Dt be its depreciation expense to be claimed in

year t.

The separated incremental after-tax cash flow for each depreciation expense is +T Dt. (This is

just like the +T E for an expense.)

3. Calculating Incremental Cash Flows

Net initial investment outlay.

Future net operating cash flows.

Non-operating cash flows required to support the initial investment outlay.

Net salvage value received upon termination of the project.



WWW.BSSVE.IN

3.1. Changes in Net Working Capital

At the start of a project, an investment of net working capital may be required.

Operating cash

Inventory

Accounts receivable

But, an increase in accounts payable offsets some of the net working capital

needs.

A project could also reduce the net working capital requirements.

3.2. Net Cash Flow from Sale of Old Asset

If an existing asset is being replaced by a new one, the sale of the old asset

may generate a cash flow.

If the selling price is greater than the net book value of the old asset, taxes will

have to be paid on this sale.

If the selling price is less than the net book value of the old asset, a tax credit

is generated.

Let S0 be the selling price of the old asset, and B0 be its net book value.

Taxes on the sale will be T (S0 B0). So the net cash flow from the sale of old

asset is: S0 - T (S0 B0)

3.3. Net Initial Outlay

Let C0 be the net initial outlay. Let DW be the change in the net working

capital. Let Ic be the investment tax credit. Then,

C0 = I0 DW (1 T) E0 + S0 T(S0 B0) + Ic



WWW.BSSVE.IN

3.4. Net Salvage Value

Let S be the selling price of the asset and B its book value. Let REX be the

cleanup and removal expenses (to be expensed) and DW the net working

capital recovered upon termination of the project.

Net salvage value = S - T(S - B) - (1 - T)REX + DW

4. Inflation

Inflation affects the projects expected cash flows.

Inflation also affects the cost of capital.

So effects of inflation must be properly incorporated in the NPV analysis.

4.1. Effect of Inflation on the Cost of Capital

Inflation increases the nominal amounts of both revenues and expenses, even

though their real values may stay the same.

However, depreciation expense is fixed. It is based on historical cost.

If expected future cash flows are given in nominal terms, then we must use the

nominal cost of capital to calculate their present value.

If expected future cash flows are given in real terms, we must use the real cost

of capital to calculate their present value.

4.2. Inflation and NPV Analysis

The NPV of the project is unchanged as long as the cash flows and the cost of

capital are expressed in consistent terms.

If inflation is expected to affect revenues and expenses differently, these

differences must be incorporated in the analysis.



WWW.BSSVE.IN

4.3. Depreciation

The total amount of depreciation tax credits over the life of the project is

independent of the depreciation method used.

The present value of these tax credits are dependent on the depreciation

method.

A firm should use the depreciation method that results in the largest present

value of depreciation tax credits.

5. Evaluating Replacement Cycles

Certain assets need to be replaced after the original is worn out.

The initial choice may involve alternative models that essentially do the same job but differ in

their costs and usable life.

: Capital Budgeting In Practice

Topic Objective:


Describe the important role of capital budgeting options in valuing projects.

Distinguish between hard and soft capital rationing.

Describe the important role in capital budgeting of factors that are difficult to quantify.

Explain the drawbacks of simple mechanical rules in complex capital budgeting cases.

Apply the principles of finance to capital budgeting.



WWW.BSSVE.IN


Expansion Option: An expansion option is the ability to change the size of a project. A

price-setting option is the ability to change the cash flows of a project by changing a

products price. An abandonment option is the ability to quit a project if it is more

profitable than continuing. A postponement option is the ability to wait for more

information before making a decision. The replacement option is the ability to continue

using equipment or buy new equipment. Future investment options arise because a

capital budgeting project may not be profitable in and of itself, but it may give rise to

future positive-NPV projects.

Post-audits: Post-audits are important because actual cash flows can be compared to the

estimates. This comparison can help improve the ability of the analysts that made the

estimates. One of the pitfalls of post-audits is the difficulty of measuring opportunity

costs and options. Also, measuring and identifying cash flows from a decision may be

impossible.

Pricing of a product: The pricing of a product has important implications for capacity

because price affects demand. If a firm raises the price of its product, it will sell less of

the product. Likewise, if a firm lowers the price, it will sell more of the product. The

pricing of a product can affect the decision of whether to expand or not because the

decision to raise the price and not expand may have a higher NPV than the decision to

keep pricing constant and expand plant capacity.

Key Points:

1. Real Options

Option to replace an asset

Future investment opportunities

The abandonment option

The postponement option



WWW.BSSVE.IN

1.1. Future Investment Opportunities

These are options to identify future, more valuable investment possibilities

resulting from current opportunities.

Manufacturing and distributing a new product now puts a

marketing/distribution network in place for future use.

Money spent on research and development of a new idea gives the option to

develop the product later on.

Not all future investment possibilities can be accurately measured in terms of

their value.

1.2. The Abandonment Option

The abandonment option is the option to stop the project earlier than

originally planned.

The abandonment value of assets is enhanced by the presence of active used-

equipment markets.

1.3. The Postponement Option

The option to postpone a project is widely used. If anything, it might be used

when it shouldnt be used.

Decision trees can be used to analyze the value of postponement.

Evaluate three mutually exclusive projects:

▪ Start the project today.

▪ Start the project in one year.

▪ Start the project in two years.

▪ Calculate the NPV at time zero for each one and pick the highest



WWW.BSSVE.IN

2. Problems Defining Incremental Cash Flows

Cash flows for a capital budgeting project are computed on an incremental basis.

Incremental cash flows are measured with respect to the status quo.

But this assumes there are not differences in risk.

If two alternative manufacturing processes differ only in their levels of operating leverage, sales

revenues are not affected by the choice of the process.

This does not imply that sales revenues can be ignored in the analysis.

The high-risk projects total cash flows are riskier than the low-risk projects:

With lower sales, the project with the lower operating leverage will also have lower cost.

2.1. Capital Rationing

Capital rationing limits the firms capital expenditures during a given time

period.

The first method reflects managerial desire to be conservative:

In a perfect capital market, a firm can always obtain the necessary funds for a

positive-NPV project.

In practice, obtaining necessary funds may be difficult

2.2. Hard versus Soft Capital Rationing

With hard capital rationing, the limit on total capital rationing is strictly

enforced.

With soft capital rationing, the firm sets a target limit on capital expenditures.

Exceptions may be made if a particularly desirable project becomes available.

Alternatively, the firm might under-spend if conditions warrant.



WWW.BSSVE.IN

2.3. Project Choice Under Capital Rationing

The objective is to select the set of projects that maximize the total NPV of

the capital budget, subject to the constraints on the invested capital.

The Profitability Index (PI) can help in this process.

PI measures the NPV per dollar invested.

2.4. Managing the Firms Capital Budget

Capital rationing can be used as a planning tool for capital expenditures.

A divisional manager must have some leeway in approving capital projects.

If managers are evaluated and rewarded for their performance, self-interested

behavior leads to optimal performance for the good of the firm.

2.5. Post-Audits

A post-audit is a procedure for evaluating the performance of a capital

budgeting decision after its implementation.

Abandonment option.

Advantage of hindsight.

: Options

Topic Objective:


Explain the importance of asset pricing models.

Demonstrate choice of an investment position on the Capital Market Line (CML).

Understand the Capital Asset Pricing Model (CAPM) and its uses.

Describe the arbitrage pricing model and differentiate it from the CAPM.



WWW.BSSVE.IN


Option: An option is the right to do something, without the obligation to it. A call option

is the right to buy an asset and a put option is the right to sell an asset.

Strike Price: The strike price is the price at which the option holder may buy or sell the

underlying asset when the option is exercised. In-the-money means that it is

advantageous to exercise an option as opposed to buying or selling the underlying in the

open market. Out-of-the-money means that it is not advantageous to exercise an option

because the option holder could get a better price by buying or selling the underlying in

the open market. Exercise value is the amount of advantage an in-the-money option

offers over buying or selling the underlying in the open market. The time value of an

option is its price minus its exercise value.

American Call Option: An American call option traded in an efficient capital market

will never be worth less than its exercise value because of arbitrage. If a call was selling

below its intrinsic value, traders would simultaneously buy the call, exercise it, and sell

the underlying asset to get a riskless profit. Traders will do this until their buying causes

the price of the call to equal the exercise value and they can no longer profit from such a

transaction.

The exercise value is determined by the price of the underlying, the strike price, and whether the

option is a put or call. The greater the value of the underlying minus the strike price, the greater

the exercise value of a call. The greater the value of the strike price minus the underlying, the

greater the value of a put. The time premium is affected by time until expiration, the risk of the

underlying asset, and the riskless return. A longer time until expiration results in a higher time

value. A greater risk in the underlying asset also causes a higher time value. A higher riskless

return increases the time value of a call and decreases the time value of a put.



WWW.BSSVE.IN

The time premium for an American option can never be negative because an American call

option can never be worth less than its exercise value. An American call option can never be

worth less than its exercise value because of the arbitrage transactions of simultaneously buying

the call, exercising it, and selling the underlying to realize a riskless profit.

An American option is never worth less than a comparable European option because the holder

of an American option can exercise the option at any time during the options life whereas the

holder of a European option can only exercise on the expiration date. The American option

offers more optionality, because the choice of when to exercise is an option is itself an option,

and as always, options are valuable.

At expiration, each option on an individual asset can be in-the-money or out-of-the-money. An

owner will discard all the out-of-the-money options (bad outcomes) and take the exercise value

of all the in-the-money options (good outcomes). But with a single option on a comparable

portfolio the good and bad outcomes for the assets can partly cancel each other out (because of

diversification) before value of the option is determined. The result is that bad outcomes of

assets are included and hurt the single options value, whereas bad outcomes for options on

individual assets are discarded (no obligation). Therefore the single option on a portfolio is

never worth more (and almost always worth less) than a portfolio of comparable options on

individual assets.

Key Points:

1. Options: Basic Terminology

An option is the right to do something, without the obligation to do it.



WWW.BSSVE.IN

A call option is the right to buy an asset at a fixed price, within a fixed time period.

A put option is the right to sell an asset at a fixed price, within a fixed time period.

Exercising the option involves exchanging cash for the underlying asset.

When a call option is exercised by the holder, the underlying asset is purchased by paying the

exercise price.

When a put option is exercised by the holder, the underlying asset is sold for the exercise price.

An option is in-the-money if exercising it provides an advantage over directly buying or selling

the underlying asset in the open market.

A call option is in-the-money if the open market price of the underlying asset is more than the

exercise price.

A put option is in-the-money if the open market price of the underlying asset is less than the

exercise price.

An option is out-of-the-money if directly buying or selling the underlying asset in the open

market provides an advantage over exercising it.

A call option is out-of-the-money if the open market price of the underlying asset is less than the

exercise price.

A put option is out-of-the-money if the open market price of the underlying asset is more than

the exercise price.

The exercise value is the amount of advantage that an in-the-money option provides over buying

or selling the asset at the open market price.

The exercise value of out-of-the-money options is zero.

2. Valuing an Option

At maturity, the value of an option is either zero (if the option is out-of-the-money) or the

positive difference between the value of the underlying asset and the options exercise price (if

the option is in-the-money).

Prior to maturity, the value of the option is generally greater than its exercise value.

This excess value is called the time premium of the option.



WWW.BSSVE.IN

3. The Time Premium of an Option

It arises since the option gives the holder the right to claim certain outcomes and reject others

and is dependent on:

The time until expiration of the option

The risk of the underlying asset

Riskless rate of return (think put-call parity)

4. Asset Risk and Option Values

The higher the risk of an asset, the greater the time premium.

With higher risk, the probability of extremely good outcomes increases.

This increases the probability that the option will be in-the-money at expiration.

Even though the probability of extremely bad outcomes increases, the option will be worthless

anyway.

4.1. Riskless Return and Option Values

The higher the riskless rate of return, the lower the present value of a known future

amount. Exercising the option involves either

The payment of the exercise price by the option holder (in the case of a call),

or the receipt of the exercise price (in the case of a put).

A call holder will pay the exercise price to receive the asset. With higher

riskless returns, the present value of this payment is lower and the call option

value is higher.

A put holder will receive the exercise price to receive the asset. With higher

riskless returns, the present value of this payment is lower and the put option

value is lower.



WWW.BSSVE.IN

5. Hidden Options

Common stock as a call option on the firms assets.

Stakeholder relationships in financial contracting.

Refunding a home mortgage.

Tax-timing options.

Options connected with capital investments.

Variable cost reduction.

6. Portfolios of Options

The value of an option on a portfolio of assets cannot be greater than the sum of the values of

options on the individual assets.

The risk of a portfolio is less than the sum of the risks of the individual assets.

In Section 3 of this course you will cover these topics:Derivatives Applications

Agency Theory

Capital Market Efficiency

Why Capital Structure Matters

Managing Capital Structure


semester end date.





WWW.BSSVE.IN

: Derivatives Applications

Topic Objective:


Describe four basic types of derivative securities.

Use the BlackScholes option pricing model (BSOPM) to value call and put options on common

stock, and also to value warrants.

Explain how a firm can force conversion of its outstanding convertible securities.

Explain how a firm can use derivatives to hedge specific risks.


A derivative is a financial instrument whose value depends on the value of another asset.

The variables that affect the value of a call option are the options strike price, the time to

expiration, the underlyings price, the underlyings volatility, and the riskfree rate.

The exercise value of a put option has an inverse relationship with the exercise value of a

call option. As the exercise value of a call option increases, the exercise value of a put

option decreases.

A warrant is a long-term call option that is issued by a firm. It entitles the holder to buy

shares of the firms common stock at a stated price for cash.

A convertible security is a security that can be converted into common stock at the

option of the holder. Convertible bonds are bonds that can be converted into common

stock at the option of the bondholder and convertible preferred stock is preferred stock

that can be converted to common stock at the option of the holder.

A convertible bond can be viewed as a package consisting of a straight bond and

warrants. The straight bond represents the cash flows to the investor assuming the

investor decides not to convert the bond into common shares. The investors option to



WWW.BSSVE.IN

convert the bond into common shares at a specific conversion ratio can be represented by

a warrant.

An interest rate swap is a contract that obligates two parties to exchange cash flows that

are determined by two different interest rates. The swap contract specifies a notional

amount and the two interest rates. The counterparties calculate the amount of their

payment obligations at the end of each interest period, and the one that owes the greater

amount writes a check to the other counterparty for the difference.

Warrants are options to purchase the firms common stock at a specified price for a

specified period of time. Since options are valuable, warrants are not costless for the firm

to include in the bond issue.

Futures contracts are similar to forward contracts because they obligate two parties to

contract at a price that is set today no matter what the price in the future is. Futures are

different than forward contracts in that they are standardized and are traded on

exchanges.

Key Points:

1. Options

A call option gives the holder the right to buy one share of the underlying stock at a specified

price within a stated time period.

A put option gives the holder the right to sell one share of the underlying stock at a specified

price within a stated time period.

The fixed price is called the exercise or strike price.

1.1. Some Properties of Options

As stock price increases, value of call option increases and value of put option

increases.



WWW.BSSVE.IN

As exercise price increases, value of call option decreases, value of put option

increases.

As the time to maturity increases, value of call option increases, value of put

option increases.

2. Warrants

A warrant is a long-term call option issued by the firm.

Entitles holder to buy a fixed number of shares from the firm, at a stated price, within a stated

time period.

When a warrant is exercised, the number of outstanding shares increases.

3. Convertible Debt

At the option of the bondholder, a convertible bond can be converted into a pre-specified number

of shares of the firms common stock.

Each bond can be converted into common stock at a stated conversion price.

Conversion price exceeds issuers share price at the time of issue by about 10% to 20%.

Conversion price is adjusted for stock splits, stock dividends, rights offerings, and other

distributions.

Conversion ratio is the number of shares that can be purchased with one bond.

Bondholders who convert do not receive accrued interest.

If bonds are called, conversion option expires just before the redemption date.

The market value of a convertible bond always exceeds its conversion value (unless the

conversion option is about to expire).

The difference in the market value and the bonds conversion value is the time premium of the

conversion option.

Time premium is zero at option expiration.

As long as the underlying stock does not pay any dividends, bondholders would never convert

voluntarily.

Sell the bond in the open market since the market value exceeds the conversion value.



WWW.BSSVE.IN

If the stock does pay dividends, bondholders would not convert as long as the interest on the

bond exceeds the total dividends from the stock.

3.1. Forced Conversion

As long as the call price exceeds the market value of the underlying stock,

bondholders will not voluntarily convert.

Calling the bonds merely transfers wealth from stockholders to bondholders.

To force conversion, the firm should call the bonds when the conversion value

reaches the effective call price.

The effective call price = optional redemption premium plus accrued interest.

3.2. Convertible Preferred Stock

Similar to convertible bonds:

Can be exchanged into shares of common, at the option of the preferred

stockholder.

Convertible exchangeable preferred stock can be converted into convertible

debt.

4. Valuing Warrants

Warrants are long-term call options written by the firm.

When a warrant is exercised, the number of shares outstanding increases.

The value of the warrant before it is issued is simply C/(1+ ) where C is the value of a call

option to buy one share.

After the warrant is issued, an efficient market will reflect the dilution in the firms stock price,

and the warrants value is equal to that of the call option.

5. Interest Rate Swaps

An interest rate swap obligates two parties to exchange specified cash flows at specified time

intervals.



WWW.BSSVE.IN

The cash flows are determined by two different interest rates.

The simplest interest rate swap involves swapping fixed interest rates for floating interest rates,

and vice versa.

Only net cash flows are paid by one party to the other.

The amount on which the interest cash flows are based is called the notional amount.

The notional amount is never exchanged.

5.1. Why Swaps Exist

Comparative advantage

Information asymmetries

Transaction costs

6. Forward Contracts

A forward contract obligates the holder to buy a specified amount of a particular asset at a stated

price on a particular date in the future. All terms of the contract are fixed at the time the contract

is entered into:

The amount of the asset.

The specified price (the exercise price).

The delivery date and location.

At contract origination, the NPV if the forward contract is zero.

A forward contract has default risk.

There are no intermediate cash flows during the life of the contract.

Most forward contracts require physical delivery, although some may be cash settled.

7. Futures Contracts

Futures contracts are similar to forward contracts.

A long position in a futures contract obligates you to take delivery of the underlying asset.

A short position in a futures contract obligates you to make delivery of the underlying asset.

The agreed-upon price at which the asset will be traded in the future is called the futures price.



WWW.BSSVE.IN

8. Differences between Forward and Futures Contracts

Forward contract profits (or losses) are recognized only at maturity. Futures profits (or losses)

are recognized daily.

Futures contracts are traded on exchanges, while forward contracts are traded over-the-counter.

Futures contract obligations can be offset by a reversing trade on the exchange.

Active markets exist for futures contracts.

Futures contracts have low default risk.

Futures contracts have greater liquidity.

9. Hedging

A firm engages in hedging to reduce its sensitivity to changes in the price of a commodity, a

foreign exchange rate, or an interest rate.

As interest rates increase, value of the firm falls.

Profits are made on a short position in interest rate futures.

A perfect interest-rate hedge neutralizes the effect of changes in interest rates.

Hedging may be accomplished by using:

Options

Interest rate swaps

Futures or forward contracts

9.1. Hedging with Interest Rate Swaps

A floating-interest-rate borrower can hedge against adverse movements in

interest rates by entering into a swap to pay fixed and receive floating.

An interest rate cap pays the holder if a specified interest rate rises above a

specified value.

An interest rate floor places a lower limit on interest rates.



WWW.BSSVE.IN

9.2. Hedging with Forwards and Futures

Hedge by buying oil futures.

Hedge by selling yen futures (short position).

: Agency Theory

Topic Objective:


Identify and understand contractual relationships in a corporation.

Describe various corporate situations in a principal-agent framework.

Analyze the principal-agent relationships in terms of decision making, control, and incentives.

Identify conflicts of interest when incentives diverge.


Principal-agent Relationship: A principal-agent relationship is a relationship where

an agent makes decisions that affect the principal. Examples of explicit principal-agent

relationships are the relationships between a client and a lawyer and between an investor

and a money manager. Examples of implicit principal-agent relationships are an

employee acting on behalf of its employer and a consumer making decisions, such as

copying and selling a product, that can affect a manufacturer.

Free rider: A free rider is one who receives benefit from someone elses expenditure

simply by imitation. One free-rider problem is the copying of pharmaceuticals. Drug

companies spend hundreds of millions of dollars on research and development to

discover new drugs. Other drug firms are able to duplicate the drug and produce it



WWW.BSSVE.IN

themselves, without the research and development costs. In the United States, patents

protect pharmaceutical companies for a limited time from facing competition from the

free-riding firms.

Agency Problem: An agency problem is a potential conflict of interests between the

agent and the principal. One agency problem is the ability of an employee to slack off

during working hours. Another agency problem is the ability of a manager to make the

decision to grow a company to a large size rather than maximizing shareholders wealth.

Another agency problem is the ability of the stockholders to gamble with the bondholders

money by means of asset substitution.

Agency Costs: Agency costs are the costs of making agents act in the best interest of the

principal. The components are direct contracting costs, monitoring costs, and the

misbehavior costs of agents not acting in the best interest of the principal. An example of

direct contracting costs is an employee bonus. An audit is an example of a monitoring

cost. Shirking by employees is a cost caused by agents not acting in the best interest of

their employer.

Key Points:

1. Principal-Agent Relationships

An agent has decision-making authority that affects the well-being of the principal. Examples of

agents are:

1.1. Agents

Money managers

Lawyers

Corporate managers



WWW.BSSVE.IN

1.2. Principals

Investors in a money market fund

Clients of lawyers

Stockholders of the firm

2. Agency Problem

An agency problem arises when there is a conflict of interest between agents and principals.

It can also arise due to asymmetric information

The principal cannot monitor the agents behavior perfectly.

Moral hazard can occur when agents take actions in their own best interest that are unobservable

by and detrimental to the principal.

3. The Role of Monitoring

The principal can monitor the agents actions, but not perfectly.

Costs are incurred in monitoring the agents behavior.

Perfect monitoring of all actions of the agent can eliminate the agency problem.

This can be prohibitively costly.

There is a trade-off between resources spent on monitoring and the possibility of agent

misbehavior.

3.1. Alternatives to Monitoring

Alternatives to monitoring include:

Constraints on agents behavior

Incentives to align agents interests with the principals interests

Punishments for agent misbehavior

Principal-agent contracts that eliminate all agency problems cannot be

designed



WWW.BSSVE.IN

4. Agency Costs

These are costs incurred in an attempt to push agents to act in the principals best interest.

They are the incremental costs of working through others.

They consist of three types:

Direct contracting costs

Monitoring costs

Loss of principals wealth due to residual, unresolved agency problems

4.1. Direct Contracting Costs

Transaction cost of setting up a contract.

Opportunity costs imposed by constraints that preclude otherwise optimal

decisions

Incentive fees paid to agents to encourage behavior consistent with the

principals goals

5. Role of Financial Contracting

To design financial contracts between agents and principals that minimize total agency costs.

Perfect contracts that eliminate all agency problems are not feasible.

Periodic misbehavior may be less costly than the cost of eliminating it.

The optimal contract transfers decision-making authority from the principal to the agent in the

most efficient manner.

6. Stockholder-Manager Conflicts

Created by the separation of ownership and control of the corporation

Stockholders elect the Board of Directors, who in turn appoint managers

The self-interested behavior of managers may be at conflict with the interest of stockholders

Managers may favor growth and larger size of the firm:

Greater job security

Larger compensation



WWW.BSSVE.IN

Greater prestige

Larger discretionary expense accounts

Consumption of excessive perquisites

7. Non-Diversifiability of Human Capital

Managers expertise is closely tied to the firm.

This leads to a divergence of goals.

7.1. Capital Investment Choices

Preference for low-risk projects even though their NPV may be lower than

other riskier projects. If the firm ceases to operate as a result of bad outcomes

of risky projects, managers lose their jobs.

Asset Uniqueness: If a managers human capital is closely tied to the firm and

the firms assets (and products and services) are unique, a managers human

capital may not be transferable to other firms.

8. Debtholder-Stockholder Conflicts

When a firm issues risky debt, stockholders have an option against the debtholders.

The option to default on debt

Now, stockholders are the agents and the debtholders are the principals.

Debtholders want to protect themselves against adverse decisions taken by stockholders.

This conflict can manifest in three ways:

Asset substitution

Underinvestment

Claim Dilution

8.1. Asset Substitution Problem

Occurs when riskier assets are substituted for the firms existing assets.

This appropriates wealth from the firms existing debtholders.



WWW.BSSVE.IN

Stockholders have the option to default on debt. As the risk of the firms

investments increases, the value of this option increases the expected payment

to debtholders decreases.

With risky debt, stockholders can gain even if the new, risky project has a

negative NPV.

This happens as long as the debt holders loss exceeds the (negative) NPV of

the project.

Stockholders wealth declines by the (negative) NPV.

Stockholders wealth increases by the loss of the debtholders.

A levered position in common stock can be viewed as a call option on the

firms assets.

The exercise price of the call is the amount of money promised to the

bondholders.

If the option is in the money, the shareholders exercise their option and pay

off the bondholders.

If the option is out of the money, the shareholders elect not to exercise and

default on the debt.

A major determinant of the value of a call option is the riskiness of the value

of the underlying assets.

8.2. The Underinvestment Problem

With risky debt outstanding, if stockholders gain from an increase in the risk

of the firms investments, they lose from a decrease in the risk of the firms

investments.

Value of an option declines as the risk of the underlying asset decreases.

Thus, stockholders may refuse to invest in a low-risk but positive NPV

investment.



WWW.BSSVE.IN

8.3. Claim Dilution Problem

Claims of existing debtholders can be diluted in two ways:

Via dividend policy

Via new debt

8.3.1. Claim Dilution via Dividend Policy

▪ Paying out cash dividends has two effects:

▪ It reduces the firms cash and its owners equity.

▪ It increases the risk of the remaining assets (since cash is riskless).

▪ Reduction in owners equity enlarges the firms proportion of debt

financing.

▪ This increases the risk of the debt, and decreases its value.

▪ Increase in the risk of the firms assets also increases stockholder wealth.

▪ Newly issued debt can reduce the chance that existing debtholders will

not be paid the promised amount.

▪ This occurs if the new debts claims are at least as senior as the old debts

claims.

▪ This increased risk of existing debt reduces its value.

▪ Stockholders get the benefit from this decline in value.

9. Consumer-Firm Conflicts

These can be of two types, depending on who is the agent and who is the principal.

Guarantees and Service after Sale



WWW.BSSVE.IN

The Free Rider Problem

9.1. Guarantees and Service After Sale

The firm is the agent, and the consumer is the principal.

If the principal does not expect the agent to fulfill its promise, it will not pay

full value for the firms products and services.

9.2. The Free Rider Problem

The firm is the principal and the consumer is the agent.

The agent has the option to duplicate the firms products/services at a lower

cost.

Examples include copying of computer software, books, videotapes etc.

Copyright and patent laws are designed to protect and encourage the

development of valuable ideas.

10. Working in Contractual Relationships

Financial distress increases the conflicts between the various stakeholders of the firm.

Firms in financial distress have a greater incentive to engage in asset substitutions and

underinvestment - they have little to lose, and a lot to gain.

Stakeholders may form coalitions to act in their best interest, even though these actions may

conflict with shareholder interests.

11. Agency Costs of Overvalued Equity

This is a danger that a firms equity could be overvalued (the opposite of distress).

Much of top management compensation and wealth can depend on the firms stock price.

If a high stock valuation cannot be justified by the firms cash flows, managers may take steps to

justify the high valuation even thought it cannot be sustained.



WWW.BSSVE.IN

Actions managers might take to create a smoke screen include:

Earnings management and earnings manipulation

Massive capital investment campaign

Use overvalued equity to purchase other firms

Managers with overvalue equity are in a difficult position.

12. Mitigating Stockholder-Manager Conflicts

Agents with good reputation can demand higher prices for their products /

services. Management contracts can include monetary incentives:

Stock options

Performance shares

Bonuses:

Threat of takeovers and replacement can induce managers to act in

shareholder interests.

Debt-holders may restrict wealth appropriating behavior on the part of

stockholders through debt contracts.

An indenture is the explicit legal contract for a publicly traded bond.

The indenture contains covenants:

▪ Negative covenants restrict certain actions of the firm.

▪ Positive covenants require certain actions on the part of the firm.

▪ Covenants benefit the bondholders by lowering the risk of the bonds.

▪ They also benefit the stockholders since the reduced risk of the bonds

implies lower interest rates.

▪ Covenants can be costly to the stockholders:



WWW.BSSVE.IN

13. Monitoring Devices

13.1. New External Financing

When a firm seeks new external financing, it is subject to special scrutiny.

The willingness of investment bankers to underwrite the issue acts as a

certification device.

Firms that frequently raise capital from external sources are monitored more

efficiently.

Other devices include:

▪ Financial statements and auditors reports

▪ Cash dividends

▪ Bond ratings

▪ Bond covenants

▪ Government regulation

▪ The legal system

▪ Reputation effects

▪ Multi-level organizations

: Capital Market Efficiency

Topic Objective:


Explain why it makes sense that capital markets should be efficient.

Describe factors that help make capital markets efficient.

Describe sufficient conditions for a perfect capital market.

Explain how market imperfections affect capital market efficiency.



WWW.BSSVE.IN


Public securities: Public securities provide a measure of value because the prices at

which they are traded are quickly reported to the public. The price of the last transaction

reflects all current information and is a good measure of the value of the security.

Perfect Market: A perfect market can be defined as a market in which there are never

any arbitrage opportunities.

A zero NPV does not mean that the investor does not earn any money, rather, it means

that the investors earns a percentage return that is fair according to the risk of the

investment.

Asymmetric taxes, asymmetric information, and transaction costs are capital market

imperfections that can impact corporate decisions. Asymmetric taxes mean that the

parties to a transaction have different tax treatment, such as having different rates or even

methods of taxation. Because of this, both parties can be better or worse off because they

make a transaction in a particular way. For example, asymmetric taxes can make it

beneficial to both a corporation and its investors to use at least some debt contracts for

the investment in the corporation. Thus, asymmetric taxes can affect the type of security

a corporation decides to issue. Asymmetric information means that participants do not all

have the same information. In such cases, if participants refuse to make transactions,

market prices may be incorrect. For example, participants might refuse to purchase new

shares of stock unless they believe they are buying the stock for less than its true value.

Thus, asymmetric information might cause a firm to use internal rather than external

financing for a capital budgeting project. Transaction costs are the time, effort, and

money required to make a transaction. Transactions costs discourage transactions

because they reduce the value of a transaction by draining of part of its value. For

example, transaction costs usually make it better for a corporation to borrow larger

amounts of money less frequently, even if some of the borrowed money must be

temporarily invested in low return/low risk investments. Thus, transaction costs might

cause a corporation to temporarily alter its capital structure.



WWW.BSSVE.IN

Key Points:

1. Efficiency

Even if capital markets are not perfect, they can be efficient. Efficiency refers to the amount of

wasted energy. Efficient machines work without frictions, without a loss of energy.

1.1. Frictions in Capital Markets

Frictions in the capital markets prevent these markets from being perfectly efficient.

Frictions include:

Transaction Costs: time, effort, and money required to make a transaction.

Asymmetric taxes

Asymmetric information

1.2. Liquidity and Value

In an efficient capital market, the transfer of assets occurs with little loss of

wealth.

In such markets, prices reflect all available information.

Thus, financial asset prices are fair prices.

They are neither too high, nor too low.

1.3. Three Forms of Capital Market Efficiency

Strong form of capital market efficiency: Current prices reflect all information that can possibly

be known to anyone.

Semi-strong form of capital market efficiency: Current prices reflect all publicly available

information.



WWW.BSSVE.IN

Weak form of capital market efficiency: Current prices reflect only the information contained in

past prices.

1.4. Why Capital Markets Exist

Capital markets facilitate the transfer of capital (i.e. financial) assets from one owner to another.

They provide liquidity.

Liquidity refers to how easily an asset can be transferred without loss of value.

A side benefit of capital markets is that the transaction price provides a measure of the value of

the asset.

1.5. Implication of Efficiency for Investors

Future market prices cannot be predicted based on available information.

Investments in these markets have a zero NPV.

The expected rate of return equals the required rate of return.

The expected rate of return compensates the investor for the risk borne.

Abnormally high returns are earned by pure chance.

1.6. Arbitrage: Striving for Efficiency

Arbitrage refers to buying an asset in one market and selling it at a higher

price in another market.

People who engage in arbitrage are known as arbitrageurs (or simply, arbs).

In a perfect market, there are no arbitrage opportunities.

As soon as one is discovered, competition among arbitrageurs will eliminate

it.

1.7. Arbitrage versus Speculation

In an arbitrage transaction, the asset is bought and sold immediately.



WWW.BSSVE.IN

Speculators hold the asset for some time period, and thereby incur risk.

Speculators try to anticipate future prices and trade on their beliefs.

The future price is based on imperfect information that they receive about the

value of the asset.

2. Signaling and Information Gathering

Market participants react quickly to events that convey useful information.

Actions convey asymmetric information.

Watch what management does.

Interpreting signals is a valuable talent.

Deductive reasoning: a general fact provides information about a specific situation.

Inductive reasoning: a specific situation is used to draw general conclusions.

3. The Collective Wisdom

In an efficient capital market, prices reflect all available information.

When new information arrives, prices react instantaneously to it.

Since new information is that which cannot be predicted, it would arrive at random points in

time.

Price movements are random (i.e. cannot be predicted).

4. Value Conservation

In a perfect market, value is conserved across transactions.

Imperfections (taxes, transaction costs) may appear to violate the law of value conservation.

Value conservation holds if all losses due to frictions are included.

5. Implications for corporate financing

Firms create most of their value with positive-NPV real investments.



WWW.BSSVE.IN

Positive NPV financing can occur due to

Tax savings from a tax asymmetry

Reducing flotation or transactions costs

Financing that reduces agency costs

Designing securities that reduce or reallocate risk

Fooling or lying to investorsbackfires.

6. Perfect Capital Markets

No barriers to entry.

Perfect competition.

Each participant is sufficiently small and cannot affect prices by her/his actions.

Financial assets are infinitely divisible.

No transaction costs.

All information is fully available to every participant, at no cost.

No tax asymmetries.

No restrictions on trading.

6.1. The three persistent imperfections

Asymmetric taxes

Asymmetric information

Transaction costs

7. Empirical Challenges to the Efficient Market Hypothesis (EMH)

Tests of the weak-form EMH

Serial correlation tests

Runs tests

Trading rules

Momentum indicators



WWW.BSSVE.IN

Tests of semistrong-form EMH

8. Behavioral Challenges to Market Efficiency

Psychological behaviors may interfere with market rationality

Investors remember winners and forget losers

Investors trade too much

Sell winners early and hang on to losers (disposition effect)

Investors hang on to get their money back

Investors dont rebalance or diversify appropriately.

There are many anomalies in investor and manager behavior.

Recognize and avoid psychological biases in your own decision making.

Biases of others may provide opportunities to profit. Not all markets are as efficient as financial

markets.

: Why Capital Structure Matters

Topic Objective:


Describe six different views of capital structure.

Describe how these views depend on the three capital market imperfections.

Explain how capital market imperfections lead to a preference ordering of financing alternatives.

Evaluate the effect of capital structure on the firms weighted average cost of capital.


Corporate Tax View: The corporate tax view of capital structure is the view that since interest

payments on debt are tax deductible and dividend payments are not, the after-tax cost of capital



WWW.BSSVE.IN

is cheaper for debt than for equity. Optimally, a firm should be 100% debt financed. According

to the perfect market view, the WACC curve is a horizontal line. The WACC does not change

with the mix of debt and equity financing because there is no asymmetric tax or transaction cost

causing one type of financing to be advantageous to the other. The capital market imperfections

view of capital structure incorporates the several other views into an overall view of capital

market capital structure. It states that debt financing is generally valuable, but a companys

optimal choice of capital structure is a dynamic process in a complex environment that involves

a mixture of financing methods. The exact mix at any particular point results from considerations

of asymmetric taxes, asymmetric information, and transaction costs.

Key Points:

1. Capital Structure

Capital structure refers to how a firm is financed.

In simple terms, capital structure refers to the proportion of debt financing used by the firm.

1.1. Perfect Market View of Capital Structure

In perfect capital markets, capital structure does not affect firm value.

Capital structure choice is a pure risk-return tradeoff.

Leverage does not affect the firms cost of capital.

1.2. Arbitrage Argument for Capital Structure Irrelevance

If firm value varies with leverage, arbitrage profits can be made.

In perfect markets, arbitrage opportunities cannot exist.

The arbitrage profits are eliminated when firm value is independent of capital structure.



WWW.BSSVE.IN

2. Capital Market Imperfections: Corporate Income Taxes

Interest payments made by a corporation are tax deductible, while dividend payments are not.

This tax asymmetry makes debt financing cheaper than equity financing.

The corporate tax view of capital structure implies that firm value is maximized when the firm is

all-debt financed.

2.1. Personal Income Taxes

Interest and dividend income received by investors in the firm is taxed immediately upon receipt.

Capital gains are taxed only when the shares are sold.

Capital gains taxes can be postponed by not selling the shares.

Capital losses can be deducted immediately by realizing the gain.

Tax timing option is valuable.

The capital gains timing option lowers the effective tax rate on shareholder income.

The differential between tax rates on personal income from debt and equity cancels out the effect

of corporate tax asymmetry.

The personal tax view is that capital structure is again irrelevant.

2.2. Capital Structure with Corporate and Personal Taxes

With corporate and personal taxes, the firm value and shareholder wealth is independent of the

firms capital structure.

The personal tax asymmetry cancels the effect of the corporate tax asymmetry.

This occurs only for a particular set of tax rates.

3. Agency Costs View of Capital Structure

Capital market imperfections resulting from agency cost considerations create a complex

environment in which capital structure affects firm value. There are four types of costs:

Debt

Equity



WWW.BSSVE.IN

Employee

Consumer

3.1. Agency Costs of Debt

Asset substitution

Claim dilution

Underinvestment problem

Asset uniqueness

As leverage increases, the potential for these conflicts increases.

The cost of resolving these conflicts increases.

There are agency costs associated with obtaining any financing.

Agency costs are also associated with other firm claimants:

▪ Employees

▪ Customers

▪ Society

4. Bankruptcy Cost View of Capital Structure

Capital market imperfections associated with financial distress and bankruptcy offset the other

benefits from leverage created by taxes and agency costs.

At the optimal capital structure, the marginal expected costs of financial distress and bankruptcy

equal the marginal benefits of leverage.

Firm value is at a maximum.

4.1. Direct Costs of Bankruptcy

Notification costs, court costs, legal fees.

Paid only if bankruptcy occurs.

Generally small when compared to the indirect costs.



WWW.BSSVE.IN

4.2. Indirect Costs of Bankruptcy

Lost tax credits.

Lost sales and goodwill.

4.3. Expected Costs of Bankruptcy

The expected costs of bankruptcy depend on:

The degree of specialization of a firms assets.

Type of assets - tangible versus intangible.

Personal and corporate taxes.

Agency costs.

5. Pecking Order View of Capital Structure

The firm incurs transaction costs when external financing is obtained.

There are both direct and indirect costs.

In the pecking order view, the firm should use the method of financing with the least amount of

transaction costs first.

Financing methods with higher transaction costs are used next.

Retained earnings (internal equity) have the least cost.

Debt-Equity combinations are third in the pecking order.

New external equity comes last in the pecking order.

6. Signaling and Capital Structure Decisions

A firms decision about a projects financing reflects its choice of capital structure.

It also conveys information about the project.

If a project has a large positive NPV, financing it internally will allow the current owners of the

firm to get all of the benefits.



WWW.BSSVE.IN

If a project has a small (or zero) NPV, the current owners would be indifferent to allowing

outside investors to share in the gains.

Thus, how a project is financed (internal versus external funds) conveys information about the

projects value.

Alternatively, if the firm is currently overvalued, existing owners may want to seek outside

partners so as to share the decline in value.

If the firm is currently undervalued, the firm might use debt financing to keep the gains to

themselves.

Thus, new equity issues signal overvaluation, while new debt issues signal undervaluation.

7. Financial Leverage Clienteles

Investors will take into account their own tax situations into account in deciding which firm to

invest in.

The clientele effect refers to the investors choice of a particular security or a firm with a

particular capital structure.

Investors in high tax brackets may find debt securities less attractive.

Debt income is taxed at a higher rate than equity income.

Investors in low tax brackets may prefer corporate leverage to personal leverage because of the

higher corporate tax rate.

When a firm selects its capital structure, it attracts investors with a certain personal-tax driven

incentive for investment.

High leverage firm will attract investors in lower tax brackets and vice versa.

If the demand for each type of leverage is satisfied, there is no gain from changing the current

capital structure.

8. Capital Market Imperfections View of Capital Structure

Debt is generally valuable.

At low levels of leverage, the expected costs of financial distress are low.

As leverage increases, these costs increase and at some level will exceed the benefits of leverage.



WWW.BSSVE.IN

: Managing Capital Structure

Topic Objective:


Apply concepts of capital structure theory to choose a firms capital structure.

Explain why a firms senior debts rating indicates the firms exposure to default risk.

Use debt ratings to choose and manage the firms capital structure.


Pro forma analysis: Pro forma analysis is important when choosing a capital structure to make

sure that the firm will be able to service the debt and use its tax credits.

Selecting a target senior debt: Selecting a target senior debt rating is a reasonable approach to

choosing a capital structure because it ensures that the firm has access to the debt markets. A

single-A rating is prudent because it is more likely that the firm will have access to the debt

markets at all stages in the economy. Below a single-A rating, the company may not be able to

raise capital during economic downturns, a time when the firm may need capital the most.

Key Points:

1. Industry Effects

There are systematic differences in capital structures across industries. These are largely due to

differences in:

The degree of operating risk.

Non-debt tax shelters such as depreciation, tax credits and operating tax loss carryforwards.



WWW.BSSVE.IN

The ability of assets to support borrowing.

2. Debt Ratings

Two major debt rating services:

Moodys Investor Service, Inc.

Standard & Poors Corporation.

These ratings are indicators of the likelihood of financial distress.

The lower the rating, the higher the risk.

The highest four rating categories are known as investment grade ratings.

Various state laws impose minimum ratings standards and other restrictions that bonds must

meet to qualify as legal investments.

2.1. Choosing a Bond Rating Objective

The choice of a bond rating objective involves a decision about:

The chance of future financial distress, and

Desire to maintain access to capital markets.

When a firm that uses less than value-maximizing debt, the missed value can be seen as a margin

of safety.

The desired margin of safety depends on the firms willingness to bear financial risk.

2.2. Bond Rating Criteria

Ratings agencies use many different criteria to rate a bond, including financial ratios

including:

Market position

Strength of management

Improving credit ratings requires a proven track record.

Standards and averages may change over time.



WWW.BSSVE.IN

Operating risk

Profitability

Conservatism of accounting policies

Fixed-charge coverage

Adequacy of cash flow to meet future debt service obligations

Future financial flexibility

3. Factors Affecting a Firms Choice of Capital Structure

Ability to service debt

Ability to use interest tax shields fully

Protection against illiquidity

Desired degree of access to capital markets

Dynamic factors and debt management over time

3.1. Choosing an Appropriate Capital Structure

Comparative Credit Analysis

Ability to service debt.

Ability to use interest tax shields fully.

Protection against illiquidity.

4. Comparative Credit Analysis

Select the desired rating objective.

Identify a set of comparable firms that also have the desired senior debt rating.

Perform a comparative credit analysis of these firms to define a range of capital structures

consistent with the rating objective.



WWW.BSSVE.IN

4.1. Selected Items for Comparative Credit Analysis

Profitability measures

Capitalization measures

Capitalization ratios

Fixed charge coverage ratios

Current year

Prior years

5. Pro-Forma Analysis

The objective is to project the firms ability to maintain the desired bond rating in the future.

The analysis is conducted under various assumptions about the growth in pre-interest taxable

income:

The final decision also depends on the managements willingness to bear the risk of financial

distress.

6. Other Aspects of Capital Structure Decisions

Subordinated debt

Convertible debt

Capitalized lease obligations

Preferred equity

6.1. Changing the Capital Structure

Issue new securities of the desired type and amount.

Exchange offer

Recapitalization offer

Debt or share repurchase

Stock-for-debt swap



WWW.BSSVE.IN

6.2. The Projects Cost of Capital

The WACC (an opportunity cost) can be expressed as: WACC = (1 - L)re + L(1 - T)rd

However, L, T, re, and rd are more easily measured for the firm than for a specific project.

Financing cannot be accounted for on a project-by-project basis.

Loans also can be tied to specific assets or projects, and the firms capital structure will change

over time.

Many corporations, therefore, use the Adjusted Present Value method for capital budgeting

projects.

6.2.1. Adjusted Present Value

▪ Consider the case where a firms debt is tied to one or more specific asset:

▪ The interest and principal payments occur within the assets life.

▪ The assets value declines over time with use.

▪ The capital structure (i.e. remaining debt) changes over time as debt is

repaid.

▪ In such cases, the Adjusted Present Value (APV) accounts for the

changing capital structure over the assets life.

▪ The APV is the present value of the project as if it were financed solely

with equity plus the net benefits from debt financing.

6.2.2. Leverage Rebalancing

▪ A firms actual capital structure may deviate from the optimal capital

structure.

▪ Adjusting the capital structure to bring it back to the optimal level is

called leverage rebalancing.



WWW.BSSVE.IN

▪ If the firm has perpetual debt, and its leverage ratio is constant (at the

optimal level of L*), then the net gain from leverage is T*rdD.

▪ The present value of these net gains is

▪ With leverage rebalancing, only the first years benefit can be discounted

at rate rd.

▪ The net benefit in subsequent periods must be discounted at the

unleveraged rate r.

▪ The net benefit will vary as the project value varies in the future.

▪ The net benefit from leverage in period 1 is T*rdD = T*rd(LVL) =

▪ The net benefit in each subsequent period t (t > 1) is: T*rdD =

T*rd(LEVL) = h

7. Estimating the WACC for a Capital Budgeting Project

Choose one or more publicly traded firms that are comparable in risk and return to the project.

Estimate L

Estimate rd as the yield to maturity of the firms outstanding debt

Estimate re

Estimate the firms marginal tax rate, T

Estimate the net benefit to leverage factor, T*

For each comparable firm, use the parameter estimates from above to estimate

Make a single estimate of r. Usually an average can be used, but use your judgment.



WWW.BSSVE.IN

In Section 4 of this course you will cover these topics:Why Dividend Policy Matters

Issuing Securities And The Role Of Investment Banking

Long-Term Debt

Leasing And Other Asset-Based Financing

Liquidity Management


semester end date.


area to save and continue later

: Why Dividend Policy Matters

Topic Objective:


Describe common dividend policy characteristics.

Explain the mechanics of dividend payments.

Apply the three-step approach to dividend decisions.

Distinguish special dividends from regular dividends and stock dividends from cash dividends.

Describe five methods of share repurchase.


Dividend policy: Dividend policy is irrelevant in a perfect capital market because no wealth is

transferred through the payment of a dividend. When a dividend is paid, the stockholder

receives cash, but the value of the equity decreases by the amount of the dividend. The signal of

paying a dividend can cause dividend policy to affect a firms value because it mitigates the

information asymmetry between owners and management. The payment (or non-payment) or



WWW.BSSVE.IN

increase (or decrease) of a dividend sends a signal to the owners about the financial health of the

firm.

Dividend Clientele: A dividend clientele is a group of investors with the same preference for

dividends because of their similar tax status. The existence of dividend clienteles can eliminate

the tax differential view of dividend policy because each clientele will purchase securities with

the type of preferred dividend policy. As long as there is a sufficient supply of all types of

securities, investors will not pay a premium for a security with a specific type of dividend policy.

Share repurchase programs and dividend payments can be viewed as substitutes for each other

because both are methods of distributing cash to the shareholders, and neither have an effect

shareholder wealth in a perfect capital market environment. A share repurchase program will

distribute cash to the shareholders that choose to sell their holdings. A dividend payment will

distribute cash to all shareholders. A share repurchase program and a dividend payment can be

perfect substitutes for each other in a perfect capital market. The major advantages of share

repurchase over a cash dividend are that the distributions are taxed at the capital gains tax rate

instead of the ordinary income tax rate and that the shareholder has the option of whether to

participate or not. In a share repurchase, the shareholder sells stock holdings to the company,

resulting in capital gain, whereas a dividend payment is treated as ordinary income. A share

repurchase also creates a valuable tax timing option because shareholders with a low cost basis

can choose not to sell shares and thus avoid a large tax liability.

A firms share price falls on the ex-dividend date because new shareholders will not be able to

receive the dividend. Since the value of a stock is the present value of the future cash flows, new

investors that do not receive the dividend will value the stock at a lower price. The price should

fall by the amount of the dividend. A stock dividend should have the same effect as a cash

dividend because the number of shares increases and dilutes the value of each share.



WWW.BSSVE.IN

Key Points:

1. Dividend Policy in Practice

1.1. Preference for paying common dividends

Smaller and younger firms

Mature firms

1.2. Stability of dividends

Dividends are more stable from year to year than are earnings.

They follow the trend in cash flow more closely.

Review dividend policy at least annually, and at about the same time each year.

Quarterly payments most common.

Annual, semi-annual and monthly payments are less common.

Dividend cut is interpreted as a negative signal.

1.3. Industry Differences in Dividend Policy

Payout ratios vary systematically across industries.

Investment opportunities are comparable within an industry, but vary across industries.

Behavioral principle suggests using payout ratios similar to those of other firms in the industry.

Firm-specific information must be taken into account.

1.4. Dividend Payment Mechanics

Dividends are declared by the board of directors:

Amount of dividend

Record date

Payment date



WWW.BSSVE.IN

1.5. Irrelevance of Dividend Policy

A compelling case can be made that dividend policy is irrelevant.

Since investors do not need dividends to convert shares to cash, they will not pay higher prices

for firms with higher dividend payouts.

In other words, dividend policy will have no impact on the value of the firm because investors

can create whatever income stream they prefer by using homemade dividends.

1.6. Why Does Dividend Policy Matter?

Dividend policy is not irrelevant.

Actual capital markets are not perfect.

Capital market imperfections affect our conclusions about dividend policy.

However, when there is an open flow of information (transparency) and reasonably efficient

capital markets, a firms value is less affected by its dividend policy than it is by its capital

budgeting decisions.

2. Asymmetric Information

Asymmetric information is the main reason why dividend policy matters.

Dividends can provide a monitoring device.

2.1. Transaction Costs

Flotation costs and brokerage commissions vary inversely with the size of the transaction.

This makes it cheaper for the firm to sell a large block of shares than for individual shareholders

to make small purchases to reinvest their dividends.

Restrictions in bond indentures, loan agreements, and preferred stock agreements, designed to

prevent excessive payments of dividends.

Often prohibit dividends to exceed a legally defined surplus



WWW.BSSVE.IN

2.2. DRIPs

Dividend Reinvestment Plans offer shareholders the option to reinvest their dividends with little

or no brokerage commission.

This reduces the transaction-cost penalty a high-dividend-payout policy would otherwise impose

on shareholders who wish to reinvest their dividends.

DRIPs permit firms to reduce issuance costs substantially.

They do not, however, eliminate the tax bias in favor of capital gains because shareholders must

recognize the dividend income.

2.3. The Role of Income Taxes

Investor income taxes have historically created a bias in favor of capital gains and against

dividends.

This also reinforces the clientele effect.

3. Dividend Policy Guidelines

Earnings and cash flow projections for the next few years.

Include depreciation generate funds.

Deduct capital expenditures.

Determine an appropriate target payout ratio.

Range of payout ratios.

Set the quarterly dividend.

Evaluate alternative dividend policies.

4. Share Repurchases

Factors Influencing Share Repurchase Tax advantage to share repurchases

Reaction of investors

Impact on debt ratings



WWW.BSSVE.IN

Effect on accounting for acquisitions

4.1. Implementing a Share Repurchase Program

Open-market purchases

Cash tender offers

Transferable put rights

Privately negotiated block purchases

Exchange offers

4.2. Transferable Put Rights

Serve as a mechanism for reducing the cost of share repurchase program.

A Transferable Put Right is the right to sell the firm one share of its common stock at a fixed

price (the strike price) within a stated period (the time to maturity of the option).

Its transferable because the option can be sold independent of its birth share.

The put right can be bought or sold on the open market.

In this way, shareholders can get the option value by selling the put if they do not want to

exercise it.

Shareholders with a low cost basis would sell the option to avoid triggering a capital gains tax.

These shareholders would not have participated in a traditional share repurchase.

4.2.1. Valuing Transferable Put Rights

▪ Transferable put rights are usually issued deep-in-the-money to induce

shareholders (or the eventual put option holders) to sell the shares to the

firm.

▪ The time to maturity is usually small, and the options time premium is

typically small. For convenience, we will ignore it.



WWW.BSSVE.IN

5. Stock Dividends

The fair market value of these new shares is transferred from retained earnings to paid-in capital

and capital contributed in excess of par value.

Total common stockholders equity remains unchanged.

5.1. Financial Impact of Stock Distributions

Apart from any informational effects, the total market value of the stock remains unchanged after

a stock dividend or a stock split.

Since the number of shares outstanding increases in either case, the per-share price will drop

correspondingly.

A popular rationale for stock dividends and stock splits is to bring the stock price to a more

popular trading range (about $10 to $30 per share).

This may broaden the ownership of the firms shares

: Issuing Securities And The Role Of Investment Banking

Topic Objective:


Describe methods for issuing new securities.

Explain differences between general cash offers and rights offerings.

Describe the role of the investment banker in the issuance of securities.

Describe going private transactions.


Dilution: Dilution can refer to dilution in percentage ownership, dilution in price, or dilution in

book value or earnings per share. The meanings are different because each type of dilution



WWW.BSSVE.IN

refers to a different effect caused by the issuance of new securities. Shareholders should only

care about shareholder wealth and the dilution in market value caused by the issuance of new

securities.

Public and private differ in many respects. One way that the financing methods differ is that

firms use underwriters for public offerings while they sell securities directly to investors in

private placements. Another difference is that almost anyone can purchase publicly offered

securities while only a few sophisticated investors can participate in private placements.

Some of the advantages of a private placement are that private placements can be placed quickly,

private placements offer flexibility in terms of size, and that private placements offer flexibility

in terms of security arrangements. The main disadvantage of a private placement is that it is

costly because investors demand a high yield to compensate for low liquidity.

The principal features of common stock are voting rights, dividend rights, liquidation rights, and

preemptive rights. The principal features of preferred stock are different from the principal

features of common stock in that preferred stock has a par value, a stated dividend rate, a

cumulative dividend feature, and may be redeemable. Under Rule 144A, more investors are

capable of participating in the offer. This increases the liquidity of the securities relative to a

typical private placement and enables the firm to offer a lower yield on the investment.

Key Points:

1. Main Sources of Raising Long-Term Funds Externally

Common stock

Preferred stock

Debt

Flotation costs

Fixed costs



WWW.BSSVE.IN

Variable costs

Public offering

Private placement

1.1. Public Offering

General cash offer

Rights offering

1.2. General Cash Offers

Decide what to issue:

Obtain required approvals.

File a registration statement:

Determine initial pricing and file an amended registration statement.

Close the offering.

1.3. Primary and Secondary Offerings

In a primary offering, the firm sells newly issued shares to investors.

In a secondary offering, insiders and large institutional shareholders sell shares they hold in a

registered public offering.

1.4. Role of the Underwriters

An intermediary between the issuer and the purchaser.

Provide advice regarding type of security, terms, and price.

Help prepare documentation.

Underwriters bear the price risk.



WWW.BSSVE.IN

1.5. Flotation Costs

Include both the gross underwriting spread and the out-of-pocket expenses.

Economies of scale

Vary by security type:

Holding issue size constant,

Common stock has the highest flotation cost.

Bonds have the lowest flotation cost.

Flotation cost of preferred stock is in between.

2. Negotiated versus Competitive Offerings

In a negotiated offering, the issuer selects one or more firms to manage the offering and works

closely with them in designing and pricing the issue.

In a competitive offering, the issuer, specifies the type and amount of security to be sold and

selects the investment banker through a competitive bidding process.

3. Private Placements

Securities are sold directly to institutional investors.

Exempt from registration requirements.

Private placements are restricted:

Limited number of investors may be offered the securities.

Restrictions on resale.

3.1. Advantages of Private Placements

Lower issuance costs.

Issue can be placed quickly.

Greater flexibility of issue size.

Greater flexibility of security arrangements.

More favorable share price reaction than a public offering.



WWW.BSSVE.IN

Lower cost of resolving financial distress.

3.2. Disadvantages of Private Placements

Higher yield required by investors.

More stringent covenants and restrictive terms.

4. Main Features of Common Stock

Perpetual security

Not redeemable

May or may not have a par value

Outstanding shares

Treasury shares

Multiple classes of common stock are possible

4.1. Rights and Privileges of Common Stock

Dividend rights

Voting rights

Cumulative

Noncumulative

Voting by proxy

Liquidation rights

Preemptive rights

4.2. Public Offering of Common Stock

Gross underwriting spread

Out-of-pocket expenses

A firms share price often declines upon the announcement of a public offering.



WWW.BSSVE.IN

Managers sell new shares when shares are overpriced.

5. Rights Offerings

Firm issues one right per share outstanding.

Rights are call options on newly issued shares:

Rights are issued in-the-money.

Rights offerings are frequently underwritten.

5.1. Advantages

Allows shareholders to retain their proportionate ownership in the firm.

Protects existing shareholders from loss of wealth resulting from a public offering.

Beneficial if firm does not have broad ownership.

5.2. Disadvantages

Takes longer to complete.

Cannot sell large blocks of new shares to institutional shareholders.

6. Dividend Reinvestment Plans (DRiPs)

A DRIP allows each shareholder to use the dividends received to purchase additional shares of

the firms stock.

Purchase price is often below market price (5% discount).

Resemble rights offerings.

Lower transaction costs for purchaser than open market purchase.

7. Initial Public Offering (IPO)

Subsequent issues of common stock are called seasoned issues.



WWW.BSSVE.IN

Underwriters try to price the IPO issue at 10% to 15% below the expected trading price.

7.1. Advantages of Going Public

Raise new capital

Achieve liquidity and diversification for current shareholders

Create a negotiable instrument

Increase the firms equity financing flexibility

Enhance the firms image

7.2. Disadvantages of Going Public

Disclosure requirements

Accountability to public shareholders

Market pressure to perform short-term

Pressure to pay dividends

Dilution of ownership interest

Expense of going public

Higher estate valuation

8. Features of Preferred Stock

Claims senior to common stock, junior to debt.

Dividends must be paid to preferred before they can be paid to common.

Usually have a par or stated value.

Dividend rate is usually specified.

8.1. Financing with Preferred Stock

Sinking fund preferred is like debt:



WWW.BSSVE.IN

The interest payments are not tax-deductible, but this is offset by the fact that missing a

scheduled payment does not lead to bankruptcy.

Preferred stock dividends also qualify for the 70% dividends-received deduction when the

preferred shareholder is another corporation.

Because of this, preferred-stock yields are usually lower than the yields of comparable debt

instruments.

Plus, if the firm is not paying taxes currently due to poor operating results, the forgone interest

tax deduction is not an issue.

Utility companies have been the heaviest issuers of fixed-rate preferred stock.

Regulated utilities can pass the cost of preferred dividends through to their customers.

: Long-Term Debt

Topic Objective:


Describe the four main classes of corporate long-term debt.

Briefly explain the features of long-term debt.

Describe the main characteristics of a Eurobond.

Explain the debt service parity approach to bond refunding.


The difference between secured debt and unsecured debt is that secured debt is backed by

specific assets whereas unsecured debt is not. Debt covenants impose restrictions, intended to

protect bondholders, on the firm that issued the bonds. Debt covenants may limit the issuance of

additional debt, the payment of dividends, liens, subsidiary borrowing, asset disposition,

mergers, and sale and leaseback. Ideally, a firm would choose a debt maturity that causes its cash

outflows to match its expected cash inflows.



WWW.BSSVE.IN

Key Points:

1. Types of Long-Term Debt

Secured debt

Unsecured debt

Tax-exempt corporate debt

2. Main Features of Corporate Debt

Stated maturity

Stated principal amount

State coupon rate of interest

Mandatory redemption (or sinking fund) schedule

Optional redemption provision

Protective covenants

3. Sinking Fund Requirements

A sinking fund requires the firm to repay the debt in installments, rather than in a lump sum.

Serves as a monitoring device

Reduces the effective life of the debt.

3.1. Setting the Coupon Rate

Coupon rate is set to zero.

Reduces lenders reinvestment risk.

Borrowers benefited from tax asymmetry (until 1982).

Fixed versus floating rate bonds



WWW.BSSVE.IN

3.2. Optional Redemption Provisions

Call provisions

Put options

4. Recent Innovations in the Bond Market

Commodity-linked bonds

Collateralized mortgage obligations (CMOs)

Floating-rate notes

Credit-sensitive notes

Extendible notes

5. International Debt Financing

Eurobonds

Yields may be lower than U.S. domestic bond yields.

Shorter maturity, smaller issue size.

Eurobond market is essentially unregulated.

6. Bond Refunding

Methods of retiring outstanding bonds:

Call the bonds

Open market repurchase

Exchange new securities for the bonds

Exchanging new bonds for old is called bond refunding.

Take advantage of lower interest rates.

Eliminate restrictive bond covenants.

Lengthen maturity of outstanding issue.



WWW.BSSVE.IN

6.1. Debt Service Parity (DSP) Approach

Debt refunding can change the capital structure of the firm.

To neutralize the effect of a change in the capital structure, construct a hypothetical replacement

debt obligation that has the same after-tax cash flows as the outstanding debt obligation.

6.2. Tax Considerations in Debt Refunding

All expenses incurred with a refunding are tax-deductible.

Expenses connected with retiring the old issue may be deducted in the year of refunding.

Expenses connected with the new issue must be amortized over the new issues life.

6.3. Immediately Deductible Expenses

Call premium

Unamortized balance of issue expenses plus original issue discount (or minus original issue

premium) on old debt.

Net overlapping interest cost (income) is deductible (taxable).

6.4. Refunding High-Coupon Debt

From this gross savings, deduct the after-tax transaction costs:

Call premium

Tax credit for unclaimed issue costs

New issue expense

Call option time premium

Immediate expenses of new issue



WWW.BSSVE.IN

6.5. Accounting Considerations

If the bonds reacquisition price is greater than its carrying (or par) value, the difference is

recorded as a loss even if the NAR is positive.

Agency problem occurs when managers forego the refunding to avoid this book loss.

6.6. Refunding in Practice

Cost of overlapping interest is small.

Interest rate differential between new conventional debt and installment debt is small.

7. Callable Bonds

Asymmetric information and the possibility of wealth expropriation

Most high-yield bonds are callable.

7.1. Timing Considerations When Refunding Debt

Calling the old bonds when the call price exceeds the market price expropriates wealth from

shareholders to bondholders.

Optimal time to call the bonds is when the market price equals the effective call price.

Effective call price = stated call price + accrued interest.

Wealth transfer is avoided if called optimally.

If old debt is called at the optimal time, the options time premium is zero.

7.2. Sinking Fund Complications

If bonds are selling at a premium, redeeming them at par under the sinking fund provisions may

be advantageous.

Double-up options allow the issuer to increase the amount of bonds retired at par.



WWW.BSSVE.IN

8. Tender Offers and Open Market Purchases

If the bonds contain a no-call period, the issuer can still purchase the bonds through a tender

offer or through open market purchase.

Usual method of analysis applies.

Issuer pays market price instead of the call price.

Bondholders are free to reject offer.

Amount of debt refunded is uncertain.

Transaction costs are higher if fees are paid to soliciting dealers.

: Leasing And Other Asset-Based Financing

Topic Objective:


Describe and compare three different types of lease financing.

Explain the concept of the net advantage to leasing.

Explain project financing and its advantages.


Lease: A lease is a rental agreement that extends for one year or longer. The owner of the asset

that is being rented is the lessor, and the entity that is renting the asset is the lessee.

The advantages of leasing are efficient use of tax deductions and tax credits, reduced risk,

reduced costs of borrowing, flexibility under bankruptcy, circumvention of debt covenants, and

off balance sheet financing. The disadvantages of leasing are that the lessee forfeits the tax

deductions associated with ownership and usually forgoes the residual value. The advantages of



WWW.BSSVE.IN

leasing that are of dubious value are trying to fool investors through accounting games,

achieving 100% financing, and circumventing debt covenants. A dollar of lease financing

replaces a dollar of debt financing because a firm must meet its lease payment obligations on

time in order to have uninterrupted use of the leased asset. If the lessee misses a lease payment,

the lessor can reclaim the asset and sue for the missed lease payment. The consequences are

similar to those of missing an interest or principal repayment.

Key Points:

1. Lease Financing

A lease is a rental agreement that extends for one year or longer.

The owner of the asset (the lessor) grants exclusive use of the asset to the lessee for a fixed

period of time.

In return, the lessee makes fixed periodic payments to the lessor.

At termination, the lessee may have the option to either renew the lease or purchase the asset.

2. Types of Leases

Full-service lease

Net lease

Operating lease

Financial lease

Direct leases

Sale-and-lease-back agreements

Leveraged leases

2.1. Synthetic Leases

Firms have used synthetic leases to get the use of assets but keep debt off their balance sheets.



WWW.BSSVE.IN

An unrelated financial institution invests some equity and sets up a special-purpose-entity that

buys the assets and leases it to the firm under an operating lease.

Since the Enron bankruptcy, firms have been reluctant to use synthetic leases.

2.2. Advantages of Leases

Efficient use of tax deductions and tax credits of ownership

Reduced risk of obsolescence

Reduced cost of borrowing

Bankruptcy considerations

Tapping new sources of funds

Circumventing restrictions

2.3. Disadvantages of Leasing

Lessee forfeits tax deductions associated with asset ownership.

Lessee usually forgoes residual asset value.

2.4. Valuing Financial Leases

Basic approach is similar to debt refunding.

Lease displaces debt.

Missed lease payments can result in the lessor claiming the asset.

Risk of a firms lease payments is similar to that of its interest and principal payments.

2.5. Analyzing Leases

The Net Advantage to Leasing (NAL) equals the purchase price (P) minus the present value of

the incremental after-tax cash flows (CFAT) associated with the lease:

NAL = P PV(CFATs)



WWW.BSSVE.IN

2.5.1. Analyzing Leases - the Discount Rate

▪ The discount rate should be the lessees after-tax cost of similarly secured

debt.

▪ Since the lease obligation is not overcollateralized, the secured debt rate

should reflect this.

▪ Use weighted average of secured and unsecured debt rates.

2.5.2. Analyzing Leases - the Cash Flows

▪ Cost of asset (saving)

▪ Lease payments (cost)

▪ Incremental differences in operating and other expenses (cost or savings)

▪ Depreciation tax shelter (foregone benefit)

▪ Expected net residual value (foregone benefit)

▪ Investment tax credits (foregone benefit)

3. NPV of Lease to the Lessor

In a perfect market, leasing is a zero-sum game.

The NPV of the lease to the lessor will be - (NAL to the lessee).

If lessee and lessor have the same marginal income tax rates, leasing is still a zero sum game.

4. Tax Treatment of Financial Leases

Internal Revenue Service has established guidelines for distinguishing between true leases and

installment sales agreements.



WWW.BSSVE.IN

If lessor meets these guidelines, lessor is entitled to tax deductions and credits of asset

ownership. The lessee can deduct full amount of lease payment for tax purposes.

5. IRS Guidelines for Financial Leases

Term of lease < 80% of assets useful life.

Lessor must maintain an equity investment of at least 10% of assets original cost.

Exercise price of the purchase option must equal the assets fair market value at the time the

option is exercised.

Lessee does not pay any portion of the assets purchase price.

Lessor must hold title to the property.

6. Advantages and Disadvantages of Project Financing

6.1. Advantages

Risk sharing

Expanded debt capacity

Lower cost of debt

6.2. Disadvantages

Significant transaction costs and legal fees

Complex contractual agreements

Lenders require a higher yield premium

7. Limited Partnership Financing

Another form of tax-oriented financing.

Allows the firm to sell the tax deductions and credits associated with asset ownership to the

limited partners.

Income (or loss) for tax purposes flows through to the limited partners.



WWW.BSSVE.IN

Limited partners are passive investors.

General partner operates the limited partnership and has unlimited liability.

8. Limited Partnership Cash Flows

8.1. Initial cash flows

Net proceeds from sale of limited partnership interests (inflow).

The investment tax credit (if any) allocated to limited partners (outflow).

8.2. Annual cash flows

Taxes payable on the portion of partnership taxable income allocated to limited partners (inflow).

Cash distributions to limited partners and tax shields from losses allocated to limited partners

(outflow).

: Liquidity Management

Topic Objective:


Explain working capital and the cash conversion cycle.

Describe motives for holding cash.

Describe and apply float management techniques.

Describe the mechanics of different types of short-term borrowings and evaluate their costs.


Cash conversion cycle: The cash conversion cycle is the length of time between the

payment of accounts payable and the receipt of cash from accounts receivable. It is



WWW.BSSVE.IN

important to working capital management because a firm may choose to finance its raw

materials and inventories through trade credit.

Float: Float is the difference between the available balance at the bank and the firms

book balance. It arises from the time that it takes for transactions, such as checks and

credit card payments, to be processed.

Cash Conversion Cycle: The cash conversion cycle is the length of time between

payment of accounts payable and the receipt of cash from accounts receivable.

Inventory Conversion Period: The inventory conversion period is the length of time

from the purchase of inventory to the time the sales are made on credit.

Receivables Collection Period: The receivables collection period is the average number

of days it takes to collect on accounts receivable. This is equal to days sales outstanding

(DSO)

Payables Deferral Period: The payables deferral period is the average length of time

between the purchase of materials and labor and the payment of cash for the same.

The three philosophies of working capital management are the maturity-matching approach, the

conservative approach, and the aggressive approach. In the maturity-matching approach, the

firm hedges its risk by matching the maturities of its assets and liabilities. The conservative

approach guards against the risks of a credit shutoff by using more long-term financing and less

short-term financing. The aggressive approach seeks to increase profitability by using less long-

term financing and more short-term financing because short-term financing often has a lower

interest cost. Of course, lower (higher) interest cost comes with greater (less) risk, so the three

approaches are on a continuum of a risk-return tradeoff.

The three basic motives for holding cash are the transactions demand, the precautionary demand

and the speculative demand. The transactions demand is the need for cash to make everyday



WWW.BSSVE.IN

payments. The precautionary demand is the margin of safety required to meet unexpected

needs. The speculative demand is the desire to take advantage of unexpected opportunities.

A firm with short term funds could invest in a treasury bill, which is a short-security issued by

the U.S. government. A firm could also invest in federal agency securities which are backed to

varying degrees by the U.S. government. Negotiable certificates of deposits and Eurodollar

certificates of deposits are promises to pay written by commercial banks and are another form of

short-term investment. Another investment is a bankers acceptance which is a guarantee to pay

the face amount of the security. Commercial paper is a promissory note sold by a very large

creditworthy company.

Key Points:

1. Working Capital Management

Working capital management refers to choosing the levels and mix of:

Cash, marketable securities, receivables and inventories.

Different types of short-term financing.

2. Considerations in Liquidity Management

Sales impact

Liquidity

Relations with stakeholders

Short-term financing mix



WWW.BSSVE.IN

3. Approaches to Working Capital Management

3.1. Maturity Matching Approach

Hedge risk by matching the maturities of assets and liabilities.

Permanent current assets are financed with long-term financing, while temporary current assets

are financed with short-term financing.

There are no excess funds.

3.2. Conservative Approach

Long-term funds are used to finance both permanent as well as some temporary short-term

assets.

When there are excess funds, they are invested in marketable securities.

4. Cost and Risk Considerations

Yield curve is usually upward sloping.

Short-term rates are more volatile than long-term rates.

Firm's ability to obtain needed short-term financing.

5. Cash Management

As long as we have the money, we can choose.

Payment at time of service.

Use of credit cards

Verifying insurance coverage

Harassing insurance companies and clients/collection agency



WWW.BSSVE.IN

5.1. Demands for Cash

Transactions demand

Precautionary demand

Speculative demand

Compensating balances

5.2. Short-Term Investment Alternatives

U.S. Treasury securities

U.S. federal agency securities

Negotiable certificates of deposit

Short-term tax-exempt municipals

Bankers acceptances

Commercial paper

Preferred stock & money market preferred stock

5.3. Other Factors in Cash Management

Compensating balance requirements

Optimal amount of marketable securities

Transaction costs

Maturity

Risk

Yield

Special tax situations

6. Float

Float is the difference between the available (or collected) balance at the bank and the firms book

or ledger balance.



WWW.BSSVE.IN

Disbursement float occurs when the firm writes a check but the check has not yet cleared the

banking system.

Collection float occurs when a check has been deposited but the funds are not yet credited to the

firms bank account.

6.1. Float Management Techniques

Wire transfers

Zero balance accounts (ZBAs)

Controlled disbursing

Centralized processing of payables

Lockboxes

6.2. Short-Term Financing

Trade Credit

Secured Bank Loans

Unsecured Bank Loans

Commercial Paper

Cost of Trade Credit

6.3. Effective Use of Trade Credit

6.3.1. Advantages

▪ Readily available

▪ Informal

▪ Flexible

▪ Stretching payments



WWW.BSSVE.IN

6.3.2. Disadvantages

▪ High cost of discounts foregone

▪ Stretching of payments can hurt reputation

6.4. Bank Loans

6.4.1. Short-term unsecured loans

▪ Transaction loan

▪ Line of credit

▪ Revolving credit agreement

6.4.2. Short-term secured loans

▪ Inventory

▪ Accounts receivable

6.4.3. Short, medium, and long-term loans

▪ Secured or unsecured

▪ Bullet, balloon, or installment

6.5. Factors Affecting the Short-Term Financing Mix

Cost of the source of funds

Desired level of current assets

Seasonal component of current assets



WWW.BSSVE.IN

Flotation costs

Restricted access to sources of long-term capital

Bankruptcy costs

Firm's choice of risk level

In Section 5 of this course you will cover these topics:Accounts Receivable And Inventory Management

Financial Planning

Mergers And Acquisitions

Financial Distress

International Corporate Finance


semester end date.



: Accounts Receivable And Inventory Management

Topic Objective:


Explain the reasons for granting credit.

Evaluate credit granting decisions using the NPV rule.

Describe important accounts receivable management tools.

Identify and compute inventory management costs.

Apply inventory management models to optimize the firms inventory.



WWW.BSSVE.IN


5 Cs of credit: The 5 Cs of credit are character, capacity, capital, collateral, and conditions.

Character is relevant for estimating the probability of whether or not the borrower will pay.

Capacity is relevant because it measures the ability of the borrower to pay from cash flows.

Capital is also relevant for determining the ability of the borrower to pay from net worth.

Collateral is relevant for determining what possible recourse the lender has if the borrower

doesnt pay. Economic conditions are also relevant in determining the risk of the loan.

Suppliers are better able to handle the collateral because when the collateral is repossessed in the

event of default, it is more valuable to the supplier who has expertise in producing, maintaining,

and marketing this collateral.

A supplier may have accumulated information about its customers through its normal business

relations. The supplier has a cost advantage over a bank because the bank must collect

information on the creditworthiness of a borrower.

Trade credit sends a positive signal about the quality of a product because it is in essence a

quality guarantee. If the customer finds the product defective, the customer can ship the product

back and refuse to pay.

Trade credit can reduce employee opportunism because it helps to separate the employees who

handle products and who handle payments.

Trade credit is pervasive because of the advantages associated with financial intermediation,

collateral, information costs, product quality, and employee opportunism. Financial

intermediation allows for the interest rate of a trade credit loan to benefit both parties. Suppliers

are better able to handle the collateral because when the collateral is repossessed in the event of



WWW.BSSVE.IN

default, it is more valuable to the supplier who has expertise in producing, maintaining, and

marketing this collateral. A supplier has an information cost advantage over a bank because the

supplier may have accumulated information about its customers through its normal business

relations. Trade credit sends a positive signal about the quality of a product because it is in

essence a quality guarantee. If the customer finds the product defective, the customer can ship

the product back and refuse to pay. Trade credit can also reduce employee opportunism because

it helps to separate the employees who handle products and who handle payments.

Key Points:

1. Accounts Receivable Management

Credit sales create accounts receivable

Trade credit

Consumer credit

1.1. Why Grant Credit?

To facilitate business and promote efficiency

Financial intermediation

Collateral

Information costs

Product quality information

Employee theft

Steps in the distribution process

Convenience, safety, and buyer psychology



WWW.BSSVE.IN

1.2. The Basic Credit Granting Decision

Credit should be granted if the NPV of granting credit is positive. The NPV depends on:

Amount of the sale

Investment in the sale

Probability of payment

Payment period

Required return

Collection efforts

1.3. Credit Policy Decisions

Choice of credit terms

Setting evaluation methods and credit standards

Monitoring receivables

Taking actions for slow payments

Controlling & administering the firms credit functions

1.4. Sources of Credit Information

A credit application, including references

Applicants payment history

Information from sales representatives

Financial statements for recent years

Reports from credit rating agencies

Credit bureau reports

Industry association credit files

1.5. Judgmental Approach to Credit Decisions

Character

Capacity



WWW.BSSVE.IN

Capital

Collateral

Conditions

2. Credit Scoring Models

These combine several financial variables to create a single score or index: S = w1X1 + w2X2

+ . . .

Credit is granted if the score is above a pre-specified cut-off value.

2.1. Advantages

Easy to compute

Easy to change standards

Avoids bias or discrimination

2.2. Disadvantages

Requires large samples to calibrate.

Can be gamed if parameter values are known

3. Monitoring Accounts Receivables

Aging schedules

Average age of receivables

Collection fractions and receivables balance fractions

Pursuing delinquent credit customers

Changing credit policy



WWW.BSSVE.IN

4. Inventory Management

Types of inventories:

Raw materials

Work-in-process

Finished goods

4.1. Quantity Discounts

Quantity discounts can impact the optimal order size.

Suppose Acer were offered a discount of $0.02 per unit if it ordered in lots of 500.

Total cost with this order size = Annual Ordering Cost + Annual Carrying Cost Total Discount

4.2. Inventory Management with Uncertainty

4.2.1. Types of uncertainty:

▪ Future demand

▪ Inventory usage rate

▪ Delivery time

4.3. ABC System of Inventory Management

Inventory items are classified into three groups on the basis of critical needs.

Group A items are most critical.

Group C items are least critical.

Critical items are managed very carefully.

5. Objectives of Materials Requirement Planning Systems

MRPs are computer-based inventory planning and management systems.



WWW.BSSVE.IN

Smooth production

No interruptions

Handle complex inventory requirements

5.1. Just-In-Time (JIT) Inventory Systems

Materials should arrive exactly as they are needed in the production process.

Reduces inventory holding costs

5.1.1. Important factors determining success of JIT systems

▪ Planning requirements

▪ Supplier relations

▪ Setup costs

▪ Other cost factors

▪ Impact on credit terms

: Financial Planning

Topic Objective:


Describe the financial planning process.

Forecast the firms future financing needs on the basis of sales growth.

Describe the usefulness of pro forma financial statements.



WWW.BSSVE.IN


Financial Plan: At a minimum, a complete financial plan includes clearly stated

objectives, assumptions, strategies, contingency plans, budgets, a financing program, and

pro forma financial statements. The benefits of financial planning are that it standardizes

assumptions, focuses on the future, is objective, helps develop employees, meets lender

requirements, provides a benchmark to measure performance, and helps prepare for

contingencies.

Key Points:

1. The Financial Plan

Financial planning is the process of evaluating the impact of alternative investing and financing

decisions of the firm. Every financial plan has three components:

model

Inputs

Outputs

The model is a set of mathematical relationships between the inputs and the outputs.

Inputs to the model may include:

Projected sales

Collections

Costs

Interest rates

Exchange rates

The outputs of the financial plan are:

Pro forma financial statements

A set of budgets including:

Sales budget

Advertising budget

Cash budget



WWW.BSSVE.IN

1.1. Short-term financial plans

Usually have a planning horizon of one year or less.

Are detailed and very specific.

1.2. Long-term financial plans

Usually have a five- or ten-year planning horizon.

Tend to be less detailed.

1.3. Components of the Financial Plan

Clearly stated strategic, operating and financial objectives.

Assumptions on which the plan is based.

Description of underlying strategies.

Contingency plans for emergencies.

Budgets, classified by

▪ time period

▪ division

▪ type

The financing program, classified by

▪ Time period

▪ Source of funds

▪ Types of funds



WWW.BSSVE.IN

2. Planning Cycles

A planning cycle specifies how frequently plans are reviewed and updated.

The planning horizon is also renewed with each update.

Short-term plans are updated more frequently than long-term plans.

2.1. Bottom-Up and Top-Down Planning

A bottom up planning process starts at the production level and proceeds upwards through the

corporate hierarchy.

A top-down planning process starts with top management making strategic decisions.

These decisions are then implemented by managers further down the corporate hierarchy.

2.2. Phases of the Financial Planning Process

Formulating the plan

Implementing the plan

Evaluating performance

2.3. Benefits of Financial Planning

Standardizing assumptions

Future orientation

Objectivity

Employee development

Lender requirements

Better performance evaluation

Preparing for contingencies

3. Cash Budgets

Project and summarize cash inflows and outflows.



WWW.BSSVE.IN

Show monthly cash balances.

Show any short-term borrowing needed to cover cash shortfalls.

They are usually based on sales forecasts.

They are usually constructed on a monthly basis.

More frequent planning may be warranted.

4. Percent of Sales Forecasting Method

Allows firm to estimate funds required to finance growth. Sales growth results in:

increase in current and fixed assets.

increase in spontaneous short-term financing.

increase in profitability.

The increase in current assets must be financed from internally generated funds or external

funds.

If internally generated funds are insufficient to finance the growth, the firm may:

Reduce the growth rate.

Sell assets not required to run the firm.

Obtain new external financing.

Reduce or stop paying cash dividends.

: Mergers And Acquisitions

Topic Objective:


Understand valid motives for merging.

Explain why a corporate acquisition can be analyzed as a complex capital investment.

Describe differences in the methods of acquisitions.

Estimate the value of a potential acquisition using different methods.

Explain the significance of paying for an acquisition with common stock.



WWW.BSSVE.IN


Vertical Merger A vertical merger is a merger of two firms involved in the same

industry but operating at different points in the supply chain.

Conglomerate Merger: A conglomerate merger is a merger of two firms in unrelated

businesses. A tender offer is an offer made by the acquiror to purchase stock from the

shareholders of the acquiree. The acquiror can gain control of the acquiree by purchasing

enough of the outstanding shares. The main advantages are that it is fast, flexible, simple

and allows the original acquiror to profit even if another bidder emerges.

Proxy Contest: A proxy contest is an effort by one or more individuals to oppose

incumbent management by obtaining sufficient shareholder votes to elect a new board of

directors. Control of a firm can be gained if the opposing board of directors is elected.

The disadvantage of a proxy contest relative to a tender offer is that few succeed, as

shareholders prefer to receive cash for their shares instead of a new management team.

Key Points:

1. Mergers and Consolidations

A merger involves a combination of two firms: the acquirer and the acquiree.

The acquirer is the surviving firm and it absorbs all the assets and liabilities of the target firm.

In a consolidation, two or more firms combine to form a new entity.

1.1. When Do Mergers Create Value?

Mergers create value when the merging firms are worth more in combination than separately.



WWW.BSSVE.IN

The Net Advantage to Merging (NAM) is the net benefit to the acquirer's shareholders.

1.2. Types of Mergers

Horizontal mergers: Combination of two firms in the same line of business.

Vertical mergers: Integrating forward towards the consumer, or backwards towards the supplier,

in a particular line of business.

Conglomerate mergers: Combination of firms in unrelated lines of business.

1.3. Valid Motives for Merging

Achieving economies of scale

Operating efficiencies and economies of scale are the main source of synergy.

Realize tax benefits

Free up surplus cash

Grow more quickly or more cheaply

1.3.1. Questionable Motives for Merging

▪ Diversification

▪ Corporate versus personal diversification.

▪ Enhanced Earnings per Share

▪ Financial synergy

2. Methods of Acquisition

Merger or consolidation: In a merger, the acquirer absorbs the acquiree and emerges as the

surviving firm. In a consolidation, a new business entity is created from the combination.

Acquisition of stock: Executed via a tender offer.



WWW.BSSVE.IN

Acquisition of assets: Acquirer purchases only the assets. Acquirees liabilities are not assumed.

2.1. Antitrust Considerations

A transaction must comply with

Federal antitrust laws (The Clayton Act)

State anti-takeover statutes

Federal and state securities laws

Corporate charter of each firm

2.2. Tax Considerations

In a tax-free acquisition, the selling shareholders are treated as having exchanged their old shares

for similar new shares.

Selling shareholders do not have to pay any taxes on the gain realized as a result of the exchange,

until the shares are sold.

Tax basis of each asset acquired is the same for the two firms.

In a taxable acquisition, the selling shareholders are treated as having sold their shares.

Selling shareholders must pay taxes on the gain immediately.

Acquirer can step-up the tax basis of the assets acquired to their fair market value.

2.3. Requirements for Tax-Free Treatment

Business Purpose Test

Continuity of Business Test

Mode of Acquisition Test

Medium of Payment Test

2.4. Accounting Considerations

One firm is identified as the acquirer.



WWW.BSSVE.IN

Purchase price, after adding the fair market value of the liabilities acquired, is allocated to the

acquired assets.

Excess of purchase price over fair market value of net assets acquired is recorded as goodwill.

2.5. Valuing Corporate Acquisitions

Infer the value from the prices paid for firms in comparable transactions.

Provides an estimate of a reasonable price to pay.

Impact of acquisition on acquirer's shareholder wealth, given the acquisition cost.

3. Discounted-Cash-Flow Analysis

An acquisition is a special type of capital budgeting decision.

Weighted average cost of capital approach

Adjusted present value approach

4. Merger Tactics

Merger: Merger requires approval of target management

Tender offer: It is made directly to targets stockholders, it can bypass target management and

executed quickly. The tender offer must be open for at least 20 days. The tender offer is subject

to regulation through the Williams Act amendments to the Securities Exchange Act of 1934

Proxy contests: Initiated by individuals who oppose incumbent management

4.1. Anticipatory Defensive Tactics

Dual class recapitalization

ESOPs

Poison pills

Staggered election of directors

Supermajority voting / fair price provisions



WWW.BSSVE.IN

4.2. Responsive Defensive Tactics

Asset purchases / sales

Litigation

Pac-Man defense

Leveraged recapitalization

Share repurchase / sale

Standstill agreement

4.3. Leveraged Buyouts (LBOs)

Acquisition is financed principally by borrowing.

Debt is secured by a lien on the assets.

Operating cash flow from assets is used to service the debt.

LBOs often take the firm private.

: Financial Distress

Topic Objective:


Explain the main causes of financial distress.

Describe differences between reorganization and liquidation under the bankruptcy code.

Describe differences between reorganization outside of, and in, bankruptcy.

Explain prepackaged bankruptcy.



WWW.BSSVE.IN


Absolute Priority Doctrine: The absolute priority doctrine means that a senior claim

must be paid in full before a junior claim is permitted to receive any distribution. The

argument for enforcing the doctrine is that the senior creditors have a legal claim to be

paid before the junior creditors. The argument against enforcement of the doctrine is that

a small payment to a junior class may speed up the reorganization process.

Holdouts: Holdouts are holders of outstanding securities who refuse to exchange their

securities for new ones. Holdouts frustrate the financial reorganization process by

attempting to get a better deal for themselves

The five basic conditions necessary to confirm a plan of reorganization are that the plan

must be feasible, the plan cannot discriminate unfairly among creditors of equal classes,

at least one creditor must accept the plan, the plan must satisfy the fair-and-equitable test,

and the plan must satisfy the best-interests-of-creditors test.

The purpose of the bankruptcy code is to allow debtors and creditors to negotiate to

achieve a consensual plan of reorganization. A firm should file for bankruptcy

protection when the going-concern value of the reorganized debtor exceeds its liquidation

value.

Key Points:

1. Four Aspects of Financial Distress

A firm is bankrupt when it has filed a petition for relief from its creditors.

A firm is in default when it violates one of the terms of a loan agreement or a bond indenture.



WWW.BSSVE.IN

A firm is said to have failed when it ceases operations or otherwise voluntarily withdraws from

obligations.

A firm is insolvent when it is unable to pay its debts.

1.1. Causes of Financial Distress

Poor management

Unwise expansion

Intense competition

Excessive debt

Massive litigation

Unfavorable contracts

1.2. Early Detection of Financial Distress

Losses increase as financial distress sets in.

Interest coverage declines.

Operations absorb more cash than they generate.

Debt-to-equity ratio increases.

Other key ratios worsen.

1.3. Other Indicators of Distress

When credit-default swaps written on a firms debt rise sharply in price.

When the firms debt falls sharply in price.

When a firm suddenly has to draw down all of its standby credit lines to pay off commercial

paper which it was unable to roll over.

When a firm engages one of the leading bankruptcy-advisory investment banks.



WWW.BSSVE.IN

2. Reorganization Outside Bankruptcy

Bankruptcy is time consuming and expensive. A firm can restructure its liabilities outside

bankruptcy in three ways:

Exchange new securities for existing ones.

Solicit security holders consent to modify the terms of existing securities.

Repurchase existing securities for cash.

Higher interest rate

More senior ranking

Stronger covenants

Cash incentive

Structure exchange offers such that non-exchanged securities are subordinated to the new

securities.

Try to avoid the holdout problem

3. Reorganization in Bankruptcy

According to Chapter 11 of the bankruptcy code, a plan is developed to reorganize the debtors

business and restore its financial health.

According to Chapter 7 of the bankruptcy code, the assets of the firm are liquidated and the cash

proceeds paid to the firms creditors according to strict rules of priority.

4. Guiding Principle of Chapter 11

A debtor should be given the opportunity to reorganize provided that the going concern value of

the reorganized debtor exceeds its liquidation value.

Protection from creditors

Voluntary filings

Involuntary filings



WWW.BSSVE.IN

4.1. The Chapter 11 Process

Firm files for Chapter 11 protection.

Bankruptcy judge issues an automatic stay.

Firm becomes debtor in possession.

Firm seeks additional financing for working capital.

Different creditor classes form committees.

The committees and the debtor negotiate a plan of reorganization.

Creditors approve the proposed plan of reorganization.

Bankruptcy court confirms the plan of reorganization.

Reorganized firm emerges from bankruptcy.

Firm executes the plan of reorganization.

Firm must satisfy all the conditions in the plan.

4.2. Plan of Reorganization

Includes a business plan for the firm.

Establishes new capital structure.

Shows how old debts will be paid off.

Provides for the distribution of cash and or new securities to the firms creditors and

shareholders.

4.3. Priority of Claims

Administrative expenses

Priority claims such as small trade claims and unpaid taxes, etc.

Secured debt

Unsecured senior debt

Subordinated debt

Preferred stock

Common stock



WWW.BSSVE.IN

4.4. Absolute Priority Doctrine

Distributions must be made among claimants according to the priority of their claims.

A more senior claim must be paid in full before a junior claim is permitted to receive any

distribution.

Reorganization plans often deviate from absolute priority.

4.5. Requirements for Confirmation

Proposed plan must be feasible.

Cannot discriminate unfairly among creditors with equal seniority of claims.

Must be accepted by at least one class of creditors.

Must satisfy the fair-and-equitable test.

Must satisfy the best-interests-of-creditors test.

5. Cramdown

Cramdown procedure permits confirmation of a plan over the objections of one or more classes

of creditors provided that:

The plan provides the holders with property whose value is at least equal to the allowed amount

of their claims, and

No junior class receives anything.

6. Bankruptcy

6.1. Advantages of Bankruptcy

Automatic stay of all creditor collection efforts.

Debtor can negotiate within a single forum - the bankruptcy court.

Court can allow debtor to reject unfavorable contracts.

All claims can be dealt with at one time.



WWW.BSSVE.IN

Interest stops accruing on unsecured claims.

Bankruptcy court can affirm plan over the objections of dissenting creditors.

Cramdown rules apply.

Upon confirmation, all creditors and stockholders are bound by the plan.

Avoid taxes on income that results when debt is retired at less than face value.

6.2. Disadvantages of Bankruptcy

Business is disrupted.

Debtor in possession must meet stringent reporting requirements.

Bankruptcy court must approve all transactions outside the ordinary course of business.

Bankruptcy filing can trigger other claims.

Legal and administrative expenses paid by the debtor.

7. Prepackaged Plans of Reorganization

In prepackaged bankruptcy, the debtor and creditors negotiate and file the plan of reorganization

with the bankruptcy petition.

7.1. Advantages

Alleviates holdout problem.

Confirmed plan is binding on all debtholders.

Tax advantages that are not available in out-of-court restructuring.

Allows debtor to reject burdensome leases and contracts.

8. Liquidation in Bankruptcy

Bankruptcy petition with intent to liquidate is filed under Chapter 7.

Liquidation is preferable when liquidation value of debtors assets exceeds their value under a

plan of reorganization.



WWW.BSSVE.IN

Liquidation value must be estimated by asset class.

Liquidation by assignment

Court-supervised liquidation

: International Corporate Finance

Topic Objective:


Learn about five basic foreign exchange transactions.

Learn about two key parity relationships.


Forward Contract: A forward contract for a foreign currency is a customized

agreement between two parties to exchange a specified amount of currency at a specified

exchange rate on a specified day. A futures contract is similar to a forward contract

except that it is standardized and traded on an exchange. The advantage of a forward

contract is that it can be tailored to meet the needs of the two parties. The advantage of

the futures contract is that positions can quickly be opened and closed as the needs of a

party change.

Interest rate parity: Interest rate parity is the relationship between the spot rate, forward

exchange rates, and interest rates for two countries.

Purchasing power parity: Purchasing power parity is the relationship between the spot

rate, expected future spot rate, and inflation rates for two countries.



WWW.BSSVE.IN

Unbiased forward exchange rate: An unbiased forward exchange rate is the

relationship between the forward rate and the expected future spot rate.

Equality of expected real returns: Equality of expected real returns is the relationship

between real interest rates, expected inflation rates, and nominal interest rates in two

countries.

Key Points:

1. Eurocurrency

Eurocurrency represents funds deposited in a bank outside the country in whose currency the

funds are denominated.

Eurodollars are U.S. dollar deposits in a bank outside the U.S.

Euroyen represent Japanese yen deposits in a bank outside Japan.

Eurocurrencies represent all major world currencies.

2. The Euro

The euro () is the currency of the European Monetary Union.

As time goes on, more states will become members and the euro currency zone will widen.

3. Foreign Bonds

A foreign bond is a bond issued by a foreign firm or government in the country in whose

currency the bond is denominated.

A Yankee bond is denominated in U.S. dollars and is issued in the U.S. by foreign firms or

governments.

Other foreign bonds include:

Bulldog bonds - issued in Britain



WWW.BSSVE.IN

Matador bonds - issued in Spain

Samurai bonds - issued in Japan

Rembrandt bonds - issued in the Netherlands

3.1. Eurobonds

A Eurobond is a bond issued outside the country in whose currency it is denominated.

Eurodollar bonds are dollar-denominated bonds issued outside of the U.S.

Eurobonds exists in many currencies:

▪ U.S. dollars

▪ Canadian dollars

▪ Japanese yen

▪ British pounds

4. London Interbank Offer Rate (LIBOR)

The LIBOR is the interest rate at which large international banks lend funds to each other in the

London money market.

Not unlike the U.S. Federal Funds rate, the rate at which member banks of the Federal Reserve

System lend to each other.

Different LIBOR rates prevail for overnight loans or longer.

5. American Depository Receipts (ADRs)

ADRs represent ownership of shares of a foreign company.

The shares are held in trust, usually by a U.S. bank.

ADRs are issued and traded in the U.S.

Price is expressed in U.S. dollars.

ADRs may be firm-sponsored or unsponsored.



WWW.BSSVE.IN

6. Foreign Exchange Markets

A market where foreign currencies are traded.

Most trading takes place in five currencies:

U.S. dollar ($)

Euro ()

British pound ()

Swiss franc (SF)

Japanese yen ()

7. Types of Foreign Exchange Transactions

Spot transactions

Forward transactions

Currency futures

Currency options

Currency swaps

7.1. Spot Transactions

These involve exchange of currencies with immediate delivery by all parties.

The exchange rates used are called spot rates.

7.2. Forward Transactions

These involve exchange of currencies at an exchange rate determined today, but delivery to take

place at a fixed point in the future.

The specified exchange rate is called the forward rate.

Different forward rates may exist for each future delivery time.



WWW.BSSVE.IN

If the forward rate is less (more) than the spot rate, the currency is trading at a forward discount

(premium).

7.3. Currency Futures and Options

Currency Features

This is a standardized forward contract that is traded on an exchange.

A position in the futures contract can be closed by taking an opposite position in the same

contract.

Like options on common stock.

Call (put) options give holder the right to buy (sell) the underlying currency at a fixed exchange

rate.

7.4. Currency Swaps

Two parties swap currencies and agree to exchange payments of specified amounts in one

currency for receipt of specified amounts in another.

Two firms seeking to borrow in each others home currency can engage in a currency swap

directly.

Swaps can also be negotiated by a firm with a swap bank.

It may be cheaper to borrow in the home country and enter into a swap than to borrow in the

foreign country.

Cost savings are due to market imperfections:

▪ Tax asymmetries

▪ National regulations restricting international capital flows

▪ Asymmetric information

▪ Comparative advantage



WWW.BSSVE.IN

8. International Parity Relationships

Law of One Price: An asset traded in two markets must have the same price in both markets.

Law of one price can be applied to international markets. This results in equilibrium

relationships for exchange rates, interest rates, and inflation rates. These relationships are called

parity relationships.

8.1. Types of Parity Relationships

Interest rate parity.

Purchasing power parity.

Expectations theory of forward exchange rates.

International Fisher effect.

8.1.1. Interest Rate Parity

▪ Differences between the forward and spot exchange rates offset the

difference between the interest rates between two countries.

▪ The higher interest rate in one country is offset by the forward discount.

▪ If interest rate parity does not hold, arbitrage profits are available.

8.1.2. Purchasing Power Parity

▪ This gives an equilibrium relationship between expected inflation rates

in two countries and the exchange rate.

▪ The higher inflation rate in one country is fully offset by the expected

rate of depreciation of that countrys currency.



WWW.BSSVE.IN



WWW.BSSVE.IN

Documents

· finance function allocates resources, which includes acquiring, investing, and managing the resources. Financial management: Financial management is an area of finance that applies