FIN 370 Exam Study Guides
FIN 370 Exam Study Guides FIN 370
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Finance 370 Study Guide 1 Chapter 1 – Overview Corporations filed papers of incorporation with state: charter, bylaws o Advantages: unlimited life, transfer ownership, limited liability, ease to raise capital o Disadvantages: double taxation, cost of setup Primary objective should be shareholder wealth maximization Employment growth is higher in firms that maximize stock price Three aspects of CF that affect investment value o Amount, Timing, Risk Free CF: are available for distribution to all investors FCF = sales revenue – operating costs – operating taxes – required investments in operating capital WACC: the average rate of return required by investors o (Affected by) Capital structure, Interest Rates, Risk, Investor’s attitude toward risk Price/cost of debt capital: interest rate Price/cost of equity capital: cost of equity = required return = dividend yield + capital gain 4 factors that affect cost of money: production opportunities, time, risk, expected inflation o International conditions: country risk, exchange rate risk Financial Institutions: banks, S&L, Life insurance, Mutual funds, Pension, Hedge Fannie Mae shifts risk: o Pools mortgages, sells shares of these pools to investors (investors have more risk/return) Securitization: new securities have been created based on original securities o Can also be securitized: Car Loans, student Loans, Credit Card balances CDOs: pooled assets, such as mortgages, are debt obligations that serve as collateral for the CDO Chapter 4 – Bond Valuation Call Provision: issuer can refund if rates decline: helps issuer but hurts investor o Borrowers are willing to pay more, lenders require more o Most bonds have a deferred call and a decline call premium Sinking Fund: provision to pay off a loan over its life rather than all at maturity (amortization) o Reduces risk to investor, shortens average maturity – not good for investor if rates fall o Call if return is below the coupon rate and bond sells at premium o Use open market purchase if return is above coupon rate and bond sells at discount If coupon rate > rate, price rises above par, and bond sells at premium If coupon rate < rate bond sells at discount If coupon rate = bond sells at par Current Yield = Annual coupon PMT / current price Capital gains yield = change in price / beginning price Expected total Return = YTM = Exp Current Yield + Exp capital gains Yield to Call: if the rate is lower than the previous coupon rate, than call bonds paying $100 coupon payments and reissue with bonds that pay $75 o If bond sells at premium, then coupon > rate, so call is likely (expect to earn YTC on premium, YTM on par & discount) Required Rate = risk free + Inflation + Default + Liquidity + Maturity Risk Required Risk Free Rate (rate on treasury securities) = (1+r*)(1+IP)1 o Treasury InflationProtected Securities (TIPS) Bond Spread = Difference between corporate bond’s yield and a treasury security’s yield (DRP+LP) Investment Grade Bonds: AAABaa Junk Bonds: BBCaa Factors that affect Default risk and bond ratings: Debt Ratio, coverage ratio, profitability ratio, current ratio o Other: bond provisions: secured/senior debt, guarantee provisions, sinking provisions, debt maturity o Earnings stability, Regulatory environment, potential product liability, accounting policies Reinvestment Rate Risk: risk that CFs will have to be reinvested in the future at lower rates, reducing income Bankruptcy: Chapter 11 (Reorganization) – Chapter 7 (Liquidation) o Company wants 11 – Creditors prefer 7 o Company files 11 – has 120 days to file reorganization plan o Company must demonstrate it’s worth more “alive than dead” or judge will order Chp 7 o Liquidation Priority: property tax, secured creditors, trustee’s costs, expenses after bankruptcy, wages and unpaid benefits, unsecured customer deposits, taxes, pension, unsecured creditors, preferred stock, common stock Chapter 6 – Accounting for Financial Management Income Statement Balance Sheet Cash Flows FCF is the amount of cash available from operations for distribution to all investors after making necessary investments to operations o Five Uses: Pay interest on debt, pay principal on debt, pay dividends, buy back stock, buy nonoperating assets Net operating Profit after Taxes (NOPAT) = EBIT (1Tax) Operating Current Assets: CA needed to support operations (cash, inventory, receivables) Operating current liabilities: CL resulting from normal operations (accounts payable, accruals) Net Operating Working Capital (NOWC) = Operating CA – Operating CL Operating Capital = NOWC + Net fixed assets FCF = NOPAT – Net investment in operating capital Return on Invested Capital (ROIC) = NOPAT / Operating Capital Economic Value Added (EVA) = NOPAT –(WACC)(CAPITAL) Market Value Added (MVA) = Market value of the firm – book value of the firm o Market Value = (# shares of stock * Price per share) + Value of debt o Book Value = Total common equity + Value of Debt Corporate Taxation: o Deduct its interest expenses but not its divided payments o Carry back losses for two years, carry forward losses for 20 o Exclude 70% of dividend income if owns less than 20% of the company’s stock Individual Taxation: o Face progressive tax rates, from 10%35% o Rate on longterm capital gains is 15%, but taxed if you sell the asset o Dividends are taxed at same rate as capital gains o Interest on municipal bonds (state & local gov) is not subject to Fed taxation Breakeven Tax Rate: Municipal Yield = Corporate Yield (1T) o If T > 30% buy tax exempt If T < 30% buy corporate bonds Only high income individuals should buy muni Chapter 8 – Basic Stock Valuation Classified Stock: has special provisions o Classify existing stock as founders’ shares, with voting rights but dividend restrictions o New shares might be called “Class A” shares with, voting restrictions but full dividend rights Tracking Stock: dividends of tracking stock are tied to a particular division, rather than the company as a whole (usually no voting rights) o Investors can separately value, easier to compensate division managers FCF Valuation Model = PV of expected future FCF discounted at the WACC, is the value of a company’s operations Sources of Value: Value of operations – Nonoperating Assets Claims on Corporate Value: Debt holders have first claim, preferred stock, then remaining stockholders Tax Liability 1. Operating Income 2. Interest Income 3. Taxable Dividend Income (Dividends .7(Dividends) 4. = Taxable Income 5. Taxable income 6. Do the Tax things (150k * T)(…) = Tax WACC ATkd (WTd*kd)+(WTs*ks)+(WTp*kp) Price of Stock = Dividend/Return Rate – Contsant growth rate Free Cash Flow = FCF1/(1+WACC)1 Other Income Statement 2014 2015 Sales $3,432,000 $5,834,400 COGS 2,864,000 4,980,000 Other expenses 340,000 720,000 Deprec. 18,900 116,960 Tot. op. costs 3,222,900 5,816,960 EBIT 209,100 17,440 Int. expense 62,500 176,000 Pretax earnings 146,600 (158,560) Taxes (40%) 58,640 (63,424) Net income $ 87,960 ($ 95,136) Balance Sheet: Assets 2014 2015 Cash $ 9,000 $ 7,282 ST invest. 48,600 20,000 AR 351,200 632,160 Inventories 715,200 1,287,360 Total CA 1,124,000 1,946,802 Gross FA 491,000 1,202,950 Less: Depr. 146,200 263,160 Net FA 344,800 939,790 Total assets $1,468,800 $2,886,592 Balance Sheet: L&E 2014 2015 Accts. payable $ 145,600 $ 324,000 Notes payable 200,000 720,000 Accruals 136,000 284,960 Total CL 481,600 1,328,960 Longterm debt 323,432 1,000,000 Common stock 460,000 460,000 Ret. earnings 203,768 97,632 Total equity 663,768 557,632 Total L&E $1,468,800 $2,886,592 Operating Activities Net Income ($ 95,136) Adjustments: Depreciation 116,960 Change in AR (280,960) Change in inventories (572,160) Change in AP 178,400 Change in accruals 148,960 Net cash provided (used) by ops. ($503,936) Investing Activities Cash used to acquire FA ($711,950) Change in ST invest. 28,600 Net cash prov. (used) by inv. act. ($683,350) Financing Activities Change in notes payable $ 520,000 Change in longterm debt 676,568 Payment of cash dividends (11,000) Net cash provided (used) by fin. act. $1,185,568 Agency Relationship Arises whenever one or more individuals (principals - owners) hires another individual or organization (agent – directors/senior executives) to perform some service and then delegates decision-making authority to that agent. Their service is to run the company. Agency Conflicts Employees/investors are agents – they have an interest in the company as well and may want to see different things than the owner (principal) so it could create conflict. No agency problem would exist if you are the only employee and only your money is invested in the business. A potential agency problem arises whenever the manager of a firm owns less than 100% of the firm’s common stock, or the firm borrows. An agency relationship or problem could exist between the principal and employees, if the principal hired the employees to perform some service and delegated some decision- making authority to them. Agency conflicts lead to a reduction in the company’s intrinsic value. Fiduciary Duty Fiduciary is a person who holds a legal and ethical relationship of trust with one or more parties’ financial assets. Legal obligation to act in best interest of other party, not their own. Proxies Stockholder who doesn’t want to attend a specific decision-making meeting sign a proxy card (legal binding document) to the proxy holder who will vote on your behalf. Proxy Access o What is takes to get onto the shareholder meeting's agenda. Have to be a big player to get what you want on the agenda. o In 2010, the SEC proposed a rule that would have allowed shareholders owning at least 3 percent of a company for at least three years to include in the company’s proxy materials director nominees for up to 25 percent of the board. The SEC rule was struck down in 2011. However, the core elements of the rule have over time become the basis of an increasing flow of shareholder proposals. o Proxy Access Proposals Example: Whole Foods says if you owned 3% of stock for 3 years then you were big enough to get something on the agenda. Doesn't guarantee a win, but you are a big enough shareholder that the rules of whole foods can let you put something up for a vote. Proxy Advisory Firms Provide services to institutional investors – can be hired to be the expert of a company and investigate to see if they are doing the right things and maximizing shareholder benefit. They can then go to the shareholder meeting and vote one way or another based off findings. Big institutions, big money. ISS - Institutional Shareholder Services (largest proxy agency) and Glass Lewis (second largest proxy firm/agency in the country). Independent Chair Proposals The CEO used to hire their friends for the board of directors to show up to the shareholder voting and they would vote in the CEO's favor because of their friendship. Now a certain percentage has to be outside sources with no relationship with the CEO prior - bring outside experience and perspectives to the board and keep a watchful eye on the inside directors and how the organization is run. Activist Investors Search for firms with poor profitability and replace management with new teams that are well versed in values-based management techniques. Generally, improves profitability and stock price of the firm due to expectations of the firm doing better under active investors. Even without taking over the firm completely, the active investor can alter or influence the board to act with better corporate governance. Institutional Investors An institutional investor is an or organization that trades securities in large enough share quantities or dollar amounts that they qualify for preferential treatment and lower commissions. Institutional investors face fewer protective regulations because it is assumed that they are more knowledgeable and better able to protect themselves. Monitor, manage, and influence the board, leading to better corporate governance. Poison Pills - (aka Shareholder Rights Provision) Any corporation provision, or strategy, that is used by a company to protect itself from a hostile takeover bid. Used to dilute the acquiring company’s ownership and usually triggered when one investor obtains an ownership interest of 20%. Used to describe several approaches the target company can employ to make the potential acquisition less desirable. Provisions: o Preferred Stock Plans: this is preferred stock registered with the SEC and paid as a dividend to common shareholders. This preferred stock has an important feature: it is convertible to common stock only after the takeover is completed. This strategy both dilutes the ownership of the acquiring company (which is highly undesirable for the acquirer) as well as increases the cost of the merger. o Flip-Over Plans: this allows shareholders to purchase shares of common stock in the new company at a substantial discount after the merger. While this approach is simpler to implement than a preferred stock plan, it does not prevent a company from purchasing a controlling share of the target. o Flip-In Plans: this strategy provides shareholders of the target company with the right to purchase additional stock in the target company at substantial discounts. The right to purchase stock occurs before the merger is finalized, and the provision is usually triggered when the acquirer owns greater than a 20% share of the target's stock. o Back-End Plans: this approach provides shareholders of the target company with the right to cash or debt securities at a price established by the company's Board of Directors. By doing so, the target company has essentially established an above- market selling price for the company. o Poison Puts: this is a bond that allows investors to cash in the security before it matures, if the target company is engaged in a hostile takeover attempt. The poison put places pressure on the acquiring company to raise substantial sums of money to pay off the owners of the puts. opposite of callable bonds. Puts pressure on acquiring company to raise money in order to pay off debt of these "puts" Advantages: o Extremely effective: Historically, poison pills have a high rate of success. They are actually one of the most useful tactics for fighting a takeover. This can be a good thing for investors, especially if they are concerned that a takeover will not be beneficial to the organization. o Informal structure: The poison pill is a flexible system that can be tailored to a company’s needs. They can structure which assets the pricing terms apply to, such as convertible bonds, notes, stocks, options, bonds, and CDs. o Protects against unscrupulous buyers: Every company that initiates a hostile takeover does so for their own benefit. They may intend to dismantle their target and sell it piece by piece, or they may lack the industrial insight and experience to run the company effectively. As a result, the target company may create a poison pill to protect themselves from a buyer that would ultimately hurt management and existing shareholders. o Gives management time to seek other offers: Rather than prevent a takeover, poison pills can provide management the opportunity to find a better offer or create a bidding war. o Obtain higher premiums: Studies suggest that firms with poison pills receive a 10% to 20% higher premium from acquiring firms over companies that do not have a poison pill in place. Disadvantages: o Dilutes the value of stock: When companies issue a number of new shares at a discount, they are saturating the supply of stock. This ends up reducing the value of existing shares and investors are forced to purchase new shares in order to maintain their prior ownership percentage. o Investors forgo profit from a takeover: During a takeover, investors are often paid a premium for their stock. Therefore, the use of a poison pill may deprive investors of potentially hefty profits. Unfortunately, investors who would prefer that the takeover go through successfully don’t have much power to fight a poison pill. o Poison pills tend to protect poor managers: Companies that are the targets of takeovers are often subject to poor performance. The acquirer typically realizes that the target company has major room for improvement if managed properly. As a result, poison pills are instituted by management to protect their own jobs and, ultimately, deprive investors of a better management team. o Discourages institutional investors: Institutional investors have been increasingly apprehensive about poison pills since they can make it easy for management to make selfish decisions at the expense of shareholders. For example, a CEO who makes $10 million per year will have a huge incentive to turn down any takeover offer in order to preserve his or her job. Since takeover premiums sometimes offer the highest return for shareholders, they can lead to decreased institutional interest in the company, which can in turn hurt stock prices since institutions are the largest buyers. Ultimately, institutions are less likely to invest in a company that purposely looks to scare off potential suitors. Escape Clauses - o When poison pills are put into place by management, they are usually accompanied by an escape clause. The escape clause allows the issuing company to redeem the poison pill via a small payment to the shareholder. o One of the advantages of the escape clause is that it prevents dilution of ownership if the acquiring company is not viewed as hostile. For example, this can occur when the acquiring company is offering shareholders a substantial premium over the current market price of their stock. Cost of Debt Tax effects associated with financing can be incorporated with cost of capital, therefore focus on after-tax cost. Only cost of debt is affected. Use nominal rate. Flotation costs are so small, so ignore. Interest is tax deductible, so the after-tax (AT) cost of debt is: o RdAT = RdBT(1-T) = 10% (1-.40) = 6% Cost of Preferred Stock Preferred dividends are not tax deductible, so no tax adjustment. Preferred stock is riskier to investors than debt. Companies are not required to pay preferred dividend. However, firms want to pay preferred dividend. Otherwise they cannot pay common dividend, it is difficult to raise additional funds, and preferred stockholders may gain control of the firm. The yield is lower on preferred than debt because corporations own most preferred stock (70% of preferred dividends are nontaxable to corporations. Preferred often has a lower BT yield than debt and the AT yield to investors and the AT cost to the issuer are higher on preferred than on debt, which is consistent with the higher risk of preferred. Rps = DIV/P(1-F) Cost of Equity/Common Stock Companies can raise common equity by issuing new shares of common stock or by reinvesting earnings that are not paid out as dividends (i.e. retained earnings). Earnings can be reinvested or paid out as dividends, but because investors could buy other securities and earn a return on those, there is an opportunity cost to reinvestment. Two ways to calculate: Capital Asset Pricing Model (CAPM) and Discounted Cash Flow Model (DCF). When a company issues new common stock, they also have to pay a flotation cost to the underwriter. Issuing new stock may send negative signals to the capital markets, which may depress the stock price. Capital Asset Pricing Model (CAPM) Rs = Risk Free Rate + Beta (Market Rate – Risk Free Rate) Rs = Rrf + b(Rm-Rrf) OR Rs = Rrf + b(RPm) Discounted Cash Flow Model Rs = Dividend/Price + Growth Rate Rs = D1/P1 + g OR Rs = D0(1+g)/P + g Weighted Average Cost of Capital (WACC) The weights are percentages of the firm that will be financed by each component. Market conditions (especially interest rates), market risk premium, and tax rates are uncontrollable factors that influence a company’s WACC. Controllable factors are capital structure policy, dividend policy, and investment policy (firms with riskier projects generally have a higher cost of equity). The WACC reflects the risk of an average project undertaken by the firm. Different divisions may have different risks. Step 1: Find weights Step 2: Solve formula – WACC = WdRd(1-T) + WpsRps + WsRs Example: Suppose the stock price is $50, there are 3 million shares of stock, the firm has $25 million of preferred stock, and $75 million of debt. Target weights for the company, or the market value weights, are 10% for debt, 9% for preferred stock, and 12.8% for common stock. So this means: Common stock = $50(3,000,000) = $150,000,000 Preferred Stock = $25,000,000 Debt = $75,000,000 Total Value = $150 + $25 + $75 = $250 million Therefore, the weights are: Ws = 150/250 = .6 Wps = 25/250 = .1 Wd = 27/250 = .3 So the Weighted Average Cost of Capital is: WACC = WdRd(1-T) +WpsRps + WsRs WACC = .3(10)(1-.4) + .1(9) + .6(12.8) WACC = 10.38% Floatation Costs Flotation costs depend on the risk of the firm and the type of capital being raised. The flotation costs are highest for common equity. However, since most firms issue equity infrequently, the per-project cost is fairly small. We frequently ignore flotation costs when calculating the WACC. Flotation costs are ignored for cost of debt because they are so small. Risk Stand-alone risk is the easiest to calculate. Market risk is theoretically best in most situations. Corporate risk affects creditors, customers, suppliers, and employees more. Market Risk Premium Market Risk Premium = Market’s Rate of Return - Risk-Free Rate Real Options (Examples) Real options exist when managers can influence the size and risk of a project’s cash flows by taking different actions during the project’s life in response to changing market conditions. Most important part of an option is that it does not obligate its owner to take action. It merely provides the right to buy or sell an asset. A real option has an underlying asset that is not a security – for example a project or a growth opportunity, and it is not traded. Real options are “found” or created inside of projects. Their payoffs can be varied. Types of Real Options: o Investment timing options o Growth options: Expansion of existing product line New products New geographic markets o Abandonment options Contraction Temporary suspension o Flexibility options Procedures for valuing real options: o Discounted Cash Flow analysis of expected cash flows, ignoring the option o Qualitative assessment of the real option’s value The value of any real option increases if the underlying project is very risky or there is a long time before you must exercise the option o Decision Tree Analysis o Standard model for a corresponding financial option o Financial engineering techniques The option to wait changes risk – the cash flows are less risky under the option to wait since we avoid the low cash flows. Also, the cost to implement may not be risk-free. Real World Example: o Oreos were created and they made a certain amount of money with the original product. Embedded into this capital project to sell oreos, there are real options to create new products based off the original. If the original was a flop as opposed to success, they would not have had these real options, but they have arisen with the positive response and sales of the original product. Option Exercise Price The price stated in the option contract at which the security can be bought (or sold). Also called the strike price. Option Expiration Date The date after which an option may no longer be exercised. In the U.S. many options expire on the Saturday following the third Friday of the expiration month. Financial Options Allows its owner to purchase a share of stock at a fixed price, called the strike price or the exercise price, no matter what the actual price of the stock is. Stock options always have an expiration date; after which they cannot be exercised. Financial options have an underlying asset that is traded – usually a security like a stock. The payoffs for financial options are specified in the contract. Puts: o A person who buys a put option has: limited loss and profit potential. o Profit potential is limited since the price of underlying stock cannot go below zero. o Loss potential is limited to the amount paid for the put option. o During a put you benefit from a stock decrease. Calls: o The option to wait resembles a financial call option - we get to “buy” the project for $70 million in one year if the value of the project in one year is greater than $70 million. o This is a call option with a strike price of $70 million and an expiration date of one year. o A person who buys a call provision has: limited profit potential, limited loss potential, unlimited profit potential, unlimited leverage potential Black Scholes Model What ought to be the equilibrium market price for a call option. Key inputs: o X = Strike Price = cost to implement project o Rrf = Risk-free rate o T = Time to maturity o P2= current stock price o σ = variance of stock price For a financial option: o Estimation of P = current stock price = PV of all stock’s expected future cash flows. o Current price is unaffected by the exercise of cost of the option. For a real option: o P = PV of all the project’s future expected cash flows. o P does not include the project’s cost. FIN 370 Spring 2016 Study Guide – Exam 3Chapters 15,18,20,22,25,27 C HAPTER 15 K EY T ERMS AND C ONCEPTS Key Dates when Paying Cash Dividends Ex-Dividend Date: o The day on which all shares bought and sold no longer come attached with the right to be paid the most recently declared dividends. o Investors must own a stock before the ex-dividends date in order to receive the next scheduled dividend. Record Date: o Shareholders who properly registered their ownership on or before the record date will reveive the dividend. Payment Date: o The day when the dividend checks will actually be mailed to the shareholders. Declaration Date: o The day the company’s board of directors announces its next dividend payment. Example: o November 19: Board declares a quarterly dividend price per share to holders of record as of December 18. o December 15: Dividend goes with stock. o December 16: Ex-dividend date. o December 18: Holder of record date. o January 8: Payment Date to holders of record. Bird in the Hand Theory Investors prefer a high payout because dividends are less risky than potential future capital gains. High payouts help reduce agency costs by depriving managers of cash to waste and causing managers to have more scrutiny by going to the external capital markets more often. Investors value high payout firms more and would require a lower rate of return to induce them to buy its stock. Signals of Dividends Investors view dividend changes as signals of management’s view of the future. Managers hate to cut dividends, so won’t raise dividends unless they think raise is sustainable. A stock price increase at time of a dividend increase could reflect higher expectations for future EPS, not a desire for dividends. Residual Model Find the invested earnings needed for the capital budget. Payout any leftover earnings (the residual) as either dividends or stock repurchases. This policy minimizes flotation and equity signaling costs, hence minimizes the WACC. Using the Residual Model to calculate distributions paid: 1 FIN 370 Spring 2016 Study Guide – Exam 3Chapters 15,18,20,22,25,27 Distribution = Net Income – ((Target Equity Ratio) (Total Capital Budget)) = Net Income – Required Equity Advantages: Minimizes new stock issues and flotation costs. Disadvantages: Results in variable dividends, sends conflicting signals, increases risk, and doesn’t appeal to any specific clientele. Conclusion: Consider residual policy when setting target payout, but don’t follow it rigidly. Clientele Theory Different groups of investors, or clienteles, prefer different dividend policies. Firm’s past dividend policy determines its current clientele of investors. Clientele effects impede changing dividend policy. Taxes & brokerage costs will hurt investors who have to switch companies do to a change in payout policy. Stock Dividend A dividend payment made in the form of additional shares, rather than a cash payout. Firm issues new shares in lieu of paying a cash dividend. If 10%, get 10 shares of each 100 shares owned. When the company declares the dividend, the accountant records this in the financial records based on the market price of the stock on the date the dividend was declared. Company may decide to distribute stock to shareholders of record if the company’s availability of liquid cash is in short supply. Cash dividends are taxable, so when a company issues a stock dividend, there usually are not tax consequences until the shares are sold. Example: A company has 2000 shares of common stock outstanding when it declares a 5% stock dividends. This means that 2,000*5% is 100 new shares of stock being issued to existing stockholders. Stock Split Firm increases the number of shares outstanding, say 2:1 – this means that each investor will own two shares of stock for each individual share owned prior to the split. If share price before the split was $6, the par value equals $3 after the split (divide by two or factor). Increasing the number of shares outstanding by multiplying each share by a factor. Determines this factor by deciding how many shares of stock each investor will own after the split. A firm should consider splitting a stock when: Optimal price range for stocks is $20-$80. Stock splits can be used to keep the price in optimal range. Stock splits generally occur when management is confident, so are interpreted as positive signals. 2 FIN 370 Spring 2016 Study Guide – Exam 3Chapters 15,18,20,22,25,27 Dividend vs. Split: Both stock dividends and stock splits increase the number of shares outstanding, so “the pie is divided into smaller pieces.” Unless the stock dividend or split conveys information, or is accompanied by another event like higher dividends, the stock price falls so as to keep each investor’s wealth unchanged. But splits/stock dividends may get us to an “optimal price range.” 3 FIN 370 Spring 2016 Study Guide – Exam 3Chapters 15,18,20,22,25,27 C HAPTER 18 K EY T ERMS AND C ONCEPTS Process for Going Public Select investment banker Consider: Reputation and experience in the industry Existing mix of institutional and retail (i.e. individual) clients Support in the post-IPO secondary market File registration document (S-1) with SEC Choose price range for preliminary (or “red herring”) prospectus o Formal legal document, which requires by and filed with the SEC, that provides details about an investment offering for sale to the public. Should contain the facts that investors need to make informed investment decisions. o Document has red print on cover which is where it got the name Go on a Road Show o Presentation to get large institutional investors interested in purchasing your stock offering. o Senior management team, investment banker, and lawyer visit potential institutional investors o Usually travel anywhere between ten and twenty cities in a two-week period, making three to five presentations each day. o Management can’t say anything that is not in prospectus, because company is in “quiet period” to avoid insider trading – have to be careful not to release information not generally known by the public. Set final offer price in final prospectus o Final legal document that all buyers of the stock must be given, with all prerequisite disclosures of what you have just purchased. Also referred to as the “offer document.” Role of Investment Banking Firms Selling, or underwriting, shares of new companies in the process of the IPO. Preliminary valuation Underwriters will prepare a preliminary valuation of the company. Factor in the assumed growth rate of the company and industry, as well as the multiples (or price/earnings ratio) assigned to comparable publicly traded companies. Book Building Investment banker asks investors to indicate how many shares they plan to buy, and record this in a “book.” Investment banker hopes for oversubscribed issue. Based on demand, investment banker sets final offer price on evening before IPO. Documentation for the SEC Compiling financial statements, information about the company’s management, current ownership, and statement of how the firm plans to use the proceeds. Benefits of Going Public for Shareholders Current stockholders can diversify Liquidity is increased 4 FIN 370 Spring 2016 Study Guide – Exam 3Chapters 15,18,20,22,25,27 Going public establishes firm value Increases customer recognition 5 FIN 370 Spring 2016 Study Guide – Exam 3Chapters 15,18,20,22,25,27 C HAPTER 20 K EY T ERMS AND C ONCEPTS Warrant Features A long-term call option New shares of common stock are being created by the company and sold to the person exercising that option. Issued directly through the company, so this dilutes outstanding stock amount. Bonds with warrants have a lower coupon rate Generally, a warrant will sell in the open market at a premium above its exercise value (it would never sell for less) so warrants tend not to be exercised until just before expiration. Each warrant brings in an amount equal to the strike price. This is equity capital and holders will receive one share of common stock per warrant. The strike price is typically set some 20% to 30% above the current stock price when the warrants are issued. Since no dividends are earned on the warrant, holders will tend to exercise voluntarily if a stock’s payout ratio (proportion of earnings paid out as dividends to shareholders) rises enough. The investor can detach the warrants from the bond and sells them to the secondary market. Company doesn’t care if this is done because it doesn’t make a difference who owns the claim to them. Unlimited leverage and upside potential because exercise is fixed. Profits get bigger the higher the price of the stock can go. With a call option, the most you can lose is the premium, same with a warrant. Limited downside risk. American Warrants vs. European Warrants European Warrants There is no possibility of early exercise so if it is a 6-month call option, you can exercise it on the last day of that call period but not prior. American Warrants The possibility of an early exercise does exist. You can exercise any time between purchase and expiration. Provision If there are no dividends, then Black Scholes is going to be identical so the option to exercise early has zero value. Without dividends the exercise early option does not increase value. As long as there are no dividends then you are ALWAYS better off selling the option than exercising. Selling your option can sometimes be better than exercising the option. The farther in the money you are, the more value the option has. Therefore, someone will be more willing to pay a higher premium and that will result in more profit than exercising. Warrant Valuation Bond with Warrant = Value of Bond + Value of Warrant = Par Value Example: A 20-year bond with 27 warrants. Each has a strike price of $25. Each warrant’s value is estimated at $5. 6 FIN 370 Spring 2016 Study Guide – Exam 3Chapters 15,18,20,22,25,27 Package = Bond + Warrants = $1000 Warrants = 27($5) = $135 Bond + $135 = $1000 Bond = $865 Call Options vs. Warrants Warrants usually use the term exercise price, Options (calls and puts) usually use strike price. Same thing but different term, just fundamentals. Issuer: Warrants are issued by a specific company, while exchange-traded options are issued by an options exchange such as the Chicago Board Options Exchange. As a result, warrants have few standardized features, while exchange-traded options are more standardized in certain aspects such as expiration periods and number of shares per option contract (typically 100). Maturity: Warrants usually have longer maturity periods than options. Warrants generally expire in one or two years, and can sometimes have maturities well in excess of five years. Call options have maturities ranging from a few weeks or months to about a year or two. Dilution: Warrants cause dilution because a company is obligated to issue new stock when a warrant is exercised. Exercising a call option does not involve issuing new stock, since a call is a derivative instrument on an existing common share of the company. Convertible Bonds A convertible consists of a fixed rate bond plus the option to convert the bond into stock. Imbedded into the bond is an option that you as an investor have, to buy a certain number of shares of a company’s common stock at a fixed exercise price. In essence, you are sending bond back to a company so you are no longer eligible for your interest and principle payments and receive a certain number of common stock shares in place of the bond. When the convertible is converted, the debt ratio would decrease and the firm’s financial risk would decrease – thus impacting WACC. Convertible is seen as a debt. Exercise of warrant brings in new equity capital but does not bring in new funds. A new, lower debt ratio can support more financial leverage. Minimum Value The higher of the straight debt value and the conversion value. Also called floor value A convertible will generally sell above its floor value prior to maturity because convertibility constitutes a call option that has value. Example: Straight Debt = $872.30 and CV = $800 so Floor Value = $872.30 7 FIN 370 Spring 2016 Study Guide – Exam 3Chapters 15,18,20,22,25,27 Implied Convertibility Value Convertibles will sell for par at $1000, the implied value of the convertibility feature is Par – Present value. $1000 - $872.20 = $127.70 Straight Bond Value Present Value calculated on calculator. Conversion Value The price at which conversion will take place. Usually 20%-30% higher than the stock price on the issue date. Pc = Par Value / Number of Shares Received = 1000/40 = $25 Difference between Warrants and Convertibles Warrants usually provide for fewer common shares than do convertibles. Bonds with warrants typically have much higher flotation costs than do convertible issues. Bonds with warrants are often used by small start-up firms. Warrants bring in new capital, while convertibles do not. Most convertibles are callable, while warrants are not. Warrants typically have shorter maturities than convertibles, and expire before accompanying debt. Convertible conversion removes debt, while the exercise of warrants does not. C HAPTER 22 K EY T ERMS AND C ONCEPTS Effective Annual Rate Used to evaluate loans (comparing loan cost rates and choosing the alternative with the lower cost) when loans have different terms. The effective annual rate is the rate that, under annual compounding, would have produced the same future value at the end of 1 year as was produced by more frequent compounding, say quarterly. If the compounding occurs annually, then the effective annual rate and the nominal rate are the same. If compounding occurs more frequently, then the effective annual rate is greater than the nominal rate. With Discount Interest 8 FIN 370 Spring 2016 Study Guide – Exam 3Chapters 15,18,20,22,25,27 Interest that is calculated on the face amount of a loan but is paid in advance. Thus, the borrow receives less than the face value of the loan. The effective rate on a discount loan is always higher than the rate on an otherwise similar simple interest loan. (1+ i/n)^n – 1 With Compensating Balances A minimum checking account balance that a firm must maintain with a bank to compensate the bank for services rendered or for making a loan; generally equal to 10%–20% of the loans outstanding. Analyzing a Proposed New Credit Policy If a firm’s credit policy is eased by such actions as lengthening the credit period, relaxing credit standards, following a less tough collection policy, or offering discounts, then sales should increase. This means the cos will also rise because more labor, materials, and other inputs will be required to produce the additional goods. Receivables outstanding will also increase which will increase carrying costs. Bad debts and or discount expenses will also rise. The key question: Will sales revenues increase more than costs, including credit-related costs, or will the increase in sales revenue be more than offset by higher costs? Cost of Passing Up a Discount With Accounts Payable ((1+Discount / 100-Discount) ^ 360/ (days credit is outstanding – discount period)) - 1 C HAPTER 25 K EY T ERMS AND C ONCEPTS Chapter 11 Process Business reorganization guidelines A trustee will be appointed to take over the company if the court deems current management incompetent or if fraud is suspected BUT existing management usually remains in control. Avoids holdout problems Due to automatic stay provisions, avoids common pool problem. Interest and principal payments may be delayed without penalty until reorganization plan is approved. Permits the firm to issue debtor in possession (DIP) financing. Gives debtor exclusive right to submit a proposed reorganization plan for agreement from the parties involved. Reduces fraudulent conveyance problem. Cramdown if majority in each creditor class approve plan. Cramdown: reorganization plans that are mandated by the bankruptcy court and binding on all parties. 9 FIN 370 Spring 2016 Study Guide – Exam 3Chapters 15,18,20,22,25,27 Chapter 7 Process Liquidation procedures Trustee is always appointed for liquidation Priority of claims: Secured creditors Trustee’s administrative costs. Trustee is an appointed person who controls the company when current management is incompetent or fraud is suspected. Only used in unusual circumstances. Expenses incurred after involuntary case begun but before trustee appointed. Wage due workers within 3 months prior to filing. Unpaid contributions to employee benefit plans that should have been paid within 6 months prior to filing. Unsecured claims for customer deposits Taxes due Unfunded pension plan liabilities. General (unsecured) creditors. Preferred stockholders. Common stockholders. Absolute Priority Doctrine States that claims must be paid in strict accordance with the priority of each claim, regardless of the consequence to other claimants. Most formal reorganization plans were guided by this under early bankruptcy laws. Senior claims must be paid in full before junior claims can receive even a dime. If there were any change that a delay would lead to losses by senior creditors, then the firm would be shut down and liquidated. Relative Priority Doctrine More flexible than absolute priority. Gives a more balanced consideration to all claimants in a bankruptcy reorganization than does the absolute priority doctrine. The current law represents a shift towards relative priority and away from absolute. Informal Reorganization Economically sound company whose financial difficulties appear to be temporary will generally get help from creditors willing to work with the company in order to help it recover and reestablish itself on a found financial basis. Advantages: o Less costly o Relatively simple to create o Typically allows creditors to recover more money and sooner Disadvantages: o Common Pool Problem 10 FIN 370 Spring 2016 Study Guide – Exam 3Chapters 15,18,20,22,25,27 The absence of protection under the Bankruptcy Act, individual creditors would have an inventive to foreclose on the firm even though it is worth more as an ongoing concern. o Holdout Problem All of the involved parties do not agree to the voluntary plan. Holdouts are usually made by creditors in an effort to receive full payment on claims. Extension: o A form of debt restructuring in which creditors postpone the dates of required interest or principal payments, or both. o Creditors prefer this over composition because it promises eventual payment in full. Composition: o Creditors voluntarily reduce their fixed claims on the debtor by accepting a lower principal amount, reducing the interest rate on the debt, accepting equiy in place of debt, or some combination of these changes. Informal Liquidation Used when it is obvious that a firm is more valuable dead than alive. Assignment is an informal procedure for liquidating a firm, and usually yields creditors a larger amount than they would get in a formal bankruptcy liquidation. o Only feasible if the firm is small and its affairs are not too complex. o Calls for title to the debtor’s assets to be transferred to a third party, known as an assignee or trustee who will liquidate the assets through a private sale or public auction and then distribute the proceeds among the creditors on a pro rata basis. Advantages over liquidation in federal bankruptcy courts: o Time – the assignee has more flexibility in disposing of property than does a federal bankruptcy trustee, so action can be taken sooner, before inventory becomes obsolete or machinery rusts. o Legal Formality o Expense o Assignee is often familiar with the debtor’s business, so better results may be achieved. Disadvantage: o Does not automatically result in a full and legal discharge of all the debtor’s liabilities. o Does not protect the creditors against fraud. C HAPTER 27 K EY T ERMS AND C ONCEPTS Exchange Rates Direct Quote o The number of units of a foreign currency that can be purchased by 1 unit of the home currency. o Euro and the British pound are referred to as direct – USD relative to Euro/Pound o Direct quote = Dollars of foreign currency o EUR/USD = 1.25 means 1 Euro gets you $1.25 Dollars Indirect Quote o Gives the amount of a foreign currency required to buy one unit of home currency. 11 FIN 370 Spring 2016 Study Guide – Exam 3Chapters 15,18,20,22,25,27 o Every country that does not use the Euro or British pound is indirect. o USD/YEN = 108 so $1 USD gets you 108 yen Strengthening and Weakening Currency o Strengthening dollar hurts profits from international sales o To determine whether currency X has appreciated or depreciated against currency Y: Write the exchange rate as the number of units of Y per unit of X. Comparing the old rate with the new rate shows how much more (or less) of currency Y that X can purchase. The percentage that X appreciates against Y is not the same as the percentage Y depreciates against X. Example: Suppose the exchange rate goes from 7 kronor per dollar to 9 kronor per dollar. This means the dollar now buys more kronor. The dollar appreciated against the krona by ((9-7)/7) = 28.6% The krona has depreciated against the dollar. Kronor per Dollar = 7 9 1/7 = .1429 1/9 = .1111 (.1429-.1111)/.1111 = -0.222 so the Kronor depreciated 22.2% Cross Rates o Exchange rate between two currencies not involving US dollars. o Cross rates are usually calculated on the basis of US dollar exchange rates. o Example: Calculate the Yen per Euro Cross Rate Yen/Dollar * Dollars/Euros 7/1 * 1.25/1 = 7 * 1.25 = 8.75 Yen/Euro Euros per Yen cross rate is reciprocal of the Yen per Euro cross rate, therefore Euros per Yen cross rate = 1/8.75 = .1143 Exchange Rate Risk o The risk that the value of a cash flow in one currency translated from another currency will decline due to a change in exchange rates. Spot Rate o Direct quotations o Spot rate (current rate of exchange) is the rate applied to buy currency for immediate delivery Forward Rate o The rate applied to buy currency at some agreed-upon future date. Guaranteed rate for maturity o Forward rates are normally reported as indirect quotations. Forward Rate at Premium to Spot Rate o If the US dollar buys fewer units of a foreign currency in the forward than in the spot market, the foreign currency is selling at a premium. o Example: Suppose the spot rate is .5 EUR/USD and the forward rate is .4 EUR/USD. The Dollar is expected to depreciate, because it will buy fewer pounds. The pound is expected to appreciate, because it will buy more dollars. So the forward rate for the pound is at a premium. In other words, the dollar can buy more pounds now than it will be able to in the future, so the future price is at a premium to the current price. Forward Rate at Discount to Spot Rate o If the US dollar buys more units of a foreign currency in the forward than in the spot market, the foreign currency is selling at a discount. 12 FIN 370 Spring 2016 Study Guide – Exam 3Chapters 15,18,20,22,25,27 o The primary determinant of the spot/forward rate relationship is the relationship between domestic and foreign interest rates. Interest Rate Parity o Implies that investors should expect to earn the same return on similar-risk securities in all countries: forward rate/spot rate = (1+ rh)/(1+rf) Rh = periodic interest rate in the home country Rf = periodic interest rate in the foreign country Arbitrage o A positive cash flow, with no risk and none of the traders own money invested. o Traders could borrow at the US rate, convert to euros at the spot rate, and simultaneously lock in the forward rate and invest in French securities. Purchasing Power Parity o Implies that the level of exchange rates adjusts so that identical goods cost the same amount in different countries. Ph = Pf(spot rate) or Spot Rate = Ph/Pf P = Price H = Home F = Foreign Central Bank Intervention in Currency Markets Prior to 1971, a fixed exchange rate was in effect. The US dollar was tied to gold and other currencies were tied to the dollar at fixed exchange rates. Central banks intervened by purchasing and selling currency to even out demand so that the fixed exchange rates were maintained. Economic difficulties from maintaining fixed exchange rates led to its end. The current system for most industrialized nations is a floating rate system where exchange rates fluctuate due to changes in demand. Currency demand is due primarily to: o Trade deficit or surplus o Capital movements to capture higher interest rates Monetary Policy – Sovereign Nation vs Common Currency Countries Every nation has a monetary system and a monetary authority. If countries are to trade with one another, there must be some sort of system in place to facilitate payments between nations. The international monetary system is the framework within which exchange rates are determined. Floating Exchange Rate o Managed floating rate system with significant government intervention to manage the exchange rate by manipulating the currency’s supply and demand. o About 31 currencies have freely floating exchange rates and these include the dollar, euro, pound, and yen. Pegged Exchange Rate o When a country locks in a currency’s exchange rate to another currency or basket or currencies. o It is common for a country with a pegged rate to allow its currency to vary within specified limits or banks. Sovereign Nation 13 FIN 370 Spring 2016 Study Guide – Exam 3Chapters 15,18,20,22,25,27 o The power of a state to do everything necessary to govern itself. Includes making, executing, and applying laws; Imposing and collecting taxes; Making war and peace; and forming treaties or engage in commerce. o A sovereign nation would have their own monetary policies
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