finance and financial arithmetic

8/10/2019 Finance and Financial Arithmetic

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FFA CHAPTER 1

Sole proprietorship: a business owned and run by one person. Few, if any employees. Most common

type of firm, but do not account for much sales revenue. Characteristics: straightforward to set up->

many new businesses use this form, no separation between the firm and the owner->if other

investors they cannot hold an ownership stake, owner has unlimited personal liability for any firmsdebts-> has to pay loans from personal assets if firm is unable to pay, life of a sole proprietorship is

limited to life of owner and its difficult to transfer ownership. Typically converted to other form of

business when point reached where it can borrow without the owner agreeing to be personally liable

Partnership: identical to sole proprietorship, but more than one owner. Characteristics: all partners

are liable for the firms debt-> lender can require any partner to repay for outstanding debts,

partnership ends on death or withdrawal of any single partner-> partners can avoid liquidation if

partnership agreement provides alternatives, such as buyout of a deceased or withdrawn partner.

Limited partnership: two kinds of owners, general partners and limited partners. General partners

have same rights and privileges as partners in normal partnership-> liable for firms debt obligations.Limited partners have limited liability-> their liability is limited to their investment. Death or

withdrawal of limited partner does not dissolve partnership, and his interest in transferable. He has

no management authority and cannot be legally involved in decision making of business.

Limited liability company: owners liability is limited to their investment-> they cannot be held

personally liable for debts. Two types: private limited liability company: not allowed to trade their

shares on an organized exchange (->GmbH). Public limited liability company: may trade their shares

on organized exchange, different names in different countries. (->AG)

Corporation: a legally defined, artificial being (a judicial person or legal entity), separate from itsowners. Can enter into contracts, acquire assets, incur obligations, enjoys protection under most

jurisdictions against seizure of its property. Solely responsible for its own obligations. Owners are not

liable for any obligations of company and vice versa.

Formation of a corporation: must be legally formed. Legal document (corporate charter in USA) is

created-> more costly than setting up a sole proprietorship. Corporate charter specifies initial rules

that govern how the company is run

Ownership of a corporation: no limit to number of owners. Each owner owns fraction of corporation.

Entire ownership stake of corporation is divided into shares/stock. Collection of all outstanding

shares of corporation is the equity. An owner of shares in corporation is known as shareholder,

stockholder or equity holder, and is entitled to dividend payments, which are payments made at the

discretion of the corporation to its equity holders. Dividend received is proportional to number of

shares owned. No limitations on who can own shares-> no expertise needed -> allows to trade shares

-> raises big amounts of capital because of sale of ownership shares.

Tax implications for corporations: because its a separate legal entity, shareholders of a corporation

have to pay taxes twice. 1) corporation pays tax on its profits 2) when profits are distributed,

shareholders pay their own personal income tax on this income. -> known as classical system/double

taxation. Another system is imputation system: dividend is regarded as flow of profits direct to

shareholders and is therefore only one source of income that is not subject to double taxation. In

USA S corporations , corporations that elect subchapter S tax treatment, are exempted from double


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taxation, instead, profits and losses are allocated directly to shareholders based on their ownership

share. Shareholders must include these profits as income on their individual tax returns.

Qualifications for subchapter S treatment: being US citizen/resident, cant be more than 100 of them.

Most corporations: C corporations: corporations subject to corporate taxes

In a corporation, the board of directors and chief executive officer (CEO) possess direct control,rather than owners.

Board of directors: elected by shareholders. Have ultimate decision-making authority in the

corporation. Mostly, each share gives shareholder one vote in election of board of directors. If one or

two shareholders own very large proportion of outstanding stock, they might be either themselves

on the board of directors or have the right to appoint a number of directors. They make rules on how

corporation should be run (how top managers are compensated), set policies, monitor performance

of company. Assign most decisions about day-to-day running of corporation to its management.

Chief executive officer: is charged with running the corporation by instituting the rules and policiesset by board of directors. The size of the rest of the management team varies from corporation to

corporation. CEO often also chairman of board of directors.

Chief financial officer (CFO): most senior financial manager. Also called finance director, often reports

directly to CEO.

Board of directors->chief executive officer->chief operating officer AND chief financial officer->

controller (accounting and tax department) AND treasurer (capital budgeting, risk management,

credit management)

Financial manager: responsible for three main tasks: investment decisions (weigh costs and benefitsof all investments and projects, decide which of them qualify as good uses of money invested by

shareholders. These decisions shape what the firm does), financing decisions (how to pay for

investments, how to raise additional money, raise from new and existing owners by selling more

shares or by borrowing money), cash/treasury management (ensure that firm has enough cash on

hand to meet day-to-day obligations, also called managing working capital, ensure that access to

cash does not hinder firms success)

Agency problems: if managers, despite being hired as the agent of shareholders, put their own self-

interest ahead of the interests of shareholders. -> minimize number of decisions managers must

make for which own self-interest is different from interests of shareholders. Corporate charity: firmdonates (on behalf of shareholders) to local or global causes.

Share price is barometer for corporate leaders that continuously gives them feedback on their

shareholders opinion of their performance.

Hostile takeover: an individual or organization (sometimes known as corporate raider) can purchase

large fraction of equity and acquire enough votes to replace board of directors and CEO.7

When corporation borrows money: debt holder also becomes investor in corporation. Debt holders

are entitled to seize assets of corporation in compensation of default. To prevent seizure:

renegotiate with debt holders or file for bankruptcy. -> when firm fails to repay debts, control passes

from equity holders to debt holders. Bankruptcy needs not to result in a liquidation of firm (shutting


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down business and selling off assets), because if assets go to debt holders, their interest is still to run

the firm in most profitable way.

Stock market/stock exchange: shares of public companies trade here. Those markets provide liquidity

and determine a market price for the companys shares. Investment is said to be liquid if it is possible

to sell it quickly and easily for a price close to the price you could buy it.

Primary market: where listed companies issue new shares and sell them to investors.

Secondary market: after initial transaction between corporation and investors shares continue to

trade here. Without involvement of corporation, between shareholders only.

NYSE: new York stock exchange. Physical place. Market makers/specialists match buyers and sellers.

They post 2 prices for every stock they make a market in: bid price (price they are willing to buy the

stock), ask price (price they are willing to sell the stock for). Ask prices exceed bid prices = bid-ask

spread. Customers always buy at ask price, and sell at bid price. Bid-ask spread is a transaction cost

investors have to pay in order to trade.

NASDAQ: market connecting market makers and dealers by computer network and telephone. On

NYSE each share has only one market maker, on NASDAQ shares can have multiple market makers

who compete. NASDAQ posts best prices first and fills orders accordingly.

FFA CHAPTER 2

Financial statements: accounting reports issued by a firm periodically (usually quarterly and

annually), that present past information and a snapshot of the firms financial position.

Annual report: need to be sent with financial statements to a firms shareholders

Generally Accepted Accounting Principles (GAAP): together with International Financial Reporting

Standards, they provide a common set of rules and standard formats for public companies to use.

Auditor:neutral third party, checks the annual financial statements to ensure theyre reliableand

according to GAAP

-every country has own GAAP. Now IASB issued IFRS, which was accepted by every country except

USA and Japan. USA keeps own GAAP

Four financial statements: balance sheet, income statement, statement of cash flows, statement of

changes in stockholders equity

Balance sheet: also called statement of financial position, lists firms assets and liabilities, providing a

snapshot of the firms financial position at a given point in time. Two sides: assets left, liabilities right.

Assets: cash, inventory, property, plant, equipment and any other investments the company made.

Current assets: either cash or assets that can be converted to cash within one year. E.g.: 1) cash and

other marketable securities (short-term, low-risk investments, can be easily sold), 2) accounts

receivable (amounts owed to the firm by customers), 3) inventories (raw materials, goods etc.), 4)

other current assets e.g. prepaid expenses


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Long-term/ non-current assets: are assets such as land, property, machinery, which produce tangible

benefits for more than one year. E.g.: 1) Depreciation: reducing value of fixed assets (other than

land), over time, according to a depreciation schedule depending on the assets life span. Book value:

also carrying amount, is equal to its acquisition cost less accumulated depreciation, 2)

Goodwill/intangible assets: e.g. if a firm is purchased for more money than the total tangibles

accumulate. Reason for that is for example a brand name, trademarks etc., 3) Amortization

/impairment charge: captures the change in value of the acquired assets. Not an actual cash outflow,

4) other long-term assets, e.g. unused property, start-up costs etc.

Liabilities: a firms obligations to creditors. The stockholders equity section is also shown there.

Current liabilities: liabilities that will be satisfied within one year. E.g.: 1) Accounts payable (amounts

owed to suppliers for products or services purchased with credit, 2) short-term debt (or notes

payable, current maturities of long-term debt which are all repayments of debt that will occur within

the next year), 3) accrual items, e.g. salary that are owed but not yet paid, deferred or unearned

revenue

The difference between current assets and current liabilities: net working capitalcapital available in

the short term to run the business

Long-term liabilities: liabilities that extend beyond on year. 1) long term debt (any loan or debt

obligation with a maturity of more than a year) 2) capital leases (long-term lease contracts that

obligate a firm to gain use of an asset by leasing it 3) deferred taxes (taxes owed but not yet paid)

Stockholders equity:difference between a firms assets and liabilities, accounting measure of firms

net worth. Also: book value of equity

Market capitalization: market value, market price per share times the number of shares

Liquidation value: the value that would be left if its assets were sold and liabilities paid.

Market-to-book ratio: also: price-to-book ratio (P/B ratio). For successful firms: exceeds 1, meaning

that if assets are put to use they exceed historical costs.

Value stocks/shares: companies with low market-to-book ratios

Growth stocks/shares: companies with high market-to-book ratios

Leverage/gearing: the extent to which a firm relies on debt as a source of financing

Debt-to-equity ratio: assesses leverage. Either with book or market values (market is better)

Enterprise value: assesses the value of the underlying business assets, unencumbered by debt and

separate from any cash and marketable securities

Current ratio: ratio of current assets and current liabilities, to see if sufficient working capital to meet

short-term needs

Quick ratio: /acid test/liquidity ratio, ratio of current assets other than inventory, to current liabilities

->a higher current or quick ratio implies less risk of experiencing cash shortfall


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Income statement: or statement of comprehensive income, lists firms revenues and expenses over a

period of time. The last line (bottom line) shows the firms net income/net profit, which is a measure

of profitability. It is also called profit and loss account/P&L account. Net income is also called

earnings.

Gross profit: the first 2 lines of the income statement list revenues from sales and costs incurred tomake and sell products. The third line is gross profit which is the difference between sales revenues

and cost of sales

Operating expenses: expenses from ordinary course of running the business, not directly related to

producing the goods. E.g.: administrative expenses, overhead, salaries, marketing costs, research and

development expenses. Also: depreciation and amortization, but they dont represent actual cash

expenses. Then: gross profit +- operating expenses = operating income.

Earnings before interest and taxes (EBIT): other sources of income or expenses that arise from

activities that are not the central part of a companys business. E.g.: income from the firms financialinvestments. After that we have: EBIT

Pretax and net income: from EBIT we deduct interest expense and then we deduct corporate taxes to

determine net income, often reported as earnings per share (EPS)

Share/stock options: give the holder the right to buy a certain number of shares by a specific date at

specific price, Convertible bonds: form of debt that can be converted into shares. Both produce more

shares in total, to be divided into the same earnings, so this growth in shares is called dilution. It is

disclosed as diluted EPS

Profitability ratios: gross margin: ratio of gross profit to revenues/sales reflects ability to sell aproduct for more than the cost of production. Operating margin: ratio of operating profit to

revenues, important because there are additional expenses of operating a business beyond the direct

costs of goods sold. It reveals how much a company earns before interest and taxes from each dollar

of sales. One can similarly compute EBIT margin. It is useful to assess relative efficiency of firms

operations. Net profit margin: ratio of net income to revenues/sales. Shows the fraction of each

dollar in revenues that is available to equity holders after the firm pays its expenses plus interest and

taxes.

Working capital ratios: accounts receivable days: the number of days worth of sales that a firm

represents. Similar ratios: accounts payable days, inventory days.

EBITDA: earnings before interest, taxes, depreciation and amortization. Reflects the cash a firm has

earned from its operations

Leverage ratios: interest coverage ratio: compare income or earnings with interest expenses. If the

ratio is high, it indicates that the firm is earning much more than is necessary to meet payments

Investment returns: return on equity (ROE): evaluates firms return on investments. A high ROE

indicates that the firm is able to find investment opportunities that are profitable. Also common:

return on assets (ROA): net income divided by total assets

The DuPont identity: expresses ROE as the product of profit margin, asset turnover and a measure of

leverage. Asset turnover: measures how efficiently a firm is utilizing its assets to general sales.


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Equity multiplier: indicates the value of assets held per euro or dollar of shareholder equity. The

higher the multiplier, the greater is the firms reliance on debt financing.

Valuation ratios: ratios to gauge the market value of a firm. Price-earnings ratio (P/E): ratio of the

value of equity to the firms earnings, either on a total basis or on a per-share basis. Assesses

whether a share is over- or undervalued based on the idea that the value of a share should beproportional to the level of earnings it can generate for its shareholders.

Statement of cash flows: utilizes information from the income statement and balance sheet to

determine how much cash the firm has generated and how that cash has been allocated during a set

period. Divided into three sections:

Operating activities: starts with net income from the income statement. Then adjusts this number by

adding back all non-cash entries related to the firms operating activities. Depreciation is added back,

as well as any other non-cash expenses. Accounts receivable: if sale is recorded as part of net

income, but cash has not yet been received, we must deduct the increases in accounts receivable.Accounts payable: we add increases in accounts payable. Inventory: we deduct increases to

inventory.

Investing activities: lists the cash used for investment. Capital expenditures: e.g. purchases of

property, plant and equipment. Those are subtracted.

Financing activities: shows the flow of cash between the firm and its investors. Retained earnings: Is

net income minus dividends. Any cash the company received from the sale of its own shares or cash

spent repurchasing its own shares.

Management discussion and analysis (MD&A): also business and operating review. Is a preface to thefinancial statements in which the companys management reviews the recent years performance,

providing a background on the company and any significant events.

Off-balance sheet transactions: transactions or arrangements that can have a material impact on the

firms future performance yet do not appear on the balance sheet. They must be disclosed.

Statement of changes in shareholders equity:provides a reconciliation of the opening and closing

equity position. It provides details of the movements in share capital, reserves and retained earnings

derived from the income statement.

Notes to the financial statements: everything important, taxes, rules used to prepare statements etc.

Sarbanes-Oxley Act (SOX): wants to improve the accuracy of information given to both boards and

shareholders. 1.) Overhaul incentives and the independence in the auditing process 2.) Stiffen

penalties for providing false information 3.) force companies to validate their internal financial

control process

CHAPTER 3


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Skills needed to analyze costs and benefits: marketing (to forecast increase in revenues resulting

from an ad campaign), accounting (to estimate tax savings from restructuring), economics (to

determine the increase in demand from lowering the price of a product), OB (to estimate

productivity gains from change in management structure), Strategy (to predict a competitors

response to a price increase), Operations (to estimate cost savings from plant modernization)

Competitive market: a market in which it can be bought and sold at the same price. In a competitive

market the price determines the cash value of the good

Valuation principle: the value of an asset to the firm or its investors is determined by its competitive

market price. The benefits and costs of a decision should be evaluated using these market prices, and

when the value of the benefits exceeds the value of the costs, the decision will increase the market

value of the firm.

Time value of money: the difference in value between money today and money in the future

Risk-free interest rate: the interest rate at which money can be borrowed or lent without risk over

that period, rf.

Interest rate factor: 1+rf. For risk-free cash flows. Defines the exchange rate across time, has units of:

$in one year/$today.

Value of investment in one year: cost= value today * 1+rf

Value of investment today: Benefit= value in one year / 1+rf

Present value (PV): value expressed in terms of dollars today

Future value (FV): value expressed in terms of dollars in the future

Discount factor: 1 / 1+rf. -> rf = discount rate

Dollars Today / gold price = ounces of gold today, Dollars Today * exchange rate = euros today,

Dollars Today * 1+rf = dollars in one year

NPV rule = golden rule of financial decision making

Net present value (NPV): difference between PV of benefits and PV of costs. NPV= PV(benefits)-

PV(costs), or NPV=PV(all project cash flows). If NPV is positive: decision increases value of firm and isa good decision, regardless of your current cash needs

Regardless of preferences for cash today vs cash in the future, you should always maximize NPV first.

You can still borrow or lend to shift cash flows.

Arbitrage: practice of buying and selling equivalent goods in different markets to take advantage of a

price difference

Arbitrage opportunity: any situation in which it is possible to make a profit without taking any risk or

making any investment (positive NPV)

Normal market: competitive market without arbitrage opportunities


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Law of one price: if equivalent investment opportunities trade simultaneously in different

competitive markets then they must trade for the same price in both markets -> when calculating

NPV you only need to check one price, not all

Financial security: an investment opportunity trading in a financial market

Bond: security sold by governments and corporations to raise money from investors today in

exchange for the promised future payment

Short sale: the person who intends to sell the security first borrows it from someone who already

owns it. Later that person must either return the security by buying it back of pay the owner the cash

flows he would have received.

No-arbitrage price: price how it should be in a normal market. Price (Security) = PV (all cash flows

paid by the security)

Pricing other securities: 1) identify cash flows that will be paid by security 2) determine the do-it-yourself cost of replicating those cash flows on our own->the PV of the securitys cash flows

Determine risk-free interest rate: 1+rf = FV/PV

Return: percentage gain earned from investing in bond. Return=Gain at end of year/initial cost. If no

arbitrage: risk-free interest rate = return

NPVs of all security trades in normal markets must be zero

Separation principle: security transactions in a normal market neither create, nor destroy value on

their own. Therefore we can evaluate the NPV of an investment decision separately from thedecision the firm makes regarding how to finance the investment or any other security transactions

the firm is considering.

Portfolio: collection of securities

Value additivity: price of C must equal price of portfolio with A+B.

CHAPTER 4

Stream of cash flows: a series of cash flows lasting several periods

Timeline: linear representation of the timing of the expected cash flows

Rule 1: comparing and combining values: it is only possible to compare or combine values at the

same point in time.

Rule 2: moving cash flows forward in time: to move a cash flow forward in time you must compound

it. Value today * (1+r) = value in one year -> C * (1+r)^n

Compounding: a value being moved forward in time

Compound interest: earning interest on interest


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Rule 3: moving cash flows back in time: to move a cash flow back in time we must discount it. Value

in one year / (1+r) = value today -> C / (1+r)^n

Discounting: move a value backward in time, find equivalent value today of a future cash flow

Present value of a cash flow stream: Cn / (1+r)^n

Future value of a cash flow stream with a present value of PV: FVn = PV * (1+r)^n

Perpetuity: a stream of equal cash flows that occur at regular intervals and last forever. First cash

flow arrives at end of first period-> payment in arrears. PV of perpetuity = C / r -> by depositing C/r

today, we can withdraw interest of C/r * r = C each period in perpetuity.

Common mistake: if first cash flows in 2ndperiod: PV = C / 1+r = cash flow in 1stperiod

Consol: perpetual bond, British government bond

Annuity: a stream of N equal cash flows paid at regular intervals. Also payment in arrears. PV of

annuity = C * (1/r) * (1- ( 1 / 1+r^n)), FV of annuity = C * (1/r) * ((1+r)^n -1)

Growing perpetuity: a stream of cash flows that occur at regular intervals and grow at a constant rate

forever. The first payment does not grow. Growth rate = g. G < r for a growing perpetuity. PV of a

growing perpetuity = C / (r-g).

Growing annuity: a stream of N growing cash flows, paid at regular intervals. PV of a growing annuity

= C * 1/(r-g) * ( 1((1+g) / (1+r))^n ).

Loan payment: C = P / ((1/r) * ( 1- 1/(1+r)^n )) -> P = amount borrowed

Internal rate of return (IRR): the interest rate that sets the NPV of the cash flows equal to zero.

Rule of 72: fairly accurate for interest rates higher than 2%. Years to double = 72 / interest rate in %

CHAPTER 5

Effective annual rate (EAR): the actual amount of interest that will be earned at the end of one year.

Adjusting the discount rate to different time periods: (1+r)^n-1 (n smaller than 1 if period less thanone year, n is bigger than 1 if period more than one year)

Annual percentage rate (APR): the amount of simple interest earned in 1 year (->without effect of

compounding)

Interest rate per compounding period= APR / k periods per year

Converting an APR to EAR: 1+EAR = (1+(APR/k))^k

Continuous compounding: compounding the interest every instant

Amortizing loans: each month interest is paid on loan, plus some part of the loan balance.


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Computing the outstanding loan balance: also: outstanding principal, equal to PV of remaining future

loan payments.

Adjustable rate mortgages (ARMs):have interests that are not constant over the life of the loan

Nominal interest rates: the rate at which your money will grow if invested for a certain period, r

Real interest rate: rate of growth of your purchasing power after adjusting for inflation, denoted rr

Growth in purchasing power = 1+rr = (1+r)/(1+i) = growth of money/growth of prices) (i=inflation

rate). -> real interest rate = rr = (r-i)/(1+i) = r-i

Term of an investment/loan: the horizon of the loan/investment

Term structure: relationship between the investment term and the interest rate

Yield curve: a graph showing the term structure

PV of a cash flow stream using a term structure of discount rates= Cn / (1+rn)^n, Cn= risk-free cash

flow received in n years, rn= risk-free interest rate (EAR) for an n-year term

Federal funds rate: the rate at which banks can borrow cash reserves on an overnight basis

Increasing (steep) yield curve with higher long-term rates than short-term rates = interest rates are

expected to rise in future

Decreasing (inverted) yield curve with lower long-term rates = signals expected deadline in future

interest rates

The right discount rate for a cash flow is the rate of return available in the market on other

investments of comparable risk and term

After-tax interest rate: the reduced amount of interest the investor can keep, after taxes. r= interest

rate, = tax rate. r- (*r) = r* (1-).

Opportunity cost of capital/cost of capital: the best available expected return offered in the market

on an investment of comparable risk and term to the cash flow being discounted.

The EAR for a continuously compounded APR: (1+EAR) = e^APR

The continuously compounded APR for an EAR: APR = ln(1+EAR)

PV of a continuously growing Perpetuity: PV = C / (rcc-gcc), where rcc=ln(1+r) and gcc=ln(1+g).

CHAPTER 6

NPV profile: calculation which graphs the projects NPV over a range of discount rates.

The difference between the cost of capital and the IRR is the maximum estimation error in the cost of

capital that can exist without altering the original decision.


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Internal rate of return (IRR) investment rule: Take any investment opportunity where the IRR exceeds

the opportunity cost of capital. Turn down any opportunity whose IRR is less than the opportunity

cost of capital.

->the IRR rule is only guaranteed to work for a stand-alone project if all of the projects negative cash

flows precede its positive cash flows.

Situations in which the IRR fails: 1) delayed investments 2) multiple IRRs 3) nonexistent IRR

Payback investment rule: you should only accept a project if its cash flows pay back its initial

investment within a pre-specified period.

Payback period: the amount of time it takes to pay back the initial investment

->accept project if payback period is less than a pre-specified length of time.

Pitfalls of Payback rule: 1) ignores the projects cost of capital and the time value of money 2) ignorescash flows after the payback period 3) relies on an ad hoc decision criterion ->typically used for small

investment decisions.

IRR rule and mutually exclusive investments: When projects differ in their scale of investment, the

timing of their cash flows or their riskiness, then their IRRs cannot be meaningfully compared.

Differences in scale: it depends on the size of the investment. Differences in timing: long-term

investments are more profitable than short-term. Differences in risk: ignores differences of risk!

Incremental IRR: the IRR of the incremental cash flows that would result from replacing one project

with the other. Identifies the discount rate at which the optimal decision changes. Problems: if

negative cash flows do not precede the positive ones, the incremental IRR is difficult to interpret and

may not exist or may not be unique. The incremental IRR cannot indicate whether either project has

a positive NPV on its own. When projects have different costs of capital it is not obvious what cost of

capital the incremental IRR should be compared to.

We can only compare returns if the investments: 1) have the same scale 2) have the same timing 3)

have the same risk

Evaluate projects with different resource requirements: sometimes, if you have a budget, it is

possible to choose 2 investments instead of 1, where the added NPVs of the 2 investments exceed

the NPV of the single investment.

Profitability index: Value created/resource consumed = NPV / resource consumed

Conditions of the profitability index: 1) the set of projects taken following the profitability index

ranking completely exhaust the available resource. 2) There is only a single relevant resource

constraint.

CHAPTER 7

Capital budget: lists the projects and investments that a company plans to undertake during the

coming year


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Capital budgeting: analyzing alternative projects and decide which ones to accept. Begins with

forecasts of the projects future consequences to the firm

Incremental earnings: the amount by which the firms earnings are expected to change as a result of

the investment decision.

Straight-line depreciation: assets cost (less any expected salvage value) is divided equally over its

estimated useful life

Unlevered net income: indicates that it does not include any interest expenses associated with debt

Marginal corporate tax rate: tax rate firm will pay on an incremental dollar of pre-tax income. Income

tax = EBIT * c (c=marginal corporate tax rate)

Unlevered net income=EBIT*(1-c)= (Revenues-costs-depreciation)*(1-c)

Opportunity cost of using a resource: the value it could have provided in its best alternative use

Project externalities: indirect effects of the project that may increase or decrease the profits of other

business activities of the firm.

Cannibalization: when sales of a new product displace sales of an existing product

Sunk cost: any unrecoverable cost for which the firm is already liable

->If our decision does not affect the cash flow, then the cash flow should not affect our decision.

Overhead expenses: associated with activities that are not directly attributable to a single business

activity, but instead affect many different areas of the corporation

Sunk cost fallacy: describes the tendency of people to be influenced by sunk costs and to throw

good money after bad. Also calledConcorde effect

Free cash flow: the incremental effect of a project on the firms available cash

Trade credit: difference between receivables and payables; net amount of the firms capital that is

consumed as a result of these credit transactions

Increase in net working capital in year t: deltaNWCt = NWCtNWCt-1

Free cash flow = (revenuescosts) * (1-c) CapExdeltaNWCt + c * depreciation

Depreciation tax shield: the tax savings that result from the ability to deduct depreciation;

c*depreciation

Present value of each free cash flow in the future: PV(FCFt)= FCFt * (1/(1+r)^t), t=year discount factor

MACRS depreciation: MACRS= modified accelerated cost recovery system. Firm first categorizes

assets according to their recovery period, based on that depreciation tables assign a fraction of the

purchase price that the firm can recover each year.

Gain on sale = sale pricebook value


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Book value = purchase priceaccumulated depreciation

After-tax cash flow from asset sale = sale price(c*gain on sale)

Terminal/continuation value: an additional, one-time cash flow at the end of the forecast horizon.

Represents the market value (as of the last forecast period) of the free cash flow from the project atall future dates

Tax loss carryforwards and carrybacks: additional features of the tax code, allow corporations to take

losses during a current year and offset them against gains in nearby years.

Break-even level: the level for which the investment has an NPV of zero

Break-even analysis: for each parameter, we calculate the value at which the NPV of a project is zero

EBIT break-even: for sales, the level of sales for which the projects EBIT is zero

Sensitivity analysis: breaks NPV calculation into its component assumptions, shows how NPV varies

as the underlying assumptions change. Allow us to explore effects of errors in NPV estimates -> learn

which assumptions are most important

Scenario analysis: considers the effect on the NPV of changing multiple project parameters.

CHAPTER 8

Bond certificate: indicates the amounts and dates of all payments to be made

Maturity date: final repayment date

Term: time remaining until the repayment date

Coupons: promised interest payments of a bond

Face value/principal: the notional amount we use to compute the interest payments. Usually repaid

at maturity

Coupon rate: set by the issuer, stated on bond certificate, expressed as an APR, determines the

amount of each coupon payment. Amount of each coupon payment = CPN = (coupon rate*facevalue)/number of coupon payments per year

Zero-coupon bond: a bond that does not make coupon payments. Investor only receives face value.

Also called pure discount bonds

Treasury bills: U.S. government bonds with maturity of up to one year, zero-coupon bonds

Discount: price lower than face value

Yield to maturity (YTM): YTM of a bond is the discount rate that sets the PV of the promised bond

payments equal to the current market price of the bond. -> yield to maturity of an n-year zero-coupon bond: YTMn = ((FV/P)^1/n)1 P= current price


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Risk-free interest rate with maturity n: rn = YTMn

Spot interest rates: default-free, zero-coupon yields

Coupon bonds: pay investors face value at maturity AND make regular coupon interest payments

Treasury notes: have original maturities from one to 10 years

Treasury bonds: have original maturities of more than 10 years

Yield to maturity of a coupon bond: P = CPN*(1/y)*(1-(1/(1+y)^N))+(FV/(1+y)^N) ->trial and error.

Result is rate per coupon interval, so multiply by number of coupons per year = APR

Premium: price greater than face value

Par: price equal to face value

If a bonds yield to maturity has not changes, then the IRR of an investment in the bond equals itsyield to maturity even if you sell the bond early.

As interest rates and bond yields rise, bond prices will fall, and vice versa.

Dirty/invoice price of a bond: price of a bond as actual cash price

Clean price: the bonds cash price less and adjustment for accrued interest (= Coupon amount * (days

since last coupon payment/days in current coupon period))

Price of a coupon bond: P = PV (Bond cash flows)= CPN/1+YTM1 + .... + (CPN+FV)/(1+YTMn)^n,

CPN=bond coupon payment, YTMn = yield to maturity of a zero-coupon bond that matures at thesame time as the nth coupon payment, FV = face value of bond

Coupon-paying yield curve: the plot of the yields of coupon bonds of different maturities

On-the-run bonds: most recently issued bonds

Corporate bonds: bonds issued by corporations

Credit risk: risk of default. Bonds cash flows are not known with certainty

The yield to maturity of a defaultable bond is not equal to the expected return of investing in the

bond.

The bonds expected return, which is equal to the firms debt cost of capital, is less than the yield to

maturity if there is a risk of default. Moreover, a higher yield to maturity does not necessarily imply

that a bonds expected return is higher.

Investment-grade bonds: low default risk, bonds in the top four categories

Speculative/junk/high-yield bonds:bonds in the bottom five categories, high likelihood of

default

Default/credit spread: the difference between the yields of the corporate bonds and the

treasury yields


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CHAPTER 9

Equity cost of capital: rE, the expected return of other investments available in the market

with equivalent risk to the firms shares

Dividend yield: the expected annual dividend of the stock, divided by its current price

Capital gain: the difference between the expected sale price and purchase price for the stock

Capital gain rate: capital gain, divided by current stock price

Total return of stock: sum of dividend yield and capital gain rate

->The expected total return of the stock should equal the expected return of other

investments available in the market with equivalent risk

Short interest: number of shares sold short

Dividend-discount mode: P0 = (DivN/1+rE^N)

->The price of the stock is equal to the present value of the expected future dividends it will

pay

Constant dividend growth model: P0 = Div1/rE-g

Dividend payout rate: the fraction of a firms earnings that it pays as dividends each year

Increase dividend in 3 ways: 1) increase earnings/net income 2) increase dividend payout

rate 3) decrease shares outstanding

Retention rate: fraction of current earnings that the firm retains

->cutting the firms dividend to increase investment will raise the stock price if, and only if,

the new investments have a positive NPV

Share repurchase: the firm uses excess cash to buy back its own stock

Total payout model: values all of the firms equity, rather than a single share -> P0 =PV(future total dividends and repurchases)/shares outstanding0

Discount free cash flow model: begins by determining the total value of the firm to all

investorsboth equity and debt holders -> V0 = PV(future free cash flow of firm)

Weighted average cost of capital (WACC): rwacc, the average cost of capital the firm must

pay to all of its investors, both debt and equity holders

PV of dividend payments determines stock price, PV of total payouts/all dividends and

repurchases determines equity value, PV of free cash flow determines enterprise value


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Method of comparables: comps, estimating the value of the firm based on the value of

other, comparable firms or investments that we expect will generate very similar cash flows

in the future

Valuation multiple: a ratio of the value to some measure of the firms scale

Forward P/E: the P/E multiple computed based on its forward earnings (expected earnings

over the next twelve months)

Trailing P/E: uses trailing earnings (earnings over the prior 12 months)

Efficient markets hypothesis: implies that securities will be fairly priced, based on their

future cash flows, given all information that is available to investors

CHAPTER 23

Angel investors: individual investors who buy equity in small private firms, often friends

Venture capital firm: a limited partnership that specializes in raising money to invest in the

private equity of young firms

Venture capitalists: the general partners who run the venture capital firm

Carried interest: a share of any positive return generated by the fund in a fee

Private equity firm: organized like a venture capital firm, but invests in equity of existing

privately held firms rather than start-up companies

Leveraged buyout (LBO): transaction of taking the company private by purchasing

outstanding equity of a publicly traded firm

Corporate investor/corporate partner/strategic partner/ strategic investor: a corporation

that invests in private companies

Preferred stock: issued by mature companies (banks), has a preferential dividend andseniority in any liquidation and sometimes special voting rights

Convertible preferred stock: preferred stock by young companies, because it typically does

not pay regular cash dividends but gives the owner the option to convert into common stock

Pre-money valuation: the value of the prior shares outstanding at the price in the funding

round

Post-money valuation: the value of the whole firm (old and new shares) at the funding round

price

Exit strategy: how a private company will eventually realize the return from their investment


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Initial public offering (IPO): process of selling stock to the public for the first time

+ of going public: greater liquidity, better access to capital

-of going public: equity holders of corporation become more widely dispersed

Underwriter: an investment banking firm that manages the offering and designs its

structure; type of shares to be sold, mechanism the financial advisor will use to sell stock

Primary offering: new shares in IPO that raise new capital

Secondary offering: existing shares in IPO that are sold by current shareholders

Best-efforts IPO: underwriter does not guarantee that stock will be sold, but tries to sell

stock for best possible price. Often: all-or-none clause (either all of shares sold in IPO or deal

is called off)

Firm commitment IPO: underwriter guarantees that it will sell all of the stock at offer price;

underwriter purchases entire issue at slightly lower price than offer price and then resells at

offer price-> if entire issue does not sell out shares must be sold cheaper and underwriter

takes the loss

Auction IPO: called OpenIPO. Lets market determine price of the stock by auctioning off the

company. Investors place bids over set period of time, auction IPO then sets highest price

such that the number of bids at or above that price equals the number of offered shares. All

winning bidders pay this price, even when bid was higher

Lead underwriter: the primary banking firm responsible for managing the deal

Syndicate: group of other underwriters

Registration statement: required by SEC, a legal document that provides financial and other

information about the company to investors, prior to an IPO

Preliminary prospectus/red herring: part of registration statement, circulates to investors

before stock is offered

Final prospectus: contains all details of IPO, including number of shares offered and offer

price

Road show: senior management and lead underwriters travel around country/world

promoting the company and explaining their rationale for the offer price to the

underwriters largest customers institutional investors

Book building: process for coming up with offer price based on customers expressions of

interest

Underwriting spread: fee paid to underwriters


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Over-allotment allocation/greenshoe provision: an option that allows the underwriter to

issue more stock, amounting to 15% of the original offer size, at the IPO offer price

180-day lockup: shareholders cannot sell their shares for 180 days after IPO

1) IPOS appear to be underpriced->price at end of trading on first day is often higher thanIPO price 2) number of issues is highly cyclical->good times: market is flooded with new

issues, bad times: number of issues dries up 3) costs of an IPO are very high, unclear why

firms willingly incur them 4) long-run performance of newly public company (3-5 years from

date of issue) is poor

Who benefits from underpricing? Underwriters, investors who bought stock in IPO. Who loses? The

pre-IPO shareholders of issuing firms

Winners curse:a form of adverse selection; you win (get all shares requested) when demand for

shares by others is low and IPO is likely to perform poorly.

Seasoned equity offering (SEO): a type of offering, many similar steps to IPO, but market price for the

stock already exists so the price-setting process is not necessary

Primary shares: new shares issued by company

Secondary shares: shares sold by existing shareholders

Tombstones: intermediaries advertised sale of stock by advertisements in newspapers

Cash offer: seasoned equity offering, firm offers new shares to investors at large

Rights offer: seasoned equity offering, firm offers new shares only to existing shareholders

CHAPTER 24

Indenture: a formal contract between the bond issuer and a trust company

Original issue discount (OID) bond: a coupon bond issued at a discount

Bearer bonds: like currency; whoever physically holds the bond certificate owns the bond. To

receive coupon payment you must provide an explicit proof of ownership -> clip off bond

certificate and remit it to paying agent

Registered bonds: issuer has list of all holders of bonds. Brokers keep issuers informed about

changes in ownership

Unsecured debt: in event of bankruptcy bondholders have a claim to only the assets of the

firm that are not already pledged as collateral on other debt


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Secured debt: specific assets are pledged as collateral that bondholders have a direct claim

to in the event of bankruptcy

Notes: unsecured, original maturity less than 10 years

Debentures: unsecured

Mortgage bonds: secured with property

Asset-backed bonds: secured with any asset

Tranches: kinds of debt

Seniority: the bondholders priority in claiming assets in event of default

Subordinated debenture: when a firm conducts a subsequent debenture issue that has lower

priority than its outstanding debt, the new debt is known as subordinated debenture

Domestic bonds: bonds issued by a local entity, traded in local market, purchased by

foreigners, denominated in local currency

Foreign bonds: bonds issued by foreign company in local market, intended for local

investors, denominated in local currency

Yankee bonds: foreign bonds in United States

Samurai bonds: bonds in Japan

Bulldogs: bonds in United Kingdom

Eurobonds: international bonds, not denominated in local currency of country in which they are

issued -> no connection between physical location of the market on which they trade and the

location of the issuing entity

Global bonds: combine features of domestic, foreign and Eurobonds, offered for sale in several

different markets simultaneously

Private debt: debt that is not publicly traded, private debt market is larger than public. Advantage:

avoids cost of registration. Disadvantage: illiquid

Term loan: a blank loan that lasts for a specific term

Syndicated bank loan: single loan, funded by a group of banks. One member of syndicate (lead bank)

negotiates terms of bank loan

Revolving line of credit: credit commitment for a specific time period up to some limit

Private placement: a bond issue that does not trade on public market, rather sold to small group of

investors. Does not need to be registered, less costly to issue

Sovereign debt: debt issued by national governments


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Treasury bills: discount, maturity: 4,13,26 weeks, treasury notes: coupon, maturity: 2,3,5,10 years,

treasury bonds: coupon, maturity: 20,30 years, treasury inflation-protected securities (TIPS): coupon,

maturity: 5,10,20 years

Stop-out yield: highest yield accepted

STRIPS: separate trading of registered interest and principal securities; zero-coupon treasury

securities with maturities longer than one year

Municipal bonds: munis; issued by state and local governments, income on them is not taxable at

federal level, also called: tax-exempt bonds

Serial bonds: bond with number of different maturity dates, scheduled to mature serially over a

number of years

Revenue bonds: pledge specific revenues generated by projects that were initially financed by the

bond issue

General obligation bonds: backed by full faith and credit of a local government

Double-barreled: commitment is over and above usual commitment, because local government can

always use its general revenue to repay bonds like the one above

Asset-backed security (ABS): security made up of other financial securities, securities cash flows

come from the cash flows of the underlying financial securities that back it

Asset securitization: process of packaging a portfolio of financial securities and issuing an asset-

backed security backed by this portfolio

Mortgage-backed security (MBS): asset-backed security backed by home mortgages

Prepayment risk: risk that bond will be partially or wholly repaid earlier than expected

Collateralized debt obligation (CDO): new asset-backed security when banks resecuritize asset-

backed and other fixed income securities

Covenants: restrictive clauses in bond contract that limit issuer from taking actions that may

undercut its ability to repay the bonds

Subprime mortgages: mortgages not satisfying certain credit criteria, with high default probability

Collateralized mortgage obligations (CMO): different tranches of securities, distinguished by their

seniority

Callable bonds: bonds containing call provision that allows issuer to repurchase bonds at

predetermined price

Call date: date on which or after which issuer can retire all outstanding bonds

Call price: generally set at or above, expressed at percentage of bonds face value

Yield to call (YTC): annual yield of callable bond, assuming the bond is called at earliest opportunity


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Sinking fund: company makes regular payments into a sinking fund, administered by a trustee over

the life of the bond. These payments are used to repurchase bonds

Balloon payment: large payment on maturity date of a sinking fund

Conversion ratio: ratio at which bondholder converts each bond owner into fixed number of sharesof common stock

Warrant: the special type of call option of a convertible bond

Conversion price: the strike price of the embedded warrant, is equal to the face value of the bond

divided by the conversion ratio

CHAPTER 26

Cash cycle: length of time between when the firm pays cash to purchase its initial inventory and

when it receives cash from the sale of the output produced from that inventory

Cash conversion cycle (CCC): CCC = accounts receivable days + inventory daysaccounts payable

days; ARD = accounts receivable/average daily sales, ID = Inventory/average daily cost of goods sold,

APD = Accounts payable/average daily cost of goods sold

Operating cycle: the average length of time between when a firm originally purchases its inventory

and when it receives the cash back from selling its product

Trade credit: the credit that the firm is extending to its customers; Net30 = payment not due until 30

days from date of invoice; 2/10, Net30 = if paid in 10 days, discount of 2%

Benefits of trade credits: lower transaction costs than alternative sources of funds-> no paperwork;

flexible source of funds, can be used as needed; sometimes only source of funding available

Collection float: the amount of time it takes for a firm to be able to use funds after a customer has

paid for its goods. Determined by 3 factors: mail float (how long it takes the firm to receive the check

after the customer has mailed it), processing float (how long it takes the firm to process the check

and deposit it in the bank), and availability float (how long it takes before the bank gives the firm

credit for the funds)

Disbursement float: the amount of time it takes before payments to suppliers actually result in a cash

outflow for the firm -> same factors. Too late payments can result in CBD (required to pay before

delivery) or COD (required to pay on delivery) or supplier refuses to do business with firm

Check clearing for the 21stcentury act (check 21): eliminated the disbursement float due to the

check-clearing process. Banks can process check information electronically and funds are deducted

from a firms checking account on the same day that the firms supplier deposits the check in its bank

-> does not serve to reduce collection float

How to reduce collection float: streamline in-house check-processing procedures, use electronic

collection


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Motivations for holding cash: 1) Meet day-to-day needs 2) Compensate for uncertainty associated

with cash flows 3) Satisfy bank requirements

Transaction balance: the amount of cash a firm needs to be able to pay its bills> depends on

average size of transactions made by firm and firms cash cycle -> use quick ratio

Precautionary balance: the amount of cash a firm holds to counter the uncertainty surrounding its

future cash needs -> depends on degree of uncertainty surrounding a firms cash flows -> use

volatility

Compensating balance: may be required by bank, as compensation for services the bank performs;

mostly on accounts that earn no interest or pay very low interest rate

MONEY MARKET INVESTMENT OPTIONS:

Investment Description Maturity Risk Liquidity

Treasury Bills Short-term debtof US government

4 weeks, 3months or 6

months when

newly issued

Default risk free Very liquid andmarketable

Certificates of

Deposit (CDs)

Short-term debt

issued by banks,

minimum

denomination of

$100,000

Varying

maturities up to 1

year

If issuing bank

insured by FDIC

any amount up to

$250,000=free of

default->covered

by insurance, over

that=not insured=

subject to defaultrisk

Sell on secondary

market, less liquid

than treasury bills

Repurchase

agreements

Loan

arrangement,

security

dealer=borrower,

investor=lender,

investor buys

securities with

agreement to sell

it back to dealer

at later date forspecified higher

price

Very short term,

from overnight to

3 months

Collateral for the

loan-> investor is

exposed to little

risk. Investor

needs to consider

trustworthiness o

dealer when

assessing risk

No secondary

market for

repurchase

agreements

Bankers

Acceptances

Drafts written by

borrower,

guaranteed by

bank on which it

is drawn, used in

international

trade

transactions,

borrower isimporter who

writes draft in

1-6 months Borrower and

bank have

guaranteed draft-

> very little risk

When exporter

receives draft he

may hold it until

maturity and

receive its full

value or he may

sell the draft at

discount prior to

maturity


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payment for

goods

Commercial

paper

Short-term,

unsecured debt

issued by large

corporations.Minimum

denomination=

250,000, mostly

face value of

$100,000

1-6 months Depends on

creditworthiness

of issuing

corporation

No active

secondary

market, issuer

may repurchasecommercial paper

Short-term tax

exempts

Short-term debt

of state&local

governments; pay

interest that is

exempt from

federal taxation>pre-tax yield is

lower than that of

similar risk

investment

1-6 months Depends on

creditworthiness

of issuing

government

Moderate

secondary market

CHAPTER 27

First step in short-term financial planning is to forecast future cash flows. Those allow companies to

determine whether it has cash flow surplus or deficit and whether surplus or deficit is long- or short-

term

Firms need short-term financing to deal with seasonal working capital requirements, negative cash

flow shocks or positive cash flow shocks

The matching principle specifies that short-term needs for funds should be financed with short-term

sources of funds, and long-term needs with long-term sources of funds

Bank loans are primary source of short-term financing, especially in small firms. Most straightforward

type of bank loan is single, end-of-period payment loan. Bank lines of credit allow a firm to borrowany amount up to stated maximum. Line of credit may be uncommitted which is a nonbinding

informal agreement or may more typically be committed. A bridge loan is a short-term bank loan

that is used to bridge the gap until the firm can arrange for long-term financing

The number of compounding periods and other loan stipulations such as commitment fees, loan

origination fees and compensating balance requirements affect the effective annual rate of a bank

loan

Commercial paper is a method of short-term financing that is usually available only to large, well-

known firms. It is a low cost alternative to a short term bank loan for those firms

Short term loans may also be structured as secured loan. The accounts receivable and inventory of a

firm typically serve as collateral in short term secured financing arrangements


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Accounts receivable may be either pledged as security for a loan or factored. In a factoring

arrangement the accounts receivable are sold to lender/factor and the firms customers are usually

instructed to make payments directly to factor

Inventory can be used as collateral for a loan in several ways: a floating lien (also general or blanket

lien), a trust receipts loan (or floor planning) or a warehouse arrangement. These arrangements varyin their extent to which specific items of inventory are identified as collateral; so they vary in the

amount of risk the lender faces

Permanent working capital: the amount a firm must keep invested in its short-term assets to support

its continuing operations

Temporary working capital: the difference between the actual level of investment in short-term

assets and the permanent working capital investment

Aggressive financing policy: financing part or all of permanent working capital with short-term debt

Funding risk: the risk of incurring financial distress cost, should the firm not be able to refinance its

debt in a timely manner or at reasonable rate

Conservative financing policy: firm finances its short-term needs with long-term debt

Promissory note: a written statement that indicates amount of loan, date payment is due, interest

rate

Prime rate: the rate banks charge their most creditworthy customers

London inter-bank offered rate (LIBOR): the rate of interest at which banks borrow funds from eachother in the London interbank market

Line of credit: common type of bank loan arrangement, in which a bank agrees to lend a firm any

amount up to a stated maximum

Line of credit may be uncommitted: it is an informal agreement that does not legally bind the bank to

provide funds

Committed line of credit: consists of written, legally binding agreement that obligates bank to

provide funds, regardless of financial situation of firm

Revolving line of credit: a committed line of credit that involves a solid commitment from bank for

longer period of time, 2-3 years

Evergreen credit: revolving line of credit with no fixed maturity

Bridge loan: type of short-term bank loan, used to bridge the gap until firm can arrange for long-term

financing

Discount loan: borrower is required to pay interest at beginning of loan period

Loan origination fee: charged by bank to cover credit checks and legal fees


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Commercial paper: short-term, unsecured debt, used by large corporations, usually cheaper source

of funds than short-term bank loan

Direct paper: firm sells security directly to investor

Dealer paper: dealers sell commercial paper to investors in exchange for a spread or fee for services

Secured loans: loans collateralized with short-term assets (accounts receivable or inventory)

Factors: firms that purchase receivables of other companies

Pledging of accounts receivable agreement: lender reviews invoices that represent credit sales

of borrowing firm and decides which credit accounts it will accept as collateral for loan

based on its own credit standards

Factoring of accounts receivable: firm sells receivables to lender=factor, lender agress to pay

firm the amount due from its customers at the end of the firms payment period

Factoring arrangement with recourse: lender can seek payment from borrower in case

borrowers customers default on their bills

Without recourse: lender bears the risk of bad-debt losses

Floating/general/blanket lien: all of inventory is used to secure loan

Trust receipts loan/floor planning: distinguishable inventory items are held in a trust as

security for loan

Warehouse arrangement: inventory that serves as collateral for loan is stored in warehouse,

least risky

Public warehouse: a business that exists for sole purpose of storing and tracking the inflow

and outflow of inventory

Field warehouse: operated by third party, set up on the borrowers premises in a separate

area, so that inventory collateralizing the loan is kept apart from borrowers main plant

CHAPTER 28

Acquirer or bidder: buyer of another firm

Target firm: bought by acquirer or bidder

Takeover: both a merging and an acquisition

Merger waves: peaks of heavy activity followed by quiet troughs of few transactions in

takeover market


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Conglomerate wave: increase in activity in 1960s, because firms typically acquired firms in

unrelated businesses. 1980s: known for hostile, bust-up takeovers, acquirer purchased

poorly performing conglomerate and sold off its individual business units for more than the

purchase price. 1990s: known for strategic, global deals, more likely to be friendly and

involve companies in related businesses. 2004: marked by consolidation in many industries.Financial crisis and severe contraction of credit in 2008 ended latest merger wave

Horizontal merger: target and acquirer are in the same industry

Vertical merger: targets industry buys or sells to the acquirers industry

Conglomerate merger: target and acquirer operate in unrelated industries

Stock swap: target shareholders receive stock as payment for target shares

Term sheet: summarizes the structure of a merger transaction (who will run new company,size and composition of new board, location of headquarters, name of new company)

Acquisition premium: the percentage difference between the acquisition price and the

premerger price of the target firm

Reasons to acquire: economies of scale, economies of scope (savings from combining the

marketing and distribution of different types of related products), vertical integration

(merger of 2 companies in same industry, making products required at different stages of

production cycle-> enhance product if direct control), expertise, monopoly gains (reduce

competition->increase profits, but in some countries laws that limit this), efficiency gains

(elimination of duplication), tax savings from operating losses, diversification (direct risk

reduction, lower cost of debt/increased debt capacity, liquidity enhancement), earnings

growth (by acquiring company with low growth potential, company with high growth

potential can raise its earnings per share; but: adds no economic value), managerial reasons

to merge (conflict of interest, overconfidence-> hubris hypothesis: overconfident CEOs

pursue mergers that have low chance of creating value because they truly believe that their

ability to manage is great enough to succeed)

Risk reduction: large firms bear less idiosyncratic risk. Ignores the fact that investors canachieve diversification themselves by purchasing shares in the two separate firms

Debt capacity and borrowing costs: larger, more diversified firms have lower probability of

bankruptcy given the same degree of leverage. ->increase leverage -> enjoy tax savings

Liquidity: acquisition provides targets owners with way to reduce risk exposure by cashing

out their investment in private target and reinvest in a diversified portfolio

Takeover synergies: any additional value created in takeover

Takeover process: Valuation-the offer-merger arbitrage-tax and accounting issues-board

and shareholder approval


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The offer: public announcement of its intention to purchase a large block of shares. Two

methods to pay for target: cash or stock. Price offered is determined by exchange ratio

(number of bidder shares received in exchange for each target share multiplied by market

price of acquirers stock).

Maximum number of new shares the acquirer can offer and still receive positive NPV: x often price must be raised. If

board does not agree-> ask shareholders to not sell shares

Risk arbitrageurs: believe that they can predict outcome of a deal, take positions

Merger-arbitrage spread: potential profit which arises from difference between targets

stock price and implied offer price

Friendly takeover: target board of directors supports merger, negotiates with potential

acquirers and agrees on price that is ultimately put to a shareholder vote

Hostile takeover: board of directors and upper-level management fights the takeover

attempt. To succeed, acquirer must garner enough shares to take control of target and

replace board of directors. The acquirer is then called raider

Proxy fight: acquirer attempts to convince target shareholders to unseat the target board by

using their proxy votes to support the acquirers candidates for election to the target board

Poison pill: a rights offering that gives existing target shareholders the right to buy shares in

the target at a deeply discounted price once certain conditions are met. Acquirer excluded

from this right. Purchase is effectively subsidized by existing shareholders of the acquirer

making the takeover very expensive

Staggered/classified board: every director serves a 3-year term and terms are staggered so

that only one-third of directors are up for election each year. ->if bidders candidates win

board seat, it will only control minority o target board

White knight: another, friendlier company to acquire a firm

White squire: large investor or firm agrees to purchase substantial block of shares in target,

with special voting rights. Prevents hostile raider from acquiring control of target

Golden parachute: an extremely lucrative severance package that is guaranteed to a firms

senior managers in the event that the firm is taken over and the managers are let go.

Toehold: initial stake in target, bought anonymously


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Freezeout merger: the laws on tender offers allow the acquiring company to freeze existing

shareholders out of the gains from merging by forcing non-tendering shareholders to sell

their shares for the tender offer price

For a merger to proceed, both the target and the acquiring board of directors must approve

the merger and put question to a vote of the shareholders of the target (sometimes also

shareholders of acquiring firm). If the target board opposes the merger, then the acquirer

must go around the target board and appeal directly to the target shareholders, asking them

to elect a new board that will support the merger

A target board of directors can defend itself in several ways to prevent mergers. Most

effective strategy: poison pill. Or: having a staggered board, looking for friendly bidder,

making it expensive to replace management, changing the capital structure of the firm

When a bidder makes an offer for a firm, the target shareholders can benefit by keepingtheir shares and letting other shareholders sell at a low price. However, because all

shareholders have the incentive to keep their shares, no one will sell. This scenario is called

free rider problem. To overcome: bidders can acquire a toehold in target, attempt a

leveraged buyout or, when acquirer is corporation, offer a freezeout merger.

finance and financial arithmetic

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