Chapter 13 13-1 Definition: A. Assets in place: The securities, real estate, and other property that a company already owns, and therefore does not need to buy in order to execute a particular investment strategy is known as assets in place. Growth Options: Growth option is defined at the firm level in terms of a growth-abandonment swapping option with three state variables -dividends, estimated abandonment proceeds, and borrowings. Non-operating assets: These are the assets that are not required in the normal operations of a business but can generate income in the future. B. Net operating working capital (NOWC): It is a financial metric that measures a company’s operating liquidity by comparing operating assets to operating liabilities. Operating capital: It is the cash that is used for daily operations in a company. NOPAT: Net operating profit after tax (NOPAT) is a company's potential cash earnings if its capitalization were unleveraged. It is a measure of profit that excludes the costs and tax benefits of debt financing. Free cash flow: it is the cash a company produces through its operations, less the cost of expenditures on assets. C. Value of operations: It is generally considered to be limited to that period in which the documented activities occur and ending with any audit of those activities. Horizon Value: It is the sum of all cash flows from an investment or project beyond a forecast period based on specified rate of return. D. Value based management: It is a management philosophy that states management should foremost consider the interests of shareholders in its business actions. This framework encompasses the processes for creating, managing, and measuring value. Value drivers: A value driver is an activity or capability that adds worth to a product, service or brand. E. Managerial entrenchment : This occurs when managers gain so much power that they are able to use the firm to further their own interests rather than the interests of shareholders. Non pecuniary benefits: The Benefits that are not in a monetary form. F. Greenmail: Greenmail is the practice of buying enough shares in a company to threaten a takeover, forcing the owners to buy them back at a higher price in order to retain control. Poison pills: It's a tactic used by a company threatened with an unwelcome takeover bid to make itself unattractive to the bidder. Restricted voting rights: A restricted voting rights provision automatically deprives a shareholder of voting rights if he or she owns more than a specified amount of stock. G. Stock option: A stock option is a contract between two parties in which the stock option buyer purchases the right to buy/sell 100 shares of an underlying stock at a predetermined price from/to the option seller within a fixed period of time. ESOP: An employee stock ownership plan also known as ESOP is a plan that gives workers ownership interest in the company for which they work for. 13-2) Explain how to use the corporate valuation model to find the price per share of common equity. There are two types of formulae to estimate the value of stock under the corporate valuation model. Common stock equity includes the investment of stockholders, retained earnings, and paid in capital. The first and familiar method of corporate valuation is dividend growth model. In this model, growth of common stock in the future can be determined based on the dividend distribution. Stock price can be valued by dividing the excess of return (r) overgrowth (g) with dividend per share. In calculating dividend, present values would take into consideration. In this model corporate value can be determined by the following formula. P = D1 / r-g The second method for corporate valuation is Free Cash Flow (FCF) model is suitable for a firm which pays zero or low dividends therefore cash flows and weighted average cost of capital can be used. In this model corporate value can be determined by the following formula. P = Free Cash flow (1+ growth) divided by the weighted average cost of capital (WACC) – growth (g). 13-3) Explain how it is possible for sales growth to decrease the value of a profitable company. Not all sales are made with cash. Some are made on credit. Sales made on credit can cost the company money because the company has to provide short-term financing for customers until they can pay off the debt. Some companies, in an effort to grow sales, will loosen credit policies. As a result, sales will grow, but not cash flow. In fact, cash flow has gone down because the company is funding the growth in sales. Since value is based on cash flows, and cash flows are being sucked up by customers, the growth is sales has actually decreased the value what seems to be a profitable company. 13-4) What are some actions an entrenched management might take that would harm shareholders? If senior managers believe there is little chance they will be removed, we say that they are entrenched. Such a company faces a high risk of being poorly run, because entrenched managers are able to act in their own interests rather than in the interests of shareholders. Entrenched managers consume too many perquisites, such as lavish offices , excessive staff, country club memberships, and corporate jets. They also invest in projects or acquisitions that make the firm larger, even if they don't make the firm more valuable. 13-5) How is it possible for an employee stock option to be valuable even if the firm's stock price fails to meet shareholders expectations? Employee stock option is an instrument granted to the employees of the company (mostly to the management of the company) which gives them the right to purchase a certain no. of share only after a specified period. This instrument cannot be exercised before specified period. This period is also known as Lock in period. The price at which the options are being issued is known as "strike price" of an option. The positive difference between the current stock price and the strike price of an option implies the gain to the employees. So, as the expectation of shareholders are derived on the basis of such difference . So as the price of stock falls, it deviates from shareholders expectation simultaneously. But the Employee stock option will hold the value till the time stock price is higher than that of option's strike price, Despite the fact that it failed to meet Shareholder's expectations. Chapter 14 14-1) Definitions A. Optimal distribution policy: A corporate policy outlining how messages and data can be shared and distributed throughout the various divisions and departments of the company. A company's distribution policy can also affect how documents are filed. B. Dividend Irrelevance Theory: A theory that investors are not concerned with a company's dividend policy since they can sell a portion of their portfolio of equities if they want cash. Bird In Hand: A theory that postulates that investors prefer dividends from a stock to potential capital gains because of the inherent uncertainty of the latter. Based on the adage that a bird in the hand is worth two in the bush, the bird-in-hand theory states that investors prefer the certainty of dividend payments to the possibility of substantially higher future capital gains. Tax effect Theory: Tax effect theory is the effects associated with a tax policy. It comprises of the 4Rs which are Revenue, Redistribution, Repricing and Representation. C. Signaling: It occurs when a person in the market who has information that others do not have. Clientele effect: The clientele effect is the notion that certain types of investors, who are interested in a certain type of security, will have an impact on the price when circumstances turn whether that's because of a change in policy or performance. D. Residual Dividend Model: It implies the Irrelevance of Dividends Theory, which claims that investors are indifferent between returns in the form of dividends or capital gains. E. Declaration date: This is the date on which the board of directors announces to shareholders and the market as a whole that the company will pay a dividend. Ex-dividend date: On (or after) this date the security trades without its dividend. If you buy a dividend paying stock one day before the ex-dividend you will still get the dividend, but if you buy on the ex-dividend date, you won't get the dividend. Conversely, if you want to sell a stock and still receive a dividend that has been declared you need to sell on the ex-dividend day. The ex-date is the second business day before the date of record. Payment Date: This is the date the company mails out the dividend to the holder of record. This date is generally a week or more after the date of record so that the company has sufficient time to ensure that it accurately pays all those who are entitled. F. Dividend reinvestment plan (DRIP): A plan offered by a corporation that allows investors to reinvest their cash dividends by purchasing additional shares or fractional shares on the dividend payment date. G. Stock Split: In a stock split, a company will divide each share of its existing stock into multiple shares to bring down the company's stock price. Stock Dividend: Stock dividends are similar to cash dividends; however, instead of cash, a company pays out stock. As a result, a company's shares outstanding will increase, and the company's stock price will decrease. Stock Repurchase: A stock repurchase occurs when a company asks stockholders to tender their shares for repurchase by the company. This is an alternate way for a company to increase value for stockholders. 14-2) What is the difference between a stock dividend and a stock split? As a stockholder, would you prefer to see your company declared a 100% stock dividend or a 2-for-1 split? Assume that either action is feasible. A stock dividend occurs when the company uses the amount of money that would be paid as a cash dividend to purchase additional common shares for the shareholder. A stock split happens when a company issues two or more new shares for every existing share an investor holds. CHAPTER 17 17-1) DEFINITION A. Multinational corporation: A multinational company is a business that operates in many different countries at the same time. In other words, it's a company that has business activities in more than one country. B. Exchange rate: An exchange rate is how much one currency is worth compared to another currency. C. Fixed exchange rate system: A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime in which a currency's value is fixed against either the value of another single currency, a basket of other currencies, or another measure of value. D. Exchange rate risk: Exchange rate risk is the risk of losses due to fluctuations in the value of the dollar relative to the values of foreign currencies. Convertible currency: A convertible currency is one that may be readily exchanged for other currencies. E. Interest rate parity: Interest rate parity holds that investors should expect to earn the same risk-free return in all countries after adjusting for exchange rates. Purchasing power parity: Purchasing power parity, sometimes referred to as the law of one price, implies that the level of exchange rates adjusts so that identical goods cost the same in different countries. F. Spot rate: Spot rates are the rates paid for delivery of currency on the spot. Forward exchange rate: Forward exchange rate is the rate paid for delivery at some agreed-upon future date G. Political risk: It is the risk that the foreign government will take some action that will decrease the value of the investment. CHAPTER 18 18-1) DEFINITION A. Lessee: The lessee is the party leasing the property. Lessor: The party receiving the payments from the lease is the lessor. B. Operating lease: An operating lease, sometimes called a service lease, provides for both financing and maintenance. Generally, the operating lease contract is written for a period considerably shorter than the expected life of the leased equipment, and contains a cancellation clause. Financial lease: A financial lease does not provide for maintenance service, is not cancelable, and is fully amortized; that is, the lease covers the entire expected life of the equipment. In a sale and leaseback arrangement, the firm owning the property sells it to another firm, often a financial institution, while simultaneously entering into an agreement to lease the property back from the firm. Sale-and-leaseback: A sale and leaseback can be thought of as a type of financial lease. Combination lease: A combination lease combines some aspects of both operating and financial leases. Synthetic lease: A synthetic lease is an arrangement between a company and a special purpose entity that it creates to borrow money and purchase equipment. SPE: A special purpose entity (SPE) is a company set up to facilitate the creation of a synthetic lease. It borrows money that is guaranteed by the lessee, purchases equipment, and leases it to the lessee. Its purpose is to keep the lessee from having to capitalize the lease and carry its payments on its books as a liability. C. Off–balance sheet financing: Off-balance sheet financing refers to the fact that for many years neither leased assets nor the liabilities under lease contracts appeared on the lessees’ balance sheets. To correct this problem, the Financial Accounting Standards Board issued FASB Statement 13. Capitalizing: Capitalizing means incorporating the lease provisions into the balance sheet by reporting the leased asset under fixed assets and reporting the present value of future lease payments as debt. D. FASB Statement 13: FASB Statement 13 talks about the conditions under which a lease must be capitalized (shown directly on the balance sheet) as opposed to shown only in the notes to the financial statements. E. Guideline lease: A lease that meets these guidelines is called a guideline lease. F. Residual value: The residual value is the market value of the leased property at the expiration of the lease. The estimate of the residual value is one of the key elements in lease analysis. G. Lessee’s analysis: The lessee’s analysis involves determining whether leasing an asset is less costly than buying the asset. Lessor’s analysis: The lessor’s analysis involves determining the rate of return on the proposed lease. H. Net advantage to leasing (NAL): The net advantage to leasing (NAL) gives the dollar value of the lease to the lessee. It is, in a sense, the NPV of leasing versus owning. I. Alternative minimum tax (AMT): The alternative minimum tax (AMT), which is figured at about 20 percent of the profits reported to stockholders, is a provision of the tax code that requires profitable firms to pay at least some taxes if such taxes are greater than the amount due under standard tax accounting. The AMT has provided a stimulus to leasing for those firms paying the AMT because leasing lowers profits reported to stockholders. 18-2) Distinguish between operating leases and finance leases. Would you be more likely to find an operating lease employed for a fleet of trucks or for a manufacturing plant? An operating lease is usually cancelable and includes maintenance. Operating leases are, frequently, for a period significantly shorter than the economic life of the asset, so the lessor often does not recover his full investment during the period of the basic lease. A financial lease, on the other hand, is fully amortized and generally does not include maintenance provisions. An operating lease would probably be used for a fleet of trucks, while a financial lease would be used for a manufacturing plant. 18-4) The banks, when they initially went into leasing, were paying relatively high tax rates. However, since municipal bonds are tax-exempt, their heavy investments in municipals lowered the banks’ effective tax rates. Similarly, when the REIT loans began to sour, this further reduced the bank’s income, and consequently cut the effective tax rate even further. Since the lease investments were predicated on obtaining tax shelters, and since the value of these tax shelters is dependent on the banks’ tax rates, when the effective tax rates were lowered, this reduced the value of the tax shelters and consequently reduced the profitability of the lease investments. 18-5)The Pros and cons are: Pros: ● The use of the leased premises or equipment is actually an exclusive right, and the payment for the premises is a liability that often must be met. Therefore, leases should be treated as both assets and liabilities. ● A fixed policy of capitalizing leases among all companies would add to the comparability of different firms. For example, Safeway Stores’ leases should be capitalized to make the company comparable to A&P, which owns its stores through a subsidiary. ● The capitalization highlights the contractual nature of the leased property. ● Capitalization of leases could help management make useful comparisons of operating results; that is, return on investment data. Cons: ● Because the firm does not actually own the leased property, the legal aspect can be cited as an argument against capitalization. ● Capitalizing leases worsens some key credit ratios; that is, the debt-to-equity ratio and the debt-to-total capital ratio. This may hamper the future acquisition of funds. ● There is a question of choosing the proper discount rate at which to capitalize the leases. ● Some argue that other items should be listed on the balance sheet before leases; for example, service contracts, property taxes, and so on. ● Capitalizing leases violates the principle that liabilities should be recorded only when assets are purchased. 18-6) Lease payments, like depreciation, are deductible for tax purposes. If a 20-year asset were depreciated over a 20-year life, depreciation charges would be 1/20 per year . However, if the asset were leased for, say, 3 years, tax deductions would be 1/3 each year for 3 years. Thus, the tax deductions would be greatly accelerated. The same total taxes would be paid over the 20 years, but because of the high deductions in the early years, taxes would be deferred more under the lease, and the PV of the future taxes would be reduced under the lease. 18-7) In fact, Congress did this in 1981. Depreciable lives were shorter than before; corporate tax rates were essentially unchanged and the investment tax credit had improved a bit by the easing of recapture if the asset was held for a short period. As a result, companies that were either investing at a very high rate or else were only marginally profitable were generating more depreciation and/or investment tax credits than they could use. These companies were able to “sell” their tax shelters through a leasing arrangement, being “paid” in the form of lower lease charges. A high-bracket lessor could earn a given after-tax return with lower rental charges, after the 1981 tax law changes, than previously because the lessor would get larger tax credits and faster depreciation write-offs. 18-8) A cancellation clause would reduce the risk to the lessee since the firm would be allowed to terminate the lease at any point. Since the lease is less risky than a standard financial lease, and less risky than straight debt, which cannot usually be prepaid without a prepayment charge, the discount rate on the cost of leasing might be adjusted to reflect lower risk. The effect on the lessor is just the opposite--risk is increased. CHAPTER 19 19-1) DEFINITION A. Preferred stock: Preferred stock is a hybrid that is similar to bonds in some respects and to com- mon stock in other ways. B. Cumulative dividends: Cumulative dividends is a protective feature on preferred stock that requires all past preferred dividends to be paid before any common dividends can be paid. Arrearages: Arrearages are the preferred dividends that have not been paid, and hence are “in arrears.” C. Warrant: A warrant is a long-term call option issued along with a bond. Detachable warrant: A detachable warrant is one that can be detached and traded separately from the underlying security. Most warrants are detachable. D. Stepped-up price: A stepped-up price is a provision in a warrant that increases the striking price over time. This provision is included to prod owners into exercising their warrants. E. Convertible security: A convertible security is a bond or preferred stock that can be exchanged for common stock at the option of the holder. F. Conversion ratio: The conversion ratio is the number of shares of common stock received upon conversion of one convertible security. Conversion price: The conversion price is the effective price per share of stock if conversion occurs. Conversion value: The conversion value is the value of the stock that the investor would receive if conversion occurred. G. Sweetener: Sweeteners are used to make the underlying debt or pre- ferred stock issue more attractive to investors. 19-2) Preferred stock is best thought of as being somewhere between debt (bonds) and equity. Like debt, preferred stock imposes a fixed charge on the firm affords its holders no voting rights, and has priority over common stock in the event of bankruptcy. However, like equity, its payments are considered dividends from both legal and tax standpoint, it has no maturity date, and it is carried on the firm’s balance sheet in the equity section. From a creditor’s viewpoint, preferred stock is more like common stock, but from a common stockholder’s standpoint, preferred stock is more like debt. 19-3)The trend in stock prices subsequent to an issue influences whether or not a convertible issue will be converted, but conversion itself typically does not provide a firm with additional funds. Indirectly, however, conversion may make it easier for a firm to get additional funds by lowering the debt ratio, thus making it easier for the firm to borrow. In the case of warrants, on the other hand, if the price of the stock goes up sufficiently, the warrants are likely to be exercised and thus to bring in additional funds directly. 19-4)Either warrants or convertibles could be used by a firm that expects to need additional financing in the future--warrants, because when they are exercised, additional funds will be brought into the firm directly; convertibles, because when they are converted, the equity base is expanded and debt can be sold more easily. However, a firm that does not have additional funds requirements would not want to use warrants. 19-5) a. The value of a warrant depends primarily on the expected growth of the underlying stock’s price. This growth, in turn, depends in a major way on the plowback of earnings; the higher the dividend payout, the lower the retention rate. Hence, the slower the growth rate. Thus, warrant values will be higher, other things held constant, the smaller the firm’s dividend payout ratio. This effect is more pronounced for long-term than for short-term warrants. b. The same general arguments as in Part a hold for convertibles. If a convertible is selling above its conversion value, raising the dividend will lower growth prospects, and, at the same time, increase the cost of holding convertibles in terms of forgone cash returns. Thus, raising the dividend payout rate before a convertible’s conversion value exceeds its call price will lower the probability of eventual conversion, but raising the dividend after a convertible’s conversion value exceeds its call price raises the probability that it will be converted soon. c. The same arguments as in Part b apply to warrants. 19-6) The statement is made often. It is not really true, as a convertible’s issue price reflects the underlying stock’s present price. Further, when the bond or preferred stock is converted, the holder receives shares valued at the then-existing price, but effectively pays less than the market price for those shares. 19-7) The convertible bond has an expected return which consists of an interest yield (10 percent) plus an expected capital gain. We know the expected capital gain must be at least 4 percent, because the total expected return on the convertible must be at least equal to that on the nonconvertible bond, 14 percent. In all likelihood, the expected return on the convertible would be higher than that on the straight bond, because a capital gains yield is riskier than an interest yield. The convertible would, therefore, probably be regarded as riskier than the straight bond, and rc would exceed rd. However, the convertible, with its interest yield, would probably be regarded as less risky than common stock. Therefore, rd < rc < rs. CHAPTER 20 20-1) DEFINITION A. Initial public offering (IPO): A public offering is the first sale of stock in which shares of a company sold to institutional investors that in turn sells to the general public on a securities exchange, for the first time. IPOs are often issued by smaller, younger companies seeking the capital to expand. IPO process is colloquially known as going public. B. Public offering: A public offering is the offering of securities of a company or a similar corporation to the public. Generally, the securities are to be listed on a stock exchange Private placement: Private placements are securities offerings to a limited number of investors and are exempt from registration with the SEC. C. Venture capitalists: The managers of a venture capital fund are called venture capitalists, Roadshow: A road show is a series of marketing events Spread: The spread is the difference between the price at which an underwriter sells a security and the proceeds that the underwriter gives to the issuing company. D. Securities and Exchange Commission (SEC): The Securities and Exchange Commission (SEC) regulates securities markets. Registration statement: a registration statement is a set of documents, including a prospectus, which a company must file with the U.S. Securities and Exchange Commission before it proceeds with a public offering. Shelf registration: Shelf registration allows a company to register an issue and then sell that issue in pieces over time rather than all at once. Margin requirement: A Margin Requirement is the percentage of marginable securities that an investor must pay for with his/her own cash. Insiders: a person recognized or accepted as a member of a group, category, or organization: such as. a : a person who is in a position of power or has access to confidential information. E. Prospectus: “red herring” prospectus: It is a legal formal document which is required to be filed with the securities exchange that contains details about investment offering for the sale to the public. F. National Association of Securities Dealers (NASD): The NASD was a self-regulatory organization of the securities industry responsible for the operation and regulation of the Nasdaq stock market and over-the-counter markets. G. Best efforts arrangement: Best-effort arrangements are usually created in weak market conditions or with securities that seem to be higher risk. Underwritten arrangement: Underwritten arrangement is an agreement in which an underwriter promises to make a full fledged attempt to sell as much of an initial public offering as possible to the public. H. Refunding: Refunding is the process of retiring or redeeming an outstanding bond issue at maturity by using the proceeds from a new debt issue. Project financing: In project financing, the payments on debt are secured by the cash flows of a particular project. Securitization: Securitization occurs when assets such as mortgages or credit card receivables are bundled together into a pool. Maturity matching: Maturity matching is a strategy of working capital financing wherein short term requirements are met with short-term debts and long-term requirements with long-term debts. CHAPTER 22 22-2) Why do creditors usually accept a plan for financial rehabilitation rather than demand liquidation of the business? The reason that creditors do this is that they believe that they will get more of their money back than they would in a liquidation. 22-3) Would it be a sound rule to liquidate whenever the liquidation value is above the value of the corporation as a going concern? Discuss. Not necessarily. The growing concern value of a firm is a function of its outlook--it might be improved by changing the management or otherwise improving operations. The firm may be temporarily distressed. The value of a company as an ongoing entity. This value differs from the value of a liquidated company's assets, because an ongoing operation has the ability to continue to earn profit, while a liquidated company does not. This value includes the liquidation value of a company's tangible assets as well as the present value of its intangible assets. The going-concern value is worked into the purchase price of a company, and is the main reason why the purchase price of a company tends to be higher than the current value of the assets of the company. 22-4) Why do liquidations usually result in losses for the creditors or the owners, or both?. Would partial liquidation or liquidation over a period limit their losses? Explain. Liquidations usually result in losses for the following reasons: a) Assets typically have characteristics which make their value in existing uses greater than when resold. b) The organizational value of a company is lost when liquidation takes place. c) Because the claims of numerous parties must be adjudicated, considerable administrative, accounting, and legal costs may be incurred. Partial liquidation over a period would have the following results: a) Probably would not decrease losses. b) Failure to institute the necessary operating and management changes might cause losses to continue and might cause further deterioration in the value of the company. It is often said that a swift major "surgery" for a business firm is preferred to an extended illness. 22-5. Are liquidations likely to be more common for public utility, railroad, or industrial corporations? Why? Explain. Because public utilities and railroads often involve essential services, reorganizations and mergers rather than liquidations are likely to take place. This is less true for industrial companies. CHAPTER 25 25-1) DEFINITION A. Real option: Real options are opportunities for management to respond to changes in market conditions and involve “real” rather than “financial” assets. Strategic option: Strategic options are creative alternative action-oriented responses to the external situation that an organisation (or group of organisations) faces. Embedded option: An embedded option is a special condition attached to a security and, in particular, a bond, that gives the holder or the issuer the right to perform a specified action at some point in the future. B. Growth option: In Growth Options no dividends are declared. Dividend option declares dividend and NAV gets reduced to the extend of dividend declared. Abandonment option: An abandonment option is a clause in a contract that permits either party to leave the contract before obligations have been fulfilled. Flexibility option: Flexibility option are non-standard options that allow both the writer and purchaser to negotiate various terms. C. Decision tree A decision tree is a decision support tool that uses a tree-like graph or model of decisions and their possible consequences, including chance event outcomes, resource costs, and utility. 25-2) What factors should a company consider when it decides whether to invest in a project today or to wait until more information becomes available? Postponing the project means that cash flows come later rather than sooner; however, waiting may allow you to take advantage of changing conditions. It might make sense, however, to proceed today if there are important advantages to being the first competitor to enter a market. 25-3) In general, do timing options make it more or less likely that a project will be accepted today? Timing options make it less likely that a project will be accepted today. Often, if a firm can delay a decision, it can increase the expected NPV of a project. 25-4)If a company has an option to abandon a project, would this tend to make the company more or less likely to accept the project today? Having the option to abandon a project makes it more likely that the project will be accepted today.
