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2FB3 Finance Exam Notes
Commerce (McMaster University)
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Chapter 14: Cost of Capital
Why Cost of Capital is Important
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Cost of capital shows a company the cost to raise funds from the public
o Whether it be from debt capital or equity capital
o Shows the returns that the shareholders/bondholders require (required rate of return =
cost of capital)
Required rate of return depends on the riskiness of what the company plans to do with those
funds
Knowing cost of capital allows you to evaluate whether or not you can take certain projects
o Cost of capital is only calculated when the company is planning to undertake a project
Cost of capital is interchangeable with: required rate of return, hurdle rate, and discount rate
Cost of Equity, Debt, and Preferred Stock
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Cost of Equity: the return required by equity investors given the risk of the cash flows from the
firm
Equity investors receive cashflow from the firm via:
o Dividends (Periodic)
o Selling Shares (Terminal)
Cost of Equity can be determined using either the Dividend Growth Model (DGM) or SML/CAPM
Dividend Growth Model Approach
o Condition: the dividend expected growth rate should be stable (cost of capital > growth
of dividend)
o Price of Stock (Dividend Growth Model)

o
𝐷1
𝐸 −𝑔
Cost of Equity (expressed as %)

𝑅𝐸 =
𝐷1×(1 + 𝑔)
𝑃0
+𝑔
Where D1 is the next periods dividend, g is the stable growth, P0 is the current price of a
stock , and RE is cost of equity
Estimating the Dividend Growth Rate
o Can be estimated using historical average (average of percentage change)
o

𝑃0 = 𝑅
o
o
o
(5.7 + 4.6 + 5.1 + 4.9)/4 = 5.1%
Alternative Approach:
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Company must have stable ROE, stable dividend policy, and is not planning on
raising new external capital
𝑔 = 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑖𝑜 × 𝑅𝑂𝐸
 Part of net income is used to pay dividends, the rest is retained,
retention ratio is the amount retained compared to the total net income


𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑖𝑜 =
𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝐼𝑛𝑐𝑜𝑚𝑒
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
Pros and Cons of the Dividend Growth Model Approach
Pros

Easy to understand and use
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Cons
Only applicable to companies that
currently pay dividends
Only applicable if dividend growth
rate is constant
Very sensitive to estimated growth
rate (1% increase in g increases cost
of equity by 1%)
Does not explicitly consider risk
The SML (CAPM) Approach
o Requires the following:
 Risk free rate, Rf
 Market risk premium, E(RM)-Rf
 (expected market return – risk free rate)
 Systematic risk, βE
o 𝑅𝐸 = 𝑅𝐹 + 𝛽𝐸 × [𝐸 (𝑅𝑀 ) − 𝑅𝑓 ]
o 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑅𝑖𝑠𝑘 𝐹𝑟𝑒𝑒 𝑅𝑎𝑡𝑒 + 𝑆𝑦𝑠𝑡𝑒𝑚𝑎𝑡𝑖𝑐 𝑅𝑖𝑠𝑘 × 𝑀𝑎𝑟𝑘𝑒𝑡 𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚
o This approach assumes the company is financed entirely by equity
o Reject project if 𝑅𝐸 > return of the project, accept if 𝑅𝐸 < return of the project
Pros and Cons of SML (CAPM) Approach
Pros
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Explicitly adjusts for systematic risk
Applicable to all companies, as long as
you can compute beta
Cons
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Requires expected market risk
premium which varies over time
Requires beta which also varies over
time
Relies on the past to predict the
future, which is not always reliable
Both Cost of Equity Approaches
o DGM and SML both provide similar estimates for the cost of equity
o If the estimates diverge by a significant amount:
 Use an average of the two rates
 Use the cost of equity estimate using SML
Cost of Debt: the required return on a company’s debt
o Usually focuses on the cost of long-term debt or bonds
o Debt investors receive cashflows from the firm in two forms
 Coupon (Periodic)
 Selling Bond (Terminal)
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The required return is best estimated by computing the yield-to-maturity on the existing
debt
 May also be estimated using current rates based on the bond rating we expect
when we issue new debt
 Use excel or financial calculator
o Cost of debt is NOT the coupon rate
Cost of Preferred Stock
o Preferred stock is paid as a consistent dividend every period
 Expected to be paid every period forever
o Preferred stock is a perpetuity that can be valued as:
 𝑃0 = 𝐷/𝑅𝑃
o Rearrange to solve for cost of preferred stock
 𝑅𝑃 = 𝐷/𝑃0
o Where D is dividend price, P0 is the current stock price, and RP is the cost of the
preferred stock
o

Weighted Average Cost of Capital (WACC)
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Simply use the 3 components of cost of capital and use them to determine the average cost of
capital for the firm
This “average” is the required return on assets, based on the markets perception of the riskiness
of those assets
The weights can be determined by how much of each type of financing is used. Two methods:
o Target Debt/Equity (D/E) Ratio
o Market Value of Debt and Equity
Weights always add to 100% if the capital structure is composed of only debt and common
equity:
o D/V + E/V = 1 or WD + WE = 1
 D/V = WD and E/V = WE (W represents weight)
o Notation
 D = market value of debt = # of outstanding bonds * bond price
 E = market value of equity = # of outstanding shares * price per share
 V = market value of firm = D + E
 Target Capital Structure (D/E)
o Suppose you are given the target D/E, to find capital structure weights:
 D/E = 0.4 means D/E + 1 = 1.40
 D + E / E = 1.40; V/E = 1.40
 E/V = 1/1.40 = 0.7143 = 71.43% = WE
 D/V = 1 – 0.7143 = 28.57% = WD
 TLDR: 1/(D/E + 1) = WE ; WD = 1 - WE
Impact of Taxes
o We are concerned with after-tax cashflows, so we need to account for the effect of
taxes on the different costs of capital
o Interest expense reduces tax liability
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
 The reduction in taxes reduces the cost of debt
 After tax cost of debt = 𝑅𝐷 (1 − 𝑇𝐶 )
o Dividends are not tax deductible, so there is no tax impact on the cost of equity
The Weighted Average Cost of Capital (WACC) Formula
o 𝑊𝐴𝐶𝐶 = (𝑊𝐸 × 𝑅𝐸 ) + [𝑊𝐷 × 𝑅𝐷 (1 − 𝑇𝐶 )]
o


𝐸
𝐷
𝑊𝐴𝐶𝐶 = (𝑉 × 𝑅𝐸 ) + [ × 𝑅𝐷 (1 − 𝑇𝐶 )]
𝑉
o Note: debt weight should be calculated with current market price, not face value
WACC represents the rate of return the market requires for financing the average riskiness of
project
Divisional and Project Costs of Capital
o You can only use WACC to compare projects of the same risk as the firms current
operations
 If the risk difference is large enough, a different discount rate should be used
o Different divisions in a company also requires separate discount rates because of the
varying level of risk
Pitfalls of evaluating ALL projects with WACC
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Using one WACC to evaluate all projects irrespective of their riskiness will lead the firm to accept
more risky projects and reject less risky projects
o This is due to the fact that riskier projects have higher expected returns and less risky
projects have lower expected returns
Solution 1: The Pure Play Approach
o Use a WACC that is unique to a particular project
 Use WACC of a “peer” group of companies
o Peer Group: companies that specialize in the project being considered
o Compute the beta for each company and find an average
 Then find the return for a project of that risk using CAPM
Solution 2: Subjective Approach
o Consider the projects risk relative to the firm overall
o If the project is riskier than the firm
 Use a discount rate greater the firm wide WACC
o If the project is less risky than the firm
 Use a discount rate less than the firm wide WACC
o May result in incorrect acceptance or rejection; but the error rate should be lower than
not considering differential risk at all
o
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Using WACC to Value a Company
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Companies are valued using the capital budgeting approach
o I.e. discounting all cashflows of the firm to find the NPV
o Future adjusted cash flows from assets (CFA) are discounted at WACC
Step 1: Calculate adjusted CFA using:
o 𝐶𝐹𝐴 = 𝐸𝐵𝐼𝑇 × (1 − 𝑇𝐶 ) + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 − 𝐶ℎ𝑎𝑛𝑔𝑒𝑠 𝑖𝑛 𝑁𝑊𝐶 − 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑆𝑝𝑒𝑛𝑑𝑖𝑛𝑔
Step 2: Assume that CFA is expected to grow at a constant rate, g, forever. The terminal firm
value at a future date, t:
o

𝐶𝐹𝐴𝑡+1
𝑊𝐴𝐶𝐶−𝑔
Step 3: Value the firm using:
o

𝑉𝑡 =
𝐶𝐹𝐴
𝐶𝐹𝐴
𝐶𝐹𝐴
𝐶𝐹𝐴 +𝑉
1
2
3
𝑡
𝑡
𝑉0 = (1+𝑊𝐴𝐶𝐶)
+ (1+𝑊𝐴𝐶𝐶)
2 + (1+𝑊𝐴𝐶𝐶) 3 + ⋯ + (1+𝑊𝐴𝐶𝐶) 𝑡
Nuances in Valuation of a Company
o CFA is calculated under the assumption that the firm was 100% equity financed
 Adjusted taxes (EBIT x Tc) are used instead of the actual taxes on the income
statement
o The impact of the interest tax shield in entirely incorporated in the WACC, by using the
after-tax cost of debt
Flotation Costs
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Flotation Costs: the cost companies incur when offering its securities to the public
The required return depends on the risk, not how the money is raised
o But the costs of issuing new securities cannot be ignored as they are “relevant costs”
Basic Approach:
o Compute the average flotation cost
o Use the target weights because the firm will issue securities in these percentages over
the long term
o Essentially, increase the cost of the project to cover flotation costs
o Weighted Average Flotation Cost:


o

𝐹
Where fE and fD is flotation cost of equity and debt
𝑇𝑟𝑢𝑒 𝐶𝑜𝑠𝑡 =



𝐸
𝑓𝐴 = (𝑉 × 𝑓𝐸 ) + ( × 𝑓𝐷 )
𝑉
𝐶𝑎𝑝 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
1−𝑓𝐴
or 𝐶𝑎𝑝 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 × (1 + 𝑓𝐴 )
If true cost > pv of future cash flows from project; reject
If true cost < pv of future cash flows from project: accept
NPV = PV – True Cost
 If NPV is negative reject
 If NPV is positive accept
Flotation Costs for Internal Equity
o Companies often use internal equity (retained earnings) to finance projects and rarely
issue new equity for every new project
 There is no flotation cost associated with retained earnings
o When calculating weighted flotation cost set flotation cost of equity (𝑓𝐸 ) to 0 to account
for retained earnings
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Chapter 15: Raising Capital
Early Stages: Venture Capital (VC)
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Since only concept or beta testing is availible, meaning funds from external sources are unlikely
The idea generator must use personal sources of financing to fund their expenditures
o Can be from personal funds, friends, or family
Venture Capital (VC) Market: private financing for relatively new businesses
o Field of private equity depicts equity financing for yet-to-be-public companies
Venture capitalists do not help for free; they work in exchange for stock and share of profits
Investing as a venture capitalist entails:
o Hands-on guidance for the new business
o Financing provided in stages; the promised funds are not given all at once
o Restrictions on management; venture capitalist determines what the idea generator can
and cannot do with the money or how quickly they have to show progress in certain
business functions like production or R&D
o The possibility of going public; through initial public offering (IPO), the investor will
benefit from the capital raised in the process
Who are the financers?
o Specialized VC firms, financial and investment institutions, and government agencies
o Angel Investors: wealthy individuals who invest in early-stage ventures
 Think of shark tank panelists, they help raise a company with the promise of
control in the company and shared profit
o VC firms from a group of investors that pool capital and then have partners in the firm
decide which companies will receive financing
o Large corporations like Google, Qualcomm, Comcast, Dell, Microsoft, Nokia, and Intel,
have professional active venture arms
 May buyout the company if it becomes successful at a later stage
o Crowdfunders: everyday people being able to invest and take part in the growth of a
new company
Types of Venture Capitalist Companies
o Private independent firms
 Accel, Sequoia Capital, and Index Ventures
o Labour-Sponsored Funds: companies that are supported by labour unions
 GrowthWorks Capital, Fondaction
o Corporate Venture Capital Funds
 Google Ventures, Intel Capital
o Government Run Funds
 Venture Capital Catalyst Initiative – I, II
o Institutional Funds
 University Pension Funds, Insurance Companies
Stages of Development
o It is possible for a company to be financed by multiple venture capitalists; multiple at a
single stage or different ones throughout the company’s development
o Seed Stage
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o
o
o
o
 Idea generator has an idea but no money
 Prototyping and testing for idea occurs
Start-up Stage
 Initial product is built and has passed testing
 More renovations to product may occur and may need additional financing
Expansion Stage
 When product is up and running, market testing will occur
 Marketing and distribution will need additional financing
Acquisition/Buyout Stage
 The company and product are established in the market
 The company may be acquired by another company (acquisition)
 Or the company may be bought out by financing VC firm, outside VC firm, or by
the original idea generator
Turnaround Stage
 If the company fails to prove their product, they will have to turn back and
redevelop the product
o
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Companies need financing most in the seed and early stage
 But not a large amount of funds in the seed stage
 Companies need more funds later in its development
 But not many companies need these funds as they have been bought
out or found their own source of financing
Venture Capital Exits
o Venture capitalists need to have an exit strategy
 Venture capitalists ideally don’t stay in the company for too long, they try to
make a quick turn around from their investments
o Four Exit Strategies
 Acquisition by a third party
 Once the company has grown, you sell your share to another VC firm
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Merger with another entity
 Upon merging, you may sell your share to the other entity
 Company buy back by the entrepreneur (reverse take over)
 The original idea generator buys back the shares from the venture
capitalist
 Initial public offering (IPO)
 When the company goes public, you can sell your shares to the market,
in either the IPO or secondary market
o If the company fails, the investor will have to write off their investment in the company
Choosing a Venture Capitalist
o Look for financial strength; they must have enough money to fund the company at
different stages
o Choose someone with a compatible management style; find a VC that manages you in a
style that best suits you
o Obtain and check references; check what companies they have financed before and their
relationships with them
o What contacts does the VC have; are they in contact with possible, suppliers, customers,
a network of people who can help develop your business
o What is their exit strategy; find someone that has a strategy and wont leave when things
get tough
o It is a two-way relationship; while the company does need funds, they have the right to
choose who to obtain funds from
Raising Funds from Public and Role of Underwriters


The Public Issue
o The creation and sale of securities (financial instruments) to be traded on the public
markets
o All companies on the Toronto Stock Exchange come under the Ontario Securities
Commission’s (OSC) jurisdiction
o Once public, the firm must select an Underwriter or Investment Banker (IBs) to help
them sell their securities to the public
 Underwriters pay is included with flotation cost
 Flotation also includes commissions, legal, accounting, and other administrative
costs
Selling securities to the Public – Steps
o Step 1: management obtains permission from the board of directors
o Step 2: Firm prepares and distributes copies of a preliminary prospectus (red herring) to
the OSC and potential investors
 Red herring contains:
 What the company has been doing the last few years and where the
company wants to go in the future
 A summary providing information on an issue of securities; what kind of
securities, how much they are planning to raise, and what they plan to
do with the funds
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
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 The risks associated with investing in the firm
 OSC then studies the red herring and notifies the company of required changes
(~2 weeks)
o Step 3: Once the prospectus is approved, the price is determined, and security dealers
begin selling the new issue (primary market)
Alternative Issue Methods (Equity)
o General Cash Offer: New securities offered for sale to the general public on a cash basis
(IPO, SEO)
 Securities are out in the market for anyone to buy
 Types of General Cash Offers:
 Initial Public Offering (IPO): a company’s first equity issue made
availible to the public
 Seasoned Equity Offering (SEO): a new issue for a company that has
been previously issued to the public
o Rights Offer: new securities are first offered to existing shareholders (pre-emptive
rights)
Issuing New Securities – Methods
o Public
 Traditional Negotiated Cash Offer: purchase of securities is open to everyone
 Firm Commitment
 Best Efforts
 Dutch Auction
 Privileged Subscription: only a privileged section of the market may purchase
securities
 Direct Rights Offer
 Standby Rights Offer
 Non-traditional Cash Offer: a method that does not fall under traditional
negotiated cash offer or privileged subscription
 Shelf Offer: a method where not all availible securities are issued at the
same time. The share withheld may be sold at a later date depending on
what the OSC specifies
 Competitive Firm Offer: the company will seek investments from the
public via a bidding process
o Private
 Direct Placement: The company’s investment banker will get in touch with
private investors and offer shares to them in a private manner
 More common with debt and less with equity
Under Writer/Investment Bankers
o Services provided:
 Advice on when/how to issue securities and with what attributes
 Pricing of securities using:
 Discounted cash flow calculations
 Comparables like P/E or P/S of principal competitors
 Selling securities
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

Price stabilization (by lead underwriter)
 Once the shares begin selling in the secondary market, the lead
underwriter will buy shares from the secondary market so that the
share price in the market does drop too low
o How IBs take an issue to market
 Syndicate: Forming a group of underwriters that market the securities and
share the risk associated with selling the issue
o How IBs are compensated
 Spread: difference between what the syndicate pays the company for the share
and what the security sells for in the market
 If the IBs sell stock for $20 and give $18 to the issuing company, the $2
remaining is the spread
 IBs are rarely paid directly by the issuing company
 Management Fees
 Selling Concession
Types of Traditional Negotiated Cash Offers
o Firm Commitment Underwriting (Bought Deal)
 Issuer firm sells entire issue to underwriting syndicate
 The syndicate then resells the issue to the public
 Underwriter makes money on the spread between the buy and sell price
 The syndicate bears the risk of not being able to sell the entire issue for more
than the cost
 Most common type of underwriting
 Carried out for high quality offerings
 Involves smaller offer price discount and smaller underwriting fee
o Best Efforts Underwriting
 Underwriter makes their “best effort” to sell the securities at an agreed-upon
offering price
 Underwriter agrees, for a commission, to sell as much as possible, but does NOT
guarantee to sell the entire issue
 Issuing company bears the risk of the issue not being sold
 The offer may be pulled if there is not enough interest/demand at the offer
price
 The company does not get the capital and will incur substantial flotation
costs
o Dutch Auction Underwriting (Uniform Price Auction)
 Underwriter conducts an auction where investors bid for shares
 Typically carried out for debt
 Offer price is determined based on submitted bids
 Highest bid price at which all shares can be sold is the price that all
winning bidders pay
 Shares are distributed based on how much an investor bought after
price is set and winners are determined
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
Example:
 The price will be set to $12
because all 400 shares will be
sold at $12 (100 + 100 + 200 =
400)
 Anyone who bid at or above the
set share price may bid (A, B, C,
D)
 Since the quantity of shares is
400 and the demand is 600
(100 + 100 + 200 + 200)
each bidder will receive 67%
(400/600) of the share they bid on
 At $12 a share, A & B get 67 shares each and C & D get 134 each
 XYZ Co earns $4,800 (400 * $12) by selling 400 shares
Public Issue and Flotation Costs
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Selling Period
o While the issue is being sold to the public, the underwriting syndicate agrees not to sell
securities for less than the offering price until the syndicate dissolves
o The principal underwriter may buy shares if the market price falls below offering price
to stabilize the price
o If the issue remains unsold for a period of time (ex. 30 days), members can leave the
group and sell their shares at whatever price the market allows
Overallotment Option/ Green Shoe Provision
o Allows the syndicate to purchase an additional 15% of the issue from the issuer
 Only feasible if the IPO is underpriced and there is significant demand
o Allows the issue to be oversubscribed
Lockup Agreement
o The number of days company insiders must wait after and IPO before they can sell stock
 Insiders include company owners, management, and venture capitalists
 ~180 days
o To ensure that insiders maintain a significant economic interest in the company going
public
o After the 180 days, companies backed by venture capital are likely to experience a loss
in value, as the venture capitalists cash-out around that time
Quiet Period
o Period for which all communications with the public must be limited to ordinary
announcements and other purely factual matters after a new issue
 10 days after IPO, 3 days after SEO
 Also the time between submitting preliminary prospectus to OSC and its
acceptance
o During the quiet period, the underwriters analysts are prohibited from making
recommendations to investors
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The end of the quiet period leads to favorable “buy” recommendation from managing
underwriters
IPO Underpricing
o If shares are sold for $23 in the secondary market and the IPO was $20, the IPO was
underpriced by $3
 Meaning that the shares could have been sold for $23 because the market was
willing to pay that much
o IPOs are hard to price because there isn’t a current market price availible
o Information asymmetry between insiders and outsiders causes uncertainty and risk
which leads to discounted cash flows
 This is why the issuing company is ok with having and underpriced IPO
o Underwriters want to ensure that their clients earn a good return on IPOs on average
 Syndicates may have large investor clients who like to invest in the IPOs that
they underwrite. To keep them happy, syndicates may offer a lower price so
that the investors have a good bargain and profit margin
o Underwriters also want to avoid being stuck with IPO shares in case the market thinks
the offer price is too high
 Shares are priced at a lower range to guarantee that they sell
o Underpricing causes the issuer to “leave money on the table”
 When a company wants to go public and raise money by issuing shares, they
have to enlist the help of underwriters
o There is less underwriting when:
 The issuer is a large company; their information is easy to access by the public
which means there are fewer instances of underpricing occur
 The market is developed; in developed markets underwriters are trusted
because IPO investors trust their ability to judge the value of a company
Seasoned Equity Offering (SEO)
o Stock prices tend to decline once the new equity is issued in SEOs
o There is no information asymmetry
o When a company announces seasoned equity offerings, that information is always taken
negatively
 The market realizes that company insiders know more about their company
than the investors
 The issuer understands that their share price is overpriced, so they try
to sell more to raise more funds
 Equity is more expensive than debt. Why would they choose equity over debt?
 Is their relationship with the bank not good?
 The flotation costs associated with equity is more expensive than the flotation
costs associated with debt
o The drop in price can be significant and it is important for management to be aware of
the signals they are sending and try to reduce the effect when possible
 Share prices drop by 3% on average (abnormal return/cost of issuing securities)
 When the issuer uses the equity market to maintain the debt-to-equity ratio,
they should send provide information to why they are financing with equity
o


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Other Costs of Issuing Securities
o Other Direct Expenses: direct costs that are not part of the compensation to
underwriters. May include filing fees, legal fees, and taxes which are all reported on the
prospectus
o Indirect Expenses: costs that are not reported on the prospectus and include the costs
of management time spent working on the new issue
Empirical Evidence – Flotation Costs
o Substantial economies of size exist – larger firms can raise equity more easily and at a
lower cost
o The cost associated with underpricing can be substantial and can exceed the direct costs
o The issue costs are higher for and IPO than SEO
Privileged Subscription: Rights Offering


Rights Offerings: Offerings where the company offers its existing shareholders the right to buy
additional shares at a subscription price, which is a price significantly below market value
o Rights offering ensures that existing shareholders maintain their percentage ownership
in the company
o The company doesn’t have to entice new shareholders to invest in the company
o “Rights” are given to the shareholders specifying:
 Number of share that can be purchased through rights offerings
 A shareholders existing amount of shares determines how many they
can buy through rights offering. For example, for every 2 shares a
shareholder may buy 1 new share via rights offering at the subscription
price
 Subscription price
 Time frame
 Refers to the holder-of-record date
o Rights are separated from the stocks and usually trade on the same exchange in the
company’s stock
 Rights are optional, meaning shareholders can sell their rights to other investors
Who has the Rights?
o The firm announces the right issue and sets a holder-of-record date
 Holder-Of-Record Date: the date on which shareholders appearing on the
company’s records are entitled to receive the stock rights
o Two trading days before the holder-of-record date is the ex-rights date
 If the stock is sold before this date, the new owner will receive the rights, so the
price will be with rights
 If the stock is sold after this date, the buyer is not entitled to the rights – sold on
ex-rights date or without rights attached
 Value of stock drop by the rights value due to the rights not being
attached to the stock (rights-on price – ex-rights price = value of a right)


𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑅𝑖𝑔ℎ𝑡, 𝑅0 =
𝑀0 −𝑆
𝑁+1
Where M0 is rights-on stock price, S is subscription price, and N is the
number of rights to buy one new share
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


Value of a Right Nuances
o The subscription price in a rights offering is generally less than the current market price
o The share price will adjust (decrease) based on the number of new shares issued
o The interested shareholders will have to pay the subscription price and the produce the
requisite number of rights to purchase one new share
Rights Offering Example One
o Suppose a company wants to raise $5 million. The subscription price is $10, and the
current stock price is $20. The firm currently has 1,000,000 shares outstanding.
o How many shares must be issued?
 # of shares = Funds to be raised/Subscription Price
$5 million/$10 a share = 500,000 shares
o How many rights will it take to purchase one new share?
 # of rights to buy one new share = # of old share/# of new shares
1m/500k = 2
o What is the value of a right
 R0 = 20-10/(2+1) = 3.33
Value of Right to Individual Shareholder
o This individual has 2 shares which give her the right to buy 1 additional share at $10. She
can:
 Exercise rights: will result in gain
 Sell rights: will result in neither gain or loss
 Do nothing: will result in loss
Rights Offering Example Two
o ABC Corp currently has 9 million shares outstanding. The market price is $15 per share.
ABC decides to raise additional funds via a 1 for 3 offer at $12 per share. If we assume
100% subscription, what is the value of each right
o Market value = 9 mil x $15 = $145 mil
o New shares issued = 9 mil/3 = 3 mil
o Total shares after rights = 9 mil + 3 mil = 12 mil
o New funds = 3 mil x $12 = $36 mil
o Market value after rights offering = $145 mil + $36 mil = $171 mil
o Share price after rights offering - $171 mil/12 mil = $14.25
o Value of right = Rights on price – Ex-rights price = $15 - $14.25 = $0.75
Standby Rights Offer
o Underwriter agrees to buy any shares that are not purchased through the rights offering
o Stockholders can either exercise their rights or sell them – they are not hurt by the
rights offering either way
o The company may give its shareholders an Oversubscription Privilege allowing them to
purchase any unsold shares at the subscription price
 This allows existing shareholders without rights to purchase new shares at the
subscription price
Types of Long-Term Debt

Public Issue: Bonds
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Private Issue
o Term Loans
 Direct business loans from commercial banks, insurance companies, etc.
 Maturities between 1-5 years
 Repayable during life of the loan
 Not very large amounts; 100k to a few million
o Syndicate Loans
 Very large loans
 Loans from a group of banks or other institutional investors
 May be a line of credit or fully used by the borrowing firm/country
 Rated investment grade; must be a borrower rating of triple B or higher
o Private Placements
 Longer maturity loans
 Easier to renegotiate than public issues; only 2 parties involved
 Lower costs than public issues
 Occurs when the underwrite approaches different individual banks or financial
institutions
Chapter 16: Capital Structure Theory
The Pie Theory

Changes in capital structure only benefit stockholders if the value of the firm increases
o The value of a grim is the sum of the firms debt and equity
o 𝑉 = 𝐷 + 𝐸 or 𝐹𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒 = 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐷𝑒𝑏𝑡 + 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦
o Value of the firm can also be calculated using the discounted cash flow valuation


o Total firm value is equal, despite different debt and equity weights
If the goal of the firm is to maximize profits, the firm should choose the debt-equity ratio that
maximizes the size of the pie
o 50% of 10 vs. 25% of 100
o We can maximize stockholder wealth by maximizing cash flow to the firm or by
minimizing WACC
Capital Restructuring


Looking at how changes in capital structure affect the firm, all else being equal
Changing the amount of debt (leverage) and equity without affecting the firm’s assets
o Increase debt – issue debt and repurchase outstanding shares using the proceeds
o Decrease debt – issue new shares and retire outstanding debt using the proceeds
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
The Effect of Leverage
o Increased debt financing increases the fixed interest
expense
o High earnings lead to more leftovers for stockholders
(low fixed interest expense)
 Considered a “Good Year”
o Low earnings lead to less leftovers for stockholders (high
fixed interest expense)
 Considered a “Poor Year”
Leverage amplifies the variation in both EPS and ROE
o The range of EPS and ROE increases with the presence of
debt
o Meaning there is more volatility, high risk, high return
 When the company is doing well, debt is
advantageous for shareholders, when the
company is doing poorly, no debt is
advantageous for shareholders
Break-Even EBIT: The level of earnings where EPS is the same under current and proposed
capital structures. Also known as the indifference point (refer to above graph)
o If expected EBIT > break-even point; leverage is beneficial to shareholders
o If expected EBIT < break-even point; leverage is detrimental to shareholders
o Formula (Solve for EBIT):
 𝐸𝑃𝑆 𝑖𝑛 𝐴𝑙𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 𝐹𝑖𝑟𝑚 = 𝐸𝑃𝑆 𝑖𝑛 𝐹𝑖𝑟𝑚 𝑤𝑖𝑡ℎ 𝐷𝑒𝑏𝑡
𝐸𝐵𝐼𝑇−𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝐸𝐵𝐼𝑇
= # 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 *




# 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠
𝐵𝑟𝑒𝑎𝑘 𝐸𝑣𝑒𝑛 𝐸𝐵𝐼𝑇 =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝐹𝑖𝑟𝑚 𝑤𝑖𝑡ℎ 𝐷𝑒𝑏𝑡 𝑆ℎ𝑎𝑟𝑒𝑠
|
𝐹𝑖𝑟𝑚 𝑤𝑖𝑡ℎ 𝐴𝑙𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 𝑆ℎ𝑎𝑟𝑒𝑠
− 1|
Homemade Leverage
o Despite the company not having any debt, shareholders can create their own debt
 Happens when shareholder desires ROE of a debt firm but is in an all-equity firm
o Occurs when the shareholder borrows at the same rate as the company.
 I.e. replicating the D/E ratio of the company as if they had debt
o Assumes no taxes and that anyone can borrows at the same rate as the company
Homemade Unleverage
o Individual shareholders preferring ROE like an all-equity firm in a levered firm
o Occurs when the shareholder lends at the same rate as the company
 Replicating the D/E ratio
o Assumes no taxes and that anyone can lend at the same rate and the company
Capital Structure Theories

Modigliani and Miller (M&M) Theory of Capital Structure
o 3 Scenarios that have 2 propositions each
o Proposition One: Firm Value
 How the capital structure affects firm value
o Proposition Two: WACC, RE
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 What happens to WACC and cost of equity as the capital structure changes
o In order to change firm value there must be a D/E that causes a change in:
 The riskiness of cash flows (WACC)
 The cash flows themselves (CFA)
 Or both
Restrictive Assumptions of the M&M Model
o Homogeneous Expectations: all investors and corporations in the market have the same
expectations of the future
o Homogeneous Business Risk Classes: all investors and firms know what risk class they
belong to and their knowledge of it is similar
o Cash flows are perpetual in nature
 EBIT and Interest will stay constant
o Assumes that the capital markets are perfect
 Perfect competition: prices are set by demand and supply interactions
 Firms and investors can borrow/lend at the same rate
 Equal access to all relevant information
 No transaction costs
 No taxes
Capital Structure Theory Under Three Cases

Case One: No Taxes or Bankruptcy Costs
o Proposition One
 Value of the firm is not affected by changes in capital structure
 Cashflows do not change, therefore value does not change
 There is no optimal D/E ratio that adds value because management cannot play
with debt
 This is due to investors using homemade leverage or unleverage
 Value of levered firm = Value of unlevered firm

o
𝑉𝑢 =
𝐸𝐵𝐼𝑇
𝑅𝐸 𝑢
= 𝑉𝐿 = 𝐸𝐿 + 𝐷𝐿
 Vu = Value of the unlevered firm
 VL = Value of the levered firm
 EBIT = Perpetual operating income
 REu = Equity required return for the unlevered firm
 EL = Market value of equity of levered firm
 DL = Market value of debt
Proposition Two
 WACC is not affected by capital structure
 WACC stays the same because as you change the D/E ratio, cost of
equity adjusts accordingly
 Cost of equity increases with the use of debt
 Cost of Equity Formula
 𝑅𝐸 = 𝑅𝐴 + (𝑅𝐴 − 𝑅𝐷 ) × (𝐷⁄𝐸 )
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

RA represents the business risk; the volatility associated with the
cashflows that the company’s assets generate
 The rest of the formula represents the financial risk of the company that
increases as debt increases in the company
 RA is return on firms assets (cost of capital) and RD, is cost of debt
 As cost of equity increases, so does the required return of investors
Case Two: Corporate Taxes but no Bankruptcy Costs
o Proposition One
 Value of the firm increases as the use of debt increases
 Cash flows increase with an interest tax shield
 What happens with corporate taxes
 Debt increases interest expense (is tax deductible)
 When a firm adds dent, it reduces taxes, all else equal
 Reduction in taxes leads to increased cash flow
 Cash flows raise value of the firm






𝑃𝑉 𝑜𝑓 𝐴𝑛𝑛𝑢𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑 =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒
o 𝑃𝑉 = 𝐷𝑒𝑏𝑡 × 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒
Value of levered firm > value of unlevered firm
 Value of levered firm = value of unlevered firm + PV of interest tax
shield
Assuming perpetual cash flows

o
Interest tax shield example showing how levered firms have higher cash
flows
𝐴𝑛𝑛𝑢𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑 = 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒 × 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒
𝑉𝑈 = 𝐸𝐵𝐼𝑇 ×
1−𝑇𝐶
𝑅𝑈
o RU is unlevered cost of capital or WACCU
 𝑉𝐿 = 𝑉𝑈 + (𝐷 × 𝑇𝐶 )
 𝑉𝐸 = 𝑉𝐿 − 𝐷
Proposition Two
 WACC decreases with the increased use of debt
 The increased use of cheaper source of capital (debt) and decreased use
of expensive source of capital (equity) will lead to a lower WACC
 Cost of equity increases with the use of debt
 𝑊𝐴𝐶𝐶 = (𝐸⁄𝑉 × 𝑅𝐸 ) + [ 𝐷⁄𝑉 × 𝑅𝐷 (1 − 𝑇𝐶 )]
 𝑅𝐸 = 𝑅𝐴 + (𝑅𝐴 − 𝑅𝐷 ) × (𝐷⁄𝐸 ) × (1 − 𝑇𝐶 )
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o

 WACC of levered firm < WACC of unlevered firm
Asset Beta vs. Equity Beta
 Until this point, CAPM assumed that the firm was unlevered, where βA is the
systematic risk of the firms assets
 Equity beta considers different levels of the company’s debt
 𝑅𝐸 = 𝑅𝐹 + 𝛽𝐴 (1 + 𝐷⁄𝐸 ) × (𝑅𝑀 − 𝑅𝐹 )
 where 𝛽𝐸 = 𝛽𝐴 (1 + 𝐷⁄𝐸 )
 𝛽𝐸 = 𝛽𝐴 (1 + 𝐷⁄𝐸 ) means that systematic risk of the stock depends on:
 Systematic risk of the assets 𝛽𝐴 (business risk)
 Level of leverage D/E (financial risk)
Case Three: Corporate Taxes and Bankruptcy Costs
o Proposition One
 Value of the firm increases as the use of debt increases, BUT too much debt
causes bankruptcy costs to increase and eventually lowers the firm’s value
 The increased cash flow from interest tax shield is offset by the decreased cash
flows from bankruptcy costs
o Proposition Two
 WACC decrease with the increased use of debt, BUT too much debt increases
the cost of debt due to associated bankruptcy costs
 Cost of equity increases with the use of debt
o What happened with bankruptcy costs?
 As the D/E ratio increases, so does the probability of bankruptcy
 Increased probability means increased expected bankruptcy costs
 At some level of debt, the additional value of the interest tax shield will be
offset by the expected bankruptcy cost
 At this point, the value of the firm will start to decrease and the WACC
will increase as more debt is added
 Bankruptcy and costs
 Financial distress
o Significant problems meeting debt obligations
o Most firms that experience financial distress do not file for
bankruptcy
 Direct costs
o Legal and administrative costs
o Cases bondholders to incur additional losses
 Disincentive to debt financing
 Indirect costs
o Loss of asset value, management is worried about bankruptcy
rather than running the business
 Larger than direct costs, but harder to measure
o Stockholders and bondholders want to avoid a formal
bankruptcy
o Optimal Capital Structure: Static Theory
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

o
The firm borrows up to the optimal point where there tax benefit of an extra
dollar is equal to the cost of financial distress
This is the point where WACC is minimized, and CFA is maximized
Static Theory and the Cost of Capital
 WACC falls initially due to the advantage of debt
 Beyond the optimal point, WACC rises because of the financial distress costs
Real World Observations


Static Theory vs. Ground Reality
o Why do large, profitable firms use little debt?
 There are flotation costs associated with issuing new securities
 Selling securities is time consuming take time away from management
 They have internal sources of capital
 They generate sufficient cash flows from the operations of the firm
Pecking Order Theory: Making Meaning of Reality
1. Internal financing (no associated costs)
2. Issuing debt (cheaper external financing)
3. Issuing Equity (last resort)
o Managers are sensitive to the signals they send when they issue new securities
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
Signaling and Pecking Order Theory
o A company announces its selling stock
 Investors believe that the managers will sell shares when they are overpriced
 The stock price falls because the announcement sends a negative signal to the
market
o Managers do not want the stock price to fall, so they prefer internal financing since it
does not send a negative signal
 If external financing is required, firms refer debt
 External equity is issued as a last resort
o The most profitable firms borrow less because they don’t need external financing, not
because they want a lower D/E ratio
Observed Capital Structures
o Capital structure differs by industry
o Firms and lenders uses the industry D/E ratio as a guide
o Changes in financial leverage affect firm value
 Stock price increases as leverage increases and vice-versa
 Consistent with M&M and taxes
 Firms signal good news when they lever up
o There is evidence that firms behave as if they had a target D/E ratio
Chapter 17: Dividend Policy

What are dividends?
o A portion of net income distributed to the company’s shareholders
o The amount paid is decided by the board of directors and is then announced by the CEO
 The decision to how many dollars to allocate to dividends is called the firm’s
dividend policy
o The leftover the money is retained earnings
Types of Dividends



Regular Cash Dividend: “non-surprising” cash payments made directly to stockholders
o Expected monthly, quarterly, etc. depending on dividend policy
o Are “sticky” meaning the next dividend doesn’t deviated too much from last dividends
amount
Extra Cash Dividend (Bonus Dividend): a “extra” or “bonus” dividend that may not be repeated
in the future
Special Cash Dividend: While similar to an extra dividend, this dividend will NOT be repeated
o Typically occurs when the company divests from an investment or project and wants the
cash to go to shareholders
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


Liquidating Dividend: a dividend paid after a part of all of the business has been sold
o This money is the leftover after the company’s creditors have been paid
Scrip Dividend: instead of a dividend, the company offers a promissory note because the
company doesn’t have the required funds to pay dividends
o Dividends are promised at some later date (essentially an IOU)
o Shows as a notes payable in the balance sheet
Dividend in kind: a non-monetary dividend where the company shares its assets with
shareholders
o Assets may include shares/bonds of other companies
Stock Dividend: distribution of income in the form of company shares rather than cash
Dividend Payment Chronology




Declaration Date
o Board declares the dividend, and it becomes a liability of the firm
Ex-dividend Date
o Two business days before the date of record
o Stock bought on or after this date will not receive the dividend
o Stock price typically drops by the amount of the dividend
Date of Record
o Holders of record are determined, and they will receive the dividend payment
Date of Payment
o Checks are mailed
Dividend Policies


Does it matter?
o “Yes” because the value of the stock is based on the present value of expected future
dividends (dividend discount model)
o “No” because the decision is whether or not to pay dividends. In theory, if the firm
reinvests that money, it will grow and pay higher dividends in the future
o If the company can earn the required return, then it doesn’t matter when it pays the
dividends
Irrelevance of Dividends Policy: Homemade Dividends
o A dividend policy is irrelevant when there are no taxes or other market imperfections
o Shareholders can effectively undo the firms dividend strategy
 The shareholder who receives more than they wanted can reinvest the excess
money back into the company’s shares
 The shareholder who received less than they wanted can sell part of their share
holdings
o Automatic Dividend Reinvestment Plans (DRIPS) are offered by some companies
High or Low Dividend Payouts

Why Low Dividend Payout?
o Investors in upper tax brackets prefer low or no dividends at all for tax reasons
 Effective personal tax rate on dividend income is lower due to dividend tax
credit
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
 Capital gains are taxed at 50% of the marginal tax rate
o Dividends are double taxed once at the corporate level and once at the investor level
o Low flotation costs for low payouts
o Dividend restrictions: debt contracts might limit the percentage of income that can be
paid out as dividends
o What to do with the free cash (FCF)?
 Good Actions
 Repurchase shares, reducing outstanding shares, reducing amount of
dividends to pay
o Is a positive signal
 Purchase financial assets like T-bills, bonds, stocks of other companies
o Compare after-tax effects of these investments vs dividend paid
out
o Must be liquid enough so that they can get the money when
they need it
 Bad Actions
 Select additional capital budgeting projects
o May not be positive NPV projects which may lead to takeover
 Acquire other companies
o Premium paid can be value destroying
Why High Dividend Payout?
o Investors in the lower tax bracket desire high dividends as a source of income
o Risk adverse investors desire high dividends because they would rather stick with the
dividend payments instead of trading to make money
o Tax-exempt investors (pension funds, trust funds, endowment funds) don’t have to
worry about differential treatment between dividends and capital gains
 Corporations will not have to pay taxes on dividend earnings (up to 100%)
Dividends Signals and Effect on Value of a Firm


Dividends and Signals
o Asymmetric information: managers have more information about the health of the
company than investors
o Changes in dividends convey information
 Information content effect: for example a dividend price increase of 5 cents will
affect the price of dividends for more than 5 cents
Signals: Dividend Increases
o Expected:
 Management believes they can sustain the higher dividend payout
 Expectation of higher future dividends, increasing present value
 Signal of a healthy, growing firm
 Good corporate governance
o Alternative:
 Company’s future growth is uncertain
 No positive NPV projects at disposal
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
 Signal of a slow-down
Signals: Dividend Decreases
o Expected:
 Management believes it can no longer sustain the current dividend payouts
 Expectation of lower dividends; decreasing present value
 Signal of a firm that is having financial difficulties
o Alternative:
 Signal of a growing firm in need of extra funding to undertake positive NPV
projects
 saving on flotation costs
 management’s confidence to generate a higher rate of return on retained
capital than the individual investors ability to generate
Clientele Effect
o Despite signals some investors may buy stock because of their preference for high or
low dividend payouts
o Managers should focus on capital budgeting decisions and ignore investor preferences
o The dividend policy wont increase or decrease the value of a firm
The 3 Dividend Policies


Residual Dividend Policy
o Policy where a firm pays dividends after meeting its investment needs while maintain a
target capital structure
o Dividends paid is based company’s earnings and new funds
o Not ideal because the dividend price may fluctuate and send mixed messages
o Steps involved:
 Determine capital budget (how much funding is needed for new project(s))
 Determine target capital structure (D/E)
 Finance investments while adhering to the target capital structure
 Remember that retained earnings is equity
o The leftover net income after using retained earnings to finance new projects is what
gets paid to stockholders as dividends
o Under this policy, if the project(s) require a lot of financing, the company may not pay
any dividends
o Example:
 Given
 Need $5 million for new investments (Cap Budget)
 Target capital structure: D/E = 2/3 (Cap Str)
 Debt: 40%; Equity: 60%
 Net Income = $4 million
 Finding dividend
 40% financed with debt = $5 m *40% = $2 m
 60% financed with equity = $5 m * 60% = $3 m
 Dividends = NI – equity financing = $4 million - 3 million = $1 million
Sticky Dividend Policy
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Policy where a firm’s new dividend follows very closely to the last dividend paid out
Managers “stick” to the last dividend’s price and only increase the amount if they are
certain they can maintain the new level of dividends
o Managers defer from decreasing dividend payments to avoid sending negative signals
Compromise Dividend Policy
o A compromise between residual and sticky dividend policies
o Goals (loosely) ranked in order of importance
 Avoid cutting back on positive npv projects to pay a dividend
 Avoid dividend cuts
 Avoid the need to sell equity
 Maintain the target D/E ratio
 Maintain the target payout ratio (dividend/net income)
o Companies want to accept positive npv projects without sending negative signals
o Use of extra dividends along with regular cash dividends
 This is in order to maintain expectations without the commitment of consistent
higher dividend payments
What factors do managers deem important when deciding dividend price?
o Stability of earnings
o Pattern of past dividends
o Level of current earnings
o Level of expected future earnings
o Desire to maintain a stable payout in the long run
o
o


Alternatives to Cash Dividends

Stock Repurchase
o Company buys back its own share of stock
 Tender Offer: company states a purchase price and a desired number of shares;
asks existing shareholders to tender their shares
 Open Market: buys stock in the open market
o Returns cash from the firm to the stockholders (like cash dividends)
o How does a repurchase differ from cash dividends?
 Shareholders get a decision
 Stock repurchases allow investors to decide if they want the current
cash flow and associated tax consequences
 Dividends and associated income tax ramifications cannot be chosen by
shareholders; stock repurchase allows shareholders a choice
 Tax consequences of participating in a repurchase
 The income tax act requires investors to report a deemed dividend
equal to the excess of the amount purchase over book value
 This removes the tax advantage of stock repurchases over dividends
 Example: if a shareholder bought a stock for $10 but then later sold it to
the company in a repurchase for $22, the difference of $12 is taxed
o Stock Repurchase Signals
 Sends a positive signal that management believes that the current price is low
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


Tender offers send a more positive signal than open market because the
company is stating a specific price
Stock price often increases when repurchases are announced
Repurchases lead to higher EPS (lower outstanding shares), however this is NOT
a signal of superior performance, just and accounting adjustment
Stock Dividends
o The company pays additional shares of stock instead of cash
o Increases the number of outstanding shares (lowering EPS and value per share)
o Company declares a percentage stock dividend
 A 15% stock dividend would mean an investor with 100 shares gets 15 shares
o Stock dividends will increase common stock by the same amount that retained earnings
decreases (shares issues * share value)
 Meaning that there is no change in total owners equity
Stock Splits and Reverse Splits


Stock Splits
o Similar to stock dividends but is expressed as a ratio
 Example, apples 4 for 1 split in 2020: this means 1 share becomes 4
 Example, 2 for 1 stock split is the same as a 100% stock dividend
o Stock price is reduced when the stock splits
o No cash is paid out, and shareholder ownership is unaffected
o Splits are done in order to return the price to a “more desirable trading range”
o In the balance sheet, it is just an accounting entry for the distributing firm
o Example:
 100k shares outstanding, $80 per share, and a 4 for 1 stock split announcement
 Total shares outstanding = 100k * 4 = 400k
 Price per share = $80/4 = $20
 $80 * 100k = $20 *400k
 There is no change in retained earnings and total owners’ equity
 Only change is the increased number of outstanding shares
Reverse Splits
o Each investor exchanges multiple old shares for one new share
o Reduced transaction costs for shareholders
o Improved liquidity and marketability of a stock as its price is raised to the popular
trading range
o Gain respect and maintain trading at exchanges
o Example:
 700k shares outstanding, $0.02 per share, and a 2 for 7 reverse stock split
announcement
 Total shares outstanding = 700k *(2/7) = 200k
 Price per share = $80* 7/2 = $0.07
 $0.02 * 700k = $0.07 *200k
 There is no change in retained earnings and total owners’ equity
 Only change is the decreased number of outstanding shares
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Chapter 18: Short Term Financial Planning
Tracing Cash – Balance Sheet Items



Networking Capital
o 𝑁𝑒𝑡 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = 𝐿𝑇 𝐷𝑒𝑏𝑡 + 𝐸𝑞𝑢𝑖𝑡𝑦 − 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠
o 𝑁𝑒𝑡 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = (𝐶𝑎𝑠ℎ + 𝑂𝑡ℎ𝑒𝑟 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠) − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
Cash of Company
o 𝐶𝑎𝑠ℎ = 𝐿𝑇 𝐷𝑒𝑏𝑡 + 𝐸𝑞𝑢𝑖𝑡𝑦 − 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠 + 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏 − 𝑂𝑡ℎ𝑒𝑟 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
o Shows how cash increases or decreases within a company
Sources and Uses of Cash
Sources (Increase in Cash)
Uses (Decrease in Cash)
 Increase in long-term debt
 Decrease in long-term debt
 Increase in equity
 Decrease in equity
 Increase in current liabilities
 Decrease in current liabilities
 Decrease in assets other than
 Increase in assets other than cash
cash
 Increase in fixed assets
 Decrease in fixed assets
Operating and Cash Cycles





Operating Cycle: the period between inventory
purchased and when cash is received for selling
the inventory
Cash Cycle: the period between cash paid for
inventory and cash is received for selling the
inventory
o Also the period where the company has no
money and must finance
Operating Cycle Example
o Inventory period: time required to purchase and
sell the inventory. 60 days.
o Accounts receivables period: time to collect on
credit sales. 45 days.
o Operating cycle = inventory period + accounts
receivable period = 60 days + 45 days = 105 days
Cash Cycle Example
o Accounts payable period: time between
purchase of inventory and payment for the inventory. 30 days.
o Cash cycle = Operating cycle – accounts payable period = 105 days – 30 days = 75 days.
 Cash cycle = Inventory period + Accounts receivable period – Accounts payable
period
Full Example
o Assumes all sales and purchases are on credit unless mentioned otherwise
o If possible, find the average of the balance sheet items
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o
o
o
o
o
Inventory Period
 Average inventory = 2,500
 Inventory turnover = CoGS/Inv = 8,200 / 2,500 = 3.28 X
 Inventory period = 365 / 3.28 = 111.3 days
Accounts Receivable Period
 Average receivables = 1,800
 Receivables turnover = Net Sales/AR = 11,500/1,800 = 6.4 X
 Accounts Receivables period = 365 / 6.4 = 57 days
Payables Period
 Average payables = 875
 Payables turnover = CoGS/AP = 8,200/875 = 9.37 X
 Payables period = 365 / 9.37 = 39 days
Result
 Operating cycle = Inventory period + Receivables period = 111.3 + 57 = 168.3
days
 Cash Cycle = Operating cycle – Payables period = 168.3 – 39 = 129.3 days
 Inventory financing needed for 129 days
Types of Short-Term Financial Policies


2 Pronged Aspects of Short-Term Financial Policies
o Size of investments in current assets, relative to the firm’s level of sales revenue
 Flexible Policy: maintain a high ratio of current assets to sales
 Restrictive Policy: maintain a low ratio of current assets to sales
o Financing of current assets: measured as the ratio of short-term liabilities and long-term
debt used to finance current assets
 Flexible Policy: less short-term debt and more long-term debt
 Restrictive Policy: more short-term debt and less long-term debt
o A firm with a flexible policy would have relatively large investment in current assets. It
would finance this investment with relatively less in short-term debt. The net effect of a
flexible policy is a relatively high level of net working capital.
Size of Investments in Current Assets
o Flexible (Restrictive) short-term financial policies include such actions as:
 Keeping large (low) balances of cash and marketable securities.
 Making large (small) investments in inventory.
 (Not) Granting liberal credit terms, which result in a high (low or no) level of
accounts receivable.
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o
o
Optimal investment level in short-term assets - objective is to minimize the cost without
affecting operations
 Based on the different costs of alternative
short-term financing policies
 Managing short-term assets involves a
trade-off between carrying costs and
shortage costs
 Carrying Costs: costs to store and finance
the assets
 Increases as the level of current
assets increases
 Shortage Costs: stockout costs, costs to
replenish assets
 Decreases as the level of current assets increases
 Costs related to lack of safety reserves: lost sales, lost customers, and
production stoppages
 Trading or order costs
Optimal Amount of Current Assets for Both Policies
 A flexible policy is more appropriate when carrying costs are low relative to
shortage costs.


A restrictive policy is more appropriate when carrying costs are high relative to
shortage costs.
Financing Current Assets
o In an ideal world, current assets should be financed with current liabilities and noncurrent assets should be financed with long term debt and equity
o Permanent Current Assets
 Firms need to carry a minimum level of current assets
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These assets are “permanent” because the level is constant, not because they
aren’t being sold
Temporary Current Assets
 Sakes or required inventory build-up are often seasonal
 The additional current assets are carried during “peak” times
 The level of current assets will decrease as sales occur and will be low during off
season

o
o


Flexible or Restrictive Policy?
 Flexible Policy: large cash and marketable security investments along with
short-term cash surplus off season
 Restrictive Policy: long-term financing for permanent assets only and shortterm borrowing for peak season

Factors in Choosing the Best Policy
o How much cash reserve to hold
 Trade-off between safety and opportunity cost of lost interest
o Doing the best in maturity hedging
 Financing assets with sources of financing with similar maturities
o Playing the term structure interest rates
 Trade-off between lower short-term borrowing rates and uncertainty of these
rates and their availabilities
Result: A Compromise Financing Policy
o Firms keep a reserve of liquidity that is used to finance peak season current asset needs
o Short-term borrowing is used when this reserve is used up
o During the off seaon the company will invest in marketable securities
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The Cash Budget



Cash Budget: Forecast of cash inflows and outflows over the next short-term planning
o Typically monthly, but can be daily for small family-owned businesses
Primary tool in short-term financial planning
o Determines when the firm should experience cash surpluses and when it will need to
finance to cover working-capital costs
o Prepared managers find better alternatives
 i.e. lower borrowing costs and higher/secure returns on investment
Cash Budget Example
o
o
o
Cash Collections
 Collection period for accounts receivable is 30 days meaning that in 1 quarter (3
months) you can collect two months receivables and 1 month from last quarter
 Beginning receivables of $250 will be collected in the first quarter

Cash Disbursements
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
Payables period is 45 days, so 50% of the purchases (45/90 = ½) will be paid for
each quarter and the remaining will be paid the following quarter (X)


o

Total Cash Disbursement = Disbursement of Purchases + Other Expenses +
Interest and Dividend Payments
 Sum of Red Text
Net Cash Flow and Cash Balance

Sources of Short-Term Borrowing
o Operating loans with compensating balance
 Companies get expensive loans from banks for running their day-to-day
business
 To counteract that, they need to have a compensating balance
o Letter of credit
 When a company is purchasing something from a foreign country using foreign
currency
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

Banks will offer the company letters of credit which is a banks guarantee to the
selling company that purchaser has good credit
o Secured loans with covenants
 Loans with accounts receivable or inventory as collateral
o Maturity factoring: Sale of A/R at a discount
 Similar to secured loans with covenants but instead the company sells its
products on credit then sells the accounts receivable to another company
 Company loses some money on the sale of A/R. for example, they sell to a
customer on credit for $100 but then sell the A/R for $95
o Trade credit: Spontaneous source of credit from operations
 Usual source of credit that comes with the regular operations of the company
 Occurs when the company is employing a lot of employees or when the
company is purchasing a lot of raw materials on credit
 Trade credit is the A/P period where the company has time to pay its employees
or suppliers
o Money Market financing like commercial paper and bankers’ acceptance
 Companies can borrow money by issuing short-term securities
Compensating Balance Example
o A firm has $500,000 operating loan with a 15% compensating balance requirement
o Quoted interest rate is 9% and you need $150,000 for inventory for one year
o How much do we borrow?

𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝐹𝑢𝑛𝑑𝑠
(1 − 𝑐𝑜𝑚𝑝. 𝑏𝑎𝑙. %)
 $150k/(1-0.15) = $176,471
What interest rate are you effectively paying
 Interest paid = $176,471*9% = $15,882
 Effective rate = $15,882/$150,000 = 10.59%
Sale of A/R Factoring
o A firm had an average A/R of $2 million, credit sales were $24 million, and receivables
are factored by discounting 2%
o What is the annual percentage rate (APR) on factoring?
 Receivables turnover = 24/2 = 12 X
 APR = 12*(0.02/(1-0.02) = 24.49%
o What is the effective annual rate (EAR) on factoring?
 𝐸𝐴𝑅 = (1 + 𝐴𝑃𝑅/𝑚)𝑚 – 1
 EAR = (1 + 0.2449/12)12 – 1 = 27.43%
o

𝐵𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 𝐴𝑚𝑜𝑢𝑛𝑡 =
Chapter 19: Cash and Liquidity Management


Cash Management: optimizing mechanisms for collecting and disbursing cash
Liquidity Management: concerns the optimal quantity of liquid assets a firm should have on
hand (current asset management).
o Involves management of cash, marketable securities, inventories, and accounts
receivables.
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Reasons for Holding Cash



Transactive Motive: cash is held to pay day-to-day bills
o Example: payment of salaries, trade debts, taxes, and dividends
Precautionary Motive: cash is held in case of emergencies
o Example: sudden legal charges, adherence to legislative requirements for worker
safety/environment etc. issues
Speculative Purposes: cash is held to take adv advantage of unexpected opportunities
o Example: bargain purchases, attractive interest rates, favorable currency exchange rate
fluctuations
How Much Cash to Hold?



Holding cash has its costs
o Opportunity cost of holding cash: there is an opportunity cost of interest income lost
because holding cash doesn’t earn any interest
o Agency Issues of holding cash: cash is the most liquid asset and can be easily converted
into private benefits. Large cash holdings can also exact a price in the form of
managerial discretion problems
Why then hold Cash?
o To provide liquidity necessary for transaction needs.
o If the firm runs out of cash, they can borrow money or sell marketable securities.
 Both options are short-term solutions
Optimum Cash Balance: trade-off between opportunity cost of holding cash relative to the
transaction cost of converting marketable securities to cash or short-term borrowing cost
Target Cash Balance




A firms desired cash level is determined by the trade-off between carrying cost and shortage
cost
o Carrying Cost: opportunity cost of holding too much cash
o Shortage Cost (Adjustment Cost): cost associated with holding too little cash
Flexible Working Capital Policy: the firm maintains a marketable securities portfolio which is
sold to meet cash needs
o Trading cost; agency cost
o Larger companies
Restrictive working Capital Policy: the firm borrows short-term to meet cash shortages
o Interest cost
o Smaller companies
Target Cash Balance
o The greater the interest rate, the higher the opportunity cost and the lower the
optimum cash balance
 Interest rate↑; opportunity cost ↑ optimum cash balance ↓
o The greater the trading cost the higher the optimum cash balance
 Trading cost ↑; optimum cash balance ↑
o All else equal, target cash balance should be higher for firms facing greater uncertainty
in forecasting their cash needs
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o
o
 Cost of holding cash is lowest where opportunity cost and trading costs intersect
Note:
 For large firms, trading costs for securities are small when compared to the
opportunity cost of holding cash
 Borrowing is likely to be more expensive than trading costs of selling securities
Float and its Management





Float: the difference between cash balance recorded in the cash account (ledger) and the
balance reported at the bank (availible balance)
o Represents the net effect of cheques in the process of clearing (moving through the
banking system)
Disbursement Float: generated when a firm writes cheques causing a decrease in its ledger but
no change in its availible balance in the bank
o 𝐷𝑖𝑠𝑏𝑢𝑟𝑠𝑒𝑚𝑒𝑛𝑡 𝐹𝑙𝑜𝑎𝑡 = 𝐴𝑣𝑎𝑖𝑙𝑖𝑏𝑙𝑒 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 𝑎𝑡 𝑏𝑎𝑛𝑘 − 𝐵𝑜𝑜𝑘 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 > 0
o The company’s bank becomes aware when the recipient presents it to their bank
o Disbursement float arises because the bank shows that the company has the balance,
but the company books shows that they paid the check
Collection Float: cheques received by the firm create collection float causing an increase in its
ledger before the bank credits the account
o 𝐶𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝐹𝑙𝑜𝑎𝑡 = 𝐴𝑣𝑎𝑖𝑙𝑖𝑏𝑙𝑒 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 𝑎𝑡 𝑏𝑎𝑛𝑘 − 𝑏𝑜𝑜𝑘 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 < 0
o Occurs when check is being received and is in the process
o Collection Float arises when the company records payment via cheque, but the bank has
not recognized it yet
𝑁𝑒𝑡 𝐹𝑙𝑜𝑎𝑡 = 𝐷𝑖𝑠𝑏𝑢𝑟𝑠𝑒𝑚𝑒𝑛𝑡 𝐹𝑙𝑜𝑎𝑡 + 𝐶𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝐹𝑙𝑜𝑎𝑡
Float Example: You have $3000 in your checking account. You just deposited $2000 and wrote a
cheque for $2500.
o Disbursement Float = $3000 – $500 = $2500
o Collection Float = $3000 – $5000 = -$2000
o Net Float = $2500 - $2000 = $500
 Net disbursement is positive
 Net collection is negative
o Book Balance = $3000 + $2000 - $2500 = $2500
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o
Bank Balance = $3000
Parts of Float







Mail Float: during the collection and
disbursement process where cheques are
trapped in the postal system
Processing Float: the time it takes the receiver
to process the cheque and deposit into a bank
Availability Float: the time required to clear a
cheque through the banking system
Example: Measuring Float
o Size of float depends on dollar amount
and time delay
 𝐷𝑒𝑙𝑎𝑦 = 𝑀𝑎𝑖𝑙𝑖𝑛𝑔 𝐷𝑒𝑙𝑎𝑦 + 𝑃𝑟𝑜𝑐𝑒𝑠𝑠𝑖𝑛𝑔 𝐷𝑒𝑙𝑎𝑦 + 𝐴𝑣𝑎𝑖𝑙𝑖𝑏𝑖𝑙𝑖𝑡𝑦 𝐷𝑒𝑙𝑎𝑦
o Suppose you mail a cheque every month for $1,000. It takes 3 days to reach its
destination, 1 day to process and 1 day before the bank will make the cash available.
 Delay = 5 days (3 + 1 + 1) and the size of the cheque is $1000
 Average Daily Float (assuming 30-day months) = (5*$1000)/30 = $166.67
 Average Daily Float: (5/30)*1,000 + (25/30)*0 = $166.67
Float Management
o Float management involves controlling the collection and disbursement of cash
o Collection Float Objective: to speed up collections and reduce the lag between the
payment and collection of cheques
o Disbursement Float Objective: to control payments and minimize the firms costs
associated with making payments
o Speeding up collections involves reducing one or more parts of float and slowing
disbursements involves increasing the delays.
Accelerating Collections
o Incentivized credit terms
 Instead of n/30, use 2/10 n/30
o Over-the-counter systems; payment in person
o Lockbox system: special post office boxes that intercept accounts receivable payments
 RBC maintains lockboxes in 6 Canadian and 4 American cities
 Minimizes mail flow
o Electronic collection systems: electronic fund transfers (EFT)
 Credit/debit cards (POS system)
 Preauthorized payments
Accelerating Collections – Benefits
o Results in opportunity cost of not having access to cash – lost interest earning or
interest expense for borrowing
o Suppose the average daily receipt is $2M with a weighted average delay of 3 days. What
is the total amount unavailable to earn interest?
 3*2M = $6M
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What is the NPV of a project that could reduce the delay by 2 days if the cost is $2.5
million?
 Immediate additional cash inflow = 2*2M = $4M
This additional cashflow will happen only once – the day the project is initiated. The rest
of the cashflows will continue like before.
 NPV = $4M – 2.5M = $1.5M
Cash Management

Cash Concentration: after collection, surplus funds are transferred from the various local
branches to a single central concentration account for cash management

Example: Accelerating Collections
o Your company does business nationally and currently all cheques are sent to the
headquarters in Toronto. You are considering a lock-box system that will have cheques
processed in Hamilton, Vancouver and Halifax.
 Collection time will be reduced by 2 days on average
 Daily interest rate on T-bills = 0.01%
 Average number of daily payments to each lockbox is 5,000
 Average size of payment is $500
 The processing fee is $0.10 per check plus $10 to wire funds to a centralized
bank at the end of each day.
o Benefits
 Average daily collections from 3 lockboxes= 3*5000*$500 = $7,500,000
 One-time increased cashflow after lockbox initiation = 2 days*$7,500,000 =
$15,000,000
o Costs
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
Daily cost = processing fee + wire fee = $0.10*5000*3 days + 3 days *$10 =
$1,530 (perpetual cash flow)
Present value of daily cost = $1,530/0.0001 = $15,300,000

o NPV
 NPV = PV of benefit – PV of cost = $15,000,000 – 15,300,000 = - $300,000
 Therefore: Reject
Cash Disbursements
o Slowing down payments may not be ethical or optimal
o Controlling Disbursement
 Zero Balance Account: together the firm and bank transfers enough funds to
cover cheques that day. The total cash held as a buffer is small, thereby freeing
cash for other purposes
 Controlled Disbursement Account
 Writing cheques on a geographically distant bank
 Making payments on payables on the last day, e.g., if facing a credit
term of 2/10, n/30 – either pay on the 10th day or on the 30th day
Short-term Investment of Cash

Investing Idle Cash
o Money Market: financial instruments that mature in less than a year
 Example: T-bills, commercial paper, and forward rate agreements
o Temporary Cash Surpluses
 Seasonal or Cyclical Activities: buy stocks and bonds and convert them back to
cash when deficits occur
 Save for Planned/Possible Expenditures: accumulate stocks and bonds in
anticipation of upcoming expenses.
 Example: dividends payments, new projects, lawsuits, etc.
o

 Time 1: Surplus cashflow. Invested in marketable securities.
 Time 2: Deficit cashflow. Sell marketable securities, borrow from bank.
Characteristics of Short-Term Securities
o Maturity is 90 days or less to avoid loss of principal due to changing interest rates
o Be wary of default risk; avoid investing in securities with a significant default risk
o Easy to convert to cash
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They have different tax characteristics of interest and dividend/capital gains (Dividend
Capture Strategy)
Chapter 23: Mergers and Acquisitions
Types of Acquisitions




There are three legal forms of acquisition
o Merger or consolidation
o Acquisition of Stock
o Acquisition of Assets
The Canada Business Corporation Act (CBCA) and Ontario Business Corporation Act (BCA) define
all types of acquisitions as amalgamations
o In the textbook all types are classified as mergers
Parties and Payments:
o Acquirer (Bidder): the firm making an offer (in cash or securities) to obtain the stock or
assets of another company
o Acquired (Target): the firm that is sought after and/or acquired
o Consideration: the cash or securities offered to the firm
Merger and Consolidation
o Merger
 One firm is acquired by another; all assets and liabilities are acquired
 Buying firm retains name and identity, bought firm ceases to exist
o

Consolidation
 Two firms combine to create an entirely new firm
 Both acquiring and acquired firm terminate their previous legal existence and be
come a new firm
 Distinguishing acquirer and acquired is not important

Merger and Consolidation Features
 Pro: simple and less expensive than other acquisition techniques
 Con: must be approved by stockholders of both firms.
 Obtaining votes can be costly
 Target management may have agency issues increasing the time and
cost.
Acquisition of Stock
o Acquisition of purchasing voting shares of the target’s stock for cash and/or financial
securities
o

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The acquirers don’t want the assets of the company, they want enough shares
so that they can control/run the company
o Tender Offer: a public offer to buy shares made by a bidder firm directly to shareholders
of the target firm (newspaper advertisements)
 Offer is dependant on the bidder obtaining some percentage of the total coting
shares
 If not enough shares are tendered, the offer might be withdrawn or
reformulated
o Methods of taking the takeover bid to target shareholders
 Circular Bid: a bid communicated via direct mail.
 Target management sends response (accept or reject) to shareholders
via mail
 Stock Exchange Bid: a bid communicated though a stock exchange.
 Target management sends response (accept or reject) to shareholders
via press release
o Acquisition of Stock Features
 Pro: no stockholder vote required for the target firm. Bidder can deal directly
with stockholders, even if target management is unfriendly
 Con: in case of “unfriendly” acquisition attempt, target management creates
barrier which raises the cost of acquisition
 Con: some target shareholders will “hold-out” for more money, thus hindering
the complete absorption required by a merger
Acquisition of Assets
o A firm can acquire another firm by buying all (or most) of its assets
 The target firm does no necessarily crease to exist- the shell exists unless its
shareholders choose to dissolve it
 Requires a formal vote from the shareholders of the target firm
o Acquisition of Assets
 Pro: no problems with minority shareholders holding out
 Con: may involve transferring titles to different assets
 The legal process of transferring assets can be costly


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
Acquisitions Classifications – Financial Analysts
o Horizontal: bidder and target are in the same industry. They
compete in the same product market.
 Merger may become subject to The Competition Bureau
scrutiny
 Examples: Facebook — Instagram (2012), Exxon —
Mobil (1998); Walt Disney — Pixar (2006).
o Vertical: bidder and target are in different stages of the
production process. Supplier/customer relationship.
 eBay — PayPal (2002); Google — Android (2005); AT&T
—Time Warner (2018).
o Conglomerate: bidder and target are in unrelated industries
 Amazon — Whole Foods (2017); Comcast — Universal
(2011)
Types of Takeovers





Takeover: when the control of a firm transfers from one group of shareholders to another
Methods for Taking Over a Company:
o Acquisition
o Proxy Contest
o Going Private
Proxy Contest (Proxy Fight)
o Proxy Contest: when a group attempts to gain controlling seats on the board of
directors by voting in new directors
 A proxy is the right to cast someone else’s vote
 Proxies are obtained by an unhappy group of shareholders from the rest of the
shareholders
 Shareholder Activism: when a shareholder uses their share in the company to
put pressure on management
 Costly defence for management
o Shareholder Activism in Canada
 Highest level of activism campaign happened during the financial crisis of 20092009
 Usually around 30-40 public contests per year
 Mostly happen in the small- and mid-cap sector; very few in the large-cap
(>US$1 billion) companies
Going Private
o All publicly owned stock is replaced with complete equity ownership by a private group
o Shares of the firm are delisted from the stock exchanges and are not purchasable
o Private groups consist of incumbent management – Management Buyout (MBO)
o Leveraged Buyouts (LBO): going-private transactions in which a large percentage pf the
money used to buy the stock is borrowed
o Examples: Burger King (2010); Dell Computers (2013); Hilton Holdings (2007)
Alternatives to Mergers
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o
Strategic Alliances: agreement between firms to cooperate in pursuit of a joint goal
 “MasterCard worked with Apple to deliver a seamless and secure payment
experience. For consumers and merchants alike, that means that every
purchase made with a MasterCard using iPhone and Apple Watch will offer the
security, benefits and guarantees of any MasterCard Transaction.”
 Starbucks and Target; Uber and Spotify; Louis Vuitton and BMW
Joint Venture: Agreement between firms to create a sperate, co-owned entity
established to pursue a joint goal
 Sun Life Everbright Life Insurance
 Google and GSK
 Volvo and Uber
Taxes and Accounting of Mergers


Taxes for Mergers and Acquisitions
o Some mergers are tax free
 Exchange of shares, no cash involved
 Continuity of equity interest – stockholders of target firm must be able to
maintain equity interest in the combined firm
 Stockholders in target firm should still be stockholders in the combined
company after the merger
 Generally stock for stock acquisition
o Some mergers have tax implications
 Shares purchased with cash – target shareholders may have capital gain taxes
 Assets are written up – affects depreciation expense; gets CRA interested
Accounting for Acquisitions
o The Purchase Method
 Assets of acquired firm are reported (written up to) at fair market value
 Goodwill is created – difference between purchase price and estimated fair
market value of net assets
 Goodwill must be tested for impairment annually and depreciated (IAS 36)
 Equity of acquired form is bought out
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



The market value of the fixed assets of Firm B is $14 million
Firm A pays $18 million for Firm B by issuing debt.
Calculations for Firm AB
 Working capital = WC of Firm A + WC of Firm B
 Debt = cost of acquisition
 Fixed assets = FA of Firm A + Market Value of FA of Firm B
 Equity = Equity of Firm A
 Goodwill = (Debt + Equity) – (Working Capital + Fixed Assets)
$2 million of goodwill created in the acquisition.
Synergy & Sources of Value in Mergers



Mergers Occur because of synergy
o Mergers happen because the bidder believes the other firm will be worth more in their
hands then its current worth.
 More positive cash flows from the merger
o Synergy Example:
 All equity firms A and B have after-tax cash flows of $10 per year forever and
have an overall cost of capital of 10%. Firm A wants to buy Firm B. The after-tax
cash flow would be $21 per year. Is the merger worth it?
 The merger generates value: $21 per year is $1 more than the firms make
combined currently ($10 + $10)
 Both firms are currently worth $10/0.1 = $100 (perpetuity), for a total of $200
 The merger would value the firm at $21/0.1 = $210
 Incremental gain (delta Δ) from merger a.k.a synergy = $210 - $200 = $10
 The total value of Firm B to Firm A (VB*) = $100 (the value of B as a separate
company) + $10 (synergy) = $110
Where does Synergy come from?
o If the synergy results from a merger, the merged firm (VAB) is worth more than the sub
of the individual firms (VA + VB)
 (VAB) > (VA + VB)
o 𝑆𝑦𝑛𝑒𝑟𝑔𝑦, ∆V = (𝑉𝐴𝐵 ) − (𝑉𝐴 + 𝑉𝐵 ) > 0
o The source of value (synergy) can be traced in the incremental cash flows
o Incremental Cash Flow:
 ∆𝐶𝐹 = ∆𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − ∆𝐶𝑜𝑠𝑡𝑠 − ∆𝑇𝑎𝑥𝑒𝑠 − ∆𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑚𝑒𝑛𝑡𝑠
Sources of Synergy
o Revenue Enhancement
 Marketing Gains
 Better media and advertising
 Improved distribution network
 Balanced product mix
 Strategic Benefits
 Beachhead: a small market with specific characteristics that make it an
ideal target to sell a new product or service. Once the “beach” has been
taken, adjacent markets can be targeted
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o
Target company is used to test their market/country/area of
expertise before the bidder company jumps into that area

o
o
Market Power
 Higher prices
 Reduced competition
Cost Reduction
 Economies of Scale; higher production means fixed costs will be divvied up
among the number of units the combined firm is producing
 Economies of Vertical Integration
 Technology Transfer
 Complementary Resources
 Efficient Management
 Reduced Capital (LT and CA) Requirements
Tax Gains
 Use of Net Operating Losses (NOL)
 Carry-back and carry-forward
 Use of unused debt capacity
 Use of surplus funds
 Pay dividend
 Repurchase shares
 Buy another firm
 Asset write-up: depreciation tax shield
Cautions with Mergers



Cautions in valuing a Merger
o Value of Target: focus on market value of the target not on book values
o Cashflows: estimate only incremental cash flows to measure synergy – not al l cashflows
from the target
o Discount Rate: use of required rate of return for the incremental cash flows associated
with the acquisition
 i.e. the targets WACC not the bidder’s
o Other Costs: consider other transactions costs; legal fees, investment banker’s fees,
accountant fees, fees associated with additional disclosures required for the deal
Dubious reasons for Merger – Diversification
o Stockholders can diversify their own portfolio cheaper than a firm can diversify by
acquisition
o Stockholder wealth may actually decrease after the merger because the reduction in risk
in effect transfers wealth from the stockholders to the bondholders
Dubious reasons for Merger – EPS Growth
o Mergers may create the appearance of growth in earnings per share (EPS)
o If there are no benefits to the merger, the growth in EPS is just artifact of a larger firm
an its not true growth
 P/E ratio should fall because the combined market value should not change
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o

Zero-synergy merger with stock as consideration
Valuing a Merger

Benefits and Cost of Acquisition
o The total value of Firm B to Firm A (VB*) = VB + ∆V
o For bidder A, NPV = VB* - Cost of Acquisition
o Example:



Both Firm A and Firm B are 100% equity financed. B’s selling price $150
(merger premium is $50)
 Incremental Value (Synergy), ∆V is $100
 The Value of B to A is, VB + ∆V = $100 + $100 = $200
 NPV?
 The Next two methods of acquisition are based on this example
Cost of Acquisition – Payment by Cash
o NPV = $200 - $150 = $50
o Value of the combined firm
 𝑉𝐴𝐵 = 𝑉𝐴 + (𝑉𝐵∗ − 𝐶𝑎𝑠ℎ 𝐶𝑜𝑠𝑡)
 V = $500 + ($200 - $150) = $550
o Price per share = $550/25 = $22
o Effect on Shareholders
 Firm A Shareholders will get a $2/share gain ($20 → $22)
 Firm B Shareholders will get a $5/share gain ($10 → $15)
 Cash cost = $150
 EPS = $150/10 shares = 15/share
o Synergy of $100 Divvy
 Firm A Shareholders will get (25*$2) = $50 benefit of synergy
 Firm B Shareholders will get (10*$5) = $50 benefit of synergy
 Often, the entire synergy value goes to the target firm
Cost of Acquisition – Payment by Stock
o Target firm shareholders own shares in merged firm, no cash changes hands
o Cost of Acquisition is determined by:

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
 # of shares given to the target stockholders
 The price of the combined firms stock after the merger
o The value of the merged firm is equal to the sum of the 2 firms value plus the synergy
gain from the merger
 𝑉𝐴𝐵 = 𝑉𝐴 + 𝑉𝐵 + ∆V
 V = $500 + $100 + $100 = $700
o For Firm A to buy $150 worth of Firm B stock, Firm as must give up $150/$20 = 7.5
shares
 Shares after merger = 25 + 7.5 = 32.5
 Share Value = $700/32.5 = 21.54
 Value payment = 7.5 shares @ 21.54 = $161.55
o NPV = $200 - $161.55 = $38.45
Cash Vs. Stock Acquisition
o Sharing Gains – Target stockholders don’t participate in stock price appreciation with a
cash acquisition
 Target shareholders don’t share the loss either in the case of a value destroying
merger
o Taxes – cash acquisitions are generally taxable
o Control – Cash acquisitions do not dilute control as the target shareholder become
shareholders of the new firm
Defensive Tactics in Mergers


Why Defend?
o Firms defend against mergers to prevent the transaction or to increase the bidding firms
offer
o Agency Issue – management may resist due to self-interest at the expense of the
shareholders
 Merger defence may increase amount receive by shareholders
 Merger defence may defeat all takeover attempts to the detriment of the
shareholders
Defence Tactics
o Pre-offer Mechanisms: triggered by changes in control, making the target less attractive
 Control Block >50%: managers own over 50% of the company, meaning the
board of directors will always be elected by the managers
 Dual Class Shares: shares with different voting rights, certain shares may have
more voting power than others
 Example: Meta (Facebook)
 Corporate charter making requirements like supermajority amendment for
mergers and acquisitions
 Staggered election of the board of directors
 Shark Repellent: tactics adopted to discourage unwanted offers
 Poison Pills: right offers triggered in case of hostile takeover attempt
 Poison Puts: firm to buy back shares from shareholders at high prices
after a hostile takeover
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


Golden Parachutes: large cash compensation for target management in case of
a takeover
o Post-offer Mechanism: addresses ownership of shares and reduces the bidders power
gained from its ownership interest in the target
 “Just Say No” Defence
 Litigation: the firm goes to court and makes it so that the bidder cannot
approach the target firm for the next two weeks
 Standstill agreement and Greenmail / targeted share repurchase
 Leveraged Recapitalization: Issue more debt reducing the debt capacity
 Going private/ LBO
 New asset purchases make proposed merge subject to the competition bureaus
scrutiny
 Crown Jewels (Scorched Earth Strategy): selling off major assets to make itself
less attractive for acquisitions
 White Knight: seeking a competitive bid from a friendly bidder where the
management keeps their job even after a merger
Evidence on Acquisitions
o Shareholders of target companies earn excess returns in a merger
 Target company shareholders gain more in tender offer than in a straight
merger
 Target firm managers have a tendency to oppose mergers, thus increasing the
tender price
o Shareholders of bidding firms earn significantly less from takeovers
 Overestimation of synergy
 Agency issue of bidder management – empire building
 Competitive mergers and acquisition market ensures the “right” price for
targets
Divestures – Reverse of Mergers
o Divestitures: the sale of assets, operations, or divisions to a third party
o Sell of for reasons unrelated to merger
 Lack of strategic fit
 Shift in corporation vision
 Low returns
 Great selling offer
o Is common after a merger
o Three Types of Divestitures
 Equity Carve-out: sale of stock in a wholly owned subsidiary via an IPO (large
sized divestiture)
 Spin-off: distribution of shares in a subsidiary to existing parent company on a
pro-rata (proportional) basis
 Split-up: Splitting a company into two or more companies; existing shareholders
own shares in both companies
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Chapter 24: Enterprise Risk Management
What is Enterprise Risk Management?





A process of identifying and assessing a company’s risks
Decide which risks to offset (manage) and if it makes sense financially
Use an appropriate risk management tool to manage the chosen risk
Risk Management Process
o Prevention
 Steps taken to promote product safety and accident avoidance
 Company specific and will vary
 Risk related to operating activities rather than financial activities
o Identify Risks
 Some risks are obvious, and some are not
 Example: prices for commodities change vs. developments in other
countries
o Prioritize Risks
 Not all risks are worth eliminating
 Prioritize risks with the greatest impact
 Some risks may offset each other – look at the firm as a portfolio of risks, not
each risk by themselves
 Compare the cost and benefits of managing a particular risk
o Use Risk Profiles
 A tool for determining the impact of different types of risks on the company
Risk Profiles
Wheat Grower
Wheat Buyer
As wheat prices increases, so does the
As wheat prices decrease, so does the
firms value
firms value
Both risk profiles have a steep slope
 Both have a significant exposure to wheat price fluctuations
 They should both take steps to reduce that exposure
Which Risks Can Be Hedged?
o Short-run Exposure
o
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
o
Transitory changes (in price and/or cost) that can drive a business into financial
distress, in the long run, the business is financially sound
 Firm has sudden cost increases that I cannot pass onto customers immediately
 Can be managed in a variety of ways
fi Exposure
 Longer-run, more permanent changes (in price and/or cost) in the industry
conditions
 Requires the firm to be flexible and adapt to permanent changes in the business
climate
 Almost impossible to manage
Types of Risks





Hazard Risks: damage done by outside forces such as natural disasters, theft, and lawsuits
Financial Risks: loss arising from adverse exchange rate changes, commodity price fluctuations,
and interest rate movements
o If the cost of raw materials increases or selling price to customers decreases
o If the value of another country’s currency increases, the cost of purchasing from that
country will increase
o If the value of another country’s currency decreases, the value of a receivable from that
country will decrease
o As the interest rate decreases, investments that are interest bearing (bonds) will have
lower interest payments
o As the interest increases, the cost of borrowing will increase
Operational Risks: loss from disruptions in operations
o Example: human resources, product development, distribution, and marketing; and
supply chain management
Strategic Risks: large-scale issues like competition
o Example: changing customer needs, social and demographic changes, regulatory and
political trends, and technological innovation
o Reputation risk from product problems, fraud, or other unfavorable publicity
Risks That Can Be Managed
o Hazard Risks
 Can be managed with Insurance, the most widely used risk-management tool
 Insurance protects against:
Type of Insurance
Protects Against
Property
Large-scale losses due to hazards ranging from fire to storm
damage
Commercial Liability
Costs that can occur because of damages to others caused by the
company's products, operations, or employees
Business Interruption
Loss of earnings if business operations are interrupted by an
insured event, such as fire or natural disaster
Key Personnel
Losses due to loss of critical employees
Workers Compensation Costs a firm is required to pay in connection with work-related
and Employer’s Liability injuries sustained by its employees
 Buying insurance is an NPV decision, only get insurance if it has a positive NPV
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o
Financial Risks
 Hedging (Immunization): reducing a firm’s exposure to price or rate fluctuations
 Derivative Securities: financial assets that represents a claim to another asset
 It derives its value from another asset (underlying asset)
 Derivative Instruments can hedge due to volatility from interest, exchange, and
commodity rates
Hedging


Hedging and The Use of Risk Profiles
o Risk profiles depict the sensitivity of a firms value relative to changes in rates/prices
 Steeper slopes signify greater exposure and the more a firm needs to manage
that risk
o The goal of hedging is to lessen the slope of the risk profile, it is not normal for hedging
to completely eliminate the risk
 Only price risk can be hedged, not quantity risk
 You may be able to guarantee the price at which you sell your goods to
customers, but you cannot guarantee how much you will sell
 We can guarantee that we wont pay more than 10% interest when we
borrow, but we cannot guarantee that we will get a 10% rate for all $10
million dollars we borrow
 The manager may not want to completely reduce the risk, because they may
miss on the potential benefits
 For Example: when you completely eliminate price changes, you remove
both price increases and decreases in your selling price
Hedging and Firm Value
o Hedging can help enhance a firm value by:
 Stabilizing short-term cash flows
 Giving the firm time to react and adapt to changing market conditions
 Allowing the firm to take on new projects that would otherwise be considered
too risky
Tools to Hedge Financial Risks

Hedging financial risk involves taking a long (buy) or a short (sell) position in one of the four
derivative securities:
o Forward Contracts
o Future Contracts
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
o Swaps
o Options Contracts
Forward Contracts: a contract where two parties agree on the price (forward price) of an asset
today to be delivered and paid in the future (settlement date)
o Legally binding for both parties
o Tailored to meet the needs of both parties
o Can be large in size
o No exchange in cash initially
o Usually limited to large, creditworthy corporations
o Buyer (long position) has the obligation to take delivery and pay for the goods
 Long position benefits if prices increase because the buyer will have locked in a
lower price
o Seller (short position) has the obligation to make delivery and accept payment
 Short position benefits if prices fall because higher selling price has been locked
in
o Zero-sum Game: one party will win at the expense of the other
 What one party wins, one party loses the same amount
Forward Contract – Arrangement
o Dell Inc. has ordered memory chips from its supplier in Japan. The bill for ¥53 million
must be paid on February 27.
o Dell enters a forward contract with its bank to buy ¥53 million on February 27
(settlement date) at a price of ¥110 per dollar (forward price)
o On the settlement date, Dell pays ¥53 million/110 = $481,818 and receives ¥53 million
o By committing forward to exchange $481,818 for ¥53 million, Dell’s dollar costs are
locked in.
o What If?
 If the firm had not used the forward contract to hedge, it would buy ¥ from spot
market
 Scenario 1: Price of ¥ goes up, e.g., the spot exchange rate on 27th February is
¥100/dollar.
 Dollar cost to Dell to buy ¥ = 53,000,000/100 = $530,000 necessary to
pay its bill
 Savings made by forward contract = $530,000 – 481,818 = $48,182
 Dell doesn’t pay as much as they should have, bank could have charged
more
o Dell wins, bank loses
 Scenario 2: Price of ¥ goes down, e.g., the spot exchange rate on 27th February is
¥115/dollar.
 Dollar cost to Dell to buy ¥ = 53,000,000/115 = $460,870 necessary to
pay its bill
 Loss suffered for forward contract = $460,870 – 481,818 = -$20,948
 Dell pays more than they should have, bank make more profit
o Dell loses, bank wins
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o




Price Risk Hedged
 Dells risk profile + Dells risk profile with
forward contract = new line
 Dell pays the same $-price irrespective if
the price of ¥ changes; firm value
unaffected by ¥ price change
Hedging with Forward Contracts – Caveats
o Entering a forward contract can completely remove the price risk
 But it cannot eliminate credit risk
 Example: the bank not being able to come up with the money required for the
transaction
o Hedging with forwards contracts eliminates both the potential loss and potential gain
from price changes
o Forward contracts are primarily used to hedge exchange rate risk
Future Contracts
o Same risk reduction capabilities as a forward contract
o Are standardized, have a standard size, and have a fixed delivery date
 Firm may not be able to hedge the exact quantity, quality, and/or delivery date
it requires
o Availible on a wide range of assets
 Commodity futures (lumber, petrol, gold)
 Financial futures (stocks, bonds, indices, currencies)
o Contracts trade publicly on organized securities exchange
Future Contract Features
o Requires an upfront cash payment called margin
 Small relative to the value of the contract (~2%)
o “Marked-to-market” daily – credit risk is diminished
 Winner and loser is determined everyday, but the contract price is based on the
last price for the day
o Clearinghouse guarantees performance on all contracts
 Exchange markets act as clearinghouses, and they guarantee that the losers pay
the winners
o Clearinghouse and margin requirements technically eliminate credit risk
Future Contract – Gains & Losses
o Daily resettlement of gains and losses rather than one big settlement at maturity
o Every trading day:
 If price goes down, long (buyer) pays short (seller)
 If price goes up, short (seller) pays long (buyer)
o Marking-to-market: After daily resettlement, each party has a new contract at the new
price with one-day-shorter maturity.
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


o Gain (loss) for the day = The change in settlement price * contract size
Future Contract – Daily Cashflow and Marketing to Market
o Suppose you purchase (long) an Mar 2022 crude oil futures contract on January 21,
2022, at last price. Size of contract is 1,000 barrels of crude oil.
o Suppose the price becomes $84.79 on January 22, 2022, in the spot market
 Change in price = (spot price – contract price) = ($84.79 – 85.14) = - $0.35
 Loss = $0.35* 1,000 barrels = $350
 Buyer (long) pays seller (short) $350 on January 22nd
 New contract for $84.79
o Suppose the price becomes $85.77 on January 23, 2022, in the spot market
 Change in price = (spot price – contract price) = ($85.77 – 84.79) = $0.98
 Gain = $0.98* 1,000 barrels = $980
 Seller (short) pays buyer (long) $350 on January 23rd
 New contract for $85.77
Swaps: a long-term agreement between two parties to exchange cash flows at specified times
based on specified relationships
o Can be viewed as a series of forward contracts
o Traded over the counter
o Limited to large creditworthy institutions or companies
Swap Types
o Currency Swaps: two currencies are swapped based on agreed upon exchange rates
o Interest Rate Swaps: floating rate loans are swapped with fixed rate loans
 Often combined with currency swaps; the net cash flow is exchanged based on
interest rates
o Commodity Swaps: prices set are based on an underlying commodity’s trailing prices
 Similar to a forward contract
 Example: oil prices are usually set by airlines and oil producers
Interest Rate Swap Example
Fixed Rate
Floating Rate
Action Taken
Company A
10%
Prime + 1%
Borrow Floating
Company B
9.5%
Prime + 2%
Borrow Fixed
Difference (A-B)
0.5%
-1%
Discrepancy = 1.5%
o Company A wanted fixed rate, but its too high for them
o Company B wanted floating rate, but its too high for them
o A discrepancy means that there is an opportunity for a swap
o By entering a swap agreement through the help of a swap dealer, both companies will
be better off compared to borrowing from the bank
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Pay
Receive
Net
Savings/Win
Company A (Prime + 1%)
9.75%
Prime + 1%
-9.75%
0.25%
Swap Dealer with A
Prime + 1%
9.75%
Company B (9.5%)
Prime + 1.5%
9.5%
-(Prime + 1.5%)
0.5%
Swap Dealer with B
9.5%
Prime + 1.5%
Swap Dealer Net
Prime + 10.5% Prime + 11.25%
+0.75%
o Company A’s Situation
 The swap dealer pays the creditor the same amount Company A promised
(Prime + 1%)
 In return, Company A pays a rate lower that what they wanted to pay.
 In their case they wanted to borrow using the fixed rate, so they paid a
rate lower that their current fixed rate; 9.75% < 10%
 Company A has a 0.25% saving (10% - 9.75%)
o Company B’s Situation
 The swap dealer pays the creditor the same amount Company B promised
(9.5%)
 In return, Company B pays a rate lower that what they wanted to pay.
 In their case they wanted to borrow using the float rate, so they paid a
rate lower that their current float rate; Prime + 1.5% < Prime + 2%
 Company B has a 0.5% saving (Prime + 2% - Prime + 1.5%)
o Swap Dealer’s Situation
 Swap Dealers Net Pay = Sum of the Pay from Both Deals = 1% + 9.5% = 10.5%
 Swap Dealers Net Receive = Sum of the Receive from Both Deals = 9.75% + 1.5%
= 11.25%
 Savings/Win = Net Receive – Net Pay = 11.25% - 10.5% = 0.75%
 The sum of the savings/win from Company A, Company B, and the Swap Dealer
equals the discrepancy
 0.25% + 0.5% + 0.75% = 1.5%
 Option Contracts: the right to buy or sell an asset for a set price (strike/exercise price) on or
before a specified date
o Call Option: the right to buy the asset
 Long Call (Buyer) – have the right to buy
 Short Call (Seller) – have the right to buy; obligated to sell if buyer intends
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Put Option: the right to sell the asset
 Long Call (Buyer) – have the right to sell
 Short Call (Seller) – have the right to sell; obligated to sell if buyer intends
Option Contract Features
o Have a specific strike price and expiration date
 “Exercise the Option”: the act of buying or selling the underlying asset using the
option contract
 “American” Options: can be exercised at anytime up to and on the expiration
date (the last day)
 Most options are American, options are not limited to the area
 “European” Options: can only be exercised on the expiration date
o The buyer (long position) pays are price, known as the option premium, for this benefit
o Unlike forwards and futures, options allow the buyer to hedge their downside risk, but
still participate in upside potential
Call Options
o Occurs when a company needs to buy an asset at a later date and wants to lock-in the
maximum price. Used when the company is “bullish”
o The company goes the long call
o If the spot market price is lower than the strike price at the time of
the transaction, buy the asset in the spot market; don’t exercise the
call option
o If the spot market price is higher than the strike price at the time of
the transaction, buy the asset at the actual time of the transaction;
exercise the call option
 Graph Example: If we make a call option for $30, any
market price below that wont affect the firms value, but
any price above will because we can exercise the call option
and pay $30
o Call Option Example
 ABC wants to buy 5,000 tons of coal to be used in production in three months.
The management thinks that the price of coal might go up in three months time.
They have bought a call option on 5,000 tons of coal with a strike price of
$37.50 per ton. Ignoring transaction costs, what would be ABC’s benefit/loss in
the following scenarios?
 Three months later, coal is selling in the spot market for $37.85
 Spot price > strike price = $37.85 > $37.50 =
 Exercise call option
 Save (37.85 – 37.50) * 5,000 = $1,750
 Three months later, coal is selling in the spot market for $37.40
 Spot price < strike price = $37.40 < $37.50
 Throw away call option; buy from spot market
 No benefit from call option
Put Options
o



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Occurs when the company needs to sell an asset at a later date and
wants to lock in the minimum price. Used when the company is
“bearish”
o The company goes the long put
o If the spot market price is lower than the strike price at the time of the
transaction, exercise the put option
o If the spot market price is higher than the strike price at the time of the
transaction, do not exercise the put option
 Graph Example: If we make put option for $30, any market price above that
wont affect the firms value, but any price below will because we can exercise
the call option and sell for $30
o Put Option Example
 A corn farmer wants to sell 10,000 bushels of corn in three months. The farmer
thinks that the price of corn may drop in three months time. She has bought a
put option on 10,000 bushels of corn with a strike price of $6.25 per bushel.
Ignoring transaction costs, what would be her benefit/loss in the following
scenarios?
 Three months later, corn is selling in the spot market for $6.36
 Spot price < strike price = 6.36 > 6.25
 Throw away put option; sell in spot market
 No benefit from put option
 Three months later, corn is selling in the spot market for $6.12
 Spot price < strike price = 6.12 < 6.25
 Exercise put option
 Gain (6.25 – 6.12) * 10,000 = $1,300
Interest Rate Risk
o Caps: prevents a floating rate from going above a certain level
o Floor: prevents a floating rate from going below certain level
o Collar: rate the firm pays/receives will always be between the floor and the ceiling
o

Chapter 25: Options and Corporate Securities
Option Payoffs and Valuation


Pricing Terminology
o
Payoff
o Variables
 S1 = Stock price at expiration (in one period)
 S0 = Stock price today
 C1 = Value of the call option on the expiration date (in one period)
 C0 = Value of the call option today
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 E = Exercise price on the option
 Intrinsic value = the lowest price for an option
o Long Call
 Value at expiration is the intrinsic value
 Payoff = C1 = Max (0, S1 - E)
 Maximum loss is the premium for the call option
 Assume the exercise price is $30 (for graph)
o Short Call
 Loss is unlimited, as share price increases, loss of call
writer increases
 Profit is limited to the option premium received when
the option was sold
 Assume the exercise price is $30 (for graph)
o Long Put
 Value at expiration is the intrinsic value
 Payoff = C1 = Max (0, E - S1)
 Maximum loss is the premium for the put option
 Assume the exercise price is $30 (for graph)
o Short Put
 Loss increases as market price decreases
 Profit is limited to the option premium received when
the option was sold
 Assume the exercise price is $30 (for graph)
Call Option Current Price
o Upper Bound
 Call price cannot exceed stock price
 Upper bound is less than or equal to the stock price
 C0 ≤ S0
o Lower Bound
 Call price cannot be lower than intrinsic value
 Lower bound must be great than or equal to the stock price minus the exercise
price or zero, whichever is greater
 C0 = Max (0, S0 - E)
 Must be worth something until it expires. C0 ≥ 0
 If the stock price is greater than the exercise price, the call option is
worth at least S0 – E
o C0 ≥ (S0 – E)
o 𝐵𝑜𝑢𝑛𝑑𝑠 = 𝑀𝑎𝑥 (0, 𝑆0 − 𝐸) ≤ 𝐶0 ≤ 𝑆0
Arbitrage if Bounds are Broken
o If either bounds are violated, there is an arbitrage opportunity
 Upper bound is violated more than lower bound
o Example:
 Suppose C0 = $4, S0 = $10, and E = $5.
 Bounds = 5 ≤ 4 ≤ 10, the lower bound is violated
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

 You can buy the call for $4 and exercise it for $5, making he total cost $9
 Then you can immediately sell it for $10 making an arbitrage profit of $1
o The price will react immediately to the disequilibrium and adjust to a price level that
restricts
Value of a Call Option
o Lower bound/Intrinsic Value
 At expiration an option is worth its intrinsic value
 Generally worth more than that of any time before expiration due to the
probability of the option being “in-the-money” in future before expiration
o Typical call option values for different stock prices before maturity
 Exact shape and location of this curve depends on a number of factors

Determinants of Call Value
o If the option is certain to be “in-the-money”:
 𝐶𝑎𝑙𝑙 𝑂𝑝𝑡𝑖𝑜𝑛 = 𝑆𝑡𝑜𝑐𝑘 𝑉𝑎𝑙𝑢𝑒 – 𝑃𝑉 𝑜𝑓 𝐸𝑥𝑒𝑟𝑐𝑖𝑠𝑒 𝑃𝑟𝑖𝑐𝑒

𝐸
(1+𝑅𝑓 )𝑡
Determinants:
 Stock Price ↑ Call Price ↑
 (S0 ↑ C0 ↑)
 Exercise Price ↑ Call Price ↓
 (E ↑ C0 ↓)
 Time to Expiration ↑ Call Price ↑
 (t ↑ C0 ↑)
 Risk-free Rate ↑ Call Price ↑
 (Rf ↑C0 ↑)
o If the option may end up “out of the money” (expire without being exercised)
 Variance of the return on the underlying asset
 Downside risk is limited, the only effect is to increase the upside potential
 Variance ↑ Call Price ↑
Determinants of Put Value
o If the option is certain to be “in-the-money”:
 𝑃𝑢𝑡 𝑂𝑝𝑡𝑖𝑜𝑛 = 𝑃𝑉 𝑜𝑓 𝐸𝑥𝑒𝑟𝑐𝑖𝑠𝑒 𝑃𝑟𝑖𝑐𝑒 − 𝑆𝑡𝑜𝑐𝑘 𝑉𝑎𝑙𝑢𝑒
𝐸
 𝑃0 =
𝑡 − 𝑆0
o

𝐶0 = 𝑆0 −
o
(1+𝑅𝑓)
Determinants:
 Stock Price ↑ Put Price ↓
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o
 (S0 ↑ P0 ↓)
 Exercise Price ↑ Put Price ↑
 (E ↑ P0 ↑)
 Time to Expiration ↑ Put Price ↑
 (t ↑ P0 ↑)
 Risk-free Rate ↑ Put Price ↓
 (Rf ↑ P0 ↓)
If the option may end up “out of the money” (expire without being exercised)
 Variance of the return on the underlying asset
 Downside risk is limited, the only effect is to increase the upside potential
 Variance ↑ Put Price ↑

Employee Stock Options (ESO)


Employee Stock Options
o Employee’s rights to buy shares of stock in the company at a future date but at todays
price
o A call option that a firm gives to employees as a part of their benefits package
 A tool used to recruitment and motivation – goal congruence
o Features of ESO:
 Typical ESO has a ten-year life
 ESOs cannot be sold
 ESOs are usually “at the money” when they are issued
 ESOs have a ‘vesting period’ – cannot be sold during that time and must be
forfeited if employee leaves during this period
 ESO repricing - underwater ESOs may be repriced with lower strike price
Uses of Employee Stock Options
o Often used as a bonus or incentive
 to align employee interests with stockholder interests and reduce agency
problems
 67% of the 100 largest firms listed on the TSX used stock options (2014)
 Was very effective in the 1990s as a motivational tool
 ESOs don’t work as well as anticipated due to the lack of diversification
introduced into the employees’ portfolios
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o
Used to save immediate bleeding of cash
 ESO causes no immediate, upfront, out-of-pocket cost to the corporation
 ESOs are a major recruiting tool, allowing businesses to attract talent that they
otherwise could not afford
Equity as an Option


Equity as a Call Option
o Equity can be a call option on company assets when the firm is leveraged
o Exercise price is the value of the debt
o If the assets are worth more than the debt when its due, the option will be exercised,
and the stockholders will retain ownership
o If the assets are worth less than the debt when its due, stockholders will let the option
expire and the asset will belong to the bondholders
Example
o Swenson Software has a pure discount bond with a face value of $100. The bond is due
in a year. At that time, the assets in the firm will be worth either $55 or $160, depending
on the sales success of Swenson's latest product. The assets of the firm are currently
worth $110.
 If the risk-free rate is 10 percent, what is the value of the equity in Swenson?
 The value of the bond?
 The interest rate on the bond?
o If the value of the firm goes up to $160, then the bond will be
Up
paid off in full and the equity holders will retain firm (exercise
Value of Assets
160
option)
Payoff for Bond
100
o If the value of the firm drops to $55, then the bondholders
Payoff for Equity
60
will only receive $55 as the equity holders would default on
debt (throw away option)
o Replicating Asset Value
 Invest the PV of $55 in the risk-free asset
 55/(1+ Risk Free Rate) = 55/1.1 = $50 investment
 Asset Value Goes Down:
 If assets become worth $55, the option is worthless, but the RF is worth
$55
 Asset Value Goes Up:
 Assets are worth $160; one option is worth $160 - $100 = $60
 Options need to have a payoff of $160 - $55 = $105 at expiration
o # Of call options = $105/$60 = 1.75
o Replicating portfolio has $50 in risk-free asset and 1.75 call
options with a strike price of $100
o Firm is currently worth $110.
 110 = 1.75 * C0 + 50
 C0 = 34.29
o The equity is worth $34.29
 The debt is worth $110 − 34.29 = $75.71.
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o
 D0 = $75.71 → D1 = $100
The interest rate on the debt is about $100∕$75.71 − 1 = 32.1%
Warrants and Convertible Bonds

Warrants
o Gives the holder the right to purchase shares of stock at a fixed price over a long time
period
o Acts like a call option issued by corporations in conjunction with other securities to
reduce the yield
 Long-term option
o Usually included with a new debt or preferred shares issue as a sweetener, equity
kicker, or incentive
 The warrant can be detached and sold by the holder as a separate security
 Warrants vs. Call Options
Warrants
Call Options
Usually long-term
Usually short-term
Written by company and exercise results in
Issued by individuals and exercise results in
additional shares outstanding
investors buying from one another
Exercise price is paid to the company and
Has no cashflow effect for the firm
generates cash for the firm
Can be detached from the original security and
Options are always detached from the original
sold separately
security
o Exercising warrants dilutes ownership as new shares are issued an new shareholders are
included in the company
 Warrants when exercised lower the EPS
 Warrant-holder extracts value from existing shareholders when a warrant is
exercised
 Warrants Example
o Gould and Rockefeller are two investors who together purchase six ounces of platinum
at $500 per ounce.
o The total investment is 6 × $500 = $3,000, and each of the investors puts up half.
o They incorporate, print two stock certificates, and name the firm the GR Company. Each
certificate represents a one-half claim to the platinum, and Gould and Rockefeller each
own one certificate.
o Gould and Rockefeller decide to issue a warrant and sell it to Fiske. The warrant gives
Fiske the right to receive a share of stock in the company at an exercise price of $1,800.
If Fiske decides to exercise the warrant, the firm issues another stock certificate and
gives it to Fiske in exchange for $1,800.
o Situation:
 Platinum rises to $700 an ounce; firm is now worth
6 * $700 = $4,200
 Wealth is split 50/50 among Gould and Rockefeller,
each has $2,100
 Fiske uses her warrant
 She pays $1,800 to the firm
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


The firm prints one stock certificate and
give it to Fiske. The stock certificate
represents a one-third claim on the
platinum of the firm. Gould, Rockefeller and
Fiske each own a third of the company now.
 Value of firm = $4,200 + 1,800 = $6,000
 Share of each investor = $6,000/3 = $2,000
 Fiske’s gain = $2,000 – 1,800 = $200
 Gould and Rockefeller’s loss = $2,100 – 2,000 = $100 each
Convertible Bonds
o Convertible Bonds give the right to exchange the bond for a fixed number of shares of
stock anytime up to and including the maturity date of the bond
 The option cannot be separated from convertible bonds
o Conversion Price: the effective price paid for the stock when the bond is being
converted
o Conversion Ratio: the number of shares received when the bond is converted (Par value
of bond/Conversion price)
Value of Convertible Bonds
o Straight Bond Value: The value of a convertible bond if it could not be converted into
common stock
 𝑆𝑡𝑟𝑎𝑖𝑔ℎ𝑡 𝑏𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = 𝑃𝑉 𝑜𝑓 𝑎𝑙𝑙 𝑓𝑢𝑡𝑢𝑟𝑒 𝐶𝐹𝑠 𝑓𝑟𝑜𝑚 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑 𝑢𝑠𝑖𝑛𝑔 𝑌𝑇𝑀
o Conversion Value: The value of the bond if it were immediately converted into common
stock.
 𝐶𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑉𝑎𝑙𝑢𝑒 = 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒 ∗ 𝑐𝑜𝑛𝑣𝑒𝑟𝑡𝑒𝑑 𝑠ℎ𝑎𝑟𝑒𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑
o Floor (minimum) Value: Either the straight bond value or the conversion value
 Convertible bonds will be worth at least as much as the straight bond value or
the conversion value, whichever is greater
o Example
 Discovery Air convertible bonds – face value of $100. Conversion price $5.07 per
share.
 Conversion ratio = $100∕$5.07 = 19.72
 So, the holder of a Discovery Air convertible bond can exchange that
bond for 19.72 shares of Discovery Air stock.
 If Discovery Air shares are trading at $4.30 on the TSX
 the option to convert at $5.07 per share is out of the money
 the holder will not exercise the conversion option
 If Discovery Air shares are trading at $5.30 on the TSX
 the option to convert at $5.07 per share is in the money
 the holder may exercise the conversion option
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Value of option to wait ensure market price of convertibles are higher than the
floor value
Valuing Convertibles
o Suppose you have a 10% bond that pays semi-annual coupons and will mature in 15
years. The face value is $1,000 and the yield to maturity on similar bonds is 9%. At this
YTM, the bonds should be selling for $1,081.44 in the market. The bond is also
convertible with a conversion price of $100. The stock is currently selling for $110. What
is the minimum price of the bond?
o Conversion ratio = Face value / Conversion price = 1000/100 = 10 shares
o Conversion value = 10*110 = $1,100
o Straight bond value = 1081.44
o Minimum price = higher of the straight and conversion value = $1,100
Why Companies Issue Warrants and Convertibles
o Reduce costs of financing: These allow companies to issue cheap bonds by attaching
sweeteners to the new bond issue. Coupon rates can then be set at below market rate.
o They give companies the chance to issue common stock in the future at a premium over
current prices.
Other Options
o Call provision on a bond (Callable bonds)
 Issuing company redeems the bond before maturity
 Convertible bonds often have this feature
o Put bond (Putable bonds)
 Bondholder has the right to require the company to repurchase the bond prior
to maturity at a fixed price
o Over allotment option
 Underwriters have the right to purchase additional shares from a firm in an IPO
o Insurance and Loan Guarantees
 These are essentially put options in case peril occurs or the borrower defaults
o Managerial options
 Real options of expansion, diversify, divestment etc.
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Flexible production plants versus fixed production plants
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