BIP 390 - End-Of-Chapter Questions & Answers

Chapter 1 Overview of Investment Banking:

1. Looking at the leverage ratios of former pure-play investment banks GS and
MS in exhibit 1.4, why were these banks able to operate at higher leverage
ratios as investment banks compared to bank holding companies?
Bank holding companies are required to comply with Fed leverage regulations. Pureplay investment banks did not operate deposit-taking businesses and therefore were
only regulated by the SEC. Therefore they were able to operate with higher leverage
ratios due to less regulation.
2. U.S. companies currently report their financials based on U.S. GAAP rules.
Many companies in Europe report according to IFRS rules. There has been a
movement for all companies to shift to an IFRS basis globally. When this
occurs what may happen to the leverage ratios of U.S. banks?
IFRS shows gross exposure in accounting for derivatives, non-derivative trading
assets & reverse repos/borrowed securities, while U.S. GAAP shows values on a net
basis. Switching to IFRS will result in higher leverage ratio US banks will need to
cut leverage further under current Feds regulation.
3. Why might a universal bank be better able to compete against a pure play
investment bank for M&A and other investment banking engagements?
Universal banks have more stable and have countercyclical business cycles and are
better able to compete internationally. Universal banks, like Citigroup, were able to
develop a broad-based investment banking business, hire professionals from other
pure-play investment banks and use their significant lending capability as a platform
to capture greater IB market share.
---->Not sure on this part from Tians notes, I think this is describing a bank holding
company, not necessarily a universal bank: A universal bank has stable deposittaking business, lower capital risk, access to discount window, FDIC guarantees
(<$250,000), more capital efficient/safe.
4. Who within the investment bank is responsible for balancing these
competing interests (issuers & investors)?
The Capital Markets Groups (ECM & DCM) balance competing interests between
issuers (on the private side) and investors (the public side) by working with both
investment bankers and traders to negotiate prices for debt and equity offerings.
5. what is a key consideration in determining the cost and other parameters of

a corporate debt offering, and why is it important?

The impact debt offerings have on the companys credit ratings are very important as
credit ratings determine borrowing costs, which indirectly impacts the leverage of the
company. If issuing more debt negatively impacts the credit ratings of a company,
the cost of borrowing increases through higher coupons and cheaper prices.
6. Why might an investment bank place higher priority on sell-side m&a
engagements over buy-side engagements?
Sell-side M&A engagements have a higher probability of completion. As fees a
typically paid to M&A bankers only upon successful completion of a transaction,
there is greater incentive alignment with sell-side engagements compared to the
buy-side.
7. Many investment banks have a principal investment group that invests
directly in public and private companies. What conflicts of interest might arise
from operating this type of business?
The principal investment group may compete with a private equity group for an
acquistion. This is a conflict of interest because the investment bank reaps fees
from underwriting and M&A advisory from private equity firms but can also reap
rewards from their own principal investment group.
8. What conflicts might exist between the proprietary trading division and the
rest of the investment bank?
They can use internal information to make trades, though this is prohibited.
Internalization of trade orders also can occur. Bank can also exploit inherent conflicts
of interest in their trades
9. What conflicts might exist as a result of having both an asset management
business and a private wealth management business?
PWM clients may be encouraged to invest in funds managed by the own banks AM.
The bank also can co-invest in the funds that are managed by AM

Chapter 2 Regulation of the Securities Industry (Devlin):

1. Following the 1929 stock market crash, Congress passed a series of Acts
to regulate the securities industries. Name 4 of the Acts and briefly
describe their purpose.
Glass-Steagall Act 1933 - separated commercial and investment banks, created
the Federal Deposit Insurance Corporation (FDIC) which insured depositors
assets in the event of a bank default.

Securities Exchange Act of 1934 - supervision of new security offerings,

ongoing reporting requirements for these offerings, and the conduct of
exchanges. Changed secondary market for securities by requiring minimal
reporting standards and codifying rules for transactions.
Public Utility Holding Company Act 1935 - allowed the SEC to supervise the
relationship between utility holding companies and investment banks. The Act
restricted investment banks from owning these utility companies on the belief that
the banks would limit competition and engage in monopolistic behavior.
The Chandler Act 1938 - added chapter X bankruptcies to the National
Bankruptcy Act. Before this act, corporate bankruptcies had limited government
involvement and were largely run by private companies. The Chandler Act gave
the SEC the authority to be a party to all corporate restructuring activity, giving
investors additional protection against inequitable restructuring plans.
2. A goal of many parts of U.S. regulatory legislation has been to eliminate
or minimize conflicts of interest between issuers, investment banks, and
investors. Provide examples of conflicts of interest in the U.S. investment
banking industry and the corresponding regulations that attempted to
resolve those issues.
-investment banking division and equity research groups within the same bank,
resolved by the Global Research Settlement in 2003
-fraudulent information about sale of securities between investment banks and
issuers and investors, Securities Act of 1933 required information be released
about securities offered for public sale
-banks incentive to be involved in bankruptcy proceedings, suspicion that banks
were using bankruptcy accesses to rake in excessive profits, resolved by the
Chandler Act in 1938

3. Disclosure of information to investors is another recurring theme in U.S.

regulation of the securities industry. Provide examples of disclosure
required by U.S. regulations.
Companies must give regulators and prospective investors through a filing with
the SEC called the Registration Statement. Companies are also required to
provide investors with a prospectus, which contains certain elements of the
information included in the registration statement. The prospectus cannot be
distributed until after the issue has been registered with the SEC.
4. What is the role of U.S. states in regulating the investment banks?

There was limited federal regulation of the investment banks before the Great
Depression but banks had to adhere to state securities laws called Blue Sky
laws. After the passage of the National Securities Markets Improvement Act in
1996, states were effectively removed from securities regulation of investment
banks, except for antifraud matters. Now states only regulate antifraud matters.
5. what types of U.S. securities offerings do not need to be registered with
the SEC?
-Private offerings to a limited number of persons or institutions
-offerings of limited size
-securities of municipal, state, and federal governments
6. What is a red herring?
A preliminary registration statement that must be filed with the SEC describing a
new issue stock. Its called a red herring because it contains a passage in red
that states the company is not trying to sell shares before registration is approved
by the SEC.
7. Widgets inc. is a publicly traded company with approximately $300mil in
market capitalization. The company filed a registration statement for a
follow-on offering in May of this year, but began selectively speaking to
investors about the issue in March. Its offering is now being delayed by the
SEC. What is the likely reason for the delay?
Widgets Inc. might have been gun-jumping by speaking to select investors in
the pre-filing period and the subsequent delay might be an SEC-imposed
cooling off period following the violations.
8. What are the risk factors in a prospectus. Why are they important to the
issuer and to the investor?
It is a section that highlights the specific risks an investor faces. Theyre
important for the investor to understand the risks they might be facing in investing
in the security and the company. The issuers use the section to specify risks and
provide transparency to potential investors. This covers the bases of the issuers.
-risks related to a borrowers default
-risks inherent in investing
-risks related to compliance and regulatory requirements

9. What is the significance of the Gramm-Leach-Bliley Act of 1999 in

relation to the securities industry?

The Act overturned the mandatory separation of commercial banks and
investment banks required by Glass-Steagall. Its also referred to as the Financial
Services Modernization Act. The argument behind the act was that it would
create a more stable business model, regardless of the economic environment.
10. What are some securities regulations in place in the United Kingdom,
Japan and China that mirror U.S. regulations?
Japan - Similar to U.S. Glass-Steagall Act, Japanese regulators distinguished
banks based on their business activities. Commercial banks were restricted from
underwriting securities until 1999. In 2006, the Financial Instruments and
Exchange Law which provides for registration and regulation of broker-dealers,
disclosure obligations and internal controls in public companies.
United Kingdom - Securities Investment Board (SIB) is similar to the SEC,
financial firms have to register with the SIB.
China - The Securities Law of 1998, there was a separation of banks engaging in
deposit taking and securities activities.
11. What are some major differences between the regulatory frameworks of
the 4 countries covered in this chapter?
U.S.
U.K. Self-regulation prevailed until 1986, until the Securities and Investment
Board (SIB) was created to be a comprehensive government regulator. Financial
firms have to register with the SIB unless they are SROs. The SROs were given
enforcement powers (fines, censures, bans). SIB became the FSA in 1997 and
combined the powers of all 9 regulatory bodies into a single regulator for the
industry, removing the influence of SROs. Like the SEC, FSA rules are binding
without any Parliamentary Action. The U.K. is also subject to the EU banking and
securities legislation as a member of the EU.
China originally had two commissions in 1992, the State Council Securities
Commission and the China Securities Regulatory Commission and the China
Securities Regulatory Commission. The SCSC deal with centralized market
regulation whereas the CSRC is the enforcer of the regulations. These two
entities merged in 1998 and became a direct entity of the state council, the head
council of the Central Peoples Government of China.
Japan Pre-WWII Japanese banks were controlled by a Zaibatsu, a large
conglomerate of businesses owned by a single holding company. Japan initiated

the Big bang and began to deregulate the financial industry. They separated the
Ministry of Finance and the Securities Exchange and Surveillance Commission
and created the Financial Supervisory Agency which is the current securities
regulatory body.
12. Compare the regulatory bodies of the four countries covered in this
chapter.
U.S. & Japan are very similar, because the U.S. directed the rebuilding of Japan
following WWII so the two regulatory bodies were very similar. (This question is
basically the previous one, reworded, so just use question 11 answer).

Chapter 3 Financings (Brian):

1. What type of securities offerings do not need to be registered with the SEC?
The resales of restricted securities, including a majority of debt offerings and a large
portion of convertible offerings in the US, to Qualified Institutional Buyers (QIBs) are
exempt by Rule 144A. Transactions in securities that are exempt from registration
are called private placements, in which investors in private placements cannot be
contacted through general solicitation or advertising processes.
2. List the three types of bank participants in an underwriting syndicate and
their core responsibilities, in order of compensation received, from high to
low.
Lead bookrunners of the transaction have the responsibility for determining the
marketing method and the pricing for the transaction and therefore, receive the
highest underwriting allocation and a proportionately higher percentage of the gross
spread. Comanagers provide minor input to the bookrunners on marketing a pricing
issues, but dont control this process, and have less risk and less work to do, and so
receive lower compensation. There is also the Selling Group for the offerings, who
dont take any financial risk and receive even lower compensation.
3. What are league tables and why are league tables important in investment
banking?
League tables is the way that the investment banking industry keeps track of
underwriting participations by all banks and this becomes a basis for comparing
banks underwriting capabilities, and there is one for every different type of security
and geographic region.
4. Describe the function of the equity capital markets group, including the two
major divisions they directly work with and the two types of clients they
indirectly work with.

The Equity Capital Markets Groups help private companies determine if an IPO of
stock is a logical decision based on an analysis of benefits and disadvantages. The
bank then must determine if there is sufficient investor demand to purchase those
new securities, and then the company will proceed to determine the expected value
of the firm based on common valuation methodologies: public comps, DCF. The
equity capital markets group would work with the investment banking division (which
will conduct the valuation) as well as the sales & trading divisions that will handle
equity transactions to investors. They indirectly work with institutional clients
(conveys ideas to equity researchers, who conveys ideas to the S&T division, who
completes transactions for institutional clients) as well as the issuing companies
themselves (they help market and provide opinions on the viability of the equity
being offered by the company).
5. Describe the unique process utilized by Google in its IPO, including its
intended advantages and potential disadvantages.
Google was determined to IPO using a Dutch Auction, in which potential investors
weigh in with bids, listing the number of shares they want and how much they are
willing to pay for those shares. Bids are then ranked with the highest price at the top.
And then, going from the highest price down, the market price is established in which
all the shares that can be sold will be sold at the lowest price offered. The
advantages of a Dutch auction are that it guarantees the greatest distribution to retail
investors. The auction would allow Google to avoid some of the excesses that can
occur in large IPOs, particularly the large first-day pop in a stocks price.
Disadvantages would include the alienation of large institutional clients since it
disenfranchises those clients pricing input and also removes the opportunity to
receive large allocation directed by the book-runner. The commissions received in
the underwriting would also be considerably less for the investment bankers.
6. What is a shelf registration statement and what securities can be included in
it?
A shelf registration is typically filed with the SEC at some point after completing an
IPO; this allows a company to file one registration statement that covers multiple
issues of different types of securities (under Rule 415). Once accepted by the SEC,
the company is allowed to have multiple offerings of several types of securities
over a three-year period, as long as the company updates the registration with
quarterly financial statements and other required updates. Securities of any public
capital markets financings, such as equity offerings, debt, and convertible securities
can be included after a shelf registration statement is made.
7. Why might a younger high-tech company select equity over debt when
raising capital?
A high-tech company, that has a less certain future cash flow, will prefer an equity
offering since there are no regular payments required in raising equity capital; it may

not be able to generate the necessary cash to make regular coupon payments on
debt capital. A young company that does not have the same credit reputation as
older, more established companies, will have to pay more for debt financing, i.e.
interest rates are higher and so raising debt capital will be more expensive.
8. A BBB-/Baa3 rated company is looking at acquiring a smaller (but sizeable)
competitor. Discuss considerations the company should take into account
when deciding whether to fund the acquisition with new debt, equity, or
convertible securities.
This company is barely investment grade rating, and so must seriously take into
consideration the debt structure of the company that it is looking at acquiring. The
company, when considering funding the acquisition with debt, will need to determine
how much debt it is capable of taking on, since an increase in debt may cause the
debt offering rating to go below BBB-/Baa3 and thus become noninvestment grade.
If the company is considering an equity funding, then it must consider the dilutive
effects of the equity offering, and thus the loss in shareholder value for each
shareholder. If the company would like to fund the acquisition with convertible
securities, it must determine whether it would be better to issue optionally converting
convertibles or mandatorily converting convertibles. This is consideration is important
since, from a credit agency point of view, the optionally converting convertible will
exhibit bond-type characteristics (and may reduce the credit rating), whereas the
mandatorily converting convertible will exhibit equity-type characteristics.
9. Suppose a company issues a $180 million convertible bond when its stock
is trading at $30. Assuming it is convertible into 5 million shares, what is the
conversion premium of the convertible?
$180 million/5 million shares = $36/share. Conversion premium: (36-30)/(30)*100% =
20%.
10. How many shares will be issued by a convertible issuer if conversion
occurs for a $200 million convertible with a conversion premium of 20%, which
is issued when the issuers stock price is $25? Show your calculation.
Current price = 25*1.2= $30. $200 million/$30 = 6.66 million shares.
11. Why did the SEC delay declaring Googles IPO registration effective?
Google had violated quiet-period rules, in which the SEC allows a company to
disclose their interest in offering IPO shares to investors only by means preliminary,
red herring prospectus, when Googles founders discussed Googles IPO in a
magazine interview with Playboy. This riled the SEC, causing the delay in declaring
the IPOs registration effective.
12. Provide reasons that an investment bank might give to support their advice

that a private company should go public.

i)
If a private company goes public that it now has access to public market
funding (in its IPO as well as in follow-on offerings), which allows the company to
have a broad, diverse ownership structure that may help stabilize the companys
share prices during market down cycles.
ii)
Public companies would have enhanced profile and marketing benefits
since public companies generally receive more media attention, and thus will be able
to increase interest in their products and increased market share.
iii)
New equity creates an acquisition currency and compensation vehicle,
in which public stock can be used instead of cash for future transactions as well as in
creating employee incentives and compensation (stock and stock options).
iv)
Creates liquidity for shareholders, i.e. IPOs will allow founders to reduce
exposure to their company by selling shares. Founders and other key employees
usually cannot sell more than 25% of their shares to provide IPO purchasers with
confidence that founders and managers will remain economically motivated to
increase shareholder value.
13. List six characteristics of companies that are good targets for an equity
issuance.
Strong stock performance or supportive equity research.
Large insider holdings or illiquid trading.
Overly leveraged capital structure.
Strategic events imminent: financing an acquisition or large capital expenditure.
Sum of Parts analysis (Carve-out, spin off, tracking stock) indicates hidden
value.
Investor focus, i.e. a Road Show focuses investors on misunderstood value and
brings in additional equity research.
14. How does a negotiated (best efforts) transaction differ from a bought
deal?
A negotiated/best efforts transaction differs to a bought deal in that the issuer will
bear the price risk; whereas in the underwriting in a bought deal, the investment
bank bears the price risk.
15. What are some methods used by investment banks to help equity issuers
mitigate price risk during the marketing process?
Investment banks may use different distribution alternatives to help issuers mitigate
price risk. This may include completing an accelerated offering with a shorter road
show period of one or two days (red herring prospectus delivered), or by carrying out
a block trade, in which the investment bank buys the securities without a road show
and bears full price risk (red herring prospectus not delivered).
16. Explain what a green shoe is.

A Green Shoe is an overallotment option that gives an investment bank the right to
sell short a number of securities equal to 15% of an offering the bank is
underwriting for a corporate client. The SEC permits this activity to enable
investment banks to stabilize the price of an equity offering following its initial
placement, in order to mitigate downside share price movement in the secondary
market. This benefits the shareholders, the company, and the investment bank
underwriters.
17. When a company has agreed to a green shoe, who does the underwriter
buy shares from if the share price drops? Who do they buy shares from if the
share price increases?
If the share price drops, then the investment bank will buy shares in the market at
the prevailing market price in order to generate demand and support the stock. If the
share price increases, then the bank will buy shares from the issuer at the offering
price.
18. Calculate the investment banks fees and profit for a 5 million share equity
offering at $40/share, with a 15% green shoe option (fully exercised) assuming
a 2% gross spread, assuming the issuers share price decreases to $38/share
after the offering.
Investment bank buys 5 mill*0.15 = 750,000 shares at $38 (750,000*38 = 28.5
million) to deliver to short sale buyers. Company receives proceeds of 5 mill*$40 =
$200 mill and issues 5 million shares. Banks Profit = (750,000*40) (750,000*38) =
1.5 million. Fee = 0.02*($200 mill) = $4 million.
19. What is the tradeoff for having a stabilizing green shoe option in a common
equity offering?
Having a green shoe offering means that the board must give approval for a issuing
a range of shares that is 100% - 115% of the original shares intended to be issued,
meaning that the company must accept the negative earnings per share
consequences of issuing more shares. The cost of mitigating the potential downside
risk of a share price decrease is the negative earnings per share impact of issuing
more shares.

Chapter 4 Mergers & Acquisitions(Brian):

1. Provide definitions for strategic buyers and financial buyers in a prospective
M&A transaction.
Strategic Buyers in an M&A deal aim to purchase another company in the hopes of
generating synergies in the context of reduced costs or increased revenues.
Financial buyers are those firms whose business model is to buy, to develop, and

subsequently to sell businesses. Financial buyers acquire operating companies for

their funds portfolio by making direct equity investments into these companies in
exchange for a percentage ownership. By doing this, the financial buyers expect to
profit from both the cash flow that the operating company generates and the capital
gains realized upon exit.
2. Why have strategic buyers traditionally been able to outbid financial buyers
in auctions?
Strategic buyers traditionally outbid financial buyers in auctions because of their
willingness to pay a higher price than the current market price for a public company
due to the potential for both expected synergies (cost-cutting and revenue
generating) and a control premium.
3. Why are revenue synergies typically given less weight than cost synergies
when evaluating the combination benefits of a transaction?
Revenue synergies should be discounted from managements projections since they
are very difficult to capture, though cost-synergies are generally easier to forecast
since cost-structures typically do not regularly and drastically change.
4. In the United States, if an M&A transaction is relatively large within its
industry, what is the name of the regulatory filing that is probably necessary
before the transaction can be consummated? Which agency is it filed with?
How long is the waiting period after a filing is made? What is the name of the
European regulator that may be relevant in an M&A transaction?
Most large M&A transactions require a Hart-Scott-Rodine (HSR) filing before the
transaction can be consummated. It is usually filed with the Federal Trade
Commission (FTC) and the Department of Justice (DOJ). The waiting period after a
filing last for 30 days in which the FTC and DOJ may request further information. The
European Commission is the European regulator that may require further filings in an
M&A transaction.
5. Assume an acquiring companys P/E is 15x and the target companys P/E is
11x. Is the acquirer more or less likely to use stock as the acquisition
currency? Why?
The acquirer is likely to use stock as the acquisition currency because the acquirer
has to pay less for each dollar of earnings than the market values its own earnings.
Hence, the acquirer will issue proportionally less shares in the transaction.
Mechanically, proforma earnings, which equals the acquirers earnings plus the
targets earnings (the numerator in EPS) will increase more than the proforma share
count (the denominator), causing EPS to increase.

6. What is a potential risk of trying to complete a stock-based acquisition

during periods of high market volatility?
In a stock-based acquisition, if a fixed exchange ratio, the number of acquiring
company shares to be exchanged for each target company shares, is used, then
high market volatility would greatly change the economic value of the acquiring stock
7. Assume an investment bank has provided a fairness opinion on a proposed
M&A transaction. Does this mean the board should go ahead and approve the
transaction?
After a fairness opinion is provided, the board should not go ahead and approve the
transaction since the fairness opinion is not an evaluation of the business rational for
the transaction, a legal opinion, or a recommendation to the board to approve the
transaction. It is only a statement that shows the fairness of the transaction from a
financial point of view from a summary of the valuation analysis conducted by the
investment bank.
8. Why might a board want to include a go-shop provision in the
merger/purchase agreement?
A go-shop provision would allow a target company to shop its current deal with
other prospective buyers, whereas a no-shop provision will disallow this. A board
will opt for a go-shop provision because it will encourage other potential buyers, who
may be competitors of the acquiring company, to be willing to pay more for the target
company after seeing the viability of the company and the deal.
9. When is a break-up fee paid? What is the typical fee charged as a percent of
equity value?
A break-up fee is paid if a transaction is not completed because a target company
walks away from the transaction after a Merger Agreement or Stock Purchase
Agreement is signed. A reverse breakup fee is paid if the acquiring company walks
away from a transaction after signing the agreement. These fees are usually set at 24% of the target companys equity value, but is subject of considerable negotiation
during the documentation process.
10. Of the various methods by which a corporate subsidiary can be separated
from the parent company in the public markets (IPO, carve-out, spin-off, splitoff, and tracking stock), which ones offer the subsidiary the most and least
independence?
Of the various corporate restructurings that involve a parent company and its
subsidiaries, the subsidiaries that arise from an IPO, a Spin-Off, and a Split-Off will
have the most independence from the parent company. Carve-Outs and Tracking
Stock transactions will give the least independence to subsidiaries since the parent
company will continue having control over the business (depending on the size of the

transaction).
11. List the four principal alternative methods for establishing value in an M&A
transaction.
i) Preemptive: where bankers will screen and identify the single most likely buyer
and contact that buyer only.
ii) Targeted Solicitation: where bankers identify and contact the two to five most
likely buyers.
iii) Controlled/Limited Auction: where bankers approach a subset of buyers (mabe
6-20 buyers potential buyers) who have been prescreened to be the most logical
buyers.
iv) Public Auction: where the company publicly announces the sales process and
invites all interested parties to participate.
12. Of the major valuation methods, which one(s) are based on relative
values? on intrinsic values? on ability to pay?
Comparable company analysis and comparable transactions analysis are multiplesbased methods for determining value in relation to a peer group of public companies
and so are methods based on relative values. A DCF is a cash flow-based method of
valuation which attempts to determine the intrinsic value of a company based on
future cash flow projections. An LBO analysis attempts to determine an internatl rate
of return based on future cash flow projections and so is a valuation method based
on the companys ability to pay.
13. Suppose you are the sell-side advisor for a multinational household and
personal products manufacturer and marketer that sells primarily to the mass
consumer markets. The analyst on your deal team prepares the following
comparable companies analysis. Which, if any, of the companies in the list
would you potentially remove from the analysis?
Remove Beiersdorf AG (only skincare), Henkel (has personal care, but large on
adhesives business, not the focus here), McBride (not so necessary to remove since
its around Europe, but just seems to be nowhere else)
14. Which valuation method tends to show the lowest valuation range? Why?
The LBO analysis valuation method tends to show the lowest valuation range
because it provides a floor value for a company since it represents the price that a
financial buyer would be willing to pay, based on achievement of their required IRR.
Strategic buyers will generally use the other valuation methods because they are
able to pay more than the financial buyers since they can take advantages of
synergies with their own company.
15. Which of the following companies would make a better LBO target, and

why? (a) A diversified manufacturer of consumer snack products or (b) a

manufacturer of factory automation equipment for car makers, agricultural
equipment and other heavy machinery.
(a) would be a better LBO target because selling snack products have a steadier
cash flow and the diversified products can be easily divested in the event that more
cash needs to be raised to pay off debt more quickly. Lower capex too.

Chapter 5 Trading (Michael):

Q1.
why?

When might an investment bank decline participation in an underwriting and

An investment bank may decline to participate in underwriting when the

commitments committee assign to determine the risk decide the firm will lose money
or expose itself to significant risk for the underwriting.
Q2.

How do professionals in sales, trading and research work together?

Research helps traders gain knowledge and analysis of securities they are trading.
Sales professionals bring investing or hedging ideas as well as pricing to clients.
Salespeople help both clients and traders create profits.
Q3.
Describe what Prime Brokerage is, including four principal products in this
area and the generic name of the financial institutions that are targeted for this
business.
Prime brokerage business focuses mainly on hedge funds and other clients who
borrow securities and cash. It also provides trade clearing, custody and settlement,
real estate and computer assistance and performance measurement and reporting to
clients. It is housed in the Trading Division.
Q4.

Explain traders market-making function.

Market making is the client-focused trading activities of large investment banks. It

means that the bank will quote a client a bid price or an offer price on securities or
derivatives at any time. Market making traders desire to capture bid-ask spread,
difference between bid price and offer price in those transactions.
Q5.
Why would a prospective issuer prefer to hire as underwriter an investment
bank that has traders already active in its security?
Issuers prefer traders active in its security because this can lead to more accurate
pricing and higher trading-based revenue.
Q6.
FICC is one of the main Divisions in an Investment Bank. What does FICC
stand for? Other than during 2007 and 2008, how does this division typically rank

from a profitability point of view, compared to other Divisions? What happened during
these two years, and which part of the FICC Division was most responsible for this
outcome?
FICC stands for fixed income, currency and commodities. It historically had been the
most profitable division in most investment banks. Because the FICC division
handles collateralized bond obligations (CBO) and collateralized loan obligations
(CLO), it suffered massive losses during the 2007 credit crisis. The risk in many
CDOs in Mortgage-backed securities was underestimated and the result was heavy
losses when the real estate bubble popped. These were part of the structured credit
business.
Q7.
Which stock would likely have a lower rebate and why: a stock whose issuer
has a large amount of convertible securities outstanding, or a stock whose issuer
has no convertible securities and has no significant share-moving news in the nearterm?
The stock whose issuer has large amount of convertible securities outstanding will
have lower rebate because this stock would most likely have more demand than the
stock with no convertible securities nor share-moving news. As demand increases,
higher the effective cost for borrower, lower the rebate.
Q8. An investor lends 10,000 shares of ABC for two months when the stock is at $50
and requires 102% cash collateral. The market interest on cash collateral is 4.0%. The
rebate rate on ABC shares is 2.5%. Calculate the combined profit for the stock lender
and investment bank.
10,000 shares * $50 = $500,000. 102% cash collateral = $500,000 * 1.02 = $510,000
(510,000 * 0.04)/6 = $3400
(510,000 * 0.025)/6 = $2125
Combined profits = 3400 2125 = 1275

Q9. Suppose Company XYZ has an average daily trading volume of 1 million shares
and shows a current short interest ratio of 3.0. It currently has a $100 million
convertible outstanding that is convertible into 4 million shares. The hedge ratio on
convertible bond is 55%, which means hedge funds investing in the security will sell
short 55% of the shares underlying the convertible. Assume all investors in the
convertible are hedge funds. Based on this information, estimate the adjusted short
interest ratio that is a better representation of the current bearish sentiment on the
stock.
Short interest = conv. shares * hedge ratio = 4mil * 0.55 = 2.2 mil
Short interest ratio = short interest/ADTV = 2.2mil/1mil = 2.2
Q10.
How were senior tranches of a CDO able to obtain investment-grade credit
ratings when some of the underlying assets were non-investment-grade?
Many senior tranches of CDO were able to obtain investment-grade ratings as the

pool is highly diversified of many assets.

Q11. A domestic airline based in the United States has placed a large $10 billion
order for new airplanes with French aircraft manufacturer Airbus. Delivery is
scheduled in 4 years. Payments are staggered based on a percentage of completion
rate. The U.S. airline believes the Euro will appreciate against the Dollar during this
time frame. How can the U.S. airline hedge currency risk related to this purchase
with an investment bank?
Foreign-exchange futures contract, value of contract increases if Euro appreciates
against dollar.
Q12.
What does VaR stand for? What is its definition and why is it important to
investment banks? What are some of the criticisms of VaR?
VaR stands for value at risk. It represents the potential loss in value of a trading
position due to adverse market movements over a defined time horizon based on
specific statistical confidence level. Criticisms of VaR include that it gives a false
sense of security and creates risk to take excessive risk for positions.

Chapter 6 Asset Management, Wealth Management, and

Research (Michael):
1. What is the difference between asset management (AM) and wealth management
(WM)?
Asset management is the professional management of funds for individuals, families
and institutions. Wealth management advisors do not manage the funds which are
the duty of AM, rather they help and give advice on the type of investments clients
should make. Thus, there could be conflict of interest if advisors do not pick products
from his or her own bank.
2. Why would a wealth manager choose to allocate some of a clients asset to
another bank?
Wealth managers may choose products from another bank if they deem that banks
products to be the best in terms of returns and risk to the wealth managers own
bank.
3.How are the different functions of the sell-side versus the buy-side manifested
through their fee structures?
Sell side research is research provided to investing clients of the firm while buy side
is to prop traders and asset managers. Sell-side research is paid through soft dollar
compensation which is money redirected to research department from investor

commissions.
4. What drove the need to separate research and investment banking?

The potential for conflict of interest and potential for nonobjective research that led to
separation of investment banking and research. For example, the investment
banking division may put pressure on research to modify negative views of the
company when doing a deal which may not be in the interest of clients.
5. How have the U.S. enforcement actions against sell-side research in 2003
heightened the issue of declining research revenues?
Government regulations have made it that research analysts compensation cannot
be based on the revenue of the investment banking division or input from investment
bankers, which lessened payment from the investment banking division.
6. What are the objectives of Regulation FD? What are the concerns about this U.S.based regulation?
The objectives of Regulation Full Disclosure were to prevent executives from
selectively disclosing material information that could affect a companys share price.
They must disclose all stock moving information with SEC before with analysts.
However, concerns are that because companies must be more careful in disclosing
information to analysts and investors, less information is distributed in less timely
way. The need for lawyers also causes a problem on the quality of information
disclosed.

Chapter 7 Credit Rating Agencies, Exchanges, and Clearing

and Settlement (Robert):
1. Compare the different roles provided to the investor community by credit
analysts and sell-side research analysts.
credit analyst: assign ratings to companys debt, ratings are used by investors, banks
and governments as an input into their decisions. Leads to increased efficiency in
the market, lower costs for borrowers, investors and lenders and expands the total
supply of capital. The issuer, not the investor, must pay for the rating.
Sell-side research analysts: provide research to investing clients of the firm. Sell side
research consists of building models to forecast a company's future earnings based
on factors like company guidance econ conditions historical trends etc. also use
multiples based on revenue, epitda, earnings, book value and cash flow to asses a
future share price. They are basically doing research to help a client determine if
they should invest in a security.

2. What is the difference between business risk and financial risk?

Financial risk is the risk that a businesss cash flows are not enough to pay creditors
and fulfill other financial responsibilities. The level of financial risk, therefore, relates
less to the business's operations themselves and more to the amount of debt a
business incurs to finance those operations. Taking on higher levels of debt or
financial liability therefore increases a business's level of financial risk. Business risk
refers to the chance a business's cash flows are not enough to cover its operating
expenses like cost of goods sold, rent and wages. Unlike financial risk, business risk
is independent of the amount of debt a business owes.
3. What precipitated the decline in CDO values during the 2007-2008 credit
crisis?
Monoline insurers, which focus on insuring capital markets bonds, provided
guarantees to CDOs that were backed by subprime mortgages. As the mortgages
declined in value in 2007-2008 the potential future payment obligations of the
monoline insurers increased dramatically which resulted in credit ratings agencies
downgrading the credit ratings of the monolines. This in turn caused the ratings
agencies to downgrade the CDOs guaranteed by the monolines.
4. What are the major criticisms directed at Moodys, Standard & Poors and
Fitch?
Ratings agencies have been criticized for their role in rating mortgage backed
securities higher than they should have leading up to the credit crisis. They are also
criticized for not downgrading them quickly enough. Other criticisms stem from their
relationships to issuers of bonds and other non-asset-backed securities. Since the
issuers pay to have the securities rated it has been suggested that the agencies are
influenced by the corporations into giving their securities a higher rating.
5. In 2001 the NYSE switched from a fractional pricing system do a decimal
pricing system. Explain how this might encourage front-running by traders?
Front running: This is a practice where traders step "in front" of their client''s orders
by offering a better price, and then filling their customers'' orders by selling them the
shares they have just bought at a higher price. This increases the spread and/or their
commission. The decimal system could make "front running" easier because under
the old system traders would have to pay 1/16 or 6.25 cents a share to "step in
front." Now they can do it for only a penny or two, thereby significantly reducing risk.
By beating (or hiding) bids by a penny, specialists and floor brokers can make
sizable--although illegal--profits.
6. Why might OTC Derivatives be considered more risky than exchange traded
derivatives?

OTC derivatives are not in the public domain and remain confidential unless reported
by the parties to the trade. The market for OTC derivatives is also much larger than
the one for listed derivatives. Newly proposed regulations may require OTC
contracts to be cleared through regulated exchanges. Companies with OTC are
usually smaller, unable to meet exchange listing requirements, so more risky.
Exchange traded derivatives are more regulated and guaranteed by the exchange,
and theres also the Clearing House that acts as an intermediary between buyer and
seller.
7. How is derivatives settlement different from securities settlement?
Derivatives often remain outstanding for months or years while securities are
generally cleared and settled in 3 days. Securities are simultaneously delivered and
paid in full while a derivative represents an obligation or an option to buy or sell an
asset at a future date. This exposes the buyer or seller to financial risk for an
extended period of time, meaning derivatives require more complex risk
management systems than securities.

Chapter 8 International Banking (Robert):

1. What are the benefits of issuing and investing in Eurobonds?
Eurobonds, and euro markets themselves, are attractive because they are largely
unregulated and can, at times, offer higher yields. They are issued and traded
outside the country whose currency the bond is denominated in and are outside the
regulations of a single country. Interest income from the bonds is exempt from
withholding tax and the bonds are generally not registered w/ any regulatory body.
They are usually issued by multinational corporations or sovereign entities with high
credit quality.
2. Why are most corporate Eurobond issuers large multinational corporations?
Since an international syndicate of banks typically underwrites a Eurobond issuance
and distributes those bonds to international investors, it's a lot easier for
multinational corporations to issue debt, and not have it tied to the regulations of the
parent country.
3. Discuss why the Japanese governments guarantee to Ripplewood as part
of its buyout of Long term Credit Bank is similar to granting Ripplewood a put
option on the banks assets.
The Japanese government agreed to purchase any LTCB assets that fell by 20% or
more post acquisition. This is similar to a put option because Ripplewood could sell
back the assets (should they drop 20% in value) at an agreed-upon price back to the
Japanese government, which is essentially a put option.

4. Why did China institute an A-share B-share system? How has regulator
easing benefited QFIIs?
The A share B share system was instituted because since the A share market is so
much larger than the B share one (10x) this ensures that the largest market is only
utilized by Chinese residents and corporations, in addition to QFIIs. The goal was
most likely to keep money confined to Chinese companies and give Chinese banks
underwriting opportunities they may not have obtained if they had to compete with
the larger international banks. Regulatory easing allowed the Qualified Financial
Institutional Investor QFII program in which qualifying foreign investors to participate
in the Chinese equity market through domestic A shares and the Chinese debt
market.
5. In a comparable transactions analysis, what additional considerations might
an investment banker factor in when valuing an emerging market company?
You must take into account the country the company is in and factor in political
volatility, political risk, and possible liquidity issues. Accounting and tax policies can
quickly change in a developing country, their currency could collapse or there could
even be a political coup. All of these factors can affect the weighted average cost of
capital.
6. Suppose you are a wealth advisor and a client has asked for your
recommendation on which of the BRIC countries poses the least risk and most
opportunity for investment growth. Briefly compare the perceived risks and
benefits of each of the countries and provide support for your selection.
Brazil:
Benefits: Became the third largest IPO market in the world in 2007. The Sao
Paolo stock exchange (BOVESPA) merged with Brazilian Mercantile and Futures
Exchange (BM&F) in 2008 to create a new exchange that has adopted US-style
corporate governance standards, one-share/one-vote rules, greater transparency,
minority shareholder protection and enhanced quality of disclosed information. In
2008 Standard & Poors upgraded Brazils credit rating to BBB- (investment grade
status).
Risks: Foreign investors accounted for over half of IPO sales leaving the local
IPO market susceptible to changes in conditions outside of its control
Russia:
Benefits: Stock market value has increased 10 fold between 2000-2007. 2007
IPO market included the largest in the world, an 8 billion offering from
Vneshtorgbank, the second largest Russian state owned bank.
Risks: The Moscow exchange provides limited liquidity and an opaque prices
system, although improvements are underway. Some international investors are
apprehensive about the ambiguity of Russian regulations, particularly relating to tax,
financial statements and legal restructuring.

India:
Benefits: IPO market is growing, the largest volume raised in one year was in
2007. Average deal size was $83mm, much smaller than Brazil or Russia. As they
build their infrastructure through, industrial and power sectors should see an
increase in IPO volume. They are allowed to duel list IPOs on local exchanges and
international ones. In 2007 the Mumbai Stock Exchange and the National Stock
Exchange became 20% owned by foreign investors including NYSE Euronext,
Deutche Bourse and the Singapore Exchange. The sharing of management and
regulatory practices have facilitated many improvements in the Indian exchanges.
Risks: Due to regulatory limits, a foreign institutional investor can invest in no
more than 10% of total issued capital of a listed Indian Company.
China:
Benefits: During 2007, it led the world in IPO funds raised ($66 billion) and
transactions (259). The Chinese government is considering allowing Chinese
investors to purchase H-shares, which will reduce the price disparity between Hong
Kong listed and Shanghai listed companies. Compared with the mainland
exchanges, the Hong Kong exchange offers better access to global capital, greater
brand recognition, higher corporate governance standards and less volatility.
Risks: The A-share B-share and H-share program causes problems as the Ashares typically trade at a premium. Capital controls prevent average Chinese
investors from investing in shares in Hong Kong or any non-Chinese market
overseas. The government passed regulations in 2006 that made it more difficult for
Chinese companies to list anywhere outside of the mainland.

Chapter 9 Convertible Securities and Wall Street Innovation

(Tian):
1. After an initial hedge is in place, what do hedge fund investors in convertible
bonds do with shares of the underlying stock when the stock price increases or
decreases?
When stock price increases, hedge fund (=HF) investors in convertible bonds short
more shares of the underlying security (increase their hedge ratio). When stock price
decreases, HFs buy shares to reduce current short position (decrease their hedge
ratio).
2. True or false: Convertible arbitrage hedge funds invest in convertible bonds
because the fund managers have a bullish view on the companys stock. Explain
your answer.
False. Convertible securities are generally sold at par, undervalued compared to
their theoretical value, which is usually 102%-107%. So by delta hedging their
investment, HFs should be able to make trading profits at least equal to the
difference between the theoretical value and par. Convertible arbitrageurs invest in
convertible bonds to monetize the volatility of the underlying stock, so they dont
necessarily have a bullish view on it.

Convertible arbitrageurs would profit from short positions if stock price goes down,
and value of conv. shares wont decrease the much due to its fixed income nature.
Value of conv. shares would also increase if stock price goes up.
3. Discuss whether you feel the SECs temporary ban on short-selling financial
stocks in 2008 during the financial crisis unfairly punished convertible arbitrage
funds.
During the 2008 financial crisis, some HFs were allegedly spreading negative rumors
about financial institutions like Lehman Brothers, which put a lot of downward
pressure on those companies stock price. These HFs were then able to make huge
trading profits from their short positions in those stocks. SEC was trying to fix that by
temporarily banning short-selling financial stocks in distressed market conditions, but
SEC didnt recognize that some HFs shorted financial stocks as a delta hedging
strategy to their long positions in those stocks.
4. If companies A and B are identical in every respect except B has higher stock
price volatility, which company would likely achieve better convertible pricing?
Assuming convertibles issued by A and B have the same terms except for
conversion price, would the company you selected have a higher or lower
conversion price?
B will have better convertible pricing because it has higher stock price volatility. And
convertible arbitrageurs are willing to accept higher conversion price for B.
5. WheelCo is raising $200 million via a mandatory convertible bond issuance.
Assuming the companys share price on the date of issuance is $20 and the
convertible bond carries a 25% conversion premium, what is the number of shares
WheelCo has to deliver to investors if its share price at maturity is (a) $19; (b) $22;
(c) $26; and (d) $30?
Floating conversion price for mandatory convertibles
a)
$200M/$20 = 10M shares
b)
$200M/$22 = 9.09M shares
c)
$200M/$25 = 8M shares
d)
$200M/$25 = 8M shares
6. Suppose you are a current shareholder in a company that is contemplating capital
raising alternatives. Assuming the transaction would have no negative credit
repercussions and you want minimal EPS dilution, rank the following types of
convertibles from least potential for dilution to most potential for dilution: couponpaying convertible, mandatory convertible, zero coupon convertible.
Least to most potential for EPS dilution: zero coupon convertible < coupon-paying
convertible < mandatory convertible

a)
b)
c)

ZCC: no coupon payment + tax deductions in relation to annual accretion

= positive cash-flow bond financing; lower probability of conversion (higher
principal at maturity)
Coupon-paying convertibles: tax deductions, optional convertible
Mandatory convertible: extent of dilution depended on share price at
maturity

7. A U.S.-based BBB-rated company is looking to make a large acquisition.

Management believes synergies from the acquisition will create new market
opportunities. Unfortunately, these new opportunities will take a few years to realize,
and until then, benefits will not be fully reflected in the companys stock price. If the
company has rating agency concerns and wants tax deductions from interest
payments, what type of security is this company likely to issue in support of its
acquisition and why?
Unit-structure mandatory convertibles:
a)
Tax deduction on interest payments
b)
50%-70% equity credit address rating agency concerns, strengthen
balance sheets
8. Why was the Nikkei Put Warrant program so profitable for Goldman Sachs?
The Nikkei Warrant Put program was so profitable for GS because it had accurately
estimated that future volatility of the Nikkei 225 Index would be higher during the
delta hedging period than the implied volatility of the Japanese stock market at the
time of the purchase of the Nikkei put warrants. By purchasing Nikkei put warrants at
a below theoretical market cost from the Nikkei-linked bond issuer and delta hedging
this risk position, GS created the opportunity for significant trading profits that
exceeded the Nikkei put warrant purchase cost.
9. What is ASR an abbreviation for? Describe this transaction and the principal
benefit for a client. What additional benefit did IBM achieve in the ASR program
described in this chapter?
ASR stands for Accelerated Share Repurchase program. This is accomplished by a
contract under which a company purchases a large block of its shares from an IB at
the closing market price on the date of the purchase, with a cash adjustment to
follow at the end of the contract. IB borrows the shares it sells to the company from
existing shareholders, creating a short position, which it covers through daily open
market purchases that are limited to 25% of the companys ADTV. Once IB
purchases enough shares to cover its short position, the total cost for the purchases
of shares over this period is determined.
The principal benefit for a client is an immediate realization of EPS benefit of a
repurchase program. IBM achieved an additional repatriation-related tax benefit in an
ASR program.
10. Assume a companys ADTV is 240,000 shares. How many days would it take to

complete a 10.8 million share repurchase program? The company has 120 million
shares outstanding and its estimated EPS for the current fiscal year is $3.40.
Assuming the company meets its earnings estimate, what would year-end EPS be
under an ASR program for the full 10.8 million shares, assuming it is executed 20
business days before the companys fiscal year end? And under an open market
repurchase program?
a) 10,800,000 / (240,000*0.25) = 180 days
b) (3.4*120M) / (120M 10.8M) = $3.74
c) (3.4*120M) / (120M 240,000 *0.25*20) = $3.43

Chapter 10 Investment Banking Careers, Opportunities, and

Issues(Daniel):
1. What are the core differences between Investment Banking (IB) and Sales
and Trading career paths?
The same titles are prescribed to both IBD and S&T but the period of time it takes for
promotion, in S&T, could be accelerated for particularly capable employees, whereas
the time periods are quite fixed in IBD. Compensation in S&T may initially be
comparable or slightly lower than in IBD, but over time, especially for highperforming employees, the compensation could be higher for S&T professionals
since they have the ability to create greater revenue for the firm. More Associates
are promoted from the Analyst level in S&T than in IB. Hours are usually shorter for
S&T (50 - 60) than in IB (70 - 100), but time spent on a trading floor can be more
intense.
2. Describe what a Chinese Wall is and which U.S. regulator would be
concerned with issues involving the wall.
A Chinese Wall is the physical and legal separation, as well as restricted
communication, between the proprietary traders and the client-related traders in a
firm because of potential conflicts of interests since both sets of traders could be
competing for the same trades. The Securities and Exchange Commission (SEC)
would be concerned with issues involving the wall and making sure that there is no
insider trading.
3. What advancement in the mortgage market set the foundation for the
subprime crisis and why?
Traditionally, commercial banks held mortgages on their balance sheet. Banks then
began to securitize their mortgages, pooling them and then dividing them into
portions (tranches) that could be sold as securities on the capital markets. However,
because commercial banks could now immediately sell the mortgages that theyve
originated, they would transfer the credit and interest rate risk onto institutional and
individual investors, thereby giving lenders little incentive to adhere to strict mortgage

underwriting standards. This agent-principal problem contributed to the explosion of

subprime mortgages that became the epicenter of the credit crisis.
4. Describe a Credit Default Swap (CDS). What are the regulators trying to do
to mitigate risk in the CDS market?
A Credit Default Swap is a derivative contract between three parties (the protection
buyer, the protection seller, and the reference entity) that is designed to spread risk
and reduce exposure to credit events such as a default or bankruptcy. In a CDS, the
protection buyer makes periodic payments to a second party in exchange for a
payoff in the event that the reference entity defaults on its debt obligation. To mitigate
risk in the CDS market, regulators have required protection sellers to disclose the
nature and terms of the credit derivative, the reason it was entered into, the current
status of its payment and performance risk, the amount of future payments it might
be required to make, the fair value of the derivative, and whether there are
provisions that would allow the seller to recover money or assets from third parties.
5. Under what scenarios will the SIV market arbitrage model fail to work?
The SIV market arbitrage model fails to work when faced with high liquidity and
interest rate risk. During a flattening yield curve, profit drops because returns from
investments do not increase at a rate commensurate with the rise in funding costs.
Also, when refinancing is not possible, an SIV may be forced to sell investments in
order to meet its debt obligations.
6. Why were U.S. investment banks allowed to operate at higher leverage
ratios compared to commercial banks?
US investment banks were allowed to operate at higher leverage ratios compared to
commercial banks because higher leverage enhances their return on equity (a
closely watched metric for financial services companies), and when business plans
are realized, leverage boosts returns and profits.
7. How does the phrase perception is reality apply to Bear Stearns?
Bears ultimate undoing had been due to the perception that it was facing a cash
crunch. Because of this perception, counterparties began placing margin calls in
droves, leading creditors to pull funding from the bank. Effectively, the perception
that they were facing a cash crunch caused a cash crunch, and so perception is
reality.
8. How do Asian and petrodollar investors fit into the genesis of the financial
crisis during 2007-2008? Structure your answer around the themes of easy
credit, excess liquidity and cheap debt.
Asian and petrodollar investors profits continued to grow during mid-2007, their

assets possibly reaching the size of assets under management by insurance

companies. This excess liquidity might foster asset price inflation through large
purchases of US Treasuries and corporate bonds, lowering US long-term interest
rates (easy credit). Although this may have helped create low-cost capital (cheap
debt), the easy money conditions led to rising real estate prices and then to the
subsequent mortgage crisis.
9. Discuss how CDS can be used for hedging and speculative purposes.
For protection buyers, a CDS resembles an insurance policy, so it can be used to
hedge against a default or bankruptcy by the reference entity. CDSs allow traders to
speculate on the likelihood of default and the true creditworthiness of the entity

Case 1:

Investment Banking in 200 (B): A Brave New

World
1. Why were proponents of deregulation so successful in the late
1990s? How much can we blame deregulation for the meltdown in the
investment banking industry, and how could the government have
foreseen and/or stopped the domino effect before the crisis of 2008?
Deregulation was so successful in the 1990s because those years had
seen amazing growth that would otherwise have been stemmed if
regulation were very strict. Clintons bipartisan deregulation had
allowed for more competition in traditional banking, securities
industries and insurance, which gave consumers more choices at lower
costs. This in turn sparked employment and saw great prosperity in the
1990s. Although it can be easy to blame deregulation for the meltdown
of the investment banking industry, it needs to be understood that the
investment banks that were in trouble during the meltdown had not
been affiliated with commercial banks at the time. Instead, their
troubles were caused more by having simply invested in bad
mortgages or mortgage-backed securities. Therefore it can be
misleading to say that deregulation had caused the meltdown. In terms
of how the government could have stopped the crisis in 2008, a simple
preventative would have been to cap the leverage ratio of the
investment banks beforehand when it became obvious that the banks
were beginning to overleverage and take on enormous amounts of risk.
2. Could any one of the investment banks have remained competitive
without following the industry trend of taking on increasing amounts of
leverage to boost returns on investment? If so, how?
With all the other banks taking on so much leverage and boasting such
high returns, in terms of profits and revenue, there does not seem to

be a way that any of the investment banks could have stayed

competitive if they chose not to follow the overleveraging trends that
the other banks seemed to be doing. If there had been a way, clearly
the firms wouldnt have all needed to resort to having such high
leverage ratios. If, however, you define competitiveness as the rate
that you are chosen by clients compared with other investment banks,
it does not necessarily depend on the leveraging but more on the
success and returns on the M&A deals that you helped clients to close.
3. Why was Lehman Brothers allowed to collapse while Bear Stearns
was not?
Bear Sterns was able to be bailed out by JP Morgan because the
government had been willing to take on the costs of Bears toxic assets
after JP Morgan took on the first $1B, whereas the government had not
been willing to do the same for Lehman Brothers, since it had just done
it with Bear using taxpayer money and it would have been a very
unpopular move by the government. No financial institution was willing
to take on such costs without the help of the government and so
Lehman was allowed to collapse.
4. Did the compensation structure of the investment banking industry
encourage banking executives and employees to take on excessive risk
to boost short-term profits? Why or why not?
Because bonuses are such a large portion of investment bankers
salaries, it is no wonder that many were tempted to sell as many
securities as possible to boost their annual earnings. This would
encourage the sale of relatively riskier securities with the payoff of
having a larger bonus. Indeed, the compensation structure definitely
encouraged executives and employees to take on excessive risk.
5. How much of the industry-wide crisis stemmed from the investment
banks financials and the current economic climate as opposed to
investor panic and speculation?
Although investor panic and bleak speculations had started the
avalanche, it had been the banks overleveraged structures that made
them so vulnerable to the down swing in investor confidence. It can be
argued that without the investor panic, the crisis may not have
occurred, but it would be unwise to ignore that the overleveraging
sparked the initial concerns that spread into an industry-wide
reluctance to lend and maintain the high levels of leverage.
6. Both Bear and Lehman bailed out their proprietary hedge funds. Did
they have any other option? What would have happened had they not
done so?

Because Bear and Lehmans hedge funds had used investors funds to
finance trades, they would have to bail them out or else face litigation
from their investors. Either way, large sums of money would have to be
used to resolve the situation. Bailing out, however, could be seen as a
more respectable course of action as opposed to potentially being
sued, which would tarnish the banks reputations.
7. Could Morgan Stanley and Goldman Sachs have survived without
becoming bank holding companies? What were the benefits and
disadvantages of becoming bank holding companies? What does
designation as bank holding companies mean for the way Morgan and
Goldman operate going forward?
It is likely that both Morgan Stanley and Goldman Sachs may have had
to also consider bail outs if they had not become bank holding
companies. By becoming bank holding companies, investors remained
confident in lending to them since they would be backed by the Fed
and are deleveraging in the face of regulation by the FDIC. They would
then be able to continue to operate and even also be able to use
deposits now to finance their transactions. Further, they were also able
to now benefit from the $700 billion federal bailout, which was passed
in early October 2008. On the downside, deleveraging would inevitably
mean reduced profits, which is epitomized by the layoff of 3,200
employees.

Case 2: Freeport-McMoRan: Financing an Acquisition

1. Why do you think JPMorgan and Merrill Lynch were selected to
underwrite and book-run all $23.3 billion in financings (all debt,
common stock, and convertible), instead of sharing the underwriting
with additional firms?
JP Morgan and Merrill Lynch were exclusively selected to underwrite
and book-run all $23.3 billion in financings because they had wellestablished ties with FCX who trusted them with all M&A advisory and
underwriting responsibilities. From Exhibit 4, JP Morgan and BOA were
also described to be among the biggest players in the leveraged-loan
business and so FCX probably had a lot of confidence in them to
complete all the underwriting and the transaction successfully.
2. What was the role of the leveraged finance group at JPMorgan and
why was its involvement important to the acquisition?
The leveraged finance group at JP Morgan was involved in the analysis
behind creating the bridge financing commitment to FCX, which was

never drawn down because JP Morgan was successful in placing highyield notes with institutional investors. FCX needed to be able to show
committed financing to Phelps Dodge and so the bridge loan created
by JP Morgan was especially important to the acquisition.
3. Describe the forms of risk that an investment bank must consider in
relation to acquisition and underwriting transactions. Describe what it
means for a firm to set aside capital when it completes underwriting
transactions.
There are two forms of risk that an investment bank must consider
when underwriting transactions: capital risk and reputation risk.
Although reputation risk is not exactly tangible, it is important for
future business because if an investment bank is underwriting for a
company and causes serious problems, this would tarnish its
reputation and make it harder to solicit clients in the future to help with
their underwriting. Capital risk is the financial risk that a investment
bank incurs when it makes a financing commitment to a company
involved in the acquisition of another company. Because most
investment banks are not able to provide the entire amount necessary
for the transaction, it often mitigates its risk by syndicating up to 90%
of the loans to a wider group of banks and money managers. The
banks must, however, keep the debt that they cannot syndicate to
others. When a firm sets aside capital when it completes underwriting
transactions, it will invest a certain amount of cash, comparable with
the amount of capital risk it is taking on in, in low return and low risk
securities like US treasuries. This buffers against potential trading
losses and reduces the risk incurred by the bank.
4. Describe the role and importance of credit rating agencies in the
Freeport-McMoRan
Transaction. Which group within an investment bank has the primary
responsibility to work with companies regarding rating agency
considerations?
The credit rating agencies rate the risk of the securities issued by the
investment bank. Therefore, the credit rating determines the interest
rate at which the loans are issued and in turn determining the cost to
and the amount that the bank can borrow. The ratings advisory
professionals in the debt capital markets group have the primary
responsibility of working with companies regarding rating agency
considerations.
5. Describe the role of equity research at JPMorgan in the transaction.
How has the role of equity research changed since 2003?

The role of the equity research institutional sales force at JP Morgan in

the transaction is to hear the teach-in by the analysts that advised in
the transaction and to get a general overview of the equity and
convertible securities and their uses. The analysts are not able to give
investment opinion (which had been the change since 2003) on the
shares of FCX but are able to answer any other questions about the
offering. The equity research team would also have the opportunity to
hear from FCXs management team regarding the rationale for the
Phelps Dodge acquisition and the method of financing chosen. They
would then have enough information to discuss the offerings with their
institutional asset manager clients.
6. Who are the clients of the institutional sales team at JPMorgan?
What is meant by a limit order, and what is its impact on the sales
function? Describe the role of an Equity Capital Markets Syndicate
group.
The clients of institutional sales teams at investment banks like JP
Morgan are large asset managers such as pension funds, mutual funds,
hedge funds, and insurance companies. A limit order is the highest
price that an investor is willing to buy newly issued stock and this may
impact the sales function because the issuer may want to reduce the
offer price if the market price is above the limit order of large and
important investors. The Equity Capital Markets Syndicate group keeps
track of investor concern and overall sentiment about the transaction.
Salespeople would provide feedback to the syndicate group about what
their institutional investor clients thought about the stock and
convertibles. The syndicate group would then relay recurring issues to
the company management, and through this looping of feedback, the
syndicate team is able to properly price for the offering.
7. Assume the following fees were paid: M&A fee of 0.5 percent of the
transaction value; debt fees of 0.75 percent on all debt and loan
financing; equity fees of 3 percent on all equity and convertible
financing. Calculate the estimated total fees for both JPMorgan and
Merrill Lynch. Indicate whether you think these fees were justified and
support your views.
M&A fees = 0.005(25.9B) = 129.5M
Debt fees = 0.0075(23.3B - 2.9B - 2.9B) = 131.25M
Equity fees = 0.03(2.9 + 2.9) = 174M
Total fees for both JP Morgan and Merrill Lynch = 129.5M + 131.25M +
174M = 434.75M
Considering the huge amount of financial risk that JP Morgan and
Merrill Lynch had to incur during the financing, and taking into account

the quality of the advisory that these two well-established investment

banks provide, the fees that they collect seem to be quite fair. They
provided a service successfully and they did it well, why would they not
deserve the fee paid to them?

Case 3:

The Best Deal Gillette Could Get? Proctor &

Gambles Acquisition of Gillette
1.What were the possible synergies and forces propelling the merger between P&G and
Gilletteas well as the history of other takeover attempts for Gillette?

P&G and Gillette were naturally stronger in distinct gender segments. P&G was more
skilled in marketing to women with products like Olay and Tide, and Gillette better at
targeting male customers with their line of razors. As a combined firm, they would be
able to more effectively reach both male and female consumer segments. The two firms
could also benefit from regional synergies because of their success in different regions,
Gillette being extremely successful in India and Brazil, and P&G with expertise in the
Chinese market. As a single firm, this would also allow them to better negotiate with
large retailers like Wal-Mart and Target. There are also potential cost synergies that may
emerge from the removal of redundant management positions. James Kilts and other
people in management probably also wanted to push the deal to go through because they
would stay on according to the terms with P&G, whereas if the deal did not close, another
firm may attempt a hostile takeover and potentially remove Kilts and other management
at Gillette. The investment banks eagerness to close the deal and reap the advisory fees
was probably also a force that propelled the closing of the deal.
2. In light of Gillettes large increase in value during James Kiltss tenure, was his
compensation reasonable? Was his pay package in the best interest of shareholders?
James Kilts compensation package had originally been signed when the company had
not seen much growth. As stated, investors had not balked at the structure of Kilts
package in 2001 since it had been based on performance and this was at a time where
Gillettes stock price had been stagnating. Through to 2005, however, he had turned the
company around and created about $20 billion in shareholder value. Considering how
much value he had added to the company, there seems to be no reason to say that his new
compensation package is unreasonable. Moreover, there would be less incentive for him
to work so hard at maintaining the growth of the company, before and after, the deal had
his pay not been based on performance (i.e. if he was not compensated with stock and
options) and so his compensation package is definitely also in the best interest of
shareholders. His compensation as CEO of a conglomerate does not seem to be an outlier
in the industry either so there is even less reason to balk at his pay.
3. Evaluate the P&G offer. Make a list of the positive and negative aspects of receiving
shares or cash from both the perspective of P&G and Gillette shareholders.
P&G and Gillette eventually agreed on a modified all-stock deal where 0.975 stock of
P&G would be given per stock of Gillette, followed by a $18-22B share repurchase plan
set up by the investment banks UBS, Goldman Sachs and Merrill Lynch. This played out
to be a roughly 60% stock and 40% cash transaction. Using cash for the deal was good
for Gillette shareholders because they can realize the investment gain of the deal
immediately, which otherwise is unclear if stock was issued instead. Cash would also
prevent share dilution that would otherwise occur from issuing stock. However, Gillette
shareholders would have to pay immediate capital gain taxes and Gillette would also
have to pay corporate income take if the sale of their assets are higher than their book
value. P&G may also have to take on more debt to accumulate enough cash for the deal,
which would increase their leverage and increase financial stress. As a result, their
corporate bonds may also be downgraded which would increase the cost of debt. Issuing

shares would be good for Gillette shareholders since they do not need to pay immediate
capital gain taxes but some investors may not want shares of P&G and may be
uncomfortable with holding their shares and the risk associated with it. For P&G, using
shares would mean not needing to take on more debt that using cash would otherwise
have needed, but it also means that share dilution would dampen the gains due to stock
price increases after the merger.
4. Compare the valuation analyses in Case Exhibits 6 and 7. Why are they different?
Support and defend the validity of using each valuation method.
They are different because Gillette is quite diverse in its different businesses, including
mens razors, Duracell batteries and toothbrushes, so the sum-of-the-parts valuation
would produce a higher valuation than the standalone DCF valuation because of
conglomerate discounts. Using the standalone DCF analysis would be a good valuation
approach since Gillette was planning to remain in its entirety after the merger. If,
however, it was planning to divest some of its businesses after the merger, it is likely that
the sum-of-the-parts valuation would be more valid.
5. Discuss the conflicts of interest for the investment bank in an M&A transaction where
the same firm that writes the fairness opinion in support of the deal stands to be paid a
large fee if the transaction is completed.
It is obvious that no firm would ever want to tell a companys shareholders that the deal
is not fair, especially if it is advising that exact company in the deal and would be paid a
large fee once the transaction is completed. Therefore, if the bank actually did not think it
would be a fair deal, this would pose an obvious conflict of interest since they would love
to push the deal to completion to get that fee ($30 MM for each of the banks involved)
and so say that it is fair anyways. We can then conclude that letting the same bank that is
advising the deal, in this case Goldman Sachs, write the fairness opinion to the
shareholder may not be in the shareholders best interests.
6. Should investment bankers and companies spend their time appeasing politicians
worried about the effects of possible mergers? Are politicians representing the interests of
the American public when they question the merits of a deal? Also evaluate the role
played by federal and international regulators. Is there any better solution to the
complicated regulatory process?
From a business standpoint, it is worth the time of bankers to appease the politicians
worried about the merger only if the politicians are able to hinder the progress of the deal
or make it more costly. The politicians are worried about the long-term social and
economic impact that the reduced employment by the deal can cause the community, and
so it would be safe to presume that politicians do represent the best interests of the
American public. The federal and international regulators want to make sure that the deal
would be fair for all other stakeholders including consumers and employees, federal
regulators taking care of US nationals while international regulators worry about
consumers would-wide. They want to make sure that the combined company would not
violate applicable state and federal laws, and antitrust laws. This is an extremely

important role and requires a very complex process, including a series of forms needed to
be filed with the SEC and then further scrutiny from the FTC and other consumer
watchdogs. If there were a better solution, it would definitely already be in effect. Hence
it is unlikely that there is a better solution.
7. Evaluate the role played by Warren Buffett in the merger. Should the support of one
investor be a deciding factor in the completion of an M&A transaction?
Warren Buffetts approval of the deal was crucial to winning over the support and
calming the concerns of the other investors since his opinion is so well respected in the
investing community. Without the support of more than 50% of shareholders, the deal
would not be approved and so Buffetts approval, including his enormous 11% in the
company, was key in getting the approval of all the other shareholders. As to the question
of whether the support of one investor should be a deciding factor in the closing of a deal,
its probably not a good idea to have one individual to possess so much influence over the
decision making of the company since he may have personal reasons to reject or accept
offers that may not necessarily be in the interest of minority shareholders.

Case 4: Kmart, Sears and ESL: How a Hedge Fund Became

one of the Worlds Largest Retailers
1. Describe recent trends in the hedge fund and private equity industry and the growing
overlap between the two. (p.477)

In recent years, we have seen much more activity in the market for M&A from private
equity firms due to the fact that LBO funds had huge reserves of cash in the late 1990s,
while traditional corporate strategic acquirers seemed to shun M&A as a potential avenue
for growth and efficiency. The historically low interest rates that caused potential
strategic buyers to retreat from M&A activity also benefitted LBO funds since they relied
on borrowing to fund acquisitions that cost many times their available cash. Hedge funds
had also originally been most active in the distressed arena, buying defaulted or near
default bonds and then reselling them weeks or months later for a profit. We can therefore
draw the differentiation between hedge funds, who trade liquid assets, and PE firms, who
invest in more illiquid assets and have a longer investment horizon. However, over the
years, the growing overlap emerges as hedge funds began hanging onto their distressed
investments through the entire restructuring process and often possessing controlling
stakes in the new entity after bankruptcy.
2. Analyze different issues surrounding a purchase by a financial or strategic buyer and
their respective strengths and weaknesses. (p.472)
Financial buyers, unlike strategic buyers, are only concerned with the return on an
investment balanced with its risk. Thus financial buyers would theoretically pay for less
than strategic buyers because they also look for synergies when considering an
acquisition. Strategic buyers during this time before the Kmart acquisition, however,
often found themselves without the ability to acquire available assets at the most
attractive prices because they did not have much of the cash at hand, unlike financial
buyers like Warren Buffett who had built up cash for deployment in a counter-cyclical
manner in several different industries. Also important for financial buyers were the
flexibility and expertise to acquire large, illiquid, and complex assets that often had no
synergies with other entities in the portfolio, which had allowed Buffett to purchase
assets unchallenged from other pension funds, endowments, and mutual funds.
3. Provide a brief historical background of the problems facing Kmart and the
characteristics of the distressed debt market, including factors that influence an
investment in a distressed company. (p.470)
Kmart began suffering from stagnant same-store sales by mid-2000 after mismanaged
Internet efforts and the inability to keep its supply chain as low-cast as rivals. Kmart also
had low sales per square feet compared with its competitors, and complaints from
customers that stores were disorganized and run-down. Hedge funds that specialized in
trading distressed debt began evaluating Kmarts assets, but none had the capital nor the
confidence to purchase a controlling stake in the default bonds. Because assets of
bankrupt companies belonged solely to creditors, they would receive either cash from
complete asset liquidation or equity in the new company. However, this process requires
both court approval and agreement among bondholders, and so the complexities of such
procedures makes difficult for mainstream investment managers to include defaulted debt
in their portfolios since they do not understand the risks and rewards. This gave rise to a

small industry of bankruptcy specialists, who considered the bankruptcy of a company to

be an opportunistic time for competitors to cheaply acquire said business with the chance
of large synergies. However, industries often face the same business cycle, and this is
why financial buyer interest in Kmart had been more relevant.
4. Compare Kmarts financials before and after bankruptcy (see Case Exhibit 6).
The most notable changes in Kmarts financials after the bankruptcy are the large
increase in cash and short-term investments and reduction of total long-term debt. The
reduction of total PP&E implies that Kmart had probably sold a lot of unused or
inefficient locations to boost its cash and help pay of its long-term debts. This effectively
brought the company out of distress and is proof of the success of Kmarts bankruptcy
and restructuring.
5. Discuss the causal events facilitating the acquisition of Sears. Could Sears have
succeeded as a standalone retailer?
Kmarts initial sale of 50 locations to Sears had turned the heads of each chains
management as the transaction provided tens of millions of dollars in value from the
conversion of dozens of stores, due mainly to the fact that Searss sales were $80 higher
per square foot than Kmarts. It had really been the sudden acquisition of 4.3% of Sears
common stock by the real estate investor Vornado Realty Trust that provided the catalyst
for the sale of Kmart to Sears. Lampert knew that both Kmarts and Searss real estate
had been undervalued in the market and in the face of an investment firm with a lot more
expertise in real estate, he found himself to be a potential strategic buyer as opposed to
just acquiring a larger stake in Sears. Searss sales had been eroded by stand-alone big
box retailers during the 1990s, and so they desperately needed the cheap real estate in
rural and suburban areas that Kmart offered. Thus it would have been extremely difficult
for Sears to remain competitive if it had not succeeded in acquiring Kmart and its
strategically advantageous locations.
6. Evaluate Lamperts strategy and the benefits for Searss shareholders. (p.485)
Lampert had identified the importance of scale and low-cost structures that would allow
Sears to compete effectively against competitors. The low-cost structure would have to
also be consistent with the reputation and quality of service that Sears has always
provided and that which Kmart strives to achieve. The conversion of Kmart stores have
also solved Sears problems of being unable to open stores nearer the customer in more
rural and suburban areas, helping to launch the Sears Grand stores. Around $1 billion a
year that Sears spends on marketing and capital expenditure can no be directed at very
high return on investment opportunities, both in the conversion process as well as helping
to upgrade existing Kmart stores. The simple fact that Sears stores are $80 more

productive than Kmart stores per square foot also means a potential $8 billion
opportunity, which in itself marks a very large benefit to Sears shareholders.

Too Big to Fail: (feel free to help with this one...)

Notes from class:
Was the decision to let Lehman fail the right decision?
Stowell: Lehman should not have been allowed to fail while Bear Stearns was bailed out.
As a
result, there was catastrophic damage to the macroeconomic landscape which was much
larger
than it would have been had the hemorrhage had been stopped.
What role did Warren Buffett play in the bankruptcy?
Buffett bought large amounts of GS convertible preferred stock
Buffett was prepared to buy Lehman stock but wanted 9% dividends, which was very
high. Fuld saw
that as Buffett ripping him off, and refused to take the deal. However, that was a stupid
move, it was
Fulds ego getting in the way of doing what is best for the company.
Stowell: Fuld should have accepted the deal in a heartbeat. It was the best deal he was
offered.
What role did Jim Cramer play?
Jim Cramer is a TV personality and former hedge fund manager.
He developed a relationship with Dick Fuld, but then Fuld had a huge dispute with
Cramer regarding hedge funds managers that were shorting Lehman stock. Fuld was
convinced that the shorts were destroying Lehman stock price, though Cramer was
skeptical. However, Fuld was not listening to Cramer either. Hubris was his ultimate
downfall.
Who took over Fannie Mae and Freddie Mac?
On September 6, 2008 the Federal Housing Finance Agency took over Fannie Mae
(Federal
National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage
Corporation). The
decision was supported by US Treasury Secretary Hank Paulson. It was the biggest
government bailout ever, with $200 billion injected into these GSEs.
-Consider the role of government

-Psychology is a HUGE part of the industry, and CEOs must consider psychological
impacts of their actions