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Finance 2

Summary

Chapter 14: Capital structure in a perfect market


Capital structure of a firm constitutes of relative proportions of debt, equity, and other
securities.
Unlevered equity: equity in a firm with no debt.
Levered equity: equity in a firm that also has debt outstanding.
Debt is risk free when projects cash flow in weak and strong economy exceeds the amount of
debt.
Modigliani-Miller (MM) proposition: with perfect capital markets, the total value of a firm
shouldnt depend on its capital structure.
Leverage increases the risk of the equity of a firm, so the discount rate increases. The discount
rate for unlevered equity is lower than for levered equity.
Perfect capital market:
o Investors and firms can trade the same set of securities at competitive market prices
equal to the present value of their future cash flows;
o There are no taxes, transaction costs, or issuance costs associated with security
trading;
o A firms financing decisions doesnt change the cash flows generated by its
investments, nor do they reveal new information about them.
MM proposition I: in a perfect capital market, the total value of a firm is equal to the market
value of the total cash flows generated by its assets and isnt affected by its choice of capital
structure.
Homemade leverage: investors use leverage in their own portfolios to adjust the leverage
choice made by the firm. Perfect substitute for use of leverage by the firm as long as investors
can borrow or lend at the same interest rate as the firm. Works only in perfect capital market.
Turn unlevered equity into levered equity.
To turn levered equity into unlevered equity, the investor can replicate the payoffs of
unlevered equity by buying both the debt and the equity of the firm.
Market value balance sheet: similar to accounting balance sheet, with two distinctions:
o All assets and liabilities of the firm are included (also intangible assets like
reputation);
o All values are current market values rather than historical costs.
Market value of equity = market value of assets market value of debt and other liabilities.
Leveraged recapitalization: when a firm repurchases a significant percentage of its
outstanding shares by borrowing the money to pay for the repurchase.
MM proposition 1: E + D = U = A
E: market value of equity in levered firm. D: market value of debt in levered firm.
U: market value of equity if firm is unlevered. A: market value of firms assets.
Total market of firms securities = market value of its assets, whether firm is levered or
unlevered.
MM proposition II: the cost of capital of levered equity increases with the firms market
value debt-equity ratio.
Re = return of levered equity. Rd = return of debt. Ru = return of unlevered equity.

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Summary

E
D
+
Rd=Ru
E+ D
E+ D
=Ru+

D
( RuRd )
E

Risk without leverage | additional risk due to leverage


This equation shows the effect of leverage on the return of the levered equity. The extra effect
(additional risk) pushes the return of levered equity higher when firm performs well (Ru >
Rd), but makes them drop lower when firm does poorly (Ru < Rd). The amount of additional
risk depends on amount of leverage, measured by firms market value debt-equity ratio (D/E).
Cost of capital of levered equity:

=ru+

D
( rurd )
E

Small r = expected return.


Pretax WACC: weighted average of firms equity and debt cost of capital.
Unlevered cost of capital (pretax WACC):
ru = (fraction of firm value financed by equity)(equity cost of capital) + (fraction of firm
value financed by debt)(debt cost of capital)
E
D
ru=
+
rd
E+ D
E+ D
rwacc = rU = rA
That is, with perfect capital markets, a firms WACC is independent of its capital structure and
is equal to its equity cost of capital if it is unlevered, which matches the cost of capital of its
assets.
After-tax WACC (computed using firms after-tax cost of debt) here isnt necessary: perfect
capital markets no taxes or interest WACC = unlevered cost of capital.
With perfect capital markets, a firms WACC is independent of its capital structure and equal
to its equity cost of capital if it is unlevered, which matches the cost of capital of its assets.
With perfect capital markets, the firms WACC, and therefore the NPV of expansion is
unaffected by how the company chooses to finance the new investment.
More complex capital structure: ru and rwacc are calculated by computing the weighted
average cost of capital of all of the firms securities.
E
D
e+
d=u
E+ D
E+ D
e=u+

D
( ud )
E

Measure leverage in terms of the firms net debt: debt = holding of excess cash or short-term
investments.
The assets on a firms balance sheet include any holdings of cash or risk-free securities.

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Summary

Because these holdings are risk-free, they reduce the riskand therefore the required risk
premiumof the firms assets. For this reason, holding excess cash has the opposite effect
of leverage on risk and return. From this standpoint, we can view cash as negative debt.
Leverage can increase a firms expected earnings per share, but doesnt increase the firms
stock price because the risk of earnings has changed.
EPS increases on average, but this increase is necessary to compensate shareholders for the
additional risk theyre taking. So the share price doesnt increase as a result of the transaction.
Fallacy: issuing equity will dilute existing shareholders ownership, so debt financing should
be used instead. This is not true.
Dilution of ownership: if the firm issues new shares, the cash flows generated by the firm
must be divided among a larger number of shares, thereby reducing the value of each
individual share.
But: the cash raised by issuing new shares increases firms assets.
As long as the firm sells the new shares of equity at a fair price, there will be no gain or loss
to shareholders associated with the equity issue itself. The money taken in by the firm as a
result of the share issue exactly offsets the dilution of the shares. Any gain or loss associated
with the transaction will result from the NPV of the investments the firm makes with the
funds raised.
Conservation of value principle for financial markets: With perfect capital markets,
financial transactions neither add nor destroy value, but instead represent a repackaging of
risk (and therefore return).

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Summary

Chapter 15: Debt and taxes


Interest tax shield: the gain to investors from tax deductibility of interest payments. Its the
additional amount that a firm would have paid in taxes if it didnt have leverage.
Interest tax shield = corporate tax rate x interest payments.
Cash flows to investors with leverage = cash flows to investors without leverage + interest tax
shield.
VL: value of firm with leverage and VU: value of firm without leverage.
Change to MM proposition I in presence of taxes:
The total value of the levered firm exceeds the value of the firm without leverage due to the
present value of the tax savings from debt.
VL = VU + PV(interest tax shield).
Assumption: firm issues debt and plans to keep the dollar amount of debt constant forever.
Firm never pays off principal but refinances it whenever it comes due debt is effectively
permanent.
c = firms marginal tax rate. r = risk free interest rate.
f

PV(interest tax shield) =

c D

Market value of debt = D = PV(future interest payments)


With tax-deductible interest, the effective after-tax borrowing rate is r(1

WACC, after tax:


E
D
r WACC =
r +
r (1 c )
E+D E E+D D
r WACC =

E
D
D
r E+
r D
r
E+D
E+D
E+ D D c
Pretax WACC | Reduction due to interest tax shield

The higher the firms leverage, the more the firm exploits the tax advantage of debt, and the
lower its WACC.
When securities are fairly priced, the original shareholders of a firm capture the full benefit of
the interest tax shield from an increase in leverage.
Market value balance sheet: total market value of a firms securities must equal total market
value of firms assets. We must include the interest tax shield as one of the firms assets.
Even though leverage reduces the total value of equity, shareholders capture the benefits of
the interest tax shield upfront (share price rises at announcement of recap).
By reducing a firms corporate tax liability, debt allows the firm to pay more of its cash flows
to investors. But after receiving the cash flows, investors are taxed again. Individuals: income
tax, equity investors: also taxes on dividends and capital gains.

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Just like corporate taxes, personal taxes reduce the cash flows to investors and diminish firm
value the actual interest tax shield depends on the reduction in the total taxes that are paid.
Every $1 received after taxes by debt holders from interest payments costs equity holders $(1
*) on an after-tax basis, where
1
1
1
( i)
( c )(1 e )

( i)=1
( 1 i ) ( 1 c ) (1 e )

No personal taxes on debt and equity


c

. But when equity income is taxes less heavily:

, the formula then reduces to =


i

>

, then > c

VL = VU + x D
Personal taxes:
o Reduce benefit of leverage;
o Cause WACC to decline more slowly with leverage than otherwise.
Preference for debt as a source of external financing for most firms.
Most investment and growth is supported by internally generated funds, like retained
earnings.
The use of leverage varies greatly by industry. Many firms retain large cash balances to
reduce their effective leverage (net debt is negative when cash holdings > outstanding debt).
But: debt provides a tax advantage that lowers a firms WACC and increases firm value, so
why dont more firms have half debt in their capital structure?
No tax benefit when: interest payments > EBIT tax disadvantage at investor level:
investors pay higher personal taxes.

Tax disadvantage for excess interest payments ( c = 0)


1
1
( i)<0
( )
( i)= e i
(1 e )
ex =1

ex is negative because equity is taxed less heavily for investors ( e > i) .


optimal level of leverage from a tax saving perspective is the level that interest = EBIT.
But: cant predict future EBIT precisely. Uncertainty regarding EBIT: higher interest expense
greater risk of interest expense > EBIT. As a firms interest expense approaches its

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expected taxable earnings, the marginal tax advantage declines, limiting the amount of debt
the firm should use.
The optimal proportion of debt in the firms capital structure [D/(E+D)] will be lower, the
higher the firms growth rate.
Taxable earnings will be reduced, to the extent that a firm has other tax shields.
Increasing the level of debt increases the probability of bankruptcy. Debt payments must be
maid to avoid bankruptcy.

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Summary

Chapter 16: Financial distress, managerial incentives and information


Financial distress: when a firm has trouble meeting its debt obligations.
Default: not paying the obligated interest or principal payments on debt. Debt holders can
collect payment by seizing firms assets.
If a new product fails, there will be economic distress, which is a significant decline in the
value of the firms assets. It doesnt matter if the firm is levered or not. Bankruptcy results
from a firm having leverage, but bankruptcy alone doesnt lead to a greater reduction in the
total value to investors.
Direct costs of bankruptcy: outside experts (consultants etc) with experience selling distressed
assets are hired costly.
Workout: when a financially distressed firm is successful at reorganizing outside of
bankruptcy.
Prepackaged bankruptcy (prepack): firm first develops a reorganization plan with the
agreement of its main creditors and then implement the plan. Firm emerges quickly from
bankruptcy, with minimal costs.
Indirect costs of bankruptcy:
o Loss of customers;
o Loss of suppliers;
o Loss of employees;
o Loss of receivables;
o Fire sales of assets (sold at price below real price);
o Inefficient liquidation;
o Costs to creditors.
Debtor-in-possession (DIP) financing: new debt issued by a bankrupt firm. Its senior to all
existing creditors and thus allows a firm that has filed for bankruptcy renewed access to
financing to keep operating.
Fear that firm will not honor long-term commitments in bankruptcy highly levered firms
may need to pay higher wages to employees, charge less for products and pay more to
suppliers than similar firms with less leverages.
Firm is in bankruptcy equity holders lose interest (wont get anything), debt holders will
not be able to get the full value of the assets pay less for the debt initially: how much less:
present value of bankruptcy costs. But if they pay less for the debt, theres less money
available for the firm, this difference is money from the equity holders.
Trade-off theory: weighs the benefits of debt that result from shielding cash flows from taxes
against the costs of financial distress associated with leverage.
VL = VU + PV(interest tax shield) PV(financial distress costs)
Three factors determine the present value of financial distress costs:
1. Probability of financial distress;
a. Increases with amount of firms liabilities relative to its assets;
b. Increases with volatility of a firms cash flows and asset values.
2. Magnitude of costs if the firm is in distress;

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3. Appropriate discount rate for distress costs, depends on firms market risk. Distress
costs are high when firm does poorly beta of distress costs will have opposite sign
to that of the firm. The higher the firms beta, the more likely it will be in distress, the
more negative the beta of its distress costs will be. Negative beta leads to lower cost of
capital (below risk-free rate), other things equal the PV of distress costs will be higher
for high beta firms.
Trade-off theory: firms should increase their leverage until it reaches the level D* for which
VL is maximized. The tax savings that result from increasing leverage are just offset by the
increased probability of incurring the costs of financial distress.
Higher costs of financial distress firm chooses lower leverage.
Capital structure can alter managers incentives and change their investment decisions.
Agency costs: the costs that arise when there are conflicts of interest between stakeholders.
When a firm faces financial distress, shareholders can gain from decisions that increase the
risk of the firm sufficiently, even if they have a negative NPV.
Asset substitution problem: leverage gives shareholders an incentive to replace low-risk
assets with riskier ones.
Can lead to over-investment: shareholders may gain if the firm undertakes negative-NPV, but
sufficiently risky projects.
Both ways: total value of the firm will be reduced. Anticipating this, security holders will pay
less for the firm initially.
When a firm faces financial distress, it may choose not to finance new, positive-NPV projects.
Debt overhang / under-investment problem: shareholders prefer not to invest in a positiveNPV project. Is costly for debt holders and overall value of the firm.
Management entrenchment: facing little threat of being fired and replaced, managers are
free to run the firm in their own best interests may take decisions that benefit themselves at
investors expense.
Leverage can provide incentives for managers to run the firm more efficiently and effectively:
o Leverage allows original owners of the firm to maintain their equity stake;
o Holding cash tight (FCF hypothesis), leverage commits firm to making future interest
payments;
o Managers are more likely to be fired when a firm faces financial distress;
o Creditors will closely monitor the action of managers;
o Manager can become a fiercer competitor in protecting markets, cant risk possibility
of bankruptcy.
Why managers over-invest:
o Managers prefer to run large firms rather than small ones empire building, engage
in negative-NPV investments that increase the size rather than profitability. Large
firms higher salaries, more prestige, greater publicity;
o Theyre overconfident, can become committed to investments the firm already made
and continue to invest in them, while they should have been canceled.

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Free cash flow hypothesis: wasteful spending is more likely to occur when firms have high
levels of cash flow in excess of what is needed to make all positive-NPV investments and
payments to debt holders.
VL = VU + PV(interest tax shield) PV(financial distress costs) PV(agency costs of debt) +
PV(agency benefits of debt).
Management entrenchment theory: managers choose a capital structure primarily to avoid
the discipline of debt and maintain their own entrenchment seek to minimize leverage to
prevent job loss that would accompany financial distress. Firms will have leverage that is less
than optimal level D*, and increase it towards D* only in response to a takeover threat or the
threat of shareholder activism.

Credibility principle: claims in ones self-interest are credible only if they are supported by
actions that would be too costly to take if the claims were untrue.
Signaling theory of debt: use of leverage as a way to signal good information to investors.
Adverse selection lemon principle: when a seller has private information about the value of
a good, buyers will discount the price theyre willing to pay due to adverse selection.
Implications of adverse selection for equity issuance:
Lemons principle implies that:
o Stock price declines on announcement of an equity issue;
o Stock price tends to rise prior to the announcement of an equity issue;
o Firms tend to issue equity when information asymmetries are minimized, such as
immediately after earnings announcements.
Implications for capital structure:
o Managers who perceive the firms equity is underpriced will have a preference to fund
investment using retained earnings, or debt, rather than equity.
Pecking order hypothesis: idea that managers will prefer to use retained earnings first, and
will issue new equity only as a last resort.

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Summary

Chapter 17: Payout policy


Payout policy: the way a firm chooses what to do with free cash flow.

Here we focus on pay out of cash to shareholders.


Dividends
Declaration date: date on which board authorizes dividend firm is obligated to make
payment.
Record date: date that firm will pay dividend to all shareholders of record.
Ex-dividend date: date two business days prior to record date, anyone who purchases the
stock on or after the ex-dividend date wont receive the dividend.
Payable date/distribution date: month after record date, firm mails dividend checks to
registered shareholders.
Stock split / stock dividend / 2-for-1 stock split: a firm splits its stock so that each owner of
one share receives a second share. The company issues additional shares rather than cash to its
shareholders.
Share repurchases
Firm uses cash to buy shares of own outstanding stock. These are held in corporate treasury
and can be resold if company needs to raise money in the future.
Three possible transaction types for a share repurchase:
o Open market repurchase: most common. Firm announces intention to buy own shares
in open market and proceeds to do so over time.
May take a year or more;
Not obligated to repurchase full amount that is stated;
Not buy shares in a way that might appear to manipulate share price.
o Tender offer: offers to buy shares at pre-specified price during short time period (20
days).
Price is usually at substantial premium to current market price;
Offer depends on shareholders tendering a sufficient number of shares. If they
dont tender enough shares, firm may cancel offer and no buyback occurs.
Related method: Dutch auction share repurchase: firm lists different prices at
which it is prepared to buy shares, and shareholders indicate how many shares
they are willing to sell at each price. Firm pays lowest price at which it can buy
back its desired number of shares.
o Targeted repurchase: firm purchases shares directly from major shareholder.
Purchase price is negotiated directly with seller;
May occur if major shareholder desires to sell a large number of shares but
market for shares isnt sufficiently liquid to sustain such a large sale without
severely affecting the price. Shareholder may be willing to sell shares back to
firm at a discount to current market price;

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If major shareholder is threatening to take over firm and remove its


management, firm may decide to eliminate the threat by buying out
shareholder, price > market price = greenmail.

In perfect capital markets setting of Modigliani and Miller: method of payment (dividend /
share repurchase) doesnt matter.
Example: Genron Corporation:
o $20 million in excess cash, no debt;
o 10 million shares outstanding;
o Expects to generate additional free cash flows of $48 million per year;
o Unlevered cost of capital is 12%;
o Enterprise value = PV(future FCF) = 48/12% = $400 million;
o Including cash: total market value is $420 million;
How to pay out $20 million in excess cash to shareholders?
1. Pay dividend with excess cash;
2. Share repurchase (no dividend);
3. High dividend (equity issue).
1. Pay dividend with excess cash
Use all excess cash to pay a dividend. 10 million shares outstanding $2 dividend
immediately. Firm expects to generate future FCF of $48 million future dividend of $4.80
per share.
Fair price for share is PV of expected dividends given firms equity cost of capital.
Price(cum) = current dividend + PV(future dividends) = 2 + (4.80/0.12) = $42
Stock trades cum-dividend (with dividend) because anyone who buys stock will get
dividend.
Price(ex) = PV(future dividends) = (4.80/0.12) = $40
Stock trades at ex-dividend.
Holders of the stock have no loss, because they already have the $2 in cash.
in a perfect capital market, when a dividend is paid, the share price drops by the amount of
the dividend when the stock begins to trade ex-dividend.
2. Share repurchase (no dividend)
Genron doesnt pay dividend, but uses $20 million to repurchase its shares on the open
market. How will this affect the share price?
Share price = $42 repurchase $20million/$42 = 0.476 million shares, leaving 10 0.476 =
9.524 million shares outstanding.
The market value of Genrons assets falls when company pays out cash, but number of shares
outstanding also falls, they offset each other so share price remains the same.
By not paying a dividend today and repurchasing shares instead, Genron is able to raise its
dividends per share in the future. This compensates shareholders for the dividend given up
today.
in perfect capital markets, an open market share repurchase has no effect on the stock
price, and the stock price is the same as the cum-dividend price if a dividend were paid
instead.
What would an investor prefer? Issue a dividend or repurchase stock? Only difference is
distribution between cash and stock holdings. Prefer one approach or other based on whether
needing the cash or not.

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Summary

In the case of a share repurchase, by selling shares an investor can create a homemade
dividend, and gets the money anyway.
in perfect capital markets, by selling shares or reinvesting dividends, the investor can
create any combination of cash and stock desired investor is indifferent between various
payout methods.
3. High dividend (equity issue)
Board wants to pay > $2 per share.
Next year: $48 million in dividends. If they want to start with that today, it needs an additional
$28 million now.
Raise cash by:
o Scaling back investments (reducing investments with positive NPV lower firm
value);
o Borrow money;
o Sell new shares (equity issue).
Consider the equity issue. Share price is $42. Raise $28 million by selling 28/42= 0.67 million
shares. Increases number of outstanding shares to 10.67 million dividend per share:
48/10.67 = 4.50 per share.
Price(cum) = 4.50 + 4.50/0.12 = 4.50 + 37.50 = 42.
initial share value is unchanged by this policy, and increasing the dividend has no benefit
to shareholders.
If a company pas a higher current dividend per share, it will pay lower future dividends per
share.
MM dividend irrelevance: in perfect capital markets, holding fixed the investment policy of
a firm, the firms choice of dividend policy is irrelevant and doesnt affect the initial share
price.
It is the imperfections in capital markets that should determine the firms dividend and payout
policy.
Now we look at the market imperfection: taxes.
Shareholders pay taxes on the dividends they receive and on capital gains when they sell their
shares.
Do taxes affect investors preferences for dividends versus share repurchases? Mostly:
dividends are charged at higher rate than capital gains shareholders prefer share
repurchases to dividends.
The optimal dividend policy when dividend tax rate > capital gain tax rate = pay no dividends
at all.
Dividend puzzle: fact that firms continue to issue dividends despite their tax disadvantage.
Many investors have a tax preference for share repurchases instead of dividends, the strength
of that preference depends on
difference between dividend tax rate
and capital gains tax rate they face.

Effective dividend tax rate: d


It measures the additional tax paid by the investor per dollar of after-tax capital gains income
that is instead received as a dividend.

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Summary

= investors dividend tax rate.

= investors capital gains tax rate.

The effective dividend tax rate for an investor depends on the tax rates he faces on dividend
and capital gains, they differ across investors for a variety of reasons:
o Level of income;
o Investment horizon;
o Tax jurisdiction;
o Type of investor or investment account.
Clientele effects: differences in tax preferences, in which dividend policy of a firm is
optimized for the tax preference of its investor clientele. Individuals in highest tax brackets
want stocks with low or no dividends, tax-free investors and corporation want stocks with
high dividends. A firms dividend policy is optimized for the tax preference of its investor
clientele.

Dividend-capture theory: absent transaction costs, investors can trade shares at the time of
the dividend so that non-taxed investors receive the dividend. Non-taxed investors need not
hold the high-dividend-paying stocks all the time, it is necessary only that they hold them
when the dividend is actually paid.
For some the transaction costs and risks of trading the stock offsets the benefits associated
with dividend capture.
clientele effects and dividend-capture strategies reduce the relative tax disadvantage of
dividends, but dont eliminate it.
Payout versus retention of cash
Once a firm has taken all positive-NPV investments, it is indifferent between saving excess
cash and paying it out.
MM payout irrelevance: in perfect capital markets, if a firm invests excess cash flows in
financial securities, the firms choice of payout versus retention is irrelevant and doesnt affect
the initial value of the firm.
The decision on whether to retain cash depends on market imperfections: taxes.
Corporate taxes make it costly for a firm to retain excess cash.
The decision to payout versus retain cash may also affect the taxes paid by shareholders.
Effective tax disadvantage of retaining cash:

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= investors capital gains tax rate.

= corporate tax rate.

= investors personal

tax rate.
After adjusting for investor taxes, there remains a substantial tax disadvantage for the firm to
retaining excess cash.
Other market imperfection: asymmetric information.
Firms adjust dividends relatively infrequently = dividend smoothing. And also, dividends are
more increased than cut. Theyre only raised when theres a long-term sustainable increase in
expected level of future earnings.
Dividend increases positive signal to investors.
Dividend decreases earnings are reducing, negative signal to investors.
= dividend signaling hypothesis: dividend changes reflect managers views about a firms
future earnings prospects.
Share repurchases may also signal managers information to the market, but:
o Managers are less committed to share repurchases than to dividend payments;
o Firms dont smooth their repurchases from year to year;
o Cost of a share repurchase depends on market price of the stock:
Stock = overvalued share repurchase is costly to shareholders who choose
to hold onto their shares;
Stock = undervalued positive NPV investment for shareholders.
Managers more likely buyback shares if they believe the stock to be undervalued.
Stock dividend: each shareholder who owns the stock before it goes ex-dividend receives
additional shares of stock of the firm itself (stock split) or of a subsidiary (spin-off).
Stock split
With a stock dividend, a firm doesnt pay out any cash to shareholders total market value
of firms assets and liabilities (its equity) doesnt change. Only thing that changes is number
of shares outstanding stock price will fall.
50% stock dividend = 3 for 2 stock split. 100% stock dividend = 2 for 1 stock split.
Motivation for stock split: keep share price in a range thought to be attractive to small
investors. This can increase the demand for and liquidity of the stock, which can boost the
stock price.
Firms also dont want their stock prices to fall too low:
o Raises transaction costs for investors;
o Exchanges require stocks to maintain a minimum price to remain listed on an
exchange.
If the price of the stock falls too low: company can do reverse split: reduce number of shares
outstanding. In a 1:10 reverse split, every 10 shares of stock are replaced with 1 share
share price tenfold.
Through a combination of splits and reverse splits, firms can keep their share prices in any
range they desire.
Market capitalization: total market value of equity; equals market price per share x number
of shares.

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Chapter 18: Capital budgeting and valuation with leverage


Interest payments are an deductible expense debt financing creates interest tax shield. Can
include this in capital budgeting decision in several ways:
o WACC method: discount unlevered free cash flows using weighted-average cost of
capital. We calculate the wacc using the effective after-tax interest rate as the cost of
debt;
o Adjusted present value (APV) method: value a projects FCF without leverage by
discounting them using unlevered cost of capital, then separately estimate and add
present value of interest tax shields from debt;
o Flow-to-equity (FTE) method: use value firms equity based on total payouts to
shareholders.
Simplifying assumptions for now:
o Project has average risk (market risk of project = average market risk of firms
investments cost of capital = firms wacc);
o Firms debt-equity ratio is constant;
o Corporate taxes are the only imperfection.
WACC method
E
D
r WACC =
r E+
r (1 c )
E+D
E+D D
D = net debt (debt cash)
Since WACC stays constant (debt-equity ratio stays constant), the initial levered value of the
project is:

Key steps of this method:


o Determine FCF of investment;
o Compute WACC using above equation;
o Compute value of investment using above equation.
To hold a constant debt-equity ratio, while undertaking a new project (which adds new assets
to the firm), it must add is debt-equity ratio x the initial market value of the investment to new
debt (reducing cash / borrowing and increasing debt).
Debt capacity of an investment (Dt): amount of debt at date t that is required to maintain the
firms target debt-to-value ratio, d.
VLt: projects levered continuation value on date t (levered value of FCF after date t)
Dt = d x VLt

Adjusted Present Value (APV) method


Determine levered value VL of an investment by first calculating its unlevered value VU and
then adding the value of the interest tax shield:

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Summary

APV formula: VL = VU + PV(interest tax shield)


Unlevered cost of capital of the project:
Interest paid in year t = rD x Dt-1 = interest paid x corporate tax rate.
The tax shield will fluctuate with, and therefore share the risk of, the project itself, so they
should be discounted at the projects unlevered cost of capital.
Key steps of this method:
o Determine investments value without leverage, by discounting its FCF at the
unlevered cost of capital rU;
o Determine the present value of the interest tax shield;
o Add unlevered value to present value of interest tax shield to determine value of
investment with leverage.
Flow-to-Equity (FTE) method
Calculate the FCF available to equity holders after taking into account all payments to and
from debt holders. These cash flows to equity holders are then discounted using the equity
cost of capital.
First calculate the FCFE: free cash flow to equity: free cash flow that remains after adjusting
for interest payments, debt issuance, and debt repayment.
Net borrowing at date t = Dt Dt-1
FCFE shows expected amount of additional cash firm will have available to pay dividends /
conduct share repurchases each year. These cash flows represent payments to equity holders
and should thus be discounted at the projects equity cost of capital.
Key steps of this method:
o Determine FCFE of investment;
o Determine equity cost of capital rE;
o Compute contribution to equity value, E, by discounting FCFE using rE.
FTE and APV approach have same disadvantage in this setting:
o We need to compute projects debt capacity to determine interest and net borrowing
before we can make the capital budgeting decision.
But: risk of a project mostly is different from risk of the firm.
look at comparable firms to estimate the unlevered cost of capital APV method can be
applied.
To apply WACC or FTE method: estimate of projects equity cost of capital (depending on
incremental debt the firm will take on a result of the project) is needed.
Equity cost of capital:

To obtain WACC:
d is the projects debt-to-value ratio (D/(E+D)).

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For capital budgeting: the projects financing is the incremental financing that results if the
firm takes on the project = change in firms total debt (net of cash) with project versus without
the project.
Some important concepts to remember when determining the projects incremental financing:
o Cash is negative debt;
o Fixed equity payout policy implies 100% debt financing;
o Optimal leverage depends on project and firm characteristics;
o Safe cash flows can be 100% debt financed.
Until now: debt-equity ratio should stay constant. Now we will relax this equity cost of
capital and WACC for a project will change over time as debt-equity ratio changes WACC
and FTE method are difficult to implement, APV method is preferred.
Two alternative leverage policies:
o Constant interest coverage;
o Predetermined debt levels.
Constant interest coverage
Constant interest coverage ratio: when firm keeps its interest payments to a target fraction
(k) of its FCF. Interest paid in year t = k x FCFt
tax shield is proportional to projects FCF, has the same risk as it and should be discounted
at the same rate (unlevered cost of capital rU)

Applying the APV method:

Predetermined debt levels


Firm adjusts debt according to a fixed schedule that is known in advance. Debt levels are
known immediately compute interest payments and corresponding interest tax shield.
At what rate should we discount this tax shield? Fixed debt schedule, thus amount of debt
wont fluctuate tax shield is less risky than project, so discounted at lower rate.
When debt levels are set according to a fixed schedule, we can discount the predetermined
interest tax shields using the debt cost of capital, rD.
PV(interest tax shield) = interest tax shield 1 / rD + interest tax shield 2 / rD + interest tax
shield 3 / rD etc.
Using APV method: VL = VU + PV(interest tax shield).

How to choose between the tree methods: WACC, APV and FTE?
Each method produces same valuation for investment matter of convenience. Mostly
WACC method is easiest when having a constant debt-equity ratio.
For alternative leverage policies, APV method is easiest.
FTE method only used in complicated settings.
Other imperfections associated with leverage:

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o Issuance and other financing costs: if the bank providing the loan charges fees after
tax deductions: NPV = VL (Investment) (After-Tax Issuance Costs)
o Security mispricing: if securities are mispriced, the NPV of the transaction (difference
actual money raised and true value of securities) should be included when evaluating
decision;
o Financial distress and agency costs: affect future FCF, so can be incorporated directly
into estimates of projects expected FCFs. When debt level (and thus probability of
financial distress) is high expected FCF will be reduced by expected costs of
financial distress and agency problems. Financial distress and agency costs also have
consequences for cost of capital: increase sensitivity of firms value to market risk,
further raising cost of capital for highly levered firms. How incorporate these costs in
valuation methods?
Adjust FCF estimates to account for costs and increased risk;
First value project ignoring these costs, and then add PV of incremental cash
flows associated with financial distress and agency problems.

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Chapter 20: Financial options


Financial option contract: gives owner right (not obligation) to purchase or sell an asset at a
fixed price at some future date. Two kinds of option contracts:
o Call option: right for owner to buy asset;
o Put option: right for owner to sell asset.
Option writer: is at other side of contract.
Stock option: option for holder to buy or sell a share of stock on or before a given date for a
given price.
Exercising option: when the agreement is enforced.
Strike price / exercise price: price at which holder buys / sells.
American options: allow holders to exercise option on any date up to and including final date
called expiration date.
European options: allow holders to exercise option only on expiration date.
Option buyer / holder: has right to exercise option, has long position in contract.
Option seller / writer: sells the option and has short position in contract. Obligation to fulfill
the contract.
When you sell an option you get paid for it. The market price of the option is called the
option premium. This upfront payment compensates the seller for the risk of loss in the event
that the option holder chooses to exercise the option.
Open interest: total number of outstanding contracts of an option.
Option is at-the-money when exercise price = current price.
Option is in-the-money when exercise price < current price.
Option is out-of-the-money when exercise price > current price.
Deep in-the-money / deep out-of-the-money: strike price and stock price are very far apart.
Options can be used to reduce risk: hedging, and allow investors to speculate, place a bet on
the direction in which they believe the market is likely to move.
Payoffs for option holder
On expiration date: when stock price (30) > strike price (20), you can make money by
exercising the call (paying 20) and immediately selling the stock in open market for 30. 10
difference is what the option is worth.
When stock price (10) < strike price (20), you wont exercise your option, so option is worth
nothing.
S = stock price at expiration, K = exercise price, C = value of call option.
Call value at expiration: C = max(S K, 0)
Put price at expiration: P = max(K S, 0)
Exercise option if S < K (receives K when stocks worth S, gain is K S)
Payoffs for option writer
A short investor can only pay money.
Short position in call option with exercise price 20. Stock price (25) > strike price (20), holder
will exercise option. You have to sell the stock for 20, but first purchase it for 25, you lose 5
per share. If stock price < strike price, holder wont exercise option, you lose nothing, no
obligation.
The further in-the-money an option is, the higher its initial price and the larger your potential
loss. An out-of-the-money option has a smaller initial cost and thus a smaller potential loss,
but the probability of a gain is also smaller because the point where profits become positive is
higher.

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Returns for holding an option to expiration.


o Call options: maximum loss is 100% (option may expire worthless). An out-of-the
money call option is more likely to have a -100% return, but if the stock goes up
sufficiently it will have a much higher return than an in-the-money call option. If a
stock has a positive beta, call options written on the stock will have even higher betas
and expected returns than the stock itself;
o Put options: higher return with low stock prices: if the stock has a positive beta, the
put has a negative beta and a lower expected return on the option. The deeper out-ofthe money the put option is, the more negative its beta, and the lower its expected
return.
Combinations of options by holding a portfolio, most common ones:
o Straddle: combining call option with put option, you will receive cash so long as the
options do not expire at-the-money. To construct this combination requires purchasing
both options, so profits after deducting these costs are negative for stock prices close
to the strike price, and positive elsewhere;
o Butterfly spread: long position in $20-call, long position in $40-call, short position in
2 $30-calls. Makes money when stock and strike prices are far apart;
o Portfolio insurance: used to insure a stock against a loss:
Purchase the stock and a put;
Purchase a bond and a call.
Put-Call parity: purchase stock and put or purchase bond and call, provide exactly same
payoff should have same price.
S + P = PV(K) + C
K = strike price, C = call price, P = put price, S = stock price.
Price of European call option for a non-dividend-paying stock: C = P + S PV(K)
= put-call parity.
What if the stock does pay a dividend? Put-call parity: C = P + S PV(K) PV(Div).
The factors that affect option prices:
o Strike price and stock price:
Call: value of call option is higher if strike price the holder must pay to buy the
stock is lower. For a given strike price, value of a call option is higher if
current price of the stock is higher (greater likelihood the option will end up inthe-money).
Put: value of put option is lower if strike price the holder must pay to buy the
stock is lower. For a given strike price, value of a put option is lower if current
price of the stock is higher.
o Arbitrage bound on option prices:
An American option cannot be worth less than its European counterpart;
Call: the lower the strike price, the more valuable the call option. If the strike
price is 0, the holder would always exercise the option a call option cannot
be worth more than the stock itself;
Put: maximum payoff occurs if stock becomes worthless, then its payoff is
equal to strike price a put option cannot be worth more than its strike price;
Intrinsic value of an option: value it would have if it expired immediately.
Amount by which option is currently in-the-money, or 0 if its out-of-the-

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money. An American option cannot be worth less than its intrinsic value
(arbitrage);
Time value of an option: difference between current option price and its
intrinsic value. American option cannot have a negative time value.
o Option prices and the exercise date:
American options: longer time to exercise date, more valuable option. An
American option with a later exercise date cannot be worth less than an
otherwise identical American option with an earlier exercise date;
European options: longer time to exercise date, sometimes less valuable
option.
o Option price and volatility of underlying stock: the value of an option generally
increases with the volatility of the stock. Increase in volatility increases likelihood of
very high and very low returns for the stock. (Lowest return still is 0, so gain from
increase in volatility). Put options are more valuable too, because buying insurance
against more volatile stock is more valuable.
Exercising options early
Non-dividend-paying stocks
Price of zero-coupon bond: PV(K) = K dis(K). dis(K) = amount of discount from face value
to account for interest.
Call
The price of any call option on a non-dividend-paying stock always exceeds its intrinsic value
never optimal to exercise a that option early.
An American call on a non-dividend-paying stock has the same price as its European
counterpart, because the right to exercise the call early is worthless.
Put
Does it make sense to exercise it early?
S is high, and put option is deep in-the-money, discount will be large relative to value of the
call, and time value of a European put option will be negative. It will sell for less than its
intrinsic value. Its American counterpart cannot sell for less than its intrinsic value (arbitrage)
American option worth more than European option.
Dividend-paying stocks
Call
Put-call parity relationship:
If PV(Div) is large enough, the time value of a European call option can be negative,
implying price < intrinsic value. American option can never be worth less than intrinsic value
American price > European price.
Put
Put-call parity relationship:

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Less likely that a put option on a dividend-paying stock will be exercised early, because
holder of put option will benefit by waiting for the stock price to drop after it goes exdividend before exercising.
For the deep in-the-money puts, the interest on the high strike prices > dividends earned,
making it costly to wait.
Equity as a call option. Think of a share of stock as a call option on the assets of the firm with
a strike price equal to the value of debt outstanding. If the firms value < the value of debt
outstanding at the end of the period, the firm must declare bankruptcy and the equity holders
receive nothing. If the firms value > value of debt outstanding at the end of the period, the
equity holders get whatever is left once the debt has been repaid.
Debt as an option portfolio. Debt holders: owning firm and sold call option with strike price =
required debt payment. Value of firm > required debt payment: call is exercised: debt holders
receive strike price and give up firm. Value of firm < required debt: call is worthless, firm will
be bankrupt and debt holders are entitled to firms assets.
Another way to view corporate debt: as a portfolio of risk-free debt and a short position in a
put option on the firms assets with a strike price equal to required debt payment:
Risky debt = risk-free debt put option on firm assets.
Firms assets < required debt payment: put = in-the-money: exercise option and receive
difference between required debt and firms asset value.
Firms assets > required debt payment: put is worthless; debt holder is left with required debt
payment.

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Chapter 21: Option valuation


Binomial Option Pricing Model
Prices options by making simplifying assumption that at the end of the next period, the stock
price has only two possible values (go up, or go down).
Replicating portfolio: portfolio of other securities that has exactly the same value in one
period as the option. Law of one price: current value of call & replicating portfolio must be
equal.
Assume: stock pays no dividends!

= number of shares of stock. B = position in bond. u = up. d = down.


General formula for replicating portfolio in Binomial Model:

Option price in Binomial Model:


This is for call different for put in the tree, rest is same!
Problem with this example: many more than two possible outcomes for stock price in real
world must allow for possibility of many states and periods. In each period, two possible
outcomes (up or down), but by adding additional period, number of possible stock prices
increases. To calculate the value of an option with multi periods: start at end and work
backwards.
Dynamic trading strategy: idea that you can replicate the option payoff by dynamically
trading in a portfolio of the underlying stock and a risk-free bond.
Realistic model is constructed by decreasing length of each period, and increasing number of
periods.
Black-Scholes Option Pricing Model
Let length of each period, and movement of stock price per period go to zero, let number of
periods grow infinitely large.
S = current stock price, T = number of years left to expiration, K = exercise price, = annual
volatility (standard deviation) of stocks return.

with
N(d) = cumulative normal distribution.

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This model assumes that call is a European option. In this case (no dividends): both American
and European call options on non-dividend-paying stocks.
Put
Price of European put from put-call parity is: P = C S + PV(K)
Black-Sholes Price of a European Put Option on a Non-Dividend-Paying Stock:

Dividend-paying stocks
European call option: holder doesnt receive dividends prior to expiration date of option.
Market price security identical to the stock:
Because a European call option is the right to buy the stock without these dividends, we can
evaluate it using the Black-Scholes formula with S* in place of S.
Q = stocks (compounded) dividend yield until expiration date.
S* = S/(1+q)
The parameter , volatility, is not directly observable. Two strategies to estimate it:
o Use historical data on daily stock returns;
o Use current market prices of traded options to back out the volatility that is consistent
with these prices based on the Black-Scholes formula.
Implied volatility: estimate of a stocks volatility which is implied by an options price. Can
be used to estimate the value of other options on the stock with the same expiration date.
Black-Scholes Replicating Portfolio of a Call Option:
= N(d1) and B = PV(K) N(d2)
N(d): cumulative normal distribution function. Minimum of 0, maximum of 1.
B is between K and 0
The replicating portfolio is a leveraged position in the stock: long position in the bond, short
position in the stock.
Black-Scholes Replicating Portfolio of a Put Option:
= [1 N(d1)] and B = PV(K) [1 N(d2)]
= between -1 and 0, B is between 0 and K.
Replicating portfolio consists of a long position in the bond and a short position in the stock.
Put options on a positive beta stock, will have a negative beta.
Risk-Neutral Two-State Model
If all market participants were risk neutral, then all financial assets would have the same cost
of capital: the risk-free rate of interest.
The risk-neutral probability that the price will be S satisfies the following condition
u

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Derivative security: any security whose payoff depends solely on the prices of other
marketed assets.
Monte Carlo simulation: risk-neutral pricing method is basis for this common technique for
pricing derivative securities. The expected payoff of the derivative security is estimated by
calculating its average payoff after simulating many random paths for the underlying stock
price. In the randomization, the risk-neutral probabilities are used, and so the average payoff
can be discounted at the risk-free rate to estimate the derivative securitys value.

Measure risk of an option: compute option beta. Simplest way: compute beta of replicating
portfolio. Beta of portfolio = weighted average beta of the constituent securities that make up
the portfolio.

Call: > 0 en B < 0. Call on stock with positive beta, beta of call > beta of stock.
Put: < 0 en B > 0. Put on stock with positive beta, beta of put < beta of stock.
Options leverage ratio: S / (S + B) ratio of amount of money in stock position in the
replicating portfolio to the value of the replication portfolio.
Out-of-the-money calls have the highest expected return & highest beta.
Out-of-the-money puts: lowest expected return & lowest beta.
Calculate the beta of equity from the unlevered beta of equity (beta of debt is 0):

Calculate the beta of equity from the unlevered beta of equity when beta of debt is not 0:

When debt is risk free, firms equity is always in-the-money: = 1.


Beta of debt:
Beta of debt in terms of the beta of assets:

Debt is riskless: = 1 and

= 0.

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Chapter 22: Real options


Real option: right to make a particular business decision, such as a capital investment.
Key distinction real option and financial option: real options, and the underlying assets on
which theyre based, are often not traded in competitive market.
Three kinds of real options that are most frequently encountered in practice:
o Option to delay an investment opportunity;
o Option to grow;
o Option to abandon an investment opportunity.
Option to delay an investment opportunity
Decision to wait is a trade-off between the costs (profits project might generate in interim)
and benefit of remaining flexible.
Call: C = S*N(d1) PV(K)N(d2)
When you have the option of deciding when to invest, it is usually optimal to invest only
when the NPV is substantially greater than zero. Given the option to wait, an investment that
currently has a negative NPV can have a positive NPV.
Factors affecting real options:
o Volatility: when theres a lot of uncertainty, waiting is valuable;
o Dividends: with real options: dividends = any value from investment that we give up
by waiting. It is always better to wait unless there is a cost to doing so. The greater the
cost, the less attractive the option to delay.
Option to grow or abandon
Growth option: when firm has a real option to invest in the future.
Abandonment option: option to disinvest, to walk away from a project.
If continuing a project is a negative-NPV undertaking, you can create value by abandoning,
regardless of how much investment has already been sunk into the project.
How to decide between investing in two mutually exclusive projects of different lengths?
First calculate NPV of each decision on a standalone basis.
When longest project has highest NPV:
To truly compare the two options, we must consider what will happen once the short-lived
equipment wears out. Three possibilities:
1. Technology is not replaced: no additional benefits, choose longest project;
2. Technology is replaced at the same terms: 2 x NPV of short project, increases its NPV;
3. Technological advances allow us to replace it at improved terms: NPV of short project
+ new NPV with improved terms, increases total NPV even more.
How to determine the order of investment for a staged investment opportunity?
Equivalent Annual Benefit (EAB) method: accounts for difference in project lengths. Is
constant annuity payment over life of project that is equivalent to receiving its NPV today.
Select project with higher EAB.
Mutually dependent investments: value of one project depends upon outcome of others.
Other thing being equal, it is beneficial to make the least costly investments first, delaying
more expense investments until it is clear they are warranted.
Other thing being equal, it is beneficial to invest in riskier and lengthier projects first,
delaying future investments until the greatest amount of information can be learned.
cost, time, and risk of a project will determine the optimal order in which to invest.

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Find optimal order to stage mutually dependent projects by ranking each, from highest to
lowest according to: (1 PV(success))/PV(investment)
PV(success): present value of risk-neutral probability of success.
PV(investment): projects required investment, expressed as a present value at the projects
start.
Two commonly used rules of thumb:
o Profitability index;
o Hurdle rates.
Profitability index rule: invest whenever the profitability index exceeds some predetermined
number. When investment cannot be delayed: invest whenever profitability index > 0.
Profitability index = NPV / initial investment.
Hurdle rate rule: raises discount rate. Uses higher discount rate than cost of capital to
compute NPV, and then applies regular NPV rule. Higher discount rate = hurdle rate.
When source of uncertainty that creates a motive to wait is interest rate uncertainty: natural
way to approximate the optimal hurdle rate.
Hurdle rate = cost of capital x (callable annuity rate / risk-free rate)
Callable annuity rate: rate on a risk-free annuity that can be repaid (or called) at any time.
Invest whenever NPV of project is positive using this hurdle rate as discount rate.
Key insights from real options:
o Out-of-the-money real options have value: maybe it is worth something in the future;
o In-the-money real options need not be exercised immediately: option to delay might
be worth more than exercising it now;
o Waiting is valuable: you can make better decision with better information. No costs of
waiting wait. Costs of waiting trade-off uncertainty and costs;
o Delay investment expenses as much as possible: incur investment expenses at last
possible moment. Committing capital before it is absolutely necessary reduces value
because it gives up the option to make a better decision once uncertainty has been
resolved;
o Create value by exploiting real options: firm must continually re-evaluate investment
opportunities and optimize decision-making dynamically.

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Chapter 23: Equity financing for private companies


Sources of funding for a private company:
o Angel investors: individual investors who buy equity in small private firms, mostly
friends or acquaintances of entrepreneur. Typically receive a sizable equity share in
business in return for their funds, may also bring expertise to firm that entrepreneur
lacks;
o Venture capital firms: limited partnership that specializes in raising money to invest in
the private equity of young firms. Typically institutional investors are the limited
partners. The general partners run the venture capital firm, called venture capitalists.
Advantage: diversification (invest in many start-ups). Carried interest: share of any
positive return generated by the fund for general partners;
o Private equity firms: organized much like a venture capital firm, but invests in equity
of existing privately held firms rather than start-up companies. Initiate their
investment by finding a publicly traded firm and purchasing the outstanding equity,
taking the company private in a transaction called a leverage buyout (LBO). Key
difference private equity and venture capital: magnitude invested;
o Institutional investors: pension funds, insurance companies, endowments, foundations:
manage large quantities of money;
o Corporate investors: corporate investor, corporate partner, strategic partner,
strategic investor: corporation that invests in private companies.
Preferred stock:
o Mature companies (banks): preferential dividend and seniority in any liquidation and
sometimes special voting rights;
o Young companies: no regular cash dividends, but gives owner an option to convert it
into common stock on some future date. Often called convertible preferred stock.
Pre-money valuation: value of prior shares outstanding at the price in the funding round.
Post-money valuation: value of whole firm (old + new shares) at funding round price.
Exit strategy: how investors will eventually realize the return from their investments. Two
main ways:
o Through an acquisition: large corporations purchase successful start-up companies;
o Through a public offering: company becomes publicly traded company.
Initial Public Offering (IPO): process of selling stock to the public for the first time.
Advantages of going public:
o Greater liquidity;
o Better access to capital.
Major advantage of IPO is also major disadvantage: when investors diversify their holdings,
the equity holders of the corporation become more widely dispersed. Lack of ownership
concentration undermines investors ability to monitor companys management, and investors
may discount the price theyre willing to pay to reflect the loss of control.
Underwriter: investment banking firm that manages the IPO and designs its structure.
Primary offering: shares sold in IPO are new shares that raise new capital.

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Secondary offering: shares sold in IPO are existing shares that are sold by current
shareholders (as part of their exit strategy).
Best-efforts IPO: underwriter doesnt guarantee the stock will be sold, but tries to sell the
stock for best possible price. Either all of shares are sold in IPO, or deal is called off.
Firm commitment IPO: underwriter guarantees it will sell all of the stock at the offer price.
Underwriter purchases entire issue at lower price and resells at offer price. If entire issue
doesnt sell out, underwriter takes the loss. More common.
Auction IPO: selling new issues directly to the public using online auction IPO mechanism
called OpenIPO. Market determines price of stock by auctioning off the company.
Lead underwriter: primary banking firm responsible for managing the deal. Provides most
of advice and arranges for a group of other underwriters = syndicate, to help market and sell
the issue.
The SEC requires that companies prepare a registration statement: legal doc that provides
financial and other info about the company to investors prior to an IPO.
Before the offer price is set, underwriter work closely with company to come up with a price
range they believe provides a reasonable valuation for the firm. Two ways to value a
company: estimate future cash flows and compute present value, or estimate value by
examining comparable companies.
Road show: senior management and lead underwriters travel around country promoting the
company and explaining their rationale for the offer price to the underwriters largest
customers.
Book building: process for coming up with the offer price based on customers expressions of
interest.
Underwriting spread: fee for underwriters that company has to pay.
Over-allotment allocation / greenshoe provision: allows underwriter to issue more stock or
the original offer size at the IPO offer size. Way for underwriter to protect themselves against
a loss.
Lockup: shareholders cannot sell their shares for 180 days after the IPO.
Four characteristics of IPOs puzzle financial economists:
o On average, IPOs appear to be underpriced: price at end of trading on the first day is
often substantially higher than IPO price. Who benefits? Underwriters by controlling
their risk, investors who are able to buy stock from underwriters at IPO price. Who
bears costs? Pre-IPO shareholders of issuing firm. They are selling stock in their firm
for less than they could get in the aftermarket. So why do they do that? Winners
curse: you get all the shares you requested (win) when demand for shares by others is
low, and IPO is more likely to perform poorly;
o Number of issues is highly cyclical: when times are good, market is flooded with new
issues, when times are bad, number of issues dries up. Surprising: magnitude of
swings. Number of IPOs is not solely driven by demand for capital, sometimes firms
and investors seem to favor IPOs, sometimes alternative sources of capital;
o Costs of an IPO are very high, unclear why firms willingly incur them. No good
answer;
o Long-run performance of a newly public company is poor a three- to five-year buy
and hold strategy appears to be a bad investment. Also associated with subsequent
issuances.

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Seasoned equity offering (SEO): firms return to equity markets and offer new shares for
sale.
Using SEO follows many of same steps as for an IPO. Main difference: a market price for
stock already exists with SEO.
Two kinds of SEOs:
o Cash offer: firm offers new shares to investors at large;
o Rights offer: firm offers new shares only to existing shareholders.
Advantage of cash offer: underwriter takes on larger role and can credibly certify the issues
quality. But rights offer is cheaper.
Announcement of SEO price drop: investors infer from decision to sell that company is
likely to be overvalued.

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Chapter 24: Debt financing


A public company can become private through a leveraged buyout (LBO): a group of private
investors purchases all equity of a public corporation.
Indenture: formal contract between bond issuer and trust company (trust company represents
bondholders).
Original issue discount (OID) bond: coupon bond, issued at a discount.
Coupons are paid in one of two ways:
1. Bearer bonds: like currency, whoever holds the bond certificate owns the bond;
2. Registered bonds: issuer maintains list of all holders of its bonds.
Unsecured debt: bankruptcy bondholders have claim to only assets of firm that arent
already pledged as collateral on other debt.
Secured debt: bankruptcy specific assets are pledged as collateral that bondholders have a
direct claim to.
Four types of corporate debt:
o Notes: unsecured debt: original maturity less than 10 years;
o Debentures: unsecured debt;
o Mortgage bonds: secured debt: secured with property;
o Asset-backed bonds: secured debt: secured with any asset.
Junk bonds: bonds rated below investment grade.
Bonds seniority: bondholders priority in claiming assets in the event of default. Default
first pay off all senior debt.
Subordinated debenture: when a firm conducts a debenture issue that has lower priority
than its outstanding debt.
Four categories of international bonds:
o Domestic bonds: issued by local entity and traded in local market, but purchased by
foreigners. Denominated in local currency;
o Foreign bonds: issued by foreign company in local market and intended for local
investors. Denominated in local currency;
o Eurobonds: international bonds, arent denominated in local currency of country in
which theyre issued. The trading of these bonds is not subject to any particular
nations regulation;
o Global bonds: combine above features, are offered for sale in several different
markets simultaneously.
A bond that makes its payments in a foreign currency contains the risk of holding that
currency and is priced off the yields of similar bonds in that currency. For example the eurodenominated note has a different yield from the dollar-denominated note, though both have
the same seniority and maturity. They have the same default risk, but differ in exchange rate
risk (risk that foreign currency will depreciate in value relative to local currency).
Private debt: is not publicly traded (bank loans). Advantage: avoids registration costs.
Disadvantage: illiquid.
Two segments of private debt market:
o Term loans: bank loan that lasts for a specific term. Syndicated bank loan: single
loan that is funded by a group of banks rather than just one bank. Revolving line of

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Summary

credit: credit commitment for a specific time period up to some limit (i.e. five years
and 1.6 billion) which a company can use as needed;
o Private placements: bond issue that doesnt trade on a public market but rather is
sold to a small group of investors. Doesnt need to be registered less costly.
Above is all about corporation, but other entities issuing debt are:
o Sovereign debt: by national governments. See table 24.4;
o Municipal bonds: by state and local governments. Income isnt taxable at federal
level. Coupons can be fixed (same coupon over life of bond) or floating (coupon is
adjusted periodically). Municipal bonds arent as secure as bonds backed by federal
government;
o Asset-backed securities (ABS): security made up of other financial securities. Asset
securitization: process of creating an asset-backed security. Largest sector: mortgagebacked security (MBS). Holders of MBSs face prepayment risk: risk that bond will
be partially/wholly repaid earlier than expected. Collateralized debt obligation
(CDO): new ABS after banks resecuritize asset-backed and other fixed income
securities.
Covenants: restrictive clauses in a bond contract that limit issuer from taking actions that
may undercut its ability to repay the bond.
Repayment provisions:
o Callable bonds;
o Sinking funds;
o Convertible bonds: converting them into equity.
Callable bonds: bonds that contain a call provision that allows the issuer to repurchase the
bonds at a predetermined price.
A call feature allows the issuer of the bond the right to retire all outstanding bond on a
specific date (call date) for the call price.
When yields have risen, the issuer will not choose to exercise the call on the callable bond.
Issuer will exercise call option only when coupon rate of bond > prevailing market rate.
A callable bond will trade at a lower price (and therefore a higher yield) than an otherwise
equivalent non-callable bond.
Yield to call (YTC): annual yield of a callable bond assuming that the bond is called at the
earliest opportunity.
Sinking fund: way of repaying bonds. Instead of repaying entire principal balance on
maturity date, company makes regular payments into a sinking fund administered by a trustee
over the life of the bond. These payments are used to repurchase bonds. Which bonds to
repurchase? Bonds that are trading below their face value. If all are trading above face value,
decision is made by lottery.
Sinking fund allows issuer to repurchase bonds at par.
Balloon payment: sometimes sinking fund payments < entire issue, company must make
large payment on maturity date.
Conversion ratio: ratio at which the bondholder can convert each bond owned into a fixed
number of shares of common stock. Such bonds: convertible bonds. Its like a regular bond +
special type of call option: warrant: call option written by company itself on new stock
(regular call option is written on existing stock).

Finance 2
Summary

Conversion price: face value / conversion ratio.


Convertible bond with 1000 face value and conversion ratio of 15: if you converted bond into
stock, you would receive 15 shares, at a price per share of 1000/15=66.67. If the price of
stock exceeds 66.67: convert.

Finance 2
Summary

Chapter 25: Leasing


Lessee: liable for periodic payments in exchange for the right to use the asset.
Lessor: owner of the asset, entitled to the lease payments in exchange for lending the assets.
Different types of leasing:
o Sales-type lease: lessor is manufactures (primary dealer) of asset, sets terms of leases;
o Direct lease: lessor is independent company that specializes in purchasing and leasing
assets. Lessee identifies equipment it needs first and then finds a leasing company to
purchase the asset;
o Sale and lease-back: if a firm already owns an asset it would prefer to lease. Lessee
receives cash from sale of asset and then makes lease payments to retain use of asset;
o Leveraged lease: lessor borrows from bank or other lender to obtain initial capital for
purchase;
o Synthetic lease: Sometimes lessor is a separate business partnership (special-purpose
entity (SPE)), created by lessee for sole purpose of obtaining lease.
Costs of lease will depend on assets residual value: market value at end of the lease.
In perfect capital market: NPV of transaction is 0 and lessor breaks even. Assume that lessee
gives asset back after lease period.
PV(lease payments) = purchase price PV(residual value).
The difference between leasing an asset and borrowing money to purchase the asset is the
residual value: PV(lease payments) + PV(residual value) = PV(loan payments).

In many cases the lease allows the lessee to obtain ownership of the asset for some price:
o Fair market value (FMV) lease: lessee has option to purchase asset at its FMV at
termination of lease;
o $1.00 out lease (finance lease): ownership of asset transfer to lessee at end of the
lease for nominal cost of $1.00;
o Fixed price lease: lessee has option to purchase asset at end of the lease for fixed
price set upfront in lease contract. Market value > fixed price: lessee buys asset at
below market value. If not, lessee doesnt buy and purchase asset for less money
elsewhere higher lease rate to compensate for this option for lessor;
o Fair market value cap lease: lessee has option to purchase asset at minimum of FMV
and a fixed price (cap).
Perfect capital market, without imperfections: MM proposition: leases neither increase nor
decrease firm value, but only divide firms cash flows and risks in different ways.
Effects of leasing on accounting:
Lessees accounting balance:
o Operating lease: viewed as rental. Lessee reports entire lease payments as operating
expense. Doesnt deduct depreciation expense for asset and doesnt report asset, or
lease payment liability on balance sheet. Are disclosed in footnotes of financial
statements;
o Capital lease (finance lease): viewed as acquisition. Asset is listed on balance sheet,
lessee incurs depreciation expenses for asset. Future lease payments are listed as
liability. Increase leverage on balance sheet.

Finance 2
Summary

FASB: lease is capital lease and must be listed on balance sheet if it satisfies any of following
conditions:
o Title to property transfers to lessee at end of lease term;
o Lease contains option to purchase asset at bargain price that is less than FMV;
o Lease term is 75% or more of estimated economic life of asset;
o PV of minimum lease payments at start of lease is 90% or more of assets FMV.
Effects of leasing on taxes
Two broad categories of leases:
o True-tax leases: lessor receives depreciation deductions associated with ownership of
asset. Lessee can deduct full amount of lease payments as an operating expense, for
lessor: these lease payments are revenue;
o Non-tax lease: legal ownership of assets resides with lessor, but lessee receives
depreciation deductions. Lessee can also deduct interest portion of lease payments as
interest expense. These are interest income for lessor.
If the lease satisfies any of these conditions it is treated as non-tax lease:
o Lessee obtains equity in leased asset;
o Lessee erceives ownership of asset on completion of all lease payments;
o Total amount that lessee is required to pay for a relatively short period of use
constitutes an inordinately large proportion of total value of total value of asset;
o Lease payments exceed current fair rental value of asset;
o Property may be acquired at a bargain price in relation to FMV of asset at time when
option may be exercised;
o Some portion of lease payments is specifically designated as interest or its equivalent.
Leasing and bankruptcy
Treatment of leased property in bankruptcy depends on how the lease is classified by the
bankruptcy judge. Two categories:
o Security interest: firm is assumed to have effective ownership of asset and asset is
protected against seizure. Lessor is treated as any other secured creditor and must
await firms reorganization or ultimate liquidation;
o True lease: lessor retains ownership rights over asset. Bankrupt firm must choose
whether to assume or reject the lease. Assume: settle all pending claims and continue
to make all promised lease payments. Reject: asset must be returned to lessor.
Operating and true tax leases are mostly viewed as true leases.
Capital and non-tax leases are mostly viewed as security interest.
Should I buy or should I lease?
Perfect capital market: doesnt matter.
Real world decision depends on market frictions.
For a true tax lease:
Lease-equivalent loan: loan that is required on the purchase of the asset that leaves the
purchases with the same obligations as the lessee would have.
Loan balance = PV(Future FCF of lease versus buy at r (1- )).
D

Finance 2
Summary

We can compare leasing to buying the asset using equivalent leverage by discounting the
incremental cash flows of leasing versus buying using the after-tax borrowing rate.
Negative NPV: leasing unattractive compared to traditional debt financing.
For a non-tax lease:
Directly comparable to traditional loan in terms of cash flows.
Attractive if it offers better interest rate than would be available with a loan: discount lease
payments at firms pretax borrowing rate and compare to purchase price of asset.
Lease has to be attractive to both lessee and lessor gains must come from some underlying
economic benefits that the leasing arrangement provides:
o Tax differences;
o Reduced resale costs;
o Efficiency gains from specialization;
o Reduced distress costs and increased debt capacity;
o Transferring risk;
o Improved incentives.
Other arguments for leasing:
o Avoiding capital expenditure controls;
o Preserving capital
o Reducing leverage through off-balance-sheet financing.

Finance 2
Summary

Chapter 28: Mergers and acquisitions


Two mechanisms by which ownership and control of a public corporation can change:
o Another corporation can acquire the target firm;
o The target firm can merge with another firm.
Types of mergers:
o Horizontal merger: if target and acquirer are in same industry;
o Vertical merger: if targets industry buys or sells to acquirers industry;
o Conglomerate merge: if target and acquirer operate in unrelated industries.
Stock swap: target shareholders receive stock of acquirer or newly created merged firm as
payment for target shares.
Acquisition premium: percentage difference between acquisition price and premerger price
of target firm.
Reasons to acquire:
o Economies of scale: savings from producing goods in high volume;
o Economies of scope: saving from combining marketing and distribution of different
types of related products;
o Vertical integration;
o Expertise;
o Monopoly gains;
o Efficiency gains;
o Tax savings from operating losses;
o Diversification:
Risk reduction;
Debt capacity and borrowing costs;
Liquidity.
o Earnings growth;
o Managerial motives.
Exchange ratio: price offered for target firm.
Exchange ratio = x/NT < ((T+S)/A)(NA/NT)
Exchange ratio < PT/PA(1 + (S/T))
A = premerger value of acquirer. S = value of synergies created by merger.
T = premerger value of target. NA = shares outstanding of acquirer before merger.
x = number of new shares issued to pay for target. NT = premerger number of target shares
outstanding.
Premerger target share price: PT = T/NT. Premerger acquirer share price: PA = A/NA.
Merger-arbitrage spread: potential profit from difference between targets stock price and
implied offer price. Not a true arbitrage opportunity: risk that deal will not go through.
Proxy fight: acquirer attempts to convince target shareholders to unseat the target board by
using their proxy votes to support the acquirers candidates for election to the target board.
Takeover defenses:
o Poison pill: gives existing target shareholders the right to buy shares in the target at a
deeply discounted price once certain conditions are met. Acquirer is excluded from
this right;

Finance 2
Summary

o Staggered boards: every director serves a three-year term and terms are staggered so
that only one-third of directors are up for election each year;
o White knights: target company looks for another company to acquire it;
o Golden parachute: guaranteed to firms senior managers in event that firm is taken
over and managers are let go;
o Recapitalization: company changes its capital structure to make itself less attractive
as a target;
o Regulatory approval: mergers must be approved by regulators.
Free rider problem of takeovers: existing shareholders dont have to invest time and effort, but
still participate in all the gains from the takeover. Solve this problem:
o Toehold: acquire initial stake in target, to gain control of company;
o Leveraged buyout;
o Feezeout merger: laws on tender offers allow acquiring company to freeze existing
shareholders out of gains from merging by forcing non-tendering shareholders to sell
their shares for the tender offer price.
Acquiring company must give up most of the value added to the target shareholders.