Brealey/Myers: Principles of Corporate Finance (1996 & 2000

Chapter 1: Why Finance Matters • The financial manager is anyone responsible for a significant corporate investment or financing decision. He decides on: o What investments should the firm make? (answered by the firm's investment or capital budgeting decision) o How should it pay for those investments? (answered by the firm's financing decision) A good capital budgeting decision is one that results in the purchase of a real asset that is worth more than it costs. This is an asset that makes a net contribution to value. Financial managers therefore need to know how investors value a firm and how financial markets work, as financing decisions cannot be separated from financial markets. For example, he must know theories on how financial choices (e.g., debt or stock) affect value or he must understand how interest rates are set and how loans are priced in case of huge debts that last a long time. Financial managers have the responsibility of looking into whether an opportunity is worth more than it costs and whether the debt burden can be safely borne. He copes with time and uncertainty factors. Flow of cash between financial markets and the firm's operations: 1. Cash is raised from the financial market by selling financial assets to investors. 2. This is invested into the firm's operations and is used to purchase real assets. 3. Cash is generated by the firm's operations. 4. a) Cash is reinvested. b) Cash is returned to investors. Note: The financial manager stands between the firm and the financial markets. Specializations: o Treasurer: obtains finance, manages the firm's cash account and its relationships with banks and other financial institutions, makes sure that the firm meets its obligations to the investors o Controller: checks that the money is used efficiently, manages budgeting, accounting and auditing

Chapters 2 & 3: Present Values and the Opportunity Cost of Capital • • • • Objective of the capital budgeting decision: to find real assets that are worth more than what they cost Present value calculation: To arrive at the PV, expected future payoffs are discounted by the rate of return denoting the opportunity cost of capital, which is the return forgone by investing in the project rather than investing in the capital market. What about risk? To account for risk, we have to think of expected payoffs and the expected rates of return. Decision rules: 1. NPV rule: Accept investments with + NPVs. And invest so as to maximize the NPV of the investment. This is the difference between the discounted value (PV) and the initial investment. 2. Rate of return rule: Accept investments with rates of return above the opportunity cost of capital; that is: [(expected value - initial investment)/initial investment] > opportunity cost of capital In view of productive opportunities, invest up to the point at which the marginal return

on investments is equal to the rate of return on investments in the capital market. This is the point of tangency between the interest-rate line and the investment-opportunities line. Note: The opportunity cost of capital is not: 1. The risk-free rate. The investment is risky! 2. The rate imposed on the loan provided by the project. This rate does not reflect the health of the existing business. It does not also matter whether the loan is made or not. The decision maker still has to decide whether to invest in the project or in an equally risky stock. Irving Fisher: Managers do not need to know anything about the personal tastes of their shareholders and should not consult their own tastes. Their task is to maximize NPV. Copeland/Weston: Exchange opportunities permit borrowing and lending at the same rate of interest. Thus, different shareholders will be unanimous in their preference as regards production decisions. Managers will then choose to invest until the rate of return on the least favorable project is exactly equal to the market-determined rate of return.

Chapter 5, 6 & 11: Why NPV Leads to Better Investment Decisions (B/M and C/W put together) • Criteria for the qualifaction of captial budgeting techniques: (Copeland/Weston) 1. All CFs! (and only CFs, not accounting profits) (Brealey/Myers) 2. Discount at the opportunity cost of capital. 3. From a mutually exclusive set, select the one which maximizes shareholder wealth. 4. From an independent set, value additivity must hold so that projects may be considered independently. Payback: How long does it take for an investment's return to cover up fully the initial investment? Rule: Choose the project with the shortest payback (C/W) Problems: o Not all CFs are included o Gives equal weight to all CFs before the payback date and no weight to subsequent flows (B/M) Discounted payback: How long does it take for an investment's discounted returns to cover up fully the initial investment? This is not a big improvement from the payback method! Accounting rate of return: How much returns does an investment yield relative to the invested capital? Rule: Choose the highest average after-tax provided by the intial cash outlay. (C/W) Problems: (C/W and B/M) o Uses accounting profits, not CFs o No time value of money, no discounting Internal rate of return: the rate at which the PV of outflows equals the PV of the inflows (NPV = 0) = the rate of return that a project is returning to the firm; the true rate of return of a longlived asset Rule: Accept any project that has an IRR > opportunity cost of capital (C/W) Problems: o Not all CFs have NPVs that decline as the discount rate increases. In such cases, the IRR could be lower than the opportunity cost of capital. (B/M) o Assumes that IRR is the time value of money (reinvestment rate assumption). The reinvestment rate should be the opportunity cost of capital. (C/W)

• •

But: § Expensive § Good data? § Assumes that all future investments are known § Cannot be used when large. If the discount rate is in nominal terms. o Multiple rates of return if the CF direction changes more than once or perhaps there will be no IRR at all! (C/W and B/M) NPV is then the better decision rule because: o It solely recognizes all CFs. we are saying that the CFs are enough to satisfy the required rate of return of creditors. If there are five projects. we have to consider all possible combinations of projects and choose the combination with the greatest IRR. o Positive NPVs add value to shareholder wealth. the value of the firm is the sum of the values of the separate projects. Some Considerations: o Inflation: Just be consistent in your treatment of inflation. Profitability index = NPV/investment Advantage: simple Disadvantages: § What if more than one resource is constrained? § Cannot cope in cases where there are mutually exclusive projects or when one project is dependent on another Other methods: Use of variables or constraints in linear programming. and payment of expected dividends to shareholders. management has to consider 32 combinations! Where positive NPVs come from (Chapter 11): o economic rents = profits that more than cover the opportunity cost of capital. Value additivity does not hold.• • • o Assumes that the opportunity cost of capital is the same for all CFs. A note on mutually exclusive projects (C/W): If the value additivity principle holds. The NPV of an investment is simply the discounted value of the economic rents that it will produce. discounts at the opportunity cost of capital. then the CFs must be in nominal terms. (C/W) When we discount CFs by WACC and achieve positive NPVs. If we use the IRR. repayment of the face amount of debt. If we adopt the NPV rule. then we can choose between two mutually exclusive projects. o Values of projects change when we combine them. It has to select the projects that offer the highest NPV per initial investment. . Hard rationing: Market imperfections impose the restrictions. Soft rationing: Provisional limits are adopted. (B/M) o Value additivity holds. Short-term interest rates are normally different from long-term interest rates. indivisible projects are involved. a firm cannot simply choose projects with positive NPVs. o It recognizes the time value of money. regardless of their being independently considered or their being together in a valuation. Relationship between the nominal and real interest rates: (1 + rnom) = (1 + rreal) ( 1 + inflation rate) o Capital rationing: When funds are limited. Note: You do not have to apply DCF when market values are readily available. Rule: Avoid expansion when competitive advantages are absent and economic rents are unlikely.

o Disadvantages: § Costly and time-consuming § The more realistic. (In principle.Chapter 10: A Project is Not a Black Box ==> Know it well! • Sensitivity analysis: Express CFs in terms of key project variables. o Disadvantages: § Complexity of considerations (depends on the analyst) § All possible future events will never be displayed anyhow. which is a list of planned investments by plant and division. The portfolio risk will be smaller than the sum of the risks of two separate projects. Model the project. probably implicit but not the optimal one. • Decision Trees: To analyze projects that involve sequential decisions. § The risk-free rate is normally used to discount the CFs. Subject them to pessimistic and optimistic scenarios and see how bad the situation can get before the project begins to lose money (break-even analysis). although the projects are separate. 3. This will encourage joint project proposals. Specify probabilities. decision via DCF or other methods . Appropriation requests with back-up info for project authorization. § No idea provided as to how the options are to be valued o Lesson: Decision trees allow the explicit analysis of possible future events and decisions. Problems are solved by thinking about what would be done next. This leads to the violation of the value additivity principle. Prospects are schemed and given their probabilities. The total expected value at a particular point in time is then calculated.) 2. Of what use is looking at an effect in isolation of the others? • Monte Carlo simulation: Consider all possible scenario combinations and inspect the entire distribution of project outcome results. This should be judged not on the basis of their comprehensiveness but on whether they show the most important links between today's and tomorrow's decisions. only a "business as usual" strategy § The distribution arrived at depicts losses that may not even be realized. Preparation of an annual capital budget. What does optimistic/pessimistic mean? § Underlying variables are likely interrelated. Extremes should be analyzed/treated with extreme caution. the more complex § Two unrelated projects can be combined in the simulation. 2. o Disadvantages: § Ambiguous results. The final decision should involve the NPV. o Steps: 1. Chapter 12: Organizing Capital Expenditures • Steps in the investment process/investment performance evaluation: 1. this should be a list of all positive NPV projects. Simulate the CFs. This is not the opportunity cost of capital. o Lesson: Simulation should be regarded as a way of obtaining information about expected CFs and risk. § No strategy taken up. As a result. correlated risk can reduce the total risk figure.

when managers have to act in the interest of the shareholders. Post-audit. This is biased upward for companies with intangible investments. Performance measurement: Use of accounting measures Advantages: o based on absolute performance rather than on performance relative to investor expectations o makes possible the measurement of the performance of junior managers whose responsibility extends to a single division or plant Disadvantages: o partly within management control o can be biased in measuring true profitability. For ex. The main goal is to maximize shareholder wealth. Eliminate conflicts of interest. Another: depreciation effects (accounting profitability is low when a project or business is young and too high as it matures because of straight line depreciation) o a growth in earnings does not mean shareholders are better off Chapter 4: The Value of Common Stocks • • Changes in security prices are fundamentally unpredictable (a natural consequence of well-functioning capital markets). if these have some relation to management performance measurement and compensation. unless the true cost of capital is known.. Check on the progress of recent investments. Projects cannot be judged correctly. esp. 4. In evaluating operating performance. A firm's capital investment choice should reflect both "bottom up" and "top-down" processes – capital budgeting and strategic planning. 3. They should however not be exposed to fluctuations in value over which they have no control. 2.g. tying up management compensation with stock price movements. Points to consider: 1. Ensure that the forecasts are consistent. that is. such as R&D.. Establish forecasts of economic indicators and particular items that are important to the firm's businesses and use them as basis for all project analyses. Beware of forecast bias. Control is established by accounting procedures for expenditures. e. there are two possibilities: a) Compare actual operating earnings with projected CFs. overoptimism. 4. esp. Problems could arise when book returns are given importance or when the attitudes toward risk are different. b) Compare actual profitability with absolute standards of profitability (cost of capital). Incentives for performance: The ideal scheme is to let management bear all the consequences of their actions.. Get the right info. Recognize strategic fits. ROI = [after-tax operating income / net (depreciated) book value of assets].• • • 3. Stock valuation is important: o upon going public o in order to understand what determines stock value. Control projects in progress. 5. because accountants do not put these outlays in the balance sheet. when they have to increase shareholder value PV calculation: same as any other asset PV(stock) = PV (expected future dividends) • . e.g.

provided that r > g Caution: o g: § Such a simple constant growth formula is only an approximation because a regular future growth is assumed. Good practice gives no sufficient weight to single-company cost-of-equity estimates. Ergo: P0 = å • • ∞ DIVt r) t t =1 (1 + • • • Stocks with dividends with a constant growth rate (growing perpetuity): P0 = DIV1 / (r .g) .. If it approaches infinity. the PV of FCFs 3.DIV/EPS Meanwhile: ROE = EPS / Book equity per share Then: g = plowback ratio x ROE Calculate r accordingly. errors will inevitably occur in the estimation of g. H could go as far as infinity. What if there is no growth? P0 = DIV1 / r = EPS1 / r This also holds when earnings are reinvested. It will not likely be sustained. The average r of similar companies gives a more reliable benchmark. § Even if the approximation is acceptable. the PV of average future earnings under no growth: P0 = DIV1 / r = EPS1 / r or the PV of average of future earnings with growth: P0 = (EPS1 / r) + PVGO or P0 = DIV1 / (r . One way to do this is: Plowback ratio = 1 . o r: § Any estimate of r for a single common stock is noisy and subject to error.• Consideration of capital gains? The price in any period is determined by the expected dividends and capital = cash not retained and not reinvested (==> paid out as dividends!) because P0 = å and thus. In principle. Ergo: P0 = å H DIVt r) t t =1 (1 + + PH (1 + r ) H . Another form of the DCF formula: FCF = revenue .. Estimating r: Given the constant growth formula. § It is not proper for firms with currently high growth rates. the PV of the terminal price ought to approach zero.costs .g) . P0 = ∞ DIVt t =1 (1 + r) t ∞ FCF t å t t =1 (1 + r ) • Summary: A stock's value represents either: 1. it holds that: r = DIV1 / P0 + g = dividend yield + growth rate The growth rate will have to be calculated by the analysts. the PV of the expected stream of future dividends 2. where H is the final period.payout ratio = 1 . P0 = (DIV1 + P1)/(1+r) because P1 is incorporated in the determination of P0 P1 = (DIV2 + P2)/(1+r) .

Calculating PF risk 2-stock PF: The variance of the PF = weighted average of the variances + covariance = X12 var1 + X22 var2 + 2 X1 X2 cov1 2 Many stocks: Var (PF) = å (Xi Xj varij ) i =1. The equivalent rates of return on all risky assets are a function of their covariance with the market PF. Thereby. divisibility o no transaction costs. Market risk is however undiversifiable.d.rf = beta ( rm .rf ) r = rf + beta (rm . The portfolio beta is the average of the security betas. for a given expected return.d. the spread of outcomes usually measured by the standard deviation/variance If returns are normally distributed... The diversification concept cannot however be transposed to the level of firms. or the lowest s.rf ) The expected risk premium varies in proportion to beta..Chapter 7 & 8: Risk and Return. rB = rL o no market imperfections . Putting them together eliminates "unique" risk (= unsystematic risk.d. One arrives then at an efficient PF. OPM . he extends his possibilities beyond M. An investor can invest in T-bills and then put the rest of his money in stock. This is what matters most in a well-diversified PF. he chooses the best PF of common stocks and combines this with borrowing and lending to obtain an exposure to risk that is "satisfactory". PF selection consists of increasing expected returns and decreasing s. If he chooses to lend. If he chooses to borrow. the highest level of expected return is achieved by a mixture of portfolio M and borrowing/lending. CAPM: r . Firms will just incur high costs and waste time.. • Risk: the uncertainty of future returns. then there is a possibility of borrowing/lending at rf. Value additivity: Diversification does not add to a firm's value or subtract from it. Investors are better off in doing the diversification itself via the securities held in the PF. j=1 n • • • • • • Calculating the contribution of one asset to the PF risk: o Calculate the market risk of the instrument and not the risk of the instrument in isolation ==> Beta! o Security betas determine the portfolio risk. betai = covim / varm Portfolio selection: According to Markowitz. Extension of choices with borrowing and lending: If there is a capital market. specific risk). we only need the mean and variance to assess risk and return Diversification: reduces variability: the risk of the PF < sum of the risks of components This is because prices of different stocks do not move exactly together. he ends up halfway between rf and M. The total value is the sum of its parts. (C/W) Assumptions: o risk aversion o homogeneous expectations o marketable assets. which gives the highest expected return for a given s. At every level of risk. CAPM.

if all assets are held according to their market value weights.rf] / s. Assumptions: o perfectly competitive and frictionless markets o homogeneous beliefs on the linear factor model Why APT is better than the CAPM: (C/W) o not just one beta o no risk aversion assumption / no strong utility function o testable: relative pricing o no assumptions on the distribution of returns . This denotes the risk-return tradeoff. policy: o Cost of equity is given directly by the CAPM. and not beta. CML: the straight line connecting the risk-free asset and the market PF. Applications of the CAPM for corp. (homogeneous expectations) M is the market PF of all risky assets held according to their market value weights. Otherwise.m. arbitrage.• • • • • • o a risk-free asset exists CAPM derivation: grounded on the same idea as that of Markowitz' PF selection together with borrowing/lending (C/W) With the existence of a risk-free asset. then there should be no extra demand for an individual risky asset such that the slope of the risk-return tradeoff evaluated at M in market equilibrium should equal the slope of the CML. because the company's beta is measured by calculating the covariance between the returns of common stock and the market PF. o If projects have different risk levels as the firm as a whole: Estimate the risk of the project and use the CAPM to determine the appropriate required rate of return Points against the CAPM: o The slope of the line has been flat over the years. APT: the rate of return on a security is a linear function of k factors r = a + b1 (rfactor1) + b2 (r factor2) + . The true market PF cannot be formed. Now. o Returns in the recent years are related to other measures.. o The CAPM cannot be tested. the line is called the security market line. firm size and marketto-book ratio. ==> CAPM If you graph this. empirically.e. because all can do better with this combination of the risk-free asset and the PF. (Rearrange the formulas and solve for E(ri). investors will choose to hold this and allocate the rest of his endowment in a risky portfolio that lies in the efficient set. Use of the CAPM for valuation: o Risk-adjusted rate of return valuation instead of a discount rate without risk considerations o Certainty equivalent valuation: instead of adding the risk premium to the discount factor. + noise A diversified PF constructed to have 0 sensitivity (b1 = b2 = 0 ) is risk-free and should be priced to offer rf. market risk. Defense: CAPM deals with expected returns and not actual returns. reduce the expected CFs by the risk premium. Still. investors do require extra returns for taking on risk. e. Note that the slope is [E(rm) . It graphs the required rate of return on any asset. and are concerned principally with those risks that cannot be eliminated by diversification. i. A PF constructed to have an exposure to factor 1 will offer a risk premium that varies proportionally with the sensitivity to that factor.g. Defense: That is a long-term consideration.d.. No other investor will invest in another PF. which we will designate as M. given the risk-free asset and M.

The standard error thereby is smaller. divestitures and other investment policy decisions. consider cyclicality and operating leverage (fixed production charges that add to the beta of a project) Note that beta is assumed to be constant throughout a project's life. Reasons: § most projects can be treated as "average" projects § the company cost of capital is a useful starting point for unusually risky projects as compared to estimating each project's cost of capital from scratch. it may be wise to use probability point masses for possible CFs and separately calculate their NPVs while weighting them to come up with the total NPV. spinoffs. 20) Note: rf is used here (risk-neutral valuation). In determining the asset beta. In the estimation of the beta of a project: o look for similar companies (But what does "similar" mean?. This can also shift over time. warrants and abandonment decisions. because if past price changes could be used to predict future price changes. valuation of M&As. Weak: Prices reflect the information contained in the record of past prices. beta = slope of the line that regresses the rates of return against the market rates o take PF betas or industry betas that are market-value weighted. All the information in past prices will be reflected in today's stock price and not tomorrow's. Puzzles and Anomalies o High returns of small firms: Where does the growth come from? Coincidence or CAPM error? Exception to the theory? o Short-term behavior of stock prices: January effect.. (More in Ch. In competitive markets. analysis of convertible debts.. • Chapter 13: Corporate Financing and the 6 Lessons of Market Efficiency • Three Forms of Market Efficiency 1. Chapter 9: Capital Budgeting and Risk • The company cost of capital is the correct discount rate for projects that have the same risk as the company's existing business but not for those projects that are riskier or safer than the company's average. Monday effect o New issues: subsequent losses o Earnings announcement puzzle: outperformance for stocks of companies boding good news • . such easy profits will not last.) o look at how the stock price has responded to market movements in the past. It makes sense to use a single risk-adjusted discount rate for as long as the project has the same market risk at each point of its life. Semi-strong: Past prices plus all other published information 3.• o easily extended to a multi-period context o no special role for M OPM: can also be applied for the valuation of equity (call option) and debt (put option) Other extensions: determination of dividend policy. Stock prices follow a random walk. Strong: All the information that can be acquired by painstaking analysis of the company and the economy. then investors could make easy profits. capital structure considerations. o set the project beta equal to the asset beta. Later CFs are thereby subjected to a higher discounting because they are subjected to a longer market risk horizon. To account for varying risk across time. 2.

5. will not trick investors to think that they are better off. Debt: funded/unfunded debt. everybody will scramble to buy. 2. Retained earnings are additional capital invested by shareholders and represent in effect a compulsory issue of shares. Do it yourself Do not pay others to do things you can do. Convertible securities: Warrants. But this could not be proven to be a long-term phenomenon. convertible bonds (Chapter 22) • • . 3. Overview of Corporate Financing 1. Chapter 14 & 15: An Overview of Corporate Financing • On average. There is no God-given. Stock splits. new fundamental information to justify it 6 Lessons of Market Efficiency 1. Are managers simply taking the line of least resistance and avoiding the "discipline of security markets"? Are they avoiding the costs of new issuances? Is the announcement of a new equity issue considered to be bad news? Recently. subordinated debt. This does not affect the opportunity cost of capital in the same way as when a project is financed by depreciation or a new stock issue. This could possibly reflect an unjustified reluctance to undertake projects that require external financing. Read the entrails If prices impound all available information. Trust market prices They impound all available information. identify whether there are abnormal returns or extract the indications of summative investor opinion for prices. There is no way for most investors to achieve consistently superior rates of return. If returns are high. seen it all Demand for stocks should be highly elastic.. as well as accounting changes. But it need not follow that less risk is better. correct debt ratio. 4. firms have issued more debt than equity. Markets have no memory The weak form of efficiency states that the sequence of past price changes contains no information about future price changes. public/privately placed debt 4. e. secured/unsecured debt. nobody will hold it. then learn how to abstract these information. Common stock: issued and outstanding. stock dividends. If returns are too low. Higher debt ratios mean that more companies will fall into financial distress if there will be a recession.• o October 1987 crash: Prices fell sharply even though there was no obvious. issued and not outstanding (repurchased shares) Costs of new issues: § Administrative costs § Underwriting costs (+ underpricing costs) New issuance procedure: § Fixed price offer § Auctions 2. Preferred stock: relatively rare but useful in financing mergers: offers a fixed dividend and priority over common stockholders 3. 6.g. Seen one stock. internal funds make up the bulk of company funds. There are no financial illusions Investors are concerned with the firm's CFs and their portion thereof.

Investors can distinguish real money makers from marginally profitable firms through an analysis of dividend policy. This capital loss is borne by the shareholders. then it is B/M Labhart C/W B/M Labhart C/W Labhart C/W B/M . dividend payouts and capital losses merely offset each other. If for instance a company reports good earnings and simultaneously pays generous dividends. keine Transaktionskosten o keine Steuern Given that there are no taxes. Thus. Derivatives: § Options: Instruments with the right to buy/sell an asset in the future at a price agreed upon today § Futures: Advanced orders to buy/sell an asset at a fixed price to be paid at the delivery date § Forwards: Futures contracts not traded in an exchange. it should not matter to investors how high dividends are. for hedging o Reduction of costs Points to Note: o There are economies of scale in issuing securities.g. Dividenden signalisieren zukünftige Unternehmensperformance. inefficiencies or whether stockholders are fully rational. Knowing this. Miller/Modigliani 1963) The best form of payment to shareholders is the one subject to least taxation.. Meanwhile. (e.h. (e. d. Dividendenpolitik hat keinen Einfluss auf den Unternehmenswert. esp. usually on foreign exchange § Swaps: Entail an exchange of payment obligations: currency or interest rate Causes of innovation: o Taxes and regulation (avoidance) o To widen investor choice. this means that the firm will have to give up capital. Miller/Modigliani 1961) Annahmen: o perfekte Kapitalmärkte. 2. Thus. the firm can choose any dividend policy without affecting the stream of CFs received by shareholders..g. The dividend per se does not affect the value of the firm. o New issues may depress the price. firms ought not worry about dividend policy. two firms that are identical in every respect except for their dividend payout should have the same value. 3. When there are dividend payouts. But it serves as a message from management that the firm is anticipated to do better. There are worries that they will end up paying for overpriced issues. Aktionäre haben eine Präferenz für Dividenden. As long as the tax rate on capital gains is lesser than the personal tax rate.• • 5. shareholders will prefer capital gains to dividends. Drei Denkansätze 1. o Underpricing is a hidden cost for the existing shareholders o The winner's curse: Would-be investors in an IPO do not know how other investors will value the stock. Dividenden haben einen Steuernachteil. information asymmetry or transaction costs. Chapter 16 : The Dividend Controversy • • The dividend controversy boils down to arguments about imperfections.

usw. Share repurchases relay the information that the firm has accumulated more cash that they can invest profitably. Banken mit gesetzlichen Eigenmittelregelungen) o Unternehmensspezifische Charakteristika (KMU. Es empfiehlt sich i. o Agency-Aspekte: Dividendenzahlungen sind eine Art externe Kontrollgrösse. stock prices rise after stock repurchase announcements.bzw. B/M Dividends may take on other forms: automatic reinvestment plans.und risikopolitischen Entscheidungsfindung zusammen. No complete satisfactory theory has been found for the existence of an optimal B/M C/W . familiengebundenen Gesellschaften: kein generell zutreffendes theoretisches Handlungskonzept. Finanzmarktpraxis. the advantage is that this is only one-time. but pretence cannot last long.) o Aktionärsstruktur und privates Vermögen (Mehrheiten und Minderheiten. Kapitalmarktbezug. share repurchases. eine stabile Dividendenpolitik. und der Abfluss verfügbarer Mittel reduziert die Gefahr von Fehlinvestitionen seitens des Managements o Signalling-Effekte: Gesellschaften können mit DividendensatzErhöhungen positive Signale aussenden.• • • truly profitable. Die Dividendenpolitik fällt direkt mit der investitions. personen.) Chapter 17 &18: Does Debt Policy Matter?/How Much Should a Firm Borrow? • The manager has to find the combination of securities that maximizes the value of the firm or that maximizes shareholder value. Irrelevanz der Dividendenpolitik wie oben dargestellt.B.) Rahmenbedingungen der Dividendenpolitik: o Nationale Gegebenheiten (Handelsrecht. (For firms. whereas dividend payout is continual.und Konsumpräferenzen. Aus steuerlicher Sicht wären unter den heutigen Umständen eher zurückhaltende Ausschüttungen angebracht.. Für reine Publikumsgesellschaften: Relevanz vs. Volkart etc. usw. Repurchases could signal good future prospects. They can also be taken to mean that the company will not simply waste money.) Für kleine. AGs. It can also mean that the firm wishes to increase its debt percentage levels. Empirically. Für Eigenkapitalknappe KMU: Berücksichtigung der Kapitalstrukturpolitik und Risikopolitik in Kombination mit den aktionärsseitigen Einkommens. stock splits. (You lose your clients because of the imposed transaction costs. Steuerrecht. These are not really good news. but investors find this good (more often than not).d. Familienstruktur. Änderungen führen zu Transaktionskosten und der sogenannter „clientele effect“. Dividend policy could affect firm value when investors prefer high payouts and are reluctant to invest in firms that finance mainly through retained earnings. Firms could possibly pretend this. non-cash dividends. Höhe der Ausschüttungen: (Faktoren) o Aktionärspräferenzen: Aktionäre in tieferen Einkommensklassen ziehen Volkart tendenziell höhere Dividenden vor.R. Cash is required for that.) o Branchenbesonderheiten (z. In der Praxis dominiert konstante Dividendenauszahlungen gegen der gewinnabhängigen Auszahlungen.

But MM I does not hold in practice. two firms that offer the same stream of operating income and differ only in their capital structure must have the same cost. Assumptions: o perfekte Kapitalmärkte. It is wrong to think of debt as such. Firm value is in this case determined by the left side of the balance sheet (i. d. As long as investors can borrow/lend on their account on the same terms as the firm.e. o Tax shields can only be used when there are future profits to shield. two investments that offer the same payoff must have the same cost. they can “undo” the effect of any changes in the firm’s capital structure. As proposed by value additivity. Casual empiricism suggests that firms behave as though it exists. then there must also be a target debt/equity ratio. Financial managers do worry about debt policy: o Taxes play a role. Any combination of securities is as good as another. V L = V U + τc B B/M C/W B/M B/M C/W B/M New assumptions: corporate tax. real assets) and not by how much debt and how much equity there are. i. If there is a target dividend payout.• • capital structure. the value of an unlevered firm must equal the value of the levered firm. o Many firms face marginal tax rates less than 35%. Thus. the market value of the corporation can increase as it takes on more and more debt. No firm can absolutely be sure of that. no personal tax If the government allows the deduction of interest payments on debt as an expense. Thus. then the firm should ideally take on 100% debt. the value of a firm can be segregated into the corresponding PVs of the components. Therefore.e. o There are conflicts of interest between the firm’s security holders. But MM Proposition II is an extreme proposition. The value of the firm is unaffected by its choice of capital structure. . Miller/Modigliani II: The value of the levered firm is equal to the value of the unlevered firm plus the present value of the tax shield provided by the debt. Law of conservation of value: The value of an asset is preserved regardless of the nature of the claims against it. Miller/Modigliani I: Financing decisions do not matter. the gain from leverage. This is wrong because: o It will appear that debt is fixed and perpetual... keine Transaktionskosten o keine Steuern o same borrowing and lending rate o no bankruptcy costs o no agency costs o only two types of claims: debt and equity o all firms of the same risk class In well-functioning markets. debt policy should not matter. o Bankruptcy is painful.h. o There are incentive effects of financial leverage on management’s investment and dividend payout decisions. If the PV of the tax shield C/W increases the after-tax value of the firm.

There are other ways to shield income against tax. Low target ratios are expected from companies with risky. In the end. Firms incur for example bankruptcy costs. debt. There is a tradeoff between tax shields and costs of financial distress. This is also evident in Myer’s pecking order theory. This includes the personal taxes paid. whose investment opportunities outrun internally generated funds are driven to borrow. the shareholders’ required rate of return also increases. Given corporate and personal taxes: The firm should arrange its capital structure so as to maximize after-tax income. Corporate tax shields from debt are worth more to some firms than to others.. Managers convey information to the market through their financial policy decisions. although not to the degree predicted by Proposition II. Moreover: Tradeoff theory of capital structure: Costs of financial distress matter. VL= VU + PV(tax shield) – PV (costs of financial distress) The theoretical optimum of debt is reached when: PV(tax savings due to additional borrowing) = increases in the PV(costs of distress) Thus. the probability of bankruptcy increases. WACC must be minimized. and thus. As the proportion of debt is increased. intangible assets. The attraction of tax shields is second-order. Firms with plenty of non-interest tax shields and uncertain prospects should borrow less than consistently profitable firms with lots of taxable income to shield. There is no well-defined target ratio. by means of write-offs. Hence. the optimal capital structure results from a consideration of the required rate of return of debt claims. tangible assets and plenty of taxable income to shield. On the other hand. Extreme levels of debt are also inadvisable because of the risk/return tradeoff. High ratios are expected from companies with safe. The value of the firm will be lower than the discounted expected CFs.• • • • • • • • o There are other factors that offset the PV of the tax shield. firms. Pecking order theory: Retained earnings.g. Signals cannot be mimicked by unsuccessful firms. A moderate degree of financial leverage may increase the expected equity return. Another factor leading to the violation of M/M II: government manipulations Signalling Hypothesis: There is a projected optimal capital structure. Asymmetric information affects the choice between internal and external financing and between new issues of debt and equity securities. There is an optimal capital structure that minimizes agency costs. It should try to minimize the PV of all tax paid on corporate income. Effect of bankruptcy costs: If there are bankruptcy costs. equity. That includes changes in capital structure and dividend policy. Any increase in expected returns is offset by an increase in risk. Imperfections make borrowing costly and inconvenient. Highly profitable firms with limited investment opportunities are the ones with low debt ratios. Effect of agency costs: There is a trade-off between tax shield benefits and agency costs. “Traditional” position: The objective is not just to maximize overall market value but also to minimize WACC. e. target debt ratios may vary from firm to firm. then payments must be made to third parties other than bond and shareholders. B/M B/M B/M B/M .

as well as the business risk of the firm. Add or subtract the PV of side effects. except when such is only temporary. it is quite difficult or impossible to get the discounted value by first valuing its assets via interest income less administrative expenses and then subtracting the PV of the deposit business. is then difficult to estimate. the entity approach is difficult to use. For banks. C/K/M B/M . the formula will give the right discount rate only for projects. interest expenses. which are main sources of financing. Still another problem is the fact that the spread between the interest received on loans and the cost of capital is so low. If the company’s debt ratio is stable. costs of issuance. given consistent assumptions. check clearing and tellers) is lower than the cost of raising an equivalent amount of funds with equal risk in the open market. Under the equity approach. whose cost of capital is just like that of the firm. because it treats liabilities management as part of the business operations. Small errors in estimating the cost of capital can result in huge swings in the calculated value of equity. Discounting CFs at the WACC and calculating the APV will give nearly identical answers. This implies that the debt ratio is expected to be relatively stable. since the tax advantages of debt financing are accounted for.g. Equity Approach: The entity approach entails discounting the CFs by the chosen company WACC formula. on the financial risk. as the retail bank division is legitimately a separate business. the CFs are discounted at the cost of equity (after interest and after taxes). If financial leverage will change significantly. Adjusted Present Value (APV): APV is useful when side effects (e. Thus. On the other hand. the equity approach is the ideal method for valuation purposes. the method should give the same answer as discounting at the WACC and subtracting debt. interest tax shields. When there are more than two sources of financing: WACCn = k FK (1 − s)FK + k EK EK + k PS PS FK +EK + PS B/M B/M B/M • • • • Note further that only long-term financing is considered in WACC.g. Value the project as if it were a firm financed solely by equity. But this depends on the financial leverage. discounting flows to equity at the cost of equity will not give the right answer..Chapter 19: Financing and Valuation • Weight-Adjusted Capital Cost (WACC) Formula k FK + k EK EK Grundformel: WACC = FK FK +EK Skript Berücksichtigung von Ertragssteuern: WACCs = k FK (1 − s)FK + k EK EK FK +EK Note: WACCs < WACC. All the variables in the WACC applies to the entire firm. A positive spread that creates value for shareholders comes when the cost of issuing deposits (e. and government subsidized loans tied to the project) are relevant. that is. Leaving out the cost of short-term debt is actually incorrect. Entity Approach vs. seasonal or incidental short-term financing. This is because the bank creates value on the liabilities side of its balance sheet.. because the cost of capital for non-interest-bearing customer deposits. Moreover. The equity approach is appropriate.

can be valued as a mixture of simple options on that asset Option Value Boundaries: o Upper bound: Share price o Lower bound: Payoff When the stock is worthless. Check out at each node whether early exercise is good.• Adjusted Cost of Capital: This is an adjusted opportunity cost or hurdle rate that reflects the financing side effects of an investment project. Valuation via the step-bystep binomial method o American Puts (No Dividends): American Put > European Put. If you know the adjusted cost of capital.B. To value an option. 2.S. because early exercise reduces its value. They can take advantage of good fortune or mitigate loss. the option is worthless. B/M Chapter 20 & 21: Spotting and Valuing Options and Real Options • • Any set of contingent payoffs -. although the option is always riskier as the stock. discussed subsequently. set up a package of investments in the stock and a loan that will exactly replicate the payoffs of the option.that is. Examples of Real Options 1. the more probable is the exercise of the option. DCF will not work for options. Management can add value to assets by responding to changing circumstances. S = C + B .P Early Exercise of Options? o American Calls (No Dividends): Same as European call. The net cost of buying the equivalent must equal the value of the option. where N(d1) and Nd(2) are cumulative probabilities of the distribution of a standard unit variable Put-Call Parity: Value of Call + PV(K) = Value of Put + S C = P + S . P = C + B . we can also price the option. American Put – European Put <= PV(interest on K) It can sometimes pay to exercise early and receive interest. set up an option equivalent by combining common stock investment and borrowing. This is covered by the OPM. B/S applies o American Calls (W/ Dividends): If Div > interest on K. Valuation via the stepby-step binomial method. The delay in payment is valuable. because the risk of an option changes every time the stock price moves (and we know that it will move along a random walk through the option's lifetime).PV(K). General rule: The higher S is relative to K. The option to abandon • • • • • .B N(d2). The rule is: Accept projects with positive NPVs at the adjusted cost of capital. C= S N(d1) . DCF misses on this extra value. the safer the option. If we can price S and B. The option to follow-on investment opportunities The true value of a project could be the DCF value + the value of the option to expand. It thus neglects the value of management. you do not have to calculate the APV. When S increases. Investors. the option price = S . The higher S is. The option's risk changes every time the stock price changes. Black/Scholes Formula: In pricing any option. if interest rates are high and the option has a long maturity. are buying on credit. payoffs which depend the value of some other asset -. o Forecasting expected CFs is messy although feasible o Finding the opportunity cost of capital is impossible. Use NPV and discount at the adjusted cost of capital. who acquire stock by way of a call option.

The option to vary the firm's output or production methods (flexible production facilities) A firm will be granted the option of exchanging one risky asset for another. when DIV > interest on K) 3. 3. Thus the owner owns a bond and a call option on the firm's stock. Valuation of real options: Black/Scholes. This double does not have to exist. Usually: § included in a large private placement bond or in a small public issue § sometimes with issues of common or preferred stock § also given to investment bankers as compensation for underwriting services or used to compensate creditors in case of bankruptcy § no right to vote or to receive dividends 2. ==> dilution Modifications are necessary to the B/S formula in valuing the warrant. when with dividends. no dividends § Step-by-step binomial method. It is thus like a call option. exercise means that the firm's assets and profits would be spread over a large number of shares. What it is: an option whereby the owner can purchase a set number of shares at a set price before the set date. it may pay to convert before maturity. What it is: The option to exchange the bond for a predetermined number of shares. (Early exercise. who will simply exercise or not exercise. At maturity. the conversion value serves as the lower bound.) Convertible Bond: 1. Effects of the Exercise of Warrants: The exercise of warrants increases the number of shares. (But such is not needed by the holder. 4. who could employ either the arbitrage or risk-neutral method. It is enough to know how it would be valued by investors. Therefore. To value a convertible. Chapter 22: Warrants and Convertibles • Warrant: 1. If dividends are higher than the interest on bonds. Not all can be easily replicated but approximations by some simple assets and options may be worth it. the success of an investment in a positive NPV project depends on the timing. when no unusual features. Effects of the Conversion: • . it is then easiest to break the convertible bond into two parts: the bond value and the value of the conversion option. powerful framework for describing complex decision trees.. look out for dilution and the fact that the convertible owner is missing out on the dividends on the stock.• Value of project = DCF value + the value of the abandonment put 3. Valuation § B/S Formula. Valuation: Two lower boundaries! The lower bound to the price of a convertible before maturity is the higher of the bond value and conversion value. To value the conversion option. if not binomial method Option theory gives a simple. An opportunity to postpone investments could be summarized as an "American call on a perpetuity with a constant dividend yield". The timing option In the face of uncertainty. What would investors pay for a real option based on the project? The same as for an identical traded option written on a double. 2..

Low coupon bonds This may be convenient for rapidly growing firms facing heavy capital expenditures. Contingent equity A convertible bond that is callable is like a contingent issue of equity. they do not pay cash. The only reason for an upward-sloping term structure is that investors . 2. Thus. the result will be equivalent to selling stock at a premium rather than at a discount. If the forward rate were less than the expected future spot rate. provided that the investors are interested only in expected return.) 5. 4. allowing the financial manager to call back and force conversion of the bond into equity.• • Conversion has no effect on the total value of the firm's assets. Cash inflow/Better than fresh equity A company that wishes to sell common stock must usually offer the new stocks at 10% to 20% below the market price for the flotation to be a success. the company gets fresh equity when it is most needed for expansion. Warrants may be issued on their own. If options are properly priced. its stock price is likely to increase. exercisable at 20 to 50% above the market price. the proceeds from their sale will become a clear profit for the company! Options can also be considered as valuable securities. When the owners of the convertible bond wish to exercise the option to buy shares. 2. The difference between warrants and convertibles: 1. 4. Chapter 23: Valuing Debt • Important factor: the discount rate Things to consider: o Consistent treatment of inflation o Term structure of interest rates (graphs the relationship between short-term and long-term rates of interest. Its market value is hinged on the stock price tomorrow. if warrants are sold for cash. 3. but it does affect how asset value is distributed among the different classes of security holders. Costly risk assessment Convertible bonds and warrants make sense whenever it is unusually costly to assess the risk of debt 3. However. Agency Costs Bondholders may be worried that management will not act in the bondholders' interest. They just give up the bond. Warrants can be detached. plots a series of spot rates over time) Theories: § Expectations Theory f2 = E(1r2) Forward rates of interest must equal expected future spot rates. (But it will be stuck with debt. If the warrants are never exercised. Taxation: warrants may reduce the tax paid by the issuing company and increase the tax paid by the investor. this will be a fair trade. if the company does not prosper. no one would be willing to hold two-year bonds. 5. If a company's investment opportunities expand. Warrants are usually issued privately. despite the risk and time value involved. which could be favorable. Why do companies issue warrants and convertibles? 1.

vola = duration / (1 + yield) o Probability of default: The reason why some borrowers have to pay a higher rate of interest than others. What about other risk factors?) § New Theories Price movements are related with each other (based on observations that returns on bonds with different maturities tend to move together) short rates are high ==> long-term rates are high short rates are low ==> long-term rates are low o Yield-to-maturity (a single rate of discount that would produce the same PV as that when each of the payments are discounted at different rates of interest) Problems with YTM: § The same rate is used to discount all payments to the bondholder. Calculate the put value. § It is a complicated average of spot rates. o Volatility: summary measure of the likely effect of a change in interest rates on the bond value. 2... (But the uncertainty here only comes from inflation. This is normally depicted in bond ratings. § Yields to maturity do not determine bond prices. When a firm defaults.) § Liquidity Preference The term structure is more often than not upward sloping because of the required liquidity premium. § Returns calculated do not add up.g. earnings-to-interest ratio. which is the difference between forward rates and expected future spot rates. Calculate the bond value assuming no default. It is related to duration. The key figures for the determination of the bond rating includes the following: debt-equity ratio. (This does not say anything about risk. e. . § Inflation Theory Borrowers must offer some incentive if they want investors to lend long.• expect future spot rates to be higher than current spot rates and vice versa. It is the other way around. Since bond ratings reflect the probability of default. ROA.. which are judgments about firms' financial and business prospects.. No one can make a completely risk-free investment.P Two-step bond valuation: 1. o Duration: average time to each payment A firm can ensure that the value of the bonds held is always sufficient to meet the liabilities by making sure that the duration of the bonds is always the same as the duration of the pension liability. Discount the promised interest payments and the principal at the rates offered by Treasury issues. B = bond value with no default . Bond Valuation as an Option: o A corporate bond = lending money with no chance of default but at the same time giving the stockholders a put option on the firm's assets.. there is a close correlation between the bond rating and the promised yield. that is. It hides much interesting info. f2>E(1r2)! This is because future inflation rates are never known with certainty. The bondholder may actually demand different rates of return for different periods. its stockholders are in effect exercising their put.

Standardization leads to low administrative and transactions costs. Insurance deals may however not have 0-NPVs because of the costs that the insurance company incurs.discounted summation of lease CFs Not a zero-sum game: Both the lessor and the lessee can "win" if their tax rates differ. Chapter 25: Leasing • Lease = a rental agreement on a series of payments that extends for a year or more. K = promised payment to bondholders o A corporate bond = owning the firm's assets but giving a call option on the assets to the stockholders. 4. B = asset value . but a lower immediate inflow. It is an alternative to buying capital equipment. If you can devise a borrowing plan that provides the same future cash outflows as the lease but a higher immediate CF. A financial lease is superior to buying and borrowing if the financing provided by the lease exceeds the financing generated by the loan. Hedging: . o The interest rate is high. 3. then you should not lease. Tax shields can be used. Valuation of a lease: Construct a table showing the equivalent loan (difficult) or discount the lease CFs at the after-tax interest rate that the firm would pay on an equivalent loan. 2. then leasing is the better choice. However. 5. o The lease period is long and the lease payments are concentrated toward the end of the period.C ==> If you can value puts and calls on a firm's assets. the decision centers on "lease vs. you can value its debt. For operational leases. • • • • Chapter 26: Managing Risk • • Insurance and hedging are at best 0-NPV transactions. borrow". Chapter 24: The Many Different Kinds of Debt See Volkart Skript. buy". Cancellation options are available. The aim is risk reduction. If it were 0. For financial leases. The highest gains are achieved when: o The lessor's tax rate is substantially higher as the lessee's. Maintenance is provided. Net value of lease = initial financing provided . Why lease? 1. o The depreciation tax shield is received early in the lease period.Note that the maturity of the put equals the maturity equals the maturity of the bond. there would be no advantage to postponing tax in PV terms. the decision centers on "lease vs. Short-term leases are convenient. if the equivalent loan provides the same future cash outflows as the lease.

• • o Futures: A commitment to buy/sell an asset/commodity in a standardized market at a future time. A company that covers its forex commitments does not pay extra for this insurance. A margin is normally put up. o Equal real interest rates o Expectations theory of forward rates: On the average. for example. How to set up a hedge: Expected change in value of A = a + δ(change in value of B) δ measures the sensitivity of A to changes in the value of B ==> hedge ratio: the number of units of B which should be sold to hedge the purchase of A. Financial assets: PV(futures) = Futures price/(1 + rf) = spot price .PV(convenience yield) o Forwards: Unstandardized futures o Swaps: Currency swaps. o The cost of forward cover is not the difference between the forward rate and today's spot rate. Note: Option deltas change as the stock price changes and time passes. Advantage: You can gain interest on the still unpaid price Disadvantage: You miss out on the dividend paid in the meantime. This is equal to calculating the CFs in SFR and discounting this at the SFR cost of capital. hedge by either selling a forward or borrowing forex and selling spot. optionbased hedges need to be adjusted frequently. Therefore. default swap (credit derivative). o On the basis of interest rate parity. Exchange risk and international investment decisions: If Roche. the forward rate is equal to the future spot rate. it is assuming that the currency risk is hedged. It is the difference between the forward rate and the expected spot rate when the forward contract matures. while fixing the price today. One minimizes risk by offsetting the position in A by selling delta units of B. • • . Options can thus be used for hedging. interest rate swaps.PV(dividends or interest payments forgone) Commodities: PV(futures) = Futures price/(1 + rf) = spot price + PV(storage costs) . ignores currency risk and discounts the dollar CFs at a dollar cost of capital for its US investments. Any change in the value of the stock position can be offset by a change in the value of the option position. o The expectations theory suggests that protection against FX risk is usually worth having. Another method: via duration and PVs (matching assets and liabilities) The option delta: summarizes the link between the option and the asset. Assumptions: o A is owned o Percentage changes in the value of A follow the specified relationship The question is: How is the hedge ratio determined? Historical data may help. and the value is marked to market. Chapter 27: Managing International Risk • Points to consider: o Interest rate parity theory: Money can otherwise be easily moved. o Purchasing power parity Practical Implications: o Use forward rates to adjust for FX risk in contract pricing.

§ Quick ratio (acid test) = (cash + short-term securities + receivables)/current liabilities Idea: Some assets are closer to cash than others. Efficiency Ratios: indicate how productively the company is using its assets § Sales-to-Assets Ratio (Asset Turnover) = sales/average total assets ==> how hard are the firm's assets being used? A high ratio means that the firm is working close to capacity. the net working capital is not affected by short-term financial decisions and yet the current ratio changes. It does not probably matter much. the number of days that it takes for the goods to be produced and sold A low level of inventories is often regarded as a sign of efficiency. Leverage Ratios: show how heavily the company is in debt § Debt ratio = (long-term debt + value of leases)/(long-term debt + value of leases + equity) ==> ratio of long-term debt to long-term capital § Debt-equity ratio = (long-term debt + value of leases)/equity The abovementioned ratios use book rather than market values. § Cash ratio = (cash + short-term securities)/current liabilities Only the most liquid assets Note: None of the standard liquidity measures takes the firm's reserve borrowing power into account. They assist in asking the right questions but seldom answer them. 4. It may be difficult to generate further business without an increase in invested capital. and these are not readily saleable. Liquidity Ratios: measure how easily the company can lay its hands on cash § Current ratio = current assets/current liabilities ==> measures the margin liquidity Rapid decreases in the current ratio sometimes signify trouble. Profitability Ratios: show the returns that the firm earns from investments § Net Profit Margin = (EBIT . However. they can be misleading. 1. § Time-Interest-Earned (Interest Cover) = (EBIT + depreciation)/interest ==> The extent to which interest is covered by EBIT plus depreciation Rationale: Regular interest payment is a hurdle that companies must duly face up to. For this ==> the proportion of sales that finds its way into profits . [Inventory Turnover = cost of goods sold/average inventory] § Average Collection Period = average receivables/(sales/365) ==> how quickly do cusotmers pay their bills A low ratio indicates an efficient collection department but could mean an unduly restrictive credit policy. At times. 3. But it may indicate simply that the firm is living from hand to mouth. Market values are often not available. it may be good to take away short-term investments and debt. Lenders however look into liquidity ratios because of their reliability as against book values. 2.Chapter 28: Financial Analysis and Planning • Financial ratios: a convenient way to summarize large quantities of financial data and to compare firms' performances. because market values include the value of intangible assets. § Days in Inventory = average inventory/(cost of goods sold/365) ==> the speed with which a company turns over its inventory.

§ Market-to-Book ratio = Stock price/Book value per share [Book value per share = stockholders' book equity (net worth)/number of outstanding shares] [Book equity = common stock + retained earnings] ==> how much is the firm worth in comparison to what the past and present shareholders have put into it § Tobin's q = market value of assets/estimated replacement cost ~ market-to-book ratio. The difference is that the numerator includes all debt and equity securities and the denominator includes all assets. but as ask: if there is a high ROA. short-term leases) o Pensions o Derivatives o Foreign accounting practices Examples on the use of financial ratios: 1. It may be cheaper to acquire assets through mergers when q < 1.• • Return on Assets = (EBIT .tax)/average total assets (or ROI) ROE = earnings available for common stockholders/average equity § Payout Ratio = Dividends/Earnings ==> the proportion of earnings that is paid out as dividends 5. capital equipment > cost of replacement.e. is the firm charging excessive prices? § . This could however also mean temporarily low earnings. The shareholders do the same and welcome high ROAs. There is an incentive to invest when q > 1. The lenders are interested in bond quality. Market Value Ratios: show how highly the firm is valued by investors § P/E ratio = Stock price/EPS ==> measures the price that investors are prepared to pay for each dollar earnings High P/E ratios: investors think that the firm has good growth opportunities or its earnings are relatively safe and therefore more valuable. § Dividend yield = Dividend per share/stock price ==> the expected dividend as a proportion of the stock price Low dividend yield: investors are content with a relatively low rate of return or are expecting rapid growth in dividends that could bring in capital gains. Accounting Definitions: Things to think about when interpreting financial ratios: o Depreciation and deferred tax o Intangible assets (expenditures that create valuable assets that may generate future CFs) o Goodwill o Off-balance sheet debts (esp. The rating agencies look at the creditworthiness of the firm and their ability to service new debt. 2. He thus looks at the debt ratio and times-interest-earned ratios. Consumer groups and regulators do likewise. They then also look at leverage ratios. i. They also look at the leverage ratios.. Review of operations to identify which activities should be shut down or expanded: The manager looks at the ROA of each business. Bond issuance: The financial manager looks into the prudence of new borrowings and whether the leverage is within the standard practice levels.

This is because they are easily reversed. is hence when: marginal reduction in order cost = marginal carrying cost This formula could be carried over to the choice between T-bills or cash. Unsecured bank borrowing 2. The cumulative capital requirement -. The financial manager's task is to forecast future sources and uses of cash Cash budgeting: Inflows and outflows Short-term financing plan: developed by trial and error Alternatives for short-term financing: 1. Short-term capital comes in when the firm must make up for the difference between cumulative capital requirements and long-term financing. The marginal value of this liquidity = marginal value of the interest on an equivalent investment in T-bills A sensible balance has to be found for the proportion wealth held in cash and in securities. Essential points in cash management: o Trade-off between the benefits and costs of liquidity o Making sure that the collection and disbursement of cash is efficient Cash vs. Stretching payables . given order costs. The optimal order size. The relationship is per Baumol: Q = square root of [(2*annual cash disbursement*cost of selling T-bills)/interest rate] • • . accounts receivable • Steps: 1. Chapter 29: Short-Term Financial Planning • • Short-term financial decisions involve short-lived assets and liabilities.the total cost of assets -.3. "accounting betas" may also be calculated. surplus cash can be allotted for short-term investments. Inventory: Miller/Orr Model Inventories have carrying costs. If long-term capital is overflowing. Fix terms of sale 2. By means of financial ratios.defer payment of bills (often costly because discount for early payments are missed) • • Chapter 30: Credit Management ==> management of accounts payable. This can help in predicting bond ratings.should be financed by either long-term or short-term financing. Which customer should be offered credit? Credit analysis: o ratings agency indications o financial ratio analysis o numerical credit scoring: decisions to grant credit are made on the basis of a scoring system • Chapter 31: Cash Management • Cash is held for liquidity. This is the sensitivity of each company's earnings to changes in the aggregate earnings of all companies. The financial manager does not have to look far into the future. Decide whether to sell an open account or ask customers to sign IOUs 3.

91/360 * 4.) Yield: o Many are pure discount securities (no interest). Types: o Horizontal merger: same line of business o Cross border: in two different countries o Vertical merger: companies at different stages of production o Conglomerate merger: unrelated lines of business Motives: o Economies of scale (horizontal mergers) o Economies of vertical integration (vertical mergers) o Complementary resources o Unused tax shields o Surplus funds o Elimination of inefficiencies. Large corporations may have literally hundreds of accounts. Price of a 91-day bill = 100 .36 = 98. This is due to the risk of default on commercial paper. (Such can be forecasted. because: o the range of possible outcomes is smaller o only well-established companies borrow in the money market. T-bills can be easily turned to cash on short notice. Cash may be left in non-interest bearing accounts to compensate banks for the services they provide. (Nevertheless. as well as the different degrees of liquidity. the firm should hold smaller average cash balances and make smaller and more frequent sales of T-bills. rates are often quoted on a discount basis 2. o It is difficult to find out the yield of money market securities: 1. (Why many accounts? . there are often significant differences in yield between corporate and government securities. 2. the danger of default is less.• If interest rates are high.898 Given that the face value = 100 and it is selling at a discount of 4. The return consists of the difference between the amount you pay and the amount you receive at maturity. it should hold larger cash balances. usually quoted on a 360-day year Ex. • Chapter 33: Mergers • • A merger adds value only if the two companies are worth more together than apart. only one group is elected every year • • . Two reasons for holding significant amounts of cash: 1. better management (not essentially out of the benefit of combining two firms) Takeover Battles and Tactics: o Shark-repellent charter amendments: § Staggered board: 3 groups.decentralized management) Chapter 32: Short-Term Lending and Borrowing • • Short-term lending: in the money market Valuation: In general.) It highlights the basic trade-off that the cash manager needs to make between the fixed cost of selling securities and the carrying costs of holding cash balances. (low Q) If the firm uses up cash at a high rate or incurs high costs in securities.36%. It is often better to leave idle cash in some of these accounts than to monitor them daily and make daily transfers. (high Q) Note: This does not consider net inflow of cash vis-à-vis net outflows.

but shares are sold in a public offering. it is easier to see the value and performance of managers. o good news for investors: funds will not be siphoned to unprofitable businesses. its shares will no longer trade in the open market. partly corporate control and corporate governance plus legal form. independent company created by detaching part of a parent company's assets and operations o not taxed so long as shareholders in the parent are given at least 80% of the shares in the new company o management can concentrate on the spin-off's main activity. This is a focused firm.• Supermajority: 80% have to approve a merger Fair price: Mergers are allowed only when a fair price is paid. Financial architecture: the financial organization of a business. (It is held by a partnership of usually institutional investors. Moreover. subject to corporate tax Privatization: a sale of a government-owned company to private investors Motives: increased efficiency. revenue for the government Conglomerates: o Pros: § Good managers could effectively manage firms involving many business areas and take advantage of complementarities. sources of financing. It entails the mechanisms by which managers are led to act in the interest of the shareholders.Anti-trust o Asset restructuring o Liability restructuring § § § Chapter 34: Control. Carve-outs: like spin-offs. When this group is led by the company's management. ordinary acquisitions: o A large fraction of the purchase is debt-financed o The LBO goes private. Governance and Financial Architecture • • • Corporate control: the power to make investment and financing decisions Corporate governance: the role of the board of directors.) Motives of LBOs: o Junk bond markets . the acquisition is called a management buyout. proxy fights and other actions taken by shareholders to influence corporate decisions. § Possibility of an internal capital market o Cons: § It is not a real internal market. and relationships with financial institutions Where financial architecture differs. governance and control are different too. shareholder voting. Leveraged buyouts vs. • • • • • • .cheap financing o Leverage and taxes o Motivates managers to work harder Spin-off: o a new. etc. share ownership. Restricted voting rights: if they own more than a specified proportion of shares § Waiting period: passage of time before merger completion o Poison pills: Existing shareholders are given the right to purchase additional stocks at a bargain price o Poison put: Existing bondholders can demand repayment in a hostile takeover Post-Offer Defenses: o Litigation .

the largest companies and the group as a whole.• Shareholders can diversify better. a system of corporate governance where power is split between the main bank. Possibility that misallocations could just end up with a subtraction in value rather than an addition Keiretsu: a network of companies usually arranged around a bank. § § .

Sign up to vote on this title
UsefulNot useful

Master Your Semester with Scribd & The New York Times

Special offer for students: Only $4.99/month.

Master Your Semester with a Special Offer from Scribd & The New York Times

Cancel anytime.