Measuring Firm Output

A. Accounting
a. Historic Cost Principle
i. Assets are reported on accounting statements at cost acquired at some earlier point
1. Why? Mark value fluctuates
ii. Exceptions
1. Assets held for sale (inventory): value at lower of historical and market value (conservative
estimate)
2. Liquid assets held for sale: recorded at FMV
b. Reliability Principle
i. Anything in accounting should be verifiable from records of company
ii. Info must be reliableonly need to report material info
c. Economic Entity Principle
i. Include all the companys subsidiaries which includes economic reality of situation (consolidate
related companies); includes subsidiaries
d. Matching Income & Expense in Accounting Period (Accrual Accounting) (vs. Cash Method)
i. Income is earned and reflected in accounting statements when business has legal right to it,
regardless of whether its been paid
1. EX: sell something, buyer promises to pay next year, reflect now
ii. Expense is reflected when it is incurred, not when payment due
e. Transparency of Methods
i. Decision made should be reflected on accounting statements
ii. Methods you used should be disclosed and statements should be understandable
f. Consistency of Methods
i. Cant change accounting methods from one statement to next, same methods as others in inds.
g. Going Concern Assumption
i. Company is on-going entity: assume will keep going and not liquidate
h. Conservatism Principle
i. Accountant is supposed to use technique that will say income is lower: understate profits
i. Problem 2.1: Buy $100K dog with two $50K cats already owned.
i. Dont value dog on balance sheet because no arms-length transaction, need to look at market
value, not subjective personal value
ii. Need to know historic value of cats (issue if not market transaction)
iii. Conservatism: need to look at market value of cats, not just what purchased for (if more than
FMV)
B. Balance Sheet
a. Balance Sheet
i. Snapshot on a certain day of a companys financial position
ii. Assets = Liabilities + Equity
b. Assets
i. Listed in order of liquidity (quickness in which can be converted into cash)
ii. Current Assets + LT assets = total assets
1. Current: can be converted into cash within one year
a. Cash & equivalents, ST investments, receivables (decreased by allowance for
doubtful accounts), inventories, deferred income taxes (can be both an asset &
liability depending on different approach used), other current assets
2. Long-term: not expected to be converted to cash within one year
a. Property, plant, equipment [all at cost], land and improvement, buildings and
improvement, machinery, equipment
i. Less accumulated depreciation and amortization
1. Big difference between FMV and book value of depreciating assets
(non-current assets)
b. Goodwill and other intangible assets, net
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i. Arises when company purchases another for more than reported assets of
acquired company
ii. Goodwill can evaporate overtime, so must frequently evaluate (i.e. company
doesnt do as well as predicted)
c. Non-current marketable securities, deferred income taxes, other assets
c. Liabilities
i. Obligations to provide economic benefit to third party in the future
ii. Current Liabilities + LT liabilities = total liabilities
iii. Arranged in order of currency
1. Accounts payable usually first and taxes near the end
2. Listed before equity b/c liabilities are claims prior to those of SH in insolvency
iv. Current Liabilities
1. Current maturities on long-term debt; accounts payable; accrued liabilities; income taxes
currently payable
v. Non-Current Liabilities
1. LT debt, less current maturities; deferred income taxes: an asset that can be used to pay
taxes in future; other liabilities
vi. *Contingent Liabilities: disclosed in footnotes
1. If a contingency is probable and amount of charge can be reasonably estimated, company
must take a charge against earnings
2. Otherwise, not reflected b/c dont know amount
d. Shareholders Equity
i. SH Equity = Assets Liabilities
ii. Preferred stock; Common stock (par value * # issued); Additional paid in capital
iii. Retained earnings
1. Companies can either retain profits or give them out as dividends
iv. Accumulated and other comprehensive income
v. Less: treasury stock (stock company owns/buys back)
vi. SH Equity does not accurately reflect value of company b/c assets are reflected at historical cost
e. Capital Leases
i. An ordinary ST lease would not create an asset entry, but when looks more like LT secured
borrowing, lessee must capitalize it. Must capitalize if meets any of the following:
1. Contains bargain purchase option, defined as price so low that exercise almost certain
2. Lease automatically passes title at end of lease to lessee w/o further payment
3. Lease term is equal to at least 75% of estimated useful life of asset
4. NPV of lessees minimum payments under lease equals 90% or more of FMV of asset at
beginning of lease
f. Limitations on Balance Sheet
i. Historical approach omits FMV of most assets: usually understates companys value
1. Exceptions: accts receivable, certain fin. instruments w/ readily ascertainable value
(publicly-traded securities)
ii. Depreciation of tangible LT assets contributes to understatement of asset values on BS
1. Depreciation: acct. process that allocates cost of LT assets to expense in systematic manner
over time period expected ot benefit from use Deduct depreciation expense on BS, but no
adjustment to reflect FMV of assets
a. Amortization if intangible (patents); useful life indefinite (good will), only amortize
when value been impaired
iii. Subjective estimates of, and assumptions about current value of certain items, like receivables that
will be paid erodes usefulness of BS
iv. BS omits items that are of financial value b/c cant be objectively quantified
1. Items of value that may not be reported: workforce, managerial skills, research superiority,
reputation with consumers

Sample
Assets
Current Assets
Cash and Cash equivalents
Short-Term Investments
Receivables, less allowance for doubtful accounts
Inventories
Deferred Income Taxes
Other Current Assets
Total Current Assets
Property, plant and equipment, at cost
Land and improvements
Buildings and improvements
Machinery and equipment
Less-accumulated depreciation and amortization
Goodwill and other intangible assets, net
Non-current marketable securities
Deferred income taxes
Other assets
Total Assets
Liabilities
Current Liabilities
Current maturities of long-term debt
Accounts payable
Accrued liabilities
Income taxes currently payable
Total current liabilities
Long-Term Debt, less current maturities
Deferred Income Taxes
Other Liabilities
Total Liabilities
Shareholders Equity
Preferred stock
Common stock (par value * # issued)
Additional paid-in capital
Retained earnings (if profits not given out as dividends)
Accumulated other comprehensive income
Less - Treasury Stock (stock company owns/buys back)
[Stockholders Equity]
C. Income Statement
a. Overall
i. Shows how company got from balance sheet one year to the next (what happened in company
during that period)
ii. Tells you about the flow
b. Start with sales
i. Less: returned items (sales usually deemed to be net sales)
1. Gross margin on sales (gross receipts on sales cost of production)
2. Sales returns =net sales/revenue
ii. Less Costs and Expenses
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c.

d.

e.

f.
g.

h.

1. Gross margin = sales COGS

a. Gross Margin on Sale: subtract direct costs from sales
2. COGS Cost of sales (Cost Of Goods Sold), labor and materials that go into product
3. Subtract from gross margin on sale:
a. Sales and administrative
b. Research and development
c. Depreciation
d. Stock Compensation
iii. Less additional items to find full amount of profits that can be distributed or retained
1. R&D, Administrative costs, Depreciation, Interest expense, Other income expense
Operating Profit: once the additional costs are subtracted from gross margin (also EBIT)
i. Operating profit = gross receipt on sales cost of production sales & administrative, etc.
1. Operating Profit= Gross margin on sale Additional Items
Total will give you Net Earnings
i. Earnings Per Share: divide net earnings by number of shares
1. Basic: average number of shares issued and outstanding during the year
a. For CS: [net income declared preferred dividends]/weighted # shares outstanding
2. Diluted: includes basic number of shares and number of shares that would have been
outstanding if all stock options were exercised and all convertible securities were
converted into CS (potential new SHs, so large numbers, means lower EPS)
Manipulation of figures: most of these numbers can be manipulated
i. (1) Reducing apparent income reduces taxes: but companies dont always want to minimize
income b/c CEOS want to ensure that their company appears profitable (tension between what SH
and management wants)
ii. (2) Borrowing vs. Stock: Company that raises money by issuing stock rather than borrowing
appears to have higher net earnings because no interest expense (larger net income)
1. BUT, companies can deduct cost of interest from income and reduce taxes
iii. To better compare companies, look at operating profit (similar to EBIT)
1. Earnings before interest and taxes
EBIT= Earnings + interest expense + taxes
EBITDA (earnings before interest, taxes, depreciation, and amortization)
i. Not good b/c if ignore amount that plant is depreciating, doesnt reflect economic success of
company b/c real economic cost to plant wearing out
ii. So EBIT is more appropriate measure
In re Software Toolworks, Inc.: income statement can be messed with
i. Underwriter who can be held liable when helping with stock issuance has due diligence defense
(made reasonable investigation and no reason to think were false and relied on expert statements
(unless reason to believe false))
Sales
Cost and Expenses
Cost of Sales (usually COGS)
Gross margin on sales
Sales and administrative
Research and development
Depreciation
Stock Compensation
Operating Profit
Interest Expense (-)
Interest Income (+)
Other (income) expenses, net (-)
Total costs and expenses (-)
Earnings before income taxes
Provision for income taxes (-)
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Net Earnings
Earnings per common share
Basic
Diluted
Weighted average number of common shares outstanding
Basic
Diluted
D. Cash Flow Statement
a. Income statement does not tell how much more cash a company has at end of year
i. Want to know how much of net earnings represents cash in hand vs. entitlement in future
1. Different because of accrual method
2. Better to have cash now and cash flow statement shows cash in hand
b. Benefits
i. Provide info about comp.s cash receipts & cash payments during period
ii. Provide info on cash basis about comp.s operating, investing, financing activities
iii. Reader will get information about comps ability to generate cash & pay obligations
c. Start with Net Earnings on Income Statement
i. Adjust numbers to reflect actual cash that came in
ii. Various expenses on IS dont involve cash: depreciation (so add amount to cash flow)
d. Calculation: Net Income + Depreciation/Amortization + Comp. for stock benefit plans + Provision for
doubtful accts + (change in operating assets/liabilities, i.e. subtract out sales on credit) + (change in cash
as result of investion activities, e.g. purchase of PPE) + (change in cash as result of financing activites)
i. Step 1: Net earnings from IS
1. Adjust to reflect amount of available cash
ii. Step 2: Add in expenditures that were not actually cash losses
1. Depreciation, amortization, compensation for stock benefit plans, provision for doubtful
accts, loss of partnership, etc
iii. Step 3: Add in (or subtract) changes in operating assets and liabilities
1. Receivables, inventories, deferred income taxes, accounts payable, accrued liabilities, etc)
2. Accts receivable is income, so must subtract out sales on credit
3. Deferred income taxes: paid more tax this year for right to pay less in future years (so
reduces cash b/c paid cash for right to not pay in future)
iv. Step 4: Adjust for reductions (or increases) in cash as result of investing activities
1. Purchase of PPE (Property, Plant, Equipment), sale of investments
v. Step 5: adjust for changes in cash as result of financing activities
e. Divided by operating activities, investing activities, financing activities ???
Operating Activities
Net Earnings
Adjustments to reconcile net earnings to net cash provided by operating activities:
(Gains) on marketable securities, net (-)
Depreciation and amortization (+)
Compensation relative to stock benefit plans (+)
Provision for doubtful accounts (+)
Losses on sale of property, plant and equipment (+)
(Gain) on sale of businesses, net (-)
(Earnings) losses of partnerships, net (-)
Changes in Operating Assets and Liabilities, net of effects of acquisitions
Receivables (-)
Inventories (+)
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Deferred income taxes (-)

Accounts payable and accrued liabilities (+)
Other assets (-)
Other liabilities (+)
Exchange rate fluctuations, net (-)
Net Cash Provided by Operating Activities
Investing Activities
Purchases of property, plant and equipment (-)
Purchases of short-term investments (-)
Tender for share of PowerTV (-)
Proceeds from the sale of businesses
Proceeds from the sale of investments (+)
Other investments (-)
Other (+)
Net Cash Provided (Used) by Investing Activities
Exchanging one asset for another is not reflected on IS, but does change cash on hand
o All investing activities consume cash, but dont show up on IS
Purchase of capital equipment is necessary to replace obsolete/worn-out equipment, support growth in
sales/production
Financing Activities
Principal payments on long-term debt (-)
Dividends paid (-)
Issuance of stock (+)
Treasury shares acquired
Net cash provided (used) by financing activities
f. Operating Profit vs. EBIT
i. Possible for a company to have high OP, but low after tax profit
1. Common in companies that have a lot of debt financing (capital structure)
ii. Finance through equity, cost to you is loss of ownership
1. Cost of issuing new stock dilutes existing stock, decreases entrepreneurs entitlement to
profits
2. Financing through debt: increases interest expense
3. BUT, in IS, cost of choice only reflects interest expense, reducing after tax profit
a. Cost of lost ownership when financed through equity is not reflected on IS
iii. Income statement is distorted view b/c doesnt account for different capital structures
1. To compare companies w/ different capital structures, must ignore interest expense & taxes
b/c that is affected by amount of interest
g. EBITDA: ignores depreciation/amortizationdebatably not good
i. =Net Earnings + Interest Expense + Income Taxes + Depreciation & Amortization Expense
1. Look more for actual cash that changed hands
ii. Not necessarily good
1. Failure to account for depreciation will mean that you are not leaving enough cash
available to replace/repair things once they are fully depreciated
2. Since depreciation and amortization are arbitrary though, you might try to add it in but then
come up with more realistic estimate of amount
E. Statement of Changes in Shareholders Equity
a. Best answers question: How well did stockholders fare?
b. Cumulative account and at end of year, explains changes in retained earnings entry on balance sheet
c. If company issues addl stock, SHs equity might increase, but equity per SH might not increase

d. Change in SHs equity = net income this year dividends paid + funds raised by new share sales funds
expended on stock repurchases
e. Reflects changes in: capital stock at par value acct, additional paid in capital acct, and retained earnings
o Net income this year
o Less dividends paid
o Plus funds raised by new share sales
o Less funds expended on stock repurchases (like dividends, but not pro
rata)
Accounting Manipulations
A. Inventory Accounting
a. Firm needs to determine cost of inventory to reflect on IS
i. Can have vast effect on reported income when inflation is high & cost to produce is higher in
subsequent years (if price remains stable, FIFO & LIFO differences may be trivial)
b. COGS can be determined using different inventory methods:
i. FIFO: first in, first out (look at oldest in inventory and use those costs)
1. Makes profits seem high, good if you want to issue stock
ii. LIFO: last in, first out (use cost of newest item manufactured)
1. Makes profits seem lower: good for taxes
iii.
c. Use FIFO to make net profit seem large
i. BUT, LIFO probably benefits SHs more b/c they dont care about net profits and dont want
companies throwing away money on taxes
ii. In Inflationary Periods:
1. LIFO decreases net incomeyou want to do this when you want to pay less taxes (less
income means less taxes)
2. FIFO increases net incomeyou want to do this when want to sell company or make stock
offerings
iii. LIFO matches current costs with current sales prices, telling more about replacing invenotry
d. FIFO dominates in practice even though means companies throwing away money
B. Depreciation
a. Treats wearing out of asset as a cash outlay, although not really a cash outlay every year
b. Differences in assumptions used has impact on success or failure of enterprise
c. Straight line depreciation versus accelerated
i. Straight line doesnt accurately reflect what happens to assets and values
ii. Have to determine useful life
d. Straight Line Depreciation
i. Assumes constant depreciation throughout life of asset
ii. Problem: can manipulate by making different assumptions about useful life
1. Assume asset has longer life: will report higher income b/c will subtract less for the year
(and will have higher taxes)
2. CEO is throwing money away to govt (not maximizing SH value)
iii. Assumes dont invest money that is set aside
iv. *Most common method
e. AcceleratedSum of Digit Method
i. In year one, income will be lower than straight line. Year 10, income will be higher
ii. Assets are depreciated much more quickly in the beginning
iii. All of fractions add up to 1 so you recover purchase price less salvage value
iv. Good for cars
v. Adding up number of years of assets useful life then use a fraction
1. Numerator: first year is number of years
2. Denominator: sum of the years
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f. AcceleratedDouble Declining Balance Depreciation

i. Declining depreciation expense
ii. Uses double the straight line rate and applies it to the declining balance (you have to take
percentage out of remaining balance = amount left after depreciation from previous year is taken
out)
iii. Depreciation expense declines each year, but never reaches zero
C. Comparison of Methods
a. End up with a recovery of entire purchase price of asset
i. Not very economically efficient though
ii. Suppose you earned interest on the amounts set aside each year for depreciation
iii. If set aside a certain amount each year for dep., would think sum would be original purchase price,
but actually would be greater because of interest earned
iv. One indication that depreciation amounts do not reflect economic reality
b. If look at two companies IS with same net income, doesnt mean same success b/c may use different
methods
i. 5 year vs. 10 year dep. Rate: assuming they have equal net income and are depreciating same asset,
company with 5 year rate is more successful b/c it is depreciating assets quicker and deductin more
from net income each year
1. If reported profits are same, economic profits are larger for first company
ii. Transparency: knowing which method is being used will be in footnote 1
c. Comparison of all three for identical companies:
i. In beginning years, company that uses straight-line will have higher reported profits
d. EX: Movie Profits
i. Would not be wise to agree to contract to take percentage of profit b/c income can be minimized
(incentive to make acct. profits appear to be zero by making inventory expenses high with LIFO,
huge depreciation expenses, etc.)
ii. Might want to require consistency in accounting methods over the years (so wont change when
movie comes out etc.)
iii. Advise client to get part of gross instead of net profit b/c net profit can be manipulated
Ratios
A. Overview
a. Need to look at ratios to compare how company is doing and to get feel for how company itself is doing
b. Govts way of classifying businesses
i. Divide up world of commerce into units and subunits until can find a small niche for bus. you are
looking at
c. For all ratios
i. Net sales = sales returns
ii. Average = (amount at end of last year + amount at end of this year)/2
d.
B. Profitability Ratios: shows how well company has performed
a. Earnings Per Share (most widely reported info)
i. =Net Earnings/average weighted shares (b/w end of this year and last)
1. Note: this was only ratio shown for Scientific Atlantas Income Statement
ii. Shows how much of companys earnings are available to common shareholders after paying
interest on debt, taxes, and dividends on preferred stock
iii. If negative number, doesnt mean company failing, could be investing
iv. Problems w/ this ratio
1. Net earnings from IS can be manipulated depending on inventory, depreciation, & revenue
recognition
2. Want to check calculations used to determine net earnings (look behind it at acct. choices)
3. Must be careful of situations of stock split
v. EX: EPS is $5 for company 1 and $10 for company 2 and they are expected to stay this way, then
pay twice as much for $10/share b/c earning twice as much
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b. Gross Profit Margin (%)

i. =Gross Profit/Sales = (Sales Cost of Goods Sold)/Sales
ii. How profitable company is from selling products, but doesnt include operating expenses
iii. Would you always prefer company with higher gross profit margin? It depends
1. Doesnt take into account amount spend on admin, taxes, R&D, etc.
2. Comp. may be efficient at making things, but horrible at amount of money spent on other
things
3. Must know more b/c cant compare GPM across industries (each inds. Has own practices)
4. But, generally higher number tends to be better
5. Not a good way to compare industries
c. Profit Margin
i. =Net Income/Sales
ii. Remember, net income comes from income statement & is manipuable
iii. How much of a sales dollar winds up as net income
iv. Better than Gross Profit Margin, but problematic b/c capital structure alters number (seems higher
for equity)
1. If company financed entirely through debt, company has large interest expense. Makes net
income lower and will give it lower profit margin
a. Could be equally successful as one financed through equity, but one with debt has
lower profit margin
v. Weakness: If you have companies with same capital structure, still need to look at total profit
because company with low profit margin might make up for it with high volume
vi. To correct differences w/ capital structure, look at Return on Sales
d. Return on Sales (ROS)
i. = EBIT/sales
ii. Take net earnings, add back interest expense and income taxes
iii. Adjusts for differences in capital structure
iv. BUT, doesnt account for companies with different levels of sales
v. Look at Return on Assets to deal with these problems
e. Return on Assets (ROA)
i. =EBIT/avg total assets
1. Avg total assets = avg of beginning and ending assets, taken from previous years bal. sheet
a. Weakness: book value of assets may not be equivalent to FMV
ii. Allows for comparison of companies w/ high and low volume
1. Two companies might have diff. strategies (high v. low volume), but can be equally
profitable if they have same EBIT/avg total assets
iii. Shows what income is from your assets
iv. Advantage is that it removes capital structure from calculations (can evaluate how efficiently a
company is running regardless of whether company got assets by debt or equity)
v. Number is often used in rate-making proceedings
vi. Tells what return is per investment in company (b/c company gets assets through investment)
vii. EX: Publicly owned company that is regulated by govt (i.e. utility company)since this company
is a monopoly, it has to agree not to rip off public and accept normal rate of return. ROA is
commonly looked at in determining what to charge public
f. Return on Equity (ROE)
i. = Net Income/avg. shareholders equity
1. Average shareholders equity is average of ending equity for this and last year
ii. Does not allow for comparison of companies with different capital structures b/c both equity figure
and income figures are influenced by how much debt a company has
1. Income figure has taxes and interest subtracted from it
C. Financial Leverage Ratios
a. Overview
i. Capital structure of company: how debt compares to equity
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ii. Important ratios if considering lending money to a company

iii. More leveraged a company is (more debt they have), magnifies ownership interest, but more
endangered a company is of not being able to pay back its debts
1. Only want to use debt if can predict company will do well
2. If use debt and company is in bad financial situation, leverage magnifies losses
iv. Before lending money, look at leverage of company AND then make sure company doesnt
borrow more money and become risky after loan
1. Include in loan documents limits on what company can do (addl debt it can get)
v. Higher leverage is dangerous for lenders
vi. But good if things are going well
b. HYPO
i. Company 1 borrows money ($900K debt); Company 2 issues stock ($900K equity) (each invested
$100K)
1. Total value of assets for each is $1M
ii. If both companies earn addl $1M, first company has made huge profit, but lender doesnt see any
of it. Value of increase for second company is divided among all SHs, so increase in equity is less
because divided (only 1/10 of gain would remain if there were 10 shareholders)
iii. Why raise money by equity then?
1. If value of company falls to $800k
a. The entrepreneur in the first company (that is highly leveraged) has a company that
is bankrupt and he has lost entire investment
b. In a company with equity, company has declined in value, but not out of business
but each investor has suffered loss/10 (so each has $20K).
iv. Leverage is great if you succeed, but can be disastrous if market goes down
v. When considering lending money, want to lend to less leveraged company
1. Lend to company w/ equity with restrictions on how much it can borrow in the future
c. Debt/Assets Ratio
i. = Total Liabilities/Total Assets
ii. Higher the ratio, higher burden on company of interest payments and of repaying debt when it
becomes due
iii. If want to lend to company, want to see low number here
iv. High ratio leads to two difficulties for firm:
1. Higher variance in returns to shareholders and
2. Greater probability of bankruptcy
v. Defects w/ this number:
1. Total assets is not completely reliable b/c book valueactual value could be higher/lower
vi.
d. Debt-Equity Ratio
i. S-A Debt (total liabilities)/Total Stockholders Equity
ii. Describes the proportions of assets contributed by creditors and shareholders
1. Used to describe leverage of a firm
iii. Gives idea of capital structure (how much debt is part of overall capital structure)
D. Liquidity Ratios
a. Overview
i. Another indication of whether it is advisable to lend money to company
ii. Liquidity shows if company has enough cash to pay bills (ST ability to pay debts)
iii. Even if company has low debt/equity ratio, might lack cash to pay bills
iv. Lenders will look at these ratios and impose limits on them
b. Current Ratio
i. =Current Assets/Current Liabilities
ii. Amount of liquid assets that will be available in order to pay the obligations that are going to
become due
iii. Compare with industry norms
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iv. May or may not include inventory--depends

c. Working Capital
i. =Current Assets Current Liabilities
d. Quick (Acid Test) Ratio
i. =[Cash + Short-Term Securities + Receivables]/Current Liabilities
ii. Compare with industry norms
iii. More conservative figure b/c doesnt include inventories in current assets b/c inventories might
become worthless
1. Recognizes that inventory might not be readily convertible to cash if no one is buying
e. Cash Ratio
i. =(Cash + ST Securities)/Current Liabilities
ii. Even more conservative ratio (includes neither inventories nor receivables): in very ST, assets
creditors can count on
iii. More conservative b/c doesnt include things that you could never get money for
f. Time-Interest Earned (Interest Cover) Ratio
i. =EBIT/Interest
ii. Take net earnings and add back interest expense, taxes
iii. This measures the extent to which interest obligations are covered by earnings before interest
iv. Compare to industry
v. If ratio falls below certain level, default will occur
vi. If managed conservatively, then will have high ratio and great ability to pay back interest, but is
this good?
1. There is tax advantage to having higher debt. This company is safe (so lender would be
more likely to lend money), but company might acquire more debt & become more
leveraged to create maximum value for shareholders (but if industry is risky, might want to
play it safe).
E. Activity Ratios
a. Asset Turnover Ratio
i. =Sales/Average Total Assets
ii. Tells how vigorously a company is employing its assets (dont want lots of assets, no sales)
iii. If ratio is huge: seems company is efficiently using assets, but might also suggest company isnt
investing for future (selling lots of stuff with no assets), could be problematic
b. Receivables Turnover Ratio
i. =Sales/Average Receivables
ii. Average receivables is end of last year and end of this year divided by 2
iii. Gives indication how much of companys sales are on credit
c. Inventory Turnover Ratio
i. =Cost of goods sold/Average inventory
ii. Tells how quickly the company turns over its inventory
1. If COGS is much higher than inventory (sell more than you have in inventory), then turned
over quickly
iii. Efficient firms have relatively low inventory compared to sales (dont want to spend a lot of
money maintaining inventory if you could be selling it instead); but failing firm might also have
low inventory because it doesnt have money to make new products, so difficult to interpret
iv. If ratio is out of line w/ competitors, should check it out
F. Market Ratios
a. Measures relationship between accounting measures of earnings and value to market value of firms
securities
b. Price-Earnings Ratio (PE Ratio)
i. =Market Price Per Share/Earnings Per Share
ii. Market price is current market price
iii. Shares that would be issued
iv. What does it mean to have high PE ratio?
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1. Peoples expectations are of a high return on their investment

2. People are willing to pay more for stock than it is earning now b/c people think future
earnings will be high (prospective growth)
3. Useful to analyze what the market (other investors) think this companys earnings will be
in future
c. Dividend Yield Ratio
i. =Dividend per share/stock price
ii. Dividend per share comes from equity statement
iii. If ratio is low, doesnt mean money is being thrown out; earnings not distributed to SH and being
retained and invested in opportunities, so will further increase earnings of investors
1. Then when someone goes to sell shares and receive higher price, called a capital gain
d. Market to Book Ratio
i. =Stock Price/Book Value per share
ii. True value to SHs depends on what its future earnings are expected to be (even though value on
income statement is different)
iii. Book value on income statement=SHs equity divided by number of outstanding shares
iv. Another reason why looking at just SHs equity on balance sheet doesnt tell how well company is
doing or how much you should be willing to pay for its securities
v. Gives you a rough idea of how well-managed the company issuccessful company if market
value is greater than book value, but imperfect measure b/c ways to manipulate book value
vi. Book value is function of value of assets as recorded in its accounting records
vii. Want management to create value
VALUING FIRM OUTPUT
Introduction
A. Techniques for valuation
a. Show me the moneyhow much value does asset produce
i. For paying an employee, look at how much value they will add to business
B. Why is cost of assets not a good measure of value of corporation?
a. Corporation might spend millions of dollars on assets, but if doesnt do anything with those assets, wont
be successful
C. Book value not a good way to value assets b/c problems inherent in costs are inherent in book values
D. Normal way to value anything is to look at cash flowsvalue of any assets depends on how much money it can
produce
a. EX: value of a machine depends on how much output it can produce
E. Basic Premise: you purchase an asset if the cost is less than the cash the asset will produce
F. Three things you do to figure out the value of an asset:
a. (1) Determine stream of income from asses (subtract out cost of inputs)
b. (2) Calculate value of income streamswhat is the most that other people will be willing to pay for that
stream of income, given other potential investment opportunities?
i. The most other people are willing to pay for income stream is NPV of stream
ii. If NPV is more than current market price, you should buy into the company
c. (3) Calculate how much you would need to invest elsewhere to get this stream of income
SUMMARY OF EQUATIONS
1. Future valueCompounding of interest or returns.
FV = PV(1+r)^n

2. Discounting future payments to present value. PV =

P__
(1+r)^n

3. Valuing Annuities
PV = P P__
r
r (1 + r)^n

12

4. Valuing Perpetuities

PV =

5. Valuing Perpetuities with Growth

PV =

P
r

P __
r-g
6. Net Present Value = PV (income) PV (investments)

PV= Present value; r= interest rate; n= number of periods; FV= future value;
Discounting and Present Value
A. Compounding
a. Compounding tells how much money you have at some future date if you invested X today at certain
interest rates
b. FV= s*(1+r)^n
i. S=a sum
ii. R=interest rate
iii. N=number of periods
c. Rule of 72: how long your money will take to double (72/interest rate)
d. Compounding Quarterly vs. Annually
i. More frequent compounding is more valuable than interest that is compounded less frequently
e. Effective Annual Rate= [1+(annual percentage rate/N)]^m 1
i. EX: if interest rate is 10%, earned monthly, you earn 1/12 of 10%
1. =.10/12=.83%
ii. Effective Annual Rate= (1+.0083)^12 1 =10.46%
1. So a nominal interest rate of 10% can become 10.46% if compounded monthly
iii. Receiving interest payments earlier than year-end has the effect of increasing your return over the
stated interest rate b/c interest received now counts as part of amount that will receive interest in
future
iv. Effective annual rate allows you to compare compounding at different rates
B. Net Present Value
a. PV=s/(1+r)^n
i. S=sum you will receive in the future
ii. PV=most someone would be willing to pay this year for future returns on the asset
b. Money you receive in the future is worth less than money received today b/c can invest today
c. Better to receive money now that later because can invest it
i. So money in future would be worth less to you now (you will pay amount that you would get for
similar investment)
d. **PV of a fixed payment varies inversely with the market interest rate
i. The present value of a fixed payment in the future rises if interest rates fall (direct effect)
e. What is the most someone will be willing to pay for $1,000 next year? What is current FMV of the $?
i. Need to know the interest rate to determine how much people will be willing to payassume 10%
ii. Most someone will be willing to pay =1,000/1.10=$909
1. Why? B/c if investor took $909 and put it in bank at 10% interest would have $1000
2. If interest rate dropped to 5%, would be willing to pay more ($952)
f. Quick Check Problem 3.4: Brothers 10th birthday gets $10,000 savings bond that matures in 8 years. 7%
i. PV= 10000/(1,07)^8=$5820
ii. Someone would only have to invest $5280 today in order to receive $10K 8 years from now
Annuities
A. Overview
a. Stream of fixed payments to be received for a set number of years, such as a bond (but with a bond, get
original amount back at the end with annuity you do not)
b. Certain amount of money being paid out each year
c. PV of annuity is discounted PV of each payment summed
13

d. For bond, find PV of annuity and PV of principle payment and add them together
B. PV of Annuity= (annuities payment/r) (annuities payment/(r(1+r)^n))
a. **Note: do (1+r)^n, then multiply by r
i. Annuity Chart 3-5: Page 100
b. Quick Check 3.6: Suppose interest rate on bond is 8%, 10 years $100 payment each year
i. =$671.01 (NOTE: PV is greater than if interest rate were 10%)
ii. Principal payment is lump sum after 10 years= $1K x .4632=$463.10
iii. Total market value of bond now is $1,134.11 (value has increased because interest rate has
decreased)
iv. As interest rate increases, bond price decreases
C. Bond Price
a. (1) Find PV of interest payments, use annuity formula (multiply annual interest rate * discount rate from
table 3-5)
b. (2) To find PV of principal payment, use PV formula (multiply principal * interest rate from 3-4)
c. (3) Add them
d. Bond payment problems
i. Annual annuity payment = bonds interest rate * bond principal amount
1. EX $1000 bond with 5% interest rate, annuity payment = $50
ii. Interest rate used in formula is whatever market rate is
1. If market interest rate increases (discount rate), the present value of bond decreases (and
market value decreases)
Perpetuities
A. PV of perpetuity = payment/r
B. Annuity that continues forever
C. Common stock and a shared stock are perpetuities
D. If earnings were expected to be constant forever and the market interest rate for investment of equivalent risk is
10%, what is P/E ratio?
a. PV of perpetuity=earnings/interest rate
b. So, if r=10%, then PV = earnings/.10
c. PV/earnings = 1/.10=10
d. So if we know earnings are going to be constant forever, the only factor that determines P/E ratio is
market interest rate
E. Quick Check 3.7: What is value of share preferred stock carrying $8 annual dividend, discounted at 7%, assuming
it is neither callable nor subject to forced redemption. What is value of this perpetuity?
a. =8/.07 = $114.29
b. If discount rate is 10% (interest rate increases), PV = 8/.1 = $80 (value of perpetuity declines)
Valuing Common Stock
A. Valuing a Perpetuity w/ Constant Growth
a. Valuing a stock is a special case of valuing a perpetuity
i. Determine the earnings of a company and, assuming the earnings will be constant and paid out as
dividends forever, value of stock is just a perpetuity
b. PV = P/(r g) [where g/growth rate]
c. $10 dividend and 10% interest rate, wouldnt pay more than $100 FMV for stock
d. If expect to grow (not a constant income stream) at 4% a year: PV = 10/(.1-.04)
B. Valuing a Perpetuity w/ Initial Growth
a. Not all stocks can be expected to have growth earnings indefinitely. In this event, there will be two
periods of calculations to consider
b. How to Calculate:
i. (1) For first year of initial growth determine PV of initial dividend payment (dividend * interest
rate in Table 3-4 for year 1)
1. TABLE 3-4: Page 97
ii. (2) For X year of growth, dividend payment = dividend from year before * (1+growth rate). Then
find PV of that dividend (multiply dividend * interest rate from Table 3-4 using year X)
14

iii. (3) Sum all of these PV values for initial growth years
iv. (4) Once it stops growing, use (Dividend/interest rate) * PV from Table 3-4 (using the number of
growth years + 1 as the year)
v. (5) Add values during growth period (Step 3) + perpetuity after initial growth (Step 4)
vi. After the growth period, we arrive at the assumed perpetuity for the rest of the time.
1. Must remember that perpetuity does not kick in until after growth period has finished, so if
start using PV for perpetuity, must be further discounted for later starting date.
2. Later starting date is called the Terminal Value
Suppose there is a five-year growth period (at 4%), followed by level
earnings in perpetuity:
Year Dividend x Discount Factor at 10%

= Present

$1.00

.9091

$.9091

$1.04

.8264

$.8594

$1.0816

.7513

$.8126

$1.1249

.6830

$.7683

$1.17

.6209

$.7264

Value

Subtotal:
6

$4.0759
Perpetuity of $1.17 / .10 = $11.7 x .5645 = $6.6046
Total Present Value

$10.6805

C. Valuing Investments w/ Different Timing of Returns

a. If present discounted value of the project is greater than present discounted cost of the project (positive
value), then good project
i. Even though project might have higher return, timing of returns can make a difference
ii. If payments are made at a later time, have to discount this as well
Suppose there are two investments that will each require $400,000 invested at the
beginning of year one. Again, assume a discount rate of 10%. Here are the expected
returns:
Project A

Project B

End of Year

Return

End of Year

Return

$200,000

$100,000

$150,000

$100,000

$150,000

$325,000

Total
$500,000
Total
$525,000
This would make you think B is the better project b/c it has a higher nominal value
(continued on next page)
Here are the discounted present values:
Project A
End of Return x NPV
1

$200,000 x .9091 = $181,920

Project B
End of Return x NPV
1

$100,000 x .9091 = $90,910

15

$150,000 x .8264 = $123,960

$100,000 x .8264 = $82,640

$150,000 x .7513 = $112,695

$325,000 x .7513 = $244,172

Total:

$418,575

Total:

$417,722

Thus, Project A has the higher discounted present value, despite the higher nominal
(undiscounted) value of Project B.
Even without looking at the numbers, you can tell A is better because it receives the
highest returns at the beginning. Income received now is always better than income
received later because it can be invested.
D. Net Present Value
a. NPV of Project = PV of funds received PV of costs
i. *Be sure to discount costs and money received
b. Every time you are offered an investment opportunity, you forgo a different opportunity
i. Use different discount rates to reflect that
c. Two identical projects except one requires payment later: select later payments b/c smaller PV
d. Note: even if PV is $400K and will cost $1M, doesnt necessarily mean dont want to do it. Must calculate
PV of $1M when have to pay itwhat do you need to invest now to have $1M when have to pay
i. EX: $1M to be paid in 10 years (10% discount rate) = 1M/[(1+.1)^10]=$385,543
e. Quick Check 3.8: Factory costs $400K now. Will produce net cash after operating expenses of $100K in
Y1, $200k Y2, $300K Y3, after which it will shut down with 0 salvage value
1
2
3

$100k
$200k
$300k

.909
.8264
.7513

$90,900
$165,280
$225,390
$481,570
Less Cost:
($400,000)
$81,570
f. Economic cost of this investment is the opportunity cost of other investments foregone. If you did not
have the $400k, you could borrow it and the interest paid on the loan is the same thing as the foregone
opportunity from paying the $400k out of your own pocket.
g. *Even if you have 100 different projects, each with positive NPV, you should invest in all of them.
i. Even if you did not have enough money, you should borrow b/c NPV will give you more money
that if had just invested at the interest rate
1. Economically no different in cost of borrowing vs. spending: either interest you pay or
interest you lose by spending money
Assume three investments in a project: now, the end of year 1, and the end of year 2.
Assume the cost of capital of 10%.
Outlays:
Amount

End of year

Present Value

$1,000,000

immediately $1,000,000

$200,000

$181,820

$300,000

$247,920
$1,429,740

Now assume net revenues after operating expenses of $200,000 at the end of the second
year, and assume that for years 3-22, net revenues are $300,000 annually. Finally, at the
16

end of year 20, the salvage value of the assets brings in $100,000. The single payments
are simply discounted to present value at 10%. The stream of payments is a 20-year
annuity.
The present value of the annuity is 8.5136 x $300,000 = $2,554,080
(*Use annuity chart page 100)
Because this payment wont start being received until the end of year 3, it must also be
discounted to the present value at 10%.
.751 x $2,554,080 = $1,918,114
Receipts
Amount

End of year

Discount Factor

Present Value

$200,000

0.8264

$165,280

$2,554,080

0.7510

$1,918,114

$100,000

22

0.1228

$12,280
$2095,674

The present value of the returns exceeds the present value of the investments. That
means we should invest in this project, assuming we have used the correct discount rate.
When the present value of returns exceeds that of investments, we say the project has a
positive net present value. A manager should accept investment opportunities offering
rates of return in excess of the opportunity cost of capital. If the present value of the
returns were less than the present value of the funds to be invested, it would be described
as having a negative net present value. A business should accept all projects with a
positive net present value and reject all projects with a negative net present value.
E. Bad Approaches to Valuation: dont use!
a. Internal Rate of Return (IRR): you just look to see what the actual rate of return is on the investment and
compare to cost of capital and do investment if ROR>interest rate (cost of capital)
i. EX: have to invest $100 to get $115 back next year. ROR=15%, dont do if IR exceeds this
b. Payback Approach: not a good rule either b/c doesnt discount and it ignores projects that will have huge
payoffs later in life
i. Companies will use this and do projects if payback within certain time
ii. EX: wont do if payback is longer than 3 years. (would never send your kids to school)
Cost of Capital
A. Price of Risk
a. Cost of capital = how much does firm have to pay to get money through debt (interest rate on date) or
equity (rate of return an investor requires on stock)
b. Regardless of method used to raise money, cost of capital should be same in an efficient market
c. Cost of capital is combination of:
i. (1) Time value of money and
1. Time value of money is the fee you pay the lender to defer his own consumption
ii. (2) Risk premium
1. Risk premium is compensating the lender b/c you might not repay loan or make timely
interest payments
2. Risk premium is rate above t-bill rate
d. Earn much more from stocks than bonds b/c higher real ROR demanded b/c riskier
e. Declining marginal utility of money
17

B.

C.

D.

E.

i. First dollar you get is worth much more to you than millionth (use first to satisfy needs)
ii. Why people dont take a fair bet in general
1. To get people to take a bet must make upside much bigger than downside (increase payoffs
so that gains and losses in utility are equal instead of wealth)
f. People are risk averse: will have to pay more to get people to accept higher risk
g. So far, have assumed that all returns in the future are certain
h. In doing present value calculations, select interest rate that corresponds to other investments that have
similar risk as investment youre looking at
Valuing a Payment
a. Must value both the expected value and the risk: greater risk, demand higher payment
b. When valuing a project, value both expected income stream and risk that income stream actual occurs
c. Even if two firms have same expected return, not same if one has greater risk/variation
i. Get higher return if price is lower (if want return to go up, price must go down)
Measurement of Risk: Of Expected Values and Standard Deviations
a. Expected value = Sum (Expected outcome * probability)
b. Variance = Sum (squared deviation from mean * probability)
c. Standard Deviation = Square root of variance
d. Variance measures how uncertain this expected value is
i. Look at expected squared deviation from the mean
ii. Higher variance, higher risk
e. 95% of the time, expected value will fall within 2 standard deviations of mean
f. Riskier an investment, higher standard deviation of returnsneed higher returns to attract investment
Risk Diversification
a. Investors are risk averse, but doesnt mean they will always pay more for risky asset
i. Suppose there are two investments, both with expected return of $100k in five years
1. Investment A: risk-free; Investment B: risky
2. You have to discount and determine an interest rate
3. Not necessarily the case that would need higher interest rate for investment B just b/c
riskier. Why? Diversification
b. Risk can be eliminated through diversification
c. Market value of shares is not necessarily low just b/c they are risk bc investors can diversify away risk
i. If two shares inversely correlated, return will be same regardless of outcome
ii. Cost of capital for these two companies will be relatively low b/c risk can be eliminated through
diversificationsame return with less volatility
d. Two Types of Risk:
i. (1) Unique Risk (unsystematic): risk can be diversified away, so investors do not require higher
returns from companies with unsystematic risk
1. Unique to specific company/industry (e.g. umbrella maker)
ii. (2) Market Risk (systematic): cannot be diversified away (cant control stock market)
1. Risks that affect all industries (e.g. interest rates)
iii. When market moves, some stocks will move more forcefully than others
1. Each stock has different sensitivity to general market movements or this type of risk (for
example, if there is drought, some companies worse than others)
2. Beta () is the sensitivity of a stocks return to general market movements
a. Higher the Beta, more movement, more undiversifiable risk
b. 1.0: moves perfectly with market
c. 0: doesnt move at all with market (govt bonds b/c no risk)
d. 2: great movement with market (two times)
e. .5: moves as much as market
f. [Note: we dont need to be able to calculate Beta]
Capital Assets Pricing Model (CAPM)
a. Cost of capital is return (its percentage) demanded by investors
i. Shows that a securitys return is based on its Beta
18

b. How Stock Prices Depend on Beta (just depend on risk that cant be diversified away, any risk that can
wont affect stock price/return)
i. Stocks with no risk (=0): will earn risk-free rate of return; =1 will be avg. ROR for stocks
ii. Market risk premium is the increased return that SHs receive for owning portfolio of stocks over
risk-free portfolio made up of treasury bills
iii. Can get any return btwn market return (of stocks) and risk-free return (of treasuries) by owning
combination of risky/non-risky bonds
iv. By mixing risk-free and risky, can create portfolio with any risk up to of 1
1. Can create security that is riskier that market by borrowing money
a. Get increased ROR if market goes up, but increased risk if down
b. EX: can borrow at 5% and invest at 10%, 5% increment represents an increase in
total rate of return on the investors fund
i. BUT, if market goes down, you also owe money borrowed
ii. Higher volatility so is higher
c. NOTE: Margin limits are limits imposed by stock broker on how much can borrow
relative to cash put in
c. Can create portfolio with any Beta by only using T-bills and market portfolio
d. Relationship between Beta and ROR is linear
i. As risk (Beta) increases, get higher return (means lower price)
e. Linear relationship is reflected on Capital Market Line
i. All securities will be on this line, so once know Beta, can determine cost of capital for company
ii. No one would ever buy stock below the line: could get higher return with same risk (and people
are risk averse), so price of stock would fall until its return increases up to line
1. As price falls, return increases
2. Also wont be above line b/c everybody would jump to that security and price will go up
until security is offering no more than expected return on line
iii. CAPM predicts that securities will fall somewhere along line, according to level of risk. Allows
you to determine how much to charge for your stocks
1. Figure out for company, then would know cost of capital (e.g. =.5, COC 7.5%)
2. Price of security (if we assume earnings will remain same forever and dividends will be
paid out at $5 each year): if dividend is $5 and price is $100, return is 5%, no one would
buy that b/c can buy avg security with same for 7.5% return (so mkt price would be $75)
F. Expected Cost of Capital Under CAPM= risk-free rate + (equity premium * Beta)
a. Equity premium is difference between interest rate paid on this stock and IR paid on risk-free stocks
b. Cost of capital is same thing as interest rate used in PV discounting
c. EX: Assume risk-free rate of 5%, equity (risk) premium of 5%; assume =2
i. Cost of equity capital = .05 + (.05*2)= 15%
d. All of the above assumes efficient market
i. Investors wont settle for lower returns than capital market line given the risk
ii. Securities price is a function of the expected growth rate in income
1. Price=payment/(r g)
iii. Total return = r = growth + dividends
iv. PV before = payment/(r g)
e. Risky companys earnings are capitalized at lower rate: same thing as saying lower stock price
f. Change in investors expectations about growth rate has huge effect on stock market
i. Stock is a perpetuity with growth, so if change growth rate, then value changes
ii. Value of stocks is very sensitive to expect growth rate and to cost of capital (IR)
1. Even small change in expected growth rate can have huge impact on value of stock
iii. Also suggests that in all the valuations we did, once you know IR & expected growth rate, easy to
figure out PV of things
iv. Dont need to know about companys unique risk, just Beta and growth rate

19

g. Problem 3.7: Suppose between 2000-03 DOW fell from roughly 11k to 7200 at its lowest point, a fall of
nearly 35%. Given valuation model, if we assume LT IR remained stabled at 6% and dividends stable at
3%, what change would investors have to make in assumptions about dividend growth to achieve drop?
i. We know in order to invest, total return must equal growth + dividends
1. Growth = return dividends = 6% 3% = 3% growth
2. This is what investors had to be expecting in equilibrium market
ii. PV of stocks before changes?
1. PV = payment/(r g)= 3 (dividend payment of 3%)/3% = 1
iii. Suppose x = new dividend growth
1. Assume value is .65 (b/c there was 35% drop from 1)
2. .65 = 3/(6% x); x = 1.4%
iv. So to have a 35% drop in stock market, all that would have to happen is people would have to
expect growth to decline from 3% to 1.4%. Tells you even small changes can have profound
impact on price
G. Levered Betas and Cost of Capital for Leveraged Firms
a. If more leveraged, larger impact on underlying equity of corporation: more volatile if highly leveraged
i. Amount of money a company has borrowed will affect its Beta (higher leverage, higher Beta)
ii. Levered Beta / 1 + (1 tax rate)(% debt/% equity) (?)
b. If you are thinking about buying a whole company
i. You can change companys capital structure and you are interested not in the capital structure, but
the volatility of the companys underlying business
ii. Unlevered Beta (as if company had borrowed nothing)
1. We have effectively removed volatility from borrowing
H. Challenges to CAPM
a. Is CAPM correct? Not entirely
i. Returns generally operate along the CML, but not always
ii. Smaller company stocks have higher returns than larger company returns, even if they have a
smaller Beta (which is not what you would expect)
iii. People suggest you need to add additional factors to get full picture
iv. But, this is still pretty good and is basis for how COC is calculated
v. Interest rate reflects payment you must make for time value of money + risk (must give people a
risk premium if want them to incur risk)
Efficient Capital Markets
A. ECMH Model Definition
a. Theory that stock prices at any given time reflect all available info; all public information
b. Impossible to systematically make above average returns on market
c. Any above average returns are usually product of insider information
d. Price of the stock: market value
e. Theory about accuracy and value of price of stock
B. Efficiency
a. Allocative Efficiency: suggests that right amount of money always goes to companies that are always
most valuable (companys inherent value will always be reflected in stock price)no bubble in mkt
i. Fundamental efficiency: prices reflect peoples expectations
ii. If people believe a price will go up, it likely will
iii. If a market is allocatively or fundamentally efficient, would suggest that resources flow to the
securities having highest expected return, lowest risk
iv. EX: theory was that internet stock prices werent overpriced, so when value dropped, violated
allocative efficiency theory
1. There isnt always allocative efficiency, when talking about ECHM Model talking about
distributional and speculative efficiency
b. Distributional Efficiency: no bargains in stock marketone person cant make money based on anothers
ignorance (besides inside information)
20

i. Speculative efficiency: no bargains in stock market

ii. Even if reject allocative and there could be a bubble, its still impossible for people to make money
on inaccuracies
iii. Conclusion: no free money to be made in stock market
iv. Suggests that if a market is distributionally or speculatively efficient, there are no bargains (no
arbitrage opportunities)
c.
C. Forms of ECMH (Efficient Capital Market Hypothesis)
a. Weak Form: nothing in past stock prices predicts future prices (well accepted)
i. Current prices reflect all past information and trends
ii. Past performance is an indication of future performance
iii. Price today includes all info about what price will be tomorrow
iv. Intuition as to why this doesnt work:
1. If this was the way to predict future prices, then would always be reflected in current price
v. Market adjusts to reflect past information
vi. EX: Coke stock always goes up 5% after storm
1. If public knowledge, then would be reflected in price of stock
2. Return of stock = appreciation (and dividends)/price
3. Return would end up the same, price and appreciation both increase
4. Return stays the same = same return that is paid on other stocks of same Beta (based on
CAPM)
vii. Semi-Strong Form: stock prices reflect all publicly available information (pretty well accepted)
1. Essentially the same thing except says current prices reflect past information and all other
publicly available info
2. Implication: its a total waste of time to do research, hire stockbroker, etc.
3. Prices already reflect everything that is publicly known
4. Cant make money looking at public info b/ already in value of stocks: constantly being
incorporated into price
a. Argue that the stock prices reflect the anticipation
5. Only reason there is systematic difference in RORs are differences in risk. Says that there
are sometimes mistakes and bubbles, but you still cant make money on those mistakes
6. EX: Coke issues press release for new product
a. Everyone thinks stock will be more valuable, so buy
b. All people end up buying so getting a return that isnt as good once value goes up
on that information
7. How fast does market reflect all this info? Almost instantly. Dont even need trades, info
will be reflected in reservation price
viii. Stronger Form: stock prices reflect all information that sophisticated investment professionals can
acquire
1. Implies that mutual fund managers are worthless b/c if stock prices already reflect all info
they could acquire, manager wouldnt be able to do anything else to increase returns
ix. Strong Form: stock prices reflect all information, both private and public
1. This is wrong; cant make money rom inside information about a company
a. Hasnt been empirically proven
2. Stock prices reflect past information, current information, and insider information
3. Wrong b/c inside info cant affect market value until goes public
4. How do you explain Warren Buffet always making above avg returns? Inside info or
doesnt everything faster than everyone else
D. Possible Necessary Conditions for ECMH
a. (1) Zero transaction costs in securities
b. (2) All available information is costlessly available to all market participants
i. However, all you really need is a few participants to have the info b/c the ECMH states that you
can still do as well as anyone else since there are these few people w/ the info
21

E.

F.

G.

H.

c. (3) Agreement on the implications of current information for stock prices

i. Again, only a few people need info b/c their actions affect prices & eliminate pricing anomalies
d. (4) Sufficient capital to engage in risky arbitrage
i. Knowledgeable market professionals must have enough funds so that if they see an out of line
price, they can buy a stock to push it back in line
Mechanisms for Market Efficiency
a. Efficient Markets Paradox
i. If efficient, no one would pay to research
ii. To get efficient markets, need people believing markets are inefficient
iii. Traders or clients must believe markets are inefficient
iv. Purported inefficiency creates opportunities to find bargains, which create opp. For big returns
Anomalies in ECMH
a. Evidence
i. 1987 Stock Market Crash
ii. January effect: increase in stock prices in January b/c increase in buying following drop in price in
December caused by investors seeking to create tax losses to offset capital gains
iii. Weakening relationship between Beta and returns
iv. NASDAQ: internet bubble of late 1990s
v. Closed-end Mutual Funds
b. Explanations
i. Irrational behavior by some investors swamps capacity of sophisticated investors to correct
c. But, still impossible to make money on inefficiencies b/c distributional efficiency (but may not be
allocative b/c prices might not always reflect value of company
d. Even though there are anomalies and people will suggest market isnt efficient, still cant make money on
pricing anomalies
e. Conclusion: distributional efficiency, but not allocative
f. Summary of ECHM
i. Markets generally reflect all public info very quickly, so in general cant expect to make money on
market
ii. Strong form of ECMH is not accurate b/c you can make money on insider trading
Lessons from ECMH: Market Efficiency
a. Markets have no memory (so dont want to sell just bc price has gone down b/c no indication price will go
up): prices right now are unbiased predictor of what price will be in future
b. Should trust market prices: dont buy companies b/c think theyre undervalued
i. Best predictor of companys value is current price
ii. Market gives lots of info about performance of companies
iii. No stock is over or under-valued, price reflects information
c. No financial illusions in ECMH
i. EX: stock splits should not affect value. However, there is an effect of stock splits b/c tend to
indicate good things to come (so could get bump)
d. Critiques of ECMH: people dont always behave rationally
ECMH in the Courts
a. Overall
i. If there is a market in a security, this is a powerful tool b/c through ECMH, it reflects all info
(market is best estimate of value)
ii. Courts historically dont like to trust markets
iii. How Delaware judges have reacted to assertions about efficient markets
1. Old attitudes: thought market value did not reflect stock price
b. Old Attitude
i. Market value is not accurate reflection of intrinsic worth (Chicago Corp. v. Munds) or true value
of shares (Smith v. Van Gorkom, most CEOs think market undervalues companys stock)
c. Changing Attitudes (Intermediate) (Applebaum v. Avaya, West v. Prduential Securities, Easterbrook)

22

i. West: adopted semi-strong ECMH hypothesis, stockbroker lied to clients about potential merger
and clients tried to sue on behalf of all who sold/bought stock
1. Easterbrook said markets are efficient meaning will rapidly adjust to public info. If info
false, will reach incorrect level and stay there until truth emerges
a. If strongest accepted, then second discovery made would reflect info (rejects)
2. Here, info was private, so impossible for one ignorant investors false statement to move
marketno insider info here b/c not trueprice went up for other reasons
d. HYPO: if trying to determine PV of husbands future earning power, is there any way that can use mkt.
info to figure this out? NO, husband is not corp. and his future earning stream is not sold on mkts. Would
have to do PDV method to figure out. But, if husband were a company could figure out price of sec.
i. Where have publicly-listed security traded, can figure out future income stream through mkt. price
ii. If liquid mkt, there are a lot of people doing calculations so many would argue market valuation
method is more reliable
I. Valuation in Courts
a. Overview
i. Market price is consensus of other peoples PDV calculations
ii. In valuing things, should do PDV analysis, but also look to market indicators that can be used to
confirm or change PDV calculation
b. Delaware: dont use market price, but can look to it, Delaware Block Method
i. Cede & Cinerama v. Technicolor (appraisal proceedings for dissenters in merger)
1. Court uses present discounted value (calculates itself, but looks to market price as
corroborating value)DE doesnt trust market which is what Shep thinks is best estimate
2. Look at value before talks of merger (before price goes up)
ii. DE Block Method: Piemonte (thought Cede approach too easily manipulated)
1. DE assumes market price substantially low: reflects minority discount, which shouldnt be
included, so theyll add premium (Shep says this doesnt make sense)
2. Court took 3 different approaches in valuing and took weighted average (judge has
discretion to assign weights)
a. (1) Market Value: what actual shares trade for (uses ECMH)
i. If publicly traded, look at share value and multiply by shares
ii. Courts generally distrust market and wont put a lot of weight here
b. (2) Earnings Value
i. Figure out earnings number, which is often avg earnings for previous 5-year
fiscal period, then multiply average earnings by multiplier
ii. Looks like formula for perpetuity (income * multiplier)
iii. Method is very imprecise (CAPM, which figures out COC for companies w/
same volatility would be more precise)
1. Problem with looking at past five years: we dont care about past,
just future
2. If assume company will stop growing after end of five years, look at
discounted PV of it as perpetuity; if growing: perpetuity w/ growth;
if terminal value use income for that year and figure out perpetuity
a. =there are different ways to value a company
3. Judge determines multiplier by looking at similar companies and
adjusting randomly for risk/growth
4. Assumptions about risk: in case, judge adjusted multiplier; but with
Sheps calculations (perp. w/ growth), can change COC (IR) to
account for risk
iv. Bottom Line: earnings value analysis is similar to PDV, but done in a way
that doesnt make assumptions explicit and is non-systematic, so not reliable
c. (3) Net Asset Value
i. Look at various assets of corp and use book values as starting point

23

1. Note: problem with book values, so most courts will adjust to make
correspond more accurately
ii. How do you determine real value of companys assets?
1. Look at PDV of earnings that are expected from assets (circular)
2. But, courts wont do that, theyll look at book value then add in
arbitrary things like goodwill
iii. In this case, court didnt look at PDV analysis, may estimates about assets
worth and then determine value per share
iv. *Judge here put highest weight here, so thought most valuable
3. *DE Block method still employed by many courts
iii. How to Do Present Value/DE Block Method: (?)
1. (1) look at expected cash flows for next five years & discount to present day (NPV)
2. (2) Consider residual value for the indefinite period after the next 5 years
a. Discount these cash flows to present day (find NPV)
3. (3) Identify corrected discount rate
4. Can lead to battle of experts like in Cede; a lot of the times courts will just split down
middle of experts
c. Which valuation method is better? PDV or DE Block Method?
i. DE Block method is murky and assumptions are mistaken at times, but method is usually easier for
judge to understand vs. PDV is complicated and judges wont get and will be at mercy of experts
which they dont like)
d. DE SC has told courts to use PDV, but they still resist
e. Use CAPM and PDV and cash flow analysis to properly determine value of company
J. Minority Discounts, Control Premiums, and Leverage
a. Control Premium
i. Someone will be willing to pay above market price to own 51%+ of company
ii. Why would someone offer premium?
1. (1) Think if they get control they can put in their own managers and increase companys
value, OR
2. (2) They want to loot company and steal assets
3. In theory, if well run company, the controlling premium would be very small
4. *Shep says that control premiums are only appropriate when someone is taking over badly
run corp, so control block worth more than non-control block (not appropriate in looter
situation)
b. Minority Discount
i. Market price listed is the minority discountneed to pay more if getting majority of stock
c. Should minority SHs in appraisal proceedings have imposed on them the minority discount?
i. Control shares will be worth more in certain situations than others (person wanting to take over
company would not value 2% shares highly b/c no control)willing to pay premium for control
shares
d. Does FV of minority shares include minority discounting or do they get control premium?
i. Law is that when figuring out value of minoritys interest, dont have minority discount
ii. Model Act: without discounting for lack of marketability or minority interest
iii. DE Court: use PDV of minority shares (figure out expected earnings of company, discount to
present, divide by number of shares) and dont use minority discount
e. How does market value relate to above calculation?
i. PDV calculation will be higher b/c on market not buying controlling interest in company, so will
sell at discount proportionate to interest of share in companys operations
ii. Proportionate value would be avg of minority price and control price (if you do PDV, this would
be avg price)
iii. As a result, courts are hesitant to look at market price before takeoverP argues that price is
minority price and actual is higher because fair value, under low, should not include minority
interest, so add on control premium
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f. Economically sound?
i. No, there is no control premium and therefore, no minority discount so courts have it wrong
g. When would there be a control premium?
i. Where buyer thinks he can run company better, so pay more b/c thinks value will go up
ii. BUT, avg company not the casegenerally well run
iii. So, assume well-run company, no control premium b/c no one would want to take over
iv. Good indication of if there should be control premium is if someone trying to take over and if not,
likely well run and no control premium
v. But, DE courts dont sign onto theory that if no takeover attempt, should be no control premium
and they do add control premium (Rapid American Corporation)
vi. Note, minority SHs as a result get windfall b/c they bought stock at market price
h. Rapid American Corp. (DE case): looter trying to get rid of minority SHs
i. Company was holding company w/ three other companies, so figured out value of holding
companies (then discounted, used Betas of similar companies)
ii. Court added on control premium b/c P argued that should be control premium b/c owned other
companies too
iii. Does this make sense? Noguy was taking it over to loot, not make better. Nothing here indicates
that was badly run. DE has weird outcomes b/c always decides market undervaluing, allows court
to screw over looter
CAPITAL STRUCTURE
Introduction
A. Can raise money in many different ways: Two extremes are stocks and bonds, but much in between
B. All of the different possible securities are substitutable in some way
a. CAPM shows rate at which people are willing to substitute: avg person is willing to take certain interest
rates for given Beta (along the line)shows rate at which willing to substitute
C. Should corp increase its risk by borrowing more or let investors do it themselves? Better to distribute dividend or
retain earnings?
D. Debt instruments control (four corners of contract control)
Range of Financial Choices (In order of highest risk to lowest: equity to debt )
A. Warrants (Options)
a. Options are issued by company, not on market
b. Risky b/c have entitled to purchase shares at certain price, but no guarantee that price will rise above
option price (worthless until prices rises above option price)
c. Companies would give options to their officers
d. Options expire
B. Common Stock
a. Can be different classes of common stock
b. SHs are residual claimants entitled to all income and assets after the rights of senior claimants satisfied
c. Have voting rights and ultimate control of company
d. SHs have large incentives for company to perform well b/c only receive money in that circumstance
i. Vs. Bondholder that doesnt want to take risk b/c would require that the company perform well
enough for him to receive his interest payments
e. Stock is less risky than warrants b/c warrants expire, stock doesnt
f. Company supposed to be run for SH
C. Preferred Stock
a. Sounds more like debt b/c if company provides dividends, a certain amount must go to PS first
b. Can also be set up to have preference on liquidation
c. More rights than common SH
d. How is this different than debt?
i. With debt, know you will get interest payment each year. Not guaranteed with PS (only if
company gives dividends). But, if offered get them first, just fixed amount
25

e.

ii. Get something with greater certainty than common shareholders, but still not as certain as people
who loan company money
iii. Less risky than common stock b/c moving more towards debt
Types
i. Blank Preferred: details about what type of preferred stock it is are filled in later
ii. Normal Preferred: Shepherd says you should never buy this unless some protection written into
preferred SH shares, then can pay no dividend for 30 years and give big dividend to common
shareholders and will just have to give you your preference amount. (should get cumulative pref)
iii. Cumulative Preferred: when dividends are passed, no dividends can be paid on common until all
cumulative dividends are paid
1. Before the company can issue any dividend to common shareholder, must pay CP SH the
cumulative amount that wasnt paid in prior years
iv. Participating Preferred: Gives holders right to receive additional earnings payout over and above
specified dividend rate under certain conditions
1. Not only get fixed payment, but also common SH cut
2. Sells for more than cumulative preferred b/c cumulative plus more
v. Convertible Preferred: used for venture capital financing; convertible into specified number of
shares of common stock
1. Start-ups tend to issue preferred stock to outside inventors (dont expect to have profits for
a while, so type of preferred stock issued typically has no fixed or stated dividend option)
2. Frequently only preference is upon liquidation
3. Can convert preferred stock to common stock if want

D. Short-Term Debt v. Long-term Debt

i. Corporate debt is creature of contract
1. Creditors own part of corporations income stream
2. No ownership interest in the firm
ii. Can be secured or non-secured
1. Secured means its backed by a specific piece of property, so if there is a default on debt,
then property will be sold to satisfy debt obligations
2. If secured, creditors can come after your assets if you dont pay. More risk if unsecured
3. Credit card debt is unsecured, so higher risk that car loan payments
iii. Can be long- or short-term: long is more risky
1. Interest rates could fluctuate, which would have bigger impact on long-term debt
2. EX: bond pays $1000/year and interest rate is 5%. One bond is one year (value of this is
1000/1.05=$952) and second bond is infinite 1000/.05=$20,000
a. If interest rates go up to 10%? Value of 1 year is 1000/1.10=$9.09. Value of LT
perpetuity 10000/.1=$10k. How much have we lost from one year? Approx 5%, but
perpetuity has lost half its value
b. The longer the term, the greater the sensitivity to changes in interest rares (market
value went in half)
i. Investors need to be compensated for increased risk (the longer the term of a
debt, the higher the interest rate)
E. Bank Loans
a. Asset-backed financing (including structured financing)
i. Can be secured by receivables or inventory
ii. Because its secured, interest rate would be lower
b. Lines of credit for temporary working capital
c. Commercial loans
d. Loans v. Leasing? Loan can deduct interest payment from taxes, lease can deduct entire amount
F. Letter of Credit
a. Send money to a bank that issues letter of credit to potential seller saying they will give them the money
once seller delivers product (bank has reputation of being trustworthy, so makes everyone comfortable)
26

i. Bank charges a percentage

b. Document controls for these instruments, contract is with bank
G. Capital Markets
a. In Europe, companies will raise money by going to a bank. In US, people avoid intermediary by going to
capital markets.
i. Or company might issue debentures or bonds
b. Commercial paper, notes
c. Debentures
i. Unsecured corporate debt sold in public markets: IOU not secured by anything
ii. Long term debt
d. Bonds
i. Secured corporate debt (secured by some claim to specific assets of corporation)
e. Capital Leases
i. Can expense full lease payment rather than just interest if bought item & loan (good for tax
purposes)
ii. Present value of lease payment obligations is a liability
iii. Equivalent amount show is an asset of lessee if lease meets any of the following four req.:
1. Lease transfers ownership to lessee before expiration
2. Lessee can purchase asset for a bargain price upon expiration
3. Lease lasts for 75% or more of assets estimated useful life
4. PV of lease payments is 90% or more of the assets value
f. Courts tend to respect intention of parties reflect in contracts and most of litigation involves trying to
understand contract
i. Eliasen v. Itel Corporation: Posner says that SHs control company b/c they vote, so they are the
ones who get residuals when sale occurs (get fruits of their control). Here, Class B debentures that
had no control & were worthless post-bankruptcy get nothing b/c no control (surprised when
company ended up doing well and wanted more than face value, but docs ambiguous b/c didnt
anticipate succeeding)
1. *Documents important, but can look outside them when ambiguous
Modigliani & Millers Irrelevance Hypothesis
A. Irrelevant whether company raises money by issuing stock or borrowing debt
a. In absence of corporate taxes, firm cant increase its value by changing capital structure
b. Individual could do it himself and create same situation by buying stock in firm that levered itself or
individual could do the leveraging
B. If company starts off w/ equity and borrows more, its expected return will increase, but overall cost of capital will
increase on pace with this, so that leverage company has no overall net gain in value (leveraging will mean
nothing to SHs)
C. Courts dont accept this hypothesis AND doesnt follow once taxes are introduced
The Real World
A. Effect of Taxes on Debt
a. Corporate taxes can make capital structure matter (contrary to M&M hypothesis)
b. Reason to have debt is corporate taxes
c. Debt increases your leverage
i. If you borrow money, it increases your leverage, increases value and sale of company a little
ii. So the investments of the owners increase a bit
iii. Inaccurate that if you increase debt you automatically increase value of your company
d. What if you just raise money by equity?
i. There is a cost of capital and you will have to give investors something to get them to buy your
sharesif give dividends, they are not tax deductible (results in double taxation)
e. What if raise money by debt?
i. Interest payment deductible so reduces taxes owed, which allows company to increase amount that
is leftover for SHs
ii. Called a tax shield (main reason debt is preferred over equity)
27

f. Debt vs. Equity: Debt is better

i. Tax shield
ii. Debt controls agency costs:
1. Managers of companies may not have same incentives as SHs, may spend more time on
issues not important to SHS
2. Ways to prevent shirking: have managers buy lots of stock so financially invested
iii. If company has lots of equity and not much debt, will be run more riskily b/c SHs have little to
lose and a lot to gain
iv. But, depends on success of company:
1. Good times: want debt b/c keep more of your money
2. Bad times: want equity so that dont owe anyone if dont make anything
B. Impact of Taxes (Example)
a. All Equity Firm
i. Net income: $12K Corporate taxes @ 35% ($4200) = income after taxes $7800
ii. Dividend to SHs=$7800, $7.8% return
iii. Plus subtract personal SH level taxes
b. Leveraged Firm (half and half)
i. $12K interest expense ($4000) = net corp. income $8000 taxes ($2800) = $5200
ii. Dividend to shareholders = $5200 = 10.4% return
- PV Tax Shield = tax shield value / r = [Tax rate * (r*D)]/r = Tax rate * D
D = amount of debt
r = interest rate
- Value of leveraged firm = value if all-equity financed + value of tax shield =
value if all equity financed + tax rate*D
- D/(D+E): fraction of debt
c. M&M says amount of debt doesnt affect value of firm (so absent any taxes, graph of value of firm vs.
fraction of debt is straight line)
d. Once tax shield taken into account, value of firm increases as (D/(D+E)) increases up to certain point
i. Height above straight line is value of tax shield, but if raise debt fraction too high, chance youll go
bust increases, so at certain point bankruptcy risk > tax shield benefit
e. Leveraged Buy-Outs in 80s because people figured out that tax shields add value to firms
i. People borrowed money and were able to pay premium above market price b/c knew firm would
be more valuable if highly leveraged
f. Quick Check 4.1 (page 219): If tax rate of dividends declines, might expect corp to give more dividends
b/c SHs will get to keep more of it (more valuable to SHs)
C. Weighted Average Cost of Capital: use when deciding whether to do a project
a. WACC= (value of debt/value of firm)(interest rate on debt) (1-Tc) + (Value of Equity/Value of Firm *
interest rate of equity) = [D/(D+E)] * Rdebt * (1-Tc) + [E/(D+E)](Requity)
i. Tc= tax cost of debt; Value of firm = D+E
b. If interest rate of borrowing is 8%, increased cost b/c cost of capital goes up
i. Cost of borrowing isnt just interest rate you pay, it increases risk of firm, which also increases
interest rate of equity
ii. WACC uses sep. costs of debt & equity and weighs them in proportion to amount of cap. struct.
iii. So, look at WACC instead of just cost of capital of borrowing
1. More you borrow, greater the impact on the company
2. Higher % of debt, more bankruptcy risk you have
3. Cost of capital increases if you look at CAPM
4. Cost of borrowing is GREATER than just interest rate
5. Borrowing increases Beta b/c Beta affect by leverage/volatility & COC
c. If determining cost of investment, when is WACC used instead of CAPM cost of capital?
i. If trying to decide if investment is a good idea (NPV calculations) and trying to decide whether to
fund investment with debt
28

1. If debt, use WACC b/c interest rate does not reflect full cost to corporation of incurring
additional debt (if incur addl debt, it makes cost of equity capital higher b/c higher Beta
and more risky)
D. Agency Cost of Outside Equity: more debt = better managers
a. Another reason why companies might want debt: agency costs
i. If agent looks out for own interests instead of interest of principal thats a cost: can limit with debt
ii. Corporate managers dont always behave like SHs would want
b. Want managers only to take projects with positive net discounted present value (return>capital)
i. Debt is possible way to control managers incentives to do this
ii. Indifference curves between shirking and value of firm
1. Managers want to choose point on budget line where is on greatest indiff. Curve
2. If manager is not complete owner, then slope of budget line is less (b/c his personal value
in firm does not directly correlate to price of planes, etc bought)
3. Person making decision doesnt incur full cost of decision (i.e. he is getting plane at 50%
discount so will want to buy more of it)
4. If manager only has 1% ownership, he gets 99% discount
5. To get to highest indifference curve, the part owner chooses a location on budget line that
has a lot more shirking
6. Shirking: when manager looks out for own interests instead of best interests of company
(i.e. buying a plane)
iii. Problem is called Agency Cost of Outside Equity: when people running company are managers
and not owners, so dont bear full cost
c. Solution: could be having a capital structure with lots of debt
i. This will contain managers shirking: with a lot of debt, if there is any downturn company will go
bankrupt and manager will lose job
1. Makes it more dangerous for manager to direct company in a way that will cause profits to
fall b/c could put company at riskwhen highly leveraged manager will try to keep
company afloat because any small decrease in profits company goes bankrupt
a. This maximizes value for company
2. If more equity, people in mkt will reduce amount paid for companys shares b/c know they
are buying company run by manager likely to shirk, want structure to restrain agency cost
d. Will have to pay manager more b/c leading company where he has to try hard b/c of debt
e. But, still dont want too much debt so go bankrupt (outside forces beyond managers actions)
f. Other solutions to shirking problem
i. Board of Directors monitoring (imperfect)
ii. Hiring outside consultants
iii. Performance based compensation
E. Agency Cost of Debt
a. Another problem with too much debt: stockholder-bondholder conflict
i. SHs have incentive for company to try risky projects (b/c havent invested much, it has mainly
come from investors)
1. If company fails, SHs dont lose much. If succeeds, investment grows rapidly
2. When highly leveraged, incentive for SHs to want to do risky project
b. If too much debt, agency cost of debt problem (incentive for improper risks), so need balance
c. Want to minimize sum of two agency costs (cost of debt and cost of outside equity)
i. Agency costs rise with use of outside equity
ii. Outside debt financing reduces agency costs b/c discipline imposed and b/c owner/managers still
bear agency costs imposed on residual claimants
iii. Agency costs of debt rise with increasing use of debt (owners/managers tempted to take higher risk
b/c SHs capture all the gains while bondholders suffer large share of loss)
d. Another explanation for LBOs of 80s: people believed existing managers were shirking and not really
benefiting SHs so did LBO that increased debt in companys capital structure, which disciplined managers
more to behave in SHs interest and maximize SH valueLBOs properly incentivized managers
29

e. Want to balance agency costs and take advantage of tax shield

f. Greatest danger of shirking in companies: where manager owns small proportion of stock in company
(utilities): these companies will be more leveraged b/c not much danger of agency costs
i. Least danger is in start-up companies where managers are also owners
Courts Interpretation of Capital Structure
A. New England v. Debt of Public Utilities
a. Capital structure decisions usually covered by BJR
b. Utility: lower capital structure (less debt) allows company to argue for higher prices to cover costs
i. Utility commission says should have more debt b/c interest rate for debt cheaper (wrong, ignores
WACC)
ii. To get cost of capital, use CAPM (volatility of stock and where lies on CAPM line)
B. Heckman v. Ahmanson: Disney not performing well even though had valuable assets, opp for takeover
a. To ward of takeover got lots of debt, offered shark premium to buy back shares
b. SHs sued derivatively, said, and court agreed that directors and shark violated fiduciary duty even though
shark wasnt controlling SH by agreeing to pay/take money & increase debt to level that harmed Disney
i. Caused stock to fall in price b/c riskier w/ more debt so higher Beta, means demand higher return
(lower price)
c. Bottom line: if take on debt and waste money, reduce value of corporationincreasing debt/capital
structure only increases value if dont squander resources
d. Was Disney harmed by excessive payments to shark? Nolike paying dividend and whole purpose of
company is to benefit SHsother SHs were the ones harmed
C. FMC Corporation: corp. paid money to SH with inside info, harm to corp? No same as Disney case
Possible Harms of Excessive Debt
A. In stable industries, efficient to have debt. Unstable, then can lead to too much risk
B. Reasons to be careful: avoid bankruptcy and issues when borrow too much from SHs
a. As SH-lender, bad things can happen if corp. does too much of it or in wrong ways
i. Debt may be treated as equity: paid last in bankruptcy (subordination)
1. Court can deem loans to be capital contributions to company so debt is subordinated
beneath creditors (want money treated as loan in event of bankruptcy)
a. Thinly Capitalized: put up a small amount as equity, rest as loan secured by assets
that are going to be purchased (so get priority over unsecured creditors)
i. Courts wont allow this
ii. Piercing of veil: SH will be deemed liable for debts
b. In re Fett Roofing: sole proprietorship, incorporated and he loaned company money and secured it with
purchased assets. Bankruptcy had 80:1 debt-equity ratio
i. Cannot (very bad to): transfer assets to yourself (out of corp) so less for creditors (fraudulent
conveyance); grant security interest after the fact on eve of bankruptcy
ii. Court can and did here subordinate loan
1. SH not prohibited from loans, but risky (do at arms-length)
a. Also have IRS risk that will re-characterize and no interest deduction
iii. Factors favoring subordination: (1) insufficient equity capitalization (2) loans were for permanent
equipment (3) loans were at outset (4) loans made proportionately by SHs (5) no interest payment
on loans from inside member (6) other creditors paid first, despite priority (7) no efforts to seek
repayment (8) failure to observe corporate formalities
iv. Main issues arise when self-interested transaction
c.
C. Other Traps
a. Fiduciary duties to creditors
i. Normal rule: no fiduciary duties to creditors, employees, environment
1. Exception: when nearing bankruptcy
ii. But, bc creditors have voluntary relationship w/ corp, can negotiate strongly & demand protections
1. But, Bondholders dont want fiduciary duty owed b/c get higher return without one
(couldnt demand as high an interest rate)
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iii. CEOs might use fiduciary duties owed to diff groups as pretext for just benefitting himself
iv. Vicinity of Insolvency/Bankruptcy Exception
1. On eve of bankruptcy, creditors are the residual beneficiaries, so corp should be run in their
interestcreditors are now the ones at risk
a. SH is not residual beneficiarytheir money is already gone
2. Dont have to be in bankruptcyjust close. Bankruptcy defined:
a. Equity Insolvency: cant pay debts as they become due
b. Bankruptcy Insolvency: if total assets < liabilities
c. If present discounted value of assets < PDV liabilities (vicinity of bankruptcy)
v. CLBN v. Pathe: in bankruptcy, duty switches to owed to creditors & they are owners who can tell
company what to do (here told comp. to fire mgmt. & not sell assets as comp. wanted)
1. Why? Creditors become residual claimants
2. Also, company has natural interest normally to protect creditors, so can get more $$, but
near bankruptcy, lose that interest
3. To have efficient decisions made, want decision-maker to be one that has full risk/reward
vi. Dividends: Near bankruptcy cant pay dividend b/c giving away assets and hurts creditors (model
act: cant pay dividend if in insolvency or would make comp. unable to pay debts as they become
due)
1. EX: coal contract where price of coal goes down, but stuck with high price from K, so
losing money each year, but lots of assets so okay for now. Can give dividend. Two tests:
a. (1) Equity Insolvency: corp. unable to pay debts as become due
b. (2) Bankruptcy Insolvency: total assets would be less than sum of total liabilities
c. Company passes (1), but under (2) look at PDV of liabilities and future income
streamseventually will run out of money, so with discount assets <liabilities, so
no dividend
2. EX: asbestos case: good possibility of liability in futuredividend?
a. Cant if PDV of future claims > PDV assetsdetermine how much money will
need to set aside
b. Creditor Liability
i. May pierce corporate veil such that creditor is held liable for corps liabilities
1. Before lend someone money you have powerif you loan money to debtor and they
havent paid you, then debtor has power of lender
ii. Krivo v. Natl Distiller: Dominate Control Necessary to pierce veil? (kept lending $ even when
not paying for products sent, but would loan more money so would pay)
1. Instrumentality Theory
a. Did debtor become mere tool of creditor?
b. Standard: must be actual exercise of control (dominant control) AND misuse of
control which causes creditors harm
c. Factors: authority to completely control other company, have to actually use that
power, need control, need to misuse control, which harms other creditors
2. Here, standard not met-high standardhelping, but didnt have control
c. Close Corporation and Disallowance of Interest Deductions
i. Characterizing money as loan rather than equity saves money company b/c interest deduction
1. Larger interest payments = bigger deduction from taxes = increase value of company and
dividends (company exists for SHs)
2. Also advantages SH: with loan, when get principal back no taxable event, with investment
is taxable b/c no entitlement to those funds
ii. IRS will respect labels if arms-length transaction
1. No danger when not insider (wont pay excessive interest) & wouldnt want to cast outsider
debt as equity b/c gives control
iii. Issue arises when SH controls company and is making loan (close corporation)
1. Will rip off IRS and rip of other creditors in bankruptcy b/c get same priority
2. So, may disallow interest deduction and may subordinate debt in bankruptcy
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iv. Fin Hay Realty v. US: SH made equal initial loans, court looked at 16 factors (page 292), but
mainly said that look at economic reality of what happened and disregard labels
1. Couldve paid less in interest if went elsewhere, all SH made same contribution
v. Ways to reduce risk of re-classification of loan
1. Dont pay excessive interest rates, make loans secured, get loan from just one insider, make
sure corp. would actually be able to pay demand note
d. Liability of Affiliated Parties Under Deepening Insolvency Doctrine
i. If corp is on the ropes and people assist debtor in borrowing more money beyond its ability to
repay, might be liable under deepening insolvency doctrine
1. i.e. accountants help get loans to stay afloat, then could sue accountant
ii. Bankruptcy is normally just really bad for SH, but when deepening insolvency, creditors are worse
off too (b/c they have become residual beneficiaries)
e. NOTE: DE court does not accept deepening insolvency b/c BJR protects O/D that took on more debt to
avoid insolvency
f. Official Committee of Unsecured Creditors v. R.F. Lafferty: Test: at time professional was trying to help
get loans, was there a realistic possibility that this would help company? Yes, then not liable
COMMON STOCK
Limited Liability
A. Downsides of limited liability
a. If P incurs injuries worth more than corporation, then seems unfair (harm to innocent bystanders)
B. Upsides
a. Investors would not invest if unlimited liability, would only invest in very well run companies (=higher
monitoring costs)so, overall means more investment and more diverse investment
b. Introduction of LL caused huge expansion in industry
C. What about creditors?
a. Doesnt harm them b/c can demand higher interest rates to protect themselves
b. Exception: argument doesnt hold with involuntary tort creditors (cant bargain in advance)
D. What LL does for value of company: cost of equity low, cost of debt high (b/c lending costs increase, its a wash)
E. Joint and Several Liability
a. Ensures creditors dont get ripped off
b. Problem is cant limit liability, so may take less risks
i. Want to invest in only a few companies, so can monitor (=less diversification)
ii. Want to monitor investors, so you arent on the hook
iii. Cost of capital would increase
1. Increases cost of equity capital: will demand higher return b/c riskier investment
Problem of Dilution
A. When company issues more shares, your voting control decreases
a. If preexisting SH, this is bad for you: decreases voting power (own small portion, so less power)
B. Economic Dilution (trickier): if you own 6/10 shares and company is considering issuing additional shares
a. Whether good/bad depends on whether addition of more shares will increase value of corporation
i. Give shares away for free: harms existing SH b/c add nothing and cost of issuing new shares
ii. Issue shares for more (company is more valuable): smaller cut of bigger pie is okay
1. If new compensation for shares increases avergage, then good
2. EX: existing shares $10 and investment is $15 then good (increased value per share, but
voting control decreases)
iii. Sold for less/nothing: value doesnt increase so value of existing shares decreases
C. RULE: dilution is worthwhile if compensation that comes per share is greater than preexisting value of shares
a. EX: As outstanding common stock 100 shares @ $10= $1000
i. Issuance of 100 shares @ $10= 200 shares @ $10 = $2000 = SH indifferent, shares worth the same
ii. BUT, issuance 100 shares @ $0 = 200 shares total $1000
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iii. Issuance 200 shares @ $5 = 300 total shares for $2000 = lost value
D. Always a cost with dilution, even if no economic dilution, still lose voting
E. Equation for Loss from Dilution to Existing SH: L = ma [(mx+p)(a)]/(x+d)
a. L= loss through dilution to existing SH
b. m= market price of share pre-issuance
c. a= a SHs share ownership at time new shares are issued
d. x=total shares outstanding pre-new issuance
e. d=number of shares issued
f. p=proceeds from sale of new shares
F. Penalty Dilution
a. When want to induce SHs to do something, can do so by threatening that if dont do it, will dilute their
interest in company
i. Penalty for those who dont invest further, coerces SH to participate
b. Dilution when not fully compensate is bad for SH
i. So, corporation will exploit this to prevent free-riding: if dont contribute fair share, then shares
diluted, so in SHs best interest to pay full share
ii. NOTE: penalty dilution doesnt work until offering priceis less than FMV
- Rule of Dilution sale of additional shares to other people is bad for current
shareholders if sold below existing market price for shares (because average
price will be lower than initial price)
- Penalty Dilution offer existing shareholders shares at price lower than
market price because if they dont invest, their share value is lowered and
they are hurt
G. Preemptive Rights
a. Way to eliminate possibility that mgmt. would make sweetheart deals to issue new shares to themselves or
friends
b. To prevent new shares from being issue at too low a price, allow minority SHs to have first dibs at new
shares at that price
c. Problem arises when big corporation has lots of SHs and when different kinds of shareshard to track
down every shareholder
d. Basic Rule: no preemptive rights unless agreed upon (took complicated otherwise)
i. Under model act, must put rights in to get them, and then triggers default rules
1. Rights do not apply: if shares sold for something other than money, given to D/O as
compensation, if selling preferred shares and you have common (but can change default
rules)
e. Ways to protect minority SH without preemptive rights:
i. Put in articles that cannot issue new shares
ii. Make agree to put SH on Board and need unanimous approval for new issuance
H. Equitable Doctrines Governing Dilutive Stock Issues
a. Katzowitz v. Sidler: case where court rescued SH who didnt buy shares at lower price in penalty dilution
situation and two other SHs did (guy didnt want to spend more money)
i. Note: preemptive rights arent valueless if cant afford, can sell them (but, issue where close corp)
ii. Court here saw penalty dilution as bad thing, but really can be good to avoid freerider issue
1. There are valid reasons for penalty dilution and should be subject to BJR, but court here
feels bad for guy and rescues him
I. Dilution as a Takeover DefenseThe Poison Pill
a. Threat of dilution can be used by company to deter people from taking over company (Poison Pill or
Rights Plan)
i. If someone tries to take over corp, once person buys enough shares, all other SHs in company
automatically get additional shares at huge bargain price

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ii. EX: if shark acquires 15%, then everyone else can buy a lot of shares for 50% pricereduces
value of shares acquirer already has
b. Goal: deter acquirer from even starting to acquire shares in first place
c. How they normally work: if bidder acquires more than certain percentage, then various rights may be
exercised
i. Normally, rights plan gives existing SHs right to convert each of their common shares to preferred,
which then, if someone tries to take over, can be converted back to common shares at discount
pricedilutes bidders ownership b/c bidder has no preemptive rights w/ addl issuance of shares
ii. Bidder is harmed b/c shares are issued for less than FMV
d. Reality: not as powerful as may seem
i. May cause potential bidder to pass over company if can find another w/ no poison pill
ii. Normally can still buy company, just will have to pay more: avg increase in price is 6-10%
1. EX if cost w/ poison pill is $15.9M, without is $15M, rights plan cost is 6%
e. Valid Reasons for Poison Pill
i. Want to protect from takeover
ii. Managers want to provoke bidding war and get higher price
f. Invalid: managers just want to keep job (bidder wants to takeover b/c thinks managers doing crappy job)
g. If managers have veto b/c of huge poison pill, bidders may bribe managers (e.g. golden parachutes,
severance), so poison pill gives managers more leverage
h. To really prevent takeover, use Reloadable Poison Pill
i. Normal poison pill, dilution kicks in and then wont happen again
ii. Careys patented method says first time it happens there is dilution. Then it happens again once
bidders ownership gets back up to trigger amount
i. Flip-In vs. Flip-Over Poison Pill
i. Flip-In: if potential acquirer gets more than certain percent stock, current SHs get more shares
(economically means lots of dilution for potential acquirer)
ii. Flip-Over: same as flip-in (get shares in target), but also get shares in acquiring company once
merger (bad for existing SHs of acquiring company)
j. Rarely are pills triggered: people will go to another company, so dont know effect of them and when are
triggered its usually a mistake
k. Poison Pill-Management Conflict
i. Usually investor wants to take over b/c mgmt. underperforming, so takeover would be good for SH
ii. Acquirer will be willing to pay more for shares b/c sees that can increase value when takeover
iii. Conflict: mgmt. is putting poison pills in place, but takeover could be best for SH, but existing
managers dont want to lose job
1. So managers will put in place to keep job, but will say doing it b/c could get more for
company or potential acquirer is a looter
2. So, courts will consider if there was self-dealing
iv. Moran v. Household Intl: court will look at when rights plan put in place (post-takeover offer:
likely self-dealing to protect job; pre- give more deference b/c planning ahead)
1. Court said BJR applies in different way: burden on directors to show that they did it in
good faith and not just for entrenchment purposesnormally board wins
2. Court here upheld plan, but others have applied more scrutiny, but even when struck down
most state legislatures have said poison plans are legal (so managers will decide to
incorporate in their state)
J. Capital Protection: Legal Capital
a. Capital requirements originally were deal struck with state by railroads, so could ensure actually built
i. Rules in place saying that before corp. was valid entity w/ monopoly status and limited liability,
must invest certain amount
ii. Lots of bribery/corruption with monopolies, so govt mostly got rid of them
iii. States passed general corp req: anybody could become corp w/o unique deal w/ state
b. Requirements have been retained to certain degree even though no monopoly now being given
i. New rationale: protect those dealing with business (creditors or other investors)
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K. Investor Protection
a. American solution: par value
i. Want capital requirements to protect investors (specifically, later investors)unfair if later
investors misled into thinking there was more capital originally invested than there was
ii. So, want to make sure initial investors paid substantial amount for shares
1. In Europe, before can start corp, regulator must look over bus. plan & certify adeq. cap.
b. Requirements of Par Value: disclose to investors how much SHs initially invested & requirements that
corp couldnt issue stock to initial SH based on promissory note (no IOUs)
i. Par Value: minimum amount share of stock may be sold for (protects creditors & later investors)
ii. Note: can give anything in exchange for stock as long as board considers adequate consideration
1. If no par value then all is stated capital
iii. Also, now promissory notes okay (had to allow or would incorporate elsewhere)
c. Jargon
i. Stated capital: par value times number of shares outstanding
ii. Capital Surplus: amount received in excess of par value (not viewed as pat of fund to protect
creditors)
iii. If no par, board must state what goes to stated capital and capital surplus b/c if dont then all stated
capital & cant be distributed as dividend: board will want flexibility and all capital surplus
L. Creditor Protection
a. Par value is really a historical artifact and now normally can set par low and sell shares in excess of it
b. But, stated capital still meant to protect creditors: minimum that must stay in company (no dividends)
c. Competition between states led to no par value requirements in many states
d. *Trap for unwary in DE and Model Act: no par value, then all stated capital
M. Public Securities Markets & Regulation
a. How do you raise money?
i. Normally start with yourself, friends, or borrowing; then venture capitalists (business that get
investors that want to invest in high-risk companies; then angel investors or investment bankers
ii. Then, might go public (issue stock to general public in IPO instead of private investors)
1. At IPO: (1) original investors will sell stock and (2) preexisting SHs seling too
b. Regulation of IPOs
i. Must file registration statement with SEC to issue new stock to public
ii. No federal merit review requirementcan do whatever you want as long as disclose everything
(some states have one & must get permission once state looks at merits)
iii. 1933 and 1934 Act
CORPORATE DEBT
Overview
A. Contract (indentures) in debt are designed to prevent scams arising from SH-bondholder conflict
B. Company may want to load up on debt for tax reasons and reducing agency costs
a. Debt over equity will make people (like board) work harder
C. Three Main Ways Corporations Borrow Money
a. (1) Private Loan Agreements (from banks, mutual funds, anyone w/ money)
i. Tend to have variable interest rates (shift IR risk to borrower)bank is financial intermediary, so
charges more (normally fixed)
ii. So, incentive for corp to try to borrow directly from people and not bank (larger the company, the
more efficient it is for company to go to public or primary lenders over bank)
iii. Need loan agreement and documents
b. (2) Public Borrowing (Bonds)
i. Normally cheaper for larger corporations (no intermediary)
ii. Investment banks help corporation do this kind of corporate borrowing
iii. Normally owned by large fin. institutions and other companies (same hands as priv. loan agmt)

35

iv. Bond=generic way of describing all public, corporate debt (acts as IOU)usually refers to secured
corporate debt (indenture is unsecured, but sometimes used interchangeably)
c. (3) Commercial Paper
i. Borrowing with maturity of less than 9 months
ii. Sold among dealers
iii. Exempt from registration under 1933 Securities Act, but other requires by Sec. Act
iv. Large high grade debt sold by large corps to large fin. inst. like mutual funds (no chance of
bankruptcy) w/ ST maturities
D. Usually debt means dont have to report under 1933 act, less fuss than equity
a. But, company may do equity b/c cant get needed money through borrowing (start-up), so people that are
giving money want possible upside, so have to give equity
Public Borrowing
A. Bond Lingo
a. Corporate debt is issued in $1000 units
i. But, quoted in WSJ in 100s (ex: 46.50 means 465multiplied quote # by 10)
b. Bonds will sell for less than sold
i. (1) If interest rates rise (when IR rise, value of someones entitlement goes down)
ii. (2) Company becomes riskieri.e. credit rating of company went down and market thinks less
likely to pay back
1. If risky company and original owner wants to sell, people will only buy w/ high return
(lower price)
c. Rates of return are based on risk of bonds (normally reported by rating agencies like S&P)
i. Junk Bonds: substantial possibility debtor will never repay (doesnt mean you should never buy,
just means will get higher interest rate to compensate for risk) (high-yield bonds)
ii. To get high yield will want high interest rate or buy from someone else at discount
B. Bonds are issued subject to indenture (contract that sets up bond) and there is indenture trustee who is given
legal authority to sue on behalf of bondholders
a. If no indenture trustee, then violation of K terms would lead to race to courthouse to ensure payment
b. Trustee has authority and duty to look out for interests of bondholders (and is usually a bank trust dept)
C. Bond Pricing
a. Current Yield
i. Reported in WSJ, but not a meaningful figure
ii. =yearly payment/price
1. EX: at start yearly payment is 8% of $1000
iii. BUT, fails to take into account repayment of premium at maturity
1. Overtime, price of bond will rise as bond matures up to $1000 (principal paid upon
maturity)
a. If interest rates have risen, capital gains exist to person who purchases bond during
period before maturity (b/c price will be below $1000) (capital gain)
b. If IR have fallen, price of bond will be higher (above $1000), but as get closer to
maturity, drops to $1000 (capital loss)
iv. *bad indicator b/c doesnt take into account capital gain, Yield-to-Maturity is better
b. Yield to Maturity
i. Discount rate that makes PDV of bonds payments (including interest AND principal) equal to its
price
ii. YTM for zero coupon bond (no interest) maturing next year
1. = (amount will receive at end current price)/current price
iii. Measure of average return you will obtain by owning bond, includes interest + capital gains
iv. EX: current yield is 8%, current price is $880, principal repaid upon maturity is $1000, so know
maturity is greater than 8% (get back extra $120 spread over 25 years)
v. Value of interest payments: try different interest rates until end up with current market value (if
value is higher than current market value of bond, then increase IR and try again)
1. Use annuity formula for interest payments and find PDV of principal payment
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vi. Yield to Maturity will vary more from current yield the closer the bond is to maturity
c. Current Yield vs. Yield to Maturity
i. YTM includes capital gains, current yield does not
ii. EX: bond selling for $500, know over life of bond will increase in value $500
1. Current yield is 5% (payment/price), need to add capital gain for YTM
2. If maturity is next year, will get $500 capital gain
3. If in 10 years, get $50 capital gain/year
4. Sooner it is to maturity, more capital gain is substantial part of return. Longer time, less
capital gain
iii. How does return correlate with how long until bond mature? More years until maturity, greater
financial risk, so higher return demanded
1. If IR decrease, bond price goes up
2. Longer time to maturity, greater risk from IR, so require higher return (lower price)
d. Yield Curve
i. Slopes upward
ii. For obligations maturing in a few years, IR is relatively low
iii. Obligations maturing in future, IR must be high to compensate for higher risk of IR fluctuation
iv. Risks
1. IR will increase, inflation, repayment (longer period of time, greater chance company goes
bankrupt)
v. LT v. ST bonds
1. LT: change in IR causes sharp change in price
2. ST: less price sensitive, less affected by IR changes
D. Stockholder-Bondholder Conflict
a. Shareholders
i. Want high risk
ii. Once already invested, incentive to take on more risk so can make greater profits
iii. Start off at low risk, then become more risky when you already have the money
iv. Get more if high risk
b. Bondholders
i. Want lower risk
ii. End up paying for the high risk of SHs
iii. More debt means higher likelihood wont get paid
iv. Get less if high risk (company does poorly, bondholders bear most of risk)
c. Conflict: natural incentive for company to increase risk after debt has been incurred
d. EX: person started company with $1 of own money and issue $1M worth of bonds at 10%. Safe project
would return 15% (bondholders get $100K, so SHs get $50K remaining from $150k return)
i. Risky project has 10% chance of getting $100M, 90% chance nothing
1. Bondholders expect $10K but 1/10th chance SHs will get $100M = $10M minus $10k must
pay to bondholders
2. Incentive for companies to take the gamble b/c only put up $1 (risking other peoples $)
e. Documents in bond indentures are designed to keep company from increasing risk
i. Bondholder must put in protections or ensure high interest rate
ii. Could give bondholder voting rights or be able to convert to SH
f. Remember *four corners of indenture contract control, so very important whats in it
E. 4 Main Ways Companies Can Increase Risk to Bondholder (SH-Bondholder Conflict)
a. (1) Incurring More Debt (Claim Dilution)
i. Dont want company to incur more debt b/c decreases possibility loan will be repaid
ii. *What to include in contract to prevent:
1. Dollar limitations on new debt (cant have more debt past X)
2. Prescribed ratios: limit on debt-equity ratio; net assets to debt
3. Funded Debt: any obligation payable more than one year from date of determination
thereof, which under GAAP is shown on balance sheet as a liability, including obligations
37

under capital leases, but excluding items reflected below current liabilities (i.e. deferred
taxes, other reserves)
a. Capital leases are sneaky way company prohibited from taking out more debt can
get more debt
b. (2) Choosing Risky Projects (Asset Substitution)
i. If risk increases, price lowersmakes repayment less likely
ii. *To Prevent:
1. Some indentures prevent company from creating addl liens, so secured debt doesnt take
priority over current loan
2. Tangible net worth: as of any date, difference of (i) net worth, minus (ii) to the extent
included in determining amount under foregoing clause (i), the net book value of goodwill,
cost in excess of fair value of net assets acquired, patents, TMs, trade names, copyrights,
treasury stock, and all other assets which are deemed intangible assets
a. Intangibles excluded b/c too hard to value and could result in scam
3. Limit kind of assets company can invest in
c. (3) Withdrawal of SH Capital (Dividend Payment)
i. Dont want companies redistributing assets that would otherwise be available to repay debt b/c
means no cushion to pay of debt
d. (4) Underinvestment
i. Same issue as withdrawing assets if company allows plants to wear out and become useless, then
means not enough cushion to pay off debt
e. Put limits on things like entering into new lines of business, amount of new debt incurred, will continue to
invest and repair existing investments, not issue dividend above certain amount, etc
f. When risk increases, price of debt goes downwhen selling to others they will demand higher return, so
lower price
F. Contract Interpretation
a. Boilerplate: usually enforced in financial area, only not enforced when big company dealing w/ individual
& oppressive provisions that individual wouldnt understand
i. Normally boilerplate in these instances will be broad and have exceptions
1. EX: Company shall not create, incur, assume, or issue more debt including subsidiary (b/c
just as bad if sub. Does it), except
a. Indebtedness under this debenture and indenture; already outstanding indebtedness
at time of issuance of bonds
b. Sharon Steel: gives rule of successor obligor clause: debt is transferred (in this case a good thing b/c IR
went up) only if new company has taken over all or substantially all of assets
i. B/c if sold all, then still same assets backing up loan
ii. Here saw potential scam that company was selling off assets and then other company bought the
restmade company riskier, which is bad for bondholders
iii. Court said indenture controlled in this case and didnt sell off all assets, so no takeover of debt
G. LBO Structures
a. Existing SH are compensated by borrowing more money
b. New managers will be more careful b/c higher debt decreases agency costs
c. But, upsets existing bondholders (value of bonds decreases)
d. Before LBOs were popular in 80s, not a lot of restrictions in indentures
i. People didnt think theyd occur b/c mgmt. had incentive to preserve rating, but was wrong b/c SH
& bondholders have mismatched interests
e. Even if covenant against LBO, still can occur if pay off bondholders first
H. More Contract Terms
a. *Must draft carefully, only created by contract, no default protections
b. (1) Incurring More Debt
i. Met Life v. RJR Nabisco: RULE: no background rules protecting bondholders if couldve protected
themselves (foreseeable risk)
1. Met Life is sophisticated investor, so only should get protection that is in contract
38

I.
J.

K.

L.

2. So here, no protection from LBO

ii. Now lawyers will put:
1. (1) Change of Control Put Provision
a. If LBO and change of control, debt holder can require company to buy back bonds
for full price
2. (2) Change of Control Reset Provision
a. If reset, then increase IR until market value of bond is same as before
b. May deter some LBOs b/c normally SHs dont have to pay for all of risk b/c there
are bondholders, but this make SH pay for LBO
c. Would still go through with LBO if benefit to SHs after paying full cost of LBO
c. (2) Asset Substitution
i. Covenants against risky financial investments (investing in risky businesses)
1. Indentures will make exception for accounts receivable b/c technically investment in
another company
2. Or could limit to liquid investments or only invest with equity
ii. Prohibit sale of substantial assets (so cant sell and invest in risky assets)
iii. Conversion provisions: bondholder converted to SHprotects BH b/c SH can no longer exploit
iv. Could give BH direct control of company, but dont want to b/c can lead to piercing corp. veil
d. (3) Withdrawal of SH Capital
i. Define inventory of funds available for dividends and comp. prohibited from distributing dividends
that exceed that amount (exceptions: can distribute new earnings/proceeds from stock sales)
ii. Limit dividend distribution (stop you from decreasing equity)
1. SCAM: instead of giving dividend, repurchase shares (gives lots of $ to group of SH
instead of all of them, but same effect of decreasing equity)so must include repurchase
iii. Cant completely prevent dividends, just limit it
e. (4) Underinvestment
i. Covenant to maintain property, enforce through periodic statement of compliance
ii. Require insuranceinsurance company will then monitor maintenance so reduces monitoring
costs
Waiver of Covenants
a. BH can waive any covenants put in for protection (can waive one thing without waiving all)
Sinking Funds: Addl BH Protection
a. Requires company to set aside certain amount of money each year to redeem some bonds, which is good
for BH b/c decreases risk that company might go bankrupt
i. Reduces risk associated w/ LT bonds
b. BUT, BH dont want company to be able to redeem all of them at their discretion if IR decrease
c. How it works
i. Debtor can either redeem bonds at face value or pursuant to schedule or can go to market and
repurchase (will want to do this if IR go down, bc market price will have risen)
ii. Normally BH will negotiate in advance to protect for thisschedule negotiated for redemption (no
redemption in first few years, but can purchase on market), then afterwards payment schedule
where can redeem at premium just above price of bonds (so BH maintains upside if IR decline)
Call Protection
a. Morgan Stanley v. ADM: sinking fund mattercouldnt redeem if borrowed money at less than 16%
i. Court construed narrowlyokay to generally borrow less than as long as redemption $ coming
from elsewhere (but issue wont arise again b/c will contract around)general rule is dont protect
BH unless contract for it (so even if company trying to scam BH by always intending to redeem
right away, still okay)
Amendments to Indenture
a. Individual BH can waive provisions if indenture (might not be enforced, but used as bargain tool for BH)
b. Basic RULE: certain amount of BH need to agree before waiver of normal provisions (really important
ones such as interest paid, principal paidwould require majority & individual BH has veto)

39

c. Katz v. Oak Inds.: deteriorating company and said will pay higher price for bonds as long as waive
covenant that comp. will pay $1K for bonds (offering $600, FMV $300)offer cannot refuse b/c if dont
accept, then dont get $$ and bond will be worthless b/c no protections
i. Court said OKAY because BH only get protections in bond documents
Indenture Trustee & Trust Indenture Act
A. Nature of Trustee & its Duties
a. Trustee is empowered to act on behalf of BH
b. Trustee appointed before there are any BH and debtor pays trustees fees
i. Normally lazy and wont enforce covenants
ii. BUT, creates market opportunity: bond price will go down, can buy up bonds and enforce them,
pushing price up and debtor wont be as risky
c. Two Conflicting Impulses
i. Debtor would rather have trustee that would do whatever debtor wanted
ii. But, issuing bonds in competitive market & sophisticated investors will consider trustworthiness of
trustee when deciding how much to pay for bond
d. Trust Indenture Act is federal statute that governs
i. Designed to address conflict of interest b/w trustee & debtor corp.: applies to all debt issues in
excess of $10M
1. Requires indenture and contents must be approved by SEC
2. Trustee has to have capital and surplus of at least $150K (if no assets, less incentive to do
good job)
ii. Potential conflict: if trustee is also creditor of debtor itself, might look out for own interest as
creditor
1. After default, trustee cant have certain conflicts of interest
a. Conflicts only matter in default & trustee may have to withdraw
iii. Trustee must make various reports to BH annually concerning any change in eligibility to serve as
trustee and amount owed by debtor
iv. Limits on exculpation of trustee
v. Cant change rights to interest unless 75% of holders consent (lower for other provisions)
vi. Elliott Ass. V. J Hendry Schroder: no duties owed to BH unless default
1. So no issue when waived provision about notice of redemption, dont have to looking out
for BH interests with a lot of effort
B. Trustees Duties in Default
a. Default is when trustee is supposed to spring into action as provided for in TIA
i. If fails to act and 25% or more of BH want to sue, then can sue on their own. If 30% want and
50% dont, then 50% can veto right of 30%
b. When default occurs, trustee has overarching duties to behave as a prudent person (regardless of K)
c. Trustee has right to sue on behalf of BH
d. Situations in which default exists
i. (1) Failure to pay interest
ii. (2) Failure to ay back principal
iii. (3) Failure to comply with covenants
iv. (4) If file for bankruptcy
e. Can assist on acceleration in event of default, but normally give 30 days to cure default
i. If dont cure, then in default & must pay back money then
ii. NOTE: if risk bankruptcy, this will probably push you there b/c all bonds due, so would normally
work out something with bondholders
f. If trustee fails to act and BH didnt sue at that time, trustee may be sued in state court under theory of
breach of contract
g. Does TIA create private right of action? Defendants will say no, but P say yes
i. Otherwise cant sue in federal court under TIA unless diversity
ii. LNC Investments: court found that there was private right of action b/c Congress intended this
h. Implied rights of action under securities laws: sometimes courts say yes, sometimes say no, contested area
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Capital Leases
A. Capital Leases
a. ST leases are opposite of capital leases
i. Efficiency reasons associated with ST leases (dont want to buy UHaul truck for two-days youll
use it and you dont have expertise in buying them)
ii. If rarely use piece of equipment, makes more sense to lease b/c lessor has expertise in caring for it
1. Lessor gets paid for expertise by getting higher IR
b. LT Lease (financial lease)
i. Effectively buying something, but structure as lease
ii. Better tax treatment (if you purchase an asset, can deduct only the interest payments on the
borrowing you had to do (not principal payments rather than full price of asset; if you lease
equipment, you can deduct entire lease payment)
iii. Also, makes company not look leveraged
1. If borrow money to buy equipment, increases debt
2. If buy airplanes and sell them to someone else and lease them back, havent increased
leverage
3. Conceals fact that you are leveraged b/c lease doesnt show up on balance sheet
Asset Backed Financing
B. Special Purpose Entities: vehicles used by Enron and others to engage in massive fraud
a. Big company transfers assets to SPE and then gets loan, because only have that good asset of otherwise
shaky company, SPE gets better rate b/c in good financial condition
i. Legitimate use of SPE: pays money to initial owner of asset & amount paid is realtively high b/c
SPE can get better terms on loans)
b. Other advantage is it looks good on books (non-legitimate use of SPE)
i. Original debtor not getting more debt b/c selling asset to SPE and getting money, so keeps it off
balance sheet
ii. If company itself got money it would increase leverage (debt:equity ratio)
C. In bankruptcy, creditors will argue should collapse SPE with company, so make sure maintain corporate
formalities (separate them); also issue if fraudulent conveyance
D. Could violate debenture covenants about increasing leverage (if include SPE in definition) or violate covenant
that prevents sale of assets
PREFERRED STOCK
Overview
A. Defining Preferred Stock
a. 2 Basic Divisions in Corporate Finance between Debt and Equity
i. Preferred stock is in the middle
1. Get whatever dividend preference (but not more even if CS do!)
b. Debt is a fixed promise to pay interest and repay principal at maturity vs. PS
i. If failure to make interest payments, then there is acceleration & principle is immediately due
1. With preferred, dont have to pay dividend, but if do pay to CS, then must pay PS
ii. Bonds have due date for payment of principal
1. PS has no right to get money back unless put in contract
iii. Dissolution: creditors get first dibs; often PS have preference (but must look at contract)
c. Companies rather preferred stock over debt
i. Less risky b/c not obligated to make payments
ii. Companies want this b/c halfway between debt and equity
1. If company does very well, then preferred SH only entitled to dividend preference
iii. For company that is providing dividends: cant deduct but can deduct interest payments
1. But company investing in another company that receives dividends gets tax advantage as
opposed to interest payments
d. Investors rather preferred stock over common stock
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i. Get voting rights

ii. Tax reason: can deduct some amount of dividends (pay corporate tax on interest) (just applies to
one company investing in another company
iii. Venture capitalists will want preferred shares not b/c expect dividend but b/c can get liquidation
preference (set redemption amount) AND always convertible into stock
1. VC generally wants PS over convertible debt (which can convert from debt to stock) b/c
can get voting rights or control rights sometimes with PS AND remember risk of lender
liability if too much control
e. PS is missing some characteristicsall a creature of contract
f. Statutes authorizing PS
i. Default: can vote
ii. RMBCA: Must authorize one set of shares that can vote and one that receives net assets upon
dissolution, but can authorize other types
B. Use of Preferred Shares
a. Public Utilities
i. Often requirements by regs that company have certain amount of equity: cant get too debt heavy
ii. Tend to have a lot of debt b/c can get lots of loans, so to squirm around req of low debt will issue
PS
b. If investors can look and see that the company regularly pays dividends on PS, then people are willing to
pay more for PS
c. If company issues a little debt and lots of PS and pays PS dividends like clockwork and pays lots, then this
is a lot like debt
i. When company makes a killing, PS will not see this unless they are participating or convertible
ii. Normal PS does not participate in upside, so like debt
iii. So, if company has constraints on amount of debt, will issue PS, which is equity acting like debt
d. Other reasons to use preferred rather than debt
i. Less risk incurred than with debt
ii. If company does poorly, not in default if it doesnt pay dividends and does not go bankrupt
iii. For startup, PS is much better b/c no money coming in and all going out
iv. PS can vote if in contract
v. For corporate investors, purchasing another companys PSdividend payments received are not
taxable
Dividends
A. Varieties of Dividends
a. Generally subject to BJR: Directors make decision on paying dividend
i. As long as reasonable purpose for using money, its okay to not give dividends
ii. BOD makes decision of whether to issue dividends: basically okay as long as wont make bankrupt
b. Once dividend is declared, then it becomes obligation of company (cant sue for pref. div. until declared)
c. Preference for PS just says must be given dividends before CS
d. Note that statute refers to distributions, not dividends b/c can make many thins act like dividend
e. Preferred stock is a creature of contract: cases show bad drafting
i. Arizona West v. Constantin: issue about whether must pay only if profits or always (more like
debt)
ii. Constantin v. R.P. Holding: normally just four corners doc, but issue where articles & bylaws
conflict. NJ looked outside and found for bylaws though normally articles trump bylaws and
normally dont look outside
B. Types of Dividends
a. Straight: in a given year, company cant give a dividend to common SHs unless it also provides required
amount to preferred
i. Company could benefit CS by saving up money and invest and later distribute all to CS and just
required preference to PS
b. Cumulative: company must pay all dividends from past years that they didnt pay
i. Would also want to make company pay interest on back amounts, otherwise incentive to delay still
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c. Default when contract silent is no cumulative dividends (Guttman)

C. Property Rights in Dividends: no property right if
a. Hay: failed to make it clear that upon liquidation got dividends regardless declared/earned
b. Smith v. Nu-West Inds.: issue about whether dividends accrued daily or at end of year (here found prorata)
D. Three Situations for Cumulative Dividends
a. (1) When contract says so
i. When there is a dividend declared on common stock
ii. Other triggers (could say when there is profits, etc.)
b. (2) Liquidation
i. Common contractual situation
c. (3) Redemption
OPTIONS & CONVERTIBLE SECURITIES
Overview
A. Uses of Options and Option Theory
a. Definition: contract giving holder the right to buy or sell asset in or before future date at specified price
i. Conversion right is an option
b. Use of Options
i. Compensation (can pay execs with options)
1. Upside: company doesnt have to reflect this on books
2. Downside: if market price falls so low that option becomes worthless, incentive to
executives is gone (so give them more options with a lower exercise price)
ii. Hedging
1. Can protect yourself from market fall by buying put options
2. Problem is that from ECMH nobody knows and cant foresee market declines
3. Insurance to protect against fall, but it costs money
c. Types of options
i. European: must wait until future date to exercise
ii. American: can exercise at any date up until future date
1. American option is more valuable b/c can exercise before
d. Call Option: contractual right to buy asset at specified price on, or before, specified date
i. Only make money (and will want to exercise) if market price goes above call price (will buy and
then turn around and sell stock)
1. Dont exercise if price goes down
ii. If expect price of stock to go up, why would you buy option? Downside is relatively low, so youre
lowering risk
iii. If buy stock, could lose entire stock price. Buying option, losses are limited to option price (but if
price goes up, can still participate in upside)
iv. Why would corporation give options instead of stock? Accounting schemes (dont have to expense
options)
e. Put Option
i. Contractual right to sell asset at specified price on, or before, specified date
ii. Exercise if price goes down
f. Forward Contracts: no option, just agreed to sell in future
i. Good if price goes down
ii. Personal, face-to-face (futures contract usually anonymous)
g. Expiration Date: last date for exercising option
h. Warrant: call option issued by company for its own stock
i. Short Sale: selling now stock that you have borrowed (usually through broker). You then buy stock later
(at profit if price has gone down as you predicted) and return to person you borrowed from
j. Long: buying stock with expectation will go up

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i. Better to use option or long if know stock will go up? Options will be better b/c can make more
moneycan buy more options for less. Buying stock cant buy as much
1. Options allow you to control many more shares and can make a lot of money if option foes
right (dont actually have to have money to exercise b/c writer of option will just send you
check for profits)
k. Exercise/Strike Price: price at which option holder can buy or sell asset
How Options Operate
A. To profit in price decline (if think market going down), could
a. (1) Buy put option
i. Even if price goes down, still can sell at higher K price (should be worried if people buying
options on your company)
b. (2) Write a call option
i. If price declines, person wont exercise call option, so seller gets money from sale and doesnt
have to do anything
c. (3) Forward Contract
i. Face-to-face contract with someone to sell at specific price in future
d. (4) Futures Contract
i. Different from put option b/c agreeing to sell share of stock at future date at specific price (put
option gives option)
B. To profit if price increases, could:
a. (1) Purchase call option
i. Call will profit you if price increases past strike price (buy low and sell high)
b. (2) Purchase stock (going long)
c. (3) Sell/Write Option
i. If price goes up, wont exercise put option, so seller of it just keeps cost of option and doesnt have
to do anything
d. (4) Agreement to purchase stock in future (forward or future contract)
i. Agree to purchase stock at certain price in future
Valuation of Options
A. (1) Exercise/Strike Price: in the money when hits this
a. For a call option, lower the strike price, higher the price of the option
i. Guarantees youre getting profit so more costly
b. For a put option, lower the strike price, lower the price of the option
i. To make any money, market price must go below strike price
ii. If market price is above, strike price, put option is worthless
iii. If price declines below strike price, then put is worth $1 for each dollar below stock price
B. (2) Time
a. More time you can wait before expiration, higher probability price above strike price (call)/price below
(put) (so price of option will be greater the longer the time until expiration)
C. (3) Current Price of Stock
a. Closer market price is to exercise price, more it will influence price of both puts and calls
D. (4) Volatility
a. Higher the beta, higher the variance, higher value of option
b. With more variance, you have better chance of price changing and making option in the money
c. If no chance that price will ever get to exercise price, then option price is zero b/c worthless
E. (5) Interest rates
a. Interest rates can affect value of options
b. Higher the interest rate, the higher the price of the option
F. Put-Call Parity Theorem
a. Possible to sue combination of put and call options to create all sorts of returns
b. Price of option will depend on underlying price of security, so its a derivative
c. Can write a put and buy call to simulate another type of security (derivative that simulates going long);
buying put, write a call to hedge
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i. Price goes down, person will exercise put; price goes up, will exercise call
G. Options relate to corporate finance b/c lots of hidden options: conversion rights in bonds, coming to class
a. EX: oil in sand in Canada, expensive to remove and not profitable unless price goes to $120/barrel. To
profit from land when it goes up that high, need to have purchased land. Purchasing land, you have
purchased a call option. (probably didnt spend that much for land b/c cant exploit it now)
b. EX: may go to law school even though might want to be novelist, but have to go to school to be lawyer, so
by paying (tuition and opportunity cost), you have purchased a call option on becoming lawyer
Convertible Securities, Deal Protection, and Venture Capital
A. Possible protections for clients to protect their options
B. If price of stock goes up, will want to convert bond to stock. But, if company not doing well, want to stay as
bond b/c guarantee interest rate

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