FINANCE 2 FOR IBA

Chapter 14: Capital Structure in a Perfect Market

Firm’s capital structure: collection of securities a firm issues to raise capital from investors.
Unlevered: equity is used without debt.

Perfect capital markets satisfy three conditions:

1. Investors and firms can trade the same set of securities at competitive market prices equal to the PV of their
future CFs.
2. There are no taxes, transaction costs, or issuance costs associated with security trading.
3. A firm’s financing decisions do not change the CFs generated by its investments, nor do they reveal new
information about them.

MM proposition I: with perfect capital markets, the value of a firm is independent of its capital structure.

- If otherwise identical firms with different capital structures have different values, the Law of One Price
would be violated and an arbitrage opportunity would exist.
- Total market value of a firm’s assets equals the total market value of the firm’s liabilities, incl. all
securities issued to investors. Changing the capital structure therefore alters how the value of the assets
is divided across securities, but not the firm’s total value.
- Cost of capital for levered equity is:

( )

Debt is less risky than equity, so it has a lower cost of capital. Leverage increases the risk of equity  higher
equity cost of capital (benefit of debt’s lower cost is offset by the increase in rE), leaving the weighted
average cost of capital (WACC) unchanged (with perfect capital markets):

Unlevered beta: estimates market risk of a firm’s assets

Leverage increases the beta of a firm’s equity:

 ( )

Net debt: debt – holdings of cash and other risk-free securities.

Leverage: can raise E(EPS), but also increases volatility  value of equity is unchanged.

With perfect capital markets, financial transactions are a zero-NPV activity that neither add nor destroy value on
their own, but rather repackage the firm’s risk and return. Capital structure affects a firm’s value only because of
its impact on some type of market imperfection.

Chapter 15: Debt and Taxes

Interest tax shield: gain to investors from tax deductibility of interest payments.

-
- ( )
- When a firm’s marginal tax rate is constant and there are no personal taxes:
( ) .

WACC:

- Pre-tax WACC measures the required return to the firm’s investors.

- After-tax WACC (=WACC) measures the cost to the firm after including the benefit of the interest tax
shield.

- ( )

( ) ( )

( ) ( )
- Absent other market imperfections, the WACC declines with a firm’s leverage.
- is calculated as present value of FCFs using the WACC.
is calculated as present value of FCFs using unlevered cost of capital or pretax WACC.
- When securities are fairly priced, the original shareholders of a firm capture the full benefit of the
interest tax shield from an increase in leverage.
Personal taxes (income taxes): offset some of the corporate tax benefits of leverage. Every $1 received after
taxes by debt holders from interest payments costs equity holders $(1-τ*) on an after-tax basis, where
( )( )
( )

Optimal leverage from a tax-saving perspective: level s.t. interest equals EBIT. In this case, the firm takes full
advantage of the corporate tax deduction of interest, but avoids tax disadvantage of excess leverage.
- Interest expense of average firm is well below its taxable income.
- Optimal fraction of debt (as a proportion of a firm’s capital structure) declines with the growth rate.

Chapter 16: Financial Distress, Managerial Incentives, and Information

Bankruptcy:
- Modigliani-Miller setting: leverage may result in bankruptcy, but bankruptcy alone does not reduce the
value of the firm. With perfect capital markets, bankruptcy shifts ownership from the equity holders to
debt holders without changing the total value available to all investors.
- Bankruptcy imposes direct and indirect costs on a firm and its investors:
o Direct costs: costs of experts and advisors (lawyers, accountants, investment bankers).
o Indirect costs: loss of customers, suppliers, employees, or receivables. Or selling assets at
distressed prices.
- When securities are fairly priced, the original shareholders of a firm pay the PV of the costs associated
with bankruptcy and financial distress.

Trade-off theory:
- ( ) ( ).
- Optimal leverage maximizes .

Agency costs: arise when there are conflicts of interest between stakeholders.
- A highly levered firm with risky debt faces the following agency costs:
o Asset substitution: shareholders can gain by making negative-NPV investments or decisions that
sufficiently increase the firm’s risk.
o Debt overhang: shareholders may be unwilling to finance new, positive-NPV projects.
 o Cashing out: shareholders have an incentive to liquidate assets at prices below their market
values and distribute the proceeds as a dividend.
- Leverage has agency benefits/can improve managers’ incentives to run a firm better due to:
o Increased ownership concentration: managers with higher ownership concentration are more
likely to work hard and less likely to consume corporate perks.
o Reduced FCF: firms with less FCF are less likely to pursue wasteful investments.
o Reduced managerial entrenchment and increased commitment: the threat of financial distress
and being fired commits managers to pursue strategies that improve operations.

Trade-off theory extended with agency costs:

( ) ( ) ( )
( )

Asymmetric information: when managers have better information than investors.

- Managers may use leverage as a credible signal of the firm’s ability to generate FCF.
- Lemons principle: when managers have private information about the value of a firm, investors will
discount the price they are willing to pay for a new equity issue due to adverse selection.
- Managers are more likely to sell equity when they know a firm is overvalued. As a result:
o Stock price declines when a firm announces an equity issue.
o Stock price tends to rise prior to the announcement, because managers tend to delay equity
issues until after good news becomes public.
o Firms tend to issue equity when information asymmetries are minimized.
o Pecking order hypothesis: managers who perceive that the firm’s equity is underpriced will have
a preference to fund investment using retained earnings or debt, rather than equity.

Chapter 17: Payout Policy

Distribute cash to shareholders:

- Pay cash dividends (regular or one-time).
o Declaration date: firms announce that they will pay dividends to shareholders of record on the
record date. Ex-dividend date: first day on which the stock trades without the right to an
 upcoming dividend (usually two trading days prior to the record date). Dividend checks are
mailed on the payment date.
- Stock dividend: company distributes additional shares rather than cash.
o The stock price generally falls proportionally with the size of the split.
o Reverse split decreases the number of shares outstanding, and results in a higher share price.
- In perfect capital markets, stock price falls by the amount of the dividend when a dividend is paid.
- Repurchase shares (through open market repurchase, tender offer, Dutch auction repurchase, or
targeted repurchase).
o Has no effect on the stock price, which is similar to the with-dividend price if a dividend were
paid.
Modigliani-Miller dividend irrelevance proposition: in perfect capital markets (fixed investment policy), the
firm’s choice of dividend policy is irrelevant and does not affect the initial share price.
- In reality, capital markets are not perfect, and market imperfections affect firm dividend policy.

Taxes as a market friction that affects dividend policy:

- When taxes are the only market imperfection and (tax rate on dividends) > (tax rate on capital gains) 
optimal dividend policy is to pay no dividends but repurchase shares.
- Effective dividend tax rate τd*: measures the net tax cost to the investor per $ of dividend received.

( )

o τd* varies across investors, because of income level, investment horizon, tax jurisdiction and
type of investment account.
o Clientele effects: dividend policy of a firm suits the tax preference of its investor clientele.

Modigliani-Miller payout irrelevance proposition: in perfect capital markets, if a firm invests excess cash flows in
financial securities, the firm’s choice of payout vs. retention is irrelevant and does not affect the firm’s value.
Effective tax disadvantage of retaining cash:

( )( )
(
( )

- Even though there is a tax disadvantage, cash helps a firm minimize the transaction costs of raising new
capital when they have future potential cash needs. However, there is no benefit to shareholders from
firms holding cash in excess of future investment needs.
 - Agency costs may arise as managers may be tempted to spend excess cash on inefficient investments
and perks.
- Dividends and share repurchases help minimize the agency problem of wasteful spending.

Dividend smoothing: firms typically maintain relatively constant dividends.

Dividend signaling hypothesis: dividend changes reflect managers’ views about firms’ future earnings prospects.

- Increase dividend: confidence that firm will be able to afford higher dividends for the foreseeable future.
- Cut dividend: lost hope that earnings will improve.

Chapter 20: Financial Options

Call option: right to purchase an asset at some future date.
Put option: right to sell an asset at some future date.
Strike price/exercise price (K): price at which the holder agrees to buy or sell the share of stock when the option
is exercised.
- Call options with lower strike prices are more valuable than otherwise identical call options with higher
strike prices. Put options with higher strike prices are more valuable.
- When the stock prices rises, call options increase in value and put options decrease in value.

American option: can be exercised on any date up to and including the exercise date.
European option: can be exercised only on the expiration date.

Value of a call option at expiration: ( )

Value of a put option at expiration: ( )

Time value of an option = intrinsic value – current value.

- Intrinsic value > 0: in-the-money.
- S = K: at the money.

Put-call parity: relates the value of the European call to the value of the European put and the stock.
( ) ( )

Arbitrage bounds for option prices:

 - American option cannot be worth less than its European counterpart.
o Never optimal to exercise an American call option on a non-dividend paying stock early.
- Put option cannot be worth more than its exercise price.
- Call option cannot be worth more than the stock itself.
- American option cannot be worth less than its intrinsic value.
- American option with later exercise date cannot be worth less than an otherwise identical American
option with an earlier exercise date.

It can be optimal to exercise a deep in-the-money American put option. It can be optimal to exercise an
American call option just before the stock goes ex-dividend.

Credit default swap: corporate debt is a portfolio of riskless debt and a short position in a put option on the
firm’s cash flow with a strike price equal to the required debt payment.

Chapter 21: Option Valuation

Binomial Option Pricing Model:

- Two possible states for the next time period, given today’s state.
- Value of an option is the value of the portfolio that replicates its payoffs. RP holds the underlying asset
and risk-free debt, and will need to be rebalanced over time.
- RP:

and

- Value of the option:

Black-Scholes option pricing formula:
- European call option, non-dividend paying stock
o ( ) ( ) ( )
o Where N(d) is the cumulative normal distribution and
⁄ ( ) √
√
√
- European put option on a non-dividend paying stock:
o ( ) ( ) ( )
- ( ) if it is a dividend paying stock.
 o If the stock pays a (compounded) dividend yield of q prior to the expiration date, then:

- Black-Scholes replicating portfolio:

o Call option on a non-dividend paying stock:
( ) and ( ) ( )
o European put option on a non-dividend paying stock:
( ) and ( ) ( )

Risk-neutral probabilities: expected return of all securities equals the risk-free rate. These are probabilities of
future outcomes adjusted for risk, which are then used to compute expected asset values. Once the risk-neutral
probabilities are calculated, they can be used to price every asset based on its expected payoff.

- In a binomial tree, the risk-neutral probability ρ that the stock price will increase is given by:
( )

- Price of any derivative can be obtained by discounting E(CF) computed using the risk-neutral
probabilities at the risk-free rate.

Beta:

- Can also be calculated by computing the beta of RP.

- Positive beta: calls will have larger betas than the underlying stock, while puts will have negative betas.
- Magnitude of the option beta is higher for options that are further out of the money.
- When debt is risky, the betas of equity and debt increase with leverage according to:

( ) ( )( )

Chapter 23: Raising Equity Capital

Initial public offering (IPO): first time a company sells its stock to the public.
- Primary offering: shares are being sold to raise new capital.
- Secondary offering: shares are sold by earlier investors.
- Underwriter: investment bank that manages the IPO process and helps the company sell its stock.
o Lead underwriter: responsible for managing the IPO.
o Lead underwriter forms a group of underwriters (syndicate) to help sell the stock.
 o Value the company before the IPO using valuation techniques and by book building.
o Face risk during an IPO, which is managed by e.g. a greenshoe provision (right to sell investors
more shares than originally planned by the issuer).
- SEC requires that a company files a registration statement prior to an IPO. The preliminary prospectus
circulates to investors before the stock is offered. After the deal is completed, the company files a final
prospectus.
- Several puzzles are associated with IPOs:
o IPOs are underpriced on average.
o New issues are highly cyclical.
o Transaction costs of IPOs are high.
o Long-run performance after an IPO is poor on average.

Advantages of going public:

- Greater liquidity.
- Better access to capital.
Disadvantages of going public:
- Regulatory and financial requirements.
- Undermining of the investors’ ability to monitor the company’s management.

Seasoned Equity Offering (SEO): sale of a stock by a company that is already publicly traded.
- Cash offer: new shares are sold to investors at large.
- Rights offer: new shares are offered only to existing shareholders.
- The stock price reaction to an SEO is negative on average.

Chapter 24: Debt Financing

Typical types of debt:

- Public debt: trades in the public market.

- Private debt: negotiated directly with a bank or small group of investors.
o Term loans: bank loan that lasts for a specific term.
o Private placements: bond issue that is sold to a small group of investors.
Corporate bonds: securities that companies issue when raising debt.

- Indenture (for public offerings): a formal contract between the bond issuer and a trust company. It lays
out the terms of the bond issue.
- Four types:
o Notes (unsecured)
o Debentures (unsecured)
o Mortgage bonds
o Asset-backed bonds
- Differ in level of seniority. Bankruptcy: senior debt is paid in full first before subordinated debt is paid.
- Classes of international bonds:
o Domestic bonds trade in foreign markets.
o Foreign bonds are issued in a local market by foreign entity.
o Eurobonds are not denominated in the local currency of the country in which they are issued.
o Global bonds trade in several markets simultaneously.

Municipal bonds: issued by state and local governments. Not taxable at the federal level.

Asset-backed security (ABS): security’s CFs come from the CFs of the underlying financial securities that back it.
Mortgage-backed security (MBS): asset-backed security backed by home mortgages. US government agencies
(e.g. Government National Mortgage Association/GNMA/Ginnie Mae) are the largest issuers in this sector.

- Holders of agency-issued MBSs face prepayment risk: risk that the bond will be partially (or wholly)
repaid earlier than expected.
- Holders of privately issued MBSs also face default risk.

Collateralized debt obligation: ABS that is backed by other ABSs.

Covenants: restrictive clauses in the bond contract that help investors by limiting the issuer’s ability to take
actions that will increase the default risk and reduce the value of the bonds.

Call provision: gives the issuer of the bond the right to retire the bond after a specific date (before maturity). A
callable bond will generally trade at a lower price.
 - The yield to call is the yield of a callable bond assuming that the bond is called at the earliest
opportunity.

Sinking fund: another way in which a bond is repaid before maturity is by periodically repurchasing part of the
debt through a sinking fund.

Convertible bonds: provision that allows the holder to convert them into equity. It carries a lower interest rate
than other comparable non-convertible debt.

Chapter 25: Leasing

Lease: contract between two parties:

- Lessee is liable for periodic payments in exchange for the right to use the asset.
- Lessor (owner of the asset) is entitled to the lease payments in exchange for lending the asset.
- Types of lease transactions:
o Sales-type lease: lessor is the manufacturer or primary dealer of the asset.
o Direct lease: lessor is an independent company that specializes in purchasing assets and leasing
them to customers.
o If a firm already owns an asset it would prefer to lease, it can arrange a sale and leaseback
transaction.
- In a perfect market, the cost of leasing = cost of purchasing and reselling the asset.
Also, cost of leasing and then purchasing the asset = cost of borrowing to purchase the asset.
- FASB recognizes two types of leases based on the lease terms:
o Operating leases: rentals for accounting purposes.
o Capital leases: purchases.
- IRS separates leases into two broad categories:
o True tax lease: lessee deducts lease payments as an operating expense.
o Non-tax lease: treated as a loan for tax purposes, so the lessee must depreciate the asset and
can expense only the interest portion of the lease payments.
- True lease: asset is not protected in the event that the lessee declares bankruptcy, and the lessor can
seize the asset if payments are not made. If the lease is deemed a security interest, then the asset is
protected and the lessor becomes a secured creditor.
 - Evaluate the leasing decision for a true tax lease, compare costs of leasing with costs of financing using
an equivalent amount of leverage:
o Compute incremental CFs for leasing vs. buying.
o Compute NPV by discounting incremental CFs at the after-tax borrowing rate.
- Cash flows of a non-tax lease are directly comparable to the cash flows of a traditional loan, so a non-tax
lease is attractive only if it offers a better interest rate than a loan.
- Good reasons for leasing include tax differences, reduced resale costs, efficiency gains from
specialization, reduced bankruptcy costs, risk transfer, improved incentives.
- Suspect reasons for leasing include avoiding capital expenditure controls, preserving capital, reducing
leverage through off-balance-sheet financing.

Chapter 28: Mergers and Acquisitions

Mergers:

- Can be horizontal, vertical or conglomerate.

- On average, shareholders of the acquiring firm obtain small or no gains. Shareholders of the acquired
firm enjoy gains of 15% on the announcement of a takeover bid.
- Major reason: synergies:
o Economies of scale and scope.
o Control provided by vertical integration.
o Gaining monopolistic power.
o Expertise gained from the acquired company.
o Improvements in operating efficiency.
o Benefits related to diversification (e.g. increased borrowing capacity, tax savings).
- Shareholders of a private company that is acquired gain by switching to a more liquid investment.
- Bidder’s perspective: takeover is a positive-NPV project only if the premium paid does not exceed the
synergies created.
- Tender offer: public announcement of an intention to purchase a large block of shares for a specified
price. It does not guarantee that the deal will take place.
- Methods to pay for a target: cash or stock.
o Cash: bidder simply pays for the target in cash.
 o Stock-swap transaction: bidder pays for the target by issuing new stock and giving it to the
target shareholders.
o Method used has tax and accounting implications.
- Friendly takeover: target board of directors supports the merger and negotiates with the potential
acquirers.
- Target board of directors can defend itself in several ways to prevent a merger:
o Poison pill: gives target shareholders the right to buy shares in either the target or the acquirer
at a deeply discounted price. It’s effectively subsidized by the existing shareholders of the
acquirer, making the takeover very expensive.
o Staggered board: prevents a bidder from acquiring control over the board in a short period of
time.
o Looking for a friendly bidder (a white knight).
o Making it expensive to replace management.
o Changing the capital structure of the firm.
- Free-rider problem: when a bidder makes an offer, the target shareholders can benefit by keeping their
shares and letting others sell at a low price. But all have this incentive and no one will sell.
o Overcome this problem: bidders can acquire a toehold in the target, attempt a leveraged buyout
or (when the acquirer is a corporation) offer a freeze-out merger.

Chapter 29: Corporate Governance

- Corporate governance: system of controls, regulations, and incentives designed to prevent fraud from
happening.

1. The conflicts between those who control the operations of a firm and those who supply capital to the
firm are as old as the corporate organizational structure. Shareholders use a combination of incentives
and threats of dismissal to mitigate this conflict.
2. The board of directors hires managers, sets their compensation, and fires them if necessary. Some
boards become captured, meaning that they act in the interests of managers rather than share-holders.
Boards with strong, outside directors who were nominated before the current CEO took the helm of the
firm are the least likely to be captured.
3. Ownership of a company’s stock by management can reduce managers’ perquisite consumption.
However, moderate holdings of shares can have a negative effect by making the managers harder to fire
(reducing the threat of dismissal), without fully aligning their interests with those of share-holders.
4. By tying managers’ compensation to firm performance, boards can better align managers’ interests with
shareholders’ interests. Care must be taken to make sure managers do not have incentives to try to
manipulate the firm’s stock price to garner a big compensation payout.
5. If a board fails to act, shareholders are not without recourse. They can propose an alternate slate of
directors or vote not to ratify certain actions of the board.
6. A board and management can adopt provisions, such as staggered boards and limitations on special
shareholder meetings, that serve to entrench them. These provisions also have the effect of limiting the
efficacy of a hostile takeover bid.
7. Despite the defenses that a determined management can erect, one source of the threat of dismissal
comes from a hostile acquirer, which can take over a firm and fire the management, even if the board
fails to do so.
8. Regulation is an important piece of the total corporate governance environment. Regulation can be
beneficial by reducing asymmetric information between managers and capital providers and thus
reducing the overall cost of capital. Regulation also carries with it costs of compliance and enforcement.
Good regulation balances these forces to produce a net benefit for society.
9. The most recent overhaul of U.S. governance regulation is the Sarbanes-Oxley Act of 2002. The act was
intended to improve shareholder monitoring of managers by increasing the accuracy of their
information.
a. It overhauls incentives and independence in the auditing process.
b. It stiffens the penalties for providing false information.
c. It forces companies to validate their internal financial control process.
10. The Exchange Acts of 1933 and 1934 are the basis of insider trading regulation. Over time, the SEC and
the courts have developed interpretations of the law that
a. Prohibit insiders with a fiduciary duty to their shareholders from trading on material non-public
information in that stock.
b. Prohibit anyone with nonpublic information about a pending or ongoing tender offer from
trading on that information or revealing it to someone who is likely to trade on it.
11. Corporate governance, regulations, and practices vary widely across countries.
 a. Some studies suggest that countries with common-law roots generally provide better share-
holder protection than countries with civil-law origin.
b. Ownership structures in Europe and Asia often involve pyramidal control of a group of
companies by a single family. In these situations, the controlling family has many opportunities
for expropriation of minority shareholders through tunneling.
c. Dual class shares with differential voting rights allow a controlling shareholder or family to
maintain control of a company or group even if their cash flow rights are relatively small. Dual
class shares are common outside the United States.
d. Most countries give employees some role in governing a firm. Employee involvement usually
takes the form of board seats or works councils that are consulted before major decisions.
e. It is common outside the United States for a company’s largest shareholder to be another
company. These cross-holdings create incentives for firms to monitor each other.

Chapter 30: Risk Management

Summary

1. Insurance is a common method firms use to reduce risk. In a perfect market, the price of insurance is
actuarially fair. An actuarially fair insurance premium is equal to the present value of the expected loss:

2. Insurance for large risks that cannot be well diversified has a negative beta, which raises its cost.
3. The value of insurance comes from its ability to reduce the cost of market imperfections for the firm.
Insurance may be beneficial to a firm because of its effects on bankruptcy and financial distress costs,
issuance costs, taxes, debt capacity, and risk assessment.
4. The costs of insurance include administrative and overhead costs, adverse selection, and moral hazard.
5. Firms use several risk management strategies to hedge their exposure to commodity price movements.
a. Firms can make real investments in assets with offsetting risk using techniques such as vertical
integration and storage.
b. Firms can enter into long-term contracts with suppliers or customers to achieve price stability.
c. Firms can hedge risk by trading commodity futures contracts in financial markets.
6. Firms can manage exchange rate risk in financial markets using currency-forward contracts to lock in an
exchange rate in advance and currency options contracts to protect against an exchange rate moving
beyond a certain level.
7. The cash-and-carry strategy is an alternative strategy that provides the same cash flows as the currency
forward contract. By the Law of One Price, we determine the forward exchange rate by the cost-of-carry
formula, called the covered interest parity equation. For an exchange that will take place in T years, the
corresponding forward exchange rate is:

8. Currency options allow firms to insure themselves against the exchange rate moving beyond a certain
level. A firm may choose to use options rather than forward contracts if
a. It would like to benefit from favorable exchange rate movements but not be obligated to make
an exchange at unfavorable rates.
b. There is some chance that the transaction it is hedging will not take place.
9. Currency options can be priced using the Black-Scholes formula, with the foreign interest rate as a
dividend yield:

where

10. Firms face interest rate risk when exchange rates are volatile. The primary tool they use to measure
interest rate risk is duration. Duration measures the value-weighted maturity of an asset.
11. The interest rate sensitivity of a stream of cash flows increases with its duration. For a small change, ε, in
the interest rate, the change in the present value of a stream of cash flows is given by

where r is the current interest rate, expressed as an APR with k compounding periods per year.

12. The duration of a portfolio is equal to the value-weighted average duration of each security in the
portfolio. The duration of a firm’s equity is determined from the duration of its assets and liabilities:

13. Firms manage interest rate risk by buying or selling assets to make their equity duration neutral.
14. Interest rate swaps allow firms to separate the risk of interest rate changes from the risk of fluctuations
in the firm’s credit quality.
a. By borrowing long term and entering into an interest rate swap in which the firm receives a
fixed coupon and pays a floating-rate coupon, the firm will pay a floating interest rate plus a
spread that is fixed based on its initial credit quality.
b. By borrowing short term and entering into an interest rate swap in which the firm receives a
floating-rate coupon and pays a fixed coupon, the firm will pay a fixed interest rate plus a spread
that will float with its credit quality.
15. Firms use interest rate swaps to modify their interest rate risk exposure without buying or selling assets.