Teaching Slides PDF

Unit 2: 2B.
Module 1
B.1. Risk and Return
Rates of Return
Page 2-3 | LOS: 2B1a
Rates of Return
The rate of return refers to the measure of the cash flows from an investment compared with the amount of the investment.
The return on an investment (both the expected return and actual return) is crucial to the investment decision.
Annual Return
• Definition: annual returns include two components:
─ Capital return
─ Income return
• Computation: returns are generally calculated over a 12-month (annual) period
─ The formula for calculating annual return is:
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Rates of Return
• Capital return: the change in value of the underlying investment from one period to the next period
• Income return: includes dividends, interest, or royalties earned on that underlying investment during the period
• Total return: capital return plus income return over either the life of an investment or a specified period, calculated as follows:
Holding Period Return
• Definition: the holding period return is the return
earned over either a specified increment of time or a
period of time
• Computation: multiply the holding period return by the

number of holding periods in a year
Geometric Return
• Definition: compounding occurs when an asset's earnings generate additional earnings
─ Each year, the change in the asset's value along with any income earned will establish a new base on which the next
year's return is computed
• Arithmetic vs. Geometric Return
─ For shorter periods of time: arithmetic average can serve as a reasonable proxy for the true return
─ For longer periods of time: geometric average is best because it more accurately accounts for compounding
Stated Interest Rate
• Definition: also referred to as nominal interest rate, the stated interest rate represents the rate of interest charged before any
adjustment for compounding or market factors
• Computation: the rate shown in the agreement of indebtedness (e.g., a bond indenture or promissory note)
Effective Interest Rate
• Definition: represents the actual finance charge associated with a borrowing after reducing loan proceeds for charges and
fees related to a loan origination
• Computation: divide the amount of interest paid based on the loan agreement by the net proceeds received
Annual Percentage Rate
• Definition: represents a noncompounded version of the
effective annual percentage rate described and computed
as follows:
─ Required for disclosure by federal regulations
• Computation: the effective periodic interest rate times the

number of periods in a year
─ Emphasizes the amount paid relative to funds available
Effective Annual Percentage Rate
• Definition: the stated interest rate adjusted for the
number of compounding periods per year
─ Abbreviated as EAR (not EAPR)
• Computation:
Investment Risk
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Investment Risk
All investments have risk, even government notes. Risk comes from many sources, including micro and macroeconomic factors.
Market/Systematic/Nondiversifiable Risk
• The exposure of a security or firm to fluctuations in value as a result of operating within an economy
• Sometimes referred to as systematic risk because it is a risk inherent in operating within the economy
• Systematic risk is attributable to factors such as war, inflation, international incidents, and political events
• Market/systematic risk is also referred to as nondiversifiable risk because it cannot be diversified away
• Compensation for this risk is factored into models used to forecast expected return
Unsystematic/Firm-Specific/Diversifiable Risk
• Diversifiable risk, also referred to as nonmarket, unsystematic, or firm-specific risk
• Represents the portion of a firm's or industry's risk that can be eliminated through diversification
• Diversifiable risk is attributable to firm-specific or industry-specific events such as strikes, lawsuits, regulatory actions, or the
loss of a key account
Credit Risk
• The risk that an investor (lender) will not receive interest and/or principal due because the borrower is unable to make payments
• There is a direct relationship between credit risk and interest rates
─ The higher the credit risk, the higher the interest rate required by the lender to compensate the lender for the risk associated
with lending money
Foreign Exchange Risk

• Risk faced by investors seeking to diversify by investing either in securities issued by companies in other countries or in
another currency
• The value of the currency in which an investment is denominated could decrease, which would decrease the purchasing power
in the home currency
• Exposures due to foreign exchange risks include transaction, economic, and translation exposures
• Also referred to as currency risk

Foreign Exchange Risk: Transaction Exposure
• The potential that an organization could experience economic loss or gain when settling transactions as a result of exchange
rate fluctuations
• Measurement of transaction exposure is generally done in two steps:
1. Project foreign currency inflows and foreign currency outflows
2. Estimate the variability (risk) associated with the foreign currency
Foreign Exchange Risk: Economic Exposure
• The potential that the present value of a company's cash flows could increase or decrease due to changes in exchange rates
• Generally defined through local currency appreciation or depreciation, measured in relation to earnings and cash flows
• Currency appreciation (depreciation) refers to the strengthening (weakening) of a currency in relation to other currencies
• Effect of Currency Appreciation:
─ As a domestic currency appreciates or becomes stronger, it becomes more expensive in terms of a foreign currency.
─ The volume of outflows may decline as domestic exports become more expensive, while inflows increase as foreign
imports become less expensive.
• Effect of Currency Depreciation:
─ As a domestic currency depreciates or becomes weaker, it becomes less expensive in terms of a foreign currency.
─ The volume of outflows may rise as domestic exports become less expensive, while inflows decline.
Foreign Exchange Risk: Translation Exposure
• The risk that assets, liabilities, equity, or income will
change as a result of changes in exchange rates
• Generally defined by the degree of foreign involvement,

the location of foreign subsidiaries, and the accounting
methods used
─ Degree of Foreign Involvement: translation exposure

increases as the proportion of foreign involvement by
subsidiaries increases
─ Locations of Foreign Investments: exposure of the

parent company is affected by the stability of the
foreign currency in comparison to the parent's
domestic currency; the more stable (volatile) the
exchange rate, the lower (higher) the translation risk
Interest Rate Risk
• The possibility that the market interest rate
may change and impact the value of the
interest-bearing instrument
• Investors who purchase bonds, debt, or other

interest-bearing financial instruments are
subject to this risk
• The value of a fixed rate, interest-bearing

instrument decreases as interest rates rise
• If interest rates fall, the value of the fixed-rate,

interest-bearing instrument rises
Industry Risk
• Specific to an industry in which a company operates or otherwise has significant exposure
• Each industry has unique dependencies and exposures to the overall economy
• Companies within each industry are subject to challenges often faced by only that industry
─ For instance, the auto industry is constrained by negotiations with labor unions as well as fuel efficiency standards
required by the federal government.
• Increased industry risk is seen in sectors in which the entire industry is performing poorly
─ This circumstance may provide an opportunity for an innovative company to achieve above-average industry returns.
─ Industry-wide poor performance could indicate declining demand and adversely impact the industry as a whole.
Political Risk
• Represents noneconomic events or environmental conditions that are potentially disruptive to financial operations and
cash flows
• Although expropriation of productive resources represents the most extreme political risk, other features of political risk
also must be considered, including:
─ Bureaucracies and related inefficiencies or barriers to trade
─ Corruption
─ The host government's attitude toward foreign firms
─ The attitude of consumers toward foreign firms
─ Inconvertibility of foreign currency
─ War
Balancing Risk
and Return
Page 2-13 | LOS: 2B1d
Balancing Risk and Return
• Generally, there is a direct relationship between risk and the required rate of return:
─ Higher (lower) levels of risk require higher (lower) expected returns
• Investor risk tolerances vary, ranging from risk-averse to risk-neutral to risk-seeking
─ Investors who are risk-averse require lower levels of risk and accept lower levels of return
─ Risk-seekers accept higher risk in exchange for higher rates of return
• If given a choice between two assets that offer the same rate of return, rational investors will choose the investment with
the lower risk.
• Alternatively, if investors must choose between two assets with the same level of risk, rational investors will choose the
investment that has the higher rate of return.
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Diversification
• Owning individual securities exposes an investor to individual security risk, also known as firm-specific or unsystematic risk.
• Investors can reduce individual security risk by forming a portfolio of different investments.
• As an investor combines individual securities or different asset classes into a portfolio, there will be a portfolio risk.
• The key to minimizing portfolio risk is diversification, which reduces risk by combining investments with different risk profiles.
─ For example, an investment in a company that has cyclical performance can be combined with an investment in a
company that is counter-cyclical.
• Diversification entails investing in a variety of securities so that a loss in one security will have a minimal effect on the
whole portfolio.
• Risk reduction can be achieved in a portfolio when the securities held are not correlated with one another.
• By properly diversifying the investments in a portfolio, an investor can minimize risk for a given level of return or maximize
return for a given level of risk.
Diversification
The expected return for any portfolio is the weighted average of the returns of each investment in the portfolio.
Diversification
Asset Allocation
• The process of selecting assets in a portfolio to achieve the best risk/return trade-off
• Assets can include bonds, stocks, derivatives, real estate, and alternative investments (such as precious metals or oil
and gas wells)
• Assets can also be high-risk, low-risk, long-term, short-term, or another type of investment to achieve the correct balance
of risk and return
• When sufficient assets have been combined to achieve the full benefits of diversification, the portfolio is called a fully
diversified or efficient portfolio
─ A fully diversified, efficient portfolio provides the highest possible rate of return for a certain level of risk or the lowest
possible level of risk for a particular rate of return
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The Capital Asset Pricing Model (CAPM)
The CAPM is used to determine the expected return on an investment based on its level of risk, factoring in both firm-specific
risk and systematic (market) risk.
Under the CAPM formula, the [Rm − Rf] term is also known as the market risk premium.
• Risk-free rate is the theoretical rate of return on an investment with zero (or very low) risk
• Beta is a numerical representation of a stock's risk relative to the overall market risk, with a beta of 1 indicating the stock has
the same volatility as the market, and a beta of greater (less) than 1 indicating the stock is more (less) volatile than the market
• Market risk premium is the systematic (nondiversifiable) risk associated with the overall stock market, and is equal to the
difference between the overall market return and the risk-free rate
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The Capital Asset Pricing Model (CAPM): Beta
• Also called beta coefficient; is a measure of a stock's movement in price compared with the overall market during the
same period
• A measure of systematic risk, which cannot be diversified away and remains even in a fully diversified portfolio; the beta of
the overall market is 1.0, with an individual stock's beta interpreted as follows:
─ Beta > 1.0: The stock or portfolio is more volatile (riskier) than the market; more volatility requires a higher return.
─ Beta < 1.0: The stock or portfolio is less volatile than the market; less volatility requires a lower return.
─ Beta = 1.0: A beta of exactly 1.0 means that the stock or portfolio has the same volatility as the market.
• Calculated using historical data, so a beta can change over time and may be different with different historical data
• The higher the beta, the higher the risk associated with an investment; higher risk will increase the investor's required return
• An inverse relationship exists between the required return (and beta) and the price of the security
• The higher the required return, the higher the discount rate, and the lower the price (or present value) of the security
Unit 2: 2B. Module 2
B.2. Long-Term Financial
Management: Part 1
Debt Securities
B.2. Long-Term Financial Management: Part 1
Debt Securities
A company's capital structure consists of its mix of debt and equity financing. Debt may include notes payable and bonds.
Interest rates play a critical role in both the structure and the valuation of all debt securities.
Term Structure of Interest Rates

• Describes the relationship between interest rates on debt securities (bonds) and the various maturities of bonds having the
same risk characteristics
• Changes in the term structure of interest rates over time are caused by:
─ Changes in expectations regarding economic growth
─ Increases (inflation) or decreases (deflation) in price levels
─ Changes in interest rates
Term Structure of Interest Rates
A yield curve plots rates and maturities on a single curve and reflects
expectations about yields, or rates of return, at various maturities.
• Normal Yield Curve: upward sloping, showing that investors are

compensated with higher rates of return for investing their money over
longer periods of time
─ In some circumstances, the yield curve can be downward-sloping,

flat, or humped
• Downward-Sloping Yield Curves: bonds of shorter maturity that pay

higher rates
─ Downward-sloping curves are also referred to as inverted yield

curves and are considered atypical as well as indicative of a
potential recession
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Bond Features
Bonds are a long-term means of financing by which a company or government borrows money by selling debt securities to
investors.
• Represent a loan by the bondholders (investors) to the issuing company or government
• By selling a bond, the company or government makes a promise to pay the investors a certain amount of interest every
period until the bond matures
• On the maturity date, the company or government promises to pay the face amount of the bond to the investors
Bond Indentures
• A legal contract between the bond issuer and the bondholders that governs the bonds issue
• If the bond issuer does not meet the contractual obligations to make interest and/or principal payments, the bond issuer is
said to have defaulted
• Bondholders normally have legal recourse in the event of a default
Bond Covenants
• Increase the likelihood that bondholders will receive their scheduled interest payments and the repayment of their principal on
the maturity date
• Protective Covenants: also referred to as negative covenants or restrictive covenants
─ Example: a covenant stating that the bondholder will not sell specific assets because the bondholders have a higher claim
on those assets than do shareholders
• Positive Covenants: specify actions that the issuing firm must take, such as:
─ Maintaining working capital at a minimum level
─ Maintaining a specified debt to equity ratio
─ Submitting financial statements at regular intervals
Basic Bond Features
• Par Value: also called principal value, or face value; the amount that is paid by the issuer to the bondholder at maturity
• Generally issued in increments of $1,000
─ Example: if a company wants to raise $1,500,000 from issuing bonds, the company will issue 1,500 bonds each having a
par value of $1,000
• Coupon (Stated) Rate: determines the annual or semiannual bond interest payment
─ Example: a bond that has a par value of $1,000 and a coupon rate of 3.25% will pay annual interest of $32.50 ($1,000 par
value × 3.25% coupon rate)
─ If the bond pays interest semiannually, each coupon payment will be $16.25
• Maturity Date: the maturity date is the date on which the par value is paid back to the bondholder (lender)
Bond Contingency Provisions
• Many bonds include provisions for redemption prior to maturity
• Embedded options are contingency provisions found in the bond indenture that provide the issuer or the bondholders the
right, but not the obligation, to take some action
• Callable Bonds: the issuer has the option to retire or replace the bond before maturity at a specified price
─ If interest rates fall, the issuer can call the bond and then issue new bonds at the lower interest rate
─ Call provision is an advantage to the issuer and a disadvantage to the bondholder
─ Call features increase investor risk and generally result in the bond trading at a lower price
• Puttable Bonds: the bondholder has the option to demand that the issuer pay off the bond before maturity at a specified price
─ If interest rates rise, the investor can exercise the put option and then buy new bonds that pay the higher interest rate
─ Put provision is an advantage to the bondholder and a disadvantage to the borrower
─ Put features decrease investor risk and generally result in the bond trading at a higher price
• Conversion Provisions: a convertible bond is convertible into the common stock of the issuer at the option of the bondholder
─ Conversion Price: the amount the bondholder must pay for each share of stock to be received upon conversion
─ Conversion Ratio: the number of common shares into which each bond can be converted
─ Conversion Value: equal to the current stock price multiplied by the number of shares to be issued if the bond is converted
─ Conversion Premium: the difference between the convertible bond's current price and the convertible bond’s
conversion value
Issuance and Refinancing
• The decision to issue new debt depends on capital needs, interest rates, credit ratings that the company and the debt carry,
the cost of issuing debt, and the company's ability to make interest and principal payments
• Debt typically offers a lower cost of capital than equity due to the tax deductibility of interest
• The cost of debt increases as the percentage of debt in the overall capital structure increases
• Refinancing involves replacing current debt with new debt that has more favorable terms for the borrower
• Refinancing also allows the borrower to potentially move from fixed-rate to floating-rate debt, or vice versa
• The decision to refinance an outstanding debt issuance requires consideration of several factors, including:
─ Bond Terms: refinancing is only permitted when the bond indenture allows for a potential refinancing of current debt
─ Refinancing Costs: the costs of refinancing (transaction fees, underwriting fees, etc.) must be weighed against the
benefits (lower interest rates, lower payments, etc.) associated with refinancing
─ Time to Maturity: it may not make sense to refinance if the debt is close to maturity
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Bond Valuation
• Equal to the present value of the bond's future cash
flows (which consist of interest payments and principal)
• Cash flows may be discounted using a single interest

rate or multiple interest rates
• A bond with a fixed coupon rate equal to the market rate

for comparable bonds is issued at par (face) value
• A bond with a coupon rate at issuance less (more) than

the market rate will be issued at a discount (premium)
• As market interest rates change, the market value of the

bond will also change
• For fixed-rate bonds, when market interest rates rise, the

market value of the bond falls, and vice versa
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Duration and Bond Price Sensitivity
• The duration of a bond is a measure of how
sensitive the bond is to changes in market rates
• Duration is also a measure of how much the

price of the bond will change when there is a 1
percent change in the market interest rate
• Bonds with a higher duration will be more

sensitive to changes in market interest rates
than will bonds with a lower duration
• The longer the term to maturity, the higher a

bond's duration
Equity Securities
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Equity Securities
• Represent proportional ownership in a company
• Can be in the form of common stock or preferred stock
• Common stock and preferred stock have different features and rights that affect their risk, expected return, and valuation
Common Stock
• An advantageous form of financing because common stock dividend payments are not required
• Permanent capital that does not mature at some future date and, therefore, does not have to be paid back
• Has extended voting rights
• The issuance of additional shares to new investors may result in increased investor control and diluted earnings per share
Common Stock
• Common stock typically provides its owners with the following rights:
─ Right to Limited Liability: shareholders are not liable for corporate debt
─ Right to Receive Dividends: stockholders have the right to receive dividends in proportion to their holdings, although
common dividends are not required to be paid
─ Right to Vote: stockholders have the right to vote on certain company matters, such as the annual election of directors
─ Liquidation Rights: stockholders have the right to a proportional share of the residual value of the corporation in the event
of liquidation
─ Preemptive Rights: stockholders may have the preemptive right to a proportionate share of any new issue of common
stock before it is offered to other parties
Preferred Stock
• Typically pays higher dividends than common shares
• Preferred shareholders are entitled to dividends before common shareholders receive dividend payment
• Preferred shareholders have seniority over common shareholders in the event of a liquidation
• Has characteristics that more closely resemble debt
• Preferred stock typically has the following characteristics:
─ Dividends are fixed and stated as a percentage of par, face, or stated value
─ Dividends are not a contractual obligation and need to be declared and approved by the board of directors
─ Preferred stock dividends are either cumulative or noncumulative
• Cumulative dividends require that both the current dividend as well as any preferred dividends not paid in prior years
must be paid before any dividends can be paid on common stock
Preferred Stock
• May have a conversion provision that allows the shares to be converted into either common shares or a different series of
preferred shares
• May come with detachable stock warrants (also called call options), which gives stockholders the right to purchase common
stock at a predetermined price and date
• Typically, does not have voting rights
• Compared with debt, the advantages of issuing preferred stock include no fixed maturity date and no contractual obligations
to make dividend payments
• Unlike debt, which provides the benefit of a tax deduction for interest, dividends on preferred stock are paid from
after-tax earnings
Stock Valuation: Absolute Value Models (Discounted Cash Flow)
• Assigns an intrinsic value to an asset based on the present value of its future cash flows
• Estimates of cash flows are derived and discounted based on interest rates applicable to the level of risk associated with
the asset and its projected cash flows
• Annuities
─ A series of equal cash flows to be received over a number of periods
─ The annuity present value formula divides future cash flows by a rate of return to determine the value of the annuity
in today's dollars
Stock Valuation: Absolute Value Models (Discounted Cash Flow)
• Perpetuities
─ Periodic cash flows paid by an annuity that last forever (called a perpetuity, or perpetual annuity)
─ The traditional annuity formula is simplified because the duration is unknown
─ When a company is expected to pay the same dividend each period, this formula can be used to value the stock:
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Stock Valuation: Dividend Discount Models
• The value of any investment is the present value of its future cash flows
• For common stock and preferred stock, dividends represent a series of future cash flows, and each payment is discounted
to present value
• Most stock investments do not pay cash flows into perpetuity, so assumptions are made regarding future growth
• Two models can be used to calculate the intrinsic value of a stock using discounted cash flows:
─ Constant growth dividend discount model (also known as the Gordon growth model)
─ Two-stage dividend discount model
Stock Valuation: Dividend Discount Models
Constant (Gordon) Growth Dividend Discount Model (DDM)
• Assumes dividend payments are the cash flows of an equity security and that the intrinsic value of the company's stock is the
present value of the expected future dividends
• If dividends are assumed to grow at a constant rate, the constant (Gordon) growth DDM can be used to determine the value
of the company's stock
The candidate may be given the dividend at time = t or Dt. To determine Dt + 1 , the numerator of the formula becomes: Dt(1 + G)
Constant (Gordon) Growth Dividend Discount Model (DDM)
• Determining the Required Rate of Return (R): The capital asset pricing model (CAPM) is often used to determine the
required return for the DDM model as follows:
Under the CAPM formula, the [Rm − Rf] term is also known as the market risk premium.
Two-Stage Dividend Discount Model
• Assumes there are two stages of growth: an initial phase with high but unsustainable growth, and a second phase, in which the
growth rate is stable and expected to be constant
• Requires two growth rates (short-term and long-term), the required rate of return, the current period dividend, and the number of
years estimated for short-term growth
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Stock Valuation: Relative Valuation Models Calculating the P/E Ratio
• Use the value of comparable stocks to determine value
• Price multiples are metrics that represent ratios of a stock's

price to another measure of fundamental value per share
• Can be used to determine under or overvaluation
Price-Earnings (P/E) Ratio

Note: The above formula is the "forward P/E" as the
• Most widely used multiple when valuing equity securities denominator is based on expected earnings over the next year
or four quarters.
• The rationale is that earnings are a key driver of investment
value (stock price)
• Empirical research indicates that changes in this ratio are

tied to a company's long-run stock performance
Stock Valuation: Relative Valuation Models
• Valuing Equity With the P/E Ratio
─ The P/E ratio can be multiplied by anticipated future earnings per share in order to determine the current stock price
─ This requires that earnings per share be greater than zero
Stock Valuation: Relative Valuation Models
• Trailing vs. Forward P/E
─ When past earnings are used, such as earnings for the trailing 12-month EPS, the ratio calculated is the trailing P/E
─ When expected earnings of the company next year is used in the denominator, the ratio is the forward P/E
─ The trailing P/E is preferred when a company's forecasted earnings are unavailable
─ The forward P/E is the preferred method when the company's historical earnings is not representative of its future earnings
Stock Valuation: Relative Valuation Models Calculating the Price-to-Sales Ratio
• Price-to-Sales Ratio (P/S): the rationale for using this ratio

is that sales are less subject to manipulation than earnings
or book values
─ Sales are always positive so this multiple can be used

even when EPS is negative
─ Not as volatile as the P/E ratio, which includes the

effect of financial and operating leverage Valuing Equity With the Price-to-Sales Ratio
─ Empirical studies indicate that P/S is an appropriate

measure to value stocks that are associated with
mature or cyclical companies
Stock Valuation: Relative Valuation Models Calculating the P/B Ratio
• The Price-to-Book (P/B) Ratio: price multiple used by

analysts that focuses on the balance sheet rather than the
income statement or statement of cash flows
─ The rationale for using this multiple is that a firm's

book value of common equity is more stable than
earnings per share, especially when a firm's EPS is
extremely high or low for a given period
Valuing Equity With the P/B Ratio
─ Because P/B is usually positive, this multiple can be
used even when a firm's EPS is negative or zero
─ Research indicates that the P/B ratio can explain a

firm's average stock returns over the long run
B.2. Long-Term Financial
Management: Part 2
Weighted Average
Cost of Capital
Page 2-34 | LOS: 2B2q
Weighted Average Cost of Capital (WACC)
• Major link between the long-term investment decisions associated with a corporation's capital structure and the wealth of a
corporation's owners
• Average cost of all forms of financing (debt and equity) used by a company
• Often used internally as a hurdle rate for capital investment decisions
• Optimal capital structure is the mix of financing instruments that produces the lowest WACC
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Computing the WACC
• Weight the cost of each specific type of capital by its proportion to the firm's total capital structure:
• The percentage equity and debt in the capital structure is calculated using the market values of the outstanding debt and
equity, if market values are available
Computing the WACC: Individual Capital Components
• Include both long-term and short-term elements of a firm's permanent financing mix
• Long-Term Elements: long-term debt, preferred stock, common stock, and retained earnings
• Short-Term Elements: short-term interest-bearing debt (e.g., notes payable)
─ Other forms of current liabilities (e.g., accounts payables and accruals) are not included in the cost-of-capital estimate
because they generally represent interest-free capital
• After-Tax Cash Flows: after-tax cash flows are the most relevant in evaluating the cost of the components of capital structure
─ The cost of debt is computed on an after-tax basis because interest expense is tax deductible
Weighted Average Cost of Debt
• The after-tax cost of raising long-term funds through borrowing; sources of long-term debt generally include issuance of
bonds or long-term loans
• Generally stated as the interest rate of the various debt instruments and in some cases stated according to basis points
above U.S. Treasury bond rates (where one basis point is equal to one-hundredth of 1 percent, or 0.01 percent)
• Calculated by dividing a company's total interest obligations on an annual basis by the debt outstanding:
• The pretax cost of debt represents the cost of debt before considering the tax shielding effects of the debt
Weighted Average Cost of Debt
• After-Tax Cost of Debt
─ Because interest on debt is tax deductible, the tax savings reduce the actual cost of debt.
Cost of Preferred Stock
• The dividends paid to preferred stockholders
• After-tax considerations are irrelevant because dividends are not tax deductible
• Preferred stock dividend can be stated as a dollar amount or a percentage
─ Example: 5 percent preferred stock pays an annual dividend of 5 percent of par value, if dividends are declared by
the corporation
• Net proceeds of preferred stock can be calculated as the proceeds net of flotation costs (i.e., issuance costs)
Cost of Retained Earnings
• Equal to the rate of return required by the firm's common stockholders
• A firm should earn at least as much on any earnings retained and reinvested in the business as stockholders could have
earned on alternative investments of equivalent risk
• After-tax considerations are irrelevant to equity securities because dividends are not tax deductible
• Arriving at the components of the formula for the cost of retained earnings can be difficult and potentially subjective
• Three methods can be used to compute the cost of retained earnings:
─ Capital asset pricing model (CAPM)
─ Discounted cash flow (DCF)
─ Bond yield plus risk premium (BYRP)
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The Capital Asset Pricing Model (CAPM)
• Cost of Retained Earnings: equal to risk-free rate (RFR) plus risk premium
• Market Risk Premium: equal to the systematic risks associated with the overall stock market
• Beta Coefficient: numerical representation of a stock's volatility
─ A beta of 1 means the stock is as volatile as the market; a beta greater (less) than 1 means the stock is more (less)
volatile than the market
• Risk Premium: stock's beta coefficient multiplied by the market risk premium
• Market Risk Premium: market rate of return minus RFR
Discounted Cash Flow (DCF)
• Stocks are normally in equilibrium relative to risk and return.
• The estimated expected rate of return will yield an estimated required rate of return.
• The expected growth rate may be based on projections of past growth rates, a retention growth model, or analysts' forecasts.
The Bond Yield Plus Risk Premium (BYRP)
• Equity and debt security values are comparable before taxes.
• Risks are associated with both the individual firm and the state of the economy.
• Risk premiums depend on nondiversifiable risk.
• Risk estimation can be derived by using a market analysts' survey approach.
• Risk estimation can also be derived by subtracting the yield on an average (A-rated) corporate long-term bond from an
estimate of the return on the equity market.
Comparison of the CAPM, DCF, and BYRP Methods
• Each method is a valid method of calculating the cost of retained earnings.
• The average of the three cost amounts can be used as an estimate of the cost of retained earnings if there is sufficient
consistency in the results of the three methods.
Optimal Capital Structure
• Refers to the ratio of debt to equity that produces the lowest WACC
• Required rates of return demanded by debt and equity holders fluctuate as the ratio of debt-to-equity changes
• As debt to equity increases, leverage becomes more pronounced and debtors will demand a greater return for the high level
of default risk
─ Equity holders will also require a greater return due to the negative effect of high leverage on cash flows
Determination of Lowest WACC
The following graph displays an example of the cost of using equity financing, debt financing, and the resulting WACC as debt
and equity conditions change:
Page 2-41 | LOS: 2B2t, 2B2s
Application to Capital Budgeting
• Generally, new projects are funded by sources of capital that maintain the optimum capital structure (ratio of debt to equity)
and meet or exceed the hurdle rate implied by its cost.
• The historic WACC may not be appropriate for a new capital project unless the project carries the same risk as the
corporation and results in identical leveraging characteristics.
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Marginal Cost of Capital (MCC)
• Whereas the WACC is based on the cost of debt and equity already issued, the MCC is the WACC of each new dollar raised
to finance a company's investments
• Composite (weighted) rate of return required by shareholders and debtholders to finance a company's new investments
• Increases in steps as the company raises additional funds
─ A company investing in a new project can use retained earnings to maintain its current capital structure
─ Once capital requirements exceed available retained earnings, the marginal cost of capital increases as the company
issues new debt and/or new equity
• A new investment is considered feasible only if the expected rate of return is higher than the marginal cost of new capital
raised to fund the investment
Page 2-42 | LOS: 2B2u, 2B2v
(continued)
(continued)
Derivatives
Derivatives
• Useful for risk management because the fair values or cash flows of these instruments can be used to hedge or offset the
changes in fair values or cash flows of other assets or liabilities that are at risk
• May be used for speculation to profit from fluctuations in the value of the underlying asset or liability and/or fluctuations in the
price of the derivative itself
Definitions and Concepts

• Derivative Instrument: derives its value from the value of some other instrument and has all three of the following
characteristics:
─ One or more underlyings and one or more notional amounts or payment provisions (or both)
─ No initial net investment or one that is smaller than would be required for other types of similar contracts
─ Its terms require or permit a net settlement (i.e., it can be settled for cash in lieu of physical delivery), or it can readily be
settled net outside the contract (e.g., on an exchange) or by delivery of an asset that gives substantially the same results
• Underlying: a specified price, rate, or other variable (e.g., interest rate, index of prices or rates, etc.), including a scheduled
event (e.g., a payment under contract) that may or may not occur
• Notional Amount: a specified unit of measure (e.g., currency units, shares, bushels, pounds, etc.)
• Value or Settlement Amount: the amount determined by the multiplication (or other arithmetical interaction) of the notional
amount and the underlying
─ For example, shares of stock times the price per share
• Payment Provision: a specified (fixed) or determinable settlement that is to be made if the underlying behaves in a
specified way
• Hedging: the use of a derivative to offset anticipated losses or to reduce earnings volatility
─ When a hedge is effective, the change in the value of the derivative offsets the change in value of a hedged item or the
cash flows of the hedged item
Page 2-44 | LOS: 2B2j
• Long Position: a commitment to purchase an asset in the future at an agreed upon price
─ The holder of a long position benefits when the underlying asset's price increases above the agreed upon purchase price
• Short Position: a commitment to sell an asset in the future at an agreed upon price
─ The holder of a short position benefits when the underlying asset's price decreases below the agreed upon sales price
Page 2-45 | LOS: 2B2i
Forward Contract
• A customized, negotiated agreement between two parties to exchange a commodity, currency, or other asset at a specified
price on a specified future date
• Characteristics include:
─ Contracts are customized.
─ There is no active secondary market.
─ Contracts expire and must be settled on a specified date in the future.
─ Contracts require either delivery of the underlying asset or cash settlement.
─ Forward contracts are essentially unregulated and have no credit guarantees.
Futures Contract
• A standardized agreement between two parties to exchange a commodity, currency, or other asset at a specified price on
a specified future date
• Traded on exchanges and clearinghouses that record all the transactions and guarantee timely payments on the futures
contracts, which minimizes the risk of potential default
• Two basic types of futures contracts:
─ Commodity Futures: agricultural products, metals, energy products, and forest products
─ Financial Futures: contracts to buy or sell a specific financial instrument (such as Treasury bills, certificates of deposit,
or foreign currencies) at a specific future date and at a specified price
Futures Contract
• Characteristics of futures contracts include the following:
─ Standardized
─ Exchange-traded with an active secondary market
─ Require margin deposit, mark to market, and daily settlement based on a settlement price
─ Buyers and sellers of futures often settle their positions in cash on the delivery date rather than purchase or sell the
underlying asset
─ Contracts have no default (counterparty) risk as they are guaranteed through the exchange clearinghouse
Page 2-46 | LOS: 2B2n
Swaps
• A customized contract in which two parties agree to exchange a series of cash flows
• Can be based on interest rates, currency exchange rates, commodity prices, or equity prices
• Parties enter a swaps contract to change their cash position without having to adjust their original holdings
• Equivalent to a series of forward contracts
• Interest Rate Swap: one party receives a variable interest rate payment and the other a fixed-rate payment
• Foreign Currency (FX) Swaps: each party swaps payments in one currency for payments in another currency at an agreed
upon exchange rate
Page 2-49 | LOS: 2B2k, 2B2l
Option Contracts
• A contract between two parties that gives one party the right, but not the obligation, to buy or sell an underlying asset at a
specified price (the strike price or exercise price) during a specified period of time
• The option buyer, or holder, must pay a premium to the option seller, or writer, to enter into the option contract
• Call Option: gives the holder the right to buy from the option writer at a specified price during a specified period of time
• Put Option: gives the holder the right to sell to the option writer at a specified price during a specified period of time
Page 2-49 | LOS: 2B2k, 2B2l
Page 2-50 | LOS: 2B2m
Option Contracts
• Intrinsic Value: the difference between the strike price (exercise price) and the underlying asset price
─ Can only be stated as zero or positive.
─ An option can still have market value even if the intrinsic value is zero.
─ An option is considered "in-the-money" if the intrinsic value is positive.
─ The option is "out-of-the-money" if the current price of the underlying asset is greater than the option's strike price.
Option Contracts
• Black-Scholes Model: used to determine the value of a call option or put option
─ Although the model calculation itself is outside of the scope of the exam, the inputs and their effect on the value of the
option are important to understand.
─ Note that the impact with respect to the first four inputs has opposite effects on calls and puts.
Other Sources
of Long-Term
Financing
Page 2-50 | LOS: 2B20
Leases
• A contractual agreement between a lessor and a lessee
• Provides the lessee the right to use property owned by the lessor for a specified period of time
• The lessee makes periodic cash payments (rents) to the lessor
• Under U.S. GAAP, when the lease meets certain criteria:
─ The lessee must record (capitalize) the present value of future payments as a right-of-use (ROU) asset
─ The lessee must also record a corresponding lease liability
Page 2-51 | LOS: 2B20
Leases are capitalized when they meet at least one of the following criteria:
• Ownership of the underlying asset transfers from the lessor to the lessee by the end of the lease term.
• The lessee has the written option to purchase the underlying asset; the option is one that the lessee is "reasonably
certain" to exercise.
• The net present value of all lease payments plus the net present value of any guaranteed residual value are equal to or
exceed the underlying asset's fair value.
• The term of the lease represents the major part of the economic life remaining for the underlying asset.
• The asset is specialized such that it will not have an expected, alternative use to the lessor when the lease term ends.
Page 2-51 | LOS: 2B20
Lease requirements under IFRS differ from U.S. GAAP in a few critical areas:
• Lessees do not have to record leased assets under IFRS if the value is less than $5,000, whereas GAAP has no
dollar threshold.
• IFRS requires lessees to account for only finance leases and not for operating leases, whereas GAAP has two
classifications (operating and finance).
Page 2-51 | LOS: 2B20
Convertible Securities
• Convertible Bonds
─ Can be converted by the bondholder into shares of the issuer's common stock during some point in the bond's life
─ If the value of the underlying stock increases significantly, a bondholder may convert the bond and receive shares of
the underlying stock based on a preestablished conversion ratio
─ Due to the potential benefit to the holder, the interest rate paid on a convertible bond is usually lower and represents a
less expensive method of financing for the issuing company
• Convertible Preferred Shares
─ Provide the owner with the option of converting the preferred shares into common shares
─ Shareholder will benefit not only from preferential dividend payments but also from potential capital appreciation in
stock price
─ Issuer can offer a lower dividend rate than similar securities without the conversion feature due to other benefits
Page 2-51 | LOS: 2B20
Warrants
• Provide their holders the option to buy shares of stock during a future period at an established exercise price (strike price)
• The issuing company receives new capital only if the holders of the warrants exercise the warrants
• Can be offered either as standalone products or as an attachment to other offerings, such as bonds
• Allows the issuing company to reduce the interest rate on the bond because the buyers of the bonds are receiving the value
of the warrant in addition to the bond
• Usually, warrants included with bonds are detachable
─ Detachable warrants allow the holder to separate the two securities (the bond and the warrants) and choose to hold or to
sell each independently
Impact of Inflation
and Interest Rates
on Financial
Instruments
Page 2-52 | LOS: 2B2p
Nominal and Real Interest Rates
• Nominal Interest Rate: the amount of interest paid (or earned) measured in current dollars
─ In an inflationary economy, nominal interest rates are not a good measure of how much borrowers really pay or lenders
really receive when they take out or make a loan
─ A more accurate measure of the interest borrowers pay or lenders receive is the real interest rate
• Real Interest Rate: the nominal interest rate minus the inflation rate
─ A measure of the purchasing power of interest earned or paid
Page 2-52 | LOS: 2B2p
Nominal and Real Interest Rates Impact on Financial Instruments
Relationship Between Nominal Interest Rates and Inflation • As interest rates rise, prices of financial instruments fall
for several reasons:
• Nominal interest rates and inflation naturally
move together. ─ The higher discount rate used to value future cash
flows lowers the present value of an investment.
• When the inflation rate increases, so does the nominal
interest rate. ─ Companies and individuals borrow less and spend
less, which slows economic activity, reduces demand,
• The relationship may be shown by rearranging the reduces sales and profits, and lowers stock prices.
previous equation for real interest rates as follows:
─ Fixed-rate bonds become less attractive as rates
increase, lowering the value of these bonds.
─ Higher interest rates allow investors to earn more on

their idle cash, but cash that is already allocated to
stock and bond investments do not earn this
higher interest.
B.3. Raising Capital
Financial Markets
and Regulations
Financial Markets and Regulations
• Any marketplace in which securities and other financial instruments are bought and sold
• Necessary to facilitate allocation of resources, create liquidity for businesses, and provide a place of exchange for buyers
and sellers
• Used by investors or lenders seeking to earn a return on excess funds
• Securities traded include equity securities, debt securities, and derivatives
• Primary markets are those markets in which securities are initially sold, known as initial public offerings (IPOs)
• Secondary markets are exchanges where buyers and sellers come together to buy and sell securities after an IPO
Types of Financial Markets 4. Money markets
• Capital Markets: markets in which long-term securities 5. Federal funds markets

that have either no maturity or a maturity greater than
one year are traded 6. Over-the-counter markets
─ Include stocks (equity securities) and bonds 7. Foreign exchange markets

(debt securities)
8. Derivatives markets
• Money Markets: markets in which short-term debt
securities that mature in less than one year are traded
• Financial markets can be classified based on the type of

securities traded as follows:
1. Exchanges
2. Bond and fixed income securities markets
3. Government securities markets
Types of Financial Markets
Physical Exchanges
• Where sellers and buyers come together in a physical location to execute transactions
• Today, most exchanges offer their services electronically
Electronic Exchanges
• Often used by smaller companies and by dealers buying and selling for their own accounts who then resell the securities to
profit from the difference (the spread) between the selling price (ask price) and the buying price (bid price)
Bond and Fixed Income Securities Markets
• Networks of dealers who electronically buy and sell bonds
• Bonds are quoted in the market at a percentage of the security's face value
─ Example: A bond with a face value of $1,000 that is quoted in the marketplace at 102 is sold for 102 percent of face
($1,020 plus accrued interest). If quoted at 97, then the bond's market price is $970 (plus accrued interest).
Government Securities Markets
• Government securities include short-term U.S. Treasury bills (T-bills), Treasury notes (up to a 10-year maturity), and
Treasury bonds (up to a 40-year maturity)
• May be initially sold directly by a government entity or in government securities markets, then traded on secondary markets
• Treasury bills are sold at a discount and their face value is repaid at maturity; the difference is the interest earned by
the investor
• Other government securities pay a stated interest rate and are sold to yield the market interest rate
Money Markets
• Generally in large denominations, attractive mostly to wealthy individuals or large companies
• Individual investors typically access the money market by investing in pools of investment funds called money market funds
Federal Funds Market
• Governmental banking authorities (the Federal Reserve in the United States) require other banks to make a minimum deposit
at the government's bank each business day
• Amounts on reserve at the government's bank do not earn interest
• Any bank that has more cash reserves than the amount required to be deposited overnight can lend the excess to other banks
• In this overnight transaction, the lending bank earns a specified interest rate, known as the overnight bank funding rate
Over-the-Counter Market
• Brings together dealers who sell and buy securities electronically
• Similar to exchange-traded markets except for the absence of a physical exchange to act as a facilitator or a guarantor
─ Less transparency and liquidity in OTC markets
Foreign Exchange Market
• Where financial intermediaries use cash to buy and sell currencies; also called forex or an FX market
• Currencies trade in pairs (two currencies for each transaction) setting relative currency prices for all monetary denominations
• Exchange rates can be quoted two ways:
─ Direct Exchange Rate: one unit of foreign currency is expressed in terms of the domestic currency
─ Indirect Exchange Rate: one unit of domestic currency is expressed in terms of a foreign currency
Derivatives Markets
• Derivatives are financial instruments that derive their value from an underlying asset, called the underlying
• The underlying can be stocks, bonds, hybrid securities, commodities, or currencies
• Examples: futures contracts, forward contacts, and options
Market Efficiency
Market Efficiency
• How well current market prices reflect all available, relevant information
• No single investor can make above-normal profits because everyone trading in the market has the same information, which is
reflected in the market price
• As more information becomes available, the market becomes more efficient with fewer opportunities to make above-average
rates of return
There are three market efficiency hypotheses:
1. Weak Form Efficiency: market prices of securities reflect only historical information regarding trends in price and volume
─ Analysts often use technical analysis to analyze historical trends to predict future market movements
─ Abnormal or superior profits cannot be made relative to other investors because historical information is already reflected
in market prices
Market Efficiency
2. Semi-Strong Form Efficiency: market prices reflect not only historical price and volume trends but also other published
information, including earnings announcements, new product announcements, and economic news
─ Analysts use this type of information to conduct fundamental analysis, which involves analyzing a company's core
financial statements, as well as the company's industry, competition, and historical performance
3. Strong Form Efficiency: market prices reflect all possible information, including private information usually known only to
insiders (individuals with privileged information)
─ Investors would not be able to achieve an above-average return making trades using private information
Page 2-58 | LOS: 2B3l
Insider Trading
• The buying or selling of a publicly traded stock based on material, nonpublic information
• Insiders can be a company's officers, directors, owners with significant amounts of stock, and/or government employees with
access to confidential information
• The laws of many countries state that insider trading is illegal
Investment Banks
Investment Banks
• Banks that specialize in facilitating investment transactions for companies seeking to issue new shares of stock or bonds
• Offer advisory services, provide a platform for selling new securities for businesses, and act as a broker or underwriter
of the sale
Advising
• An investment bank serving as an advisor provides the following services:
─ Development of financial models to determine the type of securities to issue and the issuance price of the securities
─ Development and filing of registration statements such as those required by the Securities and Exchange Commission
(SEC) in the United States when issuers (publicly held entities) issue new securities
Underwriting
• When a company seeks to raise funds through the issuance of stocks or bonds, the company usually approaches an
investment bank that sells the securities in the market to investors
• The investment bank either facilitates a sale to the market for a fee or purchases the issue and then sells it to the market
• When underwriting, an investment bank may have three roles:
1. Firm Commitment: the parties agree that the bank assumes all the risks, with the investment bank purchasing and holding
("absorbing") all stocks or bonds that are not sold to the public
2. Best Efforts: the investment bank's role is to use the bank's best efforts to market the securities to the public, but the bank
has no commitment to absorb the unsold securities
3. All or None: the entire issue must be sold for the trade to be completed; the investment bank bears little risk and is not
responsible for purchasing the shares if the transaction is canceled
Trading: Other Services
Many investment banks offer other services, such as wealth management, asset management, research, and trade execution
• Wealth Management
─ Wealth creation and preservation strategies, along with investment and asset management services
─ Often includes a combination of advisory services, risk mitigation through insurance, investment brokerage, and
tax planning
• Investment Research
─ Buy-Side Research: focused on providing internal insights for corporations purchasing securities, giving guidance on
companies' financial health, industry position, and projected performance
─ Sell-Side Research: provided by investment firms selling securities, providing buyers insights, and potentially serving as a
tool of persuasion for institutions selling those securities
Initial Public
Offering
and Secondary
Public Offering
Initial Public Offering
• Issuing shares for the first time is called an initial public offering (IPO), called "going public"
• Requires the company to follow certain procedures, such as:
─ Filing articles of incorporation with the SEC
─ Waiting for permission to issue shares
─ Announcing the sale
─ Distributing a prospectus to interested potential investors
• Results in a substantial loss of control by the owners
• Public companies face increased regulatory scrutiny, significant reporting requirements, and the potential for more litigation
resulting from dissatisfied or dissenting stockholders
Subsequent and Secondary Offerings
• Subsequent Offering
─ Occurs after a company has gone public through an IPO
─ May consist of either newly issued shares or shares that were repurchased (treasury stock)
─ Newly issued shares make the offering dilutive, meaning existing shareholders' ownership percentages are reduced due
to an increase in total outstanding shares
• Secondary Offering
─ Occurs when a shareholder decides to sell some or all of the interest in the company
─ Has no dilutive impact because there is no change in the total shares outstanding
Credit Rating
Agencies
Credit Rating Agencies
• Independent companies that analyze financial and qualitative data to assess an entity's ability to pay both the interest and
principal on debt
• Entities may be companies, state or local governments, non-for-profit organizations, or sovereign nations
• Debt instruments include government bonds, corporate bonds, certificates of deposit, municipal bonds, preferred stock, or
collateralized debt obligations
• At the completion of the credit rating agency's analysis, a grade or rating is given to the entity
─ A higher rating signals to the market that the entity is less risky, which allows the entity to borrow from lenders at lower
rates of interest
• Major credit rating agencies are Moody's Investors Service, Standard & Poor's (S&P), and Fitch Ratings
─ Each agency has a rating system that divides securities into either investment grade (high-quality bonds) or speculative
(junk bonds); the lower the rating, the higher the interest rate the entity must pay on its debt securities
Distribution to
Shareholders
Distribution to Shareholders
• A pro rata distribution by a corporation based on the shares of a particular class of stock
• Cash dividends are most common, although there are many other types
• Preferred stock usually pays a fixed dividend, expressed in dollars or as a percentage
The Dividend Payment Process

• There are three dates associated with dividend payments:
─ Date of Declaration: the date the board of directors formally approves a dividend; on the declaration date, a liability is
created (dividends payable) and retained earnings is reduced (debited)
─ Date of Record: the date the board of directors specifies as the date the names of the shareholders to receive the
dividend are determined
─ Date of Payment: the date on which the dividend is actually disbursed by the corporation or its paying agent
Preferred Stock Dividends
• Preferred shareholders must be paid first before any dividend is paid to common shareholders
• Cumulative Preferred Stock: all or part of the preferred dividend not paid in any year accumulates and must be paid in the
future before dividends can be paid to common shareholders
─ The accumulated amount is referred to as dividends in arrears
─ The amount of dividends in arrears is not a legal liability, but must be disclosed in total and on a per-share basis either
parenthetically on the balance sheet or in the footnotes
• Noncumulative Preferred Stock: dividends not paid in any year do not accumulate and preferred shareholders lose the right to
receive dividends that are not declared
Preferred Stock Dividends
• Participating Preferred Stock: the participating feature provides that preferred shareholders share (participate) with common
shareholders in dividends in excess of a specific amount
─ Fully Participating: preferred shareholders participate in excess dividends without limit, receiving their preference dividend
first, and then additional dividends are shared between common and preferred shareholders
─ Partially Participating: preferred shareholders participate in excess dividends, but to a limited extent (e.g., a
percentage limit)
• Non-participating Preferred Stock: preferred shareholders are limited to the dividends provided by their preference and do
not share in excess dividends
Cash Dividends
• May be declared on common or preferred stock
• Paid from retained earnings
• Only paid on authorized, issued, and outstanding shares (not paid or declared on treasury stock)
Property (In-Kind) Dividends

• Nonreciprocal transfers of noncash assets (e.g., inventory, investment securities, etc.) distributed to shareholders
• On the date of declaration, the property distributed is restated at fair value, with a gain or loss recognized in income
• The dividend liability and related debit to retained earnings should be recorded at the fair value of the assets transferred
Scrip Dividends
• A special form of notes payable whereby a corporation commits to paying a dividend, and possibly interest, at some later date
• May be used when there is a cash shortage
• On the date of declaration, retained earnings is debited and notes payable (instead of dividends payable) is credited
Liquidating Dividends
• Occur when dividends to shareholders exceed retained earnings, with the excess of retained earnings charged (debited) first
to additional paid-in capital and then to common or preferred stock
Stock Dividends
• Additional shares of a company's own stock is distributed to shareholders
• Treatment of a small stock dividend (< 20–25 percent)
─ When less than 20 to 25 percent of the shares previously outstanding are distributed, the dividend is treated as a small
stock dividend
─ The issuance is not expected to affect the market price of the stock
─ The fair market value of the stock dividend at the date of declaration is transferred from retained earnings to capital stock
and additional paid-in capital
─ There is no effect on total shareholders' equity, as paid-in capital is substituted for retained earnings
Stock Dividends
• Treatment of a large stock dividend (> 20–25 percent)
─ Occurs when more than 20 to 25 percent of the previously issued shares outstanding are distributed
─ May be expected to reduce the market price of the stock
─ The par (or stated) value of the stock dividend is normally transferred from retained earnings to capital stock
• Stock dividends on treasury stock
─ Generally not distributed because such stock is not considered outstanding
─ Exceptions are made when:
1. The company is maintaining a ratio of treasury shares to shares outstanding in order to meet stock option or other
contractual commitments
2. State law requires that treasury stock be protected from dilution
Stock Splits
• Occur when a corporation issues additional shares of its • Reverse Stock Splits
own stock (without charge) to current shareholders and
reduces the par (or stated) value per share proportionately ─ Reduces the number of shares outstanding and
increases the par (or stated) value proportionately
• No change in the total book value of the shares
outstanding • Stock Splits on Treasury Stock
• The memo entry for a stock split is only a formality ─ Stock splits are usually not applied to treasury stock
because such stock is not considered outstanding
• A stock split usually does not affect retained earnings or
total shareholders' equity: ─ Exceptions are made when:
1. The company is maintaining a ratio of treasury

shares to shares outstanding to meet contractual
agreements
2. State law requires that treasury stock be protected

from dilution
Dividend Policy
• A company's board sets the policy for what profits to distribute as dividends and what to retain for expansion
• The dividend policy that the board adopts signals its expectations of future profitability
• Dividend policies may include:
─ Equal Annual Payments: regular payments made by companies that have stable earnings and cash flows; dividends are
the same each year regardless of earnings
─ Equal Annual Percentage: a fixed percentage of earnings distributed annually to shareholders
─ Irregular: the board of directors decides annually whether to distribute dividends and how much to pay out
─ No Dividends: start-ups, high-growth companies, and firms in an expansion mode may choose to retain earnings for
growth rather than pay dividends; compensation to investors comes from stock price appreciation
─ Residual Distribution: the board declares dividends only if earnings are more than the amount needed for reinvestment
Dividend Policy Factors
When establishing dividend policy, the board of directors considers several factors, including:
• Stability of Earnings: companies with stable earnings may distribute a higher percentage of those earnings compared with
companies with less predictable earnings
• Financing Policy: if financing operations through borrowing is less expensive than using internal funds (retained earnings), the
board may choose to borrow funds and distribute a higher percentage of retained earnings to shareholders
• Liquidity: increased liquidity means that cash is available to distribute cash dividends to shareholders
• Competitor Policies: higher dividends paid by competitors may attract investors to the competition
• History: companies may prefer to be consistent with dividend payments
Dividend Policy Factors
• Debt Level: companies with higher levels of debt need cash and may not be able to distribute cash dividends
• Access to Capital Markets: larger companies may have better access to capital markets to borrow funds and may be able to
distribute a higher percentage of their earnings as dividends
• Growth and Expansion: companies may invest internally rather than pay dividend payments if the expected return on growth
opportunities is higher than the cost of retained earnings
• Legal Requirements: some countries require that each company maintain a certain level of retained earnings or have laws
governing distributions
• Tax Considerations: in countries in which the corporate tax rate is high, companies have less earnings to distribute
─ Tax codes in some countries (including the U.S.) impose taxes on dividend income to the shareholders, making the
receipt of dividends less appealing
Page 2-66 | LOS: 2B3k
Stock Repurchase (Treasury Shares)
• A corporation's own stock that has been issued to shareholders and subsequently reacquired (but not retired)
• Treasury stockholders are not entitled to any of the rights of ownership given to common shareholders, such as the right to
vote or to receive dividends
• A portion of retained earnings equal to the cost of treasury stock may be restricted and may not be used as a basis for the
declaration or payment of dividends (depending on applicable state law)
Reasons to Repurchase Shares
• A company may repurchase its shares for treasury purposes for one or more of the following reasons:
─ Increase Earnings per Share (EPS): treasury shares are issued but not outstanding shares; when the number of
outstanding shares decreases, EPS will increase
─ Employee Stock Options: using treasury shares is often less expensive than issuing new shares to fulfill employee stock
option contracts
Stock Repurchase (Treasury Shares)
─ Defense: reducing the number of outstanding shares can be used to defend against takeover attempts because it can
prevent others from buying the stock and obtaining control
─ Create Demand: purchasing shares in the marketplace may cause the stock price of the remaining shares to increase and
create more demand for the stock
─ Tax Incentives: paying a higher price to repurchase shares from shareholders, rather than distributing dividends, may
allow shareholders to pay the long-term capital gains tax rate, which may be lower than the dividends tax rate
Lease Financing
Lease Financing
• Used by public and private entities as a means of gaining access to assets and reducing exposure to the full risks of
asset ownership
• A lease is defined as a contractual agreement between a lessor who conveys the right to use real or personal property (an
asset) and a lessee who agrees to pay consideration for this right over a specific period of time
• In order for a contract to be a lease or contain a lease, both of the criteria below must be met:
1. The contract must depend on an identifiable asset in which the lessor does not have a substantive substitution right.
2. The contract must convey the right to control the use of the asset over the lease term to the lessee, and the lessee will
have the right to obtain substantially all of the economic benefits from using the asset.
Advantages of Leasing (Lessee)
• Steady Cash Outflows: the lessee can avoid significant one-time cash outflows for assets, allocating cash payments over time
• Use Newest Technology: lessees can use the most advanced assets without purchasing and reduce repairs and
maintenance costs
• Increased Investment Opportunities: funds that would have been used for the purchase of assets may be used for other
capital investment opportunities
• Tax Benefits: lease expenses and lease payments may be tax deductible to the lessee
• Protection Against Inflation: lease payments are usually fixed and protect the lessee against inflation in the later years of the
lease contract
• Avoid Obsolescence Risks: lessees do not bear the risk of declining asset value due to obsolescence because the asset is
owned by the lessor
• Flexibility: lease terms may range from days to years, provide an option to buy the asset or return it to the lessor, and may
allow for cancellation during the term of the lease
Disadvantages of Leasing (Lessee)
• Cost: can be a more costly option than an outright purchase
─ To determine if the lease is more costly, the present value of the lease payments should be compared with the cost of
purchasing the asset
• Debt: the lease contract creates a commitment to make future payments
─ The present value of all lease payments is recognized as a lease liability and may reduce the company's ability to borrow
additional funds
• Ownership: the lessor retains ownership of the asset while the lessee pays for all maintenance expenses
Buy or Lease Decisions
The important issue for financial decision-making is the cash flows
created by a lease, as compared with purchasing the asset
Investment Decision
• Discount the after-tax operating cash inflows at the firm's weighted average capital (WACC)
Financing Decision
• Discount the cash flows specific to each financing option at the after-tax cost of debt
• The preferred financing option is that with the lowest NPV
• The relevant cash flows to consider include:
─ Buy Asset: purchase cost or present value of lease payments, tax savings from depreciation, and scrap proceeds
─ Lease Asset: lease payments, tax savings on lease payments
(continued)
(continued)
B.4. Working Capital
Management: Part 1
Working Capital
B.4. Working Capital Management: Part 1
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Working Capital
• Working capital policy and working capital management involve managing cash so that a company can meet its short-term
obligations
• Includes all aspects of the administration of current assets (CA) and current liabilities (CL)
─ The optimal mix of current assets and current liabilities depends on the nature of the business and the industry
─ Optimization also requires offsetting the benefit of CA and CL against the possibility of technical insolvency
• The goal is to manage liquidity efficiently
Definition of Net Working Capital
• Net working capital is defined as the difference between current assets (CA) and current liabilities (CL)
• Current Assets: cash and other assets that are expected to be converted into cash, sold, or consumed within one year or
within one operating cycle (whichever is longer)
• Current Liabilities: amounts owed by a company that will be repaid or liquidated using current assets within one year or
within one operating cycle (whichever is longer)
Current Ratio
• Measures the number of times current assets exceed current liabilities
• Demonstrates a firm's ability to generate cash to meet its short-term obligations
• Evaluating the Current Ratio
─ A ratio of 1 indicates a company has exactly enough in current assets to fully pay off or liquidate all current liabilities
─ Ratio greater than 1 implies that a company has a positive working capital reserve
─ Generally, a current ratio of 1.5 or 2 indicates sufficient liquidity, but this ratio varies by industry, company size, and the
economic circumstances
─ A ratio over 2 may reflect unnecessary investment in current assets or may reflect too much uninvested cash
─ A ratio of less than 1 may indicate potential liquidity problems as current liabilities come due
Current Ratio
• Properly evaluating a firm's current ratio requires comparing the ratio for other companies in the same industry and
comparing the company's own ratio over several years.
• Deteriorating Current Ratio
─ A decline in the current ratio can be attributed to increases in current liabilities, decreases in current assets, or a
combination of both.
• Improving Current Ratio
─ An increase or improvement in the current ratio implies an increased ability to pay off current liabilities.
─ Unless short-term liquidity is a relevant issue, the current ratio is not necessarily the best measure of the health
of a business.
Financing
Decisions and
Working Capital
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Financing Decisions and Working Capital
Companies use a mix of short-term and long-term financing • Advantages
to meet their capital requirements because each has
different advantages and disadvantages as well as different ─ Increased Profitability: due to rapid conversion of
effects on working capital. operating cycle components into cash
Short-Term Financing ─ Decreased Financing Cost: short-term interest rates

are generally lower than long-term interest rates
• Rates: tend to be lower than long-term rates and
presume greater liquidity • Disadvantages
• Effect on Working Capital ─ Increased Interest Rate Risk: rates can change
given shorter maturities, may require greater
─ Decreases working capital financing charges
─ Usage depends on risk tolerance of management, ─ Decreased Capital Availability: lender evaluation of
with shorter-term financing strategies requiring creditworthiness may change, making financing
current asset levels to be sufficient to meet short- impossible or less favorable by virtue of increased
term obligations rates and/or less favorable terms
Long-Term Financing
• Generally classified as non-current and mature after one year
• Rates: tend to be higher than short-term rates and presume less liquidity on the part of the organization
• Effect on Working Capital: classified as non-current and is not included in the calculation of working capital
─ Dividend, interest, and principal repayments all require cash, which can reduce working capital over time
─ The extent to which an organization uses long-term financing is dependent on both the amount of current assets it
maintains and the risk tolerance of management
─ Long-term financing increases financial leverage
Long-Term Financing
• Advantages
─ Decreased Interest Rate Risk: locks in a rate over a long period, reducing exposure to fluctuations
─ Increased Capital Availability: reduces the risk that refinancing might be denied or modified with less favorable terms
• Disadvantages
─ Decreased Profitability: higher financing costs reduce profitability
─ Increased Financing Costs: generally carry a higher rate given the longer duration
─ Disadvantages from the Lender's Perspective: the likelihood that rates will change over the period of the loan increases
over the life of the loan, subjecting the lender to higher interest rate risk
─ Disadvantages from the Borrower's Perspective: locked into a long-term interest rate to reduce interest rate risk, but pay
a premium to do so
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Working Capital Management
• Managing working capital involves a trade-off between profitability and risk
• Conservative Approach: advocates using long-term financing to purchase non-current assets, permanent current assets,
and some temporary current assets
─ When current asset needs are low, a company invests excess funds in marketable securities (i.e., "storing liquidity")
• Maturity-Matching Approach (MMA) or Hedging Approach: uses this approach to hedge risks by matching the maturities of
assets and liabilities
─ Current assets mature and are liquidated as current liabilities become due, and non-current assets are financed with
long-term debt and equity securities
• Aggressive Approach: uses a combination of long-term and short-term debt, or only short-term debt, to finance
long-term assets
─ Because long-term borrowing generally charges higher rates of interest than short-term loans, the use of short-term
financing can reduce interest costs
Cash Management
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Cash Budgets
• Necessary for anticipating liquidity and working capital needs
• Cash balances are affected by the anticipated volume and timing of both cash collections and disbursements
• Assists management by allowing it to:
─ Plan to borrow additional funds in periods of anticipated cash shortages
─ Invest in short-term marketable securities in times of excess cash
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Motives for Holding Cash
• Motives for holding cash include:
─ Transaction Motive: a company may hold cash to meet payments arising from the ordinary course of business
─ Speculative Motive: cash may be needed to take advantage of temporary opportunities
─ Precautionary Motive: it is important to have enough cash on hand to maintain a safety cushion to meet
unexpected needs
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Factors Influencing Cash Levels
• When determining a company's optimal cash levels, managers should consider the following factors:
─ A company will need more cash if short-term liabilities mature in the near term.
─ Cash balances should be higher if management has low risk tolerance; lower cash levels mean a higher risk of insolvency.
─ A company can hold less cash if cash collections are consistent, reliable, and sufficient to cover cash disbursements.
• Compensating balance requirements may stipulate minimum cash levels to ensure that the borrower will pay interest and
repay debt as it becomes due.
─ Banks may require borrowers of short-term, unsecured loans to maintain a compensating balance with the bank in the
borrower's checking account.
─ The compensating balance typically ranges from 10 percent to 20 percent of the borrowed amount.
Operating Cycle and Cash Conversion Cycle
• Either speeding up cash inflows or slowing down cash
outflows increases cash balances.
• Improved rates of cash collection are generally

achieved through faster accounts receivable
collections.
• Reduced cash outflows are often achieved through

delayed (or deferred) disbursements.
• The combination of current cash inflows and current

cash outflows related to a business is called the
operating cycle.
─ The objective of financial managers is to shorten the

operating cycle.
Operating Cycle and Cash Conversion Cycle
1. Operating Cycle 3. Elements of the Cash Conversion Cycle Formula
2. Cash Conversion Cycle
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Methods to Accelerate Collections
Conversion cycles can be improved by accelerating cash collections and decreasing the days in accounts receivable
• Customer Screening and Credit Policy
─ A company can choose to extend credit to more customers who are more likely to pay bills promptly
• Prompt Billing
─ Timely billing of charges serves to speed collections
• Payment Discounts
─ Offering payment discounts may influence customers to pay faster and can result in improved collections
─ Discounts foregone represent a higher cost to the customer than a bank loan for similar financing
─ The formula for calculating the annual cost (APR) of a quick payment discount (using a 360-day year) follows:
• Electronic Funds Transfer
─ The electronic movement of funds from one institution to another, ensuring timely payment
─ Facilitates immediate collection rather than waiting for checks to be deposited
• Lockbox Systems
─ Expedite cash inflows by having a bank receive payments from a company's customers directly via mailboxes to which
the bank has access
─ Payments that arrive in these mailboxes are deposited into the company's account immediately
• Lockbox Systems
─ Although a company may earn additional interest income, the system also involves a service fee paid to a bank.
─ Management must compare the cost of the service to the benefit of expediting cash collections using the following process:
1. Calculate the average daily collection by multiplying the average number of daily payments by the average
payment amount.
2. Calculate the increase in cash balances resulting from the use of the lockbox system by multiplying the average daily
collections from the first step by the number of days saved using the system.
3. Calculate the benefit the company will receive each year from interest on additional cash balances by multiplying the
additional cash balance from the previous step by the annual interest rate on cash balances.
4. Calculate the annual cash net savings by comparing the benefits with the annual fee charged for the service by
the banks.
• Concentration Banking
─ Characterized by the designation of a single bank as a central depository
─ Advantages include:
• Improved controls over inflows and outflows of cash
• Reduced idle balances
• Improved effectiveness for investments; all cash deposited in one central bank account can be invested in short-term
securities to improve investment returns
Delayed Disbursements
• The cash conversion cycle can also be improved by delaying disbursements
• Defer Payments
─ Postponing payment of accounts payable provides a spontaneous source of credit
─ Communications to creditors that payments will arrive later than usual serve to mitigate possible damage to relationships
with suppliers and to credit ratings
• Line of Credit
─ Serves to slow down payments
─ Extends the company's trade credit by paying off the company's trade accounts with borrowed funds
─ Allows the company a longer period to pay back that loan to the bank
Delayed Disbursements
• Use of Drafts
─ Bank drafts are payments guaranteed by the issuing bank that travel through the banking system more slowly, because
once a draft is presented by the payee, it must first be approved before it is paid.
─ Can also be used to delay cash disbursements instead of checks, which increases the payable float.
• Zero-Balance Accounts (ZBA)
─ Deposits are made to a central interest-bearing account, and cash is moved into the zero-balance account automatically
when necessary to cover check payments as needed.
─ Example: Zero balance accounts are often used for payroll payments. The account has a balance of zero during most of
the month, but funds equal to the total payroll amount are transferred to the account when payroll is processed.
Float and Overdraft Systems
• Float occurs when there is a difference between the bank balance per the company's books versus the cash in the
company's account per the bank's records
─ Disbursement Float (positive from the depositor's perspective): occurs when the depositor has issued checks, but those
checks have not yet been received and recorded by the bank
─ Collections Float (negative from the depositor's perspective): occurs when deposits have been recorded in the
depositor's books, but those deposits have not yet been recorded by the bank
• Elements of Float
─ Time required for checks and deposits to travel to the bank
─ Time required for processing by the bank where the payee deposits the check received
─ Time required for check clearance by the bank where the payor has the checking account
Float and Overdraft Systems
• Managing Float
─ If handled efficiently, a positive net float will result
─ Proper management allows a negative cash balance on its books but a positive bank balance per the bank's books
─ Technology reducing these delays is causing float to dwindle significantly
• Overdraft Protection
─ For a fee, most banks will provide overdraft protection, which allows a withdrawal to occur even when there are no funds
─ Companies can provide some protection against overdrafts by arranging short-term overdraft loans with the bank
(generally less than one week) that may be automatically repaid with the next deposit
Marketable
Securities
Management
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Marketable Securities Management
• Provide lower returns than operating assets but higher returns than cash deposited in savings accounts
• Each type of marketable security has features relating to safety, marketability, yield, maturity, and taxability
• Can be debt securities (bonds) or equity securities (stocks)
Common Marketable Securities

• United States Treasury Bills (or T-Bills): T-bills are sold at a discount and mature at par value
─ Maturities are 30, 60, and 90 days and are guaranteed (backed) by the U.S. government
─ Lowest default risk, lowest liquidity risk, and are maturity risk-free
• Treasury notes (T-notes) and Treasury bonds (T-bonds): issued by the U.S. Treasury and have a stated interest rate that is
paid semiannually
─ Traded on secondary markets and are low risk; T-notes maturing in one to 10 years and T-bonds maturing in 30 years
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• Federal Agency Bonds
─ Issued by certain federal agencies and traded on secondary markets, maturing in periods from nine months to 30 years
─ Pay higher interest rates than Treasury issues (Example: Fannie Mae)
• Negotiable Certificates of Deposit (CDs)
─ Money market instruments with maturities of one year or less and are not exchange traded
─ Can be purchased through brokers with guarantees by the Federal Deposit Insurance Corporation (FDIC) keeping risk
and return low
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• Banker's Acceptances
─ A negotiable instrument that is similar to a postdated check, except that it is guaranteed by the bank rather than by the
account holder
─ The risks are only marginally higher than those of government securities, and yields are only slightly higher, but are
traded on secondary markets
• Commercial Paper
─ Unsecured, short-term debt issued by creditworthy corporations to finance payroll, accounts payable, inventory, and
other short-term liabilities
─ Most are sold at a discount, mature at par value, have terms of 90 to 180 days, and usually sold in amounts of $100,000
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• Eurodollars
─ Represent U.S. dollars that are deposited in international banks, making them free from U.S. banking regulations
─ Often these investments are simply time deposits, which are investments in the form of interest-bearing accounts in
which deposits are kept for a specified period
• Money Market Mutual Funds
─ Professionally managed portfolios of marketable securities that only include highly liquid, short-term instruments such as
cash, cash-equivalent securities, and high credit rating debt-based securities with a short-term maturity
─ Because of the low level of risk, they generally have returns comparable to negotiable CDs and commercial paper
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• Repurchase Agreements
─ An arrangement in which a bank or a security dealer sells securities and agrees to repurchase them at a specified
price and time
─ Usually customized in terms of maturity based on the purchaser's needs and have a slightly higher risk than
Treasury issues
• Municipal Bonds (Local Government Bonds)
─ Bonds issued by a municipality (also called muni bonds)
─ Beneficial to investors because the return on these bonds is nontaxable in some countries, including the United States
Factors Influencing the Level of Marketable Securities
• Companies often hold marketable securities because they can be converted to cash on short notice
• Because marketable securities yield higher returns than cash, many firms will hold marketable securities instead of cash
─ Liquidity Motives: when cash outflows exceed inflows, companies can liquidate marketable securities to increase cash
─ Precautionary Motives: may be held as a precaution against possible shortages of bank credit in times of cash need
Strategies for Holding Marketable Securities

• If interest rates are low and if the time required to liquidate is substantial, then cash holdings (cash in bank accounts) are
preferable to marketable securities
• If interest rates are relatively high and if the time required to liquidate is minimal, then holding marketable securities is
preferable to cash
B.4. Working Capital
Management: Part 2
Accounts
Receivable
Management
Page 2-92 | LOS: 2B4q
Accounts Receivable Management
Achieving a balance between converting accounts receivable into cash quickly to meet short-term obligations and extending
enough credit to capture additional sales without increasing bad debt expense
• Factors that influence the level of receivables
─ Total Sales: higher sales generally mean higher receivables
─ Level of Credit Sales: receivables are higher for companies that primarily sell on credit rather than cash
─ Credit Policies: companies with less-stringent credit policies, including lower credit standards and longer payment periods,
generally have higher receivables but may also have higher write-offs
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Credit Policy
• One of the major determinants of demand for a firm's products or services, along with price, product quality, and advertising
• Typically established by a committee of senior company executives
• Credit Period: length of time buyers are given to pay for their purchases, with a commonly used credit period of 30 days
─ If the credit period is too long, the company may experience cash shortages
─ If it is too short, then it may damage relationships with customers and negatively affect future sales
• Credit Standards: the required financial strength of credit customers
─ Extending credit to only financially strong customers minimizes uncollectible receivables, but also limits potential sales
─ Extending credit to a broader base of customers increases sales, but adds risk in that a greater percentage of receivables
is likely to be written off
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Credit Policy
• Collection Policy: measured by the stringency or laxity in collecting delinquent accounts; can be a balancing act between
wanting to collect cash owed quickly versus maintaining positive relationships with customers
• Discounts: include the discount percentage and period
─ Offering discounts to customers who pay early may result in faster receivables collection, depending on the terms of the
discount and the customer's own cash needs
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Factoring
• Entails turning over the collection of accounts receivable to a third-party factor in exchange for a discounted short-term loan
• Cash is collected from the factor immediately rather than from the customer according to the credit terms
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Inventory
Management
Inventory Management
• Balances the cash requirements of the firm with the product delivery requirements of customers
• Means having adequate product in the right place at the right time to meet consumer demand without incurring excessive or
unnecessary inventory carrying costs
Factors Influencing Inventory Levels

• Accurate sales forecasts enable management to optimize inventory levels
• A lack of inventory can result in lost sales, and excessive inventory can result in burdensome carrying costs, including:
─ Storage costs
─ Insurance costs
─ Opportunity costs of inventory investment
─ Lost inventory due to obsolescence or spoilage

Optimal Levels of Inventory
• Factors that affect the optimal level of inventory include:
─ The usage rate of inventory per period
─ Cost per unit of inventory
─ Cost of placing orders for inventory
─ Time required to receive inventory
• Concepts related to the determination of the optimal level of inventory include:
─ Safety stock
─ Reorder point
─ Economic order quantity
Safety Stock
• Excess inventory used to ensure that manufacturing or customer supply requirements are met
• Determined by the following factors:
─ Reliability of sales forecasts
─ Possibility of customer dissatisfaction from back orders
─ Stockout costs (the cost of running out of inventory), including loss of income, the cost of restoring goodwill, and the cost
of expedited shipping to meet demand
─ Lead time (the time that elapses from the placement to the receipt of an order)
─ Seasonal demands on inventory
Reorder Point
• The inventory level at which a company adds more inventory to meet demand and to avert incurring stockout costs:
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Economic Order Quantity (EOQ)
• When managing inventory, there is a trade-off between carrying costs and ordering costs
• If the order quantity is small then carrying costs are low, but inventory must be ordered more frequently to meet demand, so
ordering costs increase
• Ordering costs typically represent the costs of labor associated with order placement
• The costs are driven by order frequency and include the cost of:
─ Entering the purchase order
─ Processing the receipt of the inventory
─ Inspecting the inventory received
─ Processing the vendor invoice and payment
• EOQ inventory model minimizes total ordering and carrying costs
Economic Order Quantity (EOQ)
• Assumptions
─ Demand is known and is constant throughout the year
─ Does not consider stockout costs or safety stock
─ Assumes that carrying costs per unit and ordering costs per unit are fixed
• The EOQ Equation and Equation Components
Order size (EOQ)

S = Annual Sales (in units)
O = Cost per Purchase Order
C = Annual Carrying cost per unit
Note the annual carrying cost may also be stated as a percentage of the unit's cost.
Other Inventory Management Issues
• Just-in-Time Inventory Models
─ Developed to reduce the lag time between inventory arrival and inventory use by tying delivery of components to the
speed of the assembly line
─ Reduces the need of manufacturers to carry large inventories, but requires considerable coordination between the
manufacturer and supplier
─ Benefits include tying production scheduling with demand, more efficient flow of goods between warehouses and
production, reduced setup time, and greater employee efficiencies
• Kanban Inventory Control
─ Gives visual signals that a component required in production must be replenished
─ Prevents oversupply or interruption of the entire manufacturing process as the result of lacking a component
Other Inventory Management Issues
• Computerized Inventory Control
─ Operates by establishing real-time communication links between the cashier and the stock room
─ Every purchase is recognized instantaneously by the inventory database, as is every product return
─ Computers are programmed to alert inventory managers as to reorder requirements
─ In some cases, company databases interface directly with supplier software to allow for instantaneous reorders, thereby
removing the human element
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Relationship Between Inventory Turnover and Gross Margin
• An entity with high gross margin and/or high inventory turnover will be more profitable
• If gross margin declines, inventory turnover will need to increase in order to maintain profitability
• Conversely, if inventory turnover declines, gross margin will need to increase to maintain profits
Short-Term Credit
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Short-Term Credit • Short-Term Bank Loans
• Entities unable to satisfy current asset acquisitions with cash ─ Notes payable to financial institutions that are due in
on hand often finance them with short-term loans 12 months or less from the time of issuance
─ Compensating balance requirements related to bank

Short-Term Financial Instruments loans increase the effective annual interest rate on such
borrowings, calculated using the following formula:
• Trade Credit
─ Provides the largest source of short-term credit for

small firms
─ Used for purchases of goods and services as part of

usual and customary business transactions
─ Generally paid 30 to 60 days after acquisition of goods
Short-Term Financial Instruments
• Line of Credit
─ An arrangement with a financial institution that establishes a maximum loan amount that can be borrowed
─ The borrower can access and pay back funds at any time as long as the credit limit is not exceeded
• Commercial Paper
─ Unsecured, short-term debt issued by creditworthy corporations to finance payroll, accounts payable, inventory, and other
short-term liabilities
─ Most are sold at a discount, mature at par value, and have terms of no more than 270 days
─ Commercial paper is issued in denominations of $100,000 or more
Short-Term Financial Instruments
• Banker's Acceptances
─ A negotiable instrument that is similar to a postdated check, except it is guaranteed by the bank rather than the
account holder
─ Can be used as a bank-backed payment for large transactions
─ After issuance, banker's acceptances can be traded at a discount in the money market
Current Asset
Levels
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Current Asset Levels
• Determining the appropriate level of current assets and the best method to finance those assets is a matter of judgment
and risk appetite
• Risk-Aggressive Managers
─ May employ short-term financing sources to fund acquisitions of long-term assets
• Risk-Averse Managers
─ May prefer the use of current liabilities to acquire current assets
(continued)
(continued)
B.5. Corporate
Restructuring
Business
Combinations
B.5. Corporate Restructuring
Business Combinations
• Two or more companies combine to create a new, larger company that may expand its production capabilities, workforce,
market share, and/or access to new markets
• New company becomes more valuable as one entity by reducing duplicative functions and/or combining advanced
technological capabilities
• The four primary types of combinations include:
─ Horizontal, vertical, circular, and diagonal combinations
• Transactions include:
─ Mergers, acquisitions, consolidations, tender offers, purchases of assets, and management acquisitions
Types of Business Combinations
• Horizontal Combination
─ Occurs when companies in the same industry producing the same goods or providing the same services join under single
management/leadership
─ Benefits include reduced competition, economies of scale leading to reduced costs, expertise at various levels of
production, minimized overproduction, and maximized profits
• Vertical Combination
─ Involves the combination of companies at different stages of the production process, from the same or different industries
─ Helps assure the supply of raw materials (backward integration) or provide a stable market for products sold
(forward integration)
─ Offers benefits similar to horizontal combinations
• Circular Combination (Conglomerate Combination)
─ Occurs when different business units with relatively remote connections come together under single management
─ Synergies could come from using similar distribution, advertising channels, or similar production processes
─ Having one management group over the combined units reduces overall administrative and other operational costs
• Diagonal Combination
─ Occurs when a company that engages in an activity integrates with another company that provides ancillary support for
that primary activity
─ Ensures the ancillary support is delivered in a timely and effective manner, which is crucial to the mission of the primary
activity and business
Transactions
• A company acquiring another company has several options to complete the transaction, including:
─ Merger
─ Acquisition
─ Tender offer
─ Acquisition of assets
─ Management of assets/leveraged buyout
• Local laws, including antitrust laws, govern each of these transactions
• Attempts to monopolize a market are illegal in many countries, complicating global business combinations
Transactions
Merger
• Two (or more) entities combine to form one new entity, with the stocks of all merging companies surrendered and replaced
with new stock of the new company
• Often involve the combination of like-sized companies
• The boards of directors of both companies initiate and approve the plan, and notice is given to all shareholders
Transactions
Acquisition
• An acquirer purchases majority ownership of the acquired company
• The acquisition of one company by another involves no new company
• Only the acquirer remains after the acquisition, although the acquired firm might retain its legal structure and name
Transactions
Tender Offer
• A company makes an offer directly to shareholders to buy the outstanding shares of another company at a specified price
• Offer may be in the form of cash or securities of the acquiring corporation (stocks, warrants, debt issuances)
• Shareholders of the target company have the option of accepting or rejecting the offer
Transactions
Purchase of Assets
• Occurs when a portion (or all) of the selling company's assets are purchased by the acquiring company
• May result in the dissolution of the selling company
• Shareholder approval must be obtained, but the buyer need not assume all liabilities of the selling company
─ Liabilities not assumed by the buyer continue to be the responsibility of the selling company
Transactions
Management Acquisition/Leveraged Buyout
• A company's executives purchase a controlling interest in a company, causing the acquired company to become
privately held
• Many management acquisitions are financed with large amounts of debt and referred to as leveraged buyouts (LBOs)
─ Some LBOs are financed with junk bonds that are risky for the lender and come with high interest rates
Resulting Synergies of Business Combinations
• Realized when the value of the merged company exceeds the combined value of the separate companies
• Revenue synergies occur when the combined company can generate revenues exceeding the sum of revenues of the
separate companies by:
─ Entering a market's geographic areas where only one of the companies operated before the combination
─ Better utilizing existing distribution channels of both companies and by encouraging the sales force to sell more
complementary products
─ Capitalizing on each company's area of expertise, since a company with excellent products can increase its sales when
merging with a company with excellent distribution channels and sales force
• Cost synergies occur when the combined company can reduce costs more than the two companies are able to individually.
─ Production costs may be reduced through economies of scale, as is more common in horizontal mergers
─ Information technology costs may be reduced or leveraged by pooling the IT resources of both companies
─ Warehousing costs can be reduced through sharing storage space
─ Redundant activities may be eliminated, and supply chain relationships may be better utilized
─ Enhanced research and development efforts may be used to improve efficiencies of the other company
─ Better negotiating power for better prices and payment terms with vendors may be achieved
─ Reduced staffing needs through the elimination of duplicate positions
• Financial synergies may be achieved if the cost of borrowing can be reduced by the combined companies borrowing funds at
lower interest rates.
─ The cost of capital may be reduced for the combined company if the larger company is perceived to be less risky than the
smaller, individual companies
─ Tax benefits may be achieved when a company with strong earnings merges with a company with accumulated losses
─ Larger companies may have better investment opportunities
─ Excess funds from the combined liquidities may be used to purchase higher-return investment opportunities
─ Reduced portfolio risk may be achieved by merging with a company in a different industry
─ Diversification can help stabilize earnings of the combined company
Takeover Defenses
Takeover Defenses
Takeover is the term used to describe one company (or a group of owners) assuming control of another company.
• The term may be used to describe any merger or consolidation, but a hostile takeover is a takeover that is not negotiated or
approved by the directors of the target company.
• During a hostile takeover attempt, the buyer may approach shareholders and initiate a tender offer or may ask to control the
shareholders' proxies in a proxy fight.
─ A proxy is the authority to represent shareholders in voting.
Issuing Restricted or Differential Voting Rights
• A hostile takeover can be prevented by selling shares with fewer voting rights to outside shareholders while management
owns shares with higher voting rights
─ This combination makes it difficult for a buyer to buy enough shares to take control of the company
• Another defense is to require a shareholder owning a significant number of shares to obtain board permission to vote once a
specified ownership threshold occurs
Stock Repurchase
• Involves a target company purchasing its own shares from its shareholders
─ Reduces the number of available shares that a hostile buyer may purchase, potentially resulting in an increase in the
market price per share
─ May increase the cost of the takeover target and reduce potential gains from the acquisition
Poison Pill
• Allows the shareholders of the target company to receive rights to purchase additional shares of the target or acquirer
• Shareholders of the target company can exercise the rights when the buying corporation acquires a certain percentage of the
target company
• Exercising these rights dilutes ownership of the target company or acquirer, deterring the takeover
• Types of poison pills:
─ Flip-in Poison Pill: allows the shareholders of the target company to purchase additional target company shares at a
discounted price
─ Flip-over Poison Pill: gives shareholders of the target company the right to purchase shares of the buying company at a
deep discount
─ Voting Rights Plan: implemented when a company issues preferred stock with superior voting rights to common
shareholders
Staggered Board of Directors
• Electing only a few board members each year makes it difficult for the buyer to control the target company
• The buyer must wait several years before having the ability to appoint a majority representation to the target company's board
Shark Repellent
• The charter or bylaws are amended to include some provisions that make the takeover unattractive to the buyer (the shark)
• Example: provisions in the charter that require a supermajority of shareholders' votes to approve a takeover
Golden Parachutes
• Additional, substantial compensation that the target company's executive officers will receive in the event of a successful
takeover
• Reduces the available assets of the target company and may force the buyer to reduce the offering price for the target
company's shares
Greenmail
• When an acquirer buys enough stock to threaten a target with a hostile acquisition and then resells it to the target at a
substantial premium to prevent the takeover
Standstill Agreements
• The buyer agrees not to buy any additional shares of the target company within a specified period
• Usually accompanies the greenmail strategy
Crown Jewels
• Target company sells its valuable assets (the crown jewels) to a company other than the one attempting the takeover
• With the crown jewels no longer owned by the target company, the target company generally is no longer attractive
to the buyer
• In a crown jewels/lockup provision, the target company may buy back the crown jewels (assets) from the third party (which
could be a white knight) at a predetermined price
Leveraged Recapitalization
• Management of the target company restructures its own debt-to-equity ratio by borrowing a large amount of funds and paying
a cash dividend to its shareholders
• Increasing the debt and reducing the equity through the payment of dividends makes the target company less attractive
• The target company may choose to borrow funds to repurchase stock instead of using its own funds, having the same effect
White Knight
• A desirable buyer that the management of the target company wants to be acquired by (rather than the hostile buyer)
• Management of the target company asks the management of the white knight to issue a competing tender offer to buy the
shares of the target company
• Management of the target company hopes the white knight's competing tender offer will outbid or ward off the hostile
buyer's offer
Pac-Man Defense
• The target company issues a tender offer to the buyer's shareholders to purchase the shares of the buyer at a premium
Fair Price Provision

• A provision in the bylaws of the target requiring any buying company to pay noncontrolling interest shareholders of the target
company a fair price for their shares
• The fair price may be linked to the historical earnings of the target company and/or may require the buyer to wait for a certain
period of time before the acquisition
• The fair price provision may also require the acquiring company to pay all target company shareholders the same amount
per share
Divestitures
Divestitures
• The partial or full disposal of a component or business unit of a company, including sell-offs, spin-offs, equity carve-outs,
split-ups, and tracking stock
Sell-off
• An outright sale of a subsidiary
• May be done because a subsidiary's core competencies do not align with the overall company's or because there is a lack of
synergy between the company and its subsidiary
• Legal action stemming from anticompetitive or antitrust practices may also require a sell-off
Spin-off
• Creates a new, independent company by separating a subsidiary business from a parent company
• Can be completed by:
─ Distributing stock in the new entity as a stock dividend to existing shareholders
─ Offering shareholders stock in the new company in exchange for their stock in the parent company
• Typically occurs when a unit is less profitable and/or unrelated to the core parent business
• The assumption is the unit after a spin-off is expected to have more value
• Shares are distributed to shareholders in the same proportion as their previous ownership in the original corporation
─ Example: a shareholder owning 10 percent of the shares of the original company will receive 10 percent of the shares of
the new company
Split-up
• The parent company is broken into two or more entirely new entities.
• Unlike sell-offs and spin-offs, in which the parent company survives, the parent company does not survive a split-up.
Equity Carve-out
• Occurs when a subsidiary is made public through an initial public offering (IPO), thereby creating a new publicly
listed company
• Unlike a spin-off, the sale generates cash for the parent as well as a controlling interest in the subsidiary
• The hope is that this will unlock the independent value of the subsidiary previously contained within the merged entity
Tracking Stock
• Used by companies to issue separately traded equity securities for separate portions of the business
• Tracking stock shareholders receive dividends based on the performance of the tracked business
• Changes in the price of tracking stock may not align with changes in the price of the issuer's other stock
• Tracking stock is an opportunity for investors to invest in a division they prefer
• Beneficial to the corporation, which can raise additional capital by issuing new tracking stock representing ownership equity in
a specific division
Business Valuation
Business Valuation
• After the buyer identifies the target that it wishes to acquire, the value of the target must be estimated using a discounted
cash flow method.
Discounted Free Cash Flow

• The value of the target can be determined by discounting the entity's free cash flows (FCF) to present value using the
following steps:
1. Determine the free cash flows (FCFs)
2. Determine the required rate of return using the capital asset pricing model (CAPM)
3. Calculate the present value of the future FCFs using the discount rate from CAPM by using the Gordon growth model
Free Cash Flow
• The starting point for FCF is after-tax earnings before deducting interest paid by the target company.
• Interest expense is not included in order to ascertain the value of the company as if there were no debt.
Required Rate of Return (Capital Asset Pricing Model)
• When calculating the present value of future cash flows, a discount rate is used and can be calculated using the capital asset
pricing model (CAPM).
• Under the CAPM formula, the [Rm − Rf] term is also known as the market risk premium.
Gordon Growth Model
• Can be used to calculate the present value of the target company's free cash flows.
• The acquirer can use the two-stage Gordon growth model (GGM) if the target will generate after-tax cash flows for
several years.
(continued)
(continued)
Evaluation of
Proposed Business
Combinations
Quantitative Considerations
• Consolidated Earnings per Share (EPS): EPS of the pre-combined entities should be evaluated and then compared with
projected post-consolidated EPS to determine whether the combination is beneficial.
─ In calculating the EPS, the ratio of exchange must be factored, calculated as:
─ This ratio is then multiplied by the number of the acquiree's shares being acquired, resulting in the number of the
acquirer's shares to issue.
Quantitative Considerations
• Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA): A non-GAAP measure, EBITDA is important
because it removes income statement line items that are not a result of current performance, including:
─ The cost of interest paid to finance the assets generating returns, taxes paid, and noncash charges of depreciation
and amortization
• Post Balance Sheet Debt and Net Assets: The acquiring company should consider the debt load it is assuming when
purchasing another company because it will be responsible for paying off that debt.
─ Evaluating net assets as a percentage of total assets can help in this determination
• Multiples: Used in valuations for deciding whether a company is a good acquisition target; these include multiples of:
─ Revenue, assets, EBITDA, and other figures (e.g., Price of the company = 1.5 × EBITDA)
Qualitative Considerations
• Control: Noncontrolling shares hold less value because the shares are subject to decisions of shareholders with more
influence, potentially influencing the decision to combine.
• Restrictions on Stock Transfers: Preemptive rights of other shareholders to buy or sell prior to any transfers may be required
before any other stock is transferred, making the acquisition less appealing.
• Regulatory Factors: Industry regulations, antitrust laws, and other restrictions in the country of operation may apply and
should be evaluated prior to combination.
• State of Assets Being Acquired: If vital equipment is near the end of its useful life and in need of replacement, excess cash
needed to replace obsolete assets should be factored in the evaluation period.
Qualitative Considerations
• Employees: In many cases, executive exit packages may be triggered or negotiated in the event of an acquisition, placing an
undue hardship on the consolidated firm.
• Marketplace Reaction: Competitors may take action during an acquisition, perceiving the event as an opportunity to launch
new products or services while the merger is taking place, while others may exit the market.
• Outlook: If a post-combination company appears to gain only quick synergies as a result of basic consolidation efforts, then
the gains may be short-lived.
Financial and
Operating
Restructuring
Financial and Operating Restructuring
• An entity's management may consider modifying its capital structure or its operations significantly when the corporation is
facing significant financial or operational problems
• Considered important to eliminate financial problems and to enhance performance
• An entity facing problems may consider its debt financing, its operations, and, in some cases, selling a portion or all of the
company to interested investors
Financial Restructuring
• Could include changes to the composition of an organization's debt load, equity, or contractual agreements that significantly
impact solvency
Debt Modifications
• Renegotiating the terms of existing debt so the debtor can continue to pay both interest and principal
─ Changes may include a lower interest rate, longer maturity date, reduced debt covenant requirements, or changes in the
default triggers
• Debt Repurchases: involves shareholders purchasing the company's existing debt in full at a discount, and then canceling
that debt by issuing equity in exchange
• Debt Exchanges: replaces old debt with a completely new debt issue
─ May be a good option when amendments to existing debt are not adequate or a mutual agreement cannot be reached
─ The new issue may reduce the principal, extend the maturity date, change pieces of the debt covenant or lower
interest rates
Debt Modifications
• Equity Swaps: debtholders are requested to convert their debt to equity, which deleverages the company and frees up cash
that was being used for debt payments
• Access to Short-Term Capital: companies may opt for short-term loans or rely more heavily on lines of credit for liquidity in
times of a cash crunch
─ Alternative to taking out long-term debt or significantly altering a company's capital structure
• Sale-Leasebacks: involves a company selling assets to get cash from the buyer, and then the buyer leasing those assets
back to the seller
─ Provides liquidity, giving the seller access to cash as well as use of the assets over the lease term
Equity Modifications
Similar to debt modification, the structure of equity may be revised to make it easier for a company to meet its obligations and
remain solvent, including:
• Issuance of Equity to Reduce Outstanding Debt: the company issues equity shares and those funds are used to pay down
existing debt
• Stock Buybacks: the company repurchases outstanding shares to reduce future dividend payments or to take a company
from being publicly traded to privately held
• Stock Class Modifications: companies may choose to change the rights of preferred shareholders or introduce new classes of
stock in an attempt to retain funds that would otherwise be paid out
─ Includes changes in dividend accumulation rights (e.g., cumulative rights, which accrue when not paid, versus
noncumulative, which do not accrue) or changing voting rights
Court and Bankruptcy Restructuring
• Bankruptcy is a form of court-approved reorganization that allows the filing company to continue to operate, while agreeing to
pay back its creditors in part or in full
─ Accomplished by revising agreements with creditors, extending the maturity for debt repayment, and settling various other
matters under modified terms
Other Forms of Financial Restructuring
• Companies may decide to sequester certain assets and liabilities into a separate company; creating separate legal entities
with a more attractive credit profile to obtain debt or equity
• Renegotiating contracts with various business partners, such as vendors, landlords, distributors, and other companies vital to
an organization's function, including the following:
─ Modifying Terms With Partners or Joint Ventures: may involve redefining profit-sharing agreements or seeking a larger
interest for more favorable terms
─ Negotiating Better Discounts or Payment Periods With Suppliers
─ Accelerating Collections: by working with customers to accelerate revenue collections or by tightening credit standards in
order to cut down on potential bad debts, a company may be able to improve liquidity
─ Renegotiating Lease Terms: seeking a lower interest rate or lower monthly payment in exchange for a longer lease term
may be an option
Operational Restructuring
Reorganizing the way a company operates by adding lines of business or products, expanding into new geographic markets,
divesting business units, or making significant changes to the workforce and technology
• Downsizing Production: cutting production and downsizing operations reduces costs
• Downsizing the Workforce: reducing headcount can be a quick way to short-term financial savings, but has a potentially
negative impact on long-term growth
• Shifting Talent Sourcing: accessing a different pool of employees by moving headquarters to a location with a lower cost of
living or sourcing foreign labor can lower costs
Operational Restructuring
• Expanding Products and Services: increases the scope of products and services offered, helping increase revenue or
maintain market share
• Entering New Geographic Markets: expand market reach by entering new geographic markets
• Selling Assets: additional funds to support operations can be obtained by selling idle assets
• Automating Functions: adding new technology lowers costs in the long run and increase efficiency
B.6. International
Finance
International
Diversification
B.6. International Finance
International Diversification
• A multinational corporation (MNC) is a large corporation with economic activities in several countries.
• Activities of multinational corporations can be important for both the home country and for the host country or countries.
─ Home Countries: those in which the corporate, administrative, and/or head offices that lead global operations are based
─ Host Countries: extensions of the home country where additional functions or lines of business operate
• MNCs typically must pay income and other applicable taxes in each country in which they operate.
• Home countries often impose additional taxes on foreign-derived income, but in most cases a credit based on the amount of
foreign taxes paid can be used to offset this additional tax.
• Multinational corporations benefit the host country through job opportunities, which reduce unemployment, and may also
bring new knowledge and technology to the host country.
Foreign Direct Investment (FDI)
• The primary manner by which multinational corporations create activities in foreign countries
• Occurs when a firm or individual residing in one country invests in business interests located in another country
• Generally, FDI takes place when an investor either establishes foreign business operations or acquires foreign business
assets in a foreign company
Benefits to the Host Country
• Increased Employment and Economic Growth: Employed individuals generate income, pay taxes, have increased purchasing
power, and provide more revenue for the host country, all of which leads to consumer spending, borrowing, economic
expansion, and growth.
• Development of Human Capital: When a multinational corporation operates in a host country, local job seekers and
employees gain access to new opportunities as well as access to platforms for training and improving skills.
─ Development of the human capital in a country has a multiplier effect
• Enhanced Efficiency and Effectiveness of the Industry: The benefits of FDI include transfers of general or technical
knowledge, advanced technologies, industrial improvements, experienced employees, and trade networks.
Benefits to the Host Country
• Increased Exports: If the production in the host country is meant to be a point of export, the host country's balance of trade
(exports versus imports) may improve.
• Improved Stability of Exchange Rates: When goods manufactured in a host country are exported, the host country's foreign
currency reserves improve, and exchange rates are more stable.
• Improved Physical and Financial Infrastructure of a Country: The host country's government will collect more taxes as a result
of the increased economic activity and then will be reinvested in the development of the host country.
• Improved Inflows of Financial Capital: Host countries that do not have access to international financial markets can receive
funds through foreign direct investments.
Benefits to the Multinational Corporation
• Access to New Markets: The MNC's sales and profits may increase because new markets mean more customers for its
products or services.
─ Manufacturing and selling goods in the host country may allow the MNC to avoid host-country trade barriers and
trade restrictions
• Reduced Portfolio Risk: Investing in foreign affiliated companies or in branches in other countries may allow an MNC to
diversify and better manage its total risk.
• Improved Return on Investment: When an MNC operates in an emerging market, the MNC may be able to operate as a
monopoly until competition enters the market, boosting the overall return on the investment.
Benefits to the Multinational Corporation
• Access to Factors of Production: In many cases an MNC may be able to access labor and materials at rates that are lower
than those available in the home country, lowering costs and increasing profits.
─ Certain raw materials may only be available in other countries, requiring MNCs to globally diversify to access and secure
the supply chain
• Implementation of a Natural Hedge: Exchange rate risk may be mitigated by using the local currency both to buy materials
and labor, and sell on credit with the local currency.
─ Payables and receivables may be matched in terms of maturity, and this matching eliminates exchange rate risks
─ Producing and selling in the same country allows a multinational corporation to avoid import and export fluctuations that
result from changes in exchange rates
• Access to Lower Interest Rates: An MNC may decide to operate in other countries where debt financing is available at a
lower cost.
Risks to the Multinational Corporation
• Risk of Political Instability: Investing in other countries may result in significant risks because of events such as civil unrest,
expropriation of assets by the foreign government, and wars.
• Risk of Changing Tax and Regulatory Environments: The applicable regulations and tax codes in place at the inception of the
investment may change and negatively impact the MNC's profits.
• Risk of Cultural Unfamiliarity: Demand for the MNC's products may be lower than expected because of negative customer
attitudes toward the MNC or its home country.
─ There is also the risk that the MNC misjudges local consumer preferences, producing products or services unappealing to
the host country's consumers
• Risk of Inflation: High inflation rates drive down the value of the investment.
• Risk of Exchange Rate Fluctuation: The value of an investment or operations in a host country can be diminished by
unfavorable exchange rates.
Currency
Exchange Rates
Currency Exchange Rates
• Exchange rates express the price of one currency in terms of another.
─ Direct Method: the domestic price of one unit of another currency
─ Indirect Method: the foreign price of one unit of the domestic currency
The Currency Market

• Where currencies are exchanged; demand for a currency is driven by demand for the products and services of the country
that issued the currency.
• The quantity of currency demanded is determined by its price relative to other currencies.
Floating Exchange Rates
Established by supply and demand in currency markets; derived from transactions involving goods and services from that country.
Fixed Exchange Rates
• Set by government or central bank policy, these rates must be defended in currency markets through the purchase or sale of
the domestic currency.
─ If the market exchange rate falls below the fixed rate, the government purchases the home currency on the currency
market, increasing demand for the home currency and increasing the exchange rate
─ If the market exchange rate rises above the fixed rate, the government sells the home currency in the market, increasing
the supply of the home currency and reducing the exchange rate
Managed Float
• The current method of determining international exchange rates.
• In a managed float system, exchange rates are primarily determined by supply and demand in currency markets.
• In periods of extreme fluctuation, governments and central banks will intervene in an attempt to maintain stability.
Currency Exchange
Rate Risk
Currency Exchange Rate Risk
• Within domestic environments, a single currency defines the value of assets, liabilities, and operating transactions.
• In international settings, the values of assets, liabilities, and operating transactions are established not only in terms of the
single currency, but also in relation to other currencies.
• Exchange rate (FX) risk exists because the relationship between domestic and foreign currencies may be subject to volatility.
Factors Influencing Exchange Rates

• Trade-Related Factors: includes differences in inflation, income, and government regulation
• Financial Factors: includes differences in interest rates and restrictions on capital movements between companies
Trade Factor (Relative Inflation Rates)
• When domestic inflation exceeds foreign inflation, holders of domestic currency are motivated to purchase foreign currency to
maintain the purchasing power of their money.
• Increases in demand for foreign currency forces the value of the foreign currency to rise, thereby changing the rate
of exchange.
Trade Factor (Relative Income Levels)
• As income increases in one country relative to another, exchange rates change as a result of increased demand for foreign
currencies in the country in which income is increasing.
Trade Factor (Government Controls)
• Various trade and exchange barriers that artificially suppress the natural forces of supply and demand affect exchange rates.
Financial Factors (Relative Interest Rates and Capital Flows)
• Interest rates create demand for currencies by motivating either domestic or foreign investment.
• The forces of supply and demand create changes in the exchange rate as investors seek fixed returns.
• The effect of interest rates is directly affected by the volume of capital that is allowed to flow between countries.
Risk Exposure Categories: Transaction Exposure
• The potential that an organization could suffer economic loss or gain upon settlement of individual transactions due to
exchange rate changes
• Generally measured in relation to currency variability or currency correlation
• Measurement of transaction exposure is generally done in two steps:
1. Project foreign currency inflows and foreign currency outflows
2. Estimate the variability (risk) associated with the foreign currency
Risk Exposure Categories: Economic Exposure
• Potential that the present value of an organization's cash flows could increase or decrease as a result of changes in the
exchange rates
• Defined through local currency appreciation or depreciation and measured in relation to organization earnings and cash flows
• Currency Appreciation and Depreciation
• Effect of Currency Appreciation: As a domestic currency appreciates in value or becomes stronger, it becomes more
expensive in terms of a foreign currency.
─ The volume of inflows tends to increase as foreign imports become less expensive
• Effect of Currency Depreciation: As a domestic currency depreciates in value or becomes weaker, it becomes less expensive
in terms of a foreign currency.
─ The volume of inflows tends to decline as foreign imports become more expensive
• The economic exposure created by domestic currency appreciation or depreciation with respect to a foreign currency
depends on the net inflow or outflow of foreign currency.
Risk Exposure Categories: Translation Exposure
• The risk that financial results of a consolidated organization that includes foreign subsidiaries will change as a result of
changes in exchange rates
• Generally defined by the degree of foreign involvement, the location of foreign subsidiaries, and the accounting methods used
and measured in relation to the effect on the organization's earnings or comprehensive income
• Translation exposure increases as the proportion of foreign involvement by subsidiaries increases
• The exposure of the parent company to translation risk is affected by the stability of the foreign currency in comparison to the
parent's domestic currency
Mitigating and
Controlling
Transaction
Exposure
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Mitigating and Controlling Transaction Exposure
Financial instruments and hedging can be used to mitigate the effect of exchange rate fluctuations on individual transactions.
Measuring Specific Net Transaction Exposure

Net transaction exposure is the amount of gain or loss that might result from either a favorable or an unfavorable settlement
of a transaction.
• Selective Hedging
─ In effect, hedging is a process of reducing the uncertainty of the future value of a transaction or position by actively
engaging in various derivative investments
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Measuring Specific Net Transaction Exposure
• Identifying Net Transaction Exposure
─ The effect of transaction exposure on the entity taken as a whole rather than on individual subsidiaries
─ Although exchange rate fluctuations might adversely affect one subsidiary, they might favorably affect another
─ The net transaction exposure is computed as follows:
1. Accumulate the inflows and outflows of foreign currencies by subsidiary.
2. Consolidate the effects on the subsidiary by currency type.
3. Compute the net effect in total.
• Adjusting Invoice Policies
─ International companies may hedge transactions without complex instruments by timing the payment for imports with the
collection from exports
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Mitigating Transaction Exposure: Futures Hedge
• A futures hedge entitles its holder to either purchase or sell a particular number of currency units of an identified currency for
a negotiated price on a stated date.
• Accounts Payable Application
─ Accounts payable denominated in a foreign currency represents potential transaction exposure to exchange rate risk in
the event that the domestic currency weakens
─ Should the domestic currency weaken relative to the foreign currency, more domestic currency will be required to
purchase the foreign currency, increasing the company's cost of settling the liability
─ A futures hedge contract to buy the foreign currency at a specific price at the time the account payable is due will mitigate
the risk of a weakening domestic currency
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Mitigating Transaction Exposure: Futures Hedge
• Accounts Receivable Application
─ Accounts receivable denominated in a foreign currency represents potential transaction exposure to exchange rate risk in
the event that the domestic currency strengthens
─ Should the domestic currency strengthen, less domestic currency can be purchased with the foreign currency received,
and an exchange loss will result
─ A futures hedge contract to sell the foreign currency received in satisfaction of the receivable at a specific price at the time
the accounts receivable is due will mitigate the risk of a strengthening domestic currency
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Mitigating Transaction Exposure: Forward Hedge
• Similar to a futures hedge in that it entitles its holder to either purchase or sell currency units of an identified currency for a
negotiated price at a future point
• Accounts Payable Application
─ Accounts payable denominated in a foreign currency represent a potential transaction exposure to exchange rate risk if
the foreign currency strengthens
─ A forward hedge contract to buy the foreign currency at a specific price at the time accounts payable are due for an entire
subsidiary will mitigate the risk of a weakening domestic currency
• Accounts Receivable Application
─ Accounts receivable denominated in a foreign currency represent a potential transaction exposure to exchange rate risk if
the domestic currency strengthens
─ A forward hedge contract to sell the foreign currency received in satisfaction of the receivables at a specific price at the
time the accounts receivable are due or on the monthly cycle of a particular subsidiary will mitigate the risk of a
strengthening domestic currency
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Mitigating Transaction Exposure: Money Market Hedge
• Uses international money markets to plan to meet future currency requirements
• Uses domestic currency to purchase a foreign currency at current spot rates and invest them in securities timed to mature at
the same time as related payables
• Money Market Hedge: Payables (Excess Cash)
─ Firms with excess cash use money market hedges to lock in the exchange rate to satisfy payables when they come due,
using the following steps:
1. Determine the amount of the payable.
2. Determine the amount of interest that can be earned prior to settling the payable.
3. Discount the amount of the payable to the net investment required.
4. Purchase the amount of foreign currency equal to the net investment required and deposit the proceeds in the
appropriate money market vehicle.
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• Money Market Hedge: Payables (Borrowed Funds)
─ Firms that do not have excess cash follow the same basic procedure for a money market hedge on payables
─ However, they first borrow funds domestically and invest them internationally to satisfy the payable denominated in a
foreign currency
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• Money Market Hedge: Receivables
─ Involves factoring receivables with foreign bank loans, borrowed in discounted amounts that are repaid in the maturity
value of the receivable denominated in the foreign currency
─ Borrowed foreign currency amounts are converted into the domestic currency
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Mitigating Transaction Exposure: Currency Option Hedges
• Use the same principles as forward hedge contracts and money market hedge transactions
• Instead of requiring a commitment to a transaction, the currency option hedge gives the business the option of executing the
option contract or purely settling its originally negotiated transaction without the benefit of the hedge
• Currency Option Hedges: Payables
─ A call option (option to buy) is the currency option hedge used to mitigate the transaction exposure associated with
exchange rate risk for payables
─ Similar to a futures contract or forward contract, the business buys a foreign currency at a low rate in anticipation of the
foreign currency strengthening in order to settle its liability at the predicted value
─ The business has the option (not the obligation) to purchase the security at the option (strike or exercise) price
─ The business evaluates the relationship between the option price and the exchange rate at the settlement date
─ Generally, if the option price is less than the exchange rate at the time of settlement, the business will exercise its option
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Mitigating Transaction Exposure: Currency Option Hedges
• Currency Option Hedges: Receivables
─ A put option (an option to sell) is the currency option hedge used to mitigate the transaction exposure associated with
exchange rate risk for receivables
─ The business plans to sell a foreign currency at a higher rate, in anticipation of the foreign currency weakening to ensure
that it can capitalize on receivable collections at a stable or predicted value
─ The business has the option (not the obligation) to sell the collected amount of the foreign currency from the receivable at
the option (strike or exercise) price
─ The business evaluates the relationship between the option price and the exchange rate at the settlement date
─ Generally, if the option price is more than the exchange rate at the time of settlement, the business will exercise its
put option
─ If the put option price is less than the exchange rate at the time of settlement, the business will allow the put option
to expire
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Mitigating Transaction Exposure: Long-Term Transactions
The following hedge transactions are used to mitigate exchange rate risk presented by transaction exposure.
• Long-Term Forward Contracts
─ Stabilize transaction exposure over long periods
• Currency Swaps
─ A series of long-term forward contracts, covering a series of transactions
─ Two firms with coincidental needs may swap their currencies in an exchange negotiation completed years in advance of
their receipt of the currencies
─ Financial intermediaries broker or match firms with currency needs
─ In a parallel loan arrangement, two firms may mitigate their transaction exposure by exchanging or swapping and
simultaneously agreeing to re-exchange or repurchase their domestic currency at a later date
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Mitigating Transaction Exposure: Alternative Hedging Techniques
• Leading and Lagging
─ Represent transactions between subsidiaries or a subsidiary and a parent
─ The entity that is owed may bill in advance if the exchange rate warrants (leading) or possibly wait until the exchange rate
is favorable before settling (lagging)
• Cross-Hedging
─ Involves hedging one instrument's risk by taking a position in a related derivatives contract
• Currency Diversification
─ The simplest hedge for long-term transactions is to diversify foreign currency holdings over time
─ A substantial decline in the value of one currency would not affect the overall dollar value of the firm if the currency
represented only one of many foreign currencies
Mitigating and
Controlling
Economic
Exposure
Assessing Economic Exposure
• Businesses have various methods of managing the economic and translation exposure associated with exchange rate risks.
• Economic exposure is defined as the degree to which cash flows of the business can be affected by fluctuations in
exchange rates.
• The extent to which revenues and expenses are denominated in different currencies could seriously affect the profitability of
an organization and represents economic exposure.
Techniques for Economic Exposure Mitigation
• Restructuring
─ Economic exposure to currency fluctuations can be mitigated by restructuring the sources of income and expense.
─ Decreases in Sales: A company fearful of a depreciating foreign currency may elect to reduce foreign sales to preserve
cash flow.
─ Increases in Expenses: A company anticipating a depreciating foreign currency may elect to increase reliance on those
suppliers to take advantage of paying for raw materials or supplies with cheaper currency.
Trade Finance
Methods
Cross-Border Factoring
• Exporters may elect to factor or sell receivables to a third party, without recourse, to ensure cash collections and expedite
cash flows
• The risk of default is assumed by the factor, which mitigates the risk associated with the creditworthiness of the importers
• Involves an international network of factors who assess the creditworthiness of importers
• The factor engaged by the exporter contacts another factor in the importer's country to both assess the buyer's
creditworthiness and to handle the cash collections
• Commercial banks, commercial finance companies, and specialty finance houses provide cross-border factoring services
Letters of Credit
• Protect cash flows by guaranteeing the seller's (exporter's) cash collections
• Involve Two Banks: a bank engaged by the debtor/buyer (importer) called the issuing bank and a bank representing
creditor/seller (exporter) called the advising bank
• An irrevocable letter of credit obligates the issuing bank to honor all funds drawn on it upon presentation of documentation
that conforms to the terms of the letter of credit
• The issuing bank substitutes its credit for that of the importer's and guarantees payment to the exporter, with the issuing bank
seeking reimbursement plus fees for providing the letter of credit guarantee
Banker's Acceptances
• A negotiable instrument that is similar to a postdated check, except that it is guaranteed by the bank rather than the
account holder
• Can be used as a bank-backed payment for large transactions, and may be either collected at the specified time or sold in the
money market at a discount
Forfaiting
• Represents a credit facility for importers of higher-priced capital goods that may be financed over several years
• Forfaiting transactions share the characteristics of factoring and use the transaction mechanics of letters of credit
• Importers that purchase capital goods from exporters (generally in excess of $500,000) may do so by issuing a promissory
note payable over a three- to five-year period
• Forfaiting mitigates the extra risk from the extended payment terms
─ The seller (exporter) sells the promissory note to a forfaiting bank (essentially a factor) for discounted proceeds and
thereby assures both cash collection and cash flows to the exporter
─ The forfaiting bank, in turn, seeks collection from the importer through a prearranged, collateralized agreement that uses
bank guarantees or letters of credit issued by the importer's bank
─ This ensures collection of the purchased promissory note by the forfaiting bank
Countertrade
• The mutual exchange of goods in bartering arrangements or the purchase of goods through clearing houses with either
partial or full compensation arrangements
• Bartering involves the exchange of goods without monetary compensation
• Agricultural products from Canada (such as wheat) might be exchanged for seafood harvested in Peru in a
bartering transaction
• Compensation Arrangements: represent the guaranteed purchase of goods paid for with currency
─ Example: In full compensation transactions, agricultural products from Canada might be purchased by a Peruvian
company with the full understanding that the Canadian company will purchase either an equal (full compensation) or
different (partial compensation) amount of seafood products from a Peruvian company.

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Unit 2: 2B.

• Definition: annual returns include two components:

• Computation: returns are generally calculated over a 12-month (annual) period

─ The formula for calculating annual return is:

• Computation: multiply the holding period return by the

• Arithmetic vs. Geometric Return

─ Required for disclosure by federal regulations

• Computation: the effective periodic interest rate times the

─ Emphasizes the amount paid relative to funds available

─ Abbreviated as EAR (not EAPR)

• There is a direct relationship between credit risk and interest rates

Foreign Exchange Risk

• Also referred to as currency risk

• Measurement of transaction exposure is generally done in two steps:

1. Project foreign currency inflows and foreign currency outflows

2. Estimate the variability (risk) associated with the foreign currency

• Effect of Currency Appreciation:

• Effect of Currency Depreciation:

• Generally defined by the degree of foreign involvement,

─ Degree of Foreign Involvement: translation exposure

─ Locations of Foreign Investments: exposure of the

• Investors who purchase bonds, debt, or other

• The value of a fixed rate, interest-bearing

• If interest rates fall, the value of the fixed-rate,

─ Bureaucracies and related inefficiencies or barriers to trade

─ The host government's attitude toward foreign firms

─ The attitude of consumers toward foreign firms

─ Inconvertibility of foreign currency

─ Higher (lower) levels of risk require higher (lower) expected returns

• Investor risk tolerances vary, ranging from risk-averse to risk-neutral to risk-seeking

─ Risk-seekers accept higher risk in exchange for higher rates of return

Term Structure of Interest Rates

─ Changes in expectations regarding economic growth

─ Increases (inflation) or decreases (deflation) in price levels

─ Changes in interest rates

• Normal Yield Curve: upward sloping, showing that investors are

─ In some circumstances, the yield curve can be downward-sloping,

• Downward-Sloping Yield Curves: bonds of shorter maturity that pay

─ Downward-sloping curves are also referred to as inverted yield

• Represent a loan by the bondholders (investors) to the issuing company or government

• Bondholders normally have legal recourse in the event of a default

• Protective Covenants: also referred to as negative covenants or restrictive covenants

─ Maintaining working capital at a minimum level

─ Maintaining a specified debt to equity ratio

─ Submitting financial statements at regular intervals

• Generally issued in increments of $1,000

─ Call provision is an advantage to the issuer and a disadvantage to the bondholder

─ Put provision is an advantage to the bondholder and a disadvantage to the borrower

• Cash flows may be discounted using a single interest

• A bond with a fixed coupon rate equal to the market rate

• A bond with a coupon rate at issuance less (more) than

• As market interest rates change, the market value of the

• For fixed-rate bonds, when market interest rates rise, the

• Duration is also a measure of how much the

• Bonds with a higher duration will be more

• The longer the term to maturity, the higher a

• Can be in the form of common stock or preferred stock

• Has extended voting rights

• Has characteristics that more closely resemble debt

• Preferred stock typically has the following characteristics:

─ Preferred stock dividends are either cumulative or noncumulative

• Typically, does not have voting rights

─ A series of equal cash flows to be received over a number of periods