Financial Markets

Chapters: 10, 11, 12, 13, 14, 15, 16, 17, 20, 21, 22, 23, 24, 28, 29

Perfect capital markets are characterized by certain conditions:

(1) Trading is cost less, and access to the financial markets is free;
(2) information about borrowing and lending opportunities is freely available;
(3) there are many traders, and no single trader can have a significant impact on market
prices.

The term cash flow refers to the net amount of cash and cash equivalents being transferred in
and out of a company.

Free cash flow (FCF) is the money a company has left over after paying its operating
expenses (OpEx) and capital expenditures (CapEx). The more free cash flow a company has,
the more it can allocate to dividends, paying down debt, and growth opportunities.

Capital structure refers to the specific mix of debt and equity used to finance a company's
assets and operations.

In business, a proxy allows shareholders to participate in corporate governance even if

they cannot be physically present at the general meeting.
Chapter 10 – Capital Markets and the Pricing of Risk

10.1 Risk and return: Insights From 92 Years of Inventor History

 Standard & Poor’s 500: portfolio of stocks consisting of largest firms in terms of
market value
 Small stocks: U.S. traded on NYSE with market capitalizations in bottom 20%
(updated quarterly
 World Portfolio: portfolio of international stocks from all of world’s major stocks
markets
 Corporate Bonds: portfolio of long-term, AAA-rated U.S. corporate bonds with
maturities of approximately 20 years
 Treasury bills: investment in one-month U.S. Treasury Bills – short-term U.S.
government debt obligation backed by the Treasury Department with maturity of one
year or less.

Small stocks are very volatile  Treasury bills steady/modest gains.

Volatility high-low: small stocks, S&P500, world portfolio, corporate bonds, Treasury Bills

Double Whammy: increased risk of being unemployed when value of savings eroded.

Risk premium: compensation for investor to bear risk of the investment.

10.2 Common Measures of Risk and Return

 Probability Distribution: probability pR that each possible return R will occur
 Expected Return: weighted average of possible returns, where weights correspond to
probabilities

 Variance and Standard Deviation:

o Variance is a measure of how spread out the distribution of return is
o Standad Deviation is a measure of volatility of the sotcks return

If the return is risk-free and never deviates from its means, the variance is zero.
Otherwise, the variance increases with the magnitude of the deviations from the
mean.
10.3 Historical Returns of Stocks and Bonds
 The realized return: return that
actually occurs over particular time
period.
o Empirical distribution of returns: plot probability distribution in way using
historical data
 The average return: average of realized returns of each year.

 Excess return: difference between average return of investment and average return on
Treasury Bills (risk free investment)  measures the average risk premium investors
earned for bearing risk.
 Simple Model: investments with high volatility should have higher risk premium.
 Common risk = perfectly correlated risk (earthquake)
 Independent risk = risk that shares no correlation (theft)
 diversification: averaging out of independent risk in large portfolio

Standard Error: standard deviation of estimated value of the mean of the actual
distribution around its true value  standard deviation of average return

95% confidence interval for expected return  Historical Average Return +/- (2 SE)

Stocks prices and dividend fluctuate due to 2 types of news:

 Firm specific new: independent risk, good/bad news about company itself
o Idiosyncratic-/unique/diversifiable risk
o Risk premium is 0  investors are not compensated for holding firm-
specific risk  Law of One Price: large portfolio with only firm-specific
risk has no risk and therefore must earn risk-free interest rate

 Market-wide news: common risk, news about the economy as a whole

o Systematic-/undiversifiable-/market risk
o Investors will demand risk premium to hold systematic risk
o Measure systematic risk of stock  determine how much of variability of
its return is caused by systematic risk

Efficient portfolio: cannot be diversified any further and therefore the changes in
price of portfolio will correspond to systematic shocks in economy
 market portfolio: portfolio of all stocks traded in capital markets (S&P500)

Beta: expected % change in its return given a 1% change in the return of the market
portfolio  measures sensitivity of security to market-wide risk factors

Capital Asset Pricing Model (CAPM): important method for estimating cost of
capital, uses the market portfolio as benchmark for systematic risk
Chapter 11 – Optimal portfolio Choice and the Capital Asset Pricing Model

11.1 Expected Return of Portfolio

 Portfolio weights: fraction of total investment in portfolio held in each investment in

portfolio  add up to 1, represent way we have divided our money between the
different investments in portfolio
 Portfolio’s expected return:

11.2 The Volatility of a Two-Stock Portfolio

Combining stocks in portfolio  reduce risk through diversification

Amount of risk eliminated in portfolio depends on degree to which stocks face common risks
and their prices move together.

 Covariance: expected product of deviations of two returns from their means

 Correlation: always between -1 and +1  gauge the strength of relationship between

stocks.
o The closer to +1, the more returns tend to move together
o When equals 0, returns are uncorrelated
o -1, the more returns tend to move in opposite direction

Stock returns will move together if they are affected similarly by economic events 
stocks in same industry

11.3 Volatility of a Large Portfolio

 Equally weighted portfolio: portfolio in which the same amount is invested in each
stock

When combining stocks in portfolio that puts positive weight on each stock, unless all
of stocks have a perfect correlation of +1 with the portfolio, the risk of the portfolio
will be lower than the weighted average volatility of the individual stocks
 Expected return of portfolio = weighted
average expected return, BUT volatility of
portfolio < weighted average volatility 
can eliminate some volatility by diversifying

11.4 Risk VS Return: Choosing an Efficient

Portfolio

Inefficient portfolio: possible to find another

portfolio that is better in terms of both expected

return and volatility.

Efficient portfolio: no other portfolio who

offers higher expected return with lower
volatility

 correlation has no effect on expected

return of portfolio. The lower the correlation
the lower the volatility we obtain. When 2 stocks are perfectly negatively correlated it
becomes possible to hold a portfolio that ears absolutely no risk

 Long position: positive investment in security

 Short position: investing in negative amount in stock
o By engaging in short sale, transaction in which you sell stock today that you
do not own, with the obligation to buy it back in future

When set of investment opportunities increases from 2-3 stocks, efficient frontier improves.
Even if added stocks appear to offer inferior risk-return combination. They can help
diversification and therefore improve our efficient frontier

11.4 Risk-free Saving and Borrowing

Keep money in safe, no risk-investment like Treasury Bills to reduce risk (besides
diversification)  reduce expected return

Buying stocks on margin = borrowing money to invest in stocks (using leverage) –

levered portfolio  portfolio that consists of short position in risk-free investment

To earn highest possible expected return for any level of volatility  find portfolio that
generates the steepest possible line when combined with risk-free investment
 slope of this line: Sharpe Ratio: measures ratio of reward-to-volatility provided by
portfolio
The optimal portfolio to combine with the risk-free investment will be the one with the
highest Sharpe Ratio  Tangent Portfolio: provides biggest reward per unit of volatility of
any portfolio available
Every investor should invest in tangent
portfolio independent of his/her taste for
risk, the investor’s preference will decide how
much they will invest

Efficient portfolio: tangent portfolio, the with

the highest Sharpe Ratio in economy 
combining it with risk-free investment,
investor will earn highest possible expected
return for any level of volatility they want to
bear.

11.5 Efficient Portfolio and Required Returns

Adding investment to portfolio:

1. Expected Return: giving up risk-free return and replacing it with i’s return  ER
will increase by i’s excess return
2. Volatility: will increase with risk that i has in common with portfolio, other risk will
be diversified

Required return: expected return necessary to compensate for risk investment will
contribute to the portfolio
 equal to risk-free interest rate plus risk premium of current portfolio, scaled by i’s
sensitivity to P
 as you buy shares of security I its correlation with portfolio increases and required return
will therefore increase as well

11.6 Capital Asset Pricing Model

Three underlying assumptions in CAPM

1. Investors buy and sell all securities at competitive market prices (without increasing
taxes or transactions costs) and can borrow and lend at the risk-free interest rate
2. Investors hold only efficient portfolios of traded securities – portfolios that yield the
maximum expected return for a given level of volatility
3. Investors have homogenous expectations regarding the volatilities, correlations and
expected returns of securities
 Homogenous expectations: all investors have same estimates concerning future
investments and returns

When investors have homogenous expectations, they will all identify the same portfolio as
having highest Sharpe Ratio. All investors will demand the same efficient portfolio of risky
securities. Since all investors hold the same tangent portfolio, the efficient, tangent portfolio
of risky securities must equal market portfolio

When CAPM holds the market portfolio is efficient and therefore equal to tangent portfolio.
Tangent line through market portfolio  capital market line (CML)  every investor
should choose portfolio on CML
Use CAPM to find expected return of security or cost of capital of investment

11.8 Determining the Risk Premium

Beta of security: volatility due to market risk relative to market as a whole – captures
security’s sensitivity to market risk

Security market line (SML) depicts linear relation between stock’s beta and expected return
 line among which all individual securities should lie when plotted according to their
expected return and beta

Relationship between risk and return only becomes evident when we measure market risk
rather than total risk
Chapter 12 – Estimating the Cost of Capital

12.1 The equity cost of capital

Cost of capital = best expected return available in market on investments with similar risk
Under CAPM investments have similar risk, if they have the same beta with market portfolio

Investors will require a risk premium comparable to what they would earn taking the same
market risk through an investment in the market portfolio

12.2 The market portfolio

Constructing the Market Portfolio

 Market portfolio = total supply of securities, proportions of each security should
correspond to proportion of total market that each security represents  contains
more of largest stocks and less of smallest stocks  specifically investment in each
security is proportional to its market capitalization

 Value-weighted portfolio: portfolio like market portfolio in which each security is held in proportion
market capitalization
o Also an equal-ownership portfolio: hold equal fraction of total number of
shares outstanding of each security in the portfolio
o Also an passive portfolio  very little trading required to maintain it

 Market Index: value of particular portfolio of securities

 Price-weighted portfolio: holds equal number of shares of each stock, independent
of their size
 Index funds: funds offered by many mutual fund company
o Represented by exchange-traded fund (ETF): security that trades directly on
an exchange, like a stock, but represents ownership in a portfolio of stocks
o S&P500 used as market proxy  portfolio whose return they believe closely
tracks the true market portfolio

 Risk-free interest rate in CAPM corresponds to risk-free rate at which investors can
both borrow and save

12.3 Beta estimation

 Historical approach: historical average excess return of the market. The yield curve
has tended to be upward sloping (long-term int rate > short-term interest rate)
o SE of estimate are large (-)
 o Backward looking; cannot be sure they are representative for the future (-)
 Fundamental approach: using an assessment of firm’s future cash flows, we can
estimate the expected return of the market by solving for the discount rate
o Highly inaccurate for individual firm (-)
o More reasonable when considering overall market (+)

Beta estimated using stock’s historical sensitivity  makes sense when beta remain relatively
stable over time
Beta corresponds to slope of best-fitting line in plot
of security’s excess returns vs market excess returns

Linear regression: identifies best-fitting line through

set of points

Alpha: measures historical performance of security

relative to expected return predicted by SML 
distance of stock’s average return from SML.
According to CAPM, alpha should not be
significantly different from 0

12.4 Debt Cost of Capital

Debt cost of capital: cost of capital firm must pay on its debt
 Debt yields vs returns: if there is little risk of default we can use the bond’s YTM as
an estimate of expected return. When there is higher risk of default the YTM of
firm’s debt will overstate investor’s expected return
 Debt betas: using CAPM – ch 21

12.5 Project’s cost of capital

Most common method for estimating project’s beta is to identify comparable firms in the
same line of business as project we are considering undertaking  if we can estimate cost of
capital of assets of comparable firms  can use this estimate as proxy for projects cost of
capital

 All equity firm comparable to project. Bc firm is all equity holding the firm’s stock is
equivalent to owning portfolio of its underlying assets. When firm has similar market
risk to our project, we can use it as an estimate
 Levered firm comparable: cash flows generated are used to pay both equity and debt
holders  returns on equity are NOT representative of firm’s underlying assets 
equity riskier due to leverage (refers to use of debt to amplify returns from investment
or project)
o Recreate claim on firm’s assets by holding debt and equity  by holding both
you are entitled to all cash flows  beta of firm’s assets = beta of this
portfolio
 Unlevered cost of capital: expected return acquired by firm’s investors to hold firm’s
underlying assets  weighted average of firm’s equity and debt costs of capital
  Unlevered beta: weighted average betas of the securities in portfolio

 Enterprise value: combined market value of firm’s equity and debt, less any cash
 Asset betas reflect market risk of average project in firm  but individual projects
may be more or less sensitive to market than average

12.6 Project risk characteristics and financing

Operating leverage: relative proportion of fixed versus variable costs. Higher proportion of
fixed costs will increase the sensitivity of project’s cash flows to market risk and rais the
project’s beta

Weighted average cost of capital (WACC): firm’s effective after-tax cost of capital

Unlevered cost of capital  pretax WACC)

- Unlevered cost of capital is expected return investors will earn holding
firm’s assets  can be used to evaluate an all-equity financed project
with same risk as firm
- WACC is effected after-tax cost of capital to the firm  interest
expense is deductible, the WACC is less than the expected return of
firm’s assets  can be used to evaluate project with same risk and
same financing as the firm itself
Chapter 13 – Investor Behavior and Capital Market Efficiency

13.1 Competition and Capital Markets

New info arises plus market prices remain unchanged  news would raise expected return
 alpha of stock might change
When market portfolio is efficient  all stock are on SML and have alpha of 0  sharpe
ratio of stock might increase with positive alpha

 Positive alpha  higher demand  higher price  lower return  stock will move
back to SML
 Negative alpha  more supply  lower price  higher return  stock will move
back to SML

13.2 information and rational expectations

 Investors have rational expectations  profit by buying positive alpha, must be

someone willing to sell it  investors correctly interpret and use their info, as well as
info that can be inferred from market prices or the trades of others

 Homogenous expectations  no one is willing to sell

Important conclusion CAPM: investors should hold market portfolio and this investment
advice does not depend on quality of investor’s info or trading skills

Market portfolio can be inefficient (so it is possible to beat the market) only if a significant
number of investors either
1. Do not have rational expectations  misinterpret info  believe they are investing in
positive alpha;
2. Care about aspects of their portfolios other than expected return and volatility 
willing to hold inefficient portfolios of securities

13.3 behavior of individual investors

Diversification  reducing risk  individual investors fail to diversify

 Familiarity bias: investors will likely invest in firms they are familiar with
 Relative wealth concerns: investors care most about performance of their portfolio
relative to that of peers  living up to potential of portfolio

Market portfolio  passive portfolio  investor does not need to trade in response to daily
price changes in order to maintain it
In reality; lot of trading occurs every day  may come from overconfidence bias:
uninformed individuals tend to overestimate the precision of their knowledge
When you trade more  portfolio tends to have lower returns due to high transaction cost

13.4 Systematic trading biases

 systematic patterns in types of errors of individual investors

 Disposition effect: hang on to losers (stocks down in value) and sell winners 9stocks
risen in value)
 Attention, mood and experience: investors may be influenced by attention grabbing
news when choosing investment, investors tend to put too much eight on their own
experience
 Herd behavior: individuals actively trying to follow each other’s behavior
o Others might have superior info that they can take advantage of by copying 
informational cascade effect
o Due to relative wealth concerns, individuals choose to herd in order to avoid
risk of underperforming their peers
o Professional fund managers may face reputational risk if they stray too far
from the action of peers

 easy way to fix: buy and hold market portfolio

In order for sophisticated investors to profit from investor mistakes

1. Alpha must be non-zero trading opportunity must arise due to their behavior
2. Limited competition to exploit these non-zero alpha opportunities

13.5 Efficiency of market portfolio

Average fund manager can add more value to investment than individual investor
 Individual often do lot of trading: transactions cost > return
 Managers added value is offset by fees funds charge
 Skilled managers attract capital: manage larger funds  higher added value  higher
fees

Average investors earn alpha equal to 0 BEFORE fees

Net alpha = alpha after fees

13.6 style-based techniques and market efficiency debate

Size effect: small stocks tend to have high market risk, their returns appear high even
accounting for their higher beta  earn positive alpha

Book-to-market ratio: ratio of book value of equity to the market value of equity, to form
stocks into portfolios

Conclusions:
1. Ignoring positive NPV investment opportunities
2. Positive alpha-trading strategies contain risk investors are unwilling to bear, but
CAPM does not capture

Arbitrage Pricing Theory: portfolio can be interpreted as either risk factor itself or
portfolio of stocks correlated with unobservable risk factor
Smart beta strategy: investors can tailor their risk exposures based on common risk factors

CAPM is mot commonly used method to practice to estimate cost of capital  virtues of
being simple to implement, theoretically justifiable, and reasonably consistent with investor
behavior
 CALCULATES EXPECTED RETURN FOR ASSET OR INVESTMENT
Chapter 14 – Capital Structure in a Perfect Market

14.1 Equity versus Debt financing

Capital structure: relative proportions of debt equity, and other securities that a firm has
outstanding
 Unlevered equity: firm with no debt  date 1 cash flows are equal to those of project
 Levered equity: equity in firm that also has debt outstanding  debt payments must
be made BEFORE any payments to equity holders

Leverage increases the risk of equity even when there is no risk that the firm will default 
debt may be cheaper when considered on its own  raises cost of capital for equity

14.2 Modigliani – Miller I: leverage, arbitrage, and firm, value

Law of one price  leverage would not affect the total value of firm  changes allocation of
cash flows between debt and equity without altering total cf of firm

Modigliani and Miller (MM): in perfect capital market, total value of firm’s securities is
equal to market value of total CF generated by its assets and not affected by its choice of
capital structure
1. Investors and firms can trade the same set of securities at competitive market prices
equal to PV of CF
2. There are no taxes, transactions costs, or issuance costs associated with security
trading
3. Firm’s trading decision do not change cash flows generated by its investments, nor do
they reveal new info about them

In absence of taxes or other transaction costs, total CF paid out to all of firm’s security
holders is equal to total CF generated by firm’s assets. Through law of one price: firm’s
securities and its assets must have same total market value

 Homemade leverage: investors use leverage in their own portfolio to adjust the
leverage choice made by firm  as long as investors can borrow or lend at same
interest rate as firm, homemade leverage is perfect substitute for use of leverage by
firm

 Market value balance sheet: equal to accounting balance sheet, but with two
important distinctions
o Assets and liabilities of firm are included (even intangible assets – reputation,
brand name, or human capital)
o All values are current market values instead of historical costs

 Leveraged recapitalization: when firm repurchases significant percentage of its

outstanding shares using leverage

14.3 Modigliani-Miller II: Leverage, risk and cost of capital

MM Proposition II: the cost of capital of levered equity increase with the firm’s market alue
debt-equity ratio

With perfect capital markets, firm’s WACC is independent of its capital structure and is equal
to its equity cost of capital if unlevered, which matched cost of capital of its assets

Unlevered Beta measures market risk of firm’s underlying assets  can be used to assess
cost of capital of comparable investments  when capital structure changes w/o changing
investment: unlevered beta unchanged

14.4 Capital structure fallacies

Leverage can increase firm’s expected earning per share

Incorrect arguments in favor of leverage

 Leverage should increase a firm’s stock price  due to fact that leverage can increase
a firm’s expected earnings per share: increase in EPS is necessary to compensate the
shareholders for additional risk they are taking  share price unchanged
 Issuing equity will dilute existing shareholders’ ownership, so debt financing should
be used instead (CF generated divided among more shareholders) ; but the issuance of
new share will increase the firm’s assets which will offset this

Leverage can raise firm’s expected EPS and return on equity  also creates volatility of
EPS and riskiness of equity  in perfect market shareholders not better off and value of
equity is unchanged
As long as shares are sold to investors at fair price, there is no cost of dilution associated
with issuing equity

14.5 MM beyond the propositions

With perfect capital markets  financial transactions are a zero-NPV activity that neither add
nor destroy value on their own, but rather repackage firm’s risk and return
Capital structure affect firm’s value only bc of its impact on some type of market
imperfection
Chapter 15 – Debt and taxes

MM – capital structure does not matter in perfect capital markets

1. Investors and firms trade same set of securities at competitive market prices equal
to PV of future CF
2. No taxes, transactions costs or issuance costs associated with security trading
3. Firm’s financing decisions do not change CF generated by its investments, nor do
they reveal new info
15.1 Interest tax deduction

Corporations must pay taxes on income  profits after interest payments are deducted 
interest expenses reduce profits and therefore taxes  incentive to use more debt

Interest tax shield: gain to investors from tax deductibility of interest payments – additional
amount firm would have paid in taxes if they did not have leverage

15.2 Valuing interest tax shield

Firm makes interest payments each year, cash flows it pays to investors will be higher than
they would be w/o leverage by the amount of the interest tax shield

The total value of the levered firm exceeds to the firm without leverage due to present value
of tax savings from debt

Shen a firm has outstanding debt with coupon of 5 years  principal is due  firm raises
money needed to pay by issuing new debt  permanent debt

With tax-deductible interest, the effective after-tac borrowing rate is

Including benefits of interest tax shield  lower wacc than pre-tac wacc
The higher the firm’s leverage, the more the firm exploits tax advantage of debt and the
lower its wacc is

15.3 Recapitalizing to capture the tax shield

Recapitalization: transactions when firm makes significant change to its capital structure

When securities are fairly prices, original shareholders of firm capture full benefit of interest
tax shield from an increase in leverage

Leveraged recapitalization can reduce tax payments

 once investors know the recap will occur, the share price will rise immediately to a level
that reflects the value of the interest tax shield that the firm will receive

In presence of corporate taxes, we must include the interest tax shield as one of the firm’s
assets  total market value of firm’s securities must equal total market value of firm’s asset
Even though leverage reduces total market capitalization of firm’s equity, shareholders
capture benefits of interest tax shield upfront

15.4 Personal taxes

Investors get taxed again after receiving cash flow

Value of firm = amount of money firm can raise by issuing securities – amount of money
investor will pay for security depends on benefits they receive (cash flows investor will
receive after all taxes have been paid)  influences amount of capital firm can raise 
actual interest tax shield depends on ALL taxes

Personal taxes can offset some of the corporate tax benefits. Income taxes > capital gain tax
Under new tax code there is a slight tax advantage to debt for some individual investors

Unlikely that all or even majority of investors are taxed with highest tax rate  many
investors face no personal taxes (pension funds investors)
Both investors saving for requirements as short-term investors and securities dealers are taxed
symmetrically on interest, dividends and capital gains

2 important tendencies looking at historical data about sources of funding

1. Use of leverage varies greatly by industries
2. Many firms retain large cash balance to reduce their effective leverage

The optimal leverage from a tax saving perspective is the level such that interest just equals
the income limit
 firm shields all of taxable income and does not have any tax-advantaged excess interest

Optional fraction of debt, as proportion of firm’s capital structure,

declines with the growth of the firm
 tax optimal capital structure of firm with high growth potential does
not include debt  such firm will have taxable income due to not yet received revenues 
can assume that this firm is only using equity for investments
The interest expense of average firm is well below its taxable income, implying that firms do
not fully exploit tax advantages of debt

Chapter 16 – Financial Distress, managerial incentives and information

16.1 Default and bankruptcy in perfect market

Default: firm fails to make required interest or principal payments on debt  extreme case
debtholders take legal ownership of firm’s assets through process called bankruptcy
Firms not legally obligated to pay equity holders

Scenario 1
 firm has access to capital markets and can issue new securities at fair price, then it need
not default as long as the market value of its assets exceeds its liabilities
Whether default occurs depends on firm’s assets and liabilities and not CF
Scenario 2
 project financed with (partly) debt and firms value turns out to be less than debt they have
 firm is in financial distress and has no other option than default
Debt holder have the right to the amount the firm is worth (assets) leaving equity holders
with the difference

 Economic distress: significant decline of firm’s assets, whether or not it experiences

financial distress due to leverage

 Financial distress: firm has trouble meeting its debt obligations

No disadvantage to debt financing  firm will have same total value and will be able to raise
same amount initially from investors of either choice. Investors as a group are not worse off
because a firm has leverage

16.2 costs of bankruptcy and financial distress

With perfect capital markets, risk of bankruptcy is not disadvantage of debt – shifts
ownership from equity holders to debtholders without changing total value available to all
investors
 long and complicated process that imposes both direct and indirect costs on firm and its
investors

2 forms of bankruptcy
 Liquidation: trustee is appointed to oversee liquidation of firm’s assets through an
auction  proceeds are used to pay firm’s creditors and firm ceases to exist

 Reorganization: all pending collecting attempts are automatically suspended and

firm’s existing management is given opportunity to propose reorganization plan.
Creditors may receive new debt or equity securities of firm. Creditors must vote to
accept plan and bankruptcy court must approve  otherwise liquidation

Bankruptcy code: provide orderly process for setting firm’s debts

Direct costs of bankruptcy: creditors seeking legal representation and professional advice
 workout: when firm negotiates with creditors directly
Direct costs of bankruptcy should not exceed workout costs
 prepackaged bankruptcy: firm will first develop reorganization plan with agreement of
its main creditors, and then implement plan

Indirect costs of financial distress – difficult to measure, much larger than direct costs
 Loss of customers
 Loss suppliers
o Debtor-in-possession (DIP) financing: new debt issued by a bankrupt firm
 Loss of employees
 Loss of receivables
 Fire sale of assets
 Inefficient liquidation
 Costs to creditors
Bankruptcy is a choice the firm’s investors and creditors make, there is a limit to direct and
indirect costs on them that results from firm’s decision to go through the bankruptcy process.
A lot of indirect costs are incurred prior to bankruptcy

Overall impact indirect costs

 Identify losses to total firm value
 Identify incremental losses that are associated with financial distress, above and
beyond any losses that would occur due to firm’s economic distress

16.3 Financial distress costs and firm value

MM assumed that CF of firm’s assets do not depend on choice of capital structure

 direct and indirect costs important departure from MM

When securities are fairly prices, the original shareholders of a firm pay the PV of the costs
associated with bankruptcy and financial distress
 debt holders are not foolish and want to pay debt amount they will give up - PV of
bankruptcy costs

16.4 optimal capital structure: tradeoff theory

Tradeoff theory: weights benefits of debt that results from shielding CF from taxes against
costs of financial distress associated with leverage

Present value of financial distress costs depends on

 Probability of financial distress:
o Firms whose value and CF are very volatile must have lower levels of debt to
avoid a significant risk of default.
 Magnitude of costs if the firm is in distress
o Magnitude of financial distress costs will be lower when greater portion of
their value is from relatively liquid assets (real estate)
 Appropriate discount rate for distress costs
o PV of distress costs will be higher for high beta firms
o More negative beta leads to lower cost of capital

Tradeoff theory  firms should increase leverage until reaches level D* for which VL is
maximized
 Presence of financial distress costs can explain why firms choose debt levels that are
too low to fully exploit interest tax shield
 Differences in magnitude of financial distress costs and volatility of cash flows can
explain the differences in use of leverage across industries

16.5 exploiting debt holders: agency costs of leverage

Capital structure can affect firm’s cash flows  can alter managers’ incentive and change
their investment decisions  negative NPV, they will be costly for firm
 Agency costs: costs that arise when there are conflicts of interest between stakeholders
When firm is levered  conflict of interest arises when decisions have different
consequences for the value of equity and value of debt (likely when risk of financial distress
is high)
 Managers may take action that benefits shareholders but harms firms creditors and lowers
total value of the firm

 When firm faces financial distress, shareholders can gain from decisions that
increase risk of firm sufficiently, even if they have negative NPV
 leverage gives shareholders incentive to replace low-risk assets with riskier ones =
asset substitution problem
 over-investment, as shareholders gain if the firm undertakes negative NPV but
sufficiently risky projects

 When firm faces financial distress, may choose not to finance new positive NPV
projects  shareholders do not benefit: debt overhang/underinvestment: costly for
debt holders

 Firms can sell equipment, lowering value of firm (negative for debt holders) and use
cash to pay out dividends to shareholders = cashing out

 Equity holders will benefit from new investment only if

Leverage ratchet effect: once existing debt is in place (1) shareholders may have
incentive to increase leverage even if it decreases value of firm, (2) shareholders will
not have incentive to decrease leverage by buying back debt, even it will increase
value of firm.

Mitigate agency costs of debt

 Agency costs are smallest for short-term debt – less time to take advantage
 Debt covenants: condition of making loan, creditors often place restrictions on
actions that firm can take

16.6 motivating managers: agency benefits of leverage

Management entrenchment: separation of ownership and control  facing little threat of

being fired and replaced, managers are free to run firm in their own best interest  managers
make decisions that benefit themselves at investor’s expense

Due to dilution of ownership there may be consequences like reduced effort and excessive
spending

Empire building: managers willing to invest negative NPV investments to increase size of the
firm. Because managers often prefer runner larger businesses than small ones
Free cashflow hypothesis: view that wasteful spending observation is more likely to occur
when firms have high levels of cash flows in excess of what is needed to make all positive-
NPV investments and payments to debt holders
 only when cash is tight, managers be motivated to run firm as efficiently as possible

16.7 agency costs and tradeoff theory

Relative magnitude of different costs and benefits of debt vary with characteristics of firm
 R&D-Intensive Firms  firms with high R&D costs and future growth opportunities
typically maintain low debt levels bc they won’t have (much) tax advantage due to
low cash flow levels
 Mature, low growth firms with stable cash flows and tangible assets often fall into
high-debt category – have higher leverage – high free cash flow

Proponents of management entrenchment theory of capital structure believe that managers

choose capital structure primarily to avoid discipline of debt and maintain their own
entrenchment  managers seek to minimize leverage

16.8 Asymmetric info and capital structure

May be asymmetric info between managers and investors

 credibility principle: claims in one’s self-interest are credible only if they are supported
by actions that would be too costly to take if claims were untrue
 actions speak louder than words

Signaling theory of debt: use of leverage as way to signal good info to investors
Adverse selection leads to lemon principle: when seller has private info about value of
good, buyers will discount price they are willing to pay due to adverse selection
 Stock price declines on announcement of an equity issue
 Stock price tends to rise prior to announcement of equity issue
 Firms tend to issue equity when info asymmetries are minimized, such as immediately
after earnings announcements

Issuing new shares when managers know they are underpriced is costly for original
shareholders

Managers who perceive firm’s equity is underpriced will have preference to fund investment
using retained earnings, or debt, rather than equity
 firm can avoid underpricing altogether by financing investment using its cash (RE)
 pecking order hypothesis: managers prefer retained earning first, and will issue new
equity only as a last resort

Market timing: firm’s overall capital structure depends in part on market conditions that
existed when it sought funding in the past  similar firms in industry might end up with
very different, but nonetheless optimal capital structures
Chapter 17 – payout policy

17.1 distribution to shareholders

Payout policy: way firm chooses

between retaining or paying out free
cash flow

 Declaration day: date on

which board authorizes the
dividends  after this legally
obligated to make payment
 Record date: firm will pay
dividend to all shareholders
of record on specific date, set
by board  takes three
business days to register
shares
 Ex-dividend date: anyone who purchases stock on or after ex-dividend date will not
receive the dividend
 Payable date/distribution date: firm mails dividend checks to registered
shareholders

Stock split/stock dividend: company issues additional shares rather than cash to its
shareholder  each owner of ONE share received SECOND share

Return of capital/liquidating dividend: dividends attributed to other accounting sources,

such as paid-in capital or liquidation of assets

Alternative way to pay cash to investors  share repurchase/buyback  firm uses cash to
buy back outstanding stock. 3 possible ways:
 Open market repurchase: firm announces its intention to buy its own shares in open
market  proceeds to do overtime like any other investor. Firm is not obliged to buy
full amount stated. Firm must not buy shares in a way that might appear to manipulate
price  recommend that firm does not purchase more than 25% of average daily
trading volume in single day
 Tender offer: firm offers to buy shares at prespecified price during short time period
(within 20 days)  price usually set at substantial premium to current price
o Dutch auction: firm lists different prices at which it is prepared to buy shares,
and shareholders in turn indicate how many shares they are willing to sell at
each price  firm pays lowest price at which it can buy back number of shares
 Targeted repurchase: purchasing share directly from major shareholder  price
directly negotiated
o Greenmail: when shareholder is threatening to take over firm and remove
management, the firm may decide to eliminate the threat by buying out
shareholder, often at large premium
17.2 comparison of dividends and share repurchases

3 policies of paying out excess cash to shareholders

  Pay dividend with excess cash: in perfect capital market, when dividend is paid, the
share price drops by amount of dividend when stock begins to trade ex-dividend
 Share repurchase: in perfect capital markets, open market share repurchase has no
effect on stock price and stock price is same as the cum-dividend (with dividend)
price if dividend were paid instead
o In perfect capital markets investors are indifferent between firm distributing
funds via dividends or share repurchases. By reinvesting dividends or selling
share, they can replicate either payment methods on their own
 High dividend (equity issue)

If firm pays higher current dividend per share, it will pay lower future dividend per share
 MM dividend irrelevance: in perfect capital markets, holding fixed the
investment policy of firm, the firm’s choice of dividend policy is irrelevant and does
not affect initial share price

17.3 Tax disadvantage of dividends

Shareholders must pay taxes on dividends they receive and pay capital gains taxes when they
sell their shares. There is tax advantage for share repurchase over dividends for long-term
investors since capital gains taxes are deferred until asset is sold
 optimal dividend policy when dividend tax rate > capital gains rate is to pay NO
DIVIDENDS

Dividend puzzle: firms continue to issue dividends despite their tax disadvantage

17.4 Dividend capture and tax clienteles

Investor earns profit by trading to capture the dividend if the after-tax dividend > the after-tax
capital loss  if the after tax capital loss > after-tax dividend, investor benefits by selling
stock just before it goes ex-dividend and buying it afterward

Effective dividend tax rate for investor depends on tax rates investor faces on dividends
and capital gains
 Income level – fall into different tax brackets
 Investment horizon – long-term investors can defer the payment of capital gains taxes
 Tax jurisdiction – investors are subject to state taxes that differ per state
 Type of investor or investment account – stock held by investors in retirement account
are not subject to taxes on dividends or capital gains

Corporations enjoy tax advantage associated with dividends due to high corporate tax rate

Differences in tax preferences across investor groups create clientele effects: dividend policy
of firm is optimized for tax preference of its investor clientele
 Investors in highest tax brackets have preference for stock with low dividends
 Tax-free investors and corporations have preference for stock with high dividends

 dividend-capture theory: absent transaction costs, investors can trade shares at time
of dividend so that non-taxed investors receive dividend  non-taxed investors need not
 hold the high-dividend paying stocks all the time; it is necessary only that they hold them
when the dividend is actually paid
 high-tax investors sell stock just before ex-dividend, after ex-dividend the trades
are reversed
The ex-date or ex-dividend date represents the date on or after which a security is
traded without a previously declared dividend or distribution.

17.5 Payout vs Retention of cash

MM payout irrelevance: in perfect capital markets, if a firm invests excess cash in financial
securities, the firm’s choice of payout versus retention is irrelevant and does not affect the
initial value of the firm
 retain cash or not depends on market imperfections
 Corporate taxes make it costly for a firm to retain excess cash  when firm pay
interest, it received tax reduction for that interest, whereas when a firm receives
interest, it owes taxes on interest

Interest on retained earnings is taxed twice  cost of retained cash therefore depends on
combined effect of corporate and capital gains taxes

Firms retain cash balances to cover future potential cash shortfalls  strategy allows a firm
to avoid transaction costs of raising new capital (+)

Payout policies are generally set by managers whose incentives may differ from those of
shareholders  managers may prefer to retain cash rather than paying it out
 managerial entrenchment theory of policy payout: managers only pay out cash when
pressured to do so by firm’s investors

17.6 Signaling with payout policy

Dividend smoothing: practice of maintaining relatively constant dividends – result from:

 Management’s belief that investor prefer stable dividend with sustained growth
 Management’s desire to maintain a long-term target level of dividends as a fraction of
earnings
 firms raise dividends only when perceive long-term sustainable increase in
expected level of future earnings, and cut them only as last resort

Dividend signaling hypothesis: idea that dividend reflect manager’s views about a firm’s
future earning prospects
 increase dividend: signaling that management expects to be able to afford higher dividend

Share repurchase may also signal manager’s info to market BUT

 Managers are much less committed to share repurchases than to dividend payments
 Firm do not smooth their repurchase activity from year to year  does not represent
long-term prospects
 Cost of share repurchase depends on market price of stock – repurchasing is a
positive-NPV investment when you believe stock is undervalued
17.7 stock dividends, splits and spin-offs

 Stock dividend: each shareholder will receive one new share of stock for every x
shares already owned (10%  1 stock per 10 shares owned
o Will cause stock price to fall since number of shares outstanding increases but
total equity value remains the same
o Stock dividends are NOT taxed
 Stock split: stock dividend of 50% or higher
o Motivation: keep share price in attractive range for small investors

Reverse split: reversed stock split, reduces number of shares outstanding and is done when
stock prices fall too low  results in higher share price

Spin-off: a firm distributing shares of a subsidiary

Chapter 20 – financial options

20.1 Option Basics

 Financial option: owner right (but not obligation) to purchase or sell asset at fixed
price at some future date
o Call option: owner right to buy asset
o Put option: owner right to sell asset

 contract; so option writer: person who takes other side of contract

 Exercising option: holder of option enforced agreement and buys or sells a share of
stock at agreed-upon price
 Strike price/exercise price: price at which holder buys or sell share of stock when
option is exercised
 Two kind of options
o American options: allow their holders to exercise option on any date up to
and including final date called the expiration date
o European options: allow their holders to exercise option only on the
expiration date – cannot exercise before expiration date

Because long side (option buyer) has option to exercise, short side (option writer) has
obligation to fulfill contract
Option always have positive prices - market price of option is option premium: upfront
payment compensates the seller for risk of loss in event that option holder chooses to exercise
option

Open interest: total number of outstanding contracts of that option

 At-the-money: exercise price of option equal to current price of stock

 In-the-money: payoff from exercising an option immediately is positive
o Call options with strike prices below current stock price
o Put options with strike prices above current stock price
 Out-of-the-money: payoff from exercising the option immediately Is negative
o Call options with strike price above current stock price
o Put options with strike price below current stock price
 holder does not want to exercise out-of-the-money
 Deep in-the-money/deep out-of-the-money: strike and stock price very far apart

 Hedging: option used to reduce risk

 Speculate: place bet on direction in which they believe market is likely to move

20.2 option payoff at expiration

 S = stock price, K = exercise price, C = value call option

Short position’s cash flows are negative of long position’s cash flows
Bc investor who is long an option can only receive money at expiration – will not exercise
option that is out-of-the-money – short investor can only pay money

The distinction between going long and going short is brief but important: Being long a
stock means that you own it and will profit if the stock rises. Being short a stock means
that you have a negative position in the stock and will profit if the stock falls

Straddle
 combining put and call option  receive cash so long as option do not expire at-the-
money
 The farther away options are from money, the more money you will make
 Purchasing both options, so profits
after deducting this cost are
negative for stock prices close to
strike price and positive elsewhere
(dashed line)
 Used by investors who expect
stock to be volatile and move up or
down, but do not have view which
direction stock will move

Butterfly spread
 A long butterfly spread with calls
is a three-part strategy that is created by buying one call at a lower strike price,
selling two calls with a higher strike price and buying one call with an even
higher strike price. All calls have the same expiration date, and the strike prices are
equidistant.
 Payoff is positive, it must have positive initial cost

Portfolio insurance
 Using put options on portfolio of stocks as a whole rather than just a single stock 
holding stocks and put options
 Purchasing a bond and a call option

20.3 put-call parity

Put-call parity
Consider (1) purchase stock an put or (2) purchase bond and call
 Law of One Price states that they must have same price
 Price of European call equal price of stock plus an otherwise identical put – price of bond
that matures on exercise date op option

20.4 Factors affecting option prices

Put option right to sell stock  less valuable when strike price is lower
Call option is right to buy asset  more valuable when strike price is lower (easier to make
profit)

The value of option generally increases with volatility of stock

 Holder of call option benefits from higher payoff when stock goes up and option is in-
the-money, but earns the same (zero) payoff no matter how far stock drops when
option is out-of-the-money
Because of this asymmetry of option’s payoff, option holder gains from increase in
volatility

American option cannot be worth less than its European counterpart  because otherwise
you could make arbitrage profits by selling European call and using part of the
proceeds to buy equivalent call option
 Arbitrage is an investment strategy in which an investor simultaneously buys and sells an
asset in different markets to take advantage of a price difference and generate a profit.

 Put option cannot be worth more than its strike price  highest possible payoff if
stock becomes worthless

 Call option cannot be worth more than stock itself  the lower the strike price, the
more valuable the call option. If call option had strike price of 0, holder would always
exercise option and receive stock at no cost

 Intrinsic value: value of option when it would immediately expire  can NOT be
negative, either in-the-money or zero
 American option cannot be worth less than intrinsic value bc otherwise would be
arbitrage opportunity

 Time value: difference between current option and intrinsic value

 American option cannot have negative time value bc cannot be worth less than
intrinsic value

How longer the time to exercise date, the more valuable the American option
 holder of 1-year option can turn it into 6-month option, by exercising his option early
 as the 1-year option has same rights and privileges  Law of One Price states that 1-year
option can NOT be worth less than 6-month option

 not the case for European option

The value of an option generally increases with volatility of stock  increase volatility
increases likelihood of very high and very low returns for stock

20.5 Exercising options early

Non-dividend-paying stocks
Call options
 There will be no dividends paid before expiration date of options, value of call option:

 Price of zero-coupon bond: PV(K) = K – dis(K)

Dis(K) = amount of discount from face value to account for interest

As long as interest rates remain positive, the discount on zero-coupon bond before
maturity date is positive, and put price is also positive  European call always have
positive value
American option is worth at least as much as European option  American must
also have positive time value before expiration  price of any call option on a non-
dividend paying stock always exceeds intrinsic value (positive time value)

SO, it is not beneficial to exercise call option on non-dividend paying stock early 
always better off by just selling option
BECAUSE when you sell option you get intrinsic value  price of non-dividend
paying stock always exceeds its intrinsic value  so you get higher price when you
sell call option compared to when you exercise it  the right to sell an American
call option a non-dividend paying stock is worthless since it is never optimal to
exercise the option
Therefore American call options on non-dividend-paying stock has same price as its
European counterpart

Put option

 Time value of money includes negative term: dis(K) = opportunity of waiting to

receive strike price K. when strike price is high and put option is sufficiently deep-in-
the-money, this discount will be large relative to value of call  time value of
European put option will be negative (dis(K) > C), however its American counterpart
can NOT be worth less than its intrinsic value  American can be worth more than
identical European option

Example
Extreme case to illustrate when exercise put early: when a firm goes bankrupt the stock’s
value = 0, the value of the put option equal the strike price. The price can NOT go any
higher (no possibility of appreciation), but when you exercise the put early, you can get
strike price and earn interest on the proceeds in the interim
Dividend paying stocks
Call Option
 When stock pay dividends 
right to exercise option on them
early is generally valuable for
both calls and puts

S-K = intrinsic value dis(K) + P – PV(div) = time value

 If PV(div) is high enough – time value of European call option can be negative
BECAUSE American option can never be worth less than its intrinsic value – price of
American option can exceed price of European option

Note that when company pays dividend, investors expect price of stock to drop to
reflect the cash paid out. This price drop hurts the owner of a call option bc stock
price falls, but unlike the owner of the stock, the option does not get the dividend as
compensation

 expect drop bc reflects fact that new shareholders are not entitled to that payment

 By exercising call option early, owner can capture value of dividend. Because a call
should only be exercised to capture the dividend. It will only be optimal to do so
before the stock’s ex-dividend date

Put option
 Other way around: when we are rephrasing put-call parity:

 The likelihood of exercising early increases whenever the stock goes ex-dividend (bc
stock price is expected to drop after ex-dividend date)

20.6 Options and corporate finance

Equity as option
 Share of stock can be seen as call option on assets of firm – with strike price equal to
value of debt outstanding
 When firm does not exceed value of the debt outstanding at the end of period, it must
be declare bankruptcy and equity holders receive nothing
  If equity > debt outstanding, equity holders get paid whatever is left after debt-
payment (amount in-the-money)

Debt as option
 Debtholders can be seen as owning firm and having sold a call option with strike
price equal to required debt payment  short position in call option
 If value of firm exceeds required debt payment, the call will be exercised and debt
holders will “giver up” firm
 If value of firm < required debt payment  call will be worthless and firm will
declare bankruptcy and debt holders will be entitled to firm’s assets

 Other way to view corporate debt: portfolio of risk-free debt and short position in a
put option on firm’s assets with strike price equal to required debt payment

 When firm’s assets < required debt payment  put is in-the-money: the owner of the
put-option will therefore exercise the option and receive the difference between the
required debt payment and firm’s asset value  leaves debt holder with just the assets
of firm
 If firm’s value > required debt payment  put is worthless leaving portfolio holder
with required debt payment

Credit default swaps

 Refer to as put option  Buyer buys premium to seller (period payments) and
receives payment from seller to make up for loss if underlying bond defaults

Option valuations can be used to estimate the appropriate yield for risky debt, as well as to
estimate magnitude of agency cost problem within firm
Chapter 21 – Option valuation

21.1 Binomial option pricing model

 model prices options by making the simplifying assumption that at end of next period, the
stock price has only two possible values

 Black and Scholes – option payoff can be replicated exactly by constructing portfolio
out of risk-free bond and underlying stock
 Replicating portfolio: portfolio of other securities that has exactly the same value in
one period as the option
 Law of One Price implies that current value of call and replicating portfolio must
be equal
 Binomial tree – timeline with two branches at every date representing possible events
that could happen at those times

o Stock price up – up state

o Stock price down – down state
o By using Law of One Price – able to solve for price of option without know
probabilities of states in binomial tree. That is, we
did not need to specify likelihood that stock would
go up vs down
 Do not need probabilities to value options
 Do not need to know expected return of
stock

 do not require that option we are valuing is call option – can use them to value any
security whose payoff depends on stock price

Problem with simple two-state example: many more than two possible outcomes for
stock price in real world

21.2 Black-Scholes option pricing model

Black-Scholes pricing model can be derived from Binomial Option Pricing Model 
making length of each period, and movement of stock price per period shrink to 0 and
letting number of periods grow infinitely large
S = current price - T = years to expiration - K = exercise price - delta= annual volatility

 Only need 5 input parameters to price call: stock price, strike price, exercise date,
risk-free interest rate (to compute PV of strike price) and volatility of stock
o Do NOT need to know probabilities, expected return on stock to calculate
option price
 Stock’s volatility much easier to compute than expected return – black-scholes can be
very precise

 American call option on non-dividend-paying stock always has same price as

European counterpart  black-scholes can be used to price American or European
call options on non-dividend-paying stocks

 Price of European put from put-call parity

 Dividend-paying stocks – holder of European call option does not receive benefit of
any dividend that will be paid prior to the expiration date of option
 Stock prices tend to drop by amount of dividend when stock goes ex-dividend
o Because European call option is right to buy stock without these dividends, we
can evaluate it using Black-Scholes formula with Sx in place of S

Two approaches of estimating volatility

 Use historical data on daily stock return and estimate its volatility – volatility tends to
be persistent, such estimates can provide reasonable forecast for stock’s volatility in
near future
 Use current market prices of traded options to black out volatility that is consistent
with these prices based on Black-Scholes formula
o Implied volatility: estimate of stock’s volatility that is implied by one
option’s price  implied volatility of one option can be used to estimate value
of other options on stock with same expiration date

Replicating portfolio

 Delta is between 0 and 1 bc N(d) Is normal distribution function

 B is between -K and 0
 Delta has natural interpretation – change in price of option given a $1 change in price
of stock
  Because delta < 1  change in call price less than change in stock price

 Delta between -1 and 0, B

between 0 and K  replicating
portfolio of ut option always
consists of long position in bond and short position in stock  put options on positive
beta will have negative beta

21.3 Risk-neutral probabilities

If all market participants were risk neutral, then ALL financial assets would have the same
cost of capital – risk free rate of interest

Binomial pricing model and Black-Scholes gives same option prices no matter what actual
risk preferences and expected returns are  same prices for securities
 Real world: investors are risk averse  expected return of typical stock includes
positive risk premium to compensate investors for risk
 Hypothetical risk-neutral world, investors do not require compensation for risk 
investors must be more pessimistic to be stock same as in real world  stocks in
reality have expected returns above risk-free rate  expected returns equal to risk-
free rate

 p is not the actual probability of stock price increasing  represents how actual
probability would have to be adjusted to keep stock price same in risk-neutral world
 p and (1 – p) risk-neutral probabilities / state-contigent prices / state prices /
martingale prices

By using probabilities in risk-neutral world, can price any derivative security – any security
whose payoff depends solely on prices of rather marketed assets
 Monte Carlo Simulation: expected payoff of derivative security is estimated by
calculating its average payoff after simulating many random paths for underlying stock price

21.4 risk and return of an option

Call: Delta> 0 and B < 0  call written on stock with positive beta, beta of call ALWAYS
EXCEEDS beta of stock
Put: delta < 0 and B > 0  beta of put option written on positive beta is ALWAYS
NEGATIVE
Put option is hedge so price goes up when stock price goes down!!
Leverage ratio: ratio of amount of money in stock position in replicating portfolio to the
value of replicating portfolio (or option price)

21.5 corporate applications of option pricing

 Debt is risky – betas of equity and debt increase with leverage according to

 Option valuation methods can be used to asses magnitude of agency costs 00> debt
overhang, equity holders benefit from new investment only if

 Equity holders’ incentive to increase volatility can be estimated as sensitivity of value

of equity call option to an increase in volatility
Chapter 22 – Real options

22.1 Real vs financial options

Real option  right to make particular business decision, such as capital investment, after
new info is learned
 allow decision maker to choose most attractive alternative after new info becomes
available  adds value to investment opportunity

Real vs financial option

 Real option, and underlying assets on which they are based, are often NOT traded in
competitive markets

22.2 Decision tree analysis

Decision tree: graphical representation that shows current and future decision and their
corresponding risks and outcomes over time
 include branches to represent different choices available to decision maker
 decision node (invest vs do nothing) that
occurs after information node in decision
tree is real option

 Decision nodes showing choices

available at each stage
o Determine optimal choice by
comparing PV of remaining payoffs along each brand
 Information nodes showing payoff relevant info to be learned
o Compute expected PV of payoffs from subsequent branches
 Investments made and payoffs earned over time

22.3 Option to Delay: Investment as Call Option

 When you have option to invest  usually optimal to invest only when NPV > 0
 Given option to wait, an investment that currently has negative NPV can have positive
value

Counterparts for real options

 Volatility: delaying investment, can base decision on additional info  option to wait
is most valuable when there is great deal of uncertainty regarding value of future
investment  little uncertainty, benefit of waiting diminished
 Dividends: (any value from investment we give up by waiting), always better to wait
unless there is cost of doing

When comparing firms in industry, betas may vary depending upon firm’s growth
opportunities. All else equal, firms for which higher fraction of their value depends on future
growth will tend to have higher beta
 when financial analysts estimate individual project beta by using beta of firm with
substantial growth option  may overestimate project beta
22.4 Growth and abandonment options

 Growth option: when firm has

real option to invest in future
 Abandonment option: firm
may have option to reduce scale of its investment in future – disinvest
o Can add value to project bc firm can drop project if it turns out to be
unsuccessful

 most growth options tend to be out-of-the-

money, growth component of firm value is
likely to be riskier than ongoing assets of firm  young (and small) firms may have higher
returns than older/established firms

Strategy firms may use when undertaking big projects: rather than commit to entire project
initially, firm experiments by undertaking project in stages

If continuing a project is a negative-NPV  can create value by abandoning, regardless of

how much investment has already been sunk into the project

22.5 Investments with different lives

Long-term investment – cost of return advantages

Short-term investment – re-investment option that should be ignored
 3 possibilities after short-term investment
o No replacement: no additional benefits
o Replacement at same term: allowing replacement at same terms substantially
increases NPV of project
o Replacement at improved terms: if terms are expected to improve short-term
investment might be more attractive (higher NPV) than long-term investment

22.6 Optimally Staging investment

Mutually dependent investments: value of one project depends upon outcome of others
 need to determine optimal order of investment that will minimize expected cost of
development

All else equal, most beneficial to make least costly investment first, delaying more expensive
investments until it is clear they are warranted
All else equal, beneficial to invest in riskier and lengthier projects first, delaying the future
investments until greatest amount of info can be learned

Failure cost index: value of uncertainty that is resolved per dollar invested – by undertaking
investments with highest index first we gain most info at lowest cost upfront

22.7 Rules of thumbs

Profitability index
Invest whenever profitability index exceeds a specified level
  RULE: directs you to invest whenever profitability index exceeds some
predetermined number
 when investment cannot be delayed; optimal rule is to invest whenever
profitability index > 0
 when there is option to delay; common rule of thumb is to invest only when index
exceeds higher threshold
Better to wait too long, than to invest too soon!

Hurdle Rate Rule

Uses discount rate > cost of capital to compute NPV; invest whenever NPV calculated
with higher discount rate is positive – does NOT provide accurate measure of value
 callable annuity rate: rate on risk-free rate annuity that can be repaid/called at
any time
 invest whenever NPV of project is positive using hurdle rate as discount

22.8 Key insights

 Out-of-the-money real options have

value: as long as there is chance that
investment opportunity could have positive-NPV in future, opportunity is worth
something today
 In-the-money real options need not to be exercised immediately: if you can delay
investment opportunity, option to delay might be worth more than NPV of
undertaking investment immediately
 Waiting is valuable: if there is no cost to wait, investing early never makes sense
 Delay investment expenses as much as possible: waiting is valuable – only incur
investment expenses at last possible moment
 Tackle hardest problem first
 Create value by exploiting real options: in uncertain environment – real options
create value
Chapter 23 – Raising equity capital

23.1 Equity Financing for private companies

Angel investors: early-stage entrepreneur able to find individual investors; who will provide
initial capital to start their business – often rich, successful entrepreneurs who are willing to
help new companies get started in exchange for share of business
 Number of investors has grown enormously – angel groups have formed; group of
angel investors who pool their money and decide as group which investments to fund
 Cost of setting business dropped dramatically

Angel financing occurs in early stage of business, difficult to assess value of firm; angel
investors circumvent problem by holding convertible note or SAFE rather than equity
 securities are convertible into equity when company faces equity for first time

Venture capital firm: limited partnership that specializes in raising money to invest in
private equity of young firm
 Limited partners: institutional investors (pension funds)
 General partners: run venture capital firm  venture capitalists: charge substantial
fees to run firm and take share of positive return generated by the fund (carried
interest)

Private equity firm: organized much like venture capital firm, but invests in equity of
existing privately held by firms rather than start-up companies
Often initiate investment by finding publicly traded firm and purchasing outstanding
equity, thereby taking company private (leveraged buyout, LBO)

Institutional investors: mutual funds, pension funds, insurance companies, endowments

and foundation manage large quantities of money – major investor in many different
types of assets – also active investors in private companies

Corporate investors: established corporation who purchases equity in younger, private

companies  corporate/strategic investor/partner

Venture capital investing

Founder decides to sell equity to outside investor for first time, common practice for
private companies to issue preferred stock rather than common stock to raise capital
 Preferred stock: issued by mature companies usually has preferential dividend,
liquidation or voting rights relative to common shareholders. Often option to convert
into common stock (convertible preferred stock). If there are financial difficulties,
preferred stockholders have senior claim on firm’s assets relative to common
stockholders. If things go well, will convert preferred into common stock
 Funding round: each time firm raises money, and each round will have own set of
securities with special terms and provisions
o Pre-money valuation: value of prior share outstanding at price in funding
round
o Post-money valuation: value of whole firm (old plus new shares) at funding
round price
Venture capital financing terms
 Typical features of preferred stock (all negotiable)
o Liquidation preference: specifies minimum amount that must be paid to
these security holders – before payment to common stock holders
o Seniority: ensure that they are repaid first – when they have equal seniority it
is called pari passu
o Participation rights: receive both their liquidation preference and any
payments to common shareholders as though they’d have converted shares
o Anti-dilution protection: lowers price of at which investors in earlier rounds
can convert their shares to common, effectively increasing their ownership
percentage in a down round (if things are not going well and firm raises new
funding at lower price than prior round)
o Board membership: may negotiate right to appoint one or more members of
the board

Exit strategy – describes how investors will eventually realize the return from their
investment
 Acquisition
 Public offering

23.2 Initial Public Offering (IPO)

IPO = process of selling stock to public for first time

 Advantages
o Greater liquidity: give private equity investors ability to diversify
o Better access to capital: public companies have larger access to capital through
public markets – in IPO but also in subsequent offerings
 Disadvantages
o Diversification: when investors diversify their holdings, the equity holders of
corporation become more widely dispersed. This undermines ability to
monitor company’s management

Underwriter = investment banking firm that manages offering and designs IPO structure

Primary offering: shares sold in IPO may either be new shares that raise capital
Secondary offering: existing shares that are sold by current shareholders

Smaller IPOs, underwriter commonly accepts deal on best-efforts IPO basis – underwriter
does not guarantee that stock will be sold, but tries to sell stock for best possible price (either
all shares are sold, or deal is called off)

 underwriter and issuing firm agree to firm commitment IPO: underwriter guarantees that
it will sell all of stock at offer price, and then sells all of stock at offer price – if shares are not
sold, underwriter is on the hook (taking loss for cheaper shares)
Auction IPO: let market determine price of stock by auctioning off company – auction IPO
sets highest price such that number of bids at or above price equal number of offered shares

IPO process:
  Underwriters and syndicate: finding the lead underwrites who then arranges for
group of other underwriters (the syndicate) to help market and sell the issue
 SEC fillings: companies need to prepare registration statement (legal document that
provides financial and other info about company to investors) – part of registration
stamen (preliminary prospectus) circulates investors before stock is offered
 Pricing the deal and managing risk: underwriters often use info from book-building
stage to intentionally underprice IPO – reducing exposure to loss

23.3 IPO puzzles

 Underpriced: underwriters generally set price so the average first-day return is

positive. The pre-IPO shareholders bear cost for this under-pricing since these owners
are selling stock in their firm for less than they could get in the aftermarket. If you do
not underprice  might not be able to gain sufficient market share

 winner’s curse: you win, and get all the shares you requested, when demand for
the shares by others is low, and IPO is more likely to perform poorly  may be
substantial enough that it is beneficial to invest in every IPO because it won’t yield
an above-market return

 Cyclicality and recent trends: expect there to be greater need for capital in times
with more growth opportunities than in times with fewer growth opportunities
(cyclicality), but magnitude of swings is surprising. Also, average number of IPOs has
fallen

 Cost of an IPO: seeming lack of sensitivity of fees to issue size: although lager issue
required some additional effort, one would not expect increased effort to be rewarded
as lucratively. Underwriters charging slightly lower fee appear to enjoy a greater
market share. But when fee is too small will give you smaller market shares due to
bad signaling

 Long-run underperformance: shares of IPOs generally perform very well

immediately following public offering. But new firms appear to perform relatively
poor over the following years; performance difference is due to characteristics of firm
that chooses to undergo IPO and not IPO itself

23.4 Seasoned Equity Offering

 offering new shares for sale on equity market

Difference between SEO and IPO process is price setting process. There is no price to be
determined for SEO since market price for stock already exists
Primary shares: new shares issued by company
Secondary shares: shares sold by existing shareholders

Two kinds of SEO:

 Cash offer: firms offers new shares to investors at large
 Rights offer: firms offer new shares only to existing shareholders
Usually, price drops after SEO  often value destroyed by price decline can be a significant
fraction of new money raised
Stock price reaction to an SEO is negative on average
Chapter 24 – Financing

24.1 Corporate debt

Leverage buyout: groups of private investors purchase all equity of public corporation 
public company becoming private

Original issue discount (OID): coupon bond issued at discount

Indenture: formal contract between bond issuer and trust company

Most corporate bonds are coupon bonds – paid in two different ways
 Bearer bonds: whoever physically holds bond certificate owns the bond – provide
explicit proof of ownership to get coupon payment
 Registered bonds: issuer of bond maintains a list of all holders of its bonds
o Facilitates tax collection bc government ca easily keep track of interest
payments

Types of corporate debt

 Notes, debentures, mortgage bonds and asset-backed bonds
o Unsecured debt: event of bankruptcy bondholders have a claim to only the
assets of firm that are not already pledged as collateral on other debt (notes
and debentures)
o Secured debt: specific assets pledged as collateral that bondholders have
direct claim to in the event of bankruptcy (asset-backet and mortgages)

Seniority: bondholder’s priority in claiming assets in event of default

Subordinated debenture: firm conducts subsequent debenture issue that has lower priority
than its outstanding debt

Bond markets
 Domestic bonds: bonds issued by local entity and traded in local market, but
purchased by foreigners
 Foreign bonds: bonds issued by foreign company in local market and are intended
for local investors  in US known as Yankee Bonds
 Eurobonds: international bonds that re not denominated in local currency of country
in which they are issued – no connection between physical location and location of
issuing entity
 Global bonds: features of domestic, foreign and Eurobonds, and are offered for sale
in several different markets simultaneously

 bond that makes payments in foreign country contains risk of holding that currency
and is priced off the yields of similar bonds in that currency

Private debt: debt that is not publicly traded

Syndicated bank loan: single loan that is funded by group of banks rather than just
single bank
Revolving credit: credit commitment for specific time period up t some limit, which
company can use as needed
 Private placement: bond issue that does not trade on public market but rather is sold to
small group of investors

24.2 Other types of debt

 Private debt
 Sovereign debt: debt issued by national governments – Treasury securities (single
largest sector of US bond market)
 Municipal bonds: issued by state and local governments – income on municipal
bonds is not taxable at federal level – tax-exempt bonds
 Asset-backet securities (ABS): security made up of other financial securities –
security’s CF come from CF of underlying financial securities that back it
o Largest sector: mortgage-backed-security (MBS)

24.3 Bond covenants

Covenants: restrictive clauses in bond contract that limit the issuer from taking actions that
may undercut its ability to repay bonds
Think about levered firms – managers want to take action that benefit equity holders
at expense of debt holder
 Restrict ability to pay dividends
 Restrict level of further indebtedness
 Issuer must maintain certain amount of working capital

24.4 repayment provisions

Bonds issuer repays bonds by making coupon and principal payments as specified in bond
contract
Other ways of repaying bonds
 Callable bonds: bonds that include call option that allows issuer to repurchase the
bonds at predetermined price (exercise when e.g. interest rate drop)
 Sinking funds: company makes regular payments into sinking fund administrated by
trustee over life of bond – payments used to repurchase bonds
 Convertible provisions: bonds that can be converted into equity; bondholder has the
option to convert each bonds owned into fixed number of shares of common stock at
ratio (conversion ratio)
 regular bond (written on existing stock)plus special type of call option (warrant –
call option written by company itself on new stock)
Chapter 28 – Mergers and acquisitions

28.1 Background an Historical Trends

Within merger  acquirer/bidder and seller/target firm  takeover

 merger waves: peaks of heavy activity followed by quiet troughs of few transactions

Types of mergers
 Horizontal: target and acquirer in same industry
 Vertical: target’s industry buys or sells to acquirer’s industry
 Conglomerate merger: target and acquirer operate in unrelated industries
o Fallen out of favor – difficulty in creating value when combining two
unrelated businesses

 Stock swap: receiving stock – target shareholders are swapping their old stock for
new stock in either acquirer or the newly created merge firm
 Term sheet: structure of merger transaction

28.2 Market Reaction to a Takeover

Unlikely that bidder acquire target company for less than current market value  most
acquirers pay acquisition premium: percentage difference between acquisition price and
premerger price of target firm

28.3 Reasons to acquire

 Synergies: two categories

o Cost reduction: layoffs of overlapping employees and elimination of
redundant resources
o Revenue enhancement: creating possibilities to expand new markets or gain
more customers
 Economies of scale: savings from producing high volume which is not available to
small countries
Economies of scope: savings that come from combining marketing and distribution
of different types of related products
 Expertise
 Monopoly gains: mergers enables firm to substantially reduce competition within the
industry and thereby increasing profits
 Efficiency gains: achieved through elimination of duplication
 Tax savings from operating losses: since you pay taxes over profits, losses in one
division may be offset by profits in another  since you do not pay taxes over losses
(conglomerate merger)
 Diversification
o Direct risk reduction
o Lower cost of debt or increased debt capacity
o Asset allocation – reallocate assets across industries
o Liquidity enhancement
  Earning growth: EPS may exceed the premerger earnings of either company even
when the merger itself creates no economic value
 Managerial motive to merge
o Conflicts of interest
o Overconfidence

28.4 Valuation and takeover process

Tender offer: public announcement of its intention to purchase a large block of shares for a
specified price – can use two methods of payments: cash and stock
 stock swap merger is. Positive NPV investment for acquiring shareholders if the share
price of the merged firm exceeds the premerger price of the acquiring firm

 Friendly takeover: target board of directors supports the merger, negotiates with
potential acquirers and agrees upon a price that is ultimately put to a shareholder vote
 Hostile takeover: board of directors fight takeover attempt
o Acquirer often called raider

28.5 Takeoff defences

Proxy fight: acquirer attempts to convince target shareholders to unseat board by using their
proxy votes to support acquirer’s candidates for election to the target

 price offered determined by exchange ratio – number of bidder shares received in

exchange for each target – multiplied by market price of acquirer’s stock

 Poison pill: rights offering that gives existing target shareholders the right to buy
shares in target at deeply discounted price once certain conditions are met
o Rights offering dilutes value of any share held by acquirer, dilution makes
takeover too expensive
 Staggered boards: prevent a coup – every director serves prespecified term and after
that term a new director is appointed (laagjes)
 White knights: look for more friendly acquirer (white knight) when takeover is not
preventable
 Golden parachutes: extremely lucrative severance package that is guaranteed to
firm’s senior managers in event that firm is taken over and the managers are let go –
lessens likelihood of management entrenchment
 Recapitalization: recapitalizing to make capital structure less attractive
 Regulatory approval: all mergers must be approved

28.6 who gets the value from takeover?

Free rider: existing shareholder do not have invest time and effort, but they still participate
and benefit from gains (increase stock)

Toeholds: buy the shares in market anonymously to get initial stake in target firm

Leveraged buyout: borrowing money through a shell corporation by pledging the shares
themselves as collateral on the loan
Freezeout merger: laws on tender offers allow acquiring company to freeze existing
shareholders out of the gains from merging by forcing non-tendering shareholders to sell their
shares for tender price offer

When bidder makes offer for firm, target shareholder can benefit by keeping their shares and
letting other shareholders sell at low price. However, bc all shareholders have incentive to
keep their shares, no one will sel. This scenario is known as free rider problem. To overcome
this problem, bidders can acquire a toeholds in target, attempt a leveraged buyout, or, in
case when acquirer is corporation offer a freezeout merger
Chapter 29 – Corporate Governance

29.1 corporate governance and agency costs

Corporate governance: system of controls, regulations and incentives designed to prevent

fraud
 story of conflicts of interest and attempts to minimize them

Agency conflicts likely to arise any time manager does not internalize the full cost of his
actions  closely aligning the interest of managers and shareholders increases the risk
exposure of managers

Corporate governance tries to mitigate conflict of interest that results from separation of
ownership and control without underly burdening managers with risk of firm

29.2 monitoring by board of directors

Simple solution to conflicts: monitoring – but this takes costs, no one wants to take this cost
into account

Types of directors
 Inside directors: employees, former employees, family members of employees
 Gray directors: people who are not as directly connected to firm as insiders are, but
who have existing or potential business relationship with firm
 Outside (or independent) directors: all other directors, most likely to make decision
solely in interest of shareholders
o Common to pay outside directors with stocks; aligns interests with
shareholders

Board is captured when its monitoring duties have been compromised by connections or
perceived loyalties to management

Dodd-Frank Act (2010): required that all members of firm’s compensation committee be
independent board members
While independent directors are unbiased, they also least likely to be experts in firm’s
business

Smaller boards associated with greater firm value and performance: smaller groups make
better decisions than larger groups

29.3 compensation policy

In absence of monitoring, conflict of interest between managers and shareholders can be

mitigated by closely aligning their interest through manager’s compensation policy

Different ways of linking manager’s pay to their performance

 Bonusses based on firm performance
  Granting stocks to managers

Backdating: practice of choosing grant date of stock option retroactively, so that date of
grant would coincide with dare when stock price was at its low for quarter or for the year 
executive receives stock that is already in-the-money

29.4 Managing agency conflict

If all else fails  shareholder’s last line of decline is direct action: they have different
options for expressing they displeasure
 Resolution: put to a vote at annual meeting – rarely receive majority but if they are
backed by large shareholders it is embarrassing for the managers
 No votes: refuse to vote to approve the slate of nominees for the board
 Shareholders must approve any major action taken by board
 Say on pay votes: nonbinding vote to approve or disapprove of compensation plan for
senior executives each year
 Holding proxy contest: entails introducing rival slate of directors for election of the
board  announcement of proxy contest likely increases stock price

29.5 regulation

Sarbanes-Oxley Act (SOX – 2002)

Overall intent of legislation was to improve the accuracy of info given to both boards and
shareholders
 Overhauling incentives and independence in auditing process
 By stiffening penalties for providing false info
 Forcing companies to validate their internal financial control process

Auditing firms are supposed to ensure that company’s financial statements accurately reflect
their financial state – BUT most auditing firm shave long-standing relationships with their
audit clients  make auditors less willing to challenge management

Section 404: senior management and boards of public companies require to be comfortable
enough with process through which funds are allocated and controlled to be willing to attest
to their effectiveness and validity

Dodd-Frank Act (2010)

Spurred by 2008 financial crisis – includes several clauses to strengthen governance
 Independent compensation committee: fully independent board member
 Nominating directors: large shareholders may nominate candidates for board of
directors
 Vote on executive pay and golden parachutes: firm must provide shareholders with
non-binding vote on compensation of firms CEO, CFO and three most highly paid
executives (leidinggevenden)
 Clawback provision: public companies must establish policies that allow firm to take
back up to three years of an executive incentive compensation erroneously awarded in
the vent of accounting restatement
  Pay disclosure: companies must disclosure ratio of CEO annual total compensation
to that of median employee – disclosure the relationship between firm performance
and executive compensation

Insider trading: conflict of interest between managers and outside shareholders – occurs
when person makes trade based on privileged info – managers have access to info that
outside investors do not
 by using this info managers can exploit trading opportunities that are not available to
outside investors

29.6 Corporate governance around the world

Ways to gain control over firm for families

 Dual class shares: scenario in which companies have more than one class of shares
and one class has superior voting rights over the other class
 Pyramid structure: family first creates company in which it own more than 50% of
the shares, this company then owns controlling interest in another company
 tunneling: family has incentive to try and move profits up the pyramid

Stakeholder model: giving explicit consideration to other stakeholders – rank-andfile

employees

Keiretsu: groups of firms connected through cross-holdings and a common relation to a bank
 Japan often biggest shareholder is another firm

29.7 tradeoff of corporate governance

Corporate governance is system of checks and balances that trades off costs and benefits
Good governance is value enhancing and so, in principle, is something investors in the firm
should strive for  many ways to implement good governance, one should expect firms to
display wide variation in their governance structures