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• Objective of the capital budgeting decision: to find real assets that are worth more than
what they cost
• Present value calculation: To arrive at the PV, expected future payoffs are discounted by
the rate of return denoting the opportunity cost of capital, which is the return forgone by
investing in the project rather than investing in the capital market.
• What about risk? To account for risk, we have to think of expected payoffs and the
expected rates of return.
• Decision rules:
1. NPV rule: Accept investments with + NPVs.
And invest so as to maximize the NPV of the investment. This is the difference
between the discounted value (PV) and the initial investment.
2. Rate of return rule: Accept investments with rates of return above the opportunity cost
of capital; that is:
[(expected value - initial investment)/initial investment] > opportunity cost of capital
In view of productive opportunities, invest up to the point at which the marginal return
on investments is equal to the rate of return on investments in the capital market. This
is the point of tangency between the interest-rate line and the investment-opportunities
line.
Note: The opportunity cost of capital is not:
1. The risk-free rate. The investment is risky!
2. The rate imposed on the loan provided by the project. This rate does not reflect the
health of the existing business. It does not also matter whether the loan is made or not.
The decision maker still has to decide whether to invest in the project or in an equally
risky stock.
• Irving Fisher: Managers do not need to know anything about the personal tastes of their
shareholders and should not consult their own tastes. Their task is to maximize NPV.
Copeland/Weston: Exchange opportunities permit borrowing and lending at the same rate
of interest. Thus, different shareholders will be unanimous in their preference as regards
production decisions. Managers will then choose to invest until the rate of return on the
least favorable project is exactly equal to the market-determined rate of return.
Chapter 5, 6 & 11: Why NPV Leads to Better Investment Decisions (B/M and C/W put
together)
• Risk: the uncertainty of future returns, the spread of outcomes usually measured by the
standard deviation/variance
If returns are normally distributed, we only need the mean and variance to assess risk and
return
• Diversification: reduces variability: the risk of the PF < sum of the risks of components
This is because prices of different stocks do not move exactly together. Putting them
together eliminates "unique" risk (= unsystematic risk, specific risk).
Market risk is however undiversifiable. This is what matters most in a well-diversified PF.
The diversification concept cannot however be transposed to the level of firms. Investors
are better off in doing the diversification itself via the securities held in the PF. Firms will
just incur high costs and waste time.
Value additivity: Diversification does not add to a firm's value or subtract from it. The
total value is the sum of its parts.
• Calculating PF risk
2-stock PF:
The variance of the PF = weighted average of the variances + covariance = X12 var1 + X22
var2 + 2 X1 X2 cov1 2
Many stocks:
n
Var (PF) = å (Xi Xj varij )
i =1, j=1
• The company cost of capital is the correct discount rate for projects that have the same
risk as the company's existing business but not for those projects that are riskier or safer
than the company's average. In the estimation of the beta of a project:
o look for similar companies (But what does "similar" mean?... This can also shift
over time.)
o look at how the stock price has responded to market movements in the past.
beta = slope of the line that regresses the rates of return against the market rates
o take PF betas or industry betas that are market-value weighted. The standard error
thereby is smaller.
o set the project beta equal to the asset beta. Reasons:
§ most projects can be treated as "average" projects
§ the company cost of capital is a useful starting point for unusually risky
projects as compared to estimating each project's cost of capital from
scratch.
In determining the asset beta, consider cyclicality and operating leverage (fixed
production charges that add to the beta of a project)
• Note that beta is assumed to be constant throughout a project's life. It makes sense to use a
single risk-adjusted discount rate for as long as the project has the same market risk at
each point of its life. Later CFs are thereby subjected to a higher discounting because they
are subjected to a longer market risk horizon. To account for varying risk across time, it
may be wise to use probability point masses for possible CFs and separately calculate their
NPVs while weighting them to come up with the total NPV.
• On average, internal funds make up the bulk of company funds. This could possibly
reflect an unjustified reluctance to undertake projects that require external financing.
Retained earnings are additional capital invested by shareholders and represent in effect a
compulsory issue of shares. This does not affect the opportunity cost of capital in the same
way as when a project is financed by depreciation or a new stock issue. Are managers
simply taking the line of least resistance and avoiding the "discipline of security markets"?
Are they avoiding the costs of new issuances? Is the announcement of a new equity issue
considered to be bad news?
• Recently, firms have issued more debt than equity. But this could not be proven to be a
long-term phenomenon. Higher debt ratios mean that more companies will fall into
financial distress if there will be a recession. But it need not follow that less risk is better.
There is no God-given, correct debt ratio.
• Overview of Corporate Financing
1. Common stock: issued and outstanding, issued and not outstanding (repurchased
shares)
Costs of new issues:
§ Administrative costs
§ Underwriting costs (+ underpricing costs)
New issuance procedure:
§ Fixed price offer
§ Auctions
2. Preferred stock: relatively rare but useful in financing mergers: offers a fixed dividend
and priority over common stockholders
3. Debt: funded/unfunded debt, subordinated debt, secured/unsecured debt,
public/privately placed debt
4. Convertible securities: Warrants, convertible bonds (Chapter 22)
5. Derivatives:
§ Options: Instruments with the right to buy/sell an asset in the future at a
price agreed upon today
§ Futures: Advanced orders to buy/sell an asset at a fixed price to be paid at
the delivery date
§ Forwards: Futures contracts not traded in an exchange; usually on foreign
exchange
§ Swaps: Entail an exchange of payment obligations: currency or interest rate
• Causes of innovation:
o Taxes and regulation (avoidance)
o To widen investor choice, esp. for hedging
o Reduction of costs
• Points to Note:
o There are economies of scale in issuing securities.
o Underpricing is a hidden cost for the existing shareholders
o The winner's curse: Would-be investors in an IPO do not know how other
investors will value the stock. There are worries that they will end up paying for
overpriced issues.
o New issues may depress the price.
Chapter 17 &18: Does Debt Policy Matter?/How Much Should a Firm Borrow?
• The manager has to find the combination of securities that maximizes the value B/M
of the firm or that maximizes shareholder value.
No complete satisfactory theory has been found for the existence of an optimal C/W
capital structure. Casual empiricism suggests that firms behave as though it
exists.
If there is a target dividend payout, then there must also be a target debt/equity B/M
ratio.
• Miller/Modigliani I: Financing decisions do not matter.
Any combination of securities is as good as another. The value of the firm is
unaffected by its choice of capital structure.
Assumptions:
o perfekte Kapitalmärkte, d.h. keine Transaktionskosten C/W
o keine Steuern
o same borrowing and lending rate
o no bankruptcy costs
o no agency costs
o only two types of claims: debt and equity B/M
o all firms of the same risk class
In well-functioning markets, two investments that offer the same payoff must
have the same cost. Thus, two firms that offer the same stream of operating
income and differ only in their capital structure must have the same cost.
Therefore, the value of an unlevered firm must equal the value of the levered
firm.
As long as investors can borrow/lend on their account on the same terms as the
firm, they can “undo” the effect of any changes in the firm’s capital structure.
Thus, debt policy should not matter.
Law of conservation of value: The value of an asset is preserved regardless of the B/M
nature of the claims against it. As proposed by value additivity, the value of a
firm can be segregated into the corresponding PVs of the components. Firm
value is in this case determined by the left side of the balance sheet (i.e., real
assets) and not by how much debt and how much equity there are.
But MM I does not hold in practice. Financial managers do worry about debt C/W
policy:
o Taxes play a role.
o Bankruptcy is painful.
o There are conflicts of interest between the firm’s security holders.
o There are incentive effects of financial leverage on management’s
investment and dividend payout decisions.
• Miller/Modigliani II: The value of the levered firm is equal to the value of the B/M
unlevered firm plus the present value of the tax shield provided by the debt, i.e.,
the gain from leverage.
V L = V U + τc B
New assumptions: corporate tax, no personal tax
If the government allows the deduction of interest payments on debt as an
expense, the market value of the corporation can increase as it takes on more and
more debt.
But MM Proposition II is an extreme proposition. If the PV of the tax shield
increases the after-tax value of the firm, then the firm should ideally take on C/W
100% debt. This is wrong because:
o It will appear that debt is fixed and perpetual. It is wrong to think of debt
as such.
o Many firms face marginal tax rates less than 35%.
o Tax shields can only be used when there are future profits to shield. No
firm can absolutely be sure of that.
o There are other factors that offset the PV of the tax shield. Firms incur for
example bankruptcy costs.
Given corporate and personal taxes: The firm should arrange its capital structure
so as to maximize after-tax income. It should try to minimize the PV of all tax
paid on corporate income. This includes the personal taxes paid.
• Extreme levels of debt are also inadvisable because of the risk/return tradeoff.
Any increase in expected returns is offset by an increase in risk, and thus, the
shareholders’ required rate of return also increases.
• Moreover: Tradeoff theory of capital structure: Costs of financial distress matter.
There is a tradeoff between tax shields and costs of financial distress.
VL= VU + PV(tax shield) – PV (costs of financial distress)
The theoretical optimum of debt is reached when:
PV(tax savings due to additional borrowing) = increases in the PV(costs of
distress) B/M
Thus, target debt ratios may vary from firm to firm. High ratios are expected
from companies with safe, tangible assets and plenty of taxable income to shield.
Low target ratios are expected from companies with risky, intangible assets. B/M
Effect of bankruptcy costs: If there are bankruptcy costs, then payments must be
made to third parties other than bond and shareholders. The value of the firm will
be lower than the discounted expected CFs. As the proportion of debt is
increased, the probability of bankruptcy increases. Hence, the optimal capital
structure results from a consideration of the required rate of return of debt claims.
In the end, WACC must be minimized.
• “Traditional” position: The objective is not just to maximize overall market
value but also to minimize WACC. A moderate degree of financial leverage may
increase the expected equity return, although not to the degree predicted by
Proposition II. Imperfections make borrowing costly and inconvenient.
• Another factor leading to the violation of M/M II: government manipulations
• Signalling Hypothesis: There is a projected optimal capital structure. Managers
convey information to the market through their financial policy decisions. That
includes changes in capital structure and dividend policy. Signals cannot be
mimicked by unsuccessful firms. This is also evident in Myer’s pecking order B/M
theory.
• Pecking order theory: Retained earnings, debt, equity. Asymmetric information
affects the choice between internal and external financing and between new
issues of debt and equity securities. There is no well-defined target ratio. The B/M
attraction of tax shields is second-order. Highly profitable firms with limited
investment opportunities are the ones with low debt ratios. On the other hand,
firms, whose investment opportunities outrun internally generated funds are
driven to borrow.
• Effect of agency costs: There is a trade-off between tax shield benefits and
agency costs. There is an optimal capital structure that minimizes agency costs.
• There are other ways to shield income against tax, e.g., by means of write-offs.
Corporate tax shields from debt are worth more to some firms than to others.
Firms with plenty of non-interest tax shields and uncertain prospects should
borrow less than consistently profitable firms with lots of taxable income to
shield.
Chapter 19: Financing and Valuation
Chapter 20 & 21: Spotting and Valuing Options and Real Options
• Any set of contingent payoffs -- that is, payoffs which depend the value of some other
asset -- can be valued as a mixture of simple options on that asset
• Option Value Boundaries:
o Upper bound: Share price
o Lower bound: Payoff
When the stock is worthless, the option is worthless.
When S increases, the option price = S - PV(K).
The higher S is, the more probable is the exercise of the option.
Investors, who acquire stock by way of a call option, are buying on credit. The delay in
payment is valuable, if interest rates are high and the option has a long maturity.
• DCF will not work for options.
o Forecasting expected CFs is messy although feasible
o Finding the opportunity cost of capital is impossible, because the risk of an option
changes every time the stock price moves (and we know that it will move along a
random walk through the option's lifetime).
General rule: The higher S is relative to K, the safer the option, although the option is
always riskier as the stock. The option's risk changes every time the stock price changes.
To value an option, set up an option equivalent by combining common stock investment
and borrowing. The net cost of buying the equivalent must equal the value of the option.
This is covered by the OPM, discussed subsequently.
• Black/Scholes Formula: In pricing any option, set up a package of investments in the stock
and a loan that will exactly replicate the payoffs of the option. If we can price S and B, we
can also price the option.
C= S N(d1) - B N(d2), where N(d1) and Nd(2) are cumulative probabilities of the
distribution of a standard unit variable
• Put-Call Parity: Value of Call + PV(K) = Value of Put + S
C = P + S - B; P = C + B - S; S = C + B - P
• Early Exercise of Options?
o American Calls (No Dividends): Same as European call, because early exercise
reduces its value; B/S applies
o American Calls (W/ Dividends): If Div > interest on K; Valuation via the step-by-
step binomial method
o American Puts (No Dividends): American Put > European Put, American Put –
European Put <= PV(interest on K)
It can sometimes pay to exercise early and receive interest. Valuation via the step-
by-step binomial method. Check out at each node whether early exercise is good.
• Examples of Real Options
1. The option to follow-on investment opportunities
The true value of a project could be the DCF value + the value of the option to expand.
Management can add value to assets by responding to changing circumstances. They
can take advantage of good fortune or mitigate loss. DCF misses on this extra value. It
thus neglects the value of management.
2. The option to abandon
Value of project = DCF value + the value of the abandonment put
3. The timing option
In the face of uncertainty, the success of an investment in a positive NPV project
depends on the timing. It is thus like a call option.
4. The option to vary the firm's output or production methods (flexible production
facilities)
A firm will be granted the option of exchanging one risky asset for another...
• Valuation of real options: Black/Scholes, if not binomial method
Option theory gives a simple, powerful framework for describing complex decision trees.
An opportunity to postpone investments could be summarized as an "American call on a
perpetuity with a constant dividend yield". Not all can be easily replicated but
approximations by some simple assets and options may be worth it.
What would investors pay for a real option based on the project? The same as for an
identical traded option written on a double. This double does not have to exist. It is
enough to know how it would be valued by investors, who could employ either the
arbitrage or risk-neutral method.
• Warrant:
1. What it is: an option whereby the owner can purchase a set number of shares at a set
price before the set date. Usually:
§ included in a large private placement bond or in a small public issue
§ sometimes with issues of common or preferred stock
§ also given to investment bankers as compensation for underwriting services
or used to compensate creditors in case of bankruptcy
§ no right to vote or to receive dividends
2. Valuation
§ B/S Formula, when no unusual features, no dividends
§ Step-by-step binomial method, when with dividends. (Early exercise, when
DIV > interest on K)
3. Effects of the Exercise of Warrants:
The exercise of warrants increases the number of shares. Therefore, exercise means
that the firm's assets and profits would be spread over a large number of shares. ==>
dilution
Modifications are necessary to the B/S formula in valuing the warrant. (But such is not
needed by the holder, who will simply exercise or not exercise.)
• Convertible Bond:
1. What it is: The option to exchange the bond for a predetermined number of shares.
Thus the owner owns a bond and a call option on the firm's stock.
2. Valuation:
Two lower boundaries! The lower bound to the price of a convertible before maturity
is the higher of the bond value and conversion value. At maturity, the conversion value
serves as the lower bound.
To value a convertible, it is then easiest to break the convertible bond into two parts:
the bond value and the value of the conversion option.
To value the conversion option, look out for dilution and the fact that the convertible
owner is missing out on the dividends on the stock. If dividends are higher than the
interest on bonds, it may pay to convert before maturity.
3. Effects of the Conversion:
Conversion has no effect on the total value of the firm's assets, but it does affect how
asset value is distributed among the different classes of security holders.
• The difference between warrants and convertibles:
1. When the owners of the convertible bond wish to exercise the option to buy shares,
they do not pay cash. They just give up the bond.
2. Warrants are usually issued privately.
3. Warrants can be detached.
4. Warrants may be issued on their own.
5. Taxation: warrants may reduce the tax paid by the issuing company and increase the
tax paid by the investor.
• Why do companies issue warrants and convertibles?
1. Cash inflow/Better than fresh equity
A company that wishes to sell common stock must usually offer the new stocks at 10%
to 20% below the market price for the flotation to be a success. However, if warrants
are sold for cash, exercisable at 20 to 50% above the market price, the result will be
equivalent to selling stock at a premium rather than at a discount. If the warrants are
never exercised, the proceeds from their sale will become a clear profit for the
company!
Options can also be considered as valuable securities, despite the risk and time value
involved. If options are properly priced, this will be a fair trade. Its market value is
hinged on the stock price tomorrow, which could be favorable.
2. Costly risk assessment
Convertible bonds and warrants make sense whenever it is unusually costly to assess
the risk of debt
3. Agency Costs
Bondholders may be worried that management will not act in the bondholders' interest.
4. Contingent equity
A convertible bond that is callable is like a contingent issue of equity. If a company's
investment opportunities expand, its stock price is likely to increase, allowing the
financial manager to call back and force conversion of the bond into equity. Thus, the
company gets fresh equity when it is most needed for expansion. (But it will be stuck
with debt, if the company does not prosper.)
5. Low coupon bonds
This may be convenient for rapidly growing firms facing heavy capital expenditures.
==> If you can value puts and calls on a firm's assets, you can value its debt.
• Lease = a rental agreement on a series of payments that extends for a year or more.
It is an alternative to buying capital equipment.
For operational leases, the decision centers on "lease vs. buy".
For financial leases, the decision centers on "lease vs. borrow".
• Why lease?
1. Short-term leases are convenient.
2. Cancellation options are available.
3. Maintenance is provided.
4. Standardization leads to low administrative and transactions costs.
5. Tax shields can be used.
• If you can devise a borrowing plan that provides the same future cash outflows as the
lease but a higher immediate CF, then you should not lease.
However, if the equivalent loan provides the same future cash outflows as the lease, but a
lower immediate inflow, then leasing is the better choice.
A financial lease is superior to buying and borrowing if the financing provided by the
lease exceeds the financing generated by the loan.
• Valuation of a lease:
Construct a table showing the equivalent loan (difficult) or discount the lease CFs at the
after-tax interest rate that the firm would pay on an equivalent loan.
Net value of lease = initial financing provided - discounted summation of lease CFs
• Not a zero-sum game:
Both the lessor and the lessee can "win" if their tax rates differ. The highest gains are
achieved when:
o The lessor's tax rate is substantially higher as the lessee's.
o The depreciation tax shield is received early in the lease period.
o The lease period is long and the lease payments are concentrated toward the end of
the period.
o The interest rate is high.
If it were 0, there would be no advantage to postponing tax in PV terms.
• Insurance and hedging are at best 0-NPV transactions. The aim is risk reduction.
Insurance deals may however not have 0-NPVs because of the costs that the insurance
company incurs.
• Hedging:
o Futures: A commitment to buy/sell an asset/commodity in a standardized market at
a future time, while fixing the price today.
A margin is normally put up, and the value is marked to market.
Advantage: You can gain interest on the still unpaid price
Disadvantage: You miss out on the dividend paid in the meantime.
Financial assets: PV(futures) = Futures price/(1 + rf) = spot price - PV(dividends or
interest payments forgone)
Commodities: PV(futures) = Futures price/(1 + rf) = spot price + PV(storage
costs) - PV(convenience yield)
o Forwards: Unstandardized futures
o Swaps: Currency swaps, interest rate swaps, default swap (credit derivative).
• How to set up a hedge:
Expected change in value of A = a + δ(change in value of B)
δ measures the sensitivity of A to changes in the value of B ==> hedge ratio: the number
of units of B which should be sold to hedge the purchase of A. One minimizes risk by
offsetting the position in A by selling delta units of B.
Assumptions:
o A is owned
o Percentage changes in the value of A follow the specified relationship
The question is: How is the hedge ratio determined? Historical data may help.
Another method: via duration and PVs (matching assets and liabilities)
• The option delta: summarizes the link between the option and the asset. Options can thus
be used for hedging. Any change in the value of the stock position can be offset by a
change in the value of the option position.
Note: Option deltas change as the stock price changes and time passes. Therefore, option-
based hedges need to be adjusted frequently.
• Points to consider:
o Interest rate parity theory: Money can otherwise be easily moved.
o Equal real interest rates
o Expectations theory of forward rates: On the average, the forward rate is equal to
the future spot rate. A company that covers its forex commitments does not pay
extra for this insurance.
o Purchasing power parity
• Practical Implications:
o Use forward rates to adjust for FX risk in contract pricing.
o The expectations theory suggests that protection against FX risk is usually worth
having.
o On the basis of interest rate parity, hedge by either selling a forward or borrowing
forex and selling spot.
o The cost of forward cover is not the difference between the forward rate and
today's spot rate. It is the difference between the forward rate and the expected spot
rate when the forward contract matures.
• Exchange risk and international investment decisions:
If Roche, for example, ignores currency risk and discounts the dollar CFs at a dollar cost
of capital for its US investments, it is assuming that the currency risk is hedged. This is
equal to calculating the CFs in SFR and discounting this at the SFR cost of capital.
Chapter 28: Financial Analysis and Planning
• Financial ratios: a convenient way to summarize large quantities of financial data and to
compare firms' performances. They assist in asking the right questions but seldom answer
them.
1. Leverage Ratios: show how heavily the company is in debt
§ Debt ratio = (long-term debt + value of leases)/(long-term debt + value of
leases + equity)
==> ratio of long-term debt to long-term capital
§ Debt-equity ratio = (long-term debt + value of leases)/equity
The abovementioned ratios use book rather than market values. Market
values are often not available. It does not probably matter much, because
market values include the value of intangible assets, and these are not
readily saleable.
§ Time-Interest-Earned (Interest Cover) = (EBIT + depreciation)/interest
==> The extent to which interest is covered by EBIT plus depreciation
Rationale: Regular interest payment is a hurdle that companies must duly
face up to.
2. Liquidity Ratios: measure how easily the company can lay its hands on cash
§ Current ratio = current assets/current liabilities
==> measures the margin liquidity
Rapid decreases in the current ratio sometimes signify trouble. However,
they can be misleading. At times, the net working capital is not affected by
short-term financial decisions and yet the current ratio changes. For this
reason, it may be good to take away short-term investments and debt.
§ Quick ratio (acid test) = (cash + short-term securities + receivables)/current
liabilities
Idea: Some assets are closer to cash than others.
§ Cash ratio = (cash + short-term securities)/current liabilities
Only the most liquid assets
Note: None of the standard liquidity measures takes the firm's reserve borrowing
power into account. Lenders however look into liquidity ratios because of their
reliability as against book values.
3. Efficiency Ratios: indicate how productively the company is using its assets
§ Sales-to-Assets Ratio (Asset Turnover) = sales/average total assets
==> how hard are the firm's assets being used?
A high ratio means that the firm is working close to capacity. It may be
difficult to generate further business without an increase in invested capital.
§ Days in Inventory = average inventory/(cost of goods sold/365)
==> the speed with which a company turns over its inventory; the number
of days that it takes for the goods to be produced and sold
A low level of inventories is often regarded as a sign of efficiency. But it
may indicate simply that the firm is living from hand to mouth.
[Inventory Turnover = cost of goods sold/average inventory]
§ Average Collection Period = average receivables/(sales/365)
==> how quickly do cusotmers pay their bills
A low ratio indicates an efficient collection department but could mean an
unduly restrictive credit policy.
4. Profitability Ratios: show the returns that the firm earns from investments
§ Net Profit Margin = (EBIT - tax)/sales
==> the proportion of sales that finds its way into profits
§ Return on Assets = (EBIT - tax)/average total assets
(or ROI)
ROE = earnings available for common stockholders/average equity
§ Payout Ratio = Dividends/Earnings
==> the proportion of earnings that is paid out as dividends
5. Market Value Ratios: show how highly the firm is valued by investors
§ P/E ratio = Stock price/EPS
==> measures the price that investors are prepared to pay for each dollar
earnings
High P/E ratios: investors think that the firm has good growth opportunities
or its earnings are relatively safe and therefore more valuable.
This could however also mean temporarily low earnings.
§ Dividend yield = Dividend per share/stock price
==> the expected dividend as a proportion of the stock price
Low dividend yield: investors are content with a relatively low rate of
return or are expecting rapid growth in dividends that could bring in capital
gains.
§ Market-to-Book ratio = Stock price/Book value per share
[Book value per share = stockholders' book equity (net worth)/number of
outstanding shares]
[Book equity = common stock + retained earnings]
==> how much is the firm worth in comparison to what the past and
present shareholders have put into it
§ Tobin's q = market value of assets/estimated replacement cost
~ market-to-book ratio. The difference is that the numerator includes all
debt and equity securities and the denominator includes all assets.
There is an incentive to invest when q > 1, i.e., capital equipment > cost of
replacement.
It may be cheaper to acquire assets through mergers when q < 1.
• Accounting Definitions: Things to think about when interpreting financial ratios:
o Depreciation and deferred tax
o Intangible assets (expenditures that create valuable assets that may generate future
CFs)
o Goodwill
o Off-balance sheet debts (esp. short-term leases)
o Pensions
o Derivatives
o Foreign accounting practices
• Examples on the use of financial ratios:
1. Bond issuance:
The financial manager looks into the prudence of new borrowings and whether the
leverage is within the standard practice levels. He thus looks at the debt ratio and
times-interest-earned ratios.
The rating agencies look at the creditworthiness of the firm and their ability to service
new debt. They then also look at leverage ratios.
The lenders are interested in bond quality. They also look at the leverage ratios.
2. Review of operations to identify which activities should be shut down or expanded:
The manager looks at the ROA of each business.
The shareholders do the same and welcome high ROAs.
Consumer groups and regulators do likewise, but as ask: if there is a high ROA, is the
firm charging excessive prices?
3. By means of financial ratios, "accounting betas" may also be calculated. This is the
sensitivity of each company's earnings to changes in the aggregate earnings of all
companies. This can help in predicting bond ratings.
• Short-term financial decisions involve short-lived assets and liabilities. This is because
they are easily reversed. The financial manager does not have to look far into the future.
• The cumulative capital requirement -- the total cost of assets -- should be financed by
either long-term or short-term financing. Short-term capital comes in when the firm must
make up for the difference between cumulative capital requirements and long-term
financing. If long-term capital is overflowing, surplus cash can be allotted for short-term
investments.
• The financial manager's task is to forecast future sources and uses of cash
Cash budgeting: Inflows and outflows
Short-term financing plan: developed by trial and error
• Alternatives for short-term financing:
1. Unsecured bank borrowing
2. Stretching payables - defer payment of bills (often costly because discount for early
payments are missed)
• Steps:
1. Fix terms of sale
2. Decide whether to sell an open account or ask customers to sign IOUs
3. Which customer should be offered credit?
• Credit analysis:
o ratings agency indications
o financial ratio analysis
o numerical credit scoring: decisions to grant credit are made on the basis of a
scoring system
• A merger adds value only if the two companies are worth more together than apart.
• Types:
o Horizontal merger: same line of business
o Cross border: in two different countries
o Vertical merger: companies at different stages of production
o Conglomerate merger: unrelated lines of business
• Motives:
o Economies of scale (horizontal mergers)
o Economies of vertical integration (vertical mergers)
o Complementary resources
o Unused tax shields
o Surplus funds
o Elimination of inefficiencies; better management (not essentially out of the benefit
of combining two firms)
• Takeover Battles and Tactics:
o Shark-repellent charter amendments:
§ Staggered board: 3 groups, only one group is elected every year
§ Supermajority: 80% have to approve a merger
§ Fair price: Mergers are allowed only when a fair price is paid.
§ Restricted voting rights: if they own more than a specified proportion of
shares
§ Waiting period: passage of time before merger completion
o Poison pills: Existing shareholders are given the right to purchase additional stocks
at a bargain price
o Poison put: Existing bondholders can demand repayment in a hostile takeover
• Post-Offer Defenses:
o Litigation - Anti-trust
o Asset restructuring
o Liability restructuring