Corporate Finance

sem1

__seasoned equity offering__

any issuance of shares that follows IPO on stock market

__Pros of IPO__

1. Source of financing:
2. Strategic advantages: (publicity for company, facilitates M&A activity, management compensation using stock options)

Costs of IPO

1. Transparency
2. Direct costs of IPO
3. Agency problems

Underwriter:

firm that buys an issue of securities from a company and resells it to the public

Underwriting Arrangements:

1. Firm commitment: underwriters buy securities from firm and resell them to the public
2. Best Efforts Commitment: Underwriters agree to sell as much of the issue as possible but do not guarantee the same of the entire issue
3. Flotation Costs: costs incurred when a firm issues new securities to the public

__Spread:__

difference between public offer price and price paid by underwriter

PV (dividends)

market value of equity

Free Cash Flows (FCFF)

Market value of firm = equity + debt

__Cost of capital (COC):__

a company’s calculation of the minimum return that would be necessary in order to justify undertaking a capital budgeting project

= how much a company would need in order to justify purchasing new equipment/building/etc

- based on average beta of assets

Random walk:

the movement of stock prices from day to day to not reflect any pattern

* generally speaking, they are skewed positive over the long term

Efficient Market Hypothesis (EMH)

\

theorizes that the market is generally efficient.

* the market cannot be beaten because it incorporates all important info instead current share prices, so stocks are generally traded at fairest value

Weak form (in)efficiency:

\

ie random walk theory - stock prices reflect all historical information, no form of technical analysis can aid investors

current prices are not effected by past events

Semi-strong form (in)efficiency:

\

market prices reflect all publicly available information

public information is part of the stock’s current price, investors cannot utilize either technical or fundamental analysis to benefit themselves, HOWEVER they may benefit from information not available to the general public

Strong form (in)efficiency:

all information, public and not public, is completely accounted for in current stock prices and no type of information an give an investor an advantage on the market

* market is effected by past events of the market history and not just random occurrences

Evidence for Efficient Market:

\

financial investors do not consistently beat the market

\
Anchoring:

\

cognitive bias that causes us to rely too heavily on the first piece on information we are given about a topic

__Internal rate of return (IRR):__

\
 

= the percentage that makes your NPV = 0

= graphically if the discount rate was zero

\- Use as long as the signs are always positive, otherwise the measurement is too complicated

Pitfalls of Internal Rate of Return:

\

1. Does not distinguish between lending or borrowing
2. Multiple rates of return, meaning as many solutions as there are in sign changes
3. Mutually exclusive projects: IRR sometimes ignores the magnitude of project
4. More than one opportunity cost of capital
5. Assume constant state of return (not consistent with that you expect from yield curve/term structure as they usually have an upward sloping curve)

PI (Profitability index)

* tool for selecting between project combinations and alternatives


* set of limited resources and projects can yield various combinations
* highest weighted average PI indicates optimal project

__Weighted average profitability index (WAPI):__

 

\
 

calculates potential profit to help evaluate whether to proceed with a project

A variation of NPV, but differs as because it is a ratio, it provides no indication of the size of the actual cash flow

__Capital rationing:__

limit set on amount of funds available for investment

__Soft rationing:__

imposed by management

__Hard rationing:__

imposed by unavailability of funds in capital market

__Nominal rate of return:__

real interest rate without taking into account taxes and inflation

__Real rate of return:__

actual return, taking into account taxes and inflation

__Acellerated Depreciation__ leads to creation of…

tax shield = t\*depreciation

tax shield = t\*depreciation

= reduction In taxable income achieved through claiming allowable deductions such as donations, amortization, depreciation, etc.

= tax advantage of having depreciation

__Equivalent Annual Cash flow (EAC):__

the cash flow per period with the same present value as the actual cash flow as the project

\
Use when you are comparing two projects  that have different amounts of times to determine which one is more profitable (ie one is 5 years and the other is 7 years_

Risk premium:

premium, the higher the risk, the higher rate of return you can expect to earn from stocks

aka equity risk

Equity premium (EP):

difference between returns on equity/individual stock and the risk-free rate of return,

Maturity premium:

compensates investors for the risk that bonds that mature many years into the future, to compensate investors for taking on more risk

* expected rates of return on longer term securities that are typically higher than rates on shorter term securities

Risk free rate (Rf):

* can be benchmarked to longer term government bonds, assuming there is zero default risk by the government

Market risk premium (MRP):

* the difference between the expected return on a market portfolio and the risk free
* different than market risk premium as it refers to additional return that you make on investments that are not risk free
* a higher premium implies you would invest a greater share of your portfolio into stocks

Variance:

measure that reflect variability in a distribution, how far the data values are dispersed from the mean = average squared deviations from the mean

Standard deviation:

\
\

measure that reflect variability in a distribution, square root of variance

Covariance:

describes the relationship of two variables whenever one variable changes

* positive covariance: both variables tend to be high or low at the same time
* negative covariance: one variable tend to be high, when the other one is low and vice versa

Correlation:

tells us the extent to which two variables are linearly related

* always between -1 and 1

Diversification effect:

by spreading your investment across different assets, the lower your risk/volatility.

* once you diversify to a certain point, you cannot decrease it anymore however it will not be risk free as there will always be market risk

Unique risk:

\

* specific company risk that can be eliminated through diversification eg. labour strikes, patent decisions, new competitors, etc.
* unlike market risk, unique risk is in your control to a degree and can be helped with diversifying

Diversifiable Risk aka Specific Risk:

\

risk of losing an investment due to company or industry specific hazard, opposite to market or systematic risk eg. shortage of specific materials (ie memory chips, silicon), new legislation specific to that industry

Market risk:

\
\

possibility that an investor may experience losses due to factors that affect the overall performance of the market, volatility of the market as a whole

* measured by beta

Systematic risk:

\

risk that is inherent to the entire market or market segment aka undiversifiable risk, meaning you cannot continue to diversify to completely remove this risk

* measured by beta

Market portfolio:

portfolio all assets in economy (hypothetical), typically uses broad stock market index to represent the market as a whole

Beta:

measures how volatile an investment is compared to the overall market

beta > 1 means…

higher volatility: (riskier than the market)

beta < 1 mean….

lower volatility: (less risky than the market

adding lower volatility stocks to your porfolio will….

it will reduce the risk of a portfolio of your overall portfolio

Efficient Portfolio:

a portfolio that provides the greatest expected return for a given level of risk (ie standard dev) or, the lowest risk for a given expected return

* remember that yield curves are typically similar to normal distributions, however they have fatter tails
* rational investors want to take on the least amount of risk while still getting the highest amount of reward, meaning that you want to have the highest expected return and the lowest standard deviation

Markowitz portfolio theory:

given a desired level of risk, an investor can optimize the expected returns of a portfolio through diversification

__Efficient frontier:__

set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return

\- each half egg shell represents the possible weighted combinations for two stocks

Efficient Set

You would want to pick a portfolio that is on that line, however, you want to have both the highest expected return as possible E(R) and the lowest st dev, therefore you want to have it on the upper part E to B, where both of this criteria is met.

Explain this diagram

The light blue U’s represent all of the possible combinations of weighted averages you can have between risk free and riskier portfolios. Theoretically, there is an option that is completely risk free, ie the intersection of y axis on rf. However, to get a higher pay off, you will want to balance between rf and rm (as it’s the highest point on the minimum variance portfolio

 

__Capital Market Line (CML):__

represents portfolios that optimally combine risk and return, ie the risk free rate and the market portfolio of risky assets. (see red line on graph above)

\
Under CAPM, all investors will choose a position on CML as it maximizes return for a certain level of risk - reward ratio

__Sharpe ratio:__

essentially measures the slope of line of CML

\
the higher the slope, the better the asset

Generally speaking, purchase assets if Sharpe ratio is above CML, sell if they’re below CML

\

__Security Market Line (SML):__

represents the markets risks and return at a given time, and shows expected return of individual assets

ie risk to reward ratio

Explain relationship bewteen beta and expected return

if your beta is higher (more volatile), then there is a linear relationship between Beta and the expected return… the higher the beta, the higher the expected return

Explain this graph

Stock B is undervalued because it’s under SML, and it is higher risk because it’s beta is higher than one. It’s expected return is too low, so sell it.  Once people begin to sell it, it will drive down the price and correct itself in terms of equilibrium.

Stock A is undervalued because it’s under SML, it’s relatively low risk as it’s below beta but that means it’s not very profitable.

Stock C is undervalued, you get a higher return that expected therefore people will buy it and eventually drive up the price and reach equilibrium.

Growth stocks:

companies with potential to outperform the overall market over time because of their future potential.

Value stocks:

\

companies currently trading below what they are really worth and will thus provide a superior return.

What does value and growth stocks say about CAPM?

Conclusion: value stocks outperform growth stocks meaning that value stocks should have some sort of risk that is not included in CAPM…

__Real assets__

assets used to produce goods and services

__Financial assets__

financial claims to the income generated by the firms’ real assets

equity

residual claim

Investment decision

purchase of real assets

Financial decision

sale of financial assets

Capital structure:

choice between debt and equity financing

Investment Decision / Capital budgeting decision / CAPEX

decision to invest in tangible or intangible assets

__Hurdle rate/Cost of capital__:

minimum acceptable rate of return on investment

ie. the hurdle you need to jump over in order for people to invest

\

Opportunity cost of capital:

investing in a project eliminates other opportunities to use invested cash

Agency problem:

= represent the conflict of interest between management and owners

= agents have the power to make decisions on behalf of the principal but both have different incentives and agent generally has more information

= managers are agents for stockholders and are tempted to act in their own interests rather than maximizing value

Agency problem I:

Dispersed ownership: conflict between shareholders and management

* more prevalent in UK, USA

* Agency problem II:

\

* Concentrated ownership: conflict between majority and minority shareholders, differing nature of corporate governance
* more prevalent in Asia, Europe

Corporate governance:

the system in which companies are directed/controlled, checks and balances within the organization, the rules, practices and processes used to run a company

* establishes company direction and business integrity, promotes financial viability and builds trust with investors and community

Solutions for Agency Problems:

\

1. Corporate governance codes:
2. Stock options:


3. Board of directors: could consist of executive and/or non-executive members, make sure the board of directors is not too big, have HR member on panel or an executive that does not have majority of stock, etc.


4. Monitoring
5. Market for corporate control: mergers and acquisitions?
6. Shareholder pressure

 

__Present value:__

value today of a future cash flow

__Future value:__

amount to which an investment will grow after earning interest

Perpetuity:

financial concept where a cash flow is theoretically received forever  

__PVAF:__

present value of $1 a year for each of the t years

\
Useful when determining whether to take a lump sum payment now, or to accept an annuity payment in future periods

__Perpetuity with constant growth rate__

\

eg. constant growth in dividends could signal to investors that all is going well with the firm

__Note:__ these formulas can be used to value a perpetuity at any point in time

*only use this formula if the growth rate is lower than the rate r – meaning, you must be dividing by a positive number.*

__Effective Annual Interest Rate (EAR):__

\

annualized interest rate using compound interest

= (1 + monthly interest rate)^12 -1

APR

monthly interest rate x 12

__Annual Percentage Rate (APR):__

 

annualized interest rate using simple interest

__Bond:__

security that obligates issuer to make specified payments to the bondholder

__Face Value:__

par price/principal value, payment at the maturity of the blond

__Coupon:__

\

interest payments made to bondholder

__Coupon rate:__

annual interest payment, as a percentage of face value

Interest rate risk:

\

the exposure of a bank’s current and future earnings and capital to adverse changes in the market

\
Can be caused by decline in an interest rate of an asset, therefore long-term bonds tend to be more price sensitive than short term bonds.

Inverse relationship between price and yield that is not linear (compound interest)

Duration:

= measurement of weighted average time before having cash flow

\
* the higher a bond's duration, the more its value will fall as interest rates rise, because when rates go up, bond values fall and vice versa.

\

General Rules of Duration:

\- duration is shorter than maturity for all bonds (except zero coupon bonds)

\- duration positively related to bond volatility (%)

\- central measure of the interest rate sensitivity of a bond

\- only good approximation for small interest rate changes

__Modified duration/volatility:__

= measures price sensitivity to interest rates, ie percentage change in price in terms of yield

Explain Yield Curve/Term Structure with Interest Rates Graph

Shows YTM based on the prices on the bond market.

“Normal” = upward sloping yield curve

ie. Long term interest rates are higher than short term interest rates

This is because short term and long term interest rates do not always move parallell

Term structure

\

same thing as yield curve, refers to the relationship between short term and long term interest rates

__Spot rate:__

\

actual interest rate today (t=0)

“On the spot”

__Forward rate:__

\

interest rate, fixed today, on a loan made in the future at a fixed time

__Future rate:__

\

spot rate that is expected in the future

__Yield curve:__

\

shows the yield on bonds over different times to maturity

Note: Short term and long term interest rates do not always move in parallel

 

__Yield to maturity (YTM):__

IR on an interest bearing instrument

\- positive slope suggests future economic upswing, downward slope suggests recession

What acts as a __leading indicator__ of real economic activity?

YTM

Explain this graph

 

The EU yield curve rates are negative, meaning that gov’ts are able to, on average, borrow at negative interest rates

Meaning that they receive interest instead of paying interest. \[exceptional circumstance\]

__Expectations Theory:__  

yields on financial assets of different maturities are related primarily by market expectations of future yields

Meaning, that the long interest rate is the average of expected future short term interest rates.