Fin exam 3

FIN 3001-01 Final Exam Ch. 8, 9, 10

  1. Straight (majority) Voting:

    1. Directors are elected one at a time and every share gets one vote. Good for freezing out minority shareholders.

  1. Cumulative Voting:

    1. Directors are elected all at once. Total votes that each shareholder may cast equal the number of shares times the number of directors to be elected. In general, if N directors are to be elected, it takes [1/(N+1)] percent of the stock + 1 share to assure a deciding vote for one directorship. Good for getting minority shareholder representation on the board.

  1. Staggered Elections:

    1. Directors’ terms are rotated so they aren’t elected at the same time. This makes 1) it harder for a minority shareholder group to elect a director and 2) takeover attempts less likely to be successful.

    2. Example: 9 member board might be divided into 3 classes, with only 3 members standing for election to a 3 year term each year. Thus, a new majority shareholder would have to wait at least two annual meetings to gain control. 

  1. Proxy Voting:

    1. A proxy statement is the grant of authority by a shareholder to someone else to vote his or her shares. A proxy fight is a struggle between management and outsiders for control of the board, waged by soliciting shareholder’s proxy statements.

    2. Proxy fight is a fight for more statements.

  1. Dual or Multiple Classes of Common Stocks:

    1. Created with unequal voting rights in order to provide management or family owners with voting power disproportionately greater than provided by their holdings under a “one share-one vote” rule. 

    2. Example: 10 votes per share, 1 vote per 10 shares (Limited-voting), nonvoting common stocks.

    3. Look at market price, with the highest market price leads to a super voting power.

  1. Preemptive Rights:

    1. Existing common stockholders have rights to purchase on a pro rata basis new issues of common stock to maintain control or protect delusion. All new issues of common stock should be through rights offering.

  1. Cumulative Dividends:

    1. Current preferred dividends plus all arrearages (unpaid dividends) to be paid before common stock.

  1. Non-cumulative Dividends:

    1. Preferred does not have the same features as cumulative dividends.

  1. Types of Markets

    1. Direct Search Market:

      1. Buyer and seller search each other directly.

  1. Brokered Market:

    1. Brokers offer search (match making) services to buyers and sellers. Do not buy and resell.

  1. Dealer Market:

    1. Dealers purchase specialized assets at the lower bid price and sell them at higher asked price. Bid-asked spread is the profit margin to a dealer.

    2. In the perspective of a dealer, always look for the higher price in Ask.

  1. Auction Market: 

    1. All participants in an asset coverage at one place (physically or electronically) to bid on or offer an asset.

  1. NYSE (U.S. Only and Organized Exchange)

    1. Commission Brokers:

      1. Partners in a brokerage firm who execute customer orders to buy and sell securities on the floor of the exchange.

  1. Floor Brokers:

    1. Execute orders for commission brokers on a fee basis. Freelancers.

  1. Registered traders (floor traders):

    1. Buy and sell for their own accounts.

  1. Specialist:

    1. Acts as a dealer for a small set of securities (about 25% of members).

    2. With a few exceptions, each security listed for trading on the NYSE is assigned to a single specialist.

    3. Specialist provides a dealer function to provide continuous and liquid market by absorbing temporary imbalance in buy and sell order. Posts the ask prices and bid prices for securities assigned.

    4. Most of the trading that occurs directly between brokers around the specialist’s post. This is called trading in the crowd.

  1. NASDAQ (National Association of Security Dealers Automated Quotation System) (Over-the-Counter)

    1. Is a price quotation system, not a trading system. In 1987, Nasdaq instituted a Small Order Execution System (SOES), which is a trading system.

    2. Multiple market makers post ask and bid prices

    3. NASDAQ National Market (National Market Issues): All translations are immediately reported on the NASDAQ system. Larger and more actively traded securities.

    4. NASDAQ Capital Market (Small Cap Issues): Reported once a day. Small companies’ securities.

    5. Majority of bonds are in NASDAQ. Bond market is bigger than the stock market. When selling, go for the highest bid price. When buying, go for the lowest ask price.

  1. Stock Market Reporting: (Ch 8-23)

    1. Information about stock prices, trading volume, and related financial data that are gathered, summarized, and made available to the public. A large number of stocks in several different markets. 

  1. Independent Projects:

    1. Do not compete with one another. You either Accept or Reject the approach.

  1. Mutually Exclusive Projects:

    1. Are a group of projects that compete with one another in such a way that the acceptance of one project precludes (eliminates) all others in the group. Ranking approach.

  1. Net Present Value (NPV) 1 through 3:

    1. 1) Definition and Rules

      1. Present value of all net cash flows from one project at time = 0 through at time = n where n means end of project life.

      2. Rule of NPV is to 

        1. Accept/Reject: Accept all independent projects whose NPVs are greater than zero

        2. Ranking: Rank mutually exclusive projects by their NPVs, selecting the project with the highest NPV=

    2. 2) 

      1. The NPV of a project is the same as the increase in the value of common equity today by undertaking an investment.

    3. 3)

      1. The NPV rule satisfies all three criteria.

  1. Internal Rate of Return (IRR) 1 through 2:

    1. 1) Definition and Rule:

      1. The discount rate that forces the NPV to equal zero.

      2. Rule of IRR is to

        1. Accept/Reject: Accept all independent projects whose IRRs are greater than R (the required return)

        2. Ranking: Rank mutually exclusive projects by their IRRs, selecting the project with the highest IRR.

    2. 2) Net Present Value Profile (Useful when required rate of return is not certain):

      1. Plot of an investment’s NPV at various discount rates.

  2. Comparison of the NPV and IRR methods:

Independent projects (Accept/Reject)

Mutually exclusive projects (Rankings)

One cash outflow at the beginning -, +, +, +, +

No conflict

Possible conflict

One cash out flow at the end          +, +, +, +, -

Conflict

Conflict

Several cash outflows                    -, +, -, +, +

Possible conflict

Possible conflict

  1. Two conditions for no conflict between NPV and IRR

    1. If only one cash outflow at the beginning (conventional), and 

    2. If the project is independent, then NPV and IRR will give the same accept or reject decision.

  1. If only one cash outflow at the end (the cash flows are of loan type), then the IRR is really a borrowing rate and lower is better.

  1. If cash flows change sign more than once, then it can result in multiple IRR. The maximum number of IRRs that can be is equal to the number of times the cash flows change signs. Some cases, there is no IRR solution. NPV has only one solution.

  1. For mutually exclusive projects, IRR can be misleading. 

    1. Conflict ( R < 11.1%)

      1. NPVA < NPVB 

      2. IRRA > IRRB 

    2. Crossover Point (R = 11.1%)

      1. NPVB = NPVA 

      2. IRRA = IRRB 

    3. No Conflict (R > 11.1%)

      1. NPVA > NPVB 

      2. IRRA > IRRB 

  2. Redeeming Qualities of the IRR:

    1. People seem to prefer talking about rates of return (IRR) than dollars of values (NPV).

    2. NPV requires a market discount rate, IRR relies only on the project cash flows, although you do need an estimate of a required return to make the final decision.

  1. Relevant Cash Flows

    1. Concentrate on cash flows after tax excluding any financing costs. Financing costs are incorporated in the required rate of return on the project (discount rate).

    2. Always judge investments on an incremental basis. 

      1. Incremental cash flows = Cash flows if the new project is accepted

  • Cash flows if the new project is rejected

  1. Exclude any sunk costs. Sunk cost is a cost that has already been incurred and cannot be recovered.

  2. Include opportunity costs. Opportunity cost is the loss of the benefit that could have been enjoyed if the best alternative choice was chosen instead. Cash flows that could be generated from assets the firm already owns if the assets are not used for the project in question.

  3. Include side effect (externalities (+ or -), spillover, incidental effects). Can be positive or negative.

  4. Tax benefits of noncash charge = (tax rate) x (Noncash charge) at t = 1 through t = n where n is the end of project life.

    1. Modified Accelerated Cost Recovery System (MACRS) od depreciation.

    2. Straight-line depreciation: the flag-year convention, the full-year convention (ignore the half-year convention)

  5. Relevant Cash Flows:

    1. Incremental cash flows = Cash flows if accept - Cash flows if reject.

    2. Cash inflows (+)

    3. Cash outflows (-)