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Econ304 - Business Finance > Business Finance Definitions/ Long Question Answers > Flashcards

Business Finance Definitions/ Long Question Answers Flashcards

1
Q

Advantages of going public

A

Liquidity (larger investor pool of wider markets)

Better access to capital

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2
Q

Disadvantages of going public

A

Must satisfy all requirements of being a public company such as SEC Filings and listing requirements

Annual financial statements made public

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3
Q

What type of IPO do underwriters face the most risk?

A

Firm commitment IPO

Guarantee they will sell all the stock for offer price

Purchase entire stock for lower than offer price

If the issue does not sell at offer price, remaining shares sold at lower price

Underwriter bears loss

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4
Q

Describe a best efforts IPO?

A

Underwriter cannot guarantee that stock will be sold

Tries to sell stock at best price

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5
Q

Describe an auction IPO?

A

Underwriters let market determine price by auctioning off the company

Final price determined using bids

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6
Q

Describe the IPO puzzles of underpricing and cyclicality in IPO Issues

A

IPOs appear to be underpriced

Price at the end of trading on the first day is higher than IPO price

Number of issues is highly cyclical

Good Times = Market flooded with issues

Bad Times = Few number of issues

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7
Q

What is book building?

A

Customers inform underwriters of their interest by telling them the number of shares they want to purchase

Customers value their relationship with underwriters

Underwriters add up all the total demand and adjust price until its unlikely that the issue will fail

Process for coming up with the offer price is based on customer interest

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8
Q

Treasury Bills

A

Pure discount bonds

Maturities ranging from few days - 26 weeks

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9
Q

Treasury Notes

A

Semi annual coupon bonds

Maturities between 1-10 years

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10
Q

Treasury Bonds

A

Securities with maturity longer than 10 years

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11
Q

TIPS

A

Standard coupon bonds adjusted for inflation

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12
Q

What are the alternative sources from which private companies can raise equity capital?

A

Angel investors
VC Firms
Private Equity firms
Corporate Investors

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13
Q

Advantages of Private company raising money from a corporate investor

A

Corporate partner provides capital, expertise, and access to distribution channels

Corporate partner may become an important customer for a start-up

Willingness of an established company to invest is an important endorsement

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14
Q

Disadvantages of private company raising money from a corporate investor?

A

Not all corporate investors are successful due to interference

Corporate investor can gain access to proprietary technology

Once young firm aligns with corporate partner, competitors of partner not willing to do business with private company in early stages

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15
Q

Main areas of corporate finance

A

M&A
Equity capital market
Debt capital market

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16
Q

Key Principles of Corporate Finance

A

Intra-company corp finance
Broader corp finance

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17
Q

Yield to Maturity

A

Discount rate that sets PV of promised bond payments equal to current market price of bond

IRR on a bond

Total rate of return that investors will earn on their invested money if they buy the bond at current price and hold until maturity

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18
Q

When a firm has no debt

A

Cost of unlevered equity increases

All equity financed

Cost of financing project without incurring debt

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19
Q

How can a bond have a negative yield?

A

Investor receives less interest payments and principal over duration of the bond.

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20
Q

Modigliani-Miller 1

A

Perfect capital markets
Value of firm not affected by capital structure
Value of unlevered firm = value of levered firm

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21
Q

Key Assumption of Modigliani-Miller 1

A

Operate in perfectly efficient markets
No taxes
No transaction costs
No brokerage fees
Firms lend/borrow at any risk rate

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22
Q

Explain how the YTM differs from annual coupon rate?

A

Investor makes a loss at maturity

If a bond selling at discount, price will be below FV

Bond selling at par has price which is equivalent to FV

Bond trading at discount against par would earn a return from receiving the annual coupon and the FV

YTM exceeds annual coupon rate

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23
Q

Advantage of Debt Financing

A

Cheaper source of finance

Debt cost is lower

Offsets increase in equity cost

Interest expense is tax deductible

Reduced taxable income

24
Q

Modigliani-Miller 2

A

Cost of capital of levered equity = cost of capital of unlevered equity

Premium is proportional to market value debt equity ratio

25
Q

Explain the inverse relationship between price and YTM

A

When a bond’s price increases, YTM falls

When a bond’s price falls, YTM increases

When interest rates and yield increase, investors require a greater yield to invest

Higher YTM reduces impact of PV of separate cash flows and price

When interest rates and bond yields decrease, reduces discounting impact on cash flow, resulting in price hike.

26
Q

When Debt to equity ratio increases

A

Cost of unlevered equity increases

Cost of debt is constant

Cost of debt increases above threshold

Increases risk of insolvency

27
Q

Value of firm with leverage

A

Made of interest paid to debt holders

Made of income to equity holders

Levered firm exceeds unlevered firm

Due to present value of tax savings

28
Q

How firms spend free cash flow

A

Retain & reinvest into new invest opportunities

Retain in cash reserves

Pay out to shareholders through dividend payout

Share repurchase

29
Q

Advantages of a rights offer?

A

New shares offered to existing shareholders

Protects existing shareholders from underpricing

Lower demand as shareholders are only a fraction of all existing shareholders

Investors don’t want to increase their percentage weight of stock in portfolios.

30
Q

Tender offer

A

Purchase specific number of shares at prespecified price

Occurs over 20 days

If not enough shares, offer is cancelled

No buyback occurs

31
Q

Targeted Repurchase

A

Purchase shares from major shareholder

Includes pension funds

32
Q

How are merger waves caused

A

There is economic expansion

Greater consumer confidence

Markets are bullish

Prices rise

Opportunities to create shareholder value

33
Q

What is a public debt offering?

A

Prospectus created with details of the offering

Formal contract between bond issuer and trust company signed

Trust company ensures terms of contract enforced

34
Q

Advantages of Horizontal merger

A

When target & acquirer in same industry

Cost reduction synergies

Easier to layoff overlapping employees, parallel departments & terminate redundant resources

Increases purchasing power between suppliers

35
Q

What is a private offering?

A

No need for prospectus or formal contract

Promissory note is enough

Contract in private placement does not have to be standard

36
Q

Why shouldn’t managers acquire firms in different industries for diversification

A

Investors achieve diversification themselves

Purchase shares in two separate companies

Costly to run larger firms

Difficult to reallocate resources effectively

Agency costs as profitable divisions subsidise unprofitable divisions

37
Q

Difficulties of merger

A

Integration Failure

Different cultures, working styles, management

Creates toxic environment

Difficulty to rationalise duplicate departments

E.g, difficult to choose between two r&d departments

Differences in training, HR processes, production & accounting

38
Q

Treasury Bills

A

Pure discount bonds with maturities of upto 26 weeks

Risk free and liquid

Cash immediately available

39
Q

Treasury Notes

A

semi-annual coupon bonds with maturities between 2-10 Years

Low risk as government issued

40
Q

Treasury Bonds

A

Semi-annual coupon bonds with maturities longer than 10 years

41
Q

TIPS

A

Bonds with coupon payments that adjust with inflation

Final payment protected against deflation since value of final payment is maximum between FV and inflation adjusted FV

42
Q

Why does the yield of a bond that trades at a discount exceed a bond’s coupon rate?

A

Discount implies that bond is trading at less than par on FV

When bond matures receive full FV back

When priced at discount, return to the holder will be fixed known coupons + difference between FV and below par price paid for bond.

43
Q

Cannibalisation

A

Decrease in sales of current project because of launching of new project

44
Q

Sunk Cost

A

Money that will be paid regardless of decision whether or not to proceed a project

45
Q

Opportunity cost

A

Value of unused space that will be used as new capital budgeting project

46
Q

What is price to earnings ratio?

A

Widely used financial indicator

Investors think a firm has good growth potential

Current price reflects investor belief about a firm’s future earnings

Ratio of current market price and EPS of a stock

Major price corrections if future earnings prove to be short of their forecast

If a PE ratio is based on most recently reported earnings, a low PE suggests that market price is low

Infers market has doubts about future earnings growth

47
Q

What options does a firm have to spend its free cash flows?

A

Retain them and use for investment opportunities

Hold them in cash reserves in anticipation of future financing requirements

Pay then to equity holders via dividend or share repurchase

48
Q

3 mechanisms to repurchase shares

A

Open market repurchase - repurchase shares in open market and common in US

Tender off - repurchase a fixed number of shares, for a fixed price

Targeted Repurchase - not open to all shareholders, only specific shareholders can tender shares

49
Q

Which policy, either dividend or share repurchase makes investors better off?

A

Share repurchase - investor will have cash from repurchase

Dividend - Investor receives cash dividend which offsets any reduction in value of shares

50
Q

What two primary mechanisms can ownership and control of a public corporation change?

A

Corporation can acquire target firm

Target firm can merge with another firm

51
Q

Why do mergers cluster in time, causing merger waves?

A

Occur during periods of economic expansion

Consumer confidence is high and bullish markets drive up price

Mergers looking for investment opportunities to create shareholder value

Investors more willing to invest in M&A

52
Q

Reasons for horizontal merger and why is creates value for shareholders?

A

Combine two firms in same industry

Greater potential synergies to eliminate redundant functions

Increases price power with both vendors and customers

53
Q

Concerns with post merger integration structure with intellectual capital compared to buying physical capital

A

If you are buying lots of intangible assets such as human capita, you have to be concerned about how you create incentives for target’s employees to stay on

Retention bonuses common for employees

Difficult to be successful with hostile acquisition when retention of target employees is critical

Keeping uncertainty low and moving quickly during integration is important

54
Q

Why shouldn’t managers acquire firms in different industries to diversity a company?

A

Investors can diversify themselves by purchasing shares in different companies

Not efficient for managers diversity the company rather than leaving it to investors to manage their portfolios

55
Q

Difficulties with a typical merger

A

Integration of product lines
Processes
Training
R&D
Merging two corporate cultures

Econ304 - Business Finance (5 decks)

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