Business Finance Definitions/ Long Question Answers Flashcards
Advantages of going public
Liquidity (larger investor pool of wider markets)
Better access to capital
Disadvantages of going public
Must satisfy all requirements of being a public company such as SEC Filings and listing requirements
Annual financial statements made public
What type of IPO do underwriters face the most risk?
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
Describe a best efforts IPO?
Underwriter cannot guarantee that stock will be sold
Tries to sell stock at best price
Describe an auction IPO?
Underwriters let market determine price by auctioning off the company
Final price determined using bids
Describe the IPO puzzles of underpricing and cyclicality in IPO Issues
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
What is book building?
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
Treasury Bills
Pure discount bonds
Maturities ranging from few days - 26 weeks
Treasury Notes
Semi annual coupon bonds
Maturities between 1-10 years
Treasury Bonds
Securities with maturity longer than 10 years
TIPS
Standard coupon bonds adjusted for inflation
What are the alternative sources from which private companies can raise equity capital?
Angel investors
VC Firms
Private Equity firms
Corporate Investors
Advantages of Private company raising money from a corporate investor
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
Disadvantages of private company raising money from a corporate investor?
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
Main areas of corporate finance
M&A
Equity capital market
Debt capital market
Key Principles of Corporate Finance
Intra-company corp finance
Broader corp finance
Yield to Maturity
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
When a firm has no debt
Cost of unlevered equity increases
All equity financed
Cost of financing project without incurring debt
How can a bond have a negative yield?
Investor receives less interest payments and principal over duration of the bond.
Modigliani-Miller 1
Perfect capital markets
Value of firm not affected by capital structure
Value of unlevered firm = value of levered firm
Key Assumption of Modigliani-Miller 1
Operate in perfectly efficient markets
No taxes
No transaction costs
No brokerage fees
Firms lend/borrow at any risk rate
Explain how the YTM differs from annual coupon rate?
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
Advantage of Debt Financing
Cheaper source of finance
Debt cost is lower
Offsets increase in equity cost
Interest expense is tax deductible
Reduced taxable income
Modigliani-Miller 2
Cost of capital of levered equity = cost of capital of unlevered equity
Premium is proportional to market value debt equity ratio
Explain the inverse relationship between price and YTM
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.
When Debt to equity ratio increases
Cost of unlevered equity increases
Cost of debt is constant
Cost of debt increases above threshold
Increases risk of insolvency
Value of firm with leverage
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
How firms spend free cash flow
Retain & reinvest into new invest opportunities
Retain in cash reserves
Pay out to shareholders through dividend payout
Share repurchase
Advantages of a rights offer?
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.
Tender offer
Purchase specific number of shares at prespecified price
Occurs over 20 days
If not enough shares, offer is cancelled
No buyback occurs
Targeted Repurchase
Purchase shares from major shareholder
Includes pension funds
How are merger waves caused
There is economic expansion
Greater consumer confidence
Markets are bullish
Prices rise
Opportunities to create shareholder value
What is a public debt offering?
Prospectus created with details of the offering
Formal contract between bond issuer and trust company signed
Trust company ensures terms of contract enforced
Advantages of Horizontal merger
When target & acquirer in same industry
Cost reduction synergies
Easier to layoff overlapping employees, parallel departments & terminate redundant resources
Increases purchasing power between suppliers
What is a private offering?
No need for prospectus or formal contract
Promissory note is enough
Contract in private placement does not have to be standard
Why shouldn’t managers acquire firms in different industries for diversification
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
Difficulties of merger
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
Treasury Bills
Pure discount bonds with maturities of upto 26 weeks
Risk free and liquid
Cash immediately available
Treasury Notes
semi-annual coupon bonds with maturities between 2-10 Years
Low risk as government issued
Treasury Bonds
Semi-annual coupon bonds with maturities longer than 10 years
TIPS
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
Why does the yield of a bond that trades at a discount exceed a bond’s coupon rate?
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.
Cannibalisation
Decrease in sales of current project because of launching of new project
Sunk Cost
Money that will be paid regardless of decision whether or not to proceed a project
Opportunity cost
Value of unused space that will be used as new capital budgeting project
What is price to earnings ratio?
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
What options does a firm have to spend its free cash flows?
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
3 mechanisms to repurchase shares
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
Which policy, either dividend or share repurchase makes investors better off?
Share repurchase - investor will have cash from repurchase
Dividend - Investor receives cash dividend which offsets any reduction in value of shares
What two primary mechanisms can ownership and control of a public corporation change?
Corporation can acquire target firm
Target firm can merge with another firm
Why do mergers cluster in time, causing merger waves?
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
Reasons for horizontal merger and why is creates value for shareholders?
Combine two firms in same industry
Greater potential synergies to eliminate redundant functions
Increases price power with both vendors and customers
Concerns with post merger integration structure with intellectual capital compared to buying physical capital
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
Why shouldn’t managers acquire firms in different industries to diversity a company?
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
Difficulties with a typical merger
Integration of product lines
Processes
Training
R&D
Merging two corporate cultures
