Corporate Finance Flashcards
Modified Accelerated Cost Recovery System (MACRS)
- Accelerated depreciation generally improves the NPV of a capital project compared to straight-line depreciation
- Reduces operating income after taxes (NOPLAT) in early years and increases them in later years
- Increases after-tax operating cash flows (CFAT) in early years and decreases them in later years
Mutually exclusive projects with unequal lives - the two methods used to compare them are
- Least common multiple of lives
- Equivalent annual annuity
Risk analysis stand alone methods
- Sensivity analysis: impact of one variable
- Scenario analysis: impact of many variables in a given situation
- Simulation (Monte Carlo): Stochastic (@Risk)
APT
Arbitrage Pricing Theory
Pure-play method
Using other publicly traded company or assets to estimate parameters
Real options
- Timing
- Sizing
- Abandonment
- Growth
- Flexibility
- Price-setting
- Production-flexibility
- Fundamental
EP = NOPAT - $WACC
- EP - Economic profit
- NOPAT - Net operating income after taxes (also NOPLAT) = EBIT (1 - T)
- $WACC - Dollar cost of capital
- Market value added (MVA)
Residual income
= Net income - equity charge
Agency costs of equity
- Monitoring
- Bonding
- Residual
Asymmetric information
An unequal distribution of information arises from the fact that managers have more information about a company’s performance and prospects than do outsiders such as owners and creditors
Value of the company VU & VL
- VU = [EBIT(1 - T)] /WACC
- VL = VU + tD
- D is the value of the Debt
Value of the company VL considering financial distress
Jensen’s free cash flow hypothesis
- Managers (agents) may create an overincestment agency cost to benefit themselves at the detriment of the shareholders
Lintner’s dividend model
- Target payout ratio is based on long-term sustainable earnings
- Managers are more concerned with dividend changes than with dividend levels
- Companies will cut or eliminate dividends only in extreme circumstances
- [( this year’s expected increase in earnings per share in $) x (the target payout ratio) x (an annual adjustment factor)]
- The annual adjustment factor = 1 / (number of years over which the adjustment is to take place)
Dividend policies
- Stable dividend
- Constant dividend payout ratio policy
- Residual dividend policy
ESG
Environmental, social and corporate governance
US EPA
Environmental protection agency
Weak corporate governance risks
- Accounting
- Asset
- Liability
- Strategic
- Policy
Bear hug
The merger proposition is presented directly to the board of directors and bypasses the CEO
The two types of poison pills
- A “flip-in” allows existing shareholders (except the acquirer) to buy more shares at a discount
- A “flip-over” allows stockholders to buy the acquirer’s shares at a discounted price after the merger
Proxy fight
When a group of shareholders are persuaded to join forces and gather enough shareholder proxies to win a corporate vote. This is referred to also as a proxy battle
Pre-offer takeover defenses
- Shark repellents
- Poison pill
- Poison put
- Dead-hand provision
- Staggered board of directors
- Retricted voting rights
- Supermajority vorting provision
- Fair price amendement
- Golden parachute
Herfindahl-Hirschman index
HHI values
- Not concentrated: 1000-
- Moderately concentrated: 1000 - 1800
- Concentrated: 1800+
- Antitrust concerns: +100 in a moderately concentrated market
- Antitrust concerns: +50 in a concentrated market
Terminal value using the constant growth rate
Cash flow after taxes (CFAT)
- = NI + depreciation + other NCC
or
- = (S – C – D) (1 – T) + D
- S = sales
- C = cash operating expenses
- D = depreciation charge
Terminal year non-operating cash flow (TNOCF)
= SalT + NWCInv – T(SalT – BVT)
Economic profit calculation
- = NOPAT - $WACC
- The PV of economic profit discounted at the WACC equals the NPV of a project
Economic income calculation
- = after-tax cash flow - economic depreciation*
- *beginning market value - ending market value
- = after-tax cash flow + change in the market value
Z-spread
Appropriate spread measure for option-free corporate bonds
MCPPS
- Market conversion premium per share
- = [Market price of the bond / Conversion ratio] - Market price of the stock
Average accounting rate of return (AAR)
= Average net income / Average book value
Profitability index (PI)
- = PV of future cash flows / Initial investment
- = 1 + NPV / Initial investment
NPV vs IRR
Whenever the NPV and IRR rank two mutually exclusive projects differently, you should choose the project based on the NPV
- After-tax operating cash flow
- Terminal year after-tax non-operating cash flow
- Replacement project outlay
- CF = (S - C - D)(1 - T) + D or CF = (S - C)(1 - T) + TD
- TNOCF = SalT + NWCInv - T(SalT - BT)
- Outlay = FCInv + NWCInv - Sal0 + T(Sal0 - B0)
RIt
Residual earning dividends
- = NI - (capital expenditures paid with retained earnings)
- Find the debt-to-equity ratio
- Allocate FCInv to debt and equity in function of the ratio
- Subtract the part paid with equity from NI
NPV of future residual income
rWACC - with taxes
r0 as the cost of capital for a company financed only by equity - without taxes
r0 as the cost of capital for a company financed only by equity - with taxes
Asset beta
Equity beta
Pecking order theory
Suggests that managers choose methods of financing according to a hierarchy that gives first preference to methods with the least potential information content (internally generated funds) and lowest preference to the form with the greatest potential information content (public equity offerings)
Clientele effect
The existence of groups of investors (clienteles) attracted by (and drawn to invest in) companies with specific dividend policies
Pw - price just before the share goes ex-dividend
Px - price just after the share goes ex-dividend
Price decrease when the share goes ex-dividend
- TD = marginal tax rate on dividends
- TCG = marginal tax rate on capital gains
Marginal tax rate on dividend in relation to the marginal tax rate on capital gains and the share price
- If the investor’s marginal tax rate on dividends is equal to the marginal tax rate on capital gains, the share’s price should drop by the amount of the dividend when the share goes ex-dividend
- If the investor’s marginal tax rate on dividends is higher than the marginal tax rate on capital gains, the share’s price should drop by less than the amount of the dividend when the share goes ex-dividend
- If the investor’s marginal tax rate on dividends is less than the marginal tax rate on capital gains, the share’s price should drop by more than the amount of the dividend when the share goes ex-dividend
Franking credit
A tax credit received by shareholders for the taxes that a corporation paid on its distributed earnings
Impairment of capital rule
A legal restriction that dividends cannot exceed retained earnings
- FCFE coverage ratio
- Dividend/earnings payout ratio
- Earnings/dividend coverage ratio
- FCFE coverage ratio = FCFE/ [Dividends + Share repurchases]
- Dividends/ NI
- NI/ Dividends
Bootstrapping
The bootstrap effect occurs when the shares of the acquirer trade at a higher price–earnings ratio (P/E) than those of the target and the acquirer’s P/E does not decline following the merger
Managerialism theories
Posit that because executive compensation is highly correlated with company size, corporate executives are motivated to engage in mergers to maximize the size of their company rather than shareholder value
Tender offer
The acquirer invites target shareholders to submit (“tender”) their shares in return for the proposed payment
Shark repellents
Synonym for takeover defense strategies
Dead-hand provision
This provision allows the board of the target to redeem or cancel the poison pill only by a vote of the continuing directors
Poison puts
Give rights to the target company’s bondholders
NOPLAT
- NOPLAT = unlevered NI + change in deferred taxes
- Unlevered income = NI + net interest after tax
- Net interest after tax = (interest expense - interest income) x (1 - t)
FCF
= NOPLAT + NCC - change in net working capital - Capex
Takeover premium
- PRM = takeover premium (as a percentage of stock price)
- DP = deal price per share of the target company
- SP = stock price of the target company
Target and acquirer’s gain
- PT = price paid for the target company
- VT = pre-merger value of the target company
- S = synergies created by the business combination
- Target shareholders’ gain = Premium = PT – VT
- Acquirer’s gain = Synergies – Premium = S – (PT – VT)
Post-merger value
- PT = price paid for the target company
- VT = pre-merger value of the target company
- S = synergies created by the business combination
- VA* = post-merger value of the combined companies
- VA = pre-merger value of the acquirer
- C = cash paid to target shareholders
Stock offer valuation
- Must account for the stock dilution before calculating the gain for the target’s shareholders
- VA* = VA + VT + S - 0, because there is no cash paid
Equity carve-out
Involves the creation of a new legal entity and sales of equity in it to outsiders
- Spin-off
- Split-off
- Shareholders of the parent company receive a proportional number of shares in a new separate entity
- Some of the parent company’s shareholders are given shares in a newly created entity in exchange for their shares of the parent company
After-tax operating cash flow (CFAT)
- = sales - cash operating expenses - depreciation(1 - t) + depreciation
- = operating income(1 - t) + depreciation
Economic profit from EBIT
When there is interest expense on operating income, the economic profit is calculated as
EBIT(1 - t) - $Cost of capital
COGS forecasting
- As a percentage of sales
- ex. COGS will decline 0.5% for the next year // COGS = [(COGSt - 1 / Salest - 1) - 0.005] x Salest
Net present value (NPV)
- CFt = after-tax operating cash flow (CFAT)
Audit committee best practice
The audit committee should
- include only independent directors;
- have sufficient expertise in financial, accounting, auditing, and legal matters;
- oversee the internal audit function;
- meet with auditors independently of management or other company interest parties periodically but at least once annually;
Global best practice
- At least 75% of the board members have to be independent
- The Chairman of the Board has to be independent
- The entire board must stand for reelection annually
- Independent board members must meet in separate sessions at least annually
Fully depreciated
It means that the book value is zero and there would be a capital gain if sold
Competing projects
*They are mutually exclusive
Tax shield or tax on capital gain
- If BV - sale price > 0 → tax shield = (BV - sale price) * tax rate
- If BV - sale price < 0 → tax on capital gain = (sale price - BV) * tax rate
Statutory merger
The target company ceases to exist as a separate entity
Taxes on securities offering
There is no taxes at the corporate level but there are taxes on capital gain for the shareholders of the target entity
Shareholder’s approval on asset purchase
Generally required only when 50% or more of the assets of the firm are being purchased
Leveraged recapitalization
A post-offer takeover defense mechanism that involves the assumption of a large amount of debt that is then used to finance share repurchases
Greenmail
This technique involves an agreement allowing the target to repurchase its own shares back from the acquiring company, usually at a premium to the market price
Pac Man defence
The target can defend itself by making a counteroffer to acquire the hostile bidder
Fair price amendments
Fair price amendments are changes to the corporate charter and bylaws that disallow mergers for which the offer is below some threshold
Golden parachutes
Golden parachutes are compensation agreements between the target company and its senior managers. These employment contracts allow the executives to receive lucrative payouts, usually several years’ worth of salary, if they leave the target company following a change in corporate control
Restricted voting rights
Some target companies adopt a mechanism that restricts stockholders who have recently acquired large blocks of stock from voting their shares
Poison put
Whereas poison pills grant common shareholders certain rights in a hostile takeover attempt, poison puts give rights to the target company’s bondholders. In the event of a takeover, poison puts allow bondholders to put the bonds to the company
Shark repellent
A pre-offer takeover defense mechanism involving the corporate charter
Benefits and risks of a cash offer
- Are assumed by the acquirer
- If synergies are higher than expected, the acquirer reaps the gains
- If synergies are lower than expected, the acquirer takes the loss
- The gain for the target is limited to the takeover premium
Dead-hand provision
A poison pill provision that allows for the redemption or cancellation of a poison pill provision only by a vote of continuing directors (generally directors who were on the target company’s board prior to the takeover attempt)
- Comparable companies method
- Comparable transactions method
- Find the average of the parameters and then add the premium of recent transactions
- Find the average (since the average already reflects recent transactions it is not needed to add a premium)
Modigliani–Miller propositions without taxes
- Proposition I states that a firm’s leverage does not affect its value
- Proposition II—debt is less expensive than equity because of seniority (ignoring distress costs)
To keep the cost of capital the same for the firm no matter the capital structure (i.e., consistency with Proposition I), equity must become more expensive as the proportion of debt is increased within the capital structure. Mathematically, Proposition II states that the cost of equity (re) is a linear function of the company’s debt-to-equity ra
Modigliani–Miller propositions with taxes
- Proposition I with taxes values a leveraged firm (VL) based on the value of an unleveraged firm (VU) and the firm’s debt level (D) with associated tax rate (t)
- Proposition II States that a higher debt-to-equity ratio leads to a higher required return on equity, because of the higher risk involved for equity-holders in a company with debt
