Corporate finance Flashcards
Liquidation
All company assets are sold
The proceeds from the liquidation are used to pay the firms creditors and the firm ceases to exist
Reorganization:
It is the more common form of bankruptcy for large corporations
the firms existing management is given the opportunity to propose a reorganization plan
What happens to the expected costs of financial distress when leverage increases
They increase
Three key factors determine the present value of financial distress costs
1) The probability of financial distress
2) The magnitude of financial distress costs
3) The discount rate for financial distress costs
1) distress costs have negative CAPM beta (costs are high when the firm (the market) does poorly
2) So the beta of the financial distress costs is negative
2) This makes the expected costs of financial distress even higher
Total value of a company VL =
V^L = VÛ + PV(interest tax shield) - PV(Financial distress costs)
Value of a levered firm:
V^L = Vû + PV(interest tax shield) - PV(Financial distress costs) - PV(Agency costs of debt) + PV(Agency Benefits of Debt)
What happens when you have too little leverage
Lost tax benefits
Excessive perks
Wasteful investment
Empire building
Too much leverage
Excess interest
Financial distress costs
excessive risk taking
under-investment
How can we mitigate agency
The structure of the debt can help:
Short term debt is associated with more oversight of managerial actions by creditors
capital structure
The relative proportions of debt, equity, and other securities that a firm has outstanding
Cost of capital
The return required by the investors who provide capital to the firm
Cost of capital for the entire firm
Cost of equity capital
Cost of debt capital
Leverage ratio
D/D+E
Debt-to-equity ratio
D/E
Perfect capital markets (assumptions)
Investors and firms can trade the same set of securities at competitive market prices equal to the present value of the future cash flows
There are no taxes, transaction costs, or issuance costs associated with security trading
A firms financing decisions do not change the cash flows generated by its investments, nor do they reveal new information about them
Cost of equity
Re= Ru + D/E(Ru -Rd)
Cost of equity definition
Cost of equity is the return that a company requires for an investment or project, or the return that an individual requires for an equity investment.
EPS Fallacy
If you increase the leverage of the firm, the earnings per each share (EPS) will increase
Since the value of a share is discounted value of future earnings, and these earnings go up for each share, then the price of a share must go up
Earnings per share (Formula)
Earnings/Number of shares
Equity issuance fallacy
“an unlevered company is currently worth 1000$ and issues 200$ in equity
Having collected the new cash makes the price of equity increase WHICH IS NOT TRUE
Payout policy
The way a firm chooses between the alternative ways to distribute free cash flow to equity holders
Special dividend
A one time dividend payment a firm makes, which is usually much larger than a regular dividend
Stock dividend
Instead of cash, shareholders get more shares
Share repurchases
An alternative way to pay cash to investors is through a share repurchase or buyback. The firm uses cash to buy shares of its own outstanding stock
Open market Repurchase
When a firm repurchases shares by buying shares in the open market
Open market share repurchases represent about 95% of all repurchase transactions
Greenmail
When a firm avoids a threat of takeover and removal of its management by a major shareholder by buying out the shareholder, often at a large premium over the current market price
cost of capital
the minimum rate of return or profit a company must earn before generating value.
Effective dividend tax rate T*d (weird looking t)
T*d = (Td -Tg)/(1-Tg)
Tg is the capital gains rate tax, and Td is the dividend tax rate
MM payout irrelevance
In perfect capital markets, if a firm invests excess cash flows in financial securities, the firms choice of payout versus retention is irrelevant
Agency costs of retaining cash
When firms have excessive cash, managers may use the funds inefficiently by paying excessive perks, over-paying for acquisition, etc
Why is retaining cash bad
The firm invests and it incurs corporate taxes
Managers can appropriate (steal) cash more easily
Issuance and distress costs
Generally, firms retain cash balances to cover potential future cash shortfalls, despite the tax disadvantage to retaining cash
Dividend smoothing
The practice of maintaining relatively constant dividends
Dividend signaling hypothesis
The idea that dividend changes reflect managers views about a firms future earning prospects
Advantages of venture capital firms
Limited partners are more diversified
They also benefit from the expertise of the general partners
Disadvantages of venture capital firms
General partners usually charge substantial fees
Most firms charge 20% of any positive return they make
They also generally charge an annual management fee of about 2% of the funds committed capital
Pre-money valuation
The new valuation of the firms outstanding shares before the infusion of capital and the issuance of new shares
Post-Money valuation
The value of the whole equity (old plus new shares) at the price at which the new equity is sold
Liquidation preference
Specifies a minimum amount that must be paid to these shareholders before any payment to common stakeholders
Seniority
In case of liquidation investors get paid as long as every investor with higher seniority has already been paid
Participation rights
Holders of convertible shares without participation rights must choose between demanding their liquidation preference or converting their share to common stock. Participation rights allow investors to “double dip”
Initial public offering
The process of selling stock to the public for the first time
Advantages of IPO
Greater liquidity
Better access to capital
Disadvantages of IPO
The equity holders become momre widely dispersed
The firm must satisfy all the requirements of public companies
Best effort basis
For smaller IPOs, a situation in which the underwriter does not guarantee that the stock will be sold, but instead tries to sell the stock for the best possible price
Firm commitment
An agreement between an underwriter and an issuing firm in which the underwriter guarantees that it will sell all of the stock at the offer price
Auction IPO
A method of selling new issues directly to the public. The underwriter in an auction IPO takes birds from investors and then sets the price that clears the market
Two ways to value a company
Compute the present value of the estimated future cash flows
Estimate the value by examining comparable IPOS
A roadshow
In a roadshow, the firm and the underwriter pitch the idea behind the firms plans to a set of large institutional investorss, aiming at gaining insight into the demand that these large investors have for the stock, and these investor reservation price for the stock
Lockup (managing risk)
A restriction that prevents existing shareholders from selling their shares for some period, usually 18ß days after an IPO
Over-Allotment allocation (risk management)
An option that allows the underwriter to issue more stock, usually 15% of the offer size, at the IPO price
Green shoe provition
Underwriters initially market both the initial allotment and the allotment in the green shoe provision by short selling the green shoe allotment
If the issue is a success: the underwriter exercises the green shoe option
If not: the underwriter covers the short position by repurchasing the green shoe allotment in the aftermarket, thereby supporting the price
4 IPO puzzles
Underpricing: the price at the end of the first trading day is often substantiall higher than the IPO price
The number of issues are highly cyclical
The costs of an IPO are very high and it is not clear why firms willingly incur them
The long-run performance of a newly public company (2-5 years) is poor
Underpricing (IPOs)
The underwriters benefit from the underpricing because it allows them to manage their risk. The pre-IPO shareholders bear the cost of underpricing
Although IPO returns are attractive, all investors cannot earn these returns.
When an IPO goes well, the demand for thestock exceeds the supply. Thus the allocation of shares for each investor is rationed
When an IPO does not go well, demand at the issue price is weak, so all initial orders are filled completely
The winners curse (underpricing + long-term reversal)
Refers to a situation in competitive bidding when the high bidder, by virtue of being the high bidder, has very likely overestimated the value of the item being bid on. You “win” (get all the shares you requested) when demand for the shares by others is low and the IPO is more likely to perform poorly
Debt (everything)
investor provides refundable money. She is called debt-holder or creditor
Legal obligation for debtor to repay creditor
If you have debt in sufficiently profitable firm, it is not risky but bankrupcy can happen. When a frim goes bankrupt, not even creditors can be repaid in full Creditors may get a haircut
Equity (everyting)
Investor provieds non-refundable money. She is called shareholder
Residual claim on future cash flows
Risky:
Return from stocks is volatile
It is the type of volatility equity holders cannot diversify away
in the event of bankrupcy, equity may be worth nothing
Yield of a bond
The required return from investing in the bond
Bond at a premium
This happens when coupon-rate>bond yield
yield to maturity of a bond
the percentage rate of return for a bond assuming that the investor holds the asset until its maturity date. It is the sum of all of its remaining coupon payments.
coupon rate
the annual amount of interest that the owner of the bond will receive. To complicate things the coupon rate may also be referred to as the yield from the bond.
Bond at par
(this happens when coupon-rate = bond yield)
Bond at discount
(this happens when coupon-rate < bond yield)
Leverage buyout
When a group of private investors purchase all the equity of a public corporation and finances the puchase primarily with debt
Indenture
Included in a prospectus (public bond issue), it is a formal contract between a bond issuer (a corporation) and a trust company
Senior debt
In the event of a liquidation, senior debt has the highest priority in repayment
Asset backed debt
In the event of brankruptcy/liquidation, the asset that was used as “collateral” for the loan is used to repay the creditor
Unsecured debt
In the event of bankruptcy/liquidation, unsecured bondholders are paid from the sale of assets of the firm that are not already pledged as collateral on other debt
A bond issuer typicall repays its bonds by making coupon and principal payments as specified in the bond contract. However, the issuer can:
Repurchase a fraction of the outstanding bonds in the market
Make a tender offer for the entire issue
Exercise a call provision
What happens when a frim sells a callable bond
It is “short” a bond
It is “long” an option to buy back the debt “before” maturity
Sovereign debt
government debt
Term loan
A bank loan that lasts for a specific term
Revolving line of credit
A credit commitment for a specific time period, typically two or three years, which a company can use as needed
Private placement
A bond issue that is sold to a small group of investorsrather than the general public; tradable among institutional investors
Morgage-backed security
Largest sector of the asset-backed security market
Backed by home mortgages
Largest issuers are U.s. government agencies and sponsored enterprises, such as the government national mortgage association
Covenants
Restrictive clauses in a bond contract that limit the issuers from undercutting their ability to repay the bonds
For example covenants may:
Restrict the ability for management to pay dividends
Restrict the level of further indebtedness
Specify that the issuer must maintain a minimum amount of working capital
Convertible bond
A corporate bond with a provision that gives the bondholder an option to convert each bond owned into a fixed number of shares of common stock
Conversion ratio
The number of shares received upon conversion of a convertible bond, usually stated per $1000 of face value
Conversion price
The face value of a convertible bond divided by the number of shares received if the bond is converted
Value of an investment (at time 0) with the WACC method
V0^L = E(FCF1)/(1+rwacc) + E(FCF2)/(1+rwacc)^2 + E(FCF3)/1+rwacc)^3 + …
Wacc method procedure summary
Determine the expected FCF stream of the investment (unlevered)
Compute the weighted average cost of capital
Compute the value ofthe investment, including the tax benefit of leverage, by discounting the expected FCF stream using the WACC
Debt capacity (Dt)
The amount of debt at a particular date that is required in order to maintain the firms target debt ratio (=debt/value), given the firms rwacc
APV method (market value)
1) Determine the FCF stream of the investment (unlevered)
2) Determine the unlevered cost of capital from the pre-tax weighted average cost of capital
3) Obtain the unlevered value by discounting the FCF stream at the unlevered cost of capital
4) Determine the present value of the interest tax shield
(determine the expected interest tax shield amounts, Determine the appropriate discount rate to use for the interest tax shield amounts and discount the interest tax shield amounts to obtain PV(ITS)
Add the unlevered value to the present value of the interest tax shield in order to determine the value of the investment with leverage
Target leverage ratio
When a firm adjusts its debt proportionally to a projects value or its cash flows
The proportion need not remain constant over time, as long as it is a proportion
A constant debt-equity ratio is a special case of a target leverage ratio
(it can be shown that the interest tax shield will have the same risk as the firm if the firm maintains a target leverage ratio)
FTE method valuing an investment
1) Determine the free cash flow to equity (FCFE) of the investment
2) Determine the relevant equity cost of capital
3) Compute the equity value by discounting the FCFE stream using the equity cost of capital
4) This gives the NPV of the project, since this is exactly what accrues to equity holders
FCFE formula
FCFE = (net income) - (non cash operational items) + (net inflow from borrowing) = (EBIT-interest)(1-Tc) + (Depreciation - deltaNWC - CapEx) + delta(debt capacity) = FCF - (1-Tc)Interest + delta(debt capacity)
Advantages of the FTE method
May be simpler to use when calculating the value of equity for the entire firm
If the firms capital structure is complex
The market values of the other securities in the firms capital structure are unknown
It may be viewed as a more transparant method for discussing a projects benefit by emphasizing a projects implication for equity holders
FTE method disadvantages
We must compute the projects debt capacity in order to determine the interest and net borrowing before we can make the capital budgeting decision
We must know the future market value of debt in the project before we can assess the projects addition to market value
This is also a disadvantage of the APV method. The WACC method doees not suffer from this limitation
Predetermined debt levels
No targe debt-equity ratio, leverage ratio or interest coverage ratio. The firm adjusts its debt according to a fixed schedule that is known in advance
Issuance costs
Intermediaries such as banks charge underwriting fees. These should be included as part of the projects required investment
Security mispricing
If management believes that securities are being mispriced by outsiders, hten it should exploit this in the interest of existing shareholders
Thhe gains from eg issuing overpriced securities hould be included in the NPV of the project
On the other hand, issuing underpriced securities reduces the NPV
Call (put) option
A contract that gives its owner the right to purchase (sell) an underlying asset at a fixed price during a fixed period of time
At-the-money
Exercise price approximately equal to the current underlying asset price
In-the-money
If immediately exercised, option would yield a positive amount
Out-of-the-money
Immediate exercise would yield a negative amount
Underlying value
Mostly some stock, but also stock indices and a variety of other financial assets
Speculating motive
When investors use options to place a bet on the direction in which they believe the price of the underlying asset is likely to move
Hedging motive
In order to reduce risks by holding contracts or securities whose payoffs are negatively correlated with some risk exposure
Call option value (C) at expiration
C = max(S-K,0)
S = underlying stock price at expiration
K = exercise price of the option
Option returns are highly levered for two reasons
1) For a small fraction of the current stock price, you are entitled to the full upward potential above the strike price (call option)
2) Option positions normally have a multiplier, i.e. they can only be engaged in for (usually) 100 stock equivalents
Law of one price
Two positions with exactly the same future payoff must have the same price today
Credit default swaps
Is the put option P in the previous formulation of debt
Risk-free debt = risky debt + put option on the firms assets
The value of a call (put) option increases as …
The stock price increases (decreases) (and vice versa)
Why is the valuation of call and put options important?
It allows traders in options markets to benchmark actual prices
It enables developing valuation tools for more complex derivative securities
It contributes to corporate finance theory through the option analogy of equity finance
It opens up ways to quantify the value of strategic flexible alternatives in investment projects (i.e. real topic of chapter 22)
Binomial price model
Stock price follows a binomial tree with a given number of periods
In every oeriod the stock price may either go up or down by a known amount or percentage
The one-period risk-free interest rate is given
Replicating portfolio
Portfolio consisting of
1) A number delta of stocks
2) a number b of risk-free bonds maturing at the end of the period
Such that this portfolio has exactly the same payoff as the call option at the end of the period
Parameters of the black-scholdes model
S = current stock price
K = exercise price of the option
T= time of maturity of the option
rf = risk-free interest rate
PV(K)= present value of K = K/1+rf)^T
omega = annualized volatility
Volatility
The annualized standard deviation of stock returns
N(d) function
The N(d) function is the standard normal cumulative density function
What is the beta of a (call ) option
Equal to that of its replicating portfolio:
beta = (sdelta/sdelta + B) *betas + (B/sdelta + B) *betaB
Leverage effect
We see that the beta of a call option is (much) larger than the beta of its underlying stock
Leasing contract
contractt allowing the firm to use specific assets for several years in exchange for periodic payments
Lessee/lessor definition
Lessee: the party in a lease using the asset and liable for the periodic payments
Lessor: the party that lends the asset and is entitled to the lease payments
Typical lease contract
Involves litttle or no upfront payment by the lessee
The lessee just commits to make regulr lease payments for the term of the contract
At the end of the contract term, the lease specifies who will retain ownership of the asset and at what terms
Operational lease
Firm uses the asset during the contract term, after which it is returned to the lessor
Financial lease
Firm has the obligation/right to buy the asset after the contract term
Sales-type lease
The lessor is the manufacturer of the asset, offering lease financing services
Usually through a financial service subsidiary
Direct lease
The lessor is an independent company that specializes in purchasing assets and leasing them to customers
Very often subsidiaries of commercial banks
Sale and lease-back
Firm already owns the asset but would prefer to lease it
Firm sells the asset to the lessor in return for cash
Leases it back to continue using the asset
Leverage leases
The lessor borrows from a bank or other lender to obtain the initial capital to purchase the asset
The lessor uses the lease payments from the lessee to pay interest and principal on the loan
Special-purpose entity/vehicle (SPE or SPV)
Separate business partnership created by the lessee for the sole purpose of obtaining a lease
synthetic lease
Lease that uses an SPE for lease constructions that are targeted to obtain specific favorable accounting and/or tax treatments
Leasing is an alternative for
Purchasing + financing + servicing/maintainging + finally selling the asset (whether by lessor or lessee)
Primary determinant of lease payments
Residual value at the end of the leasing period, since (purchase price - residual value) will be depreciated, and may differ for lessor and lessee
Other costs such as servicing and maintenance are:
1) not that large
2) usually not very different for lessor/lessee
Ignoring servicing/maintenance costs
Competitive pricing in perfect capital markets implies that the lessor sets the lease payments such that
PV(lease payments) = purchase price - PV(residual value)
Fair market value (FMV) lease
Lessee has the option to purchase the asset at its fair market value at the end of the lease term
In perfect capital markets, there is no difference between an FMV lease and an operational lease
Fixed price lease
Lessee has the option to purchase the asset at the end of the lease term for a fixed price that is set upfront
Very common for consumer leases
Since the lessee has an option to purchase, he will buy the asset elsewhere if the fair MV is lower than the fixed price
The lessor will set a higher lease payment to compensate for the value of this option
Fair market value cap lease
The lessee can purchase the asset at the minimum of its fair market value and a fixed price (or “cap”)
Similar to the fixed price lease, but the lessee is not likely to go elsewhere to buy the asset at the end of the lease term
Operating lease (viewed as rental of the asset)
Lessee includes the lease payments as operational costs
Lessor depreciates the asset on its balance sheet
Lessee does not carry the asset on its balance sheet, and so does not depreciate it
Sessee discloses the lease obligations in the footnotes of its financial statements
Capital lease (viewed as acquisition with longterm financing
Lessee carries the asset on its balance sheet and depreciates it
Lessee deducts the interest part of the lease payments as an interest expense
Lessee lists the present value of the future lease payments as a liability on the balance sheet
True tax lease
Lessor receives the depreciation deduction associated with the ownership of the asset
Lessee can deduct the full amount of the lease payments as an operating expense
Lease payments are treated as revenue for the lessor
Non tax lease
Lessee receives the depreciation deduction for tax purposes
Lessee can also deduct the interest portion of the lease payments as an interest expense
The interest portion of the lease payment is interest income to the lessor
Tax authorities will classify a lease as a non-tax lease if it satisfies any of :
◦ Lessee obtains equity in the leased asset
◦ Lessee receives ownership of the asset on completion of all lease payments
◦ Total amount that the lessee is required to pay for a relatively short period of use constitutes an
inordinately large portion of the value of the asset
◦ The lease payments greatly exceed the current fair rental value of the asset
◦ The property may be acquired at a bargain price in relation to the fair market value of the asset at
the time when the option may be exercised
◦ Some portion of the lease payments is specifically designated as interest or its equivalent
security interest
The firm is regarded to have effective ownership of the asset and the asset is protected against seizure by the lessor
The lessor is treated as any other secured creditor and must await the firms reorganization or ultimate liquidation
True (tax) lease
The lessor retains ownership rights over hte asset
The firm must decide, within a limited period of time, whether it assumes or rejects the lease
If it assumes, it must settle all pending claims and continue to make all promised lease payments
If it rejects the lease, the asset must be returned to the lessor
Cash conversion cycle (CCC)
CCC is a measure of the cash cycle
Reflects the “habits” of the industry the firm is in
Inventory days formula
Inventory / Average daily COGS
Accounts receivable days formula
Accounts receivable / Average daily sales
Accounts payable days formula
Accounts payable / average daily COGS
Cash conversion cycle formula
CCC = inventory days + Accounts receivable days - accounts payable days
Trade credit
The credit that the firm extends to its customers, or receives from its suppliers
Accounts receivable days
Average number of days that it takes the firm to collect its sales
Compare this to the overall credit terms
See if a trend can be identified
Payment pattern
Provides information on the percentage of monthly sales tha tthe firm collects in each month after sale
If e.g. it is normal that 10% of sales are usually collected in the same month, 25% in two months, etc…, it can be compared with the current payment pattern
stretching accounts payable
= ignoring a payment due period and deliberately pay later
Seasonal patterns and/or positive/negative cash flow shocks cause short-term financing needs since:
Extra investment in fixed assets and working capital is needed in order to accomodate these
Increased earnings follow these investments with a time delay
And this must be (temporarily) financed
it can be argued that the short-term financing needs are due to
Increased fixed asset investment
Extra (net) working capital investment
Permanent working capital
The amount that the firm must keep invested in its short-term assets to support its continuing operations
Temporary working capital
The difference between the actual level of working capital needs nad its permanent working capital requirements
Golden financing rule
Fixed assets + permanent NWC should be financed with long-term capital (mix of equity and long term debt)
Line of credit
Bank agrees to lend a firm any amount up to a stated maximum
Firm decides to what extent to use this credit falicy
Bridge loan
Short-term bank loan that is used to “bridge the gap” until the firm has arranged long-term financing
Discount loan
Loan requiring the borrower to pay the interest at the beginning of the period
The lender deducts the interest from the loan proceeds
Commercial paper
Short-term unsecured debt issued by large corporations directly to the investing public
-Usually a cheaper source of funds than a short-term bank loan
-Mostly uses in US
-Face value in the order of 100 000
-Average maturity is 30 days, maximum maturity is 270 days
-rated by credit rating agencies
Trust receipt loan
Distinguishable inventory items are held in a trust as security for the loan
When these items are sold, the firm remits the proceeds from their sale to the lender as repayment
Horizontal merger
Target and acquirer are in the same industra
Vertical merger
Targets industry buys from or sells to acquirers industry
Conglomerate merger
Target and acquirer operate in unrelated industries
stock swap
Target shareholders are swapping old stock for new stock in either the acquirer or a newly created merged firm
Reasons to acquire (firms)
Cost reductions: such as layoff of overlapping employees and elimination of redundant resources, are more common and easier to achieve
Revenue enhancements: Such as increased revenues from increased market share, are much harder to predict and achieve
Economies of scale
Larger companies enjoy savings from producing goods in high volume that are not available to small companies
Economies of scope
Savings large companies can realize that come from combining the market and disribution of different types of related products
Synergies: expertiese
Buying new technologies (patents) and experienced workers directly may be more efficient than inventing/hiring them
Synergie: monopoly gains
Buy your competitor in order to substantially reduce competition and increase profits
Synergies: efficient gains
Acquirers often claim that they can run the target organization more efficiently than existing management
Synergies : Tax savings from operating losses:
Conglomerate merger may enjoy losses in one division being offset against profits in another division
Takeover process
Tender offer, sometimes in several rounds with higher prices (offer may be in cash, stock or combination)
US differential taxation
Cash receipts by target shareholders are immediately taxed since it triggers capital gains realization
Stock swaps allow target shareholders to defer capital gains realization
Friendly takeover
Targets board of directors supports the merger and negotiates with potential acquires
Proxy fight takeover defence mechanism
The acquirer attempts to convince the targets shareholders to remove the target board by using their proxy votes and support the acquireres candidates
poison pills (takeover defenses)
A rights offering giving target shareholders the opportunity to buy shares in either the target or an acquirer at a deeply discounted price
Existing shareholders of the acquirer effectively subsidize these purchases, making the takeover so expensive that they choose to pass on the deal
White knight/squire (takeover defense)
some other (friendly) entity shows up that acquires the company
golden parachute
incumbent management receives an extremely lucrative and guaranteed package in the event that the firm is taken over and the managers are let go
Free rider problem
If the target firm is poorly managed, this results in a low share price
After taking over control in the target (not necessarily 100%) by the acquirer, the value of any sharefolder will be increased if the acquirer succeeds in its strategy
Leverage buyout (LBO) usually hostile takeover by a corporate raider, where the raider announces a tender offer for a controlling interest in the target firm instead of using his own cash to pay for these shares he borrows and pledges the shares as collateral on the loan. AFTER taking control of the target:
Us legislation allows that the loans can be directly attached to the acquired company, so the company has borrowed, not the raider. The raidr owns half of the shares, while the company is responsible for repaying the loan with interest. The corporate raider has effectively obtained half the shares without paying for them!
Insurance covers the costs/losses due to specific events e.g.
Property insurance: fire storm earthquakes etc.
Business liability insurance: the comapny is liable for a third party claim
Business interruption insurance: loss of earnings due to fire, accident, product recall, etc.
Key personnel insurance: copensates the firm for the loss or unavoidable absence of crucial employees in the firm
Insurance premium & actually fair insurance premium
The fee a firm pays to an insurance company for the purchase of an insurance policy
When the NPV from selling insurance is zero ie. when:
Insurance premium = present vlaue of the expected payment
Actually fair insurance premium formula
SUMPr(loss at time t) x E(payment in the event of loss at time t)/(1+rL)^t
Tax rate fluctuations
If the corporate tax code has different bracket, insurance can provide a tax saving if the firm is in a higher tax bracket when it pays the premium compared to the tax bracket it is in when it receives the insurance payment in the event of a loss
Debt capacity
Insurance reduces the risk of financial distress, so the tradeoff between leverage and financial distress costs is relaxed, allowing the firm to increase its use of debt financing
Risk assessment
Insurance companies specialize in assessing risk and will often be better informed about the extent of certain risks faced by the firm than the firms own managers
Two types of exposure management
Vertical integration and/or storage
Hedging this exposure in commodity or financial markets
Vertical integration
Refers to a merger of a firm with its supplier
Commodity price increase raises the firms costs and the suppliers revenues, so that they may offset each other
May add value if combining the firms results in important synergies
Vertical integration is not a perfect hedge
Long term storage
E.g. airliner could purchase a large quantity of fuel today and store it until it is needed, so that he cost of fuel is locked in
Disadvantages of supply contracts
They expose each party to the risk that the other party may default and or will fail to live up to the terms of the contract
The cannot be entered into anonymously: the buyer and seller know each otehrs identity
the market value of the contract at any future time may be difficult to determine
A lot of investors are only interested in the commodity price movement, and do not want any actual delivery of commoditites
Future contract
Agreement to trade an asset on some future date at a price that is locked in today
Exchange rate risk
Exchange rate fluctioations
Importer-exporter consideration
If the supplier sets its prices in GBP then the euro firm faces the risk that the euro may fall, making the GBP and therefore the parts more expensive
Hedging instruments include
Currency forward contracts
Currency futures contracts
Loosely defined: a forward contract is the same as a futures contract, with two differences:
Actual delivery of the underlying value occurs at the expiration date
There is no marking-to-market feature
CIRP definition + formula
States that the difference between the forward and spot exchange rates is related to the interest rate differential between the currencies
Ft = S*(1+r$)^T/(1+reuro)^T
Interest rate risk
Interest rate risk is commonly measured in terms of duration
A securities duration is computed as D =
SUM(t*PV(Ct)/P
P= security price = SUM PV(Ct) = SUM(Ct/(1+r)^t)
Ct = cash flow of the security at date t
PV() = present value at the yield to maturity (r)
Duration measures the security price sensitivity
Interest rate sensitivity (risk)
dP/P = D*dr/1+r = percentage change in the bond given yield to maturity r and duration D
Duration-based hedging
Managing/hedgin interest rate risk
Try to make the interest rate sensitivites of assets and liabilities more or less the same
This translates directly into matching of the durations of assets and liabilities
Duration of a portfolio of securities =
Market value weighted average of the individual durations
In other words
D1+2 = P1/P1 + P2 *D1 + P2/P1 + P2 * D2
In order to protect its equity from overal small increases or decreases of interest rates, the firm needs an equity duration of zero this is acomplished how?
On balance hedging:
Reduce the duration of the assets and/or increase the duration of the liabilities
Easy to understand but usually difficult to execute
Off balance hedging:
Use financial derivatives to immunize equity, leaving balance sheet items intact
Although this entails complex analysis, it is by far the most used immunization strategy for fixed-income portfolios
