Corporate Finance Flashcards
Corporate Governance
System of internal controls and procedures (checks and balances) that minimizes and manages conflicts of interest between insiders and external shareholders
Shareholder Theory
Primary focus of corporate governance is the interests of the firm’s shareholders, which is the maximization of market value of firm’s common equity
Stakeholder Theory
Considers conflicts among several groups that have an interest in the activities and performance of the firm (employees, suppliers, customers, etc.)
Principal-Agent Conflict
Agent is hired to act in the interest of the principal, but agent’s interests might not coincide with those of the principal
Information Asymmetry
Managers have more and better information about the functioning of the firm and its strategic direction than shareholders do
Related Party Transactions
Agreements or specific transactions that benefit entities in which they have a financial interest, to the detriment of minority shareholders
Stakeholder Management
Management of company relations with stakeholders based on having good understanding of stakeholder interests and maintaining effective communication with stakeholders
Legal Infrastructure
Laws relevant to and the legal recourse of stakeholders when their rights are violated
Contractual Infrastructure
Contracts between the company and its stakeholders that spell out the rights and responsibilities of the company and stakeholders
Organizational Infrastracture
Company’s corporate governance procedures (internal systems and practices)
Governmental Infrastructure
Regulations to which companies are subject
Proxy
Shareholder assigns right to vote to another who will attend the meeting (director, management, financial advisor)
Special Resolutions
Require supermajority vote for passage (two thirds or three fourths). Mergers, takeovers, amending corporate bylaws
Majority Voting
Candidate with the most votes for each single board position is elected
Cumulative Voting
Shareholders can cast all their votes for a single candidate or divide them among board candidates (greater minority shareholder representation)
One Tier Board
Single board of directors that includes both internal (executive) and external directors
Independent Directors
Non-executive directors who have no other relationship with the company
Two Tier Board
Supervisory board that excludes executive directors. Management board with executive directors. Both operate independently
Staggered Board
Elections for some board positions are held each year. Limits the ability of shareholders to replace board members in any one year
Audit Committee
Oversight of financial reporting, implementation of accounting policies, effectiveness of internal controls and internal audit, recommending external auditor, proposing remedies
Governance Commitee
Oversight of governance code, implementing code of ethics, managing conflicts of interest, ensuring compliance with laws and regulations
Nominations Committee
Proposes qualified candidates for election to the board, aligns board’s composition with company’s corporate governance policies
Compensation Committee
Remuneration. Recommends amounts and types of compensation to be paid to directors and senior managers. Oversight of employee benefits
Risk Committee
Informs board about appropriate risk policy and risk tolerance of the organization
Investment Committee
Reviews and reports proposals for large acquisitions or projects, sale or disposal of company assets or segments, performance of acquired assets
Activist Shareholders
Pressure companies in which they hold a significant number of shares for changes, often changes they believe will increase shareholder value
Proxy Fight
Seek the proxies of shareholders to vote in favor of their alternative proposals and policies
Tender Offer
Offer made for a specific number of shares of a company to gain enough votes to take over the company
Hostile Takeover
Senior managers and boards of directors can be replaced by shareholders in a move not supported by company management
Common Law System
Judges’ rulings become law (shareholder and creditor interests benefit)
Civil Law System
Judges are bound to rule based only on specifically enacted laws
Dual Class Structure
One class of shares may be entitled to several votes per share, while another class is entitled to one vote per share
ESG Investing
Use of environmental, social, and governance factors in making investment decisions (sustainable/responsible investing)
Negative Screening
Exclusionary, Norms-Based. Excluding companies in specific industries from consideration for the portfolio based on their practices regarding human rights, environmental concerns or corruption.
Positive Screening
Investors attempt to identify companies that have positive ESG practices
Best In Class
Seeks to identify companies within each industry group with the best ESG practices
Impact Investing
Investing to promote specific social or environmental goals while still making profitable investments
Green Finance
Producing economic growth achieved in a more sustainable way by reducing emissions and better managing natural resource use
Green Bonds
Bonds for which the funds raised are used for projects with a positive environmental impact
Thematic Investing
Investing in an industry or sector based on a single goal
Capital Budgeting Process
Process of identifying and evaluating capital projects (projects where the cash flow to the firm will be received over a period longer than a year)
Replacement Projects to Maintain the Business
Made without detailed analysis (can existing operations continue)
Replacement Projects for Cost Reduction
Determine whether equipment that is obsolete, but still usable, can be replaced (detailed analysis)
Expansion Projects
Taken on to grow the business (require explicit forecast of future demand –> very detailed analysis)
New Product or Market Development
Detailed analysis due to large amount of uncertainty involved
Mandatory Projects
Required by a governmental agency or insurance company (safety related or environmental concerns). Generate little to no revenue
Other Projects
Pet projects of senior management, high-risk endeavors (difficult to analyze)
Incremental Cash Flows
Changes in cash flows that will occur if the project is undertaken
Sunk Costs
Costs that cannot be avoided, even if the project is not undertaken. Not affected by the accept/reject decision, not included in analysis (consulting fees)
Externalities
Effects the acceptance of a project may have on other firm cash flows (can be positive or negative)
Cannibalization
Occurs when a new project takes sales from an existing project
Conventional Cash Flow Pattern
Sign on the cash flows changes only once (one or more cash outflows followed by one or more cash inflows)
Unconventional Cash Flow Pattern
More than one sign change (initial investment outflow, a series of inflows, cash outflow at the end)
Opportunity Costs
Cash flows that a firm will lose by undertaking the project under analysis (cash flows generated by an asset the firm already owns that would be forgone if the project is undertaken)
Independent Projects
Projects that are unrelated to each other and allow for each project to be evaluated based on its own profitability
Mutually Exclusive Projects
Only one project in a set of possible projects can be accepted (projects compete with each other)
Project Sequencing
Investing in a project today creates the opportunity to invest in other projects in the future (project undertaken today is profitable, can invest in a second project down the road)
Capital Rationing
If a firm’s profitable project opportunities exceed the amount of funds available, firm must ration, or prioritize, its capital expenditures
Net Present Value
Sum of the present values of all the expected incremental cash flows if a project is undertaken
Discount Rate
Cost of capital adjusted for the risk level of the project
Internal Rate of Return
Discount rate makes the present value of the expected incremental after tax cash inflows just equal to the initial cost of the project –> PV(inflows) = PV(outflows) –> Discount rate for which which NPV of a project equals zero
IRR > required rate of return, accept the project
IRR < required rate of return, reject the project
Payback Period
Number of years it takes to recover the initial cost of an investment (when cumulative net cash flow equals zero)
Cumulative Net Cash Flow
Running total of the cash flows at the end of each time period
Discounted Payback Period
Number of years it takes a project to recover its initial investment in present value terms (greater than the payback period without discounting)
Profitability Index
Present value of a project’s future cash flows divided by the initial cash outlay
PI > 0, accept the project
PI < 0, reject the project
NPV Profile
Graph that shows a project’s NPV for different discount rates (x axis = discount rates, y axis = NPVs)
Crossover Rate
Discount rate at which the NPVs of two projects are equal
Weighted Average Cost of Capital
Marginal Cost of Capital. Rate at which to discount the cash flows associated with a capital budgeting project (k). Cost of financing firm assets (opportunity cost). Average risk of the projects that make up the firm
Capital Components
Right side of the balance sheet (liabilities). Debt, preferred stock, common equity
Component Cost
Cost of the capital components. Increase in firm’s total assets is financed through increase in at least one of these capital accounts
Kd
Rate at which the firm can issue new debt (YTM on existing debt)
Kd(1 - t)
After tax cost of debt (t is marginal tax rate) used to calculate WACC. Interest rate at which firms can issue new debt net of the tax savings from the tax deductibility of interest
Kps
Cost of preferred stock
Kce
Cost of common equity. Required rate of return on common stock
Target Capital Structure
Proportions based on market values of debt, preferred stock and equity that the firm expects to achieve over time
Marginal Cost of Capital Curve
Firm’s WACC may increase as larger amounts of capital are raised (cost of raising additional capital) –> upward sloping
Investment Opportunity Schedule
Given expected returns (IRRs) on potential projects, order expenditures on additional projects from highest to lowest IRR. Ranking of all the projects available to a company
Optimal Capital Budget
Intersection of investment opportunity schedule and marginal cost of capital curves. Firm should undertake all projects with IRRs greater than cost of funds
Matrix Pricing
Valuing a bond based on the yields of comparable bonds (same rating yield curve)
Dividend Discount Model
Dividends are expected to grow at a constant rate (g), gives current value of stock
Beta
Measure of systematic or market risk (based on business risks of its projects and financial structure)
Pure Play Method
Estimate a company’s beta based on a publicly traded company engaged in a business similar to, and with risk similar to, project under consideration (engaged purely in similar business)
Asset Beta
Adjust pure play beta from comparable company for company’s leverage (unlever) and then adjust (re-lever)
Country Risk Premium
Reflect the increased risk associated with investing in a developed country (beta does not adequately capture country risk). Added to market risk premium when using CAPM
Sovereign Yield Spread
Difference in yields between the developing country’s government bonds and Treasury bonds of a similar maturity
Developing Country Equity Risk Premium
Adjust sovereign yield spread by ratio of volatility between country’s equity market and government bond market
Marginal Cost of Capital
Cost of raising an additional dollar of capital
Marginal Cost of Capital Schedule
WACC for different amounts of financing (upward slope)
Break Points
Occur any time the cost of one of the components of a company’s WACC changes
Flotation Costs
Fees charged by investment bankers when a company raises external equity capital (2%-7%) –> adjust the initial project cost (multiply flotation cost rate by amount of equity capital raised, then subtract that number from initial cash outlay)
Market Risk Premium
Expected return of the market minus the risk free rate
Leverage
Amount of fixed costs a firm has. Greater leverage leads to greater variability of firm’s after tax operating earnings and net income
Business Risk
Risk associated with a firm’s operating income. Result of uncertainty about a firm’s revenues and expenditures necessary to produce those revenues. Combination of sales and operating risk
Sales Risk
Uncertainty about the firm’s sales
Operating Risk
Additional uncertainty about operating earnings caused by fixed operating costs (greater proportion of fixed to variable costs)
Financial Risk
Additional risk firm’s common stockholders must bear when the firm uses fixed cost (debt) financing
Degree of Operating Leverage
Percentage change in operating income (EBIT) that results from a given percentage change in sales –> highest at low levels of sales
Degree of Financial Leverage
Ratio of the percentage change in net income (or EPS) to the percentage change in EBIT
Degree of Total Leverage
Combines degree of operating leverage and degree of financial leverage. Measures sensitivity in EPS to changes in sales
Breakeven Quantity of Sales
Quantity of sales for which revenues equal total costs, so net income is zero. Sales a firm must generate to cover all fixed and variable costs
Contribution Margin
Difference between price and variable cost per unit
Operating Breakeven Quantity of Sales
Consider only fixed operating costs and ignore fixed financing costs
Primary Sources of Liquidity
Sources of cash it uses in its normal day to day operations
Cash Balances
Result from selling goods and services, collecting receivables, generating cash from other sources (short term investments)
Short Term Funding
Trade credit from vendors and lines of credit from banks
Secondary Sources of Liquidity
Liquidating short term or long lived assets, negotiating debt agreements, filing for bankruptcy and reorganizing the company
Drags on Liquidity
Delay or reduce cash inflows or increase borrowing costs (uncollected receivables, bad debts, obsolete inventory, tight short term credit)
Pulls on Liquidity
Accelerate cash outflows (paying vendors sooner than is optimal and changes in credit terms that require paying outstanding balances)
Operating Cycle
Average number of days it takes to turn raw materials into cash proceeds from sales
Cash Conversion Cycle
Length of time it takes to turn the firm’s cash investment in inventory back into cash, in the form of collections from the sales of inventory
Daily Cash Position
Uninvested cash balances a firm has available to make routine purchases and pay expenses as they come due
Adjustable Rate Preferred Stock
Dividend rate reset quarterly to current market yields (percent of dividends received exempt from federal tax)
Aging Schedule
Calculate average days of receivables over time. Can make percentage of total outstanding receivables
Weighted Average Collection Period
Indicates average days outstanding per dollar of receivables (weights % of total receivables in each category, multiplied by average days to collect)
Uncommitted Line of Credit
Bank extends offer of credit for a certain amount but may refuse to lend if circumstances change
Committed Line of Credit
Bank extends offer of credit that it commits to for certain period of time
Revolving Line of Credit
For longer terms than committed lines of credit. Can be verified and listed on firm’s financial statements in footnotes as source of liquidity
Blanket Lien
Gives bank a claim to all current and future firm assets as collateral in case primary collateral is insufficient
Banker’s Acceptances
Used by firms that export goods. Guarantee from the bank of the firm that has ordered the goods stating that a payment will be made upon receipt of the goods
Factoring
Actual sale of receivables at a discount from their face values. Factor (buyer) takes on responsibility of collecting receivables and credit risks
Commercial Paper
Short-term debt securities that can be issued by large, creditworthy companies. Interest costs slightly less than rate they could get from bank
