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CFAI Flashcards > Corporate Finance > Flashcards

Corporate Finance Flashcards

1
Q

Formula to Calculate Economic Profit

A

NOPAT - $WACC

where $WACC = WACC x Capital

and Capital = Investment = Capital Investment Required + Additional working capital

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2
Q

Inflation adjustment to nominal cost of equity to determine real cost of equity

A

real cost of equity = [(1 + nominal cost of equity) / (1 + inflation rate)] - 1

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3
Q

Poison Pill

A

A pre-takeover offer defense mechanism, make it prohibitively costly for an acquirer to take control of a target without prior approval of the target’s board of directors.

Most create rights that allow for issuance of shares of the target company’s stock at a substantial discount to market value

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4
Q

Poison Put

A

A pre-takeover offer defense mechanism, allows bondholders to “put” (sell) the bonds to the company at a pre-specified price in the contract

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5
Q

Pre-Takeover Offer Defense Provisions

A

Incorporating in state with restrictive take over laws (US only)

Staggered Board of Directors (extend the time it would take to elect enough directors to take control of the board)

Restricted voting rights (restrict stockholders who recently acquired large block of stock from voting their shares without board consent)

Super majority voting provisions (usually combined with restricted voting rights, is triggered to require more than the typical 51% majority to approve merger)

Fair Price Amendments (Require the acquirer to pay the highest stock price target company held in the market over a specified period)

Golden Parachutes (compensation agreements between target company and its senior managers. Least effective)

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6
Q

Greenmail

A

Post-takeover offer defense that involves an agreement allowing the target to repurchase its own shares back from the acquiring company (at a premium)

Not so common anymore due to 50% tax on profits realized by the acquirer

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7
Q

Crown Jewel Defense

A

Post-takeover offer defense, target may decide to sell off a subsidiary or asset to a third party

Courts may declare this strategy illegal once a takeover bid is announced

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8
Q

Pac-Man Defense

A

Post-takeover offer defense, target makes counter offer to acquire the hostile bidder

(rare occurrence as hostile bidder is more commonly much larger than target company being acquired)

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9
Q

White Knight Defense

A

Post-takeover offer defense, target company’s board finds a third party to purchase the company instead of hostile bidder (often the best outcome for target shareholders)

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10
Q

White Squire Defense

A

Post-takeover offer defense, target seeks a friendly party to buy a substantial minority stake in the target, enough to block takeover without selling the entire company

Carries high litigation risk

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11
Q

What is the impact of inflation on capital budgeting analysis?

A

It reduces the value of depreciation tax savings thereby reducing profitability. Inflation shifts wealth from taxpayers to government.

Also reduces value of fixed payments to bondholders. Higher than expect inflation shifts wealth from bondholders to issuing corporations, on real terms.

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12
Q

Timing option

A

Company can delay investing and await for more or improved information instead of investing now

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13
Q

Abandonment Option

A

After investing, company can abandon the project when financial results are disappointing.

At a future date, if cash flow from abandoning a project > PV of CF from continuing project, exercise the option

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14
Q

Expansion (Growth) Option

A

Company can make additional investments when future financial results are strong

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15
Q

Price-setting option

A

If demand exceeds capacity, management can increase prices to benefit from excess demand since it cannot do so by increasing production

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16
Q

Production-flexibility options

A

Company can profit from working overtime or from adding additional shifts

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17
Q

Fundamental options

A

Options embedded in a project that can raise its value. Payoffs from investment are contingent on an underlying asset

e.g., value of oil well or refinery equipment is contingent on the price of oil

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18
Q

Stable dividend policy

A

Regular dividends are paid that generally do not reflect short-term volatility in earnings

*Most common as managers are reluctant to cut dividends

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19
Q

Constant dividend payout ratio policy

A

Policy of paying out a constant percentage of net income in dividends

*Implemented infrequently in reality

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20
Q

Residual dividend policy

A

based on paying out as dividends any internally generated funds remaining after such funds are used to finance positive NPV projects

*Rarely used in practice

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21
Q

Target payout ratio

A

A goal that represents the proportion of earnings that the company intends to pay out to shareholders as dividends over the long term

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22
Q

Target Payout Adjustment Model

A

Expected increase in dividends =

(Exp. earnings x Target payout ratio - Prev. Dividend) x Adj. factor

where Adj. factor = 1 / numbers of years adj. will take

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23
Q

Tax impact on investor selling shares before ex-dividend date

A

Current Share Price - (Current - Purchase Price)(Capital Gains Tax)

The dividend tax burden is transferred to the buyer

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24
Q

Tax impact on investor selling shares after the share goes ex-dividend

A

Share Price on Ex-Dividend Date - (Current - Purchase Price)(CG Tax) + After-tax Dividend

Investor pays taxes on both capital gains and on dividend earned

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25
Q

Formula to solve for the amount of price decrease when share goes ex-dividend

A

Pw - Px = D * (1-TD)/(1-Tcg)

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26
Q

Levered Cost of Equity (MM Proposition II w/ Taxes)

A

To determine WACC based on a desired level of debt for an all equity company:

Levered r(e) = r(e) + [r(e) - rd][1-T][D/E]

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27
Q

Levered WACC

A

(D/V)(rD)(1-T) + (E/V)(rE)

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28
Q

Herfindahl-Hirschman Index (HHI)

A

Sum [(Sales or output of firm x / total sales or output of market) *100]^2

HHI between 1000 - 1800 is considered a moderately concentrated market (increase of 100 points will result in antitrust issues)

<1000 is not concentrated

> 1800 is highly concentrated (increase of 50 points will result in antitrust issues)

29
Q

Free Cash Flow

A

Net Operating Profit Less Adjusted Taxes (NOPLAT) + Depreciation - (change in NWC - CapEx)

where change in Net Working Capital =
(Current A - Current L in Current Year) - (Current A - Current L in Previous Year)

where capital expenditures =
(net fixed assets in current year) - (net fixed assets in previous year)

30
Q

Terminal Value FCF

A

FCF (1+g) / WACC - g

31
Q

Advantages of DCF

A

Expected changes in target company’s cash flows can be readily modeled

An estimate of intrinsic value based on forecast fundamentals is provided by the model

Changes in assumptions and estimates can be incorporated by customizing and modifying the model

32
Q

Disadvantages of DCF

A

Difficult to apply when FCF doesn’t align with profitability within “first stage”

Estimating cash flows and earnings far into the future is not an exact science - i.e. uncertainty

Estimates of discount rate can change overtime due to market developments and can significantly impact acquisition estimates

Estimated of terminal value is prone for estimate error and can differ depending on the technique used. Small changes in assumed growth or WACC can result in dramatic change of estimates

33
Q

How to Calculate Post-Acquisition EPS (All-stock acquisition)

A

Step 1. Calculate shares needed to be acquired from Target

[(Target company share price * target company shares outstanding) / Acquirer share price]

Step 2. Calculate total shares of Acquirer after acquisition

Step 3. Calculate combined earnings

Step 4. Calculate EPS after acquisition

34
Q

Dispersed ownership

A

Corporate governance term that refers to the existence of many shareholders, none of which have the ability to individually exercise control over the corporation

35
Q

Horizontal ownership

A

Involves companies with mutual business interest (e.g. key customers or suppliers) that have cross-holding share arrangements

36
Q

Vertical ownership (pyramid ownership)

A

Involves a company or group that has controlling interest in two or more holding companies, which in turn have controlling interest in various operating companies

37
Q

What is the Principal-principal problem?

A

With concentrated ownership and voting powers, controlling owners may be able to allocate company resources to their own benefit at the expense of minority owners

38
Q

One-tier board

A

Structure that consists of a single board of directors, composed of executives (internal) and non-executive directors (external)

*Most common board structure

39
Q

Two-tier board

A

Board structure consists of a supervisory board that oversees a management board

Supervisory board serves as a control function through activities such as inspecting the books and records, reviewing annual report, oversight of external auditors, influencing management compensation, etc…

40
Q

Bootstrapping Earnings

A

The effect occurs when the shares of the acquirer trade at a higher P/E ration than those of the target and the acquirer’s P/E does not decline following the merger

In order for this to work, the acquirer P/E must be higher than the targets P/E prior to the acquisition

41
Q

Managerialism theories

A

Executive compensation is highly correlated with company size, which motivates corporate executives to engage in mergers to maximize the size of their company rather than shareholder value

42
Q

Company’s break up value

A

Value that can be achieved if a company’s assets are divided and sold separately

43
Q

Define Industry Lifecycle stage: Pioneering development

Motivation for merger

Type of merger that are common

A

Industry exhibits substantial development costs and has low but slowly increasing sales growth

Younger, Smaller companies exit strategy is to be bought out by larger mature companies

Conglomerate or horizontal type mergers are common

44
Q

Define Industry Lifecycle State: Rapid Accelerating Growth

Provide motivation for merger

Types of merger common

A

Industry exhibits high profit margins with limited competition in the market

Motivation

Rapid growth in sales may require large capital requirements to expand existing capacity

45
Q

Define Industry Lifecycle State: Mature Growth

Motivation for Merger

Common Type(s) of Merger

A

Industry experiences a drop in the entry of new market participants but growth potential remains

Merger to achieve economies of scale and operational efficiencies

Horizontal or vertical are common types of mergers

46
Q

Define Industry Lifecycle State: Stabilization and market maturity

Motivation for merger

Common mergers

A

Industry faces increasing competition and capacity constraints exist

Merge to achieve economies of scale in research, production, and marketing to lower cost and improve performance

Horizontal mergers are common

47
Q

Define Industry Lifecycle State: Deceleration of growth and decline

Merger motivation

Common types of mergers

A

Industry faces overcapacity and decreasing profit margins

Poorly performing firms will look to merge with profitable company to survive (within same industry)

Achieve economics of scale to reduce cost and boost profit margins (within supply chain)

Acquire younger companies for EPS growth or bootstrap earnings

48
Q

How to calculate mean takeover premium on recent comparable takeovers to determine fair acquisition price?

A

Step 1. Mean Takeover Premium =

[Sum (%change in stock price from acquisition for recently acquired companies) / number of comparable takeovers]

Step 2. Fair acquisition price for target =

Avg stock price pre-takeover * (1+mean takeover premium)

49
Q

Enterprise Value

A

(Market Value of Debt + Equity) - Cash and Investments

50
Q

Advantages of Using Comparable Company Analysis

A
  • Provides reasonable approximation of a target company’s value relative to similar companies in the market
  • data required is readily available
  • market derived estimates (relative valuation metrics used)
51
Q

Disadvantages of Using Comparable Company Analysis

A
  • Sensitive to market mispricing (market multiples used for valuation)
  • Requires a two-step process to determine fair acquisition price
  • Analysis is limited to what the analyst and also market knows (internal plans of the target company are not known such as if company is planning a capital structure change or eliminating duplicative resources)
  • Market conditions may be different from when past acquisitions took place
52
Q

Advantages of Comparable Transaction Approach

A
  • Does not require separate estimation of a takeover premium
  • market derived estimates
  • reduces probability of litigation risk for all parties involved regarding merger transaction pricing because of recent and relevant transaction data available
53
Q

Disadvantages of Comparable Transaction Approach

A
  • Calculation assumes market has accurately determined true intrinsic value of prior acquisitions, posing a real risk to target company post-merger if past transactions were not accurate
  • There may not be adequate number of transactions taken place recently within the industry, forcing analyst to look for similar companies in other industries, posing higher risk of variability in valuation
  • Difficult to incorporate plans target company may have (change in capital structure)
54
Q

Divestiture

A

When a company decides to sell, liquidate, or spin off a division or a subsidiary

55
Q

Equity carve-out

A

Involves the creation of a new legal entity and sales of equity in it to outsiders

56
Q

Spin-off

A

Shareholders of the parent company receive a proportional number of shares in a new, separate entity.

Shareholders end up owning stock in two different companies instead of one

57
Q

Split-off

A

Some of the parent company’s shareholders are given shares in a newly created entity in exchange for their shares of the parent company

58
Q

Liquidation

A

Involves breaking up a company, division, or subsidiary and selling off its assets in piecemeal

Typically associated with bankruptcy

59
Q

Benefits of effective corporate governance

A
  • higher profitability
  • growth in return on equity
  • better access to credit
  • higher and sustainable dividends
  • favorable long-term share performance
  • lower cost of capital
60
Q

Impact of ineffective corporate governance to companies

A
  • may experience reputational damage
  • reduce competitiveness
  • potential share price weakness/volatility
  • reduced profitability
  • higher cost of capital
61
Q

Executive Remuneration (Compensation) clauses

A

“Say-on-pay” provision allows shareholders to vote and/or provide feedback on executive compensation

Claw-back policy allows a company to recover previously paid compensation if certain events, such as financial restatements, misconduct, breach of law, or risk management deficiencies are uncovered

62
Q

Straight voting share structures vs. Dual Class share structures

A

Straight voting structure:

Shareholders are granted the right of one vote for each share owned

Dual-class structure:

Company founders and/or management have shares with more voting power than the class of shares available to the general public

63
Q

Economic Income vs. Accounting Income

A

Economics income is calculated before interest expense b/c cost of capital is reflected in discount rate

= After-tax Cash flows + change in proj. MV

Accounting income is calculated after interest (financing cost) is deducted

64
Q

Market Value Added

A

=Sum{EP / (1+WACC)^t}

Whereas, EP = Economic Profit

Calculated as, NOPAT - $WACC

65
Q

Dividend Irrelevance Theory

A

In a no-tax/no-fee world, dividend policy is irrelevant because investors can create a homemade dividend

66
Q

Dividend Preference Theory

A

Investors prefer the certainty of current cash to future capital agains

67
Q

Tax Aversion Theory

A

Investors are tax averse to dividends and prefer companies to buy back shares instead

68
Q

FCFE Coverage Ratio Formula

A

FCFE / dividends + share repurchases

CFAI Flashcards (10 decks)

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