FM211 Flashcards

Question

share repurchase

Answer 1

firm uses cash to purchase its own stock from shareholders

Answer 2

firms repurchase shares in the open (i.e. secondary market) anonymously; usually lasts up to 3 years.

Answer 3

firm pre-specifies the no. of shares and the price at which it will offer to repurchase shares (at a premium to the current market price)

Answer 4

firm provides a schedule of possible repurchase shares prices and invites stockholders to state the no. of shares they are willing to sell at each price

Answer 5

firm offers to repurchase shares from the specific shareholders, normally at a significant premium to the market price. By buying out a major shareholder, the firm can remove the the threat of a takeover ("greenmail")

Answer 6

an increase in the demand for cash will make investors buy A's stock because of their larger dividend more than B because of their smaller dividend. Therefore, the price of firm A becomes > than B and the value of A>B. MM showed that in perfect capital markets, this argument is IRRELEVANT! if the following assumptions hold: 1. investment is kept constant 2. no transaction costs 3. efficient capital mkts 4. managers maximise shareholders' wealth 5. no taxes (capital gains/dividend tax) THEN, dividend policy doesn't affect the value of the firm & wealth of the shareholders!!

Answer 7

there is NO impact on shareholder value, but there are differences in how this value is distributed between shares and cash. this difference doesn't matter to investors! shareholders can create a dividend they desire by selling/buying shares and therefore WON'T pay higher prices today for firms with higher dividend payouts! -> capital loss to old shareholders (i.e. dilution offsets dividend)

Answer 8

1. firms have long term target dividend payout ratios 2. managers focus more on dividend changes than on absolute levels 3. managers are reluctant to make dividend changes that might have to be reversed 4. dividend changes follow shifts in LR, sustainable levels of earnings rather than SR changes in earnings. 5. firms repurchase stock when they've accumulated a large amount of unwanted cash/wish to change their capital structure by replacing equity with debt. -> suggests that market DOES respond (unlike MM!)

Answer 9

investment may NOT be held constant if investment decisions (positive/negative) are affected by dividend policy, firm value can change. if surplus cash will be wasted by managers, then paying out dividends increases firm value OR if paying out dividends means sacrificing valuable investment, it decreases firm value.

Answer 10

there ARE transaction costs - costs to mailing dividends, buying/selling stocks!

Answer 11

capital mkts are NOT efficient! - information asymmetry: managers often know more about the firm than outsiders, they "signal" their private info to outsiders by e.g. changes to dividend payouts - irrationally: if mkt participants exhibit systemic biases in processing info, then stocks may be mispriced.

Answer 12

managers' preferences DIFFER from shareholders' preferences - have short term objectives - prefer to underinvest and inflate dividends to increase the current stock price and their pay

Answer 13

taxes are NOT equivalent - dividends are tax similar to ordinary income (when you receive dividend) - capital gain is usually taxed separately (when you sell your investment) - dividends are tax inefficient, taxes are usually higher - dividend paying firms should be less valuable than non dividend paying firms - investors may form clientele based on their tax brackets: those in higher tax brackets may invest in stocks which don't pay dividends and vice versa (lower tax brackets invest in stocks that DO pay dividends)

Answer 14

the mix of financing instruments a firm uses to fund its investments (assets). We can think of a firm's capital structure as broadly being composed of two components: debt and equity leverage ratio = debt/assets = debt/debt + equity

Answer 15

an ownership stake in the firm - are residual claiments to a firm's CFs, entitled but not obligated to receive payments (i.e. dividends) from after-tax profits

Answer 16

- loans, bonds, notes - typically recieve legally obligated interest payments, at a repayment of principal at maturity - generally paid out of pre-tax profits - chapter than equity - increasing debt boosts expected EPS and the E(r) to equity (as long as the cost of debt is lower than the firm's expected return on invested capital). - BUT, increases the risk of equity

Answer 17

in perfect capital markets, changing the capital structure changes how the firm's assets CFs are divided amongst debt and equity holders, but does NOT change the total cash flow going to all investors. - when there are no taxes and capital markets function well, it makes no difference whether the firm borrows/individual shareholders borrow. - shareholders can borrow and make their returns riskier on their own "homemade leverage" so will not pay more to invest in an otherwise identical levered firm - mkt value of a firm doesn't depend on its capital structure

Answer 18

strategy: buy a 1% stake in U dollar investment: 0.01 x Vu dollar retun = 0.01 x profits replication strategy: buy 1% of both debt and equity of firm : dollar investment debt: 0.01 x DL equity: 0.01 x EL dollar return debt: 0.01 x interest equity: 0.01 x (profits - interest) total dollar investment: 0.01(DL-EL) = 0.01 x VL dollar return = 0.01 x profits both strategies produce the same dollar return! therefore by law of one price 0.01 x Vu = 0.01 x VL VU = VL if this condition doesn't hold, then an arbitrage opportunity exists

Answer 19

dollar investment debt: -0.01 x DL equity: 0.01 x Vu dollar return debt: -0.01 x interest equity: 0.01 x profits total dollar investment: 0.01(VU - DL) dollar return: 0.01(profits - interest)

Answer 20

in perfect capital markets: A = VU = VL = D + EL rA = rU = (WD x rD) + (WE x rE) therefore rA = rU = (D/D+E)rD + (E/D+E)rE = WACC(pretax weighted cost of capital) rE = rU + D/E(rU - rD) the expected return on the common stock of a levered firm increases in proportion to the debt-equity ratio (D/E) rU = compensation for businesses/operating risk D/E(rU - rD) = compensation for "financial risk" if CAPM is true, then these changes in E(r) should correspond to CAPM betas BA = BU = BD(D/D+E) + BE(E/D+E) therefore BE = BU + (D/E)(BU - BD)

Answer 21

financial leverage doesn't affect: - risk/expected return on the firm's assets - firm value it does affect - risk and E(r) on a firm's common stock it may affect: - risk/E(r) on debt, depending on the amount of leverage and the nature of default

Answer 22

interest payments in many jurisdictions are treated as the cost of doing business and hence deducted from pre-tax income adding debt can reduce pre tax income and therefore, the % of tax, this is known as the interest tax shield (ITS) = (D x rD) x tc

Answer 23

because ITS reduces the firms' effective cost of capital, we can incorporate the benefit it brings to the firm and shareholder value by modifying the firm's cost of capital. We define the firm's effective after tax cost of capital (WACC): WACC = rD(1-Tc)(D/V) + rE(E/V) expanding this formula, we see its relationship with the company cost of capital (i.e. before tax WACC) WACC = rD(1-Tc)(D/V) + rE(E/V) = rD(D/V) + rE(E/V) - rDTc(D/V) = before tax WACC - rDTc(D/V)

Answer 24

if taxes aren't the only deviation from MM and the firm doesn't constantly rebalance its leverage to a target ratio D/V, then don't discount FCF using the after tax WACC USE APV which doesn't capture taxes or other financing effects in a WACC type tax adjusted discount rate APV = base case NPV + sum of PV financing side effects since in any year, leveraged CF to investors = unleveraged CF to investors + ITS by no arbitrage, we must have: VL = VU + PV(interest tax shield)

Answer 25

1. firm/project value if unlevered 2. the PV of the future stream of tax savings generated by leverage

Answer 26

assume a firm plans to keep a fixed dollar amount of debt, D on its balance sheet permanently at a cost rD PV(ITS) = (D x rD x Tc)/rD = D x Tc

Answer 27

1. you can only use interest tax shields if there will be future profits to shield 2. interest expense isn't the only tax shield 3. consider investor/personal taxes 4. consider bankruptcy costs

Answer 28

in addition to corporate taxes (Tc) paid on profit of the firm, the shareholders have to pay personal taxes on equity income - the dividends they receive from the firm - capital gains from the increase in mkt value of the firm - can reduce the tax advantage of debt found at the corporate level

Answer 29

after all personal and corp taxes have been deducted by comparing the after tax amount that found by received by bondholders for each after tax dollar received by stockholders RAD = (1 - TP)/ (1 - TPE)(1 - Tc) if RAD > 1 -> issue debt if RAD < 1 -> issue equity

Answer 30

a firm is in financial distress when it's experiencing difficulty meeting its debt obligations if a firm fails to make debt payments, it is in default or bankrupt/insolvent costs of financial distress: 1. direct: legal and admin 2. indirect: loss of stakeholders abandoning the firm before/during bankruptcy

Answer 31

if a firm fails to make debt payments, it is in default or bankrupt/insolvent

Answer 32

costs arising from conflicts between stakeholders in a firm. in firms with leverage, between shareholders and debtors when projects have different consequences for their payoffs: - debtholders prefer safer projects: they have priority in CF - equity holders prefer risky projects: they are a residual claimant with limited liability and potentially unlimited upside! 1. asset subsitution/risk shifting 2. debt overhang

Answer 33

when debt is in place, equity has the incentive to take excessive and inefficient risks levered equity as a call option: an option is more valuable if the volatility of the underlying (i.e. the asset) increases

Answer 34

Even if the company takes on big risky projects and fails, shareholders don’t have to pay out of pocket. Their maximum loss is already capped — they just lose the value of their shares (which might already be close to nothing). 2. Upside goes to shareholders If a risky move succeeds, the gains go to shareholders first, after debt holders get their fixed repayments. Because their downside is limited, but the upside is unlimited, shareholders now prefer risky bets (even if the chance of success is low). 3. Debt holders bear the downside If the risky project fails, the firm may not be able to pay back its debts. The losses fall on the debt holders, not the shareholders. So in a way, shareholders are gambling with the creditors' money.

Answer 35

In a levered firm (i.e., one with debt), equity holders can be seen as owning a call option on the firm's assets, with a strike price equal to the face value of debt. Strike price (K) = amount owed to debtholders at maturity Underlying asset = total value of the firm’s assets Maturity = time until the debt is due

Answer 36

Market value of assets < face value of debt (i.e., asset value is below the strike price of the call option) This means the call is out-of-the-money right now. So the intrinsic value of equity = 0 if the debt were due today. But the option still has time until maturity — and thus time value. This time premium reflects the possibility that asset values might rise in the future, putting the option (i.e., equity) back in the money. Why does this make shareholders prefer risk? Because of how options work: A call option’s value increases with volatility. More asset volatility = greater chance the asset value rises above debt = more chance equity ends up in the money. So shareholders want the firm to take on more risk, even if the expected value of the project isn’t positive. That’s the essence of the risk-shifting problem.

Answer 37

when debt is in place, equity has the incentive to refuse +ve NPV projects 1. positive NPV projects require inputs 2. equity pays the costs 3. improved CF largely goes back to paying back debt 4. payoff to debt increases 5. gross terminal payoff to equity increases, but net of the costs, it can decrease 6. equity pays the costs but not "too much" of the benefit accrues to debt 7. as a result, some positive NPV projects are passed up

Answer 38

the optimal leverage should balance the benefits (e.g. tax shields) and the cost of debt (financial distress costs) how do you quantify this tradeoff? USE APV VL = VU + PV(Tax Shields) - PV(Costs of Financial Distress) where Tax Shields are the value of tax savings from debt and costs of financial distress is the value of all direct/indirect costs of financial distress consistent with trade off theory: - most companies have high target debt ratios - high tech growth companies with risky assets normally use relatively little debt - BUT tradeoff theory cannot explain why some of the most profitable companies with large income tax bills thrive with little debt why debt ratios haven't increased since the time when corp income tax rates were low

Answer 39

PV(CFD) = pCFD/ (rD + p) where p = probability of bankruptcy CFD = cost of bankruptcy rD = bond expected return

Answer 40

- a firm's managers often know more about the company's prospects, risk and value than do outside investors (information asymmetry) . If value relevant private information is NOT reflected in the market prices, then financial transactions may not be fair. - however, certain actions taken by the better informed party (managers) can help the uninformed party (outside investors) infer the party's private info ("signalling"), causing the market to react. - stock prices tend to rise on the announcement of an increase in the regular dividend as investors tend to interpret this as a credible signal of management's confidence in future earnings

Answer 41

1. a firm is considering a new project that will yield a positive NPV 2. however, the firm doesn't have sufficient internal funds and must raise equity. 3. manager's interest is to maximise the wealth of existing shareholders 4. if new equity dilutes the value of existing shares, managers might be reluctant to issue equity even for a good project. 5. because managers know more about a firms' "true" value than its outside investors, if managers offer new equity, investors may infer that the firm is "overvalued", because why else would a firm want to sell shares? 6. therefore, the market discounts new shares, equity is issued at a price below its true value, this hurts existing shareholders, managers choose not to issue equity and forego positive NPV projects (underinvestment).

Answer 42

1. cash on hand: use RE (internal equity) to avoid asymmetric information 2, risk free debt (equity % is multiplied against vfirm, debt is minused)

Answer 43

firms prefer to use least information sensitive securities when financing projects 1. least sensitive: RE (cash) 2. risk free debt 3. risky debt 4. most sensitive: equity

Answer 44

- primary offering: when a firm issues stock; no. of shares, total value of equity and the value of firm increases (signalling & capital structure changes) - secondary offering: when one shareholder sells a large block of stock to another shareholder, the firm isn't involved in this transaction, so there is no change in the number of shares

Answer 45

- "effort problem" more outside equity reduces the incentive for managers to exert effort, because they own less of the firm, therefore value of firm decreases. - solutions: let managers own 100% of the firm, options (high powered incentive contracts - stock options only provide benefits if S>K), debt

Answer 46

long term, (>10y) long term secured debt (in the UK), long term unsecured issues (in the US)

Answer 47

short term (<10y)

Answer 48

principal at maturity, often 1000

Answer 49

interest payment

Answer 50

the discount rate for future promised payments

Answer 51

the amount of accumulated interest since the last coupon payment

Answer 52

the actual price you pay to purchase a bond

Answer 53

dirty price - accrued interest

Answer 54

local currency denominated bond that is issued/sold by a foreign company to investors in the local market

Answer 55

a bond that is underwritten by international bond syndicates and sold in several national markets in a major non local currency

Answer 56

a very large bond issue that is marketed both internationally (that is, the eurobond market) and in individual domestic markets.

Answer 57

carry credit risk, i.e. the possibility of default

Answer 58

lender can seize collateral upon default

Answer 59

no collateral, backed by the company's creditworthiness

Answer 60

long term debt secured by a firm's property

Answer 61

backed by a portfolio of assets

Answer 62

senior > junior (riskier, so the return is higher) secured > unsecured debt holders > equity holders

Answer 63

the % an investor gets back in bankruptcy

Answer 64

a lumpy payment of the entire principal can be disruptive. a sinking fund is established to retire debt gradually before maturity. the firm is obligated to make regular payments into the sinking fund.

Answer 65

payments don't have to be in cash. interest/sinking funds can be paid by bonds too (sometimes purchased from the market). when in trouble, cheaper way to pay than cash.

Answer 66

- restrictions imposed by bondholders on the activities of the borrower - POSITIVE COVENANTS specify actions that the firm must take e.g. working capital must remain above a minimum level etc. - NEGATIVE COVENANTS: limit/forbid actions that the firm may take (dividend restrictions)

Answer 67

1. callable bonds - can be called by the firm 2. puttable bonds - can be called by investors 3. convertible bonds - investors can exchange the bond 4. callable convertible bonds - include a call option (for the issuer) and a conversion option (for the bondholder)

Answer 68

- can be repurchased ("called") by the issuer before its maturity at a predetermined price (the call price) - e,g, after a specific date (T) the firm can buy back the bonds at 105% of par value - Pt callable = Pt straight - Ct - where Ct is the call option value - option value is subtracted because it represents a cost to the issuer

Answer 69

- to adjust capital structure (e.g. lowering leverage) - to take advantage of lower prevailing interest rates - optimal strategy: call the bond when its market price reaches the call price

Answer 70

- gives the investors the right to demand early payments (usually at par value), after a certain date (T) - straight bond + long put option - put options can be particularly damaging to issuers. when the bond's market price falls (often when the firm is in trouble) investors will exercise the put option - forcing the firm to redeem the bond when it may not have the funds, potentially leading to default

Answer 71

- allows bondholders to exchange the bond for a predetermined number of shares of the issuing company 1. conversion ratio 2. conversion price 3. conversion value convert ONLY if conversion value > straight bond value Convertible bond = straight bond + equity call option where straight bond: use coupon and maturity of the convertible bond, use market interest rate the firm would pay on a straight bond equity call option: tricker! american call price with random exercise price, conversion options are LT dilution effect on equity Option value = convertible price - straight bond price

Answer 72

the number of shares each bond can be converted into conversion price/face value

Answer 73

face value/conversion ratio

Answer 74

the value of of the bond if converted into shares Pt convertible = Pt straight + Ct where Ct is the value of the call option to acquire common stock

Answer 75

includes a call option (for the issuer) and a conversion option (for the bondholder)

Answer 76

Cost consideration: Convertibles might seem cheaper because they offer lower interest rates, but the issuer is essentially giving investors an option to buy equity, which has a cost. Different views on risk: Management and the market may disagree on how risky the firm is. If the market overestimates the risk, convertibles can be attractive — similar to the logic in the pecking order theory. Reducing agency conflicts: Convertible bonds can help align the interests of shareholders and debt holders. They reduce the risk of asset substitution, where shareholders might push for risky projects that benefit them more than debt holders.

Answer 77

conversion ratio - no effect on straight bond value - increases option components stock price - mixed effect on straight bond value - increases option components stock volatility - decreases straight bond value - increases option components dividend - decreases straight bond value - decreases option components PRICE OF CONVERTIBLE BOND MUST ALWAYS BE ATLEAST THE STRIGHT BOND/CONVERSION VALUE (WHICHEVER IS LARGER)

Answer 78

Pac = stock after conversion 1. if Vfirm < Pac, firm defaults, payoff = Vfirm (i.e. gets the entire firm) 2. if Pac < Vfirm < Vac , bondholders receive principal and interest 3. if Vfirm > Vac, bondholders convert and receive gradient of the firm

Answer 79

1. Vfirm < Pac, default, equity gets nothing 2. if Pac < Vfirm < Vac, receive residual value of firm, Vfirm - Pac 3. if Vfirm > Pac, original equity holders retain 1-gradient of the firm

Answer 80

If bondholders choose not to convert P = (Vfirm(principal + interest) x contracts)/ shares

Answer 81

small firms are primarily self financed with equity supplemented with "informal" finance (e.g. debt from family, friends, etc.) as the firm grows, the ability/willingness of informal finance to meet the needs of the business declines RE - a firm can reinvest profits Banks - use past performance VC's - for risky, opaque, intangible firms

Answer 82

a financial intermediary specialising in providing equity financing to new firms - commonly use convertible preferred stock: gives investors the option to convert their shares into common stock, offering a blend of fixed income and potential for capital appreciation low probability of success but much higher than usual returns active investors - monitoring (seats etc.) - staged financing (funds usually appear in stages after a certain level of success is achieved) belong to the PE industry

Answer 83

contribute most (98% approx.) of capital don't directly make investment decisions

Answer 84

choose and monitor the fund's investments ("portfolio firms") contribute skill

Answer 85

insitutional investors are LPs who provide most of the capital for VC firms e.g. pension funds, insurance companies, soverign wealth funds... these funds go to VC's which are GP who manage the funds, they raise money from LP's and find startups to invest in, and manage the shares in those startups these funds reach the startups (portfolio firms), which give VC's equity returns from this equity are given back to institutional investors

Answer 86

PE Funds are limited duration, closed end funds 1. limited duration (10-12yrs) - the fund has a fixed lifespan - after that, the fund is liquidated, meaning all investments (portfolio firms) are sold and the money is returned to investors (LPs) - this forces GPs to prove themselves, if they don't perform well, they wont be able to raise money for the next fund 2. closed end - once GP's launch their funds, no money can be added and LP's cant pull their money out - LPs cant sell their stake in the fund, so it's usually very illiquid - but, this gives the fund stability, as everyone is locked in for the duration

Answer 87

1. management fee (fixed) - GP gets paid 2% of the committed capital per year - this happens regardless of performance, kind of like a salary 2. carried interest - this is the performance based bonus, GP's usually get 20% of profits but only after a fund hits a minimum return (called a hurdle rate, like 8% or so). if the fund does poorly, they don't get this part.

Answer 88

- shareholders of large public companies have no skill/incentive to monitor the company because they hold a small number of shares - so the managers are liable to take advantage of the company's resources and generate personal benefits that hurt the firms' overall value (monitoring would make overpriced shares fair!) - result: no one monitors -> cost of monitoring > benefits; others would just free ride anyway - VCs are big shareholders of a firm, so they enjoy being part of the benefits of monitoring!!

Answer 89

1. angel investors: only raw ideas, no product (50k-500k) 2. seed capital: prototype perhaps; business plan (1M - 5M) 3. early stage VC: generate revenue; perhaps not profitable (size>2M) 4. last stage VC: profitable; need cash to invest (5M-15M) 5, mezzanine stage: last stage before IPO, multiple securities (debts, convertibles) are used.

Answer 90

VC contributes X for a startup After startup, the firm is worth V the original investor (OI) holds a fraction of the pre-contributed firm of the POST contributed firm: VC -> X/V OI -> (1 - X/V) x s

Answer 91

1. M&A: startup is bought by another company 2. IPO: - primary offering: new shares are issued (IPO) to raise additional capital - secondary offering: existing large shareholders cash in by selling part of their stake in the firm (i.e. unrelated to the firm)

Answer 92

+ funds for investment + diversify the initial investors: founders can cash out and use the money for other ventures. current equity holders sell a fraction of their shares, but not a large fraction because it would sell a negative signal if an insider sells a large % of their holdings + exit strategy for VCs and other investors: founders want VCs out/VCs want out - monetary costs - admin costs: at IPO, 2-10%, this is smaller for bigger companies due to economies of scale. after IPO, its expensive to comply with regulatory filing requirements after becoming a PLC. - underwriting spread (approx. 7%) that IBs charge for their services: they tell them what price to sell the IPO at, prospectus for new investors - underpricing: D1 price >> IPO price (sold for less than worth) - disclosure requirements - dilution of ownership stake and greater regulatory oversight

Answer 93

- sale of new securities by a firm that is already publicly traded 1. general cash offer 2. private placement 3. rights issue

Answer 94

sale of securities open to ALL investors (IPO)

Answer 95

sale of securities open to alimited number of investors without a public offering (sophisticated invesots - lower costs, no prospectus!!)

Answer 96

issue of securities offered only to current stockholders "X for Y right": for every Y shares you own, you have the right but not the obligation to buy X more shares from the company

Answer 97

value of right = (P current x Pissue) x N/N+1

Answer 98

1) D1 returns average 16% higher than IPO price -> underpricing 2) Returns are risky and vary widely by year 3) underpricing varies with uncertainty avout the stock's value - larger firms with more sales are underpriced less. Underpricing is smaller for older firms. 4) international results are similar LONG RUN 1) long run returns are low - poor relative performance in the subsequent 3-5 years

Answer 99

1. due diligence and determine firms valuation 2. prospectus preparation and SEC filings (regulatory requirement) 3. marketing the IPO - IBs are allowed to enter the market and buy shares at the IPO price/lower -> creates a floor on how low the stock can go generally -> left side is truncated -> D1 returns are positive - IBs buy all the IPOs at a set price from the firm, and sell them at a lower IPO price, essentially taking all the risk from the firm. IBs price low so they don't have excess stock. They also get a % return from proceeds (about 7% underwriting fee) although this might lower their returns it will be offset by other sources of revenue generated during the IPO process IBs give favoured clients a portion of the IPO (private placement) which gives them more business in the future

Answer 100

- information asymmetry ("Winner's Curse") informed investors stay away from bad deals, uninformed investors recieve a disproportionate allocation of shares in bad deals (they cannot distinguish between good and bad deals). to participate in IPOs, uninformed investors need a discount on the fall price in order to break even. We need participation by uninformed investors, or IPO won't go through!! for uninformed investors: when they bid at their estimate, then when the IPO is a good deal, informed investors also subscribe to the IPO, uninformed recieve a small (or no allocation). when the IPO is bad, informed withdraw -> you recieve a large allocation on average, when you "win" in the IPO share alloication, it's more likely to be a bad IPO. in order to break even, you bid at a DISCOUNT!!

Answer 101

two firms combine to form a single firm

Answer 102

one firm "acquirer" buys a signifcant number of shares/asset sfrom "target" to gain control

Answer 103

a publicly traded firm or a division of a firm is bought and then taken private

Answer 104

1. horizontal - same industry - same stage of production process 2. vertical - same industry - different stage of production process 3. conglomerate - different industries

Answer 105

the board of directors of both firms agree to combine and seek shareholders' approval for the combination, generally >50%

Answer 106

raider can directly take over the board of directors/shareholders a hostile takeover attempt will often result in the firm being sold to a friendly 3rd party.

Answer 107

1. cash deals: target shareholders recieve cash compensation, e.g. every share of target recieves $10 2. stock deals ("stockswap"): target shareholders recieve payment in the form of the acquirers' stock. e.g. every share of the target recieves 0.3 shares of the acquirer 3. combination of cash and stock payment method doesn't matter in the MM world, but it does in the real world

Answer 108

1. restructuring: M&A can be a cost effective way to restructure, made necessary due to obsolete product/increased foreign competition/deregulation 2. market power: if you can't undercut competitors, buying them could be an alternative. fewer participants leads to monopoly pricing which leads to higher stock prices and profits 3. synergies/strategic benefits: higher CFs (i.e. increased revenue, decreased costs) through EoS, allows smaller firms to gain access to distribution/advertising 4. reduction in taxes: ITS (advantage of debt, not merger) other tax tricks 5. realign management's incentives: replace bad managers, prevent "empire building" (decisions driven by executives rather than to raise the value of the firm)

Answer 109

1. increasing financial slack: managers may otherwise reject profitable investment opportunities, and instead choose to acquire a firm if they have to raise external capital to finance them -> generated 0NPV to buy a takeover to acquire its cash 2. diversification: combining several industries to lower risk at the firm level - but invwstors can diversify by building a portfolio! 3. CEO hubris: CEOs are often overconfident in their management's abilities and might overestimate potential gains => they might think a project is positive NPV when actually its negative NPV 4. boost EPS: EPS can change even if Vfirm stays the same! not a reliable indicator of whether an acquisition creates/destroys value - acquiring firm has low E/P ratio - selling firm has high E/P ratio (perhaps due to low growth expectations) - after merger, acquiring firm has a short term higher E/P - in the long term, acquierer will have low E/P due to share dilution

Answer 110

1. gain = Vat - (Va - Vt) 2. cost = cash paid - Vt 3. NPV = gain - cost 4. cost using stock = (N x Pat) - Vt

Answer 111

+ construct transparent spreadhseets of FCFs + CFs come from specific forecasts and assumptions + can see impact of changes in strategies - isn't just based on the market, it is grounded in how much cash the firm is actually expected to produce - CFs are only as good as your forecasts/assumptions - if your assumptions are wrong, your valuation can be way off! - might "forget" something - you could overlook an important factor! like taxes, change in NWC/one time costs, which could distort the results - need to forecast managerial behaviour (unless you're in control) - you're assuming how managers will run the company (how much they will invest and spend). if you're not the one making these decisions, that adds uncertainty! - need to estimate the discount rate using a theory (like CAPM) that may be incorrect/imprecise

Answer 112

assess a firm's/division's value based on "multiples" of the publicly traded comparable. multiple = market valie/some accounting measure of "fundamentals" where multiple: - CF based value: earnings/EBITDA/FCF - CF based price: P/E, EBITDA, FCF - Asset based: book value of assets, book value of equity

Answer 113

1. hope firms in the business have similar multiples e.g. P/E 2. identify firms in the same business as the firm you want to value 3. calculate P/E ratio for comparables and come up with estimate of the P/E for the firm you want to value (avg of the comparables' P/E) 4. estimated P/E x actual EPS

Answer 114

+ incorporates alot of info from other valuations in a simple way + embodies mkt consensus about discount & growth rate + free ride on mkt's info + can provide discipline in valuation process by ensuring your valuation is in line with other valuations - implicitly assumes all companies are alike in growth rates, cost of capital, and business composistion - hard time incorporating firm specific info - accounting differences are particularly problematic if operating charges are going to be implemented (EBIDTA/FCF are preferable) - BVs can vary across firms depending on age of assets - if everyone uses comparables, who does fundamental analysis?

Answer 115

you are a shareholder of TAA, the value of your stock is 45. if run optimally, it would be 60. BT is known to acquire and turn around firms for their better BT makes an offer of X per share of TAA. they can only turn around TAA if they are able to purchase enough shares how high must X be? you can always sell for 45, but, if BT succeeds your shares will jump to 60. therefore, there is no reason for you to sell below 60. but, at 60, BT makes no profits. If there are transaction costs, BT will pay 60+ costs, to recieve a firm worth 60. however, current shareholders will want to "free ride" on raiders efforts, therefore BT overpays, reducing profits for themselves/no raid happens at all. therefore, as soon as BT announces the takeover, everyone assumes that the company might be worth 60, so the stock price immediately jumps up, say to 58-60 BEFORE the takeover -> gain goes to shareholders why is this called the free rider problem? - only BT does the hardwork to improve TAA, existing shareholders don't help, they just WAIT, hope BT suceeds and then enjoy the benefits without contributing - as a result, BT has to pay the FULL price - there's NO profit left for him, even though he unlocked a new value - BUT he makes 0 returns (60 for 60)/ a loss once you add costs so: he may decide not to do the takeover, he does it and overpays

Answer 116

- a trading strategy that tries to profit from the gap between the current market price and the deal price e.g. BT offers $60 for company X, but X is currently trading at $57 (because there is a risk that the deal won't happen), you buy X at $57, hoping to make $3 if the deal happens -> this is called "spread": long the target stock and short the bidder stock to a hedge risky because there is NO guarantee that the deal will go through! 1) regulatory rejection 2) board/shareholder resistances 3) financing issues 4) mkt volatility

Answer 117

1. the company buys back it's own shares specifically from the raider at a premium (about 16%), this hurts regular shareholders since the money comes from the company's resources 2. delay/block the takeover by claiming the merger would violate competition laws 3. anti take over amendments a) allows existing shareholders to buy shares cheap; diluting the bidders stake and making the takeover more expensive b) only a fraction of the board can be replaced at each election, slowing down any hostile takeover attempts c) give employees shares (and voting rights), making it harder for the bidder to gain control if employees vote against it. 4. the target finds a friendlier acquirer instead of accepting the hostile one

Answer 118

+ job security/control + bargaining power - could get a better deal + preserve more valuable, LT projects + if managers aren't constantly worried about being fired in a take over, they might think more long term!

Answer 119

financial transactions with offset the risk of a real asset - when the real asset increases in value, hedge loses money - when the real asset decreases in value, hedge gains money (-) risk isn't eliminated; just transferred (-) if the risk is systematic, e.g. oil prices/i.r/FX rates then everyone is exposed, so you must pay a premium to shift that risk (like an insurance premium) therefore, even a perfect hedge will lose its money on average, because you're paying a premium to avoid large, uncertain losses

Answer 120

+ they face big unwanted risks they cant easily absorb + reduces financial distress costs/smooths earnings + helps create value, like helping get a better loan rate - firm is diversified, cash-rich, can self insure - risk is small & hedging is costly - shareholders can hedge on their own (portfolio) - not in an MM world - reducing risks to security holders has no value if they can hedge those risks themselves!