Sec B Flashcards
1
Q
Bonds
A
- Obligation:To pay theface amount(par value) at maturity and periodic interest (coupon payments).
- Bonds are sold in increments (usually $1,000 per bond), and investors purchase bonds based on their desired investment amount.
2
Q
Bond Agreements / Indenture (Deed of Trust)
Key Components:
A
Terms & Conditions: Subordination: Debt repayment order in liquidation.
Protective Covenants:
Positive: Required actions (e.g., maintain ratios).
Negative: Restrictions (e.g., no excessive debt).
Coupon Rate:
Sinking Fund Terms:
Maturity Date: Principal due date.
Callability: Issuer’s right to redeem early.
Default Conditions: Triggers for default.
Conversion Feature: Convert bonds to stock.
Collateral: Secured assets.
3
Q
Trustee’s Role:
A
A trustee ensures the indenture’s terms are followed, protecting bondholders.
4
Q
Trustee’s Duties:
A
Authenticate legality.
Manage sinking fund & redemptions.
Ensure issuer’s obligations. Handle defaults and legal actions.
5
Q
Bond Administration:
A
The trustee ensures proper bond management, handling redemptions, sinking fund payments, and defaults.
6
Q
Lender
A
Investor Bond Holder Interest receiver
7
Q
Borrower
A
Company Issuer Interest provider
8
Q
Advantages of Bonds to the Issuer
A
Tax-Deductible Interest:Reduces taxable income significantly, especially for high tax-rate corporations.
No Equity Dilution:Shareholders maintain control, as bonds do not involve ownership.
9
Q
Disadvantages of Bonds to the Issuer
A
Legal Obligation:Payments (interest and principal) must be made, even if cash flow is insufficient.
Increased Risk: Raises a firm’s risk level. May result in a decline in stock prices due to higher capitalization rates demanded by shareholders.
Long-Term Commitment: Difficulties arise if interest rates drop, and refinancing isn’t possible.
Debt Covenants:Issuers lose some managerial flexibility due to contractual obligations
Debt Limits:Excessive debt increases costs or restricts further borrowing.
10
Q
Debt Covenants .
A
Protective clauses in bond agreements to reduce risk for creditors.
Limits on issuing additional debt, Restrictions on dividends, Financial ratio maintenance, Specific collateral requirements
11
Q
Debt Covenants .
Breach Consequence:
A
Debt becomes immediately payable.
12
Q
Debt Covenants :
Impact on Interest Rates:
A
Stricter covenants lead to lower risk and lower interest rates.
13
Q
Bond Redemption and Repayment Features
A
Call Provisions:Allow issuers to redeem bonds early (investors demand higher returns).
Sinking Funds:Payments made into a fund to ensure principal repayment at maturity.
14
Q
Types of Bonds
A
Term Bond:Single maturity date.
Serial Bond:
Zero-Coupon Bonds:
Commodity-Backed Bonds:
Callable Bonds:
Convertible Bonds:
Debentures:
Mortgage Bonds:
Income Bonds:
Foreign Bonds:
Eurobonds:Issued in a currency different from the country where sold, often with more favorable interest rates.
Indexed Bonds:
Government Bonds:
Municipal Bonds:
Agency Bonds
Participating Bonds
15
Q
Bond Ratings
A
Credit-rating agencies (e.g., Moody’s, Standard & Poor’s) assign ratings to assess a bond issuer’s creditworthiness.
16
Q
Investment-Grade Bonds:
A
Low-risk, moderate return.
Rated as “BBB” or higher (highest rating isAAA).
Preferred by fiduciary organizations like banks and insurance companies.
17
Q
Non-Investment Grade Bonds (Junk Bonds):Speculative Grade
A
High-risk, high-return.
RatedBBor lower.
Typically carry a higher default risk.
18
Q
Yield Curve:
Upward Sloping:
A
Long-term rates > short-term rates (most common).
19
Q
Yield Curve:
Downward Sloping:
A
Long-term rates < short-term rates.
20
Q
Yield Curve:
Flat:
A
Long-term rates = short-term rates.
21
Q
Yield Curve:
Humped:
A
Intermediate-term rates > short-/long-term rates
22
Q
Yield Curve:
Practical Applications
A
- Economic Indicators: An inverted yield curve is often viewed as a predictor of recessions.
- Investment Decisions: Helps investors select bonds based on risk and return preferences.
- Financing Decisions: Guides borrowers in choosing between short-term and long-term financing based on cost implications.
23
Q
Interest Rate Effects
1. Bond Demand:
A
Higher rates increase demand for bonds but decrease demand for common stock.
24
Q
- Interest Rate Risk:Risk of bond value fluctuation due to interest rate changes.
- Duration Impact:
- Inflation Effect:
A
- Duration Impact:Longer-term bonds are more sensitive to rate changes.
- Inflation Effect:Higher inflation expectations → Higher interest rates.
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3. Bond Valuation
The valuation of bonds determines the cash proceeds the issuer receives upon issuance, based on the present value of the bond’s cash flows.
* Face amount (paid at maturity).
* Periodic interest payments (coupon payments).
* Discounting Rate: Market rate (effective rate) prevailing at issuance.
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bond :Stated = Market Rate
Cash Proceeds = Face Amount Par: Market and stated rates are equal.
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bond : Stated > Market Rate
Cash Proceeds > Face Amount Premium
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bond : Stated < Market Rate
Cash Proceeds < Face Amount Discount
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1. Common Stock
last in priority during liquidation.
Voting Rights:
Returns are not guaranteed
Preemptive Rights
4. Par Value: Represents legal capital and the shareholder's maximum liability.
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Advantages to the Issuer Common shares
No obligation to pay fixed dividends.
No maturity date for repayment of capital.
Increases the firm’s creditworthiness.
Often more attractive to investors as stock value grows with firm success.
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Disadvantages to the Issuer Common shares
Dividends are paid from after-tax profits and are not tax-deductible. Underwriting costs are higher than those for debt issuance.
Issuance of new stock dilutes: Too much equity can increase the firm’s average cost of capital.
Voting rights of existing shareholders. Inflation and higher bond yields reduce the attractiveness of stock investments.
Earnings per share (EPS) available to shareholders.
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Common stock classifications
Blue-chip stocks: Stocks of the largest and most consistently profitable publicly traded corporations Value stocks: Stocks that appear inexpensive when compared to earnings and other performance measures
Growth stocks: Stocks of corporations that have strong growth potential, with sales, earnings, and market share, growing faster than the overall economy Income stocks.: Stocks of typically solid performers with good track records that usually generate a steady dividend income stream
Cyclical stocks: Stocks of corporations whose earnings are highly dependent on economic conditions (e.g., economic upturns and slowdowns) Defensive stocks / Non Cyclic/ Conservative stock : Conservative stocks that are relatively stable and impervious to most economic conditions Eg: necessity goods, pharmaceutical goods
Speculative stocks.; Stocks that are risky investments in corporations that have yet to prove their true worth
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2. Preferred Stock
hybrid security
Priority in Bankruptcy
cumulative, participate
* Dividend Paid as a percentage of par value.
4. Retirement: redeemable, callable, or convertible into common stock, sinking fund
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Tax Advantage for Investors
pref and common shares
* At least 70% of dividends received are tax-deductible. In contrast, bond interest is fully taxable.
* The dividends-received deduction also applies to common stock dividends.
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1. High Dividend Rate vs. Growth Rate:
* A high dividend rate results in a slower growth rate.
* A high growth rate typically corresponds with a lower dividend rate.
* Stable earnings → Higher dividends. Volatile earnings → Conservative dividends
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Factors Influencing Dividend Policy
Legal Restrictions
Stability of Earnings
Growth Rate
Cash Position
Restrictions in Debt Agreements
Tax Position of Shareholders
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Residual Theory of Dividends:
* Dividends are determined by available investment opportunities and maintaining an optimal debt-equity ratio.
* Retained earnings are preferred if they yield higher returns than comparable investments.
* Dividends are prioritized when investment opportunities are poor or internal equity financing would alter the capital structure unfavorably.
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Declaration Date:
* The board approves the dividend. Announces the date of record and the payment date.
* The company records it as a liability (Dividends Payable).
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1. Stock Dividend: Concept & Effects
A stock dividend distributes additional shares to existing shareholders (e.g., a 10% stock dividend gives 1 new share for every 10 owned). It does not involve cash and does not change total equity.
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Date of Record:
he date when the company identifies eligible shareholders for the dividend.
* Identifies shareholders eligible for the dividend.
* Shareholders owning shares by this date qualify. Typically 2-6 weeks after declaration.
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Ex-Dividend Date:
* Determines who qualifies based on trade settlement. Occurs 1-2 days before the record date.
* Buyers on or after this date are not eligible. Stock price drops by the dividend amount.
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Payment Date:
* The date dividends are paid.
* Company debits Dividends Payable and credits Cash. Usually 2-4 weeks after the record date.
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Dividends signal long-term stability and management's confidence, while net income can fluctuate due to one-time events.
Dividends signal long-term stability and management's confidence, while net income can fluctuate due to one-time events.
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Stock Splits:
Issuance of additional shares to existing shareholders, reducing the price per share while maintaining total market capitalization.
* Increases shares outstanding, decreases price per share, Decrease EPS
* Ownership percentage remains unchanged.
* No entry recorded in accounts, but par value is adjusted.
* Example: A 3-for-1 split turns 500,000 shares into 1,500,000 shares, with a price drop from $60 to $20 each.
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Reverse Stock Splits:
Reduces the number of shares, increasing the price per share, with no change in total market capitalization.
* Decreases shares outstanding, increases price per share. Ownership percentage and market value remain the same.
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Treasury Stock / Share Repurchases:
* Shares repurchased by the company, not considered outstanding or assets.
* Reduces equity and does not receive dividends or voting rights.
* Used for strategic purposes, price support, or increasing EPS.
* If resold, treasury shares become outstanding and eligible for dividends.
* Prevent hostile takeovers or eliminate specific ownership interests.
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Stock Dividends:
* Issuing additional shares to shareholders instead of cash dividends, transferring retained earnings to paid-in capital.
* Purpose: Used by growing companies to reward shareholders while conserving cash.
* Impact: Increases the number of shares, reducing the market price per share but keeps the total value unchanged.
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Motives for Share Repurchases:
Issuing stock dividends.
Preventing hostile takeovers.
Eliminating specific ownership interests.
Increasing earnings per share and financial leverage.
Meeting share option obligations.
Issuing stock dividends.
Mergers
Providing tax advantages to shareholders (e.g., capital gains rates).
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Stock Dividend:
Declaration Entries
Retained Earnings ↓ → Common Stock ↑, APIC ↑
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Stock Dividend: Payment Entries
Payment Entries No further accounting entries
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Cash Dividend:
Declaration Entries
&
Payment Entries
Retained Earnings ↓ → Dividends Payable ↑
Cash ↓ → Dividends Payable ↓
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Stock Dividend
Cash Dividend
purpose:
Signals growth, preserves cash
Rewards shareholders with cash income
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Stock Dividend
Cash Dividend
EPS Impact
↓ (due to increase in shares outstanding)
No direct impact
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Stock Dividend
Cash Dividend
Par Value Impact
No change
No change
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Financial Markets: Aspects
connect entities with funds to invest and those needing financing.
* Transactions create assets for investors and obligations for borrowers.
* Transfers of funds: Direct and Indirect:
Direct Investor to the borrower.
Indirect: Via intermediaries (e.g., banks), improving efficiency and reducing costs.
* Securities: Include stocks, bonds, mortgages, loans, leases, certificates of deposit, government securities, and derivatives.
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Money Markets
Money Markets trade debt securities with maturities of less than 1 year.
dealer-driven markets, where transactions involve dealers who buy and sell instruments at their own risk.
* The dealer is a principal in most transactions, unlike a stockbroker who acts as an agent.
short-term and marketable. * They usually have low default risk.
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Examples of Money Market Securities:
Government Treasury bills
Short-term tax-exempt securities
Federal agency securities
Eurodollar CDs
Certificates of deposit Repurchase agreements
Bankers' acceptance
Commercial paper
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* Capital Markets:
* Capital Markets: Trade long-term debt and equity securities (e.g., NYSE).
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* Primary Markets:
Issuers raise new capital by selling securities directly, receiving the sale proceeds.
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* Secondary Markets:
Investors trade previously issued securities.
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* Auction Markets:
Trade at physical locations (e.g., exchanges), require company listing for trading with benefits like increased liquidity and risks like disclosure requirements and hostile takeovers.
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* Listing on Stock Exchanges
* Requirement: Companies must apply and meet listing standards for their shares to be traded on an exchange.
* Benefits: Enhances prestige and increases the liquidity of a firm's securities.
* Disadvantages: Involves stricter SEC disclosure requirements and higher risk of hostile takeovers.
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* Over-the-Counter (OTC) Market
is a dealer market: It consists of numerous brokers and dealers who are linked by telecommunications equipment enabling them to trade throughout the country.
* The OTC market handles transactions involving:
* Bonds of U.S. companies, Bonds of federal, state, and local governments
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Insider Trading
Definition: Trading securities based on nonpublic information about them.
Legality: Illegal, as it harms investor confidence in the fairness and integrity of financial markets.
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The Efficient Markets Hypothesis (EMH)
The EMH suggests that current stock prices fully and immediately reflect all relevant information, ensuring securities are always priced at their fair value. The market continually adjusts to new information, correcting any pricing errors. In other words, securities prices are always in equilibrium.
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The Efficient Markets Hypothesis (EMH)
securities prices are always in equilibrium.
* This is because securities are subject to intense analysis by thousands of highly trained individuals working for well-capitalized institutions with the resources to take very rapid action when new information is available.
* Abnormal Returns: EMH asserts that it is impossible to consistently achieve abnormal returns using:
* Fundamental Analysis: Evaluating future price movements based on financial statements, industry trends, and economic factors.
* Technical Analysis: Predicting price movements based on historical price trends and trading volumes.
* Fair Value: Each security’s price reflects its fair value based on perceived risk and expected return by investors.
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Forms of Efficient Markets Hypothesis (EMH)
Strong Form(Empirical data refute this form.)
All public and private (insider) information is instantaneously reflected in securities’ prices.
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Forms of Efficient Markets Hypothesis (EMH)
Semi strong Form (- Widely supported by empirical evidence.)
All publicly available data are reflected in security prices, but private/insider data are not included.
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Forms of Efficient Markets Hypothesis (EMH)
.
Weak Form (- Supported by empirical evidence.)
Prices reflect all recent past price movements and trading data.
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Rating Agencies
A firm must pay for its debt rating. Ratings are based on the probability of default and the protection for investors in case of default. They are determined from corporate information such as financial statements.
* Key factors in analysis include: Cash flows to service debt, existing debt, debt type, and cash flow stability.
* Ratings are reviewed periodically. A rating downgrade can: Increase cost of capital and reduce the ability to borrow long-term, as institutional investors often avoid lower-grade securities.
* Higher ratings reduce interest costs, while lower ratings increase required returns.
S&P Ratings: AAA & AA: Low risk. A & BBB: Investment-grade. BB & Below: Junk bonds, speculative.
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Investment Banking
Investment bankers act as intermediaries between businesses and capital providers. They help sell securities, assist with business combinations, act as brokers, and trade for their own accounts.
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Investment Banking
They help
* They help determine the method of issuing securities and the price, distribute them, provide advice, and perform a certification function.
* Most issuers select investment bankers through a negotiated deal, not competitive bids, due to the high costs of learning about issuers.
* Investment bankers issue securities via best efforts sales (no guarantee of sale) or underwritten deals (guaranteed sale).
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Determining the offering price is crucial:
* For seasoned issues, the price is often based on existing securities’ market price or bond yield.
* Investment bankers typically don’t underwrite an entire issue unless it’s small. They create underwriting syndicates to share risks and commissions.
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Flotation Costs
Flotation costs are higher for small issues and common stock compared to preferred stock and bonds.
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Components of flotation costs:
* Underwriting spread: Difference between the price paid and the net amount received.
* Other expenses include filing fees, taxes, and professional fees.
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* Unseasoned securities
(IPOs) are often underpriced compared to aftermarket prices.
* Seasoned securities: Securities traded long enough to eliminate short-term effects from their IPO (e.g., Euromarket requires 40 days).
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Initial Public Offerings (IPOs)
An IPO is a firm’s first issuance of securities. The process of issuing to the public is called going public.
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* Secondary offerings:
* Dilutive (subsequent offering or follow-on offering ): New stock issued, proceeds go to the company, increasing outstanding shares.
* Non dilutive :the existing shareholders (e.g. founders, executives) offer shares to the market. Company doesn’t receive proceeds, and shares don’t increase.
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Advantages of Going Public
* Raise Funds: Access to additional capital for growth. Market Value: Establishes the firm’s value in the market.
* Liquidity: Increases stock liquidity for shareholders.
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Disadvantages of Going Public
* Regulatory and Transparency Costs: Expenses for SEC compliance, exposure of operational data, and shareholders' net worth.
* Insider Restrictions & Loss of Control: Limits on self-dealing by insiders and potential loss of management control as ownership diversifies.
* Pressure for Growth & Stock Price Misalignment: External pressure for earnings growth and stock prices not reflecting true value.
* Increased Costs: Higher shareholder servicing and administrative costs due to expanded operations.
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Financial Risk and Return
The return is the compensation an investor receives for the risk taken.
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- [x] Return on Investment
= Amount received – Amount Invested
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- [x] rate of return =
= Return on Investment / Amount Invested
- [x] Return on Investment = Amount received – Amount invested
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Basic Types of Investment Risk
1. Systematic Risk / un diversifiable risk(Market Risk): Affects all firms due to overall economic changes (e.g., business cycle).
2. Unsystematic Risk / diversifiable risk (Company Risk): Specific to a company or industry (e.g., management, products, customer loyalty).
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Other Types of Investment Risk
Credit Risk: Risk of issuer defaulting on debt. Liquidity Risk: Risk of being unable to sell a security quickly at market value.
Foreign Exchange Risk: Risk of currency fluctuations affecting foreign transactions. Purchasing-Power Risk: Risk of inflation eroding the value of money.
Interest Rate Risk: Risk of value changes due to interest rate shifts; higher for longer maturities. Financial Risk: Risk from changes in financial markets, such as interest rates or investor return expectations.
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* Risk-Averse Investor:
Prefers lower risk for a lower but stable return due to diminishing utility of wealth.
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* Risk-Neutral Investor:
Views risk and return equally and bases decisions on expected value.
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* Risk-Seeking Investor:
Prefers higher risk for potentially higher returns, valuing gains more than losses.
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Efficient Portfolios
An efficient portfolio maximizes return for a given risk or minimizes risk for a given expected return.
Two key decisions in managing a portfolio:
1. The amount to invest.
2. The selection of securities to invest in.
Portfolio construction should consider:
* Expected net cash flows and cash flow uncertainty.
* Maturity matching to align fund needs with security maturity, maximizing returns and flexibility.
* Higher yield securities have less certainty, and their marketability and transaction costs must be considered.
* When cash flows are certain, maturity date is a key factor.
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- [x] Expected rate of return (R):
R=∑(Possible rate of return×Probability)
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Security Risk vs. Portfolio Risk
For a portfolio, risk and return should be evaluated for the whole, not just individual assets.
* Portfolio return is the weighted average of individual returns.
* Portfolio risk is often less than the average individual security risks due to diversification.
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correlation coefficient (r)
The correlation coefficient (r) measures how two variables are related, ranging from +1.0 to -1.0:
* Perfect positive correlation (1.0): Variables move together.
* Perfect negative correlation (-1.0): Variables move in opposite directions, potentially eliminating risk.
Normal stock correlation is between 0.50 to 0.70, reducing but not eliminating risk.
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Beta
The beta (β) of a stock measures its sensitivity to market movements.
* β = 1.0: Stock moves in sync with the market.
* β < 1.0: Stock is less volatile. β > 1.0: Stock is more volatile.
Portfolio beta is the weighted average of individual stock betas.
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CAPM calculates the required return based on risk.
- [x] M−RF)Required return=RF +β(RM −RF )
* Market Risk Premium (RM − RF): The extra return investors require to invest in the market instead of a risk-free asset.
* Specific Stock Risk Premium (β[RM − RF]): Reflects the premium specific to a security, proportional to its beta.
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* β,Risk Premium(β(Rm-Rf), Ke(Required rate of return) are in Direct Relation.
* Beta (ß) and intrinsic value(Intrinsic Value: The true, fundamental value of an asset, based on its expected future cash flows, earnings, and growth. It's what the asset is worth in reality.), market price is in Inverse Relation
* β,Risk Premium(β(Rm-Rf), Ke(Required rate of return) are in Direct Relation.
* Beta (ß) and intrinsic value(Intrinsic Value: The true, fundamental value of an asset, based on its expected future cash flows, earnings, and growth. It's what the asset is worth in reality.), market price is in Inverse Relation
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* If Beta = 1
* If Beta = 1 then Ke = Km
* “ Market Risk = Systematic Risk = Beta (ß)
* Market Return (km) is an average not exact return there will be variations.
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undervalued
* Ke < Km: Stock is undervalued, actual stock price lies above the SML.
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overvalued
* Ke > Km: Stock is overvalued, actual stock price lies below the SML.
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CAPM focuses only on systematic risk because investors can mitigate unsystematic risk by holding a diversified portfolio.
CAPM provides a framework to assess the minimum acceptable return required by an investor given the systematic risk of a security
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Increase in Beta:
Leads to a higher required rate of return.
Decreases intrinsic value (via discounted cash flow models).
Results in a lower market price.
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Decrease in Beta:
Leads to a lower required rate of return.
Increases intrinsic value.
Results in a higher market price.
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The Security Market Line (SML)
The SML visually represents the Capital Asset Pricing Model (CAPM), illustrating the relationship between an asset’s systematic risk (beta) and its expected return.
1. Purpose: Determines the required return for securities based on their risk profiles.
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1. Slope of the SML
(Market Risk Premium): Represents the return investors expect above the risk-free rate per unit of beta.
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Using the Security Market Line (SML)
* If a security’s expected return matches the required return, it is fairly valued and lies on the SML.
* Above SML: Expected return > Required return → Undervalued (Bargain)
* Below SML: Expected return < Required return → Overvalued (Overpriced)
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under valued and over valued using SML
* Above SML: Expected return > Required return → Undervalued (Bargain)
* Below SML: Expected return < Required return → Overvalued (Overpriced)
Impact of Key Changes
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1. Risk-Free Rate: An increase in the risk-free rate
shifts the SML upward, raising required returns.The SML shifts upward (indicating higher required returns across the market. (When Rf increases Km also increases same % so the difference (km-Rf) will be equal to before and Ke increases.
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2. Investor Risk Aversion: Increased risk aversion
steepens the SML, requiring higher returns for the same level of risk.
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Quantitative Risk Assessment Tools
* Value at Risk (VaR): Determines the maximum potential loss over a period with a given confidence level.
* 95% confidence: Within 1.96 standard deviations from the most probable event.
* 99% confidence: Within 2.57 standard deviations.
* Cash Flow at Risk and Earnings at Risk are similar to VaR.
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Sources of Short-Term Financing:
1. Market-based instruments: These are financial instruments that are traded in markets (e.g., commercial paper).
2. Spontaneous sources: These sources arise naturally in the course of business, such as accounts payable (trade credit).
3. Commercial banks: Banks provide loans and lines of credit that companies can use for short-term needs.
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Spontaneous Forms of Financing
The most common source of short-term financing is trade credit, which is provided by suppliers when a firm buys goods on credit and agrees to pay later.
Trade credit arises when suppliers allow a customer to purchase goods on account (not using cash), receive them, and pay later.
Credit Terms: Often expressed as 2/10, net 30.
Widely Available: Accessible financing for small firms. Free Financing: No cost if payment is made within the discount period.
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Formula to Calculate Usable Funds: When taking advantage of the discount,
Usable funds = Invoice amount × (1.0 – Discount %)
- [ ] This formula calculates the actual amount a buyer needs to pay when utilizing a discount on an invoice.
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Other Spontaneous Financing:
* Accrued Expenses: These include wages, interest, dividends, and taxes payable. Employees might work 5 or 6 days a week, but they are paid every two weeks. This timing gives businesses an interest-free loan from employees.
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Cost of Not Taking a Discount =
= Discount % / (100 - Discount %) * Days in Year / ( Total Payment Period - Discount Period)
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Short-Term Bank Loans
provide capital not available through trade credit, allowing firms to finance growth opportunities.
* Risk of insolvency: If the firm can’t repay the loan, it may face financial difficulties.
* Loan renewal risk: Banks may not renew short-term loans, which could lead to liquidity problems.
* Contractual restrictions: Banks may impose requirements like maintaining a compensating balance (a minimum balance in the bank account).
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Types of Short-Term Bank Loans:
1. Term Loans:
2. Line of Credit
3. Revolving Line of Credit:
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1. Term Loans:
These loans must be repaid by a certain date. They typically have fixed interest rates and specific repayment schedules.
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2. Line of Credit:
This is a flexible borrowing arrangement where a company can borrow money up to a specified limit and make minimum monthly payments. (similar to a consumer’s credit card).
* Advantages: Often unsecured, meaning no collateral is required.
* Self-liquidating; the loan is repaid with the proceeds from acquired assets (e.g., inventory).
* Disadvantages: It’s not a guaranteed loan, so the credit might not be renewed.
* Some banks may require the borrower to "clean up" its debt for a few months each year.
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3. Revolving Line of Credit:
This allows businesses to borrow, repay, and borrow again as needed. The line of credit is continuously available as long as the business stays within its limit.
* Commitment Fee: A fee is often charged on the unused portion. Interest Expense: Calculated based on the amount borrowed at the given interest rate.
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* Commitment Fee:
* Commitment Fee: A fee is often charged on the unused portion.
The effective interest rate (EIR) measures the true cost of borrowing, expressed as a percentage. It is calculated as the ratio of the amount a firm pays to the amount it can use.
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Effective Interest Rate on a Loan
The effective interest rate (EIR) measures the true cost of borrowing, expressed as a percentage. It is calculated as the ratio of the amount a firm pays to the amount it can use.
- Effective Interest Rate = Net Interest Exp / Usable Funds
- Effective rate on Discounted Loan = Stated Rate / (1- Stated Rate)
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Simple Interest Loans
interest is calculated on the original loan amount (principal), and interest is paid at the end of the loan term.
* Loan Amount: This is equal to the amount of usable funds received by the borrower.
* Interest Expense: Calculated as the loan amount times the stated interest rate.
- [x] Interest Expense = Loan Amount× Stated Rate
Effective Rate: For a simple interest loan, the effective rate and the nominal rate are the same because the interest is calculated based on the full loan amount.
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Discounted Loans
* A discounted loan deducts the interest amount upfront, meaning the borrower receives less than the loan's face value but repays the full face value at the end of the term.
Usable Funds = Loan Amount−Interest Deducted. Interest Expense = Loan Amount × Stated Rate
Effective Interest Rate (EIR): Since the borrower receives less upfront, the EIR is higher than the quoted nominal rate.
- [x] Formula: EIR=Interest Expense / Usable Funds ×100
Example: If a bank quotes a rate of 8%, but the borrower only receives a portion of the loan after interest is deducted, the effective rate could be as high as 8.696%.
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Lines of Credit with Commitment Fees
A line of credit allows borrowing up to a maximum limit. It can be term-based or revolving (repay and re-borrow). Commitment Fee: Charged on unused credit.
* Effective Rate: The effective rate for a line of credit is influenced by the interest paid on the drawn amount and the commitment fees on the unused portion of the credit line.
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Market-Based Instruments
Market-based instruments are short-term financing tools that companies use to secure funds for their operations. These instruments provide flexibility and allow companies to access funding from the financial markets.
* 1. Bankers’ Acceptances
2. Commercial paper
3. Secured Financing
4. Receivables Financing:
5. Chattel Mortgage:
6. Floating Lien:
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* 1. Bankers’ Acceptances
A banker’s acceptance is a bank-guaranteed payment sold at a discount, providing short-term financing (e.g., 90 days). The drawer must repay the bank at maturity.
* Bankers’ acceptances are sold at a discount.
* The difference between the face value and the proceeds the drawer receives from the investor represents the interest expense.
Bankers’ acceptances are typically used for international trade but can also be used for short-term financing needs. They are essentially a form of short-term credit.
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* 2. Commercial paper
is an unsecured short-term debt instrument issued by large corporations with high credit ratings. The main purpose of commercial paper is to raise funds for operating expenses or short-term financing needs.
* Issued in large denominations (usually $100,000 or more).
* Typically has a maximum maturity of 270 days.
* Sold to institutional investors like pension funds, banks, and insurance companies.
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· Advantages of Commercial Paper:
* Broad and efficient distribution: It allows large corporations to access a wide pool of investors.
* Cost-effective: It is generally cheaper than obtaining funds from bank loans.
* Large amounts of funds: Corporations can raise significant funds quickly.
* Avoids costly financing: It eliminates the need for more expensive forms of financing.
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· Disadvantages of Commercial Paper:
* Impersonal market: Commercial paper does not involve personal relationships between lenders and borrowers.
* Limited availability: The funds available depend on the liquidity of large corporations, meaning smaller companies might not be able to access this market.
· Cost Calculation: The annualized rate for commercial paper can be calculated by determining the difference between the amount raised and the interest expense.
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* 3. Secured Financing
Secured financing involves using assets as collateral to back loans. This reduces the lender’s risk and allows the borrower to access funding at lower interest rates.
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* 4. Receivables Financing:
In this type of secured financing, a company pledges its receivables (money owed by customers) as collateral for a loan. Typically, a bank will lend up to 80% of the value of outstanding receivables, depending on factors like the age of accounts and the likelihood of collection.
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* 5. Chattel Mortgage:
Loan secured by movable property, such as equipment, livestock, or vehicles. If the borrower defaults, the lender can seize the property.
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* 6. Floating Lien:
This type of financing is secured by inventory. Unlike a fixed lien, a floating lien allows the borrower to use and sell the inventory as part of regular operations. The lien "floats" over the assets, and the lender has a claim on the inventory even though it may change over time.
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Maturity Matching:
Maturity matching aligns the duration of an asset with the debt used to finance it, reducing financial risk.
* Short-term debt should finance short-term assets (e.g., a 30-day loan matched with a 30-day marketable security).
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Maturity Matching:
Why it Matters:
*
This approach mitigates financial risk because the company can match short-term liabilities with short-term assets, ensuring liquidity when needed.
* Careful planning is required to ensure that long-term debt is repaid with dedicated funds, not from operational funds that are needed for day-to-day activities.
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Risks of Short-Term Financing:
* Refinancing Risk: Frequent refinancing is needed, making the company vulnerable to market changes or financial instability.
* Leverage: Using more short-term debt doesn’t change the debt-to-equity ratio but raises financial risk due to refinancing frequency.
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Leasing vs. Debt Financing:
* Decision: Choose whether to finance an asset via lease or debt.
* Goal: Select the method with the lowest present value of after-tax cash outflows.
* Tax Shield: After-tax cash flows consider interest and depreciation expenses, which provide tax savings by offsetting lease or loan payments. Tax savings = tax rate × expense.
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Net Advantage to Leasing (NAL):
* NAL is the difference between the present value of lease payments and debt financing (cost of ownership). If leasing results in lower after-tax costs, it's the better option.
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Convertible Securities
Convertible securities are debt or preferred stock that can be converted into a set number of common shares after a certain period.
* For Investors: The conversion feature gives investors the opportunity to convert to common stock later, potentially benefiting from the company’s growth.
* For Companies: Provides flexibility to raise funds and offers potential upside to investors, all at a lower cost than directly issuing equity.
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Stock Purchase Warrants
* A stock purchase warrant is like a call option on a company’s common stock. The holder of the warrant has the right (but not the obligation) to purchase common stock at a specified price after a set period.
* Purpose: Warrants are used to reduce the cost of debt. When attached to debt securities, warrants make those securities more attractive to investors, lowering the interest rate the company must pay on the debt.
* Key Features: The holder can exchange the warrant for stock at the specified price, potentially benefiting if the stock price increases.
* Warrants act as a sweetener, making it easier for companies to issue debt by offering investors additional potential benefits.
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Retained Earnings:
Retained earnings are the cumulative earnings of a corporation, minus cash dividends paid and amounts reclassified as additional paid-in capital from stock dividends.
* Benefit: Retained earnings represent the lowest-cost form of capital since they are internally generated with no issuance costs.
Cost of Retained Earnings:
: consider Growth,
do not consider flotation cost, underpriced, any premium or discount adjustments not relevant
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Cost of Retained Earnings:
Retained earnings directly fund growth through reinvestment.
Growth rate (g) is critical in valuing retained earnings (via ROE and retention ratio).
Flotation costs/underpricing are excluded because they pertain to external equity, not internal retained earnings
any premium or discount adjustments not relevant
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Preferred Stock Valuation:
Similar to Bond Valuation: Preferred stock is valued similarly to bonds, based on its dividend payments.
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1. Zero Dividend Growth Model:
Assumes dividends remain constant forever, suitable for mature industries with little or no growth.
- [x] Formula: P0 =Annual Dividend / Investors’ Required Rate of Return (R). Or V = D/Ks
Where, V or P0 = Common stock price to be estimated , D = Dividend, Ks or Ke= Investors required rate of return on common stock (cost of equity)
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2. The Constant Growth Dividend Discount Model
p0=d1/ks-g
ks= (d1/p0) +g
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3. Common Stock with Variable Dividend Growth
two-stage growth:
1. Calculate and sum the present value of dividends during the high growth phase.
2. Calculate the present value of the stock during the steady growth phase using the constant growth dividend discount model.
Discounting back to Year 1
Step 3: Sum of present values:
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4. Valuing Common Stock Using Dividends + Expected Future Stock Price
Formula: P0 =D1 +P1 / 1+R
* P0 or V0 : Intrinsic value today of the stock D1 : Next annual dividend to be paid
* P1 : Expected price of the stock at the end of one year R or Ke: Investors’ required rate of return
This formula calculates the present value of both the expected dividend and the assumed sale price of the stock after one year.
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5. Using the Capital Asset Pricing Model (CAPM) with the Dividend Growth Model
- [x] CAPM Formula: R =RF +β(RM −RF )
Zero Growth Dividend Model
For stocks with no expected dividend growth:
P0 = Annual Dividend / R
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6) Present Value of Expected Future Cash Flows
- [ ] Formula: P0 ∑ {Cash Flowt / (1+R)t}
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7) Bond Yield Plus Risk Premium Method
* Definition:Estimates the cost of retained earnings by adding a risk premium to the bond yield (pre-tax cost of long-term debt).
- [x] Formula: Cost of Retained Earnings=Bond Yield+Risk Premium (Km-Rf : the difference between the market rate and the risk-free rate)
* Advantages: Simple and easy to calculate, Useful when detailed market data is unavailable.
* Disadvantages: Relies on estimated risk premium, which may vary, Less precise than other methods like CAPM or DCF.
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7) Relative or Comparable Valuation Models
Example Metrics:
* P/E Ratio: Determines undervaluation/overvaluation based on earnings. mps/ eps
* P/B Ratio: Assesses intrinsic value relative to net assets. mps/beps
* P/S Ratio: Evaluates revenue valuation, especially for growth companies.
mps/sales per share
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Cost of Capital
* The required rate of return (also known as opportunity cost of capital) becomes the company’s cost of capital.
* The cost of capital is used to discount future cash flows of long-term projects.
* Projects with returns higher than the cost of capital increase firm value (shareholders' wealth), while those lower decrease it.
* Not used for working capital decisions, as short-term needs are covered by short-term funds.
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* Cost of Preferred Stock: Calculated using the dividend yield ratio:
Formula: Cash dividend on preferred stock ÷ Market price of preferred stock (D / V0)
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* Cost of Common Stock: Similar to preferred stock, using the dividend yield ratio:
* Formula: Cash dividend on common stock ÷ Market price of common stock
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* Cost of Retained Earnings:
Same as the cost of common stock, but typically lower due to the lack of issuance costs.(flotation cost)
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Weighted-Average Cost of Capital (WACC)
The WACC expresses the overall cost of capital as a weighted average of the costs of debt, preferred equity, and common equity, with each component weighted according to its market value in the company’s capital structure.
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Steps to Calculate WACC:
1. Calculate the After-Tax Cost of Each Component:
* Debt: The cost of debt is adjusted for taxes because interest payments are tax-deductible.
* Preferred Equity: The cost is calculated based on the dividend paid to preferred equity holders.
* Common Equity: The cost is calculated based on the return required by common shareholders (using models like the Dividend Growth Model or CAPM).
2. Assess the Capital Structure:
* Determine the market value of each component (debt, preferred equity, common equity).
* Find the weight of each component as a percentage of the total market value of the company’s capital.
3. Calculate WACC:
* Multiply the after-tax cost of each component by its respective weight.
* Add up the products to get the WACC.
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Optimal Capital Structure:
Firms aim to minimize WACC to maximize shareholder wealth. The optimal capital structure is a balance between debt and equity, as too much debt increases risk.
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* Why MCC Rises:
Each additional dollar of new capital becomes more expensive as investors demand higher returns for increased risk.
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Cost of New Common Stock:
Formula: (Next Dividend ÷ Net Issue Proceeds) + Dividend Growth Rate = (D1/v0)+g
* Used mainly by young, growing companies. Mature firms avoid issuing new common stock due to high costs and potential stock price impact.
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A derivative instrument
is an investment transaction where the gain or loss depends on another economic event(underlying asset), such as:
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Notional Amount
Total value of the underlying asset in a contract (used for calculations). E.g., A 1Mfuturescontract→Notional=1Mfuturescontract→Notional=1M (but you don’t pay $1M upfront).
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Settlement Amount
Actual cash exchanged at settlement (usually a fraction of notional). If notional = 1Mandsettlement=51Mandsettlement=550k paid.
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Exercise Price
Pre-agreed price to buy/sell the asset (also called strike price). E.g., Option to buy stock at 50→Exerciseprice=50→Exerciseprice=50.
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Premium
Price paid to buy an option (paid upfront). E.g., Pay $5 to buy a call option.
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Intrinsic Value
Profit if exercised NOW. Exists onlyif the option is "in the money". Call: 50strike,stockat50strike,stockat60 → Intrinsic = 10.Ifstock≤10.Ifstock≤50 → $0.
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Time Value/ extrinsic value
Extra value due to time left until expiration + volatility. If premium = 5andintrinsicvalue=5andintrinsicvalue=3 → Time value = $2.
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Premium Formula
Premium = Intrinsic Value + Time Value Premium (5)=Intrinsic(5)=Intrinsic(3) + Time Value ($2).
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In the Money (ITM)
Option has intrinsic value (profitable to exercise). Call: Stock price > strike price. Put: Stock price < strike price.
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Out of the Money (OTM)
Option has no intrinsic value (not profitable to exercise). Call: Stock price < strike price. Put: Stock price > strike price.
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Hedging
is the process of using offsetting commitments to minimize or avoid the risk of adverse price movements.
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Types of Hedges:
Fair-Value Hedge : Uses financial instruments (e.g., derivatives)
Requires specialized contracts or instruments
Hedging bond value with a swap
May involve fees or additional costs
Natural Hedge : Relies on operational strategies
Simple, based on business practices
Financing equipment over its useful life
Typically cost-effective
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Options as Derivatives
Options are a type of derivative giving the buyer the right, but not the obligation, to take a specific action (e.g., buy or sell an asset) on or before a set date.
* Buyer’s Right: The buyer decides whether to exercise the option.
* Seller’s Obligation: The seller (writer) must fulfill the buyer's decision.
* Expiration Date: Options expire after a set date and cannot be used afterward.
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Types of Options:
* Stock Option: Based on traded stocks.
* Index Option: Based on market indexes, settled in cash.
* LEAPS: Long-term options (up to 3 years).
* Foreign Currency Option: Right to buy a specific foreign currency at a fixed exchange rate.
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call option
call option gives the buyer the right to purchase the underlying asset at a fixed price (exercise/strike price).
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call option gain or loss ; for Long position
- [x] Gain/Loss Formula: Units of underlying × (Market price – Exercise price – Option price).
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call option gain or loss gain or loss of Short position
- [x] Gain/Loss Formula: Units of underlying × (Option price – (Market price – Exercise price)).
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Put Options
Gives the buyer (holder) the right to sell the underlying asset at a fixed price.
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Calculation of Gain/Loss:
. Seller of underlying asset (long position : buyer of the option):
* Gain/Loss = Units of underlying × (Exercise price – Market price – Option price)
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Calculation of Gain/Loss:
1. Buyer of underlying asset (short position):
* Gain/Loss = Units of underlying × (Option price – (Exercise price + Market price)
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1. American Option
Can be exercised at any time up to the expiration date.
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2. European Option
Can only be exercised on the expiration date.
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3. Covered Call Option
A call option where the seller owns the underlying stock, reducing risk.
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4. Naked Call Option
A call option where the seller does not own the underlying stock, increasing risk significantly.
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Valuing an Option
Market Value of an Option
= Intrinsic Value + Extrinsic Value (Time Value)
Let's say an investor buys a call option for ABC stock:
* Market Price of ABC = $63
* Strike Price of Call Option = $60
* Premium Paid for Option = $3.50
1. Intrinsic Value:
* Since the option is in-the-money, we subtract the strike price from the market price:
* Intrinsic Value = $63 - $60 = $3.
2. Time Value:
* Subtract the intrinsic value from the total premium:
* Time Value = Premium - Intrinsic Value = $3.50 - $3 = $0.50.
So, for this option: Intrinsic Value = $3. Time Value = $0.50.
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Increase in
Exercise Price
Effect on Call Option Effect on Put Option
Decreases Increases
A lower exercise price benefits a call buyer, while a higher exercise price benefits a put buyer.
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Interest Rates increases
Effect on Call Option
Effect on Put Option
Increases
Decreases
Rising interest rates make call options more attractive, as they allow for future payments with inflated dollars. For puts, higher rates make them less attractive.
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increas Price of Underlying:
Effect on Call Option
Effect on Put Option
Increases
Decreases
As the price of the underlying asset increases, the call option becomes more valuable, while the put option becomes less valuable.
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Time Until Expiration increases
Effect on Call Option
Effect Volatility of Priceon Put Option
Increases
Increases
More time increases the likelihood of price fluctuations, making both call and put options more valuable.
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Volatility of Price increases
Increases
Increases
Greater price fluctuations increase the potential for higher gains, making both call and put options more valuable.
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* For Buyers:
You can exercise, offset, or let the option expire. The main goal is to manage your position before expiration to secure a profit or limit a loss.
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* For Sellers:
You can only offset your position early, and exiting early typically results in a loss if the option is in-the-money.
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Call Option
Buyer: gain, VS loss.
Call Option Buyer: Unlimited gain, limited loss.
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Call Option Seller: gain, VS loss.
Call Option Seller: Limited gain, unlimited loss.
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Put Option Buyer: gain, VS loss.
Put Option Buyer: Limited gain, limited loss.
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Put Option Seller: gain, VS loss.
Put Option Seller: Limited gain, limited loss.
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Forward Contracts
Definition: An agreement to exchange an asset at a set price on a future date, locking in prices and quantities to reduce risk.
Traded OTC:
not exchange-traded
counterparty risk
must fulfill their obligations.
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Valuation of Forward Contracts
* The value of a forward contract during its term is the difference between the current market price of the asset and the present value of the agreed forward price.
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Futures Contracts
Futures Contracts(Traded on an Exchange)
* Definition: A commitment to buy or sell an asset at a fixed price during a specific future month. The counterparty is unknown.
* Traded on Exchanges: Futures are actively traded on exchanges, creating a liquid market where positions can be netted out.
Flexibility,
* Clearinghouse Role: The clearinghouse matches sellers and buyers for contracts, minimizing default risk.
Mark-to-Market: Prices are updated daily to account for profits and losses,
reducing default risk
* Most futures contracts are not settled through physical delivery.
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* Most futures contracts are not settled through physical delivery.
Over-the-counter (private agreements).
Customized terms for quantity, price, etc.
Counterparty credit risk exists.
At expiration (physical delivery or cash).
Limited; no secondary market.
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Futures Contracts
Traded on regulated exchanges.
Standardized contracts for ease of trading.
No credit risk; exchanges guarantee trades.
Marked-to-market daily; positions often closed before delivery.
Highly liquid with active secondary markets.
Initial margin required; daily margin adjustments.
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Swaps
Contracts where two parties exchange cash flows based on agreed terms.
1. Interest Rate Swaps:
2. Currency Swaps:
Purpose: Swaps are used to manage financial risks, such as interest rate or currency fluctuations.
Swaps are highly customized and can be used for managing a variety of financial risks such as interest rate fluctuations and currency exchange risks.
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1. Interest Rate Swaps:
An agreement to exchange interest payments based on a notional principal:
* One party pays a fixed rate, the other pays a floating rate (e.g., tied to LIBOR).
* Convert floating-rate debt to fixed to avoid rising rates.
* Match fixed revenue with fixed payments for stability.
* Example: A company swaps its floating-rate loan for fixed-rate payments to reduce interest rate risk.
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1. Currency Swaps:
An agreement to exchange cash flows in different currencies:
* Structure: Swap interest payments and sometimes principal amounts.
* Purpose: Hedge against exchange rate risk for foreign-denominated debt.
* Example: A U.S. company issues euro bonds. A European company issues dollar bonds. Both swap payments, eliminating exchange rate risk.
Exchange Rate: Based on the average expected rates over the life of the swap agreement.
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Working Capital Management
Working capital finance involves managing current assets (e.g., cash, inventory, receivables) and current liabilities (e.g., payables) to ensure liquidity and solvency.
* Objective: Minimize the cost of maintaining liquidity while avoiding insolvency.
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1. Permanent Working Capital:
* Minimum level of current assets required to support operations.
* Grows with the firm and is typically financed with long-term debt for stability.
* Risk of short-term debt financing: Liquidity issues, rising interest rates, or non-renewal of loans.
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Working Capital Policies
1. Conservative Policy: Focuses on minimizing liquidity risk by increasing working capital.
* Higher current ratio and acid-test ratio, Ensures adequate cash, inventory, and payables are minimized, Trades off higher returns for greater liquidity.
2. Aggressive Policy: Focuses on increasing profitability by reducing working capital.
* Characteristics: Lower current ratio and acid-test ratio, Accepts higher risk of short-term cash flow problems.
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EOQ MODEL Applied to cash management
Q= root of (2bt/i)
q= optimal cash balance
b= fixed cost per trnasaction
t= total demand
i= interest rate on marketable securities
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EOQ model applied to inventory
Q= root of (2bt/c)
q= optimal inventory
b= fixed cost per
t= total demand
c= carrying cost per unit
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Firms hold cash for three key reasons:
1. Transactional: As a medium of exchange for day-to-day operations.
2. Precautionary: To provide a reserve for contingencies (unexpected costs or emergencies).
3. Speculative: To take advantage of opportunities that might arise unexpectedly.
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