; Lecture 1 – Introduction to Corporate Finance
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Lecture 1 – Introduction to Corporate Finance


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									Lecture 1 – Introduction to Corporate Finance                                          Class notes

Lecture 1 – Introduction to Corporate Finance

Financial Management Duties

• Capital Budgeting – The process of planning and managing a firm’s long-term investments.

• Capital Structure – The specific mixture of long-term debt and equity the firm uses to finance
   it operations.

• Working Capital Management – Managing the firm’s short-term assets and liabilities.
Financial Officers

• Chief Financial Officer – oversees the treasurer and controller and sets overall financial

• Treasurer – responsible for financing, cash management, and relationships with financial
   markets and institutions.

• Controller – responsible for budgeting, accounting, and auditing.
Forms of Business Ownership

• Proprietorship – An unincorporated business owned by a single individual.
    ¤ Easily and inexpensively formed.
    ¤ Few government regulations.
    ¤ Avoids corporate income taxes.

    ¤ Unlimited liability for the owner.
    ¤ Limited to the life of the owner.
    ¤ Illiquid.
    ¤ Difficult to obtain large amounts of capital.

• Partnership – Business owned by tow or more persons who are personally responsible for all
   its liabilities.

    ¤ Easily and inexpensively formed.
    ¤ Few government regulations.
    ¤ Avoids corporate income taxes.

Lecture 1 – Introduction to Corporate Finance                                          Class notes

    ¤   Unlimited liability for general partners.
    ¤   Limited life for the organization.
    ¤   Difficult to transfer ownership.
    ¤   Difficult to obtain large amounts of capital.

• Corporation – A business that is legally distinct from its owners.
    ¤ Unlimited life.
    ¤ Easy to transfer ownership.
    ¤ Limited liability.

    ¤ Double taxation.
    ¤ Complex legal requirements.

• Hybrid Forms of Organization
    ¤   Limited partnership – Certain partners are designated general partners, who have unlimited
        liability. Other owners are limited partners because their liability is limited.

    ¤   Professional Corporation – A type of corporation common among professionals. An S
        corporation has 75 or fewer shareholders.

The Goal of Financial Management

• Maximize Shareholder Wealth – Mangers work on behalf of shareholders and should pursue
   policies that enhance shareholder value.

• Social Responsibility – The concept that businesses should be actively concerned with the
   welfare of society at large.

Agency Problems and Control of the Corporation

• Agency Problem – The conflict of interest between the firm’s owners and managers.

• Management Goals – Managers have a tendency to increase their own perks or to increase the
   size of the organization in an attempt to increase their power.

• Methods to Entice Managers to Act in the Best Interests of Stockholders
    ¤   The threat of firing
    ¤   The threat of takeovers
    ¤   Managerial compensation
    ¤   Direct Intervention by Shareholders
Lecture 1 – Introduction to Corporate Finance                                      Class notes

• Ownership Structure outside the U.S. – in some countries, ownership is more concentrated,
   creating separate problems.
Lecture 2 – Financial Statements, Taxes, and Cash Flow                                        Class notes

Lecture 2 – Financial Statements, Taxes, and Cash Flow

• Review the income statement, balance sheet, and cash flow statement.
• Emphasize cash flows and the difference between accounting accruals.
Income Statement

• Income Statement – Shows how profitable a firm has been over some period of time.
    ¤   GAAP – Revenues appear when they accrue, not when they are collected. Expenses are
        matched with the revenues that appear.

    ¤   Noncash items – Depreciation.

    ¤   Taxes – The marginal tax rate is the most relevant when evaluating projects.

Balance Sheet

• Balance Sheet – Presents a snapshot of the firm’s assets, liabilities, and owner’s equity.
    ¤   Assets – Listed in order of their liquidity on the left-hand side of the statement.

         - Current Assets – life of less than one year.

         - Fixed Assets – life longer than one year.
    ¤   Liabilities and Owners’ Equity – The claims against assets.

         - Current Liabilities – life of less than one year.

         - Long-term Liabilities – debt (financial leverage) that is not due in the next year.

         - Owners’ Equity – value of the capital supplied by common stockholders.

    ¤   Book Values vs. Market Values – assets must be shown on the balance sheet at their
        historical cost adjusted for depreciation. These are not market values.

Cash Flow Analysis

• Cash Flows Analysis – shows the firm’s cash receipts and cash payments over a period of

    ¤   Cash Flow from Operations – begins with net income and adjusts for non-cash items.
Lecture 2 – Financial Statements, Taxes, and Cash Flow                               Class notes

    ¤   Cash Used for Investments – money spent on fixed assets and received from sales of fixed

    ¤   Cash Flow from Financing Activities

         - Cash flow to creditors – interest paid minus net new borrowing.

         - Cash flow to stockholders – dividends paid minus net new equity.
Lecture 3 – Ratio Analysis                                                              Class notes

Lecture 3 – Ratio Analysis


• Introduce the analysis of financial statements through the use or ratios.

• Review the uses and limitations of ratios.
Ratio Analysis

• Ratio Analysis – designed to help evaluate financial statements.

    ¤ Liquidity Ratios

    ¤ Asset Management Ratios

    ¤ Long-Term Solvency (Debt) Ratios

    ¤ Profitability Ratios

    ¤ Market Value Ratios

• Liquidity Ratios – show the relationship of a firm’s cash and other current assets to its
   current liability.

    ¤ Current Ratio – indicates the extent to which current liabilities are covered by those
       assets expected to be converted to cash in the near future.

    ¤ Quick Ratio – a measure of the firm’s ability to pay off short-term obligations
       without relying on the sale of inventories.

    ¤ Cash Ratio – a very short-term measure of liquidity.

• Asset Management – A set of ratios which measure how effectively a firm is
   managing its assets.

    ¤ Inventory Turnover – the number of times per year that the firm fills up and
       completely empties its inventory.

    ¤ Days’ Sales in Inventory – the number of days it would take to sell off the firm’s
       current level of inventory.

    ¤ Receivables Turnover – measures how fast sales are collected.
Lecture 3 – Ratio Analysis                                                               Class notes

    ¤ Days Sales in Receivables – the average length of time the firm must wait after
       making a credit sale before receiving cash.

    ¤ Fixed Asset Turnover – measures how effectively the firm uses its plant and

    ¤ Total Asset Turnover – measures how effectively the firm uses all of its assets.
Ratio Analysis

• Long-Term Solvency (Debt) Ratios – The extent to which a firm uses debt financing.
   It has three implications:

    ¤ Stockholders maintain control while limiting their investment.

    ¤ Risks of the firms is transferred to creditors.

    ¤ Return on the owner’s equity is magnified.

    ¤ Total Debt Ratio – measures the percentage of funds provided by creditors.

    ¤ Times-Interest-Earned – measures the ability of the firm to meet its annual interest

• Profitability Ratios – show the combined effects of liquidity, asset management, and
   debt on operating results.

    ¤ Profit Margin – measures income per dollar of sales.

    ¤ Return on Assets (ROA) – measure of profit per dollar of assets.

    ¤ Return on Equity (ROE) – measures the rate of return on common stockholders’

• Market Value Ratios – relates the firm’s stock price to its earnings and book value per

    ¤ Price-Earnings (P/E) Ratio – shows how much investors are willing to pay per
       dollar of reported profits.

    ¤ Market-to-Book Ratio – the ratio of a stock’s market price to its book value and
       gives an indication of how investors regard the company.
Lecture 3 – Ratio Analysis                                                            Class notes

Financial Statement Uses

• Internal Uses – evaluate management and planning for the future.

• External Uses – Investor sand creditors find the information useful in their decision

• Time-Trend Analysis – Examine whether there is a strengthening or weakening

• Peer Group Analysis – Compare a particular company with a group of ‘benchmark’

Limitations of Ratio Analysis

• Not as useful for large, diverse companies.

• Inflation distorts balance sheets.

• Seasonal factors distort ratio analysis

• ‘Window dressing’ techniques distort financial statements.

• Different accounting practices can distort comparisons.

• No objective standard on what is good and bad.
Lecture 4 – Long-Term Financial Planning and Growth                                 Class notes

Lecture 4 – Long-Term Financial Planning and Growth


• Examine the reasons for financial planning.

• Outline the process for developing a budget.

• Present some common problems.
Financial Planning

• Basic Policy Elements

    ¤ Needed investment in new assets.

    ¤ Degree of financial leverage the firm uses.

    ¤ Firm’s dividend policy.

    ¤ Working capital policy.
Financial Planning Process

• Analyzing the investment and financing choices.

• Projecting the future consequences of current decisions.

• Deciding which alternatives to undertake.

• Measuring subsequent performance against goals.

• Dimensions of Financial Planning – focus is on capital budgeting for the next two to
   five years.

    ¤ Worst case scenario – planning for lean economic times.

    ¤ Normal growth – firm grows with its markets.

    ¤ Aggressive growth – rapid growth with market or exceeding market.

• Planning Accomplishments
Lecture 4 – Long-Term Financial Planning and Growth                              Class notes

    ¤ Examining interactions

    ¤ Explore options

    ¤ Avoid surprises

    ¤ Ensure feasibility and internal consistency
Financial Planning Model

• Percent of Sales Approach – Most variables are proportional to sales.

    ¤ Inputs and Considerations

        - Sales forecast

        - Asset requirements

        - Financial requirements

        - The plug – external financing needed

    ¤ Inputs and Considerations

        - Dividend payout ratio

        - Retention ratio

        - Spontaneous financing

        - Fixed asset requirement

            » Excess capacity

            » Lumpy assets

• Determinants of Growth

    ¤ Profit margin – higher profits support higher growth.

    ¤ Dividend policy – lower dividend provide more internal funds for growth.

    ¤ Financial policy – debt can be used for growth.
Lecture 4 – Long-Term Financial Planning and Growth                                    Class notes

    ¤ Total asset turnover – increases allow for higher growth. Current assets would
      support increased sales.


• Establishes goals and used to evaluate subsequent performance.

• Forces the financial manager to prepare for adverse events and devise strategies.

• Proceeds by trial and error.
Lecture 7 – Interest Rates and Bond Valuation                                          Class notes

Lecture 7 Interest Rates and Bond Valuation

• To explain how bonds are valued

• Examine different bond features.

• To explain the relationship between interest rates and bond valuations.

• Bond – simply a long-term loan.

• Treasury Bond – issued by the federal government.

• Corporate Bond – issued by corporations.

• Municipal Bonds – issued by state and local governments.

• Foreign Bonds – issued by either foreign governments or foreign corporations.
Bonds Characteristics

• Par Value – the face value of the bond.

• Coupon – the specified number of dollars of interest paid each period.

• Coupon Rate – the annual coupon divided by the face value of a bond.

• Maturity – the date on which the principal amount of a bond is paid.

• Yield to Maturity – the rate of return earned on a bond if it is held to maturity.

• Current Yield – annual coupon payments divided by bond price.
Alternative Types of Bonds

• Floating Rate Bond – a bond whose interest rate fluctuates with shifts in the general
   level of interest rates.

• Zero Coupon Bond – a bond that pays no annual interest but is sold at a discount
   below par.

• Convertible Bond – A bond that is exchangeable, at the option of the holder, for
   common stock of the issuing firm.
Lecture 7 – Interest Rates and Bond Valuation                                            Class notes

• Income Bond – A bond that pays interest only if the interest is earned.

• Indexed Bond – A bond that has interest payments based on an inflation index so as to
   protect the holder from inflation.

Bond Features

• Call Provisions – gives the issuing corporation the right to call the bonds for

    ¤ Call Premium – the additional sum the company must pay the bondholders to call
       the bonds.

    ¤ Deferred Call – Bonds are often not callable until several years after they were

    ¤ Refunding Operation – issuing lower-yielding securities and using the proceeds to
       retire a previous higher-rate issue.

• Sinking Funds – a provision in a bond contract that requires the issuer to retire a
   portion of the bond issue each year.

    ¤ The company can call in for redemption a certain percentage of the bonds each

    ¤ The company may buy the required number of bonds on the open market.
Bond Valuation

• Bond Valuation – the value of any financial asset is simply the present value of the
   cash flows the asset is expected to produce.

• Changing Bond Values Over Time – The value (price) of bonds drop when interest
   rates rise and vice-versa.

    ¤ Par bond – Whenever the going rate of interest is equal to the coupon rate, a fixed
       rate bond will sell at its par value.

    ¤ Discount bond – Whenever interest rates rise above the coupon rate, a fixed-rate
       bond’s price will fall below its par value.

    ¤ Premium bond – Whenever interest rates fall below the coupon rate, a fixed-rate
       bond’s price will rise above its par value.
Lecture 7 – Interest Rates and Bond Valuation                                            Class notes

    ¤ The market value of a bond will always approach its par value as its maturity date

• Semiannual Adjustment

    ¤ Divide the annual coupon interest payment by two to determine the amount of
       interest paid each six months.

    ¤ Multiply the years to maturity by two to determine the number of semiannual

    ¤ Divide the nominal interest rate by two to determine the periodic semiannual
       interest rate.

Bond Risks

• Interest Rate Risk – the risk of a decline in a bond’s price due to an increase in interest

• Reinvestment Rate Risk – the risk that a decline in interest rates will lead to a decline
   in income from a bond portfolio.

• Default Risk – the likelihood that the issuers will not be able to make payments.
Corporate Bonds

• Mortgage Bonds – a bond backed by fixed assets.

• Debentures – a bond that is not secured by a mortgage on specific property.

• Subordinate Debentures – a bond having a claim on assets only after the senior debt
   has been paid off in the event of liquidation.

Bond Ratings

• Bond Ratings – Bonds have been assigned quality ratings that reflect their probability
   of going into default.

    ¤ Investment Grade Bonds – rated triple-B or higher.

    ¤ Junk Bonds – A high-risk, high-yield bond. Double-B and lower bonds.

    ¤ Importance
Lecture 7 – Interest Rates and Bond Valuation                                            Class notes

        - Has a direct, measurable influence on the bond’s interest rate and cost of capital.

        - Many institutions are restricted to investment-grade securities.
Bond Markets

• Corporate bonds are traded primarily in the over-the-counter market.

• Most bonds are owned by and traded among large financial institutions.

• Over-the-counter bond dealers arrange transfers of large blocks of bonds among the
   relatively few holders of the bonds.

Term Structure of Interest Rates

• Term Structure – the relationship between bond yields and maturities.

    ¤ Upward Sloping – rates are lower in the short-term and higher in the long-term.

    ¤ Downward Sloping – rates are higher in the short-term and lower in the long-term.
Yield Curve Explanations

• Expectations Theory – the shape of the yield curve depends on investors’ expectations
   about future interest rates.

• Liquidity Preference Theory – the preference for more liquid short-term securities
   places upward pressure on the slope of a yield curve.

• Segmented Markets Theory – investors and borrowers choose securities with
   maturities that satisfy their forecasted cash needs.
Lecture 8 –Stock Valuation                                                                Class notes

Lecture 8 – Stock Valuation

• Review characteristics of equities

• Introduce stock valuation methods

• Examine capital market efficiency theories.
Common Stock Valuation

• Common Stock – Valued the same as any other asset – by discounting all expected
   future cash flows. The cash flow comes in two forms:

    ¤ Dividends

    ¤ Capital Gains

• Cash Flows – the basic stock valuation equation
        Value of stock = P0 = PV of future dividends

• Zero Growth – a common stock whose future dividends are no expected to grow at all.
        P0 = D/k

• Constant Growth – a common stock whose growth is expected to continue into the
   foreseeable future at a constant rate.

    ¤ Constant Growth Model – a model used to find the value of a constant growth
      stock. Total return is comprised of a capital gains return and a dividend return.

                         P0 = D1/(k – g)

• Nonconstant (supernormal) Growth – a company which grows much faster for a
   specified period of time.

    ¤ Find the PV of the dividends during period of rapid growth.

    ¤ Find the price of the stock at the end of the nonconstant growth period using the
      dividend growth model.

    ¤ Add these two components to find the intrinsic value of the stock.
Lecture 8 –Stock Valuation                                                                Class notes

• Capital Asset Pricing Model (CAPM) – theory where the expected return of a security
   equals its beta times the market risk premium.

   Expected rates of return depend on two things:

   1. Compensation for the time value of money.

   2. A risk premium, which depends on beta and
      the market risk premium.

      Expected return = risk-free rate + risk premium

      ks = kRF + âs(kM – kRF)

Common Stock Features

• Control of the firm – the right to elect directors who appoint officers to manage the

    ¤ Proxy – a document giving one person the authority to act for another, typically the
      power to vote shares of common stock.

    ¤ Proxy Fight – An attempt by a person or group to gain control of a firm.

    ¤ Takeover – an action whereby a group succeeds in ousting a firm’s management
      and taking control of the company.

• Preemptive Right – a provision the gives common stockholders the right to purchase
   new issues of common stock.

• Dividends – Payments by a corporation to shareholders, made in either cash or stock.
Preferred Stock Features

• Preferred Stock – stock with dividend priority over common stock, normally with a
   fixed dividend and without voting rights.

    ¤ Stated Value – normally $100 per share.

    ¤ Cumulative Dividends – Preferred dividends must be paid in full prior to the
      payment of common dividends.

Stock Markets
Lecture 8 –Stock Valuation                                                             Class notes

• Primary Market – the market in which new securities are originally sold to investors.
   Initial Public Offerings

• Secondary Market – the market in which previously issued securities are traded among

• Dealer – maintains an inventory and stands ready to buy and sell at any time.

• Broker – an agent who arranges security transactions among investors.
New York Stock Exchange (NYSE)

• Member – the owner of a seat on the NYSE

• Commission Brokers – members that take orders that customers have placed with their
   respective brokerage firms and execute them on the exchange.

• Specialist – acts as a dealer and maintains a limit order book.

• Floor Brokers – NYSE members who execute orders for commission brokers on a fee

• SuperDOT System – an electronic NYSE system allowing orders to be transmitted
   directly to the specialist.

• Floor Traders – NYSE members who trade for their own accounts.

• Operations – the business of the NYSE is to attract order flow. They do this by
   attracting blue chip companies to list on their exchange.

• Floor Activities – Specialists normally operate in front of their posts to monitor and
   manage trading in their assigned stocks.


• NASDAQ – National Association of Securities Dealers Automated Quotations system.

    ¤ A computer network of securities dealers.

    ¤ No physical location where trading takes place.

    ¤ Multiple market maker system rather than a specialist system.
Capital Market Efficiency
Lecture 8 –Stock Valuation                                                             Class notes

• Price Behavior in an Efficient Market – prices instantaneously adjust to and fully
   reflect information.

• Efficient Markets Hypothesis – securities are typically in equilibrium.

• Levels of Market Efficiency

    ¤ Weak-Form Efficiency – all information contained in past price movements is fully
      reflected in current market prices.

    ¤ Semistrong-Form Efficiency – Market prices reflect all publicly available

    ¤ Strong-Form Efficiency – Market prices reflect all pertinent information, whether
      publicly available or privately held.
Lecture 9 – Capital Budgeting: Net Present Value and Other Investment Criteria        Class notes

Lecture 9        Capital Budgeting: Net Present Value and Other Investment Criteria

• Investigate different methods to evaluate projects;
• Examine the benefits and drawbacks of Net Present Value, Payback, and Internal Rate
    of Return.

Project Classifications (Investments)

•   Replacement: maintenance of business.
•   Replacement: cost reduction.
•   Expansion of existing products or markets.
•   Expansion into new products or markets.
•   Safety and environmental projects.
•   Other

Capital Budgeting Evaluation Techniques

• Net Present Value (NPV) – a measure of how much value is created or added today by
    undertaking an investment.
    ¤ Estimating NPV – Discounted Cash Flow Valuation
       - Find the present value of each cash flow
       - Sum these discounted cash flows
       - If the NPV is positive, the project should be accepted.

• Payback – time until cash flows recover the initial investment of the project.
   ¤ Benefits
      - Quick and simple analysis
      - Biased towards liquidity
      - Adjusts for illiquidity of distant cash flows
   ¤ Drawbacks
      - Ignores the time value of money
      - Ignores cash flows received after the payback period
      - Fails to consider risk differences
      - No obvious criterion
Lecture 9 – Capital Budgeting: Net Present Value and Other Investment Criteria       Class notes

• Discounted Payback – the length of time required for an investment’s cash flows,
   discounted at the cost of capital, to cover its costs.
    ¤ Remaining issues
       - Easy to understand analysis
       - Still ignores cash flows after the payback period
       - No obvious decision criterion

• Internal Rate of Return – the discount rate that makes the NPV of an investment zero.
    ¤ Problems
        - Nonconventional Cash Flows
        - Mutually Exclusive Investments
Lecture 10 – Capital Investment Decision                                              Class notes

Lecture 10 Capital Investment Decisions

• Identify relevant cash flows for project evaluation;

• Create pro forma financial statements with identified cash flows;

• Examine alternate methods to derive operating cash flow and special cases.
Project Cash Flows

• Relevant Cash Flows – the specific cash flows that should be considered in a capital
   budgeting decision.

    ¤ Based on cash flows, not accounting income.

    ¤ Only incremental cash flows are relevant.

• Stand-Alone Principal – assumption that the evaluation of a project may be based on
   the project’s incremental cash flows.

• Actual Cash Flows

    ¤ Initial Investment – occurs at the beginning.

    ¤ Working Capital – current assets minus current liabilities. Occurs at beginning and
       end of project.

    ¤ Operating Cash Flows – cash flows produced by the project. EBIT + Depr – Taxes

    ¤ Salvage Value – occurs at the end. Sale of the equipment or project.

        - Capital Gain – taxes must be paid on gain.

        - Capital Loss – tax shelter has been created.

        - Calculation – After tax cash = MV – (MV – BV)(t)
Incremental Cash Flows

• Sunk Costs – a cash outlay that has already been incurred and which cannot be
   recovered regardless of whether the project is accepted or rejected.

• Opportunity Costs – the return on the best alternative use of an asset.
Lecture 10 – Capital Investment Decision                                               Class notes

• Side Effects – the effects of a project on cash flows in other parts of the firm.

    ¤ Erosion – the cash flows of a new project that come at the expense of a firm’s
       existing projects.

• Net Working Capital – the increased current assets resulting from a new project, minus
   the increase in accounts payable and accruals.

• Other issues

    ¤ Interested only in project cash flows when it actually occurs, not when it accrues.

    ¤ Interested in after-tax cash flow.

    ¤ Beware of allocated overhead costs.
Pro Forma Statements and Project Cash Flow

• Pro Forma Financial Statement – financial statements projecting future years’

• Project Cash Flows – operating cash flows minus change in net working capital and
   capital spending.

• Depreciation – accounting depreciation is a noncash deduction. Therefore,
   depreciation has cash flow implications because it influences taxes.

    ¤ Modified Accelerated Cost Recovery System (MACRS)

    ¤ Book Value versus Market Value
Operating Cash Flow

• Operating Cash Flow – cash generated from the operation. Generally calculated as

    ¤ Bottom-Up Approach – NI + DEPR

    ¤ Top-Down Approach – Sales minus relevant costs

    ¤ Tax-Shield Approach – (sales – costs)(1 – TAX) + (DEPR)(TAX)
Lecture 11 –Project Analysis and Evaluation                                               Class notes

Lecture 11 Project Analysis and Evaluation

   Evaluate NPV estimates;

   Examine sensitivity and break-even analysis;

   Look at the effects of operating leverage.
       Evaluating NPV Estimates
       How reliable is the NPV estimate?

   Projected versus Actual Cash Flows

   Forecasting Risk – the possibility that errors in projected cash flows will lead to
    incorrect decisions.

   Sources of Value – the ability to identify why the company is going to make money
    on a project.

What-If Analysis

   Sensitivity Analysis – a technique in which key variables are changed one at a time.

   Scenario Analysis – a technique in which ‘bad’ and ‘good’ sets of financial
    circumstances are compared.

   Simulation Analysis – estimation of the probabilities of different possible outcomes
    from an investment project.

Break-Even Analysis

   Break-Even Analysis – analysis of the level of sales which the company breaks even
    on a project.

     Variable Costs – costs that change when the quantity of output changes.

     Fixed Costs – costs that do not change when quantity changes.

     Total Costs – sum of the above.

Operating Cash Flow and Break-Even

   Accounting Break-Even – the sales level that results in zero net income.

   Cash Break-Even – the sales level that results in a zero operating cash flow.

   Financial Break-Even – the sales level that results in a zero NPV.
Lecture 11 –Project Analysis and Evaluation                                              Class notes


   Operating Leverage – the extent to which fixed costs are used in a firm’s operations.

   Implications – the higher the operating leverage, the greater the risk.

   Degree of Operating Leverage – the percent change in operating cash flow relative to
    the percent change in quantity sold.

   Financial Leverage – the extent to which a firm relies on debt.

   Total Leverage (risk) – combines the effects of operating and financial leverage. It
    shows how sensitive earnings are to changes in sales.

Additional Considerations

   Managerial Options – opportunities that managers can exploit if certain things happen
    in the future.

     Contingency Planning – option to abandon, wait, expand, etc.

     Strategic Options – options for future, related business products or strategies.
   Capital Rationing – the situation that exists if a firm has positive NPV projects but
    cannot find financing.

     Soft Rationing – occurs when units in a business are allocated a certain amount of
      financing for capital budgeting.

     Hard Rationing – occurs when a business cannot raise financing for a project
      under any circumstances.
Lecture 12 –Weighted Average Cost of Capital (WACC)                                        Class notes

Lecture 12 – Weighted Average Cost of Capital (WACC)

   Review the capital components and their calculations;

   Introduce the Weighted Average Cost of Capital (WACC) equation;

Cost of Capital: Some Preliminaries

   Required return versus cost of capital – the terms required return, appropriate
    discount rate, and cost of capital are used interchangeably.

   Financial Policy and Cost of Capital – a firm attempts to minimize their cost of
    capital through a couple of different methods.

Cost of Equity

   Cost of Equity – the return that equity investors require on their investment in the

   Discounted Cash Flow Approach – Using the dividend growth model, solve for K.

    o Advantages – simplicity

    o Disadvantages – needs stable dividends, doesn’t consider risk, sensitive to growth

   CAPM Approach – Use beta to calculate the return.

    o Advantages – adjusts for risk, use on companies without dividends.

    o Disadvantages – variables must be predicted, reliance of past information to
      predict future.

Cost of Preferred Stock and Debt

   Cost of Preferred Stock – simply the fixed dividend divided by the price of the stock.
    Alternatively, it can be estimated by observing the required return on similar

   Cost of Debt – the return that lenders require on the firm’s debt. Generally, we will
    use the bond valuation equation.

Weighted Average Cost of Capital (WACC)

   WACC – the weighted average of the costs of debt, preferred stock, and common
Lecture 14 – Conclusion                  Class notes

Lecture 13 – Raising Capital and Initial Public Offerings (IPOs)

   Introduce financing methods;

   Follow the initial pubic offering process;

Early-Stage Financing

   Personal Equity

   Bank Loans

   Small Business Administration (SBA)

   Suppliers/Customers

   Credit Cards

   Angels – wealth, individual investors inside a community that are willing to invest in
    small companies.

   Venture Capital – investment companies that specialize in investing in privately held
    companies with the intention of taking them public.

   Initial Public Offering (IPO) – when a privately-owned firm issues stock to the public
    for the first time.

Initial Public Offering Process

   Selection of an Underwriter – an investment that oversees the process.

     Underwriting Syndicate – many investment banks assist the lead underwriter with

     Firm Commitment Underwriting – Underwriter has full responsibility for selling
      the issue.

     Best Efforts Underwriting – Underwriter can return unsold shares to the company.

   Registration Statement - a statement filed with the SEC that discloses all material
    information about the company.

   Road Show – Company and lead underwriters meet with institutional investor to
    market the company and gauge demand.

     Indications of Interest – non-binding orders from institutional investors.
Lecture 14 – Conclusion                   Class notes

   Setting the Offer Price and Number of Shares – underwriter uses discounted cash
    flow analysis, peer comparisons, and indications of interest.

   Building the Book – the underwriting syndicate will begin filling orders once the
    price has been set.

The Aftermarket

   Initial Return – closing price on the first day of trading is usually substantially higher
    than the offer price.

     Flipping (Spinning) – the practice of buying at the offer price and selling on the
      first day or the first week.

     Overallotment Option – the underwriter has the option of purchasing an additional
      15% of shares.

     Unwritten Agreements – handshake agreements by institutions to purchase
      additional shares in the early aftermarket.

   Underwriter Support – Generally, the underwriter purchases shares in the open
    market during the first month if the price approaches the offer price.

   Lockup Agreement – Insiders (original owners and venture capitalists) agree to not
    sell their shares for a specified length of time (typically six months).

   Summary of Price Movements – Generally, the price rises in the early aftermarket
    and tails off over the long-term.

Rights Offerings

   Rights Offering – an issue of common stock offered to existing stockholders.

   Mechanics of a Rights Offering

     Number of New Shares – funds to be raised divided by the subscription price.

     Number of rights needed to buy a share of stock – Old shares/New shares.

   Value of a Right – the difference between the value of the shares before and after the
    rights offering.

   Ex-Rights – the stock price will drop by approximately the value of the right when
    the rights expire.
Lecture 14 – Conclusion                  Class notes

   Setting the Subscription Price – the price does not matter. It has to be lower than the
    market price and greater than zero.
Lecture 14 – Conclusion                   Class notes

Lecture 14 – Dividends

   Examine dividend policy and its relevance;

   Look at the implications of a dividend policy;

   Consider alternatives to dividends;

   Introduce stock dividends and stock splits.

Cash Dividends and Dividend Payments

   Dividend – a payment made out of a firm’s earnings to its owners, in the form of
    either cash or stock.

   Distribution – a payment made by a firm to its owners from sources other than current
    or accumulated retained earnings.

Cash Dividends and Dividend Payments

   Regular Cash Dividends – a cash payment made in the normal course of business,
    usually four times per year.

   Target Payout Ratio – the percentage of net income paid out as cash dividends.

   Optimal Dividend Policy – the dividend policy that strikes a balance between current
    dividends and future growth and maximizes the firm’s stock price.

Cash Dividends and Dividend Payments

   Dividend Payment: A Chronology

¤ Declaration Date – the date on which the board of directors passes a resolution to pay
    a dividend.

    ¤ Ex-Dividend Date – the date two business days before the date of record.

    ¤ Date of Record – the date by which a holder must be on record in order to be
        designated to receive a dividend.

    ¤ Date of Payment – the date the checks are mailed.
Does Dividend Policy Matter?
Lecture 14 – Conclusion                   Class notes

   Dividend Irrelevance Theory – a firm’s dividend policy has no effect on either its
    value or its cost of capital.

   Bird-in-the-Hand Theory – a firm’s value will be maximized by setting a high
    dividend payout ratio.

   Tax Preference Theory – investors prefer low dividends because capital gains are
    taxed at a lower rate.

Does Dividend Policy Matter?

   Real World Factors

    ¤ Information Content of Dividends – investors regard dividend changes as signals
        of management’s earnings forecasts.

    ¤ Clientele Effect – the tendency of a firm to attract a set of investors who like its
        dividend policy.

Dividend Policy

   Residual Dividend Approach – firm pays dividends only after meeting its investment
    needs while maintaining a desired debt-equity ratio.

   Dividend Stability – Firm maintains its dividends whenever possible.

Dividend Policy

   Compromise Dividend Policy

    ¤ Avoid cutting back on positive NPV projects to pay dividends.

    ¤ Avoid dividend cuts.

    ¤ Avoid the need to sell equity.

    ¤ Maintain a target debt-equity ratio

    ¤ Maintain a target dividend ratio.
Stock Repurchases

   Repurchases – another method used to pay out a firm’s earnings to its owners.

Stock Dividends
Lecture 14 – Conclusion                 Class notes

   Stock Dividends – a payment made by a firm to its owners in the form of stock.

   Stock Split – an increase in a firm’s shares outstanding without any change in
    owners’ equity.

   Trading Range – the price range between the highest and lowest prices at which a
    stock is traded.

   Reverse Split – a stock split in which a firm’s number of shares outstanding is
Lecture 14 – Conclusion                  Class notes

Lecture 14 – Conclusion

   Review what we have covered in this course and some things we should have

   What we know

   What is unknown


What We Do Know

   Net Present Value – is a project worth more than it costs?

   Risk and Return

     Investors don’t like risk and require a higher return to compensate.

     The risk that matters is the risk that investors cannot get rid of.

   Efficient Capital Markets – security prices accurately reflect available information
    and respond rapidly to new information as soon as it becomes available.

   Agency Theory – the conflicts of interest that arise among management, employees,
    shareholders, and bondholders. These conflicts and how companies try to overcome
    such conflicts.

What We Do Not Know

   How are Major Financial Decisions Made?

        Our ignorance is largest when it comes to major strategic decisions.

   What Determines Project Risk and Present Value?

        How do you find positive NPV projects?

   Risk and Return – Have We Missed Something?

     CAPM is hard to prove or disprove conclusively.

     Have we missed a key variable?

   How Can We Explain Capital Structure?
Lecture 14 – Conclusion                  Class notes

        Theoretically, the amount of debt should not affect the value of a firm. In reality,
        it does matter.

   The Dividend Controversy Continues – many people believe dividends are good,
    others believe they are bad, and still others believe they are irrelevant.

   How Can We Explain Merger Waves?

        Many firms seemed to be merging in 1989 and nobody merging in 1992. Why?

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