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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 strategy. • 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. Advantages ¤ Easily and inexpensively formed. ¤ Few government regulations. ¤ Avoids corporate income taxes. Disadvantages ¤ 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. Advantages ¤ Easily and inexpensively formed. ¤ Few government regulations. ¤ Avoids corporate income taxes. Disadvantages 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. Advantages ¤ Unlimited life. ¤ Easy to transfer ownership. ¤ Limited liability. Disadvantages ¤ 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 time. ¤ 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 assets. ¤ 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 Objectives • 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 equipment. ¤ 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 payments. • 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’ investment. • Market Value Ratios – relates the firm’s stock price to its earnings and book value per share. ¤ 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 making. • Time-Trend Analysis – Examine whether there is a strengthening or weakening position. • Peer Group Analysis – Compare a particular company with a group of ‘benchmark’ companies. 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 Objectives • 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. Summary • 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. Bonds • 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 redemption ¤ 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 issued. ¤ 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 year. ¤ 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 approaches. • 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 periods. ¤ 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 rates. • 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 business. ¤ 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 investors. • 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 basis. • 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 • 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 information. ¤ 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’ operations. • 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 EBIT + DEPR – TAX ¤ 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 Leverage 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 firm. 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 rate. 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 securities. 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 equity. 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 placement. 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 reduced. Lecture 14 – Conclusion Class notes Lecture 14 – Conclusion Review what we have covered in this course and some things we should have covered. What we know What is unknown Conclusion 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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