IMPORTANT

DEFINITIONS
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 IMPORTANT DEFINITIONS

IMPORTANT DEFINITIONS
Merger
It is a type of business combination in which two companies combined. Out of the two
companies, one company will be liquidated and the survivor company will take over the net
assets of the liquidated company in exchange of voting common stock approved by the Board of
Directors of the company (sometimes preferred stock, cash, long term debt etc. are also
exchanged as purchase consideration).

Types of Merger

1.Horizontal Merger
Merger that takes place between firms in the same line of business.

2.Vertical Merger
Merger that takes place between firms in the different stages of production and distribution of a
produ ct. It can be classified into two. Forward & Backward Vertical merger.

(a)Forward Vertical Merger

If a firm merges with a company that supplies it with a distribution network.

(b)Backward Vertical Merger

In backwards vertical merger the firm merges with its source of raw material.

3.Conglomerate Merger
It’s the type of merger that takes place between the companies involved in unrelated line of
business.

Benefits of Merger
 Economies of scale
 Synergy
 Improvement in management
 Sales Enhancement
 Diversification
 Increase in financial leverage

Challenges in Merger
 Communication challenges
 Employee retention challenges
 Complex as well as time consuming legal procedures
 Cultural challenges

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Elements of Flow Triangle

1. Pressure: The employee has a financial problem that he or she cannot share and cannot solve
through legitimate means.
2. Opportunity: The employee sees a way to use his/her position of trust with an employer to
solve the problem in secret and believes it can be done in such a way that there will be a low risk
of getting caught.
3. Rationalization: The employee needs to be able to justify the crime as an acceptable or
justifiable act.

Break-Even Point
It is the point at which the total cost and total revenue are equal and there is no net loss/gain.

Benefits of Break-Even analysis

 Enables the business to measure profit &losses at different level of production and sales.
 Predict the effect of changes in sales price.
 Analyse the relationship between fixed and variable cost.
 Predict the effect of cost and efficiency changes in profitability.

Disadvantages of Break-Even
Break-Even analysis assumes that the selling prices, production quantity, sales quantity are
constant.

Margin of safety
Margin of safety is the difference between actual sales and break-even sales.

Limitations & Advantages of using Ratio

Advantages
 It makes the financial statement more simple and understandable.
 Helps in comparing the companies of different sizes with each other.
 Helps in trend analysis.

Disadvantages
 Ratio analysis may be misleading while comparing companies in different industries
having different environmental conditions.
 Financial accountimg information is affected by various accounting principles and
assumptions which impairs comparability using ratio analysis.
 Ratio analysis gives us the past information while users are concerned about present and
future informations.

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Liquidation & Re-organization

Similarities
 Both are initiated in the same way at the time of bankruptcy.
 A trustee may be appointed by the court to look after both proceedings.

Differences
 In reorganization the debtor retains the ownership of its assets and continues its
operations while renegotiating debt repayments with creditors.
 However, in liquidation the creditor seize control of the debtor’s assets and sell them to
pay off the debt. The debtor ceases normal operations after liquidation.

Standards on Ethics
1. Competence: Is the quality of having the required skill, knowledge, qualifications and
capacity to fullfil a particular job effectively.
2. Confidentiality: Is not disclosing the information to people who are not authorized to know
it.
3. Integrity: Involves adhering firmly to the code of values.
4. Credibility: Is the quality of being believable and trustworthy.

Conditions of relevant cash flow

Relevant cash flows are cash inflows and outflows whose inclusion or exclusion from
investement evaluation can affect the overall investment decision. These cash flows will be
future cash flows, incremental cash flows or opportunity costs. Initial investments, working
capital requirements, tax shields are examples for relevant cash flows.

Solving a problem of not paying a bank loan

1. The company can approach the bank for a voluntary settlement (workouts). They can ask
for an extension or composition.

2. If the workouts are not successful they can file a bankruptcy petition so that the court will
issue a stay.

Earning profit by a foreign subsidiary by taking advantage of the exchange rate

movements

It could establish a subsidiary in a foreign country where the national currency was weak, if that
currency is expected to strengthen in future. Since the currency was weak the initial cash
outflows will be low and the future inflows will be high (due to the strengthening of the weak
currency).

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What is Capital Budgeting?

Capital budgeting is the process in which a business evaluate a project proposal by comparing its
relevant cash inflows and outflows.

Stages of Capital Budgeting

1. Identification stage

2. Search stage

3. Information & Acquisation stage

4. Selection stage

5. Financing stage

6. Implementation stage

Safety Stock

It’s a level of stocks company carries as a protection against stockouts.

Lead Time

It’s the amount of time a company must wait to receive the next shipment of inventory after it
places an order.

Sensitivity Analysis

It is a what-if technique. It answers the question what happens to the result if some underlying
assumptions changes. It can be simply defined as the change in a dependant variable with respect
to the changes in an independent variable.

Currency Swap:

A Currency Swap involves the exchange of interest and sometimes of principle in one currency
for the same in another currency. It is not required to be shown on a companys’ Balance Sheet.
Often one party will pay fixed interest rate while another party will pay floating interest rate.
This is called Fixed to Floating arrangement. There is also fixed to fixed and floating to floating
arrangements. Unlike interest rate Swap the principal and interest are both exchanged in full. It is
used to hedge Foreign Exchange risk or Currency risk.

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Currency Option:

A currency option is a contract that grants the buyer the right but not the obligation to buy or sell
a specified currency at a specified exchange rate on or before specified date. For this right a
premium is to be paid to the seller. It is used to hedge Foreign Exchange risk or Currency risk.

Currency Forward:

A Currency forward is a contract to purchase or sell currency on a future date at a specified rate
agreed upon today. This is usually used as a hedging tool against currency risk. They are usually
traded over the counter.

Currency Futures:

A Currency Future is a standardized contract to purchase or sell currency on a future date at a

specified rate agreed upon today. They are marked to market daily. There is no delivery at the
time of expiration instead the investors close out their positions. They are traded in exchanges
and used as a hedging tool against currency risk.

Risk in Foreign Currency:

Foreign Exchange Risk, is also known as currency risk, is a financial risk that exists when a
financial transaction is denominated in a foreign currency. The risk is due to the fluctuation in
exchange rate of the foreign currency. This risk can be hedged using derivatives.

Determinants in Foreign Currency Exchange Rate:

Relative inflation rate, Relative interest rate, Relative income levels, Expectations of Future
exchange rate, Government controls. These factors affect the demand or supply of the foreign
currency and there by contributes to the fluctuations.

Two methods of reducing risk in foreign currency:

Currency Futures, Currency swaps, Currency forwards, Currency Options (Any two)

OR Operational Hedges and Natural Hedges.

Risk in Foreign Currency Investment or Direct Foreign Investments:

There are mainly two types of risks, Political risk and Financial risk in Foreign Direct
Investment. Political risk includes expropriation of government, war, blockage of fund transfer,
inconvertible currency, Corruption, regulation and taxes, and attitude of customers, whereas
financial risk includes fluctuations in Interest rate, exchange rate and inflation rate.

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Causes of Exchange Rate Risk:

Exchange Risk is the uncertainty in cash flows due to the fluctuations in exchange rate. The
fluctuations in exchange rates are due to Relative inflation rate, Relative interest rate, Relative
income levels, Expectations of Future exchange rate, Government controls.

Transfer Pricing:

A transfer price is the price at which divisions of a company transact with each other. A transfer
price is also known as a transfer cost. When transfer of goods or services is made from one
division to another within the same company, revenue to the selling division is a cost to the
purchasing division. These revenue and cost are both eliminated when the
companys’consolidated financial statements are prepared. The transaction between these
divisions is now measured in arms length price to avoid tax frauds.

Method financing in Foreign Currency Transaction Account Receivable Financing:

It is a type of financing in which bank makes a short term loan to the exporter usually from one
to six months secured by an account receivable (importer). If the importer fails to pay the
receivable the exporter is still obligated to repay the loan principal as well as accrued interest
until the loan is paid in full. A bank providing this type of financing ask the exporter to carry
export credit insurance to cover all the financial and political risk involved.

Cross Border Factoring:

In this type of financing, the exporter sells the receivable to a third party called factor. The factor
will advance certain percentage of receivables to the exporter in 3-5 working days and the
remaining amount is paid after receiving the amount from the importer. For this they will charge
a fee called

Factor’s Fee.

The exporter can eliminate the risk of the default if it sells the receivable without recourse ie, the
risk of nonpayment are with the factor. But the fee paid to the factor will be high in that case.
Factors also use export credit insurance to cover the risk involved.

Letter of Credit:

A letter of credit is a letter from a bank guaranteeing that a buyer’s payment to a seller will be
received on time. It is a negotiable instrument because it is transferrable.

Bankers’ Acceptance:

It is time draft that has been issued under a letter of credit by the importers’ bank. The importers’
bank is then obligated to pay the amount of the draft to the holder of the draft on maturity date.
The exporter can sell the bankers’ acceptance in money market at a discounted price.
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Forfaiting:

It refers to the purchase of financial obligation such as bills of exchange without recourse to the
exporter. The negotiable instruments like bills of Exchange, Promissory note issued by the
importer can be sold to a forfaiting bank by the exporter. These transactions are usually in
amounts greater than 5 lakh dollars. Forfaiting transaction generally require a Letter of credit or
bank guarantee from the importers’ bank.

Counter trade:

It means exchanging goods and services which are paid for in whole or part with other goods or
services. It reduces currency risk during foreign trade since no currency is exchanged. There are
4 types counter trade: Barter, Counter purchases, Compensation deals, Buyback.

Bankruptcy:

Bankruptcy is a situation in which the company does not have adequate cashflows to meet its
obligations. The bankruptcy process begins with a petition filed by the company or by the
creditors. When the debtor(company) files the petition the proceeding is voluntary. Otherwise if
the creditors files the petition it is involuntary. Usually there are two forms of insolvency.

Equitable Insolvency:It is a situation in which the company is unable to pay its debts due to lack
of liquidity. This is only temporary and may be remedied.

Legal Insolvency:It is a situation in which the firms’ liability exceeds its assets at fair value.

Derivatives:

Derivatives are the contracts which derive its value from its underlying asset. That means the
value of the contract is determined by fluctuations in the underlying assets like stock, bonds,
commodities, interest rates and market indexes. They can be traded either over the counter or on
an exchange.

Different types of derivative contracts are Options,Swap,Future and Forward. (Use the
definitions given in the case of currency options,currency forwards etc but replace the words
currency in the definition with underlying asset)

Off balance sheet financing:

Off balance Sheet financing includes joint ventures, operating leases etc.

Functional Currency:

It is the currency used by the company in its business activities. It simply the home currency of
the country ie., The currency of the nation in which it is headquartered.

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Methods of Capital raising:

The main sources of capital are Retained earnings, Bond Issues, Preferred Stock Issues and
Equity Stock Issues. However the companies can also approach a venture capitalist for capital.

Venture Capitalist:

It is a firm who provides capital to startup ventures. If the promoters of the company are able to
convince the venture capital firm that their idea has good potential for growth the venture
capitalist may make an investment in the company. In exchange for the money they will receive
apercentage of ownership as well as seats on the Board of Directors.

Investment Bank:

An investment Bank is a financial intermediary that performs a variety of services related to

designing and dealing in securities,underwriting.It act as a broker or financial advisor to its
clients.Major investment bank includes Barclays,JP Morgan etc.

Corporate Spinoff & Equity Carve Out:

It is a type of divestiture in which a segment in parent company is spun off to become a

completely different company.It is done by distributing ownership interest in that spun off unit as
a stock dividend to existing shareholders on a pro rata basis.It gives the investors an opportunity
to invest in just one part of business.The employees, assets,technology etc are taken from the
parent company.

Equity Carve out is similar to spinoffs but the shares in new company is not given to existing
shareholders of the parent. The shares are sold in initial public offering however the majority
stocks are retained by the parent company.The new organization has its own board of directors
and financial statements.

Types of foreign exchange exposures:

Transaction Exposure:This arises from the effect that exchange rate fluctuations have on
companies receivables and payables denominated in foreign currency in future. This is
usually short term in nature.

Translation Exposure:This arises from the effect of currency fluctuations on a

company’s consolidated Financial Statements particularly when it has a foreign subsidy.
This is usually long term.

Economic or Operating Exposure:It is caused by the effect of unexpected currency

fluctuations on companies future cashflows and market value. This is long term in nature.

Contingent Exposure:Contingent exposure will affect the cashflows of the firms who bid
for foreign projects or contracts with foreign firms or have Foreign Direct Investments.
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When firms negotiate with foreign firms the currency rate will continuously change
before, during and after negotiations occur.

Take Over Defenses:

Pre Offer Defenses:

It is usually known as Shark Repellants. These are the changes in company’s charter that makes
unwelcome takeovers more difficult or by devising strategies that make the company a less
attractive target. Different pre offer defenses are as follows

Staggered Election of Board of Directors:

A staggered election of board of directors makes the takeover process difficult by preventing
the entire board from being replaced at the same time. In this type of election, members of the
board are elected at different times. So the acquirer company has to wait long for achieving the
majority of their own people on the Board.

Changing State of Incorporation:

In this technique the company may change its state of incorporation to a state in which it may be
able to gain the ability to install antitakeover amendments and defend it legally. The state of
incorporation can be changed to the state where takeover procedures are more difficult. These
steps make the takeover more undesirable.

Super Majority Merger Approval provisions:

It is an amendment in company’s charter requiring a large majority(anywhere from 67-90%) of

share holders to approve important changes such as a merger. This provision makes takeovers
more difficult.

Fair Merger Price Provision:

It is a provision in company’s charter requires a bidder to pay non controlling shareholders

atleast a fair price for their shares.It will be a stated price or the price calculated using earning
per share and PE ratio .If the stated minimum price is not offered, the combination can be
approved only if a supermajority approves. This makes takeovers more difficult.

Golden Parachutes

These are the Provision passed by Board of Directors requiring large payments to specified
executives if the companies taken over or if the acquiring terminates their employments.

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Poison Pills

These are the provisons included in corporation charters bylaws or contracts that reduce the
value of the targets. It could involve a termination of a valuable contract or distribution of rights
to share holders. Some e.g. of poison pills include

 Flip Over Pill

It is a rights plan that enables the share holders on the receiving end of the bid to
purchase more shares in the acquirer company at price below market value after
acquisition. This causes dilution and devaluation of the acquirer company’s shares. This
discourages the share holders of the acquiring company since the new share holders from
the target company will be able to purchase new shares in the acquirer company below
market value and thereby causing dilution of ownership in the new company
 Flip In Rights
The acquisition of a specified ownership interest in the target company by acquirer
triggers additional rights in the previously outstanding stock not acquired by the acquirer.

Poison Put

It is a clause in bond indenture living bond holders the right to demand repayment at the time of
hostile takeover.

Voting Rights Plan

This is also called restricted voting rights. The company charter in a specify that that share
holders holding more than a certain percentage of the company have no voting rights unless
approved by board of directors. This helps the management to keep the people whom they like in
control of the company.

Employes Stock Option Plan

The share holders acquired shares through an ESOP are usually favorable to the current
management and they are likely to vote against the hostile takeover.

Post Offer Defenses

Stock Efforts:

In this type of defense the target corporation issues new stock. It increases the amount of
outstanding stock in the market. This makes the takeover more difficult asset increase the cost of
take over.

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Pac man Defense or Reverse Tender:

When a hostile acquirer begins to acquire stock in the target company, the target company may
issue new shares to dilute the holdings and raise cash. They use this cash to attempt to take over
the acquirer in a reverse bid. Then the acquirer will call of its bid and may sign a standstill
agreement in which it agrees not to acquire additional shares. The shares purchased by the
acquirer maybe purchased back by the target company in a payment called green mail payment.

White Knight Defense:

At the time of a hostile takeover, the management of the company may look for a White Knight.
A White Knight is a company that the target company’s management views more favorable to
them and this company make a bid for the target company in a tender offer and defeat the
acquirer.

Lockup Provision:

It is an offer by target company to sell stock or asset to a White Knight in order to prevent the
hostile acquirers efforts. This offer is attractively priced but it also locks up the asset of shares so
that they cannot be resold by the White Knight without target firms approval.

Leveraged Recapitalization or Restructuring :

In this technique the company may borrow money to pay large one time dividend to its share
holders. The increased debt discourages the acquirer. Management and other insiders take their
dividends as stock dividends, giving them a large proportion of ownership in the company. It
further discourages the acquirer. This technique may also involve borrowing of money to
repurchase its own shares.

Crown Jewel Transfer:

In this defense the target company may sell or disposes a major asset (Crown Jewel) that made it
a desirable target. This action makes the company a less desirable target.

Litigation:

It is technique of filing suits against the bidder for the violation of antitrust or securities law and
there by making the takeover more difficult.

Asset Restructuring:

In this technique the target company may buy assets that acquirer do not like or will create an
antitrust problem for the acquirer.

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Going Private:

It is the process of changing a public company into private. A group of investors purchases all
stocks from the share from the shareholders. Usually the current management of the company
has a large ownership stake while going private. It means shares will be purchased by the
management or the persons who are favorable to them. This makes the hostile takeover more
difficult as the control vests with the management.

Leveraged Buyouts:

It is the method of financing the purchase of the company using very little equity. It is moreover
a cash purchase. The cash offered is financed through debt. An LBO may be financed with a
combination of senior debt and junior subordinated debt. The senior debt is a secured loan while
junior debt will be a unsecured loan with a higher interest. This junior subordinated debt is called
mezzanine financing.

Liquidation:

After filing the bankruptcy petition with the court the bankruptcy judge appoints an interim
trustee ,a disinterested private citizen to meet with the creditors. At the first creditors meeting the
creditors may replace the interim trustee or they may keep the court appointed one. He is
responsible for selling the assets and distributing the money to the creditors.

Beta:

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to

the market as a whole. Beta is used in the capital asset pricing model (CAPM), which calculates
the expected return of an asset based on its beta and expected market returns. Beta is also known
as the beta coefficient. A beta of 1 indicates that the security's price moves with the market. A
beta of less than 1 means that the security is theoretically less volatile than the market. A beta of
greater than 1 indicates that the security's price is theoretically more volatile than the market.

Negative Beta: A negative beta correlation would mean an investment that moves in the opposite
direction from the stock market.

The formula for calculating beta is the covariance of the return of an asset with the
return of the Market divided by the variance of the return of the Market over a
certain period.

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Similarly, beta could be calculated by first dividing the security's standard

deviation of returns by the Market’s standard deviation of returns. The resulting
value is multiplied by the correlation of the security's returns and the market return.

Calculating Portfolio Return,Risk and Beta:

Expected Return of a portfolio:

E(R) of a portfolio = w1R1 + w2Rq + ...+ wnRn

It is simply the weighted average of return of individual securities in a portfolio where weights
are the proportion of investment in each security with respect to total investment.

Portfolio Risk:

Portfolio Beta:

Beta of a portfolio = w1beta1 + w2beta2 + ...+ wnbetan

It is simply the weighted average of beta of individual securities in a portfolio where weights are
the proportion of investment in each security with respect to total investment.

Calculating Free Cash Flow:

EBIT (1-tax rate) + (depreciation) + (amortization) +/- (change in net working

capital)*- (capital expenditure)
*Remember

If the working capital increases, then subtract such increase from thecashflow.If the working
capital decreases, then add such increase to the cashflow

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Interest Rate:

Always remember that interest rates should be annualized.

Usually interest rates given in the question are annualized rates.

Security Market Line

The security market line (SML) is a line drawn on a chart that serves as a graphical
representation of the capital asset pricing model (CAPM), which shows different levels of
systematic, or market, risk of various marketable securities plotted against the expected return of
the entire market at a given point in time. SML is a visual of the capital asset pricing model
(CAPM), where the x-axis of the chart represents risk in terms of beta, and the y-axis of the chart
represents expected return. The market risk premium of a given security is determined by where
it is plotted on the chart in relation to the SML

The security market line is commonly used by investors in evaluating a security for inclusion in
an investment portfolio in terms of whether the security offers a favorable expected return
against its level of risk. When the security is plotted on the SML chart, if it appears above the
SML, it is considered undervalued because the position on the chart indicates that the security
offers a greater return against its inherent risk. Conversely, if the security plots below the SML,
it is considered overvalued in price because the expected return does not overcome the inherent
risk.

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