2010 CMA Part 2 Section B: Corporate Finance

2010 CMA Part 2 Section B
CORPORATE FINANCE
2010 CMA Part 2 Section B: Corporate Finance
Introduction to Corporate Finance

The Corporate Finance section represents 25% of the CMA Part 2 exam. The corporate finance section of the exam covers the following topics:
Risk and Return Financial Instruments Capital Structure and Cost of Capital Working Capital Management Raising Capital Corporate Restructuring, Business Combinations and Divestitures International Finance.
Investment Annual Rate of Return

Return is income received by an investor on an investment. Rate of return is expressed as a percentage of the principal amount invested. The amount of return on an investment is a function of three things:
1. Amount invested 2. length of time that amount is invested 3. the rate of return on the investment
Depending on the type of investment, all of those things can vary.

Rates of return are always quoted as annual rates. In other words, what percentage of the amount invested would be earned if the investment were held for one full year? The formula for the annual rate of return is: Return Received for One Years Investment Average Balance of Amount Invested

There are three important rules to follow to calculate an annual rate of return on an investment:
1. When the income received is for an investment that was held for less than one full year, the amount of income must be annualized. 2. The amount invested in the calculation must be the average balance of the amount invested during whatever period of time the funds were invested, up to one year. 3. If the funds were invested for less than one full year, we assume that the average balance during the period the funds were invested was the average balance for one full year (even though the investment was not held for a full year).
Risk
Risk can be classified as either pure risk or speculative risk.
Pure risk is defined as the chance that an unwanted and detrimental (harmful) event will take place. Insurance is designed to address pure risk, because pure risk yields only a loss. Because investments have the possibility (or even expectation) of return, pure risk is not the risk that we are concerned with in financial analysis. Instead we are concerned with speculative risk. In investing, speculative risk is defined as the variability of actual returns from expected returns, and this variability may be a gain or a loss.
Types of Risk
Interest rate risk (price risk) is the risk that the value of the investment will change over time resulting from changes in the market rate of interest.
The longer the maturity period of the investment, the greater the interest rate risk as there is a longer investment horizon to be affected by the changes in interest rates. Therefore prices of long-term bonds are more sensitive to interest changes than short-term bonds.
Purchasing power risk is the risk that the purchasing power of a fixed amount of money will decline as the result of an increase in the general price level (inflation).
Types of Risk
Reinvestment rate risk means that invested money cant be put into in another investment that will provide the same, or a higher, level of return.
This impacts short-term more than long-term bonds. As interest rates decline, the funds from the original investment cannot be reinvested upon maturity at the same higher rate as the original investment. The sooner a bond matures, the sooner this reinvestment must occur, so short-term bonds carry more reinvestment rate risk.
Types of Risk
Default risk is the risk that a borrower of money will not be able to repay their debt as it becomes due. The higher the lender determines the default risk, the greater the interest rate that he will charge. Securities that are issued by stable governments will have the lowest level of default risk. Liquidity risk is the possibility that an investment cannot be sold (converted into cash) for its market value. Whenever an investment must be discounted significantly in order to be sold, the investment has a high level of liquidity risk.
Types of Risk
Exchange rate risk is the risk that a transaction that has been denominated in a foreign currency will be impacted negatively by changes in the exchange rate. This occurs when the company must spend more of their own currency to settle the transaction as a result of changes in the exchange rate. Political risk is the risk that something will happen in a country that will cause an investments value to change, or even to become worthless. The government of a country may change its policies, and this could affect investments in the country.
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Types of Risk
Examples of political risk include:
government expropriation (government seizure of private property with some minimal compensation offered which is generally not an adequate amount) war (affect employee safety and create additional costs to ensure employees safety) blockage of fund transfers inconvertible currency (government of host country not allowing currency to be exchanged into other currencies) government bureaucracy, regulations and taxes corruption (bribery being used by local firms that firm doing business in a country must compete with to get contracts)
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Types of Risk
Business risk is the variability of the firms earnings before interest and taxes (or operating income).
Business risk depends on many factors such as the:
variability of demand over time, variability of the sales price over time variability of the price of inputs to the product over time degree of operating leverage that the firm has
Total risk is the risk of a single asset taken by itself and not set off against any other investments. It is defined as the variability of the assets relative expected returns. It is also called standalone risk.
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Types of Risk
Systematic risk is risk that all investments are subject to. It is caused by factors affecting all assets.
Examples are inflation, macroeconomic instability such as recessions, major political upheavals and wars. Systematic risk cannot be diversified away, and so it remains even in a fully diversified portfolio.
Unsystematic risk is risk specific to a particular company or industry in which the company operates.
An example of unsystematic risk is a strike that halts production at one company or at all the companies that employ members of the union that has gone on strike. Unsystematic risk can be reduced through appropriate diversification of investments in a portfolio.
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Types of Risk
Market risk is a type of systematic risk. It is the risk that an investment that is traded on a market has simply because it is traded on a market, and thus it is subject to market movements.
Market risk refers to the fluctuations in the price of a stock or option. As a general rule, an individual stocks price will rise when the market rises, and it will fall when the market falls. This risk has nothing to do with conditions in the company but only with conditions in the market. Like systematic risk, market risk cannot be diversified away.
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Types of Risk
Industry risk is risk specific to a particular industry.
For example, a few years ago there were only a few companies supplying a specific component that was required in solar electricity panels. The component was in high demand, the price was high, and profits were high. The high profits encouraged other companies to get into the field. This caused the supply to increase and the price to decrease. Then a newer technology emerged, and the demand and the price for this specific component fell even further. The prices of the stocks of companies in that industry declined sharply. That was a risk that all companies in that particular industry were subject to and affected by.
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How to Measure Risk

Risk can be measured in either:
absolute terms relative terms.
The absolute measure of risk is usually expressed by means of the standard deviation of probable expected future returns. The relative measure of risk (i.e., the amount of risk when compared with the risk of other assets) is expressed by the coefficient of variation.
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Variance of Returns
The variance is another measure of the variability of possible outcomes. The variance is the square of the standard deviation. When calculating standard deviation with a discrete probability distribution, we determine the variance first, and then take the square root of the variance to get the standard deviation.
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Standard Deviation of Returns

The standard deviation of returns measures the dispersion of all the possible returns about their mean (and the mean is the expected return).
This measurement of dispersion is done both above and below the mean.
The larger the standard deviation for a particular investment is, the greater the variation among possible returns is and thus, the riskier the investment. This is logical because if there is a great degree of uncertainty as to what the expected outcome of the investment will be, there is greater risk.
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Coefficient of Variation
The coefficient of variation is calculated as the standard deviation divided by the expected return.
measures the expected level of risk for each unit of return
The coefficient of variation is used to:

measure the risk of securities relative to expected returns compare the risks of different securities.
It is used because different investments usually have different expected returns.

Using standard deviation alone to compare the risk of different investments can lead to misleading conclusions when the investments have different expected returns as well as different standard deviations.
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Capital Asset Pricing Model

The capital asset pricing model (CAPM) is frequently used to estimate the investors expected rate of return on a security or a portfolio of securities. The CAPM uses the security or portfolios risk and the market rate of return to calculate the investors required return. The theory behind the CAPM is that investors will price investments so that the expected return on a security or a portfolio will be equal to the risk-free rate plus a risk premium proportional to the risk, or beta, for that investment.
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The capital asset pricing formula is: r = rF + (rM rF) where: r = Cost of Retained Earnings (based upon investors required rate of return) rF = Risk-free rate of return = Beta coefficient rM = Market rate of return
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The risk-free rate (rF) is the rate of return on an investment in a riskless asset (approximated by the return on very short-term U.S. Treasury bills). The market rate of return (rM) is the required return on the average stock in the market. (rM rF) is the market risk premium. It measures the additional return (above the risk-free rate) that investors demand to invest in stocks, which are generally riskier, versus bonds.
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Risk in the Capital Asset Pricing Model

The market risk of an individual security is measured by its beta coefficient. The CAPM uses the security or portfolios risk, the market rate of return and the risk-free rate to calculate the investors required return. The theory behind the CAPM is that investors will price investments so that the expected return on a security or a portfolio will be equal to the risk-free rate plus a risk premium proportional to the risk, or beta, for that investment.
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Interpretations of Beta
According to the capital asset pricing model (CAPM), an investments beta measures its sensitivity to changes in the market (measured by some benchmark). For stocks, the benchmark may be any of a number of stock indexes. The greater the beta of an individual security, the more the return on that security varies in proportion to the variation in return of the benchmark index that it is compared with.
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Interpretations of Beta
Five primary interpretations of a stocks beta are:
1. A beta greater than 1.0 means that the individual security has historically been more volatile than the market as a whole. 2. A beta of less than 1.0 but greater than zero means that the individual security has historically been less volatile than the market. 3. A beta of exactly 1.0 means that the individual security has historically moved in lockstep with the market as a whole. Note that the market has a beta of exactly 1.0. 4. A risk-free security has a beta of zero. 5. A negative beta (less than zero) means the security has historically moved counter to the market.
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Arbitrage Pricing Theory

Arbitrage Pricing Theory (APT) is a multifactor theory based on the idea that in a competitive financial market, arbitrage will assure equilibrium pricing according to risk and return. Arbitrage is simultaneously purchasing and selling the same asset in different markets where its price is different in order to profit from the unequal prices. Arbitrage Pricing Theory looks at common risk factors to calculate the correct price for a security. The goal is to identify securities that are underpriced and can be purchased and immediately resold for a higher price.
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Arbitrage Pricing Theory

The APT formula, if there are two risk factors, is: R = rf +1k1 + 2k2 Where: R = Expected rate of return rf = Risk-free rate 1,2 = Individual factor beta coefficients k1,2 = Individual factor risk premiums (Required Returns for factor rf)
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Fama-French Three Factor Model

The Fama-French Three Factor Model is similar to the Arbitrage Pricing Theory. It is a method to calculate the expected return and risk from an individual security based upon three factors:
Market factor: the return on a market index minus the risk-free rate of return. Size factor: the return on small-firm stocks minus the return on large-firm stocks. Book-to-market factor: the return on high book-to-market ratio stocks minus the return on low book-to-market stocks.
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Fama-French Three Factor Model

The formula to calculate the expected return and/or the expected risk premium is: r rf = +bmarket (rmarket factor) + bsize (rsize factor) + bbook-to-market (rbook-to-market factor)
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Business Risk
Business risk is the variability of the firms earnings before interest and taxes (i.e., its operating income, or EBIT). Several factors give rise to business risk:
The variability of demand over time The variability of the sales prices over time The variability of the price of inputs to the product over time The degree of operating leverage that the firm has.
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Operating Leverage
Operating leverage is the relationship between the % change in revenue (volume) and the % change in operating profit (or earnings before interest and taxes - EBIT). The proportion of fixed costs in a firms total cost structure controls the firms operating leverage.
If the firm has fixed operating costs (costs that do not vary with changes in volume) and revenue increases, operating profit will increase by a greater % than revenue increases
A firms degree of operating leverage (DOL) is one part of the firms overall business risk.
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Degree of Operating Leverage (DOL)

The DOL is important, because it magnifies the impact of the other factors on the variability of the firms operating profits. The DOL is calculated as follows: % Change in Operating Income (EBIT) % Change Revenue If only one year of income is available, the following formula can be used to calculate the degree of operating leverage: Contribution Margin Operating Income (EBIT)
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Business Risk
Business risk is measured by calculating the variability of a firms operating income using the coefficient of variation. The technique is used to calculate the amount of business risk that a company is subject to. The formula for the coefficient of variation of a firms operating income is:
Standard Deviation of Forecasted Operating Income (EBIT) Expected Value of Forecasted Operating Income (EBIT)
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Business Risk
We measure the variability of a companys operating income by calculating the standard deviation of the operating income forecast.
If the standard deviation of the forecasted operating income is small, then the forecast is fairly certain to be achieved. If the standard deviation of the operating income forecast is large, there is a lot of potential variability and uncertainty about it.
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Financial Risk
The increased volatility of net income caused by fixed interest expense is called financial risk. Financial risk includes two aspects:
1. risk that the firm will not be able to pay its interest and other obligations because of a lack of cash flow 2. increased variability in earnings per share caused by the use of debt and requirement to pay interest on the debt.
As the firm increases the proportion of fixed cost financing to total financing in its capital structure, its fixed cash outflows for interest expense will increase.
As a result, the possibility that the firm becomes insolvent (unable to pay its obligations) increases.
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Financial Risk
Fixed interest costs have the same effect on the firms net income as fixed operating expenses have on the firms operating income. They increase the volatility of that net income.
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Financial Leverage
Financial leverage is the use of debt to increase the profitability of the company. It exists because of the presence of fixed financing costs primarily interest on the firms debt.
As the volume of revenue and the level of operating profit increase (or decrease), these fixed financing amounts remain constant.
This is important because interest expense must be paid or the firm will default and risk liquidation by the bankruptcy courts.
The more fixed financing costs that a company has, the greater the risk of default for the company.
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Degree of Financial Leverage

The more fixed financing costs a company has, the more its net income will increase (or decrease) as earnings before interest and taxes (EBIT) change. The formula for the degree of financial leverage is: % Change in Net Income % Change in Operating Income (EBIT) If only one year of income is available, the following formula can be used to calculate the degree of financial leverage: Operating Income (EBIT) Earnings Before Taxes (EBT)
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How to Measure a Firms Financial Risk

Financial risk is calculated by comparing the :
coefficient of variation of net income if there were no interest expense (in other words, the firms business risk) with the coefficient of variation of net income when interest expense is present (the firms total risk).
The difference is the amount of financial risk. As such, the firms financial risk is a figure that is backed into.
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Portfolio Risk
Portfolio risk is the risk of several assets held in combination. The asset combination is a portfolio. The expected return of a portfolio is the weighted average of the expected returns of the assets held in the portfolio. The weights are each assets proportion of the total portfolio. However, the risk of a portfolio is not an average of the risk of the individual securities in the portfolio.
Whether the portfolios risk is higher or lower than the average of the individual assets risks will depend on the structure of the portfolio and how the returns of the individual assets move in relation to each other.
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Asset Diversification
The process of combining assets to reduce risk is called diversification. Asset allocation is the process of selecting assets to combine in a portfolio to achieve the best risk/return tradeoff possible through diversification. When a sufficient number of assets have been combined to achieve the full benefits of diversification, the portfolio is called a fully diversified or efficient portfolio.
This means that the portfolio gives the highest rate of return for a particular level of risk or the lowest level of risk for a particular rate of return.
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Correlation is the term used to describe how the returns of two investments in the diversified portfolio move in respect to each other. Risk reduction is achieved in a portfolio when the securities held are not correlated with one another. The portion of an individual assets risk that can be minimized in a diversified portfolio is called diversifiable, unsystematic or non-market risk.
This type of risk can be minimized because it is caused by factors that are unique to the asset, not things that affect the market as a whole.
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The risk that cannot be reduced through asset diversification is called market risk, systematic risk, and undiversifiable risk. Market risk, also called systematic or undiversifiable risk, is created because economic cycles affect all businesses.
publicly-held investments are traded in a market that can go up and down with economic news. market risk includes risk from imperfect correlations between or among securities intended to offset each other.
Market risk cannot be diversified away, and all stocks are subject to it.
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Portfolio Theory
Portfolio theory deals with the balancing of the risk and the rate of return of investments and the selection of the investments in the portfolio. The portfolio attempts to manage this balance of risk and return through proper asset allocation. Individual investments selected for inclusion in a portfolio should have characteristics that balance each other. If the portfolio is put together correctly, the risks of the individual securities will be inversely related to one another and will therefore offset each other to some extent when taken as a portfolio.
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Portfolio Theory
This means that the risk of the whole is less than (or at least should be less than) the risks of the individual securities in the portfolio. Asset allocation is the process of taking the amount that is to be invested and distributing the investments among bonds, stock, real estate, and other investments in order to achieve the correct balance of risk and return.
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Portfolio Theory
Risk in a portfolio is measured by determining the variability of the portfolios returns and how much the returns of any two investments tend to move in respect to each other.
The more the individual securities returns move in different directions, the more the variability of the portfolios returns will be reduced. A portfolios risk can be reduced by investing in securities that behave the opposite of each other.
The variability of a portfolios returns is measured by its variance and standard deviation.
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Portfolio Theory
Calculating the variance and the standard deviation of a portfolio requires using:
the variances of the returns of the securities in it the correlation coefficients or the covariances of every possible combination of two securities in the portfolio the standard deviations of the individual securities.
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Correlation Coefficient
The degree of correlation in the returns of any two securities is measured by their coefficient of correlation, or correlation coefficient. The variable for this is r and its value is between 1 and +1.
A correlation coefficient of +1 means that the two securities returns have in the past always moved together, in the same direction and to the same extent. A correlation coefficient of 1 means that the two investments returns have in the past always moved in exactly opposite directions. A correlation coefficient of 0 means that historically, there has been no relationship between the returns of the two securities.
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Covariance
Covariance is a statistical measure of the amount by which two securities returns move together.
A positive covariance means that the two returns move together. A negative covariance means that the two returns move in opposite directions. A covariance of zero means that the two returns are completely unrelated to one another and they do not vary together in either a positive or negative way.
Covariances need to be determined between returns for all possible combinations of two securities in a portfolio.
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Variability of Returns
The variability of the returns of an individual project refers to the difference between its actual returns and the projects expected returns. A projects variability of returns is measured by its variance or by its standard deviation. The variance is the square of the standard deviation.
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Variability of Returns
The variability of the returns of a portfolio of projects is measured by the variance and the standard deviation of the portfolio. As with liquid securities, the variance and standard deviation of a portfolio of projects depend upon:
The variances of the individual projects within the portfolio The percentage of total funds invested in each project The correlation of the projects with one another
The variance and standard deviation of a portfolio of projects is calculated in the same manner as it is calculated for a portfolio of securities.
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Managing Foreign Exchange Risk

Multinational companies with foreign subsidiaries may or may not be exposed to exchange rate risk. When the foreign subsidiarys cash flows adjust naturally to currency exchange rate fluctuations, this can act as a natural hedge. Examples include:
if a subsidiarys costs are determined by the global market and its products are sold in the global market, it will have very little exposure to exchange rate fluctuations. if a subsidiarys costs are determined by the country in which it is located and its products are also sold in that same country, again, there will be very little exposure to exchange rate fluctuations.
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While there are a number of techniques that can be used when we have certain knowledge of the direction of future exchange rates, in most cases we are not able to predict the future. The best policy to manage foreign exchange risk is one of balancing monetary assets against monetary liabilities in order to neutralize as much as possible the effect of exchange-rate fluctuations. A company can do this by maintaining a balance between payables and receivables denominated in a foreign currency.
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A firm may also attempt to manage its exchange rate risk through diversification.
By investing in different economies and currencies, the risk that all of them will drop at the same time is reduced.
A firm can keep foreign-denominated payables or receivables at a minimum level so as to avoid the risk completely. A firm can borrow in a foreign currency to offset a net receivables position in that currency. A company with a foreign subsidiary can borrow in the country where the subsidiary is located in order to offset its exposure.
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Capital Structure and Permanent Financing

The capital structure of a firm includes the longterm liabilities and equity sections of the balance sheet. This shows how the company obtained the necessary money to buy the assets that the company holds. In contrast to working capital, the capital structure relates to the permanent financing that the firm has. These sources of permanent financing are:
long-term debt which generally takes the form of loans from banks or the issuance of securities called bonds. preferred stock
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Capital Structure and Permanent Financing

These sources of permanent financing are (cont`d):
Common shareholders equity made up of :
Common stock (the par value of the shares), Additional paid-in capital (this represents the excess of the sales price of the shares of the stock over the par value of the shares) Retained earnings (undistributed company profits)
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Optimal Capital Structure

The optimal allocation of financing between different types of capital considers many factors including:
The future prospects of the company The equity market (if the market is doing poorly, the cash received from the stock sale will be less than in a strong market The composition of the companys assets The amount of risk that the company is willing to accept (debt is inherently more risky to the firm than equity) The reputation of the issuer (company) and the interest rate that they would pay to issue debt The cost of each source of capital
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Factors Influencing the Bond Interest Rate

The rate of interest of a bond is influenced by eight primary factors:
1. Risk-free rate 2. Implied inflation factor included in the risk-free rate (which is always stated in nominal terms) 3. Credit or default risk of issuer 4. Liquidity of bond 5. Tax status of bond 6. Term to maturity: relationship between the maturity of a security and its rate of return, defined by the term structure of interest rates.
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Factors Influencing the Bond Interest Rate

The rate of interest of a bond is influenced by eight primary factors (contd):
7. The term of a bond traded in the secondary market creates another risk: risk of loss of principal due to a general increase in market rates which leads to a decline in the market value of the bond. 8. Special provisions: an example is a call feature, which gives the issuer the option of buying back the bond prior to its maturity at a given price.
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Nominal Yield Calculation: Debt Security

We calculate the nominal yield on a debt security by starting with the risk-free rate. However, we do not necessarily have to use the short-term U.S. Treasury Bill rate for the risk-free rate. Rather, we can use the rate for the U.S. Treasury security that is closest in term to the term of the security for which we are calculating an appropriate rate.
By doing this, we eliminate having to consider term to maturity of the issue as a factor in determining its rate, because that risk premium is already built in as part of the risk-free rate we use as the basis of our calculation.
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Nominal Yield Calculation: Debt Security

The formula to make this calculation is: Yield of Treasury security with same term + Default premium + Liquidity premium +/ Premium or Discount for tax status +/ Premium or Discount for special provisions = Yield of debt security
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Conversion: Nominal Rate to a Real Rate

Remember that the total, or the appropriate yield of a debit security, is a nominal rate which contains an inflation premium. To convert a nominal rate to a real yield, we use the following formula: 1 + Nominal Rate 1 1 + Inflation Rate
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Interpretation of Yield Curve

The slope of the yield curve says the markets expectations about interest rates:
Up-sloping, or Normal, Yield Curve: Normally longerterm interest rates will be higher than shorter-term interest rates. Down-sloping Yield Curve: If the market expects interest rates to decrease in the future, borrowers will prefer to borrow short term, while investors will prefer to invest long-term. Flat Yield Curve: If the market expects interest rates will not change in the future, the yield curve will be flat.
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The slope of the yield curve says the markets expectations about interest rates (contd):
Humped Yield Curve: As expectations change from increasing rates to decreasing rates, the yield curve may pass through a period where it is humped, or raised in the middle. During this period, long-term rates will be about the same as short-term rates, but medium-term rates will be higher.
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There are four major theories that attempt to explain the slopes of yield curves:
1. The Pure Expectations Theory: shape of yield curve is determined by market expectations of future interest rates. 2. Liquidity Preference Theory: if investors increase their risk by holding long-term bonds, they require higher compensation (higher rate) for assuming increased risk. 3. The Segmented Markets Theory: focuses on cash needs of different groups of investors and borrowers. Each group chooses securities meeting its forecasted cash needs. 4. The Preferred Habitat Theory: a compromise combining the elements of the Segmented Markets Theory and the Pure Expectations Theory.
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General Information about Bonds

The selling price of any bond is calculated by determining the present value of all of the future cash flows of the bond. There are two cash flows that are relevant to this process:
Each of the interest payments The repayment of the face amount at maturity.
This discounting to the present value is done using the market rate of interest for bonds with similar characteristics (same maturity, default risk, terms and conditions, etc).
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The market rate is used because this is the rate of the investment alternatives available and is therefore the minimum return that an investor would require. In a situation where the stated rate of interest on the bond is higher than the market rate, the bond will be sold at a price above the face value. This higher price (but still unchanged interest payment) makes the effective rate of the bond equal to the market rate of the bond. This is called a premium.
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If the selling price of the bond is less than the face value of the bond, it is said that the bond is selling at a discount.
This situation arises when the market rate of interest is higher than the interest rate that is stated on the bond. If the bond were sold at its face value, nobody would buy the bond because they can receive a larger return from another bond in the marketplace. By reducing the selling price of the bond (but not the amount of interest that is actually paid each period) the effective interest rate of the bond becomes equal to the market rate of interest.
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Advantages of Bonds to Issuer

Advantages to the issuer of bonds include:
No loss of control or ownership: bond holders are not owners and have no voice in the running of the company. Total cost of the bonds is limited and known because the interest rate is constant. The interest that is paid on the bonds is tax-deductible as an expense of the business. This is an advantage because dividends that are paid to shareholders are paid after taxes and are not deductible for tax purposes. If the bonds are callable, or otherwise can be retired early, there is flexibility for the company to eliminate the interest payment if there is no longer a need for the financing.
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Disadvantages of Bonds to Issuer

Disadvantages for the company issuing bonds are:
The cost of servicing the bonds because the interest is fixed and required.
Even in periods of losses and low cash balances, the interest must be paid. If it is not paid on time, the company breaches its contract with the bondholders and defaults on the bond (loan), which can lead to bankruptcy and liquidation of the firm. In comparison to equity, this is a disadvantage because dividends never have to be paid. Therefore, equity provides more flexibility for the company.
The maturity of the debt will result in a large cash payment that needs to be made at one time in the future.
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Disadvantages of Bonds to Issuers

Disadvantages for the company issuing bonds are (contd):
Increased risk to the firm because of the chance of default on the debt.
As the level of debt grows, the interest rate on the next loan and return required by shareholders will increase. In times of low income or poor cash flows, this interest requirement may become too large for the company.
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Common Terms and Conditions of Bonds

Restrictive covenants limit the actions that a company may take that may be detrimental to the bondholders. These covenants may be related to various ratios, working capital amounts or even dividend payments. Some bonds are issued with a call provision, which enables the issuing company to call the bonds (repurchase them) at their option.
This is very beneficial to the issuer (therefore not beneficial to the investor) because the issuer can call these bonds (retire them) if the interest rate in the market falls below the rate that they are paying in interest on the bonds.
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Common Terms and Conditions of Bonds

Convertible bonds may be converted by the bondholder into a stated number of shares of common stock anytime during the bonds life.
This is advantageous for the holder if the firms common stock price increases during the bonds life. As a result of this benefit to the holder, this provision results in a significant reduction of the bond interest rate.
Some bonds may be putable. This is similar to callable, except that the option to retire the bond belongs to the purchaser of the bond.
If certain events occur, or if the issuing company violates any bond covenants, the investor can require that the issuer repurchase the bonds from them.
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Types of Bonds
Debenture bonds are not backed by any specific asset as collateral. The only backing to the bond is the company itself.
Because of the lack of specific assets pledged as collateral, only companies with a very high credit rating and a large amount of public confidence can issue debenture bonds. Also, due to the additional risk, these bonds will usually have a higher interest rate than collateralized bonds.
Income bonds pay interest only if the company achieves a certain level of income. These bonds are riskier for the purchaser of the bonds because the payment of interest is not guaranteed.
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Types of Bonds
Mortgage bonds have specific asset(s) pledged as the collateral for the loan.
This collateral makes the bonds less risky to investors because, in the event of default, the sale of the assets may cover the remainder of the unpaid debt. Therefore, mortgage bonds carry a slightly lower interest rate than debentures.
Serial bonds are bonds issued so that they mature over a period of time. Some of the bonds mature each year, which enables the issuer of the bonds to retire the bonds over this period of time without the need for a single, large cash payment.
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Types of Bonds
Subordinated debentures are bonds that will not have the first claim to the assets of the company in case of a bankruptcy. This is because these bonds are subordinated (inferior) to other debts that the company has.
In case of bankruptcy, all superior debts will be settled before subordinated debentures. Because of this additional risk, subordinated debentures will generally pay a higher rate of interest than unsubordinated debt.
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Types of Bonds
Zero-coupon bonds do not pay any interest, but they sell at a price significantly less than the face value.
The large discount on the sale of the bonds offsets the fact that there is no interest payment. In a sense all of the interest is withheld to maturity and paid at that time. The advantage to the issuer is that there is no cash outlay for the payment of interest. (This works in much the same way as discounted interest on a bank loan.)
Indexed bonds have an interest rate that is indexed to some other measure, such as the price index or a general economic indicator.
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Types of Bonds
There are two types of international bonds:
1. Foreign bonds are issued in a single country (not the issuing corporations home country) and are usually denominated in the currency of the country where they are sold. 2. Eurobonds are sold in multiple countries but all are denominated in a single currency usually the currency of the issuers home country, not the country where the bond is primarily sold. For example, a U.S. company may issue Eurobonds denominated in U.S. dollars in many countries. Eurobonds may be cheaper than issuing the bonds in the home country because there may be lower registration and reporting requirements related to government regulations.
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Rights of Common Shareholders

Most common shareholders have the following rights:
Voting. There are different methods used for voting, but almost all owners of common shares have the right to vote at the annual shareholders meeting. While votes are taken on a variety of corporate issues such as mergers, the most significant vote is the election of a Board of Directors to oversee the company management on behalf of the shareholders. Dividends if declared, which may or may not be paid in a given year. Shareholders may receive but are not guaranteed dividends by the Board.
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Rights of Common Shareholders

Most common shareholders have the following rights (contd):
Preemptive rights to purchase new shares issued by the corporation so that their % of ownership is not diluted by the issuance of new shares Rights to share in the distribution of residual assets (after the satisfaction of all liabilities) if the company is liquidated.
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Advantages of Issuing Common Stock

The advantages of issuing common stock are:
Common stock does not have a fixed payment (like bond interest) that must be made to the holders. Shares do not mature and do not require a lump sum repayment of the principal in the future. There is greater flexibility in the financial structure of the firm because there is no interest payment to be serviced and no covenants need to be maintained. The issuance of shares brings additional capital into the firm, thereby lowering its debt ratios and perceived risk. Investors often prefer common stock because there is the chance of the significant appreciation of the value of the stock when the company is successful.
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Disadvantages of Issuing Common Stock

The disadvantages of issuing common stock are:
As shares are issued to others, the current shareholders lose control over the company. There is a limit as to the number of shares that a company may issue. The cost of issuing the shares may be higher than the cost of issuing debt. Since common stock is the riskiest security from an investor viewpoint, investors expect the highest return on their investment. Unlike interest on bonds, the distributions that are made in the form of dividends are not a tax deductible business expense in the U. S.
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Comparison: Preferred Stock to Bonds

Preferred stock is a hybrid, or cross, between common stock and bonds. There are five main ways in which preferred stock is similar to a bond:
1. Preferred stockholders usually do not vote on issues at the Annual Meeting, 2. Preferred stock usually pays a constant annual dividend. Also, these preferred dividends are usually stated as a percentage of par value (covered in an upcoming slide regarding cumulative dividends),
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Comparison: Preferred Stock to Bonds

There are five main ways in which preferred stock is similar to a bond (contd):
3. Preferred shareholders receive preference over common shareholders in the case of asset distribution in a liquidation 4. Preferred shareholders generally receive dividends before common stock shareholders 5. Preferred stocks are issued with bond-like features: call, convertibility, maturity date, sinking fund, etc.
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Comparison: Preferred to Common Stock

Preferred stock is similar to common stock in three ways:
1. Not paying dividends during times of financial distress does not breach the contract and cannot result in bankruptcy proceedings 2. Preferred dividends are paid after interest and taxes. Therefore, they are not tax-deductible from the firms standpoint 3. In the event of asset distribution in a liquidation, preferred shareholders are junior to bondholders and other creditors. However, they are senior to common shareholders
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Cumulative Dividends
Cumulative dividends are a type of preferred dividend that are earned every year even if not paid. This cumulative dividend is a percentage of the face value of the stock:
In a period in which the preferred cumulative dividends are not paid, they become in arrears. These preferred dividends in arrears must be paid before any common dividends can be paid.
The amount of cumulative dividends in arrears must be disclosed in the financial statements because this amount can impact whether common shareholders will be able to receive a dividend.
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Advantage-Disadvantages: Preferred Stock

The main advantages of issuing preferred shares are:
the voting control of the company is not diluted in most cases any unusually high profits are maintained for the common shareholders rather than needing to be distributed as a dividend to preferred shareholders.
The disadvantages of issuing preferred stock are that

the dividends are not tax-deductible in the case of cumulative dividends, there is still a need to pay dividends in periods when there are low, or no, profits .
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Zero Growth Dividend Model

The zero-growth dividend model is used to value preferred shares. The value of a preferred share under this model is calculated as follows: Annual Dividend Investors Required Rate of Return
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Constant-Growth Dividend Model

The constant-growth dividend model is used to value common shares. The value of a common share under this model is calculated as follows:
Next Annual Dividend Investors Required Rate of Return - Annual Dividend Growth Rate
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Stock Rights
A stock right is simply the ownership of the right to buy a share of stock. Rights to buy additional shares are often created or issued when the common shares of a company are originally issued. The most common of these are called preemptive rights which means:
whenever the company issues new common shares, all of the existing shareholders have the right to buy the same proportion of the new shares as the proportion of the company that they owned prior to the issuance.
This preemptive right prevents their ownership percentage from being diluted as the result of more shares being issued.
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Stock Rights
It is important to remember that the preemptive right is applicable only for new issuances of stock. This means shares that are newly registered. If a company has shares that have been previously registered, but not sold, there is no preemptive right when they choose to issue these old shares. If a stock right is not exercised by its holder before the expiration date (and the required purchase price paid for the newly-issued stock), then the holder of the right does not get the new stock.
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Stock Rights
Anyone buying the stock before the ex-rights date is an owner on the record date and will receive the rights. So, after the announcement and before the ex-rights date, the stock is sold rights-on. The buyer does not need to do anything to get the rights when they are issued. The buyer will get them because he is the shareholder of record on the specified record date. In that case, the stock is said to be trading "rights-on. Once the stock rights have been issued and the stockholders receive them, the rights belong to the stockholders who received them.
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Stock Rights
If a stockholder sells his stock after receiving the rights, the selling stockholder continues to own the rights. The rights do not go along with the share.
In that case, the stock is sold "ex-rights." The former stockholder could still exercise the rights and buy the authorized number of newly-issued shares anytime before the expiration date of the rights. The ex-rights period extends from the ex-rights date until the expiration date of the stock right.
If the rights are not exercised by their owner, they simply expire worthless.
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Stock Rights
A share sells Rights-On when the rights are attached to the share and they will be purchased together. The formula to calculate the value of a right when it is selling Rights-On is: Po-Pn r+1 Where: r is the number of rights needed to buy one share Po is the value of the share with the right attached Pn is the subscription price (sales price) of the share when it is purchased through the rights
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Stock Rights
A share is selling Ex-Rights when the rights are no longer attached to the share and they may be purchased separately. The formula to calculate the value of a right when it is selling Ex-Rights is:
Market Value of the Stock, Ex-Rights - Subscription Price Number of Rights Needed to Buy one Share
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Stock Options and Warrants

Employee stock options and stock warrants are similar to a stock right in that each gives their holder the option to buy a share of stock during a future period of time at a set (exercise or strike) price. Warrants and employee stock options differ from stock rights since they may be given to investors who are not shareholders (they are not based on number of shares already held as rights are). Employee stock options are often distributed to employees as a form of compensation. Or warrants may be attached to debt instruments such as a bond and sold with the bond.
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Stock Options and Warrants

There are three types of stock warrants:
1. Usually, warrants included with bonds are detachable warrants meaning that the holder may immediately separate the two securities and choose to hold or sell each independently. 2. A non-detachable warrant has no value unless it is attached to the bond. 3. Standalone warrants: sometimes given to business partners to complete or sweeten a business deal. They allow the holder to buy stock in the company offering the warrant at a specified price and time.
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American Depository Receipts

American Depository Receipts (ADRs) are the method by which a foreign company can, in a sense, sell shares in the U.S. without having to go through the formal SEC share registration process.
In an ADR, the foreign company deposits some of its shares with a bank. The bank then issues the ADRs, which represent the shares of the foreign company that the bank holds. This process enables a foreign company to participate in the U.S. capital market without having to go through all of the formal procedures.
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Forward Contracts
A forward contract is an over-the-counter agreement between two parties to buy or sell an asset at a certain time in the future for a certain price.
The party that bought as a protection against increasing prices of the underlying asset has a long position. The party that sold as a protection against a possible declining price of the underlying asset has a short position. The distinguishing characteristic of a forward contract is that it is not traded on any market or exchange. They are therefore called over-the-counter.
The delivery price is such that the initial value of the contract is zero. The contract is settled at maturity by the sale and purchase of the asset.
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Futures Contracts
A futures contract is similar to a forward contract: it is an agreement to buy or sell a specified quantity of a specified asset on a future date for a specified price. Parties to a futures contract have the same long and short positions as the parties to forward contracts:
The party committing to buy the underlying asset as a protection against increasing prices holds a long position. The party committing to sell the underlying asset as a protection against declining prices holds a short position.
Futures contracts are different from forward contracts because they are traded on exchanges.
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Futures Contracts
The two basic types of futures contracts are:
1. commodity futures 2. financial futures.
Examples of commodities traded in commodity futures markets are agricultural products, metals, energy products, and forest products. Examples of financial futures traded are futures contracts on debt securities (interest rate futures) and stock index futures
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Management of Interest Rate Risk

An investor in fixed income securities or a financial institution has a significant amount of interest rate risk. When interest rates increase, the market value of fixed rate assets held will decrease. Interest rate risk can be managed by use of:
interest rate futures duration hedging interest rate options maturity matching (a financial institution can use this method to hedge its interest rate risk)
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Interest Rate Futures Contracts

Futures contracts are available for interest rate futures to hedge fixed income securities. Financial futures contracts on debt securities such as U.S. Treasury securities are called interest rate futures.
Financial institutions such as mortgage companies, commercial banks, and insurance companies use interest rate futures to hedge their exposure to interest rate movements.
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Interest Rate Futures Contracts

A commercial bank might use interest rate futures as a short hedge if the bank holds a large amount of fixed-rate commercial loans as assets but its primary source of funds (liabilities) is short-term deposits. This action hedges the risk from increasing interest rates. Interest rate futures might also be used by a bank to create a long hedge, in order to reduce the financial institutions exposure to the possibility of declining interest rates.
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Duration Hedging
Another way to hedge against interest rate risk is to use duration hedging. Duration (also called Macaulay Duration) is a weighted average of the times until the receipt of both interest and principal, weighted according to the proportion of the total present value of the bond represented by the present value of each cash flow to be received.
As duration increases, the price volatility of the debt instrument increases. In a sense, duration is a measure of the elasticity of the security. Duration is lower if the nominal rate on the instrument is higher (more of the return is received earlier in the life of the instrument).
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Interest Rate Options

An interest rate option is an option over an instrument such as a bond that gives the buyer, in exchange for the payment of a premium, the right to buy (if a call option) or to sell (if a put option) the specific bond at a specified price, on or before the expiration date of the option. The underlying securities are usually for interest rate futures contracts and are direct obligations of the U.S. Government such as Treasury bills, notes, and bonds.
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Maturity Matching
Maturity matching is a technique that can be used by a financial institution that has both financial assets and financial liabilities. If a financial institution can equate (make their duration the same) the duration of its assets and liabilities (deposits and loans), the bank can immunize its net worth (assets minus liabilities) against fluctuations from changes in interest rates.
This is due to the fact that the total change in value for assets as a result of a change in interest rates will be equivalent to the total change in value for liabilities as a result of the change.
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Swaps
Swaps are contracts when two parties trade payment streams, usually payment on debt. An interest rate swap takes place when two parties exchange interest payments, one at a fixed rate and one at a floating (or variable) rate that is pegged to some sort of market rate of interest and changes whenever the market rate changes. A swap can also be a currency swap in which two parties exchange the currency that a payment will be made in.
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Swaps
The primary purpose of a swap (either interest rate or currency) is to match the characteristics of the firms revenue stream with the characteristics of its payment stream.
if a firm has a revenue stream that increases or decreases with the market rate of interest, it would want its payment stream to also increase or decrease with interest rates. Swapping a fixed rate loan for a floating rate loan would achieve this goal, and reduce the firms overall risk.
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Options
The writer of an option (the seller of the option) must obey the will of the owner of the option (the buyer) and buy/sell an asset if the owner of the option decides to exercise the option. The two types of options are:
1. A call option: the long party (the buyer of the option) has the right to buy the underlying security at the strike price (i.e., the exercise price) from the short party (the seller of the option). 2. A put option: the long party (the buyer of the option) has the right to sell the underlying security at the strike price to the short party (the seller of the option).
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Call Options
A call option is the most common type of option. It gives the owner (the buyer) of the option the right but not the obligation to buy the asset covered in the option by the expiration date at the price that is fixed in the option.
If the exercise price of a call option is lower than the market price of the asset, the call option is in-the-money. If the exercise price is greater than the market price, the option is said to be out-of-the-money as it is not sensible to exercise the option since that would cost more than buying the asset on the open market. When the exercise and market prices are the same, the option is at-the-money.
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Put Options
A put option gives the owner (buyer) the right to sell the asset covered in the option by the expiration date at the price that is fixed in the option. With a put option, the seller of the underlying asset is in the long position while the buyer of the underlying asset is in the short position. This is the reverse of the long and short parties in a call option. The same terms (in-the-money, etc.) apply for put options but they are opposite from call options.
a put option has value if the exercise price is above the market value, and the put option is therefore in-the-money.
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Option Premium
The option premium is the amount paid for an option by the person who purchases it. The option premium is priced on a per share basis. Each option on a stock corresponds to 100 shares. Therefore, if the premium of an option is priced at 2, the total premium for that option would be $200 (2 x 100 = $200).
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American and European Options

An American option is an option in which the owner has the right to buy or sell the covered asset at a fixed price at any time before or on the expiration date.
A European option also gives the owner the right to buy or sell an asset, but it is exercisable only at the maturity date.
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Covered Options
A covered option is a call option for stock that is held in the option writers portfolio. A person who writes a covered call option on a stock that they already own is obligating himself to sell that stock at a specific price up until the expiration date.
If the market price rises above the strike price, the call option is exercised. The seller of the stock receives only the strike price for the sale, not the higher market value. However, the seller of the stock also receives the sale price for the option. This payment will partially or fully offset the sellers loss from having to sell the stock at a price below that of the market.
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Covered Options
Conversely, if the market price declines below the strike price, the following situation exists:
call option will not be exercised the seller of the option will continue to own the underlying stock, while keeping the price received for the option as an offset to the market value loss.
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Naked Option
A naked option is a call option for a stock which the option writer does not hold in his or her portfolio. A naked call option is more risky than a covered call option. If the call option is exercised by the option holder, the writer will probably lose money:
If the call option is exercised, it means that the market price has risen above the strike price. Therefore, the writer of the option will have no choice but to purchase the stock at the higher market price and sell it to the option holder at the lower strike price. Unless the price the writer received for the sale of the option offsets the difference, the option writer will lose money.
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Naked Option
A naked option would be written by someone who is betting that the market price of the stock will go down, not up, and that the option will never be exercised, leaving the writer with the income from the sale of the option while not being required to buy the stock in order to sell it to satisfy the call.
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Open Interest
Open interest represents the total outstanding options contracts for an asset at the end of each day. The net change in the total outstanding options and futures contracts helps investors determine if money is flowing into or out of the instrument. Open interest is a factor used by technical analysts:
an increase in open interest combined with higher volume and prices for a stock is an indication that the upward trend in share prices for the security will continue a decrease in open interest combined with a decrease in volume and higher prices for a stock is an indication of an impending end to the securitys upward trend.
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Existing Option Positions

The option owner has three choices to exit the option position to make a profit or avoid a loss:
1. Exercising the option: the owner chooses to take delivery of (if a call) or to sell (if a put) the underlying asset at the option's exercise price, also called the strike price. 2. Offsetting the option: offsetting is a method of reversing the original transaction to exit the trade.
A call buyer sells the call with the same strike price and expiration. A call seller buys a call with the same strike price and expiration. A put buyer sells a put with the same strike price and expiration. A put seller buys a put with the same strike price and expiration.
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Existing Option Positions

The option owner has three choices to exit the option position to make a profit or avoid a loss (contd):
3. Letting the option expire: if an option has not been offset or exercised by its expiration date, the option expires worthless.
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Components of an Options Value

The premium is the market price of the option itself at any particular time. This is the amount that is paid by the buyer to the seller in order to receive the rights conveyed by the contract. Two of the primary determinants of an options price are its intrinsic value and its time value:
total option premium = intrinsic value + time value The intrinsic value of an option is the amount by which the option is in-the-money at any point in time.
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Components of an Options Value

Two of the primary determinants of an options price are its intrinsic value and its time value:
The time value represents that portion of an options premium in excess of its intrinsic value.
An option usually has an expiration date after which it can no longer be exercised. If the option has not been exercised prior to expiration, the option will no longer be available and it will cease to exist. The longer the time before its expiration, the more valuable the option is, because there is more time for a favorable price fluctuation.
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Option Valuation: Binomial Model

The binomial model takes a risk-neutral approach to valuation. It assumes that underlying security prices can only either increase or decrease with time until the option expires worthless. Since it provides a stream of valuations for a derivative for each node during a period of time, it is useful for valuing American options that can be exercised at any point prior to the exercise date (unlike European options which are exercisable only at the expiration date).
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Option Valuation: Binomial Model

The model makes several assumptions:
reduces possibilities of price changes removes the possibility for arbitrage assumes a perfectly efficient market shortens the duration of the option.
It uses an iterative (running many times) procedure, allowing for the specification of nodes, or points in time, during the time span between the valuation date and the options expiration date.
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Option Valuation: Black-Sholes Model

The Black-Scholes Option Pricing Model is a pricing model for a European call option. It assumes the option can be exercised only on its expiration date. The model makes the following seven assumptions:
1. The risk-free rate is known and constant over the entire life of the option 2. The probability distribution of stock prices is lognormal 3. The variability of the underlying stocks return is constant 4. There are no transaction costs for trading the option 5. Tax rates are similar for all participants who trade options 6. The underlying stock does not pay any cash dividends 7. The underlying stock does not pay dividends
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Straddles and Strangles

A straddle is a call and a put position purchased by the same investor or sold (written) by the same investor. The main characteristics are:
The call and put have the same strike price Both expire in the same month Both are on the same stock Both are for the same number of shares The strike price is at or close to the money The investor does not own the underlying stock when the straddle is set up.
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Straddles and Strangles

A strangle is similar to a straddle because they use both put and call options on the same number of shares of the same underlying stock. Often the puts and calls have the same expiration date. However, these put and call options have different strike prices. Instead of using strike prices that are at-the-money, the investor chooses puts and calls with strike prices that are out-of-the-money: well above or below the underlying stocks current price. This costs less but requires the stock to move more before it is profitable.
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Put-Call Parity Theorem

The put-call parity theorem states:
if all of the following conditions exist:
Market equilibrium for all prices Equal exercise prices for put and call options Same expiration date for put and call options
then: a person who buys one share of stock, buys one put option and sells one call option will have a risk-free return on these investments.
The gain, or loss, from the share and the put should be equal to the loss, or gain, from the call.
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Put-Call Parity Theorem

This equivalency is expressed in a formula as: C P = S0 X / (1 + rf)T Where: C = Call premium P = Put premium S0 = Purchase price of stock X = Exercise price of the call/put options rf = Discount rate for exercise price, or risk-free rate T = Time to expiration (years or fraction of year)
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The Cost of Capital

The most common way to calculate the cost of capital is on a weighted average basis. In order to do this, one must perform two calculations:
1. Calculate the cost of each component (debt, preferred stock, common equity) of the firms capital structure, 2. Determine the appropriate weighting to be assigned to each component.
The formula looks as follows: Total Costs of Financing Total Fair Value of Financing
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Cost of Debt
The cost of debt is the interest rate to pay (yield demanded by investors) adjusted for taxes.
This adjustment for taxes is made because interest is a tax-deductible expense. The actual cost of interest is less than the amount of cash paid for interest.
Because of this tax deductibility and their inherently lower risk than equity sources, bonds are generally the lowest after-tax cost source of new financing.
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Cost of Debt
The formula to calculate the cost of debt is as follows: Cd = C (1-t) Where: Cd is the after tax cost of debt C is the cost of the debt before taxes t is the marginal tax rate
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Effective Interest Rate Calculation

The effective interest rate before tax for the first year only can be calculated as follows: Interest expense Cash received from the sale of the bond
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Cost of Preferred Stock

The cost of new preferred stock is calculated in much the same way as the cost of debt because most preferred shares pay their dividend in the form of some percentage of the face (par) value of the shares. Because preferred dividends are a distribution of income, they are not tax deductible.
As a result of this, the calculation for the cost of preferred shares does not include an adjustment for taxes.
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Cost of Preferred Stock

When issuing new shares, however, the firm will incur flotation costs including administrative expenses associated with registration of the security, and investment banking fees paid to brokers who sell the securities. The flotation costs reduce the proceeds from the sale of the securities. The formula to calculate the cost is: Yearly Dividend Net Proceeds from Issuance
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Cost of Retained Earnings

The cost of retained earnings to the company is not a cash cost that is paid in the form of dividends or interest. Rather, it is the opportunity cost of the next best investment that was not made by the shareholders.
This makes it harder to visualize the cost incurred by the company Think of it as the return that the shareholders of the company would have received had they gotten all the profit in form of a dividend and invested that money somewhere else.
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Cost of Retained Earnings

The cost of retained earnings is based upon the risk of the firm and the investors required rate of return. There are three different ways to calculate the cost of retained earnings:
1. Dividend (Gordon) Growth model, 2. Capital Asset Pricing Model (CAPM) 3. Arbitrage Pricing Theory (APT).
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Dividend (Gordon) Growth Model

The dividend (Gordon) growth model uses
dividends per share the expected growth rate the market price of the share
in order to estimate the cost of retained earnings. For the company to support a decision not to distribute its profits, it must generate a greater return than the amount calculated by the dividend plus a growth rate in the level of dividends paid.
This is the same formula used to calculate the cost of new common equity except the firm does not incur issuance (flotation) costs to retain earnings .
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Dividend (Gordon) Growth Model

The formula for calculating the cost of retained earnings using the dividend growth model is: The Next Dividend Paid + Annual Dividend Growth Current Common Stock Price
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Many companies pay little or no dividend to their shareholders. In these cases, it is impossible to use the dividend valuation models previously described to calculate the cost of equity capital. Therefore, the capital asset pricing model (CAPM) is frequently used to estimate the cost of equity either retained earnings or new equity.
In cases of new equity offerings with substantial flotation costs or under-pricing ( like IPOs), using CAPM is not recommended.
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The capital asset pricing model uses the following formula to calculate the cost of retained earnings: r = rf + B(rm rf) Where: rf is the risk-free rate B is Beta rm is the Market Rate of Return r is the cost of retained earnings
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Cost of New External Common Equity

The cost of new external common equity is higher than the cost of retained earnings because the process of registering and selling the stock will cost the company money.
These flotation (issuance) costs need to be factored into the calculation of the cost of issuing new shares.
It is more expensive for a company to raise money through the issuance of shares than through debt because the shareholders will require an additional return to compensate them for the additional risk of owning equity (with no fixed payment) instead of debt.
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Cost of New External Common Equity

The formula to calculate the cost of new common equity is: The Next Dividend Paid + Annual Dividend Growth The Net Proceeds of the Issue
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Marginal Cost of Capital

The marginal cost of capital is the cost of the next dollar of capital that is raised.
When we calculated the Weighted Average Cost of Capital, we always used marginal costs, or the cost to acquire new dollars of capital.
The concept of marginal weighted average cost of capital (MCC or MWACC) is very important in any discussion about optimizing the capital structure.
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Marginal Cost of Capital

As a company has more financing outstanding (becomes larger), its weighted average cost of capital (WACC) will increase.
This is because the company should have used the cheapest sources of financing first. Therefore, the next dollar of financing will be more expensive than the previous dollar of financing.
Additionally, as a company has more financing outstanding, the risk to the supplier of the next financing will be greater. Since the risk is greater they will demand a higher return.
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Short-term Financing
The questions of short-term financing relate to the companys current liabilities that need to be paid or settled within 12 months. There are two main sources of short-term financing:
1. Bank Loans: The most common source of short-term financing is provided by the banks. 2. Factoring of Receivables: A company sells its receivables NOW to a bank or another company. If sold with without recourse, the risk of not collecting the receivables transfers to the company that bought the receivables.
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Level of Working Capital

The level of working capital that a company has at any point in time is calculated as:
Current Assets Current Liabilities = Net Working Capital
There are a number of issues for a company related to working capital. Among these are:
the optimal level of working capital to maintain the mix of current assets carried the timing of the liabilities.
Working capital measures the short-term solvency of the firm. This is the ability of the firm to meet its short-term obligations as they come due.
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Level of Working Capital

The working capital (WC) policy of a firm is based on the amount of WC that the company maintains.
The more working capital that a company maintains, the less risk of insolvency.
However, since short-term assets do not provide the highest return, maintaining high WC causes the firm to lose the higher return of longer-term assets.
WC Policies Conservative Aggressive Negative Level of Liquidity High Low Very Low Risk of Insolvency Low High Very high Impact on Returns Negative Positive Positive
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Types of Working Capital

Because a company may have different cash needs throughout the year, it is possible that it will maintain different levels of working capital at different times of the year.
The minimum amount of working capital that is maintained at all times is called permanent working capital. Increases that occur from time to time are called temporary working capital.
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Current Assets
The five main classifications of assets that are included in current assets are:
1. 2. 3. 4. 5. Cash and Cash Equivalents Marketable Securities Inventory Accounts Receivable Prepaid expenses
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Cash Management
The factors that influence how much cash is held by a company include:
How much cash is needed in the near future The amount of risk a company is willing to take in respect to solvency The level of other short-term assets that a company holds At what point in its business cycle it is in (if a business is a seasonal business it will have more cash at the peak periods than at the slow periods).
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Cash Management
The factors that influence how much cash is held by a company include (contd):
The available return on other short-term investments
Cash is a non-interest bearing asset. If cash earns a low interest rate, the opportunity cost of holding cash is reduced. However, when there is a high interest rate, the cost of holding the cash instead of other investments increases. A company may decide to hold less cash and accept higher solvency risk in return for a more interest received.
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Cash Management
Cash management can be looked at from two different time perspectives:
1. In the short-term it is essential that the company has enough cash to pay its debts as they come due. 2. In the long-term it is critical that the company has enough cash to grow and expand as needed.
There are four main reasons for a firm to hold cash:

1. Medium of exchange for business transactions. 2. Precautionary measure for emergency situations. 3. Speculation to take advantage of bargain purchases or other investment opportunities that need quick action. 4. Compensating balance to maintain a minimum balance in its bank account during the period of loan.
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Operating and Cash Conversion Cycles

The operating cycle is the # of days that inventory is held before it is sold and the number of days that accounts receivables is held before collection.
It represents the total number of days the firm has funds invested in working capital.
The cash conversion cycle (also called cash flow cycle) is the operating cycle minus the average age of accounts payable.
It represents the number of days from when the firm pays for the inventory until when it receives the cash from the sale. It is one way of evaluating a companys cash management. Shortening this cycle without affecting sales can add to the firms profitability.
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Acceleration of Cash Inflows

A company can accelerate cash inflows through the following:
Mailing invoices as soon as possible. Having credit terms that encourage prompt payment. Using electronic data interchange (EDI). Accepting credit cards. Using a lockbox system.
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Disbursement Float
Disbursement float is funds spent by a company but not yet debited to the company bank account. Disbursement float occurs when a company writes a check.
The check is mailed. When it is received by the payee, the payee deposits it in their bank. When the check is deposited in the payees bank, it usually takes a day or two before the money is deducted from the companys account due to delays in the clearing system.
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Disbursement Float
So disbursement float consists of:
mail float (time for check to be delivered through the mail) operational float (time for payee to record the payment and deposit it in their bank) clearing float (time for check to clear)
The disbursement float may also be seen as the difference between what is in the company's bank account according to the companys books and what the bank shows to be in the account.
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Slowing Cash Outflows

A company can slow cash outflows through the following:
Making payments as close to the deadline as possible. Making payments using checks. Using payable through drafts (PTD). Having a zero balancing checking accounts. Using overdrafts.
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Types of Marketable Securities

The main types of marketable securities are:
1. Treasury bills are guaranteed by the U.S. government and the interest on them is exempt from state and local taxation. They are sold with a discount. 2. Certificate of deposits the longer the period of the CD, the higher the interest rate. Negotiable CDs are a denomination greater than $100,000, and they fall under the regulation of the Federal Reserve System. 3. Money Market Accounts may be withdrawn at any time without penalty. Interest rate is less than on CDs. 4. Higher-grade Commercial Paper issued by large companies in denominations > $100,000. They are unsecured. Interest rate is > than on CDs.
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Types of Marketable Securities

The main types of marketable securities are (contd):
5. Other types such as Bankers Acceptances, Federal Agency Securities, Eurodollars, Money Market Mutual Funds, State and Local Government Securities, Treasury Notes and Bonds, and Repurchase Agreements.
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Baumol Cash Management Model

The Baumol cash management model calculates the optimal cash level to receive every time it converts marketable securities to cash. In this model the assumption is that cash not needed in the immediate future by the company is held as marketable securities. So to get more cash the company simply needs to convert these marketable securities into cash.
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However there are transaction and opportunity costs to consider:
In order to convert these securities to cash, there is a fixed fee (such as a brokerage fee) that is paid for each conversion. Also, any time that cash is held, the company gives up the interest that was being earned by the marketable securities.
The model balances the cost of converting marketable securities into cash with the interest benefit of holding marketable securities.
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The Baumol cash management model is calculated as follows: OC = 2bT Where: i OC = The optimal level of marketable securities to convert to cash b = Fixed cost per transaction T = Total demand for cash for the period i = Interest rate for marketable securities, or the opportunity cost lost by holding cash instead of marketable securities
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Miller-Orr Cash Management Model

The Miller-Orr cash management model attempts to fix one limitation of the Baumol model:
the demand for cash is not known or constant over time the source of cash is not known and not constant
The Miller-Orr Model creates an upper and a lower limit for the cash balance that a company holds.
As long as the cash balance is between these two levels, there is no need for the company to make any cash transactions to either increase or decrease the balance. However, as soon as the cash balance moves outside of this corridor, the company needs to do something to bring it back into the corridor.
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Miller-Orr Cash Management Model

The model also establishes a cash balance that the company will move towards whenever it makes a cash transaction. This point to which it returns the cash balance is, in a sense, the starting point it uses whenever the cash balance gets outside of the corridor.
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Accounts Receivable Management

Managing accounts receivable (AR) is the process of balancing increased sales from extending credit (AR) and the cost to extend credit (including bad debts). One of the main factors in receivables management is the credit policy (i.e. who will receive credit). The key elements of a companys credit policy are:
Credit Terms: including the repayment schedule, discounts, and interest charged on outstanding debt. Credit Standards: the requirements that the person must meet in order to receive credit. Credit Scoring: how a company controls the distribution of credit so that only creditworthy customers get credit.
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Accounts Receivable Credit Terms

If a company relaxes its credit terms (makes it easier to receive credit), more people will receive credit and make purchases on credit. This hopefully leads to increased sales and higher profits. However, the increase in receivables can also lead to increased collection costs and higher bad debts.
The company must be confident that the increase in sales will offset the increased costs and bad debts.
It is also possible that the relaxed credit terms will not lead to increased sales. Customers may simply use credit instead of making cash purchases.
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Accounts Receivable Credit Terms

If the company makes its credit terms more strict(harder to get credit), it will experience reduced bad debts and collection costs.
However, there will also be lower sales and profits.
Again, the company must balance the costs and benefits of this decision.
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Accounts Receivable Turnover

Receivables Turnover is the number of times that the average accounts receivable is collected throughout the year. It is calculated as: credit sales average accounts receivable If this number is too high it may indicate that the company is not holding enough inventory. On the other hand, if the number is too low, the company may be holding too much inventory.
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Accounts Receivable Turnover

Average Collection Period is the number of days for collection of a receivable. It is calculated as: 365 the receivables turnover (Some companies use a different number of days than 365.)
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Inventory Management
A company should minimize its total inventory costs. This includes the costs of holding and ordering inventory and stockout costs (the costs of not having inventory when a customer wants to buy it). A small per unit decrease in the cost of holding inventory can become a very large amount when multiplied by the number of units held in inventory. Just-in-Time (JIT) means that nothing is produced until a customer orders it. The level of inventory held at all stages of production is minimized, thereby the carrying cost of inventory is kept low.
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Inventory Management
There are three main categories of costs of inventory: Ordering Costs Carrying Costs Stock-out Costs - Placing orders - Storage - Loss in sales - Receiving orders - Insurance - Lost cash - Any setup costs - Security - Lost profit - Taxes - Customer ill - Depreciation will or rent - Opportunity costs
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Economic Order Quantity Calculation

The Economic Order Quantity (EOQ) calculates the number of units that the company should order each time inventory is ordered for the purpose of achieving the minimum total cost. The calculation is: EOQ 2aD K where a = variable cost of placing an order D = periodic demand K = carrying cost per unit per period
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Inventory Turnover Ratio

The inventory turnover ratio measures the firms effectiveness in selling its inventory by calculating how many times during the year the firm sells its average level of inventory.
An increase in cost of sales without an equivalent increase in inventory increases the inventory turnover ratio An increase in inventory without an equivalent increase in cost of sales decreases the inventory turnover ratio
The ratio is calculated as follows: Annualized Cost of Sales Average Annual Inventory
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Days Sales in Inventory Ratio

The days sales in inventory ratio measures the companys effectiveness in selling its inventory by calculating the number of days that the average inventory item remains in stock before it is sold.
This number should be low but not too low, because if it is too low, the company is risking lost sales by not having enough inventory on hand. The higher the number, the less risk that there is for a stockout, but the more cash is invested in inventory.
The ratio is calculated as follows: 365, 360 or 300 Inventory Turnover

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Cost of Prompt Payment Discounts

Payments should be made within the discount period if the cost of not taking the discount (calculated below) is greater than the firms cost of capital. The cost of not taking the cash discount is calculated as follows: 360 (Total period of payment Period for discount) * Discount % 100% - Discount
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Effective Interest Rate on Different Loans

The effective interest rate is calculated based upon the type of loan:
Regular (Simple) Interest: Interest Paid Borrowed Amount Loan requiring Compensating Balance (CB): Interest paid Interest received on additional amount for CB Amount of loan Additional amount for CB
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Effective Interest Rate on Different Loans

The effective interest rate is calculated based upon the type of loan (contd):
Discounted Interest : Interest Paid (Borrowed Amount Interest) Installment Loan = Interest to be Paid Average outstanding Amount
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Factoring Receivables
Factoring receivables occurs when the owner sells the receivables to another party. This enables the owner to collect on the receivables earlier than if he or she waited to receive the money directly from the customer. The amount of money that is actually received from the factor of the receivables is reduced by:
Factoring Fee: the more risk related to receivables, the higher the amount. Interest Charge: almost always higher than market rate. Reserve Amount: if all receivables are collected, the reserve will then be paid to the seller.
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Factoring Receivables
The cash to be received from factoring is equal to:
Face amount of receivables Reserve Amount Factors Fee Interest on the Amount of Cash to be Received = Cash to be received from factoring
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Secured versus Unsecured Debt

Secured debts involve an asset that is used as collateral for repayment of the loan should the borrower default. Secured debt includes chattel mortgages, floating liens, pledged receivables, warehouse financing and inventory financing. Unsecured debts have no such collateral backing them, so the interest rate paid by the borrower is higher than on a secured debt. Unsecured debt includes trade credit, repurchase agreements, accrued expenses, lines of credit, commercial paper and bankers acceptances.
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Working Capital and Maturity Matching

The maturity matching approach to financing current assets (also called the hedging or the selfliquidating approach) matches assets to be financed with financing having the same maturity. Permanent working capital need (inventory and accounts receivable) is financed by long-term debt or equity under the maturity matching approach. Longterm assets, such as property, plant and equipment, are financed with long-term capital as well. If the company has seasonal cash needs, it would borrow short-term to finance those needs.
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Three Types of Stock Exchanges

There are three types of stock exchanges:
1. Specialist systems: stock exchanges such as the New York Stock Exchange have physical locations where buyers and sellers of stocks come together. The NYSE uses the specialist system to accomplish trades. Trading of a stock is overseen by a specialist, who is a facilitator, auctioneer, dealer, and agent. 2. Electronic exchanges: electronic exchanges, such as the NASDAQ (National Association of Securities Dealers Automated Quotations) have no physical location and specialists.
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Three Types of Stock Exchanges

There are three types of stock exchanges (contd):
3. Electronic Communications Networks (ECNs): these are automated stock trading systems separate from stock exchanges. ECNs are passive order matching systems. They do not use specialists. They match buy and sell orders that have the same prices for the same number of shares.
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Market Characteristics: Bonds

The bond markets are dealer markets, because bonds are traded through dealers.
Availability and the prices of bonds vary from dealer to dealer. Large bond dealers maintain an inventory of bonds which may not be available through other dealers. Many dealers have websites where an investor can open an account and then have access to their offerings.
There are also online bond trading websites that act as electronic exchanges, giving accountholders access to several dealers inventories.
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Market Characteristics: Bonds

Bonds are generally quoted on the basis of their yield to maturity.
Bond prices are calculated from the yield to maturity and are quoted as a bid price (the price at which a dealer will buy a bond) and the offer, or ask, price (the price at which a dealer will sell the bond). The difference between the bid and ask prices is the dealers compensation.
Therefore, a bond quote consists of a bid yield to maturity and an ask yield to maturity.
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Market Characteristics: US Gvmt Securities

Government securities are initially issued in government auctions.
Short-term Treasury bills are auctioned every Monday. Longer term bills, notes and bonds are auctioned at intervals as necessary.
Treasury bills are discounted, which means they are purchased at a discount to their face value, and on their maturity date, the government pays the face value. The difference is interest income and it is not received until the maturity date.
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Market Characteristics: US Gvmt Securities

Treasury Notes and Treasury Bonds are longer term.
T-notes have maturities of from 1-10 years T-bonds mature in 10 to 30 or 40 years from their original issue date.
Both Treasury notes and Treasury bonds pay a stated interest rate semi-annually, and are redeemed at their face value at maturity. After original issue, U.S. government securities are traded in the secondary bond and money markets
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Market Characteristics: Over-the-Counter

Over-the-counter (OTC) markets are dealer markets where transactions are completed by computer or over the telephone. Over-the-counter markets exist for stocks, bonds, U.S. Government securities, money market instruments, even derivatives after trading hoursjust about anything that is not traded in an auction exchange.
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Market Characteristics: Money Market

The money market is a subset of the fixed income market. Money market instruments, though, have very short maturities (less than one year), whereas fixed income securities are considered to be medium and long-term (longer than one-year maturities).
Money market instruments are short-term borrowings by governments, financial institutions, and large corporations. Money market securities include negotiable short-term securities such as U.S. Treasury bills, commercial paper, bankers acceptances, Eurodollars, and repurchase agreements.
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Market Characteristics: Money Market

Like the bond market, the money market is a dealer market, with dealer firms buying and selling securities in their own accounts and making money on the spread when they sell them. Deals are transacted over the telephone or through electronic networks.
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Market Characteristics: Federal Funds

Banks borrow funds from other banks, if necessary, in order to meet their reserve requirements with the Federal Reserve Bank.
The reserve requirement is the amount that a bank must have on deposit with the Federal Reserve Bank each day, and each day, it must be a certain percentage of the deposits entrusted to it by its depositors.
The federal funds market is a means of distributing these reserves in the banking system. The borrowing and lending occur in the federal funds market at a competitively determined interest rate known as the federal funds rate.
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Market Characteristics: Federal Funds

On any given day, individual banks may be either above or below their desired reserve positions.
Reserve accounts bear no interest, so if a bank has reserves that are in excess of its reserve requirement, it has an incentive to lend them to another bank and earn interest on them.
Thus, a bank with excess funds on deposit to cover its reserve requirement may lend the excess, usually on an overnight basis, to a bank that does not have enough funds on deposit.
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Market Characteristics: Derivatives

Derivatives such as futures contracts and options are traded on commodity exchanges such as the New York Mercantile Exchange and the Chicago Board of Trade.
The prices on the exchange are determined in an open, continuous auction during trading hours on the exchange floor by the members acting on behalf of their customers, the companies they represent, or themselves Price movements are controlled by supply and demand The action process is called open outcry
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Market Characteristics: Derivatives

In the open outcry process, the buyers determine how much they are willing to pay and announce their bids to the other brokers in the ring. Sellers cry out their offers.
When the minds meet on price and quantity, the cry of "sold" or "done" is heard, and the trade is recorded.
The exchanges guarantee each trade, ultimately acting as the seller to every buyer and the buyer to every seller. This is accomplished through a group of member firms called clearing members.
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U.S. Treasury Bills

U.S. Treasury bills are U.S. government securities that mature in one year or less from the date issued.
They are issued with 3-month, 6-month and 1 year maturities.
Treasury bills are discounted, which means they are purchased at a discount to their face value.
On their maturity date, the government pays the face value. The difference is interest income and it is not received until the maturity date.
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U.S. Treasury Bills

Treasury bills are the only money market instruments that are issued in small denominations. They can be purchased in denominations of $1,000, $5,000, $10,000, $25,000, $50,000, $100,000, and $1 million. U.S. government securities are essentially risk-free, so Treasury bills are a very safe investment.
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Commercial Paper
Commercial paper is unsecured, short-term notes due from large, financially sound corporations, usually for the purpose of financing short-term assets such as accounts receivable and inventory. Commercial paper is usually issued at a discount and reflects current market interest rates. Typically, only very creditworthy companies issue commercial paper. Because of the financial soundness of the company issuing it and short term of the loan, commercial paper is a very safe investment. Commercial paper is usually issued in denominations of $100,000 or more.
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Bankers Acceptances
Bankers acceptances are used to finance traderelated transactions, usually international trade.
Importers use them to finance purchases. Exporters use them to finance receivables.
Important characters of bankers acceptances are:

They are created for terms between 30 days and 180 days. The bank may hold the acceptance in its portfolio or it may sell (rediscount) it in the secondary market. If the bank holds the acceptance, it is effectively making a loan to the importer or exporter. If the bank rediscounts the acceptance, it is substituting its credit for that of the importer or exporter, enabling its customer to borrow in the money market.
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Bankers Acceptances
On or before the maturity date, the importer/exporter pays the bank the face value of the acceptance.
If the bank has rediscounted the acceptance in the market, the bank receives the face value of the acceptance and pays it to the holder of the acceptance on the maturity date.
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Eurodollars
Eurodollars are deposits in banks outside of the U.S. that are denominated in the U.S. dollar. The Eurodollar market has expanded because banks outside the U.S. are not as highly regulated as U.S. banks are, and so they can operate with narrower margins than U.S. banks require. Thus, they may be able to pay higher interest rates. Eurodollar deposits are generally in the millions of dollars and mature in less than 6 months. Thus, smaller investors can invest in this market only through a money market fund.
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Repurchase Agreements
Repurchase Agreements, or repos, are a form of short-term borrowing. An organization that owns government securities (either a dealer or an investor), usually Treasury bills, can use them to borrow short-term.
The owner of the T-bills sells them to the lender subject to an agreement to repurchase them at an agreed future date and an agreed future, higher, price. The difference is interest.
The purchaser (the lender) has an asset The seller (the borrower) has a liability.
The term of a repurchase agreement is usually one day but may be up to 30 days or more. Since the
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Repurchase Agreements
The term of a repurchase agreement is usually one day but may be up to 30 days or more. Since the purchaser (lender) receives the government securities as collateral for the loan, repos can provide lenders with low risk loan assets. Securities dealers use repos to finance their securities inventories. They typically use one-day repurchase agreements, rolling over the repos from one day to the next. The buyers of repos are usually institutions with short-term funds to invest such as corporations or money market funds.
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Market Efficiency
According to the Efficient Market Hypothesis, financial markets are efficient. The term market efficiency means that market prices of securities consider all knowledge about the market, including public information about the economy, the specific security, and the market the security is traded in. Market efficiency and competition among investors (who are assumed to all have the same knowledge) causes debt and equity issues ultimately to be priced fairly, eliminating the opportunity to add value to a project by financing it with a below-market rate instrument.
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Market Efficiency
This competition in the financial markets, when combined with perfect information on the part of all investors, will ensure that the debt instrument is priced at the market rate. The more market participants there are and the more rapid the release of information is, the more efficient a market should be.
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Market Efficiency
Economists classify efficient markets on the basis of the types of the information that they reflect. They have classified them into three forms of market efficiency: weak, semi-strong, and strong.
1. Weak-form efficiency says that market prices of securities reflect all historical information: price movements and trading volume, and that investors will not be able to beat the market by basing their analysis and strategy solely on past price movements. 2. Semi-strong-form efficiency says that security prices reflect not only historical price and trading volume information but also all other published information.
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Market Efficiency
Economists have classified efficient markets on the basis of the types of the information that they reflect. They have classified them into three forms of market efficiency: weak, semi-strong, and strong (contd).
3. Strong-form efficiency suggests that security prices reflect all possible information, including the private information known only to insiders.
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Sources of Capital for Public Companies

If a publicly-held company requires new capital, it has four sources of the capital:
1. 2. 3. 4. Retained earnings, or internally-generated funds Bond issues Preferred stock issues Equity (common stock) issues.
Bond financing is generally available to a company only after it has issued equity and attained a credit rating from one or more of the rating agencies.
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Sources of Capital for Public Companies

A brand new company planning to come to market for the first time usually relies on retained earnings, bank loans, and venture capital before raising its first equity issue.
If the stock market is weak, many companies will rely on retained earnings or bond issues. If the stock market is strong, more companies will turn to equities.
Debt is generally considered the cheapest source of funds because interest is tax deductible.
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Investment Banks
Investment banks are not banks in the sense that commercial banks are banks. Investment banks are intermediaries that bring together businesses in search of new capital with investors in search of new investments. The investment bank plays a triple role:
It helps its customer to design the deal and the securities It underwrites it or buys the new issue It then markets the issue to the public.
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Investment Banks
The investment bank advises the company on capital structure, interest rates, anticipated investor demand, and in setting the offering price for the securities. The investment bank, along with attorneys and accountants, also assists the company with the preparation of the SEC registration statement.
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SEC Registration Statement

The SEC registration statement is a lengthy document that describes the proposed stock financing and how the proceeds will be used. The statement includes the following information:
the companys history its present business, including information about its management, executive and director compensation its audited financial statements its plans for the future
The registration statement is required unless the offering is an IPO and it qualifies for exemption.
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SEC Registration Statement

Examples of the exemptions to the registration requirement include:
Regulation D of the Securities Act of 1933 grants an issue exemption from SEC registration if the securities are to be sold exclusively intrastate (within one state). SEC Rule 144 permits sale of restricted securities without registration under the 1934 Securities and Exchange Act if the purchasers of the stock are exclusively affiliated persons who acquire the stock in a private transaction.
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SEC Review of the Registration Statement

The SEC has 20 days to review the registration statement after it is filed. The SEC may take the following actions as part of the review process:
If the SEC does nothing, the registration statement is approved as submitted. If there are substantial deficiencies in the registration statement, the SEC will issue a letter of deficiency, which identifies the problems and explains how to correct them.
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SEC Review of the Registration Statement

The SEC may take the following actions as part of the review process (contd):
The SEC may tell the company to withdraw its offering if the registration statement has many problems. This is a bedbug letter, and is very rare.
It is sent only if the filing is so deficient that the SEC would have to spend too much time to identify the problems and tell the issuer how to correct them.
The SEC may initiate stop order proceedings if the registration statement contains untrue statements of material fact, omits material facts required, fails to provide required current and historical financial information, or has other major problems.
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Company Activities during the SEC Review

After the registration statement has been filed with the SEC, while it is awaiting approval by the SEC, four activities take place:
1. The important sections of the registration statement are used to develop the prospectus. The prospectus cannot be distributed until the registration statement is approved by the SEC. However, a preliminary prospectus, called a red-herring prospectus, may be distributed while awaiting SEC approval. 2. A tombstone ad may be published. A tombstone ad is an advertisement, usually placed in a business periodical, announcing the offering and its dollar amount
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Company Activities during the SEC Review

After the registration statement has been filed with the SEC, while it is awaiting approval by the SEC, four activities take place (contd):
3. After SEC approval of the registration statement, the final prospectus is sent to potential investors. 4. A road show may be arranged. A road show involves the investment bankers and company representatives making a sales presentation to potential investors.
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Important Dates for Dividend Payments

There are four dates in a companys process of paying a dividend.
1. The declaration date: corporation directors approve the payment of a dividend. The company makes a journal entry in its accounting records recognizing the liability on the declaration date as it is now a liability to the company. 2. The date of record: determines which shareholders are eligible for the dividend and which are not. 3. The ex-dividend date: company records are updated to reflect change in owners for shareholders who buy or sell shares in the days preceding the date of record. 4. The payment date: dividend is paid to the shareholder.
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Stock Dividends and Stock Splits

In a stock dividend the company issues shares instead of cash as a dividend.
This is a good method for providing a return to their shareholders without distributing cash.
A stock dividend may be used by a new company that is trying to conserve its cash for growth, but also wants to provide a continuing return to shareholders. As a result of a stock dividend, the company has
lower earnings per share (calculated as income divided by the number of shares outstanding) a lower book value per share.
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Stock Dividends and Stock Splits

A stock split is similar to a stock dividend in that it involves the issuance of new shares without the receipt of additional cash. In a stock split, each share is split into a greater number for example, in a 2-for-1 split, each original share results in 2 shares (1 additional) after the split.
Since the value of the company is unchanged, a proportional decrease in stock price results. The par value of the share is reduced.
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Dividend Reinvestment Programs

A dividend reinvestment program (DRIP) is when cash dividends received by the shareholder are automatically used to purchase more shares of the company. Benefits for the company are:
The company provides the program with very little cost as it is a one-time purchase of shares for all of the shareholders and thus any fees, charges or commissions can be divided amongst all of the shareholders. Additionally for the company it is essentially a nondividend since the money that was to be paid as the dividend is returned to the company through the purchase of shares.
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Treasury Stock
Treasury stock is shares of a company that have been sold to other parties and then repurchased by the company. The company has become a holder of its own shares and may either retire these shares or hold them for sale at a later time. Note: Treasury shares do not receive dividends, do not get to vote and are not classified as outstanding. Treasury shares are issued, but are not outstanding. If they are later resold or reissued, those shares will again become issued and outstanding.
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Treasury Stock
A company may repurchase treasury shares for a number of reasons. Among them are:
temporarily provide a market for its shares reconsolidate ownership, As an investment if the company thinks its shares are undervalued use the shares for a stock dividend, to re-sell them, or to reissue them as share-based payment.
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Leasing
Leasing is an alternative form of financing for a business. A lease is a contractual agreement between a lessor and a lessee that gives the lessee the right to use specific property, owned by the lessor, for a specified period of time in return for stipulated, periodic, cash payments (rents). An essential element of the lease agreement is that the lessor conveys less than the total interest in the property. The lessor is the owner of the property. The lessee is the one using the property and making payments in exchange for the right to use it.
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Leasing
The advantages of leasing are:
Convenience of short-term leases 100% financing at fixed rates. Protection against obsolescence. Flexibility. Depreciation tax shields can be used. Alternative Minimum Tax problems. Off-Balance-Sheet-Financing. A means to avoid budgetary constraints. Tax deductibility. A means to avoid loan restrictions. An advantage in the event of bankruptcy.
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Leasing
There are some disadvantages to leasing:
Cost. Loss of depreciation, other deductions and salvage value. Lack of flexibility if the lease is noncancelable.
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Business Combinations
There are four common types of business combinations:
1. 2. 3. 4. Merger Consolidation Acquisition of common stock Acquisition of assets.
Eight common good reasons for business combinations include:

1. 2. 3. 4. Economies of scale Complementary resources Use of surplus funds Sales enhancement
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Business Combinations
Eight common good reasons for business combinations include (contd):
5. 6. 7. 8. Management improvements Communication to the market Tax reasons Financial leverage
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Mergers
A merger is executed under the provisions of applicable state laws. The boards of directors of the companies involved approve a plan for the exchange of voting common stock (and possibly some preferred stock, cash, or long-term debt) of one of the corporations (the survivor) for all the outstanding voting common stock of the other corporation(s).
Stockholders of all the companies must approve the terms of the merger.
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Mergers
In exchange for the outstanding voting common stock of the other company, the survivor issues its common stock to their stockholders at an agreedupon exchange rate.
After the exchange, all the other corporations are dissolved and liquidated; they cease to exist as legal entities
The survivor does not own the outstanding common stock of the liquidated corporations, because that stock no longer exists.
Instead the survivor owns the net assets of the liquidated corporations (their assets and their liabilities).
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Mergers
There are five common types of mergers:
1. Mergers that take place between or among firms in the same line of business are called horizontal mergers 2. When companies who are at different stages of production and distribution of a product merge, it is a vertical merger. A vertical merger can be a forward or backward vertical merger. 3. In a forward vertical merger, the acquiring company expands forward toward the ultimate consumer. It may purchase a company that supplies it with a distribution network for its products, i.e., it acquires a company that it sells to.
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Mergers
There are five common types of mergers (contd):
4. In a backward vertical merger, the acquiring company expands backward toward the source of its raw materials. For instances, a soft drink company might purchase a sugar manufacturer. 5. A conglomerate merger takes place when the companies involved are in unrelated lines of business.
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Consolidations
A consolidation is executed as per state laws. In a consolidation a new corporation is formed to issue its stock for the outstanding stock of two or more existing corporations (which then are dissolved). The new corporation acquires the net assets of the former corporations, whose activities may be continued as divisions of the new corporation, or they may be divested by the new corporation.
The boards of directors of the companies involved work out the terms of the consolidation. Stockholders of all the companies must approve the terms in accordance with their corporate bylaws and state laws.
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Consolidations
The shareholders of the former companies own the stock of the new company and the new company owns the net assets of all the former companies.
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Common Stock Acquisitions

Most hostile takeovers are accomplished by means of an acquisition of common stock.
One corporation (the investor) offers to purchase from the present stockholders a controlling interest in the voting common stock of another corporation (the investee). If the target corporation is a closely-held corporation, the acquisition takes place through negotiations with the principal stockholders. If the target corporation is publicly held, the stock acquisition takes place through direct purchase in the stock market or through a tender offer to its stockholders.
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Common Stock Acquisitions

If the tender offer results in another companys acquiring a controlling interest in the targets voting common stock, the target becomes affiliated with the acquiring company as a subsidiary, but it is not dissolved or liquidated and it remains a separate legal entity.
The investor corporation owns a controlling interest in the common stock of what becomes a partially or whollyowned subsidiary.
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Asset Acquisitions
A buyer may acquire from an enterprise all or part of either the gross assets or the net assets of the other enterprise In an acquisition of assets, the buyer does not acquire any of the selling corporations common stock. Unlike the other forms of business combinations, where the surviving corporation acquires responsibility for all of the liabilities known and unknown of the acquired corporation, the buyer in an acquisition of assets can determine which liabilities of the seller it will assume.
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Asset Acquisitions
Which liabilities will be assumed by the buyer and which will stay with the seller are part of the negotiation and the terms of the acquisition agreement. The selling enterprise may continue its existence as a separate entity (minus the assets or net assets sold), or it may be liquidated by its seller following the sale. It does not become an affiliate of the acquiring company.
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Proxy Contest
A proxy is a form that a shareholder uses to give his or her voting rights to another person.
Most votes are cast by proxy at annual meetings, because few shareholders attend. Proxies are solicited by the company prior to the annual meeting.
If shareholders are satisfied with the company management, they usually sign their proxies in favor of management and allow the company management to vote their shares.
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Proxy Contest
One means of taking over a company without negotiations is called a proxy contest, or proxy fight.
In a proxy contest, the potential acquirer seeks the support of shareholders at an annual meeting. This is an alternative to making a tender offer in a hostile takeover. An outside group that seeks to take control of a company through a proxy contest is required to register its proxy statement with the SEC so that information it presents will not be misleading or false.
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Pre-offer Defenses against Takeovers

Eleven common pre-offer company defenses against hostile takeovers include:
1. 2. 3. 4. 5. 6. 7. 8. Staggered election of board members Changing the state of incorporation Supermajority merger approval provisions Fair merger price provision Golden parachutes Poison pills Poison put Restricted voting rights
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Pre-offer Defenses against Takeovers

Eleven common pre-offer company defenses against hostile takeovers include (contd):
9. Flip-over rights 10. Flip-in rights 11. ESOPs (employee stock ownership plans)
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Post-Offer Defenses against Takeovers

Eight common post-offer company defenses against hostile takeovers include:
1. 2. 3. 4. 5. 6. 7. 8. Issuing stock Pacman defense (or reverse tender) White knight defense Leveraged recapitalization or restructuring Crown jewel transfer Going private Litigation Asset restructuring
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Corporate Divestitures
Corporate restructurings include not only mergers. Sometimes in order to create value for shareholders, a company will divest part of the company or even liquidate entirely. There are various methods by which a company may accomplish a divestiture. The five common forms of divestitures are:
1. 2. 3. 4. 5. Voluntary corporate liquidations Partial sell-off of assets Corporate spin-offs Equity carve-outs Tracking stock
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Voluntary Corporate Liquidations

Financial distress is not the only reason a corporate liquidation may occur. A voluntary corporate liquidation can occur because the firms assets are more valuable to shareholders in liquidation than the present value of the expected cash flows from those assets. If a liquidated firm has debt outstanding, it must be paid off at face value. If the market value of the debt is below face value, this means that bond holders will gain from the liquidation, although it will be at the expense of the shareholders who will then receive less.
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Partial Sell-off of Assets

An asset sale is the sale of part of a company to another company.
If the sale of part of the company, such as a business unit, results in a positive net present value to the company when compared with the present value of the expected cash flows from continuing the operation, then it is better that it be sold. Payment is usually received as cash or securities.
Usually asset sales enhance shareholder value, for both the purchasing firm and the selling firm.
The productivity of the sold assets increases after the sale, possibly because the assets are transferred to a company that can manage them better.
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Spin-Off
A spin-off is similar to a partial sell-off. The business unit is not sold for cash or securities. Instead, common stock in the spun-off segment is distributed to shareholders on a pro rata basis.
The segment becomes a completely separate company.
If the shareholders in the parent company receive at least 80% of the new company shares, they have no tax liability at the time of the spin-off.
Their basis in their original stock is divided on a pro rata basis between the two securities and any gain or loss is reported only when each of the separate securities is sold.
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Spin-Off
However, if less than 80% of the stock is distributed, the value of the distribution is taxed as a dividend. A spin-off gives investors the opportunity to invest in just one part of the business.
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Equity Carve-outs
Equity carve-outs involve the divestiture of a part of the company, as do spin-offs. The difference is that the shares in the new company are not given to existing shareholders of the parent but rather are sold in an initial public offering. The parent company usually sells only part of the stock in the carved-out new company while retaining majority control. The equity carveout is a form of equity financing.
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Equity Carve-outs
Shareholders of the carved-out company have claims only on cash flows and assets of the carvedout company, not on those of the parent company. Information about the business and financial conditions of the carved-out subsidiary is more easily available to investors, which may allow its value to be more accurately assessed by the market. After a carve-out, a parent company may later spin off the remaining shares of the subsidiary that it is holding.
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Tracking Stock
Instead of a spin-off or a carve-out, a company may issue tracking stock, tied to the performance of a particular company division. This does not involve a corporate divestiture. It is simply the creation of a new class of common stock. The separate classes of common stock lets the company see the share price for each business segment and structure incentives for each group based on their stocks performance.
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Leveraged Buyout
A leveraged buyout is method of financing the purchase of a company or a segment of a company using very little equity. The main characteristics of a leveraged buyout are:
The purchase is a cash purchase; but a large proportion of the cash offered is financed with large amounts of debt. The company or segment being purchased is the borrower, and its assets are the collateral for the debt that finances the purchase. a company needs to have stable cash flows, little debt, and assets with market values high enough that they can be used as collateral for the borrowings.
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Leveraged Buyout
The leveraged buyout is considered because a company wants to divest itself of a division, and that divisions managers want to take over the ownership. Or it may be that an entire company is purchased in this way.
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Mezzanine Finance
An LBO may be financed with a combination of senior debt and junior subordinated debt.
The senior debt is secured by all the assets of the company and may be provided through a large commercial bank, complete with a loan agreement containing protective covenants and other restrictions.
The junior subordinated portion of the debt is another loan, unsecured and with a much higher interest rate and possibly other provisions such as stock warrants. It is called mezzanine financing, because it is in between the senior debt and the equity in priority.
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Voluntary Settlements
Voluntary settlements are work-outs. The debtor works with the creditors to get concessions in an attempt to avoid bankruptcy proceedings. It is in the creditors interests to avoid a bankruptcy, as well as in the debtors interests, because the creditors may end up getting more than they would if the debtor declared bankruptcy.
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There are three forms of voluntary settlements:
1. Extension: creditors postpone the maturities of their obligations. Usually the major creditors form a committee that negotiates with the company. All creditors must agree. 2. The creditors may also agree to accept a composition, i.e., a partial settlement, and write off the uncollectible amounts. The settlement may be in cash or a combination of cash and promissory notes. All creditors must agree. Any creditors who do not agree must be paid in full.
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There are three forms of voluntary settlements:
3. Voluntary liquidation: an orderly liquidation of the company without declaring bankruptcy. It is likely to be more efficient than a liquidation in bankruptcy court and less costly. Therefore creditors probably receive a higher settlement. But all creditors must agree. A company with many creditors would likely not be able to achieve that.
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Bankruptcy
If informal workout efforts are unsuccessful to restructure an insolvent or illiquid company, the next step is a bankruptcy. Two sections of the bankruptcy law deal with business failures:
1. Chapter 7, which deals with liquidation 2. Chapter 11, which deals with the reorganization of the enterprise.
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Bankruptcy
A bankruptcy filing is voluntary or involuntary. When the debtor files the bankruptcy petition, the proceeding is voluntary.
The filing results in an immediate stay preventing creditors from taking further collection action until the court decides whether the petition has merit. The court can either accept the petition or dismiss it.
If the creditors take the initiative, the proceeding is involuntary.

Three or more creditors are required to initiate an involuntary bankruptcy.
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Bankruptcy
If the creditors take the initiative, the proceeding is involuntary (contd):
The total amount of their claims must be a certain minimum amount to initiate bankruptcy. Their petition must give evidence that the debtor is in equitable insolvency, i.e., has not paid its debts when due. The bankruptcy court decides whether the petition has merit.
If the court accepts the petition, it orders a stay of creditor actions pending a more permanent solution. If the court decides the petition does not have merit, it dismisses it.
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Bankruptcy Chapter 7
The primary characteristics of a chapter 7 liquidation bankruptcy are:
Purpose of Chapter 7 is to oversee the firms liquidation. If there is no hope that the company can operate successfully, liquidation is the only possibility. Usually, small firms make use of Chapter 7. The bankruptcy judge appoints an interim trustee, a disinterested private citizen, to meet with the creditors. At the first creditors meeting, the creditors may elect a trustee to replace the appointed interim trustee; or they may keep the court-appointed trustee. The trustee is responsible for selling the company assets and distributing the proceeds to the creditors.
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The priority creditors in a chapter 7 liquidation are (listed below in order of priority of their claims against the bankrupt company):
1. Secured creditors receive the proceeds of the sale of the property pledged to them. If the secured creditors claims are not fully satisfied by the sale of their collateral, the remainder of their claims are treated as unsecured claims. 2. Administrative fees, including trustees fees and attorney fees, incurred in liquidating the property. 3. Creditor claims that arose in the course of the debtors business from the time the case begins until the time a trustee was appointed.
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4. Unpaid wages earned by employees within 90 days of the bankruptcy petition, limited to $4,925 per employee (as of April 2004) 5. Claims for unpaid contributions to employee benefit plans for services rendered within 180 days of the petition up to a maximum of $4,925 per employee. 6. Claims for cash deposits made for goods or services not provided by the debtor, up to a maximum of $2,225 per customer (as of April 2004).
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7. Taxes due 8. Debts to government regulatory agencies such as the Pension Benefit Guarantee Corporation 9. Unsecured claims, either filed on time or, if filed late, filed by creditors who had knowledge of the bankruptcy 10. Unsecured claims filed late by creditors who had knowledge of the bankruptcy 11. Fines and punitive damages
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12. Interest accrued on claims after the date the petition was filed 13. Subordinated debt holders 14. Claims of preferred shareholders, up to the par value of the issue 15. Claims of common shareholders
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A chapter 11 reorganization is an attempt to rehabilitate the company by changing its capital structure. Equity and limited-income securities are substituted for debt. The primary characteristics of a chapter 11 reorganization are:
Reorganizations are started like liquidations. Usually, the debtor continues to operate the business, but a trustee may be appointed to assume that responsibility. To enable the debtor to obtain new financing, post-petition creditors are given priority over pre-petition creditors if the bankruptcy should proceed to liquidation.
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The primary characteristics of a chapter 11 reorganization are (contd):
A reorganization plan must be drawn up and filed with the court within 120 days. Reorganization plans must be approved by creditors and stockholders. The plan should be fair, equitable, and feasible to all parties. Once the bankruptcy court confirms the plan, the terms are binding for the debtor and all claimholders, even dissenting claimholders.
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Direct Foreign Investment

Direct foreign investment (DFI) involves investment by a multinational corporation in real assets (land, buildings, or plants and equipment) in foreign countries and managing those assets by the company directly.
It represents capital movement from one country to another.
Direct foreign investment includes:

joint ventures with foreign firms the acquisition of foreign firms establishing new foreign subsidiaries.
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Foreign Direct Investment - Benefits

Benefits of direct foreign investment include:
New sources of demand Opportunity to enter profitable markets Monopolistic advantages Reaction to trade restrictions International diversification Economies of scale Availability of lower cost foreign factors of production Availability of lower cost foreign raw materials Availability of foreign technology Opportunity to take advantage of exchange rate movements
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Foreign Direct Investment - Benefits

Benefits of direct foreign investment include (contd):
Offset exchange rate fluctuations Decrease demand fluctuations caused by exchange rate fluctuations Interest rates in another country may be more favorable
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Foreign Direct Investment - Risks

The risks of direct foreign investment include:
Political and cultural risks:
risk of government expropriation blockage of fund transfers inconvertible currency government bureaucracy, regulations and taxes corruption (such as bribery) attitude of consumers in host country-preferring local products a lack of understanding of the business culture in the host country.
Financial risks:
the state of the host countrys economy exchange rate fluctuation causing fluctuations in reported financial results and possibly endangering debt covenants.
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FDI Measuring Returns

The coefficient of correlation measures the amount of correlation in the returns of any two investment projects. This approach applies to international projects as well. When the projects returns are not highly correlated (do not move in the same direction at the same time), the portfolio of projects is diversified and risk is reduced.
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FDI Measuring Returns

The value of the correlation coefficient is always between "1 and +1.
A correlation coefficient of +1 means that the two projects returns have in the past always moved together, in the same direction and to the same extent. A correlation coefficient of "1 means that the two projects returns have in the past always moved in exactly opposite directions. A correlation coefficient of 0 means that there has been no historical relationship between the returns of the two projects.
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FDI Measuring Expected Variance

To calculate the expected variance of a portfolio of two international projects, you must know:
The weights (w) of Projects A and B in the portfolio (they must total to 1.00 or 100%) The variances ( 2 ) of Projects A and B. Since the variance is the square of the standard deviation, if you have the standard deviations of A and B, you can square them to get their variances. The standard deviations ( ) of Projects A and B. If you have the variances of A and B, you can take their square roots to get their standard deviations. The correlation coefficient between Projects A and B.
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FDI Measuring Expected Variance

The formula to calculate the expected variance of a two project portfolio involving an international investment is therefore:
E( ) =
2 p
w
2 A
2 + A
w
2 B
2 + 2w r w A B A B B

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FDI Expected Return

The expected return of a portfolio of international projects is the weighted average of the expected returns of the projects held in the portfolio. The weights are each projects proportion, or percentage, of the total portfolio.
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Determining Foreign Currency Rates

The ways in which currency exchange rates are established are:
Floating: Currencies are bought and sold freely without government intervention. The price of each currency is determined solely by supply and demand in the market. Fixed: The exchange rate for a particular currency is fixed by the countrys government, and it will buy and sell its reserves as necessary to maintain this rate.
Under the gold standard the currency is backed by gold. This is a type of fixed exchange rate, but it is no longer used by any country.
Managed float: combination of floating and fixed, the government allows the market to determine the currency price, but it intervenes if/when necessary to prevent excessive fluctuations in the rate.
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Floating exchange rates are determined by the supply and demand for currencies:
Short term: relative interest rates between two countries. An increase in the interest rate in Country A will cause that currency to appreciate against Country Bs currency because it will be demanded as an investment by more people. Medium term: the economies of the two countries. A recession in one country causes its population to spend less on imports and therefore to demand less of the foreign currency needed. The reverse is true when a countrys economy is expanding.
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Floating exchange rates are determined by the supply and demand for currencies (contd):
Long term:- relative price level changes. According to the Purchasing Power Parity Theory, the exchange rates will adjust until the prices are the same for all goods in all countries.
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The following six items are key points to understand the floating exchange rate system:
1. The exchange rate is the price of one currency stated in terms of another currency. 2. If the dollar appreciates, import prices fall in the USA and prices for US exports rise. 3. When the dollar depreciates, import prices rise in the USA and export prices fall. 4. Demand for dollars by foreigners reflects demand for US products and investments.
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The following six items are key points to understand the floating exchange rate system (contd):
5. The supply of dollars to foreigners by US citizens reflects US demand for foreign goods, services, and foreign investments. 6. At the equilibrium exchange rate, the dollars purchased equal those sold. The dollar value of goods and services bought by foreigners and sold by U.S. citizens will be equal.
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Fixed Rate Impact on Foreign Trade

Under fixed exchange rates, a government buys and sells its own currency in order to maintain a certain exchange rate against other currencies.
To do this, the government accumulates large holdings of other nations currencies to use them as needed to buy its own currency so as to maintain its currencys value. It sells its own currency to buy other currencies when necessary to bring the price of its own currency down.
As a result, the demand for and the supply of the currency in the market no longer have to be equal since the government makes up any differences from its reserves of currencies.
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Fixed Rate Impact on Foreign Trade

When the exchange rate is fixed above the equilibrium rate, the government will face a deficit in its balance of payments, because its exports will be too expensive to foreigners, but its citizens can buy a large quantity of imports. The opposite is the case when the fixed exchange rate is below the equilibrium rate.
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Fixed Exchange Rate Systems

Three key points to the fixed exchange rate system are:
1. The government buys and sells its own currency at a fixed rate that it determines. 2. An overvalued currency is one whose exchange rate is held above the free market.
If a government overvalues its currency, it has a balance-ofpayments deficit. It must run down its reserves of foreign currency to maintain the exchange rate. If its reserves run out, it must devalue its currency by lowering the exchange rate.
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Fixed Exchange Rate Systems

Three key points to the fixed exchange rate system are (contd):
3. An undervalued currency occurs if the fixed exchange rate is below free market value.
In this case the government will have a balance of payments surplus. It must accumulate foreign currency reserves. Currency revaluation (increasing the exchange rate) may be needed to avoid having excess foreign currency reserves.
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Determining Foreign Exchange Cross Rates

Exchange rate quotations are usually quoted relative to the U.S. dollar. If a German company wants to buy Japanese yen, it may need to determine the cross rate using the U.S. Dollar. The foreign exchange cross rate is the currency exchange rate between any two currencies when neither of the currencies is the official currency of the country in which the rates are quoted. In the U.S., the exchange rate between the euro and the British pound sterling is a cross rate,
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Determining Foreign Exchange Cross Rates

To calculate a cross rate, divide one cross rate by the other cross rate.
Note that this works only when both of the cross currencies are quoted the same way with the same third currency. If one or both of the quotes are reversed (1 unit of one of the cross currencies is equal to X units of the third currency), dividing one exchange rate by the other will not result in the correct answer. In this case we need to reverse one or both of the quotes so that the value of the currency that both of the other currencies are quoted in is equal to 1.
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Foreign Exchange Management

There are several methods to management foreign exchange issues:
Natural Hedges: Strategic decisions affecting markets served, pricing, operations or sources, because when a subsidiarys cash flows will adjust naturally to currency exchange rate fluctuations, this can act as a natural hedge. Operational Hedges (Balancing Monetary Items): maintaining a balance between payables and receivables denominated in a foreign currency neutralizes the effect of exchange rate fluctuations.
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Foreign Exchange Management

There are several methods to management foreign exchange issues (contd):
International Financing Hedges: borrowing in a foreign currency to offset a net receivables position in that currency. Or, a company with a foreign subsidiary can borrow in the country where the subsidiary is located in order to offset its exposure. Currency Market Hedges: forward contracts, futures contracts, and currency options.
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Currency Swaps
A currency swap is a variation of an interest rate swap. With an interest rate swap, only interest payments are exchanged, because the principal is the same for both parties. In a currency swap, principal payments are exchanged too. The principal and interest are in different currencies. A floating-to-floating currency swap will have interest payments in floating rates for both parties, but in different currencies.
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Currency Swaps
In a fixed-to-floating currency swap, one stream of interest payments will be in currency X and at a fixed rate, while the other stream will be in currency Y and at a floating rate. Currency swaps can be liability swaps or asset swaps.
A liability swap is the exchange of interest and principal payments on one liability for interest and principal payments on another liability. An asset swap is the exchange of interest and principal receipts on one asset for interest and principal receipts on another asset.
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Spot and Forward Exchange Rates

In currency markets, the spot rate is the current exchange rate that is used in transactions that are completed at that point in time. Currency for immediate delivery is traded in the spot market. The forward rate is the rate used for transactions that will be completed at a future date (meaning that the monies will be exchanged in the future). Forward contracts are negotiated in the forward market, and commercial banks generally act as counterparties to forward contracts for their customers who desire them.
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A forward contract occurs between two parties:
1. one agreeing to buy the currency 2. one agreeing to sell the currency
The contract specifies the amount of the particular currency that will be purchased/sold at a specified future date and at a specified exchange rate. Forward trades involve the purchase and sale of a currency for future delivery on the basis of exchange rates that are agreed to today. A foreign currency is selling at a forward discount if its forward price in USD is lower than its spot price.
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If the foreign currencys forward price in USD is greater than its spot price, it is selling at a forward premium. The forward rate is not a predictor of the future spot rate. The forward rate for a currency transaction to take place 30 days in the future is not going to be exactly the same as the spot rate will be 30 days in the future. Nor will it be what currency traders expect the spot rate to be in 30 days.
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Effective Int Rate: Foreign Currency Loan

The effective financing rate on a foreign currency loan can be calculated using the following formula. rf = (1 + if) (1 + ef) 1 Where:
rf = if = ef =
The effective financing rate The interest rate of the foreign currency loan The percentage change in the foreign currency unit against the U.S. dollar
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Financing International Trade

Seven common methods of financing international trade transactions include:
1. 2. 3. 4. 5. 6. 7. Accounts receivable (AR) financing, Cross-border factoring, Letters of credit, Bankers acceptances, Working capital financing, Forfaiting (medium-term capital goods financing) Countertrade
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Financing Intl Trade: AR Financing

If an exporter agrees to ship goods to an importer without payment assurance such as a letter of credit, then the exporter ships under an open account or with a sight draft. Either way, the exporter is relying on the importer to make payment
essentially extending credit.
After extending credit, the exporter may need the funds immediately. In this case, the exporter gets financing from a bank. This is called accounts receivable financing.
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Financing Intl Trade: AR Financing

The bank makes a short-term loan to the exporter, usually from one to six months, secured by an assignment of the account receivable.
The bank makes its loan decision on the basis of the exporters creditworthiness and is looking to the exporter as the primary source of repayment. If the importer fails to pay the receivable, the exporter is still obligated to repay the loan principal as well as interest that accrues until it is paid in full.
Because of the added risk in a foreign receivable, export credit insurance is usually required by the bank and the exporter.
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Financing Intl Trade: Factoring

Factoring involves selling a receivable to a third party, or a factor. The exporter can eliminate the risk of the receivable not being paid by the importer if it sells the receivable without recourse. Since the foreign importer is the source of the factors repayment, cross-border factoring is often used. The exporters factor works with a correspondent factor in the buyers country, and the correspondent factor determines the importers creditworthiness and handles the collection of the receivable from the buyer.
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Financing Intl Trade: Factoring

Factors generally provide 70% of the face value within 3-5 working days. After final payment is received from the buyer, the factor will pay the remaining 30% to the exporter, less the service fee of 4% to 5%. Factors often use export credit insurance because of the risk of the foreign receivable
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Financing Intl Trade: Letters of Credit

A commercial letter of credit is a guarantee by the buyers bank that the bank will pay for the merchandise, provided that the seller (exporter) can provide the required documents in accordance with the terms of the commercial letter of credit. The required documents are generally bills of lading and freight documents evidencing shipment of the goods. The seller is assured of payment when the conditions of the letter of credit are met; and the buyer is assured of receiving the goods ordered.
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However, if any of the documents are not exactly right, the buyer can reject the shipment, or the bank may refuse to make payment. The buyer has the disadvantage of having their bank tie up their account or their credit line from the date the letter of credit is accepted until it is either paid, rejected, expires, or is cancelled.
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A standby letter of credit is a guarantee by the buyers bank saying that if the buyer fails to pay, the bank will pay. It is not usually used as the primary payment method. The terms of a standby letter of credit are somewhat simpler and easier for the seller to comply with than the terms of a commercial letter of credit.
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Financing Intl Trade: Drafts

A draft is a written order by one party (seller), directing a second party (buyer) to make payment to a third party (buyers bank). Drafts facilitate international payments through intermediaries such as banks, but the intermediary banks do not guarantee performance by either party.
The buyer pays a sight draft as soon as he sees it. The exporter gets paid when shipment is made and the draft is presented to the buyer for payment. The buyers bank does not release the shipping documents to the buyer until the buyer has made payment. The buyer claims the shipment only with the documents.
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Financing Intl Trade: Drafts

Payment for a time draft is demanded at a specified time after the buyer accepts the draft and receives the goods.
The exporter instructs the buyers bank to release the shipping documents when the buyer accepts the draft. The buyer writes accepted on the draft and is then contractually liable to pay. The accepted draft, called a trade acceptance, is the buyers promise to pay the seller at a specified future date. If the buyer does not pay the draft on its maturity date, the bank does not have any obligation to pay. In addition, the buyer can delay payment by delaying acceptance of the draft.
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Financing Intl Trade: Bankers Acceptance

A bankers acceptance is a time draft that has been issued under a letter of credit and has been accepted by the importers bank.
The draft represents the exporters demand for payment. The time period is usually from 30 to 180 days.
When the importers bank accepts the time draft, a bankers acceptance is created. The bank that has accepted the draft is obligated to pay the amount of the draft to the holder of the draft on the maturity date.
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Financing Intl Trade: Bankers Acceptance

If the exporter does not want to wait for payment, the exporter may sell the bankers acceptance in the money market. The buyer of the bankers acceptance will receive the banks payment on the maturity date. Thus, trade financing for the exporter is provided by the holder of the bankers acceptance.
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Financing Intl Trade: Working Capital Fin

Both importers and exporters may make use of working capital financing.
For the importer, the loan finances the working capital cycle that includes purchase of inventory, sale of the inventory and creation of an account receivable, and finally conversion of the receivable to cash. For the exporter, the loan might finance the manufacture of the goods that are to be exported, or it may finance the period from when the sale is made until payment is received.
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Financing Intl Trade: Forfaiting

Forfaiting is the financing of medium-term capital goods sold internationally. Forfaiting refers to the purchase of financial obligations such as bills of exchange, without recourse to the exporter.
The importer issues a promissory note in favor of the exporter for a period of three to seven years. The exporter then sells the note, without recourse, to the forfaiting bank.
Forfaiting is similar to factoring in that:

The forfaiter must collect from the buyer/importer. The forfaiting bank assesses the creditworthiness of the importer because it is extending to the importer a mediumterm loan.
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Financing Intl Trade: Countertrade

Countertrade or barter may be used if:
the buyer does not have access to currency conversion if exchange rates are unfavorable if the two parties can exchange goods or services on a mutually satisfactory basis.
Types of countertrade are:

Barter - The exchange of goods or services between two parties without the use of any currency as a medium of exchange. Counterpurchase - The seller gets paid the regular amount, and agrees to purchase goods worth the same amount from the buyer.
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Financing Intl Trade: Countertrade

Types of countertrade are (contd):
Compensation deals - The sale is paid partially in cash and partially in goods, or it may be paid 100% in goods. Buy-back - The seller agrees to supply technology, equipment or raw materials that will enable the recipient to produce goods.
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Transfer Pricing
The transfer price is the price that is charged by one unit of the company to another unit of the same company for the services or goods produced by the first unit and sold to the second unit. They are used by profit and investment centers in order to calculate the costs of services received from service departments and revenues when selling a product to another department when that product has an outside market.
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Transfer Pricing
A transfer pricing system must accomplish the following:
It must give senior management the information it needs to evaluate the performance of the profit centers. It must motivate the profit center managers to pursue their own profit goals while also working toward the success of the company as a whole. It must encourage the cost center managers efficiency while maintaining their autonomy as profit centers. It must be equitable, permitting each unit of a company to earn a fair profit for the functions it performs. It must meet legal and external reporting requirements. It should be easy to apply.
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Transfer Pricing
The common transfer pricing methods are:
Market price Cost of production plus opportunity cost Variable cost Full cost Cost plus Negotiation Arbitrary pricing
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Transfer Pricing
The transfer price is set as the current price of the selling divisions product in an arms-length transaction. When there is an external market for the product, this is almost always the best transfer price to use for profitability and performance measurement, because it is objective.
It satisfies the arms length requirement by taxing authorities. Furthermore, it satisfies the management of the buying company that they are paying a fair price for the goods and the management of the selling company that they are receiving a fair price for the goods.
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Transfer Pricing
However, pure arms-length market based pricing may be difficult to implement:
sometimes there is no external market and thus a market price is not available. each transfer of product entails an element of profit and loss. It may be difficult to determine the actual cost of the final product. intra-company profit must be eliminated from inventories when consolidated financial statements and the income tax return are prepared.
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Transfer Pricing
The cost of production plus opportunity cost transfer pricing method is a calculation that includes not only the cost of production (called outlay cost), but also the contribution margin that the selling department is giving up by selling the product internally rather than externally. Though this approximates a market price, it is not exactly a market price because a true market price may only be set in an arms length transaction, which this is not.
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Transfer Pricing
The variable cost transfer pricing method uses the selling divisions variable costs only.
This works well of the selling division has excess capacity and when the main objective of the transfer price is simply to satisfy the internal demand for goods. It is not appropriate if the seller is a profit or investment unit because it will decrease the sellers profitability.
Therefore, when the selling division does not have excess capacity, the selling division will prefer to sell to an outside customer. However, a transfer price equal to variable cost does encourage the buying division to buy the item internally.
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Transfer Pricing
The full cost transfer pricing method includes all materials, labor and a full allocation of overhead. It is the full cost of production and is calculated using absorption costing. The advantages of using full cost are:
it is well understood the cost information is easily available in the accounting records there is no need to eliminate intracompany profits from inventories in consolidated financial statements
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Transfer Pricing
The disadvantages of using full cost are that it can result in poor decision-making.
The transfer price may be higher than a third party price. The buying department might prefer to go outside. However the external price may be more than the selling departments variable cost. Since the fixed cost will be the same whether the part is manufactured internally or purchased outside, the consolidated profit of the firm will be lower if the purchasing department buys the item outside.
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Transfer Pricing
Under the cost plus transfer pricing method we add some fixed dollar amount or a percentage of costs to the cost of production to approximate a normal profit markup.
It can be used when a market price is not available.
This method may use either standard costs or actual costs:

If standard costs are used, then there will be an opportunity to separate out variances.
322
Transfer Pricing
This method may use either standard costs or actual costs (contd):
If actual costs are used:
there is no motivation for the manager of the producing and selling department to control the departments costs, because whatever costs are incurred will be passed on to the next department. if the profit markup is a percentage of cost, it actually gives the selling department an incentive to inflate the cost through production inefficiencies and excessive allocation of common costs.
323
Transfer Pricing
In order for the negotiation transfer pricing method to work, each department must be able to determine the amount of its materials that it buys or the amount of its output that it sells. This method is the most useful when the products in a market are rapidly changing and the companies need to react quickly to changes in the market place. It is also helpful if the units have a conflict: Negotiation can bring a resolution. However, in order to be effective, neither negotiating party should have an unfair bargaining position.
324
Transfer Pricing
A drawback is that negotiation can be timeconsuming and require frequent revision of prices because of changing costs and market conditions.
Time required for negotiating diverts the attention of division managers away from more productive activities that would benefit the company, to activities that benefit the division.
325
Transfer Pricing
In the arbitrary pricing method of transfer pricing the transfer prices may simply be set by central management to achieve tax minimization or some other overall objective.
The advantage to this method is that the price achieves the objectives that central management considers most important. The disadvantages far outweigh the advantages, however, because this method defeats the goal of making divisional managers profit conscious. It hampers their autonomy as well as their profit incentive.
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2010 CMA Part 2 Section B: Corporate Finance

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2010 CMA Part 2 Section B