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CORPORATE FINANCE

MANAGEMENT 2
Master Course VFS
Fall 2013
Doc. Ing. Irena Jindichovsk, CSc.
irena.jindrichovska@mail.vsfs.cz

Doc. Irena
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Literature
Brigham, E and Ehrhardt, M (2004) Financial management:
theory and practice, 13th ed., Thomson Learning ISBN-10:
0324259689; ISBN-13: 9780324259681
Other recommended sources:
Brealey, R., Myers, S. and Allen, F. (2006) Corporate Finance,
8th international ed., McGraw-Hill ISBN: 0-07-111795-4
Ross, Westerfield & Jaffe; Fundamentals of Corporate Finance,
4th edition
Bender and Ward: Corporate Financial Strategy, 3rd ed.
Butteworth-Heinemann, 2009
Jindrichovsk I. (2013) Finann management. 1. ed.C.H.Beck
Praha, 320 s., ISBN 978-80-7400-052-2 (in Czech)

More sources may be recommended in lectures. Presentation will be


updated during the course
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Teaching plan
Regular studies:
12 hours lectures
6 hours excercises+ presentation of own
work
Assignment conditions - essay on topic
given M&A case study + active
participation in seminars more details Ing. Kateina Kalinov
Exam: Written exam consisting of short
essays and calculations
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Outline of the course


1. Introduction to Corporate finance management
2. Mergers and acquisitions
3. Cost of capital and capital structure
4. Strategy and tactics of financing decisions investment decision making
5. Capital Restructuring and Multinational Fin.
Management
6. Lease Financing and Working Capital
Management
7.
Management
and
Real
Options
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Finance
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INTRODUCTION TO
CORPORATE FINANCE
MANAGEMENT

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Outline Lecture 1

Introduction
Capital structure
Company lifecycle
Role of financial manager
Financial markets
Agency theory
Stakeholders theory
Summary, exercises, references

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Introduction to
Corporate Finance

Basic questions not only from corporate


finance:

1. What long-term investment strategy


should a company take on?
2. How can cash be raised for the required
investments?
3. How much short-term cash flow does a
company need to pay its bills?
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The Balance-Sheet Model of the


Firm
Current assets

Current liabilities

Net working capital

Long term debt


Fixed assets
Tangible fixed assets
Intangible fixed assets

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Shareholders equity

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Capital Structure
Financing arrangements determine how
the value of the firm is sliced up.
The firm can then determine its capital
structure.
Capital structure changes in the lifetime of
the firm

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Capital Structure
The firm might initially have raised the
cash to invest in its assets by issuing more
debt than equity;
Later again it can consider changing that
mix by issuing more equity and using the
proceeds to buy back some of its debt

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Life Cycle of the company and


its funding
Boston Consulting Group Matrix
Axes
horizontal: speed of growth of the market share
vertical: market share

Start-up
Growth
Maturity
Decline

Each phase requires different approach to financial


management according to generated Cash Flow
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Life Cycle of the company II


Maturity
Low investment need
High CF generated

Growth
High investment need
High CF generated

Decline
Low investment need
Low CF generated

Start up
High investment need
Low CF generated

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Role of the Financial Manager


1. The firm should try to buy assets that
generate more cash than they cost.
2. The firm should sell bonds and stocks
and other financial instruments that raise
more cash than they cost.

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Role of the Financial Manager


The firm must create more cash flow than
it uses.
The cash flows paid to bondholders and
stockholders of the firm should be higher
than the cash flows put into the firm by the
bondholders and stockholders.

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Financial Markets

Primary and secondary markets


Spot and forward markets
Money markets
Equity markets
Organized and over-the-counter markets
LSE, AMEX, NYSE; NASDAQ

Derivative markets
LIFFE, CBOT
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Primary and secondary markets1


Help to get financing for companies
Investment companies
Pool together and manage the money of
many investors
Arrange corporate borrowings and security
issues
Issuing process

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Primary and secondary markets2


Establish the price of securities through
supply and demand
Execute and settle the transaction
Guarantee the settlement through the
Clearing house- a special institution
connected with each Stock Exchange
There is also a securities exchange
commission (SEC ) setting the standards and
rules of listing
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Agency Theory
There are two groups with different interest in
each corporation Shareholders and Managers
Goals of shareholders and managers are not the
same
Jensen and Meckling (1976): Theory of the Firm:
Managerial Behavior,Agency Costs and
Ownership Structure, JFE 1976
Defined Principal Agent relation

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Principal - Agent
Owners i.e. Shareholders are Principals
Managers are Agents
Shareholders want value of their firm to be
maximized
Managers should act on principals behalf
but have different goals
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Management Goals
Survival - avoid risky business decisions
Selfsufficiency prefer internal financing to
issuance of new stock
Shareholders need to control management
Agency Costs
Monitoring costs
Incentive fees to convince management to act in
shareholders interest

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Control methods
Directors are voted by Shareholders and
management is selected by directors
Management compensation methods
Stock option plan
Bonuses
Performance shares

Threat of takeovers
Competition on management labor market
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Stakeholders theory
All interested parties that have some relation to
the company

Shareholders
Employees
Creditors
Banks
Suppliers
Clients
Environment
Municipalities

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Summary
1.

2.

The goal of financial management in a for-profit


business is to make decisions that increase the value
of the stock, or, more generally, increase the market
value of the equity.
Business finance has three main areas of concern:
a. Capital budgeting. What long-term investments should the firm
take?
b. Capital structure. Where will the firm get the long-term financing
to pay for its investments? In other words, what mixture of
debt and equity should we use to fund our operations?
c. Working capital management. How should the firm manage its
everyday financial activities?

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Summary 2
3. The corporate form of organization is superior
to other forms when it comes to raising money
and transferring ownership interests, but it has
the significant disadvantage of double taxation.
4. There is the possibility of conflicts between
stockholders and management in a large
corporation. We call these conflicts agency
problems and discussed how they might be
controlled and reduced.
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Exercise problems

Define and compare the three forms of


organisation a proprietorship, a partnership
and a corporation.
Explain the agency problem and discuss the
relationship between managers and
shareholders
What are the two types of agency costs?
How are managers bonded to shareholders?
Can you recall some managerial goals?
What is the set-of-contracts perspective?
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Useful web source


On Agency theory A review paper
http://classwebs.spea.indiana.edu/kenrich
a/Oxford/Archives/Oxford
%202006/Courses/Governance/Articles/Ei
senhardt%20-%20Agency%20Theory.pdf

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RECOMENDED READINGS
Brigham and Houston: Fundamentals of
Financial Management, 12th ed, Ch 1
Ross, Westerfield & Jaffe; Fundamentals
of Corporate Finance, 4th edition Ch 1
and 2
Bender and Ward: Corporate Financial
Strategy, 3rd ed. Butteworth-Heinemann,
2009, Ch 2
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COST OF CAPITAL AND


CAPITAL STRUCTURE

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Outline

Introduction
Sources of long term financing
Debt versus equity
Long term debt
Preferred shares
Retained earnings
Newly issued shares,
Gordon model, debt plus risk premium, CAPM approach

WACC
Value of a company
Summary, exercises, references
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Equity versus debt


Feature:

Equity

Debt

Income:

Dividends

Interest

Tax
status:

Taxed as personal income.


Are not business expense

Taxed as personal income.


Are business expense

Control:

Common stocks
(sometimes preferred)
usually have voting right

Control is exercised with


loan agreement

Default:

Firms cannot become


Unpaid debt is a liability.
bankrupt for nonpayment of Nonpayment results in
dividends
bankruptcy

Bottom
line:

Tax status favours debt, but default favours equity.


Control features of debt and equity are different but one is
not better than other

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Long term debt


Loans and bonds
Loans (interest is paid before taxes
creation of tax shield, that lowers the cost
of L/T debt); T = tax rate

k d k nom (1 T )

Bonds (yield to maturity)

1 (1 r ) t
M
BC

r
(1 r ) t
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Preferred shares
Perpetuity P = C/r; i.e.
kp= C / P
May need to take in consideration
issuance cost (flotation cost F)
kp= C / (P-F)

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Cost of retained equity


Using Gordon model of growing
perpetuity:
P=D1/ (r-g); i.e.
ks = (D1 / P) + g

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Cost of new equity


Using Gordon model of growing perpetuity
taking in consideration flotation cost:
ke = (D1 / (P-F)) + g

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The CAPM approach


Estimate using the CAPM
Estimate of risk free rate rRF
Estimate the market premium RPM
Estimate the stocks beta coefficient s
Substitute in the CAPM equation:

rs rRF ( RPM ) s
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Bond yield plus risk premium


approach
Some analysts us an ad hoc procedure to
estimate the firms cost of common equity
Adding a judgmental risk premium (3-5%)
rs = bond yield + bond risk premium

It is logical to think that firms with risky, low


rated high-interest-rate debt will also have
risky high-cost equity
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WACC
Weighted average cost of capital one
way of measuring cost of capital of a
company
WACC=wd*kd + wp*kp + ws(e)* ks(e)
Another way may be estimating through
market model (SML) ex-post valuation
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Factors that affect the weighted


average cost of capital
Factors that firm cannot control
The level of interest rates
Market risk premium
Tax rates

Factors the firm can control


Capital structure policy
Dividend policy
Investment policy
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Summary
1.

2.

Earlier chapters on capital budgeting assumed that


projects generate riskless cash flows. The appropriate
discount rate in that case is the riskless interest rate.
Of course, most cash flows from real-world capitalbudgeting projects are risky. This chapter discusses
the discount rate when cash flows are risky.
A firm with excess cash can either pay a dividend or
make a capital expenditure. Because stockholders can
reinvest the dividend in risky financial assets, the
expected return on a capital-budgeting project should
be at least as great as the expected return on a
financial asset of comparable risk.

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Summary 2
3.

4.
5.

The expected return on any asset is dependent upon


its beta. Thus, we showed how to estimate the beta of
a stock. The appropriate procedure employs
regression analysis on historical returns.
We considered the case of a project whose beta risk
was equal to that of the firm.
If the firm is unlevered, the discount rate on the project
is equal to RF+( M - RF)*
where M is the expected return on the market portfolio
and RF is the risk-free rate. In words, the discount rate
on the project is equal to the CAPMs estimate of the
expected return on the

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Exercise questions
1. Describe the various sources of
capital.
2. Describe the optimal capital structure.
3. Explain the concept: weighted average
cost of capital (WACC).
4. Explain how to calculate a value of a firm
using WACC.
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Exercise problem 1
12.13 RWJ
Calculate the weighted average cost of capital
for the Luxury Porcelain Company.
The book value of Luxurys outstanding debt is
$60 million. Currently, the debt is trading at 120
percent of book value and is priced to yield 12
percent. The 5 million outstanding shares of
Luxury stock are selling for $20 per share. The
required return on Luxury stock is 18 percent.
The tax rate is 25 percent.
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Exercise problem 2
12.14 RWJ
First Data Co. has 20 million shares of common
stock outstanding that are currently being sold
for $25 per share. The firms debt is publicly
traded at 95 percent of its face value of $180
million. The cost of debt is 10 percent and the
cost of equity is 20 percent. What is the
weighted average cost of capital for the firm?
Assume the corporate tax rate is 40 percent.
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Useful web sources


Online Tutorial #8: How Do You
Calculate A Company's Cost of
Capital?
http://www.expectationsinvesting.com/tu
torial8.shtml
And a video lecture (rather easy)
http://www.youtube.com/watch?
v=JKJglPkAJ5o
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RECOMENDED READINGS
Fundamentals of Corporate Finance,
Ross, Westerfield and Jaffe, 6 th edition.
Ch 12
Brigham and Houston: Fundamentals of
Financial Management, 12th ed, Ch 10

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MERGERS AND
TAKEOVERS

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Outline

Introduction
Mergers ad acquisition rationale
Underling principles
Business motives for acquisitions
Financial strategy
Price reaction n acquisition announcement
Takeover defense
Summary, exercises, references

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Mergers and Acquisitions


Mature companies try to reverse or accelerate
the life cycle through dynamic changes in the
structure of the business by mergers or
acquisitions
Two businesses combine into one
Mergers are rare Acquisitions
Larger and smaller company acquirer and
target company
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Underlying principles
Combined future CFs are bigger than sum
of CFs of two individual companies
Not in case of large premium paid to
shareholders of the target
(90%-125% of exp. value of the synergy has
been paid to the sellers) - better to be seller
then buyer

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M&As = market
imperfections

Asymmetric price reaction on acquisition


announcement:
Target company is undervalued in the
market (inefficient market)
Participants do not agree on the price of
the target company stock
? Synergy effect (2+2=5)
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Source of synergy from acquisitions


Revenue Enhancement
Marketing Gains
Strategic Benefits
Market or Monopoly Power

Cost Reduction

Economies of Scale
Economies of Vertical Integration
Complementary Resources
Elimination of Inefficient Management

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Source of synergy from


acquisitions 2

Tax Gains

Net Operating Losses


Unused Debt Capacity
Surplus Funds

The Cost of Capital

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Two bad reasons for mergers


Earnings Growth
EPS Game

Diversification
Systematic variability cannot be eliminated by
diversification, so mergers will not eliminate
this risk at all. By contrast, unsystematic risk
can be diversified away through mergers.

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Influence of innovative products


Management may forget the underlying
principles justifying M&A
Target company must be worth more than
it will cost the acquirer

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Cash versus Common Stock


Whether to finance an acquisition by cash or by
shares of stock is an important decision.
The choice depends on several factors, as
follows:
1. Overvaluation. If in the opinion of management
the acquiring firms stock is overvalued, using
shares of stock can be less costly than using
cash.
2. Taxes. Acquisition by cash usually results in a
taxable transaction. Acquisition by exchanging
stock is tax free.
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Cash versus Common Stock 2


3. Sharing Gains. If cash is used to
finance an acquisition, the selling firms
shareholders receive a fixed price. In the
event of a hugely successful merger, they
will not participate in any additional gains.
Of course, if the acquisition is not a
success, the losses will not be shared and
shareholders of the acquiring firm will be
worse off than if stock were used.
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Financial strategy in
acquisitions
Financial role - to evaluate the synergy
effect
Strategy - change the financial structure of
target company leverage the company
Target company with cash surpluses
(mature group) Corporate raider
acquires the company, strips it off the cash
and leverages the company
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Diversified companies
Diversified group should be valued at
minimum weighted average P/E applicable
to its component businesses
If the company does not perform well after
acquisition sell parts of the group for
higher P/E divestiture, spin-offs,

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Greenmailing
Significant minority impacts on the
corporate strategy
Raider buys a significant part of the co.
which he considers undervalued and
greenmails the management, asserting
that the company is badly managed
Management buys him out cash drain
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EPS game
Growth in P/E is automatically created by an
equity funded acquisition if P/E of bidder > P/E
of target
If companies have the same P/E multiple
And financial structure of target company is
changed debt instead of equity
EPS of the group
However, increased growth prospects are offset
by financial risk due to debt
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EPS game
Company A is considering acquiring companies
B, C, and D but it wishes to ensure that each
deal increases EPS. Finance can be raised
through equity or debt or through any other
financial mechanism. After-tax cost of debt =
5%.
PE

G ro u p

P A T A cq * P E

A cq

P A T Tg * P E

Tg

P A T A cq P A T Tg

S h a r e p r ic e P E * E P S

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Acquirer

A no of shares

10 000 000

share price ()

Target

A no of shares

10 000 000

share price ()

A no of shares

10 000 000

share price ()

A no of shares

10 000 000

share price ()

PAT ()

1 000 000

PAT ()

1 000 000

PAT ()

1 000 000

PAT ()

1 000 000

EPS ()

0,1

EPS ()

0,1

EPS ()

0,1

EPS ()

0,1

P/E

10

P/E

10

P/E

10

P/E

10

B no of shares

5 000 000

share price ()

C no of shares
share price ()

10 000 000
0,5

D no of shares
share price ()

1 000 000
5,0

D no of shares

1 000 000

share price ()

5,0

PAT ()

1 000 000

PAT ()

500 000

PAT ()

250 000

PAT ()

250 000

EPS ()

0,2

EPS ()

0,05

EPS ()

0,25

EPS ()

0,25

P/E

P/E

10

P/E

20

P/E

20

P/EA > P/EB

P/EA = P/EC

P/EA < P/ED

Invert the transaction !

Deal

A issues 5 mil shares at 1

A issues 5 mil debt for (5%)

A issues 5 mil shares at 1

D issues 2 mil shares at 5

structure

and buys B

and buys B

and buys D

and buys A

New shares

5 000 000

New shares
New debt
cost of debt

Result

AB no of shares

15 000 000

AC no of shares

New shares

5 000 000

New shares

2 000 000

15 000 000 DA no of shares

3 000 000

5 000 000
250 000
10 000 000 AD no of shares

PAT ()

2 000 000

PAT ()

1 250 000

PAT ()

1 250 000

PAT ()

1 250 000

EPS ()

0,133

EPS ()

0,125

EPS ()

0,083

EPS ()

0,417

P/E
share price ()

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7,5
1,00

P/E
share price ()

10
1,25

P/E
share price ()

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1,00

P/E
share price ()

12
5,00

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Higher growth companies


EPS bidding < EPS target
P/E bidding < P/E target
Post-acquisition P/E to appropriate
weighted average of the original
businesses
EPS because bidding company is larger
than target company
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Takeover defense
Pre-offer defense

Shark repellent
Staggered board
Quorum
Poison pills
Re-capitalization with special right shares

Post offer defense

Pacman defense
Violation of antitrust law
Change of asset structure
Change of liabilities structure

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Summary
1. The synergy from an acquisition is defined as the
value of the combined firm (VAB) less the value of
the two firms as separate entities (VA and VB), or
Synergy VAB - (VA + VB)
The shareholders of the acquiring firm will gain if
the synergy from the merger is greater than the
premium.
2. The three legal forms of acquisition are merger and
consolidation, acquisition of stock, and acquisition
of assets.
3. Mergers and acquisitions require an understanding
of complicated tax and accounting rules
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Summary 2
4. The possible benefits of an acquisition come
from:
a. Revenue enhancement, b. Cost reduction, c.
Lower taxes, d. Lower cost of capital
The reduction in risk from a merger may help
bondholders and hurt stockholders.
5. The empirical research on mergers and
acquisitions is extensive. Its basic conclusions
are that, on average, the shareholders of
acquired firms fare very well, while the
shareholders of acquiring firms do not gain
much.
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Exercise problems
1. Do M&As create value at all?
2. Who are the main beneficiaries of M&A in the
short term / long term?
3. In an efficient market with no tax effects,
should an acquiring firm use cash or stock?
4. Explain the Japanese Keiretsu, how does it
function?
5. M&A valuation problem on separate sheet
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Useful web sources


A book on Mergers and acquisitions by
Weston and Weaver (2001) - book preview
http://www.google.com/books?
hl=cs&lr=&id=Y2Mz7tOuJBgC&oi=fnd&pg=
PP9&dq=mergers+and+acquisitions&ots=8
5kGKKGutc&sig=iY_Ztx8tQY42Kzmw2UrVp25rTM#v=onepage&q=mergers
%20and%20acquisitions&f=true
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Useful web source 2


Characteristics of takeover defense
strategies
http://www.investopedia.com/articles/stock
s/08/corporate-takeoverdefense.asp#axzz29MjA54dw

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RECOMENDED READINGS
Fundamentals of Corporate Finance,
Ross, Westerfield and Jaffe, 4th edition.
Ch 29
Brigham and Houston: Fundamentals of
Financial Management, 12th ed, Ch 15

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CAPITAL STRUCTURE

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Outline

Capital structure concept maximizing value


Optimal capital structure
M&M Theory of Independence
M&M Theory of Dependence
Taxes and financial leverage
Cost of financial distress and agency costs
EBIT-EPS analysis
Summary, exercises, references

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Goal of capital structure


management
Maximize the share price
Minimize the weighted average cost of
capital
Too big financial leverage can bring firm to
bankruptcy
Too small financial leverage leads to
undervaluing of share price
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Miller & Modigliani (1958)


The Cost of Capital, Corporation Finance
and the Theory of Investment, American
Economic Review 48: 261-297

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Importance of capital structure


Cost of capital is one of the cost and
therefore influence dividends
If the cost of capital are minimized, the
payments to shareholders is maximized
If the cost of capital can be determined by
corporate capital structure then the capital
structure management is an important part
of firm management
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Assumptions
The share price is a perpetuity: P0 = Dt/Kc
The firm pays constant dividends
Dividend-Pay-Out = 100%, i.e. no retained
earnings
There are no taxes
Capital structure consists of Debt & Equity
only
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Further assumptions
Financial structure is modified by issuing
new shares to buy out debt or the other
way around
EBIT is assumed to remain constant
Shares and other securities are traded on
efficient market

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Proposition I.
Independence Hypothesis
The cost of capital of the firm (K0) and share
price P0 are both independent on capital
structure (financial leverage)
Total market value of the firm securities stays
unchanged disregarding the degree of leverage
(picture)
The basic relation of Independence Hypothesis:
Percentage change of cost of equity Kc =
Percentage change in dividends Dt
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Proposition II.
Dependence Hypothesis
Both the cost of capital (K0) and share
price (P0) are influenced by firms capital
structure
Weighted average cost of capital (K 0) will
decrease as the D/E increases, and the
share price (P0) increases with growing
leverage, therefore companies should use
as high leverage as possible (picture)
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Dependence Hypothesis
According to Dependence Hypothesis:
Percentage change of cost of equity K c=
0, however, percentage change in
dividends Dt > 0
Percentage change of price = percentage
change of dividends

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Taxes and financial leverage


The interest is deductible from the tax
base
Use of debt in capital structure should lead
to increased market value of firm
securities
The middle view assumes that interest tax
shied has its market value which
increases total market value of the firm
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Cost of financial distress


The probability of bankruptcy increases with
increasing leverage.
The firm has the highest costs if it gets bankrupt

Assets are liquidated for lower than market price


Banks refuse to lend
Suppliers refuse to grant commercial credit
Dividend payments are stopped

At certain point the expected bankruptcy costs


outweigh the tax shield and the firm has to
change the capital structure (Pictures)
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Further topics

Optimal financial structure


EBIT-EPS analysis
Point of financial indifference
Implicit cost cost of debt increased risk
Practical measures of capital structure
management

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Capital structure theories


The trade-off theory
The trade-off between benefits and costs of
debt
Small debt small tax shield but more
financial flexibility

Pecking order theory


Different types of capital have different costs
-the least expensive source is used first
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Summary 1

In general, a firm can choose among many


alternative capital structures.
It can issue a large amount of debt or it can
issue very little debt.
It can issue floating-rate preferred stock,
warrants, convertible bonds, caps, and callers.
It can arrange lease financing, bond swaps,
and forward contracts.

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Summary 2

Because the number of instruments is so


large, the variations in capital structures are
endless.
We simplify the analysis by considering only
common stock and straight debt in this
chapter.
We examine the factors that are important in
the choice of a firms debt-to-equity ratio.

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Exercise questions
1. Explain the concept of capital structure
2. Define the optimal capital structure
3. Explain the logic of M&M Theory of
independence
4. Explain M&M Theory of dependence
5. Explain the role of taxes in financial structure
6. Explain the cost of financial distress and
agency costs
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Exercise problem 1

Gearing Manufacturing, Inc is planning a $ 1 000


000 expansion of its production facilities. The
expansion could be financed by the sale of $1 250
000 in 8% notes or by the sale of $ 1 250 000 in
capital stock. Which would raise the number of
shares outstanding from 50 000 to 75 000.
Gearing pays income taxes at a rate of 30%.
Suppose that income from operations is expected
to be $ 550 000 per year for the duration of the
proposed debt issue, Should Gearing be financed
with debt or stock? Explain your answer.

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Useful web sources


Financing decisions: Capital Structure and
cost of capital
http://www.slideshare.net/meowbilla/4a304capital-structure
CFA 1 Materials
http://www.investopedia.com/exam-guide/cfalevel-1/corporate-finance/mm-capitalstructure-versus-tradeoffleverage.asp#axzz1sgRpYOfd
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RECOMENDED READINGS
Fundamentals of Corporate Finance,
Ross, Westerfield and Jaffe, 6 th edition.
Ch 12
Brigham and Houston: Fundamentals of
Financial Management, 12th ed, Ch 10

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STRATEGY AND TACTICS


OF FINANCING DECISIONS
- INVESTMENT DECISION
MAKING

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Outline

Introduction
Investment decision making
Nature of projects and incremental cash flows
Project phases and relevant cash flows
Decision making methods incl. pros and cons
Comparing different projects
Summary, exercises, references

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Investment Projects
Nature of project
Profit generating projects
Increasing capacity, new equipment
Replacement projects

Ecological projects minimizing loss

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Long-term nature of projects


Analyzing - incremental cash flows
Changes of the firms cash flow that occur as
a direct consequence of accepting the project

Costs vs. Cash flows


Sunk costs
Opportunity costs (potential revenues form
alternative uses are lost)
Side effects - transfers
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Project Phases
1. Investment phase
2. Operating phase (income and taxes)
3. Liquidating phase (sometimes included
in operating phase)

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Investment decision making


methods
Net Present Value - NPV
Internal Rate of Return - IRR
Payback Period - PP
Profitability Index - PI
Modified Internal Rate of Return - IRR*

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Net Present Value


The most frequently used decision making
method
Discounts individual positive and negative
cash flows to the present finding their
present value
Projects with positive net present value
are accepted
This method is sensitive to the discount
rate used in the process of calculation
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Internal Rate of Return


The discount rate of the project that forces its net
present value to equal zero
NPV = 0
Positive and negative cash flows are discounted at
rate IRR. APPROXINMATION of this rate can be
found using iterations or linear interpolation
Advantage - comparison with cost of capital
STRONG ASSUMPTION - cash inflows are
reinvested at a rate IRR
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Payback Period

Non-discounted method
Discounted method
Cumulated cash flows
ASSUMPTION- evenly distributed cash
flows during the course of each period

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Profitability index
Present value of cash inflows to present
value of cash outflows
Decision rule: PI > 1
The same decisions as NPV
Profitability indexes of two projects can
not be added, whereas the NPVs can
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Modified Internal Rate of Return


Removes the strong assumption about
reinvesting cash inflows for the high IRR
Maintains the advantage - easy
comparison with cost of capital the
appropriate discount rate

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Modified IRR* - formula


T

t0

C O Ft
t
1 r
T

IR R *

t0

(1 IR R * ) T

C IF t(1 r) Tt

t 0
T

t 0

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(T t)

C IF t 1 r

C O Ft
(1 r)t

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Comparing projects
Conflict between NPV and IRR
Projects with irregular cash flows
Projects with several negative cash flows
Comparing projects with different time horizon
Crossover rate
Capital Asset Pricing Model - CAPM
application in capital budgeting
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Summary
1. Investment decision making must be placed on
an incremental basis - sunk costs must be
ignored, while both opportunity costs and side
effects must be considered.
2. Inflation must be handled consistently. One
approach is to express both cash flows and the
discount rate in nominal terms.
3. When a firm must choose between two machines
of unequal lives, the firm can apply either the
matching cycle approach or the equivalent annual
cost approach. Both approaches are different
ways of presenting the same information.
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Summary 2
4.

5.

In this chapter we cover different investment decision


rules. We evaluate the most popular alternatives to the
NPV: the payback period, the accounting rate of return,
the internal rate of return, and the profitability index. In
doing so, we learn more about the NPV.
The specific problems with the NPV for mutually
exclusive projects was discussed. We showed that,
either due to differences in size or in timing, the project
with the highest IRR need not have the highest NPV.
Hence, the IRR rule should not be applied. (Of course,
NPV can still be applied.)

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Exercise questions
1.
2.
3.
4.
5.
6.
7.

What are the difficulties in determining incremental


cash flows?
Define sunk costs, opportunity costs, and side effects.
What are the items leading to cash flow in any year?
Why is working capital viewed as a cash outflow?
Discuss the pros and cons of investment decision
making methods
What is the difference between the nominal and the
real interest rate and nominal and real cash flow?
Discuss the problems of IRR method

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Useful web sources

http://www.studyfinance.com/lessons/capbudget/
http://www.capitalbudgetingtechniques.com/
What is capital budgeting - text
http://www.exinfm.com/training/capitalbudgeting.
doc
Impact of inflation on investment decision
making
http://www.studyfinance.com/jfsd/pdffiles/v9n1/m
ills.pdf
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RECOMENDED READINGS
Fundamentals of Corporate Finance,
Ross, Westerfield and Jaffe, 4th edition.
Ch 7
Brigham and Houston: Fundamentals of
Financial Management, 12th ed, Ch 9, 10

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RISK AND RETURN


RELATIONSHIP

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PORTFOLIO RISK AND RETURN

Risk and risk aversion


Investors attitudes
Diversification
Capital asset pricing model and SML
Beta coefficient
Arbitrage pricing theory
Exercises, web-sources and recommended
readings

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INVESTMENTS AND RISK VS


RETURN
The investment process consists of two broad tasks.
One task is to find security and market analysis, by
which we assess the risk and expected-return
attributes of the entire set of possible investment
vehicles.
The second task is the formation of an optimal
portfolio of assets, which involve the determination of
the best risk-return opportunities available from
feasible investment portfolios and the choice of the
best portfolio from the feasible set
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RISK AND RISK AVERSION


The presence of risk means that more
than one outcome is possible.
A simple prospect is an investment
opportunity in which a certain initial wealth
is placed at risk, and there are only two
possible outcomes.

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PORTFOLIO MANAGEMENT
Risk and return relation (figures)
Diversification
not perfect correlation ( ) of assets
investor is able to obtain higher return whilst
maintaining the same risk

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PORTFOLIO RETURN
Return on n-asset portfolio

E (R p)
E(Rp)
E(Ri)
xi

Expected return of the portfolio


Expected return of the i-th asset
Weight (proportion) of i-th asset
n
within a portfolio
x 1

i1

n
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i1

xiE (R i)

Number of assets in the portfolio


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PORTFOLIO RISK
Risk of the n-asset portfolio

p
ij
xi and xj
n
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i1

j1

x i x j

ij

Standard deviation of a portfolio


Covariance of i-th and j-th assets
Weight (proportion) of i-th and j-th assets
within a portfolio
Number of assets in a portfolio
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CAPITAL MARKET LINE (CML)


Market portfolio
Market return (RM)
Risk-free return (Rf)
Risk of the market (M)

R
p

All efficient portfolios will lie on the new efficient frontier


Return of the portfolio (Rp)
Risk of the portfolio (p)

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BETA COEFFICIENT
A measure of volatility
Standardized measure of risk,
- relative risk compared to the market portfolio

i,M
i 2
M
i risk of the i-th asset
i,M covariance of the i-th asset with the market portfolio
M2 variance of the market portfolio
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SECURITY MARKET LINE


(SML)
Return on the i-th security
Market return (RM )
Risk-free return (Rf )
Security beta (i )
Market premium (RM - Rf )

Ri R

(R

R f )i

The expected return on any security can be estimated using the


Capital Asset Pricing Model
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CAPITAL ASSET PRICING


MODEL (CAPM)
All assets can be organized on the Security market line (SML)
in the Risk - Return space
Expected return of i-th asset can be calculated as:

Ri R

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(R

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ASSUMPTIONS OF CAPM
(1)

No transaction costs
All assets are infinitely divisible
No taxation
No single investor can affect the price
(perfect market)
Investors make decisions solely in terms of
expected returns and standard deviations
Unlimited short sales are allowed
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ASSUMPTIONS OF CAPM
(2)
Unlimited lending and borrowing of funds at the
(the same) riskless rate
Homogeneous expectations concerning the
mean and variance of assets
All investors have identical expectations with
respect to the portfolio decision inputs (1.exp.
returns, 2.variances, 3.correlations)
All assets (eg, including human capital) are
marketable
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CHARACTERISTIC LINE
SML can be rewritten as:

(Ri - Rf ) Excess return of the security


(RM - Rf ) Excess return of the market

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BETA ESTIMATES
Estimating beta from historical returns using regression

Beta is a slope of a characteristic line of i-th security

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Beta koeficient
Standardized measure of risk
- Relative risk compared to Market portfolio

i,M
i 2
M
i risk of i-th asset
i,M covariance of i-th asset with market portfolio
M2 variance of market portfolio
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ALPHA
An investor can be convinced, that the security is wrongly priced
according to CAPM.
His estimate will differ by I

i R
i R

in v e s to r
i

in v e s to r
i

R
f

CAPM
i

If i > 0 the investor believes that the security is undervalued


If i < 0 the investor believes that the security is overvalued
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IMPACT ON THE
CHARACTERISTIC LINE

in v e s to r
i

R
i

Excess return of the security (Riinvestor - Rf ) is composed from:


1)
2)
3)
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difference between investors estimate


and CAPM estimate (i)
excess return of the market times beta (RM - Rf ) *i
an error (i)
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ARBITRAGE PRICING
THEORY (APT)
New and different approach to determining
the asset prices
More general then CAPM which takes into
account means and variances of security
returns
Law of one price: two assets that are the
same can not sell at different prices

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FACTOR (INDEX) MODELS


Return on any security is related to a set
of factors, eg:
growth of real GDP
real interest rates
unexpected inflation
commodities prices
growth of population

Not only to the market excess return


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SINGLE FACTOR MODEL RETURN


Uncertain return on an i-th security is determined by:

R i a i bi * F ei
F
ai
bi
ei

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uncertain value of a factor


expected value of i-th security in case
the value of factor F = 0
sensitivity of i-th security to factor F
uncertain error term

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FACTOR MODEL ASSUMPTIONS


error term and factor are not correlated
error terms of any two assets are not
correlated
returns of assets are correlated since they
depend on the same factor

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Summary
Speculation is the undertaking of a risky
investment for its risk premium.
The risk premium has to be large
enough to compensate a risk-averse
investor for the risk of the investment.
Hedging is the purchase of a risky asset
to reduce the risk of a portfolio.
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Summary 2
The negative correlation between the
hedge asset and the initial portfolio turns
the volatility of the hedge asset into a riskreducing feature..
When a hedge asset is perfectly negatively
correlated with the initial portfolio, it serves
as a perfect hedge and works like an
insurance contract on the portfolio.
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Exercise problem

Riskless rate is 8 per cent and market rate is 12 per cent.


You investigate the following three investment opportunities:

Portfolio
A
B
C

Beta
0,6
1
1,4

a) Calculate for each of the three portfolios the expected return


consistent with CAPM
b) Show graphically the expected portfolio returns
c) Indicate on the graph what would happen to the capital market line in
(a) if the expected return on the market portfolio were 10 percent.
d) Explain various implications of such movement.
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Useful web source


The website listed below has an online
journal entitled Efficient Frontier: An
OnlineJournal of Practical Asset
Allocation. The journal contains short
articles about various investment
strategies that are downloadable in Adobe
format.
http://www.efficientfrontier.com
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RECOMENDED READINGS
Fundamentals of Corporate Finance,
Ross, Westerfield and Jaffe, 4th edition.
Ch 9 and 10
Bodie, Z., Kane, A and Marcus, A.
Investments 5th Ed., Mc Graw Hill. 2001 ch
6 and 7
Sharpe, W., Alexander, G., Bailey, J.:
Investments, 6th ed Ch. 6-9
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BONDS AND SHARES

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OUTLINE

Introduction
Debt securities, characteristics and risk
Different types of bonds
Bond rating
Equity valuation
Debt vs. equity
Summary, exercises, references

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DEBT SECURITIES - BONDS

t 1

M
y

Bbond price
Ctfixed coupon, ccoupon rate
Mprincipal (nominal value)
y.yield, or discount rate ( r )

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RISK CHARACTERISTICS OF
BONDS

Bonds are perceived as a safer


investment alternative than stocks
Long term bonds are more sensitive to the
changes in interest rates than short term
bonds
Types of risk
default risk & time risk
interest rate risk & reinvestment risk
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MATURITY AND VOLATILITY


Prices and returns for long-term bonds are
more volatile than those for shorter term
bonds
Interest rate risk

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DIFFERENT TYPES OF BONDS

Plain vanilla bonds


Floating rate bonds
Deep discount bonds
Income bonds (dependent on income)
Convertible bonds
Bonds with warrants

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BOND RATING
Moodys Investor Service
Standard and Poors
Rating default risk
Investment Grade, Non-investment grade
lower grade bonds below BBB for S&P and below Ba
for Modys

Junk Bonds in 1970s Michael Milkin in Drexel


Burnham Lambert developed the high yield junk
bond market
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YIELD TO MATURITY
Coupon bond:
B=C/(1+r)+C/(1+r)2++C/
(1+r)n+M/(1+r)n,
Consol (perpetuity) r=C/Pc )
Discount bond (1 year) r= (M-Pd)/Pd)

Current bond prices and interest rates are


negatively related: When interest rate
rises, the bond price rise falls and vice
versa
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EQUITY - VALUATION
Present value of future cash flows
(dividends)
Preference shares
Common shares
Zero growth
Constant growth (Gordon Model)
Supernormal growth
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NEW ISSUE
Approval from BOD
File the Registration statement with SEC
details of financial information (50 pages)

Preliminary prospectus distributed to


potential investors
After approval by SEC the price of new
issue is added and selling begins
Compare with rights offer
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EQUITY VERSUS DEBT


Feature:

Equity

Debt

Income:

Dividends

Interest

Tax
status:

Taxed as personal income.


Are not business expense

Taxed as personal income.


Are business expense

Control:

Common stocks
(sometimes preferred)
usually have voting right

Control is exercised with


loan agreement

Default:

Firms cannot become


Unpaid debt is a liability.
bankrupt for nonpayment of Nonpayment results in
dividends
bankruptcy

Bottom
line:

Tax status favours debt, but default favours equity.


Control features of debt and equity are different but one is
not better than other

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Summary
1. Pure discount bonds and perpetuities
can be viewed as the polar cases of
bonds. The value of a pure discount
bond (also called a zero-coupon
bond, or simply a zero) is
PV =F/(1+r)T
2. The value of a perpetuity (also called
a consol) is PV = C/r
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Summary 2
3. Ordinary bonds can be viewed as an
intermediate case. The coupon payments form
an annuity and the principal repayment is a lump
sum. The value of this type of bond is simply the
sum of the values of its two parts.
4. The yield to maturity on a bond is that single
rate that discounts the payments on the bond to
its purchase price.

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Summary 3
5.A stock can be valued by discounting its
dividends. We mention three types of situations:
a. The case of zero growth of dividends.
b. The case of constant growth of dividends.
c. The case of differential growth.
6.An estimate of the growth rate of a stock is
needed for formulas (b) or (c) above. A useful
estimate of the growth rate is
G = Retention ratio * Return on retained earnings
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Exercise (1)

Consider two bonds, bond A and bond B, with


equal rates of 10 percent and the same face values
of $1,000. The coupons are paid annually for both
bonds. Bond A has 20 years to maturity while bond
B has 10 years to maturity.
a. What are the prices of the two bonds if the
relevant market interest rate is 10 percent?
b. If the market interest rate increases to 12
percent, what will be the prices of the two bonds?
c. If the market interest rate decreases to 8
percent, what will be the prices of the two bonds?

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Exercise (2)

Consider a bond that pays an $80


coupon annually and has a face value of
$1,000.
Using excel calculate the yield to
maturity if the bond has
a. 20 years remaining to maturity and it
is sold at $1,200.
b. 10 years remaining to maturity and it
is sold at $950.

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USEFUL WEB SOURCES


On financial instruments
http://www.investopedia.com/terms/f/financiali
nstrument.asp#axzz1e50d197V
Corporate finance a practical approach Clayman, Fridson, Troughton - CFA institute
(incl. examples and calculations) Ch 4?
http://www.google.com/books?
hl=cs&lr=&id=PwyqVX3H1YkC&oi=fnd&pg=P
T10&dq=corporate+finance+a+practical+appr
oach&ots=r4Lk6fqqou&sig=zrTrbFmB1KiNKIu
n2Jxgey24XGU#v=onepage&q=bond&f=false
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RECOMENDED READINGS
Fundamentals of Corporate Finance,
Ross, Westerfield and Jaffe, 4th edition.
Ch 5
Brigham and Houston: Fundamentals of
Financial Management, 12th ed, Ch 6

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