CH-1-31 Introduction to Corporate Finance – Corporate Finance : Chapter Notes

This Document Contains Chapters 1 to 26, 29 to 31 Chapter One Introduction to Corporate Finance Overview This first chapter is a “soft chapter.” No mathematics are involved and the lecture is primarily a terminology lecture. Some instructors will spend their first class going over a syllabus, discussing class requirements and going slow on the material. This chapter fits a ‘night one’ lesson plan very well. Students familiar with finance terminology will breeze through this material and be ready to move on. Students new to the material will get a nice dose of “terminology shock.” It is highly recommended that the instructor set expectations at this point. Let the class know that the chapter is very easy and that if they cannot grasp the material in chapter one, they should be prepared for many challenges in the chapters to follow. Even if students are experienced in finance, there is enough in this lecture dealing with current events that everyone should find something of interest. One thing I do is to try and get the students to talk about their own country and why it is different. It’s a great opportunity to get students to buy into the class and in many cases this tends to be one of the most enjoyable lectures for students. I’m anticipating a core lecture of 2 hours. If you have a one hour lecture, shorten the material to core information. Three hour lectures should explore the examples more. Chapter Synopsis This chapter introduces some of the basic ideas in corporate finance: 1. Corporate 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? Also, what mixture of debt and equity should it use to fund operations? c. Working capital management: How should the firm manage its everyday financial activities? 2. The goal of financial management in a for-profit business is to make decisions that increase the value of the shares, or, more generally, increase the market value of the equity. The most important issue that is introduced in this chapter is the goal of financial management: maximizing share value. Lecture Material It’s always good to start off a lecture with an example of current events in corporate finance. It catches students’ interest and can also be used as a touchstone for the rest of the lecture. Any example could be used. I have simply gone on to Google News and searched for news in this area and chosen an appropriate news story. Chapter Two Corporate Governance Chapter Synopsis After reading this chapter, students should: 1. Be familiar with the different forms of corporate organizations. 2. Understand the effect of different regulatory, legal, economic, and market systems on corporate objectives and decision making. 3. Know about the different agency relationships that exist in a firm and how they impact upon managerial decision-making. 4. Be aware of the different corporate governance principles underlying the efficient operation of corporate organizations. Lecture Material This chapter provides an introduction to corporate governance. In recent times, it has been recognized that many failures in corporate decision making result in poor corporate governance. When firms are well governed, managers are more likely to make corporate finance decisions that maximize shareholder wealth. Lecturers can use this chapter as a supplementary material for core corporate finance course or treat it as a topic in its own right. The lecture can be covered in a 2 hour session quite comfortably. It can also form the basis of a greater number of lectures if the principles are expanded in more detail. Alternatively, many lecturers like to discuss the differences in systems across countries and this topic can be expanded. It is sensible to use case studies to accompany this lecture and these are available all over the internet. Looking at the governance structure of one of your country’s biggest companies is also a good idea for the students. In this context, go to any listed company’s website and look at the investor relations section. Normally, there will be a governance or stakeholder relations section with lots of corporate governance information. Another good website is the European Corporate Governance Institute (www.ecgi.org) where a large body of material can be downloaded. Chapter Three Financial Statement Analysis and Long-Term Planning Chapter Synopsis After reading this chapter, students should: 1. Be familiar with the different types of financial statements that are used by financial managers and analysts. 2. Be able to interpret financial statements and compare the financial statements of several companies. 3. Understand the meaning of financial ratios and use them to form views on the performance of companies. 4. Be able to use financial statements to help in the financial long term planning of corporations. Lecture Material Chapter 3 is the necessary accounting chapter that places a substantial amount of accounting material required for understanding corporate finance. International Accounting Standards have changed quite a lot over the last few years and so this chapter contains a lot of new material. One of the biggest changes relates to IAS 1 and how financial statements are presented. In particular, the term, ‘Balance Sheet’, is no longer to be used, with ‘The Statement of Financial Position’ to be its replacement. Given that this is probably the first textbook to use the term regularly, the conventional usage is still very much in its infancy. With 80 slides, the lecture is far too large to be used comfortably in a 2 hour session. It would be better to break up this lecture into 2 sessions – one related to financial statement analysis and another related to long-term financial planning. Many finance students will have already covered the material on financial statement analysis in earlier courses and so this could easily be omitted. It is advisable not to delete the slides in the presentation but to hide them instead. To do this, right-click on the slide in the slide bar at the left of the screen and choose ‘hide slide’. Chapter Four Discounted Cash Flow Valuation Chapter Synopsis After reading this chapter, students should: 1. Understand the basic concepts of present value and future value. 2. Be familiar with the concept of compounding and compound interest. 3. Know the net present value formula for valuing a stream of cash flows. 4. Be able to use all short cut formulae for annuities and perpetuities and employ these in a variety of different scenarios. Lecture Material We now enter the main part of the text and the starting point of many valuation courses. The techniques discussed in this chapter form the basis for the rest of the book and should be given as much time as needed to ensure that students are fully familiar with the work. Much emphasis has been placed on examples to give the reader as much experience as possible with the discounting techniques. Some lecturers prefer to go into the first principles of valuation and time value of money and the appendix to this chapter covers this in more detail. This is another very large chapter that can be spread out over several lectures (including the appendix slides) if needed. There are a large number of examples and questions in the chapter and they should be drawn upon to ensure that the principles are fully understood. Many students find the concept of ‘time value of money’ difficult to grasp at first and so it is better to use more examples rather than less when lecturing. The animations in the powerpoint slides are specifically designed so that students are able to attempt each example first before going on to look at the solution. This provides a much more effective learning experience than just giving a solution to each question. Chapter Five How to Value Bonds and Shares Chapter Synopsis After reading this chapter, students should: 1. Be able to value coupon bonds and pure discount bonds of any maturity. 2. Be familiar with the different types of bonds in existence. 3. Know what is meant by yield to maturity and how to calculate it. 4. Be able to value equities of any type. 5. Understand how to arrive at a measure of growth and its main determinants. 6. Be familiar with the concept of ‘net present value of growth opportunities’ and how to value equities with it. 7. Know what is meant by a price-earnings ratio and its main determinants. Lecture Material The discounting techniques introduced in the Chapter 4 are used in this chapter to value financial securities. The main difference is the introduction of some new concepts, such as yield to maturity, dividend yields, and the cash flow streams from bond and equity securities. The appendix to this chapter covers the term structure of interest rates in case lecturers wish to go into the topic in more detail. If the course is primarily concerned with the valuation of real assets, this chapter can be omitted. The lecture material covers both bond valuation and equity valuation. It is likely that the lecture slides will be split over two 2-hour sessions. With nearly 60 slides, it would be rushing thing to try and fit it into 120 minutes and expect students to be able to fully follow all the new material. The slides have animations and have been designed so that lecturers can give a question and let students attempt to solve it before giving the answer on the next slide or animation. Chapter Six Net Present Value and Other Investment Rules Chapter Synopsis After reading this chapter, students should: 1. Be familiar with the main investment decision rules used by corporations, namely, the payback period, the discounted payback period, the accounting rate of return, the internal rate of return, and net present value. 2. Be fully cognisant of the strengths and weaknesses of each investment appraisal rule. 3. Know how to choose between mutually exclusive projects. 4. Understand how project scale affects the investment decision rule and be able to employ incremental cash flows in the capital budget decision. 5. Know how to deal with capital rationing in the investment appraisal. Lecture Material This chapter will definitely be at the core of any valuation course. The techniques that are covered are the standard investment appraisal methods and the chapter is replete with examples. This will give invaluable experience to students who are meeting these techniques for the first time. It is possible to cover all the material in the slides in a two hour lecture. However, if the course is on valuation, it may be better to split the slides over two lectures and go into many more examples. Many students find that they are overloaded with information when going through this chapter in too short a time. Furthermore, a full understanding of the discounting techniques that were introduced in chapter 4 is necessary to fully understand the slides in this chapter. Chapter Seven Making Capital Budgeting Decisions Chapter Synopsis After reading this chapter, students should: 1. Understand and be able to calculate the incremental cash flows of projects. 2. Be able to carry out a full capital budgeting analysis that incorporates sunk costs, opportunity costs, cannibalization of cash flows, different approaches to depreciation, and tax effects. 3. Know how to deal with inflation in a capital budgeting analysis if it is likely to be an issue. 4. Be familiar with and able to compare assets with unequal lives using the equivalent annual cost approach. Lecture Material Chapter Seven follows on from Chapter 6 by increasing the complexity of the business decision issues in real life situations. Specifically, issues relating to incremental cash flow, mutually exclusive projects, capital rationing decisions, depreciation, and tax are covered in detail. Other important factors such as sunk and opportunity costs and inflation are also covered. The main capital budgeting steps are given in this chapter, namely, a) determine the depreciation schedule of assets, b) Calculate the net income arising from the project, c) Estimate operating cash flows, d) Carry out the cash flow analysis. The slides in this chapter form a trilogy of slides (with those for chapters 4, and 6) that can be used for any corporate valuation course. With 62 slides, it is impossible to cover all the material in one 2 hour lecture and so you should decide whether you wish to split the lecture over 2 or more sessions. You should also ensure that the students are fully familiar with the material in chapters 4 and 6. Otherwise, many will be lost by the time they reach the material in this chapter. Chapter Eight Risk Analysis, Real Options and Capital Budgeting Chapter Synopsis After reading this chapter, students should: 1. Understand why real option analysis is necessary in may capital budgeting decisions. 2. Know how to carry out a real option analysis, sensitivity analysis, scenario analysis and monte carlo simulation to inform investment appraisal decisions. 3. Be familiar with the main types of options that are present in capital budgeting decisions, namely the option to expand, the option to abandon, and timing options. 4. Know how to use decision trees in an investment appraisal decision. Lecture Material Real Options are often ignored by lecturers when giving a valuation course. However, they are definitely increasing in importance and some effort should be made to at least include a reference to them in the course. The chapter can also form the introduction for a Real Options course, and be combined with chapters from later parts of the text to create a cohesive body of lectures. This chapter will probably be the first time that students will have met real options and contingent valuation and it is worthwhile to spend some time getting the students to come up with their own examples where real option analysis could be used. Ensure that the students are fully familiar with the material in chapters 4, 6, and 7 before attempt to cover this material. Chapter Nine Risk and Return: Lessons from Market History Chapter Synopsis After reading this chapter, students should: 1. Understand the relationship between risk and return and appreciate the distributional differences between equities and debt. 2. be able to calculate returns on financial investments. 3. Be familiar with the concepts and measures of risk and return, specifically mean, median, standard deviation, skewness, and kurtosis. Lecture Material Chapter 9 is an introductory lecture into to risk and return. It provides a primer in how to calculate the distribution of equity returns – distribution asymmetry, mean, standard deviation, skewness, and kurtosis. The chapter also shows the different ways in which to calculate equity returns. The other contribution of the chapter is its coverage of the history of stock market returns of several countries, together with a very long term analysis of US returns. This chapter should easily be covered in a 2-hour lecture. There aren’t that many worked examples and most of the slides are explanatory in nature. Given that stock market data can age quite rapidly, it would be sensible to update some of the slides to current times. For example, slides 12-14 relate to data that ends in 2007. Since then, there has been the major falls in 2008 followed by the rebound in 2009. The slides that calculate returns and standard deviations later in the lecture would also have to be rewritten. Chapter Ten Risk and Return: The Capital Asset Pricing Model Chapter Synopsis After reading this chapter, students should: 1. Be able to calculate the expected return and risk of individual securities. 2. Know how to extend the efficient frontier analysis of a 2 asset world to a world with many assets. 3. Understand how risk is diversified in a portfolio of many assets. 4. Be familiar with the concept of riskless and risky borrowing and how the combination of investment in a risk-free asset and risky portfolio can lead to an optimal investment decision. 5. Understand what is meant by systematic risk or beta. Lecture Material A major chapter, and one the forms the basis of many asset pricing courses. The CAPM is central to the estimation of the cost of equity capital and so this is an exceptionally important chapter. Chapter 10, along with Chapters 9 and 11 can form an asset pricing course within a corporate finance degree. This lecture is best split over two 2-hour lectures to ensure that students fully understand the various aspects of CAPM. If time is of the essence, lecturers should focus only on the core CAPM material and leave out the slides towards the end of the lecture. It is also advisable to give the class a number of additional examples in calculating Ri, rf, Rm, beta, and the risk premium using just the CAPM. Chapter Eleven Factor Models and the Arbitrage Pricing Theory Chapter Synopsis After reading this chapter, students should: 1. Know what is meant by the Arbitrage Pricing Theory and the assumptions upon which it is based. 2. Understand factor models and how these can be used to explain the impact of diversification on portfolio risk. 3. Know what is meant by the Fama French 3 factor model and the Carhart Momentum model. 4. Be familiar with the relationship between total risk, systematic risk and unsystematic risk and how these are determined in factor models. 5. Be able to calculate the expected return on a security from a series of factor exposures. 6. Know what is meant by the term, beta. Lecture Material Chapter 11 follows on from the material in Chapter 10 on asset pricing. The chapter extends the material from the earlier chapter to consider factor models and the APT. The lecture can easily be fitted into a 2 hour session. The main contribution of the lecture is the formalization of factor models and the Arbitrage Pricing Theory. It’s up to the lecture how much material is included from the chapter and the intuitive derivation of factor models could be left out or the insights gained with respect to portfolio diversification. The examples and questions for the chapter are all very easy compared to other chapters and so not much time is needed to go over these. Chapter Twelve Risk, Cost of Capital, and Capital Budgeting Chapter Synopsis After reading this chapter, students should: 1. Be aware of the decisions a manager must make when deciding to issue a dividend or authorize capital expenditure. 2. Know how to calculate the beta of an equity using real data. 3. Know what to do when calculating the cost of equity if the risk of a new project is different from the risk of the firm. 4. Be familiar with the main determinants of beta. 5. Know when and how to use the weighted average cost of capital. 6. Understand the role of liquidity in a firm’s cost of capital Lecture Material Together with the chapters on valuation, this chapter will allow the reader to undertake a full capital budgeting analysis. Whereas earlier chapters focused on estimating the correct cash flows for the investment appraisal, Chapter 12 concentrates on the discount rate. This chapter closes the core material on valuation and this topic will be revisited later in the book when option valuation is covered in more detail. Depending on the requirements of the course, a lot of the material in this chapter can be taken out. For example, if the course is for basic valuation principles, the slides that relate to estimating Carrefour’s cost of capital can easily be omitted. Similarly, the slides pertaining to EVA and liquidity could also be removed. Chapter Thirteen Efficient Capital Markets and Behavioural Finance Chapter Synopsis After reading this chapter, students should: 1. Know what is meant by market efficiency and its main implications. 2. Be aware of the three types of markets efficiency and the criteria for their existence. 3. Be able to compare behavioural theories of market dynamics with efficient markets theory and arrive at an educated view on the most appropriate explanation. 4. Have an awareness of the different empirical studies that have been carried out to investigate the efficient markets hypothesis. Lecture Material Chapter 13 focuses on concepts of market efficiency and arguments for and against the efficient markets hypothesis. There is a strong element of empirical evidence provided in this chapter but ultimately it is up to the reader to decide whether they believe in EMH or other behavioural interpretations of market pricing dynamics. This chapter can easily fit into a 2 hour lecture format. It is recommended that the instructor updates the slides to include research that pertains to their own country, since that is naturally more interesting to the students. An up-to-date reference list is provided at the end of the chapter. Chapter Fourteen Long-Term Financing: An Introduction Chapter Synopsis Students should know that the basic sources of long-term financing are long-term debt, preference shares, and ordinary shares. 1. Ordinary shareholders have a. Residual risk and return in a corporation. b. Voting rights. c. Limited liability if the corporation elects to default on its debt and must transfer some or all of its assets to the creditors. 2. Long-term debt involves contractual obligations set out in indentures. There are many kinds of debt, but the essential feature is that debt involves a stated amount that must be repaid. Interest payments on debt are considered a business expense and are tax deductible. 3. Preference shares have some of the features of debt and some of the features of ordinary equity. Holders of preference shares have preference in liquidation and in dividend payments compared to holders of ordinary equity. 4. Firms need financing for capital expenditures, working capital, and other long-term uses. Most of the financing is provided from internally generated cash flow. 5. In many parts of the world where the Muslim faith is common, standard investment instruments that involve interest payments are not acceptable. In response, Islamic Financing has developed to counter the problems associated with raising capital for firms wishing to adhere to Islamic principles. Lecture Material Part III of the textbook starts with this chapter and we begin our exploration of the second main aspect of corporate financial decision-making – The Financing Decision. This chapter introduces the different forms of equity and debt and is very much a descriptive chapter that could be treated as supplemental reading for courses short on time. In addition, the various financing products that firms following shariah principles use are also reviewed. As an introductory chapter to financing, this lecture may be omitted or included as part as a later chapter. Many courses do not have an Islamic financing component and so this part may also be removed from the slides. Given that the examples are about companies, it is recommended that the instructor updates the slides to include information on companies from their own country, since that is naturally more interesting to the students. Chapter Fifteen Capital Structure: Basic Concepts Chapter Synopsis We began our discussion of the capital structure decision by arguing that the particular capital structure that maximizes the value of the firm is also the one that provides the most benefit to the shareholders. In a world of no taxes, MM Proposition I proves that the value of the firm is unaffected by the debt–equity ratio. In other words, a firm’s capital structure is a matter of indifference in that world. The authors obtain their results by showing that either a high or a low corporate ratio of debt to equity can be offset by homemade leverage. The result hinges on the assumption that individuals can borrow at the same rate as corporations, an assumption we believe to be quite plausible. MM’s Proposition II in a world without taxes states that This implies that the expected rate of return on equity (also called the cost of equity or the required return on equity) is positively related to the firm’s leverage. This makes intuitive sense because the risk of equity rises with leverage.. Although the above work of MM is quite elegant, it does not explain the empirical findings on capital structure very well. MM imply that the capital structure decision is a matter of indifference, whereas the decision appears to be a weighty one in the real world. To achieve real-world applicability, we next consider corporate taxes. In a world with corporate taxes but no bankruptcy costs, firm value is an increasing function of leverage. The formula for the value of the firm is Expected return on levered equity can be expressed as Here, value is positively related to leverage. This result implies that firms should have a capital structure almost entirely composed of debt. Because real-world firms select more moderate levels of debt, the next chapter considers modifications to the results of this chapter. The chapter closes with a discussion of personal taxes. If distributions to shareholders are taxed at a lower effective personal tax rate than are interest payments, the tax advantage to debt at the corporate level is partially offset. Lecture Material This chapter introduces the pie concept of capital structure and, more importantly, the Modigliani-Miller propositions relating to the irrelevance of capital structure choices. Tax considerations are also introduced. Chapter 15 and 16 form the core of a Capital Structure/Financing course and so the slides for this chapter should be split up over two or more lectures. An idea is to spend one lecture on MM in a world with no taxes and another on MM in a world with taxes. Chapter Sixteen Capital Structure: Limits to the Use of Debt Chapter Synopsis We mention in Chapter 15 that according to theory, firms should create all-debt capital structures under corporate taxation. Because firms generally employ moderate amounts of debt in the real world, the theory must have been missing something at that point. We state in Chapter 16 that costs of financial distress cause firms to restrain their issuance of debt. These costs are of two types: direct and indirect. Lawyers’ and accountants’ fees during the bankruptcy process are examples of direct costs. We mention four examples of indirect costs: a. Impaired ability to conduct business. b. Incentive to take on risky projects. c. Incentive toward underinvestment. d. Distribution of funds to shareholders prior to bankruptcy. Because financial distress costs are substantial and the shareholders ultimately bear them, firms have an incentive to reduce costs. Protective covenants and debt consolidation are two common cost reduction techniques. The chapter goes on to argue that the costs of financial distress can be reduced but not eliminated. Therefore, firms will not finance entirely with debt. Firms select the debt–equity ratio at which firm value is maximized. Signaling theory argues that profitable firms are likely to increase their leverage because the extra interest payments will offset some of the pretax profits. Rational shareholders will infer higher firm value from a higher debt level. Thus investors view debt as a signal of firm value. Agency issues are also discussed. Managers owning a small proportion of a firm’s equity can be expected to work less, maintain more lavish expense accounts, and accept more pet projects with negative NPVs than managers owning a large proportion of equity. Because new issues of equity dilute a manager’s percentage interest in the firm, such agency costs are likely to increase when a firm’s growth is financed through new equity rather than through new debt. A number of theories relating to capital structure are introduced in the chapter. The pecking-order theory implies that managers prefer internal to external financing. If external financing is required, managers tend to choose the safest securities, such as debt. Firms may accumulate slack to avoid external equity. The Market timing theory suggests that there is no pecking order or trade-off of capital structure choices. Observed debt ratios are simply a function of past market to book valuations and the timing of funding requirements. Firms will have more equity if the needed funding when market to book valuations were high. Conversely, if financing was required during low market to book periods, debt will tend to dominate. Finally, empirical evidence relating to capital structure is discussed. Lecture Material Chapter 16 continues with the material on Capital Structure by extending the discussion to financial distress costs, taxes and other reasons for why firms choose their leverage levels. Chapter 16 goes hand in hand with Chapter 15 and so the slides should presented as a set. Lectures could also benefit from some coverage of the most up to date research in this area. A list of recent references are included at the end of the chapter. Chapter Seventeen Valuation and Capital Budgeting for the Levered Firm Chapter Synopsis Rational corporations should employ some debt in a world of this type. Because of the benefits and costs associated with debt, the capital budgeting decision is different for levered firms than for unlevered firms. The present chapter discusses three methods for capital budgeting by levered firms: the adjusted present value (APV), flows to equity (FTE), and weighted average cost of capital (WACC) approaches. The APV formula can be written as: There are four additional effects of debt: • Tax shield from debt financing. • Flotation costs. • Bankruptcy costs. • Benefit of non–market-rate financing. The FTE formula can be written as: The WACC formula can be written as: The chapter gives guidelines one which approach to use under different conditions: • Use WACC or FTE if the firm’s target debt-to-value ratio applies to the project over its life. • Use APV if the project’s level of debt is known over the life of the project. The APV method is used frequently for special situations like interest subsidies, LBOs, and leases. The WACC and FTE methods are commonly used for more typical capital budgeting situations. The APV approach is a rather unimportant method for typical capital budgeting situations. Finally, Chapter 17 discusses the positive relationship between the beta of the equity of the firm the leverage of the firm. Lecture Material Chapter 17 introduces the more advanced subjects in corporate finance. In this chapter, three capital budgeting techniques (adjusted present value, flow to equity, and weighted average cost of capital) that expressly incorporate the effect of debt are introduced. There are a large number of slides in Chapter 17. However, it should be possible to cover everything in a two-hour lecture. Chapter Eighteen Dividend Policy Chapter Synopsis Chapter 18 is concerned with Dividend Policy. The chapter argues that the dividend policy of a firm is irrelevant in a perfect capital market because the shareholder can effectively undo the firm’s dividend strategy. If a shareholder receives a greater dividend than desired, he or she can reinvest the excess. Conversely, if the shareholder receives a smaller dividend than desired, he or she can sell off extra shares of equity. This argument is due to MM and is similar to their homemade leverage concept, discussed in a previous chapter. Shareholders will be indifferent between dividends and share repurchases in a perfect capital market. Because dividends are taxed, companies should not issue equity to pay out a dividend. Also because of taxes, firms have an incentive to reduce dividends. For example, they might consider increasing capital expenditures, acquiring other companies, or purchasing financial assets. However, due to financial considerations and legal constraints, rational firms with large cash flows will likely exhaust these activities with plenty of cash left over for dividends. Much of the discussion in the chapter relates to a world where no taxes are paid. In a world with personal taxes, a strong case can be made for repurchasing shares instead of paying dividends. Nevertheless, there are a number of justifications for dividends even in a world with personal taxes: a. Investors in no-dividend equities incur transaction costs when selling off shares for current consumption. b. Behavioral finance argues that investors with limited self-control can meet current consumption needs via high-dividend equities while adhering to a policy of “never dipping into principal.” c. Managers, acting on behalf of shareholders, can pay dividends to keep cash from bondholders. The board of directors, also acting on behalf of shareholders, can use dividends to reduce the cash available to spendthrift managers. The stock market reacts positively to increases in dividends (or an initial payment) and negatively to decreases in dividends. This suggests that there is information content in dividend payments. High (low) dividend firms should arise to meet the demands of dividend-preferring (capital gains–preferring) investors. Because of these clienteles, it is not clear that a firm can create value by changing its dividend policy. Time varying demand for dividends mean that in some periods companies that pay dividends are traded at a premium and in other cases they are not. Managers will time their dividend policies to take advantage of this premium. Lecture Material Chapter 18 has a large number of slides. However, several of these relate to empirical findings. With some effort, the slides can be reduced to fit into a 2 hour lecture. Chapter Nineteen Equity Financing Chapter Synopsis This chapter looks closely at how equity is issued. The main points follow: 1. Large issues have proportionately much lower costs of issuing equity than small ones. 2. Firm commitment underwriting is far more prevalent for large issues than is best-efforts underwriting. Smaller issues probably primarily use best efforts because of the greater uncertainty of these issues. For an offering of a given size, the direct expenses of best-efforts underwriting and firm commitment underwriting are of the same magnitude. 3. Rights issues are cheaper than general cash offers and eliminate the problem of underpricing. Yet most new equity issues are underwritten general cash offers. 4. Shelf registration is a new method of issuing new debt and equity. The direct costs of shelf issues seem to be substantially lower than those of traditional issues. 5. Private Equity an increasingly important influence in start-up firms and subsequent financing. Lecture Material The slides for this chapter can easily fit into a two-hour lecture slot. A considerable proportion of this chapter relates to the Royal Bank of Scotland rights issue. It would enhance students’ learning if an example from their own country was used. The calculations are relatively easy and so it shouldn’t take too much time to update the slides. Chapter Twenty Debt Financing Chapter Synopsis This chapter looks closely at how Debt is issued. The main points follow: 1. The written agreement describing the details of the long-term debt contract is called an indenture. Some of the main provisions are security, repayment, protective covenants, and call provisions. 2. There are many ways that shareholders can take advantage of bondholders. Protective covenants are designed to protect bondholders from management decisions that favor equity holders at bondholders’ expense. 3. Unsecured bonds are called debentures or notes. They are general claims on the company’s value. Most public industrial bonds are unsecured. In contrast, utility bonds are usually secured. Mortgage bonds are secured by tangible property, and collateral trust bonds are secured by financial securities such as equities and bonds. If the company defaults on secured bonds, the trustee can repossess the assets. This makes secured bonds more valuable. 4. Long-term bonds usually provide for repayment of principal before maturity. This is accomplished by a sinking fund. With a sinking fund, the company retires a certain number of bonds each year. A sinking fund protects bondholders because it reduces the average maturity of the bond, and its payment signals the financial condition of the company. 5. Most publicly issued bonds are callable. A callable bond is less attractive to bondholders than a noncallable bond. A callable bond can be bought back by the company at a call price that is less than the true value of the bond. As a consequence, callable bonds are priced to obtain higher stated interest rates for bondholders than noncallable bonds. Generally, companies should exercise the call provision whenever the bond’s value is greater than the call price. There is no single reason for call provisions. Some sensible reasons include taxes, greater flexibility, management’s ability to predict interest rates, and the fact that callable bonds are less sensitive to interest rate changes. 6. There are many different types of bonds, including floating-rate bonds, deep-discount bonds, and income bonds. This chapter also compared private placement with public issuance. 7. Islamic businesses can invest in special types of bonds, known as Sukuk, that are designed to be consistent with Shariah law. Lecture Material The slides for this chapter can easily fit into a two-hour lecture slot. Lecturers should not need to change much for this chapter. Chapter Twenty-One Leasing and Off-Balance Sheet Financing Chapter Synopsis Off-balance sheet financing has become a major issue for most of the world’s corporations. While many may see off-balance sheet financing as a bad thing, it has many positive characteristics. In particular, leasing can help firms increase debt capacity when they would otherwise be financially constrained. A large fraction of the corporate world’s equipment is leased rather than purchased. This chapter both describes the institutional arrangements surrounding leases and shows how to evaluate leases financially. It also examined special purpose vehicles and how they can be used to shift risk off a company’s balance sheet. 1. Leases can be separated into two polar types. Though operating leases allow the lessee to use the equipment, ownership remains with the lessor. Although the lessor in a financial lease legally owns the equipment, the lessee maintains effective ownership because financial leases are fully amortized. 2. When a firm purchases an asset with debt, both the asset and the liability appear on the firm’s balance sheet. If a lease meets at least one of a number of criteria, it must be capitalized. This means that the present value of the lease appears as both an asset and a liability. A lease escapes capitalization if it does not meet any of these criteria. Leases not meeting the criteria are called operating leases, though the accountant’s definition differs somewhat from the practitioner’s definition. Operating leases do not appear on the statement of financial position (balance sheet). For cosmetic reasons, many firms prefer that a lease be called operating. 3. Firms generally lease for tax purposes. To protect their interests, tax authorities allow financial arrangements to be classified as leases only if a number of criteria are met. 4. We showed that risk-free cash flows should be discounted at the aftertax risk-free rate. Because both lease payments and depreciation tax shields are nearly riskless, all relevant cash flows in the lease–buy decision should be discounted at a rate near this aftertax rate. We use the real-world convention of discounting at the aftertax interest rate on the lessee’s secured debt. 5. If the lessor is in the same tax bracket as the lessee, the cash flows to the lessor are exactly the opposite of the cash flows to the lessee. Thus, the sum of the value of the lease to the lessee plus the value of the lease to the lessor must be zero. Although this suggests that leases can never fly, there are actually at least three good reasons for leasing: a. Differences in tax brackets between lessor and lessee. b. Shift of risk bearing to the lessor. c. Minimization of transaction costs. We also documented a number of bad reasons for leasing. Lecture Material The slides for this chapter revolve around a large leasing example. Students may find it difficult to follow this lecture because of the new concepts as well as the fairly complex problem that is covered. It is important that the lecturer ensures that students are following and understanding the lecture because, otherwise, the student will quickly become confused. Chapter Twenty-Two Options and Corporate Finance Chapter Synopsis This chapter serves as an introduction to options. 1. The most familiar options are puts and calls. These options give the holder the right to sell or buy shares of equity at a given exercise price. American options can be exercised any time up to and including the expiration date. European options can be exercised only on the expiration date. 2. We show that a strategy of buying a share and buying a put is equivalent to a strategy of buying a call and buying a zero coupon bond. From this, the put–call parity relationship was established: 3. The value of an option depends on five factors: a. The price of the underlying asset. b. The exercise price. c. The expiration date. d. The variability of the underlying asset. e. The interest rate on risk-free bonds. The Black–Scholes model can determine the intrinsic price of an option from these five factors. 4. The “Greeks” (Delta, Gamma, Theta, and Vega) measure different aspects of the risk of options. 5. Much of corporate financial theory can be presented in terms of options. In this chapter, we point out that: a. Equity can be represented as a call option on the firm. b. Shareholders enhance the value of their call by increasing the risk of their firm. Lecture Material It is exceptionally unlikely that all the material in this chapter could be adequately covered in one two-hour session. A recommended approach is to spend one lecture on option basics and another on the applications of options in corporate finance. Chapter Twenty-Three Options and Corporate Finance: Extensions and Applications Chapter Synopsis Real options, which are pervasive in business, are not captured by net present value analysis. Chapter 8 valued real options via decision trees. Given the work on options in the previous chapter, we are now able to value real options according to the Black–Scholes model and the binomial model. In this chapter, we describe and value five different types of options: Executive share options, which are technically not real options. The option to expand and abandon operations. The embedded option in a start-up company. The option in simple business contracts. The option to shut down and reopen a project. We try to keep the presentation simple and straightforward from a mathematical point of view. The binomial approach to option pricing in Chapter 22 is extended to many periods. This adjustment brings us closer to the real world because the assumption of only two prices at the end of an interval is more plausible when the interval is short. Lecture Material Another very large chapter and one which will need to be spread over a number of lectures. Chapters 22 and 23 can be incorporated into a full real options course. Chapter Twenty-Four Warrants and Convertibles Chapter Synopsis Chapter 24 goes into warrants and convertibles in detail. The main points follow: 1. A warrant gives the holder the right to buy shares of equity at an exercise price for a given period. Typically, warrants are issued in a package with privately placed bonds. Afterward they may become detached and trade separately. 2. A convertible bond is a combination of a straight bond and a call option. The holder can give up the bond in exchange for shares. 3. Convertible bonds and warrants are like call options. However, there are some important differences: a. Warrants and convertible securities are issued by corporations. Call options are traded between individual investors. i. Warrants are usually issued privately and are combined with a bond. In most cases the warrants can be detached immediately after the issue. In some cases, warrants are issued with preference shares, with equity, or in executive compensation programs. ii. Convertibles are usually bonds that can be converted into equity. iii. Call options are sold separately by individual investors (called writers of call options). b. Warrants and call options are exercised for cash. The holder of a warrant gives the company cash and receives new shares of the company’s equity. The holder of a call option gives another individual cash in exchange for shares. When someone converts a bond, it is exchanged for equity. As a consequence, bonds with warrants and convertible bonds have different effects on corporate cash flow and capital structure. c. Warrants and convertibles cause dilution to the existing shareholders. When warrants are exercised and convertible bonds converted, the company must issue new shares of equity. The percentage ownership of the existing shareholders will decline. New shares are not issued when call options are exercised. 4. Many arguments, both plausible and implausible, are given for issuing convertible bonds and bonds with warrants. One plausible rationale for such bonds has to do with risk. Convertibles and bonds with warrants are associated with risky companies. Lenders can do several things to protect themselves from high-risk companies: a. They can require high yields. b. They can lend less or not at all to firms whose risk is difficult to assess. c. They can impose severe restrictions on such debt. Another useful way to protect against risk is to issue bonds with equity kickers. This gives the lenders the chance to benefit from risks and reduces the conflicts between bondholders and shareholders concerning risk. 5. A puzzle particularly vexes financial researchers: Convertible bonds may have call provisions. Companies appear to delay calling convertibles until the conversion value greatly exceeds the call price. From the shareholders’ standpoint, the optimal call policy would be to call the convertibles when the conversion value equals the call price. Lecture Material The lecture material concentrates mostly on examples to price convertibles and warrants. Lecturers should also seek out examples from their own country to make the material more relevant to their students. Chapter Twenty-Five Financial Risk Management with Derivatives Chapter Synopsis Chapter 25 considers how firms manage their risk with derivatives. The main points follow: 1. Firms hedge to reduce risk. This chapter shows a number of hedging strategies. 2. A forward contract is an agreement by two parties to sell an item for cash at a later date. The price is set at the time the agreement is signed. However, cash changes hands on the date of delivery. Forward contracts are generally not traded on organized exchanges. 3. Futures contracts are also agreements for future delivery. They have certain advantages, such as liquidity, that forward contracts do not. An unusual feature of futures contracts is the mark-to-the-market convention. If the price of a futures contract falls on a particular day, every buyer of the contract must pay money to the clearinghouse. Every seller of the contract receives money from the clearinghouse. Everything is reversed if the price rises. The mark-to-the-market convention prevents defaults on futures contracts. 4. We divide hedges into two types: short hedges and long hedges. An individual or firm that sells a futures contract to reduce risk is instituting a short hedge. Short hedges are generally appropriate for holders of inventory. An individual or firm that buys a futures contract to reduce risk is instituting a long hedge. Long hedges are typically used by firms with contracts to sell finished goods at a fixed price. 5. An interest rate futures contract employs a bond as the deliverable instrument. Because of their popularity, we work with Treasury bond futures contracts. We show that Treasury bond futures contracts can be priced using the same type of net present value analysis that is used to price Treasury bonds themselves. 6. Many firms face interest rate risk. They can reduce this risk by hedging with interest rate futures contracts. As with other commodities, a short hedge involves the sale of a futures contract. Firms that are committed to buying mortgages or other bonds are likely to institute short hedges. A long hedge involves the purchase of a futures contract. Firms that have agreed to sell mortgages or other bonds at a fixed price are likely to institute long hedges. 7. Duration measures the average maturity of all the cash flows in a bond. Bonds with high duration have high price variability. Firms frequently try to match the duration of their assets with the duration of their liabilities. 8. Swaps are agreements to exchange cash flows over time. The first major type is an interest rate swap in which one pattern of coupon payments, say, fixed payments, is exchanged for another, say, coupons that float with LIBOR. The second major type is a currency swap, in which an agreement is struck to swap payments denominated in one currency for payments in another currency over time. Lecture Material This lecture can be extended to include more examples. Many students find this material quite difficult and counter-intuitive and so it is important to ensure they are following the discussion. The material on duration hedging may benefit from greater and more indepth coverage. Chapter Twenty-Six Short-Term Finance and Planning Chapter Synopsis This chapter introduces the management of short-term finance. Short-term finance involves short-lived assets and liabilities. We trace and examined the short-term sources and uses of cash as they appear on the firm’s financial statements. We saw how current assets and current liabilities arise in the short-term operating activities and the cash cycle of the firm. From an accounting perspective, short-term finance involves net working capital. Managing short-term cash flows involves the minimization of costs. The two major costs are carrying costs (the interest and related costs incurred by overinvesting in short-term assets such as cash) and shortage costs (the cost of running out of short-term assets). The objective of managing short-term finance and short-term financial planning is to find the optimal trade-off between these costs. In an ideal economy, a firm could perfectly predict its short-term uses and sources of cash, and net working capital could be kept at zero. In the real world, net working capital provides a buffer that lets the firm meet its ongoing obligations. The financial manager seeks the optimal level of each of the current assets. The financial manager can use the cash budget to identify short-term financial needs. The cash budget tells the manager what borrowing is required or what lending will be possible in the short term. The firm has a number of possible ways of acquiring funds to meet short-term shortfalls, including unsecured and secured loans. Lecture Material Short-term capital management is not covered in any depth in many universities. As a result, Chapters 26-28 are usually the least interesting to many lecturers. However, given the financial crisis and the liquidity crunch in 2007 and 2008, renewed interest has emerged in this area. Chapter Twenty-Nine Mergers and Acquisitions Chapter Synopsis Chapter 29 covers Mergers and Acquisitions in a lot of detail. The following points are covered in detail: 1. One firm can acquire another in several different ways. The three legal forms of acquisition are merger and consolidation, acquisition of equity, and acquisition of assets. Mergers and consolidations are the least costly from a legal standpoint, but they require a vote of approval by the shareholders. Acquisition by equity does not require a shareholder vote and is usually done via a tender offer. However, it is difficult to obtain 100 percent control with a tender offer. Acquisition of assets is comparatively costly because it requires more difficult transfer of asset ownership. 2. 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): Synergy = VAB  (VA + VB) The shareholders of the acquiring firm will gain if the synergy from the merger is greater than the premium. 3. The possible benefits of an acquisition come from the following: a. Revenue enhancement. b. Cost reduction. c. Lower taxes. d. Reduced capital requirements. 4. Shareholders may not benefit from a merger that is done only to achieve diversification or earnings growth. And the reduction in risk from a merger may actually help bondholders and hurt shareholders. 5. A merger is said to be friendly when the managers of the target support it. A merger is said to be hostile when the target managers do not support it. Some of the most colorful language of finance stems from defensive tactics in hostile takeover battles. Poison pills, golden parachutes, crown jewels, and greenmail are terms that describe various antitakeover tactics. 6. The empirical research on mergers and acquisitions is extensive. On average, the shareholders of acquired firms fare very well. The effect of mergers on acquiring shareholders is less clear. 7. In a going-private transaction, a buyout group, usually including the firm’s management, buys all the shares of the other equity holders. The equity is no longer publicly traded. A leveraged buyout is a going-private transaction financed by extensive leverage. Lecture Material This chapter is very large and the slides have been condensed as much as possible to ensure that the material can be covered in as short a period as possible. It is likely that it will be too difficult to fit everything into a two-hour lecture and so instructors should consider ways in which the material can be split up over two or more lectures. This area is very well suited to case studies and these can be utilized to great effect. Chapter Thirty Financial Distress Chapter Synopsis This chapter examines what happens when firms experience financial distress. 1. Financial distress is a situation where a firm’s operating cash flow is not sufficient to cover contractual obligations. Financially distressed firms are often forced to take corrective action and undergo financial restructuring. Financial restructuring involves exchanging new financial claims for old ones. 2. Financial restructuring can be accomplished with a private workout or formal bankruptcy. Financial restructuring can involve liquidation or reorganization. However, liquidation is not common. 3. Corporate bankruptcy involves liquidation or reorganization. An essential feature of bankruptcy codes is the absolute priority rule. The absolute priority rule states that senior creditors are paid in full before junior creditors receive anything. However, in practice the absolute priority rule is often violated. Lecture Material Although the chapter is fairly short, the topic is one of importance in the current economic climate. The slides can fit easily into a two hour session. Chapter Thirty-One International Corporate Finance Chapter Synopsis The international firm has a more complicated life than the purely domestic firm. Management must understand the connection between interest rates, foreign currency exchange rates, and inflation, and it must become aware of many different financial market regulations and tax systems. This chapter is intended to be a concise introduction to some of the financial issues that come up in international investing. Our coverage has been necessarily brief. The main topics we discussed are the following: 1. Some basic vocabulary: We briefly defined some exotic terms in international finance. 2. The basic mechanics of exchange rate quotations: We discussed the spot and forward markets and how exchange rates are interpreted. 3. The fundamental relationships between international financial variables: a. Absolute and relative purchasing power parity, PPP. b. Interest rate parity, IRP. c. Unbiased forward rates, UFR. Absolute purchasing power parity states that a currency, such as the euro, should have the same purchasing power in each country. This means that an orange costs the same whether you buy it in Brussels or in Oslo. Relative purchasing power parity means that the expected percentage change in exchange rates between the currencies of two countries is equal to the difference in their inflation rates. Interest rate parity implies that the percentage difference between the forward exchange rate and the spot exchange rate is equal to the interest rate differential. We show how covered interest arbitrage forces this relationship to hold. The unbiased forward rates condition indicates that the current forward rate is a good predictor of the future spot exchange rate. 4. International capital budgeting: We showed that the basic foreign exchange relationships imply two other conditions: a. Uncovered interest parity. b. The international Fisher effect. By invoking these two conditions, we learned how to estimate NPVs in foreign currencies and how to convert foreign currencies into the home currency to estimate NPV in the usual way. 5. Exchange rate and political risk: We described the various types of exchange rate risk and discussed some common approaches to managing the effect of fluctuating exchange rates on the cash flows and value of the international firm. We also discussed political risk and some ways of managing exposure to it. Lecture Material The chapter is an introduction to international corporate finance and so the material is covered in a fairly descriptive way. The main objective of the lecture is to get across the international parity conditions and apply these to corporate financial decision-making. Instructor Manual for Corporate Finance David Hillier, Stephen Ross, Randolph Westerfield, Jeffrey Jaffe, Bradford Jordan 9780077139148