Notes, summaries, assignments, exams, and problems for University

The cash inflows (collections) and outflows (disbursements) are not perfectly synchronized, and some level of cash holdings is necessary to serve as a buffer. Perfect liquidity is the characteristic of cash that allows it to satisfy the transactions motive.

Determining the Target Cash Balance

The target cash balance involves a trade-off between the opportunity costs of holding too much cash (lost interest) and the trading costs of holding too little. If a firm tries to keep its cash holdings too low, it will find itself selling marketable securities more frequently than if the cash balance were higher. The trading costs will tend to fall as the cash balance becomes larger. The opportunity costs of holding cash rise as the cash holdings rise.

Investing

Options and Futures Contracts Fundamentals

Options vs. Futures Contracts: Key Differences

• Option Buyer: Has the right, but not the obligation, to transact. The buyer can abandon the option if desired. The option premium paid is the maximum financial exposure.
• Futures Contract Buyer: Cannot abandon the contract. The buyer is obligated to transact, leading to theoretically unlimited exposure.

Types of Options

• European Options: Can be exercised only at the expiration date.
• American Options: Can be exercised at any time up to the expiration date.

Call Options Defined

A Call Option gives the holder the right, but not the obligation, to buy a given quantity of an asset on or before some time in the future, at prices agreed upon today (the strike price, $... Continue reading "Options Trading Basics: Definitions, Payoffs, and Sensitivity Factors" »

TOPIC 7: INTRODUCTION TO OPTIONS AND FUTURES

1. INTRODUCTION TO DERIVATIVES

Definition: financial instrument whose payoffs and values are derived from / depend on something else. Goals:

• To illustrate the economic function/application of derivatives
• Understand how derivative markets are organized
• Be aware of the main derivative markets

Risk: The chance that an investment's actual return will be different than expected. Risk includes the possibility of losing some or all of the original investment.

Types:Market risk: Change in the value of an asset due to changes in exchange rates, interest rates, inflation rates, bond prices, equity prices, or commodity pricesCredit risk: The other party fails to meet the agreed conditions (payments and dates). Example:... Continue reading "Introduction to Derivatives: Types, Risks, and Markets" »

Operating Leverage

The degree of operating leverage measures how sensitive a firm is to its fixed costs. It increases as fixed costs rise and variable costs fall. Operating leverage magnifies the effect of cyclicality on beta. That is, a firm with a given sales cyclicality will increase its beta if fixed costs replace variable costs in its production process.

Financial Leverage and Beta

Financial leverage is the sensitivity to a firm's fixed costs of financing.

The equity beta will always be greater than the asset beta with financial leverage: the equity beta of a levered firm will always be greater than the equity beta of an otherwise identical all-equity firm.

Extensions of the Basic Model

The Firm vs. the Project

Any project's cost of capital depends... Continue reading "Understanding Operating and Financial Leverage in Business Valuation" »

NPV Analysis in Mergers

Typically, a firm uses Net Present Value (NPV) analysis when making acquisitions. The analysis is straightforward with a cash offer, but it becomes more complicated when the consideration is stock.

Friendly vs. Hostile Takeovers

• In a friendly merger, the management of both companies are receptive to the deal.
• In a hostile merger, the acquiring firm attempts to gain control of the target without its management's approval. This can be done through a:
  • Tender offer
  • Proxy fight

Merger and Acquisition Defensive Tactics

Target companies may use several tactics to defend against a hostile takeover:

• Corporate charter amendments:
  • Classified board (i.e., staggered elections for directors)
  • Supermajority voting requirement
• Golden parachutes:

CHAPTER 9: MERGERS AND ACQUISITIONS

1. The Basic Forms of Acquisitions

• Merger or Consolidation
• Acquisition of Stock
• Acquisition of Assets

Merger vs. Consolidation

Merger

• One firm is acquired by another
• Acquiring firm retains name and acquired firm ceases to exist
• Advantage – legally simple
• Disadvantage – must be approved by stockholders of both firms

Consolidation

• Entirely new firm is created from combination of existing firms

Acquisition

A firm can be acquired by another firm or individual(s) purchasing voting shares of the firm’s stock

• Tender offer – public offer to buy shares
• Stock acquisition
  • No stockholder vote required
  • Can deal directly with stockholders, even if management is unfriendly
  • May be delayed if some target shareholders hold out for more

The Company Beta (β)

β = Cov(R_i, R_M) / Var(R_M)

Problems of Beta:

1. Betas may vary over time.
2. The sample size may be inadequate.
3. Betas are influenced by changing financial leverage and business risk.

Solutions:

1. Problems 1 and 2 can be moderated by more sophisticated statistical techniques.
2. Problem 3 can be lessened by adjusting for changes in business and financial risk.
3. Look at average beta estimates of several comparable firms in the industry.

Stability of Beta

Most analysts argue that betas are generally stable for firms remaining in the same industry, but they can change due to:

• Changes in product line
• Changes in technology
• Deregulation
• Changes in financial leverage

Using an Industry Beta

It is frequently argued that one can better estimate a firm's beta... Continue reading "Understanding Beta in Finance: Calculation, Stability, and Determinants" »

Loan Types and Capital Cost Analysis

Understanding Loan Structures

American Loans Explained

In American loans, all intermediate payments only include interest expenses. The principal is paid back at maturity.

C − Fees = I = ∑T_i · C_o + C_o

_{o o j=1} (1+R_B)^j (1+R_B)^T

French Loans Explained

The loan is repaid with equal payments (P), which include both interest and partial repayment of the principal. The process requires three steps:

1. Calculate the constant payment per period ‘P’.
2. With the computed value ‘P’, calculate the cost of debt.
3. Compute the effective annual rate.

The Cost of Equity Capital

Firms with excess cash can either pay a dividend or make a capital investment. Because stockholders can reinvest the dividend in risky financial assets,... Continue reading "Financial Valuation: Loan Structures and Equity Cost Models" »

Dividends

• Unless a dividend is declared by the board of directors of a corporation, it is not a liability of the corporation (A corporation cannot default on an undeclared dividend)
• The payment of dividends by the corporation is not a business expense. (Therefore, they are not tax-deductible)
• Dividends received by individual shareholders are, for the most part, considered ordinary income by the IRS and are fully taxable (There is an intra-corporate dividend exclusion)

Preferred Stock

Preferred stock represents equity of a corporation, but is different from common stock because it has preference over common in the payments of dividends and in the assets of the corporation in the event of bankruptcy. They have a stated liquidating value (usually $... Continue reading "Understanding Dividends, Preferred Stock, Debt, and Equity in Corporate Finance" »