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

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" »

Understanding Common and Preferred Stock

Par Value Explained

Par Value: The stated value on a stock certificate.

• An accounting value, not market value.
• Represents the dedicated capital of a corporation, calculated as the total par value (number of shares * par value of each share).

Authorized vs. Issued Common Stock

• The articles of incorporation must state the number of shares of common stock the corporation is authorized to issue.
• The board of directors, after a vote of the shareholders, may amend the articles of incorporation to increase the number of shares.
• Authorizing a large number of shares may concern investors about dilution because authorized shares can be issued later with the approval of the board of directors but without a vote of the

Mercantile Companies

Classification of Companies

Companies can be classified as either civil or mercantile. Partnerships can be further categorized into the following types:

• Collective Company
• Limited Partnership (Comanditary Company)
• Limited Partnership by Shares
• Limited Liability Company
• Anonymous Company (Corporation)

Companies can also be classified based on whether they are person-based or stock-based.

Concept of Mercantile Company

Article 35 of the Civil Code (CC) states that legal persons include associations of private interest, whether civil, business, or industrial, to which the law grants legal personality independent of that of each member. According to Article 36 of the CC, these legal persons are governed by the provisions relating to the... Continue reading "Understanding Mercantile Companies: Types and Legal Framework" »

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