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

Compensating Balances

Compensating balances are deposits a firm maintains with a bank in low-interest or non-interest-bearing accounts, typically ranging from 2% to 5% of the credit amount used. By leaving these funds with the bank, the firm increases the effective interest earned by the bank on the line of credit.

Secured Loans

Security for short-term loans usually consists of accounts receivable or inventories.

Accounts Receivable Financing

Receivables are either assigned or factored:

• Assignment: The lender holds a lien on the receivables and retains recourse to the borrower.
• Factoring: Involves the sale of accounts receivable; the factor collects the payments and assumes the full risk of default.

Inventory Loans

An inventory loan uses inventory as... Continue reading "Corporate Cash Management and Short-Term Financing Strategies" »

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" »

Reasons to Use Derivatives

• Hedging: Mitigates risks related to interest rate, stock price, exchange rate, and commodity price volatility.
• Speculation: Utilizes high leverage for potential huge returns, though it remains extremely risky.

Types of Derivative Assets

Derivatives exist on a wide variety of assets:

• Options: Trade on individual stocks, market indexes, metals, interest rates, and futures contracts.
• Forward and Futures Contracts: Trade on agricultural commodities (wheat, live cattle, precious metals like gold and silver), energy (crude oil, gas, and heating oil), foreign currencies, U.S. Treasury bonds, and stock market indexes.
• Swap Contracts: Trade on interest rates, foreign currency, and other assets.

Market Structures

• Listed Derivatives:

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" »

Equity and Ownership Interest

Equity represents an ownership interest in a corporation. Key characteristics include:

• Common stockholders vote for the board of directors and other corporate issues.
• Dividends are not considered a cost of doing business and are not tax-deductible.
• Dividends are not a liability of the firm, and stockholders have no legal recourse if dividends are not paid.
• An all-equity firm cannot go bankrupt.

Interest vs. Dividends

Debt is not an ownership interest in the firm. Creditors do not usually have voting power. The corporation’s payment of interest on debt is considered a cost of doing business and is fully tax-deductible. Conversely, dividends are paid out of after-tax dollars. Unpaid debt is a liability of the firm; if... Continue reading "Corporate Finance: Equity vs Debt Fundamentals" »

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" »