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61 Cards in this Set
- Front
- Back
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Sources of Capital
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1. Internal Capital - returned earnings, used the most, cheaper - no txn costs, no covenants, no convincing someone of your idea, shows you're confident
2. External Capital - 2 types - Debt and Equity 3. Public or Private Offerings 4. International Markets |
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Differences btwn Debt and Equity
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1. Debt holders have K specifying their claims must be paid in full before the firm can make pymts to equity holders.
2. Debt claims are senior to equity claims 3. Debt payments are tax deductible and equity (dividends) are not 4. Equity is bigger - incl stocks, warrants, RE |
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Public v. Private Sources of Capital
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a) Can be a publicly traded financial instrument, creates secondary market for some debt - don't have to sell only to the company
b) Private Placements - an offering of securities that are not registered with SEC, generally no secondary market, e.g. hedge funds, allows us to customize |
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Some Req'ts for filing w SEC
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1. Identify underwriting syndicate - who else is selling this stock for primary offering
2. due diligence - audited, verified 3. Separation of commercial and investment banking - law repealed but still the norm in US. |
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What is the underwriting process?
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The process of issuing securities,
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Investment Banks role in Underwriting Process
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1. Organization - originate securities, advise whether to go public and how many shares
2. Distribution of shares to buyers 3. Certification - due diligence, provide information to whether stock is risky or not |
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Elements of an Underwriting agreement
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1. K btwn i-bank and firm
2. # of shares to be sold and price 3. Underwriting spread - Fee charged by a syndicate, equal to the difference between the gross sales to investors and the net proceeds received by the issuer. 4. Green Shoe Options - permits i-bank to request more shares be issued on the same terms already sold. |
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Process of Going Public
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0. firm choses underwriter and assembles data req'd for registration stmt
1. Audited financial stmts 2. Desc of buz 3. All material info: info that if omitted would alter the value of the firm 4. Underwriter - estimates demand for the issue. markets the stock and allocates shares, conducts road shows in which mngmt tries to sell the IPO to institutional investors. |
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Firm Commitment Offering
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Underwriter agrees to buy the whole offering from the firm at a set price and off it to the public for a slightly higher price.
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Best Efforts Offering
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Underwriter and the firm fix a price and the min and max # of shares sold. Investors express interest by depositing in underwriter's escrow acct. If min # of shares are NOT sold in 90 days, offer w/drawn and money refunded
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Negotiated offering
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Firm negotiates the underwriting agreement w underwriter
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Completive Offering
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Firm specifies the K and puts out a bid (only used by utilities)
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Shelf Offerings
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2 years to sell
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Rights Offerings
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entitle existing shareholders to buy new shares in the firm at a discounted price.
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Types of Offerings
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1. IPO - Initial public offering - first time issue of stock
2. Seasoned offering - selling more stock 3. Primary issue - sold directly to the public 4. Secondary issue - undertaken for existing larger shareholders who want to sell a substantial # of shares they currently own - so enlist an i-bank to help them out |
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Why is issuing debt cheaper than equity?
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1. Cheaper to issue debt, less risky
2. IPO's more expensive bc less is known, riskier 3. Issuing public debt is more routine than issuing equity |
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Shareholder Suits -- Direct v Derivative Suits
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1. Direct actions - personal to the shareholder; damages suffered as a result of buying stock too high a price to a misleading prospectus, usu class actions
2. Derivative actions - enforce corp righs - damages paid to the corp, against a director who reaped excessive process, fiduciary duty violation |
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Legal methods for enforcing rights of Creditors
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Creditors generally cannot sue a corporation direct but can under a derivative suit when the corp is insolvent. Whether they can sue when corp enters the "zone of insolvence" is still up in the air.
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What is the zone of insolvency
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A corporation looks like its about to go under.
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Why would you want creditors to sue?
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Prevent squandering of assets to the shareholders
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Why can't creditors sue directly?
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1. BOD is supposed to act for the shareholder; BOD may act more risk adverse if knows its going to be sued
2. would write ability to sue into K 3. would more the creditor up the chain to being paid off. 4. Harder to get indemnification for BOD if exposed to more risk. |
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Types of debt financing
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1) Fixed income investments - pay off in the future a fixed stream of payments to the investor over a certain period of time.
2) Bank loans - arrangement w bank, short-term loan, authorizes max amt, but not i-rate |
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Benchmark for floating rates
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1. Treasury Rate - Notes, bonds, bills
2. Fed fund rate - overnight loans btwn 2 financial institutions 3. LIBOR - londong interbank 4. Commercial paper rate - yields short-term, zero-coupon notes 5. Prime rate - charged by banks |
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Asset Covenants
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1. Secured Bond - A bond for which the firm has pledged the title of an asset
2. Mortgage bond - secured bond giving lenders first-mortgage lien on an asset 3. Collateral trust bond - secured bond where assets are placed in trust 4. Debenture - unsecured bond, unsecured creditors. Have a claim on |
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Types of Bond Options
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1. Callability - call bond
2. Convertibility - convert to diff't security 3. Exchangability - change bond for diff't type of bond 4. Putability - right of bond holder to sell bonds back to the firm |
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Leveraged Buyout Process
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occurs when a financial sponsor acquires a controlling interest in a company's equity and where a significant percentage of the purchase price is financed through leverage (borrowing). The assets of the acquired company are used as collateral for the borrowed capital, sometimes with assets of the acquiring company. The bonds or other paper issued for leveraged buyouts are commonly considered not to be investment grade because of the significant risks involved.
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12 Types of Equity
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1. Stocks
2. Warrants 3. RE 4. ... |
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Advantages of Going Public
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1. Better access to capital markets
2. Public markets provide liquidity 3. Original owners can diversity 4. Monitoring and source of information to the fimr 5. Publicity |
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Disadvantages of Going Public
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1. Expensive
2. Costs of dealing w shareholders 3. Info revealed to competitors 4. Public Pressure |
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Why IPO's often underpriced?
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Some investors have better info than others
winner's curse Underwriters incentive is to set the price low enough that all shares sell Underpricing makes underwritier's job less risky want to under price to show good performance for another offering lawsuits |
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How IPOs are priced and allocated
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I-bankers react to info provided by investors when they price the IPO. Investors who provide more favorable info are allocated more shares.
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formula of NPV and comparing projects
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Accept any project w a positive NPV.
NPV = (PV of all cash flows) - (PV of current and future cash outflows) Chose the project w the greatest NPV |
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What is captured by the i-rate?
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risk free rate + default risk + change in interest rate risk + inflation (real rate) (if not already built in to the rate used)
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Things to remember about balance sheets
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1. Debits (liabilities) go one the right side; Credits (assets) on the left
2. Depreciation is subtracted from the asset and from the retained earnings on the right. 3. Assets = Liabilities + Owner's Equity [Firms Net Worth] 4. Snap shot |
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Things to Remember about Income Statements
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1. Summarizes profitability of firm over time
2. Difference btwn revenues and expenses 3. Depreciation is deducted as an expense. |
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Formula For Net Cash Flows - accounting
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A: Sources of Cash - investments, cash
B: Use of Cash - Fixed assets, expenses, inventory, notes Subtract A-B = Net Cash Flow |
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Accounting Info to Compare for Future of Company
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Positive Cash Flow? Cash Flow is the most important thing for stability
Current Assets Exceed Current Liabilities? Going forward, these may be as or more important than current P&L? |
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Importance of Footnotes
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1. Explain non-cash transactions that are hard to find on financial stmts
2. Explanation of major items that have an impact on the financial stmt s.a. Stock compensation and long-term debt terms and conditions 3. All significant accounting policies must be rported 4. Accounting principles and methods disclosed 5. Options are not on the balance sheet 6. Liabilities of possible litigations |
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Use and Abuse of Accounting Ratios
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1. Must be standardized for financial comparisons
2. Evaluates current operations 3. Compares performance w past performance 4. Compares firms across an industry |
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Current Ratio
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Liquidity Ratio
= Current Assets / Current Liabilities |
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Debt Ratio
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Total Liabilities/Total Assets
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Auditor's Liability
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GR: No liability for straight negligence to third ptys. Liability if 1) neg misrep or 2) fraudulent mispre.
Fraud Misrep liability - foreseeable third parties Neg Misrep liability -- to thos whom or for whom mis reps were made and for those whose benefit he intends to supply the info for benefit of third party or knows the recipient intends to supply it. and also w respect to an identified txn or substantially similar txn |
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Valuing a Degree as a debt owed to the nondegreeing spouse - how its assessed and problems
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principle + interest
risk: est risk premium and incl it in the "interest rate" NDS could easily invest the money him him/herself so implication is the return would be greater if she invested in him. * he could deflect after he rec'd his degree - so rate she would demand knowing the marriage would fail *NDS i-rate v what DAS can get from bank - makes sense that she would charge more and he could get a better rate from the bank; hwr costs absorbed by the home so doesn't seem like he is paying as much for the degree. NDS can also charge less i-ate bc altruism. |
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Valuing a Degree as equity owed to the nondegreeing spouse - how its assessed and problems
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Comparing the avg lifetime earnings of ppl w BS degrees against the lifetime earnings of ppl w MDs and assigning a present value of the difference. PV(MD-BS)/2.
Risk: bc the avg was used, the pressure is on the DAS to hedge more than the average. NDS will get the avg re of what DAS does - this is a high risk on DAS. Stock solution - selling the "doctors stock" on the market. |
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Valuing degree as gratuitous
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Ppls real motivation is altruism.
Too hard to figure out amt - some forms of household production have good market equivalents (housework) so have poor market equivalents (sex) |
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What is the expected rate of return w no risk?
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probability weighted average of all possible outcomes
Er = p1r1+p2+r2+...+pnrn |
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how is risk quantified?
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Risk is the standard deviation
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What are the different risk management techniques?
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1. risk avoidance - a conscious decision not to be exposed to particular risk
2. loss preventino and control - actions taken to reduce the likelihood or severity of losses 3. Risk retention - absorbing the risk and covering costs out of own resources 4. Risk transfer - transferring risk to others hedging - action taken to reduce one's exposure to loss - also causes one to give up the possiblity of gain insurance - pay a premium, guaranteed loss, for the possiblity of a larger loss if you do not insure diversifying - holding similar amts of many risky assets instead of concentrating all of your investment into one. |
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relationship btwn interest rates and credit risk (default risk)
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as default risk goes up then the i-rate goes up to get the same amount of expected return on the same amount of money but w/ different possibilities of returns from diff't scenarios.
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i-rate for a t-bond w no default risk is 10% on $1Mill. if you know there is a 50% chance of default paying back $750K and 50% entire $1Mil, what should be the adjusted i-rate to take on this risk?
Expected rate of return = (total return/lending amt) - 1 |
45% i-rate -- 10% is the time premium and 35% is the default or credit premium.
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Amoco -- Determining the i-rate
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Court holds the borrower (wrongdoer) must pay the market rate for money - prejudgment i-rate at market rate puts both parties in the position that they would have occupied had compensation been paid promptly.
THus i-rate should be the rate the victims would rec'v had they borrowed the money. Court assumes market (prime) rate that the bank would charge their best customers- but does not take into account the victim's creditworthiness. THe court also does not use the Def's internal rate of return bc victims do not have access to that type of return. Using the prime rate -- what should be the i-rate - the weighted avg since the damages began? prime rate at time of litigation? just avg prime rate? |
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A little bit about leverage
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is borrowing money to supplement existing funds for investment in such a way that the potential positive or negative outcome is magnified and/or enhanced.
Leverage allows greater potential returns to the investor than otherwise would have been available but the potential for loss is also greater because if the investment becomes worthless, the loan principal and all accrued interest on the loan still need to be repaid. |
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Law of One Price and Arbitrage
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In a competitive market, if two assets are equivalent, they will tend to have the same price "equivalent" - risk you are asking to bear.
The law of one price is enforced by a process called arbitrage. the practice of taking advantage of a price differential btwn two or more markets - buy in low market and turn around and sell in high market. Some barriers to arbitrage -- transaction costs (ideally, no two parts of the country should differ by no more than the transaction costs of moving it); untradeable goods if 2 similar securities are trading at significantly diff't prices, we first suspect some unknown difference. |
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Valuation Using Comparables for assets not traded and Valuation Models
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Some assets are not traded, but still need to be evaluated. So law of one price is used to evaluate assets. Find a comparable asset if you can as similar as possible and then assign some value attributed to the differences in the assets.
Valuation Models - a quantitative method used for estimating an asset's value from known prices of other assets that are not its exact equivalent. valuation is the process of estimating the market value of a financial asset or liability. Valuations can be done on assets (for example, investments in marketable securities such as stocks, options, business enterprises, or intangible assets such as patents and trademarks) or on liabilities (e.g., Bonds issued by a company). |
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Efficient Capital Market Hypothesis (ECMH) and assumptions
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An asset's current price reflects all publicly avail info about future economic fundamentals affecting market price.
Different forms of ECMH 1. Weak form - means that you cannot predict stock prices. Assumes that info is readily avial to all traders; only new public info can affect stock prices. Can infer nothing from price movement - no info at all. 2. Semi-strong - All publicly avail info reflected in stock prices. If there is a release of info, it is immediately reflected in stock prices; what will not be reflected is insider info or info that is too costly to get. Assumes some ppl have more info than others. Until the knowledge raises to a certain level of knowledge, you can make money on that knowledge.. 3. Strong: All info, public or not, is reflected in the stock price. Everyone knows all information. The mere act of trading on info reveals it to everyone else. Means that insiders cannot gain from their knowledge bc the stock price will immediately start to trade. reality - there is a lag time. Assumptions zero txn costs in securities all avail info is costlessly avail to market |
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"Behavior" Finance
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Challenges to ECMH
Investors react to irrelevant information Assumes ppl are rational and trade on relevant info Ppl exhibit loss aversion - reluctant to sell stocks that lose vlaue Framing matters -- ppl stick to what they have |
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Bonds and changes in the i-rate
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if the i-rate goes up, then the PV is going to be lower bc if making the same payment, the discounted rate of the same amt of money is going to be less.
Bond prices rise as the i-rate falls. when feds cut i-rate - bond prices go up. and when bond prices go up, ppl switch to stocks and stock prices go up. bc i-rate is changing, prices of fixed income securities are uncertain until they mature |
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Current Yield
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Coupon/Price
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Coupon rate
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coupon / face value = % paid out in payments of a bond
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Par , Premium, Discount bonds
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par -- a bond is worth its par value when the market price is equal to the face value. current yield is = coupon rate.
premium bond - A bond that is priced higher than its par value. Means the i-rate dropped after the bond was issued. YTM < current yield < coupon rate discount bonds -- a bond that is priced lower than its par value. this happens when the i-rate goes up. YTM > Current Yield > Coupon Rate |
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Yield to Maturity
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is the discount rate that makes the PV of the cash flows of the bond + fave value = to the current price to the bond.
PV(bond) = PV(all payments) + PV(FV) |
