Fete Section 1

Front 1

Essential Properties of Capital Budgeting Techniques

Back 1

1. Consider all CFs
2. Discount CFs at opportunity cost
3. Select form mutually exclusive projects
4. Consider each independently

Front 2

Four Capital Budgeting Techniques

Back 2

1. Payback method
2. Accounting rate of return
3. NPV
4. IRR

Front 3

Problems of IRR

Back 3

1. Do not obey the value-additivity principle
2. Assume opportunity costs = IRR
3. Can lead to multiple IRRs

Front 4

Three Key Assumptions for Pricing Real Options

Back 4

1. Marketed Asset Disclaimer
2. No Arbitrage
3. Random Walk

Front 5

Types of Real Options

Back 5

1. Expansion options/growth options
2. Contraction options
3. Abandonment options
4. Extension options
5. Deferral options
6. Compound options
7. Rainbow options
8. Sequential compound options
9. Switching options

Front 6

Miller and Modigliani's Assumptions

Back 6

1. Frictionless markets
2. Issue risk-free debt and risky equity only
3. No bankruptcy costs
4. Assume all firms in the same risk class
5. No change in Oper CFs in capital structure is changed
6. Corp taxes are the only gov't levy
7. Everybody has the same info
8. Can borrow/lend at the risk-free rate
9. All CF streams are perpetuities
10. SH's wealth is maximized by managers

Front 7

Non-Equilibrium Effects

Back 7

1. Signaling
2. Pecking order
3. Foregone investment opportunities

Front 8

Reasons why convertible bond is used

Back 8

1. The acct'g rules favor the CB
2. Better tailored to the CF patterns of rapidly growing firms
3. Easier for bond issuer and purchaser to agree on the bond value
4. Reduce the agency costs
5. Has a call provision built in
6. Lower the issuance costs

Front 9

The objectives of Joint Ventures

Back 9

1. Share risks
2. Reduce Investment costs
3. Gain the economies of scale
4. Gain knowledge
5. Share or exchange technology
6. Share managerial skills

Front 10

Alliances

Back 10

1. Less formal than joint ventures
2. Do not create a new entity
3. May not have a formal contract
4. Unequal size of participants
5. Partner firms pool resources
6. Require mutual trust
7. Rapid change in a relationship

Front 11

Main techniques for Shedding Assets to Create Value

Back 11

1. Divestitures
2. Equity Carveouts
3. Spin-offs
4. Split-ups
5. Tracking stocks

Front 12

Five Categories of Merger Defense

Back 12

1. Defensive restructuring
2. Poison pills
3. Poison puts
4. Antitakeover amendments
5. Golden parachutes

Front 13

Two Sources of Deadweight Costs

Back 13

1. Information Costs
2. Higher taxes & agency costs of free CFs

Front 14

Areas Affected by Deadweight Costs

Back 14

1. The overall capital costs
2. The investment opportunities
3. The RM policies

Front 15

Methods to Allocate Risk Capital

Back 15

1. Stand-alone basis
2. Fully allocated basis
3. Marginal basis

Front 16

Reasons Why Co's Favor using EC

Back 16

1. EC reflects the risks of the LOBs
2. RC may not reflect firm-specific risks
3. RC varies by political jurisdiction
4. The diff btw RC & EC can be hedged through "rule arbitrage"
5. EC can be compared across LOBs

Front 17

Major Applications of EC

Back 17

1. Product the risk profile
2. ALM
3. Product pricing
4. Eval req'd capital in M&A situations
5. Risk tolerances & constraints
6. Calc RAROC
7. Lead rating agency & regulatory discussions
8. Incentive comp
9. Performance measurement
10. Seek capital budgeting

Front 18

Approaches to Calc EC

Back 18

1. Full econ scenarios
2. Stress test method
3. Factor tables
4. Stoch models
5. Scenario generator
6. Credit risk methods
7. Statistical methods
8. Operational risk methods
9. Option pricing theory - B-S Model
10. Adjustments for correlation

Front 19

Four Approaches to Allocated Face Capital

Back 19

1. Hold in Corp line
2. Marginal
3. Pro-rata
4. Treat each LOB as if monoline

Front 20

Pros & Cons of Holding in Corporate Line

Back 20

Pros:
1. Simple
2. Insulate product lines from vagaries of RC formulas

Cons:
1. Could lead to over investment in LOBs that tie up excessive RC

Front 21

Pros and Cons of Marginal Approach

Back 21

Pros:
1. Attempts to allocate true cost of face capital for adding given LOB

Cons:
1. Complicated

Front 22

Pros & Cons of Pro-Rata Approach

Back 22

Pros:
1.Simple
2. Allocate FC to business units

Cons:
1. May allocated FC to LOB that generated none & vice versa

Front 23

Pros & Cons of Treating each LOB as if Monoline

Back 23

Pros:
1.Easier to understand
2. Neither help nor hurt a given LOB due to presence of other LOBs

Cons:
1. May allocate FC to LOB that adds little RC due to diversification

Front 24

What factors influence Managerial Incentives?

Back 24

1. The amt of time the managers have spent on the job
2. The number of shares they own

Front 25

The Investment Choices that Managers Prefer Making Investment

Back 25

1. Fit the manager's expertise
2. Be visible/fun industries
3. Pay off early
4. Min the manager's risk & increase the scope of the firm

Front 26

Pros & Cons of Stock Based Compensation

Back 26

Pros:
1. Motivate manager to improve stock prices

Cons:
1. Stock prices change for reasons outside the control of managers
2. Stock prices move due to changes in expectations and realization

Front 27

Pros & Cons of Earnings Based Compensation

Back 27

Pros:
1. The numbers are generally available

Cons:
1. Difficult to calc the CF number
2. The accounting numbers might not provide a reliable measure of a firm's performance

Front 28

Pros & Cons of Value Based Compensation

Back 28

Pros:
1. Recognize economic values and cost of capital

Cons:
None listed

Front 29

Sole Proprietorship Form

Back 29

1. A business with one owner
2. The owner is personally liable for all debts of the company
3. Business profits are taxed as ordinary income of the owner

Front 30

Partnership Form

Back 30

1. Two or more owners
2. No legal distinction btw business and the owners
3. Each can execute contracts binding
4. Each is personally liable for all the debts
5. Business is dissolved if any partner dies
6. Each shares the income & management authority equally
7. Income is taxed at the personal level

Front 31

Corporate Form

Back 31

1. A separate legal entity
2. The corp is the property of the SHs
3. Shares of stock have voting rights
4. SHs w major votes can select the BoD's and set corp policy

Front 32

Limited Partnership Form

Back 32

1. Lim'd liability to lim'd partners
2. Tax income at the personal level
3. At least one general partner who has unlimited personal liability
4. The general partner operates the business and receive bigger income
5. The lim'd partners are passive

Front 33

S Corporate Form

Back 33

1. Tax business income at personal level not corporate level
2. Lim'd liability to SHs
3. Can easily switch to be a C corp

Front 34

Factors Affect the Business Form Used

Back 34

1. Investor's liabilities
2. Tax treatment of business income
3. Access to capital
4. Length of existence
5. Ease of formation

Front 35

Pros & Cons of Sole Proprietorship Form

Back 35

Pros:
1. Easy to est. & wind down
2. Tax treatment of the business income
3. Easy record keeping
4. Simple tax filing
5. Can deduct legit business expenses

Cons:
1. Lim'd life
2. Lim'd access to capital
3. Unlim'd personal liability

Front 36

Pros & Cons of Partnership Form

Back 36

Pros:
1. Allow large number of ppl
2. Business income taxed once
3. Pool capital from different partners
4. Not terminated if any partner dies

Cons:
1. Lim'd life
2. Lim'd access to capital
3. Unlim'd personal liability

Front 37

Pros & Cons of Corporate Form

Back 37

Pros:
1. Lim'd liability
2. Perpetual life time
3. Contract authority
4. Unlim'd access to capital
5. Free trade in ownership

Cons:
1. Tax Income at the firm & personal levels
2. Expensive to create and maintain

Front 38

Pros & Cons of the Limited Partnership Form

Back 38

Pros:
1. Lim'd liability to lim'd partners
2. Tax income at the personal level

Cons:
1. Relatively long lives & illiquidity
2. Costly to establish
3. Difficult to monitor the general partner
4. Having LP income is a IRS "red flag"

Front 39

Pros & Cons of S Corporate Form

Back 39

Pros:
1. Tax income at personal level
2. Lim'd liability to SHs
3. Can easily switch to be a C Corp

Cons:
1. Must have 35 or fewer SHs
2. They must be individuals or trusts
3. S-Corp can't be a holding co
4. S-Corm can only have one class of equity

Front 40

Characteristics of Open Corporation

Back 40

1. Have large number of SHs
2. Rely on public capital markets
3. Have large stock & bond markets
4. Small stockholders are the focus
5. Controlled by professional managers
6. Rely on equity-based compensation
7. Active market for corporate control

Front 41

Strengths & Weaknesses of Open Corporation

Back 41

Strengths:
1. Fund raising and diversification
2. Transparency
3. Allocational efficiency
4. Allow for specialization of labor
5. Promote pension systems
6. Id & fund growth firms

Weaknesses:
1.Separation of ownership & control
2. Entrenchment incentives
3. Lack of monitors
4. Competitive disadvantages

Front 42

Characteristics of Closed Corporation

Back 42

1. Mid-sized & privately/family-owned
2. CBs dominate corp financing and play key governance roles
3. CBs have investment banking powers
4. Capital markets play small roles in finance
5. Less transparency in corp finance
6. Less reliance on regulations
7. Greater reliance of business relationships
8. Less reliance on pro managers & equity-based comp
9. Inactive market for corp control

Front 43

Strengths & Weaknesses of Closed Corporations

Back 43

Strengths:
1. Corporate monitors
2. Comparative advantages
3. Long-term client relationships
4. Easier to handle distress
5. Can fund multi-year projects

Weaknesses:
1. Conflict of interest
2. Little transparency
3. Higher financing costs
4. Technology

Front 44

Characteristics of Industrial Group

Back 44

1. Small numbers
2. Contain diff group members
3. The lead firm controls the group
4. Close relationships w the gov't
5. Capital markets play small roles in corp financing & governance
6. Managers do not own much shares

Front 45

Strengths & Weaknesses of Industrial Group

Back 45

Strengths:
1. Effective econ development
2. Discourage foreign firms entries
3. Efficient financial contracting
4. Rapid disseminate info, expertise & tech innovations

Weaknesses:
1. Diff growth rates among firms make the group inherently unstable
2. Hard to discipline group contracting
3. Higher costs on consumers
4. Industrial group system is difficult to be transplanted outside of Japan & Korea

Front 46

Definition of Risk Capital

Back 46

The smallest amt invested to insure the value of the firm's net assets against a loss in value relative to the risk-free investment of those net assets

Front 47

Problems of Standard Acct'g Methods

Back 47

1. Don't affect consolidation accounting
2. Materially affect the calc'd profit rates of indiv. businesses w/in the firm
3. Overstate profits when the underlying assets perform well
4. Understate profits when the underlying assets perform poorly

Front 48

Value At Risk

Back 48

Var satisfy these properties:
1. Translation invariance
2. Positive homogeneity
3. Monotonicity
But fails Subadditvity

Front 49

Reasons why VaR s/b Rejected

Back 49

1. Does not work well for addition of risks
2. Can't recognize an undue concentration of risks
3. Fail to allocate risks among firms
4. Do not encourage diversification

Front 50

GAAP vs. Embedded Value

Back 50

GAAP
1. Returns can send the wrong message
2. GAAP Equity only partially writes off the lost earnings in the year of the shock

Embedded Value
1. Produce a level ROE when discount rate equals IRR
2. Account for the impact of events only in the year in which they occur