Flashcards in Corporate Finance Deck (70):
Capital Budgeting Steps
1) Generating Ideas
2) Analyzing Individual Proposals
3) Planning the Capital Budget
4) Monitoring and Post-Auditing
Capital Budgeting Assumptions
1) Decisions are based on cash flows
2) Timing of cash flows is crucial
3) Cash flow is based on opportunity costs
4) Cash flows are analyzed on an after-tax basis
5) Financing costs are ignored (already captured in discount rate)
Incremental Cash Flow
The cash flow that is realized because of a decision. Cash flow with a decision minus cash flow without that decision.
The effect of an investment on other things besides the investment itself. ie: cannibalization.
Projects whose cash flows are independent of each other.
Mutually Exclusive Projects
Projects whose cash flows compete with each other. ie: can choose project A or B, but cannot choose both.
Internal Rate of Return (IRR)
The discount rate that makes the present value of future after-tax cash flows equal the investment outlay.
Average Accounting Rate of Return (AAR)
AAR = average net income/average book value
Initial Outlay for New Investment
Outlay = FCInv + NWCInv
Terminal Year After-Tax Non-Operating Cash Flow
TNOCF = Salvage Value + NWCInv - Tax(Salvage Value - Book Value)
Inflation and Capital Budgeting
Nominal cash flows include the effects of inflation, while real cash flows are adjusted downward to remove the effects if inflation.
(1+Nominal Rate) = (1+Real Rate) (1+Inflation Rate)
Hard Capital Rationing
Fixed budgets and managers cannot go beyond it. Can be computationally intensive.
Soft Capital Rationing
Managers may be allowed to over-spend their budgets if they argue effectively that the additional funds will be deployed profitably.
Two Equilibrium Models for Estimating Risk Premium
CAPM and Arbitrage Pricing Model (APT)
The profit realized from the investment. Market Value is the NPV of all the remaining cash flows
EP = NOPAT - $WACC = EBIT x (1-Tax Rate) - WACC x Capital
$WACC = dollar cost of capital = WACC x Capital
A periodic measure of profit above and beyond the dollar cost of capital invested in the project.
Residual Income = Net Income - Equity Charge
Equity Charge = required rate of return on equity x beginning of period book value
Modigliani and Miller Proposition 1
Assuming no taxes, the market value of a company is not affected by the capital structure of the company. The value of a levered company is equal to the value of an unlevered company.
Modigliani and Miller Proposition 2
The cost of equity is a linear function of the company's debt/equity ratio. The cost of equity increases in such a manner as to exactly offset the increased use of cheaper debt in order to maintain a constant WACC.
The Expected Cost of Financial Distress
1) the costs of financial distress and bankruptcy, in the event that they happen
2) the probability that financial distress and bankruptcy happen
Static Trade-Off Theory
Indicates that there is a trade-off between the tax shield from interest on debt and the costs of financial distress, leading to an optimal amount of debt in a company's capital structure.
Peking Order Theory
States that internally generated funds are preferable to both new equity and new debt. If internal financing is insufficient, managers next prefer new debt, and finally new equity.
The existence of groups of investors attracted by and drawn to invest in companies with specific dividend policies.
A Marginal Investor
An investor who is very likely to be part of the next trade in the share and who is therefore important in setting price.
Market Value Added
Is also the NPV of the investment
Dividend Imputation Tax System
A system which ensures that corporate profits distributed as dividends are taxed just once, at the shareholders rate. Used by Australia, New Zealand and France.
Split-Rate Tax System
Corporate earnings that are distributed as dividends are taxed at a lower rate at the corporate level than earnings that are retained.
Impairment of Capital Rule
Requires that the net value of the remaining assets as shown on the balance sheet be at least equal to some specified amount (related to the company's capital).
Residual Dividend Policy
Based on paying out as dividends any internally generated funds remaining after such funds are used to finance positive NPV projects.
Expected Increase in Dividend (Formula)
Expected increase in dividends = increase in earnings x target payout ratio x adjustment factor
Dividend Payout with Residual Dividend Policy (Formula)
Dividend = Earnings x (capital budget x equity percent in capital structure) or 0, whichever is greater
Dividend Coverage Ratio
Dividend coverage ratio = net income/dividends
FCFE Coverage Ratio
FCFE coverage ratio = FCFE/(dividends + share repurchases)
The system of principles, policies, procedures, and clearly defined responsibilities and accountabilities used by stakeholders to overcome the conflicts of interest inherent in the corporate form.
Qualifications and Core Competencies for Board Members
2) relevant expertise
3) indications of ethical soundness
4) experience in strategic planning and risk management
5) other board experience with companies regarded as having sound corporate governance
6) dedication and commitment to serving the board and investors' interest
7) commitment to the needs of investors
Annual Election of Board Members
Every member of a board is up for re-election every year. Ensures shareholders are able to express their views in individual members' performance but can be disruptive to effective board oversight of the company.
Staggered Board Re-election
Allows for a portion of the board to be up for re-election every year. Ensures continuity of the knowledge and experience in the company essential for good corporate governance.
Board Member Compensation
2) benefits (perquisites/additional compensation) such as insurance, use of company planes/cars, etc
3) bonus awards, normally based on performance of company
4) stock options
5) stock awards or restricted stock
The purchase of some portion of one company by another. It can refer to the purchase of assets, a definable segment or another entity, or entire company.
The absorption of one company by another. One company remains and the other ceases to exist.
One of the companies ceases to exist as an identifiable entity and all it's assets and liabilities become part of the purchasing company.
The company being purchased becomes a subsidiary of the purchaser, which is often done in cases where the company being purchased has a strong brand or good image among consumers that the acquiring company wants to maintain.
Both companies terminate their previous legal existence and become part of a newly formed company. Common in mergers where both companies are approximately the same size.
Attempts to takeover a company against the wishes of its managers and boards or directors.
Merging companies are in the same business, usually as competitors.
The acquirer buys another company in the same production chain.
When an acquirer purchases another company that is unrelated to its core business.
When a company's earnings increase as a consequence of the merger transaction itself, rather than because of resulting economic benefits of the combination.
Theories that state that because executive compensation is highly correlated with company size, corporate executives are motivated to engage in mergers to maximize the size of the company rather than shareholder value.
Definitive Merger Agreement
A contract written by both companies' attorneys and is ultimately signed by each party to the transaction. Contains the details of the transaction, including terms, warranties, conditions, termination details, and the rights of all parties.
The acquirer circumvents the target's management's objections by submitting a merger proposal directly to the target company's board of directors and bypassing the CEO.
The acquirer invites target shareholders to submit or "tender" their shares in return for the proposed payment. Up to the individual shareholders to physical tender shares to the acquiring company's agent for payment.
A company or individual seeks to take control of a company through a shareholder vote.
A legal device that makes it prohibitively costly for an acquirer to take control of a target without the prior approval if the target's board. Creates rights that allow for the issuance of shares of the target company's stock at a substantial discount to market value.
Types of Poison Pills
Flip-in Pill - when the common shareholder has the right to buy the shares at a discount.
Flip-over Pill - when the target's common shareholders have the right to buy the acquirer's shares at a significant discount.
Dead Hand Provision
Allows the board of the target to redeem or cancel the poison pill only by a vote of the continuing directors.
Give the rights to the target company's bond holders. In the event of a takeover, allows bond holders to put the bonds to the company.
An agreement allowing the target to repurchase its own shares back from the acquiring company, usually at a premium to the market price.
The assumption of a large amount of debt that is then used to finance share repurchases (but in contrast to a leveraged buyout, some shares remain in public hands).
Herfindahl-Hirschman Index (HHI)
A measure of market power between firms in a industry. If post merger index is less than 1,000, than the market is not considered concentrated. Moderate is between 1,000-1,800.
The sum of squared market shares in %.
When a company decides to sell, liquidate, or spin off a division or a subsidiary.
Equity Carve Out
Involves the creation of a new legal entity and sales of equity in it to outsiders.
Equivalent Annual Annuity Approach
For an investment project with an outlay and variable cash flows in the future, the project NPV summarizes the equivalent value and time zero. The EAA is the annuity payment that is equivalent in value to the NPV.
These are the costs borne by management to assure owners that they are working in the owners' best interest. These include the cost of noncompete employment contracts and the explicit cost of insurance to guarantee performance.
This consists if the costs that are incurred even when there is sufficient monitoring and bonding, because monitoring and bonding mechanisms aren't perfect.
Michael Jensen's Free Cash Flow Hypothesis
Higher debt levels discipline managers by forcing them to manage the company efficiently so the company can make its interest and principal payments. Decreases cash flow and decreases management's opportunities to misuse cash.
Two Major Objectives of Corporate Governance
1) To eliminate or mitigate conflicts of interest, particularly those between managers and shareholders
2) To ensure that assets of the company are used efficiently and productively and in the best interests of its investors and other stakeholders
Super Majority Voting Provision
A pre-offer defense requiring shareholder approval in excess of a simple majority.