Final Exam Flashcards

Question

How are R&D expenses treated by accountants?

Answer 1

They are not capitalized. They are expensed in the current period, which can distort incentives (making it more attractive to purchase firms that paid for R&D and booking it as goodwill/intangible benefits).

Answer 2

Earnings Before Interest and Taxes

Answer 3

It helps analysts make comparisons across businesses and isolates the value of the business from the consequences of its financing and legal structure.

Answer 4

Basic: Net Income / Number of Shares Outstanding Diluted: Assumes all convertible securities or options are turned into shares

Answer 5

Designed to show how much more (or less) cash a business has at the end of the year than it had at the beginning. Comprised of three parts: 1) Operating Activities 2) Investing Activities 3) Financing Activities

Answer 6

Shows how stockholders' equity has changed over the year. Classifies changes into contributed capital, retained earnings, and other stockholder's equity.

Answer 7

Manager who is compensated based on his sector's revenues and thinks that the company recognized revenues before he came on board that they shouldn't have. He complains internally and is fired, which he alleges was retaliation. Holding: Court is unwilling to find exception to at-will employment in this context. Previous managers might have wanted credit for those revenues for their own bonuses or to smooth income.

Answer 8

What was the unit of accounting? The overall IMAX system What incentives were there for aggressive accounting tactics? Want to show growth over time, have appealing books for merger negotiations. Did IMAX muddy the waters on causation? Merger fell apart at the same time they disclosed this SEC investigation, which makes it harder for plaintiffs to claim they've been hurt by manipulation.

Answer 9

Key ratios that can be used to generate comparisons across time and across businesses. Those ratios include: gross profit percentage, profit margin

Answer 10

Gross Profit / Revenue *This will account for COGS, but not general selling and administrative costs

Answer 11

Net Income / Sales (Revenue) *A company that is focusing on human capital by paying huge executive salaries will not see that reflected in GPP, but it will show up here.

Answer 12

Allows you to think about the capital needed to generate cash flows. Ratios: EPS, ROE

Answer 13

No, because a business without any assets might be less stable. Businesses based on human capital or brand identity can see those disappear overnight. Owning valuable assets gives a company more of a defense.

Answer 14

Net Income After Preferred Dividends / Weighted Average # of Shares *Good to compare with share price and can give you a sense of economic return for your money when you buy shares.

Answer 15

When calculating EPS, imagine that all options and conversion rights have been exercised.

Answer 16

Net Income / Average Shareholders' Equity *Helps you think about the business in terms of what managers are able to do with shareholders' dollars

Answer 17

By increasing financial leverage

Answer 18

Creditors have fundamentally different interests than shareholders, so they will be looking at different ratios. Ratios: Debt Ratio, Debt to Equity, Current Ratio, Interest Coverage Ratio

Answer 19

Total Liabilities / Total Assets

Answer 20

Total Liabilities / Total Equity

Answer 21

Debt to Equity Ratio

Answer 22

Total Current Assets / Total Current Liabilities *Assets you expect to convert into cash within the current year and bills you expect to be due and payable within the coming year. *Captures whether you will have enough cash to meet impending needs.

Answer 23

EBIT / Annual Interest Expense *Captures whether the business is generating enough in earnings to cover its expenses.

Answer 24

EBIT, EBITDA, Free Cash Flow

Answer 25

Earnings Before Interest and Taxes. Backs out the consequences of financing decisions

Answer 26

Earnings Before Interest, Taxes, Depreciation, and Amortization. Backs out accounting impact of prior investment decisions

Answer 27

SEC allows it to be self regulating--the profession develops its own standards.

Answer 28

Reasonable assurance - not an absolute guarantee of accuracy

Answer 29

Captures the idea that a business ought to be worth more than the sum of the fair value of each of its assets.

Answer 30

A certain $1 is worth more than an uncertain $1, so people need to be compensated for risk.

Answer 31

$1 today is worth more than $1 tomorrow. You would rather have your money in hand than hope someone pays you in the future. Investors need compensation for forgoing the value of current consumption, other opportunities to invest, inflation risks, and interest rate risks.

Answer 32

FV = PV(1+r)^t

Answer 33

FV = PV(1+r/n)^(t*n)

Answer 34

FV = PVe^rt

Answer 35

PV = FV/(1+r)^t

Answer 36

Value the individual cashflows and add them up.

Answer 37

Gives you a fixed payment forever. PV = Payment / Discount Rate

Answer 38

Dividend discount model assumes that the value of a stock is the sum of the present values of all expected dividend payments PV = Initial Payment / (Discount Rate - Growth Rate)

Answer 39

NPV helps managers determine whether the project creates value. If NPV is positive, the project creates value and should be pursued. If negative or zero, don't.

Answer 40

Another way to evaluate projects. It refers to the time it takes for a project to return its initial investment.

Answer 41

The discount rate that would make the NPV of a project zero.

Answer 42

IRR is still popular despite these flaws: -May not be unique if cashflows alternate between negative and positive -Assumes that cashflows can be reinvested at the same rate as the overall project, which can create a bias in favor of projects that return money more quickly

Answer 43

Generally shows higher rates for longer-dated maturities. if investors are pessimistic about the future of the economy, the yield curve can be inverted and show lower rates for longer-dated maturities.

Answer 44

-Segmented markets: the market for short term securities is separate from the market for long term securities -Expectations theory: long term rates are averages of expected future short term rates -Liquidity premium theory: long term rates are based on expected future short term rates but also reflect investors' preference for avoiding inflation and interest rate risk

Answer 45

Diversification

Answer 46

Firm-specific, unsystematic, idiosyncratic risk

Answer 47

Systematic or market risks

Answer 48

-Markets are perfectly competitive -Investors can borrow and lend at the risk-free rate -Investors share the same beliefs about the distribution of returns -Investors seek to maximize expected returns while minimizing variation

Answer 49

(Portfolio Return - Risk Free Rate) / Portfolio Vol.

Answer 50

Market risk

Answer 51

Cost of Equity = Risk Free Rate + Beta*Market Return

Answer 52

The correlation between the share's returns and market returns. It captures the relationship between the individual share and the market.

Answer 53

High beta: highly sensitive to market conditions Low beta: insensitive to market conditions

Answer 54

Plotting the output of the CAPM results in a straight line risk with expected returns. Securities should be driven toward the SML by trading. If a security is undervalued, investors should be willing to buy it until the anomaly is eliminated. If a security is overvalued relative to what the model predicts, investors should sell it until the anomaly is eliminated.

Answer 55

-Size: small companies deliver higher returns -Book to market: Value companies deliver higher returns -Prior returns: correlations with past returns in the short and long term -Accounting ratios: earnings/price, cash flow/price, past sales growth all seem to have some predictive power

Answer 56

When the company's value is backed by actual assets rather than just theory (it seems they deliver higher returns)

Answer 57

-Common indices like the S&P500 do not capture the full market (it captures only large, mostly American companies, and ignores things like real estate and crypto that help diversify risk) -Recent history may not be representative

Answer 58

-Large companies may influence the market index -Securities' correlation with the market can vary over time

Answer 59

-Arbitrage Pricing Theory suggests that we can isolate factors that make a company vulnerable to non-diversifiable, market-wide risks, then price on the basis of those risks. -This invites researchers to convert findings about anomalies into factor models.

Answer 60

Treats returns as a linear function of the risk free rate, market returns, size, and value (Claims that size and value are capturing some sort of undiversifiable risk)

Answer 61

Captures the impact of momentum (the idea that prior returns have predictive power)

Answer 62

-Empirical problems (model misspecification, omitted variable bias, changing underlying relationships) -Risks of data mining -Does not seem to predict actual cost of capital reliably

Answer 63

One that incorporates all relevant information into prices. It is impossible to outsmart an efficient market.

Answer 64

-It is not constant across all markets (relies on mechanisms and institutions that are not present for all markets - people must be processing information) -It is not constant across time (markets behave strangely and can remain irrational longer than you can remain solvent)

Answer 65

WACC=[D/V*(1-T_C )*r_debt ]+[E/V*r_equity ]

Answer 66

-Number of market participants (more players = better processing of information) -Availability of information -Costs of acquiring information -Limits on trading

Answer 67

Stock prices readily reflect public information. You cannot make money trading on the basis of past prices

Answer 68

All publicly available information is instantly reflected in securities prices. You cannot make money trading on public reporting

Answer 69

All information is fully reflected in securities prices. You cannot make money even though insider trading

Answer 70

A popular industry approach that is based on summing up risk premia. Although it has a similar form to the CAPM and FF Model, it is not based on the same kind of empirical estimation and does not have the same theoretical foundations. Instead of using regressions, there is a fixed number added for all companies in the market of a given size.

Answer 71

-Facts: Orchard's common stockholders are cashed out at $2.05 in a merger by Orchard's controlling stockholder. The Orchard stockholders argued that each share was actually worth $5.42, while Orchard contended that the common shares were only worth $1.53 each. The case is an appraisal valuation issue. -The court prefers a CAPM model over a build-up model because of the greater academic acceptance/theoretical justification -The court analyzes equity risk premium (choosing supply-side over historical), company-specific risk premium (don't apply it at all), size premium (smaller premium because Orchard is not comparable to distressed firms in the portfolio).

Answer 72

Cost of Debt = Time Premium + Default Premium + Non-diversifiable Risk Premium

Answer 73

Captured by risk-free rate for the relevant time period, so compare with a treasury note.

Answer 74

The fact that expected payments are less than face value of the note. Even if you trust someone, there's a risk you won't be paid back

Answer 75

Compensation for investors bearing risks that they cannot eliminate through diversification.

Answer 76

The internal rate of return on buying a bond at market price, assuming the promised payments are made.

Answer 77

Uses the market values to determine a discount rate, which helps firms evaluate whether to pursue a project using the NPV approach. This includes the cost of both equity and debt to assess whether the project creates value for the firm as a whole.

Answer 78

Because the company can treat interest as an expense (this incentivizes financing activities with debt instead of equity). This will be accounted for in the WACC by multiplying the cost of debt by (1-T)

Answer 79

If it's a random project outside of the company's usual wheelhouse.

Answer 80

1. Identify a set of "comparable" firms 2. Identify a metric (or set of metrics) to compare to market values 3. Compute an average multiple across the comparables 4. Apply to the firm being analyzed

Answer 81

If markets are behaving strangely - you might not be able to justify stock prices based on a DCF analysis.

Answer 82

When you are comparing a privately held company to publicly owned companies, you may want to subtract a percentage because the owner of shares of a private company will not be able to immediately go out and sell shares. This could be 25-30%

Answer 83

Once the company goes private, there's an elimination of numerous costs related to dealing with shareholders. This benefit might add as much as 30% to the value of the company.

Answer 84

Computing a net present value of the cash flows that the firm generates for all investors. This requires a calculation of free cash flows.

Answer 85

Free Cash Flows = EBIT*(1-T) + DEPR – CAPX – dNWC

Answer 86

-We want to include interest expenses as a positive cash flow, so start from EBIT instead of net income -But we want to subtract out taxes because those sums are not available to investors (not going to equity or debt holders)

Answer 87

Because depreciation is not a real cash flow, and is instead just an accounting calculation intended to get at the decline in economic value of long-lived assets, we add depreciation expenses back in.

Answer 88

We need to subtract out actual expenditures on capital equipment (things like maintenance costs). Without subtracting this, investors would have the false impression that they could count on this level of earning without having to spend to keep the equipment working.

Answer 89

Working capital is the difference between current assets and current liabilities. An increase in working capital entails a decrease in cash flows, so it must be subtracted out.

Answer 90

-Cash flows are projected out a certain number of years and a terminal value is chosen at the end of that period. You lose granularity at a certain point and can't accurately predict far out cash flows. -The growth rate must be less than the discount rate and less than the growth rate of the overall economy.

Answer 91

-Comparables -DCF -Market prices

Answer 92

If the firm's securities are publicly traded, it is the cost of purchasing all securities needed to capture 100% of the cash flows. This approach makes sense if you believe markets are working properly (so go back to efficient market discussion)

Answer 93

Market efficiency requires people to gather information, analyze it, and trade on it. Absent that behavior, information will not be reflected in prices. Index funds just track the market rather than attempt to process information, so greater prevalence of index funds may undermine market efficiency.

Answer 94

Carefully studies information and makes well-resourced bets on companies - not just passively tracking the market like an index fund.

Answer 95

-Zero transaction costs -Costless access to information (largely true for public corporations, but processing publicly available information is expensive) -Agreement on implications of current information (agreement on information and its effect on value) -Sufficient capital to engage in risky arbitrage

Answer 96

When the company reduces its shares down. For example, for every 100 shares, company will issue 1.

Answer 97

-Pre-judgment interest, which gave you 5% on top of the federal funds rate. It was essentially a risk-free way to get 5%, even if the court decided that the fair price was the deal price -Uncertainty about what courts were doing - they were often treating deal price as floor and going up from there.

Answer 98

Bankruptcy, appraisal

Answer 99

When shareholders are forced to part with their shares, they can argue that they did not receive the proper value for those shares. This is NOT supposed to compensate shareholders for any value that comes from the transaction because they dissented from the transaction (so synergies should not be factored in)

Answer 100

An out of date approach to valuation based on a weighted average of market-based value, an analysis of the company's assets, and a comparables analysis.

Answer 101

Del. Block Method did not represent modern valuation techniques. The court permits any valuation method, so long as it is consistent with widely accepted financial principles.

Answer 102

Clear up front about what the court will do, easy to create predictions about what will happen (ex: Del. Block Method)

Answer 103

Allow more discretion on the part of the trial court (ex: post-Weinberger valuations)

Answer 104

-Issue: Shareholders exercise their appraisal rights after Dell is taken private -Facts: Michael Dell & private equity firm take Dell private at a price per share that is over the market price. There is a dispute among experts about the real value of the company. -Holding: Delaware Supreme Court says that the purpose of appraisal valuation is to get at the "fair or intrinsic value" of the company as a standalone entity, excluding synergies that would be generated from the transaction. They do not specify how the chancery court should be calculating this. -Criticize the chancery court for essentially ignoring the ECMH--there are plenty of signs that Dell's stock was traded in an efficient market. -If there is no strategic buyer, the company is worth less, not more

Answer 105

Bootstrapping, equity (options/warrants, common stock, preferred stock), debt

Answer 106

When corporations rely on retained earnings or internal capital markets for funding. This lowers transaction costs but may give managers a license to pursue irrational or uneconomical projects.

Answer 107

The right to buy a security at a particular price on a particular date.

Answer 108

The difference is who issues. Warrants are issued by the company, while options can be issued by anyone.

Answer 109

A customizable form of investment that is a hybrid between debt and equity. It is also called mezzanine financing because of its place on the balance sheet (before equity but after debt). The features are determined by each particular contract.

Answer 110

Term, security, and market

Answer 111

Capital structure/leverage does not matter for a firm's value. This is not true, but looking at the assumptions behind it can help us see why capital structure creates value.

Answer 112

The idea that identical assets must trade at the same price globally. You should not be able to make money risk free by buying an asset from one place and selling it at a higher price somewhere else.

Answer 113

The cost of equity is a function of the debt ratio

Answer 114

-Debt changes the tax burden, which changes cash flows to investors (interest is an expense and not taxed at the firm level, so using debt increases total cash flows to investors) -Debt creates the potential for financial distress, which can be expensive -Different financing choices can send different signals to investors -Debt can solve some principal/agent problems while creating others

Answer 115

At a basic level, it is the tax that would have been paid if that amount went to shareholders instead of being interest payments to creditors. Shielding some of the value created by the firm from taxes by taking on debt. With debt, a portion of payments are going to creditors as an expense. These expenses are deducted before you get to net income, and taxes are based on net income. This means that your interest payments are only being taxed at the individual level, not the firm level.

Answer 116

Tax rate*total indebtedness It's technically tax rate*interest rate*total indebtedness, then discounted at the rate of interest of the debt, but the interests rates cancel out. This is the perpetuity formula

Answer 117

Originally, it was VL=VU. Now, it is VL=VU+TCD The tax shield also challenges Proposition II because you need to add in a factor for taxes.

Answer 118

-Bankruptcy reorganization, which is not a zero-sum process due to the costs of litigation and professionals -The threat of misbehavior at heavily-levered firms (firms may be managed in a different in a different way during times of distress - this also creates monitoring costs)

Answer 119

-Companies with high and steady income -Companies with safe, tangible assets that can be liquidated if necessary

Answer 120

Investors lack information required to properly value firms, so they're looking for signals about this risk. The risk varies across different ways to access capital.

Answer 121

Internal resources --> debt --> equity

Answer 122

Shareholders will reasonably assume that the manager has private information that the stock is overvalued. They're selling stock because they're theoretically getting more in cash than they're giving up for the value of the ownership stake.

Answer 123

No, you only care about the downside (i.e. the risk of not getting paid).

Answer 124

Yes, it can exacerbate the signaling problem. If managers are selling equity as a last resort, then seeing them sell equity might cause you to reduce how you value the firm.

Answer 125

Managers have opportunities to divert value to themselves in wasteful or destructive ways (giving themselves perks, pursuing questionable projects). A heavy debt load limits managerial discretion by forcing them to pay out money and return to capital markets if they want to pursue a major project.

Answer 126

-Improved monitoring by outside accountants and independent directors -Concentrated ownership and shareholder activism (letter from Dell shareholders) -Executive compensation schemes

Answer 127

When the debt load is large, shareholders and their agents do not internalize the full downside of failure. As a result, they have an incentive to undertake risky projects.

Answer 128

-Issue: Could creditors proceed with a derivative lawsuit? -Facts: Athilon was in financial trouble but was continuing to pay out EBT, which had junior debt and was a controlling shareholder. Additionally, Athilon was taking the company into new and risky investments. Quadrant was a senior creditor claiming that Athilon was destroying value because Quadrant was bearing the downside risk, so they bring this lawsuit. -Holding: The derivative lawsuit is a relatively weak check, and the creditors here were closely aligned with interests of the corporation. The lawsuit can proceed.

Answer 129

If a firm borrows money and uses the proceeds to buy back and retire shares, the debt-to-equity ratio will increase (because you're increasing debt and decreasing equity).

Answer 130

When faced with a takeover by Perelman, the Revlon board borrowed and engaged in repurchases. Perelman was planning on creating value by loading up Revlon with debt, so the board took that opportunity away from him with their actions.

Answer 131

This still increases the debt-to-equity ratio by increasing debt and decreasing equity, but it allows the firm to pay a dividend to shareholders (i.e. sharing benefits with shareholders)

Answer 132

When someone proposes a transaction like an LBO, it's always worth asking whether the same benefits could be obtained more cheaply or shared more broadly.

Answer 133

This will decrease the debt-to-equity ratio, which is why it is often referred to as a deleveraging recapitalization. This makes sense when the company is facing financial distress.

Answer 134

Facts: Hallmark owned Crown, and Crown owed Hallmark $1.1 billion. Crown tried to find a buyer for the company but was unable, and Hallmark keeps giving Crown extensions (pushing their repayment obligations down the road). Hallmark suggests a recapitalization proposal for Crown that would ultimately increase Hallmark's stake in Crown. Issue: A shareholder brings a suit saying Crown is devalued and the recapitalization diluted other equity holders. Holding: Court reviews transaction under entire fairness standard because of the controlling shareholder. They find that the recapitalization was fair because of the independent committee and the price.

Answer 135

A firm is acquired using a lot of debt, typically conducted by the managers of a firm. The debt is secured by the target company's assets. Essentially, this is recapitalization accomplished through M&A activity.

Answer 136

They require managers to take on large ownership stakes. When managers are willing to be on the hook, they send a costly signal of the value they see in the firm (they presumably would not tie up their net worth in a bad investment).

Answer 137

-When the target company has fungible assets and stable cash flows (this reduces the cost of distress) -When the business is mature

Answer 138

If public markets do not understand the business. There may be a situation where managers know something about the business and are trying to extract that benefit for themselves.

Answer 139

Packaging different kinds of interests into one security. By combining debt and equity interests, strip financing gives investors an incentive to renegotiate and offer waivers if there are problems instead of simply trying to hold up deals and extract value.

Answer 140

It comes in waves. An early wave was driven by the excesses of conglomerates, and a more recent wave was driven by extremely low interest rates (which made refinancing with debt attractive).

Answer 141

-LBOs can entail breaking up companies and violating implicit contracts (which could damage surrounding communities and potentially the overall economy) -LBOs can contribute to fragility at enterprises, which ultimately creates systematic problems and externalities -Tax policy can subsidize LBOs by applying a lower rate to capital gains (encouraging people to behave like traders when buying companies, which may be unproductive financial activity) -Tax policy can subsidize and distort LBOs by favoring debt (this may allow a financial buyer to bid more than a strategic buyer, even though a company would actually be worth more to a strategic buyer)

Answer 142

Facts: Sam Zell takes over newspaper company through tender offer and squeeze out. Saddles company with debt to take it private. Issue: Can the LBO-related debts be avoided? Holding: The court accepts that the proposed plan of reorganization included a reasonable settlement value for an avoidance action.

Answer 143

They are generally the residual claimants on the enterprise. They get what is leftover after the enterprise satisfies the regulatory obligations and meets contractual obligattions.

Answer 144

Creditors have a fixed claim, while shareholders participate in the upside of the firm as its value increases. If business does great, the best a creditor can hope for is an increased chance of repayment.

Answer 145

Shareholders absorb marginal costs and benefits of corporate decisions, so they are well-suited to make decisions that maximize value. As a result, shareholders vote and directors/managers have fiduciary duties toward them.

Answer 146

Authorized shares are ones that the corporation is justified to issue based on the charter. Outstanding shares are ones that have been issued and are entitled to votes/dividend payments.

Answer 147

It can be used to give outsized power to an individual by giving expanded voting rights to certain shareholders (i.e. more than one vote per share). Benefits: -allows founder to feel comfortable offering shares to the public because they retain control -guarantees that the founder will be able to pursue their vision

Answer 148

Allows founders to diversify their wealth and internalize the broader consequences of decisions they are making about the enterprise.

Answer 149

Serves as social leverage - founders can act without accountability. This can be problematic if founders have weird or eccentric preferences or dangerous outside interests.

Answer 150

No, after a few years the rationale becomes weaker as it is less plausible that the founder has a unique ability to drive growth. When the company matures, the growth curve will flatten, so it is more controversial to give one person unchecked power.

Answer 151

It is highly controversial -SEC tried and failed to impose rules that would discourage its use -Larges indices do not include new companies with dual class stock (though older companies are grandfathered in).

Answer 152

More permissive toward them (for example, now you can use tools like a voting trust to amplify the voice of stockholders)

Answer 153

Taking outside interests to balance the risks of an investment. For example, a fund might own shares while simultaneously shorting the stock, so they would be indifferent as to whether the price goes up or down. They may also own shares in companies on both sides of a major transaction. Less controversially, investors will own diversified portfolios.

Answer 154

Fund managers may vote shares even though they have no direct financial interest. They have no obligation to make sure their vote is consistent with the preferences of the actual investors.

Answer 155

Economic (reducing value of stockholder's shares, only occurs if shares are being offered below fair market price) Voting (reducing the stockholder's voting power)

Answer 156

Charter may automatically protect, preemptive rights, anti-dilution protections, fiduciary duties.

Answer 157

Basic Idea: The relevant shareholder has a right to participate in any share issuance that would otherwise dilute their stake. Existing shareholders should get a right of first refusal to buy shares on those terms. Preemptive rights preserve the shareholder's stake without preventing the company from raising new capital.

Answer 158

-They lock the existing structure in place. The company's hands will be tied if they care about WHO is buying shares (for example, if they want to pursue a strategic investment from a particular person/entity). -Can raise difficult questions regarding interpretation of the right, application to diverse capital structures, and remedies

Answer 159

Facts: Stokes was a shareholder worried about dilution. Continental Trust wanted to double its shares through a strategic association with Blair & Co, which would cut Stokes's voting power in half. Stokes wanted to be able to pay par value for the shares rather than the premium that Blair & Co was going to pay. Holding: Court acknowledges the existence of preemptive rights. There are both formal and functional justifications. -Formal: corporation is a voluntary association amongst people where everyone gets a vote on who else gets to join -Functional: we don't want oppression of the minority shareholder, so preemptive rights serve as a check. Dissent: Focused on price and remedy, noting that Stokes was getting a windfall and his objection was not necessarily in good faith.

Answer 160

Contractual preemptive rights can be written to protect MAJOR investors, rather than all investors, from dilution as the capital structure evolves.

Answer 161

An antidilution mechanism will directly address the threat of economic dilution by issuing shares or cash to a stockholder if there is a new issuance at a reduced price. This will impact the pricing of the deal and the payment to the existing shareholder.

Answer 162

#ExtraShares = #OldShares*(Old Price / New Price) - #Old Shares New Price = Pre-Financing Valuation / (#Old Shares + #Extra Shares) Because the number of extra shares is a function of new price, you either have to do some sad algebra or use Excel's iterative function.

Answer 163

Unlike preemptive and anti-dilution rights, fiduciary duties are ex post mechanisms imposed after the fact to help curb opportunistic behavior.

Answer 164

Facts: -two shareholders vote to do a stock issuance at a price of $100 per share. The other shareholder, Katzowitz, had previously said that he did not want to contribute additional capital. -offering price substantially below the book value of the shares. -after the corporation is wound up, K receives less than the others and brings suit. He demands an equal share, after the other shareholders’ contribution has been subtracted out. Issue: Was approving this issuance a violation of fiduciary duty? Holding: Court applies a totality of circumstances test and determines an equal shares, less the amount his fellow shareholders paid for the extra shares, is appropriate. Because this is a closely held corp, K can't just sell his shares and it's easier for him to be taken advantage of here.

Answer 165

It is designed to force a shareholder to make appropriate contributions. If they refuse to contribute, they will be substantially diluted. This is an effort to prevent free riding on the contributions of others.

Answer 166

A poison pill is a dilution mechanism that encourages an acquirer to negotiate with the board instead of simply acquiring shares on the open market.

Answer 167

Takeover technique where someone offers to buy a certain number of shares at a certain price. Stockholder can tender into that offer, and acquiring enough shares leads to control of the company. There are limits on tender offers imposed by the Williams Act.

Answer 168

Poison pills are usually called "Shareholder Rights Plans" -Shareholders are issued rights to purchase shares, which ordinarily have a very high purchase price. -Upon a triggering event, such as someone acquiring 15% or launching a substantial tender offer, the rights change. Everyone other than the acquiring person is allowed to buy shares at a discount. -The goal is to dilute the stake of an acquirer, forcing them to come talk to the board. The rights are typically redeemable by the board

Answer 169

The right in a poison pill to buy shares of the target's common stock at a discount

Answer 170

The poison pill right to buy shares of the acquirer's stock AFTER the merger. These are designed to survive a merger the acquirer might push through.

Answer 171

Facts: Household installs a poison pill with a trigger for a 30% tender offer and a trigger for a 20% acquisition. -Upon 20% acquisition, possible to buy preferred. -If not exercised and there’s a merger, possible to purchase $200 of common in acquirer for $100 -Household’s concern is that the company is undervalued. There has been a wave of bust-up transactions and takeovers, and the threat of a takeover is a distraction for employees. Issue: Was it appropriate for the Household board to install this plan? Holding: This was an appropriate action on the part of the board. This sort of "clear day" planning for the future is appropriate, and nothing in the statutes limits the purpose of this sort of financing transaction. The board followed a reasonable process and did not install this plan on a whim.

Answer 172

Not in a takeover context, but in Selectica, a pill was used to protect "net operating loss" carryovers.

Answer 173

It may be less disruptive to the balance sheet than doing something like disposing of assets or acquiring debt.

Answer 174

They may be distributed across different documents, including the certificate of incorporation, the bylaws, or contracts between shareholders.

Answer 175

-Distribution: Workers might be guaranteed governance rights or guaranteed income in retirement, they may bargain for protections against removal, and they may expect compensation for the work they do at the company. -Risky Investment Choices: Different shareholders have different levels of risk tolerance. Shareholders may have the right to vote before significant changes are made, or the corporation's activities may be limited. -Exits: Company might promise to buy shares upon retirement, death, or disability, and the agreement would address valuation problems. -Transfer Restrictions: In close corporations, you might need majority consent to transfer shares, or perhaps a right of first refusal.

Answer 176

If one share holder sells, the other shareholders have a right to participate in the sale on the same terms.

Answer 177

If one shareholder sells, they can force other shareholders to sell on the same terms.

Answer 178

When one shareholder is contributing labor and is granted shares for that labor rather than a cash contribution. They might end up with a windfall in the event of a sudden liquidation.

Answer 179

-VC fund and worker both receive equal shares, but VC fund contributes capital by lending. This ensures that VC fund will have seniority in a liquidation but may create a risk of creditor liability. -VC fund and worker receive equal common shares, but the VC fund also buys nonvoting preferred shares with a liquidation preference. -Worker receives common shares, while VC fund receives convertible preferred shares. The preferred shares ensure a liquidation preference while also allowing the VC to share in value if company prospers.** **Dominant approach today

Answer 180

Securities must be registered before they are offered or sold. There is a default registration statement and disclosures that must be shared with offerees.

Answer 181

These are exceptions for investors who can fend for themselves. For example, if a large company is granting shares to its CEO, the CEO knows the status of the company and is a sophisticated investor, so insisting on regulation is a little unnecessary.

Answer 182

Rescission. If a company does really poorly, everyone will be crawling out of the woodwork seeking their money back.

Answer 183

Imposes continuing requirements on firms that are listed on a registered stock exchange or otherwise held by a large number of investors. Companies must submit quarterly/annual reports and promptly report specific corporate events. It also governs the proxy materials that companies distribute in connection wtih shareholder voting.

Answer 184

Raising capital through sales to a small set of investors, such as venture capital firms. These are generally structured to avoid registration requirements.

Answer 185

Early stage investing by wealthy individuals. They may take convertible securities, though historically they have taken common stock.

Answer 186

Relatively recent practice of obtaining small amounts of capital from a large number of individuals.

Answer 187

Also known as "blank check" companies. They are essentially shell corporations that are publicly listed. SPACs hold cash and have a mandate to merge with a previously private company within a set period. If it doesn't find a merger company to take public, it returns the money to investors.

Answer 188

Raising capital through a full formal process. A company will work with underwriters to issue shares to the public and with the SEC to complete a registration statement.

Answer 189

The underwriters actually take on economic risk by buying shares from the company before selling them to investors.

Answer 190

The underwriters act more as agents. They promise only to do their best to place securities.

Answer 191

Underwriters may have an incentive to underprice the offering to limit their risk and generate excitement about the stock.

Answer 192

Larger businesses can use this instead of completing the full process every time they want to issue shares. They can submit a registration statement for future use, which permits faster reactions to market conditions.

Answer 193

An IOU - a contractual promise to make specific payments

Answer 194

The repayment owed to the holder of a bond. Also known as face value or par value

Answer 195

The annual interest that the bond issuer will have to pay

Answer 196

Contractual limits on the borrower that persist after the transaction has closed (such as maintenance of a certain debt-to-equity ratio)

Answer 197

Private agencies evaluate the creditworthiness of borrowers and grade the level of risk for different bonds. These are private organizations that evaluate your likelihood of being repaid and assign a grade to the debt.

Answer 198

-Bank's trust department has a contract (indenture) with borrower. The bank acts as trustee on behalf of bondholders (the lenders) -Trustee collects money from bondholders and loans it to the actual borrower

Answer 199

A collective action problem. Without a trustee, none of the individual bondholders will have adequate economic incentive to monitor the borrower or bring suits to keep them in compliance.

Answer 200

Facts: Individual bondholder writes anonymous letter; trustee takes allegations seriously and pursues it through litigation. Allegation is that "substantially all" of Liberty's assets have been transferred in violation of a covenant. Ultimate question: Is there an overarching liquidation strategy at Liberty, or was it piecemeal transactions? Holding: Each spinoff at Liberty was an independent decision. The court does not look to the specific intent of the parties.

Answer 201

-New debt and claim dilution (existing creditors are disadvantaged when additional debt is issued) -Risky investments (may be taking on more debt, getting into risky new areas of business) -Dividends and distributions (transferring economic value out of enterprise, making it unavailable for creditors) -Underinvestment (failing to keep enterprise running or to complete necessary maintenance)

Answer 202

-Categorically prohibit new debt -Prohibit new debt unless certain conditions are met -Place specific dollar limits on the amount of new debt -Limit total debt to a set percentage of net tangible assets -Limit total debt so that debt service is a set percentage of earnings -Limit current debt to a set percentage of current assets -Limit senior debt to make sure the creditor's place in line is not impacted (includes prohibiting mortgages/liens)

Answer 203

Capital leases

Answer 204

Another party supplies capital for equipment in one of two ways: -You're loaned money, you go out and buy equipment and give a security interest to the entity that loaned money -The person loaning can buy the equipment and lease it to you.

Answer 205

-Facts: RJR Nabisco proposes LBO of company's shareholders led by CEO and an investment firm. As part of LBO, RJR Nabisco would assumed $19 billion of new debt. MetLife is a creditor who claims that RJR Nabisco's actions impaired the value of bonds previously issued to them and delivered and windfall to shareholders. -Holding: RJR Nabisco did not breach any contractual actions

Answer 206

A form of protection for creditors. The debtor sets money aside each year to cover the eventual repayment of the principal.

Answer 207

-Payments into a sinking fund -Regular recalling or purchasing of bonds (retires debt) -Conversion features (allows creditors to become shareholders and see upside in company)

Answer 208

Allows creditors to protect themselves against risk of repayment because it requires the debtor to pay a premium to redeem debt (you would want this if your debt is paying a higher interest rate than other investments available)

Answer 209

-Facts: ADM offers bonds at a 16% interest rate with call protections, but wants to refinance because interest rates have gone down to the point that even with the penalties, it's a better deal. ADM raises money through two bond issuances and two common stock issuances before attempting to repurchase. Morgan Stanley protests, saying this is essentially a prohibited refinancing. -Holding: A redemption directly funded through equity financing is not prohibited despite contemporaneous borrowing by the issuer. Money is fungible--as long as there is a significant equity issuance, you can probably get away with this sort of arrangement.

Answer 210

It may be treated as an event of default -Creditors may accelerate the debt or foreclose on any assets offered as security -Creditors may file an involuntary petition for bankruptcy, or the debtor may file a voluntary petition

Answer 211

Consent from the holders of a majority of the principal (which can result in some opportunistic behavior). -Changes that defer interest on debts normally require consent from holders of at least 75% of the principal.

Answer 212

-Facts: Katz has a complicated financial structure and is in distress. Allied SIgnal is willing to buy a division of the company and common stock if 85% of Oak's debt was converted into equity. Katz objects to Oak's proposed transaction to effectuate this. -Holding: This is a contractual issue, not a fiduciary duty issue. There is no violation of good faith and fair dealing--an attractive financial proposition is not the same as a forced redemption or a takeover.

Answer 213

-Solves collective action problems and enforces terms of covenants -Will sometimes pursue trivial issues or interfere with deals that would create real value -Can insulate themselves from economic exposure to defaults and other events

Answer 214

-Minimum capitalization requirements for trustees -Upon default, trustees can't have arrangements with debtor that would create a conflict of interest -Trustees must report annually to bondholders and notify in event of default -Trustees cannot be exculpated for various forms of misconduct.

Answer 215

-Facts: Elliott owned convertible subordinated debentures that had notice provisions for redemption. Elliott brought suit claiming that the trustee breached fiduciary duty by waiving the notice period. -Holding: There is no claim against the trustee. The trustee had no obligation to insist on the notice provisions, even though doing so would have delivered an economic benefit to the shareholders.

Answer 216

-Facts: KH issues a bunch of bonds subject to the TIA, of which WF is the trustee. An event of default occurred, triggering the "prudent person" language. -Holding: WF failed to meet the prudent person standard because they did not accelerate the debt, notify the bondholders, or file the continuation of the financing statement. Good faith would be an affirmative defense, but plaintiff did not need to defeat that up front at the pleading stage.

Answer 217

A short term lease (relative to the economic life of the asset). User of the equipment is often not responsible for maintenance, and it is often offered by someone who is in the business of lending out that equipment.

Answer 218

Can be long relative to the economic life of the asset, often makes the user responsible for maintenance and is offered by a financial company.

Answer 219

-Owner of asset can claim depreciation expenses (tax benefit) -User may be able to avoid putting a liability on its balance sheet.

Answer 220

When a firm wants to borrow against the value of a set of income-generating assets -they can borrow while granting the lender a security interest in the relevant assets OR -they can structure the transaction where the assets are sold to a special purpose vehicle/entity, which finances the purchase through borrowing. This allows the seller to keep indebtedness off its balance sheet.

Answer 221

Strict contractual approach (typically)

Answer 222

-Highly customizable between debt and equity (each type is different) -Must be authorized in some part by the articles of incorporation (either specific terms or a blank check for board to issue) -Have economic and control preferences

Answer 223

Economic: Dividends, liquidation, redemption, conversion Control: Basic or preferential voting rights

Answer 224

The preferred shares are paid a dividend every year the common shares receive a dividend. This can create an incentive for the company to hold off on dividends for long periods, then pay out in a lump sum.

Answer 225

Dividends accumulate in every year that they are not paid out. This means that the company can't get away with paying preferred less by holding off on dividends for everyone--the amount owed will just continue to accumulate.

Answer 226

Preferred shares can be promised a payout ahead of common stock in the event of a liquidation. -"participating" preferred shares receive a liquidation preference plus a share of any distribution made to common shareholders -"pari passu" means that every series of preferred has the same level of priority. A liquidation preference is about downside, protection as the company winds down, and can curb various forms of opportunism.

Answer 227

The company or the preferred shareholders might be granted a redemption right that allows them to force a redemption for cash (this creates a risk for the company, so it might be qualified by time or capital requirements). This is an important right if you hold shares in a company where there is no liquid market.

Answer 228

Each preferred share might be convertible into common shares or at a set ratio. This allows the preferred to participate in the upside, cleans up the capital structure, and can curb opportunism. It does require shareholders to forfeit the preferences attached to preferred stock.

Answer 229

When the value of the stock has grown substantially--enough to make giving up the preferences worth it.

Answer 230

Preferred shares have the same voting rights as common stock.

Answer 231

These are common in the VC context. They might have more votes per share, a right for some classes to select directors, or a right to vote on particular transactions or decisions.

Answer 232

Preferred shares can be a way to offer a debt-like instrument to investors without violating regulatory restrictions on total indebtedness. You can avoid putting debt on your balance sheet by issuing preferred stock.

Answer 233

An instrument that is also used to solve the regulatory capital features know as "additional tier 1 capital securities." Features: -Bond with a fixed amount that pays regular interest -Is perpetual, so banks don't have to pay it off -Is written down or converted after a triggering event (such as regulatory capital dropping below 7% or regulators determining that it is necessary to preserve solvency of issuing bank). Basically, it acts like a bond but if the issuing bank gets into trouble, it takes losses before anyone else does.

Answer 234

It can be used to maintain a targeted debt ratio

Answer 235

Its debt-like features can protect the investment in the event of failure and heighten incentives for founder-managers. The debt-like features can be useful in maintaining the investors' influence at firms and in giving the investors a share of the upside.

Answer 236

Because preferred stock has both contractual and equity-like features. Under DE law, you don't owe fiduciary duties to your creditors, but because it is laid out in the articles like stock and has equity features, things get confusing.

Answer 237

-Where the parties negotiated a contractual provision, the provision ought to control even if there is later an argument about unfairness -Where the preferred is asserting a position that the common would also assert, fiduciary duties are appropriate.

Answer 238

Facts: Orban starts Office Mart and puts in $15,000 of his own money. After a refinancing, there are three tiers of preferred stock and Orban's stake falls. Staples proposes a merger but requires each class of stock to approve the transaction with a 90% vote, so Orban can't block it. Analysis: Court finds that it is okay for the board to act against Orban in this case because their decision was in the best interests of the company overall, not just deferring to one shareholder.

Answer 239

Facts: Trados, a tech company, brought on several rounds of financing. Each major preferred shareholder could appoint someone to the board. As growth slows, Trados looks for purchasers and adopts the MIP, which was an incentive plan for managers to pursue the highest price possible (and gave them a payout). Common stockholders claim there is a breach of fiduciary duty after the company sells for $60 million and the money goes to the MIP and the preferred shareholders. Analysis: Court says the transaction was permissible due to price and the fact that the common shareholders never stood to make money on the transaction. The court applies entire fairness and finds that the directors were not independent/disinterested, but the fair price overrules that lack of fair dealing.

Answer 240

An option to buy at a specific price at some point in the future

Answer 241

An option to sell at a specific price at some point in the future

Answer 242

An American option can be exercised at any time prior to expiry. A European option can only be exercised at expiration. And a Bermudan option can be exercised at particular times prior to expiration.

Answer 243

The value an option would have if exercised today. For a call option, this is the underlying security minus the strike price.

Answer 244

Intrinsic value is positive

Answer 245

Intrinsic value is negative

Answer 246

The intrinsic value is zero

Answer 247

A long position means holding/buying, while a short position means selling

Answer 248

Holding the option without using the underlying security as a hedge

Answer 249

An executive who receives a fixed salary has no real stake in the success or failure of the enterprise. Options provide an instrument that is sensitive to the executive's performance/decisions that is relatively inexpensive. It's better than just giving them stock outright because stock hands them value even if the price doesn't increase.

Answer 250

They can help you tailor risk. If you own a lot of stock in a company because you are excited about the upside but want to manage the risk of a bad outcome, you might buy some put options OR sell the stock and buy some call options.

Answer 251

Any time an investor is free to postpone a decision on whether to invest or how much, they can obtain more value. THE RIGHT TO WAIT IS VALUABLE.

Answer 252

The investor holds an underlying stock, purchases an out of the money put, and sells an out of the money call. It limits both the upside and downside potential while allowing the investor to profit from price increases in between.

Answer 253

Exercise Price / (1+RFR)^t = Value of Share + Value of Put - Value of Call This essentially means that owning one share and one put and selling a call replicates a risk-free bond. You can rearrange to figure out how to get any of these components.

Answer 254

At some point, you need to get cash out of an enterprise in order for the investment to be valuable

Answer 255

Using their same framework of assumptions, Modigliani and Miller say that as long as a company is earning more than its cost of capital, investors should be indifferent between the company using cash or sending it to investors. If the investor needs cash more quickly, they can always sell their shares. The investor should be indifferent between the firm earning 10% on capital and earning 10% in the market with the same level of risk. The firm should be indifferent between using retained earnings that investors expect the company to earn 10% on and paying out dividends while raising new capital.

Answer 256

Different shareholders may have different interests and needs. If they are able to collect cash by trading for themselves, they can tailor their strategy to their particular needs. Investors face different tax consequences and seek different levels of growth, while a dividend imposes one outcome across the board.

Answer 257

Dividends can.... -send a positive signal about managers' belief about eh firm's prospects (because once you issue dividends, you are effectively committing to maintaining and growing them) -help reduce agency costs by subjecting managers to additional discipline from capital markets (when they make dividends, they have to go to the capital markets to raise money and face scrutiny there)

Answer 258

Historically, firms had a sense of a "fair" dividend payout rate. A greater focus on delivering financial returns to shareholders led firms to distribute more capital to shareholders through dividend payments or share repurchases.

Answer 259

-Repurchases can be more tax efficient and can allow investors to choose whether or not to cash out (so they are more customizable) -Investors are less likely to interpret a repurchase as a commitment to maintaining payments (which means that there is less of a negative impact if firms do fewer repurchases in the future).

Answer 260

Par value times number of shares outstanding (consideration for no-par shares assigned to stated capital)

Answer 261

Assets minus liabilities

Answer 262

Excess of net assets over stated capital (Explaining par value from estimate of equities)

Answer 263

Accumulated net profits not paid to shareholders, minus accumulated losses (sort of aligns with retained earnings)

Answer 264

The remainder of the surplus (sort of aligns with additional paid in capital)

Answer 265

This restriction seeks to protect creditors by preventing distributions unless the company has collected or is generating value that belongs to the shareholders. This rule still allows a company to pay dividends when they have to tap into things like accounts receivable instead of solely using cash on hand. This can prevent a company from meeting an emergency by reducing their cash on hand.

Answer 266

Yes, they can make a payment out of net profits from the current or immediately preceding year. This may be prudent if the dividend is not an unreasonable risk and is necessary to maintain support from long-suffering shareholders.

Answer 267

Court recognizes that balance sheets prepared in accordance with accounting principles may not align with actual current values. They give deference to the directors and officers in figuring out what the surplus is, allowing them to evaluate assets based on present value, not just accounting value.

Answer 268

-It abandons the pretense of legal capital as a tool for protecting creditors -It focuses on solvency and whether distributions would compromise the corporations ability (1) to pay off debts as they come due and (2) to pay off debts upon a dissolution.

Answer 269

A company should not be able to transfer value away when the value is supposed to be available to creditors.

Answer 270

Section 4 protects present and future creditors. -4(a)(1): "actual intent to hinder, delay, or defraud." -4(a)(2): Without receiving reasonably equivalent value, either (i) undercapitalized relative to business or (ii) unable to pay debts as they come due.

Answer 271

Section 5 protects current creditors -Section 5(a): Transfer made without receiving reasonably equivalent value, and debtor was or became insolvent -Section 5(b): Transfer made to an insider, the corporation was insolvent, and the insider had reasonable cause to believe that the debtor was insolvent.

Answer 272

Holding: UFCA does apply to novel LBO transactions. Bad faith can be triggered by knowledge and not just motives because it is a "constructive fraud" provision.

Answer 273

Distributions, so they encompass stock repurchases as well as dividends.

Answer 274

-Share repurchases increase EPS and keep share prices high, which can lead to distortions -Executive compensation plans or options can be pegged to metrics that are affected by repurchases.

Answer 275

-company can repurchase shares through trading in the market (just as ordinary investors in the market) -company can make a self-tender offer and publicly offer to buy a set number of shares from the public -company can engage in a targeted repurchase and buy shares from a specific large shareholder

Answer 276

Company has superior resources, a concentrated interest, and substantial financial resources. Individual investors generally lack these advantages. Creates potential for types of abuse: trading on inside information, manipulation, non-disclosure

Answer 277

Yes. They must make a disclosure pursuant to Rule 13e-1. They can also self-tender for their own shares.

Answer 278

The process of buying out the shares of someone threatening a takeover. This is no longer a common takeover defense because it is weak (it doesn't prevent the person from coming back later) and it is now discouraged by the tax code.

Answer 279

The idea that an increase in volatility increases the value of the call option.

Answer 280

The value of the option increases. More things can happen in a longer time frame, so it's essentially increasing variation.

Answer 281

Asset-backed financing and securitization

Answer 282

To repackage risks by slicing up the cash flows from particular assets. By doing this, you can devise instruments that provide almost any level of risk.

Answer 283

A call protection calculated to make the creditor whole if they are repaid due to a shift in the interest rate environment.

Answer 284

-If the interest rate later increases, the debtor wins because the obligation to repay is worth less (the value of the future promise goes down). -If the interest rate later decreases, the value of the future promise will increase and the debtor will want to refinance.

Answer 285

-Majority or 75% approval for changes to covenants -Each bondholder must consent to a reduction in the debt owed to them -Implication: large bondholders can hold up transactions, even if they would be valuable to the bondholders as a group.

Answer 286

They have to meet the prudent person standard. This is the difference in the outcome in Elliott vs. Wells Fargo.

Answer 287

The court will not look to the specific intent of the parties because they are probably not negotiated for their substance. Rather, the court will use a uniform interpretation of the provisions.

Answer 288

Debt offerings to the public of over $10 million

Final Exam Flashcards

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