Bulletpoint summary with the 3rd edition of Fundamentals of Corporate Finance van Hillier

What is corporate finance? - BulletPoints 1

• Financial manager represents the owners’ interests and he makes the financial decisions. He co-ordinates with the treasurer (finance) and the controller (accounting). Goal: to maximize the share price of the company by earning or increasing profits and controlling risk.

• Capital budgeting: planning and managing the long-term investments. The firm has to find investments that create value.

• Capital structure: the firm’s mixture of long-term debt and equity.

• Working capital management: This contains the firm’s short-term assets and its short-term liabilities.

• Financial markets - Bringing buyers and sellers together

• Primary markets: The corporation sells and thereby raises money for the corporation. There are two types of transaction: public and private offerings.

• Secondary markets: One owner or creditor sells to another. This means transferring the ownership of corporate securities. Two types: The auction markets: Has a physical location, matches sellers and buyers. The dealer markets: Connected electronically, over-the-counter (OTC) markets.

How are ownerships and corporate governance organized? - BulletPoints 2

• Legal classifications of businesses:

  • Sole proprietorship; The business is owned by one person

  • Partnership; The business is owned by at least two persons > general partners, so they operate the daily business together, limited partners, these only operate part of the business, or silent partners, who just invest and do not operate daily business.

  • Corporations; Here, the company is a legal entity

• The agency problem:

  • Type I agency problem = The possibility of conflict of interest between the shareholders and the management of the firm.
    Reasons to think that managers have a significant incentive to act in the interests of the shareholders are because of managerial compensations, the control of the firm and shareholder rights.

  • Type II agency problem = The possibility of conflict of interest between controlling and minority shareholders.

• Corporate governance = a term that describes the way a company does its business and how it monitors whether the right procedures and behavior are used while conducting the business. > Solution of the agency problem

How to analyze and use financial statements? - BulletPoints 3

• Annual report – Three financial statements:

• Balance sheet; shows a firm’s accounting value on a particular date.

  • Assets = Liabilities + Shareholders’ equity.

  • Net working capital: Current assets – Current liabilities.

• Income statement; summarizes a firm’s performance over a period of time. Revenues – Expenses = Income = EBIT -> minus interest and taxes = net income Corporate tax rate: the tax rate that corporations have to pay.

• Average tax rate: your tax bill / your taxable income.

• Marginal tax rate: if you earn one more euro, the tax that you have to pay over that euro. The new tax flows.

• Statement of cash flow:

  • Cash flow from assets = cash flow to creditors + Cash flow to shareholders.

  • Total cash flow = CF from operating activities + CF from investing activities + CF from financing activities.

• Ratio analysis: Analyze the financial ratios to see how healthy a company is.

  1. Short-term solvency or liquidity measures

  • Current ratio = Current assets / Current liabilities
  • Quick ratio = (Current assets – Inventory) / Current liabilities
  • Cash ratio = Cash / Current liabilities

2. Long-term solvency measures (leverage ratios)

• Total debt ratio = (Total assets – Total equity) / Total assets

• Times interest earned ratio = Operating profit / Interest (TIE ratio)

• Cash coverage ratio = (Operating profit + Non-cash deductions) / Interest

3. Asset management (turnover measures)

• Inventory turnover = Cost of goods sold / Inventory

• Receivables turnover = Sales / Trade receivables

• Payables turnover = Credit purchases / Trade payables

• NWC Turnover = Sales / NWC

• PPE Turnover = Sales / Property, plant and equipment

• Total asset Turnover = Sales / Total assets

4. Profitability measures

• Profit margin = Net income / Sales

• Return on assets = Net income / Total assets

• Return on equity = Net income / Total equity

5. Market value measures

• Earnings per share (EPS) = Net income / Shares outstanding

• P/E ratio = Prices per share / Earnings per share

• PEG ratio = Price-earnings ratio / Earnings growth rate (%)

• Price-sales ratio = Price per share / Sales per share

• Market-to-book ratio = Market value per share / Book value per share

• Tobin’s Q = Market value firm’s debt and equity / Replacement cost firm’s assets

• The DU Pont Identity:

  • ROE = Profit margin x total asset turnover x equity multiplier

  • The return on equity (ROE) is affected by three things: Operating efficiency (profit margin), asset use efficiency (total asset turnover) and financial leverage (equity multiplier).

• Problems with Financial Statement Analysis: across the national border there are different standards and procedures.

What is the present and future value of money? - BulletPoints 4

• Future value = What is the value of a specific amount of money in x years?

  • Compound interest = The interest earned on interest.

  • FV = PV * (1+r)n

  • The last part of the equation, (1+r)n is the FVIF (future value interest factor), which combines the time periods with the interest rate. You can use a table (Appendix A Table A.1)

• Present value = How much should I put aside now the be able to have amount x in the future?

  • PV = FV * 1 / (1+r)n

  • The last part of the equation is the PVIF (present value interest factor), which can also be found in a table (Appendix A Table A.2)

• Determining the discount rate; The basic PV equation; PV = FVt / (1+r)t

  • There are four parts in this equation [PV, FV, r, and t]. Given any of these (3 values known) the fourth can always be found

• Finding the number of periods; The basic PV equation; PV = FVt / (1+r)t

  • There are four parts in this equation and given any of these (3 values known) the fourth van always be found >> n = [ln(FV / PV)] / [ln(1+r)]

What are annuities and perpetuities? - BulletPoints 5

• It is very critical when the cash flows occur. Unless stated otherwise, you should assume that cash flows occur at the end of a period.

• Annuity = any continuing payment with a fixed total annual amount. 

• Annuity PV = PMT * [(1-(1+r)t)/r]

  • The term PMT is multiplied with is called the Present Value Interest Factor for Annuities (PVIFA). This PVIFA can also be found in Appendix A Table A.3

  • If you transform the formula using data you have, you can find the number of payments and the correct rate

• Annuity FV = PMT x [(1+r)n – 1] / r

  • Where PMT is the periodical cash flow. The last part of the equation is the FVIFA (future value interest of an annuity). So FVIFA = [(1+r)n – 1] / r

• Annuity due = Payments are made at the beginning of the period instead of at the end of the period

  • FV annuity due = PMT x [(1+r)n – 1] / r x (1+r)

• Perpetuity = An annuity that goes on forever

  • PV = PMT / r

• Annuities very often have payments that grow over time at factor g.

  • Growing annuity PV = PMT * [1 – (1 + g / 1 + r)t / r – g]

• Nominal interest rate = The interest rate expressed in terms of the interest payment made each period. Also known as the stated or quoted interest rate

• Effective annual percentage rate (EAR) = The interest rate expressed as if it were compounded once per year.

  • EAR = [1 + (Quoted rate/m)]m – 1

• Annual percentage rate (APR) = The harmonized interest rate that expresses the total cost of borrowing or investing as a percentage interest rate.

• Discount loan = Pay the principal and all the interest at the maturity date

• Interest-only loan = Pay interest as you go and pay the last interest plus the principal when the maturity date has come

• Amortized loan = Pay both the principal and the interest as you go

What are bonds (in corporate finance)? - BulletPoints 6

• Coupon = The stated interest payment made on a bond

• Face value = The principal amount of a bond that is repaid at the end of the term. Also called par value.

• Coupon rate = The annual coupon divided by the face value of a bond.

• Maturity = The specified date on which the principal amount of a bond is paid.

• Yield to maturity = The rate required in the market on a bond

  • Finding YTM actually comes down to ‘plug and chug’. If you know the par value of a bond is $1000 and the real price is $955,14 and the coupon rate is 8%, you know that the YTM has to be higher than 8%. Just plug in 9, 10 or 11 into the formula to get to your answer.

• Bond value = C * [ (1 – 1 / (1 + r)t) / r ] + F / (1 + r)t, where C * [ (1 – 1 / (1 + r)t) / r ] is the present value of the coupons and F / (1 + r)t is the present value of the face amount.

• Interest rate risk = Arises for bond owners from fluctuating interest rates. How much risk depends on how sensitive a bonds’ price is to interest rate changes. This depends on two things; time to maturity and coupon rate.

• Indenture = The written agreement between corporation and the lender detailing the terms of the debt issue

• Many different types of bonds. The most important ones;

  • Government bonds

  • Zero coupon bonds = A bond that makes no coupon payments and is thus initially priced at a deep discount.

  • Floating rate bonds = With floating rate bonds the coupon payments are adjustable.

• Real rates = Interest rates or rates of return that have been adjusted for inflation.

  • Future value / inflation rate = real value

• Nominal rates = Interest rates or rates of return that have not been adjusted for inflation

• Fisher effect = The relationship between nominal returns, real returns and inflation.

• R = nominal rate, r = interest rate, h = inflation rate > 1 + R = (1+r) * (1+h)

What is equity valuation? - BulletPoints 7

• Share valuation. Cash flows aren’t known in advance, the life of a share is forever and there is no easy way to observe the rate of return.

• Current share price: P₀ = (D₁ + P₁) / (1 + R). What we see is that the share price today (P₀) is equal to the present value of all of the future dividends.

• Pattern of future dividends;

  1. Zero growth rate, P₀ = D / R.

  2. Constant growth rate, P_t = (D_t x (1 + g)) / (R – g) met D_{t =} D₀ x (1 + g)^t.

  3. Non-Constant growth; Time line, notice when constant growth starts. Determine the price at the end of the non-constant growth. Calculate the total value of the equity: P₀ = [D₁ / (1+R)¹] + [D₂ / (1+R)²] + [D₃ / (1+R)³] + [P₃ / (1+R)³].

  4. Two-Stage growth;

     • First stage: P_t = [D₀ x (1+g₁)^t x (1+g₂)] / (R - g₂).

     • Second stage: P₀ = (D₁ / R-g₁) x [1 – ((1+g₁) / (1+R)^t)] + (P_t / (1+R)^t).

• Required return: the dividend yield and the capital gains yield. R= (D₁ / P₀) + g%.

• Preference shares: receive their dividend before holders of ordinary shares.

• Stock Markets: The primary market is where companies sell securities to investors. In the second market investors trade existing shares with each other.

What are investment criteria? - BulletPoints 8

• Net present value, the effect that the investment has on the value of the firm’s shares. Net present value (NPV) = investment’s market value – its cost. This is a measure of the value created or added.

• Estimating the net present value. We can estimate the future cash flows of the investment. Then we discount the cash flows to estimate the present value.

  • Present value = cash inflow x [1 – (1/(1+R)^t)] / R + (single lump-sum inflow / (1+R)^t.

  • NPV = - the cost of the investment + the present value of future cash flows.

• The net present value rule: An investment should be accepted if the net present value is positive, and rejected if it is negative.

• Payback rule: the time it takes to earn the money from our initial investment back.

  • An investment is acceptable if its payback period is less than some pre-specified number of years.

• Discounted payback. An investment is acceptable if its discounted payback is less than some pre-specified number of years.

• Average accounting return = Average net income / Average book value.

  • A project is acceptable if its AAR exceeds a target average accounting return.

• The average book value = (the initial investment + the residual value) / 2.

• The average net income = the sum of the net income in the depreciation years / number of years.

• AAR = Average net income / Average book value.

• Internal rate of return. An investment is acceptable if the IRR exceeds the required return. The IRR on an investment is the required return that results in a zero NPV when used as the discount rate. To find the IRR we have to set the NPV equal to zero and solve it to find the discount rate.

• The relationship between the IRR and the NPV can be illustrated in a net present value profile. On the horizontal side the R (%) and on the vertical side the NPV. Where the curve cuts through the x-axis, the NPV is equal to zero.

• Non-Conventional cash flows -> there is more than one discount rate that will make the NPV of an investment zero.

• Mutually exclusive investments -> instead of looking at the IRRs we have to look at the relative NPVs.

• Investment-type cash flows: the higher the discount rate, the smaller the NPV.

• Financing-type cash flows: the higher the discount rate, the higher the NPV.

• Modified internal rate of return (MIRR)

  1. Discount approach: Before calculating the IRR, we discount all negative cash flows to the present at the required return and add them to the initial cost.

  2. Reinvestment approach: Before calculating the IRR, we compound all cash flows (except the first one) to the end of the project’s life. We don’t take the cash flow out of the project, but we reinvest them.

  3. Combination approach: This is a combination of the discount and the reinvestment approach. The negative cash flows are discounted to the present, the positive cash flows are compounded to the project’s end.

• Profitability Index: Measures the value created per cash unit invested.

  • PI = Present value future cash flows / initial investment.

Decisions on capital investment? - BulletPoints 9

• Project cash flows. These cash flows are the changes in the firm’s future cash flows as a direct consequence of taking the project.

• Evaluating a proposed investment

  1. Pro Forma Financial Statements

     Summarizing much of the relevant information for a project:

     • Projected income statement:

Sales

Variable costs -

Gross profit

Fixed costs

Depreciation -

Profit before taxes

Taxes (%) -

Net income

• Projected capital requirements:

Net working capital

Net non-current assets +

Total investment

2. Project Cash Flows

   • Project cash flow = Project operating cash flow – Project capital spending.

   • Project operating cash flow = Net income + Depreciation – Increase (or +Decrease) in net working capital.

   • Net working capital and capital spending = Total investment.

3. Projected Total Cash Flow and Value

   • Net present value

   • Internal rate of return

   • Payback

   • Average accounting return

   • Net working capital

• Total cash flow = Operating cash flow – Change in NWC – Capital spending

• Depreciation. Straight-line depreciation = (initial value – residual value) / life in years.

• Book value vs. Market value

• If the market value exceeds the book value we paid too little taxes, so we have to make up the difference.

• If the book value exceeds the market value, the difference is a loss for tax purposes. Then the difference x the tax rate is a tax saving.

• Operating Cash Flow (OCF), some alternative definitions.

• Basic approach: OCF = EBIT + Depreciation – Taxes

• The bottom-up approach: OCF = Project net income (= EBIT-Taxes) + Depreciation

• The top-down approach: OCF = Sales – Costs – Taxes

• The tax shield approach: OCF = (Sales – Costs) x (1 – T) + Depreciation x T

• Discounted cash flow analysis: Evaluating cost-cutting proposals, setting the bid price, evaluating equipment options with different lives.

How to analyze and evaluate projects? - BulletPoints 10

• Evaluate the NPV estimates -> Forecasting risk: the possibility that some errors lead to incorrect decisions (estimation risk).

• When we have estimated the NPV to be positive. We need to find why it’s positive, the source of value.

• What-if analysis. Assess the degree of forecasting risk and identify the most critical components of success or failure of an investment.

• Scenario analysis. We will find the worst-case and the best-case scenario. These two scenarios tell us the minimum and the maximum NPV of the project.

• Sensitivity analysis. To discover how sensitive the estimated NPV is to the changes in one variable.

• Break-even analysis. To analyze the relationship between profitability and sales volume.

• Variable costs (VC): Depends on the quantity of output.

  • Total variable cost = Total quantity of output x Cost per unit of output.

• Fixed costs (FC): Don’t change during a particular time, a quarter or a year. We can see the fixed costs as sunk cost, because we have to pay it no matter what.

• Total costs (TC): TC = VC + FC. Marginal (or incremental) cost is the change in costs as a result of a small change in output.

• Accounting break-even. This is the sales level where the project net income is zero.

  • Calculate the break-even point: Q = (FC + D) / (P – v).

• Sales volume and operating cash flow: OCF = (P – v) x Q – FC

• Different break-even measures:

  1. General break-even. Q = (FC + OCF) / (P – v)

  2. Accounting break-even = when net income is zero. Q = (FC + D) / (P – v).

  3. Cash break-even = when operation cash flow is zero. So we put a zero for OCF: Q = (FC + 0) / (P – v)

  4. Financial break-even. Q = (FC + OCF*) / (P – v). OCF* is the level of OCF that results in a zero NPV.

• Operating leverage. The degree to which a firm or project is committed to its fixed costs. The degree of operating leverage (DOL) is the percentage change in OCF relative to the percentage changed in the quantity sold.

  • DOL = 1 + FC / OCF, DOL = %Δ OCF / %Δ Q

• Capital rationing. A firm has profitable investments available, but can’t find the necessary financing.

How do Capital Markets operate? - BulletPoints 11

• Return on your investment = dividend income + capital gain or capital loss on the equity.

• Selling equity: Total cash = initial investment + total return.

• Percentage returns = dividend yield + capital gains yield.

  • Dividend yield = Dt+1 / Pt. Capital gains yield = (Pt+1 – Pt) / Pt.

• Average returns is the sum of the years divided by the number of years.

  • Geometric average return is the average return earned per year

  • Arithmetic average return is what you have earned in an average year.

• Combining the two averages with the Blume’s formula:

  • A risk premium is a reward for bearing the risk. The greater the risk, the greater the excess return.

  • Variance = the average squared difference between actual return and average return. Var(R)

  • Standard deviation = the square root of Var(R). SD(R) = σ

  • Normal distribution is a bell-shaped figure that gives the probability of a return ending up in a given range.

• Market efficiency. A market is efficient when prices adjust to new information. When new information arrives, the market can have an efficient market reaction, a delayed reaction or an over-reaction.

  • Market efficiency forms:

    • Weak-form efficient, share prices are based on the equity’s past prices.

    • Semi-strong-form efficient, the public information is reflected in the share prices.

    • Strong-form efficient, all information is reflected in the share prices.

How does return, risk, and the security marketline work? - BulletPoints 12

• The expected return (E) = sum of the possible return rates multiplied by their probabilities.

• Variance

  • σ2. σ is the standard deviation; this is the square root of the variance.

  • The lower the variance and the standard deviation, the less risky the project.

• Investors have a portfolio of different assets, for example equities and bonds. The portfolio weight = the value of the asset divided by the total portfolio’s value

  • Portfolio expected returns, E(Rp) = X1 x E(R1) + X2 x E(R2) + … + Xn x E(Rn).

• Risk

  • Systematic risk = Has influence on a large number of assets, also called market risk

  • Unsystematic risk = Has influence on a small number of assets, also called unique

• Diversification = spreading an investment across different assets. The principle of diversification says that spreading an investment will eliminate some risk

• The systematic risk of an investment determines the reward for bearing risk.

  • The beta coefficient (β) stands for the amount of systematic risk in an asset relative to that in an average asset.

  • We can calculate the portfolio beta in the same way as the portfolio expected return. Multiply each asset’s beta by its portfolio weight. The sum of those results is the portfolio’s beta.

  • When having risky and risk-free investments in your portfolio, we have to calculate the E(Rp) and the βP this way
    E(RP) = Weight RA x E(RA) + (1 – weight RA) x Rf.

  • βP = Weight RA x βA + (1 – Weight RA) x 0

• Security market line = Shows the relationship between the beta and the expected return.

  • Reward-to-risk ratio Slope (%) = [E(RA) – Rf] / βA
    This means that RA has a risk premium of … % per ‘unit’ of systematic risk.

  • Market portfolio = A portfolio that consists of all of the assets in the market. The expected return on the market portfolio is E(RM).
    We could express the SML slope as: E(RM) – Rf.

  • Capital asset pricing model (CAPM) = Shows that expected return on a risky asset has three components: The time value of money (Rf),

  • The market risk premium [E(RM) – Rf)] and The beta for that asset (βi)
    So the expected return on asset I = E(Ri) = Rf + [E(RM) – Rf) x βi

What are costs associated with capital? - BulletPoints 13

• The cost of capital: the minimum required return on a investment. A risk-free investment has the risk-free rate as its cost of capital.

• Cost of equity: The required return on the investments in the firm of equity investors.

• Dividend growth model: R_E = D₁ / (P₀ + g). D₁ = D₀ x (1+g)

• Security market line (SML) approach: R_E = R_f + β_E x (R_M – R_f)

• Cost of debt and preference shares. The cost of debt (R_D) is the return lenders require on the firm’s debt. The cost of preference shares: R_P = D / P₀.

• Weighted average cost of capital (WACC). Total market value = Equity + Debt.

• The capital structure weights: 100% = E / V + D / V

• WACC = the weighted average of the cost of equity and the after-tax cost of debt.

  • WACC = (E / V) x R_E + (D / V) x R_D x (1 – T_C)

  • With preference shares -> WACC = (E / V) x R_E + (P / V) x R_P + (D / V) x R_D x (1 – T_C)

• Pure play approach = using a WACC which is unique to a project, based on companies in similar business lines.

• Flotation costs happen when a firm issues new bonds and shares. So we have to include these costs in the project analysis. f_A = (E / V) x f_E + (D / V) x f_D

  • The true cost when flotation cost is included = expansion cost / (1 – f_A)

How does raising capital work? - BulletPoints 14

• Venture capital (VC) is financing new ventures, often with high risk.

• Private equity firms: venture equity and non-venture equity markets.

• Venture capital: Wealthy families, provide start-up capital. Private partnerships and corporations. Large corporations, venture capital subsidiaries. Individual investors.

• Stages of financing: 1. Seed money, 2. Start-up, 3. Later stage capital, 4. Growth capital, 5. Replacement capital, 6. Buyout financing.

• Public issue of securities: pathfinder prospectus, pre-underwriting conferences, full prospectus, public offering and sale, market stabilization.

  • Two types: General cash offer and right issue.

  • The initial public offering (IPO) is the first time that a company makes its equity issue available to the public.

• Underwriting: Intermediaries between company and public. Their tasks are:

  • Formulate issue method, Pricing the securities, Selling the securities.

  • Gross spread: compensation for selling securities = offering price – buying price.

  • Types of underwriting: Firm commitment, Best effort underwriting, Dutch auction underwriting.

• Green shoe provision: the underwriters have the option to purchase additional shares from the issues at the offering price.

• Lock-up agreement: after an IPO insiders must wait before they can sell equity.

• Underpricing. An IPO is mostly offered below his true market price.

• Costs of issuing securities: gross spread, other direct expenses, indirect expenses, abnormal returns, underpricing, green shoe option.

• Rights: Shareholders can buy with the rights a number of new shares at a specified price within a specified time.

• Dilution = loss in existing shareholders’ value. Dilution of proportionate ownership, dilution of market value, dilution of book value and earnings per share.

• Long-term financing: Term loans or private placements.

• Bank loan: Line of credit or loan commitment.

How does financial leverage and capital structure policy work? - BulletPoints 15

• Capital structure. When the WACC is minimized the value of the firm is maximized, then there is an optimal capital structure.

• Financial leverage. This is the degree on how much a firm relies on debt. If the EBI is higher than the break-even point, the leverage is beneficial.

• Taxes. Firms can benefit from interest paid on debt, because it’s tax deductible. The tax savings, also called interest tax shield, is the interest payment x the corporate tax rate.

• M&M Proposition 1 says that the capital structure of the firm doesn’t have influence on the value of the firm. This is without taxes.

  • If we include the taxes, we see that the capital structure in fact does matter.

• M&M Proposition 2. Tells us that the cost of equity has three components: the required rate of return , the cost of debt and the debt-equity ratio .

  • Two components cost of equity capital: Business risk and financial risk.

    If we include the taxes, we add to the and the formulas.

• Bankruptcy. When a firm’s value of debt is the same as the value of its assets.

• Optimal capital structure, point where it’s value is maximum. *, that point also represents the optimal amount of borrowing D*.

  • D* / * in debt, 1 – (D* / *) in equity

• When the costs of capital are minimum (WACC*), the debt-equity ratio is optimal.

  • WACC* = D*/E*

• Extended pie model: CF = payments to shareholder + payments to creditors + payments to government (tax) + payments to bankruptcy courts and lawyers + other claimants to the cash flow.

• Total value claims

• Liquidation is when the firm sells its assets. The cash generated from these sales is distributed to creditors.

• APR, the absolute priority rule, is the order of creditor claims.

What are issues around dividends and payouts? - BulletPoints 16

• Dividend = A payment made out of a firm’s earnings to its owners, in the form of either cash or stock

• Dividend payment

  • Declaration date = Date on which the board of directors passes a resolution to pay a dividend

  • Ex-dividend date = The date of two business days before the date of record

  • Date of record = The date by which a holder must be on record to be designated to receive a dividend

  • Day of payment = The date on which the dividend is paid

• Dividend policy = The time pattern of dividend payout. In particular, should the firm pay out a large percentage of its earnings now or a small percentage?

• Stock dividend = A payment made by a firm to its owners in the form of equity, diluting the value of each share outstanding. A stock dividend is commonly expressed as a percentage

• Stock split = An increase in a firm’s shares outstanding without any change in owners’ equity

• Reverse split = A stock split in which a firm’s number of shares outstanding is reduced

What is short-term financial planning and management? - BulletPoints 17

• Liquidity: speculative motive, precautionary motive or transaction motive.

• Liquidity management: a firm should have the right quantity of liquid assets.

• Cash management: collecting and disbursing cash.

• Float: The difference between book cash and bank cash, effect of checks in process. Disbursement floats or collection floats.

• Net float = total collection floats + total disbursement floats.

• Float management = Speed up collections, slow down disbursements

• Average daily float = total float (amount x delay days) / total days (30 -> month)

• Average daily float = average daily receipts x weighted average delay

  • Cost of float = the opportunity cost, because you can’t use the cash.

• Temporary cash surplus:

  • Seasonal or cyclical activities. There’s a surplus in cash flows part of the year and a deficit in cash flows the rest of the year.

  • Planned or possible expenditures. Building up cash surpluses for large purchases.

• Holding too much cash (carrying costs). Holding too little cash (adjustment costs).

  • C* = optimal size of cash balance = target balance, where the cost curves cross.

• BAT model: Determine the optimal strategy:

  1. R = opportunity costs = (C/2) x R = average cash balance x interest rate.

  2. T = trading costs = (T/C) x F. T = amount of cash disbursed during the year.

  3. Total cost = opportunity costs + trading costs = (C/2) x R + (T/C) x F.

  4. C* = the optimal cash balance.

• Miller-Orr model. U* = upper limit, L = lower limit and C* = target cash balance.

  • Reaches upper limit, buy marketable securities from cash.

  • Falls to lower limit, then get cash from selling securities.

  • C* =

  • U* = 3 x C* - 2 x L

• Average cash balance = (4 x C* - L) / 3

• Components of credit policy: Terms of sale, credit analysis, collection policy.

• Granting credit; the sale, customer sends check, firm deposits check, firm’s account is credited for the amount of the check.

• Trade receivables = average daily sales x average collection period.

• Terms of sale: Example: 2/10, net 60. Customers have 60 days to pay, if they pay in 10 days, they get a 2% discount rate.

• Effective interest rate, EAR = effective annual rate.

• Proposed credit policy analysis.

  1. Cash flow with old policy = (price –variable cost) x current quantity

  2. Cash flow with new policy = (price-var) x quantity new policy

  3. Incremental cash flow = (price – var) x (new Q – old Q)

  4. Present value = [(P-v)(Q’- Q)] / R

  5. Cost of switching = PQ + v (Q’- Q)

  6. NPV of switching = - [PQ+ v (Q’- Q)] + [(P-v)(Q’- Q)] / R = [- Costs of switching] + [incremental cash flow] / R

• Break-even: Q’- Q = PQ / [(P-v) / (R-v)] = units

• Credit cost curve = the sum of the carrying costs and the opportunity costs of a credit policy.

• Credit analysis

  • One-time scale. NPV of granting credit = -v + ( 1 – ) x P / (1 + R) = Percentage of customers who won’t pay.

  • The breakeven probability. Solve NPV = 0 for .

• Collection policy: monitoring receivables, obtaining payments.

• Inventory management: Types of inventory: raw material, work in progress and finished goods.

• Carrying costs: Storage and tracking costs, insurance and taxes, losses due to obsolescence, deterioration or theft, opportunity cost of capital.

• Shortage costs: When you have an inadequate inventory. This brings restocking costs and costs related to safety reserves.

• ABC approach: divide inventory into groups. Expensive vs. inexpensive, basics.

• Economic order quantity model.

  • Q* = the minimum total cost point where the size of inventory order is optimal.

    1. Total carrying costs = average inventory x carrying costs per unit = (Q/2) x CC.

    2. Total restocking cost = fixed cost per order x number of orders = F x (T/Q).

    3. Total costs = carrying costs + restocking costs.

    4. Find the value of Q, which minimizes the total inventory costs.

    5. Q* = the economic order quantity (EOQ)

• Safety stocks = a firm needs to have a minimum level of inventory on hand.

• Reorder points = when the firm places its inventory orders.

• Just-in-time (JIT) inventory: minimize inventories, only enough inventory to meet immediate production needs.

How to manage international corporate finance? - BulletPoints 18

• American depository receipt: makes it possible to trade equity in the united states, by representing shares of a foreign equity,

• Cross-rate: the exchange rate between two currencies quoted in a third currency.

• Eurobond: a way to raise capital for international companies and governments.

• Eurocurrency: the money is deposited in a financial center outside the country.

• Foreign bonds: issued in a single country.

• Gilts; securities from the British and Irish government.

• London interbank offered rate; rate for overnight loans.

• Swaps: exchange two securities or currencies. Interest rate or currency swaps.

• Exchange rate: price of one country’s currency in terms of another currency.

• Triangle arbitrage opportunity = profit by exchanging in steps with the cross-rate.

• Spot trade: trade currencies based on the exchange rate today, the spot exchange rate.

• Forward trade: exchange currency in the future, with the forward exchange rate.

• Purchasing power parity. Keeping purchasing power constant.

• Relative PPP: How change in the exchange rate over time will happen, the expected exchange rate. E (St) = .

• Interest rate parity (IRP). What must the forward rate be to prevent covered interest arbitrage?

• Unbiased forward rate (UFR): Forward exchange rate and future spot exchange rate are equal.

• International Fisher Effect (IFE): an estimated change in the exchange rate between two currencies is directly proportional to the difference between the two countries nominal interest rates.

• International capital budgeting. Take the investment?

  • Method 1: Home currency approach, convert before estimating the NPV.

  • Method 2: Foreign currency approach, convert after estimating the NPV.

• Short-run exposure. Your profit will depend on the future exchange rate. Reduce or eliminate fluctuations by locking in an exchange rate.

• Long-run exposure; unanticipated changes in economic conditions, for example higher wages. Reduce or eliminate by borrowing in foreign country.

• Translation exposure: problems for the accountants;

  1. Appropriate exchange rate to use for translating each balance sheet account

  2. How should balance sheet accounting gains and losses from foreign currency translation be handled?

• A difference between Islamic corporate finance and "Western" corporate finance is that in Islamic countries it is not done to charge interests of any kind on financial securities; making money from money is forbidden.

How to understand behavioral finance? - BulletPoints 19

• Three main categories of cognitive errors: Biases, Framing effects, Heuristics.

• Biases: Making systematic errors in judgment. There are three relevant biases: Overconfidence, over-optimism, confirmation bias.

• Framing effects: Framing dependence is making a different decision if the question is asked in an other way. The answer you give depends on how the question is framed.

• Loss aversion = focusing on gains and losses instead of overall wealth

• Break-even effect: something will happen that will allow them to break even and escape without a loss.

• House money = taking more risk with money you have won (casino), it’s less upsetting to lose this money instead of lose the money that you brought / lose from your investment gains.

• Self-attribution = When something good happens for reasons beyond your control, taking credit for it.

• Disposition effect = sell winners and hold losers.

• Mental accounting = having a personal relationship with your investments, so its harder to sell them.

• Myopic loss aversion = focusing on the avoidance of short-term losses

• Regret aversion = avoiding to make a decision because of the fear that the decision is less than optimal

• Endowment effect = considering something that you own worth more than when you wouldn’t own it.

• Money illusion = confused between nominal buying power and real buying power.

• Heuristics: Making decisions based on shortcuts or rules of thumb. Not always a good call, because all the situations are different.

• Affect heuristic = the reliance on instinct.

• Representativeness heuristic = make stereotypes or limited samples representative of a larger group.

• Clustering illusion = thinking that clustered random events aren’t really random.

• Gambler’s fallacy = assuming that things that occur in the long run, will be corrected in the short run.

• Hot-hand illusion = predicts continuation in the short run (basketball).

• Other heuristic errors and biases: law of small numbers, recency bias, anchoring and adjustment, aversion to ambiguity, false consensus, availability bias.

• Market Efficiency. Markets are efficient because of some smart and well-financed investors. They buy and sell to exploit mispricings. This is called arbitrage. Arbitrage is risky and costly, so there are only a few arbitrageurs.

• Limits to arbitrage (barriers): Firm-specific risk, noise trader risk, implementation costs.

• Bubble = market prices soar far in excess.

• Crash = market prices collapse.

What is financial risk management? - BulletPoints 20

• Hedging: Reducing the exposure to future price or rate fluctuations.

• Increase of volatility: Interest rate, exchange rate, commodity price.

• To analyze a firm’s exposure to financial risks, a risk profile can be made. This shows how the changes in prices or rates affect the value of the firm.

  • ΔV = changes in value, vertical.

  • ΔP = changes in price, horizontal.

  • The steeper the slope, the more important it is to reduce that exposure.

• Short-run exposure: Unforeseen events or shocks result in temporary changes in prices. This is also called transitory changes.

• Transaction exposure is a short-run financial risk, which arises from needs to buy or sell in the near future at uncertain prices or rates.

• Long-term exposure (economic exposure). This is the risk arising from more permanent price fluctuations.

• Forward contract: two parties agree on the sale of an asset or product in the future for a certain price. The date that the sale is done is the settlement date.

• A pay-off profile shows the hedge of financial risks. The two parties have agreed on a locked price, the pay-off profile shows the gains and losses on the contract.

• Futures contract: gains and losses are realized each day, not only on the settlement date.

• Financial future: goods are financial assets as equities, bonds or currencies.

• Commodity future: goods can be anything other than financial assets.

• Cross-hedging: use contract from a closely related asset for hedging another asset.

• Swap contract: Two parties agree to exchange specified cash flows at specified intervals in the future.

• Interest rate swaps is the exchange of a floating interest rate for a fixed one. The parties agree on paying each other’s loan.

• Commodity swaps is an agreement of exchanging a certain quantity of commodity at fixed times in the future.

• Call option: buy an asset at the strike price (or exercise price).

• Put option: sell an asset at a fixed price.

• Option pay-off profiles, ΔP horizontal, ΔV vertical.

• If the price rises above the strike price, the owner will exercise option and enjoy a profit (ΔV).

• Option on a swap: convert floating-rate loan to a fixed-rate loan in the future.

What are options? - BulletPoints 21

• Exercising the option: buying or selling the asset via the option contract.

• Strike or exercise price: the holder can buy or sell the asset at a certain price.

• Expiration date: maturity date of the option.

• American option: can be exercised before the expiration date.

• European option: can only be exercised on the expiration date.

• Out of money is when the share price is less than the exercise price. In the money is when the share price is higher than the exercise price.

• Protective put = buying a put on the equity. Protects against losses.

  • Price of underlying equity + price of put = price of call + present value of strike price.

  • S+P = PV (E) + C = put-call parity (PCP) condition.

• Option out of the money: C1=0 if S1 – E 0.

• Option in the money: C1= S1 – E if S1 – E > 0.

• Time premium = Investors are willing to pay an extra amount if there is a possibility that the share price will rise.

• Upper bound = share price. Lower bound = share price – exercise price.

• Value of an option depends on five factors: current value of the underlying asset, exercise price on the option, time to expiration on the option, risk-free rate, variance of return on the underlying asset.

• Value of the option = share price – exercise price.

• Option pricing model -> Present value of the exercise price on the option, calculated at the risk-free rate;

• PV = E / (1 + ), S0 = C0 + (E/1+Rf), C0 = S0 – (E/1+Rf).

• The value of the call option = share price – present value exercise price.

• Total value/share price = risk-free asset value + call value.

• Equity value – risk-free investment = an amount short.

• Determine how many call options needed: ΔS / ΔC.

• Black-Scholes Model

• Call option:

• N (d) = probability that a standardized, normally distributed, random variable will be less than or equal to d.

• Put option: Put-call parity (PCP), rearrange to solve the put price: .

• Employee share options (ESO): 10-year life, cannot be sold, ‘vesting’ period.

• Values of debt and equity:

  • The debt is risk free: Equity worth = Face value – (Present value – risk-free part).

  • The debt is risky:

  • ΔS / ΔC = number of options that exactly replicates the value of the assets.

  • S (lowest) / (1+ risk-free rate) = PV

  • . Solve

  • The equity is thus worth

  • The debt is worth

  • Interest rate on the debt = (face value / debt) – 1 = %

• Investment timing decision: all projects compete with themselves in time. Compare the NPV of taking the project now with the NPV of taking it later.

  • NPV = - costs + cash flow / discount rate

  • NPV= NPV future / n * discount rate

• Option to wait = ΔNPV = extra value created.

• Managerial options; opportunities to modify a project.

• Contingency planning, look at some of the possible futures that could come about, and what actions we might take if they do. Option to expand, to abandon, to suspend or contract operations, in capital budgeting, strategic.

What are mergers and acquisitions? - BulletPoints 22

• Merger: when one company takes over the assets and liabilities of another company. The acquiring firm keeps its name and identity. Sometimes an entire new firm is created, this is called a consolidation.

• Acquisition of shares: purchasing the firm’s voting shares. The firms offers in public to buy shares, this is called a tender offer.

• Acquisition of Assets, buying the assets of another firm.

• The horizontal acquisition, the bidder chooses a firm in the same industry. When de firms are in de same production process, we speak of vertical acquisition. And when the firms don’t have any relation to each other, then it’s called a conglomerate acquisition.

• Proxy contests: replace the existing management to gain control of the firm.

• Going private. A small group of investors buys the equity shares of a public firm, this is often called leveraged buyouts.

• If the value of the combined firm is greater than the value of the sum of the separate firms, than the acquisition is beneficial.

• The difference between those values is the incremental net gain (ΔV). The value of the company is thus ΔV + Vb = Vb* = the value of Firm B to Firm A.

• The incremental cash flow (ΔCF) is the difference in cash flow of the combined company and the sum of the two companies.

• The cash flow benefits can arise from: revenue enhancement, cost reductions, lower taxes, reductions in capital needs.

• Diversification can reduce unsystematic risk, but we need to reduce the systematic risk to increase the value of the assets.

• Cost of a merger: First calculate the net incremental gain (ΔV), then the total value of Firm B to firm A (Vb*). If we know the costs of the acquisition, we can calculate the NPV: NPV = Vb* - Cost to Firm A of acquisition.

• Pay for a merger: cash acquisition and equity acquisition.

• Equity acquisition: calculate how many shares you have to give up.

  • Number of shares = costs / share price.

• A firm has to choose between financing the acquisition with cash or with shares of equity. Factors to think about when making that choice: Sharing gains, taxes and control.

• Defensive tactics (to resist unfriendly attempts): corporate charter, repurchase and standstill agreements, poison pills and share right plans, going private and leveraged buyouts.

• Divestiture, selling business assets, operations, divisions and/or segments to a third party.

• Equity carve-out. A new completely separate company is created and the only shareholder is the parent company. Then there’s an initial public offering to sell a part of the parent’s equity to the public.

• Spin-off. Distribute shares to existing parent company shareholders.

• Split-up. To split a company into two or more new companies.