Corporate Finance terms Flashcards

Terms Definitions
1)Financial covenants
2)Debt restrictions
3)Restricted payments
4)Restrictions on distributions from subsidiaries
5)Restrictions on selling assets and subsidiary stock
6)Transactions w/ affiliates
Debt Ratio
Total Liabilities/Total Assets
rate of return
[amount received
a. §548: Fraudulent Transfer code
i. Every state has a corollary statute that is available outside of the bankruptcy code for fraudulent conveyances or fraudulent transfers
Shelf Offerings
2 years to sell
Diversification provides a benefit to investors when:
the investor finds that one security that has the optimal expected rate of return
the investor selects two or more securities for which returns are highly correlated with each other
liquidity, or marketability premium. The preium charged by lenders to reflect the fact that some securities cannot be converted to cash on short notice at a reasonable price. LP is very low for treasury securities and securities issued by large strong firms, but is is relatively high on securities issued by very small firms
Freeze out:
• Forced disinvestment of the minority by the majority.
o Go private to get rid of public SHs
o Treats SHs as if they owned stock that is redeemable at option of C without SHs having known this
o Coercive but it is not on its own illegal.
 Legal mechanism for eliminating minority SHs
Fraudulent conveyance law
• Contains moral principals governing the conduct of debtors toward their creditors
o Truth, primacy and evenhandedness
Golden Parachutes:
Provisions in employment contracts, that allows for the payment of a lump-sum or cash flows over a period, if managers covered by these contracts lose their jobs in a takeover.
Market risk is synonymous for systematic risk.
A. True
B. False
Which of the following is true?
The future value of a cash flow will be greater if an investment earns 5% instead of 10%
The future value of a cash flow will be unchanged by the rate of return that the investment earns
The future value of
Assume that two investments have the same number of years of generating cash flows; a high discount rate tends to favor:
the investment with large cash flows early
the investment with large cash flows late
the investment with even cash fl
Your parents have promised to give you $25,000 on your wedding day if you wait 10 years to get married. Your sister is getting married this year. What amount should she receive today to match your gift? The interest rate is 12%.
As the discount rate increases, the present value of a one-time future cash flow increases.
A. True
B. False
Why would an analyst calculate the equivalent annual cost of a project?
An analyst can compare alternative investments that are mutually exclusive and have different lives
An analyst can compare independent projects that have different live
The annual percentage rate (APR) and the effective annual interest rate (EAR) are always the same if the number of compounding periods per year is one.
A. True
B. False
what risks are relevant?
only market risk
maturity risk premium. Longer term bonds, including Treasury bonds, are exposed to a significant risk of price declines and a maturity risk premium is charged by lenders to reflect this risk
The tighter the distribution, the _____ the risk assigned to a stock.
Discount Brokers
A brokerage firm that processes customer orders at lower prices than \"full service\" brokers.
 As long as company doesn’t issue anymore CS in the meantime, PS holders will be able to keep % ownership upon conversion
• Potential for problems if new stock is issue:
o Maybe offer right of first refusal?
Residual claim on the assets of corporation-->get periodic return on investment (dividends) in exchange for lower priority
a. Preferred: a preference as to dividends and on liquidation
b. Common: more residual possibilities but more risk
Kirk Kerkorian: Owned 69% of MGM Grand's issued and outstanding common stock and 74% of its Series A Redeemable Preferred Stock. Set up a merger where MGM merged with shell subsidiary of Bally Manufacturing.
Preferred rights are measured by legal standards relating to the contract.
Rights shared with CS holders may be measured by equitable as well as legal standards
d Three of plaintiff’s claims fairly implicated fiduciary duties:
i a fair allocation of merger consideration
ii exercise of due care in negotiating the merger
iii a prohibition on self-dealing
e Things that are wrong with this
i Two masters: the preferred complain that they did not have enough but to give the preferred money would have been to take it away from the common
ii Uncertainty: FD are not rules they are standards
iii Greater rights with regards to non-preference matters- things that are not in contract are protected but those things that are, are not.
Three valuation methods
1)Kitchen sink method 262(h)
2)DE block method/weighted average metho
3)Book value method
Auditor's Liability
GR: No liability for straight negligence to third ptys. Liability if 1) neg misrep or 2) fraudulent mispre.

Fraud Misrep liability - foreseeable third parties

Neg Misrep liability -- to thos whom or for whom mis reps were made and for those whose benefit he intends to supply the info for benefit of third party or knows the recipient intends to supply it. and also w respect to an identified txn or substantially similar txn
Why would an analyst need to consider the recovery of working capital in the terminal year of a project's life?

ignoring the working capital investment recovery seriously overestimates the project's NPV
the recovery of the project's workin
Which of the following cash flows would not be considered in the initial investment of a project?
increase in working capital from projected increases in credit sales
cost of issuing new bonds to finance asset purchases
installation costs
The rate of return that investors can earn on financial assets with similar risk to that of real assets is known as the opportunity cost of capital.

A. True
B. False
At what rate must $400 be compounded annually for it to grow to $1432.80 in 10 years?
5 percent
6 percent
7 percent
8 percent
What is a major deficiency of using the IRR?

the decision from using the IRR generally contradicts the decision from using the NPV
interest rate is not an intuitive measure of risk
it ignores time value of money concepts
under ce
agency costs
costs that stockholders must incur, which include all costs borne by stockholders to encourage managers to maximize the firm's long term stock price rather than act in their own self interests
coefficient of variation calculation
std. deviation/ expected return
Corporate Governance
The set of internal controls, processes and procedures by which firms are managed. 1. The board of directors protects shareholder interests. 2. The firm acts lawfully and ethically in dealings with shareholders. 3. The rights of shareholders are protected and shareholders have a voice in governance. 4. The board acts independently from management. 5. Proper procedures and controls cover managements day to day operations. 6. The firms financial, operating and governance activities are reported to shareholders in a fair, accurate, and timely manner.
Blue Chip
A well-known corporation with a long history of growth and profits; higher quality relative to smaller or less established organizations.
The increase in value of an investment over time such as the amount received when stock sold or bond redeemed.
In re Spang Industries:
PA-->valuation method outside of DE.
o Used 3 methods of valuation
 Net Asset value
 Investment value
 Actual market value
o Weighted average method is not the only possible method to use.
Two steps in capitalization process
o Calculate representative annual earnings figure
 Earnings before depreciation may be better b/c depreciation is not reflective of how well the company is doing.
o Choice of a capitalization ratio which reflects the stability and predictability of earnings of the particular C
 Ratio: reflects how much someone would pay to get earnings of this company
 VE = E/R
• V= valuation based on earnings
• E=earnings (use EPS)
• R=cap rate
• R= 1/(P/E)
 Get P/E ratio from similar company
• Same industry, growth rate
Tort claims v. contract claims
Involuntary creditor doctrine
o More likely to pierce tort claims b/c it creates an involuntary creditor
o But not dispositive-->usually requires the existence of another factor
The Societal Response
1)If firms consistently flout societal norms and create large social costs, the governmental response (especially in a democracy) is for laws and regulations to be passed against such behavior.
2)For firms catering to a more socially conscious clientele, the failure to meet societal norms (even if it is legal) can lead to loss of business and value
2)Finally, investors may choose not to invest in stocks of firms that they view as social outcasts.
Expected return
Probability x Return, summed for all potential outcomes
o Probability: k = (P1)(k1) + (P2)(k2) + (P3)(k3), etc.
Burden of Proof (Weinberger)
 P must demonstrate unfairness (fraud, misrepresentation, etc.)
 Then burden shifts to C to prove entire fairness (heavy burden)
• Fair dealing + fair price
o Fair dealing: how transaction is timed, initiated, structured, negotiated, disclosed to directors, and how director and SH approval was obtained
 Here: Candor (conflict of interest with Lehman and didn’t disclose reports to minority), timing, lack of negotiation
o Fair price: economic factorswhether price is fair
 “Delaware block" or weighted average method of valuation should not control.
• Endorsed a more liberal approach requiring consideration of all relevant factors pursuant to DGCL § 262(h)
• Legitimate purpose test: overturned hereno longer good law in DE
 But an informed vote of the majority of the minority or by a fully functioning independent committee shifts burden back to plaintiff to show the transaction was unfair.
• C has to prove that there was an informed vote
o Not informed here b/c minority never saw report saying that up to $24/share would be fair
Sources of Capital
1. Internal Capital - returned earnings, used the most, cheaper - no txn costs, no covenants, no convincing someone of your idea, shows you're confident
2. External Capital - 2 types - Debt and Equity
3. Public or Private Offerings
4. International Markets
A stock with a beta greater than one has returns that are _____ volatile than the market and a stock with a beta less than one has returns that are _____ volatile than the market.

more; more
more; less
less; more
less; less
What is the payback period for a $20,000 project that is expected to return $6000 for the first two years and $3000 for years three through five?

3.67 years
4.76 years
4.5 years
4.67 years
The present value of a single cash flow:
increases as the discount rate decreases
decreases as the discount rate decreases
increases as the number of discount periods increases
increases as the discount rate increases
A stock's beta is a measure of its:
market risk
unsystematic risk
unique risk
diversifiable risk
If files for a corporation are not paid it's considered _____
Managers are naturally inclined to act in their own ____ ______
best interests
intrinsic value
stock valuation based on expected free cash flows
Dupont Expression
ROE = (NI/Revenues) x (Revenues/ Avg. Total Assets) x (Avg. Total Assets / Total Shareholders Equity). = Net Profit Margin x Total Asset Turnover x Financial Leverage
Balanced Portfolio
A set of investments that offers both income and an increase in value at reasonable risk.
Mutual Fund
A kind of investment that a company makes on behalf of shareholders. The company sells shares in the fund and invests the money in a group of assets, usually stocks. The funds managers make investment decisions according to stated objectives.
retail broker
A financial advisor that works for a brokerage firm that offers a wide range of services to clients. Such services may include research materials and advice on what stocks, bonds, and/or mutual funds to buy and sell. A retail brokers commissions and other account fees will generally be higher than the commissions and fees discount broker charges. Retails brokers may only sell investment products approved by their firm.
The objective in decision making
1)In traditional corporate finance, the objective in decision making is to maximize the value of the firm.
2)A narrower objective is to maximize stockholder wealth. When the stock is traded and markets are viewed to be efficient, the objective is to maximize the stock price.
3)All other goals of the firm are intermediate ones leading to firm value maximization, or operate as constraints on firm value maximization.
Equity holders
Don’t get paid until debt is paid off so want company in engage in riskier, and thus potentially more lucrative, investments.
Subordinated debt:
Agreed to have its debt rank below that of other creditors.
If there is a pattern of behavior that is detrimental to one of the SHs and as a capstone of that conduct there is a low-ball offer, it could constitute breach of fiduciary duty.
 Massachusetts
Valuing degree as gratuitous
Ppls real motivation is altruism.
Too hard to figure out amt - some forms of household production have good market equivalents (housework) so have poor market equivalents (sex)
The future value of a lump sum of money using a simple interest calculation and a compounded interest calculation will provide the same result in one period's time.
A. True
B. False
when the market price of a stock is equal to the true intrinsic value
economic value added
a new metric that measures managerial performance. Overcomes the flaw in conventional accounting to reflect the true economic value.
- Is a better measure than EPS and ROE
- Found by subtracting from after-tax operating profit the annual cost of ALL the capital a firm uses
- the higher the metric, the more the firm is creating wealth for its shareholders
- There is a higher correlation between this metric and stock prices compared to other accounting measures
% Discount from Fair Value
=(Face Value-Price) / Face Value
capital budgeting (pg 2)
the process of making and managing expenditures on long-lived assets
Dividend Yield
The annual rate of return earned by a stockholder. To find a corporations dividend yield, divide the annual dividend by the current market price of a share of the corporations stock.
Importance of conversion right:
• If company had done really well and was liquidating
o No upside/residual value with PS: just original investment and maybe cumulative dividends
o CS: get to participate in residual value (upside of C performance)
• As long as value of company is greater than original value
• What do you lose?
o Preferred status
o Adjustment advantage of anti-dilution provisions (ratchet)
Actual market value
Price at which the stock was selling on the market prior to the action which is objected to, disregarding any change in price due to action. Given little weight b/c stock was lightly traded
What is an objective?
An objective specifies what a decision maker is trying to accomplish and by so doing, provides measures that can be used to choose between alternatives.
Fiduciary duty analysis
1)Do they have a FD?
2)What is the standard for FD?
b)Duty of Loyalty and Duty of Care
i)Entire fairness test or intrinsic fairness test
A)Unfair dealing: Weinberger
B)Fair price: fairness opinion, other prices/alternate prices, informed vote
3)Things to consider:
a)Duty of care:
 Alternatives-->legitimate business purpose
 Timing
• How much time took?
• Right before something big?
 Access to the investment banker
 Amount of deliberation
 How much does the disclosure count for? Was it really informed?
b)Duty of loyalty:
 Conflict of interest with investment
 Insider information
Investment Banks role in Underwriting Process
1. Organization - originate securities, advise whether to go public and how many shares
2. Distribution of shares to buyers
3. Certification - due diligence, provide information to whether stock is risky or not
Advantages of Going Public
1. Better access to capital markets
2. Public markets provide liquidity
3. Original owners can diversity
4. Monitoring and source of information to the fimr
5. Publicity
Completive Offering
Firm specifies the K and puts out a bid (only used by utilities)
Why IPO's often underpriced?
Some investors have better info than others
winner's curse
Underwriters incentive is to set the price low enough that all shares sell
Underpricing makes underwritier's job less risky
want to under price to show good performance for another offering
r*+ IP and it is the quoted risk free rate of interest on a securilty such as a US Treasury bill, which is very liquid and also free of most risks
corporation (pg 5)
a business that is its own entity, but is owned through shareholders -ownership is easily transferred between shareholders -split into shareholders, board of directors, and management officers -unlimited life -shareholders' liability limited to their investments
-corporation is taxed along with dividend income of shareholders (double taxation)
When traditional corporate financial theory breaks down, the solution is:
1)To choose a different mechanism for corporate governance
2)To choose a different objective:
3)To maximize stock price, but reduce the potential for conflict and breakdown:
a)Making managers (decision makers) and employees into stockholders
b)By providing information honestly and promptly to financial markets
Why traditional corporate financial theory often focuses on maximizing stock prices as opposed to firm value?
1)Stock price is easily observable and constantly updated (unlike other measures of performance, which may not be as easily observable, and certainly not updated as frequently).
2)If investors are rational (are they?), stock prices reflect the wisdom of decisions, short term and long term, instantaneously.
3)The stock price is a real measure of stockholder wealth, since stockholders can sell their stock and receive the price now.
How PS holders can protect themselves:
 Prohibit this type of stock dividend or make them fully participating in dividend
 Require change in conversion ratio on occurrence of certain things
• Proportionate adjustment
 Maybe: get whatever you contract for and get FDs for everything you don’t contract for
• Once it is considered and passed on, you SOL
Efficient Capital Market Hypothesis (ECMH) and assumptions
An asset's current price reflects all publicly avail info about future economic fundamentals affecting market price.

Different forms of ECMH
1. Weak form - means that you cannot predict stock prices. Assumes that info is readily avial to all traders; only new public info can affect stock prices. Can infer nothing from price movement - no info at all.
2. Semi-strong - All publicly avail info reflected in stock prices. If there is a release of info, it is immediately reflected in stock prices; what will not be reflected is insider info or info that is too costly to get. Assumes some ppl have more info than others. Until the knowledge raises to a certain level of knowledge, you can make money on that knowledge..
3. Strong: All info, public or not, is reflected in the stock price. Everyone knows all information. The mere act of trading on info reveals it to everyone else. Means that insiders cannot gain from their knowledge bc the stock price will immediately start to trade. reality - there is a lag time.

zero txn costs in securities
all avail info is costlessly avail to market
Asset Covenants
1. Secured Bond - A bond for which the firm has pledged the title of an asset
2. Mortgage bond - secured bond giving lenders first-mortgage lien on an asset
3. Collateral trust bond - secured bond where assets are placed in trust
4. Debenture - unsecured bond, unsecured creditors. Have a claim on
three major categories of agency costs
1. expenditures to monitor managerial action, such as auditing costs
2. expenditures to structure organizations in ways that will limit undesirable managerial behavior, such as appointing outside investors to the board of directors

3. opportunity costs that are incurred when a shareholder imposes restrictions
basis for creditors lending funds
1. riskiness of the firm's existing assets
2. expectations concerning the riskiness of the future asset additions
3. existing capital structure
4. expectations conerning the future capital structure changes
The longer the maturity of a bond, the greater the
interest rate risk
Bank Discount Yield
= (Face value - Price / Face Value) (360/days til maturity)
What can go wrong for financial markets?
1)Delay bad news or provide
misleading information
2)Markets make mistakes and can overeact
Minority objections to being ousted:
1. Paid for right to be investors, not to be liquidated.
2. Not happy with liquidation price.
Objective. For publicly traded firms in reasonably efficient markets, where bondholders (lenders) are protected:
Maximize Stock Price: This will also maximize firm value
Use and Abuse of Accounting Ratios
1. Must be standardized for financial comparisons
2. Evaluates current operations
3. Compares performance w past performance
4. Compares firms across an industry
steps in direct intervention by shareholders
1. Talk with management and make suggestions on how to run the business (like "lobbyists")

2. Anyone who has owned at least $1000 of a company's stock for one year can sponsor proposal that must be voted on at the annual stockholders' meeting, even if management opposes the proposal

3. Institutional money managers have to votes to replace a badly performing management team
4. Hedge funds have the ability to buy a controlling interest in any company they regard as being badly managed and thus undervalued and then change management
Discounted Payback Method
The # of years it takes a project to recover its initial investment in present value funds. It is greater than payback period w/out discounting b/c it considers PV.
Why do we need an objective?
1)If an objective is not chosen, there is no systematic way to make the decisions that every business will be confronted with at some point in time.
2)A theory developed around multiple objectives of equal weight will create quandaries when it comes to making decisions.
3)The costs of choosing the wrong objective can be significant.
Law of One Price and Arbitrage
In a competitive market, if two assets are equivalent, they will tend to have the same price "equivalent" - risk you are asking to bear.

The law of one price is enforced by a process called arbitrage. the practice of taking advantage of a price differential btwn two or more markets - buy in low market and turn around and sell in high market. Some barriers to arbitrage -- transaction costs (ideally, no two parts of the country should differ by no more than the transaction costs of moving it); untradeable goods

if 2 similar securities are trading at significantly diff't prices, we first suspect some unknown difference.
Why would you want creditors to sue?
Prevent squandering of assets to the shareholders
Shareholder Suits -- Direct v Derivative Suits
1. Direct actions - personal to the shareholder; damages suffered as a result of buying stock too high a price to a misleading prospectus, usu class actions

2. Derivative actions - enforce corp righs - damages paid to the corp, against a director who reaped excessive process, fiduciary duty violation
Long term bonds are heavily exposed to __________________ while short term bonds are heavily exposed to _______________ .
interest rate risk; reinvestment rate risk
Social Costs and Benefits are difficult to quantify because ..
1)they might not be known at the time of the decision (Example: Manville and asbestos)
2)they are 'person-specific' (different decision makers weight them differently)
3)they can be paralyzing if carried to extremes
Accounting Info to Compare for Future of Company
Positive Cash Flow? Cash Flow is the most important thing for stability
Current Assets Exceed Current
Going forward, these may be as or
more important than current P&L?
nominal/quoted risk free rate of interest
r(rf) is the real risk free rate plus the premium expected for inflation
Valuing a Degree as equity owed to the nondegreeing spouse - how its assessed and problems
Comparing the avg lifetime earnings of ppl w BS degrees against the lifetime earnings of ppl w MDs and assigning a present value of the difference. PV(MD-BS)/2.
Risk: bc the avg was used, the pressure is on the DAS to hedge more than the average.
NDS will get the avg re of what DAS does - this is a high risk on DAS.
Stock solution - selling the "doctors stock" on the market.
the real risk free rate of interest changes over time depending on what conditions?
1. the rate of return corporations and other borrowers expect to earn on productive assets
2. the people's time preferences for current vs. future consumption
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