Corporate Finance Exam Flashcards

Terms Definitions
Debtor protections
1)Contractual-->restrictive covenants
Book value
o Total Assets-Total Liabilities
o Represents liquidation value, not value as a going concern
 Doesn’t account for any appreciation (historical costs/prices).
 Needs to treat corporation as sum of the parts. Don’t value the parts individually
o Adjust to show current value of assets and adjust for goodwill.
 Multiply book value to approximate market value. Look at multiples from comparable public companies.
• Get market to book ratio: only accurate if traded heavily
• Divide by that company’s book value
Who owns a corporation?
Stuctured Finance
• Securitization: creation of securities out of a pool of assets
o Idea: take a particularly risky asset, when put with similar assets, the risk goes downdiversification
 If you aggregate thousands of risky receivables, risk goes down
Dividend provisions
 Certificate of designations: contract between the company and preferred stock holdersspecifies rights and preferences
• In CA, it is called the Certificate of Determination
 By custom only, PS par value equals the total amount invested
 Problems with dividends:
• Discretionary
• Even if they do get paid, they get paid on a class by class basiscan be paid to CS but not PS
• Designed to protect the PS from CS siphoning out money even though CS is lower in priority.
• Middle of road provision:
o PS gets to participate in dividend without converting but if it had converted
 If they convertlose the preferences of PS
 Cumulative provisions:
• Dividends cumulate or accrue
• If don’t pay PS dividends one year, must make back payments before can pay any dividends to CS holders
• Tend to be onerous so don’t see them much
 Things to consider: If dividends are cumulative and if there are fully participating (get whatever CS on dividendsnot at liquidation)
Depreciation expenses affect cash flows by:

depreciation increases taxable income, thus increases taxes
depreciation decreases taxable income, thus decreases taxes
depreciation is a non-cash expense and has no impact on cash flows
biggest agency issue
shareholders vs. managers
a legal document with information about a mutual fund or other types of investments. it describes the investments objective, management style, performance over the past ten years, background of its officers, and expenses.
Valuation methods:
• Discounted dividends: valuing a company based on its future stream of dividends/earnings (actual payouts or ability to make payouts)
• Book value: not frequently usedapplicable for certain industries
• Multiple of earnings: use P/E ratios from comparable companies
Initial Outlay Cash Flow in Period
0 1 2 3 4
-$20,000 $7,730.85 $7,730.85 $7,730.85 $7,730.85

The Internal Rate of Return (to nearest whole percent) is:
The modified internal rate of return of a project will always provide a value between the cost of capital and the IRR of that project.

A. True
B. False
At 8%, compounded annually, how long will it take for $7,500 to double?
4 years
8 years
9 years
12 years
Dr. Kilic currently has $300,000 in a stock fund. The fund pays a 10% annual return. If he never makes another deposit into the account, how long will it take for the account to grow to $1 million?
23.33 years
12.63 years
33.33 years
The simple interest rate per payment period multiplied by the number of payment periods per year is known as the:
simple interest
compounded interest
annual percentage rate
effective annual interest rate
default risk premium. The premium reflects the possibility an issuer will not pay interest or principal at the stated time and in the stated amount. DRP is zero for US treasury securities, but it rises as the riskiness of issuers increases.
ke using CAPM
= RFR + Beta{E(Rmkt)-RFR}
Annual Return
Increase in value of investment, expressed as % per year.
Hierarcy of senior upon liquidation
1)Secured debt
2)Unsecured debt
Present Value
o Why prefer money today: Opportunity cost and Risk of future event
o PV = xn / (1 + k)n
 xn = money to be received in future
 k = interest rate
 n = future years
o If compounding more than once per year: PV = xn / (1 + k/m)nm
Risk Aversion
Most people are risk averse
o Riskier proposition requires a higher return to attract people
o Discount rate for riskier company will be higher
o Efficient frontier: points between the risky and the no risk that will give the optimal return
 Portfolio theory: optimal return from diversify risk
Liquidation preference
o Indifferent to higher valuation 1x or lower valuation 3x. Almost always can get founders to get multiple on liquidation preference. In northern CA only about 24% have multiple of liquidation provisions. Much higher back East.
o Ever agree to a cap on participation? Yes.
"Behavior" Finance
Challenges to ECMH
Investors react to irrelevant information Assumes ppl are rational and trade on relevant info
Ppl exhibit loss aversion - reluctant to sell stocks that lose vlaue
Framing matters -- ppl stick to what they have
Calculations of cash flows over a project's life should include which of the following?
interest expense
sunk costs
overhead shared with other projects
opportunity costs
How do variable costs and fixed cost impact operating cash flows for a project?

since variable costs change with different levels of output, this could have a significant impact on the cash flows of a project
since variable costs remain th
If an expected return of a potential investment is negative, then the standard deviation of the risk associated with that investment is negative.
A. True
B. False
The coefficient of variation is a useful measure for comparing between alternatives with different expected returns and different standard deviations.
A. True
B. False
agency relationship
whenever a principal hires someone else to perform some service
disadvantages to a corporation
1. double taxation (corporate/personal)
2. cost of set up and report filings (legal restrictions)
Operating Cycle
=Days in inventory + days receivables
The concept of not putting all your eggs in one basket. The opposite of diversification is \"concentration\"- where a large portion of the investors money is invested in only a few stocks.
Bear Market
A term that describes a prolonged period of declining stock prices.
Risk tolerance
Every investor has the ability to tolerate a certain amount of change in his or her portfolios value, including short-term losses from market declines. Younger investors can usually tolerate more risk because that have ample time to recover from these short-term losses. Thats not the case for older investors.
Stock Split
When a company's stock price gets higher than the company prefers, it can choose to split the stock into pieces in order to bring the price down to where investors may feel more comfortable buying. For example, if company ABC selling for 120$ per share executes a 2 for 1 split, each investors number of shares doubles- but each share is now worth 60$.
Fairness opinions
Developed because of Smith V. Van Gorkim. No real financial analysis, market check. Relates to BJR and that as long as board does work is ok.
B When it comes to sales and mergers there is no real BJR because the inside management is necessarily self conflicted.

When are fairness opinions used: when company is going to go public.
How to get beta?
o Public company: Regression analysis of stock performance to market performance.
o Private companies: no public information.
 Look at comparable public company or a private company that was recently sold.
Walkovsky v. Carlton
1966, 2nd circuit, NY
• D owned stock in 10 Cs, each owning 2 cabs. Cabs were insured for minimum amount with no other assets.
• P is injured by one of the cabs and sues D personally.
• Court: Cannot pierce veil simply b/c of inadequate capital.
o Policy to hold more insurance is a matter of legislature, not the courts
Policy of Unlimited Liability
a. Checking corporate power: limit growth through debt financing b/c of risk of liability, protection of creditors
b. May be more efficient for small, closely held companies that can contract with creditors to limit liability of owners.
Payment of a constant sum of fixed intervals over a period of years
Leveraged Buyout Process
occurs when a financial sponsor acquires a controlling interest in a company's equity and where a significant percentage of the purchase price is financed through leverage (borrowing). The assets of the acquired company are used as collateral for the borrowed capital, sometimes with assets of the acquiring company. The bonds or other paper issued for leveraged buyouts are commonly considered not to be investment grade because of the significant risks involved.
12 Types of Equity
1. Stocks
2. Warrants
3. RE
4. ...
The value of the assets of a project is its net present value.

A. True
B. False
What is the expected return for a stock that has a beta of 1.5 if the risk-free rate is 6 percent and the market rate of return is expected to be 11 percent?
dollar terms
one way of expressing an investment return
default risk premium is also known as
bond spread
= wd{kd(1-t)} + wps(kps) + wcekce. wd= % debt in capital structure. wps = % preferred stock in capital structure. wcs= % common stock in capital structure.
Time when a bond issuer pays you back the money you loaned plus any interest earned.
What can go wrong for society?
1)Significant social costs
2)Some costs cannot be traced to firms
Cross-default provision
Make debt due and payable upon default on any other obligation-->debt is automatically deemed in default on such an occurrence
• May require C to report a default on other obligations
Ratio/asset surplus test
 Dividends are paid freely out of RE, like ES test.
 If RE are insufficient, may pay dividends out of capital if, after the distribution:
• The C’s ratio of assets to liabilities exceeds 1.25:1 and
• Its current liquid assets at least equal its current liabilities
Firm Commitment Offering
Underwriter agrees to buy the whole offering from the firm at a set price and off it to the public for a slightly higher price.
What is the present value of a 5 year annuity with annual payments of $200 and a 15 percent discount rate?
major areas of finance
1. money and capital markets
2. investments
3. financial management
executive stock options
options that are worth more for managers when the stock price is high and so in theor makes the executives work harder to improve the stock price. This is hardly the case however.
Some debt is good, too much/little is ___ ____
not good
Money Market Yield
=(Face Value - Price) / Price (360/Days) = HPY x (360/Days)
partnership (pg 4)
a business owned by two or more people-general and limited partners-general partners manage business and assume all liabilities-limited partners only invest and are limited in liability to their investment-terminated when general partner dies-income taxed only as income to partners
Selling short (Short position)
The investor borrows stock from a broker and sells it. At a later time or date, the investor buys the stock and returns it to the broker. An investor uses this strategy when she expects the stocks price to fall.
Policy of limited liability
o Entity theory:C is a separate entity and thus debts of the C are not debts of the SHs as individuals
o Concession theory:C exists only by virtue of governmental concession
Alaska Plastics, Inc. v. Coppock:
o Threshold Question: Is there a fiduciary duty?
o Minority SH not notified of several shareholder meetings. However, she attended a meeting during which she ratified merger.
o C gave her a lowball offer for her shares.
o She sued C for an involuntary liquidation of the corporate assets.
o Court:
 Involuntary liquidation is a severe remedy not favored by the courts.
• So Trial court had ordered a repurchase of her shares at FV
o Second rationale for repurchase: requirements for IL have been met but too extreme a solution
 Trial court failed to make the necessary finding as to whether the acts of the other shareholders were illegal, oppressive, or fraudulent.
• A low offer is not a breach of fiduciary duty on its own
• Without evidence of self-dealing, only get appraisal rights in merger
• Oppression:
o Reasonable expectations of minority SHs
o Proof that controlling SHs took unfair advantage of minority
 Held that the forced buy back could not be justified as a result of a "de facto merger" because the had approved of the transaction and her interest in the C remained unchanged.
 Remedy for breach of FD = equal treatment
Net Asset value
: share which the stock represents in the value of the net assets of the C. Gave greatest weight to this method.
• Two approaches to NAV:
o (1) Adjust BV to current value and goodwill
o (2) Multiply BV to get to market value
Best Efforts Offering
Underwriter and the firm fix a price and the min and max # of shares sold. Investors express interest by depositing in underwriter's escrow acct. If min # of shares are NOT sold in 90 days, offer w/drawn and money refunded
inflation premium is equal to
the average expected inflation rate over the life of the security.
Most investors are ______ and will choose the stock with _____________
risk adverse; lower risk
fundamental value/price (true intrinsic value)
the intrinsic value an analyst would calculate given complete and accurate information about the company's future cash flows and risk.
Pure Play Method
Method used to estimate beta of a project by beginning w/ the beta of a co. or group of co.'s that are comparable to the project b/c they are purely engaged in a business similar to that of a project.
Conflicts of interest between the different groups.
1)Managers may have other interests (job security, perks, compensation) that they put over stockholder wealth maximization.
2)Actions that make stockholders better off (increasing dividends, investing in risky projects) may make bondholders worse off.
3)Actions that increase stock price may not necessarily increase stockholder wealth, if markets are not efficient or information is imperfect.
4)Actions that makes firms better off may create such large social costs that they make society worse off.
Managers taking advantage of stockholders leads to
much more active market for corporate control
Return is a function of:
o TV of money (return available from risk-free investment)
o Riskpossibility that expected return will not materialize
Things to Remember about Income Statements
1. Summarizes profitability of firm over time
2. Difference btwn revenues and expenses
3. Depreciation is deducted as an expense.
basic goal of a financial management
create value for customers through profit maximization
Payback Period
The # of years it takes to recover the initial cost of an investment. It is useless as a measure of profitability because it does not take into account TVM or CFs after the payback period. It is a measure of liquidity. =Full Years Until Recovery + (Unrecovered Costs @ beginning of year / CF During the Year)
Selling Long (Long Position)
The investor buys a stock and sells it at a later time or date. This is the traditional buy/ hold / sell strategy. An investor uses this strategy when she expects the stocks price to rise.
Issuance of new shares would dilute the other SHs holdings:
o Voting dilution: don’t own same percentage of the company as they did before
o Economic/equity dilution: share of economic value of the company goes downvalue of individual share goes down
o Book value dilution: Temporary reduction in book value per share but creates earning power for C.
Conflicts of interest among CS holders:
• The value of a minority SH’s shares might be valued less b/c of the market, what a willing buyer would pay, etc. (marketability and minority discounts)
o Closely held corporation: potential for freeze-out by majority, loss of control or say in corporation, possibility of oppression and persecution
o Publicly held firm: don’t worry too much about oppression
 A SH has an exit opportunity (marketability) so SH can sell shares if doesn’t like behavior of majority
o Remedies:
 Court ordered redemption
 Forced dissolution (only allowed in extreme situations)
Things to remember about balance sheets
1. Debits (liabilities) go one the right side; Credits (assets) on the left
2. Depreciation is subtracted from the asset and from the retained earnings on the right.
3. Assets = Liabilities + Owner's Equity [Firms Net Worth]
4. Snap shot
structure of a senior executives' compensation
1. specified annual salary
2. cash or stock paid bonus paid at the end of the year, pending profitability
3. options to buy stock or actual shares of stock which reward the executive for long term performance
Average Accounting Rate of Return
The ratio of a projects avg. net income to its average book value. = Avg. NI / Avg. BV The AAR is based on accounting income, not CFs which violates the basic principal of capital budgeting.
Structuring C to maintain limited liability:
o Single new C: all projects would be J&S liable for losses of one project-->LL
o 6 separate Cs: each project would only be liable for its own losses-->protects individual investments by separating them out
 Issue of enterprise liability: piercing of C veil if don’t separate individual from C.
• So may be seen as one big C if not careful
 High transaction costs
o Stock of 6 Cs owned by a holding company: Less likely to find piercing
 May be marginally better than 6 separate Cs but not enough to really matter
Why can't creditors sue directly?
1. BOD is supposed to act for the shareholder; BOD may act more risk adverse if knows its going to be sued
2. would write ability to sue into K
3. would more the creditor up the chain to being paid off.
4. Harder to get indemnification for BOD if exposed to more risk.
Formula For Net Cash Flows - accounting
A: Sources of Cash - investments, cash
B: Use of Cash - Fixed assets, expenses, inventory, notes
Subtract A-B = Net Cash Flow
two components an asset's risk can be divided when in a portfolio context
1. diversification risk component, can be minimized through diversification of asset allocation
2. market risk component, which reflects the risk of the general stock market decline and is not diversable
Directors lack the expertise to ask the necessary tough questions..
1)The CEO sets the agenda, chairs the meeting and controls the information.
2)The search for consensus overwhelms any attempts at confrontation.
Par , Premium, Discount bonds
par -- a bond is worth its par value when the market price is equal to the face value. current yield is = coupon rate.

premium bond - A bond that is priced higher than its par value. Means the i-rate dropped after the bond was issued. YTM < current yield < coupon rate

discount bonds -- a bond that is priced lower than its par value. this happens when the i-rate goes up.
YTM > Current Yield > Coupon Rate
what does it mean when we say "risk free rate"
the nominal risk free rate, which includes inflation premium equal to the average expected inflation rate over the life of the security
The power of stockholders to act at annual meetings is diluted by three factors
1)Most small stockholders do not go to meetings because the cost of going to the meeting exceeds the value of their holdings.
2)Incumbent management starts off with a clear advantage when it comes to the exercising of proxies. Proxies that are not voted becomes votes for incumbent management.
3)For large stockholders, the path of least resistance, when confronted by managers that they do not like, is to vote with their feet.
Why is the amount of money a company invests into operations important?
Because it takes money to make money
How do we know if a premium is reasonable?
Look at available data on what is a reasonable premium- for a company this size and this industry. See what other people are willing to pay. Make sure break up fee is not large, and that the board has an out.
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