Advanced Corporate Finance Wajeeh Elali

1 Basic Concepts 1

 

1.1 Consumption, Investment, and Financial Markets 3

 

Transferring Wealth from One Period to Another 3 Role of the Financial Market in Facilitating Wealth Transfer 3

 

Impact of Interest Rate Levels on the Spending Pattern 7

 

Including Real Assets as Investment Choices—the Investment Schedule 8 Total Return and Marginal Return 10 Marginal Return—the Appropriate Measure for Investment Purposes 11 independence of Investment and Financing Decisions 13

 

Developing the Investment Schedule in Practice 17 Conclusions 17

 

1.2 Market Efficiency 17 How Information Affects Prices 18 Forms of Market Efficiency 19 Conditions for Market Efficiency 19 Empirical Evidence on Market Efficiency 21 Implications of Market Efficiency 22

 

1.3 Agency Issues, Ethical Considerations, and Other Stakeholder Issues 23

 

Managers as Agents for Shareholders 23

 

Corporate Governance : 23

 

Economic Value Added 24

 

Ethical Considerations 25

 

Moral Purposes and Limits of Business Activity 28

 

Examples of Situations Requiring Ethical Judgment 29

 

1.4 Relationship between Net Present Value and Required Return 31

 

1.5 Estimating Cash Flows for Capital Budgeting Purposes 34

 

Overview 34

 

Identifying and Estimating the Incremental After-Tax Cash Flows 35

 

1.6 Capital Budgeting Evaluation Criteria 41 Net Present Value Technique 41

 

Using Spreadsheets for Project Evaluation 44 Alternative Valuation Techniques used in Capital Budgeting 44

Comparison of Capital Budgeting Techniques 50 Estimating the Cash Flows of Economically Dependent Projects 50 Dealing with Inflation 53 Methods Used in Practice 54

 

Chapter Summary 65 Key Terms 65 Important Equations 66 Web Links 70 Self-Test Questions 71 Appendix A 84

 

2 Capital Budgeting under Uncertainty 85

 

2.1 Basics of Portfolio Theory 87

 

Expected Return and Standard Deviation in a Portfolio Setting 87 The Impact of the Correlation Coefficient on Portfolio Risk 92 Investment Opportunity Set 95 Including the Risk-Free Rate in the Investment Opportunity Set 97 Borrowing at the Risk-Free Rate 98

 

2.2 Measuring the Risk and Return of a Single Security 100

 

Total Risk, Systematic Risk, and Unique Risk 100 A Measure for Systematic Risk 102 Calculating Coefficients of the Characteristic Line 103 Capital Asset Pricing Model 107

 

2.3 Capital Budgeting in a Portfolio Framework 109

 

CAPM and Project Beta 110 Practical Difficulties in Estimating Project Betas 112 Betas for Classes of Risky Projects 114 Divisional Costs of Capital 114 Using the Betas of Similar Firms as Proxies for Project Betas 115 Adjusting Project Betas for Project Financial Leverage 115

 

2.4 Market Risk and Total Risk 117

 

Use of Total Risk for Project Analysis 118 Measuring Total Risk for a Project 120 Incorporating Total Risk into Project Evaluation 122

2.5 Capital Rationing 123 Reasons for Capital Rationing 123 Incorporating Rationing into the Capital Budgeting

 

Process 125

 

2.6 Annual Capital Budgeting Process 129

 

New Project Ideas 129 Preparation of Proposals 130 Evaluation of Proposals 130 Generation of Capital Budgets 130 Periodic Review of Progress 131 Post-Completion Audits 132

 

Chapter Summary 133 Key Terms 133 Important Equations 134 Web Links 137 Self-Test Questions 138

 

3 Long-Term Sources of Funds 155

 

3.1 Bank Financing 157 Term Loans from Banks 157 Advantages of Term Loans 161 Cost of Bank Loans 161 Compensating Balance 162 Types of Interest Costs 163 Choosing a Financial Institution 166

 

3.2 Bonds 167 Types of Bonds 168 •

 

Bond Provisions 172 Bond Ratings 175

 

Advantages and Disadvantages of Long-Term Debt Financing 176

 

3.3 Bond Refinancing 176

 

Reasons for Bond Refinancing 176 Bond Refinancing Analysis 176

 

3.4 Preferred Shares 180 Types of Preferred Shares 180 Preferred-Share Provisions 181

 

Advantages and Disadvantages of Preferred-Share Financing 182

 

3.5 Preferred-Share Refinancing 183

 

3.6 Common Shares 186 %

 

Rights of Common Shareholders 186 Different Classes of Common Shares 189 Common-Share Financing; Advantages and

 

Disadvantages 189

 

3.7 Issuing Securities 190 Private and Public Share issues 190 Role of the Investment Banker 191 Underwritten Offerings 192

Negotiated Offerings 192 Offerings on a Best-Efforts Basis 192 Rights Offerings 193

 

Chapter Summary 19-6 Key Terms 196 Important Equations 198 Web Links 200 Self-Test Questions 201

 

4 Capital Structure 211

 

4.1 Capital Structure Theory 213 Financial Risk 213

 

Traditional View 217 Perfect-Market View 218 Homemade Leverage 219 4-2 Impact of Corporate Taxes 221 Modifying the M&M Propositions 224

 

4.3 Impact of Personal Taxes 225 Tax Treatment of Interest, Dividends,

 

and Capital Gains 226 Miller Model of Firm Value 227

 

4.4 Effect of Bankruptcy Costs 230 Direct Bankruptcy Costs 230

 

Indirect Bankruptcy Costs 231

 

4.5 Other Influences on Capital Structure 233 Business Risk 233

 

Agency Costs 238

 

Signalling and Asymmetric Information 238 Managerial Preference 240

 

4.6 Selecting Capital Structure in Practice 248 Leverage-Indifference EBIT Level 248

 

Industry Averages 259

 

Rating and Lending Agencies 261

 

Other Factors 261

 

Chapter Summary 268 Key Terms 268 Important Equations 268 Web Links 272 Self-Test Questions 273

 

5 Dividend Policy 281

 

5.1 Theoretical FotuihuL^i. .A3 Traditional “Bird in-Hano” Vlev. 253 Perfect-Market View 285 Dividend Relevance View 286 Expectations View 299

 

Other Considerations 299

 

5.2 Dividend Policy in Practice 302 Important Features of Dividend Policies 302 Alternative Dividend Policies 304

53 Payment Procedures 311 important Dates 311 Payment Processing 313 Valuation Issues 313 Dividend Reinvestment Plans 313

 

5.4 Stock Dividends and Stock Splits 314 Stock Dividends 314

 

Stock Splits 314 Reverse Stock Splits 315 Differences between Stock Dividends and Stock Splits 316

 

5.5 Share Repurchases and the Dividend Decision 316

 

Share Repurchases as Alternatives to Cash Dividends 317

 

Advantages and Disadvantages of Share Repurchases 319

 

Other Reasons Why Firms Repurchase Their Shares 320

 

Methods of Repurchase 3 21

 

Chapter Summary 324 Key Terms 324 Web Links 325 Self-Test Questions 326

 

6 Special Financing and Investment Decisions 333

 

6.1 Introduction to Project Financing 335 Project Financing Arrangements 335 Advantages of Project Financing 337 Disadvantages of Project Financing 338

 

6.2 Interactions of Investment and Financing Decisions 338

 

Setting the Stage 338

 

Adjusted Present Value Method 339

 

Weighted Average Cost of Capital Method 348

 

Differences between the WACC and APV Methods 350

 

Equity Residual Method 353

 

Comparing the Three Methods 356

 

6.3 Evaluating Lease Financing 358 Types of Leases 358

 

Leasing as a Substitute for Debt Financing 360 Analysis of the Lease Financing Decision 361 Benefits of Leasing 372

 

6.4 Mergers and Acquisitions 373 Similarities and Differences 373 Types of Mergers 374

 

Motives for Mergers 376

 

Important Considerations for Undertaking a Merger 377

Advantages and Disadvantages of Vertical Mergers 377

 

Strategies of Mergers 381

 

Anti-Takeover Measures 381

 

Evaluating Merger Targets 385

 

6.5 Leveraged Buyouts 390

 

Good Targets for Leveraged Buyouts 391

 

Financing a Leveraged Buyout 392

 

Using Leasing to Finance a Leveraged Buyout 392

 

Chapter Summary 399 Key Terms 399 Important Equations 400 Web Links 404 Seif-Test Questions 404

 

7 Treasury-Risk Management 413

 

7.1 Types of Treasury Risk 414 Interest-Rate Risk 415 Foreign-Exchange Risk 420 Commodity-Price Risk 421

 

7.2 Measuring Risk Exposure 422

 

Micro Approach to Measuring Risk Exposure 423 Macro Approach to Measuring Risk Exposure 427 Using a Spreadsheet to Measure Risk Exposure 431 Using Volatility Analysis to Measure Portfolio Risk 436

 

7.3 Basic Risk Management 439 Gap Analysis and Risk Reduction 439 Duration and Risk Management 439

 

7.4 Risk Management Considerations 440 General Risk Management Approaches 441

 

7.5 Financing International Trade 453 Terms of Payment m International Trade 453 International Trade Financing Using Letters of Credit 455 The Export Development Corporation 457

 

Chapter Summary 459 Key Terms 459 Important Equations 460 Web Links 461 Self-Test Questions 462

 

8 frfurss and Forwards 467

 

8.1 Furores and Forwards 468 Characteristics of Futures and Forward Contracts 468 Futures and Forward Traders M0

 

Futures Price Quotations M-i The Clearing House 475 Margin Requirements 476 Daily Price Limits 481

 

Covering a Futures or Forward Position before the Delivery Date 482

Difference between Futures and Forward Contracts 482

 

8.2 Basic Valuation Concepts of Financial Futures and Forwards 483

 

Law of One Price 483

 

A General Model for Futures and Forward Prices 484

 

8.3 Hedging with Futures and Forward Contracts 489

 

Hedging with Forward Contracts 498

 

Chapter Summary 499 Key Terms 499 Important Equations 500 Web Links 501 Self-Test Questions 502

 

9 Options and Swaps 511

 

9.1 Options 512 Characteristics of Options 512 Trading Options 514

 

Differences between Options and Futures/Forwards 519

 

9.2 Basic Valuation Concepts of Financial Options 522

 

Relationship between the Premium and the Exercise Price 522

 

Black-Scholes Option-Pricing Model 527 Value of a Put 532

 

9.3 Corporate Securities and Option Theory 537

 

Levered Common Shares: An Implicit Call Option 537 Corporate Securities with Attached Options 539 Pricing Corporate Securities with Built-In Options 541

 

9.4 Hedging with Options 542

 

Four Key Decisions 542 Over-the-Counter Options 543 Importance of Time Value in a Hedged Position 543 General Rules for Hedgers under Falling Interest Rates 547

 

General Rules for Hedgers under Rising Interest Rates 548

 

9.5 Swaps 548

 

Currency Swaps 548 Interest-Rate Swaps 551 %

 

9.6 Hedging with Swaps 555

 

9.7 Costs of Hedging 559

 

Chapter Summary' 566 Key Terms 566 Important Equations 566 Web Links 568 Self-Test Questions 569 Appendix B 578

10 Financial Planning 581

 

10.1 OvervVw V the WnamriD Planning Process 584

 

Basic Concepts of Financial Planning 584 Steps in the Financial Planning Process 586

 

10.2 Role of Forecasting 587

 

Forecasting Sales 588 Forecasting Operating Costs 592 Forecasting Fixed Financial Obligations 593 Forecasting Future Capital Expenditures 593 Forecasting the Cash Flows Needed to Pay Dividends 594

 

10.3 Role of Pro Forma Financial Statements 594

 

Income Statement, Statement of Retained Earnings, and Balance Sheet 595 Cash Flovt Statement 596

 

10.4 Short-Term Financial Planning 599 Cash Budgeting 600

 

Annual Cash Budget 614

 

The Cash Budget and Financial Control 615

 

10.5 The Long-Term and Short-Term Financing Decisions 615

 

Risk-Return Trade-Off between Short-Term and Long-Term Financing 615 Approaches to Short-Term and Long-Term Financing Decisions 616

 

Liquidity and the Cost of Financing 619

 

10.6 Interpreting Financial Ratios 620

 

Alternative Methods of Financial Analysis 638

 

10.7 Long-Term Financial Planning Model 638 Groundwork for the Model 638

 

Preparing Pro Forma Financial Statements 639 Analyzing the Pro Forma Financial Statements Using Ratio Analysis 640

 

Scenario Analysis 640 «

 

Limitations of Financial Planning 648

 

10.8 Strategic Decisions and Ethical Considerations 648

 

Ethics and Financial Performance 650 Ethical Issues in Strategic Planning 654

 

Chapter Summary 659 Key Terms 659 Important Equations 660 Web Links 661 Self-Test Questions 663

 

Glossary 674 Index 683