Corporate Finance

Sole proprietorship
Partnership
Corporation

Capital expenditure benefitting CEO but not shareholders

Monitoring CEO actions

Opportunity costs because of short term objectives being set by CEO

Majority shareholders can abuse their powers by appointing biased directors

CEO sometimes favour one type of principle over the other.

Look at formula sheet

Unexpected events

Possible changes in cash flows

Future Opportunities

it provides the best, worst and expected scenario according to underlying assumptions. Gives a matrix of NPV

OECD 2004

Sensitivity Analysis

Monte Carlo Simulation

Decision Tree

Present value break even

Accounting break even

Direct costs

Indirect costs

Administrative costs

Negotiation costs

Loss of reputation

Loss of key employees

Tax benefits of debt should balance with cost of financial distress

Use internal funds first, then debt, then equity

CEO will issue debt or equity depending on whether he believes the firm is under or overvalued. He will issue equity if overvalued and debt if undervalued and price adjusts.

Over investment

Under investment

When managers take excessive risk (invest in negative NPV projects) to try and achieve profits and pay dividends to shareholders.

When managers doesn't invest in positive NPV projects because they want to pay out large dividends to shareholders.

Empire Building

Wasteful investment

Shirking

Monitoring costs

Managerial peaks

Leverage increases debt agency costs

- Creditors anticipate problem and increase interest rate and place debt covenants

- Encourage over- and underinvestment

Leverage reduces equity costs by committing firm to future interest rate payments.

When a firm's operating cash flows cannot satisfy it's legal obligations.

Asset expansion policies

Operational contraction policies

Financial policies

External control activities

Change in managerial control

Wind up company

Issuing securities --> Equity financing

Borrowing funds and public issue of debt --> Debt Financing

Public offering of shares done via investment bank.

- Banks act as underwriter's and buy all new shares at a discount (against risk of not selling all shares)

Private equity firms act as underwriters, sold to institutional investors and funds.

Bonds

- Public

- Private

Bank Loans

- Line of credit

- Loan commitment

Maximum amount is determined but interest rate is not set and can hence be changed. Firm is flexible to accept or decline offer at any time.

Revolving loan commitment

- Firm can borrow more or pay down the low during the term

Non-revolving loan commitment

- Fund is restricted

The right to buy or sell an asset at a predetermined right

The holder of the right of an option

The holder of the obligation to the owner of the option

The right to buy an asset at a predetermined price

The right to sell an asset at a predetermined price

Buy a stock and a put option for the price you bough the stock. You can maximum lose the premium but potential return is infinite.

The return of a share can actually be replicated by buying a call option and a bond and selling a put option, all sharing the same price and date of maturity.

Black Scholes Model

Binomial Option Model

Protective put

Synthetic share

Long guts

Call bullish spread

Buying a call option with the higher strike price and a put option for the low price with the security and same maturity.

Base cash salary

Cash bonuses

Retirement bonuses, restricted stocks and options

Aligns objectives with shareholders

Can offer lower base salary

Make executives pay dependent on firm performance

Only aligns interest with that of shareholders

No upper limit of pay

Gives the owner the right to buy shares in a company at a given price for a fixed price.

(A call option for shares)

Gives the owner the right to exchange the bond for a given number of shares up until the maturity of the bond.

They don't have the credit rating to issue normal debt

(Usually employed by smaller and high growth firms because convertibles are insecure)

Buying a call option with a lower strike price and selling a call option with a higher strike price on the same security with the same maturity.

Hedging

Increase risk and return

A contract obliging the partners to complete a transaction at a set date at a set price

Standardized forwards contract that can be traded. Price is marked against the market everyday.

An arrangement to exchange cash flows over time

Firm pays a fixed interest rate against the receiving the floating interest rate, The received floating interest can be use to match and hedge against floating interest obligations

Two firms or organisations swap principals and interests received to hedge against exchange rate risks.

Forwards, futures, options and swaps.

An investment whose payoff is dependent on the performance of underlying assets.

Repackaging of "pools" of loans and other receivables to create a new financial instrument that can be sold to investors.

Easier to hedge against risks

Better and more effective use of capital

Traders can exploit differences in country specific regulations

Global economy is more exposed

Higher degree of complexity in financial system

Quoting the exchange rate with the domestic currency first

Quoting the exchange rate with the foreign currency first

The currency actively used in many international transactions around the world

Exchange rate between two currencies not involving the vehicle currency

Earning risk free profit at the expense of someone else

The possibility of taking a loss in foreign exchange transaction due to the uncertainty of the currency exchange rate.

What a unit of a currency can buy in another country given the price level in that country

Explains how much of a currency would be needed to buy the same basket of goods in two different countries

PPP adjusted for inflation

Considers the inflation rate in different countries and suggests the future exchange rate should reflect the inflaton

The relation between current spot exchange and the future FX rate should reflect the interest rates in the countries

Explains the relation between current and future exchange rate

Different countries can have different inflation and interest rate but the difference between these two factors should be the same throughout the countries to prevent arbitrage.

A bond that allows the issuer of the bond to redeem the bond before the maturity date.

Can only be exercised on expiration date

Can be exercised at any point up until the maturity date

The relationship saying that a call option and the present value of the exercise price is equal to the put option and the underlying stock or arbitrage is possible.