FFA CHAPTER 1

Sole proprietorship: a business owned and run by one person. Few, if any employees. Most common
type of firm, but do not account for much sales revenue. Characteristics: straightforward to set up->
many new businesses use this form, no separation between the firm and the owner->if other
investors they cannot hold an ownership stake, owner has unlimited personal liability for any firms
debts-> has to pay loans from personal assets if firm is unable to pay, life of a sole proprietorship is
limited to life of owner and its difficult to transfer ownership. Typically converted to other form of
business when point reached where it can borrow without the owner agreeing to be personally liable
Partnership: identical to sole proprietorship, but more than one owner. Characteristics: all partners
are liable for the firms debt-> lender can require any partner to repay for outstanding debts,
partnership ends on death or withdrawal of any single partner-> partners can avoid liquidation if
partnership agreement provides alternatives, such as buyout of a deceased or withdrawn partner.
Limited partnership: two kinds of owners, general partners and limited partners. General partners
have same rights and privileges as partners in normal partnership-> liable for firms debt obligations.
Limited partners have limited liability-> their liability is limited to their investment. Death or
withdrawal of limited partner does not dissolve partnership, and his interest in transferable. He has
no management authority and cannot be legally involved in decision making of business.
Limited liability company: owners liability is limited to their investment-> they cannot be held
personally liable for debts. Two types: private limited liability company: not allowed to trade their
shares on an organized exchange (->GmbH). Public limited liability company: may trade their shares
on organized exchange, different names in different countries. (->AG)
Corporation: a legally defined, artificial being (a judicial person or legal entity), separate from its
owners. Can enter into contracts, acquire assets, incur obligations, enjoys protection under most
jurisdictions against seizure of its property. Solely responsible for its own obligations. Owners are not
liable for any obligations of company and vice versa.
Formation of a corporation: must be legally formed. Legal document (corporate charter in USA) is
created-> more costly than setting up a sole proprietorship. Corporate charter specifies initial rules
that govern how the company is run
Ownership of a corporation: no limit to number of owners. Each owner owns fraction of corporation.
Entire ownership stake of corporation is divided into shares/stock. Collection of all outstanding
shares of corporation is the equity. An owner of shares in corporation is known as shareholder,
stockholder or equity holder, and is entitled to dividend payments, which are payments made at the
discretion of the corporation to its equity holders. Dividend received is proportional to number of
shares owned. No limitations on who can own shares-> no expertise needed -> allows to trade shares
-> raises big amounts of capital because of sale of ownership shares.
Tax implications for corporations: because its a separate legal entity, shareholders of a corporation
have to pay taxes twice. 1) corporation pays tax on its profits 2) when profits are distributed,
shareholders pay their own personal income tax on this income. -> known as classical system/double
taxation. Another system is imputation system: dividend is regarded as flow of profits direct to
shareholders and is therefore only one source of income that is not subject to double taxation. In
USA S corporations , corporations that elect subchapter S tax treatment, are exempted from double

taxation, instead, profits and losses are allocated directly to shareholders based on their ownership
share. Shareholders must include these profits as income on their individual tax returns.
Qualifications for subchapter S treatment: being US citizen/resident, cant be more than 100 of them.
Most corporations: C corporations: corporations subject to corporate taxes
In a corporation, the board of directors and chief executive officer (CEO) possess direct control,
rather than owners.
Board of directors: elected by shareholders. Have ultimate decision-making authority in the
corporation. Mostly, each share gives shareholder one vote in election of board of directors. If one or
two shareholders own very large proportion of outstanding stock, they might be either themselves
on the board of directors or have the right to appoint a number of directors. They make rules on how
corporation should be run (how top managers are compensated), set policies, monitor performance
of company. Assign most decisions about day-to-day running of corporation to its management.
Chief executive officer: is charged with running the corporation by instituting the rules and policies
set by board of directors. The size of the rest of the management team varies from corporation to
corporation. CEO often also chairman of board of directors.
Chief financial officer (CFO): most senior financial manager. Also called finance director, often reports
directly to CEO.
Board of directors->chief executive officer->chief operating officer AND chief financial officer->
controller (accounting and tax department) AND treasurer (capital budgeting, risk management,
credit management)
Financial manager: responsible for three main tasks: investment decisions (weigh costs and benefits
of all investments and projects, decide which of them qualify as good uses of money invested by
shareholders. These decisions shape what the firm does), financing decisions (how to pay for
investments, how to raise additional money, raise from new and existing owners by selling more
shares or by borrowing money), cash/treasury management (ensure that firm has enough cash on
hand to meet day-to-day obligations, also called managing working capital, ensure that access to
cash does not hinder firms success)
Agency problems: if managers, despite being hired as the agent of shareholders, put their own selfinterest ahead of the interests of shareholders. -> minimize number of decisions managers must
make for which own self-interest is different from interests of shareholders. Corporate charity: firm
donates (on behalf of shareholders) to local or global causes.
Share price is barometer for corporate leaders that continuously gives them feedback on their
shareholders opinion of their performance.
Hostile takeover: an individual or organization (sometimes known as corporate raider) can purchase
large fraction of equity and acquire enough votes to replace board of directors and CEO.7
When corporation borrows money: debt holder also becomes investor in corporation. Debt holders
are entitled to seize assets of corporation in compensation of default. To prevent seizure:
renegotiate with debt holders or file for bankruptcy. -> when firm fails to repay debts, control passes
from equity holders to debt holders. Bankruptcy needs not to result in a liquidation of firm (shutting

down business and selling off assets), because if assets go to debt holders, their interest is still to run
the firm in most profitable way.
Stock market/stock exchange: shares of public companies trade here. Those markets provide liquidity
and determine a market price for the companys shares. Investment is said to be liquid if it is possible
to sell it quickly and easily for a price close to the price you could buy it.
Primary market: where listed companies issue new shares and sell them to investors.
Secondary market: after initial transaction between corporation and investors shares continue to
trade here. Without involvement of corporation, between shareholders only.
NYSE: new York stock exchange. Physical place. Market makers/specialists match buyers and sellers.
They post 2 prices for every stock they make a market in: bid price (price they are willing to buy the
stock), ask price (price they are willing to sell the stock for). Ask prices exceed bid prices = bid-ask
spread. Customers always buy at ask price, and sell at bid price. Bid-ask spread is a transaction cost
investors have to pay in order to trade.
NASDAQ: market connecting market makers and dealers by computer network and telephone. On
NYSE each share has only one market maker, on NASDAQ shares can have multiple market makers
who compete. NASDAQ posts best prices first and fills orders accordingly.

FFA CHAPTER 2
Financial statements: accounting reports issued by a firm periodically (usually quarterly and
annually), that present past information and a snapshot of the firms financial position.
Annual report: need to be sent with financial statements to a firms shareholders
Generally Accepted Accounting Principles (GAAP): together with International Financial Reporting
Standards, they provide a common set of rules and standard formats for public companies to use.
Auditor: neutral third party, checks the annual financial statements to ensure theyre reliable and
according to GAAP
-every country has own GAAP. Now IASB issued IFRS, which was accepted by every country except
USA and Japan. USA keeps own GAAP
Four financial statements: balance sheet, income statement, statement of cash flows, statement of
changes in stockholders equity
Balance sheet: also called statement of financial position, lists firms assets and liabilities, providing a
snapshot of the firms financial position at a given point in time. Two sides: assets left, liabilities right.
Assets: cash, inventory, property, plant, equipment and any other investments the company made.
Current assets: either cash or assets that can be converted to cash within one year. E.g.: 1) cash and
other marketable securities (short-term, low-risk investments, can be easily sold), 2) accounts
receivable (amounts owed to the firm by customers), 3) inventories (raw materials, goods etc.), 4)
other current assets e.g. prepaid expenses

Long-term/ non-current assets: are assets such as land, property, machinery, which produce tangible
benefits for more than one year. E.g.: 1) Depreciation: reducing value of fixed assets (other than
land), over time, according to a depreciation schedule depending on the assets life span. Book value:
also carrying amount, is equal to its acquisition cost less accumulated depreciation, 2)
Goodwill/intangible assets: e.g. if a firm is purchased for more money than the total tangibles
accumulate. Reason for that is for example a brand name, trademarks etc., 3) Amortization
/impairment charge: captures the change in value of the acquired assets. Not an actual cash outflow,
4) other long-term assets, e.g. unused property, start-up costs etc.
Liabilities: a firms obligations to creditors. The stockholders equity section is also shown there.
Current liabilities: liabilities that will be satisfied within one year. E.g.: 1) Accounts payable (amounts
owed to suppliers for products or services purchased with credit, 2) short-term debt (or notes
payable, current maturities of long-term debt which are all repayments of debt that will occur within
the next year), 3) accrual items, e.g. salary that are owed but not yet paid, deferred or unearned
revenue
The difference between current assets and current liabilities: net working capital capital available in
the short term to run the business
Long-term liabilities: liabilities that extend beyond on year. 1) long term debt (any loan or debt
obligation with a maturity of more than a year) 2) capital leases (long-term lease contracts that
obligate a firm to gain use of an asset by leasing it 3) deferred taxes (taxes owed but not yet paid)
Stockholders equity: difference between a firms assets and liabilities, accounting measure of firms
net worth. Also: book value of equity
Market capitalization: market value, market price per share times the number of shares
Liquidation value: the value that would be left if its assets were sold and liabilities paid.
Market-to-book ratio: also: price-to-book ratio (P/B ratio). For successful firms: exceeds 1, meaning
that if assets are put to use they exceed historical costs.
Value stocks/shares: companies with low market-to-book ratios
Growth stocks/shares: companies with high market-to-book ratios
Leverage/gearing: the extent to which a firm relies on debt as a source of financing
Debt-to-equity ratio: assesses leverage. Either with book or market values (market is better)
Enterprise value: assesses the value of the underlying business assets, unencumbered by debt and
separate from any cash and marketable securities
Current ratio: ratio of current assets and current liabilities, to see if sufficient working capital to meet
short-term needs
Quick ratio: /acid test/liquidity ratio, ratio of current assets other than inventory, to current liabilities
->a higher current or quick ratio implies less risk of experiencing cash shortfall

Income statement: or statement of comprehensive income, lists firms revenues and expenses over a
period of time. The last line (bottom line) shows the firms net income/net profit, which is a measure
of profitability. It is also called profit and loss account/P&L account. Net income is also called
earnings.
Gross profit: the first 2 lines of the income statement list revenues from sales and costs incurred to
make and sell products. The third line is gross profit which is the difference between sales revenues
and cost of sales
Operating expenses: expenses from ordinary course of running the business, not directly related to
producing the goods. E.g.: administrative expenses, overhead, salaries, marketing costs, research and
development expenses. Also: depreciation and amortization, but they dont represent actual cash
expenses. Then: gross profit +- operating expenses = operating income.
Earnings before interest and taxes (EBIT): other sources of income or expenses that arise from
activities that are not the central part of a companys business. E.g.: income from the firms financial
investments. After that we have: EBIT
Pretax and net income: from EBIT we deduct interest expense and then we deduct corporate taxes to
determine net income, often reported as earnings per share (EPS)
Share/stock options: give the holder the right to buy a certain number of shares by a specific date at
specific price, Convertible bonds: form of debt that can be converted into shares. Both produce more
shares in total, to be divided into the same earnings, so this growth in shares is called dilution. It is
disclosed as diluted EPS
Profitability ratios: gross margin: ratio of gross profit to revenues/sales reflects ability to sell a
product for more than the cost of production. Operating margin: ratio of operating profit to
revenues, important because there are additional expenses of operating a business beyond the direct
costs of goods sold. It reveals how much a company earns before interest and taxes from each dollar
of sales. One can similarly compute EBIT margin. It is useful to assess relative efficiency of firms
operations. Net profit margin: ratio of net income to revenues/sales. Shows the fraction of each
dollar in revenues that is available to equity holders after the firm pays its expenses plus interest and
taxes.
Working capital ratios: accounts receivable days: the number of days worth of sales that a firm
represents. Similar ratios: accounts payable days, inventory days.
EBITDA: earnings before interest, taxes, depreciation and amortization. Reflects the cash a firm has
earned from its operations
Leverage ratios: interest coverage ratio: compare income or earnings with interest expenses. If the
ratio is high, it indicates that the firm is earning much more than is necessary to meet payments
Investment returns: return on equity (ROE): evaluates firms return on investments. A high ROE
indicates that the firm is able to find investment opportunities that are profitable. Also common:
return on assets (ROA): net income divided by total assets
The DuPont identity: expresses ROE as the product of profit margin, asset turnover and a measure of
leverage. Asset turnover: measures how efficiently a firm is utilizing its assets to general sales.

Equity multiplier: indicates the value of assets held per euro or dollar of shareholder equity. The
higher the multiplier, the greater is the firms reliance on debt financing.
Valuation ratios: ratios to gauge the market value of a firm. Price-earnings ratio (P/E): ratio of the
value of equity to the firms earnings, either on a total basis or on a per-share basis. Assesses
whether a share is over- or undervalued based on the idea that the value of a share should be
proportional to the level of earnings it can generate for its shareholders.
Statement of cash flows: utilizes information from the income statement and balance sheet to
determine how much cash the firm has generated and how that cash has been allocated during a set
period. Divided into three sections:
Operating activities: starts with net income from the income statement. Then adjusts this number by
adding back all non-cash entries related to the firms operating activities. Depreciation is added back,
as well as any other non-cash expenses. Accounts receivable: if sale is recorded as part of net
income, but cash has not yet been received, we must deduct the increases in accounts receivable.
Accounts payable: we add increases in accounts payable. Inventory: we deduct increases to
inventory.
Investing activities: lists the cash used for investment. Capital expenditures: e.g. purchases of
property, plant and equipment. Those are subtracted.
Financing activities: shows the flow of cash between the firm and its investors. Retained earnings: Is
net income minus dividends. Any cash the company received from the sale of its own shares or cash
spent repurchasing its own shares.
Management discussion and analysis (MD&A): also business and operating review. Is a preface to the
financial statements in which the companys management reviews the recent years performance,
providing a background on the company and any significant events.
Off-balance sheet transactions: transactions or arrangements that can have a material impact on the
firms future performance yet do not appear on the balance sheet. They must be disclosed.
Statement of changes in shareholders equity: provides a reconciliation of the opening and closing
equity position. It provides details of the movements in share capital, reserves and retained earnings
derived from the income statement.
Notes to the financial statements: everything important, taxes, rules used to prepare statements etc.
Sarbanes-Oxley Act (SOX): wants to improve the accuracy of information given to both boards and
shareholders. 1.) Overhaul incentives and the independence in the auditing process 2.) Stiffen
penalties for providing false information 3.) force companies to validate their internal financial
control process

CHAPTER 3

Skills needed to analyze costs and benefits: marketing (to forecast increase in revenues resulting
from an ad campaign), accounting (to estimate tax savings from restructuring), economics (to
determine the increase in demand from lowering the price of a product), OB (to estimate
productivity gains from change in management structure), Strategy (to predict a competitors
response to a price increase), Operations (to estimate cost savings from plant modernization)
Competitive market: a market in which it can be bought and sold at the same price. In a competitive
market the price determines the cash value of the good
Valuation principle: the value of an asset to the firm or its investors is determined by its competitive
market price. The benefits and costs of a decision should be evaluated using these market prices, and
when the value of the benefits exceeds the value of the costs, the decision will increase the market
value of the firm.
Time value of money: the difference in value between money today and money in the future
Risk-free interest rate: the interest rate at which money can be borrowed or lent without risk over
that period, rf.
Interest rate factor: 1+rf. For risk-free cash flows. Defines the exchange rate across time, has units of:
$in one year/$today.
Value of investment in one year: cost= value today * 1+rf
Value of investment today: Benefit= value in one year / 1+rf
Present value (PV): value expressed in terms of dollars today
Future value (FV): value expressed in terms of dollars in the future
Discount factor: 1 / 1+rf. -> rf = discount rate
Dollars Today / gold price = ounces of gold today, Dollars Today * exchange rate = euros today,
Dollars Today * 1+rf = dollars in one year
NPV rule = golden rule of financial decision making
Net present value (NPV): difference between PV of benefits and PV of costs. NPV= PV(benefits)PV(costs), or NPV=PV(all project cash flows). If NPV is positive: decision increases value of firm and is
a good decision, regardless of your current cash needs
Regardless of preferences for cash today vs cash in the future, you should always maximize NPV first.
You can still borrow or lend to shift cash flows.
Arbitrage: practice of buying and selling equivalent goods in different markets to take advantage of a
price difference
Arbitrage opportunity: any situation in which it is possible to make a profit without taking any risk or
making any investment (positive NPV)
Normal market: competitive market without arbitrage opportunities

Law of one price: if equivalent investment opportunities trade simultaneously in different

competitive markets then they must trade for the same price in both markets -> when calculating
NPV you only need to check one price, not all
Financial security: an investment opportunity trading in a financial market
Bond: security sold by governments and corporations to raise money from investors today in
exchange for the promised future payment
Short sale: the person who intends to sell the security first borrows it from someone who already
owns it. Later that person must either return the security by buying it back of pay the owner the cash
flows he would have received.
No-arbitrage price: price how it should be in a normal market. Price (Security) = PV (all cash flows
paid by the security)
Pricing other securities: 1) identify cash flows that will be paid by security 2) determine the do-ityourself cost of replicating those cash flows on our own->the PV of the securitys cash flows
Determine risk-free interest rate: 1+rf = FV/PV
Return: percentage gain earned from investing in bond. Return=Gain at end of year/initial cost. If no
arbitrage: risk-free interest rate = return
NPVs of all security trades in normal markets must be zero
Separation principle: security transactions in a normal market neither create, nor destroy value on
their own. Therefore we can evaluate the NPV of an investment decision separately from the
decision the firm makes regarding how to finance the investment or any other security transactions
the firm is considering.
Portfolio: collection of securities
Value additivity: price of C must equal price of portfolio with A+B.

CHAPTER 4
Stream of cash flows: a series of cash flows lasting several periods
Timeline: linear representation of the timing of the expected cash flows
Rule 1: comparing and combining values: it is only possible to compare or combine values at the
same point in time.
Rule 2: moving cash flows forward in time: to move a cash flow forward in time you must compound
it. Value today * (1+r) = value in one year -> C * (1+r)^n
Compounding: a value being moved forward in time
Compound interest: earning interest on interest

Rule 3: moving cash flows back in time: to move a cash flow back in time we must discount it. Value
in one year / (1+r) = value today -> C / (1+r)^n
Discounting: move a value backward in time, find equivalent value today of a future cash flow
Present value of a cash flow stream: Cn / (1+r)^n
Future value of a cash flow stream with a present value of PV: FVn = PV * (1+r)^n
Perpetuity: a stream of equal cash flows that occur at regular intervals and last forever. First cash
flow arrives at end of first period-> payment in arrears. PV of perpetuity = C / r -> by depositing C/r
today, we can withdraw interest of C/r * r = C each period in perpetuity.
Common mistake: if first cash flows in 2nd period: PV = C / 1+r = cash flow in 1st period
Consol: perpetual bond, British government bond
Annuity: a stream of N equal cash flows paid at regular intervals. Also payment in arrears. PV of
annuity = C * (1/r) * (1- ( 1 / 1+r^n)), FV of annuity = C * (1/r) * ((1+r)^n -1)
Growing perpetuity: a stream of cash flows that occur at regular intervals and grow at a constant rate
forever. The first payment does not grow. Growth rate = g. G < r for a growing perpetuity. PV of a
growing perpetuity = C / (r-g).
Growing annuity: a stream of N growing cash flows, paid at regular intervals. PV of a growing annuity
= C * 1/(r-g) * ( 1 ((1+g) / (1+r))^n ).
Loan payment: C = P / ((1/r) * ( 1- 1/(1+r)^n )) -> P = amount borrowed
Internal rate of return (IRR): the interest rate that sets the NPV of the cash flows equal to zero.
Rule of 72: fairly accurate for interest rates higher than 2%. Years to double = 72 / interest rate in %

CHAPTER 5
Effective annual rate (EAR): the actual amount of interest that will be earned at the end of one year.
Adjusting the discount rate to different time periods: (1+r)^n-1 (n smaller than 1 if period less than
one year, n is bigger than 1 if period more than one year)
Annual percentage rate (APR): the amount of simple interest earned in 1 year (->without effect of
compounding)
Interest rate per compounding period= APR / k periods per year
Converting an APR to EAR: 1+EAR = (1+(APR/k))^k
Continuous compounding: compounding the interest every instant
Amortizing loans: each month interest is paid on loan, plus some part of the loan balance.

Computing the outstanding loan balance: also: outstanding principal, equal to PV of remaining future
loan payments.
Adjustable rate mortgages (ARMs): have interests that are not constant over the life of the loan
Nominal interest rates: the rate at which your money will grow if invested for a certain period, r
Real interest rate: rate of growth of your purchasing power after adjusting for inflation, denoted rr
Growth in purchasing power = 1+rr = (1+r)/(1+i) = growth of money/growth of prices) (i=inflation
rate). -> real interest rate = rr = (r-i)/(1+i) = r-i
Term of an investment/loan: the horizon of the loan/investment
Term structure: relationship between the investment term and the interest rate
Yield curve: a graph showing the term structure
PV of a cash flow stream using a term structure of discount rates= Cn / (1+rn)^n, Cn= risk-free cash
flow received in n years, rn= risk-free interest rate (EAR) for an n-year term
Federal funds rate: the rate at which banks can borrow cash reserves on an overnight basis
Increasing (steep) yield curve with higher long-term rates than short-term rates = interest rates are
expected to rise in future
Decreasing (inverted) yield curve with lower long-term rates = signals expected deadline in future
interest rates
The right discount rate for a cash flow is the rate of return available in the market on other
investments of comparable risk and term
After-tax interest rate: the reduced amount of interest the investor can keep, after taxes. r= interest
rate, = tax rate. r- (*r) = r* (1-).
Opportunity cost of capital/cost of capital: the best available expected return offered in the market
on an investment of comparable risk and term to the cash flow being discounted.
The EAR for a continuously compounded APR: (1+EAR) = e^APR
The continuously compounded APR for an EAR: APR = ln(1+EAR)
PV of a continuously growing Perpetuity: PV = C / (rcc-gcc), where rcc=ln(1+r) and gcc=ln(1+g).

CHAPTER 6
NPV profile: calculation which graphs the projects NPV over a range of discount rates.
The difference between the cost of capital and the IRR is the maximum estimation error in the cost of
capital that can exist without altering the original decision.

Internal rate of return (IRR) investment rule: Take any investment opportunity where the IRR exceeds
the opportunity cost of capital. Turn down any opportunity whose IRR is less than the opportunity
cost of capital.
->the IRR rule is only guaranteed to work for a stand-alone project if all of the projects negative cash
flows precede its positive cash flows.
Situations in which the IRR fails: 1) delayed investments 2) multiple IRRs 3) nonexistent IRR
Payback investment rule: you should only accept a project if its cash flows pay back its initial
investment within a pre-specified period.
Payback period: the amount of time it takes to pay back the initial investment
->accept project if payback period is less than a pre-specified length of time.
Pitfalls of Payback rule: 1) ignores the projects cost of capital and the time value of money 2) ignores
cash flows after the payback period 3) relies on an ad hoc decision criterion ->typically used for small
investment decisions.
IRR rule and mutually exclusive investments: When projects differ in their scale of investment, the
timing of their cash flows or their riskiness, then their IRRs cannot be meaningfully compared.
Differences in scale: it depends on the size of the investment. Differences in timing: long-term
investments are more profitable than short-term. Differences in risk: ignores differences of risk!
Incremental IRR: the IRR of the incremental cash flows that would result from replacing one project
with the other. Identifies the discount rate at which the optimal decision changes. Problems: if
negative cash flows do not precede the positive ones, the incremental IRR is difficult to interpret and
may not exist or may not be unique. The incremental IRR cannot indicate whether either project has
a positive NPV on its own. When projects have different costs of capital it is not obvious what cost of
capital the incremental IRR should be compared to.
We can only compare returns if the investments: 1) have the same scale 2) have the same timing 3)
have the same risk
Evaluate projects with different resource requirements: sometimes, if you have a budget, it is
possible to choose 2 investments instead of 1, where the added NPVs of the 2 investments exceed
the NPV of the single investment.
Profitability index: Value created/resource consumed = NPV / resource consumed
Conditions of the profitability index: 1) the set of projects taken following the profitability index
ranking completely exhaust the available resource. 2) There is only a single relevant resource
constraint.

CHAPTER 7
Capital budget: lists the projects and investments that a company plans to undertake during the
coming year

Capital budgeting: analyzing alternative projects and decide which ones to accept. Begins with
forecasts of the projects future consequences to the firm
Incremental earnings: the amount by which the firms earnings are expected to change as a result of
the investment decision.
Straight-line depreciation: assets cost (less any expected salvage value) is divided equally over its
estimated useful life
Unlevered net income: indicates that it does not include any interest expenses associated with debt
Marginal corporate tax rate: tax rate firm will pay on an incremental dollar of pre-tax income. Income
tax = EBIT * c (c=marginal corporate tax rate)
Unlevered net income=EBIT*(1-c)= (Revenues-costs-depreciation)*(1-c)
Opportunity cost of using a resource: the value it could have provided in its best alternative use
Project externalities: indirect effects of the project that may increase or decrease the profits of other
business activities of the firm.
Cannibalization: when sales of a new product displace sales of an existing product
Sunk cost: any unrecoverable cost for which the firm is already liable
->If our decision does not affect the cash flow, then the cash flow should not affect our decision.
Overhead expenses: associated with activities that are not directly attributable to a single business
activity, but instead affect many different areas of the corporation
Sunk cost fallacy: describes the tendency of people to be influenced by sunk costs and to throw
good money after bad. Also called Concorde effect
Free cash flow: the incremental effect of a project on the firms available cash
Trade credit: difference between receivables and payables; net amount of the firms capital that is
consumed as a result of these credit transactions
Increase in net working capital in year t: deltaNWCt = NWCt NWCt-1
Free cash flow = (revenues costs) * (1-c) CapEx deltaNWCt + c * depreciation
Depreciation tax shield: the tax savings that result from the ability to deduct depreciation;
c*depreciation
Present value of each free cash flow in the future: PV(FCFt)= FCFt * (1/(1+r)^t), t=year discount factor
MACRS depreciation: MACRS= modified accelerated cost recovery system. Firm first categorizes
assets according to their recovery period, based on that depreciation tables assign a fraction of the
purchase price that the firm can recover each year.
Gain on sale = sale price book value

Book value = purchase price accumulated depreciation

After-tax cash flow from asset sale = sale price (c*gain on sale)
Terminal/continuation value: an additional, one-time cash flow at the end of the forecast horizon.
Represents the market value (as of the last forecast period) of the free cash flow from the project at
all future dates
Tax loss carryforwards and carrybacks: additional features of the tax code, allow corporations to take
losses during a current year and offset them against gains in nearby years.
Break-even level: the level for which the investment has an NPV of zero
Break-even analysis: for each parameter, we calculate the value at which the NPV of a project is zero
EBIT break-even: for sales, the level of sales for which the projects EBIT is zero
Sensitivity analysis: breaks NPV calculation into its component assumptions, shows how NPV varies
as the underlying assumptions change. Allow us to explore effects of errors in NPV estimates -> learn
which assumptions are most important
Scenario analysis: considers the effect on the NPV of changing multiple project parameters.

CHAPTER 8
Bond certificate: indicates the amounts and dates of all payments to be made
Maturity date: final repayment date
Term: time remaining until the repayment date
Coupons: promised interest payments of a bond
Face value/principal: the notional amount we use to compute the interest payments. Usually repaid
at maturity
Coupon rate: set by the issuer, stated on bond certificate, expressed as an APR, determines the
amount of each coupon payment. Amount of each coupon payment = CPN = (coupon rate*face
value)/number of coupon payments per year
Zero-coupon bond: a bond that does not make coupon payments. Investor only receives face value.
Also called pure discount bonds
Treasury bills: U.S. government bonds with maturity of up to one year, zero-coupon bonds
Discount: price lower than face value
Yield to maturity (YTM): YTM of a bond is the discount rate that sets the PV of the promised bond
payments equal to the current market price of the bond. -> yield to maturity of an n-year zerocoupon bond: YTMn = ((FV/P)^1/n) 1 P= current price

Risk-free interest rate with maturity n: rn = YTMn

Spot interest rates: default-free, zero-coupon yields
Coupon bonds: pay investors face value at maturity AND make regular coupon interest payments
Treasury notes: have original maturities from one to 10 years
Treasury bonds: have original maturities of more than 10 years
Yield to maturity of a coupon bond: P = CPN*(1/y)*(1-(1/(1+y)^N))+(FV/(1+y)^N) ->trial and error.
Result is rate per coupon interval, so multiply by number of coupons per year = APR
Premium: price greater than face value
Par: price equal to face value
If a bonds yield to maturity has not changes, then the IRR of an investment in the bond equals its
yield to maturity even if you sell the bond early.
As interest rates and bond yields rise, bond prices will fall, and vice versa.
Dirty/invoice price of a bond: price of a bond as actual cash price
Clean price: the bonds cash price less and adjustment for accrued interest (= Coupon amount * (days
since last coupon payment/days in current coupon period))
Price of a coupon bond: P = PV (Bond cash flows)= CPN/1+YTM1 + .... + (CPN+FV)/(1+YTMn)^n,
CPN=bond coupon payment, YTMn = yield to maturity of a zero-coupon bond that matures at the
same time as the nth coupon payment, FV = face value of bond
Coupon-paying yield curve: the plot of the yields of coupon bonds of different maturities
On-the-run bonds: most recently issued bonds
Corporate bonds: bonds issued by corporations
Credit risk: risk of default. Bonds cash flows are not known with certainty
The yield to maturity of a defaultable bond is not equal to the expected return of investing in the
bond.
The bonds expected return, which is equal to the firms debt cost of capital, is less than the yield to
maturity if there is a risk of default. Moreover, a higher yield to maturity does not necessarily imply
that a bonds expected return is higher.
Investment-grade bonds: low default risk, bonds in the top four categories
Speculative/junk/high-yield bonds: bonds in the bottom five categories, high likelihood of

default
Default/credit spread: the difference between the yields of the corporate bonds and the
treasury yields

CHAPTER 9
Equity cost of capital: rE, the expected return of other investments available in the market
with equivalent risk to the firms shares
Dividend yield: the expected annual dividend of the stock, divided by its current price
Capital gain: the difference between the expected sale price and purchase price for the stock
Capital gain rate: capital gain, divided by current stock price
Total return of stock: sum of dividend yield and capital gain rate
->The expected total return of the stock should equal the expected return of other
investments available in the market with equivalent risk
Short interest: number of shares sold short
Dividend-discount mode: P0 = (DivN/1+rE^N)
->The price of the stock is equal to the present value of the expected future dividends it will
pay
Constant dividend growth model: P0 = Div1/rE-g
Dividend payout rate: the fraction of a firms earnings that it pays as dividends each year
Increase dividend in 3 ways: 1) increase earnings/net income 2) increase dividend payout
rate 3) decrease shares outstanding
Retention rate: fraction of current earnings that the firm retains
->cutting the firms dividend to increase investment will raise the stock price if, and only if,
the new investments have a positive NPV
Share repurchase: the firm uses excess cash to buy back its own stock
Total payout model: values all of the firms equity, rather than a single share -> P0 =
PV(future total dividends and repurchases)/shares outstanding0
Discount free cash flow model: begins by determining the total value of the firm to all
investors both equity and debt holders -> V0 = PV(future free cash flow of firm)
Weighted average cost of capital (WACC): rwacc, the average cost of capital the firm must
pay to all of its investors, both debt and equity holders
PV of dividend payments determines stock price, PV of total payouts/all dividends and
repurchases determines equity value, PV of free cash flow determines enterprise value

Method of comparables: comps, estimating the value of the firm based on the value of
other, comparable firms or investments that we expect will generate very similar cash flows
in the future
Valuation multiple: a ratio of the value to some measure of the firms scale
Forward P/E: the P/E multiple computed based on its forward earnings (expected earnings
over the next twelve months)
Trailing P/E: uses trailing earnings (earnings over the prior 12 months)
Efficient markets hypothesis: implies that securities will be fairly priced, based on their
future cash flows, given all information that is available to investors

CHAPTER 23
Angel investors: individual investors who buy equity in small private firms, often friends
Venture capital firm: a limited partnership that specializes in raising money to invest in the
private equity of young firms
Venture capitalists: the general partners who run the venture capital firm
Carried interest: a share of any positive return generated by the fund in a fee
Private equity firm: organized like a venture capital firm, but invests in equity of existing
privately held firms rather than start-up companies
Leveraged buyout (LBO): transaction of taking the company private by purchasing
outstanding equity of a publicly traded firm
Corporate investor/corporate partner/strategic partner/ strategic investor: a corporation
that invests in private companies
Preferred stock: issued by mature companies (banks), has a preferential dividend and
seniority in any liquidation and sometimes special voting rights
Convertible preferred stock: preferred stock by young companies, because it typically does
not pay regular cash dividends but gives the owner the option to convert into common stock
Pre-money valuation: the value of the prior shares outstanding at the price in the funding
round
Post-money valuation: the value of the whole firm (old and new shares) at the funding round
price
Exit strategy: how a private company will eventually realize the return from their investment

Initial public offering (IPO): process of selling stock to the public for the first time
+ of going public: greater liquidity, better access to capital
-of going public: equity holders of corporation become more widely dispersed
Underwriter: an investment banking firm that manages the offering and designs its
structure; type of shares to be sold, mechanism the financial advisor will use to sell stock
Primary offering: new shares in IPO that raise new capital
Secondary offering: existing shares in IPO that are sold by current shareholders
Best-efforts IPO: underwriter does not guarantee that stock will be sold, but tries to sell
stock for best possible price. Often: all-or-none clause (either all of shares sold in IPO or deal
is called off)
Firm commitment IPO: underwriter guarantees that it will sell all of the stock at offer price;
underwriter purchases entire issue at slightly lower price than offer price and then resells at
offer price-> if entire issue does not sell out shares must be sold cheaper and underwriter
takes the loss
Auction IPO: called OpenIPO. Lets market determine price of the stock by auctioning off the
company. Investors place bids over set period of time, auction IPO then sets highest price
such that the number of bids at or above that price equals the number of offered shares. All
winning bidders pay this price, even when bid was higher
Lead underwriter: the primary banking firm responsible for managing the deal
Syndicate: group of other underwriters
Registration statement: required by SEC, a legal document that provides financial and other
information about the company to investors, prior to an IPO
Preliminary prospectus/red herring: part of registration statement, circulates to investors
before stock is offered
Final prospectus: contains all details of IPO, including number of shares offered and offer
price
Road show: senior management and lead underwriters travel around country/world
promoting the company and explaining their rationale for the offer price to the
underwriters largest customers institutional investors
Book building: process for coming up with offer price based on customers expressions of
interest
Underwriting spread: fee paid to underwriters

Over-allotment allocation/greenshoe provision: an option that allows the underwriter to

issue more stock, amounting to 15% of the original offer size, at the IPO offer price
180-day lockup: shareholders cannot sell their shares for 180 days after IPO
1) IPOS appear to be underpriced->price at end of trading on first day is often higher than
IPO price 2) number of issues is highly cyclical->good times: market is flooded with new
issues, bad times: number of issues dries up 3) costs of an IPO are very high, unclear why
firms willingly incur them 4) long-run performance of newly public company (3-5 years from
date of issue) is poor
Who benefits from underpricing? Underwriters, investors who bought stock in IPO. Who loses? The
pre-IPO shareholders of issuing firms
Winners curse: a form of adverse selection; you win (get all shares requested) when demand for
shares by others is low and IPO is likely to perform poorly.
Seasoned equity offering (SEO): a type of offering, many similar steps to IPO, but market price for the
stock already exists so the price-setting process is not necessary
Primary shares: new shares issued by company
Secondary shares: shares sold by existing shareholders
Tombstones: intermediaries advertised sale of stock by advertisements in newspapers
Cash offer: seasoned equity offering, firm offers new shares to investors at large
Rights offer: seasoned equity offering, firm offers new shares only to existing shareholders

CHAPTER 24
Indenture: a formal contract between the bond issuer and a trust company
Original issue discount (OID) bond: a coupon bond issued at a discount
Bearer bonds: like currency; whoever physically holds the bond certificate owns the bond. To
receive coupon payment you must provide an explicit proof of ownership -> clip off bond
certificate and remit it to paying agent
Registered bonds: issuer has list of all holders of bonds. Brokers keep issuers informed about
changes in ownership
Unsecured debt: in event of bankruptcy bondholders have a claim to only the assets of the
firm that are not already pledged as collateral on other debt

Secured debt: specific assets are pledged as collateral that bondholders have a direct claim
to in the event of bankruptcy
Notes: unsecured, original maturity less than 10 years
Debentures: unsecured
Mortgage bonds: secured with property
Asset-backed bonds: secured with any asset
Tranches: kinds of debt
Seniority: the bondholders priority in claiming assets in event of default
Subordinated debenture: when a firm conducts a subsequent debenture issue that has lower
priority than its outstanding debt, the new debt is known as subordinated debenture
Domestic bonds: bonds issued by a local entity, traded in local market, purchased by
foreigners, denominated in local currency
Foreign bonds: bonds issued by foreign company in local market, intended for local
investors, denominated in local currency
Yankee bonds: foreign bonds in United States
Samurai bonds: bonds in Japan
Bulldogs: bonds in United Kingdom
Eurobonds: international bonds, not denominated in local currency of country in which they are
issued -> no connection between physical location of the market on which they trade and the
location of the issuing entity
Global bonds: combine features of domestic, foreign and Eurobonds, offered for sale in several
different markets simultaneously
Private debt: debt that is not publicly traded, private debt market is larger than public. Advantage:
avoids cost of registration. Disadvantage: illiquid
Term loan: a blank loan that lasts for a specific term
Syndicated bank loan: single loan, funded by a group of banks. One member of syndicate (lead bank)
negotiates terms of bank loan
Revolving line of credit: credit commitment for a specific time period up to some limit
Private placement: a bond issue that does not trade on public market, rather sold to small group of
investors. Does not need to be registered, less costly to issue
Sovereign debt: debt issued by national governments

Treasury bills: discount, maturity: 4,13,26 weeks, treasury notes: coupon, maturity: 2,3,5,10 years,
treasury bonds: coupon, maturity: 20,30 years, treasury inflation-protected securities (TIPS): coupon,
maturity: 5,10,20 years
Stop-out yield: highest yield accepted
STRIPS: separate trading of registered interest and principal securities; zero-coupon treasury
securities with maturities longer than one year
Municipal bonds: munis; issued by state and local governments, income on them is not taxable at
federal level, also called: tax-exempt bonds
Serial bonds: bond with number of different maturity dates, scheduled to mature serially over a
number of years
Revenue bonds: pledge specific revenues generated by projects that were initially financed by the
bond issue
General obligation bonds: backed by full faith and credit of a local government
Double-barreled: commitment is over and above usual commitment, because local government can
always use its general revenue to repay bonds like the one above
Asset-backed security (ABS): security made up of other financial securities, securities cash flows
come from the cash flows of the underlying financial securities that back it
Asset securitization: process of packaging a portfolio of financial securities and issuing an assetbacked security backed by this portfolio
Mortgage-backed security (MBS): asset-backed security backed by home mortgages
Prepayment risk: risk that bond will be partially or wholly repaid earlier than expected
Collateralized debt obligation (CDO): new asset-backed security when banks resecuritize assetbacked and other fixed income securities
Covenants: restrictive clauses in bond contract that limit issuer from taking actions that may
undercut its ability to repay the bonds
Subprime mortgages: mortgages not satisfying certain credit criteria, with high default probability
Collateralized mortgage obligations (CMO): different tranches of securities, distinguished by their
seniority
Callable bonds: bonds containing call provision that allows issuer to repurchase bonds at
predetermined price
Call date: date on which or after which issuer can retire all outstanding bonds
Call price: generally set at or above, expressed at percentage of bonds face value
Yield to call (YTC): annual yield of callable bond, assuming the bond is called at earliest opportunity

Sinking fund: company makes regular payments into a sinking fund, administered by a trustee over
the life of the bond. These payments are used to repurchase bonds
Balloon payment: large payment on maturity date of a sinking fund
Conversion ratio: ratio at which bondholder converts each bond owner into fixed number of shares
of common stock
Warrant: the special type of call option of a convertible bond
Conversion price: the strike price of the embedded warrant, is equal to the face value of the bond
divided by the conversion ratio

CHAPTER 26
Cash cycle: length of time between when the firm pays cash to purchase its initial inventory and
when it receives cash from the sale of the output produced from that inventory
Cash conversion cycle (CCC): CCC = accounts receivable days + inventory days accounts payable
days; ARD = accounts receivable/average daily sales, ID = Inventory/average daily cost of goods sold,
APD = Accounts payable/average daily cost of goods sold
Operating cycle: the average length of time between when a firm originally purchases its inventory
and when it receives the cash back from selling its product
Trade credit: the credit that the firm is extending to its customers; Net30 = payment not due until 30
days from date of invoice; 2/10, Net30 = if paid in 10 days, discount of 2%
Benefits of trade credits: lower transaction costs than alternative sources of funds-> no paperwork;
flexible source of funds, can be used as needed; sometimes only source of funding available
Collection float: the amount of time it takes for a firm to be able to use funds after a customer has
paid for its goods. Determined by 3 factors: mail float (how long it takes the firm to receive the check
after the customer has mailed it), processing float (how long it takes the firm to process the check
and deposit it in the bank), and availability float (how long it takes before the bank gives the firm
credit for the funds)
Disbursement float: the amount of time it takes before payments to suppliers actually result in a cash
outflow for the firm -> same factors. Too late payments can result in CBD (required to pay before
delivery) or COD (required to pay on delivery) or supplier refuses to do business with firm
Check clearing for the 21st century act (check 21): eliminated the disbursement float due to the
check-clearing process. Banks can process check information electronically and funds are deducted
from a firms checking account on the same day that the firms supplier deposits the check in its bank
-> does not serve to reduce collection float
How to reduce collection float: streamline in-house check-processing procedures, use electronic
collection

Motivations for holding cash: 1) Meet day-to-day needs 2) Compensate for uncertainty associated
with cash flows 3) Satisfy bank requirements
Transaction balance: the amount of cash a firm needs to be able to pay its bills > depends on
average size of transactions made by firm and firms cash cycle -> use quick ratio
Precautionary balance: the amount of cash a firm holds to counter the uncertainty surrounding its
future cash needs -> depends on degree of uncertainty surrounding a firms cash flows -> use
volatility
Compensating balance: may be required by bank, as compensation for services the bank performs;
mostly on accounts that earn no interest or pay very low interest rate
MONEY MARKET INVESTMENT OPTIONS:
Investment
Treasury Bills

Description
Short-term debt
of US government

Certificates of
Deposit (CDs)

Short-term debt
issued by banks,
minimum
denomination of
$100,000

Repurchase
agreements

Loan
arrangement,
security
dealer=borrower,
investor=lender,
investor buys
securities with
agreement to sell
it back to dealer
at later date for
specified higher
price
Drafts written by
borrower,
guaranteed by
bank on which it
is drawn, used in
international
trade
transactions,
borrower is
importer who
writes draft in

Bankers
Acceptances

Maturity
4 weeks, 3
months or 6
months when
newly issued
Varying
maturities up to 1
year

Very short term,

from overnight to
3 months

1-6 months

Risk
Default risk free

Liquidity
Very liquid and
marketable

If issuing bank
insured by FDIC
any amount up to
$250,000=free of
default->covered
by insurance, over
that=not insured=
subject to default
risk
Collateral for the
loan-> investor is
exposed to little
risk. Investor
needs to consider
trustworthiness o
dealer when
assessing risk

Sell on secondary
market, less liquid
than treasury bills

Borrower and
bank have
guaranteed draft> very little risk

When exporter
receives draft he
may hold it until
maturity and
receive its full
value or he may
sell the draft at
discount prior to
maturity

No secondary
market for
repurchase
agreements

Commercial
paper

Short-term tax
exempts

payment for
goods
Short-term,
unsecured debt
issued by large
corporations.
Minimum
denomination=
250,000, mostly
face value of
$100,000
Short-term debt
of state&local
governments; pay
interest that is
exempt from
federal taxation>
pre-tax yield is
lower than that of
similar risk
investment

1-6 months

Depends on
creditworthiness
of issuing
corporation

No active
secondary
market, issuer
may repurchase
commercial paper

1-6 months

Depends on
creditworthiness
of issuing
government

Moderate
secondary market

CHAPTER 27
First step in short-term financial planning is to forecast future cash flows. Those allow companies to
determine whether it has cash flow surplus or deficit and whether surplus or deficit is long- or shortterm
Firms need short-term financing to deal with seasonal working capital requirements, negative cash
flow shocks or positive cash flow shocks
The matching principle specifies that short-term needs for funds should be financed with short-term
sources of funds, and long-term needs with long-term sources of funds
Bank loans are primary source of short-term financing, especially in small firms. Most straightforward
type of bank loan is single, end-of-period payment loan. Bank lines of credit allow a firm to borrow
any amount up to stated maximum. Line of credit may be uncommitted which is a nonbinding
informal agreement or may more typically be committed. A bridge loan is a short-term bank loan
that is used to bridge the gap until the firm can arrange for long-term financing
The number of compounding periods and other loan stipulations such as commitment fees, loan
origination fees and compensating balance requirements affect the effective annual rate of a bank
loan
Commercial paper is a method of short-term financing that is usually available only to large, wellknown firms. It is a low cost alternative to a short term bank loan for those firms
Short term loans may also be structured as secured loan. The accounts receivable and inventory of a
firm typically serve as collateral in short term secured financing arrangements

Accounts receivable may be either pledged as security for a loan or factored. In a factoring
arrangement the accounts receivable are sold to lender/factor and the firms customers are usually
instructed to make payments directly to factor
Inventory can be used as collateral for a loan in several ways: a floating lien (also general or blanket
lien), a trust receipts loan (or floor planning) or a warehouse arrangement. These arrangements vary
in their extent to which specific items of inventory are identified as collateral; so they vary in the
amount of risk the lender faces
Permanent working capital: the amount a firm must keep invested in its short-term assets to support
its continuing operations
Temporary working capital: the difference between the actual level of investment in short-term
assets and the permanent working capital investment
Aggressive financing policy: financing part or all of permanent working capital with short-term debt
Funding risk: the risk of incurring financial distress cost, should the firm not be able to refinance its
debt in a timely manner or at reasonable rate
Conservative financing policy: firm finances its short-term needs with long-term debt
Promissory note: a written statement that indicates amount of loan, date payment is due, interest
rate
Prime rate: the rate banks charge their most creditworthy customers
London inter-bank offered rate (LIBOR): the rate of interest at which banks borrow funds from each
other in the London interbank market
Line of credit: common type of bank loan arrangement, in which a bank agrees to lend a firm any
amount up to a stated maximum
Line of credit may be uncommitted: it is an informal agreement that does not legally bind the bank to
provide funds
Committed line of credit: consists of written, legally binding agreement that obligates bank to
provide funds, regardless of financial situation of firm
Revolving line of credit: a committed line of credit that involves a solid commitment from bank for
longer period of time, 2-3 years
Evergreen credit: revolving line of credit with no fixed maturity
Bridge loan: type of short-term bank loan, used to bridge the gap until firm can arrange for long-term
financing
Discount loan: borrower is required to pay interest at beginning of loan period
Loan origination fee: charged by bank to cover credit checks and legal fees

Commercial paper: short-term, unsecured debt, used by large corporations, usually cheaper source
of funds than short-term bank loan
Direct paper: firm sells security directly to investor
Dealer paper: dealers sell commercial paper to investors in exchange for a spread or fee for services
Secured loans: loans collateralized with short-term assets (accounts receivable or inventory)
Factors: firms that purchase receivables of other companies
Pledging of accounts receivable agreement: lender reviews invoices that represent credit sales

of borrowing firm and decides which credit accounts it will accept as collateral for loan
based on its own credit standards
Factoring of accounts receivable: firm sells receivables to lender=factor, lender agress to pay
firm the amount due from its customers at the end of the firms payment period
Factoring arrangement with recourse: lender can seek payment from borrower in case
borrowers customers default on their bills
Without recourse: lender bears the risk of bad-debt losses
Floating/general/blanket lien: all of inventory is used to secure loan
Trust receipts loan/floor planning: distinguishable inventory items are held in a trust as
security for loan
Warehouse arrangement: inventory that serves as collateral for loan is stored in warehouse,
least risky
Public warehouse: a business that exists for sole purpose of storing and tracking the inflow
and outflow of inventory
Field warehouse: operated by third party, set up on the borrowers premises in a separate
area, so that inventory collateralizing the loan is kept apart from borrowers main plant

CHAPTER 28
Acquirer or bidder: buyer of another firm
Target firm: bought by acquirer or bidder
Takeover: both a merging and an acquisition
Merger waves: peaks of heavy activity followed by quiet troughs of few transactions in
takeover market

Conglomerate wave: increase in activity in 1960s, because firms typically acquired firms in
unrelated businesses. 1980s: known for hostile, bust-up takeovers, acquirer purchased
poorly performing conglomerate and sold off its individual business units for more than the
purchase price. 1990s: known for strategic, global deals, more likely to be friendly and
involve companies in related businesses. 2004: marked by consolidation in many industries.
Financial crisis and severe contraction of credit in 2008 ended latest merger wave
Horizontal merger: target and acquirer are in the same industry
Vertical merger: targets industry buys or sells to the acquirers industry
Conglomerate merger: target and acquirer operate in unrelated industries
Stock swap: target shareholders receive stock as payment for target shares
Term sheet: summarizes the structure of a merger transaction (who will run new company,
size and composition of new board, location of headquarters, name of new company)
Acquisition premium: the percentage difference between the acquisition price and the
premerger price of the target firm
Reasons to acquire: economies of scale, economies of scope (savings from combining the
marketing and distribution of different types of related products), vertical integration
(merger of 2 companies in same industry, making products required at different stages of
production cycle-> enhance product if direct control), expertise, monopoly gains (reduce
competition->increase profits, but in some countries laws that limit this), efficiency gains
(elimination of duplication), tax savings from operating losses, diversification (direct risk
reduction, lower cost of debt/increased debt capacity, liquidity enhancement), earnings
growth (by acquiring company with low growth potential, company with high growth
potential can raise its earnings per share; but: adds no economic value), managerial reasons
to merge (conflict of interest, overconfidence-> hubris hypothesis: overconfident CEOs
pursue mergers that have low chance of creating value because they truly believe that their
ability to manage is great enough to succeed)
Risk reduction: large firms bear less idiosyncratic risk. Ignores the fact that investors can
achieve diversification themselves by purchasing shares in the two separate firms
Debt capacity and borrowing costs: larger, more diversified firms have lower probability of
bankruptcy given the same degree of leverage. ->increase leverage -> enjoy tax savings
Liquidity: acquisition provides targets owners with way to reduce risk exposure by cashing
out their investment in private target and reinvest in a diversified portfolio
Takeover synergies: any additional value created in takeover
Takeover process: Valuation-the offer-merger arbitrage-tax and accounting issues-board
and shareholder approval

The offer: public announcement of its intention to purchase a large block of shares. Two
methods to pay for target: cash or stock. Price offered is determined by exchange ratio
(number of bidder shares received in exchange for each target share multiplied by market
price of acquirers stock).
Maximum number of new shares the acquirer can offer and still receive positive NPV: x<
((T+S)/A) * NA (T=premerger (stand-alone) value of target, S=value of synergies created by
merger, A= premerger/stand-alone value of acquirer, NA= shares outstanding of acquirer)
If offer is announced, does not mean takeover takes place-> often price must be raised. If
board does not agree-> ask shareholders to not sell shares
Risk arbitrageurs: believe that they can predict outcome of a deal, take positions
Merger-arbitrage spread: potential profit which arises from difference between targets
stock price and implied offer price
Friendly takeover: target board of directors supports merger, negotiates with potential
acquirers and agrees on price that is ultimately put to a shareholder vote
Hostile takeover: board of directors and upper-level management fights the takeover
attempt. To succeed, acquirer must garner enough shares to take control of target and
replace board of directors. The acquirer is then called raider
Proxy fight: acquirer attempts to convince target shareholders to unseat the target board by
using their proxy votes to support the acquirers candidates for election to the target board
Poison pill: a rights offering that gives existing target shareholders the right to buy shares in
the target at a deeply discounted price once certain conditions are met. Acquirer excluded
from this right. Purchase is effectively subsidized by existing shareholders of the acquirer
making the takeover very expensive
Staggered/classified board: every director serves a 3-year term and terms are staggered so
that only one-third of directors are up for election each year. ->if bidders candidates win
board seat, it will only control minority o target board
White knight: another, friendlier company to acquire a firm
White squire: large investor or firm agrees to purchase substantial block of shares in target,
with special voting rights. Prevents hostile raider from acquiring control of target
Golden parachute: an extremely lucrative severance package that is guaranteed to a firms
senior managers in the event that the firm is taken over and the managers are let go.
Toehold: initial stake in target, bought anonymously

Freezeout merger: the laws on tender offers allow the acquiring company to freeze existing
shareholders out of the gains from merging by forcing non-tendering shareholders to sell
their shares for the tender offer price
For a merger to proceed, both the target and the acquiring board of directors must approve
the merger and put question to a vote of the shareholders of the target (sometimes also
shareholders of acquiring firm). If the target board opposes the merger, then the acquirer
must go around the target board and appeal directly to the target shareholders, asking them
to elect a new board that will support the merger
A target board of directors can defend itself in several ways to prevent mergers. Most
effective strategy: poison pill. Or: having a staggered board, looking for friendly bidder,
making it expensive to replace management, changing the capital structure of the firm
When a bidder makes an offer for a firm, the target shareholders can benefit by keeping
their shares and letting other shareholders sell at a low price. However, because all
shareholders have the incentive to keep their shares, no one will sell. This scenario is called
free rider problem. To overcome: bidders can acquire a toehold in target, attempt a
leveraged buyout or, when acquirer is corporation, offer a freezeout merger.