Exam 3 Notes
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Western University *
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Course
1023
Subject
Finance
Date
Jan 9, 2024
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Introduction to Finance
Finance: the science or study of the management of funds
The Goal of the Firm
●
Goal is to create value for the firm's shareholders
●
How? Maximizing the price of the existing common stock
●
Good financial decisions will help increase stock price and poor financial decisions will lead to a decline in stock price
Role of Management
●
Serves as an arbitrator and moderator between conflicting interest groups or stakeholders and objectives
●
Creditors, managers, employees and customers hold contractual claims
against the company ●
Shareholders have residual claims against the company
The Role of Finance in Business
●
3 basic issues addressed by the study of finance
o
What long-term investments should the firm undertake? (Capital budgeting decision)
o
How should the firm raise money to fund these investments? (Capital structure decision)
o
How to manage cash flows arising from day-to-day operations? (Operating decision)
Principles of Finance
1.
Cash Flow is What Matters
o
Accounting profits are not equal to cash flows
o
It is possible for a firm to generate accounting profits but not have cash or to generate cash flows but not report accounting profits in the books
o
Cash flow, and not profits, drive the value of a business
o
We must determine additional cash flows when making financial decisions
2.
Money Has a Time Value
o
A dollar received today is worth more than a dollar received in the future
▪
Since we can earn interest on money received today, it is better to receive money sooner rather than later
3.
Risk Requires a Reward
o
Risk is the uncertainty about the outcome or payoff of an investment in the future
o
Rational investors would choose a riskier investment only if they feel the expected return is high enough to justify the greater risk
o
If you're gonna take a risk, you will only take it if you get a higher rate of return
4.
Market Prices are Generally Right
o
A financial market is "information efficient" if at any point in time, the prices of securities reflect all information available to the public
o
When new info becomes available, prices quickly change to reflect their info
o
Info efficient markets provide liquidity and fair prices
o
Note that there are inefficiencies in the market that may distort the market prices from value of assets
o
Such inefficiencies are often caused by behavioral biases
▪
E.g., bitcoin price went up even though it's not actually physically valuable
5.
Conflicts of Interest Cause Agency Problems
o
The separation of management and the ownership of the firm creates an agency problem
o
Owners or equity investors want to maximize the returns on their investments
o
Management vs. Owner Objectives
▪
Management objectives may differ from owner objectives
▪
Empire building: when managers seek to increase the size of the firm
▪
Managers may make decisions that are not in the best interest of the shareholder (principal-agent problem)
▪
Managers may seek to emphasize the size of firm sales, assets, or other perks
▪
Dispersed ownership
▪
Agency conflict is reduced through monitoring (e.g. annual reports) and compensation plans (e.g. stock options)
6.
Ethics and Trust in Business
o
Ethical behaviour is when you do the right thing, but what is the right thing
o
Sound ethical standards are important and personal success
o
Unethical decisions can destroy shareholder wealth
Computation of Present Value: an investment can be viewed in two ways - its future value or its present value
Present Value Example
●
If a bond will pay $100 in 2 years, what is the present value of the $100 if an investor can earn a return of 12% on investments
●
P = F
N / (1+R)
N
●
P = 100/(1+.12)^2 = 79.7194 ●
This process is called discounting
o
We discounted the $100 to its present value of $79.72
o
The interest rate used to find the present value is called the discount rate
●
If you put $79.72 in the bank today at 12% interest, it will grow to $100 in 2 years
Net Present Value Method
1.
Calculate the present value of cash inflows
2.
Calculate the present value of cash outflows
3.
Subtract the present value of the outflows from the present value of the inflows (Inflows - outflows)
Examples of Outflows
●
Initial investment (cash needed to purchase asset)
●
Incremental operating costs
●
Repairs and maintenance of new equipment
●
Additional investment in inventory
Examples of Inflows
●
Incremental revenues
●
Reduction of operating costs
●
Salvage value
Choosing a Discount Rate
●
The firm's cost of capital is usually regarded as the minimum required rate of return
●
The cost of capital is the average rate of return
the company must pay to its long-term creditors and stockholders for the use of their funds
Example
Bonds
50% x 6%
= 3%
Stock
50% x 10%
= 5%
W.A.C.C (Weighted Average Cost of Capital)
8%
●
This means that the company must make at least 8% profit on every investment
●
Another example is on the slideshow - slide 19/20
Net Present Value Example
●
To find 10% factor, use net present value equation, the year is the exponent in the denominator each time
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●
Earns back $683, meaning that you can earn at least 10% and pay back all creditors
●
Reject any value that is negative
●
Estimate salvage value and add it to the year 4 value, since you're assuming that's what it will be worth
Diversification of Investments ●
All investment risk is not the same
●
Some risk can be removed or diversified by investing in several different securities
●
Firm specific risk (unsystematic)
o
Applies to a specific company
o
E.g. if it snows in July, could negatively impact golf course which makes it a risky investment, but could also help snow removal company, making it less risky to invest
in (balances out your risk a bit)
●
Market (systematic)
o
Inevitable, faced by all firms
o
E.g. raised taxes
o
Everyone in the system
Corporate Governance Functions
●
Oversight: board of directors to oversee management
●
Managerial: run company
●
Compliance: laws, regulations, standards
●
Internal audit: assurance and consulting activity
●
Legal and advisory: advice
●
External audit: lend credibility
●
Monitoring: elect or remove directors and management
Real vs. Financial Assets
●
Real assets are tangible things owned by persons and businesses
o
Residential structures and property
o
Major appliances and automobiles
o
Office towers, factories, mines
o
Machinery and equipment
●
Financial assets are what one individual has lent to another o
Consumer credit
o
Loans
o
Mortgages
The Functions of Money
●
Medium of Exchange
o
How transactions are conducted:
▪
Something that is generally acceptable in exchange for goods and services
▪
In this function, money removes the need for double coincidence of wants by separating sellers from buyers
●
Standard of value
o
How the value of goods and services are denominated
▪
Something that circulates and provides a standardized means of evaluating the
relative price of goods and services
●
Store of value
o
How the value of goods and services are maintained in monetary terms: the ability of
money to command purchasing power in the future
The Financial System
●
Banks and other deposit-taking institutions
●
Insurance companies
●
Pension funds
●
Mutual funds
Channels of Intermediation
●
Intermediary helps you lend and borrow throughout financial process
●
E.g. mortgage broker
●
Indirect financial intermediary ●
(
An indirect distribution channel involves intermediaries that perform a company's distribution functions.)
●
Direct intermediaries are something that’s directly from the company ●
A direct distribution channel is organized and managed by a company that sells directly to
consumers. In such a case, the company keeps all aspects of delivery in-house (instead of using vendors) and is solely responsible for ensuring that customers receive their purchases successfully.
Financial Markets
●
Primary markets are markets where something gets sold for the first time (e.g., Walmart) ●
Secondary market is when something gets sold after the first time (e.g., Shoe reseller) ●
Money markets buy and sell loans that are very short term, very low risk, don't charge much interest
o
Operate over the counter (could be on the phone)
●
Capital markets buy and sell everything else: bonds, stocks, derivatives
Debt Instruments Issues by Corporations
●
Commercial paper: debt that operates in the money market and is traded over the counter (like an IOU)
●
Bankers’ Acceptance: like commercial paper but the bank of the borrowing company guarantees the repayment of the debt
●
Corporate Bonds: you buy a bond from a company for a certain amount of time (loan them money), then they pay you back with interest when the time is up (e.g., 10 years)
o
Debentures: unsecured debt, backed only by the general assets of the issuing corporation, no collateral or belief that the company will pay except for the company's word
o
Secured debt: (mortgage debt) - secured by specific assets, you can take the company to court if they don't pay you back
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o
Subordinated debt: in default, holders get payments only after other debtholders get their full payment, you get paid last
o
Senior debt: in default holders get payment before other debtholders get, you get paid first, will pay less interest than subordinated because subordinated debt is taking a much larger risk
o
Zero coupon: pay face value at maturity only, sold at discount, you don't get interest
throughout it, you just get paid right amount with interest at the end
o
Junk bonds: bonds with below investment grade rating, high yield, a risk bond, really high interest, there's a risk you won't get paid back
Bond Features
●
Retractable: means that you can force the company to give you your money back as an investor
●
Convertible: you, the investor, can choose to exchange or convert or change your bond into shares of the company
●
Extendable: the company can choose to take longer to pay you back, if they extend, they still have to keep sending you regular interest payments during extended period
●
Callable (Redeemable): the company can choose to pay you back early, the don't have to
wait till the full duration
Equity instruments issued by Corporations: Common stocks
●
The common stockholders are the owners of the corporation's equity
●
Voting rights
●
No specified maturity date and the firm is not obliged to pay dividends to shareholders
●
Returns come from dividends and capital gains
Equity instruments issued by Corporations: Preferred stocks
●
Have face value, predetermined periodical (dividend) payments with priority over common stockholders
o
Cumulative
o
Non-cumulative: o
Participating: you get your set dividend, and if the company makes more money, you
get some of it
o
Non-participating
●
If dividend payment is not paid, preferred stockholders may get voting rights
●
Preferred shares are like bonds/debt
o
Usually accounted for as a liability and not as equity on financial statements
●
Companies give out preferred shares because debt is cheaper than equity??
Derivatives securities: securities whose value is derived from the value of some underlying asset
●
A financial instrument that derives its value from something else, a derivative on its own has no value, it gains value because of something else
o
E.g. in the futures market, ….
●
Securities whose value is derived from the value of some underlying asset
●
Most important derivatives are options and futures
●
Stock options: not a tool of fundraising, it is a method of compensation
●
Prices of financial instruments are determined in equilibrium by demand and supply forces
●
They reflect market expectations regarding the future as inferred from currently available information
How Firms Raise Capital - pg.206 - 226
IPO: initial public offering (company)
●
Companies can raise money by themselves, by merging with another firm, or by going public with their shares
How New Businesses Get Started
●
Usually started by an entrepreneur, not as a large corporation
●
The process by which many entrepreneurs raise "seed" money and obtain other resources
necessary to start their businesses is bootstrapping
, which basically means to accomplish something on your own
●
Initial seed money usually comes from the entrepreneur or other founders
o
During the starting stage of development for a business, venture capitalists or banks are not normally willing to fund the business
o
The deliverables at this stage are whatever it takes to satisfy investors that the new business concept can become a viable business and deserves their financial support
o
This stage usually lasts 1 to 2 years
Venture Capital
●
Venture capitalists
are individuals or firms that help new businesses get started and provide much of their early-stage financing
●
Angel investors: individual venture capitalists who are wealthy individuals who invest their own money in emerging businesses at the very early stages
●
Individual venture capitalists or angel investors, are typically wealthy individuals who invest their own money in emerging businesses at the very early stages in small deals
●
Primary sources of funds for venture capital firms include financial and insurance firms, private and public pension funds, wealthy individuals and families, corporate investments not associated with employee pensions, and endowments and foundations
●
Many venture capitalist firms manage more than one fund at a given time
●
Investment activity decreased during 2007-2008, but increased again during 2009
●
3 reasons as to why traditional sources of funding do not work for new or emerging businesses:
1.
The high degree of risk
: most suppliers of capital, such as banks, pension funds, and insurance companies are averse to undertaking high-risk investments, and much
of their risk-averse behaviour is mandated in regulations that restrict their conduct
2.
Types of productive assets
- no assets to weigh risk over, most assets are not tangible, it’s easier to secure loans when tangible assets are present, so new firms whose primary assets are intangibles, like patents or trade secrets, often find it difficult to secure financing from traditional lending sources
3.
Informational asymmetry problems
- banks don't know about your idea as much as you, and when dealing with highly specialized technologies or companies emerging in new business areas, most investors do not have the expertise to distinguish between good and bad entrepreneurs, so they are more reluctant to invest in their firms
●
The venture capitalists' investments give them an equity interest in the company
●
Often in the form of preferred stock that is convertible into common stock at the discretion of the venture capitalist
●
The extent of the venture capitalists' involvement depends on the experience of the management team
●
One of their most important roles it to provide advice
●
Use their knowledge about industry and general knowledge to help business figure out how to succeed, provide counsel for entrepreneurs when a business is being started and during early stages of operation
●
Modern venture capitalist firms tend to specialize in a specific line of business, such as clean energy, business software, hospitality, etc.
●
One of the roles of a VC is to provide advice to entrepreneurs
o
When businesses start, the people managing it are usually good with technical skills but not as good on the skills necessary to successfully manage growth, which VCs can help advise on
●
VCs may want a seat on the board of directors, and will at least want an agreement that gives them unrestricted access to info about the firm's operations and financial performance, and the right to attend and observe and board meeting
o
They also want the authority to assume control over the firm if the firm's performance
is poor, as well as the authority to install a new management team if necessary
The Venture Capital Funding Cycle
●
Bootstrap financing: entrepreneur supplies funds, prepares business plan, and searches
for initial outside funding
●
Seed-stage financing: venture capitalists provide funds to finish development of the concept
●
Early-stage financing: VCs provide funds to finish development of the concept
●
Latter-stage financing (mezzanine financing): typically includes 1-5 additional stages
●
Venture capitalists then exit by selling to a strategic buyer, selling to a financial buyer, or selling stock to the public
Value proposition: why consumers find your business/product attractive
How Venture Capitalists Reduce their Risk
●
VCs know that only a handful of new companies will survive to become successful firms
●
Tactics to reduce risk
o
Funding the ventures in stages
: not giving all of the money at once, e.g. $1 Million for 8 months, then more later if you show you are using the money properly
▪
If the performance does not meet expectations, the VCs can bail out and cut their losses, but if they still have confidence in the business, they can help management make some midcourse corrections so that the project can proceed
▪
The VCs' investments give them an equity interest in the company, which is typically in the form of preferred stock that is convertible into common stock at the discretion of the VC, which ensures that VCs have the most senior claim among the stockholders if the firm fails
o
Requiring entrepreneurs to make personal investments proves commitment and confidence in business
▪
VCs want your financial rewards to come from building a successful business, not from your salary
o
Syndicating investments:
sharing the risk with other venture capitalists
o
Maintaining in-depth knowledge about the industry: specializing in and understanding a business field gives the VC an advantage over other lenders who may be generalists
●
Syndication
o
When a group of venture capitalists get together
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o
Reduces risk in 2 ways:
o
Increases the diversification of the originating venture capitalist's investment portfolio, since other VCs now own a portion of the deal and the originating VC has less money invested
o
The willingness of other venture capitalists to share in the investment provides independent corroboration that the investment is a reasonable decision
●
In-Depth Knowledge o
If a VC has an in-depth knowledge of the industry and technology that they’re investing in the risk drops dramatically The Exit Strategy
●
Venture capitalists are not long-term investors in the companies, but usually exit over a period of 3 to 7 years
●
Every venture capital agreement includes provisions identifying who has the authority to make critical decisions concerning the exit process, including:
o
Timing (when to exit)
o
The method of exit
o
What price is acceptable ●
3 principles ways in which VC firms exit-venture backed companies:
o
Sell to a strategic buyer in the private market
▪
Somebody who buys the company because it helps them (e.g. Facebook buying a new tech. company to further their brand)
▪
Strategic buyer is looking to create value through synergies between the acquisition and the firm's existing productive assets
o
Sell to financial buyer in the private market
▪
Buy it to gain financial value, not cause they are concerned with bettering themselves through the concept
▪
This occurs when a financial group, like a private equity firm, buys the new firm with the intention of holding it for a period of time, usually 3-5 years, and then selling it for a higher price (leveraged buyout)
▪
Differs from strategic buyout because a financial buyer does not expect to gain from operating or marketing synergies
●
In a financial sale, the firm operates independently, and the buyer focuses
on creating value by improving operations as much as possible
o
Initial Public Offering:
selling common stock in an initial public (IPO)
▪
To obtain the highest price possible in the IPO, a VC will not sell all of the shares he or she holds at the time of the IPO, selling everything would send a bad signal to investors
▪
The majority of VCs exit through strategic and financial sales, rather than public
sales (IPOs)
The Cost of Venture Capital Funding
●
High cost, but also high potential rates of return
●
For every 10 businesses backed by VCs, only 1 or 2 prove successful
●
If a venture capital-financed new business is successful, the venture capitalists like have made a substantial contribution to creating value for the other owners
●
It is estimated that a typical VC fund will generate annual returns of 15-25% on the money that it invests, compared with an average annual return of 11.82% for the S&P 500 (this is the American stock market index based on the market capitalizations of 500 large companies that have stocks listed on NYSE, NASDAQ, or the Cboe BZX Exchange
IPO
●
One way to raise larger sums of cash or to facilitate the exit of a venture capitalist is through an IPO, or the company's common stock
●
First-time stock issues are given a special name because the marketing and pricing of these issues are distinctly different from those of seasoned offerings, MADE TO APPEAL TO INVESTORS AS THE COMPANY ENTERS THE MARKET FOR THE FIRST TIME
●
Advantages of going public
o
You can raise much more equity capital than through private sources
o
Once an IPO has been completed, additional equity capital can usually be raised through follow-on seasoned public offerings at a low cost
▪
This is because the public markets are highly liquid and investors are willing to pay higher prices for more liquid shares of public firms than for the relatively illiquid shares of private firms
o
Can enable an entrepreneur to fund a growing business without giving up control
o
After the IPO, there is an active secondary market in which stockholders can buy and
sell its shares
o
Publicly traded firms find it easier to attract top management talent and to better motivate current managers if a firm's stock is publicly traded
o
For publicly traded companies, it is easy to offer incentives tied to stock performance
because market info about the value of a share of stock is readily available
●
Disadvantages
o
High cost of the IPO itself, due to the fact that the stock is not seasoned yet, meaning it does not have an established record
▪
Out-of-pocket costs like legal fees and accounting expenses can be expensive
o
The cost of complying with ongoing SEC disclosure requirements
▪
Regulatory costs can be significant for small firms
o
The transparency that results from this compliance can be costly for some firms
▪
If firms have to publicly provide all info about the company, it might take away their competitive advantage against companies that choose to remain private
o
Some investors argue that the SEC's requirement of quarterly earnings estimates and quarterly financial statements encourages manager to focus on short-term profits rather than long-term value maximization
●
Shares are sold on stock market a couple days after IPO day
●
Seasoned public offering: a sale of securities (either sock or bonds) by a firm that already has similar publicly traded securities outstanding
o
Public offering means that the securities being sold are registered with the Securities
and Exchange Commission and can be legally sold to the public at large
o
Only registered securities can be sold to the public
Investment-Banking Services
●
To complete an IPO, a firm will need the services of investment bankers, who are experts in bringing new securities to the market
●
Investment bankers provide 3 basic services when bringing securities to market
o
Origination
o
Underwriting
o
Distribution
Origination
●
Includes giving the firm financial advice and getting the issue ready to sell
●
The investment banker helps the firm determine whether it is ready for an IPO
o
Based on the management team, historical financial performance, and the firm's expected future performance
●
Once the decision to sell stock is made, the firm's management must obtain a number of approvals
o
Firm's BOD must approve all security sales, and stockholder approval is required if the number of shares of stock is to be increased
●
File a registration statement with the Securities Exchange Commission
o
Includes the preliminary prospectus
, which is the initial registration statement filed with the SEC by a company preparing to issue securities in the public market, and contains detailed info about the issuer and the proposed issue
o
Legally, no sales can be made from this document
o
Designed to allow investors to make intelligent decisions about investing in a security
issue and the risks associated with it
●
Must also decide how much money the firm needs to hold and how many shares must be sold
Underwriting
●
The risk-bearing part of investment banking
●
The securities can be underwritten in 2 ways
o
On a firm-commitment basis:
the IB negotiates a deal with you and says they will buy your shares at a price they agree upon, and they will then go and try to sell them
in the market on IPO day
▪
The IB actually buys the stock from the firm at a fixed price and then resells it to the public
▪
The underwriter bears the risk that the resale price might be lower than the price the underwriter pays, which is called price risk
▪
The IB's compensation is called the underwriter's spread
●
In a firm-commitment offering, this is the difference between the IB's purchase and the offer price
o
On a best-efforts basis: when the IB doesn’t guarantee a price or how many shares
sell, but will try to sell as many shares as possible and try to get the highest price they possibly can, but they will take a commission (a piece of the sales)
▪
The IB does not bear the price risk associated with underwriting the issue, and compensation is based on the number of shares sold
●
Most corporations issuing stock prefer firm-commitment arrangements to best-
effort contracts, more than 95% are firm-commitment arrangements
o
Best-effort offerings arise when underwriters do not want to accept the risk of guaranteeing the offering price
●
Underwriting Syndicates
o
To share the underwriting risk and to sell a new security issue more efficiently, underwriters may combine to form a group called an underwriting syndicate
o
Participating in the syndicate entitles each underwriter to receive a portion of the underwriting fee as well as an allocation of the securities to sell its own customers
o
To broaden the search for potential investors, underwriting syndicates may enlist other IB firms in a syndicate known as a selling group
, which assists in the sale of the securities
▪
These firms receive commission for each security they sell and bear none of the risk of underwriting the issue
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●
Determining the Offer Price
o
One of the investment banker's most difficult tasks is to determine the highest price at which the bankers will be able to quickly sell all of the shares being offered and that will result in a stable secondary market for the shares
o
Must consider the firm's expected future cash flows, as well as the stock price implied by multiples of total firm value to EBITDA or stock price to earnings per share
for similar firms that are already public
o
Finally, the IB conducts a road show
where management makes presentations about
the firm and its prospects to potential investors, which helps the IB determine the number of shares that investors are likely to purchase at different prices
●
Due Diligence Meeting
o
Before the shares are sold, reps from the underwriting syndicate hold a due-diligence
meeting with reps of the issuer
o
IBs hold due-diligence meetings to protect their reps and to reduce the risk of investors' lawsuits in the event the investment goes sour later
o
These meetings ensure that all material issues about the firm and the offering are discovered and fully disclosed to investors
Distribution
●
Once the due-diligence process is complete, the underwriters and the issuer determine the
final offer price in a pricing call
●
The pricing call typically takes place after the market has closed for the day
●
By either accepting or rejecting the investment banker's recommendation, management ultimately makes the pricing decision
●
If management finds the price acceptable, the issuer files and amendment to the registration statement with the SEC, which contains the terms of the offering and the final prospectus
o
Once the securities are registered with the SEC, they can be sold to investors
The First Day of Trading
●
Syndicate's primary concern is to sell the securities as quickly as possible at the offer price
●
Speed of sale is important because the offer price reflects market conditions at the end of the previous day and these conditions can change quickly
●
If the securities are not sold within a few days, the underwriting syndicate disbands,
and members sell the securities at whatever price they can get
The Closing
●
At the closing of a firm-commitment offering, the issuing firm delivers the security certificates to the underwriter and the underwriter delivers the payment for the securities, net of the underwriting fee, to the issuer
●
Closing usually takes place on the third business day after trading has started
The Proceeds
●
3 questions to consider when deciding what happens with the proceeds
1.
What are the total expected proceeds from the common-stock sale?
2.
How much money does the issuer expect to get from the offering
3.
What is the IB's expected compensation from the offering, based on the underwriter's spread
IPO Pricing and Cost
●
Underpricing: offering new securities for sale at a price below their true value
o
The lower the offering price, the more likely the securities will sell out quickly and the less likely the underwriters will end up with unsold inventory
o
IB's say that underpricing helps attract long-term institutional investors who help provide stability for the stock price once the secondary market for the shares is established ●
If the stock is priced too high, the entire issue will not sell at the proposed offer price
●
In a firm-commitment offering, the underwriters will suffer a financial loss if the offer price is set too high
●
In a best-effort agreement, the issuing firm will raise less money than expected
●
If the stock is priced too low, the firm's existing stockholders will experience an opportunity
loss and make less money
o
The IB firm will also suffer a loss of reputation for failing to price the new issue correctly and raising less money for its client than it could have if the price is too low
●
Data shows that the shares hold in an IPO are typically priced between 10-15% below the price at which they close at the end of the day of the first day of trading
o
This implies that underwriters tend to sell shares of stock in IPOs to investors for between 90-85% of their true market value
o
Average underpricing during the 2001-2013 years was 10.6%, and the weighted average first-day return from 1997-2013 was 11.6%, excluding 1999-2000
●
3 basic costs are associated with issuing stock in an IPO
o
Underwriting spread is the difference between the proceeds the issuer receives and the total amount raised in the offering
o
Out-of-pocket expenses: include other investment banking fees, legal fees, accounting expenses, printing costs, travel expenses, SEC filing fees, consultant fees, and taxes
▪
All of these expenses are reported in the prospectus
o
Underpricing: typically defined as the difference between the offering price and the closing price at the end of the first day at the IPO
▪
The opportunity loss that the issuer's stockholders incur from selling the security below its true market value
▪
Underpricing of IPOs is more pronounced for larger issues, but there are significant economies of scale in direct costs
Private Markets
●
Because many smaller firms and firms of lower credit standing have limited access, (or no access) to the public markets, the cheapest source of external funding is often the private markets
●
When market conditions are unstable, some smaller firms that were previously able to sell securities in the public markets no longer can
●
Bootstrapping and VC financing are part of the private market as well
●
Many private companies that are owned by entrepreneurs, familiars, or family foundations,
and are sizable companies of high credit quality, prefer to sell their securities in the private
markets even though they can access public markets
●
Private Placements
o
Occur when a firm sells unregistered securities directly to investors such as insurance companies, commercial banks, or wealthy individuals
o
Private lenders are more willing to negotiate changes to a bond contract
o
If a firm suffers financial distress, the problems are more likely to be resolved without
going to a bankruptcy court
o
Other advantages include the speed of private placement deals and flexibility in issue size
o
The biggest drawback of private placements involves restrictions on the resale of the
securities
Private Equity Firms
●
Like VCs, private equity firms pool money from wealthy investors, pension funds, insurance companies, and other sources to make investments
●
Private equity firms invest in more mature companies, and they often purchase 100% of a business
●
The managers of these firms look to increase the value of the firms they acquire by closely
monitoring their performance and providing better management
●
Once value is increased, they sell the firms for a profit
●
Profit equity firms generally hold investments for 3 to 5 years
General Cash Offer by a Public Company
●
If a public firm has a high credit rating, the lowest-cost source of external funds is often a general cash offer
, which is a sale of debt or equity, open to all investors, by a registered public company that has previously sold stock to the public GENERAL CASH OFFER IS A SALE OF DEBT OR EQUITY, OPEN TO ALL INVESTORS, BY A REGISTERED COMPANY THAT HAS PREVIOUSLY SOLD STOCK TO THE PUBLIC
●
Procedures involved in a general cash offer:
1.
Type of security and amount to be raised is determined
(e.g., debt, common stock, preferred stock)
2.
Approval
is obtained from the BOD to issue securities. If the size of a stock issue exceeds
the previously authorized number of shares of common or preferred stock, approval from stockholders is required as well
3.
The issuer files a registration statement
and satisfies all the securities laws enforced by the SEC. For a debt issue, the registration statement must contain a bond indenture which
specifies the details of the issue
4.
After assessing demand, the underwriter and the issuer agree on an offer price
5.
Closing:
at the closing of a firm-commitment offering, the issue delivers the securities to the underwriter, and the underwriter pays for them, net of its fees. The securities are then sold to individual investors
●
The issuer has flexibility in the method of sale and the way the securities are registered, and both factors can affect the issuer's funding cost
●
Total cost on a general cash offer
only includes underwriting spread and out-of-pocket expenses (does not include data on underpricing), GENERAL CASH OFFER COST DOES NOT INCLUDE DATA ON UNDERPRICING
o
Issuing common stock is the costliest alternative and issuing corporate bonds (nonconvertible) is the least costly
o
Higher costs for equity issues reflect greater underwriting risk, higher sales commissions for those involved in selling the issue, and the higher administrative expenses required to bring equity securities to market
●
The cost of an IPO is significantly higher than the cost of a general cash offer of equity, even when the cost of underpricing for the IPO is not included in the total
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There is usually greater risk involved in underwriting an IPO and a higher cost of distributing the shares in an IPO
Competitive vs. Negotiated Sale
●
Competitive sale: when the issuer specifies the type and number of securities it wants to sell and hires an IB firm to do the origination work
o
Once the origination work is completed, the issuer invites underwriters to bid competitively to buy the issue, and the IB firm that pays the highest price for the securities wins the bid
o
Winning underwriter then pays for the securities and makes them available to individual investors at the offer price
●
Negotiated sale: the issuer selects the underwriter at the beginning of the origination process
o
At that time, the scope of the work is defined, and the issuer negotiates the origination and underwriter's fees to be charged
o
The issuer and underwriter then work together to design the issue and determine the
most favourable time to take the securities to market
o
Following an assessment of demand, the offer price is set and the underwriter pays the issuer for the securities and sells them to individual investors
●
For competitive bidding, the greater the number of bidders, the greater the competition for the security issue, and the lower the cost to the issuer
o
Negotiated sales lack competition and therefore should be the more costly method of
sale
o
Proponents of negotiated sales argue that through this method, the IB works closely with the issuer and thus has intimate knowledge of the firm and its problems, meaning the IB can reduce uncertainty surrounding the issue and tell the firm's story to potential investors, resulting in a lower issue cost
▪
The potential competitors are actually the other IB's that were not chosen to underwrite the current issue but would like to underwrite the firm's next issue, so the threat of potential competition provides similar benefits to direct competition
●
For debt issue, most experts believe that competitive sales are the least costly method of selling so-called vanilla bonds
(bonds with not unusual features) when market conditions are stable
o
These securities are like commodities because market participants understand the risks of investing in them and are comfortable buying them
●
In contrast, when there are complex circumstances to explain or when market conditions are unstable, negotiated sales provide the least costly method of sale for
debt issues
o
A negotiated sale allows the underwriter to better manage uncertainty and explain the firm's situation, resulting in the lowest funding cost
●
For equity securities and issues, negotiated sales generally provide the lowest-cost method of sale
Shelf registration: a type of SEC registration that allows firms to register to sell securities over a two-year period and, during that time, take the securities "off the shelf" and sell them as needed
●
Costs of selling the securities are reduced because only a single registration statement is required
●
This statement can cover multiple securities, and there is no penalty if authorized securities are not issued
●
Corporations gain greater flexibility in bringing securities to market
o
Securities can be taken off the shelf and sold within minutes, so firms can sell their securities when market conditions are more favourable
●
Shelf registration allows firms to periodically sell small amounts of securities, raising money as it is actually needed, rather than banking a large amount of money from a single
security sale and spending it over time
Private vs. Equity Markets
●
Firms that sell securities in the public market are usually large and well-known
●
Many smaller firms and firms of lower credit standing have limited access, or no access, to
the public markets PRIVATE MARKET IS MORE FOR SMALLER FIRMS
o
Their cheapest source of funding is often private markets
●
When market conditions are unstable, some smaller firms that could previously sell securities in public markets are no longer able to do so at a reasonable price, since investors seek to hold high-quality securities rather than high-risk securities during times like this
o
This is called flight to quality
on Wall Street, and refers to moving capital to the safest possible investments to protect oneself during unsettled periods in the market
●
Some large companies with high credit quality prefer to sell their securities in private markets even though they have access to public markets
o
One reason is because these firms wish to avoid the regulatory costs and transparency requirements that come with public sales of securities
o
Others believe that their firms have intricate business structures or complex legal or financial structures that can best be explained to a small group of sophisticated investors rather than to the public at large
●
Bootstrapping and venture capital financing are part of the private market as well, and are primary sources of funding for new businesses
Dividends, Stock Repurchases, Payout Policy - pg. 227 – 245
●
Any time value is distributed to a firm's stockholders, the amount of equity capital invested in the firm is reduced
●
Unless the firm raises additional equity by selling new shares, distributions to stockholders
reduce the availability of capital for new investments and increase the firm's financial leverage
●
Payout policy: the policy concerning the distribution of value from a firm to its stockholders
●
Dividend: something of value distributed to a firm's stockholders on a pro-rate basis (meaning it is in proportion to the percentage of the firm's shares that they own)
o
When a firm distributes value through a dividend, it reduces the value of the stockholders' claims against the firm
o
Read example on page 228 to understand how this works
Dividends
●
Dividend policy: refers to a firm's overall policy regarding distributions of value to stockholders
●
A dividend is something of value that is distributed to a firm's stockholders on a pro-rata
●
A dividend can involve the distribution of cash, assets, or something else, such as discounts on the firm's products that are available only to stockholders
●
When a firm distributes value through a dividend, it reduces the value of the stockholders' claims against the firm
●
A dividend reduces the stockholders' investment in a firm by returning some of that investment to them
Types of Dividends
●
Regular Cash Dividend
o
The most common form, it is the cash dividend that is paid on a regular basis
o
Are generally paid on a quarterly basis and are a common means by which firms return some of their profits to stockholders
o
The size of a firm's regular cash dividend is typically set at a level that management expects the company to be able to maintain in the long run, barring some major change in the fortunes of the company
o
Stock market investors often view a dividend reduction negatively
●
Extra Dividends
o
Management can afford to err on the side of setting the regular cash dividend too low
because it always has the option of paying an extra dividend if earnings are higher than expected
o
Extra dividends are often paid at the same time as regular cash dividends, and some
companies use them to ensure that a minimum portion of earnings is distributed to stockholders each year
o
Extra money cause of a good year
●
Special Dividend
o
One-time payment to stockholder, like an extra dividend
o
Larger than extra dividends and to occur less frequently
o
When companies have extra money because they've done something special in the business like sold parts of the business
●
Liquidating Dividend
o
Is a dividend that is paid to stockholders when a firm is liquidated
o
Can only be paid after firms use proceeds of selling its assets to pay all wages owed to employees and the companies’ obligations to suppliers, lenders, taxing authorities,
etc.
●
When companies pay dividends, the stock price goes down by the amount of the dividend
●
Distribution of value to stockholders can also take the form of discounts on the company's products, free samples, etc., but these are not
thought of as dividends because the value received by stockholders is not in cash and does not reflect their proportional ownership in
the firm
Dividend Payment Process
●
First, board of directors must vote on the dividends value and type, every 3 months
●
Then, company makes a public announcement about the dividends
o
The date on which it publicly announces the divided is known as the declaration date
o
Typically includes the amount of value that stockholders will receive for each share of stock that they own, as well as the other dates associated with the dividend payment process
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An announcement that a company will pay an unexpectedly large divided can indicate that management is optimistic about future profits, suggesting that future cash flows are higher than expected, resulting in an increase in the company's stock price
●
And vice versa ●
Then, there is the ex-dividend date
, which is the first day that the stock trades without the
right to get the dividend that's been announced
o
This is the date when stock prices go down after dividends have been announced
o
An investor who buys shares only before this date will receive a dividend o
Before the ex-dividend date, a stock is said to be trading cum dividend
, or with dividend, and on or after the ex-dividend date, the stock is said to trade ex-dividend
o
If an investor purchases the company's shares before the ex-dividend date, the investor knows that he or she will soon receive a dividend on which taxes will have to
be paid
●
23.8% is the max tax that can be paid on dividends
o
The price of the firm's shares changes on the ex-dividend date even if there is no new info about the firm, which simply reflects the change in the value of the cash flows that the stockholders are entitled to receive before and after the ex-dividend date
o
E.g. if investors pay a 23.8% tax on dividends, the $10 price of a stock should include $0.762 for the dividend and $9.238 for other cash flows ($10-$0.762 = $9.24) so the stock price should drop to $9.24 on the ex-dividend date
●
Then, one or two days later is the record date
, which is when they try to figure out who in the world owned the shares on the ex-dividend date
o
By the record date, an investor must be a stockholder in order to receive a dividend, must be a stockholder of record
o
They have a record of everyone that is legally entitled to the dividend
o
Board specifies this date when it votes to make the dividend payment
o
Once the company informs the exchange on which its stock is traded what the record
date is, the exchange sets the ex-dividend date
o
The ex-dividend date precedes the record date because it takes time to update the stockholder list when someone purchases shares
o
If you buy the shares before the ex-dividend date, the exchange will ensure that you are listed as a stockholder of record or that company as of the record date
●
Then, they eventually pay it to everyone on the record by the record date, done on the payable date
o
Typically a couple weeks after the record date
Dividend Payment Process at Private Companies
●
It is not as well defined for private companies because
o
Shares are bought and sold less frequently
o
Fewer stockholders
o
No stock exchange is involved in the dividend payment process
●
It is easy to inform all stockholders of the decision to pay and actually pay them, as the board knows the identities of the stockholders when they vote to authorize a dividend, since the list of stockholders is relatively short and the largest stockholders are on the board
●
It is easy to pay it
●
There is no public announcement
●
No need for an ex-dividend date
●
The record date and payable date can be any day on or after the day that the board approves the dividend
Stock Repurchases
●
Stock repurchases: the purchase of stock by a company from its stockholders, an alternative way for the company to distribute value to the stockholders
●
Unlike dividends, they do not represent a pro-rate distribution of value to the stockholders because not all stockholders participate, whereas in a dividend distribution, every stockholder receives the dividend
●
When a company repurchases its own shares, it removes them from circulation
o
This can decrease or increase the fraction of shares owned by the major stockholders and thereby diminish their ability to control the company
o
If a company with a relatively small number of shares in the public market distributes a lot of cash to investors through a stock repurchase, there will be less liquidity for the remaining shares
●
Stock repurchases are taxed differently than dividends
o
When a stockholder sells shares back to the company, the stockholder is taxed only on the profit from the sale
o
Unlike the case with dividends, since stockholders choose whether to participate in a
repurchase plan, they are able to choose when they pay taxes on the profits from selling their stock
●
Investors would rather be taxed on gains from stock repurchases than dividends
(talked to Barry about this)
●
When a company uses cash to repurchase stock, the cash account on the assets side of the balance sheet is reduced, while the treasury stock account on the liabilities and stockholders' equity side of the balance sheet is increased (becomes more negative)
o
In contrast, when a company pays a cash dividend, the cash account on the assets side of the balance sheet and the retained earnings account on the liabilities and stockholders' equity side of the balance sheet are reduced
How Stock is Repurchased
1.
Open market Repurchase: go into market and buy shares at whatever the price is
●
Company may use repurchases to distribute some of its profits instead of paying a regular cash dividend
●
There are limits on the number of shares that a company can repurchase on a given day, which hare intended to restrict the ability of firms to influence their stock price through trading activity, meaning that it could take months for a company to distribute a large amount of cash using open-market repurchases
2.
Tender Offer:
an open offer by a company to purchase shares
●
Used when a company wants to distribute a large amount of cash at one time and does not want to use a special dividend
●
Fixed Price: company announce that they want to buy back X number of shares and are willing to pay whatever the fixed price is for the share, and that offer is good for the next 30 days
●
Interested stockholders then tender their shares by letting management know how many shares they are willing to sell
●
Dutch auction: investors choose the price they want to sell at, then they wait and see if someone accepts the price to buy shares or not
●
Take the highest last price offered and everybody gets that price
●
Firm announces the number of shares that it would like to repurchase and
asks the stockholders how many shares they would sell at a series of prices, ranging from just above the price at which the shares are currently
trading to some higher price
●
Once these offers to sell have been collected, management determines the price that would all them to repurchase the number of shares that they
want
●
All of the tendering stockholders who indicate a willingness to sell at or below this price will then receive this price for their shares
3.
Targeted Stock Repurchase:
a stock repurchase that targets a specific shareholder
●
Means a company has a set number of shares they want to rebuy, they could go into the open market to by them, make a tender offer, or see if they can find a rich person/company with a shitload of shares, then you call them and try to buy all the shares (e.g. 1 million shares) from them, makes demand go up and stock price go up in the market ●
Such repurchases can benefit stockholders who are not selling because managers may be able to negotiate a per-share price that is below the current market price
●
This is possible because the only alternative for a stockholder who own a large block of shares and wants to sell them at one time often involves offering the shares for a below-market price in the open market
●
Most common way to repurchase shares is through open-market repurchases
o
But the average percentage of shares repurchases is smaller for this method than the other methods, confirming the managers tend to use other methods when they want to distribute a large amount of cash at once
●
Almost half of the targets stock repurchases involve a purchase price that is below the stock's price in the open market
●
However, a large stockholder's willingness to sell their shares may signal this investor's pessimism about the firm's prospects, causing other market participants to drive down the stock price (may think business is going down)
Dividends and Firm Value
●
Capital structure policy does not affect firm value if there are no taxes, no information or transaction costs, and if the real investment policy of the firm is fixed
●
Dividends do not matter under these conditions because a stockholder can "manufacture" any dividends he or she wants at no cost, and the total cash flow a firm produces from tis real assets are not affected by the dividends that it pays
●
Dividends only provide a signal concerning a fundamental change at the firm, meaning they are only byproducts of change
Benefits of dividends
●
Paying dividends attracts investors who prefer to invest in stocks that pay dividends
o
E.g. retiree, or institutional investor (like an endowment or foundation)
o
But some investors may choose to avoid stocks that pay dividends, since they might to pay taxes on the dividends and would face transaction costs when they reinvest the dividends they receive
●
Many companies pay regular cash dividends on the one hand while routinely selling new shares on the other
o
This could be because management is trying to appeal to their investors who prefer dividends
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o
This practice also helps to align the incentives of managers and stockholders
●
If the company's BOD votes to pay dividends that amount to more than the excess cash that the company is producing from its operations, the board is effectively forcing management to sell equity periodically in the public markets (since the money to pay the dividends has to come from somewhere)
●
This increases the cost to managers of operating the business inefficiently, so it
aligns their incentives with the stockholders, as the process of raising new equity involves a lot of auditing
●
When considering the outside certification coming from the public and auditors,
paying a dividend and issuing equity rather than just keeping cash inside the firm can lead to better company performance and the willingness of investors to
pay a higher price for the company's stock
●
Dividends can be useful in managing the capital structure of a company, and paying dividends can help keep the firm's capital structure near its optimal mix
Costs of dividends
●
Dividends are taxable, which can be a hefty tax
o
Taxed as ordinary income, which is higher than the capital gains tax rate
●
Owners of stocks that pay dividends often have to pay brokerage fees if they want to reinvest the proceeds
o
To eliminate this cost, some companies offer dividend reinvestment programs (DRIPs)
, through which a company can sell shares, commission free, to dividend recipients who elect to automatically reinvest their dividends in the company's stock
o
But these do not affect taxes that must be paid on the dividends
●
Total value of the assets in a company go down when a dividend is paid, paying dividends can increase the cost of debt
o
With less valuable assets, the debt holders face greater risk of default, and to compensate this greater risk, they will charge the company a higher rate on its debt
Dividends vs. Stock Repurchases
●
Stock repurchases are an alternative to dividends as a way of distributing value
●
Stock repurchases give stockholders the ability to choose when they receive the distribution, which affects the timing of the taxes they must pay as well as the cost of reinvesting funds that are not immediately needed
o
Stockholders who sell shares back to a company pay taxes only on the gains they realize, and historically, these capital gains have been taxed at a lower rate than dividends
●
For managers, stock repurchases provide greater flexibility with distributing value
o
Even when a company publicly announces an ongoing open-market stock repurchase program, as opposed to a regular cash dividend, investors know that management can always quietly cut back or end the repurchases at any time
●
In contrast, dividend programs represent a stronger commitment to distribute value in the future because they cannot be quietly ended
●
Investors know that managers will only initiate dividends when they are quite confident that they will be able to continue them for the long run
o
If future cash flows are not certain, managers prefer to distribute extra cash today by repurchasing shares through open-market purchases because this enables them to preserve some flexibility
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●
One disadvantage of stock repurchases is that since most ongoing stock repurchase programs are not as visible as dividend programs; they cannot be used as effectively to send a positive signal about the company's prospects to investors
●
Managers know more than investors so they can create repurchase programs to benefit themselves or transfer wealth from one investor to another, which isn't really in the best interest of all stockholders
●
Companies in the U.S. have historically distributed more value through dividend payments than through stock repurchases, indicating manager may like dividends more
o
But in recent years, popularity of stock repurchases has increased
o
Nowadays, more companies of considering stock repurchases over dividends, and the companies that still pay dividends usually pay large dividends
●
The fraction of total equity value that is being distributed to stockholders has declined
Stock Dividends and Stock Splits
●
Stock Dividend: a distribution of new shares to existing stockholders in proportion to the percentage of shares that they own (pro rata), the value of the assets in a company does not change with a stock dividend
o
One type of "dividend" that does not involve the distribution of value is known as a stock dividend
●
Stock dividends do not increase a company's wealth, it's just a different distribution of money
●
Companies still issue more dividends to try and lower their stock prices
o
When a company pays a stock dividend, it distributes new shares of stock on a pro-
rata basis to existing stockholders
o
Value of company does not change
o
The stockholder is left with the same value as before
o
All that happens when a stock dividend is paid is that the number of shares each stockholder owns increases and their value goes down proportionately
●
Stockholder is left with exactly the same value as before
●
Stock Split: a pro rata distribution of new shares to existing stockholders that is not associated with any change in the assets held by the firm; stock splits involve larger increases in the number of shares than stock dividends
o
A stock split is quite similar to a stock dividend, but it involves the distribution of a larger multiple of the outstanding shares
o
Companies take your shares and split them into more
o
Shareholders do not have to agree to stock splits
o
We can often think of a stock split as an actual division of each share into more than one share
o
Benefit: they can send a positive signal to investors about the outlook that management has for the future and this, in turn, can lead to a higher stock price
o
Management is unlikely to want to split the stock of a company two-for-one or three-
for-one if it expects the stock price to decline
●
This is when stockholders receive one additional share for each share they already own
o
Reverse stock splits: opposite of stock split
●
When the number of shares each investor has is reduced
●
May be undertaken to satisfy exchange requirements
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●
E.g. NASDQ requires shares to trade for at least $1, and if there is a fear that this cannot be met by a company, the company can use a reverse stock split to keep the per-share price above the required thresholds
o
Companies want to make their share prices lower because shareholders think that companies splitting stock is a good thing
o
If a stock gets too high, less people in the market can afford it or choose to want to afford it
o
Similar to a stock dividend, a stockholder might own twice as many shares after the split, but because the split does not change the nature of the company's assets, those shares represent the same proportional ownership in the company as the original shares
●
Stock dividends are typically regularly scheduled events, like regular cash dividends, whereas stock splits tend to occur infrequently during the life of a company
Reasons for Stock Dividends and Splits
●
Trading range argument: proposes that successful companies use stock dividends or splits to make their shares more attractive to investors
o
This is because as the price of the stock of a successful company increases over time, it might become harder for investors to afford to purchase a round lot of 100 shares, which could affect the company's stock price
●
It has been more expensive for investors to purchase odd lots
, which consist of
less than 100 shares, than round lots, which are multiples of 100 shares
●
Odd lots are less liquid because more investors want to buy round lots
●
It can also be more expensive for companies to service odd-lot purchases
●
Because of these disadvantages, investors tend to be less enthusiastic about purchasing odd lots and managers prefer that they do not as well
o
Therefore, when buying a round lot becomes too expensive, investors may choose not to invest in the company at all
o
Stock dividends and splits offer ways to bring the price of the stock down to the appropriate trading range, so that investors can still buy round lots
o
This argument is not always valid though
●
One real benefit of stock splits is that they can send a positive signal to investors about management's outlook for the future, as management is unlikely to want to split the stock of a company two-fore-one if it expects the stock price to decline, it is only likely to split the
stock when it is confident that the stock's current market price is not too high
Setting a Dividend Payout
What Managers Tell Us
●
Surveys about how managers set their firms' dividend payouts indicate that:
o
Firms tend to have long-term target payout ratios
o
Dividend changes follow shifts in long-term sustainable earnings
o
Managers focus more on dividend changes than on the level (dollar amount) of the dividend
o
Managers are reluctant to make dividend changes that might have to be reversed
●
Managers tend to use dividends to distribute excess earnings and they are concerned about unnecessarily surprising investors with bad news
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●
More recent surveys indicate that rather than setting a target level for repurchases, managers tend to repurchase shares using cash that is left over after investment spending, and many managers prefer repurchases because repurchase programs are more flexible than dividend programs
o
Also, because they can be used to time the market by repurchasing shares when management considers a company's stock price too low
●
Also believe that these two methods of distributing value have little effect on who owns the
company's stock (institutional investors do not prefer dividends over repurchases or vice versa)
Practical Considerations in Setting a Dividend Policy/Payout
●
A company's dividend payout is about how the excess value in a company is distributed to
its stockholders
●
Choosing this payout involves determining how much value should be distributed
●
It is extremely important that managers choose their firm's dividend policies in a way that enables them to continue to make the investments necessary for the firm to compete in this product markets ●
Managers should consider several practical questions when selecting a dividend policy:
1. Over the long term, how much does the company’s level of earnings (cash flows from operations) exceed its investment requirements? How certain is this level?
2. Does the firm have enough financial reserves to maintain the dividend payout in periods when earnings are down or investment requirements are up?
3. Does the firm have sufficient financial flexibility to maintain dividends if unforeseen circumstances wipe out its financial reserves when earnings are down?
4. Can the firm quickly raise equity capital if necessary?
5. If the company chooses to finance dividends by selling equity, will the increased number of stockholders have implications for the control of the company?
Stock price reactions to dividend announcements
●
Cash flow identity
o
States that the sources of cash must equal the uses of cash in a firm
●
Let's say a company has announced an increase in its dividend payments that investors did not expect
●
If the company is not selling new equity or debt, not repurchasing stock, and its investment
in fixed assets and net working capital does not change, then the cash flow identity indicates that the cash to investors from operating activity must be expected to increase
●
An expected increase in the cash flow to investors from operating activity is a good signal, and investors will interpret it as suggesting that cash flows to stockholders will increase in the future, so the stock price would go up
●
Normally, when a company announces that it will increase its regular cash dividends, stock prices rise
●
In contrast, when a company announces that it will reduce its regular cash dividend,
stock prices tend to fall
●
An announcement that a company will pay a special dividend is also associated with an average stock price increase
●
These are all suggestions that have occurred in the past, but there is not absolute proof that increasing dividends results in an increase in stock prices
●
Cash flow identity just shows that managers make changes in dividends when something fundamental changes in the company
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●
There is no evidence that it is possible to increase firm value by increasing dividends, dividend changes only provide a signal concerning a fundamental change at the firm
If a discount is given in proportion to the ownership percentage, then it can be a dividend
On the ex-dividend date, the stock price falls but not usually by the same amount as the dividend, usually falls by a little less than that (b/c other values in the market like supply and demand may raise it or lower it, so it's hard to predict the exact amount)
Mergers and Acquisitions - pg. 275-298
Types of Takeovers
●
A takeover
is a transfer of control from one ownership group to another
●
Acquisition: the purchase of one firm by another, when one firm completely absorbs another
o
Acquiring firm keeps identity whereas acquired firm ceases to exist
●
Merger: the combination of two or more firms into a new legal entity in which one entity keeps their identity while the others lose their identities
o
Issues can arise if companies have announced their intent to merge as equals, but events occur that take them down a different path
●
Amalgamation:
a blending together of two or more entities where both lose their identities, and a new separate entity is born. Both (all) sets of shareholders must approve the transaction
o
In a genuine merger, both sets of shareholders must approve the transaction
o
The basic rule is that 2/3 of the shareholders of both amalgamating firms have to approve the special resolution to amalgamate
o
An amalgamation also takes place when the acquirer has purchased all the shares in
the target, but if the acquirer owns all the shares, the process is a formality
o
Going private transaction/issuer bid: a special form of acquisition where the purchaser already owns a majority stake in the target company
o
When a controlling shareholder seeks approval for an amalgamation, it is assumed that they have a much more accurate knowledge of the true value of the shares and will abuse this portion unless safeguards are in place
▪
The critical safeguards are that a majority of the minority shareholders approve the special resolution to amalgamate the 2 companies and that there be a fairness opinion
▪
Fairness opinion: an opinion provided by an independent expert regarding the
true value of a firm's shares, based on an external valuation
●
These valuations are difficult, given that with a controlling shareholder, there is little possibility of any other party buying the shares
●
Related businesses (horizontal relationships)
●
Transferring competitively valuable expertise
●
Combining the related activities of separate businesses into a single operation to lower costs (cost synergies)
●
Exploiting common use of a well-known brand name
●
Majority of Minority Rule: When minority shareholders hold less than 10% of a company’s shares, they must accept the offer that has been accepted by the other shareholders
Financing Takeovers
●
Cash transaction: the receipt of cash for shares by shareholders in a target company
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o
Generally, when one company acquires another, the approval of the target company's shareholders is required, since they have to agree to sell their shares
o
The shareholders of the acquiring company do not have to generally give their approval
●
Share transaction: the offer by an acquiring company of shares or a combination of cash and shares to the target company's shareholders
o
In contrast to a cash transaction, this often does require the approval of the acquiring
firm's shareholders, depending on whether the firm has a limit on its authorized share capital
o
E.g. if the firm's share capital is limited to 3 million shares, and it wants to offer shares in excess of this limit, then shareholder approval is needed
How the Deal is Financed
●
Cash Transaction
o
The receipt of cash for shares by shareholders in the target company
●
Share Transaction
o
The offer by an acquiring company of shares or a combination of cash and shares to the target company's shareholders
●
Going Private Transaction (Issuer Bid)
o
A special form of acquisition where the purchaser already owns a majority stake in the target company
o
When a company goes from public to private because a shareholder who owns the majority of the company wants it to be private
General Intent of the Legislation
●
Transparency - Information Disclosure
o
To ensure complete and timely information be available to all parties while at the same time not letting this requirement stall the process unduly
●
Fair treatment
o
To avoid oppression or coercion of minority shareholders
o
To permit competing bids during the process and not have the first bidder have special rights (in this way, shareholders have the opportunity to get the greatest and fairest price for their shares)
o
To limit the ability of a minority to frustrate the will of a majority (minority squeeze out
provisions)
Tender offer: a public, open offer or invitation by a prospective acquirer to all stockholders of a publicly traded corporation to tender their stock for sale at a specified price during a specified time
●
Need to be made when you are trying to buy 20% or more of a company
Exempt Takeovers
●
Private companies are generally exempt from provincial securities legislation
●
Public companies that have few shareholders in one province may be subject to takeover laws of another province where the majority of shareholders reside
●
Purchase of shares from fewer than 5 shareholders
Creeping Takeovers
●
The 5% rule
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o
Normal course tender offer is not required as long as no more than 5% of the outstanding shares are purchased through the exchange over a one-year period of time
o
This allows creeping takeovers where the company acquires the target over a long period of time
o
But once you reach 20%, you do have to make the tender offer if you want even one more share
Securities Legislation and Takeovers
●
Authorities can reject takeovers due to:
o
Concerns related to national security
o
Concerns about "sensitive" industries that are seen as critical to the nation (which is why there are foreign ownership restrictions for Canadian banks)
o
Anti-trust concerns in situations where an amalgamation of two or more businesses would create an entity that would too narrowly restrict competition
Critical Shareholder Percentages
1.
10% Early Warning
o
When a shareholder hits this point, a report is sent to OSC
o
This requirement alerts other shareholders that a potential acquisitor is accumulating
a position (toehold) in the firm, and lets them know if a significant block of the company has been bought by a potential acquirer
2.
20% Takeover Bid
o
Not allowed further open market purchases but must make a takeover bid
o
This allows all shareholders an equal opportunity to tender shares and forces equal treatment of all at the same price
o
This requirement also forces the acquisitor into disclosing intentions publicly before moving to full voting control of the firm
3.
50.1% Control
o
Shareholder controls voting decisions under normal voting (simple majority), meeting
is held, and 5% ownership is required to attend the meeting
o
Can also change the membership of the BOD
4.
66.7% Amalgamation
o
Can approve amalgamation proposals requiring a 2/3 majority vote (supermajority)
5.
90% Minority Squeeze-Out
o
Once the shareholder owns 90% or more of the outstanding stock minority shareholders can be forced to tender their shares and sell them at the takeover price
o
This provision prevents minority shareholders from frustrating the will of the majority
The Takeover Bid Process
Moving Beyond the 20% Threshold
●
After buying 20% of the company's shares, buying any more shares requires a takeover bid, which is an offer to purchase outstanding voting shares that, together with the offeror's shares, equal 50% or more of the target's shares
●
A takeover circular (similar to a prospectus) describing the bid, financing, and all relevant info must be sent to all shareholders for review
●
Target has 15 days to circulate letter to shareholders with the recommendation of the board of directors to accept/reject
●
Bid must be open for 35 days following public announcement
●
Shareholders tender to the offer by signing authorizations
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o
Tender: to sign an authorization accepting a takeover bid made to target company shareholders
●
A competing bid automatically increases the takeover window by 10 days and shareholders during this time can withdraw authorization and accept the competing offer
●
Takeover bid does not have to be for 100% of the shares
o
If 80% of shares are tendered and 60% of shares are bought, then everyone who has tendered gets to sell 75% (60/80 = 0.75) of the shares tendered
o
While the tender offer is outstanding, the acquirer can buy another 5% of shares through the facilities of the stock exchange as long as it announces that it intends to do so
●
Tender offer price cannot be for less than the average price that the acquirer bought shares in the previous 90 days (prohibits coercive bids)
o
Tender offer is usually higher than current stock price to encourage the company to sell
●
If more shares are tendered than required under the tender, everyone who tendered shares will get a prorates number purchased
●
These rules are made to ensure that the acquirer treats all the shareholders fairly and everyone gets the same price
o
Otherwise, there is an economic incentive to lock up shares early at a high price, so that an acquirer has control and can then offer a lower price, knowing that no one else can mount a competing bid
o
In this way, different classes of shareholders are treated differently, and the shares are sold below their true value
●
All takeovers abide to this rule unless they are exempt from the Ontario Securities Act for one of the following reasons
o
When there is limited involvement by shareholders in Ontario
o
When securities legislation is concerned with the involvement of the public (so takeovers of private firms are exempt)
o
An acquirer can also buyer share from fewer than 5 shareholders as long as the premium over the market price is not more than 15%
o
A normal tender offer can be made through a stock exchange as long as no more than 5% of the shares are purchased through the exchange over a one-year period
▪
This 5% rule allows for creeping takeovers
, where a company acquires a target over a long period of time by slowly accumulating shares
Friendly Takeovers
●
Friendly acquisition: the acquisition of a target company that is willing to be taken over
o
Can start if the target voluntarily puts itself into play, which could occur when the founder is no longer actively involved in the business, and it is time for the firm to leave the controlling owner and be sold to other interests
●
Usually, the target will accommodate overtures and provide access to confidential information to facilitate the scoping and due diligence processes
The Friendly Takeover Process
1.
Normally starts when the target voluntarily puts itself into play
o
Target uses an investment bank to prepare an offering memorandum, which is a document describing a target company's important features to potential buyers, mainly so that its fair value can be estimated
▪
May set up a data room
, which is a place where a target company keeps confidential info about itself for serious potential buyers to consult, and use confidentiality agreements
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●
Both companies sign legal document promising that they will not share info they learn about one another when deciding if they should buy the shares or not
●
Objective of this agreement is to restrict access to important info to serious potential inquirers
●
The process of evaluating a target company by a potential buyer is called due diligence, and is an important part of the acquisition process
▪
If the acquirer then goes forward, it signs a letter of intent
, which sets out the terms of agreement of its acquisition, including legal terms (usually includes a no-shop clause and a termination or break fee)
●
No-shop clause says that if we will start talking about prices, shares, all that stuff, you as the company being purchased cannot go out and research and try to sell to another potential buyer, need to be loyal to the company interested in buying buyer
●
Break fee:
put in place after signing letter of intent, where company interested in buying is paid a fee if you decide to back out, often 2.5% of the value of the transaction
●
Meant to stop you from backing out as the seller
●
Meant to compensate buyer for all the time wasted by the company interested in buying you
●
If you back out because another company became interested rather than it being your own decision, it is kind of like sharing some of the profit you made from the other buyer with the initial buyer you backed away from
▪
Legal team checks documents
o
Once the final due diligence phase has been completed and everything has worked out to the satisfaction of the acquirer, the final sale agreement is reached and ratified, or agreed to, by both parties
▪
If the firm is public, the deal then goes to the shareholders for approval
2.
Can be initiated by a friendly overture by an acquisitor seeking information that will assist in the valuation process
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Structuring the Acquisition
●
In friendly takeovers, both parties have the opportunity structure the deal to their mutual satisfaction including:
1.
Taxation issue
o
When an acquirer uses cash to purchase a company, that cash is always taxable in the hands of the target company shareholders
o
If the share price has run up significantly, this could mean the shareholders must pay capital gains tax on the appreciation in the value of their shares
o
On the other hand, a share swap is usually non-taxable, which is why in many smaller acquisitions, the target company's shares are swapped for preferred shares in the acquiring company
2.
Asset purchases rather share than share purchases
o
When a company is buying to get another company's assets (e.g. technology, equipment), rather than the actual corporation
o
Can't do this with hostile takeover
o
Asset purchase: a purchase of the firm's assets rather than the firm itself
▪
In this case, the target firm receives the proceeds from the sale and uses these
proceeds to pay off its debts
▪
The target firm then has the option of either reinventing itself or liquidating itself
and paying out the proceeds to the firm's shareholders
2.
Earn outs
where there is an agreement for an initial purchase price with conditional later payments depending on the performance of the target after acquisition
o
If your business profits greatly after the buy, the company gets a piece of the profit
o
Earn outs are used to bridge the valuation gap when the acquisition is small
▪
Often the targets manager's/founders are optimistic about the future prospects of the firm and value it based on a scenario in which everything goes right, but in contrast, the acquirer may have experience with acquisition that didn't go so well and may approach this one with caution
●
An earn out mitigates this issue, because it allows the acquirer to pay an upfront price and then make future payments conditional on the performance of the target after it has been acquired (these future sales are usually based on divisional sales or other reasonably objective date that both parties agree on)
o
Some legal experts tell their clients to not sign a letter of intent, because this is essentially a preliminary sale agreement and the acquirer could be held liable if it backs out of the deal
Hostile Takeovers
●
Hostile takeover: when the target has no desire to be acquired, actively rebuffs the acquirer, and refuses to provide any confidential info
●
When a company buys another company simply by taking over their shares, not much negotiation because company B doesn't want to sell
●
Target has no desire to be acquired and actively rebuffs the acquirer and refuses to provide any confidential info
●
The acquirer usually has already accumulated an interest in the target (20% of the outstanding shares) and this preemptive investment indicates the strength of resolve of the
acquirer
The Typical Process
1.
Slowly acquire a toehold by open market purchase of shares at market prices without attracting attention
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2.
File statement with OSC at the 10% early warning stage while not trying to attract too much attention
3.
Accumulate 20% of the outstanding shares through open market purchase over a longer period of time
4.
Make a tender offer
, a public offer in which the acquiring firm offers to purchase shares of
the target firm from its existing shareholders, to bring ownership percentage to the desired level (either the control (50.1%) or amalgamation level (67%))
●
This offer contains a provision that it will be made only if a certain minimum percentage of the outstanding votes is obtained
●
The advantage of this approach to the bidder is that a formal vote by the target shareholders is not required, since they merely decide on their own whether or not they want to sell their shares to the acquiring firm
●
During this process the acquirer will try to monitor management/board reaction and fight attempts by them to put into effect shareholder rights plans or to launch other defensive tactics
Capital Market Reactions and Other Dynamics
●
When a hostile tender offer is launched, external parties always look for certain market clues to indicate the potential outcome of a hostile takeover attempt:
1.
Market price jumps above the offer price
●
A competing offer is likely or if the bid price is too low
●
The bidder will have to increase the offer price
2.
Market price stays close to the offer price
●
The offer price is fair and the deal will likely go through
3.
Little trading in the shares
●
A bad sign for the acquirer because shareholders are reluctant to sell
4.
Great deal of trading in the shares
●
In contrast to the previous case, a large amount of trading indicates that shares are cycling from regular investors into the hands of specialists called arbitrageurs/arbs, who are specialists who predict what will happen in takeovers and buy and sell shares in target companies (with the possibility of earning a premium)
▪
This is good for the acquirer, since arbs are only interested in selling as long as the price is right, arbs don't have any ulterior motives other than making money ▪
However, arbs buy the shares after the announcement, so they pay a premium and then expect to get a bigger premium when they sell, their motivation is to extract the highest possible price
●
Large numbers of shares being sold from normal investors to arbitrageurs (arbs) who are themselves building a position to negotiate an even bigger premium for themselves by coordinating a response to the tender offer
Hedge funds: professionally managed funds with managers who are experts in securities law and tactics designed to get the highest price for their shares
Defensive Tactics Against Takeovers
●
Shareholders Rights Plan: a plan by a targeting company that allows its shareholders to buy 50% more shares at a discounted price in the event of a takeover, which makes the target company less attractive
●
Known as a poison pill or deal killer
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●
Can take different form
s but often gives non-acquiring shareholders the right to buy
50% more shares at a discount price in the event of a takeover
▪
Makes acquisition more expensive, and if everything else is constant, forces the acquirer to negotiate with the target company and make a friendly offer, since the BOD can then remove the poison pill through a vote
●
Acquirer can go to the Canadian securities commission to try and get the poison pill nullified, which is when the securities commission looks at 3 basic criteria:
▪
Is there a likelihood of another offer
▪
Can the offer be withdrawn
▪
Are the shareholders lobbying for the removal of the poison pill
●
In Canada, poison pills can be used only as a delaying tactic, they cannot be used to
frustrate a bid the way they are in the U.S
●
Selling the Crown Jewels: the sale of a target company's key assets, which the acquiring
company is most interested in, to make the target company less attractive for takeover
●
Can involve a large dividend to remove excess cash from the target's balance sheet
●
E.g. giving your tech. that Google wants to their competitor, so the reason they wanted you is now with someone else too
●
White Knight: an entity that rescues a target company from a hostile takeover by making a counter bid
●
The target seeks out another acquirer considered friendly to make counter offer and thereby rescue the target from a hostile takeover
●
Try to get other people to buy your shares, who they are more willing to negotiate with
Classifications of Mergers and Acquisitions
●
3 broad classifications:
●
Horizontal merger: a merger in which two firms in the same industry combine
●
Removing a competitor is often a motive for an acquisition
●
Vertical merger: a merger in which one firm acquires a supplier or another firm that is closer to its existing customers
Vertical Integration Strategies
●
Vertical integration extends a firm's competitive scope within same industry
●
Backward into sources of supply
●
Forward toward end-users of final product
●
Can aim at either full or partial integration
●
Conglomerate merger: a merger in which two firms in unrelated businesses combine
●
Motivation to create this is that the different businesses face different risks, which tend to cancel each other out, lowering the overall risk of the combined company
Cross-border (international) M&A: a merger or acquisition involving a Canadian and a foreign
firm as either the acquiring or target company
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Unrelated Diversification
●
Favors capitalizing on a portfolio of businesses that are capable of delivering excellent financial performance
●
Entails hunting to acquire companies:
o
Whose assets are undervalued
o
That are financially distressed
o
With high growth potential but are short on investment capital
Motivations for M&A's
●
Creation of Synergy Motive for M&As
●
The primary source of motive should be creation of a synergy
o
Synergy value is created from economies of integrating a target and acquiring a company; the amount by which the value of the combined firm exceeds the sum value of the two individual firms
●
1 + 1 = 3
●
Most M&A announcements go to great lengths to describe the synergies, or total positive gains, associated with the proposed transaction
Operating Synergies
1.
Economies of Scale
o
Make more of the same product with the same assets
o
Can lead to reducing capacity in an overpopulated industry
●
Known as over-capacity M&A: a merger or acquisition that occurs when an industry has too many firms operating in it
o
Focuses on spreading fixed costs
●
By increasing the company's size, these costs are spread over greater volumes, and the firm is more efficient
o
Geographical synergies
●
Often an industry is fragmented and ripe for consolidation
●
Geographic roll-up: occurs when a national firm is created out of a series of regional firms
2.
Economies of Scope
o
Making similar products with the same assets
o
When the combination of two activities reduces costs, such economies typically result when two products share similarities in their production process, which can be exploited
3.
Complementary Strengths
o
Buy a business that does something well that we do poorly
o
Extension M&A: a merger or acquisition that extends a firm's expertise
o
E.g. many mineral finds have been made by small firms consisting of a few geologists, but after a deposit is found, they sell the company to the major international companies that have the skills and resources to develop it
●
Sometimes, the exploration and development functions, as opposed to the R&D functions are best carried out by separate entities
Value Creation Motivations for M&A
●
Efficiency increases
o
Efficiency gains materialize whenever one or both of the firms involved have excess capacity, meaning they possess factors that are currently being underused
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●
This is a common motivation for merges, and unfortunately for employees, some of the synergy that arises involves the elimination of jobs
o
New management team will be more efficient and add more value than that the target now has
o
The combined firm can make use of unused production/sales/marketing channel capacity
●
Financing Synergy
o
Reduced cash flow variability - seasonality
●
Cash flow volatility tends to be lower for larger entities, especially if the cash flows from the two underlying businesses are not highly correlated, which may enable the company to reduce its need for external financing, since future financing needs can be forecast with greater certainty
o
Increase in debt capacity - buy a company to borrow money
●
Debt capacity may rise due to the increase in size and/or reduction in cash flow
volatility of the new company
●
Smaller and riskier firms generally cannot carry as much debt as large firms, and the use of additional debt provides the firm with greater tax savings
o
Reduction in average issuing costs - stock market
●
Since most security issues occur in large increments, the average cost of floating new debt or equity will decrease as the firm issues larger amounts
●
Larger firms can access more sources of capital than smaller ones, resulting in cost savings
o
Fewer information problems - large firms attract more external security analysts and have greater exposure in the media, attracting big institutional investors, which may lower the
ir financing costs
●
Tax Benefits
o
Make use of tax deductions and credits which are available by putting the companies
together
o
If a weak firm combines with a profitable firm in the same industry, these losses can be used to offset the other firm's profits to reduce taxes
o
Benefits may also arise due to the depreciation of capital assets that can be claimed by the combined entity, and the increased use of debt financing with more interest tax shields
o
Tax benefits can also provide an incentive for M&A activity across different tax jurisdictions
●
Strategic Realignments
o
Permits new strategies that were not feasible prior to the acquisitions
o
The acquisition of new management skills, connections to markets or people, and new products/services
Managerial Motivations for M&As
●
Managers have their own motivations to pursue M&As
o
Increased firm size
▪
More highly rewarded financially for building a bigger business
▪
Many associate power and prestige with the size of the firm, but this can sometimes cause issues when two managers are being indecisive (
textbook example)
o
Reduced firm risk through diversification
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▪
Managers have an undiversified stake in the business and so they tend to dislike risk
▪
M&As can be used to diversify the company and reduce risk that might concern
managers, done geographically, across industries, or in its product mix, through conglomerate mergers
▪
Evidence suggests that diversification is generally a poor motive for a merger, often resulting in additional managerial complications and a lack of focus by managers running disparate businesses
●
Investors tend to pay a premium for "pure play" companies that are focused on one strategic plan
Gains Resulting from Mergers
●
Evidence suggests tha
t target firm shareholders gain the most
, with premiums over the
prior stock market price in the 15-20% range for stock-financed takeovers, and from 25-
30% for cash-financed takeovers
●
Takeover gains to the target can be even higher, especially if bidding wars develop, and they tend to be higher still when the deals are 100% cash, since the target shareholders usually have to pay capital gains tax
●
In contrast, the acquiring firm's shareholders, on average, see no change in their stock price, which sometimes even dips (indicating that acquiring firms may pay too much for target firms, a
cquire them for the wrong reason, and/or overestimate the benefits resulting from the merger)
●
Studies indicate that there are usually no synergistic gains to the acquirer, which are the supposed rational for mergers, and little to no increase in value
●
Acquirers are freer with their shares than they are with their cash, financing with shares is probably better in case you lose
●
In acquisitions involving cash as a medium of exchange, the acquisition resulted in a shift of wealth from the acquiring shareholders to the target shareholders, value was not created, it was merely shifted
●
In the case of the exchange of shares, researchers observed synergistic gains only in non-
competitive markets
●
Shareholder value at risk: illustrates that when using cash, the acquirer bears all the risk,
whereas when using share swaps, the risk is borne by the shareholders in both companies
o
If there's a market crash, both parties lose, rather than just the party who invested so
much money into the acquisition
o
SVAR supports the argument that when firms make deals using cash, they are a lot more careful about the acquisition price than when they use their shares
▪
One reason for this is that the managers have less interest in the financing of the deal than in getting it done in the first place, unless their cash is involved
The Concept of Fair Market Value
●
Value is simply a willingness to sell or buy, also considering supply and demand curves
●
The price is the value at which the deal is completed
●
For a companies, while the shares may trade between many buyers and sellers, there is a limited market for the company as a whole, so we are dealing with only a few points on the
supply and demand curve
o
This naturally leads to a wide range of possible deal prices
●
If two parties can come to an agreement, the transaction price can be anywhere between the two prices on the supply and demand curves which represent both what the company's value actually is and what the buyer values the company at
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International Financial Management pg. 299-304
Globalization of the World Economy
●
Globalization: the removal of barriers to free trade and the closer integration of national economies
o
Also called deregulation
●
Large companies often generate more than half of their revenue in countries other than the one in which they are based
●
Consumers in many countries buy goods that are purchased from a number of countries other than just their own
●
The production of goods and services has also become highly globalized
o
Firms seek to purchase components and locate production where costs are lower to generate higher margins
●
The financial system has also become highly integrated
o
Mainly due to Asian and Western nations deregulating their foreign exchange markets, money and capital markets, and banking systems
●
Multinational corporation: a business firm that operates in more than one country but is headquartered or based in its home country
o
Owned by a mixture of domestic and foreign stockholders
o
These corporations engage in traditional lines of business such as manufacturing, mining, oil, etc.
o
May purchase raw materials from one country, obtain financing from a capital market
in another country, produced finished goods, sell finished goods in other countries, etc.
●
Transnational corporations: a multinational firm that has widely dispersed ownership and that is managed from a global perspective
o
Managed from a global perspective rather than the perspective of a firm residing in a particular country, regardless of the location of their headquarters
o
Viewed as stateless corporations
, with no allegiance or social responsibility to any nation or region of the world
Factors Affecting International Financial Management
●
6 factors affect international business
1.
The uncertainty of future exchange rate movements
o
Foreign exchange rate risk/exchange rate risk: the uncertainty associated with future currency exchange rate movements
2.
Differences in legal systems and tax codes
o
Legal systems can vary on simple matters like the requirements for opening a business, selecting a site location, hiring employees, taxation of companies and dividends, right and legal liabilities of ownership, and the resolution of business conflicts
o
Thus, legal and tax differences can affect financial decisions on what assets to
acquire, how to organize the firm, and what capital structure to use
3.
Language differences:
While English is the official business language, it is not the world's social language
Two important levels of communication in international business: Business communication and social communication o
Need to know the countries language for social interactions, and sometimes even business interactions
4.
Cultural views
also shape business practices and people's attitudes toward business
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o
Due to larger size of British Empire historically
o
Cultural views shape business practices and people's attitudes toward business
▪
E.g. willingness to assume risk, management style, tolerance for inflation, attitude toward race, gender, and business failure
5.
Differences in economic systems:
An economic system determines how a country mobilizes its resources to produce goods and services needed by society, as well as how the production is distributed
o
In a centrally planned economy
, resources are allocated, produced, and distributed
under the direction of the central government, like in the former Soviet Union
▪
There are no financial markets or banking systems to allocate capital flows
▪
Central govt's set interest rates and foreign exchange rates, and financial managers need not worry about capital budgeting decisions because capital resources are allocated centrally
o
In market economies
, resources are allocated, produced, and distributed by market forces rather than government decree
▪
These economies have proven to be much more efficient in producing goods and services than traditional centrally planned economies
6.
Differences in country risk
refers to political uncertainty associated with a particular country
o
At the extreme, a country's government may even expropriate business's assets within the country, meaning they will take over the assets
▪
These types of actions can affect a firm's cash flows and thus, the value of the firm
o
Other actions include change in tax laws, restrictive labor laws, local ownership, tariffs and quotas, disallow any cash from subsidiary to parent
o
These types of actions clearly can affect a firm's cash flows
o
Country risk: the political uncertainty associated with a particular country
Goals of International Finance Management
●
Stockholder value maximization is the accepted goal for firms in Canada, the UK and the USA
●
In Continental Europe, for example, countries such as France and Germany focus on maximizing corporate wealth
●
The European manager's goal is to earn as much wealth as possible for the firm while considering the overall welfare of all stakeholders
Country Differences
●
In Japan, companies form tightly knit interlocking business groups and the goal of the Japanese business manager is to increase the wealth and growth of the group (group is called keiretsu
)
o
As a result, they might focus on maximizing market share rather than stockholder wealth
●
In China, which is moving from a command or central economy to a market-based economy, there are sharp differences between state-owned companies and emerging private-sector firms
o
The large state-owned companies have an overall goal that can best be described as
maintaining full employment in the economy while the new private-sector firms fully embrace the Western standard of stockholder value maximization
●
In European countries, the goal is to maximize corporate wealth
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o
This means that stockholders are treated the same as stakeholders, such as management, labour, suppliers, creditors, and even the government, everyone's welfare is being considered while trying to create as much wealth as possible
Basic Principles
●
3 basic principles of managerial finance remain the same whether a transaction is domestic or international
●
The time value of money is not affected by whether a business transaction is domestic or international (a dollar today is still worth more than a dollar tomorrow)
●
The same models are used for valuing capital assets, bonds, stocks, and entire firms
●
But some input variables change when making financial calculations, such as required rates of return, which differ across countries
o
Cash flows may be stated in terms of home or foreign currency
●
Tax codes and accounting standards differ across countries as well
●
REFER TO CHART ON LAST PAGE TO SEE DOMESTIC VS INTERNATIONAL DIFFERENCES
Foreign Exchange Market: group of international markets connected electronically where currencies are bought and sold in wholesale accounts
●
Factors that affect currency exchange rates
o
Supply and demand relationships
o
Relative inflation rate
o
Relative interest rate
o
Other factors (political and economic risk)
●
The major participants in the foreign exchange markets are
o
Multinational commercial banks
o
Large investment banking firms
o
And small currency boutiques
●
Spot rate: the rate at which one agrees to buy or sell a currency today
●
Forward rate: the rate at which one agrees to buy or sell a currency on some future date
o
This is established at the date on which the agreement is made and defines the exchange rate to be used when the transaction is completed in the future
●
By contracting now to buy or sell foreign currencies at some future date, can lock in the cost of foreign exchange and do not have to worry about the risk of an unfavourable movement in the exchange rate in the future
o
Companies can use forward transactions to lock in (hedge) the cost of foreign exchange
o
Bid-Ask Spread= Ask rate- Bid rate/ Ask rate o
Forward premium(discount) = Forward rate-Spot Rate/Spot Rate x 360/n x 100
●
N is the number of days in the forward agreement
Currency Exchange Rate: value of one currency relative to another currency
Direction Quotation Method: indicates the amount of a home country's currency (CAD)needed
to purchase one unit of a foreign currency
●
You need 1.34 CAD to buy 1 USD
Indirect Quotation Method: indicates the amount of a foreign currency needed to purchase one unit of the home country's currency
●
You need 0.74 USD to buy 1 CAD
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International Capital Budgeting
●
Capital budgeting:
determining what we as a business invest our money in
●
When a multinational firm wants to consider overseas capital projects, the financial manager faces the decision of which capital projects should be accepted on a company-
wide basis
●
The decision to accept projects with a positive Net Present Value increases the value of the firm and is consistent with the fundamental goal of financial management, which is to maximize stockholder wealth
Determining Cash Flows
●
Several issues complicate the determination of cash flows from overseas capital projects
●
Companies find it more difficult to estimate the incremental cash flows for foreign projects
●
Problems with cash flows can arise when foreign governments restrict the amount of cash that can be repatriated, or returned, to the parent company
Exchange Rate Risk
●
Financial managers must deal with foreign exchange rate risk on international capital investments
●
To convert the project's future cash flows into another currency, we need to come up with projected or forecast exchange rates
●
One of the problems with obtaining currency rate forecasts for use in analysis of capital projects is that many projects have lives of 20 years or more
●
One way for a company to deal with this issue is to increase their discount rate (based on W.A.C.C) from previous lecture, higher risk means higher reward, change the interest rate on the investment (discount rate)
Derivatives - pg. 247-258
Derivative: electronic piece of paper that derives value from the right that it gives you
●
Contracts between 2 parties (buyer and seller) that have a price and that trade in specific markets
●
Compared to a stock or real estate, derivatives are fleeting and generally have a short life span
●
A small change in an asset's underlying life usually means a much larger change in its derivative's value
Financial derivative securities: derive all or part of their value from another (underlying) security
●
Why trade these indirect claims?
o
Expand investment opportunities
o
Lower cost
o
Increase leverage
o
Gives you as an investor another way to try and make money
▪
You can use derivatives to reduce your risk, called hedging, or you can use derivatives to gamble
●
Equity-derivative securities: securities that derive their value in whole or in part by having a claim on the underlying common stock
o
Gains or losses will depend on the difference between the purchase price and the sales price
●
As derivative securities, options are innovations in risk management, not in risk itself
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Hedging: done to protect you when you own shares and you're worried about the price going down
●
If your share today is worth $250 and you think the stock will be worth $100 in a couple years, you can buy a put option, pay premium, and then be able to legally sell it someone at a set price by a given date
Stock option: gives holder the option or right, but not the obligation, to exercise that right or option
Options: claims that give the holder the right, but not the obligation, to buy or sell a stated number of shares of stock within a specified period at a specified price
●
Created by investors, sold to other investors
●
The corporation whose common stock underlies these claims has not direct interest in the transaction, being in no way responsible for creating, terminating, or executing pull and call contracts
●
2 main types of stock options:
●
Call: an option that gives the holder the right, but not the obligation, to buy a specified number of shares of stock at a stated price within a specified period
o
Buyer has the right, but not the obligation, to purchase a fixed quantity from the seller
at a fixed price up to a certain date
●
Put: an option that gives the holder the right, but not the obligation, to sell a specified number of shares of stock at a stated price within a specified period
o
Buyer has the right, but not the obligation, to sell a fixed quantity to the seller at a fixed price of particular stock up to a certain expiration date
o
If exercised, the share are sold by the owner (buyer) of the put contract to a writer (seller) of the contract, who has been designated to take delivery of the shares and pay the specified price
o
Investors purchase puts if they expect the stock price to fall, because the value of the put will rise as the stock price declines
●
Call means buy, put means sell
●
One person creates and sells the option and is called the writer
●
One person gets the option and pays for it and is called the buyer
●
Buying of option and buying of stock are two separate transactions
●
Once legal right has been given through an option, the writer is obligated to provide the share to the buyer once they demand it, since the option has already been sold
Why Options Market?
●
Puts and calls expand the opportunity set available to investors, making available risk-
return combinations that otherwise would be impossible or that improve the risk-return characteristics of a portfolio
o
E.g. an investor can sell a stock short and buy a call, which decreases the risk on the
short sale for the life of the call since the investor has a guaranteed max purchase price until the call option expires
●
In the case of calls, an investor can control (for a short period) a claim on the underlying common stock for a much smaller investment than required to buy the stock itself
●
In the case of puts, an investor can duplicate a short sale without a margin account and at a modest cost in relation to the value of the stock
●
The option buyer's max loss is known in advance, if an option expires worthless, the most the buyer can lose is the cost (price) of the option
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●
Options provide leverage by magnifying the percentage gains in relation to buying or short selling the underlying stock
o
Options can provide greater leverage potential than fully margined stock transactions
●
Using options on a market index such as the S&P/TSX 60 Index allows an investor to participate in market movements with a single trading decision
Option Terminology
●
Exercise (Strike) price: the per-share price at which the common stock may be purchased from or sold to a writer
o
As the stock price changes, options with new exercise prices are added
●
Expiration date: last date at which an option can be exercised
o
American:
allows you to exercise at any point you want up until expiration
o
European:
you can choose to exercise the option only on the very last day
o
Bermudan:
allows you to exercise the option on certain days during the period of life
on every Friday, for example
o
Difference between these types of options is expiration date
●
Option premium: the price paid by the option buyer to the writer of the option, whether put or call
o
The premium is stated on a per-share basis for option on organized exchanges
o
Since the standard contract is for 100 shares, a $3 premium represents a cost per contract of $300
●
Long-term options (LEAPs): options on individual stocks with maturities greater than one
year and ranging to 2 years and beyond
How Options Work
●
Both puts and calls are created by sellers who write a particular contract
●
Sellers (writers) are investors, either individuals or institutions, who seek to profit from their
beliefs about the underlying stock's likely price performance, just as the buyer does
●
The buyer and the seller have opposite expectations about the likely performance of the underlying stock and therefore the performance of the option
●
Call buyer expects the price of the underlying security to increase
●
Call seller expects the price of the underlying security to decrease or stay the same
●
Put buyer expects the price of the underlying security to decrease
●
Put seller (writer) expects the price of the underlying security to increase or stay the
same
●
Possible courses of action
o
Options may expire worthless, be exercised, or be sold prior to expiry
●
READ EXAMPLE ON PAGE 254 TO REFRESH
Example: Call Options
●
Writer sells a call option for $1.00 to you to purchase 1,000 shares at $10.00
●
You must expect shares to increase, writer expects shares to decrease
●
If shares increase to$15.00 you will exercise option - buy shares at $10.00 and sell for $15.00 (you earned $4.00 profit on option contract)
●
If shares decrease to below $10.00, you will not exercise - seller gets the $1.00
Example - Put Options
●
Writer sells a put option for $1.00 to you to sell 1,000 shares at $10.00
●
You must expect shares to decrease, writer expects shares to increase
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●
If shares decrease to $5.00, you will exercise option - buy shares at $5.00 and sell for $10.00 (you earned $4.00 profit on option contract),YOU SELL THEM TO THE SELLER/WRITER OF THE OPTION
●
If shares rise over $10.00 you will not exercise - seller gets the $1.00
Options Trading
●
Options Exchanges
o
Montreal Exchange (ME)
o
Chicago Board Options Exchange (CBOE)
●
Standardized exercise dates, exercise prices, and quantities
o
Facilitate offsetting positions through a clearing corporation
▪
Clearing corporation is guarantor, handles deliveries
●
Like an insurance company: gets a fee from every option trade and uses the money it makes to help buyers if sellers try to default on options
●
Most exchange-listed options are American style
●
Index options and over-the-counter (OTC) options are typically European, meaning they can only be exercised on the expiration date
●
The options markets provide liquidity to investors, which is a very important requirement for successful trading
●
Investors know that they can instruct their broker to buy or sell whenever they desire at a price set by the forces of supply and demand
●
Liquidity problems, which often plague the OTC options markets, are overcome by
o
Offering standardized option contracts
o
Having all transactions guaranteed by a clearing corporation, which effectively becomes the buyer and seller for each option contract
●
Certificates representing ownership are not used for puts and calls, instead, transactions are handled as bookkeeping entries
●
Option trades settle the next business day after the trade, the exercise of an equity option settles in 3 business days, the same as with a stock transaction
●
An investor must receive a risk disclosure statement issued by the clearing corporation before the initial order is executed
●
Largest options trade exchange is CBOE
●
Stock-index options are "cash-settled" based on 100 times the value of the index at the expiration date
●
Bond options trade on the ME on Government of Canada bonds, while US dollar options are available on the ME, and other currency options are available in U.S. markets
Thin trading: when there is little trading activity in a market because of a lack of buy or sell orders to drive up the volume
The Clearing Corporation
●
Canadian Derivatives Clearing Corporation (CDCC): the clearing corporation that issues and guarantees all equity, bond, and stock index positions on options exchanges in Canada (which is owned by the ME)
●
A corporation separate from, but associated with, each exchange
●
Exercising on options trading on exchanges is accomplished by submitting an exercise notice to be the clearing corporation
●
The clearing corporation then assigns the exercise notice to a member firm, which then assigns it to one of its accounts
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●
Clearing corps function as the intermediaries between the brokers representing the buyers
and the writers
o
Exchange members must be members or pay a member for these services
o
Once the buyers and sellers negotiate the price on the floor of the exchange, they no
long deal with each other, they settle with the clearing corporation
●
Help facilitate an orderly market
●
Keeps track of obligations
●
Through their brokers, call writers contract with the CDCC itself to deliver shares of the particular stock, and buyers of calls actually receive the right to purchase the shares from the CDCC
o
Thus, the CDCC becomes the buyer for every seller and the seller for every buyer, guaranteeing that all contract obligations be met
o
This prevents the risk and problems that could occur as buyers attempted to force writers to honour their obligations
o
Net position of the CDCC is zero, because contracts sold = contracts bought
●
Investors who want to exercise their options inform their brokers, who in turn inform the CDCC of the exercise notice
o
The CDCC randomly selects a broker who holds the same written contract, and the broker randomly selects a customer who has written these options to honour the contract
o
Once assigned, the writer cannot execute an offsetting transaction to eliminate
the obligation, meaning a call writer who receives an assignment must sell the underlying securities, and a put writer must purchase them
●
Since the CDCC maintains all the positions for both buyers and sellers, it can cancel out the obligations of both call and put writers wishing to terminate their position
o
E.g. a call writer can terminate the obligation to deliver the stock any time before the expiration date or assignment by making a "closing purchase transaction" at the current market price of the option o
The CDCC offsets the call written with the call purchased in the closing transaction
●
Margin: the collateral that option writers provide their brokers to ensure fulfillment of the contract in case of exercise, with regards to puts and calls
o
This collateral is required by the CDCC of its member firms whose clients have written options, in order to protect the CDCC against default by option writers
o
This collateral can be in the form of cash or marketable securities (including shares in the underlying security)
o
Options cannot be purchased on margin, and buyers must pay 100% of the purchase
price
Options Characteristics
●
In-the-money options have a positive cash flow if exercised immediately
o
When the price of the common stock exceeds the exercise price of a call, it has an immediate exercisable vale
o
Call options: stock price ($) > exercise price ( E )
o
Put options: S < E
●
Out-of-the-money
options should not be exercised immediately
o
When the price of the common is less than the exercise price of a call
o
Call options: S < E
o
Put options: S > E
●
At the money options/calls are those with exercise prices equal to the stock price
o
If S = E, an option is at the money
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●
Near the money options are those with exercise prices slightly greater than the current market price
Covered call: when you sell options for stocks that you already own
Naked call: when you sell options for stocks that you don't already own
Factors Affecting Prices
●
Stock price:
the value of the current stock price
●
Exercise price:
the value of the selling price that can be exercised
●
Time to maturity:
the time remaining till the expiration of the option
o
As you get closer to the expiration date, the value of the option will keep going
down
●
Stock volatility:
how rapidly does the stock price change, more volatility is good because the more it swings, the more likely it can go up within the expiration period
o
The more volatile the stock, the higher the option cost
●
Interest rates:
Google this********
●
Cash dividend:
when a stock pays a dividend, on the X dividend day, the stock price goes down by the amount of the dividend
o
As soon as the dividend is paid, the price goes down which is not good for call options, but is good for put options, good for put options because you can sell the option to the writer on that day for more than it is worth
Rights and Warrants
●
Right: to purchase a stated number of common shares at a specified price with a specified time
(often a few months
)
o
Issues by the corporation
o
Are transferrable, you can sell your right to somebody else, person you sell it to does
not also have to be a shareholder
o
Option to purchase shares a price often lower than the market price
o
Issued to current shareholders on pro rata basis
●
Corporations issue rights because they want to raise more money, it's easier to go to existing shareholders and try to sell to them (e.g. with discounts), in comparison to doing a seasoned offer
●
Warrant: to purchase a stated number of common shares at a specified price with a specified time (often several years
)
o
Often attached to debt or preferred shares as a sweetener
o
Are detachable
o
Not issued when company is trying to raise new money
o
Instead, they're given as bonds or preferred shares
●
You can use warrants to buy shares from the company at a discounted price
o
E.g. "This warrant will let you buy Bell Canada shares for $50 any time within the next 3 years"
▪
As soon as price goes higher than $50, you win
▪
Bell does this because they attach warrants to bonds and preferred shares that
people don't really want
▪
Or even if it is a good bond, warrants have values, so Bell can save money (bond at 5% interest vs bond at 4% interest with a warrant attached)
Futures - pg. 259-273
Future Markets: created to allow people to sell stocks for business purposes
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●
Futures allow investors to manage investment risk and to speculate in the equity, fixed-
income, and currency markets
Understanding Future Markets
●
Physical commodities and financial instruments are typically traded in cash markets
●
A cash contract calls for immediate delivery and is used by those who need a new commodity now (e.g. food processors)
●
There are 2 types of cash markets:
o
Spot or cash market: price refers to item available for immediate delivery
▪
What is the price if you negotiate and sell it right now (today's price)
o
Forward market: price refers to item available for delayed delivery
▪
Forward price, the price you negotiate with somebody for future delivery
▪
E.g. wheat farmer finds someone who wants to buy wheat, negotiates with company to buy wheat in September even though it is only April (they agree upon a forward price)
▪
Forward contract is a commitment today to transact in the future
●
Futures market: sets features (contract size, delivery date, and conditions of the items) for delivery
o
Basically organized and standardized foreign markets o
Only the price and number of contracts are left for futures traders to negotiate
o
You can buy and sell contracts to sell wheat, but you don't have to know the other person
o
E.g. if a farmer's farm grows 15,000 bushels of wheat and the only contract available
is for 10,000 bushels of wheat or 20,000 bushels of wheat, it is a drawback (contract sizes)
o
Serves a valuable economic purpose by allowing hedgers to shift price risk to speculators
o
The risk of price fluctuations is shifted from participants unwilling to assume such risk
to those who are
o
Also, because the price of a futures contract reflects current expectations about values at some future date, transactors can establish current prices against later transactions
●
An obligation to buy or sell a fixed amount of an asset on a specified future date at a price set today
●
Forward and future markets were developed to allow individuals to deal with the risks they face
Current Futures Markets
●
Futures contracts are currently traded on futures exchanges can be divided into 2 broad categories:
o
Commodities:
agricultural, metals, energy-related
o
Financials:
foreign currencies as well as debt and equity instruments
●
For each type of contract, such as corn or silver, different delivery dates are available
●
Futures on canola are by far the most active commodity futures that are traded in Canada
●
Financial futures contracts presently trade in Canada on the ME
o
ME trades contracts on bankers' acceptances, Government of Canada bonds, and equity-based futures contracts
●
Futures markets in Canada are very small and much less developed than those in the USA, both in terms of the variety of available products and trading volume
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●
Centre of commodity futures trading in North America is the Chicago Board of Trade (CBT)
Future Market Characteristics
●
Centralized marketplace allows investors to trade with each other
●
Performance is guaranteed by a clearinghouse
●
Commodities: agricultural, metals, and energy related
●
Financials: foreign currencies as well as debt and equity instruments
Futures contract: standardized, transferable agreement providing for the future exchange
of a particular asset between buyer and seller at a specified date for a specified amount, in a specific geographical area or of a financial instrument
●
The futures price at which this exchange will occur at contract maturity is determined today
●
The trading of futures contracts means only that commitments have been made by buyers and sellers, so buying and selling does not have the same meaning in futures transactions
as it does in stock and bond transactions
o
Although these commitments are binding because futures contracts are legal contracts, a buyer or seller can eliminate the commitment simply by taking an opposite position in the same commodity or financial instrument for the same futures month
The Structure of Futures Markets
Future Exchanges
●
Where future contracts are traded
o
Most contracts never get exercised
o
If you forget to cancel contract, they will fulfill it (e.g. 10,000 barrels of oil can end up on your loan)
●
Voluntary, nonprofit associations, typically unincorporated
●
Organized marketplaces where established rules govern conduct
o
Financed by membership dues and fees charged for services rendered
●
Members trade for self or for others
o
E.g. floor traders trade for their own accounts, whereas floor brokers often act as agents for others
o
Futures commission merchants (FCMs) act as agents for the general public, for which they receive commissions
●
The Clearing Corporation
o
Similar to options market, used in futures market to reduce default risk and to arrange deliveries as required
o
Also ensure that participants maintain margin deposits or earnest money, to ensure fulfillment of the contract
o
CDCC currently issues and clears futures and futures options contracts traded on the
ME
o
Buyers and sellers settle with the clearing house, not each other, and it is actually on
the other side of every transaction, and ensures that all payments are made as specified, standing ready to fulfill a contract if either buyer or seller defaults
o
Makes the futures market impersonal
o
Clearing house also allows participants to easily reverse a position before maturity because it keeps track of each participant's obligations
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The Mechanics of Trading
●
Through open-outcry, seller and buyer agree to take or make delivery on a future date at a
price agreed on today (like in the video)
●
The terms sell and buy can be better thought of as:
●
Short position (seller) commits a trader to deliver an item at contract maturity
o
Means that a contract that is not previously purchased is sold
o
For every futures contract, someone sells it short and holds it long
●
Long position (buyer) commits a trader to purchase an item at contract maturity
●
Like options, futures trading is a zero-sum game
●
Unlike an options contract which involves the right
to make or take delivery, a futures contract involves an obligation
to take or make delivery
●
However, future contracts can be settled by delivery or by offset
●
Offset: the liquidation of a futures position by an offsetting transaction, buyers sell their positions and sellers buy their positions prior to the settlement of the contract (delivery)
o
Thus, to eliminate a future market position, the investor simply does the reverse of what was done originally
o
Clearing house makes this easy to accomplish
●
With stocks, short-selling can be done only on an uptick, but futures have no such restriction
●
Stock positions, short or long, can literally be held forever
o
But futures positions must be closed out within a specified time, either by offsetting the position or by making or taking delivery
●
Brokerage commissions on commodities contracts are paid on the basis of a completed contract (both a purchase and a sale), rather than being charged for each
purchase and each sale, as in the case of stock
●
No certificates exist for futures contracts
●
Open interest increases when an investor goes long on a contract and is reduced when the contract is liquidated
Futures Margin: the good faith deposit (earnest money) made by the buyer or seller to ensure the completion of a contract
●
Good faith deposit made by both buyer and seller to ensure completion of the contract
o
Not an amount borrowed from broker
●
Not a down payment because ownership of the underlying item is not being transferred at the time of the transaction
●
Each clearing house sets its own requirements
o
Brokerage houses can require higher margin
●
The margin required for futures contracts, which is small in relation to the value of the contract itself, represents the equity of the transactor (either buyer or seller)
●
Initial margin usually less than 10% of contract value
●
Margin calls occur when price goes against investor's equity to fall below the maintenance margin level, requiring the transactor to deposit more cash or close account
●
Profit can be withdrawn from a futures account only if net equity rises above the initial margin requirement
o
All future contracts are marked-to-market
daily, which means that all profits and losses on a contract are credited and debited to each investor's account every trading day
o
Those contract holders with a profit can withdraw the gains, whereas those with a loss will receive a margin call when the equity falls below the specified variation margin
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▪
This process is call daily resettlement
, and the price uses is the contract's settlement price
●
Each contract has maintenance or variation margin level below which the investor's net equity cannot drop
o
Net equity is defined as the value of deposited funds plus the open profit or minus the open loss
o
If the market price of a futures contract moves adversely to the owner's position, the equity declines
●
Aggregate gains and losses through futures trading net to zero, meaning that the aggregate profits enjoyed by the winners must be equal to the aggregate losses suffered by the losers
o
This also means that the net exposure to changes in the commodity's price must be zero
●
READ EXAMPLE ON PAGE 268 IF NEEDED
Using Futures Contracts
●
Hedgers
o
At risk with a sport market asset and exposed to unexpected price changes
o
Buy or sell futures to offset their risk
▪
They actually deal in the commodity or financial instrument specified in the futures contract
o
By taking a position opposite to that of one already held, at a price set today, hedgers plan to reduce the risk of adverse price fluctuations, in order to hedge
the risk of unexpected price changes
▪
Used as a form of insurance
o
Willing to forgo some profit in order to reduce risk/have someone else assume a part of the risk
▪
Hedged return has smaller change of low return but also smaller change of high return
o
With futures, risk is reduced by having the gain in the futures positions offset the loss
on the cash position and vice versa
o
Unhedged position has a greater chance of a larger loss, but also a greater chance of a larger gain
o
Hedged position has a smaller chance of low return but also a smaller chance of a high return
o
Thus, hedging is used by investors who are uncertain of future price movements and
who are willing to protect themselves against adverse price movements at the expense of possible gains
How to Hedge with Futures
●
The key to any hedge is that a futures position is taken opposite to the position in the cash
market
●
A commodity or financial instrument held (in inventory) represents a long position because
these items could be sold in the cash market
●
But an investor who sells a futures contract has created a short position
●
There are two basic hedge positions
1.
The short (sell) hedge
▪
A cash market inventory holder must short the futures
▪
Like a means of protecting the value of the investors' portfolios
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▪
Since they are holding securities, they are long in the cash position and need to
protect themselves against a decline in prices
▪
Short hedge reduces or even eliminates the risk taken in a long position
2.
The long (buy) hedge
▪
An investor who current holds no cash inventory (no commodities or financial instruments) is short in the cash market, and to hedge with futures, requires a long position
▪
Someone who is not currently in the cash market but who plans to be in the future and wants to lock in current prices and yields until cash is available to make the investment can use a long hedge, which reduces the risk of a short position
●
Basis risk
o
The basis for financial futures often is defined as the difference between the cash price and the futures price of the item being hedged: Basis = Cash Price - Futures price
o
Basis must be zero on the maturity date of the contract
o
Basis risk is the risk that hedgers face as a result of unexpected changes in basis
o
The significance of basis risk to investors is that risk cannot be entirely eliminated, hedging a cash position will involve basis risk
●
Short hedge: a transaction involving the sale of futures (a short position) while holding the
asset (a long position)
●
Long hedge: a transaction where the asset is currently not held but futures are purchased
to lock in current prices
Speculating
●
In contrast to hedgers,
Speculators:
o
Buy or sell futures contracts in an attempt to earn a return
o
Absorb excess demand or supply generated by hedgers
o
Willing to assume the risk of price fluctuations that hedgers wish to avoid, hoping to profit from them
o
Speculation encouraged by leverage, ease of transacting, low costs
o
Typically do not transact in the physical commodity or financial instrument underlying
the futures contract, meaning they usually have no prior market position
●
Although most speculators are not actually present at the futures market, floor traders trade for their own accounts as well as the accounts of others and often take very short-
term positions in an attempt to exploit any short-lived market anomalies
●
Speculators contribute to the liquidity of the market and reduce the variability in prices over
time
●
Potential advantages of speculating in futures markets include:
o
Leverage: magnification of gains (and losses) can easily be 10 to 1
o
Ease of transacting: an investor who thinks interest rates will rise will have difficulty selling bonds short, but it is very easy to take a short position in a bond futures contract
o
Transaction costs: these are often significantly smaller in futures markets
●
An investor's likelihood of success when speculating in futures is not very good, and the small investor is up against stiff odds
Financial futures: futures contracts on financial assets such as equity indexes, fixed-income securities, and currencies
●
Give investors a greater opportunity to fin-tune the risk-return characteristics of their portfolios
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●
This flexibility has become increasingly important as interest rates have become much more volatile and as investors have sought new techniques to reduce the risk of equity positions
●
The drastic changes that have occurred in the financial markets in the last 15-20 years could be said to have generated a genuine need for new financial instruments that allow market participants to deal with these changes
Example
●
Farmer grows wheat, so he goes short, he currently owns the assets
●
Bread company needs wheat, so they go long
●
Enter deal to buy/deliver wheat in 6 months, 100,000 bushels at $10/bushel
o
This means there is a $1,000,000 constant
●
In 6 months, price will probably be higher than $10 or lower than $10, so either the farmer or the company won
●
Deal probably won’t go through, it's more to just set the price of the bread at $10
●
In order for contract to be valid, farmer sends $80,000 to Clearing House and company sends $80,000 to Clearing House
o
Clearing house keeps these amounts in each party's margin
o
Every time the spot price changes, money in the margins will exchange with one another
●
E.g. if the price of wheat goes up to $10.25, the farmer lost
o
So the $0.25 change times the 100,000 bushels goes from the farmer account to the company account ($25,000)
●
Now farmer has $55,000 and company has $105,000
●
After this, say the price of wheat drops to $9.75, the company loses
o
So the $0.50 change times the 100,000 bushels goes from the company account to the farmer account
●
Now the farmer has $105,000 and the company has $55,000
●
If this was the last day of the contract, the farmer made a profit of $25,000 and the company made a lost of $25,000
●
Company goes into the market to buy the wheat, maybe from someone other than that farmer
●
The price is $9.75 now, so 100,000 bushels is now $975,000
●
They write a cheque for $975,000, but they already lost the $25,000, so they lost a total of $1,000,000 (price is back to $10/bushel)
●
Farmer takes the $975,000 and adds the $25,000 made, which totals $1,000,000, once again adding up to a value of $10/bushel
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