CorporateFinance

Reading23
SunkCost:acostalreadyincurred.Youcannotchangeasunkcost.ThesecostsarenotrelevanttoNPVanalysis.
OpportunityCost:iswhataresourceisworthinitsnextbestuse.
IncrementalCashFlow:thecashflowthatisrealizedbecauseofadecision:thecashflowwithadecisionminus
thecashflowwithoutthatdecision.
Externality:Theeffectofaninvestmentonotherthingsbesidestheinvestmentitself.
Cannibalization:happenswhenaninvestmenttakescustomersandsalesawayfromanotherpartofthe
company.
ConventionalCashFlow:aninitialoutflowfollowedbyaseriesofinflows.
UnconventionalCashFlow:theinitialoutflowisnotfollowedbyinflowsonlybutthecashflowscanflip
frompositivetonegativeagain.ThemultipleIRRproblemhappenswithunconventionalCF.
Independentprojects:projectswhosecashflowsareindependentofeachother.
MutuallyExclusiveProjects:cashflowscompetedirectlywitheachother.
ProjectSequencing:Manyprojectsaresequencedthroughtime,sothatinvestinginaprojectcreatestheoptionto
investinfutureprojects.
UnlimitedFunds:environmentassumesthatthecompanycanraisethefundsitwantsforallprofitableprojects
simplybypayingtherequiredrateofreturn.
CapitalRationing:existswhenthecompanyhasafixedamountoffundstoinvest.
PaybackPeriod:numberofyearsrequiredtorecovertheoriginalinvestmentinaproject.
ProjectswithashorterperiodwontnecessarilyhaveapositiveNPV.
AverageAccountingRateofReturn(AAR)=averagenetincome/averagebookvalue
ProfitabilityIndex(PI)=PVoffuturecashflows/initialinvestment.Or1+NPV/initialinvestment.
Theinvestmentinnetworkingcapital(NWC)isthenetinvestmentinshorttermassetrequiredforthe
investment.Thisistheinvestmentinreceivablesandinventoryneeded,lesstheshorttermpayablesgeneratedby
theproject.
Outlay=FCinv+NWCinv
Outlay=FCinv+NWCinvSal0+T(Sal0B0);Sal0=salvagevalue,B0=bookvalue,T=taxrate
Annualaftertaxcashflow:CF=(SCD)(1T)+D,orCF=(SC)(1T)+TD;S=sales,C=cashoperating
(variableandfixed)costs,D=depreciationcharge
Terminalyearaftertaxnonoperatingcashflow:TNOCF=SalT+NWCinvT(SalTBT)
TaxsavingsduetoincreasedFCinv=increaseddepreciationxT
AccelerateddepreciationgenerallyimprovestheNPVofacapitalprojectcomparedtostraightlinedepreciation.
UseonlyincrementalCFwhenanalyzingCFforareplacementproject.
Financingcosts/interestcostsareNOTsubtractedoutofNPVandIRRcalculations.
Inflationreducesthevalueofthedepreciationtaxsavings.Ifinflationishigherthanexpected,theprofitabilityof
theinvestmentislowerthanexpected.Inflationessentiallyshiftswealthfromthetaxpayertothegov't.Higher
thanexpectedinflationshiftswealthfrombondholderstotheissuingcorporations.
AccelerateddepreciationshiftsCFfromlateryearstoearlieryears,increasingNPV.
Theanalysisofaonetimeinvestmentdiffersfromthatofaninvestmentchain(investmentthatisregularly
replacedinthefuture.)YouCANNOTuseNPVorIRRforinvestmentchains.Twowaystofixthis:
Leastcommonmultipleoflives:Theanalystextendthetimehorizonofanalysissothatthelossofboth
projectswilldivideexactlyintothehorizon.Forexample,ifoneprojectis2yearsandtheotherprojectis
threeyears,youwouldextendtheanalysistwo6years.
Equivalentannualannuityapproach(EAA):1)findtheprojectsNPV.2)calculateanannuitypmtthathas
thevalueequivalenttotheNPV.WhicheverhasthehigherEEAisbetter.NPV=PV,solveforPMT.
Bothoftheaboveapproacheswillresultinthesamedecision.
WhenaprojectismoreorlessriskythanthecompanysWACC,theWACCshouldNOTbeusedastheprojects
requiredrateofreturn.Ideally,itisbesttouseprojectspecificrequiredratesofreturn.
Realoptionsarecapitalbudgetingoptionsthatallowthemanagertomakedecisionsinthefuturethatalterthe
valueofcapitalbudgetinginvestmentdecisionsmadetoday.
AbandonmentOption:thecompanycanabandontheproject.Ifthecashflowsfromabandoningthe
projectexceedsthePVofthecashflowsfromcontinuingtheproject,youshouldabandonit.
GrowthOption:optiontoexpand.
1

PricesettingOption:abletochangethepriceofthegood/service.
ProductionFlexibilityOption:abletoworkovertimeoraddadditionalshifts.
ProjectedNPV=NPV(basedonDCFalone)costofoptions+valueofoptions
Ifcostofoption<valueofoption,thenthiswillincreasetheNPV.
ProjectedNPV=NPV(basedonDCFalone)NPVofoption
IRRissoundforindependentprojectswithconventionalcashflows.
Ifaprojectisbeingfinancedwithdebt(orwithequity),youshouldstillusetheprojectsrequiredrateofreturn,
notthecostofdebt(orequity).
EconomicIncome=CF(NPV0NPV1).Thesecondpartiscalledeconomicdepreciation.TopictestScott#1
Economicrateofreturnistheeconomicincome/beg.marketvalue.
Interestexpensesareignoredwhencomputingtheeconomicincome,thesecostsarecapturedinthe
discountrate.
EconomicProfit(EP)=NOPAT$WACC;NOPAT=netoperatingprofitaftertax,$WACC=WACCxcapital.
NOPAT=EBIT(1T)
MarketValueAdded(MVA):EPt/(1+WACC)t
ResidualIncome(RI)=Netincomeequitycharge;RIt=NItreBt1;thesecondpartistherequiredrateofreturn
onequityxbeg.BVofequity(ornetworth).
RIt/(1+re)t;Totalvalueofinvestment=NPVofRI+equityinvestment+debtinvestment
Thismethodtakestheperspectiveofequityinvestors.
Sensitivityanalysischangesonevariableatatime,scenarioanalysischangesseveralvariablesatatime.
WhencalculatingWACC,usemarketweights.

Reading24
ModiglianiandMiller(MM)Propositions:
PropositionI:themarketvalueofacompanyisnotaffectedbythecapitalstructureofthecompany.
VL=VU
Thispropositiondoesntchangethefactthatleverageincreasestheriskofequityholders.
PropositionII:thecostofequityisalinearfunctionofthecompany'sdebt/equityratio.
re=r0+(r0rd)(D/E)
r0=companyfinancedonlybyequity.
Costofequityincreasesastheamountofdebtincreases
Debtislessexpensivethanequitybecauseofseniority.
Assetbeta: a=(D/V) d+(E/V) e

e= a+( a d)(D/E)
Introducetaxes:VL=VU+tD
re=r0+(r0rd)(1t)(D/E).TopictestChu#4.
Iftaxesareconsideredbutfinancialdistressandbankruptcycostsarenot,thethecostofcapitaldeclinesas
moredebtisused,andoverallvalueisincreased
Costofequityrisesstill,butataslowerpaceifinterestistaxdeductible.
Ifinvestorsfaceahighertaxrateonincomefromdebtrelativetoequity,theywilldemandahigherreturn
ondebt.
Financialdistressaddscosts,bothexplicitandimplicit,toacompany.
Twocomponents:1)thecostsoffinancialdistressandbankruptcy,intheeventtheymayhappen,and2)
theprobabilitythatfinancialdistress.
Directcostsincludeactualcashexpensesassociatedwiththebankruptcyprocess,indirectcosts
includeforgoneinvestmentopportunitiesandimpairedabilitytoconductbusiness.
Companieswithlesstangibleassets(suchastechcompanies),havehighercostsassociatedwith
financialdistress.
AgencyCosts:costsassociatedwiththefactthatallpubliccompaniesaremanagedbynonowners.Theyarethe
costsarisingfromconflictsofinterestwhenanagentmakesdecisionsforaprincipal.Thesmallerthestakethat
managershaveinthecompany,thelessistheirshareinbearingthecosts.Thebetterthecompanyisgoverned,the
lowertheagencycosts.
MonitoringCosts:costsbornebyownerstomonitorthemanagers.
BondingCosts:costsbornebymanagementtoassureownersthattheyareworkingintheownersbest
interest.
ResidualLoss:coststhatincurredevenwhenthereissufficientmonitoringandbonding.
2

FreeCashFlowHypothesis:higherdebtlevelsdisciplinemanagersbyforcingthemtomanagethe
companyefficientlysothecompanycanmakeitsdebtpayments,loweringmanagementsabilitytomisuse
cash.
AsymmetricInformation:arisesfromthefactthatmanagershavemoreinformationthanoutsiderssuchas
ownersandcreditors.
PeckingOrder:managerschoosemethodsoffinancingaccordingtoahierarchythatgivesfirstpreference
twomethodswiththeleastpotentialinformationcontent(internallygeneratedfunds)andlowest
preferencetotheformwiththegreatestpotentialinformationcontent(publicequityofferings).Managers
preferinternalfinancing,thendebt,thenequity.Thus,additionalissuancesofstockisofteninterpretedasa
negativesignal.
VL=VU+tDPV(costsoffinancialdistress)
StaticCapitalStructureTheory:capitalstructureisbasedonbalancingtheexpectedcostsfromfinancial
distressagainstthetaxbenefitsofdebtpayments.Optimaldebtusageisthepointwhereanyadditional
debtwouldcausethecostsoffinancialdistresstoincreasebyagreateramountthanthebenefitofthe
additionaltaxshield.
Asleveragerises,debtratingsfall,andthissignifiesincreasedriskforbothdebtandequityholders.
IfcompanysWACCincreasesafterissuanceofadditionaldebt,thentheyhavemovedbeyondtheoptimalcapital
range.
Theuseoflongmaturitydebtisinverselyrelatedwithinflationlevels.
Theaftertaxcostofdebtdecreasesasthemarginaltaxrateincreases.
VL=
VU=

Reading25
Inperfectcapitalmarketsacompany'sdividendpolicyshouldhavenoimpactonitscostofcapital.
Ifacompanypaidoutadividendthatrepresents5%ofequity,itssharepricewouldbeexpectedtodropby
5%.
FlotationCosts:costsassociatedwithsellingsharessuchasunderwritersfees,legalcosts,andregistration
expenses.Canrangefrom410%ofthecapitalraised.
ExDividendPrice:sharepricewhenthesharefirsttradeswithouttherighttoreceiveanupcomingdividend.
Anargumentcanbemadethatinacountrythattaxesdividendsathigherratesthancapitalgains,taxableinvestors
shouldprefercompaniesthatpaylowdividendsandreinvestearningsandprofitablegrowthopportunities.
ClienteleEffect:theexistenceofgroupsofinvestors(clientele)attractedbycompanieswithspecificdividend
policies.
Ifdividendtaxrate=capitalgainstaxrate,thentheexpectedpricedropwhenthesharegoesexdividendisthe
amountofthedividend.
MarginalInvestor:aninvestorwhoisverylikelytobepartofthenexttradeintheshareandwhois
thereforeimportantinsettingprice.
PwPx=
TD>TCG,shareshoulddropbylessthantheamountofthedividend.
TD<TCG,sharepricedropbymorethantheamountofthedividend.
Dividendincreasesconveypositiveinformationandareassociatedwithfutureearningsgrowth,whereasdividend
omissionssaytheopposite.
Companiesthatconsistentlyincreasedividendssharecertainsimilarities:1)Dominateornichepositionsintheir
industry,2)globaloperations,3)relativelyhighreturnonassets,and4)relativelylowdebtratios.
PayingoutdividendswouldconstrainmanagersintheirabilitytooverinvestbyundertakingnegativeNPV
projects.
Payingdividendscanexacerbatetheagencyconflictbetweenshareholdersandbondholders.Thepaymentof
dividendsreducesthecashcushionavailabletothecompanyforthedisbursementofdebtpayments.
Factorsthataffectacompany'sdividendpolicy:1)investmentopportunities,2)expectedvolatilityoffuture
earnings,3)financialflexibility,4)taxconsiderations,5)flotationcosts,and6)contractualandlegalrestrictions.
Acompanywithminiprofitableinvestmentopportunitieswillpayoutlessdividends.
Themorevolatileearningsare,themorecautiouscompanieswillbetoincreasethesizeofthedividend.
Companiesmaynotinitiate,ormayreduceoromit,dividendstoobtainthefinancialflexibilityassociated
withhavingsubstantialcashonhand.
3

DoubleTaxationSystem:corporateearningsaretaxedatthecorporatelevelandattheshareholder
dividendlevel.
DividendImputationTaxSystem:ensuresthatcorporateprofitsdistributedasdividendsaretaxedjust
once,attheshareholderstaxrate.
FrankCredit:acredittheshareholderreceivesforthetaxesthatthecorporationpaidonthose
distributedearnings.
SplitrateTaxSystem:corporateearningsthataredistributedasdividendsaretaxedatalowerratethan
earningsthatareretained.
Flotationcostsareexpensive,socompaniestrytoavoidestablishingalevelofdividendsthatwouldcreate
theneedtoraisenewequitytofinancepositiveNPVprojects.
ImpairmentofCapitalRule:requiresthatthenetvalueoftheremainingassetsasshownonthebalance
sheetbeatleastequaltosomespecifiedamount.Notsurewhatthismeans.
Dividendsonpreferencesharesmustbepaidfirst.
StableDividendPolicy:policyinwhichdividendsareregularlypaidthatgenerallydonotreflectshortterm
volatilityinearnings.
Mostcommon.Involveslessuncertaintyforshareholdersabouttheleveloffuturedividends.
TargetPayoutRatio:representaproportionofearningsthatthecompanyintendstodistributeto
shareholdersasdividendsoverthelongterm.
Modelofgradualadjustmentshasthreeconclusions:1)targetpayoutratioisbasedonlongterm,
sustainableearnings,2)managersaremoreconcernedwithdividendchangesthanwiththelevelofthe
dividend,and3)companieswillcutoreliminatedividendsonlyinextremecircumstances.
DPSt=DPSt1+(increaseinEPSxtargetpayoutxadjustmentfactor)
Adjustmentfactor=1/numberofyearsoverwhichtheadjustmentwilltakeplace
ConstantDividendPayoutRatioPolicy:constantpercentageofnetincomeispaidout.
Dividendsfluctuatewithearnings.
ResidualDividendPolicy:basedonpayingoutasdividendsanyinternallygeneratedfundsremainingaftersuch
fundsareusedtofinancepositiveNPVprojects.Rarelyused.
Dividendsmayswingfromloworzerowhencapexislargetohighwhenthereversesituationholds.The
increaseduncertaintymayleadinvestorsrequireahigherrateofreturnonequity.
Factorsinconsideringasharerepurchase:1)potentialtaxadvantages,2)sharepricesupport,3)addedmanagerial
flexibility,4)offsettingdilutionfromemployeestockoptions,5)increasingfinancialleverage.
TD>TCG=sharerepurchasesarebeneficial.
Managementmayviewitsownsharesasundervalued.
Sharerepurchasesdonotcreatetheexpectationamonginvestorsofcontinuanceinthefuture.
Manycompaniestrytopurchaseatleastasmanysharesaswereissuedintheexerciseofstockoptions.
Sharerepurchasesincreaseleverage.
Sharerepurchasesincreaseinvolumewhentheeconomyisstrongandcompanieshavemorecash.
DividendCoverageRatio:netincome/dividends.Lowerdividendcoverageratio(orhigherdividendpayout
ratio)tendstoindicateahigherriskofadividendcut.
FCFEcoverageratio=FCFE/(dividends+sharerepurchases)
Ratioof1indicatesthatthecompanyisreturningallavailablecashtoshareholders.>1,thecompanyis
improvingliquiditybyusingfundstoincreasecash.<1isnotsustainable,sincethecompanyispayingout
morethanitcanafford.
FCFE=FCFFinterestexpense(1t)+netborrowing
FCFEdeclinesintheyeardebtispaiddown.Afterthedebtisreduced,FCFEincreasesbecauseofthe
reducedinterestexpense.
Effectivetaxrate=1(1T)(1TD)
Signaling:thebeliefthatshareholderswillviewadividendreductionasbadnews.Occurswhenthereis
asymmetricalinformation.

Reading27
CorporateGovernance:thesystemofprinciples,policies,procedures,andclearlydefinedresponsibilitiesand
accountabilitiesusedbystakeholderstoovercometheconflictsofinterestinherentinthecorporateform.
Twomajorobjectives:1)toeliminateconflictsofinterestbetweenmanagersandshareholders,and2)to
ensurethattheassetsofthecompanyareusedefficientlyandproductivelyandinthebestinterestsofits
investorsorotherstakeholders.
4

Corporation:alegalentitythathasrightssimilartothatofaperson.
Canraiselargeamountsofcapital.
Ownersneednotbeexpertsintheindustry.
Ownershipiseasilytransferable.
BoardofDirectorsaretheretoprovideanintermediarybetweenmanagersandtheowners.Membersofthe
boardserveasagentsfortheowners,amechanismdesignedtorepresenttheinvestorsandtoensurethattheir
interestsarebeingwellserved.
Shouldbecomposedofatleastamajorityofindependentboardmemberswiththeautonomytoact
independentlyfrommanagement.
Specializedexpertisebyatleastsomeboardmembersmayberequired.
Internalmechanismsareneededtosupporttheindependentworkoftheboard.
Directorsmusthaveaccesstocompleteandaccurateinformationaboutthefinancialpositionofthe
companyanditsunderlyingvaluedriverstoenablethemtosteerthecompanyinthebestlongterm
interestsofowners.
Chairmanoftheboardshouldnotbeaseniorexecutivemember.
Membersoftheboardshouldbeelectedannually.
Theboardshouldselfassessatleastannually.ItshouldNOTbeassessedbymanagement.
Bestpracticerequiresthatindependentdirectorsoftheboardmeetatleastannually,andpreferably
quarterly,inmeetingswithoutthepresenceofthemanagement.
Theinternalauditfunctionshouldbeentirelyindependentandseparatefromanyoftheactivitiesbeing
audited.InternalauditorsshouldreportdirectlytothechairmanoftheAuditCommitteeoftheBoardof
Directors
Thecompensationcommitteeshouldbecomposedofindependentboardmembers.
Bestpracticerequiresthatnomineestotheboardbeselectedbyanominatingcommitteecomprisingonly
ofindependentdirectors.
Ingeneral,shareholderswouldpreferthatsalaryandperquisiteawardsconstitutearelativelysmall
portionofthetotalcompensationaward.Becausethesefixedcostsmustbebornebyshareholders
regardlessofcorporateperformance,executivesshouldnotautomaticallyberewardedforpoor
performance.
Stockoptionsandstockawardshavebeenarguedtobetteraligntheinterestofmanagerswith
thoseofshareholdersbymakingaportionofthemanagerscompensationdependentonthevalue
ofthestock.
Stockoptionspotentialdilutiveeffectsonshareholderscanbeassessedbyameasure
knownasshareoverhang.Theoverhangisthenumberofsharesrepresentedbythe
optionsrelativetothetotalamountofstockoutstanding.
Investorsshouldbeawareofanyprovisionsthatallowtherepricingofstockoptions.This
allowsthecompany,withboardapproval,toadjusttheexercisepriceofoutstandingoption
grantsdownwardtothecurrentpriceofthestock.
LegislativeandRegulatoryRisk:theriskthatgov'tallawsdirectlyorindirectlyaffectingacompany'soperations
willchangewithpotentiallysevereadverseeffects.
LegalRisk:theriskthatfailuresbycompanymanagerstoeffectivelymanagethecompanywillleadtolawsuits.
ReputationalRisk:duh.
OperatingRisk:theriskthatacompanysoperationsmaybeseverelyaffectedbyenvironmental,social,and
governance(ESG)factors,eventotherequirementsthatoneormoreproductlinesorpossiblealloperationsmight
beshutdown.
FinancialRisk:TheriskthatESGfactorswillresultinsignificantcostsorotherlossestothecompanyand
shareholders.
AccountingRisk:theriskthatacompanysfinancialstatementrecognitionandrelateddisclosuresareincomplete,
misleading,ormateriallymisstated.
AssetRisk:theriskthatthefirm'sassetswillbemisappropriatedbymanagersordirectorsintheformof
excessivecompensation.
LiabilityRisk:theriskthatmanagementwillenterintoobsessiveobligationsthatdestroythevalueof
shareholdersequity.
StrategicPolicyRisk:theriskthatmanagersmayenterintotransactionsthatmayresultinlargepayoffsfor
managementorthedirectorsatthecostofshareholders.
5

Reading28
Acquisition:purchaseofsomeportionofonecompanybyanother.
Merger:theabsorptionofonecompanybyanother.
StatutoryMerger:oneofthecompaniesceasestoexistasanidentifiableentityandallitsassetsandliabilities
becomepartofthepurchasingcompany.
SubsidiaryMerger:thecompanybeingpurchasebecomesasubsidiaryofthepurchaser,whichisoftendonein
caseswherethecompanybeingpurchasedhasastrongbrandimage.
Consolidation:similartoastatutorymergerexceptthatthetwocompaniescreateanewcompany.
HostileTakeover:attemptstoacquireacompanyagainstthewishesofitsmanagersandboardofdirectors.
FriendlyTransaction:apotentialbusinesscombinationthatisendorsedbythemanagersofbothcompanies.
HorizontalMerger:oneinwhichtheemergingcompaniesareinthesamekindofbusiness.
VerticalMerger:theacquirerbuysanothercompanyinthesameproductionchain.
BackwardIntegration:theinquirerpurchasesatargetthatisbehinditinthevaluechain(asupplier).Ex:
steelmanufacturerbuysanironoreminingcompany.
ForwardIntegration:anacquirerpurchasesacompanythatisfurtherdownthevaluechain(a
distributor).
Possibilityofeconomiesofscaleinahorizontalmerger.
ConglomerateMerger:whenanacquirerpurchasesacompanythatisunrelatedtoitscorebusiness.
CorporateRaider:apersonororganizationseekingtoprofitbyacquiringacompanyandresellingit.
OrganicGrowth:makinginvestmentsinternally.
ExternalGrowth:buyingthenecessaryresourcesexternally.Typicallyfasterforcompaniestogrowexternally.
Bootstrapping:Whenacompany'searningsincreaseasaconsequenceofthemergertransactionitself.the
bootstrapeffectoccurswhenthesharesoftheacquirertradeatahigherP/Eratiothanthoseofthetargetandthe
acquirersP/Edoesnotdeclinefollowingthemerger.Themarketrecognizesthebootstrappingeffect,andpost
mergerP/Esadjustaccordingly,althoughbootstrappingsometimeshaspaidoffintheshortrun.
TheEPSofanacquiringfirmwillincreasewhenthepreacquisitionP/Eoftheacquirerishigherthanthe
preacquisitionP/Eofthetargetfirm.
ManagerialismTheories:positthatbecauseexecutivecompensationishighlycorrelatedwithcompanysize,
corporateexecutivesaremotivatedtoengageinmergerstomaximizethesizeoftheircompanyratherthan
shareholdervalue.
StockPurchase:whentheacquirergivesthetargetcompanysshareholderssomecombinationofcashand
securitiesinexchangeforsharesinthetargetcompanysstock.Mustbeapprovedbyatleast50%oftargets
shareholders.
Thetargetcompany'sshareholdersexchangetheirsharesforcompensationandmustpaytaxontheir
gains.
Theacquiringcompanyassumesthetargetcompany'sliabilities.
AssetPurchase:whentheacquirerpurchasesatthetargetcompany'sassetsandpaymentismadedirectlytothe
targetcompany.Oneadvantageofthistypeoftransactionisthatitcanbeconductedmorequicklyandeasilythana
stockpurchasebecauseshareholderapprovalisnotnormallyrequired,unlessasubstantialportionoftheassets
arebeingsold,usuallymorethan50%.
Therearenodirecttaxconsequencesforthetargetcompanysshareholders.
Acquiringcompanygenerallyavoidsassumingthetargetsliabilities.
MixedOffering:combinationofcashandsecurities.
CashOffering:cashmightcomefromtheacquiringcompanysexistingassetsorfromadebtissue.
Whenanacquiringcompanysmanagementishighlyconfidentintheirabilitytocompletethemergerand
thenthevaluetobecreatedbythemerger,theyaremoreinclinedtonegotiateforacashoffering.
StockOffering:targetshareholdersreceivesharesoftheacquirerscommonstock.
Targetcompanyshareholdersassumeaportionoftherewardaswellofaportionoftherisk.
Whenanacquirerssharesareconsideredovervaluedrelativetothetargetcompanysshares,astock
offeringismoreappropriate.
ExchangeRatio:determinesthenumberofsharesthatstockholdersinthetargetcompanyreceiveinexchangefor
eachoftheirsharesinthetargetcompany.
Acquirerscost=exchangeratioxoutstandingsharesoftargetcompanyxacquirersstockvalue
BearHug:acquirercircumventsthetargetmanagementsobjectionstothemergerandsubmitstheproposaltothe
BoardofDirectors.
6

TenderOffer:theacquirerinvitestargetshareholderstosubmittheirsharesinreturnfortheproposedpayment.
Canbemadewithcash,sharesoftheacquirersstock,orothersecurities.
ProxyFight:acompanyorindividualseekstotakecontrolofacompanythroughashareholdervote.Proxy
solicitationisapprovedbyregulatorsandthenmaileddirectlytotargetcompanyshareholders.Theshareholders
areaskedtovotefortheacquirer'sproposedslateofdirectors.
Courtsgenerallyfavorpreofferdefensemechanismsvs.postofferdefensemechanisms.
Preoffermechanismsarebelow:
PoisonPill:alegaldevicethatmakesitprohibitivelycostlyforanacquirertotakecontrolofthetarget
withoutthepriorapprovalofthetarget'sboardofdirectors.
FlipinPill:whenthecommonshareholderofthetargetcompanyhastherighttobuyitssharesat
adiscountthepillistriggeredwhenaspecificlevelofownershipisexceeded.Thiscauses
significantdilution.
FlipoverPill:thetargetcompany'scommonshareholdersreceivetherighttopurchasesharesof
theacquiringcompanyatasignificantdiscountfromthemarketprice.Hastheeffectofcausing
dilutiontoallexistingacquiringcompanyshareholders.
DeadHandProvision:allowstheboardofthetargettoredeemorcancelthepoisonpillonlyby
avoteofthecontinuingdirectors.Becausecontinuingdirectorsaregenerallydefinedasdirectors
whowereonthetargetcompany'sboardpriortothetakeoverattempt,thisprovisionhastheeffect
ofmakingitmuchmoredifficulttotakeoveratargetwithoutpriorboardapproval.
PoisonPuts:allowsbondholderstoputthebondtothecompany.Theeffectistorequirethatanacquirer
bepreparedtorefinancethetargetsdebtimmediatelyafterthetakeover.Itincreasestheneedforcashand
raisesthecostoftheacquisition.
Restrictedvotingrightsrestrictsshareholderswhoareaboveanownershiptriggerpoint(1520%)from
exercisingtheirvotingrightswithoutthethetargetcompanysboardreleasingtheshareholderfromthe
constraint.
Fairrightsamendmentsmightrequiretheacquirertopayatleastasmuchasthehigheststockpriceat
whichthetargethastradedoveraspecifiedperiod.
GoldenParachute:anemploymentcontractthatallowstheexecutivestoreceivelucrativepayouts,
usuallyseveralyearsworthofsalary,iftheyleavethetargetcompanyfollowingachangeincorporate
control.
Postoffermechanismsarebelow:
Greenmail:techniqueinvolvesanagreementallowingthetargettorepurchaseitsownsharesbackfrom
theacquiringcompany,usuallyatapremiumtothemarketprice.Isusuallyaccompaniedbyanagreement
thattheacquirerwillnotpursueanotherhostiletakeoverattemptforasetperiod.
LeveragedBuyout:Themanagementteampartnerswiththeprivateequityfirmthatspecializesin
buyouts.Convertsfromapubliccompanytoaprivatecompany.
LeveragedRecapitalization:involvestheassumptionofalargeamountofdebtthathasbeenusedto
financesharerepurchases.Theeffectsaretodramaticallychangethecompany'scapitalstructurewhile
attemptingtodeliveravaluetotargetshareholdersinexcessofthehostilebid.
CrownJewelDefense:atargetmaydecidetoselloffofsubsidiaryorassettoathirdparty.Ifthe
acquisitionofthissubsidiarywasoneoftheacquirersmajormotivationsfortheproposedmerger,then
strategycouldcausetheacquirertoabandonitstakeoverattempt.
WhiteKnight:whenatargetcompanyseeksathirdpartytopurchaseit.Thiscankickoffacompetitive
biddingenvironmentwhichmayresultinthewinner'scurse.
WhiteSquire:thetargetcompanyseeksafriendlypartytobuyasubstantialminoritystakeinthetarget
enoughtoblockthehostiletakeover.
Antitrustlawsprohibitmergersandacquisitionsthatimpedecompetition.
HerfindahlHirschmanIndex(HHI)=[x100]2
HHI<1,000=nothighlyconcentrated,nogov'taction.
1,800>HHI>1,000=moderatelyconcentrated,achangeof100ormoremaywarrantgovtaction.
HHI>1,800=highlyconcentrated,achangeof50ormorewillwarrantgovtaction.
ThecalculationofFCFinvolvesfirstmakingadjustmentstonetincometoconvertittonetoperatingprofitless
adjustedtaxes(NOPLAT).
Step1:unleveredincome=netincome+(interestexpenseinterestincome)x(1t)
Step2:NOPLAT=unleverednetincome+ deferredtaxes
Step3:FCF=NOPLAT+NCC NWCcapex
7

 Capex=netfixedassetstnetfixedassetst1+depreciationt(notsureaboutthis )
OnceFCFisestimated,itisdiscountedusingtheWACC.
TerminalvalueT=
Theentirevalueofthefirmistheenterprisevalue,soyoushouldsubtractoutthedebttogetthevalueof
theequity.TopictestNationalPlastics#3.
TakeoverPremium:theamountbywhichthetakeoverpriceforeachstockmustexceedthecurrentstockpricein
ordertoenticeshareholderstorelinquishcontrolofthecompanytoanacquirer.
PRM=;DP=dealprice,SP=stockprice
IfthereisapreannouncementrunupinQuadrantspricebecauseofspeculation,thetakeoverpremium
shouldbecomputedonthepricepriortotherunup.
Thetakeoverpremiumisimplicitlyrecognizedinthecomparabletransactionapproach.
TargetShareholdersgain=premium=PTVT;PT=pricepaidfortargetcompany;VT=premergervalueof
targetcompany
Acquirersgain=synergiespremium=S(PTVT);S=synergies
Postmergervalue:VA*=VA+VT+SC
Whenevaluatingabid,thepremergervalueofthetargetcompanyistheabsolutelowestthatthetarget
shareholdersshouldaccept.
Themoreconfidenttheacquirersmanagersareaboutthesynergies,themoretheywillprefertopaycash,
andthemorethetargetwillprefertheacquirersstock.
Doproblemsinbackofthebook!Page299.#710arereallygood.
Divestiture:whenacompanydecidestosell,liquidate,orspinoffadivision.
EquityCarveout:thecreationofanewlegalentityandsalesofequityinittooutsiders.Createsacash
inflowfortheoriginalcompany.
Spinoff:shareholdersoftheparentcompanyreceiveaproportionalnumberofsharesinthenew,separate
entity.
Splitoff:shareholdersoftheparentcompanycanreceivesharesinthecompanyinexchangeforparent
companyshares.
Liquidationinvolvesbreakingupthecompany,division,orsubsidiaryandsellingoffitsassetspiecemeal.
Typicallyassociatedwithbankruptcy.

RandomNotes
FreeCashFlowtotheFirm(FCFF)=NI+NCC+int(1t)FCinv NWCinv
NWCinvexcludescashandcashequivalents

JusticeTheory:basedontheideaofaveilofignorancetocreateanimpartialjudgmentofasituation.
FriedmanDoctrine:afirmonlyneedstoobeythelawsofthecountry,itdoesntneedtoconsideranyotherethical
issuesifitsfollowingthelaws.
Selfdealingiswhenmanagersfindawaytofeathertheirownnestswithcorporatemonies.
Youshouldavoidinterlockingdirectorships.Theyarenotconsideredindependent.
Expectedamountofcapitalavailableforprojectinvestment=[1+xequityportionfromexpectedearningsleftfor
projectinvestment.TopictestKocher#6.
Taxableincome=operatingincomebeforetaxinterest
Netincome(accountingincome)=taxableincomex(1t)
Realcostofequity=1