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Corporate Finance Theory and Practice (Maurizio Dallocchio, Yann Le Fur, Pascal Quiry etc.) - 4_8=8AB@0B_@

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Matheus Puppe

· 217 min read

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  • The book aims to provide a comprehensive overview of corporate finance as it is practiced globally.

  • It emphasizes a way of thinking about finance that integrates financial analysis, valuation, and a mastery of financial decision making concepts.

  • Unlike purely theoretical or practical books, it presents theory and practice side by side, mirroring the authors’ experience as investors, board members, and business school professors.

  • Concepts are prioritized over techniques, with the goal of providing an understanding of situations rather than technical skills that may become outdated.

  • Rigorous analysis is combined with practical examples and case studies to help readers apply principles to real-world scenarios.

  • Updates are made to each edition to reflect changes in markets and regulations. But the core approach of integrating analysis, valuation, concepts and practical application remains consistent.

  • The book has been successful due to this balanced approach between theory and practice, aimed at both students and finance professionals. It distinguishes itself from other corporate finance textbooks.

  • The book provides an overview of key concepts in corporate finance and financial management. It is intended to give students and practitioners a solid foundation in analysis, valuation, and decision making.

  • The book is divided into five main sections covering financial analysis, valuation, value creation, corporate financial policies, and financial management.

  • Examples and problems are provided throughout to illustrate concepts in a real-world context. International standards and examples from around the world are also included.

  • Financial concepts and tools covered include accounting, ratios, discounted cash flow analysis, cost of capital, capital budgeting, capital structure, dividends, mergers and acquisitions, and more.

  • The authors believe core financial concepts will still be valid and important for practitioners to understand in 20 years, whereas some specific topics may become outdated or less applicable over time as markets evolve.

  • Overall the book aims to equip readers with a rigorous yet practical understanding of corporate finance and financial management through a comprehensive overview of key theoretical foundations and their real-world application.

Here is a summary of the key points from the chapter:

  • The financial manager’s primary role is to ensure the company has adequate capital/funding. They are at the intersection of the real economy and financial markets.

  • Traditionally, the financial manager is viewed as a buyer of capital who seeks to minimize costs. Their job is to procure funds at the lowest possible prices.

  • However, the chapter proposes an alternative view - that the financial manager should be seen as a seller of financial securities who aims to maximize prices/values.

  • From this perspective, the financial manager deals in the market for financial instruments (debt, equity, etc.), not the capital markets. Their focus is on maximizing security values rather than minimizing costs.

  • Supply and demand are flipped between the two views. Traditionally demand for funds comes from companies and supply from investors. But as a seller, the financial manager supplies securities while investors demand them.

  • The equilibrium price in the traditional view is the interest rate or cost of funds. As a seller, the financial manager aims to maximize the value of the securities being sold on the financial instruments market.

So in summary, the chapter outlines two perspectives - the traditional view of the financial manager as a cost-minimizing buyer of capital, and an alternative view proposing they act as a value-maximizing seller of financial securities.

  • When the demand for financial securities is greater than the supply, the value of the securities rises. Conversely, when the supply of funds is greater than demand, the cost of money falls and the value of securities falls.

  • The cost of capital and the value of securities vary inversely - as one goes up, the other goes down.

  • Minimizing financing costs is equivalent to maximizing the value of the underlying securities.

  • Viewing the financial manager as a seller of financial products casts their role in a different light - they must understand investor needs and sell high-quality products at high prices.

  • Considering only cost when choosing financing sources can lead to short-sighted decisions that prioritize the short term over the long term or take on excessive risk. Investor risk must be properly accounted for.

  • A financial security is essentially a contract that represents a series of future cash flows for the holder and commitments to pay cash flows for the issuer. It can be seen as the right to receive cash flows or the obligation to pay them out.

  • Main types of financial securities are debt instruments like bonds and commercial paper, and equity shares in a company.

  • Equity as a source of financing guarantees investors no fixed income or repayment. Shareholders can only realize their investment by selling shares to others. However, they have claims to company earnings and management oversight via voting rights.

  • Financial engineers have created hybrid securities that combine characteristics of debt and equity. Some instruments look like equity from the company’s perspective but have fixed cash flows, while others have yields dependent on company performance but are considered debt.

  • Options convey rights to the investor but no obligations. Financial instruments represent a spectrum of characteristics from rights to commitments from the investor’s perspective.

  • Primary markets involve new issuance of securities to raise funds, while secondary markets involve trading of existing securities without generating new funds for the company. Both ensure equilibrium between financing needs and sources.

  • Secondary markets make investments liquid and allow investors to exit positions by selling to others. They also determine security prices that influence primary market issuance. Derivative markets allow taking positions on underlying assets with reduced initial outlay.

  • The financial manager’s main roles are to ensure the company has sufficient funding, that it uses funds efficiently to generate returns higher than what investors require, and that it manages financial risks.

  • To fulfill the funding role, the manager transforms the company’s real assets into financial assets by issuing securities like equity and debt. They then sell these securities to various investors like banks, financial institutions, and individuals.

  • In analyzing investment projects, the manager must consider whether projected returns are higher than the company’s cost of funds. They act as a “party pooper” rejecting projects that destroy value.

  • If profits consistently fall below what investors require, the manager should work to improve the situation or suggest strategic changes like selling underperforming business units.

  • The manager is also responsible for identifying and managing financial risks from factors like interest rates, currencies, and commodity prices. This includes hedging risks through derivative markets when possible.

  • In summary, the financial manager fulfills multiple interconnect roles related to funding, value creation, risk management, and acting as an intermediary between the company and its investors.

Here are the key points about operating cash flows:

  • Operating cash flows come from a company’s day-to-day business operations, such as producing and selling goods/services.

  • They are impacted by the timing differences between cash outflows (e.g. for raw materials, wages) and cash inflows (e.g. from sales).

  • This timing difference stems from the operating cycle, which includes factors like production time, inventory holding periods, and customer/supplier credit terms.

  • The operating cash flow is the net cash generated or used by operations after accounting for these timing differences over a given period (usually monthly or annually).

  • It reflects the actual cash flows from operations, independent of accounting policies like depreciation or inventory valuation methods.

  • A company’s operating cash flow should generally be positive over the long-run, unless there are unusual circumstances like start-up losses or steep growth requiring cash.

  • Capital expenditures related to maintaining or expanding the business are generally not considered part of operating cash flows, even though they are for operating activities. They are separate investment cash flows.

  • Changes to a company’s operating cycle, like adding new product lines, can impact the timing of cash flows and thus the operating cash flow number. This should be taken into account.

Does this help explain the key aspects of operating cash flows? Let me know if you need any clarification or have additional questions.

  • The operating cycle refers to the time lag between inputs (payments to suppliers) and outputs (receipts from customers) in a business. The cycle length depends on the specific industry and complexity of the end product.

  • Investments are capital expenditures meant to boost or enhance future operating cash flows over multiple operating cycles. They carry more risk than regular operating outlays.

  • The greengrocer needs to invest in a chest freezer, which is a prerequisite for starting a new activity of selling frozen goods. This investment has uncertain success and higher risk than operating costs.

  • There is a distinction between operating outflows (expenses) and investment outflows from a cash flow perspective. Investments are made with a long-term view to increase future cash flows, while operating expenses provide immediate enjoyment or use.

  • Financing is needed to address timing differences between cash inflows and outflows in the operating and investment cycles. Financial resources from shareholders and lenders fill this funding gap.

  • Investors expect a return from providing financial resources to make the operating and investment activities possible. This return comes from positive future cash flows generated by these cycles.

So in summary, it distinguishes operating, investment and financing cash flows and cycles in a business, and highlights the roles of capital expenditures, risk, and timing differences that require financing.

Here is a summary of key points about the income statement and how it shows how a company creates wealth:

  • The income statement reflects the results of a company’s operating, investment and financial cycles over an accounting period.

  • It shows how revenues generated by the operating cycle compare to expenses incurred to generate those revenues. The difference is operating income/loss.

  • Operating income captures the wealth created by day-to-day business operations after deducting all related expenses.

  • If there are further gains/losses from investing activities or financing activities, they are added/subtracted to operating income to calculate net income.

  • Net income reflects the total wealth generated by the company after considering the results of all its business cycles during the period.

  • The income statement allows analysis of how profitable a company’s core operations are and how effectively it deploys capital through investments and financing to increase overall wealth.

  • It is important to distinguish between accounting profit/income on the income statement and cash flows, as the timing of revenues and expenses can differ from the timing of actual cash inflows and outflows.

  • Regularly analyzing trends in revenues, expenses and profitability on the income statement can provide insights into a company’s value creation ability over time.

  • The income statement shows additions to a company’s wealth (revenues) and deductions from wealth (expenses/costs) for a period of time. The difference between revenues and costs is earnings, which represents the change in net worth.

  • Earnings are positive when wealth is created and negative when destroyed. Operating activities, investing activities, financing activities, and extraordinary items all impact earnings.

  • Operating activities involve the core business operations and are shown as revenues and operating costs on the income statement. Investing activities like asset purchases do not directly impact earnings as the assets retain value over time.

  • Non-cash expenses like depreciation recognize the decrease in value of fixed assets used in operations. Financing activities involve interest payments on debt and net earnings distributed to shareholders. Extraordinary items are unusual and non-recurring events outside management’s control.

  • The income statement provides a way to measure a company’s creation of wealth over a period by showing all additions and subtractions from wealth. Earnings represent the net change in wealth for that time.

  • Statement gains and losses on capital assets like property, plant, and equipment appear on the income statement under exceptional/non-recurring items. It is up to the analyst to determine if these gains and losses are recurring or non-recurring in nature.

  • Non-recurring items can have either a cash impact or non-cash impact (e.g. goodwill depreciation has no cash impact).

  • It is easier for analysts to analyze and forecast profits before tax and non-recurring items rather than net income/profit, which is affected by non-recurring items and taxes.

  • Net income measures wealth creation/destruction over the fiscal year but does not always capture increases in value until realized through sales. It incorporates non-cash items like depreciation.

  • The two main income statement formats are: by function (presents costs by function like COGS, selling, G&A) and by nature (presents costs by type like materials, labor, depreciation). Either way, operating profit is the same.

  • Non-recurring items and their tax effects are usually shown separately after operating profit in the income statement.

  • Analysts prefer looking at profits before non-recurring items and taxes for forecasting purposes as it removes volatility.

  • When a company raises funds through equity financing like shareholders’ equity, it does not directly become richer or poorer as the funds provided are not profit/loss.

  • In this case, the company spent half the funds on R&D in the first two years with no results, so it became poorer by the amount spent with no return.

  • In year 3, it used the remaining funds to overpay for an acquisition. So it became poorer by the amount overpaid, which was 25% of the acquisition price.

  • However, the synergies from the acquisition improved earnings by €75m. After accounting for the 25% overpayment, the company became richer by €75m - 25% of acquisition price.

  • Key accounting items that add wealth are net income, increase in equity/shareholders’ funds, and retained earnings. Items deducting wealth are financial expenses, taxes, dividends.

  • A company creates wealth equal to its net income/net profit over the period as calculated on the income statement, because this is the amount available to shareholders after all other claims.

  • The statements about covering losses through debt and financing an acquisition through profits are confusing cash and accounting profits - debt does not cover losses from a wealth perspective, and profit does not directly translate to cash available for investment.

  • Free cash flow turning negative by itself does not determine if wealth was created or destroyed - need to examine the full financial statements.

  • EBITDA does not directly flow to a company’s bank account, as it does not account for all costs below the operating line.

  • Depreciation is a non-cash cost/expense that reduces wealth, not a cash outflow, though the asset originally required a cash outlay.

  • Cash and wealth can differ in treatment of investments like property/R&D that do not immediately generate cash but do add long-term value.

  • Loan repayments are not recorded on the income statement, only interest, though they are cash outflows. Inflation increases are also not recorded on the income statement.

Here are the key points about analyzing a balance sheet from the two perspectives:

  • Capital-employed analysis looks at how the company finances its operating assets and how it uses funds. It focuses on returns and valuation as a going concern.

  • It computes returns on capital employed and equity. It is a first step to valuing equity as a going concern.

  • Solvency-and-liquidity analysis regards the company as sets of assets and liabilities. Equity is the difference between assets and liabilities.

  • It focuses on measuring solvency (ability to meet long-term obligations) and liquidity (ability to meet short-term obligations).

  • It is a first step to valuing equity in a bankruptcy scenario rather than as a going concern.

So in summary, capital-employed analysis looks at efficient use of funds from a going concern perspective, while solvency-and-liquidity analysis focuses on financial health and ability to meet obligations from more of a creditor/risk perspective.

The capital employed analysis divides a balance sheet into uses of funds (assets) and sources of funds (liabilities and equity).

Uses of Funds (Assets):

  1. Fixed assets - Property, plant, equipment, intangibles used in operations. Distinguish operating vs non-operating assets.

  2. Operating working capital - Inventories + Receivables - Payables. Represents cash needs of the operating cycle.

  3. Non-operating working capital - Items not in the operating cycle like long-term receivables.

Sources of Funds (Capital Employed):

  1. Capital employed = Fixed assets + Operating working capital + Non-operating working capital. Represents total assets invested in the business.

Sources of Funds (Financing):

  1. Shareholders’ equity - Capital provided by shareholders.

  2. Net debt - Borrowings - Cash - Marketable securities. Represents non-equity funding.

The capital employed must equal the sum of shareholders’ equity and net debt, representing how the business is financed. A solvency and liquidity analysis then classifies liabilities as short term vs long term to evaluate repayment ability.

Here is a summary of the key points from the chapter:

  1. A capital-employed analysis of the balance sheet shows all the uses of funds by a company as part of the operating cycle and analyses the origin of the sources of a company’s funds at a given point in time. It looks at assets (fixed assets and working capital) and capital invested (shareholders’ equity and net debt).

  2. A solvency-and-liquidity analysis lists everything the company owns and everything that it owes, with the balance being the book value of shareholders’ equity or net asset value. It analyzes solvency and liquidity.

  3. Capital employed comprises fixed assets plus working capital. Working capital includes operating working capital (inventories and receivables minus payables) and non-operating working capital.

  4. Capital employed is financed by capital invested, which includes shareholders’ equity and net debt. Net debt is borrowings minus cash/equivalents and marketable securities.

  5. Sales do not appear on the balance sheet because the balance sheet shows a snapshot of cumulative inflows/outflows, while sales represent a flow during an accounting period.

  6. Key financial concepts covered include operating cycle, fixed vs current assets, working capital, shareholders’ equity, net debt, capital employed, solvency and liquidity.

  7. Examples are given of businesses that typically have positive or negative working capital.

So in summary, it presents different analytical frameworks for reviewing a company’s balance sheet, including capital employed analysis and a solvency/liquidity perspective. Key concepts around assets, liabilities, equity and the use of funds are also explained.

Based on the summarized content:

  • The chapter aims to reconcile cash flow and earnings approaches by examining revenues and costs from a cash flow perspective and establishing a link between changes in wealth (earnings) and changes in net debt.

  • There are timing differences between operating revenues/costs and operating receipts/payments due to factors like payment terms and changes in inventories. These timing differences result in changes to working capital.

  • The change in operating working capital represents the difference between EBITDA and operating cash flows, and accounts for timing differences between income statement and cash flows. It can represent a financing need or source.

  • Capital expenditures affect cash flows directly but are not reflected on the income statement, representing a key difference between the two statements.

  • Understanding the transition from earnings to changes in net debt is important for comprehending a business’ financial workings. The change in working capital bridges earnings and cash flows/changes in net debt.

In summary, the chapter emphasizes reconciling earnings and cash flows by examining the links between them via changes in working capital and discussing how this reconciliation is important for financial analysis.

  • The cash flow statement records capital expenditures at the time they are purchased, while the income statement recognizes depreciation over the life of the asset through depreciation charges. So there is no direct link between net income and cash flows for capital expenditures.

  • Financing appears on the cash flow statement (sources/uses of cash from financing activities like new borrowings/debt repayment), but not on the income statement which only shows costs like interest expense. Dividends also affect cash flows and retained earnings.

  • Cash flow can be calculated from the income statement by adding back non-cash expenses like depreciation/amortization that impact net income but not cash flows. It provides a link between net income and the decrease in net debt.

  • Adjusting cash flow for changes in working capital gives cash flow from operating activities, which isolates the impacts of the operating cycle on cash. Capital expenditures, asset disposals and financing activities like debt/equity changes are then separated into investing and financing activities.

  • The passage discusses the cash flow statement, specifically comparing the direct and indirect methods.

  • Under the indirect method, which is more common, the cash flow statement starts with net income and works down through changes in balance sheet items to arrive at net change in cash.

  • Important non-cash items like depreciation and amortization are added back to net income to reconcile it to operating cash flows.

  • Changes in working capital accounts for the difference between cash flow from operating activities and EBITDA.

  • There is no direct link between capital expenditures in the income statement vs cash flow statement due to timing differences in capitalization vs cash outlays.

  • The cash flow statement also considers financing cash flows related to debt and equity activities, which are not reflected in the income statement.

  • Net debt is considered a better measure than cash alone, as it reflects the true debt position independent of short-term cash balances.

  • Overall the cash flow statement reconciles accrual-based net income to cash-based changes in a company’s cash and debt position over a period.

  • The accounts of a subsidiary are fully consolidated if it is controlled by the parent company. Control is defined as having over 50% of voting rights or power over more than 50% of voting rights.

  • Full consolidation involves transferring all the subsidiary’s assets, liabilities, and equity to the parent company’s balance sheet, and all revenues and costs to the parent company’s income statement.

  • The parent company’s investment in the subsidiary is eliminated from its balance sheet. The subsidiary’s equity is added to the parent company’s equity.

  • Minority interests, representing the share of non-controlling shareholders, are shown separately on the consolidated balance sheet and income statement below the parent company’s shareholders’ equity and net income figures.

So in summary, full consolidation combines the subsidiary’s line items with the parent’s, eliminating the parent’s investment, and shows the portion belonging to non-controlling interests separately.

  • When consolidating subsidiaries, financial analysis assumes the parent company owns 100% of the subsidiary’s assets and liabilities. However, from a legal perspective this is not the case, as minority shareholders have ownership interests as well.

  • Full consolidation treats the parent and subsidiary as a single economic entity. It combines their balance sheets and income statements. Minority interests represent the portion of the subsidiary owned by third parties.

  • Changes in the scope of consolidation, such as excluding a previously consolidated subsidiary, means its losses, shareholders’ equity, and liabilities will no longer appear on the group’s financial statements. There are techniques to remove controlled subsidiaries from the consolidation scope.

  • Equity method accounting applies when the parent has significant influence over an associate, usually through a 20%+ voting interest. It replaces the carrying value of the parent’s investment with its share of the associate’s equity, and includes its share of the associate’s profits in its income. It is a valuation method rather than true consolidation.

  • Companies sometimes use special purpose vehicles (SPVs) and accounting techniques to make their consolidated financial statements look more attractive. However, IFRS and US GAAP rules make it difficult to use SPVs to artificially boost financial results.

  • Any changes to the scope of consolidation require preparing pro forma financial statements so analysts can compare performance on a consistent basis over time.

  • When one company acquires another, there is often a difference between the acquisition price paid and the book value of the shares acquired. This difference usually represents things like unrecorded intangible assets, expected synergies from the merger, preventing competitors from acquiring the target, or overpayment.

  • This difference is recorded as goodwill on the acquirer’s balance sheet. Goodwill is tested annually for impairment and written down if the fair value falls below carrying value.

  • Financial analysts should treat goodwill impairment charges as non-operating items and exclude them from return and EPS calculations to better evaluate underlying performance. They should also be wary of “adjusted” financial results that exclude the impact of purchase price allocations.

  • Consolidation involves aggregating the financial statements of a parent company and its subsidiaries by combining their assets, liabilities, equity, revenues and expenses.

  • It aims to present them as if they were a single entity.

  • Full consolidation is used when the parent controls a subsidiary, replacing the subsidiary’s financials line by line in the consolidated statements and accounting for minority interests.

  • The equity method is used when the parent has significant influence over an associate, replacing the investment with the parent’s share of the associate’s equity.

  • Ownership level refers to the parent’s direct and indirect capital holding, while control level refers to voting rights held, which determines the consolidation method.

  • Ownership is used to separate the group and minority interests, while control determines the method.

  • Acquiring a company at a premium leads to goodwill on consolidation, calculated as the excess paid over book equity, net of revaluations. Goodwill is tested annually for impairment.

Here are the key points about accruals:

  • Accruals are used to recognize revenue and costs in the period they relate to, rather than when the cash is received or paid.

  • Prepaid costs are costs relating to future goods/services paid in advance, recorded as an asset. Deferred income is income received in advance for future goods/services, recorded as a liability.

  • Accrued income and costs work in reverse - recognizing income/costs relating to the current period that will be received/paid in a future period.

  • Prepaid costs and deferred income form part of working capital on the balance sheet.

  • Accruals follow the matching and revenue recognition principles to report expenses against the revenues they help generate in the appropriate period.

Some examples provided are prepaid three-quarters of annual rent as a prepaid asset and three-quarters of annual subscription fees received in advance as deferred income. Accruals allow for a more accurate reflection of the company’s financial position and performance between periods.

  • Cash equivalents are now more tightly defined after the 2007-08 liquidity crisis showed some claimed cash equivalents were actually risky investments that lacked liquidity during the crisis.

  • IFRS values cash assets based on fair value, with gains/losses impacting income statements as financial income.

  • Classification of cash vs. long-term assets is important for evaluating company liquidity. Analysts examine if assets contribute to operating earnings or are financial investments.

  • Construction contracts use percentage of completion method to recognize sales/profit over multiple years as work is completed.

  • Convertible bonds have debt and equity components under IFRS accounting based on their terms. Treatment impacts financial ratios.

  • Deferred tax arises from temporary differences between book and tax values of assets/liabilities and accounting/taxable incomes. Timing differences create deferred tax assets/liabilities.

  • Deferred tax is mandatory for liabilities but assets based on likelihood of future taxable profits. Not recorded for certain items like goodwill. Intended to reflect future tax impacts rather than current amounts due.

  • A parent company records a dilution profit or loss when its subsidiary carries out a capital increase at a valuation above or below the subsidiary’s book value. This impacts the parent’s ownership percentage and share of the subsidiary’s equity.

  • Provisions for deferred taxes arise when assets are revalued for consolidation. The difference between the tax base and book value results in a deferred tax liability/asset. This represents potential future tax payments/savings and should be deducted from goodwill or equity, not considered a debt.

  • Financial hedging instruments are used to hedge risks like foreign exchange, interest rates, commodity prices. Under IFRS, they are generally recorded at fair value with changes in the income statement.

  • Hedge accounting allows exemptions if the hedge is effective. For fair value hedges, changes in the hedged asset and instrument offset in income. For cash flow hedges, changes in the instrument are recorded in other comprehensive income until the hedged flow occurs to match gains/losses.

Pense (the company) will likely report a loss on its forward contract to hedge the purchase price of cocoa. This loss will reflect the difference between the actual market price of cocoa at the time of purchase, and the fixed price that was agreed to in the forward contract earlier. Since the actual market price turned out to be lower than was forecasted when the contract was signed, pense will have to pay more than the current market price under the terms of the forward contract. This price difference will result in a loss for pense on the hedging contract, which aims to fix an agreed price in advance to provide certainty for corporate planning and reduce risk from price fluctuations.

  • Inventories are an important asset for companies as their valuation can impact future profits and shareholders’ equity. Higher inventory valuations mean lower future profits, assuming inventory volumes stay the same.

  • Different inventory valuation methods (FIFO, LIFO, weighted average) can affect reported net income in different ways depending on whether prices are inflating or deflating.

  • IFRS allows FIFO, weighted average, and identified purchase cost methods. US GAAP allows all methods including LIFO.

  • Leases can be either finance/capital leases or operating leases. Finance leases are treated as purchased assets on the balance sheet while operating leases are treated as rent expenses.

  • The new IFRS and US GAAP standards will treat all leases as finance leases, significantly increasing reported assets and liabilities. However, some argue this misunderstands the economic substance of operating leases.

  • Analysts need to carefully consider inventory valuations and leasing activities, as they can impact reported profits and financial position in different ways depending on the methods and economic environment. Cash flows are a more reliable metric than profits alone in some sectors and conditions.

  • An operating lease is more flexible than a finance lease as the equipment or building is rented rather than owned. This provides flexibility to easily change the leased asset.

  • The purpose of a finance lease is to carry out an acquisition of an asset through debt financing. The asset being leased is used as collateral for the debt used to acquire it.

  • Finance leases effectively transfer ownership of the leased asset to the lessee, while operating leases do not.

  • Analysts should be wary of companies that have large operating lease obligations, as these fixed costs are off-balance sheet and increase the company’s breakeven point. Operating leases can hide debt levels.

  • Provisions are amounts set aside in anticipation of future costs. Adding to provisions reduces current net income, while writing back provisions in the future when costs are incurred neutralizes the income statement impact of recognizing expenses over time. Provisions allow for the anticipation of future costs.

(a) Companies may book provisions (expenses) against current earnings in a given year to cover the future costs of a restructuring program such as site closures and redundancies.

(b) These restructuring costs are accounted for as a liability if they derive from an obligation to third parties or employees. The liability must be confirmed prior to the end of the accounting period.

(c) Financial analysts should treat restructuring provisions as part of operating expenses if they relate to productivity enhancements. Shutdown costs should be treated as non-recurring items. Most analysts treat restructuring charges as structural costs that impact operating profit. Provisions are treated similarly to financial debt on the balance sheet.

(a) Provisions for decommissioning or restoring sites (e.g. mines, industrial plants) after use are long-term commitments often required for environmental reasons.

(b) They are accounted for as the net present value of future commitments, booked as a provision.

(c) Financial analysts should treat these provisions as net debt due to their long-term nature.

  • Financial analysis involves analyzing a company’s accounts and data to assess its value for shareholders and solvency/ability to repay debts for lenders. The techniques are generally the same for both purposes.

  • It is important to understand the company’s business, industry, strategy and accounting methods before analyzing the numbers. Analysis should provide insights beyond just describing the data.

  • Financial analysts must consider how accurately accounting figures reflect economic reality and may need to adjust figures to make them more useful.

  • Both internal and external analysis aims to comprehensively assess the company, seeing it from an outsider’s perspective based on key factors.

  • Effective analysis identifies inaccuracies in accounting or concealed problems, rather than just using sophisticated techniques. It evaluates issues over the medium term.

  • An economic analysis focuses on understanding the company’s market and position, production model, distribution networks, and motivations of key individuals through reasoning and common sense.

Here are the key points about market share and growth from the passage:

  • Market share indicates what percentage of total market sales or revenues a company achieves. Higher market share is generally advantageous.

  • Market share provides some customer loyalty and a stronger bargaining position with customers and suppliers. It also makes a company more attractive for potential partnerships, sales, or hiring talented people.

  • However, market share numbers are not always relevant and meaningful. In certain industries like construction, contracts are awarded through bidding rather than regular repeat purchases. Market share is also meaningless if it is gained just through temporary price cuts but not held on to long-term.

  • Sustainable growth in a developed market often comes from value growth rather than just volume/unit growth, as population and pure demand growth is slower. Value can be increased through things like product innovation, packaging changes, or moving upmarket.

  • Technological changes, lifestyle/cultural shifts, demographic trends, and other macro factors can drive new growth opportunities in developed markets over time. But forecasting the duration of growth opportunities is difficult.

  • The risk profile depends on whether products are original equipment or replacements - replacements are more sensitive to general economic conditions. Barriers to entry also impact competitive risks over time as they tend to weaken with globalization and technology changes.

  • Share must create value for the company, otherwise it serves no purpose. Having a large share of a small market is more valuable than a middling share of a vast market.

  • When a market is expanding, it is better to have smaller rivals rather than a few large rivals who can take all the growth. In a mature market, it is better to have large rivals who will not risk attacking niche small players.

  • Competition can be price-driven or product-driven. Price competition focuses on reducing costs and increasing scale. Product competition focuses on differentiation, service, and building loyalty. Most competition has elements of both.

  • Analyzing a company’s production model, capital expenditures, and place within the value chain can provide insights into strengths, weaknesses, and risks, especially during difficult economic periods. Different production models like workshops, mass production, and process-specific production each have pros and cons that should align with a company’s strategy. Investing too early in large production facilities before a product is proven carries risks.

Companies are increasingly outsourcing their manufacturing and service operations to reduce their core expertise to just project design and management. In the past, value was concentrated in production, but now it lies more in research, innovation and marketing.

This allows companies to organize external production through contract manufacturers like Foxconn who specialize in low-cost mass production. However, companies still rely on distribution systems to handle logistics, provide customer advice/service, and finance inventory. Strong distribution is vital for producers, especially in industries like furniture where distribution plays a limited role.

The best distribution approach depends on factors like how important branding, service and quality are to customers compared to price. Being closer to customers allows faster feedback but requires more investment, while distance reduces costs but delays insights. Overall, human resources, shareholders, managers and corporate culture are important to analyze to understand a company’s strategies and risks. Accounting practices must also be carefully reviewed before doing a financial analysis of a company.

  • Financial analysis should look at trends over multiple years (usually 3+) to identify any deterioration or warning signs. Analyzing a single year in isolation does not provide full context.

  • Comparative analysis evaluates a company’s performance metrics and ratios compared to the median/average of peers in the same industry. This helps assess if the company is performing better or worse than its rivals.

  • Normative analysis takes comparative analysis a step further by comparing metrics to industry-specific norms or standards derived from large samples. For example, norms for inventory turnover, hotel room costs, etc.

  • Both comparative and normative analysis have limitations - industry definitions may be vague, samples may not be fully representative, and whole industries can become temporarily overvalued.

  • Trend analysis only works if the company’s business, accounting policies, and scope remain reasonably comparable over time. Published financials also always lag the present situation.

  • A company is viable or not relative to its peers - during downturns, weaker companies will be eliminated while healthier peers survive. So comparative analysis assesses relative performance.

  • Shareholders’ equity refers to the owners’ claim on the company’s assets after subtracting liabilities. Analyzing shareholders’ equity helps understand the financial structure of the company from the owners’ perspective.

  • Financial rules of thumb suggest that fixed assets should be financed through stable sources like shareholders’ equity rather than debt. This matches the duration of assets with financing sources.

  • Sales per square meter is a common metric analyzed in supermarkets and retail sectors to evaluate space utilization and sales efficiency. Higher sales per square meter indicates better performance.

  • Some standard ratios like net debt to EBITDA below 3x provide guidelines but need to be interpreted carefully based on the company’s specific industry and business model.

  • Ultimately, profitability is the most important factor, and there is no single ideal capital structure. Companies have flexibility as long as they remain profitable. Financial analysis needs to consider both quantitative and qualitative company-specific aspects.

Here is a summary of the key points from the questions:

  • Scoring techniques in financial analysis can be criticized for oversimplifying companies and not accounting for nuances. Reliance on ratios and scores may lead to a self-fulfilling prediction of failure or poor performance.

  • The financial expense/EBITDA ratio is fundamental to scoring because it reveals both high debt levels (financial expense) and profitability (EBITDA).

  • Trend analysis strength is that it helps understand a company’s strategy over time.

  • Wealth creation for shareholders should be the starting point since that is the reason the company exists.

  • Financial analysis is not always too late if the analyst considers the company’s economic context, not just past financials.

  • When translating financials, it is important to consider differences in accounting principles that may provide different pictures of a company’s health.

  • Vertical integration may not provide much value after analyzing weaknesses in the company’s value chain.

  • International financial analysis requires assuming comparable accounting practices between countries.

  • The ultimate objective of financial analysis is to understand the past, present and future of the company based on its financial and economic characteristics.

  • The analysis examines a company’s margins as the first step in any financial analysis. Positive margins are necessary but not sufficient to ensure success or avoid bankruptcy.

  • Net income is less important than operating profit (EBIT) which better indicates a company’s core performance and future prospects.

  • The analysis first evaluates the company’s accounting practices used to prepare the income statement. There is incentive to present a favorable view of recurring operating profit.

  • A trend analysis of revenues and costs over several years is then conducted to understand past performance and inform future predictions. Business activities should be consistent over the period.

  • The analysis calculates growth rates of key revenue and cost items to understand changes in margins. A purely descriptive approach without analytical insights is insufficient.

  • Margin trends reflect a company’s strategic position and risk profile, but these strategic aspects are often neglected in favor of ratios.

  • Sales trends are essential as growth, stagnation, decline impact problems differently. Organic versus external growth and volume versus price changes must be considered.

  • Production is an accounting concept that relates materials to sales but mixes elements valued differently. Faster production versus sales growth could indicate overproduction or inventory issues.

  • Gross margin is the difference between production and cost of raw materials used.

Here is a summary of key points from Section I of Chapter 9:

  • Gross margin, defined as sales minus cost of goods sold/raw materials purchased, is useful for analyzing companies in industrial sectors where raw material costs are significant. It is difficult to separate price and volume effects for raw materials.

  • Gross trading profit is useful for retail, wholesale, and trading companies. It is calculated as sales minus cost of goods sold/purchased plus/minus change in inventories.

  • Value added represents the value created by a company through its activities. It can be calculated in various ways using gross trading profit, gross margin, and operating costs purchased from third parties.

  • Personnel costs are an important expense to analyze in terms of productivity, cost control, and growth. Productivity is estimated using ratios of sales, production, or value added per employee.

  • EBITDA is a key metric, representing operating profits before depreciation, taxes, interest and amortization. Trends in EBITDA margin (EBITDA/sales) are important to explain changes in profits.

  • Sector EBITDA margins have varied over time, with some sectors seeing declines and others improvements in margins from 2000-2017 based on estimates.

  • EBITDA, EBIT, operating profit/margin are important indicators analyzed by financial analysts to measure operating performance.

  • EBITDA excludes non-cash costs like depreciation/amortization, while EBIT further deducts these costs from EBITDA.

  • Operating profit is defined as sales minus cost of goods sold, selling/admin costs, R&D costs, plus/minus other operating income/costs.

  • Companies may try to artificially boost operating profit by excluding certain charges that should logically be included. Analysts must carefully analyze what is included/excluded.

  • The sectors exhibit very different operating margin trends over time, with mining generally having the highest margins due to heavy investment needs. Food retail has the smallest but stable margins.

  • Net financial income/expense reflects the company’s debt burden and interest rates, not the operating cycle.

  • Exceptional/extraordinary items are tricky to classify as recurring vs. non-recurring. Large firms may have recurring restructuring costs.

  • Effective tax rate should be monitored over time to assess tax management. Tax reconciliations explain differences from theoretical rates.

  • Associates’ profits/losses may significantly impact net income and require separate analysis if material. Minority interests also merit attention.

Here is a summary of the key points about minority interests from the provided text:

  • Minority interests relate to subsidiaries that are partially owned by the parent company. They represent the portion of equity in the subsidiaries that is not owned by the parent.

  • Minority investors do not necessarily finance losses - it depends on the financial performance of the specific subsidiaries they have interests in. If a subsidiary is profitable, minority investors will receive a share of the profits proportional to their ownership percentage.

  • However, minority investors are also not insulated from losses. If a subsidiary performs poorly and records losses, the minority investors will have to absorb a share of the losses as well.

  • Analyzing minority interests can help identify which subsidiaries are the most profitable/unprofitable for the group. Subsidiaries that generate large minority interests are likely among the most profitable, as the minority shareholders are receiving a significant portion of the earnings. Those with small or negative minority interests may be less profitable or unprofitable.

  • In summary, minority interests relate to partially-owned subsidiaries and provide insight into how earnings are being generated across different parts of the corporate group.

Here are the identified sectors for each company:

  1. Electricity producer - Utilities

  2. Supermarket - Retail

  3. Temporary employment agency - Staffing/HR

  4. Specialized retailer - Retail

  5. Construction and public infrastructure - Construction

  6. Here are the identified sectors for each company:

  7. Cement - Building materials

  8. Luxury products - Luxury goods

  9. Travel agency - Travel/tourism

  10. Stationery - Retail

  11. Telecom equipment - Technology

Here is a summary of key points about operating leverage and calculating breakeven points from the passage:

  • Operating leverage refers to how changes in sales/activity affect operating profit and overall profits. Higher operating leverage means profits are more sensitive to sales fluctuations.

  • Breakeven point is the level of sales/activity where total revenue equals total costs, resulting in zero profit/loss. It depends on a company’s cost structure and the period being considered.

  • Costs can be classified as fixed or variable depending on the time period. In the long run all costs may be considered variable.

  • Breakeven point is calculated by setting the contribution margin (sales - variable costs) equal to fixed costs.

  • Three types of breakeven points can be calculated: operating, financial, and total. Operating only considers production costs while financial and total include financing costs.

  • Total breakeven adjusts costs to include an expected profit level to satisfy shareholders. Below this point the company may profit but not satisfy investors.

  • Interest charges are a fixed cost that increase earnings instability, so highly indebted firms have higher leverage.

  • An example calculates the different breakeven points for ArcelorMittal using estimated cost classifications and figures.

  • The table provides financial information for ArcelorMittal from 2011-2015, including costs (fixed costs, financial fixed costs, variable costs), contribution margin, sales levels at different breakeven points (operating, financial, total), and the company’s position relative to each breakeven point.

  • Overall, the data shows that ArcelorMittal has generally been running at a loss or just below breakeven from 2011-2015. Its position has been -1% to -38% below the different breakeven points over this period.

  • Fixed costs have decreased from 2011 to 2015 but remain substantial. Financial fixed costs have increased over time. Variable costs have generally decreased from 2011-2015.

  • Contribution margin has remained stable at around 24.9-26.4% of sales over this period.

  • Sales levels needed to reach the different breakeven points have decreased from 2011-2015 but the company remained a significant percentage below these levels, indicating ongoing losses or low profits.

  • This financial analysis provides context for ArcelorMittal’s financial performance and challenges in breaking even from 2011-2015 during a difficult period for the steel industry. Ongoing cost restructuring would be needed for the company to consistently achieve breakeven.

Here are the key points about easing its sales, lowering its breakeven point or boosting its margins from the passage:

  • Increasing sales is only a viable option if the company has real strategic strength in its market. Otherwise, it will just delay the inevitable as sales growth will come at the expense of profitability.

  • Lowering the breakeven point involves restructuring operations like modernization and capacity reductions. However, there is a risk management believes they are just lowering breakeven when they are actually shrinking the business. This can trigger a downward spiral.

  • Boosting margins depends on strengthening competitive position through factors like market share, brands, distribution networks, etc. It also depends on incremental productivity gains from industrial processes.

  • Simply adjusting sales, costs or margins in projections without understanding drivers, competition responses and strategic coherence is unrealistic. Forecasts need to be explicitly stated and verified for significance.

So in summary, the passage cautions that simply easing sales, lowering breakeven or boosting margins may not be viable or sustainable strategies on their own without a solid understanding of market dynamics and strategic strengths. Restructurings to lower costs also carry risks of unintentionally shrinking the business.

Here is a summary of the key points regarding a company’s potential earnings power:

  • A company’s earnings power is fundamentally determined by its cash flow generation capacity. This depends on factors like revenue growth, profit margins, capital expenditure needs, and working capital requirements.

  • Revenue growth allows earnings to increase over time if it outpaces cost growth. Higher profit margins directly boost earnings for a given level of sales.

  • Capital expenditures must be efficient and aligned with revenue growth to support the business without being unduly burdensome. Excessive capex can weigh on cash flow.

  • Working capital requirements tie up cash that could otherwise be available for reinvestment or distribution to shareholders. Tighter management of working capital can free up more cash.

  • Debt usage amplifies earnings power if the pre-tax cost of debt is below the company’s return on invested capital. Excessive debt also increases financial risk.

  • Other factors like tax rates, continuity of management team/strategy, barriers to competition also influence a company’s ability to consistently convert revenue into profits and cash flows over the long run.

So in summary, a company’s potential earnings power depends on optimizing key elements of its business model like revenue growth, margins, capital efficiency, working capital management and financial leverage. Proper execution in these areas allows cash flows and long-term shareholder value to be maximized.

  • A company’s working capital needs to have funds equal to about a quarter of its annual sales on hand to pay suppliers and employee salaries for products/services that have not yet been manufactured, sold, or paid for by customers.

  • Over the past two decades, the working capital of large European companies has generally shrunk as a percentage of sales across most sectors.

  • Working capital is considered both liquid in that it turns over regularly through the business cycle, but also permanent in that a minimum level is always needed to maintain operations.

  • For seasonal businesses, working capital requirements fluctuate during the year but a minimum level is always needed to cover costs between seasons. About half the working capital may be considered permanent for very seasonal businesses.

  • Year-end working capital numbers need to be analyzed in the context of the company’s fiscal year-end date and any window dressing may be occurring. Comparing year-over-year changes can still provide useful insights.

Here is a summary of the key points about calculating and analyzing working capital ratios:

  • Accounts payable can be calculated as annual purchases (including VAT) divided by 365 days. Purchases include goods for resale, raw materials, and other external costs, all inclusive of VAT.

  • Total accounts payable is the sum of accounts payable plus advances/deposits paid on orders.

  • Days payables outstanding approximates accounts payable multiplied by 365 days divided by sales (including VAT) if annual purchases are unavailable.

  • Days inventory outstanding can be approximated as inventories and WIP multiplied by 365 days divided by annual sales (excluding VAT). More detailed ratios can be calculated for raw materials, goods for resale, finished goods, and work in progress depending on available data.

  • Turnover ratios have limitations if the business is seasonal or does not provide breakdowns of asset/liability components. Averages may only provide a general idea.

  • Working capital levels should generally remain stable as a percentage of sales as business grows. Increases in working capital represent a use of funds like capex.

  • Efficient companies control working capital growth relative to sales growth through strict management practices.

  • Recessions can initially stabilize working capital, then it may inflate as purchases drop while other items remain high, before returning to normal levels.

Here is a summary of the key points about working capital and ier credit from the provided text:

  • Working capital stabilization occurs at a low level proportional to sales after a recession crisis that can last up to a year.

  • Reducing working capital through contraction strategies requires psychological adjustment from management and can take several months to accomplish.

  • During recessions, working capital paradoxically tends to grow before restructuring measures are implemented. It only subsides late in the recessions.

  • Companies that vertically integrate by acquiring suppliers or distributors lengthen production cycles and increase working capital needs, as value added is incorporated in working capital line items like receivables and inventory.

  • Companies can have negative working capital if collection cycles are shorter than payment cycles, such as through long supplier payment terms or advance customer payments.

  • Negative working capital provides funding sources for expansion without external capital but can lead to management errors if not properly overseen.

  • Intercompany credit/payment terms vary significantly between countries due to cultural, historical, technical and strategic factors in customer-supplier power dynamics.

So in summary, it discusses the behavior of working capital during economic downturns and contractions, and how vertical integration and intercompany payment terms impact working capital levels and financing opportunities for companies.

Based on the information provided:

  • ArcelorMittal’s operating working capital has declined sharply from 2011 to 2015, from 58 days of sales to 39 days of sales. This reduction of €8 billion in working capital would have been only €5 billion if working capital had kept pace with sales.

  • The decrease in working capital is largely explained by a reduction in inventories, which adapted quickly to the drop in sales in 2015. Receivables and payables have remained relatively stable.

  • ArcelorMittal’s ratios for receivables (33-55 days) and payables (45-51 days) indicate respectable payment periods that seem reliable given the industry is not highly seasonal.

  • The ratio of net fixed assets to gross assets has declined from 67% to 57% from 2011-2015, but is not considered worrying at this stage.

  • Capital expenditures have declined slightly and only represented about 3/4 of depreciation from 2013 onward, focused on maintenance and productivity rather than expansion.

So in summary, yes it can be said that ArcelorMittal has managed its working capital well over this period, reducing it significantly faster than the drop in sales through inventory management particularly, while maintaining stable receivables and payables. This helped free up cash flow during a challenging period for the steel industry.

Here are the key points from the questions:

  1. Permanent working capital calculated on the balance sheet is representative of the company’s non-current or long-term needs. It finances relatively stable assets like property, plant and equipment.

  2. Recording income when received and costs when paid would generate working capital, as it increases the time lag between cash received from customers and cash paid to suppliers. This working capital would differ from the standard calculation in its timing assumptions.

  3. No, the permanent part of working capital is not liquid as it is tied up in non-current assets. It represents a long-term investment.

  4. During a recession, sales typically decline faster than costs can be adjusted. So working capital declines more slowly as costs are stickier than sales in the short run.

  5. During inflationary periods, the value of working capital increases due to rising prices, even if the quantities sold/purchased remain unchanged. More working capital is needed to finance higher cost inventories and receivables.

  6. The CFO’s comments confuse different performance metrics and raise concerns about increased working capital burdening the company. The auditor would advise checking debt levels and reviewing credit/inventory policies to contain risks.

In summary, the key is understanding how a company finances its ongoing operational needs through management of working capital - the focus should be on optimizing the balance between risk, liquidity and profitability over time.

Here are the summaries of the selected articles on working capital management and corporate capex:

Working capital management and corporate profitability:

  • Analyzed the relationship between working capital management and corporate profitability. Found that better working capital management through reduced receivable and inventory days leads to improved profitability as measured by return on assets and return on equity. Maintaining an optimum level of working capital is important for corporate performance.

Political uncertainty and corporate investment cycles:

  • Examined how political uncertainty affects corporate investment. Found that political uncertainty leads firms to scale back capital expenditures, especially for more sensitive capital items. However, firms resume investing as uncertainty is resolved. Political uncertainty introduces time-varying risk that disrupts corporate investment cycles.

CAPEX Excellence: Optimizing Fixed Asset Investments:

  • Provides a framework and best practices for aligning capex planning and implementation with corporate strategy. Discusses how to establish a capex governance structure, develop a robust prioritization and funding process, and monitor and report on capex performance. Aims to help firms maximize returns from capital investments.

Annual Capital Expenditures Survey:

  • Presents findings from an annual US government survey tracking nonresidential private fixed investment in the US. Includes data on expenditures, investment types and industries for equipment, intellectual property products, and structures. Provides insights into macroeconomic trends in corporate capital spending.

Corporate asset purchases and sales:

  • Studies the factors influencing corporate asset purchase and sale decisions. Found that macroeconomic conditions, industry dynamics, and corporate governance structures affect the scale and timing of asset transactions. Both internal and external factors need to be considered for capital budgeting decisions.

  • A core shareholder of a company may have an easier time underwriting a new share issue, as they know the company well. It depends on the value of equity capital - only a “vulture fund” may be interested if equity is near zero.

  • Analysts commonly use the ratio of net debt to EBITDA to assess a company’s ability to repay debt. A ratio of 2.5 is considered critical, signaling the debt could be repaid in 2.5 years if cash flow was devoted only to that. Higher ratios indicate heavier debt loads.

  • Bankers are more willing to lend to sectors with stable, predictable cash flows even at high debt ratios, versus volatile sectors. Effective cash flow generation capacity is also important.

  • The interest coverage ratio (EBIT to interest expense) is also examined, with a ratio of 3:1 seen as critical. Above this level, lenders can be more at ease about debt repayment.

  • Cash flow to net debt is preferred by rating agencies, as cash flow is closer to actual debt repayment capacity than EBITDA.

This passage discusses liquidity and working capital issues for a company. Some key points:

  • Liquidity is the ability to meet short-term obligations as they come due. Several liquidity ratios are discussed like the current ratio, quick ratio, and cash ratio which compare current assets to current liabilities.

  • The company will need to manage its debt in the next few years and may need to restructure it.

  • It has cumulative amounts due within 3 months, 1 year, 2 years, 5 years, and 10 years. There is a large debt falling due within 5 years that will need to be addressed.

  • Working capital is discussed. Ideally it should be financed through permanent sources like equity rather than short-term debt. However companies often use revolving credit facilities to finance working capital.

  • Negative working capital is discussed, noting the company relies more on payment terms from suppliers in this situation and is more vulnerable to declines in business volume.

  • For the specific company ArcelorMittal, free cash flows after financial expenses from 2011-2015 were positive and helped reduce net bank debt due to declining working capital and lower capital expenditures. Dividends paid matched capital raises over this period.

Here is a summary of the key points about borrowings and long-term debt from the passage:

  • At the end of 2015, ArcelorMittal’s borrowings and long-term debt amounted to $20.3 billion, excluding additional pension fund commitments of $9.2 billion.

  • While ArcelorMittal reduced its net debt by 20% excluding pension funds, its net debt to EBITDA ratio sharply deteriorated from 2.7 in 2011 to 5.3 in 2015, and 7.8 when including pension commitments. This was due to a significant decline in EBITDA.

  • ArcelorMittal launched a $3.5 billion capital increase in early 2016 to help reduce debt levels. It also suspended dividend payments starting in 2016.

  • ArcelorMittal’s debt consists entirely of bonds maturing over several years through 2020, with an average maturity of 6.2 years. This means there is no medium-term liquidity risk unless the steel market sees another downturn.

  • In the short-term, ArcelorMittal’s liquidity is more precarious as outstanding liabilities account for an increasingly large share of current assets. However, it has $6 billion in undrawn credit lines expiring in 2018-2020 to help with short-term liquidity.

In summary, while ArcelorMittal reduced gross debt levels, its debt burden significantly increased relative to operating performance due to declining EBITDA. It took measures like a capital increase and suspending dividends to help boost liquidity and reduce debt levels in response to this deterioration.

Here are summaries of the sources provided:

  1. View of Financial Studies, 20(5), 1429–1460, September 2007.

No summary is possible as no title or authors were provided for this source. More context would be needed to generate a useful summary.

  1. R. Elsas, M. Flannery, J. Garfinkel, Financing major investments: Information about capital structure decisions, Review of Finance, 18(4), 1341–1386, July 2014.

This article examines how firms finance major investments and what information is revealed about their capital structure decisions through this process. However, without accessing the full text, no more detailed summary can be provided.

  1. E. Morellec, Asset liquidity, capital structure and secured debt, Journal of Financial Economics, 61(2), 173–206, August 2001.

This article looks at how asset liquidity influences capital structure decisions, particularly the use of secured debt. However, without the full text, only a basic overview can be provided.

  1. Excerpts from Corporate Finance: Theory and Practice, Fifth Edition By Pierre Vernimmen, Pascal Quiry, Maurizio Dallocchio, Yann Le Fur and Antonio Salvi

The excerpt discusses different measures of corporate profitability like return on capital employed (ROCE) and return on equity (ROE). It explains how financial leverage through the use of debt can increase ROE relative to ROCE through the leverage effect. Various concepts involved in calculating returns and relating them to operating margins and asset turnover are also covered at a high level.

When a company raises additional debt, its return on capital employed (ROCE) must be higher than the cost of borrowing that debt. Otherwise, the company will be borrowing at a higher rate than the returns it generates by investing the borrowed funds into its capital employed.

This gives rise to a deficit, which reduces the company’s rate of return on equity (ROE). Specifically:

  • The company’s earnings will decline as interest payments increase

  • The ROE will dip below the ROCE

  • The leverage effect of debt shifts from enhancing returns to reducing returns

So in situations where ROCE falls below the after-tax cost of debt, the use of debt leverage backfires and acts to decreases ROE relative to ROCE. Returns on equity are pulled down by the negative “leverage effect”.

Mathematically, ROE equals ROCE plus the leverage effect (i.e. the difference between ROCE and cost of debt, multiplied by the ratio of net debt to shareholders’ equity). When ROCE declines below the cost of debt, this leverage effect turns negative.

So in summary, additional debt can only increase shareholder returns through financial leverage if the company’s ROCE remains above its cost of borrowing. Otherwise, debt usage will diminish ROE by generating deficits on invested funds.

Here is a summary of the key points about return on debt/leverage effect:

  • Leverage effect shows how use of debt impacts return on equity. It’s calculated as (ROCE - cost of debt) x gearing (debt/equity ratio).

  • Higher gearing amplifies both positive and negative impacts of cost of debt on ROE through leverage effect.

  • ROE can be calculated either directly or via return on capital employed plus leverage effect. Both should give the same result.

  • Issues that can impact calculations include treatment of goodwill, losses carried forward, and income from associates.

  • For negative capital employed firms, financial income must be included in calculating ROCE.

  • Book returns only reflect historical performance and do not consider risk. They should not be used alone to set financial targets or project future required returns.

  • An aggressive strategy of high capex, low margins, and debt use was common in high growth periods to rapidly gain market share, though it leads to unstable ROE. This was the approach of firms like Suntech.

So in summary, leverage effect quantifies debt’s ROE impact through gearing, but book returns alone do not capture risk and cannot be used to set financial objectives.

  • The leverage effect refers to the difference between return on equity (ROE) and return on capital employed (ROCE) arising from the capital structure of a company (proportion of debt vs equity).

  • It is calculated using the leverage effect equation: ROE = ROCE + (ROCE - Cost of debt) x Debt/Equity

  • This equation is an accounting tautology as total assets must equal total liabilities plus equity.

  • The leverage effect can increase ROE by boosting it above ROCE when ROCE exceeds the cost of debt, but it can also dilute ROE if ROCE falls below the cost of debt.

  • In the long run, only sustained high ROCE ensures high ROE; the leverage effect alone does not create value.

  • ROCE, ROE and cost of debt are historical accounting measures that do not capture risk-adjusted returns required by investors.

  • Goodwill impairments can artificially increase reported ROCE by reducing capital employed in the denominator.

  • The leverage effect helps identify whether high ROE comes from ROCE or capital structure influences.

  • The passage discusses solvency and value creation as key questions to answer after completing a financial analysis of a company.

  • Solvency depends on the break-up value of assets relative to debt obligations. Some assets like real estate may have independent value, while others like specialized equipment may not.

  • Losses hurt solvency by reducing equity and increasing debt through cumulative effects. Loss-making companies lose the tax shield benefit of debt.

  • An example shows how losses and declining returns quickly increase debt ratios and shrink equity and asset values over time. This spiraling debt can lead to restructuring or bankruptcy if losses continue.

  • The main points are that financial analysis should evaluate solvency and value creation, losses threaten solvency through debts piling up, and declining returns can start a downward spiral for a company through increasing debt burdens over time.

Here is a summary of the key points about solvency and assessing a company’s financial stability based on the passage:

  • Solvency refers to a company’s ability to repay all of its debts or creditors in full. It considers whether the value of a company’s assets is greater than its total liabilities.

  • Net assets, calculated as total assets minus total liabilities, is a traditional measure used to assess a company’s solvency. Positive net assets indicate the company is solvent.

  • For consolidated financial statements, calculating net assets can be complicated by factors like minority interests, goodwill, and intangible assets whose values are uncertain.

  • When a company’s financial reports are delayed, a reverse cash flow statement starting from the change in net debt can provide an estimate of earnings to assess solvency. A decreasing cash balance not explained by investments/financing may indicate operating losses.

  • To fully analyze solvency, the passage recommends examining individual statutory accounts of group entities before consolidating net asset figures.

  • Being insolvent does not automatically require declaring bankruptcy, but insolvency will likely doom a company’s survival as an independent entity over the long run.

So in summary, the passage outlines how to assess a company’s solvency primarily by analyzing its net assets position based on statutory accounts, and provides alternate approaches using cash flows if full financial reports are unavailable. Maintaining positive net assets is presented as key to a company’s long-term viability.

  • The section provides an overview of analyzing a company’s financial statements, including evaluating total assets, liabilities and equity capital.

  • It emphasizes the importance of looking at consolidated accounts to get a full picture of all assets, debts and risks across a corporate group.

  • Special attention should be given to analyzing highly leveraged subsidiaries, as the parent company may end up bearing significant debt loads from subsidiaries that cannot pay sufficient dividends.

  • Examples are provided of analyzing companies based on their debt levels, returns on capital employed, and whether their current equity value is positive or negative based on financial ratios.

  • The analysis evaluates the financial health and sustainability of a company based on its use of leverage and ability to service and repay debt obligations. Highly leveraged companies with debt exceeding earnings capacities may be at risk of bankruptcy.

  • Mutual funds have grown in popularity as financial intermediation shifts from banks making loans to brokerages placing companies’ securities directly with investors.

  • Banks primarily extend loans to households (consumer credit, mortgages) and small businesses that don’t access capital markets.

  • Growing disintermediation has forced banks to align deposit and loan rates with market rates. Market forces increasingly influence all financial instruments.

  • Rising capital markets are evidenced by increasing numbers of listed companies, market capitalization, and trading volumes on stock exchanges worldwide.

  • Financial systems efficiently allocate funds to profitable investment projects while allowing investors to convert current income into future consumption and borrowers to access current resources at the cost of future spending.

  • Key financial system functions include means of payment, financing, savings/borrowing, risk management, information provision, and reducing/resolving conflicts.

  • Large financial conglomerates emerged from mergers of commercial and investment banks, adopting a universal bank model with businesses like retail banking, investment banking, asset management, and trading.

Investment and corporate banks provide sophisticated financial services to large corporate clients. These services include:

  • Access to equity and bond markets through initial public offerings and bond issuances to help companies raise funds. Banks advise on these transactions.

  • Bank financing such as syndicated loans, bilateral lines of credit, and structured financing.

  • Mergers and acquisitions advisory services, though often public offerings accompany acquisitions.

  • Access to foreign exchange, interest rate, and commodities markets for hedging risks. Banks also speculate on these markets.

Asset management divisions have their own clients like institutional investors and high-net-worth individuals. They also manage funds for some retail banking clients. Asset managers sometimes use investment banking products for hedging and order execution.

Some banks focus on specific services like M&A advisory or geographic areas, while large global banks operate across all these banking activities. The financial crisis showed the central role of banks and how poorly managed banks were most severely impacted. No single business model proved definitively better.

  • There is evidence of a risk premium that varies inversely with the liquidity of a security. Less liquid securities command a higher premium as compensation for their illiquidity.

  • Chapter 19 will measure the size of this illiquidity premium.

  • The efficient market theory states that markets are efficient when investors are rational and act based on available information. But various anomalies have been observed that contradict perfect efficiency.

  • Behavioral finance rejects the assumption of perfect rationality and considers how actual human psychology and behavior can impact markets. Models from behavioral finance have not yet replaced efficient markets theory but provide additional insights.

  • At any time, investors can be hedgers (seeking to reduce risk), speculators (willing to take risks in hopes of profit), or arbitrageurs (seeking temporary mispricing to exploit for riskless profit). Both hedging and speculation play important roles in financial markets, though speculation is often criticized despite its function of facilitating price discovery.

Here are the key points summarized from the passage:

  • Speculators assume risks that other market participants like companies and investors do not want to accept. This allows the risks to be transferred and minimizes the risk borne by others.

  • For example, a European company with US dollar debt can buy dollars forward from a speculator to lock in the exchange rate and eliminate its exchange rate risk. The speculator takes on the risk of exchange rate fluctuations until the debt is repaid.

  • Likewise, if an asset class is in short supply long-term but there is excess short-term savings, a speculator will bridge the gap by borrowing short-term to lend long-term, taking on intermediation risk.

  • Speculative bubbles are isolated events and normal speculative activity is necessary for well-functioning markets. It allows risks to be distributed efficiently.

  • A speculative market is one where all participants are speculators, so market forces become divorced from economic reality and self-reinforcing based on collective expectations rather than fundamentals. This can lead to bubbles and crashes.

  • In contrast, arbitrageurs exploit small temporary price differences between equivalent assets to lock in risk-free profits, bringing markets back into alignment. They assume no net market risk.

  • Arbitrage activities benefit markets by increasing liquidity and reducing disequilibriums, leading to more efficient prices. Their actions are on the boundary between speculation and true risk-free arbitrage.

  • For a market to function properly it needs a mixture of hedgers, speculators and arbitrageurs, as their collective actions distribute risk efficiently and keep markets stable yet responsive to new information.

Here are a few key points about the time value of money concept and its applications:

  • The time value of money refers to the concept that money available at different points in time has different value due to interest, return, inflation, or other factors. Basically, money today is worth more than the same amount in the future due to its potential earning capacity.

  • This gives rise to the fundamental techniques of capitalization, discounting, and net present value analysis. Capitalization involves determining the value today of future cash flows through discounting. Discounting involves determining the present value of future cash flows or obligations.

  • Net present value (NPV) analysis allows comparing the value today of the future cash flows from an investment opportunity to the amount of capital required upfront. It helps evaluate whether long-term projects are economically viable or not.

  • These concepts and techniques are important for areas like security valuation, investment analysis, capital budgeting decisions, liability quantification, and overall financial planning and management.

  • They provide a common framework and language for comparing financial prospects that occur over different time periods on an “apples-to-apples” basis. This time value of money approach is deemed universally applicable.

  • Mastering these valuation and investment analysis tools is considered a core reflex or competence for anyone dealing with financial decisions that involve cash flows occurring over time.

So in summary, the time value of money principle and its applications like discounting, capitalization and NPV are crucial for both economic progress and sound financial decision-making where the timing of cash flows is a key consideration.

  • The businessman initially invested €100,000 in his business 10 years ago. After 10 years, the business was worth €1,800,000 without any additional funds being invested during that time.

  • To calculate the return, we compare the profit (€1,700,000) to the initial investment (€100,000). This gives a return of 1,700% over 10 years.

  • However, simply dividing the total return by the number of years does not accurately calculate the annual return, as there were no annual payouts.

  • To properly calculate the annual return rate, we must use the capitalization formula. This formula calculates the hypothetical annual return rate that would be needed to grow the initial €100,000 to €1,800,000 over 10 years with annual reinvestment.

  • Using the capitalization formula, the annual return rate is calculated to be 33.5%. This is a good return, but not as impressive as the initial 170% figure suggested.

  • In summary, to accurately calculate returns over multiple periods when there are no interim payouts, the capitalization formula must be used to determine the equivalent annual compound return rate. Simply dividing the total profit by years can misstate the actual annual return.

  • Discounting involves calculating the present value of future cash flows by applying a discount rate. It converts future values into present values.

  • Discounting and capitalization are two ways of expressing the time value of money. Capitalization converts present values into future values, while discounting does the opposite.

  • The discounting formula is: Present Value = Future Value / (1 + Discount Rate)^Time Period

  • Net present value is calculated as the present value of cash flows minus the initial investment amount. If NPV is positive, the investment is worthwhile.

  • As the discount rate increases, present value and net present value decrease. A higher discount rate means less value is placed on future cash flows.

  • Perpetuities represent constant cash flows that continue indefinitely. Their present value can be calculated by dividing the cash flow amount by the discount rate.

  • Growing perpetuities involve cash flows that increase at a constant growth rate indefinitely. Their present value factors in both the discount and growth rates.

  • Discounting and NPV analysis can be applied to evaluate any stream of future cash flows, such as capital investments or acquisition opportunities.

  • Net present value (NPV) measures the value created or destroyed by an investment or security purchase by discounting future cash flows.

  • Discounting future cash flows is necessary to compare them to current values, as money has time value. The higher the discount rate, the lower the present value.

  • The discount factor is equal to 1/(1+r)^n where r is the discount rate and n is the number of periods.

  • NPV is equal to the present value of cash inflows minus the present value of cash outflows.

  • When markets are in equilibrium, NPVs are usually zero as assets are correctly priced.

  • Factors like required rate of return correspond to the discount rate used in NPV formulas. Initial investment flows are often negative while later cash flows are positive.

  • Calculating NPV allows determining if an investment is worthwhile by seeing if it has a positive NPV over the required rate of return. This considers the time value of money.

  • Discounting is necessary even without inflation or risk to account for the fact that money available now is worth more than the same amount in the future due simply to the ability to reinvest it.

  1. Net present value (NPV) and internal rate of return (IRR) are two methods used to evaluate investments and projects. They can sometimes give conflicting results.

  2. IRR is the discount rate that sets the NPV equal to zero. It represents the expected annual return rate of an investment.

  3. The decision rule is to accept investments with an IRR higher than the required rate of return.

  4. Comparing multiple investments using just IRR or NPV can be problematic as they may indicate different preferred choices.

  5. With reinvestment, NPV assumes reinvestment at the required rate of return, while IRR assumes reinvestment at the same exceptional IRR rate of the project. This can lead IRR to overstate returns.

  6. To address this, the modified IRR (MIRR) formula separates the investment and reinvestment rates, assuming reinvestment at the required rate of return like NPV. This makes MIRR directly comparable to NPV.

  7. In situations of conflicting NPV and IRR results, NPV is generally considered a more reliable investment evaluation method as it accounts for reinvestment in a more realistic way. MIRR can also be used for a more accurate comparison.

The modified internal rate of return (MIRR) is the rate of return that yields an NPV of zero when the initial outlay is compared with the terminal value of the project’s net cash flows reinvested at the required rate of return.

To determine the MIRR, we do two stages:

  1. Calculate forward until the end of the project to determine the terminal value of the project by compounding all intermediate cash flows at the required rate of return.

  2. Find the internal rate of return that equates the terminal value with the initial outlay.

In other words, the MIRR takes into account both the cost of capital used to invest in the project initially and the expected reinvestment rate of future cash flows. It provides a more accurate measure of return for projects with non-linear cash flows compared to the traditional IRR.

Here is a summary of the key points from the chapter:

  • The effective annual interest rate should be used when comparing investments or loans that have different interest payment frequencies. It takes into account the compounding effect of interest paid more often than annually.

  • Nominal interest rates only indicate the periodic interest rate and do not reflect the true overall return when interest is compounded more frequently.

  • The yield to maturity is the internal rate of return and discounts all cash flows to the present value, equaling the purchase price. It can be used to compare investments regardless of term or cash flow schedule.

  • Proportional rates are calculated to simply determine the actual periodic interest payment, but cannot be used for comparison purposes like effective annual rates or yield to maturity.

  • Internal rate of return should only be used to evaluate a single investment, not to compare multiple alternatives, since it assumes cash flows are reinvested at the same rate. Net present value is better for comparisons.

  • For a given loan, total interest paid is highest with annual repayment, lower with constant amortization, and lowest if repaid in full at maturity due to the effects of compound interest.

  • Higher frequency of interest payments on a loan results in a higher effective annual rate and total cost compared to a nominal rate.

  • There are many types of risk involved in holding financial securities, including industrial/commercial risk, liquidity risk, solvency risk, foreign exchange risk, interest rate risk, systemic risk, political risk, regulatory risk, inflation risk, fraud risk, and natural disaster risks.

  • Risks can affect the value of a security by changing anticipated cash flows or the discount rate used. If a risk materializes and hurts company cash flows, the value of the security will fall. If a company faces significant risk, some investors will be reluctant to buy its securities, reducing the value even before a risk materializes.

  • Modern finance is based on the premise that investors seek to reduce uncertainty about future cash flows. Risk increases this uncertainty, so risk is priced into the market value of a security. Investors only care about risk to the extent it impacts the value.

  • No distinction is made between upside risk and downside risk - it is the existence of risk itself that matters, not whether the risk is of asset value rising or falling. The perception of risk and uncertainty is what reduces the value of a security.

  • All risks, regardless of their nature, lead to fluctuations in the value of a financial security. Anything that introduces uncertainty about the expected cash flows of a security increases its risk.

  • Risk is measured by the volatility or dispersion of possible returns around the expected return. Greater volatility means greater risk. It can be quantified using variance and standard deviation.

  • The main types of risks that affect security values are market risk, which is risk due to overall market movements, and company-specific risk, which is risk driven by factors unique to the individual company.

  • Other risks include interest rate risk, inflation risk, currency risk, liquidity risk, political/regulatory risk, etc. But they all ultimately manifest through their impact on the security’s expected cash flows and value.

  • Risk generally decreases over longer time horizons as short-term fluctuations average out. But investors may not be able to endure potential short- and medium-term losses. So risk perception affects how investors behave.

  • There are two main sources of risk for stocks - market risk and specific risk.

  • Market risk, also called systematic or undiversifiable risk, is due to overall economic trends that affect all stocks. Specific risk is independent of market trends and comes from company-specific factors.

  • Total risk is the combination of market risk and specific risk. Market risk can be measured by a stock’s beta, which indicates its volatility relative to the overall market. Specific risk is the residual risk not explained by market movements.

  • Factors like a company’s sector, cost structure, financial leverage, information disclosure, and growth prospects influence its specific risk and beta. More economically sensitive sectors and those with higher fixed costs tend to have higher betas.

  • When comparing two stocks, looking at expected returns and risk individually does not provide a full picture. Diversifying a portfolio across the two stocks may yield a better risk-return tradeoff than investing in just one. This captures the benefits of diversification.

  • Risk-free assets have zero risk (standard deviation) by definition, as their returns are certain. Government bonds and Treasury bills are traditionally considered risk-free.

  • A portfolio can combine a risk-free asset with Heineken shares. Its expected return is a weighted average of the risk-free rate and Heineken’s expected return.

  • Its risk is the risk of the Heineken shares only, weighted by their proportion in the portfolio.

  • By combining the equations for expected return and risk, we can derive an expression that shows the portfolio’s expected return as equal to the risk-free rate plus a risk premium that is the difference between Heineken’s expected return and the risk-free rate, weighted by the ratio of the portfolio’s risk to Heineken’s risk.

  • This final expression shows the trade-off between risk and return - an investor can increase expected return by taking on more risk relative to the risk-free asset.

Here is a summary of the key points about Heineken’s standard deviation:

  • For a portfolio that includes both risky assets (like stocks) and risk-free assets (like bonds), there is a linear relationship between expected return and risk. Adding more risk-free assets lowers the portfolio’s risk.

  • The portfolio’s expected return and standard deviation can be expressed as a weighted average of the risky and risk-free components.

  • With the Heineken example, a portfolio consisting of 50% in a risk-free asset earning 3% and 50% in a stock with an expected return of 6% and standard deviation of 10% would have an expected return of 4.5% and standard deviation of 5%.

  • Graphically, this mixed portfolio would lie on the capital market line between the risk-free rate and the alpha portfolio. Portfolios on this line provide the optimal risk-return tradeoff for a given level of risk.

So in summary, it outlines how to calculate the expected return and standard deviation of a mixed portfolio containing both risky and risk-free assets, and how this portfolio sits in relation to the capital market line.

  • Hedge funds offer additional diversification beyond traditional equities and bonds since their performance is theoretically not correlated to the market.

  • Short-selling hedge funds make profits when stock prices fall by borrowing shares, selling them, then buying them back at a lower price and returning them.

  • As of 2015, over 8000 hedge funds globally managed around $2900 billion in assets.

  • In recent years, hedge funds have achieved higher risk-adjusted returns than traditional investments, even during bear markets, with relatively low correlation to other opportunities.

  • Hedge funds may have restrictions on investing (size, duration, etc.). Funds of funds allow more investors to access hedge funds by bundling the best managers.

  • Private equity funds mainly invest in non-public companies at different maturity stages.

Here is a summary of the key points about risk premium from the passage:

  • Risk premium refers to the difference between the risk-free rate and the expected return on the market portfolio. It represents the additional return expected by investors for taking on risk.

  • The concept of risk premium only makes sense when an investor holds a diversified portfolio of investments, not a single investment. Diversification allows the failure of one investment to be offset by successes of others, reducing overall risk.

  • Portfolio theory and diversification are central to understanding how the risk premium works. Investors can estimate the risk-return of individual investments within their diversified portfolio.

  • For a non-diversified entrepreneur running their own company, the risk premium is not relevant as their assets are not diversified. The company’s success or failure depends entirely on that one investment.

  • Financial investors need tools like the CAPM to estimate risk-return for individual investments within their diversified portfolio. This allows them to properly price risk and required returns.

  • In summary, the risk premium quantifies the trade-off between risk and return for diversified investors, but does not apply to those with concentrated, non-diversified exposures to a single investment. Diversification is key to the risk premium concept.

  • The Capital Asset Pricing Model (CAPM) aims to define the expected return of an individual security based on its risk, building on portfolio theory and the concept of diversifiable vs. non-diversifiable (market) risk.

  • According to CAPM, in an efficient market where arbitrage is possible, investors will only be compensated for non-diversifiable market risk, not for risk that can be diversified away.

  • CAPM states that the expected return of a security is equal to the risk-free rate plus a risk premium that is proportional to the security’s non-diversifiable systematic risk (beta).

  • Beta measures how sensitive a security’s returns are to movements in the overall market. A beta of 1 means the security moves with the market; less than 1 means it is less volatile than the market.

  • The model has limitations in practice, such as difficulty determining the true risk-free rate and market portfolio, declining ability to diversify risk, and statistically declining relevance of beta over time.

So in summary, CAPM provides a framework for relating a security’s expected return to its non-diversifiable risk based on the concept of systematic vs. unsystematic risk, but has practical limitations in implementation.

  • The CAPM assumes markets are fairly valued and investors have rational expectations, but markets are not always at fair value and technical analysis shows doubts about market efficiency.

  • Beta is the main measure of risk in CAPM but it is unstable over time. Forecast beta should be used rather than historical beta.

  • APT expands on CAPM by assuming return depends on multiple macroeconomic factors rather than just the market. However, it does not define which specific factors to use.

  • Empirical models have found size, liquidity, and past performance also help explain returns, but they are not based on theory like CAPM and APT.

  • A liquidity premium should be added to CAPM-derived returns to reflect lower expected returns for less liquid small caps.

-Price movements may not follow random walks as efficient markets theory assumes. Alternative theories model potential for large price changes using chaotic functions or fractals.

  • CAPM is a single-period model and does not distinguish short vs long-term interest rates. The yield curve relates interest rates of different bond maturities and reflects expectations of inflation, monetary policy, and debt management.

  • Strong expectations of recovery from the recession would put upward pressure on long-term rates, as investors anticipate rate hikes from central banks.

  • Credible central bank policy is important - if central banks are seen as firmly fighting inflation, it increases confidence they will keep rates low, putting downward pressure on long-term rates.

  • Diminishing inflationary trends also put downward pressure on long-term rates, as it reduces expectations of future rate hikes. However, very strong inflation could keep rates stable for longer if markets expect inflation to persist.

  • In June 2008, short-term rates were above long-term due to lack of liquidity, an inverted yield curve situation.

  • As long as rates are expected to fall further, investors will buy bonds, keeping the curve flat. But expectations of lower limits will cause rates to stabilize or rebound and the curve to steepen.

  • The degree of curve movements depends on the currency and economy-specific factors.

  • Short and long-term rates are fundamentally linked, contrary to old theories of segmentation. Investors consider future expected short rates to determine required returns on long-term bonds.

  • Liquidity preference theory explains upward sloping curves, as liquidity premiums normally rise with maturity despite expectations of stable future short rates.

  • To properly value bonds, each cash flow should be discounted at the corresponding point on the yield curve rather than a single rate.

Here is a summary of the key points about a rest rate:

  • Rest rate refers to the interest rate paid on an asset when it is sitting idle or at “rest”, generating no additional income or returns.

  • For debt instruments like bonds, the rest rate is usually the risk-free rate, which is the minimum return an investor expects to earn over a similar time period with no risk of default. Common examples used as proxies for the risk-free rate include short-term government bonds or treasury bills.

  • In asset pricing models like the Capital Asset Pricing Model (CAPM), the rest rate or risk-free rate acts as the baseline return against which risky assets are compared. The expected return on a risky asset is equal to the rest rate plus a risk premium.

  • Knowing an asset’s rest rate is important for calculating its required return, evaluating if it is fairly valued, and making investment decisions about whether the potential returns compensate for the additional risk above the rest rate.

  • If the actual expected returns on an asset are lower than the required returns based on its risk level and the rest rate, it could be undervalued by the market.

Here are the key points summarized from the provided texts:

  • Kritzman (2002) discusses six practical problems in finance and their remarkable solutions.

  • La Porta et al. (1998) examines the relationship between legal protection of investors and various measures of financial development across countries. It finds countries with common law systems have more developed financial markets and better investor protections than countries with civil law systems.

  • Mehra (2003) discusses why the apparently high returns of holding the market portfolio compared to risk-free rates, known as the equity premium puzzle, has confounded financial economists for decades.

  • Peters (1996) examines chaos theory and its applications to capital markets, arguing markets exhibit chaotic behavior that is inherently unpredictable.

  • Vernimmen et al. (2018) discusses fixed interest rates on debt securities. A debt security represents the borrower’s obligation to repay funds to the lender. Interest can be fixed or floating. Bonds are the most common type of debt security but other instruments like commercial paper are also discussed. Key terms like maturity, yield to maturity and credit ratings are explained.

  • On chaos theory, Peters (1996) discusses applying chaos theory to analyze inherently unpredictable behavior in capital markets, while Vernimmen et al. (2018) discusses factors that determine the actual return or cost of a fixed-rate debt security compared to the nominal interest rate.

  • The spread is the difference between a bond’s yield and a benchmark yield, such as the swap rate or government bond yield. For floating rate bonds, the spread is typically measured against a short-term rate like Euribor.

  • The easyJet bond was issued with a spread of 147 basis points above the mid swap rate, meaning it paid 1.47% more in interest than the benchmark swap rate.

  • The spread depends on the issuer’s credit quality and maturity, and is reflected in their credit rating. Stronger issuers command lower spreads. Spreads tend to widen during financial crises.

  • After issuance, the bond trades on the secondary market and its yield fluctuates based on price changes. However, this does not affect the issuer’s financing cost which was fixed at issuance.

  • Floating rate bonds have coupons that periodically reset based on a reference rate plus a fixed spread. This cancels out interest rate risk for both issuer and investor. Price is stable around par except for credit risk factors.

  • Index-linked bonds can have coupon or principal payments linked to inflation indexes or other market indicators like commodity prices. This provides investors protection against those risks.

  • Green bonds finance projects or initiatives that have positive environmental outcomes. However, from a financial perspective, they are standard bonds.

  • Extra costs are involved in monitoring spending to ensure it aligns with the intended green objectives. This results in green bonds having slightly higher costs for issuers compared to traditional bonds.

  • Green bonds are also a communication tool for companies, even those in industries not traditionally associated with environmental friendliness.

  • Volumes of green bond issuance are growing rapidly but still represent a relatively small portion (around 10%) of the overall bond market.

  • Social bonds and sustainability bonds have also emerged, following a similar principle as green bonds but focused on financing social or broader sustainability goals.

The value of a bond portfolio can fluctuate due to changes in interest rates over time, specifically due to capital risk and coupon reinvestment risk. An immunized portfolio is protected against these risks.

Immunization refers to choosing bonds for the portfolio such that the duration of the overall portfolio matches the intended investment time period. For example, an investor looking to invest for 3 years would choose a portfolio with a duration of 3 years.

Duration is a measure that indicates the sensitivity of a bond’s price to interest rate changes. It takes into account the present value of all future cash flows from the bond. A bond’s duration can be calculated at issue and will change over the lifetime of the bond as it nears maturity. Zero-coupon bonds have a duration equal to their time to maturity.

By making the duration of the portfolio match the investment time period, any capital losses from interest rate changes will be offset by gains from reinvested coupon payments, resulting in the same overall return as originally intended. The portfolio is thus immunized against fluctuations in interest rates.

Here is a summary of the key points about how the speed of appreciation or slug: gishness of depreciation of a bond’s price is affected by changes in interest rates:

  • If interest rates decline, the price of existing fixed-rate bonds will appreciate faster due to capital gains. This is because new bonds issued at lower rates will be more attractive than existing bonds, driving up the price of the existing bonds to keep their yields in line.

  • The duration measures how sensitive the bond price is to interest rate changes. Longer duration bonds will see greater price appreciation for a given decrease in rates compared to shorter duration bonds.

  • Conversely, if interest rates rise, the price of existing fixed-rate bonds will depreciate more slowly. Again this is to keep the yields of existing bonds in line with newly issued bonds at higher rates.

  • Floating-rate bonds are less sensitive to changes in interest rates since their coupon payments adjust with market rates. Their prices tend to remain closer to their par/face value compared to fixed-rate bonds.

  • Finally, the reinvestment risk for coupon payments on a bond portfolio decreases if interest rates decline, since those coupons can now be reinvested at higher yields. This provides support for the bond portfolio value.

So in summary, falling rates benefit existing bond prices through faster appreciation, while rising rates soften the pace of depreciation. Duration and type of bond (fixed vs floating) determine the degree of sensitivity.

  • The passage describes various debt products that corporations can issue to raise funds, similar to bonds but shorter-term or placed privately.

  • Commercial paper refers to negotiable debt securities issued on the money market by companies for 1 day to 1 year. The average maturity is 1-3 months. Two major European commercial paper markets are the ECP (London) and French TCN.

  • Private placements are another alternative, placed privately with institutional investors. Examples include bonds placed in the US, Germany, and Belgium (Euro PP). They provide long-term funding without a rating.

  • Banks also provide various credit products tailored to corporate needs, including overdrafts, commercial loans, revolving credit facilities (RCFs), term loans, bridge loans, and syndicated loans. Syndicated loans above €50M are arranged by a lead bank and syndicated to other participating banks.

  • Master credit agreements provide confirmed credit lines between a corporation and several banks, offering facilities like overdrafts, loans, guarantees, etc. across the corporate group.

In summary, the passage outlines the key short-term debt securities and bank credit products available to corporations to raise funds as alternatives to public bond issues.

  • Master agreements for credit lines allow large corporate groups to centralize financing for themselves and their subsidiaries through multi-currency and multi-company backup lines. They offer advantages like pooling cash between subsidiaries to minimize balances and harmonizing financing costs.

  • The agreements are based on guarantees between subsidiaries and the parent company. Subsidiaries can access credit lines at the same conditions across countries.

  • Short-term financing techniques like discounting and factoring allow companies to access funding based on outstanding trade receivables to bridge the gap until invoices are paid. Discounting involves remitting bills of exchange to a bank in exchange for an advance, while factoring involves selling receivables to a factoring company.

  • Lease contracts involve companies making fixed payments to the owner of an asset for the right to use it. Operating leases are for terms shorter than the asset’s life, while financial leases typically last the asset’s lifetime and involve more risk transfer to the lessee.

Here is a summary of the key principles of finance and operating leases:

  • Finance leases transfer substantially all risks and rewards to the lessee. Lessees should capitalize a finance lease at the present value of minimum lease payments.

  • Rental payments under a finance lease should be split between reducing the liability and a finance charge designed to decrease in line with the liability.

  • Lessees should calculate depreciation on leased assets using their useful life, unless ownership is uncertain, in which case the shorter of useful life or lease term is used.

  • Lessees expense operating lease payments. Lessor accounting differs between finance and operating leases.

  • There are various reasons a firm may prefer leasing over purchasing an asset outright, such as lack of borrowing capacity, off-balance sheet financing benefits, or avoiding bond covenants. However, leasing also has potential downsides such as higher financial costs.

Project financing involves grouping financiers, future project managers, and contractors into a single company specifically set up to finance and complete the project. Repayment of loans depends on the project’s cash flows once operational.

Project financing is only suitable if operating cash flows are certain and experts are managing operations. The political environment must also be stable. Risks exist during setup, construction, and operations. Cost overruns, delays, non-completion, and market or operational issues can impact cash flows and loan repayment.

Risks are mitigated through performance bonds, take-or-pay contracts, political risk insurance, and overcollateralization. International organizations and export credit agencies can also participate by lending, guaranteeing loans, or insuring risks.

Project financing allows complex, long-term investments to be completed but relies on accurate cash flow forecasts and management of numerous execution risks throughout the life of the project.

Here is a summary of key points from Chapter 22 of the textbook “Practice, Fifth Edition By Pierre Vernimmen, Pascal Quiry, Maurizio Dallocchio, Yann Le Fur and Antonio Salvi”:

  • The chapter discusses basic concepts for analyzing the value of stocks, including shares, EPS, dividends, dividend yield, payout ratio, book value, cost of equity, shareholder return, liquidity, and market capitalization.

  • EPS is calculated as net attributable profit divided by total shares. Dividend yield is the ratio of the last dividend to the current share price.

  • Payout ratio is the percentage of earnings distributed as dividends. It shows how much a company reinvests earnings vs pays out.

  • Book value represents the accounting value of shares. Market cap is the market value of all shares based on share price.

  • Liquidity refers to how easily shares can be traded and is important for share price relevance. It is measured by free float, trade volumes, and analyst coverage.

  • Multiples like P/E ratio allow comparison of a stock’s price to financial metrics like earnings. This helps investors analyze whether a stock is under or overvalued relative to peers.

  • The chapter introduces key concepts for fundamental analysis of stocks and their prices based on financial metrics. This provides a framework for assessing stock valuation.

  • Enterprise value is the market value of equity plus the book value of net debt. It represents the total value of the invested capital in the company.

  • The EBIT (earnings before interest and taxes) multiple is a valuation metric that compares a company’s enterprise value to its EBIT. It shows how many years it would take to recover the investment based on current EBIT levels.

  • The key drivers of the EBIT multiple are the expected growth rate of EBIT, the risk level of the capital employed, and interest rates. Higher growth, lower risk, and lower rates lead to a higher multiple.

  • Similarly, the P/E ratio compares market capitalization to earnings per share (EPS). It shows how many years it would take to recover the investment based on current EPS levels.

  • P/E is conceptually similar to the EBIT multiple and is also driven by growth expectations, risk, and interest rates. Higher growth, lower risk, and lower rates lead to a higher P/E.

  • Both multiples are commonly used by investors and analysts to value companies based on how the market values comparable firms, as well as to track market valuations over time across sectors.

The passage discusses various valuation multiples that can be used in addition to enterprise value (EV)/EBIT and price-earnings (P/E) ratios, along with their pros and cons:

  • Sales multiple: Used for small companies but should not be used for mid-sized or large companies as it disregards profitability.

  • EV/EBITDA multiple: Used in sectors like telecom where depreciation is high/variable between companies, but should not be generalized to all sectors. Can overvalue low-margin companies.

  • Free cash flow multiple: Reflects cash returns to shareholders but is volatile due to variable capital expenditures. Best for mature sectors with steady capex.

  • Price-to-book ratio (PBR): Compares market value to book value of equity. Above 1 if return on equity exceeds required return, below 1 if ROE is lower. Helps assess if valuation reflects fundamental performance.

It also discusses situations when inverse P/E (earnings yield) can approximate required return (rare cases of nil growth and 100% payout) versus cases when it would under- or overestimate required return.

Finally, it provides an example chart with key financial and market data for steel company ArcelorMittal to illustrate the use of these multiples.

Here is a summary of the key points from Section II:

  • Adjustment of past share prices is necessary when there are events like rights issues, free share awards, etc. that change the number of shares outstanding. Adjustment factors must be applied to make the share prices and metrics comparable.

  • A growth stock is expected to increase profits and pay little or no dividends, while an income stock pays higher dividends from stable/mature profits.

  • A company paying out all profits would have limited growth prospects since it is not retaining earnings to reinvest in expansion.

  • A high P/E does not necessarily mean high growth - it could reflect high risk or high required returns as well.

  • For inverse P/E to approximate required returns, the company must pay out all profits and markets must be in equilibrium. In reality required returns are generally underestimated this way.

  • EBIT multiple is another valuation metric calculated as enterprise value divided by EBIT.

  • Future events like bond conversions or warrant exercises can also be factored into the stock analysis on a fully diluted basis.

Here is a summary of key points about options:

  • An option gives the holder the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a predetermined price (strike price) on or before a specified date (expiration date).

  • The buyer of the option pays a premium to the seller for this right. The seller takes on the obligation to fulfill the terms of the option if exercised.

  • Options can be American style (exercisable at any time up to expiration) or European style (exercisable only at expiration). Most exchange-traded options are American style.

  • Calls provide gain if the underlying asset price rises above the strike price. Puts provide gain if the price falls below the strike.

  • Option buyers’ risk is limited to the premium paid. Sellers take on unlimited risk depending on the asset price movement.

  • Options allow for leverage since the buyer needs only put up the premium, not the full cost of the underlying asset.

  • Options are useful financial tools for hedging risks, speculation, or getting asymmetric risk-return profiles compared to owning the underlying asset.

  • Many financial products like warrants and convertible bonds have characteristics that can be analyzed using options theory.

In summary, options provide conditional exposure to an underlying asset’s price movement via the right but not obligation to buy or sell at a preset price, allocated risk asymmetrically between buyers and sellers.

The value of an option depends on potentially unlimited factors. Specifically, the passage says an option’s value is determined by 6 criteria:

  1. The price of the underlying asset
  2. The strike price
  3. The volatility of the underlying asset
  4. The option’s maturity
  5. The risk-free rate
  6. Any dividends or coupons from the underlying asset

Of these factors, the price of the underlying asset and the strike price can impact the value of an option in potentially unlimited ways, as their values are not bounded. So in summary, the factors that determine an option’s value, and specifically the price of the underlying asset and the strike price, are potentially unlimited.

  • The value of call and put options increases with the underlying asset’s volatility, as higher volatility means a greater chance for the asset’s price to move in a direction favorable to the option.

  • Option value also increases as the time to expiration gets longer, giving more opportunity for fluctuations in the asset’s price.

  • A higher risk-free interest rate increases the value of a call option but decreases the value of a put option.

  • Dividends or coupons on the underlying asset decrease call value and increase put value.

  • The Black-Scholes model prices options using a replicating portfolio approach and assumes the asset’s returns follow a log-normal distribution. It gives a formula to calculate the theoretical option price based on factors like the asset price, strike price, volatility, time to expiration, and risk-free rate.

  • Cox-Ross-Rubinstein developed the binomial option pricing model, which models the asset price path using a discrete step-up or step-down approach over time to replicate the Black-Scholes continuous distribution.

  • The models make assumptions like constant volatility and interest rates over the life of the option that may not reflect reality. Extensions have been made to handle factors like dividends and pricing non-European options.

  • The Black-Scholes model can be used to value European-style call options by applying the model to the share price minus the discounted dividend, if the underlying share pays dividends.

  • To determine the precise value of an American-style call option that pays dividends, a more complex iterative method is required.

  • The formula for valuing European-style put options using Black-Scholes is provided.

  • In practice, implied volatility used in the Black-Scholes model is derived from observed option prices, rather than using historical volatility, as anticipated volatility in the future may differ. Market participants adjust implied volatility to reflect their views.

  • Delta, gamma, theta and vega measure the sensitivity of an option’s theoretical value to changes in the underlying asset price, volatility, and time respectively. Understanding these “Greeks” is important for managing an options portfolio.

  • The VIX index provides a measure of implied volatility in the market. Higher implied volatility results in higher option values per the Black-Scholes model.

  • Model risk has emerged as a concern given limitations of the Black-Scholes model, such as the assumption of log-normal returns which may understate risk of extreme events. Implied volatility derived from options prices is not always consistent.

  • An option is a contract that gives the holder the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a predetermined strike price on or before the expiration date.

  • The six key factors that determine an option’s value are: the underlying asset price, strike price, volatility, time to expiration, risk-free rate, and any dividends on the underlying asset.

  • Models like Black-Scholes and binomial models are commonly used to calculate theoretical option values based on these factors.

  • Options can be used in corporate finance for various purposes like raising financing, resolving conflicts between stakeholders, hedging risks, valuing assets, and taking over companies.

  • The chapter emphasizes the flexibility and versatility of options in analyzing complex corporate finance problems. Options valuation is important as their use in corporate finance continues to grow in new and varied ways.

So in summary, the key points are an introduction to options, the factors that determine their value, commonly used valuation models, and the importance and breadth of applications of options in corporate finance. The chapter establishes options as a useful financial tool.

Here is a summary of the article:

The article discusses warrants, which are securities that give the holder the right to purchase another security, such as shares or bonds, at a predetermined price within a specified time period. Warrants can be attached to new share or bond issues, or can be issued independently.

The key points made in the article include:

  • Warrants conceptually work like call options but have some differences, such as typically longer time periods and the possibility of underlying asset dividends/price changes.

  • Models like Black-Scholes need modification to properly value warrants.

  • From an agency theory perspective, warrants can help resolve conflicts between shareholders, creditors, and managers by providing flexibility and upside potential for all parties.

  • Warrants are increasingly used in corporate finance, for example by struggling companies to raise capital or by private equity firms in leveraged buyouts.

  • Both traditional and more exotic variants of warrants exist, and they provide alternative ways for companies to raise funds and investors to gain exposure to asset price moves.

In summary, the article discusses what warrants are, how they are valued, their theoretical appeal from an agency perspective, and their increasing usage in corporate finance situations.

  • Convertible bonds allow the holder to exchange the bond for a set number of shares of the issuing company during a conversion period specified in advance. This gives the holder flexibility.

  • Components of a convertible bond’s value include the straight bond value, conversion value, and option value of the conversion feature.

  • The bond value dominates when the company value is low. The conversion value dominates when the company value is high. There is also a hybrid zone where both influence the price.

  • Companies may redeem convertible bonds early by calling them back. There is often a minimum non-call period and conditions like the share price exceeding the conversion price.

  • Peculiar convertible bonds have been issued where the company also acquires call options that mirror the bonds’ conversion options, so that only shares are delivered, not cash, upon conversion or call. This avoids short-term dilution for shareholders.

  • A cash settlement refers to paying the counter value of the shares in cash if the option is exercised, instead of delivering the actual shares.

  • For the firm, structuring a transaction as a convertible bond plus a call option replicates the cash flows of a regular bond. This can be an attractive structure when there is high market demand for convertible bonds.

  • In some cases, the firm may be able to sell the call option for more than it paid for it, resulting in a lower effective yield on the instrument than a traditional bond.

  • This combination, called a synthetic convertible bond, allows firms without direct access to bond markets to still raise financing this way.

  • Some examples of companies that have issued synthetic convertible bonds include LVMH, Total, Iberdrola and National Grid.

  • Preference shares are a type of hybrid security that have characteristics of both debt and equity. They provide a fixed annual dividend but rank below debt in terms of repayment priority.

  • Preference shares are treated as equity by analysts and rating agencies, even though the dividend resembles interest payments on debt. This allows firms to issue them while keeping leverage low.

  • Valuing preference shares is complex as they can have varying features. Generally they are valued like ordinary shares but accounting for the higher dividend stream, with discounts for liquidity and lack of voting rights.

  • For companies, preference shares can attract investors when in financial difficulty. Banks often issue them as they count as capital reserves. However, they are more expensive than regular equity raises.

  • For existing shareholders, preference shares without voting rights allow capital raises without diluting control. However, it effectively raises the company’s cost of equity long-term.

  • Hybrid bonds, mandatory convertibles, and exchangeable bonds are other forms of “equity in drag” that combine debt and equity features for tax and accounting purposes.

  • Hybrid securities like convertible bonds appear to lower financing costs but do not actually do so once the full risks are accounted for. All sources of financing have the same cost when adjusted for risk in efficient markets.

  • Their use often indicates the issuer is struggling to raise funds through ordinary debt or equity. They can help resolve conflicts between shareholders/creditors or shareholder-managers and outside shareholders.

  • A convertible bond functions like a traditional bond but also includes a call option allowing conversion to shares. Its value equals the bond value plus the call option value.

  • Bonds with warrants attached are similar to options sold by the company on future shares. Warrants allow gradual equity financing.

  • Preference shares, mandatory convertibles, deeply subordinated debt, and exchangeable bonds are other hybrid securities.

  • Hybrids’ costs must be fully considered, not just apparent rates. They indicate difficulty raising ordinary capital rather than financial sophistication.

  • When companies issue new securities, their main goal is to obtain the highest possible price to access capital markets in the future. Investors need sufficient information to price the securities fairly based on their risk.

  • Banks play a role in arranging the deal, circulating issuer information to investors through due diligence, research notes and roadshows, distributing the securities to investors, and sometimes underwriting the deal by guaranteeing placement at a certain price.

  • Public offerings generally require a syndicate of several banks with roles like global coordinator, lead manager, book-runner, joint-lead, co-lead, and co-manager.

  • Banks may purchase securities directly in a bought deal and resell them, taking some balance sheet risk. A firm underwriting commits the bank to purchase unsold securities if investor demand is insufficient.

  • Book-building allows banks to gauge investor demand and interest levels before committing to an underwriting price. The goal is a successful placement at the optimum market-clearing price.

  • Book-building allows banks running an IPO transaction to limit their risk by determining investor demand before setting the price and allocating shares.

  • It helps establish the best price for the seller/company and allocate shares discretionarily.

  • Banks may commit fully to the deal through an underwriting or provide a “best efforts” commitment where they only pledge to make their best efforts to ensure the deal succeeds.

  • Techniques like extension clauses, greenshoes, and clawbacks give flexibility to adjust the offering based on actual investor demand and behavior.

  • IPOs typically offer shares at a discount of 10-15% to attract investors and compensate for information asymmetries.

  • The major technique for IPOs, especially for institutional investors, is book-building where banks market the shares to investors before determining the final price and allocation.

  • The offering process begins with the distribution of a prospectus containing information about the company and transaction. Marketing then takes place over 5-15 days through roadshows and meetings with investors.

  • Investor demand is recorded in an order book based on a preliminary price range.

  • After this period, the sale price is set based on market conditions, demand, and price sensitivity expressed by investors.

  • Banks then enter a firm underwriting agreement. Shares are immediately allocated to limit bank risk.

  • Risks for banks include a market crash before allocation or needing to stabilize prices after.

  • The final prospectus is sent after pricing. Retail investors can participate via a retail public offering, fixed price offering, or minimum price offering depending on the structure.

Here is a summary of the key points about a 3-2(b) waiver and private placements discussed in the text:

  • A 3-2(b) waiver allows a private company to issue securities to US investors without having to register with the SEC. All the private company has to do is translate the information it has already provided to its domestic market.

  • “Private placements” refer to the direct sale of securities to a limited number of qualified institutional buyers without any public offering or advertising. They are usually done to raise capital.

  • Rule 144A private placements specifically target qualified institutional buyers in the US private placement market. The securities placed this way are not freely tradeable.

  • In the text, “private placements” and “Rule 144A private placements” are used interchangeably to refer to the direct and private issuance of securities to institutional investors in the US without a public offering. The key aspect is that it allows companies to raise funds privately in the US market without having to fully register with the SEC.

  • A 3-2(b) waiver simplifies this process by only requiring companies to translate, rather than reconcile or modify, the information already provided to their domestic regulators.

  • The passage describes a situation where a company is issuing new shares through a rights issue. Existing shareholders are given pre-emptive rights to purchase new shares at a discounted issue price in proportion to their existing holdings.

  • It provides an example where the pre-deal share price is €50, the issue price for new shares is €40, and shareholders receive 10 pre-emptive subscription rights for each existing share.

  • It calculates that for an existing shareholder to be in the same position as an investor who buys subscription rights and new shares, the theoretical post-deal share price must be €49.09.

  • It explains how to calculate the theoretical value of subscription rights using a provided formula.

  • Advantages of pre-emptive rights include allowing existing shareholders to maintain their ownership percentage. Disadvantages include the issue price needing to be discounted and complications if shareholders’ holdings are not evenly divisible.

  • It compares rights issues to issuances without pre-emptive rights, where underwriting banks must market and sell the new shares. Regulations typically impose pricing limitations in such cases.

  • Equity lines are described as an alternative that spreads the impact of capital increases over time through warrant exercises.

  • The corporate bond market is separated into investment grade bonds and higher-risk, below-investment-grade or “high yield” bonds. High yield bonds must offer higher interest rates to compensate for the added risk.

  • The euro switchover has led to a larger pan-European bond market, allowing larger bond issues than previously possible on national markets alone.

  • Bond offerings have evolved techniques used for share offerings, like book-building instead of competitive bidding. Book-building allows the issue price to be set based on investor demand rather than pre-determined.

  • The process for bond issues is usually shorter than for shares, taking only a few hours for frequent investment-grade issuers issuing locally. It is longer for first-time issuers or those targeting international investors.

  • High yield bond issues take longer and more aggressive marketing due to fewer potential buyers.

  • Private placements are a smaller alternative to regular bond issues. Placement is more like syndicated loans, contacting investors in advance.

  • Syndicated loans involve multiple banks loaning to a company. The lead arranger markets and arranges the loan, which can take around two months to complete.

The bank or banking syndicate that handles an equity placement works to structure the deal, distribute the securities to investors, and generally provides the issuer with a guarantee that a certain level or percentage of the securities will be purchased if not all are sold to investors.

There are two main types of equity placements:

  • Book-building: The bank only commits to the deal if there is confirmed investor appetite and orders are recorded in an order book. This limits the bank’s risk.

  • Bought deal: The bank purchases the securities from the issuer up front and then works to place them with investors as quickly as possible, taking on more risk if the market changes before placement.

Initial public offerings (IPOs) are complex transactions that require disseminating appropriate information to investors. There can be an underwritten component with orders recorded and a concurrent retail public offering. Pricing varies depending on market demand. Listings for already public companies use similar techniques depending on shareholder eagerness to subscribe.

  • An investment decision can impact the value of a company’s capital employed (enterprise value) in three ways: increase value if return is higher than required, maintain value if return equals required, or decrease value if return is lower than required.

  • Value is created when return on capital employed (ROCE) exceeds the weighted average cost of capital (WACC), which is the minimum return required by investors.

  • From the company’s perspective, funds raised from investors are resources, and securities issued to investors are liabilities on the balance sheet. The rates of return required by investors represent a financing cost to the company.

  • Financial markets continuously value the securities issued by a company, thus indirectly valuing the company’s capital employed and equity. If a company cannot meet investors’ required risk/return, its securities will be penalized with a lower valuation.

  • Investors play an active role in financing by choosing whether to buy newly issued securities. If terms are unacceptable, lack of funding can eventually lead to bankruptcy. Financial markets also impose sanctions through ongoing valuation of existing securities.

  • In summary, investment decisions can impact company value, and meeting required returns for investors is important for accessing financing and maintaining optimal security valuations.

  • Investors who are unhappy with the risk/reward trade-off of a company’s securities will sell their holdings, lowering the price of the securities and reducing the company’s valuation and access to capital. This puts financial pressure on the company.

  • The main way this “financial sanction” impacts a company is through decreases in the valuation of its shares and debt securities. This affects the valuation of the company’s capital employed, which is key for financial policy.

  • Creditors are usually protected as long as the company is operating normally. Issues mainly arise when the company is in financial difficulty and declines in debt valuation occur. Then creditors play a bigger role.

  • Valuation of capital employed and equity are important variables that any financial policy should aim to maximize in order to create value for fund providers like shareholders.

  • The value of a company is the same whether it is independent or part of a larger group, unless there are industrial synergies that increase cash flows. Financial diversification alone does not create value.

  • Kuka’s value will increase only if Midea management allows it to improve its return on capital. Pure financial diversification does not create value.

  • Signalling theory acknowledges that information is not perfectly symmetrical. Managers may send signals to investors through financial decisions to reduce information asymmetries. However, signals must be credible to be effective.

  • Different stakeholders like shareholders and creditors have diverging interests due to their different risk-return profiles. Financial decisions can impact how value is distributed between these groups.

  • The role of the financial manager is to make decisions that maximize value while balancing the interests of different stakeholders. Communication is important to influence market perception.

  • Signaling theory suggests that corporate financial decisions send signals to investors about the company’s financial health. Good managers signal their company’s strength while struggling companies try to obscure problems.

  • Information asymmetry between managers and investors can lead to underpricing of shares if investors don’t fully understand the company’s value. This skews financing toward debt which has less information problems.

  • Agency theory views the company as an arrangement between individuals with conflicting goals, like shareholders vs managers. It analyzes how financial decisions affect different stakeholders.

  • The divergence of interests creates “agency costs” like monitoring managers and reassuring shareholders. Compensating managers with stock aims to align manager-shareholder interests.

  • “Free riders” are investors who benefit from value-creating actions by other investors without contributing. This must be considered in financial decisions.

  • A project can only consistently outperform required returns if it has a strategic advantage creating imperfect competition and barriers to entry - known as economic rents. Financial strategy aims to obtain and defend such rents.

So in summary, it discusses the signaling behavior of managers, agency problems between managers and shareholders, and importance of strategy in achieving above-market returns through competitive advantages.

  • Debt allows investments to be made immediately so that the required return is achieved from the start, rather than having to wait for returns to accumulate from equity investments over time.

  • However, everything must proceed smoothly - if actual returns end up being lower or higher than expected, this could cause problems in achieving the required return. Returns need to match expectations.

  • Certain securities like debt can carry tax benefits depending on a company’s situation. This creates value by reducing taxes paid.

  • Tax planning should aim to reduce costs, but not at the expense of increased risk. The impact on value, rather than just costs, must be considered.

  • Key issues around taxation of different financing options like debt vs equity, depreciation, capital gains vs dividends, financial income/expenses will be addressed in subsequent chapters.

  • Tax optimization should not compromise financial decisions - the AstraZeneca-Pfizer merger failing despite tax benefits shows this. Value, not just taxes, must be considered.

  • The goal of corporate finance is value creation by earning returns above the required rate given risk. If not, share price will decline over the medium-term as returns equalize with requirements.

  • Signaling and agency theory address limitations of markets in equilibrium theory by recognizing information asymmetries and differing interests between stakeholders.

So in summary, debt allows immediate returns but risks must be managed, tax benefits create value if not increasing risk disproportionately, and the objective is medium-term value creation by outperforming return requirements through competitive advantages. Signaling and agency theory provide additional context.

  • There are many value creation indicators used by companies, which can be confusing. They generally fall into four categories: accounting indicators, accounting/financial indicators, financial indicators, and stock market indicators.

  • Early indicators like net profit and EPS are easy for companies to manipulate. More sophisticated indicators like EBIT, EBITDA, ROCE, and ROE are more difficult to manipulate but still based on accounting.

  • Indicators that compare returns to cost of capital, like EVA/economic profit, measure true value creation by considering risk. These hybrid accounting/financial indicators are useful for management incentives.

  • Pure financial indicators like NPV are the theoretically best but rely on projections that are hard to assess accurately.

  • Stock market indicators like TSR and MVA best reflect what investors actually value but are outside management’s control.

  • Over time, the indicators that are hardest to manipulate and most influenced by financial markets, like EVA and stock market metrics, tend to be the most reliable for measuring long-term value creation.

  • NPV is considered the most precise measure of value creation as it discounts future cash flows at the WACC. However, it is difficult for external analysts to use as it requires forecasts over multiple periods.

  • Other common ratios like EVA, CFROI, MVA, and TSR are simpler to use but less precise. They can provide misleading results if not used carefully.

  • EVA measures value creation by taking the difference between ROCE and WACC multiplied by capital employed. It is related to but less ambitious than NPV.

  • CFROI measures the IRR earned on existing investments by taking the ratio of cumulative after-tax EBITDA to gross capital employed.

  • MVA compares market cap plus net debt to book value of capital employed. It reflects investor expectations of future value creation.

  • Market indicators like MVA and TSR are sensitive to stock market movements. They may show value destruction due to declining expectations even if ROCE > WACC. They tend to anticipate rather than measure past performance.

  • Economic indicators and market value measures are complementary rather than contradictory, but a clear distinction must be made.

So in summary, it outlines the key value creation ratios used, their strengths and weaknesses, and emphasizes that NPV is the most precise but difficult to apply, while other ratios provide simpler but less accurate assessments of value creation.

Here is a summary of key points about market value added (MVA) and its relationship to intrinsic value creation:

  • MVA is the difference between a company’s market capitalization and the book value of its equity. It can be measured as a ratio by dividing market cap by capital invested.

  • MVA and changes in MVA are considered better measures of value creation than share price alone, as it assesses increases in value relative to capital invested.

  • In an efficient market, long-term MVA should equal the net present value of all future economic profits generated above the cost of capital.

  • Some critics argue MVA is flawed because it relies on volatile market values outside management’s control. However, market volatility is inherent to valuation.

  • MVA can also be difficult to measure precisely due to using accounting book values, which do not always reflect intrinsic value.

  • In periods where markets are not perfectly efficient, intrinsic value creation and MVA growth may not be perfectly correlated in the short term. However, they should converge over the long run in efficient markets.

So in summary, MVA aims to measure value creation relative to invested capital, but it still relies on market valuation and accounting figures which are imperfect measures that may diverge from intrinsic value, particularly in the short run.

  • EPS growth can only be used to evaluate value creation if three conditions are met: 1) the company’s risk profile remains the same before and after an operation, 2) the number of shares outstanding remains the same, and 3) the company’s financial structure remains the same over time. If any of these conditions are not met, EPS cannot reliably indicate value creation or destruction.

  • Accounting rates of return like ROE and ROCE are accounting measures that do not account for risk. They are also easy to manipulate and do not reflect changes in a company’s equity or capital employed.

  • Measures like NPV are better for evaluating value creation as they consider the time value of money and required rates of return. However, they are difficult to apply to external analysts assessing publicly traded companies.

  • Financial/accounting criteria like EVA attempt to measure value creation by comparing return to a company’s weighted average cost of capital. However, tools like EVA are still limited by being calculated over single financial periods and being open to manipulation.

  • Overall, no single measure is perfect, and managers may select measures that make their results appear more favorable. The key is for managers to focus on long-term value creation rather than short-term accounting performance.

  • The concepts of present value, internal rate of return (IRR), and net present value (NPV) that were covered in previous chapters for investment decisions can also be applied to analyzing financial securities.

  • For financial securities, the IRR is referred to as yield to maturity - it is essentially the same calculation.

  • IRR/yield to maturity determine the discount rate that makes the present value of an investment or security equal to zero.

  • NPV measures the value created by an investment and is the best criterion for deciding whether to accept or reject an industrial investment or financial security. It considers the time value of money.

  • So the same theoretical approaches of present value, IRR/yield, and NPV can be used for both industrial capital budgeting decisions and analyzing financial securities like bonds. The principles are consistent regardless of whether it is for an industrial project or financial asset.

  • NPV and IRR are the most commonly used criteria for evaluating investments. NPV is preferable when choosing between mutually exclusive projects.

  • Cash flows, not accounting data, should be considered. Only incremental cash flows from the project matter, not sunk costs.

  • Opportunity cost principle - the value of an investment is its market value, not book value. Value should be assessed based on what could be gained by selling an asset instead of using it for the project.

  • Financing method should be disregarded when evaluating the project itself. The return should be compared to the cost of capital, not the costs or terms of specific financing.

  • Taxation effects should be considered as taxes impact cash flows.

  • Analyses should be consistent in terms of the principles and discount rates used.

In summary, the key points are that NPV is preferable to IRR for investment choices, only incremental cash flows from the project matter, and opportunity cost, disregarding financing, considering taxes, and consistency are important principles for investment evaluation.

  • When analyzing cash flows for a project, only operating and investment flows should be included, not financing flows like interest, repayments, or dividends. Including financing flows would double count the cost of financing.

  • Failure to exclude financing flows could overstate the project’s NPV and IRR by artificially improving cash flows through leverage.

  • The article provides an example demonstrating how taking on more debt financing can manipulate NPV and IRR numbers, but this increased leverage also increases risk for equity holders.

  • The appropriate discount rate must be adjusted upward to account for increased risk when using higher leverage. Otherwise, NPV stays constant but IRR increases in a misleading way.

  • It is incorrect to think a project’s return just needs to exceed cost of debt financing. Equity holders require higher return due to bearing more risk from leverage.

  • Cash flows and discount rates should be calculated consistently on an pre-tax or after-tax basis and in the same currency to avoid inconsistencies.

  • Payback period measures the number of years to recover the initial investment from annual cash flows. It is compared to a cut-off period to determine if a project should be accepted or rejected.

This chapter discusses various methods used to evaluate investment decisions, including:

  • The payback ratio looks at the number of years to recover the initial investment. However, it does not take into account cash flows after payback or the time value of money.

  • Return on capital employed (ROCE) calculates operating profit after tax divided by average capital employed. It is influenced by accounting methods like depreciation.

  • Net present value (NPV) and internal rate of return (IRR) are preferred as they consider all cash flows and the time value of money.

To summarize:

  • The payback ratio only looks at recovery period and ignores subsequent cash flows.

  • ROCE can be misleading as it is influenced by accounting conventions like depreciation methods.

  • NPV and IRR are better criteria as they consider all cash flows and discount future amounts to reflect the time value of money.

  • Depreciation and amortization impact cash flows used in NPV and IRR calculations. Faster depreciation methods reduce taxes for companies that pay taxes.

  • For a non-taxed company, the optimal depreciation is the economic depreciation that best reflects asset value decline over time.

So in summary, NPV and IRR are recommended criteria as they provide the most accurate valuation of investments by considering all relevant cash flows and the time value of money. Accounting-based metrics like ROCE can be influenced by conventions.

Here is a summary of the key points regarding investment decisions at the standard rate:

  • The standard rate refers to the minimum required rate of return that a company uses to evaluate potential investments. It is also called the hurdle rate or cost of capital.

  • Investments are only undertaken if they are expected to earn a return higher than the standard rate. Projects with a net present value (NPV) equal to or higher than zero at the standard rate will be accepted.

  • The internal rate of return (IRR) of a project should exceed the standard rate for the project to be accepted.

  • Residual/salvage value of long-lived assets must be considered, as it can significantly impact NPV and IRR calculations for investments with long time horizons.

  • Inflation should be accounted for when evaluating long-term investments, as future cash flows will be eroded by inflation if not adjusted.

  • Tax implications like deductions, credits, etc. should be included in the cash flow analysis from a tax perspective.

  • Subsidies received to undertake a project should be treated as a reduction in initial investment rather than adjusting the discount rate.

  • Working capital requirements may often be ignored for short-term projects but should be included for investments with long-term impacts on net working capital.

Here are summaries of the key points from the passages:

  • The cost of capital is the minimum rate of return a company must earn on its investments to satisfy both shareholders and debtholders. It is the weighted average cost of the company’s financing sources.

  • According to the capital asset pricing model (CAPM), the cost of capital depends solely on the risk of the company’s assets, known as the asset beta. It is the rate of return required by investors given the risk level of the company’s capital employed.

  • The cost of capital can be calculated directly using the CAPM formula, indirectly by calculating the WACC, or via enterprise valuation techniques.

  • Under the CAPM, the cost of capital is equal to the risk-free rate plus the asset beta multiplied by the market risk premium. The asset beta measures how volatile the company’s future cash flows are relative to the market.

  • Asset betas are typically lower than equity betas since they exclude the impact of net debt. Betas vary significantly across industries based on factors like operating leverage, economic sensitivity, predictability, and growth rates.

  • The asset beta can be estimated as a weighted average of the equity beta and debt beta, with weights based on the market value of equity and debt. For lowly leveraged companies, the debt beta is often assumed to be zero for simplicity.

  • The WACC is commonly used to indirectly calculate the cost of capital by taking a weighted average of the cost of equity and post-tax cost of debt. The weights used are the market value of equity and debt.

  • The formula provides a way to calculate the beta (β) of a company’s assets based on its equity beta (βE), debt, and the corporate tax rate (1-TC).

  • It assumes the company can borrow at the risk-free rate and that the firm value equals the unlevered value plus the tax shield of debt. These are simplifying assumptions based on Modigliani and Miller’s theory.

  • In practice, borrowing rates include credit spreads that vary based on the company’s credit rating. And financial distress costs are not considered.

  • A more accurate approach is to calculate the weighted average cost of capital (WACC) based on the market values and costs of the various securities issued by the company.

  • The WACC represents the blended rate of return required by all providers of funds to the company. It considers both the costs and market-based weights of equity and debt in the capital structure.

  • Caution is urged against changing the capital structure in WACC calculations without also adjusting the costs of equity and debt, as those costs are dependent on leverage.

  • The key is distinguishing between the cost of capital for a company versus a specific project, as project risk may differ from the overall company risk. Appropriately adjusting for project-specific risk is important for investment evaluation.

  • Valuing equity using the discounted cash flow (DCF) model presents a dilemma, as the DCF model requires the cost of equity to calculate value, but calculating the cost of equity requires knowing the value of equity.

  • There are three ways to solve this: 1) Use target capital structure parameters, 2) Iterate to find the discount rate that fits, 3) Use the direct method to avoid errors in matching costs to structures.

  • When analyzing divisions or international investments, the cost of capital should reflect the unique risk profiles rather than blindly using the parent company’s cost.

  • In developing markets, bonds may not exist so sovereign spreads and regional betas can estimate the cost of capital in local currency.

  • Companies with negative net debt (cash exceeding debt) should calculate cost of capital using the indirect method with a negative debt value rather than just using the cost of equity.

  • Financially distressed firms have high equity costs but the same overall cost of capital as healthier peers in the same sector, as distress is a nonsystemic risk.

  • Truly reducing cost of capital requires lowering business risk, not just financial engineering, as riskier strategies will demand higher returns from investors.

  • Chief financial officers (CFOs) have little ability to directly lower a company’s cost of capital while also creating value. Their main strategy is to improve return on capital employed by increasing cash flows and reducing capital required.

  • However, CFOs should try to benefit from any temporary market inefficiencies, such as issuing securities when a particular sector is overvalued.

  • Increasing risk for capital employed can increase cost of capital, but this does not necessarily destroy value if profitability also improves.

  • A company’s cost of capital reflects the overall risk of its business profile and operations. For a diversified company, there may be different costs of capital for different business sectors or regions.

  • Managers have limited ability to strategically reduce cost of capital through capital structure decisions alone. Their best hope is providing more accurate information to the market.

Here is a summary of the provided text:

The text discusses different methods for analyzing risk and valuation in capital investment projects. It covers traditional discounted cash flow analysis using the weighted average cost of capital and net present value. It then discusses limitations of only using these techniques and how they do not adequately capture uncertainty.

Other risk analysis methods discussed include scenario analysis, sensitivity analysis, and Monte Carlo simulations. Scenario analysis models different potential outcomes, sensitivity analysis varies assumptions to see the impact, and Monte Carlo simulations assign probability distributions to input variables.

The text notes these techniques are still based on the same principles as net present value analysis but attempt to model uncertainty in different ways. However, they still assume investments are irreversible, which is often not realistic as managers can adapt projects over time.

The last part of the text introduces how real option theory can help value the flexibility or optionality inherent in many investments. This captures how managers can respond to new information by abandoning, postponing, extending or changing a project. Real options analysis moves beyond the limitations of only assuming fixed, irreversible investments.

  • The flexibility industrial managers have to react to ongoing events, like increasing/reducing investment, gives them real options similar to financial options. This flexibility has value not reflected in conventional analysis.

  • For an investment to offer real options, it needs uncertainty, the ability to gain new information during the project to make meaningful changes, and some degree of irreversibility in initial and future decisions.

  • Examples of real options include options to launch new projects, develop/expand existing projects, reduce/contract projects, defer starting or progressing projects, and abandon projects.

  • R&D can generate real options in new products. Flexibility at different stages, like building factories, also enables options.

  • Option theory says uncertainty plus flexibility adds value over traditional NPV approaches, as higher risk means higher option value. However, this value is unstable and decreases as uncertainty declines over time.

  • The example considers a software publisher offered a license to market connected homes software for £5m. If they don’t accept, it will be offered to a rival.

  • Using traditional NPV analysis, the project appears to destroy value. But this ignores the real option value of flexibility - the publisher can delay investing in production for a year to gain more information.

  • If the right technological standard is adopted, the project has positive NPV of £49m. If the wrong standard, NPV is -£39m and they drop it.

  • Using a binomial options pricing model, the real option value is estimated at £23.3m. Adding this to the license cost, the total value is positive at £18.3m.

  • Real options theory values the flexibility managers have to adapt plans as new information emerges over time. Traditional DCF ignores this optionality.

  • Applying real options models in practice can be difficult due to challenges in parameter estimation and communicating findings. But it forces consideration of alternative scenarios.

So in summary, real options theory accounts for project flexibility and optionality, while traditional NPV ignores this and may misvalue projects with uncertainty resolved over time.

  • There are two main methods for valuing a company - the direct method and the indirect method.

  • The direct method values equity directly. The indirect method first values the firm as a whole (enterprise value), then subtracts net debt to get equity value.

  • Both methods have two main approaches - the intrinsic value approach (DDM, DCF) and the comparable approach.

  • The intrinsic value approach discounts future cash flows to arrive at present value.

  • The comparable approach values the company based on multiples of comparable firms.

  • Other methods include sum-of-the-parts and options theory, but DDM, DCF, comparables are most commonly used.

  • Choosing a method depends on available data and the industry/company characteristics. Multiple methods may provide a range of values.

So in summary, the key valuation methods are direct vs indirect, intrinsic value vs comparables, with DDM, DCF and comparables being the most widely used fundamental techniques. The goal is to estimate a company’s intrinsic worth based on future prospects and industry comps.

  • The discounted cash flow (DCF) method values a company based on the present value of its projected future cash flows. It discounts the expected future after-tax cash flows using the company’s weighted average cost of capital.

  • Cash flows are projected over an explicit forecast period, which can range from 2-3 years for some companies to 20-30 years for utilities. Beyond this period, a terminal value is established.

  • The terminal value, which represents the value of the company at the end of the explicit forecast period, is usually calculated using the Gordon-Shapiro method. This involves using a normalized perpetual cash flow and growth rate.

  • Choosing the appropriate normalized cash flow and long-term growth rate requires assumptions about factors like long-term profitability, investment needs, and growth potential relative to the overall economy. The growth rate cannot expect the company to outperform indefinitely.

  • In the example provided, projections were made for ArcelorMittal through 2020. A terminal value was calculated using a 2021 normalized cash flow and 1.5% long-term growth rate.

So in summary, the DCF method values a company based on the present value of its explicit future cash flow projections plus an estimated terminal value at the end of the projection period. Key elements are the cash flow projections, discount rate, and terminal value assumptions.

  • The passage discusses methods for calculating the terminal value when performing a discounted cash flow (DCF) valuation of a company.

  • It advises against using a “horizon multiple” approach, which applies a comparative multiple to terminal cash flows, as this mixes intrinsic and comparative valuation methods.

  • A better approach is to use a “cash flow fade” methodology, which models the return on capital employed (ROCE) gradually converging to the weighted average cost of capital (WACC) over time.

  • The discount rate used is the WACC. Adjustments may need to be made to the calculation of enterprise value for items like net debt, provisions, unconsolidated investments, tax losses, and minority interests if not already captured in cash flow projections.

  • Careful consideration is needed around items like debt valuation, pension liabilities, and seasonal/year-end working capital balances to ensure an accurate representation of the company’s true financial position.

  • The multiples approach values a company based on comparable publicly traded companies (market multiples) or recent acquisition prices (transaction multiples).

  • It values the company as a whole based on its profit-generating capacity, using multiples of metrics like EBIT, EBITDA, and net income.

  • Multiples depend on factors like expected growth, risk, and interest rates. Higher growth, lower risk, and lower rates lead to higher multiples.

  • For market multiples, a peer group of comparable publicly traded companies is selected based on sector, size, growth, risk, etc. Their shares should be liquid and well covered.

  • Multiples can be based on enterprise value (EV) or equity value. EV multiples use metrics like EBIT and EBITDA in the denominator. Equity value multiples use metrics like P/E.

  • For EV multiples, the peer group’s EVs are calculated by adding market cap and net debt. The multiple is the average EV/metric over current, past and future periods.

  • Common EV multiples include EBIT multiple (for profit-generating capacity) and EBITDA multiple. Equity value multiples include P/E.

  • Transaction multiples use actual prices paid in recent acquisitions rather than market prices.

The key points are that the multiples approach values the company as a whole based on its profitability relative to comparable firms, and uses averages of common valuation metrics like EV/EBIT, P/E applied to the subject company. Flexibility in peer group selection and metrics used is important.

  • The passage discusses different valuation multiples that can be used to value a company, including enterprise value multiples (EV/EBIT, EV/EBITDA) and equity value multiples (P/E, cash flow multiples, price-to-book).

  • It emphasizes using EV multiples like EV/EBIT as they eliminate distortions from different financial structures between companies.

  • Transaction multiples from M&A deals can be used but they reflect control premiums paid.

  • Mean and median multiples can mask differences within comparable company samples. Understanding why multiples vary is more important.

  • Linear regressions relating multiples to factors like growth can position an unlisted company within the sample.

  • The passage also briefly mentions the sum-of-the-parts method which values separate divisions/assets of diversified groups separately.

The key takeaway is that the passage analyzes different valuation multiples that can be derived from comparable public companies or transactions, and discusses best practices in selecting and applying appropriate multiples to value an unlisted company.

  • The sum-of-the-parts (SOTP) method values a company by separately valuing each asset and liability on its balance sheet using market values, liquidation values, or replacement costs.

  • For conglomerates or diversified groups, subsidiaries and business units are valued individually using discounted cash flow (DCF) analysis or comparable company multiples. The values are summed and consolidated debt and central costs are deducted.

  • Tangible assets can be valued using replacement cost, liquidation value, or going-concern value depending on the approach. Inventories are usually easily valued based on book value.

  • Intangible assets like brands, patents, and lease rights are more difficult to value but should be included using methods like discounting excess profits attributable to the brand.

  • Taxes may be included or excluded depending on whether the goal is liquidation or maintaining the business as a going concern.

  • Sum-of-the-parts values can be speculative and volatile for companies with high net asset value but low cash flows, since the value relies more on terminal values and resale prices.

  • Differences between SOTP, DCF, and comparable company values should be analyzed to understand which method may be overstating or understating value. Consistency is important when applying the SOTP method.

  • If a company’s sum-of-the-parts value or peer valuation multiples are higher than its discounted cash flow (DCF) valuation, it means the market is valuing the company more based on its past performance and assets rather than its future profitability outlook.

  • In this case, the company should consider divesting and liquidating assets to boost profitability and allocate resources better rather than continuing to invest. This “breakup” strategy was popular in the 1980s and 2007-2008.

  • If the valuations are the opposite (DCF higher than sums/multiples), the company is very profitable and should continue investing in projects above its cost of capital due to strong expertise, positioning and barriers.

  • Net asset value and cash flow value evolve differently over a company’s lifecycle. Cash flow value is usually higher than net asset value during growth phases but may dip below it during declines. Understanding these differences provides insights.

  • Valuation is both an art and a science. The market for corporate control/M&A uses similar principles to financial valuation but applies them to whole companies rather than individual assets or securities.

The key points are:

  • When control of a listed company changes hands, minority shareholders receive the same premium as the majority shareholder. This reflects the principle of equality among shareholders.

  • Nevertheless, entrepreneurs often view minority shareholders as passive beneficiaries and think they should not receive the same premium as the entrepreneurs who took the risks in building the company.

  • The control premium paid above market price can be justified if the new controlling shareholders expect to create value through synergies from combining the company with their existing businesses. This is called strategic value.

  • Minority shareholders should not be subject to a discount simply for being minority shareholders. However, a discount may be justified due to illiquidity of the minority stake.

Here is a summary of key points from Chapter 32 of Corporate Finance: Theory and Practice:

  • The chapter discusses whether a financial “paradise” exists where investors are always satisfied and always find value creation opportunities.

  • From the investors’ perspective, a perfect situation would be one where returns are high and risks are low. However, this is impossible as high returns generally require high risks.

  • For companies, a perfect situation would be unlimited access to low-cost financing. But investors require compensation for the risks they bear.

  • There is no single financial system that will satisfy all participants at the same time. Trade-offs must be made between the interests of investors, companies, and the economy.

  • The main debt financing options for companies are bank loans, bonds, and hybrid securities. Equity financing options include IPOs and seasoned equity offerings.

  • No system is perfect, as evidenced by financial crises. But with appropriate regulation and prudent behavior, systems can work reasonably well by balancing the interests of stakeholders over time.

  • The chapter concludes that while a universal financial “paradise” does not exist, European and North American systems have generally been able to reliably finance economic growth when reasonably well regulated. Compromise and balance are needed to operate financial systems that can satisfy major participants to a reasonable degree over the long run.

In summary, the chapter examines whether a perfect financial system is possible from different stakeholder perspectives, and ultimately finds that balance and compromise are necessary to achieve reasonably stable and productive systems, even if full satisfaction of all parties is unattainable.

The question asks about the optimal capital structure, which refers to the right combination of equity and debt that minimizes the weighted average cost of capital (WACC) and maximizes enterprise value.

The reader may expect that more leverage through increased debt usage would always reduce WACC based on the accounting concept of return on equity (ROE) being increased through leverage. However, the discussion here shifts to a finance perspective where value is based on discounting future cash flows.

From a finance perspective, simply increasing leverage does not necessarily reduce WACC. While debt is generally cheaper than equity, increasing debt also increases risk for shareholders. The market will then demand a higher required return on equity (kE) to compensate for this increased risk, which can offset or even outweigh the benefit of cheaper debt (kD).

There may be an optimal capital structure that balances these factors to achieve the lowest WACC. However, the passage suggests traditional theories claiming a leverage benefit may be “useless” from a finance perspective, as shareholder risk perception changes non-linearly with leverage. Overall increased debt does not guarantee a lower WACC.

  • According to traditional capital structure theory, there is an optimal debt-to-equity ratio that minimizes a firm’s weighted average cost of capital (WACC) and maximizes firm value. However, empirical evidence from real-world firms does not clearly show an optimal ratio.

  • Modigliani and Miller’s 1958 theory argued that in perfect capital markets with no taxes or bankruptcy costs, the value of the firm is independent of its capital structure. The WACC remains constant regardless of the debt-equity ratio.

  • If the theory held true, there would be arbitrage opportunities if one capital structure resulted in higher firm value than another. Arbitrage would continue until all structures had equal value.

  • In reality, costs such as taxes, financial distress, and asymmetric information mean the theory does not perfectly hold. However, it forms the basis of understanding how capital structure, WACC, and firm value are linked.

  • The modern view is that firm value is maximized at the point where the next dollar of debt increases WACC by exactly the tax benefit of debt. But every firm’s optimal structure depends on precise variables like tax rate.

  • In summary, while an optimal structure may exist in practice due to market imperfections, the level is hard to pinpoint and the basic M&M proposition that value is independent of structure still largely holds true conceptually.

Here are the key points about taxes and their impact on capital structure from the passage:

  • Taxes provide one of the fundamental factors that can explain why companies borrow funds and why they stop borrowing at a certain level of debt.

  • Tax savings from interest deductibility provide a benefit to taking on debt financing, which is factored into trade-off models of capital structure.

  • Ignoring the impact of taxes would be foolhardy, as taxes significantly reduce the net return to investors compared to pre-tax cash flows.

  • Tax optimization is an important consideration for financial managers and forces them to devote significant time and effort to capital structure decisions.

  • Including taxes makes the theoretical arguments about capital structure more real-world applicable, as taxes are a major real-world factor that cannot be ignored.

So in summary, taxes introduce an asymmetry between debt and equity financing that incentivizes some level of debt usage through interest tax deductibility. This tax benefit is one factor weighed in trade-off models ofoptimal capital structure.

  • Modigliani and Miller initially showed that factoring in corporate income tax created an incentive to use more debt financing since interest expenses are tax deductible while dividends are not.

  • This tax shield of debt financing provides value to companies by reducing their tax burden. However, companies face bankruptcy costs and malfunction costs if they take on too much debt.

  • There is likely an optimal debt ratio that balances the tax shield value against the costs of financial distress from too much debt. Most evidence suggests this ratio balances around 40-50% debt financing.

  • While taxes influence capital structure decisions, they are unlikely to be the sole determinant. Non-tax factors like bankruptcy costs also play an important role. Managers should not focus too narrowly on taxes alone.

  • In a later paper factoring in both corporate and personal taxes, Miller argued the taxes paid at each level could cancel out, implying the value of the firm is independent of capital structure when both taxes are considered. However, real world complications make this an oversimplification.

So in summary, taxes incentivize more debt financing due to tax shields, but distress costs impose limits, and non-tax factors are also important determinants of optimal capital structure.

  • Miller’s paper in 1963 argued that the tax benefits of debt are not as big as assumed, because it did not factor in personal taxation of investors. When accounting for personal taxes on interest income, dividends, and capital gains, the tax benefits of debt are reduced or eliminated.

  • In reality, different investors are taxed at different rates, and both equity returns and capital gains on stock sales are taxed. Miller’s objective was to show that the real world is more complicated than simple theories and models assume.

  • When personal taxes are included, the tax shield depends on whether the personal tax rate on dividends is higher or lower than the tax rate on interest income. If the dividend tax rate is higher, debt provides a bigger tax shield. If lower, the tax shield is smaller.

  • For firms, the objective is to minimize total taxes paid by bondholders and shareholders, not just corporate taxes. This removes some of the tax benefits of debt.

  • Debt can serve as an internal control mechanism by incentivizing management to improve performance and take risks to ensure debt obligations are met. This is another limitation of perfect market theories that assume different financing options have no impact on manager decisions.

  • The success of leveraged buyouts is not primarily due to accounting leverage, but that management has stronger incentives to improve the company when they have personal equity at stake as well as ensuring the company remains solvent.

  • Signalling theory assumes managers know more than investors, so positive signals about future cash flows or lower risks can help the company’s value. But signals only work if investors believe management is providing honest information.

According to signaling theory, taking on more debt signals management’s confidence in the company’s prospects and ability to repay the debt. This carries a penalty if the signal is wrong and the company is unable to repay, potentially leading to manager dismissal. For the signal to be credible, there must be an actual penalty for sending the wrong signal to dissuade deliberately misleading the markets.

The pecking order theory proposes that managers prioritize sources of financing, choosing internal financing first if possible due to low costs, then low-risk debt with protections for lenders. Riskier debt and hybrid securities come next, with equity issues last due to their high signaling and intermediation costs. Managers tend to minimize these costs subject to ensuring the company’s financial health.

Overall, some debt is optimal due to tax shields, but bankruptcy costs and investors’ tax situations mean too much debt is detrimental. Information asymmetries also influence capital structure choices, as managers seek to credibly signal private information to markets. Different theories aim to explain observed structures while accounting for real-world complications beyond early perfect market assumptions.

Based on the questions provided,

  • The theories of capital structure described in this chapter, such as the trade-off theory and pecking order theory, are based on behavioral assumptions rather than mathematical certainties. They cannot be proven with the same level of certainty as concepts in options pricing theory like put/call parity.

  • It is better to calculate leverage ratios using market values rather than book values, as market value better reflects a company’s true financial condition and ability to meet its debt obligations.

  • The pecking order theory does not imply companies have an optimal capital structure. Rather, it describes the order in which companies prefer various types of financing depending on needs and circumstances, with internally generated funds first, then safe debt, followed by risky debt, and finally external equity.

  • A company’s optimal debt-to-equity ratio according to theories like the trade-off theory should not necessarily remain stable over time, as market conditions, tax rates, and other factors that influence the costs and benefits of leverage can change.

  • The different financial structures proposed in the LBO example seem unrealistic and could indicate some kind of trap or unrealistic assumptions. Simply changing the debt-equity split would not reasonably account for such a large difference in purchase price.

So in summary, the key points are around the uncertainty of capital structure theories, importance of using market values, pecking order theory not implying an optimal level, and skepticism around the example financial structures changing value so significantly.

  • Shareholders have a call option on the firm’s assets, with an exercise price equal to the amount of debt to be repaid. If the asset value exceeds the debt, shareholders repay the debt and keep the excess. If asset value is below debt, shareholders let creditors take the assets.

  • Creditors, in effect, have sold shareholders a put option. If shareholders exercise this option by defaulting, creditors take ownership of the assets in lieu of full debt repayment.

  • Debt can be viewed as the firm selling its enterprise value to creditors but with an option for shareholders to buy it back by repaying the debt.

  • Equity value equals the value of the call option on assets. Debt value equals the risk-free present value of debt cash flows minus the value of the put option sold to shareholders.

  • Additivity holds - enterprise value equals equity value plus debt value. The type of financing does not affect enterprise value.

So in summary, this approach values equity and debt using option pricing theory and establishes their relationship via the options shareholders and creditors hold on the firm’s assets.

The value of equity is equal to the present value of debt at the risk-free rate plus the value of the call option on the firm’s capital employed minus the value of the put option.

Present value of debt at the risk-free rate is the value of the firm’s debt discounted at the risk-free interest rate to account for the time value of money until the debt matures.

Value of the call option on capital employed represents the time value of equity, which is the possibility that the value of the firm’s assets will increase above the face value of debt by the time the debt matures.

Value of the put option is equivalent to the value of the creditors’ position, as it represents the risk that the value of assets will fall below the face value of debt, forcing the firm into bankruptcy. It acts as a risk premium for the creditors.

So in summary, viewing equity as a call option and debt as a put option allows breaking down the value of equity into its intrinsic value (present value of debt) and time value (call option value minus put option value). This underscores the relationship between equity, debt, and the volatility of the firm’s assets.

  • Holding plc has £320,000 of bonds maturing in 3 years that are currently trading at a steep discount. The bonds have a redemption value of £1,000 each, so 320 bonds x £1,000 = £320,000 total.

  • The company wants to improve the equity value for shareholders. It considers redeeming some bonds early by issuing new bonds.

  • 20 new bonds are issued at £219,900/320 original bonds = £13,744. This cash goes to shareholders, improving their position.

  • Creditors lose out as the value of their bonds falls to account for the riskier capital structure. Their loss of £12,344 exactly offsets the shareholders’ gain.

  • The company could also issue riskier debt, exchange assets for riskier ones, or extend the debt maturity to transfer more value from creditors to shareholders through an improvement in the option value of equity.

  • Creditors need protections like convertible bonds, warrants or restrictive covenants to prevent value transfers from damaging their position.

  • Companies often refinance debt before it matures to manage liquidity risk and interest rate risk on the difference in duration between cash flows and maturing debt.

  • When making a comparison with options, shareholders’ equity corresponds to a call option granted by creditors on the company’s operating assets. The strike price is the value of debt and maturity is the debt repayment date.

  • A credit risk corresponds to a put option sold by creditors to shareholders, with a strike price equal to the debt to be repaid.

  • The options theory can be applied to leveraged companies with significant debt repayment obligations in the near future (a few months or quarters).

  • According to the theory, the value of a company’s equity can be nil if the value of assets is lower than the debt.

  • The theory is more useful for analyzing companies in financial difficulty as it better captures uncertainty around refinancing ability.

  • It provides a different perspective than theories assuming perfect markets and rational expectations.

  • Expropriation of creditors can occur without renegotiation, e.g. high risk investments that increase equity value but reduce debt value.

  • Expropriation results from misaligned interests rather than market inefficiency per se.

  • Decisions have different impacts on creditors versus shareholders depending on company health and financial structure.

  • Options concept helps analyze such situations and value transfers between stakeholders.

  • Young, high-growth companies with significant uncertainties have equity composed mostly of time value.

  • If lenders hedge by shorting shares, it would likely negatively impact the borrower’s share price.

Here are the key points made in this section:

  1. The required rate of return on an investment depends on its risk profile, not the method of financing or nationality of the investor. The cost of equity, debt, or any source of funds will be the same given the risk of the investment.

  2. It is short-sighted to choose a financing source based only on its apparent or accounting cost. The true cost is the required market rate of return for the risk.

  3. Good financing cannot make up for a bad investment. The choice of investments is far more important for value creation than the capital structure or financing decisions.

  4. Situations of financial market disequilibrium are short-lived due to arbitrage. It is difficult to create lasting value through financing decisions alone. Industrial markets take longer to arbitrage, so investment choices have a bigger impact.

  5. A financing source is only a “bargain” if it provides cash in excess of its market value, not just because it has a low stated cost. Things like convertible bonds are good deals only if the embedded option value exceeds market pricing.

In summary, the key lesson is to focus on high quality investment choices over tricky financing maneuvers, as financing costs ultimately depend on the risk and returns of the underlying assets or project. Apparent financing “bargains” may not be real if they do not generate value above required market returns.

The key difference between apparent cost and true financial cost of different sources of financing arises from confusing the accounting cost shown on financial statements with the true economic cost calculated using financial theory.

For debt, the difference is minor as interest payments capture most of the true cost. Equity has a greater error as the dividend yield doesn’t include expected growth. Internal financing shows no apparent cost, but has a true cost equal to the company’s cost of capital.

Hybrid securities like convertibles obscure their true costs, which requires valuation techniques to determine. Apparent costs are misleading and true costs depend on factors like market rates, default risk, and growth opportunities.

When choosing a capital structure, companies consider both accounting impacts and flexibility. While taxes and bankruptcy costs matter less, maintaining credit ratings is a top priority. Preserving flexibility is also valued over rigid targets. Apparent costs like EPS dilution still influence decisions, despite not capturing true value impacts. Optimal structures are firm-specific and change over time based on economic conditions. High inflation can encourage overinvestment and debt, while disinflation has the reverse effect. Equity provides financing but also acts as an insurance buffer, justifying its higher cost.

The passage discusses various factors that influence a company’s capital structure:

  • The need for financial flexibility to take advantage of opportunities and deal with crises. Too much debt leaves no capacity for future borrowing.

  • The desire to maintain an adequate credit rating for access to debt markets. Ratings are increasingly important.

  • The lifecycle stage of the company and industry characteristics, with startups relying on equity and mature companies relying more on debt.

  • Shareholder risk preferences and their willingness to be diluted with equity issues. Some block dilutions.

  • Availability and conditions in financial markets, which can create opportunities for certain financing options.

  • Competitors’ capital structures which provide a benchmark.

  • Management preferences in terms of control and risk tolerance, which influence financing choices.

The capital structure results from complex tradeoffs between these different factors. Maintaining flexibility is a key concern for finance directors in their financing decisions over time.

  • Financing policy should not be based solely on opportunistic access to low-cost financing, as such opportunities are unpredictable and cannot be relied upon long-term. A company’s image and ability to raise future capital can be damaged if investors feel taken advantage of.

  • Taking on more debt than competitors means betting more heavily on future profitability, making a company more vulnerable to downturns. Business leaders prefer to take industrial/commercial risks rather than financial risks.

  • Capital structure choice is relative to industry averages and competitors. Analyses consider company and sector financial ratios.

  • Managers’ risk tolerance impacts capital structure choices - more risk-averse managers choose lower leverage. Past experiences like recessions make managers more prudent about debt.

  • Higher debt raises insolvency risk and breakeven point due to fixed interest costs. Sensitivity analyses examine profit impact from interest rate changes.

  • Debt raises EPS if investment returns exceed cost of debt after-tax. Equity raises EPS if investment returns exceed reciprocal of P/E ratio. Lower returns reverse this.

  • Simulations of financing impacts on liquidity, profitability, ratios and cash flows are necessary to inform capital structure decisions considering different scenarios.

  • Through judicious investment, the cost of financing a particular asset is equal to the required rate of return on that asset, regardless of whether the financing comes from debt or equity.

  • However, the apparent cost of different financing sources (e.g. the coupon rate on bonds) may differ from their true financial cost once factors like risk, growth prospects, and the potential for changes in capital structure are accounted for.

  • Internal financing appears to have no cost but actually has the highest financial cost to evaluate since growth opportunities are difficult to measure.

  • The choice of financing depends on macroeconomic conditions, the need for financial flexibility, industry norms, shareholder preferences, and opportunistic financing options - not purely on apparent costs.

  • Simulations of debt vs equity financing mainly show the effects of leverage on metrics like breakeven point, EPS growth, returns, but not whether one creates more value for the particular company/investment.

  • In summary, apparent costs are misleading and the best financing choice depends on multiple company-specific factors, not just relative costs between debt and equity. Judicious investment is more important than financing alone.

Here is a summary of the key points from the given text:

  • An often held view is that companies should solely rely on internal financing (reinvesting cash flows) for development as it benefits managers, creditors and shareholders. However, this can lead to misallocation of resources if capital is cut off from external markets.

  • While internal financing has no apparent immediate costs, it does have an opportunity cost equal to the cost of equity as shareholders forego dividends. Retaining earnings is equivalent to raising new equity capital.

  • The value of the company must increase by at least the amount of profit reinvested. However, creating shareholder value means increasing equity value by more than reinvested earnings.

  • Internal financing is not truly “free” as assumed. Everything has a cost, and the cost of internal funds is the cost of equity capital. However, investments do not need to earn the full cost of equity, as the required return depends on project risk levels.

  • A total reliance on internal financing cuts off capital mobility and access to external markets, potentially allowing investments in unprofitable areas. Regular access to capital markets and dividend distributions are preferable.

  • Retained earnings add to a company’s financial resources, but they only increase shareholder wealth if the rate of return on new investments is greater than the weighted average cost of capital. If the return is lower, shareholders are worse off.

  • The cost of equity increases with additional debt financing due to higher risk. New investments need to earn the cost of capital, not just the cost of debt, to create value for shareholders.

  • Internal financing via retained earnings allows companies to reduce debt and costs of financing over time. However, this only benefits shareholders if investments earn above the cost of capital.

  • Comparing changes in book value and market value of equity shows whether reinvested earnings are creating or destroying value for shareholders. Two examples of companies are analyzed.

  • The growth rate of equity depends on return on equity and the proportion of earnings retained. Calculations are provided to illustrate how growth rates are determined based on financing structure and retention ratios.

  • Internal growth allows parallel growth in total capital employed if capital structure and returns remain constant. Various ratios must also stay constant for revenue, production, EBITDA to grow at the same rate as equity.

  • Employed capital/capital employed: The higher the level of capital employed, the higher the potential growth rate of financial resources, as more assets are generating returns.

  • Cost of debt: The lower the cost of debt, the greater the leverage effect on returns. Lower borrowing costs allow a company to take on more debt to invest and grow its capital base, thereby increasing its potential growth rate.

  • Capital structure: The mix of debt and equity financing can impact a company’s potential growth rate, as different structures offer different costs of capital and leverage effects.

  • Payout ratio: The percentage of earnings paid out as dividends. A lower payout ratio means retaining more profits for reinvestment, which can fuel higher growth, all else equal.

  • In equilibrium, all financial metrics like EPS, BVPS, dividends, etc. will grow at the same rate as the overall growth potential/rate. However, this assumes perfect conditions that may not reflect reality.

  • The actual growth rate depends on the returns earned on reinvested profits. Higher returns lead to faster growth, while lower or zero returns slow growth over time.

  • Signaling theories suggest dividends provide information to investors and help distinguish profitable companies from less profitable ones. They signal management’s confidence in future prospects.

Here is a summary of the key points from the chapter:

  • Internal financing (retaining earnings) has several advantages, including reducing creditor risk, enabling capital gains for shareholders, and giving managers access to funds without outside parties. However, excessive reliance on internal financing can lead to value destruction if low-return projects are financed.

  • Dividends and share buybacks aim to return funds to shareholders that cannot be productively reinvested by the company at a rate above its cost of capital. This prevents value destruction and reallocates capital to other firms.

  • The threat of takeovers serves as a market sanction for companies that excessively rely on internal financing and underperform over the long run.

  • Dividend policy can balance reinvestment flexibility for managers with accountability to shareholders and market discipline. It also serves signaling purposes about a company’s financial strength and cash flow stability.

  • The optimal policy depends on factors like a company’s growth opportunities, financial position, and shareholders’ preferences which vary over time (e.g. favoring dividends or capital gains).

  • While intuitive, excessive reliance on internal financing to avoid outside scrutiny can allow value-destroying investments and poor accountability. Dividends play an important role in aligning managers’ interests with shareholders.

Here are the key points about returning cash to shareholders that were discussed in Chapter 37:

  • Ordinary dividends are fixed by the general meeting of shareholders based on a proposal from the board of directors. They are then paid to shareholders in the following days or months.

  • The two key criteria for dividends are the growth rate of dividends per share and the payout ratio (dividends paid divided by net profit). Other criteria like dividend yield are less relevant.

  • Exceptional dividends and share buybacks are alternative ways to return cash to shareholders besides regular dividends. Exceptional dividends are one-time payments.

  • Capital reductions involve reducing the stated capital and returning the difference to shareholders in cash. They can be an alternative to regular or exceptional dividends.

  • Managing cash returns to shareholders is part of the broader capital structure decision about the appropriate level of financial leverage and balance between debt and equity. Returning too much cash could increase financial risk.

  • Signaling theories suggest returning cash to shareholders can be a way for management to signal confidence in the company’s prospects. But it also locks the company into a steady payout, reducing financial flexibility.

So in summary, the chapter discussed the various tools companies have to return cash to shareholders, including regular dividends, exceptional payments, buybacks and capital reductions, as well as some of the implications of these decisions.

Here is a summary of the key points about public dividend policies:

  • In Europe, a payout ratio (percentage of earnings paid out as dividends) lower than 20% is considered a low dividend policy, while over 60% is considered high. The average payout ratio in Europe in 2016 was about 55%.

  • Payout ratios have fluctuated over time but have generally been similar between Europe and the US, ranging from 20-60% since the 1970s.

  • In 2015, only 50 out of the 600 largest listed companies in Europe paid no dividend.

  • Payout ratios may temporarily rise in years with poor earnings to maintain dividends, and fall in years with good profits.

  • Dividend policies aim to provide some stability and regularity in dividends over time, either matching steady earnings growth or maintaining steady dividends through business cycles. Frequent changes undermine credibility.

  • A high payout ratio reduces share price volatility by making the stock behave more like a bond. But low payout also supports growth through retained earnings.

  • Dividend payment options include interim dividends, scrip dividends (payment in shares), and preferential dividends for long-term shareholders. Share buybacks can also return cash to shareholders.

  • A company can reduce its share capital, and thus redistribute cash to shareholders, through several methods: reducing the par value of shares, conducting a tender offer to buy back shares, issuing put warrants, or through capital reduction approved at an EGM.

  • A share buyback can create value if the shares are repurchased at less than their estimated value, it increases management’s focus on performance, or the funds returned had a lower return than the company’s cost of capital. However, a buyback alone does not reduce the cost of capital.

  • The choice between dividends, buybacks, and capital reductions depends on flexibility needs, impact on signaling to investors, and tax implications for shareholders. Dividends are less flexible but send stronger signals of future earnings, while buybacks and capital reductions are more flexible but send weaker signals.

  • Buybacks allow temporary excess cash to be returned while maintaining future dividend flexibility, but dividend changes imply longer-term commitments to payout levels. Extraordinary dividends are the most neutral signaling-wise.

Here are the summaries of the key points from the passage:

  1. Dividend policy should be judged based on two criteria: the company’s marginal rate of return on capital employed compared to its weighted average cost of capital. If the marginal rate is above the cost of capital, the company can reinvest earnings to create value, so the dividend can be low. If the marginal rate is below the cost of capital, shareholders are better off receiving the earnings as dividends.

  2. Signaling theory interprets dividends as information communicated to investors about future earnings. A dividend increase signals good news, a cut signals bad news.

  3. Agency theory views dividends as a way to mitigate conflicts between owners and managers by reducing excess cash under managerial control. But high dividends can also aggravate conflicts with lenders.

  4. Companies usually aim for a target dividend payout ratio that balances growth needs and shareholder satisfaction as the company moves through maturity phases. Dividends are also smoothed over time to avoid erratic signals.

  5. Dividend policy influences shareholder composition - no dividends risks low loyalty, while paid dividends attracts shareholders seeking income.

  6. Capital reductions can return cash to shareholders or increase control of non-participating shareholders. They are used when managers cannot find good investments or the stock is undervalued.

  7. A capital reduction increases EPS if the P/E ratio is higher than the after-tax cost of debt. But it does not necessarily create value on its own.

  8. Share buybacks increase EPS and book value per share if shares are acquired at a price below book value. It also benefits holders of stock options.

  9. Capital reductions are sound when they reallocate equity from mature, predictable cash flow companies to growing companies, preventing overinvestment. They only create value if the conditions mentioned in point 7 and 8 are met.

Based on the information provided:

(d) In December 2016, the company’s market capitalisation has fallen to 90 million (still with the same number of shares in issue) and the estimated value of the share is 120. Rowak’s chairman puts forward his proposal again. What do you think now?

In this situation, I think the board should reconsider and approve the chairman’s proposal to devote 50 million to buy back and cancel outstanding shares.

Previously when the market capitalization was higher than the estimated share value, buying back shares did not make financial sense. However, now the situation has changed - the market capitalization has fallen below the estimated share value of 120 per share.

By buying back shares at the current market price, which is below estimated value, and cancelling them, it increases the value for remaining shareholders. The company can borrow at 10% to finance the buyback, which is higher than the estimated return from continuing to hold the shares.

So in summary, the buyback now makes financial sense where it did not before, as the market price has fallen below estimated intrinsic value per share based on the information given. The board should approve the chairman’s revised proposal.

  • A share issue is conceptually a sale of new shares by the company. It raises cash for the company’s treasury but also dilutes existing shareholders’ ownership percentages if they do not participate fully in the issue.

  • A share issue introduces the market valuation/price into the company’s management as the cash proceeds are tied to the share price. However, shareholders and creditors can still benefit if the money is used productively.

  • Unlike debt, a share issue requires existing shareholders to share control and future earnings with new shareholders. The degree of sharing depends on the market value and size of the issue.

  • For troubled companies, a share issue transfers some value from shareholders to creditors by reducing risk for creditors.

  • Share issues provide information to the market and help reduce agency problems by aligning management interests with shareholders. However, they may also signal that future cash flows are lower than expected or that the share is overvalued.

  • Empirically, share prices often drop 3-5% on announcement of an issue as existing shareholders are immediately diluted, even if the company’s fundamental value increases.

  • Companies like Lafarge and Pernod-Ricard initially financed external growth (acquisitions) through debt.

  • CRH (a construction materials company) anticipated future transactions by raising capital ahead of time to avoid having to rely solely on debt financing for acquisitions. They did this by conducting capital raisings to have funds available for future transactions.

So in summary, Lafarge and Pernod-Ricard initially relied on debt financing for acquisitions, while CRH implemented a strategy of periodically raising capital in the markets in anticipation of future transactions, allowing them to avoid being solely reliant on debt financing for external growth opportunities.

  • It is the duty of managers to consider the possibility of carrying out a capital increase to raise funds for the company. This involves diluting existing shareholders’ stakes.

  • A capital increase mechanically increases the book value of equity since the proceeds from the new share issuance are included. More interestingly, one can compare the percentage increase in book value to the ratio of proceeds to pre-issue market value and the growth in value per share.

  • The dilution of control from a capital increase, where existing shareholders’ voting rights are reduced, should be distinguished from the impact on financial ratios in the short term. Dilution is generally less of an issue if the company’s market value exceeds its book value.

  • Capital increases can provide significant funding with relatively little dilution of control if done at a time when the stock is viewed as undervalued by the market. However, managers must ensure the capital is invested productively to create value over the long run.

  • It is the duty of managers to consider capital increases as one option to raise funds for productive investment opportunities. However, dilution impacts on existing shareholders must be carefully considered based on factors like the company’s valuation and potential long-term returns from investment of the proceeds.

Cy is usually explained by the low liquidity of rights. Because it leads to a dilution of control. Rights issues often lead to dilution of existing shareholders’ control over the company. This is because when new shares are issued, existing shareholders’ voting rights as a percentage of total voting rights are reduced. Rights have low liquidity because there is often no organized market for shareholders to trade their rights. This makes it difficult for shareholders who do not want to take up the rights issue to pass on or liquidate their rights. The low liquidity of rights discourages large shareholders from selling down their stakes, which would otherwise limit the dilution of their control.

  • The appreciation of risk is the real cost of financing the company. Interest rates and flat fees must be added to determine the total cost.

  • Bank loans are more flexible in terms of amounts and repayment terms compared to bonds, which have minimum sizes of around €5 million and longer maturities. However, bonds provide less restrictive covenants.

  • Factors like a company’s credit rating, the state of the financial markets, and strategic operations can impact the feasibility and timing of issuing bonds.

  • Choices around fixed vs floating interest rates and currency denomination involve balancing costs and risk exposure over time. Hedging requirements should also be considered.

  • Debt can be classified based on seniority - senior debt has priority in collateral/repayment, while subordinated debt provides additional protections for other creditors but ranks below them if the company is liquidated.

  • Subordinated debt sits lower than secured and senior debt in the priority order for repaying creditors in the event of bankruptcy. This increases the risk for subordinated creditors.

  • In exchange for taking on more risk, subordinated creditors demand a higher interest rate than senior creditors who face less risk.

  • Using subordinated debt allows risks and returns to be distributed across different layers or “tiers” of debt, allowing each creditor to choose their preferred risk level.

  • In leveraged buyouts (LBOs), subordinated debt is structured like a multi-layered “wedding cake” with the most risky/highest returning debt on the bottom layers.

  • Covenants in debt agreements protect creditors by restricting risky investments, additional borrowing, dividends, and changes in company control that could weaken the company’s financial position.

  • Debt agreements are often renegotiated to adjust terms as companies’ situations change over time, such as extending maturities when cash flows decrease or improving terms when financial conditions are stronger. This helps companies avoid defaults due to covenant violations.

  • Companies that keep large cash balances on their balance sheets tend to gain market share from competitors in subsequent years, as clients, suppliers, and workers are reassured by the company’s liquidity.

  • For R&D-intensive companies or those with many intangible assets, cash reserves help offset fluctuations in cash flow and reduce investment risk for shareholders.

  • Investment does not always immediately follow the proceeds from divestments. There can be lag times between selling assets and reinvesting the funds.

  • Cash reserves will remain an attractive option for companies given the volatile business environment. However, excess cash that is not being productively used in the business could be better deployed elsewhere in the economy.

  • Instead of holding cash, firms can opt to maintain undrawn revolving credit facilities to provide flexibility and liquidity as needed.

The key points focus on how large cash balances can strengthen a company’s competitive position and provide a financial buffer, while noting that excess cash should still be productively deployed and alternatives like credit facilities exist as well.

  • The passage discusses maintaining an optimal debt policy for a company. A good debt policy leaves cash on the balance sheet to deal with unexpected events, reduce risk, and seize opportunities.

  • It recommends the financial director establish close relationships with a limited number of banks to diversify financing sources. Debt maturities should match expected cash flows. Covenants and asset-backed financing should be used cautiously to maintain flexibility.

  • Maintaining some cash reserves provides a buffer against unexpected costs or needs for investment. It reassures stakeholders and allows the company to act if opportunities arise.

  • Diversifying lenders but keeping the number small helps balance risk protection with maintaining oversight relationships. Carefully structuring covenants and secured loans can give flexibility while obtaining favorable terms. The overall aim is reducing risk and costs while retaining room to maneuver.

Here are the key points from the summaries:

  • Time for a change: Loan conditions and bank behavior when firms switch banks (2010) examines what happens when companies switch banks, including changes in loan conditions and bank behavior.

  • Short-term debt as bridge financing (2015) studies the use of commercial paper as bridge financing and evidence from that market.

  • Should one borrow at a fixed or floating rate? (2010) discusses the tradeoffs of fixed vs floating rate debt.

  • Corporate ownership structure and the choice between bank debt and public debt (2013) analyzes how ownership structure impacts the use of bank debt vs public debt.

  • The supply-side determinants of loan contract strictness (2012) examines what drives variations in strictness of loan contract terms.

  • Renegotiation of financial contracts (2009) studies renegotiation evidence from private credit agreements.

  • Bank loans, bonds, and information monopolies (2008) analyzes bank loans, bonds, and information asymmetries over the business cycle.

  • Corporate leverage, debt maturity, and credit supply (2013) examines how default swaps impact corporate leverage, debt maturity and credit supply.

  • The choice of debt maturity (2009) discusses factors that influence the choice of short-term vs long-term debt maturities.

  • The passage discusses the relationship between entrepreneurs and investors in startups. It notes that investors take high risks but closely monitor their investments, providing advice and contacts to help steer the company.

  • The entrepreneur values this involvement as it brings experience, contacts, objectivity, and advice on difficult decisions in addition to capital. This helps address the loneliness of the entrepreneur.

  • As the company will need to raise funds multiple times before becoming profitable, investors have an interest in ensuring the company follows its roadmap so they can decide whether to reinvest. Their close involvement is not disinterested but helps the manager.

  • Share prices of startups like Néovacs are extremely volatile, reflecting the high risks at this stage of development, unlike more established companies like Sanofi. Néovacs’ price fluctuated drastically based on research results.

  • The passage discusses why serial funding rounds rather than a single large round is preferred by both entrepreneurs and investors, allowing for staged investment based on achieving milestones. This gives both parties more control over risk.

  • The entrepreneur has faced failure with their initial investors and concept. They now want to pivot the company in a new direction.

  • It will be difficult to convince new investors since the initial investors opted not to continue investing after the failure, which sends a negative signal. Finding new funding will likely end in failure as well.

  • If new funding is found, the new investors will demand shares at a lower price. The initial investors will then ask for additional shares to maintain their ownership stake, diluting the entrepreneur significantly.

  • The entrepreneur may be forced to sell the company in poor conditions or liquidate it if no new funding is found, which is a common outcome.

  • Paying high valuations to initial investors carries a high risk for the company’s survival since a start-up’s development is rarely linear and failures can occur. An alternative approach is proposed where investors only pay goodwill/valuation upon exit based on actual results and performance targets.

  • However, this may not properly motivate the entrepreneur who wants significant ownership and control from the start. Finding the right balance of motivation and risk is important.

  • Investors want protection of their investment through various clauses in case the valuation they agreed to turns out to be too high. This includes things like ratchet clauses that issue them additional shares if later rounds are at a lower price.

  • They want their investment returned first in case of an exit or sale before founders can realize capital gains. Alignment of interests is important.

  • Information rights are sought to ensure they are kept aware of company performance and major decisions. Qualified majority voting rights may also be demanded on key matters.

  • An early start to fundraising is advised to avoid running out of cash. Planning is important as the process takes time.

  • Valuing startups is difficult due to uncertainty. The venture capital method is commonly used, estimating future value in 4-7 years based on comparables, then discounting that value back to the present using high discount rates around 50-60% reflecting risk.

  • The passage discusses the venture capital method of financing start-up companies through multiple rounds of equity financing from friends/family, business angels, and venture capitalists.

  • Example SAS is used as a case study, describing how it raised capital in successive rounds over 8 years to fund development of a social networking website. This allowed it to reach product milestones and grow its user base.

  • Key points discussed include high risk of startups and need for flexible long-term equity financing. Financing rounds are tied to development stages. Founders are initially key but get progressively diluted as companies raise more funds.

  • Investors require high return rates to compensate for risk, with rates calibrated based on projections but recognizing many startups fail. Subsequent rounds dilute earlier investors requiring higher ownership stakes.

  • Example SAS ultimately raised a total of €10.5 million over 8 rounds to develop its business model before reaching profitability, demonstrating the long-term iterative process of startup financing.

In summary, it outlines the venture capital method for providing staged equity financing to startups over many years as they develop through various milestones, allowing founders and investors to share in success if business plan is realized.

Here is a summary of the key points from the section:

  • A company’s shareholder structure is important to analyze, beyond just valuing the equity. Understanding who owns the shares and how shareholders are organized is often overlooked but critical in practice.

  • There are several reasons to closely examine a company’s shareholder base:

  1. Shareholders theoretically determine strategy, but managers may actually wield power. Understanding the agency dynamic is important.

  2. Shareholder objectives need to be understood, especially if they are also stakeholders. Their incentives and conflicts of interest matter.

  3. Shareholder agreements are pivotal, as they define control rights, information rights, exit rights, etc. Their rules shape decision making.

  4. Shareholder cooperation/conflict impacts governance and operational decisions. Harmonious vs. divided shareholders lead to different outcomes.

  5. Identifying majority/influential shareholders is crucial, as their priorities will drive strategic direction.

So in summary, a company’s shareholder structure provides important insights beyond valuation. It reveals agency issues, stakeholder alignments, governance rules, cooperation levels, and ultimate decision-making power - all shaping a company’s path. A thorough shareholder analysis is a critical part of the corporate finance evaluation.

  • Shareholders can take the form of managers seeking wealth, power and fame. In some cooperatives, shareholders are also customers or suppliers, making the cooperative serve producer needs rather than maximize profits. This can lead to less profitable cooperatives.

  • Family-owned companies can be paralyzed by shareholder disagreements. Everything related to shares, including shareholder structure, can create or destroy value for a company.

  • Shareholders generally have the ultimate decision-making power through shareholder meetings. They vote on matters like board appointments, auditors, annual accounts, dividends, mergers, capital increases. Voting requirements vary by country and decision type.

  • Blocking minority shareholders can veto changes to articles of association or capital structure. They have more influence when the company needs restructuring. Family ownership remains common in Europe but is declining due to capital needs of new industries, mature financial markets allowing diversification, and desire for independence among family members.

Traditionally, family-owned companies have performed well on average due to the family’s strong incentives to monitor managers and ensure responsible management. However, increasingly these companies are being managed based on financial criteria, leading the family either to exit or dilute its ownership stake among a larger pool of investors.

Private equity funds, financed by large institutional investors, play a major role in company ownership. These funds focus on various stages of company maturity from venture capital to later-stage growth. They help address agency problems through strict reporting requirements and management incentives. They also bring resources and expertise to acquire and restructure companies.

Other institutional investors like pension funds and mutual funds collectively own significant stakes in public companies and are increasingly engaging in activism and applying pressure on underperforming companies.

Financial holding groups also historically played a role in financing and growing large companies. Employee shareholders can provide stability, though their ownership should not be too concentrated given risks ofjobs overshadowing restructuring.

Government ownership is declining but sovereign wealth funds from foreign governments are growing shareholders, bringing both deep pockets and some opacity concerns given their ties to political interests. Minority shareholders can help protect their interests through shareholders’ agreements.

  • Shareholders’ agreements are used by several shareholders of a company to define their future relationships and complement the company’s articles of association. They are usually confidential except for listed companies that must publish them.

  • They contain clauses around corporate governance issues like board seats, major decisions, and information disclosure. They also contain clauses around future sales or purchases of shares, like rights of first refusal, tag-along/drag-along rights, and exit provisions.

  • Joint venture agreements also often contain exit clauses like buy-sell provisions where one partner can either buy the other out or be bought out at a set price, or appraisal clauses where an independent party sets the transaction price. Managing potential future exits is important when creating a joint venture.

  • Defensive measures companies use to maintain control, like different classes of shares, come at a cost of reduced access to finance. Regulations around these measures vary by country depending on how concentrated ownership and management is. Common defensive measures separate management from ownership, control shareholder changes, strengthen loyal shareholders, and exploit legal protections.

  • Company articles of association determine how executives are chosen. Top managers have extensive powers to act on behalf of the company and can only be fired under terms specified in the articles.

  • In some countries, general partners can set up a holding company to limit their financial liability. This allows management control to be handed down within the holding company while it continues managing operations.

  • Theoretically, a company’s chief executive can have absolute power to manage without owning shares, as control derives from by-laws rather than financial ownership.

  • Structures like limited partnerships allow separation of ownership and control of a company.

In summary:

  • Change-of-control provisions in contracts, like those that allow employees significant payouts in the event of a takeover, can make takeovers more complex and expensive for the acquiring company.

  • While designed to protect employees, these kinds of provisions essentially act as anti-takeover defenses and are generally not considered effective ways to prevent unwanted takeovers in practice. They increase costs but do not necessarily stop determined acquirers.

  • Investors now prefer “pure play” stocks where they can select individual industries or sectors, rather than conglomerates where their investment is tied to management’s portfolio choices.

  • In a conglomerate, investors cannot choose the specific assets in the company’s portfolio. They are stuck with whatever the holding company decides.

  • Head office costs associated with managing a conglomerate absorb some value that would otherwise go to investors.

  • This often leads to a “conglomerate discount” where the market value of the conglomerate is less than the sum of its parts.

  • If the discount persists, it can result in a spin-off where parts of the conglomerate are separated, or a hostile takeover bid from another company looking to break up the conglomerate.

  • Some large conglomerates like GE and Berkshire Hathaway avoid significant discounts because investors are convinced of their efficient management and portfolio choices.

  • But the trend is for investors to prefer more focused “pure play” stocks where they can select industries, rather than being stuck with conglomerate portfolio decisions made by management.

  • The book argues that a company’s fundamental factors like performance, profits, etc. are best expressed through its share price when publicly listed on a stock exchange. While these factors also apply to unlisted companies, listed companies get immediate market feedback through share price movements.

  • Being listed provides access to capital markets to issue and trade shares, allowing direct assessment of company value. Stock exchanges facilitate efficient exchange of shares compared to private financing negotiations.

  • Financial analysts’ research and listing disclosure requirements enhance market efficiency. Listing links company performance directly to share price and risk of takeover for poor management.

  • Several advantages of listing include visibility, access to funding/acquisitions using stock, valuation of subsidiaries, and employee incentives. However, listing does not guarantee investor support and comes with new transparency and communications obligations. Going public is a lengthy process requiring financial and legal preparations.

  • Companies need to consider various factors when deciding on an IPO, such as whether existing shareholders want to sell shares, if the company needs funds, and the appropriate size of the offering.

  • Parameters like the stock market, primary vs secondary offering, size of offering, and lock-up clauses all need to be determined. The goals are to balance the various stakeholder needs while not sending overly negative market signals.

  • IPO shares are often underpriced intentionally to ensure buyer satisfaction and smooth transaction. This helps account for information asymmetries and signals the seller’s confidence in the company’s prospects.

  • Successful IPOs require an attractive company, clear seller motivations, and marketing like roadshows and anchor investors. Timing the market and initial share performance are also important.

  • Companies may consider going private again if the original listing reasons like capital raising are no longer relevant and costs now outweigh benefits such as lower liquidity requirements for shareholders. Maintaining a listing requires ongoing disclosure and market interactions.

  • Companies typically list on a stock exchange to raise capital through an IPO, which gives them access to public markets to fund future growth. Listing also increases a company’s profile and reputation.

  • Shareholders may prefer an IPO over a straight sale because it allows them to sell a portion of their stake while maintaining control of the company. An IPO also offers the potential for future price appreciation.

  • A company will typically launch a takeover bid for the remaining shares of a subsidiary if it already owns 85% or more. Reaching a 90-95% ownership threshold enables it to buy out minority shareholders in a “squeeze out”.

  • Companies listing on public exchanges often need to change their corporate governance to comply with listing rules and protect minority shareholders. This includes adding independent directors and adopting best practices.

  • It can be difficult for a sole shareholder to sell 100% of their shares in an IPO as it sends a negative signal to the market. Investors prefer when founders maintain a stake after listing.

  • Jean-Louis Dumas’ comment about his grandchildren reflects the potential conflict between short-term thinking of public shareholders and longer-term approach of family/founder shareholders.

  • Companies risk severe disappointment if they pursue an IPO solely based on market fads rather than clear strategic benefits.

  • Risks of an IPO include failure during the process if markets decline, an underwhelming offering price, and future loss of control through a takeover bid.

  • Large private companies will eventually need to provide liquidity to shareholders through mechanisms like an internal stock exchange or full sale/IPO to avoid stagnation.

  • The chapter discusses corporate governance, which covers the organization, control, and management of a firm. This includes shareholders’ rights, management rules, disclosure of financial information, and oversight bodies like the board of directors.

  • Corporate governance becomes more important as a company’s ownership structure changes from a single owner-manager to dispersed shareholders. It deals with the relationship between shareholders and management.

  • Good corporate governance can foster value creation by ensuring efficiency, responsibility, transparency, fairness and ethics in decision-making. However, there is no single best system - governance must adapt to a company’s ownership structure and country.

  • Company law defines the framework for governance, while codes and guidelines provide best practice recommendations around board composition, shareholder rights, and transparency. Compliance with these codes is voluntary however.

  • The chapter emphasizes increasing transparency around board operations as a key governance recommendation over the past 20 years.

  • Companies have become more transparent about board meeting frequency, internal regulations, board charters, and performance assessments. The average number of board meetings increased from 3 to 8.3 per year between 2015-2018.

  • Compensation of managers and directors has also become more transparent, with numbers now being disclosed. The compensation of Eurotop 100 CEOs in 2015 included a base salary, bonus, and long-term incentives like stock options.

  • Stock options can help align manager and shareholder interests but also encourage short-term behavior. Alternatives like granting free shares have emerged.

  • An independent board is recommended, with at least half the directors being independent of management. However, defining “independence” is controversial.

  • Board committees oversee areas like auditing, compensation, appointments, strategy, and risk.

  • Obstacles to shareholder power like multiple voting rights or voting caps are discouraged. However,mandatory voting and proxy voting are encouraged to improve shareholder democracy.

  • Power within the board can be organized through a one-tier CEO-chairman model, dual CEO-chairman model, or two-tier supervisory-executive board model. Separating the CEO and chairman roles is considered better for oversight.

  • Agency theory recognizes that conflicts of interest can arise between shareholders and managers due to information asymmetry. Corporate governance aims to structure decision-making to reduce these conflicts and limit self-dealing by managers at the expense of shareholders.

  • However, entrenchment theory notes that governance mechanisms are not always enough to force managers to act in shareholders’ interests, as some managers try to entrench themselves to hold onto power and jobs.

  • Surveys show institutional investors are willing to pay a premium (12-14% in developed markets, 30% in emerging markets) for shares in companies with good governance.

  • Empirical studies find companies with higher governance ratings by rating agencies tend to perform better financially. Local laws alone do not guarantee good governance.

  • Companies with a major shareholder holding 30-50% of shares tend to perform better than average, as large shareholders have strong incentives to ensure company success. However, the best performers have a large free float as well to avoid issues with lack of transparency at fully family-owned firms.

  • There are limits to systematically applying governance rules, but complying with basic, common-sense rules can help prevent abuses by managers. Each situation requires case-by-case assessment.

  • Corporate governance refers to how companies are organized and controlled. It involves the relationships between shareholders, board of directors, and management.

  • Corporate governance developed mainly at listed companies due to lower agency costs when ownership is widely held.

  • Stock options help align manager and shareholder interests by allowing managers to benefit from share price increases. However, they can also encourage short-term risk taking.

  • Even companies with independent boards can experience failures if there is a lack of control over managers.

  • Specialized board committees carry a danger of becoming decision-making bodies rather than preparatory bodies.

  • Overworked directors who cannot fulfill their duties should resign.

  • The ideal director is competent, courageous, independent and hard-working.

  • Corporate governance is most important in countries with weak ownership protection and loosely regulated frameworks.

  • Good corporate governance should reduce capital costs by limiting risks to minority shareholders.

  • Research has provided mixed evidence on whether regular auditor rotation improves governance.

  • M&A activity tends to come in waves, driven by periods of overvalued/undervalued companies, availability of financing, and herd behavior.

  • During economic downturns, companies focus on operations, but as the economy improves they gain confidence and openness to M&As. High share prices also facilitate financing.

  • Technological changes and innovation spur consolidation as new companies face challenges and seek support. Globalization also drives need for scale.

  • Legislative/regulatory changes like deregulation force restructuring in many industries like telecom, energy, and finance. Privatization of state companies makes them potential M&A players.

  • Financialization gives companies access to capital markets to fund expansion and restructuring. Cash/share transactions depend on valuations - shares favored in high markets, cash in low markets.

  • M&As are pursued for synergies, cost savings, market power, new skills/products, and financial benefits like tax savings. Negotiations balance buyer/seller interests to find the equilibrium price accounting for synergies.

  • The financial system has undergone a structural shift from primarily credit-based systems, where banks were the main suppliers of funds, to financial market systems characterized by disintermediation.

  • This shift was accompanied by a transfer of power from banks and other financial institutions to investors. Shareholders now exert more pressure on corporate managers to deliver returns through the threat of selling shares and depressing prices or enabling takeovers.

  • Low population growth and strict immigration controls in Europe have made organic growth more difficult for firms. As a result, managers look to M&As as an alternative growth strategy, seeking opportunities for economies of scale, market share gains, geographic or product complementarity, or risk mitigation through larger size.

  • Factors like increasing size to reduce costs, broadening market scope, gaining a first-mover advantage, entering new markets or businesses, boosting stature for risk-taking, and addressing succession issues also drive M&A activity.

  • While risky, M&As are a normal part of a company’s lifecycle and can be a useful growth tool if synergies are realized and integration is managed well. However, about half of deals fail to achieve promised synergies due to overestimated benefits and underestimated costs and challenges of integration.

  • The seller will receive payments of $100 this year and next year for the sale of the company. While this totals $200, if discounted at 10% it is actually only worth $190.90 today. However, the seller only thinks about the total $200 payment and not the time value of money.

  • This type of financial structuring hides the real price being paid. Companies often use complex structures initially in negotiations that get simplified over time as the parties get comfortable with the sale price.

  • Investment bankers have some common techniques for structuring deals, such as using holding companies with debt financing, paying with stock of the acquiring company, deferred/contingent payments, and earn-out clauses tying payments to future performance.

  • Representations and warranties in the sale agreement are important for the buyer to ensure the profitability and assets/liabilities of the target company have not been misrepresented, though they do not protect against overvaluation. They certify control of assets, accuracy of financials, and disclosure of liabilities.

Here is a summary of key points from the passage:

  • AP.7 refers to Generally Accepted Accounting Principles, which are a common set of accounting standards, procedures and practices.

  • The seller makes representations and warranties about the company’s financial status, including that it is up-to-date on taxes, salaries and other payments. Any exceptional items have been disclosed to the buyer.

  • The seller guarantees prudent management during the transition period between the last statements and the sale. No assets were sold or dividends distributed without buyer agreement.

  • Warranties hold the seller responsible for additional liabilities not disclosed to the buyer that emerge after the sale, up to an agreed time period and cap amount.

  • A holdback or bank guarantee is often used to secure the warranties, with part of the purchase price held back in an escrow account until liabilities are clear.

  • The representations and warranties clause is a key addition to the sale agreement but other clauses may also be included depending on the agreement.

  • An io deal involves an acquirer making an offer to purchase another company (the target) in exchange for stock in the acquiring company. This allows the shareholders of the target to become shareholders of the larger combined company.

  • Offers can be friendly/recommended if negotiated with the target’s management and board in advance, or hostile if launched without their approval. Most hostile offers later become friendly after sweetening terms.

  • Offers are either voluntary, at the acquirer’s discretion, or mandatory if a certain ownership threshold is passed, requiring an offer to all remaining shareholders. Mandatory offers face tighter regulations.

  • Capital markets authorities oversee the offer process to ensure equal treatment of shareholders and transparency. They approve offer documents and set timelines.

  • A target company facing a takeover bid has limited defensive options compared to secret stock accumulation. It can try to convince shareholders the bid undervalues the company, find a competing bidder, launch its own bid for the hostile acquirer (if public), or take actions like share buybacks or new share issues.

  • Shareholder authorization is often required before a takeover bid, as there is usually not enough time to convene an EGM to fit the bid timetable. Reserved issues are also often not allowed.

  • Warrants can act as a strong deterrent to hostile takeovers, as the negative consequences of the target company issuing warrants means the bidder is generally prepared to negotiate. Warrants can be neutralized in exchange for a higher offer price.

  • “Poison pill” warrants strengthen the target’s negotiating position but do not ensure independence. If warrants are issued, directors may face responsibility for causing shareholders to lose out on a higher price.

  • The target can take legal action regarding market regulations, misleading information, abuse of dominant position, or failing to protect employee interests. The aim is to gain time for management.

  • Anti-takeover measures generally force the bidder to increase their offer but rarely make them abandon it. Initiatives taken early have a clear advantage. Loyal long-term shareholders can be the best defense.

  • EU and national regulations set rules for mandatory bids, minimum bid levels, defenses, and squeeze-out thresholds. The table summarizes rules in different countries.

Here is a summary of key points about mergers and acquisitions using stock as consideration:

  1. A legal merger is when two companies combine to form a single legal entity, with one company typically absorbing the other. Shareholders of the acquired company become shareholders of the acquiring company.

  2. A stock-for-stock merger allows two companies to combine operations while maintaining separate legal identities. Shareholders of both companies exchange their shares for shares of the newly combined entity.

  3. Valuing the companies is important to determine the exchange ratio of shares. Synergies from the merger are estimated and factored into the valuations.

  4. Gaining shareholder approval can be challenging. Both sets of shareholders want to maximize the value of what they receive in the merger.

  5. Integrating operations and cultures post-merger is critical to achieving projected synergies. Management attention is required to ensure a successful integration.

  6. Using stock as consideration avoids cashing out the sellers, allowing them to benefit from future upside of the combined company. But it also subjects them to execution risk of the merger plans.

  7. Friendly mergers using stock are more likely when both managements strongly support the strategic rationale of the deal. Hostile bids using stock are less common.

In summary, mergers using stock as consideration combine operations of companies while distributing ownership in the new merged entity to pre-merger shareholders. Successful value creation depends on valuation, integration execution and management of the post-merger organization.

A business combination involves merging the assets, liabilities, and shareholders of two or more companies into a single legal entity. There are a few main ways this can be done:

(1) Merger - This is when two companies combine to form an entirely new single company, with shareholders of both original companies receiving shares in the new combined company.

(2) Acquisition - One company purchases another company entirely for cash. The acquired company becomes a subsidiary of the acquiring company.

(3) Asset/liability contribution - One company contributes assets and liabilities to another company in exchange for shares. The contributing company becomes a shareholder in the receiving company.

(4) Share exchange offer - Shareholders of one company exchange their shares for shares in the acquiring company, leaving the acquired company as a subsidiary.

From a legal/tax perspective, all transactions except a pure cash acquisition are treated as non-taxable contributions of assets in exchange for shares. While the structure and impact on shareholders differs, the end economic outcome of combining the two companies is generally the same. Paying with stock allows for larger combinations without cash but provides less immediate payout to selling shareholders. Determining exchange ratios considers metrics like earnings, cash flows, dividends and share prices of the combining companies.

  • EBITDA per share and EBIT per share can be used to evaluate mergers when the capital structures of the companies are similar.

  • When companies have dissimilar activities, a full valuation comparing the standalone value of each company and separately valuing synergies is generally performed.

  • The same valuation methods should be used to value each company.

  • The relative value ratio agreed in the merger determines the ownership stakes in the new combined company for shareholders of the acquirer and acquiree.

  • Exchange ratios are calculated based on the relative value ratio and pre-merger number of shares.

  • Synergies from the merger are valued separately and factored into the overall valuation of the combined company. The value attributed to synergies is usually lower than initial estimates due to execution risks.

  • The relative value ratio negotiation determines how the value of synergies is split between the shareholders of the acquirer and acquiree.

  • The scenario describes a potential merger between Company A and Company B. Company A currently owns 36.7% of the combined company, while Company B owns 63.3%.

  • In the merger, the ownership would change to a 50/50 split, with each company owning 50% of the combined entity.

  • Determining the value of potential synergies from the merger is crucial for negotiations. It sets the maximum premium Company A will pay to Company B shareholders to approve the deal. It must be large enough to incentivize approval but small enough to still create value for Company A shareholders.

  • Initially the combined market cap was assumed to simply be the sum of the two individually. However, mergers often cause a re-rating (increase) or de-rating (decrease) of the price-to-earnings (P/E) ratio.

  • If the combined company gets a P/E of 30 like Company A pre-merger, its market cap would be €975m. Company A shareholders’ stake would then be worth €531m, more than their pre-merger €450m stake in just Company A. Company B shareholders’ stake would be worth €444m, more than their pre-merger €330m stake in just Company B.

  • So while A shareholders appeared to lose value in ownership percentage terms, the rerating meant the merger actually creates value for both sets of shareholders in this example.

  • Lenders are generally not in favor of demergers because they increase risk by reducing business diversity and volatility of cash flows.

  • If debt is assigned unevenly between the post-demerger companies, it could significantly decrease the value of the lenders’ debt.

  • Loan agreements usually have clauses that the debt becomes immediately payable if a demerger occurs, allowing lenders to negotiate terms.

  • Empirical studies show demergers on average do not transfer value from lenders to shareholders.

  • Sharing group debt between post-demerger companies is a major issue that can jeopardize the demerger.

  • Demergers require 6+ months of complex preparation so are less frequent than mergers.

  • Demergers can unlock value from conglomerate discounts or increase manager motivation, but small spun-off entities may suffer liquidity issues.

  • In emerging markets where capital markets access is limited, diversification through conglomerates may be more valuable.

So in summary, lenders are cautious of demergers due to increased risk, but agreements allow them to negotiate, and studies show on average values are maintained. Preparation complexity also makes demergers less common than mergers.

  • An LBO involves a private equity firm using leverage (debt financing) to acquire a company. The private equity firm sets up a holding company that borrows money to purchase the target company.

  • The holding company’s equity is reduced significantly and previous shareholders sell their shares. This increases the financial gearing of the company.

  • An LBO can improve operating performance as management is highly incentivized through equity stakes and pressure to pay down debt.

  • Different types of LBOs include MBO (management buyout), MBI (management buy-in), BIMBO (buy-in and MBO combined), and LBU (leveraged build-up involving continued acquisitions).

  • Obtaining tax consolidation between the holding company and target is important to offset financial costs against taxable profits, reducing taxes.

  • If tax consolidation is not possible, a debt push down may be needed where the target takes on some of the holding company’s debt.

  • LBO lifespans depend on performance improvements and ability to sell to a third party, typically 2-8 years. Possible exit strategies include trade sale, IPO, refinancing/recapitalization, or sale to another private equity firm.

Here is a summary of the key points about price mentioned in the passage:

  • When a private equity firm exits an investment, either the market or company must have changed for a strategic/trade buyer to be interested. For example, KKR exited SMCP by selling it to a Chinese textile group.

  • Common exit strategies for private equity firms include IPO, sale to another financial investor who sets up another LBO, or a leveraged recapitalization.

  • From 2007-2016, the most common exit routes in Europe were sale to a strategic buyer, secondary/tertiary LBO, and IPO. Sale to a strategic buyer made up around 25% of exits on average each year.

  • Setting up an LBO requires special expertise. Private equity sponsors/LBO funds specialize in them since they are high risk due to leverage. Funds seek high returns of 20-25% annually to compensate for the risk.

  • When exiting investments, private equity funds return proceeds to their limited partners (large institutional investors). The general partners receive carried interest, usually 20% of capital gains above a 6-8% hurdle rate.

  • LBO financing involves various types of debt instruments to spread risk, from senior secured debt (lowest risk) to equity (highest risk).

  • Senior debt is traditionally 3-5x the target’s EBITDA and is composed of tranches A, B, C with different repayment periods and interest rates. It is secured by shares/covenants.

  • Subordinated/junior debt includes high yield bonds and mezzanine debt from specialized funds. They allow higher leverage and flexible cash flow. Interest includes cash, PIK, and capital gains.

  • Other financing includes securitization of receivables/inventory, revolving credit lines, and acquisition/capex facilities.

  • Until 2007, investor appetite for risk led to more complex structures including second lien debt, equity bridges, and CDOs/CLOs distributing debt to institutional investors.

  • Equity requirements declined while use of mezzanine/high yield debt expanded until the mid-2010s when market normalized again. Target purchase prices relative to EBITDA also rose until 2007.

  • An LBO involves using significant borrowing to finance the purchase of a company by a new owning entity. This new entity contracts the debt and uses the target company’s cash flows to pay interest and principal on the loans over time.

  • The debt levels involved in an LBO put pressure on management to improve operating performance and cash flows in order to service the debt obligations. This helps align management and shareholder interests.

  • Simply relying on tax benefits of debt financing or promising operational improvements does not fully explain the value created in LBOs. Agency theory provides a better explanation - the debt pressures motivate more efficient management.

  • Studies have shown companies often improve operating metrics like cash flows and returns after an LBO compared to peer companies. This suggests LBOs can help address agency problems between owners and managers.

  • Common exit routes for LBOs include sell to another financial sponsor, IPO, or strategic sale to an operating company looking to acquire assets.

  • Corporate governance under LBOs focuses more on cash flows and debt repayment than listed firms or family firms. Reporting is more rigorous and management incentives are closely aligned with ownership.

  • Bankruptcy is a legal process that allows a company facing financial difficulties to reorganize or liquidate assets in an orderly manner. It aims to reallocate resources from inefficient to efficient firms.

  • Financial difficulties usually stem from market problems like reduced demand or higher costs than competitors. Too much short-term debt can also accelerate problems if liquidity is lacking.

  • Bankruptcy procedures vary globally but broadly fall into “creditor-friendly” or “debtor-friendly” types. Creditor-friendly prioritizes repayment, while debtor-friendly aims to maximize chances of restructuring.

  • Creditor-friendly processes give more control to creditors and usually result in liquidation. They aim to deter over-leveraging through discipline. Debtor-friendly processes maximize chance of recovery but may delay repayment to creditors.

  • Analysis tools like credit scoring and ratings estimate bankruptcy risk to help banks assess lending decisions. Bankruptcy rates historically track economic cycles and credit market conditions.

  • Bankruptcy procedures differ between countries in terms of whether they are more debtor-friendly or creditor-friendly, whether restructuring is possible or liquidation is the main outcome, whether management stays in place, whether secured debts are included, and the level of creditor involvement.

  • Creditor-oriented systems like the US Chapter 11 and Canada are found to be more efficient based on factors like length/cost of process, recovery rates, and ability to restructure viable companies. This encourages more lending.

  • In bank-based systems like Germany and France, restructuring is often done privately through bank relationships rather than via formal bankruptcy processes.

  • Bankruptcy involves significant costs beyond direct legal fees, like loss of credibility and business opportunities. Total costs can be 4.5% of company value.

  • Bankruptcy is a key part of signaling theory, as it makes management’s aggressive borrowing/growth strategies credible by threatening sanction if wrong.

  • Close to bankruptcy, all decisions impact creditors vs shareholders as they affect risk levels and possibility of repayment. Conflicts emerge between these parties.

  • Recovery rates are highly dependent on creditor seniority, with senior creditors recovering around 45% on average but junior creditors only 25%.

  • Conflicts also exist between expedient liquidation desired by creditors vs prolonged restructuring hoped for by shareholders/management.

  • Companies go bankrupt when they can no longer meet their short-term commitments due to insufficient profitability, resulting in a liquidity crisis. Heavy debt alone does not necessarily cause bankruptcy but can accelerate the onset of financial difficulties.

  • Taking over a subsidiary of a group in financial distress carries risks like inherited debts, loss of suppliers/customers, potential bankruptcy of the parent company.

  • In the event of bankruptcy, conflicts of interest arise between shareholders and creditors due to limited liability and risk of loss for shareholders vs. fixed claims for creditors. This is less of an issue for partnerships where owners have unlimited liability.

  • Bankruptcy procedures can help companies survive by restructuring debts, but come with direct costs and indirect costs from lost credibility. They also involve conflicts between creditors over priority of claims.

  • Bankruptcy costs impact taxation by reducing the incentive for debt financing through interest deductions.

-Companies emerging from bankruptcy in countries with debtor-friendly laws can be strong due to reduced debts and operational restructuring. Those in creditor-friendly countries often struggle due to piecemeal liquidation.

  • Even debt-free companies can go bankrupt by destroying value through poor management or adverse conditions.

  • During bankruptcy protection, companies get financing to restructure operations and have a chance to restore profitability before debt claims are settled.

  • Creditors provide financing during this period hoping for repayment or to preserve the going concern value of their collateral.

The key points are why companies go bankrupt, the conflicts that arise in bankruptcy between different stakeholders, how bankruptcy procedures differ cross-countries, and their impacts.

Here is a summary of the key points regarding working capital from the company’s point of view:

  • Working capital is part of commercial conquest. Payment periods and inventory levels help win customers and avoid lost sales.

  • It is a source of financing when reduced and a source of financing requirement when increased. Managing working capital levels impacts cash flow and funding needs.

  • It poses risks if customers don’t pay on time, only pay partially, or go bankrupt. This can create payment issues and bankruptcies across companies.

  • There are also inventory obsolescence risks if goods expire or go unsold.

  • Effectively managing working capital is important for cash flow, risk management, and maintaining financing levels, regardless of interest rate environment. Reducing it is one option but not the only one.

  • The issues and levels of working capital vary significantly by industry sector (e.g. manufacturing vs services).

So in summary, working capital is both an investment in the commercial relationship as well as a financing and risk factor that companies must prudently manage.

  • A tool that helps customers or suppliers who are experiencing liquidity problems due to an economic crisis. For example, during the 2008 financial crisis, Renault and Peugeot provided support to their main subcontractors by reducing payment periods to help address liquidity issues and avoid bankruptcies that could disrupt supply chains.

  • A source of value creation when interest rates are negative, for industries with high inventory levels, as the inflationary gains outweigh holding costs. Managing working capital is not necessary in this case.

  • A potential source of risk if a company overstocks raw materials in speculation that prices will rise, exposing them to price fluctuations.

  • Working capital levels result from corporate strategy decisions around supply chain integration and distribution networks. For example, owning raw material sources or running retail shops increases working capital needs. Outsourcing production also increases working capital for suppliers.

  • Financial trade-offs exist between margins, costs, and working capital. Quick payment terms generate cash flow but reduce margins. Paying cash for supplies secures discounts despite mediocre working capital.

  • Working capital management depends on economic conditions, with tighter control used in downturns and looser standards in expansions when sales and margins take priority. Cultural factors also influence cash discipline.

The passage discusses ways for a company to manage late payments from customers and late payments to suppliers in order to avoid financial issues.

For late payments from customers, it recommends setting credit limits, monitoring customer solvency, using secure payment methods, and potentially taking out credit insurance. It also advises proactively contacting customers about upcoming invoices and resolving any disputes quickly.

For late payments to suppliers, it suggests reviewing payment terms with each supplier to negotiate longer terms if possible. It also recommends validating deliveries on time to avoid payment delays, resolving disputes quickly, and paying suppliers on or before the due date agreed in contracts.

The ability to efficiently manage inventories depends on accurately forecasting demand and production levels. Costs and risks can be minimized through just-in-time delivery strategies and optimization of inventory levels, lead times, safety stocks and reorder points. Effective collaboration with suppliers is also important for inventory management.

  • A company’s inventory includes safety stocks, anticipation inventories, structural stocks like cyclical and in-process stocks, and stocks in transit.

  • Cross-analyzing product and customer families allows for better supply and storage policies based on demand patterns.

  • Reducing supply periods helps optimize inventory levels.

  • Rapidly transforming raw materials to finished goods and selling them optimizes the production process.

  • Monitoring stock levels is important for control and visibility.

  • Achieving a high service rate prevents stockouts from occurring.

  • Management tools like cross-analysis, reducing supply times, production process optimization, stock monitoring, and high service rates help the company improve its inventory carrying ability.

  • Strategic actions like changing the production mode or customizing offerings can structural impact inventory levels but require investments.

  • Coordination between financial, operational, sales and other functions is needed for effective working capital management.

  • Cash management from a treasurer’s perspective looks at cash flows based on value dates rather than accounting dates or bank statement dates. Value dates determine when funds are actually available.

  • Company bank accounts are intended for day-to-day cash management but offer unsatisfactory borrowing and investment conditions, with high overdraft costs and low credit balances rates.

  • Treasurers aim to avoid financial costs from debit and credit balances by transferring funds between accounts through account balancing. Cash surpluses are pooled in a concentration account and used to finance debit accounts through interbank transfers. Automatic account balancing services are offered by banks.

When a bank lends money to a company, it uses part of its bank equity because it needs to maintain a minimum solvency ratio (equity to weighted assets). Banks now tend to directly invoice companies for the actual costs of financial services rather than subsidizing other services. Managing company cash flows is seen as a strategic activity by banks to better understand client risks and improve their own liquidity. However, bank fees are not always transparent, and companies are pushing for standardization of fees.

Cash budgets show expected cash inflows and outflows over various time horizons in order to ensure sufficient credit lines and define expected loan uses. They allow treasurers to efficiently manage interest costs by utilizing competition among banks and financial markets. Annual budgets are based on profit/loss forecasts, then refined over 1-6 month rolling periods using actual cash data. Daily forecasting covers all movements impacting cash positions and exploits payment method differences. Payment methods vary in terms of which party controls timing of payments/receipts and flexibility of account usage, impacting forecast accuracy. Experience is important for forecasting customer payment and creditor collection behaviors.

  • Cash pooling involves centralized management of a corporate group’s cash positions and balances the accounts of subsidiaries. This allows the group to benefit from economies of scale.

  • Key benefits include interest savings from reducing external borrowing needs, lower banking fees, easier access to financial markets for the whole group, and reduced operational costs from centralized treasury functions.

  • Effective cash pooling requires timely and accurate cash forecasting from subsidiaries as well as robust IT systems to facilitate fund movements.

  • A high degree of centralization can reduce fraud risks but also limits local treasury initiative. Subsidiaries may not optimize local cash management if responsibilities are too limited.

  • Different cash pooling models exist, ranging from complete centralization to more decentralized approaches that still allow for netting of positions. The appropriate model depends on factors like group structure and needs.

  • While cash pooling aims to reduce financing costs, risks still need to be properly managed to avoid deteriorating the group’s overall cost of funding over the long run. Internal and external financing need to be appropriately matched to asset risk profiles.

Here is a summary of the key points about approaches to cash management:

  • Most common is centralizing cash balances and liquidity by pooling cash from subsidiaries’ bank accounts at the group level. The group balances the accounts just like subsidiaries balance their own accounts.

  • Less common is centralizing cash flows, where the group receives all incoming payments and makes all disbursements, reducing subsidiaries’ roles. This is more hypercentralized.

  • Centralization can be dictated top-down or requested by subsidiaries, who choose internal or external funds based on rates charged. Flexibility can alleviate demotivation.

  • Notional pooling calculates interest as if accounts were balanced but doesn’t actually transfer funds, giving subsidiaries more flexibility while still benefiting from pooling.

  • Internationally, regulatory differences make direct cross-border pooling tricky. Groups often use a two-tier system with local concentration banks and an international overlay bank handling transfers.

  • In the Eurozone, cash pooling is easier due to payment system integration and cross-border transfer abilities.

  • Groups in financial distress manage cash more operationally by maximizing credit to ensure continued financing availability if conditions deteriorate.

  • The corporate treasurer’s main concerns when investing cash are liquidity and security. Liquidity refers to being able to easily access funds when needed, while security refers to minimizing risk of loss of principal or interest.

  • Liquid investments can fluctuate in value if sold before maturity, so there is a tradeoff between liquidity and certainty of return. Treasury bills are liquid but returns depend on sale price. Fixed-return investments lack liquidity if sold before maturity.

  • Accounting standards define cash equivalents as short term (under 3 months), liquid, convertible to cash, and with low valuation change risk. This impacts measures like net debt.

  • Other potential cash investments discussed include interest-bearing bank accounts, time deposits, repurchase agreements, treasury bills/notes, certificates of deposit, money market funds, and securitization vehicles. Each has pros and cons regarding return, risk, and liquidity.

  • Technological advances now allow for more centralized cash management within large companies and use of off-the-shelf outsourcing solutions. But some companies still view cash management as an internal, strategic function.

Here are the key points from the passage:

  1. What are the four major categories of risk?
  • Market risk (interest rates, exchange rates, commodity prices)
  • Loss probability risk (bad debts, damaged goods, etc.)
  • Volatility risk (exceptional events like fires)
  • Disaster risk (once in a century events like tsunamis)
  1. What are the typical steps in risk management?
  • Identification: Mapping out the risks, determining intensity and probability
  • Assessing existing internal controls and procedures that can mitigate risk
  • Evaluation of potential financial impact of risks
  • Determining risk tolerance and acceptable levels of risk
  • Selection of appropriate risk management techniques
  • Monitoring and review of risks and risk management strategies

The passage discusses how companies are increasingly focused on risk management due to volatility in factors like exchange rates, commodity prices, freight costs. It outlines the key characteristics of different types of risks and provides an overview of the typical process involved in identifying, analyzing and managing risks.

  • Companies face various financial risks, including market risk, counterparty/credit risk, liquidity risk, operating risks, and political/regulatory risks.

  • Market risk is the risk from unfavorable changes in prices, interest rates, exchange rates, commodity prices, etc. It can occur at the position, business, or portfolio level.

  • Counterparty risk is the risk of loss if a debtor defaults on payments owed. It depends on amount owed, likelihood of default, and amount that can be recovered in default.

  • Liquidity risk is the inability to meet debt payments due to lack of liquid assets or inability to liquidate assets without significant losses.

  • Operating risks include risks from employee errors, systems failures, facilities damage, technology issues, climate/weather impacts, and environmental problems.

  • Political/regulatory risks come from changes in a company’s external environment and regulations that could impact its competitive situation or business model.

  • Companies have financial positions related to market risks from their commercial, financial, and accounting activities that expose them to risks like currency fluctuations over time.

  • Any’s competitors like Boeing earn revenues and pay costs in dollars, so they are not exposed to currency risks in the same way.

  • Hedging commercial cash flows beyond a few quarters through financial instruments is risky if exchange rates move in the wrong direction. It allows time for corrective actions like price increases or cost cuts.

  • There are also risks from foreign currency financial assets/liabilities and accounting translation differences in consolidated foreign subsidiaries.

  • In addition to currency and interest rate risks, companies may have strategic positions in commodities markets like oil that expose them to price risks.

  • Risk management options include self-hedging, locking in prices, insurance, and asset/liability disposal. Self-hedging is mainly for very large companies that can treat risk as a cost through reserves.

  • Setting up a captive insurance subsidiary allows greater control over risks but requires sophisticated management like access to reinsurance markets.

  • Forward transactions allow companies to lock in future prices or rates for transactions like currency exchanges to eliminate risk from future price fluctuations. This prevents upside gains but also downside losses.

  • Forward currency transactions work by borrowing the future currency amount at today’s value, exchanging it at the current rate, and investing the funds in the other currency until maturity. This locks in an exchange rate.

  • Forward rate agreements (FRAs) allow companies to lock in future interest rates without actually borrowing or lending funds. They involve payments based on the difference between the agreed rate and the actual future rate.

  • Interest rate swaps involve exchanging fixed and floating rate payment obligations over time on a notional principal amount. This allows companies to manage interest rate risk by switching from fixed to floating or vice versa.

So in summary, forward transactions, FRAs and swaps help companies manage currency and interest rate risks by locking in future rates and prices without needing to fully transact, just exchange payment obligations based on rates.

  • The transaction described is an interest rate swap where one party will pay a fixed interest rate of 7% and receive a floating interest rate linked to the Euro Interbank Offered Rate (Euribor).

  • The other party will receive the 7% fixed rate and pay the floating rate. However, they will also receive an upfront payment of 1% of the notional swap amount.

  • Effectively, their borrowing rate will be the 6% Euribor rate, since they receive the 1% upfront to offset the 7% fixed rate they pay out.

  • So this swap allows one party to exchange their floating rate obligation for a fixed rate of 7%, while the other party exchanges their fixed rate obligation for an effective floating rate of 6% Euribor.

  • Barrier currency options and barrier interest rate options allow the option’s strike price to be adjusted if the underlying asset crosses a preset barrier level. This provides more customized hedging options compared to standard options. However, they also require careful management.

  • Confirmed credit lines allow companies to obtain short to medium term loans from banks in exchange for a commitment fee. They function like an option to take out a loan when needed.

  • Credit insurance protects against default of a debt payment in exchange for an insurance premium of around 0.3% of the nominal debt amount. Specialized insurers assess default risk.

  • Credit derivatives arose in 1995 to transfer credit risk from one party to another in exchange for compensation, like an insurance contract. Main products are credit default swaps, where protection is bought against default in exchange for regular payments.

  • Political risk insurance covers risks like expropriation and changes in foreign investment laws for major investments. It is increasingly offered by private insurers.

Here is a summary of the key points from the buyers and sellers SECTION V:

  • Derivatives markets allow buyers and sellers to trade derivatives contracts through a clearing house rather than directly with each other. The clearing house acts as the central counterparty to all trades.

  • Clearing houses require traders to post initial margin deposits that cover potential losses over a few days. They also perform daily mark-to-market and make margin calls if needed to keep traders’ positions fully collateralized.

  • Margin requirements provide leverage for traders but also control counterparty risk by limiting maximum potential losses to a single day’s movements. Clearing houses have strict rules to avoid defaults cascading through the market.

  • Futures contracts create a zero-sum game, as one trader’s profits equal another’s losses. However, derivatives markets help spread and price risks more efficiently to improve market liquidity overall.

  • Corporate risk management aims to identify key risks like market, credit, liquidity, operational and political risks. Companies can self-hedge, lock in prices via forwards, purchase insurance, or dispose of risky assets to manage these exposures.

  • Derivatives like forwards, futures, options and swaps allow companies flexible ways to hedge specific risks on exchanges or OTC depending on their needs and willingness to assume counterparty risk.

Here is a summary of key points from the provided text:

  • Managing operational real estate is an important issue for companies that needs to be addressed strategically. Different departments within a company often have differing views on real estate.

  • Real estate assets can be used to back financing through borrowing or provide comfort to lenders, shareholders, and other stakeholders due to their stable value. However, excessively borrowing against real estate can limit future financing options.

  • Directly mortgaging real estate assets is a straightforward way to back debt financing, but it can be cumbersome. More flexible options include negative pledge clauses or banking covenants requiring a minimum amount of real estate on the balance sheet.

  • Securitization of real estate is only an option for large real estate companies or industrial groups with significant real estate holdings.

  • Finance leasing is a common long-term financing structure where a financial institution acquires the real estate asset and leases it to the company. This provides liquidity to the company while keeping the real estate asset on its books.

In summary, the key points focus on different options for using operational real estate assets to back financing or provide security to lenders, while maintaining flexibility for the company’s future financing needs. Managing real estate strategically is important given its role in many industries.

  • Property leasing typically covers 80% of an asset’s value, which is higher than a standard loan and at a lower interest rate. Financial lessors may finance over 90% of necessary renovation costs.

  • Property leasing can provide a marginal tax advantage in most countries as rent reflects accelerated amortization of the property, even if this surplus must be recouped when an option is exercised. This benefits companies through tax deferral.

  • Operating leases commit companies only for the lease duration, which can vary. Rents are often indexed to commercial indexes or a company’s economic activity/turnover to share risk.

  • The capitalization rate represents rent divided by asset value. Rent-to-turnover ratio is rent relative to business turnover (some use EBITDAR instead of turnover).

  • Sale-and-leaseback frees up cash for companies while unlocking property value, with tax implications on capital gains that must be considered.

  • Younger, growing companies benefit most from flexibility of operating leases to adapt to changing space needs without depleting cash reserves. Mature companies may invest in owned real estate for stability.

  • A company facing financial difficulties may sell its real estate assets as a way to quickly raise cash. This “liquifies” the real estate by exchanging future rental income streams for an upfront cash payment.

  • However, the real estate then becomes a simple financial asset rather than an operational asset. The buyer takes on risks related to potential vacancy or non-use of the property.

  • For a financial investor, owning real estate means they believe it will create value through buying at a discount to market value, or through risk reduction. But diversification alone does not create value, and assuming prices are inefficient is speculative.

  • Comparing cash flows of ownership vs leasing options is important, using different discount rates for each that reflect different risk levels. Yield differences can also inform the choice.

  • Studies on share price impact of sale-leasebacks have found mixed results, with some initial value creation but potential long-term value destruction from rental constraints.

  • Internal restructuring with separate property (Propco) and operating (Opco) subsidiaries can help address issues like real estate being viewed as cost-free by operators when it is owned. This structures requires the operating units to pay market rent.

  • A subsidiary of a group occupied a whole building that it owned for its store, based on the principle that when real estate is considered free, the store is the building.

  • An analytical market rent was charged to this store, resulting in operating losses. After some objections, the store managers had to admit this rent charging, while new, was not unreasonable as other group stores in other towns paid third-party landlords rent.

  • As losses could not continue long-term, the managers reconsidered their product offering given customer needs and competition. They concluded 25% of floorspace could be returned while still having a relevant offer to better compete with outskirts competitors.

  • This extra space was rented to a third-party retailer with a complementary offer. Combined with renovations financed from new rent, this injected new energy and profitability into the commercial offering.

  • A subsidiary dedicated to real estate management was set up to have professionals manage group real estate synergistically, as real estate management is its own expertise (asset management, works monitoring, real estate taxation, service providers, etc.).

  • Using real estate to extend debt maturity is easier if all assets are within one vehicle. The group can sell or open internal property capital to third parties over time.

  • There are constraints limiting Propco setup within groups, mainly high latent capital gains taxes discouraging sales between companies. But analytical accounting can show Opco and Propco presence even without legal structure.

  • For groups not publishing this financial statement breakdown, external analysts can recreate Opco and Propco virtually to better compare performance and valuation homogenously.

Here are the key points from the given text:

  1. Payable and rental: If a company sells its operating real estate then leases it back (sale-leaseback), any cash received from the sale would be payable. Whereas in a pure rental arrangement, the company would seek to terminate the lease as soon as possible to regain ownership/control of the asset.

  2. Journal references: There are 6 journal references listed that have analyzed various aspects of corporate sale-leaseback transactions, including their impact on shareholder wealth and empirical evidence from studies.

  3. Top 20 companies tables: There are tables listing the top 20 largest publicly listed companies by market capitalization for various countries/regions - Benelux, Brazil, China, France, Germany, India, Italy. The tables provide data on key financial metrics like revenues, profits, employees etc. for these major companies.

  4. Corporate Finance textbook section: This appears to be a selection or excerpt from the textbook “Corporate Finance: Theory and Practice”.

So in summary, it discusses the concepts of payable vs rental in sale-leaseback deals, references academic literature on the topic, and includes data on large publicly traded companies in key markets.

Here is a summary of the key aspects of the Parmalat scandal:

  • Parmalat was an Italian dairy and food company that went bankrupt in 2003 in one of the largest corporate bankruptcies in Europe at the time.

  • An investigation found that for years Parmalat had disguised its huge debts through a complex financial fraud. Fake assets were recorded on the balance sheet and debts were hidden in offshore funds.

  • This allowed Parmalat to fraudulently borrow more money to cover losses from its operations and pay out investors and shareholders. The debts amounted to over €14 billion by the time it collapsed.

  • Founder Calisto Tanzi and other executives were arrested and charged with fraudulent bankruptcy, false accounting and market rigging. Tanzi received jail time. Auditors from Grant Thornton were also implicated for failing to catch the fraud over many years of auditing Parmalat.

  • The scandal shook confidence in Italian and European financial markets and regulation. It highlighted weaknesses in controls and oversight of large companies. Reforms were implemented to strengthen financial reporting rules.

  • Parmalat’s bankruptcy was one of the largest in Europe and led to massive losses for banks, investors, creditors and employees. It demonstrated how easily financial results could be manipulated through off-balance sheet activities and fake assets. Strict rules and verification of financial statements were needed.

Here is a summary of key points from the book:

  • The book covers various topics in corporate finance theory and practice, including capital structure, valuation, mergers and acquisitions, risk management, and more.

  • It discusses concepts like the capital asset pricing model (CAPM), weighted average cost of capital (WACC), net present value (NPV), internal rate of return (IRR), and other valuation and investment decision-making tools.

  • Significant portions are devoted to raising finance (debt vs equity, IPOs, private equity), capital structure optimization, payout policies (dividends and share buybacks), and corporate governance.

  • Mergers and acquisitions are examined in depth, covering deal structures, valuation methods, negotiations, and post-merger integration.

  • Other topics include working capital management, foreign exchange and interest rate risk management, financial statement analysis, and corporate restructurings like bankruptcy.

  • Numerous case studies and examples are provided throughout to illustrate practical applications of the concepts discussed.

  • In summary, the book provides a comprehensive overview of key aspects of corporate finance theory and how they are applied in real-world business settings. Both academic and practical perspectives are covered.

  • Gross cash refers to total cash holdings without deductions. Perfect capital markets refer to an ideal theoretical market structure. Growth rate and return on capital metrics are important for valuation.

  • Policy refers to principles or strategies that guide decisions like capital structure or dividend policy. Market value is the price at which an asset or security is trading. Capitalization involves determining the market value of equity and debt.

  • Ratios like capitalization/value ratios and return on capital are used to evaluate performance and compare companies. Shares refer to equity ownership in a company. Capitalization factors are used to determine terminal value in discounted cash flow models.

  • Risk refers to uncertainty of outcomes. Capital structure and weighted average cost of capital (WACC) depend on the relative risks of debt and equity. CAPM is a model used to determine required rates of return for assets based on systematic risk.

  • Net present value (NPV) calculations involve discounting future cash flows to determine value today. Terminal values estimate continuing value beyond explicit forecast periods. Very high risk increases uncertainty and required returns.

  • Real estate acquisition, options, and restating of accounts are also mentioned. Discount rates incorporate factors like time value of money. Captive insurance and carried interest relating to private equity are covered.

Here is a summary of the key terms:

  • ting - A type of credit agreement or loan documentation.

  • credit agreements - Formal contracts between a lender and borrower outlining the terms of a loan.

  • credit-based economy - An economy driven by the availability and use of consumer and commercial credit.

  • credit default swap (CDS) - A derivative contract that transfers credit risk of a debt issuer from one party to another.

  • credit derivatives - Financial instruments whose value is linked to an underlying asset or index representing a particular credit risk.

  • credit insurance - Insurance that reimburses a lender or investor for losses stemming from a borrower’s default.

  • credit investors - Those who invest in corporate debt and loans rather than equity.

  • credit limits - Maximum amount a customer can receive on credit from a supplier.

  • credit lines - Pre-arranged limits that allow businesses to borrow money as needed.

  • credit manager - Person responsible for oversight of a company’s credit granting and collections.

  • credit ratings - Evaluation of credit risk performed by ratings agencies like S&P, Moody’s and Fitch.

  • credit risk - Risk of loss arising from a borrower’s failure to repay a loan or meet contractual obligations.

  • cross default clauses - Provision allowing lenders to declare default if borrower defaults on other obligations.

  • crowdfunding - Raising funds from the public through online platforms.

  • cultural differences - Variations in business practices and norms across countries/regions that impact working capital.

  • currency options - Derivatives that give the right but not obligation to buy or sell a currency at a set price.

So in summary, it covers various terms related to corporate financing, credit, debt instruments and risk management.

  • Cash pooling allows companies within a group to jointly manage their cash balances.

  • Options theory provides a framework for valuing equity and equity-like securities based on the concept that they provide the holder the right but not obligation to buy or sell the underlying asset.

  • The economy and performance of individual sectors can impact the sensitivity of a stock’s price.

  • Swaps allow parties to exchange interest rate cash flows, enabling management of interest rate risk.

  • The effective annual rate and time value of money concepts are used to calculate interest rates over different periods.

  • Return on equity and shareholder value are important metrics for measuring financial performance from the equity holder’s perspective.

  • Secondary markets allow for trading of existing financial securities between investors rather than direct issuance by companies.

  • Financial managers play an important role in capital allocation and financing decisions for companies.

  • Various methods can be used to calculate a stock’s sensitivity to overall market movements (beta).

Here is a summary of the key terms from the list provided:

  • hoosing 711–12: Foreign currency debt
  • cash 716: Working capital
  • swap for 909: Interest rate swaps
  • cost of 2: Cost of capital
  • floating-rate bonds 353–6: Floating-rate bonds and the interest rate risk associated with them
  • exchange-traded 318: Exchange-traded funds
  • floor rate, interest rate options 911: The minimum interest rate that can be achieved with an interest rate option
  • “frozen” 179: Frozen assets, likely referring to assets with limited liquidity
  • floor underwriting commitment 446: A minimum level of participation guaranteed by underwriters in an equity offering
  • investment of 400: Methods of investing funds, like the investment of funds method
  • floor value, convertible bonds 432: The minimum price a convertible bond can be converted to
  • leverage effect 219: Financial leverage and its impact on returns
  • flowback 449: Funds returned to the company after an equity offering
  • leveraged buyout 841–2: Leveraged buyouts
  • fluctuation: Fluctuations in variables like interest rates and the value of underlying assets
  • pooling 251–2: Pooling of interests accounting method for mergers/acquisitions
  • transfer of 883, 888: Transfer of cash between entities, likely in a corporate group
  • funds from operations (FFO) 205: Funds from operations, a cash flow measure for real estate companies

Here are the summaries of the key points from the passages provided:

last in, first out (LIFO) method 101: LIFO is an inventory costing method where the most recently produced or purchased items are considered sold first, resulting in higher costs of goods sold and lower net income in periods of rising inventory costs.

return on 483: Return on capital employed (ROCE) and return on equity (ROE) are two common measures used to evaluate how efficiently a company generates profits from its used or invested capital. ROCE focuses on operating income and capital employed, while ROE focuses on net income and book value of equity.

investment yield 501: Investment yield refers to the amount of cash flow or income generated by an investment, expressed as a percentage of the investment’s total cost. It is a key factor for investors to consider when evaluating potential investments and their expected returns.

investor base, diversification 434: Diversification of an investor base refers to spreading investments across many different industries, companies and asset classes to reduce risk. A diversified investor base helps reduce company-specific risk for the company.

lease rights 573: Lease rights refer to the legal right of a lessee (tenant) to use an asset, typically real estate property, for a specified period of time as laid out in a lease agreement with the lessor (landlord). Lease rights are an important component of the valuation of companies that own significant leased assets.

leases 103–4, 376, 923–6, 928: Leases are contractual agreements where the owner of an asset (lessor) allows another party (lessee) to use the asset for a specified period in exchange for periodic payments. Types of leases commonly used include operating leases and finance/capital leases. Leasing is widely used in real estate and business equipment financing.

legal protection, corporate structure 761–2: Corporate structure choice like limited liability companies can provide legal protections to shareholders such as limited liability, where shareholders are not personally liable for a company’s debts or actions. This legal protection encourages investment by reducing risk for shareholders.

listing shares 451–2: Listing shares involves a company issuing and offering existing or new shares to the public and having them admitted for trading on a stock exchange market. This allows the company to raise capital directly from public investors and provides shareholders with liquidity.

P/E and 393: The price-to-earnings (P/E) ratio compares a company’s share price to its per-share earnings. It is a commonly used metric for valuing companies and assessing whether their stock price seems high or low relative to their level of earnings and growth.

listed contracts 914: Listed contracts refer to standardized contracts that are listed and traded on a futures, options or other regulated exchange. Listing contracts provides benefits like centralized clearing and settlement, price transparency and lowering of counterparty risk compared to over-the-counter derivatives.

listed companies capital increases 453: When listed companies need to raise additional capital, one option is to issue new shares to existing shareholders via a rights issue or private placement. This provides an opportunitty for existing investors to maintain their ownership percentage by purchasing additional new shares.

  • EBT 842, 843 - Earnings before tax for years 842 and 843

  • Necessity concept 511 - The concept that investments should only be undertaken if they are necessary

  • Microeconomic factors 799-800 - Factors at the individual company or industry level that are relevant to negotiations

  • Negative capital employed 226 - When a company’s liabilities exceed its assets

  • Miller, M. 527, 529, 594, 596, 602–3, 606, 608, 643 - References to papers/work by author M. Miller

  • Negative covenants 374 - Covenants in debt agreements that limit certain business activities

  • Negative net debt 221–2, 536 - When a company’s debt exceeds its cash reserves

  • Peer comparison method 556, 565–70, 574–5 - Valuation method that compares a company to similar peers

  • Options theory 556, 618–36 - Theoretical framework for valuing and analyzing financial options

  • Portfolio management 318–20 - Techniques for combining assets to reduce risk and optimize returns

  • Price to earnings ratio (P/E) 388 - Ratio of a company’s share price to its earnings per share

  • Primary market, financial securities 7 - The market where new securities are first sold to investors

Let me know if you need any part of the summary expanded on or explained further.

Here is a summary of the key terms related to ocation private equity funds:

  • Private equity funds - Funds that invest in private companies rather than public stock markets. They seek to generate returns through holding and actively managing portfolio companies.

  • Private equity sponsors - Firms that organize and manage private equity funds. They aim to buy companies, improve their operations, and sell them at a profit within 3-5 years.

  • Private negotiations - Private equity funds prefer to take control of companies through private negotiations rather than public bids to avoid scrutiny and higher prices.

  • Private placements - Direct sale of securities to a relatively small number of select investors rather than a public offering. Often used by private equity funds to acquire companies.

  • Pre-emptive rights - Rights of existing shareholders to maintain their proportionate ownership if new shares are issued. Can be waived/modified by shareholder approval.

  • Preemptive action - Taking control of a company before others get the chance, such as through private negotiations or pre-emptive share purchases.

So in summary, it covers some of the key strategies and mechanisms used by private equity funds to acquire companies privately rather than through public markets.

Here is a summary of the key points from the passages provided:

  • Sections deal with topics like balance sheets, security markets, options, capital employed, shareholders, financial cycle, earnings ratios, valuation methods, risk and return, diversification, capital structure.

  • Specific concepts and terms mentioned include consolidated accounts, earnings per share, market segmentation, book value, capital structure, derivatives like options and hedging, discounted cash flow valuations, equity valuation models, portfolio theory.

  • Debt related topics covered are senior and subordinated debt, leverage, credit ratings, bonds, yield curves.

  • Accounting topics covered are earnings, profits, provisions, deferred tax.

  • Corporate finance areas covered include M&A, private equity, leveraged buyouts, split-offs, shareholder returns and agreements, dividend policy.

  • Other financial markets areas covered are risk analysis, efficient markets theory, cost of capital, capital allocation.

So in summary, the passages touched on a broad range of corporate finance, security analysis, valuation and accounting related concepts at a high level. Let me know if you need any specific sections or concepts summarized in more detail.

Here are the key points about the relationship between corporate finance and strategy according to the passage:

  • Neither finance nor strategy should be the sole/exclusive focus of running a company. An imbalance can lead to failure.

  • A strong industrial/business strategy is needed, but it must be financially healthy and make returns above the cost of capital.

  • Corporate strategy determines the company’s direction and involves issues like diversification, refocusing, integration, market share, internationalization, etc. using internal or external growth.

  • The goal of corporate strategy from a financial perspective is to enable the company to stand out competitively in order to generate higher income/earnings than competitors.

  • Barriers to entry like brands, patents, economies of scale, etc. help companies achieve profitable strategies.

  • However, high returns attract new competition who will try to circumvent barriers over time, reducing margins through increased competition.

  • Effective strategy requires understanding the economic, industry, technological and competitive environment to develop policies for sustained higher earnings over time as the competitive landscape changes.

  • Both finance and strategy are influenced by shareholders and the broader macroeconomic context. Finance supports the implementation of strategic goals financially.

So in summary, it advocates for a balanced approach where strategy drives the overall direction but is financially viable, and finance supports strategy, not the other way around. Sustained success requires evolving strategies as competition intensifies.

Here is a summary of the key points about cation of competition:

  • When risk is remunerated at too high a rate in a sector (e.g. luxury sector), new competitors will enter the sector, bringing down earnings.

  • When risk is remunerated at too low a rate, companies will abandon the sector, some will go bankrupt, and the sector will consolidate, reducing competition and increasing earnings over time.

  • On industrial markets, like financial markets, there is a relationship between risk and return. Adjustments to achieve the right risk-return balance happen more slowly on industrial markets than financial markets.

  • Some sectors may generate earnings higher than normal given their risk, but competition will eventually bring those returns down to normal levels.

  • A company can use an internal growth strategy of innovation or cost-cutting to differentiate itself and establish barriers to entry for competitors through scale advantages and lower costs. This dissuades new competitors from entering.

  • External growth through acquisitions requires a company to have access to significant financial resources on short notice to capitalize on opportunities.

So in summary, it discusses how competition is regulated in markets through the relationship between risk and return, and how companies can use strategies like innovation, scale, and consolidation to manage competition.

  • There are three main ownership and management structures for family-run businesses: majority shareholder is also the manager, minority shareholder is the manager, or an external manager is hired since no minority shareholders want to manage.

  • When the majority shareholder is also the manager, there can be a blurring of lines between personal assets and company assets. The financial policy may prioritize the shareholder’s goals over theory.

  • Some large family businesses like Bouygues have diversified their operations to retain control while diversifying the family’s wealth.

  • Growth often requires diluting ownership through new shares, but shareholders want to avoid this. This leads to more debt and financial fragility.

  • Wise entrepreneurs convince families to dilute ownership to some degree (10-20%) to fund growth, as the Pernod Ricard families successfully did while maintaining control.

  • When the manager is a minority shareholder, their goals are often to retain management control and pay dividends to keep other shareholders loyal, using debt over new shares.

  • An external manager not owning shares could pursue their own goals over shareholders’, so boards must prevent behaviors like high dividends or aversion to debt/new shares.

  • Economic growth, interest rates, and inflation all influence company strategies and financial policies in complex ways. High inflation can encourage fragility if firms rely on it rather than adapting strategies.

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