I'A

ADVANCED CORPORATE
FINANCE STUDY GUIDE




Financial Management
Association of Australia
(FMAA) Monash
Important Notice




The following notes have been prepared and provided as a
skeleton (sketch) of the course for this unit.


It is the responsibility of the student to make note of any changes
in course content.


These notes may exclude some topics and therefore be
inconsistent with current faculty teaching.


These notes should not be relied upon solely.


These notes should only be used to provide a basis from which
students can create an individual extensive set of notes in
preparation for unit assessments.


These notes should not be duplicated, either in part or in full,
during assessments
FMAA MONASH ADVANCED CORPORATE FINANCE
STUDY GUIDE


CAPITAL STRUCTURE

Capital structure theory

Capital structure is the mix of a companys debt (D) and equity (E). Optimal capital structures, that
maximise company value, exist for companies that operate within imperfect capital markets.

Business risk, or systematic risk, is the risk that arises from the operation of a companys assets to
generate operating cash flows and it is borne equally by holders of company E, typically
shareholders, and D, typically bondholders.

Financial risk is the risk that arises from a companys leverage as E holders may receive zero or no
dividends because D holders have priority to distribution of a companys cash flows. This risk is
borne solely by E holders.

Cost of capital (K
0
) reflects the business risk of a company. It is the rate of return that holders of D or
E in a company require. WACC is used as the cost of capital for levered companies.

K
0
= WACC = = R
f
+
0
(R
m
R
f
)

Asset beta (
0
) is a parameter that measures how sensitive a companys generation of operating
cash flows from use of assets is to movements within the market that a company operates in, that is,
it is a measure of business risk.

0
=
e
(E/V) +
d
(D/V)

Cost of equity (K
e
) reflects both business risk and financial risk because holders of E are exposed to
the companys risk of default to holders of D (see above).

K
e
=R
f
+
e
(R
m
R
f
)

Equity beta () is a parameter that measures how sensitive cash flows to E holders are to movements
within the market. It reflects E holders exposure to both business risk and financial risk.

e
=
0
+ (
0

d
) (D/E)

Optimal value calculation (limited to corporate taxation and bankruptcy costs)

For levered companies corporate taxation provides a tax shield because of the deductibility of
interest payments which increases company value, however, the probability of default imposes a
present value of bankruptcy costs burden on the company which decreases the companys value.


V
L
= V
U
+ PV (tax savings on debt) PV (bankruptcy costs) = V
U
+ t
c
x D Pr (default) x costs
Arbitrage transactions

When the market applies a different cost of capital to companies with the same degree of business
risk and a different capital structure, opportunities for arbitrage arise. Homemade gearing, which is
borrowing on personal account, allows investors to substitute investments in a company for
investments in another company, whilst maintaining a constant level of gearing in their investment
despite investing in a company with a different capital structure.
FMAA MONASH ADVANCED CORPORATE FINANCE
STUDY GUIDE


LEASING

Leasing theory

A lease is a contractual arrangement whereby the owner of an asset (lessor) provides the asset to a
user (lessee) for use but does not transfer legal ownership.

Operating leases are shortterm rental agreements whereby the lessee can use the asset for a
specified period for a fee. Most risk is borne by the lessor. These are treated as an expense by the
lessee.

Financial leases are longterm uncancellable arrangements whereby the lessee can use the asset for
the economic life of the asset but is responsible for maintaining the asset. Most risk is borne by the
lessee. These are treated as both an asset and a liability by the lessee.

Lease calculations

The following template can generally be used for leasing calculation questions:

Cash flow Year
Cost of asset $
Lease payments $
Tax savings on lease payments $
Depreciation tax savings $
Lease residual $
Tax savings on sale $

Remember, cost of debt for debt used to finance acquisition of the asset is always used as the
discount rate for lease payments because this rate reflects the opportunity cost of leasing.

Operating lease cancellation clauses as American put options

An American put option is an option that provides the option holder with the right, but not
obligation, to sell the underlying at any time before or during the expiration date. The cancellation
clause in an operating lease can be viewed as an American put because the lessee can cancel the
lease contract at any time prior to expiration of the lease and save the PV of future lease payments.

AGENCY PROBLEMS

Agency problems arise when there is conflict between the interests of company stakeholders. They
arise between shareholders and managers when managers:

Are paid a fixed salary and reduce their effort and seek perks
Are more concerned with empire building than maximising shareholder wealth
Entrench company investment in only what is familiar to the managers
Avoid taking risks that are beneficial to the company because they do not share in upside

Solution
FMAA MONASH ADVANCED CORPORATE FINANCE
STUDY GUIDE


Compensate toplevel management based on stock performance and lowlevel based on accounting
measures such as book return on investment or book economic value added (EVA) or economic
profitability measures.
REAL OPTION

Real option theory

Traditional discounted cash flow analysis of options fails to account of options imbedded in the
underlying investment. Consequently, a premium should be paid on discounted cash flow estimates
of option value.

The difference between the value of the project without the option and one with the option is the
real options value.

Option to delay

This is valuable because you have the choice to wait before making an investment. This allows you to
confirm if certain desirable conditions are or are not the case because committing yourself.

Option to abandon

This is valuable because you have the choice to cancel a project if it is not doing so well. If you did
not have the option then you would be stuck in potentially poor investment.

Option to expand

This is valuable because you have the choice to expand a project if it is expected to do well (usually
after some confirmation of success). If you did not have the option then you might be stuck in a poor
performing business.

ADVANCED ASSET PRICING

Options

An option is a contract that gives you the right but not the obligation to buy or sell a certain asset on
or before a certain time.

If it gives you the right to buy then it is called a call option. Otherwise, it is called a put option.

If you only have the right to exercise this option at the contracts maturity then the option is known
as a European option. If you can exercise it on or before this time then it is known as an American
option.

The value of the option is called its premium.

Since an option is a right, not an obligation, a person would only exercise it if it profitable to do so.
Holding it can only possibly lead to a gain if anything. Therefore, the writer (creator) of the option
must be compensated for taking this risk of only possible future loss (just like an insurance company
for creating insurance).

An options value is made of two components: intrinsic value and extrinsic value.
FMAA MONASH ADVANCED CORPORATE FINANCE
STUDY GUIDE



Intrinsic value is the profit that you can make from immediately exercising the option. This could
only be the case if the current asset price was above the exercise price (for calls, vice versa for puts).

Extrinsic value is the price attached to the chance that the options intrinsic value might increase.
Even if an option currently has no intrinsic value it will have an extrinsic one. This factors in the
possibility that the option might have an intrinsic value at some point before expiry.

Option Pricing Models

The BlackScholes model is the most commonly used Option Pricing Model. Deriving it is not part of
this unit.

Valuing the Equity of Deeply Troubled Firms

Equity is the residual ownership interest in a company. Prima facie, if the market value of its debt
(Vd) outstanding is greater than the value of its assets (Va) then that means that equity holders will
receive nothing.

However, in these situations the companys equity is usually not valueless. It represents the chance
that the firms assets might be worth more than its debt.

Therefore, one can value this chance as an option that the Va will be greater than Vd. This acts like a
call option whereby if this is the case then equity holders get the intrinsic value of the option.

This optionlike payoff characteristic of equity holding is at odds with debt holders. The upside to
gains in equity is theoretically unlimited. It is limit to the recovery of principal and interest for debt.

Therefore, equity holders might start to seek riskier projects to potentially earn higher returns. Debt
holders will not like this. This puts the two at odds with each other. This is particular true for deeply
troubled firms since then the equity holders really have nothing to lose by making bigger and riskier
bets but could only possible gain.

CORPORATE RESTRUCTURING

Company groups may restructure and merge themselves to increase their combined value.

They will do so if merging two (or more) firms will produce a value of a company greater than the
sum of its parts (the original individual companies).

The firm proposing the merger is the known as the acquirer. The firm they are proposing to merge
with is known as the target.

Merger Rationale

This may be for several reasons:
Synergies. Eliminating duplicate functions and gaining efficiency.
Strengthening market power. I.e., reducing the competitiveness that the two companies
face (because they have now merged with each other). This means they can charge higher
prices and have higher profit margins.
Tax reasons. One may have tax losses which might offset tax profits of the acquirer.
FMAA MONASH ADVANCED CORPORATE FINANCE
STUDY GUIDE


Poor management of the target. New management could improve operations and value.

The Takeover Process

If there are gains to be made from merging then the takeover target of the merger can ask that its
shares be purchased for higher than their current price. This is because they know that they are
worth more than this to the acquiring firm.

A proposed takeover (a bid) may be friendly or hostile. Being hostile means that the target
companys board shall be rejecting the acquirers offer to merge and shall advise their shareholders
to do the same. Vice versa for friendly.

Typically, acquirers in hostile takeovers overpay for target firms. This could be due to the hubris of
the acquirers managers as explained in agency theory.

There are a range of defences to hostile takeovers that the targets management might employ.
These include:
White knight. Another investor might come in and make a better offer.
Disclosing favourable information. This makes the merger more expensive.

Finally, sometimes competition regulators will reject a proposed takeover due to concerns that it will
lessen competition in the market place to unacceptable levels.

Types of Takeover Offers

A bid may offer cash or scrip or a combination. Cash means that the acquirer will buy the shares of
the target for cash. Scrip means that the shareholders in the target will receive a certain number of
shares in the newlyformed company. Accepting a scrip offer would imply remaining an owner and
indeed in the merged entity. This may or may not be attractive as such.

There can be different tax implications between the two types of offers. Shareholders must weigh this
up depending on how the deal is structured. EG, selling shares at a profit to their initial purchase price
may incur capital gains tax but being offered new shares in their place (a scrip bid) may not.



INTERNATIONAL FINANCE

This part of this unit is covered under the International Finance study guide.