Special Topics in Financial Management Example:

Reviewer: Final Examination A company has preferred stock that has an annual
dividend of $3. If the current share price is $25, what is
the cost of preferred stock?
Chapter 1: Preferred Stock
Rp = D / P
Preferred Stock
Rp = 3 / 25 = 0.12 or 12%
- Preferred Stock is also known as preference
shares. These are securities that represent
ownership in a corporation, and that have a Types of Preferred Stocks
priority claim over common shares on the
1. Prior Preferred Stock - refers to the order in
company's assets and earnings.
which preferred stock is ranked when considered
- The shares are more senior than common stock
for prioritization for creditors or dividend
but are more junior relative to bonds in terms of
awards.
claim on assets.
2. Preference Preferred Stock - considered the
- Holders of preferred stock are also prioritized
next tier of stock terms of prioritization. Though
over holders of common stock in dividend
it falls behind prior preferred stock, preference
payments.
preferred stock often has greater priority
Features of Preferred Share compared to other issuances of preferred stock.
3. Perpetual Preferred Stock - Some types of
1. Preference in assets upon liquidation. The
preferred stock have a fixed end date in which,
shares provide their holders with priority over
much like a bond, the original capital
common stockholders to claim the company's
contributed is returned to shareholders. In most
assets upon liquidation.
cases, preferred stock is considered perpetual.
2. Dividend payments. The shares provide
This means that the initial capital invested will
dividend payments to shareholders. The
not be returned. An investor must sell their
payments can be fixed or floating, based on an
shares at their choosing to redeem the shares.
interest rate benchmark such as LIBOR.
4. Convertible Preferred Stock - allows a
3. Preference in dividends. Preferred shareholders
shareholder to trade their preferred stock for
have a priority in dividend payments over the
common stock shares. The exchange may
holders of the common stock.
happen when the investor wants, regardless of
4. Non-voting. Generally, the shares do not assign
the prices of either share.
voting rights to their holders. However, some
5. Cumulative Preferred Stock - an equity
preferred shares allow its holders to vote on
investment that guarantees dividend payments to
extraordinary events.
shareholders. Unpaid dividends–also referred to
5. Convertibility to common stock. Preferred
as dividends in arrears–accumulate and are then
shares may be converted to a predetermined
paid out at a future date. Those dividend
number of common shares. Some preferred
payments are made before any dividends are
shares specify the date at which the shares can
paid out to common stock shareholders.
be converted, while others require approval from
6. Noncumulative Preferred Stock - allows the
the board of directors for the conversion.
issuing company to skip dividends and cancel
6. Callability. The shares can be repurchased by
the company's obligation to eventually pay
the issuer at specified dates.
those dividends. This means that shareholders
do not have a claim on any of the dividends
The Cost of Preferred Stock: Formula that were not paid out.
7. Participating Preferred Stock - a type of
Rp = D (dividend)/ P (price) preferred stock that gives the holder the right to
receive dividends equal to the customarily
specified rate that preferred dividends are paid to
preferred shareholders, as well as an additional
 dividend based on some predetermined
condition.
8. Adjustable Rate Preferred Stock - a type of
preferred stock that pays out a dividend that is Chapter 2: Leasing
modified by changes in a benchmark rate.
Leasing
Preferred Stock Common Stock
 Equity ownership  Equity ownership - A common practice in business and personal
of a company of a company finance, offering flexibility and financial
 Tradable on public  Tradable on public advantages for both lessors and lessees. There
exchanges (for exchanges (for are various types of leases, each with its own
public companies) public companies) characteristics and implications.
 Have first right to  No guarantee of
Three Types of Leasing
dividends and dividends; must
must be paid wait until 1. Operating Lease - Operating leases, sometimes
before common preferred called service lease, provide for both financing
stockholders stockholders are and maintenance. Operating leases are short-
 Typically do not made whole
term agreements where the lessor retains
have as much  Often has higher
ownership of the asset.
capital capital
appreciation appreciation 2. Finance Lease - Finance lease sometimes called
 Typically has no  Typically has capital leases, are differentiated from operating
voting rights voting rights leases in three respects: They do not provide for
 May have the  Do not have the maintenance services, they are not cancelable,
option to be option to be and they are fully amortized.
convertible to convertible to 3. Sale and Leaseback - Sale and leaseback, a
common stock preferred stock firm that owns land, buildings, or equipment
sells the property and simultaneously executes
an agreement to lease the property back for a
Right to Vote specified period under specific terms.
- Preferred shares usually do not carry voting
rights, although under some agreements these
rights may revert to shareholders that have not Financial Statements Effects
received their dividend.
1. Operating Lease
Calling of Preferred Stock - In income statement the lease payments are
shown as operating expenses.
- If shares are callable, the issuer can purchase - It is often called "Off-balance-sheet financing"
them back at par value after set date. If interest - Cash payments for operating leases are recorded
rates fall, for example, and the dividend yield as operating cash outflows.
does not have to be as high to be attractive, the 2. Finance Lease
company may call its shares and issue another - The financial lease has an effect to income
series with a lower yield. statement through depreciation expense and
Convertibility interest expense.
- Financial Accounting Standards Board issued
- Some preferred stock is convertible, meaning it FAS 13 (now referred to as Accounting
can be exchanged for a given number of Standards Codification Topic 840 or ASC 840),
common shares under certain circumstances. which requires that for an unqualified audit
The board of directors might vote to convert the report firms that enter into financial leases must
stock, the investor might have the option to restate their balance sheets to: report leased
convert, or the stock might have a specified date assets as fixed assets, and show the present
at which it automatically converts. value of future lease payments as liabilities.

Other Factors that Affect Leasing Decision
 Residual Value - It is the value of leased
property at the end of the lease term. This is also
the amount of money that a company can expect
to get if they sell the asset once it has been fully
depreciated.
 Increase Credit Availability - The available
credit is the amount of credit you have left to
spend on a credit account. You can calculate
your available credit by subtracting your card's
current balance from its credit limit.
 Warrants - Are derivatives that companies issue
that give investors the right — but not the
obligation to buy company stock at a particular
price on or before the expiration date.
Chapter 3: Warrants
Warrants
- Also called stock warrants. A long-term option
to buy a stated number of shares of common
stock at a specified price
Types of Warrants
1. Call Warrant - Call warrant provides the holder
with the option to purchase a particular quantity
of a company's shares at a predetermined price
during a specific time frame.
2. Put Warrant - A put warrant gives the holder the
right to sell a specific number of shares of a
company's stock at a predetermined price, within
a certain period.
3. Covered Warrant - Covered warrants are issued
by financial institutions, and they are backed by
the institution's own shares or by shares of
another company.
4. Naked Warrant - Naked warrants are similar to
covered warrants, except they are not backed by
any underlying assets.
Impact of Incorrect Pricing
Incorrectly pricing the warrants on the market price of
the bond can have significant consequences. If the
bankers underestimate the value of the warrants, they
may attach more warrants to each bond than necessary,
leading to more dilution of the original shareholders'
equity than necessary when those warrants are exercised.
On the other hand, if the bankers overestimate the value
of the warrants, the issue may not be sold at the offering
price, and the firm would not obtain the funds it needed.
Call Option Vs. Warrants
When call options are exercised, the stock provided to
the option holder comes from the secondary market; but
when warrants are exercised, the shares provided are
newly issued. As a result, the exercise of warrants
dilutes the value of the original equity, which could
cause the value of the original warrant to differ from the
value of a similar call option.
Use of Warrant in Financing
Small, rapidly growing firms generally use warrants as
"sweeteners" when they sell debt or preferred stock.
Firms often offer warrants along with the bonds.
Receiving warrants along with bonds enables investors
to share in the company's growth, assuming it does in
fact grow and prosper. A bond with warrants has some
characteristics of debt and some characteristics of equity.
It is a hybrid security that provides the financial manager
with an opportunity to expand the firm's mix of
securities and thus to appeal to a broader group of
investors. Virtually all warrants today are detachable.
Thus, after a bond with attached warrants is sold, the
warrants can be detached and traded separately from the
bond. Further, even after the warrants have been
exercised, the bond (with its low coupon rate) remains
outstanding.
*’Yong computation sa ppt na lang nila kasi ‘di ko
mintindihan.
Chapter 4: Convertibles
Convertibles
- A "convertible security" is a security—usually a
bond or a preferred stock—that can be converted
into a different security—typically shares of the
company's common stock.
Convertible Bonds
- A convertible bond is a fixed-income corporate
debt security that yields interest payments, but
can be converted into a predetermined number
of common stock or equity shares.
Types of Convertible Bonds
1. Vanilla Convertible Bonds - These are the most
common types of convertible bonds. Investors
are granted the right to convert their bonds to a
 certain number of shares at a predetermined
conversion price and rate at the maturity date.
2. Mandatory Convertible Bonds - Mandatory
convertibles provide investors with an obligation
to convert their bonds to shares at maturity. The
bonds usually come with two conversion prices.
3. Reverse Convertible Bond - Reverse convertible
bonds give the issuer an option to either buy
back the bond in cash or convert the bond to the
equity at a predetermined conversion price and
rate at the maturity date.
Convertible Preferred Stock
- Convertible preferred stocks are preferred shares
that include an option for the holder to convert
them into a fixed number of common shares
after a predetermined date.
Advantages and Disadvantages of Convertible
Securities
Advantages:
1. Ease of Conversion
 The different types of bonds and debentures
which are convertible, allow their owners the
chance to convert them fast and without any
hassle. This allows them to better adapt to
market conditions and in turn effectively earn
more in interest payment.
2. Tax Benefits
 Compulsorily convertible debentures and some
specific types of securities which are convertible
are eligible for tax benefits. The interests earned
on these securities are eligible for deduction
from the total taxable income of an investor.
However, investors must also keep in mind that
these securities might not be eligible for tax
benefits after they are converted.
Disadvantages:
1. Risk of Dilution
 EPS or Earning Per Share rate of the stocks of a
company go down when it introduces
convertible securities. This can lead to further
difficulties for the company in availing any line
of credit from a financial institution for
themselves in the future.
2. Risk of Losing Ownership
 When a company converts its securities to
common equity, the majority of shareholders
always run the risk of losing ownership.
Essentially, dilution of the share can lead to the
ownership being diluted across multiple
shareholders.
Conversion Price
- The conversion price is the price per share at
which a convertible security, such as corporate
bonds or preferred shares, can be converted into
common stock. The conversion price is set when
the conversion ratio is decided for a convertible
security.
Par Value of Bond Given Up
Conversion Price =
Shares Received
Conversion Ratio
- The conversion ratio is the number of common
shares received at the time of conversion for
each convertible security. The higher the ratio,
the higher the number of common shares
exchanged per convertible security.
Conversion Ratio =
Par Value of Bond Given Up
Conversion Price
VALUE COMPONENTS OF CONVERTIBLES
A convertible security can be as a combination
of a straight bond and a long call option on the shares of
the company. A straight bond is a bond that pays interest
at regular intervals, and at maturity pays back the
principal that was originally invested. A straight bond
has no special features compared to other bonds with
embedded options.
Value of Convertible Security = Value of Straight Bond
+ Value of the Call Option or the Conversion Option
USE OF CONVERTIBLES IN FINANCE
A “convertible security” is a security—usually a
bond or a preferred stock—that can be converted into a
different security—typically shares of the company’s
common stock. In most cases, the holder of the
convertible determines whether and when to convert. In
other cases, the company has the right to determine
when the conversion occurs.
How Will Companies Know if the Price of Stock is
Temporarily Depressed?
 Management may know, for example, that Synergistic Effects Can Arise from These Sources
earnings are depressed because of start-up costs
associated with a new project, but they expect earnings 1. Operating Economies
to rise sharply during the next year or so, pulling up the 2. Financial economies
stock price. Thus, if the company sold stocks now, it 3. Differential Efficiencies
would be giving up more shares than necessary to raise a 4. Increased Market Power
given amount of capital.
How can the Company Make Sure that Conversion
Will Occur if the Stock Price Rises Above the
Conversation Price? Tax Considerations

Most convertibles contain a call provision that - Tax considerations are the potential impact of
allows the issuer to force conversion to the common taxes on a financial decision. Businesses and
stock. Such a provision limits the value associated with individuals alike factor in tax implications
potential growth in the stock price. before making choices to minimize their tax
burden and keep more of their money.
A Final Comparison of Warrants And Convertibles
Warrants Importance of Tax Considerations
It grants investors the right to purchase the underlying
- Financially responsible decisions
bond, share, or other security at a given price and on a
- Compliance
specified future date. Investors are not obligated to
- Reduced tax burden
purchase the underlying security at that particular time
- Decision-making
or price, though. Furthermore, an investor must pay the
- Business planning
predetermined amount in order to purchase the stock,
investment, or instrument if they want to exercise their
warrant. A warrant and an option have many Purchase of Assets Below Their Replacement Cost
characteristics.
A replacement cost may fluctuate, depending on factors
Convertible such as the market value of components used to
reconstruct or repurchase the asset and the expenses
Convertible securities offer investors the chance to involved in preparing assets for use.
repurchase bonds or preferred stocks at a predetermined
price and date in the future. This kind of security is
Sometimes a firm will be touted as an acquisition
typically used by businesses who need to borrow funds
candidate because the cost of replacing its assets is
quickly or do not have access to conventional finance
considerably higher than its market value.
sources.
Purchase of Assets Below Their Replacement Cost
Chapter 5: Rationale of Mergers
- Cost Savings
Mergers and Acquisition - Strategic Advantage
- Increased Profitability
- Mergers and acquisitions (M&A) refer to - Market Impact
transactions between two companies combining - Tax Benefits
in some form. Although mergers and
acquisitions (M&A) are used interchangeably, Things to Consider Before Buying Below
they come with different legal meanings. In a Replacement Cost
merger, two companies of similar size combine
to form a new single entity. - Warranty
Rationale for Mergers - Reason for Discounted Price
- Forced Sale
- Some companies pursue a merger as a one-time - Condition of the Asset
opportunity that arises, whereas others make it - Remaining Useful Life pact
an ongoing strategy they utilize to grow their
business. Diversification
Managers often cite diversification as a reason for
mergers. They content that diversification helps stabilize
a firm's earnings and thus benefits.
Manager’s Personal Incentives
Financial economists like to think that business
decisions are based only on economic considerations,
especially maximization of firms' values. However,
many business decisions are based more of managers'
personal motivations than on economic analyses.
Breakup Value
- Breakup value refers to the value of a company
if its individual components (such as business
segments or subsidiaries) were to be sold off or
spun off and operated independently. It is an
important consideration in valuation, especially
when analyzing potential takeover opportunities.
Chapter 6: Types of Mergers
Merger
- A merger is a corporate strategy involving the
combination of two or more companies into a
single entity. This is usually done to achieve
synergies, increase market share, expand into
new markets, or gain competitive advantages.
Types of Mergers
There are five basic categories or types of mergers:
1. Horizontal merger: A merger between companies
that are in direct competition with each other in terms of
product lines and markets
A horizontal merger is a merger between companies that
directly compete with each other. Horizontal mergers are
done to increase market power (market share), further
utilize economies of scale, and exploit merger synergies.
2. Vertical merger: A merger between companies that
are along the same supply chain (e.g., a retail company
in the auto parts industry merges with a company that
supplies raw materials for auto parts.)
Vertical mergers can have mixed effects on small
businesses. On one hand, small businesses may benefit
from increased access to distribution channels or
improved relationships with larger vertically integrated
companies. However, vertical mergers can also create
challenges if small businesses face increased
competition or encounter barriers to accessing certain
markets controlled by the merged entity.
3. Congeneric merger: Congeneric mergers involve the
combining of companies that serve the same customer
base but offer different products or services. This results
in the merged entity becoming able to cross-sell or
bundle products, creating synergies in marketing and
distribution.
A congeneric merger, also known as concentric merger
or product-extension merger is a merger between
companies that are part of the same industry and operate
in the same market but feature a different line of
products.
A congeneric merger, also known as concentric merger
or product-extension merger is a merger between
companies that are part of the same industry and operate
in the same market but feature a different line of
products.
4. Conglomerate merger: A merger between companies
in unrelated business activities (e.g., a clothing company
buys a software company)
These mergers provide the merging companies with the
advantage of diversification of business operations and
target markets. As the merging companies operate in
distinct industries and/or markets, the merged company
is less vulnerable to declines in sales in one industry or
market.
Chapter 7: Level of Merger Activity
The level of merger activity in the industry has been
steadily increasing over the past few years. Companies
are seeking to consolidate their resources, expand their
market reach, and gain a competitive edge by joining
forces with other businesses. This trend is driven by
various factors such as the desire for economies of scale,
access to new technologies, and the need to diversify
product offerings.
First Wave (1897 - 1907)
During this period, majority of merger activities – about
two thirds of them – were concentrated in a few
industries which were mainly the dealers in petroleum
products, metals, mining, transportation, and food
products. These industries also became highly
concentrated because most of the mergers were
horizontal mergers.
Second Wave (1916 -1929)
It began during the period of the World War I and
persisted until the stock market crash of October 29,
1929. Due to the heightened Government vigilance that
emerged towards the end of the first Merger Wave, the
Second Merger Wave endured an even greater and
increased Government scrutiny. In addition to the
Sherman Antitrust Act, federal authorities used the
Clayton Act (1914) against uncompetitive mergers.
Third Wave (1965-1969)
This wave was characterized by a period of economic
prosperity in the United States, during which firms had
accumulated significant wealth, allowing them to afford
acquisitions of other companies. The focus was on
diversification and creating conglomerates.
Fourth Wave (1981 - 1990)
Occurring during the economic boom of the 1980s, this
wave saw a mix of friendly mergers and a greater
number of hostile takeovers than in any previous wave.
It was a time of strategic realignments and industry
consolidations.
Fifth Wave (1993 - 2000)
The Fifth Merger Wave lasted from 1993 to 2000, a
period after the economic slump of 1990 to 1991. The
rate at which large mergers were formed was about the
same level as that of the Fourth Merger Wave. However,
there was a major decline in the rate of hostile takeovers.
As compared to the Fourth Merger Wave, creation of
debt- financed mergers had reduced too.
Chapter 8: Hostile Versus Friendly Takeover
Hostile Takeover
- A hostile takeover occurs when one
company (the acquiring company) attempts
to take over another company (the target
company) against the wishes of the target
company's management and board of
directors.
Characteristics and Strategies
 Hostile takeovers usually involve a direct
offer to the target company's shareholders.
 The acquiring company may use tactics such
as a tender offer or a proxy fight to gain
control.
 Hostile takeovers can be motivated by a
desire to gain access to valuable assets,
eliminate competition, or achieve other
strategic objectives.
 They often face legal and regulatory
challenges, as well as opposition from the
target company's management.
Friendly Takeover
- A friendly takeover, also known as a
friendly acquisition or merger, occurs when
the target company's management and board
of directors are in agreement with the
acquisition proposal put forth by the
acquiring company.
Characteristics and Strategies
 Friendly takeovers are typically negotiated
and agreed upon by both companies'
management teams.
 The acquiring company may offer a
premium to the target company's
shareholders to gain their approval.
 Friendly takeovers are often driven by
strategic goals such as expanding market
presence, diversifying product offerings, or
achieving cost synergies.
 They generally face fewer regulatory
hurdles and legal challenges compared to
hostile takeovers.
Chapter 9: Merger Analysis
Merger - A legal consolidation of two companies into a
single entity.
Types of Mergers
1. Horizontal Merger - Combines competitors
within the same industry.
2. Vertical Merger - Integrates different stages of
the production process.
3. Conglomerate Merger - Merges companies in
unrelated industries.
Objectives of Mergers
1. Economies of scale - Achieve cost savings
through increased production volume.
2. Economies of scope - Leverage shared resources
and expertise across different business units.
3. Market power - Gain a larger market share and
influence over pricing.
4. Product diversification - Offer a broader product
range to customers.
 5. Tax benefits - Utilize tax advantages of the
target company.
Steps in Merger and Acquisition
1. Pre-Acquisition Review
2. Search & Screen Targets
3. Investigate & Value The Targets
4. Acquire Through Negotiation
5. Post-Merger Integration
Valuation in Mergers

 Discounted cash flow (DCF) - Estimate the

present value of the merged company’s future
cash flows.
 Market multiples - Compare the target
company’s valuation to similar companies in the
industry.
 Precedent transactions - Analyze past M&A
deals in the same industry for reference.