Corporate Finance Review

7/29/2019 Corporate Finance Review

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S T U D Y G U ID E B M C F 5 1 0 3 C o rp o ra te F in a n c e

Topic 1: Information Asymmetry and Agency Theory

1.1 An Overview of Corporate Finance

Corporate finance includes three main areas of concern:

(a) Capital budgeting: What long-term investments should the firmchoose?

(b) Capital structure: Where will the firm get the long-term financingto pay for its investments?

(c) Working capital: How should the firm manage its daily financial

activities?The Balance Sheet model is used to address the three basic questions

that corporate finance managers must answer:

(a) Capital budgeting: Long-term investment decisions determine thelevel of fixed assets.

(b) Capital structure: Financing policy determines the liabilities andequity side of the balance sheet.

(c) Working capital: Short-term asset management choices (e.g.,conservative versus aggressive) affect the level of net workingcapital.

Financial Managers should make decisions that increase firm value,

which effectively involves three primary categories of financialdecisions:

(a) Capital budgeting: process of planning and managing a firmsinvestments in fixed assets. The key concerns are the size,timing, and risk of future cash flows.

(b) Capital structure: mix of debt (borrowing) and equity (ownershipinterest) used by a firm. What are the least expensive sources offunds? Is there an optimal mix of debt and equity? When andwhere should the firm raise funds?

(c) Working capital management: managing short-term assets andliabilities. How much inventory should the firm carry? What creditpolicy is best? Where will we get our short-term loans?

These broad categories, however, can be summarised to two concreteresponsibilities:(a) Selecting value creating projects

(b) Making smart financing decisions

The Financial Managers are:(a) The Chief Financial Officer (CFO) or Vice-President of Finance,

who coordinates the activities of the treasurer and the controller.

(b) The controller, who handles cost and financial accounting, taxes,and information systems (i.e., data processing).

(c) The treasurer, who handles cash and credit management,financial planning, and capital expenditures.


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1.2 The Importance of Cash FlowsTo create value, the firm must generate more cash than it uses. Stated

differently, the firm must generate sufficient cash flow, after taxes, to

compensate investors for providing the firm with financing. Additionally,

the value of the cash flows generated by the firm must be analysed in light

of both the timing of the cash flows, as well as the risk of the cash flows.

1.3 The Goal of Financial Management

(a) Possible GoalsProfit maximization is an imprecise goal. Do we want to maximize long-run or

short-run profits? Do we want to maximize accounting profits or some measure

of cash flow? Because of the different possible interpretations, this should not

be the main goal of the firm.

Other possible goals include minimising costs or maximising market share. Both

have potential problems. We can minimise costs by not purchasing new

equipment today, but that may damage the long-run viability of the firm. Many

dot.com companies got into trouble in the late 1990s because their goal was to

maximize market share. They raised substantial amounts of capital in IPOs and

then used the money on advertising to increase the number of hits" on their

site. However, many firms failed to translate those hits" into enough revenue

to meet expenses, and they quickly ran out of capital. The stockholders of

these firms were not happy. Stock prices fell dramatically, and it became

difficult for these firms to raise funds. In fact, many of these companies have

gone out of business.

(b) A More General Goal

The more general goal is to maximize the market value of owners equity. But it

does not mean that firms should do anything" to maximize stockholder

wealth. It is important to note that unethical behaviour does not ultimatelybenefit owners.

There are a number of ethical issues which can be related to wealth

maximization. One good example that we can relate to is the issue of the

responsibility of the managers and stockholders of tobacco firms. Is it ethical to

sell a product that is known to be addictive and dangerous to the health of the

user even when used as intended? Is the fact that the product is legal

relevant? Do recent court decisions against the companies matter? What about the

way companies choose to market their product? Are these issues relevant to

financial managers?


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1.4 The Agency Problem

(a) Information AsymmetryInformational asymmetry arises as a result of the separation of ownership andmanagement. The distinguishing feature of a corporation is that the ownership ofthe firm is separated from its management. In theory, the objective of a firmshould be determined by the firm's owners. Information asymmetry is chief

among violations of the homogenous expectations assumption of an ideal capitalmarket. It occurs when buyers and sellers have different amounts of informationabout a market transaction.

(b)Agency RelationshipsThe relationship between stockholders and management is called the agencyrelationship. This occurs when one party (principal) hires another (agent) toact on their behalf. The possibility of conflicts of interest between the parties istermed the principal- agent (agency) problem.(c) Agency CostsAgency costs arise in a corporation as a result of principal-agent problems.Managers may not act in the best interests of the shareholders while makingdecisions. Hence the shareholders incur monitoring and bonding costs which

are a part of agency costs. It arises as result of informational asymmetrybetween managers and other stakeholders of a firm. Agency costs tend toreduce the value of a firm.

An optimal financial contract between agents and principals that minimisestotal agency costs. The optimal contract transfers decision-making authorityfrom the principal to the agent in the most efficient manner. Stock options canbe used to align the interests of managers with those of shareholders, in thebelief that those managers will then make decisions, which will enhance thewealth of all stockholders, including those executives.In countries and cultures in which the ownership of the firm has continued tobe an integral part of management, agency issues and failures have beenless of a problem. On the contrary, in countries like the United States, inwhich ownership has become largely separated from management (andwidely dispersed), aligning the goals of management and ownership is muchmore difficult.

(d)Do Managers Act in the Stockholders Interests?Managerial compensation can be used to encourage managers to act in thebest interest of stockholders. One commonly cited tool is stock options. Theidea is that if management has an ownership interest in the firm, they will bemore likely to try to maximize owner wealth.

A 1993 study performed at the Harvard Business School indicates that the totalreturn to shareholders is closely related to the nature of CEO compensation.Specifically, higher returns were achieved by CEOs whose pay packages

included more option and stock components. However, this may not even be thebest way to encourage managers to act in the stockholders best interest. SternStewart & Company has developed a tool called EVA, which measures howmuch economic value is being added to a corporation by managementdecisions. According to Stern- Stewarts web site (www.sternstewart.com),


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S T U D Y G U ID E B M C F 5 1 0 3 C o rp o ra te F in a n c ecompanies that tie management compensation to EVA significantly outperformcompetitors that do not. They are conducting ongoing studies to measure thisperformance, but the preliminary data indicate that the stock returns for thesecompanies have outperformed their competitors by a significant amount. Both ofthese examples illustrate that carefully crafted compensation packages canreduce the conflict between management and stockholders. According to TheNational Centre for Employee Ownership, broad based stock option plans haveincreased dramatically, not only for technology firms, but also for non-tech firms

such as Starbucks and the Gap. Some firms have found a way to providestock- based incentive to employees without giving them equity ownership atall. As reported in the October 26, 1998, issue of Fortune, phantom stock isused by private companies such as Kinkos and Mary Kay, Inc., as well aspublic companies, to provide employees with an incentive to work harder.Generally, an employee is awarded shares" on a bonus basis, and the sharevalues increase if the value of the business increases. (For a private firm, thismeans obtaining outside appraisals of value based on earning multiples, etc.) Atsome future point, the employee has the right to cash in his shares."Stockholders technically have control of the firm, and dissatisfied shareholderscan oust management via proxy fights, takeovers, etc. However, this is easiersaid than done. Staggered elections for board members often make it difficultto remove the board that appoints management. Poison pills and other anti-takeover mechanisms make hostile takeovers difficult to accomplish.

(e) StakeholdersThe management and its shareholders are not the only parties with an interestin the firms decisions. Stakeholders, besides stockholders, also have a vestedinterest in the firm and potentially have claims on the firms cash flows.Stakeholders can include creditors, employees, customers, and the government.Consideration should also be given to the interests of non- stockholderstakeholders which results in the decentralisation of management. By giving moreconsideration to other stakeholder interests (as opposed to a discussionexclusively geared toward stockholder interests) would provide a betterunderstanding of the nature of the corporate form of organisation, the role

of the corporation in society (and the question of corporate socialresponsibility), as well as the role of contracting in the labour and financialmarkets. Theories of ethical behaviour focus on the rights of all parties affected bya decision, not just one or two. The utilitarian model defines an action asacceptable if it maximizes the benefit, or minimises the harm, to stakeholders inthe aggregate. The golden rule model deems a decision ethical if allstakeholders are treated as the decision maker would wish to be treated. Finally,the Kantian basic rights model defines acceptable actions as those thatminimise the violation of stakeholders rights.

1.5 RegulationHistorically, most regulation has focused on the disclosure of relevantinformation, which is intended to put all investors on an equal playing field,

and thereby to reduce conflicts of interest. On the other hand, regulationimposes costs on corporations and any analysis of regulation must includeboth benefits and costs.(a) The Securities Act of 1933 and the Securities Exchange Act of

1934


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S T U D Y G U ID E B M C F 5 1 0 3 C o rp o ra te F in a n c eThese Acts provide the basic regulatory framework for the public trading ofsecurities in the United States. The 1933 Act focuses on the issuance ofsecurities, while the 1934 Act established the SEC and addressed otherregulatory issues, such as insider trading and corporate reporting.(b) Sarbanes-OxleyFollowing the scandals at Enron, WorldCom, and Tyco, among others, Sarboxwas enacted in 2002. This Act significantly increased the auditing andreporting requirements that public firms face, and it also explicitly placed the

responsibility for any fraud on the corporate directors.As with any law, however, there is a cost. In response to the added burden,many (particularly small) firms have delisted and others have foregone goingpublic. For others, the cost of compliance has significantly increased, therebyreducing profits.

Topic 2: Company Valuation

Content Summary

1.1 Adjusted PresentValueMethod

The adjusted present value (APV) for a project with debt financing isbest described by the following formula:

APV has the conceptual advantage of separating the value of theunlevered investment NPV !rom the value of financing side effects

NPVF.NPV is the net present value of the project to an all-equity firm: NPV= present va lue o f un levered cash f lows ini tial investment fo r en tirep ro je ct ; u nl ev er ed c as h f lo w s = c as h f lo w s f ro m o p er at in g capitalspending a dd ed n et w o rk in g c a pit al; t he d is c ou nt ra te u se d is t heunlevered cost of capi tal .NPVF is the net present value of financial side effects, which include: (1)

tax subsidy to debt, (2) the costs of issuing new debt and equitysecurities, (3) the costs of financial distress arising from the use of debt,and (4) subsidies to debt financing. One of these side effects has beenintroduced in some introductory financial management course, the taxshield from debt in Modigliani-Miller Proposition I, Value of levered firm

ULB = Value of unlevered firm (+ ) + value of tax benefits (TcB).

Flow to Equity Method

This method focuses on value to equity holders. Its calculation involvescomputing free cash flow to equity holders, excluding all paymentsmade to debt. The FTE method has an advantage primarily in that itemphasises the value to equity holders.

The three steps in the flow to equity approach are:(a) Determine the free cash flow to equity;

(b) Determine the equity cost of capital; and(c) Compute the equity value by discounting the free cash flow to

equity using the equity cost of capital.


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S T U D Y G U ID E B M C F 5 1 0 3 C o rp o ra te F in a n ce

2.3 Weighted Average Cost of Capital MethodA firm's overall WACC is a market value weighted average of the aftertax cost of debt and cost of equity:

The intuit ion of the WACC approach is s imple and appealing. I f a

projects expected after tax return is higher than the weighted averageof the after tax required returns on debt and equity capital, i t is apositive NPV project.

2.4 A Comparison of MethodsThese three methods for calculating the value of a proposed projectshould be viewed as complementary. The following table summarisesthe similarities and differences between the three methods.


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Topic 3: Financing Decisions and Market Efficiency

Content SummaryPay strategies generally vary and are designed to bridge the organisationscritical challenges in attracting, motivating and retaining their key personnel.There are some common elements used as basic building blocks, namely,compensation objectives, pay policy, work content and value in designing

pay structure.

3.1 Efficient Market Hypothesis

An efficient capital market is one in which stock prices fully reflectavailable information. The efficient market hypothesis (EMH) hasimplications for investors and firms:(a) Since information is reflected in security prices quickly, knowing

information when it is released does an investor little good; and(b) Firms should expect to receive the fair value for securities that they

sell. Firms cannot profit from fooling investors in an efficient market.According to Andrei Shleifer, there are three conditions which will leadto efficiency:(a ) Ra ti onalit y a ll in vestors respond in a rat ionale way to new

information;(b) Independent devia tions f rom rationa li ty investor deviations are

countervailing and unrelated; and(c) Arbitrage competition among investors (professionals) and

traders makes a market efficient.An efficient market is one in which information is quickly and costlesslydisseminated to all participants. And while the markets are not efficient tothat extent, the advancement of information technology has resulted in itbeing closer to an ideal capital market. Some analysts believe thatrequired returns have fallen because the cost of obtaining information hasdropped so dramatically. This would lead to higher sustainable P/E ratios.No one is certain for sure that markets are more efficient, but the changes

in the last few years seem to be moving the markets in that direction,assuming the theories of what makes a market efficient are correct.

The Different Types of Efficiency

(a) Weak form efficiency

Security prices reflect all information found in past prices andvolume. If the weak form of market efficiency holds, then technicalanalysis is of no value. Since stock prices only respond to newinformation, which by definition arrives randomly, stock prices aresaid to follow a random walk. Evidence suggests that markets areweak form efficient based on the trading rules that we have beenable to test.

(b) Semistrong form efficiencyAll public information is already incorporated in the price. Public lyavailable information includes historical price and volumeinformation, published accounting statements, and information


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found in annual reports. It argues that investors cannotconsistently earn excess returns using available information to dofundamental analysis. Evidence is mixed, but suggests that itholds for widely held firms.

(c) Strong form efficiencyAll information, both public and private is already incorporated inthe price. Empirical evidence indicates that this form of efficiencydoes not hold.

3.3

3.4

The Behavioural Challenges to Market EfficiencyEfficiency is built on investor rationality, independence, and arbitrage;however, these may not hold in practice. Behavioural finance suggeststhat investors deviate from these assumptions in predictable ways. Assuch, efficiency may not hold. A primary example is speculativebubbles. Studies have found evidence inconsistent with efficiency. Forexample, small stocks tend to outperform large stocks, and valuestocks tend to outperform growth stocks. Also, investors appear toreact slowly to earnings announcements. In addition, arbitrage hastransactional limits. Lastly, the existence of bubbles and crashes isinconsistent with efficiency.

Implications for Corporate Finance

(a) Accounting choices, financial choices, and market efficiency:Early studies find that stock prices do not react to changes inaccounting methods, such as last-in first-out (LIFO) versus first-in first-out (FIFO). These findings are consistent with the semi- strongform EMH and suggest that Gilding the lily" by restating financialperformance in a deceptively favourable light is unlikely to increasevalue unless it can also decrease taxes, bankruptcy costs or agencycosts.

(b) The timing decision

Studies find that firms that issue new equity have negative abnormalreturns in following years, and firms that repurchase equity have positiveabnormal returns in following years, suggesting that managers time"equity sales (repurchases) correctly. If managers use information notpublicly available to time security sales, the evidence is consistent withthe strong form.

(c) Speculation and efficient marketsIf financial markets are efficient, firms should not waste their time trying toforecast the issues of debt and equity. Their forecasts will likely be nobetter than chance. This is not to say, however, that firms should randomlychoose the maturity or the denomination of their debt. A firm must choosethese parameters carefully. However, the choice should be based on otherrationales, not an attempt to beat the market.

(d)Information in market pricesManagers can reap many benefits by paying attention to market prices.For example, managers should pay attention to the stock price reaction toany of their announcements, whether it concerns a new venture, adivestiture, a restructuring etc.


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Topic 4: Issuing Securities to the Public

Content Summary

4.1

4 . 2

The Procedure for a New IssueThe first step of any issue of securities to the public is to obtain approvalfrom the board of directors. Next, the firm prepares and files a registrationstatement with the Securities and Exchange Commission (SEC). The SECrequires a 20-day waiting period and studies the registration statementduring the waiting period. The firm prepares and files an amendedregistration statement with the SEC. If everything is copasetic with theSEC, a price is set and a full-fledged selling effort gets underway.

The Cash OfferThere are two kinds of public issues:(a) The general cash offer; and(b) The rights offer.Cash offer refers to securities offered for sale to the general public on acash basis and rights offer is public issue in which securities are firstoffered to existing shareholders on a pro rata basis. Equity is sold byboth the cash offer and the rights offer but almost all debt is sold in

general cash offerings.Initial Public Offering (IPO) refers to a companys first equity issue madeavailable to the public. A seasoned equity offering refers to a new equityissue of securities by a company that has previously issued securities tothe public. There are three methods for issuing securities for cash:(a) Firm commitment;(b) Best efforts; and(c) Dutch auction.(i) Firm commitment underwriting

Under this method, the underwriting syndicate purchases theshares from the issuing company and then sells them to thepublic. The syndicates profit comes from the spread between the

prices, and it bears the risk that the actual spread earned will notbe as high as anticipated (or may not even cover costs). This isthe most common type of underwriting.Best efforts underwritingThe underwriters are legally bound to make their best effort tosell the securities at the offer price, but they do not actuallypurchase the securities from the issuing firm. In this case, the


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issuing firm bears the risk of the market being unwilling to buy atthe offer price.Dutch auction underwritingThe underwriter does not set the offer price. Instead, a series ofbids is solicited from potential investors, and the price that is paidby everyone is the price that will result in all shares being sold.The incentive is to bid high to guarantee that you get in on the

offer price, knowing that you will only pay the lowest acceptedprice. The U.S. Treasury has sold bills, bonds, and notes usingthe Dutch auction process for many years. Google was the firstlarge Dutch auction IPO.

Determining the correct offering price is difficult because there is nocurrent market price available. Private companies tend to have moreasymmetric information than companies that are already publiclytraded. Underwriters want to ensure that, on average, their clients earna good return on lPOs. Underpricing causes the issuer to leave moneyon the table."The underpricing (there is a large increase above the offer price thefirst day of trading) of lPOs is very common. The record year is still

1999, with an average first day return of almost 70%. There are manypossible explanations for underpricing, but there is no consensusamong scholars as to which explanation is correct. Two points,however, are worth noting. First, much of the underpricing appears tobe concentrated in smaller issues. Second, when the issue price is toolow, the issue is often oversubscribed.

4.3 The Announcement of New Equity and the Value of the FirmThe market value of existing equity drops on the announcement of anew issue (a seasoned equity offering) of common stock. Why? Muchof the decline may be due to the private information known bymanagement (called asymmetric information) and the signals that thechoice to issue equity sends to the market. Some possible reasons to

explain that phenomenon include:Managerial information concerning value of the stock: Since themanagers are the insiders, expectation that managers will issue equityonly when they believe the current price is overpriced.Debt capacity: Expectation that a firm will issue debt as long as it canafford to (allows stockholders to benefit more from good projects);consequently, a stock issue indicates that management believes thatthe firm is too highly leveraged.

Falling earnings: Unanticipated financing tends to be roughly equal tounanticipated shortfalls in earnings.


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4.4 The Cost of New IssuesThe costs of issuing securities can be divided into six categories:(a) Spread;(b) Other direct expenses;(c) Indirect expenses;(d) A bno rm a l re tu rn s;(e) Underpricing; and

(I) Green Shoe option.

4.5 Rights

If a preemptive right (or privileged subscription) is contained in thefirms articles of incorporation, the firm must offer any new issue ofcommon stock first to existing shareholders. This allows shareholdersto maintain their percentage ownership if they so desire. Rights areoften traded on securities exchanges or over the counter.

(a) The Mechanics of Rights OfferingEarly stages are the same as for a general cash offer, i.e., obtainapproval from directors, file a registration statement, etc. The differenceis in the sale of the securities. Current shareholders get rights to buynew shares. They can subscribe (buy) the entitled shares, sell the rightsor do nothing.In rights offering, the subscription price is the price that existingshareholders are allowed to pay for a share of stock. In the context ofoptions, this is similar to an exercise price. The management of thefirm must decide the exercise price (the price existing shareholdersmust pay for new shares) and the number of rights will be required topurchase one new share of stock.To avoid under subscription, rights offerings are typically arranged bystandby underwriting. Here the firm makes a rights offering and the

underwriter makes a commitment to "take up (purchase) anyunsubscribed shares. In return, the underwriter receives a standbyfee. In addition, shareholders are usually given oversubscriptionprivileges (the right to purchase unsubscribed shares at the subscriptionprice).

b. The Rights PuzzleA pure rights offe ring is typica lly cheape r th an un derwriting or arights offer with standby underwriting. However, over 90% of offerings are

underwritten. A few possible explanations exist: (1) underwriter increasesstock price, (2) underwriter provides guaranteed price, and (3) theproceeds from underwriting may be available sooner than the proceeds from

a rights offering. All these arguments are confusing, none seemsconvincing.


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4.6 The Private Equity Market

The previous sections of this topic assumed that a company is bigenough, successful enough, and old enough to raise capital in thepublic equity market. For start-up firms and firms in financial trouble,the public equity market is often not available. The market for venture

capital is part of the private equity market.Private placements avoid costly registration procedures by placingsecurities directly with qualified investors. The SEC typically restrictsprivate placement issues to less than one hundred qualified investors,including institutions such as insurance companies and pension funds.The biggest drawback of privately placed securities is that thesecurities cannot be easily resold.Most private placements involve debt securities. Equity securities canalso be privately placed especially for small companies. Smaller firmstend to use the private placement market mainly because they face thehighest costs in a public issue and often require specialised, flexibleloan arrangements. On the other hand, the costs of investigation and

negotiation may be higher, and lenders in private placements expectsome compensation for holding an instrument with limited liquidity.Private equity firms are typically set up as limited partnerships.Institutional investors and qualified individuals act as the limitedpartners, and professional managers serve as the general partners.The limited partnership is the dominant form of intermediation in theprivate equity market. There are four types of suppliers of venture

capital:(a) Old-line wealthy families;(b) Private partnerships and corporations;

(c) Large industrial or financial corporations have established venture-

capital subsidiaries; and(d) Individuals, typically with incomes in excess of $100,000 and networth over $1,000,000. Often these angels have substantial businessexperience and are able to tolerate high risks.


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Topic 5: Options

Content Summary

5.1 OptionsAn option gives the holder the right, but not the obligation, to buy or sella given quantity of an asset on (or before) a given date, at pricesagreed upon today. Call options gives the holder the right, but not the

obligation, to buy a given quantity of some asset on or before theexpiration date, at prices agreed upon today. When exercising a calloption, you call in the asset. Put options gives the holder the right, butnot the obligation, to sell a given quantity of an asset on or before theexpiration date, at prices agreed upon today. When exercising a put,you put the asset to someone.5.2 Option Pricing ModelsThere are two types of option pricing models. The binomial optionpricing model is a two-state single-period model. For the value optionusing the binomial model, we need to create a replicating portfolio, andshow that the price is not a function of the probabilities of the states inthe binomial tree. The binomial model can be extended to a continuousmodel; the Black-Scholes option pricing model. The derivation of theBlack-Scholes formula is not required in this course. The Black-Scholesformula can be used to value a call or put option. The price of aEuropean put on a non-dividend-paying stock can be valued using put-call parity.5.3 Stocks and Bonds as OptionsThe underlying asset is the value of the firm (the value of its assets).The stockholders have a call on this value with a strike price equal tothe face value of the firms debt. If the firms assets are worth morethan the debt, the option is in-the-money and stockholders exercise theoption by paying off the debt. If, however, the face value of the debt is

greater than the value of the f irms assets, the option expiresunexercised (i.e., the company defaults on its debt). Thus, thebondholders can be viewed as owning the firms assets and havingwritten a call against them.

Alternatively, we could view owners as having a put option thatgives them the right to put the firm to the creditors in the case ofbankruptcy. Specifically, if at the maturity of their debt, the assetsof the firm are less in value than the debt, shareholders have anin-the-money put. They will put the firm to the bondholders. If atthe maturity of the debt the shareholders h ave an out-of-the-money put , they will not exercise the option (i.e. not declarebankruptcy) and let the put expire.


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5.4 Application of Options to Corporate Finance

(a) Mergers and Diversification

Diversification is a frequently mentioned reason for mergers. We canuse option valuation to investigate whether diversification is a goodreason for a merger from a stockholders viewpoint. Diversificationreduces risk. If diversification is the only benefit then a merger will

reduce volatility without increasing cash flow. Decreasing volatilitydecreases the value of the call option (equity) and the put option.Since risky debt can be viewed as risk-free debt minus a put option,decreasing the value of the put increases the value of the risky debt.Thus, mergers for diversification only transfer wealth from thestockholders to the bondholders. The standard deviation of returnson the assets is reduced, thereby reducing the option value of theequity. If managements goal is to maximize stockholder wealth, thenmergers for reasons of diversification should not occur.(b) Options and Capital BudgetingIf a firm has a substantial amount of debt, stockholders may preferriskier projects, even if they have a lower NPV. The riskier projectincreases the volatility of the asset returns. The increased volatilityincreases the value of the call (equity) and the put. The increasedput value decreases the value of the debt. This transfers wealth fromthe bondholders to the stockholders. Stockholders may even prefer anegative NPV project if it increases volatility enough. The wealthtransfer from bondholders to stockholders may outweigh the negativeNPV.Bondholders recognise the desire of stockholders to take on riskierprojects. Consequently, provisions are typically put into the bondindentures to try to prevent this wealth transfer. These provisions addto the firms cost either directly through a higher interest rate or

through additional monitoring costs. These costs are all consideredagency costs.

5.5 Real OptionsReal options provide the right to buy or sell real assets. Theseoptions often apply in capital budgeting situations and can bevery valuable. These options can be in forms of explicit optionswhere contracts giving the holder the right to buy or sell theasset or implicit options that exist in many capital budgetingsituations and are often hidden.Option to wait is particularly valuable when the economy ormarket is expected to be bigger in the future. It is not valuable

when trying to capitalise on current fads. The option to waitmay actually turn a bad project into a good project. By waitinga year or two may allow the firm to capture higher cash flows.


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Managerial options are options to modify a project once it has beenimplemented. Classic NPV calculations generally ignore the flexibilitythat real-world firms typically have. These include:(a) Option to expand: ability to make the project bigger if it is a

successful. We underestimate the NPV if we ignore this option.

(b)

(d)

Option to abandon: ability to shut down the project if things do notgo as planned. The NPV could have been underestimated if weignore this option.Option to suspend or contract: ability to downscale when themarket is weaker than expected.Strategic options: using a project to explore possible newventures or strategies. These projects open up a wide number offuture opportunities but are more difficult to analyse withtraditional discounted cash flow analysis.


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Topic 6: Application of Options to Corporate Finance

Content Summary6.1 Executive Stock OptionsExecutive Stock Options (ESOs) exist to align the interests of shareholders andmanagers. ESOs are call options (technically warrants) on the employersshares. They typically have these characteristics:

(a) Inalienable (cannot be sold);(b) Typical maturity is 10 years; and(c) Typical vesting period is three years, and most include implic itreset provisions to preserve incent ive compatibi l i ty.Executive Stock Options give executives an important tax break. Grants of at-the-money options are not considered taxable income. Taxes are due if theoption is exercised. However, the economic value of a long-lived call option isenormous, especially given the propensity of firms to reset the exercise priceafter drops in the price of the stock.

Valuing Executive CompensationSince ESOs are essentially like a call option, they can be valued using theBlack-Scholes Model, or other option pricing models. However, due to the

intricacies of some contracts, the value provided by the models may only begood estimates of true value. For example, due to the inalienability, the optionsare worth less to the executive than they cost the company. The executive canonly exercise, not sell his options. Thus he can never capture the speculativevalue but only the intrinsic value. This dead weight loss is overcome by theincentive compatibility for the grantor.

6.2 Valuing Start-UpWhen estimating the value of a start-up firm, the option to expand is of greatimportance in determining the underlying value of the venture.

6.3 An Application of Binomial Model

The binomial option pricing model is an alternative to the Black-Scholes option

pricing model. Especially in cases of path dependence, it is a superioralternative. Path dependency is when how you arrive at a price (the path youfollow) for the underlying asset is important. One example of a path dependentsecurity is a no regret call option where the exercise price is the lowest priceof the stock during the options life. Further, although we still consider only twopossible movements (up or down), we extend the model to illustrate multipleperiods, which essentially creates a tree with many branches. For example, the2-period binomial model can be extended to 3- period or more.

6.4 Shut Down and Reopening DecisionsThe true value of a project is equal to its NPV plus any embedded optionvalue, such as the option to abandon, wait, or expand. We can calculate themarket value of a project as the sum of the NPV of the project without options

and the value of the managerial options implicit in the project. A good examplewould be comparing the desirability of a specialised machine versus a moreversatile machine. If they both cost about the same and last the same amountof time, the more versatile machine is more valuable because it comes withoptions.


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Topic 7: Derivatives and Hedging Risk

Content Summary

7.1 Hedging with Futures and Forward ContractsForward contract is an agreement between a buyer (long) and a seller (short) forfuture delivery of an asset at a price specified today. The forward price is the priceagreed upon today to be paid at a future date when delivery occurs. Settlement

date is the date when delivery occurs and the forward price is paid (received). In aforward contract, both parties are legally bound to execute the transaction in thefuture at the agreed-upon price, but no money changes hands at the inception ofthe contract.

Futures contract is forward contract traded only on an exchange with gains andlosses recognised on a daily basis. A futures contract is like a forward contract. Itspecifies that a certain commodity will be exchanged at a specified time in thefuture at a price specified today. Futures are standardised contracts trading onorganised exchanges with daily resettlement (marking to market") through aclearinghouse. Typically, futures contracts are divided into two broad categories:(a) Commodity contracts such as oil, gold, or wheat; and(b) Financial contracts such as T-bond or S&P SOO.One problem with forward contracts is enforcing the agreement on the deliverydate. If the cash price on the delivery date is higher than the agreed price, theseller has the incentive to default, and vice versa. Futures contracts greatly reducethe risk of default relative to forward contracts by: (1) having an exchangeclearinghouse take one side of every transaction, (2) requiring an initial and amaintenance margin, and (3) marking to market on a daily basis.

Hedging and Speculating

Hedging is the process of reducing risk, whether it be the risk of changing prices,currency fluctuations, or changes in interest rates. Speculating is the opposite ofhedging, which implies it is the process of increasing risk. Both hedgers andspeculators are necessary for an active, liquid derivatives market. While forward

and futures contracts can be used for speculative purposes, the topic focuses onthe use of these derivative securities to reduce risk. Either side of a forward orfutures contract can be used to hedge:(a) A short futures hedge involves selling a futures contract. Shorthedges are used when you will be making delivery of an asset at a future date(e.g., a farmer anticipating a harvest of wheat) and wish to minimise the risk of adrop in price.(b) A long futures hedge involves buying a futures contract. Longhedges are used when you must purchase an asset at a future date (e.g., a bakerywith a demand for wheat) and wish to minimise the risk of a rise in price.

7.2 Interest Rate Futures(a) Pricing of Treasury Bonds

Recall the general expression for the value of a bond:Bond value = present value of coupons + present value of par


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This formula assumes a flat yield curve. If this is not the case,then each cash flow must be discounted at the rate specific to thetiming of the cash flow.

Pricing of Forward ContractsWith the forward contract, you are agreeing to purchase the bondat a specified point in the future. The value of the bond at thattime is just the present value of the subsequent cash flows. Thisprice can then be discounted to the present to find the value attime 0. Futures contracts are priced similarly to forwards, with theexception of the daily resettlement.

7.3 Duration HedgingAs an al te rnat ive to he dg ing with fu tu res or fo rw ards , on e can he dge byma tching the in te rest r ate ri sk o f assets w ith the i nteres t r ate r isk o f l iab il it ies . Dura tion is the key to measur ing inte rest rate r isk . Dura tionmeasures the comb ined e ffec t o f ma tu rit y, coupon rate, and y ie ld tom a tu rity ( YT M ) o n a b o nd s p ric e s en sitiv ity t o in te re st r at es . T hedura tion o f an asse t w ith cash payments (C 1. . ,C T) as the we igh tedaverage maturi ty of an asset stated in terms of present values:

It represented the price elasticity of an asset with respect to a changein the level of interest rates. The relationship between changes ininterest rate, changes in bond prices, and duration is:


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Matching Liabilities and AssetsBy matching the duration of financial assets and liabilities, a change ininterest rates has the same impact on the value of the assets andliabilities, leaving the value of equity unchanged. Duration as ameasure of price elasticity is important in many portfolio managementapplications. In banking, matching the duration of financial assets andliabilities is referred to as "asset-liability management." In insurance,duration hedging is used in "insulating" a portfolio of assets andliabilities against changes in interest rates. The basic concept hasapplications in corporate finance as well.

7.4 Swaps Contracts

Swaps are arrangements between two counterparties to exchange cashflows over time. Thus, swaps are essentially a series of forwardcontracts. The swap bank acts as either a broker (matchingcounterparties) or dealer (serving as one of the counterparties).Just as two companies can agree to exchange currencies at specificfuture dates, they can also agree to exchange the cash f lows

associated with respective loan agreements. Interest rate swaps aregenerally used to convert a fixed rate obligation to a floating rateobligation, or vice versa, depending on the needs of the company. Onlythe net interest payment is exchanged since the swap contract involveswith one currency. As for currency swaps, two firms agree to exchangea specific amount of one currency for a specific amount of anothercurrency at specific future dates.


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Topic 8: Mergers and Acquisitions

Content Summary

8.1 The Basic Forms of AcquisitionsThere are three basic legal procedures that one firm can use to acquireanother firm: (1) Merger or consolidation; (2) Acquisition of stock; and(3) Acquisition of assets.

(a) Merger or ConsolidationMerger refers to the complete absorption of one company byanother (assets and liabilities). The bidder remains, and the targetceases to exist. As for consolidation, a new firm will be createdand joined firms cease their previous existence.

(b) Acquisition of StockA second way to acquire another firm is by buying the votingstock of another firm with cash, securities or both. A tender offeris an offer by one firm or individual to buy shares in another firmfrom any shareholder. Such deals are often contingent on thebidder obtaining a minimum percentage of the shares; otherwise,no go. Some factors involved in choosing between a tender offerand a merger:( i) No shareholder vote is required for a tender offer.

Shareholders choose to sell or not.The tender offer bypasses the board and management ofthe target firm.In unfriendly bids, a tender offer may be a way aroundunwilling managers.

In a tender offer, if the bidder ends up with less than 800/ ofthe target firms stock, it must pay taxes on a portion of thedividends paid by the target.Complete absorption requires a merger. A tender offer isoften the first step toward a formal merger.

Acquisition of AssetsIn an acquisition of assets, one firm buys most or all of anothersassets, but l iabil it ies are not involved as with a merger.Transferring titles can make the process costly. The selling firmmay remain in business.

Synergy

Most acquisitions fail to create value for the acquirer. The main reasonwhy they do not lies in failures to integrate two companies after amerger. Intellectual capital often walks out the door when acquisitionsare not handled carefully. Traditionally, acquisitions deliver value whenthey allow for scale economies or market power, better products andservices in the market, or learning from the new firms.

Suppose firm A is contemplating acquiring firm B. The differencebetween the value of the combined firms (VAB) and the sum of theindividual firms (GA + IBM is the incremental gain. The synergy from the

acquisition is IV = TAB UA + IBM. Synergy occurs if the value of the


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whole exceeds the sum of the parts (IV > 0). The possible benefits ofan acquisition come from the following: (1) revenue enhancement, (2)cost reduction, (3) lower taxes, and (4) reduced capital requirements.When calculating the gains from synergy, avoid the following mistakes:(a) Do not ignore market values. Use the current market value as a

starting point and ask, What will change if the merger oracquisition takes place?"

(b)

(d)

Estimate only incremental cash flows. These are the basis ofsynergy.Use the correct discount rate. Make sure to use a rate appropriateto the risk of the cash flows.Be aware of transaction costs. These can be substantial andshould include fees paid to investment bankers and lawyers, aswell as disclosure costs.

8.3 Two Financial Side Effects of Acquisitions

a. Earnings GrowthAn acquisition may give the appearance of growth in EPS withoutactually changing cash flows. This happens when the biddersstock price is higher than the targets, so that fewer shares areoutstanding after the acquisition than before.b. Diversification

A firms attempt at diversification does not create value becausestockholders can buy the stock of both firms, probably morecheaply. Firms cannot reduce their systematic risk by merging.Using option pricing theory in an earlier chapter, it is shown thatconflicts of interest may exist between stockholders andmanagers in publicly traded firms. As noted above, diversification-based mergers do not create value for shareholders. However,these mergers may increase sales and reduce the total variabilityof firm cash flows. If managerial compensation and/or prestige is

related to firm size, or if less variable cash flows reduce thelikelihood of managerial replacement, then some mergers maybe initiated for the wrong reasons. They may be in the bestinterest of managers but not stockholders.


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8.4 A Cost to Stockholders from Reduction in RiskThe coinsurance effect in a merger or acquisition occurs because evenif one of the pre-merger firm fails, bondholders will be still be paid bythe surviving firm. The coinsurance effect can reduce the costs offinancial distress if the cash flows between two firms are not perfectlycorrelated. While this can increase total stakeholders value, there mayalso be a transfer of value from the stockholders to the bondholders

through the coinsurance effect.In the topic on options, stocks can be valued as a call option on thefirms debt. In this view, bondholders own the firm but sell shareholdersan option to buy the firm at an exercise price equal to the face value ofdebt. Recall that one of the inputs to the option pricing model is thevariability of the underlying asset. When the variability of the underlyingasset decreases, so does the value of the call option.Stapleton (1982) has shown that this is exactly what occurs when twofirms merge. Because of the coinsurance effect, the value of equity (acall option) falls and there is a transfer of wealth from stockholders tobondholders. The coinsurance effect, however, can also result ingreater debt capacity. This in turn means greater interest tax shields

and lower taxes.

8.5 Friendly versus Hostile TakeoversIn a friendly merger, both companies management are receptive. In ahostile merger, the acquiring firm attempts to gain control of the targetwithout their approval. For examples, (1) tender offer attempt topurchase enough shares to gain control and (2) proxy fight attempt togather enough votes to force the merger. Some defensive tactics inhostile takeover battles include: poison pills, golden parachutes, crown

jewels, and greenmail.

8.6 Do Mergers Add Value?

Available evidence suggests that target stockholders make signif icantgains more in tender offers than in mergers. On the other hand,bidder stockholders earn comparatively little (breaking even onmergers and making a few percent on tender offers).


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Topic 9: Corporate Culture and Compensation

Content Summary

9.1 Corporate Financial DistressFinancial distress is a situation where a firms operating cash flows arenot sufficient to satisfy current obligations, and the firm is forced to take

corrective action. Financial distress may lead a firm to default on acontract, and it may involve financial restructuring between the firm, itscreditors, and its equity investors. The definition of financial distresshas two general themes:(i) Stock-based insolvency; and(ii) Flow-based insolvency.Stock-based insolvency occurs when the value of assets is less thanthe value of promised payments to debt. The stock-based insolvency iscommonly regarded as a signal of financial distress. Flow-basedinsolvency occurs when operating cash flows are insufficient to covercontractually required payments. This type of insolvency typicallyresults in more immediate actions, and often leads to bankruptcy.Financial distress can serve as the firms "early warning" signal.

Ironically, firms with high financial leverage often face financial distressearlier and, therefore, have more time to reorganise. Firms with lowleverage may not recognise they are in distress until it is too late.

(a) Responses to Financial DistressA firm can respond to financial distress by increasing availablecash flows (asset restructuring) or by reducing liabilities (financialrestructuring). Low leverage firms have very limited options infinancial restructuring, and, due to delay in their response, theasset values have often deteriorated. For these reasons, firmswith low financial leverage are more likely to liquidate than firmswith high leverage.Financial distress may involve both asset restructuring and

financial restructuring in several ways such as these: sellingmajor assets, merging with another firm, and reducing capitalspending and R&D spending asset restructuring; issuing newsecurities, negotiating with banks and other creditors, exchangingdebt for equity, and filing for bankruptcy financial restructuring.


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9.2 Bankruptcy Liquidation and ReorganizationFirms that cannot meet their obligations have two choices: liquidationor reorganization. Liquidation means termination of the firm as a goingconcern. It involves selling the assets of the firm for salvage value. Theproceeds, net of transactions costs, are d istributed to creditors in orderof priority. Reorganization is the option of keeping the firm a going

concern. Reorganization sometimes involves issuing new securities toreplace old ones.

a. Bankruptcy LiquidationAn involuntary bankruptcy liquidation petition may be filed bycreditors if both of the following conditions are met:(i) The corporation is not paying debts as they come due; and(ii) If there are more than 12 creditors, at least three with claims

totalling $13,475 or more must join in the filing.If there are fewer than 12 creditors, then only one with a claim of$13,475 is required to file.

b. Absolute Priority RuleThe absolute priority rule (APR) determines priority of claim inbankruptcy liquidation and reorganization. The rule states thatsenior claims must be fully satisfied before junior claims areserviced. Exceptions to the APR are possible such as a mortgagesecured by real estate property.c. Bankruptcy ReorganizationChapter 11 petitions can be filed by the corporation or by itscreditors. In the Chapter 11 reorganization, the bankruptcy judgehas responsibility for major business decisions, althoughmanagement input and cooperation is essential to a smoothreorganization.

9 . 3 Private Workout or Bankruptcy

In order to avoid the costs and delays of formal bankruptcy, firms cantry to negotiate a private workout with creditors. If creditors cooperatein a private workout and forego a part of their original claim, they arebetting that their ultimate payoff will be higher than if the firm were to bedragged through the bankruptcy courts. Gilson (1989) estimates thatonly 30% of senior managers (CEO, chairman, and president) survivethe four-year period starting two years prior to a Chapter 11 bankruptcy


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filing. The survival rate of senior management in private workouts wasonly slightly higher at 40 0/

(a) Advantages of Formal Bankruptcy versus Private Workout(i) Formal bankruptcy allows firms to issue new debt ("debtor in

possession" or "DIP" debt) that is senior to all previouslyissued debt. This new senior debt can provide enough cashfor the firm to continue to conduct its business.

(ii) Interest on pre-bankruptcy unsecured debt stops accruingafter formal bankruptcy is recognised.

(ii i) An automatic stay provision protects the firm from itscreditors during bankruptcy proceedings.

(iv) There are tax advantages to formal bankruptcy relative toprivate workouts.

(v) While a private workout requires acceptance of the plan byall creditors, formal bankruptcy requires acceptance of theplan by one half of creditors owning 2/3 of outstandingclaims.

(b) Disadvantages of Formal Bankruptcy versus Private Workout(i) Legal and professional fees have top priority according to

the absolute priority rule. Because legal fees accrue on anhourly basis, lawyers and investment bankers have littlereason to work toward a rapid reorganization of the firm.

(ii) In a bankruptcy reorganization through Chapter 11, judgesare required to approve all major business decisions. Allstakeholders can be adversely affected if judges makefinancing and investment decisions that are not based onmaximising firm value. Lost investment opportunitiesrepresent one form of opportunity costs in bankruptcyproceedings.

(ii i) Similarly, if managers attention is diverted by thebankruptcy proceedings, they may not pursue all positive

NPV investment opportunities.(iv) Stockholders may be able to hold out for a better deal inChapter 11 bankruptcy than in a private workout becauseinterest on pre-bankruptcy debt has stopped accruing andthe availability of "debtor in possession" debt.

Both formal bankruptcy and private workouts involve exchanging newfinancial claims for old financial claims. Usually, senior debt is replacedwith junior debt, and debt is replaced with equity. When they work,private workouts are better than a formal bankruptcy. Complex capitalstructures and lack of information make private workouts less likely.


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(c) Prepackaged BankruptcyPrepackaged bankruptcy is a combination of a private workoutand legal bankruptcy. The firm and most of its creditors agree toprivate reorganization outside the formal bankruptcy. After theprivate reorganization is put together (pre-packaged) the firm filesa formal bankruptcy (under Chapter 11). The main benefit is thatit forces holdouts to accept a bankruptcy reorganization. It offers

many of the advantages of a formal bankruptcy, but is moreefficient.McConnell and Servaes (1991) view prepackaged bankruptciesas an administrative extension of an informal reorganization, withthe following advantages:(i) Because only one half of creditors holding at least two thirds

of the f irms l iabil it ies are needed for approval of abankruptcy plan, holdouts can be reduced.

(ii) In addition to reducing holdout disputes, prepackagedbankruptcies can capture all of the advantages of formalbankruptcy (including tax advantages) while minimising thedisadvantages.

9.4 Predicting Corporate Bankruptcy

Credit scoring models provide a quick, objective way to assess thecreditworthiness of prospective borrowers by assessing factors thathave historically been associated with the risk of default. Altmans Zscore is found using the following equation:Z = 3.3(EBIT/Total Assets) + 1.2(Net Working Capital/Total Assets) +1.0(Sales/Total Assets) + 0.6(Market Value of Equity / Book Value ofDebt) + 1.4(Accumulated Retained Earnings / Total Assets)

A Z-score less than 2.675 is indicative of a high probability (95%) ofdeclaring bankruptcy within the next year. However, 1.81 to 2.99 isreally a grey area, with the critical high and low probabilities ofbankruptcy being below 1.81 and above 2.99, respectively.

The above model requires a firm to have publicly traded equity and bea manufacturer. A revised model can be used on private firms and non-manufacturing companies:

Z = 6.56(Net Working Capital/Total Assets) + 3.26(AccumulatedRetained Earnings / Total Assets) + 1.05(EBIT/Total Assets) +6.72(Book Value of Equity / Total Liabilities)The critical levels for this model are 1.23 and 2.90, respectively.


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Topic 10: International Corporate Finance

Content Summary

10.1 The Foreign Exchange MarketThe foreign exchange market (FOREX) is highly efficient and is theworlds largest financial market. In this market, one countrys currencyis traded for anothers. Most of the trading takes place in some majorcurrencies including U.S. dollar ($), British pound sterling (), Japaneseyen (Y) and Euro ( ). Market participants include importers andexporters, international portfolio managers, brokers, market markers,and central banks.

An exchange rate is the price of one countrys currency in terms ofanother. There are two types of transactions in the FOREX; spot andforward trades. The spot trade is an exchange of currencies atimmediate prices (spot rate). The forward trade is a contract for theexchange of currencies at a future date at a price specified today(forward rate). If the forward rate is greater than the spot rate (based ondirect quotes), then the foreign currency is expected to appreciate and

is selling at a premium. If the forward rate is below the spot rate (basedon direct quotes), then the foreign currency is expected to depreciateand is selling at a discount

10.2 International Parity Relations

a. Purchasing Power ParityAbsolute purchasing power parity (PPP) indicates that acommodity should sell for the same real price regardless of thecurrency used. This is often referred to as the law of one price.The absolute PPP can be violated due to transaction costs,barriers to trade and differences in the product. According to therelative PPP, the change in the exchange rate depends on the

difference in inflation rates between countries. This relationshipprovides information about what causes changes in exchangerates.b. Covered Interest Arbitrage

A covered interest arbitrage exists when a riskless profit can bemade by borrowing in the domestic market at the risk-free rate,converting the borrowed dollars into a foreign currency, investingat that country's rate of interest, taking a forward contract toconvert the currency back into the domestic currency andrepaying the loan.

Unbiased forward rates refers to that the forward rate, Fo. is equal to theexpected future spot rate, E[Set. That is, on average, the forward rate


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neither consistently underestimates nor overestimates the future spotrate. That is, Ft - E[Set. The International Fisher Effect tells us that thereal rate of return must be constant across countries. If it is not,investors will move their money to the country with the higher real rateof return.

10.3 International Capital BudgetingTo evaluate an overseas investment, two methods are available; homecurrency approach and foreign currency approach. The home currencyapproach involves converting foreign cash flows into the domesticcurrency and finding the NPV, while in the foreign currency approachwe determine the comparable foreign discount rate, find the NPV offoreign cash flows, and convert the NPV to dollars.

10.4 Exchange Rate RiskExchange rate risk is the natural consequence of internationaloperations in a world where relative currency values move up anddown. It refers to the risk of loss arising from fluctuations in exchangerates. There are three different types of exchange rate risk or exposure:short-term exposure, long-term exposure, and translation exposure.

(a) Short-term ExposureRisk from day-to-day fluctuations in exchange rates and the factthat companies have contracts to buy and sell goods in the shortrun at fixed prices. One way to offset the risk from changingexchange rates and fixed terms is to hedge with a forwardexchange agreement. Another hedging tool is to use foreignexchange options. An option will allow the firm to protect itselfagainst adverse exchange rate movements and still benefit fromfavourable exchange rate movements.

(b) Long-term ExposureLong-run fluctuations come from unanticipated changes in relativeeconomic conditions. It may be due to changes in labour markets

or government policies. These long-run changes in exchangerates can be partially offset by matching foreign assets andliabilities, inflows and outflows.Translation ExposureIncome from foreign operations must be translated back to homecurrency for accounting purposes, even if foreign currency is notactually converted back to the domestic currency. If gains andlosses from this translation flowed through directly to the incomestatement, there would be significant volatility in EPS. Currentaccounting regulations require that all cash flows be converted at


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the prevailing exchange rates, with currency gains and lossesaccumulated in a special account within shareholders equity.Translation gains and losses are accumulated in the specialequity account and are not recognised in earnings until theunderlying assets or liabilities are sold or liquidated.

(d) Managing Exchange Rate RiskLarge multinational firms may need to manage the exchange rate

risk associated with several different currencies. The firm needs toconsider its net exposure to currency risk instead of just looking ateach currency separately. Hedging individual currencies could beexpensive and may actually increase exposure.

10.5 Political RiskPolitical risk refers to the changes in value due to political actions in theforeign country. Investment in countries that have unstable governmentsshould require higher returns. Blocking funds and expropriation ofproperty by foreign governments are among the routine political risksfaced by multinationals. Terrorism is also a concern. Financing thesubsidiarys operations in the foreign country can reduce some risk.

Another option is to make the subsidiary dependent on the parentcompany for supplies; this makes the company less valuable to someoneelse.

Corporate Finance Review

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