Test Bank

TEST BANK
ADVANCED CORPORATE FINANCE:

Policies and Strategies
Joseph P. Ogden
State University of New York, Buffalo
Frank C. Jen
State University of New York, Buffalo
Phiip F. O!Connor
Southern Utah University
Prentice Hall, Upper Saddle River, New Jersey 07458
A"#$isi%ions Edi%or: &i"ke' Co(
Asso"ia%e Edi%or: Ke)in *an"o"k
Pro+e"% edi%or:
&an$,a"%$rer:

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,

7 ,00, Prentice Hall, -nc
A Si%!n 5 Sch&ster 4!%pany
Upper Saddle River, New Jersey 07458
PREFACE
8his test #an$ has #een prepared "!r pr!"ess!rs &sing the te9t#!!$, Ad)an"ed Corpora%e
Finan"e: Policies and Strategies, #y :gden, Jen, and :;4!nn!r, Prentice Hall, ,000 8he test
#an$ pr!vides, "!r each chapter, sets !" %&ltiple/ch!ice <&esti!ns and essay <&esti!ns =!r each
%&ltiple/ch!ice <&esti!n, the c!rrect answer is highlighted with an asteris$ 0>2, and i" the
<&esti!n inv!lves n&%erical calc&lati!ns, the applica#le "!r%&la is pr!vided
J!seph P :gden
+
CONTENTS
4hapter (?????????????????????????????????
5
4hapter ,?????????????????????????????????
8
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4hapter 4?????????????????????????????????
(7
4hapter 5?????????????????????????????????
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4hapter *?????????????????????????????????
,,
4hapter 7?????????????????????????????????
,*
4hapter 8?????????????????????????????????
+0
4hapter )?????????????????????????????????
+4
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+8
4hapter ((????????????????????????????????
4+
4hapter (,????????????????????????????????
45
4hapter (+????????????????????????????????
48
4hapter (4????????????????????????????????
5(
4hapter (5????????????????????????????????
5+
4hapter (*????????????????????????????????
5*
4hapter (7????????????????????????????????
*(
4hapter (8????????????????????????????????
*4
4hapter ()????????????????????????????????
*7
4
C * A P T E R -
)ulti"le Choice *uestions
@@@ ( =!r p&#lic US n!n"inancial "ir%s in c!%p!site, the "racti!ns !" c&rrent assets and n!n/c&rrent
assets 0all in #!!$ val&esA year/end ,0002 are approximatelyB
4&rrent N!n/c&rrent
Assets Assets
a (C+ ,C+ >
# (C, (C,
c ,C+ (C+
@@@ , =!r p&#lic US n!n"inancial "ir%s in c!%p!site, the "racti!ns !" lia#ilities 0c&rrent pl&s n!n/
c&rrent2, and e<&ities 0all in #!!$ val&es, year/end ,0002 are approximatelyB
3ia#ilities 6<&ities
a (C+ ,C+
# (C, (C,
c ,C+ (C+ >
@@@ + :ver the years ()8(/,000, 4,770 n!n"inancial "ir%s exited the US %ar$ets "!r p&#licly traded
e<&ity 'hich !" the "!ll!wing was the %!st "re<&ent reas!n "!r a "ir%;s e9itD
a Eerger !r ac<&isiti!n >
# .an$r&ptcy !r li<&idati!n
c 8he "ir% reverted t! private e<&ity !wnership
d 8he "ir% changed its listing t! a "!reign st!c$ e9change
@@@ 4 'hat average ann&al pr!p!rti!n !" the t!tal n&%#er !" p&#lic US n!n"inancial "ir%s at year/end
()80 e9ited !ver the years ()8(/,000 0ie, the average attrition rate2D
a 5)F >
# (5)F
c ,5)F
d +5)F
@@@ 5 'hich categ!ry !" c!%p!site assets 0"!r p&#lic US n!n"inancial "ir%s2 sh!wed the largest
pr!p!rti!nal decrease !ver the years ()80/,000D
a cash and e<&ivalents
# invent!ries
c net PP56 >
d !ther n!n/c&rrent assets
5
@@@ * 8hr!&gh!&t the peri!d ()80/,000, the c!%p!site pr!p!rti!n !" the 8A !" US n!n"inancial "ir%s
accounted for #y net PP56 generally @@@0i2@@@@, and the pr!p!rti!n !" 8A financed #y
e<&ity @@@0ii2@@@ "airly steadily
@@@0i2@@@ @@@0ii2@@@
a decreased increased
# increased decreased >
c increased als! increased
d decreased als! decreased
@@@ 7 'hich categ!ry !" lia#ilities 5 e<&ities had the s%allest pr!p!rti!n in every year "r!% ()80/
,000D
a c&rrent lia#ilities
# de#t
c !ther n!n/c&rrent lia#ilities
d c!%%!n st!c$
e pre"erred st!c$ >
@@@ 8 =!r p&#lic US n!n"inancial "ir%s !ver the years ()80/,000, the c!%p!site %ar$et/t!/#!!$
e<&ity rati! generallyB
a increased "r!% ()80/,000 >
# decreased "r!% ()80/,000
c re%ained sta#le "r!% ()80/,000
@@@ ) 'hich gr!&ps !" US n!n"inancial "ir%s have the highest c!%p!site pr!p!rti!ns !" PP56 t! 8AD
a S5P -nd&strials
# S5P Eid4aps
c S5P S%all4aps
d S5P 8ransp!rts and Utilities >
@@@ (0 Acc!rding t! the c!%p!site s!&rces/and/&ses data presented in 4hapter (, the %ain net s!&rce !"
"&nds "!r US n!n"inancial "ir%s !ver the years ()80/,000 isB
a pr!ceeds "r!% de#t !""erings
# pr!ceeds "r!% e<&ity !""erings
c retained earnings 0net cash "l!w "r!% !perati!ns2 >
d sales !" invest%ents 0net !" increases in invest%ents2
@@@ (( :ver the ,0/year peri!d !" ()80/,000, the c!%p!site dividend yield !" p&#lic US n!n"inancial
"ir%s has generallyB
a increased
# decreased >
c re%ained
@@@ (, 8he !wnership str&ct&res !" %!st p&#licly traded US n!n"inancial "ir%s is #etter characteriGed
#y the ter%B
a cl!sely held
# di""&se >
*
+ssay *uestions
( =!r p&#lic US n!n"inancial "ir%sB Hisc&ss evidence !n changes in c!%p!site de#t rati!s !ver ti%e
0()80/,0002 and di""erences in c!%p!site de#t rati!s acr!ss types !" "ir%s 0at year/end ,0002
, =!r p&#lic US n!n"inancial "ir%sB Hisc&ss evidence !n changes in c!%p!site %ar$et/t!/#!!$ e<&ity
rati!s and c!%p!site PC6 rati!s !ver ti%e 0()80/,0002
+ =!r p&#lic US n!n"inancial "ir%sB Hisc&ss evidence !n changes in c!%p!site dividend pay!&t rati!
and c!%p!site dividend yields !ver ti%e 0()80/,0002
7
C * A P T E R .
Va$a%ion and Finan"ing
De"isions in an Idea
Capi%a &arke%
@@@ ( 'hich !" the "!ll!wing ass&%pti!ns !" an ideal 0!r per"ect2 capital %ar$et %!st cl!sely relates t!
the ass&%ed symmetry !" in"!r%ati!n set shared #y all "ir%s and all invest!rsD
a 4apital Ear$ets are "ricti!nless
# H!%!gene!&s e9pectati!ns >
c At!%istic c!%petiti!n
d 8he "ir% has a "i9ed invest%ent pr!gra%
e :nce ch!sen, the "ir%;s "inancing is "i9ed
@@@ , Until n!w, Helaware 6ast, -nc has #een an all/e<&ity "ir%A its %!st recent %ar$et e<&ity val&e
was I(00 %n, and its c!st !" e<&ity 0and c!st !" assets2 is (5F N!w, the "ir% decides t!
increase its leverage #y iss&ing I40 %n in de#t, with the pr!ceeds #eing &sed t! pay a
dividend t! shareh!lders 8he c!st !" the de#t is rHJ7F 'hat is the "ir%;s new c!st !" e<&ity
capital, acc!rding t! E!digliani and Eiller;s Pr!p!siti!n --D
a (5++F
# (8,0F
c ,0++F >
d ,,50F
=:REU3AB r6 J rA K 0HC62LrA / rHM
@@@ + Until n!w, Helaware 6ast, -nc has #een an all/e<&ity "ir%A its %!st recent %ar$et e<&ity
val&e was I80 %n, and its c!st !" e<&ity 0and c!st !" assets2 is (5F N!w, the "ir%
decides t! increase its leverage #y iss&ing I40 %n in de#t, with the pr!ceeds #eing &sed
t! pay a dividend t! shareh!lders 8he c!st !" the de#t is rHJ7F 'hat is the "ir%;s new
c!st !" e<&ity capital, acc!rding t! E!digliani and Eiller;s Pr!p!siti!n --D
a (5++F
# (8,0F
c ,0++F
d ,+00F >
=:REU3AB r6 J rA K 0HC62LrA / rHM
@@@ 4 =ir% NOP is c&rrently "inanced entirely with e<&ity 8he %ar$et val&e !" the "ir%;s assets and
e<&ity is QUJ6UJ500, and the e9pected ret&rn !n the "ir%;s assets and e<&ity is rAJr6J(,5F
S&pp!se the "ir% iss&es de#t with a val&e !" H3J ,00, and &ses the pr!ceeds t! retire e<&ity
8he %ar$et val&e !" the "ir% re%ains the sa%e, Q3J63KH3J500 -" the e9pected ret&rn !n the
de#t is rHJ7F, what is the e9pected ret&rn !n the "ir%;s levered e<&ityD
a (5++F
# (8,0F
c ,0++F
d ,+00F >
=:REU3AB r6 J rA K 0HC6320rA / rH2
8
@@@ 5 =!r the e<&ity !" Helaware 6ast, J(,5 -" the e9pected ret&rn !n the %ar$et is (5F and the
ris$/"ree rate is 5F, what is the e9pected ret&rn !n the "ir%;s e<&ityD
a (,50F
# (500F
c (750F >
d (875F
=:REU3AB ri J r" K iLr%/r"M
@@@ * 8he %ar$et val&e !" Helaware 6ast;s assets is I(00 %n 8he "ir% has !ne iss&e !" p&re/disc!&nt
de#t !&tstanding which pr!%ises t! pay I*0 %n in 5 years -" the standard deviati!n !" the
"ir%;s assets is ,,F and the ris$/"ree rate is 5F, what are the val&es !" the "ir%;s e<&ity
and de#t, #ased !n the .lac$/Sch!les %!delD
val&e !" e<&ity val&e !" de#t
a I54 %n I4* %n >
# I4* %n I54 %n
c I+8 %n I*, %n
d I+0 %n I70 %n
=:REU3AB 4JQ>N0d2 /
e
r
"
8
N>N0d/82, where dJ
ln0 C 2 L 0 C 2M Q N r 8
8
"
+ +
,
,
0Als! need 4&% N!r%al Histr =n ta#le2
@@@ 7 S&pp!se y!& devel!p a %&t&al "&nd that incl&des 500 NOS6 st!c$s, all with e<&al weights in
the "&nd;s p!rt"!li! 8he average standard deviati!n !" the st!c$s is +*F, and the
average pair/wise c!rrelati!n a%!ng the st!c$s is 040 'hat is y!&r esti%ate !" the
standard deviati!n !" the "&nd;s p!rt"!li!D
a ())F
# ,,8F >
c ,*,F
d +,(F
=:REU3AB
, C ( , ,
p
2M 0 > 2
N
(
( 0 2 0 >
N
(
L +
@@@ 8 S&pp!se y!& devel!p a %&t&al "&nd that incl&des 78 st!c$s, all with e<&al weights in the "&nd;s
p!rt"!li! 8he average standard deviati!n !" the st!c$s is 44F, and the average pair/wise
c!rrelati!n a%!ng the st!c$s is 0+0 'hat is y!&r esti%ate !" the standard deviati!n !"
the "&nd;s p!rt"!li!D
a ()5F
# ,45F >
c ,)5F
d +45F
=:REU3AB
, C ( , ,
p
2M 0 > 2
N
(
( 0 2 0 >
N
(
L +
)
@@@ ) Using the .in!%ial E!del, "ind the val&e !" a "ir%;s levered e<&ity 0632 given the "!ll!wing
val&esB QJ(00, &J(+, dJ(C&, pJ07, r"J5F, NJ(00, and 8J+
63
a +,+4
# ,7+4
c ,+)*
d (8)* >
=:REU3ASB
d
( 3
&
( 3
d
(
&
(
6 6
Q Q
A 6
3
J
8
"
&
( 3
&
(
2 r ( C0 6
(
Q M
(
L Q +
1
]
1

,
_
A
2 N Q , 0 %a90 6 2A N Q , 0 %a90 6
d
38
d
38
&
38
&
38

@@@ (0 Using the .in!%ial E!del, "ind the val&es !" a "ir%;s levered e<&ity 0632, and the e9pected ret&rn
!n the e<&ity, r36, given the "!ll!wing val&esB QJ(00, &J(+, dJ(C&, pJ07, r"J5F, NJ(00, and
8J+
63 r36
a +,+4 *),F
# +,+4 (074F
c (8)* *),F
d (8)* (074F >
=:REU3ASB
d
( 3
&
( 3
d
(
&
(
6 6
Q Q
A 6
3
J
8
"
&
( 3
&
(
2 r ( C0 6
(
Q M
(
L Q +
1
]
1

,
_
A
2 N Q , 0 %a90 6 2A N Q , 0 %a90 6
d
38
d
38
&
38
&
38
A
1
]
1

+
1
]
1
3
3
d
8
3
3
&
8
36
6
6 6
2 p ( 0
6
6 6
p r
@@@ (( 8he e9pected ret&rns !n the de#t and e<&ity !" a levered "ir% are r6J(5F and rHJ7F, and the
c&rrent %ar$et val&e !" the de#t and e<&ity are 6J** and HJ44, respectively 'hat is the
"ir%;s weighted average c!st !" capital 0'A442D
a 78F
# )8F
c ((8F >
d (+8F
=:REU3AB 'A44JrH0HCQ2Kr3606CQ2
@@@ (, 8he e9pected ret&rns and standard deviati!ns "!r st!c$s A and . are rAJ(4F and r.J()F,
respectively, and AJ,+F and .J+4F, respectively 8he c!rrelati!n !" the ret&rns !n the
tw! st!c$s is A.J0+ 'hat is the e9pected ret&rn, rP, and standard deviati!n, P, !" a
p!rt"!li! with weights !" wAJ0*0 and w.J040 in st!c$s A and ., respectivelyD
rP P
a (*F ,,(F >
# (*F ,48F
c (7F ,,(F
d (7F ,48F
=:REU3ASB rp J wArA K w. r.A pJ L
A. . A . A
,
.
,
.
,
A
,
A
w w , w w + + M
(C,

(0
@@@ (+ =!r y!&r retire%ent "&nd, y!& have decided t! place 40F !" y!&r c!ntri#&ti!ns int! a ris$"ree
asset that pays 4F interest per ann&%, and the re%aining *0F !" y!&r c!ntri#&ti!ns will
#e placed in an availa#le st!c$ %&t&al "&nd that appr!9i%ates the h!ldings !" the %ythical
market portfolio O!& e9pect this "&nd t! pr!vide an average ret&rn !" rPJ)F, #&t will e9p!se
y!& t! ris$, %eas&red in ter%s !" an esti%ated standard deviati!n !" PJ,0F 'hat is y!&r
esti%ate !" the e9pected ret&rn and standard deviati!n !" y!&r c!%plete p!rt"!li!, r4 and 4,
respectivelyD
rP P
a *F 5)F
# *F ,00F
c 7F (,0F >
d 7F ,00F
=:REU3ASB rc J w"r" K wprpA c J wpp J *0,0F2J(,F
@@@ (4 S&pp!se the #eta !" the st!c$ !" Eicr!s!"t, -nc is %s"tJ(45 -" r"J4F and rEJ)F, what is the
e<&ili#ri&% e9pected ret&rn !n Eicr!s!"t st!c$, r%s"t, acc!rding t! the 4APED As an analyst
!" the "ir%s in the high/techn!l!gy ind&stry, y!& e9pect Eicr!s!"t t! pr!vide a ret&rn !" (0F
!ver the ne9t year 4!%paring y!&r esti%ate with e<&ili#ri&% e9pected ret&rn !n Eicr!s!"t
that y!& R&st calc&lated, w!&ld y!& rec!%%end t! y!&r invest!rs that they #&y Eicr!s!"t
st!c$D
a OesB Eicr!s!"t is &nderpriced
# N!B Eicr!s!"t is !verpriced >
=:REU3AB r" K iLrE/r"M
+ssay *uestions
( =ir% NOP is c&rrently a privately held, all/e<&ity "ir% 8he "ir%;s shareh!lders are a#!&t t! sell
all !" the "ir%;s shares t! the p&#ic in an initial p&#lic !""ering 0-P:2 Ass&%ing that an !pti%al
capital str&ct&re that inv!lves a "inite pr!p!rti!n !" de#t e9ists "!r "ir% NOP, present an
arg&%ent that, even th!&gh the c&rrent shareh!lders will present an all/e<&ity "ir% t! the p&#lic, the
pr!ceeds that the c&rrent shareh!lders will receive will #e e<&al t! the val&e !" the "ir% at
its !pti%al capital str&ct&re
, S&pp!se a "ir% is "inanced entirely with e<&ity, and the c&rrent %ar$et val&e !" its assets and
e<&ity is QUJ6UJ(00 As an ar#itrage&r, y!& $n!w that i" the "ir% was capitaliGed with 50F
e<&ity and 50F de#t, the %ar$et val&es !" the de#t and e<&ity !" this levered versi!n !" the
"ir% w!&ld #e 63J*0 and H3J50, respectively 'hat w!&ld y!& d!D
ANS'6RB P&rchase the "racti!n !" the e<&ity !" the &nlevered "ir% at a c!st !" (00 Place
these shares in a tr&st, and iss&e de#t with a val&e !" H3J50 that is a clai% against the
shares in the tr&st, $eeping the pr!ceeds !" this de#t !""ering 8hen sell this Slevered; tr&st "!r a
price !" 63J*0 O!&r pr!"it will #e 050K*0/(002J(0
+ S&pp!se a "ir% is "inanced with 50F e<&ity and 50F de#t, and the c&rrent %ar$et val&e !" the
"ir% is Q3J(00, with 63J50 and H3J50 As an ar#itrage&r, y!& $n!w that i" the "ir% was
"inanced entirely with e<&ity, the %ar$et val&e !" its assets and e<&ity w!&ld #e QUJ6UJ(,5
'hat w!&ld y!& d!D
ANS'6RB P&rchase the "racti!n !" #!th the e<&ity and de#t !" this levered "ir% at a t!tal c!st
!" 63KH3J(00, place these sec&rities in a tr&st, and sell &nlevered e<&ity sec&rities
against this tr&st, which w!&ld yield pr!ceeds !" (,5 8h&s, y!&r pr!"it will #e 0(,5/(002
((
(,
C * A P T E R /
Separa%ion o, O0nership and
Con%ro1 Prin"ipa2Agen%
Con,i"%s1 and Finan"ia Poi"ies
@@@ ( 8ransacti!n c!sts and pers!nal ta9es %ay a""ect invest!rs; a#ility t! &nderta$e ar#itrage Als!, a
"ir%;s earnings are ta9ed, and interest pay%ents are ded&cti#le while dividends are n!t
8hese are e9a%ples !" the vi!lati!n !" which !" the ass&%pti!ns !" an ideal capital %ar$etD
a 4apital Ear$ets are "ricti!nless >
# H!%!gene!&s e9pectati!ns
@@@ , Qariati!n in pers!nal ta9 rates and transacti!n c!sts acr!ss #!th invest!rs and sec&rities %ay
di""erentially a""ect the val&es !" c!rp!rate sec&rities Als! a "ir% "aces s&#stantial
transacti!n c!sts in iss&ing sec&rities, which %ay inhi#it its a#ility t! &nderta$e !therwise
pr!"ita#le capital invest%ents 8hese are e9a%ples !" the vi!lati!n !" which !" the
ass&%pti!ns !" an ideal capital %ar$etD
a 4apital Ear$ets are "ricti!nless >
@@@ + Information asymmetry is chie" a%!ng vi!lati!ns !" which !" the ass&%pti!ns !" an ideal capital
%ar$etD
# H!%!gene!&s e9pectati!ns >
@@@ 4 An individ&al invest!r has either s&""icient wealth !r s&""icient #!rr!wing capacity t! p&rchase !r
sell a s&#stantial pr!p!rti!n !" a given "ir%;s sec&rities, s! that invest!r;s trades %ay a""ect the
%ar$et val&e !" these sec&rities 8his is an e9a%ple !" the vi!lati!n !" which !" the
ass&%pti!ns !" an ideal capital %ar$etD
c At!%istic c!%petiti!n >
(+
@@@ 5 :ne principal/agent c!n"lict is that #etween a "ir%;s credit!rs 0as a principal2 and its
shareh!lders 0as agent2 =!r e9a%ple, a"ter iss&ing ris$y de#t, st!c$h!lders have an incentive
t! increase the ris$iness !" the "ir%;s assets 0eg, #y changing !perating strategy2, which w!&ld
tend t! e9pr!priate wealth "r!% credit!rs t! st!c$h!lders 'hich !" the ass&%pti!ns !" an ideal
capital %ar$et is vi!lated in this e9a%pleD
d 8he "ir% has a "i9ed invest%ent pr!gra% >
@@@ * A "ir% initially "inances its assets with speci"ied pr!p!rti!ns !" de#t and e<&ity, and then later
iss&es additi!nal de#t, &sing the pr!ceeds t! pay a dividend t! shareh!lders -" the new de#t
has the sa%e pri!rity as the !riginal de#t, the val&e !" the !riginal de#t will pr!#a#ly "all, an
e""ect called claim dilution 'hich !" the ass&%pti!ns !" an ideal capital %ar$et is vi!lated in
this e9a%pleD
e :nce ch!sen, the "ir%;s "inancing is "i9ed >
@@@ 7 8he tw! %!st "&nda%ental aspects !" a c!rp!rati!n 0as a "!r% !" #&siness !rganiGati!n2 that lead
t! n!t !nly tre%end!&s ec!n!%ies !" scale and sc!pe 0as a p!sitive2 #&t als! are lin$ed t! the
"inancing pr!#le%s that we address in the c!&rse 0as a negative2 areB
a the separati!n !" !wnership and c!ntr!l ANH private !wnership
# li%ited lia#ility ANH private !wnership
c the separati!n !" !wnership and c!ntr!l ANH li%ited lia#ility >
d private !wnership ANH leverage
@@@ 8 N&triti!n, -nc, a vita%in s&pple%ent %an&"act&rer, is "inanced entirely with e<&ity that is
c&rrently privately !wned #y its %anagers 8he "ir% is e9pected t! generate earnings !" I5
%illi!n per year int! perpet&ity, and all earnings are paid !&t in dividends 8he !wner/
%anagers receive n! additi!nal c!%pensati!n =!r all !" the !wner/%anagers, their shares !"
the "ir%;s e<&ity acc!&nt "!r the #&l$ !" their pers!nal wealth As a res&lt, in deter%ining
their pers!nal val&ati!n !" the "ir% they apply a high disc!&nt rate !" ++F t! their "&t&re
e9pected dividends, and th&s they val&e the "ir% at I(5(5 %n 0JI5 %nC0++2
8he %anage%ent tea% has recently c!ns&lted with an invest%ent/#an$ing "ir% a#!&t selling all
!" the "ir%;s e<&ity p&#liclyA that is, a#!&t going pulic with the "ir%;s shares Ass&%ing
that the c&rrent %anage%ent will c!ntin&e t! !perate the "ir%, the invest%ent #an$er esti%ates that
the %ar$et will val&e the "ir%;s e<&ity #y applying a ,5F disc!&nt rate t! e9pected "&t&re
dividends H!wever, e9pected dividends t! p&#lic shareh!lders will #e !nly I4 %n, #eca&se
%anagers will n!w #e paid a t!tal !" I( %n per year in salaries -gn!ring ta9es and transacti!n
c!stsB the %ar$et val&e !" the "ir%;s p&#lic shares is @@@0i2@@@A the present val&e !"
%anage%ent;s salaries 0disc!&nted at ++F int! perpet&ity2 is @@@0ii2@@@ A and there"!re the
%anage%ent tea%;s wealth gain 0!r l!ss2 "r!% g!ing p&#lic is @@@0iii2@@@
@@@0i2@@@ @@@0ii2@@@ @@@0iii2@@@
a I(, %n I+0+ %n /I0(, %n
# I(* %n I+0+ %n I4(, %n >
c I(* %n I4 %n I485 %n
d I(, %n I4 %n I085 %n
(4
@@@ ) All !" the "!ll!wing were %enti!ned in the te9t as %eans #y which the %anager !" a "ir% %ay
increase his !r her c!%pensati!n 0!n a sel"/serving #asis2 6N46P8B
a having the "ir% p&rchase his/her principal private residence >
# e9cessive c!ns&%pti!n !" per<&isites
c %anip&lati!n !" earnings and dividends
d %a9i%iGing the siGe !" the "ir%, rather than its val&e
@@@ (0 All !" the "!ll!wing were %enti!ned in the te9t as %eans #y which the %anager !" a "ir% %ay
decrease the his !r her pers!nal e9p!s&re t! the "ir%;s ris$ 0!n a sel"/serving #asis2 6N46P8B
a e9cessive c!rp!rate diversi"icati!n
# #ias t!ward invest%ents with near/ter% pay!""s
c sec&ring his !r her li"eti%e c!%pensati!n with a pr!perty/cas&alty ins&rance p!licy
p&rchased #y the "ir% >
d &ndere%pl!y%ent !" de#t
e %anage%ent entrench%ent
" pac$ing the #!ard
@@@ (( S&pp!se a "ir%;s initial para%eter val&es areB QJ500, NJ+00, 8J+, r"J,F,
&
+
Q J750, and
d
+
Q J+++++ 4!%p&te the c&rrent val&es !" the "ir%;s de#t and levered e<&ity, H and
63, respectively
H 63
a ,8,7 ,(7+ >
# ,5,7 ,47+
c ,,,7 ,77+
d ,007 +00+
=:REU3ASB J
d
38
&
38
d
8
&
8
6 6
Q Q
A 63 J
8
"
&
38
&
8
2 r ( C0 6
(
Q M
(
L Q +
1
]
1

,
_
A
2 N Q , 0 %a90 6 2A N Q , 0 %a90 6
d
38
d
38
&
38
&
38

@@@ (, 4!ntin&ing with the n&%#ers "r!% the previ!&s <&esti!n, c!%p&te new val&e !" the "ir%;s
levered e<&ity,
>
3
6 , a"ter the "!ll!wing acti!ns #y the "ir%;s %anage%entB Eanage%ent
iss&es additi!nal p&re/disc!&nt de#t which has a pr!%ised pay%ent !" N;J*,( at 8J+ and has
the sa%e pri!rity as the "ir%;s !riginal de#t 8he "ir% receives t!tal pr!ceeds !" 500 "!r the
new de#t Eanage%ent &ses the pr!ceeds t! d!&#le the "ir%;s !perati!ns &nder identical
c!nditi!ns, s&ch that Q>J(,000,
> &
5
Q
J(,500, and
> d
5
Q
J****7

>
3
6
a ,(7+
# ,58+ >
c ,)8+
d ++8+
=:REU3ASB
d
38
&
38
d
8
&
8
6 6
Q Q
A 6
3
J
8
"
&
38
&
8
2 r ( C0 6
(
Q M
(
L Q +
1
]
1

,
_
A
2 N Q , 0 %a90 6 2A N Q , 0 %a90 6
d
38
d
38
&
38
&
38

(5
@@@ (+ 8he c&rrent val&e !" levered "ir% A.4, -nc is I(00 %illi!n -ts capital str&ct&re c!nsists !"
e<&ity and p&re disc!&nt de#t !n which a pay%ent !" I80 %n is d&e in 5 years 8he ris$/"ree rate
is 5F Using the .lac$/Sch!les :pti!n Pricing E!del, the val&e !" the "ir%;s e<&ity is @@@0i2@@@
i" J,0F, and is @@@0i2@@@ i" J40F Ass&%ing that the increase in was a deli#erate acti!n !"
the "ir%;s %anage%ent designed t! e9pr!priate wealth "r!% #!ndh!lders t! st!c$h!lders, what
was the val&e !" this e9pr!priati!nD
@@@0i2@@@ @@@0ii2@@@ @@0iii2@@
a I40+ %n I40+ %n I0
# I+++ %n I504 %n I(7( %n
c I+++ %n I40+ %n I70 %n
d I40+ %n I504 %n I(0( %n >
08he .S:PE "!r%&la and val&es !" the c&%&lative n!r%al distri#&ti!n "&ncti!n, %&st #e
s&pplied2
+ssay *uestions
( .rie"ly disc&ss the e""ects !" vi!lati!ns !" each !" the ass&%pti!ns !" the -deal 4apital Ear$et listed
#el!w
0a2 Ass&%pti!n (B =ricti!nless Ear$etsA
0#2 Ass&%pti!n ,B All %ar$et participants share h!%!gene!&s e9pectati!nsA
0c2 Ass&%pti!n +B At!%istic c!%petiti!nA
0d2 Ass&%pti!n 4B 8he "ir%;s capital invest%ent pr!gra% i" "i9ed and $n!wnA
0e2 Ass&%pti!n 5B :nce ch!sen, the "ir%;s "inancing is "i9ed
, 69plain the tw! %aR!r #ene"its t! shareh!lders !" the separati!n !" !wnership and c!ntr!l
+ 3ist and #rie"ly disc&ss the sel"/serving acti!ns that %anage%ent %ay ta$e t!B
0a2 increase their c!%pensati!n
0#2 decrease the ris$ !" their pers!nal p!rt"!li!s
4 3ist and #rie"ly disc&ss three acti!ns that %anage%ent can ta$e t! e9pr!priate wealth "r!% the "ir%;s
de#th!lders t! the "ir%;s shareh!lders
5 H!w d! li%ited lia#ility and the separati!n !" !wnership and c!ntr!l re"lect ris$ aversi!n !n the part
!" the !wners !" 0e<&ity2 capitalD
* 'hy is the separati!n !" !wnership and c!ntr!l a virt&al necessity "!r the s&ccess"&l "inancing !"
large c!rp!rati!nsD
7 69plain the tw! %aR!r #ene"its t! shareh!lders !" the separati!n !" !wnership and c!ntr!l
8 'hat are the three p!sitive e""ects !" shareh!lders; diversi"icati!n acr!ss "ir%s !n the %ar$et val&e !"
a "ir%;s sharesD
) 'hy is the separati!n !" !wnership and c!ntr!l partic&larly i%p!rtant "!r a "ir% that !perates in an
e9tre%ely c!%petitive pr!d&ct %ar$etD 8hat is, what is a critical r!le !" %anage%ent &nder s&ch
circ&%stancesD
(0 He"ine the classical !#Rective "&ncti!n !" %anage%ent, and descri#e a set !" circ&%stances in which it
is the appr!priate !#Rective "!r %anage%ent t! "!ll!w in !rder t! act in the shareh!lders; interest
(*
(( H!w d!es the sta$eh!lder the!ry !" the "ir% in"l&ence !&r &nderstanding !" the !#Rective "&ncti!n !"
%anage%entD 'hat is the revised !#Rective &nder these circ&%stancesD
(, 3ist and #rie"ly disc&ss three sel"/serving acti!ns that %anage%ent %ay ta$e t! increase their
c!%pensati!n
(+ 3ist and #rie"ly disc&ss "ive sel"/serving acti!ns that %anage%ent %ay ta$e t! decrease the ris$ !"
their pers!nal p!rt"!li!s
(4 3ist and #rie"ly disc&ss three acti!ns that %anage%ent can ta$e t! e9pr!priate wealth "r!% the "ir%;s
de#th!lders t! the "ir%;s shareh!lders
(5 'hat is empire uildingD 'hy d!es it see% t! #e s&ch a c!%pelling g!al "!r %anagersD
(* 69plain the underin!estment prolem "!r a "ir% that has ris$y de#t !&tstanding, !therwise $n!wn as
the det"o!erhang pr!#le%
(7
C * A P T E R 3
In,or4a%ion As'44e%r'
And %he &arke%s ,or
Corpora%e Se"$ri%ies
@@@ ( As A$erl!" arg&es, sellers wh! have a lemon, !" c!&rse, $n!w they have le%!n #&t are n!t
willing t! tell the tr&th a#!&t the c!nditi!n !" their a&t! and, "!r the sh!rt selling peri!d
inv!lved, can p&t their a&t! in a satis"act!ry c!nditi!n that appr!9i%ates the n!r%al c!nditi!n
!" the a&t! that are n!t le%!ns -n s&#se<&ent literat&re, this pr!#le% called the @@@@@@@@@@
pr!#le%
a in"!r%ati!nal asy%%etry
# agency
c %!ral haGard >
d certi"icati!n
@@@ , A$erl!" als! disc&sses the pr!#le% !" @@@@@@@ in the health ins&rance %ar$et Health ins&rers
atte%pt t! esti%ate, "!r each individ&al ins&rance applicant, the pr!#a#ility that they will "ile
an ins&rance clai%, and price ins&rance pre%i&%s acc!rdingly H!wever, this is an i%per"ect
pr!cess, s! the ins&rer %&st !""er a c!%%!n pre%i&% t! a speci"ied gr!&p !" individ&als that
re"lects the a!erage health !" the individ&als in the gr!&p, even th!&gh the individ&als in the
gr!&p di""er in ter%s !" their health and th&s the pr!#a#ility !" a clai% 6ach individ&al $n!ws
their !wn health #etter than the ins&rer, s! th!se %e%#ers !" the gr!&p wh! are less healthy 0and
th&s %!re li$ely t! "ile a clai%2 will #e %!re li$ely t! p&rchase ins&rance p!licy, and th&s the
pre%i&% set #y the ins&rer t! re"lect the average health !" the entire gr!&p will #e inade<&ate t!
c!%pensate the ins&rer "!r the ex post s&#/gr!&p !" individ&als that act&ally p&rchase a p!licy
a adverse selecti!n >
# certi"icati!n
c %!ral haGard
d in"!r%ati!nal asy%%etry
@@@ + 'hich !" the "!ll!wing was N:8 %enti!ned #y A$erl!" t! %itigate the le%!ns pr!#le%D
a certi"icati!n
# &sing a c!stly signal
c private neg!tiati!n >
d esta#lishing a rep&tati!n
e c!ntract en"!rce%ent
@@@ 4 Acc!rding t! the "inance literat&re related t! in"!r%ati!nal asy%%etry, !ne !" the %!st i%p!rtant
r!les !" an invest%ent/#an$ing "ir% 0in ter%s !" assisting a "ir% in iss&ing sec&rities t! the
p&#lic2 is t! v!&ch "!r the val&e !" the sec&rity, a"ter it has !#tained c!n"idential
in"!r%ati!n "r!% the "ir%;s %anage%ent a#!&t its #&siness strategy 8his v!&ching is
$n!wn asB
a certi"icati!n >
# &sing a c!stly signal
c private neg!tiati!n
(8
d esta#lishing a rep&tati!n
e c!ntract en"!rce%ent
@@@ 5 3eland and Pyle 0()772 e9a%ine the e""ect !" in"!r%ati!nal asy%%etries !n e<&ili#ri&%
c!rp!rate val&ati!n and "inancial str&ct&re 8he a&th!rs devel!p a signaling %!del and w!r$
thr!&gh a speci"ic e9a%ple, "!c&sing !n !pti%al de#t levels &nder c!nditi!ns !"
asy%%etric in"!r%ati!n -n their signaling %!del, an entreprene&r see$s "inancing "!r a
pr!Rect wh!se tr&e val&e is $n!wn !nly t! hi% 4learly, direct trans"er !" in"!r%ati!n t! lenders
is i%p!ssi#le -n"!r%ati!n %ay, h!wever, #e trans"erred #y a credi#le signal Here, the
signal isB
a the entreprene&r;s willingness t! incl&de de#t in the "ir%;s capital str&ct&re
# the willingness !" the entreprene&r t! invest in his !wn pr!Rect >
c the entreprene&r;s a#ility t! attract private e<&ity capital
d the entreprene&r;s e9pressed willingness t! re%ain as a %anager !" the "ir%
@@@ * Eiller and R!c$ 0()852 devel!ped an ingeni!&s signaling %!del in which @@@@@@@@ #y a "ir%
serve as p!wer"&l signals !" the "ir%;s earnings capacity, and th&s its val&e Any s&ch
@@@@@@@ reveal that the "ir% has #een generating, and is e9pected t! c!ntin&e t! generate, high
net cash in"l!ws
a cash pay!&ts >
# de#t iss&ance
c e<&ity iss&ance
d earnings ann!&nce%ents
@@@ 7 8he leading piece !" the!retical research in c!rp!rate "inance is Eyers and EaRl&" 0()842 8hey
sh!wed that when there is in"!r%ati!n asy%%etry #etween the %ar$et and %anagers, a
pecking order e%erges in ter%s !" h!w the "ir% sh!&ld !#tain "&nds "!r capital invest%ents
Speci"ically, a "ir% w!&ld pre"er t! &seB
a de#t, then retained earnings, and "inally !&tside e<&ity
# retained earnings, then de#t, and "inally !&tside e<&ity >
c retained earnings, then !&tside e<&ity, and "inally de#t
d de#t, then !&tside e<&ity, and "inally retained earnings
+ssay *uestions
( .rie"ly e9plain the lemons prolem as presented #y A$erl!"
, .rie"ly e9plain the &se"&lness !" each !" the "!ll!wing %eans !" %itigating the e""ects !"
in"!r%ati!nal asy%%etry in the credit %ar$etsB
a ScreeningA
# 4erti"icati!nA
c 4!stly SignalingA
d Rep&tati!n
e Hiscl!s&re r&les
+ -n 3eland and Pyle;s %!del !" the e""ects !" in"!r%ati!nal asy%%etry !n !wnership str&ct&reB
a 'hat is the costly signal e%pl!yed #y the entreprene&rD
# -n what sense is this a costly signal "!r the entreprene&rD and h!w d!es this signal lead t!
separating e<&ili#ria that %itigates the in"!r%ati!nal asy%%etry pr!#le%D
4 .rie"ly e9plain the lemons prolem as presented #y A$erl!"
()
5 -n ec!n!%ic %!dels "!c&sing !n in"!r%ati!nal asy%%etry, h!w d! we generally interpret the price !"
a given asset in a pooling e#uiliriumD H!w w!&ld y!& descri#e the set !" prices in a separating
e#uiliriumD
* Hescri#e the pr!#le% !" moral ha$ard in the %ar$et "!r an asset "ra&ght with in"!r%ati!nal
asy%%etry and &n!#serva#le variati!ns in the <&ality !" the asset
7 Hescri#e the pr!#le% !" ad!erse selection in the ins&rance %ar$et
8 .rie"ly e9plain the &se"&lness !" each !" the "!ll!wing %eans !" %itigating the e""ects !"
in"!r%ati!nal asy%%etry in the credit %ar$etsB
a ScreeningA
# 4erti"icati!nA
c 4!stly SignalingA
d Rep&tati!n
e Hiscl!s&re r&les
) 3ist and #rie"ly e9plain the three c!nditi!ns re<&ired in !rder "!r ex post c!ntract en"!rce%ent t! #e
an e""ective %eans t! %itigate the lemons prolem in credit %ar$ets
(0 -n 3eland and Pyle;s %!del !" the e""ects !" in"!r%ati!nal asy%%etry !n !wnership str&ct&reB
a 'hat is the costly signal e%pl!yed #y the entreprene&rD
# -n what sense is this a c!stly signal "!r the entreprene&r, and h!w d!es this signal lead t!
separating e<&ili#ria that %itigates the in"!r%ati!nal asy%%etry pr!#le%D
(( Hisc&ss the pecking order hyp!thesis !" c!rp!rate "inancing as Eyers 0()842 de"ined it
(, Hisc&ss Eyers and EaRl&";s 0()842 the!retical %!del that rati!naliGes the pec$ing !rder hyp!thesis in
the c!nte9t !" in"!r%ati!nal asy%%etry
,0
C * A P T E R 5
The Roes o, 6o)ern4en%1
Se"$ri%ies &arke%s1 Finan"ia
Ins%i%$%ions1 O0nership
S%r$"%$re1 Board O)ersigh%1
and Con%ra"% De)i"es
@@@ ( Under the Sec&rities 69change Act !" ()+4, 4!ngress created the Sec&rities and 69change
4!%%issi!n 0the SS64;2 8he S64;s %issi!n is t! ad%inister "ederal sec&rities laws and
iss&e r&les and reg&lati!ns t! pr!vide pr!tecti!n "!r invest!rs and t! ens&re that the sec&rities
%ar$ets are "air and h!nest 8his is acc!%plished primarily #yB
a creating a nati!nal syste% !" sec&rities #r!$ers and dealers
# re<&iring p&#lic "ir%s t! discl!se acc&rate and ti%ely in"!r%ati!n t! the investing p&#lic >
c creating a syste% !" ar#itrati!n #!ards t! pr!vide R&dg%ents !n invest!rs; c!%plaints
d reg&lating the trading pr!ced&res in US sec&rities %ar$ets
@@@ , Eeans #y which the sec&rities %ar$ets serve t! %itigate principal/agent !r in"!r%ati!n
asy%%etry pr!#le%s incl&de all !" the "!ll!wing 6N46P8B
a Eanage%ent realiGes that its reputation with invest!rs is val&a#le, and can #e s&stained !nly
i" acc&rate in"!r%ati!n is pr!vided !n a ti%ely #asis
# Qari!&s %ar$et %echanis%s e9ist t! discipline a "ir%;s %anage%ent, and th&s t! %itigate
c!n"licts !" interest #etween %anage%ent and shareh!lders :ne !" the %!st p!wer"&l is
the threat !" a h!stile ta$e!ver !" the "ir%, a"ter which %anage%ent is "ired
c 69changes s&ch as the NOS6 reg&larly p&#lish lists !" "ir%s that appear t! #e !verval&ed
#eca&se their %anage%ent is p!!r >
@@@ + =inancial instit&ti!ns 0s&ch as c!%%ercial #an$s and "inance c!%panies2 play an i%p!rtant r!le
in %itigating in"!r%ati!n asy%%etry pr!#le%s in "inancial %ar$ets #eca&seB
a they re<&ire a p!tential #!rr!wer t! discl!se c!n"idential in"!r%ati!n a#!&t their pr!Rect t!
the p&#lic #e"!re they are appr!ved "!r a l!an
# they reg&larly receive private in"!r%ati!n "r!% the "ir% a#!&t the <&ality !" the "ir%;s
pr!Rects, and yet will $eep s&ch in"!r%ati!n c!n"idential >
c they lend !nly t! "ir%s that d! n!t s&""er "r!% in"!r%ati!n asy%%etry pr!#le%s
@@@ 4 A "ir%;s #!ard !" direct!rs has a variety !" t!!ls at its disp!sal t! c!ntr!l %anage%ent;s
activities, incl&ding all !" the "!ll!wing 6N46P8B
a 4!ntr!lling the "ir%;s capital str&ct&re
# Re<&iring #!ard appr!val !" %aR!r capital e9pendit&res, ac<&isiti!ns, divestit&res, sec&rity
!""erings, etc
c re<&iring #!ard appr!val !" all %ergers and ac<&isiti!ns
d hiring !&tside c!ns&ltants t! scr&tiniGe %aR!r pr!Rects
e "iring the 46:
" A33 := 8H6 A.:Q6 AR6 8::3S AQA-3A.36 8: 8H6 .:ARH >
,(
@@@ 5 8! %itigate deadweight c!sts ass!ciated with the shareh!lder/%anage%ent principal/agent
c!n"lict, s!%e invest!rs #ec!%e %aR!r shareh!lders and atte%pt t! in"l&ence %anage%ent t!
act in the #est interest !" shareh!lders 8his is an e9a%ple !"B
a a ta$e!ver
# shareh!lder activis% >
c pac$ing the #!ard
d principal interventi!n
+ssay *uestions
( H!w can a "ir%;s internal c!ntr!l %echanis%s, partic&larly a "ir%;s #!ard !" direct!rs, #e #r!&ght t!
#ear t! ens&re that the "ir%;s %anage%ent acts in the shareh!lders; interestD
, 3ist and #rie"ly disc&ss the e9ternal and internal g!vernance gr!&ps that c!nstrain the sel"/interested
#ehavi!r !" a p&#lic "ir%;s %anage%ent
+ Hescri#e vari!&s %eans #y which contract specifications can #e &sed t! %itigate agency c!sts !"
de#t
4 Hescri#e vari!&s %eans #y which contract specifications can #e &sed t! %itigate agency c!sts !"
%anagerial discreti!n
5 Hisc&ss an e9a%ple each !" a c!ntract that c!&ld #e &sed t! %itigate principal/agent c!n"licts
#etweenB
0a2 shareh!lders and %anage%entA and
0#2 shareh!lders and #!ndh!lders
* .rie"ly disc&ss the c!ntent !" the Sec&rities Acts !" ()++ and ()+4 and their relati!nship t! the
"&nda%ental c!rp!rate "inance pr!#le%s 0ie, principal/agent c!n"licts and in"!r%ati!n asy%%etry2
7 Hescri#e vari!&s %eans #y which the sec&rities %ar$ets the%selves %itigate agency and
in"!r%ati!nal asy%%etry pr!#le%s
8 H!w d! "inancial instit&ti!ns help t! res!lve in"!r%ati!nal asy%%etry pr!#le%s ass!ciated with a
"ir%;s iss&ance !" sec&ritiesD
) H!w d! "inancial instit&ti!ns help t! %itigate c!n"licts !" interest #etween a "ir%;s 0di""&se2
shareh!lders and its %anage%entD
(0 Hisc&ss the r!le !" c!n"identiality in the c!nte9t in which a "ir% see$s the assistance !" a "inancial
instit&ti!n t! raise de#t !r e<&ity capital
(( H!w d!es the in"!r%ati!n/pr!d&cti!n "&ncti!n !" a "inancial instit&ti!n serve t! %!nit!r a "ir%;s
%anage%entD
(, Hescri#e the t!!ls availa#le t! a "ir%;s #!ard !" direct!rs t! discipline %anage%ent in !rder t!
%itigate c!n"licts !" interest #etween the shareh!lders and %anage%ent !" a "ir%
(+ Hescri#e vari!&s %eans #y which c!ntract speci"icati!ns can #e &sed t! %itigate c!rp!rate "inancing/
related pr!#le%s
,,
C * A P T E R 7
The 8e)erage De"ision
@@@ ( 4!%p&te the present val&e !" the ta9 shield generated when S%ith 4!%pany iss&es I(00 %n in
perpet&al de#t with an 8F c!&p!n rate, and &ses the pr!ceeds t! retire e<&ity 8he c!rp!rate
ta9 rate is +4F
a I,7, %n
# I8 %n
c I+4 %n >
d ,7, %n
@@@ , -n this pr!#le%, we ad%it !nly !ne real"world factor in an !therwise ideal capital %ar$et 8his
real w!rld "act!r is c!rp!rate ta9ati!nA speci"ically that interest pay%ents !n de#t are
ded&cti#le while dividend pay%ents are n!t ded&cti#le S&pp!se Helaware 6ast, -nc has &ntil
n!w #een an all/e<&ity "ir% with a %ar$et val&e !" I(00 %n N!w, the "ir% decides t!
increase its leverage #y iss&ing I40 %n in de#t, with the pr!ceeds #eing &sed t! pay a dividend
t! shareh!lders Ass&%ing that this de#t will #e a per%anent part !" the "ir%;s capital
str&ct&re, and that the "ir%;s ta9 rate is +4F, and acc!&nting "!r the ded&cti#ility !" the interest !n
the de#t, what is the t!tal %ar$et val&e !" the "ir% a"ter the recapitaliGati!nD
a I((+* %n >
# I(00 %n
c I7+* %n
d I(+* %n
=:REU3AB Q3JQUKcH
@@@ + 8he val&e !" J!nes 4!%pany as an &nlevered "ir% is QUJ+00 H!wever, J!nes 4!%pany has
perpet&al de#t !&tstanding with a val&e !" HJ(50 8he rate !n the "ir%;s de#t is rHJ7F 8he
"ir%;s ta9 rate is 4J+4F 8he "ir%;s e9pected ann&al a"ter/ta9 cash "l!w t! shareh!lders and
#!ndh!lders c!%#ined is A84=JI40, int! perpet&ity 4!%p&te the "ir%;s val&e,
>
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adR&sted c!st !" capital,
>
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>
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>
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>
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>
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r
a +00 ((4F (47F
# +00 (00F (+0F
c +00 ((4F (+0F
d +5( ((4F (47F >
e +5( ((4F (+0F
" +5( (00F (+0F
=:REU3ASB
>
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>
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>
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,+
@@@ 4 8he val&e !" J!nes 4!%pany as an &nlevered "ir% is QUJ,00 H!wever, J!nes 4!%pany has
perpet&al de#t !&tstanding with a val&e !" HJ)0 8he rate !n the "ir%;s de#t is rHJ7F 8he
"ir%;s ta9 rate is 4J+4F 8he "ir%;s e9pected ann&al a"ter/ta9 cash "l!w t! shareh!lders
and #!ndh!lders c!%#ined is A84=JI,5 4alc&late the "ir%;s val&e,
>
3
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!" capital,
>
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>
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r
>
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>
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r
>
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r
a ,+0* (084F ((+F
# ,+0* (444F (,+F
c ,+0* (084F (++F >
d ,*80 (084F ((+F
e ,*80 (444F (,+F
" ,*80 (084F (++F
=:REU3AB
>
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>
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>
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6
@@@ 5 8he tradeoff in the traditi!nal trade!"" the!ry !" !pti%al capital str&ct&re is #etweenB
a agency c!sts !" de#t and in"!r%ati!n asy%%etry c!sts !" de#t
# the ta9 #ene"it !" de#t and the e9pected c!sts !" "&t&re "inancial distress >
c the ta9 #ene"it !" de#t and agency c!sts !" de#t
@@@ * =ir% NOP is c&rrently "inanced entirely with e<&ity that has a t!tal %ar$et val&e !" I)00 %n
8he "ir%;s %anage%ent is c!nsidering engaging in a de#t/"!r/e<&ity swap t! add leverage t!
the "ir%;s capital str&ct&re Eanage%ent rec!gniGes tw! "act!rs that w!&ld a""ect the
val&e !" the "ir% as leverage is added =irst, the additi!n !" per%anent de#t in the a%!&nt
!" H w!&ld pr!vide a ta9 shield that has a val&e !" cH, where "!r "ir% NOP cJ0+4,
!r +4F 8he sec!nd, and !""setting, "act!r is the present val&e !" e9pected c!sts !" "&t&re
"inancial distress, PQL%04==H2M, which increases at an accelerating rate with leverage
Eanage%ent decides that the relati!nship !" PQL%04==H2M t! leverage can #e
appr!9i%ated with the "!ll!wing e<&ati!nB PQL%04==H2MJH
,
, where J00005 Tiven
these speci"icati!ns, "ind the val&e !" de#t, H>, that w!&ld %a9i%iGe the val&e !" "ir%
NOP 'hat is the %ar$et val&e !" the "ir%,
>
3
Q , i" it has this a%!&nt !" de#tD
H>
>
3
Q
a +40 I(,0(5*
# +40 I)578 >
c 500 I)450
d 500 I)0)8
,4
@@@ 7 =ir% NOP is c&rrently "inanced entirely with e<&ity that has a t!tal %ar$et val&e !" I)00 %n
8he "ir%;s %anage%ent is c!nsidering engaging in a de#t/"!r/e<&ity swap t! add leverage t!
the "ir%;s capital str&ct&re Eanage%ent rec!gniGes tw! "act!rs that w!&ld a""ect the
val&e !" the "ir% as leverage is added =irst, the additi!n !" per%anent de#t in the a%!&nt
!" H w!&ld pr!vide a ta9 shield that has a val&e !" cH, where "!r "ir% NOP cJ0+4,
!r +4F 8he sec!nd, and !""setting, "act!r is the present val&e !" e9pected c!sts !" "&t&re
"inancial distress, PQL%04==H2M, which increases at an accelerating rate with leverage
Eanage%ent decides that the relati!nship !" PQL%04==H2M t! leverage can #e
appr!9i%ated with the "!ll!wing e<&ati!nB PQL%04==H2MJH
,
, where J000( Tiven
these speci"icati!ns, "ind the val&e !" de#t, H>, that w!&ld %a9i%iGe the val&e !" "ir%
NOP 'hat is the %ar$et val&e !" the "ir%,
>
3
Q , i" it has this a%!&nt !" de#tD
H>
>
3
Q
a (00 I)480
# +40 I)578
c (70 I)578
d (70 I),8) >
@@@ 8 Acc!rding t! the @@@@@@@@@@@ hyp!thesis, sh!rt/ter% assets sh!&ld #e "inanced with sh!rt/ter%
capital and l!ng/ter% assets with l!ng/ter% capital
a %at&rity %atching >
# hedging
c ris$/ret&rn
d capital asset
@@@ ) 8he @@@@@@@@@ hyp!thesis is stated as "!ll!wsB A%!ng l!ng/ter% assets, the "ir% sh!&ld "inance
l!ng/ter% tangi#le assets, s&ch as PP56, with l!ng/ter% de#t, while !ther l!ng/ter% assets,
s&ch as invest%ents and intangi#les, %&st #e "inanced with e<&ity
a tangi#le asset
# de#t/e<&ity
c c!llateral >
d =isher
@@@ (0 8he c&rrent %ar$et val&e !" the assets !" levered "ir% A.4, -nc is I(00 %illi!n 8he ann&al
standard deviati!n !" ret&rns !n the assets is +0F 8he "ir%;s capital str&ct&re c!nsists !" e<&ity
and p&re disc!&nt de#t "!r which pay%ent !" I80 %illi!n is d&e in 5 years 8he ris$/"ree rate is
5F Using the .lac$/Sch!les :pti!n Pricing E!del t! calc&late the val&e !" the "ir%;s de#t
a I44
# I55 >
c I**
d I77
08he .S:PE "!r%&la and c&%&lative n!r%al distri#&ti!n "&ncti!n val&es %&st #e s&pplied2
+ssay *uestions
( Hisc&ss 0in w!rds2 and descri#e 0with a graph2 the Miller e#uilirium regarding !pti%al capital
str&ct&re
, Hescri#e the #asic "eat&res !" the -RS ta9 c!de as it applies t! #!th c!rp!rati!ns and individ&als
,5
+ -n a w!rld with c!rp!rate ta9es, e9plain h!w the g!vern%ent #ec!%es a sta$eh!lder in each "ir%
h!w ris$y is the g!vern%ent;s clai% !n a "ir%;s earningsD
4 Hescri#e the &nderinvest%ent, !r de#t/!verhang, pr!#le%, and speci"y the circ&%stances &nder
which it can a""ect a "ir%;s &se !" de#t "inancing
5 3ist and #rie"ly e9plain the real/w!rld "act!rs thatB
a ind&ce a positi!e relati!nship #etween "ir% val&e and leverageA and
# ind&ce a negati!e relati!nship #etween "ir% val&e and leverage
* Hisc&ss 0in w!rds2 and descri#e 0with e<&ati!n0s2 and a graph2 the Miller %#uilirium
7 69plain why the c!rrect "!r%&la "!r a "ir%;s a"ter/ta9 'A44 is given #y e<&ati!n 0(2 #el!w rather
than e<&ati!n 0,2 #el!wB
6<&ati!n 0(2B
>
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8 .el!w is the list !" "ir% characteristic and p!licy and decisi!n varia#les that were &sed as
independent varia#les in !&r cr!ss/secti!nal regressi!n !" year/end ())8 "ir% de#t rati!s
a -n the space pr!vided #eside each varia#le, indicate the sign !" the relati!nship "!&nd in the
regressi!n
# =!r each varia#le, #rie"ly e9plain why the sign was p!sitive !r negative
Relati!nship t! Relati!nship t!
-ndependent He#t Rati! -ndependent He#t Rati!
Qaria#le 0K !r /2 D Qaria#le 0K !r /2 D
=ir% SiGe 0ln8A2 Hiv;s Paid 0last + yrs2C8A
PP56C8A Sales !" 4!%% St$0last + yrs2C8A
R5H0last + yrs2C8A @@@@@@@@@@ Rep&rch !" 4!%% St$0last + yrs2C8A
N-0last + yrs2C46U 4hg 0N!n/He#t 4&rr 3ia#0last + yrs2
4hg H0last + yrs2C8A HUEEOLJ( i" HC8A0+ yrs ag!2J0M
HUEEOLJ( i" HC8A0+ yrs ag!2V50FM
,*
C * A P T E R :
Ana'sis o, %he Fir4 and %he
Va$a%ion o, E#$i%' and De;%
@@@ ( %conomies of scale are present where the c!st !" pr!d&cing each &nit declines as the <&antity !"
pr!d&ct pr!d&ced increases -n this envir!n%ent, large/scale "ir%s have a c!st advantage
8h&s, ec!n!%ies !" scale serve t! @@@@@@@ the c!st !" entry int! an ind&stry
a increase >
# decrease
@@@ , &apacity surpluses res&lt in 0i2 pr!d&ct prices and 0ii2 pr!"it %argins
0i2 0ii2
a l!wer higher
# higher l!wer
c l!wer l!wer >
d higher higher
@@@ + -n a the!retical paper, 'illia%s 0())52 devel!ps a %!del !" ind&stry e<&ili#ri&% that
inc!rp!rates agency c!sts d&e t! #!th credit!r/shareh!lder and %anage%ent/shareh!lder c!n"licts
His %!del has i%plicati!ns "!r the distri#&ti!n !" "ir%s within an ind&stry in e<&ili#ri&%
'hich !" the "!ll!wing state%ents c!rrectly descri#es 'illia%s; depicti!n !" ind&stry
e<&ili#ri&%D
a 6ach ind&stry has a c!re !" large, pr!"ita#le, sec&re, capital/intensive "ir%s, each with at least
s!%e e9ternal de#t, and a c!%petitive "ringe !" s%all, %arginally pr!"ita#le !r &npr!"ita#le,
ris$y, la#!r/intensive "ir%s >
# All "ir%s in an ind&stry will &lti%ately #e large, la#!r/intensive "ir%s with large pr!p!rti!ns
!" de#t in their capital str&ct&res
c All "ir%s in an ind&stry will &lti%ately #e s%all, capital/intensive "ir%s with n! de#t
d All "ir%s in an ind&stry will &lti%ately #e large, capital/intensive "ir%s with large pr!p!rti!ns
!" de#t in their capital str&ct&res
@@@ 4 8he standard deviati!n !" a "ir%;s st!c$ ret&rns is generally greater than the standard deviati!n !"
its acc!&nting ret&rn !n e<&ity
a 8r&e
# =alse
@@@ 5 8he @@@@@@@ hyp!thesis p!sits that a "ir% %ay ch!!se high leverage as a c!%petitive strategy t!
either win %ar$et share "r!% rivals !r t! deter entry int! the ind&stry
a l!ng/p&rse
# strategic capital str&ct&re
c c!%petitive leverage
d leverage aggressiveness >
,7
@@@ * 8he @@@@@@@ hyp!thesis p!sits that a "ir% %ay ch!!se l!w leverage as a c!%petitive strategy t!
s<&eeGe !ther, %!re highly levered, "ir%s !&t !" its ind&stry
a having a l!ng/p&rse >
# strategic capital str&ct&re
c c!%petitive leverage
d leverage aggressiveness
@@@ 7 6%pirical evidence indicates that the %ar$et e<&ity val&e !" a %&ltiple/seg%ent "ir% generally
is @@@0i2@@@ than the s&% !" the i%p&ted %ar$et val&es !" its individ&al seg%ents, a
phen!%en!n called the @@@0ii2@@@
@@@0i2@@@ @@@@@@@@0ii2@@@@@@@@
a l!wer diversi"icati!n disc!&nt >
# l!wer seg%ent e""ect
c higher diversi"icati!n pre%i&%
d higher seg%ent e""ect
The ne(% %hree pro;e4s re#$ire %he da%a sho0n ;eo0 ,or a arge ,ir4 <P,i=er> and a
s4aer ,ir4 <I44$nogen> in %he Che,icals - !llied Products ind$s%r':
=:REU3ASB R:6tJ0N-tC.6Ut/(2J0N-tCSalest20SalestC8At/(208At/(C.6Ut/(2
@@@ 8 4alc&late each "ir%;s ,000 R:6
R:60P"iGer2 R:60-%%&n!gen2
a ,,,F (0,F
# ,,,F /44F
c 4(8F (0,F
d 4(8F /44F >
@@@ ) 4!nd&ct a H&P!nt R:6 #rea$d!wn analysis "!r each "ir% 'hich #rea$d!wn rati! is %!st
i%p!rtant in e9plaining R:6 di""erential #etween the tw! "ir%sD
a pr!"it %argin >
# t!tal asset t&rn!ver
c leverage
@@@ (0 'hich !" the "!ll!wing "act!rs %!st li$ely e9plains the di""erence in the pr!"ita#ilities !" these
tw! "ir%sD
a di""erential a#ility t! sec&re de#t "inancing
# di""erential ec!n!%ies !" scale >
c the di""erence in the n&%#er !" #&siness seg%ents
,8
No.
B$s.
Co4pan' Seg. PP?E TA De;% BE@ Saes Ne%.In". BE@ &E@
P=-P6R + 5,+4+ ,0,574 5,5,* 8,887 ,),574 +,7(8 (*,07* ,)0,,(*
-EEUN:T6N ( (58 7(7 007 5+ (((8 /0,4 (54 8,,+
.alues /0 ,n(1
22.alues /0 ,n(1 at Y2+ 344422 3444 .alues /0 ,n(1 at Year2+nd %&&&
+ssay *uestions
( Hisc&ss the e""ects !" ind&stry c!%petiti!n !n a "ir%;s !pti%al leverage
, .rie"ly disc&ss the the!retical papers that "!c&s !n principal/agent c!n"licts "r!% an ind&stry
perspective
+ .rie"ly disc&ss the in"!r%ati!n asy%%etry pr!#le% "r!% an ind&stry perspective, incl&ding a
disc&ssi!n !" discl!s&re p!licies
4 Hisc&ss the &se !" "inancing decisi!ns as part !" a "ir%;s c!%petitive strategies within an ind&stry
5 S&%%ariGe the reas!ning #ehind, and the vari!&s predicti!ns !", 'illia%s; the!retical %!del !"
ind&stry e<&ili#ri&% 4!%%ent !n the e9tent t! which these predicti!ns are s&pp!rted #y e%pirical
evidence presented in the chapter
* Hisc&ss Ea$si%!vic;s 0())02 arg&%ents a#!&t the i%p!rtance !" the type !" l!an c!ntract that a
"ir% receives "r!% a #an$, with respect t! its a#ility t! c!%pete in its ind&stry
7 =ries, Eiller, and Perra&din 0())+2 arg&e that the !pti%al initial capital str&ct&re "!r a "ir% within a
c!%petitive ind&stry depends cr&cially !n the de%and elasticity "!r ind&stry !&tp&t, and %ay
generally #e relatively l!w H!wever, "ir%s %aintain val&a#le options t! increase their leverage
!ver ti%e Hisc&ss their arg&%ent, and arg&e whether !r n!t the hist!rical evidence presented in
=ig&res 74 and 75 s&pp!rts their arg&%ent
8 69plain Ea$si%!vic and Pechner;s 0())(2 arg&%ent that a "ir%;s leverage decisi!n %&st #e
addressed in an ind&stry "ra%ew!r$
) 69plain Shlei"er and Qishny;s 0()),2 arg&%ent a#!&t the relati!nship #etween li<&idati!n val&e and
de#t capacity, which is set in an ind&stry c!nte9t 4!&ld their arg&%ent e9plain why the e%pirical
evidence "!r the 'etroleum Refining and Related Inds( ind&stry s! severely vi!lates the c!llateral
hyp!thesisD 69plain
(0 EcAndrews and Na$a%&ra;s 0()),2 arg&e that, when viewed "r!% an ind&stry perspective, an
increase in leverage can itsel" i%pr!ve pr!"ita#ility Hisc&ss their arg&%ent
(( S&%%ariGe the res&lts !" the analyses presented in the chapter c!ncerning the c!ncentrati!n !"
e<&ity %ar$et val&es acr!ss "ir%s in %aR!r US ind&stries
(, He"ine and di""erentiate the le!erage aggressi!eness hyp!thesis and the long"purse hyp!thesis
(+ 69plain h!w the asset s&#stit&ti!n pr!#le% can create a leverage dich!t!%y a%!ng the "ir%s in a
given ind&stry in which s!%e "ir%s ad!pt leverage and p&rs&e ris$ier pr!Rects, while !ther "ir%s are
less levered and p&rs&e less ris$y pr!Rects
(4 69plain h!w the dyna%ics !" asset li<&idity in an ind&stry creates circ&%stances in which the !pti%al
leverage !" an individ&al "ir% depends !n the leverage !" !ther "ir%s in its ind&stry
,)
(5 69plain h!e a "ir%;s !pti%al leverage %ay #e deter%ined #y a trade!"" #etween %anagerial agency
c!sts and c!sts !" rivals; pr!d&ct/%ar$et aggressiveness
(* =r!% the perspective !" ind&stry c!%petiti!n, e9plain the val&e t! a "ir% !" retaining de#t capacity
0ie, retaining the !pti!n t! increase leverage at any ti%e2
(7 H!w can an inc&%#ent "ir% in a given ind&stry &se leverage t! deter entryD
(8 Hisc&ss the p!ssi#le interacti!ns #etween a "ir%;s pr!d&cti!n and pr!d&ct/%ar$et decisi!ns and its
"inancing decisi!ns
() 69plain h!w pr!visi!ns in a 46:;s c!%pensati!n c!ntract can a""ect the "ir%;s c!%petitive strategy
,0 4!%pare and c!ntrast R!int vent&res and strategic alliances as %eans #y which a "ir% can c!%pete
%!re e""ectively in its ind&stry
+0
C * A P T E R A
The Fir4!s En)iron4en%1
6o)ernan"e1 S%ra%eg'1
Opera%ions1 and Finan"ia
S%r$"%$re
@@@ ( =!r which !" the peri!ds #el!w was US %acr!ec!n!%ic per"!r%ance p!!restD
a ()*0/()7+
# ()74/()8, >
c ()8+/,000
@@@ , 8echn!l!gical advances all!w a "ir%;s earnings t! gr!w !ver ti%e #eca&se they increase the
pr!d&ctivity !"B
a la#!r
# capital
c #!th la#!r and capital >
@@@ + 8he %!st "&nda%ental services that g!vern%ents pr!vide t! "ir%s areB
a the esta#lish%ent !" pr!d&ct and "inancial %ar$ets
# the reg&lati!n !" ind&stries
c the esta#lish%ent !" pr!perty rights and the en"!rce%ent !" legal c!ntracts
d #&ilding in"rastr&ct&re and %!nit!ring %anagers >
@@@ 4 Scr&tiny #y the %edia and analysts has at least tw! i%p!rtant i%plicati!ns "!r a "ir%, #&t d!es
N:8 incl&deB
a in"!r%ati!n they generate red&ces in"!r%ati!n asy%%etry
# their !versight !" a "ir%;s %anage%ent serves shareh!lders; interest
c they acc&rately "!recast the ret&rns !n individ&al "ir%s #ased !n private in"!r%ati!n they
generate >
@@@ 5 A typical @@@@@@ inv!lves a ca%paign a%!ng c!%peting gr!&ps "!r the right t! cast
shareh!lders; v!tes !n their #ehal" in electi!ns "!r a "!cal "ir%;s #!ard direct!rs
a pr!9y c!ntest >
# shareh!lder/initiated pr!p!sal
c initiati!n pr!ced&re
d ta$e!ver c!ntest
@@@ * A typical @@@@@@ inv!lves changing s!%e aspect the "ir%;s internal c!rp!rate g!vernance, s&ch
as the str&ct&re !r c!%p!siti!n !" a "ir%;s #!ard !" direct!rs
a pr!9y c!ntest
# shareh!lder/initiated pr!p!sal >
c initiati!n pr!ced&re
d ta$e!ver c!ntest
+(
@@@ 7 Shareh!lders have s&ed #!ard direct!rs "!r l!sses arising "r!% alleged %is%anage%ent :ver the
years ()84/87, a direct!r lia#ility crisis e%erged in the US #eca&se !" accelerating litigati!n
against c!rp!rate direct!rs 8he threat !" litigati!n severely decreased the s&pply !"
<&ali"ied !&tside direct!rs nati!nwide -n resp!nse t! this crisis, %any states have passed
@@@0i2@@@ stat&tes, which all!w "ir%s t! ad!pt new @@@0ii2@@@ that pr!tect direct!rs "r!%
shareh!lder s&its
@@@@@@@0i2@@@@@@@ @@@@@@@0ii2@@@@@@@@
a direct!rs; i%%&nity lia#ility li%itati!n pr!visi!ns 033Ps2
# lia#ility li%itati!n direct!rs; i%%&nity pr!visi!ns 0H-Ps2
c c!rp!rate i%%&nity direct!rs; inde%nity pr!visi!ns 0H-Ps2
d lia#ility li%itati!n lia#ility li%itati!n pr!visi!ns 033Ps2 >
@@@ 8 8he @@@@@@@ !" a "ir%;s %anage%ent hierarchy is de"ined in ter%s !" the all!cati!n !" decisi!n/
%a$ing p!wer a%!ng seni!r %anagers vers&s l!wer/level %anagers
a steepness >
# c!%p!siti!n
c sharpness
d str&ct&re
@@@ ) A "ir%;s @@@@@@ pr!vides val&a#le services in ter%s !" ens&ring thatB 0i2 all parties inv!lved in a
pr!Rect are w!r$ing !n c!!rdinated and ti%ely #asesA 0ii2 !riginal plans and speci"icati!ns are
"!ll!wed, !r alternatively that necessary changes are appr!ved #y seni!r %anage%entA
0iii2 e""ective pr!d&ct <&ality and c!st c!ntr!ls are instit&ted at every stage !" the pr!cessA
and 0iv2 rep!rts !n all activities are acc&rate
a internal a&diting tea% >
# inspecti!n tea%
c e9ternal g!vernance c!%%ittee
d internal g!vernance c!%%ittee
@@@ (0 6%pirical st&dies have "!&nd that, acr!ss "ir%s, Toin)s * rati! initially increases with
%anagerial !wnership "racti!n, #&t #ey!nd a critical level, the rati! decreases with "&rther
increases in %anagerial !wnership :ne arg&%ent "!r why this rati! decreases at higher
%anagerial !wnership levels is thatB
a #!ard direct!rs n! l!nger #elieve that they need t! %!nit!r %anage%ent;s incentives
# "ewer passive shareh!lders !wn the "ir%;s st!c$
c !&tside #l!c$h!lders tend t! #e attracted t! "ir%s with high %anagerial !wnership, and
!&tside #l!c$h!lder !wnership generally destr!ys "ir% val&e
d %anage%ent can &se their shares t! leverage their entrenched p!siti!n >
@@@ (( 3ang, :"e$, and St&lG 0())*2 analyGed the relati!nship #etween leverage and gr!wth
!pp!rt&nities 8hey "!c&s !n the %ar$et;s assess%ent !" the a#ility !" the "ir% t! generate
profitale gr!wth 8heir %eas&re !" pr!"ita#le gr!wth !pp!rt&nities is Toin)s # ratio,
the rati! !" the %ar$et val&e !" the "ir%;s e<&ity t! its #!!$ val&e 8hey s&%%ariGe their
res&lts as "!ll!wsB W'e sh!w that there is a negative relati!n #etween leverage and "&t&re
gr!wth 8his negative relati!n #etween leverage and gr!wth h!lds "!r "ir%s with 0i2
8!#inXs < rati!, #&t n!t "!r "ir%s with 0ii2@@ 8!#in;s <
0i2 0ii2
a l!w high >
# high l!w
+,
@@@ (, At the end !" year ( "ir% NOP has 8AJI+,5 #n, and it is "inanced with de#t with a #!!$ val&e
!" I(,5 %n and e<&ity with a #!!$ val&e !" I,00 %n 8he "ir% %&st pay (0F interest
ann&ally !n its de#t -n year ,, the "ir% had a net inc!%e !" I55 %n 8he "ir%;s year , R:A
was @@@0i2@@@, and the "ir%;s year , R:6 was @@@0ii2@@@
R:A R:6
a (,0F ,75F
# (,0F (7(F
c (*)F ,75F >
d (*)F (7(F
=:REU3ASB R:AJN-C8AA R:6JN-C.6U
@@@ (+ =!r "ir% NOP in the previ!&s pr!#le%, s&pp!se the "ir%;s #&siness ris$ is de"ined in ter%s !"
0R:A2, and 0R:A2J()F Ass&%ing that the de#t is de"a&lt/"ree, c!%p&te 0R:62
0R:62
a ()000F
# ,4+,5F
c +0875F >
d 4)400F
=:REU3AB 0R:62J 0R:A2L8AC.6UM
+ssay *uestions
( 3ist and #rie"ly disc&ss the "!&r ele%ents that de"ine a "ir%;s #&siness envir!n%ent
, 3ist the external g!vernance gr!&ps that in"l&ence a "ir%, and h!w they c&r# sel"/serving decisi!ns #y
a p&#lic "ir%;s %anage%ent
+ 3ist the internal g!vernance gr!&ps that in"l&ence a "ir%, and h!w they c&r# sel"/serving decisi!ns #y
a p&#lic "ir%;s %anage%ent
4 69plain h!w the c&rrent and e9pected "&t&re states !" the ec!n!%y %ay a""ect a "ir%;s capital
invest%ent decisi!ns #y a""ecting 0i2 e9pected pr!"itsA 0ii2 ris$A and 0iii2 the "ir%s; c!st !" capital
5 H!w d!es a "ir%;s internal g!vernance str&ct&re interact with its #&siness strategyD
* .rie"ly disc&ss the g!vernance r!le !" a "ir%;s #!ard !" direct!rs, and "act!rs that %ight %a$e a #!ard
wea$ !r str!ng in this respect
7 He"ine and #rie"ly disc&ss the n!ti!n !" the steepness !" a "ir%;s %anagerial hierarchy
8 Hisc&ss the vari!&s advantages !" #eing a large 0vs s%all2 "ir%
) Several st&dies have st&died the relati!nship #etween the percentage !" a "ir%;s shares held #y
e9ec&tives and the "ir%;s per"!r%ance 'hat did they "indD H!w w!&ld y!& e9plain the res&ltsD
(0 Henis, Henis, and Sarin 0())72 c!nd&cted an e%pirical investigati!n t! deter%ine whether the
li$elih!!d !" t!p e9ec&tive t&rn!ver is related t! the "ir%;s !wnership str&ct&re .rie"ly disc&ss their
"indings
++
(( Acc!rding t! Agrawal and NagaraRan 0())02, why d! %any s%all "ir%s have n! de#t in their capital
str&ct&resD
(, 3ang, :"e$, and St&lG 0())*2 test tw! c!%peting hyp!theses a#!&t the relati!nship #etween leverage
and gr!wth 3ist these hyp!theses and s&%%ariGe their "indings
(+ Hisc&ss the &se !" incentive devices in %anagerial c!%pensati!n c!ntracts
(4 .rie"ly disc&ss the e""ects !" each !" the "!ll!wing !n a "ir%;s #&siness ris$B 0a2 the "ir%;s ch!sen
ind&stryA 0#2 the "ir%;s siGeA and 0c2 the "ir%;s capital intensity
(5 3ist and #rie"ly descri#e the pri%ary ele%ents !" a "ir%;s !perati!nal str&ct&re
(* 3ist and #rie"ly descri#e the pri%ary ele%ents !" a "ir%;s "inancial str&ct&re
(7 He"ine #&siness ris$ and "inancial ris$ 'hat is the relati!nship #etween the%D
(8 'hy is the standard deviati!n !" a "ir%;s st!c$ ret&rns, 0R2, generally %&ch greater than the
standard deviati!n !" its ret&rn !n e<&ity, 0R:62D
+4
C * A P T E R B
&arke% E,,i"ien"'1 E)en%
S%$dies1 Cos% o, E#$i%' Capi%a1
and E#$i%' Va$a%ion
@@@ ( -" the sec&rities %ar$ets are e""icient, the %ar$et;s reacti!n t! new in"!r%ati!n a#!&t a "ir%;s
val&e 0s&ch as an earnings ann!&nce%ent2 sh!&ld #eB
a grad&al, as invest!rs rati!nally deli#erate the e""ect !" the in"!r%ati!n !n the st!c$;s val&e
# i%%ediate and &n#iased >
c sl!w !r "ast, depending !n the a%!&nt !" Ss&rprise; c!ntained in the new in"!r%ati!n
d negligi#le 0the in"!r%ati!n w!&ld have already #een i%p!&nded int! the "ir%;s st!c$ price2
@@@ , -n the @@@@0i2@@@@ !" the e""icient %ar$et hyp!thesis 06EH2, a sec&rity;s price re"lects all
p&#licly availa#le in"!r%ati!n -n the @@@@@0ii2@@@@ "!r% !" the 6EH, a sec&rity;s price
re"lects all in"!r%ati!n that %ay #e c!ntained in the hist!rical prices !" a sec&rity -n the
@@@@0iii2@@@@ !" the 6EH, a sec&rity;s price re"lects all in"!r%ati!n, whether it is p&#lic
in"!r%ati!n !r in"!r%ati!n held privately
0i2 0ii2 0iii2
a wea$ se%istr!ng str!ng
# str!ng se%istr!ng wea$
c wea$ str!ng se%istr!ng
d se%istr!ng str!ng wea$
e se%istr!ng wea$ str!ng >
@@@ + -n an event st&dy, what tw! steps d!es a researcher ta$e t! adR&st "!r the val&ati!n e""ects !" !ther
new 0and si%&ltane!&sly/revealed2 val&e/relevant in"!r%ati!n, in !rder t! is!late the val&ati!n
e""ect !" a speci"ic eventD
a 0i2 &sing the %ar$et %!del t! re%!ve the e""ects !" !ther "ir%/speci"ic "act!rsA and 0ii2
averaging a#n!r%al ret&rns acr!ss %any "ir%s with a si%ilar event t! wash !&t the e""ect
!" the %ar$et
# 0i2 &sing the %ar$et %!del t! re%!ve the e""ect !" the %ar$etA and 0ii2 averaging a#n!r%al
ret&rns acr!ss %any "ir%s with a si%ilar event t! wash !&t the e""ects !" !ther "ir%/
speci"ic "act!rs >
c 0i2 averaging ret&rns !n Sevent; st!c$s !ver several days t! Ss%!!th; the in"!r%ati!n i%pactA
and 0ii2 washing !&t the e""ect !" the %ar$et #y incl&ding !nly days when the %ar$et
ret&rn was s%all
d 0i2 averaging ret&rns !n Sevent; st!c$s !ver several days #y incl&ding !nly days when the
%ar$et ret&rn was s%allA and 0ii2 washing !&t the e""ect !" the %ar$et t! Ss%!!th; the
in"!r%ati!n i%pact
+5
@@@ 4 :ver the wee$end pri!r t! April +, ,000, a US Histrict 4!&rt r&led that Eicr!s!"t 4!rp is a
%!n!p!ly :n E!nday, April +, Eicr!s!"t;s st!c$ ret&rn was /(447F, while the ret&rn !n
the S5P500 0the S%ar$et;2 was 04)F =!r the tw! years leading &p t! this date, the S%ar$et
%!del; relati!nship #etween Eicr!s!"t;s daily ret&rns and the %ar$et;s daily ret&rns was as
given #el!w Using this %ar$et %!del relati!nship, c!%p&te the Sa#n!r%al ret&rn; !n
Eicr!s!"t;s st!c$ !n April +, ,000
RES=8J0()F K 0*00RE182 K
a /,5*F
# /55*F
c /85*F
d /(4)5F >
=:REU3ASB Rit J i K iR%t K itA ARi0 J Ri0 / 0

i K
iR%02
@@@ 5 8he "!ll!wing in"!r%ati!n !n the st!c$ !" Av!n, -nc was !#tained !n 8h&rs, N!v ((, ()))B
St!c$ price J Q6 J I,850A
3atest ann&al dividends per share J Ht/( J I07,
5/year average earnings gr!wth rate J ghist!rical J 4+(F
S&pp!se dividends per share "!r the ne9t year are pr!Rected t! #e Ht J I075 -" we als! ass&%e
that the %ar$et is pricing Av!n st!c$ t! have an e9pected ret&rn !" r6 J )F, is the %ar$et
pricing Av!n st!c$ t! have @@@@@@@@ earnings gr!wth rate, g, thanCas it had !ver the past 5
yearsD
a a higher >
# a l!wer
c the sa%e
=:REU3AB Q6JHtC0r6/g2JHt/(0(Kg2C0r6/g2
@@@ * 8he "!ll!wing in"!r%ati!n !n the st!c$ !" Av!n, -nc was !#tained !n 8h&rsday, N!ve%#er
((, ()))B PC6 rati! J ,4+*, and the latest ann&al earnings is 6t J ((7 per share -" we
ass&%e that the e9pected ret&rn !n Av!n st!c$ is r6J)F, what is the present val&e !"
Av!n;s pr!"ita#le "&t&re invest%ent !pp!rt&nities 0PQP=-:2D
a I 7,5
# I(+,5 >
c I,0,5
d I,7,5
=:REU3AB
6
PQP=-:
r
(
6
Q
6
6
+
@@@ 7 -n recent years, Sears, R!e#&c$ 5 4! has paid !&t !nly +,F !" its earnings in dividends
Retained earnings have #een invested in e9pansi!n pr!Rects that have yielded an average
R:6 !" ,0F -" Sears; c!st !" e<&ity capital is (*F and ne9t year;s e9pected dividend is I(
per share, c!%p&te the val&e !" Sears; shares &sing the c!nstant dividend gr!wth %!del as
interpreted thr!&gh the s&staina#le gr!wth %!del
a I50(
# I)87
c I,047
d I4(*7 >
=:REU3ASB gJ#$A QJHtC0r/g2
+*
@@@ 8 At date 0, the %ar$et;s e9pectati!n "!r the year ( dividend !n "ir% NOP;s st!c$ is H(JI(45
8he %ar$et als! e9pects dividends t! gr!w at an ann&al rate !" gSJ,F in the "!ll!wing +
years 0ie, years ,, +, and 42 a"ter which dividends will gr!w at an ann&al rate !" gNJ*F int!
perpet&ity -" the "ir%;s c!st !" e<&ity capital is r6J(F, the val&e !" NOP st!c$ isB
a I+(5, >
# I,55,
c I()5,
d I(+5,
=:REU3AB
8
6
8
( t
N 6
8
S (
t
6
( t
S (
6
r ( 0
(
g r
2 g ( 0 H
2 r ( 0
2 g ( 0 H
Q

,
_
+
1
1
]
1
+
+
+
+
@@@ ) Eas&lis 0()802 d!c&%ented evidence that the %ar$et generally reacts "av!ra#ly t! a leverage/
increasing de#t/"!r/e<&ity swap, and &n"av!ra#ly t! a leverage decreasing e<&ity/"!r/de#t
swap 'hich !" the "!ll!wing is N:8 a legiti%ate the!retical e9planati!n "!r these %ar$et
reacti!nsD
a -ncreasing leverage increases the ta9 shield !" de#t, while e9ting&ishing de#t decreases it
# -ncreasing leverage ind&ces an e9pr!priati!n !" wealth "r!% e9isting credit!rs, while
e9ting&ishing de#t acc!%plishes the !pp!site
c -ncreasing leverage via a swap inv!lves paying a dividend t! shareh!lders while decreasing
leverage via a swap "!rces the "ir% t! iss&e e<&ity >
d -ncreasing leverage disciplines %anage%ent t! act in shareh!lders; interest #y a#s!r#ing "ree
cash "l!w, while decreasing leverage increases %anage%ent;s a#ility t! p&rs&e sel"/
serving activities
@@@ (0 8he %anage%ent !" "ir% NOP tends t! pay !&t +5F !" its earnings in dividends each year, while
the re%ainder is retained "!r capital invest%ents that pr!vide an e9pected R:6 !" (8F -" the
"ir%;s c!st !" e<&ity capital is (+F and ne9t year;s e9pected dividend is HtJI050 per share,
c!%p&te the val&e !" the "ir%;s shares &sing the c!nstant dividend gr!wth %!del as
interpreted thr!&gh the s&staina#le gr!wth %!del
a I74* >
# I(74*
c I,74*
d I+74*
=:REU3ASB gJ#$A QJHtC0r/g2
@@@ (( 8he price !" T6 st!c$ is I+8, and its latest ann&al earnings per share was I(+7 -" the
appr!priate disc!&nt rate "!r T6 st!c$ is r6J(0F, what is the present val&e !" T6;s pr!"ita#le
"&t&re invest%ent !pp!rt&nities 0PQP=-:2D
a I(4+0
# I()+0
c I,4+0 >
d I+4+0
=:REU3AB PQP=-:JQ/6tCr
@@@ (, 8he #eta 02 !" A%es; st!c$ is ,5 8he ris$"ree rate is ,F, and the e9pected ret&rn !n the %ar$et
p!rt"!li! is (*F 'hat is the e9pected ret&rn !n A%es; st!c$D
a ,,F
# ,7F
c +,F
d +7F >
+7
=:REU3AB riJr"KiLr%/r"M
+ssay *uestions
( Hisc&ss the general asserti!n !" the 6""icient Ear$et Hyp!thesis 06EH2 a#!&t the price !" a
sec&rity, and its speci"ic asserti!ns &nder the wea$ "!r%, se%istr!ng "!r%, and str!ng "!r%
, -n an event st&dy, what two steps d!es a researcher ta$e t! adR&st "!r the val&ati!n e""ects !" !ther
new 0and si%&ltane!&sly/revealed2 val&e/relevant in"!r%ati!n, in !rder t! is!late the val&ati!n e""ect
!" a speci"ic eventD
+ Hisc&ss the!retical arg&%ents that can e9plain Eas&lis; 0()802 "indings that the %ar$et reacts
p!sitively t! leverage increasing e9changes 0ie, de#t "!r e<&ity2 and negatively t! leverage
decreasing e9changes 0ie, e<&ity "!r de#t2
4 H!w c!&ld a "ir%;s !wnership str&ct&re a""ect its c!st !" e<&ity capitalD
+8
C * A P T E R -C
Corpora%e Bonds: Ter4s1
Iss$an"e1 and Va$a%ion
@@@ ( 4!n"licts !" interest #etween a #!rr!wing "ir% and its credit!rs 8his pr!#le% is e9acer#ated in
the case !" a p&#lic #!nd, #eca&se the !wnership !" p&#lic #!nds is generally dispersed
a%!ng %any #!ndh!lders =!r these reas!ns, the interests !" the invest!rs in a p&#lic c!rp!rate
#!nd are pr!tected in part #y the app!int%ent !" a @@@@@@@, wh! is charged with %!nit!ring the
"ir%;s c!%pliance with the vari!&s ter%s, c!venants, and pr!visi!ns in the c!ntract
a liais!n !""icer
# tr&stee >
c sec&rity !""icer
d c!%pliance g&ardian
@@@ , Regarding c!rp!rate #!nds, i" the iss&ing "ir% d!es n!t pledge speci"ic assets as c!llateral, the
#!nd is called a @@@@@@@
a de#ent&re >
# %!rtgage
c chattel %!rtgage
d n!te
@@@ + .!nd c!ntracts generally incl&de restricti!e co!enants, designed t! pr!tect the interests !" the
#!ndh!lders 8ypical c!venants restrict all !" the "!ll!wing 6N46P8B
a the #!rr!wing "ir%;s invest%ent activities
# the #!rr!wing "ir%;s a#ility t! iss&e additi!nal de#t
c the #!rr!wing "ir%;s dividend p!licy
d the "ir%;s hiring !" %anage%ent pers!nnel >
@@@ 4 8he @@@@@@@@@@ pr!visi!n in a c!rp!rate #!nd c!ntract re<&ires the "ir% t! retire a speci"ied
percentage !" the #!nds each year, typically a"ter a de"er%ent peri!d !" 5 t! (0 years
a sin$ing "&nd >
# call
c p&t
d c!nversi!n
@@@ 5 6ssentially, a c!nverti#le #!nd is a p!rt"!li! !"B
a a #!nd and an a&t!%!#ile wh!se t!p can #e re%!ved
# an !therwise e<&ivalent n!nc!nverti#le #!nd and shares !" the iss&ing "ir%;s st!c$
c an !therwise e<&ivalent n!nc!nverti#le #!nd and a call !pti!n !n the "ir%;s st!c$ >
d an !therwise e<&ivalent n!nc!nverti#le #!nd and a p&t !pti!n !n the "ir%;s st!c$
@@@ * -nvest%ent #an$s "!r% a te%p!rary alliance, called a @@@@@@, t! &nderwrite a #!nd iss&e
a selling gr!&p
# syndicate >
c c!aliti!n
d pricing ass!ciati!n
+)
@@@ 7 -n @@@@@@@, an iss&ing "ir% s!licits #ids "r!% a%!ng several invest%ent #an$s "!r the R!# !"
&nderwriting a #!nd iss&e
a c!%petitive #idding >
# neg!tiated &nderwriting
c aggressive #idding
d #argain #idding
@@@ 8 -n ()8,, the S64 ad!pted R&le 4(5, als! $n!wn as the @@@@@@@ r&le, which all!ws <&ali"ying
"ir%s t! register a #!nd !""ering and then sell it either as a wh!le !r piece%eal at any ti%e
!ver several years
a delayed registrati!n
# de"erred registrati!n
c shel" registrati!n >
d piece%eal registrati!n
@@@ ) Underwriter generally places n!n/s!licitati!n advertise%ents in the 'all Street J!&rnal andC!r
!ther i%p!rtant newspapers n!ti"ying the p&#lic !" the availa#ility !" an iss&e 8hese are
called @@@@@@@
a t!%#st!ne ads >
# headst!ne ads
c n!ti"icati!ns !" availa#ility
d #!nd iss&e sched&les
@@@ (0 -n resp!nse t! c!%petiti!n "r!% the 6&r!#!nd %ar$et, the S64 ad!pted @@@@@@@ in ())0, which
all!ws "ir%s t! iss&e #!nds in the US %ar$et with %ini%al reg&lat!ry red tape as l!ng as
they are s!ld !nly t! <&ali"ied invest!rs 0eg, "inancial instit&ti!ns2
a the N!nregistrati!n 69cepti!n
# U&ali"ied -nvest!rs R&le 0U-R2
c R&le )).
d R&le (44A >
@@@ (( 8he p&#lic %ar$et "!r new spec&lative/grade #!nds, als! $n!wn as high"yield !r +unk onds, was
created virt&ally single/handedly #y Eichael Eil$en and his "ir%, Hre9el .&rnha% 3a%#ert,
in the late ()70s Pri!r t! that ti%e, the !nly c!rp!rate #!nds that carried a spec&lative/grade
rating were s!/called @@@@@@@, #!nds that initially garnered an invest%ent/grade rating, #&t
later the iss&er e9perienced "inancial distress s! that their rating "ell int! the spec&lative/grade
categ!ry
a disc!&nt #!nds
# c!ncessi!n #!nds
c "allen angels >
d c&t rate #!nds
@@@ (, 8RU6 !r =A3S6 Underwriter spreads !n c!rp!rate #!nds re"lect s&#stantial ec!n!%ies !" scale
a 8RU6 >
# =A3S6
@@@ (+ Si%&lati!ns #ased !n the .lac$/Sch!les %!del indicate that, "!r all c!%#inati!ns !" leverage
0HCQ2 and "ir% ris$ 02, de#t ris$B
a increases as de#t %at&rity increases >
# decreases as de#t %at&rity increases
c re%ains "airly c!nstant as de#t %at&rity increases
40
@@@ (4 Standard 5 P!!rs ratings are gr!&ped int! tw! %aR!r categ!ries, in!estment"grade and
speculati!e"grade .!nds that are rated 0i2 are incl&ded in the invest%ent/grade
gr!&p, while spec&lative/grade #!nds are th!se rated 0ii2
0i2 0ii2
a AAA, AA, A ..., .., ., 444, 44, 4
# AAA, AA, A, ... .., ., 444, 44, 4 >
c AAA, AA, A, ..., .. ., 444, 44, 4
d AAA, AA, A, ..., .., . 444, 44, 4
@@@ (5 -n Jan&ary, ,00,, J!nes 4!%pany iss&es a p&re/disc!&nt #!nd with a pr!%ised pay%ent !"
NJI(000 that %at&res in 8J5 years 8he %ar$et price !" the #!nd is PJI777 8he #!nd is
de"a&lt/ ris$y Speci"ically, the pr!#a#ility is 08 that J!nes 4!%pany will pay the "&ll
a%!&nt !" N at %at&rity, and is 0, that the "ir% will de"a&lt, in which case the pay!"" t!
#!ndh!lders will #e !nly I555 4alc&late the #!nd;s pr!%ised yield t! %at&rity, y, and e9pected
ret&rn t! %at&rity, rH
y rH
a 8(8F 5(8F
# 5(8F 5(8F
c 8(8F +,+F
d 5(8F +,+F >
e 5(8F (57F
=:REU3ASB y J LNCPM
(C8
Y(A rH J L60PAO2CPM
(C8
Y(, where 60PAO2J pLNM K 0(/p2LN;M
@@@ (* 4!%p&te the promised yield to maturity and expected return to maturity !n a de"a&lt/ris$y 5/year
p&re/disc!&nt c!rp!rate #!nd that has a c&rrent price !" I54( 'ith a pr!#a#ility !" 07, the
iss&er will repay the principal !" I(,000 at %at&rity H!wever, the pr!#a#ility is 0+ that the
iss&er will de"a&lt, in which case #!ndh!lders will receive !nly I500 per #!nd
Pr!%ised 69p Ret
Oield t! Eat
a (7*+F (+0*F
# (7*+F )4*F
c (+0*F )4*F >
d (+0*F ++0F
=:REU3ASB y J LNCPM
(C8
Y(A rH J L60PAO2CPM
(C8
@@@ (7 4!%p&te the promised yield to maturity and expected return to maturity !n a de"a&lt/ris$y +/year
p&re/disc!&nt c!rp!rate #!nd that has a c&rrent price !" I54+ 'ith a pr!#a#ility !" 0*, the
iss&er will repay the principal !" I(,000 at %at&rity H!wever, the pr!#a#ility is 04 that
the iss&er will de"a&lt, in which case #!ndh!lders will receive !nly I,00 per #!nd
Pr!%ised 69p Ret
Oield t! Eat
a ,,57F (+0*F
# ,,57F 77)F >
c (+0*F (+0*F
d (+0*F 77)F
=:REU3ASB y J LNCPM
(C8
Y(A rH J L60PAO2CPM
(C8
@@@ (8 8he pr!#a#ility !" a calla#le #!nd #eing called, and th&s the yield pre%i&% that invest!rs de%and
"!r the ris$ !" a call, is directly related t!B
a the v!latility !" the #!nd;s yield >
# the de"er%ent peri!d
4(
c the call price
4,
5he ne6t two "ro7le,s re8uire the 7ond yield s"read ,atri6 given 7elow
@@@ () Using the #!nd yield spread %atri9 a#!ve, calc&late the "air yield !n a ,0/year calla#le c!rp!rate
#!nd that is rated W...Z #y S5P, given als! that the yield !n ,0/year 8reas&ries is 555F
a (**F
# 7,(F >
c *54F
d 88)F
@@@ ,0 Using the #!nd yield spread %atri9 a#!ve, calc&late the "air yield !n a 5/year n!ncalla#le
c!rp!rate #!nd that is rated W.Z #y S5P, given als! that the yield !n 5/year 8reas&ries is
444F
a 4(5F
# *(5F
c 85)F >
d (05)F
@@@ ,( -" a "ir% atte%pts t! call an !&tstanding c!nverti#le #!nd, the #!ndh!ldersB
a have the pree%pt!ry right t! c!nvert the #!nds int! st!c$ >
# %&st tender their #!nds i%%ediately and receive the call price
c %&st challenge %anage%ent;s decisi!n t! call the #!nds via a pr!9y c!ntest
d have the !pti!n t! $eep their #!nds !&tstanding
@@@ ,, 8RU6 !r =A3S6 Oield spreads !n new c!nverti#le #!nds generally are negative
a 8RU6 >
# =A3S6
+ssay *uestions
( A "ir%;s !riginal credit!rs $n!w that the #!rr!wing "ir% has an incentive t! iss&e additi!nal de#t as a
%eans !" e9pr!priating val&e "r!% the% 3ist three restricti!e co!enants that can #e placed in the
#!nd c!ntract that can pr!tect the "ir%;s credit!rs "r!% s&ch e9pr!priati!n
, Hescri#e the sin$ing "&nd pr!visi!n !n a c!rp!rate #!nd and disc&ss its e""ect !n the yield !n a #!nd
+ 3ist and #rie"ly de"ine each !" the S5P rating categ!ries "!r c!rp!rate #!nds
4 =irst, list and #rie"ly disc&ss the "act!rs that are incl&ded in S5P "ra%ew!r$ "!r assessing the de"a&lt
ris$ !" a c!rp!rate #!nd Sec!nd, c!%%ent !n whether any !ther "act!rs sh!&ld #e added t! this
"ra%ew!r$
4+
S?P Ra%ingD AAA AA A BBB BB B CCC
&a%$ri%'EF-C 'rsG Non"aa;e +4 5, *) (07 ,+* 4(5 *87
&a%$ri%'EF-C 'rsG Caa;e 58 7, (0, (50 +04 45* 5+0
&a%$ri%'D-C 'rsG Non"aa;e 5+ 7, ), (,) ,+* ,++ nCa
&a%$ri%'D-C 'rsG Caa;e ((0 (0* (+( (** ,)0 4++ 5+0
A BOND HIE8D SPREAD &ATRII <;asis poin%s>
5 69plain why the #!nd yield spread %atri9 is a p!p&lar appr!ach "!r deter%ining the "air yield !n a
c!rp!rate #!nd
* Hisc&ss the para%eters that deter%ine the val&e !" a c!nverti#le #!nd
44
C * A P T E R --
Pri)a%e E#$i%' and
Ven%$re Capi%a
@@@ ( S&pp!se a vent&re re<&ires I7 %n in e<&ity "inancing t! %!ve t! the ne9t stage !" devel!p%ent
8he "ir%;s %anage%ent is neg!tiating with a vent&re capital "ir% 0Q42 "!r the "&nding
Ass&%ing that the "ir%;s #&siness g!als are achieved, it will generate earnings !" I,(
%n per year int! perpet&ity starting #eginning !n the har!est date, "!&r years "r!% n!w,
when the "ir% will g! p&#lic At that ti%e, the "ir% will #e val&ed in the %ar$et acc!rding t! a
PC6 rati! !" (8 8h&s, the harvest /date val&e !" the "ir%, ass&%ing that it is s&ccess"&l, will
#e I+78 %n0J(8LI,( %nM2 H!wever, the pr!#a#ility that the "ir% will #e s&ccess"&l is !nly ,5F,
while the pr!#a#ility !" t!tal "ail&re !" the vent&re is 75F 8here"!re, the e9pected
harvest/date val&e !" the "ir% is I)45 %n 0J0,5LI+78M2 A disc!&nt rate !" ++F is applied t!
this val&e t! deter%ine the present val&e !" the vent&re, yielding a val&e !" QJI+0, %n
0JI)45 %n CL(++M
4
2 .ased !n this val&e and the Q4;s c!ntri#&ti!n !" I7 %n, what "racti!n
!" the "ir%;s e<&ity shares sh!&ld the Q4 receiveD
a (+,F
# ,+,F >
c ++,F
d 4+,F
@@@ , J!e :gden, the 4hair%an and 46: !" :gdenergy, -nc, a pr!%ising vent&re in the nat&ral gas
ind&stry, is neg!tiating with S&%%er Street 4apital Partners, a .&""al!, NO/#ased vent&re
capital "ir% 0Q42, "!r "&nding !" I(5 %n, which will #e &sed "!r #&ilding PP56 S&%%er Street is
i%pressed with the vent&re, and is c!nsidering pr!viding the "&nding in e9change "!r
e<&ity shares H!wever, S&%%er Street is c!ncerned that i" they de%and an e<&ity
!wnership percentage that is t!! high, :gdenergy;s entreprene&rs %ay #e less inclined
t! w!r$ hard t! ens&re the vent&re;s s&ccess 8hey deter%ine that i" they de%and a 40F
e<&ity percentage, the "ir% will #e w!rth I44 %n, #&t i" they de%and a *0F !wnership
percentage, the "ir%;s val&e will #e !nly I,* %n 'hich e<&ity !wnership percentage sh!&ld
S&%%er Street ta$eD 0ie, which %a9i%iGes S&%%er Street;s NPQD2
a S&%%er Street sh!&ld ta$e a 40F e<&ity percentage >
# S&%%er Street sh!&ld ta$e a *0F e<&ity percentage
@@@ + 'hich !" the "!ll!wing is the least li$ely s!&rce !" "&nding "!r a vent&re that is in the seed stage
!" devel!p%entD
a angel "inanciers
# #!!tstrapping
c #an$s >
@@@ 4 8RU6 !r =A3S6B Q4s are rarely inv!lved in the g!vernance and %anage%ent !" a vent&re that
they "inance
a 8RU6
# =A3S6 >
45
@@@ 5 8he Q4 ind&stry did n!t #ec!%e a %aR!r "!rce in "inancing vent&res &ntil which 8': pr!#le%s
were s!lvedD
a in"!r%ati!nal asy%%etry and principal/agent pr!#le%s
# legislati!n all!wed instit&ti!nal invest!rs t! pr!vide signi"icant capital #ac$ing, and an
e""ective legal/lia#ility arrange%ent "!r c!ntri#&ting parties was devised >
c c!ntracting pr!#le%s with the vent&re and c!%pensati!n "!r e9ec&tives
d "inancing pr!#le%s 0ie, de#t vs e<&ity2 and the &nderinvest%ent pr!#le%
@@@ * Q4s generally ta$e the "!r% !" a
a li%ited partnership >
# c!rp!rati!n
c pr!priet!rship
d R!int vent&re
@@@ 7 T!%pers; 0())52 the!retical %!del !" vent&re "inancing "!c&sed !n %itigating principal/agent
c!n"licts #etween the entreprene&r and an !&tside "inancier His %!del e9plains why
vent&res are devel!ped in stagesB the end !" each stage is
a a cash/!&t !pp!rt&nity
# an !pp!rt&nity t! harvest parts !" the vent&re
c a ti%e "!r %anage%ent t! rest and rec&perate
d a %!nit!ring !pp!rt&nity >
@@@ 8 Ad%ati and P"leiderer 0())42 arg&ed that #y having #!th inside and !&tside invest!rs c!ntri#&te
t! a vent&re, @@@@@@@@@@@@, and th&s a rati!nal c!ntin&ati!nCter%inati!n decisi!n w!&ld #e
%ade at each stage !" devel!p%ent
a #!th in"!r%ati!n asy%%etry and principal/agent pr!#le%s are res!lved
# ta9es and ris$ are #!th %ini%iGed
c the !verinvest%ent and &nderinvest%ent pr!#le%s are #alanced !&t >
d percepti!n #iases cancel !&t
+ssay *uestions
( 3ist and descri#e the eight stages !" a vent&re;s devel!p%ent and "inancing
, Hisc&ss s!%e !" the pr!#le%s that entreprene&rs have in neg!tiating with a Q4
+ Hisc&ss s!%e !" the pr!#le%s that Q4s have in neg!tiating with entreprene&rs
4 8he Q4 ind&stry did n!t #ec!%e a %aR!r "!rce in "inancing vent&res &ntil which 8': pr!#le%s
were s!lvedD
4*
C * A P T E R -.
Ini%ia P$;i" O,,erings
o, S%o"k
@@@ ( 'hich !" the "!ll!wing is N:8 c!nsidered an advantage !" g!ing p&#licD
a Sharing c!rp!rate c!ntr!l with !&tsiders >
# .etter access t! #!th e<&ity and de#t %ar$ets in the "&t&re
c .etter li<&idity "!r the "ir%;s shares
d 8he "ir%;s entreprene&rs have a chance t! li<&idate part !" their invest%ent and diversi"y
@@@ , 'hich !" the "!ll!wing is N:8 generally c!nsidered a c!st !" g!ing p&#licD
a UnderpricingB -P:s appear t! #e s&#stantially &nderpriced
# 4!%petiti!nB N!w that the "ir% is %!re visi#le, ind&stry rivals will c!%pete %!re
intensively >
c -ss&ance 4!stsB 8he typical &nderwriter spread "!r an -P: is 7F !" the !""ering pr!ceeds
d Eanage%ent;s ti%e in preparing "!r the !""ering
e 3!ss !" 4!ntr!lB New e<&ityh!lders %ay press the "ir% t! change its invest%ent, "inancing,
!r dividend p!licies, and %ay als! atte%pt t! replace the "ir%;s !riginal %anage%ent
tea%
@@@ + 'hich !" the "!ll!wing is N:8 generally c!nsidered a c!st !" g!ing p&#licD
a Agency 4!sts !" Eanagerial Hiscreti!nB Separating !wnership and c!ntr!l leads t! s&ch
c!sts, th!&gh they can #e %itigated with %!nit!ring, incentive c!ntracting, etc
# -n"!r%ati!n Asy%%etryB Hiscl!s&re re<&ire%ents %ay c!%pr!%ise the "ir%;s strategic
p!siti!n in the ind&stry
c 8a9esB P&#lic "ir%s "ace higher "ederal and state ta9 rates than private "ir%s >
d Per"!r%ance Press&resB Eanage%ent will "ace press&re "!r per"!r%ance "r!% invest!rs, the
"inancial press, e<&ity research analysts, and #!nd rating agencies
e Histracti!nsB Eanage%ent is !"ten distracted #y ti%e/c!ns&%ing invest!r/relati!ns tas$s,
s&ch as press releases, pers!nal visits "r!% !r t! %aR!r shareh!lders, etc
@@@ 4 T!%pers 0())*2 arg&ed that s%aller, y!&nger Q4s !"ten #ring their "ir%s p&#lic earlier in !rder
t! esta#lish a rep&tati!n and there"!re attract additi!nal capital in the "&t&re He re"ers t!
s&ch sel"/serving #ehavi!r !n the part !" a Q4 as
a grandstanding >
# #!asting
c rep&tati!n #&ilding
d rep&gnant
@@@ 5 S!%e pre/-P: shareh!lders %ay wish t! ta$e the !pp!rt&nity a""!rded #y the -P: t! cash !&t
s!%e !r all !" their shares in the @@@0i2@@@ p!rti!n !" the -P: -P: "ir%s als! generally raise
"&nds "!r the "ir% in the @@@0ii2@@@ p!rti!n !" the !""ering
@@@0i2@@@ @@@0ii2@@@
a pri%ary sec!ndary
# sec!ndary pri%ary >
c tertiary pri%ary
47
d sec!ndary tertiary
48
@@@ * An i%p!rtant aspect !" insiders; c!%%it%ent t! c!ntin&ing !wnership is the @@@@@@, where#y
insiders agree t! h!ld their shares "!r a peri!d 0typically (80 days2 a"ter the -P: date
a !wnership c!%%it%ent
# signaling agree%ent
c stat&e <&! agree%ent
d l!c$&p pr!visi!n >
@@@ 7 An -P: "ir% has a ch!ice !" tw! %eth!ds !" selling shares -n the @@@0i2@@@ %eth!d, the
&nderwriter essentially acts as a @@@0ii2@@@, agreeing t! p&rchase all shares !""ered at a "i9ed
price, and then ta$es the ris$ !" reselling the shares t! the p&#lic -n the @@@0iii2@@@
%eth!d, the &nderwriter essentially acts as a @@@0iv2@@@, agreeing !nly t! c!nd&ct a search
"!r interested #&yers
@@@0i2@@@ @@@0ii2@@@ @@@0iii2@@@ @@@0iv2@@@
a "ir%/c!%%it%ent #r!$er #est e""!rts dealer
# "ir%/c!%%it%ent dealer #est e""!rts #r!$er >
c #est e""!rts dealer "ir%/c!%%it%ent #r!$er
d #est e""!rts #r!$er "ir%/c!%%it%ent dealer
@@@ 8 -n an -P:, the @@@@@@ !pti!n all!ws the &nderwriter t! sell additi!nal shares i" it is pr!"ita#le t!
d! s!
a !verall!t%ent >
# !""er e9tensi!n
c c!ntin&ance
d pr!l!ngati!n
@@@ ) :ver the years ()80/,000, %!st US "ir%s that have g!ne p&#lic have ch!sen the @@@@@ as their
listing %ar$et
a NOS6
# AE6N
c NASHAUC:84 >
d .&lletin .!ard
@@@ (0 'hich !" the "!ll!wing is N:8 a the!ry that has #een s&ggested t! e9plain e%pirical evidence
that -P:s are initially &nderpricedD
a litigati!n ris$
# the winner;s c&rse
c signaling 0ie, strategic &nderpricing2
d the -P: %ar$et is ine""icient >
@@@ (( A well/d!c&%ented an!%aly ass!ciated with -P:s is evidence that -P:s @@@@@@ !ther st!c$s in
the aftermarket "!r &p t! + years
a !&tper"!r%
# &nderper"!r% >
@@@ (, 'hat is a unit I',D
a An -P: !" a previ!&s &nit 0!r divisi!n2 !" a "ir% that is #eing sp&n !"" !" its parent
# A pac$age that incl&des #!th c!%%!n st!c$ and warrants >
c An -P: !" c!%%!n shares that is s!ld in #&l$ 0ie, as a &nit2 t! a single invest!r
4)
@@@ (+ 'hat types !" "ir%s are %!st li$ely t! g! p&#lic via a &nit -P:D
a larger, !lder, %!re esta#lished "ir%s
# s%aller, y!&nger, %!re spec&lative "ir%s >
@@@ (4 N&triti!n, -nc, a vita%in s&pple%ent %an&"act&rer, is "inanced entirely with e<&ity that is
c&rrently privately !wned #y its %anagers 8he "ir% is e9pected t! generate earnings !" I5
%n per year int! perpet&ity, and all earnings are paid !&t in dividends 8he !wner/%anagers
receive n! additi!nal c!%pensati!n =!r all !" the !wner/%anagers, their shares !" the "ir%;s
e<&ity acc!&nts "!r the #&l$ !" their pers!nal wealth As a res&lt, in deter%ining their
pers!nal val&ati!n !" the "ir% they apply a high disc!&nt rate !" ++ percent t! their "&t&re e9pected
dividends, and there"!re they val&e the "ir% at I(5(5%n 0JI5%nC0++2 8he "ir%;s
%anage%ent tea% has recently c!ns&lted with an invest%ent/#an$ing "ir% a#!&t selling all
!" the "ir%;s e<&ity p&#liclyA that is, a#!&t going pulic with the "ir%;s shares Ass&%ing that the
c&rrent %anage%ent will c!ntin&e t! !perate the "ir%, the invest%ent/#an$ing "ir% esti%ates
that the %ar$et will val&e the "ir%;s e<&ity applying a ,5F disc!&nt rate t! e9pected "&t&re
dividends H!wever, e9pected dividends t! p&#lic shareh!lders will #e !nly I4 %n,
#eca&se %anagers will n!w #e paid a t!tal !" I( %n per year in salaries 0-gn!re ta9es and
transacti!n c!sts2 8he t!tal %ar$et val&e !" the "ir%;s p&#lic shares is @@@0i2@@@ Acc!&nting
"!r #!th the present val&e !" %anage%ent;s salaries 0disc!&nted int! perpet&ity at ++F2 and
the pr!ceeds "r!% the p&#lic sale !" shares, %anage%ent;s wealth gain "r!% g!ing p&#lic is
@@@0ii2@@@
@@@0i2@@@ @@@0ii2@@@
a I(, %n I,,, %n
# I(, %n I+88 %n
c I(* %n I,,, %n
d I(* %n I+88 %n >
+ssay *uestions
( 'hat are the advantages and disadvantages "!r a "ir%;s %anage%ent and invest!rs !" g!ing p&#lic
vers&s staying privateD
, .rie"ly descri#e three the!ries that have #een s&ggested t! e9plain e%pirical evidence that -P:s are
&nderpriced
+ 'hat is a unit I',D Under what circ&%stances w!&ld a "ir% #e #etter !"" g!ing p&#lic via &nitsD
4 'hat are the advantages and disadvantages !" g!ing p&#licD
5 Hisc&ss the the!ries that have #een s&ggested t! e9plain e%pirical evidence that -P:s are
initially &nderpriced Are these arg&%ents pers&asiveD
50
C * A P T E R -/
&anaging In%erna E#$i%' and
Seasoned E#$i%' O,,erings
@@@ ( -n the te9t;s e<&ity %anage%ent %!del #ased !n Eyers 0,0002, a "ir%;s net cash "l!w is all!cated
in three directi!ns 'hich !" the "!ll!wing is N:8 !ne !" these directi!nsD
a ac<&isiti!ns >
# dividends and share rep&rchases
c reinvest%ent
d %anage%ent;s private #ene"its !" c!ntr!l 0ie, per$s2
@@@ , Eyers 0,0002 rec!gniGes three i%per"ect s!l&ti!ns t! the #asic c!ntracting pr!#le% #etween
di""&se shareh!lders and %anage%ent 'hich !" the "!ll!wing is N:8 !ne !" these
s!l&ti!nsD
a dividends
# %!nit!ring
c incentive c!%pensati!n
d c!ntingent shareh!lder interventi!n >
@@@ + :ne sh!rtc!%ing !" the traditi!nal capital #&dgeting paradig% is thatB
a it d!es n!t rec!gniGe that pr!Rects %&st #e eval&ated !n the #asis !" their NPQs
# it d!es n!t rec!gniGe that the "ir% %ay "ace capital rati!ning
c it d!es n!t deal with why s!%e "ir%s have %&ltiple activities >
@@@ 4 :ne sh!rtc!%ing !" the traditi!nal capital #&dgeting paradig% is thatB
a it d!es n!t rec!gniGe that pr!Rects %&st #e eval&ated !n the #asis !" their NPQs
# it d!es n!t rec!gniGe that the "ir% %ay "ace capital rati!ning
c it d!es n!t deal with why capital rati!ning is necessary >
@@@ 5 'hich !" the "!ll!wing is N:8 a stated reas!n why an internal capital %ar$et, %anaged #y a
"ir%;s head<&arters, %ay #e s&peri!r t! e9ternal "inancingD
a 69ternal e<&ity "inancing is pr!#le%atic #eca&se !" the in"!r%ati!n asy%%etry pr!#le%
# 6ven i" internal and e9ternal pr!viders !" capital have the sa%e a#ility t! %!nit!r, internal
pr!viders will ch!!se t! %!nit!r %!re intensely #eca&se they have resid&al c!ntr!l !ver
the assets, and there"!re get %!re !" the gains "r!% %!nit!ring
c -" !ne &nit per"!r%s p!!rly, its assets can #e redepl!yed e""iciently
d Eanage%ent is generally #etter at %anaging internal 0vs e9ternal2 e<&ity >
@@@ * -n a %&lti/divisi!nal "ir%, what are the tw! "&nda%ental 0and related2 pr!#le%s with the internal
capital all!cati!n pr!cessD
a centraliGed in"!r%ati!n and ta9/av!idance
# %!nit!ring and signaling
c decentraliGed in"!r%ati!n and incentive pr!#le%s >
d signaling and ta9/av!idance
5(
@@@ 7 -n &nderta$ing a seas!ned e<&ity !""ering 0S6:2, why d! "ir%s al%!st always hire an
&nderwriter via neg!tiati!n rather than c!%petitive #iddingD
a 8he S64 %andates neg!tiati!n "!r S6:s 0e9cept in rare cases2
# 8he selling pr!cess can #e pr!#le%atic #eca&se !" in"!r%ati!nal asy%%etry pr!#le%s >
c Neg!tiati!n act&ally res&lts in a l!wer &nderwriter spread
@@@ 8 'hich !" the "!ll!wing is the e9planati!n !" why the %ar$et generally reacts negatively t! the
ann!&nce%ent !" a S6: !""ered in the pecking order hypothesisD
a Eanage%ent is ta$ing a sel"/serving acti!n
# Eanage%ent is signaling that the shares are !verpriced >
c 4redit!rs are "!rcing the "ir% t! increase its e<&ity #ase
d 8he "ir% is revealing that it has n!t generated as %&ch earnings as the %ar$et e9pected
@@@ ) Researchers p!int t! the decades !" the ()*0s and ()70s as a peri!d when internal capital %ar$ets
%ay have #een s&peri!r t! e9ternal capital %ar$ets in the US 8! test this arg&%ent, H&##ard
and Palia 0()))2 e9a%ined +), #idding "ir%s inv!lved in %ergers in the ()*0s 8h!se
#idders that realiGed the highest ret&rns "r!% %erger were cases in which the #idding "ir% was
"inancially @@@0i2@@@ while the target "ir% was "inancially @@@0ii2@@@
@@@0i2@@@ @@@0ii2@@@
a c!nstrained &nc!nstrained
# &nc!nstrained c!nstrained >
@@@ (0 A @@@@@@ is a seas!ned e<&ity !""ering 0S6:2 !" a "ir% that has recently g!ne p&#lic
a "!ll!w/!n >
# s&pple%ental -P:
c l!c$&p !""ering
d <&asi/seas!ned e<&ity !""ering
+ssay *uestions
( Hisc&ss the three c!%p!nents !" the !verall &nderwriting c!st !" a seas!ned e<&ity iss&e
, Hisc&ss the pecking order hypothesis as interpreted #y Eyers and EaRl&" 0()842
+ Hisc&ss the vari!&s e%pirical st&dies !" the %ar$et;s reacti!n t! seas!ned e<&ity iss&ances
4 -n a %&lti/divisi!nal "ir%, what are the tw! "&nda%ental 0and related2 pr!#le%s with the internal
capital all!cati!n pr!cessD
5 69plain the inter/s&#sidiary s&#sidiGati!n pr!#le%
* -n &nderta$ing a seas!ned e<&ity !""ering 0S6:2, why d! "ir%s al%!st always hire an &nderwriter via
neg!tiati!n rather than c!%petitive #iddingD
7 69plain h!w the pec$ing !rder hyp!thesis e9plains why the %ar$et generally reacts negatively t! the
ann!&nce%ent !" a S6:
8 'hy are &nderwriter spreads inversely related t! the siGe !" a S6:D
5,
) Acc!rding t! evidence presented in the te9t, the %ar$et;s reacti!n t! a S6: is negatively related t!
the &nderwriter;s spread Pr!vide a reas!n why this %ay is s!
(0 Acc!rding t! evidence presented in the te9t, the %ar$et;s reacti!n t! a S6: is p!sitively related t! the
pri!r year;s %ar$et ret&rn Pr!vide a reas!n why this %ay is s!
(( Harris and Raviv 0())*2 arg&e that a "ir%;s internal capital #&dgeting pr!cess is #eset #y a
c!%#inati!n !" agency and in"!r%ati!nal asy%%etry pr!#le%s 69plain their arg&%ent
5+
C * A P T E R -3
Di)idend Poi"' and
S%o"k Rep$r"hases
@@@ ( 8RU6 !r =A3S6 8he d!llar val&e !" aggregate share rep&rchases has gr!wn relative t!
aggregate dividends in recent years
a 8RU6 >
# =A3S6
@@@ , H!w d!es Jensen;s free cash flow hypothesis relate t! a "ir%;s dividend p!licyD
a Hividends discipline %anage%ent #y "!rcing "ree cash "l!w t! #e disg!rged t! shareh!lders,
th&s %itigating %anage%ent;s tendency t! engage in e%pire #&ilding >
# Hividends act as a signal !" "ir% val&e
c Hividends s!lve the principal/agent pr!#le% #etween shareh!lders and credit!rs
d Hividends s!lve the &nderinvest%ent pr!#le%
@@@ + Under what circ&%stances w!&ld a "ir% engage in share rep&rchases rather than increasing
dividendsD
a -" the "ir% has e9cess "ree cash "l!w that %anage%ent e9pects will c!ntin&e inde"initely
# -" the "ir% has e9cess "ree cash "l!w that %anage%ent e9pects will #e !nly te%p!rary >
c -" shareh!lders are in a l!wer ta9 #rac$et "!r dividends than "!r realiGed capital gains
@@@ 4 'hich !" the "!ll!wing c!rrectly descri#es the Dutch auction %eth!d !" share rep&rchaseD
a 8he "ir% c!nd&cts !pen/%ar$et p&rchases
# 8he "ir% speci"ies a price and a <&antity !" shares that it will rep&rchase
c 8he "ir% a&cti!ns shares t! the highest #idder, as l!ng as that #idder %eets the "ir%;s
reservati!n price
d 8he "ir% esta#lishes an accepta#le range !" prices, s!licits and c!llects sell !""ers, calc&lates
the average price !" these !""ers, and this average price is applied t! all tendered shares
>
@@@ 5 S&pp!se =ir% NOP paid a dividend !" I( per share last year, and this year;s earnings per share
was I+ 8he "ir%;s target pay!&t rati! is J050, and the val&e !" the "ir%;s speed !"
adR&st%ent para%eter is J0+ 'hat is the "ir%;s e9pected dividend "!r this yearD
a 085
# (00
c ((5 >
d (+0
=:REU3AB H-Qt / H-Qt/( J H-Qt J 0>6ARNt/H-Qt/(2
+ssay *uestions
( Hisc&ss the agency c!st the!ry !" dividend p!licy
, Hisc&ss the signaling the!ry !" dividend p!licy
54
+ H!w d!es the !wnership str&ct&re !" the "ir% a""ect its dividend p!licyD
4 'hy d! "ir%s engage in share rep&rchase pr!gra%sD Hisc&ss the!ry and evidence
5 E!st "ir%s that ann!&nce a speci"ic n&%#er !" shares that they plan t! rep&rchase, in "act !nly
rep&rchase a "racti!n !" the shares that they speci"ied -s there a p!ssi#le signal g!ing !n hereD
* Hisc&ss reas!ns why the d!llar val&e !" aggregate share rep&rchases has gr!wn relative t! aggregate
dividends in recent years
7 H!w d!es Jensen;s free cash flow hypothesis relate t! a "ir%;s dividend p!licyD
8 Histing&ish the H&tch a&cti!n and "i9ed price tender !""er %eth!ds !" rep&rchasing shares 'hich
generally garners a higher %ar$et reacti!n and whyD
) Under what circ&%stances w!&ld a "ir% engage in share rep&rchases rather than increasing its
dividendD
55
C * A P T E R -5
Corpora%e 8ia;ii%ies: S%ra%egi"
See"%ions o, 8enders and
Con%ra"% Ter4s
@@@ ( Acc!rding t! the @@@@@@@@@ principal, sh!rt/ter% assets sh!&ld #e "inanced with sh!rt/ter%
capital and l!ng/ter% assets with l!ng/ter% capital
a %at&rity %atching >
# hedging
c ris$/ret&rn
c capital asset
@@@ , Monitoring is !ne %eans #y which credit!rs can c!ntr!l a #!rr!wer;s incentive t! e9pr!priate
wealth "r!% the credit!rs H!wever, direct %!nit!ring !" a #!rr!wer;s acti!ns is %!re
di""ic&lt in a p&#lic #!nd iss&e than in a private #!nd iss&e #eca&se !" theB
a "ree/rider pr!#le% >
# re<&ire%ent !" registrati!n with the S64 "!r a p&#lic #!nd iss&e
c %!ral haGard pr!#le%
d adverse selecti!n pr!#le%
@@@ + 8he val&e !" a c!nverti#le #!nd is relatively insensitive t! changes in the riskiness !" the "ir%,
#eca&se the val&e !" the &nderlying #!nd is in!ersely related t! changes in the "ir%;s ris$, while
the val&e !" the i%plicit call !pti!n is directly related t! changes in the "ir%;s ris$ 4!nse<&ently,
with a c!nverti#le #!nd the "ir%;s %anage%ent n! l!nger has an incentive t! engage in
@@@@@@@@@ t! e9pr!priate val&e "r!% the #!ndh!lders, and there"!re !ne !" the %aR!r agency
pr!#le%s ass!ciated with de#t is res!lved
a e9cessive c!ns&%pti!n !" per<&isites
# ris$ shi"ting >
c e9cessive dividend pay%ents
d e9cessively c!nservative invest%ent p!licies
@@@ 4 'hich !" the "!ll!wing is N:8 !ne !" the si9 "&nda%ental "act!rs that deter%ine the !pti%al
s!&rce !" de#t "&nding "!r a "ir%D
a the "ir%;s de#t rati! >
# lender;s need t! %!nit!r the #!rr!wer;s !perati!ns
c in"!r%ati!n asy%%etry, and speci"ically the pr!#le% !" assessing creditw!rthiness
d the "ir%;s need "!r "le9i#ility
5*
@@@ 5 S&pp!se a "ir% wants t! #!rr!w I,00 %illi!n "!r 5 years t! "&nd capital e9pendit&res, and is
c!nsidering the ch!ice !" a #an$ l!an !r a p&#lic iss&e thr!&gh an invest%ent #an$ing "ir% as
&nderwriter =!r si%plicity, we will ass&%e that in either case the "ir% will iss&e p&re/
disc!&nt de#t 8he #an$ de%ands a (0,5F interest rate 0with n! "ee2, while the &nderwriter
states that the interest c!st will #e ),5 percent with +F "l!tati!n c!sts 'hich "&nding s!&rce
pr!vides the l!wer e""ective interest c!stD
a the #an$ l!an
# the p&#lic iss&e >
c #!th pr!vide e9actly the sa%e e""ective interest c!st
@@@ * 'hich !" the "!ll!wing is the "&nda%ental di""erence #etween private 0#an$2 de#t and p&#licly
iss&ed de#tD
a P&#lic de#t is !"ten re"erred t! as inside det #eca&se !" the cl!se relati!nship #etween the
lenders and the #!rr!wer, while a #an$ l!an is called outside det #eca&se the lender
essentially has n! active relati!nship with the #!rr!wer
# A #an$ l!an is !"ten re"erred t! as inside det #eca&se !" the cl!se relati!nship #etween
lender and #!rr!wer, while p&#lic de#t is called outside det #eca&se the lenders
essentially have n! active relati!nship with the #!rr!wer >
@@@ 7 S&pp!se a "ir% wants t! #!rr!w I,00 %illi!n "!r (0 years t! "&nd capital e9pendit&res, and is
c!nsidering the ch!ice !" a private place%ent with several ins&rance c!%panies !r a p&#lic iss&e
thr!&gh an invest%ent #an$ing "ir% as &nderwriter =!r si%plicity, we will ass&%e that in
either case the "ir% will iss&e p&re/disc!&nt #!nds 8he ins&rance c!%panies de%and interest at
a rate !" (0 percent, with a +F "l!tati!n c!st, while the &nderwriter states that the interest c!st
will #e ),5F with 5F "l!tati!n c!sts 'hat is the e""ective c!st !" the l!an in each caseD
0-NS.%RS/ (0+,5F and )785F, respectively2
private p&#lic
place%ent iss&e
a (0+,5F )785F >
# )785F (0+,5F
c 8)75F ((,,5F
d ((,,5F 8)75F
@@@ 8 A "ir% wants t! #!rr!w I(00 %illi!n "!r 5 years 0p&re disc!&nt, "!r si%plicity2 'hich !" the
"!ll!wing s!&rces has the l!wer effecti!e interest costD
:rig =eeC
S!&rce -nterest Rate =l!tati!n 4!st
Private Place%ent )00F (F
P&#lic -ss&e 8,5F +F
a 8he private place%ent
# 8he p&#lic iss&e >
c 8he c!sts are the sa%e
=:REU3AB 6""ective interest c!stJie""ective J (
P
2 i ( 0 > 2 " ( 0 P
8 C (
8
stated
1
]
1
+ +
, where P is
the a%!&nt !" l!an pr!ceeds that the "ir% needs, " is the l!an !riginati!n "ee !r "l!tati!n c!st as a
"racti!n !" P, and istated is the stated interest c!st
57
+ssay *uestions
( Hisc&ss the ec!n!%ic %ilie& that s&rr!&nded the si%&ltane!&s 0partial2 de%ise !" the traditi!nal +0/
year "i9ed/c!&p!n calla#le c!rp!rate #!nd and the e%ergence !" the sh!rter/ter%, varia#le/rate n!te
, 3ist the si9 "&nda%ental "act!rs that deter%ine the !pti%al s!&rce !" de#t "&nding "!r a "ir%
+ 69plain the "&nda%ental di""erences #etween private 0#an$2 de#t and p&#licly iss&ed de#t
4 69plain the S%at&rity %atching; r&le "!r deciding whether t! iss&e sh!rt/ !r l!ng/ter% de#t
5 69plain the r!le !" the call pr!visi!n in res!lving agency pr!#le%s !" de#t
* 69plain the r!le !" the sin$ing "&nd pr!visi!n in res!lving agency pr!#le%s !" de#t
58
C * A P T E R -7
&ergers1 A"#$isi%ions1
Takeo)ers1 and B$'o$%s
@@@ ( -n a @@@@@@@@, #!th "ir%s cease t! e9ist, and a new c!rp!rati!n is esta#lished with a new na%e, a
new #!ard, andC!r a new %anage%ent tea%
a %erger
# ac<&isiti!n
c c!ns!lidati!n >
d #&y!&t
@@@ , -n a @@@@@@@@ the #idder;s intenti!n is t! ac<&ire the target and replace the target;s inc&%#ent
%anage%ent, wh! vig!r!&sly resist the atte%pt
a %erger
# ac<&isiti!n
c #&y!&t
d h!stile ta$e!ver >
@@@ + A @@@@@@@@ !cc&rs when a gr!&p !" individ&als &ses cash t! p&rchase the shares !" a "ir% and
ta$es !wnership and c!ntr!l !" the "ir%
a #&y!&t >
# ac<&isiti!n
c c!ns!lidati!n
d %erger
@@@ 4 -n a @@@@@@@ %erger, tw! "ir%s that heret!"!re have #een c!%petit!rs in the sa%e line !"
#&siness c!%#ine
a c!ngl!%erate
# vertical
c diag!nal
d h!riG!ntal >
@@@ 5 A @@@@@@@ %erger !cc&rs #etween tw! "ir%s that had #een d!ing #&siness in di""erent stages !"
the pr!d&cti!n pr!cess in a given ind&stry
a c!ngl!%erate
# vertical >
c diag!nal
d h!riG!ntal
@@@ * A @@@@@@@@@@@@@ %erger inv!lves the c!%#inati!n !" tw! "ir%s in &nrelated ind&stries
a c!ngl!%erate >
# vertical
c diag!nal
d h!riG!ntal
5)
@@@ 7 @@@@@@@@@ !#tains i" a %erger res&lts in i%pr!ve%ents in any #&siness "&ncti!n, incl&dingB 0i2
%anage%entA 0vii2 la#!r c!stsA 0ii2 pr!d&cti!n !r distri#&ti!nA etc
a :perating synergy >
# =inancial synergy
c .&siness synchr!niGati!n
d 6c!n!%ies !" sc!pe
@@@ 8 @@@@@@@@@ !#tains in a %erger i" s!%e aspect !" the "inancial c!n"ig&rati!n !" the %erged "ir%
ca&ses its %ar$et val&e t! #e greater than the s&% !" the %ar$et val&es !" the separate "ir%s
a :perating synergy
# =inancial synergy >
c .&siness synchr!niGati!n
d 6c!n!%ies !" sc!pe
@@@ ) 8he !riginal credit!rs !" #!th "ir%s in a %erger w!&ld #ene"it "r!% the !verall decrease in the
pr!#a#ility !" #an$r&ptcy that attends the %erger, which in t&rn res&lts "r!% the @@@@@@@@@
ass!ciated with credit!rs n!w having a clai% against a larger c!%#ined "ir%
a ta9 red&cti!n
# increased interest pay%ents
c decreased principle
d c!/ins&rance >
@@@ (0 A legiti%ate %eans !" averting an &nintended trans"er !" wealth t! credit!rs in a %erger is t!B
a decrease leverage
# red&ce the v!latility !" !perating pr!"its
c !""er a g&arantee t! the separate "ir%s; credit!rs
d increase leverage >
@@@ ((Acc!rding t! the @@@@@@ hyp!thesis, in an ac<&isiti!n !r a ta$e!ver the #idder;s %anage%ent
!verval&es the target #eca&se they !veresti%ate their a#ility t! create val&e !nce they wrest
c!ntr!l !" the target;s assets
a h&%id!r
# h&#ris >
c h&%&ng!&s eg!
d ha&ghty head<&arters
@@@ (, -n a @@@@@@, a diversi"ied "ir% is ta$en !ver and assets !r divisi!ns are s!ld, s! that the re%aining
"ir% is %!re "!c&sed and e""icient
a spin/!""
# e<&ity carve/!&t
c #&st&p ta$e!ver >
d dispersal
@@@ (+ 8he literat&re e%phasiGes three %!tives "!r a #&y!&t, incl&ding all !" the "!ll!wing 6N46P8B
a t! increase access t! capital %ar$ets >
# t! increase %anagerial incentives
c t! avert a ta$e!ver
d t! realiGe ta9/red&cti!n #ene"its
*0
@@@ (4 A @@@@@@ is an agree%ent a%!ng the "ew d!%inant "ir%s in an ind&stry t! c!!rdinate pr!d&cti!n
and, as alleged, t! c&t prices te%p!rarily in !rder t! drive !&t !r ac<&ire s%aller c!%petit!rs,
a"ter which they c!&ld raise prices s&#stantially
a syndicate
# tr&st >
c n!n/c!%pete cla&se
d c&t/thr!at acc!rd
@@@ (5 8he =inancial Acc!&nting Standards .!ard 0=AS.2 has recently v!ted t! eli%inate @@@0i2@@@
acc!&nting "!r %ergers, and hence"!rth will all!w !nly the @@@0ii2@@@
@@@0i2@@@ @@@0ii2@@@
a p&rchase %eth!d p!!l !" interest
# a%alga%ati!n c!ns!lidati!n
c p!!ling !" interest p&rchase %eth!d >
d c!ns!lidati!n a%alga%ati!n
@@@ (* 8RU6 !r =A3S6B A %erger ann!&nce%ent ind&ces a s&#stantial p!sitive a#n!r%al ret&rn !n the
ac<&iring "ir%;s st!c$ 0appr!9i%ately ,0F, !n average2, while the target "ir%;s st!c$h!lders
are either &na""ected !r s&stain s%all l!sses, !n average
a 8RU6
# =A3S6 >
@@@ (7 Perhaps the #est circ&%stance that w!&ld lead t! gains "!r the shareh!lders !" #!th the #idder and
the target in a ta$e!ver is when a well/%anaged "ir% ta$es !ver a p!!rly %anaged "ir% 8h&s, the
greatest gains in th!se ta$e!vers in which the #idder has a @@@0i2@@@ 8!#in;s < rati! 0is well
%anaged2 and the target has a @@@0ii2@@@ < rati! 0is p!!rly %anaged2 6vidence s&pp!rts this
arg&%ent
@@@0i2@@@ @@@0ii2@@@
a high l!w >
# l!w high
@@@ (8 8he #idder in a ta$e!ver generally sh!&ld ta$e advantage !" te%p!rary an!ny%ity t! p&rchase
shares !" the target #e"!re its intenti!ns are p&#licly $n!wn and the target "ir%;s price rises
S&ch initial p&rchases esta#lish a @@@@@@@
a "!!th!ld
# legh!ld
c ar%h!ld
d t!eh!ld >
@@@ () A pr!#le% with the tender !""er %echanis% in a ta$e!ver is the @@@@@@ 8he ter% re"ers t! a
sit&ati!n in which rati!nal #ehavi!r #y each individ&al shareh!lder res&lts in shareh!lders as
a gr!&p #eing w!rse !"" -" individ&al target shareh!lders 0c!rrectly2 "!resee that the val&e !"
their shares will #e w!rth %!re after the ta$e!ver than they will receive in the tender !""er,
they will ch!!se n!t t! tender their shares
a h!ld!ver pr!#le%
# "ree rider pr!#le% >
c h!ld!&t pr!#le%
d n!n/tender pr!#le%
*(
@@@ ,0 -" the #idder in a h!stile ta$e!ver "aces target %anage%ent resistance, as an alternative t! either
#idding higher !r ter%inating the tender !""er pr!cess, #idders s!%eti%es !""er target
%anage%ent c!%pensati!n t! end its resistance 8his c!%pensati!n is calledB
a a g!lden parach&te >
# a silver #&llet
c a g!ld watch
d re%!val re%&nerati!n
@@@ ,( -n a ta$e!ver #id, target %anage%ent %ay !""er t! rep&rchase the #idder;s shares at a large
pre%i&% i" the #idder pr!%ises t! cease and desist 8he pre%i&% pay!"" is called @@@0i2@@@,
and the agree%ent t! cease and desist is called a @@@0ii2@@@
@@@0i2@@@ @@@0ii2@@@
a s&#!rnati!n stand d!wn agree%ent
# s&#!rnati!n standstill agree%ent
c green%ail standstill agree%ent >
d green%ail stand d!wn agree%ent
@@@ ,, 4!ntract devices e9plicitly designed t! thwart a h!stile ta$e!ver atte%pt are called poison pills !r
shark repellents 69a%ples incl&de all !" the "!ll!wing 6N46P8B
a a shareh!lder rights plan that can #e iss&ed as dividends at %anage%ent;s discreti!n
# an event/triggered p&t pr!visi!n in !ne !" the "ir%;s de#t c!ntracts
c a pr!visi!n in the "ir%;s charter that gives inc&%#ent %anage%ent their p!siti!ns "!r li"e >
@@@ ,+ State legislati!n designed t! thwart ta$e!vers has #een enacted in recent years, incl&ding
@@@@@@@, which restrict the v!ting p!wer !" a c!ntr!lling shareh!lder
a #&siness c!%#inati!n laws
# v!ting share reprisal laws
c ta$e!ver p!stp!ne%ent laws
d c!ntr!l share laws >
@@@ ,4 State legislati!n designed t! thwart ta$e!vers has #een enacted in recent years, incl&ding
@@@@@@@, which can delay the c!ns&%%ati!n !" #&siness c!%#inati!ns "!r years
a #&siness c!%#inati!n laws >
# v!ting share reprisal laws
c ta$e!ver p!stp!ne%ent laws
d c!ntr!l share laws
@@@ ,5 8he p&rchasers in a #&y!&t !"ten !#tain "inancial and strategic assistance "r!% a @@@@@@@ wh!, as
a sponsor, &s&ally "inances the transacti!n with e<&ity c!ntri#&ted #y a n&%#er !" invest!rs and
de#t #!rr!wed "r!% several s!&rces
a #&y!&t specialist >
# 3.: inter%ediary
c "inance c!%pany
d vent&re capital "ir%
@@@ ,* -n %any cases a "ir% that has g!ne private via an 3.: s&#se<&ently re/e%erges as a p&#licly
traded "ir% 0via an!ther -P:2 8his transacti!n is called a
a reprise -P:
# res&%pti!n
c reverse 3.: >
d r!ll!ver
*,
+ssay *uestions
( Hisc&ss Jensen;s arg&%ents a#!&t the "ail&re !" internal c!ntr!l %echanis%s
, Hisc&ss hyp!theses and e%pirical evidence !n %ergers and ac<&isiti!ns
+ Histing&ish and disc&ss each !" the "!ll!wingB 3.:, E.:, 6.:
*+
C * A P T E R -:
Finan"ia Dis%ress and
Res%r$"%$ring
@@@ ( .an$r&ptcy ris$ plays a r!le in the pr!pagati!n !" recessi!ns #yB
a ca&sing a #ac$l!g in the casel!ads !" #an$r&ptcy c!&rts
# ca&sing "ir%s t! increase capital e9pendit&res as the ec!n!%y #egins t! sl!w
c "!rcing "ir%s t! pay d!wn de#t
d straining the li<&idity p!siti!ns !" #!th individ&als and "ir%s, #!th !" which try t! av!id
#an$r&ptcy #y %aintaining li<&idity >
@@@ , 'hen the =ederal Reserve .!ard;s !pen %ar$et c!%%ittee uys 8/#ills, it is p&rs&ing
a c!ntracti!nary %!netary p!licy
# e9pansi!nary %!netary p!licy >
c "iscal discipline
d a p!licy !" #alancing the "ederal #&dget
@@@ + Acc!rding t! the!ry, the en mass reversal !" the c!ngl!%erate diversi"icati!n trend !" the ()*0s
and ()70s in "av!r !" focus in the ()80s and ())0s was #r!&ght a#!&t #y
a "ederal legislati!n
# ec!n!%ic, techn!l!gical, and reg&lat!ry changes that #!!sted the advantage !" internal
capital %ar$ets relative t! external capital %ar$ets
c ec!n!%ic, techn!l!gical, and reg&lat!ry changes that #!!sted the advantage !" external
capital %ar$ets relative t! internal capital %ar$ets
d gl!#aliGati!n
@@@ 4 8RU6 !r =A3S6 Agency c!sts !" %anagerial discreti!n are !ne !" the "ew c!sts that are n!t
e9acer#ated when a "ir% is &nder "inancial distress
a 8RU6
# =A3S6 >
@@@ 5 P!rter;s 0i!e 0orces %!del !" ind&stry c!%petiti!n incl&des all !" the "!ll!wing "!rces 6N46P8B
a entryCe9it #arriers
# the #argaining p!wer !" s&ppliers
c the #argaining p!wer !" #&yers
d the gr!wth p!tential !" the ind&stry
e the threat !" s&#stit&te pr!d&cts
" rivalry a%!ng c!%peting "ir%s
@@@ * -" !ne "ir% in a given ind&stry declares #an$r&ptcy, the %ar$et %ay l!wer the val&es !" !ther
"ir%s in a given ind&stry #eca&se the reveals new, negative in"!r%ati!n a#!&t the stat&s !" the
ind&stry as a wh!le 8his phen!%en!n is calledB
a the c!ntagi!n e""ect >
# the intra/ind&stry wealth trans"er e""ect
c irrati!nal #ehavi!r
d the sy%pathy e""ect
*4
@@@ 7 6%pirical evidence indicates that "!r distressed "ir%s, higher pre/distress leverage increases the
pr!#a#ility !" !perati!nal acti!ns 0eg, asset restr&ct&ring and e%pl!yee lay!""s2 and
"inancial acti!ns 0eg, dividend c&ts2 8his evidence is c!nsistent with theB
a disciplinary r!le !" de#t >
# waste"&l c&ts hyp!thesis
c %anagerial discreti!n hyp!thesis
d leverage aggressiveness hyp!thesis
@@@ 8 Acc!rding t! which hyp!thesis #el!w, the %ar$et generally reacts "av!ra#ly t! an asset sale
#eca&se s&ch sales pr!%!te e""iciency #y all!cating assets t! #etter &ses
a the "inancing hyp!thesis !" asset sales
# the e""icient depl!y%ent hyp!thesis >
c the in"!r%ati!n hyp!thesis
d the "ire/sales hyp!thesis
@@@ ) -n a0n2 @@@@@@@@@@, the parent !" a %&ltiple/s&#sidiary "ir% iss&es, via an -P:, e<&ity shares
"!r a partic&lar s&#sidiary, th!&gh the parent &s&ally $eeps %aR!rity !wnership !" the shares,
and th&s c!ntr!l !" the s&#sidiary
a asset sale
# spin/!""
c e<&ity carve/!&t >
d targeted st!c$ iss&ance
@@@ (0 -n a d&al/class recapitaliGati!n 0!r Srecap;2, a "ir%
a creates tw! classes !" %anagers[!perati!nal and "inancial
# esta#lishes tw! classes !" sec&rities[de#t and e<&ity
c esta#lishes tw! classes !" de#t sec&rities[seni!r and s&#!rdinated
d creates a sec!nd class !" c!%%!n st!c$ that has li%ited v!ting rights and generally a
pre"erential clai% t! the "ir%;s cash "l!ws >
@@@ (( 8argeted st!c$, als! $n!wn as trac$ing st!c$ !r letter st!c$, is a class !" c!%%!n st!c$ !" a
diversi"ied c!%pany that is
a lin$ed t! the per"!r%ance !" a partic&lar #&siness &nit !r divisi!n >
# seni!r t! !ther classes !" the "ir%;s c!%%!n st!c$
c c!nverti#le int! the st!c$ !" an independent target c!%pany
d st!c$ that trac$s the per"!r%ance !" a st!c$ inde9 s&ch as the S5P 500
@@@ (, -n an e<&ity carve/!&t, the parent !" a %&ltiple/s&#sidiary "ir% iss&es e<&ity clai%s against a
partic&lar s&#sidiary via a
a private place%ent
# pr!/rata distri#&ti!n t! the parent;s c&rrent st!c$h!lders
c p&#lic !""ering >
d &nit distri#&ti!n
@@@ (+ A spin/!"" is a
a pr!/rata distri#&ti!n !" new e<&ity clai%s !n a s&#sidiary t! the parent;s shareh!lders >
# sale !" a divisi!n "!r cash t! an!ther "ir%
c ta9/driven sale !" depreciati!n rights t! an!ther "ir%
d sale !" patent rights 0eg, "!r a phar%ace&tical dr&g2 t! an!ther "ir%
*5
@@@ (4 8! address distress, any !" the "!ll!wing changes in the "!cal "ir%;s #!ard str&ct&re are c!nsistent
with the!ry 6N46P8B
a replacing insiders with !&tsiders
# li%iting the a#ility !" the #!ard t! vet! the 46:;s pr!p!sals >
c re<&iring direct!rs t! h!ld e<&ity shares
d li%iting the ten&re !" direct!rs
e ending the staggering !" #!ard electi!ns
" red&cing the siGe !" the #!ard
+ssay *uestions
( Andrade and 1aplan 0())82 pr!vided e%pirical evidence !n the ca&ses and c!sts !" "inancial distress
a 'hat did they "ind as the chie" ca&se !" "inancial distressD
# 'hat three i%p!rtant c!sts !" "inancial distress did they identi"yD
, 8w! hyp!theses have #een devel!ped t! e9plain the %ar$et;s reacti!n t! ann!&nce%ents !" asset
sales 8hese areB 0a2 the efficient deployment hypothesis, and 0#2 the financing hypothesis of asset
sales .rie"ly e9plain each !" these hyp!theses and h!w they are c!nsistent with e%pirical evidence
!n ann!&nce%ent e""ects !" asset sales
+ H!w d! asset sales relate t! the c!ncept !" corporate focusD
4 H!w d! "ir%s adR&st their dividend p!licy in the "ace !" pr!tracted "inancial distressD
5 69plain h!w each !" the "!ll!wing c!sts are e9acer#ated when a "ir% is &nder "inancial distressB 0a2
ta9esA 0ii2 transacti!n c!stsA 0iii2 agency c!sts !" %anagerial discreti!nA and 0iv2 l!ss !" li<&idity
* He"ine and di""erentiate each !" the "!ll!wingB
a asset sale1
# spin"offA
c e#uity car!e"outA
d issuance of targeted stock
7 'hat is it a#!&t a spin/!"" that elicits a "av!ra#le %ar$et reacti!nD Researchers have pr!""ered "ive
hyp!theses t! e9plain the %ar$et;s p!sitive reacti!n 3ist the%
8 H!w d! "ir%s adR&st their dividend p!licy in the "ace !" pr!tracted "inancial distressD
) Hisc&ss the de#ate !ver, and pertinent evidence regarding, diversi"icati!n vers&s "!c&s
(0 69plain h!w in"!r%ati!n asy%%etry the!ry can e9plain the %ar$et;s di""erential reacti!ns t! spin/!""
ann!&nce%ents
(( Hisc&ss arg&%ents and evidence !n e<&ity carve/!&ts
(, Hisc&ss the iss&es ass!ciated with "iring the seni!r %anage%ent !" a distressed "ir%
(+ Hisc&ss -.E;s restr&ct&ring e""!rts in the ())0s
**
C * A P T E R -A
De;% Res%r$"%$ring1 Being
A"#$ired1 Bankr$p%"'1
Reorgani=a%ion1 and
8i#$ida%ion
@@@ ( 6%pirical evidence indicates that the %aR!rity !" distressed p&#lic "ir%s that d! n!t re%ain
p&#licB
a "ile "!r 4hapter (( #an$r&ptcy 0re!rganiGati!n2
# "ile "!r 4hapter 7 #an$r&ptcy 0li<&idati!n2
c are ac<&ired >
d &nderg! a g!ing/private transacti!n 0ie, a #&y!&t2
@@@ , 8RU6 !r =A3S6B A%!ng p&#licly traded US n!n"inancial "ir%s, %!st #an$r&ptcy
ann!&nce%ents are c!%plete s&rprises t! the %ar$et, as indicated #y the "act that, "!r !ver
)0F !" s&ch "ir%s, their ann!&nce%ent/%!nth %ar$et e<&ity val&e 0E6U2 is at least as high as their
E6U at %!nth Y(, relative t! the ann!&nce%ent
a 8RU6
# =A3S6 >
@@@ + -n de#t restr&ct&ring, all de#t clai%ants %&st agree !n the reassign%ent !" de#t clai%s, #&t !ne !r
%!re clai%ants has an incentive t! wait "!r a #etter deal 8his is $n!wn as the @@@@@@ pr!#le%
a h!ld!&t >
# instigati!n
c c!ncessi!n
d c!%pr!%ise
@@@ 4 He#t restr&ct&ring is generally acc!%plished via a c!%#inati!n !" @@@0i2@@@ and @@@0ii2@@@
@@@0i2@@@ @@@0ii2@@@
a de"a&lt "!rgiveness
# c!ns!lidati!n e9it 0!" s!%e credit!rs2
c "!rgiveness e9 p!st regret
d e9change !""ers c!erci!n >
@@@ 5 Acc!rding t! signaling the!ry, 4hapter (( is a &se"&l %echanis% "!r screening ine""icient "ir%s
!&t !" de#t reneg!tiati!n -ne""icient "ir%s v!l&ntarily ch!!se 4hapter (( #eca&seB
a the "ir% can #e li<&idated %!re <&ic$ly
# neg!tiati!ns therein generally res&lt in s!%e val&e retained #y shareh!lders >
c credit!rs are pr!tected "r!% vi!lati!ns !" the a#s!l&te pri!rity r&le 0APR2
d %anage%ent can #etter signal a higher "ir% val&e within 4hapter ((
*7
@@@ * -nvest!rs wh! specialiGe in the de#t !r e<&ity !" distressed "ir%s are calledB
a spec&lat!rs
# ar#itrage&rs
c #!tt!% dwellers
d v&lt&re invest!rs >
@@@ 7 8RU6 !r =A3S6B =!r distressed "ir%s with #!th #an$ and p&#lic de#t !&tstanding, #an$s never
%a$e c!ncessi!ns &nless p&#lic de#th!lders als! restr&ct&re their clai%s
a 8RU6 >
# =A3S6
@@@ 8 8RU6 !r =A3S6B Acc!rding t! e%pirical st&dies, the c!%#inati!n !" sec&red private de#t and
n&%er!&s p&#lic de#t iss&es 0in a distressed "ir%;s capital str&ct&re2 i%pedes !&t/!"/c!&rt
de#t restr&ct&ring and increases the pr!#a#ility !" a 4hapter (( "iling
a 8RU6 >
# =A3S6
@@@ ) 8! preserve the val&e !" a distressed "ir%, it is generally i%p!rtant "!r the "ir% t! c!ntin&e
!perating thr!&gh!&t 4hapter (( pr!ceedings Tenerally, the "ir%;s c&rrent %anage%ent is
all!wed t! r&n the "ir% d&ring the pr!ceedings &nder a restrictive arrange%ent called
a the val&e/preservati!n dict&%
# de#t!r/in/p!ssessi!n >
c %anagerial discreti!n
d tr&stee assign%ent
@@@ (0 Acc!rding t! the A#s!l&te Pri!rity R&le 0APR2, the c!rrect descending !rder !" clai% pri!rity isB
a ad%inistrative clai%sA stat&t!ry pri!rity clai%sA sec&red credit!rs; clai%sA &nsec&red
credit!rs; clai%sA e<&ity clai%s >
# e<&ity clai%sA ad%inistrative clai%sA stat&t!ry pri!rity clai%sA sec&red credit!rs; clai%sA
&nsec&red credit!rs; clai%s
c stat&t!ry pri!rity clai%sA ad%inistrative clai%sA sec&red credit!rs; clai%sA &nsec&red
credit!rs; clai%sA e<&ity clai%s
d ad%inistrative clai%sA stat&t!ry pri!rity clai%sA &nsec&red credit!rs; clai%sA sec&red
credit!rs; clai%sA e<&ity clai%s
@@@ (( -n 4hapter ((, the c!&rt has tw! %echanis%s t! i%ple%ent an !pti%al #an$r&ptcy !&tc!%eB
a the right t! e9ting&ish any clai%, and the &se !" a restricted a&cti!n
# the right t! e9ting&ish any clai%, and restricti!ns !n #argaining #etween clai%ants
c restricti!ns !n #argaining #etween clai%ants, and the threat !" "ines
d restricti!ns !n #argaining #etween clai%ants, and the &se !" a restricted a&cti!n >
@@@ (, 8RU6 !r =A3S6B -n 4hapter (( pr!ceedings, the c!&rt al%!st always strictly adheres t! the
A#s!l&te Pri!rity R&le 0APR2
a 8RU6
# =A3S6 >
@@@ (+ -n a@@@@@@, the clai%ants have already w!r$ed !&t the ter%s !" the re!rganiGati!n, and #asically
"ile R&st t! %a$e the agree%ent !""icial
a per"&nct!ry "iling
# t!$en "iling
c prepac$aged #an$r&ptcy >
*8
d gest&re "iling
@@@ (4 -n c!%plete v!l&ntary li<&idati!ns, the s&% !" the "ir%;s parts is w!rth %!re than the wh!le, "!r
all !" the "!ll!wing reas!ns 6N46P8B
a the assets 0!r divisi!ns2 %ay #e w!rth %!re in the hands !" %!re c!%petent %anagers
# li<&idated assets always sell at a pre%i&% t! their "air val&e >
c the special ta9 treat%ent a""!rded li<&idati!ns pr!vides a s!&rce !" val&e !ver and a#!ve the
"ir%;s val&e as a g!ing c!ncern
d any disec!n!%ies ass!ciated with e9cessive diversi"icati!n can #e eli%inated #y piece%eal
sale thr!&gh li<&idati!n
+ssay *uestions
( 69plain h!w "inancial distress can e9acer#ate the dist!rti!n !" a "ir%;s invest%ent incentives that
!cc&rs when a "ir% has de#t in its capital str&ct&re
, 'hat are the e""ects !" #an$r&ptcy !n the "ir%;s sta$eh!lders, partic&larly the "ir%;s !wnership
str&ct&re and the "ir%;s direct!rsD
+ Hisc&ss their arg&%ents and evidence related t! the incentives !" "inancially distressed "ir%s t!
restr&ct&re their de#t privately rather than thr!&gh "!r%al #an$r&ptcy
4 Hisc&ss the evidence !n the e""ects !" #an$r&ptcy !n a "ir%;s sta$eh!lders
5 Hisc&ss the evidence !n the p!st/#an$r&ptcy str&ct&re and per"!r%ance !" re!rganiGed "ir%s
*)
C * A P T E R -B
Organi=a%iona Ar"hi%e"%$re1
Risk &anage4en%1
And Se"$ri%' Design
@@@ ( 8he tw! c!nstr&cts that "!r% a "ir%;s !rganiGati!nal architect&re areB
a #&siness architect&re and ec!n!%ic architect&re
# ec!n!%ic architect&re and "inancial architect&re
c #&siness architect&re and "inancial architect&re >
d !rganiGati!nal hierarchy and "inancial str&ct&re
@@@ , Regarding c!%p!nents and ele%ents !" the "ir%;s #&siness architect&re, which !" the "!ll!wing
represents the l!gical directi!n !" ca&sality 0ie, in ter%s !" which c!%p!nentCele%ent drives
an!ther c!%p!nentCele%ent2 generally r&ns as "!ll!ws 0indicated #y arr!ws2B
a %acr!ec!n!%ic 5 "in %ar$et envir!n%ents internal legal 5 g!vernance
str&ct&res >
# diversi"icati!n vers&s "!c&s ind&stry characteristics
c #&siness strategies and gr!wth !pp!rt&nities "inancial %ar$et envir!n%ent
d siGe and capital intensity %acr!ec!n!%ic 5 "inancial %ar$et envir!n%ents
@@@ + Regarding a "ir%;s !verall !rganiGati!nal architect&re, the directi!n !" ca&sality 0ie, in ter%s !"
which c!%p!nentsCele%ents drive !ther c!%p!nentsCele%ents2 generally r&nsB
a #&siness architect&re"inancial architect&re >
# "inancial architect&re#&siness architect&re
c ec!n!%ic architect&re"inancial architect&re
d "inancial architect&reec!n!%ic architect&re
@@@ 4 8he %acr!ec!n!%ic c!%p!nent !" a "ir%;s #&siness architect&re incl&des all !" the "!ll!wing
ele%ents 6N46P8B
a ec!n!%ic gr!wth pr!Recti!ns, in"lati!n, and ta9es
# ind&stry characteristics >
c legal envir!n%ent
d %acr!ec!n!%ic ris$ "act!rs
@@@ 5 -n the c!n"ig&rati!n !" an e""icient "inancial syste% architect&re, #!th #an$s and capital %ar$ets
!""er lending t! "ir%s .!rr!wers wh! p!se relatively !ner!&s asset/s&#stit&ti!n %!ral
haGard pre"er @@@0i2@@@ "inancing, while #!rr!wers wh! p!se less seri!&s %!ral haGards g!
directly t! @@@0ii2@@@
@@@0i2@@@ @@@0ii2@@@
a capital %ar$et #an$s
# #an$ capital %ar$ets >
70
@@@ * 'hich !" the "!ll!wing is N:8 an ele%ent !" invest!rs; pre"erences that in"l&ences a "ir%;s
"inancial architect&reD
a pre"erences "!r w!r$ vs leis&re >
# li<&idity needs
c invest%ent h!riG!n
d ris$ t!lerance
@@@ 7 'hich !" the "!ll!wing is N:8 a valid reas!n "!r a "ir% t! esta#lish s&#sidiariesD
a t! #etter c!ntr!l ris$ e9p!s&re !" either parent/t!/ s&#sidiary !r s&#sidiary/t!/parent
# t! enhance the c!%pany;s a#ility t! eval&ate individ&al per"!r%ance and t! create di""erent
c!%pensati!n syste%s "!r a diverse set !" its #&sinesses
c t! !#"&scate "inancial rep!rting >
d t! c!n"!r% with reg&lat!ry re<&ire%ents speci"ic t! a partic&lar #&siness envir!n%ent
@@@ 8 A @@@@@@@ c!ntract is a private, tail!red, #ilateral agree%ent #etween tw! parties in which !ne
party agrees t! p&rchase, and the !ther t! sell, a speci"ied n&%#er !" &nits !" a speci"ied asset
at a given "&t&re date and at a speci"ied price
a swap
# "!rward >
c "&t&res
d warrant
@@@ ) =&t&res trading "eat&res daily @@@@0i2@@@@ in cash and @@@@0ii2@@@@
@@@@0i2@@@@ @@@@0ii2@@@@
a cl!sing %ar$ing/t!/%ar$et
# resettle%ent cl!sing
c resettle%ent %ar$ing/t!/%ar$et >
d swapping %ar$ing/t!/%ar$et
@@@ (0 A swap c!ntract is in essence a p!rt"!li!, !r series, !" @@@@@@@@@
a "!rward c!ntracts >
# "&t&res c!ntracts
c rep&rchase agree%ents
d resettle%ent agree%ents
@@@ (( -" a g!ld pr!d&cer wishes t! e%pl!y a n!n/c!ntingent hedge, it sh!&ld &se a0n2 @@@0i2@@@
c!ntract, while i" it wishes t! e%pl!y a c!ntingent hedge 0ie, t! hedge !nly d!wn/side ris$2,
it sh!&ld &se a0n2 @@@0ii2@@@ c!ntract
@@@0i2@@@ @@@0ii2@@@
a "!rward p&t !pti!n >
# p&t !pti!n "!rward
c "!rward call !pti!n
d call !pti!n "!rward
@@@ (, =ir%s that "ace a @@@@@@@@ ta9 rate str&ct&re have an incentive t! hedge, #eca&se it can red&ce
the "ir%;s e9pected ta9 lia#ility
a "lat
# regressive 0!r c!ncave2
c decelerating
d pr!gressive 0!r c!nve92 >
7(
@@@ (+ @@@@@@ #!nds pay c!&p!n interest in the "!r% !" additi!nal #!nds instead !" cash
a He"erred c!&p!n
# Pay%ent/in/$ind >
c Per!/c!&p!n
d -n lie&
@@@ (4 8he @@@@@@@@@ is a c!nverti#le #!nd in which the date !" c!nversi!n is "i9ed in advance
a %anaged c!nverti#le
# %andat!ry c!nverti#le >
c "i9ed c!nverti#le
d dated c!nverti#le
@@@ (5 A spec&lative/grade #!nd that had an invest%ent/grade rating when it was !riginally iss&ed is
called a @@@0i2@@@, while an !riginal/iss&e spec&lative/grade #!nd is called a @@@0ii2@@@
@@@0i2@@@ @@@0ii2@@@
a revised/d!wn #!nd R&n$ #!nd
# #erated #!nd "allen angel
c R&n$ #!nd "allen angel
d "allen angel R&n$ #!nd >
@@@ (* 8he @@@@@@@@@ gives the #!nd iss&er an !pti!n t! redee% a speci"ied "racti!n !" the #!nd iss&e
within a speci"ied peri!d at a predeter%ined price, #&t !nly #y &sing "&nds "r!% a s&#se<&ent
e<&ity !""ering
a s&#se<&ent events pr!visi!n
# claw#ac$ pr!visi!n >
c c!ntingency pr!visi!n
d c!nversi!n pr!visi!n
@@@ (7 'ith a %a$e wh!le call pr!visi!nB
a the "ir% t! pay a call price that is s&""icient t! pr!vide #!ndh!lders an e9 p!st ret&rn e<&al t!
the ret&rn they w!&ld have received !n a n!ncalla#le 8reas&ry #!nd with the sa%e
!riginal %at&rity as the called #!nd >
# the "ir% %&st retire either the entire 0!r wh!le2 #!nd iss&e !r n!ne !" the #!nds
c #!ndh!lders are all!wed t! redee% their #!nds at par val&e
d the "ir% has the !pti!n t! rest!re #!ndh!lders; wealth #y iss&ing new #!nds, that w!&ld sell
at par val&e, in e9change "!r the !riginal #!nds
@@@ (8 @@@@@@@ has #ec!%e an i%p!rtant %eans #y which h&ge in"rastr&ct&re pr!Rects are privately
"inanced
a Private place%ent "inancing
# -n"rastr&ct&re "&nding
c Pr!Rect "inance >
d 4!&ntry "inance
+ssay *uestions
( Hisc&ss the i%p!rtance !" integrating the "ir%;s #&siness and "inancial architect&res
, 69plain tw! alternative r!les !" derivatives, ins&rance c!ntracts, and g&arantees within a "ir%;s
!verall !rganiGati!nal architect&re
7,
+ 69plain h!w hedging can %itigate the underin!estment and asset"sustitution pr!#le%s
4 69plain h!w hedging canB 0i2 red&ce e9pected c!sts !" e9ternal "inancingA and 0ii2 increase de#t
capacity
5 Hisc&ss %anage%ent;s sel"/serving incentives t! hedge
* 69plain h!w an ins&rance c!ntract is si%ilar t!, and yet di""ers "r!%, a p&t !pti!n
7 Hisc&ss the c!rp!rate &se !" g&arantees
8 69plain h!w splitting a "ir%;s clai%s int! tw! sec&rities[!ne Sin"!r%ati!nally insensitive; and the
!ther %!re Sin"!r%ati!nally sensitive;[%a$es in"!r%ed trading %!re pr!"ita#le, and th&s %a9i%iGes
the "ir%;s pr!ceeds !" iss&ing sec&rities
7+

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