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Corporate Finance Summary 1

Corporate Finance
Realized return: the total return that occurs over a particular time period.
Average annual return: the arithmetic average of an investment’s realized returns for each year.
Standard deviation: a common method used to measure the risk of a probability distribution.
Variance: a method to measure the variability of return.
Normal distribution: a symmetric probability distribution that is completely characterized by its average and
strandard deviation.
Prediction interval: a range of values that is likely to include a future observation. A 95% prediction interval
should have a 95% chance of including the observed future observations.
Common risk: risk that is linked across outcomes.
Independent risk: risks that bear no relation to each other. If risks are independent, then knowing the outcome
of one provides no information about the other.
Diversification: the averaging of independent risks in a large portfolio.
Unsystematic risk: fluctuations of a stock’s return that are due to company- or industry- specific news and are
independent risks unrelated across stocks.
Systematic risk: fluctuations of a stock’s return that are due to market-wide news representing common risk.
Equation 11.1: realized return from your investment in the stock from P old to Pnew
𝑅𝑑 + 1 =
𝐷𝐼𝑉𝑑 + 1 + 𝑃𝑛𝑒𝑀 − π‘ƒπ‘œπ‘™π‘‘ 𝐷𝐼𝑉𝑑 + 1 𝑃𝑛𝑒𝑀 − π‘ƒπ‘œπ‘™π‘‘
Equation 11.2: annual realized return
1 + π‘…π‘Žπ‘›π‘›π‘’π‘Žπ‘™ = (1 + 𝑅1)(1 + 𝑅2)(1 + 𝑅3) … (1 + 𝑅𝑛)
Equation 11.3: average annual return of a security
(𝑅1 + 𝑅2 + 𝑅3 + β‹― + 𝑅𝑑)
Equation 11.4: variance estimate using realized returns
π‘‰π‘Žπ‘Ÿ(𝑅) =
[(𝑅1 − Ṝ)2 + (𝑅2 − Ṝ)2 + (𝑅3 − Ṝ)2 + β‹― + (𝑅𝑑 − Ṝ)2 ]
Equation 11.5: Standard deviation (volatility)
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Corporate Finance
𝑆𝐷(𝑅) = √π‘£π‘Žπ‘Ÿ(𝑅)
Equation 11.6: prediction interval
Ṝ ± (2 × π‘†π·(𝑅))
Portfolio weights: the fraction of the total investment in a portfolio held in each individual investment in the
Return of a portfolio: the weighted average of the returns on the investments in a portfolio, where the weights
correspond to the portfolio weights.
Expected return of a portfolio: the weighted average of the expected returns of the investments in a portfolio,
where the weights correspond to the portfolio weights.
Volatility of a portfolio: the total risk, measured as SD, of a portfolio.
Correlation: a measure of the degree to which returns share common risk. It is calculated as the covariance of
the returns divided by the product of the standard deviations of each return.
Equally weighted portfolio: a portfolio in which the same amount of money is invested in each stock.
Market portfolio: the portfolio of all risky investments, held in proportion to their value
Market capitalization: the total market value of a firm’s equity; equals the market price per share times the
number of shares.
Value-weighted portfolio: a portfolio in which each security is held in proportion to its market capitalization.
Market proxy: a portfolio whose return should closely track the true market portfolio
Market index: the market value of a broad-based portfolio of securities.
Beta (ß): the expected percentage change in the excess return of a security for a 1% change in the excess
return of the market portfolio.
Market risk premium (equity risk premium): the historical average excess returns on the market portfolio.
Capital Asset Pricing Model (CAPM): an equilibrium model of the relationship between risk and return that
characterizes a security’s expected return based on its beta with the market portfolio.
Required return: the expected return of an investment that is necessary to compensate for the risk of
undertaking investment.
Security market line (SML): the pricing implication of the CAPM; it specifies a linear relation between the risk
premium of a security and its beta with the market portfolio.
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Corporate Finance
Equation 12.1: portfolio weight
π‘Šπ‘– =
π‘‰π‘Žπ‘™π‘’π‘’ π‘œπ‘“ π‘–π‘›π‘£π‘’π‘ π‘‘π‘šπ‘’π‘›π‘‘ 𝑖
π‘‘π‘œπ‘‘π‘Žπ‘™ π‘£π‘Žπ‘™π‘’π‘’ π‘œπ‘“ π‘π‘œπ‘Ÿπ‘‘π‘“π‘œπ‘™π‘–π‘œ
Equation 12.2: return of a portfolio
𝑅𝑝 = π‘Š1𝑅1 + π‘Š2𝑅2 + π‘Š3𝑅3 + β‹― + π‘Šπ‘›π‘…π‘›
Equation 12.3: expected return of a portfolio
𝐸[𝑅𝑝] = π‘Š1𝐸[𝑅1] + π‘Š2𝐸[𝑅2] + π‘Š3𝐸[𝑅3] + β‹― + π‘Šπ‘›πΈ[𝑅𝑛]
Equation 12.4: computing the Variance of portfolio’s return
π‘‰π‘Žπ‘Ÿ(𝑅𝑝) = π‘Š12 𝑆𝐷(𝑅1)2 + π‘Š22 𝑆𝐷(𝑅2)2 + 2π‘Š1π‘Š2πΆπ‘œπ‘Ÿπ‘Ÿ(𝑅1, 𝑅2)𝑆𝐷(𝑅1)𝑆𝐷(𝑅2)
Equation 12.5: market capitalization
π‘šπ‘Žπ‘Ÿπ‘˜π‘’π‘‘ π‘π‘Žπ‘π‘–π‘‘π‘Žπ‘™π‘–π‘§π‘Žπ‘‘π‘–π‘œπ‘› = (π‘›π‘’π‘šπ‘π‘’π‘Ÿ π‘œπ‘“ π‘ β„Žπ‘Žπ‘Ÿπ‘’π‘  π‘œπ‘’π‘‘π‘ π‘‘π‘Žπ‘›π‘‘π‘–π‘›π‘”) × (π‘π‘Ÿπ‘–π‘π‘’ π‘π‘’π‘Ÿ π‘ β„Žπ‘Žπ‘Ÿπ‘’)
Equation 12.6: CAPM
𝐸[𝑅𝑖] = 𝑅𝑓 + 𝐡𝑖(𝐸[π‘…π‘šπ‘˜π‘‘] − 𝑅𝑓)
Equation 12.7: beta of a portfolio
𝐡𝑝 = π‘Š1𝐡1 + π‘Š2𝐡2 + β‹― + π‘Šπ‘›π΅π‘›
Important for the test: how to use Beta and CAPM to find Cost of Capital
Capital: a firm’s sources of financing – debt, equity, and other securities that it has outstanding.
Capital structure: the relative proportions of debt, equity, and other securities that a firm has outstanding.
Weighted average cost of capital (WACC): the average of a firm’s equity and debt costs of capital, weighted by
the fractions of the firm’s value that correspond to equity and debt, respectively.
Market-value balance sheet: similar to an accounting balance sheet, but al values are current market values
rather than historical costs.
Unlevered: a firm that does not have debt outstanding.
Levered: a firm that has debt outstanding.
Leverage: the relative amount of debt on a firm’s balance sheet.
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Corporate Finance
Effective cost of the debt: a firm’s net cost of interest on its debt after accounting for the interest tax
Net debt: total debt outstanding minus any cash balances.
Levered value: the value of an investment, including the benefit of the interest tax deduction, given the firm’s
leverage policy.
WACC method: discounting future incremental free cash flows using the firm’s WACC. This method produced
the levered value of a project.
Debt-equity ratio: a ratio of the market value of debt to the market value of equity.
Equation 13.1: Market Value of Assets
π’Žπ’‚π’“π’Œπ’†π’• 𝒗𝒂𝒍𝒖𝒆 𝒐𝒇 𝒂𝒔𝒔𝒆𝒕𝒔 = π’Žπ’‚π’“π’Œπ’†π’• 𝒗𝒂𝒍𝒖𝒆 𝒐𝒇 π’†π’’π’–π’Šπ’•π’š + π’Žπ’‚π’“π’Œπ’†π’• 𝒗𝒂𝒍𝒖𝒆 𝒐𝒇 𝒅𝒆𝒃𝒕
Equation 13.2: Weighted Average Cost of Capital (Pretax)
π‘Ήπ’˜π’‚π’„π’„ = (π‘­π’“π’‚π’„π’•π’Šπ’π’ 𝒐𝒇 𝒕𝒉𝒆 π’‡π’Šπ’“π’Ž 𝒗𝒂𝒍𝒖𝒆 π’‡π’Šπ’π’‚π’π’„π’†π’… π’ƒπ’š π‘’π‘žπ‘’π‘–π‘‘π‘¦) ∗ (πΈπ‘žπ‘’π‘–π‘‘π‘¦ π‘ͺ𝒐𝒔𝒕 𝒐𝒇 π‘ͺπ’‚π’‘π’Šπ’•π’‚π’)
+ π‘­π’“π’‚π’„π’•π’Šπ’π’ 𝒐𝒇 𝒕𝒉𝒆 π’‡π’Šπ’“π’Ž 𝒗𝒂𝒍𝒖𝒆 π’‡π’Šπ’π’‚π’π’„π’†π’… π’ƒπ’š 𝑑𝑒𝑏𝑑) ∗ (𝐷𝑒𝑏𝑑 π‘ͺ𝒐𝒔𝒕 𝒐𝒇 π‘ͺπ’‚π’‘π’Šπ’•π’‚π’)
= (𝐴𝑠𝑠𝑒𝑑 π‘ͺ𝒐𝒔𝒕 𝒐𝒇 π‘ͺπ’‚π’‘π’Šπ’•π’‚π’)
Equation 13.3: Effective after-tax borrowing rate:
π‘¬π’‡π’‡π’†π’„π’•π’Šπ’—π’† 𝒄𝒐𝒔𝒕 𝒐𝒇 𝒅𝒆𝒃𝒕 = 𝒓𝑫 (𝟏 − 𝑻π‘ͺ )
Equation 13.4
a: Expected Return:
𝑹𝑬 =
Equation 13.4
b: if g=0, than:
π‘ͺ𝒐𝒔𝒕 𝒐𝒇 𝑷𝒓𝒆𝒇𝒆𝒓𝒓𝒆𝒅 π’”π’•π’π’„π’Œ π’„π’‚π’‘π’Šπ’•π’‚π’ =
𝑷𝒓𝒆𝒇𝒆𝒓𝒓𝒆𝒅 π’…π’Šπ’—π’Šπ’…π’†π’π’…
𝑷𝒓𝒆𝒇𝒆𝒓𝒓𝒆𝒅 π‘Ίπ’•π’π’„π’Œ π‘·π’“π’Šπ’„π’†
Equation 13.5: Cost of Equity
π‘ͺ𝒐𝒔𝒕 𝒐𝒇 π‘¬π’’π’–π’Šπ’•π’š =
Equation 13.6: Weighted Average Cost of Capital (WACC):
π‘Ήπ’˜π’‚π’„π’„ = 𝑹𝑬 𝑬% + 𝑹𝒑𝒇𝒅 𝑷% + 𝒓𝑫 (𝟏 − 𝑻π‘ͺ )𝑫%
Equation 13.7: WACC for company’s who does not have preferred stock:
π‘Ήπ’˜π’‚π’„π’„ = 𝑹𝑬 𝑬% + 𝒓𝑫 (𝟏 − 𝑻π‘ͺ )𝑫%
Equation 13.8: Net Debt:
𝑫𝒆𝒃𝒕 = π‘ͺ𝒂𝒔𝒉 𝒂𝒏𝒅 π‘Ήπ’Šπ’”π’Œ − 𝑭𝒓𝒆𝒆 π‘Ίπ’†π’„π’–π’“π’Šπ’•π’Šπ’†π’”
Equation 13.9: the investment’s levered value (V/L,0)
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Corporate Finance
π‘½π‘³πŸŽ = 𝑭π‘ͺπ‘­πŸŽ +
𝟏 + π’“π’˜π’‚π’„π’„ (𝟏 + π’“π’˜π’‚π’„π’„ )
(𝟏 + π’“π’˜π’‚π’„π’„ )
(𝟏 + π’“π’˜π’‚π’„π’„ )𝒏
Ch14: Raising Equity Capital
Sources of Equity fund for private companies (start-ups)
IPO procedure
Pre and post-money valuation
Angel investors: individual investors who buy equity in small private firms.
Venture capital firm: a limited partnership that specializes in raising money to invest in the private equity of
young firms.
Venture capitalists: the general partners who work for and run a venture capital firm.
Corporate investor, corporate partner, strategic partner, strategic investor: a corporation that invests in private
Preferred stock: preferred stock issued by mature companies such as banks usually has a preferential dividend
and seniority in any liquidation and sometimes special voting rights. Preferred stock issued by young companies
has seniority in any liquidation but typically does not pay cash dividends and contains a right to convert to
common stock.
Convertible preferred stock: a preferred stock that gives the owner an option to convert it into common stock
on some future date.
Pre-money valuation: the value of a firm’s prior shares outstanding at the price in the funding round.
Post-money valuation: the value of the whole firm(old plus new shares_ at the price at which the new equity is
Exit strategy: an important consideration for investors in private companies, it details how they will eventually
realize the return from their investment.
Initial Public Offering (IPO): the process of selling stock to the public for the first time.
Underwriter: an investment banking firm that manages a security issuance and designs its structure.
Primary offering: new shares available in a public offering that raise new capital.
Secondary offering: an equity offering of shares sold by existing shareholders (as part of their exit strategy).
Lead underwriter: the primary banking firm responsible for managing a security issuance.
Syndicate: a group of underwriters who jointly underwrite and distribute a security issuance.
Registration statement: a legal document that provides financial and other information about a company to
investors prior to a security issuance.
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Preliminary prospectus (red herring): part of the registration statement prepared by a company prior to an IPO
that is circulated to investors before the stock is offered.
Final prospectus: part of the final registration statement prepared by a company prior to an IPO that contains
all the details of the offering, including the number of shares offered and the offer price.
Road show: during an IPO, when a company’s senior management and its lead underwriters travel to prmote
the company and explain their rationale for an offer price to institutional investors such as mutual funds and
pension funds.
Book building: a process used by underwriters for coming up with an offer price based on customers’
expressions of interest.
Firm commitment: an agreement between an underwriter and an issuing firm in which the underwriter
guarantees that it will sell all of the stock at the offer price.
Spread: the fee a company pays to its underwriters that is a percentage of the issue price of a share of stock.
Over-allotment allocation (greenshoe provision): in an IPO, an option that allows the underwriter to issue more
stock, usually amounting to 15% of the original offer size, at the IPO offer price.
Lockup: a restriction that prevents existing shareholders from selling their shares for some period after an IPO,
usually 180 days.
Best-effort basis: for small IPO’s, a situation in which the underwriter does not guarantee that the stock will be
sold, but instead tries to sell the stock for the best possible price.
Auction IPO: an online method for selling new issues directly to the public that lets the market determine the
price through bids from potential investors.
Seasoned equity offering (SEO): when a public company returns to the equity markets and offers new shares
for sale.
Primary shares: new shares issued by a company in an equity offering.
Secondary shares: shares sold by existing shareholders in an equity offering.
Tombstone: newspaper advertisements in which underwriters advertise a security issuance.
Cash offer: a type of seasoned equity offering (SEO) in which a firm offers the new shares to investors at large.
Rights offer: a type of SEO in which a firm offers the new shares only to existing shareholders.
Adverse selection: reflects the lemons principle or the idea that when quality is hard to judge, the average
quality of goods being offered for sale will be low.
Equation 14.1: Post-Money Valuation
𝑷𝒐𝒔𝒕 − π‘΄π’π’π’†π’š π‘½π’‚π’π’–π’‚π’•π’Šπ’π’ = 𝑷𝒓𝒆 − π‘΄π’π’π’†π’š π’—π’‚π’π’–π’‚π’•π’Šπ’π’ + π’‚π’Žπ’π’–π’π’• π’Šπ’π’—π’†π’”π’•π’†π’…
𝑷𝒐𝒔𝒕 − π‘΄π’π’π’†π’š π‘½π’‚π’π’–π’‚π’•π’Šπ’π’ = 𝒕𝒐𝒕𝒂𝒍 π’π’–π’Žπ’ƒπ’†π’“ 𝒐𝒇 𝒔𝒉𝒂𝒓𝒆𝒔 ∗ 𝒕𝒉𝒆 π’‘π’“π’Šπ’„π’† π’‘π’‚π’Šπ’… 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆
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Corporate Finance
Ch15: Debt Financing
Private debt
Public debt, prospectus and indenture
Bond market
Repayment provisions (callable, convertible)
Private debt: that that is not publicly traded.
Term loan: a bank loan that lasts for a specific term.
Syndicated back loan: a single loan that is funded by a group of banks rather than a single bank.
Revolving line of credit: a credit commitment for a specific time period, typically two to three years, which a
company can use as needed.
Asset-backed line of credit: a type of credit commitment, in which the borrower secures a line of credit by
pledging an asset as collateral.
Private placement: a bond issue that does not trade on a public market but rather is sold to a small group of
Indenture: including in a prospectus, it is a formal contract between a bond issuer and a trust company, which
represents the bondholders’ interests.
Original issue discount (OID) bond: a coupon bond issued at a discount.
Unsecured debt: a type of corporate debt, in the event of a bankruptcy, gives bondholders a claim to only the
assets of the firm that are not already pledged as collateral on other debt.
Notes: a type of unsecured corporate debt with maturities of less than 10 years.
Debentures: a type of unsecured corporate debt with maturities of 1- years or longer.
Secured debt: a type of corporate loan or debt security in which specific assets are pledged as a firm’s collateral
that bondholders have a direct claim to in the event of a bankruptcy.
Mortgage bonds: a type of secured corporate debt in which real property is pledged as collateral.
Asset-backed bonds: a type of secured corporate debt in which specific assets are pledged as collateral
Tranches: different classes of securities that comprise a single bond issuance.
Seniority: a bondholder’s priority, in the event of a default, in claiming assets not already securing other debt.
Subordinated debenture: a debenture issue that has a lower priority claim to the firm’s assets than other
outstanding debt.
Domestic bonds: bonds issued by a local entity, denominated in the local currency, and traded in a local
market, but purchased by foreigners.
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Corporate Finance
Eurobonds: international bonds that are not denominated in the local currency of the country in which they are
Global bonds: bonds that are offered for sale in several different markets simultaneously.
Covenants: restrictive clauses in a bond contract that limit the issuer from taking actions that may undercut its
ability to repay the bonds.
Callable bond: bonds containing a call provision that allows the issuer to repurchase the bonds at a
predetermined price.
Call date: the date in the call provision on or after which the bond issuer has the right to retire the bond.
Call price: a price specified at the issuance of a bond for which the issuer can redeem the bond.
Yield to call (YTC): the yield of a callable bond calculated under the assumption that the bond will be called on
the earliest call date.
Yield to worst: quoted by bond traders as the lower of the yield to call or yield to maturity.
Sinking fund: a method for repaying a bond in which a company makes regular payments into a fund
administered by a trustee over the life of the bond. These payments are then used to repurchase bonds,
usually at par.
Balloon payment: a large payment that must be made on the maturity date of a bond when the sinking fund
payments are not sufficient to retire the entire bond issue.
Convertible bonds: corporate bonds with a provision that gives the bondholder an option to convert each and
owned into a fixed number of shares of common stock.
Conversion ratio: the number of shares received upon conversion of a convertible bond, usually stated per
$1000 of face value.
Conversion price: the face value of a convertible bond divided by the number of shares received if the bond is
Straight bond: a non-callable, non-convertible bond (also called a plain-vanilla bond).
Leveraged buyout (LBO): when a group of private investors purchases all the equity of a public corporation and
finances the purchase primarily with debt.
Yield to Call: use financial calculator.
Ch17: Payout Policy
Payout procedure
Dividend vs. share repurchase
3 alternative options
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Corporate Finance
Pay-out policy: the way a firm chooses between the alternative ways to pay out cash to shareholders.
Declaration date: the date on which a public company’s board of directors authorizes the payment of a
Record date: the specific date set by a public company’s board of directors such that the firm will pay a
dividend to all shareholders of record on this date.
Ex-dividend date: a date, two days prior to a dividend’s record date, on or after which anyone buying the stock
will not be eligible for the dividend.
Payable date (Distribution date): a date, generally within a month after the record date, on which a firm mails
dividend checks to its registered stockholders.
Special dividend: a one-time dividend payment a firm makes that is usually much larger than a regular dividend.
Return of capital: when a firm, instead of paying dividends from current earnings (or accumulated retained
earnings), pays dividends from other sources, such as paid-in capitals or the liquidation of assets.
Liquidating dividend: a return on capital to shareholders from a business operation that is being terminated.
Open market repurchase: when a firm repurchases its own shares by buying them on the open market over
Tender offer: a public announcement of an offer to all existing security holders to buy back a specified amount
of outstanding securities at a prespecified price over a short time period, generally 20 days.
Dutch auction: shareholders indicate prices and quantities of shares for sale. The firm pays the lowest possible
price to repurchase its desired number of shares.
Targeted repurchase: a firm purchase shares directly from a specific shareholder at a negotiated price.
Greenmail: when a firm avoids takeover and removal of its management by a major shareholder by buying-out
that shareholder, often at a premium.
Cum-dividend: when a stock trades before the ex-dividend date, entitling anyone who buys the stock to the
MM dividend irrelevance: in perfect capital markets, holding fixed the investment policy of a firm, the firm’s
choice of dividend policy is irrelevant and does not affect the initial share price.
Dividend puzzle: when firms continue to issue dividends despite their tax disadvantage.
Clientele effect: when the dividend policy of a firm reflects the tax preferences of its investor clientele.
MM Pay-out Irrelevance: in perfect capital markets, if a firm invests excess cash flows in financial securities, the
firm’s choice of pay-out versus retention is irrelevant and does not affect the initial value of the firm.
Dividend smoothing: the practice of maintaining relatively constant dividends.
Dividend signalling hypotheses: The idea that dividend changes reflect managers’ views about a firm’s future
earnings prospects.
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Stock dividend (stock split): when a company issues a dividend in shares of stock rather than cash to its
Spin-off: when a firm sells a subsidiary by selling shares as a non-cash special dividend in the subsidiary alone.
Equation 1: enterprise Value:
π‘¬π’π’•π’†π’“π’‘π’“π’Šπ’„π’† 𝑽𝒂𝒍𝒖𝒆 = 𝑷𝑽(𝑭𝒖𝒕𝒖𝒓𝒆 𝑭π‘ͺ𝑭) =
π’‚π’…π’…π’Šπ’•π’Šπ’π’π’‚π’ 𝑭π‘ͺ𝑭
(𝒖𝒏𝒍𝒆𝒗𝒆𝒓𝒆𝒅) 𝒄𝒐𝒔𝒕 𝒐𝒇 π’„π’‚π’‘π’Šπ’•π’‚π’
Equation 2: cum-dividend stock price:
π‘·π’„π’–π’Ž = π‘ͺ𝒖𝒓𝒓𝒆𝒏𝒕 π’…π’Šπ’—π’Šπ’…π’†π’π’… + 𝑷𝑽(𝒇𝒖𝒕𝒖𝒓𝒆 π’…π’Šπ’—π’Šπ’…π’†π’π’…π’”) = 𝒄𝒖𝒓𝒓𝒆𝒏𝒕 π’…π’Šπ’—π’Šπ’…π’†π’π’… +
𝒄𝒐𝒔𝒕 𝒐𝒇 π’„π’‚π’‘π’Šπ’•π’‚π’
Equation 3: ex-dividend stock price:
𝑷𝒆𝒙 = 𝑷𝑽(𝒇𝒖𝒕𝒖𝒓𝒆 π’…π’Šπ’—π’Šπ’…π’†π’π’…π’”) =
𝒇𝒖𝒕𝒖𝒓𝒆 π’…π’Šπ’—π’Šπ’…π’†π’π’…
𝒄𝒐𝒔𝒕 𝒐𝒇 π’„π’‚π’‘π’Šπ’•π’‚π’
Equation 4: stock price with share repurchase:
# 𝒐𝒇 𝒔𝒉𝒂𝒓𝒆𝒔
𝒄𝒐𝒔𝒕 𝒐𝒇 π’„π’‚π’‘π’Šπ’•π’‚π’
Financial option: a contract that fives its owner he right (but not the obligation) to purchase or sell an asset at a
fixed price at some future date.
Call option: a financial option that gives its owner the right to buy an asset.
Put option: a financial option that gives its owner the right to sell an asset.
Option writer: the seller of an option contract.
Derivatives: securities whose cash flows depend solely on the prices of other marketed assets.
Warrant: a call option written by a company itself on new stock.
Exercising (an option): when a holder of an option enforces the agreement and buys or sells a share of stock at
the agreed-upon price.
Strike (exercise) price: the price at which an option holder buys or sells a share of stock when the option is
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American options: the most common kind of option, they allow their holders to exercise the option on any date
up to and including the expiration date.
Expiration date: the last date on which an option holder has the right to exercise the option.
European options: options that allow their holder to exercise the option only on the expiration date.
Open interest: the total number of contracts of a particular option that have been written and not yet closed.
At-the-money: describes options whose exercise prices are equal to the current stock price.
In-the-money: describes an option whose value if immediately exercised would be positive.
Out-of-the-money: describes an option that if exercised immediately results in a loss of money.
Deep in-the-money: descries options that are in-the-money and for which the strike price and sock price are
very far apart.
Deep out-of-the-money: describes options that are out-of-the-money and for which the strike price and the
stock price are very far apart.
Hedging: to reduce risk by holding contracts or securities whose payoffs are negatively correlated with some
risk exposure.
Speculate: when investors use securities to place a bet on the direction in which they believe he market is likely
to move.
Protective put: purchasing a put option on a stock you already own.
Portfolio insurance: a protective put written on a portfolio rather than a single stock.
Put-call parity (for non-dividend paying stocks): the relationship that gives the price of a call option in terms of
the price of a put option plus the price of the underlying stock minus the present value of the strike price.
Equation 21.1: call value at expiration:
𝒄𝒂𝒍𝒍 𝒗𝒂𝒍𝒖𝒆 = π’”π’•π’π’„π’Œ π’‘π’“π’Šπ’„π’† − π’”π’•π’“π’Šπ’Œπ’† π’‘π’“π’Šπ’„π’†
Call value = 0, if stock price ≤ strike price
Equation 21.2: put price at expiration:
𝒑𝒖𝒕 𝒗𝒂𝒍𝒖𝒆 = π’”π’•π’“π’Šπ’Œπ’† π’‘π’“π’Šπ’„π’† − π’”π’•π’π’„π’Œ π’‘π’“π’Šπ’„π’†
Put value = 0, if stock price ≥ strike price
Equation 21.3: black-scholes price of a call option on a non-dividend-paying stock:
𝒄𝒂𝒍𝒍 π’‘π’“π’Šπ’„π’† = π’”π’•π’π’„π’Œ π’‘π’“π’Šπ’„π’† × π‘΅(π’…πŸ ) − 𝑷𝑽(π’”π’•π’“π’Šπ’„π’Œ π’‘π’“π’Šπ’„π’†) × π‘΅(π’…πŸ )
Equation 21.4: European call option for a non-dividend-paying stock:
𝒄𝒂𝒍𝒍 π’‘π’“π’Šπ’„π’† = 𝒑𝒖𝒕 π’‘π’“π’Šπ’„π’† + π’”π’•π’π’„π’Œ π’‘π’“π’Šπ’„π’† − 𝑷𝑽(π’”π’•π’“π’Šπ’Œπ’† π’‘π’“π’Šπ’„π’†)
Equation 21.5: put-call parity:
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𝒄𝒂𝒍𝒍 π’‘π’“π’Šπ’„π’† = 𝒑𝒖𝒕 π’‘π’“π’Šπ’„π’† + π’”π’•π’π’„π’Œ π’‘π’“π’Šπ’„π’† − 𝑷𝑽(π’”π’•π’“π’Šπ’Œπ’† π’‘π’“π’Šπ’„π’†) − 𝑷𝑽(π’…π’Šπ’—π’Šπ’…π’†π’π’…π’”)
Acquirer (or bidder): a firm that, in a takeover, buys another firm.
Target: a firm that is acquired by another in a merger or acquisition.
Takeover: refers to two mechanisms, either a merger or an acquisition, by which ownership and control of a
firm can change.
Merger waves: peaks of heavy activity followed by quiet troughs of few transactions in the takeover market.
Horizontal merger: the type of merger when the target and acquirer are in the same industry.
Vertical merger: the type of merger when the target’s industry buys or sells to the acquirer’s industry.
Conglomerate merger: the type of merger when the target and acquirer operate in unrelated industries.
Stock swap: merger deal when the target shareholders receive stock as payment for target shares.
Term sheet: summary of the structure of a merger transaction that includes details such as who will run the
new company, the size and composition of the new board, the location of the headquarters, and the name of
the new company.
Acquisition premium: paid by an acquirer in a takeover, it is the percentage difference between the acquisition
price and the premerger price of a target firm.
Synergies: value obtained from an acquisition that could not be obtained if the target remained an
independent firm.
Economy of scale: the savings a large company can enjoy from producing goods in high volume, that are not
available to a small company.
Economies of scope: savings large companies can realize that come from combining the marketing and
distribution of different types of related products.
Vertical integration: refers o the merger of two companies that make product required at different stages of
the production cycle for the final good. Also, refers to the merger of a firm and its supplier of a firm and its
Exchange ratio: in a takeover, the number of bidder shares received in exchange for each target share.
Risk arbitrageurs: traders who, once a takeover offer is announced, speculate on the outcome of the deal.
Merger-arbitrage spread: in a takeover, the difference between a target stock’s price and the implied offer
Step up: refers to an increase in the book value of a target’s assets to the purchase price when an acquirer
purchases those assets directly instead of purchasing the target stock.
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Friendly takeover: when a target’s board of directors supports a merger, negotiates with potential acquirers,
and agrees on a price that is ultimately put to a shareholders vote.
Hostile takeover: a situation in which an individual or organization (corporate raider) purchases a large fraction
of a target corporation’s tock and in doing so gets enough votes to replace the target’s board of directors and
its CEO.
Corporate raider or raider: the acquirer in a hostile takeover.
Proxy fight: in a hostile takeover, when the acquirer attempts to convince the target’s shareholders to unseat
the target’s board by using their proxy votes to support the acquirers’ candidates for election to the target’s
Poison pill: a defense against a hostile takeover. It is a right offering that gives the target shareholders the right
to buy shares in either the target or an acquirer at a deeply discounted price.
Staggered (classified) board: in many public companies, a board of directors whose three-year terms are
staggered so that only one-third of the directors are up for election each year.
White knight: a target company’s defense against a hostile takeover attempt, in which it looks for another,
friendlier company to acquire it.
White squire: a variant of the white knight defense, in which a large, passive investor or firm agrees to
purchase a substantial block of shares in a target with special voting rights.
Golden parachute: an extremely lucrative severance package that is guaranteed to a firm’s senior managers in
the event that the firm is taken over and the managers are let go.
Toehold: an initial ownership stake in a firm that a corporate raider can use to initiate a takeover attempt.
Management buyout (MBO): a leveraged buyout in which the buyer group includes the firm’s own
Freezeout merger: a situation in which the laws on tender offers allows an acquiring company to freeze existing
shareholders out of the gains from merging by forcing non-tendering shareholders to sell their share for the
tender offer price.
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