КФ / Лекции / Brealey Myers - Principles Of Corporate Finance 7th Ed (eBook)

c.False. The borrower has the option.

d.True. But debt issues with weak covenants suffered in such takeovers.

e.True. The costs of renegotiation are less for private placements.

10.Chapter 7 usually leads to liquidation. Chapter 11 “protects” the firm from its creditors while a reorganization plan is developed.

11.(a) False; (b) true; (c) true, except for costs incurred by the bankruptcy court or trustee; (d) true; (e) false. Tax-loss carry-forwards do not survive liquidation.

12.There is always a chance that the company can recover, allowing creditors to be paid off and leaving something for shareholders. Also, shareholders may retain some claims on the firm after reorganization in Chapter 11.

Chapter 26

1.A, c; B, d or i; C, b or e; D, f; E, a; F, h; G, g.

2.a, b, d, f, and h (though there may be other ways to reduce AMT).

3.a. The lessor must charge enough to cover the present value of the costs of owning and operating the asset over its expected economic life. In a competitive leasing market the present value of rentals cannot exceed the present value of costs. The competitive rental payment ends up equal to the lessor’s equivalent annual cost.

b.The user’s equivalent annual cost is the annual cost to the user of owning and operating the asset. If the operating lease rate is less than this cost, it pays to lease.

4. (a) True; (b) true; (c) true, but compare aftertax rates; (d) true; (e) true; (f) true; (g) true.

5.The present value of depreciation tax shields on the $3,000 desk, using the 5-year schedule from Table 6.4, is

PV 1at 9 percent2 .35 PV 15-year schedule2

3,000

$832.

After-tax administrative costs are 400(1 .35) $260 per year for 6 years. If the first costs are incurred immediately, their present value is $1,271. Thus the present value of all costs is $3,000 832 1,271 $3,439. The break-even lease rate is about $703 after tax. In other words, the present value of six payments of $703, with the first payment due immediately, is about $3,439. The breakeven rate pretax is $703/.65 $1,082.

6.Administrative costs drop to $200 per year. Moreover, the lease payments are a fixed commitment of

the blue-chip company. The six lease payments are discounted at the after-tax rate at which Acme would lend money; that is, 6(1 .35) 3.9%. The break-even lease rate falls to about $514 after tax. The pretax break-even rate is $791.

7.a. $59,307; the present value of the lease cash flows

from t 1 to t 3, discounted at r(1 Tc)

.10(1 .35) .065.

b.$62,000 59,307 2,693.

c.It should not invest. The lease’s value of 2,693 does not offset the machine’s negative NPV. It would be happy to sign the same lease on a more attractive asset.

Chapter 27

1. (a) True; (b) true; (c) false (depends on coupon);

(d) false; (e) false; (f) false; (g) true.

2. Since the futures price has risen, your sale is now showing a loss. Your broker will ask you for money.

3. Value of future 95 4.

1.049

Value of future 95.46.

2,408

4. 1.12 2,550 100 PV (convenience yield). PV 1convenience yield 2 $500.

5.a. A shortage of heating oil increases net convenience yield and reduces the futures price relative to spot price.

b.Spot and futures prices decrease. The futures price rises relative to spot because convenience yield falls and storage costs rise.

6.Storage costs are likely to be high. Other things equal, firms will prefer to hold the future rather than the spot commodity, and net convenience yield will be low.

7.(a) Profit; (b) If the bank took out a new 4-year swap, it would need to pay an extra $.25 million a year. At the new interest rate of 6.5%, the extra payment has a present value of $856,000. This is the amount that the bank should charge to terminate.

8.Basis risk means that the hedging instrument is imperfectly correlated with the risk to be hedged. It is highest in a, because Disney stock has considerable nonmarket risk. In b basis risk is likely to be small, and in c it should disappear.

9.Sell short $1.2 million of the market portfolio. In practice rather than “sell the market” you would sell futures on $1.2 million of the market index.

10.(a) Sell; (b) sell 3-month futures on Italian government bonds.

b.A has a duration of 1.949 years. So does a portfolio with 45.5% invested in B and 54.5% invested in C. To hedge A sell $4.55 million of B and $5.45 million of C.

c.Sell $5.13 million of A, borrow 10 5.13 $4.87 million short-term. Alternatively, sell $3.65 million of C and borrow $6.35 million.

Chapter 28

1.a. 9.139.

b.9.1865 pesos $1.

c.premium.

d.Using the 1-year forward rate, (9.924 9.139)/9.924 .0791, or 7.91%.

e.By interest rate parity 1 rpeso 1.05 12.36/9.84; rpeso .126, or 12.6%.

f.9.307 pesos $1.

g.If real exchange rate is constant, expected inflation in Mexico over 3 months must be 9.307/9.139 1 .018, or 1.8%, greater in Mexico than in the USA (equivalent to 1.0184 1

.076, or 7.6%, a year).

2.a. The interest rate differential equals the forward premium or discount, i.e.,

fx/$ E1sx/$ 2 sx/$ sx/$

c.Prices of goods in different countries are equal when measured in terms of the same currency. It follows that the expected change in the spot rate equals the expected inflation differential; i.e.,

d.Expected real interest rates in different countries are equal; i.e.,

5.b.

6.Zero, of course. You don’t need to do any calculations.

7.It can borrow the present value of a1 million, sell the euros in the spot market, and invest the proceeds in an 8-year dollar loan.

8.(a) (100/1.03)/(100/1.03652) 1 .043, or 4.3%;

(b)1.043 115/120.7 1 .006, or .6%;

(c)1.043 116.52/120.7 1 .007 or .7%.

9.a. NPV 6.61 1.2 $7.94 million.

c.It doesn’t. The company can always hedge against a fall in the euro.

Chapter 29

1.(a) 5,114/(5114 6,832) .43; (b) (1,674 859)/3517.2; (c) 3,288/2,704 1.2; (d) (115 1,247)/2,704

.5; (e) (1,674 483)/15,980 .07; (f) ((1,499 1,329)2)/(12,035 365) 42.9; (g) 840/((6,832 7,173)2) .120; (h) 263/840 .31.

2.The illogical ratios are a, b, c, f, and i. The correct definitions are

long-term debt value of leases

equity

earnings available for common

average equity

dividend Payout ratio earnings per share

current assets Current ratio current liabilities

average receivables

sales 365

3.(a) False; (b) true; (c) false; (d) false; (e) false—it will tend to increase the price–earnings multiple.

4.(a) Shipping company; (b) United Foods; (c) paper mill; (d) mail order company; (e) Fledgling Electronics.

5.$365,000; 12.2.

6.(a) 12%; (b) 16%.

7. .25.

8.3.65%; .73.

9.(a) 1.47; (b) Net working capital 40. Total capitalization 540. Debt to total capitalization .52.

10.$10 million.

11.$82 million.

12.The return on equity is higher when the return on assets exceeds the debt interest rate.

13.a. False (it is a process of deciding which risks to take).

b.False (financial planning is concerned with possible surprises as well as expected outcomes).

c.True (financial planning considers both the investment and financing decisions).

d.False (a typical horizon for long-term planning is 5 years).

e.True (perfect accuracy is unlikely to be obtainable, but the firm needs to produce the best possible consistent forecasts).

f.False (excessive detail distracts attention from the crucial decisions).

14.(a) $2,900,000; (b) $225,000; (c) .25.

15.Archimedes will earn $550 and invest $320 to expand assets. Additional borrowing is $120, so retained earnings is $320 120 $200. The residual dividend is $550 200 $350.

16.(a) 8.6%; (b) 13.75%.

Chapter 30

1.a. Long-term financing, cumulative capital requirements, marketable securities

b.Cash, cash, cash balance, marketable securities

c.Trial, error, financial models

2.

3.(a) Inventories go up (use). (b) Accounts receivable go up (use). (c) No change shown on the firm’s books. (d) Increase in cash (source) and reduction in assets. A loss of $100,000 is deducted from retained earnings. (e) Cash declines (use) and equity declines.

(f) Cash unchanged, although net working capital increases (the debt issue is a source of funds).

4.Month 3: 18 (.5 90) (.3 120) (.2 100) $119,000.

Month 4: 14 (.5 70) (.3 90) (.2 120) $100,000.

5.(a) 19.2, 16.8, 15, 13.2, 12, 12; (b) 19.2, 23.2, 20.6, 18.2, 16.4, 16.

6.a. Table 30.2: Bank loans 3, Cash 8, Current assets 68, Current liabilities 30, Total assets Total liabilities and net worth 118. Table 30.4: Repaid short-term bank loan 2, Increase in cash balance 4. Tables 30.5 and 30.6 unchanged.

b.Table 30.2: Long-term debt 22, Gross investment

82, Net fixed assets 62, Cash 3, Total assets

Total liabilities and net worth 125. Table 30.4: Issued long-term debt 17, Total sources 41, Invested in fixed assets 26, Total uses 42, Increases in cash balance 1. Table 30.5: Fixed and Total assets change as in Table 30.2, as do Long term debt and Total liabilities and net worth. Table 30.6: same changes as in Table 30.4, except Increase in net working capital 6.

c.Table 30.3: Operating costs 289, Pretax income

56, Net income 28, Retained earnings 27. Table 30.2: Net worth 92, Total liabilities and net worth Total assets 131; Inventory 22.5, Cash 23.5. Table 30.5: Net worth 92, Longterm liabilities and net worth Total assets 104, Net working capital 54. Table 30.6: Net income

28, increase in Net working capital 24.

d.Table 30.7: Third quarter, Total collections 120.1, Ending receivables 26.6. Fourth quarter, Total collections 129.5, Ending receivables 28.1. Table 30.8, Third quarter: Sources minus uses and Cash at end of period increase by 11.6, Cumulative financing required decreases by 11.6. Fourth quarter: Sources minus uses increase by 1.5, Cumulative financing required decreases by 13.1 to 12.6.

e.Table 30.8: Labor, etc. 26, Sources minus uses decrease by 4 in each quarter. Cumulative financing required decreases by 4 in first quarter, 8 in second, etc.

f.Table 30.8: Other sources of cash increase by 10 in the second quarter, increasing Sources minus uses and decreasing Cumulative financing required.

g.Table 30.8: Minimum operating cash balance 2, Cumulative financing required decreases by 2 in all quarters.

7.(a) True; (b) false (borrower has a call); (c) true; (d) false (100/90 1 .111, or 11.1%); (e) true.

8.(a) Line of credit; (b) commitment fee; (c) floating charge; (d) collateral; (e) warehouse receipt; (f) commercial paper; (g) medium-term notes.

Chapter 31

1.a. Payment float $25,000. Availability float $75,000.

b.It can earn interest on these funds.

c.Payment float increases. The bank’s gross ledger balance and available balance increase by the same amount.

2.a. The $.40 per check fee is cheaper at 300 .40 $120 per day. The cost of putting up $800,000 of compensating balances is .09 800,000 $72,000 per year, or 72,000/365 $197 per day.

b.The lock-box system costs $120 per day, or $43,800 per year. You would need $486,700 additional cash to generate this much interest. Thus, the lockbox system must generate at least this much cash. The cash flow is 300 1,500 $450,000 per day. Thus the lock box must speed up average collection time by 486,700/450,000 1.08 days.

3.Payment float; availability float; net float; concentration banking; FEDWIRE; CHIPS; lock-box banking.

4.The formula for optimal order size is

Q212 sales cost per order 2/carrying cost

212 216 2 2/6 2144 12 books.

Everyman should place 216/12 18 orders a year and its average inventory should be 12/2 6 books.

5. The formula gives

Q 12 annual cash disbursements 2

B 1cost per sale of securities 2/interest rate

212 20,000 2 2/.02 24,000,000

$2,000.

Everyman should sell securities 20,000/2,000 10 times a year and its average cash balance should be 2,000/2 $1,000.

6.(a) Less; (b) less; (c) invest the same amount; (d) more.

7.Price 100 (182/360)1.75 99.115. Compound annual return (100/99.115)2 1 .0179, or 1.79%.

8.(a) Repurchase agreements; (b) commercial paper; (c) finance company commercial paper; (d) mediumterm notes; (e) 3-month bills; (f) Treasury bills; (g) Treasury bills.

9.Only 30% of the floating-rate preferred dividend is taxed versus 100% of bond interest. The fixeddividend preferred also has this advantage but its price fluctuates more than the floating-rate preferred’s.

Chapter 32

1.a. 1% of $1,000 $10.

b.1% for 30 days 12.2% per annum simple interest or 12.9% compound interest.

c.(i) Shorter; (ii) longer; (iii) shorter.

2.a. Due lag decreases, therefore pay lag decreases;

b.Due lag increases, therefore pay lag increases;

c.Terms lag increases, therefore pay lag increases.

3.Open account, commercial draft, shipping documents, trade acceptance, the customer’s, banker’s acceptance, letter of credit, the customer’s, his or her own, letter of credit, shipping documents, shipping documents.

4.Reject because PV of Q’s order (.75 50)/1.101/240 $4.25 per iron, or $4,250 in total.

Therefore, grant credit if probability of payment exceeds 87.5%.

b.Expected profit from selling to slow payer:

.8(150) .2(1050) 90. Break-even point for credit check: (.05 90 units) 12 0. Units2.67.

6.Total expected profit on initial order 40 .8[(p2200) 1,000(1 p2)]/1.2 0

p2 .88, or 88%.

7.(a) False; (b) true; (c) false; (d) false—should be collection agency or attorney; (e) true.

Chapter 33

1. (a) Horizontal; (b) conglomerate; (c) vertical;

(d)conglomerate.

2.a and d; c can also make sense, although merging is not the only way to redeploy excess cash.

3.(a) $5 million (We assume that the $500,000 saving is an after-tax figure.); (b) $4 million; (c) $7.5 million; (d) $1 million; (e) $2.5 million.

4.a, b.

5.(a) True; (b) false; (c) false; (d) true; (e) false (They may produce gains, but “large” is stretching it.);

(f)false; (g) true.

6.Such companies are tempted to undertake nega- tive-NPV investments. If they do, a bidder may try to take over and force a cutback of investment.

7.a. Any premium paid by the bidder over the book value of the target’s equity is reflected in the bidder’s balance sheet, e.g., it is shown as “goodwill.”

b.The bidder offers to buy the target’s stock directly from its shareholders.

c.The target’s stockholders can purchase additional shares at a bargain price.

d.The target purchases shares held by the bidder; the bidder agrees to go away.

e.The target frustrates a hostile bidder by agreeing to merge with a friendlier and more compatible suitor.

Chapter 34

1.a. Purchase of a business using mostly debt financing. The company goes private. Management is given a substantial equity stake.

b.An LBO undertaken by management.

c.A parent company creates a new company with part of its assets and operations. Shares in the new business are distributed to the parent’s stockholders.

d.Like a spin-off, but shares in the new business are sold to investors.

e.Sale of specific assets rather than entire firm. A company borrows to repurchase a large fraction of its shares. Like an LBO, except that the company remains public.

f.A government-owned business is sold to private investors.

g.A company moves to a much higher debt ratio. Proceeds of additional borrowing are paid out to stockholders.

2.(a) True; (b) false; (c) false; (d) true; (e) true; (f) false;

(g) false.

3.Increased efficiency, broader share ownership, and revenue for the government.

4.a. Internal capital markets often misallocate capital. The market values of the conglomerate’s divisions can’t be observed separately, so it’s hard to set incentives and to reward risk-taking.

b.In a smaller, developing economy, size may give easier access to capital markets and make it easier to attract professional management. It may also give political power. An internal capital market may be helpful when external markets are undeveloped or inefficient.

5.In Germany, banks own large, often controlling stakes in nonfinancial corporations. In the U.S. this is not allowed. In Japan, banks play central roles in keiretsus, groups of companies linked by crossownership.

6.Temporary conglomerates, such as LBO funds, purchase businesses in different industries but not to invest and manage for the long run. The objective is to buy, fix, and sell.

A

Abnormal return Part of return that is not due to systematic influences, e.g., marketwide price movements.

Absolute priority Rule in bankruptcy proceedings whereby senior creditors are required to be paid in full before junior creditors receive any payment.

Accelerated depreciation Any depreciation method that produces larger deductions for depreciation in the early years of a project’s life.

Accounts payable (payables, trade debt) Money owed to suppliers.

Accounts receivable (receivables, trade credit) Money owed by customers.

Accrued interest Interest that has been earned but not yet paid.

ACH Automated Clearing House.

Acid-test ratio Quick ratio.

Adjusted present value (APV) Net present value of an asset if financed solely by equity plus the present value of any financing side effects.

ADR American depository receipt.

Adverse selection A situation in which a pricing policy causes only the less desirable customers to do business, e.g., a rise in insurance prices that leads only the worst risks to buy insurance.

Agency theory Theory of the relationship between a principal, e.g., a shareholder, and an agent of the principal, e.g., the company’s manager.

Aging schedule Record of the length of time that accounts receivable have been outstanding.

All-or-none underwriting An arrangement whereby a security issue is canceled if the underwriter is unable to resell the entire issue.

American depository receipt (ADR) A security issued in the United States to represent shares of a foreign company.

American option Option that can be exercised any time before the final exercise date (cf. European option).

Amex American Stock Exchange.

Amortization (1) Repayment of a loan by installments;

(2) allowance for depreciation.

Annual percentage rate (APR) Annual interest rate calculated using simple interest.

Annuity Investment that produces a level stream of cash flows for a limited number of periods.

Annuity due Annuity whose payments occur at the start of each period.

Annuity factor Present value of $1 paid for each of t periods.

*Italicized words are listed elsewhere in the glossary.

Anticipation Arrangements whereby customers who pay before the final date may be entitled to deduct a normal rate of interest.

Appraisal rights A right of shareholders in a merger to demand the payment of a fair price for their shares, as determined independently.

Appropriation request Formal request for funds for a capital investment project.

APR Annual percentage rate.

APT Arbitrage pricing theory.

APV Adjusted present value.

Arbitrage Purchase of one security and simultaneous sale of another to give a risk-free profit.

“Arbitrage” or “risk arbitrage” Often used loosely to describe the taking of offsetting positions in related securities, e.g., at the time of a takeover bid.

Articles of incorporation Legal document establishing a corporation and its structure and purpose.

Asian currency units Dollar deposits held in Singapore or other Asian centers.

Asian option Option based on the average price of the asset during the life of the option.

Ask price (offer price) Price at which a dealer is willing to sell (cf. bid price).

Asset-backed securities Securities issued by a special purpose company that holds a package of low-risk assets whose cash flows are sufficient to service the bonds.

Auction-rate preferred A variant of floating-rate preferred stock where the dividend is reset every 49 days by auction.

Authorized share capital Maximum number of shares that a company can issue, as specified in the firm’s articles of incorporation.

Automated Clearing House (ACH) Private electronic system run by banks for high-volume, low-value payments.

Availability float Checks deposited by a company that have not yet been cleared.

Aval Bank guarantee for debt purchased by forfaiter.

B

BA Banker’s acceptance.

Backwardation Condition in which spot price of commodity exceeds price of future (cf. contango).

Balloon payment Large final payment (e.g., when a loan is repaid in installments).

Banker’s acceptance (BA) Written demand that has been accepted by a bank to pay a given sum at a future date (cf. trade acceptance).

Barrier option Option whose existence depends on asset price hitting some specified barrier (cf. down-and-out option, down-and-in option).

1040 GLOSSARY

Basis point (bp) 0.01 percent.

Basis risk Residual risk that results when the two sides of a hedge do not move exactly together.

Bearer security Security for which primary evidence of ownership is possession of the certificate (cf. registered security).

Bear market Widespread decline in security prices (cf. bull market).

Benchmark maturity Maturity of a newly issued Treasury bond.

Benefit–cost ratio One plus profitability index.

Best-efforts underwriting An arrangement whereby underwriters do not commit themselves to selling a security issue but promise only to use best efforts.

Beta Measure of market risk.

Bid price Price at which a dealer is willing to buy (cf. ask price).

Bill of exchange General term for a document demanding payment.

Bill of lading Document establishing ownership of goods in transit.

Blue-chip company Large and creditworthy company.

Blue-sky laws State laws covering the issue and trading of securities.

Boilerplate Standard terms and conditions, e.g., in a debt contract.

Bond Long-term debt.

Bookbuilding The procedure whereby underwriters gather nonbinding indications of demand for a new issue.

Book entry System whereby only one global certificate is issued for bond and evidence of ownership is receipt showing interest in this certificate.

Book runner The managing underwriter for a new issue. The book runner maintains the book of securities sold.

Bought deal Security issue where one or two underwriters buy the entire issue.

bp Basis point.

Bracket A term signifying the extent of an underwriter’s commitment in a new issue, e.g., major bracket, minor bracket.

Break-even analysis Analysis of the level of sales at which a project would just break even.

Bridging loan Short-term loan to provide temporary financing until more permanent financing is arranged.

Bull–bear bond Bond whose principal repayment is linked to the price of another security. The bonds are issued in two tranches: In the first the repayment increases with the price of the other security; in the second the repayment decreases with the price of the other security.

Bulldog bond Foreign bond issue made in London.

Bullet payment Single final payment, e.g., of a loan (in contrast to payment in installments).

Bull market Widespread rise in security prices (cf. bear market).

Buy-back Repurchase agreement.

C

Cable The exchange rate between U.S. dollars and sterling.

Call option Option to buy an asset at a specified exercise price on or before a specified exercise date (cf. put option).

Call premium (1) Difference between the price at which a company can call its bonds and their face value; (2) price of an option.

Call provision Provision that allows an issuer to buy back the bond issue at a stated price.

Cap An upper limit on the interest rate on a floating-rate note.

Capital budget List of planned investment projects, usually prepared annually.

Capitalization Long-term debt plus preferred stock plus net worth.

Capital lease Financial lease.

Capital market Financial market (particularly the market for long-term securities).

Capital rationing Shortage of funds that forces a company to choose between worthwhile projects.

Capital structure Mix of different securities issued by a firm.

CAPM Capital asset pricing model.

CAR Cumulative abnormal return.

CARDs (Certificates for Amortizing Revolving Debt) Passthrough securities backed by credit card receivables.

CARs (Certificates of Automobile Receivables) Passthrough securities backed by automobile receivables.

Carve-out Public offering of shares in a subsidiary.

Cascade Rational herding in which each individual deduces that previous decisions by others may have been based on extra information.

Cash and carry Purchase of a security and simultaneous sale of a future, with the balance being financed with a loan or repo.

Cash budget Forecast of sources and uses of cash.

Cash-deficiency arrangement Arrangement whereby a project’s shareholders agree to provide the operating company with sufficient net working capital.

CAT bond Catastrophe bond.

Catastrophe bond (CAT bond) Bond whose payoffs are linked to a measure of catastrophe losses such as insurance claims.

CD Certificate of deposit.

Certainty equivalent A certain cash flow that has the same present value as a specified risky cash flow.

Certificate of deposit (CD) A certificate providing evidence of a bank time deposit.

CFTC Commodity Futures Trading Commission.

CFO Chief financial officer.

Chaebol A Korean conglomerate.

CHIPS Clearing House Interbank Payments System.

Clean price (flat price) Bond price excluding accrued interest (cf. dirty price).

Clearing House Interbank Payments System (CHIPS) An international wire transfer system operated by a group of major banks for high-value dollar payments.

Closed-end mortgage Mortgage against which no additional debt may be issued (cf. open-end mortgage).

CMOs Collateralized mortgage obligations.

Collar An upper and lower limit on the interest rate on a floating-rate note.

Collateral Assets that are given as security for a loan.

Collateralized mortgage obligations (CMOs) A variation on the mortgage pass-through security, in which the cash flows from a pool of mortgages are repackaged into several tranches of bonds with different maturities.

Collateral trust bonds Bonds secured by common stocks or other securities that are owned by the borrower.

Collection float Customer-written checks that have not been received, deposited, and added to the company’s available balance (cf. payment float).

Commercial draft (bill of exchange) Demand for payment.

Commercial paper Unsecured notes issued by companies and maturing within nine months.

Commitment fee Fee charged by bank on an unused line of credit.

Common stock Security representing ownership of a corporation.

Compensating balance Non-interest-bearing demand deposits to compensate banks for bank loans or services.

Competitive bidding Means by which public utility holding companies are required to choose their underwriter (cf. negotiated underwriting).

Completion bonding Insurance that a construction contract will be successfully completed.

Compound interest Reinvestment of each interest payment on money invested to earn more interest (cf. simple interest).

Compound option Option on an option.

Concentration banking System whereby customers make payments to a regional collection center. The collection center pays the funds into a regional bank account and surplus money is transferred to the company’s principal bank.

Conditional sale Sale in which ownership does not pass to the buyer until payment is completed.

Conglomerate merger Merger between two companies in unrelated businesses (cf. horizontal merger, vertical merger).

GLOSSARY 1041

Consol Name of a perpetual bond issued by the British government. Sometimes used as a general term for perpetuity.

Contango Condition in which spot price of a commodity is below that of the future (cf. backwardation).

Contingent claim Claim whose value depends on the value of another asset.

Contingent project Project that cannot be undertaken unless another project is also undertaken.

Continuous compounding Interest compounded continuously rather than at fixed intervals.

Controller Officer responsible for budgeting, accounting, and auditing in a firm (cf. treasurer).

Convenience yield The extra advantage that firms derive from holding the commodity rather than the future.

Conversion price Par value of a convertible bond divided by the number of shares into which it may be exchanged.

Conversion ratio Number of shares for which a convertible bond may be exchanged.

Convertible bond Bond that may be converted into another security at the holder’s option. Similarly convertible preferred stock.

Convexity Term often used to describe the fact that the effect of an interest rate change on bond prices declines as the interest rate rises.

Correlation coefficient Measure of the closeness of the relationship between two variables.

Cost company arrangement Arrangement whereby the shareholders of a project receive output free of charge but agree to pay all operating and financing charges of the project.

Cost of capital Opportunity cost of capital.

Coupon (1) Specifically, an attachment to the certificate of a bearer security that must be surrendered to collect interest payment; (2) more generally, interest payment on debt.

Covariance Measure of the comovement between two variables.

Covenant Clause in a loan agreement.

Credit derivative Contract for hedging against loan default or changes in credit risk (see default swap, credit option).

Credit option Similar to a long-term insurance policy against loan default.

Credit scoring A procedure for assigning scores to borrowers on the basis of the risk of default.

Cross-default clause Clause in a loan agreement stating that the company is in default if it fails to meet its obligation on any other debt issue.

Cum dividend With dividend.

Cum rights With rights.

Cumulative preferred stock Stock that takes priority over common stock in regard to dividend payments. Dividends

1042 GLOSSARY

may not be paid on the common stock until all past dividends on the preferred stock have been paid.

Cumulative voting Voting system under which a stockholder may cast all of his or her votes for one candidate for the board of directors (cf. majority voting).

Current asset Asset that will normally be turned into cash within a year.

Current liability Liability that will normally be repaid within a year.

Current ratio Current assets divided by current liabilities— a measure of liquidity.

D

DCF Discounted cash flow.

Debenture Unsecured bond.

Decision tree Method of representing alternative sequential decisions and the possible outcomes from these decisions.

Default swap Credit derivative in which one party makes fixed payments while the payments by the other party depend on the occurrence of a loan default.

Defeasance Practice whereby the borrower sets aside cash or bonds sufficient to service the borrower’s debt. Both the borrower’s debt and the offsetting cash or bonds are removed from the balance sheet.

Delta Hedge ratio.

Depository transfer check (DTC) Check made out directly by a local bank to a particular company.

Depreciation (1) Reduction in the book or market value of an asset; (2) portion of an investment that can be deducted from taxable income.

Derivative Asset whose value derives from that of some other asset (e.g., a future or an option).

Diff Differential swap.

Differential swap (diff, quanto swap) Swap between two

LIBOR rates of interest, e.g., yen LIBOR for dollar LIBOR. Payments are in one currency.

Dilution Diminution in the proportion of income to which each share is entitled.

Direct lease Lease in which the lessor purchases new equipment from the manufacturer and leases it to the lessee (cf. sale and lease-back).

Direct quote For foreign exchange, the number of U.S. dollars needed to buy one unit of a foreign currency (cf. indirect quote).

Dirty price Bond price including accrued interest, i.e., the price paid by the bond buyer (cf. clean price).

Discount bond Debt sold for less than its principal value. If a discount bond pays no interest, it is called a “pure” discount, or zero-coupon, bond.

Discounted cash flow (DCF) Future cash flows multiplied by discount factors to obtain present value.

Discount factor Present value of $1 received at a stated future date.

Discount rate Rate used to calculate the present value of future cash flows.

Discriminatory price auction Auction in which successful bidders pay the price that they bid (cf. uniform price auction).

Disintermediation Withdrawal of funds from a financial institution in order to invest them directly (cf. intermediation).

Dividend Payment by a company to its stockholders.

Dividend reinvestment plan (DRIP) Plan that allows shareholders to reinvest dividends automatically.

Dividend yield Annual dividend divided by share price.

Double-declining-balance depreciation Method of accelerated depreciation.

Double-tax agreement Agreement between two countries that taxes paid abroad can be offset against domestic taxes levied on foreign dividends.

Down-and-in option Barrier option that comes into existence if asset price hits a barrier.

Down-and-out option Barrier option that expires if asset price hits a barrier.

DRIP Dividend reinvestment plan.

Drop lock An arrangement whereby the interest rate on a floating-rate note or preferred stock becomes fixed if it falls to a specified level.

DTC Depository transfer check.

Dual-currency bond Bond with interest paid in one currency and principal paid in another.

Duration The average number of years to an asset’s discounted cash flows.

E

EBIT Earnings before interest and taxes.

Economic exposure Risk that arises from changes in real exchange rates (cf. transaction exposure, translation exposure).

Economic income Cash flow plus change in present value.

Economic rents Profits in excess of the competitive level.

Economic Value Added (EVA) A measure of residual income implemented by the consulting firm Stern Stewart.

Efficient market Market in which security prices reflect information instantaneously.

Efficient portfolio Portfolio that offers the lowest risk (standard deviation) for its expected return and the highest expected return for its level of risk.

Employee stock ownership plan (ESOP) A company contributes to a trust fund that buys stock on behalf of employees.

EPS Earnings per share.

Equipment trust certificate Form of secured debt generally used to finance railroad equipment. The trustee retains ownership of the equipment until the debt is repaid.

Equity (1) Common stock and preferred stock. Often used to refer to common stock only. (2) Net worth.

Equivalent annual cash flow Annuity with the same net present value as the company’s proposed investment.

ESOP Employee stock ownership plan.

Euribor Euro Interbank Offered Rate.

Euro Interbank Offered Rate (Euribor) The interest rate at which major international banks in Europe lend euros to each other.

Eurobond Bond that is marketed internationally.

Eurodollar deposit Dollar deposit with a bank outside the United States.

European option Option that can be exercised only on final exercise date (cf. American option).

EVA Economic Value Added.

Evergreen credit Revolving credit without maturity.

Exchange of assets Acquisition of another company by purchase of its assets in exchange for cash or shares.

Exchange of stock Acquisition of another company by purchase of its stock in exchange for cash or shares.

Ex dividend Purchase of shares in which the buyer is not entitled to the forthcoming dividend (cf. with dividend, cum dividend).

Exercise price (striking price) Price at which a call option or put option may be exercised.

Expectations hypothesis Theory that forward interest rate

( forward exchange rate) equals expected spot rate.

Expected return Average of possible returns weighted by their probabilities.

Ex rights Purchase of shares in which the buyer is not entitled to the rights to buy shares in the company’s rights issue (cf. with rights, cum rights, rights on).

Extendable bond Bond whose maturity can be extended at the option of the lender (or issuer).

External finance Finance that is not generated by the firm: new borrowing or an issue of stock (cf. internal finance).

Extra dividend Dividend that may or may not be repeated (cf. regular dividend).

F

Face value Par value.

Factoring Arrangement whereby a financial institution buys a company’s accounts receivable and collects the debt.

Fair price provision Appraisal rights.

FASB Financial Accounting Standards Board.

FCIA Foreign Credit Insurance Association.

GLOSSARY 1043

FDIC Federal Deposit Insurance Corporation.

Federal funds Non-interest-bearing deposits by banks at the Federal Reserve. Excess reserves are lent by banks to each other.

Fedwire A wire transfer system for high-value payments operated by the Federal Reserve System (cf. CHIPS).

Field warehouse Warehouse rented by a warehouse company on another firm’s premises (cf. public warehouse).

Financial assets Claims on real assets.

Financial engineering Combining or dividing existing instruments to create new financial products.

Financial lease (capital lease, full-payout lease) Longterm, noncancelable lease (cf. operating lease).

Financial leverage (gearing) Use of debt to increase the expected return on equity. Financial leverage is measured by the ratio of debt to debt plus equity (cf. operating leverage).

Fiscal agency agreement An alternative to a bond trust deed. Unlike the trustee, the fiscal agent acts as an agent of the borrower.

Flat price Clean price.

Float See availability float, payment float.

Floating lien General lien against a company’s assets or against a particular class of assets.

Floating-rate note (FRN) Note whose interest payment varies with the short-term interest rate.

Floating-rate preferred Preferred stock paying dividends that vary with short-term interest rates.

Floor planning Arrangement used to finance inventory. A finance company buys the inventory, which is then held in trust by the user.

Foreign bond A bond issued on the domestic capital market of another country.

Forex Foreign exchange.

Forfaiter Purchaser of promises to pay (e.g., bills of exchange or promissory notes) issued by importers.

Forward cover Purchase or sale of forward foreign currency in order to offset a known future cash flow.

Forward exchange rate Exchange rate fixed today for exchanging currency at some future date (cf. spot exchange rate).

Forward interest rate Interest rate fixed today on a loan to be made at some future date (cf. spot interest rate).

Forward rate agreement (FRA) Agreement to borrow or lend at a specified future date at an interest rate that is fixed today.

FRA Forward rate agreement.

Free cash flow Cash not required for operations or for reinvestment.

FRN Floating-rate note.

Full-payout lease Financial lease.