Category Archives: Corporate Finance

Glossary Of Frequently Used Symbols in Corporate Finance

Whilst this is again not one of my more substantive posts, I thought the following glossary of frequently used symbols in corporate finance may be of some interest:

ANk Annuity factor for N years and an interest rate of k
ABCP Asset Backed Commercial Paper
ACES Advanced Computerised Execution System
ADR American Depositary Receipt
APT Arbitrage Pricing Theory
APV Adjusted Present Value
ARR Accounting Rate of Return
BIMBO Buy In Management Buy Out
BV Book Value
Capex Capital Expenditures
CAPM Capital Asset Pricing Model
CAR Cumulative Abnormal Return
CB Convertible Bond
CD Certificate of Deposit
CDO Collateralised Debt Obligation
CE Capital Employed
CFROI Cash Flow Return On Investment
COV Covariance
CVR Contingent Value Right
D Debt, net financial and banking debt
d Payout ratio
DCF Discounted Cash Flows
DDM Dividend Discount Model
DECS Debt Exchangeable for Common Stock; Dividend Enhanced Convertible Securities
DFL Degree of Financial Leverage
Div Dividend
DJ Dow Jones
DOL Degree of Operating Leverage
DPS Dividend Per Share
DR Depositary Receipt
EAT Earnings After Tax
EBIT Earnings Before Interest and Taxes
EBITDA Earnings Before Interest, Taxes, Depreciation and Amortisation
EBRD European Bank for Reconstruction and Development
ECAI External Credit Assessment Institution
ECP European Commercial Paper
EGM Extraordinary General Meeting
EMTN European Medium Term Note
ENPV Expanded Net Present Value
EONIA European Over Night Index Average
EPS Earnings Per Share
EðrÞ Expected return
ESOP Employee Stock Ownership Programme
EURIBOR EURopean Inter Bank Offer Rate
EV Enterprise Value
EVA Economic Value Added
EVCA European Private Equity and Venture Capital Association
f Forward rate
F Cash flow
FA Fixed Assets
FASB Financial Accounting Standards Board
FC Fixed Costs
FCF Free Cash Flow
FCFF Free Cash Flow to Firm
FCFE Free Cash Flow to Equity
FE Financial Expenses
FIFO First In, First Out
FRA Forward Rate Agreement
g Growth rate
GAAP Generally Accepted Accounting Principles
GCE Gross Capital Employed
GCF Gross Cash Flow
GDP Global Depositary Receipt
i After-tax cost of debt
IASB International Accounting Standards Board
IFRS International Financial Reporting Standard
IPO Initial Public Offering
IRR Internal Rate of Return
IRS Interest Rate Swap
IT Income Taxes
k Cost of capital, discount rate
kD Cost of debt
kE Cost of equity
K Option strike price
KPI Key Performance Indicator
LBO Leveraged Buy Out
LBU Leveraged Build Up
L/C Letter of Credit
LIBOR London Inter Bank Offer Rate
LIFO Last In, First Out
LMBO Leveraged Management Buy Out
ln Naperian logarithm
LOI Letter Of Intent
LSP Liquid Share Partnership
LYON Liquid Yield Option Note
m Contribution margin
MM Modigliani–Miller
MOU Memorandum Of Understanding
MTN Medium Term Notes
MVA Market Value Added
n Years, periods
N Number of years
NðdÞ Cumulative standard normal distribution
NASDAQ National Association of Securities Dealers Automatic Quotation system
NAV Net Asset Value
NM Not Meaningful
NMS National Market System
NOPAT Net Operating Profit After Tax
NPV Net Present Value
NYSE New York Stock Exchange
OGM Ordinary General Meeting
OTC Over The Counter
Frequently used symbols xxiii
P price
PBO Projected Benefit Obligation
PBR Price to Book Ratio
PBT Profit Before Tax
P/E ratio Price Earnings ratio
PERCS Preferred Equity Redemption Cumulative Stock
PEPs Personal Equity Plans
POW Path Of Wealth
PRIDES Preferred Redeemable Increased Dividend Equity Security
PSR Price to Sales Ratio
P to P Public to Private
PV Present Value
PVI Present Value Index
QIB Qualified Institutional Buyer
r Rate of return, interest rate
rf Risk-free rate
rm Expected return of the market
RNAV Restated Net Asset Value
ROA Return On Assets
ROCE Return On Capital Employed
ROE Return On Equity
ROI Return On Investment
RWA Risk Weighted Assessment
S Sales
SA Standardised Approach
SEC Securities Exchange Commission
SEO Seasoned Equity Offering
SPV Special Purpose Vehicle
STEP Short Term European Paper
SV Salvage Value
t Interest rate, discount rate
T Time remaining until maturity
Tc Corporate tax rate
TCN Titres de Cre´ances Negociables
TMT Technology, Media, Telecommunications
TSR Total Shareholders Return
V Value
VAT Value Added Tax
VC Variable Cost
VD Value of Debt
VE Value of Equity
VðrÞ Variance of return
WACC Weighted Average Cost of Capital
WC Working Capital
y Yield to maturity
YTM Yield to Maturity
Z Scoring function
ZBA Zero Balance Account

I obtained the above list from the book Corporate Finance, Theory and Practice by Pierre Vernimmen, John Wiley and sons, 2005.

The Disadvantages of a Company Going Public or ‘Floating’

Following on from my post about the advantages of company going public, The following article discusses the disadvantages of a company going public through an IPO; as outlined in IPO and Equity Offerings by Ross Gedes.

The disadvantages brought about through the flotation of a company in an IPO are typically perceived differently by different companies with different focuses and requirements.

There are the costs involved that include both the direct costs, in time and money, of the flotation process as well as the opportunity costs of underpricing the offering and subsequently the costs of increased disclosure to public shareholders.

The disadvantages of private company going public are:

  1. Increased disclosure,
  2. Costs of IPOs,
  3. Potential loss of control,
  4. Separation of ownership and control,
  5. Perceptions of short-termism (Wall street),
  6. Meeting investor expectations.

Increased disclosure

When a company moves from private ownership to public, it vastly increases the number of people who have access to its financial records. This can be a huge shock to the existing owners, not just the reporting of the company’s results, but the disclosure of management salaries and perks that often piques the interest of newspaper editors on a slow day.

Companies are required by stock exchanges, securities commissions and regulators to disclose information on a regular basis so that investors and potential investors can make buy, sell or hold decisions. A much greater amount of information is required at the time of the IPO and is included in the offering prospectus.

Disclosure requirements vary by country. Those countries with the largest stock markets, relative to the economy, typically have the highest disclosure requirements (e.g. Australia, Canada, UK, USA).

The development of efficient capital markets in Central and Eastern Europe has been hindered partially by the reticence of corporate executives to disclose information about their firm’s operations and performance.

It’s not all bad though. Botosan (1997) has found that increased disclosure on the part of the company can reduce its cost of equity. By reducing its cost of equity, a company is able to invest in more projects, raise capital more cheaply, and enhance its valuation.

Costs of IPOs

Initial public offerings aren’t cheap. Investment bankers take commissions of between 2 and 7 per cent of the total amount raised; lawyers and accountants bill by the hour, and many hours are required. The ancillary costs, such as public relations, printing, corporate advertising and others can add several hundred thousand more dollars, euros or pounds.

In addition to the upfront costs of the IPO, there are the costs of maintaining a quote on the stock exchange (stock exchange fees, management time, more extensive audits and reporting, reconciliation of accounts to US GAAP if listed on a US exchange, etc.).

However, the direct costs of an IPO can pale beside the indirect cost of underpricing. Because no cash is coming directly out of the issuer’s pocket, underpricing can sometimes be ignored as a cost. It should not be. IPOs around the world are under priced compared with their short-term performance. On average, an IPO will close at a price that is 15 to 20 per cent above its issue price, although this varies by market and industry and over time. This means that selling shareholders and the company are leaving significant sums of money on the table when they go public.

The amount of money left on the table is calculated by subtracting the offer price from the first day closing price and multiplying by the number of shares offered. For example, many analysts believe Google left too much money on the table in its 2004 IPO.

Potential restrictions on management action

In many private companies, the managers are the owners. Therefore there are few restrictions on management action other than statutory and legal regulations and common sense. However, this is not a problem as the linkage of ownership and control should lead to little divergence of opinion about the appropriate course of action for the company.

In public companies, the managers are the agents of the shareholders – they should be acting on behalf of the shareholders and in the shareholders’ best interests. In order to ensure that they do, public companies have boards of directors who are meant to oversee management’s actions on behalf of shareholders. In some circumstances a strong board of directors may limit the actions of management.

Potential loss of control

Not all IPOs are for more than 50 per cent of the issuer’s voting shares, in fact, the average is around 30 per cent. So although control is not lost through the IPO, if the company requires further equity to fuel its growth, existing shareholders will suffer dilution. For the majority of companies, control will pass to public shareholders at some point in time.

‘This risk [passing of control] can be minimized by limiting the number of shares sold to the public, seeking to ensure a broad distribution of shares to the public, creating tiered classes of stock with differential voting rights, entering into voting agreements among pre-IPO shareholders, adopting supermajority provisions or staggering the terms of the directors. Creating a dual class voting structure can depress the price of the shares with less voting power. While some structures may prove more effective than others, there is no guarantee that a public company will not be threatened by a hostile acquiror.’ (Greenstein et al., 2000: 7)

Perceptions of short-termism

One of the most common complaints of corporate management is that Wall Street or the City are too ‘short-termist’. Short ‘termism’ outlines that investors and analysts focus exclusively on the current quarter/reporting period, without giving due consideration to the long-term impact of the company’s decisions. Shareholders generally judge management’s performance in terms of profits and stock price.

Significant pressure exists to increase profits each period and to meet analysts’ expectations and this pressure may cause management to emphasize near-term strategies instead of longer-term goals (Garner, Owen and Conway, 1994).

In order to meet investors’ quarterly or semi-annual earnings expectations, a company may be forced off the long-term strategy that was in place prior to the IPO. Managers may feel compelled to follow strategies that support the share price in the short term, rather than over a long time horizon.

I have watched several interviews with Warren Buffet where he has stated that he predominately wishes for long term investors in his company Berkshire Hathaway to avoid the Wall Street phenomenon of short termism. The corollary of this wish is a somewhat reduced daily liquidity of the stock, but if the company is returning above average dividends over time as a result of better decisions being made, this is less of an issue.

Dealing with institutional investors

Along with the above complaint about short-termism, many chief executives, often those heading a company with badly performing stock prices, complain that the stock market doesn’t understand entrepreneurs, and that entrepreneurial decision making and creativity are stifled by the men in blue pinstripe suits.

Additionally, dealing with shareholders, financial analysts and the press is time consuming. The CEO and CFO/Finance Director should expect to expend, on average, at least one day per month meeting with and discussing the company’s strategy, performance and operations. Those companies that do not establish good relationships with the financial community can find themselves without friends in times of need, such as when faced with a hostile take-over.

‘The performance expectations of Wall Street can only be described as brutal. Miss your earnings forecasts, especially in the first year after your IPO, and you could see a catastrophic decline in the price of your stock of 50 percent or better. Once a young management team has discredited itself with Wall Street, there may be no recovery.’ (American Lawyer Media, ‘The Survival Guide to IPOs’, p. 15)

Whilst many believe the advantages of company going public outweigh the disadvantages, every year dozens of companies voluntarily leave the stock market in what is called a ‘public to private transaction’. These transactions are typically management buy-outs and leveraged buy-outs of the public shareholders and come after extended periods of a depressed share price.

The Advantages of a Company Going Public or ‘Floating’

Whilst reading IPO and Equity Offerings by Ross Gedes, I came across the following advantages of going public. These will be compared with the disadvantages of a company going public in a later post.

The advantages of going public that will be discussed in this article include:

  1. Liquidity and increased share price,
  2. Management and employee motivation,
  3. Enhanced image/prestige,
  4. Access to alternative sources of capital,
  5. Ancillary benefits.

Valuation and liquidity impact

Companies listed on a stock exchange are typically worth more than similar companies that are privately held. The information contained in an IPO prospectus and subsequent annual reports reduces the uncertainty around performance and hence increases the value of a business.

In addition, investors are willing to pay a premium for liquidity: the ability to easily buy or sell shares. Private companies have limited or no liquidity in most cases. The liquidity premium varies over time and economic conditions, but a reasonable estimate would be in the 30 per cent range. This means that if two identical companies exist, one listed and the other not, the listed company will typicallly be valued approximately 30 per cent more than the private company in the marketplace by investors.

Daily liquidity means that insiders know the value of their holdings more accurately, as well as facilitating further sales of shares. This leads a good proportion of private companies to at least consider going public.

Motivate management and employees

The use of incentives such as stock options and stock bonuses to attract and retain both employees and management became very popular; particularly in the USA and UK during the 1990s.

Equity-based awards and ownership tend to be spread more broadly among management and employees in public companies compared to private companies. In addition, management and employees of public companies can see the results of their efforts in the share price more immediately.

Prestige/enhanced image

A significant, but intangible, benefit of a flotation is the increased visibility of the company through its ongoing disclosures to the stock exchange or securities commission. Many analysts believe there is considerable prestige attached to managing and working for a publicly listed company.

A flotation may bring marketing benefits, by making the company seem stronger and more substantial. Press coverage of public companies is typically greater than that of privately owned firms.

These factors can lead to the recruitment and retention of higher quality employees and increased sales due to greater corporate exposure.

‘While both good and bad news must be disseminated to enable investors to make well-informed decisions, a public company that is well run and compiles a record of success can gain a first class reputation that can prove an immeasurable benefit in many ways. As a company’s name and products or services become better known, not only do investors take notice, but so do customers and suppliers, who often prefer to do business with well-known companies.’ (Garner et al., 1994: 17)

Access to alternative sources of capital

Another benefit as a result of a company going public is the ability to gain access to alternative sources of capital in the future. Public companies are often able to raise money for expansion more easily and at better rates than private companies of similar size. The public debt markets are more accessible to public companies than to companies without a listing.

Moreover, going public generally improves a company’s debt to equity ratio and may enable it to borrow on better terms in the future.

One study by Pagano et al. (1998) found that Italian companies that went public were able to borrow more cheaply after their IPO. They also found that the number of banks willing to lend to a company increases after its flotation. However, they report that a similar study conducted in Spain (Planell) uncovered no significant decrease in interest rates paid after the IPO.

Ancillary benefits of flotation

The flotation process often forces a company’s management to formulate and document a clear business strategy for the first time.

This is typically beneficial to the future success of the business and in many cases is just what a private company required to truly grow from small to medium or from medium to large in size.

Along similar lines, the anticipation of public ownership leads many companies into improving their management and financial structure. Fast growing medium-sized companies often neglect the formal structures which will help them in their attempts to become larger and more profitable companies.

If you enjoyed this article, please also have a look at my blog on the disadvantages of a company going public.

11 step guide to create a business plan to attract investment

Corporate finance

Whilst reading Getting started in consulting by Alan Weiss, I came across the following 11 steps to go through to create a business plan that is likely to attract investment. I have listed them below:

1 – Company Particulars – Make sure to note the name of the company, the address, the type of public or proprietary company that it is (eg proprietary limited liability company), and the contact details of the company.

2 – Officers and Shareholders – Include the names, addresses and positions of each of the relevant people.

3 – Brief Description of the firm – It is important to give a brief (1-2 sentence) introduction to the company. It should describe the products or services the company offers, the type of company and the target market. An example would be “Baker and McKenzie is an international law firm for medium to large organisations and specialises in mergers and acquisitions and environmental law.” Continue reading 11 step guide to create a business plan to attract investment

9 types of financial markets for capital raising

wall street

I am currently making my way through the Five Minute MBA in Corporate Finance, which is likely to take about a month at the rate i am going (its 657 pages).

Anyway, Having found a particularly good summary of the different types of financial markets, i thought i would copy it across for those that are interested. I give full credit to the author but i have only been able to find a link to the book here. I also give credit to some definitions i found here.

Types of Markets

People and organizations who want to borrow money are brought together with those with surplus funds what are known as financial markets.

  • Each market deals with a somewhat different type of instrument in terms of the instrument’s maturity and the assets backing it.
  • Different markets serve different types of customers, or operate in different parts of the world.

Continue reading 9 types of financial markets for capital raising