Topics in Financial Management - Midterm - Study GuideI. Essentials of Corporate ArbitrageA. Arbitrage by Corporations1. Sources of Profitable Opportunitiesa) Use information outsider do not have on real assetsb) Exploit disagreements among outsiders (different expectations)c) Exploit other parties’ mistakesd) Cheating (manipulation and fraud)2. Arbitrage is a situation in which you cannot lose, you can only win or break-even. Within arbitrage you do not commit your own funds, there is no risk and there is no loss. An effective arbitrage requires a set of simultaneous transactions - buy undervalued securities for a long positions and short overvalued securities that are highly correlated.3. Corporate Arbitrage Opportunities: corporations have an advantage over individual investors because they create private information that is not known to the market, can raise larger amounts of capital for a longer time, sheer trading volume, can invest in assets that are not publicly traded, have the ability to issue debt and equity and have a limited liability status (gives them the ability to issue equity and debt backed by the corporation’s assets). Sources of Corporate Arbitrage...a) Profiting from the mistakes of others (investors, the market, the government)b) Taking a long position in an undervalued security and a short position in an overvalued security(1) Long position is financed by a short position(2) M&A is an example of this when they take a long position in an acquisition and finances it by issuing debt or issuing stocks to shareholders of the target firmc) Short overvalued assets and long undervalued assets(1) When a firm sells overvalued assets and uses the money to repurchase stock(2) A firm covers a previous short position that was created by issuing debt in the past by issuing new lower interest cost debt and using the proceeds to retire the existing debt4. Limitations of Individual Investors: searching for stock lenders can be costly and time consuming; stocks on loan are subject to recall; may need additional collateral; security lending market may be illiquid; transaction and holding costs; and the risk that the other party may not fulfill its obligationsB. Net Present Value1. Difference between the present value of cash inflows and present value of cash outflows2. Start-up costs of a company are $100m (present value) and $120m (future value) but the company would be valued at $120m (present value) and $150m (future value). You can either take the profit of $20m now ($120m - $100m) or in the future, take the profit of $30m ($150m - $120m).C. The Football Example1. One person bets team A will win by 20 pts and another bets that team Z will win by 10pts. You decide to bet against both of them2. If team A wins by 20 pts, you lose that bet but still win the second - breaking even.3. If team B wins by 10 pts, you lose the best but still win on the first - breaking even4. If team A wins by less than 20 pts or team B wins by less than 10 pts, you win both bets!II. Documenting the M&A DealA. First Round Documents: Purpose is to address the risks that may arise before a definitive agreement can be reached. Buyer uses the documents to gain inside information on target and to express pre-commitment to the concept of the deal. The target has two fears with these documents - the potential leakage of inside information to competitors and the possibility of a hostile takeover.1. Retention of Advisors: specialists in law, accounting, ibanking, pr and risk management to help with deal2. Engagement Letters: scope of engagement, compensation, tail provision (whether the obligation to compensate extends to events after possible cessation of talks), indemnification of adviser against liabilities, length of engagement and method of terminating the engagement.3. Confidentiality of Information: the buyer can’t disclose non-public information4. Exclusivity of Negotiation: period in which you can’t work with other potential buyers5. Termination of Transaction: decide which side consumes the fees is the deal doesn’t go through6. Standstill on Purchasing Additional Shares: keeps buyer from short-circuiting the merger negotiations7. Term Sheet: brief summary of the deal - price, form of payment, structure8. Letter of Intent: an agreement to agree, very weak level of commitment, public disclosure. Confirms understanding between two parties, expresses commitment, preempts the market rumors, tests investor sentiment, helps get financing for a deal, starts to shape integration efforts and deters competition.B. Definitive Agreement: sets out all the necessary detail relevant to consummating the deal and is a legally binding contract, subject to any conditions such as shareholder approval. It is also used as a risk management device to complete the transaction1. Parties to the Deal: specifies the various players and their roles2. Recitals: tells the reader what the parties want to accomplish3. Definition of Terms: confirms a mutual understanding of terminology, a dictionary4. Description of the Basic Transaction: Purchase or Sale ofAssets or Equity or Merger: specifies what is to be exchanged, by whom and when5. Representations and Warranties: representation is a statement of fact, a warranty is a commitment that a fact is or will be true. These can trigger a no liability exit is the are untrue.6. Covenants: manages risks that might arise from the behavior of the parties between signing and closing. What the buyer and sell promise to do and promise not to do.7. Conditions to Closing: conditions each side must observe to consummate the transaction, failure for one party to meet the conditions allows the other to walk away8. Termination: outlines the condition where one party will let the other to exit from the agreement without penalty9. Indemnifications: specifies damage payments in the event of losses discovered after closing or in breach of provisions in the agreement10. Misc. ItemsC. Merger Proxy Statement and Prospectus: The role of the proxy statement is to disclose the deal to investors in sufficient detail to enable them to vote on the transaction, these documents are the means to communicate to the investing public. The proxy statement aims to disclose the terms, history and effects of the merger, along with standards to evaluate the price against. A prospectus is a document that informs shareholders in advance of a vote to