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Public vs
Private Equity,
by
John J. Moon, Journal of Applied Corporate Finance, Summer 2006
This
is a phenomenal article that helps us to understand how private
equity actually works as a corporate governance mechanism.
Traditionally private equity has been viewed as “expensive” capital
and public equity as a relatively “cheap” source of funds.. But
this logic misses the point. For both private companies considering
whether to go public and public companies considering whether to go
private there is much more to making sound equity-raising decisions
than simply comparing investor returns.
Who
provides equity capital to a company is as important as how much
equity is raised. Moon argues that private equity and public
ownership represent very different packages of costs and benefits.
Public equity may not turn out to be as cheap as it seems. And, in
some cases, the benefits of private equity may prevail. Only by
recognizing the costs and benefits of each can companies make the
value-maximizing choice.
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The Venture Capital Revolution
by Paul Gompers and Josh Lerner, Journal of Economic Perspectives,
Spring 2001
Venture capital has emerged as an important source of funding for
small firms that would otherwise have problems in accessing capital
markets. These firms are subject to various uncertainties and
typically operate in fast changing markets with few tangible assets.
There are large information gaps between the entrepreneurs involved
and the investors. Venture capital as opposed to public equity comes
in handy in such situations. This article by two of the leading
researchers in the field provides deep insights about the art and
science of venture capital.
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Capital Structure by Stewert C
Myers,
Journal of Economic Perspectives, Spring 2001
In
this article, a well known scholar examines the tradeoffs underlying
the use of debt and equity. Contrary to what Miller and Modigliani
mentioned, capital structure does matter because of taxes,
differences in information and agency costs. Accordingly, Myers
examines three theories in detail. The trade off theory tries to
balance the tax advantages of debt and the possibility of distress.
The pecking order (differences in information ) theory states that
firms will first borrow rather than raise equity when they are short
of funds. The free cash flow (agency costs) theory argues that cash
flows belong to equity holders. Even dangerously high levels of debt
can create value for shareholders if the free cash flows are more
than the investment opportunities.
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You have more Capital Than You Think
by Merton, Robert C, Harvard
Business Review, November 2005
Thanks to modern financial markets,
managers can ensure that virtually the only risks its shareholders,
debt holders, trade creditors, pensioners, and other liability
holders must bear are value-adding risks. Those are the risks
associated with positive-net-present-value activities in which the
company has a comparative advantage. All other risks can be hedged
or insured against through the financial markets. In most large
companies, equity capital is used to cushion against a great many
risks where the firm does not have a comparative advantage. If it
can remove these non-value-adding risks, a company will be able to
use its existing equity capital to finance a lot more value-adding
assets and activities than competitors. The Nobel prize winner
argues that the potential for creating shareholder value through
financial engineering is enormous.
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Enterprise Risk Management: Theory and Practice, by Brian W. Nocco and René M. Stulz,
Journal of Applied Corporate Finance, Fall 2006
Companies can manage risks in piece meal fashion or they can bring
in an integrated approach. Such an approach which takes a view of
the risks facing the organization as a whole and comes up with the
most effective way of managing risk is called Enterprise Risk
Management. ERM creates value at both a “macro” or company-wide
level and a “micro” or business- unit level. At the macro level, ERM
creates value by enabling senior management to quantify and manage
the risk-return trade off that faces the entire firm. This way, ERM
helps the firm maintain access to the capital markets and other
resources necessary to implement its strategy and business plan. At
the micro level, ERM becomes a way of life for managers and
employees at all levels of the company. It makes them think of
various projects using a risk- return framework.asel
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Basle 2 :
The route ahead or cul de sac by Richard Brealey,
Journal of Applied Corporate Finance, Fall 2006
This article examines some strategic issues pertaining to Basle 2.
The new Basle accord is expected to enhance banks’ safety and
soundness, strengthen the stability of the financial system as a
whole, and improve the financial sector’s ability to serve as a
source for sustainable growth for the broader economy. But the
record of success of past changes to the regulatory system in
reducing bank failures suggests that this may be a somewhat rosy
assessment. While an increase in capital requirements may reduce the
incidence of bank failure, its efficacy depends on the accuracy and
frequency with which bank assets are valued. Brealey argues that the
right way is to move toward an explicit system for regulatory
purposes of market-value accounting for bank assets.
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The Summer of '07 And The Shortcomings of Financial Innovation by Joseph R. Mason,
Journal of Applied Finance, Spring/Summer 2008
Various financial innovations developed over the past several
decades failed in the summer of 2007, as the sub prime crisis got
under way. The $9 trillion of US securitizations that spawned
various instruments including asset-backed securities,
mortgage-backed securities, collateralised debt obligations,
asset-backed commercial paper, structured investment vehicles, and
credit default swaps had grown into a monster of an unregulated and
conflicted market. The author argues that financial innovations
invariably create conditions of asymmetric information that can
lead to financial crises and panics. Also, financial innovations
that are not fundamentally diversifying, market completing, or
capital deepening will not survive to become mature financial market
products. He concludes that finance academics should spend more time
focusing on financial efficiencies and less time focusing on Wall
Street hype in order to better understand which financial
arrangements are beneficial to savers and borrowers, therefore
promoting economic growth.
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Regulating risk: A
Measured Response To The
Banking Crisis by David Halliday McIlroy, Journal of
Banking Regulation Vol. 9, 4 284–292
Bank
regulation must minimise the adverse consequences of banks taking
excessive risks. The author proposes three reforms: requiring banks
to retain a proportion of any loan that they originate, so as to
reduce the risks of moral hazard; insisting that the risks involved
in the financial products in which banks trade are transparent; and
reforming Basel II so that the amounts of regulatory capital that
banks are required to hold are less procyclical than is currently
the case.
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How Financial Engineering Can Advance
Corporate Strategy, by
Peter Tufano, Harvard Business Review, Jan/Feb96,
Inc
Financial engineering - the use of derivatives to manage risk and
create customized financial instruments - can advance a company's
strategic goals. It is true that when traders speculate and their
bets backfire, companies lose millions and executives lose their
jobs. Managers who seek to avoid disasters certainly must be
cautious. But that does not imply that financial engineering should
not be used by nonfinancial companies to advance core business
goals. Many leading organizations have used financial engineering
to solve classic and vexing business problems. These are not narrow
finance problems but rather broad strategic problems in marketing,
production, human resources, investor relations, and strategic
restructuring - for which advanced financial techniques have offered
new solutions. This article presents five case studies that
illustrate innovative applications of financial engineering and
offers managers guidance for determining when such techniques are
appropriate.
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